Capital Budgeting Techniques

Prof. Nidhi Bandaru

 Introduction
“Commitment of resources made in the hope
of getting benefits that are expected to occur
over a reasonably long period of time into the
future.”
Bierman & Smith

 Investment for a long-term purpose

 Irreversibility of Decisions
Capital Budgeting Process
1 Identification of Potential Investment Opportunities
●

2 Assembling of Proposed Investments

●

3 ●
Decision Making

4 Preparation of Capital Budget and Appropriations

●

5 ●
Implementation

6 ●
Performance Review
Project Classification
 Mandatory investments
 Replacement projects / Investment in new

technology
 Diversification projects
 R & D projects
 Miscellaneous projects
 Marketing and Advertising
 Choices among different production processes
 Expanding into new products, industries, or

markets
 Acquisitions
Investment Criteria

Invetsment Criteria

Discounting Techniques Non - Discounting Techniques

Pay back period
 It is simple to understand and easy to
calculate.
 It facilitates to determine the liquidity and

solvency of the firm.

 It enables the firm to select an investment

that yields a quick return on cash funds.

 It is used as a measure of ranking competitive

projects.
 It ensures the reduction of cost of capital

expenditure.
Acceptance Rule of PBP
If pay back period is less than the maximum
pay back period which is set up by the
management, the project would be accepted,
on the contrary, it would be rejected. Project
which has a shorter period will be selected
between the two.
Disadvantages of PBP
 It does not measure the profitability of a
project.
 It does not consider income beyond the pay

back period.
 It does not give proper weightage to timing of

cash flows.
 It does not consider cost of capital and

interest factors, which are very important

factors in taking sound investment decisions.
Accounting Rate of Return
 Average Rate of Return / Return on
Investment
 According to this technique all those projects

whose ARR is higher than the minimum rate

of return established by the management and
reject those projects expected to give a
return below the minimum rate.
Advantages of ARR
 It considers all years involved in the life of a
project rather than only the pay back years.
 It is simple to use and understand.
 It applies accounting profit as a criteria of

measurement and not cash flow.

Disadvantages of ARR
 It applies profit as a measure of yardstick and
not cash flows.
 The time value of money is ignored.
 Determining yearly profit may be a difficult

task sometimes.
 It does not consider the length of lives of the

project.
Net Present Value (NPV)
 Excess Present Value/ Net Gain Method
 All cash inflows and outflows are converted

into PV by discounting
 NPV = PV of cash inflows - PV of cash

outflows
 Acceptance rule:

◦ PV of cash inflows >= PV of cash out flows (accept)

◦ NPV is positive (accept)
◦ PV of cash inflows < PV of cash out flows (reject)
◦ NPV is negative (reject)
Advantages of NPV
 Scientific approach as it recognizes TVM
 All cash flows spread out through the life of

the project are used

 Facilitates comparison between projects
 This method can be applied where cash flows

are uneven
Disadvantages of NPV
 Not easy to determine the discounting rate
 Comparatively difficult than non-discounted

techniques
 Difficult to forecast economic life of any

investment exactly
 When the projects in consideration involve

different amounts of investment, the NPV

method may not give satisfactory results
Internal Rate of Return (IRR)
 Time adjusted Rate of Return Method
 It I defined as that rate which equates the PV of each
cash inflows with the PV of cash outflows of an
investment
 IRR is that discount rate at which NPV of the
investment is zero
 The trail and error method needs to be used to
calculate IRR
 Interpolation:
IRR = lower interest rate + (NPV of Lower Rate /NPV of
lower rate – NPV of higher rate) * (lower rate – higher
rate)
Rules of Acceptance of IRR
 Accept the project when IRR>k
 Reject the project when IRR<k
 Project may be accepted when IRR = k

◦ K is opportunity cost/hurdle rate/required rate of

return
Profitability Index (PI)
 Benefit Cost Ratio
 Gives the PV of future benefits, computed at

the required rate of return

 The ratio of the present value of the cash

flows to the initial outlays in profitability

index or benefit cost ratio.
 The profitability index = PV of cash inflows /

Initial Cash Outlays

Rules of Acceptance of PI
 Profitability Index > 1 (accept)
 Profitability Index < 1 (reject)
 Profitability Index = 1 (may accept)
Advantages of PI
 It duly recognizes the TVM
 For calculations, when compared with IRR

method it requires less time

 It helps in ranking the project for investment

decisions
 It considers all cash flows
 It is consistent with the shareholder’s wealth

maximization objective.
Disadvantages of PI
 It is similar to NPV approach
 It measures the present value of return per

rupee invested
 It measures the PV of return per rupee

invested. Whereas NPV depends on the

difference between PV of NCF and PV of cash
outflow.
 Estimation of Project Cash flows
 How much to invest (capital decision)
 What are the recurring expenses (revenue

decision)
 Cost for day to day activities (Working Capital

decision)
Elements of Cash Flow Stream
 Conventional project stream

◦ Initial Investment

◦ Operating Cash Inflows

◦ Terminal Cash Inflows

 Time Horizon for Analysis
 Physical Life of the Plant

 Technological Life of the Plant

 Product Market life of the Plant

 Investment Planning Horizon of the Firm

 Basic Principles of CF Estimation
 Separation Principle

 Incremental Principle

 Post-tax Principle

 Consistency Principle
Separation Principle
 Cash flows associated with investment side
and financing side should always be
separated.
Project

Financing Investment
 Operationally it means that interest of debt is
ignored while computing profits and taxes
thereon.
 If, interest is deducted for arriving at profit

after tax, an amount equal to “interest (1-tax)

” should be added to PAT.
 PBIT

◦ = (PBT + I) (1-Tax)
◦ =(PBT)(1-Tax) + Interest (1-Tax)
◦ = PAT + Interest (1-Tax)
Incremental Principle
 Cash flows should always be measured in
incremental terms (dynamic approach)
 Consider position of cash flows with and

without the project

 Consider all Incidental Effects
 Ignore Sunk Costs
 Include Opportunity Costs
 Estimate Working Capital properly
 Post-Tax Principle
◦ Cash flows should be measured on post tax basis

 Consistency Principle
◦ The cash flow of a project may be estimated from
the point of view of all investors or from the point
of view of equity shareholders.
◦ The discount rate must be consistent.
◦ Cash flow to all investors – WACC
◦ Cash flow to equity – Cost of Equity