Capital Budgeting

Long term investment decision

 Definitions
• Capital budgeting consists in planning the
development of available capital for the purpose of
maximizing the long term profitability of the firm.
• Capital budgeting decisions may be defined as the
firm’s decision to invest its current funds most
efficiently In long term activities in anticipation of an
expected flow of future benefits over a series of
years.
 Nature of Investment Decisions
• The investment decisions of a firm are generally known
as the capital budgeting, or capital expenditure
decisions.
• The firm’s investment decisions would generally include
expansion, acquisition, modernisation and
replacement of the long-term assets. Sale of a division
or business is also as an investment decision.
• Decisions like the change in the methods of sales
distribution, or an advertisement campaign or a
research and development programme have long-term
implications for the firm’s expenditures and benefits,
and therefore, they should also be evaluated as
investment decisions.
 Features of Investment Decisions

• Capital expenditure plans involve a huge

investment in fixed assets.
• The exchange of current funds for future benefits.
• The funds are invested in long-term assets.
• The future benefits will occur to the firm over a
series of years.
• Capital expenditure once approved represents long
term investment that cannot be reserved or
withdrawn without sustaining a loss.
 Procedure of capital budgeting
• Origination of investment proposals
• Screening the proposals
• Evaluation of projects
• Establishing priorities
• Final approvals
• Evaluation
 Importance of Investment Decisions
• Long term implications
• Growth expansion
• Risk bearing
• Huge Funding
• Irreversibility decisions
• Complexity
Types of Investment Decisions

• The classification is as follows:

– Expansion of existing business
– Expansion of new business
– Replacement and modernisation
 Evaluation methods

• 1. Non-discounted Cash Flow methods

– Payback Period (PBP)
– Accounting Rate of Return (ARR)

2. Discounted Cash Flow methods

– Net Present Value (NPV)
– Internal Rate of Return (IRR)
– Discounted Profitability Index (DPI)
 Payback periods
• Payback is the number of years required to recover
the original cash outlay invested in a project.
• If the project generates constant annual cash
inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow. That
is:

• Assume that a project requires an outlay of Rs

50,000 and yields annual cash inflow of Rs 12,500
for 7 years. The payback period for the project is:
 Payback periods
• Unequal cash flows In case of unequal cash inflows,
the payback period can be found out by adding up the
cash inflows until the total is equal to the initial cash
outlay.
• Suppose that a project requires a cash outlay of Rs
20,000, and generates cash inflows of Rs 8,000; Rs
7,000; Rs 4,000; and Rs 3,000 during the next 4 years.
What is the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
 Acceptance Rule
• The project would be accepted if its
payback period is less than the maximum
or standard payback period set by
management.
• As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest
ranking to the project with highest
payback period.
 Evaluation of Payback
• Certain virtues:
– Simplicity
– Cost effective
– Short-term effects
– Risk shield
– Liquidity
• Serious limitations:
– Cash flows after payback
– Cash flows ignored
– Cash flow patterns
– Administrative difficulties
– Inconsistent with shareholder value
 Accounting Rate of Return Method

• The accounting rate of return is the ratio of the

average after-tax profit divided by the average
investment. The average investment would be equal
to half of the original investment if it were
depreciated constantly.

