LORD KRISHNA COMMERCE ACADEMY 1

CMA. CHANDER DUREJA [9811981369]

SUMMARY FOR CAPITAL BUDGETING

1. MEANING:
It is a Process of evaluating long term projects on the basis of cash inflows & outflows

2. TOOLS OF CAPITAL BUDGETING

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Pay Back Period NPV IRR PI ARR

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Simple Discounted PV of Cash Internal Profitability Accounting
Pay Back Period Pay Back Inflows Rate Of Index Rate Of

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Period minus PV of Return Return
Cash O/F

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= NPV m
aF

Timed Period: Timed Period Discounted Factor for Star 1 Star 2 Star 3
Within which within which NPV
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investment of firm investment

comes back. comes back i. Cost of Capital
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after ii. Minimum

Case I: If Cash I/F considering Desire Return
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are same TVM. iii. Opportunity

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Cost of Capital
Simple PBP = Step I: Find PV iv. Desire Return
nd

of Cash I/F
ℎ
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ℎ . . Step II: Find Project with Highest

Cumulative NPV will be accepted
Case II: Cash inflows
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If Cash I/F are not NPV shows how much

same Step III: Find a firm will have cash
discounted flows from project
Step I: Find payback period after deducting
cumulative cash I/F Using i. Discounting Factor
Step II: Use Interpolating ii. Cash outflow (PV)
interpolating Method
method
 LORD KRISHNA COMMERCE ACADEMY 2
CMA. CHANDER DUREJA [9811981369]

Star 1 ; IRR: It is the rate earned by investor from investment in Project.

OR
IRR is the rate at which
PV of cash Inflows = PV of cash outflows

e.g.
T0 T1 T2 T3 T4
Cash Outflow at T0 = 10L
Cash Inflow = 5L 3L 5L 4L

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Solution: For IRR
10L = 5L + 3L + 5L + 4L .

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(1 + r)1 (1 + r)2 (1 +r)3 (1 + r)4

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Steps for Computing IRR

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Step 1: Find Initial “R”
m
Approx PVAF =
aF
.

Step 2: See PVAF table & find initial “R”

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Step 3: Use Hit & Trial METHOD

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Star 2 ;
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PI = Profitability Index =
nd

>1 <1 =1
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Means: NPV = +ve NPV = -ve NPV = 0

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Project May be accepted Project will be Rejected Project Recovers only

Opportunity cost of capital

Project may or may not be

ACCEPTED

Star 3 ARR: Accounting Rate Of Return

ARR = Accounting rate of return OR Average rate ARR
.  Does not include TVM
of return = .
× 100
 It is based on Accounting Profit (PAT)

3.COMPUTATION OF CASH INFLOWS

 LORD KRISHNA COMMERCE ACADEMY 3
CMA. CHANDER DUREJA [9811981369]

Computation of cash inflows

Method 1 Method 2 Method 3

Sales = xx Sales = xx Sales (Net of tax) = Sales (1 – t)

- Variable Cost = xx
Contribution = xx
- Fixed Cost = xx
(Cash)
- Depreciation = xx
- Variable Cost = xx
Contribution = xx
- Fixed Cost = xx
(Cash)
- Depreciation = xx
- Variable cost (Net of Tax) = V.C. (1
– t)
- Fixed cost (Net of Tax) = FC (1 – t)

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EBIT = xx Not to
EBIT = xx + Tax savings on
- Interest = xx be EBT xx Depreciation xx

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EBT xx consider Tax xx
Tax xx EAT = xx CASH INFLOW = XX

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EAT = xx + Tax savings on
+ Depreciation = xx Depreciation = xx

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CASH INFLOW = XX CASH INFLOW = XX m
aF
Depreciation * Tax rate
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4.CONFLICT BETWEEN NPV & IRR

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Sometimes NPV & IRR provide different project to be selected on ranking

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Because of following assumptions:

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 Assumption of NPV: Cash inflows arises in life of project are re-invested @ Cost of capital
 Assumption of IRR: Cash inflows arises in life of project are re-invested @ IRR itself
nd

Conclusion: Assumption of NPV is MORE realistic & hence NPV is PREFERED method of selection
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5.MODIFIED IRR:
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Modified IRR: It is the rate at which PV of Terminal cash inflows = PV of cash outflows

