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Capital Budgeting
Capital Budgeting
Capital Budgeting
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When cash inflows are uneven, we need to calculate the cumulative
net cash flow for each period and then use the following formula:
B
Payback Period = A+
C
Where,
A is the last period number with a negative cumulative cash flow;
B is the absolute value (i.e. value without negative sign) of cumulative net cash
flow at the end of the period A; and
C is the total cash inflow during the period following period A
Cumulative net cash flow is the sum of inflows to date, minus the initial outflow.
Year CFAT Cumulat ive
CFAT
0 (500000)
1 1,50,000 (3,50,000)
2 1,80,000 (1,70,000)
3 1,50,000 (20,000)
4 1,32,000 1,12,000
5 1,20,000 2,32,000
= 1
payback period
It applies only when equated cash inflows every
year.
Ref eg1 500000/200000*100= 25% or ¼*100= 25.00%
ARR is the annualized net income earned on
the average funds invested in a project
A, In case of method on original investment :
ARR = (Average net earnings / initial investment)* 100
B, In case of method on average investment :
ARR = (Average net earnings/ Average investment) *100
Deduct profit with tax and depreciation
PAT (profit after tax) is calculated as average
for ‘N’Years.
Calculate ARR by dividing earnings by
investment
The project would be accepted if its ARR ishigher
than the maximum orARR set by management.
r – Discount rate
n – number of years
Computation method:
1. Ascertain total cash inflows, outflows of the project
and time period
2. Calculate present value for cash inflow (CFAT*PV)
3. Calculate present value for outflow
4. NPV = PV cash inflow – PV cash outflow
5. Whichever project with high NPV accept the
proposal
Net present value canbe find by subtracting present
value of cash outflows from present value of cash
inflows.
WHERE
• C1 =cash inflow for period1,2,3,4,……n
• K = discounting rate
• Co = cash outflow
1. NPV > 0 ; accepted
2. NPV< 0 ; reject
3. NPV = 0 ; May accept
Contd…
Now apply formula IRR = Lower rate + (positive
NPV/diff in PV)*diff in rate
= 14+ (1190/2620) *1
= 14.45%
Example 7
PV Calculations Difference
PV Required 16000
200
PV at lower rate (15%) 16200
257
PV At Higher rate (16%) 15943
Therefor IRR
Or r = Lower rate + (higher PV rate% - Lower PV rate %) Diff. b/w PV
required and PV at lower Rate / diff. B/W PV at higher rate and PV at lower
rate
: r = 15% + ( 16% - 15%)*200/257
= 15% + 0.80%
Or r = 15.80%
Variant of NPV method – also known as benefit cost
ratio or present value index
Formula : PI = PV of cash inflows/ PV of cash outflows
Amount obtained from PI is every rupee invested in
project
- If PI is more than 1, then accept
- If PI is less than 1, then reject
• PI > 1 ; accepted
• PI< 1 ; reject
• PI = 1 ; May accept
Market conditions
Amount of financing
1. Historical cost and Future cost
2. Explicit cost and Implicit cost
3. Specific cost and Overall cost
4. Average cost and Marginal cost
Cost of Debt: returns expected by the
potential investors of debt securities of a
firm.
The debt is tax deductible
Two types of debt: 1. Irredeemable Debt 2.
Redeemable Debt
- Perpetual debt - not redeemable during the life time of the firm
a. Cost of Debt before tax:
K db = interest / Net proceeds = I/NP
Net proceeds can be calculated by:
1. Debt issued at par: NP = Face value – Issue expense
2. Debt issued at premium: NP = face value + securities – issue price
3. Debt issued at discount = NP = face value – Discount – issue
expenses
Contd…
B. Cost of debt after tax (K da)
Contd…
In India, Companies Amendment Act, 1988 prohibits
issue of irredeemable preference shares
1.Cost of Irredeemable preference share capital
Cost of preference share (kp) = Annual preference
dividend / Net proceeds
2.Cost of Redeemable preference share capital Cost
of Redeemable preference share (kp) =Annual
cost / Average value of preference share
1. Annual preference dividend xxxx
2. Add: Issue expenses xxxx
3. Add: Discount on issue xxxx
4. Add: Premium on redemption xxxx
5. Less: Premium on issue xxxx
t - Tax rate
b- Brokerage
Allen ltd., pays the dividend per share Rs. 4.
Market price of share Rs. 40 and expected to
grow by 10% p.a.
Calculate the cost of equity.
Cost of equity = (D/MP) + g
= (4/40*100)+10
Ke = 20%
A company assess its risk free return 12 % Beta co-
efficient = 1.75 and expected market return is
15%
Compute Cost of equity underCAPM
Solution: Ke under CAPM = 12% + [1.75(15%-12%)]
= 0.12+ 1.75(0.03) = 0.1725
= 17.25%
Average of costs of each source of funds – given
weightage by proportion or percentage
Computation of weighted Average Cost of Capital:
Step1: Calculate specific costs (i.e) equity, preference
and debenture
Step 2: Calculate the proportion and multiply each
specific cost with its proportion
Step 3: Add all the weighted specific costs
Source of Amount Proportio After tax Weighted
funds n to total cost cost
Debt xxx W1 Kda Kda*w1