CAPITAL BUDGETING

By-Megha Mohan
 INTRODUCTION

• Capital budgeting decision may be defined 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.
• These decisions are also known as investment decisions.
Following are the Features of Capital Budgeting Decisions

Exchange of current funds for future Benefits

Funds are invested in Long Term Assets

Future Benefits will occur to the firm over a series of

Years
 CAPITAL EXPENDITURES AND THEIR FEATURES

• The basic characteristic 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 the future.
The following is the Features of Capital Expenditures-are

Long Term Consequence

Substantial Outlays

Difficulty in Reversing
 CAPITAL BUDGETING PROCESS

1. Identification II. Assembling IV. Preparation

of Of III. Decision of
Potential Investment Making Capital Budgeting
Investments Proposals and Appropriations

VI. Performance V.
Review Implementation
 INVESTMENT CRITERIA

Investment
Criteria

Non-
Discounting
Discounting
Criteria
Criteria

Internal rate Accounting

Net Present Profitability Pay-Back
of Return Rate of
Value(NPV) Index (PI) Period
(IRR) Return
 PAY-BACK PERIOD

• The payback period is the length of time required to recover the initial cash outlay on the project.

• PBP tries to answer the question: How many years will it take for the cash inflows to pay the
original cost of investment?

PayBack period (Equal Cash Flows)= (Initial Cash Outlay)/(Annual Cash Inflows)
PayBack Period (Unequal Cash Flows)= Year before full recovery + (Unrecovered cost at the
beginning of the year / Cash flow during the year)
 FOR EXAMPLE- (PAYBACK PERIOD)

A 5 year project requires an initial outlay of Rs. 50,00,000 which generates a constant annual
cash inflow of Rs. 12,00,000.

DECISION
RULE

PBP = 50,00,000 ÷ 12,00,000 = 4.17 years

According to payback criterion, the shorter the payback period, the more desirable the
project. Firms using PBP specifies the maximum acceptable PBP.
PBP ≤ Benchmark PBP = Accept the Project PBP > Benchmark PBP = Reject the Project
 PAYBACK PERIOD(UNEQUAL CASH
FLOWS)

Suppose that a project requires a cash outlay of Rs. 20,000, and generates cash Inflows of Rs. 8,000, Rs.
7,000 and Rs. 4,000 and Rs.3,000 during next 4 Years.

Year Cash Inflows Cumulative Cash Inflow

0 (20,000)
1 8,000 8,000
2 7,000 15,000
3 4,000 19,000
4 3,000 22,000

PayBack Period (Unequal Cash Flows)= Year before full recovery + (Unrecovered cost at the
beginning of the year / Cash flow during the year)

PBP= 3+((20,000-19,000)/ 3,000)= 3.33 years (Approx)

 PAYBACK PERIOD- MERITS AND DEMERITS

Merits:
▪ It is simple, both in concept and application. It does not involve any tedious calculations and has few hidden
assumptions.
▪ It is a rough and ready method for dealing with risks.
▪ A sensible criterion if the firm is pressed with the problem of liquidity.

Limitations:
▪ It fails to consider the time value of money, since projected cash flows are simply added towards determining
PBP.
▪ It ignores cash flows beyond the payback period. This leads to discrimination against projects which
generate substantial cash inflows in later years.
▪ It is a measure of capital recovery, not profitability.
 PROBLEM-1

A co. is planning to start a project which involves an

initial investment of Rs.25,00,000. It is expected to yield
Annual Cash flows of Rs. 5,00,000 for 8 years. Should the
Co. opt for this Project?
 PROBLEM-I1

Suggest the management Which machinery they should Buy considering the
payback period approach?
Machine-1:
Initial Investment- Rs. 15,00,000
Cash Flow= Rs. 5,00,000 p.a.
Machine-II
Initial Investment- Rs. 20,00,000
Cash Flow= Rs. 5,50,000 p.a.
 PROBLEM-I1I

An asset costs Rs.210,000 with a Rs.30,000 salvage value

at the end of its ten-year life. If annual cash inflows are
Rs. 30,000, the cash payback period is
_________________.
 DISCOUNTED PAYBACK PERIOD

Overcomes an inherent shortcoming of PBP criterion by factoring in time value of money into the analysis.

