Course Code: CO5CRT16

Module III-INVESTMENT DECISION

Topic: Capital Budgeting
 INVESTMENT DECISION
 These decisions are concerned with the effective utilisation of
funds in one activity or the other.
 A business firm requires funds for investing them in various fixed
assets and current assets of the business.
 Investment decision can be either capital expenditure decision
and working capital decision
 A capital expenditure may be defined as an expenditure the
benefits of which are expected to be received over period of
time exceeding one year.
 Working capital is money that's available to a company for its
day-to-day operations.
 Capital Expenditure/ Capital Budgeting Decisions

 It is a process of making decisions regarding long term

investments in fixed assets.
 Capital Budgeting’ is the process of making investment
decisions in capital expenditures.
 It includes;
Cost of acquisition of fixed assets such as land and buildings,
plant and machinery, etc.
Cost of expansion, improvement or addition in fixed assets.
Cost of alteration and replacement of fixed assets.
Research and Development expenditures
 Capital Budgeting involves a current investment in
which the benefits are expected to be received beyond
one year in the future”--James C. Van Horne.
 Features of Capital Budgeting
1. Capital expenditure plans involve huge investments.
2.Capital expenditure once approved cannot be withdrawn.
3.Several years profits or cash inflows are to be forecasted
in order to rank the profitability of the various projects.
4. Any error in the evaluation of investment projects may
lead to serious consequences, financially and otherwise
and may adversely affect the other future plans of the
organisation.
5. A capital budget looks to have much longer range future
than other budgets do
 Importance of Capital Budgeting

 Heavy investments
 Long-term Commitment of Funds
 Irreversible Decisions
 Long term impact on profitability
 Wealth maximisation of shareholders
Factors affecting capital expenditure decisions

1.Availability of Funds
2. Minimum Rate of Return on Investment
3. Future Earnings
4.Quantum of Profit Expected
5.Cash Inflows
6.Legal Compulsions
7.Ranking of the Capital Investment Proposal
 Steps in Capital Budgeting

1. Creative search for profitable opportunities

2. Screening and selection
3. Evaluation of the project
4. Establishing priorities
5. Final Approval and Implementation
6. Evaluation
 Capital budgeting Techniques

• The capital budgeting appraisal methods are

techniques of evaluation of investment proposal will
help the company to decide upon the desirability of
an investment proposal depending upon their;
relative income generating capacity and rank them in
order of their desirability.

METHODS
 Traditional methods
 Discounted Cash flow methods
 Capital budgeting Techniques

1. Traditional Methods
a) Pay back Period Method
b)Average Rate of Return Method
2. Discounted Cash flow Methods
a) Net Present Value Method
b) Profitability Index Method
c) Internal Rate of Return Method
d) Discounted Payback Period Method
 Traditional methods

 A method which is used to determine the desirability

of an investment project on the basis of its useful life
and expected returns.
 These methods depend upon the accounting
information available from the books of accounts of
the company.
 These will not take into account the concept of ‘time
value of money’, which is a significant factor to
determine the desirability of a project in terms of
present Value.
 Traditional Methods
1) Pay-back Period Method:

 A traditional method of evaluating the investment

proposals.
 Pay Back Period-‘the number of years required to recover
the original cash out lay invested in a project’.
 According to James. C. Vanhorne, “The payback period is
the number of years required to recover initial cash
investment.
 A project with the least payback period will be selected

 Payback period =
Total Investment in the project=Rs. 200000

Year Cash Inflow

1 20000
2 30000
3 40000
4 50000
5 60000
 Practical Problem I
( When annual cash inflows are constant)

 A project requires Rs.200000 as initial investment. It

will generate an annual cash inflow of Rs.50000 for
eight years. Calculate the pay back period.
 Practical Problem
 A project requires Rs.200000 as initial investment. It
will generate an annual cash inflow of Rs.50000 for
eight years. Calculate the pay back period.

Pay Back Period=

= 200000/50000
= 4 Years
 Practical Problem II
 A project costs Rs.2000000 and yields a profit of Rs.
400000 annually for 10 years. The profit is before
depreciation and tax. You are required to calculate
the pay back period assuming 50% tax and
depreciation on straight line method.

