Module III: Capital Budgeting

Module III: Capital Budgeting

• Capital budgeting: Meaning, Capital budgeting process, Project
classification, Investment Criteria – Payback period method, Net
Present Value Method, Internal Rate of Return Method, Accounting
Rate of Return Method.
Investment Decision
• The investment decision is concerned with selection of asset in which
funds will be invested by the firm
Capital budgeting meaning
• Capital budgeting is the process that businesses use to evaluate and
decide on long-term investments or major expenditures.
• These investments typically involve purchasing assets like machinery,
buildings, equipment, or launching new projects that will generate
returns over several years.
Capital budgeting Definition
• “Capital budgeting is the long term investment decision for
functioning of acquires, upgrades, replaces the assets such as land
and buildings, plant and machinery and different types of long term
projects.”
• “According to Charles T Horngren “Capital budgeting is the long term
planning to make and finance proposed capital analysis.”
NATURE OF CAPITAL BUDGETING:
[Link]-Term Investment Decisions – It focuses on investments that will
impact the company’s financials for years.
[Link] and Return Assessment – Companies analyze potential returns
and risks before committing resources.
[Link] Flow Analysis – Future cash inflows and outflows are estimated
to determine project feasibility.
[Link]-Making Tools – Techniques like Net Present Value (NPV),
Internal Rate of Return (IRR), and Payback Period help assess project
profitability.
SIGNIFICANCE OF CAPITAL BUDGETING:
• Substantial capital outlays
• Long term implications
• Strategic in nature
• Irreversible
SCOPE OF THE CAPITAL BUDGETING
• Construction of new building.
• Renovation of existing building.
• Purchase of technology from a foreign country.
• Building a production facility.
• Buying a new delivery truck.
• Building a bridge.
• Making a new product.
• Starting a new business.
• Expansion decision of existing plant and equipment.
Kinds of capital Budgeting Decisions
1. Replacement
2. Expansion
3. Diversification
4. Research and development
Process of Capital budgeting

Evaluation of Evaluation of
cash flow technique
Steps in Capital Budgeting
Step1. Planning and Identifying Investment Opportunities
• Companies identify potential projects such as purchasing new machinery,
expanding operations, launching a new product, or acquiring another
business.
• Example: A manufacturing company may consider investing in automated
equipment to improve efficiency.
Step2. Evaluating the Investment Proposal
• Gather relevant data about costs, expected returns, and risks.
[Link] the Cash Flows
• Forecast the expected revenue and costs over the project’s life.
• Identify initial investment costs and ongoing operational expenses.
• Consider depreciation, salvage value, and tax impacts.
2. Assessing Project Feasibility Using Capital Budgeting Techniques
• Companies use financial tools to determine if the project is worthwhile with Net
Present Value (NPV):,Internal Rate of Return (IRR), Payback Period, Profitability
Index (PI)
Step 3. Selecting the Best Investment Option
• Compare multiple projects using the above techniques also aligns with business
strategy, risk tolerance, and financial goals.
Step4- Implementing the Investment Decision
• Arrange financing (debt, equity, or internal funds).
• Purchase necessary assets, hire employees, or start construction.
• Monitor project execution and budget adherence.
Step 5 &6 Post-Implementation Review & Performance Monitoring
• Compare actual performance with initial projections.
• Identify deviations and take corrective actions if needed.
• Learn from past investments to improve future decision-making.
 Capital Budgeting Techniques

The capital budgeting appraisal

methods are techniques of
evaluation of investment proposal
will help the company to decide upon
the desirability of an investment
proposal depending upon their;
relative income generating capacity
and rank them in order of their
desirability
Pay-back period method
Pay-back period method
• It is the most popular and widely recognized traditional method of
evaluating the investment proposals. It can be defined, as ‘the number
of years required to recover the original cash out lay invested in a
project’.
• According to James. C. Vanhorne, “The payback period is the number
of years required to recover initial cash investment.
• The Payback Period is the time it takes for an investment to recover its
initial cost through cash inflows. It is a simple method used in capital
budgeting to evaluate how quickly an investment pays for itself.
Formula for Payback Period:
Example
• Consider a manufacturing company that invests in a solar power
system to reduce electricity costs.
• Initial Investment: ₹5,00,000Annual Cash Inflows (Savings on
Electricity Bills): ₹1,25,000 per year
 Example 2
• Uneven Cash Flows Calculation

