Capital Budgeting

CHAPTER – 1

CAPITAL BUDGETING

Capital budgeting, or investment appraisal, is the planning process used

to determine whether an organization's long term investments such as new
machinery, replacement machinery, new plants, new products, and research
development projects are worth the funding of cash through the firm's
capitalization structure (debt, equity or retained earnings). It is the process of
allocating resources for major capital, or investment, expenditures one of the
primary goals of capital budgeting investments is to increase the value of the
firm to the shareholders

The term Capital Budgeting refers to the long-term planning for proposed
capital outlays or expenditure for the purpose of maximizing return on
investments. The capital expenditure may be:

(1) Cost of mechanization, automation and replacement.

(2) Cost of acquisition of fixed assets. e.g., land, building and machinery etc.

(3) Investment on research and development.

(4) Cost of development and expansion of existing and new projects.

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 Capital Budgeting

DEFINITION OF CAPITAL BUDGETING

Capital Budget is also known as "Investment Decision Making or Capital

Expenditure Decisions" or "Planning Capital Expenditure" etc. Normally such
decisions where investment of money and expected benefits arising therefrom
are spread over more than one year, it includes both raising of long-term funds
as well as their utilization. Charles T. Hangmen has defined capital budgeting
as "Capital Budgeting is long- term planning for making and financing
proposed capital outlays."

In other words, capital budgeting is the decision making process by which a

firm evaluates the purchase of major fixed assets including building,
machinery and equipment. According to Hampton John.1. "Capital budgeting
is concerned with the firm's formal process, for the acquisition and investment
of capital."

From the above definitions, it may be concluded that capital budgeting relates
to the evaluation of several alternative capital projects for the purpose of
assessing those which have the highest rate of return on investment.

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 Capital Budgeting

CHAPTER -2

FEATURES OF CAPITAL BUDGETING

• Capital budgeting decisions are based on cash flows and not on accounting
income concept so for example if company spends $20000 on a project of 4
years then in normal accounting this expense would be accounted as $5000
every year assuming company uses straight line method of depreciation
whereas in case of capital budgeting it would be taken into account
immediately and shown as $20000 expense.
• Effects of acceptance of a project has on other project cash flows. For example
if a project has very good cash flow but if due to acceptance of that project cash
flows of current projects of the company are reduced than chances are that
project will not be undertaken and some other project will be selected.
• While making capital budgeting decision opportunity cost should be included
in project cost so for example if company has project which requires initial
outlay of $50000 and if the interest rate of fixed deposit is 8 % then while
making any decision company should take into account the loss of 8 % which
the company is incurring by not investing in fixed deposit.
• Time value of money is another important feature which should be taken into
account because while making capital budgeting decision company is likely to
favor those projects which start generating cash flows quickly because cash
flows received earlier are worth more than cash flow received later due to time
value of money.

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 Capital Budgeting

• Capital budgeting decision are taken by top level management because these
decisions are for long period of time usually more than a year and cost of asset
or project is very high and hence any mistake done can lead to locking
of capital of the company for long period of time and also can result in big
losses
for the company in the long run.

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 Capital Budgeting

CHAPTER - 3

IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting is important because of the following reasons:

• Develop and formulate long-term strategic goals:-

The ability to set long-term goals is essential to the growth

and prosperity of any business. The ability to appraise/value investment
projects via capital budgeting creates a framework for businesses to plan out
future long-term direction.

• Seek out new investment projects:-

Knowing how to evaluate investment projects gives a

business the model to seek and evaluate new projects, an important function for
all businesses as they seek to compete and profit in their industry.

• Estimate and forecast future cash flows:-

Future cash flows are what create value for businesses

overtime. Capital budgeting enables executives to take a potential project and
estimate its future cash flows, which then helps determine if such a project
should be accepted.

• Facilitate the transfer of information:-

From the time that a project starts off as an idea to the time
it is accepted or rejected, numerous decisions have to be made at various

5
 Capital Budgeting

levels of authority. The capital budgeting process facilitates the transfer

of information to the appropriate decision makers within a company.

• Monitoring and Control of Expenditures:-

By definition a budget carefully identifies the necessary

expenditures and R&D required for an investment project. Since a good project
can turn bad if expenditures aren't carefully controlled or monitored, this step
is a crucial benefit of the capital budgeting process.

• Creation of Decision:-

When a capital budgeting process is in place, a company

is then able to create a set of decision rules that can categorize which projects
are acceptable and which projects are unacceptable. The result is a more
efficiently run business that is better equipped to quickly ascertain whether or
not to proceed further with a project or shut it down early in the process,
thereby saving a company both time and money.

