Capital Budgeting

Should we
build this
plant?

Dr. Akshita Arora

IBS-Gurgaon
What is Capital Budgeting?
 Is it worth to put money into a project?

 Is
it worth to use money to buy new
machine?

 Is
it worth to invest money in this
business?
 Capital Budgeting Decisions

 Decision to invest the funds for addition,

modification or replacement of fixed assets.
 Allocation of investible funds to different long-
term assets.
 Involve cash outlays in return for a stream of
benefits in the future years.
 Success and failure of any business depends on
how available resources are being utilized.
 Examples-
 Purchase of fixed assets;
 Diversify into new product line;
 Invest into new project etc.
Significance
 Substantial Commitment of funds
 Gap between investment and
estimated returns
 Long-term Implications
 Irreversible Decisions
 Ability to compete
Techniques of Evaluation
Capital Budgeting
Techniques

Discounting
Non-Discounting
Net Present Value
Pay-back Period
Profitability Index
Internal Rate of
Accounting Return
Rate of Return
Pay-back Period
 Length of time required to recover the initial
cost of project.
 No. of years required for the proposal’s
cumulative cash inflows to be equal to its cash
outflows.
 Indication of liquidity
 Method of capital recovery rather than a
measurement of profitability.
 Decision rule:
 comparison with pre-determined PB period.
 Calculate Payback period?
 Initial Investment : Rs. 40,000
 Cost of capital: 10%
Year Cash Flows
1. 7000
2. 7000
3. 7000
PB = 5.62 years
4. 7000
5. 7000
6. 8000
7. 10000
8. 15000
9. 10000
10. 4000
Accounting Rate of Return
 Annualized net income earned on the average
funds invested in a project.
 ARR = Average annual profit (after tax) * 100

Average investment
 Based on accounting profit rather than cash
flows.
 Decision rule:
 comparison with pre-determined ARR
 Calculate ARR
Year B. V of Profit after tax
investment
1 Rs. 90,000 Rs. 20,000

2 80,000 22,000

3 70,000 24,000

4 60,000 26,000

5 50,000 28,000

ARR = 34%
 Cash Flows

Cash
CashOutflows
Outflows Cash
Cash Inflows
Inflows
(Cost) (Benefit)

Cash outlay
Cash-oriented
measures of return
generated by the
investment
 Net Present Value (NPV)

 Weighs the elements of trade-off between

investment costs and future benefits in equivalent
terms

NPV = P.V of cash inflows

n
– P. V of cash outflows
CFi
NPV  i 1 (1  k ) i
C

 Decision Rule:
 NPV > 0 , Accept the proposal
 NPV < 0 , Reject.
Calculation of Cash Outflows
 Cost of New Machinery/Project
(+) Installation cost
(+) Transportation cost
(+) Any other cost(s)
(-) Proceeds from sale of existing old
machine
(+) Increase in working capital
(-) Decrease in working capital
 Calculate NPV
 Initial Investment : Rs. 40,000
 Cost of capital: 10%
Year Cash Flows
1. 7000
2. 7000
3. 7000
4. 7000
5. 7000
6. 8000
7. 10000
8. 15000
9. 10000
10. 4000
 Solution

Year Cash Flows PVF@10% P.V of Cash

flows
1. 7000 0.909 6363
2. 7000 0.826 5782
3. 7000 0.751 5257
4. 7000 0.683 4781
5. 7000 0.621 4347
6. 8000 0.564 4512
7. 10000 0.513 5130
8. 15000 0.467 7005
9. 10000 0.424 4240
10. 4000 0.386 1544
Total 48,961
 Calculation of NPV
 NPV = Benefits – Costs (in equivalent terms)
= P.V of Cash Inflows – P.V of Cash Outflows
= 48,961- 40,000
= Rs. 8,961

