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Capital Budgeting refers to the expenditure on the capital assets. Spending money on capital assets is a very important decision that a finance manager is required to take. Capital investment expenditure may be on Plant, Machinery Equipment, Land, Building and Bridges Etc.

Dr. Gurendra Nath Bhardwaj 1

Significance

Although spending money on anything is important, but the capital expenditures are more important and the finance manager is therefore, required to be much more cautious in making such decision for the following reasons.-

Dr. Gurendra Nath Bhardwaj

2

Contd.

It involves substantially higher amounts than for other routine expenses. The decision is irreversible, i.e. it is not possible to withdraw your steps easily, once you have taken few steps in this regard. It has long term impact on the affairs of a company and it, infect, determines the future of a company.

Dr. Gurendra Nath Bhardwaj 3

This expenditure involves a big cash outflow of funds initially. Gurendra Nath Bhardwaj 4 .Contd. An expenditure made on a capital asset has a long term prospective. compensated by small but recurring doses of inflow of funds in future for some time. Dr. We spend today. to gain some advantages in future.

Contd. The essence of the capital budgeting decision making is to determine. whether the initial expenditure of funds is duly compensated by the inflow of funds occurring in future. Gurendra Nath Bhardwaj 5 . then that the capital investment proposal must be accepted because that will add to the wealth of the company. If greater values can be assigned to the inflow of funds than the present expenditure. Dr.

The assets are return expected to reap benefits to the company for the years to come. Dr.Nature of Capital Budgeting The Capital Budgeting decision is a decision on an expenditure of capital nature (as against revenue expenditure) which is intended to create physical assets. Gurendra Nath Bhardwaj 6 .

Contd. Dr. Only investment in physical assets is appraised in capital budgeting while investment in monetary and financial assets is appraised under portfolio analysis. Gurendra Nath Bhardwaj 7 . Debentures etc. The expenditure on monetary assets like purchase of Bonds. Shares.) is not to be treated as a capital budgeting expenditure. Treasury bills.

Renewal Projects 4. Research & Development (R & D) Projects. Gurendra Nath Bhardwaj 8 . New Projects 2.Types of Capital Budgeting Decision It consists broadly following investment decisions. Expansion Project 3. 1. 6. Exploration Projects (Oil Well) 5. Projects For Compliance of Certain Statutory Requirement. Dr.

Estimating Cash Flows Evaluating Cash Flows Selecting Projects Execution and Monitoring Dr. Gurendra Nath Bhardwaj 9 .Capital Budgeting Process Generation of Investment Ideas.

to assess whether the value of inflows is greater then the outflows or not. Gurendra Nath Bhardwaj 10 . acceptable. Dr.Cash Flow – Concept & Estimation Every investment proposal involves cash flows. the proposal may be treated as profitable and therefore. The crux of the whole process is. If the greater value can be assigned to the inflows/ returns than the outflows/ expenditure.large initial cash outflow followed by small but recurring inflows.

The reason is that cash flows are very certain amounts and are not subject to different interpretation by different people. Dr.Principles of Cash flows Estimation Capital Budgeting should be based on cash flows. Gurendra Nath Bhardwaj 11 .

but for a long term investment decision making. Dr.Contd. Gurendra Nath Bhardwaj 12 . Accrual principle is considered better for the purpose of accounting (Probably because it calculates profit or loss for a given period). cash principle will be better.

Every payment of cash. Gurendra Nath Bhardwaj 13 . for whatever reason is an inflow. Any Non cash expenditure (like depreciation) will not be accounted for because it does not involve any cash out flows. While every receipt of cash.Contd. for whatever purpose is an outflow. Dr.

Dr.Contd. Cash flow should be taken on ‘ After– Tax’ basis. The cost which have already been incurred should not be taken in to account while calculating cash outflows for a period. Gurendra Nath Bhardwaj 14 . One should calculate Cash Flow After Tax (CFATs) Sunk Costs should be ignored.

Contd. Dr. because the discounting of cash flow for their time value of money automatically takes in to account the interest cost of any investments. Gurendra Nath Bhardwaj 15 . while making the calculation of cash flow. A very important aspect of each cash flow calculation is that cash flow on account of interest payments are not to be considered. Calculation of cash flow should also take in to account the opportunity cost. even no actual cash inflow or outflow takes place.

Dr. Increase or decrease of working capital should be treated as outflows and inflows respectively as and when they take place. Cash needs for working capital should be treated as a cash outflow at the time of commencement of a project and should be treated as inflow when that cash is released at the time of closure or termination of projects. Gurendra Nath Bhardwaj 16 .Contd.

