Capital Budgeting

What is capital budgeting? y Capital budgeting refers to planning the deployment of available capital for the purpose of maximizing the long-term profitability of the firm. y In other words. Capital budgeting may be defined as the firm·s decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. . It is the firm·s decision to invest its current funds most efficiently in long-term activities in anticipation of flow of future benefits over a series of years.

Classification of capital budgeting process y Planning/Idea Generation y Evaluation/Analysis y Selection y Financing y Execution/Implementation y Review .

Capital Budgeting Appraisal Methods y Traditional Methods (Non Discounted Cash Flow method) y Payback period method y Accounting rate of return method or Average Rate of Return (ARR) y Modern methods (discounted cash flow methods) y The Net Present Value method (NPV) y Internal Rate of Return (IRR) y Profitability Index or Benefit-Cost Ratio .

. y Using formula ² when the cash flows stream of each year is equal in all the years of projects life. The cash flow after taxes is used to compute pay back period. y Payback period = Original Investment or Initial investment or cash outlay / Constant annual cash flows after taxes y Using cumulative cash flow method ² when the cash flows after taxes are unequal or not uniform over the projects· life period.Payback Period Method y Period required to recover the original cash outflow invested in a project.

Accept-Reject Rule y Accept: Calculated PBP < Standard PBP y Reject: Calculated PBP > Standard PBP y Consider: Calculated PBP = Standard PBP .

annual EAT or PAT/Original Investment x 100 OI = Original Investment + Additional NWC + Installation Charges + Transportation Charge Whenever it is clearly mentioned as average rate of return: Average Rate of Return = Average annual EAT/Average investment x 100 AI = (original investment ² scrap)/2 + Additional NWC + Scrap value .Accounting Rate of Return/Average Rate of Return y It is also known as Return on Investment (ROI). It is calculated in two y y y y y y ways: Whenever it is clearly mentioned as accounting rate of return: Accounting Rate of Return (ARR) = Avg.

Accept-Reject Rule y Accept: Calculated ARR > Predetermined ARR or Cut-off rate y Reject: Calculated ARR < Predetermined ARR or Cut-off rate y Considered: Cal ARR = Predetermined ARR or Cut-off rate .

Net Present Value method (NPV) y It is one of the discounted cash flow methods. NPV can be defined as present value of benefits minus preset value of costs. It is also known as discounted benefit cost ratio method. It is the process of calculating present values of cash inflows using cost of capital as an appropriate rate of discount and subtract present value of cash outflows from the present value of cash inflows and find the net present value. Positive net present value occurs when the present value of cash inflow is higher than the present value of cash outflows and vice versa. . which may be positive or negative.

y Steps involved in computation of NPV are: y Forecasting of cash inflows of the investment project based on realistic assumptions. which is used as discounting factor for conversion of future cash inflows into present values. . y Finding out NPV by subtracting present value of cash outflows from present value of cash inflows. y Calculation of cash flows using cost of capital as discounting rate/factor. y Computation of cost of capital.

Accept Reject Rule: y Accept: NPV > Zero y Reject: NPV < Zero y Consider: NPV = Zero .

C=Present value of cash inflow in the low trial. It is the rate at which the net present value of the investment is zero.y IRR is that rate at which the sum of discounted cash inflow equals the sum Internal Rate of Return (IRR) of discounted cash outflow. O = Original or Initial outlay. y IRR = A + (C ² O)/(C ² D) x (B ² A) y Where: A = Discounted factor of low trail. . D = Present value of cash inflow in the high trial. This method is also known by names: y Marginal Efficiency of Capital y Rate of Return over Cost y Time adjusted rate of return y Yield on Investment y IRR can also defined as the discounting factor at which the present value of cash inflows equals to the present value of cash outflows. B = Discounted factor of high trial.

Accept Reject Rule: y Accepted: IRR > Cost of Capital y Reject: IRR < Cost of Capital y Consider: IRR = Cost of Capital .

Reinvestment in funds is assumed to be at the IRR. Reinvestment is assumed to be at the cut-off rate. Earnings from the project in the form of cash flow will help us to get back the funds already invested. . It assumes that the cash inflows can be reinvested at the discounting rate in the new projects.Comparison of npv & irr NPV Method Interest rate is a known factor. It also assumes that the cash inflows can be reinvested at the discounting rate in the new projects. It attempts to find out the maximum rate of interest at which funds are invested in the project. It involves computation of the amount that can be invested in a given project so that the anticipated earnings will be sufficient to repay this amount with market rate of interest. IRR Method Interest rate is an unknown factor.

to the initial cash outflow of the investment proposal. NPV method is not reliable to evaluate projects requiring unequal initial investments. PI method measures the present value of future cash inflows and present value of cash outflows. y PI = PV of cash inflows/Initial Cash outlay .Profitability Index (PI) / Discounted Benefit Cost Ratio (DBCR) y This method is similar to NPV method. PI method provides solution to this problem. at the required rate of return. It is the ratio of the present value of cash inflows.