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Accounting and Finance for Managers

LESSON

18
CAPITAL BUDGETING
CONTENTS
18.0 18.1 18.2 18.3 Aims and Objectives Introduction Aim of Capital Budgeting Methods of Capital Budgeting 18.3.1 Pay Back Period Method 18.3.2 Accounting or Average Rate of Return 18.3.3 Discounted Cash Flows Method 18.4 18.5 18.6 18.7 18.8 18.9 18.10 18.11 18.12 18.13 Present Value Method Capital Rationing Divisible Project Indivisible Project Risk Analysis in Capital Budgeting Let us Sum up Lesson-end Activity Keywords Questions for Discussion Suggested Readings

18.0 AIMS AND OBJECTIVES


After studying this lesson you will be able to: (i) decide why capital budgeting is most important decision of the financial management (ii) describe various objectives and methods of capital budgeting (iii) distinguish between divisible and indivisible projects.

18.1 INTRODUCTION
The capital budgeting is one of the important decisions of the financial management of the enterprise. The decisions pertaining to the financial management of the firm are following:
Decisions of Financial Management

Financing

Investment

Dividend

Liquidity

Long Term Investment

Short Term Investment

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Capital Budgeting

Working Capital Management

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Why the capital budgeting is considered as most important decision over the others? The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets. The importance of the capital budgeting is only due to the benefits of the long term assets stretched to many number of years in the future. It is a tool of analysis which mainly focuses on the quality of earning pattern of the fixed assets. The capital budgeting decision is a decision of capital expenditure or long term investment or long term commitment of funds on the fixed assets. Charles T. Horngreen A long-term planning for making and financing proposed capital outlays.

Capital Budgeting

18.2 AIM OF CAPITAL BUDGETING


To make rational investment: The study of capital budgeting on capital expenditures evades not only over capitalization but also under capitalization. The long-term investment normally demands heavy volume of investment which is met out by the firm either through external or internal source of financing. Hence, the amount of capital raised by the firm should neither greater nor lesser than the investment. Locking up of capital: The amount invested is requiring longer gestation to recover. The longer gestation is connected with future horizon in getting back the investment. The future is uncertain unlike the present. If the longer is the gestation in the future leads to greater risk involved. Effect on the profitability of the enterprise: The profitability of the enterprise is mainly depending on the proper planning of the capital expenditure. Nature of Irreversibility: The improper/ unwise capital expenditure decision cannot be immediately corrected as soon as it was found. Once it is invested is invested which cannot be reversed. The poor investment decision will require the firm either to keep it as an idle in the form of investment or to unnecessarily meet out fixed commitment charge of the capital which excessively raised more than the requirement.

18.3 METHODS OF CAPITAL BUDGETING


The methods are the nothing but the instruments of the capital budgeting to study the quality of the investments/fixed assets. The investments are studied by the firms in the following angles: l Based on the number of years taken for getting back the investment Pay Back Period Method l Based on the profits accrued out of the investment Accounting Rate of Return/ Average Rate of Return l Based on the timing of benefits Present value of future benefits of the investment Discounted cash flow methods v Based on the comparison in between the cash outlay and receipts discounted with the help of minimum rate of return - Net present value method v Based on the identification of maximum rate of return, in between the initial cash outlay and discounted expected future receipts - Internal Rate of return method v Based on the ration in between the present values of cash inflows and outflows Present value index method
Check Your Progress

(1)

Capital budgeting means a study of


(a) (b) Budgeting of long-term capital Budgeting of short-term capital Contd....
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(c) (d)

Budgeting of short-term assets Worthiness of long-term assets Yearly basis On the basis of return On the basis of present value of money (a), (b) & (c) Acceptance of the investment proposal Rejection of investment proposal Neither can be accepted nor rejected

(2)

Capital budgeting tools are classified into


(a) (b) (c) (d)

(3)

Selection criterion are classified into


(i) (ii) (iii)

(a) (b) (c) (d)


l

(i) only (ii) only (iii) only (iv), (ii) & (iii)

The classification of methods are generally in two categories: Traditional methods v Pay Back Period method v Accounting Rate of Return Discounted cash flow methods v Net present value method v Internal Rate of Return method v Present value index method v Discounted pay back period method

18.3.1 Pay Back Period Method


What is pay back period? The pay back period is the period taken by the firm to get back the investment. The pay back period is nothing but number of years/months/days required by the firm to get back its investment invested in the project. To find out the pay back period, the following are two important covenants required: l Initial outlay / Initial investment/ Original investment l Cash inflows How the pay back period is calculated? The pay back period is calculated by way of establishing the relationship between the volume of investment and the annual earnings While calculating the pay back period, the nature of annual earnings should be identified. The nature of the annual earnings can be classified into two categories: l Cash flows are equivalent or constant l Cash flows are not equivalent or constant If the cash flows are equivalent, How the pay back period is to be calculated ? The cost of the project is Rs.1,00,000. The annual earnings of the project is Rs.20,000. Calculate the pay back period.