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 Capital Budgeting

CHAPTER - 4
OBJECTIVES OF CAPITAL BUDGETING
The following are the important objectives of capital budgeting:

• Setting Priorities:-

You don't always spend capital on growth. Sometimes you have

to buy replacement equipment, for example. Your capital budget must clearly
define priorities, especially when you are faced with the choice between
maintaining current productivity and seeking additional income. Your capital
budget should make provisions for spending on assets that will keep your core
business operating, in addition to spending on new assets for growth.

• Purchasing Assets for Positive Returns:-

An asset produces income. An asset also costs money. One

objective of your capital budget should be to purchase assets whose net income
runs higher than the ongoing costs of the asset. For example, consider a printing
press that provides $500,000 of annual income and costs $200,000 in
loan interest plus $50,000 in maintenance. This purchase would meet the capital
budget objective of buying assets that produce positive returns.

• Alignment with Marketing Plan:-

If you buy income-producing assets, but have no marketing plan

for the products or services from those assets, they will go unused. An objective
of the capital budget is to support the marketing plan with strategic purchases.
The capital budget must clearly state criteria for meeting this objective. For
example, the budget could say, "No expenditure for assets shall be made
without a review of the marketing plan for that asset's output."

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 Capital Budgeting

• Keeping Pace with Projected Growth:-

Your growth projections depend on acquiring the assets that

contribute to that growth. The capital budget must be built around the objective
of making purchases that are timed with growth initiatives. For example, if you
anticipate increasing sales by 50 percent over the next year, your capital budget
must include money for assets that will help you produce or acquire
more products. This could be production equipment, for example, or
warehouse space to store additional inventory.

• Least-Cost Objective:-

The capital budget should contain an objective of keeping costs

low. For example, if you consider two assets that will both provide the same
income, the least expensive one fits in with the least-cost objective. Your
consideration must not focus on purchase or lease price only, but also
on maintenance costs.

• Keeping Debt in Line:-

Some capital expenditures require you to borrow money. The

budget can include loans as part of its resources, but the need for an asset does
not necessarily mean you can afford to service a loan for that asset. The capital
budget must set an objective of keeping your debt within the limits you set.

• Increased Retained Earnings:-

A capital budget should contain measures that will replenish the

capital expenditure account. In other words, when you buy an asset, part of the
income from that asset should go into retained earnings. Retained earnings do
not get paid out as dividends or other distributions. The capital budget can

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 Capital Budgeting

earmark retained earnings from an asset for future capital expenditures.

Meeting the objective of using retained earnings for asset purchases can reduce
the need to borrow.

• Anticipating Inflation:-

A capital budget should set the objective of keeping up with

inflation. If you set a budget for an asset five years from the present,
for example, that budget should include expected price increases. These
increases will be estimates based on projected inflation rates, but estimates are
better than omissions. You will have rough price estimates in mind for
future purchases.

• Determine Product Scope:-

Capital budgeting lets project planners define the financial scope

of a project. Because capital budgeting begins long before the project begins, it
spells out how much money the business plans to spend on each individual
aspect of the project. For example, with a renovation, it determines how much
it is willing to spend on improving handicap accessibility or installing energy-
efficient heating units. Capital budgeting also determines the scope in terms of
the length of time the project will take as it also budgets for labor and potential
downtime.

• Determine Funding Sources:-

While capital budgeting spells out the details of project expenses,

it also details where the money is coming from to pay for the project. These
sources might include a capital investment account, cash, bank loans,
government or nonprofit grants or stock offerings. Most often, a project will
require a mix of those funding channels. The capital budgeting process

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 Capital Budgeting

identifies how much money will be needed from each source and the costs
associated with using that funding method.

• Determine Payback Method:-

An important element of capital budgeting is determining the

project's payback time. Most businesses expect a new building, new equipment
or renovation to eventually pay for itself. Some projects will pay for themselves
quicker than others. As there are several ways of calculating payback method,
some involving the present value of money and inflation, the capital budget will
have to identify which method the company plans to use. It will also
include an estimate of how long it will take for the business to realize a return
on their capital investment.

• Control Project Costs:-

Capital budgets act as control documents throughout the life of the

project. As the project progresses, the project managers track costs and try to
ensure that the project stays within budget. When there is an overage or a
significant underage, the project managers must provide explanations for the
variances and the business must make sure it has money to complete the
project. Typically a capital budget for a specific project is maintained until the
payback period is complete.

