Capital Budgeting

Should we
build this
plant?
 Meaning of Capital Budgeting
It is the investment decision of a firm.

It’s the firm’s decision to invest its current funds most

efficiently in the long-term assets in anticipation of an
expected flow of benefits over a series of years.
 Importance of capital budgeting

Huge investments
Irreversibility
Risk
Long-term effect on profitability
Among the most difficult decisions to make
Types of Investment Decisions
Expansion of existing business
Expansion of new business
Replacement and modernisation
Mutually exclusive investments
Independent investments
Contingent investments
Types of Investment Decisions

Expansion and diversification:

 A company may add capacity to its existing product
lines to expand existing operations.
 e.g. the Gujarat State Fertiliser Company may
increase its plant capacity to manufacture more
urea. It is an example of related diversification.
 A firm may expand its activities in a new business.
 If a packaging manufacturing co. invests in a new
plant & machinary to produce ball bearings, which
the firm has not manufactured before, this
represents expansion of new business or unrelated
diversification.
Types of Investment Decisions

Replacement and modernisation:

The main objective of modernisation and replacement
is to improve operating efficiency and reduce costs.
Replacement decisions help to introduce more
efficient and economical assets and therefore, are also
called cost-reduction investments.
However, replacement decisions that involve
substantial modernisation and technological
improvements expand revenues as well as reduce
costs.
Types of Investment Decisions

Mutually exclusive investments:

Mutually exclusive projects are those where acceptance of
one implies automatic rejection of the other.
e.g. a company may either use a more labour-intensive,
semi-automatic machine, or employ a more capital-
intensive, highly automatic machine for production.
Choosing the semi-automatic machine precludes the
acceptance of the highly automatic machine.
Types of Investment Decisions

Independent investments:
Independent investment projects are those which do not
compete with each other.
e.g. a heavy engineering company may be considering
expansion of its plant capacity to manufacture additional
excavators and addition of new production facilities to
manufacture a new product-light commercial vehicles.
Depending on their profitability and availability of funds,
the company can undertake both investments.
Types of Investment Decisions

Contingent investments:
Contingent investments are dependent projects; the choice
of one investment necessitates undertaking one or more
other investments.
e.g. if a company decides to build a factory in a remote,
backward area, it may have to invest in houses, roads,
hospitals, schools, etc. for employees to attract the work
force.
Kinds of Capital Budgeting Decisions
Accept-reject decision
Mutually exclusive project decisions
Capital rationing decisions
- It refers to a situation in which a firm has more
acceptable investments than it can finance. It is
concerned with the selection of a group of investment
proposals out of many investment proposals acceptable
under the accept-reject decision.
Capital budgeting process
1. Idea generation
2. Evaluation or Analysis
3. Selection
4. Financing
5. Execution or Implementation
6. Review
 Techniques of Investment Evaluation

Project Evaluation Techniques

Traditional Techniques
or Non-discounted Cash Modern or Time-adjusted
Flow Techniques or Discounted Cash Flow

Average Pay-back
Rate of Period Internal
Net Present Profitability
Return Method Rate of
Value Index
Return
 Average Rate of Return (ARR) Method
Also known as Accounting Rate of Return or Return on
Investment (ROI).
This method uses accounting information as revealed by financial
statements to measure the profitability of an investment.
The average rate of return is the ratio of the average after tax
profit divided by the average investment.
ARR = Average annual profit after tax * 100
Average investment
Average annual profits after taxes =
After-tax profits
Number of years
 Average Rate of Return (ARR) Method
Average investment = I0 + In
2
Where, I0 = book value of investment in the beginning
In = book value of investment at the end of n number of
years
If the machine has salvage value, then only the depreciable
cost (cost – salvage value) of the machine should be divided
by 2 in order to ascertain the average net investment. It is
shown as:
Average investment =
Salvage value + 1 (Initial cost of machine – Salvage
value)
2
 Average Rate of Return (ARR) Method
If any additional net working capital is required in the initial
year which is likely to be released only at the end of the
project’s life, the full amount of working capital should be
taken in determining relevant investment for the purpose of
calculating ARR.
Thus, Average investment =
Net working capital + Salvage value + 1 (Initial cost of machine–Salvage
value)
2
 Average Rate of Return (ARR) Method
Accept – Reject Criteria:
The actual ARR would be compared with a predetermined or
a minimum required rate of return or cut-off rate.
A project would qualify to be accepted if the actual ARR is
higher than the minimum desired ARR. Otherwise, it is liable
to be rejected.
If Actual ARR > Minimum Required ARR Project
Accepted
If Actual ARR < Minimum Required ARR Project
Rejected
 Average Rate of Return (ARR) Method
Merits of ARR:
Easy to calculate.
Simple to understand and use.
The total benefits associated with the project are taken into
account while calculating the ARR.

