Capital Budgeting Techniques, Accountancy and Financial management Video Lecture | Accountancy and Financial Management - B Com

Hi there, this is Imran here in this
video you would learn about return on
investment techniques such as net
present value internal rate of return
profitability index and payback period
these are also called as Capital
budgeting techniques the knowledge that
you would acquire by learning capital
budgeting techniques would be helpful
for you in project management program
management financial management and for
students who are attending and via tasks
if you're preparing for PMP or prince2
it is very important for you to learn
the Capital budgeting techniques because
you may get a couple of questions in
exams that you may need to answer with
respect to decisions you make to choose
between different projects and if you
are a project manager and if you are not
aware of capital budgeting techniques
then I would say you must learn the
capital budgeting techniques and the
recently it could help you to make
informed decisions when you're faced
with challenges with respect to the
financial viability and business
justification of projects capital
budgeting techniques fall under the
branch of financial management let me
give you a brief overview of where does
the capital budgeting technique fit into
under financial management the financial
management is primarily divided into 201
corporate finance to account in your
control these are further divided into
sub functions each function is a big
subject in itself and would take hours
if not days to learn about each function
and our focus would be on capital
budgeting, the reason why
I am showing you the financial
management overview is that it would
help you to understand where exactly the
capital budgeting technique fit into
under financial management and if an
organization decides to undertake a
project it could usually do two studies
one is technical feasibility and other
is finish survival
if the project is not technically
feasible then there is no point in going
ahead with the project and if the
project is technically feasible and then
the organization's would conduct
financial viability for the projects
with the help of Capital budgeting okay
so the point is what exactly is capital
budgeting technique
capital budgeting technique is a
planning process it determines whether
it is worth to take our invest
organisations capsule into projects and
it always works for the benefit of the
firm by increasing its financial value
and before we get started to learn about
capital budgeting techniques it is very
important for you to learn among the
terms discounted cash flow and non
discounted cash flow so the question is
what is discounted cash flow and to
explain this you must first understand
the time has a money value discounted
cash flow takes the time value of money
into consideration for example the money
in hand today it invested in the bank
will earn let's say 6% per annum
so this six percent can be considered as
a discounted cash flow and you need to
remember one thing it's not only about
the interest rate it could also be the
rate of return that an organization gets
back if it invests the money in a
business which could earn more than the
interest rate and let's say 8% rate of
return is what we are getting by
investing the capital in a business then
this 8% rate of return should be
considered as a discounted cash flow and
this discounted cash flow is also called
as opportunity cost of capital or
sometimes it is referred as cost of
capture and now let's move on to non
discounted cash flow now this is simple
it does not take time value of money
into consideration so therefore the
interest or the rate of
Britain is not taken into consideration
now let's see what is opportunity cost
of cats
what is opportunity cost of capital
opportunity cost of capital is something
that you would give up in order to get
something else let me ask you this
question
what do you think is the opportunity
cost for me for making this video if I'm
not making this video for you then I
would be spending this I'm going out
with my friends or I would be spending
time with my one-and-a-half here please
so the opportunity cost of making this
video is the time lost spending with my
kid or with my friends and it applies to
everyone even you watching this video if
you're not watching this video then you
would be doing something else and the
opportunity costs for you would be that
something else and then the big question
comes why do people let go the
opportunity cost the reason is because
people think rational meaning you weigh
the pros and cons of all mutually
exclusive alternatives available you
would choose the best alternative
available at that point in time because
people expect to achieve greater
benefits choosing one alternative over
the other mutually exclusive opportunity
discounted cash flow is nothing but the
opportunity cost of capital so when I
say this houndred
cash flow it also means that I'm
referring to the opportunity cost of
capital or just say cost attached now
let's look at these capital budgeting
methods a net present value internal
rate of return profitability index these
capsule budgeting techniques would
always consider the discounted cash flow
without taking into consideration the
opportunity cost of capsule or the
discounted cash flow we cannot calculate
