MODULE 4

CAPITAL BUDGETING
CAPITAL BUDGETING

 Capital is the amount invested in operating assets that are used in the
production of goods or services
 Budgeting includes formulating plan of expected cash flows during the
future period
 Capital budgeting is a blue-print of planned investments in operating
assets
 Capital Budgeting is process of evaluating the profitability of projects
under consideration for implementation.
 It involves investment of current funds in anticipation of future cash
flows occurring at different future time intervals.
CAPITAL BUDGETING

Characteristics
1. A huge Investment is required.
2. Allocation of funds and commitment of funds
3. Irreversible of funds.
4. Long-term profitability

Process/ Steps followed in Capital Budgeting

1. Planning- Identifying Potential Investment Opportunity (Use SWOT Analysis)
2. Evaluation- Assembling of Proposals (Replacement, expansion, new product, obligatory/welfare
investments) Preparation of Capital Budget and appropriations
3. Selection-Decision Making
4. Implementation
5. Control
6. Performance Review
 CAPITAL BUDGETING TECHNIQUES

1. Traditional Methods (Non-Discounting Techniques)

1. Pay-back period Method
2. Accounting/Avg. Rate of Return
2. Modern Methods (Discounting Techniques)
1. Discounted Pay-back Period Method
2. Net Present Value Method
3. Profitability Index method
4. Internal Rate of Return Method
5. Terminal Value Method
 1. PAYBACK PERIOD METHOD

1. This method is the simplest and most widely used method.

2. Payback period is the time required to recover the initial investment.
3. A firm is always interested in knowing the amount of time required to recover
its investment.
4. It is based on the concept of cash flow and is a non-discounting technique.
PAYBACK PERIOD -
CALCULATION
1. When Cash inflows are even/equal
When cash inflow of all year is equal, we use the following formula
Payback Period = 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤
2. When Cash inflows are even/equal
When cash inflows of each year is different we use the formula below
Payback Period = E + 𝐵
𝐶
Where,
E = Year immediately Preceding to year of recovery
B = Amount left to be recovered
C = Cash inflow during the year of final recovery
Note: Before using these values we must find cumulative cash inflows
PAYBACK PERIOD: MERITS &
DEMERITS
Merits
1. Simple concept and in application
2. Emphasis on recovery of capital invested
3. It’s best method for project with high uncertainty.
4. It could be used to rank the mutually exclusive projects
5. Firms with shortage of fund, this method is preferred as this method measures
liquidity of the project.

Demerits
1. Ignores time value of money
2. It doesn’t measure profitability of the project.
PROBLEM 1

The following details in Table below, are in respect of the cash flows of two projects A & B.

Year Project A - Cash inflow Project B - Cash Flow

0 (400,000) (500,000)
1 200,000 100,000
2 175,000 200,000
3 25,000 300,000
4 200,000 400,000
5 150,000 200,000

Find out the cumulative cash flows of each project and determine how many years it would take to
recover initial cash outlays of both projects. Which project should you choose based on the PBP method?
SOLUTION

Cash flows and Cumulative Cash flows of Project A and Project B

Year Project A Project B

Cash inflow Cumulative Cash Cash Flow Cumulative Cash
Flows Flow
1 200,000 200,000 100,000 100,000
2 175,000 375,000 200,000 300,000
3 25,000 400,000 300,000 600,000
4 200,000 600,000 400,000 10,00,000
5 150,000 750,000 200,000 12,00,000
SOLUTION
From Cumulative Cash Flow Project recovers the initial investment of 400K at the end of 3rd year.

Project B recovers Initial investment between 2nd and 3rd Year.

𝐵
∴ 𝑃𝐵𝑃 = 𝐸 +
𝐶
= 2 + 500K−300K
300𝐾
= 2.67 Years
PROBLEM 2

The following details in Table below, are in respect of the cash flows of two projects A & B.

Year Project A - Cash inflow Project B - Cash Flow

0 (400,000) (500,000)
1 200,000 100,000
2 100,000 300,000
3 30,000 25,000
4 100,000 25,000
5 150,000 70,000

Find out the cumulative cash flows of each project and determine how many years it would take to
recover initial cash outlays of both projects. Which project should you choose based on the PBP method?
2. AVERAGE RATE OF RETURN

ARR measures the profitability of the investment (projects) using the information taken
from financial statements.

