Capital budgeting (1)

Capital Budgeting
Learning Outcome:
After this lecture students will be able to

•Understand meaning of Capital budgeting
•Understand importance of Capital budgeting
Decisions
•Understand Types of Capital Budgeting Decisions
•Evaluate Payback Period, Accounting Rate of
Return, Net Present Value, IRR and Profitability
index
Investment Decisions
The investment decisions of a firm are
generally known as the capital budgeting, or
capital expenditure decisions.
A capital budgeting decision may be defined as

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.
The long-term assets are those that affect the firm’s
operation beyond the one-year period.
The firm’s investment decisions would generally

include expansion, acquisition, modernization and
replacement of the long-term assets.
Meaning
 The process through which different
projects are evaluated is known as capital
budgeting
 Capital
formal process forthe
budgeting acquisition
is defined “as the and
investment
firm’s of capital. involves
decisions to invest It its current fundsfirm’s
for
addition, disposition, modification and
replacement of fixed assets”.
 “Capital budgeting is long term planning for
making and financing proposed capital
outlays”- Charles T Horngreen.
Significance of capital budgeting
• The success and failure of business mainly depends

on how the available resources are being utilised.
• They influence the firm growth in long run
• These types of decisions are exposed to risk and
uncertainty.
• They involve commitment of larger amount of funds
• They are irreversible, or reversible at substantial loss
• Capital rationing gives sufficient scope for the
financial manager to evaluate different proposals and
only viable project must be taken up for investments.
• It helps the management to avoid over investment
and under investments
Methods of capital budgeting
Traditional methods
 Payback period
 Accounting rate of return method
Discounted cash flow methods

 Net present value method
 Profitability index method
 Internal rate of return
Payback period method
• It is one of the most popular and widely recognized
traditional methods of evaluating investment proposals
• Payback is the number of years required to recover the
original cash outlay invested in a project
Payback Period = Initial investment
-------------------------
Annual cash inflow
• They compare the project’s payback with a
predetermined standard payback
• The project would be accepted if its payback period is
less than the maximum or standard payback period set
by management.
Evaluation of payback
Merits:
• Simplicity
• Cost effective
• Short-term effect: be setting up a shorter standard
payback
• Risk shield
• Demerits:
• Cash flows ignored
• Timing of cash flows
• Inconsistent with shareholder value
Accounting rate of return
• The accounting rate of return is also known as return on

investment (ROI)
• It uses accounting information as revealed by financial
statement to measure the profitability of an investment
• The accounting rate of return is the ratio of the average
after tax profit divided by the average investment
ARR = Average Income (earnings after taxes )

--------------------------------------------------
Average Investment (book value of investment in the beginning
& book value of investment at the end of n number of years)
Evaluation of ARR method
Merits:
• Simplicity
• Accounting data
• Accounting profitability
Demerits
• Cash flows ignored
• Time value ignored
• In this method ranks a Project as number one, if it has

highest ARR, and lowest rank is assigned to the project
with the lowest ARR.
Net present value method
• It is considered as the best Discounted cash flow

method of evaluating the capital investment
proposal.
• It recognises the impact of time value of money
• It correctly postulates that cash flows arising at different

time periods differ in value and are comparable only
when their equivalents- present value are found out.
Steps involved in the calculation of NPV
1. Cash flows of the investment project should be

forecasted based on realistic assumption
2. Appropriate discount rate should be identified to
discount the forecasted cash flows. The appropriate
discount rate is project’s opportunity cost of capital
3. Present value of cash flows should be calculated using
the opportunity cost of capital as the discount rate
4. Net present value should be found out by subtracting
present value of cash inflows from present value of cash
outflow The project should be accepted if NPV is positive
(i.e, NPV > 0)
Acceptance rule
Accept the investment project if its NPV is positive (NPV>0)

Reject the project when NPV is negative (NPV<0)
May accept the project when NPV is zero (NPV=0)
• The positive NPV will result only if the project generates cash
inflows at a higher than the opportunity cost of capital
• A zero NPV implies that project generates cash flows at a rate just
equal to opportunity cost of capital
Evaluation of NPV method
Merits:
• Time value
• Measures of true profitability
• Shareholder value
Demerits:
• Cash flow estimation
• Discount rate
• Mutually exclusive projects
Internal rate of return method
• It is another discounted cash flow technique which takes into

account of the magnitude and timing of cash flows
• It is that rate at which the sum of discounted cash inflows equals
the sum of discounted cash outflows It is the rate at which
present value of the investment is zero
• It is called internal rate because it depends mainly on the outlay
and proceeds associated with the projects and not any rate
determined outside the investment
Calculating IRR
• Select any discount rate to compute the present value of

cash inflows
• If the calculated present value of expected cash inflow is
lower than the present value of cash outflows a lower
rate should be tried
• On the other hand higher value should be tried if the
present value of inflows is higher than the present value
of outflows
• This process will be repeated unless the net present value
becomes zero.
Acceptance rule
• Accept the project if its internal rate of return is higher

than the opportunity cost of capital (r> k)
• Reject the project when (r< K)
• May accept the project when (r=k)
Profitability index
• Another time adjusted method of evaluating the investment proposals is the benefit-cost
ratio or profitability index
• It is the ratio of the present value of cash inflows at the required rate of return to the
initial outlay of the investment
PI = PV of cash inflows
--------------------------
Initial cash outlay
Acceptance Rule:
Accept the project PI is greater than one (PI>1)
Reject the project when PI is less than one (PI<1)
May accept the project when PI is equal to 1 (PI=1)

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Capital Budgeting

After this lecture students will be able to

A capital budgeting decision may be defined as

The firm’s investment decisions would generally

• The success and failure of business mainly depends

Discounted cash flow methods

• The accounting rate of return is also known as return on

ARR = Average Income (earnings after taxes )

• In this method ranks a Project as number one, if it has

• It is considered as the best Discounted cash flow

• It recognises the impact of time value of money

• It correctly postulates that cash flows arising at different

1. Cash flows of the investment project should be

Accept the investment project if its NPV is positive (NPV>0)

• It is another discounted cash flow technique which takes into

• Select any discount rate to compute the present value of

• Accept the project if its internal rate of return is higher

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