CAPITAL BUDGETING

DEFINATION

CAPITAL BUDGETING IS THE PROCESS OF MAKING

INVESTMENTS DECISIONS IN CAPITAL EXPENDITURE.

CAPITAL BUDGETING IS LONG TERM PLANNING FOR

MAKING AND FINANCING PROPOSED CAPITAL OUTLAYS.
 WHY DO WE NEED CAPITAL
EXPENDITURE

1. WEAR AND TEAR OF ASSETS.

2. OBSOLESCENCE.

3. CHANGE IN VOLUME OF PRODUCTION.

4. EXPANSION.

5. CHANGE OF PLANT SITE.

6. DIVERSIFICAITON.
 EXAMPLES OF LONG TERM
CAPITAL EXPENDITURE

re
 CAPITAL BUDGETING

FOLLOWING POINTS DISTINGUISH CAPITAL BUDGETING DECISION

FROM ORDINARY DAY TO DAY DECISIONS:-

1. INVOLVES EXCHANGE OF CURRENT ASSETS FOR BENEFITS TO

BE ACHIEVED IN FUTURE.

2. FUNDS ARE INVESTED IN NON-FLEXIBLE AND LONG TERM

ACTIVITIES.

3. INVOLVES HUGE FUNDS.

4. THE DECISIONS ARE IRREVERSIBLE.

5. STRATEGIC INVESTMENT DECISIONS.

6. RISKY DECISIONS.
 PROCESS

1. IDENTIFICATION OF INVESTMENT PROPOSALS.

2. SCREENING THE PROPOSALS.

3. EVALUATION OF VARIOUS PROPOSALS.

4. FIXING PRIORITIES.

5. FINAL APPROVAL.

6. IMPLEMENTING THE PROPOSALS.

7. REVIEWING THE PROPOSALS.

 The Position of Capital Budgeting

Financial Goal of the Firm:

Wealth Maximisation

Investment Decison Financing Decision Dividend Decision

Long Term Assets Short Term Assets Debt/Equity Mix Dividend Payout Ratio

Capital Budgeting
 KINDS OF CAPITAL BUDGETING
DECISIONS

1. ACCEPT OR REJECT DECISIONS.

2. MUTUALLY EXCLUSIVE DECISIONS.

3. CAPITAL RATIONING DECISIONS.

 DIFFERENCE BETWEEN INDEPENDENT
AND MUTUALLY EXCLUSIVE PROJECTS

PROJECTS ARE:
INDEPENDENT, IF THE CASH FLOW OF ONE ARE UNAFFACTED BY
THE ACCEPTANCE OF THE OTHER.

MUTUALLY EXCLUSIVE, IF THE CASH FLOW OF ONE CAN BE

ADVERSELY IMPACTED BY THE ACCEPTANCE OF THE OTHER.
 CAPITAL BUDGETING:
METHODS
DECISION CRITERIA

METHODS

TRADITIONAL TIME ADJUSTED/DISCOUNTED

METHOD METHOD

PROFITABILITY
PAY BACK PERIOD RATE OF RETURN NET PRESENT INTERNAL RATE
METHOD OF RETURN INDEX
METHOD VALUE

IMPROVMENTS

POST PAY BACK DISCOUNTED PAY

PROFITABILITY BACK PERIOD
INDEX METHOD
 WHAT IS THE PAY BACK PERIOD?

The number of years required to recover

a project’s cost,

or

how long does it take to get the business’s

money back?
 PAY BACK PERIOD METHOD

1. Calculate annual net earnings before depreciation and after taxes.

2. Divide the initial outlay of the project by annual cash inflow if the
project generates constant cash inflow.

3. Where the annual cash outlaw are unequal the pay back period is
calculated by adding the cash inflows.
 CALCULATION PAY BACK
PERIOD

0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

 STRENGTHS OF PAY BACK

1. Provides an indication of a project’s risk and liquidity.

2. Easy to calculate and understand.

WEAKNESSES OF PAY BACK

1. Ignores the TVM.

2. Ignores CFs occurring after the payback period.

 POST PAY BACK
PROFITABILITY

Post pay back period method takes into account the

period beyond the pay back method.

This method is also known as Surplus Life over pay

back method.

According to this method, the project which gives the

greatest post pay back period may be accepted.
 DISCOUNTED PAY BACK PERIOD
METHOD

Under this method the present value of all cash

outflows and inflows are computed at an appropriate
discount rate.

The present values of all inflows are cumulated in

order of time. The time period at which the cumulated
present value of cash inflows equals the present value
of cash outflows is known as discounted pay back
period.

The project which gives a shorter discounted pay back

period is accepted.
 CALCULATION OF DISCOUNTED PAY
BACK PERIOD

0 1 2 3
10%

CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

Recover invest. + cap. costs in 2.7 yrs.

