2

Capital Budgeting
Capital budgeting decisions are related to the allocation of
funds to different long assets.
Broadly speaking, the capital budgeting decisions a
decisions situation where the lump sum funds are
invested in the initial stages of projects and the returns
are expected over a long period.
 3

Significance of capital budgeting

Decisions

• Long-term Effects.

• Substantial commitments.

• Irreversible decisions.

• Affect the capacity and strength to compete

 4

Types of Capital Budgeting Decisions

Every capital budgeting decisions is a specific

decisions in the given situation, for a given firm and with
given parameters and therefore, an almost infinite number
of types or forms of capital budgeting decisions may occur.

Even if the same decision being considered by the

same firm at two different points of time, the decisions
consideration may changes as a result of changes in any of
the variable.
 5

Types of Capital Budgeting Decisions

However, the different types of capital budgeting decision
undertaken from time to time by different firm can be classified
on a number of dimension. In general, the projects can be
categorized as follows:
From the point of view of firm’s existence:
New firm.
Existing firm :
• Replacement and modernization.
• Expansion.
• Diversification.
• Contingent decisions.
• Mutually exclusive investment.
• Independent investment.
 6

Types of Capital Budgeting Decisions

However, the different types of capital budgeting decision
undertaken from time to time by different firm can be classified on a
number of dimension. In general, the projects can be categorized as
follows:
From the point of view of firm’s existence:
New firm.
Existing firm :
• Replacement and modernization.
• Expansion.
• Diversification.
• Contingent decisions.

From the point view of decision situation:

• Mutually exclusive investment.
• Independent investment.
 7

Evaluation Criteria
Non-discounted Cash Flow Criteria
• Payback Period (PB)
• Discounted payback period (DPB)
• Accounting Rate of Return (ARR)

Discounted Cash Flow (DCF) Criteria

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
 8

PAYBACK
• Payback is the number of years required to recover the
original cash outlay invested in a project.
• If the project generates constant annual cash inflows, the
payback period can be computed by dividing cash outlay
by the annual cash inflow. That is:
 9

Example
• Assume that a project requires an outlay of Rs 50,000
and yields annual cash inflow of Rs 12,500 for 7 years.
The payback period for the project is:
 10

PAYBACK
Unequal cash flows : In case of unequal cash inflows, the
payback period can be found out by adding up the cash
inflows until the total is equal to the initial cash outlay.
Suppose that a project requires a cash outlay of Rs
20,000, and generates cash inflows of Rs 8,000; Rs
7,000; Rs 4,000; and Rs 3,000 during the next 4 years.
What is the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
 11

Acceptance Rule
• The project would be accepted if its payback period is
less than the maximum or standard payback period set by
management.

• As a ranking method, it gives highest ranking to the

project, which has the shortest payback period and lowest
ranking to the project with highest payback period.
 12

DISCOUNTED PAYBACK PERIOD

• The discounted payback period is the number of periods
taken in recovering the investment outlay on the present
value basis.
• The discounted payback period still fails to consider the
cash flows occurring after the payback period.
 13

Evaluation of Payback
Certain virtues:
• Simplicity
• Cost effective
• Short-term effects
• Risk shield
• Liquidity
Serious limitations:
• Cash flows after payback
• Cash flows ignored
• Cash flow patterns
• Administrative difficulties
• Inconsistent with shareholder value
 14

Evaluation of Payback
Cash flows after pay back :

Cash flows (Rs)

Project C0 C1 C2 C3 Payback NPV
X -4,000 0 4000 2000 2 years 806
Y -4000 2000 2000 0 2 years -530
 15

Evaluation of Payback
Cash flows ignored :

Cash flows (Rs.)

Project C0 C1 C2 C3 Payback NPV
C -4,000 0 4000 2000 2 years 806
D -4000 2000 2000 0 2 years -530
 16

Evaluation of Payback
Cash flows patterns:

Cash flows (Rs.)

Project C0 C1 C2 C3 Payback NPV
P -5,000 3000 2000 2000 2 years 881
X -5000 2000 3000 2000 2 years 798
 17

Accounting Rate of Return (ARR)

The accounting rate of return is also known as “ return on
investment” or return on capital employed”.
Method employing the normal accounting technique to
measure the increase in profit expected to result from an
investment by expressing the net accounting profit arising
from the investment as a percentage of that capital
investment.
Accounting rate of return= Average annual profit after tax 100
average or initial investment

Average investment = Initial investment +salvage value

2
 18

ACCOUNTING RATE OF RETURN

METHOD
• The accounting rate of return is the ratio of the average
after-tax profit divided by the average investment. The
average investment would be equal to half of the original
investment if it were depreciated constantly.

Or

• A variation of the ARR method is to divide average

earnings after taxes by the original cost of the project
instead of the average cost.
 19

Example
• A project will cost Rs 40,000. Its stream of earnings before
depreciation, interest and taxes (EBDIT) during first year
through five years is expected to be Rs 10,000, Rs
12,000, Rs 14,000, Rs 16,000 and Rs 20,000. Assume a
50 per cent tax rate and depreciation on straight-line
basis.
 20
Cacualtion of Accounting Rate of Return
Period 1 2 3 4 5 Average (RS)
Earning Before Depreciation, Interest and Taxes ( EBDIT) Rs. 10,000 Rs. 12,000 Rs. 14,000 Rs. 16,000 Rs. 20,000 Rs. 14,400
Depreciation Rs. 8,000 Rs. 8,000 Rs. 8,000 Rs. 8,000 Rs. 8,000 Rs. 8,000
Earning before , Interest and Taxes ( EBIT) Rs. 2,000 Rs. 4,000 Rs. 6,000 Rs. 8,000 Rs. 12,000 Rs. 6,400
Taxes at 50% Rs. 1,000 Rs. 2,000 Rs. 3,000 Rs. 4,000 Rs. 6,000 Rs. 3,200
Earning before interest and after taxes [EBIT(1-T)] Rs. 1,000 Rs. 2,000 Rs. 3,000 Rs. 4,000 Rs. 6,000 Rs. 3,200
Book value of investment
Begning Rs. 40,000 Rs. 32,000 Rs. 24,000 Rs. 16,000 Rs. 8,000
Ending Rs. 32,000 Rs. 24,000 Rs. 16,000 Rs. 8,000 Nil
Average Rs. 36,000 Rs. 28,000 Rs. 20,000 Rs. 12,000 Rs. 4,000 Rs. 20,000
 21

