UNIT 4 CAPITAL BUDGETING

Capital Budgeting

UNIT 4 CAPITAL BUDGETING

Structure NOTES
4.0 Introduction
4.1 Unit Objectives
4.2 Cases of Capital Budgeting Decisions
4.3 Concept of Capital Budgeting
4.4 Importance of Capital Budgeting
4.5 Kinds of Capital Investment Proposals
4.6 Factors Affecting Capital Investment Decisions
4.7 Determination of Cash Flows for Investment Analysis
4.8 Capital Budgeting Appraisal Methods
4.9 Summary
4.10 Key Terms
4.11 Answers to ‘Check Your Progress’
4.12 Questions and Exercises
4.13 Practical Problems
4.14 Further Reading

4.0 INTRODUCTION
A finance manager is concerned with both financing as well as investment decisions.
Financing decisions relate to determination of the amount of long-term finance required
and the sources from which such finance is to be raised. He has to determine the
optimum capital structure keeping in view the cost and risk associated with each
source of finance. The methods for determining the amount of long-term finance
required and the technique of determining optimum capital structure have already
been explained in section B of the book. The sources from which long-term finance
is to be raised has already been explained in an earlier unit.
The investment decisions, also popularly termed as capital budgeting decisions,
require comparison of cost against benefits over a long period. For example, the
deployment of finances of additional plant and equipment cannot be recovered in
the short run. Such investment may affect revenues for the time period ranging
from two to twenty years or more. Such investment decisions involve a careful
consideration of various factors, viz., profitability, safety, liquidity, solvency, etc.
The present unit primarily deals with this important function of the finance
manager.

4.1 UNIT OBJECTIVES

z Concept of capital budgeting
z Difference between technical and strategic investment decisions
z Importance of capital budgeting
z Different kinds of capital investment decisions
z Evaluation and ranking of different capital investment proposals

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Capital Budgeting
4.2 CASES OF CAPITAL BUDGETING DECISIONS
A business organization has to quite often face the problem of capital investment
decisions. Capital investment refers to the investment in projects whose results would
NOTES be available only after a year. Investments in these projects are quite heavy and to
be made immediately, but the return will be available only after a period of time. The
following are some of the cases where heavy capital investment may be necessary:
(i) Replacements: Replacements of fixed assets may become necessary
either on account of their being worn out or becoming outdated on
account of new technology.
(ii) Expansion: A firm may have to expand its production capacity on
account of high demand for its products and inadequate production
capacity. This will need additional capital investment.
(iii) Diversification: A business may like to reduce its risk by operating in
several markets rather than in a single market. In such an event, capital
investment may become necessary for purchase of machinery and
facilities to handle the new products.
(iv) Research and Development: Large sums of money may have to be
expended for research and development in case of those industries where
technology is rapidly changing. In case large sums of money are needed
for equipment, these proposals will normally be included in the capital
budget.
(v) Miscellaneous: A firm may have to invest money in projects which do
not directly help in achieving profit-oriented goals. For example,
installation of pollution control equipment may by necessary on account
of legal requirements. Thus, funds will be required for such purposes
also.

4.3 CONCEPT OF CAPITAL BUDGETING

The term ‘Capital Budgeting’ refers to long-term planning for proposed capital
outlays and their financing. Thus, it includes both raising of long-term funds as
well as their utilization. It may thus be defined as ‘the firm’s formal process for
the acquisition and investment of capital’.1 It is the decision-making process by
which the firms evaluate the purchase of major fixed assets. It involves the firm’s
decision to invest its current funds for addition, disposition, modification and
replacement of long-term or fixed assets. However, it should be noted that
investment in current assets necessitated on account of investment in a fixed
assets is also to be taken as a capital budgeting decision. For example, a new
distribution system may call for both a new warehouse and an additional investment
in inventories. An investment proposal of this nature must be taken as a capital
budgeting decision and evaluated as a single package, not as an investment in a
fixed asset (i.e., warehouse) and in a current asset (i.e., inventory) separately.
Capital budgeting is a many-sided activity. It includes searching for new and more
profitable investment proposals, investigating engineering and marketing considerations
to predict the consequences of accepting the investment and making economic analysis

1. Hampton. John. J., Financial Decision-Making, p. 245.

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to determine the profit potential of each investment proposal. Its basic features can Capital Budgeting
be summarized as follows:
(i) It has the potentiality of making large anticipated profits.
(ii) It involves a high degree of risk.
(iii) It involves a relatively long-time period between the initial outlay and the NOTES
anticipated return.
On the basis of the above discussion it can be concluded that capital budgeting
consists in planning the development of available capital for the purpose of
maximizing the long-term profitability (i.e., ROI) of the firm.

4.4 IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting decisions are among the most crucial and critical business
decisions. Special care should be taken in making these decisions on account of
the following reasons:
(i) Involvement of heavy funds: Capital budgeting decisions require large
capital outlays. It is, therefore, absolutely necessary that the firm should
carefully plan its investment programme so that it may get the finances
at the right time and they are put to most profitable use. An opportune
investment decision can give spectacular results. On the other hand, an
ill-advised and incorrect decision can jeopardize the survival of even
the biggest firm.
(ii) Long-term implications: The effect of capital budgeting decisions
will be felt by the firm over a long period, and, therefore, they have
a decisive influence on the rate and direction of the growth of the firm.
For example, if a company purchases a new plant for manufacture
of a new product, the company commits itself to a sizable amount of
fixed cost in terms of indirect labour, such as supervisory staff salary
and indirect expenses, such as rent, rates and insurance. In case the
product does not come out or comes out but proves to be unprofitable,
the company will have to bear the burden of fixed cost unless it decides
to write off the investment completely. A wrong decision, therefore,
can prove disastrous for the long-term survival of the firm. Similarly,
inadequate investment in assets would make it difficult for the firm to
run the business in the long run just as an unwanted expansion results
in unnecessary heavy operating costs to the firm.
(iii) Irreversible decisions: In most cases, capital budgeting decisions are
irreversible. This is because it is very difficult to find a market for the
capital assets. The only alternative will be to scrap the capital assets
so purchased or sell them at a substantial loss in the event of the
decision being proved wrong.
(iv) Most difficult to make: The capital budgeting decisions require an
assessment of future events which are uncertain. It is really a difficult
task to estimate the probable future events, the probable benefits and
costs accurately in quantitative terms because of economic, political,
social and technological factors.

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Capital Budgeting On account of these reasons, capital expenditure decisions are among the class
of decisions which are best reserved for consideration by the highest level of
management. In case some parts of it are delegated, a system of effective control
by the top management should be evolved.
NOTES
4.5 KINDS OF CAPITAL INVESTMENT PROPOSALS
A firm may have several investment proposals for its consideration. It may adopt one
of them, some of them or all of them depending upon whether they are independent,
contingent or dependent or mutually exclusive.
(i) Independent proposals
These are proposals which do not compete with one another in a way that acceptance
of one precludes the possibility of acceptance of another. In case of such proposals
the firm may straightaway ‘accept or reject’ a proposal on the basis of a minimum
return on investment required. All those proposals which give a higher return than a
certain desired rate of return are accepted and the rest are rejected.
(ii) Contingent or dependent proposals
These are proposals whose acceptance depends on the acceptance of one or more
other proposals. For example a new machine may have to be purchased on
account of a substantial expansion of the plant. In this case investment in the
machine is dependent upon the expansion of the plant. When a contingent
investment proposal is made, it should also contain the proposal on which it is
dependent in order to have a better perspective of the situation.
(iii) Mutually exclusive proposals
These are proposals which compete with each other in a way that the acceptance
of one precludes the acceptance of other or others. For example, if a company
is considering investment in one of two temperature control systems, acceptance
of one system will rule out the acceptance of another. Thus, two or more mutually
exclusive proposals cannot both or all be accepted. Some technique has to be
used for selecting the better or the best one. Once this is done, other alternatives
automatically get eliminated.

