Capital Budgeting

By- Ayisha Shaikh

Meaning

 Capital budgeting is a process of evaluating investments and huge

expenses in order to obtain the best returns on investment.
 An organization is often faced with the challenges of selecting between
two projects/investments or the buy vs replace decision.
 An organization would like to invest in all profitable projects but due to the
limitation on the availability of capital an organization has to choose
between different projects/investments.
 Capital budgeting is the budgeting of capital expense
Objectives

 To find out the profitable capital expenditure.

 2. To know whether the replacement of any existing fixed assets gives more
return than earlier.
 3. To decide whether a specified project is to be selected or not.
 To find out the quantum of finance required for the capital expenditure
 To assess the various sources of finance for capital expenditure.
 6. To evaluate the merits of each proposal to decide which project is best.
Features
 Capital budgeting involves the investment of funds currently for getting
benefits in the future.
 2. Generally, the future benefits are spread over several years.
 3. The long term investment is fixed.
 4. The investments made in the project is determining the financial
condition of business organization in future.
 5. Each project involves huge amount of funds.
 6. Capital expenditure decisions are irreversible.
 7. The profitability of the business concern is based on the quantum of
investments made in the project.
Limitations

 The economic life of the project and annual cash inflows are only an
estimation. The actual economic life of the project is either increased or
decreased. Likewise, the actual annual cash inflows may be either more or
less than the estimation. Hence, control over capital expenditure can not
be exercised.
 2. The application of capital budgeting technique is based on the
presumed cash inflows and cash outflows. Since the future is uncertain, the
presumed cash inflows and cash outflows may not be true. Therefore, the
selection of profitable project may be wrong.
 3. Capital budgeting process does not take into consideration of various
non-financial aspects of the projects while they play an important role in
successful and profitable implementation of them. Hence, true profitability
of the project cannot be highlighted.
 It is also not correct to assume that mathematically exact techniques always
produce highly accurate results.
 5. All the techniques of capital budgeting presume that various investment
proposals under consideration are mutually exclusive which may not be
practically true in some particular circumstances.
 6. The morale of the employee, goodwill of the company etc. cannot be
quantified accurately. Hence, these can substantially influence capital
budgeting decision.
 7. Risk of any project cannot be presumed accurately. The project risk is varying
according to the changes made in the business world.
 8. In case of urgency, the capital budgeting technique cannot be applied.
 9. Only known factors are considered while applying capital budgeting
decisions. There are so many unknown factors which are also affecting capital
budgeting decisions. The unknown factors cannot be avoided or controlled.
Capital Budgeting Process
Techniques of Capital Budgeting
Modern Methods

 Modern Methods are also known as discounted cash flow techniques

 It takes into consideration time value of money
 There are broadly three methods NPV, PI, IRR and Cost Benefit Analysis
NET PRESENT VALUE

 The net present value of a project is equal to the sum of discounted cash
flows associated with the project. Symbolically represented as
 NPV = CF0 / (1+r)0 +CF1 / (1+r)1 +CF2 / (1+r)2 +………… CFn / (1+r)n -I
 NPV = σ∞
𝒏=𝟏 CFn / (1+r) - Initial Investment
n

NPV= Net Present Value (summation of PV of all Cash flows)

CF= Cash flow at the end of the year n
r= Rate of Discount
n= Life of the Project

When NPV Rule

>1 Accept
<1 Reject
MINI CASESTUDY-2
 2. ABC Ltd has been pondering of the different investment opportunities it
has. Help it to invest in the most profitable one if the rate of interest is 8%
p.a. The cash flow from both the projects are as listed below and the
investment required for each project is Rs. 1,20,000
Year Project-A Project-B

1 40,000 50000

2 60,000 30,000

3 75,000 90,000

4 20,000 60,000

5 45,000 55,000

 PV of cash flow of Project-A= Rs. 1,93,336

 PV of cash flow of Project-B = Rs. 2,24,989
Merits of NPV

 It takes into consideration tive value of money

 It considers cash flow stream of the project in its entirety. Ie till the life of the
project
 It perfectly aligns with the financial objective of maximization of wealth of
the shareholders
 The additive property of NPV makes it unique and distinct from all the other
techniques
 Its easy to understand and calculate, whichever project has a higher NPV
that project is considered
 Future investment in the project is also taken into consideration
Demerits of NPV

 Though one of the most popular method of capital budgeting it suffers from
the following demerits
 It is expressed in absolute term and not relative term
Profitability Index

