Capital Budgeting

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 1. Financing (procurement of fund)
Finance
2. Investment (utilization of fund)
decisions of 3. Working capital decisions
the firm 4. Dividend (distribution of fund)
 It is the process of planning for
purchases of long-term assets.

Capital
Budgeting The decision-making process by
which, firms evaluate the purchase
of major fixed assets, including
buildings, machinery, equipment,
etc.
 Types of Assets

Two types of assets

1. Short Term or Current Assets
2. Long Term or Fixed Assets

5
 Investment Decisions

There are 2 types of investment

decisions.

1. First type of decisions relate to

short term assets – are called
short term investment decisions

2. Second type of investment

decisions relate to long term
assets are called long-term
investment decisions. These
long-term decisions are nothing
but the Capital Budgeting
decisions. 6
Importance of Capital Budgeting
Large Investment

Long-term commitments of Funds

Irreversible Nature

Long-term effect on profitability

Difficulties of Investment Decisions

 Complexities in Capital Budgeting

Measurement Uncertainty Change in Difficulty in

Problems Environment calculation of
benefits
 Investment Screen
proposals proposals

Evaluate
various Fix priorities
Capital proposals

Budgeting
Process Final approval
Implement the
proposal

Review
performance
Techniques of Capital Budgeting
Time-Adjusted Method
Traditional
Or
Method Discounted Method

Net Present Value

Pay-back Period
Internal Rate of Return

Accounting Rate of
Return Profitability Index
 Calculation of Net Cashflows
Sales = xxxxx
Less: Expenses (includes Depreciation) = xxxx
Profit Before Interest and Tax (PBIT) = xxxxx
Less: Interest = xxxx
Profit Before Tax (PBT) = xxxx
Tax = xxxx
Profit After Tax (PAT) = xxxx
Add: Depreciation = xxxx
Net Cash Inflows = xxxx
 Payback Period

It measures the period of time

for the original cost of a project
to be recovered from the
additional earnings of the
project itself.
 Decision Rule
< the predetermined cut-off:
Accept
> the predetermined cut-off:
Reject
Formula for Even Payback period =
Cash Flows
 Even and Uneven Cashflows

Year Even Cashflows Uneven Cashflows

1 10000 10000

2 10000 12500

3 10000 17000

4 10000 21000

5 10000 18000
 Example – 1

A project costs ₹1,00,000 and

yields an annual cash inflow of
₹20,000 for 8 years. Calculate
its pay-back period.
 Example – 2

Company ABC Ltd. is planning to undertake a project

requiring initial investment of ₹1,05,000. The project
is expected to generate ₹25,000 per year in net cash
flows for 7 years. Calculate the pay-back period of the
project.
 A project costs ₹5,00,000 and yield
annually a profit of ₹80,000 after
Example – 3 depreciation @12% p.a., but before tax
of 50%. Calculate the pay-back period.
Example – 4
A company wants to increase the production for a period, and it is considering to
purchase automatic machine or ordinary machine (lifetime 8 years).
Cost of automatic machine – ₹2,24,000
Cost of ordinary machine – ₹60,000
From the following information, calculate payback period and suggest which
machine is preferable.
Particulars Automatic Ordinary
Sales (₹) 1,50,000 1,50,000
Expenses:
Materials (₹) 50,000 50,000
Wages (₹) 12,000 60,000
Overheads (₹) 24,000 20,000
Formula for Un-even Cash Flows

https://www.youtube.com/watch?v=tPeku7Rw_Ts
 Company A is planning to
undertake a project requiring
initial investment of ₹5,00,000
and is expected to generate
₹1,00,000 net cash flow in
Example – 5 Year 1, ₹1,30,000 in Year 2,
₹1,60,000 in year 3, ₹1,90,000
in Year 4 and ₹2,20,000 in Year
5. Calculate the pay-back
value of the project.
Example – 6
There are two projects X and Y. Each project requires an investment
of ₹20,000. You are required to rank theses project according to
the pay-back method from the following information.