NOTE:: Terminal cash inflows after investing all cash inflows @ cost of capital till end of life of Project

6. NPV WITH TERMINAL APPROACH

Step 1: Invest all cash inflows @ Deposit rate till end of life of Project = Terminal cash I/F at end of life

Step 2: Now find NPV using Terminal cash I/F

i.e. NPV [With Terminal Method] = PV of [Terminal cash inflows @ Cost of capital] – PV of cash outflows
 LORD KRISHNA COMMERCE ACADEMY 4
CMA. CHANDER DUREJA [9811981369]

7.SELECTION OF PROJECT

Selection of Project
When Projects have same life When Projects have Unequal life
Only outflows are given Inflows & Outflows are Only outflows are given Inflows & Outflows are
given given
Select a Project with Select a Project with Step 1: Find equivalent Step 1: Find equivalent
minimum PV of cash Maximum NPV of annualized cost = EAC = NPV =
/ ( , )
outflows of Project Project
( , ) Step 2:

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Step 2: Select MINIMUM Select Highest ENPV
EAC option

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Note: We can also use shortcut in computing EAC if cash outflows are same for future .

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8.TREATMENT OF WORKING CAPITAL m
 Cash Outflow in the year in which it is incurred
aF
 Cash Inflows at the end of life of Project

9.TREATMENT OF SCRAP
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 Considered for depreciation in SLM method

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 At the end of life considered as terminal cash inflows net of capital gain tax OR Tax Savings On
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Capital Loss
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10 .STATEMENT SHOWING NPV

nd

Years Particulars PVF (r, t) Cash flows PV of Cash Flows

(A) (B) (A) * (B)
0 Cost of M/C 1 () ()
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1–n Cash Inflows XXX + +

n Terminal Scrap XXX + +
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0 Working Capital 1 () ()
n Working Capital XXX + +
Released
NPV

PVAF (r, t) If Cash I/F are different for different years then use
PVF for each REPLACEMENT
year separatelyOF MACHINERY

We will use incremental approach i.e. we will consider EXTRA cash inflows &
extra cash outflows .
 LORD KRISHNA COMMERCE ACADEMY 5
CMA. CHANDER DUREJA [9811981369]

11.Computation of NPV

Years Particulars Cash flows PVF PV WN 1: Incremental Cash flows

Incremental
(A) (B) (A) * (B) Cost of New M/C =
0 Incremental WN1 1 () - Net Realized value of old M/C =______
Cash outflow Incremental cash outflows ______
1 Incremental WN2
Cash Inflows Net Realized value of old machinery
2 Incremental
Cash Inflows Scrap of old M/C at T0 = xx

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3 Incremental - Capital Gain
#
Cash Inflows + Capital Loss

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4 Incremental Tax savings = xx
Cash Inflows

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5 Incremental # Capital Gain / Loss
Cash Inflows Scrap value = xx

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0 Working Capital 1 ()
Introduced Book value = (xx)
m
n Working Capital +
aF
Released
n Scrap
NPV
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WN 2:
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Computation of incremental cash inflows

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Method 1 Method 2 Method 3

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When S.P/U, V.C/U & Fixed cost If S.P/U, , V.C/U & Fixed cost are If Inflows of cost is given
remains constant not same
nd

Units sold in old M/C = xx Step 1: Find cash inflows in old Cost involved in old M/C = xx
Units sold in new M/C = xx M/C Cost involved in New M/C = xx
Incremental Units sold = xx Step 2: Find Cash inflows in new Cost Savings = xx
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M/C Or incremental Profit

Contribution per unit =xx - Incremental depreciation= xx
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Incremental contribution = xx Step 3: Find incremental cash Incremental Profit before tax = xx
- Incremental depreciation= xx inflows
Incremental profit = xx - Tax @ t = xx
- Tax on incremental profit =xx
Incremental profit after tax = xx Incremental Profit after tax =xx
+ Incremental Depreciation = xx + incremental Depreciation = xx
Incremental cash inflows = xx Incremental cash inflows = xx
Incremental Depreciation
Depreciation of old M/C = xx
Depreciation of New M/C = xx