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ccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccccKOMAL KHEMANI

MBA-II SEMESTER

D.E.I
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 ......................................................................................... 3c
 .................................................................................................. 3c
ñ ......................................................................................................... 3c
Evaluation of Capital Projects ........................................................................................................... 4c
Capital Budgeting Process ................................................................................................................ 5c
Traditional Methods ...................................................................................................................... 6c
Discounted cash flow techniques................................................................................................. 10c
CONCLUSION .............................................................................................................................. 19c
REFERENCES ............................................................................................................................... 20c
  c
  ccc
 c

Capital budgeting is the technique of making long-term planning decisions for investment and their
finance. Decisions on capital expenditure are difficult as future is uncertain. It includes current cash
outlay or a series of cash outlays in return for an anticipated flow of future benefits. Capital
budgeting is employed to evaluate long-term expenditure decisions which involve current outlays
and the benefits that occur in the future years.
c

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Îc To help select projects that assist in maximizing the market value of the firm while rejecting
projects which do not assist in maximizing value. Only by seeking and accepting projects
that return an incremental amount above the opportunity cost of capital will the firm be
adding to its value.
Îc To estimate the total change in the firm's cash flows that results because a project is
undertaken. Hence indirect effects on the costs and/or revenues associated with a firm's other
projects that occur as a result of the acceptance of a new project should be considered when
evaluating the cash flows from a new project
c

ccc
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Capital budgeting decision ultimately affects the profitability of the business. Scope of capital
Budgeting may be summarised as follows:
Îc Investment in long term projects or fixed assets is undertaken with a view to expand, or to
increase production or to reduce costs which will lead to increase profits.
Îc The benefits of such investment decisions are likely to accrue in the future after a long period
of time. Apart from the costs of the fixed assets purchased, other costs also increase.
Îc Huge amount of capital outlay are involved when a decision to purchase fixed assets or
invest in projects is take.
  cc c"c

Evaluation of capital projects refers to the development and applications of basic

theory, techniques and procedures for the appraisal of capital projects, bath as the time of their
approval and in the course of their implementation.

Capital Budgeting Decision

OR
Investment decision

Project Project Project Screening Project Control of Capital

Generation Evaluation and Selection Execution Expenditure

Cash Flow Selection of

Estimates Evaluation methods

Cash out Cash in

Flow Flow

With
Uncertainty
Certainty

Risk Return

Trade Off

Market value Per

Share
The following are the Evaluation methods:-
 c Payback period(PB)
 c Post-payback profitability(PPP)
 c Average Rate of Return(ARR)
 c Minimum Unit Cost
 c Net Present value(NPV)
 c Profitability Index(PI)
 c Internal Rate of Return(IRR)
 c Net Terminal Value(NTV)
 c Discounted payback period(DPP)
 c Cut-off rate

c
 c"c
Capital Budgeting process is very complex process. There would be conceptual idea
about a project generation and it should be evaluated by measuring the projects worth in its
economy, productivity and profitability. Project evaluation involves eight steps;
(a)c Estimation of cash flow i.e.; investment.
(b)cEstimation of benefits
(c)c Estimation of costs
(d)cTechnical and flexibility evaluation, Project schedules, PERT and CPM charts
(e)c Estimation of cash inflows taking the depreciation and tax into account
(f)c Estimation of risk and uncertainty
(g)cSelection of suitable evaluation method
(h)cFinally, selection of project among the various alternatives

Various alternative items are to be screened and finally selected by application of a suitable
appraisal method. Then the project is to be executed with strict control on capital expenditure sot
that the authorized outlay is not exceeded. While execution of this project, the physical process of
work and capital expenditure are to be matched. Time and cost-over runs should be avoided as this
will increase the cost of the project. There should be a point of equilibrium between the risk and
return so that the market value per share is optimum.

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 c |
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It indicates the number of years required to recover the initial cash outlay invested in a
project. The payback period is one of the most popular and widely recognized traditional methods of
evaluating investments proposals. It is defined as the number of years required to recover the
original cash outlay invested in a project. The following are the formulas for calculating the payback
period:-
Uc if cash flows are even(uniform):-
If the cash flows are even (uniform) then the payback period is
calculated by following formula;

Payback Period= Investment

Annual Cash Flow
Uc if cash flows are uneven or not even:-
If cash flows are uneven or not even then the payback period is
determined by  c c c  c c c c  c  c c c  c c c c c
c c

c cc
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Many firms use the payback period as an accept/reject criteria as well as a method of
ranking projects. If the payback period calculated for a project is less than the maximum or standard
payback period set by management, it would be accepted; if not, it would be rejected.

c  c
c
As a ranking method, it gives highest ranking to the project which has the shortest
payback period and lowest ranking to the project with highest payback period.
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If the firm has to choose among the two mutually exclusive projects, the project with
shorter payback period will be selected.

