Financial Management Basics of Capital Budgeting

Financial Management
Basics of Capital Budgeting
S. Maninder Singh (Roll No 16)

Vandana Kaushik (Roll No 13)
Krupa Adhi (Roll No 14)
Kareem Mohammed (Roll No 15)
Capital Budgeting
• Capital Budgeting is a project selection exercise
performed by the business enterprise.
• Capital budgeting uses the concept of present value and
future value to select the projects.
• Capital budgeting uses tools such as pay back period,
net present value, internal rate of return, to select
projects.
• It helps the company to choose the best project among
the options available for the management.
• It narrows down the risk involved in the project.
Methods of Capital Budgeting
• Payback Period
• Accounting Rate of Return
• Net Present Value
• Profitability Index
• Internal Rate of Return
Let us check the above methods in next few
slides.
Payback Period
 Payback period is the time duration
required to recoup the investment
committed to a project.
 Business enterprises following payback
period use "stipulated payback period",
which acts as a standard for screening the
project.
Payback Period
Eg: If a company has invested in a project x an amount of
1,00,000. Payback period will review each year as to how
much returns are received. If company receives as follows:
Year Return on investment (Annually)
1 30,000
2 50,000
3 20,000
4 40,000
Payback period = Initial Investment/Annual cash inflow

Here, company has received its investment back in 3 years.
Accounting Rate of Return
• Accounting rate of return is the rate arrived at by expressing the
average annual net profit (after tax) as given in the income
statement as a percentage of the total investment or average
investment.
• The accounting rate of return is based on accounting profits.

Accounting profits are different from the cash flows from a
project and hence, in many instances, accounting rate of return
might not be used as a project evaluation decision.
• Accounting rate of return does find a place in business decision

making when the returns expected are accounting profits and not
merely the cash flows.
Accounting Rate of Return
Eg: If there are two projects A & B. Average profit after tax and
average investment if given. Then we calculate ARR as follows:
ARR = Avg Annual profit after tax/Avg Investment * 100
Avg Annual profit = Total profit/No. of Yrs
Avg Investment = Half of (cost of project + Installation – Scrap)
Note: The project which has more ARR than other project has to
be selected as return on investment will be more.
Net Present Value (NPV)
Net present value of an investment/project
is the difference between present value of
cash inflows and cash outflows.
The present values of cash flows are

obtained at a discount rate equivalent to
the cost of capital.
Net Present Value (NPV)
Eg: If there are two projects say X & Y. If cash inflows and
cash outflow is given. We can calculate NPV.
NPV = PV of Cash flows/Cash outflows
Present Value (PV) is taken “Cost of capital”, which is the

percentage. If cost of capital is not given, then we take 10%.
Note: The project which has more NPV will have more
return on investment, therefore, we should select the
project which has more NPV.
Profitability Index (PI)
• Profitability ratio is otherwise referred to as Benefit/Cost ratio. This
is an extension of the Net Present Value Method.
• This is a relative valuation index and hence is comparable across

different types of projects requiring different quantum of initial
investments.
• Profitability index (PI) is the ratio of present value of cash inflows to

the cash outflows.
• PI = PV of Cash inflows/Cash outflows.
• The project which has more Profitability Index, will have more
return on investment. Hence we select the project having more PI.
Internal Rate Of Return (IRR)
• The internal rate of return method is also
known as the yield method.
• In this method, we should select two

percentages or two rates in such a way
that one present value must be more than
the cost of project and another amount
must be less than the cost of project.
Internal Rate Of Return (IRR)
• IRR is calculated separately for two or
more projects.
• The project which has more IRR, we select

that project because return on that project
will be more than other projects.
Importance of Capital Budgeting
• It reduces risk.
• It provides management a tool for
selecting right project.
• Return on investment can be carefully
planned.
• Investments can also be managed
properly.
Thank You

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Financial Management

Basics of Capital Budgeting

S. Maninder Singh (Roll No 16)

Payback period = Initial Investment/Annual cash inflow

• The accounting rate of return is based on accounting profits.

• Accounting rate of return does find a place in business decision

ARR = Avg Annual profit after tax/Avg Investment * 100

Avg Annual profit = Total profit/No. of Yrs

Avg Investment = Half of (cost of project + Installation – Scrap)

The present values of cash flows are

NPV = PV of Cash flows/Cash outflows

Present Value (PV) is taken “Cost of capital”, which is the

• This is a relative valuation index and hence is comparable across

• Profitability index (PI) is the ratio of present value of cash inflows to

• PI = PV of Cash inflows/Cash outflows.

• In this method, we should select two

• The project which has more IRR, we select

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