CAPITAL

BUDGETING:
 Investment decisions are
generally known as capital
budgeting or capital expenditure
decisions.
 Investment decisions deal with
investment of organizations
resources in Long tern (fixed) Assets
and / or Short term (Current) Assets.

Decisions pertaining to investment in

Short term Assets fall under Working
Capital Management.

Decisions pertaining to investment in

Long term Assets are classified as
 In evaluating such investment
proposals, it is important to
carefully consider the expected
benefits of investment against the
expenses associated with it.
Organizations are frequently
faced with Capital Budgeting
decisions. Any decision that
requires the use of resources is a
 For Example: Purchase of Land is an
example of Capital Budgeting decision.
Similarly
replacement of outdated equipment with
modern machines,
purchase of a brand or business,
computerization and networking the
organization,
investment in research and development
of a product launch of a major promotional
campaign etc are all example of Capital
Budgeting decisions.
 Capital Budgeting Techniques:

1. Pay Back period

2. Discounted Payback Period
3. Accounting rate of return
4. Profitability Index(PI)
5. Net Present Value(NPV)
6. Internal rate of return(IRR)
 PAY BACK PERIODE METHOD:
The pay back period is defined as the
period required for the proposals
cumulative cash flows to be equal to its
cash outflows. In other words, the payback
period is the length of time required to
recover the initial cost of the project.
The payback period is usually stated in
terms of number of years. It can also be
stated as the period required for a
proposal to break even on its net
investment.
 If project generates constant annual cash
inflows, the pay back period is completed as
follows:

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 initial
cash outlay.
Acceptance Rule:
Accept if calculated value is less than
standard fixed by management otherwise
reject it.
If the payback period calculated for a project
is less than the maximum payback period set
up by the company it can be accepted.
As a ranking method it gives highest rank to a
 DISCOUNTED PAY BACK
PERIOD:
.
The discounted payback is
defined as the length of time it
takes the discounted net cash
revenue/cost savings of a project
to payback the initial investment.
Pay Back Period
1.Compute the Payback Period for the
investment from the following data. Capital
outlay is Nu 70,000
Cash Flow afterYear Tax Cash Flow

0 -70000

1 30000

2 30000

3 20000

4 10000

5 50000
 2.Compute the Payback Period for the
investment from the following data. Capital
outlay is Nu -40 K
Year Cash Flow
0 -40k
1 10k
2 12k
3 15k
4 10k
5 7k

Answer:3.3 Years
3.Suppose that a project
requires a cash outlay of Rs
20,000 and generates cash
inflows of Nu 8000:Nu
7000:Nu 4000 and Nu 3000
during the next 4 years. What
is the project Payback?
4.A company is considering the following
investment projects:
Project CF0 CF1 CF2 CF3
A -10000 10000 ---- ----
B -10000 7500 7500 ----
C -10000 2000 4000
12000
D -10000 10000 3000 3000
Calculate the payback period for the above
investments?
5.Axe limited is in need of a bottling machine.
The brands Sachs and Tachs are
available in the market. The relevant details
in respect of these brands
Sach
are given
Tach
below.
Price 35000 40000
Net cash Flow
Year 1 10000 10000
Year 2 10000 15000
Year 3 10000 20000
Year 4 15000 25000

You are required to advice Axe limited as to

which machine has to be purchased
6.Calculate the payback period for Ramsay &
Co who intends to purchase a truck assuming
50% PAT ,zero scrap value and use straight
Truck
line method depreciation.
x Y
Purchase price -200000 -250000
Income
Year1 200000 220000
Year2 200000 215000
Year3 200000 215000
Year4 250000 220000
Year5 250000 250000
Operating Cost
Year 1 100000 120000
Year 2 100000 110000
Year 3 100000 110000
Year 4 125000 100000
Year 5 125000 100000
7.Karma Ltd is planning a major investment
to expand its current manufacturing of
digital clocks with initial capital outlay of Nu
350 lakh.The finance department has
projected a following cash flows over the
next 7 years considered to be the life of the
project.
Year 0 1 2 3 4
5 6 7
Cash Flow -350 100 150 400
450 300 250 50
 8.Find out the payback period and
discounted payback period for both the
projects. Cash Flow in Ngultrum

Year Project-A Project-B

0 -1000 -1000

1 50 500

2 100 350

3 250 250

4 300 60

5 400 100

6 450 100

7 500 150
9.Two types of equipments are available in the
market. Touch Limited requires one such
equipment. The details relating to the equipment
are given below. Brand
X Y
Initial 70000 60000
capital
outlay
Life 6 5
Residual 0 0
Value
Tax rate 50% 50%
Depreciati Straight Straight
Profit Before tax and Depreciation

Year CF(X) CF(Y)

