Unit 4

Capital Budgeting

K. SRINIVASAN M.COM., MBA.,(Ph.D.)

ASST. PROFESSOR
Department of MBA
AITS, TIRUPATI
 Introduction
• Capital budgeting is investment decision-making as
to whether a project is worth undertaking or not.
• Therefore, a financial manager must be able to
decide whether an investment is worth
undertaking and be able to choose intelligently
between two or more alternatives.
• A sound procedure to evaluate, compare, and
select projects is needed.
• This procedure is called capital budgeting.
 What is Capital Budgeting?
• A Capital Budgeting Decisions may be defined
as the firm’s decision to invest it current funds
its current funds most efficiently in the long
term assets in anticipation of an expected flow
of benefits over a period of time.
Examples of Investment Decisions
• New Business project
• R & D Projects
• Expansion
• Modernization
• Replacement
• Mergers / Acquisitions
 Features of Capital Budgeting
1. Huge investments
• requires huge investments of funds, but the available funds are limited,
• Before investing projects, plan and control its capital expenditure.
2. Long-term nature
• permanent in nature.
• Therefore financial risks involved in the investment decision are high
3. Irreversible
• The capital investment decisions are irreversible, are not changed back.
• it is very difficult to dispose off those assets without involving huge losses.
4. Long-term effect
• It will bring significant changes in the profits or losses of the company
• it is required carefully planning and analysis of the project thoroughly.
Types of Investment Projects / Proposals

1. Independent Projects 
• These are projects such that the acceptance of one
does not affect the acceptance of another project.
2. Mutually Exclusive Projects
• These are alternatives projects.
• Either one or the other can be accepted, but not
both.
• This means that the two or more projects cannot
be accepted at the same time.
 Capital Budgeting Process
1. Estimation of Cash flows (Cash inflows of
entire life and Cash outflows)
2. Determining the minimum required rate of
return to be used as Discount rate.
3. Application of Capital Budgeting Techniques
4. Application of Decision Rule
 Time Value of Money
• Time value of money means that “worth of a
rupee received today is different from the
worth of rupee to be received in future”.
• “Time value of money means that the value of
a sum of money received today is more than
its value received after some time”
 Reasons for changes in Time value of Money
Money has time value because of the following reasons:
Risk and Uncertainty
• Future is always uncertain and risky. There is no certainty for future cash
inflows. As an individual or firm is not certain about future cash receipts,
it prefers receiving cash now.
Inflation
• In an inflationary economy, the money received today, has more
purchasing power than the money to be received in future.
Consumption
• Individuals generally prefer current consumption to future consumption.
Investment opportunities
• An investor can profitably employ a rupee received today, to give him a
higher value to be received tomorrow or after a certain period of time.
 Present Value
• Present Value determines what the final amount or
cash flow to be received in future is worth in today's
value or present time. We can find the present value
(PV) of future cash flow using the following formula:

Where:
PV – Present Value;
FV – Future Value;
i – interest rate;
n – number of periods.
 Present Value
Example 
• If you invest $100 (the present value) for 1 year at a
5% interest rate (the discount rate), then at the end of the
year, you would have $105 (the future value).
• So, according to this example, $100 today is worth $105 a
year from today.
PV = FV/(1+ i)n
PV = $105 / (1.05)1
PV = $ 100
 Calculation of Cashflows After Taxes (CFAT)
Particulars Year 1
Amount
(Rs.)
Revenues (Sales) XXX
Less: Operating and other Expenses XXX
Earnings / Profit Before Depreciation and Taxes (EBDT/ NBDT) XXX
Less: Depreciation XXX
Earnings / Profit after Depreciation and Before Taxes (EBT/PBT) XXX
Less: Taxes XXX
Earnings / Profit After Taxes (EAT/PAT) XXX
Add: Depreciation XXX
Cash flows After Taxes (CFAT) XXX
 Capital Budgeting Methods

1. Traditional methods or Non-Discounted Cash

Flow methods
a) Pay Back Period (PBP)
b)Accounting Rate Of Return (ARR)

2. Discounted Cash flow methods

a) Net Present Value (NPV)
b) Internal Rate of Return (IRR)
c) Profitability Index (PI)
 Capital Budgeting
Techniques

Discounted
Traditional
Cash flows

Pay Back Average Rate

Period of Return NPV IRR PI
( PBP) (ARR)
 Capital Budgeting Techniques
1. Pay Back Period  (PBP)
2. Average Rate of Return (ARR)
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
5. Profitability Index (PI)
 1. Pay Back Period (PBP)
PBP means the number of years required to recover the
original cash out lay invested in a project’.
1. Even or Constant Cash in flows

2. Uneven Cash in flows

PBP = Adding C1 + C2 +C3 … until total equals to Investment
 Acceptance Rule
Independent Project
• Accept, If PBP < = standard PBP
• Reject, If PBP > standard PBP
Mutually Exclusive projects
• The Shortest PBP should be selected in two or
more project proposals
 PBP Example (even cash in flows)
• Project cost is Rs. 30,000 and the cash inflows
are Rs. 10,000, the life of the project is 5
years. Standard PBP is 4 Years. Calculate the
pay-back period.
 PBP Example (uneven cash in flows)

• A project requires an initial cash outflow of Rs.

