budgeting: meaning, significance, process, project classification, and investment criteria: payback method, ARR method, net present value, IRR method, profitability

1. CAPITAL BUDGETING
Dr.Bharath V

2. CAPITAL BUDGETING DECISION
• The term capital refers to long-term assets used in
production, while a budget is a plan that details projected
inflows and outflows during some future period.
• Thus, the capital budget is an outline of planned
investments in fixed assets, and capital budgeting is the
whole process of analyzing projects and deciding which
ones to be included in the capital budget.
• Capital Budgeting is the process of identification,
evaluation, selection and implementation of capital
projects with the objective of wealth maximization.
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4. Importance of Capital Budgeting
• Long-term impact – growth of the firm
• Define the strategic direction of growth
• Irreversible decision
• Helps in budgetary control and performance evaluation
• Facilitates technological advancement and innovation
• Mobilization of capital and other resources on a large
scale
• Success of the firm depends upon efficient system of
Capital Budgeting
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5. Capital Projects
• A project involving investments to produce a new product,
increase output of existing products, replacement of
existing plant etc.,
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7. MEASUREMENT OF NCFs
• Evaluating capital budgeting decisions generally requires
two types of information-
• Estimates of relevant cash flows and the appropriate
discount rate(s).
• Cash flows refers to cash revenues minus cash
expenses.
• Cash flow method of ascertaining future economic
benefits consider time value of money.
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8. Cash flows vs Accounting flows
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Cash Flows Accounting Flows
Managerial Concept
(used in decision making process)
Accounting Concept
(used for external reporting)
Free from Accounting
conventions/Postulates
Subjected to accounting
conventions/postulates
Not affected by non-cash expenses
like Depreciation
Affected by Depreciation and other
sunk costs
It implies Net cash flow (after Tax) It may be Net Income before tax or
after tax
Interest not included in estimating Net
cash flow of a project
Interest is generally included in Net
income estimation
Net cash flow are generally estimated
on annual basis
Not necessarily on annual basis

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10. Initial Cash Flows (to)
Rs.
• Cost of property/Plant and Equipment XXX
• (+) Installation expense XXX
• (+) Initial working capital XXX
• (-) After-tax proceeds of sale of assets , XXX
cash subsidy, etc
Initial cash flow. XXX
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11. Operating Cash Flows (t1 to tn)
• Operating cash revenue XXX
• Less: operating cash expenses XXX
•
• Profit before depreciation and taxes XXX
• Less: Depreciation XXX
•
• Profits before taxes XXX
• Less: Taxes XXX
•
• Net Profits XXX
• Add: Depreciation XXX
• Net cash flows (NCF) XXX
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12. Terminal Cash Flows (tn)
• If any
• Add: Recover of working capital XXX
• Scrap value XXX
• Total terminal flows XXX
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13. Problem on NCFs
• ABC ltd is evaluating the purchase of a new project with a
cost of Rs.1,00,000, expected economic life of 4 years
and change in EBT and Depreciation of Rs.45,000 in year
1, Rs.35,000 in year 2,Rs.25,000 in year 3 and Rs.
35,000 in year 4.
• Assume straight-line depreciation and a 20% tax rate. You
are required to compute relevant cash flow.
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14. Problem -1
• You have been asked by the President of Nagarjuna Construction
Company, headquartered in Hyderabad, to evaluate the proposed
acquisition of a new earthmover.
• The mover’s basic price is Rs.15 lakh and it will cost another
Rs.80,000 to modify it for special use by Nagarjuna Construction. It
will be sold after 3 years for Rs.2 lakh, and it will require an increase
in net operating working capital (spare parts inventory) of
Rs.40,000.
• The earthmover purchase will have no effect on revenues, but it is
expected to save Nagarjuna Rs.6 lakh per year in before-tax
operating costs, mainly labor. Nagarjuna’s marginal tax rate is 40
percent.
• What is the company’s net investment if it acquires the earthmover? (That is,
what are the Year 0 cash flows)
• What are the operating cash flows in Years 1,2 and 3?
• What is the terminal cash flows?
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15. CB Techniques
Traditional
Payback
Period (PBP)
Average Rate
of Return
(ARR)
Modern
Net Present
Value (NPV)
Internal Rate
of Return
(IRR)
Profitability
Index (PI)

16. Payback Period
• The Payback Period (PBP) is the time required to
recover the initial investment in a project from its cash
inflows.
• It is a simple capital budgeting technique used to assess
the liquidity risk of an investment.
• Decision Rule
• Accept the project: if the payback period is less than or
equal to the company's target or cutoff period.
• Reject the project : if the payback period is longer than
the company's target period.
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17. Formula
• When Cash Flows Are Even
• When Cash Flows Are Uneven
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18. Exercise: 1
A project requires an initial investment of Rs. 1,00,000 with a useful life of 5 years. The projected
cash inflows after tax (CFAT) for 4 years ₹40,000 Calculate Pay Back Period. (Ans: 2.5 years)
Exercise: 2
A project cost ₹ 40,00,000 and yields annually a profit of ₹6,00,000 after depreciation at 12.5% but
before tax at 50%. Calculate Payback period. (Ans: 5 years)
Exercise: 3
SSN Ltd is considering two alternative machines, first machine costs ₹ 25,00,000 and estimated cash
flow from it amounts to ₹5,00,000. The second machine costs ₹20,00,000 and estimated cash flow
from it amounts to ₹6,00,000. Both the machines economic life is 6 years. Suggest the management
with the best alternative by using payback period. (Ans: 5 years and 3.3 years- Machine 2 is
preferrable)
Exercise: 4
Compute payback period from the given information; Original Investment on project is ₹8,25,000,
Expected annual cash inflow after tax from project is ₹80,000 and annual depreciation ₹40,000.
(Ans: 6.6 years)