Discounted PBP of above project = Years Until Break-even + [(Outlay – CCF LL) ÷ (CCFUL – CCFLL)]
Where,
CCFLL = Cumulative Cash Flow- Lower Limit
CCFUL= Cumulative Cash Flow-Upper Limit

Year Cash Flows PVF(r,n) Present Value Cumulative

Preset Value
XXXX XXXX XXXX XXXX XXXX

XXXX XXXX XXXX XXXX XXXX

XXXX XXXX XXXX XXXX XXXX

XXXX XXXX XXXX XXXX XXXX

 DISCOUNTED PAYBACK PERIOD-
EXAMPLE

Discounted PBP of above project = Lower Year + [(Outlay – CCFLL) ÷

(CCFUL – CCFLL)]
=3 + [(10,000 – 8,209) ÷ (2372)] = 3.6 years
 PROBLEM-1

• A company is considering an investment project that requires an initial outlay

of Rs. 100,000. The project is expected to generate the following cash flows:
Year 1: Rs.20,000 Year 2: Rs. 30,000 Year 3: Rs.40,000 Year 4: Rs.50,000 Year
5: Rs.60,000. The discount rate for the project is 10%. Calculate the PayBack
Period.
 PROBLEM-1I

A company is considering investing in a project that requires an initial investment

of Rs.150,000. The project is expected to generate cash flows of Rs.40,000,
Rs.50,000, Rs.60,000, Rs.70,000, and Rs.80,000 over the next five years. Using a
discount rate of 8%, calculate the Payback Period of the project.
 PROBLEM-1II

B Company is considering the purchase of a piece of

equipment that costs Rs. 23,000. Projected net annual cash
flows over the project’s life are: Year 1 2 3 4 Net Annual
Cash Flow Rs. 3,000, Rs. 8,000, Rs.15,000, Rs. 9,000.
 PROBLEM-IV

Evaluate the sensitivity of the discounted payback period for a project with the following cash
flows:
Year 1: Rs.50,000 Year 2: Rs.60,000 Year 3: Rs.70,000 Year 4: Rs.80,000 Year 5: Rs.90,000
The initial investment is Rs.200,000. Calculate the discounted payback period for discount
rates of 10%, 15%, and 20%, and comment on the impact of the discount rate on the payback
period.
 PROBLEM-V

Compare two projects with the following cash flows and initial investments:
Project C: Initial Investment: Rs.300,000 Year 1 Cash Flow: Rs.80,000 Year 2 Cash Flow:
Rs.90,000 Year 3 Cash Flow: Rs.110,000
Project D: Initial Investment: Rs.400,000 Year 1 Cash Flow: Rs.120,000 Year 2 Cash Flow:
Rs.140,000 Year 3 Cash Flow: Rs.160,000
Which project should be invested in if the decision is to made on the basis of Discounted Payback
Period?
 ACCOUNTING RATE OF RETURN(ARR)

An accounting oriented criterion of investment appraisal. It is also referred to as ‘Average Rate of Return’.
It can be calculated as following-

ARR (Equal Profits)=Profit after Tax ÷ Book value of Investments

In case of Unequal Profits Numerator represents average annual post-tax profit over the life of the
investment/project, while the denominator is the average book value of fixed assets committed to the project.
 EXAMPLE- ACCOUNTING RATE OF
RETURN

