Capital Budgeting

 Three major decisions managers make

– Investing
– Financing
– Dividend
 Capital budgeting focuses on the investing decision.
 Capital budgeting is the process of evaluating and selecting long-term investments
that are consistent with the firm’s goal of maximizing owner wealth.
 It is a process of deciding whether to invest or not to invest in a particular asset, the
benefit of which will be available over a period of time.

Investment decisions are of two types –

• Long term decisions (Capital budgeting)

• Short term decisions (Working Capital Management)

• A capital expenditure is an outlay of funds by the firm that is expected to

produce benefits over a period of time greater than 1 year.

• An operating expenditure is an outlay of funds by the firm resulting in benefits

to be received within 1 year.

Nature of Capital Budgeting

Capital budgeting decisions -

• have long-term impact on the business stability, growth & success.

• involve huge investment of funds.

• are more complicated from concerns of future cash flow estimates and their
evaluation at the time of making investment.

• are not easily reversible mainly because of loss of investment.

Importance of capital budgeting decisions

• Strategic decisions

• Huge amount of resources are involved that has impact on business strategy, growth,
and survival.
 • Difficult to “bail out”, once an investment is made.

• The capital investments are challenging and critical to the success of the company. An
incorrect decision may end with the company’s closing-out from the market.

Steps in the capital budgeting process

1. Proposal generation

Proposals for new investment projects are made at all levels within a business organization
and are reviewed by finance personnel.

2. Review and analysis

Financial managers perform formal review and analysis to assess the merits of investment
proposals.

3. Decision making

Firms typically delegate capital expenditure decision making on the basis of dollar limits.

4. Implementation

Following approval, expenditures are made and projects implemented. Expenditures for a
large project often occur in phases.

5. Follow-up

Results are monitored and actual costs and benefits are compared with those that were
expected. Action may be required if actual outcomes differ from projected ones.

Why organizations face these kind of decisions

• New projects

• Expansion projects

• Diversification projects

• Replacement and Modernisation projects

• Research and Development projects

Basic Terminology

Independent versus Mutually Exclusive Projects

 • Independent projects are projects whose cash flows are unrelated to (or independent
of) one another; the acceptance of one does not eliminate the others from further
consideration.

• Mutually exclusive projects are projects that compete with one another, so that the
acceptance of one eliminates from further consideration all other projects that serve a
similar function.

Unlimited Funds versus Capital Rationing

• Unlimited funds is the financial situation in which a firm is able to accept all
independent projects that provide an acceptable return.

• Capital rationing is the financial situation in which a firm has only a fixed number of
dollars available for capital expenditures, and numerous projects compete for these
dollars.

Accept-Reject versus Ranking Approaches

• An accept–reject approach is the evaluation of capital expenditure proposals to

determine whether they meet the firm’s minimum acceptance criterion.

• A ranking approach is the ranking of capital expenditure projects on the basis of some
predetermined measure, such as the rate of return.

CRUX OF ALL CAPITAL BUDGETING TECHNIQUES

• The purpose of evaluation under all capital budgeting techniques is to estimate the
monetary benefit arising out of investment made in a given project.

• If a project is estimated to maximize shareholder’s wealth at the end of a given period

of time by returning surplus monetary benefit than the investment made, then decision
is made to take up the project for investment.

NON-FINANCIAL FACTORS that could be considered while evaluating projects

Company Goodwill, Image & Reputation

Management may reject an investment opportunity, as it will reflect badly on the company
goodwill, image and reputation.

Company Policies, Objectives & Culture

Management is bound to check, if the investment opportunity conforms to the policies,
objectives and culture of the company.

Environmental, Social, Legal & Ethical Issues

Management is required to make sure that the investment opportunity under consideration is,
legally, environmentally, socially and ethically acceptable and viable.

Impact on Stakeholder Relationships

Management appraises the impact of the investment on competitors, shareholders,

employees, buyers, bankers, suppliers and government institutions, etc.

Management can reject a project based on non-financial factors though the financial
performance of a project is found satisfactory.

Types of techniques

Traditional techniques or
Modern techniques or
non discounted cashflow
discounted cashflow method
method

Payback period Net present

method value method

Discounted
Profitability
payback period
index method
method

Accounting rate
Internal rate of
of return
return method
method

Terminal value
method

Payback Period

The payback method is the amount of time required for a firm to recover its initial investment
in a project, as calculated from cash inflows.

PBP = Initial investment / Annual cash inflow

Decision criteria: –

• The length of the maximum acceptable payback period is determined by management.

 • If the payback period is less than the maximum acceptable payback period, accept the
project.

• If the payback period is greater than the maximum acceptable payback period, reject
the project.

Advantages

• The payback method is widely used by large firms to evaluate small projects and by
small firms to evaluate most projects.

• Its popularity results from its computational simplicity and intuitive appeal.

• By measuring how quickly the firm recovers its initial investment, the payback period
also gives implicit consideration to the timing of cash flows and therefore to the
liquidity aspect of the project.

