CAPITAL BUDGETING

One of the decision of Finance Manager is when to Invest and how much to Invest, The Investment is
made to purchase fixed assets (Long term Investments) as well as in current Assets (Short term
Investment). Capital budgeting is about long term Investment.

Basic features of such Investment is the cash out flow is required to made immediately, however the
cash inflow are expected in future. Therefore we cannot directly compare the cash outflow which is
at present with the cash inflows which are in future. In such cases it is necessary to convert the
future cash flow into its present worth. Such conversion of future value into its present value is
knows discounting technique. To know its present worth we need to apply discounting factor which
is calculated based on some discounting such rate can be expected rate of return or alternatively
weighted average cost of capital.

Following are the basic feature of capital budgeting.

a) Huge Amount Involved

b) High Risk Involved
c) Irreversible Decision

Methods of evaluating Capital Budgeting proposal

1) Non-Discounting technique
a) Simple Payback period

b) Accounting Rate of Return or Average rate of return

a) Simple payback period: A businessman is Interested know how much time period is required to
recover the original Investment, the project which gives lesser payback will be selected

b) Accounting rate of return is calculated based average profit after tax (PAT), it is calculated
percentage between two project the project which gives higher rate of return will be selected.

Accounting Rate of Return = Average PAT X 100

Investment

2) Discounting Methods: Under this method we discount the Future cash flows with help of
discounting rates.

Following Methods are popular

a) Discounted Payback
b) NPV (Net Present value)
c) Profitability Index
d) Internal Rate of Return (IRR)
a) NPV: Under NPV we calculate the excess of discounted cash inflow over discounted cash
outflow if NPV is positive we accept the project, If it is negative we reject the Project
Example: Project A require an Investment of Rs. 50000 while project B required an Investment of Rs.
60000 to be paid in equal Instalments i.e 50% right now and balance at the end of 1st Year, The
estimated cash flows are given as under.

Year Project A Project B

1 20,000 25,000
2 25,000 20,000
3 40,000 50,000

Considering cost of raising the fund is 12%, Calculate NPV and Suggest.
Solution:

Project A Project B
Year DF CF DCF CF DCF
0 1.000 -50,000 -50,000 -30,000 -30,000
1 0.893 - - -30,000 -26,786
1 0.893 20,000 17,857 25,000 22,321
2 0.797 25,000 19,930 20,000 15,944
3 0.712 40,000 28,471 50,000 35,589
NPV 16,258 17,069

DF Discounting Factor =1/(1+R)^n

CF Cash Flow
DCF Discounted Cash Flow

Q9 (Question Bank) Company is forced to choose between two machines A and B. both the
machines are designed differently but have identical capacity and can do exactly the same job.
Machine A cost 1,50,000 and will have a life of 3 years. Machine B would cost 1,00,000 but will have
a life of 2 years. It will require 40,000 pa to run machine A and 60,000 pa to run machine B. ignore
tax. Opportunity cost is 10%. Suggest the best machine.

Solution:

Machine A Machine B
Year DF CF DCF CF DCF
0 1.000 -1,50,000 -1,50,000 -1,00,000 -1,00,000
1 0.909 -40,000 -36,364 -60,000 -54,545
2 0.826 -40,000 -33,058 -60,000 -49,587
3 0.751 -40,000 -30,053 -
NPV -2,49,474 -2,04,132

Sum of DF 2.487 1.736

Annualise NPV =NPV/Sum of DF -1,00,317 -1,17,619
Machine A is better option
IRR (Internal Rate of Return): It is the rate of generated by the project internally, when we calculated
NPV we are required to apply the discounting rate, such discounting rate is generally the weighted
average cost of capital or alternatively the expected rate of return, by applying such discounting rate
to the expected cash flows, we get the discounted cash flows. If the discounted cash flow is more
than the cash outflow we accept the project since NPV comes positive. It indirectly indicates that the
project is capable of generating the returns as expected, in fact if NPV is positive project is actually
giving a return more than the considered under NPV. We want to calculate how much return the
project is generating.

At internal rate of return (IRR) NPV is exactly zero.