Pay back period =


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Initial Investment Average Annual Earnings Rs. 1,00,000 = = 5 Years Rs. 20,000

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It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5 years time period to get back the original volume of the investment. If the cash flows are not equivalent, How the pay back period is to be calculated ? The cost of the project is Rs.1,00,000. The annual earnings of the project are as follows
Year Net Income Amount Rs 1st 40,000 2nd 30,000 3rd 20,000 4th 20,000 5th 20,000

Capital Budgeting

The ultimate aim of determining the cumulative cash inflows to find out how many number of years taken by the firm to recover the initial investment. The next step under this method is to determine the cumulative cash flows
Year 1. 2. 3. 4. 5. Annual Net Incomes Rs 40,000 30,000 20,000 20,000 20,000 Cumulative cash flows Rs. 40,000 70,000 90,000 1,10,000 1,30,000

3 years full time required to recover the major portion of investment Rs.90,000

The uncollected portion of the investment is Rs,10,000. This Rs.10,000 is collected from the 4th year Net income / cash inflows of the enterprise. During the 4th year the total earnings amounted Rs.20,000 but the amount required to recover is only Rs.10,000. For earning Rs.20,000 one full year is required but the amount required to collect it back is amounted Rs.10,000. How many months the firm may require to collect Rs.10,000 out of the entire earnings Rs.20,000? Pay back period consists of two different components
l l

Pay back period for the major portion of the investment collection in full course E.g.: 3 years Pay back period for the left /uncollected portion of the investment
Rs.10,000 = 0.5 years Rs. 20,000

For the second category =

Total pay back period= 3 Years +.5 year = 3.5 years Criterion for selection: If two or more projects are given for appraisal, considered to be mutually exclusive to each other for selection, the pay back period of the projects should tabulated in accordance with the ascending order. The project which has lesser pay back period only to be selected over the other projects given for scrutiny. Why lesser pay back has to be chosen? The reason behind is that the project which has lesser pay back period got faster recovery of the initial investment through cash inflows/Net income. Selection criterion
Lesser the pay back period is better for acceptance of the project

Illustration 1: A project costs Rs.2,00,000 and yields and an annual cash inflow of Rs.40,000 for 7 years. Calculate pay back period First step is identify the nature of the annual cash inflows
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In this problem, the annual cash inflows are equivalent throughout life period of the project Pay Back Period =
Initial Investment Rs. 2,00,000 = = 5 years Annual Cash Inflows Rs. 40,000

Illustration 2: Calculate the pay back period for a project which requires a cash outlay of Rs.20,000 and generates cash inflows of Rs 4,000 Rs.8,000 Rs. 6,000 and Rs. 4,000 in the first, second, third, and fourth year respectively First step is to identify the nature of the cash inflows The cash inflows are not equivalent/constant Year Cash Inflows Rs 4,000 8,000 6,000 4,000 Cumulative Cash Inflows Rs 4,000 12,000 18,000 22,000

1. 2. 3. 4.

Cost of the project is to be recovered Rs.20,000. The project takes 3 full years time period to recover the major portion of the initial investment which amounted Rs.18,000 out of Rs.20,000 The remaining amount of the initial investment is recovered only during the fourth year. The left portion Rs.2,000 has to be recovered only from the fourth year cash inflows of Rs.4,000. Pay Back Period = Pay Back period of the major portion + Pay Back period of the remaining portion Pay Back period of the major portion = 3 years Pay Back period of the remaining portio: For the entire earnings of Rs.4,000, the firm consumed one full year/12 months time period. How many number of months required to recover Rs.2,000 ?
Rs. 2,000 = 0.5 12 months = 6 months Rs. 4,000

Total pay back period = 3 years + 6 months = 3 years 6 months Illustration 3: A project cost of Rs.10,00,000 and yields annually a profit of Rs.1,60,000 after depreciation and depreciation at 12% per annum but before tax 50% calculate pay back period. Pay Back Period =

Initial Investment Annual Cash inflow

In this problem, the initial investment is given which amounted Rs.5,00,000. The annual cash inflow is not given directly; to determine the cash inflow; what is meant by the cash inflow ? Cash inflow = Profit after tax + Depreciation
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Profit Before taxation

= Rs.1,60,000

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(-)Taxation Profit after taxation (+)Depreciation 12% on Annual Cash Inflow Pay Back Period

= Rs. 80,000 = Rs. 80,000 = Rs. 10,00,000 = Rs. 1,20,000 = Rs. 2,00,000 = Rs.10,00,000 = 5 years = Rs.2,00,000

Capital Budgeting

Illustration 4: A company proposing to expand its production can go in either for an automatic machine costing Rs.2,24,000 with an estimated life of 5 years or an ordinary machine costing Rs.60,000 having an estimated life of 8 years. The annual sales and costs are estimated as follows: Particulars Sales Costs Material Labour Variable overheads Automatic Machine Rs 1,50,000 50,000 12,000 24,000 Ordinary Machine Rs 1,50,000 50,000 60,000 20,000

Compute the comparative profitability of the proposals under the pay back period method. Ignore Income Tax (I.C.W.A.Final) The first step is to find out the Annual profits of the two different machines The next step is to find out the pay back period of the two different machines respectively Profitability Statement Automatic Machine Rs Sales Less : Material Labour Variable overheads Annual profit 1,50,000 50,000 12,000 24,000 64,000 Pay Back Period Particulars Cost of the Machine Annual Profit Pay Back Period Initial Investment Annual profit Automatic Machine Rs 2,24,000 64,000 Rs.2,24,000 Rs.64,000 = 3 years Ordinary Machine Rs 60,000 20,000 Rs 60,000 Rs 20,000 = 3 years Ordinary Machine Rs 1,50,000 50,000 60,000 20,000 20,000

The pay back period method highlights that the ordinary machine is more ideal than the automatic machine due to lesser pay back period i.e., 3 years. It means that the ordinary machine is bearing the faster rate in getting back the investment invested than the automatic machine.

