Capital Budgeting

Definition

Capital budgeting is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

Characteristics

1. Investment for long term benefits

2. Sacrifice of current funds

3. Benefits are to be realized over a series of years

4. It involves huge funds

5. Irreversible decision

6. It has direct impact on shareholders wealth

Capital Budgeting Process

Capital Budgeting Process

Identify Investment Proposals

ScreeningOf Proposals

Evaluate various Proposals

Fixing Priorities

Final Approval

Implement the Proposal

Review the Performance

Corrective Action from the previous step

Kinds of Capital Budgeting Decisions

1. Mutually Exclusive Investments– Best

2. Independent Investments – Accept/Reject

Methods of Capital Budgeting

Methods of Capital Budgeting

Traditional Method Discounted Method

Average Rate of Return Method

Payback Period Method

ProfitabilityIndex

Method

Internal Rate of Return

Net Present Value

Payback Period Method

Payback is the number of years required torecover the original cash outlay invested inthe project. Payback(PB) = Initial Investment / Annual Cash Inflow

Cash Flows after tax before depreciation

Constant Cash FlowsFor e.g. : The project cost = 50000 Annual cash flow =12500 for 7 years. The PB in this case is 50000/12500=4 yrs

Payback Period Method

Uneven Cash FlowsEg: The initial project cost is Rs 20000 and the Inflows is as

below

Year Cash Inflow

( Rs)

1 8000

2 7000

3 4000

4 3000

The PB = 3 years and 4 months. That is 19000(8000+7000+4000) is recovered in the first 3years and 1000 is recovered in the 4th Year. Assuming 3000 is recovered evenly during the year 1000/3000 X 12 = 4.

Average Rate of Return

Also known as accounting rate of return,

is the ratio of the average after tax profit

divided by the average investment.

ARR = Average Annual Profits after Taxes X 100

Average Investment over the life of the project

Cash Flows after tax and Depreciation

Average Rate of ReturnEg: Project Cost : 40000. EBIT during the first 5 years is expected to beRs 10000 , Rs 12000 , Rs 14000 , Rs 16000 and Rs 20000. Assume a 50 percent tax rate and depreciation on straight line basis.

Cash Inflow(Rs)Depreciation

( Rs 40000/5) EBT Tax PAT

10000 8000 2000 1000 1000

12000 8000 4000 2000 2000

14000 8000 6000 3000 3000

16000 8000 8000 4000 4000

20000 8000 12000 6000 6000

Total 3200

Average Investment = (40000+0)/2 = 20000

ARR=Average Income/Average Investment = 3200/20000=16 per cent

Net Present Value

It is a summation of the present value of

cash inflows in each year minus the

summation of the present value of the net

cash outflows in each year.

Cash Flow after Tax before Depreciation

Net Present ValueE.g.: Project cost = 2500 and the opportunity

cost is 10 %.

Year Cash Inflow PV Factor ( 1/(1+R)^N Net Present Value

1 900 0.9091 818.18

2 800 0.8264 661.15

3 700 0.7513 525.92

4 600 0.6830 409.80

5 500 0.6209 310.46

Total 2725.52

Since the inflow of Rs 2725 is greater than the outflow Rs 2500 by Rs 225 , the Project can be accepted

Profitability Index Method

It is the benefit cost ratio or present value of

cash inflow to the initial cash outflow of the

investment.

Cash Flow after Tax before Depreciation

Formula PI = PV of cash inflows / Cash Outflow

For eg : In the NPV example PV of Inflow was

2725 and the PV of outflow is 2500.Therefore the

PI is 2725/2500 = 1.09

As long as the Index is more than 1 , the project can be

accepted.

Internal Rate of Return

It is a rate that equated the investment

outlay with the present value of cash inflow

received after one period. It is also known as

the rate of return ( discount rate which

makes NPV = 0)

Cash Flow after Tax before Depreciation

Internal Rate of Return

YearCash

FlowDiscount Rate

(10%)Discount Rate

(20%)Discount Rate

(16%)

0 -20000 -20000.00 -20000.00 -20000.00

1 5430 4936.36 4525.00 4681.03

2 5430 4487.60 3770.83 4035.37

3 5430 4079.64 3142.36 3478.77

4 5430 3708.76 2618.63 2998.94

5 5430 3371.60 2182.20 2585.29

6 5430 3065.09 1818.50 2228.70

  Sum  3649.07 -1942.48 8.12

Capital Budgeting Practices in India

PI techniques is used more by public sector

than by Pvt sector.

Large firms use NPV

Small firms use PBP

High growth firms use IRR

IRR is preferred over NPV

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