Chapter - 10 – Capital Budgeting Decisions
I. Introduction
II. Capital Budgeting Process
III. Techniques of Capital Budgeting Evaluation
a. Payback Period and Discounted Payback Period Method
b. Profitability Index Method
c. Net Present Value Method
d. Internal Rate of Return Method
IV. Capital Rationing
V. Practice Questions
I. Introduction
Capital budgeting is the most important decision for a financial manager. Since it involves buying
expensive assets for long term use, capital budgeting decisions may have a role to play in the future
success of the company. The right decision made by the process of capital budgeting will help the
company to maximize the shareholder value which is the primary goal of any business.
II. Capital Budgeting Process
The capital budgeting process includes identifying and then evaluating capital projects for the company.
Capital projects are the ones where the cash flows are received by the company over long period of time
which exceeds a year.
The capital budgeting process has the following four steps :-
Generation of Ideas :- The generation of good quality project ideas is the most important capital
budgeting step. Ideas can be generated from a number of sources like senior management, employees and
functional divisions or even from outside the company.
Analysis of Proposals :- The basis of accepting or rejecting a capital project is the project’s expected cash
flows in the future. Hence, all the project proposals are analyzed by forecasting their cash flows to
determine expected profitability of each project.
Creating the Corporate Capital Budgeting :- Once the profitable projects are shortlisted, they are
prioritized according to the available company resources, a timing of the cash flows of the project and the
overall strategic plan of the company. Some projects may be attractive on their own, but may not be a fit to
the overall strategy.
Monitoring and Post-Audit :- A follow up on all decisions is equally important in the capital budgeting
process. The analysts compare the actual results of the projects to the projected ones and the project
managers are responsible if the projections match or do not match the actual results. A post-audit to
recognize systematic errors in the cash flow forecasting process is also essential as the capital budgeting
process is as good as the inputs estimates into the forecasting model.
1
, III. Techniques of Capital Budgeting Evaluation
a. Payback Period and Discounted Payback Period Method
The payback is defined as the number of years required for the proposal’s cumulative cash inflow to be
equal to its cash outflow. In other words, the payback period is the length of time required to recover the
initial cost of the project. The payback period therefore, can be looked upon as the length of time required
for a proposal to ‘break even’ on its net investment.
Q.1.
A project requires an initial outflow of ₹ 1,00,000 which could generate an operating cash inflow of ₹
20,000 in a year. What will be the payback period?
Solution :-
Payback Period = 1,00,000 = 5 Years
20,000
Q.2.
A proposal requires a cash outflow of ₹ 40,000 and is expected to generate cash inflows as follows :-
Year 1 2 3 4 5
Inflow 16,000 12,000 8,000 4,000 4,000
Solution :-
Year Cash Inflow Cumulative Cash Inflow
1 16,000 16,000
2 12,000 28,000
3 8,000 36,000
4 4,000 40,000
5 4,000 44,000
Payback Period = 4 Years
2
, Q.3.
Minda Industries is envisaging an investment of ₹ 5,00,000 which will yield an annual cash inflow as
follows :-
Year 1 2 3 4 5 6
Cash Inflow ₹ 50,000 ₹ 1,00,000 ₹ 1,40,000 ₹ 2,00,000 ₹ 2,00,000 ₹ 1,25,000
Calculate the payback period.
Solution :-
Year Cash Inflow Cumulative Cash Inflow
1 50,000 50,000
2 1,00,000 1,50,000
3 1,40,000 2,90,000
4 2,00,000 4,90,000
5 2,00,000 6,90,000
6 1,25,000 8,15,000
Outflow 5,00,000
Recovered Upto 4 Yearth 4,90,000
Recovered in 5 Year
th 10,000
₹ 2,00,000 - 12 Months
₹ 10,000 - ? Months i.e. 0.6 Months i.e. 18 Days
Therefore, Payback Period = 4 Years and 18 Days
Q.4.
LMN Industries is looking for an investment of ₹ 15,00,000 which will yield an annual cash inflow as
follows :-
Year 1 2 3 4 5 6
Cash Inflow 2,50,000 3,00,000 7,40,000 2,40,000 2,00,000 1,25,000
Calculate the payback period.
