Capital BudgetingMeaning

Capital Budgeting refers to the

expenditure on the capital assets.
Spending money on capital assets is
a very important decision that a
finance manager is required to take.
Capital investment expenditure may
be on Plant, Machinery
Equipment, Land, Building and
Bridges Etc.
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CAPITAL BUDGETING
Why?

Perhaps most impt.

function financial
managers must perform

Results of Cap Budgeting

decisions continue for
many future years, so firm
loses some flexibility
Cap Budgeting decisions
define firms strategic
direction.
Timing key since Cap
Assets must be put in
place when needed

Business Application

Valuing projects that

affect firms strategic
direction
Methods of valuation
used in business
Parallels to valuing
financial assets
(securities)

Significance

Although spending money on

anything is important, but the
capital expenditures are more
important and the finance
manager is therefore, required to
be much more cautious in making
such decision for the following
reasons.3

Contd.

It involves substantially higher amounts

than for other routine expenses.
The decision is irreversible, i.e. it is not
possible to withdraw your steps easily,
once you have taken few steps in this
regard.
It has long term impact on the affairs of
a company and it, infect, determines
the future of a company.
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Contd.

An expenditure made on a capital asset

has a long term prospective.
We spend today, to gain some
advantages in future. This expenditure
involves a big cash outflow of funds
initially, compensated by small but
recurring doses of inflow of funds in
future for some time.
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Contd.

The essence of the capital budgeting

decision making is to determine, whether
the initial expenditure of funds is duly
compensated by the inflow of funds
occurring in future. If greater values can be
assigned to the inflow of funds than the
present expenditure, then that the capital
investment proposal must be accepted
because that will add to the wealth of the
company.
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Investment Decision Rule

It should maximise the shareholders wealth.

It should consider all cash flows to determine the true
profitability of the project.
It should provide for an objective and unambiguous way of
separating good projects from bad projects.
It should help ranking of projects according to their true
profitability.
It should recognise the fact that bigger cash flows are
preferable to smaller ones and early cash flows are
preferable to later ones.
It should help to choose among mutually exclusive projects
that project which maximises the shareholders wealth.
It should be a criterion which is applicable to any
conceivable investment project independent of others.

Types of Capital
Budgeting Decision
It
consists
broadly
following
investment decisions.
1.
New Projects
2.
Expansion Project
3.
Renewal Projects
4.
Exploration Projects (Oil Well)
5.
Research & Development (R & D)
Projects.
6.
Projects For Compliance of Certain
Statutory Requirement.
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Methods based on the

assumption of certainty

Simple Methods:

Accounting/ Average Rate of Return (ARR)

Payback Period
Discounted Payback Period

Scientific Methods:

Net Present Value (NPV)

Internal Rate of Return (IRR)
Benefit- Cost (B-C) Ratio or Profitability Index
(PI)

Methods which take in to

consideration uncertainty of
cash
flows

Conservative Estimates
Certainty Equivalent Coefficient
Risk Adjusted Discounted Rate
Probability Distribution of
Uncertainty
Sensitive Analysis

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Simple Methods of Capital

Budgeting

Accounting/ Average Rate of Return

(ARR)
Payback Period
Discounted Payback Period

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Payback Period

The payback period is the time

duration required to recover the
initial cash outflows. This method
is based on cash flows and not on
accounting data like the ARR.
Initial cash outflow

Payback period =
Annual cash inflows
12

Contd.
If the cash inflows are not uniform
then
Payback period = time period in
which the cumulative cash flows
are equal to initial inflows.

13

Acceptance and Ranking

Rule:

If the calculated payback is less

than any predicted value then an
investment proposal is acceptable,
otherwise it will be rejected.
So far as ranking is concerned, the
lower the value of the payback, the
higher will be the ranking of any
investment proposal.
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Evaluation of Payback
Method:

It is a simple method in concept and

understanding.
Since its emphasis is on early recovery
of investment, it automatically takes
care of risk.
Projects with smaller payback period is
considered safer and secure as
compared to the projects with longer
payback.
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Discounted Payback
Period:

To overcome the limitation of the

payback that it does not use time
value of money, we may use the
discounted cash flows in order to
calculate the payback period.
Obviously the discounted payback
will be longer than the simple
payback period.
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Accounting/ Average Rate

of Return (ARR)

The Accounting Rate of Return also

called the Average Rate of Return.
It is the average rate of return for
different years for the whole life of
an asset.
It is a ratio between the Net Profit
After Tax and the amount of Initial
Investment made in the Project.
17

Contd.
Average PAT
ARR =
Average Investment

18

Scientific Methods:

Net Present Value (NPV)

Internal Rate of Return (IRR)
Benefit- Cost (B-C) Ratio or
Profitability Index (PI)

19

Net Present Value

(NPV)

It is net present value of all the cash flows

that occur during the entire life span of a
project
The outflows will have negative values while
the inflows will have positive values.
Obviously, if the present value of inflows is
greater than outflows, we get a positive NPV
and if the present value of outflows is
greater than inflows, we get a negative NPV.
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Contd.