the net present value or internal rate
of return or profitable limits however
payback period the opportunity cost of
capsule is an optional mostly when
calculating payback period the
discounted cash flow is not considered
now let's look at the future value
present value let's understand the
relationship between future value of
money in present value for example let's
say you have 100 dollars in hand today
then what would be the future value of
that hundred dollars after one year
similarly if you're going to get $100
after one year for sure then what is the
present value of that hundred dollars
now you should be able to calculate the
future value or the present value if one
of the two information is available to
us we can calculate using the formula FV
is equal to P V multiplied by 1 plus K
whole power M K in this formula is the
discount rate in other words it is also
the opportunity cost and n is the number
of years now let's look at calculating
the future value and present value with
some examples let's first look at
calculating the future value if you have
$100 and if you invest that money in a
bank today and Bank promised you who
give you 8 percent per annum interest
what would be the future value of that
hundred dollars after first year fifth
year and 15 Q now here $100 is the
present value of the capsule and 8%
is the opportunity cost of capsule now
8% means 8 500 that is equal to 0.08 and
1 plus K here is 1 plus 0.08 that is 1
point zero eight now you can see this on
the screen here 1 plus K value K value
and present run now let's use the
formula and calculate the future value
moons now that we know the present value
1 plus K value and the N value it's easy
to calculate the future value future
value after 1 year is $100 multiplied by
1 point 0 H to the power of 1 and that
gives you 108 dollars in future value
after five years is $100 multiplied by 1
point zero eight to the power of five
and if you do the calculations it will
give you one hundred and forty six
dollars and similarly we can calculate
the future value 100 dollars for any
period of time using the formula it
could be for 15 years or any number of
years and for 15 years we are getting
the value is three hundred and seventeen
dollars now I would request you after
you watch this video come back to the
video again pause the video on the
screen take a pen and paper in hand and
do the calculations this would help you
to get prepared for the examinations
and do this for all the examples in this
video that I show for calculations now
let's look at how to calculate the
present value
let's say you have three scenarios where
you are going to get hundred dollars
after one year five years in fifteen
years then what would be the value of
one hundred dollars today now we have
the formula through which we can
calculate the future value we would use
the same formula to calculate the
present value the formula is present
value is equal to future value divided
by one plus K to the power of n here the
future value is $100 and the opportunity
cost of capsule is given as eight
dollars eight percent sorry now using
the formula we can calculate the present
value the present value of $100 to be
received after one year would be 100
divided by one point zero eight and that
would give you 93 dollars
and similarly we can calculate the
present value of $100 to be received
after five years or 15 years and for
that matter any period of time as long
as we know the future value in the
discount rates now on the screen I've
just done the calculations for the
present value for present value for one
year present value for five years
present value for 15 years now you can
just pause the screen and you can do the
calculations or you can come back and do
the calculations now that we have
learned how to calculate the present
value and future value it is just a
cakewalk for you to calculate the net
present value and before we learn how to
calculate the net present value let's
look at the few important points that we
need to keep in mind and remember in
order to calculate the net present value
net present value is determined by
subtracting present value of all cash
outflows from the present value of all
cash inflows meaning you would need to
take into consideration all the cash
inflows for a project and calculate
their present value and we need to sum
up all the present values and from the
sum of all present values you will need
to subtract the cash outflows and that
would give you the net present value I
know you're confused a little bit here
but do not worry this would become clear
when you look at an example in the next
coming slide and this is very important
to remember once we calculate the net
present value it should always be
positive for the project
being accepted if the net present value
is negative that means the project is
not enhancing a viable now let's get
into the nitty-gritty of calculating the
net present value here is an example a
sum of $400,000 is invested in an IT
project and below we have the cash
inflows to the project up to a period of
five years and the opportunity cost of
capsule is given as eight-person all we
need to do is calculate the net present
value and bases the net present value
decide if the project is worth
undertaking or do we need to reject the
project see in this example the $400,000
is spent out right initially fit is