Calculation of Accounting Rate of Return

 22

Calculation of Accounting Rate of Return

Consider the following investment opportunity:
A machine is available for purchase at a cost of Rs.80,000.
We expect it to have a life of five years and to have a Scarp value of Rs.10,000 at the end of
the five years period. We have estimated that it will generate additional profits over its life as
follows:
Year 1 2 3 4 5
Amount (RS) 20,000 40,000 30,000 15,000 5,000

These estimate are of profit before depreciation.

Your required to calculate the return on capital employed
 23

Solution
Total profit before depreciation over the life of the machine = Rs1,10,000
Avergare profit p.a = Rs. 1,10,000/5 years = Rs.22,000
Total depricaition over the life of the machine (Rs. 80,000 - Rs. 10,000 =RS.70,000
Average depreciation p.a = Rs.70,000/5 years = Rs.14,000
Average annual profit after depreciation = Rs. 22,000 - Rs. 14,000 =Rs.8,000
Original investment required = Rs.80,000
Accounting rate of return = ( Rs.8000/Rs.80,000)X 100 = 10%
Average investment = (Rs.80,000 + Rs.10,000)/2 = Rs. 45,000
Accounting rate of return = ( Rs.8,000/Rs.45000)X100 = 17.78%
 24

Calculation of Accounting Rate of Return

X Ltd considering the purchase of a machine. Two machines are
available E and F. the cost of each machine is Rs.60,000. Each
machine has an expected life of years. Net profit before tax and
after depreciation during the expected life of the machine are given
below.
year Machine E Machine F
1 15,000 5,000
2 20,000 15,000
3 25,000 20,000
4 15,000 30,000

5 10,000 20,000

Total 85,000 90,000

Following the method of average return on average investment

ascertain the which of the alternative will be more profitable. The
average rate of tax may be taken at 50%.
 25

Calculation of Accounting Rate of Return

Solution :

Statement of Profitablity
Year Machine E Machine F

PBT(Rs) Tax @ 50%(RS) PAT(Rs) PBT(Rs) Tax @50% (Rs) PAT(Rs)

1 15000 7500 7500 5000 2500 2500
2 20000 10000 10000 10000 5000 5000

3 25000 12500 12500 20000 10000 10000

4 15000 7500 7500 30000 15000 15000
5 10000 5000 5000 20000 10000 10000
Total 85000 42500 42500 90000 45000 45000

Machine E Machine F
Avergae Profit After Tax: 42500x1/5=Rs.85,000 45000x1/5 = Rs.9,000
Avergae Investment : 60,000x1/2 = Rs.30,000 60,000x1/2 = Rs.30,000
Average return on Average investment: 8500/30,000x100 = 28.33% 9000/30,000x100=30%
Thus, Machine "F" is more profitable
 26

Acceptance Rule
• This method will accept all those projects whose ARR is
higher than the minimum rate established by the
management and reject those projects which have ARR
less than the minimum rate.

• This method would rank a project as number one if it has

highest ARR and lowest rank would be assigned to the
project with lowest ARR.
 27

Evaluation of ARR Method

The ARR method may claim some merits
• Simplicity
• Accounting data
• Accounting profitability
Serious shortcomings
• Cash flows ignored
• Time value ignored
• Arbitrary cut-off
 28

Discounted cash flows (DCF)/Time

Adjusted (TA) Techniques
The distinguishing character of the DCF capital budgeting
techniques is that they take into consideration the time
value of money while evaluating the cost and benefit of a
project.
 29

Net Present Value Method

• Cash flows of the investment project should be forecasted
based on realistic assumptions.
• Appropriate discount rate should be identified to discount
the forecasted cash flows.
• Present value of cash flows should be calculated using
the opportunity cost of capital as the discount rate.
• Net present value should be found out by subtracting
present value of cash outflows from present value of cash
inflows. The project should be accepted if NPV is positive
(i.e., NPV > 0).
 30

Net Present Value Method

• The formula for the net present value can be written as
follows:

 C1 C2 C3 Cn 
NPV      n
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
2 3

n
Ct
NPV    C0
t 1 (1  k )
t
 31

Calculating Net Present Value

• Assume that Project X costs Rs 2,500 now and is
expected to generate year-end cash inflows of Rs.900,
Rs.800, Rs.700, Rs.600 and Rs.500 in years 1 through 5.
The opportunity cost of the capital may be assumed to be
10 per cent.
 32

Calculating Net Present Value

Years Cash Inflows(Rs) Discount factor 10% Present value

0 2500 1 -2500
1 900 0.909 818
2 800 0.826 661
3 700 0.751 526
4 600 0.683 410
5 500 0.62 310
Project NPV=225
 33

Why is NPV Important?

Positive net present value of an investment represents
the maximum amount a firm would be ready to pay for
purchasing the opportunity of making investment, or the
amount at which the firm would be willing to sell the right
to invest without being financially worse-off.