Demerits of ARR:
It is based on accounting information rather than cash flows.
It does not take into account the time value of money.
Q. Determine the ARR from the following data of machine A.
Cost Rs. 56125
Annual estimated income after
depreciation & income tax:
Year 1 3375
2 5375

3 7375
4 9375
5 11375
36875
Estimated life (years) 5
Estimated salvage value 3000
Depreciation has been charged on straight line basis.
 Pay Back Period
Pay back is the number of years required to recover the
original cash outlay invested in a project.
There are two ways of calculating the Pay back period:
1. When the cash flows are uniform, the payback period
can be computed by dividing cash outlay by the annual
cash inflow. That is:
Pay back period = Initial Investment
Annual Cash Inflow
 Pay Back Period
2. Unequal cash flows: In case of unequal cash inflows, the
payback period can be found out by adding up the cash
inflows until the total is equal to the initial cash outlay.
In other words, pay back period is calculated by the process
of cumulating cash flows till the time when cumulative cash
flows become equal to the original investment outlay.

Accept – Reject Criteria:

The project having shortest pay back period Accepted
The project having longest pay back period Rejected
 Pay Back Period
Merits of Pay back:
Easy to calculate.
Simple to understand and use.
It is economical in terms of time and cost.

Demerits of Pay back:

It completely ignores all cash inflows after the pay back
period and hence the true profitability of the project can’t be
assessed.
It ignores the time value of money and does not consider the
magnitude and timing of cash inflows.
Improvements in Traditional Approach to Pay Back
Period Method

To improve the first limitation of pay back period method,

Post Pay Back Profitability Index Method is used.

To improve the second limitation of pay back period method,

Discounted Pay Back Method is used.
 Post Pay Back Profitability Index Method
This method takes into account the returns receivable
beyond the pay back period. These returns are called
post pay back profits.
Post pay back profitability index = Post pay back profits
* 100
Investments

Post pay back profits =

Annual cash inflow (Estimated life – Pay back
period)
Discounted Pay Back Method
Under this method, the present values of all cash flows
are computed at an appropriate discount rate.
The time period at which the cumulative present value of
cash inflows equals the cash outflows is known as
discounted pay back period.
The project which gives a shorter discounted pay back
period is accepted.
Net Present Value (NPV) Method
It is the sum of the present values of all the cash flows
(positive as well as negative) that are expected to occur
over the life of the project.
The general formula of NPV is:
NPV = C1 + C2 + …+ Cn - Co
(1+k) (1+k)2 (1+k)n
n

NPV = ∑ Ct/(1+k)t - Co
t=1

Where, C1, C2,…represents net cash inflow in year 1, 2,

…; k is the rate of discount; C0 is the initial cost of
investment; n is the expected life of investment.
 Net Present Value (NPV) Method
Accept – Reject Criteria:
If NPV is positive or more than zero Project
Accepted
If NPV is negative or less than zero Project
Rejected
 Net Present Value (NPV) Method
Merits of NPV:
Time value.
Measure of true profitability.
It is economical in terms of time and cost.

Demerits of NPV:
It is difficult in practice to precisely measure the discount
rate.
The NPV method is easy to use if forecasted cash flows are
known. In practice, it is quite difficult to obtain the
estimates of cash flows due to uncertainty.
Profitability Index (PI)
it is also known as Benefit Cost Ratio (B/C ratio).
It is the ratio of the present value of cash inflows, at
the required rate of return, to the initial cash out flow
of the investment.
The formula is:
PI = Present value of cash inflows
Initial cash outlay
Profitability Index (PI)

Accept – Reject Criteria:

Accept the project when PI is greater than one PI >
1
Reject the project when PI is less than one PI <
1
May accept the project when PI is equal to one PI =
1
 Internal Rate of Return (IRR)
The internal rate of return (IRR) is the discount rate which
equates the present value of cash inflows with the initial
investment outlay of a project.
This also implies that the rate of return is the discount rate
which makes NPV = 0.
Accept – Reject Criteria: Compare actual IRR with the
required rate of return or cut-off rate.
If the actual IRR > the cut-off rate Project Accepted
If the actual IRR < the cut-off rate Project
Rejected
If the actual IRR = the cut-off rate May accept
the project
 Determination of IRR
1. In case of uneven cash flows:
 The value of r can be found out by trial and error method.
 The approach is to select any discount rate to compute the
present value of cash inflows.
 If the calculated present value of the expected cash inflow
is lower than the present value of cash outflows, a lower
rate should be tried.
 On the other hand, a higher value should be tried if the
present value of cash inflows is higher than the present
value of cash outflows.
 This process will be repeated unless the NPV becomes
zero.
 Determination of IRR
In case of uneven cash flows: IRR is calculated by
using trial and error method.

IRR = rLR PVLR Cash outflow (rHR -

rLR)
PVLR PVHR

Where, PVLR = present value of cash inflows at lower

rate;
PVHR = present value of cash inflows at higher rate.
 Determination of IRR
2. In case of level cash flows:
 Firstly, calculate the present value factor annuity (PVFA).
 Then, find out the internal rate of return of the project.

Example: Assume that an investment would cost Rs. 20,000

and provide annual cash inflow of Rs. 5,430 for 6 years.
Find out the IRR.
Solution: PVFA = 20,000/5,430 = 3.683.
The rate, which gives a PVFA of 3.683 for 6 years, is the
project’s IRR. See the PVFA table across the 6-year row,
which is approx. 16%.
Thus, IRR = 16%.