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The another method to discuss is post pay back impact of the two different machines Post pay back profit is the profit of the two different machines after the recovery of the initial investment. The machine which has greater post pay back profit construe. Post Pay Back Profit Particulars Annual Profit R.No.1 Estimated Life R.No.2 Pay Back Period R.No.3 Post Pay Back Period R.No. 4=R.No.2-R.No.3 Post Pay Back Profit R.No5=R.No.1R.No.4 2 years = Rs.64,0002 years = Rs.20,0005years 5 years = Rs.1,28,000 = Rs.1,00,000 Automatic Machine Rs 64,000 5 years 3 years Ordinary Machine Rs 20,000 8 years 3 years

Post pay back profit of the Automatic machine is higher than the Ordinary machine ; which amounted Rs.1,28,000.. It means that the profit of the automatic machine after the recovery of the initial investment is greater than that of the ordinary machine. Illustration 5: A company has to choose one of the following two mutually exclusive projects. Investment required for each project is Rs 30,000. Both the projects have to be depreciated on straight line basis The tax rate is 50%. Year Profit Before Depreciation Project A Rs 1. 2. 3. 4. 5. Calculate pay back period First step is to find out the depreciation under the straight line method The next step is to determine the pay back period of the both projects A and B respectively The next step is to compare both pay back periods of two different projects. The depreciation under the straight line method is as follows For Project A 8,400 9,600 14,000 14,000 4,000 Project B Rs 8,400 9,000 8,000 10,000 20,000

Initial Investment Rs. 30,000 = = Rs.6,000 Life of the Project 5 years


For Project B

Initial Investment Rs. 30,000 = = Rs.6,000 Life of the Project 5 years


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Project A Add Depreciation Less Depreciation Cumulative Cash inflows Profit Before Depreciation

Capital Budgeting

Profit after tax

Less Tax 50%

1. 2. 3. 4. 5.

8,400 9,600 14,000 14,000 4,000

6,000 6,000 6,000 6,000 6,000

2,400 3,600 8,000 8,000 -(2000)

1,200 1,800 4,000 4,000 0

1,200 1,800 4,000 4,000 -(2000)

6,000 6,000 6,000 6,000 6,000

7,200 7,800 10,000 10,000 4,000

Cash in flows

Years

Profit

7,200 15,000 25,000 35,000 39,000

Pay back period = Pay back period of a major portion + Pay back period for remaining Pay back period of the major portion= the firm has recovered a major portion of the initial investment of Rs.25,000 within 3 full years out of Rs.30,000 The second half of the equation is that pay back period for the remaining i.e., Rs.5000 of initial investment which is to be recovered during the fourth year out of Rs.10,000 If Rs.10,000 earned throughout the year /12 months, how many months taken by the firm in recovering Rs.5,000 out of Rs10,000
= Rs. 5,000 = .5 12 months = 6 months Rs.10,000

Pay back period (Project A) = 3.6 years The next stage to find out the pay back period of the project B Project B Add Depreciation Less Depreciation Cumulative Cash inflows 7,200 14,700 21,700 29,700 42,700 Profit Before Depreciation Profit after tax Less Tax 50%

1. 2. 3. 4. 5.

8,400 9,000 8,000 10,000 20,000

6,000 6,000 6,000 6,000 6,000

2,400 3,000 2,000 4,000 14,000

1,200 1,500 1,000 2,000 7,000

1,200 1,500 1,000 2,000 7,000


Rs. 300 Rs. 13,000

6,000 6,000 6,000 6,000 6,000

7,200 7,500 7,000 8,000 13,000

Pay back period of the project B= 4 years +

= 4 years +.02 365 days = 4 years + 8 days = 4 years and 8 days Pay back period of the project B is greater than that of the earlier Project A. It means that the Project A is bearing the faster rate in getting back the investment invested.
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Cash in flows

Years

Profit

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Merits
l l

It is a simple method to calculate and understand It is a method in terms of years for easier appraisal

Demerits:
l l l l

It is a method rigid It has completely discarded the principle of time value of money It has not given any due weight age to cash inflows after the pay back period It has sidelined the profitability of the project.

18.3.2 Accounting or Average Rate of Return: Under this method, the profits are extracted from the book of accounts to denominate the rate of return. The profits which are extracted are nothing but after depreciation and taxation and not cash inflows. Selection criterion of the projects:
Highest rate of return of the project only is given appropriate weightage. The Accounting rate of return can be computed as follows

Accounting Rate of Return (ARR)=

Annual Return 100 Original Investment Average Annual Return 100 Average Investment

Accounting Rate of Return (ARR)=

Average annual return= Average profit after depreciation and taxation of the entire life of project i.e. for many number of years Average Investment =

Opening Investment + Closing Investment 2

= Illustration 6

Opening Investment Scrap 2

Calculate the average rate of return for Projects X and Y from the following Project X Investments Expected Life Rs.40,000 4 years Project Y Rs.60,000 5 years