Pay back Period=

Depreciation=Cost of the Investment/Life of investment
=2000000/10
=Rs. 200000

Note: The profit of Rs. 400000 is the profit before depreciation and
taxes. It should be remembered that tax amount is calculate on the
profit after depreciation. This is because depreciation is a
deductable item from profit for the purpose of calculating income
tax.
Calculation of profit after tax and before depreciation
Profit before depreciation and tax 4,00,000
Less: Depreciation 2,00,000

Profit after Depreciation 2,00,000

Less: Tax(50% of 200000) 1,00,000

Profit after Depreciation and Tax 1,00,000

Add: Depreciation 2,00,000

Profit before Depreciation and after Tax 3,00,000

Pay back Period =20,00,000/3,00,000

=6.67 Years
 Practical Problem III
( When annual cash inflows are not constant)

 A project requires an initial investment of Rs. 1,00,000. The

project is expected to generate cash in flow for 5 years. The
estimated cash inflows are Rs. 20,000, 30,000,30000, 40,000,
and 40,000. Calculate pay back period.
 Year Cash Inflows Cumulative Cash inflows
1 20000 20000
2 30000 50000
3 30000 80000
4 40000 120000
5 40000 160000

The cost of investment is Rs. 100000 and it is realised in between 3 rd and 4th year. Therefore;
Payback Period= 3 Years + fraction year

Fraction Year= Amount to be recovered in the 4th year /Cash inflow of the 4th Year

Fraction Year= 20000/40000

= 0.5 Years

Payback Period=3+0.5=3.5 years

 Practical Problem IV
 Two proposals X and Y with an initial investment of Rs. 100000
each are under consideration. The expected net annual cash
inflows are as under;

Year Cash Inflows

Project X Project X

1 20000 15000
2 35000 20000
3 40000 30000
4 30000 35000
5 15000 60000

Rank the proposals on the basis of payback period and give your
comments.
 Solution
Project X Project Y

Year Cash Inflow Cumulated Cash Inflow Cumulated

cash inflows cash inflows

1 20000 20000 15000 15000

2 35000 55000 20000 35000
3 40000 95000 30000 65000
4 30000 125000 35000 100000
5 15000 140000 60000 160000

Payback Period of Project X =3 years +Fraction year

Fraction Year=5000/30000=.17 years
Payback Period of Project X=3 year +.17=3.17 Years

Payback Period of Project Y =4 years

 Average Rate of Return/Accounting rate of Return
Method
 An improvement over the Payback period method
 Accounting rate of return on an investment can be calculated
as the ratio of average net income(average earnings) to the
initial investment

 ARR=

 Average Earnings= Total Earnings(After Depreciation and

Tax)/Economic life of the project

 Average Investment=Original Investment/2

 Average Investment=Original Investment + Scrap Value/2
 Practical Problem
 Calculate the average rate of return for the Project I and
Project II fro the following information;
Project I Project II
Investment 50000 75000
Expected Life 4 5

Earnings after Depreciation and Tax:

Years Project I Project II

1 5000 7500
2 3750 7500
3 3750 5000
4 2500 2500
5 ------ 2500

Total 15000 25000

If the desired rate of return is 12% which project should be

selected?
 ARR= Average Earnings/Average Investment
Average Earnings=Original Investment / 2

Project I Project II
Average Earning=50000/2=25000 Average Earnings=75000/2=37500
Average Investment=Total Earnings after depreciation and tax/ Economic life of
the project
Project I Project II
Average Investment=15000/4=3750 Average Investment=25000/5=5000

ARR=Average Earnings/ Average Investment*100

Project I Project II
ARR=25000/3750*100=15% ARR=37500/5000*100=13.33%

Minimum Rate of return is 12%

Both the projects satisfy the minimum required rate of return. However, if the
projects are mutually exclusive , Project I will be selected as its ARR is higher than
that of Project II.
 Discounted Cash flow Methods
 An improvement of traditional methods
 This method consider he concept of time value of money for
evaluating the profitability of investment opportunities
 DCF method considers the cash inflow over the entire life of a
project and profitability of a project
 Discounted cash flow methods:
a) Net Present Value Method
b) Profitability Index Method
c) Internal Rate of Return Method
d) Discounted Payback Period Method
 Net Present Value Method
 The NPV takes into consideration the time value of money
 NPV is the difference between the present value of cash inflows of
a project and the project cash outflows
 According to Ezra Solomon, “NPV is the present value of future
returns, discounted at the required rate of return minus the
present value of the cost of the investment.”
 NPV= Total Present value of cash inflow-Cost of the project
 If the NPV is positive, the project is accepted; if negative, it is
rejected
 If the two projects are mutually exclusive, the project with
higher NPV is accepted.
 Practical Problem I

 Project A and Project B require an investment of R.50000 and

Rs.80000 respectively. Calculate the NPV of these projects if
they generate net cash flows as under:
Years Project A Project B
1 25000 20000
2 15000 22000
3 12500 23000
4 ------- 25000
5 12000 18000
6 6000 8500

The discount rate is 10%.