1 15000 17000
2 15000 18000
3 20000 18000
4 25000 20000
5 25000 20000
6 20000 -

Calculate the Payback for the above two

project and which project would you choose
according to pay back acceptance rule?
Accounting rate of
return(ARR)
ACCOUNTING RATE OF RETURN
(OR)
AVERAGE RATE OF RETURN (ARR)
:

It is also known as return on investment

(ROI). It is an accounting method,
which uses the accounting
information revealed by the financial
statements to measure the
profitability of an investment proposal.
 CFAT
Average Return = ---------------------------
No of Years

Average Return
ARR = ---------------------------
Initial Investment

Acceptance Rule:
Accept if calculated rate is higher than minimum rate
established by the management.
It can reject the projects with an ARR lower than the
expected rate of return.
A highest rank will be given to a project with highest ARR,
1.The Cost of Acquisition of an asset is Rs
50,000.The firm has to spend Rs 5000 towards its
installation. The life of the assets is 5 years and
the salvage value at the end of its useful life is Rs
5000.The returns(PAT) from the assets are as
follows
The firm uses the straight line method for
Year PAT
computing depreciation. You are required to work
1 10,000
out the accounting rate of return and Payback
period based on the2initial15,000
investment.
3 15,000

4 20,000
5 20,000
2.Determine the average rate of return(ARR)
and payback period(PB) from the following
data of two machines
Particulars Machine AA and Machine
B. B
Cost -56000 -56000
PAT PAT
Year 1 3300 11000
Year 2 5400 9300
Year 3 7500 7000
Year 4 9300 5300
Year 5 11000 3000

Total 36500 35600

Expected life 5 5
Estimated Salvage 3000 3000
value
3.Two Kinds of an investment are available in
the market. Touch Ltd requires one such
equipment. The details relating to the
equipments are given below.
Brand
X
Y
1.Intial Outlay 70,000
60,000
2.Life(years) 6
5
3.Residual value 10000
 Year Cash Flow(X) Cash Flow(Y)
1 15000 17000
2 15000 18000
3 20000 18000
4 25000 20000
5 25000 20000
6 20000 ---------

5.Cost of capital is 15%

6.Applicable tax is 50%
7.The company follows straight line method of
depreciation. You are required to calculate ARR
and pay back period and advise Touch ltd as to
which machine has to be purchased.
Calculate the ARR and payback period for
Karma & Co who intends to purchase a
machine assuming 30% PAT ,zero scrap
Truck
value and use straightx line method Y
depreciation.
Purchase price -200000 -250000
Income PBDT PBDT
Year1 200000 220000
Year2 200000 215000
Year3 200000 215000
Year4 250000 220000
Year5 250000 250000
Operating Cost
Year 1 100000 120000
Year 2 100000 110000
Year 3 100000 110000
Year 4 125000 100000
Year 5 125000 100000
.Two types of equipments are available in the
market. Singye Companies requires one such
equipment. The details relating to the equipment
are given below. Brand
X Y
Initial 70000 60000
capital
outlay
Life 6 5
Residual 0 0
Value
Tax rate 40% 40%
Depreciati Straight Straight
Profit Before tax and Depreciation

Year CF(X) CF(Y)

1 15000 17000
2 15000 18000
3 20000 18000
4 25000 20000
5 25000 20000
6 20000 -

Calculate the ARR, Payback and Discounted

payback for the above two project and
which project would you choose according
to ARR, Payback and Discounted
4.The Cost of an asset is Rs 60,000.The firm has to
spend Rs 4000 towards its installation. The life of
the assets is 5 years and the salvage value at the
end of its useful life is Rs 5000.The returns(PBT)
from the assets are as follows. Assume 30% tax
and the firm uses the straight line method for
computing depreciation. Calculate ARR?
Year PBT
1 10,000

2 15,000

3 15,000

4 20,000
5 20,000
 Profitability Index
Is the ratio of the present values of cash
inflows ,at the required rate of return to the
initial cash Flow.
PI= PV of cash Inflows
Initial cash Flow
Acceptance Rule :

Accept if PI > 1
Reject if PI < 1
May accept if PI = 1
Profitability Index is a relative measure of
projects profitability
 Profitability Index
1.The initial cash outlay of a Project is Rs
100000 and it can generate cash inflow of
Rs 40,000, Rs 30000,Rs 50,000 and Rs
20000 in year 1 through 4.Assume a 10%
rate of discount. Find the Profitability
Index.
2.The initial cash outlay of an investment
is Rs 100,000 and it generates cash
inflows of Rs. 50,000, Rs. 60,000, Rs.
65,000 and Rs. 50,000 in the four years.
Calculate PI of the investment assuming
 3.Calculate the Profitability Index for the
two mutually exclusive projects X and Y
assuming a discount rate of 10%,the
details ofYear
which are
Project X given below.
Project Y

