Capital budgeting

Investment Evaluation and
Capital Budgeting
Prof.Shantilal Hajeri
Prof.Shantilal Hajeri 1

Topics covered
1. Investment Decision Rules
2. Techniques of Evaluation
3. Payback period
4. Accounting rate of return method
5. Net present value method
6. Profitability index method
7. Internal rate of return
8. Payback period

7.1 Investment Decision Rules
1. Maximise share holders’ wealth
2. Consider all cash flows
3. Separation of good project from the bad one
4. Ranking of projects according to profitability
5. Early cash flows are preferable to later ones.
6. Choice of mutually exclusive projects.
7. Acts as a criterion for application to
Investment Decision

7.2 Techniques of Evaluation
Traditional methods
• Payback period
• Accounting rate of return method
Discounted cash flow methods
• Net present value method
• Profitability index method
• Internal rate of return
• Discounted Payback period

Capital budgeting
• The process through which different projects are
evaluated is known as capital budgeting
• Capital budgeting is defined “as the firm’s formal
process for the acquisition and investment of
capital. It involves firm’s decisions to invest its
current funds for addition, disposition, modification
and replacement of fixed assets”.
• The capital budgeting decisions are decisions as to
whether or not money should be invested in long
term projects
5Prof.Shantilal Hajeri

Capital budgeting
“Capital budgeting consists in planning
development of available capital for the
purpose of maximising the long term
profitability of the concern” – Lynch
“Capital budgeting is long term planning for
making and financing proposed capital
outlays”- Charles T Horngreen.

Significance of capital budgeting
• The success and failure of business mainly
depends on how the available resources are
being utilised.
• Main tool of financial management
• All types of capital budgeting decisions are
exposed to risk and uncertainty.
• They are irreversible in nature.
• Capital rationing gives sufficient scope for the
financial manager to evaluate different
proposals and only viable project must be
taken up for investments.
• Capital budgeting offers effective control on
cost of capital expenditure projects.
• It helps the management to avoid over
investment and under investments.

Capital budgeting process involves the following
1. Project generation: Generating the proposals for
investment is the first step.
2. Project Evaluation: it involves two steps
• Estimation of benefits and costs: the benefits and costs are
measured in terms of cash flows. The estimation of the cash
inflows and cash outflows mainly depends on future
uncertainties. The risk associated with each project must be
carefully analysed and sufficient provision must be made for
covering the different types of risks. The technique of time
value of money may come as a handy tool in evaluation such
proposals
• Project Selection: If benefits are more than the cost accept the
proposal. In case of more than one project, chose the one with
highest benefit to cost ratio
• Project Execution:

Factors influencing capital budgeting
• Availability of funds
• Structure of capital
• Taxation policy
• Government policy
• Lending policies of financial institutions
• Immediate need of the project
• Earnings
• Capital return
• Economical value of the project
• Working capital
• Accounting practice
• Trend of earnings 9Prof.Shantilal Hajeri

Time Value of Money
If Mr. X is given the option that he can receive an
amount of Rs. 10,000 either today or after one
year, he will most obviously select the first
option. Because he can earn interest for one
year.
• There are two techniques available for this.
• (a) Compounding
• (b) Discounting

Compounding
• Converting Present Value into Future Value
• The interest is compounded and becomes a part of
initial principal at the end of compounding period.
• Future Value = FV , Present Value = PV
• R= rate of interest n= no of periods for compounding
• FV = PV (1+r)^n or FV = PV X compounding Factor
• (1+r)^n is called compounding factor
• Rs. 10,000 if invested for two year carrying the interest
of 10% p.a, The amount to be received after two years
will be 12,100
• 10,000X(1+0.1)^2 = 10000X1.1^2 = 10000X1.21

Discounting
Converting Future Value into Present Value
PV = FV /(1+r)^n or PV = FV X Discounting Factor
1/(1+r)^n is called Discounting factor.
The value of Rs.10,000 to be received after two
year at 10% discount will be Rs. 8,264.46
10,000/(1+0.1)^2= 10000/1.1^2 = 10000/1.21