Project X Project Y
Years
(₹) (₹)
1 1000 2000
2 2000 4000
3 4000 6000
4 5000 8000
5 8000 -
Example – 7
There are two projects X and Y. Each project requires an
investment of ₹20,000. You are required to rank theses project
according to the pay-back method from the following
information.
Project X Project Y
Years
( ₹) (₹)
1 1000 8000
2 2000 5000
3 4000 4000
4 5000 2000
5 8000 1000
 If a project requires ₹2,00,000 initial
investment and annual cash flows
after deducting depreciation before
providing taxation are as follows.
Year 1 – ₹1,00,000
Example – 8 2 – ₹2,00,000
3 – ₹80,000
4 – ₹80,000
5 – ₹40,000
Depreciate project by 20% and tax
rate 50%. Calculate Payback Period.
 Particulars Project X Project Y
Cost of machinery (₹) 600000 1000000
Life of the project 10 y 12 y
Additional cost of supervision (₹) 48000 64000
Example – 9 Additional cost of machinery (₹) 24000 44000
Indirect cost of wages (₹) 24000 32000
Estimated savings
Number of workers 150 200
Wage per worker (₹) 2400 2400
 Particulars Project - X Project - Y
Cost of machine (₹) 15000 24000

Lifetime 5y 6y

Cost of indirect material (₹) 800 900

Savings in wages (₹) 9000 12000

Example – 10 Cost of maintenance (₹) 500 1000

Cost of supervision (₹) 1200 1600

Tax rate 50% 50%

Depreciation method Straight line Straight line

 Payback Period - Merits and Demerits

– Way of resolving risks in

projects
– Emphasis on liquidity
– Ignores Time Value of
Money
– Ignore cash flows beyond
Payback Period
– Inability to handle multiple
cash out flows
 Accounting Rate of Return
The return on investment on a project which is measured as
the project’s average profits on its average investments.
• Average investment Method

ARR = (Average profit / Average Investment) x 100

• Net Investment Method

ARR = (Average profit / Net Investment) x 100

Average Investment = (Initial Investment + Closing Investment)/2

Average Profit = Profit of all years/No. of years

Net Investment = Investment – Scrap Value

 Example – 11
A project requires an investment of ₹4,00,000 and
has a scrap value of ₹40,000 after six years. It is
expected to yield profits after depreciation and taxes
during the six years amounting to ₹46,000, ₹75,000,
₹60,000, ₹64,000, ₹60,000 & ₹55,000. Calculate ARR.
 Solution
Total Profits = ₹46,000+₹75,000+₹60,000
+₹64,000+₹60,000+₹55,000 = ₹3,60,000
Average Profit = ₹3,60,000/6 = ₹60,000
Net Investment = ₹4,00,000-₹40,000 = ₹3,60,000

ARR = (Average Annual Profit / Net Investment) x 100

= (60000/360000)*100
= 16.16%
 Treatment of Scrap and Working Capital

Net Average Investment =

((Initial Investment-Scrap Value)/2) + Working Capital + Scrap

Example – 12
X Ltd. is considering the purchase of a machine. Two machines are available
A & B. The cost of each machine is ₹60,000. Each machine has an expected
life of 5 years. Net profits before tax and after depreciation during the
expected life of the machine are given below.
Year Machine A (₹) Machine B (₹)
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000
5 10,000 20,000
Following the method of Average Return on Average Investment ascertain
which of the alternatives will be more profitable. The average rate of tax
may be taken at 50%.
 Example – 13
Determine the Average Rate of Return from the following data of two projects A & B.
Particulars Project A Project B
Machine value (₹) 10,00,000 15,00,000
Working capital (₹) 5,00,000 5,00,000
Scrap 10000 10000
Lifetime 4 years 6 years
Tax 50% 50%
Income before Tax and Dep. ( ₹) (₹ )
Year 1 8,00,000 15,00,000
Year 2 8,00,000 9,00,000
Year 3 8,00,000 15,00,000
Year 4 8,00,000 8,00,000
Year 5 - 6,00,000
Year 6 - 3,00,000
 ARR – Merits and Demerits
• It consider the total earnings from the project during its entire economic
life.
• Gives due weight to the profitability of the project.
• In investment with extremely long lives, the simple rate of return will be
close to the true rate of return.
• It ignores the time value of money.
• It ignores the reinvestment potential of a project.
• Different methods are used for accounting profit. So, it leads to some
difficulties in the calculation of the project.
 Net Present Value
Net Present Value (NPV) Method

evaluates cash flows on discounted basis

after due consideration to the time value

of money and riskiness of the cash flows.

 Decision Rule

Accept - Reject -
If NPV is If NPV is
positive negative
 Example – 14
A project requires ₹200000 investment and the cash inflows are
estimated as follows.

