The document discusses capital budgeting, which refers to the process companies use to evaluate major investments. It defines capital budgeting as evaluating purchases of fixed assets using current funds. The capital budgeting process involves generating projects, evaluating them, selecting projects, and follow up. Methods to evaluate projects include payback period, accounting rate of return, net present value, and profitability index. These methods use calculations involving initial investments, expected cash flows, discount rates, and time value of money to determine which projects will be most profitable.

1. Presented by
Ateeq ur rehman
Roll No 26
Capital Budgeting

2. Introduction
The process of capital budgeting is vital to any
responsible, well managed business. If that business is
public and owned by public shareholders, the
budgeting process becomes more crucial, since
shareholders can hold management accountable for
accepting unprofitable projects that can have the effect
of destroying shareholder value.

3. Definition of capital budgeting
"The decision making process by which a firm
evaluates the purchase of major fixed assets. It
involves firm's decision to invest its current funds for
addition, disposition, modification and replacement of
fixed assets”.

4. Importance of capital budgeting
 The success and failure of business mainly depends on
how the available resources are being utilized.
 Main tool of financial management
 Capital budgeting offers effective control on cost of
capital expenditure projects.
 It helps the management to avoid over investment and
under investment

5. Capital budgeting Process
1. Project generation
2. Project Evaluation
3. Project Selection
4. Project Evaluation
5. The follow up

6. Factors influencing Capital Budgeting
1. Business Risk
2. Company's Tax Exposure
3. Financial Flexibility
4. Management Style
5. Growth Rate
6. Market Conditions

7. Methods of Capital Budgeting
Traditional methods
Payback period
Accounting rate of return method
Discounted cash flow methods
Net present value method
Profitability index method

8. Traditional Method
Payback Period
In case they are even, the formula to calculate
payback period is:
Payback Period =
Initial Investment
Cash Inflow per Period

9. Traditional Method
Example 1: Even Cash Flows
Company C is planning to undertake a project
requiring initial investment of $105 million. The
project is expected to generate $25 million per year for
7 years. Calculate the payback period of the project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow
= $105M ÷ $25M = 4.2 years

10. Traditional Method
When cash inflows are uneven, we use the following
formula for payback period:
Payback Period = A + (B/C)
In the above formula,
A is the last period with a negative cumulative cash
flow;
B is the absolute value of cumulative cash flow at the
end of the period A;
C is the total cash flow during the period after A

11. Traditional Method
Company C is planning to undertake another project
requiring initial investment of $50 million and is
expected to generate $10 million in Year 1, $13 million
in Year 2, $16 million in year 3, $19 million in Year 4
and $22 million in Year 5. Calculate the payback value
of the project. (cash flows in millions) Cumulative
Solution:
Payback Period
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years
years Cash
flow
Cash
flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30

12. Traditional Method
Accounting rate of return method
This method of ARR is not commonly accepted in
assessing the profitability of capital expenditure
Formula
Accounting Rate of Return is calculated using the
following formula:
ARR = Average Accounting Profit/Average Investment

13. Traditional Method
Example 1: An initial investment of $130,000 is expected to
generate annual cash inflow of $32,000 for 6 years.
Depreciation is allowed on the straight line basis. It is
estimated that the project will generate scrap value of
$10,500 at end of the 6th year. Calculate its accounting rate
of return assuming that there are no other expenses on the
project.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷
Useful Life in Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
Average Accounting Income = $32,000 − $19,917 =
$12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%

14. Discounted cash flow Method
Net present value method
It recognizes the impact of time value of money
Formula:
NPV = R × 1 − (1 + i)-n − Initial Investment
i
In the above formula,
R is the net cash inflow expected to be received in
each period;
i is the required rate of return per period;
n are the number of periods during which the project is
expected to operate and generate cash inflows.

15. Discounted cash flow Method
Calculate the net present value of a project which requires an initial
investment of $243,000 and it is expected to generate a cash inflow of
$50,000 each month for 12 months. Assume that the salvage value of
the project is zero. The target rate of return is 12% per annum.
Solution
We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%
Net Present Value
= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754

16. Discounted cash flow Method
Profitability Index (PI)
Profitability Index = Present Value of Future Cash Flows
Initial Investment Required
Note: PI should always be expressed as a positive
number.
If PI ≥ 1, then accept the real investment project;
otherwise, reject it.

17. Discounted cash flow Method
Example
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