CAPITAL BUDGETING

TIME VALUE OF MONEY

A rupee today is more valuable than a rupee a year hence.

Why ?
• Preference for current consumption over future
consumption
• Productivity of capital
• Inflation
Many financial problems involve cash flows occurring at
different points of time. For evaluating such cash flows, an
explicit consideration of time value of money is required
X deposits Rs 4000 at the end of every year for 5 years in his saving account
paying 10% Interest compounded annually. He wants to determine how much
sum of money he will have at the end of 5th year?
4000FVIFA 10% 5=4000x6.105=24420
Find the present value of Rs 4000 receivable 5 years hence if the rate of
discount is 5%
4000PVIFA 5%5 =4000x.784=3136
Amount= Principal + Interest
Interest are of two types: Simple interest and compound interest

SI: Received at the end of every year and then total is added to the Principal
CI: Received at the end of every year on the year end amount that gives final amount
Eg. Rs. 100 based on simple interest will amount to Rs. 150 at the end of 5 years
Rs. 100 based on CI will amount to Rs. 161.051 at the end of 5 years
Usually, we consider CI in finance; so formula of Amount is
A= p (1+r)^n and P = A/ (1+r)^n
Based on which Time value table is prepared
Capital Budgeting
• The process of identifying, analyzing, and selecting investment
projects whose returns (cash flows) are expected to extend beyond
one year.

1. New products or expansion of existing products

2. Replacement of existing equipment or buildings
3. Research and development
4. Exploration
5. Other (e.g., safety or pollution related
What is capital budgeting?
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
Require heavy cash outlay/cash outflow
Helps in taking decision: Accept or Reject
Types: Independent (Standalone): Its decision doesn’t affect
other.
Mutually Exclusive: Option; select anyone. Eg. Opening a
new store in different location.
Methods: Conventional/ Traditional (non-discounted)
Non-Conventional (Discounted)
 INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA

NET BENEFIT INTERNAL ACCOUNTING

PAYBACK
PRESENT COST RATE OF RATE OF
PERIOD
VALUE RATIO RETURN RETURN
 What is the payback period?

The number of years required to recover a project’s cost,

or how long does it take to get the business’s money back?

Cash Outflow is also known as: Initial investment/ cash outlay

Cash Inflow is also known as PAT + Dep. i.e. (Profit after Tax +
depreciation)
Discount rate= r
Number of years = n
The payback method simply measures how long (in
years and/or months) it takes to recover the initial
investment.
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.
 Practice question
• Julie Miller is evaluating a new project for her firm, Basket Wonders
(BW). She has determined that the after-tax cash flows for the
project will be $10,000; $12,000; $15,000; $10,000; and $7,000,
respectively, for each of the Years 1 through 5. The initial cash outlay
will be $40,000.
 Strengths of Payback:

1. Provides an indication of a project’s risk and liquidity.

2. Easy to calculate and understand
Weaknesses of Payback
1. Ignores the TVM.
2. Ignores CFs occurring after the payback period.
 Net Present Value (NPV
Net Present Value (NPV). Net Present Value is found by subtracting the present value of
the after-tax outflows from the present value of the after-tax inflows.
When discounting it means we are finding Present value of the Future cash inflow
Decision Criteria

If NPV > 0, accept the project

If NPV < 0, reject the project

If NPV = 0, indifferent
Financial Tables.pdf (PVIF) Rs. Value at the end of year
  c1 c2 c3 cn 
NPV      n
 co
 (1  k ) (1  k ) (1  k ) (1  k ) 
1 2 3

c1, c2 is the cash inflows and k is opportunity cost of capital, co is the initial cost of
the investment

NPV: Sum of the PVs of inflows and outflows

n
CFt
NPV    CF0 .
t 1 1  k  t
Let us assume that project x costs Rs.2,500/- and is expected to generate
year end cash in flows of Rs.900, 800, 700, 600 and Rs.500/- in year from
1-5. The discount rate may be assumed to be 10%.
Practice questions
• The cost of a project is $50,000 and it generates cash inflows of
$20,000, $15,000, $25,000, and $10,000 over four years.
• Required: Using the NPV and present value index method, appraise
the profitability of the proposed investment, assuming a 10% rate of
discount.

• Question 2 only.
• ..\..\question paper\CAPITAL-BUDGETING-QUESTION.pdf
Profitability Index (PI)

• Helps in ranking investments and deciding the best investment that

should be made.
• PI greater than one indicates that present value of future cash inflows
from the investment is more than the initial investment, thereby
indicating that it will earn profits.

• Profitability Index = Present Value of Future Cash Flows / Initial

Investment.

• Accepting criteria; if PI >1 (Accepted)

• PI<1 (Rejected)
Relevance to its applicability
• Payback is easiest method
• NPV is most popular