Capital Budgeting Techniques
Non-Discounted Cash Flow Techniques or Traditional
Techniques
Discounted Cash Flow Techniques or Modern Techniques
3 alternatives- Project A, Project B and Project C
Accepting or Rejecting
Non Discounted Cash Flow Techniques
1. Pay Back Period
2. Average Rate of Return
Pay Back Period
Investment
Returns from investment
Amount of time it takes to recover the cost of an
investment.
Rs.10 Cr =
Year Cash Flow
0 -1000000
1 300000
2 500000
3 150000
4 400000
5 500000
Pay Back Period of the project
Year Cash Flow Cumulative Cash
Flow
1 300000 300000
2 300000 800000
3 300000 950000
4 300000 1350000
5 300000 1850000
Investment – 1000000
In the 4th year Rs.50000 more to recover our investment
3 Years + 50000/400000 = 3.125 years
PBP 3 Years and 1.5 months
Ununiform Cash Flows – Uneven Cash Flows
Uniform Cash Flows – Even Cash Flows
PBP = Initial Investment / Cash Flow during the year
100000 / 300000 = 3.334 years
Standards
3 yrs
Accept if PBP >= Standard PBP
Else reject the project
Initial Investment = Rs.210000
Annual CFAT
1 – 80000
2 – 60000
3 – 60000
4 – 20000
Compute the Pay Back Period
3 years and 6 Months
PBP 3.5 years
Initial Cost = Rs.2000000
Annual Profits before tax = Rs.300000
Depreciation Rate = 12.5 % (SLM)
Tax Rate = 50%
Based on this compute PBP
Cash Flows
EBT (PBT) 300000
Less: Tax (50%) (150000)
Profit after Tax (EAT) 150000
Add: Depreciation 250000
CFAT 400000
Payback Period = 2000000 / 400000 = 5 Years
Accounting Rate of Return or Average Rate of Return
ARR = Average Annual Net Income / Investment
1. ARR on Annual Basis
1st Year, 2nd Year, 3rd Year ….. 5th Year
ARR =
Net Income of the Year / Investment in the
Beginning of the year
2. Total Investment Basis
ARR =
(Avg Annual Net Income / Initial Investment)*100
3. Average Investment
(Avg Annual Net Income / Average Investment)*100
Avg Investment = Investment / 2
Avg Investment =
½(Investment – Salvage Value) + Salvage Value +
Additional Working Capital
Problem - ARR
ST Ltd. is going to invest in a project a sum of
Rs. 3,00,000 having a life span of 3 years. Salvage value of
machine is Rs. 90,000. The profit before depreciation for
each year is Rs. 1,50,000. Compute ARR
Solution:
Year PBDT Dep PAT
Investment Investment
Beginning End
1 150000 70000 80000 300000 230000
2 150000 70000 80000 230000 160000
3 150000 70000 80000 160000 90000
Depreciation : SLM = 70000
1. ARR on Annual Basis
Net Income of the Year / Investment in the
beginning of the year
1st Year = (80000 / 300000)*100 = 26.67%
2nd Year = ((80000 / 230000)*100 = 34.78%
3rd Year = (80000 / 160000)*100 = 50%
Average ARR = (26.67+34.78+50)/3 = 37.15%
2. ARR on Total Investment Basis
(Average Net Income / Initial Investment)*100
Avg Net Income : (80000 + 80000 + 80000)/3
240000 / 3 = 80000
(80000/300000)*100 = 26.67%
3. ARR on Average Investment Basis
ARR = (Average Net Income / Avg Investment)*100
Avg Net Income = 80000
Avg Investment = ½(300000 – 90000) + 90000
= Rs.195000
ARR = (80000/195000)*100 = 41.02%
Standard ARR = 35%
Discounted Cash Flow Techniques
Time value of money – Future benefits –
Cash flows
Discount them
Net Present Value
Cash Outflow
Cash Inflow
Today Rs.100000
Future Benefits
Net Present Value:
𝐶1 𝐶2 𝐶3 𝐶𝑛
𝑁𝑃𝑉 = ( + + + ⋯ + )−𝐼
(1 + 𝑘)1 (1 + 𝑘)2 (1 + 𝑘)3 (1 + 𝑘 )𝑛
𝑛
𝐶𝑡
𝑁𝑃𝑉 = ∑ −𝐼
(1 + 𝑘)𝑡
𝑡=1
NPV is positive – Accept
NPV is Negative – Rejecting
Problem:
Compute the net present value for a project with a net
investment of Rs. 1, 00,000 and net cash flows year one
is Rs.55,000; for year two is Rs.80,000 and for year three
is Rs.15,000. Further, the company’s cost of capital is
10%?
Solution:
Year Cash Flow PVIF @ 10 % Discounted
Cash Flow
0 (100000) 1.000 (100000)
1 55000 0.909 49995
2 55000 0.826 45430
3 55000 0.751 41305
Gross Present Value 136730
Less: Investment 100000
Net Present Value 0
= 1/1.10 = 0.909
= 1/(1.10)^2=0.8264
1 years – 55000, 2 -55000, 3-55000
55000 with PVFA for 3 years @ 10%
55000 * 2.4869 = PV of Cash Inflows 136780 – 100000
36780 as NPV
NPV is positive hence project can be accepted
NPV = 55000/(1.10) + 80000/(1.10)^2 + 15000/(1.10)^3 –
100000
Profitability Index:
PV of Cash Inflows / PV of Cash Outflows
127340/100000 = 1.27
PI > 1 Accept
PI < 1 Reject
NPV = PV Cash Inflow – Investment
Even Cash Flow and Uneven Cash Flow
Internal Rate of Return
Even Cash Flows
PV LR = 10000 Investmest 5000, NPV at LD = 5000 = 5000/2000 = 2.5
PV HR = 8000 NPV at HD = 3000 = 10000/8000 = 1.25
Trial and Error Method
Solution
Investment 136000
DR = 16% 12% 14% 16% 18% 20%
NPV = 2000 400 -200 -500 -1000 -2000
IRR
Positive NPV IRR Negative NPV
0
12% 13% 14%