4.6 FACTORS AFFECTING CAPITAL INVESTMENT

DECISIONS
The following are the four important factors which are generally taken into account
while making a capital investment decision:
1. Amount of investment: In case a firm has unlimited funds for investment it
can accept all capital investment proposals which give a rate of return higher than
the minimum acceptable or cut-off rate. However, most firms have limited funds and
therefore capital rationing has to be imposed. In such an event a firm can take only
such project or projects which are within its means. In order to determine which
project should be taken up on this basis, the projects should be arranged in an
ascending order according to the amount of capital investment required, as shown
below:

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 S.No. Project Description Required Investment Capital Budgeting
1. 101 Purchase of new plant Rs 1,00,000
2. 102 Expansion of the existing plant 1,30,000
3. 103 Purchase of new sales office 1,50,000
4. 104 Introduction of a new product line 2,00,000 NOTES
In case the funds available are only Rs 1,50,000, Project 104 cannot be taken up
and it should, therefore, be rejected outright.
Computation of cash capital investment required
The term ‘capital investment required’ refers to the net cash outflow which is the sum
of all outflows and inflows occurring at zero time period.2 The net outflow is determined
by taking into account the following factors:
(i) Cost of the new project
(ii) Installation cost
(iii) Working capital
Investment in a new project may also result in increase or decrease of net
working capital requirements. For example, if the new project is expected to
increase sales investment in accounts receivables, inventories, cash balance, etc.,
are also likely to increase. A part of this increase in current assets may be offset
by increase in current liabilities for the balance additional funds will have to be
arranged. This amount should therefore be taken as a part of the initial capital.
The investment required in the form of networking capital will be recovered at
the end of the life of the project. This amount of working capital so recovered
will become part of cash inflow in the last year of the life of the project. However,
investment in working capital and the recovery of working capital will not balance
each other on account of time value of money.
It may further be noted that the amount of working capital may show a
continuous increase in each of the subsequent years on account of continuous
increase in sales. Such increase in working capital should not be taken as a part
of initial cash investment. It should rather be taken as an outflow of cash in the
year in which additional working capital is required.
Generally all capital investment proposals for increasing revenue require
additional working capital, while almost all capital investment proposals for
reduction in costs result in saving of working capital by increasing the firm’s
operational efficiency.
(iv) Proceeds from sale of asset
A new asset may be purchased for replacement of an old asset. The old asset
may therefore be sold away. The cash realized on account of such sale will
reduce the cost of new investment.
(v) Tax effects
The amount of profit or loss on the sale of the assets may affect the cash
flows on account of tax effects. The profit/loss is ascertained by taking into
account the cost of the asset, its book value and the amount realized on its sale.
The tax liability of the company will be different in each of the following cases:
(a) when the asset is sold at its book value
(b) when the asset is sold at a price higher than its book value but
lower than its cost
2 Refers to the time the expenditure is made to determine the initial investment requirement of the
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Material 53
Capital Budgeting (c) when the asset is sold at a price higher than its cost
(d) when the asset is sold at a price lower than its book value
This will be clear with the help of the following illustration :
Illustration 4.1: A company purchased a machinery a few years back for
NOTES Rs 10,000. It wants to replace this machinery by a new one costing Rs 15,000. The
company is subject to income tax @ 50 per cent while capital gains tax
@ 30 per cent. The present book value of the machinery is Rs 6,000. Calculate
the net initial cash outflow if the company decides to purchase the new machine,
in each of the following cases, if the old machine is sold for:
(a) Rs 6,000; (b) Rs 8,000; (c) Rs 12,000; (d) Rs 4,000.
Solution:
(a) Cash required for purchase of the new machine Rs 15,000
Less: Cash realized on sale of the old machine 6,000
Net cash outflow 9,000
(b) Cash required for the purchase of the new machine Rs 15,000
Less: Amount realized on sale of old machine 8,000
7,000
Add: Income tax liability on profit
made on sale of machinery (2,000 × 50/100) 1,000
Net cash outflow 8,000
(c) Cash required for the purchase of new machine Rs 15,000
Less: Cash realized on sale of the old machine 12,000
3,000
Add: Income tax liability (4,000 × 50/100) 2,000
Capital gains tax liability (2,000 × 30/100) 600 2,600
Net cash outflow 5,600
(d) Cash required for purchase of new machinery Rs 15,000
Less: Cash realized on sale of the old machine 4,000
11,000
Less: Saving in tax liability on
account of loss on the sale of the old machine
(2,000 × 50/100)3 1,000
Net cash outflow 10,000
Note: It may be noted that the method of computing depreciation under the
Companies Act is different from that under the Income Tax Act. As per Section
350 of the Companies Act, 1956, loss or profit on sale of individual asset is to
be taken to the Profit and Loss Account as a balancing charge. However, as per
the current income tax provisions, the profit or loss on an individual item of a
fixed asset is not to be taken to the P & L Account. Depreciation is to be charged
on a block of assets or according to the Group Depreciation Method. The total
amount realized on sale of an individual asset comprising a block, is to be
credited to the ‘block of assets account’ and thus reducing the written down value
of the block of assets. Hence, there can be a profit or loss only when the whole
block of assets is sold or where the block of assets comprises only of one
individual asset which has been sold away.
The profit or loss computed in Illustration 4.1 as above for ‘tax effect’ has
been computed on the presumption that the sale is of an entire block of assets
comprising one or more than one asset(s).

3 The loss can either be adjusted against current operational profits or be carried forward for eight
years, under existing rules, for setting off against future profits.
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 (vi) Investment allowance: This is allowed to encourage capital investment in Capital Budgeting
machinery and equipment. In India this allowance was allowed at 20 per cent4
of the cost of new machinery and equipment for calculating income tax liability for
the year in which such asset was put into service. Such allowance thus reduces the
cost of the initial investment on the project. NOTES
Thus, the net cash outflow on account of capital investment proposal can be
ascertained as shown below:
Original cost of the asset xxx
Add: Installation cost xxx
Increase in working capital requirements xxx
Increase in tax liability xxx xxx
xxx
Less: Decrease in working capital requirements xxx
Decrease in tax liability xxx
Investment allowance (if any) xxx xxx
Net cash outflow xxx

Illustration 4.2: A company intends to replace an old machine with a new

machine. From the following information you are required to determine the net
cash required for such replacement:
Cost of the old machine Rs 50,000
Life of the old machine 5 years
Depreciation according to straightline method
Remaining useful life 2 years
Cost of the new machine 70,000
Installation charges 10,000
Amount realized on sale of old machine 25,000
Additional working capital required 5,000
Income tax 50 per cent
Capital gains tax 30 per cent
Investment allowance 20 per cent

Solution:
ESTIMATION OF CASH REQUIREMENT FOR REPLACEMENT
Cost of the new machine Rs 70,000
Add: Installation charges 10,000
Additional working capital required 5,000
Additional tax liability:
Income tax 5,000 × 50/100 2,500
Capital gains tax —
87,500
Less: Amount realized on sale of old machine 25,000
Investment allowance (70,000 × 20/100) 14,000 39,000
Net cash outflow 48,500

2. Minimum rate of return on investment: The management expects a

minimum rate of return on the capital investment. The minimum rate of return
is usually decided on the basis of the cost of capital. For example, if the cost of

4 The investment allowance was 25% before 1st April, 1987. It was reduced to 20% w.e.f. 1st April,
1987. It has been discontinued w.e.f. 1st April, 1990.
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Capital Budgeting capital is 10 per cent, the management will not like to accept a proposal which yields
a rate of return less than 10 per cent. The projects giving a yield below the desired
rate of return will, therefore, be rejected.
Cut-off point
NOTES
Cut-off point refers to the point below which a project would not be accepted. For
example, if 10 per cent is the desired rate of return, the cut-off rate is 10 per cent.
The cut-off point may also be in terms of period. For example, if the management
desires that the investment in the project should be recouped in three years, the period
of three years would be taken as the cut-off period. A project incapable of generating
necessary cash to pay for the initial investment in the project within three years will
not be accepted.
3. Return expected from the investment: Capital investment decisions are
made in anticipation of increased return in the future. It is therefore very necessary
to estimate the future return or benefits accruing from the investment proposals.
There are two criteria available for quantifying benefits from capital investment
decisions. They are (i) accounting profit and (ii) cash flows. The term accounting
profit is identical with the income concept used in accounting. While in estimating
cash flows, depreciation charges and other amortization charges of fixed assets
are not subtracted from gross revenue because no cash expenditure is involved.
The difference between the two will be clear with the following example.
Example
Benefit as per Benefit as per
Accounting Cash flow
approach approach
Sales (i) Rs 10,000 Rs 10,000
Less: Cost of sales (ii) :
Direct material 3,000 3,000
Direct labour 2,000 2,000
Depreciation 1,000 —
Indirect expenses 1,000 1,000
7,000 6,000
Net income/cash flow before tax (i) – (ii) 3,000 4,000
Tax (say at 50 per cent of net income of Rs 3,000) 1,500 1,500
Net income/cash after tax 1,500 2,500