Solution :-
Year Cash Inflow Cumulative Cash Inflow
1 2,50,000 2,50,000
2 3,00,000 5,50,000
3 7,40,000 12,90,000
4 2,40,000 15,30,000
5 2,00,000 17,30,000
6 1,25,000 18,55,000
Outflow 15,00,000
Recovered Upto 3rd Year 12,90,000
Recovered in 4th Year 2,10,000
₹ 2,40,000 - 12 Months
₹ 2,10,000 - ? Months i.e. 10.5 Months i.e. 10 Months and 15 Days
Therefore, Payback Period = 3 Years, 10 Months and 15 Days
3
I. Introduction
II. Capital Budgeting Process
III. Techniques of Capital Budgeting Evaluation
a. Payback Period and Discounted Payback Period Method
b. Profitability Index Method
c. Net Present Value Method
d. Internal Rate of Return Method
IV. Capital Rationing
V. Practice Questions
I. Introduction
Capital budgeting is the most important decision for a financial manager. Since it involves buying
expensive assets for long term use, capital budgeting decisions may have a role to play in the future
success of the company. The right decision made by the process of capital budgeting will help the
company to maximize the shareholder value which is the primary goal of any business.
II. Capital Budgeting Process
The capital budgeting process includes identifying and then evaluating capital projects for the company.
Capital projects are the ones where the cash flows are received by the company over long period of time
which exceeds a year.
The capital budgeting process has the following four steps :-
Generation of Ideas :- The generation of good quality project ideas is the most important capital
budgeting step. Ideas can be generated from a number of sources like senior management, employees and
functional divisions or even from outside the company.
Analysis of Proposals :- The basis of accepting or rejecting a capital project is the project’s expected cash
flows in the future. Hence, all the project proposals are analyzed by forecasting their cash flows to
determine expected profitability of each project.
Creating the Corporate Capital Budgeting :- Once the profitable projects are shortlisted, they are
prioritized according to the available company resources, a timing of the cash flows of the project and the
overall strategic plan of the company. Some projects may be attractive on their own, but may not be a fit to
the overall strategy.
Monitoring and Post-Audit :- A follow up on all decisions is equally important in the capital budgeting
process. The analysts compare the actual results of the projects to the projected ones and the project
managers are responsible if the projections match or do not match the actual results. A post-audit to
recognize systematic errors in the cash flow forecasting process is also essential as the capital budgeting
process is as good as the inputs estimates into the forecasting model.
1
, III. Techniques of Capital Budgeting Evaluation
a. Payback Period and Discounted Payback Period Method
The payback is defined as the number of years required for the proposal’s cumulative cash inflow to be
equal to its cash outflow. In other words, the payback period is the length of time required to recover the
initial cost of the project. The payback period therefore, can be looked upon as the length of time required
for a proposal to ‘break even’ on its net investment.
Q.1.
A project requires an initial outflow of ₹ 1,00,000 which could generate an operating cash inflow of ₹
20,000 in a year. What will be the payback period?
Solution :-
Payback Period = 1,00,000 = 5 Years
20,000
Q.2.
A proposal requires a cash outflow of ₹ 40,000 and is expected to generate cash inflows as follows :-
Year 1 2 3 4 5
Inflow 16,000 12,000 8,000 4,000 4,000
Solution :-
Year Cash Inflow Cumulative Cash Inflow
1 16,000 16,000
2 12,000 28,000
3 8,000 36,000
4 4,000 40,000
5 4,000 44,000
Payback Period = 4 Years
2
, Q.3.
Minda Industries is envisaging an investment of ₹ 5,00,000 which will yield an annual cash inflow as
follows :-
Year 1 2 3 4 5 6
Cash Inflow ₹ 50,000 ₹ 1,00,000 ₹ 1,40,000 ₹ 2,00,000 ₹ 2,00,000 ₹ 1,25,000
Calculate the payback period.
Solution :-
Year Cash Inflow Cumulative Cash Inflow
1 50,000 50,000
2 1,00,000 1,50,000
3 1,40,000 2,90,000
4 2,00,000 4,90,000
5 2,00,000 6,90,000
6 1,25,000 8,15,000
Outflow 5,00,000
Recovered Upto 4 Yearth 4,90,000
Recovered in 5 Year
th 10,000
₹ 2,00,000 - 12 Months
₹ 10,000 - ? Months i.e. 0.6 Months i.e. 18 Days
Therefore, Payback Period = 4 Years and 18 Days
Q.4.
LMN Industries is looking for an investment of ₹ 15,00,000 which will yield an annual cash inflow as
follows :-
Year 1 2 3 4 5 6
Cash Inflow 2,50,000 3,00,000 7,40,000 2,40,000 2,00,000 1,25,000
Calculate the payback period.
Solution :-
Year Cash Inflow Cumulative Cash Inflow
1 2,50,000 2,50,000
2 3,00,000 5,50,000
3 7,40,000 12,90,000
4 2,40,000 15,30,000
5 2,00,000 17,30,000
6 1,25,000 18,55,000
Outflow 15,00,000
Recovered Upto 3rd Year 12,90,000
Recovered in 4th Year 2,10,000
₹ 2,40,000 - 12 Months
₹ 2,10,000 - ? Months i.e. 10.5 Months i.e. 10 Months and 15 Days
Therefore, Payback Period = 3 Years, 10 Months and 15 Days
3
