ITFT -Capital Budgeting

Capital budgeting
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Meaning
• Capital budgeting is the process of making
investment decisions in capital expenditure.
• A capital expenditure may be defined as an
expenditure the benefits of which areexpenditure the benefits of which are
expected to be received over period of time
exceeding one year.

Examples
• Some of the examples of capital
expenditure are:
• Cost of acquisition of acquiring permanent
assets like land, building, plant, machinery,
goodwill etc.goodwill etc.
• Cost of addition, expansion, improvement
or alteration in the fixed assets.
• Cost of replacement of permanent assents.
• Research and development project cost,
etc.

Definition
• According to G. C. Philippatos, “capital
budgeting is concerned with the allocation of
firm’s scarce financial resources among the
available market opportunities.”

Introduction
• Capital budgeting addresses
the issue of strategic long-
term investment decisions.
• Capital budgeting can be
defined as the process of
analyzing, evaluating, andanalyzing, evaluating, and
deciding whether resources
should be allocated to a
project or not.
• Process of capital budgeting
ensure optimal allocation of
resources and helps
management work towards
the goal of shareholder
wealth maximization.

Importance of Capital
Budgeting Decision
Long-term
Implications
Involvement of
large amount
of funds
Irreversible
DecisionsImplications
of funds
Decisions
Risk and
uncertainty
Difficult to
make

Methods of Capita Budgeting
Methods
Traditional
Method
Pay-Back
Period
Post- Payback
Rate of
Return
Time
Adjusted
Method
Net Present
Value
Internal Rate
of Return
Profitability
Index

Which Technique should
we follow?
• A technique that helps us in selecting projects
that are consistent with the principle of
shareholder wealth maximization.
• A technique is considered consistent with• A technique is considered consistent with
wealth maximization if
• It is based on cash flows
• Considers all the cash flows
• Considers time value of money
• Is unbiased in selecting projects

Pay-Back Period
• The Payback- period is the time duration
required to recover the initial cash outflows.
This method is based on cash flows and not
on accounting data like the ARR.
• Suppose somebody spent Rs.50,000 on any
project and expects that within 3 year he can
get back this amount, then the payback
period is 3 years.

Cont…
• Payback period of any proposal can be
calculated as follows,
• If the cash inflows are uniform then
• Under this method, various investments with a
shorter pay back period is preferred to the one
which has longer pay back period.
• Annual Net Earnings i.e before depreciation after
tax

Questions:
• Q 1 A project costs Rs 1,00,000 and yields an
annual cash inflow of Rs. 20,000 for 8 years.
Calculate its payback period.
• Q2 Determine the pay back period for a project
which requires a cash outlay of Rs. 10,000 andwhich requires a cash outlay of Rs. 10,000 and
generates cash inflows of Rs. 2,000, Rs. 4000. Rs.
3000, and Rs. 2000 in the first, second, third and
forth year respectively.
• Q 3 A project cost Rs 5,00,000 and yields annually
a profit of Rs. 80,000 after depreciation @12%
p.a. but before tax of 50%. Calculate the payback
period.

• There are two projects X and Y. Each project
requires an investment of Rs 20,000. you are
required to rank these projects according to
the pay back method from the following
information:information:
(Net profit before depreciation after tax)
Years Project X Project Y
1st 1000 2000
2nd 2000 4000
3rd 4000 6000
4th 5000 8000
5th 8000 -

Ques: X Ltd is producing articles mostly by manual
labour and is considering to replace it by a new
machine. There are two alternative models M &
N of the new machine. Prepare a statement of
profitability showing the pay-back period from
the following information:
Machine M Machine N
Estimated life of machine 4 years 5 years
Cost of Machine Rs. 90,000 Rs. 1,80,000
Estimated savings in scrap 5,000 8,000
Estimated savings in direct
wages
60,000 80,000
Additional cost of
maintenance
8000 10,000
Additional cost of supervision 12,000 18,000

Advantages
• Simple to understand and easy to calculate
• It takes lesser time and labour as compared to
other methods.
• Due to its short term approach, this method is• Due to its short term approach, this method is
particularly suited to a firm which has
shortage of cash or whose liquidity position is
not particularly good.

Disadvantage
• It doesn’t take into consideration the cash inflows
earned after the pay back period and hence the
true profitability of the projects cannot be correctly
assessed.
• This method ignores the time value of money and
does not consider the magnitude and timings of
cash in flows.
does not consider the magnitude and timings of
cash in flows.
• It may be difficult to determine the minimum
acceptable pay-back period, it is usually, a
subjective decision.
• It does not measure the true profitability of the
project as the period consider under this method is
limited to short period only and not the full life of
the asset.

