“A wise company only invests in
projects and initiatives that exceed
the Cost of Capital”
The cost of capital is simply the
return expected by those who
FIRM
provide capital for the business
Equity
shares Preference Debentures
Shares
Should be
more than
Risk free Rate of Return on investments
returns
COST OF CAPITAL
Capital •
•
Equity
Preference shares
Structure
• Debts
• Retained Earnings
• Long term Assets
• Investments in
Financing Research &
Development,
Innovations,
Expansion projects
Examples of Capital Budgeting
• A truck manufacturer is considering investment in a new
plant.
• An airliner is planning to buy a fleet of jet aircrafts
• A commercial bank is thinking of an ambitious
computerization programme
• A pharmaceutical firm is evaluating a major R&D
programme.
Capital Expenditures Revenue Expenditures
• Also called as capital expense, or
CAPEX • Revenue expenditures include
• Capital Expenditures is money the expenses required to meet
that is spent to buy, repair, the ongoing operational costs of
update, or improve a fixed running a business
company asset, such as a • Major advertising campaign,
building, business, or salary payment, Creditors
equipment. payment, Deprecation, tax
payments etc
Capital budgeting
Capital budgeting is the planning & process used to
determine whether an organizations long term
investments such as new machinery , replacement
machinery ,new plants new products and research
development projects are worth the funding of cash
through the firms capitalization structure (Preference,
debt ,equity or retained earnings)
Capital budgeting
• ‘Capital’ and ‘budgeting.
• Capital : Need Long term assets/Projects
• Budgeting: Setting targets for Purchasing
Assets/Projects to ensure maximum profitability.
• ‘Capital Budgeting’ is firms decision to invest its
long term funds efficiently in the long term assets
in anticipation of maximum rate of return over a
series of years.
• Capital budgeting, also known as an “investment appraisal,” Capital
Investment or Capital Project
Capital budgeting
methods(Project Selection
Methods)
Capital budgeting methods
Traditional Modern or Discounted
Cash flow
Pay back period
Method Net present Value
Method
Profitability Index
Accounting Rate of return
Internal Rate of return
1. Pay back period Method
• The payback period measures the time that it takes to recoup the cost
of the investment.
• The shorter the payback period, the better the investment is
• It is a measure of project’s capital recovery, not profitability
Example
Mr. Sharma wants to install a separate seafood bar in
its pub. The seafood bar will cost 150,000 and has a 7-year life expected to
generate net annual earnings of 30,000 each year . Mr. Sharma requires a
payback period of 6 years or
less on all investments.
Should Mr. sharma invest in the seafood bar?
Solution
Year Cash inflow (Even)
0 150000
1 30,000.
2 30,000. 60000 Second year
3 30,000.
90000 Third year
4 30,000.
5 30,000. 120000 Fourth year
6 30,000 150000 Fifth year
7 30,000
Decision Rule
• Accept : PBP < Standard PBP
• Reject : PBP > Standard PBP
The longer the payback period of a project, the higher the risk.
Mr. Sharma wants to install a separate seafood bar in
its pub. The seafood bar will cost 150,000 and has a 7-year life expected to
generate net annual cash earning of for first year 30,000, second year 50000,
third year 58000, fourth year 56000 fifth & sixth year 55000 seventh year
58000 . Mr. Sharma requires a payback period of 6 years or
less on all investments.
Should MR sharma invest in the seafood bar?
Using cumulative cash flow method ( when cash inflow is
uneven)
= years before full recovery + (Unrecovered investment at
start of the year/Cash flow during that year)
Solution
Year Cash inflow (Even)
0 150000
1 30,000 30000
2 50000 80000 Second year
3 58000
138000 Third year
4 56000
5 55000 12000 out of 55000 Fourth year
6 55000
7 58000
• Pay back Period = Years before full recovery + (Unrecovered
investment at start of the year/Cash flow during that year)
• Years before full recovery = 3 years + 12000/55000
= 3.218 years
Which project a company should
select to start if each Project
requires initial investment or Rs
10000/-
Year Project A Project B
1 5000 1000
2 4000 2000
3 3000 3000
4 1000 4000
5 - 5000
Initial investment of each project is
30000/-
Project A 10500 8000 6000 7500 10500 12000
Project B 3000 6000 8000 12000 80000 81000
2. Accounting Rate of return
• Accounting Rate of return(ARR) =
Annual earning after Tax or PAT
-------------------------------------------------------------- X 100
Initial investment
2. Accounting Rate of return
• Average Rate of return(ARR) =
Average Annual earning after Tax or PAT
-------------------------------------------------------------- X 100
Average investment
• Average Investments(in Assets) =
Initial Investment – scrap value/2 + Installation charges+ additional
charges.