Îc    cc|
 c
c
(a)c It is very simple measure of economic feasibility (possibility).
(b)c It is very easy to apply, calculate and interpret.
(c)c It is easy to understand.
(d)c The emphasis is on early recovery of the investment. Thus, it gives importance to liquidity
aspect. The funds so released can be put to the other uses .i.e.; it emphasizes only on liquidity
and solvency of the firm.
(e)c It costs less than most of the sophisticated technique which require a lot of the analysis time
and use of computers.
(f)c The payback period is a meaningful indicator of economic feasibility in case of the firms where
the risk of obsolescence is high in comparison to other projects is expected to pay for them
faster.
(g)c It takes less time to calculate and hence the cost of analysis is low.

Îc Ú   cc|
 c

c
In spite of its simplicity, the payback may not be a desirable investment criterion
since it suffers from a number of serious limitations;

(a)c The main limitation is that this method fails to take into account the time, value and money.
Cash flows of equal amounts are considered to be the same even though they occur in different time
periods. c
c
(b)c It does not take into account the cash flows over the entire life of project. Cash flows after the
payback period are ignored.c
c
(c)c Administrative difficulties may be faced in determining the maximum acceptable payback
period. There is no scientific basis for setting up a maximum payback period. It is a subjective
decision.c
c
(d)c It does not show the economic return on investment.c
c
(e)c This method is not consistent with the objective of maximizing the market value per share.c
c
(f)c It may choose highly risk projects because of having a shorter standard payback period as it
may ensure guarantee against loss.c
c
 c  c cc
c
Accounting rate of return is compared with predetermined or minimum required rate
of return.

„
c

ARR= Average profits after taxes

Average Investment
100

Average Investment = Net Investment

2
Net Investment = Book value of investment at beginning ± Book value of
investment at the end.

›




 

Average investment = Salvage value + ½(cost ± salvage value)

c c
cc
As ARR is compared with predetermined or minimum required rate of return, if ARR
> minimum required rate if return, then accept the project and if the ARR < minimum required rate
of return then reject the project.

c  c
c
As a method of ranking the projects, highest rank is given to projects with highest
ARR and lowest rank is given to project with lowest ARR.

Îc cc
c
(a)c It is very much simple to understand.
(b)cIt is calculated from accounting data which is readily available from books of accounts.
(c)c It tales into account the entire stream of income in calculating the projects profitability.

Îc Úcc
c
(a)c As the decision criterion is concerned, it suffers from serious shortcomings.
(b)c It uses accounting profits and not cash flows. Accounting profits are based upon arbitory
assumptions and includes non-cash items. Accounting profits are considered to be
inappropriate for measuring the projects profitability.
(c)c It ignores time, value and money. It gives equal weightage to benefits receivable in different
time periods.
 c$c%c$ &c

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½c The future stream of benefits and costs converted into equivalent values today. This is done by
assigning monetary values to benefits and costs, discounting future benefits and costs using an
appropriate discount rate, and subtracting the sum total of discounted costs from the sum total of
discounted benefits.

½c The present value of an investment's future net cash flows minus the initial investment. If
positive, the investment should be made (unless an even better investment exists), otherwise it
should not.

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1. NPV assumes that project cash flows are reinvested at the company's required rate of return; the
IRR assumes that they are reinvested at the IRR. Since IRR is higher than the required rate of return,
in order for the IRR to be accurate, the company would have to keep finding projects that would
reinvest the cash flow at this higher rate. It would be difficult for a company to keep this up forever,
thus NPV is more accurate.
2. NPV measures project value more directly than IRR. This is because NPV actually calculates the
project's value. If there is more than one project lined up, the manager can simply add the values
together to get a total.

3. Often times, during the life of a project, cash flows must be reinvested to cover depreciation. This
will give a negative cash flow for that period, thus leading to more than one IRR. If there is more
than one IRR, than calculating only 1 IRR for the project is not reliable. NPV must be used for this
type of project.

Úc    ccà|"
c

Net Present Value (NPV) is one of the most robust financial tools available to value
any type of investment or activity. NPV analysis incorporates four key benefits or elements to
establish the value of an investment:

uc ‘c" cc 

c Recognizes the time value of money concept that says a dollar earned
today is worth more than a dollar earned five years from now.

uc ÷ c„
c Calculates the expected cash flows generated from the project and incorporates
the unique risks of obtaining those cash flows. NPV also eliminates accounting inconsistencies
as the cash flows are representative of the benefits of the project not accounting profits.

uc 
c c Incorporates the risks associated with the project via the expected cash flows and/or
discount rate.

uc „!

c Provides flexibility and depth as the NPV equation can adjust for inflation as well
as incorporate other financial analysis tools such as scenario analysis, Monte Carlo simulation,
etc.
uc Ôc  !# c  c 
 It is consistent with the objective of maximizing the
market price of shares. If NPV is positive, the return is higher than the return expected by the
shareholders. This increases the share prices. If NPV is negative, it has a negative impact on
share prices.