The net present value can also be interpreted to

represent the amount the firm could raise at the required
rate of return, in addition to the initial cash outlay, to
distribute immediately to its shareholders and by the end
of the projects’ life, to have paid off all the capital raised
and return on it.
 34

Acceptance Rule
 35

Acceptance Rule
NPV is most acceptable investment rule for the
following reasons:
• Time value
• Measure of true profitability
• Value-additivity
• Shareholder value
Limitations:
• Involved cash flow estimation
• Discount rate difficult to determine
• Mutually exclusive projects
• Ranking of projects
 36

Present value of ₹.1

37
 38

Internal Rate Return

 Internal rate of return ( IRR) is a percentage discount rate used in
capital investment appraisals which brings the cost of a project and its
future cash inflows into equality.
 This technique also known as YIELD ON INVESTMENT, marginal
efficiency of capital, MARGINAL PRODUCTIVITY OF CAPITAL RATE
OF RETURN, TIME ADJUSTED RATE OF RETURN and so on.
 It is the rate of return which equates the present value of anticipated
net cash flows with the initial outlay.
 The IRR is also defined as the rate at which the present value is zero.
 The rate for computing IRR depends on bank lending rate or
opportunity cost of funds to invest in which is often called as personal
discounting rate or accounting rate.
 The test of profitability of a project is the relationship between the IRR
(%) of the project and the minimum acceptable rate of return (%).
 39

Calculation of Internal Rate Return

When future cash flows are equal:
In case the proposal has only one outflows in the beginning and
stream of equal cash flow in future, the calculation of IRR is rather
simple.
This can be explained with help of example.

Calculation of Internal Rate Return
 A firm is evaluating a proposal
costing ₹. 1,00,000 and having
annual inflows of ₹.25,000
occurring at the end of each of
next six years. There is no
salvage value. The IRR of the
proposal may be calculated as
follows:
40
Step 1:
 Make an approximate of the IRR on
the basis of cash flows data.
 A rough approximation may be
made with reference to the pay
back period.
 The payback period in the given
case is 4 years.
 Now, search for a value nearest to
4 in the 6 years row of the PVAF
table.
 The closet figure are given in rate
12%(4.111) and the rate 13%
(3.998).
 This mean that the IRR of the
proposal is expected to lie between
12% and 13%

Calculation of Internal Rate Return
 A firm is evaluating a proposal
costing ₹. 1,00,000 and having
annual inflows of ₹.25,000
occurring at the end of each of
next six years. There is no
salvage value.
41
Step 2:
 In order to make a precise
estimate of the IR, find out the
NPV of the project for both
these rates as follows:
 At 12%, NPV =
(₹25,000×PVAF12% 6𝑦) -
₹.100,000
 =(₹.25000×4.111)-
₹100,000
 = ₹. 2,775.
 At 13%, NPV =
(₹25,000×PVAF13%6𝑦) -₹.100,000
 =(₹.25000×3.998)-

Calculation of Internal Rate Return
 A firm is evaluating a proposal
costing ₹. 1,00,000 and having
annual inflows of ₹.25,000
occurring at the end of each of
next six years. There is no
salvage value.
42
Step 3.
 find out the exact IRR by
interpolating between 12% and
13%.
 It may be noted that IRR is the rate
of discount at which the NPV is
zero.
 At 12%, the NPV is ₹.2,775 and at
13% ₹.-50.
 Therefore , the rate at which the
NPV is zero will be higher than 12%
but less then 13%.
 This rate, at which NPV is Zero may
be found with the help of
interpolation technique. ……
 43

Calculation of Internal Rate Return

 A firm is evaluating a proposal

costing ₹. 1,00,000 and having ….Step 3.
annual inflows of ₹.25,000  The formula using the interpolation
occurring at the end of each of method is as follows:
next six years. There is no 𝐴
salvage value.  IRR = L 𝐻−𝐿
(𝐴−𝐵)
 Where ,L =Lower discount rate, at which NPV is
positive.
 H = Higher discount rate, at which NPV is
negative.
 A = NPV at lower discount rate, L.
 B = NPV at higher discount rate, H.
 44

Calculation of Internal Rate Return

 A firm is evaluating a proposal
costing ₹. 1,00,000 and having
annual inflows of ₹.25,000
occurring at the end of each of
next six years. There is no
salvage value.
….Step 3.
 By interpolating difference of 1% i.e.,
 ( 13%-12%), over NPV difference of
₹.2,825 i.e., [₹.2,775- (-50)],

₹.2,775
 IRR = 12%
(₹2,755−(−₹.50)
13% − 12%
 IRR = 12.98%
 So, the IRR of the project is 12.98%.
 45

Calculation of Internal Rate Return

When future cash flows are not equal:
In this case when the project is expected to generate uneven
stream of cash flows, the calculation of the IRR is complicated.
In order to minimize the number of calculation one can start by
guessing the IRR in either of the two ways.
a) If the cash inflows apparent in a broader sense, an annuity,
then the technique explained as above can be applied.
b) If there is no apparent pattern of annuity in the cash inflows
then weighted average cash inflows can be used as follows :
 46

Calculation of Internal Rate Return

 Suppose a firm is evaluating a
Step1: find out the weighted average
proposal costing ₹.1,60,000 and of cash inflows :
expected to generate cash
inflows of ₹.40,000, ₹.60,000 Year Cash inflows Weigh CF x W
₹.50,000, ₹.50,000 and 1 40,000 5 2,00,000
₹.40,000 at the end next five 2 60,000 4 2,40,000
years respectively. There is no 3 50,000 3 1,50,000
4 50,000 2 1,00,000
salvage value thereafter .
5 40,000 1 40,000
 In this case, there is an uneven Total 15 7,30,000
stream of cash inflows and the Weighted average = 7,30,000/15=Rs.48,667
IRR can be approximated as  Note that the weights used are stated n
follows: the reverse order in order to give
maximum weights to earliest cash flows.
 It may be noted that simple
(arithmetic)Average can also be used in
placed of weighted average.

