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Capital Budgeting
By
Prof. Anirban
CCIM, Blore
Prof. Anirban, CCIM, Blore, Capital Budgeting
t The investment decisions of a firm is
generally known as the capital budgeting
decisions and it consists of the Long Term
planning for the proposed capital outlays
and their financing.
t C/B may be defined as the firms decision
to invest its current funds most effective
and efficient way in the long term assets
in anticipation of an expected flow of
benefits over a series of years.
Capital Budgeting. What's that????
Prof. Anirban, CCIM, Blore, Capital Budgeting
Capital Budgeting Within The Firm
The Position of Capital Budgeting
Capital Budgeting
Long Term Assets Short Term Assets
Investment Decison
Debt/Equity Mix
Financing Decision
Dividend Payout Ratio
Dividend Decision
Financial Goal of the Firm:
Wealth Maximisation
Prof. Anirban, CCIM, Blore, Capital Budgeting
Examples of Long Term Assets
Prof. Anirban, CCIM, Blore, Capital Budgeting
Capital Budgeting. Features
t It has potentiality to anticipate a huge profit.
t It involves high degree of risk.
t Involves relatively a long period of time
between the initial outlay and the anticipated
returns.
t Involves the exchange of current funds (which
are invested in long term assets) for the future
benefits.
t Future benefits will occur to the firm over a
series of time.
Prof. Anirban, CCIM, Blore, Capital Budgeting
Importance of C/B Decisions
t Growth
t Risk
t Funding
t Irreversibility
t Complexity
Prof. Anirban, CCIM, Blore, Capital Budgeting
Capital Budgeting. Process..
t Identification of the potential investment opportunities.
t Assembling of the proposed investments.
t Decision making.
t Preparation of the capital Budget and appropriation.
t Implementation
Adequate formulation of the project.
Use of the principle of responsibility
Use of network techniques
t Performance Review

Prof. Anirban, CCIM, Blore, Capital Budgeting
Investment Evaluation Criteria
t Three steps are involved in the
evaluation of an investment:
Estimation of cash flows
Estimation of the required rate of return
(the opportunity cost of capital)
Application of a decision rule for making
the choice
Prof. Anirban, CCIM, Blore, Capital Budgeting
Modern or
Discounted Cash flow
method
C/B
Techniques
Traditional or
Non Discounted Cash
flow method
ARR
PB
PI
IRR
NPV
Prof. Anirban, CCIM, Blore, Capital Budgeting
Net Present Value
t NPV is the classic economic and generally
considered to be the best method for
evaluating capital investment proposals.
t This is one of the discounted cash flow (DCF)
techniques which explicitly recognize Time
value of Money.

Prof. Anirban, CCIM, Blore, Capital Budgeting
Steps in NPV calculation
t Cash flows of the investment project should be
forecasted based on realistic assumptions.
t Appropriate discount rate should be identified to
discount the forecasted cash flows. The appropriate
discount rate is the projects opportunity cost of
capital.
t Present value of cash flows should be calculated using
the opportunity cost of capital as the discount rate.
t The NPV is the difference between the Total present
value of the Future Cash in Flows and Future cash
outflows.
t The project should be accepted if NPV is positive
(i.e., NPV > 0).
Prof. Anirban, CCIM, Blore, Capital Budgeting
Equation of NPV
3 1 2
0
2 3
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV
(1 )
n
n
n
t
t
t
C C C C
C
k k k k
C
C
k
=
(
= + + + +
(
+ + + +

=
+

Prof. Anirban, CCIM, Blore, Capital Budgeting

Acceptance Rule
t Accept the project when NPV is positive NPV > 0
t Reject the project when NPV is negative NPV < 0
t May accept the project when NPV is zero NPV = 0
t The NPV method can be used to select between
mutually exclusive projects; the one with the higher
NPV should be selected.
Prof. Anirban, CCIM, Blore, Capital Budgeting
Profitability Index
t Profitability index is the ratio of the
present value of cash inflows, at the
required rate of return, to the initial cash
outflow of the investment.
t Criterion :
PI > 0 Implies Accept the project
PI < 0 Implies Reject the project
PI = 0 Implies the decision is indifferent

