Capital Budgeting

MEANING of Capital Budgeting

 The long term investment decisions of a
firm are generally known as Capital
Budgeting.
 capital budgeting is a process of deciding
in advance whether to invest in a
particular for no, whose benefits are
spread over a future period of time.
Egs:
Replacement investments
Expansion investments
New product investments
Diversification projects
R&D Projects etc
Features/Importance of Capital
Budgeting
 They involve Large investments
 They have Long term commitment of
funds
 They are Irreversible nature
 It may be difficult or expensive to
reverse them.
 It has Long term effect on profitability
 Process of Capital Budgeting
 Identification of investment proposals
 Screening the proposals
 Evaluation of various proposals
 Fixing priorities
 Final approval and preparation of capital
expenditure budget
 Implementing the proposal
 Performance review
 Evaluation Techniques/Criteria
Non-Discounted Cash Flow Criteria:
Payback Period (PB)
Discounted Payback Period (DPB)
Accounting Rate of Return (ARR)

Discounted Cash Flow (DCF) Criteria:

Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
 Payback
 Payback is the number of years required
to recover the original cash outlay
invested in a project.

If a project generates constant or even

cash inflows annually, the Payback period
can be computed by dividing cash outflow
by annual cash inflow
If the project genereates uneven
cashinflows then
PBP= Time taken to recover the amount so
far+ Balance to be recovered/ cash inflow
in the next year.
 Acceptance Rule
 The project would be accepted if the Payback
period is less than the maximum or Standard
Payback period set by the management.

 As a ranking method, it gives highest ranking to

the project, which has the shortest payback
period and lowest ranking to the project with
highest payback period.
 Evaluation of Payback
Certain Virtues/Advantages
Simplicity
Cost effective
Short term effects
Risk shield

Serious Limitations:
Cash flows after payback period is ignored
Cash flows patterns
Inconsistent with shareholder value
Accounting Rate of Return Method
 Under this method, various projects are ranked
in order of the rate of return.
 The project with the higher rate of return
compared to the minimum cut-off is selected
and the one with lower rate of return than the
cut-off is rejected.
 ARR
There are 4 ways to find out ARR:
1.Average rate of return method
ARR= Average profits after depreciation
&Taxes/Net investments in the
projectx100
2. Return per unit of investment method

ARR= Total profits after

depreciation&Taxes/Net investment x100
3. Return on average investment method

ARR= Total profits after depreciation and

taxes/Average investment x100

Av. Investment =Total investment/2

4.Average return on average investment

ARR= Average profits/Average investment

x100
 Acceptance Rule
 The method will accept all those projects whose
ARR is higher than the minimum rate established
by the mgmt and reject those projects which
have ARR less than the minimum rate.

 This method would rank a project as number

one if it has highest ARR and lowest rank would
be assigned to the project with lowest ARR.
 Evaluation of ARR Method
Merits:
Simplicity
Accounting Data
Accounting Profitability

De-merits:
Cash flows ignored
Time value ignored
Arbitrary/Discretionary cut-off
 Net Present Value Method
 Cash flows of the investment project should be
forecasted based on realistic assumptions.

 Appropriate discount rate should be identified to discount

the forecasted cash flows. The appropriate discount rate
is the project’s opportunity cost of capital.

 Present value of cash flows should be calculated using

the opportunity cost of capital as the discount rate.

 The project should be accepted if NPV is positive (i.e.,

NPV>0)
 Acceptance Rule
 Accept the project when NPV is positive
NPV > 0
 Reject the project when NPV is negative
NPV < 0
 May accept the project when NPV is zero
NPV = 0
 The NPV method can be used to select between
mutually exclusive projects; the one with higher
NPV should be selected.
 Evaluation of NPV
Strengths:
Tells whether firm's value is increased.
Considers all cash flows.
Considers the time value of money.
Considers the riskiness of future cash flows.
Weaknesses:
Requires estimate of cost of capital.
Expressed in terms of rupees, not as a
percentage.
 Evaluation of NPV Method
Merits:
Time Value
Measure of True Profitability
Shareholder Value

De-merits:
Involves cash flow estimation
Discount rate is difficult to determine
Mutually exclusive projects
Ranking of Projects
 Profitability Index
 Profitability Index is also called as Benefit-
Cost Ratio (B/C) or Desirability factor is
the relationship between present value of
the cash inflows and the present value of
cash outflows.
 PI=PV of cash inflows/PV of cash outflows
 Net PI=NPV/Initial cash outlay
 Acceptance Rule
 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
 The project with positive NPV will have PI
greater than one. PI less than one means
that the project’s NPV is negative.
 Evaluation of PI Method
 It recognizes the Time Value of money.
 It is consistent with the shareholder value
maximization principle.
 In the PI Method, since the present value of
cash inflows is divided by the initial cash
outflow, it is relative measure of a project’s
profitability.
 Like the NPV Method, PI criteria also requires
calculation of cash flows and estimate of the
discount rate.
 Internal Rate of Return
 The Internal Rate of Return (IRR) is the
rate that equates the investment outlay
with the present value of cash inflow
received after a period.

 This also implies that - the rate of return is

the discount rate which makes NPV = 0
 Evaluation of IRR Method
Merits:
Time Value
Profitability measure
Acceptance rule
Shareholder value

De-merits:
Multiple rates
Mutually exclusive projects
 NPV versus IRR
NPV IRR
Here, the present value is Here, the discount rate is not
determined by discounting predetermined
the future cash flows of a
project at a predetermined
rate

It recognises the importance It does not consider the

of market rate of interest market rate of interest

The intermediate cash inflows The intermediate cash flows

are reinvested at a cut off are presumed to be reinvested
rate at the IRR

It is more reliable It is less reliable

 RISK AND UNCERTAINTY IN
CAPITAL BUDGETING
 Expected economic life of the project
 Selling price of the product
 Production cost
 Depreciation rate
 Rate of taxation
 Future demand of the product
 LIMITATIONS OF CAPITAL
BUDGETING
 Not practically true
 Requires estimation of future cash inflows
and outflows
 Cannot be correctly quantified
 Urgency
 Uncertainty and risk
 Meaning of cashinflows
For PBP,NPV & IRR cash inflow means-
Profits After tax but before
depreciation.

For ARR – cash inflow means -

Profits After depreciation and tax.