Chapter 10

Investment Policy and Capital

Budgeting

Welcome to the Power Point Presentation

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 Introduction
• Chapter 10 introduces the concept of capital
budgeting
• The important points are:
Capital budgeting is the most significant
financial activity of the firm.
Capital budgeting determines the core
activities of the firm over a long term future.
Capital budgeting decisions must be made
carefully and rationally.
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 Capital Budgeting Within The Firm
T h e P o s i t i o n o f C a p i t a l B u d g e t in g

F in a n c ia l G o a l o f t h e F ir m :
W e a lt h M a x im is a t io n

I n v e s t m e n t D e c is o n F in a n c in g D e c is io n D iv id e n d D e c is io n

L o n g T e rm A s s e ts S h o r t T e r m A s s e ts D e b t / E q u it y M ix D iv id e n d P a y o u t R a t io

C a p ita l B u d g e tin g
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Examples of ‘Long Term Assets’

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 Aspects of Capital Budgeting
Capital Budgeting involves:
Committing significant resources.
Planning for the long term: 5 to 50 years.
Decision making by senior management.
Forecasting long term cash flows.
Analyzing risk.

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Importance of Capital Budgeting
• Huge Sum
• Irreversible
• Complex Task
• High Risk
• Concerned with Profitability

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 Types of Projects
• Expansion
• Substitution of Machinery for Labour
• Introduction of the New Product
• Replacement
• Change in Production Process

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• Capital budget models using net cash inflow
from operations are:
– payback
– accounting rate of return
– net present value
– internal rate of return

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 Payback...
– is the length of time it takes to recover, in
net cash inflows from operations, the rupees
of capital outlays.
• An increase in cash could result from an
increase in revenues, a decrease in
expenses, or a combination of the two.
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 Payback Example
• Assume that ABC Co. is considering the
purchase of a machine for Rs.200,000, with
an estimated useful life of 8 years, and zero
predicted residual value.
• Managers expect use of the machine to
generate Rs.40,000 of net cash inflows from
operations per year.

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 Payback Example
• How long would it take to recover the
investment?
• Rs.200,000 ÷ Rs.40,000 = 5 years
• 5 years is the payback period.

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 Accounting Rate of Return...
– measures profitability.
• It measures the average return over the life
of the asset.
• It is computed by dividing average annual
operating income by the average amount of
investment in the asset.
• ARR = Avg. net profit / Avg. net
investment

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 Accounting Rate of Return
Example
• Assume that a machine costs Rs.200,000, has no
residual value, and has a useful life of 8 years.
• How much is the straight-line depreciation per
year?
• Rs.25,000
• Management expects the machine to generate
annual net cash inflows of Rs.40,000.

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 Accounting Rate of Return
Example
• How much is the average operating
income?
• Rs.40,000 – Rs.25,000 = Rs.15,000
• How much is the average investment?
• Rs.200,000 ÷ 2 = Rs.100,000
• What is the accounting rate of return?
• Rs.15,000 ÷ Rs.100,000 = 15%

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 Discounted Cash-Flow Models
• Discounted cash-flow models take into
account the time value of money.
• The time value of money means that a rupee
invested today can earn income and become
greater in the future.
• These methods take those future values and
discount them (deduct interest) back to the
present.
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 Net Present Value
• The (NPV) method computes the expected
net monetary gain or loss from a project by
discounting all expected cash flows to the
present.
• The amount of interest deducted is determined
by the desired rate of return.
• NPV = Discounted Cash Flow - Investment

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 Net Present Value Example
• ABC Co. is considering an investment of
Rs.450,000.
• This proposed investment will yield
periodic net cash inflows of Rs.225,000,
Rs.230,000, and Rs.210,000 over its life.
• ABC Co. expects a return of 16%.
• Should the investment be made?

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 Net Present Value Example

Periods Amount PV Factor Present Value

0 450,000 1.000 450,000
1 225,000 0.862 193,950
2 230,000 0.743 170,890
3 210,000 0.641 134,610
Total PV of net cash inflows Rs.499,450
Net present value of project Rs. 49,450

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 Internal Rate of Return...
– is another model using discounted cash
flows.
• The internal rate of return (IRR) is the rate
of return that a company can expect to earn
by investing in a project.
• The higher the IRR, the more desirable the
investment.

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 Internal Rate of Return
• The IRR is the rate of return at which the
net present value equals zero.
• Investment = Expected annual net cash
inflow × PV annuity factor
• Investment ÷ Expected annual net cash
inflow = PV annuity factor

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Internal Rate of Return Example
• Assume that ABC Co. is considering
investing Rs.500,000 in a project that will
yield net cash inflows of Rs.152,725 per
year over its 5-year life.
• What is the IRR of this project?
• Rs.500,000 ÷ Rs.152,725 = 3.274 (PV
annuity factor)

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Internal Rate of Return Example
• The annuity table shows that 3.274 is in the
16% column for a 5-period row in this
example.
• Therefore, 16% is the internal rate of return
of this project.
• If the minimum desired rate of return is 16%
or less, ABC Co. should undertake this
project.
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 Profitability Index
. The PI, also called the benefit-cost ratio, is
the ratio of present value to cost. The
profitability index rule is to take an
investment if the index exceeds 1.0. The PI
measures the present value per dollar
invested.
PI = Discounted cash flow / Investment

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 Capital Rationing
• Capital we know is a scarce factor , it is
obtained at cost. It is therefore, quite natural
that the selection of the investment proposal
should be done in a manner that the rate of
return on investment exceeds the cost of
capital.

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 Capital Rationing Example
Name Investment Rate of Total
Return Return
A 2,00,000 17.5% 35000
B 2,00,000 17% 34000
C 8,00,000 16.5% 1,32,000
D 3,00,000 16% 48,000
E 3,00,000 18% 54,000
18,00,000 3,03,000 25
 Capital Rationing Example
• 18,00,000 is the total investment
• 3,03,000 is the earning per year

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 Finally
• Pay Back Method is for time period
• ARR is to take out percentage
• NPV is for Negative or Positive
• PI should not be less than one

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 Prepared by
• Rakshit Gandhi
• Ankit Khanderiya
• Digesh marsoniya
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Thank You…

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