 Profitability index is also known as benefit cost ratio

 The formula to calculate it is as follows
PI or BCR = PVB/ I
Where PVB = present value of benefits
I = initial Investment

When PI/BCR Rule is

>1 Accept
=1 Indifferent
<1 Reject
 Example-1

XYZ Ltd. Is expecting the following cashflow from a project which requires an
Investment of Rs.1,00,000, if the rate of interest applicable is 12% p.a

Year Cashflow
1 25,000
2 40,000
3 40,000
4 50,000
Solution

 BCR = PVB/I
 BCR = 25,000 + 40,000 + 40000 + 50,000
(1.12)1 (1.12)2 (1.12)3 (1.12)4
1,00,000

 BCR = 1.145
 Accept the project
Merits & Demerits of BCR

Merits
 Considers time value of Money
 It is expressed in relative term and hence comparison of projects with
different outlay can be done

Demerits
 When the cash outlay occurs in other than the initial year it does not take it
into consideration
 Aggregating several smaller projects is not possible because it does not
have addition property
Internal Rate of Return

 Internal rate of return calculate the rate of return from the project
 The formula to calculate IRR is
I = CF0 / (1+r)0 +CF1 / (1+r)1 +CF2 / (1+r)2 +………… CFn / (1+r)n

I= σ∞
𝒏=𝟏 CFn / (1+r)
n

where I = Initial Investment

CF= Cash flow from the project
n= life of the project
r= ? ( Internal Rate of Return)
 Internal Rate of Return

 This is a trial and error method

When IRR Rule

> Rate of interest Accept
= Rate of interest Indifferent
< Rate of interest Reject
Example-2

 PQR Ltd. Is expecting the following cashflow from a project which requires
an Investment of Rs.1,00,000, if the rate of interest applicable is 12% p.a

Year Cashflow
1 30,000
2 30,000
3 40,000
4 45,000
Solution

 I= σ∞
𝒏=𝟏 CFn / (1+r)
n

 1,00,000 = 30,000 + 30,000 + 40000 + 45,000

(1+r)1 (1+r )2 (1+r)3 (1+r)4
 With r= 15%, Rs.100802
 With r= 16%, Rs 98641
 Hence IRR is between 15% and 16%
 With Linear Interpolation
15% + 100802-100000 = 15.37%
100802-98641
Merits & Demerits of IRR

Merits
 It takes into consideration time value of money
 It take the cash flow of the project for its entire life
 Its highly relative since its in form of percentage so the changing rate of
interest can be easily compared
Demerits
 Its quite difficult to calculate
 It cannot distinguish between cash outflow and inflow ( table1)
 Smaller projects cannot be compared to larger projects
 It sometimes gives out more than 1 IRR which can be misleading (table-2)
Table 1

Year 0 Year1 IRR NPV (@10%)

Project A (4000) 6000 50% 145
Project B 4000 (7000) 75% -236
 Table 2

Year 0 Year 1 Year 2

(1,60,000) 10,00,000 (10,00,000)

According to IRR Formula

1,60,000 = 10,00,000/(1+r)1 - 10,00,000/(1+r)2
Solving the equation we get
1,60,000r2 -6,80,000r + 1,60,000 = 0
Dividing the whole equation with 40,000 we get
4r2 – 17r + 4 = 0
Solving the equation we get r=0.25 and r=4
Hence the rate of both 25% and 400% stands correct for this equation
When there is cash outflow in more than the initial year you will be getting more
than 1 IRR which is misleading
Modified Internal Rate of Return (MIRR)

 The two major shortcomings of IRR namely difficulty to calculate and two
IRR has lead to the formulation of MIRR which nullifies its shortcoming
 MIRR takes into consideration the rate of interest and calculate the return
from a project
 MIRR is simple to calculate
 MIRR gives out single rate of return
 PVC = FV / (1+MIRR)n
 The formula to calculate MIRR is same as the formula to calculate present
value
 MIRR Formula

 Step 1: Calculate PV of all the cash outflow pertaining to the project

 Step 2: Calculate the FV of all the cash inflow pertaining to the project
 Step 3: Use the formula to find MIRR, PVC = FV / (1+MIRR)n

When MIRR Rule

> Rate of interest Accept
= Rate of interest Indifferent
< Rate of interest Reject
 Example 3

Pentagon Ltd is expecting the following cashflow from a project it is planning to

undertake. You are required to calculate MIRR for the project if the rate of
interest is 15% p.a. Suggest whether the company should go for the project or not

