CAPITAL BUDGETING

Dr. Shailesh Mathur Dr. Richa Singhal
Associate Professor Associate Professor
Deptt. Of ABST Deptt. Of EAFM
S. S. Jain Subodh P. G. College, Jaipur
An Autonomous Institute 1

“Capital budgeting involves planning of expenditure for
assets and return from them which will be realized in future
time period”
Milton
“Capital budgeting refers to the total process of generating,
evaluating, selecting and follow up of capital expenditure
alternative”
I.M. Pandey
Hence planning and control of capital expenditure is termed
as capital budgeting.
2

 Long term investment( more than one year)
 Irreversible Decision
 High Risk
 Long Term Effect on Profitability
 Impacts Cost Structure
 Difficult Decisions
 Affects competitive Strengths
 Cost-benefit analysis
 cost- cash outflows
 return- cash inflows
3

 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
4

METHODS OF CAPITAL BUDGETING
Traditional methods Modern / Discount Methods
Pay-back Period Methods
Average Rate of Return
Net Present Value Method
Internal Rate of Return Method
Profitability Index Method
5

Pay-back period is the time required to recover the initial
investment in a project.
Accept /Reject criteria:
If the actual pay-back period is less than the
predetermined pay-back period, the project would be
accepted. If not, it would be rejected.
It is calculated as follows:
A. When annual cash in flows are equal:
Pay Back Period =
Initial investment
Annual cash inflows
6

Calculation of Annual Cash-in-Flow
Particular Amount
Sales
Less: Total Cost (Excluding depreciation)
X X X
- - -
Profit before depreciation and Tax
Less: Depreciation
= = =
- - -
Profit before Tax
Less: Tax
= = =
- - -
Profit after Depreciation and Tax
Add: Depreciation
= = =
+ + +
Cash In Flow = = =
7

Example 2:
A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after
depreciation @ 12½% but before tax at 50%. Calculate the pay-back period.
Solution: Calculation of Cash In Flow
Pay Back Period = Initial Investment / Annual Cash In Flow
= 20,00,000 / 4,00,000 = 5 years
Particular Amount
Profit after depreciation before tax
Less: Tax @ 50%
3,00,000
1,50,000
Add: Depreciation (12.5% of 20,00,000)
1,50,000
2,50,000
Cash In Flow 4,00,000
Example 1:
Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the
project is 5 years. Calculate the pay-back period.
Solution:
Pay Back Period = 30,000 / 10,000 = 3 years
8

B. When annual cash in flows are unequal:
Normally the projects are not having uniform cash inflows. In those
cases cumulative cash inflows will be calculated and then
interpreted the pay-back period as follows:
Pay
Back
Period
=
Year in which
cumulative cash in
flow is just less than
amount of investment
+
Investment – cumulative cash
in flow of the year
Cash inflows of next year
9

Example 3:
Certain projects require an initial cash outflow of Rs. 25,000. The cash inflows
for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs.
3,000. Calculate pay back period.
Solution:
Year Cash in flow Cumulative cash in flow
1
2
3
4
5
6
5,000
8,000
10,000
12,000
7,000
3,000
5,000
13,000
23,000
35,000
42,000
45,000
Pay Back Period
= Year in which cumulative cash in flow is less than amount of investment +
(Investment Amount – Cumulative Cash in Flow of the year) / Cash inflows of
next year
= 3 + (25,000 – 23,000) / 12,000
= 3.17 years or 3 years 2 months
10

Merits:
 It is easy to calculate and simple to understand.
 Pay-back method provides further improvement over the
accounting rate return.
 Pay-back method reduces the possibility of loss on account of
obsolescence.
Demerits
 It ignores the time value of money.
 It ignores all cash inflows after the pay-back period.
 It is one of the misleading evaluations of capital budgeting
11

