CAPITAL BUDGETING

DECISIONS
Capital Budgeting
• Capital budgeting is the art of deciding how to spend money wisely.
• It is the process of evaluating potential long-term investment
opportunities to determine which project will generate the most
profit. It involves analyzing future cash flows, considering the time
value of money, and assessing risks. Ultimately, the goal is to choose
investments that will help the project to grow and thrive.
Capital Budgeting
• The funds available to be invested in a project either as equity or
debt, also known as capital, are a limited resource. Accordingly,
managers must make careful choices about when and where to invest
capital to ensure that it is used wisely to create value for the projects.
The process of making these decisions is called Capital budgeting.
• This is a very powerful financial tool with which the investment in a
new project or even the acquisition of a project can be analyzed and
the basis (or cost justification) for the investment defined and
illustrated to relevant stakeholders.
Importance of Capital Budgeting
Capital budgeting helps to prioritize investments and allocate financial resources
more effectively, reducing the risk of investing in unprofitable projects and
maximizing returns. Overall, capital budgeting is an essential tool for projects to
achieve long-term growth and success because:
• Informs long-term investment decisions
• Reduces risk of unprofitable investments
• Maximizes profits by aligning with business goals
• Prioritizes investments and allocates resources efficiently
• Provides a framework for evaluating opportunities
• Promotes long-term growth and success
• Enables planning and budgeting for future investments
Capital Budgeting Techniques
and Methods
Capital Budgeting Techniques
and Methods
1. Payback Period
• The payback period is a capital budgeting technique used to
determine the amount of time required for a project to generate
enough cash flow to recover the initial investment.
• To calculate the payback period, divide the initial investment by the
expected annual cash inflows until the investment is fully recovered.
Capital Budgeting Techniques
and Methods
1. Payback Period
• For example, if a project costs 100,000 and is
expected to generate 25,000 in annual cash
inflows, the payback period would be four years.
Capital Budgeting Techniques
and Methods
Payback Period:
An enterprise plans to invest $100,000 to enhance its manufacturing process. It has
two mutually independent options in front: Product A and Product B. Product A
exhibits a contribution of $25 and Product B of $15. The expansion plan is
projected to increase the output by 500 units for Product A and 1,000 units for
Product B.

Here, the incremental cash flow will be calculated as:

(25*500) = 12,500 for Product A

(15*1000) = 15,000 for Product B

Capital Budgeting Techniques
and Methods

This brings the enterprise to conclude that Product B has a shorter

payback period and therefore, it will invest in Product B.
Capital Budgeting Techniques
and Methods
Payback Period
Advantages
• Simple and easy to understand
• Useful for evaluating short-term projects
• Provides a quick assessment of the project’s risk and liquidity
• Can help avoid investments that take too long to recoup their costs
• Does not require estimating future cash flows or discount rates
Limitations
• Ignores the time value of money
• Does not consider cash flows beyond the payback period
• Ignores profits earned after the payback period
• Ignores the risk associated with future cash flows
• Cannot be used to compare projects with different lifespans
Capital Budgeting Techniques
and Methods
2. Net Present Value (NPV)
• Net Present Value (NPV) is a financial metric that helps assess the profitability of an investment or
project. Net present value (NPV) is the difference between the present value of
cash inflows and the present value of cash outflows over a period of time. It is
widely used in capital budgeting to determine whether a project is likely to generate positive or
negative returns.
• The NPV is calculated by subtracting the initial investment cost from the present value of the
expected future cash flows. The formula for NPV is:

• NPV = Net Present Value

• T = the number of time periods (usually years)
• CFt​= Net cash flow during the time period ‘t’
• r = discount rate (the rate of return required for the investment)
• ​= Initial investment cost at time
• If the NPV is positive, it indicates that the project is expected to generate more cash inflows than the
initial investment, and it is generally considered a good investment. If the NPV is negative, it suggests
that the project may not be financially viable.
Capital Budgeting Techniques
and Methods
2. Net Present Value (NPV)
• The discount rate is often the cost of capital or the required rate of return for the project.
• Let's consider a simple example to illustrate how to calculate Net Present Value (NPV).
Suppose a company is considering an investment in a new project that requires an initial
investment of $100,000. The project is expected to generate the following net cash flows
over the next three years:
Year 1: $40,000
Year 2: $50,000
Year 3: $60,000
• Assuming a discount rate of 10%, let's calculate the NPV:
Capital Budgeting Techniques
and Methods
2. Net Present Value (NPV)