Year 0 1 2 3 4 5 6
Cashflow (120) (80) 20 60 80 100 120
Solution

 Step 1: Calculate PV of all the cash outflow pertaining to the project

PV = 120 + {80 /(1.15)} = 189.56
 Step 2: Calculate the FV of all the cash inflow pertaining to the project
FV= 20(1.15)4+ 60(1.15)3+80(1.15)2+100(1.15)1+120 = 467
 Step 3: PVC = FV / (1+MIRR)n
189.56 = 467 / (1+MIRR)6
(1+MIRR)6 = 2.463
1+ MIRR = 1.1615
 Hence MIRR= 16.2% Approx
Since MIRR is greater than the prevailing interest rate of 15% in the market we
will accept the project
Pay back Period

 The pay back period is the length of time required to recover the initial
outlay on the project
 This method does not take into consideration time value of money
 This is simple to calculate
 According to this method, the shorter the pay back period the more
desirable the project will be.
 Example 4
Year Project A Project B
0 (1,00,000) (1,00,000)
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 10,000 60,000

Here the Project A has a pay back period of 3 yrs

While Project B has a pay back period of 4 yrs, Hence according to pay back
period method we will go for project A
Merits & Demerits of Pay Back Period
Method
 Merits
 Easy to calculate
 It is a rough and ready method to deal with risk
 It is good method if the firm is looking for liquidity
 Demerits
 It does not take into consideration time value of money
 It does not take into consideration cash flow after the pay back period
 It’s a method of capital recovery and not profitability
Discounted Payback Method
Example-5
 To address the major flaw of payback period method that it does not
consider time value of money , discounted pay back period method was
introduced. Lets assume that the rate of interest is 10%
Solution
Year Project A pvif Discounted Cumulative
value
0 (1,00,000) (1,00,000) (1,00,000)
1 50,000 0.9091 45,455 (54,545)
2 30,000 0.8264 24,792 (29,753)
3 20,000 0.7513 15,026 (14,727)
4 10,000 0.6830 6830 (7897)
5 10,000 0.6209 6209 (1690)
6 10,000 0.5645 5645 3955

So here the discounted PBP is 5yrs + (1690/5645) months

Hence the Discounted Pay back Period is 5.3 yrs approx.
Post Pay back Period Method

 Its very simple method where all the cashflow of the project is taken into
consideration
 The formula to Calculate Post Payback period
 PPBP = Total Cash Flows – Initial Investment
 Project A PPBP = 1,30,000 – 1,00,000 = Rs 30,000
 Project B PPBP = 2,10,000-1,00,000 = Rs. 1,10,000
Accounting Rate of Return

 The accounting rate of return also known as the average rate of return is
calculated as
= Av. Profit after tax
Av. Book value of Investment
Here the numerator is the average annual post tax profit over the life of
investment
The denominator is the average of book value of the investment in the project

When ARR Rule

> Rate of interest Accept
= Rate of interest Indifferent
< Rate of interest Reject
Example-6

Year Book Value of Invstment Profit After Tax

1 90,000 20,000
2 80,000 22,000
3 70,000 24,000
4 60,000 26,000
5 50,000 28,000
Solution

ARR= Av. Profit after tax

Av. Book value of Investment
Step 1: Calculate Average PAT = 20,000+22,000+24,000+26,000+28000 = 24000
5
 Step 2: Calculate Average BV of Investment
 = 90,000+80,000+70,000+60,000+50,000 =70,000
5
ARR= 24,000/70,000 = 0.3428
ARR= 34.28%
Accept The Project
Merits & Demerits of ARR

 Merits
 It is simple to calculate
 It is based on accounting information which is readily available
 It takes into consideration benefits over the entire life of the project
 Demerits
 It is based on accounting profit and cash flow
 It does not take into consideration time value of money
Capital Budgeting techniques in
Practice
 Over the time NPV and IRR are the most widely used techniques
 Firms typically use multiple evaluation methods
 ARR and PBP are widely used as a supplementary methods
 Weighted Average Cost of Capital (WACC) is widely used as the discount
rate by the firms
 The most widely used discount rate is 15%
 Risk assessment and adjustment techniques have gained popularity and
are adjusted by increasing the discount rate
 Techniques in Practice

According to a research conducted by researchers about the different

techniques and importance given to those techniques by companies, the
following was revealed

Method % of Companies considering it

important
Internal Rate of Return 85%
Payback Period 67.5%
Net Present Value 66.3%
Breakeven Analysis 58.2%
Profitability Index 35.1%
 Question 1
The expected cash flow from a project is as follows. The cost of capital is 12%
per annum. Calculate the following a) NPV b) BCR c) IRR d) MIRR e) Payback
Period f)Discounted Payback period

