CAPITAL BUDGETING

Capital Expenditure Decisions

 Machinery – Imported or domestic

 Equipment's - Fully automated or Manual Equipment's
 Factory - Near Urban Locality or in Rural area
 Motor Vehicle - Petrol, Diesel or CNG
 Computer - Assembled or Branded
 Decision criteria
• Based on Net benefit of each alternative
• Net benefit = Benefit-Cost
• =Cash Inflow-Cash Outflow
• =Cash Inflow-Investment
• Alternative with highest worthiness is
chosen
Capital Budgeting Definition
Capital budgeting:
According to Charles.T.Horngreen, “Capital budgeting is a
long term planning for making and financing proposed capital
outlays.”

Capital budgeting is the process of making investment

decision regarding capital expenditure
 CAPITAL EXPENDITURES AND THEIR IMPORTANCE

• A capital expenditure is an expenditure incurred for acquiring or

improving the fixed assets, the benefits of which are expected to be
received beyond one year in future
• The basic characteristics of a capital expenditure (also referred to
as a capital investment or just project) is that it involves a current
outlay (or current and future outlays) of funds in the expectation of
receiving a stream of benefits in future
• Importance stems from
• Long-term consequences
• Substantial outlays
• Difficulty in reversing
• Determines the future profitability of business
• Involves Risk
 Types of Capital Budgeting
decision
 On the Basis of Firms existence
– Replacement decision
– Modernization decision
– Expansion Decision
– Diversification decision

 On the basis of decision situation

• Independent investment decision
• Dependent project decision
• Mutually exclusive investment decision
 Factors Influencing Capital
budgeting decision
 Availability of funds
 Urgency
 Legal compulsion
 Degree of Uncertainty
 Intangible factors
 Obsolescence
 R&D projects
 Competitors activities
 Future earnings
 PROJECT CLASSIFICATION

• Mandatory Investments

• Replacement Projects

• Expansion Projects

• Diversification Projects

• Research and Development Projects

• Miscellaneous Projects
 CAPITAL BUDGETING PROCESS

• Identification of Potential Investment Opportunities

• Screening the Proposal

• Project evaluation

• Establishing Priorities

• Final Approval

• Implementation

• Performance Review
 INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA

NET BENEFIT INTERNAL ACCOUNTING

PAYBACK
PRESENT COST RATE OF RATE OF
PERIOD
VALUE RATIO RETURN RETURN
 I. NET PRESENT VALUE
Worthiness or
NPV of One year project = Benefit from the project - Investment in the project
= Cash flow from the project - Initial investment

NPV of Long term Project= C1 + C2 + C3 - Initial investment

(1+r)1 (1+r)2 (1+r)3

n Ct
NPV =  – Initial investment
t=1 (1 + rt )t
 NET PRESENT VALUE
The net present value of a project is the sum of the present value of all the cash flows
associated with it. The cash flows are discounted at an appropriate discount rate (cost of
capital)

 Decision Rule in NPV method

• To decide on a single investment proposal – Accept the proposal when NPV is positive
• To decide on choosing the best among more than one proposal – Choose the project which has
highest NPV
Problem 1: Naveen enterprises is planning to construct a new factory for
Rs100 lacs. The cash inflow from the project is as follows
Year 1 2 3 4 5
Cash inflow (Rs in Lacs)
34 32.5 31.37 30.53 79.9
The cost of capital at which they can borrow is 15%. Is it worthwhile to
pursue the project?

