Unit 2 Capital Budgeting – Project Planning and Risk Analysis
Unit 2
Capital Budgeting – Project Planning and Risk Analysis
Meaning of Capital Budgeting:
The Capital Budgeting process includes identifying and evaluating capital projects for the
company. This process can be used to examine future earnings decisions like buying of
machine, expanding operations at another geographic location, replacing the old asset.
These decisions have the power to impact the future success of the company.
Aspects of Capital Budgeting:
Capital Budgeting process has the following four aspects:
1) Generation of Ideas:
Generation of good quality project ideas is the most important capital budgeting
aspect. Ideas can be generated at management or employees level or even from
outside the company.
2) Analysis of Proposals:
The basics of accepting or rejecting a proposal is expected cash flows in the future
to determine expected profitability of project.
3) Creating the Corporate Capital Budget:
Once the profitable projects are shortlisted, they are prioritized according to the
available company resources. Some projects may be attractive, but may not be a fit
to the company’s overall strategy.
4) Monitoring and Post-Audit:
A follow up on the decision is equally important in the capital budgeting process.
The analysis compares the actual results of the projects to the budgeted ones and
the project manager is responsible if the projections match or do not match with
the actual results.
Stages of Capital Budgeting:
1) Investment
Cost of Fixed Assets + Installation Exp - Sales of Old Fixed Assets + Payment of
tax on capital gain - Saving of tax on capital loss + Working Capital.
2) Cash Inflow
A) Sales - Variable Cost - Fixed Cost = Net Profit before tax – Depreciation – Tax
= Net profit after tax + Depreciation
B) Net Profit before tax – Tax = Net profit after tax + Depreciation
C) Net Profit after tax + Depreciation
Unit 2 Capital Budgeting – Project Planning and Risk Analysis
3) Terminal Cash Inflow
Scrap Value of New Fixed Asset – Payment of tax on capital gain + Savings of tax
on capital loss + Recovery of Working Capital
Techniques of Capital Budgeting Evaluation:
Technique 1- Traditional or Non-Discounting Technique:
This technique does not discount the cash flows to find out present worth or present
value. Methods as below-
a) Payback Period
The payback is defined as the number of years required for the proposal’s
cumulative cash inflow to be equal to its cash outflow. In other words, the payback
period is the length of time required to recover the initial investment of the project.
It is calculated in different situations-
Situation 1- when annual cash inflows are uniform
When cash inflows are uniform or equal, the payback period is calculated by
dividing the cash outflow with annual cash inflow. For example a project requires
an initial investment of Rs. 1,00,000 which could generate an annual cash inflow
of Rs. 20,000 in a year, hence the project would take five years to recover the
amount of Rs. 1,00,000
Payback Period = 1,00,000
20,000
= 5 years
Situation 2- when the annual cash inflows are not uniform
In case the cash inflows from the proposal are not same, cumulative cash inflows
are used to compute the payback period.
b) Average Rate of Return (ARR)
It is also known as Accounting Rate of Return. It is defined as the annualized net
income earned on the average investment of a project. It is expressed in
percentage.
ARR = Average Annual Net Profit after Tax * 100
Unit 2 Capital Budgeting – Project Planning and Risk Analysis
Average Investment
Average Annual Net Profit after Tax = Total Profit after Tax
No. of Years
Average Investment =
Initial Investment (Cost of Fixed Asset) + Install. Exp.
– Scrap Value of Fixed Asset + Working Capital + Scrap Value of F.A.
2
Technique 2- Time Adjusted or Discounted Technique:
Money has time value. Cash flows occur earlier in time are worth more than cash flows
that occur later. Differences are considered as inflation. Time adjusted or discounted
technique involves time value of money, more accurately reflect the true economic value
of returns. This technique is also called the present values technique and fulfils all the
requisite of good evaluation technique. Methods as below.
a) Net Present Value (NPV)
The NPV is defined as the sum of present values of all cash inflows less the sum
of present values of all the cash outflows associated with a proposal.
NPV= Present Value of Cash Inflows – Present Value of Cash Outflows
b) Profitability Index (PI)
PI is defined as the benefits-cost ratio. It is ascertained by comparing the present
value of the future cash inflows with the present value of the future cash outflows.
PI = Present value of the future cash inflows
Present value of the future cash outflows
c) Discounted Payback Period
This method is a combination of the original payback method and the discounted
cash flow technique.
d) Internal Rate of Return (IRR)
= L+ A (H – L)
(A-B)
Where, L = Lower discount rate at which NPV is positive
H = Higher discount rate at which NPV is negative
A = NPV at lower discount rate, L
B = NPV at higher discount rate, H