The NPV concept is consistent with maximizing the value of the firm
and is used by investors in the evaluation of a company or in capital budgeting decisions when
comparing the value of different projects. For these reasons, the NPV concept is being used more
and more in corporate America as substitute to other financial evaluation tools such as Internal Rate
of Return (IRR) and Total Cost of Ownership (TCO).

Úc Ú   
c

1.c It is difficult to use.

2.c The calculation of the NPV presupposes (assumes) that discount rate is known but the cost of
capital is a difficult concept to understand and measure in practice. The success of capital
budgeting techniques depends upon the correctness with which the cost of capital is determined.
3.c It does not give satisfactory answers when projects are being compared involved different
amount of investment. The limitation of NPV method is that the NPV doe not correlate the NPV
of project with its investment.
4.c It does not give satisfactory answers when we are comparing projects with unequal life¶s. The
alternative with high NPV may involve larger economic life and it would be less desirable as the
funds remain invested for a long period. The alternative having shorter life may have less NPV.
In general project with short economic life should be preferred.

 c| 
c$ !
c
c
et another time adjusted method of evaluating the investment proposals is
the benefit cost (B*C) ratio or profitability index (PI). It is the ratio of present value of cash inflows,
at their required rate of return, to the initial cash outflows of the investment. It may be gross or net;
net being simply gross minus one. The formula to calculate the profitability index is as follows:-

 !c

Profitability Index = Present value of cash inflows / Present value of cash outflows
c

àc |cc   c| 
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c
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c  cc  cc  cc

 c Siyaram silk mills ltd. Is considering the two projects namely Project Fabric and Project
Garment. Projects are available at cost of Rs. 14000 lakhs each and have a life of 5 years. The
cash flows of this company are as follows:-
ccccccccc& ''c
ears Proj.Garment Proj. Fabric
2001 2254 2150
2002 5000 5410
2003 3065 3070
2004 3908 1507
2005 3005 5623
Calculate Profitability Index (PI) method [cash flows are
given after deducting depreciation and taxes]. Also write which project is accepted and which is
rejected.
ñ
c
As discount rate is not mentioned we assume the discount rate as 7%.

 c
+! !cccc*'c!c

c c c c c c c c c cccccc ''c
ears Cash Flow after Present value factor @7% discount Present value of
depreciation and tax rate cash inflows
2001 2254 1/(1+0.07)1 = 0.934 2105.23
2002 5000 1/(1+0.07)2 = 0.877 4385.00
3
2003 3065 1/(1+0.07) = 0.819 2510.23
2004 3908 1/(1+0.07)4 = 0.763 2981.80
2005 3005 1/(1+0.07)5 = 0.714 2145.57
Present value of cash inflows= 14127.83

So,
Profitability Index = Present value of cash inflows / Present value of cash outflows
= 14127.83/14000

PI = 1.009.

 c
+! !cccc*'c

!&'c
cccccc ''c
ears Cash Flow after Present value factor @7% discount Present value of
depreciation and tax rate cash inflows
2001 2150 1/(1+0.07)1 = 0.934 2008.17
2002 5410 1/(1+0.07)2 = 0.877 4744.57
2003 3070 1/(1+0.07)3 = 0.819 2514.33
4
2004 1507 1/(1+0.07) = 0.763 1149.84
2005 5623 1/(1+0.07)5 = 0.714 4014.82
Present value of cash inflows= 14431.66
 So,
Profitability Index = Present value of cash inflows / Present value of cash outflows
= 14431.66/14000

PI = 1.030.

As the method of the accepting and rejecting criteria is concerned

then, |c ( c c c  c andc |c „ c c c  c Because Project
garment¶s period compared to Project Fabric is less.

