Introduction

• What do these projects have in common? All of them entail a

commitment of capital and managerial effort that may or may
not be justified by later performance.
• A common set of tools can be applied to assess these
seemingly very different propositions.
• The financial analysis used to assess such projects is known
as “capital budgeting.”
• How should a limited supply of capital and managerial talent
be allocated among an unlimited number of possible projects
and corporate initiatives?

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 Capital Budget
• Capital budget is the budget of capital expenditures.
• Capital Expenditures are those expenditures whose
benefit spread in number of years e.g., purchase of Plant
and Machinery , Land and building and starting a new
factory plant etc.
• Capital budgeting: is the planning process for allocating all
expenditures that will have an expected benefit to the firm
for more than one year.
 Capital Budgeting
• Capital budgeting is the process of identifying, evaluating, planning,
and financing an organization’s major investment projects.
• Decisions to expand production facilities, acquire new production
machinery, buy a new computer, or remodel the office building are all
examples of capital-expenditure decisions.
• Capital-budgeting decisions made now determine to a large degree
how successful an organization will be in achieving its goals and
objectives in the years ahead.
• Capital budgeting plays an important role in the long-range success of
many organizations because of several characteristics that
differentiate it from most other elements of the master budget.

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 BASIC FEATURES OF CAPITAL BUDGETING

 Capital budgeting decisions have long-term implications.

 These decisions involve substantial commitment of funds.
 These decisions are irreversible and require analysis of minute
details.
 These decisions determine and affect the future growth of the firm.

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 Capital Budgeting
• Capital budgeting projects require relatively large commitments
of resources. Major projects, such as plant expansion or
equipment replacement, may involve resource outlays in excess
of annual net income.
• Relatively insignificant purchases are not treated as capital
budgeting projects even if the items purchased have long lives.
For example, the purchase of 100 calculators at $15 each for use
in the office would be treated as a period expense by most firms,
even though the calculators may have a useful life of several
years.
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 Capital Budgeting
• Most capital expenditure decisions are long-term
commitments.
• The projects last more than 1 year, with many extending over
5, 10, or even 20 years.
• The longer the life of the project, the more difficult it is to
predict revenues, expenses, and cost savings.
• Capital-budgeting decisions are long-term policy decisions and
should reflect clearly an organization’s policies on growth,
marketing, industry share, social responsibility, and other
goals

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 Investment Appraisal
Firms normally place projects in the following categories:
• Replacement and maintenance of old or damaged
equipment.
• Investments to upgrade or replace existing equipment
• Marketing investments to expand product lines or
distribution facilities.
• Investments for complying with government
 OVERALL AIM
• To maximise shareholders wealth..
• Projects should give a return over and above the marginal
weighted average cost of capital.

Projects can be;

• Mutually exclusive
• Independent
 IDEAL SELECTION METHOD
• Select the project that maximises shareholders wealth

• Consider all cash flows

• Discount the cash flows at the appropriate market

determined opportunity cost of capital
 Need for Investment Appraisal
• Large amount of resources are involved and wrong
decisions could be costly
• Difficult and expensive to reverse
• Investment decisions can have a direct impact on the
ability of the organisation to meet its objectives
 Investment Appraisal Process
Stages:
• Identify objectives. What is it? Within the corporate objectives?
• Identify alternatives.
• Collect and analyse data. Examine the technical and economic
feasibility of the project, cash flows etc.
• decide which one to undertake
• authorisation and implementation
• review and monitor: learn from its experience and try to improve
future decision – making.
 Capital Budgeting - Methods
1. Accounting Rate of return

2. Payback period

3. Net Present Value

4. Internal Rate of Return

 DECISION CRITERIA
TECHNIQUES OF EVALUATION

Traditional or Time-adjusted or
Non-discounting Discounted cash flows

1. Payback period 1. Net Present Value

2. Accounting Rate of 2. Profitability Index
Return 3. Internal Rate of Return
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 Accounting Rate of Return (ARR)

Accounting Rate of Return method relates average annual profit to either the amount
initially invested or the average investment, as a percentage.
Formulae:
ARR = Average annual accounting profit x 100
Average investment
Where:
 Average annual profit = Total profit/Number of years
 Average investment = (initial capital investment + scrap value) / 2
Accounting Rate of Return (ARR)

ARR = Avg. Net Income Per Year

Avg. Investment
 Average Return on Investment

Example:
Year Net Income Cost
1 6,000 100,000 Initial
2 8,000 0 Salvage Value
3 11,000
4 13,000
5 16,000
6 18,000
 Average Return on Investment

Avg. Net Income 72,000 = 12,000

6 1. Average Net Income =
Total Net Income / No of Years
2. Average Investment=
Avg. Investment 100,000 = 50,000 [Initial Capital Investment+ Salvage (Scrap)
value]/2
2
ARR= Average Net Income/ Average
Investment
AROI 12,000 = 24%
50,000
 Average Return on Investment : Advantages
1. It is very easy to calculate and simple to understand like pay
back period. It considers the total profits or savings over the
entire period of economic life of the project.
2. This method recognizes the concept of net earnings i.e.
earnings after tax and depreciation. This is a vital factor in the
appraisal of a investment proposal.
3. This method facilitates the comparison of new product
project with that of cost reducing project or other projects of
competitive nature.
4. This method gives a clear picture of the profitability of a
project.
 Advantages

