Accounting and Finance for

Managers LESSON

18
CAPITAL BUDGETING

CONTENTS
18.0 Aims and Objectives
18.1 Introduction
18.2 Aim of Capital Budgeting
18.3 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 Present Value Method
18.5 Capital Rationing
18.6 Divisible Project
18.7 Indivisible Project
18.8 Risk Analysis in Capital Budgeting
18.9 Let us Sum up
18.10 Lesson-end Activity
18.11 Keywords
18.12 Questions for Discussion
18.13 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

Capital Budgeting Working Capital Management

246
Why the capital budgeting is considered as most important decision over the others? Capital Budgeting

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”.

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) Budgeting of long-term capital
(b) Budgeting of short-term capital
247
Contd....
Accounting and Finance for (c) Budgeting of short-term assets
Managers
(d) Worthiness of long-term assets
(2) Capital budgeting tools are classified into
(a) Yearly basis
(b) On the basis of return
(c) On the basis of present value of money
(d) (a), (b) & (c)
(3) Selection criterion are classified into
(i) Acceptance of the investment proposal
(ii) Rejection of investment proposal
(iii) Neither can be accepted nor rejected
(a) (i) only
(b) (ii) only
(c) (iii) only
(d) (iv), (ii) & (iii)
The classification of methods are generally in two categories:
l Traditional methods
v Pay Back Period method
v Accounting Rate of Return
l 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.

Initial Investment
Pay back period =
Average Annual Earnings
Rs. 1,00,000
248 = = 5 Years
Rs. 20,000
It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5 Capital Budgeting
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 1st 2nd 3rd 4th 5th

Net Income 40,000 30,000 20,000 20,000 20,000
Amount Rs

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 Annual Net Incomes Cumulative

Rs cash flows Rs.
1. 40,000 40,000
2. 30,000 70,000 3 years full time required to recover the
3. 20,000 90,000 major portion of investment Rs.90,000
4. 20,000 1,10,000
5. 20,000 1,30,000

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 Pay back period for the major portion of the investment collection in full course -
E.g.: 3 years
l Pay back period for the left /uncollected portion of the investment

Rs.10,000
For the second category = = 0.5 years
Rs. 20,000

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
249
Accounting and Finance for In this problem, the annual cash inflows are equivalent throughout life period of the
Managers
project

Initial Investment Rs. 2,00,000

Pay Back Period = = = 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 Cumulative

Rs Cash Inflows
Rs
1. 4,000 4,000
2. 8,000 12,000
3. 6,000 18,000
4. 4,000 22,000
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.

Initial Investment
Pay Back Period =
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
Profit Before taxation = Rs.1,60,000
250
(-)Taxation = Rs. 80,000 Capital Budgeting

Profit after taxation = Rs. 80,000

(+)Depreciation 12% on = Rs. 10,00,000

= Rs. 1,20,000
Annual Cash Inflow = Rs. 2,00,000
Pay Back Period = Rs.10,00,000 = 5 years
= Rs.2,00,000
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 ½ 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 Automatic Machine Ordinary

Rs Machine Rs
Sales 1,50,000 1,50,000
Costs
Material 50,000 50,000
Labour 12,000 60,000
Variable overheads 24,000 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 Ordinary Machine Rs

Sales 1,50,000 1,50,000
Less : Material 50,000 50,000
Labour 12,000 60,000
Variable overheads 24,000 20,000
Annual profit 64,000 20,000
Pay Back Period

Particulars Automatic Machine Rs Ordinary Machine Rs

Cost of the Machine 2,24,000 60,000
Annual Profit 64,000 20,000
Pay Back Period Rs.2,24,000 Rs 60,000
Initial Investment Rs.64,000 Rs 20,000
Annual profit = 3½ years = 3 years
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
251
automatic machine.
Accounting and Finance for The another method to discuss is post pay back impact of the two different machines
Managers
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 Automatic Machine Rs Ordinary Machine Rs

Annual Profit R.No.1 64,000 20,000

Estimated Life R.No.2 5½ years 8 years

Pay Back Period R.No.3 3½ years 3 years
Post Pay Back Period
R.No. 4=R.No.2-R.No.3 2 years 5 years
Post Pay Back Profit = Rs.64,000×2 years = Rs.1,28,000
R.No5=R.No.1×R.No.4 = Rs.20,000×5years = Rs.1,00,000

