Techniques of capital budgeting

1. Capital Budgeting
• What is Capital Budgeting
– Three Major Decision
– Investing
– Financing
– Dividend
• In capital Budgeting we will focus on the
Investing Decision

2. Capital Budgeting
• So investment decisions are also called
Capital Budgeting Decision
• Why organization face this kind of decisions
– New Investment( Expansion)
– Replacement

3. Capital Budgeting
• Why Capital Budgeting Decision are Important
• Large amount of money
• Irreversible
• Long term
• Affects the firms long term profitability and
standing in the industry
• We can say these decisions are
– Strategic Decisions

4. Capital Budgeting
• Why Capital Budgeting Decision are Important
• Large amount of money
• Irreversible
• Invest now but returns will come in later years
• Long term
• Affects the firms long term profitability and
standing in the industry
• We can say these decisions are
– Strategic Decisions

5. Capital Budgeting
• Types of Investment Proposals
• Independent Proposals
– Expansion in two separate geogrophies
• Mutually Exclusive
– Boat or Bridge
• Dependent
– New machine for new plant

6. Capital Budgeting
• Capital Budgeting Decision Techniques
• Pay back period method
• NPV ( Net Present Value)
• PI ( Profitability Index)
• NTV ( Net Terminal Value)
• ARR ( Accounting Rate of Return)

7. Capital Budgeting
• Pay back period method
– Even Cash Flows
– Un Even Cash Flows
• Refers to the “Time period” in which the
money invested will come back
• Example
– Initial Investment = Rs 20,000.Annual Cash inflow
from the project is 5000.What is the Payback
Period.
– 4 years

8. Capital Budgeting
• Pay back period method ( Un Even Cash Flows)
• What is the payback period
• 3 full year + .25 year = 3.25 years
Year Cash Flow Cumulative
Cash Inflow
0 -20000
1 6000 6000
2 8000 14000
3 5000 19000
4 4000 23000
5 4000 27000

9. Capital Budgeting
• Accept/Reject Criterion ?
• On what basis should one accept or reject the
project
– All depends on the management in case of single
project
– In case of choice, the one having shorter duration
is accepted

10. Capital Budgeting
• Pay back period method ( Un Even Cash Flows)
• Which Machine will be selected based on PB method
Machine A Machine B
Initial Investment 9000 18000
Estimated Life 4 years 5 years
Estimated saving in scrap 500 800
Estimated saving in wages 6000 8000
Additional Cost of
maintenance
800 1000
Additional Cost of
Supervision
1200 1800

11. Capital Budgeting
• Pay back period method ( Un Even Cash Flows)
• Which Machine will be selected based on PB method
Machine A Machine B
Estimated saving in scrap 500 800
Estimated saving in wages 6000 8000
Total Savings 6500 8800
Additional Cost of
Supervision
1200 1800
Additional Cost of
maintenance
800 1000
Total Cost 2000 2800
Net Cash Inflow 4500 6000
PB 9000/4500 = 2 18000/6000 = 3

12. Capital Budgeting
• Merits of Payback Period
– Easy to calculate
– This method is useful where the uncertainty is
high
– This method makes it clear that no profit arises till
the payback period is over

13. Capital Budgeting
• Demerits of Payback Period
– Ignores the returns generated after the payback
period
Project A ( -10,000) Project B( -10,000)
4000 3000
4000 3000
2000 3000
3000
3000
PB = 3 years PB = 3.33 years

14. Capital Budgeting
• Demerits of Payback Period
– Ignores the Time Value of Money
– Which one is better?
– A is better as the money is recovered faster in A
Project A ( -30,000) Project B( -30,000)
10000 2000
10000 4000
10000 24000
PB = 3 years PB = 3 years

15. Capital Budgeting
• Discounted Cash Flow Techniques
– Considered to be the best method to evaluate the
investment proposals
– The cash inflows and out flows are calculated
– These cash inflows and outflows are then
discounted at an appropriate discount rate
– The difference between the discounted cash
inflow and discounted cash outflow is calculated

16. Capital Budgeting
• How to calculate
NPV = ∑discounted Cash inflows - ∑ discounted Cash Outflows
 
.CF
k1
CF
NPV 0t
t
n
1t


 