One of the major limitations of pay-back period method is that it does not
consider the cash inflows earned after pay-back period and if the real
profitability of the project cannot be assessed. To improve over this
method, it can be made by considering the receivable after the pay-back
period. These returns are called post pay-back profits.
Post pay-back profitability
= Cash inflow (Estimated life – Pay-back period)+scrap value
OR
= Total Cash in flow – Initial Investment +scrap value
Post pay-back profitability index
= (Total Cash in flow – Initial Investment) x 100 / Initial Investment
OR
= Post pay-back profitability x 100 / Initial Investment
12

Example 4:
From the following particulars, compute Payback period; Post pay-back
profitability and post pay-back profitability index:
Cash outflow Rs. 1,00,000; Annual cash inflow (After tax before depreciation)
Rs. 25,000 and Estimate Life 6 years.
Solution:
a) Pay Back Period = Initial Investment / Annual cash in flow
=1,00,000 / 25,000 = 4 years
b) Post pay-back profitability
= Cash inflow (Estimated life – Pay-back period)
= 25,000 (6 – 4) = Rs. 50,000
c) Post pay-back profitability index
= Post pay-back profitability x 100 / Initial Investment
= 50,000 x 100 / 1,00,000 = 50%
13

Average rate of return means the average annual earning on the
project. under this method profit after tax and depreciation is
considered.
Accept/Reject criteria
If the actual accounting rate of return is more than the
predetermined required rate of return, the project would be
accepted. If not it would be rejected.
The average rate of return can be calculated in the following two
ways:
ARR on Average
Investment
=
Average annual profit after tax
and depreciation
x 100
Average Investment
ARR on Initial
Investment
=
Average annual profit after tax
and depreciation
x 100
Initial Investment
14

Average annual profit after tax & depreciation and Average
investment are calculated as follows:
a) Average annual profit after tax & depreciation
= Total profit after tax and depreciation / no. of year
b) Average investment
= (Initial Investment + Scrap Value) / 2
OR
= [(Initial Investment + Scrap Value) / 2] + New Working Capital
c) Annual Depreciation
= Initial Investment – Scrap/ Life of Project
15

Example 5:
The machine cost Rs. 1,00,000 and has scrap value of Rs. 10,000 after 5 years. The net
profits before depreciation and taxes for the five years period are to be projected that Rs.
20,000, Rs. 24,000, Rs. 30,000, Rs. 26,000 and Rs. 22,000. Taxes are 50%. Calculate
accounting rate of return
Solution: Calculation of Cash In Flow
Average profit after depreciation & tax = (1,000+3,000+6,000+4,000+2,000) / 5
= Rs. 3,200
Average Investment = (1,00,000 + 10,000) / 2 = Rs. 55,000
ARR on Average Investment = (3,200 / 55,000) x 100 = 5.82%
ARR on Initial Investment = (3,200 / 1,00,000) x 100 = 3.2%
Particular Amount
1Y 2Y 3Y 4Y 5Y
Profit before depreciation & tax
Less: Depreciation (1,00,000-10,000) / 5
20,000
18,000
24,000
18,000
30,000
18,000
26,000
18,000
22,000
18,000
Profit after Depreciation
Less: Tax @ 50%
2,000
1,000
6,000
3,000
12,000
6,000
8,000
4,000
4,000
2,000
Profit after depreciation & tax 1,000 3,000 6,000 4,000 2,000
16

Merits:
 It is easy to calculate and simple to understand.
 It is based on the accounting information rather than cash
inflow.
 It is not based on the time value of money.
 It considers the total benefits associated with the project..
Demerits
 It ignores the time value of money.
 It ignores the reinvestment potential of a project.
 Different methods are used for accounting profit. So, it leads to
some difficulties in the calculation of the project.
17

Net present value method is one of the modern methods for
evaluating the project proposals. In this method cash inflows are
considered with the time value of the money. Net present value is
the difference between the total present value of future cash inflows
and the total present value of future cash outflows.
If the present value of cash inflows is more than the present value
of cash outflows, it would be accepted. If not, it would be rejected.
Net Present value = Present value of cash in flow – Present
value of cash outflow
Present value of cash in flow = Σ(Annual cash inflow x Present
value of Rs. 1 for ‘n’ year)
18