The positive NPV means a net gain

in
value
maximization
and,
therefore, any project which gives
a positive NPV is an acceptable
project and if it gives a negative
NPV, then the project should not
be accepted.

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Net Present Value Method

Net present value should be found

out by subtracting present value of
cash outflows from present value
of cash inflows. The formula for the
net present value can be written as
follows

C3
Cn
C1
C2
NPV

L
C0
2
3
n
(1 k )
(1 k )
(1 k ) (1 k )
n
Ct
NPV
C0
t
t 1 (1 k )

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Acceptance Rule &

Ranking Rule:

The acceptance rule for NPV is

that, if it is positive, then the
proposal should be accepted and if
it is negative then it can not be
accepted. In case of same size
projects, the higher the value of
NPV the higher would be the
ranking of a project.
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Interpretations of NPV:

NPV is the absolute value of a net gain

in future. This may be treated as a net
addition to the value of the firm and
therefore, it is also called capital gain.
Another interpretation of NPV is that it
represents the maximum price that a
firm should pay for foregoing the right
to undertake the project or to sell the
project to some other party.
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Contd.

It also represents the amount that a firm

could raise from the market at given rate of
interest, in addition to the initial cost of the
project, and ensure that this will be paid off
from the receipts of the project.
For example; A firm is undertaking a project
at a cost of Rs. 50,000 with a positive NPV of
Rs. 10,000. In this case, the firm can not
borrow merely Rs. 50,000 to meet the initial
cost, but can also raise Rs. 10,000 (for any
other purpose) and be rest assured that this
sum with interest can be paid off from the
proceeds of the given project.
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Limitations of NPV:

It gives the absolute value and therefore,

comparison between two different projects is not
easy, especially when they are of different sizes.
Many a times, it is not possible to know in
advance the rate of interest at which discounting
is to be done. Similarly a given NPV may not be
appropriate if the rate of interest has changed.
It may lead to wrong decision making especially
when limited funds are available and we have to
choose between different options.
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Benefit- Cost (B-C) Ratio

or Profitability Index (PI)
NPV is an absolute value and therefore it is not
appropriate for comparing the relative profitability
between different projects.
In order to overcome this limitation of NPV, we make
one modification in it to make it a relative
measurement. This is called Profitability Index (P.I.)
or Benefit Cost Ratio (B-C Ratio). The P.I. is as
follows.
Present value of inflows
P.I. =
Present value of outflows

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Acceptance and Ranking

Rule:

If the P.I. is greater than 1, then the

project is to be accepted and if it is
less than 1 then it is to be rejected.
However, if we have, several
projects then the project with a
higher P.I. or B.C. ratio should have
a higher ranking.
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Comments

When Investment is different in various

projects, PI method is preferred in
comparison to NPV method because it
measures the profitability in relation to
the investment in the project. Hence,
although NPV of C is the highest, the
company will prefer project B because
of its highest profitability index.

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NPV & PI :

The NPV and PI are both based on a given rate

of discount and, therefore, the NPV and PI
values change as soon as the rate of discount is
changing.
Hence, any project which is acceptable at, say,
10% rate of discount may not be the same at,
say, 12% rate.
Therefore, there is need to find out a technique
which is autonomous in itself and not
dependent upon any externally determined rate
of interest.
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Internal Rate of Return

Method
The internal rate of return (IRR)

is the
rate that equates the investment outlay
with the present value of cash inflow
received after one period. This also
implies that the rate of return is the
discount rate which makes NPV = 0.
C0

C3
Cn
C1
C2

L
2
3
(1 r ) (1 r )
(1 r )
(1 r ) n
n

C0
t 1
n

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t 1

Ct
(1 r )t
Ct
C0 0
t
(1 r )

Acceptance Rule

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Accept the project when r > k.

Reject the project when r < k.
May accept the project when r = k.
In case of independent projects,
IRR and NPV rules will give the
same results if the firm has no
shortage of funds.

It can be expressed as follows

The Internal Rate of Return IRR can be calculated by
use of log or by a scientific calculator or by
computer instantly. However, the following
method can be used for the purpose.
x
IRR = r +
xy
Where r = the closest rate at which NPV is positive
x = value of positive NPV at that level
y = value of negative NPV at next higher rate

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Acceptance and Ranking

Rule for IRR:

The IRR should be greater than the given

discount rate (cost of capital) to make a
project acceptable.
If IRR is less than the cost of capital then,
the proposal can not be accepted as it will
lead to a negative NPV.
Since, IRR is a rate of return, the project
with a higher IRR should be ranked higher
than the other project which has a lower
IRR.
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Modified Internal Rate of

Return (MIRR)

35

The modified internal rate of

return (MIRR) is the compound
average annual rate that is
calculated with a reinvestment
rate different than the projects
IRR.

Reinvestment Rate
Assumptions

NPV assumes reinvest at r

(opportunity cost of capital).
IRR assumes reinvest at IRR.
Reinvest at opportunity cost, r, is
more realistic, so NPV method is
best. NPV should be used to choose
between mutually exclusive
projects.
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