CAPITAL BUDGETING

TECHNIQUES
MADE BY :- VARSHA[227/MBA/SAHS/2021]
TAPAS PAL [ 209/MBA/SAHS/2021]
WHY CAPITAL BUDGETING ?
● Capital budgeting decision 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”. 
● capital budgeting decisions may either be in the form of increased revenues, or
reduction in costs.
CAPITAL TECHNIQUES
Discounted Cash Flow Criteria(DCF)
 NPV Net Present Value)
 IRR(Internal Rate of Return)
 PI(Profitability Index)
Non-Discounted Cash Flow Criteria(DCF)
 Payback Method
 Discounted Payback method
 ARR(Accounting rate of Return)
 ● Those technique which explicitly
recognizes the time value of
money
● It correctly postulates that cash
NPV flows arising at different time
periods differ in value and are
NET PRESENT VALUE comparable only when their
equivalents –present values –
are found out.
NPV Formulae
NPV
ACCEPTANCE RULE
STEPS
● Cash flows should be forecasted based on
NPV>0 [accepted]
realistic assumptions
NPV<0[ rejected ]
● Appropriate discount rate should be
NPV=0 [ maybe accepted]
identified(project’s opportunity cost of
capital, which is equal to the required rate of
The NPV method can be used to select between
return expected by investors on investments
Mutually exclusive projects , the one with higher
of equivalent risk)
NPV should be selected .
● PV of Cash flows should be calculated using
opportunity cost of capital as the discount
rate
● NPV should be found out by subtracting PV of
cash outflows from PV of cash inflows
Evaluation criteria of NPV

● Time Value
● Measure of true profitability
● Value Additivity
● Shareholder Value

‘’NPV is a direct measures of how well this project will meet the goal of
increasing shareholder’s wealth’’
 ● The internal rate of return (IRR) is a
metric used in financial analysis to
estimate the profitability of potential
investments.
IRR ● IRR is a discount rate that makes the
net present value (NPV) of all cash
Internal rate of return flows equal to zero in a discounted
cash flow analysis.
● IRR calculations rely on the same
formula as NPV does.
IRR Formulae-
Rules to Calculate :-

● Set the NPV to zero and solve for

the discount rate i.e. the internal
rate of return
● The initial investment is always
negative because it represents an
outflow
● Each subsequent cash flow could
be positive or negative,
depending on the estimated cash
flow determined by the project in
the future
 ● The profitability index (PI) is a
measure of a project's or

PI investment's attractiveness.
● The PI is calculated by dividing
the present value of future
Profitability index
expected cash flows by the initial
investment amount in the project
 Rule of PI:-
If PI>0 , Good Investment.
If PI<1, bad investment.

Relationship between PI & NPV:

If PI>0 , NPV is positive.
If PI<1, bad is negative.
Non-Discounting Technique

A non-discount method of capital budgeting is one that does not consider the
time value of money. In other words, all dollars earned in the future are
assumed to have the same value as today's dollar.
Types of Non-Discounting Techniques
Payback Period Accounting Rate of
Return

Discounted Payback
Period
 ● Simplest and most widely used

Payback Period ● Time required to recover the initial

investment

(PP)
● A firm is always interested in knowing
the amount of time required to
receiver its investment.
Decision Criteria

1. If there is only one project in consideration, it would be selected only if it

has a payback period as per management’s expectations.

2. In case of more than one project, a project with lower payback period
should be selected.
 ● Used to determine the profitability of
Discounted ●
a project
Gives the number of years it takes to
Payback Period break even from undertaking the
initial expenditure, by discounting
(DPP) future cash flows and recognizing the
time value of money.
Discounted Payback Period Formula

Years before the discounted payback period occurs = Years until break even
Advantages and Disadvantages of DPP
 ● Reflects the percentage rate of return
expected on an investment or asset,
compared to the initial investment
cost.
Accounting Rate ● The ARR formula divides an asset's
average revenue by the company's
of Return (ARR) initial investment to derive the ratio
or return that one may expect over
the lifetime of an asset or project.
● Does not consider the time value of
money or cash flows
Accounting Rate of Return Formula
Decision Criteria

1. In case of many projects, a project with higher ARR will be selected.

2. In case of only one project, it would be selected if it earns more than

company's predetermined required rate of return.
Advantages and Disadvantages of ARR
Example of ARR
As an example, a business is considering a project that has an initial investment of $250,000
and forecasts that it would generate revenue for the next five years. Here's how the company
could calculate the ARR:

● Initial investment: $250,000

● Expected revenue per year: $70,000
● Time frame: 5 years
● ARR calculation: $70,000 (annual revenue) / $250,000 (initial cost)
● ARR = 0.28 or 28%