called a cash outflow and coming to the
revenue from the project at the end of
first year the project generates $70,000
and at the end of second year the
project generous $120,000 and at the end
of third year it generates one $40,000
and for fourth year it generates one
$40,000 and at the end of fifth year it
generates $40,000 now that we know how
to calculate the present value we need
to calculate the present value for year
one that is for $70,000 in for year two
that is 120 thousand dollars in for a
3-1 $40,000 and year for again one
$40,000 in for efi same $40,000 now once
we get the present value for the EO one
two three four five we need to sum them
up and subscribe to $400,000 and that
gives us the net present value
information and if the net present value
is positive you should accept the
project and if it is negative you should
check the hose I have done the
calculations here I got all the present
value details for all the ears and when
I sum them up I got the total value of
all caps in close as four hundred eight
thousand nine hundred and fifty nine
dollars and for us to calculate the net
present value we have to subtract the
cash outflows from the cash inflation
remember the cash outflows for this
example was four hundred thousand
dollars that was spent initially so that
becomes cash outflow now that we have
the cash inflow for all the cash inflow
of all present values which is four
hundred eight thousand nine fifty nine
dollars we need to subtract four hundred
thousand dollars from this announce and
that would give us eight thousand nine
hundred and fifty nine dollars and since
this net present value is positive this
project in the accepted now let's look
at another example the same example I
would say what we have done is we have
just changed the opportunity cost of the
capsule from eight percent to fifteen
percent now this was eight percent in
the previous example and this is fifteen
version in this example and let's see if
the project is still financially viable
and won't remain the same the time
period remains the same it's only just
the opportunity cost that has changed
from 8 percent per annum to 15 percent
per annum now let's look if this project
is still financially viable or not I've
done the calculations on the screen we
know the formula for present value now
using the present value formula we would
calculate the present value for year 1
year 2 year 3 year 4 and year 5 that
uses these values here on the screen now
if I sum them up I get three hundred and
forty three thousand five hundred and
ninety one dollars and the cash outflow
which we've done initially is four
hundred thousand dollars now if I
subtract four hundred thousand dollars
from three hundred and forty three five
ninety one dollars I get the net present
value as
- fifty-six thousand four hundred and
eight dollars and the net present value
has become negative here so we should
not accept this project because this
project is not financially viable now
look at the note on this page below
though we have the same inflow and
outflow of cash when compared to the
previous example the net present value
has changed from positive to negative
when the opportunity costs of captain
has increased from eight percent fifteen
version now what does they say they say
that net present value is very much
dependent on the discount rate or the
opportunity cost of capsule now with
this example we complete the net present
value and now let's move on to the
eternal rate of return calculations now
generally speaking the higher the
project's internal rate of return the
better and it's more desirable to
undertake the project's internal rate of
return is the calculations by which we
would be able to tell how much rate of
return are we getting from the project
so higher the internal rate of return
the better for the project IRR which is
also called as internal rate of return
can also be used through ranked projects
now IRR is nothing but the discount rate
at which the net present value becomes
sheer I'll make it clear in a moment
let's say you have to choose between two
projects where the net present value of
the project is say and you are asked to
choose one of the projects then you
would need to choose the project which
has the higher internal rate of return
now you may get a couple of questions in
exams asking you to choose between two
different projects they may give you the
net present value details internal rate
of return it is and they would ask you
to choose what project among the three
projects then you would need to choose
the project which has highest internal
rate of return and remember this point
the project's internal rate of return
should be greater than
because the project's internal rate of
return is greater than opportunity cost
you should always accept the cross and
if the project's internal rate of return
is less than the opportunity cost
you should reject the project because if
the internal rate of return is less than
opportunity cost the project is not
financially viable and it is better to
invest the money in a different project
where we have a better instrument now
let's look at the relationship between
internal rate of return opportunity cost
and the net present value if IRR is
greater than the opportunity cost then
the net present value will always be
positive and if IRR is less than
opportunity cost then the net present