NPV of Long term Project= C1 + C2 + C3 - Initial investment

(1+r)1 (1+r)2 (1+r)3

n Ct
NPV = -------------- - Initial investment
t=1 (1 + rt )t
Naveen Enterprise’s Capital Project ( Cost of Capital=15%)
Year Cash flow Discount factor Present
value 
1 34.00 0.870 29.58
2 32.50 0.756 24.57
3 31.37 0.658 20.64
4 30.53 0.572 17.46
5 79.90 0.497 39.71
PV of cash inflow = 131.96
NPV=PV of cash inflow - PV of Cash outflow
NPV=PV of cash Inflow- Initial investment
=131.96-100
=Rs31.96 lacs

Decision:
At 15% rate of interest, the project is having a Net present value
of Rs31.96 Lacs. NPV of the Project is positive. Hence Naveen
Enterprises can implement the project.
 PROPERTIES OF THE NPV RULE

• NPVs are additive

• Intermediate cash flows are invested at

cost of capital

• NPV calculation permits time-varying

discount rates
 NET PRESENT VALUE

  Pros Cons
1 Reflects the time value of money 1 Is an absolute measure and not a relative
2 Considers the cash flow in its entirety measure
3 Squares with the objective of wealth maximization 2 NPV does not considers the life of the
project
 II. BENEFIT COST RATIO
OR PROFITABILITY INDEX METHOD

PVB
Benefit-cost Ratio : BCR =
I

Net Benefit Cost ratio: NBCR = PVB-I

I
= BCR-1
Where, PVB = present value of benefits
I = initial investment

Decision Rule in BCR

• BCR is above 1 = Accept

• BCR is 1 = Indifferent
• BCR is below 1 = Reject

Decision rule in NBCR

• NBCR is positive =accept
• NBCR is zero = Indifferent
• NBCR is negative=Reject
Pros Cons
Measures bang per buck Provides no means for aggregation
Problem 2: A firm is evaluating the following project. Its cost of capital is 12 percent. Evaluate the project under BCR
method. And NBCR method

Initial investment : Rs 100,000

Benefits: Year 1 25,000
Year 2 40,000
Year 3 40,000
Year 4 50,000

PVB
Benefit-cost Ratio : BCR = ________
I
PVB = present value of benefits
I = initial investment

Net Benefit Cost ratio = BCR-1

 Calculation of PVB
Year Cash Inflow Discount@12% PV of cash Inflow
1 25000 0.893 22325
2 40000 0.797 31880
3 40000 0.712 28480
4 50000 0.636 31800

BCR=PVB/I
=114485/100000
=1.14485

NBCR =BCR-1
=1.14485-1
=0.14485

Decision:
BCR is above 1 and NBCR is positive. The
firm can pursue the project
 BENEFIT COST RATIO
OR PROFITABILITY INDEX METHOD
Pros Cons
1. Measures bang per buck 1. Provides no means for aggregation
2. It helps in ranking and comparison 2. It is not suitable when cash outflow occurs beyond the
current period
 III. INTERNAL RATE OF RETURN
Net Present Value

Discount rate

The internal rate of return (IRR) of a project is the discount rate that makes its NPV
equal to zero. It is represented by the point of intersection in the above diagram. To find
out IRR of a project we have to try different discount rates through trial and error
method.
Net Present Value Internal Rate of Return
• Assumes that the • Assumes that the net
discount rate (cost present value is zero
of capital) is known.
• Calculates the net • Figures out the discount rate
present value, given that makes net present value zero
the discount rate.
• IRR is the value of r in the following equation
n Ct
I= 
t = 1 (1 + r)t

PV=FV [1/(1+r)n]
Problem 2: Find out the IRR of the following project
Year Cash
flow

0 -100
1 34.00
2 32.50
3 31.37
4 30.53
5 79.90
 CALCULATION OF IRR
Year Cash Discounting Discounting Discounting
flow rate : 20% rate : 24% rate : 28%
Discount Present Discount Present Discount Present
factor Value factor Value factor Value

0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00

1 34.00 0.833 28.32 0.806 27.40 0.781 26.55
2 32.50 0.694 22.56 0.650 21.13 0.610 19.83
3 31.37 0.579 18.16 0.524 16.44 0.477 14.96
4 30.53 0.482 14.72 0.423 12.91 0.373 11.39
5 79.90 0.402 32.12 0.341 27.25 0.291 23.25
NPV = 15.88 NPV = 5.13 NPV = - 4.02
 CALCULATION OF IRR
IRR=

