Capital Budgeting:

5 Principles and Techniques

INTRODUCTION

This chapter is devoted to a disCussion of the principles and techniques of capital budgeting. The first
section discusses the nature of capital budgeting in terms of meaning, importance, difficulties, rationale and
Nes. The identification of relevant data for capital budgeting decisions is explained in section two. Section
three of the chapter examines the evaluation techniques. It also outlines the choice of an appropriate method
of appraisal in a given situation. The last section summarises the main points.

NATURE OF CAPITAL BUDGETING

Meaning
Captal budgeting decisions pertain to fixed/long-term assets which by definition refer to assets which are in
operation, and yield a return, over a period of time, usually, exceeding one year. They therefore, involve a
Curent outlay or series of outlays of cash resources in return for an anticipated flow of future benefits.! In
otner words, the system of capital budgeting is employed to evaluate expenditure decisions which involve
Curent outlays but are likely to produce benefits over a period of time longer than one year. These benefits
ay be either in the form of increased revenues or reduced costs. Capital expenditure management, therefore,
ncludes addition, disposition, modification and replacement of fixed assets. From the preceding discussion
ay be deduced the following basic features of capital budgeting"() potentially large anticipated benefits;
)a relatively high degree of risk; and (ii) a relatively long time period between the initial outlay and the
anlicipated returns. The term capital budgeting is used interchangeably with capital expenditure decision,
of fixed assets and so on.
4 expenditure management, long-term investment decision, management

Importance
Capital budgeting
udgeting
Such decisions
decisions of paramount importance
are
in financial
affect the profitability of a firm. They also have a bear
decision-making. In the first place.
on the competitive position of thee

Cnierprise mainly
mainly because
beca of the fact that they relate to fixed assets. The fixed assets represent, in a sens
the true earning assets of the firm. They enable the firm to generate finished goods that canult ultimately be
Sold ffor ing
p Rather, they provide a buffer that allows

ne Profit. The current assets are not generally earning assets.

are important to operations, but without fixed
firms to make
make sales an extend credit.
True, current assets
assets sales and converted into current assets,
the firm would not be able to.
Cnerate finished products that can be
operate rther, they are 'strategic' investment
decisions as against
t a c u c a l - w h i c h involve a relatively

Small amount investment decisions may

result in a major
mai departure from
of funds. Therefore, such capital
What the of a strategic investment will involve a a significant
pany has been doing in the past. Acceptance these profits will be subiect
ange and in the risks
to which hese
Company's expected profits
5.4 Financial Management: Text and Problems

to revise
their evaluation of the company 3
and creditors
kely to lead stockholders An oPportune investment des
of the company,
capital budgeting decision determine the future destiny endanger
decision can the
Can yield spectacular returns. On the other hand, an
ill-advised and incorrect very
durVval even of the large firms. A few wrong decisions and the firm may be IOrced into bankruptey,
ably affects the

over a long time span and inevitabl

effect
Secondly, a capital expenditure decision has its a
has been purcnased Dy company to
COmpanys future cost structure. To illustrate, if a particular plant start
of fixed costs, in terims or labour, supervisnt
itself a sizable amount ors
a new produet, the
diny, insurance, rent commitsand
of building,
company sotoon. If the investment turns out to be unsuccessful in futuraithe
o
of fixed cOsts unlesS it writes off
have to bear the burden
yields less profit than anticipated, the firm will break-even point, sales and profits will all be determined h
nvestiment completely. In short, future costs,
the selection of assets.
reversible without much financial loss to
investment decisions, once made, are not easily
Thirdly, capitai
the firm because there may be no market for second-hand plant
and equipment and their conversion to other
uses may not be financially viable.
of the firms have scarce capital resources
Finally, capital investment involves costs and the majority
This underlines the need for thoughtful, wise and correct investment deciSions, as an incorrect decision
would not only result in losses but also prevent the firm from earning profits from other investments which

could not be undertaken for want of funds.

Difficulties
future success and growth of the firm
Capital expenditure decisions are of considerable significance as the
difficulties.
depends heavily on them. But, they are beset with a number of
The future is uncertain.
Firstly, the benefits from investments are received in some future period.
an asset that is going to last for
Therefore, an element of risk is involved. For instance, a decision to acquire
serious errors which can be
15 years requires a 15-year forecast. A failure to forecast correctly will lead to
market for a
corrected only at a considerable expense. Future revenue involves estimating the size of the
of including
product and the expected share of the firm in that. These estimates depend on a variety factors,
price, advertising and promotion, and sales effort and so on. Adding to the uncertainties are the possibilites
m
of shifts in consumer preferences, the actions of competitors, technological developments and changes
the economic or political environment.
in different
Secondly, costs incurred and benefits received from the capital budgeting decisions occur

time periods. They are not logically comparable because of the time value of money.
Thirdly,it is not often possible to calculate in strict quantitative terms all the benefits or the costs relai
to a particular investment decision.

Rationale
and
The rationale underlying the capital budgeting decision is efficiency. Thus, a firm must replace won
obsolete plants and machinery, acquire fixed assets for current and new products and make str
investment decisions. This will enable the firm to achieve its objective of maximising profits either y
dgeting
of increased revenues or cost reductions. The quality of these decisions is improved by capital buus Vhich

Capital budgeting decision can be of two types: (1) those which expand revenues, and (ii) those
reduce costs.
bring

Investment Decisions Affecting Revenues Such investment decisions are expected 1o

in additional revenue, thereby raising the size of the firm's total revenue. They can be the result
 Capital Budgeting: Principles and Techniques .

af present operations or
the
development of new product lines. Both types of investment
expan uisition of new Ixea assets and are income-expansionary in nature in the case of decisio
nufacturing
involi

firms.

Investment ent Decisions Reducing Costs Such decisions, by reducing costs, add to the toal
of the firm. A classic example of such investment decisions are the replacement proposals when an
carning
ears out or becomes outdated. The firm
must decide whether to continue with the existing assets or
asset wears

1em, The firm evaluates the benefits from the

replace them.
new machine
in terms of lower operating cost and
that would be needed to replace the machine. An expenditure on a new machine uic
may be quit
outlay
able in the light of the total cost savings that result.
A Aundamental difference between the above two categories of investment decision lies in the fact that
reduction investment decisions are subject to less uncertainty in comparison to the revenue-affecting
cOst-re

stment decisions. This is so because the firm has a better 'feel' for potential cost savings as it can
investn

amine past production and cost data. However, it is difficult to precisely estimate the revenues and costs
esulting from a new product line, particularly when the firm knows relatively little about the same.

Kinds
Capital budgeting refers tothe total process of generating, evaluating, selecting and following up on capital
spenditure alternatives.* The firm allocates or budgets financial resources to new investment proposals.
Basically, the firm may be confronted with three types of capital budgeting decisions: () the accept-reject
decision; (ii) the mutually exclusive choice decision; and (ii) the capital rationing decision.

Accept-reject Decision This is a fundamental decision in capital budgeting. If the project is accepted,
the firm would invest in it; if the proposal is rejected, the firm does not invest in it. In general, all those
proposals which yield a rate of return greater than a certain required rate of return or cost of capital are
aCcepted and the rest are rejected. By applying this criterion, all independent projects are accepted.
independent projects are projects that do not compete with one another in such a way that the acceptance of
One precludes the possibility of acceptance of another. Under the accept-reject decision, all independent
projects that satisfy the minimum investment criterion should be implemented.