Post Payback Period
• One of the limitations of the pay-back period
method is that it ignores the life of the project
beyond the pay-back period.
• Post pay-back period method takes into account
the period beyond the pay-back method. This
method is also known as surplus life over pay-backmethod is also known as surplus life over pay-back
period may be accepted.

Ques: For each of the following projects compute (i)
pay back period, (ii) post-back period profitability,
(iii) post-back profitability index:
(a) Initial outlay Rs. 50,000
Annual Cash Inflow (after tax & before
dep.)
Rs. 10,000
Estimated Life 8 years
(b) Initial outlay Rs. 50,000
Annual Cash Inflow (after tax & before
dep.)
First three years Rs. 15,000
Next five years Rs. 5,000
Estimated Life 8 years

Rate of Return or Accounting
Rate of Return
• This method takes into account the earnings
expected from the investment over their whole
life.
• It is known as accounting rate of return method
for the reason that under this method the
accounting concept of profit (net profit after tax
for the reason that under this method the
accounting concept of profit (net profit after tax
and depreciation) is used rather than cash
inflows.
• The project with the higher rate of return than
the minimum rate specified by the firm also
known as cut off rate, is accepted and the other
which gives a lower expected rate of return than
the minimum rate is rejected.

This Method can be Used in
Several WaysSeveral Ways

1. Average Rate of Return
Method
• Under this method average profit after tax and
depreciation is calculated and then it is divided
by the total capital outlay or total investment in
the project. In other words, it establishes the
relationship between average annual profits torelationship between average annual profits to
total investments.
• Thus,

Q. A project requires an investment of Rs 5,00,000
and has a scrap value of Rs. 20,000 after 5 years.
It is expected to yield profits after depreciation
and taxes during the 5 years amounting to Rs.
40,000, Rs. 60,000, Rs. 70,000, Rs. 50,000 and Rs.
20,000. Calculate average rate of return on the20,000. Calculate average rate of return on the
investment.

2. Return per unit of
investment method
• This method is small variation of the average
rate of return method. In this method the
total profit after tax and depreciation is
divided by the total investment, i.e.,

Q. A project requires an investment of Rs
5,00,000 and has a scrap value of Rs. 20,000
after 5 years. It is expected to yield profits after
depreciation and taxes during the 5 years
amounting to Rs. 40,000, Rs. 60,000, Rs. 70,000,
Rs. 50,000 and Rs. 20,000. Calculate averageRs. 50,000 and Rs. 20,000. Calculate average
rate of return on the investment.

3. Return on average
investment method
¨ In this method the return on average
investment is calculated. Using of average
investment for the purpose of return on
investment is preferred because the original
investment is recovered over the life of theinvestment is recovered over the life of the
asset on account of depreciation charges.

Q. A project requires an investment of Rs 5,00,000
and has a scrap value of Rs. 20,000 after 5 years.
It is expected to yield profits after depreciation
and taxes during the 5 years amounting to Rs.
40,000, Rs. 60,000, Rs. 70,000, Rs. 50,000 and
Rs. 20,000. Calculate average rate of return onRs. 20,000. Calculate average rate of return on
the investment.

4. Average return on
average investment method
• This is the most appropriate method of rate of
return on investment. Under this method,
average profit after depreciation and taxes id
divided by the average amount of investment;
thus:thus:

Q. Calculate the average rate of return for projects
A & B from the following:
Project A Project B
Investments Rs. 20,000 Rs. 30,000
Expected Life (No Salvage value) 4 years 5 years
Projected Net Income (After interest, depreciation and taxes)
Years Project A Project B
1 2,000 3,000
2 1,500 3,000
3 1,500 2,000
4 1,000 1,000
5 - 1,000
If the required rate of return is 12%, which project should be undertaken

Advantages of Rate of
Return Method
• It is very simple to understand and easy to
operate
• It uses the entire earnings of a project in
calculating rate of return and not only thecalculating rate of return and not only the
earnings upto pay-back period and hence
gives a better view of profitability as
compared pay-back period method.
• As this method is based upon accounting
concept of profits, it can be readily calculated
from the financial data.

Disadvantages of Rate of
Return Method
• It ignores time value of money as profits earns
at different point of time are given equal
weight by averaging the profits.
• It doesn’t take into consideration the cash• It doesn’t take into consideration the cash
flows which are important the accounting
profits.
• This method cannot be applied to a situation
where investment in a project is to be made in
parts.

Time Adjusted Method or
Modern Method
• This method takes into consideration the
profitability and time value of money (the
fact that a rupee earned today has more
value than a rupee earned after 5 years.)value than a rupee earned after 5 years.)

