Financial Management - Capital Budgeting & Principles and Techniques

1. Capital Budgeting

2. 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.

3. Importance of Investment Decisions
• Growth
• Risk
• Funding
• Irreversibility
• Complexity

4. 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

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

6. 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’

7. Evaluation Criteria
• 1. Discounted Cash Flow (DCF) Criteria
– Net Present Value (NPV)
– Internal Rate of Return (IRR)
– Profitability Index (PI)
• 2. Non-discounted Cash Flow Criteria
– Payback Period (PB)
– Accounting Rate of Return (ARR)

8. 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.
• Present value of cash flows should be calculated using the
opportunity cost of capital as the discount rate.
• Net present value should be found out by subtracting present
value of cash outflows from present value of cash inflows.
The project should be accepted if NPV is positive (i.e., NPV >
0).

9. Net Present Value Method
• The formula for the net present value can be
written as follows:





















n
t
t
t
n
n
C
k
C
C
k
C
k
C
k
C
k
C
1
0
0
3
3
2
2
1
)
1
(
NPV
)
1
(
)
1
(
)
1
(
)
1
(
NPV 

10. Calculating Net Present Value
• Assume that Project X costs Rs 2,500 now and is expected to
generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs
600 and Rs 500 in years 1 through 5. The opportunity cost of
the capital may be assumed to be 10 per cent.

11. Why is NPV Important?
• Positive net present value of an investment represents the
maximum amount a firm would be ready to pay for purchasing
the opportunity of making investment, or the amount at which the
firm would be willing to sell the right to invest without being
financially worse-off.
• The net present value can also be interpreted to represent the
amount the firm could raise at the required rate of return, in
addition to the initial cash outlay, to distribute immediately to its
shareholders and by the end of the projects’ life, to have paid off all
the capital raised and return on it.

12. 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.

13. Determination of Cash Flows:There are
3 major areas which needs attention
Effect of depreciation:
In capital budgeting, costs and benefits
are measured in terms of cash flows and
not accounting profits.

14. The basic difference between the
accounting profits and cash flow is the
inclusion of a few non-cash expenses in
the profit and loss account like
depreciation.

15. Hence, accounting profit has to be
adjusted for non-cash expenditures
in order to determine the actual
cash flow.
Only cash flows reflect the actual
cash transaction associated with
that project.

16. Also, cash flows avoid accounting
ambiguities and take into account the
time value of money.
Hence, the cash flow approach is
said to be the basis of estimating
future benefits from investment
proposals.

17. Proforma of Computation of Cash
Inflows After Taxes (CFAT)
Particulars Amount (Rs.)
Earnings before Depreciation and Taxes (EBDT) xxx
Less: Depreciation xxx
Earnings Before Taxes xxx
Earnings After Taxes (EAT) xxx
Add: Depreciation xxx
Cash Flows After Tax (CFAT) xxx

18. Working capital effect:
Net Working capital is used, which
means current assets minus current
liabilities.
Sometimes net working capital
constitutes a significant part of the
total investment in a project.
The increased working capital will form
a part of the initial cash outflow.

19. The additional working capital,
when returned(released) to the
firm at the end of the life of
project, becomes part of the
cash inflows.

20. Tax effect:
Cash flows have to be considered, net of
taxes for the purpose of capital budgeting.
The Tax Law permits carrying losses
forward to be set against the future profit.
Hence, for those firms which are incurring
losses and paying no taxes, due
consideration has to be given to the tax
effect on cash flows.

21. Problem no:2
X company is considering to install a
new machine. The project cost will be
Rs.50,000 /- and will have a life of 5
years with no salvage value.
The company will follow straight line
method of depreciation.