Questions: Compounding and
Discounting
1. Mr. A invested Rs. 10,000 in fixed deposit
carrying interest @12% p.a. compounded
annually. Calculate the value of investment after
two years
2. Mr. A gets interest of 11% p.a. on his investment.
What should be the amount which he should
invest today so that he may be able to receive Rs.
10,000 after three years
3. Calculate Compounding and Discounting factors
for 3 years if the rate of interest is 10%

Answers
1. 10,000/(1.12)^2 = 12,544
2. 10,000X(1.11)^3 = 7311.91
3. Compounding factors Discounting factors
Year 1 1.100 0.9091
Year 2 1.210 0.8264
Year 3 1.331 0.7513

Step 1:Calculation of cash outflow
Cost of project/asset xxxx
Transportation/installation charges xxxx
Working capital xxxx
Cash outflow xxxx

Step 2: Calculation of cash inflow
Sales xxxx
Less: Cash expenses xxxx
PBDT xxxx
Less: Depreciation xxxx
PBT xxxx
less: Tax xxxx
PAT xxxx
Add: Depreciation xxxx
Cash inflow p.a xxxx

Note:
• Depreciation = Straight Line Method (SLM)
• PBDT – Tax is Cash inflow ( if the tax amount is
given)
• PATBD = Cash inflow
• Cash inflow- Scrap and working capital must be
added.

7.3 Pay back period method
It refers to the period in which the project will
generate the necessary cash to recover the initial
investment.
It does not take the effect of time value of money.
It emphasizes more on annual cash inflows, economic
life of the project and original investment.
PBP is the period of time required for the cumulative
expected cash flows from an investment project to
equal the initial cash outflow.
It involves simple calculation, selection or rejection of
the project can be made easily, results obtained is
more reliable.
Pay back period= No. of years + Amt to recover/ total
cash of next years.

Merits and demerits of Pay back
period
Merits
a) It is quite simple to calculate and easy to
understand
b) It costs less
c) It may be a suitable technique where risk of
obsolescence is high
Demerits
a. It does not consider the returns from a
project after its pay back period is over
b. It ignores time value of money

Pay back period method Example
In three years we have recovered 37,000. In fourth year we have
to recover 40,000-37,000=3,000.
In fourth year the cash inflow is 10,000. for 3,000 the period will
be 3,000/10,000 = 0.33
The Pay back period = 3.33 years. Or 3 years 4 months
Compare this period with the bench mark or standard.
If Pay back period < bench mark or standard, Accept the
proposal.
Year 0 1 2 3 4 5
-40 K 10 K 12 K 15 K 10 K 7 K
10 K 22 K 37 K 47 K 54 K

Illustration: Pay Back Period
Investment is Rs.500 lacs. The promoters expect a
rate of return of 10% p.a. The project has the
following future earnings. Calculate payback period
Year No. Future Earnings
1 100
1 120
3 150
3 250
5 300

Solution:Pay Back Period
Year Cash flow Cumulative Cash flow
1 100 100
2 120 220
3 150 370
4 250 620
5 300 920
Up to three years we recover 370. In 4th year we
have to receive 130 (500-370). The fraction of the
4th year is 130/250= .52 years. The pay back period
is 3.52 years.

Pay Back Period Example
• M/s XYZ have a proposal to start a project involving
an initial outlay of Rs.2,00,000. The cost of capital is
10%. The estimated cash inflows are as under:
• Year Cash flow
• 1 500000
• 2 600000
• 3 700000
• 4 800000
• 5 700000
Calculate Pay Back Period

Answer
• Step 1: Take Cumulative total of Cash flow
• Year Cash flow Cumulative Cash flow
• 1 50000 50000
• 2 60000 110000
• 3 70000 180000
• 4 80000 260000
• 5 70000 330000

• Step 2
• 1 Capital 200000
• 2 Cumulative up to 3 years 180000
• 3 Difference to be recovered
in 4th year 20000
• Step 3
• 80000 : 365 days, 20000: ? days
• (20000 X 365)/80000 = 91 days
• Answer: Payback period = 3 years three months