Net Present Value (NPV)
• It is net present value of all the cash flows that
occur during the entire life span of a project.
• The outflows will have negative values while the
inflows will have positive values.
• Obviously, if the present value of inflows is
greater than outflows, we get a positive NPV and
• Obviously, if the present value of inflows is
greater than outflows, we get a positive NPV and
if the present value of outflows is greater than
inflows, we get a negative NPV.
• The positive NPV means a net gain in value
maximization and, therefore, any project which
gives a positive NPV is an acceptable project and
if it gives a negative NPV, then the project should
not be accepted.

Steps for Calculating NPV
• First of all determine the appropriate rate of
interest that should be selected as the minimum
required rate of return called cut off rate or
discount rate. The rate should be the minimum
rate of return below which the investor considers
that it doesn’t pay him to invest. The discount
rate should be the actual rate of interest in therate should be the actual rate of interest in the
market on long-term loans or it should reflect the
opportunity cost of capital of the investor.
• Compute the present value of the total
investment outlay, i.e. cash outflows at the
determined discount rate. If the total investment
is to be made in the initial year, the present value
shall be the same as the cost of investment.

• Compute the present values of total investment
proceeds, i.e., cash inflows, (profit before
depreciation and after tax) at the above
determined discount rate.
• Calculate the net present value of each project by
substracting the present value of cash inflows
from the present value of cash outflows for eachfrom the present value of cash outflows for each
project.
• If the NPV is positive or zero the proposal may be
accepted and vice versa.
• In case of mutually exclusive projects, projects
should be ranked in order of net present values.
The project with high NPV should be given
highest rank and so on.

The Present Value of Re 1 due in any
number of years can be found with the use
of the following mathematical formula:
PV = 1/(1+r)n
Where, PV = Present value
r = rate of interest / discount rate
n = number of yearsn = number of years
The present value for all the cash inflows for a number of years is thus
found as follows:
However as n becomes large, the calculation of (1+r)n become difficult. PV can
also be found by the use of PV tables.

Internal Rate of Return
• Under this method, the cash flow of a project
are discounted at a suitable rate by hit and
trial method, which equates the NPV so
calculated to the amount of the investment.
Under this method, since the discount rate isUnder this method, since the discount rate is
determined internally, this method is called as
the internal rate of return method. The IRR
can be defined as that rate of discount at
which the PV of cash inflows is equal to the
PV of cash outflows.

It can be calculated with the
help of following formula:
• C = initial outlay at time zero
• A1, A2, A3… An = future net cash flows at• A1, A2, A3… An = future net cash flows at
different periods
• 2, 3……, = number of years
• r = Rate of discount of IRR

The IRR can also be cal. with the help of
PV tables. The following steps are
required to practice the IRR method.
• Determine the future net cash flows during the entire
economic life of project. The cash inflows are
estimated for future profits before depreciation but
after tax
• Determine the rate of discount at which the value of
cash inflows is equal to the values of cash outflows.
• Determine the rate of discount at which the value of
cash inflows is equal to the values of cash outflows.
• Accept the proposal if the IRR is higher than or equal
to the minimum required rate of return i.e. the cost
of capital or cut off rate and reject the proposal if the
IRR is lower than the cost of cut off rate.
• In case of alternative proposals select the proposal
with the highest rate of return as the rates are higher
than the cost of capital or cut-off rate.

Determination of IRR
• When the annual cash flows are equal over the
life of the asset: firstly, find out present value
factor by dividing initial outlay (cost of the
investment) by annual cash flow, i.e.
Present Value Factor
= Initial Outlay / Annual cash flow

• In case annual cash flows are unequal over the
life of the asset, the IRR cant be determined
according to the technique suggested above. In
such cases, the IRR is calculated by hit and trial an
that is why this method is also known as hit and
trial yield method. We may start any assumed
that is why this method is also known as hit and
trial yield method. We may start any assumed
discount rate and find out the total PV of cash
outflows which is equal to the cost of initial
investment where total investment is to be made
in the beginning. The rate at which the total PV of
all cash inflows equals the initial outlay, is the
IRR. Several discount rates may have to be tried
until the appropriate rate is found.

The calculation process may be
summed up as follows:
• Prepare the cash flow table using arbitrary assumed
discount rate to discount the net cash flows to the
PV.
• Find out the NPV by deducting from the PV of total
cash flows calculated in above the initial cost of
investmentinvestment
• If the NPV is positive, apply higher rate of discount
• If the higher discount rate still gives a positive NPV,
increase the discount rate further until the NPV
becomes negative
• If the NPV is negative at this higher rate, the internal
rate of return must be between these 2 rates.

Profitability Index
• NPV is an absolute value and therefore is not
appropriate for comparing the relative
profitability between different projects. In
order to overcome this limitation of NPV, we
make one modification in it to make it amake one modification in it to make it a
relative measurement. This is called
Profitability Index (P.I.) or Benefit Cost Ratio
(B-C Ratio). The P.I. is as follows:

ITFT -Capital Budgeting

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