22. The earnings before depreciation and
tax are as follows:
Year 1 2 3 4 5
EBDT (Rs.) 10000 11000 14000 15000 25000
Evaluate the project using NPV method.
Assume the cost of capital as 10% and tax rate
as 50%.
Depreciation = (Original cost – Salvage)
÷ Life of the machine
= (50000 – 0) ÷ 5
= Rs.10000

23. Calculation of Cash flows after taxes
Year EBDT (Rs.) Depreciation EBT
(EBDT-
Depreciation
EAT
(EBT-tax)
CFAT (EAT +
Depreciation)
1 10000 10000 - - 10000
2 11000 10000 1000 500 10500
3 14000 10000 4000 2000 12000
4 15000 10000 5000 2500 12500
5 25000 10000 15000 7500 17500

24. Calculation of NPV
Year CFAT Discount Rate (10%) Present Value
1 10000 0.909 9090
2 10500 0.826 8673
3 12000 0.751 9012
4 12500 0.683 8538
5 17500 0.621 10868
Present value of Cash inflows 46181
Less cash outflows 50000
Net Present Value -3819

25. Problem No:3 Determine the cash flow after
taxation with the following information and
find out the Net Present Value.
If the opportunity cost of capital is 19%.
Purchase price of each machine 6,00,000
Working Capital 3,00,000
Useful life of each machine 5 years
Actual salvage value realized at the end of useful life 1,00,000
Method of Depreciation Straight Line
Tax rate 30%

26. If earnings before depreciation and tax
are Rs.3,00,000 p.a.
Depreciation = (Original cost – Salvage)
÷ Life of the machine
(6,00,000-100,000)/5=
1,00,000
Computation of cash flow after taxes

27. Particulars 1st Year 2nd Year 3rd Year 4th Year 5th Year
EBDT 300000 300000 300000 300000 300000
Depreciation 100000 100000 100000 100000 100000
EBT 200000 200000 200000 200000 200000
Less Tax (30% 60000 60000 60000 60000 60000
EAT 140000 140000 140000 140000 140000
Add: Depreciation 100000 100000 100000 100000 100000
Cash Flow after Taxes (CFAT) 240000 240000 240000 240000 240000
Add: Release of Working Capital 300000
Add: Actual Salvage Value of Asset 100000
Total CFAT for the year 240000 240000 240000 240000 640000

28. Calculation of Net Present Value:
Year CFAT DF 19% PVs (Rs.)
1 240000 0.840 201600
2 240000 0.706 169440
3 240000 0.593 142320
4 240000 0.499 119760
5 640000 0.419 268160
PV of cash inflows 901280
Less PV of cash outflows (600000+300000) 900000
NPV = 1280
Since NPV is positive.
The machine can be purchased.

29. Evaluation of the 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

30. 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 over a period of
time. This also implies that the rate of return is
the discount rate which makes NPV = 0.
n
n
r
C
r
C
r
C
r
C
C
)
1
(
...
)
1
(
)
1
(
)
1
( 3
3
2
2
1
0









0
)
1
(
1





o
n
i
t
t
C
r
C

31. IRR equation is the same as the one
used for NPV method.
In NPV method, the rate of return ‘r’ is
known and the net present value is
found by using the equation.
In IRR method, ‘r’ is the rate of return
at which the NPV becomes zero.

32. IRR is computed based on the cash flows
after taxes.
It can be found out by trial-and-error
method.
In this method, we consider any discount
rate or normally take the cost of capital
as the first trial to compute the present
value of cash flows.

33. If the calculated present value of the
expected cash inflow is higher than
the present value of cash outflow,
then we have to choose a higher
discount rate.
On the other hand, a lower
discounting rate should be tried if the
present value of cash inflow is lower
than the present value of cash
outflow.

34. • This process has to be repeated till the
present value of cash inflows equals the
present value of cash outflows.
• It is calculated by using the following
Interpolation formula, which has been already
explained while finding out YTM .











PVHDF
PVLDF
C
PVLDF
LDF
HDF
LDF
IRR o
)
(
%

35. Steps for Calculating IRR
• Calculate the average annual cash inflows.
• Compute the fake payback period by
dividing the initial investment with the
average annual cash flows.
• Refer to the present value annuity table.
Find out the two discount rates (say X and
Y) between which the fake payback period
lies in the line of the life of the project ‘n’
years.