• Because it can be viewed as a measure of risk exposure, many firms use the payback
period as a decision criterion or as a supplement to other decision techniques.

Disadvantages

• The appropriate payback period is merely a subjectively determined number. It cannot

be specified in light of the wealth maximization goal because it is not based on
discounting cash flows to determine whether they add to the firm’s value.

• This approach fails to consider time value of money.

• There are cashflows which occur outside of the payback period as well. This method
does not take into account the latter cashflows.

• It overlooks the cost of capital aspect or the interest factor.

A. Constant cash inflows

A Project costing Rs. 5,00,000 would generate cash flows of Rs 1,00,000 each year for the
next 7 years. Calculate Payback Period.

PBP = Initial investment / Annual cash inflow

PBP = 5,00,000 / 1,00,000

PBP = 5 years
B. Uneven cash inflows

Unrecovered amount
PBP = Year before full recovery +
Cash inflows during that y ear

Year Cashflow Cumulative cashflow

0 - 20,000

1 6,000 6,000

2 8,000 14,000

3 5,000 19,000

4 4,000 23,000

5 4,000 27,000

PBP = 3 years + 1,000 / 4,000

PBP = 3 years + 0.25

PBP = 3.25 years

Practice question 1

Frito Lays Ltd. are considering two projects. Each project requires an investment of 1 crore.
The firm’s cost of capital is 10 percent. The net cash inflows from investment in two projects
A and B are as follows :

Year Project A Project B

1 50 L 10 L

2 40 L 20 L

3 30 L 30 L

4 10 L 40 L

5 - 50 L

Calculate the payback period and suggest the best out of the two depending upon the
feasibility of the projects.
Practice question 2

There are 2 machines available QWERTY 1 and QWERTY 2. A firm in requirement of the
same has a decision to make in view of a mutually exclusive purchase. Following are the cash
outflows and inflows :

Cash flows QWERTY 1 QWERTY 2

Initial investment 9,000 18,000

Additional cost of 800 1,000

maintenance

Additional cost of supervision 1,200 1,800

Estimated saving in scrap 500 800

Estimated saving in wages 6,000 8,000

Estimated life 4 Years 5 Years

You are expected to help take the decision based on PBP method.

Cash flows QWERTY 1 QWERTY 2

Additional cost of 800 1000

maintenance

Additional cost of supervision 1200 1800

Total expenses 2000 2800

Estimated saving in scrap 500 800

 Estimated saving in wages 6000 8000

Total savings 6500 8800

Total savings – Total 6500 – 2000 = 4500 8800 – 2800 = 6000

expenses

PBP 9000/4500 = 2 Years 18000/6000 = 3 years

QWERTY 1 seems to be a better investment based on PBP method

Net Present Value method

In NPV technique, the profitability of investment proposal is measured through the difference
between the cash inflows generated out of the cash outflows or the investments made in the
project.

Net Present Value = Present value of cash inflows - Present value of cash outflow

Decision Criteria

1. If the net present value is greater than zero, the proposal must be accepted.

2. If the net present value is less than zero, the proposal must be rejected. 

3. In case of multiple projects, project having the higher NPV to be selected.

4. Practice question 1

5. A project titled ‘Believe it or not’ costs INR 2500 to a company. It would generate the
following cash flows –

6. Year 1 - 900

7. Year 2 - 800

8. Year 3 - 700

9. Year 4 - 600

10. Year 5 - 500

 11. To mention, the cost of capital for the company would be 10 percent.

12. You are required to calculate the viability of this project based on NPV method.

A:

Cash outflow = INR 2500

Cash inflow as follows :

Year Inflows Discounting value Discounted inflows

@ 10 %

1 900 0.909 818.1

2 800 0.826 660.8

3 700 0.751 525.7

4 600 0.683 409.8

5 500 0.620 310

Sum 2724.4

NPV = 2724.4 – 2500

NPV = 224.4

Since the NPV is greater than 0, the company should accept the project ‘Believe it or not’.

Practice question 2

There are three mutually exclusive projects. All three are expected to cost INR 2,50,000 to
the firm. They have an estimated life of 5,4 and 3 years’ respectively.

The firm’s required rate of return is 12 percent. The anticipated cash inflows for the 3
projects are as follows :
 Year Project A Project B Project C

1 80,000 1,10,000 1,30,000

2 60,000 90,000 1,10,000

3 60,000 85,000 20,000

4 60,000 35,000 -

5 1,80,000 - -

You are required to guide the company based on NPV method!

A:

Ye Proj Discou Discou Proj Discou Discou Proj Discou Discou

ar ect nting nted ect nting nted ect nting nted
A value inflow B value inflow C value inflow
@ 12 s @ 12 s @ 12 s
% % %

1 800 0.893 71440 110 0.893 98230 130 0.893 116090

00 000 000

2 600 0.797 47820 900 0.797 71730 110 0.797 87670

00 00 000

3 600 0.712 42720 850 0.712 60520 200 0.712 14240

00 00 00

4 600 0.636 38160 350 0.636 22260 -

00 00
5 180 0.567 102060 - -
000

302200 252740 218000