Prof. Anirban, CCIM, Blore, Capital Budgeting
Internal Rate of Return Method
t The internal rate of return (IRR) is the rate that equates the
investment outlay with the present value of cash inflow received
after one period. This also implies that the rate of return is the
discount rate which makes NPV = 0.
t i.e. PVCI PVCO = 0, i.e. PVCI = PVCO
t So IRR will be rate of return where NPV =0
t This rate is also called as the rate at which the expected inflows
break even with the cash outflows of the project.
t Some time IRR lies between two trial rates called Higher or
Upper trial rate and Lower Trial rate. To calculate exact IRR we
can use the following interpolation formula.
t NPV at LTR
t Exact IRR = LTR + x Diff. of trial
NPV at LTR NPV at HTR rates

Prof. Anirban, CCIM, Blore, Capital Budgeting
Acceptance Rule
t Accept the project when r > k.
t Reject the project when r < k.
t May accept the project when r = k.
t In case of independent projects, IRR and
NPV rules will give the same results if the
firm has no shortage of funds.
Prof. Anirban, CCIM, Blore, Capital Budgeting
Average Rate of Return/ROI
t The accounting ratio and return also known as
the ROI uses accounting information as revealed
by financial statements to measure the
profitability of the investment.
t The accounting rate of return is the ratio of the
average after-tax profit divided by the average
investment. The average investment would be
equal to half of the original investment if it were
depreciated constantly.

Prof. Anirban, CCIM, Blore, Capital Budgeting
Contd

t ARR = [Average Return (PAT) / Average Invt]
t Where, AR = [Total Return / Time]
t AI = [{Cost - Scrap} / 2] or
[{Cost - Scrap } / 2} + Net W/C + Scrap Value
Prof. Anirban, CCIM, Blore, Capital Budgeting
Payback Period
t Payback is the number of years required to
recover the original cash outlay invested in a
project.
t If the project generates constant annual cash
inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow.
t PBP = [Initial Investment / Annual Cash Flows]
t Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of Rs 12,500
for 7 years. The payback period for the project
is:
50000 / 12500 = 4 years

Prof. Anirban, CCIM, Blore, Capital Budgeting
Payback Period
t Unequal cash flows In case of unequal cash
inflows, the payback period can be found out
by adding up the cash inflows until the total is
equal to the initial cash outlay.
t Suppose that a project requires a cash outlay
of Rs 20,000, and generates cash inflows of
Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000
during the next 4 years. What is the projects
payback?
3 years + 12 (1,000/3,000) months
3 years + 4 months
Prof. Anirban, CCIM, Blore, Capital Budgeting
Acceptance Rule
t The project would be accepted if its payback
period is less than the maximum or standard
payback period set by management.
t As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest ranking
to the project with highest payback period.
Prof. Anirban, CCIM, Blore, Capital Budgeting
Payback Reciprocal and Rate of Return
t The reciprocal of payback will be a close
approximation of the internal rate of
return if the following two conditions are
satisfied:
The life of the project is large or at least twice
the payback period.
The project generates equal annual cash
inflows.
Prof. Anirban, CCIM, Blore, Capital Budgeting
Capital Rationing
t Capital Rationing is the financial
situation in which a firm has only fixed
amount of allocate among competing
capital expenditure.
t It means a situation in which a firm has
more acceptable investments than it can
finance.
Prof. Anirban, CCIM, Blore, Capital Budgeting
Risk & Sensitivity Analysis
t Sensitivity analysis is a behavioral
approach that uses a number of possible
values for a given variable to assess its
impact on a firms returns.
t It provides different cash flow estimates
under three assumptions:
The worst i.e. most pessimistic
The expected i.e. most likely
The best i.e. the most optimistic

Prof. Anirban, CCIM, Blore, Capital Budgeting
Any
Questions
????