Accounting Rate of Return =(24,000 ÷ 70,000)X100 = 0.342 = 34.2%

 ADVANTAGES AND DISADVANTAGES-
ARR

PROs CONs
• Simple. • Based on accounting profit, not cash
flow.
• Based on accounting information
businessmen are familiar with. • Does not take into account the time value
of money.
• Considers benefits over the entire project
life.
 PROBLEM-1

A project costing Rs. 10,00,000 is expected to generate after tax profit of

Rs.1,50,000.p.a. Calculate the ARR of the Project.
 NET PRESENT VALUE (NPV)

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).
• NPV is a positive value =
It can be calculated using the following formula Accept the project

NPV = ∑ Ct /(1+r)t - Initial Outlay • NPV is a negative value =

DECISIO Reject the project
Where, N RULE
Ct = Cash flow at the end of year t; • NPV is exactly zero =
Matter of indifference
r = Discount Rate or Cost of Capital ‘r’ reflects the risk of the project (Either Accept or Reject)

Between two independent projects having positive NPVs, the project with greater NPV will be preferred by
the organization.
 EXAMPLE- NPV

• Since , NPV of the Above Project is Positive, it should be accepted.

 PROPERTIES OF NET PRESENT VALUE(NPV)

• Net Present Values are additive.

• Intermediate cash flows are invested at the cost of capital.
• NPV calculation permits time varying discount rates.
• NPV of a conventional project decreases as the discount rate increases.
 PROS AND CONS-NPV

Pros:
• Reflects the time value of money.
• Considers entire cash flow stream of the project.
• In sync with financial objectives of stockholder wealth maximization.
• NPVs are additive in nature enabling estimating NPV of a multi project package. This eliminates
chances of accepting poor projects combined with another good project.
Cons:
• Is an absolute measure and not a relative hence does not factor in the scale of investment.
• NPV rule does not consider the life of the project. In case of mutually exclusive projects of differing
lives, it is biased in favor of longer-term project.
 PROBLEM-1

A firm whose cost of capital is 10% is considering two mutually exclusive projects X and Y, the
details of which are—

Year X Y
COST 0 1,00,000 1,00,000
1 10,000 50,000
2 20,000 40,000
CASH
INFLOWS 3 30,000 20,000
4 45,000 10,000
5 60,000 10,000
 PROBLEM-I1

A company Requires an initial investment of Rs. 40,000. The estimated net cash flows are as follows-
Year- 1 2 3 4 5 6 7 8 9 10
Net CFs 7,000 7,000 7,000 7,000 7,000 8,000 10,000 15,000 10,000 4,000

Using 10% cost of capital, determine the Net Present Value(NPV).

 PROBLEM-1II

A company is considering investing in a project that requires an initial

investment of Rs.50,000. The project is expected to generate cash flows of
Rs.20,000 per year for the next 5 years. The company's discount rate, or cost of
capital, is 10%. Should the Company make an investment in this project?
 PROBLEM-1V

Let's consider two projects, C and D, on the Basis of NPV , which one shall the company invest in?
Project C:
• Initial investment: Rs.80,000
• Annual cash flows for 5 years: Rs.25,000
• Discount rate: 10%
Project D:
• Initial investment: Rs.120,000
• Annual cash flows for 5 years: Rs.20,000
• Discount rate: 10%
 PROBLEM V

Suppose you're evaluating an investment opportunity in a real estate development project. The initial
investment required is Rs.500,000. The expected cash flows from the project, after taxes and other expenses,
are as follows:
Year 1: Rs.100,000 Year 2: Rs.150,000 Year 3: Rs.200,000 Year 4: Rs.250,000 Year 5: Rs.300,000
However, the discount rate is not constant. It starts at 8% for the first two years, increases to 10% for the next
two years, and then decreases to 6% for the final year.
 PROBLEM-VI