Mutually Exclusive Project Decisions Mutually exclusive projects are those which compete
ith other projects in such a way that the acceptance of one will exclude the acceptance of the other
projects. The alternatives are mutually exclusive and only one may be chosen. Suppose, a company is
mending to buy a new folding machine. There are three competing brands, each withves, a
different initial
vestment and operating costs. The three machines
that the mutually
mutually
representexclusive exclusive
proJect
alternati
decisions are
as
not
only one of
independent
nfan be selected. It may be noted here be under the latter decision. In brief, in
aCcept-reject decisions. The project(s) should also acceptable
the accept-reject decision, the firnm should not buy a new
hodmple, if all the machines are rejected under significance when more than one proposal is
machine. Mutually exclusive investment decisions acquire
accept-reject decision. Then, some technique has to be used to determine the 'best
acceptable under the
one. automatically eliminates the other alternatives.
C4cceptance of this 'best' alternative

Capital
inves Rationi Decision
Kationing In asituation where the firm
has unlimited funds, all indenendant

than Some predciemnca vel are accepted. However. this

proposals yielding return greater
situati not prevail in most of the
business firms in
actual practice. They have a fixed capital budget.
Alarpe S these limited funds. The firm must. ther
compete for
fundsproposals
investment
hem e of
firm allocates to projects in a manner that t n a N d s g T u n returns. Thus, capital
 Financial Management: Text
and Problems
.6 i n v e s t m e n t s than it can finan
acceptable
firm has more
i n v e s t m e n t proposals a
rationing refers to a situation in which a out of many
investment proposals the acceptable investmentacceptable
concerned with the selection of a group of rationing employs ranking of the rate of return, Thec
the accept-reject decision.. Capital criterion
such as
projects
nder basis of a
predetermined
he projects can be ranked on the return.
are ranked in the descending order
of the rate of

RELEVANT
CASH FLOWS
IDENTIFYING
DATA REQUIREMENT:

Cash Flows Vs Accounting Profit

return over a period
of time in f t .
decisions which yield future.
budgeting is concerned with
investment
investment proposal
1S to estimate the future benef
Lapital capital
n e foremost requirement for
evaluation of any
two alternative
criteria are available to quantify th
from the investment proposal.
Theoretically, them i1S primarily due to tha
accruing difference between
basic
benefits: (i) accounting profit, and (i) cash flows. The instance, depreciation. Therefore
and loss account, for
inclusion of certain non-cash expenses in the profit determine the actual cash inflow. The
for non-cash expenditures to
the accounting profit is to be adjusted to the accounting approach as cash
of future benefits of a project is superior
cash flow approach measuring benefits of costs assOCiated with a proposed
better measures of the net economic
flows are theoretically
project. firm is interested in estimating its economic
In the first place, while considering an investment proposal, a

economic outflows (costs) and inflows (benefits) related

value. This economic value is determined by the
the cash transactions. The firm must pay for the
with the investment project. Only cash flows represent
opportunity to use cash in some other
purchase of an asset with cash. This cash outlay represents foregone
a
the future net benefits in cash terms. On the
productive alternatives. Consequently, the firm should measure
investment is allocated over its economic useful
other hand, under the accounting practices, the cost of the
life in the nature of depreciation rather than at the time when costs are actually incurred. The accounting

treatment clearly does not reflect the original need for cash at the time
of inflows and outflows in later
transactions associated with the project. Since investment
years. Only cash flows reflect the actual cash
to warrant the
analysis is concerned with finding out whether future economic inflows are sufficiently large
initial investment, only the cash flow method is appropriate for investment decision analysis.
Secondly, the use of cash flows avoids accounting ambiguities. There are various ways to value inventory,
allocate costs, calculate depreciation and amortise various other expenses. Obviously, different net incomes
will be arrived at under different accounting procedures. But there is only one set of cash flows associated
with the project. Clearly, the cash flow approach to project evaluation is better than the net income flow

approach (accounting approach).

Thirdly, the cash flow approach takes cognisance of the time value of money whereas the accounting
approach ignores it. Under the usual accounting practice, revenue is recognised as being generated whe
the product is sold, not when the cash is collected from the sale; revenue may remain a paper 11gu for
months or years before payment of the invoice is received. Expenditure, too, is recognised as being maue
when incurred and not when the actual payment is made. Depreciation is deducted from the gross
revenues to determine the betore-tax earnings. Such a procedure ignores the increased flow or funds
potentially available for other uses. In other Words, accounting profits which are quite useful as pertorn me
measures often are less useful as deciston criteria. Therefore, from the viewpoint of capital expenditure
management, the cash flow approach can be said to be the
basis of estimating future benefits from mer

The data required for the inv

proposals.. purpose would be cash revenues and cash
expenses. The din
between the cash flow approach and the accounting profit approach is depicted in Table 5.1.
 5.7
Capital Budgeting: Principles and Techniques

TABLE 5.151 AComparison of Cash Flow and Accounting Profit Approaches

towards 'benefits
Cash flow approach towards 'benefits
Accounting a p p r o a c h

Revenues
Rs 1,000 Rs 1,000
Less e x p e n s e s :

Cash e x p e n s e s Rs 500
Rs 500
Depreciation 300 800
Eanings before tax
200
Taxes (0.35) 70 70 570
Net eanings after taxes/Cash flow A30 430

Table 5.1 shows that the accounting profits amounting to Rs 130 are less than the cash flow (Rs 430).
This difference can be attributed to the depreciation charge of Rs 300. The cash available with the firm is
Rs 430. This can be utilised for further investment. The accounting approach indicates that only Rs 130 is
available and hence gives only a partial picture of the tangible benefits available. Clearly, such an approach
does not bring out the total benefits of the project available for reinvesting. Therefore, in place of earnings,
the cash flow information is employed in evaluating capital expenditure alternatives.

Incremental Cash Flow

The second aspect of the data required for capital budgeting relates to the basis on which the relevant
cash
outflows and inflows associated with
proposed capital expenditure are to be estimated. The widely
prevalent practice is to adopt incremental analysis. According to incremental analysis, only differences
due to the decision need be considered. Other factors may be important but not to the decision at hand.
for purposes of estimating cash flows in the analysis of investments, incremental cash flows, that is,
those cash flows (and only those cash flows) which are directly attributable to the investment are taken
into account. It is for this reason that fixed overhead costs, which remain the same whether the
proposal is
accepted or rejected, are not considered. However, if there is an increase in them due to the new
proposal, they must be considered.

Effect of Taxes
ally. the incremental cash flows are adjusted for tax liability. In other words, taxes paid are deducted
t h e cash flows to estimate the benefits arising out of the investment decision.
0 conclude the above discussion relating to the data required for the capital budgeting decision, the
neits to be considered are "incremental after-tax cash flows'. Table 5.2 summarises the relevant and
ireleva information in relation to asset selection decisions.