 Present Project A Project B
Value
Year Factor(RS.1) Cash Present value Cash inflow Present value
inflow (PVF*CI) (PVF*CI)

1 0.909 25000 22725 20000 18180

2 0.826 15000 12390 22000 18172
3 0.751 12500 9388 23000 17273
4 0.683 ------- ------- 25000 17075
5 0.621 12000 7452 18000 11178
6 0.564 6000 3384 8500 4794
Total Present Value 55339 86672

NPV= Total Present value – Cost of the Project

NPV of Project A NPV of Project B

NPV=55339-50000=5339 NPV=86672-80000=6672

Since the NPV of Project B is higher than that of Project A, Project A should
be selected.
 Practical Problem II

 Rohid Ltd is planning to acquire a machine. Two machines X and Y are available
costing Rs.50000 each. Earnings after tax and before depreciation are expected
to be:
Year Machine X Machine Y
1 15000 5000
2 20000 15000
3 25000 20000
4 15000 30000
5 10000 20000

A discount rate of 10 % is to be used. Present values at 10% for five years are;
0.909, 0.826, 0.751, 0.683 and 0.621 respectively

Using NPV method, find out which would be the more profitable investment?
Calculation of present value of cash inflow of Machine X
Year Cash inflows PV Factor Present Value
1 15000 0.909 13635
2 20000 0.826 16520
3 25000 0.751 18775
4 15000 0.683 10245
5 10000 0.621 6210
Total P V 65385

NPV of Machine X= Present Value of Cash Inflow- Cash Out flow

NPV=65385-50000=15385
Calculation of present value of cash inflow of Machine Y

Year Cash inflows PV Factor Present Value

1 5000 0.909 4545
2 15000 0.826 12390
3 20000 0.751 15020
4 30000 0.683 20490
5 20000 0.621 12420
Total P V 64865

NPV of Machine Y= Present Value of Cash Inflow- Cash Out flow

NPV=64865-50000=14865

As the NPV of Machine X is higher , purchasing Machine X would

 Probability Index Method (PI)

 The method is also called benefit-cost ratio

 PVI is found out by comparing the total present value of cash
inflows and the total present value of cash out flows
 If the PI is more than one (>1), the proposal is accepted else
rejected.
 If there are more than one investment proposal with the more
than one PI the one with the highest PI will be selected.
 This method is more useful ,in case of projects with different
cash outlays cash outlays and hence is superior to the NPV
method.

 Probability Index =
 Internal Rate of Return Method (IRR)

 This method is used when the discount rate is not known, but
the cash outflows and cash inflows are known.
 The IRR for an investment proposal is that discount rate which
equates the present value of cash inflows with the present
value of cash out flows of an investment.
 The IRR is also known as cut-off or handle rate.
 IRR is calculated by trail and error method
Cash Inflows
 IRR= =1
Cash Outflows
 Steps
 Calculate the present value of cash inflows by applying an
interest rate/discount rate
 Compare the present value of cash inflows with cost of the
investment
 If the present value is higher than the investment cost, a high
rate of interest applied
 If the present value is lower than the investment cost, a low
rate of interest applied
 The interest which equates the cash inflows to cash outflows
 A project with a higher IRR will be selected
 Discounted Pay-back Period
• Under this method the discounted cash inflows are
taken and then cumulated to find out pay back
• The discounted rate of one rupee for each year can
be ascertained from the present value table
 Practical Question
The details of an investment project is given below:

Cost of the 75000

project
Year Annual cash inflows
1 7000
2 12000
3 20000
4 30000
5 30000
6 27000

Discount rate is 10%. You are required to calculate

1) Pay back period
2) Discounted pay back period
Pay Back Period
Year Cash Inflows Cumulated Cash inflows

1 7000 7000
2 12000 19000
3 20000 39000
4 30000 69000
5 30000 99000
6 27000 126000

Initial Investment=75000
Up to the 4th Year Rs. 69000 is recovered. There fore the pay back period
lays between 4th year and 5th year.

Pay back period= 4+Fraction Year

Fraction Year=6000/30000=0.2 Years

Pay Back Period= 4+0.2=4.2 years

Discounted Pay Back Period
Year Cash PV Factor @10% Discounted Cash Cumulative
Inflows Inflows Discounted Cash
Inflow
1 7000 0.909 6363 6363
2 12000 0.826 9912 16275
3 20000 0.751 15020 31295
4 30000 0.683 20490 51785
5 30000 0.621 18630 70415
6 27000 0.564 15228 85643

Initial Investment=75000
Up to the 5th Year Rs. 70415 is recovered. There fore the pay back period
lays between 5th year and 6th year.

Pay back period= 5+Fraction Year

Fraction Year=4585/15228=0.3 Years