Course Name-Financial Management

Course Code- MBA-205

Lecture No-

Topic –Introduction to Capital Budgeting

Date:

Model Institute of
Engineering & Technology
 Course Outcomes

Course Mapping with

Outcomes
Program Outcomes
and Program Specific
Outcomes
CO1 Understand the basics of corporate financial objectives and functions, time value of money and its 2,3,5
utilization in managerial decision-making.

CO2 Assess the estimation of funds required for long  term and short term investment decisions 1,2,4,5

CO3 Examine the corporate restructuring strategies. 4,5

CO4 Comprehend financial leverages and the value of an organization with respect to its capital structure 1,2,4,5

CO5 Analyze the dividend policy in managing the earnings of an organization. 3,4,5
Assessment and Evaluation Plan

◻ Assessment Tools ◻ Evaluation

✔ SNAP ✔ 5 Marks
✔ MST ✔ 15 Marks
✔ Presentation ✔ 5 Marks
✔ Assignment ✔ 5 Marks
 Course Outcome 1-Delivery Plan
Course Outcomes Topics Blooms Taxonomy

Assess the estimation of Funds required for long term Understanding & Analysis
CO1 and short term investment decisions
Outcomes of Today’s Lecture

◻ To understand the concept of Capital Budgeting Decisions

INTRODUCTION TO CAPITAL BUDGETING

◻ Investment and financing of funds are two crucial functions of finance manager.
◻ The finance manager has to decide about the assets composition of the firm.
◻ The assets are broadly classified into two categories namely fixed and current assets
◻ The aspect of taking the financial decision with regard to fixed assets is known investment decision or
capital budgeting.
 CAPITAL BUDGETING

It is the firm’s decision to invest its current funds most efficiently in the long term activities in anticipation
of flow of future benefits over a series of years.

“Capital budgeting consists of planning the deployment of available capital for the purpose of maximizing
the long-term profitability of the concern”

Capital Budgeting decisions pertain to fixed/long-term assets which refer to assets that are in operation
and yield a return, over a period of time, usually exceeding one year.
Features of Capital Budgeting

a. Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in
future.
b. The future benefits are expected to be realized over a series of years.
c. The funds are invested in long-term activities.
d. They have a long term effect on profitability of the concern.
e. They generally involve huge funds.
f. The capital budgeting decisions are irreversible
g. They have the effect on increasing the capacity, efficiency or economy of operation of existing
fixed assets.
Significance of Capital Budgeting

◻ Growth: The effects of investment decisions extend into the future and have to be endured for a long
period than the consequences of the current operating expenditure.
◻ Risk
◻ Funding
◻ Irreversibility
◻ Complexity
Types of Investment Decisions

◻ Expansion of existing business or expansion of new business

◻ Replacement and modernization
◻ Another useful way to classify investment is as follows:
a) Mutually exclusive investments
b) Independent investments
c) Contingent investments
◻ A) Mutually Exclusive Investments: It serves the same purpose and compete with each other. If one
investment is undertaken, others will have to be excluded.
eg: A company may use a more labour intensive , semi-automatic machine or employ more capital
intensive , highly automatic machine.
B) Independent Investments: Do not compete with each other.
C) Contingent Investments: They are dependent projects;the choice of one investment necessitates
undertaking one or more other investments.
Eg: if a company decides to build a factory in a remote backward area, it may have to invest in
houses,roads, hospitals etc.
◻ Capital budgeting process:
It is the total process of generating,evaluating , selecting and following up on capital expenditure
alternatives for receiving a stream of benefits in term of cash flows over a series of years.
Basically the firm may be confronted with three types of capital budgeting decisions:
a) The accept- reject decisions( eg: independent projects)
b) The mutually exclusive choice decisions (which compete with other projects)
c) The capital rationing decisions (A firm has more acceptable investments than it can finance)
Data Requirement: Identifying Relevant Cash Flows

◻ Cash Flows Vs Accounting Profit:

◻ The evaluation of any capital investment proposal is to estimate the future benefits accruing from the
investment proposal. Theoretically, two alternative criteria are available to quantify the benefits:
1) Accounting profit
2) Cash Flows

The basic difference between them is primarily due to the inclusion of certain non-cash expenses in the
profit and loss account eg: depreciation

The cash flow approach of measuring future benefits of a project is superior to the accounting approach
◻Reasons
- Economic Value
- A firm while considering an investment proposal ,it is interested in estimating the economic value.
- This economic value is determined by the economic outflows(cost) and inflows(benefits ) related with
the investment project.
- Eg: depreciation
- - The use of cash flows avoids accounting ambiguities
- Eg; various ways of calculating inventory, depreciation, amortization etc.