𝑆
IRR = 𝑆𝑅 + [𝑆+𝐼𝐷𝐼 𝑥 (𝐸𝑅 − 𝑆𝑅)]

Where, SR= Start rate, ER= End rate, S= Surplus, D = Deficit

Start rate is the rate in which NPV is positive

End rate is the rate in which NPV is negative

Q6. (Question Bank) A firm whose cost of capital is 10% is considering two mutually exclusive
projects X and Y. details are as under –

Project X Project Y

Investment -70,000 -70,000

CFAT Yr 1 10,000 50,000

CFAT Yr 2 20,000 40,000

CFAT Yr 3 30,000 20,000

CFAT Yr 4 45,000 10,000

CFAT Yr 5 60,000 10,000

Compute NPV at 10%, also calculate IRR for X and Y

(Hint for X consider 25-30% DF and for Y 35-40%)

Solution:

@10% Project X Project Y

Year DF CF DCF CF DCF
Investment 1.000 -70,000 -70,000 -70,000 -70,000
CFAT Yr 1 0.909 10,000 9,091 50,000 45,455
CFAT Yr 2 0.826 20,000 16,529 40,000 33,058
CFAT Yr 3 0.751 30,000 22,539 20,000 15,026
CFAT Yr 4 0.683 45,000 30,736 10,000 6,830
CFAT Yr 5 0.621 60,000 37,255 10,000 6,209
NPV 46,150 36,578

IRR 27% Project X 38% Project Y

Year DF CF DCF DF CF DCF
Investment 1.000 -70,000 -70,000 1.000 -70,000 -70,000
CFAT Yr 1 0.786 10,000 7,861 0.727 50,000 36,350
CFAT Yr 2 0.618 20,000 12,360 0.529 40,000 21,141
CFAT Yr 3 0.486 30,000 14,575 0.384 20,000 7,685
CFAT Yr 4 0.382 45,000 17,187 0.279 10,000 2,793
CFAT Yr 5 0.300 60,000 18,016 0.203 10,000 2,031
NPV -0.0 -0.0

Q8. (Question Bank) A company is considering the replacement of existing machine by a new one.
WDV of existing machine is 50,000 and cash salvage value is 20,000. Removal of this machine would
cost 5000. Purchase price of new machine is 20 lacs and expected life is 10 years. Company follows
SLM. other expenses associated with new machines are –

Installation charges 15,000 cost of training workers to handle new machine 5000, additional working
capital 10000 (assumed to receive back at the end of project), fees paid to consultant for his advice
about new machine 10000.

Profit before tax estimated to be 200000, tax rate 35%. Company requires 10% minimum rate of
return from new machine. Should the new machine be purchased?

Solution:

Working Notes:

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 2030000−0

SLM Depreciation = = = Rs. 203000.00
𝐿𝑖𝑓𝑒 𝑜𝑓 𝑀𝑎𝑐ℎ𝑖𝑛𝑒𝑟𝑦 (𝑌𝑟𝑠.) 10

Original Cost = Machinery Cost (Rs. 2000000.00) + Installation Cost (Rs. 15000.00) + Cost of Training
(Rs. 5000.00) + Consultant Fees (Rs. 10000.00)
 Profit Before Tax 2,00,000
Less: Tax @ 35% 70,000
1,30,000

Add: Depreciation 2,03,000

Cash Flow 3,33,000

The Old Machinery sold will be sold at present and there is cash flow of Rs. 20000.00, however to
remove this machine there will be cash outflow of Rs. 5000.00, therefore net inflow from old machine
is Rs. 15000 in year zero.

Working capital: Project requires working capital as an Investment in year zero which is Rs. 10000.00,
it is assumed to be recovered at the end of year 10.

Calculation of NPV

10%
Year DF CF DCF Remarks
0 1.000 -20,30,000 -20,30,000 New Machine Purchase
0 1.000 -10,000 -10,000 Invest in Working Capital
0 1.000 15,000 15,000 Old Machine sale
1 0.909 3,33,000 3,02,727 Cash Inflows
2 0.826 3,33,000 2,75,207 Cash Inflows
3 0.751 3,33,000 2,50,188 Cash Inflows
4 0.683 3,33,000 2,27,443 Cash Inflows
5 0.621 3,33,000 2,06,767 Cash Inflows
6 0.564 3,33,000 1,87,970 Cash Inflows
7 0.513 3,33,000 1,70,882 Cash Inflows
8 0.467 3,33,000 1,55,347 Cash Inflows
9 0.424 3,33,000 1,41,225 Cash Inflows
10 0.386 3,33,000 1,28,386 Cash Inflows
10 0.386 10,000 3,855 Working Capital Recovery
NPV 24,996

New Machine should be purchased

Q7. (Question Bank) Company is considering possibility of manufacturing a component which is

being purchased from outside. Manufacturing would call for an investment of 7,50,000 in a new
machine besides an additional investment in working capital of 50,000. Life of new machine is
expected to be 10 years with salvage value of 50,000. Estimated cash savings before tax would be
15,000 pm tax rate is 35%. Company requires minimum return of 10%. Depreciation on SLM. Should
company buy new machine?