Projected net income ( after interest, depreciation and taxes) Year Project X Rs Project Y Rs 1. 2. 3. 4. 5.
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4,000 3,000 3,000 2,000 12,000

6,000 6,000 4,000 2,000 2,000 20,000

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If the required rate of return is 10% which project should be undertaken? Average Rate of Return =

Capital Budgeting

Average Annual Income 100 Original Investment

The first step is to find out the average annual income of the two different projects X and Y Average Annual Income =

Total income throughout the Project Life of the Project Rs.12,000 = Rs. 3,000 4 years Rs. 20,000 = Rs. 4,000 5 years

Average Annual Income( Project X) =

Average Annual Income ( Project Y) =

The next step is to find out the Average rate of return : Average rate of return ( Project X) = Average rate of return ( Project Y) =
Rs. 3,000 100 = 7.5% Rs.40,000 Rs.5,000 100 = 8.33% Rs. 60,000

Both the projects are lesser than the given required rate of return. These two projects are not advisable to invest only due to lesser accounting rate of return. Illustration 7 The alpha limited is considering the purchase of a machine to replace a machine which has been in operation in the factory for the last 5 years. Ignoring interest pay but considering tax at 50% of net earnings suggest which on the two alternatives should be preferred. The following are the details Particulars Purchase price Economic life of the machine Machine running hours per annum Units per hour Wages running per hour Power per annum Consumable stores per annum Other charges per annum Material cost per unit Selling price per unit Old Machine Rs.80,000 10 years 2,000 24 3 2,000 6,000 8,000 .50 1.25 New Machine Rs,1,20,000 10 years 2,000 36 5.25 3,500 7,500 9,000 .50 125

First step is to consider that few assumptions to proceed the problem without any technical difficulties. First assumption is that there is no closing stock i.e. what ever goods produced are sold out in the market. Second assumption is that the volume of the sales is expected to be remain throughout the life of the period. Third assumption is that the depreciation charged by the firm is on the basis of straight line method.
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Steps involved in the computation of the accounting rate of return The first is to compute the total number of units expected to produce Total number of units of production = Total machine hours per annum Units per hour For old machine For new machine Total volume of sales For old machine For new machine = 2,000 Hrs 24= 48,000 units = 2,000 Hrs 36= 72,000 units = Total number of units Selling price per unit = 48,000 units Rs 1.25= Rs.60,000 = 72,000 units Rs.1.25= Rs.90,000

The second step is to determine the volume of annual sale of units:

According to the second assumption, the volume of sales is known as unaffected throughout the life period of the projects. The next step is to find out the volume of the wages Total wages For old machine For new machine = wages per hour Machine running hours = Rs.3 2000 Hrs= Rs.6,000 = Rs5.25 2000 Hrs=Rs.10,500

The next step is to find out the total material cost Total material cost per unit = Total number of units Material cost per unit For old machine For new machine = 48,000 .5= Rs.24,000 = 72,000 .5=Rs.36,000

The last step is to find out the depreciation

Initial investment Depreciation under straight line method = Economic life period of the asset
For old machine For new machine = Rs.8,000 = Rs.12,000

The next step is to draft the profitability statement of the enterprise under the head of two different machine viz old and new. To find out the annual income of the enterprise under two different machines
Profitability Statement
Particulars Sales Less Direct Material Wages Power Consumable stores Other charges Depreciation Profit before tax Tax at 50% Profit after tax Old Machine Rs Rs 60,000 24,000 6,000 2,000 6,000 8,000 8,000 54,000 6,000 3,000 3,000 New Machine Rs Rs 90,000 36,000 10,500 4,500 7,500 9,000 12,000 79,500 10,500 5,250 5,250

The Average rate of return =

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Average Annual Return 100 Original Investment Average Annual Return = 100 Average Investment

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Capital Budgeting

Particulars Average Rate of Return On the basis of original investment Average Rate of Return On the basis of average investment

Old Machine Rs3,000 100 Rs.80,000 =3.75% Rs.3,000 100 Rs.40,000 =7.5%

New Machine Rs.5,250 Rs.1,20,00 =4.375% Rs.5,250 Rs.60,000 =8.75%

Merits
l l l

It is simple method to compute the rate of return Average return is calculated from the total earnings of the enterprise through out the life of the firm The entire rate of return is being computed on the basis of the available accounting data

Demerits
l l l l

Under this method, the rate of return is calculated on the basis of profits extracted from the books but not on the basis of cash inflows The time value of money is not considered It does not consider the life period of the project The accounting profits are different from one concept to another which leads to greater confusion in determining the accounting rate of return of the projects

18.3.3 Discounted Cash Flows Method

Discounted cash flows method

Present value Index Method Net Present value method Internal Rate of Return method

The discounted cash flows method is the only method nullifies the drawbacks associated with the traditional methods viz Pay back period method and Accounting rate of return method. The underlying principle of the method is time value of money. The value of 1 Re which is going to be received on today bears greater value than that of 1 Re expected to receive on one month or one year later. The main reason is that "Earlier the benefits better the principle". It means that the benefits whatever are going to be accrued during the present will be immediately reinvested again to maximize the earnings, so that the earlier benefits are weighed greater than the later benefits. The later benefits are expected to receive only during the future which is connected with the future i.e., future is uncertain. It means that there is greater uncertainty involved in the receipt of the benefits connected with the future. Why the time value of money concept is inserted on the capital budgeting tools? The main reason is that the capital expenditure is expected to extend the benefits for many number of years. The 1 Re is expected to receive one year later cannot be treated at par with the 1 Re of 2 years later. This is the only method considers the profitability as well as the timing of benefits. This method gives an appropriate qualitative consideration to the benefits of various time periods.
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The time value of money principle is used for an analysis to study about the quality of the investments in receiving the future benefits. There are general classifications which are as follows
l l l

