CAPITAL

BUDGETING-I
 Investment Decision
A capital budgeting decision may be defined as the firm’s decision to invest its funds
most efficiently in the long term assets in anticipation of an expected flow of
benefits over a series of years.
Also known as capital expenditure decision
 Capital budgeting decisions
 Is it worth to put money or capital into this project?
 Is it worth to put money for buying this machine?
 Is it worth it put money in this business?
 Significance of capital budgeting/ Importance of Capital Budgeting

1. Growth of the company

2. More risky in nature
3. Huge investments involved
4. Irreversibility
5. Effect on other projects
6. Difficult decisions
 Types of investment decisions
 Expansion
 Diversification
 Replacement
 Modernization
Capital budgeting process involves the following

1. Idea generation:
Generating the proposals for investment is the first step.
The investment proposal may fall into one of the following
categories:
⦿ Proposals to add new product to the product line,
⦿ proposals to expand production capacity in existing lines
⦿ proposals to reduce the costs of the output of the existing
products without altering the scale of operation.
⦿ Sales campaigning, trade fairs people in the industry, R&D
institutes, conferences and seminars will offer wide variety of
innovations on capital assets for investment.
2. Project Evaluation:

It involves two steps

⦿ Estimation of benefits and costs: the benefits and costs are measured in
terms of cash flows. The estimation of the cash inflows and cash outflows
mainly depends on future uncertainties. The risk associated with each
project must be carefully analyzed and sufficient provision must be made for
covering the different types of risks.
⦿ Selection of an appropriate criteria to judge the desirability of the project: It
must be consistent with the firm’s objective of maximizing its market value.
The technique of time value of money may come as a handy tool in
evaluation such proposals.
3. Project Selection: No standard administrative procedure can be laid down for
approving the investment proposal. The screening and selection procedures are
different from firm to firm.
4. Financing the selecting project- Under this phase, raising of funds would be
required to implement the selected project. Sources can be acquired through
equity , debt , preference or long term loans.
5. Execution or implementation- It involves engineering designs, negotiations,
contracting and construction etc. for implementing the selected project.
6. Review the project- The follow up, comparison of actual performance with
original estimates not only ensures better forecasting but also helps in
sharpening the techniques for improving future forecasts.
 Project evaluation criteria
 Estimation of cash flows
 Estimation of required rate of return or opportunity cost of capital
 Application of a decision rule for making the choice
Factors influencing capital budgeting

 Availability of funds
 Structure of capital
 Taxation policy
 Government policy
 Lending policies of financial institutions
 Immediate need of the project
 Earnings
 Capital return
 Economical value of the project
 Working capital
 Accounting practice
 Trend of earnings
Methods of capital budgeting
Traditional methods/ Non- discounted cash flow methods

Payback period

Accounting rate of return method

Modern/Discounted cash flow methods

Net present value method

Discounted pay back period

Profitability index

Internal rate of return

Calculation of Accounting profit

Sales xxxx
Less: VC xxxx
Contribution
Less: FC
EBDT xxxx

Less: Depreciation xxxx

EBT
less: Tax xxxx
EAT xxxx
Calculation of cash inflow or cash profit

Sales xxxx
Less: VC xxxx
Contribution
Less: FC
EBDT xxxx
xxxx
Less: Depreciation xxxx
EBT xxxx
less: Tax xxxx
EAT xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx
Payback period method- (Non-discounted)
 Most popular and widely recognized traditional method of evaluating investment
proposals
 Payback is the number of years required to recover the original cash outlay in a
project
 Payback= Initial investment/ Annual cash inflow
 Acceptance rule= Shorter pay back is acceptable
 Pay Back period method
Three methods
1. When constant cash flows are given
2. When unequal cash flows are given
3. When cash flows are not given
 When constant cash flow given
 Assume the project A and B requires an outlay of Rs. 50,000 and yields the cash
inflow of Project A Rs. 12,500 for 7 years and Cash inflow of project B Rs. 15000
for 7 years
 Payback A= Initial Investment/ Annual cash inflow
 = 50,000/ 12,500 = 4 years
 Payback B= 50,000/ 15,000= 3.33 years
 Project B (Accept)
 When cash flows are given (Unequal)
 Ex. ABC is considering two projects. Each project requires an investment of Rs.
10000. The net cash inflows are-:

Years 1 2 3 4 5
X 5000 4000 3000 1000 -
Y 1000 2000 3000 4000 5000

Calculate PBP
 Calculation of pay back period
Years Cash inflows Cumulative cash
For X inflows
1 5000 5000
2 4000 9000
3 3000 12000=(1000/3000)
= 0.33
4 1000
5 -

PBP= 2 + 0.33(Recoverable amount/ Concerned cash

flow)= 2.33 years
Or 2 years 3 months 28 days 19 hours
Practice:

 Suppose that a project requires a cash outlay of Rs 20,000 and

generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs
3,000 during the next 4 years. What is the project’s payback?
 Accumulated cash flow for three years is ₹19,000. Remaining
amount is ₹1000. Thus, payback period is:
3 years + 12 × (1,000/3,000) months
3 years + 4 months
 When cash inflows are not given
 PBP= Initial investment/ annual cash inflows

 Constant annual cash inflows= Cash profit

 E.g.- A project costs Rs.20 Lakhs and yields annual profit of Rs. 300000
after depreciation at 12.5 % but before tax. Tax rate is 50%. Calculate PBP
and suggest whether it should be accepted or rejected if standard PBP is 6
years.

