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Capital BudgetingCapital Budgeting
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Capital Budgeting
Process of planning capital expenditure to maximise
longterm profitability for the organisation
Capital budgeting refers to planning for capital assets
It helps in taking business decisions as: Investing in long term projects
Installing a machinery Creating capacities
Making inhouse, which is outsourced now
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Investment Appraisal Techniques
Traditional Techniques Payback Period Method
Accounting Rate of Return Method
Discounted Cash Flow Techniques (DCF) Net Present Value Method (NPV)
Internal Rate of Return Method (IRR)
Profitability Index Method
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Problem Pay back period
(When cash inflow is uniform)
An investment of Rs 40,000 in a machine is expected to
produce a cash inflow of Rs 8,000 p.a then
Payback period = 40,000 / 8,000 = 5 years
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Problem Pay back period
(Cash inflow in unequal)
Initial investment in a machine is Rs 50,000. The table
shows yearly cash inflow, what will be the payback
period.
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Annual Inflows (Rs) Rs
Year 1 10,000
Year 2 15,000
Year 3 20,000
Year 4 25,000
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Problem Pay back period
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Annual Inflows (Rs) Rs Cumulative inflows (Rs)
Year 1 10,000 10,000
Year 2 15,000 25,000
Year 3 20,000 45,000
Year 4 25,000 70,000
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Problem Pay back period
The initial cost of Rs 50,000 will be recovered between 3 rd
and 4th year.
By 3rd
year end Rs 45,000 will be recovered and balance Rs5,000 will be recovered between 3 rd and 4th year
= (5000 / 25000) = 1 / 5
Total money will be recovered in 3 1/5 years
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Problem Practice
Initial investment in two projects is Rs 1,00,000 and their
respective cash inflows is shown in the table. Help the
management to select between two projects.
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Year Project X (cash inflow) Project Y (cash inflow)
1 20,000 25,000
2 20,000 25,000
3 30,000 50,000
4 30,000 20,000
5 50,000 10,000
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Accounting rate of return
This method is also known as return on investment or
return on capital employed method
It measures the net profit arising from an investment inthers of percentage
Accounting rate of return
=(Avg annual profit after tax / Average Investment) x 100 Average Investment
=(Initial investment + Salvage value) / 2
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Problem - Accounting rate of return
The cost of a machine is Rs 80,000. It is expected to
have a scrap value of Rs 10,000 at the end of five year
period. It is estimated to generate a profit over life as:
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Year Net Profit (Rs)
Year 1 6,000
Year 2 26,000
Year 3 16,000
Year 4 1,000
Year 5 11,000
Total 60,000
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Problem - Accounting rate of return
ARR = (Avg annual profit / avg investment) x 100
Avg annual profit = (60,000 / 5) = 12,000
Avg investment = (80,000 + 10,000) / 2 = 45,000
ARR = (12,000 / 45,000) x 100 = 26.76 %
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Problem - Practice
ABC company has 3 options of buying a particular
machine, select the best one using ARR method
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m/c A m/c B m/c C
Cost of m/c 1,12,000 1,01,000 1,15,000
Salvage value 20,000 12,000 32,000
Life 6 years 8 years 4 years
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Problem - Practice
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Year m/c A m/c B m/c C
1 12,000 9,000 18,000
2 11,000 8,500 15,0003 10,000 8,200 12,500
4 9,000 7,800 10,000
5 8,000 7,500 -
6 7,000 7,000 -
7 - 6,000 -
8 - 5,000 -
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Net Present Value Method
The objective of the firm is to create wealth by using
existing and future resources
Net present value is obtained by discounting all cash
inflows and outflows attributable to investment
The method discounts net cash flow from an investment,
calculates rate of return and yield
If yield is positive, project is acceptable and if yield is
negative the project cannot repay for itself
The process of calculating present value is called
Discounting and factors are Discount factors
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Net Present Value Method
Discount factor
= 1
(1 + r)n
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Problem (NPV)
A firm can invest Rs 10,000 in a project with a life of 3
years. The projected cash inflow are: Year 1=Rs 4000,
Year 2= Rs 5000 and Year 3= Rs 4000. The cost of
capital is 10% p.a. Should the investment be made
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Problem Solution (NPV)
First calculate the discount factor
= 1
(1+r)n
Year 1 = 1 = 0.909
(1 + 10/100)1
Similarly year 2 = 0.826 and year 3 = 0.751
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Problem Solution (NPV)
Since the net present value is positive, investment can
be done
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Year Cash flow(Rs)
Discount factor Present Value(Rs)
0 1.00
1 4,000 0.909 3636
2 5,000 0.826 4130
3 4,000 0.751 3004
NPV = 770
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Problem
National Electronics Ltd, an electronics goods manufacturing
company manufactures large range of electronic goods. It has
under consideration two projects X and Y, each costing Rs
120 lakhs.
