Capital Budgeting

(Capital Investment Decision)

 Definition of Budget
•Budgeting: The process for preparing a budget.
• A management tool for planning and controlling future
activity.
Financial Buzz Words: A plan for saving, borrowing and spending.
•Budget : A pre-planned activity expressed in quantitative terms.

•A financial plan and a list of all planned expenses and revenues.

Budget Sector
Buisness
start-up Budget Types
budget

Corporate/ Basis of Flexibility : Fixed and Variable Budget

Buisness
budget
Basisof TimePeriod : Short-Term
and
Government
budget Long –Term Budget
Basis of Functionality: Sales budget,
Event Production budget , Marketing budget,
management
budget Project budget, Revenue budget, Cash
flow/cash budget etc.
Personal /
Family budget Govt. Budget in India Prepared by:
Budget division of Economics Department of Ministry of Finance
 Capital Budgeting
Capital: Operating assets used for production.
Budget: A plan that details projected cash flows during
some period.

Capital Budgeting: Process of analyzing projects and

deciding which ones to include in capital budget.
•Growth
Importance of Capital Budgeting
•Large Amount
•Irreversibility
•Complexity
•Risk
•Long term implications

Benefits of Capital Budgeting Decision:

•Estimation of Cash Flows

•Forecasting Return

•Risk & Uncertainty

Capital Budgeting: Project Categorization
• Establishment of New Products & Services

• Replacement Projects: Maintenance or Cost Reduction

• Expansion of Existing Projects

• Research and Development Projects

• Long Term Cotracts

• Safety and/or Environmental Projects

 Broad Prospective
Capital Budgeting is the planning process used to determine a firm’s
long term investments such as new machinery, replacement machinery,
new plants, new products and research & development projects.
 Evaluation Criteria:
Capital Investment Proposal

Evaluation Criteria

Non-Discounting Discounting
Criteria criteria

Pay-Back Discounted Profitability

ARR PBP NPV IRR
Period Index
 Non discounting: Pay-Back Period
1. Pay-Back Period Method- It is defined as the number
of years required to recover original cost invested in a
project. It has two conditions
➢ When cash inflow is constant every year
PBP= Cash outflow/cash inflow (p.a.)

➢ When cash inflow are not constant every year

Required inflow
Completed years + * 12
PBP = In flow of next year
 Simple and easy to understand and use.

Objective – using cash flows.

Merits of
For uncertainties- More approachable
Pay Back
Period Cautious & risk averse – ignores later cash
flows.

First level estimator – gives rough idea

about the recovering the investment.
 • Ignores the time value of
money.
Demerits of • Ignores cash flows after the
payback period.
Pay Back • Percentage of return on
capital invested is not
Period measured.
 DECISION RULE

Acceptance or Rejection Rule for Pay Back Period

Single or Independent Project(s) Mutually Exclusive Projects

Less than the Target Period Shortest Payback Period

12
 Non discounting Criteria: Accounting Rate of Return
2.Average Rate of Return Method - ARR means the
average annual earning on the project. Under this method,
profit after tax and depreciation is considered. The average
rate of return can be calculated in the following two ways.

Average Profit After Tax

ARR on Average investment = Average Investment * 100

ARR on Initial investment = Average Profit After Tax

* 100
Initial Investment
 • Simple and easy to calculate
and use.
Merits of • Aids internal and external
comparisons.
ARR • Looks at the whole life of the
project.
• A useful tool to measure
divisional managerial
performance.
 • Subjective – profit, not cash
Demerits of flows.
ARR • Ignores the time value of
money.
• Difficulty in use when with
same ARR and various
project sizes.
 DECISION RULE

Acceptance or Rejection Rule for ARR

Single or Independent Project(s) Mutually Exclusive Projects

Above the Target Rate With the highest ARR

12
 Discounting Criteria: Pay-Back Period
3. Discounted Pay-Back Period Method - In discounted
pay- back period method, the cash inflows are discounted
by applying the present value factors for different time
periods. For this, discounted cash inflows are calculated
by multiplying the P.V. factors into cash inflows.

Required inflow
Dis. PBP = Completed years + In flow of next year * 12
 Simple and easy to understand and use.

Objective – using cash flows.

Merits of
Disc.Pay For uncertainties- More approachable

Back Cautious & risk averse – ignores later cash

flows.
Period
First level estimator – gives rough idea
about the recovering the investment.
 • Ignores cash flows after the
Demerits of payback period.
• Percentage of return on
Disc. Pay capital invested is not
Back Period measured.
 DECISION RULE

Acceptance or Rejection Rule for Disc.Pay Back Period

Single or Independent Project(s) Mutually Exclusive Projects

Less than the Target Period Shortest Payback Period

12
 Discounting Criteria: Net Present Value
4. Net Present Value Method:- It is the best method for
evaluation of investment proposal. This method takes into
account time value of money.
NPV= PV of inflows- PV of outflows
➢ Evaluation of Net Present Value Method:- Project
with the higher NPV should be selected.

