CAPITAL BUDGETING

 Capital budgeting is a company’s formal process used for

evaluating potential expenditures or investments that are
significant in amount.

 It involves the decision to invest the current funds for

addition, disposition, modification or replacement of fixed
assets. The large expenditures include the purchase of fixed
assets like land and building, new equipments, rebuilding or
replacing existing equipments, research and development,
etc.
FEATURES
 1) It involves high risk
 2) Large profits are estimated
 3) Long time period between the initial
investments and estimated returns
PROCESS
• Project identification and generation

• Project Screening and Evaluation

• Project Selection

• Implementation

• Performance review
FACTORS AFFECTING CAPITAL
BUDGETING
• Availability of Funds • Working Capital

• Structure of Capital • Capital Return

• Management decisions • Need of the project

• Accounting methods • Government policy

• Taxation policy • Earnings

• Lending terms of financial

• Economic value of the project
institutions
CAPITAL BUDGETING
DECISIONS:
 The crux of capital budgeting is profit
maximization. There are two ways to it;
either increase the revenues or reduce the
costs.
DECISIONS
Accept /
Reject
decision

Mutually
exclusive
project
decision

Capital
rationing
decision
TECHNIQUES USED IN CAPITAL
BUDGETING

 Payback period
 Accounting Rate of Return method
 Net present value method
 Internal Rate of Return Method
 Profitability index
PAYBACK PERIOD METHOD
 The payback (or payout) period is one of the most popular
traditional methods of evaluating investment proposals, it
is defined as the number of years required to recover the
original cash outlay invested in a project, if the project
generates constant annual cash inflows, the payback
period can be computed dividing cash outlay by the annual
cash inflow.
 Payback period = Cash outlay (investment) / Annual
cash inflow = C / A
ACCOUNTING RATE OF RETURN
METHOD
 The Accounting rate of return (ARR) method uses
accounting information, as revealed by financial
statements, to measure the profitabilities of the
investment proposals. The accounting rate of return is
found out by dividing the average income after taxes by
the average investment.

 ARR= Average income/Average Investment

 NET PRESENT VALUE METHOD:
 The net present value (NPV) method is a process of
calculating the present value of cash flows (inflows and
outflows) of an investment proposal, using the cost of
capital as the appropriate discounting rate, and finding
out the net profit value, by subtracting the present value
of cash outflows from the present value of cash inflows.
 The equation for the net present value, assuming that all
cash outflows are made in the initial year (tg), will be:
INTERNAL RATE OF RETURN METHOD:
 The internal rate of return (IRR) equates the present value
cash inflows with the present value of cash outflows of an
investment. It is called internal rate because it depends
solely on the outlay and proceeds associated with the
project and not any rate determined outside the
investment.
PROFITABILITY INDEX:

 It is the ratio of the present value of future cash benefits,

at the required rate of return to the initial cash outflow of
the investment. The formula to calculate profitability
index (PI) or benefit cost (BC) ratio is as follows.
 PI = PV cash inflows/Initial cash outlay A,
PAY BACK PERIOD METHOD

 A company has 2 investment proposals of Rs.

5,00,000 each. The CFAT ( Cash Flow After Tax)
from both the investments are given.
 Use Pay Back Period Method to find the better
investment option.
PAY BACK PERIOD METHOD

YEAR INVESTMENT 1 INVESTMENT 2

CFAT Cumulative CFAT Cumulative
CFAT CFAT

1 1,00,000 1,00,000 2,25,000

2 1,25,000 2,25,000 2,00,000 4,25,000

3 1,50,000 3,75,000 1,75,000 6,00,000

4 1,75,000 5,50,000 1,50,000

5 2,00,000 7,50,000 1,25,000

6 2,25,000 9,75,000 1,00,000

BETTER ?
 Investment 1  Investment 2
PBP between 3rd and 4th PBP between 2nd and 3rd
year. year.
In 4th yr
1,75,000 --- 12 months
1,25,000 ---- ?

PBP =? PBP =?
PAY BACK PERIOD QUESTION 2
AUTOMATIC MACHINE ORDINARY MACHINE
Investment 2,24,000 60,000
Life 5 yrs 8 yrs
tax 50% 50%
ANNUAL SALES 1,50,000 1,50,000
ANNUAL COST
a. Material cost 50,000 50,000
b. Labour cost 12,000 60,000
c. Overheads 24,000 20,000
Total cost
EBDT ( sales-TC)
DEPRECIATION
EBT ( EBDT-depr)
TAX ( 50 % )
EAT ( EBT – tax )
CFAT ( EAT+ Depr )
PBP =
ACCOUNTING RATE OF RETURN
METHOD
 ARR = Average Annual EAT/Average
Investment x 100

 Average Annual EAT = Total EAT/ No. of

years
 Average Investment =
 = O.I /2
 = (O.I – Scrap Value) / 2 + S.V
 = (O.I – Scrap Value) / 2 + S.V + W.C
ARR?
TWO PROJECTS S & R NEEDS AN INVESTMENT OF 2,00,000 EACH.
Year PROJECT S (EAT) PROJECT R (EAT)
1 80,000 20,000
2 80,000 40,000
3 40,000 40,000
4 20,000 40,000
5 - 60,000
6 - 60,000
Tot. EAT =
Avg EAT =
Avg Investment =
ARR = ? ?
Better ?
ARR ?
INVESTMENT PROPOSAL FOR A NEW MACHINE COSTING RS.
50,000 WITHOUT ANY SALVAGE VALUE. TAX RATE = 50%
Year EBDT Deprecia EBT TAX EAT
tion
1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
Depreciat = Tot.
ion = EAT
Avg Inv = ?
Avg EAT=
ARR = ?
NET PRESENT VALUE METHOD
 Net Present Value Method:- It is the best
method for evaluation of investment
proposal. This method takes into account
time value of money.
 NPV= PV of inflows- PV of outflows

Evaluation of Net Present Value Method:-

Project with the higher NPV should be
selected.
 Accept if NPV>0
 Reject NPV<0
 May or may not accept NPV=0
 NPV PROBLEM 1
YEAR PROJECT A PROJECT B
PROFIT P.V P.V PROFITS P.V P.V
S FACT FACTOR
OR (
(
1 50,000 20,000
2 40,000 40,000
3 30,000 50,000
4 10,000 60,000
Total P.V
of inflows
Outflows
NPV = ?
 NPV PROBLEM 2
Yea EBDT
r
1 10,000
2 11,000
3 14,000
4 15,000
5 25,000
PROFITABILITY INDEX METHOD
 Profitability Index Method - As the NPV
method it also shows that project is
accepted or not. If Profitability index is
higher than 1, the proposal can be accepted.
 Accepted PI>1
 Rejected PI<1
 Profitability index =Total Cash Inflows/Total
Cash Outflows
EXAMPLE
 The expected cash flows of a project are:-
 The cash outflow is Rs. 1,00,000
 The cost of capital is 10%
 Calculate the following:

a) NPV b) Profitability Index

Year Cash Flows PV PV of Cash
(Rs.) Factors@10% Flows (Rs.)

1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
Total Cash ?
Inflow

Less: Cash ?
Outflows

NPV ?

P.I. ?
Year PVF Investment 1 Investment 2
(8 % ) CFAT P.V CFAT P.V

1 40,000 90,000
2 50,000 80,000
3 60,000 70,000
4 70,000 60,000
5 80,000 50,000
6 90,000 40,000
=
Outflow= 2,50,000