Capital Budgeting

Introduction
 Capital budgeting is the process of evaluating and selecting
long term investments that are consistent with the goal of
shareholders (owners) wealth maximization.
 Features of capital budgeting
 Potentially large anticipated benefits
 High degree of risk
 Long period between the initial outlay and the anticipated
returns (Long Term Implications)
 Irreversible (Reverse with significant loss)
 Complexity
 Large Amount (CAPEX)
Capital Expenditure
 Capital expenditure is an outlay of funds that is expected to produce
benefits over a period of time exceeding one year.
 Capital expenditure management includes addition, disposition,
modification and replacement of fixed assets.
 Significance of capital budgeting
 Capital Budgeting decisions affect the profitability of the firm
 Risk exposure of funds committed in capital expenditure projects
 Effects on operating expenditures and the patterns of cash flows
for a longer period
 Where a company is contemplating to diversify its operations or
expand its activity the management is required to make a series
of investment decisions
 Classification of Investments
Mutually exclusive investments
They serve the same purpose and compete with each other, if one
investment is undertaken others will have to be excluded. E.g. A
company may use the labour intensive technique or capital
intensive technique for manufacturing.
Independent investments (Accept – Reject Decision)
They serve different purposes and do not compete with each
other. E.g. Expansion or modernization decision of the Company.
Contingent investments
These are dependent projects.
The choice of one investment necessitates undertaking one or
more other investments.
Process of Capital Budgeting
 Need of Project
 Study of alternatives
 Evaluation of available Alternatives
 Financial analysis
 Feasibility analysis
 Selection of project
 Monitoring of project
 Post commercialization analysis
Cash Flow Analysis for Capital Budgeting
Cash Outflow
It is the outflow which needs to be incurred on financing the
required project.
 Cost of Fixed Assets (Project Cost)
 Working Capital Requirement
Cash Inflow
It is the expected cash inflow during the tenure of the funded
project.
 Operational Cash Inflow
 Terminal Cash Inflow
Measurement of Cash Inflows
Operational Inflow
Particulars Amount (Rs.)
Sales xxxx
Variable Cost xxxx
Fixed Cost xxxx
Depreciation xxxx
Profit Before Tax xxxx
Income Tax xxxx
Profit After Tax xxxx
Depreciation xxxx
Operational Cash Flow xxxx
Terminal Inflow
It is a cash inflow which is released after the closure of project.
Capital Budgeting Techniques
Traditional Technique Modern Technique
(Non-Discounted Methods) (Discounted Methods)
 Pay-back period  Discounted Pay-back Period
 Average Rate of Return  Net Present Value (NPV)
(ARR)  Internal Rate of Return
(IRR)
 Profitability Index (PI)
Pay-back Period
 Payback period is the time required to recover the initial investment.
 A firm is always interested in knowing the amount of time required to
recover its investment.
 It is based on the concept of cash flow and is a non-discounting
technique.
Calculation of Payback Period
When Cash Flows are equal/even throughout the project

When Cash Flows are equal/even throughout the project

Pay-back Period
Merits of Pay-back Period Demerits of Payback Period
 It is easy to calculate and simple  This method neglects cash flows
to understand. occurring after the payback period:

This method does not consider the
It is useful in case of those
amount of profit earned after the
industries where there is a lot of
recovery of the cost of investment.
uncertainty and instability
Some projects may have higher cash
because it lays emphasis on the
inflows after the payback period.
speedy recovery of investment.
 This method does not consider the
 It Measures liquidity of the
time value of money.
investment.
 This method does not consider the
risk associated with the project.
 This method ignores interest factor
which is considered very important
in taking sound investment decision.
Accounting Rate of Return (ARR)
 The accounting rate of return (ARR), also known as the
return on investment (ROI), uses the accounting information,
as revealed by the financial statements, to measure the
profitability of an investment
Calculation Methods
Return on Investment (ROI): When initial investment is taken
into account for calculation it is called ROI.

