From the given information, calculate the profitability index of the project: - Initial investment required is Rs. 50 lacs - Present value of future cash flows are: Year 1: Rs. 9,09,000 Year 2: Rs. 9,91,680 Year 3: Rs. 11,25,950 Year 4: Rs. 12,29,460 Year 5: Rs. 15,52,250 Total present value of future cash flows = Rs. 58,09,340 Profitability Index = Present value of future cash flows / Initial investment = Rs. 58,09,340 / Rs. 50,00,000 = 1.1618 Therefore, the

1. capital budgeting

2. What is capital budgeting
• Analysis of potential projects.
• Long-term decisions; involve large
expenditures.
• Very important to firm’s future.

3. importance of capital budgeting
• Capital budgeting decisions involve long-term implication for the firm,
and influence its risk complexion.
• Capital budgeting involves commitment of large amount of funds.
• Capital decisions are required to assessment of future events which are
uncertain.
• In most cases, capital budgeting decisions are irreversible. This is because
it is very difficult to find a market for the capital goods. The only
alternative available is to scrap the asset, and incur heavy loss.
• Capital budgeting ensures the selection of right source of finance at the
right time.
• Many firms fail, because they have too much or too little capital
equipment.
• Investment decision taken by individual concern is of national importance
because it deter- mines employment, economic activities and economic
growth.

4. Objective of capital budgeting
• To ensure the selection of the possible profitable capital project
• To ensure the effective control of capital expenditure in order to
achieve by forecasting the long-term financial requirements.
• To make estimation of capital expenditure during the budget period
and to see that the benefits and costs may be measured in terms of
cash flow.
• Determining the required quantum takes place as per authorization
and sanctions.
• To facilitate co-ordination of inter-departmental project funds
among the competing capital projects.
• To ensure maximization of profit by allocating the available
investible.

5. Steps in Capital Budgeting
• Identification Stage – determine which types of
capital investments are necessary to accomplish
organizational objectives and strategies
• Search Stage – Explore alternative capital
investments that will achieve organization
objectives
• Information-Acquisition Stage – consider the
expected costs and benefits of alternative capital
investments

6. • Selection Stage – choose projects for
implementation
• Financing Stage – obtain project financing
• Implementation and Control Stage – get
projects under way and monitor their
performance

7. Types of Capital Expenditure
Capital Expenditure can be of two types :
Capital Expenditure Increases Revenue: It is the
expenditure which brings more revenue to the firm
either by expanding the existing production facilities
or development of new production line.
Capital Expenditure Reduces Costs: Such a capital
expenditure reduces the cost of present product and
thereby increases the profitability of existing
operations. It can be done by replacement of old
machine by a new one.

8. Types Of Capital Investment Decisions
• On the basis of firm’s existence
– Replacement and Modernization decisions
– Expansion decisions
– Diversification decisions
• On the Basis of Decision Situation
– Mutually Exclusive Decision
– Accept and Reject Decision
– Contingent Decision

9. Cap Budgeting Evaluation Methods
• Traditional method
– Payback method
– Average accounting return
• Modern method
– Net Present value method (N.P.V)
– Internal rate of return method (I.R.R)
– Profitability index method (P.I)

10. Pay-back Period Method
Pay-back period is also termed as "Pay-out period" or Pay-
off period. Payout Period Method is one of the most
popular and widely recognized traditional method of
evaluating investment proposals.
It is defined as the number of years required to recover the
initial investment in full with the help of the stream of
annual cash flows generated by the project.
• Calculation of Pay-back Period: Pay-back period can
be calculated into the following two different situations :
(a) In the case of constant annual cash inflows.
(b) In the case of uneven or unequal cash inflows.

11. (a) In the case of constant annual cash inflows : If the
project generates constant cash flow the Pay-back period can be computed by
dividing cash outlays (original investment) by annual cash inflows. The
following formula can be used to ascertain pay-back period :
Pay-back Period = Cash Outlays (Initial Investment) /Annual Cash
Inflows

12. Illustration
• A project requires initial investment of Rs. 40,000 and
it will generate an annual cash inflows of Rs. 10,000 for
6 years. You are required to find out pay-back period.
Solution:
• Pay-back Period = Cash Outlays (Initial Investment)/
Annual Cash Inflows
= 40,000 / 10,000
= 4 Years
Pay-back period is 4 years, the investment is fully
recovered in 4 years.

13. (b) In the case of Uneven or Unequal Cash Inflows: In
the case of uneven or unequal cash inflows, the Pay-back period
is determined with the help of cumulative cash inflow. It can be
calculated by adding up the cash inflows until the total is equal
to the initial investment.

14. Illustration
From the following information you are required to calculate pay-back period
A project requires initial investment of Rs. 40,000 and generate cash inflows of Rs.
16,000, Rs. 14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth year
respectively.
Solution:
• Calculation Pay-back Period with the help of "Cumulative Cash Inflows"
Year annual cash flow (rs) cumulative cash inflows (rs)
1 16000 16000
2 14000 30000
3 8000 38000
4 6000 44000
The above table shows that at the end of 4th years the cumulative cash inflows
exceeds the investment of Rs. 40,000. Thus the pay-back period is as follows :
Pay-back Period = 3 Years +( 40000 – 38000) / 6000
= 3 Years + 2000/6000
= 3.33 Years