 Sol.

Profit after dep bef tax (EBIT) 300000

Less- Tax 50% (150000)
EAT 150000
Add- Depreciation 250000
Cash Profit Or Cash inflows 400000

PBP= 20 Lakhs/400000= 5 Years

Accept
Depreciation= 12.5% on 20 lakhs= 2,50,000
 Practice-1
 Calculate PBP if Initial investment is Rs. 56125 for both the machines

Year A B
1 14000 22000
2 16000 20000
3 18000 18000
4 20000 16000
5 25000 17000
 Shortcomings of PBP
 Neglects cash flows received after payback period
 Ignores the time value of money
 Ignores a project's profitability
Neglects cash flows received after
payback period
Particulars Project x Project Y
Total cost of the project 15000 15000
Cash inflows(CFAT)
Years-1 5000 4000
2 6000 5000
3 4000 6000
4 0 3000
5 0 3000
Payback period 3 years 3 years
Ignores the time value of money

A B
Total cost 15000 15000
Cash inflows(CFAT)
Years-1 10000 1000
2 4000 4000
3 1000 10000
Ignores a project's profitability
A B
Total cost 40000 40000
Cash Inflows
Year-1 14000 10000
2 16000 10000
3 10000 10000
4 4000 10000
5 2000 12000
6 1000 16000
7 Nil 17000
PBP 3 4
 Discounted payback period
 A discounted payback period gives the number of years it takes to break even
from undertaking the initial expenditure, by discounting future cash flows and
recognizing the time value of money.
 Illustration
 The expected cash flows of a project are as follows-:

Year Cash flows

0 (1,00,000)
1 20000
2 30000
3 40000
4 50000
5 30000

PV factor is 12% . Calculate PBP

and Discounted PBP
 Solution:
PBP
Year Cash flows Cumulative
0 (1,00,000) -
1 20000 20000
2 30000 50000
3 40000 90000
4 50000 140000= 100000-
90000= 10000
5 30000 170000

PBP= 3 + Recoverable amount/ Concerned cash flow)

= 10000/50000= 0.2
= 3.2 years or 3 years 2 months 12 days
Discounted PBP

Ye Cash flows PV PV of cash Cumulative PV

ar factor@12 flows
0 (1,00,000) - - -
1 20000 0.892 17840 17840
2 30000 0.797 23910 41750
3 40000 0.712 28480 70230
4 50000 0.635 31750 101980= 100000-
70230=29770
5 30000 0.567 17023 119003

DPBP= 3 + (Recoverable amount/ Concerned cash flow)

= 29770/31750
= 3.937 years
= 3 years 11 months 7 Days 12 hours
 Practice Sum
 Consider the following projects:
Projects C0 C1 C2 C3 C4
A (1000) 600 200 200 1000
B (1000) 200 200 600 1000
C (300) 100 100 100 1600
D (300) 0 0 300 1600

A. Calculate the payback period for each project.

B. If the standard payback period is 2 years, which project will you select? Will your answer
be different if the standard payback is 3 years ?
C. If the cost of capital is 10%,compute the discounted payback for each year ?which project
will you recommend if the payback period is 1)2 years, 2) 3 years ?
ACCOUNTING RATE OF RETURN
METHOD
 The accounting rate of return is the ratio of the average after-tax profit divided by
the average investment. The average investment would be equal to half of the
original investment if it were depreciated constantly.

 A variation of the ARR method is to divide average earnings after taxes by the
original cost of the project instead of the average cost.
 ARR
 A project will cost Rs 40,000. Its stream of earnings before depreciation, interest
and taxes (EBDIT) during first year through five years is expected to be Rs
10,000, Rs 12,000, Rs 14,000, Rs 16,000 and Rs 20,000. Assume a 50 per cent tax
rate and depreciation on straight-line basis.
Depreciation=40,000/5=₹8,000.
Average EBDIT =72,000/5=₹14,400
EBIT (1-0.50) = (14,400-8,000)=₹ 3,200
Average Investment =(40,000+0)/2=₹20,000
ARR=3,200/20,000=16%
OR Calculation of Accounting
Rate of Return
Acceptance Rule

 This method will accept all those projects whose ARR is higher than the minimum
rate established by the management and reject those projects which have ARR less
than the minimum rate.

 This method would rank a project as number one if it has highest ARR and
lowest rank would be assigned to the project with lowest ARR.
Evaluation of ARR Method

 The ARR method may claim some merits

 Simplicity
 Accounting data
 Accounting profitability
 Serious shortcomings
 Cash flows ignored
 Time value ignored