Capital Budgeting

Definition
 Capital budgeting decisions pertain to purchase of fixed
/ long-term assets which are used in the operation of the
organization and yield a return keeping in mind the goal
of wealth maximization

 In other words, the system of capital budgeting is

employed to evaluate expenditure decisions which
involve current outflow of cash but are likely to produce
benefits (inflow of cash) over a period of time.

 Capital Expenditure is an outlay of funds that is expected

to produce benefits over a period of time exceeding one
year (concept learnt in F.A.)
Importance of Capital Budgeting decisions
 Such decisions affect the profitability of an
organization.

 A capital budgeting decision has its effect over

a long time span.

 Capital expenditure decisions once made are

not easily reversible without much financial loss
to the organization.

 Such decisions involve a huge cost and so there

is a need for thoughtful, wise and correct
investment decisions.
Types of Capital Budgeting decisions

 Accept – Reject decisions – Under this, if the

project is accepted, the firm would invest in
it; if the proposal is rejected, the firm does
not invest in it.

 Mutually Exclusive Project decisions – Under

this, the projects compete with other
projects in such a way that the acceptance
of one will exclude the acceptance of the
other projects.
 Cash Flows

Co. buys Conducts business

Sells

Machine operations using
machine goods/Service
(cash outflow)

Cash Inflows:-
Sales x
(-) Expenses (x) Will Receive cash
PBD&T x inflows over a period
(-) Depreciation (x) of time through sales
PBT x every year / Profits
(-) Tax (x) every year
PAT x (Future cash Inflows)
(+) Depreciation x
Cash Inflows X
(i.e. PATBD)
 Evaluation/Investment appraisal techniques

Techniques Techniques
which recognize which consider
payback of Techniques accounting
capital which consider profit
employed Time value of
money
Accounting
Payback period Rate of return
method

NPV Profitability Discounted

IRR method payback
method Index method
method
 1) Pay Back Method/Payback period (PBP)

 This method answers the question – How many years will it

take for the cash benefits to pay off the original cost of
investment?

 Accept-Reject rule:
If PBP < Standard PBP (of similar projects) = > Accept
If PBP > Standard PBP (of similar projects) = > Reject

 There can be two different situations while using the pay

back period.
 Even / Uniform cash flows

Investment
Payback period =
Constant cash flows

 Q1: An investment of Rs. 40,000 in a machine is expected

to produce constant cash flows of Rs. 8,000 for 10 years.

 Solution: 40000 / 8000 = 5 years is PBP, It would take 5 years

to recover the investment.

 Q2: An investment of Rs. 50,00,000 in a pension plan is

expected to produce constant cash flows of Rs. 500,000
annually for the next 20 years. Calculate the payback
period.
 Solution = 50,00,000 / 500,000 = 10 years.
 Uneven / non-uniform cash flows
 In such cases , payback is calculated by a process of cumulating
cash inflows till they equate the original outlay.
 Payback period = Year before full recovery + Proportionate amount
period
 Q3:

Suppose an initial cost of a project is Rs. 50000

Annual inflows after tax before depreciation
Year Amount
1 10000
2 15000 Find PB
3 20000
4 25000
Solution:
Year Amount Cumulative
1 10000 10000
2 15000 25000
3 20000 45000
4 25000 70000

The initial cost is Rs. 50000 which will be recovered

between year 3 and 4. Therefore the PB period
will be 3 years + a fraction of the 4th year.
Rs. 45000 will be recovered by Year 3 and balance
Rs. 5000 will be recovered in the 4th year whose
annual cash flow is Rs25000 (for 12 m).
Therefore the fraction in the 4th year needed to reach
the cost of 5000 = > we say: (5000/25000*12)
PB = 3 years + 2.4 months
Q4: The following are the details of two machines A and B with
uneven cash flows. Find out the pay back period for them.

