3. Capital Budgeting
Capital budgeting is the planning
process used to determine whether an
organization's long
term investments such as new
machinery, replacement of machinery,
new plants, new products, and
research development projects are
worth the funding of cash through the
firm's capitalization structure (debt,
equity or retained earnings).
It is the process of allocating resources
for major capital, or investment,
expenditures.
One of the primary goals of capital
budgeting investments is to increase
the value of the firm to the
shareholders.
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4. Capital Budgeting - Examples
Building a
new plant
Buying a
new
machinery
/ set up
Introducing
a new
product
Establishing
a new
business
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5. Capital Budgeting - Examples
The decision
to buy new
machinery
Expansion of
business in
other
geographical
areas
Replacement
of an
obsolete
equipment
New product
or market
development
/ expansion
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6. Techniques of Capital Budgeting
Normal
Payback
period
Discounted
Payback
period
Accounting
rate of
return
Average
accounting
return
Net present
value
Profitability
index
Internal
rate of
return
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7. Normal Payback period
• Payback period in capital budgeting refers to the time required to recover
the funds invested in an investment, or to reach the break-even point.
• For example, Rs.100,000 were invested in project at the start of year 1
which returned 25000 at the end of year 1 and year 2 , 3 and 4
respectively would have a 4 year payback period.
• Formula: Payback Period = Initial Investment / Net Annual Cash inflows
Payback Period = 100,000 / 25000 = 4 Years
• Payback period is expressed in years.
• This formula is used where annual cash inflow are expected to be same.
• Cumulative cash inflows are considered in this method.
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8. Investment Inflows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
10,00,000 300000 300000 300000 300000 300000
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Normal Payback period
Example
Payback Period = Nearby years for the payback + Unrecovered amount at the end of
Nearby years / Subsequent year’s cash inflow
Year Cash Inflow Cumulative cash
inflow
1 300000 300000
2 300000 600000
3 300000 900000
4 300000 1200000
5 300000 1500000
Payback Period = 3 + 100000/300000
= 3.33 Years
or = 3 years 4 Months
This method can also be used for
uneven cash inflows.
9. Investment Inflows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
10,00,000 300000 200000 250000 350000 300000
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Normal Payback period
Example
Payback Period = Nearby years for the payback + Unrecovered amount at the end of
Nearby years / Subsequent year’s cash inflow
Year Cash Inflow Cumulative cash
inflow
1 300000 300000
2 200000 500000
3 250000 750000
4 350000 1100000
5 300000 1400000
Payback Period = 3 + 250000/350000
= 3.71 Years
or = 3 years 8.5 Months
This method can also be used for
uneven cash inflows.
10. • In this method Discounted Cash Inflows are considered.
• The cash inflows are adjusted for the time value of money.
• The time value of money assumes that a Rupee today is
worth more than a two tomorrow because it can be
invested.
10
Discounted Payback period
11. Discounted Payback Period
Discounted Cash Inflow =
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+ +
CF=The cash flow for the given year.
CF1 is for year one,
CF2 is for year two,
CFn is for additional years
r =The discount rate
12. Investment Inflows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
10,00,000 300000 300000 300000 300000 300000
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Discounted Payback period
Example
Payback Period = Nearby years for the payback + Unrecovered amount at the end of
Nearby years / Subsequent year’s cash inflow
Year Cash
Inflow
DF @
10%
DCF @
10%
Cumulat
ive Cash
Inflows
1 300000 0.909 272700 272700
2 300000 0.826 247800 520500
3 300000 0.751 225300 745800
4 300000 0.683 204900 950700
5 300000 0.621 186300 1137000
Payback Period = 4 + 49300/186300
= 3.26 Years
or = 3 years 3 Months
This method can also be used for
uneven cash inflows.
13. Accounting rate of return
Accounting rate of return, also known as the Average
rate of return or ARR is a financial ratio used in capital
budgeting.
The ratio does not take into account the concept of time
value of money.
ARR calculates the return, generated from net income of
the proposed capital investment. The ARR is a
percentage return
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14. Accounting rate of return
ARR = Average Net Income After Taxes/Average
Investment x 100
Where, Average Income After Taxes = Net Cash inflows
/ Income After Taxes/Total Number of Years of useful
life of the project &
Average Investment = Book Value of the Investment at
the beginning + Book Value of the Investment at the
end /2
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15. ARR = Average Net Income After Taxes/Average
Investment x 100
15
Investment Inflows
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
10,00,000 300000 300000 300000 300000 300000
Accounting rate of return
