The document discusses various concepts and methods related to capital budgeting, including calculating relevant cash inflows and outflows, depreciation under straight line and diminishing balance methods, and techniques for financial project appraisal such as payback period, accounting rate of return, net present value, and internal rate of return. Examples are provided to illustrate the calculation of each method. The goal is to help students understand the importance of capital budgeting in business and how different techniques can be used to evaluate investment projects.

1. Day – 1
Need for studying FM in MBA curriculum
Lessons from the History
Lessons from Warren Buffet
Re-visiting Unit - 1
Its all about purchasing power of money
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2. Day II – Introduction to Capital Budgeting
Introduction to Capital Budgeting
Importance, accounting
Difference between profit and cash flow
Concept of relevant inflows / outflows
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3. Day II –Capital Budgeting, its sub-heads
What is Capital Budgeting
Some examples
Its importance
Accounting profit and cash flow
Concept of relevant cash in/outflows
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4. Day II – Capital Budgeting , details and
calculations of relevant in/outflows
Outflows: Investment minus all rebates and
concessions, allowance etc
Outflows: Expenses plus all indirect benefits
like tax savings because of depreciation etc
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5. Day III – Calculation of relevant outflows
Cost of machine 10,00,000, expenses on installation
1,00,000, rebate due to establishment of unit in industrially
notified backward area 20% and government support in
view of production of essential goods 10% of project cost.
Here actual outflow would be as under
Outflow: Cost plus installation 11,00,000
Minus: Rebate 2,20,000
Minus: Govt. support 1,10,000
Total: 3,30,000
Net outflow = 7,70,000 (11,00,000 – 3,30,000)
In the next slide, concept of inflows will be illustrated

6. Day III – Illustration of relevant inflows
Inflows means earnings that accrue to a firm. From these gross earning
we need to subtract all expenses, depreciation, taxes etc. The resultant
figures become our Net Profit not net inflow. (Refer to slide 2, bullet III,
audio II). For decision making purpose we need to find out relevant
inflow. This is being illustrated below
Assume that a firm purchased a machine for Rs. One million. Firm has
spent 50,000 Rs. on its installation. Machine has useful life of 5 years,
after which it can be sold for Rs. 1,50,000. The firm estimates that
produce of machine can fetch Rs 5,00,000 annually. Total expenses on
production would be 60%. Straight Line Method of charging Depreciation
is applicable on machine. Taxes are payable @ 25% on net income
Calculation of annual inflows has been illustrated in the next two slides
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7. Day III – Relevant inflows …….
One needs to workout the following
1. Calculation of yearly Depreciation
2. Calculation of EBIDT
3. Calculation of EAIDBT
4. Calculation of EAIDT
5. Calculation of net inflows
------------
Calculation of Depreciation: There are various methods. (see slide 9 for more).
One in this problem can be calculated as under
Dep: Cost + Installation – Salvage / Life of machine
Dep = 10,00,000+50,000-1,50,000/5
Dep = 1,80,000 per annum
Now look at next slide for calculation from 2 to 5
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8. Day III – Relevant inflows …….
Yrs Gross
Inflows
Op Exp Dep EADBT Taxes EAIDT Inflows
(2-3-4) (5-6)
1 5,00,000 3,00,000 1,80,000 20,000 5,000 15,000 1,95,000
2 5,00,000 3,00,000 1,80,000 20,000 5,000 15,000 1,95,000
3 5,00,000 3,00,000 1,80,000 20,000 5,000 15,000 1,95,000
4 5,00,000 3,00,000 1,80,000 20,000 5,000 15,000 1,95,000
5 5,00,000 3,00,000 1,80,000 20,000 5,000 15,000 1,95,000
Salvage 1,50,000
Total inflows 11,25,000

9. Day III, more on Depreciation
• One method has been illustrated in slide 7
• There are several others. One more method based on
which depreciation is charged as per company law is
called Diminishing Balance Method or Written Down
Value Method or Reducing Balance Method. Under
this method, depreciation for first year is calculated at
a given rate (one may be asked to calculate this
percentage) and this figure of depreciation is
subtracted from cost of machine. Resultant figure is
called Written Down Value. In second year Dep is
calculated on WDV and the process continues till the
last year. See illustration on the next slide