Annual Cash Annual Cash

Inflow Inflow

Particulars Machine A Machine B
Initial Cash Outlay Rs.56,125 Rs.56,125
Year 1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000

Machine A = 3 years and 4.88 months

Machine B = 2 years and 9.42 months
Decision : Machine B is the better option.
 2.) Accounting/Average Rate of Return
Average Rate of Return – It is also known as accounting rate of return. It is
based on accounting information rather than cash flows.
ARR = Avg. Annual profits after tax x 100
Avg. Investment over the life of the project
Where,
Avg. Profits = Profit after tax for the life of the project / No. of years
Avg. Invest = Net investment /2
OR
Av. Invest = Net working cap + salvage value + 1/2 (Initial cost – salvage
value)
Accept – Reject rule
ARR > Required rate of return ACCEPT
ARR < Required rate of return REJECT
 Q5: The purchase price of a computer is Rs. 24000. Salvage
value is Rs. 4000. Working capital is Rs. 6000. Economic life is 5
years. Depreciation is to be provided on SLM. Average profits is
Rs. 40000. Required rate of return is 15%. State whether the
project is acceptable by computing ARR.

ARR = Avg. Annual profits after tax x 100

Avg. Investment over the life of the project

Average Investment = 6000 + 4000 + ½*(24000-4000) = Rs. 20000

ARR = 40000 / 20000 = 200%

The ARR > Required RoR (15%), therefore, ACCEPT the project
Q6:

Zee Ltd. provides the following information:

Purchase price – Rs. 160,000
Installation charges –Rs. 40,000
Salvage value –Rs. 80,000
Economic life – 4 years
Working capital required –Rs. 20,000
Annual earning before deprecation and tax –Rs. 130000
Rate of tax – 30%
Calculate ARR if deprecation is charged using Straight
Line method.
 Solution: Annual average earnings after tax/
Average investment

Average Investment
= 20000+ 80000+ ½*[2L – 80K] = 160,000
ARR = Annual Avg. earnings / Average Investment
ARR = 70000 / 160000 * 100 = 43.75%

Year Annual Earnings Depn PBT Tax PAT

before Depn n Tax
1 130000 30000 100000 30000 70000
2 130000 30000 100000 30000 70000
3 130000 30000 100000 30000 70000
4 130000 30000 100000 30000 70000
Total 280000
Average 70000
3) Discounted Cash Flow / Time Adjusted Techniques

 These techniques take into consideration the time

value of money while evaluating the costs and benefits
of a project.

 All these methods require cash flows to be discounted

at a certain rate. This rate is known as the cost of
capital (K) or (r)
 3 (i) Net Present Value method

NPV may be described as-

the sum of the present value of cash inflows each year
Less: the sum of present values of cash outflows

Accept – Reject Rule

If NPV > Zero (i.e. positive) ACCEPT
If NPV < Zero (i.e. negative) REJECT
If NPV = Zero INDIFFERENT (can be still accepted)
 Cash flows are equal/Uniform

Q7 Initial investment Rs. 200,000, Net cash inflow Rs. 60,000

per year, Life 6 years. Cost of capital 8%, No Scrap value,
Calculate NPV.

Solution:

When cash flows are equal, we can use ANNUITY concept

PV of cash inflow = 60,000 x 4.63 = 277,800

Less: cash outflow = 200,000
NPV = 77, 800

Since NPV is positive, the proposal should be accepted.

 Cash flows are Uneven

Q8. Given the following data calculate NPV. Initial

investment 60000. Life 5 years. Cost of capital 10%.

Year AdjustedInflows
1 14000
2 16000
3 18000
4 20000
5 25000
 Cash flows are Uneven

 Solutions:-

Year Inflows PV @ 10% PV

1 14000 0.909 12726
2 16000 0.826 13216
3 18000 0.751 13518
4 20000 0.683 13660
5 25000 0.621 15525
68645
NPV = 68645 - 60000 = 8645, ACCEPT
 3 (ii) Internal Rate of Return method
The IRR is the discount rate which Equates the aggregate present
value of net cash inflows with the aggregate present value of cash
outflows of a project.
In other words, at this rate the NPV of a project will be equal to Zero.
That is PV of Cash Inflows = PV of Cash Outflows

Accept – Reject Rule – It requires comparison of the IRR with the

required rate of return or cut-off rate.