Decision Criteria = Better ARR giving Project should be chosen

𝐴𝑣𝑒𝑟𝑎𝑔𝑒
𝐼𝑛𝑐𝑜𝑚𝑒
Average Rate of Return (ARR) =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑜𝑠𝑡 𝑡𝑎𝑥−𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑃𝑟𝑜𝑓𝑖𝑡
ARR =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Average Investment = 𝐵𝑉 𝑜 𝑓 𝐼𝑛𝑣𝑡.𝑖𝑛 𝑡ℎ𝑒 𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔+𝐵𝑉 𝑜 𝑓 𝐼𝑛𝑣𝑡. 𝑎𝑡 𝑡ℎ𝑒 𝑒𝑛𝑑

2
AVERAGE RATE OF RETURN
Merits
 Based on Accounting Information
 Simple to understand
 Considers the profits of entire economic life of the project.
Demerits
 Based on accounting income not on cash flow as the cash flow approach is considered to be
superior
 Does not account time value of money
 Denominator calculation is arguably confusing with too many alternatives.
ARR: PROBLEM

Particulars Project A Project B

Cost 40,000 60,000
Estimated Life 5 5
Salvage Value 3000 3000

Estimated Income (Profit After Tax)

Year Project A Project B
1 3000 10000
2 4000 8000
3 7000 2000
4 6000 6000
5 8000 5000
Total 28,000 31,000
SOLUTION

Average Post-tax Profit  Project A: 5600

Project B: 6200

Average Investment  Project A: 21500

Project B: 31500

ARR  Project A = 5600/21500 = 0.26

Project B = 6200/31500 = 0.197
3. DISCOUNTED PAYBACK PERIOD
 Similar to Payback period, it’s years required to recover the initial cash outlay on the
present value basis – Discounted PBP.
 Discounted PBP will be higher than normal PBP as it’s calculated based on present value.
3. DISCOUNTED PAYBACK PERIOD

 Similar to Payback period, it’s years required to recover the

initial cash outlay on the present value basis – Discounted
PBP.
 Discounted PBP will be higher than normal PBP as it’s
calculated based on present value.
DISCOUNTED PAYBACK - PROBLEM

Discounted Cash flows and Cumulative Cash flows of Project A

Year Project A
Cash inflow PV Factor at 10% PV of Cash Flows Cumulative Cash PBP = E + B/C
(a) (b) (a)*(b) Flows (Discounted)
0 (400000) 1 (400,000) - = 3 + 54,875/136600
1 200,000 0.909 181800 181800 = 3 + 0.401
= 3.40 Years
2 175,000 0.826 144550 326350
3 25,000 0.751 18775 345125
4 200,000 0.683 136600 481725
5 150,000 0.621 93150 574875
NET PRESENT VALUE
•  It recognised the time value of money
•  It argues that cash flows occurring at different time intervals has different value
•  It’s the widely used DCF method in real-world project appraisal/capital budgeting

• Decision Criteria
•  NPV > 0 = Accept
•  NPV < 0 = Reject
NET PRESENT VALUE
𝑪𝑭𝟎 𝑪𝑭𝟏 𝑪𝑭𝒏
𝑵𝑷𝑽 = + + ⋯+
(𝟏 + 𝒌) 𝟎 (𝟏 + 𝒌) 𝟏 (𝟏 + 𝒌)𝒏
𝑪𝑭𝒊
NPV = 𝒕=𝟎 (𝟏+𝒌)𝒕
σ𝒏

NPV = Net Present Value

CF = Cash flow occurring at the end of year t (t=1,2,…n)
n = life of Project
K = discount rate
 NPV: PROBLEM
Year Project A
Cash inflow PV Factor at PV of Cash Flows (a)*(b)
(a) 10% NPV = (25,000) + 30902
(b) = 5,902

0 (25,000) 1
Project is giving positive NPV. Thus,
1 10,000 0.909 9,090
decision must be based on better
2 8,000 0.826 6,608 positive NPV

3 9,000 0.751 6,759

4 6,000 0.683 4,098

5 7,000 0.621 4,347

Total 30902