Module-3 (A) Capital Budgeting

Module-3
Capital Budgeting
Capital Budgeting
• Capital budgeting is the process of taking long term investment
decisions whose benefits are expected over series of years.
• Example:
(1) Setting up of factories.
(2) Installing a machinery.
(3) Increase in production capacity.
Why are CB decisions are important?
(1) Long term growth and effects
(2) Large amount of funds involved
(3) Risk involved
(4) Irreversible decisions.
Types of CB decisions
(I) On the basis of firm’s existence
A. Replacement decisions
 Replacing fixed assets due to expiry of its economic life.
B. Modernisation decisions
 Replacing fixed assets due to its technological obsolescence.
C. Expansion decisions
 Increasing existing production capacity.
D. Diversification decisions
 Commencing new product/service lines.
Types of CB decisions…….continued
(II) On the basis of decision situation
A. Mutually Exclusive Decisions

 Firm is considering the purchase of machine A or machine B.
B. Accept – Reject Decisions
Project A, B and C are generating returns of 20 %, 18 % and 14 %
respectively. If firm’s minimum rate of requirement is 15 %, then it will
select Project A and Project B.
C. Contingent decisions/Complimentary decisions
If a company accepts a proposal to set up a factory in remote area, then it
may have to invest in building other infrastructure like houses for
employees, roads etc.
Capital budgeting Process
1. Project Planning
2. Project Evaluation
3. Project Selection
4. Project Implementation
5. Project Control
6. Project Review
Techniques of Capital Budgeting
(I) Traditional Techniques
(A) Accounting Rate of Return
(B) Payback Period
(II) Discounted Cash Flow technique

(C) Net Present Value
(D) Profitability Index
(E) Discounted Payback period
(F) Internal rate of return
Average rate of return
• Average rate of return means average annual yield on project.
• Average rate of return = Annual average earning after taxes *100

Average Investment
where,
Average Investment = ½ (Original cost – Salvage Value) + Salvage Value+ Working Capital
Rule:
Accept the project if ARR is greater than and equal to minimum acceptable rate of
return.
Q1. Calculate Average rate of return of project:
Annual Earning after tax
Year Annual EAT
1 35,000
2 40,000
3 30,000
4 35,000
Original cost = Rs. 1,00,000

Salvage Value= Rs. 40,000
Working Capital = Rs. 10,000
Note:
Average rate of return = Annual average earning after taxes
*100
Average Investment
Average Investment = ½ (Original cost – Salvage Value) +
Salvage Value+ Working Capital
Year Annual EAT
1 40,000
2 60,000
3 80,000
4 20,000
Original cost = Rs. 80,000
Installation Charges = 20,000
Salvage Value= Rs. 20,000
Working Capital = Rs. 20,000
Note:
Average rate of return = Annual average earning after taxes *100
Average Investment
Average Investment = ½ (Original cost – Salvage Value) + Salvage Value+
Working Capital
Year Annual EAT
1 50,000
2 75,000
3 25,000
4 50,000
5 50,000

Note:
Average Investment
Working Capital
Year Annual EAT
1 50,000
2 75,000
3 25,000
4 50,000
5 50,000
Salvage Value = 10,000
Note:
Average Investment
Working Capital
Year Annual EAT
1 50,000
2 75,000
3 25,000
4 50,000
5 50,000
Salvage Value = 10,000
Working Capital = 10,000
Average Investment
Working Capital
Assessment
Q6. Calculate Average rate of return on Q7. Calculate Average rate of return on
machine: project:
Annual Earning after tax Annual Earning after tax
Year Annual EAT Year Annual EAT
1 50,000 1 1,25,000
2 75,000 2 1,50,000
3 25,000 3 1,45,000
4 50,000 4 1,55,000
5 50,000 5 1,75,000
6 75000
Cost of Machine = Rs. 5,00,000 Cost of Project = Rs. 10,00,000
Installation Charges = Rs 50,000 Cost of setting up project = Rs 1,00,000
Salvage Value = 20,000 Scrap Value = 15,000
Working Capital = 20,000 Working Capital = 35,000
Payback Period
• Payback period is the number of years required to recover the cost of
project.
In case of Equal Annual Cash Inflows
Payback period = Initial Cash Outflows

Annual Cash Inflow
Q1. Calculate payback period:
Initial investment of project is Rs.1,00,000 Payback period = Initial Cash Outflows
Annual cash inflow after tax is Rs. 25000 Annual Cash Inflow
Life of project is 5 years
Note:

