MANAGERIAL ECONOMICS - VI

Capital Budgeting
 Finance Function
• According to B. O. Wheeler, Financial
Management is concerned with
– the acquisition and utilisation of capital funds in
meeting the financial needs and overall objectives
of a business enterprise
• Thus the primary function of finance is to
acquire capital funds and put them for proper
utilization, with which the firm’s objectives are
fulfilled
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 Finance Function
• Financial Management can be broken down in
to three major decisions or functions of
finance.
• They are
– (i) the investment decision,
– (ii) the financing decision and
– (iii) the dividend policy decision.

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 Investment Decision
• The investment decision relates to the selection of
assets in which funds will be invested by a firm
• The assets as per their duration of benefits, can be
categorized into two groups
– (i) long-term assets which yield a return over a period of time
in future
– (ii) short-term or current assents which in the normal course
of business are convertible into cash usually with in a year
• The investment in
– long-term assets is popularly known as capital budgeting and
– in short-term assets, working capital management

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 Capital Budgeting
• The long-term investment may relate to
acquisition of new asset or replacement of old
assets
• Whether an asset will be accepted or not will
depend upon
• the relative benefits and returns against the
standard rate of returns
• risk and uncertainty

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 Capital Budgeting
• main elements of the capital budgeting
decision depends on
• (i) The total assets and their composition
• (ii) The business risk complexion of the firm,
and
• (iii) concept and measurement of the cost of
capital

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 Capital Budgeting
• Capital budgeting is the process of making investment decision in
long-term assets or course of action
• These expenditures are related to the acquisition & improvement
of fixes assets
• Capital budgeting is the planning of expenditure and the benefit,
which spread over a number of years
• It is the process of deciding whether or not to invest in a particular
project, as the investment possibilities may not be rewarding
• The project worth shall be in-terms of cost and benefits
• The benefits are the expected cash inflows from the project, which
are discounted against a standard, generally the cost of capital

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 Capital Budgeting Process
• Project generation
• Project evaluation
• Project selection
• Project execution

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 Capital budgeting Techniques
• The capital budgeting appraisal methods are techniques
of evaluation of investment proposal will help the
company to decide upon the desirability of an
investment proposal depending upon their; relative
income generating capacity and rank them in order of
their desirability
• The most widely accepted techniques used in estimating
the cost-returns of investment projects can be grouped
under two categories.
• Traditional methods
• Discounted Cash flow methods
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 Traditional Methods
Pay-back period method
Cash outlay (or) original cost of project

Pay-back period = ---------------------------------------

Annual cash inflow

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 Pay-back period method – Exercise(1)

• A Project requires an Initial Investment of Rs.

1,20,000 and yields annual cash inflow of
Rs.12,000. Find out the payback period

• 1,20,000 / 12, 000 = 10 years

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 Pay-back period method – Exercise(2)
• A Project Requires an Initial Investment of Rs. 1,40,000
and yields annual cash inflows of Rs.
10,20,30,40,50,60,70 thousands respectively for 7 years .
What is the payback period
Year Cash in Cumulative
The table
Flowshows
(Rs) that
CF in 4 years Rs.100 thou is recovered and the balance
(Rs)
to be recovered is Rs.40 thou. But by the end of 5th year the total
recovery
1 10 will be Rs.150
10 thou, which is more than the original
investment of Rs.140 thou. Therefore the recovery is between 4th and 5th
2 20 30
year.
3 30 60 40
Payback
4 40Period is 4100
years + -----

550 50 150
4 . 80 years

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 Traditional Methods
Accounting (or) Average rate of return method (ARR)
Average net income after taxes
ARR= ----------------------------------------------- X 100
Average Investment
Total Income after Taxes
Average net income after taxes = -------------------------------
No. Of Years
Total Investment
Average investment = ----------------------
2

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 Average rate of return method (ARR)
• The working results of Two machines are given below
Machine (X) Machine (Y)
Rs. Rs.
Cost of Machine 45000 45000
Sales per Year 1,00,000 80,000
Total Cost per Year 36,000 30,000
(Excluding 22,500 15,000
Depreciation)
Expected Life of 2 years 3 years
Machine

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Average rate of return method (ARR)
Machine (X) Rs. Machine (Y) Rs.
• Solution Sales per Year 1,00,000 80,000
Less - Cost per Year 36,000 30,000
EBDT 64,000 50,000
Less – Depreciation 22,500 15,000
Net Profit 41,500 35,000
Average Income 41,500 35,000
Average Investment 22,500 15,000
Average Income
ARR = ---------------------------- X 100
Average Investment
Machine X 41,500
--------- X 100 = 184%
22,500
Machine Y 35,000
--------- X 100 = 233%
15,000
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 Discounted cash flow methods
Net present value method (NPV)
• According to Ezra Solomon –
– It is a present value of future returns,
– discounted at the required rate of return
– minus the present value of the cost of the investment
• NPV is the difference between the present value of cash inflows
of a project and the initial cost of the project
• According the NPV technique,
– A project will be selected whose NPV is positive or above zero
– If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence should
not be selected
– If there are more than one project with positive NPV’s the project is
selected whose NPV is the highest

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 Calculation of NPV
• NPV= Present value of cash inflows – investment.
C1 C2 C3 Cn
• NPV = ------ + ------- + -------- + -------
(1+K)
Co- investment , C1, C2, C3… Cn= cash inflows in
different years.
K= Cost of the Capital (or) Discounting rate
D= Years.