Present value of cash outflow = Σ(Cash outflow x Present value of Rs.
1 for ‘n’ year)
Present value of Rs. 1 for ‘n’ year = 1 / (1+r)n
where: r = Cost of the Capital (or) Discounting rate
n = No of year
For example if Cost of the Capital (or) Discounting rate is 10% then
present value of Rs. 1 for;
1st year = 1 / (1+0.10)1 = 0.909;
2nd year = 1 / (1+0.10)2 = 0.826 and
3rd year = 1 / (1+0.10)3 = 0.751
If cash inflows for 3 years are Rs. 5,000, Rs. 8,000 and Rs. 10,000, then
the present value of cash inflow will be:
=Σ(Annual cash inflow x Present value of Rs. 1 for ‘n’ year)
= Σ[(5,000 x 0.909) + (8,000 x 0.826) + (10,000 x 0.751)]
=Σ(4,545 + 6,608 + 7,510) = Rs. 18,663
19

Example 6:
From the following information, calculate the net present value of the two project and
suggest which of the two projects should be accepted, a discount rate of the two project is
10%. Other details are as follows:
The profits before depreciation and after taxation (cash flows) are as follows:
The following are the present value factors @ 10% p.a.:
Initial Investment Estimated Life Scrap Value
Project X Rs. 20,000 5 years Rs. 1,000
Project Y Rs. 30,000 5 years Rs. 2,000
Year 1 (Rs.) Year 2 (Rs.) Year 3 (Rs.) Year 4 (Rs.) Year 5(Rs.)
Project X
Project Y
5,000
20,000
10,000
10,000
10,000
5,000
3,000
3,000
2,000
2,000
Year 1 2 3 4 5
Factors 0.909 0.826 0.751 0.683 0.621
20

Solution:
Project Y should be selected as net present value of project Y is higher.
Year
Cash Inflow Present value of
Rs. 1 @ 10%
PV of CIF
Project X Project Y Project X Project Y
1
2
3
4
5
Scrap Value
5,000
10,000
10,000
3,000
2,000
1,000
20,000
10,000
5,000
3,000
2,000
2,000
0.909
0.826
0.751
0.683
0.621
0.621
4,545
8,260
7,510
2,049
1,242
621
18,180
8,260
3,755
2,049
1,242
1,242
Present value of cash inflow
Less: Present value of cash outflow
24,227
20,000
34,728
30,000
Net Present Value 4,227 4,728
21

Merits:
 It recognizes the time value of money.
 It considers the total benefits arising out of the proposal.
 It is the best method for the selection of mutually exclusive
projects.
 It helps to achieve the maximization of shareholders’ wealth.
Demerits
 It is difficult to understand and calculate.
 It needs the discount factors for calculation of present values.
 It is not suitable for the projects having different effective lives.
22

The Internal Rate of Return for an investment proposal is that discount
rate which equates the present value of cash inflows with the present
value of cash out flows of an investment. In other words it is a rate at
which discount cash flows to zero.
Step 1: Find out present value factor as follows:
= Cash Outlay or Initial Investment / Average Cash Inflow
Step 2: Find out net present value on higher and lower discount rates
Find out discount rate with the help of PV factor and calculate
net present value, if net present value is positive (negative) then
calculate negative (positive) present value with the help of higher
(lower) discounting rate.
23

Step 3: Calculate Internal Rate of Return:
Where:
IRR = Internal Rate of Return; LDR = Lower Discounting Rate;
HDR = Higher Discounting Rate; P1= present value on lower discount
rate; P2= present value on higher discount rate; Q= Net cash outflow
If the internal rate of return is greater than the normal rate of discount,
then the proposed project is accepted, otherwise it would be rejected.
IRR = LDR +
P1-Q
x (HDR – LDR)
P1-P2
24

