Economics and Capital Budgeting and Investment decisions

1. RISHAV RAJ
MBA/45008/19
VANISHRI KORNU
MBA/45016/19

2. Capital is the total investment of the company
and budgeting is the art of building budgets
The large amounts spent for these types of
projects are known as capital expenditures.
Capital budgeting usually involves calculation of
each project’s future accounting profit by period,
the cash flow by period, the present value of
cash flows after considering time value of
money, the number of years it takes for a
project’s cash flow to pay back the initial cash
investment, an assessment of risk, and various
other factors.

3. OBJECTIVES OF CAPITAL
BUDGETING
• To find out the profitable capital expenditure.
• To decide whether a specified project is to be
selected or not.
• To find out the quantum of finance required
for the capital expenditure.
• To evaluate the merits of each proposal to
decide which project is best.

4. FEATURES OF CAPITAL
BUDGETING
Capital budgeting involves the investment of funds
currently for getting benefits in the future.
Capital expenditure decisions are irreversible.
The long term investment is fixed.
The investments made in the project are determining
the financial condition of business organization in future.
Generally, the future benefits are spread over several
years.

5. LIMITATIONS OF CAPITAL BUDGETING
• The future is uncertain, the presumed cash inflows and
cash outflows may not be true. Therefore, the selection
of profitable project may be wrong.
• Capital budgeting process does not take into
consideration of various non-financial aspects of the
projects .
• It is also not correct to assume that mathematically
exact techniques always produce highly accurate
results.
• Risk of any project cannot be presumed accurately. The
project risk is varying according to the changes made in
the business world.
• In case of urgency, the capital budgeting technique
cannot be applied

6. CAPITAL BUDGETING PROCESS
PROJECT
IDENTIFICATION
AND GENERATION
PROJECT
SCREENING AND
EVALUATION
PROJECT
SELECTION
IMPLEMENTATION
PERFORMANCE
REVIEW

7. METHODS
OF
CAPITAL BUDGETING

8. AVERAGE RATE OF RETURN
Thismethodisoneofthetraditionalmethodsforevaluating
theprojectproposalsandcalculatestheaveragerateof
returns(in%)onanaverageinvestment. Itdiffersfrom
othercapitalbudgeting techniquesbecausethefocusof
thistechniqueisaverageannualnetincomeoraccounting
incomeratherthancashflows.
Accounting rateofreturn= Averageannualnetincome
Averageinvestment
Annualnetincome=SumofallPAT/n
wheren=economiclifeoftheproject
AverageInvestment=(InitialValue+EndingValue)/2)

9. PAYBACK PERIOD METHOD
Pay-back Period is the time required to recover
the initial investment in a project. It is a
simple additive method for assessing the
worth of a project.

10. NET PRESENT VALUE (NPV):
The net present value method is a discounted cash
flow approach to capital budgeting. The net present
value (NPV) of an investment proposal is the
present value of the proposal’s net cash flows less
the proposal’s initial cash outflow (ICO). In formula
form we have:
NPV=PV OF CASH INFLOWS- PV OF CASH OUTFLOWS
= CF 1 + CF2 + CF3 - CFo
(1+K)1 (1+K)2 (1+K)3
where k is the required rate of return.

11. PROFITABILITY INDEX (PI), OR
BENEFIT-COST RATIO (BCR)
ProfitabilityIndexofaprojectistheratioofthe
presentvalueoffuturenetcashflowstotheinitial
cashoutflow.Itcanbeexpressedas:
PI= Totalpresentvalueofcashinflows
Totalpresentvalueofcashoutflows

12. INTERNAL RATE OF RETURN
• The internal rate of return (IRR) for an
investment proposal is the discount rate that
equates the present value of the expected net
cash flows (CFs) with the initial cash outflow
(ICO). If the initial cash outflow or cost occurs
at time 0, it is represented by that rate, IRR,
such that
IRR= L% + [NPV+ /(NPV+ - NPV-)] x difference in
the discounting rates

13. Two investments in consideration each of 4Lakhs and
they are expected to generate following cash flow after
taxes
If the required rate of return is 10% which project will
you recommend on the basis of
NPV, PI, Payback period. Also find the ARR when
CFAT=PAT.
YEARS CFAT-A CFAT-B
1 50,0000 1,00,000
2 90,000 1,10,000
3 1,50,000 1,40,000
4 1,90,000 2,00,000
5 2,25,000 2,00,000
EXAMPLE

14. PAYBACK PERIOD
YEARS CFAT-A CFAT-B PV OF
CFAT-A
PV OF
CFAT-B
1 50,0000 1,00,000 50,000 1,00,000
2 90,000 1,10,000 1,40,000 2,10,000
3 1,50,000 1,40,000 2,90,000 3,50,000
4 1,90,000 2,00,000 4,80,000 5,50,000
5 2,25,000 2,00,000 7,05,000 8,10,000
Payback for A
= 3+ 1,10,000 X 12
1,90,000
= 6.95
3years and 6months
Payback for B
= 3+ 50,000 X 12
2,00,000
= 3
3 years and 3months
NPV NPV for A
= 5,01,935- 4,00,000
=Rs. 1,01,935
NPV for B
= 5,84,960- 4,00,000
=Rs. 1,84,960

15. YEARS CFAT-A CFAT-B PVF
@10%
PV OF
CFAT-A
CUMM.
PV OF
CFAT-A
PV OF
CFAT-B
CUMM.
PV OF
CFAT-B
1 50,0000 1,00,000 0.909 45,450 45,450 90,000 90,900
2 90,000 1,10,000 0.826 74,340 1,19,790 90,860 1,81,760
3 1,50,000 1,40,000 0.751 1,12,650 2,32,440 1,05,140 2,86,900
4 1,90,000 2,00,000 0.683 1,29,770 3,62,210 1,36,600 4,23,000
5 2,25,000 2,00,000 0.621 1,39,725 5,01,935 1,61,460 5,84,960
PI for B
= 5,84,960
4,00,000
= 1.462
PI for A
= 5,01,935
4,00,000
= 1.255
PI
ARR ARR for A
= 1,41,000
2,00,000
= 0.705
= 70.5%
ARR for B
= 1,62,000
2,00,000
= 0.81
= 81%

16. INVESTMENT DECISIONS
PARAMETERS BASIS PROJECT A PROJECT B JUDGEMENT
PAYBACK
PERIOD
Lower the
better
3 years and 6
months
3 years and 3
months
Project B
ARR Higher the
better
70.5% 81% Project B
NPV Higher is better 1,01,935 1,84,960 Project B
PI More than 1% is
accepted
1.255 1.462 Project B

17. THANK
YOU