CAPITAL BUDGETING

It is a decision involving selection of capital

expenditure proposals.

These decisions are related to allocation of funds to

different long-term assets.

Examples
Decision to purchase new plant and equipment
Introduce new product in the market

Essentially we determine whether the future benefits

are sufficiently large enough to justify the current
outlays.
 FEATURES OF CAPITAL BUDGETING

Capital budgeting decisions have long-term

implications.

These decisions involve large investment of funds.

These decisions are irreversible and require analysis of

minute details.

These decisions determine and affect the future growth

of the firm.
Project Classification Types
Replacement projects are expenditures
necessary to replace worn-out or damaged
equipment.

Cost reduction projects include

expenditures to replace serviceable but obsolete
plant and equipment.

Expansion projects increase the availability

of existing products and services
 Basic Steps of Capital Budgeting

1. Estimation of the cash flows of a proposal.

2. Estimation of the required rate of return, i.e.,

the cost of capital

3. Selection and applying the decision criterion.

ESTIMATION OF CASH FLOWS
Capital outlays are estimated by engineering dept.
after examining all aspects of production process.
Marketing dept. on the basis of market survey
forecasts the expected sales revenue.
Operating costs are estimated by the cost
accountants and production engineers.
An important point is that all cash flows are
considered only after tax basis.
 2. DECISION CRITERIA
TECHNIQUES OF EVALUATION

Traditional or Time-adjusted or
Non-discounting Discounted cash flows

1. Payback period 1. Net Present Value

2. Accounting Rate of 2. Profitability Index
Return 3. Internal Rate of Return
 TRADITIONAL OR NON-DISCOUNTING
TECHNIQUES

I . PAYBACK PERIOD:
The payback period is the length of time required to
recover the initial cost of the project.

The payback period may be suitable if the firm has

limited funds available and has no ability or willingness to
raise additional funds.
Calculation of Payback for Project A

0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackA = 2 + 30/80 = 2.375 years

 Merits Vrs. Demerits of Payback
Merits of Payback Period
Provides an indication of a projects risk and liquidity.
Easy to calculate and understand.

Demerits of Payback Period

Does not consider the time value of money.
Ignores CFs occurring after the payback period.
II . ACCOUNTING RATE OF RETURN (OR) AVERAGE

RATE OF RETURN
(ARR)
# The ARR may be defined as the annualized net
income earned on the average funds invested in a project.
# The annual returns of a project are expressed as a
percentage of the net investment in the project.

COMPUTATION OF ARR:

Average Annual profit (after tax)

ARR = x 100
Cont.
Average investment =
( value of inv. In the beginning + Value of inv. In the end)

Any project which has an ARR more the minimum

rate fixed by the management is accepted.
Calculation of ARR of Project A
 Merit Vrs. Demerits of ARR
Merits of ARR
Simple to understand
Considers the profit of entire life of project.

Demerits of ARR
Does not consider the time value of money.
 DISCOUNTED CASH FLOWS OR TIME
ADJUSTED TECHNIQUES

These are based upon the fact that the cash flows occurring at
different point of time are not having same economic worth.

I. NET PRESENT VALUE (NPV) METHOD:

The NPV of an investment proposal may be defined as the sum
of the present values of all the cash inflows less the sum of present
values of all the cash outflows associated with the proposal.

The decision rule is Accept if NPV > 0

reject if NPV < 0.
Project A: K-10%
0 1 2 3

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVA
 Merit Vrs. Demerits of NPV
Merits of NPV
Takes into account the time value of money.
Considers cash flow over entire life of the project.

Demerits of NPV
Computation of discounting rate is not so easy.
 II. PROFITABILITY INDEX METHOD:
This technique is a alternative of the NPV technique and is also
known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows

PI =
Total present value of cash outflows.

The decision rule is Accept if PI > 1

reject if PI < 1.
Calculation of Project As PI

CF
 Merit Vrs. Demerits of PI
Merits of PI
Takes into account the time value of money.
Considers cash flow over entire life of the project.

Demerits of PI
Estimation of cash flow and discounting rate is not so
easy.
III. INTERNAL RATE OF RETURN (IRR)
The IRR is a discount rate that makes the present value of
estimated cash flows equal to the initial investment.

The IRR is also known as Marginal Rate of Return or

Time Adjusted Rate of Return.

Accept the project if IRR > Cost of capital (K)

 0 1 2 3
IRR = ?

-100.00 10 60 80
PV1
PV2
PV3
0 = NPV

IRRA = 18.13%.
 Merit Vrs. Demerits of IRR
Merits of IRR
Takes into account the time value of money.
Considers cash flow over entire life of the project.
No need to calculate the cost of capital as it is evaluated
at the rate of return generated by the project.

Demerits of IRR
IRR Computation is quite tedious.
Comparison of IRR & NPV
CAPITAL BUDGETING PRACTICES IN INDIA
Capital budgeting decisions are undertaken at the top
management level and are planned in advance.

Discounted cash flow techniques are more popular now.

High growth firms use IRR more frequently whereas

Payback period is more widely used by small firms.

PI technique is used more by public sector units than by

private sector units.