The above example shows that the amount of cash flow is Rs 1,000 more
than the amount of accounting profit. The accounting approach shows that only
Rs 1,500 is available after meeting all expenses, while the cash flow approach
shows that Rs 2,500 is available for investment.
The cash flow approach for determination of benefit from a capital investment
project is better as compared to the accounting profit approach on account of the
following reasons:
(i) Determination of economic value
While making capital budgeting decisions, a firm is interested in determining the
economic value of the project which can only be determined by comparing the
cash inflows (benefits) with the cash outflows associated with the project. The
firm can by comparing them to find out for itself whether the future economic
inflows are sufficiently large to warrant the initial investment. The accounting
profit approach allocates the cost of investment over the economic useful life of
the asset in the form of depreciation rather than at the time when the cost is
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56 Material
actually incurred. It, therefore, fails to reflect the original need for cash at the time Capital Budgeting
of investment. It also does not bring out clearly the actual size of cash inflows and
outflows in later years. On account of these reasons the cash flow approach is more
appropriate for capital budgeting decisions.
(ii) Accounting ambiguities NOTES
Accounting profit approach is full of ambiguities on account of different accounting
policies and practices, regarding valuation of inventory, allocation of costs,
calculation of depreciation and amortization of various other expenses. The amount
of profit may therefore vary according to accounting policies and practices adopted
while preparing the accounts. However, there will be only one set of cash flows
associated with a project. Obviously, therefore, the cash flow approach is superior
to the accounting profit approach.
(iii) Time value of money
Under usual accounting practices revenue is considered to be realized not at the
time when the cash is received, but at the time the sale is made. It means the
amount of profit shown by the books may simply be a paper figure if the sales
are not realized. Similarly, expenditure is recognized as being made not when the
payment is made out, but at the time it is incurred. Thus, the time taken in
realizing or making payments is completely ignored. The cash flow approach
recognizes the time value of money by comparing actual cash inflows and cash
outflows. Moreover, in order to have a better picture even the future cash inflows
are discounted and their present worth is found out.
On account of the above reasons, the accounting profit approach, though
quite useful in measuring performance of an enterprise, is less useful as a tool
for managerial decisions.
Conventional and non-conventional cash flows: In case of conventional cash
flows, an initial cash outflow is followed by a series of cash inflows whether of
uniform or of different amounts. Most of the capital budgeting decisions follow
this pattern. For example, a firm may spend Rs 5,000 on capital asset in zero time
period and may receive Rs 1,000 each year for eight years.
In case of unconventional cash flows, initial cash outflow is not followed by
a series of cash inflows. In other words, there may be not one but a series of cash
outflows followed by a series of cash inflows. For example, a firm may purchase
a plant for a sum of Rs 10,000. This cash outflow may be followed by cash
inflows of Rs 3,000 each year for five years. However, after five years the asset
may need overhauling resulting in a cash outflow of Rs 3,000. This may give a
new lease of life to the asset and it may be followed by a series of cash inflows.
This practice may continue in future years also.
4. Ranking of the investment proposals: When a number of projects appear
to be acceptable on the basis of their profitability the projects will be ranked in
order of their profitability in order to determine the most profitable project.
Ranking of capital investment proposals is particularly necessary in the following
two circumstances:
(a) Where capital is rationed, i.e., there is a limit on funds available for
investment. This aspect is being discussed in detail later in the unit.
(b) Where, two or more investment opportunities are mutually exclusive, i.e.,
only one of the opportunities can be undertaken.

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Capital Budgeting Thus, the objective of ranking is to put the capital available to the best possible
use. This will be clear from the following illustration.
Illustration 4.3: A Ltd is considering the following five projects for capital
expenditure. The company can spare a sum of Rs 1,50,000 and expect a minimum
NOTES return of 15 per cent before tax on the investment. The details of the projects are
as under:
Projects Capital expenditure Estimated savings Percentage return
after tax on investment
(before tax)
(i) (ii) (iii) (iv)
A Rs 50,000 Rs 5,000 20
B 75,000 9,000 24
C 1,00,000 8,000 16
D 1,25,000 25,000 40
E 1,50,000 28,000 37
Tax rate may be taken at 50 per cent.
Solution:
On the basis of the information given, project D seems to be the most profitable,
since it is giving the highest percentage return on investment. However, in case
this project is taken up Rs 25,000 will be the surplus amount available with the
company for alternative investment. In case project D is taken up, the full amount
of Rs 1,50,000 would be used up. The difference between the additional investment
required and the additional income before tax is Rs 25,000 and Rs 6,000
respectively giving a return of 24 per cent on the balance of Rs 25,000. In case
such an opportunity is not available, the company should take up project E.
5. Risk and uncertainty: Different capital investment proposals have different
degrees of risk and uncertainty. There is a slight difference between risk and
uncertainty. Risk involves situations in which the probabilities of a particular
event occuring are known whereas in uncertainty, these probabilities are not
known. Of course in most cases these two terms are used interchangeably. Risk
in capital investment decisions may be due to general economic conditions,
competition, technological developments, consumer preferences, labour condition,
etc. On account of these reasons the revenues, costs and economic life of a
particular investment are not certain. While evaluating capital investment proposals,
proper adjustment should therefore be made for risk and uncertainty.

4.7 DETERMINATION OF CASH FLOWS FOR

INVESTMENT ANALYSIS
Capital budgeting decisions require computation of both cash outflows for and cash
Check Your Progress
inflows from a project.
1. What do capital Cash Outflows: They consitute the capital investment required for a project. The
budgeting decisions
require? capital investment required, as explained in the preceding pages, is computed on
2. What are the following basis:
independent (i) Cost of plant, equipment, building etc.
proposals?
(ii) Installation cost of plant, equipment, etc.
3. What is cut-off
point? (iii) Additional working capital required for the project
(iv) Proceeds from sale of old asset(s). The amount, realized from sale of the
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58 Material
Cash Inflows: They represent the cash profit or return generated by the project year Capital Budgeting
after year. The accounting profit will have to be adjusted for non-cash items for this
purpose.
The cash flows (both inflows and outflows) may take any one of the following
parterns over the project life. NOTES
(i) Conventional Cash Flows: A situation where initial cash outflow is
followed by a series of cash inflows, whether of uniform or of different
amounts.
(ii) Unconventional Cash Flows: There may be a series of cash outflows
and a series of cash inflows, whether of uniform or of different amounts.
Investment analysis, i.e., evaluating the profitability or otherwise of a capital
budgeting decision is largely based on the cash flows. This is explained in detail
in the following pages.