Calculation of Internal Rate Return
 Suppose a firm is evaluating a
proposal costing ₹.1,60,000 and
expected to generate cash
inflows of ₹.40,000, ₹.60,000
₹.50,000, ₹.50,000 and
₹.40,000 at the end next five
years respectively. There is no
salvage value thereafter .
47
Step2:
 Consider the weighted ( Or simple)
average as the annuity of cash
inflows and find out the payback
period. For the above case, the
payback period is
₹.1,60,000/48,667=3.288.

Calculation of Internal Rate Return
 Suppose a firm is evaluating a
proposal costing ₹.1,60,000 and
expected to generate cash
inflows of ₹.40,000, ₹.60,000
₹.50,000, ₹.50,000 and
₹.40,000 at the end next five
years respectively. There is no
salvage value thereafter .
48
Step3:
 Now, search for a value nearest a
value 3.288in 5 years row of PVAF
table.
 The closest figures given in the
table are at 15% ( 3.352) and at
16% (3.274).
 This means that the IRR of the
proposal is expected to lie between
15% and 16%.
 49

Calculation of Internal Rate Return

 Suppose a firm is evaluating a Step4:
proposal costing ₹.1,60,000 and  Find out the NPV of the proposal for
expected to generate cash both of these approximate rates as
inflows of ₹.40,000, ₹.60,000 follows:
₹.50,000, ₹.50,000 and
₹.40,000 at the end next five Year Cash inflows PVF(16%) PV PVF(15%) PV
years respectively. There is no 1 40,000 0.862 34,480 0.87 34,800
2 60,000 0.743 44,580 0.756 45,360
salvage value thereafter . 3 50,000 0.641 32,050 0.658 32,900
4 50,000 0.552 27,600 0.572 28,600
5 40,000 0.497 19,040 0.497 19,880
Total 1,57,750 1,61,540
 50

Calculation of Internal Rate

Return
• Suppose a firm is evaluating a
proposal costing ₹.1,60,000 and
expected to generate cash • AT16% NPV = ₹.1,57,750- ₹.1,60,000

inflows of ₹.40,000, ₹.60,000 • = ₹.-2,250

₹.50,000, ₹.50,000 and
₹.40,000 at the end next five
• AT 15% NPV = ₹.161,540,- ₹.1,60,000
years respectively. There is no
• = ₹.1540.
salvage value thereafter .
 51

Calculation of Internal Rate

Return
• Suppose a firm is evaluating a
proposal costing ₹.1,60,000 and
expected to generate cash inflows
of ₹.40,000, ₹.60,000 ₹.50,000,
₹.50,000 and ₹.40,000 at the end
next five years respectively.
There is no salvage value
thereafter .
• Step 5: find out exact IRR by interpolating
between 15% and 16%.
• At 15% NPV is ₹.1,540 and at 16% the
NPV is ₹. -2,250.
• Therefore . The rate at which NPV is zero
will be more than 15% but less than 16%.
• By interpolating the difference of 1% (i.e.,
16%-15%) over the NPV difference of ₹.
3,790 [i.e., ₹. 2,250-(-1,540)].

𝐴
• IRR = L+ (H-L)
(𝐴−𝐵)

1,540
• IRR =15%+ ×(16-15)
1,540−(−2,250)
• =15.40%
• So, The IRR of the project is 15.40%.

EVALUATION OF IRR
Advantage :
 It possess the advantage, which
offered by the NPV criterion such as
it consider time value of money,
takes into account the total cash
and outflows.
 IRR is easier to understand.
Business executive and non-
technical people understand the
concept of IRR much more readily
that they understand the concepts
of NPV.
 It does not use the concept of the
required cost of return ( or the cost
of capital). It self provides a rate of
return which is indicative of the
profitability of the proposal. The cost
of capital enters the calculation later
on.
52
Disadvantages
• It involves tedious calculation
• It produces multiple rates which can
be confusing.
• In evaluating mutually exclusive
proposals, the project with the
highest IRR would be picked up to
the exclusion of all others. However,
in practice, it may not turn out to be
one that is the most profitable and
consider with objective of the firm
i.e., maximization of the wealth of
shareholders.
 53

Profitability Index
• Yet another time adjusted capital budgeting technique is profitability
index (PI) or Benefit-cost ratio (B/C).
• It is similar to the NPV approach.
• The profitability index approach measure the present value of returns
per rupee invested, while the NPV is based on the difference between
the present value of future cash inflows and the present value of cash
outlays.
• A major shortcoming of the NPV method is that, being an absolute
measures, it is reliable method to evaluate projects requiring different
initial investment.
• The PI method provides a solution to this kind of problem.
• It is, in other words, a relative measure.
• It may be defined as the ratio which is obtained diving the present
value of future cash inflows by the present value of cash outlays.
 54

Profitability Index

• It may be defined as the ratio which is obtained diving the present

value of future cash inflows by the present value of cash outlays.
Symbolically :
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘𝒔
PI =
𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒇𝒍𝒐𝒘𝒔

• This method also known as the B/C ratio because the numerator
measure benefits and the denominator cost.
• A more appropriate descriptions would be present value index.
 55

PI DECISION RULE

Under PI technique, the decision rule is:

Accept the project if its PI is more then 1 and reject the project
proposal if the PI is less than 1’.
However, if the PI is equal to 1, then the firm my be indifferent
because the present value of inflows is expected to just equal to the
outflows.
In case of ranking of mutually exclusive proposals, the proposal with
highest positive PI will be given top priority.
The proposal having PI of less than 1 are likely to be out rightly
rejected.
 56

Critical Evaluation

 The PI technique, as already noted is an extension of the NPV

technique.

 In the NPV technique, the difference between the present value of

inflows and the present value of outflows was yardstick.