Example 6:
A company has to select one of the following two projects:
Using the Internal Rate of Return method suggest which is Preferable.
The following are the cumulative and annually present value factors:
Cost (Rs.)
Cash Inflow
Year 1 (Rs.) Year 2 (Rs.) Year 3 (Rs.) Year 4 (Rs.)
Project X
Project Y
22,000
20,000
12,000
2,000
4,000
2,000
2,000
4,000
10,000
20,000
Year
Cumulative present value of Rs. 1 per
annum, Receivable or Payable at the
end of each year for n years
Present value of Rs. 1 receivable or
payable for ‘n’ year payment or
receipt.
10% 12% 15% 10% 12% 15%
1
2
3
4
0.909
1.736
2.487
3.170
0.893
1.690
2.402
3.037
0.870
1.626
2.283
2.855
0.909
0.826
0.751
0.683
0.893
0.797
0.712
0.636
0.870
0.756
0.658
0.572
25

Solution:
Present value factor for project X = Initial Investment / Average Cash Inflow
= 22,000 / (28,000 /4) = 22,000 / 7,000 = 3.143
The estimated discounting rate of project A will be 10% , as in Cumulative present value
table, the value at 10% in 4th year (3.170) is nearest to PV factor value (3.143).
Calculation of negative and positive Net Present value of Project X:
Calculate Internal Rate of Return of Project X:
= 10 + (22544-22000/22544-21688) x (12 -10)
= 10 + 1.27 =11.27%
Year
Cash Inflow Present value of Rs. 1 PV of CIF
Project X @ 10% @ 12% @ 10% @ 12%
1
2
3
4
12,000
4,000
2,000
10,000
0.909
0.826
0.751
0.683
0.893
0.797
0.712
0.636
10,908
3,304
1,502
6,830
10,716
3,188
1,424
6,360
22,544
22,000
21,688
22,000
Net Present Value 544 -312
IRR = LDR +
P1-Q
x (HDR – LDR)
P1-P2
26

Present value factor for project Y = Initial Investment / Average Cash Inflow
= 20,000 / (28,000 /4) = 20,000 / 7,000 = 2.857
The estimated discounting rate of project A will be 15% , as in Cumulative present value
Calculation of negative and positive Net Present value of Project Y:
Calculate Internal Rate of Return of Project Y:
IRR = 10 + {20,134-20,000/20,134-17324} x (15 -10)
= 10 + 0.24 =10.24%
Thus, internal rate of return in project X (11.27%) is higher as compared to project Y
10.24%. Therefore project X is preferable.
Year
Cash Inflow Present value of Rs. 1 PV of CIF
Project Y @ 15% @ 10% @ 15% @ 10%
1
2
3
4
2,000
2,000
4,000
20,000
0.870
0.756
0.658
0.572
0.909
0.826
0.751
0.683
1,740
1,512
2,632
11,440
1,818
1,652
3,004
13,660
17,324
20,000
20,134
20,000
Net Present Value -2,676 134
27

Merits:
 It consider the time value of money.
 It takes into account the total cash inflow and outflow.
 It does not use the concept of the required rate of return.
 It gives the approximate/nearest rate of return.
Demerits
 It involves complicated computational method.
 It produces multiple rates which may be confusing for taking
decisions.
 It is assume that all intermediate cash flows are reinvested at the
internal rate of return.
28

Profitability index is the time adjusted method of evaluating the
investment proposal. This method is also called Benefit Cost Ratio.
It is the ratio of present value of cash inflow at the required rate of
return to the initial cash outflow of the investment.
Accept /Reject criteria:
If the PI is more than 1 (PI>1), the project would be accepted. If
the PI is less than 1 (PI<1), it would be rejected.
Profitability
Index
=
Present value of cash outflow
29