4.8 CAPITAL BUDGETING APPRAISAL METHODS

There are several methods for evaluating and ranking capital investment proposals.
In case of all these methods the main emphasis is on the return which will be
derived on the capital invested in the project. In other words, the basic approach
is to compare the investment in the project with the benefits derived therefrom.
The following are the main methods generally used:
1. Payback Period Method
2. Discounted Cash Flow Method
(a) The Net Present Value Method
(b) Present Value Index Method
3. Accounting Rate of Return Method
Each of the above methods have been explained in detail in the following
pages.
Payback Period Method
The term payback (or payout or pay-off) refers to the period in which the
project will generate the necessary cash to recoup the initial investment. For
example, if a project requires Rs 20,000 as initial investment and it will generate
an annual cash inflow of Rs 5,000 for ten years, the payback period will be four
years calculated as follows:

Payback Period Initial Investment

=
Annual Cash Inflow

Rs 20,000
=
Rs 5,000
The annual cash inflow is calculated by taking into account the amount of net
income on account of the asset (or project) before depreciation but after taxation.
The income so earned, if expressed as a percentage of initial investment, is
termed as ‘unadjusted rate to return’. In the above case, it will be calculated as
follows:
Annual Return
Unadjusted Rate of Return = × 100
Initial Investment
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Material 59
Capital Budgeting
Rs 5, 000
100 25 per cent
Rs 20, 000
Uneven cash inflows
NOTES In the above example, we have presumed that the annual cash inflows are uniform.
However, it may not always be so. The cash flow each year may be different. In
such a case cumulative cash inflows will be calculated and by interpolation, the exact
payback period can be calculated. For example, if the project requires an initial
investment of Rs 20,000 and the annual cash inflows for five years are
Rs 6,000, Rs 8,000, Rs 5,000, Rs 4,000 and Rs 4,000 respectively, the payback
period will be calculated as follows:
Year Cash Inflows Cumulative Cash Inflows
1 Rs 6,000 Rs 6,000
2 8,000 14,000
3 5,000 19,000
4 4,000 23,000
5 4,000 27,000
The above table shows that in three years Rs 19,000 has been recovered. Rs
1,000 is left out of initial investment. In the fourth year the cash inflow is Rs
4,000. It means the payback period is between three to four years, ascertained as
follows:
1,000
Payback Period = 3 years + = 3.25 years
4,000
Accept or reject criterion
The payback period can be used as a criterion to accept or reject an investment
proposal. A project whose actual payback period is more than what has been
predetermined by the management will be straightaway rejected. The fixation of
the maximum acceptable payback period is generally done by taking into account
the reciprocal of the cost of capital. For example, if the cost of capital is 20 per
cent the maximum acceptable payback period would be fixed at five years. This
can also be termed as cut-off point. Usually projects having a payback
period of more than five years are not entertained because of greater
uncertainties.
Illustration 4.4 An engineering company is considering the purchase of a machine
for its immediate expansion programme. There are three possible machines suitable
for the purpose. Their details are as follows:
Machines
1 2 3
(Rs) (Rs) (Rs)
Capital Cost 3,00,000 3,00,000 3,00,000
Sales (at standard prices) 5,00,000 4,00,000 4,50,000
Net Cost of Production:
Direct Material 40,000 50,000 48,000
Direct Labour 50,000 30,000 36,000
Factory Overheads 60,000 50,000 58,000
Administration Costs 20,000 10,000 15,000
Selling and Distribution Costs 10,000 10,000 10,000

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 The economic life of machine No. 1 is two years, while it is three years for the Capital Budgeting
other two. The scrap values are Rs 40,000, Rs 25,000 and Rs 30,000 respectively.
Sales are expected to be at the rates shown for each year during the full
economic life of the machines. The costs relate to annual expenditure resulting from
each machine. NOTES
Tax to be paid is expected at 50 per cent of the net earnings of each year. It may
be assumed that all payables and receivables will be settled promptly, strictly on a
cash basis with no outstanding from one accounting year to another. Interest on
capital has to be paid at 8 per cent per annum.
You are requested to show which machine would be the most profitable investment
on the principle of ‘payback method’.
Solution:
STATEMENT SHOWING THE NET CASH FLOW OF THREE MACHINES
Machine 1 Machine 2 Machine 3
Rs Rs Rs
Capital Cost 3,00,000 3,00,000 3,00,000
Sales (i) 5,00,000 4,00,000 4,50,000
Cost of Production 1,50,000 1,30,000 1,42,000
Administration Cost 20,000 10,000 15,000
Selling and Distribution Cost 10,000 10,000 10,000
Total Cost (ii) 1,80,000 1,50,000 1,67,000
Profit before depreciation and interest (i) - (ii) - (iii) 3,20,000 2,50,000 2,83,000
Depreciation:
Cost less scrap value
1,30,000 91,667 90,000
Economic life
Interest on borrowings 24,000 24,000 24,000
Depreciation and Interest (iv ) 1,54,000 1,15,667 1,14,000
Profit before tax (iii) - (iv) 1,66,000 1,34,333 1,69,000
Taxation (50 per cent) 83,000 67,167 84,500
Profit after tax 83,000 67,166 84,500
Add: Depreciation 1,30,000 91,667 90,000
Net Cash Inflow 2,13,000 1,58,833 1,74,500
Payback period 1.41 years 1,89 years 1.72 years
Machine No. 1 is most profitable.
Note:
(i) It has been presumed that interest on borrowings throughout the economic life of the asset.
(ii) Factory overheads do not include depreciation.
(iii) No borrowings will be required for working capital.

Merits
The payback method has the following merits:
1. The method is very useful in evaluation of those projects which involve high
uncertainty. Political instability, rapid technological development of cheap
substitutes, etc., are some of the reasons which discourage one to take up
projects having a long gestation period. Payback method is useful in such
cases.
2. The method makes it clear that no profit arises till the payback period is
over. This helps new companies in deciding when they should start paying
dividends.

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Material 61
Capital Budgeting 3. The method is simple to understand and easy to work out.
4. The method reduces the possibility of loss on account of obsolescence as
the method prefers investment in short-term projects.

NOTES Demerits
The method has the following demerits.
1. The method ignores the returns generated by a project after its payback
period. Projects having long gestation period will never be taken up if
this method is followed though they may yield high returns for a long
period. Consider the following example.
Example Project A Project B
Initial Investment Rs 10,000 Rs 10,000
Cash Inflows:
Year 1 4,000 3.000
2 4,000 3,000
3 2.000 3,000
4 —— 3,000
5 —— 3,000
Payback Period 3 years 3.33 years
In the above case Project A has a shorter payback period and therefore it
should be preferred over B. But this may not be rational decision since project
B continues to give return after the payback period which fact has been completely
ignored. As a matter of fact, on the whole, Project B is more profitable as
compared to Project A
2. The method does not take into account the time value of money. In other
words, it ignores the interest which is an important factor in making sound
investment decisions. A rupee tomorrow is worth less than a rupee today. The
following example makes this point clear:
Example. There are two projects A and B. The cost of the project is
Rs 30,000 in each case. The cash inflows are as under:
Cash Inflows
Year Project ‘A’ Project ‘B’
1 Rs 10,000 Rs 2.000
2 10,000 4,000
3 10,000 24,000
The payback period is three years in both the cases. However, project A
should be preferred as compared to project B because of speedy recovery of the
initial investment.
Discounted Payback Period Method. The method discussed above is
Traditional Payback Period Method. However in order to overcome the criticism
that this method does not take into account the time value of money, the discounted
payback period method is recommended. In case of this method, the present
value of cash inflows arising at different time intervals at the desired rate of
interest (depending upon the cost of capital) are found out. The present values
so calculated are now taken as the real cash inflows for determination of the
payback period. This technique can better be understood by the students after
studying NPV Method discussed in the following pages.

