The document discusses various capital budgeting techniques used to evaluate long-term investment projects. It defines capital budgeting as the process of planning and approving large capital expenditures. Several traditional methods are described, including payback period and accounting rate of return. Payback period calculates the years to recover the initial investment, while accounting rate of return expresses profits as a percentage of average investment. Modern discounted cash flow methods take the time value of money into account, such as net present value (NPV) which discounts future cash flows to determine if a project's present value exceeds the initial investment. The document provides examples of calculating project metrics using these various capital budgeting techniques.

1. .
▶Investment Decision
— Capital Budgeting Techniques
— Pay Back Method
— Accounting Rate Of Return
— NPV
— IRR
— Discounted Pay Back Method
— Capital Rationing
— Risk Adjusted Techniques Of Capital Budgeting.
— Capital Budgeting Practices.

2. What is an Investment?
▶ In an economic sense, an investment is the
purchase of goods that are not consumed
today but are used in the future to create wealth.
▶ In finance, an investment is a monetary
asset purchased with the idea that the asset will
provide income in the future or will later be sold
at a higher price for a profit.

3. Investment Analysis
Investment analysis, defined as the process
of evaluating an investment for profitability
and risk, ultimately has the purpose of
measuring how the given investment is a
good fit for a portfolio.

4. What is Capital Budgeting?
▶ Capital budgeting is the planning process
used to determine whether an organization’s
long term investments such as new
machinery, replacement machinery, new
plants, new products, and research
development projects are worth the funding
of cash through the firm’s capitalization
structure.

5. Definition- Capital Budgeting
“Capital budgeting is long term planning
for making and financing proposed
capital outlays”
- Charles T
Horngreen.

6. Features Of Capital Budgeting
a. Potentially large anticipated benefits
b. A relatively high degree of risk
c. Relatively long time period between the initial
outlay and the anticipated return. (Long
term return/ Benefits)
d. They are irreversible in nature

7. Need for Capital Budgeting
 Large investments
 Irreversible nature
 Difficulties of investment decision
 Long term effect on profitability
 To avoid over investment and under investments.

8. CAPITAL BUDGETING PROCESS
• Identification of Potential Investment Opportunities
• Assembling of Investment Proposals
• Decision Making
• Preparation of Capital Budget and Appropriations
• Implementation
• Performance Review

9. Methods of Capital Budgeting
Traditional Methods
Discounted Cash Flow Methods/
Modern Method
• Payback Period
• Accounting Rate Of
Return Method
• Net Present Value Method
• Profitability Index Method
• Internal Rate Of Return

10. Pay Back Period Method
It refers to the period in which the project will
generate the necessary cash to recover the
initial investment.
▶ Also called “Pay Out Or Pay Off Period
Method”
▶ It does not take the effect of time value of
money.
▶ The selection of the project is based on the
earning capacity of a project.

11. ▶ It emphasizes more on annual cash inflows, economic
life of the project and original investment.
▶It involves simple calculation, selection or rejection of the
project can be made easily, results obtained is more
reliable, best method for evaluating high risk projects.
▶Under this method projects are ranked on the basis of
length of payback period

12. Pay back period calculation
▶ Two different situations
 Equal cash inflow / Even cash inflow
 Unequal cash inflow / Uneven cash inflow

13. Initial Investment
Annual Cash Inflow
Note: Annual cash inflow is the annual earnings
(Profit before depreciation and after tax)
1. Equal Cash Inflow / Even Cash Inflow
Pay Back Period =

14. 2. Un Even Cash Inflow
Payback Period =
B
E +
C
Where,
E = No. of years immediately preceding the year of payback
B = Balance to be recovered
C = Cash flow during the year of recovery

15. Example
▶A project cost Rs.50,000 and yields an annual inflow of
Rs.10,000.
Calculate its PBP?
Initial Investment
Annual Cash Inflow
PBP=
50,000
10,000
PBP= = 5 Years.