 Therefore, the PI as a technique of evaluation of capital budgeting

proposal has the same merits and shortcoming which the NPV has.
 57

Calculation PI

The initial cash outlay of a project is ₹.100,000 and it can generate cash
inflow of ₹.40,000, ₹.30,000, ₹.50,000 and ₹20,000 in year 1 through 4.
Assume a 10 %of discount. The PV of cash inflows at 10% discount rate is:
 58

Calculation PI

year Cash flows PVF 10% NPV

0 ₹.-100000 1 ₹.-100000
1 ₹.40000 0.909 ₹.36,360
2 ₹.30000 0.826 ₹.24,780
3 ₹.50000 0.751 ₹.37,550
4 ₹.20,000 0.683 ₹.13,660
NPV = ₹.12,350
1,12,350
PI =
100,000

= 1.1235
 59

Calculation of PI
Analysis:
The following mutually exclusively Project A:
projects can be consider:

Paritcular Project A Project B

P.V of cash inflows ₹.20,000 ₹.8,000 PI =
₹.20,000
₹.15,000
Intial outlay ₹.15,000 ₹.5,000 PI =1.33
Calculate PI and suggest which Project A PI is 1.33
project is be to accept and which
project has to reject.
 60

Calculation of PI
Analysis:
The following mutually exclusively Project B:
projects can be consider:

Paritcular Project A Project B

P.V of cash inflows ₹.20,000 ₹.8,000 PI =
₹.8,000
₹.5,000
Intial outlay ₹.15,000 ₹.5,000 PI =1.60
Calculate PI and suggest which Project B PI is 1.60
project is be to accept and which Project B would be
project has to reject.
accepted.
 61

NPV v. PI – A comparison
As far as, the accept –reject decisions is concerned, the
both the NPV and the PI will give the same decision.
The reasons for this are obvious.
The PI will be greater than 1 only for that projects which
has a positive NPV, the project will be acceptable under
both techniques.
On the other hand, if the PI is equal to 1 then the NPV
would also be 0.
Similarly, a proposal having PI of less than 1 will also
have the negative NPV.
However, a conflict between the NPV and the PI may
arise in case of evaluation of mutually exclusive
proposals.
 62

Terminal value
In the NPV technique, the future cash flows are
discounted to make them comparable.
In the TV technique, the future cash flows are first
compounded at the expected rate of interest for the period
from their occurrence till the end of the economic life of
the project.
The compounded values are then discounted at an
appropriate discount rate to find out the present value.
This presents value is compared with the initial outflows
to find out the suitability of the proposal.
 63

Terminal value
 Investopedia explains 'Terminal Value - TV'
 The terminal value of an asset is its anticipated value on a certain date in
the future.
 It is used in multi-stage discounted cash flow analysis and the study of
cash flow projections for a several-year period.
 The perpetuity growth model is used to identify on-going free cash flows.
 The exit or terminal multiple approach assumes the asset will be sold at
the end of a specified time period, helping investors evaluate risk/reward
scenarios for the asset. A commonly used value is enterprise
value/EBITDA (earnings before interest, tax, depreciation and
amortization) or EV/EBITDA.
 An asset's terminal value is a projection that is useful in budget planning,
and also in evaluating the potential gain of an investment over a specified
time period.
 64

Decision Rule of T.V

The decisions rule in the TV technique is that:
Accept the proposal if the present value of the total
compounded value of all the cash inflows is greater than
the present value of the cash outflows. Otherwise, reject
the proposal.
In case ranking of mutually exclusive proposals, the
proposal with the highest net present value is assigned
top priority and the proposal with the lowest net present
value is assigned the lowest priority.
However, the project with negative net present value is
likely to rejected.
 65

Calculation of TV
• A firm has an investment Solution :
proposal costing ₹.1,20,000
with useful economic life of 4
years over which it is year cash flows Remaining Years CVF(8%,n) C.Values
expected to generate cash 1 ₹.40,000 3 1.26 50,400
inflows ₹.40,000 at end of 2 ₹.40,000 2 1.17 46,640
each of the next 4 years. 3 ₹.40,000 1 1.08 43,200
Given the rate of return as
4 ₹.40,000 0 1.00 40,000
10% and that the firm can
reinvest the cash inflows for Total compunded value = 1,80,240
the remaining period at the
rate of 8%. Calculate TV.
 66

Compound value of an annuity Re.1


Calculation of TV
• A firm has an investment
proposal costing ₹.1,20,000
with useful economic life of 4
years over which it is
expected to generate cash
inflows ₹.40,000 at end of
each of the next 4 years.
Given the rate of return as
10% and that the firm can
reinvest the cash inflows for
the remaining period at the
rate of 8%. Calculate TV.
67
 The amount ₹.1,80,240 is to be
discounted at 10% (i.e., rate of
discount) for 4 years to find out its
present values.
 The PVF(10%, 4 y) is .683.
 So, the present value of ₹.1,80,240
is ₹.1,80,240x.683 = ₹.1,23,104.
 This present value can now be
compared with the initial investment
of ₹.1,20,000 to find out the net
present value of ₹.1,23,104.
 So, the project has a net present
value of ₹.3,104. as per the TV
technique.
 68

Capital Rationing

You know the meaning of Capital !

You don’t know the meaning of Rationing !

A fixed portion.