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 Project B Rs
1. 8,400 8,400
2. 9,600 9,000
3. 14,000 8,000
4. 14,000 10,000
5. 4,000 20,000
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

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

252
 Project A Capital Budgeting

Depreciation

Cash inflows
Depreciation

Cumulative
Profit Before
Depreciation

Profit after
Less Tax

in flows
Years

Cash
Profit

Less

50%

Add
tax
1. 8,400 6,000 2,400 1,200 1,200 6,000 7,200 7,200
2. 9,600 6,000 3,600 1,800 1,800 6,000 7,800 15,000
3. 14,000 6,000 8,000 4,000 4,000 6,000 10,000 25,000
4. 14,000 6,000 8,000 4,000 4,000 6,000 10,000 35,000
5. 4,000 6,000 -(2000) 0 -(2000) 6,000 4,000 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
Depreciation

Cash inflows
Depreciation

Cumulative
Profit Before
Depreciation

Profit after
Less Tax

in flows
Years

Cash
Profit

Less

50%

Add
tax

1. 8,400 6,000 2,400 1,200 1,200 6,000 7,200 7,200

2. 9,000 6,000 3,000 1,500 1,500 6,000 7,500 14,700
3. 8,000 6,000 2,000 1,000 1,000 6,000 7,000 21,700
4. 10,000 6,000 4,000 2,000 2,000 6,000 8,000 29,700
5. 20,000 6,000 14,000 7,000 7,000 6,000 13,000 42,700

Rs. 300
Pay back period of the project B= 4 years +
Rs. 13,000

= 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.

253
Accounting and Finance for Merits
Managers
l It is a simple method to calculate and understand
l It is a method in terms of years for easier appraisal
Demerits:
l It is a method rigid
l It has completely discarded the principle of time value of money
l It has not given any due weight age to cash inflows after the pay back period
l 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

Annual Return
Accounting Rate of Return (ARR)= × 100
Original Investment

Average Annual Return

Accounting Rate of Return (ARR)= × 100
Average Investment

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

Opening Investment + Closing Investment

Average Investment =
2

Opening Investment – Scrap

=
2

Illustration 6
Calculate the average rate of return for Projects X and Y from the following
Project X Project Y
Investments Rs.40,000 Rs.60,000
Expected Life 4 years 5 years

Projected net income ( after interest, depreciation and taxes)

Year Project X Rs Project Y Rs
1. 4,000 6,000
2. 3,000 6,000
3. 3,000 4,000
4. 2,000 2,000
5. ——- 2,000
254 12,000 20,000
If the required rate of return is 10% which project should be undertaken? Capital Budgeting

Average Annual Income

Average Rate of Return = × 100
Original Investment
The first step is to find out the average annual income of the two different projects
X and Y
Total income throughout the Project
Average Annual Income =
Life of the Project

Rs.12,000
Average Annual Income( Project X) = = Rs. 3,000
4 years

Rs. 20,000
Average Annual Income ( Project Y) = = Rs. 4,000
5 years
The next step is to find out the Average rate of return :
Rs. 3,000
Average rate of return ( Project X) = × 100 = 7.5%
Rs.40,000
Rs.5,000
Average rate of return ( Project Y) = × 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 Old Machine New Machine

Purchase price Rs.80,000 Rs,1,20,000
Economic life of the machine 10 years 10 years
Machine running hours per annum 2,000 2,000
Units per hour 24 36
Wages running per hour 3 5.25
Power per annum 2,000 3,500
Consumable stores per annum 6,000 7,500
Other charges per annum 8,000 9,000
Material cost per unit .50 .50
Selling price per unit 1.25 125

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. 255
Accounting and Finance for Steps involved in the computation of the accounting rate of return
Managers
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 = 2,000 Hrs × 24= 48,000 units
For new machine = 2,000 Hrs × 36= 72,000 units
The second step is to determine the volume of annual sale of units:
Total volume of sales = Total number of units × Selling price per unit
For old machine = 48,000 units × Rs 1.25= Rs.60,000
For new machine = 72,000 units × Rs.1.25= Rs.90,000
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 = wages per hour × Machine running hours
For old machine = Rs.3 × 2000 Hrs= Rs.6,000
For new machine = 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 = 48,000 × .5= Rs.24,000
For new machine = 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 = Rs.8,000