Smaller NPV at the smaller rate Bigger Smaller

discount + of the absolute values of the
Sum X discount – discount
rate NPV at the smaller and the bigger
rate rate

discount rates

5.13
IRR=24% + x 28% - 24% = 26.24%
5.13 + 4.02
 PROBLEMS WITH IRR

• Non-conventional cash flows

• Mutually exclusive projects

• Lending vs. Borrowing

• Differences between short-term and

long-term interest rates

 NON-CONVENTIONAL CASH FLOWS
C0 C1 C2
-160 +1000 -1000

TWO IRRs : 25% & 400%

NPV

25% 400%
Discount rate( %)

NO IRR : C0 C1 C2
150 -450 375
 MUTUALLY EXCLUSIVE PROJECTS

C0 C1 IRR NPV
(12%)

P -10,000 20,000 100% 7,857

Q -50,000 75,000 50% 16,964

 LENDING VS BORROWING

C0 C1 IRR NPV
(10%)
A -4000 6000 50% 145

B 4000 -7000 75% -236

 IV. Modified Internal Rate of Return

MIRR is the internal rate of return at which present value of all cash
outflows in the project will be equal to Terminal value of all cash inflows.

Calculation of MIRR:

Step 1: Calculate PV of All cash outflows

Step 2: Calculate TV (FV) of all cash inflows
Step 3: Solve the following equation to find out MIRR
TV of Cash inflow= PV of cash outflow (1+MIRR)n
Problem 3: Find out MIRR for the following Project. The cost of
the capital for reinvestment is 15%
Year 0 1 2 3 4 5 6
Cash flow -120 -80 20 60 80 100 120

Step1: Calculate PV of cash outflow

Year Cash Outflow Discount@15% Discounted Cash Outflow
1 120 1 120.00
2 80 0.87 69.60
PV of Cash outflow= 189.60

Step2: Calculate TV of Cash inflow

Year Number of years cash in use
Cash Inflow Compounding@15% FV of cash inflow
2 4 20 1.749 34.98
3 3 60 1.521 91.26
4 2 80 1.322 105.76
5 1 100 1.15 115.00
6 0 120 1 120.00
TV of cash inflow= 467.00

Step3: Solve the equation

TV of Cash inflow= PV of cash outflow (1+MIRR)n
467= 189.6(1+MIRR)6
467/189.6=(1+MIRR)6
2.463 1/6=(1+MIRR)
MIRR=1.162-1= 0.162=16.2%
 MODIFIED IRR

0 1 2 3 4 5 6

-120 -80 20 60 80 100 120

r=15% 115
-69.6 r =15% r =15% 105.76
PVC = 189.6 r =15% 91.26
r =15% 34.98
Terminal value (TV) = 467
PV = 189.6 MIRR = 16.2%
of TV

NPV 0
 V. PAYBACK PERIOD
Payback period is the length of time required to recover the initial
outlay on the project

Payback period= Initial Investment

Annual Cash Inflow
Pros Cons
• Simple • Fails to consider the time value
of money
• Rough and ready method • Ignores cash flows beyond the
for dealing with risk payback period
• Emphasizes earlier cash inflows - Life of the project is not
considered
• Best method when there is uncertainty
in industry
Problem 4: Raj Ltd is planning for constructing new production facility
for Rs. 24 crores. The project is estimated to give a annual cash
inflow of Rs 6 crores. Calculate the pay back period

Payback period= Initial Investment

Annual cash inflow
= 24/6 =4 years
 Calculation of payback period when Cash Flow is uneven

Naveen Enterprise’s Capital Project

Year Cash flow Cumulative cash flow
0 -100 -100
1 34 - 66
2 32.5 -33.5
3 31.37 - 2.13
4 30.53 28.40
 VI. ACCOUNTING (AVERAGE) RATE OF RETURN
ARR= Average PAT
Average Book Value of Investment at the Beginning

Pros Cons
• Simple • Based on accounting profit,
• Based on accounting information not cash flow
businessmen are familiar with • Does not take into account the
• Considers benefits over the entire project life time value of money
• Gives Due weightage to the profitability of the project - Life of the project is not considered
 Problem 5: Investment data for Naveen enterprises New project
are as given below. Calculate Accounting rate of return.