TABL
ASLE 5.2 Relevant and Irrelevant lows

Relevant cash outflows Irrelevant cash outílows

1. Variable 1. Fixed overhead
labour
expenses expense
2. Sunk costs
2. Variable material expenses
3. Cost
4. Marginal taxes
of the investment
 5.8 Financial Management: Text and Problems

Cash Flow Pattern

ash W pattern associated with capital investment projects can be classified as conventional
conventional. al or non-

Conventional Cash Flows They consist of an initial cash outlay folowed by a series of
inflows. Most of the
capital expenditure decisions display this pattern of cash flow. To illustrate, the
may ofspend Rs 1,500 in time period zero and as a result may expect to receive a Rs 300 cash inflow a
end each year for the next 8 at the
years. The conventional cash flow pattern is diagrammed in
Fig: 5.1.
Rs 300 300 300 300 300 300 300 300

Cash inflows 1 2 3 4 5 6 7
Cash outflows 8
Rs 1,500
Years

Fig. 5.1 Conventional Cash Flow Pattern

Non-Conventional Cash Flows They refer to the cash flow
outlay is not followed by a series
of inflows. pattern in which an initial cash
outflows are examples of Alternating inflows and outflows and an inflow followed
is that of the non-conventional cash flow patterns. A classic by
purchase of an asset that generates cash inflows for a example of such cash flow patterns
generates a stream of cash inflows for a number of period of years, is overhauled, and again
years. To illustrate, a machine purchased for Rs 1,000
generates cash inflows of Rs 250 each for five In
years. the sixth
overhaul the machine, after which it
generates cash
an year,
outlay of Rs 400 is required to
inflows of Rs 250 for four years. Such a non-conventional
pattern of cash flows is shown in Fig. 5.2.
Rs 250 250 250 250 250 250 250 250 250

Cash inflows 0
Cash outflows 1
3 4
6
Rs 1,000 5 7
Years 8 9 10
As 400
Fig. 5.2 Non-conventional Cash Flow Pattern
Cash Flow Estimates
For capital budgeting cash flows have to be
estimated. There are certain ingredients of cash flow reams.

Tax Effect It has been

already observed that
budgeting are
of taxes. Special consideration needscash flows to be considered for
net
incurring losses and, therefore, paying no taxes. The to be given to tax effects on cashpurposes oe fim a
flows if tne t off
against future income. In such cases, tax laws
therefore, the benefits of permit carrying losses forward to Dc
tax savings
would accrue in future y
 5.9
and Techniques
Capital Budgeting: Principles

if it is not
Effect on Other
on Oti Projects
Cash flow effects of the project under consideration,
c o n s i d e r a t i o n . For

econd
independent, on other existing projects of the firm must be taken into with the existing
ically
e if a company is considering the production of a new product which competes related to the old
it is likely that as a result of the new proposa, the cash flows
instance

in the product line,

ts existinng
actual flow from the
vill be affected. Assume that there is a decline of Rs 5,000 in the
product will
from the n e w proposal.
his should be taken into consideration while estimating the cash stream:
product. Thi is in
Rs 5,000. This i
In terms, the cash flow from the new product should be reduced by
operational
in
involves identifying changes casn
ormity with the general rule of the incremental cash flows which the cash flow effects of the project
conforr

result of undertaking the project being evaluated. Clearly,

flows as a
ehould not be evaluated in isolation, if it affects other project(s) in any way.
estimating cash
factor which merits special consideration in
Effect of Indirect Expenses
Another
are allocated to the
different products on
is the effect of overheads. The indirect expenses/overheads Thee
flows common factor.
floor occupied or some other similar
paid, materials used, space
the basis of wages cash flows? The
arises 1s: should such allocation of
overheads be taken into account in the
question that decision. If
amount of overheads will change as a
result of the investment
whether the
answer hinges upon result of the investment
into account. If, however, overheads will not change as a
be taken
ves, it should
they are not relevant. an old
decision, used. Assume it intends to replace
allocates overheads on the basis of the floor space there would
A company so that
a s s u m e that the n e w
machine would occupy less space
Further in the overhead
machine by a n e w one.
there is no effect on cash flows, change
a
reduction in the overhead charged to it. Since is used for
be a
flow streams of the machine being
acquired. But if the surplus space
is not relevant to the cash calculations. Thus, the
flow is generated, it will be relevant to the
if cash of the
an alternative use, and any alternative use rule is a corollary
is alternative use. The
factor is whether there any
deciding
incremental cash flow rule.'
in
a non-cash item
of cost, is deductible expenditure
Depreciation, although Act for accounting
a Effect of Depreciation are preseribed by the Companies
provisions
determining taxable income. Depreciation
for taxation purposes.
the Income Tax Act Act is the computation of
purposes and by contained in the Companies
of depreciation statements. Since companies in
The purpose of the provisions in financial
and disclosure books of a c c o u n t s in
dividend payment depreciation in the
nanagerial remuneration, Act, they should provide
for various types of
India are regulated by the Companies the rate or depreciation
of the Act which prescribes line basis. It also permits
XIV
accordance with Schedule value (WDV)
basis
as well as straight off 95 per cent of
aepreciable assets o n written
down it has the effect of writing
other basis provided of the government. In
o n any and has
and the approval
mpanies to charge d e p r e c i a t i o n expiry of the specified period I n c o m e Tax Act with the basic obiectisVee
the original cost of the asse o n the or the
follow the provisions
companies
p r a c t i c e , however, in Section 32. The s e c t i o n
of its tax-deductibility. to aepreelaun
arc
contained
Tax Act
relating
depreciation, namely,
(i) the asset is owned by the
provisions of Income following iness and (iii) the asset is in the for
ne conditions
for of business and (ii)
three important for the p u r p o s e
vehicles, books, Scientific apparatus, surgical
scientific
ES theassessee

ships, vehicles,
the a s s e t is used by cluding
including ships,
build: ) and plants
eams
buildings, rurniture,
machinery
determined by (a)
the actual coSt of the asset and (b) its
cquipments and so on. depreciation on an
cset is
cost
the cost
the c
means
acquisition of the ass
o s t of acquis and
capihil The amount of annual assets.
The actual
the asset
in a usable state, for stance, freight
block of to put
relevant
d l o n in the
necessary
are
which
thereto

Set
expensesinciden'

ears
 Problems
. Financial Management: Text and
facilitate the use of tha
incurred to
n d carriage inwards, installation charges and expenses
construction work.
asset like
on essential
on the training of the operator or on an individual asset but
CApenses computation, not but on a
view to simplify
Depreciation is charged, with a
of assets falling
within a class or assets, beino bock
hus, lassets
ding,
ot assets. A block of assets' defined as a group
of depreciation is prescribed. T
of which the same rate
machinery, plant or furniture in respect
/rate of
the same percentage/rate
which fall within
the same class of assets and in respect of which
For example, all assets
depred
block of assets.
nas been prescribed irrespective of their nature form one
at 25 per cent will form one hloe
under t
category of plant and machinery which qualify for.depreciation block
assets depreciable aand
cpreciation is computed with reference to the actual cost of the block. Similarly, as
at 50 per cent 40
cent will constitute another block; a third block consists of assets depreciable cent, and the
per
fourth block comprises assets subject to a 100 per cent write-off.
Depreciation is computed at block-wise rates on the basis of written down value (WDV) method e
Presently, the block-wise rates for plant and machinery are at 25 per cent, 40 per cent and 100 per cent. Tio only
The
depreciation allowance on office buildings and furniture and fittings is 10 per cent. Where the actual costnt
plant and machinery does not exceed Rs 5,000, the entire cost is allowed to be written off in the first year
of
ts use. If an asset acquired during a year has been used for a period of less
than 180 days during the vear
depreciation on such assets is allowed only at 50 per cent of the computed depreciation according to the
relevant rate.
Apart from the simplification of the computation of the amount of depreciation, a significant implication
of categorising assets into blocks is that if an asset falling in a block is sold out, there is no capital gain or
terminal depreciation or balancing charge. The sale
proceeds of the asset are reduced from the WDV of the
block. Capital gain/loss can arise in these situations:
i) When the sale proceeds exceeds the WDV of the whole block;
ii) When the entire block is sold out; and
(iii) In case of 100 per cent depreciable assets.
The terminal loss is not allowed in the relevant
assessment year but is spread over a number of
allowed by way of depreciation. years to be
In case of
insufficiency/absence of profit, unabsorbed depreciation can be set off
any head against business income as in the case of against income unaer
forward for a maximum period of
unabsorbed loss. Effective 1996-97, it can be carmieu
eight years. However, it cannot be
transfer of business. assigned/transferred/claimed
by t
The mechanics of computation of depreciation is illustrated in Example 5.1.
Example 5.1
Assume the following facts relating to Avon Ltd (AL):
Block of assets Depreciation rate WDV as on
1.4.19X5 0
(percentage) Addition during 19X5
-

