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Capital Budgeting Tools

Process of
Capital Budgeting
1. Define Cash Inflows & Outflows of project
2. Test the Viability

Assess Risk of CFs.

Determine k (WACC) for Project.

Select a appropriate capital budgeting tool

Find value using tool

3. Accept / Reject based on Criteria


Dr Raju Indukoori

Defining Cash Flows


Normal Cash Flow Project
One changes of signs
-Ve CF followed by a series of +Ve cash inflows.

Non Normal Cash Flow Project


Two or more changes of signs.
-Ve CF, then +ve CFs, then Ve CFs (cost to close
project) for Example Nuclear Power plant

Dr Raju Indukoori

Inflow (+) or Outflow (-) in Year

N / NN

+
-

+
+
+
+

+
+
+
+

+
+
+
-

+
+
+
+

+
+
-

N
NN
N
N
NN

Dr Raju Indukoori

Tools Of Capital Budgeting

Traditional Tools

Accounting Rate of Return (ARR)


Pay Back Period (PBP)

Discounting tools

Net Present Value (NPV)


Benefit Cost Ratio (BCR)
or Profitability Index (PI)
Internal Rate of Return (IRR)
Annual Capital Charge (ACC)

Dr Raju Indukoori

Tools Of Capital Budgeting

Traditional Tools

Accounting Rate of Return (ARR)


Pay Back Period (PBP)

Discounting tools

Net Present Value (NPV)


Benefit Cost Ratio (BCR)
or Profitability Index (PI)
Internal Rate of Return (IRR)
Annual Capital Charge (ACC)

Dr Raju Indukoori

Accounting Rate of Return

Accounting Rate of Return

It is the simple tool to make a capital budgeting


decisions

It doesnt consider time value of money i.e.


compounding or discounting.

It is known as ARR because It considers the net


income and book value of investments for the
life of the project as stated in Accounting or
financial statements.

It is also known as
Average rate of return (ARR)
Accounting average rate of return (AARR)
Dr Raju Indukoori

Accounting Rate of Return


Formula
Average Returns for the Period
ARR
*100
Average Book Value of Investments

Profits after Tax (PAT) are the returns

Book value changes


depreciation methods

Dr Raju Indukoori

according

to

the

Accounting Rate of Return


Problem
A project is expected to give AED 233,000 PAT
every year for 10 years with an investment of AED

1,000,000. Find its ARR

Dr Raju Indukoori

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Accounting Rate of Return


Problem
What is the ARR of a project is expected to give
AED 233,000 PAT every year for 8 years with an

investment of AED 1,000,000.

Average Returns for the Period


ARR
*100
Average Book Value of Investments

Dr Raju Indukoori

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Accounting Rate of Return


- Problem Time Line
AED
233 K

14

AED
233 K

15

AED
233 K

16

AED
233 K

17

AED
233 K

AED
233 K

18

19

AED
233 K

20

AED
233 K

AED AED
233 K 233 K

21

22 23
AED
-0

AED
-1M

Dr Raju Indukoori

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Accounting Rate of Return


Problem Solution
A project is expected to give AED 233,000 PAT
every year for 10 years with an investment of AED
1,000,000. Find its ARR
Average Return is
Average Investment

= AED 233,000
= (1,000,000 + 0) /2
= AED 500,000
233,000
ARR
*100 46.6%
500,000
Dr Raju Indukoori

13

Views on ARR

Advantages

Simple measure.
Easy access to information.

Disadvantages
Can be applied for situations to take decisions
at prima facie situations but not for real time
decisions.
The value is from accounting or financial
statements but not market Value.

Dr Raju Indukoori

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Pay Back Period (PBP)

It is the simple tool to make a capital budgeting


decisions

It doesnt consider time value of money i.e.


compounding or discounting.

It is applied to the projects where the investment


manager looks at the time period covering the
investment.

Dr Raju Indukoori

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Pay Back Period (PBP)


- Formula
PBP CF1 CF2 CF3 ...... CFn till equated to investment

We add cash flows from year 1 to nth year till we equate them
to investments.

The answer is the nth year where cumulative cash flows


exactly equate the investment.

If CFn doesnt exactly equate investment in the nth year, then


we need to take the fraction of nth year according to the
fraction of CF required to equate Investment to CFn in nth
year.
Dr Raju Indukoori

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Pay Back Period (PBP)


- Time Line
0

CFt
-100
Cumulative -100
PaybackL

= 2

10
-90
+

30/80

Dr Raju Indukoori

60 100
-30
0

3
80
50

= 2.375 years

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Pay Back Period (PBP)


- Problem
What is the PBP of a AED 800,000 project with cash
Inflows of AED 250,525, AED 325,877, AED 357,289 AED
395,267, AED 410,555 of cash flows for 5 years.

Dr Raju Indukoori

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Pay Back Period


- Problem Time Line
AED
250, 525

AED
325,877

AED
357,289

AED
395,267

AED
410,555

14

15

16

17

18

0
AED
- 800 00

Dr Raju Indukoori

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Pay Back Period


- Problem Solution
AED
250, 525

AED
325,877

AED
357,289

AED
395,267

AED
410,555

14

15

16

17

18

0
AED
- 800 000

250,525 + 325,877 + 357,289 = AED 933, 691


The Answer is more than the investment value
Identify how much you need to equate the investment in 3rd year.
It is 223,598. Accordingly fraction of this to 3rd year Cash flow is 0.63.
So the answer is 2 + 0.63 = 2.63 Years.
Dr Raju Indukoori

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Pay Back Period


- Problem Time Line
AED
250, 525

AED
325,877

AED
357,289

AED
395,267

AED
410,555

14

15

16

17

18

0
AED
- 800 00

Dr Raju Indukoori

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Pay Back Period (PBP)


- Problem
A project has AED 120,000 cash inflows for

the first 4

years and AED 350,000 for rest of the years. If required


PBP is 4 years with an investment of AED 600,000,
suggest whether the project hast to be accepted / rejected
120,000 + 120,000 + 120,000 + 120,000 120,000 = 600,000

So the answer is 6 years


Project has to be rejected
But this project has attractive cash Inflows after PBP.

Dr Raju Indukoori

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Accounting Rate of Return


- Problem Time Line
AED
120 K

14

AED
120 K

15

AED
120 K

16

AED
120 K

17

AED
350 K

AED
350 K

18

19

AED
350 K

20

AED
350 K

AED
AED
350 K 350 K

21

22 23
AED
-0

AED
- 600 K

Dr Raju Indukoori

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Pay Back Period (PBP)


- Problem
A project has AED 120,000 cash inflows for

the first 4

years and AED 350,000 for rest of the years. If required


PBP is 4 years with an investment of AED 600,000,
suggest whether the project hast to be accepted / rejected
120,000 + 120,000 + 120,000 + 120,000 120,000 = 600,000

So the answer is 6 years


Project has to be rejected
But this project has attractive cash Inflows after PBP.

Dr Raju Indukoori

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Views on PBP

Advantages

Simple measure.
Easy access to information.
Suitable for ST projects

Disadvantages
Can be applied for situations to take decisions
at prima facie situations but not for real time
decisions.
The value is from accounting or financial
statements but not market Value.
Ignores post PBP cash flows making it not
applicable to LR projects.
Dr Raju Indukoori

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PBP of a Project
(Short: CFs come quickly)
0
CFt

-100

Cumulative -100

PaybackS

1.6 2

70 100 50

20

-30

40

0 20

= 1 + 30/50 = 1.6 years

Dr Raju Indukoori

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Thank You

Dr Raju Indukoori

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