Year Cashflow
0 (1,00,000)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
Solution
Year Cashflow PVIF Present Value Cummulative
@ 12%
0 (1,00,000) (1,00,000)
1 20,000 0.8929 17,828 (82,172)
2 30,000 0.7972 23,916 (58,256)
3 40,000 0.7118 28,472 (29,784)
4 50,000 0.6355 31,775 1991
5 30,000 0.5674 17,022 19013
Solution

 a) NPV = 1,19,013-1,00,000=19,013
 b) BCR = 1,19,013/1,00,000= 1.19
 c) IRR= Between 18% and 19%
 d) MIRR : PVC = FV / (1+MIRR)n
Step 1 : Present value of cash out flow= 1,00,000
Step 2 Future Value of Cash inflow = 20,000 (1.12) 4 + 30,000 (1.12)3 + 40,000
(1.12)2 +50,000 (1.12)1 +30,000 = 2,09,709
PVC = FV / (1+MIRR)n
1,00,000= 2,09,709 (1+MIRR)5
MIRR= 15.97%
Solution

 e) Pay back Period =1,00000 – (20,000+30,000+40000)

3yrs and 10,000/50000 = 3.2 yrs

 f) Discounted Payback Period = 1,00,000 – (17,828 +23,916 +28,472

+29784/31775)
= 3 .94 yrs
Question 2

 What is the Internal rate of return for a project that involves an outlay of
Rs.30,00,000 now which will result in an annual cashflow of Rs 6,00,000 for a
period of 7 yrs?
 Solution

30,00,000 = 6,00,000 (PVIFA r% 7yrs )

5= (PVIFA r% 7yrs )
IRR will be between 9% (5.0330) and 10% (4.8684) (using the table)
Using Linear Interpolation
IRR = 9% + (5.0330-5/ 5.0330-4.8684)
IRR = 9. 2%
Question 3

 Calculate the Internal rate of return of the project which has the following
cash flow

Year Cash flow

0 (3000)
1 10000
2 (3000)
Solution

 3000 = 10000 + (3000)

(1+r) (1+r)2
BY USING QUADRATIC EQUATION
3r2- 4r-4=0
3r2- 6r+2r-4=0
R=2 r= -2/3
Since IRR CANNOT BE NEGATIVE
R= 2 ie IRR =200%
Case Study -1

 Alpha Ltd has been using a machine that needs an urgent overhauling, the
company is also considering the option of outsourcing the production or
purchasing a new smaller machine. Help the company take the most
profitable decision. Calculate MIRR, PI and NPV if the rate of interest is
12%pa.
Year Outsource the Purchase a Overhaul the
production smaller machine current machine
0 (15000) (15000) (15000)
1 11000 3500 42000
2 7000 8000 (4000)
3 4800 13000 -
Solution

Method Outsource Purchase Overhaul

MIRR 20.53% 20.43% 60.8%
NPV 3818.94 3756.15 19313
PI 1.2546 1.2504 2.50
Case Study 2
 ABC Ltd is considering two mutually exclusive projects with the following
cash flow if the cost of capital is 12%

Year Project P Project Q

0 (1000) (1600)
1 (1200) 200
2 (600) 400
3 (250) 600
4 2000 800
5 4000 100

Which Project should the company choose. Which technique will you use to find
out the profitable project and why ?
Solution

 I will not choose NPV since the outlay of both the projects are different so it
will not be comparable
 I will not choose PI since it does not consider cash outlay happening after
the initial investment
 I will not choose IRR since it does not differentiate between cash inflow and
outflow which will be misleading
 I will calculate MIRR, since this technique is apt for this type of projects and
comparison
 MIRR for Project P = 18%
 MIRR for project Q= 10.4%
 Selecting Project P will be more profitable for the company
Case Study- 3
Year Project A Project B Project C
0 (6000) (6000) (6000)
1 3000 1000 2000
2 2000 2000 2000
3 1000 3000 2000
4 4000 6000 5000

a)Which project will you choose according to payback period technique.

b) Will you go for post payback period method or discounted payback period
method if discount rate is 10% and why ?
Solution

Method A B C
PBP 3 yrs 3yrs 3yrs
DPBP 3.33yrs 3.29 yrs 3.312 yrs
PPBP 4000 6000 5000

I will choose the discounted payback period method since it considers time
value of money. Accordingly I will go for Project B.