17. Capital Budgeting
• Accept/Reject Criterion
– Single Project
• NPV> 0
– Multiple Project
• Accept the one with the maximum NPV

18. Example: Projects L and S
 Both projects require a return of 10%.
Expected net cash flow
Year Project L Project S
0 (RS100) (RS 100)
1 10 70
2 60 50
3 80 20
CAPITAL BUDGETING
DECISION
CRITERIA 2

19. What’s Project L’s NPV?
10 8060
0 1 2 3
10%
Project L:
-100.00
9.09
49.59
60.11
18.79 = NPVL
NPVS = Rs 19.98.
CAPITAL BUDGETING
DECISION
CRITERIA 2

20. Capital Budgeting
• Example
There are 3 mutually exclusive projects. All the three are expected to cost
RS 2,50,000and have an estimated life if 5,4 and 3 years respectively.
The company's required rate of return is 10%.The anticipated cash
inflow after tax for the three plants are as follows .Which Plant should
be accepted
Year Plant I Plant II Plant III
1 80,000 1,10,000 1,30,000
2 60,000 90,000 1,10,000
3 60,000 85,000 20,000
4 60,000 35,000 -
5 1,80,000 - -

21. Capital Budgeting
• Find out the Total PV of cash flows for all the
three plants
Year Plant I Plant II Plant III
1 80,000X.909 1,10,000 x .909 1,30,000 x.909
2 60,000x .826 90,000x .826 1,10,000x.826
3 60,000 x .751 85,000 x.751 20,000x.751
4 60,000 x .683 35,000x .683 -
5 1,80,000 x .621 - -
Total PV 3,20,100 2,62,070 2,24,050
NPV 70,100 12070 25950

22. Capital Budgeting
• A company ltd is considering the purchase of a new machine. Two
alternative machines have been suggested, each having an initial cost of
Rs 4,00,000 and requiring an additional working capital at the end of 1
year. Earnings after tax are expected to be as follows. The company has a
required rate of return of 10%.Whihc machine would be bought. Use NPV
method
Year A B
1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000

23. Capital Budgeting
1. Find the Total PV of all the cash inflows for both the machines
2. Find the Total PV of all the cash outflows for both the machines
3. Subtract the 1 from 2 to get the NPV
4. One with the Greater NPV is selected
Year A( PV of the cash inflows) B( PV of the cash inflows)
1 40,000X.91 1,20,000X.91
2 1,20,000X.826 1,60,000X.826
3 1,60,000 X.751 2,00,000X.751
4 2,40,000X.683 1,20,000X.683
5 1,60,000X.621 80,000X.621
5,18,920 5,23,080

24. Capital Budgeting
1. Find the Total PV of all the cash outflows for both the machines
2. Total Present value of the cash out flow = PV of the outflow at the
beginning + the PV of the cash outflow in the future
3. = 4,00,000 + PV of the working capital expenditure after 1 year
4. = 4,00,000+ 0.909X20,000 = 4,18,200
5. NPV A = 5,18,400-4,18,200 = 1,00,200
6. NPV B = 5,23,200- 4,18,200 = 1,05,000

25. Capital Budgeting
1. Home Work
XYZ company is considering replacement of its existing machine by a new
machine which is expected to cost RS 1,60,000.The new machine will
have a 5 years and will yield a cash revenue of Rs 2,50,000 and incur an
annual cash expense of Rs 1,30,000.The estimated salvage value of the
new machine is nil. The existing machine has a book value of Rs 40,000
and can be sold for Rs 20,00 today. It is good for the next 5 years and is
estimated to generate a cash revenue of RS 2,00,000 and will incur
annual expense of Rs 1,40,000.Its salvage value after 5 year is Nil.
Corporate tax rate is 40%.Depriciation is25% on WDV method. The
company’s opportunity cost is 20%.Ignore the taxes in the profit or loss
on the sale of machine. Advise whether the company should replace the
machine or not.

