Capital Budgeting

1
2 Concept:

In any business investment of funds are required for two

purposes:
 Investment in fixed assets
 Investment in working capital
The aspect of taking the financial decisions with regard to
fixed assets is known as capital budgeting decision.
3 Project evaluation techniques:

 At each point of time business manager will have a

number of proposals regarding various projects in which
he can invest money. He has to compare and evaluate
all these projects and decide which one to take up and
which one to reject.
 To evaluate the financial aspects of a project, these
techniques can broadly be categorized into two classes.
4
Capital Budgeting Techniques

Non-Discounting Approach Discounting Approach

a) Accounting rate of return a) Net present value

b) Pay-back period method b) Profitability index
c) Internal rate of return
d) Discounted pay-back period
5 Non Discounting Techniques

 Pay-back period method:

It is the period within which the total cash inflows from the
project equal the cost of the project. Cash inflow means
profit after tax but before depreciation.

Selection criteria: The project with lower payback period

will be preferred.
6
Examples

 1.Project cost Rs.20,00,000. It yields annually a profit of Rs. 3,00,000 after

depreciation @ 12.5%( straight line method) but before Tax @ 50%. What is the
Pay back Period Of this Project?
 2. Project cost Rs. 4,00,000. Earning after taxation but before depreciation are
expected to be as follows:-
Year Cash flows
1 40,000
2 1,20,000
3 1,60,000
4 2,40,000
5 1,60,000
Calculate Pay back Period ?
7 Non Discounting Techniques Contd..

 Accounting or average rate of return method:

Under this method the average annual yield on the project
is considered. Here, yield means profit after tax and
depreciation.

ARR = (Average Profit / Net Investment) x 100

Net investment means  cost of project – salvage value

8 Example
 Project cost Rs. 4,00,000. Earning after taxation but before depreciation are
expected to be as follows:-

Ye Cash flows
ar
1 40,000
2 1,20,000
3 1,60,000
4 2,40,000
5 1,60,000
 Compute accounting rate of return?
 Discounting Techniques
9  Net present value method (NPV):
The net present value of an investment proposal may be
defined as the sum of the present values of all the cash
inflows less the sum of the present values of all the cash
outflows associated with the proposals.
Steps to calculate NPV:
1. Determine the cash outflows
2. Determine the cash inflows
3. Determine the discounting rate
4. Discounts cash inflows and outflows
5. NPV = Present value of cash inflows – Present value of
cash outflows
10 Acceptance rule for NPV

 A project may be accepted if NPV is positive i.e. NPV>0

and rejected when NPV is negative i.e. NPV<0.

 If NPV=0, A project may be accepted because it implies

that project generates cash flows at a rate just equal to
the opportunity cost of capital
11 Question no.-4
 Q.4 Star construction is considering installing a new crane costing Rs.20 lacs to
improve its construction efficiency. The company decides to raise Rs.6 lacs from
its own sources and raise a loan of Rs.14 lacs from the bank. This loan is re-
payable in 4 equal installments at the end of each year. Rate of bank interest is
14% per annum. The life of crane is expected to be 5 years at the end of which
salvage value will be equal to its book value.
 The company will be able to save net Rs.8 lacs in terms of cost of labour and
time even after incurring operating cost of Rs.1.5 lacs per year. This cost does
not include depreciation.
 Company’s cost of capital is 18%. The depreciation rate applicable is 25% on
WDV and tax rate for the company is 30%.
 Is the investment in new crane advisable?
12 Discounting Techniques Contd..

 Internal Rate of Return Method:

It is that rate at which discounted cash inflows are equal to
the discounted cash outflows. In other words, it is the rate
which discounts the cash flows to zero means NPV will be
zero. It can be stated in the form as a ratio:

PV of cash inflows / PV of cash outflows = 1

13 How to find the IRR?

 This rate is be found by trial and error method

 As we used a higher discounting rate the total of the
present values of inflows went down
 Similarly, if we use a lower discounting rate the present
value of cash inflows will increase
 By trial and error we can reach a rate at which the
discounted cash inflows and outflows will be equal. This
would be our IRR.
14 Acceptance rule for IRR:

 In evaluating investment proposals internal rate of return

is compared with a required rate of return, known as
cut-off rate.
 If IRR is more than cut-off rate the project may be
accepted otherwise project is rejected.
15 Question -5
 Q.5:An investment of Rs. 1,36,000 yields the following cash inflows. Determine
internal rate of return.
 Year Rs.
 1 30,000
 2 40,000
 3 60,000
 4 30,000
 5 20,000


16 Question -2
 Q.2 A company proposes to install a machine involving a Capital Cost of Rs.
3,60,000. The life of the machine is 5 years and its salvage value at the end of
the life is nil. The machine will produce the net operating income after
depreciation of Rs. 68,000 per annum. The Company’s tax rate is 45%.

 The Net Percent Value factors for 5 years are as under:


 Discounting rate : 14 15 16 17 18

 Cumulative factor :3.43 3.35 3.27 3.20 3.13

 You are required to calculate the internal rate of return of the proposal.
17 Discounting Techniques Contd..

 Profitability Index (PI) Method:

PI = PV of cash inflows / PV of cash outflows

Acceptance rule: Under PI method a project is

acceptable if PI > 1 and rejected if PI < 1.
18 Question No.-10
 Q.10 A hospital is considering purchasing a diagnostic machine costing rupees
80,000. The projected life of the machine is 8 years and has expected salvage
value of rupees 6,000 at the end of 8 years. The annual operating cost of the
machine is rupees 7,500. It is expected to generate revenues of rupees 40,000
per year for 8 years. Presently, the hospital is outsourcing the diagnostic work
and is earning commission income of rupees 12,000 per annum; net of taxes.
Tax rate is 30%.
 Required: Whether it would be profitable for the hospital to purchase the
machine? Give your recommendation under:
 Net Present Value method.
 Profitability Index method.
 Cost of capital is 10%.