Average Rate of Return (ARR): When Average investment is

taken for calculation it is called ARR.
Average Rate of Return (ARR)

Merits of ARR Demerits of ARR

 It is simple and easy to calculate.  This method ignores the time value

of money.
It takes into account all the savings
over the entire period of  This method is based on accounting
investment. profits rather than cash flows. In
 order to maximize the wealth of
It is based on accounting profit
shareholders, cash flows should be
rather than cash inflow.
taken for calculation
Accounting profit can be easily
obtained from financial  This method ignores the size of
statements. investment. Sometimes ARR may be
 It measures the benefit in the same for different projects but
percentage which makes it easier some of them may involve huge cash
to compare with other projects. flows.
 This method helps to distinguish
between projects where the
timing of savings is approximately
the same.
Net Present Value(NPV) Method
 The NPV Method is a discounted cash flow technique.
 This method compares cash inflows and cash outflows
occurring at different time period.
 The major characteristic of this method is that it takes into
account the time value of money and all cash inflows and
outflows are converted to present value.
 The project which has higher NPV is being accepted.
 It is calculated as:

 Accept the project, if NPV > 0. In case of multiple projects,

higher NPV will be preferred.
Process of NPV Measurement
 Determine Cash inflows and outflows considering the realistic
assumptions.
 A discount rate or cut-off rate is determined. This rate is also
called as cost of capital, required rate of return, the target rate
of return, hurdle rate etc.
 With the help of this rate of return, present value of cash inflows
are calculated. For this purpose, Present Value Factor should be
calculated at a given rate with the help of PVF.
 Cash inflows of each year is then multiplied with PVF
 Discounted cash inflow of all years is added. In this way, the
Present Value of all Cash inflow is obtained.
 Finally, NPV is calculated by deducting PV of cash outflow from
PV of cash inflows
Net Present Value(NPV)

Merits of NPV Demerits of NPV

 This method recognizes the time  It has complex calculation.
value of money.  The NPV technique requires the
 This method recognizes risk predetermination of required rate of
involved in the project with the return, which itself is a difficult job. If
help of discounting rate. that rate is not correctly taken, then
the whole exercise of NPV may give
 This method is best for mutually wrong result.
exclusive projects where only one
 It does not provide a measure of
project is to be selected among
projects own rate of return, rather it
many.
evaluates a proposal against an
 This method is considered best as external variable i.e. minimum rate of
it is based on cash inflow rather return.
than accounting profit.  This method may not provide
 It considers total benefits arising satisfactory results in case of projects
out of project till the end of the having different amount of investment
project. and different economic life.
Internal Rate of Return(IRR)
 The internal rate of return (IRR) is the rate of return that a
company can expect to earn by investing in a project.
 The IRR is the rate of return at which the net present value
becomes zero.
 The higher the IRR, the more desirable the investment.
 In this technique, unlike net present value, we are not given
a discount rate. The discount rate is to be ascertained by
trial and error procedure.
Process of IRR Measurement
 Calculate PV Factor by using the below formula

 Search for a value nearest to Rate of Interest (PVF) from PVAF table
for given number of years.
 One value should be higher and one value should be lower to PVF.
 Take discount rates of those higher and lower PVF.
 Calculate present values of cash inflows
 Apply the following formula to determine IRR
Decision Making Under IRR
 Accept the project if the IRR is greater than required rate for
return.
 Decision Making under various Comparative IRR, If the
 IRR > K, accept the project
 IRR < K, reject the project.
 IRR = K, may accept the project.
Profitability Index (PI)
 Profitability Index This method is also known as Benefit-Cost
Ratio Method. It is based on Net Present Value method and
calculates the benefit on per rupee investment.

Decision Criteria under Single Projects

 PI > 1 Accept
 PI < 1 Reject
Decision Criteria under Multiple Projects
 Project with higher NPV should be selected.
Profitability Index (PI)
 It is superior to NPV method.
 It gives due consideration to the time value of money.
 PI techniques gives better result in case of projects having different
outlays.
 In PI, all cash flows are considered including working capital used
and released, salvage value is also considered.
 This method is considered best for wealth maximization of
shareholders as it is based on cash inflow rather than accounting
profit.
 It considers total benefits arising out of project till the end of the
project.
 The discount rate applied for discounting the cash flows is actually
the minimum required rate of return.