Capital Budgeting

Nature or Features of Capital Budgeting

Decisions
• Long- Term Effects
• High Degree of Risk
• Huge Funds
• Irreversible Decisions
• Impact on Firm’s Competitive Strength
• Impact on Cost Structure
 Information Required For Capital Budgeting

• Costs and Benefits of Proposal

• Required rate of Return
• Economic Life of the Project
• Available Funds
• Risk of Obsolescence
 Kinds of Capital Budgeting Decisions

• Accept- Reject Decisions

• Mutually Exclusive Decisions
• Capital Rationing Decision
• Accept- Reject Decision
This is a fundamental decision in capital budgeting. If the
project is accepted, the firm would invest in it; if the
proposal is rejected, the firm does not invest in it.
Proposals which yield a rate of return greater than a
certain required rate of return or cost of capital are
accepted and the rest are rejected. This criteria is
applied to all independent projects. Independent projects
are projects that do not compete with one another in
such a way that the acceptance of one precludes the
possibility of acceptance of another. Under this type of
decision, all independent projects that satisfy the
minimum investment criterion should be implemented.
• Mutually Exclusive Project Decisions
Projects which compete with other projects in such a way
that the acceptance of one will exclude the acceptance
of the other projects. The alternatives are mutually
exclusive and only one may be chosen. These decisions
acquire significance when more than one proposal is
acceptable under the accept- reject decision. Then some
technique has to be used to determine the best one. The
acceptance of this best alternative automatically
eliminates the other alternatives.
• Capital Rationing Decision
Funds are usually limited in nature and a large number of
investment proposals compete for these limited funds.
The firm must therefore ration them. The firm allocates
funds to projects in a manner that it maximizes long term
returns.
• In Capital Budgeting Decisions, the costs and benefits of
a proposal are measured in terms of cash flows. Cash
flows refer to a cash revenue minus cash expenses or
cash oriented measures of return generated by a
proposal. The costs are denoted as cash outflows
whereas the benefits are denoted as cash inflows.
 The cash flows associated with a proposal , usually,
involves the following three types of cash flows:
• Initial Investment or Cash Outflows
• Net Annual Cash inflows
• Terminal Cash Inflows
Computation of Initial Investment
Purchase Price of the Asset (including duties and taxes, if any)
Add: Insurance, Freight and Installation Costs
Opportunity Cost (if any)
Increase in Working Capital (if required)
Less: Cash Inflows in the form of scrap or salvage value of the old assets
(in case of replacing decisions)
Decrease in Working Capital
Initial Investment or Cash Outlay
Net Annual Cash Inflows or Operating Cash
Flows
Profitability Statement (in revenue increasing decisions)

Annual Sales Revenue

Less: Operating Expenses including depreciation
Income Before Tax
Less: Income Tax
Net Income After Tax
Add: Depreciation
Net Cash Inflows
Profitability Statement (in cost reduction decisions)
(A) Estimated Savings
Estimated Savings in Direct Wages
Estimated Savings in Scrap
Total Savings (a)
(B) Estimated Additional Costs
Additional Cost of Maintenance
Additional Cost of Supervision
Add: Cost of indirect material
Additional Depreciation
Total Additional Costs (b)
Net Savings before tax (a-b)
Less: Income Tax
Net Savings after Tax
Add: Additional Depreciation
Net Savings after tax or cash inflows
 Terminal Cash Inflows

• Estimated Salvage or Scrap Value

• Working Capital Released
Conventional Cash Flows
When an initial investment or cash outflows is followed
by a series of inflow of uniform or unequal amounts, it is
called conventional cash flows.
 Non- Conventional Cash Flows- refers to the cash flow
pattern where not one but a series of cash outflows are
followed by a series of cash inflows of equal or unequal
amounts.
 Depreciation
• Depreciation is a non- cash item, hence it is not a
concept of financial management, because it does not
directly affect the firm in terms of a cash resource.
• It has the effect of reducing taxable income and also
the tax liability.
• The treatment of depreciation is done as per the
accounting standards.
• Every asset will be depreciated and it can be deducted
according to different methods.
• Two main methods of depreciation are straight line
method and the written down value method.
Capital Budgeting Methods/ Techniques
 Pay- Back Period Method

• It is the most popular and widely recognized traditional

method of evaluating capital expenditure proposals.
• It considers that recovery of the original investment in
the shortest period is an important element while
appraising capital expenditure decisions.
• The pay back period is the length of time required to
recover the initial cost of the project.
• The pay- back period can be calculated in two different
situations.
• When Annual Cash Inflows are Equal
In this case, the pay back period is computed by dividing
the initial investment or cash outlay by the net annual
cash inflows.
Pay- Back Period = Initial Investments
Net Annual Cash Inflows
• When Annual Cash Inflows are Unequal
In this case, the pay back period is calculated by the
process of cumulating the cash inflows till the time
cumulative cash inflows become equal to the initial
investment outlay.
• Decision Criterion
Under pay- back period method that project will be treated
as the best whose pay- back period is the shortest.
A project will be accepted if the pay back period calculated
is less than its economic life or the maximum pay back
period calculated is less than its economic life or the
maximum pay- back period set by the management.
In case of alternative projects, they may be ranked
according to the length of the pay- back period. The
projects having the shortest pay- back period may be
assigned one followed in that order so that the project
with the longest pay back period be ranked the lowest.
Advantages of the Pay- Back Period Method

• Simple
• Low Cost
• Risk of Obsolescence
• Liquidity Oriented
• Risk Curtailment
 Limitations of Pay- Back Period Method

• Ignores the profitability of the project

• Ignores Post Pay- Back Cash Inflow
• Ignores the magnitude and timing of cash inflows
• Ignores present value of cash inflows
• Ignores the cost of capital
• Post Pay- Back Profitability
= Total Cash Inflows in Life – Initial Cost
Or
Annual Cash Inflows (Total Life – Pay Back Period)
• Bail- Out Pay Back Period

• Pay- Back Reciprocal = Annual Cash Inflows * 100

Investment
 Average Rate of Return

• If profits after tax and depreciation are given

ARR = Average Annual Income After Tax and Depreciation * 100
Average Investment

• If annual cash inflows are given

ARR = Average Annual Cash Inflows- Annual Depreciation * 100
Average Investment

• If value of original investment is used

ARR = Average Annual Income After Tax and Depreciation * 100
Original Investment
• Average Investment
= ½ (Initial Investment- Salvage Value) + Salvage Value

Or
= ½ (Initial Investment + Salvage Value)

Therefore,
ARR= Average Annual Income after tax and depreciation * 100
½ (Initial Investment + Salvage Value)
 Internal Rate of Return Method

• Step 1 Calculate P V Factor

P V Factor = Initial Investment
Average Annual Cash Inflow

• Step 2 Locate this P V Factor in the annuity table of

present value of Rs. 1 in the row, corresponding to the
life of asset. If exact P V Factor is located in the table
than the rate corresponding to the value ( P V Factor
value) is the IRR
• Step 3 If exact value is not there than write down the
rates between which the P V Factor value lies i.e LDR
(Lower Discount Rate) and HDR ( Higher Discount Rate)
and apply the following formula
IRR = LDR + PV – C * (HDR- LDR)
PV - PV

Here, C = Initial Investment

PV = Total PV of Cash Inflow at LDR
PV = Total PV of Cash Inflow at HDR