Financial Management

Unit – 2
Capital Budgeting Decisions

ADITYA SHARMA
Assistant Professor,(Senior Grade)
ABES BUSINESS SCHOOL
E-mail: [email protected]
 Capital Budgeting
An Investment Decision Method

Presented by
Aditya Sharma

2 3/15/2016
 Capital Budgeting: Project Categorization

• Establishment of New Products & Services

• Replacement Projects: Maintenance or Cost Reduction

• Expansion of Existing Projects

• Research and Development Projects

• Long Term Cotracts

• Safety and/or Environmental Projects

3 3/15/2016
 Nature of Investment Decisions
• The investment decisions of a firm are generally known as the
capital budgeting, or capital expenditure decisions.
• The firm’s investment decisions would generally include
expansion, acquisition, modernisation and replacement of the
long-term assets.
• Decisions like the change in the methods of sales distribution,
or an advertisement campaign or a research and development
programme have long-term implications for the firm’s
expenditures and benefits, and therefore, they should also be
evaluated as investment decisions.

4
 Features of Investment Decisions
• The exchange of current funds for future benefits.
• The funds are invested in long-term assets.
• The future benefits will occur to the firm over a series
of years.

5
 Types of Investment Decisions
• One classification is as follows:
– Expansion of existing business
– Expansion of new business
– Replacement and modernisation
• Yet another useful way to classify
investments is as follows:
– Mutually exclusive investments
– Independent investments
– Contingent investments

6
 Investment Evaluation Criteria
• Three steps are involved in the evaluation
of an investment:
– Estimation of cash flows
– Estimation of the required rate of return (the
opportunity cost of capital)
– Application of a decision rule for making the choice

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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.
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 Importance of Capital Budgeting
⦿Growth
⦿Large Amount
⦿Irreversibility
⦿Complexity
⦿Risk
⦿Long term implications
Benefits of Capital Budgeting Decision:
Capital Budgeting decisions evaluate a proposed project to forecast return from the project
and determine whether return from the Project is adequate.

Capital Budgeting decisions evaluate expenditure decisions which involve current outflow
of funds but9are likely to produce benefits over a3/15/2016
period of time more than one year.
 Broad Prospective

Capital Budgeting is the planning process used to determine a firm’s long

term investments such as new machinery, replacement machinery, new
plants, new products and research & development projects.

10 3/15/2016
 Fourth Important Step of capital budgeting:
carry out Financial Analysis

Evaluation Criteria: Capital Investment Proposal

Evaluation Criteria

Non-Discounting Discounting
Criteria criteria

Pay-Back Discounted Profitability

ARR NPV IRR
Period PBP Index

11 3/15/2016
 CAPITAL BUDGETING TECHNIQUES

Non-DCF DCF

Pay-back Pay-back ARR

period Reciprocal

Pay-back NPV IRR PI

 Non discounting: Pay-Back Period

1. Pay-Back Period Method-

It is defined as the number
of years required to recover
original cost invested in a
project. It has two conditions
* 12

13 3/15/2016
 Formula for Calculating Payback period

1. When Cash inflows are even/equal

When cash inflow of all year is equal, we use the following
formula
Initial Investment
Payback period =
Annual Cah Inflow

2. When cash inflows are uneven

When cash inflows of each year is different we use the formula below
𝐵
Payback Period = 𝐸 +
𝐶
Where,
E = Year immediately Preceding to year of recovery
B = Amount left to be recovered
C = Cash inflow during the year of final recovery
Note: Before using these values we must find cumulative cash inflows
Payback Period Method

• This method is the simplest and most widely

used method.

• Payback period is the time required to recover

the initial investment.

• A firm is always interested in knowing the

amount of time required to recover its
investment.

• It is based on the concept of cash flow and is a

non-discounting technique.
Decision Criteria
1.If there is only one project in consideration, it
would be selected only if it has a payback
period as per managements expectation.

