Chapter-1
Capital Budgeting
Dr. Komal Patel
Sunshine Group of Institutions- Rajkot
Chapter Plan
• Capital Budgeting:
– Concept of Capital Budgeting,
– Nature and Process,
– Evaluation Techniques –
• Net Present Value,
• Internal Rate of Return,
• Profitability Index,
• Payback Period,
• Average Rate of Return.
Introduction of Capital Budgeting
Meaning
• Capital budgeting is a process of evaluating
investments and huge expenses in order to obtain
the best returns on investment.
• An organization is often faced with the challenges
of selecting between two projects/investments or
the buy vs replace decision. Ideally, an organization
would like to invest in all profitable projects but
due to the limitation on the availability of capital an
organization has to choose between different
projects/investments.
Example
Your mobile phone has stopped
working! Now, you have two
choices: Either buy a new one or
get the same mobile repaired.
Here, you may conclude that the
costs of repairing the mobile
increases the life of the phone.
However, there could be a
possibility that the cost to buy a
new cell phone would be lesser
than its repair costs. So, you
decide to replace your cell phone
and you proceed to look at
different phones that fit your
budget!
Definition
“According to economist, the capital is the value of total available with the business”
“According to an accountant, the capital is the difference between the assets and
liability”
“According to finance the capital is the total amount of finance required by the business
to conduct its business operations both in the short run and long run”.
Characteristics
• Investment for long Period
• Substantial Expenditure
• Need for proper forecasting
• No Routine Decision
• Difficult Decision Making
• Planning of Assets Capacity
Objectives of Capital Budget
• Replacement
• Substitution of Machinery for labor
• Change in the Method of Production
• Business Expansion
• Introduction of New Product
Types of
Investment
Welfare Prestige Strategic Replacement Development
Importance of Capital Budgeting
• Large Expenditure
• Long term effects
• Estimates and Uncertainty
• Effects on Profitability
• Irreversible Decision
Process of Capital Budgeting
Investment
Proposal
Evaluation
Selection
Implementation
Approaches of Capital Budgeting Decision
Acceptance
Acceptance Rejection
Rejection
Techniques of Capital Budgeting
Techniques
Non
Discounting
Discounting
Payback
NPV IRR PI ARR
Period
Evaluation Techniques
• Net Present Value,
• Internal Rate of Return,
• Profitability Index,
• Payback Period,
• Average Rate of Return.
Payback Period
• Payback Period
= Initial Outflow of the Project
Annual Cash Inflow
• Profit Before Depreciation and After Tax
Example.1
• Initial Investment is 10,00,000 rs.
• Cashinflow is rs. 2,00,000 pa
• Calculate Payback Period.
Example-2
• Calculate Payback Period from the following
information
– A. if cash outflow is 200000 Rs.
– B. if cash outflow is 185000 Rs.
Year Annual Cash Inflow
1 80000
2 60000
3 40000
4 20000
Example-3
• A project cost is 100000 rs. And annual cash
inflow is 20000 rs. For 8 years.
Example-4
• A project cost is rs. 250000 and yielding
annually of rs. 50000 after depreciation @12%
p.a but before tax of 50%. Calculate Payback
Period.
Advantages
• No Experts
• Liquidity
• Low Risk
Disadvantages
• Overlook Cash flow
• Equal Importance to all Cash flow
Example-2
• In a proposal , there is a cash out flow of Rs.
2,00,000 and the projected revenue generation is
not equal.
• It is as under
Year Annual Cash Inflow
1 80000
2 60000
3 40000
4 20000
Calculate Payback period
Net Present Value
• “Net present value is the present value of the cash
flows at the required rate of return of your project
compared to your initial investment,” says Knight.
• In practical terms, it’s a method of calculating your
return on investment, or ROI, for a project or
expenditure.
• By looking at all of the money you expect to make
from the investment and translating those returns
into today’s dollars, you can decide whether the
project is worthwhile.
Net Present Value
Cash flow After Tax
NPV>0, Accept
NPV<0, Reject
NPV=0 , Indefference
Example-1
Solution
NPV= PV-II
197785-200000 = -2215
Year CF PVF@ 12% PV= cf*pvf
1 35000 0.893 31255
2 35000 0.797 27895
3 35000 0.712 24920
4 35000 0.636 22260
5 35000 0.567 19845
6 35000 0.507 17745
7 35000 0.452 15820
8 35000 0.404 14140
9 35000 0.361 12635
10 35000 0.322 11270
Total Present Value 197785
Example-2
Example-3
• A firm wants to purchase a machine at a cost
of rs. 500000.
• Its cash flows are as under.
• Calculate NPV at 10%
Year Cash PVF@10% PV
Flows(RS.)
1 200000 .909 181800
2 300000 .826 247800
3 200000 .751 150200
Total PV 579800
Example-4
• Sun ltd. Is planning an investment in new
project.
• Budget is Rs. 280000
• Help them for selection of proposal by NPV
Method discounted at 10%..
Year Project A Project B
0 280000 280000
1 40000 200000
2 80000 160000
3 120000 80000
4 180000 40000
5 240000 40000
Example-5
Solution
Year CF Tax @ PAT DEP PATBD PVF PV
30%
1 150000 45000 105000 50000 155000 .909
2 180000 54000 126000 50000 176000 .826
3 200000 60000 140000 50000 190000 .751
4 210000 63000 147000 50000 197000 .683
5 160000 48000 112000 50000 162000 .621
6 225000 67500 157500 50000 217500 .564
Example-6
• Page-75
Advantages
• Time Value of Money
• Sound Method
• Shareholder’s wealth
Disadvantages
• Not easy
• Difficult Calculation
• Not Accurate Decision
Internal Rate of Return
• Yield on Investment
• Rate of Return
• Profit Before Dep. After Tax
• The internal rate of return (IRR) is a discounting cash
flow technique which gives a rate of return earned
by a project. The internal rate of return is the
discounting rate where the total of initial cash
outlay and discounted cash inflows are equal to
zero. In other words, it is the discounting rate at
which the net present value(NPV) is equal to zero.
Formula
Example-1
Example-2
Average Rate of Return
• TVM
• Easy to Understand
• Profitability
Disadvantages
• Difficult to Calculate
• Confusion
IRR Vs NPV
Profitability Index
Profit Before Dep. After Tax
Example-1
Solution
ARR
• Formula
• ARR = Average Annual Earning After
Tax/Average Investment
Average Investment= II+SV/2