Unit-2

Capital Budgeting
Business Finance
B.Com(H) 3rd Year
Group: C/D
Dr. Aftab Alam
Assistant Professor
D/O : Commerce (IUL)
 Capital Budgeting
The capital budgeting decisions are related to the allocation of investible Funds Io different
long-term assets.
The term capital refers to long term assets used in production, while a budget is a plan that
details projected inflows and outflows during some future period.
the capital budget is an outline of planned investments in fixed assets, and capital budgeting is
the whole process of analyzing projects and deciding which ones to select in the capital budget.
This decision directly affects the profits of the firm by increasing the revenue or by decreasing
cost such as purchasing a new, more efficient machine reduces the cost of manufacturing.
capital budgeting decisions basically lies in critical evaluation and analysis of various
alternative investment proposals and then to select the one, which are expected to contribute
maximum to the shareholders wealth in the long run.
 Features Of Capital Budgeting

Capital Budgeting is characterized by the following features:

• There is a long duration between the initial investments and the expected returns.

• The organizations usually estimate large profits.

• The process involves high risks.

• It is a fixed investment over the long run.

• Investments made in a project determine the future financial condition of an organization.

• All projects require significant amounts of funding.

• The amount of investment made in the project determines the profitability of a company.
 Process Of Capital Budgeting

• The process of Capital Budgeting involves the following points:

1. Identifying and generating projects: Investment proposals are the initial step in capital
budgeting. Businesses consider investments for various reasons, such as adding or
expanding a product line, increasing production, or reducing production costs.
2. Evaluating the project: To evaluate the necessity of a proposal, it's essential to select all
relevant criteria. The proposal should align with the company's mission to maximize
market value, considering the time value of money.
3. Selecting a Project: Since there is no ‘one-size-fits-all’ factor, there is no defined
technique for selecting a project. Every business has diverse requirements and therefore,
the approval over a project comes based on the objectives of the organization.
 Process Of Capital Budgeting

4. Implementation: Once the project is implemented, now come the other critical elements
such as completing it in the stipulated time frame or reduction of costs. Hereafter, the
management takes charge of monitoring the impact of implementing the project.
5. Performance Review: This involves the process of analyzing and assessing the actual results
over the estimated outcomes. This step helps the management identify the flaws and eliminate
them for future proposals.
 Importance Of Capital Budgeting
• 1. Large Investment: Capital budgeting decisions, generally, involve large investment of
funds But the funds available with the firm are always limited and the demands for the funds
far exceeds the resource. Hence it is very important for a firm to plan and control its capital
expenditure.
• 2 Funds are Blocked for Long-Term: Capital expenditure involves not only large amount of
funds but also funds are blocked for long-term or on permanent basis. The long-term
commitment of funds increases the financial risk involved in the investment decision. Grater
the risk involved, greater is the need for careful planning of capital expenditure 1 e. Capital
budgeting
• 3. Irreversible Nature: The capital expenditure decisions are of irreversible nature. Once the
decision for acquiring a permanent asset is taken, it becomes very difficult to dispose of
these assets without incurring heavy losses.
 Importance Of Capital Budgeting

• 4. Long-Term Effect on Profitability: Capital budgeting decisions have a long-term and

significant effect on the profitability of a concern. Not only the present earnings of the firm
are affected by the investment in the capital assets but also the future growth and
profitability of the firm depends upon the investment decision taken today. An unwise
decision may prove disastrous and fatal to the very existence of the concern.
• 5. Critical Investment Decision: The long-term investment decisions are difficult to be taken
because
• (1) decision extends to a series of year beyond the current accounting period,
• (ii) uncertainties of future events and
• (iii) higher degree of risk as compared to short term investment decisions.
 Capital Budgeting Techniques

(A) Traditional ( Non-Discounting Technique)

• Pay-Back Period
• Accounting Rate of Return
(B) Techniques that Recognize Time Value of Money
• Net Present Value
• Internal Rate of Return
• Profitability Index
 Pay Back Period Method:

