Capital Budgeting

Capital Budgeting
Process of planning capital expenditure to maximise longterm profitability for the organisation Capital budgeting refers to planning for capital assets It helps in taking business decisions as:

Investing in long term projects Installing a machinery Creating capacities Making inhouse, which is outsourced now
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Investment Appraisal Techniques

Traditional Techniques

Payback Period Method Accounting Rate of Return Method

Discounted Cash Flow Techniques (DCF)

Net Present Value Method (NPV) Internal Rate of Return Method (IRR) Profitability Index Method

Problem Pay back period

(When cash inflow is uniform) An investment of Rs 40,000 in a machine is expected to produce a cash inflow of Rs 8,000 p.a then Payback period = 40,000 / 8,000 = 5 years

Problem Pay back period

(Cash inflow in unequal) Initial investment in a machine is Rs 50,000. The table shows yearly cash inflow, what will be the payback period.
Annual Inflows (Rs) Year 1 Year 2 Year 3 Year 4 Rs 10,000 15,000 20,000 25,000

Problem Pay back period

Annual Inflows (Rs) Year 1 Year 2 Year 3 Year 4 Rs 10,000 15,000 20,000 25,000 Cumulative inflows (Rs) 10,000 25,000 45,000 70,000

Problem Pay back period

The initial cost of Rs 50,000 will be recovered between 3rd and 4th year. By 3rd year end Rs 45,000 will be recovered and balance Rs 5,000 will be recovered between 3rd and 4th year = (5000 / 25000) = 1 / 5 Total money will be recovered in 3 1/5 years

Problem Practice
Initial investment in two projects is Rs 1,00,000 and their respective cash inflows is shown in the table. Help the management to select between two projects.
Year 1 2 3 4 5 Project X (cash inflow) 20,000 20,000 30,000 30,000 50,000 Project Y (cash inflow) 25,000 25,000 50,000 20,000 10,000

Accounting rate of return

This method is also known as return on investment or return on capital employed method It measures the net profit arising from an investment in thers of percentage Accounting rate of return =(Avg annual profit after tax / Average Investment) x 100 Average Investment =(Initial investment + Salvage value) / 2
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Problem - Accounting rate of return

The cost of a machine is Rs 80,000. It is expected to have a scrap value of Rs 10,000 at the end of five year period. It is estimated to generate a profit over life as:
Year Year 1 Year 2 Year 3 Year 4 Year 5 Total Net Profit (Rs) 6,000 26,000 16,000 1,000 11,000 60,000
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Problem - Accounting rate of return

ARR = (Avg annual profit / avg investment) x 100 Avg annual profit = (60,000 / 5) = 12,000 Avg investment = (80,000 + 10,000) / 2 = 45,000 ARR = (12,000 / 45,000) x 100 = 26.76 %

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Problem - Practice
ABC company has 3 options of buying a particular machine, select the best one using ARR method
m/c A Cost of m/c Salvage value Life 1,12,000 20,000 6 years m/c B 1,01,000 12,000 8 years m/c C 1,15,000 32,000 4 years

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Problem - Practice

Year 1 2 3 4 5 6 7 8

m/c A 12,000 11,000 10,000 9,000 8,000 7,000 -

m/c B 9,000 8,500 8,200 7,800 7,500 7,000 6,000 5,000

m/c C 18,000 15,000 12,500 10,000 -

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Net Present Value Method

The objective of the firm is to create wealth by using existing and future resources Net present value is obtained by discounting all cash inflows and outflows attributable to investment The method discounts net cash flow from an investment, calculates rate of return and yield If yield is positive, project is acceptable and if yield is negative the project cannot repay for itself The process of calculating present value is called Discounting and factors are Discount factors
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Net Present Value Method

Discount factor = 1 (1 + r)n

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Problem (NPV)
A firm can invest Rs 10,000 in a project with a life of 3 years. The projected cash inflow are: Year 1=Rs 4000, Year 2= Rs 5000 and Year 3= Rs 4000. The cost of capital is 10% p.a. Should the investment be made

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Problem Solution (NPV)

First calculate the discount factor = 1 (1+r)n Year 1 = 1 = 0.909 (1 + 10/100)1

Similarly year 2 = 0.826 and year 3 = 0.751

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Problem Solution (NPV)