10. Day III – Illustration of Depreciation
based on WDV Method
Assumed cost of machine 10,00,000 rate of depreciation
50%, life 5 years, method WDV
Years Cost / Op Bal Dep WDV
31 Dec X1 10,00,000 5,00,000 5,00,000
31 Dec X2 5,00,000 2,50,000 2,50,000
31 Dec X3 2,50,000 1,25,000 1,25,000
31 Dec X4 1,25,000 62,500 62,500
31 Dec X5 62,500 62,500 0
**In last year, total WDV is considered as Depreciation

11. Illustration of Inflows when Dep is charged as per WDV Method
Yrs Gross
Inflows
Op Exp Dep EAIDBT Taxes EAIDT
Net
Inflows
Yrs Gross Op Exp Dep EAIDBT Taxes EAIDT
Net
Inflows
1 5,00,000 3,00,000 500000 -3,00,000 -75,000 -2,25,000 2,75,000
2 5,00,000 3,00,000 250000 -50,000 -12,500 -37,500 2,12,500
3 5,00,000 3,00,000 125000 75,000 18,750 56,250 1,81,250
4 5,00,000 3,00,000 62500 1,37,500 34,375 1,03,125 1,65,625
5 5,00,000 3,00,000 62500 1,37,500 34,375 1,03,125 1,65,625
5 Salvage 1,50,000
Total11,50,000

12. Observe Slide 11 carefully
Post your answers to the following questions to
my no., NOT in Group
1. Why do we charge taxes when income is
negative in first as well as in second year?
2. Why total inflows in slide no. 11 and slide 8
differ when there is no change in gross
income, operating expenses and tax rates
Your explanation should reach me within next
24 hours of from the time of posting audio
message
This completes our discussion for Day III

13. Day - IV
Techniques / methods of financial appraisal
• Traditional methods (Payback Period Method
and Accounting Rate of Return Method)
• Discounted Cash Flow Methods (NPV, IRR and
PI Methods)
• Introduction to assessment of risk in CB
decisions

14. Day – IV - Payback Period Method
With respect to each method, one should know:
Meaning: In what time frame (years) will the
project pay us back our investment
Calculations
Assume relevant out flow is 1,00,000, life 5 years and inflows in 5 years are
20K, 50K, 36K, 44K and 30K
How long wud it take? 2 years and 10 months. In 2 years we have received
70K, we need 30K more. In third year we are getting 36K, so we shall get
30 in 10 months. More illustration on next slide
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15. Illustration of Payback Period, one more
example
As of now look at second last row only
Years Cash flows ‘X’ “Y” “Z”
0 (5,00,000) (5,00,000) (5,00,000)
1 1,00,000 2,50,000 1,00,000
2 1,50,000 1,50,000 1,00,000
3 2,50,000 96,000 1,00,000
4 2,00,000 1,04,000 2,00,000
5 1,00,000 2,00,000 4,00,000
PBP 3 Years 3 Years and 14 days 4 Years
ARR 8,00,000/5=1.60K
1.6/5*100=32%
8,00,000/5=1.60K
1.6/5*100=32%
9,00,000/5=1.80K
1.8/5*100=36%
Which one will you recommend? Obviously project “X” because it has
the shortest PBP. Think of a few reasons for preference of “Y” over
“X” and write down in your note book before and test me on my no.
I will go ahead with mine after 5:00 pm today 15

16. Day V, PBP Method, Merits and Demerits
Merits
• Its easy to calculate
• It takes into consideration ‘Risk’ factor
• Its widely used in practice
Demerits
• It ignores Time Value of Money
• It ignores those inflows which accrue after PBP is over
• It ignores total inflows resulting from a project
From sources of your choice find out which method(s) of
Project Appraisals is/are widely used in the business world.
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17. Day V, ARR Method, Meaning, Calculation,
Merits and Demerits
Meaning: Average return means sum of returns
received over a time period divided by time
period. If life is five years, then whatever is
sum of inflow in 5 years, find out its average
Calculation: Refer to slide 15, last row in which
calculation of ARR has been illustrated
Merits and Demerits on slide No 18
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18. Day V, ARR Method, Merits and Demerits
Merits
• Its also easy to find calculate
• It takes into account total inflows
• It also takes into account inflows that accrue
after the PBP Period
Demerits
• It also ignores Time Value of Money
• It suffer from all those many more limitations
with which the concept of “average” suffers