A
(Rs lakh) (Rs lakh)
25
B 40 500
250
300
150
Assets sold during 19X5-X
amounted to Rs 35 lakh
that fresh investments in assets
during 19X6- X7 will be:(Block
Block
A) and Rs 50 lakh (lBlock B). It is expec
It is also
projected
by the AlL that disinvestment A (Rs 160
lakh) and Block BB (Rs 801
of Block A and Rs 25 lakh in case of Block B.proceeds
Assume from
that the
about 50
assets per cent of additional
Rs 45 lakhi
in* o
will amount to RS
during 19X6-X7 will be made after
m e n t

September 19X6.
 Capital Budgeting: Principles and Techniques5.11
Compute the relevant
depreciation charge for 19X5-X6
and the projected
19X6-X7.
depreciation charge
Solution

The relevant depreciation charge for 19X5-X6

in Tables 5.3 and 5.4 and the projected depreciation charge for 19AO-RI
calculated
respectively. S

TABLE 5.3 Computation of

Depreciation Charge during 19X5 X6 (Rs lakh)
Blocks
1. WDV as on 1.4.19 X5 B
2. Add cost of assets acquired 500 300
during 19 X5 X6 250 150
3. Less sales during 19 X5 X6 750 450
4. WDV 35 50
(for depreciation)
5. Depreciation allowance 715 400
6. WDV as on 1.4. 19 X6 179 160
536 240

TABLE 5.4 Computation of Depreciation Charge during 19X6-X7 (Rs lakh)

Blocks
B
1. WDV as on 1.4.19 X5
536 240
Add cost of assets
2 acquired during 19 x6 -
X7 160 80
696 320
3. Less expected proceeds of sales during 19 X6 - X7
45 25
4. WDV
5.
depreciation)
(for
Depreciation allowance°
651 295
153 110
6. WDV as on 1.4. 19 X7 498 185
Normal depreciation allowance 163 118
Less depreciation allowance inadmissible in respect of
assets acquired after 30.9.19 X6 10
(80 x 0.25 x 0.5)
(40 x 0.4 x 0.5)
153
110
Note: If the entire block of assets is sold during a year for an amount exceeding (1 + 2) or the sale proceeds
block sold is higher than (1 + 2), the difference represents short-term capital gains subieet to ta
Che
here the sale Droceeds are lower than (1 + 2), the difference is short-term capital loss and the AL is
Wher
entitled to tax shield.
capital constitutes another important ingredient of the cash
Working Capital Effect Working
to an investment
proposal. Tne term working capital is used here
flow

m which related
is directly If an investment is eynet
liabilities (net WOTKIng capital).
C,that is, current assets minus current
be an increase
assets in the form
in c u r r e n t acconte of
s e sales, it is likely that there will in c
current
u r r e n t assets offset by an
assets will be otfset an inerease in current
increase in
inventory
liahil:
and cash. But part of this
accounts and
notes payable. Obviously, the sum equivalent to the
ues in the form of increased
.12 Financial Management: Text and Problems

ifereno between these additional current assets and current liabilities will be needed to ca
investment proposal. Sometimes, total investment in a Out
it may constitute a significant part of the
increased WOrking capital forms part of the initial cash outlay. The additional net working projea he
however, be returm to the firm at the end of the project's life. Therefore, the recovery of worle i
becomes part of the cash inflow stream in the terminal year. The initial investment in, and the c apita
recovery of, working capital do not balance out each other due to the time value of money. DSequent
Ihe increase in the working capital may not only be in the zero time period, that is, at the time f initie
Cstient. There can be continuous increase in the working capital as sales increase in later
er years.
nerease in working capital should be considered as cash outflow of the year in which additional
capital is required. ditional workiThisng
uppose.there is a project that requires an initial investment of Rs 20,000 and has a useful life ofs
he
requirements of working capital are detailed in Table 5.5. f5 years.

TABLE 5.5 Working Capital

Requirements
Year
2 3
(a) Initial investment Rs 20,000
Sales (Rs)
Rs 5,000 Rs 10,000 Rs 20,000 Rs 15,000
Expenses 1,000
(b) Changes in inventory (decrease) 2,000 5,000 4,000 500
1,000 2,000
(c) Changes in receivables 6,000 (4,000) (5,00)
(d) Changes in payables 1,000 2,000 4,000 (2,000) (5,000
1,500 2,000 5,000 (3,500) (5,500)
(e) Change in working capital (b + c -

d) 500 2,000 5,000 (2,500) (4,500)

The changes in the net
working capital are
given in the last row of Table 5.5. The net
increased in years 1, 2 and 3 working capital has
cash inflows as working representing cash outflows, while it has decreased in
capital is recovered. years 4 and 5 showing
Almost all revenue-expansion
almost all
capital
investment proposals require additional working
cost-reduction capital investment capital. Likews
projects release the existing amount of
projects enhance the firm's efficiency in such a way that the
working capital. uc
receivable can be
Improved inventory control systems amount
reduced. of inventory on hand or
are some classic or ac
improved billing and collection syo
examples. From the point of view of
working capital so released should be seen as a evaluating an investment project, the
cash
proposal is being considered), reducing the net cash inflow in the zero time anou
period (when the inve
ment

vear of the project, it should be treated as a cash investment required for the project. In the ating
outflow and terminayear
adjusted against the cash inflow or ua
Determination of Relevant Cashflows
The data requirement for capital
budgeting
depends on the nature of the proposal. are cash
Capital flows,can
projects thatbeis, categorised
outflows andinto: (i) single pro Dutation
inflows. Their
replacement situations and (1ii) mutually exclusive.
pOsal, .