If IRR > cut-off rate ACCEPT

If IRR < cut-off rate REJECT

The required rate of return is known, whereas IRR is found by trial and
error method.
 Q9 A project costs Rs. 16,000 and is expected to generate cash inflows of
Rs. 8000 and Rs. 7000 and Rs. 6000 at the end of each year for next 3
years. Calculate IRR.
As a first step, we try a 20 per cent discount rate.
NPV = -16000 + Rs. 8000 (PVF1,0.20) + Rs. 7000 (PVF2,0.20) + Rs. 6000 (PVF3, 0.20).
= - 16000 + Rs. 8000*0.8333 + Rs. 7000*0.694 +6000*0.579
= -16000 + 14996 = - 1004.
A negative NPV indicates that the project`s true rate of return is lower than
20%. Lets try 16%. At 16% the projects NPV is
NPV = -16000 + Rs. 8000 (PVF1,0.16) + Rs. 7000 (PVF2,0.16) + Rs. 6000 (PVF3, 0.16)
= - 16000 + Rs. 8000*0.0.862 + Rs. 7000*0.743 +6000*0.641
= -16000 + 15943 = - 57.
Since the projects NPV is still negative at 16% a rate lower than 16% should
be tried. When we select 15% as the trial rate, the projects NPV is + 200.
NPV = -16000 + Rs. 8000 (PVF1,0.15) + Rs. 7000 (PVF2,0.15) + Rs. 6000 (PVF3, 0.15)
= - 16000 + Rs. 8000*870 + Rs. 7000*0.756 +6000*0.658
= -16000 + 16200 = +200
Hence the Internal rate of return lies between 15 % and 16%.
We can find out a close approximation of the rate of return by
the method of linear interpolation as follows:

IRR = lower rate + (higher rate– lower rate) x NPV of lower rate
(Lower rate NPV – Higher rate NPV)

= 0.15 + {(0.16-0.15)* 200} / [200 – (-57)]} = 15.78%

The IRR rule states that if the (IRR) on a project is greater than
the minimum required rate of return – the cost of capital – then
the decision would generally be to go ahead with it.

Conversely, if the IRR on a project or investment is lower than

the cost of capital, then the best course of action may be to
reject it.
 3 (iii) Profitability Index Method

It is also known as Benefit-Cost ratio. It can be defined

as the ratio obtained by dividing the present value of
cash inflows by the present value of cash outflows.

PV of cash inflows
PI =
PV of cash outflows

Accept – Reject Rule

If PI > 1 ACCEPT
If PI < 1 REJECT
 Q10
A project of 20 years life requires an original investment of Rs.

100,000. The other relevant information is given below:

Average annual earnings before depreciation and tax Rs.20,000

Annual tax rate 50%

Calculate:

A) Payback period

B) Average rate of return

C) Rate of return on original Investment

Solution

Annual earnings 20000

Less: depreciation 5000
EAD&BT 15000
Less: tax @ 50% (assume) 7500
EAT 7500
Add: depreciation 5000
EAT BD (Cash Flow) 12500
 Solution

Pay back period = 100,000 / 12500 = 8 years

ARR=[Average Annual Earnings (after tax) ÷ Avg. Investments] x 100

= 7500 / {100,000/2} *100 = 15% (avg. invt = Original invt/2)

ROR on original invt = 7500/ 100,000 * 100 = 7.5%

3(iv)Discounted payback period

 Under this method cash flows involved in a project

are discounted back to present value terms.

 Then the cash flows are compared with the original

investment to find the payback period.

 This method allows for timing of the cash flows but it

does not take into account the cash flows after the
payback period.
Q11. DCF limited is implementing a project with an initial
capital outlay of Rs. 8000. Its cash inflows are as under :

Year Cash flow

1 6000
2 2000
3 1000
4 5000
The expected rate of return is 12%.
Calculate Discounted Payback.

Year Cash inflow Disc Fac P.V. Cumulative

12%
1 6000 0.893 5358 5358
2 2000 0.797 1594 6952
3 1000 0.712 712 7664
4 5000 0.636 3180 10844
10844
Discounted PB is 3 years and 1.27 months
Investment is Rs. 8000
 Q 12
Premont Systems is evaluating a capital project with the following
characteristics:
The initial outlay is Rs.150,000.
Annual after-tax operating cash flows are Rs. 28,000.
After-tax salvage value at project termination is Rs. 20,000.
Project life is 10 years.
The project beta is 1.20.
The risk-free rate is 4.2 percent and the expected market return is 9.4
percent
Required:
1 Compute the project NPV. Should the project be accepted?
2 Compute the project IRR. Should the project be accepted?
Capital budgeting in India
 DCF technique is more popular in India
 IRR is used by almost 85% companies , it is
preferred over NPV many a times
 Large firms use NPV technique
 Public sector companies use PI technique
 Top management takes most of the decisions
regarding capital budgeting
 Organisations follow systematic approach to
capital budgeting decisions
Additional Methods Of Capital Budgeting
Modified Internal Rate of Return (MIRR)
 MODIFIED INTERNAL RATE OF RETURN(MIRR)