16. Example
▶ Un even cash inflows
Determine PBP for a project which requires a cash outlay of
Rs.12,000 and generates cash inflows of Rs. 2000, Rs.4000,
Rs.4000 and Rs.5000 in the first, Second, third, fourth years
respectively.

17. Solution – Step 1
Year Annual Cash Inflow
Cumulated Cash
Inflows
1 2000 2000
2 4000 6000
3 4000 10,000
4 5000 15,000

18. Upto 3rd year the initial investment of Rs.12,000 is
not recovered, only 10,000 is recovered.
But in the fourth year its Rs.15,000. ie Rs.3000
more than the cost of project.
We have to find Time to recover 12000
3rd Year = 10000 (Required 2000 more)
2000
5000
3 +
B
C
E +
Payback Period = = 3.4 Years

19. Problem - 1
Capital cost of three models of machine is Rs. 90,000 each and
the estimated life is 4 years. Annual returns of each machine are
given below. Decide the model of machine to be chosen on the
basis of Pay back period.
Year Model A Model B Model C
1 20,000 30,000 35,000
2 30,000 40,000 35,000
3 50,000 50,000 35,000
4 50,000 20,000 35,000

20. Problem - 2
Initial outlay for each of the following projects is Rs. 15,000 &
standard payback is 3 years. Evaluate the projects and rank
them based on payback period
Year ProjectA Project B Project C Project D
1 5,000 3,500 2,500 8,000
2 5,000 4,000 2,500 6,000
3 5,000 4,500 2,500 6,000
4 5,000 6,000 2,500 5,000
5 5,000 6,000 2,500 5,000

21. Advantages of PBP Method
▶ Easy to understand and simple to calculate.
▶ Finding out the projects which generate the
substantial cash inflows in earlier years.
▶ It is helpful in weeding out the risky projects.
▶ This method finding out the project that makes early
realization of funds, this helps to enhance the
liquidity.
▶ This method helps to reduce cost of calculation.

22. Disadvantages of PBP Method
▶ Ignores all cash inflows after the Payback period.
▶ Does not considering the total benefit from the project.
▶ It ignores the time value of money.
(Cash inflows occurring different time period treat as equal.)
▶ It only find the recovery of investment, not the profitability.
▶ It ignores the scrap or salvage value of project after life

23. 2. Average Rate of Return Method (ARR)
▶ Also called Rate of return method or Accounting rate of return method.
▶ Introduced to overcome the disadvantage of pay back period.
▶ It considers the all year earnings of the project.
▶ It is based on conventional accounting concepts.
▶ The rate of return is expressed as percentage of the earnings of the
investment in a particular project.
▶ The profits under this method is calculated as profit after depreciation and
tax of the entire life of the project.

24. Calculations
Average income after tax and depreciation
Average investment
ARR = x 100
Average Income =
Total Return
Expected Life or Life time
Average Investment =
Original investment
2

25. + Additional W/C
If scrap value or additional working capital is given
Average Investment =
Original investment + SV
2

26. ▶ Calculate ARR
Project A Project B
Investment 4,000 5,000
Expected Life 4 Years 4 Years
Income shown after Depreciation and Tax
Year ProjectA Project B
1 2000 3000
2 1500 3000
3 1500 2000
4 1000 1000
Total Income 6,000 9,000

27. Average income after tax and depreciation
Average investment
ARR = x 100
Project A Avg. Income =
Total Return
Expected Life
6000
4
= 1500
Avg. Investment =
Original investment
2
4000
2
= 2000
2000
ARR =
1500
x 100 = 75%

28. Average income after tax and depreciation
Average investment
ARR = x 100
Project B Avg. Income =
Total Return
Expected Life
9,000
4
= 2,250
Avg. Investment =
Original investment
2
5,000
2
= 2500
ARR =
2,250
x 100 = 90%
2,500

29. ▶ Calculate ARR
ProjectA Project B
Investment 50,000 50,000
Expected Life 5 Years 5 Years
Scrap Value 7000 3000
Year Project A Project B
1 6,000 7,000
2 9,000 8,000
3 10,000 10,000
4 12,000 12,000
5 14,000 16,000
Total Income 51,000 53,000

30. Advantages Of ARR Method
▶ Simple to calculate
▶ Easy to understand
▶ based on accounting information readily available
▶ It gives importance to profitability
▶ ARR is based on accounting profit
▶ It consider all cash inflows of the project.
▶ It can be used for rank and compare two projects.