Net present value method Present value index method Internal rate of return method

18.4 PRESENT VALUE METHOD


Under this method, the initial outlay or initial investment available in terms of present value is compared with the present value of future earnings of the enterprise. Why the present value of the future earnings are found out? The ultimate reason to find out the present value future earnings is that the comparison in between inflows and outflows should be meaningful as well as effective. The present value of the initial outlay cannot be converted into the future value for comparison, even otherwise the conversion takes place, the comparison cannot be meaningful. To be meaningful comparison, the future earnings are converted into the present value which is known as discounting process through the discount rate. The rate at which the future earnings are discounted is known as required rate of return. Selection criterion of Net present value method If the present value of future cash inflows are greater than the present value of initial investment ; the proposal has to be accepted. If the present value of future cash inflows are lesser than the present value of initial investment ; the proposal has to rejected.
Initial Outlay <Present value of Benefits=> +ve NPV:- Project can be accepted Initial Outlay>Present value of Benefits=>-ve NPV:-Project can be rejected

What is present value index? The major lacuna of the Net present value method is unable to rank the projects one after the another, only due to the volume of the investment involved. To rank the projects meaningfully, the present value index method is adopted. The present value index of the investment can be calculated with the help of following formula: Present value index method Selection criterion If the present value index is greater than one, accept the proposal; otherwise vice versa
Present value index>1:- Accept the investment proposal Present value index<1:-Reject the investment proposal

Pr esent value of the cash inflows Pr esent value of the cash outflows

What is internal rate of return method? IRR is the rate at which initial investment is equal to the Present Value of future case in -flows. Under this method, while matching, these two are known but the rate which is taken for equation not given or known. The rate of discounting for matching should be determined through trial and error method.

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Once the Internal rate of return is found out, the found IRR should be compared with the required rate of return. Decision criterion If the IRR is more than the Required rate of return, the project has to be accepted If the IRR is less than the Required rate of return, the project has to be rejected
Check Your Progress

Capital Budgeting

(1)

The utility of discounting principle is


(a) (b) (c) (d) To determine the future value of the cash inflow To convert the Present value of Initial outlay into Future value To determine the present value of the future cash inflows for comparison with the Initial Outlay None of the above

(2)

Why Discounted cash flows method is considered to be a superior than the Traditional method ?
(a) (b) (c) (d) Simple to understand Accuracy Time value of money Easy to calculate

Illustration 8 Project ABC Ltd. costs Rs 1,00,000. It produces the following cash flows
Year Cash Inflows Rs Present value of Re1 at 10% 1 40,000 .909 2 30,000 .826 3 10,000 .751 4 20,000 .683 5 30,000 .621

Advise either the project to be accepted or not.


Cash inflows Rs 1. 40,000 2. 30,000 3. 10,000 4. 20,000 5. 30,000 Total Present value of cash inflows Total present value of cash outlay Net present value Year Present value factor @10% .909 .826 .751 .683 .621 Present value of cash inflows Rs 36,360 24,780 7,510 13,660 18,630 1,00,940 1,00,000 940(+ve)

The investment proposal has to be accepted only due to positive Net present value. It means that the present value of the cash inflows are greater than the present value of the outlay. It means the discounted future earnings are greater than the present initial investment outlay. Illustration 9 The Alpha Co Ltd., is considering the purchase of a new machine. Two alternative machines (A and B) have been suggested, each having an initial coast of Rs.4,00,000 and requiring of Rs.20,000 an additional working capital at the end of 1st year. Earnings after taxation are expected to be follows
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Year 1. 2. 3. 4. 5.

Cash inflows Machine A Rs Machine B Rs 40,000 1,20,000 1,20,000 1,60,000 1,60,000 2,00,000 2,40,000 1.,20,000 1,60,000 80,000

Present value factor 10% .91 .83 .75 .68 .62

(CA Final Nov, 1972) The profitability statement of Two machines -Alpha company
Year Present value factor@ 10% Machine A Cash Inflow Rs 1. .91 40,000 2. .83 1,20,000 3. .75 1,60,000 4. .68 2,40,000 5. .62 1,60,000 Present value cash inflows Present value cash outflows= Rs.4,00,000+ 20,000 X.91 Net present value Present Value Rs 36,400 99,600 1,20,000 1,63,200 99,200 5,18,400 4,18,200 1,00,200 Machine B Cash Inflow Rs 1,20,000 1,60,000 2,00,000 1.,20,000 80,000 Present Value Rs 1,09,200 1,32,000 1,50,000 81,600 49,600 5,23,200 4,18,200 1,05,000