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 Calculation of NPV - Exercise
• A choice is to be made between the two competing proposals
which require an equal investment of Rs. 50000 and are
expected to generate net cash flows as under
Years Project – A Project – B
1 25,000 10,000
2 15,000 12,000
3 10,000 18,000
4 NIL 25,000
5 12,000 8,000
6 6,000 4,000
• Cost of capital of the project is 10%

Year 1 2 3 4 5 6
PV factor 0.909 0.826 0.751 0.683 0.621 0.564
@10%
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 Calculation of NPV - Solution
• Comparative Statement of NPV
Year PV Factor Project - A Project - B
@10%
Cash Inflow Present Value Cash Inflow Present Value
1 0.909 25,000 22,725 10,000 9,090
2 0.826 15,000 12,390 12,000 9,912
3 0.751 10,000 7,510 18,000 13,518
4 0.683 NIL NIL 25,000 17.075
5 0.621 12,000 7,452 8,000 4,968
6 0.564 6,000 3.384 4,000 2,256
Total Present Value : 53,461 56,819
Less : Initial Investment 50,000 50,000
Net Present Value 3,461 6,819

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 Discounted cash flow methods
• Internal Rate of Return Method (IRR)
• The IRR for an investment proposal is that discount
rate which equates the present value of cash
inflows with the present value of cash out flows of
an investment
• if the IRR is more than Required Rate of Return
(RRR) then the project is accepted else rejected.
• In case of more than one project with IRR more
than RRR, the one, which gives the highest IRR, is
selected
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 Calculation of IRR
• The IRR is not a predetermine rate, rather it is to be trial and error method
• It implies that one has to start with a discounting rate to calculate the present value of cash
inflows
• If the obtained present value is higher than the initial cost of the project one has to try with a
higher rate
• if the present value of expected cash inflows obtained is lower than the present value of cash
flow , lower rate is to be taken up
• The process is continued till the net present value becomes Zero
• As this discount rate is determined internally, this method is called internal rate of return
method. 
• P1 - Q
• IRR = L + --------- X D
• P1 –P2
•  
• L- Lower discount rate , P1 - Present value of cash inflows at lower rate.
• P2 - Present value of cash inflows at higher rate , Q- Actual investment
• D- Difference in Discount rates.

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 Calculation of IRR - Exercise
• A company is considering purchase of machinery
which costs Rs. 8.00 lac and has an estimated life
of 10 years. The machine will generate additional
sales of Rs. 4.00 lac per year , while increased
costs and maintenance will be Rs. 1.00 lac per
year. The cost of the machine is depreciated on a
straight line and has no salvage value at eh end
of 10 years life. The company has a cost of capital
of 12% and a corporate tax rate of 40%.
• Calculate IRR

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 Calculation of IRR – Solution
Step – 1 : Calculation of Annual Cash Flows Step - 2 : Payback Period

Sales : 4,00,000 Original Investment

Less : Cost and Maintenance : 1,00,000 PBP = ---------------------------
EBDT : 3,00,000 Annual Cash flows
Less : Depreciation : 80,000 8,00,000
EBT : 2,20,000 = --------------- = 3.77 years
Less : Taxes : 88,000 2,12,000
EAT : 1,32,000
Add : Depreciation : 80,000
Annual Cash Inflows : 2,12,000

Step – 3 : IRR Calculation

Expected Payback Period is 3.77 years , Using the PV Table 3.77 years lies in
between 23% (3.799 years) and 24% (3.682 years)
PV of Cash in flows at 23% = 2,12,000 X 3.799 = 8,05,388
PV of Cash in flows at 24% = 2,12,000 X 3.682 = 7,80,584
Calculation of IRR P1 – Q
= L + --------- X D = 23% +
P1 –P2 805388 - 800000
= 23 + 0.22 = 23.22 % ----------------------
805388 - 780584
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 Discounted cash flow methods
• Probability Index Method (PI)
• The method is also called benefit cost ratio
• This method is obtained with a slight modification of the NPV method
• To calculate PI, the present value of cash inflows are divide by the present value of
cash out flows
• NPV is a absolute measure, the PI is a relative measure.
•  It the PI is more than one (>1), the proposal is accepted else rejected.
• If there are more than one investment proposal with more than one PI the one
with the highest PI will be selected
• This method is more useful incase of projects with different cash outlays cash
outlays and hence is superior to the NPV method.
• The formula for PI is
Present Value of Future Cash Inflow
• Probability index = ------------------------------------------------
Investment

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 Calculation of PI - Exercise
• A company is considering purchase of machinery
which costs Rs. 8.00 lac and has an estimated life
of 10 years. The machine will generate additional
sales of Rs. 4.00 lac per year , while increased
costs and maintenance will be Rs. 1.00 lac per
year. The cost of the machine is depreciated on a
straight line and has no salvage value at eh end
of 10 years life. The company has a cost of capital
of 12% and a corporate tax rate of 40%.
• Calculate Profitability Index

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 PI Index
Present Value of Future Cash Inflow
Probability index = ---------------------------------------
Investment
PV of Cash in flows at 23% = 2,12,000 X 3.799 = 8,05,388
-------------
8,00,000
= 1.006735

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 Thank you

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