Capital Budgeting

• The process through which different projects

are evaluated is known as capital budgeting
• It is defined as “the firm’s formal process for
the acquisition and investment of capital.
• It involves firm’s decisions to invest its
current funds for addition, modification and
replacement of fixed assets”.
• It is a long-term planning for making and
financing proposed capital.
Methods of Capital Budgeting
1. Traditional Methods
 Payback period
 Accounting rate of return method

2. Discounted cash flow methods

 Net present value method
 Internal rate of return
Pay back Period Method:
 It refers to the period in which the project
will generate the necessary cash to recover
the initial investment.
 It does not take the effect of time value of
money.
 The pay-back period can be determined as:

 Annual Cash Inflow = Annual net profit

after taxes and before depreciation
 Question:
 A project having a cost of
₹80,00,000. The annual profit
earned after depreciation @
15% p.a. and before taxes of
40% is ₹12,00,000. Calculate
the pay-back period.
Accounting Rate of Return method:
 It considers the earnings of the project of the
economic life.
 This method is based on traditional accounting
concepts.
 The rate of return is expressed as percentage of the
earnings of the investment in a particular project.
 The profits under this method is calculated as
profit after depreciation and tax of the entire life of
the project.
 It can be determined as:
 Average Annual Profits = Profit after tax and
depreciation/Number of years
Question
Calculate ARR and find out which project
is better.
Project X Project Y
Investment ₹20,00,000 ₹30,00,000
Estimated 8 years 10 years
Life
continued
Projected Net Income after depreciation and tax
Years Project X Project Y
(₹) (₹)
1 2,00,000 3,00,000
2 1,50,000 2,40,000
3 1,80,000 2,00,000
4 1,90,000 3,10,000
5 1,40,000 2,70,000
6 1,30,000 2,35,000
7 1,30,000 1,90,000
8 1,80,000 2,55,000
9 - 2,10,000
10 - 1,90,000
Total 13,00,000 24,00,000
Net Present Value Method
 It is the modern method of evaluating investment
proposals.
 It recognises the impact of time value of money.
 It is considered as the best method of evaluating the
capital investment proposal.
 It recognises the fact that a rupee earned today is worth
more than the same rupee earned tomorrow.
 The cash inflow to be received at different period of
time will be discounted at a particular discount rate.
 The present values of the cash inflow are compared
with the original investment.
 The difference between the two will be used for accept
or reject criteria.
 If the different shows (+) positive value , the proposal
is selected for investment. If the difference shows (-)
negative value, it will be rejected.
 The present value of ₹ 1 due in any number of years
can be found with the use of the following formula:

 where;
 PV = Present value
 r = discount rate/rate of return
 n = Number of years
 Question:
 Calculate the net present value of
two projects and find out which
project is accepting assuming that
discount rate is 10%.
Project A Project B
Initial ₹ 2,00,000 ₹ 3,00,000
Investment
Estimated Life 5 years 5 years
Scrap Value ₹ 10,000 ₹ 20,000
The profit (cash flow) are as follows:
Years Project A Project B
(₹) (₹)
1 50,000 2,00,000
2 1,00,000 1,00,000
3 1,00,000 50,000
4 30,000 30,000
5 20,000 20,000
Internal Rate of Return
 It is that rate at which the sum of discounted
cash inflows equals the sum of discounted
cash outflows.
 It is called as internal rate because it
depends mainly on the outlay and proceeds
associated with the project and not on any
rate determined outside the investment.
 It is also called as time adjusted rate of
return method, discounted rate of return
method, yield method and trial and error
yield method.
Methods of Calculating IRR
1. When the annual net cash flow are equal over the life
of the assets/projects
Present Value Factor = Initial Outlay/ Annual Cash
Flow
2. When the annual cash flow are unequal over the
life of the assets/projects: Following calculation
process can be used;
 Prepare cash flow table using assumed discount rate
with the help of present value table.
 Calculate the NPV with the assumed discount rate.
 If the NPV is positive, apply higher discount rate.
 If NPV is negative, the IRR is between positive and
negative NPV.
 Question:
1. Suppose that the initial investment in a project is
₹ 5,00,000 and the life of the project is 6 years.
The estimated annual cash flow is ₹ 1,00,000.
Calculate the Internal Rate of Return.
2. Suppose the initial investment in a project is ₹
60,00,000 and the estimated life of the project is
4 years. The estimated annual cash flows are as
under:
YEARS CASH FLOWS (₹)
1 15,00,000
2 20,00,000
3 30,00,000
4 20,00,000

Calculate Internal Rate of Return