31. Disadvantages of ARR Method
▶ Ignores the time value of money
▶ Cash inflows of all years are given equal important.
▶ It uses accounting information rather than cash
inflow.
▶ This method is not suitable for comparing projects
with different duration or life

32. MODERN METHODS / DISCOUNTED CASH
FLOW METHOD
1. Net present value method
2. Profitability index method
3. Internal rate of return
4. Modified Internal rate of return
5. Discounted Payback period method

33. Net present value method
▶ It recognizes the impact of time value of money. It is
considered as the best method of evaluating the capital
investment proposal.
▶ It is widely used in practice.
▶ The cash inflow to be received at different period of time
will be discounted at a particular discount rate.
▶ The present values of the cash inflow are compared with
the original investment.
▶ The difference between the two will be used for accept or
reject criteria.

34. Cash
Outflow/
Investment
Future Cash
Inflow/
Return
Present Value

35. NPV= Discounted cash inflow - Discounted cash
outflow
Note1 : If only in the beginning initial
investment is made, then the discounted cash
outflow will be the same i.e., initial investment
Note2 : Cash inflow means profit before
depreciation and after tax

36. Acceptance Role
If NPV is
▶ Positive value
▶ Zero
▶ Negative Value

37. 1. Determine the appropriate Discount Rate
2. Compute the present value of Total Investment
(Discounted cash outflow)
3. Compute the present value of cash inflows
(Profit Before Depreciation and After Tax) x (Discount Rate)
4. Minus the Value of Investment from Value of Inflow
(Discounted cash inflow- Discounted cash outflow)
5. If the NPV –ve Reject it, If NPV is +ve Accept it
6. Rank the projects and maximum positive NPV Should be
chosen

38. Equation
• C1,C2…Cn represents net cash inflow for year 1,2….n
• K is the opportunity cost of capital
• C0 is the initial investment n is the expected life of investment

39. Example..
Calculate NPV of the two projects and suggest.
Assuming Discount rate is 10%
Machine A Machine B
Investment 40,000 50,000
Yearly Returns
1 12,000 25,000
2 18,000 18,000
3 7,000 12,000
4 5,000 4,000
5 4,000 4,000

40. Machine - A
12000
(1+0.1)
18000
(1+0.1) 2
+
7000
(1+0.1) 3
+
5000
(1+0.1) 4
+
4000
(1+0.1)5
+ - 40,000
NPV =
NPV = 10,909 + 14,876 + 5,259 + 3415 + 2484 - 40,000
NPV = 36,943 - 40,000 = - 3,057

41. Machine - B
25000
(1+0.1)
18000
(1+0.1) 2
+
12000
(1+0.1) 3
+
4000
(1+0.1) 4
+
4000
(1+0.1)5
+ - 50,000
NPV =
NPV = 22,727 + 14,876 + 9016 + 2732 + 2484 - 50,000
NPV = 51835 - 50,000 = 1835

42. NPV
Machine A = - 3057
Machine B = 1835
Machine B is the best investment opportunity

43. A company is considering the purchase of new machine.
Two alternative models are available. Each year cash flow is given.
If the total investment of Model A is Rs. 70,000 and Model B Rs: 60,000,
Which alternative company will select on the basis of NPV of two
models?
Year Model A Model B
1 8000 24000
2 24000 32000
3 32000 40000
4 48000 24000
5 32000 16000

