Capital Budgeting

Edited by

Amit Kumar De
M.COM., M.A., M.B.A.,
M.Phil., A.I.C.W.A., L.L.B.,PGDFA,CFM
Long Term Investment Decisions
• Reliance Industries diversifies into the
Telecommunications Section’, ‘Reddy’s Labs set
up a new plant in Andhra Pradesh’ and so on.
What do all these mean? These news headlines
are typical examples of capital expenditure
decisions.
• Capital mean Capital expenditure and Budgeting
means planning ­– therefore capital budgeting
means planning for such expenditure whose
benefit is received beyond one year
 Planning for Capital Expenditure

The benefits of capital expenditure are expected to

occur for a number of years in the future which is
highly uncertain.

Because the costs and benefits occur at different

points of time, investment proposal, for a proper
analysis of the viability of the all these have to be
brought to a common time-frame.
The key steps involved in determining whether a project is
worthwhile or not are:
• Estimate the costs and benefits of the project
• Assess the riskiness of the project
• Calculate the cost of capital
• Compute the criteria of merit and judge whether
the project is good or bad.

For pedagogic purposes, we find it more convenient to start

with a discussion of the criteria of merit, referred to as
investment criteria or capital budgeting techniques. A
familiarity with these criteria will facilitate an easier
understanding of costs and benefits, risk analysis, and cost of
capital.
 FINANCIAL APPRAISAL OF A PROJECT

The financial appraisal of a project can be viewed as

a two-step procedure:

Step 1 Define the stream of cash flows (both

inflows and outflows) associated with the project.
All costs and benefits must be measured in terms of
cash flows.

Step 2 Appraise the cash flow stream to determine

whether the project is financially viable or not.
 INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA

NET BENEFIT INTERNAL ACCOUNTING

PAYBACK
PRESENT COST RATE OF RATE OF
PERIOD
VALUE RATIO RETURN RETURN
NET PRESENT VALUE

= Present value of future

cash inflows - the initial
investment.

A project will be accepted

if its NPV is positive and
rejected if its NPV is
negative.
 Present Value of an Uneven Series
A1 A2 An
PVn = + + …… +
(1 + r) (1 + r)2 (1 + r)n
n At
= 
t =1 (1 + r)t

Year Cash Flow PVIF12%,n Present Value of

Rs. Individual Cash Flow
1 1,000 0.893 893
2 2,000 0.797 1,594
3 2,000 0.712 1,424
4 3,000 0.636 1,908
5 3,000 0.567 1,701
6 4,000 0.507 2,028
7 4,000 0.452 1,808
8 5,000 0.404 2,020

Present Value of the Cash Flow Stream 13,376

 Net Present Value

n Ct
NPV =  – Initial investment
t=1 (1 + rt )t
 NET PRESENT VALUE
The net present value of a project is the sum of the present values of all the cash
flows associated with it. The cash flows are discounted at an appropriate
discount rate (cost of capital)
Naveen Enterprise’s Capital Project
Year Cash flow Discount factor Present
value
0 -100.00 1.000 -100.00
1 34.00 0.870 29.58
2 32.50 0.756 24.57
3 31.37 0.658 20.64
4 30.53 0.572 17.46
5 79.90 0.497 39.71
Sum = 31.96
Pros Cons
• Reflects the time value of money • Is an absolute measure and not a relative

• Considers the cash flow in its entirety measure

• Squares with the objective of wealth maximisation
 Profitability Index/ Benefit Cost Ratio
PVB
Benefit-cost Ratio :PI/BCR=
I
PVB = present value of benefits
I = initial investment
Pros Cons
Measures bang per buck Provides no means for aggregation
The decision-rules based on the BCR (or alternatively
the NBCR)

If - Decision Rule

PI/ BCR > 1 (NPV > 0) Accept the project

PI/ BCR < 1 (NPV < 0) Reject the project

Since the BCR measures the present value per rupee of

outlay, it is considered to be a useful criterion for
ranking a set of projects in the order of decreasingly
efficient use of capital.
© Centre for Financial Management, Bangalore
 Internal Rate of Return
Net Present Value

Discount rate

The internal rate of return (IRR) of a project is the discount rate that
makes its NPV equal to zero. It is represented by the point of
intersection in the above diagram
Net Present Value Internal Rate of Return
• Assumes that the discount • Assumes that the net
rate (cost of capital) is known present value is zero
• Calculates the net present • Figures out the discount rate
value, given the discount that makes net present
rate value zero
 Calculation of IRR with NPV
You have to calculate NPV at 20% discount rate and also calculate IRR. Try a
few discount rates till you find the one that makes the NPV zero
Year Cash Discounting Discounting Discounting
flow rate : 20% rate : 24% rate : 28%
Discount Present Discount Present Discount Present
factor Value factor Value factor Value

0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00

1 34.00 0.833 28.32 0.806 27.40 0.781 26.55
2 32.50 0.694 22.56 0.650 21.13 0.610 19.83
3 31.37 0.579 18.16 0.524 16.44 0.477 14.96
4 30.53 0.482 14.72 0.423 12.91 0.373 11.39
5 79.90 0.402 32.12 0.341 27.25 0.291 23.25

NPV = 15.88 NPV = 5.13 NPV = - 4.02

 STEPS

1.See whether the NPV determined +ve/ -ve. If +ve ,then try
successively higher discount rate from the given rate , if
- ve ,then try successively lower discount rates until we get
the rate at which NPV marginally below zero and the rate
at which NPV is marginally above zero.