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 Capital Budgeting

CHAPTER - 5
CAPITAL BUDGETING PROCESS

The following procedure may be considered in the process of capital

budgeting decisions:-

(A) Identification of profitable investment proposals.

(B) Screening and selection of right proposals.

(D) Evaluation of measures of investment worth on the basis of profitability

and uncertainty or risk.

(E) Establishing priorities, i.e., uneconomical or unprofitable proposals may

be rejected.

(F) Final approval and preparation of capital expenditure budget.

(G) Implementing proposal, i.e., project execution.

(H) Review the performance of projects.

(I) Project identification and generation:-

The first step towards capital budgeting is to generate a proposal for

investments. There could be various reasons for taking up investments in a
business. It could be addition of a new product line or expanding the existing
one. It could be a proposal to either increase the production or reduce the costs
of outputs.

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 Capital Budgeting

(J) Project Screening and Evaluation:-

This step mainly involves selecting all correct criteria’s to judge the desirability
of a proposal. This has to match the objective of the firm to maximize its market
value. The tool of time value of money comes handy in this step.

Also the estimation of the benefits and the costs needs to be done. The total
cash inflow and outflow along with the uncertainties and risks associated with
the proposal has to be analyzed thoroughly and appropriate provisioning has to
be done for the same.

(K) Project Selection:-

There is no such defined method for the selection of a proposal for investments
as different businesses have different requirements. That is why, the approval
of an investment proposal is done based on the selection criteria and screening
process which is defined for every firm keeping in mind the objectives of the
investment being undertaken.

Once the proposal has been finalized, the different alternatives for raising or
acquiring funds have to be explored by the finance team. This is called
preparing the capital budget. The average cost of funds has to be reduced. A
detailed procedure for periodical reports and tracking the project for the
lifetime needs to be streamlined in the initial phase itself. The final approvals
are based profitability, Economic constituents, and viability and market
conditions.

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 Capital Budgeting

(L) Implementation:-

Money is spent and thus proposal is implemented. The different

responsibilities like implementing the proposals, completion of the project
within the requisite time period and reduction of cost are allotted. The
management then takes up the task of monitoring and containing
the implementation of the proposals.

(M) Performance review:-

The final stage of capital budgeting involves comparison of actual results with
the standard ones. The unfavorable results are identified and removing
the various difficulties of the projects helps for future selection and execution
of
the proposals.

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 Capital Budgeting

CHAPTER - 6

CAPITAL BUDGETING DECISIONS

The crux of capital budgeting is profit maximization. There are two ways to it; either
increase the revenues or reduce the costs. The increase in revenues can be achieved by
expansion of operations by adding a new product line. Reducing costs means
representing obsolete return on assets.

• Accept / Reject decision:-

If a proposal is accepted, the firm invests in it and if

rejected the firm does not invest. Generally, proposals that yield a rate of return
greater than a certain required rate of return or cost of capital are accepted and
the others are rejected. All independent projects are accepted. Independent
projects are projects that do not compete with one another in such a way that
acceptance gives a fair possibility of acceptance of another.

• Mutually exclusive project decision:-

Mutually exclusive projects compete with

other projects in such a way that the acceptance of one will exclude the
acceptance of the other projects. Only one may be chosen. Mutually exclusive
investment decisions gain importance when more than one proposal is
acceptable under the accept / reject decision. The acceptance of the best
alternative eliminates the other alternatives.

• Capital rationing decision:-

In a situation where the firm has unlimited funds,

capital budgeting becomes a very simple process. In that, independent
investment proposals yielding a return greater than some predetermined level
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 Capital Budgeting

are accepted. But actual business has a different picture. They have fixed
capital budget with large number of investment proposals competing for it.
Capital rationing refers to the situation where the firm has more acceptable
investments requiring a greater amount of finance than that is available with the
firm. Ranking of the investment project is employed on the basis of some
predetermined criterion such as the rate of return. The project with highest
return is ranked first and the acceptable projects are ranked thereafter.

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 Capital Budgeting

CHAPTER – 7

ADVANTAGES AND DISADVANAGES OF CAPITAL

BUDGETING

Capital budgeting is a method of analyzing the possible risks and rewards of an

investment decision. Business managers utilize capital budgeting to assess the
potential costs of an investment over time. It helps managers determine how
investment costs correlate with business earnings. Capital budgeting has many
advantages. It serves as a financial-planning tool that, when used correctly,
can save a business from making poor and costly investment decisions.

