# Capital Budgeting

**Meaning of Capital Budgeting
**

Capital Budgeting is the process of making investment decisions in capital expenditure. A Capital expenditure is defined as an expenditure the benefits of which are expected to be received over period of time exceeding one year. In other words Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the goal of shareholders wealth maximization.

**Features of Capital Budgeting
**

1. Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future; 2. The future benefits are expected to be realized over a series of years; 3. The funds are invested in non-flexible and long term activities; non4. They have a long term and significant effect on the profitability of the concern; 5. They involve generally huge funds; 6. They are irreversible decisions.

The firm select the combinations of proposals that will yield the greatest profitability by ranking them in the descending order of their profitability.
3. CAPITAL RATIONING DECISIONS = A firm may have several profitable investments proposals but only limited funds to invest.
ACCEPT REJECT DECISIONS = Accept-reject decisions relate to Acceptindependent projects which do not compete with one another.
. MUTUALLY EXCLUSIVE PROJECT DECISIONS = Such decisions relate to proposals which compete with one another in such a way that acceptance of one automatically excludes the acceptance of the other. Thus. If the proposal is accepted the firm makes investment in it. Such decisions are generally taken on the basis of minimum return on investment. In such case these various investments proposals compete for limited funds and thus firm has to ration them. All those proposals which yield a rate of return higher than the minimum required rate of return higher than the minimum required rate of return or the cost of capital are accepted and the rest are rejected.
2. one of the proposals is selected at the cost of the other.Kinds of Capital Budgeting
1. and if it is rejected the firm does not invest in the same.

Pay(2.) Rate of return Method or Accounting Method.) Pay-back period Method or Payout or Pay off method.Methods of Capital Budgeting
(A. (5.) Internal rate of return.) Improvement of traditional approach to pay-back period payMethod.) Profitability index Method.) TRADITIONAL METHODS (1.) TIME ADJUSTED METHOD OR DISCOUNTED METHODS (4.
. (3. (6.) Net Present Value Method. (B.

20000 for 8 years. This method tells us about how many years will it take for the cash benefits to pay the original cost of an investment. There are two ways of calculating the payback period which are as follows:follows:Ist Method Payback period = Cash outlay of the project Annual cash inflow EXAMPLE :. This method is based on the principle that every capital expenditure pays itself .A project cost Rs. Pay-back period Method PayThe payback sometimes called as payout or payoff period method represents the period in which the total investment in permanent assets payback itself.100000 and yields an annual cash inflow :of Rs. Payback period = 100000 = 5 years 20000
.1. This method is based on the principle that every capital expenditure pays itself back within a certain period out of the additional earnings generated from the capital assets.

)In this method.3000& Rs.)It saves cost. 2.)It is simple to understand and easy to calculate.Rs. EXAMPLE :. it requires lesser time and labour as compared to other methods of capital budgeting. 3. it reduces the loss though obsolescence and is more suited to the developing countries.
.IInd Method
When projects cash flows are not uniform but vary from year to year . MERITS OF PAYBACK PERIOD 1. it is adopted if it payback for itself within a period specified by management and if project does not payback itself within the period specified by management then it is rejected.2000. 4. like INDIA.10000 and generate Cash inflow of :Rs. Payback period = 9000 + 1000 2000 = 3 years and 6 months ACCEPTACCEPT-REJECT CRITERION = In case of evaluation of a single project.Cash outlay of Rs.2000 for 4 years.)Due to its short term approach this period is particularly suited to a firm which has a shortage of cash or whose liquidity position is not particularly good. as a a project with a shorter pay back period is preferred to the one having a longer pay back period .4000. which are in the process of development and have quick obsolescence. Rs.

.)It may be difficult to determine the minimum acceptable pay back period it is usually a subjective decision.)It ignores the life of the project.Demerits of pay-back period pay1. 3.) It does not takes into consideration the cash flows which are most important than the accounting profits.)It does not takes into account the cash inflows earned after pay back period and hence true profitability of the project cannot be assessed 2. 5. 4.)This method ignores time value of money.

PaySol:. Post Pay-back Profitability Index = Post Pay-back Profits * 100 PayPayInvestment EXAMPLE :.000 Estimated Life 8years Sol:. These returns are called post back profits.50.10.Initial Outlay :Rs.000 Annual Cash Inflow (after tax but before depreciation) Rs. Hence an improvement over this method can be made by taking into account the return receivable beyond payback period.Pay-back period = Investment Annual Cash Inflow = 50000 10000
.) POST PAY-BACK PROFITABILITY METHOD = One of the serious PAYlimitations of pay back period method is that it does not takes into account the cash inflow earned after pay back period and hence true profitability cannot be assessed.2. Improvement in Traditional Approach to Pay-back Period PayMethod
(A.

