Capital Budgeting

Dr. Teena Shivnani

Definition: What is capital budgeting
 It is a systematic approach to evaluating an
investment in long-term assets.
 Capital Budgeting involves evaluation of (and
decision about) projects.

Which project should be accepted?

 Here, the goal is to accept a project which
maximizes the shareholder wealth.

November 29, 2023 Financial Management / Teena 1

 Capital Budgeting
Capital budgeting is an important technique of
management which is widely used for the
evaluation of various capital investment proposals
and for choosing the appropriate sources of
finance and for implementation of chosen
investment proposals.

“Capital budgeting is long term planning for

making and financing proposal capital outlays.”

November 29, 2023 Financial Management / Teena 1

 Importance of investment decisions

 Influence the firm's growth in the long run

 They affect the risk of the firm
 They involve commitment of large amount of funds

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 Cash Flows of a Proposal
 Cash flow refer to cash revenue – cash expenses. The
exp. are denoted as cash outflow whereas the revenue
are denoted as cash inflow.

 Following three types of cash inflow are:-

1. Initial investment / cash outflow
2. Net annual cash inflows
3. Terminal cash inflows

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 Net Cash Inflow
The cash inflow means the net profit after tax but before
depreciation.
Sales revenue ……………..
- All operating exp. ……………….
- Depreciation ……………….
Income after dep. But before tax & Int. ……………..
-Interest …………….
Income before tax …………..
-Tax ……………
income after tax ………………
+ Depreciation ……………
Net cash inflows
………………..

Cash inflow = Net profit after tax + Depreciation.

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 Techniques of capital Bud.

Traditional Techniques or Non- Modern Techniques or

Discounted Techniques Discounted Techniques
Net Present Value (NPV)
Pay Back Period Method Profitability Index Method
Average Rate of Return Method Internal Rate of Return

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 Pay Back Period Method
The PB is one of the most popular and widely recognized
traditional method of evaluating investment proposals.
This method is called payout and payoff method.

PB is the number of years required to recover the original

cash outlay invested in a project.

On the basis of net cash inflow the pay back period of
investment is known.

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 Pay Back Period
In case of even cash inflow :-
If project generates constant annual cash inflows, the PB
can be computed by dividing cash outlay by the annual
cash inflow.

PB = Investment / Net annual Cash Inflow

PB= Pay back period

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 E.g. (Even Cash Inflows)
Cost of Machine 3,00,000
Annual sales revenue generated by the new
Machinery= 4,00,000
Variable cost = 60% of sales
Annual fixed cost other than depreciation = 20,000
Life of machine = 8 years
Tax rate = 50%

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 E.g. (Even Cash Inflows)
Cost of Building 9,00,000
Annual revenue = 5,00,000
Variable cost = 40%
Annual fixed cost other than depreciation = 30,000
Life of building = 10 years
Tax rate = 40%

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 E.g. (Even Cash Inflows)
Annual Income = 6,00,000
Variable cost = 60% of sales
Life of machine = 5 years
Tax rate = 50%
Cost of Land 3,00,000
Annual fixed cost other than depreciation = 10,000

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 PB in case of Uneven Cash Inflow
If the invest. does not give a uniform annual return
then the calculation of pay back period is done with
the help of saving.
In this situation, the PB can be found out by adding
up the cash inflows until the total is equal to the initial
cash outflow.
  R.K. ltd is considering the purchase of machine. Two
machines are available in the market X, Y each costing
Rs. 40,000. earning after tax but before dep. are expected
to be as follows:-
Years X Y
1. 10,000 5000
2. 15,000 15,000
3. 20,000 20,000
4. 10,000 15,000
5. 5,000 10,000
Evaluate the two alternatives according to pay back period
method.

November 29, 2023 Financial Management / Teena 1

 Year Annual Cash Cumulative Annual Cash Cumulative
Inflow (X) cash inflow (X) Inflow (Y) cash inflow (Y)

1 10,000 10,000 5,000 5,000

2 15,000 25,000 15,000 20,000

3 20,000 45,000 20,000 40,000

4 10,000 55,000 15,000 55,000
5 5,000 60,000 10,000 65,000

Pay back period of Machine X

= 2 + 40,000 – 25,000 / 20,000 = 2.75 years
Pay back period of machine Y = 3 years .

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  Krishna Ltd is considering the purchase of machine. Two
machines are available in the market X, Y. each costing
Rs. 90,000. earning after tax but before dep. are expected
to be as follows:-
Years X Y
1. 15,000 5000
2. 25,000 35,000
3. 40,000 30,000
4. 20,000 15,000
5. 5,000 10,000
Evaluate the two alternatives according to pay back period
method.