• In this example, the NPV is positive ($12,212.08), indicating that the project is expected
to generate more cash inflows than the initial investment. This suggests that, based on
the given assumptions and discount rate, the project is potentially a good investment.
 Capital Budgeting Techniques
and Methods
Example of Net Present Value (with 9%
Discount Rate ):
For a company, let’s assume the following
conditions:
• Capital investment = $10,000
• Expected Inflow in First Year = $1,000
• Expected Inflow in Second Year = $2,500
• Expected Inflow in Third Year = $3,500
• Expected Inflow in Fourth Year = $2,650
• Expected Inflow in Fifth Year = $4,150
• Discount Rate = 9%
 Capital Budgeting Techniques
and Methods

This indicates that if the NPV comes

out to be positive and indicates
profit. Therefore, the company shall
move ahead with the project.
Capital Budgeting Techniques
and Methods
Net Present Value (NPV)
Advantages
• Considers the time value of money
• Accounts for all expected cash inflows and outflows
• Provides a measure of the investment’s profitability
• Can be used to compare multiple investment opportunities
Limitations
• Requires accurate estimates of future cash flows and discount rates
• Can be complex and time-consuming to calculate
• Does not consider non-financial factors such as environmental impact or social
responsibility.
Capital Budgeting Techniques
and Methods
3. Internal Rate of Return (IRR)
The Internal Rate of Return (IRR) method is a capital budgeting technique that determines the
expected rate of return of an investment. It is the discount rate that makes the net present value of the
project’s expected cash inflows equal to the initial investment cost. It follows the rule that if the IRR is
more than the average cost of the capital, then the company accepts the project, or else it rejects the
project. If the company faces a situation with multiple projects, then the project offering the highest
IRR is selected by them.
Advantages
• Considers the time value of money
• Accounts for all expected cash inflows and outflows
• Provides a measure of the investment’s profitability
• Can be used to compare multiple investment opportunities
Limitations
• Requires accurate estimates of future cash flows and discount rates
• May lead to incorrect decisions when evaluating mutually exclusive projects
• May result in multiple IRR values for some projects
Capital Budgeting Techniques
and Methods
3. Internal Rate of Return (IRR)
Capital Budgeting Techniques
and Methods
Capital Budgeting Techniques
and Methods
4. Profitability Index (PI)
The Profitability Index (PI) method technique is used to evaluate investment opportunities by
calculating the ratio of the present value of cash inflows to the initial investment cost. A
Profitability Index that presents a value lower than 1.0 is indicative of lower cash inflows than
the initial cost of investment. Aligned with this, a profitability index great than 1.0 presents
better cash inflows and therefore, the project will be accepted.
Advantages
• Considers the time value of money
• Accounts for all expected cash inflows and outflows
• Provides a measure of the investment’s profitability
• Can be used to compare multiple investment opportunities
Limitations
• May lead to incorrect decisions when evaluating mutually exclusive projects
• May not always lead to the best investment decisions when budgets are limited.
Capital Budgeting Techniques
and Methods
Profitability Index (PI)
 Capital Budgeting Techniques
and Methods
Profitability Index (PI)

Example: Assuming the values given in the table, we shall calculate the
profitability index for a discount rate of 10%.
 Capital Budgeting Techniques
and Methods
Profitability Index (PI)

Example: Assuming the values given in the table, we shall calculate the
profitability index for a discount rate of 10%.

So, Profitability Index with 10% discount

= $15,807/$10,000 = 1.5807

As per the rule of the method, the

profitability index is positive for the 10%
discount rate, and therefore, it will be
selected.
Capital Budgeting Techniques
and Methods
5. Modified Internal Rate of Return (MIRR)
The Modified Internal Rate of Return (MIRR) method is a capital budgeting
technique used to determine the rate of return on investment by
considering both the cost of the investment and the reinvestment rate of
future cash flows.
Advantages
• Considers the reinvestment of future cash flows
• Accounts for the time value of money
• Provides a measure of the investment’s profitability
Limitations
• Requires accurate estimates of future cash flows and reinvestment rates
• Can be complex and time-consuming to calculate
• May not be appropriate for investments with uneven cash flows
What is an example of capital budgeting in daily life?