5. This method alone considers the accounting concept of profit for

calculating rate of return. Moreover, the accounting profit can be
readily calculated from the accounting records.
6. This method satisfies the interest of the owners since they are
much interested in return on investment.
7. This method is useful to measure current performance of the firm.
8. Eliminates Outlying Statistics : As it relies on averages, the average
rate of return method eliminates outlying statistics in sets of data.
 Average Return on Investment : Disadvantages

1. The results are different if one calculates ROI and others

calculate ARR. It creates problem in making decisions.
2. This method ignores time factor. The primary weakness of the
average return method of selecting alternative uses of funds is
that the time value of funds is ignored.
3. A fair rate of return can not be determined on the basis of
ARR. It is the discretion of the management.
4. This method does not consider the external factors which are
also affecting the profitability of the project.
5. It does not taken into the consideration of cash inflows which
are more important than the accounting profits.
Average Return on Investment : Disadvantages
6 It ignores the period in which the profits are earned as a 20% rate of return in 10 years may be
considered to be better than 18% rate of return for 6 years. This is not proper because longer the
term of the project, greater is the risk involved.
7. This method cannot be applied in a situation when investment in a project to be made in parts.
8. This method does not consider the life period of the various investments. But average earnings is
calculated by taking life period of the investment. As a result, average investment or initial
investment may remain the same whether investment has a life period of 4 years or 6 years.
9. It is not useful to evaluate the projects where investment is made in two or more installments
at different times.
 Proposed Project

 Bibba is evaluating a new project for her firm, Bibba

Bakery (BB).
 She has determined that the after-tax cash flows for the
project will be $10,000; $12,000; $15,000; $10,000; and
$7,000, respectively, for each of the Years 1 through 5.
The initial cash outlay will be $40,000.

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 TRADITIONAL OR NON-DISCOUNTING
TECHNIQUES

I . PAYBACK PERIOD:
# The payback period is defined as “the number of years
required for the proposal’s cumulative cash inflows to be equal to its
cash outflows.”
# The payback period is the length of time required to
recover the initial cost of the project.
# The payback period may be suitable if the firm has
limited funds available and has no ability or willingness to raise
additional funds. 23
 Payback Period (PBP)
-40 K 10 K 12 K 15 K 10 K 7K

0 1 2 3 4 5

PBP is the period of time required for the

cumulative expected cash flows from an investment
project to equal the initial cash outflow.
 Payback Solution (#1)

0 1 2 3 (a) 4 5

-40 K (b) 10 K 12 K 15 K 10 K(d) 7K

10 K 22 K 37 K (c) 47 K 54 K

Cumulative PBP = a + (b - c ) / d= 3 + (40 - 37) /10

Inflows
= 3 + (3) / 10 = 3.3 Years
 Payback Solution (#2)
0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7K
-40 K -30 K -18 K -3 K 7K 14 K

PBP = 3 + ( 3K ) / 10K = 3.3 Years

Cumulative Note: Take absolute value of last negative cumulative
Cash Flows cash flow value.
 PBP Acceptance Criterion
The management of Basket Wonders has set a maximum
PBP of 3.5 years for projects of this type.
Should this project be accepted?

Yes! The firm will receive back the initial cash outlay in less
than 3.5 years. [3.3 Years < 3.5 Year Max.]
 PBP Strengths
and Weaknesses
Strengths: Weaknesses:
– Easy to use and – Does not account for
understand TVM
– Can be used as a measure of – Does not consider cash
liquidity flows beyond the PBP
– Easier to forecast ST than LT – Cutoff period is
flows subjective
 Internal Rate of Return (IRR)
IRR is the discount rate that equates the present value of the future net cash flows
from an investment project with the project’s initial cash outflow.
The discount rate also refers to the interest rate used in discounted cash flow
(DCF) analysis to determine the present value of future cash flows .

CF1 CF2 CFn

ICO = + +...+
(1+IRR) 1
(1+IRR) 2
(1+IRR)n
 IRR Solution (Try 10%)

$40,000 = $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) +

$10,000(PVIF10%,4) + $ 7,000(PVIF10%,5)
$40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) +
$10,000(.683) + $ 7,000(.621)
$40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347
= $41,444
[Rate is too low!!]
 IRR Solution (Try 15%)

$40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) +

$15,000(PVIF15%,3) + $10,000(PVIF15%,4) +$ 7,000(PVIF15%,5)
$40,000 = $10,000(.870) + $12,000(.756) +
$15,000(.658) + $10,000(.572) + $ 7,000(.497)
$40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479= $36,841
[Rate is too high!!]
Capital Budgeting
1 40000 10000 1.1 9091 1.2 8696
2 12000 1.2 9917 1.3 9074
3 15000 1.3 11270 1.5 9863
4 10000 1.5 6830 1.7 5718
5 7000 1.6 4346 2 3480
41455 36830

IRR has to be increased IRR has to be lowered

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 IRR Solution (Interpolate)

.10 $41,454
.05 IRR $40,000 $4,625
X $1,454
.15 $36,830

X=
($1,454)(0.05)
$4,625
X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

 IRR Acceptance Criterion
The management of Basket Wonders has determined that
the hurdle rate is 13% for projects of this type.
Should this project be accepted?

