Capital Budgeting

Project selection exercise performed

by the business enterprise
• Capital budgeting or investment appraisal is the
planning process used to determine whether an
organization's long term investments such as
new machinery, replacement machinery, new
plants, new products, and research development
projects are worth pursuing.
• It is budget for major capital, or investment,
expenditures
Capital budgeting versus current
expenditures
• A capital investment project can be
distinguished from current expenditures by two
features:

a) such projects are relatively large

b) a significant period of time (more than one
year) elapses between the investment outlay and
the receipt of the benefits..
Capital budgeting techniques
• Non-Discounting:
Pay Back Period Method
ARR
Profitability Index
• Discounting:
NPV
Discounted Pay Back Period Method
IRR
Benefit Cost Ratio
What is the Payback Period?

The number of years required to

recover a project’s cost,

or how long does it take to get the

business’s money back?
Payback for Franchise L
(Long: Most CFs in out years)

0 1 2 2.4 3

CFt -100 10 60 100 80

Cumulative -100 -90 -30 0 50

PaybackL = 2 + 30/80 = 2.375 years

Initial Investments for the project is
Rs 50000 Yr Cash Flows
(CF)
1 5,000
2 7,000
3 10,000
4 15,000
5 15,000
6 15,000
Calculate the PBP of the project
Select the best Project
Initial Project X Project Y
Investmen (1,00,000 (1,00,000
ts ) )
1 20,000 25,000
2 20,000 25,000
3 30,000 50,000
4 30,000 20,000
5 50,000 10,000
Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and understand.

Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
Accounting Rate Of Return (ARR)

Accounting rate of return is the rate

arrived at by expressing the average annual net
profit (after tax) as given in the income
statement as a percentage of the total
investment or average investment.
Accounting profits are different from the
cash flows from a project and hence, in many
instances, accounting rate of return might not
be used as a project evaluation decision.
There are two projects (Project A and B) available for a
business enterprise, with a life of 6 years each and
requiring a capital outlay of Rs.9,000/-

Calculate ARR
Discounting Factor

1
(1+r)n
Net present value
• Net present value of an investment/project is the
difference between present value of cash inflows
and cash outflows. The present values of cash
flows are obtained at a discount rate equivalent
to the cost of capital.
Cal. NPV(cost of Capital 10%)

Initial Project X
Investmen (1,00,000
ts )
1 20,000
2 20,000
3 30,000
4 30,000
5 50,000

Method 1
Method 2
Cal. NPV
• There are two projects X & Y, each costing Rs.
120 lacs
• X has a life of 8 yrs and Y has 6 yrs. Both have a
zero salvage value at the end of their operational
lives.
• Tax Rate is 50% & cost of Capital is 15%
Yrs Project X Project Y
1 25 40
2 35 60 Advice the company
3 45 80 regarding the
4 65 50 selection of the
5 65 30 project
6 55 20
7 35 -
8 15 -
Benefit-Cost Ratio
• It is also called profitability Index

BCR =PVB Initial Project X

I Investments (1,00,000)
1 20,000
2 20,000
3 30,000
NBCR=BCR -1 4 30,000
5 50,000
IRR
• Of a project is the discount rate which makes its
NPV equal to Zero.
• Put differently, it is the discount rate which
equates the present value of future cash flows
with the initial investment.
• It is the value of r in the following equation.
Probm 1

Initial Project X
Investments (1,00,000)
1 30,000
2 30,000
3 40,000
4 40,000
Probm 2

Initial Project X
Investments (1,00,000)
1 20,000
2 20,000
3 30,000
4 30,000
5 50,000
MIRR
• PVC = TV
(1+MIRR)