0 -70,000 -70,000

1
10000 50000
2
20000 40000
3
30000 20000
4
45000 10000
5 60000 10000

Ans=1.659 & 1.523

4.The Cost of Acquisition of an asset is Rs
50,000.The firm has to spend Rs 5000 towards its
installation. The life of the assets is 5 years and
the salvage value at the end of its useful life is Rs
5000.The returns(PBT) from the assets are as
follows.The firm uses the straight line method for
computing depreciation. You are required to work
out the ProfitabilityYearIndex.
PBT
Assume a discount rate
of 8%. 1 10,000

2 15,000

3 15,000

4 20,000
5 20,000
 NET PRESENT VALUE :

The Net Present value method is a classic

economic method of evaluating the
investment proposals. It is one of the
methods of discounted cash flow. It
recognizes the importance of time value of
money.
 Net Present value

NPV = Present Value of Cash inflow

Initial cash flow
Acceptance Rule:
Accept if NPV > 0
Reject if NPV < 0
May accept if NPV = 0
One with higher NPV is selected.
 1.Find the NPV from the following data.
Initial outlay= Nu 25000 Discount rate is
30%
Net cash Flows Year Cash Flow

1 8000

2 10000

3 14000
 2.A firm use NPV rule to evaluate all its
project, should the firm accept the
following project if the required rate of
return is 18%.What if the required rate of
return isYear30%? Cash Flow
0 -30000

1 20000

2 14000

3 11000

Ans=3698.66 and -1324.66

 3.A firm whose cost of capital is 10% is
considering two mutually exclusive project
X and Y,the
Year
detailsProject
of which
X
are
Project Y

0 -70000 -70000
1 10000 50000

2 20000 40000

3 30000 20000

4 45000 10000

5 60000 10000

Compute the Net Present value at 10%.

Ans =46,150.13 & 36,550
 4.An investment was Rs 50,000 and has a
residual value of Rs 10,000 after a useful
Year Profit before depreciation
life of 4 years. Following & Tax
are the relevant
details. 1 20,000

2 20,000

3 25,000

4 25,000

The cost of capital is 20% p.aThe firm uses a

straight line method to compute
depreciation. Assess the profitability of the
 5.An investment requires the initial cash
outlay of Nu 40,000.It has a life of 4 years
and has no residual value at the end of its
useful life.
Year The profits before
Nu tax are
expected1 to be as follows.30000

2 30000

3 20000

4 10000

The firm is in the tax bracket of

50%.Compute the net present value of the
investment. Assume that the cost of capital is
 Internal rate of
return(IRR)
The internal rate of return (IRR) method is
another discounted cash flow technique
.This method is based on the principle of
present value. It takes into account of the
magnitude & timing of cash flows.
(Or) Any discount rate which results in
zero NPV is called IRR
It can be easily seen that the minimum
percentage of return required to avoid any
loss.
Acceptance Rule:
All independent projects with IRR greater than the
cost of Capital should be accepted
When choosing among the mutually exclusive
projects, the project with the highest IRR should be
accepted.

IRR= 1st Discount Rate+ Difference of Discount rate (X ) 1st NPV

Total NPV
1.Compute IRR from the following data
Initial Investment Nu 3000
Cash flow after tax

Year CF
1 2000
2 1500
2.Compute IRR from the following data
Initial Investment Nu 30000
Cash flow after tax
Year CF
1 10000

2 12000

3 15000

4 10000

5 7000
3.Compute IRR from the following data
Initial Investment Nu 80,700
Cash flow after tax
YEAR Cash Flow
0 80700
1 30000
2 30000
3 30000
4 30000
5 30000
6 30000
7 30000
8 30000
 4.A firm is contemplating to install a new equipment in
its factory. Two brands of the machine are available in
the market. The relevant data are given below.
Brands
A B
Costs 70000 80000
Life 5 4
Residual 10000 10000
PBT
1 10000 16000
2 12000 20000
3 15000 26000
4 10000 24000
5 10000 ---

You are required to advise the firm on the profitability

of investing in these machines using NPV and
IRR.The firm is in the tax bracket of 50% and the cost
 5.Calculate the Net present value of Project C
and D assuming a discount rate of 10%.Also
Calculate the IRR of both the projects?
Year Project C Project D
0 -10000 -10000
1 2000 10000
2 4000 3000
3 12000 3000
6.A firm is considering two mutually exclusive
projects, project R and project S.Each
having a life of 5 years. The cash flow for
five years for both the projects
Years are given
below. 0 1 2 3 4 5
Project-R cash flow -2000 600 300 1000 800 1100

Project -S Cash flow -1800 800 700 400 600 700

A)Find the NPV of each project assuming cost of

capital at15%
B)Find out IRR of each project
C)Which of the project would you choose and why?