Year 0 1 2 3

Cash flow (Rs) 4,000 5,000 4,000

Discount factor 1.00 0.909 0.826 0.751

Present Value (Rs) 3636 4130 3004 NPV = 770

Since the net present value is positive, investment can be done

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Problem
National Electronics Ltd, an electronics goods manufacturing company manufactures large range of electronic goods. It has under consideration two projects X and Y, each costing Rs 120 lakhs. Cash flows for the two projects are given in table. Project X has a life of 8 yrs and Y has a life of 6 yrs. Both will have a salvage value of zero. The company is making profits and its tax rate is 50%. The cost of capital is 15%. Company follows straight line method of depreciation. Compute the NPV of project X and Y
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Problem

Year 1 2 3 4 5 6 7 8

Net cash inflow (Project X) 25 35 45 65 65 55 35 15

Net cash Inflow (Project Y) 40 60 80 50 30 20 -

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Problem - Solution
Project X
End of Cash Year Flow 2 3 4 5 6 7 8 35 45 65 65 55 35 15 Depreciation 15 15 15 15 15 15 15 15
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Problem - Solution
Project X
End of Year 2 3 4 5 6 7 8 Cash Flow 35 45 65 65 55 35 15 Depr 15 15 15 15 15 15 15 15 PBT 10 20 30 50 50 40 20 0
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Problem - Solution
Project X
End of Cash Year Flow 2 3 4 5 6 7 8 35 45 65 65 55 35 15 Depr 15 15 15 15 15 15 15 15 PBT 10 20 30 50 50 40 20 0 Tax 5 10 15 25 25 20 10 0
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Problem - Solution
Project X
End of Cash Year Flow 2 3 4 5 6 7 8 35 45 65 65 55 35 15 Depr 15 15 15 15 15 15 15 15 PBT 10 20 30 50 50 40 20 0 Tax 5 10 15 25 25 20 10 0 PAT 5 10 15 25 25 20 10 0
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Problem - Solution
Project X
End of Year 2 3 4 5 6 7 8 Cash Flow 35 45 65 65 55 35 15 Depr 15 15 15 15 15 15 15 15 PBT 10 20 30 50 50 40 20 0 Tax 5 10 15 25 25 20 10 0 PAT 5 10 15 25 25 20 10 0 Net CF = PAT + Depr 25 30 40 40 35 25 15
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Problem - Solution
Project X
End of Cash Year Flow 2 3 4 5 6 7 8 35 45 65 65 55 35 15 Depr 15 15 15 15 15 15 15 15 PBT 10 20 30 50 50 40 20 0 Tax 5 10 15 25 25 20 10 0 PAT 5 10 15 25 25 20 10 0 Net CF 25 30 40 40 35 25 15 Discount factor 0.756 0.658 0.572 0.497 0.432 0.375 0.327
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Problem - Solution
Project X
End of Cash Year Flow 2 3 4 5 6 7 8 35 45 65 65 55 35 15 Depr 15 15 15 15 15 15 15 15 PBT 10 20 30 50 50 40 20 0 Tax 5 10 15 25 25 20 10 0 PAT 5 10 15 25 25 20 10 0 Net CF 25 30 40 40 35 25 15 DF 0.87 0.756 0.658 0.572 0.497 0.432 0.375 0.327 PV 17.4 18.9 19.74 22.88 19.88 15.12 9.4 4.91
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Problem Solution (Project X)

End of Cash Year Flow 2 3 4 5 6 7 8 35 45 65 65 55 35 15 Depr 15 15 15 15 15 15 15 15 PBT 10 20 30 50 50 40 20 0 Tax 5 10 15 25 25 20 10 0 PAT 5 10 15 25 25 20 10 0 Net CF 25 30 40 40 35 25 15 DF 0.87 0.756 0.658 0.572 0.497 0.432 0.375 0.327 PV 17.4 18.9 19.74 22.88 19.88 15.12 9.4 4.91 128.23 120 8.23
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P V of cash inflows Less: Initial Investment Net Present Value (NPV)

Problem Solution (Project Y)

End of Cash Year Flow 2 3 4 5 6 60 80 50 30 20 Depr 20 20 20 20 20 20 PBT 20 40 60 30 10 0 Tax 10 20 30 15 5 0 PAT 10 20 30 15 5 0 Net CF 40 50 35 25 20 DF 0.87 0.756 0.658 0.572 0.497 0.432 PV 26.1 30.24 32.9 20.02 12.43 8.64 130.33 120 10.33
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P V of cash inflows Less: Initial Investment Net Present Value (NPV)