7.4 Accounting Rate of Return method
IT considers the earnings of the project for the economic
life. 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.
This method of ARR is not commonly accepted.
ARR= (Average profit X100)/Initial investment
Average Profit = Total Profit/No of years of Profit
ARR=
(Total Profits X 100)/(Net Investment X No. of Years of Profit)

Accept or Reject Criterion:
Under the method, all project, having Accounting Rate of
return higher than the minimum rate establishment by
management will be considered and those having ARR less
than the pre-determined rate. This method ranks a Project as
number one, if it has highest ARR, and lowest rank is assigned
to the project with the lowest ARR.
Merits
• It is very simple to understand and use.
• This method takes into account saving over the entire
economic life of the project. Therefore, it provides a better
means of comparison of project than the pay back period.
• This method through the concept of "net earnings" ensures a
compensation of expected profitability of the projects and
• It can readily be calculated by using the accounting data.

Demerits of ARR
1. It ignores time value of money.
2. It does not consider the length of life of the
projects.
3. It is not consistent with the firm's objective of
maximizing the market value of shares.
4. It ignores the fact that the profits earned can be
reinvested. -

Illustration: ARR
Investment is Rs.500 lacs. The promoters expect a rate
of return of 10% p.a. The project has the following
future earnings. Calculate ARR
1 100
1 120
3 150
4 250
5 300

Solution: ARR
Total inflow 920
- Initial investment 500
Total Profit 420
Average Profit 84
ARR 84*100/500 =16.8%
ARR=
(Total Profits X 100)/(Net Investment X No. of
Years of Profit)= (420X100)/(500X5)= 16.8%

ARR Example
• Year Cash flow
• 1 500000
• 2 600000
• 3 700000
• 4 800000
• 5 700000
Calculate Accounting Rate of Return

Solution
• 1 Total Cash Inflow 330000
• 2 Capital 200000
• 3 Gross profit (3=1-2) 130000
• 4 No of years 5
• 5 Profit per year (5=3/4)26000
• 6 Profit per Rs.100. (6=5*100/2) = 13.00%

Discounted cash flow method
Time adjusted technique is an improvement over pay back
method and ARR.
The real value of money fluctuates over a period of time. A
rupee received today has more value than a rupee received
after one year.
In evaluating investment projects it is important to consider
the timing of returns on investment. Discounted cash flow
technique takes into account the interest factor.
Discounted cash flow technique involves the following steps:
• Calculation of cash inflow and out flows over the entire life
of the asset.
• Discounting the cash flows by a discount factor
• Aggregating the discounted cash inflows and comparing
the total so obtained with the discounted out flows.

7.6 Net present value method
It recognises 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. If the
different yields (+) positive value , the proposal is
selected for investment. If the difference shows (-)
negative values, it will be rejected.
NPV= PV of total inflow – initial investment

Pros of NPV:
It recognizes the time value of money.
It considers the cash inflow of the entire project.
It estimates the present value of their cash inflows
by using a discount rate equal to the cost of capital.
It is consistent with the objective of maximizing the
welfare of owners.
Cons of NPV:
It is very difficult to find and understand the
concept of cost of capital
It may not give reliable answers when dealing with
alternative projects under the conditions of
unequal lives of project.
Estimation of Cash inflow is difficult

Illustration: NPV
future earnings. Calculate NPV
1 100
1 120
3 150
4 250
5 300

Solution: NPV
Year Cash flow Discount factor Present Value
0 -500 1.0000 -500.00
1 100 0.9091 90.91
2 120 0.8264 99.17
3 150 0.7513 112.70
4 250 0.6830 170.75
5 300 0.6209 186.28
NPV 159.81

Interpretation of NPV
• NPV Negative means Loss
• NPV=0 means No Profit No Loss
• NPV Positive means Profit.
• Higher the NPV higher the profit.
• In case more than one projects select the
project with highest NPV.