If the initial investment is ₹5,00,000, the company recovers the

investment between Year 2 and Year 3.
• By Year 2, the company has recovered ₹3,25,000.
• It needs ₹1,75,000 more, which is received in Year 3.
• Since Year 3 generates ₹2,00,000, we calculate:
• Illustration 1
Initial investment = 25,00,000
Annual cash inflow= 5,00,000 for 8 years calculate Payback period.
Illustration 2

• Suggest the management using pay back period.

Machine A Machine B
Initial investment= 15,00,000 Initial investment= 20,00,000
Cash inflow= 5,00,000 Cash inflow= 5,50,000
• Machine A

• Machine B

• Machine A has a shorter payback period (3 years) compared to Machine B

(3.64 years).
• If the company prioritizes a faster return on investment, Machine A is the
better choice.
• However, if higher long-term cash inflows and a slightly longer recovery
period are acceptable, Machine B could be considered.
Illustration 3
An industry is considering investment in a project which cost Rs
6,00,000
• Cash inflows are- 1,20,000 – 1,40,000 - 1,80,000- 2,00,000-
2,50,000
Calculate Pay back period.
• we calculate the fraction of Year 4 required to recover the remaining Rs
1,60,000 (Rs 6,00,000 - Rs 4,40,000).

• The Payback Period = 3 + 0.8 = 3.8 years (or 3 years and 9.6 months).
• This means the company will recover its investment in approximately 3
years and 9.6 months.
 Illustration 4
• Using the information given below, compute the payback period under:
(i) Traditional Payback Method
(ii) Discounted Payback Method
• Initial Outlay: ₹80,000, Estimated Lifetime: 5 years
• Profit after Tax Year 1: ₹6,000, Year 2: ₹14,000, Year 3: ₹24,000, Year 4:
₹16,000,Year 5: ₹Nil
• Depreciation: Straight-line method
• Cost of Capital: 20% per annum
• Present Value (P.V.) Factors at 20%: Year 1: 0.83, Year 2: 0.69, Year 3: 0.58,
Year 4: 0.48, Year 5: 0.40
1. Traditional Payback Period (Non-
Discounted)
• Annual cash flow = Profit after tax + Depreciation
• Depreciation (Straight Line Method) = Initial Outlay / Lifetime
= ₹80,000 / 5
= ₹16,000 per year.
2. Discounted Payback Period
2. Discounted Payback Period
Average rate of return
method (ARR)
Average rate of return method (ARR)
• Accounting Rate of Return (ARR) is the percentage rate of return that
is expected from an investment or asset compared to the initial cost
of investment.
• financial metric used to evaluate the profitability of an investment
based on accounting profits rather than cash flows. It measures the
expected return from an investment as a percentage of the average
investment cost.
Q1
• A company wishes to make an investment of Rs. 50,000 in a machine.
• The machine has a life of 5 years.
• The profit after tax on account of this machine for next five years is Rs. 7,500;
Rs. 8,200; Rs. 7,900; Rs. 8,900 and Rs. 6,500 respectively.
• Calculate the ARR for this investment purpose.
Answer
Q2
Q3
Project X has a higher ARR (26.05%) compared to Project Y
(19.68%).
Therefore, based on ARR, Project X is the better choice.
NET PRESENT VALUE (NPV)
NET PRESENT VALUE (NPV)
• The NPV is a discounted cash flow method that consider time value of
money in evaluating capital investment
• It is a method of calculating the present value of cash flows (inflow
and outflow) of an investment proposal using the cost of capital as on
appropriate discounting rate.
• A positive NPV indicates that the investment is expected to generate
more value than its cost, making it a profitable decision. Conversely, a
negative NPV suggests that the investment would result in a net loss.
Formula
 Discounting