45. Example:
Year 1 Year 2 Year 3
Sales 10,000 units 20,000 units 40,000 units
Sale price per unit= 10 rs.
Raw Material = 6 rs.
Fixed expenses excluding depreciation = Rs
20,000
Depreciation = Rs 15,000
Tax rate= 30%
Initial Investment= Rs 1,30,000
Compute NPV at 10% discount rate

46. .
Q: ABC ltd. Is evaluating the purchase of a new
project with a depreciable base of Rs 1,00,000,
expected life of 4 years and change in earnings
before taxes and depreciation of Rs 45,000 , Rs
30,000 and Rs 25000 , Rs 45,000 in 1st , 2nd , 3rd , 4th
year respectively. Assume SLM and 20% tax rate.
You are required to compute required cash flows.

48. Advantages of NPV Method
▶ It consider the time value of money
▶ Converting future cash inflows to discounted present value.
▶ Consider entire life cash inflows
▶ Objective of maximizing owner’s wealth
▶ Can be estimated and compared to take a decision.
▶ It is based on profitability and liquidity.

49. Disadvantages of NPV Method
▶ Computation is difficult
▶ It is not easy to appropriate and determine discount rate.
▶ Difficulty to estimate cash inflows due to uncertainty

50. • The profitability index is an index that attempts to identify the
relationship between the costs and benefits of a
proposed project through the use of a ratio.
• Profitability index (PI), also known as profit investment
ratio (PIR) and value investment ratio (VIR), is the ratio of
payoff to investment of a proposed project.

51. Present value of cash inflow
Present value of cash outflow
PI is equal to or more than one, the proposal can be accepted
PI =
▶PI = 1
▶PI = > 1
▶PI = <1
Accept
Accept
Reject

52. Calculate PI of each project and suggest the best one.
Estimated discount rate is 12%
Project Co C1 C2 C3
A - 4,000 0 4,000 2,000
B - 4,000 2,000 2,000 0
C - 5,000 3,000 2,000 2,000
D - 5,000 2,000 3,000 2,000

53. Advantages Of Profitability Index (PI)
1. PI considers the time value of money.
2. PI considers analysis all cash flows of entire life.
3. PI makes the right in the case of different amount of
cash outlay of different project.
4. PI ascertains the exact rate of return of the project

54. Disadvantages Of Profitability Index(PI)
1. It is difficult to understand interest rate or discount
rate.
2. It is difficult to calculate if two projects having
different period of life.

55. Internal rate of return (IRR) is a metric used in
capital budgeting measuring the profitability of
potential investments.
Internal rate of return is a discount rate that
makes the net present value (NPV) of all cash
flows from a particular project equal to zero.
3. Internal Rate Of Return (IRR)

56. Discounted
Cash inflow
Discounted
Cash outflow 0
Discount Rate ?
IRR is that rate at which the sum of discounted cash inflow
equals the sum of discounted cash outflows

57. L =
P1 =
P2 =
Q =
D =
Lower discount rate
Present Value at lower (%) rate
Present Value at higher (%) rate
Actual investment
Difference in rate (%)
P1 – Q
IRR = L+ x D
P1 - P2

58. Calculate IRR of each and suggest the
best one
Investment 10000 10000 10000
Year Model A Model B Model C
1 2000 3000 2000
2 3000 3000 4000
3 3000 3000 4000
4 4000 2000 5000

59. Advantages of IRR
▶ Use of time value of money.
▶ All cash flows are equally important
▶ Uniform ranking
▶ Maximum profitability of shareholder
▶ Not need to calculate cost of capital

60. Disadvantages of IRR
▶ T
o understand IRR is difficult
▶ Not Helpful for comparing two different investment
▶ Unrealistic Assumption

61. Discounted Payback Period
▶ Payback period by considering time value of money.
▶ A project’s discounted payback period is the number
of years it takes for the net cash flows’ present values
to pay back the net investment.
▶ Shorter paybacks are better than longer paybacks.