2. Use the interpolation/Extrapolation to determine the

approximate value of IRR between the two interest rates
by the method of proportionate differences.
 Calculation of IRR

Smaller NPV at the smaller rate ( Bigger Smaller

discount + X discount – discount
rate Sum of the absolute values of the
rate rate )
NPV at the smaller and the bigger
discount rates

5.13
24% + 28% - 24% = 26.24%
5.13 + 4.02
 Calculation of IRR without NPV
Step–1: Find the average annual cash inflow after taxes
Step–2: Find the Fake pay back period = Initial outlay/Step
1 figure.
Step–3: From the table, find the interest rate at which the
PV of annuity of Re. 1 will be nearly equal to the figure
got in step 2 for the relevant life of project.
Step–4: Use the interest rate got in step 3 as the
initial value for starting the trial and error process and
keep trying at successively higher or lower rates of interest
until we get the rate at which NPV marginally below zero
and the rate at which NPV is marginally above zero.
Step–5: Use the interpolation to determine the approximate
value of IRR between the two interest rates.
© Centre for Financial Management, Bangalore
© Centre for Financial Management, Bangalore
 FINANCIAL APPRAISAL OF A PROJECT

The financial appraisal of a project can be viewed as

a two-step procedure:

Step 1 Define the stream of cash flows (both

inflows and outflows) associated with the project.
All costs and benefits must be measured in terms of
cash flows.

Step 2 Appraise the cash flow stream to determine

whether the project is financially viable or not.
 INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA

NET BENEFIT INTERNAL ACCOUNTING

PAYBACK
PRESENT COST RATE OF RATE OF
PERIOD
VALUE RATIO RETURN RETURN
 Payback Period
measures the length of time required to
recover the initial outlay in the project.

payback periods less than or equal to the cut-

off period will be accepted and others will be
rejected.
 Payback Period
Payback period is the length of time required to recover the initial
outlay on the project
Naveen Enterprise’s Capital Project
Year Cash flow Cumulative cash flow
0 -100 -100
1 34 - 66
2 32.5 -33.5
3 31.37 - 2.13
4 30.53 28.40
Pros Cons
• Simple • Fails to consider the time
value of money
• Rough and ready method • Ignores cash flows
beyond
for dealing with risk the payback period
• Emphasises earlier cash inflows
 Calculation of Fractional Year
• Fractional Year
= (Incremental cumulative cash flow to zero)
/ (Cash flow of the relevant year)
= { 0 – (- 2.13 ) } / 30.53
= 0.07
PB Period = 3+ 0.07 = 3.07 years
According to the payback criterion, the shorter the
payback period, the more desirable the project. Firms
using this criterion generally specify the maximum
acceptable payback period.

Payback period is widely used because it is simple,

both in concept and application, and it is a rough and
ready method for dealing with risk.

However, it has serious limitations :

it does not consider the time value of money;
it ignores cash flows beyond the payback period;
it is a measure of capital recovery, not profitability.
 Accounting Rate of Return
The accounting rate of return, also referred to as
the average rate of return on investment, is a
measure of profitability which relates income to
investment, both measured in accounting terms.
Accounting Rate of Return
(ARR) =Average annual Profit
After Tax/Average book value
of the investment.
Where, Average book value of
the investment = (original
investment + salvage
value ) /2
The accounting rate of return has certain virtues :
it is simple to calculate; it is based on accounting
information which is readily available and familiar to
businessmen; it considers benefits over the entire life of
the project.

However, it has serious shortcomings as well:

it is based upon accounting profit, not cash flow; it
does not take into account the time value of money; it is
internally inconsistent.
 Sinking Fund Factor
FV of an annuity = A [(1+r)n-1]/ r

So , A = FV of an annuity * r / [(1+r)n-1]
= FVA * Sinking Fund Factor

S.F.F. = r / [(1+r)n-1]
= 1 / [(1+r)n-1]/ r
= Reciprocal of FVIFA
 Capital Recovery Factor
PV of an annuity = A [(1+r)n-1]/ r (1+r)n

A = PV of annuity * r (1+r)n / [(1+r)n-1]

= PVA *Capital Recovery Factor

C.R.F. = r (1+r)n / [(1+r)n-1]

= 1 / [(1+r)n-1]/ r (1+r)n
= Reciprocal of PVIFA
 Annualized Equivalent Value
= Future Flow * Sinking Fund Factor
+ Present Flow * Capital Recovery Factor
+ Annuity amount

It is the Equivalent Annuity Worth of any

money flow, Present, Future ,or,
intermediate.
 Present Worth of Series of Flow
• Evaluate each flow in terms of its converted
value at the earliest time point ,i.e., at zero
point of time ,i.e. its present value
= Future Flow * Present Value Interest Factor
+ Present Flow at zero time point
+ Annuity * Present Value Interest Factor of
Annuity
 Future Worth of Series of Flow
• Evaluate each flow in terms of its converted
value at the latest future time point ,i.e., its
future value
= Present Flow * Future Value Interest Factor
+ Future Flow * Future Value Interest Factor
+Annuity * Future Value Interest Factor of
Annuity
 C0 C1 C2 … C3 Cn

0 1 2 n–1 n

C0 A= C1 = C2 … = C3 … = Cn =A
© Centre for Financial Management, Bangalore
© Centre for Financial Management, Bangalore
© Centre for Financial Management, Bangalore
© Centre for Financial Management, Bangalore