value will always be negative as said
earlier as long as the net present value
is positive the project is financially
viable in the moment the net present
value goes to negative the project is
not energy divided right now let's see
an example and calculate the internal
rate of return for a project the project
let's say the project cost is thousand
dollars in the panel span is five years
and it generates $200 at the end of year
one $300 at the end of year two $300 at
the end of year three $400 in the year
four and $500 in the vo hi the
opportunity cost is given here as twelve
receipts and now we are asked to
calculate if the project is financially
viable or not faces the internal riddle
now let's look at the solution first we
need to calculate the net present value
of the project then adjust the
opportunity cost until we get the net
present value regime the opportunity
cost at which the net present value
becomes 0 would be the internal rate of
return so we will tackle this solution
with the following in mind if the NPV
positive that means at 12% opportunity
cost the net present value is positive
so we need to increase the opportunity
cost above to a person and see where
does the net present value become 0
once we find out the rate at which the
net present value becomes 0 we need to
consider that rate has insulin later now
I will show you how the calculations are
done let's see the excel sheet which is
attached in this bitch and you get a
period as to how the internal rate of
return is calculated so we know the
formula to calculate the present value
and using the formula I have just
automated this in the Excel report and
let me show you how it is done now we
have all the future values here for year
1 year 3 a 3 year 4 5 we know what the
discounted rate is its whole person
that's given in the example here I have
calculated the present value for year 1
year 2 year 3 year 4 and year 5 now I
got cash inflow for all present values
as 1169 dollars I know the cash outflow
is $1,000 so I calculated the net
present value which is 1 system in
dollars now for us to calculate the
internal rate of return what we are
doing is we need to adjust the discount
rate as I said the internal rate of
return is nothing but the discount rate
at which the net present value becomes 0
now at 12% then at present values 1
system in dollars so let's increase the
12% to 13% and let's see what would be
the net present value so it dropped to
136 let's look at code in version 321 or
$5
let's see 15 versus $75 so net present
value is dropping as we increase the
discount rate now let's look at 17%
laters sorry 17% is harmful it's $18
let's see 18%
so it went to negative fruit should be
in between 70 and 80 so let's look at
some in point five right it's five point
five so let's see seventeen point six
it's two point eight 17.7 now it is
close to zero zero point two four if I
make it seven point eight invention it
so at 17 point seven percent discount
rate then it present value becomes zero
now this would be the internal rate of
return because at seventeen percent
discount rate the net present value have
become zero so this would be considered
as the internal rate of now let's go on
and let's look at the profitability
index before we move on to profitability
next let's just look at this twelve
percent discount rate the net present
value is one season in dollars in at
17.7% let us become zero point two four
close to zero so the IRR is seventeen /
17 point seven percent for this project
which is a pretty good internal rate of
return let's get on to profitability
next what is profitability index it is
also again our decision-making criteria
to choose projects now it is a ratio by
which we can tell how many dollars can
be earned in return for each dollar
spends for you to be able to calculate
the profitability index you should know
the present value of all cash inflows
and cash outflows and then divide the
cash inflows with cash outflows and you
should be able to get the profitable day
image I will show you how to calculate
the profitability index in an example
now you need to remember this you should
accept the project if the profitability
index is greater than one and you should
reject if it is less than one again the
higher the profitability
for a project it is more desirable to
undertake the project and let's look at
the relationship between net present
value and profitable index if net
present value is greater than 0 then the
profitability index is greater than 1 if
the net present value is less than 0
then the profitability index is less
than 1 and remember this point this is
very important
profitability index can never be
negative it would always be greater than
0
the reason being is not subtracting the
cash outflows from hash enclosure we're
just dividing the cash inflows in the
cash outflows so therefore the
profitability index can never be
negative it would always be greater than
zero and the ideal profitability net
should always be greater than one and
anything less than one for profitability
index the project is not financially
viable now let's look at the example for
profitability index in this example an
investment of $25,000 is invested in a
project which is giving you a series of
cash inflows that's here it's giving you
$5,000 at the end of year $100,000
enough a to $10,000 at end of year 3
again $10,000 at end of year four and
