CAPITAL BUDGETING

By CA ANIL AGRAWAL
 Techniques of Capital Budgeting

Traditional Techniques/ Discounted Cash Flow

Non Time Adjusted Techniques Techniques/Time Adjusted
Techniques
Accounting Rate of Payback Period
Return (ARR)

Discounted NPV IRR PI or NPVI

Payback Period Benefit- Cost
Ratio

By CA ANIL AGRAWAL
 AVERAGE RATE OF RETURN
• Accounting or Average Rate of Return means the average annual
yield on the project. It is found out by dividing the annual average
profits after taxes by the average investments.
• Step 1: Annual Average Earnings After Taxes =
Total Expected Earnings after Depreciation & Taxes but before Interest
on Long Term Debt during Project period/ Total period of the project

• Step 2: Average Investment= (Opening Investment +

Closing Investment)/2
(Investment is inclusive of working capital)
In case SLM depreciation is used-
Average Investment= ½ (Original cost- Salvage Value) + Salvage Value
+ Working Capital
Average Investment (during project period)= AI1+AI2+ …AIN/N
• Step 3: ARR= Annual Average EAT/ AI x 100

By CA ANIL AGRAWAL
Statement showing Computation of Annual Earnings After
Tax

Particulars
A. Sales Unit
B. Selling Price per unit (Rs.)
C. Sales (A x B)
D. Less: Total costs
Variable Costs
Depreciation
Fixed Costs other than Depreciation
Total Cost
E. Earning before Tax (C-D)
F. Less: Tax
By CA ANIL AGRAWAL
G. Earning after Tax (E-F)
Accept/ Reject Rule
1. Accept the project if ARR> Minimum Acceptable Rate
of Return
2. Reject the project if ARR< Minimum Acceptable Rate
of Return

• Projects should be ranked in the order of ARR and the

project with the highest ARR should be selected.

By CA ANIL AGRAWAL
 Merits & Demerits
• It is easy to understand &
calculate.
• It considers the entire
profits over the entire life
of the projects.
• It uses the accounting
data with which
managers are familiar.
By CA ANIL AGRAWAL
• It ignores the time value
of money.
• It does not use the cash
flows.
• There is no objective way
to determine the
minimum acceptable rate
of return.
Numerical
• Following information is provided:
1. Purchase price of machine Rs. 80000
2. Installation charges Rs. 20000
3. Estimated salvage value at the
end of useful life Rs. 40000
4. Useful Life 4 years
5. Working Capital required Rs. 10000
6. Annual Earnings before
Depreciation and Tax Rs. 65000
7. Tax Rate 30%
Calculate the Accounting Rate of Return if the method
of Depreciation is a) Straight Line Method b) WDV @
20%.
By CA ANIL AGRAWAL
 Numerical
• The following information is provided:
1. Purchase Price of each Machine Rs. 600000
2. Working Capital Rs. 300000
3. Useful Life of each machine 5 years
4. Estimated Salvage Value at the
end of useful life Rs. 100000
5. Method of Depreciation Straight line
6. Tax Rate 30%
7. Earning before Depreciation & Tax:

Machine Year 1 Year 2 Year 3 Year 4 Year 5

Machine X 300000 300000 300000 300000 300000
Machine Y - 100000 200000 300000 1200000
Machine Z 500000 400000 300000 200000 -
Suggest which of the above machine should be purchased on
the basis of Accounting Rate of Return Method.

By CA ANIL AGRAWAL
 CASH FLOW ANALYSIS

The accounting profit is affected by the discretionary

accounting policies of the management whereas
cash flows are not so affected, that is why the cost &
benefits of a project should be measured in terms of
Cash flows and not Accounting profit.
• Cash flows should be considered after tax because
the tax on earnings is considered as cash outflow
and the tax saving on loss/ cost is considered as
cash inflow.