Year 1 2 3 4 5
Cash flows 40,000 60,000 70,000 60,000 50,000

Calculate the project’s Net Present Value and offer your

suggestion. Assumed cost of Capital is 10%.
 Example – 15
An initial investment of ₹8,320 on plant and machinery is
expected to generate net cash flows of ₹3,411, ₹4,070, ₹5,824
and ₹2,065 at the end of first, second, third and fourth year
respectively. At the end of the fourth year, the machinery will be
sold for ₹900. Calculate the net present value of the investment if
the discount rate is 10%. Round your answer to nearest value.
 Example – 16
A company is considering investment in a project that costs
₹1,50,000 and at the end of 1st year ₹30,000. The salvage value at
the end of the 5th year of the project is ₹40,000. The expected cash
flows for 1st year ₹20,000, 2nd Year ₹30,000, 3rd Year ₹60,000, 4th Year
₹80,000 and 5th Year ₹30,000. You are required to calculate NPV at
12% discounting factor and advise the company on the investment.
Example – 17
 Example – 18
A company is considering two alternatives to the present machine. The following information is available
in respect to the machines.
Particulars Present Machine Machine – A Machine – B
Book Value (₹) 50000 - -
Resale Value (₹) 55000 - -
Purchase Price (₹) - 90000 100000
Fixed Cost (incl. depreciation) (₹) 46000 54000 66000
Variable cost per unit (₹) 1.5 0.75 1.25
Units produced per hour 8 8 12
Annual operating hours 2000 2000 2000
Selling price per unit (₹) 10 10 10
Material cost per unit (₹) 5 5 5
Life of each machine 5 years 5 years 5 years

Straight line method is considering to calculate deprecation (use book value if available). Rate of tax is
50%. Discounting factor is 9%. You are required to calculate NPV and advise the company.
 NPV - Merits and demerits
• It recognizes the time value of money.
• It considers the total benefits arising out of the proposal.
• It is the best method for the selection of mutually exclusive
projects.
• It helps to achieve the maximization of shareholders’ wealth.
• It is difficult to understand and calculate.
• It needs the discount factors for calculation of present values.
• It is not suitable for the projects having different effective lives.
 Internal Rate of Return
(IRR) of the project is that
rate of return at which the
net present value is zero.
Internal Rate of
Return
Decision Rule

ACCEPT IF IRR
> COST OF CAPITAL
REJECT IF IRR
< COST OF CAPITAL
 IRR

• Where Cash inflows are uniform:

– Factor = I/C
• I = Original Investment
• C = Cash inflow per year
 IRR

When Cash flows are Uneven

Low NPV at Low discounting factor

Differences
discounting + ------------------------------------------------------------- x
IRR = factor PV at Low discounting factor - PV at High
in Rates
discounting factor
 IRR - Merits and demerits
• It consider the time value of money.
• It takes into account the total cash inflow and outflow.
• It does not use the concept of the required rate of return.
• It gives the approximate/nearest rate of return.
• It involves complicated computational method.
• It produces multiple rates which may be confusing for taking
decisions.
• It is assume that all intermediate cash flows are reinvested at the
internal rate of return.
 Example – 19
ABC Ltd., have various projects and one of the project is
doing poorly and is being consider for replacement.
The company is considering two mutually exclusive
projects and investment of Project A is ₹1,20,000 and B
is ₹1,80,000. Cash flows of project ‘A’ ₹40,000 and
project ‘B’ ₹58,000 for 5 years. Calculate IRR and offer
your suggestions.
 Example – 20
X Ltd., is considering a project and expected returns are as
follows.
Year 1 2 3 4 5
Yield (₹) 80,000 80,000 90,000 90,000 75,000
Cost of machinery is ₹2,00,000 and the depreciation rate is
20% per annum on WDVM. Income Tax rate is 50%. Calculate
IRR and suggest to consider the project.
 Profitability Index (PI)
The major drawback of NPV method that does not give
satisfactory results while evaluating the projects requiring
different initial investments. PI method provides solution to this.
Present Value of Cash Inflows
Profitability Index = -----------------------------------
Present Value of Cash Outflows
Or
Present Value of Cash Inflows
Profitability Index = -----------------------------------
Initial Cash Outlay
Decision Accept - if PI > 1

