Capital Budgeting

Should we
build this
plant?

Meaning of Capital Budgeting

It is the investment decision of a firm.
Its the firms decision to invest its current

funds most efficiently in the long-term

assets in anticipation of an expected flow of
benefits over a series of years.

Importance of capital budgeting

Huge investments
Irreversibility
Risk
Long-term effect on profitability
Among the most difficult decisions to make

Types of Investment
Decisions
Expansion of existing business
Expansion of new business
Replacement and modernisation
Mutually exclusive investments
Independent investments
Contingent investments

Types of Investment Decisions

Expansion and diversification:

A company may add capacity to its existing
product lines to expand existing operations.
e.g. the Gujarat State Fertiliser Company
may increase its plant capacity to
manufacture more urea. It is an example of
related diversification.
A firm may expand its activities in a new
business.
If a packaging manufacturing co. invests in
a new plant & machinary to produce ball
bearings, which the firm has not
manufactured before, this represents
expansion of new business or unrelated
diversification.

Types of Investment Decisions

Replacement and modernisation:

The main objective of modernisation and
replacement is to improve operating
efficiency and reduce costs.
Replacement decisions help to introduce
more efficient and economical assets and
therefore, are also called cost-reduction
investments.
However,
replacement decisions that
involve substantial modernisation and
technological
improvements
expand
revenues as well as reduce costs.

Types of Investment Decisions

Mutually exclusive investments:

Mutually exclusive projects are those where
acceptance of one implies automatic rejection
of the other.
e.g. a company may either use a more labourintensive, semi-automatic machine, or employ
a more capital-intensive, highly automatic
machine for production. Choosing the semiautomatic machine precludes the acceptance
of the highly automatic machine.

Types of Investment Decisions

Independent investments:
Independent investment projects are those
which do not compete with each other.
e.g. a heavy engineering company may be
considering expansion of its plant capacity to
manufacture
additional
excavators
and
addition of new production facilities to
manufacture a new product-light commercial
vehicles. Depending on their profitability and
availability of funds, the company can
undertake both investments.

Types of Investment Decisions

Contingent investments:
Contingent
investments
are
dependent
projects; the choice of one investment
necessitates undertaking one or more other
investments.
e.g. if a company decides to build a factory in
a remote, backward area, it may have to
invest in houses, roads, hospitals, schools,
etc. for employees to attract the work force.

Kinds of Capital Budgeting Decisions

Accept-reject decision
Mutually exclusive project decisions
Capital rationing decisions

- It refers to a situation in which a firm has

more acceptable investments than it can
finance. It is concerned with the selection
of a group of investment proposals out of
many investment proposals acceptable
under the accept-reject decision.

Capital budgeting process

1. Idea generation
2. Evaluation or Analysis
3. Selection
4. Financing
5. Execution or Implementation
6. Review

Techniques of Investment Evaluation

Project Evaluation Techniques

Traditional
Techniques or
Non-discounted
Cash Flow
Average
Rate of
Return

Pay-back
Period
Method

Modern or Time-adjusted
Techniques or Discounted
Cash Flow

Net
Present
Value

Profitabil
ity Index

Internal
Rate of
Return

Average Rate of Return (ARR) Method

Also known as Accounting Rate of Return or Return

on Investment (ROI).
This method uses accounting information as revealed
by financial statements to measure the profitability of
an investment.
The average rate of return is the ratio of the average
after tax profit divided by the average investment.
ARR = Average annual profit after tax
* 100
Average investment
Average annual profits after taxes =
After-tax profits
Number of years

Average Rate of Return (ARR) Method

Average investment =

I0

+ In

2
Where, I0 = book value of investment in the
beginning
In = book value of investment at the end of n
number of years
If the machine has salvage value, then only the
depreciable cost (cost salvage value) of the
machine should be divided by 2 in order to
ascertain the average net investment. It is
shown as:
Average investment =
Salvage value + 1 (Initial cost of machine

Average Rate of Return (ARR) Method

If any additional net working capital is required in

the initial year which is likely to be released only

at the end of the projects life, the full amount of
working capital should be taken in determining
relevant investment for the purpose of
calculating ARR.
Thus, Average investment =
Net working capital + Salvage value + 1 (Initial cost of
machineSalvage value)
2

Average Rate of Return (ARR) Method

Accept Reject Criteria:
The actual ARR would be compared with a
predetermined or a minimum required rate of
return or cut-off rate.
A project would qualify to be accepted if the
actual ARR is higher than the minimum desired
ARR. Otherwise, it is liable to be rejected.
If Actual ARR > Minimum Required ARR
Project Accepted
If Actual ARR < Minimum Required ARR
Project Rejected

Average Rate of Return (ARR) Method

Merits of ARR:
Easy to calculate.
Simple to understand and use.
The total benefits associated with the project are
taken into account while calculating the ARR.
Demerits of ARR:
It is based on accounting information rather than
cash flows.
It does not take into account the time value of
money.