It should give absolute value of gain or loss. so that a ranking can be made between different proposals. It should indicate the degree of risk and the chances of getting profit or loss in a given situation. Cash flows to be recovered over the entire expected life of the asset rather than few years only.Requirements of Good Methods It should be based on cash flows rather than on profits or expenditures. It should indicate relative profitability between different alternatives. It should consider the time value of money. Gurendra Nath Bhardwaj 17 . Dr.

Example

A company desires to make an investment of Rs. 1,00,000 in a new machinery. Additional installation and transportation cost is Rs. 20,000. The Machine has a life of 5 years after which it is expected to fetch Rs. 10,000 as scrap value. The machine is expected to generate an output of 2000 units p.a. in the first 2 years and 3000 units p.a. for the last 3 years. The Product is expected to fetch Rs. 15 in the first 3 years and Rs. 18 in the last 2 years. The additional cost of operating a machine is expected to be Rs.5,000 p.a. for the first 3 years and Rs. 8,000 p.a. thereafter. Calculate Cash Flow After Tax (CFATs) for the above proposal on the assumption of Straight line depreciation and tax rate 30%.

Dr. Gurendra Nath Bhardwaj 18

Solution

Calculation of Depreciation

Cost of Machinery

Add: Transportation & Installation Cost

1,00,000

20,000 1,20,000 10,000

Less: Scrap Value

**Total Amount to be depreciated Annual Depreciation= 1,10,000/5
**

Dr. Gurendra Nath Bhardwaj

1,10,000

22,000

19

Year Output (Units) Price (Rs.) Revenue (Rs.) Operating Exp. (Rs.) Depreciation (Rs.) Profit Before Tax (Rs.) Tax @ 30% (Rs.) Profit After Tax (Rs.) CFAT (PAT + DEP.) Scrap Value

1 2,000 15 30,000 5,000 22,000 3,000 900 2,100 24,100

2 2,000 15 30,000 5,000 22,000 3,000 900 2,100 24,100

3 3,000 15 45,000 5,000 22,000 18,000 5,400 12,600 34,600

4 3,000 18 54,000 8,000 22,000 24,000 7,200 16,800 38,800

5 3,000 18 54,000 8,000 22,000 24,000 7,200 16,800 38,800 10,000

Dr. Gurendra Nath Bhardwaj

20

Interpretation As we have discussed earlier. 1. In the above solution we have not considered the time value of money. Gurendra Nath Bhardwaj 21 . Dr.400. that the non cash items like dep.100+24.600+40.800+10.100+34.800+40.000= Rs. so the total value of Cash Inflow After Tax will be 24. Will not be taken in to account while calculating the CFATs.74.

Methods of Project Evaluation and Selection The project evaluation methods can be divided in to two categories. Methods based on the assumption of certainty Methods which take in to consideration uncertainty of cash flows Dr. Gurendra Nath Bhardwaj 22 .

Gurendra Nath Bhardwaj 23 .Cost (B-C) Ratio or Profitability Index (PI) Scientific Methods: Dr.Methods based on the assumption of certainty Simple Methods: Accounting/ Average Rate of Return (ARR) Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Benefit.

Methods which take in to consideration uncertainty of cash flows Conservative Estimates Certainty Equivalent Coefficient Risk Adjusted Discounted Rate Probability Distribution of Uncertainty Sensitive Analysis Dr. Gurendra Nath Bhardwaj 24 .

Simple Methods of Capital Budgeting Accounting/ Average Rate of Return (ARR) Payback Period Discounted Payback Period Dr. Gurendra Nath Bhardwaj 25 .

Gurendra Nath Bhardwaj 26 . Initial cash outflow Payback period = Annual cash inflows Dr. This method is based on cash flows and not on accounting data like the ARR.Payback Period The payback period is the time duration required to recover the initial cash outflows.

If the cash inflows are not uniform then Payback period = time period in which the cumulative cash flows are equal to initial inflows. Dr. Gurendra Nath Bhardwaj 27 .Contd.

00. Gurendra Nath Bhardwaj 28 .000 on a new proposal.000. 40. Dr. 20.Example: A company is considering a proposal to spend Rs.000. The cash inflows are expected as follows. 30. 40. year II Rs. year V Rs. Calculate Payback period for the above proposal. year III Rs.000. 30.000. 1. year I Rs. year IV Rs.000.