Rule Reject - if PI < 1

 Example – 21
ABC Ltd., considering to purchase a project from two available projects
and each costs ₹30,000. Cost of Capital is 15%. Life span 5 years. Net
cash flows are as follows.
Year 1 2 3 4 5
X (₹) 10,000 10,000 10,000 10,000 10,000
Y (₹) 5,000 5,000 10,000 20,000 10,000
You are required to Calculate and suggest which project should be
suggestable under the following methods.
1. NPV
2. IRR
3. Profitability Index (PI)
 Example – 22 (all methods)
From the following information calculate all capital budgeting
methods and offer your suggestion to each method.
Initial Outlay ₹200000 Scrap 10%
Tax 35% Depreciation SL method
Cash inflows Year 1 50000
Year 2 95000
Year 3 70000
Year 4 55000
Year 5 NIL
Discounted Pay-back Period Method
 Example - 23
Using the information given below, compute the Pay-back period under (a) traditional
and (b) discounted pay-back method.
Initial Outlay - ₹80000
Estimated Life – 5 years
Profit after tax: year -1 ₹ 6000
year -2 ₹14000
year -3 ₹24000
year -4 ₹16000
year -5 ₹ 0
Depreciation has been calculated under straight line method. The Cost of capital may be
taken at 20%.
 Risk Adjusted
Capital Budgeting
Techniques
 Risk Vs. Uncertainty
• Risk is when the odds or probabilities of future events
can be estimated.
• Uncertainty is when the list of possible future events
is unknown, so their odds of occurring cannot be
estimated.
 • Expected economic life of the project
• Salvage value of the asset at the end
of the economic life
Future
• Capacity of the project
cashflows • Selling price of the product
estimated • Production cost
based on • Depreciation rate
• Rate of taxation
• Future demand of the product, etc.
 Methods
Risk adjusted cut off rate or Method of varying discount rate

Certainty Equivalent Method

Sensitivity Technique

Probability Technique

Standard Deviation Method

Co-efficient of Variance Method

Decision tree analysis

 The cut off rate or minimum
Risk adjusted required rate of return is raised by
adding what is called 'risk
cut off rate premium' to it.
or
Method of Example:
varying • Cost of capital 10%
discount rate • Risk premium rate 2%
• Discounting factor (10% + 2%) 12%
Example – 24
Solution
 Certainty Equivalent
Method
• It is a method in which uncertain cash
flows are converted into certain cash flows
by multiplying with probability of
occurrence such cash flows.
• Certainty coefficient assumes value
between 0 and 1. 
 Example – 25
In below table 4 years cash inflows and certainty coefficient are given
which shows the probability of occurrence of cash flows.
Year Cash inflows Certainty Coefficient
1 28,000 0.8
2 32,000 0.6
3 46,000 0.4
4 58,000 0.2

The initial cost of investment is ₹65,000 and the discount rate is 8%

annually. Find out the NPV with the help of certainty-equivalent
method.
 Solution
Year Cash Certainty Certain-Equivalent Discount Present
inflows Coefficient Cash flows Rate 8% Value
1 28,000 0.8 22400 0.926 20,740.74
2 32,000 0.6 19200 0.857 16,410.26
3 46,000 0.4 18400 0.794 14,603.17
4 58,000 0.2 11600 0.735 8529.41
Total 60,283.58

NPV = Present cash inflows-Cash outflows

= ₹(60,283.58-65,000)
= - ₹4,716.42
Sensitivity Technique
• Cash inflows are very sensitive
under different circumstances,
more than one forecast of the
future cash inflows may be made.
• These inflows may be regarded as
– Optimistic
– Most likely
– Pessimistic
• Under these circumstances, cash
flows are calculated.
Example – 26
Solution
 It is the relative frequency with
which an event may occur in
the future.

Probability Cashflows are multiplied with

the assigned probability values
Technique to get monetary value.

Monetary value multiplied with

PV factor values to get present
values.
Example – 27
Solution
 Standard Deviation Method
• If two projects have the same cost and their NPVs are also
same, standard deviations of the expected cash inflows of the
two projects may be calculated to judge the comparative risk
of the project.
• The projects having a higher standard deviation is said to be
riskier as compared to other.
Example – 28
Solution
 Coefficient of Variation Method
• It is a variation is a relative measure of dispersion.
• If the projects have the same cost but different net present
values, relative measure i.e., coefficient of variation should be
computed to judge the relative position of risk involved.
 Decision Tree Analysis
• It is a graphic representation f the relationship between a
present decision and future event, future decisions and their
consequences.
Example – 29
Solution (1/2)
Solution (2/2)
 Sources
• Shashi K. Gupta, RK Sharma & Neeti Gupta (2018). Financial
Management. Kalyani Publishers.
• SP Jain & KL Narang (2018). Cost and Management
Accounting. Kalyani Publishers.
Thank You