Scrap value: it is the approximated value at which an asset can be sold
in the open market after the expiration of its service life.
Scrap Value of an Asset = Cost of Asset – Total Depreciation
• Average Investments(in Projects) = Initial investment + year end
investment/2
Decision Rule
• Accept : ARR > Predetermined ARR or cut off
• Reject : ARR < Predetermined ARR or cut off
Disadvantages of Accounting
Rate of Return (ARR)
• This method does not consider the external factors which are also
affecting the profitability of the project.
• ARR is based on profits rather than cashflow. ARR method ignores the
cash flow from the investment.
• ARR ignores the time value of money.
• It is not useful to evaluate the projects where investment is made in
two or more installments at different times.
• The lifetime of multiple investments is not considered by the method.
But while calculating the average earnings, the lifetime of investments
are taken into account.
Time value of Money (Base of
Discounted cash flow Method)
• Money now is more valuable than money later on. Why?
Because you can use money to make more money!
• The time value of money (TVM) is the concept that a sum of money is worth
more now than the same sum will be at a future date due to its earnings
potential
Example of Compounding &
Discounting
• You invest 10000 for two years at 15% interest rate
How much will be the future value ?
• FV= PV(1+r)^n FV= 10000(1+.15)^2=13225
• To earn 20000 at 15 % discounting rate how much
investment should be made now? (Present Value)
• Pv= Fv/(1+r)^n Pv= 20000/(1+.15)^2=15122
• 1000
• FD = 10%/4 years
• Shares = 25%/2 years
• Total amount which u recd in futute = Future value after 4 years =
Fv=Pv(1+r)^n = FV= 1000(1+.1)^4 =1464.1
• Fv= 1000(1+.25)^2 = 1562.5
FD= Earrn 6000 @ 10% what amount u should invest now (after 4 years)
Share = Earn 8000 @25% what amount you should invest (now after 2 years )
• PV= FV/(1+r)^n
• Future value of money: Fv= Pv(1+r)^n (Compounding)
• Present Value = It is the value of a sum of money today.
• Present value of money= Pv=Fv/((1+r)^n). (Discounting)
• Future Value = It is the value of a sum of money in the
future.
Capital budgeting
methods(Project Selection
Methods)
Capital budgeting methods
Traditional or non Modern or Discounted
Discounted cash flow Cash flow Methods
methods
Pay back period Net present Value Method
Method
Profitability Index
Accounting Rate of return
Internal Rate of return
Net present Value Method
Net present Value = Cash inflow – Cash out flow
Cash inflow is Present Values you receive
Subtract the Present Values you pay is Cash out flow
The Net Present Value calculates is how much the investment is worth
in today's money
Internal Rate of Return
• IRR is a rate of return used in capital budgeting to measure and
compare the profitability of investments; the higher IRR, the more
desirable the project.
• A positive IRR means that a project or investment is expected to
return some value to the organization.
• A negative IRR is indicative of a more complicated cash flow stream,
no return to the organization on investments.
Internal Rate of Return: Formula
Cash flow should always be more than zero i.e. the project is giving us
more returns than the money invested today.
Profitability Index
Profitability Index = PV of Future Cash Flows / Initial
Investment
Decision Rules
• If the PI is greater than 1, the project generates value and the
company may want to proceed with the project.
• If the PI is less than 1, the project destroys value and the company
should not proceed with the project.
• If the PI is equal to 1, the project breaks even and the company is
indifferent between proceeding or not proceeding with the project.
