Capital Budgeting Decision Rules

Definition
Capital refers to be the total investment of a

company of firm in money, tangible and
intangible assets.
Budgets are a blue print of a plan and action

expressed in quantities and manners.
- - the art of building budgets - “Rowland and William”

What is Capital Budgeting?
a long-term planning for making and financing
proposed capital out lays.
Charles T. Hrongreen
is concerned with the allocation of the firms

source financial resources among the available
Capital opportunities. The consideration of investment
opportunities involves the comparison of the
Budgeting expected future streams of earnings from a project
with the immediate and subsequent streams of
earning from a project, with the immediate and
subsequent streams of expenditure”.-
G.C. Philippatos
• “capital budgeting is acquiring inputs
with long-term return”.
• -Richard and Green law
• “capital budgeting consists in planning

Capital Budgeting
development of available capital for the
purpose of maximizing the long-term
profitability of the concern”.
⚬ Lyrich
Overall Objectives?
Is that the company from is

to maximize the profits and
minimize the expenditure of
cost.
Need and Importance of
Capital Budgeting
Need and Importance of Capital Budgeting
Support we need to
Long-term
achieve this goal
Huge investments
Capital budgeting requires huge Capital expenditure is long-term in nature

investments of funds, but the available or permanent in nature.
funds are limited, therefore the firm Therefore financial risks involved in the
before investing projects, plan and investment decision are more.
control its capital expenditure.
Need and Importance of Capital Budgeting
Irreversible
Support we need to
achieve this goal
Long-term effect
The capital investment decisions are Capital budgeting not only reduces the cost but
also increases
irreversible, are not changed
the revenue in long-term and will bring significant changes in the profit of the company by avoiding over or more investment or under
investment.
back.
KINDS OF CAPITAL
BUDGETING
DECISIONS
Capital Budgeting into 2 Broad Categories:
• Screening Decisions
• Preference Decisions
• Equipment
• Expansion replacement
• Equipment • Cost Reduction

Selection
• Lease or Buy
PAY BACK
Formula PERIOD
: Pay-back period is the time
required to recover the initial
investment in a project.
(It is one of the non-discounted
cash flow methods of capital
budgeting).
1. It is easy to calculate and simple to understand.
2. Pay-back method provides further improvement over

the accounting rate return.
3. Pay-back method reduces the possibility of loss on

account of obsolescence.
Merits of Pay-back method

1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.
Demerits
If the actual pay-back period is less than the
predetermined pay-back period, the project
would be accepted.
If not, it would be rejected.
Accept /Reject criteria

Uneven Cash Inflows
Normally the projects are not having uniform

cash inflows. In those cases the pay-back
period is calculated, cumulative cash inflows
will be calculated and then interpreted.
The above calculation shows that in 3 years Rs. 23,000

has been recovered Rs. 2,000, is balance out of cash
outflow. In the 4th year the cash inflow is Rs. 12,000. It EXAMPLE
means the pay-back period is three to four years, Certain projects require an initial cash outflow of
calculated as follows: Rs. 25,000. The cash inflows for 6 years are Rs.
5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs.
Pay-back period = 3 years+2000/12000×12 months 7,000 and Rs. 3,000.
= 3 years 2 months.
Solution = Rs. 30,000
Rs. 10,000
= 3 Years
Exercise 1
EXAMPLE
Project cost is Rs. 30,000 and the cash inflows are Rs.
The annual cash inflow is calculated by considering the amount
10,000, the life of the project is
of net income on the amount of depreciation project (Asset)
5 years. Calculate the pay-back period.
before taxation but after taxation. The income precision earned
is expressed as a percentage of initial investment, is called
Formula:
unadjusted rate of return.
The above problem will be calculated as below:
Unadjusted rate of return = Annual Return ×100

Investment
= Rs. 10,000 × 100
Rs. 30,000
=
Post Pay- Considers the receivable
back
Profitability after the payback period
Method
Example:
Given:
From the following particulars, compute:
1. Payback period.
2. Post pay-back profitability and post pay-back profitability
index.
Given:
(a) Cash outflow Rs. 1,00,000
Annual cash inflow Rs. 25,000
(After tax before depreciation)
Estimate Life 6 years
(b) Cash outflow Rs. 1,00,000
Annual cash inflow
(After tax depreciation)
First five years Rs. 20,000
Next five years Rs. 8,000
Estimated life 10 Years
Salvage value Rs. 16,000
Solution
Accounting Rate of Return or Average
Rate of Return
- - Average rate of return means the average rate of return

or profit taken for considering the project evaluation
-- capital budgeting formula that is used to determine the
potential profitability of long-term investments
Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than

cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the

project.
Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to

some difficulties
in the calculation of the project.
Accept/Reject criteria
• If the actual accounting rate of return is more than the

predetermined required rate of return, the project would be
accepted.
￭ If not it would be rejected.

ARR = Average Annual Profit / Average
ARR Formula Investment
The formula for

Where:
ARR is:
Average Annual Profit = Total profit over
Investment Period / Number of Years
Average Investment = (Book Value at Year 1 +

Book Value at End of Useful Life) / 2
Example XYZ Company is looking to invest in some new
machinery to replace its current malfunctioning one.
The new machine, which costs $420,000, would

increase annual revenue by $200,000 and annual
expenses by $50,000.
The machine is estimated to have a useful life of 12

years and zero salvage value.
Step 1: Calculate Average Annual Profit
Example Inflows, Years 1-12
(200,000*12) = $2,400,000
Less: Annual Expenses

(50,000*12) = $600,000
Less: Depreciation -$420,000
Total Profit = $1,380,000

Average Annual Profit
(1,380,000/12) = $115,000
Step 2: Calculate Average Investment
Example
Average Investment
($420,000 + $0)/2 = $210,000
Step 3: Use ARR Formula

(ARR = Average Annual Profit / Average Investment)
ARR = $115,000/$210,000 = 54.76%
• Therefore, this means that for every dollar

invested, the investment will return a profit of
about 54.76 cents.

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Definition

Capital refers to be the total investment of a

Budgets are a blue print of a plan and action

- - the art of building budgets - “Rowland and William”

is concerned with the allocation of the firms

• “capital budgeting consists in planning

Is that the company from is

Capital budgeting requires huge Capital expenditure is long-term in nature

• Equipment • Cost Reduction

2. Pay-back method provides further improvement over

3. Pay-back method reduces the possibility of loss on

Merits of Pay-back method

2. It ignores all cash inflows after the pay-back period.

3. It is one of the misleading evaluations of capital budgeting.

If not, it would be rejected.

Accept /Reject criteria

Normally the projects are not having uniform

The above calculation shows that in 3 years Rs. 23,000

Unadjusted rate of return = Annual Return ×100

- - Average rate of return means the average rate of return

2. It is based on the accounting information rather than

3. It is not based on the time value of money.

4. It considers the total benefits associated with the

2. It ignores the reinvestment potential of a project.

3. Different methods are used for accounting profit. So, it leads to

• If the actual accounting rate of return is more than the

￭ If not it would be rejected.

The formula for

Average Investment = (Book Value at Year 1 +

The new machine, which costs $420,000, would

The machine is estimated to have a useful life of 12

Less: Annual Expenses

Total Profit = $1,380,000

Step 3: Use ARR Formula

• Therefore, this means that for every dollar

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