CAPITAL BUDGETING

PRESENTING BY:
MUHAMMAD AZEEM
SYED ASIM HUSSAIN
ISMAIL TARIQ

PRESENTING TO: SIR ASIF NAJI

AGENDA :
1) Capital Budgeting
2)Capital Budgeting process
3) Techniques of capital Budgeting
4) The cost of capital
5) Capital Budgeting extensions
 Capital Budgeting:
 Capital budgeting is the process of evaluating and selecting long
term investments that are consistent with the goal of shareholders
(owners ) wealth maximisation .

 Capital budgeting is the planning process used to determine a firms

long term investments . Such as new machinery , replacement
machinery, new products.

 Capital expenditure is an outlay of funds that is expected to produce

benefits over a period of time exceeding one year These benefits
may be either in the form of increased revenues or reduced costs .

 The term capital budgeting is otherwise called as

investment appraisal .
Sources of financing capital Budgeting
Decision / Project finance :

Capital budgeting decisions are financed using long term sources .

The various types of long term sources are :

• Equity capital ( Equity shares or ordinary shares )

• Hybrid capital ( preference shares )
• Debit capital ( Debentures / Bonds and Term loans )
 Stages of Capital Budgeting process :
• Planning
• Analysis : 1) Market analysis
2) Technical analysis
3) Financial analysis
4) Economic analysis
5) Ecological analysis

• Selection
• Implementation
•
Review
 Capital Budgeting Evaluation Techniques

Non –discounting techniques: Discounting techniques

Ignores the time value of Considers the time value of

money money

Average Rate Return / Net present value (NPV)

Accounting rate of return (ARR)
Internal Rate of Return (IRR)
Pay back period (PBP)
Profit index or Benefit –cost
Ratio (BCR)
Pay Back period :
Pay Back period : PBP is used as a first screening method , it gives
an indication of rough measure of liquidity . Under this method
accumulation of cash flows is made year after year until it meets the
initial capital outlay ,to identify the recovery time of the capital
amount invested.

PBP = Initial investment

Annual cash in flow
1) If PBP > Target period – Accept the proposal
2) If PBP < Target period – Reject the proposal
3) If PBP = Target period -- Further analysis is required
* Target period is the minimum period targeted by management to
cover initial investment .
ARR : Average Rate of Return :

Average rate of return also known as accounting rate of return is

defined as average cash inflows (Benefits) against unit investment

ARR = Average cash inflows(Benefits ) * 100

Initial investment
1) If ARR > Target rate – Accept the proposal
2) If ARR < Target rate – Reject the proposal
3) If ARR = Target rate – Further analysis is required
* Target rate is the minimum rate of return targeted by management
ARR is otherwise called as return on capital employed method .
Discounting techniques :
 Under discounted cash flow techniques, the future net cash flows
generated by a capital project are discounted to ascertain their present
values .

NPV: Net present value :

 UnderNPV method future cash flows are discounted at minimum
required rate of return of the project and then deduct it from initial out
lay to arrive at the NPV of the project .
 NPV = PV (Benefits) – Initial investment
1) Accept if NPV > 0
2) Reject if NPV < 0
3) May accept or Reject if NPV = 0
n
Ct - C
Net Present Value = ∑ ---------t 0
t=1 (1+k)
 IRR : Internal rate of return :
• IRR : Internal rate of return :
IRR is a percentage discount rate used in capital investment
appraisals which equates the present value of anticipated cash
inflows with initial capital outlay . It is that discount rate at which
NPV = 0 . Discount rate is ascertained by trail and error method .

C 0 = C 1 + C 2 + C 3 + ….. C n
(1+r) (1+r) 2 (1+r) 3 (1+r) n

1) Accept IRR > K

2) Reject IRR < K
3) May accept or Reject if IRR = K
Profitability index :
The profitability index is the present value of an anticipated cash in
flows divided by the initial investment . It is a method of assessing
capital expenditure opportunities in the profitability index .

Profitability index (pi) = Present value of cash inflows

Present value of cash out flows
This method is also called cost benefit ratio or desirability ratio
 Example
The expected cash flows of a project are:-
Year Cash Flows ( Rs.)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
The cash outflow is Rs. 1,00,000
The cost of capital is 10%
Calculate the following:
a) NPV b) Profitability Index
c) IRR
d) Pay-back period e) Discounted Pay-back Period
 Computation of NPV and PI
Year Cash Flows (Rs.) PV Factors@10% PV of Cash Flows (Rs.)

1 Computation
20,000 of
.909NPV & PI 18,180
2 30,000 .826 24,780
3 40,000 .751 30,040
4 50,000 .683 34,150
5 30,000 .620 18,600
Total Cash Inflow 1,25,750
Less: Cash 1,00,000
Outflows
NPV 25,750
P.I. 1.2575
 Computation of IRR
Year Cash PV Factors PV of Cash PV Factors PV of Cash
Flows (Rs.) @19% Flows (Rs.) @18% Flows (Rs.)

1
Com
20,000
p utation
.84
of NPV
16,800
&
.847
PI 16,940
2 30,000 .706 21,180 .718 21,540
3 40,000 .593 23,720 .609 24,360
4 50,000 .499 24,950 .516 25,800
5 30,000 .42 12,600 .437 13,110
Total Cash Inflow 99,250 1,01,750
Less Cash Outflows 1,00,000 1,00,000

NPV (-)750 (+)1750

Computation of IRR Contd..
Computation of non discounting pay-back period
Year Cash Flows (Rs.) Cumulative Cash Flow

1 20,000 20,000
2 30,000 50,000
3 40,000 90,000
4 50,000 1,40,000
5 30,000 1,70,000

Completed years + Required inflow *12

PBP = Inflow of Next year

= 3years+ (1,00,000-90,000) *12

50,000
= 5.4 years
 Computation of discounted pay-back period
Year Cash Flows PV PV of Cash Cumulative
(Rs.) Factors@10% Flows (Rs.) Cash Flows
1 20,000 .909 18,180 18,180
2 30,000 .826 24,780 42,960
3 40,000 .751 30,040 73,000
4 50,000 .683 34,150 1,07,150
5 30,000 .620 18,600 1,25,750

Completed years + Required inflow *12

PBP = Inflow of Next year
= 3years+ (1,00,000-73,000)*12
34150
= 12.48 years