November 29, 2023 Financial Management / Teena 1

  Mohan Ltd is considering the purchase of Plant. Two
Plants are available in the market A, B. each costing Rs.
1,20000. earning after tax but before dep. are expected to
be as follows:-
Years A B
1. 45,000 35000
2. 25,000 35,000
3. 40,000 50,000
4. 20,000 15,000
5. 5,000 10,000
Evaluate the two alternatives according to pay back period
method.

November 29, 2023 Financial Management / Teena 1

 ARR
 Data required for its calculation is derived from
accounting records.
 Based upon accounting information rather than
cash flows, becoz it considered accounting
profit ( n/p after tax and dep) not the cash
inflows.
 It does not consider the present value of cash
inflows
 ARR provides a quick estimate of a project's
worth over its useful life.
 ARR is derived by finding profits before taxes
and interest.
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 (ARR & ROI)
 If the original investment is taken into account it is called
Return on Investment

Average annual return or annual profit (after tax)

ARR (ROI) = -------------------------------------------------------- x 100
Average Investment

 when average investment is being considered for the

purpose of calculation it is called ARR
Initial invest + scrap Value
Avg. Investment= ------------------------------------------ + WC
2
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 Different formulae
 If profit after tax and depreciation is given
Average annual profit (after tax)
ARR = -----------------------------------------------------------X 100
Average investment over the life of the project

 If annual cash flows are given

Avg. annual cash inflows – Annual dep.
ARR = --------------------------------------------------------- X 100
Average investment over the life of the project

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Cont……..
Initial invest + scrap Value
Avg. Investment= ------------------------------------------
2

Initial invest - scrap Value

Annual Depreciation= --------------------------
Life

Initial invest + scrap Value

Avg. Investment= ------------------------------------------ + WC
2

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 E.g. calculate ARR form the following data of machine A &
B.
Cost of machine 1 lakh 1 lakh
Additional working capital 10,000 15,000
Estimated life 5 year 5 year
Estimated scrap value 5000 5000
Income tax rate 50% 50%
Annual earning before tax & Dep.
1 year 5000 1,10,000
2 year 12000 90,000
3year 28000 28000
4 year 80000 12000
5 year 100000 5000
Depreciation is charged on the basis of straight line method.

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 Solution

 Ave. Investment= Initial Invest. + Scrap Value / 2 + additional working

Capital
 For A machine = 100000 + 5000 / 2+ 10000 = 62500
 For B Machine = 100000 + 5000 / 2 + 15000 = 67500
calculation of Average Earning after depreciation and Tax :-
A B
Total Earning before 2,25,000 2,45,000
dep. & Tax
Life in Years 5 Years 5 Years
Average Earning 2,25,000/5 2,45,000/ 5
= 45,000 49,000
less :- dep. = 19,000 19,000
Average Earning
before tax = 26,000 30,000
Less :- Tax 50% = 13,000 15,000
Average income
After Dep & Tax. 13,000 15,000

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Solution cont……
ARR = Ave. Earning after Dep. and tax / Ave.
investment x100
For A Machine = 13000 / 62500 x 100
= 20.8%
For B Machine = 15000 / 67500 x 100
= 22.22%

November 29, 2023 Financial Management / Teena 1

 E.g. 2
Calculate ARR form the following data of Machine X & Y.
Cost of machine 2 lakh 3 lakh
Additional working capital 20,000 35,000
Estimated life 5 year 5 year
Estimated scrap value 10000 10000
Income tax rate 50% 50%
Annual earning before tax & Dep.
1 year 15000 1,10,000
2 year 10000 1,00,000
3year 28000 30000
4 year 80000 15000
5 year 100000 5000
Depreciation is charged on the basis of straight line method.

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 Discounting Methods
 Net present value method (NPV)
 Present Value Index or Profiability Index (PI)
 Internal Rate of Return Method

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 Net present value method (NPV)

The net present value method is quite important for

the analysis of capital expenditure and it is based on

time adjusted rate of return.

But this method is used only when the rate of return on

investment is pre-determined by the management.

This is called as excess present value method or net
gain method.
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 Calculation of NPV
The NPV of the project can be known quite easily. For this,

first of all the present value of cash inflow as calculated by

the required rate of discount.
The initial investment is deducted from the present value of

cash inflow to find out the net present value.