Single Proposal The cash outflows,

capital expenditure are depicted in Format comprising cash outlays required to carry the propos
CEAT) is shown in Format 5.1, while the ou
5.2. The
e r taxe

computation is computation of
illustrated in Example 5.2theandcash inflows
Example ).
Format 5.1 Cash Qutflows of New Project [Beginning of the Period at Zero Time (t 0]

(1) Cost of project

new
21Installation cost of plant and equipments
(3) Working capital requirements

Format 5.2
Format 5.2 Determination of Cash Inilows: Single Investment Proposal(= 1-N
Years
2 3
Cash sales revenues
Less Cash operating cost
Cash inflows before taxes (CFBT)
Less Depreciatioon
Taxable income
Less Tax
Earning after taxes
Pius Depreciation
Cash infiows after tax (CFAT)
Plus Salvage value (in nth year)
Pius Recovery of working capital (in nth year)

Example5.2
from an
in a new processing facility. The company extracts ore
An iron compay is considering investing
ore
the extraction process is
tons of ore is extracted. If the output from
open pit mine. During a year, 1,00,000 of ore can be
Sold immediately upon removal of dirt, rocks
and other impurities, a price of Rs 1,000 per ton
realisable
extraction costs amount to 70 per cent of the net
obtained. The company has estimated that its
value of the ore.
it is possible to process further 25 per cent of
As an alternative to all the ore at Rs 1,000 per ton,
selling would be Rs 100 per ton. The proposed ore would
the output. The additional cash cost of further processing
be sold at Rs 1,600 per ton.
yield 80 per cent final output, and can Rs. 100 lakh. The equipment
would have to instal equipment costing
For additional processing, the company balance (WDV) basis/method. It is expected to
annum on reducing
Subject 25 cent depreciation per
is estimated at Rs. 10 lakh. The company's
1S to per
have useful life of 5 years. Additional
working capital requirement
tax rate is 35 per cent.
is 15 cent. Corporate
Cut-off rate for such investments per should the company
and machinery subject to 25 per cent depreciation,
Assuming there is no other plant salvage is Rs 10
lakh and (b) there would be no salvage
value at the
instal the equipment if (a) the expected
end of year 5.

Solution of lron Ore

to Instal Equipment for Further Processing
Evaluation Whether
Inancial
Rs 1,00,00,000
(a) Cash outflows:
10,00,00
Cost of equipment 1,10,00,000
capital
Plus additional working
5.14 Financial Management: Text and Problems
(b) Cash inflows (CFAT)
Year
3
Incremental revenue
[(Rs 1,600 x 20,000)
Rs 1,000 x 25,000)] Rs 70,00,000 Rs 7o,00,000 Rs 70,00,000 Rs 70,00,000 Rs 70.00 n
Less incremental costs: 000
Processing costs (Rs 100 x
25,000 tons) 25,00,00o 25,00,000
25,00,00o 25,00,000 25,00,000
Depreciation (working note 1) 25,00,000 18,75,000 14,06,250 10,54,688
Earnings before taxes 20,00,000 26,25,000 30,93,750 34,45,312 45,00,000
Less taxes (0.35) 10,82,813 12,05,859
Earnings after taxes (EAT)
7,00,000 9,18,750
20,10,937 22,39,453
15,75,000
13,00,000 17,06,250 29,25,000
Add depreciation 18,75,000 14,06,250 10,54,688
25,00,000
CFAT 34,17,187 32,94,141
38,00,000 35,81,250 29,25,000
Working note
I Depreciation schedule
Year Depreciation base of equipment Depreciation 25% on WDV
1 Rs 100,00,000 Rs 25,00,000
2 75,00,0000 18,75,000
3 56,25,000 14,06,250
42,18,750 10,54,688
5 31,64,062 Nil
As the block consists of a single asset, no depreciátion is to be charged in the terminal year of the project.
(c) Determination of NPV (Salvage Value = Rs 10 lakh)

Year CFAT PV factor (0.15) Total PV

Rs 38,00,000 0.870 Rs 33,06,000
35,81,250 0.756 27,07,4255
34,17,187 0.658 22,48,509
4 32,94,141 0.572 18,84,249
b 29,25,000 0.497 14,53,725
Salvage value 10,00,000 0.497 4,97,000
Tax benefit on short-term capital loss 7,57,422 b 0.497 3,76,439
Recovery of working capital 10,00,000 0.497 4,97,000
1,29,70,347
Less cash outflows 1,10,00,000
Net present value (NPV) 19,70,347
(b) 0.35 x (Rs 31,64,062 R s 10,00,000) = Rs 7,57,422.
Recommendation: The company 1s advised to instal the equipment as it promises a positive NPV.
(d) Determination of NPV (Salvage Value = Zero)

PV of operating CFAT (1 5 years) Rs 1,15,78,421

Add PV of tax benefit on short term capital loss (Rs 31,64,062 x 0.35
= Rs 11,07,4,22 x 0.497, PV factor) 5,50,389

Add PV of recovery of working capital 4,97,000

(Contd)
 5.15
Techniques
Capital Budgeting: Principles and

1,26,25,810
(Contal)

Total p r e s e n t v a l u e
1,10,00,000
Less cash outflows 16,25,810

NPV

still positive,
NPV is still
NPV
the company is advised to instal the equipment.
the
1e
Since

Example .3 cent
to 25 per
other
assume plants
there and machinery subject
are
in Example >.2, choose?
Eor the company of What course of action should
the company
in the same block assets).
Aenreciation (i.e.
Solastion
outflows would
remain unchanged.
4 yeas: In year 5,
the depreciation =F
(a) Cash the s a m e for the first
also remain value) x 0.25
=
will
annual depreciation Rs 10,00,000, salvage
b) The 31,64,062 -

WDV of equipment, Rs
Rs 21,64,062 (opening
shown as below:
it will be
change. In year 5,
Rs 5,41,016.
for years, 1-4 will not
(c) The CFAT (operating) CFAT (t = 5)

Particulars
Rs 70,00,000

Incremental revenue
25,00,00o
Less incremental costs:
5,41,016
Processing costs
39,58,984
Depreciation 13,85,644
Earning before taxes 25,73,340
Less taxes (0.35) 31,14,3556

EAT
CFAT
NPV (Salvage
Value =Rs. 10 lakh) PV factor
Total PV
Determination of Rs 33,06,000
CFAT
0.870 27,07,425
Year Rs 38,00,000 0.756
22,48,509
35,81,250 0.658
18,84,249
34,17,187 0.572
15,47,8335
3 32,94,141 0.497
4,97,000
4 31,14,356 0.497
0.497
4,97,000
5 10,00,000
1,26,88,018
Salvage value 10,00,000
1,10,00,000
ecovery of working capital
16,88,018
accrue on the eligible
Less cash outflows advantage will
higher
to be
Net present value (NPV)_ is likely 5,41,016)
in ture years.
futur
equipment Rs
In fact, the NPV of the 21,64,062

i.e. (Rs
depreciation ofR. s 16,23,046,

equipment
the
should instal
Company
 gement: Text and
roblems
Determination of NPV (Salvage
Value 0) =

For the first 4

years,
=
Rs
31,64,062 depreciation amount
amount will
will remain unchanged. In the fifth-
perating
(Rs 31,64,062,
CFAT for years 1 opening WDV less zero salvage uncnanged.
th year, depreciat
Rs 4 will remain value) x 0.25 Rs 7,91.01 =

32,01,855 as shown Theunchanged.

for CFAT sth
year would be
below
Incremental revenues
Less incremental Rs 70,00,000
total costs (Rs 25,00,000
EBIT + Rs 7,91,015) 32,91,015
Less taxes (0.35)
EAT 37,08,985
12,98,145
Add depreciation
24,10,840
CFAT 7,91,015
ii) PV of
operating CFAT (1 4 years) -
32,01,855
Add PV of
operating CFAT (5th year) (Rs 32,01,855 x 0.497)
1,01,24,696
Add PV of 15,91,322
recovery of working capital
Total PV 4,97,000
Less cash outflows 1,22,13,018
NPV 1,10,00,000@
CIn effect, NPV would be higher 12,13,018
as tax
advantage will accrue on depreciation of Rs 23,73,047 in future
years.
Recommendation: The decision does not change, as NPV is positive.
Cash flows: Replacement Situation In the case of
replacement of an existing machine (asset)
by a new one, the relevant cash outflows are after-tax incremental cash flows. If a new machine is intended
to replace an existing machine, the proceeds so obtained from its sale reduce cash outflows required to
purchase the new machine and, hence, part of relevant cash flows. The calculation of after-tax incremental
cash outflows is illustrated in Format 5.3 and Format 5.4 which provide depreciation base in the case ot
replacement situations.