Multiple Budgeting Methods

An advantage of capital budgeting is that several budgeting techniques

are available to suit the varying needs of businesses. For example, the "net
present value" capital-budgeting technique measures an investment's
profitability. This method considers cash flows and analyzes the risk of future
cash flows. The "internal rate of return" capital-budgeting method helps a firm
analyze which investments or projects will yield the highest internal rate of
return. A firm is free to choose from the capital-budgeting techniques that will
provide the most complete and accurate information about a particular
investment.

Risk Assessment

Capital budgeting is a unique decision-making and risk-assessment tool.

It gives businesses the opportunity to review potential investments and projects
individually and objectively. Capital budgeting allows businesses to compare
the value of a particular investment to the company's business plan and goals.

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 Capital Budgeting

It also offers the opportunity to determine if the investment or project makes

sense financially for the firm. Capital budgeting helps businesses understand
the anatomy of an investment, which in turn helps the firm understand the risks
involved.

Predict Potential Return

Many capital-budgeting methods allow a firm to predict the future value of an

investment by considering its current value. Capital budgeting also allows a
firm to determine how long it will take an investment to mature. Some
investment dollars could earn more in interest in a bank rather than in
a particular investment vehicle. Through capital budgeting, a firm is better
equipped to predict which investment tool will provide the best return.

Long-Term Planning

Capital budgeting is advantageous because it allows a firm to make long-term

investment decisions. Investment projects vary in size. Projects also have
different benefits to the business such as in increase in cash flow or a decrease
in risk. A firm typically cannot utilize current expenditures to evaluate a
capital-investment project because the project is often too large and requires a
significant amount of time to realize a return. Capital budgeting helps a firm
create long-term goals, analyze several investment opportunities and forecast
the results of the long-term project.

Capital budgeting is an important tool for leaders of a company when

evaluating multiple opportunities for investment of the firm’s capital. Every
company has both a limited amount of capital available and a desire to deploy
that capital in the most effective way possible. When a company is looking at,
for example, acquisitions of other companies, development of new lines
of business or major purchases of plants or equipment, capital budgeting is the
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 Capital Budgeting

method used to determine whether one option is better than another. There are
several capital budgeting methods, each with its pros and cons.

Capital Budgeting by Payback Period

The most-used method of capital budgeting is determining the payback period.

The company establishes an acceptable amount of time in which a successful
investment can repay the cost of capital to make it. Investment alternatives with
too long a payback period are rejected. Investment alternatives inside the
payback period are evaluated on the basis of the fastest payback.

Payback method disadvantages include that it does not account for the time
value of money.

Net Present Value Capital Budgeting

In net present value capital budgeting, each of the competing alternatives for a
firm’s capital is assigned a discount rate to help determine the value today of
expected future returns. Stated another way, by determining the weighted
average cost of capital over time, also called the discount rate, a company can
estimate the value today of the expected cash flow from an investment
of capital today. By comparing this net present value of two or more possible
uses of capital, the opportunity with the highest net present value is the
better alternative.

A disadvantage of the net present value method is the method's dependence on

correctly determining the discount rate. That calculation is subject to many
variables that must be estimated.

The Internal Rate of Return Method

An advantage of capital budgeting with the internal rate of return method is that
the initial calculations are easier to perform and understand for company

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 Capital Budgeting

executives who may not have a financial background. Excel has an IRR
calculation function.

The disadvantage of the IRR method is that it can yield abnormally high rates
of return by overestimating the value of reinvesting cash flow over time.

A Modification of the Internal Rate of Return Method

The modified rate of return method overcomes the tendency to overestimate

returns by using the company’s current cost of capital as the rate of return on
reinvested cash flow.

As with all methods of capital budgeting, the modified rate of return method is
only as good as the variables used to calculate it. However, by using the firm’s
cost of capital as one variable, it has a figure that is grounded in a verifiable
current reality and is the same for all alternatives being evaluated.

The Accounting Rate of Return

Many financial professionals in a firm, as opposed to top management, prefer

the accounting rate of return because it is most grounded in actual numbers.
Determining an investment’s accounting rate of return is a matter of dividing
the expected average profit after taxes from the investment by the average
investment. However, as with the payback period method, it does not account
for the time value of money.

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 Capital Budgeting

DISADVANTAGES OF CAPITAL BUDGETING

Companies looking to expand or introduce new product lines use capital

budgeting as a way to determine potential profits and losses associated with
particular projects. When deciding between different project options,
companies must determine which option will provide the best return on
investment. As the value of money may change with time, capital budgeting
methods have certain limitations in terms of anticipating the effects of future
economic conditions.