Merits:
 It tells about an investment increasing or decreasing the firm
value.
 It takes into consideration all cash flows of the project
 It takes time value of money into consideration.
 It is also helpful in ranking and picking project while rationing
of capital.
Demerits
 It is not easy to determine an appropriate discount rate.
 The profitability index of a firm might not sometimes, provide
the correct decision while being used to compare mutually
excusive project under consideration.
30

Example 7:
SP Limited company is having a project, requiring a capital outflow of Rs. 3,00,000. The
expected annual income after depreciation but before tax is as follows:
Depreciation may be taken as 20% of original cost and taxation at 50% of net income.
You are required to calculated: (a) Pay-back period; (b) According rate of return; (c) Net
present value at 10% discounting rate; (d) Internal rate of return and (e) Profitability
index.
The following are the cumulative and annually present value factors:
Year 1 2 3 4 5
Amount 9,000 80,000 70,000 60,000 50,000
Year
Cumulative present value of Rs. 1 per
annum, Receivable or Payable at the
end of each year for n years
Present value of Rs. 1 receivable or
payable for ‘n’ year payment or
receipt.
10% 12% 15% 10% 12% 15%
1
2
3
4
5
0.909
1.736
2.487
3.170
3.791
0.893
1.690
2.402
3.037
3.605
0.870
1.626
2.283
2.855
3.352
0.909
0.826
0.751
0.683
0.621
0.893
0.797
0.712
0.636
0.567
0.870
0.756
0.658
0.572
0.497
31

Solution: Calculation of Annual Cash-in-Flow
Particular
Amount (Rs.)
1st Year 2nd Year 3rd Year 4th Year 5th Year
Profit before Tax
Less: Tax @ 50%
9,000
4,500
80,000
40,000
70,000
35,000
60,000
30,000
50,000
25,000
Add: Depreciation (@ 20% of 3,00,000)
4,500
60,000
40,000
60,000
35,000
60,000
30,000
60,000
25,000
60,000
Cash Inflow 64,500 1,00,000 95,000 90,000 85,000
Cumulative Cash Inflow 64,500 1,64,500 2,59,500 3,49,500 4,34,500
(a) Pay Back Period = Year in which cumulative cash in flow is less than amount of
investment + (Investment Amount – Cumulative Cash in Flow of
the year) / Cash inflows of next year
= 3 + (3,00,000 – 2,59,500) / 90,000
= 3.45 years
32

(b) According rate of return = (Average profit after tax and depreciation / Average
Investment) x 100
= (26,900 / 1,50,000) x 100
= 17.93%
Average profit after tax & depreciation = (4,500+40,000+35,000+30,000+25,000) / 5
= Rs. 26,900
Average Investment = 3,00,000 / 2 = Rs. 1,50,000
(c) Net present value
Year Cash Inflow
Present value
of Rs. 1 @ 10%
PV of CIF
Present value of
Rs. 1 @ 15%
PV of CIF
1
2
3
4
5
64,500
1,00,000
95,000
90,000
85,000
0.909
0.826
0.751
0.683
0.621
58,631
82,600
71,345
61,470
52,785
0.870
0.756
0.658
0.572
0.497
56,115
75,600
62,510
51,480
42,245
3,26,831
3,00,000
2,87,950
3,00,000
Net Present Value 26,831 -12,050
33

(d) Internal Rate of Return
Calculate of PV factor = 3,00,000 / 86,900 = 3.452
The estimated discounting rate of project will be 15% , as in Cumulative present value
Calculate Internal Rate of Return:
= 10 + {26,831 / [26,831 – (-12,050]} x (15 -10)
= 10 + 3.45 =13.45%
(e) Profitability Index = Present value of Cash Inflow / Present value of Cash Outflow
= 3,26,831 / 3,00,000
= 1.089
IRR = LDR +
P1-Q
x (HDR – LDR)
P1-P2
34

CAPITAL BUDGETING

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