- - The cash flow approach takes cognisance of the time value of money
◻ Cash flow patterns:
- Conventional cash flows: it is An initial outflow followed by only a series of inflows.
- Non conventional cash flow pattern: It is pattern in which an initial outflow is not followed by a series
of inflows
Techniques of evaluation of investment

Traditional methods:
 1. Payback period method
2. Accounting rate of return method
b. Discounted cash flow methods:
1. The net present value method
2. The internal rate of return method
3. The profitability index method
1. Payback Period:
The payback period refers to the time in which the project will generate necessary cash to recover the initial
investment.
Advantages:
a. Easy to compute and simple to understand
b. Ascertainment of risk
c. Helps in selecting a project that yields quick return.
d. This method is suitable when the management is risk averse.
This method is of great help to those industries which are subject to rapid technological changes.
Disadvantages
a. Ignores the time value of money.
b. Does not take into consideration income after payback period.
c. Profitable projects may be foregone under this methods for the fear of liquidity
◻ Project X Project Y
◻ Total cost of the project Rs 15000 Rs 15000
Cash inflows(CFAT)
Year I 5000 4000
2 6000 5000
3 4000 6000
4 0 6000
5 0 3000
6 0 3000
Pay Back Period 3YEARS 3YEARS
Computation of payback period

◻ 
◻ 
◻ Illustration 2: A project requires an initial investment of Rs. 2,50,000 and yields annual cash inflow of
Rs. 42,000 for eight years. What is payback period?
◻ ABC company Ltd, is considering two alternative machines, first alternative costs Rs. 12,000 and
estimated annual cash inflow from it amounts to Rs. 4,000 and its economic life is 5 years.

◻ The second alternative costs Rs. 10,000 and it is estimated to give a cash inflow of Rs. 4,000 P.A.
Its economic life is however only 4 years. Advise the management using payback period model
◻ 
A company is considering expanding its production. It can go either for an automatic machine costing
Rs. 4,48,000 with an estimated life of 6 years or an ordinary machine costing Rs. 1,20,000 having an
estimated life of 8 years. The annual sales and costs are estimated as follows:

Calculate payback period and advise the management.

◻ 
Concept of cash inflow

The term cash inflow refers to earnings after tax but before depreciation i.e. Earnings after tax +
Depreciation
This can be calculated as:
Case 1: If earnings after tax but before depreciation is given(EATBD): This is cash Inflow
Case 2: If earnings after tax are given(EATBD):
Cash inflow= EAT + Depreciation
Case 3: If earnings before tax are given(EBIT):
Cash inflow= EBT-Tax=EAT +Depreciation
Case 4: If earnings before depreciation and tax are given(EBDT):
Cash inflow= EBT-Tax=EAT +Depreciation
Apple Limited has an investment opportunity. The initial investment in the project is Rs.  40,000.
The expected net cash inflows after taxes and before depreciation are:
Year 1 to 5 Rs. 7,000 each year
Year 6 to 9 Rs. 8,000 each year
Determine the payback period?
Calculation of payback period
Year Cash inflow (Rs.) Cumulative Cash inflow (Rs.)
1 7,000 7,000
2 7,000 14,000
3 7,000 21,000
4 7,000 28,000
5 7,000 35,000
6 8,000 43,000
7 8,000 51,000
8 8,000 59,000
9 8,000 67,000
◻ 
◻Q:Ramesh and co is considering the purchase of a machine. The two machines X and
Y each costing Rs. 50,000 is available. Earnings after taxation are expected as
follows, Calculate Payback period.

Hint: Depreciation= Cost of machine- Scrap value

Life of Machine
Accounting Rate of Return

◻ Accounting rate of return means the average annual yield on the project.
◻ It is one of the important methods of capital budgeting technique, which takes into account
earnings over the whole life of the project.
◻ It is also known as average rate of return method.
◻ This method rates different projects on the basis of rate of return.