• The payback period method is usually expressed in years, which it takes the cash inflows
from a capital investment project to equal the cash out
• When deciding between two or more competing projects the usual vision is to accept the one
with the shortest payback.
• Payback is commonly sed as a first screening method.
• It is a rough measure of liquidity and rate of profitability
• This method recognizes the recovery of the original capital invested in a project.
• The basic element of this method is a calculation of recovery time of the cash inflows
(inclusive of depreciation) year by year until the cash inflows equal the amount of the
original investment.
 Pay Back Period Method:
• Computation of the Payback Period:
• When the cash- inflows of any project are equal per time period :
For example, a proposal requires a cash outflow of Rs. 2,00,000 and is expected to generate cash
inflows of Rs. 40,000 p.a. for 7 years. In this case, the payback period is 5 years i e, Rs. 2,
00,000/Rs. 40,000. The initial cash outflow of Rs. 2,00,000 will be fully recovered within a period
of 5 years and the cash inflows occurring thereafter (i., e., in the 6th, 7th year) are ignored.
When cash inflows from the project are not equal then the cumulative cash inflows are used to
compute the payback period.
For example, a project requires a cash outflow of Rs. 32,000 and is expected to generate cash
inflows of Rs. 10,000, Rs. 8,000, Rs. 7,000, Rs. 6,000 and Rs. 4,000 over next 5 year and the
balance of Rs 1,000 is remaining, which is received in the s next 5 years respectively. In this case,
at the ending, which a sum of Rs 31,000 year as the cash inflow in 5th year is 4,000 Rs.
 Pay Back Period Method:
Year Annual CF Cumulative CF
1 10,000 10,000
2 8,000 18,000
3 7,000 25,000
4 6,000 31,000

5 4,000 35,000

• the payback period of this problem can be calculated as follows:

• Payback=.4+1,000/4,000
• = 4.25 yrs
 Accounting Rate Of Return
• Accounting Rate Of Return: (ARR). The ARR Can Be Calculated By Dividing The Average
After Tax Profit By The Average Investment.
• Symbolically, ARR= Average Annual-profit (After Tax)*100/Average Investment.
• Average Investment : = 1/2(initial Cost+ Installation Expenses - Scrap Value) + Scrap
Value + Additional Working Capital.
• it may be noted that in the above equation, the amount of scrap val has been first deducted
and later added back.
• the scrap value has bee deducted to find out the annual amount of depreciation.
• however, this amount of scrap value remains blocked in the proposal and is released only at
the end of the useful life of proposal. therefore, the amount of scrap value has been added
back to find out the average investment.
 ACCOUNTING RATE OF RETURN

