CAPITAL BUDGETING

Capital Budgeting decision means a decision relating to planning for capital assets as to whether or not money should be invested in long-term projects. Example:- Purchase of a new machine Capital Budgeting involves financial analysis of various proposals regarding a capital expenditure and to choose the best out of the various alternatives. The following techniques are used for investment decisions: 1. 2. 3. 4. 5. 6. Payback Period Payback Profitability Average Rate of Return / Accounting Rate of Return (ARR) Net Present Value (NPV) Profitability Index Method Internal Rate of Return (IRR)

Before employing any of the techniques mentioned above, you should find out Annual Cash Inflow by using the following formula: I. When Annual Cash Inflow is constant: Particulars Profit before depreciation and tax Less: Depreciation Profit after depreciation but before tax Less: Tax Profit after depreciation and tax Add: Depreciation ANNUAL CASH INFLOW II. When Annual Cash Inflow is not constant: Particulars Profit before depreciation and tax Less: Depreciation Profit after depreciation but before tax Less: Tax Profit after depreciation and tax Add: Depreciation ANNUAL CASH INFLOW Cumulative Cash Inflow
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Year 1 Year 2 Year 3 Year 4 Year 5

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Points to remember: If the rate of depreciation is given directly, then calculate the same on the original cost of investment. (Ex.: 20% of Rs. 2,00,000) If the rate of depreciation is not given directly, then calculate the amount of depreciation by using the following formula: Amount of depreciation = Original cost of investment Scrap Value No. of years of useful life

If the cash inflows are not constant, then we have to calculate cumulative cash inflow so as to calculate payback period with ease (which will be discussed later). Let us take one example to clear the calculation of Cumulative Cash Inflow. Suppose the Annual Cash Inflows for a particular investment proposal for 5 years are as follows: Year 1 Rs. 5000 Year 2 Rs. 10,000 Year 3 Rs. 15,000 Year 4 Rs. 20,000 Year 5 Rs. 25,000 Soln: Particulars ANNUAL CASH INFLOW (Given) Cumulative Cash Inflow
Year 1 Year 2 Year 3 Year 4 Year 5

5000 5000

10,000 15,000 20,000 25,000 15,000 30,000 50,000 75,000

METHODS OF EVALUATING INVESTMENT PROPSALS 1] Payback Period: Under this method, decision is taken on the basis of number of years required to recover the original investment. It is expressed in terms of years. Formulae: I. When Annual Cash Inflow is constant: Payback Period = Initial Investment Annual Cash Inflow
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II.

When Annual Inflow is not constant: Payback Period = Year before full recovery + Unrecovered amount Annual Cash Inflow

Decision: In case of two or more investment proposals, High Payback Period Reject the proposal Low Payback Period Accept the proposal

2] Payback Profitability: Under this method, investment is revalued on the basis of overall profitability of the project. Payback Profitability = Total Cash Inflow Cash Outflow (i.e. Cost of investment) Note: If scrap value is given, Payback Profitability = (Total Cash Inflow + Scrap Value) Cash Outflow Decision: In case of two or more investment proposals, High Payback Profitability Accept the proposal Low Payback Profitability Reject the proposal

3] Average Rate of Return / Accounting Rate of Return (ARR): Under this method, decision is taken on the basis of average net return given by the investment. It is expressed in terms of percentage. I. ARR on Original Investment: ARR (Original Investment) = Average Net Profit After Tax Original Investment Where, Average Net Profit After Tax = Total Net Profit After Tax No. of years II. ARR on Average Investment: ARR (Average Investment) = Average Net Profit After Tax Average Investment Where,
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 Average Net Profit After Tax = Total Net Profit After Tax No. of years Average Investment is to be calculated as follows: a. When scrap value and additional working capital is not given: Average Investment = Total Investment 2 b. When scrap value and additional working capital is given: Average Investment= Cost Scrap Value + Scrap + Additional 2 Value Working Capital Note: Cost = Original Investment Additional Working Capital is to be added if given. Decision: In case of two or more investment proposals, High ARR Accept the proposal Low ARR Reject the proposal

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4] Net Present Value (NPV): Under this method, all the cash inflows are discounted to present values at some pre-determined rate of interest (discount). Net Present Value (NPV) = Present Value of Cash Inflow Cost of investment Note: Working capital, if given, should be added to the cost of investment. Format for solving practical problems: Particulars Profit before depreciation and tax Less: Depreciation Profit after depreciation but before tax Less: Tax Profit after depreciation and tax Add: Depreciation A] ANNUAL CASH INFLOW B] Cumulative Cash Inflow C] Discounting factor & rates (will be given in problem) D] Present Value Of Cash Inflow [A*C] Decision: In case of two or more investment proposals, Positive NPV Accept the proposal Negative NPV Reject the proposal
Year 1 Year 2 Year 3 Year 4 Year 5

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4] Profitability Index (PI): Profitability Index is suitable for projects having different capital outlays. This index shows the present value generated by each Re.1 invested in the project. Profitability Index (PI) = Present Value of Cash Inflows Present Value of Cash Outflows

Present Value of Cash Outflows = Cost of investment + Additional Working Capital (if given) Format for solving practical problems will be same as that for NPV.

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Decision: In case of two or more investment proposals, PI > 1 (greater than) Accept the proposal PI < 1 (less than) Reject the proposal

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