000 1.000 80.000 30.000 30.60.000 Dr.) 20. Gurendra Nath Bhardwaj 29 Payback period = Initial cash outflow Annual cash inflows 20.000 20.) (Rs.000 50.000 40.5 Years I II III IV V .Solution: Year Cash Cumulative inflows Cash inflows (Rs.20.000 1.000 =3+ 40.000 40.000 =3.

Dr. otherwise it will be rejected. Gurendra Nath Bhardwaj 30 . So far as ranking is concerned. the higher will be the ranking of any investment proposal.Acceptance and Ranking Rule: If the calculated payback is less than any predicted value then an investment proposal is acceptable. the lower the value of the payback.

it automatically takes care of risk. Gurendra Nath Bhardwaj 31 . Since its emphasis is on early recovery of investment. Dr. Projects with smaller payback period is considered safer and secure as compared to the projects with longer payback.Evaluation of Payback Method: It is a simple method in concept and understanding.

Drawbacks It takes in to account only early cash flows which determine the payback and ignores those which come later. This may often leading to wrong conclusions. Gurendra Nath Bhardwaj 32 . Let see the example. Dr.

50.000 30.000 20.000 20.000 30.000 0 0 Dr.000 10.000 .50.000 30.000 1.000 15.45.Example Year 0 1 2 3 4 5 6 Total Cash Inflow Project X .000 20.000 40.000 15.000 33 85. Gurendra Nath Bhardwaj Project Y .

However a comprehensive analysis of projects would show the project Y is superior with greater value of inflows.5 years for project Y whereas for project X it is 3 1/6 or 3 years two months.Interpretation: If we calculate the payback period for the above projects it is 2. payback method ignores time value of money. Secondly. Dr. Gurendra Nath Bhardwaj 34 .

000 Dr.000 30.Example: Payback period Year Project X Project Y 0 -60.000 10. Gurendra Nath Bhardwaj 35 .000 30.000 -60.000 20.000 20.000 = Initial cash outflow Annual cash inflows = 3 years 1 2 3 10.

Payback period is considered only a measure of capital recovery and it is not a perfect of measure for profitability.Interpretation: The payback period for both the project is 3 years. Gurendra Nath Bhardwaj 36 . On the basis of time value of money the project Y will be superior. Dr.

Dr. it used only for a preliminary screening and not for final decision making. it is still widely used in modern project appraisal mainly because of its simplicity. In spite of these limitations of the payback method. However. Gurendra Nath Bhardwaj 37 .Contd.

Dr. Gurendra Nath Bhardwaj 38 . we may use the discounted cash flows in order to calculate the payback period. Obviously the discounted payback will be longer than the simple payback period.Discounted Payback Period: To overcome the limitation of the payback that it does not use time value of money.

000.000 20. Gurendra Nath Bhardwaj Year 1 2 3 4 5 6 Cash Flows (Rs. ) 20. Find out the payback period by the traditional method as well as by discounted method @ 10% discount.00. The Cash inflows from the project are expected to be as follows.000 39 .000 30. Dr.Example: A company is considering a project with initial outflow of Rs.000 30. 1.000 40.000 30.

182 50.22.463 1.000 18.000 .752 40 1.000 1.11.70.514 92.628 11.000 Dr.000 40. Gurendra Nath Bhardwaj 18.50.975 65.835 1.000 5 6 30.000 1 2 3 4 Discounted Discounted Cash flows Cumulative Cash flows @ 10% 20.20.Solution: Year Cash Flows Cumulative Cash flows 20.539 27.182 18.000 80.321 42.000 30.000 20.793 22.000 30.000 24.289 1.

11.000-80.385 = 4.38 Years Dr.00.Solution: The Traditional Payback period = Initial cash outflow Annual cash inflows 1.000-80.000 = 1. Gurendra Nath Bhardwaj 41 .463–92.385 = 1.000-92.000 = 3.5 Years The discounted Payback period = Initial cash outflow Annual discounted cash inflows 1.00.20.

It is the average rate of return for different years for the whole life of an asset. Gurendra Nath Bhardwaj 42 . Dr. It is a ratio between the Net Profit After Tax and the amount of Initial Investment made in the Project.Accounting/ Average Rate of Return (ARR) The Accounting Rate of Return also called the Average Rate of Return.

Contd. Gurendra Nath Bhardwaj 43 . Average PAT ARR = Initial Investment Dr.

500 respectively. The profit after tax on account of this machine for the next five years is Rs.000 in a machine. Dr. Rs. 8. and Rs. The machine has a life of 5 years. 7.900. Gurendra Nath Bhardwaj 44 . 8.200. Calculate the ARR for this investment Proposal. 50. 7.Example: A company wishes to make an investment of Rs. Rs. 6. Rs.900.500.