Q. Determine the ARR from the following data of

machine A.
Cost
Rs.
56125
Annual estimated income after
depreciation & income tax:
Year 1
3375
2
5375
3
4
5
Estimated life (years)

7375
9375
11375
36875
5

Pay Back Period

Pay back is the number of years required to

recover the original cash outlay invested in a

project.
There are two ways of calculating the Pay
back period:
1. When the cash flows are uniform, the
payback period can be computed by
dividing cash outlay by the annual cash
inflow. That is:
Pay back period = Initial Investment
Annual Cash Inflow

Pay Back Period

2. 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.
In other words, pay back period is calculated by
the process of cumulating cash flows till the
time when cumulative cash flows become equal
to the original investment outlay.
Accept Reject Criteria:
The project having shortest pay back period
Accepted
The project having longest pay back period

Pay Back Period

Merits of Pay back:
Easy to calculate.
Simple to understand and use.
It is economical in terms of time and cost.
Demerits of Pay back:
It completely ignores all cash inflows after the
pay back period and hence the true profitability
of the project cant be assessed.
It ignores the time value of money and does not
consider the magnitude and timing of cash
inflows.

Improvements in Traditional Approach to

Pay Back Period Method
To improve the first limitation of pay back period

method, Post Pay Back Profitability Index

Method is used.
To improve the second limitation of pay back

period method, Discounted Pay Back Method

is used.

Post Pay Back Profitability Index Method

This method takes into account the returns

receivable beyond the pay back period.

These returns are called post pay back
profits.
Post pay back profitability index = Post pay
back profits * 100
Investments
Post pay back profits =

Annual cash inflow (Estimated life Pay

back period)

Discounted Pay Back Method

Under this method, the present values of all

cash flows are computed at an appropriate

discount rate.
The time period at which the cumulative
present value of cash inflows equals the cash
outflows is known as discounted pay back
period.
The project which gives a shorter discounted
pay back period is accepted.

Net Present Value (NPV) Method

It is the sum of the present values of all the cash

flows (positive as well as negative) that are

expected to occur over the life of the project.
The general formula of NPV is:
NPV =
C1
+ C2
+ + Cn
- Co
(1+k)

(1+k)2

(1+k)n

NPV = Ct/(1+k)t -

Co

t=1

Where, C1, C2,represents net cash inflow in year 1,

2, ; k is the rate of discount; C0 is the initial cost of
investment; n is the expected life of investment.

Net Present Value (NPV) Method

Accept Reject Criteria:
If NPV is positive or more than zero
Project Accepted
If NPV is negative or less than zero
Project Rejected

Net Present Value (NPV) Method

Merits of NPV:
Time value.
Measure of true profitability.
It is economical in terms of time and cost.
Demerits of NPV:
It is difficult in practice to precisely measure
the discount rate.
The NPV method is easy to use if forecasted
cash flows are known. In practice, it is quite
difficult to obtain the estimates of cash flows
due to uncertainty.

Profitability Index (PI)

it is also known as Benefit Cost Ratio (B/C

ratio).
It is the ratio of the present value of cash
inflows, at the required rate of return, to
the initial cash out flow of the investment.
The formula is:
PI = Present value of cash inflows
Initial cash outlay

Profitability Index (PI)

Accept Reject Criteria:
Accept the project when PI is greater than
one
PI > 1
Reject the project when PI is less than one
PI < 1
May accept the project when PI is equal to
one
PI = 1

Internal Rate of Return (IRR)

The internal rate of return (IRR) is the discount

rate which equates the present value of cash

inflows with the initial investment outlay of a
project.
This also implies that the rate of return is the
discount rate which makes NPV = 0.
Accept Reject Criteria: Compare actual IRR
with the required rate of return or cut-off rate.
If the actual IRR > the cut-off rate
Project
Accepted
If the actual IRR < the cut-off rate
Project Rejected

Determination of IRR
1. In case of uneven cash flows:
. The value of r can be found out by trial and
.
.

error method.
The approach is to select any discount rate to
compute the present value of cash inflows.
If the calculated present value of the expected
cash inflow is lower than the present value of
cash outflows, a lower rate should be tried.
On the other hand, a higher value should be
tried if the present value of cash inflows is
higher than the present value of cash
outflows.
This process will be repeated unless the NPV

Determination of IRR
In case of uneven cash flows: IRR is
calculated by using trial and error method.
IRR = rLR
- rLR)

PVLR

Cash outflow
PVLR

(rHR

PVHR

Where, PVLR = present value of cash inflows at

lower rate;
PVHR = present value of cash inflows at higher
rate.

Determination of IRR
2. In case of level cash flows:
. Firstly, calculate the present value factor annuity

(PVFA).
. Then, find out the internal rate of return of the
project.
Example: Assume that an investment would cost Rs.
20,000 and provide annual cash inflow of Rs. 5,430
for 6 years. Find out the IRR.
Solution: PVFA = 20,000/5,430 = 3.683.
The rate, which gives a PVFA of 3.683 for 6 years, is the
projects IRR. See the PVFA table across the 6-year
row, which is approx. 16%.
Thus, IRR = 16%.