Capital Budgeting

Satish Singh
 Capital Budgeting
• It is a long term decision regarding the application
of fund. It includes the decisions like purchase of
new plant , machines mergers and amalgamation
etc.
• Capital budgeting is the process of analyzing
additions to fixed assets. Capital budgeting is
important because, more than anything else, fixed
asset investment decisions chart a company’s
course for the future.
• Conceptually, the capital budgeting process is
identical to the decision process used by individuals
making investment decisions.
Role of capital budgeting
O v e r a l l F i n a n
M a x i m i z e S h a

I n v e s t m e F n i n t a D n e Dc c i ini vs g i do D ne

L o n g ST he or m r t D TA e s rbs m et /D tE s A i vq s iu d s i et y

C a p i t a l B u d g e t i n g
 Continue

• it includes following steps :

(1) Estimate the cash flows--interest and maturity value or dividends in
the case of bonds and stocks, operating cash flows in the case of
capital projects.
(2)Assess the riskiness of the cash flows.
(3) Determine the appropriate discount rate, based on the riskiness of
the cash flows and the general
level of interest rates. This is called the project cost of capital in
capital budgeting.
 
(4) Find (a) the PV of the expected cash flows and/or (b) the asset’s
rate of return.
 
(5) If the PV of the inflows is greater than the PV of the outflows (the
NPV is positive), or if the
calculated rate of return (the IRR) is higher than the project cost of
capital, accept the project.
•  

 
 Issues involve in capital
budgeting
• Long term decision
• Huge money is involve
• This can not be reverse
• They decide the future capability of
the co.
• These are strategic decision
 Problems of capital
budgeting
• Long term
• Future is uncertain
• Risk
• Risk and return trade off.
• Can not be reverse
 Estimation of flows
• Initial outflow: it is the amount which
incurred for the purchase of new machine ,
or a project. It also include the cost of
installation expenditure. It is capital outflow.
• Subsequent flow: it is the revenue which
will be received during the life of machine.
It is revenue income.
• Terminal flow: it the amount which
recovered at the end of life of machine. It is
known as scrap value of machine.
 Numerical problem
• X co. ltd. Wants to start a new
project at cost of rs. 1,10,000. it will
have life of 5 years and a scrape
value of 10000 rs. It will generate
revenue @ 25000 rs. Per year.
Company use S.L.M of depriciation
@20%. Tax rate is 50%.Find out the
flow of funds from the project.
 Solution of problem
• Solve it as explained earlier
 Techniques of capital
budgeting
Discounted techniques
– NPV (Net present Value)
– IRR (internal rate of return)
– PI (profitability index method)/ BCR
(Benefit cost ratio )
Non discounted techniques
– Pay back period method
– ARR method( Average rate of return
method)
• Net present value (NPV) indicates the expected impact of the project
on the value of the firm. The NPV is the present value of all expected
cash flows including the investment dollars; both positive and negative
cash flows are considered. A discount rate is chosen to get discounted
net present value. The NPV decision rule specifies that all independent
projects with a positive NPV should be accepted. When choosing among
mutually exclusive projects and when capital is constrained, the projects
with the largest positive NPV combination should be selected.
• Internal rate-of-return (IRR) is the discount rate at which the net
present value (NPV) of a project equals zero. The IRR decision rule
specifies that all independent projects with an IRR greater than the cost
of capital should be accepted when there are no capital constraints.
When choosing mutually exclusive projects and when capital is
constrained, the projects with the highest IRRs should be selected.
• Payback period represents the amount of time it takes for
a project to recover its initial cost. The payback period
decision rule specifies that all independent projects with a
payback period less than a specified number of years
should be accepted. When choosing among mutually
exclusive projects and during certain times of tight capital
constraint, the projects with the quickest paybacks are
preferred.
• Profitability index (PI) is the ratio of the present value of
change in operating cash inflows to the present value of
investment cash outflows. A project that increases owners’
wealth has a PI greater than one. If PI is less than 1, a
project should be rejected.

• ARR .
 numerical
• The XYZ co. ltd wants to choose among two projects
“ A” and “B”. The details are:
Year A B
0 25 40
1 0 10
2 5 14
3 20 16
4 14 17
5 6 8
The cost of capital or discounted rate is 16%. Find out
Pay back, NPV,PI, IRR From the details and advice.
 Pay back period
Year A CFa B CFb
0 -25 -40
1 0 0 10 10
2 5 5 14 24
3 20 25 16 40
4 14 39 17 57
5 6 45 8 65
• Pay back period is 3 years.
 NPV
Year @16% A PV a B PVb
0 -25 -25 -40 -40
1 .8620 0 10 8.620
2 .7435 3.715 14 10.402
3 .64120 12.820 16 10.256
4 .55214 7.728 17 9.384
5 .4766 2.856 8 3. 808
Total NPV 2.119 2.470
 PI
•A
27.119/25
=1.085
•B
42.470/40
=1.062
 IRR A machine
Year inflow 18% PV 20% PV
1. 0 .847 0 .833 0
2. 5 .718 3.590 .694 3.470
3. 20 .609 12.180 .579 11.580
4. 14 .516 7.224 .482 6.748
5. 6 .437 2.622 .402 2.412
Total P.V 25.616 24.210
NPV .616 -.790
 A

• IRR= 18%+.616/.616+.790 *2
= 18.88 %
 IRR of Machine B
Year inflow 18% PV 20% PV
1. 10.847 8.470 .833 8.330
2. 14 .718 10.052 .694 9.716
3. 16 .609 9.744 .579 9.264
4. 17 .516 8.772 .482 8.194
5. 8 .437 3.496 .402 3.216 Total
P.V 40.534 38.720 NPV .534 -1.28
 B
• Irr=
• 18%+.534/.534+1.28*2%
• =18.59
 Analysis
• Pay back 3 year 3 Year
• NPV@16% 2.119 2.47
• PI 1.085 1.062
• IRR 18.88% 18.59%
• In case of PI &IRR machine A is better but in
case of NPV B machine is better. However
Payback is same for both. So A should be
selected.