Financial Management

1. Capital Budgeting
An Investment Decision
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2. After studying this Chapter
, you should be able to:
Define “capital budgeting”
Features, Benefits and Types of Capital Budgeting
Calculation of Cash Inflow and justify why cash flows and not
Accounting Profits, are the most relevant to capital budgeting
decisions.
What is the difference between independent and mutually exclusive
projects?
Identify the Eight steps process involved in the capital budgeting
Understand the various techniques of Capital Budgeting
Understand the Non discounting technique i.e payback period (PBP) and
ARR method of project evaluation and selection, including its: (a)
calculation; (b) acceptance criterion; (c) advantages and disadvantages;
Understand the Four major discounted cash flow (DCF) methods of
project evaluation and selection – internal rate of return (IRR), net
present value (NPV), profitability index (PI) and Discounted Pay Back
Period
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3. Capitalised
Expenditures
Capitalised Expenditures are
expenditures that may provide
benefits into the future and therefore
are treated as capital outlays and not
as expenses of the period in which
they were incurred.
Examples: Purchase of Machinery,
its installation etc
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4. Definition of Budget
•Budgeting is a management tool for
planning and controlling future activity.
•Budget isa financial plan and a list of
all planned expenses and revenues.
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5. Capital Budgeting
Capital: Operating Fixed assets used for
production.
Budget: A plan that details projected cash
flows during some period.
Capital Budgeting: Process of analyzing
projects and deciding which ones to include
in capital budget.
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6. What is
Capital Budgeting?
The process of identifying,
analyzing, and selecting
investment projects whose
returns (cash flows) are
expected to extend beyond
one year.
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7. Features of Capital
Budgeting
1. Large Investments- Control the
capital expenditure
2. More Risky- greater the risk
greater the planning
3. Irreversibility:
4. Effect on profitability
5. Difficulties of investment decisions
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8. Benefits of Capital
Budgeting Decision:
decisions evaluate a proposed
Budgeting
forecast
whether
return
return
from
from
the project and
the Project is
Capital
project to
determine
adequate.
Capital Budgeting decisions evaluate expenditure
decisions which involve current outflow of funds but
period of time
are likely to produce benefits over a
more than one year.
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9. Types of Capital
Budgeting Decision
Establishment of New Products &
Services
Replacement Projects: Maintenance or
Cost Reduction
Expansion of Existing Projects
Research and Development Projects
Long Term Contracts
Safety and/or Environmental Projects
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10. Estimating After-Tax
Incremental Cash Flows
Basic characteristics of
relevant project flows
 Cash (not accounting income) flows
 Operating (not financing) flows
 After-tax flows
 Incremental flows
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11. What are cash Inflows in
Capital Budgeting Decision:
Cash Inflows=Profit after tax but before Depreciation.
(Exclude Depreciation as it is non cash item but include tax saving on
depreciation)
If PAT is given
Cash Inflow = PAT + Depr’n
If PBT (excluding depr’n) is given
Then first calculate PAT and then add Deprn
PAT=PBT-Deprn-tax
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12. Cash flows versus
Accounting Profit :
Cash Flows incorporates Time Value of Money
where as Accounting profit ignores TVM
In Capital budgeting a finance manger is
concerned with measuring the economic value
created by a decision rather than book entry value
Accounting Profit changes with change in
accounting policies where as Cash flows are not
affected by such discretionary Policy.
Thus The Cash Flows as a measure of Cost and
Benefit of a proposal is a better technique to
evaluates a capital budgeting proposal
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13. What is the difference between
independent and mutually exclusive
projects?
Independent projects – if the cash flows
of one are unaffected by the acceptance
of the other.
Mutually exclusive projects – if the cash
flows of one can be adversely impacted
by the acceptance of the other.
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14. Broad Prospective
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15. Step 4-Evaluation Criteria/
Evaluation Technique
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16. Non discounting:
Pay-Back Period
1. Pay-Back Period Method- It is defined as the number
invested
of years required to recover original cost
in a project. It has two conditions
 When cash inflow is constant every year
PBP= Cash outflow/cash inflow (p.a.)
 When cash inflow are not constant every year
PBP =
* 12
Required inflow
Completed years +
In flow of next
year
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17. Payback Problem
A Company is faced with a problem of choosing between two
mutually Exclusive projects. Project L and Project S.
Project L requires a cash outlay of Rs 100 lacs and is expected to
generate cash inflows of Rs 10, 60 and 80 lacs over the next 3
years respectively
Project S requires a cash outlay of Rs 100 lacs and is expected to
generate cash inflows of Rs 70, 50 and 20 lacs over the next 3
years respectively
Use Payback method to select best Project.
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18. Calculating payback
PaybackL =
= 2 + / = 2.375 years
0 1 2 3
2.4
30 80
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
Project L
CFt -100
Cumulative -100
PaybackS =
= 1 + / = 1.6 years
70 100
0 20
20
40
0 1 2 3
1.6
30 50
50
-30
Project S
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19. Payback Solution
Using Payback method to
select best Project.
Select Project S :- It takes only
1.6 years to repay total
Investment
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20. 13-20
Merits and Demerits of payback
Merits
Provides an indication of a
project’s risk and liquidity.
Easy to calculate and
understand.
Demerits
Ignores the time value of money.
Ignores CFs occurring after the
payback period.