In the above problem, among the given machines, the firm is required to chose only one machinery. To chose the ideal machinery among the given two, the net present value should be ranked. The Machine B has been considered as preferable over the machine A due to higher net present value. The ranking of the machines do not indulge any difficulties. Why it so ? The main reason is that both machines are having equivalent volume of investment outlay. Out of the same initial outlays, we can rank that both machines one after the another based upon the net present value. Illustration 10 The initial cost of an equipment is Rs. 50,000. Cash inflows for 5 years are estimated to be Rs.20,000 per year. The management's desired minimum rate of return is 15%. Calculate Net present value and Excess present value index. At the end of every year, the firm expects to earn Rs.20,000. The amount expects to earn Rs.20,000 on every year is nothing but future value of money. The future value of money should be converted into the present value for having comparison with the initial investment. On every Rs.20,000 expected to receive forms a series of future cash inflows which should be converted into present value. This conversion process i.e the process of converting the future value into present value is known as discounting process. For discounting, the rate which is used for the process pronounced as discount rate or minimum rate of return. The conversion process can be done in two different ways. Discounting process :- PV= FV/ (1+r)n For first year cash inflow Rs.20,000:PV=20,000/(1.15)=20,000.870 For second year cash inflow Rs.20,000;PV=20,000/(1.15)2 =20,000.756
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=Rs.17,400

=Rs.15,120

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For third year cash inflow Rs.20,000:PV=20,000/(1.15)3=20,000.658 For fourth year cash inflow Rs.20,000:PV=20,000/(1.15)4=20,000.572 For fifth year cash inflow Rs.20,000:PV=20,000/(1.15)5=20,000.497 =Rs.9,940 Rs.67,060 OR Alternately, the discounting can be done as follows Being Rs.20,000 is nothing but as common cash inflow throughout 5 years of the project, considered to be a series of cash inflows Rs.20,000(.870+.756+.658+.572+.497) =Rs.67,060 =Rs.11,440 =Rs.13,160

Capital Budgeting

Net present value = Present value of cash inflows - Present value of cash outlay =Rs.67,060- Rs.50,000= Rs.17,060 The net present value of the project is +ve. Hence, the project can be accepted. Illustration 11 A project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annually for 5 years. Calculate the IRR of the project. First step is to find out the fake pay back quotient Pay back =

Initial Investment Rs. 36,000 = = 3.214 Annual average return Rs. 11,200

The next step is to locate the pay back quotient in the table M-4. The present value of 1 Re should be computed for 5 number of years. The location of the pay back quotient is in between the values of table M-4 The value 3.214 which lies in between 3.274 of 16% and 3.199 of 17% The next step in the IRR calculation is that locating the maximum rate of return which equates the initial outlay with the cash inflows of various time periods. While equating the initial outlay with discounted cash inflows at certain percentage will derive the original rate of return. The process may be started from two different angles viz
l l

Low discount rate High discount rate

The computation of IRR can be had through either low discount rate or high discount rate. This is further extended to different methods of calculation., which are as follows
l l

On the basis of values extracted from the table On the basis of volume

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Calculation on the basis of discount rate table value


Lower discount Rate 3.274 Origin value i.e., unknown IRR -3.214 Higher discount rate 3.199

On the basis of Lower % of discount rate =Lower discount rate + Discount rate difference
(Pay Back quotient - Higher discount rate) (Lower discount - Higher discount rate) 3.214 3.199 = 17% 1% = 17% .2% = 16.8% 3.274 3.199

Alternately, on the basis of volume, the methodology to be adopted for the determination of IRR The cash inflows of Rs.11,200 for 5 years are discounted @ 16% which amounted Rs.36,668.8. Like wise the cash inflows of the same should be discounted at the rate of 17% which amounted Rs.35,828.8 The next step is to find out the IRR. The IRR can be found out either on the basis of lower discounted cash inflows or higher discounted cash inflows.
On the basis of discounted cash inflows Lower rate Rs.36.668.8 On the basis of discounted cash inflows Higher rate-Rs.35.828.8

(+)

Rs.36,000-Origin value@ IRR

(-)

On the basis of discounted cash inflows at lower rate @16% =16% + 1%

(Rs.36.668.8 Rs. 36,000) (668.8) = 16% + % (Rs. 36.668.8 - 35.828.8) (840)

=16%+.796=16.796% On the basis of discounted cash inflows at higher rate @ 10%

(Rs. 36,000 - Rs. 35.828.8) (172) = 17% - 1% (Rs. 36.668.8 - 35,828.8) (840)
== 17% -.204=16.796% Merits of DCF methods
l l l

It is only the best method incorporates the timing of benefits - time value of money It considers the economic life of the project It is a best method for both even and uneven cash inflows

Demerits of DCF methods


l l
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It involves with tedious method of computation It is very difficult to locate or identify the exact discounting factor It never performs functions of discounting to the tune of accounting concepts.

