CAPITAL BUDGETING

SIVAKUMAR P
 Meaning & nature of CB
• It is process of taking investment decisions
in capital expenditures
• It is an expenditure the benefits of which
are expected to be received over a period
of time exceeding one year
• Expenditure is incurred at one point of
time whereas benefits are realized at
different points of time
• It is the expenditure incurred for acquiring
or improving the fixed assets
• Cost of acquisition of permanent assets as
land & Building, plant & machinery, goodwill
• Cost of addition, expansion, improvement or
alteration in the fixed assets
• Cost of replacement of permanent assets
• Research and development project cost
 features
• It involve exchange of current funds for the future
benefits
• The future benefits are expected to be realized
over a series of years
• The funds are invested in non flexible and long
term activities
• It has a significant effect n the profitability of the
concern
• They are irreversible decisions and huge funds
• They are strategic investment decisions
 Capital budgeting process
• Identification of investment proposals
• Screening the proposals
• Evaluation of various proposals
• Fixing priorities
• Final approval & preparation of capital
expenditure budget
• Implementing proposal
• Performance review
 Kinds of Capital budgeting
decisions
• 1. Accept /reject decisions

• 2.Mutually exclusive decisions

• 3. Capital rationing
 Methods of capital budgeting
• Pay – back method
• Rate of return method( accounting method)
• Net present value method
• Internal rate of return method
• Profitability index method
 Pay- back method
• It measures the period of time the cost of
the project to be recovered from the
additional earnings of the project
• The length of time taken to repay the
initial capital cost
• In this method investment with a shorter
payback method is preferred to the one
which has longer pay back period
 methodology
• Calculate annual net earnings( profits)
before depreciation & after taxes
• It is known as Annual cash inflows
• Divide the initial outlay of the project by
constant annual cash inflows
• When annual cash flows are unequal then
add annual cash inflows until total is equal
to initial cash out lay
 Work outs
1. A project cost Rs.1,00,000 & yields an
annual cash flow of 20,000 for 8 years
2. Capital expenditure is Rs. 10,000. The cash
inflows are Rs 2000,4000,3000 & Rs 2000 in
the I,II,III & IV year respectively
3. A project cost Rs.5lakh & yields annually a
profit Rs 80000 after depreciation of 12% p.a
but before tax of 50%
 Improved PB Method
• It taken into account returns receivable after
payback period
• Post Payback profitability index
PPB PI = post pay back profits X 100/investment
 Rate of Return method
• It take into account the earning expected
from the investment over their whole life
• Accounting Rate of return
• Projects are ranked according to their rate
of return
• This method is also used to accepting or
rejecting a proposal
 Average Rate of Return
• total profit( after T&D) X 100
• ARR = Net investment X No years

• Average Annual Profit X 100

• ARR = Net investment
 Work out
• A project requires an investment of Rs.5,00,000
& has a scrap value of Rs.20,000 after 5 years.
It is expected to yield profits after depreciation
& taxes during the 5 years amounting to Rs
40,000,Rs 60,000, Rs 70,000, Rs 50,000 &
20,000
• Calculate average return on investment
 solution
• Total profit = 40,000 + 60,000+ 70,000 +
50,000 + 20,000 =
2,40,000
• Average profit = 2,40,000/5 = 48,000
• Average Annual Profit X 100
• ARR = Net investment
• = 48,000 X 100 /4,80,000 = 10%
 Return per unit of Investment
• total profit(after T& D)
• Formula = Net investment

• = 2,40,000 X 100 = 50%

• 4,80,000
 The Return on Average
Investment
• Total profit(after T&D) X 100
• RAI = Total Net investment/2

• RAI = 2,40,000 X 100

• 4,80,000/2
• = 100%
 Average Return on Average
Investment
• Average Annual Profit(afterT&D)
• ARAI = Average Investment

• Average investment = Net investment/2

• 48,000 X 100
• = 4,80,000/2
• = 20%
 NET PRESENT VALUE
• Consideration of time value of money
• Determination of interest rate(cut off or
discount rate)
• Compute the present value of total
investment outlay – cash outflows @
discount rate
• Compute present values of total
investment proceeds i.e., cash
inflows(PBDAT)
 Net Present Value
• The difference between the market value of
a project and its cost
• Discounted Cash Flow (DCF) Valuation:
– The first step is to estimate the expected future
cash flows.
– The second step is to estimate the required
return for projects of this risk level.
– The third step is to find the present value of the
cash flows and subtract the initial investment.
• Calculate NPV
• = present value of cash inflows minus
present value of cash out flows
• If NPV = zero- inflows = out flows
• If NPV = +ive- inflows > out flows
• If NPV = --ive- inflows < out flows
• Accept or reject
 Net Present Value
DECISION RULE:
DECISION RULE: Invest
Invest
in capital
in capital assets?
assets?

Is NPV
Is NPV positive?
positive? Is NPV
Is NPV negative?
negative?

Invest
Invest Do not
Do not invest
invest

22
 Net Present Value
Future Value
PV = -----------------
(1 + i)n
Where i = interest rate
n = number of years

• The PV of Re1 @ 10% in 1 years time is 0.9090

• If you invested 0.9090p today and the interest rate was
10% you would have Re1 in a year’s time
• Process referred to as:
‘Discounting Cash Flow’
 Computing NPV for the Project
• You are looking at a new project and you have
estimated the following cash flows:
– Year 0: CF = -165,000
– Year 1: CF = 63,120;
– Year 2: CF = 70,800;
– Year 3: CF = 91,080;
• Your required return for assets of this risk is 12%.
• NPV = 63,120/(1.12) + 70,800/(1.12)2 +
91,080/(1.12)3 – 165,000 = 12,627.42
• Do we accept or reject the project?