62. Year Cash Flow
1 70,000
2 70,000
3 70,000
4 70,000
5 70,000
Example.
Investment 2,00,000
Opportunity cost : 10%

63. MIRR
• MIRR= (Future value/initial investment) 1/n -1
• Whereas FV=Present value(1+i)n

64. MODIFIED IRR
0 1 2 3 4 5 6
-120 -80 20 60 80 100 120
r=15% 115
-69.6 r =15% r =15% 105.76
PVC = 189.6 r =15% 91.26
r =15% 34.98
Terminal value (TV) = 467
PV = 189.6 MIRR = 16.2%
of TV
NPV 0
 Centre for Financial Management , Bangalore

65. More to Capital Budgeting

66. “
”
Capital Rationing

67. Capital Rationing
▶ Related to Capital Budgeting
▶ Related to Investment
▶ When
▶ More investment options are available
▶ But limited resources are available (Shortage of Finance)
▶ Need to choose the best options
▶ Helps to prioritise the options based on profitability
▶ Helping to select the appropriate projects

68. Capital Rationing
• Capital rationing situation refers to the choice of investment
proposal under financial constraints.
• Capital rationing is applied when a firm has a number of
acceptable investment proposal but the resource available
is restricted to certain extend

69. Capital Rationing providing answers to
▶The required fund?
▶Available Fund?
▶How to assign the available fund?

70. Steps in Capital Rationing
1. Ranking projects (By use of any profitability measures)
(NPV,IRR,PI)
2. Selecting projects in descanting order of profitability
until the budget exhausted

71. Factors Leading to Capital Rationing
🠊 Internal Factors
🠊Restriction by management
🠊T
op mgt. Philosophy towards
capital spending
🠊Fear about current commitments
🠊Fund from current operations
🠊Feasibility of acquiring new fund
🠊 External Factors
🠊External Factors
🠊Imperfection of capital market
🠊Govt. Regulations

72. Types of capital rationing
imposed by the
1. Soft capital rationing
▶ It is when restriction is
Management (Internal Factors)
2. Hard capital Rationing
▶It is when capital infusion is limited by external
sources (External Factors)

73. Advantages of capital rationing
1. Budget
2. No wastage
3. Fewer projects
4. Higher returns
5. More stability

74. 1. Budget
• ▶Itintroduces a sense of strict budgeting of
corporate resources
2. No wastage
• ▶It prevents wastage of resources by not investing in
each and every new project available for investment
3. Fewer projects
• ▶
It ensures that less number of projects are
selected by imposing capital restrictions

75. 4. Higher returns
▶ Invest only in projects where the expected return is high,
thus eliminating projects with lower returns in capital
5. More stability
▶ Since the company is selecting those projects where the
expected return is high, thus ensures stability for tough
times as well

76. ▶ The required initial investment and Present value of inflows in
respect of 5 projects (A,B,C,D, and E) is given above. The total
funds available is Rs 13,00,000.
▶ Determine the optimal combination of projects under profitability
index
Project
Required initial
investment
Present value of
inflows
A 2,00,000 2,20,000
B 6,00,000 7,00,000
C 1,00,000 92,000
D 4,00,000 4,90,000
E 2,00,000 2,10,000

77. Project
Required
initial
investment
Present
value of
inflows
Profitability
Index
Ranking
Apportioning
available
capital
D 4,00,000 4,90,000 1.225 1 4,00,000
B 6,00,000 7,00,000 1.16667 2 6,00,000
A 2,00,000 2,20,000 1.1 3 2,00,000
E 2,00,000 2,10,000 1.05 4
1/2th of
Project E
C 1,00,000 92,000 0.92 5

78. Tate Company, a fast growing plastics company with a cost of
capital of 10%, is confronted with six projects competing for its fixed
budget of $250,000. The initial investment and IRR for each project
are shown below:
Capital Rationing