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Illustration 12 XYZ company is considering an investment proposal to install new drilling controls at a cost of Rs.1,00,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume the firm uses straight line depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax form the investment proposal are as follows:
Year 1. 2. 3. 4. 5. Cash flows Before Tax Rs 20,000 21,384 25,538 26,924 40,770

Capital Budgeting

Calculate the following 1. 2. 3. 4. Pay back period Average rate of return Net present value at 10 percent discount rate Profitability index at 10 percent discount rate

The first and foremost step is to find out the Cash Flows After Taxation For finding out the Cash flows after taxation, the amount of depreciation i.e non recurring expenditure should be appropriately considered for calculation. The depreciation has to be computed in accordance with the stipulation given in the problem. The depreciation charged by the firm is nothing but straight line method. Straight line method of depreciation =
Initial Investment - Scrap value Economic life period of the machine Rs.1,00,000 = = Rs. 20,000 5 Years

The depreciation has to be deducted initially from the cash flows before taxation, after the deduction of taxation, the earnings after taxation should be added with the depreciation which was already deducted in order to find out the total cash flows after taxation. The purpose of deducting the depreciation is nothing but an amount to be charged under the Profit & Loss account against the total revenue. Being as a non-recurring expenditure not created any outflow cash resources. When there is no cash outflow, the amount of depreciation should be added finally to derive CFAT(Col 7)
Table
Year Col 1 CFBT Rs Col 2 Depreciation Rs Col 3 Profits Before Tax Rs Col 4=Col2Col3 Nil 1,384 5,538 6,924 20,770 Taxes (.35) Col 5 Earnings After tax Rs Col6=Col4 -Col5 Nil 900 3,600 4,500 13,500 22,500 Cash flows after tax Rs Col7= Col6+Col3

1. 2. 3. 4. 5.

20,000 21,384 25,538 26,924 40,770

20,000 20,000 20,000 20,000 20,000

Nil 484 1,938 2,423 7,270

20,000 20,900 23,600 24,500 33,500 1,22,500

1.

Pay back period method: Under this, method most important step is to identify the nature of the cash flows after taxation. Are they uniform ? No, they are not even cash flows. Hence, the cumulative cash flows after taxation has to be found in order to find out the pay back period of the investment.

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Year 1. 2. 3. 4. 5.

Cash flows After Tax Rs 20,000 20,900 23,600 24,500 33,500

Cumulative CFAT Rs 20,000 40,900 64,500 89,000 1,22,500

Pay back period= Pay back period for the major portion of the investment + Pay back period for the remaining portion unrecovered = 4 year +
Rs.11,000 = 4 year + .328 year Rs. 33,500

= 4.328 years 2. Average rate of return (ARR):

ARR =

Average Income 100 Average Investment

Average Income is the average of earnings after taxation of the entire duration. Why earnings after taxation has to be taken into consideration ? Why not the cash flows after taxation to be taken for consideration ? The main purpose of considering the earnings after taxation is that the amount extracted from the book of accounts and taken for the computation of ARR, and immediately after the payment of taxation. Average investment is the average of opening and closing investment. If the depreciation charge given is nothing but straight line method, automatically final value of the asset will become equivalent to zero. The closing balance of the asset /investment is zero. How the closing balance of the investment could be adjudged as equivalent to zero?
Table of Depreciation
Year 1. 2. 3. 4. 5. Opening balance of the year Rs 1,00,000 80,000 60,000 40,000 20,000 Closing balance of the year Rs 80,000 60,000 40,000 20,000 0

At the end of the year, the closing balance amounted Rs.0 after charging the depreciation year after year constantly in volume
Opening balance + Closing balance 2 Rs. 1,00,000 + Rs. 0 = 2 = Rs. 50.000 Rs. 22,500 Average Income = = Rs.4,500 5 years Rs. 4,500 Average rate of return = 100 = 9% Rs.50,000 Average =
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3.

Net present value method: Under this method, the future cash flow after taxation should be discounted at the rate 10%

Capital Budgeting

Year Cash flows after tax 1. 20,000 2. 20,900 3. 23,600 4. 24,500 5. 33,500 Total Present value Less Initial outlay Net present value

Present value factor @ 10% .909 .826 .751 .683 .621

Total Present Value Rs 18,180 17,263 17,724 16,734 20,803 90,704 1,00,000 ( 9,296)

The net present value is negative due to excessive investment more that of the present value of future earnings of the enterprise. Under this method, the investment is not advisable to procure for the firm's requirements. 4. Profitability Index The profitability index method is more useful in the case of more number of investments, having uneven investment outlays, but this problem comes with only one investment proposal It is much easier to assess even in the case of Net present value method. Profitability Index (PI) =
Pr esent value of cash inflows Rs.90,704 = Pr esent value of cash outflows Rs. 100,000 =.90704

The present value index quotient is less than that of the norms which should be greater than one but it secures only 90704. It means that the present value earnings are not sufficient to meet the initial cost of the machine.
Check Your Progress

(1)

Why the depreciation is added at the end of computation to derive the cash flow ?
(a) (b) (c) (d) Being as recurring charge Being considered as tax shield Being as non recurring charge None of the above

(2)

Why "0" value is taken as closing balance of the investment for the computation of Average investment ?
(a) (b) (c) (d) No value for the closing balance No value due to the application of straight line method of depreciation No scrap value at the end of the life of the asset None of the above

18.5 CAPITAL RATIONING


The capital rationing means that selection of investment proposals with reference to capital budget by considering the financial constraints. The selection of the investment proposals should be to the tune of required NPV which the firm wants to earn during the future. Under the capital rationing, there are two stages involved viz

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Accounting and Finance for Managers

(i) (ii)

Identification of the investment proposals Selection of investment proposals

The selection of the investment proposals are on the basis of Discounted cash flows method. The selection of the investment proposals are subject to two different categories viz indivisible and divisible. The investment which is wholly accepted or rejected due to decision criterion which is known as indivisible project but the divisible projects are able to either accept or reject in parts.