In economics, rationing is an artificial restriction of

demand.
 69

Capital Rationing
The process of selecting the more desirable projects
among many profitable investment is called capital
rationing.
Or
The capital rationing situation refers to the choice of
investment proposal under financial constrain in term of
given of capital expenditure budget.
Or
Capital rationing refers to the selection of the investment
proposal in situation of constraint on availability of capital
funds, maximize the wealth of the company by selecting
those projects which will maximize overall NPV of the
concern.
 70

Capital Rationing
Capital rationing refers to situation where a company
cannot undertake all positive NPV projects it has identified
because of shortage of capital.
Under this situation, a decision maker is compelled to
rejects some of the viable projects having positive net
present value because of shortage of funds.
It is known as situation involving capital rationing.
 71

Capital Rationing
Investopedia explains 'Capital Rationing’ :
Companies may want to implement capital rationing in
situations where past returns of investment were lower than
expected. For example, suppose ABC Corp. has a cost of
capital of 10% but that the company has undertaken too many
projects, many of which are incomplete.
This causes the company's actual return on investment to drop
well below the 10% level.
As a result, management decides to place a cap on the number
of new projects by raising the cost of capital for these new
projects to 15%.
Starting fewer new projects would give the company more time
and resources to complete existing projects.
 72

Capital Rationing
Capital rationing exists if there is a limit on the amount of funds available for
investment.
There are two forms of capital rationing: soft rationing and hard rationing.
Soft Rationing.
Hard Rationing.

Soft Rationing exists if businesses themselves, or their senior managers,

place limits on the size of the capital budget. Soft rationing limits can be
relaxed if added NPV investments are available; financing is provided easily
by financial markets.

Hard Rationing Hard rationing or limits on the capital budget are set by
financial markets (investors).With funding constraints, positive NPV projects
are forgone. With hard rationing, the firm must choose projects, to the limit
of its financing ability, from among a list of projects with positive NPV’s.
 73

Capital Rationing
Classification of projects:

Divisible projects: ( i.e. capable of being divided)

Indivisible projects: (i.e. Unable to be divided or
separated)
 74

Capital Rationing
Classification of projects:
Divisible projects:
There are certain projects which can either be taken in full
or can be taken in parts.
For example, a building( have 5 floors) can be contrasted
at a cost of 5 corers. How ever, if the funds are not
sufficiently available then only a part of building, say only
2 floors, can be constructed for the time being. But all the
proposal may not be divided.
 75

Capital Rationing
Classification of projects:
Indivisible projects:
There are certain projects proposal which are indivisible.
These proposal have a feature that either the proposal, as
a whole, be taken in its totality or not taken at all.
For example, A proposal to buy a helicopter cannot be
taken in parts.
Similarly, a multi stage plant can only be installed fully but
not in parts.
There can be many instances of indivisible projects.
 76

Capital Rationing

Another important aspects of capital rationing is that a firm

may face capital rationing for one particular period only i.e.,
single period capital rationing or may face capital rationing
for several periods i.e., multiple periods capital rationing
 77

Capital Rationing

Single period capital rationing:

This is simple type of capital rationing and occurs when a
firm faces shortage of funds in particular year only.
Impliedly, these limited capital funds can finance fewer
than otherwise available feasible proposal.
 78

Capital Rationing

Multi-Period capital rationing:

When a firm faces limitation of funds in more than one
period then above technique may not be of much help.
In such case, the firm may have to resort to some sort of
mathematical programming in order to identify the
optimum selection of proposals.
 79

Calculation of Capital Rationing

(divisible)
A company has 7 core available for investment. It has
evaluated its options and has found that only 4 investment
projects given below have positive NPV. All these
investment are divisible. Advise the management which
investment(s) projects it selects.
Projects Intial Invesments(₹crore) NPV(₹crore) PI
x 3 0.6 1.2
y 2 0.5 1.25
z 2.5 1.5 1.6
w 6 1.8 1.3
 80

Calculation of Capital Rationing

Solution :

Ranking of the Projects in Descending Order of Profitabilty Index

Project and (Rank) Investment outlay (₹crore) Profitability Index NPV (₹crore)
Z(1) 2.50 1.60 1.50
W(2) 6.00 1.30 1.80
Y(3) 2.00 1.25 0.50
x(4) 3.00 1.20 0.60

Accept the project Z in full and W in part (₹4,50,000) as it

will maximize the NPV.
 81

Calculation of Capital Rationing

Indivisible projects:
Example:
 A company working against a self-imposed capital rationing constraint of ₹.
70 corer is trying to decide which of the following investment proposal
should be undertaken by it. All these investment proposal are invisible
as well as independent. The list of investment along with the
investment required and the NPV of the projected cash flows are
given below :
Project Initial Investment (₹. Crore) NPV(₹. Crore)
A 10 6
B 24 18
C 32 20
D 22 30
E 18 20

which investment should u be acquired by the company?


Calculation of Capital Rationing
Indivisible projects:
Example:
 A company working against a self-imposed
capital rationing constraint of ₹. 70 corer
is trying to decide which of the following
investment proposal should be
undertaken by it. All these investment
proposal are invisible as well as
independent. The list of investment
along with the investment required and
the NPV of the projected cash flows are
given below :
 which investment should u be acquired
by the company?
82
Solution:
NPV from investment D,E B
₹.68 crore with utilised
leaving ₹.6 crore to be
invested in some other
investment outlet.
No other package would
yield an NPV higher than this
amount.
The company is an integral
part of selecting optimal
investment package /set in
capital rationing situation.
 83

Calculation of Capital Rationing

Example:
Project Required intial investment NPV at the appropriate cost of capital
A 1,00,000 20,000
B 3,00,000 35,000
C 50,000 16,000
D 2,00,000 25,000
E 1,00,000 30,000

Total funds available is ₹.3,00,000. Determine the optimal

combination of projects assuming that the projects are
divisible.
 84

Calculation of Capital Rationing

Solution:
Project Required NPV at the Profitability Rank
Intial outlay Appoprite Index
(₹.) Cost of the capital (₹). [(3)/(2)]
[1] [2] [3] [4] [5]
A 1,00,000 20,000 0.2 3
B 3,00,000 35,000 0.117 5
C 50,000 16,000 0.32 1
D 2,00,000 25,000 0.125 4
E 1,00,000 30,000 0.3 2

continue…….
 85

Calculation of Capital Rationing

Rank of Investment Project Required Initial (₹.)

