CAPITAL BUDGETING

Presented By: Neha Ujjwal

 The position of Capital Budgeting:
Financial Goal of the firm:
Wealth Maximization

Investment Financing Dividend

Decision Decision Decision

Debt/Equity mix
Dividend
Long term Short term Payout
Asset Asset Ratio

CAPITAL BUDGETING
Capital Budgeting:

• Capital budgeting decisions are related to the

allocation of funds to different long term assets.

• Capital budgeting decision denotes a decision

situation where the lump sum funds are invested in
the initial stages of projects and the returns are
expected over a long period of time.

• Example: Purchasing land & building, plant &

machinery etc. or to undertake a program on R&D of
a product or to diversify a new product line.
Features/Significance of CB:

• Long term effects

• Substantial commitments

• Irreversible decisions

• Affect the capacity & strength to compete

Types of capital budgeting decisions:

• Mutually exclusive decisions

• Accept- Reject decisions

• Capital rationing decisions

 Capital budgeting techniques:

Traditional/Non- Discounting cash

discounting flows

Pay back period NPV (Net present value)

PI (Profitability index)
ARR (Accounting rate of return)

Discounted pay back

IRR (Internal rate of return)

Traditional/Non-discounting methods:
Pay-back period
• Pay back period is defined as the number of years required for the
proposal’s cumulative cash flows to be equal to its cash outflows.
Or,
• PBP is length of time required to recover the initial cash outflows of
the project.
• Calculation :
a) When annual cash inflows are equal:
PBP= Total cash outflow
Annual cash inflow
b) When annual cash inflows are unequal:
Pay back period is calculated by cumulating the cash inflows.
• Decision rule:
• If PB is less than target period- Accept
• If PB is more than target period - Reject
ARR(Accounting rate of return):
• ARR is based on the accounting concept of return on
investment or rate of return.
• ARR may be defined as the annualized net income
earned on the average funds invested in the project.

• ARR= Average annual profit (after tax)

Average investment in the project
100

• Average investment= ½ ( Initial cost + Installation

expenses – Salvage value) + Salvage value
• Decision rule:
• If ARR > Pre specified rate of return– Accept
• If ARR < Pre specified rate of return– Reject
 Discounted cash flows:
NPV (Net present value)
• NPV may be defined as the sum of present value of
cash inflows less initial investment.

• NPV= Total PV of inflows – Initial cost

• Decision rule:
• If NPV > 0 Accept
• If NPV < 0 Reject
Profitability Index:
• PI is also known as Benefit- cost ratio.

• PI= Total PV of Inflows

Initial Investment

• Decision rule:
• If PI > 1 Accept
• If PI < 1 Reject
Discounted pay- back period:
• This method is a combination of original payback method
& the discounted cash flow technique.

• Under this method the present value of all cash outflows

and inflows are computed at an appropriate discount rate.

• The present values of all inflows are cumulated in order of

time. The time period at which the cumulated present
value of cash inflows equals the present value of cash
outflows is known as discounted pay back period.

• Decision rule:
• The project which gives a shorter discounted pay
back period is accepted.
IRR (Internal rate of return):
• IRR of a proposal is defined as the discount rate at
which NPV of a project is ZERO.
• We use Trial & Error Method to compute IRR of a
project.

• Decision rule:
• If IRR > Firm’s required rate of return(k) Accept
• If IRR < K Reject
THANK YOU