Capital Budgeting

Capital budgeting centers around+ capital expenditures, which involve large

outlays of money to finance potential projects. These types of projects --- such
as building expansions, advertising campaigns or research and development
plans --- typically last for more than a year and involve a range of different
variables within the planning process. As the number of variables increases, the
risk of miscalculations and lost revenues increases accordingly. In effect,
capital budgeting limitations become more pronounced as the number of
projects under consideration increases. Maximizing return on investment
requires companies to calculate current net profits and losses based on future
projections that may or may not play out.

Budgeting Methods

Companies may choose between different methods of capital budgeting based

on the types of criteria used to determine projected profits and costs. Capital
budgeting methods vary according to the type of criteria a company uses to
gauge profits and losses. One method, known as the pay-back period, bases
project selections on the length of time it takes a company to recover its initial
investment. Another method, known as the internal rate of return, bases project

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 Capital Budgeting

selections on the actual rate of return investors can expect to receive. The net
present value method calculates a project's current value based on the net result
from anticipated profits and losses.

With each method, companies must consider the cost outlay, time investment
and profit earnings based on the time investment for of resources --- such as
equipment and supplies for new product lines versus manpower for advertising
campaigns --- companies must determine which budget method will provide
the most effective or accurate calculations when selecting among different
projects.

Discounted Cash Flows

As economic markets change over time, capital budgeting decisions must

incorporate the effects of market changes to realize the real value of the
projects under consideration. Capital budgeting processes use discounted cash-
flow calculations to assess each project's present-day value. To do this,
managers must adjust a project's future cash-flow values in present-day cash-
value terms. In effect, managers discount future cash values based on
anticipated inflation effects and opportunity losses in terms of investing
available capital now versus letting the money earn interest on its own. This
focus on present-day values may place limitations on a company's ability to
choose the most cost-effective project in cases where miscalculations in
expected profit or cost margins occur.

Time Value of Money

Supply and demand levels within an economic market determine the time value
of money as interest rates rise and fall. High interest rates result in value
increases, while low interest rates lead to decreases in money value. Capital
budgeting calculations can't anticipate the changes that occur within economic

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 Capital Budgeting

markets or the conditions that trigger these changes. As a result, calculations

used to determine future profits and costs can only estimate money values
within different points in times.

• The technique of capital budgeting requires estimation of future cash flows and
outflows. The future is always uncertain and the data collected for future may
not be exact. Obviously, the results based upon wrong data can be good.
• There are certain factors like morale of the employees, good-will of the firm
etc.’ which cannot be correctly quantified but which otherwise substantially
influence the capital decision.
• Uncertainty and risk pose the biggest limitations to the techniques of capital
budgeting.

• The payback method ignores the time value of money. The cash inflows from
a project may be irregular, with most of the return not occurring until well into
the future. A project could have an acceptable rate of return but still not meet
the company's required minimum payback period. The payback model does not
consider cash inflows from a project that may occur after the initial
investment has been recovered. Most major capital expenditures have a long
life span and continue to provide income long after the payback period. Since
the payback method focuses on short-term profitability, an attractive project
could be overlooked if the payback period is the only consideration.

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 Capital Budgeting

CHAPTER – 8

METHODS AND IMPLEMENTATION

These methods use the incremental cash flows from each potential investment,
or project. Techniques based on accounting earnings and accounting rules are
sometimes used - though economists consider this to be improper - such as the
accounting rate of return, and "return on investment." Simplified and hybrid
methods are used as well, such as payback period and discounted payback
period.

Net Present Value (NPV),

Internal Rate of Return (IRR),
Payback Period,
Discounted Payback Period,
Average Accounting Rate of Return (AAR), and
Profitability Index (PI)

Net Present Value:-

Net present value is a widely used method of capital budgeting that determines
costs. Firms should always ensure that their rate of return of their investment is
always higher than their cost of capital and the premium that they place on the
risk of the investment. This concept is known as the hurdle rate. Net present
value is calculated by subtracting the present value of the costs from the present
value of the benefits of the capital project.
R1 R2 R3 Rn
NPV = [ + + + (1+K)n ]-Initial investment
(1+K)1 (1+K)2 (1+K)3

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 Capital Budgeting

Decision Rule

In case of standalone projects, accept a project only if it’s NPV is positive,

reject it if its NPV is negative and stay indifferent between accepting
and rejecting if NPV is zero.

In case of mutually exclusive projects (i.e. competing projects), accept

the project with higher NPV.