6 % Dr.200+7.000/5) x 100 50.000 50.500+ 8.Solution: ( 7. Gurendra Nath Bhardwaj 45 .900+8.900+6.000 = 15.500)/5 x100 ARR = = (39.

it is ill defined we don not know whether to use EBIT or PAT. Initial Investment or Average Investment.Interpretation: When it is evaluated for its suitability as a investment criteria for making long term investment decisions. Each variable will give different results. Firstly. we find it deficient in several aspects. Gurendra Nath Bhardwaj 46 . Dr.

Scientific Methods: Net Present Value (NPV) Internal Rate of Return (IRR) Benefit. Gurendra Nath Bhardwaj 47 .Cost (B-C) Ratio or Profitability Index (PI) Dr.

we get a negative NPV.Net Present Value (NPV) It is net present value of all the cash flows that occur during the entire life span of a project The outflows will have negative values while the inflows will have positive values. we get a positive NPV and if the present value of outflows is greater than inflows. Gurendra Nath Bhardwaj 48 . if the present value of inflows is greater than outflows. Obviously. Dr.

therefore. The positive NPV means a net gain in value maximization and. then the project should not be accepted. any project which gives a positive NPV is an acceptable project and if it gives a negative NPV. Dr. Gurendra Nath Bhardwaj 49 .Contd.

The initial amount spent on a project Dr. NPV can be expressed as follows. n Ct NPV = Σ −C0 t=1 (1+k)t Where Ct= Net Cash Inflows in different Years (t) k =The rate of interest or cost of capital at which funds are to be discounted C0 = Initial Investment. Gurendra Nath Bhardwaj 50 .Contd.

the higher the value of NPV the higher would be the ranking of a project.Acceptance Rule & Ranking Rule: The acceptance rule for NPV is that. Dr. In case of same size projects. if it is positive. then the proposal should be accepted and if it is negative then it can not be accepted. Gurendra Nath Bhardwaj 51 .

Find out whether the project is worthwhile or not.000.000 22. The rate of discount is 10%.) 15. Gurendra Nath Bhardwaj .000 21. Year 1 2 3 4 5 CFATs (Rs.80.Example: A firm is considering an investment proposal worth Rs.000 52 Dr. The CFATs (cash flows after tax) are expected to be as follows.000 29.000 27.

Gurendra Nath Bhardwaj 53 .Solution: n NPV = Σ t=1 Ct − C0 (1+k) t = 15.39 + 13039.1) + 22. 4.50 Dr.000 = 13.50 + 19807.000 = 84.43 − 80.1)² + 27.1)4 + 21.000 = Rs.1)5 − 80.285.000/ (1.1)³ + 29.000/ (1.000 / (1.82 + 20.636.000/ (1.950.000/ (1.36 + 18.50 − 80.181.950.

000.Interpretations: In this project the PV of inflows is Rs. 80.950. Dr. Gurendra Nath Bhardwaj 54 . Hence the NPV is Rs. 84.950.50 while the PV of outflows is Rs.50 which makes the project an acceptable project because NPV is positive. 4.

This may be treated as a net addition to the value of the firm and therefore. it is also called unrealized capital gain. Gurendra Nath Bhardwaj 55 . Another interpretation of NPV is that it represents the maximum price that a firm should pay for foregoing the right to undertake the project or to sell the project to some other party.Interpretations of NPV: NPV is the absolute value of a net gain in future. Dr.

000. In this case.000 to meet the initial cost. but can also raise Rs. 10. and ensure that this will be paid off from the receipts of the project.Contd.000 with a positive NPV of Rs. Gurendra Nath Bhardwaj 56 . A firm is undertaking a project at a cost of Rs. 50. 50. 10.000 (for any other purpose) and be rest assured that this sum with interest can be paid off from the proceeds of the given project. the firm can not borrow merely Rs. Dr. For example. It also represents the amount that a firm could raise from the market at given rate of inertest. in addition to the initial cost of the project.

the total NPV of two projects is the summation of their individual NPVs.Properties of NPV: The NPV method is a very scientific and appropriate technique of capital budgeting and is therefore. Gurendra Nath Bhardwaj 57 . Dr. It considers time value of money. widely used for investment decision making. It is based on cash flows over the entire life of project. NPV for different rates of interest can be found separately. It possesses the property of additions. i.e. It is an absolute value. and It allows different rates of interest for different time period in the life of a project. The following properties can be identified.

it is not possible to know in advance the rate of interest at which discounting is to be done. It may lead to wrong decision making especially when limited funds are available and we have to choose between different options. Many a times. Similarly a given NPV may not be appropriate if the rate of interest has changed.Limitations of NPV: It gives the absolute value and therefore. comparison between two different projects is not easy. especially when they are of different sizes. Gurendra Nath Bhardwaj 58 . Dr.