Gama & Co. wants to replace its old machine with a new automatic machine.
Two models “Zee” and “Chee” are available at the same cost of Rs. 5,00,000
each. Salvage value of the old machines id 1,00,000.
• The Utilities of the existing machine can be used if the company select Zee.
Additional cost of to be purchased in that case are 1,00,000.
• If the company purchases Chee then all the existing utilities will be replaced by
new utilities for Rs.2,00,000. The salvage value of the old utilities will be Rs.
20,000.
Find out the NPV of this Project
 PROFITABILITY INDEX(PI)

Benefit Cost Ratio (BCR) or PI relates benefits offered by a project in terms of cash inflows with the initial
cost incurred.
It represents ratio of the sum of present values of all cash inflows and initial project outlay.
PI = PVB ÷ Initial Outlay
Where, PVB= Present Value of Benefits
Net PI = PI – 1

Accept the Project if PI is more than “1”

DECISION RULE
and reject if it is less than “1”
 EXAMPLE- PI

Present value of all the cash inflows is Rs.64,880

Present value of Cash Outflow is Rs. 55,020.

Profitability Index (PI)= 64880/55020 = 1.18

Since PI is more than 1 we will accept the project

 PROBLEM-1

Let's say you are considering an investment project that requires an initial outlay
of Rs.10,000 and is expected to generate cash flows of Rs.3,000 per year for the
next 5 years. The discount rate is 10%. Calculate Profitability Index and comment
if you should accept or reject the Project.?
 INTERNAL RATE OF RETURN (IRR)

Internal Rate of Return of a project is the discount rate (r) which makes its NPV equal to zero.

• It is the discount rate which equates the present value of future cash flows with the initial investment.

• Value of ‘r’ in the following equation is IRR. Accept if IRR>K

Reject if IRR<K
∑ Ct /(1+r)t - Investment = 0
Where, Ct = Cash flow at the end of year t
r = Internal Rate of Return (or the discount rate)
 STEPS –IRR- IN CASE OF EQUAL CASH
INFLOWS

I. Calculate Payback period and search for the nearest rates to the value of
Payback period in PVAF table.
II. Calculate two NPV for the Project at two different cost of capital
III. Use the following Formula to solve the IRR
STEPS TO CALCULATE IRR- UNEQUAL
CASH INFLOWS

I. Find out weighted average of cash inflows

II. Consider weighted average as the annuity of cash inflows and
calculate the payback period.
III. Now search for a nearest value in PVAF table and select the two
rates.
IV. Calculate two NPV for the Project at two different cost of capital
V. Use the following Formula to solve the IRR
 PROBLEM-1 (EQUAL CASH FLOWS)

A firm is evaluating a proposal costing Rs. 1,00,000 and having annual inflows of
Rs. 25,000 occurring at the end of each of next 6 years. Calculate IRR for the
above proposal.
 PROBLEM-II

A co is planning to invest in the following project that requires an initial investment of Rs.10,000
and is expected to generate the following cash flows over its five-year lifespan:
Year 1: Rs.2,000
Year 2: Rs.3,000
Year 3: Rs.4,000
Year 4: Rs.3,000
Year 5: Rs.5,000
Find the IRR, you need to determine the rate at which the Net Present Value (NPV) of these cash
flows equals zero.
 PROBLEM-III

A firm is evaluating a proposal costing Rs. 1,60,000 and expected to generate a

cash inflows of Rs. 40,000, Rs. 60,000, Rs. 50,000. Rs. 50,000 and Rs. 40,000 at
the end of each of next 5 years respectively. There is no salvage value at the end.
Calculate IRR of the above proposal.
 PROBLEM-1V

A co. is analyzing a project requiring an initial investment of Rs.50,000. The

project is projected to generate the following cash flows over its four-year
duration:
Year 1: Rs.10,000
Year 2: Rs.15,000
Year 3: Rs.20,000
Year 4: Rs.25,000
Ascertain the Net Present Value, Profitability Index and Internal Rate of Return
(IRR) for the above Project.
 PROBLEM-V