Decision: Accept the proposal

Critical Evaluation
 Advantages-
a) Considers time value of money.
b) Considers entire cash inflow stream and
outflows irrespective of their time of
occurrence.
c) Represents net contribution of a proposal
towards wealth of the firm.
 Limitations-

a) Involves tedious calculations.

b) Requires pre-determination of required rate
of return.
Profitability Index/ Benefit Cost ratio
 Variant of NPV technique.
n
CFi
PI  
i 1 (1  k ) i
/C

 PI = P.V of cash inflows

P.V of cash outflows
= 48,961 = 1.22
40,000
 Decision Rule:
 PI > 0 , Accept the proposal
 PI < 0 , Reject.
Internal Rate of Return
 Discount rate which produces zero NPV or which
equates P.V of cash inflows with P.V of cash outflows.
 Future cash flows are discounted in such a way that
their total P.V is just equal to P.V of total cash
outflows.
 Symbolically, IRR is the value of k in the following
equation:
n
CFi
CO  i 1 (1  k ) i

 Decision Rule:
 IRR > Cut-off rate, Accept the proposal
 IRR < Cut-off rate, Reject.
 Calculate IRR
 A firm is evaluating a proposal costing Rs.
1,00,000 and having annual inflows of Rs.
25,000 occurring at the end of each of next 6
years. There is no salvage value. Calculate IRR
IRR = L + A (H - L)
of the proposal.
A-B
where,
L – lower discount rate, at which NPV is
positive,
H – higher discount rate, at which NPV is
negative,
A- NPV at lower discount rate
B- NPV at higher discount rate
IRR = 12.98%
 Calculate IRR
 A firm is evaluating a proposal costing Rs.
1,60,000 and expected to generate cash
inflows of Rs. 40,000, Rs. 60,000, Rs. 50,000,
Rs. 50,000 and Rs.40,000 occurring at the end
of each of next 5 years. There is no salvage
value thereafter. Calculate IRR of the
proposal.
IRR = 15.40%
 NPV vs IRR
NPV
 Shows expected increase
in the shareholders’
wealth.
 Gives clear-cut accept-
reject decision rule.
 NPV of different projects
are addictive.
 Helpful in case of mutually
exclusive projects
 NPV gives better ranking.
IRR
 Gives results in %.
 IRR may give multiple
results.
 IRR of two projects are
not addictive.
 It assumes that future
cash flows are
reinvested at a rate
equal to IRR.
 Tends to be biased
towards smaller
projects which are
Calculation of Cash Inflows (CFATs)
 Earnings before Depreciation & Tax *****
(-) Depreciation ****
Earnings before Tax *****
(-) Tax ***
Earnings after Tax *****
(+) Depreciation ****
Cash Flow After Tax (CFAT) *****
(*) Discount Factor (PVF) ***
Present Value of CFAT *****
 Question
 A co. is engaged in evaluating an investment project
which requires an initial cash outlay of Rs.2,50,000 on
equipment. The project’s economic life is 10 years and
its salvage value is Rs.30,000. The project is expected
to yield annual profit (before tax) of Rs. 1,00,000. The
co. follows SLM method of depreciation. Income tax
rate is assumed to be 40%. Should the project be
accepted if the minimum required rate of return is
20%.
 Question
Axora Ltd. has a machine having an additional life of 5
years which costs Rs. 10,00,000 and has a book value of
Rs. 4,00,000. a new machine costing Rs. 20,00,000 is
available. Though its capacity is the same as that of the
old machine, it will mean a saving in variable costs to the
extent of Rs. 7,00,000 per annum.
The life of the machine will be 5years at the end of
which it will have a scrap value of Rs.2,00,000. The rate
of income-tax is 40% and Axora Ltd.’s policy is not to
make an investment if the yield is less than 12% p.a. The
old machine, if sold today, will realise Rs.1,00,000; it will
have no salvage value if sold at the end of 5th year.
Advise the company whether or not the old machine
should be replaced. Capital gain is tax-free.