Post Pay-back Profitability=Annual Cash Inflow (Estimated life±pay-back PayProfitability=Annual life±payperiod)
= 10000 (8-5) (8= Rs.) Equal cash inflows are generated every year.) PAY-BACK RECIPROCAL METHOD = Sometimes payback reciprocal method is employed PAYto estimate the IRR generated by a project. paypay-back reciprocal = Annual Cash Inflow Total Investment However.
.30000 Post Pay-back Profitability Index = 30000 * 100 Pay50000 = 60% (B. (ii) The project under consideration has a long life which must be at least twice the pay-back payperiod. this method should be used only when the following two conditions are satisfied : (i.

The time period at which the cumulated p.2.) DISCOUNTED PAY-BACK METHOD = The p. EXAMPLE :. (D.6.) POST PAY-BACK PERIOD METHOD = It is also known as surplus life over PAY-
pay back method.00. The project which gives a shorter discounted pay back period is accepted.000 Life of the Project 5 years Annual Cash Inflow Rs.(C. The method can be employed successful where the various project under consideration do not differ significantly as to their size and the expected cash inflows are even throughout life the project. According to this method the project which give the post pay back period may be accepted.v of all inflows are cumulated in order of time.v of all cash outflows and PAYinflows are computed at an appropriate discount rate The p.000 Cut off rate 10%
.v of cash outflows is known discounted payback period.Calculate discounted Pay-back period from the information :Paygiven below : Cost of Project Rs.v of cash inflows equals the p.00.

V. 2. 1. 4.YEARS
INFLOWS
P. 1.36.200 1.000
.751 .00.V.65.200
Rs. 3.000 2.97.00.621
Rs.47.58.24.00.00.683 .
Rs.000 4.81.0000 2.800 3.V.000 .000 2.600 1.
CUMULATIVE P.200 6.826 . 5. 2.800 7.00.50.33.81.800 1. AT 10 DIS FACTOR
P.200 1.909 .000 2. 1.

The expected return is determined and the project which has a higher rate of return than the minimum rate specified by the firm called the cut off rate. The return on investment method can be used in several ways as follows : (A.75 years
3. It is known as Accounting Rate of Return method for the reason that under this method.600 = 3. of years of profits or Average Annual Profits*100 Net Investment in the project
.) AVERAGE RATE OF RETURN METHOD = Under this method average profits after tax and depreciation is calculated and then it is divided by the total capital investment in the project. is accepted and the one which gives a lower expected rate of return than the minimum rate is rejected.Discounted pay-back period = 3 years + 1.02. various projects are ranked in order of the rate of earnings or rate of return. This method can also be used to make decision as to accepting or rejecting a proposal.800 pay1. According to this method.& taxes )*100 Net Investment in the project * no.Rate of return Method This method takes into account the earnings expected from the investment over their whole life .36. Average Rate of Return = Total Profits (after dep. The project with the higher rate of return is selected as compared to the one with lower rate of return.

It is expected to yield profits after depreciation and taxes during the 5 years amounting to Rs.60.20.5.000 .00.) RETURN ON AVERAGE INVESTMENT METHOD = In this method the return on average investment is calculated .000 5 Net Investment in the Project = Rs.48.5.000 after 5 years.000.000 . Rs.Rs.70.000 .000 and Rs.000(scrap value) Rs.5.00.000= Rs.40.4.000-20.A Project requires an Investment of Rs.40.000 = 10% (B.
.80.00.20.80.40000+60000+70000+50000+20000 =Rs.50.Total Profit = Rs. Using of average investment is preferred because the original investment is recovered over the life of the asset on account of depreciation charges.EXAMPLE :. calculate the Average Rate of Return Sol :.000 and has a scrap :value of Rs. Rs.40.000 *100 4.000 Average Rate of Return = 48.2.000 = Rs.000 :Average Profits = 2.

80.000*100 :4.Return on Average Investment = Total profit after depreciation and taxes *100 Total Net Investment 2 EXAMPLE :.80.40.000 2 = 100% (D.) AVERAGE RETURN ON AVERAGE INVESTMENT = It is calculated by the following formula ::Average Return on Average Investment = Average Annual Profit *100 Net Investment 2 = 48.2.000 *100 4.000 2
.

5 years may be considered to better than 18% rate of return for 12 years.
. Demerits of Rate of Return Method This method also like pay-back period method ignores the time value of paymoney as the profits earned at different points of time are given equal weight by averaging the profits.
3. The method can not be applied to a situation where investment in a project is to be made in parts. 2.1.
2. It ignores the period in which the profits are earned as a 20% rate of return in 2.
3. payAs this method is based upon accounting concept of profits . greater is the risk involved.
4.
Merits of Rate of Return Method It is very simple to understand and easy to operate. it can be readily calculated from the financial data. It does not take into consideration the cash flows which are more important than the accounting profits. This is not proper because longer the term of the project.
1. It uses the entire earnings of a project in calculating rate of return and not only the earnings upto pay-back period and hence gives a better view payof profitability as compared to pay-back period method.