1. In case of more that one project a project with lower

payback period should be selected.
 Merits of Payback Period Method
1. It is easy to calculate and simple to understand.
2. It is useful in case of those industries where there is a lot
of uncertainty and instability because it lays emphasis on
the speedy recovery of investment.
3. Many firms want to recover their investment as quickly
as possible. This method is more appropriate for them to
know how quickly they could get their investments back.
4. It Measures liquidity of the investment.
 1. Payback Period Method
• Payback is the number of years required to recover the original cash outlay invested in a
project.
• If the project generates constant annual cash inflows, the payback period can be
computed by dividing cash outlay by the annual cash inflow. That is:

Initial Investment C
Payback = = 0
Annual Cash Inflow C
• Assume that a project requires an outlay of Rs 50,000 and yields annual cash
inflow of Rs 12,500 for 7 years. The payback period for the project is: Rs. 50000
• PB = ----------------------- = 4 years
Rs. 12500

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 Example : Payback Period Method
• Calculate the payback period of an investment proposal,
requires an initial cash outlay of Rs. 350000/- and it generates
cash inflow of Rs. 50000 every years for next 10 years.
Initial Investment C
Payback = = 0
Annual Cash Inflow C
Rs. 350000
• Payback =---------------- = 7 years
Rs. 50000

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 ABES Business School
(MBA) Academic Year - 2022-23

Project cost is Rs. 30,000 and the cash inflows are

Rs. 10,000, the life of the project is 5 years.
Calculate the pay-back period
 ABES Business School
(MBA) Academic Year - 2022-23

Pay Back Period = Investment

-----------------
Annual Cash Flow

Rs.30,000
--------------= 3 Years
10,000
Calculate the payback period from the following
information: Cash outlay Rs. 50,000 and cash inflow Rs.
12,500
Investment
PBP = -----------------
Cash Flow
50,000
------------= 4 years
12,500
 ABES Business School
(MBA) Academic Year - 2022-23

A project costs Rs. 20,00,000 and yields

annually a profit of Rs. 3,00,000 after
depreciation @ 12½% but before tax at 50%.
Calculate the pay-back period
 ABES Business School
(MBA) Academic Year - 2022-23

Profit After depreciation but before Tax = 3,00,000

Less Tax @50% 1,50,000
PAT 1,50,000

Add Depreciation 2,50,000 (20,00000*12.5%)

Profit before Depreciation (Cash Flow ) 4,00,000

Pay Back Period = Investment / Cash Flow

20,00000/4,00,000
5 Years
 Payback Period - Unequal cash flows
• Unequal cash flows In case of unequal cash inflows, the payback
period can be found out by adding up the cash inflows until the
total is equal to the initial cash outlay.
• Suppose that a project requires a cash outlay of Rs 20,000, and
generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs
3,000 during the next 4 years. What is the project’s payback?
3 years + 12 × (1,000/3,000) months
Payback Period = 3 years + 4 months

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 ABES Business School
(MBA) Academic Year - 2022-23

Certain projects require an initial cash outflow of

Rs. 25,000.
The cash inflows for 6 years are
Year 1 Rs. 5,000,
Year 2 Rs. 8,000,
Year 3 Rs. 10,000,
Year 4 Rs. 12,000,
Year 5 Rs. 7,000
Year 6 Rs. 3,000.
 ABES Business School
(MBA) Academic Year - 2022-23

Year Cash inflows Cumulative Cash Inflows Remarks

1 5000 5000
2 8000 13,000
3 (E) 10000 23000 Balance 25,000-23000 = 2000
4 12000 Cash Flow 35000 In this year Investment covered

5 7000 42000
6 3000 45000

The above calculation shows that in 3 years Rs. 23,000 has been recovered Rs. 2,000, is
balance out of cash outflow. In the 4th year the cash inflow is Rs. 12,000. It means the
pay-back period is three to four years, calculated as follows

Pay-back period = E + ( B/C * 12 Months )