No! The firm will receive 11.57% for each dollar invested in
this project at a cost of 13%. [ IRR < Hurdle Rate ]
 IRR Solution

$40,000 = $10,000 $12,000

+ +
(1+IRR)1 (1+IRR)2
$15,000 $10,000 $7,000
+ + 5
(1+IRR)3 (1+IRR)4 (1+IRR)

Find the interest rate (IRR) that causes the discounted cash flows to
equal $40,000.
 Net Present Value (NPV)

• (NPV) is the difference between the setup cost of a project

and the value of the project once it is set up.
• If that difference is positive, then the NPV is positive and the
project creates wealth.
• If a firm must choose from several proposed projects, the
one with the highest NPV will create the most wealth, and
so it should be the one adopted.

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 NET PRESENT VALUE (NPV) METHOD:
• The NPV of an investment proposal may be defined as the sum
of the present values of all the cash inflows less the sum of
present values of all the cash outflows associated with the
proposal.
• The decision rule is “ Accept the proposal if its NPV is
positive and reject the proposal if the NPV is negative”.

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 Net Present Value
• For example, suppose the car company can either build the new
plant or, alternatively, can introduce a new product— a mid
segment car.
• There is not enough managerial talent to oversee more than
one new project, or maybe there are not enough funds to start
both.
• Let us assume that both projects create wealth:
• The NPV of the new plant is $1 million, and the NPV of the new-
product project is $500,000.
• If it could, the car company should undertake both projects; but
since it has to choose, building the new plant would be the right
PROFITABILITY INDEX METHOD:
This technique is a variant of the NPV technique and is also known as
BENEFIT - COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows

PI = Total present value of cash outflows.

Accept the project if its PI is more than 1 and reject the proposal
if the PI is less than 1.

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CAPITAL BUDGETING PRACTICES IN INDIA

• Capital budgeting decisions are undertaken at the top management level and are planned in
advance.
• Discounted cash flow techniques are more popular now.
• High growth firms use IRR more frequently whereas Payback period is more widely used
by small firms.
• PI technique is used more by public sector units than by private sector units.
Capital budgeting decisions are of paramount importance as they affect the profitability of
a firm, and are the major determinants of its efficiency and competing power.

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 ADVANTAGES AND DISADVANTAGES OF IRR AND NPV

• A number of surveys have shown that, in practice, the IRR method is

more popular than the NPV approach.
• The reason may be that the IRR is straightforward, but it uses cash flows
and recognizes the time value of money, like the NPV.
• In other words, while the IRR method is easy and understandable, it
does not have the drawbacks of the ARR and the payback period, both of
which ignore the time value of money.
•

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 ADVANTAGES AND DISADVANTAGES OF IRR AND NPV
• The main problem with the IRR method is that it often gives
unrealistic rates of return.
• Suppose the cutoff rate is 11% and the IRR is calculated as 40%. Does
this mean that the management should immediately accept the
project because its IRR is 40%.
• The answer is no! An IRR of 40% assumes that a firm has the
opportunity to reinvest future cash flows at 40%. If past experience
and the economy indicate that 40% is an unrealistic rate for future
reinvestments, an IRR of 40% is suspect.

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 WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT
PROJECTS
• When comparing two projects, the use of the NPV and the IRR methods
may give different results. A project selected according to the NPV may
be rejected if the IRR method is used.
• Suppose there are two alternative projects, X and Y. The initial
investment in each project is $2,500. Project X will provide annual cash
flows of $500 for the next 10 years. Project Y has annual cash flows of
$100, $200, $300, $400, $500, $600, $700, $800, $900, and $1,000 in the
same period.

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WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT
PROJECTS

• Using the trial and error method you find that the IRR of Project X is
17% and the IRR of Project Y is around 13%.
• If you use the IRR, Project X should be preferred because its IRR is 4%
more than the IRR of Project Y.
• But what happens to your decision if the NPV method is used?
• The answer is that the decision will change depending on the discount
rate you use.

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WHY THE NPV AND IRR SOMETIMES SELECT DIFFERENT
PROJECTS

• For instance, at a 5% discount rate, Project Y has a higher NPV than

X does. But at a discount rate of 8%, Project X is preferred because
of a higher NPV.
• The purpose of this numerical example is to illustrate an important
distinction: The use of the IRR always leads to the selection of the
same project, whereas project selection using the NPV method
depends on the discount rate chosen.

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