• Example: XYZ Ltd. Invest in a project with an initial out lay of Rs. 1,40,000 with Expected
life of 5 years and the scrap to 10,000
• The project expected to generate annual average profit of Rs 20,000.Calculate the ARR of
the project.
• Solution : Average investment=[(1,40,000-10,000)/2]+10,000
• =Rs. 75,000
• Average Profit=20,000
• ARR= (Average annual profit / Average investment) ×100
• = (20,000/75,000)×100
• =26.7%
 Discounted Techniques
• As discussed earlier that money has time value, cash flows that occur earlier in time are
worth more than cash flows that occur later, differences are as inflation and interest rate
increase.
• The discounted cash flow techniques or the time adjusted cash flow techniques, as against
the traditional techniques already disclosed, are based upon the fact that the cash flows
occurring at different point of time are not laving some economic worth.
• In order to make these cash flows equal in between differences flows and a predetermined
discount rate. These methods which involve the time value of money, more accurately reflect
the true economic trade-off and returns.
 Net Present Value (NPV) Method:
1. Net Present Value (NPV) Method: The net present value (NPV) of a project is equal to
the sum of present values of all the cash in flows associated with it minus the amount of
investment in the project.
2. NPV is used simply to weigh the elements of trade off between investment outlays and the
future benefits in equivalent terms, and to determine whether the net balance of the present
values is favorable or not.
3. A rate of discount must be specified and applied to both inflows and outflows in order to
find out their present values. When the present values of all inflows and outflows are
added, the resultant figure is denoted as net present value. The figure can be positive or
negative, depending on whether there is a net inflow or outflow from the project.
4. if the NPV of the proposal is 0, than the firm may be indifferent between acceptance and
rejection of the proposal.
 Net Present Value (NPV) Method:
• Q.2 The Bharat Ltd. is considering a proposal for the investment of Rs.
5,00,000 on product development which is expected to generate net cash
inflows for 6 years as under:
• Year Net Cashflows (000) Present value factor
• 1 Nil 0.87
• 2 100 0.76
• 3 160 0.66
• 4 240 0.57
• 5 300 0.50
• 6 600 0.43
 Net Present Value (NPV) Method:
Year Cash inflow Present value Present
factor value( CIF*PV)
1 Nil 0.87* Nil
2 100 0.76( 0.87/115) 76
3 160 0.66(0.76/115) 105.60
4 240 0.57(0.66/115) 136.80
5 300 0.50(0.57/115) 150.60
6 600 0.43(0.50/115) 258.00
Total=726
Less: cash outlay 500
*=100/115x100=0.87 Net Present value=
226.40
 Internal Rate Of Return (IRR):
• Internal Rate of Return (IRR): The other important discounted cash flow technique of
evaluation of capital budgeting proposals is known as technique.
• IRR as the discount rate, which produces a zero NPV i, e., the IRR is the discount rate which
will equate the present value of cash inflows with the present value of cash outflow.
• In the IRR technique, the future cash inflows are discounted in such a way that their total
present value is just equal to the present value of total cash outflows.
• In mathematical terms IRR can be expressed as the value of 'r' in theequation given below.
Present value of cash out flow =CF,/(1+r)+CF/(1+r)²+ CF,/(1+r)²+ ....+CF/(1+r) Where, CF,
(i = 1,2,3....n)
 Profitability Index (PI) Method

• Profitability Index (PI) Method : It is a method of assessing capital

expenditure opportunities in the profitability index, sometimes called the
cost benefit ratio.
• The profitability Index is the present value of anticipated net future cash
flows divided by the initial out lay.
• In general terms, a project is acceptable if its profitability index value is
greater than 1 clearly a project offering a profitability index greater than I
must also offer a net present value which is positive
• profitability index) can be expressed as follows: PI= PV of cash inflow
• PV of cash initial
outlay
 Cost Of Capital: Meaning And Importance

• Meaning: The cost of capital represents the return rate a company must earn on its
investments to maintain its market value and attract funds.
• It is essentially the opportunity cost of investing capital in a specific business,
which means it's the rate of return that investors expect from an investment with a
similar risk profile.

• There are several components to the cost of capital:

• 1. Cost of Debt
• 2. Cost of Preference Capital
• 3. Cost of Equity
• 4. Cost of Retained Earnings
 Importance Of Cost Capital
• The cost of capital is crucial for several reasons:

• 1. Investment Decisions: Companies use the cost of capital as a benchmark to evaluate new
projects and investments. A project is typically considered worthwhile if its expected return
exceeds the cost of capital. This ensures that the investment will add value to the company.

• 2. Capital Structure Optimization: Understanding the cost of different sources of capital

helps a company optimize its capital structure (the mix of debt, equity, and other financing
sources) to minimize the overall cost of capital, thereby maximizing shareholder value.