àc |cc  ccà|"càc|c" c  c|$c| 
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c
{by taking into consideration of Industry visit}

Siyaram Silk Mills Ltd. Is considering the two new projects

which would carryout some operations that present performed manually. The two alternative
projects are namely Project Fabric and Project Garment. The company¶s cash outlay is of
Rs.1310.89 lakhs. The rate of return is 10% and pays tax at 50% rate. Project will be depreciated as
on straight line basis. The net cash flows given below are before depreciation and taxes.
cccccc ''
ears Proj.Fabric Proj. Garment
2005 30235.84 28008.65
2004 29833.51 26352.61

Which of the above projects should be accepted according to the

following methods:-
uc NPV method (Net Present Value)

uc Profitability Index (P I )
 The present value of Re.1/- at 10% for different years is as
follows:-
ear Present Value Factor
2005 0.909
2004 0.826

ñ
c

Calculation for Project Fabric:-

ears CFBDAT -dep CFADBT Tax(50%) CFAT CFATAD PV PVCIF

(1) (2) (3) (4) (5) (6) (7) @10%(8) (9)
2005 30235.84 655.44 29580.4 14790.2 14790.2 15445.64 0.909 14040.08
2004 29833.51 655.44 29178.07 14589.03 14589.04 15244.47 0.826 12591.93

% 
c --., /c
% 
c /./ ,01c
c c
%c 2./,/c

CFBDAT ---------- Cash Flow before Depreciation and Tax {(given)}

CFADBT ---------- Cash Flow after Depreciation before Tax {(2) ± (3)}
CFAT ---------- Cash Flow after Tax {50 % of CFADBT}
CFATAD ---------- Cash Flow after Tax and Depreciation {(7) + (3)}
PVCIF ---------- Present Value of Cash Inflow {(8) * (7)}
PVCOF ---------- Present Value of Cash Outflow {(given)}
NPV ---------- Net Present Value {(CIF ± COF)}
 Depreciation = Investment / years given
= 1310.89 / 2
= 655.44

NPV = PVCIF - PVCOF

= 26632.01 ± 1310.89.
= 25321.12
c
àc|c" c c cc c
Profitability Index = Present value of cash inflows / Present value of cash outflows
= 26632.01 / 1310.89
c
c |$c c= 20.31.

ears CFBDAT -dep CFADBT Tax(50%) CFAT CFATAD PV PVCIF

(1) (2) (3) (4) (5) (6) (7) @10%(8) (9)
2005 28008.65 655.44 27353.21 13676.60 13676.61 14332.04 0.909 13027.82
2004 26352.61 655.44 25697.17 12848.58 12848.59 13504.02 0.826 11154.32

% 
c 3/0,/3c
% 
c c/./ ,01c
c c
%c 405/,2c

Calculation for Project Garment:-

CFBDAT ---------- Cash Flow before Depreciation and Tax {(given)}
CFADBT ---------- Cash Flow after Depreciation before Tax {(2) ± (3)}
CFAT ---------- Cash Flow after Tax {50 % of CFADBT}
CFATAD ---------- Cash Flow after Tax and Depreciation {(7) + (3)}
PVCIF ---------- Present Value of Cash Inflow {(8) * (7)}
PVCOF ---------- Present Value of Cash Outflow {(given)}
NPV ---------- Net Present Value {(CIF ± COF)}
 Depreciation = Investment / years given
= 1310.89 / 2
= 655.44

NPV = PVCIF - PVCOF

= 24182.14 ± 1310.89.
= 22871.25
c
ccccccccccccccccccccccccccccccàc|c" c c cc c

Profitability Index = Present value of cash inflows / Present value of cash outflows
= 24182.14 / 1310.89
c
c |$c c= 18.44.

In case of NPV, both the projects have positive value so both the
projects are accepted.
In case of PI method, Project Garment has got less number of period
so this project is accepted other than project fabric.

 
c

The long-term investments we make today determines the value we will have tomorrow. Therefore,
capital budgeting analysis is critical to creating value within financial management. And the only certainty
within capital budgeting is 
 
. Therefore, one of the biggest challenges in capital budgeting is to
manage uncertainty. We deal with uncertainty through a three-stage process:

1.c Build knowledge through decision analysis.

2.c Recognize and encourage options within projects.

3.c Invest based on economic criteria that have realistic economic assumptions.

Once we have completed the three-stage process (as outlined above), we evaluate capital projects using a
mix of economic criteria that adheres to the principles of financial management. Three good economic
criteria are Net Present Value, Modified Internal Rate of Return, and Discounted Payback.

Additionally, we need to manage project risk differently than we would manage uncertainty. We have
several tools to help us manage risks, such as increasing the discount rate. Finally, we want to implement
post analysis and tracking of projects after we have made the investment. This helps eliminate bias and
errors in the capital budgeting process.
Ê'Ê c

Ë

c
 c en.wikipedia.org
 c www.teachmefinance.com
 c www.investopedia.com
 c www.studyfinance.com
 c www.investorwords.com
6c
 c Financial management by I M Panday
 c Basic Financial Management by M. . Khan & P K Jain
c
c
c
c
c