36. • Try with X discounting factor and Y
discounting factor, and find out the
present value cash inflows in both the
cases.
• Using the interpolation formula, find
out the IRR of the project.
• Compare it with the cost of capital
and accept the proposal if IRR is
greater than cost of capital and reject
when IRR is less than cost of capital.

37. Acceptance Rule
• 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.

38. Problem No: 4
A project will cost Rs.1,00,000/- and it is
expected to generate annual cash flows of
Rs.20,000/-, Rs.30,000/-, Rs.45,000/-,
Rs.25,000/- and Rs.20,000/-
for a period of 5 years. If the cost of
capital is 10%, find out whether the
project can be accepted using IRR method

39. Calculate the project’s IRR.
Average CFAT =
Fake payback period = 5714
.
3
28000
100000







/
28000
5
20000
25000
45000
30000
20000
3.5714 lies between 12% and 13% in the line of
5 years in the present value annuity table.
Hence the Net Present Values are computed for
12% and 13% respectively.

40. Years CFAT 12% PV 13% PV
1 20,000 0.8929 17,858 0.885 17,700
2 30,000 0.7972 23,916 0.7831 23,493
3 45,000 0.7118 32,031 0.6931 31,190
4 25,000 0.6355 15,888 0.6133 15,333
5 20,000 0.5674 11,348 0.5428 10,856
PV of CFAT 1,01,041 98,571
Initial Cost 1,00,000 1,00,000
NPV 1,041 -1,429

41. Applying interpolation formula we get
%
42
.
12
2470
1041
%
12
571
,
98
041
,
01
,
1
000
,
00
,
1
041
,
01
,
1
1
%
12













Here the IRR (12.42%) is greater than
the cost of capital (10%) the project
proposal should be accepted.

42. Problem no: 2- Consider the following
independent project proposals to be
evaluated with 10% cost of capital.
Years 0 1 2 3 4 5
Project A (3,60,000) 60,000 1,20,000 1,80,000 1,00,000 60,000
Project B (5,00,000) 90,000 1,70,000 2,20,000 1,20,000 80,000
Calculate the NPV and IRR of project
A and Project B and advise whether
they should be accepted or not.

43. Calculation of NPV at 10% Discount Rate PV at 10%
Years CFAT of A CFAT of B DF@10% A B
1 60,000 90,000 0.9091 54,546 81,819
2 1,20,000 1,70,000 0.8264 99,168 1,40,488
3 1,80,000 2,20,000 0.7513 1,35,234 1,65,286
4 1,00,000 1,20,000 0.6830 68,300 81,960
5 60,000 80,000 0.6209 37,254 49,672
Present values of cash inflows 3,94,502 5,19,225
NPV 34,502 19,225
Decision: On the basis of the NPV method, both the
projects should be accepted as their NPV are positive.

44. 4615
.
3
000
,
04
,
1
000
,
60
,
3


Average CFAT=
000
,
04
,
1
.
5
000
,
60
000
,
00
,
1
000
,
80
,
1
000
,
20
,
1
000
,
60
Rs





PVIFA values corresponding to the fake payback
period are 3.517 and 3.433.
These correspond to internal rate of return 13%
and 14%. Accordingly,
Computation of IRR -Project A
Fake PB=

45. NPV values of Project A at Different Discount
Rates (in Rs.)
Year CFAT of A DF 13% PV 13% DF 14% PV 14%
1 60,000 0.885 53,100 0.8772 52,632
2 1,20,000 0.7831 93,972 0.7695 92,340
3 1,80,000 0.6931 1,24,758 0.675 1,21,500
4 1,00,000 0.6133 61,330 0.5921 59,210
5 60,000 0.5428 32,568 0.5194 31,164
Present Values of Cash inflows 3,65,728 3,56,846
Initial cost 3,60,000 3,60,000
NPV 5,728 NPV -3,154

46. By using Interpolation method, we get
%
64
.
13
8882
5728
13
356846
365728
360000
365728
%)
13
%
14
(
%
13 













IRR
Project A is accepted because IRR
of 13.64% is more than the cost of
capital of 10%.

