Capital Budgeting

Planning for long term investment: investment into long term assets, i.e. Land,
Building, Plant and Machinery, installations and equipment, Vehicles and
Furniture and Fixture.
Definition: Capital budgeting is a process of evaluating, analyzing and selecting
long term investment proposals.
What kind of investment proposals:
 Feasibility report for Cattle Farm, Fish Form, poultry farms, Dairy farms etc
 Feasibility report for juice factory, grading factory, packaging of fruits and
vegetables etc
 Feasibility for agro based industries, sugar industry, Flour Mill, Chip board,
oil mill, spinning, etc
Capital Budgeting Process:
1. Proposal Generation: If a firm has enough funds, The proposal are
discussed among the paradigm of the management from top to Bottom

Top Management

Middle Management

Operational management

2. Cost and Benefit Analysis :

We compute the Project cash flows, initial investment, operational cash
flows, Terminal Cash flows, tax computations, depreciation computations,
then we use Project evaluation techniques to select or reject the project,
Payback Period, Net Present Value (NPV) , Profitability Index, Internal Rate
of Return( IRR).
3. Decision Making: Yes or No , If yes then Go ahead and If no then again go
for new proposal. We decide upon that If benefits are more than Costs and
are enough then we say Yes otherwise no.
 4. Implementation

We will implement the project with full force and funds

5. Feed Back : We compare actual outcomes with the expected outcomes.
Motives Of Capital Budgeting
1. Extension ( we are interested to place one unit more , one plant
more in the same domain or in the supply chain)
2. Renewal and Replacement ( Allocation of funds for annual
renewals and replacements )
3. Repairment ( Allocation of funds for repairment)
4. Other purposes ( Social Security project, Trust, Initial
Advertisement and promotion)
Computation of Initial Investment
Cost of Long term Asset ---------------- 500000
Add : Installation Costs --------------- +60000
Total cost of long term asset ---------------- 560000
±: (Gain) or loss on Sale of Old Assets ---------------- -10000
± (Tax savings) Tax payment --------------- +5000
± Working Capital Changes --------------- +15000
Initial Investment or Initial Cash Outflow ----------------- 570000
-

Exercise
Cost of a plant is Rs 500000 and the installation cost is 60000, The Gain on
disposal of Old Asset is 10000, The tax payment is Rs. 5000 and the Net Working
Changes are ( CA<CL) 15000. Compute the initial investment.

Forecasting of Sales:
Growth in sales = (Sales this year – sales of previous year)/ sales of previous year
Sales of next year = sales of this year x ( I + Average Growth in Sales)
Computation of Operating Cash Flows
FY 2021 2022 2023 2024 2025
EBT 500000 650000 670000 750000 800000
Add Depreciation 100000 100000 100000 100000 100000
EBDT 600000 750000 770000 850000 900000
Less Taxes (40%) 240000 300000 308000 340000 360000
Earning after tax 360000 450000 462000 510000 540000
including depreciation
Less Depreciation 100000 100000 100000 100000 100000
EAT excluding 260000 350000 362000 410000 440000
Depreciation/ Operating
Cash Flow

Terminal Cash Flow

Format of Terminal Cash Flow
Proceed from Sale of Asset
± Tax Saving ( tax payments)
± Net Working Capital change +( CA<CL) , -( CA>CL)
Terminal Cash Flow

Example 2:
On the completion of the project the asset was disposed of for Rs. 100000. Upon
sale of this asset an amount of tax was levied for Rs 15000 and the Net Working
Capital changes were 10000 ( CA> CL)
Proceed from Sale of Asset 100000
- tax payments -15000
- Net Working Capital change +( CA<CL) , -( CA>CL) -10000
Terminal Cash Flow 75000
 Cash flows FY 2020 FY 2021 FY 2022 FY 2023 FY 2024 FY 2025
Initial (570000)
Cash out
flow
Operating 260000 350000 362000 410000 440000
Cash Flow
Terminal 75000
Cash flow
Time line (570000) 260000 350000 362000 410000 515000
of Cash
flows

Depreciation :
Systematic Allocation of cost of a long term asset into expense is called
depreciation:
Purchased building for Rs 50000. Estimated useful life( EUL) of the building is 5
years
Building ------------------Dr---50000
Cash----Cr--------------50000

Straight line depreciation method = (Cost of long term asset – salvage value)/ EUL

If there is no salvage value

For 1st year = 50000/ 5 = 10000
Depreciation Exp – building ---10000
Acc dep – building --------10000
For 2nd year
Depreciation Exp – building ---10000
Acc dep – building --------10000
For 3nd year
Depreciation Exp – building ---10000
Acc dep – building --------10000
For 4nd year
Depreciation Exp – building ---10000
Acc dep – building --------10000
For 5nd year
Depreciation Exp – building ---10000
Acc dep – building --------10000

Balance Sheet
Building 50000
1st year dep 10000
Book Value 40000
2nd year dep 10000
Book Value 30000
3rd year dep 10000
Book Value 20000
4th year Dep 10000
Book Value 10000
5th Year Dep 10000
Book Value 0