• 3. Performance Measurement: The cost of capital serves as a hurdle rate for measuring the
performance of existing investments. If the return on investment is lower than the cost of
capital, it indicates that the investment is underperforming.
 Importance Of Cost Capital
• 4. Valuation: In financial modeling and valuation, the cost of capital is used as the discount
rate in discounted cash flow (DCF) analysis. A lower cost of capital increases the present
value of future cash flows, enhancing the company's valuation.
• 5. Risk Management: It incorporates the risk associated with different financing sources.
Higher cost of equity reflects higher perceived risk by equity investors, while the cost of
debt reflects the risk perceived by lenders. This understanding helps in managing and
mitigating financial risks.
 Cost Of Debt
• Cost of Debt: capital structure of the firm normally includes the debt component.
Debt may be in the form of Debentures, Bonds, term loans from financial
Institutions and Banks.
• (a) Cost of Debenture: The cost of a debenture is defined as that discount rate which
equates the net proceeds from issue of debentures to the expected cash outflows in
the form of interest and principal repayments.
• Kd= I(1-t)+(F-P)/n
• (F+P)/2
• where, T =Tax Rate, I = Annual interest payment per debenture capital,
F = Redemption price per debenture, P = Net amount realized per debenture
n = Maturity period,
 Cost Of Preference Capital
• Cost of Redeemable Preference Shares: Preference shares issued by a company
which are redeemed on its maturity is called redeemable preference shares.
• Cost of redeemable preference share is similar to the cost of redeemable debentures
with the exception that the dividends paid to the preference shareholders are not tax
deductible.
• Cost of preference capital is calculated as follows:
• (k_{p}) = (PD + (RV - NP)/n)
• (RV + NP)/2)
Where, PD =Annual preference dividend
RV =Redemption value of preference shares
NP =Net proceeds on issue of preference shares
n =Life of preference shares.
 Cost Of Equity Capital
• Cost of Equity Capital: Equity capital involves an opportunity cost; ordinary
shareholders supply funds to the firm in the expectation of dividends
(including capital gains) commensurate with their risk of investment.
• The market value of the shares determined by the demand and supply forces
in a well functioning capital market reflects the return required by ordinary
shareholders.
 Methods To Calculate Cost Of Equity

1.Dividend Discount Model (DDM)

2.Capital Asset Pricing Model (CAPM)
• 1. Dividend Discount Model (DDM)
• The Dividend Discount Model calculates the cost of equity by considering the dividends
expected to be received by shareholders and the growth rate of these dividends.
• Ke=D1/P0+g
• Where:
• Ke​= Cost of equity
• D1 = Expected dividend per share next year
• P0P = Current market price per share
• g = Growth rate of dividends
• Problem: LMN Ltd. has a current share price of ₹250. The company expects to
pay a dividend of ₹15 per share next year, which is expected to grow at a rate of
4% per year. The beta of the company is 1.1, the risk-free rate is 7%, and the
expected market return is 14%. Calculate the cost of equity using both DDM and
CAPM, and comment on any differences.
• Solution:
• Using DDM:
• Ke=D1/P0+g
• Where:
• D1​= Expected dividend next year = ₹15
• P0 = Current market price per share = ₹250
• g= Growth rate of dividends = 4% = 0.04
• Ke=15/ 250+0.04
• Ke =0.06+0.04
• Ke=0.10 or 10%
 Capital Asset Pricing Model (CAPM)

• 2. Capital Asset Pricing Model (CAPM)