3 years+2000/12000×12 months
= 3 years 2 months
 Practice Questions
From the following information, calculate the pay-back
periods for the 3 projects. Which liquors Rs. 2,00,000
each? Suggest most profitable project
The machine cost Rs. 50,000 and has scrap value of Rs. 5,000
after 5 years. The net profits before depreciation and taxes
for the five years period are to be projected that Rs. 20,000,
Rs. 24,000, Rs. 30,000, Rs. 26,000 and Rs. 22,000. Taxes are
50%. Calculate pay-back period and accounting rate of
return.
 Investment Decision Rule
• Project A, B and C require an investment of Rs. 10000/- and will generate
yearend cash flows of
• Year Project A Project B Project C
• 1 5000 1000 5000
• 2 3000 1000 5000
• 3 2000 2000 0
• 4 0 2000 0
• 5 0 4000 0
Payback Period
3 Yr 5 Yrs 2 yrs
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 Acceptance Rule
• The project would be accepted if its payback period is less
than the maximum or standard payback period set by
management.
• As a ranking method, it gives highest ranking to the project,
which has the shortest payback period and lowest ranking to
the project with highest payback period.

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 Merits and Demerits of Payback Period
Method
• Certain virtues:
– Simplicity
– Cost effective
– Short-term effects
– Risk shield
– Liquidity
• Serious limitations:
– Cash flows after payback
– Cash flows ignored
– Cash flow patterns
– Administrative difficulties
– Inconsistent with shareholder value
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 2. Accounting Rate of Return Method
• Accounting rate of return is a capital budgeting metric
that's useful if you want to calculate an investment's
profitability quickly.
• Accounting Rate of Return (ARR) is the average net
income an asset is expected to generate divided by its
average capital cost, expressed as an annual percentage.

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 Accounting Rate of Return Method
• The accounting rate of return is the ratio of the average after-tax profit
divided by the average investment. The average investment would be
equal to half of the original investment if it were depreciated
constantly.
Average income
ARR =
Average Investment

Where:
• Average Income = Total profit over Investment Period / Number of
Years
• Average Investment = (Book Value at Year 1 + Book Value at End of
34 Useful Life) / 2
 ARR – Numerical Problem 1
• XYZ Company is looking to invest in some new machinery to replace its current
malfunctioning one. The new machine, which costs Rs. 420,000, would increase
annual revenue by Rs. 200,000 and annual expenses by Rs. 50,000. The machine is
estimated to have a useful life of 12 years and zero salvage value.
Step 1: Calculate Average Annual Profit
Inflows, = Cash inflows – expenses
= 2,00,000 – 50,000 = 1,50,000
Accounting profit = Cash flow – depreciation
1,50,000- 35000= 1,15,000
Depreciation = (4,20,000/12) = Rs. 35000 per year
Step 2: Calculate Average Investment
Average Investment = (Rs. 420,000 + Rs. 0)/2 = Rs. 210,000
Average income
Step 3: Use ARR Formula ARR = = Rs.115,000/Rs.210,000 =.5476
Average investment
20 = 54.76%
 ARR – Numerical Problem 1
• XYZ Company is looking to invest in some new machinery to replace its current
malfunctioning one. The new machine, which costs Rs. 420,000, would increase
annual revenue by Rs. 200,000 and annual expenses by Rs. 50,000. The machine is
estimated to have a useful life of 12 years and zero salvage value.

.0
 ARR – Numerical Problem 2
• Company is willing to purchase a new machine for Rs. 1,50,000. The usable life of the
machine is 10 years, at the end of its usable life the machine can be sold for Rs. 50000/-.
The machine will provide an additional profit of Rs. 80000 every year. Annual expenses
on operating the machine is Rs. 30,000. calculate ARR of the investment in machine.
Step 1: Calculate Average Annual Profit
Inflows, Years = (80,000 – 30,000 =50000 Income – expenses
Accounting profit = 50,000- 10000 Cash flow – depreciation