19. Day VI, NPV Method, Meaning, Calculations, Merits and Demerits
Meaning: This method takes into account PV of
inflows and outflows. Difference between PV of
Inflows and PV of Outflows is called NPV. If its
positive project is accepted, if negative rejected.
When there are many projects, one which has
higher NPV is preferred over others.
Calculations:
Apply the concept you have learnt in Unit – I,
calculate NPV. In next slide steps have been
explained and in next to next slide an illustration
has been provided

20. Steps for calculation of NPV
Arrange inflows and outflows in column 2
(column 1 for years)
Decide discounting factor and write in
column 3 (say PV at 10%)
Multiply Column 2 and column 3
Add column 3
Summation of Column 3, is GPV
Subtract outflows from sum of column 3
The answer is Net Present value
NPV = GPV – Investment
Project which results in Higher NPV is preferred
over others
20

21. Illustration, using same data as in case of PBP
Method
Years Cash
flows
‘X’
PV
Factor
@10%
GPV Cash
flows
‘Y’
PV
Factor
@10%
GPV Cash
flows
‘Z’
PV
Factor
@10%
GPV
0 -500000 1 -500000 -500000 1 -500000 -500000 1 -500000
1 100000 0.909 90900 250000 0.909 227250 100000 0.909 90900
2 150000 0.826 123900 150000 0.826 123900 100000 0.826 82600
3 250000 0.751 187750 100000 0.751 75100 100000 0.751 75100
4 200000 0.683 136600 100000 0.683 68300 200000 0.683 136600
5 100000 0.621 62100 200000 0.621 124200 400000 0.621 248400
Gross PV 6,01,250 Gross PV 6,18,750 Gross PV 6,33,600
NPV 101250 118750 133600
21

22. Day VI, Merits and Demerits of PV Method
Merits
• It takes into account time value of money
• Its popular in industry
Demerits
• Its relatively difficult to calculate
• What discounting rate is to be taken, is an issue
• It ignores time frame in which we get back our money
• Issues of time, life and size disparity (see details on next
slide)

23. Limitations of NPV (last bullet of previous slide)
1. Size Disparity, 2. Time disparity and 3. Life disparity
(1) Size disparity:
(2) A) - 5000 + 6250, IRR 25%, NPV 681.25 at 10%
B) - 7500 + 9150, IRR 22%, NPV 817.35 at 10%
(2) Time Disparity
(a) (105) + 60 + 45 + 30 +15 = IRR 21% and NPV 17.75 at 10%
(b) (105) +15+30+45+75 = IRR 17% and NPV 19.89 at 10%
(3) Life Disparity
(A)- 20,000 + 24,000 = IRR 20% and NPV 1,653 at 10%
(B)- 20,000 + 0 + 0 + 0 + 0 + 40,200 = IRR 15% and NPV 4,510 at
10%

24. Day VII – IRR; meaning calculations merits demerits and interpretation
IRR – Meaning:
In case of NPV method, we discount the inflows at an
assumed rate (how do we assume, will be explained in Unit
4). The result is either a positive or negative NPV. When
sum of inflows is more than outflows its +ve else –ve. In
case of IRR we find out a rate at which NPV becomes
“zero”. This is the maximum rate which project can yield.
Based on above IRR is defined as a discounting rate at which
NPV = zero. How do we do so? Which rate do we take to
bring NPV to zero? Steps have been explained in the next
slide

25. Day VII – IRR; Steps in calculating IRR
IRR – Meaning:
In case of NPV method, we discount the inflows at an
assumed rate (how do we assume, will be explained in Unit
4). The result is either a positive or negative NPV. When
sum of inflows is more than outflows its +ve else –ve. In
case of IRR we find out a rate at which NPV becomes
“zero”. This is the maximum rate which project can yield.
Based on above IRR is defined as a discounting rate at which
NPV = zero. How do we do so? Which rate do we take to
bring NPV to zero? Steps have been explained in the next
slide