For new machine = 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 Old Machine New Machine
Rs Rs Rs Rs
Sales 60,000 90,000
Less
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 8,000 12,000
54,000 79,500
Profit before tax 6,000 10,500
Tax at 50% 3,000 5,250
Profit after tax 3,000 5,250

Average Annual Return

The Average rate of return = × 100
Original Investment
Average Annual Return
= × 100
256 Average Investment
 Capital Budgeting
Particulars Old Machine New Machine
Average Rate of Return Rs3,000 × 100 Rs.5,250
On the basis of original Rs.80,000 Rs.1,20,00
investment =3.75% =4.375%

Average Rate of Return Rs.3,000 × 100 Rs.5,250

On the basis of average Rs.40,000 Rs.60,000
investment =7.5% =8.75%

Merits
l It is simple method to compute the rate of return
l Average return is calculated from the total earnings of the enterprise through out
the life of the firm
l The entire rate of return is being computed on the basis of the available accounting
data
Demerits
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
l The time value of money is not considered
l It does not consider the life period of the project
l 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.
257
Accounting and Finance for The time value of money principle is used for an analysis to study about the quality of the
Managers
investments in receiving the future benefits.
There are general classifications which are as follows
l Net present value method
l Present value index method
l 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:

Pr esent value of the cash inflows

Present value index method =
Pr esent value of the cash outflows

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

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
258 determined through trial and error method.
Once the Internal rate of return is found out, the found IRR should be compared with the Capital Budgeting
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

(1) The utility of discounting principle is

(a) To determine the future value of the cash inflow
(b) To convert the Present value of Initial outlay into Future value
(c) To determine the present value of the future cash inflows for comparison with
the Initial Outlay
(d) None of the above
(2) Why Discounted cash flows method is considered to be a superior than the
Traditional method ?
(a) Simple to understand
(b) Accuracy
(c) Time value of money
(d) Easy to calculate

Illustration 8
Project ABC Ltd. costs Rs 1,00,000. It produces the following cash flows

Year 1 2 3 4 5
Cash Inflows Rs 40,000 30,000 10,000 20,000 30,000
Present value of .909 .826 .751 .683 .621
Re1 at 10%

Advise either the project to be accepted or not.

Year Cash inflows Present value factor Present value of cash inflows Rs
Rs @10%
1. 40,000 .909 36,360
2. 30,000 .826 24,780
3. 10,000 .751 7,510
4. 20,000 .683 13,660
5. 30,000 .621 18,630
Total Present value of cash inflows 1,00,940
Total present value of cash outlay 1,00,000
Net present value 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
259
Accounting and Finance for Year Cash inflows Present value factor 10%
Managers Machine A Rs Machine B Rs
1. 40,000 1,20,000 .91
2. 1,20,000 1,60,000 .83
3. 1,60,000 2,00,000 .75
4. 2,40,000 1.,20,000 .68
5. 1,60,000 80,000 .62
(CA Final Nov, 1972)
The profitability statement of Two machines -Alpha company

Year Present value factor@ Machine A Machine B

10%
Cash Present Cash Present
Inflow Value Inflow Value
Rs Rs Rs Rs
1. .91 40,000 36,400 1,20,000 1,09,200
2. .83 1,20,000 99,600 1,60,000 1,32,000
3. .75 1,60,000 1,20,000 2,00,000 1,50,000
4. .68 2,40,000 1,63,200 1.,20,000 81,600
5. .62 1,60,000 99,200 80,000 49,600
Present value cash inflows 5,18,400 5,23,200
Present value cash outflows= Rs.4,00,000+ 20,000 4,18,200 4,18,200
X.91
Net present value 1,00,200 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 =Rs.17,400
For second year cash inflow Rs.20,000;-
PV=20,000/(1.15)2 =20,000×.756 =Rs.15,120
260
For third year cash inflow Rs.20,000:- Capital Budgeting

PV=20,000/(1.15)3=20,000×.658 =Rs.13,160
For fourth year cash inflow Rs.20,000:-
PV=20,000/(1.15)4=20,000×.572 =Rs.11,440
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
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

Initial Investment Rs. 36,000

Pay back = = = 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 Low discount rate
l 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 On the basis of values extracted from the table
l On the basis of volume