NPV Example
• Year Cash flow
• 1 500000
• 2 600000
• 3 700000
• 4 800000
• 5 700000
Calculate NPV

Solution
• Step 1
• Calculate discount factor or Present Value (PV)
factors using the following formula
• PV factor = 1/(1+r) where r = discount rate or cost of
capital.
• 10% should be taken as 0.10. 8% should be taken as
0.08
• Repeat the step every year by taking the PV factor of
previous year as base. The method is shown below

NPV
Year Formula PV Factor
0 1 1.000
1 1/(1+0.10) 0.909
2 0.909/1.10 0.826
3 0.826/(1.10) 0.751
4 0.751/1.10 0.683
5 0.683/1.10 0.621

Step 2 : Multiply cash flow with PV factor as
shown below
Year Cash flow Discount factors PV
0 -200000 1.000 -200000
1 50000 0.909 45454.55
2 60000 0.826 49586.78
3 70000 0.751 52592.04
4 80000 0.683 54641.08
5 70000 0.621 43464.49
Total PV NPV 45738.93Prof.Shantilal Hajeri 42

• Interpretation
• NPV = 0 means No profit No loss,
• NPV negative means loss ,
• NPV positive means Profit.
• If you have to compare two projects, you have
to repeat the same steps for both the projects.
Recommend the project having higher NPV

7.5 Profitability Index (PI)
• Profitability Index is the ratio of PV of total inflow
to the initial investment
• PI = PV of total inflow /initial investment
• It is similar to NPV. PI is expressed as a ratio.
Interpretation of PI
• PI < 1 means Loss
• PI = 1 means No Profit No Loss
• PI >1 means Profit.
• Higher the PI higher the profit.
• In case of more than one projects select the
project with highest PI.

Illustration: PI
future earnings. Calculate PI
1 100
1 120
3 150
4 250
5 300

Solution: PI
1 100 0.9091 90.91
2 120 0.8264 99.17
3 150 0.7513 112.70
4 250 0.6830 170.75
5 300 0.6209 186.28
Total 659.81
PI = PV of total inflow /initial investment
659.81/500 = 1.315

PI Example
• Year Cash flow
• 1 500000
• 2 600000
• 3 700000
• 4 800000
• 5 700000
Calculate PI

shown below
Year Cash flow Discount factors PV
1 50000 0.909 45454.55
2 60000 0.826 49586.78
3 70000 0.751 52592.04
4 80000 0.683 54641.08
5 70000 0.621 43464.49
Total PV 245738.93
PI = PV of inflow/Initial investment
2,45738.93/2,00,000 = 1.23

Comparison of NPV and PI
• NPV = 0 means No profit No loss, PI = 1
• NPV negative means loss , PI < 1
• NPV positive means Profit. PI > 1

7.7 Internal Rate of Return
IRR is the discount rate that equates the
present value of the future net cash flows from
an investment project with the project’s initial
cash outflow.
It is that rate at which the sum of discounted
cash inflows equals the sum of discounted cash
outflows. It is the rate at which the net present
value of the investment is zero.
If IRR > Cost of Capital accept the proposal

Merits of IRR method
• It consider the time value of money
• Calculation of cost of capital is not a
prerequisite for adopting IRR
• IRR attempts to find the maximum rate of
interest at which funds invested in the
project could be repaid out of the cash
inflows arising from the project.
• It considers cash inflows throughout the life
of the project.

Demerits of IRR method
• Computation of IRR is tedious and difficult to
understand
• Both NPV and IRR assume that the cash
inflows can be reinvested at the discounting
rate in the new projects. However,
reinvestment of funds at the cut off rate is
more appropriate than at the IRR.
• IT may give results inconsistent with NPV
method. This is especially true in case of
mutually exclusive project.