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2. Discounted Cash Flow (DCF) Method or Time Adjusted Technique Capital Budgeting

The discounted cash flow technique is an improvement of the payback period method.
It takes into account both the interest factor as well as the return after the payback
period. The method involves three stages:
NOTES
(i) Calculation of cash flows, i.e., both inflows and outflows (preferably after
tax) over the full life of the asset.
(ii) Discounting the cash flows so calculated by a discount factor.
(iii) Aggregating discounted cash inflows and comparing the total with the
discounted cash outflows.
Discounted cash flow technique thus recognizes that Re 1 of today (the cash
outflow) is worth more than Re 1 received at a future date (cash inflow).
Discounted cash flow methods for evaluating capital investment proposals are of
three types as explained below:
(a) The Net Present Value (NPV) Method
This is generally considered to be the best method for evaluating the capital
investment proposals. In case of this method cash inflows and cash outflows
associated with each project are first worked out. The present value of these cash
inflows and outflows is then calculated at the rate of return acceptable to the
management. This rate of return is considered as the cut-off rate and is generally
determined on the basis of cost of capital suitably adjusted to allow for the risk
element involved in the project. Cash outflows represent the investment and
commitments of cash in the project at various points of time. The working capital
is taken as a cash outflow in the year the project starts commercial production.
Profit after tax but before depreciation represents cash inflows. The Net Present
Value (NPV) is the difference between the total present value of future cash
inflows and the total present value of future cash outflows.
The equation for calculating NPV in case of conventional cash flows can be
put as follows:

R1 R2 R3 Rn
NPV 1
(I K )1 (I K )2 (I K )3 (I K )n
In case of non-conventional cash inflows (i.e., where there are a series of
cash inflows as well cash outflows) the equation for calculating NPV is as follows:
R1 R2 R3 Rn
NPV
(I K )1 (I K )2 (I K )3 (I K )n

I1 I2 I3 In
I0 n
(I K )1 (I K )2 (I K )3 (I K )n
where, NPV = Net present value, R = Cash inflows at different time periods,
K = Cost of capital or Cut-off rate, I = Cash outflows at different time periods.
Accept or reject criterion
The net present value can be used as an ‘accept or reject’ criterion. In case the
NPV is positive (i.e., present value of cash inflows is more than present value of

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Material 63
Capital Budgeting cash outflows) the project should be accepted. However, if the NPV is negative (i.e.,
present value of cash inflows is less than the present value of cash outflows) the
project should be rejected. Symbolically, the accept/reject criterion can be put as
follows:
NOTES
where NPV > Zero accept the proposal
NPV < Zero reject the proposal
Or where PV > C accept the proposal
PV < C reject the proposal
PV stands for Present Value of Cash Inflows and C for Present Value of Cash
Outflows (or outlays).
Illustration 4.5: Calculate the net present value for a small sized project requiring
an initial investment of Rs 20,000, and which provides a net cash inflow of Rs 6,000
each year for six years. Assume the cost of funds to be 8 per cent per annum and
that there is no scrap value.
Solution: The present value of an annuity of Re 1 for six years at 8 per cent
per annum interest is Rs 4.623.
Hence, the present value of Rs 6,000 comes to:
6,000 × 4.623 = Rs 27,738
Less Initial Investment Rs 20,000
Net Present Value (NPV) Rs 7,738
Illustration 4.6: A choice is to be made between two competing projects which
require an equal investment of Rs 50,000 and are expected to generate net cash flows
as under:
Project I Project II
End of year 1 Rs 25,000 Rs 10,000
End of year 2 15,000 12,000
End of year 3 10,000 18,000
End of year 4 Nil 25,000
End of year 5 12,000 8,000
End of year 6 6,000 4,000

The cost of capital of the company is 10 per cent. The following are the Present
Value Factors @ 10 per cent per annum:
Year P.V. Factors
@ 10 per cent per annum
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621
6 0.564
Which project proposal should be chosen and why? Evaluate the project proposals
under:
(a) Payback Period, and
(b) Discounted Cash Flow methods, pointing out their relative merits and
demerits.

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64 Material
Solution: Capital Budgeting
PAYBACK PERIOD METHOD
Project I Project II
Cash inflows Cum. cash Cash Cum. cash
inflows inflows inflows NOTES
End of year 1 Rs 25,000 Rs 25,000 Rs 10,000 Rs 10,000
End of year 2 15,000 40,000 12,000 22,000
End of year 3 10,000 50,000 18,000 40,000
End of year 4 Nil 50.000 25,000 65,000
End of year 5 12,000 62,000 8,000 73,000
End of year 6 6,000 68,000 4,000 77,000

Project I has the payback period of three years while project II has a payback
period of 3.4 years (i.e., Rs 40,000 in three years and Rs 10,000 in the fourth
year). Thus, Project I has to be preferred because it has a shorter payback period.
DISCOUNTED CASH FLOW METHOD
Project I
Year Cash inflow Discount Present
factor at value
10 per cent
1 Rs 25,000 0.909 Rs 22,725
2 15,000 0.826 12,390
3 10,000 0.751 7,510
4 Nil 0.683 –
5 12,000 0.621 7,452
6 6,000 0.564 3,384
Total Present Value of Future Cash Inflows 53,461
Initial Investment 50,000
Net Present Value (NPV) 3,461
Project II
Year Cash inflow Discount Present
factor at Rs 10 value
per cent per annum Rs
1 10,000 0.909 9,090
2 12,000 0.826 9,912
3 18,000 0.751 13,518
4 25,000 0.683 17,075
5 8,000 0.621 4.968
6 4,000 0.564 2,256
Total Present Value of Future Cash Inflows 56,819
Initial Investment 50,000
Net Present Value (NPV) 6,819

Both projects need the same investment of Rs 50,000. However, in case of

Project I, there is a surplus of Rs 3,461, while in case of Project II, there is a
surplus of Rs 6,819. Hence Project II is to be preferred.
Relative merits and demerits of the two methods: Payback period method is
relatively simple to understand and easy to work out as compared to the discounted
cash flow method. However, it does not take into account the return after the
payback period. Moreover, payback period ignores the time value of money.
Discounted cash flow method does not have these disadvantages. It takes into
account the returns over the effective life of the asset besides considering the
future cash inflows. The method is, therefore, more scientific and dependable.
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Material 65
Capital Budgeting (b) Excess Present Value Index
This is a refinement of the net present value method. Instead of working out the
net present value, a present value index is found out by comparing the total of present
value of future cash inflows and the total of the present value of future cash outflows.
NOTES This can be put in the form of the following formula:
Excess Present Value Index
(Or Benefits Cost (B/C) Ratio)
Present value of future cash inflows
= × 100
Present value of future cash outflows
Excess Present Value Index provides ready comparison between investment
proposals of different magnitudes. For example, Project ‘A’ requiring an investment
of Rs 1,00,000 shows excess present value of Rs 20,000 while another project ‘B’
requiring an investment of Rs 10,000 shows an excess on present value of Rs
5,000. If absolute figures of net present values are compared, Project ‘A’ may
seem to be profitable.
However, if excess present value index method is followed Project ‘B’ would
prove to be profitable.
1, 20,000
Present Value Index for Project A = × 100 = 120 per cent
1,00,000

15,000
Present Value Index for Project B = ×100 = 150 per cent
10,000
Illustration 4.7: On the basis of figures given in the previous illustration, state
which project is profitable according to the Present Value Index Method.
Solution:
Present value of future cash inflows
Present Value Index = × 100
Present value of future cash outflows
53,461
Project I = × 100 = 107 per cent (approx.)
50,000

56,819
Project II = × 100 = 114 per cent (approx.)
50,000
Since, Project II has a higher Present Value Index hence it is more profitable as
compared to Project I.
(c) Internal Rate of Return
Internal Rate of Return is that rate at which the sum of discounted cash inflows
equals the sum of discounted cash outflows. In other words, it is the rate which
discounts the cash flows to zero. It can be stated in the form of a ratio as
follows:
Cash inflows
1
Cash outflows
Thus, in case of this method the discount rate is not known but the cash
outflows and cash inflows are known. For example, if a sum of Rs 800 invested in

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66 Material
a project becomes Rs 1,000 at the end of a year, the rate of return comes to 25 per Capital Budgeting
cent, calculated as follows:
R
I=
where, I +r
NOTES
I = Cash Outflow, i.e., Initial Investment
R = Cash Inflow
r = Rate of Return Yielded by the Investment (or IRR)
Thus:
800 = 1,000/1 + r
or 800 r + 800 = 1,000
or 800 r = 200
or r = 200/800 = 0.25 or 25%
In case of return is over a number of years, the calculation would take the
following pattern in case of conventional cash flows:
R1 R2 R3 Rn
I= + + +
(1 + r ) 1
(1 + r ) 2
(1 + r ) 3
(1 + r ) n
In case of unconventional cash flows, the equation would be as follows:

⎛ R1 R2 R3 Rn ⎞
⎜⎜ + + + ......... ⎟=
⎝ (1 + r ) (1 + r )
1 2
(1 + r ) 3
(1 + r )n ⎟⎠

R1 R2 R3 Rn
I0 1 2 3
.........
(1 r ) (1 r ) (1 r ) (1 r ) n
where,
I = Cash outlay (or outflow) at different time periods.
R = Cash inflows at different time periods.
r = Rate of return yielded by the investment (or IRR).
Since I and R are known factors, r is the only factor to be calculated. However,
calculation will become very difficult over a long period if worked out according
to the above equations. Tabular values are, therefore, used.
Accept/Reject Criterion
Internal rate of return is the maximum rate of interest which an organization
can afford to pay on the capital invested in a project. A project would qualify to
be accepted if IRR exceeds the cut-off rate. While evaluating two or more projects,
a project giving a higher internal rate of return would be preferred. This is
because the higher the rate of return, the more profitable is the investment.
(1) Where cash inflows are uniform: In the case of those projects which result
in uniform cash inflows, the internal rate of return can be calculated by locating
the Factor in Annuity Table II. The factor is calculated as follows:
I
F=
C
where,
F = Factor to be located
I = Original investment
C = Cash inflow per year Self-Instructional
Material 67
Capital Budgeting Illustration 4.8: An equipment requires an initial investment of Rs 6,000. The
annual cash flow is estimated at Rs 2,000 for five years.
Calculate the internal rate or return.
Solution:
NOTES
The annual cash flow is uniform at Rs 2,000 for five years. Hence, the ‘Factor’
or the ‘Payback’ is 3, calculated by:
I 6,000
F= or F = Rs =3
C 2,000
This factor of 3 should be located in Table II 5 in the line of five years. The
discount percentage would be somewhere between 18 per cent (Rs 3.127 present
value of annuity of Re 1) and 20 per cent (Rs 2.99 present value of annuity of
Re 1). It indicates that the internal rate of return is more than 18 per cent but less
than 20 per cent. A more exact interpolation can be done (as explained in the next
illustration).
However, such an effort may not be very useful in the present case since
Rs 2.99 is very near to 3 and hence the internal rate of returns can be taken as
20 per cent.
Rs 2.99 is as a matter of fact the present value of Re 1 received annuity for
five years at 20 per cent interest rate. In case this amount is multiplied by the
annual cash inflow it will be equal to the initial investment as shown below:
Rs 2,000 × 2.99 = Rs 5,980 (or say Rs 6,000)
Relationship between payback reciprocal and rate of return
Payback reciprocal is exactly equal to the unadjusted rate of return. Unadjusted rate
means a rate which has not been adjusted by taking into account the time value of
money. For example, in the illustration given above the payback period comes to three
years. Its reciprocal is 1/3 or 0.33 or 33 per cent. The annual return is Rs 2,000 on
an investment of Rs 6,000. It also comes to 33 per cent.
Payback reciprocal also gives a reasonable approximation of the time-adjusted
rate of return as is proved by the above illustration. Of course for calculating the
discounted rate Table II has to be consulted. However, there are two assumptions
for the use of payback reciprocal:
(i) The useful life of the project/asset should be at least twice the payback
reciprocal. In any case the payback reciprocal will always exceed the
true or the discounted rate of return.
(ii) The cash inflows should be uniform over the life of the project/asset.
(2) Where cash inflows are not uniform: When cash inflows are not uniform,
the internal rate of return is calculated by making trial calculations in an attempt
to compute the correct interest rate which equates the present value of cash
inflows with the present value of cash outflows. In the process, cash inflows are
to be discounted by a number of trial rates. The first trial rate may be calculated
on the basis of the same formula which is used for determining the internal rate
of return when cash inflows are uniform, as explained above. However, in this
case ‘C’ stands for ‘annual average cash inflow’, in place of ‘annual cash inflow.’
After applying the first trial rate, the second trial rate is determined when the
total present value of the cash inflows is greater or less than the total present

5 Tables I and II are given at the end of the book.

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68 Material
value of cash outflows. In case the total present value of cash inflows is less than Capital Budgeting
the total present value of cash outflows, the second trial rate taken will be lower than
the first rate. In case the present total value of cash inflows exceeds the present total
value of cash outflows, a trial rate higher than first trial rate will be used. This process
will continue till the two flows more or less set off each other. This will be the NOTES
‘internal rates of return’.
Illustration 4.9: A company has to select one of the following two projects:
Cost Project A Project B
Cash inflows: Rs 11,000 10,000
Year 1 6,000 1,000
Year 2 2,000 1,000
Year 3 1,000 2,000
Year 4 5,000 10,000

Using the Internal Rate of Return Method suggest which project is preferable.
Solution:
The cash inflows are not uniform and hence the internal rate of return will have
to be calculated by the Trial and Error Method. In order to have an approximate idea
about such rate, it will be better to find out the ‘factor’. The factor reflects the same
relationship of investment and ‘cash inflows’ as in case of payback calculations: Thus,
I
F=
C
where, F = Factor to be located
I = Original investment
C = Average cash inflow per year
The ‘factor’ in case of project A would be:
11,000
F= = 3.14
3,500
The ‘factor’ in case of project B would be:

10,000
F= = 2.86
3,000
The factor thus calculated will be located in Table II on the line representing
number of years corresponding to estimated useful life of the asset. This would
give the estimated rate of return to be applied for discounting the cash inflows
for the internal rate of return.
In case of Project A, the rate comes to 10 per cent while in case of project
B it comes to 15 per cent.
Project A:
Year Cash Inflows Discounting Factor Present Value
at 10 per cent
1 Rs 6,000 0.909 Rs 5,454
2 2,000 0.826 1,652
3 1,000 0.751 751
4 5.000 0.683 3,415
Total Present Value 11,272

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Material 69
Capital Budgeting The present value at 10 per cent comes to Rs 11,272. The initial investment is
Rs 11,000. Internal rate of return may be taken approximately at 10 per cent.
In case more exactness is required another trial rate which is slightly higher than
10 per cent (since at this rate the present value is more than initial investment) may
NOTES be taken. Taking a rate of 12 per cent, the following results would emerge.
Year Cash Inflows Discounting Factor at 12 per cent Present Value
1 Rs 6,000 0.893 Rs 5,358
2 2,000 0.797 1,594
3 1,000 0.712 712
4 5,000 0.636 3,180
Total Present Value 10,844
The internal rate of return is thus more than 10 per cent, but less than 12 per
cent. The exact rate may be calculated as follows:
Difference in calculated
present value and required
net cash outlay
Internal Rate of Return = × Difference in rate
Difference in calculated
present values
11,272 − 11,000
= 10% + ×2
11,272 − 10,844
272
= 10% + × 2 = 11.3 per cent
428
The exact internal rate of return can also be calculated as follows:
At 10 per cent the present value is + 272.
At 12 per cent the present value is – 156.
The internal rate would, therefore, be between 10 per cent and 12 per cent
calculated as follows:
272
= 10 + ×2
272 + 156
= 10 + 1.3 = 11.3 per cent
Project B:
Year Cash Inflows Discount Factor Present Value
at 15 per cent
1 Rs 1,000 0.870 Rs 870
2 1,000 0. 756 756
3 2,000 0. 658 1,316
4 10,000 0.572 5,720
Present Value 8,662
Since present value at 15 per cent comes only to Rs 8,662, a lower rate of
discount should be taken. Taking a rate of 10 per cent, the following will be the
result:
Year Cash Inflows Discount Factor Present Value
at 10 per cent
1 Rs 1,000 0.909 Rs 909
2 1,000 0. 826 826
3 2,000 0.7518 1,502
4 10,000 0.683 6,830
Self-Instructional
Present Value 10,067
70 Material
 The present value at 10 per cent comes to Rs 10,067 which is more or less equal Capital Budgeting
to the initial investment. Hence, the internal rate of return may be taken 10 per cent.
In order to have more exactness, the internal rate of return can be interpolated
as done in case of project A.
At 10 per cent the present value is + 67 NOTES
At 15 per cent the present value is – 1,338
67 67
10% + × 5 = 10 + ×5
67 + 1,338 1,405
= 10 + .24 = 10.24 per cent.
Thus, internal rate of return in case of Project ‘A’ is higher as compared to
Project ‘B’. Hence, Project ‘A’ is preferable.
Merits
The merits of discounted cash flow method are as follows:
(i) Discounted cash flow technique takes into account the time value of
money. Conceptually, it is better than other techniques such as payback
or accounting rate of return.
(ii) The method takes into account directly the amount of expenses and
revenues over the project’s life. In case of other methods simply their
averages are taken.
(iii) The method automatically gives more weight to those money values
which are nearer to the present period than those which are farther from
it. While in case of other methods, all money units are given the same
weight which seems to be unrealistic.
(iv) The method makes possible comparison of projects requiring different
capital outlays, having different lives and different timings of cash flows
at a particular moment of time because of discounting of all cash flows.
Demerits
The following are the demerits of discounted cash flow method:
(i) The method is difficult to understand and work out as compared to
other methods of ranking capital investment proposals.
(ii) The method takes into account only the cash inflows on account of a
capital investment decision. As a matter of fact the profitability or
otherwise of a capital investment proposal can be judged only when the
net income (and not the cash inflow) on account of operations is
considered.
(iii) The method is based on the presumption that cash inflows can be
reinvested at the discounting rate in the new projects. However, this
presumption does not always hold good because it all depends upon the
available investment opportunities.
Accounting or Average Rate of Return (ARR) Method
According to this method, the capital investment proposals are judged on the
basis of their relative profitability. For this purpose, capital employed and related
income are determined according to commonly accepted accounting principles
and practices over the entire economic life of the project and then the average
yield is calculated. Such a rate is termed as Accounting Rate of Return. It may
be calculated according to any of the following methods:
Self-Instructional
Material 71
Capital Budgeting
Annual Average Net Earnings
(i) × 100
Original Investment