Annual Cash Inflow
Q2. Calculate payback period Particulars Project A Project B Project C
for projects:
Initial C/O 4,00,000 3,50,000 2,80,000
Note: Annual CFAT 1,00,000 70,000 1,40,000

Life of Project 5 years 5 years 5 years
Annual Cash Inflow
Cost of project is Rs.1,00,000
Following are Cash flow after tax:
Year CFAT
1 20,000
2 30,000
3 35,000
4 15,000
5 20,000
Following are Cash inflow after tax:
Year CFAT
1 30,000
2 40,000
3 35,000
4 35,000
5 40,000
Year CFAT
1 30,000
2 40,000
3 35,000
4 35,000
5 40,000
Year CFAT Cum CFAT
1 40,000 40,000
2 60,000 1,00,000
3 85,000 1,85,000
4 1,00,000 2,85,000
5 1,25,000 4,10,000
Year CFAT
1 1,00,000
2 1,20,000
3 1,40,000
4 2,00,000
5 1,50,000
Discounted Payback Period
• It is the period within which the entire cost of the project is expected
to be completely recovered by way of discounted cash inflows.
Q1. Calculate discounted payback period:
Cost of project is Rs.50,000
Cost of capital is 10 %. (Discounting rate)
Year CFAT
1 20,000
2 25,000
3 30,000
4 35,000
5 50,000
Payback Period = 2 + (50000-38830)

22530
= 2.49 years
Q2. Calculate discounted payback period:
Cost of capital is 10 %
Year CFAT
1 25,000
2 50,000
3 75,000
4 100,000
5 50,000
Q3. Calculate discounted payback
period:
Year CFAT
1 1,25,000
2 1,00,000
3 1,75,000
4 2,00,000
5 2,50,000
Net Present Value
• It is very important capital budgeting technique.
• It is defined as the difference between present value of cash inflow
and present value of cash outflow.
NPV = PVCI-PVCO
where, NPV is Net present value of project.
PVCI = Present value of Cash Inflow
PVCO= Present value of cash outflow.
Analysis: If NPV is +, we will accept the project.

If NPV is -, we will reject the project.
If NPV = 0, we may accept or reject the project.
Q1. Calculate the Net present value of
project if
Year CFAT
1 25,000
2 28,000
3 32,000
4 38,000
5 50,000
Q2. Calculate the Net present
value of project if
(Year 0)
Cost of capital is 10 %.
(Discounting rate)
Year CFAT
1 2,00,000
2 3,00,000
3 2,00,000
4 1,50,000
5 2,00,000
Q3. You are appointed as a consultant. You have to advise
company about the selection of project using Net Present Value.
Project A
Cost of project = 9,50,000
Year CFAT
1 2,50,000
2 3,00,000
3 2,00,000
4 2,50,000
5 3,00,000
Project B
Cost of project = 8,50,000
Year CFAT
1 1,50,000
2 2,50,000
3 2,20,000
4 1,75,000
5 2,80,000
Profitability Index
• It is defined as the ratio of present value of cash inflow and present
value of cash outflow.
PI = PVCI
PVCO
where, PI is Profitability Index.
PVCI = Present value of Cash Inflow
PVCO= Present value of cash outflow.
Analysis: If PI > 1, we will accept the project.

If PI < 1, we will reject the project.
If PI = 1, we may accept or reject the project.
Q1. Calculate Profitability Index of a
project:
Year CFAT
1 30,000
2 25,000
3 30,000
4 25,000
5 30,000
Q2. Calculate NPV and profitability index
of a project:
Year CFAT
1 55,000
2 50,000
3 75,000
4 80,000
5 50,000
Q3. You are appointed as a consultant. You have to advise
company about the selection of project using Profitability
Index.
Project A Project B
Cost of project = 9,50,000 Cost of Project = 8,50,000
Year CFAT Year CFAT
1 2,50,000 1 1,50,000
2 3,00,000 2 2,50,000
3 2,00,000 3 2,20,000
4 2,50,000 4 1,75,000
5 3,00,000 5 2,80,000
Q1. Given : Cost of project is Rs.1,00,000
Year CFAT
1 55,000
2 40,000
3 55,000
4 50,000
5 60,000
Calculate :
(1) Payback period
(2) NPV
(3) PI
(4) Discounted Payback Period.
Internal Rate of Return
• Internal rate of return is the rate which equates present value of cash inflow
with present value of cash outflow associated with the project.
• Internal rate of return is the rate at which NPV is zero.
• Internal rate of return is the rate of return earned on the initial investments
made in the project.
• Accept the project. If IRR > Cost of capital.
• IRR = L + NPV L * (H-L)

NPVL-NPVH
NPVL-NPVH
Where,
L = Lower Discounting rate
H= Higher discounting rate
NPVL = Net present value at lower discounting rate
NPVH = Net present value at higher discounting rate
IRR = Internal rate of return
Higher the discounting rate, Lower will be the NPV.