$3,000 in the VF 5 and if the required
rate of return is 12 percent what is the
profitability index the profitability
index is calculated by dividing the
present value of all cash inflows by
present value of all cash outflows so
first we need to calculate the present
value of all years all the years here
and sum them up and divide it with the
cash outflow let's see the excel sheet
in which I have automated using the
formula to calculate a profitable
English all right we know the formula
for present value
now we know all the future values you
know the years of one two three four
five I know the discount rate is 12%
I have automated the formula here so we
calculate the present value for you one
calculate the present value for here to
present value for year three per year
for input year five I got the individual
present values for year one two three
four five
now if I sum them up I get twenty six
thousand eight hundred fourteen dollars
now in this example the cash inflow for
all the present values is twenty-six
thousand eight hundred and fourteen
dollars but we have been given twenty
five thousand dollars as cash outflows
all we need to do is divide twenty six
thousand eight hundred fourteen dollars
with twenty five thousand dollars and
that would give you the profitable
business here is the profitability on
points is M so the profitability index
for this project is one point zero seven
as I said earlier if the profitability
index is greater than one we can accept
the project now if we change the
profitability index the discount rate
the profit it would affect the
profitable index if I increase this it
becomes third one four zero four see as
I increase the opportunity cost the
profitability index went down so we have
a direct relationship between the
discount rate and the property the
difference that's about the
profitability index now let's move on to
the payback period now what is payback
period it is the length of time required
for an investment to recover its initial
cash or growth for example if you invest
thousand dollars in a project and it
generates five hundred dollars every
year for a period of five years then
what is the payback period I would say
the payback period would be three years
because
it takes two years to recover the
thousand dollars we invested in the
project initiative so the payback period
is two years and generally speaking
organizations do not consider time value
of money in a back idiot and again it
depends on the organization's you're
working for however if you want to take
the time value of money into
consideration for calculating payback
period you may do so and here is the
important point good projects will not
only have a good internal rate of return
or the net present length but they also
have early payback periods so if you've
given a couple of projects with good
internal rate of return and in a present
value choose the project which has early
payback period if the internal rate of
return hundred present values are the
same for the projects you should go with
the project that has the early day back
period now let's look at the example
that's on the screen and I think with
that this video would come to an end in
this example an investment of $25,000 in
IT projects you a series of cash inflows
has described below it in the first year
$5,000 in the second year $9,000 in the
third and fourth years $10,000 and in
the fifth year it gives you $3,000 so
what would be the payback period for
this project the solution is simple we
need to calculate the time it takes to
earn $25,000 since we are not given the
discount rate we need to just calculate
this payback period without considering
the opportunity cost so in the end of
first year we got $5,000 and at the end
of second year we got $9,000 so the
total amount we got at the end of second
year is $14,000 it's just the cumulative
of all the revenue that we get at the
end of the ears okay so at the end of
third year it becomes one
four thousand dollars since we need to
get back with twenty five thousand
dollars let's see if I calculate this
the cumulative of four years it would
become thirty four thousand dollars
since we are concentrating only on 25
thousand dollars let's break the fourth
year the venue in two month wise revenue
and that would be ten thousand divided
by Club and that is eight hundred and
thirty three dollars per month so for
three years one month we would earn
about 24,000 plus eight hundred and
thirty three dollars and that would be
twenty-four thousand eight hundred and
thirty dollars close to 25 thousand
dollars and in three years two months
fine we would earn about twenty five
thousand 666 dollars so we can say that
the payback period is in between three
years one month and three years two
months for this project okay so that's
about the payback period payback period
is easy to calculate all we just need to
do is just calculate the amount at what
period of time we would be able to
recover the initial investments right so
let's have a quick recap in this video
we learned about the capital budgeting
techniques learn what is discounted cash
flow and non discounted cash flow we
learned how to calculate the future
value present value we learn how to
calculate the net present value internal
rate of return payback period and
profitable index and with this we end
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