CAPITAL BUDGETING

Introduction
• Capital Budgeting decisions involve
investment of current funds in long term
assets, so as to get future benefits for a longer
period of time.
• Capital Budgeting is the process of evaluating
and selecting long term investments that are
consistent with the goal of shareholders
wealth maximization.
 MEANING .
IT INVOLVES 2 WORDS
CAPITAL: which refers to the scarce resources
possessed by an organization
BUDGETING: refers to the systematic planning as to
fulfill the objectives of value maximization
Definition
capital budgeting refers to the decision making
process by which firm evaluate the purchase of
fixed asset
OR
A process of evaluating all the investment decision so
that right steps can be taken at right time
 IMPORTANCE/SIGNIFICANCE
1.Involvement of heavy funds
2.Long term periods
3.Irreversible decision
4.Most difficult to make
5.growth
 Techniques of Capital Budgeting

Capital
Budgeting
Methods

Traditional Modern
Methods Methods

Payback Accounting Internal Rate

Net Present Profitability
Period rate of return of Return
Value Method Index Method
Method Method Method
 1.Payback Period Method
• Payback period is the exact amount of time
required for a firm to recover its initial
investment (cash outflow) in a project as
calculated from cash inflows (BEFORE
DEPRECIATION AND AFTER TAX).
 Formula
• When Cash Inflows are equal:
Payback Period = Investment/ Constant annual
cash inflow
• When cash inflows are unequal:
Payback Period is calculated by using cumulative
cash flows.
When Cash inflows are equal: Example
• An investment of Rs. 40000 in a machine is
expected to produce cash flows after tax of Rs.
8000 for 10 years.
• PB = 40000/8000
• PB = 5 years
 When Cash Inflows are unequal:
Example
Initial Investment is 56125

Year Cash CFAT

1 14000
2 16000
3 18000
4 20000
5 25000
 Solution
Year Cash CFAT Cumulative CFAT
1 14000 14000
2 16000 30000
3 18000 48000
4 20000 68000
5 25000 93000
 Continued
• The investment can be recovered between 3rd
and 4th year.
• In third year Cumulative cash inflows are
48000, remaining cash flows are 8125 (56125-
48000) which can be recovered back in 0.406
years (8125/20000)
• Payback Period = 3.406 Years 0r
• Payback period = 3 years 4.8 Months (3+.406*12)
 Continued…
• Accept Reject Criteria:
• If payback period/ Discounted payback period of the
project is
< the predetermined cut-off: Accept
> the predetermined cut-off: Reject
 .
Ques1. An investment in a land of Rs.1,00,000 is expected
to generate a cash inflow after tax of Rs 20,000 every
year . Calculate the pay back period

Ques2 An investment proposal of Rs5,00,000 is expected

to generate an inflow of Rs 36,000 every year . Calculate
the pay back period

Ques3. A project cost Rs.3,60,000 which yields annually a

cash inflow of Rs 1,23,000 ; 1,02,000 ; 96,000 ; 1,08,000
. Calculate the pay back period
Q. A project cost Rs. 20,00,000.and yields annually a profit
of Rs. 3,00,000 after depreciation @ 25 % but before tax
at 50 % .

Calculate pay back period?

Ans. Profit after depr. = 3,00,000
less tax(50%) = 1,50,000
Profit after tax and dep 1,50,000
add depr( 25 % of 20 L) 2,50,000
CASH INFLOW 4,00,000
Pay back period = 20,00,000
4,00,000
= 5 years
 2.Accounting Rate of Return
Method
• ARR = Average Profit / Average investment
• Average Profit = Total profit after tax/no. of
years
• Average Investment = Total Investment/2
 .
Q1. A chemical company is considering an investment
proposal of Rs.5,00,000 . The salvage value is zero. Tax rate
is 55% . The company uses straight line depreciation and
the proposed project has the expected cash flows before
tax and depreciation
YEAR CFBT
1 1,00,000
2 1,00,000
3 1,50,000
4 1,50,000
5 2,50,000
Determine 1)Payback period
2)Accounting rate of return
 .
Q2.A company is considering an investment proposal to
purchase a machine costing Rs.2,50,000 . The machine has
a life expectancy of 5 years and have no salvage value . The
company tax rate is 40 % . The company uses straight line
depreciation . The proposed project has the expected cash
flows before tax and depreciation
YEAR CFBT
1 60,000
2 70,000
3 90,000
4 1,00,000
5 1,50,000
 .
Q3. A project requires an investment of Rs 5,00,000 and had a
scrap value of Rs 20,000 after 5 years . It is expected to
yield profits after depreciation and taxes during 5 years
which amount to Rs 40,000 ; 60,000 ;70,000 ;50,000 ;
20,000
You are required to calculate the average rate of return on
investment
 .
Q4. A project costs Rs. 25,000 and have a scrap value of
Rs.5,000 after 5 years . The net profits before depreciation
and taxes for the 5 years are expected to be Rs 5,000 ;
6,000 ; 7,000 ; 8,000 ; 10,000. You are required to calculate
Average rate of return on average investment assuming
50% tax and straight line depreciation method
B. Discounting method
.
1. Net present value = PV of cash inflow- PV of cash outflow
2. Profitability index
a) Gross PI = PV of cash inflows
PV of cash outflows
b) NET PI = NPV
Initial outlay
 Decision Rule
• If NPV>0, Accept the Project
• If NPV<0, Reject the project
• If NPV = 0 (May accept or Reject)
 .
Q1.A company is considering an investment proposal to
purchase a machine costing Rs.2,50,000 . The machine has
a life expectancy of 5 years and have no salvage value . The
company tax rate is 40 % . The company uses straight line
depreciation . The proposed project has the expected cash
flows before tax and depreciation
YEAR CFBT PV Factor@ 10 %
1 1,50,000 0.909
2 1,00,000 0.826
3 90,000 0.751
4 70,000 0.683
5 60,000 0.621
Calculate NPV and PI
 .
Q2. A chemical company is considering an investment
proposal of Rs.2,50,000 . The salvage value is zero. Tax rate
is 40% . The company uses straight line depreciation and
the proposed project has the expected cash flows before
tax and depreciation
YEAR CFBT
1 60,000
2 70,000
3 90,000
4 1,00,000
5 1,50,000
Determine 1)Payback period
2)Average return of return
3) NPV and PI at 10 % discount rate 4) IRR
 REVISION
Assume that project X costs Rs. 2500 now and is
expected to generate year end cash inflows of
Rs. 900, 800, 700, 600 and 500 in years 1
through 5. The opportunity cost of capital may
be assumed to be 10%. Calculate the PI for
this project.
 Solution
Year CFAT Present value Present Value
factor (10%) of CFAT
1 900 0.909 818.1
2 800 0.826 660.8
3 700 0.751 525.7
4 600 0.683 409.8
5 500 0.621 310.5
Total 2724.9
 Continued..
• Present Value of cash inflow = 2724.9
• Present value of cash outflow = 2500
• PI = 2724.9/2500 = 1.089
• Here PI>1, Project should be accepted