Financial Management
Basics of Capital Budgeting
S. Maninder Singh (Roll No 16)
Vandana Kaushik (Roll No 13)
Krupa Adhi (Roll No 14)
Kareem Mohammed (Roll No 15)
Capital Budgeting
• Capital Budgeting is a project selection exercise
performed by the business enterprise.
• Capital budgeting uses the concept of present value and
future value to select the projects.
• Capital budgeting uses tools such as pay back period,
net present value, internal rate of return, to select
projects.
• It helps the company to choose the best project among
the options available for the management.
• It narrows down the risk involved in the project.
Methods of Capital Budgeting
• Payback Period
• Accounting Rate of Return
• Net Present Value
• Profitability Index
• Internal Rate of Return
Let us check the above methods in next few
slides.
Payback Period
Payback period is the time duration
required to recoup the investment
committed to a project.
Business enterprises following payback
period use "stipulated payback period",
which acts as a standard for screening the
project.
Payback Period
Eg: If a company has invested in a project x an amount of
1,00,000. Payback period will review each year as to how
much returns are received. If company receives as follows:
Year Return on investment (Annually)
1 30,000
2 50,000
3 20,000
4 40,000
Payback period = Initial Investment/Annual cash inflow
Here, company has received its investment back in 3 years.
Accounting Rate of Return
• Accounting rate of return is the rate arrived at by expressing the
average annual net profit (after tax) as given in the income
statement as a percentage of the total investment or average
investment.
• The accounting rate of return is based on accounting profits.
Accounting profits are different from the cash flows from a
project and hence, in many instances, accounting rate of return
might not be used as a project evaluation decision.
• Accounting rate of return does find a place in business decision
making when the returns expected are accounting profits and not
merely the cash flows.
Accounting Rate of Return
Eg: If there are two projects A & B. Average profit after tax and
average investment if given. Then we calculate ARR as follows:
ARR = Avg Annual profit after tax/Avg Investment * 100
Avg Annual profit = Total profit/No. of Yrs
Avg Investment = Half of (cost of project + Installation – Scrap)
Note: The project which has more ARR than other project has to
be selected as return on investment will be more.
Net Present Value (NPV)
Net present value of an investment/project
is the difference between present value of
cash inflows and cash outflows.
The present values of cash flows are
obtained at a discount rate equivalent to
the cost of capital.
Net Present Value (NPV)
Eg: If there are two projects say X & Y. If cash inflows and
cash outflow is given. We can calculate NPV.
NPV = PV of Cash flows/Cash outflows
Present Value (PV) is taken “Cost of capital”, which is the
percentage. If cost of capital is not given, then we take 10%.
Note: The project which has more NPV will have more
return on investment, therefore, we should select the
project which has more NPV.
Profitability Index (PI)
• Profitability ratio is otherwise referred to as Benefit/Cost ratio. This
is an extension of the Net Present Value Method.
• This is a relative valuation index and hence is comparable across
different types of projects requiring different quantum of initial
investments.
• Profitability index (PI) is the ratio of present value of cash inflows to
the cash outflows.
• PI = PV of Cash inflows/Cash outflows.
• The project which has more Profitability Index, will have more
return on investment. Hence we select the project having more PI.
Internal Rate Of Return (IRR)
• The internal rate of return method is also
known as the yield method.
• In this method, we should select two
percentages or two rates in such a way
that one present value must be more than
the cost of project and another amount
must be less than the cost of project.
Internal Rate Of Return (IRR)
• IRR is calculated separately for two or
more projects.
• The project which has more IRR, we select
that project because return on that project
will be more than other projects.
Importance of Capital Budgeting
• It reduces risk.
• It provides management a tool for
selecting right project.
• Return on investment can be carefully
planned.
• Investments can also be managed
properly.
Thank You