Calculation of IRR
• In excel packages and other soft wares you can directly get
IRR for the given data. There is no direct formula to
calculate IRR. It is calculated by trial and error method.
• NPV is calculated at an assumed cost of capital.
• If NPV is negative then again NPV is calculated at a lower
assumed cost of capital where the NPV will be positive.
• NPV negative means Assumed cost of capital is > IRR
• NPV positive means Assumed cost of capital is < IRR
• IRR lies between these two assumed rates.
• Formula for IRR
• IRR = Lower assumed cost + (difference between the
cost)X100/(Difference between the NPVs at two rates)

Illustration: IRR
future earnings. Calculate IRR
1 100
1 120
3 150
4 250
5 300

Solution: NPV
0 -500 1.0000 -500.00
1 100 0.9091 90.91
2 120 0.8264 99.17
3 150 0.7513 112.70
4 250 0.6830 170.75
5 300 0.6209 186.28
NPV 159.81
Here NPV is positive at 10% discount rate.
Calculate NPV at 20% discount rate.

Solution: NPV
0 -500 1.0000 -500.00
1 100 0.8333 83.33
2 120 0.6944 83.33
3 150 0.5787 86.81
4 250 0.4823 120.56
5 300 0.4019 120.56
NPV -5.40
Here NPV is negative at 20% discount rate.
It means IRR is between 10% and 20%

Solution IRR
• IRR = Lower assumed cost + (difference
between the cost)X100/(Difference between
the NPVs at two rates)
• =.10+ (20-10)X100/(159.81-(-5.40))
• =10 + 10X100/165.21
• =10+1000/165.21 = 10+6.05
• = 16.05%

Comparison of NPV, IRR and PI
1) NPV is positive, it means IRR>cost of capital, it
means Profitability index is >1 . In all these cases
there is profit.
2) NPV is Zero, it means IRR=cost of capital, it
means Profitability index is 1 . In all these cases
there is no profit no Loss.
3) NPV is Negative, it means IRR<cost of capital,
it means Profitability index is <1 . In all these
cases there is Loss.

7.8 . Pay Back Method with
discounting
• This method is same as NPV method up to PV
stage.
• There after it is same as Pay Back Method
without discounting
• Step 1: Calculate PV of cash inflows.
• Step 2. Take cumulative total of PV
• Step 3 calculate the fraction of the year in
which the cumulative PV exceeds investment

PI Example
• Year Cash flow
• 1 500000
• 2 600000
• 3 700000
• 4 800000
• 5 700000
Calculate Pay Back period with discounting

shown below
Year Cash
flow
Discount
factors
PV Cumulative
PV
1 50000 0.909 45454.55 45454.55
2 60000 0.826 49586.78 95041.32
3 70000 0.751 52592.04 147633.36
4 80000 0.683 54641.08 202274.43
5 70000 0.621 43464.49 245738.93
Take Cumulative total of PV

1 Capital 200000.00
2 Cumulative up to 3 years 147633.36
3 Diff to be recovered in 4th year 52366.64
Step 4: 80000 : 365 days, 52366.64: ? days.
(52366.64 X 365)/ 54641.08 = 350 days
Answer: Payback period = 3 years 11 months 20
days

Summary
Pay back period
indicates the period within which the cost of the project will be
completely recovered
Accounting rate of return
computes average annual yield on the net investment in the project
Net Present value
method by subtracting present value of cash outflows from the present
value of cash inflows
Profitability Index
Profitability Index is the ratio of PV of total inflow to the initial
investment
Internal Rate of Return
It is that rate at which the sum of discounted cash inflows equals the
sum of discounted cash outflows

Summary of formulas
1. FV = PV X (1+r)^n PV = Fv/(1+r)^n
2. Payback period = Cash outlay / Annual cash inflow
3. Accounting rate of return = (Total Profits X 100)/(Net
Investment X No.of Years of Profit)
4. Net Present value = Total discounted cash inflows -
Total discounted cash outflows
5. Profitability Index = Total discounted cash
inflows/Total discounted cash outflows
6. IRR = Lower assumed cost + (difference between
the cost)X100/(Difference between the NPVs at two
rates)

Exercise
future earnings. Calculate ARR, Pay Back period, NPV, PI
and IRR
1 100
2 110
3 120
4. 115

Capital budgeting

Recommended

Recommended

More Related Content

What's hot

What's hot (20)

Similar to Capital budgeting

Similar to Capital budgeting (20)

More from Shantilal Hajeri

More from Shantilal Hajeri (20)

Recently uploaded

Recently uploaded (20)

Capital budgeting