1) Capital budgeting is the firm's decision to invest current funds in long-term assets that are expected to generate benefits over several years. 2) There are various techniques used to evaluate capital budgeting projects, including non-discounted methods like payback period and accounting rate of return, as well as discounted cash flow methods like net present value, internal rate of return, and profitability index. 3) Each method has advantages and disadvantages, such as whether it considers the time value of money, future cash flows, or maximizing shareholder wealth. The appropriate technique depends on the specifics of the project being evaluated.

1. Chapter 8
TECHNIQUES OF
CAPITAL BUDGETING

2. Meaning of Capital Budgeting
• The firm’s decision to invest its current funds most efficiently
in the long term assets in anticipation of an expected flow of
benefits over a series of years

3. Importance of Capital Budgeting
• Growth
• More risky
• Huge investments
• Irreversibility
• Effect on other projects
• Difficult decision

4. Difficulties in Capital Budgeting
• Measurement problem
• Uncertainty
• Temporal spread

5. Classification of Projects
• New projects
• Expansion projects
• Diversification projects
• Replacement and Modernisation projects
• Research and Development (R&D) project
• Interior Decoration
• Recreation facilities
• Landscaped gardens

6. Kinds of Capital Budgeting decisions
• Mutually Exclusive Investments
• Capital Rationing decisions
• Contingent investments

7. Process of Capital Budgeting
1. Idea generation
2. Evaluation or Analysis
3. Selection
4. Financing
5. Execution or Implementation
6. Review

8. Techniques of Investment Evaluation
Project Evaluation Techniques
Traditional
Or
Non-discounted Cash Flow
Modern
Or
Discounted Cash Flow
Pay Back
Period
Accounting Rate
Of Return
Net Present
Value
Internal Rate
Of Return
Profitability
Index

9. Calculation of CFAT
Particular Amount (Rs.)
Sales Revenue
Less: Variable Cost
Contribution
Less: Fixed Cost
Earning Before Depreciation and Taxes (EBDT)
Less: Depreciation
Earning Before Taxes (EBT)
Less: Taxes
Earning After Tax (EAT)
Add: Depreciation
Cash Flows After Tax (CFAT)
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
xxx
Proforma of Cash Inflows After Taxes (CFAT)

10. Pay Back Period [PBP]
• Pay Back Period: The period required to recover the original
cash out flow or investment
PBP (when cash flows are even) = --------------------------
CFAT
PBP (when cash flows are uneven): Cumulative CFs Method
Decision Rule : Accept = when calculated PBP < Std.PBP
Reject = when calculated PBP > Std.PBP
Original Investment

11. Evaluation of PBP
Advantages:
• Easy to understand
• Cost involvement in calculating PBP is less
Disadvantages:
• Ignores CFs after PBP
• Not suitable for measuring profitability
• Do not consider Time Value of Money
• No base for deciding standard PBP
• Not suitable to maximise wealth

12. ARR
• Decision Rate:Accept = Calculated ARR > Std.ARR
Reject = Calculated ARR < Std.ARR
Average Annual EAT or PAT
Accounting Rate of Return (ARR) = ------------------------------------- ×100
Original Investment (OI)*
* OI = Original investment + additional NWC + Installation Charges + Transportation Charge
(ii) whenever it is clearly mentioned as Average Rate of Return
If Average rate of return is given in the problem, return on average investment
method should be used to calculate average rate of return.
Average Annual EAT
Average Rate of Return = -------------------------------- ×100
Average Investment (AI)*
* AI = (Original investment – Scrap Value)1/2 + Additional NWC + Scrap Value

13. Evaluation of ARR
Advantages:
• Consider all profits of the project
• Information can easily be drawn from accounts department
Disadvantages:
• Consider accounting profits
• Ignores time value of money
• Does not allow profits to invest
• Does not differential between size of investment required
for each project
• Not suitable to maximum owners wealth

14. Net Present Value (NPV)
• Net Present Value: Present value of benefits minus preset
value of costs
Steps involved in computation of NPV
1. Forecasting of cash inflows of the investment project based on realistic
assumptions,
2. Computation of cost of capital, which is used as discounting factor for
conversion of future cash inflows into present values,
3. Calculation of PV cash flows using cost of capital as discounting rate,
4. Finding out NPV by subtracting PV of cash out flows from PV of cash
inflows.
Decision Rule
Accept: NPV> Zero Reject: NPV< Zero

15. Evaluation of NPV
Advantages:
• Consider time value of money
• Consider cash flows through project life
• Suitable for mutually exclusive proposals
• Help to maximum shareholders wealth
Disadvantages:
• NPV calculation involves lengthy time
• Not suitable for projects with different cash outflows
• May not give suitable suggestion-projects with unequal life
periods

16. Internal Rate of Return (IRR)
• Internal Rate of Return (IRR): The discount rate at which
PV of cash inflows equals to PV of cash out flows
PVLDF - COF
IRR = LDF % + ΔDF ----------------------
PVLDF - PVHDF
Where LDF = Lower discount factor
ΔDF = Difference between low discounting factor and High discounting factor
PVLDF = PV of cash inflows at low discounting factor
PVHDF = PV of cash inflows at high discounting factor
COF = Cash outflow
Decision Role:
Accept = Ko < IRR
Reject = Ko > IRR
IRR Computed by Trial and error approach
If not getting them interpolation formula use

17. Evaluation of IRR
Advantages:
• Consider time value of money
• Consider CFs through project life
• Gives more psychological satisfaction
• Helps to maximum shareholders wealth
Disadvantages:
• Assumption of profits are reinvested at IRR not logical
• Produces multiple rate of returns
• Not suitable for evaluation mutually exclusive projects
• May not give fruitful results when project life or cash
outflows are unequal

18. Profitability Index (PI or BCR)
• Profitability Index: The index that is desired by dividing PV of cash
inflows by PV of cash out flows
PI = PV of CIFs PV of COFs
Decision Rule:
Accept: PI>1
Reject: PI<1


19. Evaluation of PI
• It gives due consideration to time value of money,
• It considers all cash flows to determine PI,
• It will help to rank projects according to their PI,
• It recognized that the fact that bigger cash flows are better to
smaller ones and early cash flows are preferable to later ones,
• It can also be used to choose mutually exclusive projects by
calculating the incremental benefit cost ratio.
• It is consistent with the objectives maximization of
shareholders’ wealth.