Example:- An initial investment of $8,320 thousand on plant and machinery

is expected to generate cash inflows of $3,411 thousand, $4,070 thousand,
$5,824 thousand and $2,065 thousand at the end of first, second, third and
fourth year respectively. At the end of the fourth year, the machinery will be
sold for $900 thousand. Calculate the net present value of the investment if the
discount rate is 18%. Round your answer to nearest thousand dollars.

Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158

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 Capital Budgeting

The rest of the calculation is summarized below:

Year 1 2 3 4
Net Cash
$3,411 $4,070 $5,824 $2,065
Inflow

Salvage Value 900

Total Cash
$3,411 $4,070 $5,824 $2,965
Inflow
× Present Value
0.8475 0.7182 0.6086 0.5158
Factor
Present Value
$2,890.68 $2,923.01 $3,544.67 $1,529.31
of Cash Flows
Total PV of
$10,888
Cash Inflows
− Initial
− 8,320
Investment
Net Present
$2,568 thousand
Value

Internal Rate of Return:-

Internal rate of return is a complex capital budgeting method. The internal rate
of return is the discount or interest rate that makes the income stream of an
investment sum to zero. The income stream of an investment is calculated by
adding the total cash flows of the project. The initial cash outflow begins as a
negative, with the interest, or benefits, received each year listed as a positive.
When the project is completed, the value of the investment is also added to the
negative initial investment figure and the yearly interest amount. Internal rate

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 Capital Budgeting

of return is the discount percent that makes these figures total to zero, and it is
helpful when comparing alternative investments or capital projects.

The Interpolation formula can be used to measure the Internal Rate of Return
as follows:
𝑁𝑃𝑉 𝑟 𝑟
Lower Interest Rate + 𝑁𝑃𝑉 𝑟 𝑟 (−) 𝑁𝑃𝑉 ℎ𝑖ℎ𝑟 𝑟
× (Higher rate

– Lower rate)

Decision Rule

A project should only be accepted if its IRR is NOT less than the target internal
rate of return. When comparing two or more mutually exclusive projects, the
project having highest value of IRR should be accepted.

Example;-

Speed age company ltd. Is considering a project which cost

Rs.5,00,000. The estimated Savage value is Zero tax rate 55%. The company
usages straight line depreciation and the proposed project has cash inflows
before depreciation and tax as follows:-

Year end Cash inflows (Rs.)

1 1,50,000
2 2,50,000
3 2,50,000
4 2,00,000
5 1,50,000

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 Capital Budgeting

Solution
YEA CFBD DEP NET TAX EAT CFAT
R T EARNI 55%
G

1 150000 10000 50000 2750 2250 12250

0 0 0 0
2 250000 10000 150000 8250 6750 16750
0 0 0 0
3 250000 10000 150000 8250 6750 16750
0 0 0 0
4 250000 10000 100000 5500 4500 14500
0 0 0 0

5 150000 10000 50000 2750 2250 12250

0 0 0
72500
0

Cas h O u tlay s ( Initia l Inve s tme

Payback period =
nt ) Annual Cash Inflows

500000
= 725000
5𝑦

= 3.448

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 Capital Budgeting

Yea CFAT PV PV OF PV PV OF
r FACTO CFAT FACTOR CFAT
R S

1 12250 0.893 109392.50 0.877 107432.5

0 0
2 16750 0.797 133497.50 0.769 128807.5
0 0
3 16750 0.712 119260.00 0.675 113062.5
0 0
4 14500 0.636 92220.00 0.592 85840.00
0
5 12200 0.567 69457.50 0.519 63577.50
0

5,23,827.5 498720.0
0 0

𝑵𝑷 𝑽 𝒂
IRR=Lower Interest Rate + 𝑵𝑷𝑽 𝒂 (−) 𝑵𝑷𝑽 𝒂
× (Higher rate – Lower

rate)

. 𝟎 − 𝟎𝟎𝟎𝟎 𝟎
=12% + .𝟎−𝟎
× (14% – 12%)

IRR =13.89%

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 Capital Budgeting

Payback Period:-

Payback period is perhaps the most simple method of capital budgeting. The
basic premise of this method is to determine the amount of time that is required
to recoup the funds spent on the capital project or equipment expenditure. The
payback period is calculated by dividing the total expenditure amount by a
desired time frame for investment recovery. Payback period doesn't take into
consideration the time value of money and therefore may not present the true
picture when it comes to evaluating cash flows of a project. Payback
also ignores the cash flows beyond the payback period. Most major capital
expenditures have a long life span and continue to provide cash flows even after
the payback period. Since the payback period focuses on short term
profitability, a valuable project may be overlooked if the payback period is the
only consideration. This method is not a recommended means of capital
budgeting due to its simplistic concept.