25,000. The cash inflows for 6 years are Rs.
5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs.
7,000 and Rs. 3,000. Standard PBP is 4 Years
Calculate Pay Back Period.
 PBP Example (uneven cash in flows)
Cash Inflows Cumulative Cash
Year (Rs.) Inflows (Rs.)
1 5,000 5,000
2 8,000 13,000
3 10,000 23,000
4 12,000 35,000
5 7,000 42,000
6 3,000 45,000

Pay-back period = 3 years + (2000/12000) × 12

= 3 years 2 months
The Pay Back Period (3.2 Years) is Less than Standard PBP (4 Years) , So the
Project is accepted.
2. Accounting Rate of Return (ARR)

Where
 Acceptance Rule
Independent Projects
• Accept, If ARR > Standard ARR
• Reject, If ARR < standard ARR
Mutually Exclusive projects
• The Highest ARR should be selected in two or
more project proposals
 ARR Example
A project requiring an investment of 10,00,000/- and it yields Net
Profit after taxes which is as follows:
Years Net Profit after taxes (Rs.)
1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60.000

At the end of 5 years, the plant and machinery of the project

can be sold for 80,000/-. Determine Average Rate of Return. The
company’s Standard ARR is 15%.
ARR Example
 3. Net Present Value (NPV)

NPV= Total Present value of cash inflows – investment

C1, C2, C3… Cn= cash inflows in different years.

K = Cost of the Capital (or) Discounting rate
n= Years.
 Acceptance Rule
Independent Project
• Accept, If NPV is positive (> 0)
• Reject, If NPV is Negative (< 0)
Mutually Exclusive projects
• The Highest NPV should be selected in two or
more project proposals
 NPV Example
Calculate NPV for a Project X initially costing Rs. 250000. It has 10%
cost of capital. It generates following cash inflows after taxes:

Year CFAT (Rs.)

1 90,000
2 80,000
3 70,000
4 60,000
5 50,000

Do you recommend above Project X?

 NPV Example
Calculation of NPV
Year CFAT (Rs.) DF at 10% PVCF
1 90,000 0.909 81,810
2 80,000 0.826 66,080
3 70,000 0.751 52,570
4 60,000 0.683 40,980
5 50,000 0.621 31,050
Total 2,72,490
Less : Investment or Initial Costs 2,50,000
Net Present Value (NPV) 22,490

I recommend the Project X, because it is Positive NPV of

Rs.22,490
 4. Internal Rate of Return(IRR)
• The IRR represents the discount rate at which
the NPV of an investment is zero.
• At IRR, NPV =0
• It is a discounted cash flow technique which
takes into account the time value of money.
• It is calculated by Trial and error method and
Interpolation Method
PV of cash inflows = Initial Cash outflows
 Acceptance Rule
Independent Project
• Accept, If IRR > k
• Reject, If IRR < k
Mutually Exclusive projects
• The Highest IRR should be selected in two or
more project proposals
 4. Internal Rate of Return(IRR)
1. Compute approximate Payback period also
called fake payback period
2. Locate this value in PVAF table corresponding
to period of life of the project. The value may
be falling between two discount rates.
3. Compute NPV using these two discount rates.
4. Use the following interpolation Formula to
determine IRR
interpolation Formula to determine IRR

Where
L = Lower Rate,
H = Higher Rate
NPVL = NPV at Lower rate
NPVL = NPV at Higher rate
 IRR example
• A Project Costs Rs.1,36,000/ and it generates
cash in flows through a period of 5 years are
Rs30,000, Rs.40,000, Rs.60,000, Rs.30,000 and
Rs.20,000. The Company’s Required Rate of
Return was 10%. Calculate IRR and suggest the
project is valuable.
 IRR example

Calculation of NPV at 10% and 12%

Year CFAT (Rs.) DF at 10% PVCF
1 30,000 0.909 27,270
2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 30,000 0.683 20,490
5 20,000 0.621 12,420
Total 1,38,280
Less : Investment or Initial Costs 1,36,000
Net Present Value (NPV) 2,280

Year CFAT (Rs.) DF at 12% PVCF

1 30,000 0.893 26790
2 40,000 0.797 31880
3 60,000 0.712 42720
4 30,000 0.636 19080
5 20,000 0.567 11340
Total 1,31,810
Less : Investment or Initial Costs 1,36,000
Net Present Value (NPV) -4,190
 IRR

I recommend the Project X, because IRR >K

 5. Profitability Index (PI)

Acceptance Rule :
Independent Project
Accept, If PI > 1
Reject, If PI < 1
Mutually Exclusive projects
The Highest PI should be selected in two or more project
proposals
 Profitability Index Example
Calculate Profitability Index for a Project X initially costing Rs. 250000. It has
10% cost of capital. It generates following cash inflows after taxes:

Year CFAT (Rs.)

1 90,000
2 80,000
3 70,000
4 60,000
5 50,000

Do you recommend above Project X?

 Profitability Index Example
Year CFAT (Rs.) DF at 10% PVCF
1 90,000 0.909 81810
2 80,000 0.826 66080
3 70,000 0.751 52570
4 60,000 0.683 40980
5 50,000 0.621 31050
Total 272490

I recommend the Project X, because PI >1