47. 6765
.
3
000
,
36
,
1
000
,
00
,
5


Average CFAT =
000
,
36
,
1
.
5
000
,
80
000
,
20
,
1
000
,
20
,
2
000
,
70
,
1
000
,
90
Rs





PVIFA values around the surrogate payback
period are 3.696 and 3.605 which correspond
to the rate of return 11% and 12%. Accordingly,
Fake PB=
Project B

48. NPV values of Project B at Different Discount
Rates (in Rs.)
Year CFAT of A DF 11% PV 11% DF 12% PV 12%
0 (5,00,000) 1.0000 (5,00,000) 1.0000 (5,00,000)
1 90,000 0.9009 81,081 0.8929 80,361
2 1,70,000 0.8116 1,37,972 0.7972 1,35,524
3 2,20,000 0.7312 1,60,864 0.7118 1,56,596
4 1,20,000 0.6587 79,044 0.6355 76,260
5 80,000 0.5935 47,480 0.5674 45,392
Present Values of Cash inflows 5,06,441 4,94,133
NPV 6,441 NPV -5,867

49. Project B is accepted because IRR of 11.52% is
more than the cost of capital of 10%.
NPV as well as IRR methods suggest the
acceptance of both the projects and in that sense
they are in conformity with each other.
By using Interpolation method, we get
%
52
.
11
12308
6441
%
11
494133
506441
500000
506441
%)
11
%
12
(
%
11 













IRR

50. Evaluation of IRR Method
• IRR method has following merits:
Time value
Profitability measure
Acceptance rule
Shareholder value
• IRR method may suffer from
Multiple rates
Mutually exclusive projects
Value additivity

51. 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.
• The formula for calculating benefit-cost ratio
or profitability index is as follows:






n
i
t
t
C
r
C
C
C
PV
1
0
0
1
)
1
(
)
(

52. 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 percent
rate of discount. The PV of cash inflows at 10 percent
discount rate is:

53. 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.

54. Evaluation of PI Method
• Time value:It recognises the time value of money.
• Value maximization: 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.
• Relative profitability: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.

55. PAYBACK
• 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:
C
C
Inflow
Cash
Annual
Investment
Initial
=
Payback 0


56. Example
• 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:
years
4
12,500
Rs
50,000
Rs
PB 


57. PAYBACK
• The payback period, when cash flows are uneven, are
calculated through a process of cumulative cash flows, which
goes on until the period where cumulative cash inflows are
equal to the original cash outlay.
• The following formula is applied when cash flows are uneven,
– PBP = No. of years before full recovery + (unrecovered amount of
investment /Cash inflows during the year)
• 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 + (1,000/3,000)years
3 years + .33 years= 3.33 years

58. • The project’s expected net cash flows are as
follows:
Year Project P(Rs.) Project Q (Rs.)
1 6,50,000 3,50,000
2 3,00,000 3,50,000
3 3,00,000 3,50,000
4 1,00,000 3,50,000
Calculate each project’s Payback period.

59. PBP of Project P is = 2.17 years; PBP of Project Q is = 2.86 years
Project P should be accepted since 2.17 is less than the cut-off point
(2.5 years) fixed by the company.
Years P Q
Annual cash
Flow
Cumulative
Cash Flow
Annual cash
Flow
Cumulative
Cash Flow
1 6,50,000 6,50,000 3,50,000 3,50,000
2 3,00,000 9,50,000 3,50,000 7,00,000
3 3,00,000 50,000/
3,00,000=
0.17 years
3,50,000 3,00,000/
3,50,000 =
0.86 years
4 1,00,000 3,50,000

60. 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.