• An example of capital budgeting in daily life could be a household

considering purchasing a new car. The family would need to estimate
the cash inflows and outflows associated with the purchase, such as
the initial cost, maintenance expenses, fuel costs, and potential resale
value. They would also need to consider their budget, financing
options, and the feasibility of the investment in terms of long-term
financial goals.
Capital Budgeting Process/Steps
The process includes the following steps:

• Identification of Investment Opportunities

• Estimation of Cash Flows
• Evaluation of Cash Flows
• Selection of Projects
• Implementation of Projects
• Review and Monitoring
Rate of Return (ROR)
• The rate of return is the profit from an investment divided by the
initial investment, typically expressed as a percentage.
• For example, if you buy a $1.00 lottery ticket and win $10.00 (yielding
a profit of $9.00), then your rate of return would be $9.00/$1.00 =
900%.
Rate of Return (ROR)
• The rate of return (ROR) is a financial metric that represents the gain or
loss on an investment relative to the amount invested. It is expressed as a
percentage and provides a way to evaluate the profitability of an
investment over a specific period.

• Final Value: The current value of the investment or asset.

• Initial Investment: The initial amount of money invested.
• The result is then multiplied by 100 to express the rate of return as a
percentage.
Rate of Return (ROR)
• For example, if you invest $1,000 in a stock and it grows to $1,200, the rate
of return would be:

• ROR= {(1,200−1,000)/1000 }×100%=20%

• The rate of return is 20%, indicating a 20% increase in the investment.
• The rate of return does not account for the time the investment took to
generate the return, and it's a basic measure that can be influenced by
factors like dividends or interest.
 Rate of Return (ROR)

Example 2: Sam bought a house for $250,000. He plans on selling the house
six years later for $335,000, after deducting any fees and taxes. Calculate the
rate of return on the complete transaction.
Solution:
Using rate of return formula:
Rate of Return = [(Current Value - Original Value) ÷ Original Value] × 100
= [(335,000 - 250,000) ÷ 250,000)] × 100
= 34%
Therefore, the rate of return on the complete transaction = 34%
 Rate of Return (ROR)