A3. It recognizes the fact that a rupee earned today is worth more than the same rupee earned tomorrow.«.) Time-Adjusted or Discounted TimeCash Flow Method
Net Present Value Method
The NPV method is a modern method of evaluating investment proposals. This method takes into consideration the time value of money and attempts to calculate the return on investments by introducing the factor of time element. A1..An = Future net cash flows 1.2. PV = 1 (1+r)n Here..«.(B. The NPV of all inflows and outflows of cash occurring during the entire life of the project is determined separately for each year by discounting these flows by the firm µs cost of capital or a pre-determined prerate..3.A2.. PV = Present value r = rate of interest n = number of years The PV for all the cash inflows for a number of years is thus found as follows : PV = A1 + A2 + A3 +««+ An (1+r) (1+r)1 (1+r)2 (1+r)n Here.n = numbers of years
.

227 Present Value of all cash inflows 24.683 2.000 .000 2.000 NPV 4.000 Rs. Rs.000 Rs.000 3. 2.751 7. Rs. 10.000 . Rs.826 8. 1.000 .000 2.(scrap value) 1.260 3.EXAMPLE ::Calculate the NPV of the two Projects and suggest which of the two projects should be accepted assuming a discount rate of 10%.000 10. Rs.621 1.227
. Project x Project y Initial Investment Rs.000 .545 2.000 10.000 10.000 Project y 20.621 621 24.227 Less: PV of Initial Investment 20. 10.000 5.510 4.000 3.000 Sol:Sol:Year Cash Flows Present value of Rs1@10% PV of Net Cash Flows Rs. Rs.20.1.000 Estimated Life 5 years 5 years Scrap value Rs.909 4.242 5.000 . Rs.2000 The profits before depreciation and after taxes (cash flows) are as follows: Year1 Year2 Year3 Year4 Year5 Rs.000 . 5. 3.30.049 5. Project x 5.

1.000 4.242 34.000
Present value of Rs1@10% Rs. 10.909 .000 4. 5.621 .826 .755 2.000 3.683 .728
Present Value of all cash inflows Less: PV of Initial Investment NPV
We find that NPV of project y is higher than the NPV of project x and hence it is suggested that project y should be selected. 2. . 3.751 .260 3.000 2. 18.
.728 30.728 34.(scrap value) 2.621
PV of Net Cash Rs.000 5.180 8.049 1.Project y Year Cash Flows Flows Rs.000 5.242 1. 20.

Demerits of NPV .)It takes into account the earnings over the entire life of the project and the true profitability of the investment proposal can be evaluated.)In the same way as above it nay not give good results while comparing projects with unequal investment of funds.Merits of NPV 1. 2. 2. 3.)It is not easy to rank projects on the basis of this method particularly when the costs of the projects differ significantly. 5.)It takes into consideration the objective of maximum profitability. 3.)It recognizes time value of money and is suitable to be applied in a situation with uniform cash outflows and uneven cash inflows or cash flows at different periods of time.)It may not give good results while comparing projects with unequal lives as the project having higher NPV but realized in a longer life span may not be desirable as a project having something lesser NPV achieved in a much shorter span of life of the asset.)It is not easy to determine an appropriate discount rate.1. profitability.)As compared to the traditional methods.
. 4. the NPV is more difficult to understand and operate.

yield method and trial and error yield method. which equates the PV of cash inflows calculated to the amount of the investment or where NPV=Zero.IRR.5. discounted rate of return. discounted cash flow. It is also known time adjusted rate of return. Formula ::C = A1 + A2 + A3 +««+An (1+r) (1+r)2 (1+r)3 (1+r)n
.the cash flows of a project are discounted at a suitable rate by hit and trial method.) Internal Rate of Return
The internal rate of return is also a modern technique of capital budgeting that takes into account the time value of money.

50.500 cashcalculate the internal rate of return. i.e.000 Life of the asset 5 years Estimated Annual cash-flow Rs.Determination of Internal Rate of Return (A.500 = 4 Consulting Present value Annuity tables for 5years periods at Present value Factor of 4 IRR = 8% approx
.Initial outlay :Rs.000 12. Present value factor = Initial outlay Annual cash flow EXAMPLE :.) When the annual net cash flows are equal over the life of the asset : Firstly. find out present value factor by dividing initial outlay ( cost of investment ) by annual cash flow . Sol:Sol:Present value factor = 50..12.