◻ACCEPTANCE RULE:
◻Accept the project if ARR > minimum rate of return / cost of capital
◻Reject the project if ARR< Cost of capital
◻ 

Average Investment = Original Investment + Scrap/Salvage Value

2
Q. A project will cost Rs. 40,000. Its stream of earnings after tax (EAT) during 1st through 5 years is as
follows: Should the firm accept the project if it wants a minimum rate of return of 15% ?
Year Earnings After Tax (EAT)
1 1,000
2 2,000
3 3,000
4 4,000
5 6,000

Solution: Average Income = 1,000 + 2,000 + 3,000 +4,000 + 6,000 = 16,000 = 3200

5 5
Average Investment = 40,000 + 0 = Rs. 20,000
2
ARR = Average Income * 100
Average Investment

ARR = 3200 * 100

20,000

ARR = 16%

Hence, Firm should accept the machine as ARR >15% on its capital investment.
Net Present Value

◻ The NPV method is one of the discounted cash flow techniques, which recognizes time value of
money.
◻ It is considered to be one of the best methods for evaluating the capital investment projects.
◻ The term NPV refers to the excess of present value of cash inflows over the present value of cash
outflows.
NPV= Total present value of cash inflow – Total present value of cash outflow.
Advantages
1. Takes into account time value of money
2. Whole stream of cash flow is considered
3. Projects ranked as per rate of return
◻ Steps to Be Followed for Adopting Net Present Value Method:
◻ The following are necessary steps to be followed for adopting the net present value method
of evaluating investment proposals:
◻ (i) First of all determine an appropriate rate of interest that should be selected as the
minimum required rate of return called ‘cut -off rate or discount rate. The rate should be a
minimum rate of return below which the investor considers that it does not pay him to
invest. The discount rate should be either the actual rate of interest in the market on long-term
loans or it should reflect the opportunity cost of capital of the investor.
◻ (ii) Compute the present value of total investment outlay, i.e. cash outflows at the
determined discount rate. If the total investment is to be made in the initial year, the present
value shall be the same as the cost of investment.
◻ (iii) Compute the present values of total investment proceeds,/.e., cash inflows, (profit
before depreciation and after tax) at the above determined discount rate.
◻ iv) Calculate the net present value of each project by subtracting the present value of
cash inflows from the present value of cash outflows for each project.
◻ If the net present value is positive or zero, i.e, when present value of cash inflows either exceeds or
is equal to the present values of cash outflows, the proposal may be accepted.
◻ But in case the present value of inflows is less than the present value of cash outflows, the proposal
should be rejected.
◻ To select between mutually exclusive projects, projects should be ranked in order of net present
values, i.e. the first preference should be given to the project having the maximum positive net present
value.
Illustration: A firm’s cost of capital is 10% and it is considering two mutually exclusive projects X and Y
the details are as: Calculate NPV.
Sol: FOR PROJECT X :
Year Cash inflows PVF @10% Present value of Cash Inflows
1 20,000 0.909 18,180
2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 90,000 0.683 61,470
5 1,20,000 0.621 74,520
(Gross Present Value )=2,32,270
NPV = PV of Cash Inflows - PV of Cash Outflows
NPV = 2,32,270 -1,40,000
NPV = Rs.92,270
For Project Y :

NPV= 1,20,000 + 80,000 + 40,000 + 20,000 +20,000 -1,40,000

(1+ 0.10)1+ (1+0.10)2 + (1+ 0.10)3 + (1+0.10)4 + (1+0.10)5

NPV=
{1,20,000* 0.909 + 80,000*0.826 +40,000*0.751 +20,000*0.683 + 20,000* 0.621} -1,40,000

NPV = 1,09,080 + 66,080 + 30,040 + 13,660 +12,420 - 1,40,000

NPV = 2,31,280 -1,40,000 = Rs 91,280
Outcomes of Today’s Lecture

◻ To understand the IRR technique used in Capital Budgeting Decisions.

Internal Rate of Return

◻ IRR: It is another discounted cash flow technique, which takes account of the magnitude and timing
of cash flows.
◻ The concept of IRR is quite simple to understand
◻ Internal rate of return is the rate at which the sum of discounted cash inflows equals the sum of
discounted cash outflows.
◻ This is the rate which makes the NPV of a project zero.
◻ IRR is that rate of return of a project at which NPV = 0
◻The internal rate of return (IRR) determines the worthiness of any project.
◻ In addition, the IRR determines the efficiency of a project in generating profits.
◻ Therefore, companies use the metric to plan before investing in any project.
◻ Any project with an IRR exceeding the hurdle rate is considered profitable.
◻ The internal Rate of Return is much more helpful when it is used to carry out a comparative analysis.
When IRR is used in isolation as one single value, it is less effective.
◻ It is often used to rank multiple prospective investment options that a firm is planning to undertake.
The higher a project’s IRR, the more desirable it is. That project becomes potentially the best
available investment option. The actual Internal rate of return obtained may vary from the theoretical
value calculated. Nonetheless, the highest value will surely provide the best growth rate among all.
The IRR of any project is calculated by keeping the following three assumptions in mind:
1.The investments made will be held until maturity.
2.The intermediate cash flows will be reinvested.  
3.All the cash flows are periodic, or the time gaps between different cash flows are equal.
◻ The ABC Group wants to diversify its business and plan to take up a new project that requires an
initial investment of Rs.4,00,000. They will pay it off in 4 years. It will generate Rs. 40,000 in the first
year, Rs.80,000 in the second year, Rs.1,60,000 in the third year, and Rs.2,59,600 in the fourth year.
Find out the feasibility of this investment project if the discount rate is 8%.