• The Capital Asset Pricing Model calculates the cost of equity based on the risk-free rate, the
expected market return, and the stock's beta, which measures its volatility relative to the
market.
• KeKe​=Rf​+β(Rm​−Rf​)
• Where:
• Ke​= Cost of equity
• RfR = Risk-free rate
• β\betaβ = Beta of the stock
• RmR = Expected market return
• Using CAPM:
• Ke=Rf+β(Rm−Rf)
• Where:
• RfR = Risk-free rate = 7% = 0.07
• β = Beta of the stock = 1.1
• Rm = Expected market return = 14% = 0.14
• Ke=0.07+1.1(0.14−0.07)
• Ke = 0.07 + 1.1x 0.07)
• K_e = 0.07 + 0.077
• Ke=0.147 or 14.7%
• Other Methods (cost of equity):
(1) Earning yield method:
Ke = (EPS/ MPS)x 100
(ii) Dividend yield method / Dividend price ratio method:
Ke = Dividend per share / M.PS x 100
or Ke = Dividend/ NP x 100
(iii) Dividend yield growth model
Ke = (Dividendx100)+G /M.P.S.
Ke = (Dividendx100)+G /NP
• Question . The Beta coefficient of Compu-tech Ltd. is 1.2 the company has
been maintaining 5% rate of growth in dividends and earnings. The last
dividend paid was 2.40 per share. Return on Government securities is 10%.
Return on Market portfolio is 14%. The current market price of one share of
Compu-tech Ltd. is 28. The earnings per share is 3.90.
• Calculate the cost of equity capital basing on.
• (i) Dividend Yield Method
• (ii) Dividend Growth Model
(iii) Earnings Price Model
• (i) Dividend Yield Method: Ke =DPS 2,40/28x 100=8.57
• (ii) Dividend Growth Model: D1=Do (1+g) 2.40 (1.05) = 2.52
• Ke= 2.52/28 +0.05 =14%
• (iii) Earnings Price Model: Ke =EPS/MPS= 3.90/28= 13.93%
 WEIGHTED AVERAGE COST OF
CAPITAL (WACC)
• Weighted Average Cost of Capital (WACC): weighted average cost of
capital (WACO is the weighted average cost of the costs of various
sources of financing.
• WACC is also known as composite cost of capital, overall cost of capital.
• WACC= Ke x W1+ kd x w2 + Kp x w3
• Where, W₁ = Proportion of equity capital in the capital structure
• W2 = Proportion of debt in the capital structure
• W3 = Proportion of preference capital in the capital structure
• Question 31: The capital structure of a company consists of equity shares
of ₹50 lakhs, 10 percent preference shares of 10 lakhs and 12 percent
debentures of 30 lakhs. The cost of equity capital for the company is 14.7
percent and income-tax rate for this company is 30 percent
• You are required to calculate the Weighted Average Cost of Capital (
Sources Amount(lakh Weight Cost of WACC
) capital
•
Equity Capital 50 0.555 14.78 % 8.17%
10% 10 0.111 10% 1.11%
Preference
Capital
12% 30 0.333 8.4*% 2.80%
Debentures

Total Amount 90 1.000 12.08

Cost of Debentures (after tax) = 12% (1-0.30) = 84%
• (a) Book Value Weights: The weights are said to be book value weights if
the proportions of different sources are ascertained on the basis of the
face values ie, the accounting values.
• (b) Market Value Weights: The weights may also be calculated on the
basis of the market value of different sources ie, the proportion of each
source at its market value.
 COST OF RETAINED EARNING

Retained Earnings is the portion of net profit distributed to shareholders is

called Dividend and the remaining portion of the profit is called Retained
earning.
In other word, the amount of undistributed profit which is available for
investment is called Retained earning.
Retained earning is considered as internal source of long-term financing
and it is a part of shareholders equity.
■ The cost of retained earning must be at least equal to shareholders rate
of return on re-investment of dividend paid by the company
• i) Cost of retained earnings when there is no flotation cost and personal tax
rate applicable for shareholders:
• Cost of retained earnings = Cost of equity = (D1/NP)+g
D1 = Expected dividend per share
NP = Current selling price or net proceed
g = Growth rate
ii) Cost of retained earnings when there is flotation cost and personal tax rate
applicable for shareholders:
Cost of retained earnings=Cost of equity x (1-fp) (1-tp)
where, fp = flotation cost on re-investment by shareholders
tp = Shareholders' personal tax rate.
A company has issued equity share capital having a face of Rs. 10 at a
premium of 10% , incurring 5% of the issue price as cost of issue. The expected
rate of dividend is 20%
• (1) What is the cost of equity capital
• (2) What is the cost of retained earnings if the market value of equity share is
15.
• Solution:)
• Face Value/Nominal value of Equity shares = 10
• Issue 10% premium
• Issue price of the equity share = 10 1+ =11
• NP = 11 (0.5) = 10.50
• D₁ = 20% of nominal value = 0.20 x 10 = 2
• Ke = D1/NP = 2/10.45 0.1914 = 19.14%
• Kre = D1/Po = 2/₹15 = 0.1333 = 13.33%