21. Discounting Criteria:
Pay-Back Period
2. Discounted Pay-Back Period Method - In discounted
pay- back period method, the cash inflows are
discounted by applying the present value factors for
different time periods. For this, discounted cash
inflows are calculated by multiplying the P.V. factors
into cash inflows.
* 12
Required inflow
In flow of next
year
Dis. PBP = Completed years +
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22. Discounted
payback period
Uses discounted cash flows
rather than raw CFs.
0 10% 1 2 2.7 3
CFt -100 10 60 80
PV of CFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Disc PaybackL = 2 + 41.32 / 60.11 = 2.7 years
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23. Strengths and weaknesses of
Discounted payback Method
It take into consider the Time Value
of Money and the uncertainty of the
future cash flows
Same as Payback method
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24. Non discounting Criteria:
Annual Rate of Return (ARR)
3.Average Rate of Return Method - ARR means the
average annual earning on the project. Under this
method, profit after tax and depreciation is considered.
The average rate of return can be calculated in the
following two ways.
* 100
Average Profit After Tax
Average Investment
* 100
ARR on Average investment=
ARR on Initial =
investment
Average Profit After Tax
Initial Investment
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25. Average rate of return Method
It means average annual yield on
the project
This rate compared with
minimum cut off rate to decide
the acceptability of the project.
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26. Average rate of return
Method
ARR = Average profit after tax x 100
Average investment
Average Investment =
(Initial Investment + Installation charges – scrap
Value)/2 + Scrap Value
Average Profit after tax=Total profit after tax
No. of Years
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27. Merits of ARR
It is simple to calculate
It is based on Accounting
Information readily available
It consider the benefit over the
entire life of the project
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28. Demerit of ARR
It is based on accounting profit
and not cash flows
It does not consider the time
value of money.
It does not consider Uncertainty
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29. Discounting Criteria: Net Present
Value (NPV)
4. Net Present Value Method:- It is the best method
for evaluationof investment proposal.
This method takes into account time value of money.
NPV= PV of inflows - PV of outflows
Evaluation of Net Present Value Method:-
Project with the higher NPV should be selected.
Accept if Reject
May or may not
accept
NPV>0
NPV<0
NPV=0
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30. What is Project NPV?
13-30
Year
0
CFt
-100
PV of CFt
-100
1 10 9.09
2 60 49.59
3 80 60.11
NPVL = 18.79

31. Merits of NPV
It takes into account the Time
value of money
It consider the cash flow streams
in its entirely
It represents the contribution to
the wealth of shareholders
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32. Discounting Criteria: Profitability Index
5. Profitability Index Method - As the NPV method it is
also shows that project is accepted or not. If Profitability
index is higher than 1, the proposal can be accepted.
Accepted
Rejected
PI>1
PI<1
Profitability index=
Total PV of Cash Inflows
Total PV of Cash Outflows
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33. Merits of PI
Consider Time value of money
If NPV are same for two projects,
PI can be used to decide
Very useful in Capital rationing
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34. Discounting Criteria: Internal Rate of
Return(IRR)
5. Internal Rate of Return Method:- IRR is the rate of
return that a project earns. The rate of discount calculated by
trial and error , where the present value of future cash flows
is equal to the present value of outflows, is known as the
Internal Rate of Return.
* Difference in
Rate
NPV of Higher Rate
Difference in cash
flows
IRR =
* Difference in
Rate
NPV of Lower Rate
Difference in cash
flows
IRR = Lower Rate +
Higher Rate -
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35. Rationale for the IRR
method
If IRR > r (WACC), the project’s rate
of return is greater than its costs.
There is some return left over to
boost stockholders’ returns.
If IRR < r (WACC), Reject the project.
If IRR = r (WACC), Indifferent
between the project
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36. The expected cash flows of a project are:-
The cash outflow is Rs. 1,00,000 The cost of capital is
10% Calculate the following:
b) Profitability Index
a) NPV
c) IRR
d) Pay-back period e) Discounted Pay-back Period
Year Cash Flows ( Rs.)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
Example
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37. 7
Computa
t
ion of
NPV
&
PI
Year Cash Flows (Rs.) PV Factors@10% PV of Cash Flows (Rs.)
1 20,000 .909 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
Outflows
1,00,000
NPV 25,750
P.I. 1.2575
Computation of NPV and PI
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38. Co p
m
utati
o
n of
N
PV &
PI
Computation of IRR
Year Cash
Flows (Rs.)
PV Factors
@19%
PV of Cash
Flows (Rs.)
PV Factors
@18%
PV of Cash
Flows (Rs.)
1 20,000 .84 16,800 .847 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
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39. Computation of IRR Contd..
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40. 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
PBP=
Completed years +Required inflow*12
Inflow of Next year
= 3years+ (1,00,000-90,000) *12
50,000
= 3 years and 2 months
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41. Computation of discounted pay-back
period
Year Cash Flows
(Rs.)
PV
Factors@10%
PV of Cash
Flows (Rs.)
Cumulative
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
= 3 years and 9.48 months
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42. Conclusions
We have Studied various evaluation criteria for Capital
Budgeting.
Generally an impression created that the firm
should use NPV method for decision making.
Most of the large companies consider all the measures
because each one provides somewhat different piece of
relevant information to the decision maker.
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43. Practical Problems
(pg no 211)
Solve Illustration no 7.02 -7.12
(pg no 241)
Solve :-Unsolved problems, P7.1-
P7.6
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