Q1. Calculate Internal rate (i) Calculation of Average annual Cash Inflow
of return.
Year Cash Flow Average Annual Cash Inflow = Total Cash Inflow/n
0 (384000) = 1,50,000 + 1,25,000 + 1,00,000 + 75,000 + 50,000
1 1,50,000 5
= 5,00,000/5 = Rs 1,00,000
2 1,25,000
3 1,00,000
(II) Calculate fake payback period
4 75,000
Fake Payback Period = Cash Outflow/ Average annual cash inflow
5 50,000 = 3,84,000 = 3.84 years
1,00,000
PVIFA (9%, 5 years) = 3.890 (III) Refer PVIFA Table, locate the value 3.84 in 5th year row. We will
PVIFA (10%, 5 years) = 3.791 find that the value lies in between 9 % and 10 %.
After having these two rates, we will find out NPV in such a way
that one NPV should be positive and other NPV should be negative.
Year Cash PVF PVCF PVF PVCF PVF PVCF
Inflow @ @ @
9% 10% 12%
1 150000 0.917 137550 0.909 136350 0.893 133950
2 125000 0.842 105250 0.826 103250 0.797 99625
3 10000 0.772 77200 0.751 75100 0.712 71200
4 75000 0.708 53100 0.683 51225 0.635 47625
5 50000 0.650 32500 0.621 31050 0.567 28350
PVCI 405600 PVCI 396975 PVCI 380750
NPV 9 % = PVCI-PVCO NPV 10 %= PVCI-PVCO NPV12% = PVCI-PVCO

= 405600-384000 = 396974-384000 = 380750-384000
= +21600 = + 12975 = - 3250
NPVL-NPVH
= 10 + 12975 * (12-10)
12975 – (-3250)
= 10 + 12975 *2 = 11.59 %
16225
Q2. Calculate Internal rate of (I) Calculation of Average Annual Cash Inflow
return.
Year Cash Flow
0 (9,00,000)
1 3,80,000 (II) Calculation of Fake Payback Period
2 3,10,000
3 2,40,000
4 1,70,000
(III) Locate fake payback period in PVIFA table, find out
5 4,44,000 discounting rates.
PVIFA (21%, 5 years) = 2.926 (IV) Calculate NPV at both these discounting rates such that one
NPV is positive and other in negative.
PVIFA (22%, 5 years) = 2.864
(V) Apply the formula.
Inflow @ @ @
21 % 22 % %
Q3. Calculate Internal rate of
return.
Year Cash Flow
0 (40,000)
1 13,000
2 8,000
3 14,000
4 12,000
5 11,000
6 15,000
PVIFA (20%, 6 years) = 3.326