= Present value of outflows Dr. In order to overcome this limitation of NPV. we make one modification in it to make it a relative measurement. The P. This is called Profitability Index (P.I.I.I.Benefit. Gurendra Nath Bhardwaj 59 .Cost (B-C) Ratio or Profitability Index (PI) NPV is an absolute value and therefore it is not appropriate for comparing the relative profitability between different projects. Present value of inflows P. is as follows.) or Benefit Cost Ratio (B-C Ratio).

Gurendra Nath Bhardwaj 60 . several projects then the project with a higher P. However. Dr.Acceptance and Ranking Rule: If the P. or B.I. ratio should have a higher ranking. then the project is to be accepted and if it is less than 1 then it is to be rejected.C. is greater than 1. if we have.I.

Dr. any project which is acceptable at. Therefore. say. say. 12% rate. Gurendra Nath Bhardwaj 61 . Hence. therefore. 10% rate of discount may not be the same at. the NPV and PI values change as soon as the rate of discount is changing. there is need to find out a technique which is autonomous in itself and not dependent upon any externally determined rate of interest.NPV & PI : The NPV and PI are both based on a given rate of discount and.

n Ct 0=Σ t=0 (1+k) t Dr. It can be expressed as follows.Internal Rate of Return (IRR) IRR is that rate of discount at which NPV is zero. Gurendra Nath Bhardwaj 62 .

) 7.67 4.950.50 2.677.Contd.02 − 3611.06 −1600.29 63 Dr. Gurendra Nath Bhardwaj . Rate of Interest (%) 9 10 11 12 13 14 NPV (Rs. The relationship between discount rate and rate of discount for the previous illustration of NPV is calculated as follows.320.54 496.

the cut-off rate where positive NPV converts into a negative NPV. This cut off rate is the Internal Rate of Return (IRR) where NPV is zero. Dr.Contd. say 11% may not be accepted at 13% or 14%. It is therefore essential to know. This table shows that as the discount rate increase the NPV goes on diminishing. It can therefore be understood that a project which is acceptable at a given rate of discount. Gurendra Nath Bhardwaj 64 .

It can be expressed as follows The Internal Rate of Return IRR can be calculated by use of log or by a scientific calculator or by computer instantly. x IRR = r + x−y Where r = the closest rate at which NPV is positive x = value of positive NPV at that level y = value of negative NPV at next higher rate Dr. Gurendra Nath Bhardwaj 65 . However. the following method can be used for the purpose.

06 = 12 + 2096.06 and the value of y = − 1600.2367% Dr. the value of x = 496. Gurendra Nath Bhardwaj 66 .For example. the value of r = 12%.02. in the above illustration.2367 = 12. Hence the IRR is 496.08 = 12 + .

IRR is a rate of return. Since. the proposal can not be accepted as it will lead to a negative NPV. If IRR is less than the cost of capital then. Dr. Gurendra Nath Bhardwaj 67 . the project with a higher IRR should be ranked higher than the other project which has a lower IRR.Acceptance and Ranking Rule for IRR: The IRR should be greater than the given discount rate (cost of capital) to make a project acceptable.

and hence ranking of projects will not change with variation in cost of capital. Gurendra Nath Bhardwaj 68 . It is particularly useful as it helps a businessman and also a financer in assessing the margin of safety in a project. It is useful in ranking of projects because it is a rate and not any absolute value. It takes into account time value of money. It is independent of any externally determined rate (discount rate or cost of capital).Properties of IRR: It considers cash flows of projects in their entirety. It is more appealing to the businessmen who are used to thinking in terms of cost and return. Dr.

In this respect IRR seems to be having an advantage. Dr.NPV Vs IRR: Both NPV and IRR are considered scientific techniques of a project’s financial appraisal and both are commonly used. This. while IRR is a rate of return from a given investment and. therefore. may not always be so. The NPV is an absolute value of a gain or loss. more appropriate for comparison between different project proposals as well as between a given IRR and different costs of capital. however. Gurendra Nath Bhardwaj 69 .

Gurendra Nath Bhardwaj 70 . Thanks Dr.Contd.

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- Capital Budgeting ppt.pptx
- Capital Budgeting

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