Average Annual Profit = (4,00,000/10) = Rs. 40,000 per year

Step 2: Calculate Average Investment
Average Investment = (Rs. 1,50,000 + Rs. 50000)/2 = Rs. 1,00,000
Step 3: Use ARR Formula = Rs.40,000/Rs.1,00,000 =.4
22 = 40%
 ARR – Numerical Problem 3
• XYZ Company is considering investing in a project that requires an initial investment
of Rs. 100,000 for some machinery.
• There will be Earnings after tax and depreciation of Rs. 20,000 for the first two years,
Rs. 10,000 in years three and four, and Rs. 30,000 in year five. Finally, the machine has
a salvage value of Rs. 25,000.
Income
Year Amount
1 20000
2 20000
3 10000
4 10000
5 30000
Total : 90000
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 ARR – Numerical Problem 3
• XYZ Company is considering investing in a project that requires an initial investment
of Rs. 100,000 for some machinery.
• There will be inflow of Rs. 40,000 for the first two years, Rs. 20,000 in years three
and four, and Rs. 30,000 in year five. Finally, the machine has a salvage value of Rs.
25,000.
Income
Year Amount
1 40000
2 40000
3 20000
4 20000
5 30000
Total : 90000
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 ARR – Numerical Problem 3
Step 1: Calculate Average Annual Profit
Inflows, Years 1 & 2 = (40,000 x 2) = 80,000
Inflows, Years 3 & 4 = (20,000 x 2) = 40,000
Inflow, Year 5 = 30,000

1,50,000
Less: Depreciation
(100,000-25,000) = -75,000
Total Profit = 75,000
Average Annual Profit = (75,000/5) = 1 5 ,000
Step 2: Calculate Average Investment
Average Investment = (100,000 + 25,000) / 2 = 62,500
Step 3: Use ARR Formula Average income
ARR =
Average investment
ARR = 15,000/62,500 =
40
 Acceptance Rule
• This method will accept all those projects whose ARR is higher than
the minimum rate established by the management and reject those
projects which have ARR less than the minimum rate.
• This method would rank a project as number one if it has highest
ARR and lowest rank would be assigned to the project with lowest
ARR.

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 Merits and Demerits of ARR Method
• The ARR method may claim some merits
– Simplicity
– Accounting data
– Accounting profitability
• Serious shortcoming
– Cash flows ignored
– Time value ignored
– Arbitrary cut-off

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The machine cost Rs. 50,000 and has scrap
value of Rs. 10,000 after 5 years. The net
profits before depreciation and taxes for the
five years period are to be projected that Rs.
20,000, Rs. 24,000, Rs. 30,000, Rs. 26,000 and
Rs. 22,000. Taxes are 50%. Calculate pay-back
period and accounting rate of return.
 Concepts

Cash Flow Earnings

Profit Before depreciation After Tax Profit After depreciation After Tax

Depreciation is a non cash expenses :- it will decide that given profit is cash flow or Earnings
 Focus area

(1) Method :-

(2) Cash Flow / Earnings after taxation

(3) Cash flow is Even (Equal ) or Uneven Cash flow

 Even and uneven Cash flow
Year Cash Flow Cash Flow
Machine A Machine B

1 1,00,000 1,00,000
2 1,00,000 1,25,000
3 1,00,000 1,30,000
4 1,00,000 1,50,000
5 1,00,000 90,000

When Cash inflows are uniform for all the years

 3. Net Present Value Method
• Cash flows of the investment project should be forecasted based
on realistic assumptions.
• Appropriate discount rate should be identified to discount the
forecasted cash flows. The appropriate discount rate is the
project’s opportunity cost of capital.
• Present value of cash flows should be calculated using the
opportunity cost of capital as the discount rate.
• The project should be accepted if NPV is positive (i.e., NPV > 0).

49
 Qno-1 :- ABC Ltd is planning to change its old machine . They have two option Machine A
and Machine B . Both the machine has same cost of Rs. 5,00,000 with useful life of 5 Years .
Estimated scrap value 50,000 ( Residual value ) . Cost of Capital is 10% . Cash flow of the
Machine A and Machine B are as follows
Year Cash Flow Cash Flow
Machine A Machine B
1 1,00,000 1,00,000
2 1,00,000 1,25,000
3 1,00,000 1,30,000
4 1,00,000 1,50,000
5 1,00,000 90,000

