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Capital Budgeting Tools
Capital Budgeting Tools
Capital Budgeting Tools
Madumathi
MODULE 2
Capital Budgeting
• Capital budgeting uses tools such as pay back period, net present
value, internal rate of return, profitability index to select projects.
• Payback Period
• Profitability Index
Payback Period
Payback period is the time duration required to recoup the investment
project.
When the cash inflows are uniform the formula for payback period is cash
• When the cash inflows are uneven, the cumulative cash inflows are to
be arrived at and then the payback period has to be calculated through
interpolation.
• Here payback period is the time when cumulative cash inflows are
equal to the outflows. i.e.,
Decision Rules
• Select those projects from the top of the list till the capital
Budget is exhausted.
Decision Rules
C. Mutually Exclusive Projects
• The time value of money is ignored. For example, in the case of project
• A Rs.500 received at the end of 2nd and 3rd years are given same
weightage. Broadly a rupee received in the first year and during any
other year within the payback period is given same weight. But it is
common knowledge that a rupee received today has higher value than
a rupee to be received in future.
• But this drawback can be set right by using the discounted payback
period method. The discounted payback period method looks at
recovery of initial investment after considering the time value of
inflows.
Example
INTEREST (Tax adjusted) for five years and salvage value of Rs.500/- for
each project plus working capital released in the 6th year. This company
Example – Data
Project A Project B
16,000 18,000
Example
Cumulative Cumulative
Project A cash inflows Project B cash inflows
of Project A of Project B
Example
• Payback period for Project A = 3 years (cumulative cash inflows =
outflows)
different from the cash flows from a project and hence, in many instances,
making when the returns expected are accounting profits and not merely
or
Sometimes average rate of return is calculated by using the following
formula:
Decision Rules
Example
• The Profit (after tax) component of the cash inflows for each project
are given in the next slide.
Example
Example
• Taking into account the working capital released in the 6th year and
salvage value of the investment, the total investment will be (10,000-
1,500) Rs.8500 and the average investment will be (8500/2) Rs.4250
for each project.
Project A
Project B
since its rate of return is higher than that of Project A if they are mutually
value of cash inflows and cash outflows. The present values of cash flows are
• Then
• When the cash outflow is required for only one year i.e., in the
present year, then the Net present value is calculated as follows:
Decision Rules
Select Projects starting from the list till the capital budget allows.
c) Net present value = present value of cash inflows - present value of cash
outflows = 8424 -8200 = Rs.224
Since the net present value of the project is positive (Rs.224), the
Project is accepted.
The internal rate of return method is also known as the yield method. The IRR
of a project/investment is defined as the rate of discount at which the present
value of cash inflows and present value of cash outflows are equal.
IRR can be restated as the rate of discount, at which the present value
of cash flow (inflows and outflows) associated with a project equal zero.
following equation:
When Trial and error method is used to solve for the IRR, two rates are
computed one that gives a small positive NPV, another that gives a small
negative NPV. The IRR using the trial and error method will be:
Decision Rules
A. "Capital Rationing" Situation
Select those projects whose IRR (r) = k, where k is the cost of capital.
Arrange all the projects in the descending order of their Internal Rate of
Return.
Select projects from the top till the capital budget allows.
• A new machinery costs Rs.8,200 and generates cash inflow (after tax)
per annum of Rs.2,000 during its life of 5 years.
• IRR method involves trial and error in the sense that one has to
experiment with different rates of discount before arriving at the
appropriate rate at which the equation 1 and 2 are satisfied. But when
the cash inflows are by way of annuities the relevant interest factor is:
• The present value of cash inflows = Rs.8200 and the present value
• Through the trial and error method, we can begin with a 10% discount
rate. The net present value assuming a 10% discount rate is
(2000 x 3.7908) - 8200 = 7581.6 - 8200 = -618.4.
• Such projects whose IRR is equivalent to the cost of capital are called
marginal projects since the company on accepting them, will neither be
worse off nor better off. They will just pay for themselves.
• Where the cash inflows are not uniform series and/or where cash
outflows occur at other periods besides the initial period, it is
necessary to experiment different rates and the appropriate rate could
be found out through interpolation.
index(PI) is:
• k0 is cost of capital
• a0 is initial investment.
Decision Rule
A. "Capital Rationing" Situation
• A new machinery costs Rs.8,200 and generates cash inflow (after tax)
per annum of Rs.2,000 during its life of 5 years. Let us assume that the
cost of capital for the company is 6%.