26. Day VII – IRR; Steps in calculating IRR
1. Prepare a table with 6 rows and … columns
2. In column 1 write years, in 2 out/inflows, in 3 any discounting rate (say
10%), in 4th column multiplication of column 2 and 3. Add this column in
row 6. This is PV or GPV. When you subtract outflow from this figure,
your answer could be +ve or –ve. If its positive, write a higher discounting
factor in column 5 (say 15%) and again multiply these factors with inflows
and write them in column 6 and again total this column in row 6. This
time summation may be lesser than outflow. It means NPV is negative. If
it is still positive, increase the rate and repeat these steps till such time
you reach negative NPV.
• Once you have two set of NPVs, one + and the other -, you can interpolate
using the formula given below
IRR = Lower Rate + (Higher Present Value – Investment)/Higher PV minus
Lower PV)* Diff between two rates

27. Illustration of IRR
Years Cash flows PV @10%
GPV at
10%
PV @19% GPV at 19%
0 -500000 1 -500000 1 -500000
1 100000 0.909 90900 0.847458 84745.8
2 150000 0.826 123900 0.718184 107728
3 250000 0.751 187750 0.608631 152158
4 200000 0.683 136600 0.515789 103158
5 100000 0.621 62100 0.437109 43710.9
IRR @
System
17.2867%
GPV
NPV
601250
101250
GPV
NPV
491500
-8500
10%+(601250-5,00,00)/(601250-491500)*9=18.30%
NOTE: In the illustration 10% and 19% has been assumed. For a better and
accurate IRR, difference between rates have to be as least as possible, say 1-
2%. Try this illustration again using lower rate as 17 and higher rate as 19
and text me correct IRR on my no.
27

28. Day VII – Interpretation of IRR, Merits and Demerits
Interpretation: At (IRR) this rate neither wealth will be
maximized not eroded. If the firm earns more return than
IRR, its wealth will be maximized and vice-versa. It’s a
breakeven rate for borrowing money.
Merits
• Its is a reference rate based on which all calculations are
performed
• Its widely used
Demerits
• Tedious calculations
• Reinvestment assumption

29. Day VIII - Comparison of all 4 Methods and Decision
Making
Years Cash
flows
‘X’
PV
Factor
@10%
GPV ‘Y PV
Factor
@10%
GPV ‘Z’ PV
Factor
@10%
GPV
0 -500000 1 -500000 -500000 1 -500000 -500000 1 -500000
1 100000 0.909 90900 250000 0.909 227250 100000 0.909 90900
2 150000 0.826 123900 150000 0.826 123900 100000 0.826 82600
3 250000 0.751 187750 960000 0.751 72096 100000 0.751 75100
4 200000 0.683 136600 104000 0.683 71032 200000 0.683 136600
5 100000 0.621 62100 200000 0.621 124200 400000 0.621 248400
Gross PV 601250 Gross PV 618478 Gross PV 633600
PBP 3 Years 3 Years 14 days 4 Years
ARR 32% 32% 36%
NPV 101250 118750 133600
IRR 17% 20% 18%
Assignment: Your assistant has worked out the above calculations. You
have to recommend COE any one project. If you follow ARR and NPV,
you will select Z, if NPV, you will go for Y and if PBP your choice would
be X. In such a situation what would you do? Post me your
recommendations by next Monday, 5:00 pm
29

30. Day VII, Profitability Index Method (Capital
rationing)
Meaning
Calculation
Merits and demerits
Meaning Capital rationing
Divisible and indivisible projects
30

31. Projects Initial outlay (Rs.
Crore)
NPV (in
Crore)
PI
X 3.00 0.60 1.20
Y 2.00 0.50 1.25
Z 2.50 1.50 1.60
W 6.00 1.80 1.30
Illustration of PI Method
Ranking of the project in descending order of profitability index
Projects
And Rank
Investment outlay
(in Crore)
Profitability
index
NPV
(in
crore)
Z(1) 2.50 1.60 1.50
W(2) 6.00 1.30 1.80
Y(3) 2.00 1.25 0.50
X(4) 3.00 1.20 0.60
Accept project Z in full and w in part (if possible) (Rs.
4,50,000) as it will maximize the NPV. 31

32. Day 9, Unit IV, Financing Decisions - Cost of Capital
• Introduction to Cost of Capital
• Capital Structure (Different forms of financing)
• Rationale and Relevance with shareholders
value
• Types of capital and calculation of cost of
various sources of financing:
– Equity
– Debentures
– Preference shares
– Retained Earnings