Annual Average Net Earnings

NOTES (ii) × 100
Average Investment
The term ‘average annual net earnings’ is the average of the earning (after
depreciation and tax) over the whole of the economic life of the project.
Increase in expected future annual net earnings
(iii) × 100
Initial increase in required investment
The amount of ‘average investment’ can be calculated according to any of
the following methods:
Original investment
(iv) (a)
2
Original investment – Scrap value of the asset
(b)
2
Original investment + Scrap value of the asset
(c)
2
Original investment – Scrap value Addl. Net Scrap
(d) + +
2 Working Capital Value
It may be noted that results obtained under each of the above methods will be
quite different from each other. It is, therefore, necessary that while evaluating capital
investment proposals, the same method is followed in each case.
Accept/Reject criterion
Normally, business enterprises fix a minimum rate of return. Any project expected to
give a return below this rate will be straightaway rejected.
In case of several projects, where a choice has to be made, the different projects
may be ranked in the ascending or descending order of their rate of return. Projects
below the minimum rate will be rejected. In case of projects giving rates of return
higher than the minimum rate, obviously projects giving a higher rate of return will be
preferred over those giving a lower rate of return.
Illustration 4.10: Alpha Limited is contemplating the purchase of a new machine
to replace a machine which has been in operation in the factory for the last five
years.
Ignoring interest but considering tax at 50 per cent of net earnings, suggest which
of the two alternatives should be preferred. The following are the details:
Old Machine New Machine
Purchase price Rs 40,000 Rs 60,000
Estimated life of machine 10 years 10 years
Machine running hours per annum 2,000 2,000
Units per hour 24 36
Wages per running hour 3 5.25

Self-Instructional
72 Material
 Power per annum 2,000 4,500 Capital Budgeting
Consumable stores per annum 6,000 7,500
All other charges per annum 8,000 9,000
Material cost per unit 0.50 0.50
Selling price per unit 1.25 1.25 NOTES
Information regarding sales and cost of sales will hold good throughout the economic
life of each of the machines. Depreciation has to be charged according to the
straightline method.
Solution:
PROFITABILITY STATEMENT
Old Machine New Machine
Cost of the Machine (Rs) 40,000 60,000
Life of Machine (years) 10 10
Output (Units) 48,000 72,000
Sales Value (Rs) 60,000 90,000
Less: Cost of Sales :
Direct material 24,000 36,000
Wages 6,000 10,500
Power 2,000 4,500
Consumable stores 6,000 7,500
Other charges 8,000 9,000
Depreciation 4,000 50,000 6,000 73,500
Profit before tax 10,000 16,500
Tax at 50 per cent 5,000 8,250
Profit after tax 5,000 8,250

Accounting Rate of Return

Old Machine New Machine
Average Net Earnings
(i) × 100
Original Investment
8,250
= 5,000/40,000 × 100 = 12.5 per cent × 100 = 13.75 per cent
60,000
Average Net Earnings
(ii) × 100
Average Investment
8,250
= 5,000/20,000 × 100 = 25 per cent × 100 = 27.50 per cent
30,000
Incremental Earnings
(iii) × 100
Incremental Investment
3,250
= × 100
Rs. 60,000 − Rs. 20,000*
3,250
= × 100 = 8 per cent (approx.) Check Your Progress
40,000 4. What are ‘Cash
Thus, replacement of the old machine by a new machine (ignoring interest) Inflows’?
is profitable. 5. State one merit of
the payback
Advantages
method.
The following are the advantages of this method: 6. What is
(i) The method takes into account savings over the economic life of the ‘unadjusted rate’?
asset. Hence, it provides a better comparison of the projects as compared
to the payback method. Self-Instructional
Material 73
Capital Budgeting
(ii) The method embodies the concept of ‘net earnings’ while evaluating capital
investment projects which is absent in case of all other methods.
Disadvantages
NOTES The method suffers from the following disadvantages:
(i) The method does not take into account the time value of money. Thus, it
has the same fundamental defect as that of the payback method.
(ii) There are different methods for calculating the Accounting Rate of Return
due to diverse concepts of investments as well as earnings. Each method
gives different results. This reduces the reliability of the method.
On account of the above disadvantages, the Accounting Rate of Return Method
is not much in use these days.

4.9 SUMMARY
z Capital investment refers to investments in projects whose results will be available
only after a year.
z Such projects require heavy capital outflow, and therefore, appropriate planning.
z Capital investment proposals can be classified as independent proposals, contingent
or dependent proposals and mutually exclusive proposals.
z The factors affecting capital investment decisions are: amount of investment,
minimum rate of return required on investment and the rate of return expected
from the investment.
z The capital budgeting appraisal methods are: Pay Back Period Method, Net
Present Value Method, Present Value Index Method and Accounting Rate of
Return Method.

4.10 KEY TERMS

z Accounting Rate of Return: It is the return computed on the basis of matching
net accounting income with the investment required for a project.
z Capital Budgeting: It is the decision-making process concerned with the
deployment of available capital for the purpose of maximizing the long-term
profitability of the firm.
z Cut-off Point: It is the dividing line between the acceptable and non-acceptable
proposals. It may be in terms of a period or a rate. In the former case, it is
termed as ‘Cut-off Period’.
z Capital Rationing: It is the process of allocating funds to most desirable
projects due to limitations on the availability of financing.
z Discounted Cash Flow Method: It is a method of evaluation by which the
future cash flows from a project are discounted to current levels by the application
of a discount rate with the objective of reducing all cash flows to a common
denomination for making comparison.
z Internal Rate of Return (IRR): It is the rate of return at which the present
value of the future cash inflows is equal to the present value of the future cash
outflows. At this rate, the NPV is zero.
z Net Present Value (NPV) Method: It is the method under which future cash
flows are discounted to its current value at a given rate for identifying the
Self-Instructional relative return from a project.
74 Material
 z Payback Period: It is the length of time needed to regain the original investment. Capital Budgeting

z Profitability Index: It is the ratio of the total present value of future cash
inflows with the total present value of future cash outflows. It is also known as
excess present value index or benefits/costs ratio.
NOTES
4.11 ANSWERS TO ‘CHECK YOUR PROGRESS’
1. Capital budgeting decisions require large capital outlays.
2. Independent proposals are those which do not compete with one another in a way
that acceptance of one precludes the possibility of acceptance of another.
3. Cut-off point refers to the point below which a project would not be accepted.
4. Cash inflows represent the cash profit or return generated by the project year
after year.
5. The payback method is very useful in evaluation of those projects which involve
high uncertainty.
6. Unadjusted rate means a rate which has not been adjusted by taking into account
the time value of money.