Accept if NPV>0
Reject NPV<0
May or may not accept NPV=0
 Takes account of the time value
of money.
Instrumental in understanding
exact addition to shareholder’s
Merits wealth.

Takes account of risk.

of NPV Looks at total benefits over the
entire life of the project.

Particularly useful for mutually

exclusive projects.
 Adverse effects on accounting profits in the
short run.

How to choose discount rate? As NPV is

Demerits dependent on discount rate. Bank rate, or
WACC or another?

of NPV May not give satisfactory results where

projects have different lives.

In case the projects have different cash

outlays, it may not give dependable results.
 DECISION RULE

Acceptance or Rejection Rule for NPV

Single or Independent Project(s) Mutually Exclusive Projects

• NPV>0, Accept Highest NPV

• NPV<0, Reject
• NPV=0, Accept or Reject

12
 Discounting Criteria: Profitability Index
5. Profitability Index Method - As the NPV method it is
also shows that project is accepted or not. If Profitability
index is higher than 1, the proposal can be accepted.

Accepted PI>1
Rejected PI<1

Total Cash Inflows

Profitability index =
Total Cash Outflows
 Takes account of the time
Merits of value of money.

PI Better technique than NPV in

situations where capital
rationing issues are involved.
 • In mutually exclusive projects
Demerits NPV appears to be superior
of PI technique than PI.
• Difficult to understand.
 DECISION RULE

Acceptance or Rejection Rule for PI

Single or Independent Project(s) Mutually Exclusive Projects

• PI>1, Accept Highest PI

• PI<1, Reject
• PI=1, Accept or Reject

12
Discounting Criteria: Internal Rate of Return
5. Internal Rate of Return Method:- IRR is the rate of
return that a project earns. The rate of discount calculated by
trial and error , where the present value of future cash flows is
equal to the present value of outflows, is known as the Internal
Rate of Return.

NPV of Higher Rate

IRR = Higher Rate - Difference in cash flows * Difference in Rate

NPV of Lower Rate

IRR = Lower Rate + Difference in cash flows * Difference in Rate
 Takes account of the
time value of money.

Merits Easy to be understood

by managers.
of IRR
Takes into account
total cash inflows and
total outflows.
Demerits of IRR
• Involves tedious calculations.
• Difficult to use in choosing projects of varying sizes.
• Difficult to choose when projects have the same IRR.
• Not dependent on the discount rate.
 DECISION RULE

Acceptance or Rejection Rule for IRR

Single or Independent Project(s) Mutually Exclusive Projects

• Higher than the Target Rate With the highest IRR

(Cost of Capital)

12
 Example
The expected cash flows of a project are:-
Year Cash Flows ( Rs.)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
The cash outflow is Rs. 1,00,000
The cost of capital is 10%
Calculate the following:
a) NPV b) Profitability Index
c) IRR
d) Pay-back period e) Discounted Pay-back Period
 Computation of NPV and PI
Year Cash Flows (Rs.) PV Factors@10% PV of Cash Flows (Rs.)

1
Computation
20,000
of
.909
NPV & PI18,180
2 30,000 .826 24,780
3 40,000 .751 30,040
4 50,000 .683 34,150
5 30,000 .620 18,600
Total Cash Inflow 1,25,750
Less: Cash 1,00,000
Outflows
NPV 25,750
P.I. 1.2575
 Computation of IRR
Year Cash PV Factors PV of Cash PV Factors PV of Cash
Computation of NPV& PI
Flows (Rs.) @19% Flows (Rs.) @18% Flows (Rs.)
1 20,000 .84 16,800 .847 16,940
2 30,000 .706 21,180 .718 21,540
3 40,000 .593 23,720 .609 24,360
4 50,000 .499 24,950 .516 25,800
5 30,000 .42 12,600 .437 13,110
Total Cash Inflow 99,250 1,01,750
Less Cash Outflows 1,00,000 1,00,000
NPV (-)750 (+)1750
Computation of IRR Contd..
Computation of non discounting pay-backperiod
Year Cash Flows (Rs.) Cumulative Cash Flow

1 20,000 20,000
2 30,000 50,000
3 40,000 90,000
4 50,000 1,40,000
5 30,000 1,70,000

Completed years + Required inflow *12

PBP = Inflow of Next year

= 3years+ (1,00,000-90,000) *12

50,000
 Computation of discounted pay-backperiod
Year Cash Flows PV PV of Cash Cumulative
(Rs.) Factors@10% Flows (Rs.) Cash Flows
1 20,000 .909 18,180 18,180
2 30,000 .826 24,780 42,960
3 40,000 .751 30,040 73,000
4 50,000 .683 34,150 1,07,150
5 30,000 .620 18,600 1,25,750

Completed years + Required inflow *12

PBP = Inflow of Next year
= 3years+ (1,00,000-73,000)*12
34150
= 3.79 years
THANK YOU!