Terms

Capital : Total amount of finance required by

the business to conduct its business
operations both in the short run and long run

Types of Capital :
1. Fixed Capital
2. Working Capital
 Capital Budgeting
• Capital budgeting is the process of making
investment decisions in long term assets. It is
the process of deciding whether or not to
invest in a particular project as all the
investment possibilities may not be
rewarding.
 significance of capital budgeting
• Long-term Applications
• Competitive Position of an Organization
• Cash Forecasting
• Maximization of Wealth
PROCESS OF CAPITAL BUDGETING

Organization of investment proposal

Screening of proposals
Evaluation of projects
Establishing priorities
Final approval
Evaluation
 Present Value of a Series of Cash Flows

• An investment that involves a series of identical

cash flows at the end of each year is called an
annuity.
 Time Value of Money

• The TVM is the concept according to which a

sum of money owned in the present has a
greater value than the value of the same sum
received at a moment in the future

FV = PV (1 + r) 1000(1+10%) = 1100

PV = FV
(1 + r) n
 METHODS OF CAPITAL BUDGETING
Traditional methods
a. Payback Period
b. Accounting Rate of Return

Discounted cash flow methods or modern

methods
a. Internal Rate of Return (IRR)
b. Net Present Value (NPV)
c. Profitability Index (PI)
 Payback Period

“The pay back period is the number of years it takes the firm
to recover its original investment by net returns before
depreciation, but after taxes”.

It measure the length of time required for the project to

recover its Investment.

Payback period = flow ( ) of the Project

w
• If a project with life of 5 years involves an
investment of Rs. 40 lakh and is expected to
generate a fixed annual return of Rs. 16 lakh

then pay back =40/16=2.5 year.

 Accounting Rate of Return (ARR)

• Accounting Rate of Return (ARR) is the percentage rate

of return that is expected from an investment or asset
compared to the initial cost of investment

• ARR = Average annual profit / average investment

• XYZ Company is looking to invest in some new machinery to replace its
current machinery. The new machine, which costs 420,000, would increase
annual revenue by 200,000 and annual expenses by 50,000. The machine is
estimated to have a useful life of 12 years and zero salvage value.

STEP-I Calculate Average Annual Profit

Inflows Years 1-12 (200,000*12) 2,400,000
Less: Annual Expenses (50,000*12) 6,00,000
Depreciation 4,20,000
Total Profit 13,80,000
Average Annual Profits =
(1,380,000/12) 115,000
STEP-II Calculate Average Investment
(420,000 )/2 = 210,000
Step 3: Use ARR Formula

ARR = 115,000/210,000 = 54.76%

therefore, this means that for every Rupee invested, the investment will return a profit
of about 54.76 cents.
 Net Present Value Method
NPV is the difference between the present value
of cash inflows and the initial investment over
a period of time.
NPV = Present value of cash inflows – Initial
investment
Decision Rule for Accepting and Rejecting the
project:
A project with positive NPV is to be selected.
A project with negative NPV is not to be
selected
 Contd..
Net Present Value

NPV = PV of Inflows - Initial Outlay

Discounting

CF1
NPV = (1+ k)
+ CF2 + CF3 + CFn –I
(1+ k )2 (1+ k )3 (1+ k )n
 Contd..
• A projects involves an initial investment of Rs. 20 lakh and
generate net inflow as follows: ( assume cost of capital is
12% per annum Year
Cash inflow 1 Rs. 4 lakh
2 Rs. 8 lakh
3 Rs. 12 lakh

NPV = Present value of cash inflows – Initial investment

NPV= (3.572+6.376+8.544)- 20.00
NPV= -1.508
Decision Rule for Accepting and Rejecting the project
A project with negative NPV is not to be selected
NPV = Present value of cash inflows – Initial investment
NPV= (3.572+6.376+8.544)- (20.00)
NPV= -1.508
Decision Rule for Accepting and Rejecting the project
A project with negative NPV is not to be selected

Year Cash in flow (Rs. In lakh) Present value ( Rs. In Lakh)

1 Rs. 4 lakh 4 *PVIF (12,1) = 4* 0.893 =3.572

2 Rs.8 lakh 8 *PVIF (12,2) = 8* 0.797 =6.376

3 Rs.12 lakh 12 *PVIF (12,3) = 12* 0.712 =8.544

 Internal Rate of Return (IRR)

The IRR is the rate of interest at which the NPV

of a project is equal to zero

Decision criteria
If the IRR is greater than the cost of capital, accept
the project. If the IRR is less than the cost of capital,
reject the project.
 A project has the following pattern of cash flow, calculate IRR of the project

Year Cash flow ( Rs. In lakh)

0 20 lakh invested
1 10
2 10
3 6.16
4 2.40

Step1 (calculate of Average annual cash flow) Average annual cash flow =
(10+10+6.16+2.4)/4=7.14

Step2 (Divide the initial investment by average annual cash flow) 20/7.14 = 2.801

Step3 (from the PVIFA table 2.801 in 4 years , rate of interest = 15%)

Use this rate as a initial value for starting trial and error process and keep trying
until you get an interest rate at which the NPV is marginally above zero or zero.
The interest rate at this point can be deemed as the IRR for the project
• NPV at r = 15% will be equal to= 1.68 = -20 + (10*0.870)+(10*0.756)+(6.16*0.658)+(2.4*0.572)= 1.68
• NPV at r = 16% will be equal to= 1.31 = -20 + (10*0.862)+(10*0.743)+(6.16*0.641)+(2.4*0.552) = 1.31
• NPV at r = 18% will be equal to= 0.63 = -20 + (10*0.848)+(10*0.719)+(6.16*0.609)+(2.4*0.516) = 0.63
• NPV at r = 20% will be equal to= 0.00 = -20 + (10*0.833)+(10*0.694)+(6.16*0.579)+(2.4*0.482) = 0.00

r=20 NPV=0 IRR= 20%

Profitability Index

Very Similar to Net Present Value

PI = PV of Inflows
Initial Outlay

Instead of Subtracting the Initial Outlay from the PV

of Inflows, the Profitability Index is the ratio of Initial
Outlay to the PV of Inflows.