Present Value (FV) Future Value (FV)

Rs 500 Rs 455

10%
Q1
Q2
Answer
Q3
 Answer

Project C has the least negative NPV (-3,391), making it the least unprofitable option. However, since all NPVs are
negative, none of the projects are financially viable. If forced to choose, Project C would be the best option as it results
in the smallest loss.
Q4
Answer

Recommendation
Since NPV is positive
(₹326,231), the project
is feasible and should be
accepted .A positive
NPV means the project
adds value to the
company and is
expected to generate a
return above the
discount rate (13%). ​
Internal Rate of Return (IRR)
Internal Rate of Return (IRR)
• The IRR represents the discount rate at which the NPV of the
investment is ZERO
• In simpler terms, it is the rate at which the present value of
future cash inflows equals the initial investment. IRR is used
to evaluate the profitability of investments.
PV of the expected cash inflows = initial cash outflow
IRR Acceptance Rule :
Accept if IRR> required rate of return
Reject if IRR< required rate of return
Discount Rate
• The discount rate is the interest rate used to determine the present
value of future cash flows. It helps answer the question:
• "How much is future money worth today?“
Example
• Imagine you are a factory owner and want to buy a new machine that
costs ₹10 lakh today. This machine will generate ₹3 lakh per year in
profits for the next 5 years.
• Now, you need to decide: Is this a good investment?
Why Discount Rate Matters?
• Money today is more valuable than money in the future because of
inflation, interest rates, and risk.
• The discount rate helps you find out how much those future profits
(₹3 lakh per year) are worth in today’s money.
• If the discounted value of future profits is more than ₹10 lakh, the
machine is a good investment. Otherwise, it’s not.
• Using a 10% discount rate, the value of ₹3 lakh received in future
years will be less than ₹3 lakh today.
For example:
• ₹3 lakh next year is worth only about ₹2.73 lakh today (because of
10% discounting).
• ₹3 lakh after 2 years is worth even less—around ₹2.48 lakh today.
• And so on for 5 years.
• When we add up all these discounted values, if the total is more than
₹10 lakh, the machine is a profitable investment!
linear interpolation method
 Q1
Initial investment= 1,00,000, inflows – Rs 25,000 for 6 years.
Calculate Internal Rate of Return.
Q2
 Q3
• A company is considering an
investment of ₹1,50,000 in a
project that will generate the
following cash inflows over 5
years
Using the following NPVs:
• NPV at 12% = ₹5,240
• NPV at 18% = ₹-7,320
• Calculate the IRR using the
interpolation method.
Profitability Index
Profitability Index
• The Profitability Index (PI), also known as the Benefit-Cost Ratio, is a
capital budgeting metric used to evaluate the attractiveness of an
investment or project. It is calculated as:

Interpretation:
• PI > 1 → The project is profitable and should be accepted.
• PI = 1 → The project breaks even.
• PI < 1 → The project is not profitable and should be rejected.
Q1
• A company is considering investing in a project that requires an initial
investment of ₹1,00,000. The project is expected to generate the
following cash inflows over the next 4 years is given. The discount rate
(cost of capital) is 10%.
Since PI > 1, the project is profitable and should be accepted.
 i) Payback Period
The Payback Period is the time required to recover the initial investment of
₹40,000 from the cumulative cash inflows. •After 5 years, the cumulative
inflow is ₹35,000.
•In Year 6, the total inflow
reaches ₹43,000, meaning the
initial investment is recovered
sometime in Year 6.
•The remaining amount to
recover after 5 years:
₹40,000 – ₹35,000 = ₹5,000
•In Year 6, the cash inflow is
₹8,000.
The fraction of the year
required to recover ₹5,000 is:
(ii) Net Present Value (NPV) at 10% Discount Rate

(Since NPV is positive, the

project is profitable and should
be accepted.)
(iii) Profitability Index (PI)

(Since PI > 1, the project is profitable.)