Format 5.3 Cash Outflows in a Replacement Situation

Cost of the new machine

2. Installation Cost
3. Working Capital
4. Sale proceeds of existing machine

Format 5.4 Depreciation Base of New Machine in a Replacement Situation

machine
1. WDV of the existing
2. + Cost of the acquisition of new machine (including installation costs)
machine
3 . - Sale proceeds of existing

The computation is illustrated in Example 5.4.

 Capital Budgeting: Principles and Techniques 5.17

E x a m p l e . 4

Doval
Ra Industries Ltd. 1S
considering the
replacement of one of its moulding machines. The existing macnine
s in good operating condition, but is smaller than required if the firm is to expand its operations. t 13 *
TS old, has
a current salvage value of
Rs 2,00,000 and a remaining life of 6 The machine
years

initially purchased
nitially
years. was
purchased for Rs 10 lakh and is being depreciated at 25 per cent on the basis of written down vlaue
method.

The new machine will cost Rs 15 lakh and will be subject to the same method as well as the same rate of
depreciation. lt 1s expected to have a useful life of 6 years, salvage value of Rs 1,50,000 at the sixth year
end. The managemnet anticipates that with the expanded operations, there will be a need of an additional
net working capital of Rs 1 lakh.
The new machine will allow the firm to expand current operations and thereby increase annual revenues
by Rs 5,00,000; variable cost to volume ratio is 30 per cent. Fixed costs (excluding depreciation) are likely
to remain unchanged.
The rate is 35 per cent. Its cost of capital is 10 per cent. The company has several machines
corporte tax
in the block of 25 per cent depreciation.
if there is
Should the company replace its existing machine? What course of action would you suggest,
no salvage value?

Solution
Financial Evaluation Whether to Replace Existing Machine

(a) Cash outflows (incremental): Rs 15,00,000

Cost of the new machine
1,00,000
Add additional working captial 2,00,000
machine
Less sale value of existing 14,00,000

of Incremental CFAT
(Operating)
(6) Determination Taxable Taxes EAT CFAT
Incremental
Year Incremental
income (0.35) [Col.4 Col.5] [Col.6+ Col.3]
depreciation
contribution 7
4
3
2 Rs 8,750 Rs 16,250 Rs 3,41,250
Rs 25,000 3,12,812
Rs 3,25,000 37,188 69,062
Rs 3,50,000 1,06,250
2,43,750
58,515 1,08,672 2,91,485
2 3,50,000 1,67,187
1,82,813 74,512 1,38,379 2,75,488
3 3,50,000 2,12,891
1,37,109 86,509 1,60,659 2,63,491
3,50,000 2,47,168
1,02,832 1,08,632 2,01,744 2,41,368
5 3,50,000 3,10,376
39,624 (V/V) ratio]
= Rs 3,50,000
3,50,000 to value
variable cost
x 0.30,
aRs
b,00,000 [Rs 5,00,000
(Working note)
Working note
ncremental
depreciation (t =1-6) Incremental
asset cost
base Depreciation (25% on WDV)
Rs 3,25,000
Year Rs 13,00,000
2,43,750
9,75,000
1,82,8133
2
7,31,250
TContd.)
3
 ternatively, (ncrer
Alternatively,
Altern Capita
remental Cash
uncemental udgeting: Principles and
Incremental cash outflows Cash flow
flow
Approach) Techniques 5.
Investment required in
l ess investment requiredProposal
in
Y
Proposal X
Incremental CFAT and Rs 3,20,000
0 Incremental sales
NPV
2,00,000
Less incremental revenue (Y X) 1,20,000
cash
Incremental cash profit
expenses (Y -

X)
Less taxes (0.35) before taxes 70,000
Incremental CFAT 20,000
(t =
15) -
50,000
() PV of
annuity for 5 years 17,500
Incremental present value (0.12) 32,500
(t) PV of tax
savings due to incremental x 3.605
Year Incremental depreciation depreciation 1,17,162
Tax savings
Rs 25,000 PVF
Rs 8,7500 Present value
18,750 6,562
0.893 Rs 7,814
14,062 4,922
0.797
5,230
10,547 0.712
3,691 3,504
0.636
(i) PV of tax
savings on incremental 2,348 18,896
(Rs 79,102 Rs 47,461) x 0.35 x (Y-
-

0.567
X) short term capital loss
(STCL):
(iv) Incremental (Y - X) working
Incremental present value capital (Rs 70,000 Rs 50,000) x 0.567 6,279
11,340
Less incremental cash outflows 1,53,677
Incremental NPV 1,20,000
33,677
Recommendation: Proposal Yis better.
Financial Evaluation of Proposals, Assuming Salvage Value of Machines X and Y
(Incremental
Approach)
(a) Sum of PV of items (i), (ii) and (iv) (Rs 1,17,162 Rs 18,896 + Rs 11,340) Rs 1,47,398
(6) PV of incremental salvage value (Rs 15,000 x 0.567) 8,505
(c) PV of tax savings on incremental STCL@ (Rs 54,102 Rs 37,461) x 0.35 x 0.567 3,302
Incremental present value 1,59,205
Less incremental cash outflows 1,20,000
Incremental NPV 39,205
Decision: Decision (superiority of proposal Y) remains unchanged.
and (iv) when there is no salvage will not change due to salvage value.
ltems (), (i)
A s a result of salvage value, the amount of short-term capital loss (STCL) will change.

EVALUATION TECHNIQUES
for capital budgeting. Included in the methods of
evaluation techniques
This section discusses the inmportant and based on economic costs
are objective, quantified
investment are those which
proposal
appraising a n
categories:
and benefits. can be classified into two broad
expenditure proposals cash flow (DCF)
The methods of appraising capital
known as discounted
latter are m o r e popularly
time-adjusted. The
traditional, and (ii)
5.22 Financial Management: Text and Problems

Includes () average te
rate of retumn
oe
account. The first category
techniques they as take the time factor into includes (i) net present value method
second category
method and (ii) pay back eriod method. The index.
and (iv) profitability
method, (ii) net terminal value method,
(11) internal rate of return

Traditional Techniques
Average Rate of Return
Computation The average rate of return (ARR) method of evaluating proposed capital expenditursan
accounting information rather th
method. It is based upon
of return
rate of return. There are a number
also known as the accounting rate
the definition of the
Cash flows. There is no unanimity regarding of the average rate of return (ARD
most common usage
ARR. The
alternative methods for calculating the

expresses it as follows:
taxes
Average annual profits after x 100
project
5.1)
ARR Average investment over the life of the

up the
after-tax profits expected for each vear
profits after taxes are determined by adding the
The average the of annuity, average after
the number of years. In
case

of the project's dividing the result by

life and
tax profits are equal to any year's profits. averaging process
This
the net investment by two.
The average investment is determined by dividing value of the asset declines at
line depreciation, in which case the book
assumes that the firm is using straight life. This means that, on the
from its purchase price to zero at the end of its depreciable
a constant rate
in the books." Consequently, if
the machine
firms will have one-half of their initial purchase price
average,
cost (cost-salvage value) of
the machine should be divided by
value, then only the depreciable
has salvage
as the salvage money will
be recovered only at the end
net investment,
two in order to ascertain the average value remains tied up in the project
an amount equivalent to the salvage
of the life of the project. Therefore, value to determine the
life time. Hence, no adjustment is required to the sum of salvage
throughout its in the initial year whichs
Likewise, if any additional net working capital is required
average investment. should be taken
be released only at the end of the project's life, the full amount of working capital
likely to
investment for the purpose of calculating ARR. Thus,
in determining relevant
machine Salvage valu
Net working capital + Salvage value + 1/2 (Initial cost of
-

