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An efficient allocation of capital is the most important finance in the modern

times. It involves decisions to commit the firms funds to the long term assets
capital budgeting decisions or investment decisions are of considerable
importance to the firm since they tend to determine its value by influencing
its growth profitability and risk.

Capital Budgeting refers to planning the deployment of available capital for

the purpose of maximizing the long term profitability of the firm.
It is the firm’s decision to invest its current funds most efficiently in the long
term activities in anticipation of flow of future benefits over a series of

• Capital Budgeting involves :

• Search of new and more profitable investment proposals
• The making of an economic analysis to determine the profit potential
of each investment proposals.

Difficulties of investment decisions

It involves complex investment decisions as they are an assessment of future

events, which are difficult to predict.
Long term effect on profitability (Growth)

A firm’s decision to invest in long term assets has a decisive influence on

the rate & the direction of its growth.

Irreversible nature

Most investment decisions are irreversible. It is difficult to find a market for

capital item once they have been acquired.

Long term commitment of funds (Risk)

A long term commitment of fund may also change the risk complexity of the
firm. If the adoption of an investment increases average gain but causes
frequent fluctuation in its earnings, the firm would become more risky.

Large investment (Funding)

Investment decisions generally involve large amount of funds, which make

it imperative for the firm to plan its investment programs very carefully and
make an advance arrangement for procuring finances internally or


There are many ways to classify investments. One classification is as


The Expansion of Existing Business

A company may add capacity to its existing product lines to expand existing
operations. For example Gujrat State Fertilizer Company may increase its
plant capacity to manufacture more urea it is an example of related
The Expansion of New Business

A firm may expand its activities in a new business. Expansion of a new

business requires investment in new products and new kind of production
activities with in a firm. This type of expansion is unrelated diversification.

Replacement and modernization

The main objective of modernization and replacement is to improve

operating efficiency and reduce cost. Cost saving will reflect in increased
profits but the firm’s revenue may remain unchanged the firm must decide to
replace those assets with new assets that operate more economically.
Example if a cement company changes from semi automatic drawing
equipment to fully automatic drawing equipment it is an example of
modernization and replacement.


The numbers of techniques are in use in practice they may be grouped in

following two categories:
Discounted cash flow techniques
Net Present Value (NPV)
Internal rate of return (IRR)

Non-discounted cash flow techniques

Pay back period (PB)
Accounting rate of return (ARR)

Net Present Value Method (NPV)

It is the method of evaluating project that recognizes that the dollar received
immediately is preferable to a dollar received at some future date. It
discounts the cash flow to take into the account the time value of money.

This approach finds the present value of expected net cash flows of an
investment, discounted at cost of capital and subtract from it the initial cash
outlay of the project.
In case the present value is positive, the project will be accepted; if negative,
it should be rejected. If the projects under consideration are mutually
exclusive the one with the highest net present value should be chosen.

∑ = Summation
Ft = Net cash flow at time t
k = cost of capital
Io = Initial cash flow

NPV Decision Rules:

Independent Project: Accept all the projects where NPV 0, reject
otherwise. Mutually Exclusive Project: Rank projects from highest to
lowest NPV and choose the project with highest (positive) NPV.

The NPV profile is a graphical plot of the inverse relationship between the
discount rate, k, and a project’s NPV.

• When NPV = ∑ CFs – Io , k = 0

• When NPV > 0, k < the firm’s required rate of return on invested
• When NPV = 0, k = the firm’s required rate of return on invested
• When NPV < 0, k > the firm’s required rate of return on invested


• Time value: It recognizes the time value of money a rupee received

today is worth more than a rupee received tomorrow.

• Measure of true profitability: It uses all cash flows occurring over the
entire life of the project in calculating its worth. Hence it is a true
measure of the projects profitability.

• Value additivity: The discounting process facilitates measuring cash

flows in terms of present value: that is, in terms of equivalent, current
rupees. Therefore, the NPVs of projects can be added.

• Shareholder value: The NPV method is always consistent with the

objective of the shareholder value maximization.


• Cash flow estimation: The NPV method is easy to use if forecasted

cash flows are known. It is quite difficult to obtain the estimates of
cash flows due to uncertainty.

• Discount rate: It is difficult to precisely measure the discount rate.

• Mutually exclusive projects: When alternative projects with unequal
lives, or under funds constraints are evaluated. The NPV rule may not
give unambiguous results in these situations.

• Ranking of projects: The ranking of investment projects as per the

NPV rule is not independent of the discount rates.


The Internal Rate of Return (IRR) is the discount rate that generates a
zero net present value for a series of future cash flows. This essentially
means that IRR is the rate of return that makes the sum of present value of
future cash flows and the final market value of a project (or an investment)
equal its current market value.

Internal Rate of Return provides a simple ‘hurdle rate’, whereby any project
should be avoided if the cost of capital exceeds this rate. Usually a financial
calculator has to be used to calculate this IRR, though it can also be
mathematically calculated using the following formula:

In the above formula, CF is the Cash Flow generated in the specific period
(the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by
employing trial and error method.

Internal Rate of Return is the flip side of Net Present Value (NPV), where
NPV is the discounted value of a stream of cash flows, generated from an
investment. IRR thus computes the break-even rate of return showing the
discount rate, below which an investment results in a positive NPV.