 MIRR Assumes that Project cash flows are reinvested at the cost
of capital (which is more realistic), whereas the regular IRR
assumes that the project cash flows are reinvested at the
project’s own IRR.

 IRR inflates the rate of return of an investment due to its

variance with the cost of capital which causes the need
for MIRR.

 The problem of multiple rates doesn't exist with MIRR.

 Compounded Sum n
(i.e. Terminal Value of Cash Inflows)
Present Value of Cash Outflow =
n
(1+ MIRR)

OR

PV of Cash Outflow = Compounded Sum n x PV factor @ MIRR for n years

 Q 13

P ltd is evaluating a project that has the following cash flow

stream associated with it. The Cost of Capital for P Ltd is 15%.
Calculate MIRR. Investment in the project – Initially Rs 122 Lakhs
and at the end of the first year Rs 80 Lakhs and Inflow starts from
the end of second year as given below.

Year Cash Flow

(Rs lakh)
0 (122)

1 (80)
2 20
3 60
4 80
5 100
6 120
 Solution:
 Present Value of Cash Outflow
Year Cash Outflows Discounting Factor PV of Cash
(Rs Lakh) @15% Outflows
0 122 1 122
1 80 .8696 69.57
∑ = 191.57

 Compounded Sum n (i.e. Terminal Value of Cash Inflows)

Year Cash inflows Compounding Factor @15% Compounded

(Rs Lakh) Sum

2 20 For remaining 4 yrs 1.7490 34.98

3 60 For remaining 3 yrs 1.5209 91.25

4 80 For remaining 2 yrs 1.3225 105.8
5 100 For remaining 1 yr 1.15 115

6 120 No compounding 120

∑ = 467.03
 Compounded Sum n
Present Value of Cash Outflow = (i.e. Terminal Value of Cash Inflows)
n
(1+ MIRR)

i.e. 191.57 = 467.03/(1+ MIRR)6

There are following methods to get this answer

Method 1: With the help of Scientific calculator

(1+ MIRR)6 = 467.03/ 191.57
(1+ MIRR)6 = 2.43790781437
1+ MIRR = (2.43790781437) 1/6
1+ MIRR = 1.160119909
MIRR = 1.160119909 -1
MIRR = 0.160119909
MIRR = 16.01%
 Method 2: Discount the compounded value 467.03 at assumed MIRR (Trial & Error)

Compounded Sum n
Present Value of Cash Outflow = (i.e. Terminal Value of Cash Inflows)
(1+ MIRR)n

i.e. 191.57 = 467.03/(1+ MIRR)6

Assume MIRR @ 10% @ 20%

PV of 467.03 = 467.03/(1+ MIRR)6 467.03/(1+ 0.1)6 467.03/(1+ 0.2)6

= 263.63 = 156.41
NPV = PVCI - PVCO 263.63 - 191.57 263.63 - 191.57
= 72.06 = - 35.16

MIRR is to be calculated by interpolation formula :

MIRR = LR + (HR – LR) x NPV @ LR

NPV @ LR – NPV @ HR

10 x 72.06
MIRR = 10 +
72.06 – (- 35.16)

MIRR = 10 + 6.72
MIRR = 16.72 %
 OR
Method 3: With the help of Time Value of Money Tables

Compounded Sum n
Present Value of Cash Outflow = (i.e. Terminal Value of Cash Inflows)
(1+ MIRR)n

i.e. 191.57 = 467.03/(1+ MIRR)6

i.e. (1+ MIRR)6 = 467.03/ 191.57

i.e. (1+ MIRR)6 = 2.43790781437

(1+ MIRR)6 = Future Value factor(Compounding factor) @MIRR for 6 years
Hence check 2.437 in the future value tables in the row of 6th year.
Value 2.437 is closest to 16% column value.
Hence MIRR = 16%