Dr.

CHARMI SHAH

CAPITAL BUDGETING CHARMI SHAH 1

 CAPITAL - funds employed in the firm
as a whole - always scares.
 BUDGETING - detailed quantified
planning that guides future activities for
achieving its profit goals.

CAPITAL BUDGETING CHARMI SHAH 2

 Deployment of available capital for the
purpose of achieving long term profitability -
process by which a firm determines where to
apply this scarce resource.
 The decision making process by which a firm
evaluates the purchase of major fixed assets.
 Long-term planning for making and
financing proposed capital outlays.
 Refers to the total process of generating,
evaluating, selecting and following up on
capital expenditure alternatives.

CAPITAL BUDGETING CHARMI SHAH 3

 MANDATORY INVESTMENTS
 REPLACEMENT
 EXPANSION
 MODERNISATION
 STRATEGIC INVESTMENT PROPOSALS –
Defensive, Offensive, Mixed Motive
 DIVERSIFICATIONS
 RESEARCH & DEVELOPMENT

CAPITAL BUDGETING CHARMI SHAH 4

 INVESTMENT APPRAISAL
CRITERIA

NON-DISCOUNTED DISCOUNTED CASH

CASH FLOW FLOW (DCF)
(NON-DCF) CRITERIA CRITERIA

PAY ACCOU NET INTERN DISC- BENEF MODIF

BACK NTING PRESEN AL OUN IT -IED
PERIOD RATE T RATE TED COST IRR
(PBP) OF VALUE OF PBP RATIO (MIRR)
RETURN (NPV) RETURN (BCR)
(ARR) (IRR)
CAPITAL BUDGETING CHARMI SHAH 5
 PAYBACK PERIOD

• Payback Period : length of time required to recover

the initial outlay of the project.
PBP = INITIAL INVESTMENT
ANNUAL CASH INFLOW
ACCEPTANCE RULE :
• If payback period < cut-off rate – ACCEPT
• If used as a ranking method – ACCEPT the project
with the shortest payback period.
LIMITATIONS :
• Does not consider time value of money
• Gives more importance to cash flows in earlier
years.
CAPITAL BUDGETING CHARMI SHAH 6
EXAMPLE :
Assume that a project requires an outlay of Rs.50,000
and yields an annual cash inflow of Rs.12,500 for 7
years. Find out the pay back period of the project.

SOLUTION :
PBP = INITIAL INVESTMENT / ANNUAL CASH
INFLOW
PBP = 50000/ 12500
PBP = 4 YEARS

CAPITAL BUDGETING CHARMI SHAH 7

YEAR A B C
0 -100 -100 -100
1 20 50 50
2 30 30 30
3 50 20 20
4 60 60 60000
PAY 3 3 3
BACK
(YRS)

CAPITAL BUDGETING CHARMI SHAH 8

 NET PRESENT VALUE

• NPV : It is the difference between present value of cash

inflows and present value of outflows.
NPV = PV OF CIF – Initial investment (shown in –ve
as Cash outflow)

ACCEPTANCE RULE :
• If NPV > 0 - ACCEPT
• If NPV < 0 - REJECT
• If used as a ranking method – ACCEPT the project with
the highest NPV.

CAPITAL BUDGETING CHARMI SHAH 9

 NET PRESENT VALUE

LIMITATIONS :
• Gives inconsistent results while comparing projects with
unequal lives.
• Difficult to determine the precise discount rate.

CAPITAL BUDGETING CHARMI SHAH 10

EXAMPLE :
X Ltd. Is planning to buy machinery for manufacturing a
coolant needed for refrigerators. The cost of the machine
is Rs.50,400. Following are the cash flows associated with
the project over its life of 5 years.

YEAR CASH FLOW AFTER TAX

(Rs.)
1 10,000
2 14,000
3 14,000
4 12,500
5 9,800
Based on NPV criterion, determine whether the new
machine should be bought or not ?

CAPITAL BUDGETING CHARMI SHAH 11

SOLUTION :
NPV = PV OF CIF – PV OF COF
PV OF COF = Rs. 50,400
PV OF CIF =
10,000 + 14,000 + 14,000 + 12,500 + 9,800
(1+0.12)1 (1+0.12)2 (1+0.12)3 (1+0.12)4 (1+0.12)5
= 8,928.57 + 11,160.71 + 9,964.92 + 7,943.98 + 5,560.78
= Rs. 43,558.96
NPV = 43,558.96 - 50,400 = - Rs. 6,841.04
 The co. should not go in for the machinery as the

NPV is negative, in other words the benefits

associated with the machinery are less than the costs
associated with it.

CAPITAL BUDGETING CHARMI SHAH 12

Benefit Cost Ratio (BCR) or Profitability Index (PI) : It is
the ratio of present value of cash inflows at the
required rate of return and the initial cash outflow of
the investment.
PI = PV CIF / INITIAL INVESTMENT
ACCEPTANCE RULE :
 If PI > 1 - ACCEPT
 If PI = 1 - Indifferent
 If PI < 1 - Reject
 If used as a ranking method, ACCEPT the one with the
highest PI

CAPITAL BUDGETING CHARMI SHAH 13

LIMITATIONS :
 Does not give valid results when cash outlay
is spread over a no. of years.
 It is not useful when multiple projects are
acceptable but budget constraint exists.
SOLUTION :
PI = PV CIF / INITIAL INVESTMENT
43,558.96

50,400
PI = 0.8643
Since the profitability index is less than one, the co.
should not buy the machinery.

CAPITAL BUDGETING CHARMI SHAH 14

CAPITAL BUDGETING CHARMI SHAH 15