261
Accounting and Finance for Calculation on the basis of discount rate table value
Managers

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

On the basis of Lower % of discount rate

=Lower discount rate
+

(Pay Back quotient - Higher discount rate)

Discount rate difference ×
(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 On the basis of discounted

(+) Rs.36,000-Origin value- (-) cash inflows – Higher
inflows – Lower rate –
Rs.36.668.8 @ IRR rate-Rs.35.828.8

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

(Rs.36.668.8 − Rs. 36,000) (668.8)

=16% + 1% × = 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 It is only the best method incorporates the timing of benefits - time value of money
l It considers the economic life of the project
l It is a best method for both even and uneven cash inflows
Demerits of DCF methods
l It involves with tedious method of computation
l It is very difficult to locate or identify the exact discounting factor
l It never performs functions of discounting to the tune of accounting concepts.
262
Illustration 12 Capital Budgeting

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 Cash flows Before Tax Rs

1. 20,000
2. 21,384
3. 25,538
4. 26,924
5. 40,770

Calculate the following

1. Pay back period
2. Average rate of return
3. Net present value at 10 percent discount rate
4. 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.

Initial Investment - Scrap value

Straight line method of depreciation =
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 CFBT Depreciation Profits Taxes Earnings Cash flows after
Col 1 Rs Rs Before Tax (.35) After tax tax Rs
Col 2 Col 3 Rs Col 5 Rs Col7= Col6+Col3
Col 4=Col2- Col6=Col4
Col3 -Col5
1. 20,000 20,000 Nil Nil Nil 20,000
2. 21,384 20,000 1,384 484 900 20,900
3. 25,538 20,000 5,538 1,938 3,600 23,600
4. 26,924 20,000 6,924 2,423 4,500 24,500
5. 40,770 20,000 20,770 7,270 13,500 33,500
22,500 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.
263
Accounting and Finance for
Year Cash flows After Tax Rs Cumulative CFAT Rs
Managers
1. 20,000 20,000
2. 20,900 40,900
3. 23,600 64,500
4. 24,500 89,000
5. 33,500 1,22,500

Pay back period= Pay back period for the major portion of the investment
+
Pay back period for the remaining portion unrecovered
Rs.11,000
= 4 year + = 4 year + .328 year
Rs. 33,500
= 4.328 years
2. Average rate of return (ARR):

Average Income
ARR = × 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 Opening balance of the year Rs Closing balance of the year Rs

1. 1,00,000 80,000
2. 80,000 60,000
3. 60,000 40,000
4. 40,000 20,000
5. 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

Average =
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

264
3. Net present value method: Capital Budgeting

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

Year Cash flows after tax Present value factor @ 10% Total Present Value Rs
1. 20,000 .909 18,180
2. 20,900 .826 17,263
3. 23,600 .751 17,724
4. 24,500 .683 16,734
5. 33,500 .621 20,803
Total Present value 90,704
Less Initial outlay 1,00,000
Net present value ( 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.

Pr esent value of cash inflows Rs.90,704

Profitability Index (PI) = =
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) Being as recurring charge
(b) Being considered as tax shield
(c) Being as non recurring charge
(d) None of the above
(2) Why "0" value is taken as closing balance of the investment for the computation
of Average investment ?
(a) No value for the closing balance
(b) No value due to the application of straight line method of depreciation
(c) No scrap value at the end of the life of the asset
(d) 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 265
Accounting and Finance for (i) Identification of the investment proposals
Managers
(ii) 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 Initial Investment Rs Cr NPV Rs Cr PI
X 3.00 .60 1.20
Y 2.00 .50 1.25
Z 2.50 1.50 1.60
W 6.00 1.80 1.30

Project Initial Investment Rs Cr NPV Rs Cr PI

Z 2.50 1.50 1.60
W 6.00 1.80 1.30
Y 2.00 .50 1.25
X 3.00 .60 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 Initial Investment Rs Cr NPV Rs Cr
A. 10 6
B. 24 18
C. 32 20
D. 22 30
E. 18 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
266 project. To incorporate the risk in the discount rate, the meaning of the term risk should
be known and distinguished from the uncertainty. The risk situation is one in which the Capital Budgeting
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.

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) Identification of the investment proposals
(ii) 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 267
Accounting and Finance for PI: Profitability Index is the ratio in between the present value of future cash inflows
Managers
and present value of initial

18.12 QUESTIONS FOR DISCUSSION

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

268