Cas h O u tlay s ( Initia l Inve s tme n

Payback period =
t ) Annual Cash Inflows

Decision Rule

Accept the project only if it’s payback period is LESS than the target payback period.

Example: - Mimosa company ltd has invested in a machine at a cost of Rs.

9,00,000. Following details are estimated:

Retrenchment in staff 4 staff @ salary of Rs. 20,000

Additional staff required 1 staff @ salary of Rs. 40,000

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 Capital Budgeting

Savings in wastages Rs.40,000

Savings in maintenance Rs.10,000

Additional electricity bill Rs.15,000

Calculate: pay-back period. Ignore Taxation and Depreciation.

Solution

rupees

Salary 4 staff @ rs. 20,000 80,000

Savings in maintenance 10,000

Savings in wastage 40,000

Total savings (1) 1,30,000

Additional costs:

rupees

Additional staff required 1 staff @ rs. 40,000 40,000

Additional electricity bill 15,000

Total additional expenses (2) 55,000

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 Capital Budgeting

Hence Net Cash Inflows/ ((1)-(2))

Net savings

Cas h O u tlay s ( Initia l Inve s tme

Pay-back period =
nt ) Annual Cash Inflows

= 900000
75000

= 12 years.

Discounted Pay-Back:-

This method is designed to overcome the limitation of the pay- back period
method. When saving are not leveled , it is better to calculate pay - back period
by taking into consideration the present value of cash inflows. Discounted pay-
back method helps to measure the present value of all cash inflows and
outflows at an appropriate discount rate. The time period at which the
cumulated present value of cash inflows equals the present value of cash
outflow is known as discounted pay-back period.

Discounted pay-back period = A +

Where,
A = last period with a negative discounted cumulative cash flow
B = absolute value of discounted cumulative cash flow end of period A
C = Discounted cash flow during the period after A

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 Capital Budgeting

Decision Rule

If the discounted payback period is less that the target period, accept the
project. Otherwise reject.

Example:-

An initial investment of $2,324,000 is expected to generate $600,000 per year

for 6 years. Calculate the discounted payback period of the investment if the
discount rate is 11%.

Solution

Step 1: Prepare a table to calculate discounted cash flow of each period by

multiplying the actual cash flows by present value factor. Create a cumulative
discounted cash flow column.
Present Value Discounted Cumulative
Year Cash Flow
Factor Cash Flow Discounted
n CF
PV$1=1/(1+i)n CF×PV$1 Cash Flow
$

0 1.0000 $ −2,324,000 $ −2,324,000

−2,324,000

1 600,000 0.9009 540,541 − 1,783,459

2 600,000 0.8116 486,973 − 1,296,486
3 600,000 0.7312 438,715 − 857,771
4 600,000 0.6587 395,239 − 462,533
5 600,000 0.5935 356,071 − 106,462
6 600,000 0.5346 320,785 214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years.

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 Capital Budgeting

Accounting Rate of Return (ARR):-

AAR calculated by using average net income and average book value during
the life of the project.

Unlike the other capital budgeting criteria AAR is based on accounting

numbers, not on cash flows. This is an important conceptual and practical
limitation.
The AAR also does not account for the time value of money, and there is no
conceptually sound cutoff for the AAR that distinguishes between profitable
and unprofitable investments.

The AAR is frequently calculated in different ways, so the analyst should

verify the formula behind any AAR numbers that are supplied by someone else.
Analysts should know the AAR and its potential limitations in practice, but they
should rely on more economically sound methods like the NPV and IRR.

First, determine the average net income of each year of the project's life.
Second, determine the average investment, taking depreciation into account.
Third, determine the AAR by dividing the average net income by the average
investment.

Average accounting return does have a disadvantage; it does not take

time value of money into account. Therefore, there is no clear indication
of profitability.

𝑟 𝑖
ARR =
𝑟

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 Capital Budgeting

Decision Rule

Accept the project only if it’s ARR is equal to or greater than the required
accounting rate of return. In case of mutually exclusive projects, accept the one
with highest ARR.

