Capital Budgeting-I

Evaluating Investment Proposal

 Types of Investment Projects
• Profit oriented and legally binding project
• Mutually Exclusive and Accept-Reject
proposals
• Contingent vs independent proposals
• Research and not-for profit projects
 Feasibility study
• Economic feasibility
• Commercial feasibility
• Technical feasibility
• Legal feasibility
• Organizational feasibility
• Strategic analysis
• Financial appraisal
 Project Appraisal
• Cash flows
• Incremental costs and benefits
• Consider total investment
• Depreciation
• Interest expenses
• Opportunity costs
 Accounting Rate of Return
Proposal X Proposal Y
Investment required 1,00,000 1,00,000
Expected life of the 5 years 5 years
machine
Depreciation per year 20,000 20,000
Income tax 30% 30%
Scrap value at the end of 5 0 0
years

Years 1 2 3 4 5
X 90 30 30 30 30
(profits’000)
Y 30 30 30 30 30
(profits’000)
 ARR
Years 1 2 3 4 5
Profits 90 30 30 30 30
Depreciation -20 -20 -20 -20 -20
EBT 70 10 10 10 10
Income tax -21 -3 -3 -3 -3
PATR 49 7 7 7 7

• ARR=average annual profits/Initial

investment=15,400/1,00,000=15.4%
• ARR=average annual profits/average
investment=15,400/50,000=30.8%
 Payback Period Method
Years 1 2 3 4 5
Profits 90 30 30 30 30
Depreciation -20 -20 -20 -20 -20
EBT 70 10 10 10 10
Income tax -21 -3 -3 -3 -3
PAT 49 7 7 7 7
Add back 20 20 20 20 20
depreciation
Net cash 69 27 27 27 27
flow

Year Beginning bal. Net cash inflow Year-end unrecovered amount

1 1,00,000 69,000 31,000
2 31,000 27,000 4,000
3 4,000 27,000 -
 Effect of Salvage Value and Working
capital
• A company is considering a new project with an initial
investment of Rs. 1,00,000. The project would increase the
EBDT by Rs.35,000. per year for 5 years. The salvage value of
machinery is Rs.10,000. The working capital, Rs.25000,
invested will be recovered after 5 years.
• Required rate of return 12% and income tax is 25%
• What is average investment?
• (Opening bal +Cl. Bal)/2, (Rs.1,25,000+1,07,000)/2= Rs.
1,16,000
• (1,07,000+89000)/2=98000
• (89000+71000)/2=80000
• (71000+53000)/2=62000
• (53000+35000)/2=44000
• Average=(116000+98000+80000+62000+44000)/5=80000
Payback period with salvage value and
working capital
PBDT 35,000
Less: Depreciation 18,000
EBT 17,000
Less: Income Tax 4,250
PAT 12,750
ARR =12750/80,000=15.94%
Add: Depreciation 18,000
Net cash inflow 30,750
1 1,25,000 30,750 94,250
2 94,250 30,750 63,500
3 63,500 30,750 32,750
4 32,750 30,750 2,000
5 2,000 30,750+10,000+25,0 -
00=65,750