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2 It is the process of making investment
decisions in capital expenditure.
expenditure.

2 A capital expenditure is the expenditure of


which the benefits are expected to be
received for a period of time exceeding one
year..
year
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m According to Charles T. Horngreen
³ Capital Budgeting is long term planning for
making and financing proposed capital
outlays´
Õeatures of Capital Budgeting Decision
Decision::
m It involve the exchange of current funds for
the benefits to be achieved in the future.
future.
m Future benefits are expected to be realized
over a series of years.
years.
m The funds are invested in long- long-term
activities..
activities
m These are irreversible decisions.
decisions.
m They are strategic decisions.
decisions.
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x.
7. Identify
Performance
Investment
Review
Proposal

6. Implement Screen
Proposal proposal 2.

Õinal Evaluate
3.
Approval proposals
5. Õix
priorities
4.
Type of Capital Budgeting Decisions
Decisions::
m Accept-- Reject Decision
Accept

m Mutually Exclusive Decision

m Capital Rationing Decision


Methods of Capital Budgeting Decision

Methods

Time
Traditional
Adjusted
Method
Method

PB NPV IRR PI
ARR
Method Method Method Method
PB Method
m hen project generates equal (Constant) cash
inflow each year:
PB period = Investment
Constant Annual Cash Flow

m hen project generates unequal cash inflow


each year:
PB period= add up the cash inflows till the time
they become equal to the original investment.
Ñuestion for PB Method
m A project requires initial outlay of Rs.Rs.
80,,000 and is expected to generate cash
80
flow after tax but before depreciation
(CFAT) of Rs Rs.. 8000
8000,, Rs.
Rs. 20000
20000,, Rs
Rs..
x4000,, Rs
x4000 Rs.. 30000
30000,, Rs.
Rs. 32000 and Rs. Rs.
45000 during its 6 years life.
life. Calculate
the payback period.
period.
ARR (Average Rate of Return) Method
DThis method takes into account the earnings
expected from the investment over the whole life of
the project.
DAverage profit after tax and depreciation is
calculated and then it is divided by the total capital
outlay or total investment in the project.
DARR =
Total profits (After dep. & taxes) * x00
Average investment in the project * No. of years of
profits
Ñuestion for ARR Method
m A project requires an investment of Rs. 500,000
and has a scrap value of Rs. 20000 after five
years. It is expected to yield profits after
depreciation and taxes during the five years
amounting to Rs. 40000, Rs. 60000, Rs. 70000,
Rs. 50000 and Rs. 20000. Calculate the average
rate of return on the investment.
NPV Method
m Process of NPV Method:
x. Determine the appropriate rate of interest which would be a
minimum rate of return below which the investor consider
that it does not pay him to invest.
2. Compute the present value of total investment outlay.
3. Compute the present value of present value of total
investment proceeds i.e. cash inflows.
4. Calculate the net present value of each project by substracting
the present value of cash inflows from the present value of
cash outflows for each project.
5. Select the mutually exclusive projects.
Present Value
m Present Value of Re. x (PV) = x
n
(x r)
here ,
r = rate of interest/ discount rate
n= number of years

PV of all cash inflows = Ax A2 «. An


(x r) (x r)2 (x r)n
Ñuestion for NPV
m From the following information calculate the
net present value of the two project and
suggest which of the two projects should be
accepted assuming a discount rate of x0%.
Project X Project Y
Initial Investment Rs. 20000 Rs. 30000
Estimated life 5 Years 5 Years
Scrap Value Rs. x000 Rs. 2000

The Profits before depreciation and after taxes


(cash flows) are as follows:
Year 1 2 3 4 5
Project X 5000 x0000 x0000 3000 2000
Project Y 20000 x0000 5000 3000 2000
NPV of Project X
Year Cash Õlows Present Value of Present Value of
Re. 1 Net Cash Õlows
x 5000 .909 4545
2 x0000 .826 8260
3 x0000 .75x 75x0
4 3000 .683 2049
5 2000 .62x x242
5 (Scrap Value) x000 .62x (62x)
24227

Present Value of all cash inflows 24227


Less: Present Value of Initial Investment 20000
Net Present Value 4227
PI (Profitability Index) Method
m Also known as Benefit cost Ratio or
Desirability factor.
m It is the relationship between present value of
cash inflows and the present value of cash
outflows. Thus,
PI = Present value of Cash Inflows
Present Value of Cash Outflows
OR
NPV (Net Present Value)
Initial Cash Outlay
Ñuestion
The initial cash outlay of a project is Rs.
Rs. 50000
and it generates cash inflows of Rs
Rs.. 20000
20000,, Rs.
Rs.
25000 and Rs. Rs. x0000 in four years
years.. Using
present Value index method or profitability
index method, appraise profitability of the
proposed investment assuming x0 x0% % rate of
discount..
discount
(IRR)
Internal Rate of Return Method
m Process of IRR Method:
1. Calculate fake-
fake-pay Back period.
Õake pay back Period = Initial Cash Outflow
Average cash Inflow

2. Locate the closest figure to fake payback period in the


annuity table A-
A-2 against the row of number of years
of the project.

3. Õind NPV of the project at first discount rate located


above. If NPV is +ve
+ve,, higher discount rate should be
selected and vice-
vice-versa.
Õormula for IRR
m IRR =
Lower Discount rate + NPV at lower discount rate
NPV at lower discount rate ±
NPV at higher discount rate * Difference in
discount rate
Ñuestion for IRR
A firm is considering a project the details of which
are:
Particulars Amount
Investment 60500
Cash inflows Year x x4000
2 x6000
3 x8000
4 20000
5 25000