Examples:-

An initial investment of $130,000 is expected to generate annual cash inflow of

$32,000 for 6 years. Depreciation is allowed on the straight line basis. It is
estimated that the project will generate scrap value of $10,500 at end of the 6th
year. Calculate its accounting rate of return assuming that there are no other
expenses on the project.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life
in
Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
Average Accounting Income = $32,000 − $19,917 = $12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%

Profitability Index (PI)

The profitability index (PI) is the present value of a project’s future cash flows
divided by the initial investment.
PI is closely related to the NPV. The PI is the ratio of the PV of future cash
flows to the initial investment, while an NPV is the difference between the PV
of future cash-flows and the initial investment.
Whenever the NPV is positive, the PI will be greater than 1.0, and conversely,
whenever the NPV is negative, the PI will be less than 1.0

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 Capital Budgeting

Investment Rule:
Invest if PI >1.0
Do not invest if PI
<1.0
Assuming that the cash flow calculated does not include the investment made
in the project, a profitability index of 1 indicates breakeven. Any value lower
than one would indicate that the project's present value (PV) is less than the
initial investment. As the value of the profitability index increases, so does the
financial attractiveness of the proposed project.

𝑷𝑽 𝒄𝒂
PI =
𝒂

𝑵𝑷𝑽
= 1+
𝒂

Decision Rule

Accept a project if the profitability index is greater than 1, stay indifferent if

the profitability index is zero and don't accept a project if the profitability index
is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in

capital rationing since it helps in ranking projects based on their per dollar
return.

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 Capital Budgeting

Example:-

Company C is undertaking a project at a cost of $50 million which is expected

to generate future net cash flows with a present value of $65 million. Calculate
the profitability index.

Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment
Required
Profitability Index = $65M / $50M = 1.3
Net Present Value = PV of Net Future Cash Flows − Initial Investment
Required
Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate
profitability index as follows:-

Profitability Index = 1 + (Net Present Value / Initial Investment

Required) Profitability Index = 1 + $15M/$50M = 1.3

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 Capital Budgeting

CHAPTER - 9

CASE STUDY

• Droppit Parcel Company is considering purchasing new equipment to

replace existing equipment that has book value of zero and market value of
$15,000.
• New equipment costs $90,000 and is expected to provide production savings
and increased profits of $20,000 per year for the next 10 years.
• New equipment has expected useful life of 10 years, after which its estimated
salvage value would be $10,000.
• Straight-line depreciation
Effective tax rate: 34%
Cost of capital: 12%
• “Machinery Replacement” Problem: Should Droppit replace current
equipment?

1. Effective cost of new equipment: $80,100

– Droppits trades its old equipment in for new equipment by selling it
and applying sale proceeds to new equipment.
2. Calculate present value of expected benefits of new equipment.
– All benefits have been converted to after-tax basis before present values are
calculated.
– Profit increase is multiplied by 0.66 (1.00 – tax rate) to determine increased
profit remaining after tax.
– Calculate tax benefit resulting from effect of depreciation by
multiplying annual depreciation deduction by effective tax rate.
– Reflects salvage value of new equipment at end of its expected useful life.

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 Capital Budgeting

3. NPV: $13,068
4. IRR (solved by trial and error using electronic calculator): 15.7%
5. New machine should be purchased to replace old machine since NPV is
positive and IRR exceeds cost of capital.

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 Capital Budgeting

CHAPTER – 10

CONCLUSION

The DCF techniques, NPV, IRR, and PI are all good techniques. For capital
budgeting and allow us to accept or reject investment project. Consistent with
the goal of shareholder wealth maximization.

Beware, however there are times when one techniques output is better for some
decision or when a technique has to be modified given certain circumstances.
Due to the complexity and numerous issues related to the operating budget, our
scope focused primarily on the operating budget and less on the capital budget.
However, this section provides conclusions we derived from our review and
some areas designated for further study. The overall process of developing
requests and allocating funds for capital projects seems to work well, especially
given the complexities of construction funding, planning and management.

Despite FPCM’s strong management, there are still problems in the capital
project process that should be addressed. However, these problems are driven
as much by inefficiencies in resource allocation as by issues with the actual
construction management process.

Many campuses also find it difficult to fund the operating and ongoing
maintenance of new buildings with existing operating budget; while central
Administration often allocates new funds- through lump sum allocations, there
is great concern that these funds are not sufficient to keep up new buildings.
Also, many campuses have reallocated facilities dollars to fund other priorities;
at many campuses this led to costly repairs of buildings that have not been
properly maintained.

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 Capital Budgeting

CHAPTER - 11

BIBLIOGRAPHY

Books:

International Finance – V.A. Avadhani

Sites:

• www.shodganga.com
• www.investopedia.com

• www.infomedia.com
• www.rbi.org.in

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