26. Capital Budgeting
1. Excess Present Value Index
2. A refinement over NPV method
= PV of the future cash inflows X 100
PV of the future cash outflows
• A good indicator in case when the investments of the projects are
different
• Example: Project A : PV of cash out flow= 1,00,000
PV of cash inflow = 1,20,000
NPV = 20,000
• Project B : PV of cash out flow= 15,000
PV of cash inflow = 20,000
NPV = 5000
Excess PV index A =1,20,000/1,00,000 = 120%
Excess PV index B =20,000/15,000 = 150%

27. Capital Budgeting
1. Internal Rate of Return
2. It is that “ discount rate “ at which the net cash flows becomes zero
3. In other words the
∑discounted Cash inflows - ∑ discounted Cash Outflows =0
Which also means that discount rate at which NPV =0
• Interpretation
– Why I am interested in finding IRR
– For example for project A IRR = 10% and from another project B the IRR is 12%
– This means that from project A I will get a return of 10% on my investment and from
project B I will get a return of 12%. So which project should I invest in?
– Accept Reject Criterion
– A project with higher IRR is always accepted. But the decision will also depend upon
your Cost of capital.
– Some times a project with higher IRR may also get rejected if the cost of capital is
Higher.

28. Capital Budgeting
1. How to calculate IRR ?
IRR is the rate at which NPV is 0.

29. Capital Budgeting
1. How to calculate IRR ?
2. Two Methods
1. When cash inflows are equal
1. Approximation Method
2. When the cash flows are unequal
1. Hit and trial method
1. When cash inflows are equal
Example: An equipment requires an initial investment of Rs
6,000.The annual cash inflow is estimated to be Rs 2000 for
5 years. Find the IRR?

30. 30
Single Sum - Future & Present Value
1 2 30
PV1 = 2000/(1+k/100)
2000
PV2 = 2000/(1+k/100)2
2000
PV3 = 2000/(1+k/100)3
200
• The inflows are equal each year for the next 5 years
• Need to find K at which the diff, between PV of cash
flows and PV of cash inflows is zero
-6000

31. Capital Budgeting
• Steps
– Find factor F = I/C
I = initial Investment
C = cash inflows per year
F = 6000/2000 = 3
• Go to PVIF Annuity table and locate the value 3( or near 3 in
the 5th year row)
• The nearest value is 2.99 at 20%
• So IRR is 20%

32. Capital Budgeting
• Case II when the Cash inflows are not equal
Example : A company has an investment opportunity costing Rs 40,000 with
the following expected net cash inflows.
Year Cash inflow
1 7000
2 7000
3 7000
4 7000
5 7000
6 8000
7 10000
8 15000
9 10000
10 4000

33. Capital Budgeting
• Steps
– Find factor F = I/C
I = initial Investment
C = Average cash inflows per year
F = 40,000/8200
F = 4.87
The possible IRR lies between 15% and 16%
Find out the NPV at both the discount rates.

34. Capital Budgeting
Ye
ar
Cash
inflow
DF(15%) DF(16%) DF(14%)
1 7000 .870 .862 .877
2 7000 .756 .743 .769
3 7000 .658 .641 .675
4 7000 .572 .552 .592
5 7000 .497 .476 .519
6 8000 .432 .410 .456
7 10000 .376 .354 .400
8 15000 .327 .305 .351
9 10000 .284 .263 .308
10 4000 .247 .227 .270

35. Capital Budgeting
• NPV (at 15%) = 39420-40,000= -580
• NPV(at 16%) = 37851-40000 = -2149
• Since it is negative at both the rates I need to calculate at
14%
• NPV at 14 % = 41097-40,000= 1097
• Thus IRR lies between 14% and 15%
So we need the extrapolation formula
IRR = 14% + 1097 X 1 = 14+0.65 = 14.65%
1097+ (580)
Ignore the Sign

36. Capital Budgeting
• Example: A company has to select one project out of the following
2.Which one of them will be selected.
Year A B
0 -11000 -10000
1 6000 1000
2 2000 1000
3 1000 2000
4 5000 10000

37. Capital Budgeting
• Steps
– Find factor F = I/C
I = initial Investment
C = Average cash inflows per year
F = 10,000/3500
F(A) = 3.14 ( IRR is around 10%)
F(B) = 2.86 ( IRR around 15%)
Find out the IRR of both the projects
One with the higher IRR is selected.

38. Capital Budgeting
• NTV( Net Terminal Value)
• An improvement over NPV method
• It is based on the assumption that the future cash inflows
can be reinvested again at an appropriate interest rate.
• Steps in Calculating NTV
• Compound all the future cash inflows at appropriate
compounding rate
• Discount the compounded value calculate at an appropriate
discount rate.
• Subtract the discounted value from the cash outflow
• Projects with positive NTV are accepted .