 RATE OF RETURN METHOD

The accounting rate of return or the average rate of return is the ratio of
the average cash inflow to the average amount invested. In order to
arrive at the average cash inflow, depreciation on the straight – line
method is deducted from the gross profit.

1. Simple to understand and easy to operate.

2. Uses the entire earnings of a project, not only the earnings upto
pay back period.

3. Based upon accounting concept of profit.

 CALCULATION OF RATE OF
RETURN METHOD

Here profit after taxes are used instead of cash flow

Rate of return = Avg. profit after tax x100

Investment

There are many variants of rate of return ,above formula is more

useable .Other formulas are:-

ROI = Avg. profit after tax x 100

Avg. Investment

ROI = Profit after tax x 100

Avg. Investment

ROI = Profit after tax x 100

Investment
 NET PRESENT VALUE
METHOD

It is the excess of present value of cash inflow over present value of cash
outflow
NPV= At _ Outlay
(1+K)t
Where K= Cost of capital
N=Life of project
A=Annual Cash Inflow
Strength:-
1. Recognizes time value of money
2. Recognizes quality of benefits
3. No ambiguity
4. Recognizes entire life
5. Compatible with maximization of wealth principle
Weakness:-
1. Difficult to calculate
2. Cost of capital may not be right discount rate
3. It may give good results while comparing projects with unequal lives
 CALCULATION OF NET PRESENT
VALUE

Project: L
0 1 2 3
10%

-100.00 10 60 80

9.09
49.59
60.11
18.79 = NPVL NPVS = $19.98.
 CALCULATION OF NET PRESENT
VALUE

NPV: Sum of the PVs of inflows and

outflows.
n
CFt
NPV   .
t 0 1  r 
t

Cost often is CF0 and is negative.

n
CFt
NPV    CF0 .
t 1 1  r 
t
Solution of Net Present Value
SOLUTION OF NET PRESENT VALUE

Enter in CFLO for L:

-100 CF0
10 CF1
60 CF2

80 CF3

10 I NPV = 18.78 = NPVL

 IMPLICATION OF NET PRESENT
VALUE

NPV = PV inflows - Cost

= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually exclusive projects on basis of

higher NPV.
 INTERNAL RATE OF RETURN
METHOD

IRR is that discount rate which bring down the value of net cash inflow
during the life of the project so that it is equal to the value of initial
investment. It can be expressed in the form of equation as follow:

 CF /1  IRR   I 0

n
t
0
t 1
 CALCULATION OF INTERNAL
RATE OF RETURN

IRR is the rate at which present value of cash inflow is equal to the
present value of cash outflow
0 18.01%
1 2 3

-100.00 10 60 80
PV1 8.47
PV2 43.02
PV3 48.57
100.06

If the projects are independent, accept because IRR > k.

 PROFITABILITY
INDEX METHOD

The profitability index, or PI, method compares the present value of

future cash inflows with the initial investment on a relative basis.
Therefore, the PI is the ratio of the present value of cash flows (PVCF) to
the initial investment of the project.

PVCF
PI 
Initial investment
n

 CF / 1  k  / I
n
t
0
t 1
 CALCULATION OF PROFITABILITY
INDEX

0 10%
1 2 3

-100.00 10 60 80
PV1 9.09
PV2 49.59
PV3 61.11
118.79

118.79 = 1.10 Accept project if PI > 1.

100 Reject if PI < 1.0
 IMPLICATION OF PROFITABILITY
INDEX

A project with a PI greater than 1 is accepted, but a project is

rejected when its PI is less than 1.

Note that the PI method is closely related to the NPV

approach. In fact, if the net present value of a project is
positive, the PI will be greater than 1.

On the other hand, if the net present value is negative, the

project will have a PI of less than 1.
 SUMMARY

The process of evaluation of proposals from the viewpoint of long term investment
is known as capital budgeting. It is significant from the view point of maximising
corporate wealth.

Proposals relate either to the expansion of existing activities or to replacement of

assets or to some strategic activities, such as investment on research and
development or to safety and the environment. The consecutive steps in this
process are identification of long – term goals, screening of proposals, project
evaluation, project implementation, control and project audit. The project to be
evaluated are either independent projects or dependent project, such as
complementary projects, substitute projects and mutually exclusive projects.

The entire evaluation is based on the cash inflow and cash outflow. The cash flow is
divided into initial cash flow. It is computed on an after – tax basis. It does not
include depreciation and the financing cost.

The evaluation criteria based on discounting of cash flow are NPV, discounted
benefit cost ratio and IRR. The non-discounting method are pay back period and
accounting rate of return. Projects are accepted when: NPV is positive; or IRR is
higher than the firm’s cost of capital; or when the discounted benefit cost ratio is
greater than 1; or the initial investment is recovered with in the target pay back
period.
 THANKS
DR. RAKESH KUMAR
ASST. PROF.BUSINESS ADMINISTRATION
PGGC-11 ,CHANDIGARH