Calculate Which Machine is profitable if Method is

(A ) Payback Period
(B) Accounting Rate of return
(C) NPV Method
(D) PV Index Method
 Pay Back Period Method
Year Cash Flow Pay Back Period Cash Flow Cumulative Cash
Machine A Machine B Flow

1 1,00,000 1,00,000 1,00,000

2 1,00,000 1,25,000 2,25,000

E = 3 Years
3 1,00,000 PBP = Investment 1,30,000 3,55,000 B=5,00,00-3,55,000
------------------ 1,45,000
Annual Cash Flow
4 1,00,000 1,50,000 505000
5,00,000
--------------------
5 1,00,000 1,00,000 90,000 5,95,000
5 Years

Machine B PBP 3+ ( 1,45,000/1,50,000 )

3+ 11.6
3 Years + 11 Months and 18 Days
 Concept on NPV Method
Machine Purchased 1st year 2nd Year 3rd Year 4th Year 5th Year
Rs .5,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

Scrap Value
(Rs. 25,000

Machine Purchased 1st year 2nd Year 3rd Year 4th Year 5th Year
Rs .5,00,000 1,00,000 1,25,000 1,30,000 1,50,000 90,000

Scrap Value
(Rs. 25,000

52
 Concept on NPV Method
Machine Purchased 1st year 2nd Year 3rd Year 4th Year 5th Year
Rs .5,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

Scrap Value
(Rs. 25,000
1,00,000 100000 1,00,000 100000 1,00,000
PV = ---------------- ------------------ ----------------- ----------------- -----------------
( 1+ .10) 1 ( 1+ .10) 2 ( 1+ .10) 3 ( 1+ .10) 4 ( 1+ .10) 5

1,00,000 100000 1,00,000 100000 1,00,000

PV = -------------------------- + ------------------------- + ----------------------- + ----------------------- + ----------------------
1.10 1.21 1.333 1.46 1.61

90,909.09 82644.62 75018.75 68493.15 62111.80

= 3.79,177.41
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 Concept on NPV Method
Machine Purchased 1st year 2nd Year 3rd Year 4th Year 5th Year
Rs .5,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

Scrap Value
(Rs. 25,000
1,00,000 100000 1,00,000 100000 1,00,000
PV = ---------------- ------------------ ----------------- ----------------- -----------------
( 1+ .10) 1 ( 1+ .10) 2 ( 1+ .10) 3 ( 1+ .10) 4 ( 1+ .10) 5

OR

=1,00,000 x PV(10%,1) + 1,00,000 x PV(10%,2) + 1,00,000 x PV(10%,3) + 1,00,000 x PV(10%,4) + 1,00,000 x PV(10%,5)

= 1,00,000 X .9.90 + 1,00,000 X .826 + 1,00,000 X .751 + 1,00,000 X .683 + 1,00,000 X .621

= 90,909.09 + 82644.62 + 75018.75 + 68493.15 + 62111.80

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= 3.79,177.41
 Concept on NPV Method
Machine Purchased 1st year 2nd Year 3rd Year 4th Year 5th Year
Rs .5,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

Scrap Value
(Rs. 25,000

NPV = Present Value of Cash Inflow– Present Value of Outflow

Annuity Value X PVAF (10,5) + - 5,00,000
1,00,000 X 3.791 - 5,00,000
3,79,100
1,21,100
55
 Concept on NPV Method
Machine Purchased 1st year 2nd Year 3rd Year 4th Year 5th Year
Rs .5,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000

Scrap Value
(Rs. 25,000

NPV = Present Value of Cash Inflow+ PV of Scrap Value – Present Value of Outflow
Annuity Value X PVAF (10,5) + PV pf Scrap (10,5) - 5,00,000
1,00,000 X 3.791 + 25,000 x .621 - 5,00,000
3,79.000 + 15525
3,94,525 - 5,00,000
105475
56
 Concept on NPV Method
Machine Purchased 1st year 2nd Year 3rd Year 4th Year 5th Year
Rs .5,00,000 1,00,000 1,25,000 1,30,000 1,50,000 90,000