A simple decision-making criteria can be stated to accept a project if its

Internal Rate of Return exceeds the cost of capital and rejected if this IRR is
less than the cost of capital

In the context of savings and loans the IRR is also called effective interest

• Time value: The IRR method recognizes the time value of money.
• Profitability Holder: It considers all cash flows occurring over the
entire life of the project to calculate its rate of return.
• Acceptance rule: its generally gives the same acceptance rules as the
NPV method.
• Shareholder value: it is consistent with shareholders wealth
maximization objective .whenever a project’s IRR is greater than
opportunity cost of capital, the shareholders wealth will be enhanced.


• Multiple rates: A project may have multiple rates, or it may not have a
unique rate of return. These problems arise because of the
mathematics of IRR computation.
• Mutually Exclusive Projects: it may also fail to indicate a correct
choice between mutually exclusive projects under certain situations.
• Value Additivity: Unlike in the case of NPV method, the value
additivity principle doesn’t hold when the IRR method is used-IRRs
of projects do not add. Thus, projects A and B, IRR(A)+IRR(B) need
not be equal to IRR(A+B)

Despite a strong academic preference for NPV, surveys indicate that

executives prefer IRR over NPV. Apparently, managers find it easier to
compare investments of different sizes in terms of percentage rates of return
than by dollars of NPV. However, NPV remains the "more accurate"
reflection of value to the business. IRR, as a measure of investment
efficiency may give better insights in capital constrained situations.

For our project, we went to Mr. Reddy the owner of Jaipuria Institute of
Management canteen. He give us the data of the canteen in the begning he
said that he invested Rs. 200000 in the canteen as fixed cost. He deposited
Rs. 50000 to the Jaipuria Institute of Management as security management.
Return on investment for the 5 year as follows:-
1st year -> Rs. 80000
2nd year -> Rs. 82000
3rd year -> Rs. 88000
4th year -> Rs. 86000
5th year -> Rs. 90000
IRR can be determined by solving the following equation for r :

C0 = project cost

C1 = return on 1st year

C2=return on 2nd year……

C =return on n year

r =discount rate

At the discount rate of 40%, the project’s NPV is

NPV= -200000 + 80000(PVF1‚0.04) + 82000(PVF2‚0.04) + 88000(PVF3

‚0.04) + 86000(PVF4‚0.04) +

=-200000 + 80000*0.714 + 82000*0.510 + 88000*0.364 + 86000*0.260 +


=- Rs 29000

The project’s NPV is negative at 40%,a rate lower than 40% should be tried .
we select 30% , the projects NPV is

NPV= -200000 + 80000(PVF1‚0.03) + 82000(PVF2‚0.03) +

88000(PVF3‚0.03) + 86000(PVF4‚0.03) +90000(PVF5‚0.03)

= -200000 + 80000*0.769 + 82000*0.592 + 88000*0.455 + 86000*0.350 +


= Rs 4414

The true rate of return should lies between 30-40 percent. We can find out a
close approximation of the rate of return by the method of linear
interpolation as follows:-
PV required Rs. 200000
Rs. 4414
PV at lower rate 30% Rs. 204414
Rs. 34342
PV at higher rate 40% Rs. 170072

r = 30% +(40%-30%) *4414/34342

= 30% +1.285%
= 31.285%

While asking question to Mr.Reddy , he said that he can’t more return from
Jaipuria Institute of Management because there is less margin in mess of
hostel. He get more return due to selling of food products to Jaipuria school.

For seeing the project, whether it is feasible or not. We compare it with other
project. We went to Mr. Reddy and ask if you invest Rs.200000 to other
institute in the same business what will be your expected return. He gave the
return on investment for 5 years are as under:-

1st year: Rs.75000

2nd year: Rs.70000
3rd year: Rs.73000
4th year: Rs.72000
5th year: Rs.76000

The equation are:

The project NPV at 25% is:

NPV= -200000 + 75000*PVF(1,0.25) +70000*PVF(2,0.25)
+73000*PVF(3,0.25) + 72000*PVF(4,0.25) + 76000*PVF(5,0.25)

= -200000 +75000*0.8 +70000*0.64 +73000*0.512 +72000*0.41

= -200000 +60000 +44800 +37376 +29520 +24928

= -200000 +196624

= -Rs.3376

Since, the project’s NPV negative at 25%, a rate lower then 25% is tried.
When we select 24% as The trial rate, we find that the project’s NPV is RS
NPV= -200000 +75,000*PVF(1,0.24) +70000*PVF(2,0.24)
+73000*PVF(3,0.24) +72000*PVF(4,0.24)+76000*PVF(5,0.24)

= -200000 +75, 000*0.806 +70000*0.650 + 73000*0.524 +


= -200000 +60450 +45500 +38252 +30456 + 26916

= -200000 +200574
= Rs.574

The true rate of return should lie between 24-25%. We can find out a close
approximation of the rate of return by the method of linear interpolation


PV required 200000
PV at lower rate, 24% 200574
PV at higher rate, 25% 196624

 K = 24% + (25% - 24%) * 574/3950

= 24% + 0.1453%
= 24.1453%
Acceptance rule:

The accept and reject rule using IRR methode is to accept the project if its
internal rate of return is higher then the opportunity cost of capital( r>k ).K
is required rate of return or the cut-off or hurdle rate.
 Accept the project when r>k
 Reject the project when r<k
 May accept the project when r=k

In our case r>k

i.e. 31.285> 24.145
Hence we accept the project.