PVIFA (21%, 6 years) = 3.245
Inflow @ @ @
20 % 21 % % 19
IRR = L + NPV L * (H-L)
(NPVL-NPVH)
Modified IRR (MIRR)
• It is that rate of compounding which makes the initial cash outflow in zeroth
year equal to the terminal value of the cash inflows.
• Initial Cash Outflow (1+r) nth = Total Terminal Value of the Cash Inflows.
Where,
Terminal Value of Cash Inflow of Year 1 = CI1 (1+k)n-1
Terminal Value of Cash Inflow of Year 2 = CI2 (1+k)n-2
Terminal Value of Cash Inflow of Year 3 = CI3 (1+k)n-3 and so on …..
K= Reinvestment rate
r= Modified Internal Rate of Return.
Accept the project if r ≥ k.
Particulars Year Amount Compounding Compounding Terminal Value
Q1. Calculate Modified IRR (r) Period Factor @10%
using the following information:
Year CFAT CFAT for 1st year 1 2,47,500 3 1.331 329422.5
CFAT for 2nd year 2 2,47,500 2 1.210 299475
1 2,47,500 CFAT for 3rd year 3 2,47,500 1 1.100 272250
CFAT for 4th year 4 6,61,500 0 1 661500
2 2,47,500 Total of 1562647.5
3 2,47,500 terminal
values
4 6,61,500
Cost of capital = 10 %
Cash Outflow = Rs.9,00,000 Initial Cash Outflow (1+r) n = Total Terminal Value of all Cash Inflows
at zeroth year 9,00,000 (1+r) 4= 1562647.5
(1+r) 4= 1562647.5
9,00,000
(1+r) 4= 1.736
0 1 2 3 4
1+r = 1.736 ¼
1+r= 1.14
R= 1.14-1 = 0.14 = 14 %
Particulars Year Amount Compounding Compounding Terminal
Q2. Calculate Modified IRR (r) Period Factor @10% Value
using the following information: CFAT for year 1 1 37,500 3 1.331 49912.5
Year CFAT CFAT for year2 2 1,07,500 2 1.210 130075
CFAT for year 3 3 1,77,500 1 1.100 195250
1 37,500 CFAT for year 4 4 12,91,500 0 1 1291500
2 1,07,500 1666737.5
3 1,77,500
4 12,91,500
Cost of capital = 10 % Initial Cash Outflow (1+r)n = Total of all terminal values of Cash Inflows
9,00,000 (1+r)4 = 1666737.50
Cash Outflow = Rs.9,00,000
(1+r)4 = 1666737.50
at zeroth year 9,00,000
(1+r)4 = 1.851
1+r = 1.851 ¼
1+r = 1.16
0 1 2 3 4 R= 1.16-1 = 0.16 =16 %
Working Notes:
CVF (10 %, 3 year ) = (1+r) 3 = (1+0.10) 3 = 1.331
Particulars Year Amount Compounding Compounding Terminal
Q3. Calculate Modified IRR Period Factor @10% Value
(r) using the following
information: 1 3 1.331
Year CFAT 2 2 1.210
3 1 1.100
1 3,87,500 4 0 1
2 3,17,500
3 2,47,500
4 4,51,500
Cost of capital = 10 %
Cash Outflow = Rs.9,00,000
Initial Cash Outflow (1+r) n = Total Terminal Value of all Cash
at zeroth year Inflows
0 1 2 3 4
Capital Rationing
Capital Rationing is a process where by the limited funds available are
allocated amongst financially viable projects which are not mutually
exclusive under consideration.
Techniques used:
(1) Profitability Index (PI)
(2) Net Present Value (NPV)
Projects
Projects Initial C/O PVCI Life of
Tulsian Ltd having limited funds of Rs. Project
10,10,000 and cost of capital 10 % is AA 50,000 5,00,000 10 years
evaluating the desirability of following BB 1,00,000 9,00,000 10 years
projects. Rank the projects according
CC 1,50,000 12,00,000 10 years
to PI and NPV.
D
D 2,00,000 14,00,000 10 years
EE 2,50,000 16,25,000 10 years
FF 6,00,000 38,40,000 10 years
Given:
Limited Funds: Rs 10,10,000
Cost of Capital 10 %
Rank projects as per PI
Projects Initial C/O PVCI PI Ranking Formula:

(PVCO) as per PI
Profitability Index = PVCI
A 50,000 5,00,000 10 1 PVCO
B 1,00,000 9,00,000 9 2
C 1,50,000 12,00,000 8 3
D 2,00,000 14,00,000 7 4
E 2,50,000 16,25,000 6.5 5
F 6,00,000 38,40,000 6.4 6
Allocate funds as per rank by PI if projects are divisible
Amount Rs 10,10,000
Project Initial C/O PVCI PI Ranking Funds Allocated

s (PVCO) as per PI
INVESTMENT
A 50,000 5,00,000 10 1 50,000
B 1,00,000 9,00,000 9 2 1,00,000
C 1,50,000 12,00,000 8 3 1,50,000
D 2,00,000 14,00,000 7 4 2,00,000
E 2,50,000 16,25,000 6.5 5 2,50,000
F 6,00,000 38,40,000 6.4 6 2,60,000
=10,10,000- 7,50,000 = Rs. 2,60,000
Allocate funds as per rank by PI if projects are indivisible
Amount: Rs. 10,10,000
Project Initial C/O PVCI PI Ranking Funds Allocated