Naveen Enterprise’s Capital Project

Year Book Value of PAT
Investment(Beg)

1 100 14
2 80 17.5
3 65 20.12
4 53.75 22.09
5 45.31 23.57

ARR = Average PAT x100

Average Book Value of Investment at the Beginning
Average PAT = 1/5 (14+17.5 +20.12+22.09+23.57) = 19.46
Average investment =1/5(100+80+65+53.75+45.31) = 68.81

ARR = 19.46 =28.28%

68.81
Issues in calculations of Cash
outflow
Amount Amount
 Initial investment
Particulars Rs Rs.
 Installation charges Original cost of The Project XXXX
 Working capital Add:Installation charges xxxx
Increase in working Capital xxxx
 Proceeds from Increase in tax liability xxxx XXXX
sale of assets XXXX
Less: Decrease in working Capital xxxx
 Tax effect Proceeds from sale of old assets
 Investment allowance Decrease in tax liability xxxx
Investment allowance if any xxxx XXXX
Net cash outflow XXXX
Calculation of cash inflow
Particulars Amount Rs.
Net Profit From the Project xxxx
Less: Tax xxxx
Profit after tax xxxx
Add: depreciation xxxx
Cash Flow from the Project xxxx
 Problem6: A company intends to replace an old machine with a new
machine. From the following information you are required to determine
the net cash requirement for such replacement.
Amount Amount
Particulars Rs Rs.
Cost of the old machine Rs100000 Cost of the New machine 140000
Life of the machine 10 yrs Add:Installation charges 20000
Remaining usefull life 4 yrs Increase in working Capital 10000
Depreciation Stratight line Method
Increase in tax liability ( W.N.1) 3000 33000
Cost of new machine Rs140000
Installation charges Rs20000
173000
Amount realised on sale of old machineRs50000 Less:Proceeds from sale of old machine 50000
Additional working capital required for Rs10000
new machine Investment allowance (140000x20%) 28000 78000
Income tax 30% Net cash outflow 95000
Investment allowance 20%
Working note 1: Rs.
Sale of Old machine 50000
Less: Book value of Old machine
(Cost-Depreciation=100000-60000) 40000
Profit on sale of old machine 10000

Tax on Rs10000@30% 3000

Cutoff rate:

The minimum acceptable rate of return, often abbreviated

MARR, or hurdle rate is the minimum rate of return on a
project a manager or company is willing to accept before starting
a project, given its risk and the opportunity cost of forgoing
other projects

Capital rationing:

Capital rationing is the process of putting restrictions on the

projects that can be undertaken by the company or the capital that
can be invested by the company. This aims in choosing only the
most profitable investments for the capital investment decision.
• Internal capital rationing
• External capital rationing
INVESTMENT APPRAISAL
IN PRACTICE

• Over time, discounted cash flow methods have gained in

importance and internal rate of return is the most
popular evaluation method.

• Firms typically use multiple evaluation methods.

• Accounting rate of return and payback period are

widely employed as supplementary evaluation methods.
 SUMMING UP
n Ct
• NPV =  –I
t = 1 (1 + r) t

PVB
• BCR =
I
• IRR is the value of r in the following equation
n Ct
I= 
t = 1 (1 + r)t
• MIRR is calculated as follows:
TV
PVC =
(1 + MIRR)n
• The payback period is the length of time required to recover the initial cash outlay on
the
project
• The accounting rate is defined as:
Average profit after tax
Average book value of investment