• A variation of the ARR method is to divide average

earnings after taxes by the original cost of the project
instead of the average cost.
 Evaluation of ARR Method
• The ARR method may claim some
merits
– Simplicity
– Accounting data
– Accounting profitability
• Serious shortcoming
– Cash flows ignored
– Time value ignored
 Net Present Value Method
• N.P.V is the value of money approach for evaluating
the investment proposals. This is also known as
Excess Present Value. Or Investor’s Methods and is
just a variation of Present value method. Under this
method, all cash flows are discounted at a given rate
and their present values are computed. The present
value of cash outflows is subtracted from the sum of
present values of various cash inflows.
 Cont…
• Cash flows of the investment project should be
forecasted based on realistic assumptions.
• Appropriate discount rate should be identified to
discount the forecasted cash flows. The appropriate
discount rate is the project’s opportunity cost of
capital.
• Present value of cash flows should be calculated
using the opportunity cost of capital as the discount
rate.
• The project should be accepted if NPV is positive
(i.e., NPV > 0).
 Net Present Value Method
• Net present value should be found out by
subtracting present value of cash
outflows from present value of cash
inflows. The formula for the net present
value can be written as follows:
 Calculating Net Present Value
• Assume that Project X costs Rs 2,500 now and is expected
to generate year-end cash inflows of Rs 900, Rs 800, Rs
700, Rs 600 and Rs 500 in years 1 through 5. The
opportunity cost of the capital may be assumed to be 10
per cent.
 Acceptance Rule
• Accept the project when 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 NPV method can be used to select
between mutually exclusive projects; the
one with the higher NPV should be selected.
Evaluation of the NPV Method
• NPV is most acceptable investment rule for
the following reasons:
– Time value
– Measure of true profitability
– Value-additivity
– Shareholder value
• Limitations:
– Involved cash flow estimation
– Discount rate difficult to determine
– Mutually exclusive projects
– Ranking of projects
Internal Rate of Return Method

• The internal rate of return (IRR) is the rate that

equates the investment outlay with the present
value of cash inflow received after one period. This
also implies that the rate of return is the discount
rate which makes NPV = 0.
 Internal Rate of Return Method
• IRR is a rate which actually equates the present value
of cash inflows with the present value of cash
outflows. It is actually the rate of return which is
earned by a project, i.e., it is a rate at which the
N.P.V of investment is zero. Under this method, a
project is accepted when I.R.R is greater or equal to
the cut-off rate.
 When savings are even for all the years.

• The present values of future savings can be

ascertained from the annuity table by the trail
and error method
 Calculation of IRR
• Uneven Cash Flows: Calculating IRR by Trial
and Error
– The approach is to select any discount rate to compute
the present value of cash inflows. If the calculated
present value of the expected cash inflow is lower than
the present value of cash outflows, a lower rate should
be tried. On the other hand, a 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.
 Calculation of IRR
• Level Cash Flows
– Let us assume that an investment
would cost Rs 20,000 and provide
annual cash inflow of Rs 5,430 for 6
years.
– The IRR of the investment can be found
out as follows:
 Acceptance Rule
• Accept the project when r > k.
• Reject the project when r < k.
• May accept the project when r = k.
• In case of independent projects, IRR
and NPV rules will give the same
results if the firm has no shortage of
funds.
 Evaluation of IRR Method
• IRR method has following merits:
– Time value
– Profitability measure
– Acceptance rule
– Shareholder value
• IRR method may suffer from:
– Multiple rates
– Mutually exclusive projects
– Value additivity
 Profitability Index
• Profitability index is the ratio of the
present value of cash inflows, at the
required rate of return, to the initial
cash outflow of the investment.
 Profitability Index
• The initial cash outlay of a project is Rs 100,000
and it can generate cash inflow of Rs 40,000, Rs
30,000, Rs 50,000 and Rs 20,000 in year 1 through
4. Assume a 10 per cent rate of discount. The PV
of cash inflows at 10 per cent discount rate is:
 Acceptance Rule
• The following are the PI acceptance rules:
– Accept the project when 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 one.
PI = 1
• The project with positive NPV will have PI
greater than one. PI less than means that
the project’s NPV is negative.
 Evaluation of PI Method
• It recognises the time value of money.
• It is consistent with the shareholder value
maximisation principle. A project with PI greater
than one will have positive NPV and if accepted,
it will increase shareholders’ wealth.
• In the PI method, since the present value of
cash inflows is divided by the initial cash
outflow, it is a relative measure of a project’s
profitability.
• Like NPV method, PI criterion also requires
calculation of cash flows and estimate of the
discount rate. In practice, estimation of cash
flows and discount rate pose problems.