NPV = PV of cash inflow – PV of Cash outflow (Initial

Invest.)
 E.g. form the following information calculate the
NPV of two project and suggest which of the two
project should be accepted assuming a discount
rate of 10%.
Initial investment 30,000 40,000
life 5 year 5 year
Scrap value 2000 3000

Profit before dep. & after tax (cash inflow) are:-

1year 7000 22000
2year 12000 12000
3year 12000 7000
4year 5000 5000
5year 4000 4000
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Year Cash Inflow Cash Inflow PV factor PV ( A) PV (B)
(A) (B) at 10%
1 7000 22000 0.909 6363 19998

2 12000 12000 0.826 9912 9912

3 12000 7000 0.751 9012 5257

4 5000 5000 0.683 3415 3415

5 4000 4000 0.621 2484 2484

Scrap 2000 3000 0.621 1242 1862

Total 32428 42929

NPV = PV – C
A = 32,428 – 30,000 = 2428 (NPV)
B = 42929 – 40,000 = 2929 (NPV)
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 E.g.

Machine A costs Rs. 1,00,000 payable immediately. Machine B

costs Rs. 1,20,000 half payable immediately and half payable
in one year’s time. The cash flows are expected are as
follows:-

Profit before dep. & after tax (cash inflow) are:-

Year Mach. A Mach. B
1year 20,000 -----
2year 60,000 60,000
3year 40,000 60,000
4year 30,000 80,000
5year 20,000 --------

Discount factor @ 7%
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Year Cash Inflow Cash Inflow PV factor PV ( A) PV (B)
(A) (B) at 7%
1 20000 --------- .935 18700 ---

2 60,000 60,000 .873 52380 52380

3 40,000 60,000 .816 32640 48960

4 30,000 80,000 .763 22890 61040

5 20,000 ------------- .713 14260 --------

Total 1,40,870 1,62,380

NPV = PV of cash inflow – PV of cash outflow

A = 140870 – 100000= 40,870 (NPV)
B = 162380 – 116100 = 46,280 (NPV)
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Profitability Index OR Benefit cost Ratio
 It may also be a ratio of net present value and
initial cash outlay then it is called net
profitability index.
 Or we can say the profitability Index is
calculated in the form of ratio, whereas in NPV
is profit calculated in the absolute figures.
 PI = PV of cash inflow
Initial Investment
 If the profitability Index is more than 1 than the
proposal can be accepted.

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 E.g. of PI or Benefit cost ratio
The Initial cash outlay of a project is Rs. 50,000 and it
generates cash inflow of
Rs. 20000,
Rs. 15000,
Rs. 25000,
Rs.10000 in first four Years.
Using present value index method appraise
profitability of Proposed investment assuming 10%
rate of discount.
The PV of Rs. 1 at 10% discount Factor for 4 years
is .909, .826, .751, .683
November 29, 2023 Financial Management / Teena 1
Solution
Year Cash Inflow PV Factor Present Value
1 20,000 .909 18,180
2 15,000 .826 12,390

3 25,000 .751 18,775

4 10,000 .683 6,830

Total 56,175

Net Present Value = Total Present Value – Initial Investment

= 56,175 – 50,000 = 6,175
Profitability Index = present Value of Cash Inflow / initial Investment
= 56,175 / 50,000 = 1.1235
As profitability Index is More than 1, the proposal can be accepted.

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 Internal Rate of Return (IRR)
The third method based on the Time adjusted
Rate of Return is Internal rate of return method.
In present value method and profitability index
method the expected rate of return is already
known. So the present value of future earning can
be calculate easily.
If we presume that we don’t know the expected
rate of return then in such a condition the future
value of cash inflow should be made equal to the
present value of initial investment.
For this purpose the rate used is also called
discounting cash inflow
November 29, 2023
rate/ Teena
Financial Management or IRR. 1
 IRR ( Even Cash Inflow)
Even cash inflows :-

 If the annual cash inflow is equal or even in all the years

then the PV factor is calculated by dividing the Initial
investment by annual cash inflow as:-
 PV factor = Initial Invest. / Annual cash inflow
 After the PV, factor is calculated, referring to it we get
the range of the return rate from the PV Annuity Table
 IRR = LDR + [{(P1 – C )/ (P1 – P2 )}* (HDR – LDR)]
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 IRR (Uneven cash flows)
 Uneven cash inflow :-
If uneven cash flows is given rather than using even
cash inflows, use average cash flows for the
calculation of PVFA.

PV Factor = Initial Invest. / Ave. annual Cash Inflow

IRR = LDR + [{(P1 – C )/ (P1 – P2 )}* (HDR – LDR)]

November 29, 2023 Financial Management / Teena 1

 Problems with IRR
1. IRR assumes that interim positive cash flows are
reinvested at the same rate of return as that of the
project that generated them. This is usually an
unrealistic scenario.
2. More than one IRR can be found for projects with
alternating positive and negative cash flows, which
leads to confusion and ambiguity. MIRR finds only one
value.
3. One of the problems with IRR is the so-called
reinvestment rate assumption. IRR makes the
assumption that every year you will be able to earn the
IRR each time you reinvest your cash inflows.