s (PVCO) as per PI
INVESTMENT
A 50,000 5,00,000 10 1 50,000
B 1,00,000 9,00,000 9 2 1,00,000
C 1,50,000 12,00,000 8 3 1,50,000
D 2,00,000 14,00,000 7 4 2,00,000
E 2,50,000 16,25,000 6.5 5 2,50,000
F 6,00,000 38,40,000 6.4 6 -
= 10,10,000- 7,50,00 = Rs. 2,60,000
Rank projects as per NPV
Projects Initial C/O PVCI NPV Ranking Formula:
(PVCO) as per NPV
NPV = PVCI-PVCO
A 50,000 5,00,000 4,50,000 6
B 1,00,000 9,00,000 8,00,000 5
C 1,50,000 12,00,000 10,50,000 4
D 2,00,000 14,00,000 12,00,000 3
E 2,50,000 16,25,000 13,75,000 2
F 6,00,000 38,40,000 32,40,000 1
Allocate funds as per rank by NPV if projects are indivisible
Funds available: Rs. 10,10,000
Projects C, E, F
Project Initial C/O PVCI NPV Ranking Funds Total NPV

s (PVCO) as per NPV Allocated
INVESTMENT
A 50,000 5,00,000 4,50,000 6
B 1,00,000 9,00,000 8,00,000 5
C 1,50,000 12,00,000 10,50,000 4 1,50,000 10,50,000
D 2,00,000 14,00,000 12,00,000 3 2,50,000
E 2,50,000 16,25,000 13,75,000 2 13,75,000
6,00,000
F 6,00,000 38,40,000 32,40,000 1 32,40,000
56,65,000
Allocate funds as per rank by NPV if projects are indivisible
Funds available: Rs. 10,10,000
Projects: A, B, E and F
Project Initial C/O PVCI NPV Ranking Funds Total NPV

s (PVCO) as per NPV Allocated
INVESTMENT
A 50,000 5,00,000 4,50,000 6 50,000 4,50,000
B 1,00,000 9,00,000 8,00,000 5 1,00,000 8,00,000
C 1,50,000 12,00,000 10,50,000 4
D 2,00,000 14,00,000 12,00,000 3
E 2,50,000 16,25,000 13,75,000 2 2,50,000 13,75,000
F 6,00,000 38,40,000 32,40,000 1 6,00,000 32,40,000
58,65,000
• Project C ,E and F NPV = 56,65,000
• Project A, B, E and F NPV = 58,65,000
ABC Ltd having limited funds of Rs. Cash Flows Project A Project B Project C
4,00,000 and cost of capital 10 % is 0 year (3,00,000) (2,00,000) (3,00,000)
evaluating the desirability of following 1 year (1,00,000) (2,10,000) (3,00,000)
projects. Rank the projects according 1year 6,00,000 4,00,000 2,00,000
to PI and NPV.
2 year 2,00,000 4,00,000 10,00,000
Given:
Limited Funds: Rs 4,00,000
Cost of Capital 10 %
CFAT: Cash Inflow after tax
Particulars Year 1 Year 2 Year 3

Sales
Less: Total Cost
(a) Variable Cost
(b) Depreciation
(c) Fixed cost
Earning Before Taxes
Less: Taxes
Earning After Taxes
Add: Depreciation
Cash Inflows After Taxes (CFAT) XXX XXX XXX
Add: Release of Working Capital XXX
Add: Cash Salvage value of Asset XXX
Less: Tax on profit on sale asset XXX
Add: Loss of sale of asset XXX
Total CFAT for the last year XXX

Module-3 (A) Capital Budgeting

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Module-3

A. Mutually Exclusive Decisions

(II) Discounted Cash Flow technique

• Average rate of return = Annual average earning after taxes *100

Original cost = Rs. 1,00,000

Original cost = Rs. 1,00,000

In case of Equal Annual Cash Inflows

Payback period = Initial Cash Outflows

Payback period = Initial Cash Outflows

Note: Annual CFAT 1,00,000 70,000 1,40,000

Payback Period = 2 + (50000-38830)

Analysis: If NPV is +, we will accept the project.

Analysis: If PI > 1, we will accept the project.

• Internal rate of return is the rate at which NPV is zero.

• Accept the project. If IRR > Cost of capital.

• IRR = L + NPV L * (H-L)

Higher the discounting rate, Lower will be the NPV.

NPV 9 % = PVCI-PVCO NPV 10 %= PVCI-PVCO NPV12% = PVCI-PVCO

PVIFA (20%, 6 years) = 3.326

Projects Initial C/O PVCI PI Ranking Formula:

Project Initial C/O PVCI PI Ranking Funds Allocated

Project Initial C/O PVCI PI Ranking Funds Allocated

Project Initial C/O PVCI NPV Ranking Funds Total NPV

Project Initial C/O PVCI NPV Ranking Funds Total NPV

Particulars Year 1 Year 2 Year 3

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