Example 3: Eddie invested in some shares in 2005 by paying $2,000 and in 2007
he sold it for $3500. Using the rate of return formula, calculate the rate of
return.
Solution: Given,
Current value = 3500
Original value = 2000
Using rate of return formula,
Rate of Return = [(Current Value - Original Value) ÷ Original Value] × 100
= [(3500 - 2000) ÷ 2000] × 100 = 75%
Therefore, the rate of return is 75%
Minimum Rate of
Return(MARR)/Hurdle Rate
• It is the minimum rate of return on an investment that an investor, company, or
project manager is willing to accept to proceed with the investment or project. The
MARR serves as a benchmark for decision-making, helping to determine whether an
investment or project is economically viable.
• The Minimum Attractive Rate of Return (MARR) is a
reasonable rate of return established for the evaluation and
selection of alternatives. A project is not economically viable
unless it is expected to return at least the MARR. MARR is
also referred to as the hurdle rate, cutoff rate, benchmark
rate, and minimum acceptable rate of return.
• The MARR is not a rate that is calculated as a ROR. The MARR is established by
(financial) managers and is used as a criterion against which an alternative’s ROR is
measured, when making the accept/reject investment decision.
Minimum Rate of
Return(MARR)/Hurdle Rate
• The choice of MARR depends on several factors, and different
individuals or organizations may use different MARR values based on
their specific circumstances.
• An investment has been a successful one if the actual rate of return is
above the minimum acceptable rate of return. If it is below, it's seen
as an unsuccessful investment and an investor may pull out of the
investment.
Minimum Rate of
Return(MARR)/Hurdle Rate
• Let's consider a scenario: Suppose a company is evaluating a potential
project that requires an initial investment of $200,000. The project is
expected to generate cash inflows of $50,000 per year for the next
four years. The company has set a Minimum Acceptable Rate of
Return (MARR) of 12%.
• The Net Present Value (NPV) of the project can be calculated using
the MARR. The formula for NPV is:
Minimum Rate of
Return(MARR)/Hurdle Rate
• Now, calculate the NPV to determine whether the project is
acceptable based on the MARR. If the NPV is positive, it indicates that
the project is expected to generate returns higher than the MARR,
making it potentially viable. If the NPV is negative, it suggests that the
project may not meet the company's minimum return requirements.
• A financial calculator, spreadsheet software, or specialized financial
analysis tools can be used to perform these calculations.
• If you have specific values for the cash flows and MARR, you can
substitute them into the formula to find the NPV.
Choices of Minimum Rate of
Return(MARR)
• MARR, or Minimum Acceptable Rate of Return, is a crucial factor in
capital budgeting decisions and investment evaluations. Several
factors can influence the choice of MARR for a particular project or
investment.
1. Cost of Capital:
MARR is often linked to the company's cost of capital. This includes the
cost of debt, equity, and any other financing sources.
2. Risk Tolerance:
The level of risk a company is willing to accept can impact the choice of
MARR. Higher-risk projects may require a higher MARR to compensate
for the increased uncertainty and potential for failure.
Choices of Minimum Rate of
Return(MARR)
3. Inflation:
The inflation rate can affect the purchasing power of future cash flows.
Companies may adjust the MARR to account for expected inflation, ensuring
that the real rate of return meets their investment criteria.
4. Project-Specific Factors:
The nature of the project itself can influence the MARR. For example, a project
with a higher level of uncertainty or a longer payback period might require a
higher MARR.
5. Market Conditions:
Economic conditions and the state of financial markets can impact the cost of
capital. During periods of economic uncertainty or high interest rates,
companies may adjust their MARR accordingly.
Choices of Minimum Rate of
Return(MARR)
7. Stakeholder Expectations:
1. The expectations of various stakeholders, including shareholders,
lenders, and management, can play a role in determining the MARR.
Companies may aim to meet or exceed the expectations of these
groups.
8. Tax Considerations:
Tax implications can impact the choice of MARR. For example, tax
incentives or considerations may affect the effective cost of capital for a
project.
Methods of Financing
Financing projects requires careful consideration of various factors, including the
size of the project, its nature, the financial health of the entity, and the overall
economic environment. Here are different methods of financing for projects:
• Loan
• Sale and leaseback
• Retained profits
• Issuing shares
• Project grants and funding
• Mortgage loan
• Construction loan
• Finance companies
• debenture
Methods of Financing
1) Loan: A loan is a common method of financing that involves
borrowing money from a lender, with an agreement to repay the
principal amount along with interest over a specified period. Loans
are widely used by individuals, businesses, and governments to
fund various activities, projects, or purchases.
2) Sale and leaseback: it is a financial arrangement where a business
sells an asset it owns to a financial institution or a leasing company
and then leases the same asset back from the buyer. This method
allows the business to access capital tied up in the asset while still
retaining the use of the asset.
Methods of Financing
3) Retained profits, also known as retained earnings, refer to the
portion of a company's net income that is not distributed to
shareholders as dividends but is instead retained and reinvested in the
business. Using retained profits for financing projects is a common and
internally generated method of funding.
4) Issuing shares, also known as equity financing, is a method of raising
capital by selling ownership shares in a company. When a company
decides to issue shares, it essentially offers a portion of its ownership to
investors in exchange for capital.
Methods of Financing
5) Project grants and funding are crucial mechanisms for financing
various initiatives, especially in the realms of research, development,
education, social welfare, and innovation. These funds are typically
provided by government agencies, private foundations, non-profit
organizations, and sometimes international institutions.
6) Financing projects through finance companies involves obtaining
funding from specialized financial institutions that provide a range of
financial services, including loans and other credit instruments. These
finance companies may operate as non-banking financial institutions
and often focus on specific sectors or types of financing.
Methods of Financing
7) A Mortgage loan is a type of loan used to purchase/finance a project. When
a borrower obtains a mortgage loan, they agree to make regular payments over
a specified period, usually 15 to 30 years. These payments include both
principal (the amount borrowed) and interest (the cost of borrowing the
money).
8) A Construction loan is a short-term loan used to finance the cost of building
a new home or renovating an existing property. These loans typically have
variable interest rates and require interest-only payments during the
construction phase. Once the construction is complete, the loan is either paid
off in full or converted into a traditional mortgage.
9) A Debenture is a medium- to long-term debt instrument used by large
companies to borrow money, at a fixed rate of interest
 Annuity in Economics
• A series of fixed payments made at regular intervals over a specified period.
These payments can be associated with various financial arrangements, but
they generally involve a predictable and regular stream of income or cash
flows.
• There are different types of annuities, but they generally fall into two broad
categories: fixed and variable.
1.Fixed Annuities: In a fixed annuity, the insurance company or financial
institution guarantees a fixed interest rate on the invested amount for a
specified period. The payments made to the annuitant are predictable and
remain constant over the life of the annuity.
2.Variable Annuities: With variable annuities, the returns are linked to the
performance of underlying investment options, such as mutual funds. This
means that the payments to the annuitant can vary based on the
performance of the chosen investments. Variable annuities come with more
risk but also the potential for higher returns.