19. Advantages & Disadvantages of PBP
• Advantages
• Simple & Easy to Use – Quick to compute and understand.
• Focuses on Liquidity – Useful for businesses that need quick
returns
• Risk Indicator – Shorter payback means lower risk.
• Disadvantages
• Ignores Time Value of Money (TVM) – It doesn’t consider the
declining value of money over time.
• Ignores Cash Flows After Payback – It doesn’t measure profitability.
• No Discounting of Cash Flows – Can be misleading for long-term
investments.
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20. Average Rate of Return (ARR)
• The Accounting Rate of Return (ARR) is a capital
budgeting technique used to evaluate the profitability of an
investment based on its expected accounting profit rather
than cash flow.
• It measures the return on investment by comparing the
average annual accounting profit to the initial or average
investment cost.
• Decision Rule
• If ARR ≥ Required Rate of Return (cut-off rate) → Accept
the project
• If ARR < Required Rate of Return → Reject the project
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21. Formula of ARR
𝑨𝑹𝑹 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠
x 100
𝐴𝑣𝑔 𝐴𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 =
𝑇𝑜𝑡𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 𝑎𝑛𝑑 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
𝐴𝑣𝑔 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 =
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
2
In case Scrap and WC are considered
𝐴𝑣𝑔 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 =
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡−𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
2
+ 𝑊𝐶 + 𝑆𝑐𝑟𝑎𝑝 𝑣𝑎𝑙𝑢𝑒
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22. • 1. A project requires an investment of Rs. 10,00,000. The
plant & machinery required under the project will have a
scrap value of Rs. 80,000 at the end of its useful life of 5
years. The profits after tax and depreciation are estimated to
be as follows
• 2. A Project costs Rs. 10,00,000 has a 5 years life and no
scrap. It is depreciated on straight line basis. The expected
net earnings after depreciation and taxes are as follows
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Year 1 2 3 4 5
PAT ₹ 50,000 ₹ 75,000 ₹ 1,25,000 ₹ 1,30,000 ₹ 80,000
Year 1 2 3 4 5
Profit After
Tax and
Depreciation
₹ 1,00,000 ₹ 1,50,000 ₹ 2,00,000 ₹ 1,80,000 ₹ 1,70,000

23. • 3. Compute ARR from the following data
• 4. Compute the Average rate of return (Accounting Rate of
Return) from the following data of two Projects X and Y.
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Year 0 1 2 3
Investment ₹ 90,000
Sales ₹ 1,20,000 ₹ 1,00,000 ₹ 8,00,000
Less: Depreciation ₹ 30,000 ₹ 30,000 ₹ 30,000
Less: Operating
Expenses ₹ 60,000 ₹ 50,000 ₹ 40,000
Annual Income ₹ 30,000 ₹ 20,000 ₹ 10,000
Particulars Project X Project Y
Cost of Projects ₹ 40,000 ₹ 60,000
Scrap Value ₹ 3,000 ₹ 3,000
Annual Incomes after Tax:
Year 1 ₹ 3,000 ₹ 10,000
Year 2 ₹ 4,000 ₹ 8,000
Year 3 ₹ 7,000 ₹ 2,000
Year 4 ₹ 6,000 ₹ 6,000
Year 5 ₹ 8,000 ₹ 5,000

24. • A company is planning to purchase a machine for
₹10,00,000. The life of the machine is 5 years with a
scrap value of ₹2,00,000. The expected annual sales are
₹6,00,000, and the annual operating expenses (excluding
depreciation) are ₹3,00,000. The company needs
₹1,00,000 working capital, which will be recovered at the
end of the project.
Calculate:
Accounting Rate of Return (ARR) on Average Investment
Decision if the cut-off rate is 18%
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25. Advantages
• Simple and easy to understand
• Based on accounting profit, which is easily available from
financial records
• Focuses on profitability rather than cash flow
• Helps in comparing profitability of different projects
Disadvantages
• Ignores the time value of money
• Based on accounting profit, not cash flows
• Does not consider project lifespan
• Risk of manipulation in accounting profits
• Does not consider capital recovery
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26. Net Present Value (NPV)
• The Net Present Value (NPV) method is one of the most
important techniques in capital budgeting. It is used to
evaluate the profitability of an investment by comparing
the present value of cash inflows with the present value of
cash outflows.
• NPV measures the profitability of a project in today's
value by discounting all future cash flows at a required
rate of return (also called Discount Rate or Cost of
Capital).
•
It shows whether the project will generate profit or loss
over its lifetime.
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27. Formula
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𝑁𝑃𝑉 = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

28. Decision Rule
•If NPV<0 ----Reject the project
•If NPV>0 -----Accept the project
•If NPV=0 -----The investment is marginal.
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30. Advantages
• Accurate method because it considers:
• Time Value of Money
• Total Cash Inflows and Outflows
• Risk through Discount Rate
• Profitability of the project
• Best method for long-term projects
• Helps in comparing multiple projects
Disadvantages
• Difficult to calculate without a calculator or Excel
• Needs accurate estimation of Discount Rate
• Not suitable if cash flows are uncertain
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