61. Evaluation of Payback
• Certain virtues:
– Simplicity
– Cost effective
– Short-term effects
– Risk shield
– Liquidity
• Serious limitations:
Cash flows after payback
Cash flow patterns
Administrative difficulties
Inconsistent with shareholder value

62. Accounting rate of return
• Accounting Rate of Return method uses
accounting information revealed by financial
statements to measure the profitability of an
investment proposal instead of cash flows.
• There is no unanimity regarding the definition
of the rate of return.

63. The Accounting Rate of Return is the ratio
of the average after tax profit divided by
the original/average investment. Thus, in
some cases ARR is computed as follows:
Accounting Rate of Return (ARR) =
OI = Original investment + Additional NWC +
Installation Charges + Transportation Charges

64. The most common formula of ARR is as
follows:
Average Rate of Return
(ARR) =
AI = 1/2(Original Investment – Scrap Value)
+Additional Net working Capital (NWC)+ Scrap
value

65. The average annual earnings after taxes
are determined by adding the after-tax
profits of each year of the project’s life
and dividing it with the number of
years.
If in case, profits are same for each year
(Annuity) and the average annual
earnings are equal, then the annuity
amount is considered as average annual
earnings after taxes.

66. An average investment is determined by
detecting the scrap value from the original
investment and dividing the net investment by
two.
If any additional working capital is required in
the initial years which are to be released at the
end of the project’s life, the whole amount of
working capital should be added.
If the project has any salvage value, which will
be recovered at the end of the project, that
also needs to be added for the purpose of
calculating ARR.

67. Decision Rule:
Acceptance or rejection of a project
proposal is decided based on the
comparison of calculated ARR with the
pre-determined minimum acceptable
rate or the cut-off rate.
Accept when calculated ARR is > cut-off
rate
Reject when calculated ARR is < cut-off
rate

68. Problem No:
M/s. GEM Ltd., is in the process of purchase of
a new machinery at the cost of Rs.2,75,000
with a salvage value of Rs.30,000 with an
expected life of 5 years.
The expected earnings before depreciation and
taxes areas follows:
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Profits before Depreciation
and Taxes
1,04,000 1,02,000 99,000 1,03,000 1,07,000

69. Assuming straight line method of
depreciation and tax rate of 35% and a
working capital requirement of Rs.25,000,
Apply ARR method and recommend
whether the machine should be
purchased, if the required rate return is
20%
Calculation of Depreciation:
(275000-30000)/5
Depreciation = 2,45,000/5 = 49,000

70. Particulars / Years 1 2 3 4 5
Profits before Depreciation
and Taxes
1,04,000 1,02,000 99,000 1,03,000 1,07,000
Depreciation 49,000 49,000 49,000 49,000 49,000
Profit less depreciation and
before taxes (PBT)
55,000 53,000 50,000 54,000 58,000
Less: Taxes @ 35% 19,250 18,550 17,500 18,900 20,300
Profit After Taxes (PAT) 35,750 34,450 32,500 35,100 37,700
Calculation of Profit after Tax (PAT)
The Accounting Rate of Return (ARR) is measured as:
ARR =

71. Average Annual Return =
100
,
35
.
5
500
,
75
,
1
5
700
,
37
100
,
35
500
,
32
450
,
34
750
,
35
Rs






Average Investment =
= = Rs.1,77,500
%
77
.
19
100
500
,
77
,
1
100
,
35

 x
ARR

72. Since the estimated ARR of the new
machine is equal to 19.77% which is
less than the existing required rate of
return i.e., 20%, and hence the project
cannot be accepted. If accepted, it will
reduce the shareholders’ wealth.

73. Advantages of ARR:
• It is very simple and easy to understand
and calculate.
• It considers the entire profits over the
life period of the project.
• Information is easily available from the
accounting records of the firm.
• Calculating ARR saves time of the
analyst and hence, less costly.

74. Limitations:
• It ignores the concept of time value
of money.
• It uses accounting profits in lieu of
cash flows, which are inappropriate
for evaluation of projects.
Accounting profits are based on
arbitrary assumption and also includes
non-cash items.