Capital Budgeting And Investment Decision

What is Capital Budgeting?

Capital budgeting is a method of analyzing and comparing substantial future investments
and expenditures to determine which ones are most worthwhile. In other words, it’s a
process that company management uses to identify what capital projects will create the
biggest return compared with the funds invested in the project.
Capital budgeting, which is also called investment appraisal, is the planning process used
to determine whether an organization’s long term investments, major capital, or
expenditures are worth pursuing.
• Capital budgeting usually involves calculation of each project’s future accounting profit
by period, the cash flow by period, the present value of cash flows after considering
time value of money, the number of years it takes for a project’s cash flow to pay back
the initial cash investment, an assessment of risk, and various other factors.
• Capital is the total investment of the company and budgeting is the art of building
budgets.
Five Methods for Capital Budgeting

1. Net Present Value

2. Internal Rate of Return
3. Profitability Index/Benefit-Cost Ratio
4. Accounting Rate of Return
5. Payback Period
Selection Criteria of a Project under Different Capital Budgeting Methods:

SN Method Criteria Decision

NPV > 0 Accepted
1. Net Present Value (NPV)
NPV < 0 Rejected
IRR > Cost of Capital Accepted
2. Internal Rate of Return (IRR)
IRR < Cost of Capital Rejected

Profitability Index (PI)/Benefit-Cost PI > 1 Accepted

3.
Ratio (BCR) PI < 1 Rejected
PBP < Target Period Accepted
4. Payback Period (PBP)
PBP > Target Period Rejected

Accounting/Average Rate of Return Mutually Higher Accepted

5.
(ARR) Mutually Lower Rejected
 Net Present Value
•Net
  present value (NPV) is the difference between the present value of
cash inflows and the present value of cash outflows over a period of
time. NPV is used in capital budgeting and investment planning to analyze
the profitability of a projected investment or project.
The value can be calculated as positive or negative, with a positive net
present value implying that the earnings generated by a project or
investment will exceed the expected costs of the venture and should be
pursued.
NPV = - I
= + +----+ -I
•Example:
  Nice Ltd wants to expand its business and so it is willing to invest Rs
10,00,000.
The investment is said to bring an inflow of Rs.  100,000 in first year, 250,000 in the
second year, 350,000 in third year, 265,000 in fourth
Year
year
Flow
andPresent
415,000
value
inComputation
fifth year.
Assuming the discount rate to be 9%. Calculate NPV. 0
Do you accept
-1000000 -1000000
the project?
 

1 100000 91743 100000/(1.09)

2 250000 210419 250000/(1.09)^2

3 350000 270264 350000/(1.09)^3

Solution:
4 265000 187732 265000/(1.09)^4
NPV = - I
5 415000 269721 415000/(1.09)^5
= -I
  NPV 29879  
= + + ++ -I
= + + + + - 1000000
= 29879
As the value of NPV (29879) is positive so project can be accepted.
What Is the Profitability Index (PI)?
•The
  profitability index (PI), alternatively referred to as value
investment ratio (VIR), or profit investment ratio (PIR), describes
an index that represents the relationship between the costs and
benefits of a proposed project.

PI =

=
•Internal
  Rate of Return
The internal rate of return is a discount rate that makes the net present value (NPV)
of all cash flows from a particular project equal to zero.
Internal rate of return is used to evaluate the attractiveness of a project or investment.
If the IRR of a new project exceeds a company’s required rate of return, that project is
desirable. If IRR falls below the required rate of return, the project should be rejected.

IRR = A + (B - A)
Where,
A = Lower Discount Rate
B = Higher Discount Rate
C = Net Present Value at Lower Discount Rate (NPVat A)
D = Difference between Net Present Value at Lower Discount Rate (NPVat A) and Net
Present Value at Higher Discount Rate (NPVat B )
Example: Using the following information, calculate IRR and take decision
whether the project can be accepted or not, if the cost of capital is 12%.

Year Cash Flow

0 (100000)
1 30000
2 40000
3 25000
4 35000

Solution:
Let,
Lower Discount rate = 10%= A
•NPV
  = -I
= -I
= + + + -I
= + + + - 100000
= 3018.919
Higher Discount Rate = 15%=B
NPV = - I
= -I
= + + + -I
= + + + + - 100000
= -7218.03
•IRR
  = A + (B - A)
= .10+ (.15 - .10)
= 0.114745
= 11.47%
The project can not be accepted as the value of IRR (11.47%)
is less than the cost of capital (12%).
Year Cash flows
0 (100000)
1 35000
2 45000
3 40000

Calculate IRR.
Do you accept the project if cost of capital is 13%?