TECHNIQUES OF

CAPITAL BUDGETING
 LEARNING OBJECTIVES
• Say the nature of fixed assets
• Define capital budgeting
• Understand the nature and importance of capital budgeting
• Identify the difficulties involved in capital budgeting decisions
• Explain the kinds of capital budgeting decisions
• Discuss the process of capital budgeting
• Calculate cash flows after tax
• Discuss the techniques of capital budgeting with their merits
and limitations
• Compare and contrast NPV with IRR
 Nature of Fixed Assets

• Fixed assets are those assets that are of permanent in nature

and used by a firm in its normal operations
 Meaning of Capital Budgeting
• The firm’s decision to invest its current funds most efficiently
in the long term assets in anticipation of an expected flow of
benefits over a series of years
 Importance of Capital Budgeting
• Growth
• More risky
• Huge investments
• Irreversibility
• Effect on other projects
• Difficult decision
 Difficulties in Capital Budgeting

• Measurement problem
• Uncertainty
• Temporal spread
 Classification of Projects
• New projects
• Expansion projects
• Diversification projects
• Replacement and Modernisation projects
• Research and Development (R&D) project
• Interior Decoration
• Recreation facilities
• Landscaped gardens
 Kinds of Capital Budgeting decisions

• Mutually Exclusive Investments

• Capital Rationing decisions
• Contingent investments
 Process of Capital Budgeting
1. Idea generation
2. Evaluation or Analysis
3. Selection
4. Financing
5. Execution or Implementation
6. Review
Techniques of Investment Evaluation
Project Evaluation Techniques

Traditional Modern
Or Or
Non-discounted Cash Flow Discounted Cash Flow

PayPay
backBack Accounting Rate Net Present Internal Rate Profitability
period
Period Of Return Value Of Return Index
 Calculation of CFAT
Proforma of Cash Inflows After Taxes (CFAT)
Particular Amount (Rs.)
xxx
Sales Revenue xxx
Less: Variable Cost
Contribution xxx
Less: Fixed Cost xxx

Earning Before Depreciation and Taxes (EBDT) xxx

Less: Depreciation xxx

Earning Before Taxes (EBT) xxx

xxx
Less: Taxes
Earning After Tax (EAT) xxx
xxx
Add: Depreciation
Cash Flows After Tax (CFAT) xxx
 Pay Back Period [PBP]
• Pay Back Period: The period required to recover the original
cash out flow or investment
Original Investment
PBP (when cash flows are even) = --------------------------
CFAT

PBP (when cash flows are uneven): Cumulative CFs Method

Decision Rule : Accept = when calculated PBP < Std.PBP
Reject = when calculated PBP > Std.PBP
 Evaluation of PBP
Advantages
• Easy to understand
• Cost involvement in calculating PBP is less
Disadvantages
• Ignores CFs after PBP
• Not suitable for measuring profitability
• Do not consider Time Value of Money
• No base for deciding standard PBP
• Not suitable to maximise wealth
 ARR
Average Annual EAT or PAT
Accounting Rate of Return (ARR) = ------------------------------------- ×100
Original Investment (OI)*
* OI = Original investment + additional NWC + Installation Charges + Transportation Charge
(ii) whenever it is clearly mentioned as Average Rate of Return
If Average rate of return is given in the problem, return on average investment
method should be used to calculate average rate of return.
Average Annual EAT
Average Rate of Return = -------------------------------- ×100
Average Investment (AI)*
* AI = (Original investment – Scrap Value)1/2 + Additional NWC + Scrap Value

• Decision Rate:Accept = Calculated ARR > Std.ARR

Reject = Calculated ARR < Std.ARR
 Evaluation of ARR
Advantages
• Consider all profits of the project
• Information can easily be drawn from accounts department
Disadvantages
• Consider accounting profits
• Ignores time value of money
• Does not allow profits to invest
• Does not differential between size of investment required
for each project
• Not suitable to maximum owners wealth
 Net Present Value (NPV)
Net Present Value: Present value of benefits minus preset
value of costs
Steps involved in computation of NPV
1. Forecasting of cash inflows of the investment project based
on realistic assumptions,
2. Computation of cost of capital, which is used as
discounting factor for conversion of future cash inflows
into present values,
3. Calculation of PV cash flows using cost of capital as
discounting rate,
4. Finding out NPV by subtracting PV of cash out flows from
PV of cash inflows.
Decision Rule
Accept: NPV> Zero Reject: NPV< Zero
 Evaluation of NPV

Advantages
• Consider time value of money
• Consider cash flows through project life
• Suitable for mutually exclusive proposals
• Help to maximum shareholders wealth
Disadvantages
• NPV calculation involves lengthy time
• Not suitable for projects with different cash outflows
• May not give suitable suggestion-projects with unequal life
periods
 Internal Rate of Return (IRR)
• Internal Rate of Return (IRR): The discount rate at which
PV of cash inflows equals to PV of cash out flows
IRR Computed by Trial and error approach
If not getting them interpolation formula use
PVLDF - COF
IRR = LDF % + ΔDF ----------------------
PVLDF - PVHDF
Where LDF = Lower discount factor
ΔDF = Difference between low discounting factor and High discounting factor
PVLDF = PV of cash inflows at low discounting factor
PVHDF = PV of cash inflows at high discounting factor
COF = Cash outflow
Decision Role:
Accept = Ko < IRR
Reject = Ko > IRR
 Evaluation of IRR
Advantages
• Consider time value of money
• Consider CFs through project life
• Gives more psychological satisfaction
• Helps to maximum shareholders wealth
Disadvantages
• Assumption of profits are reinvested at IRR not logical
• Produces multiple rate of returns
• Not suitable for evaluation mutually exclusive projects
• May not give fruitful results when project life or cash
outflows are unequal
 Profitability Index (PI or BCR)
• Profitability Index: The index that is desired by dividing PV
of cash inflows by PV of cash out flows
PI = PV of CIFs PV of COFs
Decision Rule:
Accept: PI>1
Reject: PI<1
 Evaluation of PI
• It gives due consideration to time value of money,
• It considers all cash flows to determine PI,
• It will help to rank projects according to their PI,
• It recognized that the fact that bigger cash flows are better to
smaller ones and early cash flows are preferable to later ones,
• It can also be used to choose mutually exclusive projects by
calculating the incremental benefit cost ratio.
• It is consistent with the objectives maximization of
shareholders’ wealth.