Solution:
Given:
• n=4
• t = 0,1,2,3,4
• CF0= – Rs.4,00,000
• CF1= Rs.40,000
• CF2= Rs.80,000
• CF3= Rs.1,60,000
• CF4= Rs.2,59,600
• Discount Rate = 8%
◻ If the project’s Cost of capital/discount rate is 8%, then the NPV is:
◻ NPV= Rs. 23,451.06
 Now to calculate IRR:

Let us assume that the internal rate of return is 10% and find NPV @ 10%

Here NPV = 0
So, IRR = 10%
Since IRR (r ) > k (cost of capital),
Hence project will be accepted.
◻ Thus, if the IRR is 10%, the project will be at a break-even point. This project generates a positive
NPV, and the discount rate is lower than the IRR. In other words, the IRR is more than the project’s
required rate of return; therefore, it is a profitable investment.
◻ It is important to note that the value of CF0 is always negative as it is the cash outflow.
Steps to calculate IRR:
1. Determine NPV of 2 closest rates of return. One for Positive NPV (at lower rate) and other for
negative NPV (at Higher rate).

2. IRR= Lower rate + NPV at lower rate * Difference in rates

NPV at Lower rate – NPV at higher rate
◻ IRR Acceptance Rule:.
◻ Accept the project when r > k
◻ Reject the project when r < k
◻ May accept the project when r = k
Q.A Project Costs Rs.16,000 and is expected to generate cash inflows of Rs. 8,000, Rs.7,000 and Rs.
6,000 at the end of each year for next 3 years. Calculate Its NPV @ 16%. Then find its IRR at which
NPV = 0 Is the project investible according to you as per NPV and IRR?
Solution: A) NPV at 16% :

NPV= [ 8,000 * (PVF1,0.16 ) + 7,000 * (PVF 2, 0.16 ) + 6,000 * (PVF 3, 0.16)] – 16,000

NPV = [ 8000 * 0.862 + 7000 * 0.743 + 6000 * 0.641 ] — 16,000

NPV = 15,943– 16,000

NPV = Rs. –57

Since NPV is negative, so project is not acceptable at 16% cost of capital.

B ) Now, to calculate IRR :

Since project’s NPV is still negative at 16%, so a rate lower than 16% should be tried. When we
select 15% as trial rate, we find NPV @ 15% :

NPV = [ 8,000 (PVF1,0.15) + 7,000 (PVF 2,0.15) + 6,000 (PVF 3, 0.15) ] – 16,000

NPV = [ 8,000* 0.870 + 7,000*0.756 + 6000* 0.658 ] – 16,000

NPV = 16,200- 16,000 = Rs. 200

Hence, the true rate of return should lie between 15-16 %. We can find out a close approximation
of the rate of return by following formula :
 IRR = Lower rate + NPV at lower rate * Difference in rates
NPV at Lower rate – NPV at higher rate

NPV @ 15% = Rs. 200

NPV @ 16% = Rs. – 57

IRR = 15 + 200 * (16%-15%)

200– (-57)
IRR = 15 + 0.778
IRR = 15. 78%
◻ Illustration: A company has an investment opportunity costing Rs. 40,000 with the following
expected net cash inflows(After tax before depreciation)Calculate IRR?
◻ Discounting Factors
◻
◻
 Profitability Index

◻ 

* 100

Profitability Index Acceptance Rule:

● Accept the project if P.I > 1

● Reject the project if P.I < 1

● May Accept the project if P.I = 1

 Calculate Profitability Index (PI) :

◻ The initial outlay of the project is Rs. 1,00,000 and it generates cash inflows of Rs. 40,000, Rs.
30,000, Rs. 50,000, and Rs. 20,000. Assume a 10% rate of discount. Calculate Profitability
Index.

Profitability Index (PI) = PV of cash inflows * 100

PV of cash outflows

Solution: PV of Cash Inflows = 40,000*0.909 + 30,000*0.826 +50,000*0.751 + 20,000*0.683 = 36,360 +24,780 +37,550
+ 13,660
PV of Cash outflows = 1,00,000
P.I = 1,12,350
Hence, P.I = 1.123 > 1: hence Accept the project. 1,00,000