Solution:
Working Notes:

𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡−𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒 750000−50000

SLM Depreciation = = = Rs. 70000.00
𝐿𝑖𝑓𝑒 𝑜𝑓 𝑀𝑎𝑐ℎ𝑖𝑛𝑒𝑟𝑦 (𝑌𝑟𝑠.) 10

Cash Flow Before Tax 1,80,000

Less: Depreciation 70,000

Profit Before Tax 1,10,000

Less: Tax @ 35% 38,500
71,500

Add: Depreciation 70,000

Cash Flow After Tax 1,41,500

Calculation of NPV
10%
Year DF CF DCF Remarks
0 1.000 -7,50,000 -7,50,000 New Machine Purchase
0 1.000 -50,000 -50,000 Invest in Working Capital
1 0.909 1,41,500 1,28,636 Cash Inflows
2 0.826 1,41,500 1,16,942 Cash Inflows
3 0.751 1,41,500 1,06,311 Cash Inflows
4 0.683 1,41,500 96,646 Cash Inflows
5 0.621 1,41,500 87,860 Cash Inflows
6 0.564 1,41,500 79,873 Cash Inflows
7 0.513 1,41,500 72,612 Cash Inflows
8 0.467 1,41,500 66,011 Cash Inflows
9 0.424 1,41,500 60,010 Cash Inflows
10 0.386 1,41,500 54,554 Cash Inflows
10 0.386 50,000 19,277 Working Capital Recovery
10 0.386 50,000 19,277 Salvage Value
NPV 1,08,011

Company should buy new Machine.

Capital Budgeting Under Risk:

Risk refers to the variability that is likely to occur while taking capital budget decision, risk exists
because of inability of the Investors to make a forecast with 100% accuracy.
Risk is different from uncertainty, risk is under the situation where the probability of happening an
event is known or can be predicted with the past data. In the other hand uncertainty is the situation
where we cannot estimate the probability due to lack of historical data.

The Methods to incorporate risk in Capital Budgeting:

1) Risk Adjusted Discounting Rate (RADR) or (CAPM).

2) Certainty Equivalent (CE).
3) Probability Technique.
4) Standard Deviation.
5) Sensitivity Analysis.

1. Risk Adjusted Discounting Rate or CAPM: It is the sum of Risk free rate and risk premium.

RF (Risk Free) + RP (Risk Premium)

RF + {ß x (MR-RF)}

Beta (ß) is the indicator of risk involved in a particular business as compare to the overall
market risk, it is the regression coefficient.

When,

ß > 1 = High Risk

ß < 1 = Low Risk
ß = 1 = Risk is same as Market risk

2. Certainty Equivalent (CE): Under RADR method we have incorporated risk in discounting
rate maintaining the cash flows as it is, however under this method we are interested to
calculate cash flows with more certainty, the cash flows generally estimated are having
some risk involved, we want to eliminate that risk and one to calculate risk free cash flow.

𝑅𝑖𝑠𝑘 𝐹𝑟𝑒𝑒 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤

CE is calculated as
𝑅𝑖𝑠𝑘𝑦 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤

With the help of certainty equivalent we calculate risk free cash flows and then apply the
risk free rate of return as a discounting factor in order to calculate NPV.

Q10 (Question Bank) from the following particulars

A. select the best project, based on risk free return of 10% with risk premium adjustment
of 2% for X and 8% for Y
 X Y

1 4,00,000 5,00,000

2 3,50,000 4,00,000

3 2,50,000 3,00,000

4 2,00,000 3,00,000

Both the projects costs Rs.10,00,000

B. If certainty equivalent co-efficient is following, state which project is better off

X Y

1 0.90 0.80

2 0.80 0.60

3 0.60 0.60

4 0.50 0.50

Solution: (A)
In Project X Risk Free rate is 10% + Risk Premium is 2%, i.e. 12%
In Project Y Risk Free rate is 10% + Risk Premium is 8%, i.e. 18%

12% Project X 18% Project Y

Year DF CF DCF DF CF DCF
0 1.000 -10,00,000 -10,00,000 1.000 -10,00,000 -10,00,000
1 0.893 4,00,000 3,57,143 0.847 5,00,000 4,23,729
2 0.797 3,50,000 2,79,018 0.718 4,00,000 2,87,274
3 0.712 2,50,000 1,77,945 0.609 3,00,000 1,82,589
4 0.636 2,00,000 1,27,104 0.516 3,00,000 1,54,737
NPV -58,791 48,329

Project Y is better.

(B) Project X Project Y

Year CE CF DCF CE CF DCF
0 1.000 -10,00,000 -10,00,000 1.000 -10,00,000 -10,00,000
1 0.900 4,00,000 3,60,000 0.800 5,00,000 4,00,000
2 0.800 3,50,000 2,80,000 0.600 4,00,000 2,40,000
3 0.600 2,50,000 1,50,000 0.600 3,00,000 1,80,000
4 0.500 2,00,000 1,00,000 0.500 3,00,000 1,50,000
NPV -1,10,000 -30,000
Project Y is better.