Other Methods of Depreciation

Written Down Value Method/ Diminishing Balance Method
Sum of year digit method
Double Decline Method
MACRS: Modified Accelerated Cost Recovery System
Disposal of Assets ( Exercise)
Cost of Building = 50000
Salvage Value = 10000
Estimated useful life = 5 years
Compute Depreciation Rate
Compute Dep under straight line method
Solution
Depreciation Rate = 1/ EUL = 1/5 = 0.20 = 20%
Depreciable Value = Cost – Salvage value = 50000- 10000 = 40000
Straight Line depreciation = 40000 x 0.20 = 8000
Straight Line Depreciation = (50000-10000)/ 5 = 8000
Disposal of Assets
Book Value or Salvage value on last = 10000
Asset may be disposed of at 10000 or more than 10000 or less than 10000.
If disposed of asset More than its book value
Sold at 13000
Capital gain = 13000-10000 = 3000
Cash 13000 (Dr)
Building 10000 ( cr)
Gain on sale of Asset 3000( Cr)
Equal to salvage value = 10000
Cash ----------------------10000 (Dr)
Building -----------------------------10000(Cr)
If Sold at 8000
Cash --------------------8000 Dr
Loss on Disposal -----2000 Dr
Building ----------------10000(Cr)

MACRS RATE are given in schedule ( in Book)

Capital Budgeting Techniques

Capital budgeting techniques are used to evaluate the project that we should
accept the project or reject the project:
There are four techniques to evaluate the projects:
1. Pay Back Period (PBP)
In how much time period we recover our initial investment is called PBP
Decision Criteria
a. if PBP is < Maximum PBP, Accept the Project
b. If PBP is > Maximum PBP, Reject the project
Draw Back: This technique considers cash flow only upto the amount of
Initial investment recovery, does not consider the remaining cash flows.

2. Net Present Value (NPV)

NPV = Present value of Cash flows – Initial Investment
Decision Criteria:
a. If NPV > 0 Accept the project
b. If NPV < 0 Reject the project
c. If all projects have NPV>0 Accept the project which have higher NPV
Theoretically an ideal approach because it considers all cash flows and the
decision is made by discounting the cash flows at a given discount rate
and then compared to the initial investment.
 3. Profitability Index (PI)
PI = Present Value of Cash Flows/ Initial Investment
Decision Criteria
a. If PI > 1 Accept the project
b. If PI < 1 Reject the project

4. Internal Rate of Return (IRR)

IRR is that return of return at which NPV becomes equal to zero. i.e
Where PV of cash flows becomes equal to Initial investment
NPV (discount rate) = PV of Cash flow – Initial Investment = 0
Decision Criteria
a. If IRR > WACC ( weighted Average Cost of Capital), Accept the project
b. If IRR < WACC Reject the project
IRR is practically approach.

We have a project:
Year FY 2020 FY 2021 FY 2022 FY 2023 FY 2024 FY 2025
Time 0 1 2 3 4 5
Cash flows (570000) 260000 350000 362000 410000 515000
Pay Back Period:
1 = 260000 + ? = 570000
260000+310000= 570000
Year 1 complete Fraction Year 1.88 Year =
(310000/350000) = 1 year (0.88
0.88 x12)
1 year 9 months

260000 310000 570000

Maximum PBP 2 Years

Our decision PBP< MPBP = 1.88< 2 year Accept the project

Exercise:
Initial investment = 500000
Years Project A OCF Project B OCF
1 150000 200000
2 180000 200000
3 190000 200000
4 210000 180000
5 240000 140000

Max PBP is 2.7 years

Required:
Compute PBP for Project A and B
Net Present Value
10% discount rate
NPV = PV of Cash Flow – Initial Investment
CF 1 CF 2 CF 3 CF n
NPV =
[ + +
(1+i)1 (1+i)2 (1+ i)3
+ … … …..+
( 1+i )n]−Initial Ivestmnet

Year Project Cash flow PVIF(i = 10% , t, PV of Cash Flows

1…..5)
1 2 3= 1x2
1 260000 0.909 236340
2 350000 0.826 289100
3 362000 0.751 271862
4 410000 0.682 279620
5 515000 0.620 319300
1396222

PVIF = 1/ (1+i)t = 1/(1+ 0.10)1 = 0.909

=1/(1+ 0.10)2 = 0.826

NPV = PVCF –II

NPV = 1396222 – 570000
NPV = 826222
NPV > 0 Accept the project
Exercise 2
Initial investment = 500000
Discount Rate = 10% ,
Years Project A OCF Project B OCF
1 150000 200000
2 180000 200000
3 190000 200000
4 210000 180000
5 240000 140000

Required:
Compute NPV for Project A and B , Which project is acceptable

Profitability Index
PI = PVCF/ Initial Investment
PI = 1396222 / 570000 = 2.45
PI > 1 so accept the project:

Internal Rate of Return: IRR

IRR=L% +¿

L% = 10% Pnpv = 826222

H% = 60% Nnpv =
I RR=10 %+¿
826222
[
IRR=10 %+ (50 % ) ×
(82622 2+667) ]
IRR=10 %+ [ ( 50 % ) × 0.99 ]

IRR=10 %+ [ ( 49.95 % ) ]

IRR = 59.95%