Scrap Value
(Rs. 25,000

Year Cash Flow PV (r,t) PV Factor Present Value

1 1,00,000 PV Value (10,1 ) 0.909 90,900
2 1,25,000 PV Value (10,2 ) 0.826 103250
3 1,30,000 PV Value (10,3 ) 0.751 97630
4 1,50,000 PV Value (10,4 ) 0.683 102450
5 90,000 PV Value (10,5 ) 0.621 55890
WC 25,000 PV Value (10,5) 0.621 15525
57
4,65,645
 NPV
A company is planning to replace its Machine .Machine has Initial Cash
outlay Rs.1,00,000 .
Calculate NPV of following Proposal; Assume discounting rate is 10%.
Year Cash Inflow
1 20000
2 25000
3 30000
4 35000
5 20000
.

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 NPV
Calculation of Present Value of Machine

Year Cash Inflow PV Factor Present Value

1 20000 .909 18018
2 25000 .826 20650
3 30000 .751 22503
4 35000 .682 23870
5 20000 .620 12400
97,441
NPV = 97441-100000 = -2559
Project should not be accepted.
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 NPV
Ex. 5: Use NPV method to compare and analyse which Proposal is
better to accept; Assume discounting rate is 10%.
Project Cash Outflow Cash Inflows
Year 0 Year 1 Year 2 Year 3
X 20000 30000 20000 10000

Y 20000 10000 20000 30000

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 NPV
Ex. 5: NPV for Project X
Year Cash Inflow PV Factor Present Value
1 30000 .909 27270
2 20000 .826 16520
3 10000 .751 7510
NPV =
51300 – 20000 = 31300
NPV for Project Y
Year Cash Inflow PV Factor Present Value
1 10000 .909 9090
2 20000 .826 16520
3 30000 .751 22530
NPV = 48140 – 20000 = 28140
Project “X” is having higher NPV; hence it should be preferred.
63
64
 Acceptance Rule
• Accept the project when NPV is positive NPV > 0
• Reject the project when NPV is negative NPV < 0
• May accept the project when NPV is zero NPV = 0
• The NPV method can be used to select between mutually
exclusive projects; the one with the higher NPV should be
selected.

65
 Merits and Demerits of NPV Method
• NPV is most acceptable investment rule for
the following reasons:
– Time value
– Measure of true profitability
– Value-additivity
– Shareholder value
• Limitations:
– Involved cash flow estimation
– Discount rate difficult to determine
– Mutually exclusive projects
– Ranking of projects
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 Profitability Index
• Profitability index is the ratio of the present
value of cash inflows, at the required rate
of return, to the initial cash outflow of the
investment.

67
 Profitability Index
• The initial cash outlay of a project is Rs 100,000 and it can
generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and
Rs 20,000 in year 1 through 4. Assume a 10 per cent rate of
discount. The PV of cash inflows at 10 per cent discount rate
is:
PV = Rs 40,000(PVF 1, 0.10) + Rs 30,000(PVF 2, 0.10) + Rs 50,000(PVF 3, 0.10) + Rs 20,000(PVF 4, 0.10)
= Rs 40,000  0.909 + Rs 30,000  0.826 + Rs 50,000  0.751 + Rs 20,000  0.68
NPV = Rs 112,350 − Rs 100,000 = Rs12,350
Rs 1,12,350
PI = =1.1235 .
Rs 1,00,000

46
 Acceptance Rule
• The following are the PI acceptance rules:
– Accept the project when PI is greater than one. PI > 1
– Reject the project when PI is less than one. PI < 1
– May accept the project when PI is equal to one. PI = 1
• The project with positive NPV will have PI greater than one.
• PI less than means that the project’s NPV is negative.

69
 Merits and Demerits of PI Method
• It recognises the time value of money.
• It is consistent with the shareholder value maximisation principle.
A project with PI greater than one will have positive NPV and if
accepted, it will increase shareholders’ wealth.
• In the PI method, since the present value of cash inflows is
divided by the initial cash outflow, it is a relative measure of a
project’s profitability.
• Like NPV method, PI criterion also requires calculation of cash
flows and estimate of the discount rate. In practice, estimation of
cash flows and discount rate pose problems.

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