33. Day 10 – Cost o Debt
• Meaning of Debt (debentures)
• Types
 Convertible and non-convertible
 Redeemable and irredeemable
 Cumulative and non-cumulative
 Participative and non-participative
• Calculation of cost of Debt: Depends on terms of
issues and redemption (if redeemable)
• See next slide for details of terms of issue and
redemption

34. Day 10 - Terms of Issue and redemption
Cost of debt when:
Par means Face Value is 10 and issued at 10, discount means
FV is 10 and issued at less than 10 and premium means FV
is 10 and issued at more than 10
1. Issued at par and redeemed at par
2. Issued at par and redeemed at discount
3. Issued at par and redeemed at premium
4. Issued at discount and redeemed at par
5. Issued at discount and redeemed at discount
6. Issued at discount and redeemed at Premium
7. Issued at Premium and redeemed at par
8. Issued at Premium and redeemed at discount
9. Issued at Premium and redeemed at premium

35. Day 10 – continues
• Steps in calculations
1. Determine inflows
2. Determine Outflows
3. Equate them at an appropriate discounting rate
4. Rate that you have arrived at is Cost of Debt,
expressed as Kd
(Why is it abbreviated as “Kd” in the books of
Finance in stead of Cd? Find out and post on
my number)
• See next slide for illustration

36. Day 10 – continues
Illustration of cost of Debt
Suppose a Debenture of Rs 100 carrying 10%
interest, is issued at par and it will be
redeemed after 3 years at 20% discount
In this case out inflows are Rs. 100 (what
issuing firm receives) and outflows (what the
firm gives out) would be Rs 10 in first year as
interest, Rs 10 again as interest in second
Year 10 and in third year Rs 10 for interest
and Rs 80 as principle. It can be presented in
the following table given in the next slide

37. Year 0 100 @3% factor GPV@3% @4% factor GPV@4%
Year 1 -10 0.9708738 -9.709 0.9615385 -9.61538
Year 2 -10 0.9425959 -9.426 0.9245562 -9.24556
Year 3 -90 0.9151417 -82.36 0.8889964 -80.0097
-101.5 -98.8706
In the above table, data in red fonts represents problem
i.e. inflows and outflows. Data in black shows
calculation of discounting factor at which inflows and
outflows will be equal. This is similar to calculating
@3.57% 100 shall be equal to 100
3.57% will be called Kd
37

38. Day 11 – Cost of Debentures
• After calculating Kd, we also calculate Kdt i.e.
cost of debt after taxes. Because firm gets tax
benefit on interest paid to debenture holders
so to this extent it saves taxes its real cost of
debt becomes what it arrives at after
adjustment of taxes.
Kdt = Kd (1 – tax rate)
If Kd = 10% and tax rate is 30%, Kdt = 7%

39. Day 11 – Cost of Preference Shares
The ways in which preference shares can be issued is
exactly the same that of debentures. Terms of issue and
terms of redemption too are same.
Calculation of Cost of Preference Shares (Kp)
(Why is it that Cost of Preference share is abbreviated as
“Kp” in the books of Finance in stead of Cp? Find out and
post on my number)
Inflows and outflows as a result of issue and redemption
of a preference shares are arranged in a table and we
arrive at a discounting rate at which inflows and outflows
are equal.
This rate is called as Kp
Can the concept of Kpt be also introduced in case
preference shares? Should a firm calculate Kpt also like it
calculates Kdt? Post your answers on my no. Concept
of P&L Appropriation acocunt will help you arriving at 39

40. Day 11 …. Cost of Debentures, Cost of Pref Shares – Exercises
Attempt the following problems
1. A debenture carrying 10% interest issued at 20% premium, will
be redeemed at 20% discount after 5 years. Calculate Kd and
Kdt if tax rate is 35%
2. A debenture carrying 10% interest issued at 20% discount, will
be redeemed at 20% premium after 4 years. Calculate Kd and
Kdt if tax rate is 30%
3. A debenture carrying 10% interest issued at 10% premium, will
be redeemed at 20% premium in four equal installments in 4
years. Calculate Kd and Kdt if tax rate is 50%%
4. A preference share carrying 10% dividend issued at 20%
premium. It will be redeemed at 20% discount after 5 years.
Calculate Kp
5. For question 4 above, will you calculate cost of preference
shares after taxes or Not. Explain your answer