Average investment =

(5.2
Rs 11,000, salvage value
given the information: initial investment (purchase of machine),
For instance,
of depreciatnou
Rs 2,000, service life (years) 5 and that the straight line method
Rs 1,000, working capital, 8,000.
investment is: Rs 1,000 + Rs 2,000 + 1/2 (Rs 11,000-Rs.1,000) =Rs
is adopted, the average

Example.6
Determine the average rate ofreturn from the following data of two machines, A and B.
Machine B
MachineA
R s 56,125

Cost Rs 56,125
Annual estimated income after
depreciation and income tax
11,375
Year 1 3,375 9,376
2 5,375 (Contd)
 5.23
and Techniques
Capital Budgeting: Principles

(Contdl)
7,375
7,375 5,375
9,375
11,375 3,375
36,875
36,875 5
Estimated life (years) 5
Estimated salvage value
3,000 3,000
Depreciatior has been charged on straight line basis.

Solution
Average income
ARR = Average investment x 100

Rs 36,875
Average income
of Machines A and B = = Rs 7,375
5
Average investment =
Salvage value + 1/2 (Cost of machine
-

Salvage value)
Rs 29,562.50
= Rs 3,000+ 1/2 (Rs 56,125 - Rs 3,000) =

Rs 7,375
x100
ARR (for machines A and B) = Rs 29,562.50 =24.9 per cent

rate of return (ARR).

One
addition to the above, there are other approaches to calculate the average of the
In the average cost
variation of the above, involves using original rather than
approach, which is a
the machines would be 13.1 per
cent
the of this alternative approach, the ARR for both
project. In case

(Rs 7,375 + Rs 56,125).

decision maker can decide
whether to
With the help of the ARR, the financial
Accept-reject Rule accept-reject criterion,
As an
the actual ARR would be compared
investment proposal. to be
accept or reject the cut-off rate. A project would qualify
rate of return or
minimum required it is liable to be rejected.
with a predetermined or a desired ARR. Otherwise,
than the minimum
ARR is higher proposals. Thus, the
alternative proposals
accepted if the actual can be used
to select or reject
method with the proposal with
Alternatively, the ranking order of magnitude, starting
the descending
be arranged in
the lowest ARR. Obviously,
projects having higher
under consideration may having
with the proposal
the highest ARR and ending with lower ARR.
ARR would be preferred
to projects
investment projects., its
c r i t e r i o n to select/reject
as a
the ARR,
a t t r i b u t e of the ARR
method is its e asv
easy
ARR In evaluating
Evaluation of considered. The
most
favourable

after taxes which should be easily

afte
drawbacks need to be of accounting profits techniaues
merits and the figure to this, the
discounted flow s
is only contrast
calculatio What is required and use.
ln associated with the
inally, the total benefits instance do not
understand

Moreover, it is
simple to to
understand.
Fina
ODtainable. difficult back for use
and a r e SOme methods, pay
calculations the A R R .
involve tedious account
while
calculating
deficiencies, The
neindis

are taken into from serious

POJect
the entire stream of incomes. investment proposals surrers income instead of cash flows. The cash
income ins
evaluating nting
of accounting earn:
method of from the
use
aluation. The
evaluation. earnings calculati
iowever, this aries for proj ct
ARR approach
earnings
takes into
take account this potential
Oming of
the to
accounting
while
while the cash flow
o is markedly
superior
roiect's benefits
project's
approach
potential
ofa
reinvestment

the benefits of the project.

total
, h e n c e , the
5.24 Financial Management: Text and Problems

second principal shortcoming of ARR is that it does not take into account the time
value of
Thene
.

timing ofcash inflows and outflows is a major decision variable in financial decision making, A ney
benefits in the earlier years and later years cannot be valued at par. 1o the eXtEnt the ARR methoB

these benefits at par and fails to take account of the differences in the time value of money, it suff ats
Serious deficiency. Thus, in Example 5.6, the ARR in case of both machines, A andB is the same. al
machine B should be preferred since its returns in the early years of its ire are greater. Clearly, the lthough
ARR
method of evaluating investment proposals fails to
consider this.
does not differentiate between tha
nirdly, measuring the worth of investment
the ARR criterion of .

may have the same ARp

or the investment
required for each project. Competing investment proposals b
may require different average investments, as shown in T'able 5.6. The ARR method, in such a sit Dut
Situation,
will leave the firm in an indeterminate position.

TABLE 5.6

Machines Average annual earningsS

Average investment ARR (per cent)
2
3 4
1

Rs 6,000 Rs 30,000 20
A
10,000 20
B 2,000
20,000 20
C 4,000
which can accrue to the firm from the
Finaliy,this method does not take into consideration any benefits
sale or abandonment of equipment which replaced by the new investment. The 'new' investment, from
is
be measured in terms of incremental cash
the point of view of correct financial decision making, should
sale proceeds of the existing equipment ;
outflows due to new investments, that is, new investment minus
tax adjustment. But the ARR method does not make any adjustment in this regard to determine the level o
Investments in fixed assets are determined at their acquisition cost.
average investments.
selection.
For these reason, the ARR leaves much to be desired as a method for project

Pay Back Method

It ts
Computation The pay back method (PB) is the second traditional method of capital budgeting.
the simplest and, perhaps, the most widely employed, quantitative method for appraising capital expenditure
decisions. This method answers the question: How many years will it take for the cash benefits to pav
original cost of an investment, normally disregarding salvage value? Cash benefits here represent CFA
ignoring interest payment. Thus, the pay back method (PB) measures the number of years requred tor
CFAT to pay back the original outlay required in an investment proposal.
There are two ways of calculating the PB period. The first method can be applied when the cast
strearh is in the nature of annuity for each year of the project's life, that is, CFAT are uniform. In su
situation, the initial cost of the investment is divided by the constant annual cash flow:

PB= Investment (5.3)

Constant annual cash flow
for 10
For example, an investment of Rs 40,00O in a machine is expected to produce CFAT of Rs 8,000

years,
Rs 40,000o
PB= = 5 years
Rs 8,000
 5.25
Capital Budgeting: Principles and Techniques
second method is used when a project's cash flows are not uniform (mixed stream) but vary
The s
time when
ear. In;
toyear.
In such a situation,PB is calculated
by the process of cumulating cash flows till the
of
cumulative c a s h flows become
calculations
equal to the original
year

presents the
investment outlay. Table 5.71
ack period
paybac.
for Example 5.6.

TABLE 5.7

Annual CFAT Cumulative CFAT

Year
A B
B A
Rs 14,000 Rs 22,000 Rs 14,000 Rs 22,000
16,000 20,000 30,000 42,000
2
18,000 48,000 60,000
3 18,000
20,000 16,000 68,000 76,000
25,000 93,000
5 17,000 93,000
CFAT in the fifth year includes Rs.3,000 salvage value also.