18.6 DIVISIBLE PROJECT


A company has Rs. 7 Crore available for investment. It has evaluated its options and has found that only 4 projects given below have positive NPV. All these investment are divisible Advise the management which investments projects it should select.
Project X Y Z W Project Z W Y X Initial Investment Rs Cr 3.00 2.00 2.50 6.00 Initial Investment Rs Cr 2.50 6.00 2.00 3.00 NPV Rs Cr .60 .50 1.50 1.80 NPV Rs Cr 1.50 1.80 .50 .60 PI 1.20 1.25 1.60 1.30 PI 1.60 1.30 1.25 1.20

Out of the available Rs. 7 Cr, the first two projects selected on the basis of Profitability index viz Z and W. The total amount of investment required to invest in both the projects amounted Rs 8.50 Cr but the financial constraint is Rs.7 Cr. By considering the constraint, the first project fully accepted and the part of the next project W accepted for the remaining amount of corpus available by considering to maximize the NPV of the project as a whole.

18.7 INDIVISIBLE PROJECT


A company working against a self imposed capital budgeting constraint of Rs 70 Cr is trying to decide which of the following investment proposals should be undertaken by it. All these investment proposals are indivisible as well as independent. The list of investments along with the investment required and the NPV of the projected cash flows are given below
Project A. B. C. D. E. Initial Investment Rs Cr 10 24 32 22 18 NPV Rs Cr 6 18 20 30 20

The D, E and B are the project for making an investment which jointly amounted Rs 64 Cr and the remaining the Rs 6 cr to be invested into the project.

18.8 RISK ANALYSIS IN CAPITAL BUDGETING


In capital budgeting decisions, the risk component of the investment is not taken into consideration. The risk which is nothing but the business risk of the investment varies from one to another, to be considered in the real world situations. The risk which is nothing but the variability in between the actual returns and expected returns. The risk in the investment has to be incorporated in the discount rate for studying the worth of the project. To incorporate the risk in the discount rate, the meaning of the term risk should

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be known and distinguished from the uncertainty. The risk situation is one in which the probabilities of one particular event are known but the uncertainty is the situation in which the probabilities are not known. In the case of risk situation, the future losses can be foreseen unlike the uncertainty situation. The incorporation of the risk factor in the discount rate in accordance with the variability of the returns. If the variability of the returns are more, the investor may prefer higher return in the form of risk premium for risky project unlike in the case of government securities. The government securities are not having any variability in the returns which require the risk free return to discount only in order to know the worth of the investment but the risky projects are to be discounted only with the help of higher discount rates. There quite number of techniques available for incorporating the risk component in the capital budgeting are follows: Sensitivity analysis Standard deviation Coefficient of variation and so on.

Capital Budgeting

18.9 LET US SUM UP


The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets. The importance of the capital budgeting is only due to the benefits of the long term assets stretched to many number of years in the future. It is a tool of analysis which mainly focuses on the quality of earning pattern of the fixed assets. The methods are the nothing but the instruments of the capital budgeting to study the quality of the investments/fixed assets. The pay back period is the period taken by the firm to get back the investment. The pay back period is nothing but number of years / months/days required by the firm to get back its investment invested in the project. The capital rationing means that selection of investment proposals with reference to capital budget by considering the financial constraints. The selection of the investment proposals should be to the tune of required NPV which the firm wants to earn during the future. Under the capital rationing, there are two stages involved viz (i) (ii) Identification of the investment proposals Selection of investment proposals

18.10 LESSON-END ACTIVITY


Elucidate the advantages and disadvantages of the traditional methods of capital budgeting.

18.11 KEYWORDS
Capital budgeting: A study on Long term investment decision in terms of quality of benefits Pay back period: It is a time period during which the initial investment is recovered ARR: Accounting rate of return - It is being calculated in accordance with the financial statements PV: Present value IO: Initial outlay which is nothing but initial investment NPV: Net present value which is the difference in between the Initial investment and Present value of future cash inflows IRR: Internal rate of return which is nothing but highest rate of return expected to earn
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Accounting and Finance for Managers

PI: Profitability Index is the ratio in between the present value of future cash inflows and present value of initial

18.12 QUESTIONS FOR DISCUSSION


1. 2. 3. 4. 5. 6. 7. 8. 9. Define capital budgeting. Highlight the importance of capital budgeting. "Success of the firm relies upon the rational capital budgeting decisions"- Discuss. What are two different classification of capital budgeting tools? Illustrate the Pay back period method with an example. Explain the process of computing the Accounting rate of return and their merits and demerits. List out the various methods of discounted cash flows. Explain the meaning of IRR and the process of calculating the IRR. List out the merits and demerits of the Discounted cash flows method.

18.13 SUGGESTED READINGS


M.P. Pandikumar According & Finance for Managers Excel Books, New Delhi. R.L. Gupta and Radhaswamy, Advanced Accountancy. V.K. Goyal, Financial Accounting, Excel Books, New Delhi. Khan and Jain, Management Accounting. S.N. Maheswari, Management Accounting. S. Bhat, Financial Management, Excel Books, New Delhi. Prasanna Chandra, Financial Management Theory and Practice, Tata McGraw Hill, New Delhi (1994). I.M. Pandey, Financial Management, Vikas Publishing, New Delhi. Nitin Balwani, Accounting & Finance for Managers, Excel Books, New Delhi.

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