39. Capital Budgeting
• NTV( Net Terminal Value)
• Example: From the following data calculate the NTV of the
project
– Initial capital investment = Rs2,40,000
– Useful Economic Life of the project = 4years
– Annual cash inflows ( at the end of the year) = Rs80,000
– Cost of capital( discount rate) = 10%
– Reinvestment Rate = 8%

40. Capital Budgeting
• Now discount the compounded value at discount rate of 10%
• PVIF(10%, 4years) = 0.683
• Discounted Value = 0.683X 3,60,480 = 2,46,208
• NTV = 2,46,208-2,40,00 = Rs 6208
Year Cash
Inflow
Compounding
Factor
Compounded
Value
1 80,000 1.260 100800
2 80,000 1.166 93280
3 80,000 1.080 86400
4 80,000 1 80000
Total 3,60,480

41. Capital Budgeting
• Comparison between NPV and NTV
• Both will give the same result if the Compounding rate and discounting
rate are equal
• But if they are different they give different results
• For example: In the previous case NPV will come out to be = Rs 13,600
while NTV is 6208
• When Discount rate and Investment rate are equal at 10%
• NTV will be 80,00X 4.641=3,71,280 X0.683 = 2,53,584-2,40,000= 13,584
• NPV will be 13,600 and thus both are almost equal

42. Capital Budgeting
• ARR ( Accounting Rate of Return/Average Rate of Return)
• According to this method the projects are judged in the
basis of their relative profitabilty
• The Profitability is calculated over the entire life of the
project
• The ARR is calculated by following methods
– Annual Average Net Earnings X 100
Original Investments
– Annual Average Net Earnings X 100
Average Investment
– Increase in expected future annual net earnings
Increase in the Investment X 100

43. Capital Budgeting
• What is Annual Average Net Earnings ?
– This is the average net earnings( after depreciation and tax) over the whole life of the
project
• Average Investment can be calculates by any of the following methods
– Original Investment
2
– Original Investment – Scrap value of the asset
2
– Original Investment – Scrap value of the asset + Addl Working Capital + Scrap Value
2

44. Capital Budgeting
• Example: The FM of company is considering the replacement of an old
machine with a new machine .The old machine has been in operation for
last 5 years.The tax rate is 50%.Which of the two alternatives will be
considered based in ARR.
Old Machine New Machine
Purchase Price 40,000 60,000
LIfe 10 years 10 years
M/C running Hours per
annum
2000 2000
Units /Hour 24 35
Wages/Hr 3 5.25
Power /Year 2000 4500
Consumables/year 6000 7500
Other charges/annum 8000 9000
Material cost /unit 0.50 0.50
Selling Price/unit 1.25 1.25

45. Capital Budgeting
Old Machine New Machine
Sales 2000X24X1.25
=60,000
87500
Cost
Material Cost 0.5X2000x 24=
24000
35000
Wages 6000 10,500
Power 2000 4500
Consumables 6000 7500
Other charges 8000 9000
Depreciation 40,000/10 =
4000
60,000/10 = 6000
PBT 10,000 15000
PAT 5000 7500

46. Capital Budgeting
– Annual Average Net Earnings X 100
Original Investments
= 5000/40,000 x 100 = 12.5 %
New Mchine = 8250/60,000 X 100 = 13.75%
– Annual Average Net Earnings X 100
Average Investment
– OLD 5000/ 20,000 X 100 = 25%
– New 8250/30,000 X 100 = 27.50%
– Increase in expected future annual net earnings
Increase in the Investment X 100
8250-5000 X 100 = 16.25%
20,000

47. Capital Budgeting
• Home Work : Find ARR for the following two machines by all the three
methods
A B
Purchase Price 56125 56125
Life 5 years 5 years
Salvage Value 3000 3000
Tax rate 55% 55%
Addition in Net Working
Capital
5000 5000
Annual Income After Depr.
And Tax
1 3375 11375
2 5375 9375
3 7375 7375
4 9375 5375
5 11375 3375

48. Capital Budgeting
• Read Capital Rationing : Page C-56 to C-58 from Maheshwari.