4.12 QUESTIONS AND EXERCISES

Short-Answer Questions
1. State whether each of the following statements is True or False:
(a) The Internal Rate of Return and Net Present Value are synonymous terms.
(b) Cash flows from a project can be estimated accurately.
(c) Cash flows from a project can be worked out only on the basis of
certain probabilities.
(d) The inflation and deflation factors need not be taken into account while
estimating future cash inflows since it is difficult to predict future price
changes.
(e) It is imperative to make an estimate regarding likely increase in costs on
account of possibility of delay in implementing a project.
(f) No additional working capital will be required in case of an expansion of an
existing project.
(g) Tax concessions have no role to play in estimating the cash flows from a
project.
(h) Internal rate of return determines the maximum rate of interest that a firm
can afford to pay on the borrowings for a particular project.
(i) Payback method takes into account the cash flows after the payback period.
(j) Depreciation is considered while calculating the return on a project according
to the Accounting Rate of Return Method.
(k ) Discounted cash flow techniques takes into account the time value of money.
(l) There are no mathematical techniques available for dealing with risk and
uncertainty factors involved in determining future cash inflows from a project.

Self-Instructional
Material 75
Capital Budgeting Long-Answer Questions
1. ‘Payback method is a test of liquidity and not profitablility’. Discuss.
2. Explain briefly the following methods of ascertaining the profitability of capital
expenditure project bringing out merits and demerits of each:
NOTES (a) Payback method (b) Return on Investment method
3. ‘Capital expenditure decisions are by far the most important decisions in the field
of financial management’. Illustrate.
4. Discuss briefly the Net Present Value Method vs. Internal Rate of Return
Method of evaluation of projects.
5. What are the basic components of capital budgeting analysis ? Explain the
difference between IRR and NPV methods.
6. Explain the salient features of the ‘Present Value Method’ of project evaluation
and examine its rationality.
7. Explain the importance of proper planning and control of capital expenditure and
the various techniques that are used for comparative evaluation of mutually
exclusive capital expenditure proposals.
8. Discuss the methods used for evaluating and ranking investment proposals.
Compare the IRR Method with the NPV method.

4.13 PRACTICAL PROBLEMS

Payback Method
1. ABC Ltd is considering two projects. Each requires an investment of Rs 10,000. The
net cash inflows from investment in the two projects X and Y are as follows:
Year X Y
1 Rs 5,00 Rs 1,000
2 4,000 2,000
3 3,000 3,000
4 1,000 4,000
5 – 5,000
6 – 6,000

The company has fixed three years payback period as the cut-off point.
[Ans. Project X should be accepted]
2. Each of the following projects requires a cash outlay of Rs 10,000. You are required
to suggest which project should be accepted if the standard payback period is five
years:

Year Cash Inflows

Project X Project Y Project Z
1 Rs 2,500 Rs 4,000 Rs 1,000
2 2,500 3,000 2,000
3 2,500 2,000 3,000
4 2,500 1.000 4,000
5 2,500

[Ans. Payback period in each case is four years. However, Project Y is the best out of
all since in its case the cash inflows are higher in the initial years].
3. Using the information given below, compute the payback period under (a) Traditional
Payback Method and (b) Discounted Payback Method and comment on the results:
Initial outlay Rs 80,000
Estimated life Five years
Self-Instructional
76 Material
 Capital Budgeting
Profit after tax:
End of year 1 Rs 6,000
2 14,000
3 24,000
NOTES
4 16,000
5 Nil
Depreciation has been calculated under the straightline method. The cost of capital may
be taken at 20 per cent per annum and the P.V. of Re 1 at 20 per cent per annum is
given below :
Year 1 2 3 4 5
P.V. Factor 0.83 0.69 0.58 0.48 0.40
[Ans. (a) 2.7 years (b) 4.39 years]
[Hint. (i) Add depreciation of Rs 16,000 to net profit each year for determining cash
flows. (ii) Discount the cash flows for determining the present values for calculating
payback period according to method (b)].
4. There are two projects X and Y. X requires an investment of Rs 26,000 while Y requires
an investment of Rs 38,000. The cost of capital is 12 per cent. On the basis of the
following cash inflows and present value of Re 1 at 12 per cent, you are required to
state which project should be accepted:
Year Cash inflows Present Value of
Re 1 at 12 per cent
Project X Project Y
1 Rs 9,000 Rs 8,000 0.893
2 7,000 10,000 0.797
3 6,000 12,000 0.712
4 5,000 14,000 0.636
5 4,000 8,000 0.567
6 4,000 2,000 0.507
7 3,000 16,000 0.452
8 3,000 – 0.404
9 3,000 – 0.361
10 3,000 0.322

[Ans. NPV Project X Rs 3,981; NPV Project Y Rs 7,344; Project Y to be preferred]

5. Consider the following proposed investments with the indicated cash inflows:
Year-end Cash Inflows
Investment Initial Year 1 Year 2 Year 3
outlay (Rs ‘000) (Rs ‘000) (Rs ’000) (Rs ‘000)
A 200 200 Nil Nil
B 200 100 100 100
C 200 20 100 300
D 200 200 20 20
E 200 140 60 100
F 200 160 160 80
Rank the investment deriving the Net Present Value (NPV) using a discount rate of 10
per cent, and state your views.
Note: Present value of Re 1
Due at the end of year: Re
1 0.909
2 0.826
3 0.751
[Ans. NPV: Project A Rs 181.80, Project B Rs 248.60, Project C Rs 326.08, Project D Rs
213.34, Project E Rs 251.92, Project F Rs 337.68, Project F should be preferred.] Self-Instructional
Material 77
Capital Budgeting Internal Rate of Return (IRR)
6. A project costs Rs 16,000 and is expected to generate cash inflows of Rs 4,000 each
for five years. Calculate the Internal Rate of Return.
[Ans. 8 per cent]
7. A company is contemplating investment in a project which requires an initial investment
NOTES of Rs 40,000 generating a cash flow of Rs 16,000 every year for four years. Calculate
the Internal Rate of Return.
[Ans. 22 per cent]
8. X Ltd has currently under examination a project which will yield the following returns
over a period of time.
Year Gross Yield (Rs)
1 80,000
2 80,000
3 90.000
4 90,000
5 75,000
Cost of the machinery to be installed works out to Rs 2,00,000 and the machine is to
be depreciated at 20 per cent WDV basis. Income-tax rate is 50 per cent. If the average
cost of raising capital is 11 per cent, would you recommend accepting the project under
IRR Method ?
[Ans. IRR 14% approx, the project may be accepted]
[Hint. In the last year full remaining depreciable value of the asset is to be charged as
depreciation. Scrap value assumed to be nil.]
Accounting Rate of Return
9. ABC Ltd is proposing to take up a project which will need an investment of Rs 40,000.
The net income before depreciation and tax is estimated as follows:
Year Rs
1 10,000
2 12,000
3 14,000
4 16,000
5 20,000
Depreciation is to be charged according to the straightline method. Tax rate is 50 per
cent. Calculate the Accounting Rate of Return.
[Ans. ARR Rs 3,200/Rs 20,000 = 16 per cent]

4.14 FURTHER READING

Maheshwari, S.N. Financial Management: Principles & Practice. New Delhi: Sultan
Chand & Sons, 2007.
Maheshwari, Dr. S.N, Dr. Suneel K. Maheshwari, Mr. Sharad K. A Textbook of
Accounting for Management. New Delhi: Vikas Publication House Pvt. Ltd.

Self-Instructional
78 Material
Authors: S N Maheshwari, Sharad K Maheswari & Suneel K Maheshwari
Copyright © Authors, 2011

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