By CA ANIL AGRAWAL
Developing a relevant Information for Cash Flow
Analysis
• Step 1: Estimation of Capital Expenditures
• Step 2: Estimation of Additional Working Capital
• Step3: Estimation of Production & Sales
• Step 4: Estimation of Cash Expenses

By CA ANIL AGRAWAL
 Step 5: Estimation of Cash Inflows
A Sales units
B Selling Price per Unit
C Total Sales ( A x B)
D Less: Variable Cost
E Contribution (C – D)
F Less: Fixed Cost
(a) Fixed Cash Cost
(b) Depreciation
G Earnings before Tax (E – F)
H Less: Tax
I Earning After Tax (G –H)
J Add: Depreciation
K Cash Inflow After Tax (CFAT) ( I + J)
L Add: Release of Working Capital
M Add: Net Cash Salvage Value of Asset
N Add: Tax Saving on Loss on Sales of Asset
OR
ByAsset
Less: Tax on Profit on Sale of CA ANIL AGRAWAL
 PAY BACK PERIOD
Pay Back Period refers to the period within which the
entire cost of the project is expected to be
completely recovered by the way of cash inflows.
Cash inflows means earnings after tax but before
depreciation.
• Computation of Pay Back Period:
1. Equal Annual Cash Inflows:
PBP: Initial Cash Outflows
Annual Cash Inflow

By CA ANIL AGRAWAL
2. Unequal Cash Inflows:

PBP=(year upto which Cumulative CFAT is less than Total Cash Outflow)
Total Cash outflow – Cumulative CFAT of the year in which
+ Cumulative CFAT is less than Total Cash Outflow
CFAT in next year following the year for which for cumulative CFAT
has been considered in numerator

By CA ANIL AGRAWAL
 Computation of CFAT
A Sales units
B Selling Price per Unit
C Total Sales ( A x B)
D Less: Variable Cost
E Contribution (C – D)
F Less: Fixed Cost
(a) Fixed Cash Cost
(b) Depreciation
G Earnings before Tax (E – F)
H Less: Tax
I Earning After Tax (G –H)
J Add: Depreciation
K Cash Inflow After Tax (CFAT) ( I + J)
L Add: Release of Working Capital
M Add: Net Cash Salvage Value of Asset
N Add: Tax Saving on Loss on Sales of Asset
OR
Less: Tax on Profit on Sale of Asset
O Total CFAT for the last year By CA ANIL AGRAWAL
 Computation of Cash Outflow

Particulars
1. Purchase Price of new Machinery
2. Freight, Carriage & Installation Exp.
3. Workers’ Training Exp.
4. Less: Subsidy from Govt.
5. Add: Working Capital
6. Additional Equipment
7. Retrenchment Compensation
8. Less: Tax saving on retrenchment comp.
Total Cash Outflow
By CA ANIL AGRAWAL
 Accept/ Reject Rule

1. Accept the project if PBP< Maximum Acceptable PBP

2. Reject the project if PBP> Maximum Acceptable PBP

• Projects should be ranked in the order of PBP and the

project with the Shortest PBP should be selected.

By CA ANIL AGRAWAL
 Merits & Demerits
• It is easy to understand &
calculate.
• It emphasises liquidity.
• It uses cash flow rather
than accounting data.
• It enables the
management to cope with
associate risk.
By CA ANIL AGRAWAL
• It ignores time value of
money
• It ignores cash flow
occuring after the PBP.
• There is no objective way
to determine the
maximum acceptable
PBP.
• It is not a measure of
profitability
 Numerical
ABC Ltd. provides you the following information:
1. Purchase price of new machinery Rs. 1000000
2. Installation exp. Rs. 150000
3. Workers’ Training Exp. Rs. 50000
4. Subsidy from Govt. 60% of purchase price
5. Working Capital Rs. 300000
6. Useful Life of the machine 5 years
7. Book Salvage value 10% OF purchase price
8. Cash Salvage value Rs. 120000
9. Method of Depreciation Straight Line
10. Tax Rate 30%
11. Sales units 100000 units p.a.
12. Initial selling price per unit is Rs.10 & variable cost is 40% of Initial
selling price. Annual Fixed cost other than depreciation
is Rs. 200000. Calculate the Cash Inflow after Tax, Initial
Cash outflow & Pay Back Period.

By CA ANIL AGRAWAL