You are evaluating two investment projects with the following cash flows:
Project A:
• Initial Investment: Rs.50,000
• Cash flows at the end of Year 1: Rs.20,000
• Cash flows at the end of Year 2: Rs.30,000
Project B:
• Initial Investment: Rs.80,000
• Cash flows at the end of Year 1: Rs.40,000
• Cash flows at the end of Year 2: Rs.40,000
• Calculate the Internal Rate of Return (IRR) for both projects and determine which project is
more favorable based on IRR.
 PROBLEM-VI

You are evaluating two mutually exclusive investment projects, Project X and Project Y, each with the following cash flows:
Project X:
Initial Investment: Rs.200,000
Cash flows at the end of Year 1: Rs.50,000
Cash flows at the end of Year 2: Rs.70,000
Cash flows at the end of Year 3: Rs.90,000
Cash flows at the end of Year 4: Rs.110,000
Project Y:
Initial Investment: Rs.250,000
Cash flows at the end of Year 1: Rs.80,000
Cash flows at the end of Year 2: Rs.90,000
Cash flows at the end of Year 3: Rs.100,000
Cash flows at the end of Year 4: Rs.120,000
Considering a discount rate of 10%, determine which project should be chosen based on the Internal Rate of Return (IRR) criterion.
 PROBLEM-VII

You are considering investing in a project that requires an initial investment of Rs.200,000. The project is
expected to generate cash flows for the next 10 years. The estimated cash flows are as follows:
Year 1: Rs.30,000
Year 2: Rs.40,000
Year 3: Rs.50,000
Year 4: Rs.60,000
Year 5: Rs.70,000
Year 6: Rs.80,000
Year 7: Rs.90,000
Year 8: Rs.100,000
Year 9: Rs.110,000
Year 10: Rs.120,000
Calculate the Internal Rate of Return (IRR) for this investment project.
 PROBLEM-VII

Company proposes to install a machine involving a capital cost of Rs.3,60,000.

The life of the machine is 5 Years and its salvage value at the end of its life is
NIL. The machine will produce the net operating Income after depreciation of
Rs.68,000 per annum. The company’s Tax rate is 45%.
You are required to calculate IRR of the Project.
 PROBLEM -VIII

A company is engaged in evaluating an investment project that requires an initial cash outlay of Rs.2,50,000 on
equipment.
The project’s economic life is 10 years and its Salvage value is Rs.30,000. It would require current assets of
Rs.50,000.
An additional Investment of Rs.60,000 would also be necessary at the end of five years to restore the efficiency
of the equipment. This would be written off completely after completely over 5 years.
The Project is expected to yield annual profits of Rs.1,00,000.
The company follows written down value method of depreciation. @20%. The income tax rate is assumed to
be 40%.
Should the project be accepted if the minimum required rate of return is 20%.?
 NPV AND IRR

NPV IRR

Assumes that the discount rate (cost of Assumes that the net present value is zero.
capital) is known.

Calculates the net present value, given the Figures out the discount rate that makes
discount rate. net present value zero.
 ADVANTAGES AND DISADVANTAGES
OF IRR

Merits
▪ Easier to think in terms of rates of returns rather than absolute rupee values.
▪ Easy interpretation by all stakeholders of the project.
▪ Non-requirement of prior knowledge of discount rate, unlike NPV calculation.

Limitations
▪ Non-conventional Cash Flows.
▪ Mutually Exclusive Projects.
▪ Lending vs. Borrowing.
▪ Differences between short-term and long-term interest rates
 MCQ-1

The capital budgeting decision depends in part on the

a) Availability of funds.
b) Relationships among proposed projects.
c) Risk associated with a particular project.
d) All of these
 MCQ-1I

Which of the following is not a typical cash flow related to equipment purchase
and replacement decisions?
a) Increased operating costs
b) Overhaul of equipment
c) Salvage value of equipment when project is complete
d) Depreciation expense
MCQ III
MCQ IV