15. Average Rate of Return Method (ARR)
• Average Rate of Return Method (ARR) : Average Rate of
Return Method is also termed as Accounting Rate of Return Method. This
method focuses on the average net income generated in a project in
relation to the project's average investment outlay. This method involves
accounting profits not cash flows and is similar to the pelformance
measure of return on capital employed.
• Formulas
Average Rate of Return (ARR) = Average income / Average investment x 100
or
cash inflow – (after dep and tax )/ original investment
Average Investment = Original Investment /2

16. Illustration
• From the following information you are required to find out Average Rate
of Return :
An investment with expenditure of Rs.l0,OO,OOO is expected to produce the
following profits (after deducting depreciation)
year rs
1 80,000
2 1,60,000
3 1,80,000
4 60,000

17. • Solution
Average Rate of Return =
Average Annual Profits – Depreciation and Taxes x 100
Average Investments
Average Annual Profits = 80,000+1,60,000+1,80,000+60,000
4
= 1,20,000
Average Investments (Assuming Nil Scrap Value) = investment in beginning + investment in end
2
= 10,00,000 + 0
2
= 5,00,000
Average Rate of Return = 1,20,000 x 100
5,00,000
= 24%

18. Net present value
• The difference between the market value of a project
and its cost
• How much value is created from undertaking an
investment?
– The first step is to estimate the expected future cash flows.
– The second step is to estimate the required return for
projects of this risk level.
– The third step is to find the present value of the cash flows
and subtract the initial investment.

19. Illustration
• Mr A planning to invest rs 50 lac in a innovative machinery , the expected cash
flow for 5 years period of time given below
year cash inflow (rs)
1 10,00,000
2 12,00,000
3 15,00,000
4 18,00,000
5 25,00,000
The cost of capital is @ 10%

20. • Solution
year cash inflow (rs) dist rate present value
1 10,00,000 ( 1/1.1) 0.9090 9,09,000
2 12,00,000 0.8246 9,91,680
3 15,00,000 0.7513 11,25,950
4 18,00,000 0.6830 12,29,460
5 25,00,000 0.6666 15,52,250
= 58,09,340
less orignal investment - 50,00,000
npv = 8,09,340

21. Profitability index method (P.I)
• Ratio of the present value of a project's cash flows to the
initial investment. A profitability index number greater than 1
indicates an acceptable project, and is consistent with a net
present value greater than 0
• Formula
Profitability Index
Present Value of Future Cash Flows
Initial Investment Required

22. Illustration
• Company C is undertaking a project at a cost of 50 million which is
expected to generate future net cash flows with a present value of 65
million. Calculate the profitability index.
• Solution
Profitability Index = PV of Future Net Cash Flows / Initial Investment Required
Profitability Index = 65M / 50M = 1.3 years

23. Internal rate of return method (I.R.R)
• Internal Rate of Return Method is also called as "Time
Adjusted Rate of Return Method." It is defined as the rate
which equates the present value of each cash inflows with the
present value of cash outflows of an investment. In other
words, it is the rate at which the net present value of the
investment is zero.

24. Illustration
• x firm is considering a project the details of
which are ,
Investment Rs 70000
Year Cash Inflow
1 15000
2 17000
3 19000
4 21000
5 26000
Compute 1.R.R of the project:

25. Solution :
Step I: Calculation of fack payback period on the basis of average cash inflows:
Average cash inflows of all periods = 15000+17000+ 19000+ 21000+ 26000
5
= 98000
5
= Rs 19600
Fack Payback period = Initial Cash outflow
Average cash inflow
= 7 0000
19600
= 3.57 years
.

26. Step 2 : Locate fack payback period in annuity table A-2 (given at the end of
the chapter) against the row of number of year of the project:

27. • We locate 3.517 in 5 year row. we find 3.517 which is annuity of Rs 1 at 13%
rate. Therefore, our first discount rate is 13%
Step 3:
Now Find NPV at the first discount rate located above.
Year Cash in flow Discount Factor Present Value
1 15000 .885 13275
2 17000 .783 13311
3 19000 .693 13167
4 21000 .613 12873
5 26000 .543 14118
66744
less original value 70000
NPV Rs-3256

28. • The other discount rate should be more than 13% or less than 13% Since NPV is negative at
13% discount rate the other discount rate should be less than 13% so that we can discount
future cash inflows at lower rate and find a positive NPV. So, lets take the second discount
rate at 11% NPV of the project at 11% discount rate :
Year Cash in flow Discount Factor Present Value
1 15000 .901 13515
2 17000 .812 13804
3 19000 .731 13889
4 21000 .659 13839
5 26000 .593 15418
70465
less original value - 70000
NPV 465

29. Step 4 : Apply the formula of IRR

30. = 11 + 465 x2 ( 2 = diff between intrest rates)
465 - (-3256)
= 11 + 465 x2
3721
= 11 + .2499
IRR = 11.25 %

31. Payback Accounting Net present Internal rate
period rate of return value of return
Basis of Cash Accrual Cash flows Cash flows
measurement flows income Profitability Profitability
Measure Number Percent Rupees Percent
expressed as of years Amount
Easy to Easy to Considers time Considers time
Understand Understand value of money value of money
Strengths Allows Allows Accommodates Allows
comparison comparison different risk comparisons
across projects across projects levels over of dissimilar
a project's life projects
Doesn't Doesn't Difficult to Doesn't reflect
consider time consider time compare varying risk
value of money value of money dissimilar levels over the
Limitations projects project's life
Doesn't Doesn't give
consider cash annual rates
flows after over the life
payback period of a project