The initial investment of Rs 56,125 on machine A will be recovered between years 3 and 4.
the
The pay back period would be a fraction more than 3 years. The sum of Rs 48,000 is recovered by
end of the third year. The balance Rs 8,125 is needed to be recovered in the fourth year. In the fourth year
CFAT is Rs 20o.000. The pay back fraction is, therefore, 0.406 (Rs 8,125/Rs 20,000). The pay back period
for machine A is 3.406 years. Similarly, for machine B the pay back period would be2 years and a fraction
of a year. As Rs 42,000 is recovered by the end of the second year, the balance of Rs 14,125 needs to be
recovered in the third year. In the third year CFAT is Rs 18,000. The pay back fraction is 0.785 (Rs 14,125/
Rs 18,000). Thus, the PB period for machine B is 2.785 years.

Criterion The pay back period be used decision criterion to accept or

Accept-Reject can as a

is to compare the actual pay back with a

Teject investment proposals. One application of this technique
predetermined pay back, that is, the pay back set up by the management in terms of the maximum period
If the actual pay back period is less than the
during which the initial investment must be recovered.
predetermined pay back, the project would be accepted; if not, it would be rejected. Alternatively, the pay
back can be used as a ranking method. When mutually exclusive projects are under consideration, they may
be ranked according to the length of the pay back period. Thus, the project having the shortest pay back
so that the project with the longest pay back would be
may be assigned rank one, followed in that order
anked last. Obviously, projects with shorter pay
back pericd will he selected.
Evaluation The pay back method has certain merits. It is easy to calculate and simple to understand
Its superiority arises due to the
Moreover, the pay back method is an improvement Over the ARR approach.
The results of Example 5.6 illustrated in Table 5.10 can be cited
Tact that it is based on cash flow analysis. cash flows for
n support of this. Thus, though the averagethe both the machines under the ARR method were
B is shorter than for machine A
une same, the pay back method shows that pay back perioa ror machine
ne pay back period approach shows that machine B Shouid De prererred as it refunds the capital outlav

carlier than machine A.

The pay back approach, however, suffers
irom
serious miaons. Its major shortcomings are as follws
The first major shortcoming of the pay backK menou at Completely 1gnores all cash inflows after
s

pay back period. This can be very misleading

in
capltal budgeting evaluations. Table 5.8 reveal
back period (3 years).
ernative proje
oJects with the pay
same
 Text and Problems
5.26 Financial Management:

TABLE 5.8
Project X

Rs 15,000
Project Y
Rs 15,000
Total cost of
project
the
Cash inflows (CFAT) 5,000
Year 1 6,000
4,000
5,000
2 4,000 6,000
3 6,000
A
3,000
3,000
3 3
Pay back period (years)
inflows generated after the pay back Deriod The
in respect of cash
In fact, the projects differs widely while that of Y continues up to the sith.
X at the end of the third year, year.
cash flow for project stops
makes available to the firm cash inflows f
it
Obviously, the firm would prefer
project Y because after the third year, lUni
not yield any cash inflow
4 through 6, whereas project X does
12.000. in years
the projects would be given equal
ranking, which is apparent
however, both
the pay back method, Its failure lies in the fact that it doe
be as a measure of profitability.
incorrect. Therefore, it cannot regarded
not consider the total
benefits accruing from the project.
not m e a s u r e correctly even the cash flows
of the pay back method is that it does
Another deficiency differentiate between projects in terms o
as it does not
to be received within the pay back period as a whole. This happens
expected
of cash flows. It considers only the recovery period
the timing or the magnitude received in the second or third
cash inflows but rather treats rupee
a
does discount the future
because it not
to the extent the pay back method fais
valuable as a rupee received
in the first year. In other words,
year as
value of money.
to consider the pattern of
cash inflows, it ignores the time
in the zero time period: (i)
A and B have (i) the same cash outlays
Table 5.9 shows that both the projects But project A would
and (ii) the same pay back period of 3 years.
the same total cash inflows of Rs 15,000;
A to repay a loan or
to the firm because it returns cash earlier than project B, enabling
be acceptable the pay back
solution to this problem is provided by determining
reinvest it and earn a return. A possible
this chapter.
This is illustrated in the subsequent section of
period of discounted cash flows.

TABLE 5.9 Cashflows of Projects

Project B
Project A
Rs 15,000
Total cost of the project Rs 15,000
Cash inflows (CFAT)
1,000
Year 1 10,000
2 4,000 4,000
10,000
3 1,000
ofth
Another flaw of the pay back method is that it does not take into consideration the entire e a r part
project during which cash flows are generated. As a result, projects with large cash inflows in the l t
larger
of their lives may be rejected in favour of less profitable projects which happen to generate a f two
proportion of their cash inflows in the earlier part of their lives. Table 5.10 presents the comparisOn
such projects. On the basis of the pay back criterion, project A will be adjudged superior to projectB .
 5.27
Techniques
Capital Budgeting: Principles and

TABLE 5. 10

Project B
Project A
cost of the project Rs 40,000
Total Rs 40,000
Cash inflows (CFAT)
Year 1 10,000
2 14,000
10,000
16,000
10,000
4 10,000
10,000
5
4,000
2,000 12,000
6 16,000
7
1,000
Nil 17,000
Pay back period (years) 3 4

It is quite evident just from a casual inspection that project B is more profitable than project A, since the
cash inflows of the former amount to Rs 45,000 after the expiry of the pay back period and the cash lows
of the latter beyond the pay back period are only Rs 7,000.
The above weaknesses notwithstanding, the pay back method can be gainfully employed under certain
circumstances.In the first place, where the long-term outlook, say in excess of three years, is extremely hazy,
the pay back method may be useful. In a politically unstable country, for instance, a quick return to recover the
investment is the primary goal, and subsequent profits are almostunexpected surprises. Likewise, this method
may be very appropriate for firms suffering from liquidity crisis. A firm with limited liquid assets and no
ability to raise additional funds, which nevertheless wishes to undertake capital projects in the hope of easing
the crisis, might use pay back as a selection criterion because it emphasises quick recovery of the firm's
original outlay and little impairment of the already critical liquidity situation. Thirdly, the payback method
may also be beneficial in taking capital budgeting decisions for firms which lay more emphasis on short-run
earning performance rather than its long-term growth. The pay back period is a measure of liquidity of
investments rather than their profitability. Thus, the pay back period should more appropriately be treated as a
constraint to be satisfied than as a profitability measure to be maximised." Finally, the pay back period is
useful, apart from measuring liquidity, in making calculations in certain situations. For instance, the internal
rate of return can be computed easily from the pay back period. The pay back method is a good approximation
of the internal rate of return which otherwise requires a trial and error approach.
To conclude the discussion of the traditional methods of appraising capital investment decisions, there
are two major drawbacks of these techniques. They do not consider the total benefits in terms of (i) the
magnitude and (i) the timing of cash flows. For these reasons,the traditional methods are unsatisfactory as
capital budgeting decision criteria. The two essential ingredients of a theeoretically sound appraisal method.
therefore, are that (i) it should be based on a consideration of the total cash stream, and (i) it should
consider thetime value of money as reflected in both the magnitude and the timing of expected cash flows
cash flow) techniques satistfy
each period of a project's life. The time-adjusted (also known as discounted
inthese requirements and, to that extent, provide a more objective basis tor selecting and evaluating investment
projects
(TA) Techniques
Dis
DIsCounted Cashflow (DCF)/Time-Adjusted
of the DCF capital budgeng tecnniques is
that they take into consideration
ne distinguishing
e time characteristics
value of monev while evaluating the costS and dencLs or a project. In one form or another al