CAPITAL BUDGETING

Concerned with budgeting of the capital.

Its about spending the capital.

Thus it deals with the investment decisions of the

company.

Investment decisions include the expansion, acquisition,

modernization and replacement of long term assets.
In this part of the course we learn the methods
used to evaluate any project that the
company intends to undertake.
 METHODS

Discounted Cash Flow Non-Discounted Cash

Methods Flow
Pay-Back
Net Present Value (NPV) Period

IRR (Internal Rate of Return)

ARR
Benefit-Cost Ratio (Profitability (Accounting
Index) Rate of
Discounted Payback Return)
Period method
 NET PRESENT VALUE (NPV)

Present Value of Inflows – Present value of

= Outflows

Evaluating the Project

Accept if NPV >0
Reject if NPV <0

May Accept if NPV = 0

A project costs Rs. 81,000 and is expected to generate
net cash inflows of Rs.40,000, Rs.35,000, Rs30,000
over its life of three years. Compute the NPV of the
project if the discounting rate is 15%. Should the
project be accepted?

-26.87
 INTERNAL RATE OF RETURN (IRR)

Is the rate of return that equates the NPV of

a project to zero

Present Value of Present value of

Inflows - Outflows =0
Evaluating the Project

If r is the required rate and K is the IRR, then

Accept the project if K>r

Reject the project if K<r

May accept if K= r
A project costs Rs. 81,000 and is expected
to generate net cash inflows of Rs.40,000,
Rs.35,000, Rs30,000 over its life of three
years. Compute the IRR of the project.
Should the project be accepted if the
required rate is 16%?

14.98%
 Benefit Cost Ratio (BCR)

Also called Profitability Index

BCR = PV of future cash flows

Initial Investment

Evaluating the Project

Accept if BCR >1

Reject if BCR <1

May Accept if BCR = 1

A project costs Rs. 81,000 and is expected
to generate net cash inflows of Rs.40,000,
Rs.35,000, Rs30,000 over its life of three
years. Compute the BCR or PI of the project
if the discounting rate is 14%. Should the
project be accepted ?

1.02
 Discounted Pay Back Period

Pay back period is defined as the number of years

required to recover the original investment in a project

A project involves an initial outlay of 40,000. The

cash inflow in the first second and third year from
the project are 10,000, 20,000 and 20,000
respectively. Compute the pay back period. If the
discount rate is 10%, compute the discounted pay
back period.

2 and 6 months 2 years, 11months, 14 days

 ARR (Accounting Rate Of Return)

ARR = Average Income/ Average Investment

ARR = Σ EBIT (1-t) /n

(I0 + In)/2
A company invests Rs.30,000 in a project. The table below
shows the sales and profit that are derived from the project.
Compute the company’s ARR, assuming the tax rate is 35%.

  Year 1 Year 2 Year 3

Sales 50,000.00 60,000.00 70,000.00
Operating expenses 30,000.00 35,000.00 38,000.00
EBDIT 20,000.00 25,000.00 32,000.00
Dep 10,000.00 10,000.00 10,000.00
EBIT 10,000.00 15,000.00 22,000.00

67.89%
 Problems in IRR

Consider a project with the following cash inflow/outflow

profile:
Year 0 1 2
Cash
flow -1000 4000 -3750

Compute the IRR of the project. If the required rate

of return is 60%, then should the company take up
the project?

50% and 150%

Thus in non-conventional cash flows sometimes
IRR method would give two rates. The problem is
which rate to take for the purpose of evaluating the
project.

Use the NPV method to find whether the

project should be accepted at a discount rate
of 60%.

35.15
Thus a positive NPV gives an un-biased answer in
terms of rejection or acceptance of a project.

There are some rates at which the project is

acceptable and others at which the project
becomes un-acceptable.

Let’s plot the NPV against various

values of discount rate to see the
discount rates at which the project
becomes un-acceptable.
 200
100
0
-1000% 50% 100% 150% 200%
-200
NPV

-300
-400
-500
-600
-700
-800
Discount rate
NPV and IRR methods could give conflicting results in
case of mutually exclusive projects in the following cases:

1. When the cash flows pattern among the

cash flows differs

2. When the scale of investment required is

different.

3. When the project have different expected

lives