000 3rd Year 30.000 Calculate IRR
. 1st Year 15. the IRR calculated by hit and trial and that is why this method is also known as hit and trial yield method. the IRR cannot be determined according to the technique suggested above.(B. In such cases. EXAMPLE :.000 Life of the asset 4 years Estimated Net Annual Cash Flows Rs.60.) When the annual net cash flows are equal over the life of the asset : In case annual cash flows are unequal over the life of the asset.000 2nd Year 20.000 4th Year 20.Initial Investment :Rs.

797
15.000 . Rs.F
P.420 59.V.285
.V.657
19.035
20.V.Sol:Sol:Year
Annual Cash flows Rs.
15. 2.V.520 .V.F
P.530 .000 .V.635 .380 .674
20.345
11. Rs.
P. Rs.826
16.595
11.F
P.000 .330 .592 63.F
P.345
12.751
22. Discount
rate 10%
12%
14%
15%
P.155 .380 .635 66.710
20.700 . Rs.840 .
P.
P.V.877
13.120
30.V.711
21. 4.220 .756
15.571 60. 3.892
13.660 .940 .683
13.909
13.000 .869
13.
1.769
15.

life and timings of cash flows. Demerits of IRR Method 1. 3.) It recognizes time value of money and is suitable to be applied in a situation with uniform cash outflows and uneven cash inflows or cash flows at different periods of time.
.) It takes into consideration the objective of maximum profitability and is considered to be a more reliable technique of capital budgeting.14% ) 595 + 715 = 14.)It is difficult to understand and most difficult method of evaluation of investment proposals.)This method is based upon the assumption that the earnings are reinvested at the IRR for renaming life of the project which is not a justified assumption particularly when average rate of return earned by the firm is not close to the IRR. 2.) It takes into considers maximum profitability of the project for its entire economic life and hence enables evaluation if true profitability.)It provides for uniform ranking of various proposals due to the percentage rate of return.IRR =
595 * ( 15% .45%
Merits of IRR Method 1. 2. 4.)The results of NPV method and IRR method may differ when the projects under evaluation differ in their size. 3.

. in such a manner that one with higher profitability index is ranked higher than the other with lower profitability index. Profitability Index Method Or Benefit Cost Ratio
It is also time adjusted method of evaluating the investment proposal . Profitability Index = Present Value of Cash Inflows Present value of Cash Outflows Or P.6.( net ) = NPV (Net Present Value) Initial Cash Outlay AcceptAccept-Reject Criterion = The proposal is accepted if the profitability index is more than one and is rejected in case the profitability index is less than one.I. It is called as benefit cost ratio or desirability factor is the relationship between present values of cash inflows and present values of cash outflows. = PV of cash inflows Initial cash outlay The profitability index may be found for net present values of inflows P. The various projects are ranked under this method in order of their profitability index.I.

)It may not give good results while comparing projects with unequal lives as the project having higher NPV but realized in a longer life span may not be desirable as a project having something lesser NPV achieved in a much shorter span of life of the asset.)It takes into consideration the objective of maximum profitability. 2.)It recognizes time value of money and is suitable to be applied in a situation with uniform cash outflows and uneven cash inflows or cash flows at different periods of time. 3. the NPV is more difficult to understand and operate.)It takes into account the earnings over the entire life of the project and the true profitability of the investment proposal can be evaluated. 3.Advantages of Profitability Index Method 1. 4. To evaluate such projects the P. Disadvantages of Profitability Index Method 1.)In the same way as above it nay not give good results while comparing projects with unequal investment of funds.) The NPV has major drawback that it is not easy to rank projects on the basis of this method particularly when the costs of the projects differ significantly.)It is not easy to determine an appropriate discount rate. 4.I is most suitable. 2.
.)As compared to the traditional methods.

909 18.180 2. 10.000 Net Present Value 6. Rs. Rs.10.175 Profitability Index (gross) = Present value of cash inflows Initial cash outlay = 56.:Year Cash Inflows Present value Factor Present value Rs. @10% Rs.775 4.000.50. 15.000
. 20. 1.25.826 12. 25.EXAMPLE ::The initial cash outlay of a project is Rs.175 = 1.000 .15.683 6.000 and Rs.20.000 .000 .000 and it generates cash inflows of Rs.1235 50.390 3.000 in 4 years.175 less: Initial Outlay 50.175 Total Present value 56.830 56.000.000 . sol.:sol. appraise profitability of the proposed investment assuming 10% rate of discount.751 18. Using present value index method.

P.175 = . Net Profitability Index = NPV Initial cash outlay = 6.I.
. is higher than 1.1235As the net profitability index is positive. N. the proposal can be accepted.As the P. the proposal can be accepted.000 Or.1235 1.1235 50.1235-1 = 0.V = 1.