1 C 50,000
2 E 1,00,000
3 A 1,00,000
4 1/4th of D 50,000
Total 3,00,000
*(2,00,000X1/4)
Therefore, the optimal combination of projects is C,E,A and 1/4th
portion of D.
 86

Abandonment Evaluation Of Capital

Budgeting

Meaning of Abandon:
 To leave thing or place.

Meaning of abandonment :
The act of giving something up.
 87

Abandonment Evaluation Of Capital

Budgeting

It quite possible in practice, that though a proposal has

been evaluated and implemented after a careful analysis
of all types of risk associated with it, yet at later stage, it
may be found that the project is no longer economically
viable even if its economic life is not yet over.
The firm may be faced with a situation when it is take a
decision whether to abandon project which has failed
before the end of its estimated economic life.
 88

Abandonment Evaluation Of Capital

Budgeting
Example :
The projected cash flows and the expected net abandonment values for a
project are given below.
Year Cash Inflows(₹.) Abandonment value(₹
. .)
0 1,00,000 NIL
1 35,000 65,000

2 30,000 45,000
3 25,000 25,000
4 20,000 NIL
a) Should a project be abandoned ?if so, when ?
Assume that the minimum rate of return expected from the project is 10%.
b) Will you recommendation be different, id the project, is voluntary in
nature ? Support your answer.
 89

Abandonment Evaluation Of Capital

Budgeting
Solution :

Computation of expected NPV over 4 years of economic life for the project
Year Cash flows Abdoment value (₹.) P.V factor @ 10 % P.V of Cash flow (₹.) P.V of Abandonment value (₹.)
0 -1,00,000 0 1 -1,00,000 0
1 35,000 65,000 0.909 31,815 59,085
2 30,000 45,000 0.826 24,780 37,170
3 25,000 20,000 0.751 18,775 15,020
4 20,000 0 0.683 13,660 0

Total NPV= (10,970)

 90
Abandonment Evaluation Of Capital
Budgeting

Statement Showing Computation of total NPV of the Project at the end of each year
P.v and Total at the end of
year Praticular 1year 2year 2year
0 cash flows -1,00,000 -1,00,000 -1,00,000
1 cash flows 31,815 31815 31,815
abandonment value 59,085 0 0
2 cash flows 0 24,780 24,780
abandonment value 37,170 0
3 cash flows 0 18,775
abandonment value 15,020
TOTAL -9,100 -6,235 -9,610

Cont…
 91
Abandonment Evaluation Of Capital
Budgeting
Recommendation :
In the view of above comparative statement it may be
observed that the project should be abandoned since
there is no positive NPV at the end of any year.
It should be abandoned at the end of 2 years, where the
losses are the minimal- the total NPV at the end of 2
years being the highest, viz, (₹.6,235), where the
negative value is the least.
 92

Impact of inflation in capital budgeting

What is inflation ?
 93

Impact of inflation in capital budgeting

Inflation refers to a continuous rise in general price level

which reduces the value of money or purchasing power
over a period of time.
 94

Impact of inflation in capital budgeting

Inflation is the rate of sustained increase in the prices of
goods and services, measured as a percentage increase
over an annual period.
When there is an increase in inflation rates it means that
for each Rupee that you spend you will be able to buy a
smaller amount of a particular product or service.
Inflation means that the value of a Rupee (in terms of
what it can buy) is not constant.
This is referred to as the “purchasing power” of the
Rupee. When rates of inflation rise there is a
corresponding reduction in purchasing power as the
money is able to buy less tangible goods.
 95

Impact of inflation in capital budgeting

EXAMPLE: Assume that the inflation rate of a particular

economy is 2% per year. This means that a product that
currently costs ₹2 will cost ₹2.04 at the same time next
year. Inflation increases the price and you can’t buy the
same goods with a Rupee as you previously could.
 96

Impact of inflation in capital budgeting

General inflation, i.e., the changes in price of the various

factor which may increase the project cost e.g., wage
rates, sales prices, material costs , energy costs,
transportation charges and so on.
Every attempt should be made to estimate specific
inflation for each element of the project in a detailed
manner as feasible.
The overall estimate based on the RPI are likely to be
inaccurate and misleading.
 97

Impact of inflation in capital budgeting

Types of inflation in capital budgeting:

1. Differential inflation

2. Synchronized inflation
 98

Impact of inflation in capital budgeting

Differential inflation : Synchronized inflation:

 differential is where Synchronized inflation
costs and revenue where the cost and
change at differing revenue rise at the
rates of inflation or same rate.
where the various
items of cost and
revenue move at
different rates.
 99

Impact of inflation in capital budgeting

Types of cash flows :

 Money cash flows.

 Real cash flow.


Impact of inflation in capital budgeting
Money cash flows:
The money cash flows are
those which are expressed in
money terms.
These are the actual amount
expected to arise in future.
These cash flows include the
effect of inflation.
The money cash flows are
known as the nominal cash
flows.
The money cash flows will
occur in terms of the
purchasing power of that
period in which they occur.
100
• Real Cash Flows:
• The real cash flows are those
cash flows which have been
expressed in terms of real
values i.e., these are
expressed in term of constant
prices.
• So these cash flows exclude
the effect of inflation.
• It May be noted that the real
cash flows are not necessarily
equal to the present values
of money cash flows.
 101

Impact of inflation in capital budgeting

The money cash flows and the real cash flows differ only
because of existence on inflation.
Is there is no inflation then the money cash flows are just
equal to the real cash flows.
If there is inflation, the real cash flows can be derived by
discounting the future money cash flows at the inflation rate.
 102

Impact of inflation in capital budgeting

The relationship between nominal and real discount rate can
be expressed as:

Nominal Discount Rate = (1+Real discount Rate) (1+inflation rate) -1

1+𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑅𝐴𝑇𝐸

Real discount Rate = −1
(1+𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝐴𝑇𝐸)
 103