Cash flows for the two projects are given in table. Project X
has a life of 8 yrs and Y has a life of 6 yrs. Both will have a
salvage value of zero. The company is making profits and its
tax rate is 50%. The cost of capital is 15%.
Company follows straight line method of depreciation.
Compute the NPV of project X and Y
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Problem
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Year Net cash inflow (Project X) Net cash Inflow (Project Y)
1 25 40
2 35 603 45 80
4 65 50
5 65 30
6 55 20
7 35 -
8 15 -
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Problem - Solution
Project X
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End ofYear
CashFlow
Depreciation
15
2 35 15
3 45 15
4 65 15
5 65 15
6 55 15
7 35 15
8 15 15
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Problem - Solution
Project X
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End ofYear
CashFlow
Depr PBT
15 10
2 35 15 20
3 45 15 30
4 65 15 50
5 65 15 50
6 55 15 40
7 35 15 20
8 15 15 0
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Problem - Solution
Project X
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End ofYear
CashFlow
Depr PBT Tax
15 10 5
2 35 15 20 10
3 45 15 30 15
4 65 15 50 25
5 65 15 50 25
6 55 15 40 20
7 35 15 20 10
8 15 15 0 0
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Problem - Solution
Project X
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End ofYear
CashFlow
Depr PBT Tax PAT
15 10 5 5
2 35 15 20 10 10
3 45 15 30 15 15
4 65 15 50 25 25
5 65 15 50 25 25
6 55 15 40 20 20
7 35 15 20 10 10
8 15 15 0 0 0
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Problem - Solution
Project X
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End ofYear
CashFlow
Depr PBT Tax PAT Net CF= PAT + Depr
15 10 5 5
2 35 15 20 10 10 25
3 45 15 30 15 15 30
4 65 15 50 25 25 40
5 65 15 50 25 25 40
6 55 15 40 20 20 35
7 35 15 20 10 10 25
8 15 15 0 0 0 15
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Problem - Solution
Project X
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End ofYear
CashFlow
Depr PBT Tax PAT NetCF
Discountfactor
15 10 5 5
2 35 15 20 10 10 25 0.756
3 45 15 30 15 15 30 0.658
4 65 15 50 25 25 40 0.572
5 65 15 50 25 25 40 0.497
6 55 15 40 20 20 35 0.432
7 35 15 20 10 10 25 0.375
8 15 15 0 0 0 15 0.327
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Problem - Solution
Project X
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End ofYear
CashFlow
Depr PBT Tax PAT NetCF
DF PV
15 10 5 5 0.87 17.4
2 35 15 20 10 10 25 0.756 18.9
3 45 15 30 15 15 30 0.658 19.74
4 65 15 50 25 25 40 0.572 22.88
5 65 15 50 25 25 40 0.497 19.88
6 55 15 40 20 20 35 0.432 15.12
7 35 15 20 10 10 25 0.375 9.4
8 15 15 0 0 0 15 0.327 4.91
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Problem Solution (Project X)
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End ofYear CashFlow Depr PBT Tax PAT NetCF DF PV15 10 5 5 0.87 17.4
2 35 15 20 10 10 25 0.756 18.9
3 45 15 30 15 15 30 0.658 19.74
4 65 15 50 25 25 40 0.572 22.88
5 65 15 50 25 25 40 0.497 19.88
6 55 15 40 20 20 35 0.432 15.12
7 35 15 20 10 10 25 0.375 9.4
8 15 15 0 0 0 15 0.327 4.91P V of cash inflows 128.23
Less: Initial Investment 120
Net Present Value (NPV) 8.23
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Problem Solution (Project Y)
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End ofYear
CashFlow
Depr PBT Tax PAT NetCF
DF PV
20 20 10 10 0.87 26.1
2 60 20 40 20 20 40 0.756 30.24
3 80 20 60 30 30 50 0.658 32.9
4 50 20 30 15 15 35 0.572 20.02
5 30 20 10 5 5 25 0.497 12.43
6 20 20 0 0 0 20 0.432 8.64
P V of cash inflows 130.33
Less: Initial Investment 120
Net Present Value (NPV) 10.33