9. Capital Budgeting

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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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(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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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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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

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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


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


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

Date post:	03-Apr-2018
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9. Capital Budgeting

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