Impact of inflation in capital budgeting

• A corporate firm’s Solution:

management policy is to
earn a real rate of return Nominal rate (n) = (1+r)(1+i)-1
(r) of 10% on new projects. =(1+0.10)(1+0.06)-1
=(1.1)(1.06)-1
• It is expected that the
= 1.166-1
inflation rate (i) during the = 0.166
proposed projects life is = 16.6%
6% per year.
• Determine the nominal
discount rate (n) which
should be used by the firm
to determine the present
value of the project.
 104

Impact of inflation in capital budgeting

• Sagar industries employ 15% as Solution:

nominal required rate of return Real rate(r) =
1+𝑛
−1
to evaluate its new investment (1+𝑖)
projects.
1+.015
• In the recent meeting of its = − 1
(1+0.06)
board of directors, it has been
decided to protect the interest
(1.15)
of shareholder against = − 1
(1.06)
purchasing power loss due to
inflation.
=1.0849 – 1
• The expected inflation rate in
the economy is 6%.
=.0849
• Determine the real discount
rate to be employed now by
Sagar industries =8.49%
 105

Impact of inflation in capital budgeting

• A new machine is expected the
Solution: Step 1.
following set of incremental CFAT
during its 5 years economic useful Determination of Real CFAT
life. Year CFAT(₹) Inflation factor at 8% Real CFAT(₹)
Year CFAT(₹) 1 10,00,000 1/(1.08)=0.926 9,26,000
2 12,00,000 1/(1.08)2=0.857 10,28,400
1 10,00,000
2 3 15,00,000 1/(1.08)3=0.794 11,91,000
12,00,000
3 4 8,00,000 1/(1.08)4=0.735 5,88,000
15,00,000
4 5 1/(1.08)5=0.681 3,40,500
8,00,000
5 5,00,000

• The rate of inflation during the

period is expected to be 8% and the
project’s cost of capital in real terms
would be 10%.
• Should the machine be purchased if
it cost ₹.25 lakh?
 106

Impact of inflation in capital budgeting

• A new machine is expected the
Solution: Step 2.
following set of incremental CFAT
during its 5 years economic useful life.
Determination of NPV using real Rate of Discount
Year CFAT(₹) Year Real CFAT(₹) Discount factor at 10% Total PV(₹)
1 10,00,000 1 9,26,000 0.909 8,41,734
2 12,00,000 2 10,28,400 0.826 8,49,458
3 15,00,000 3 11,91,000 0.751 8,94,441
4 8,00,000 4 5,88,000 0.683 4,01,604
5 5,00,000 0.621 2,11,450
5 3,40,500
Total present value (₹)3198687
• The rate of inflation during the period Less : Cash outflows (₹)25,00,000
is expected to be 8% and the project’s Net present value (₹)6,98,687
cost of capital in real terms would be
10%. Recommendation : The machine should
• Should the machine be purchased if it be purchased as the NPV is positive.
cost ₹.25 lakh?
 107

Impact of inflation in capital budgeting

A company is considering a cost saving project. This

involves purchasing a machine costing ₹.7,000. which will
result in annual saving on wage costs ₹.1,000 and on
material cost of ₹.400.the following forecast are made of
the rates of inflation each year for the next 5 years:
Wages costs10%,
Material costs 5%
General prices 6%
The cost of capital of the company, in monetary terms, is
15%.Evaluate the projects, assume that the machine has
life of 5 years and no scrap value.
 108

d
Impact of inflation in capital budgeting
Solution :
Calculation of NET Present Value

Year Labour cost saving( ₹) Material Cost Saving( ₹) Total

Totalsaving(
saving(₹) ₹) DCF
DCF@15%
@15% Present Value ( ₹)
1 100×(1.1)=1,100 400×(1.05)=420 1,520 0.87 1,322
100×(1.1)2 = 1,210 400×(1.05)2 = 441 1,651 0.756 1,255
2
3 100×(1.1)3 = 1,331 400×(1.05)3 = 463 1,794 0.658 1,184
4 100×(1.1)4 = 1,464 400×(1.05)4 = 486 1,950 0.572 1,112
5 100×(1.1)5 = 1,610 400×(1.05)5 = 510 2,120 0.497 1,060

Present value of total saving 5,933

Less: initial cash outflows 7,000
Net present value ( negative) -1,067

Analysis : Since present value of cost of project exceeds the cost of savings from it and
hence it is not suggested to purchase the machine.
 109

Risk Evaluation in Capital Budgeting

Probability Analysis .
Certainty Equivalent Method.
Sensitivity Technique .
Standard Deviation Method
Co-efficient Of Variation Method
Decision Tree Analysis
 110

Risk Evaluation in Capital Budgeting

Probability Analysis :
A probability technique is the relative frequency with which
an event may occur in the future.
When future estimates of cash inflows have different
probabilities the expected monetary values may be
computed by multiplying cash inflows with the probability
assigned.
The monetary values of the inflows may further be
discounted to find out the present values.
The projects that gives higher net present value may be
accepted.
 111

Risk Evaluation in Capital Budgeting

Example :
Two mutually exclusive investment proposals are being
considered. The following information is available.
Project X(₹) Project Y(₹)
Cost (₹)6,000 (₹)6,000
Cash Inflows
Year (₹) Probability (₹) Probability

1 4,000 0.2 8,000 0.2

2 8000 0.6 9,000 0.6
3 12,000 0.2 9,000 0.2
Assuming cost of capital at 10%, advise the selection of the
project.
 112

Risk Evaluation in Capital Budgeting

Solution : Project X
Calutation of Net Present Value of the Two Projects

Year P.V.F @10% C.I (₹) Probability Monetary value P.V(₹)

1 0.909 4,000 0.20 800 727
2 0.826 8,000 0.60 4,800 3,965
3 0.751 12,000 0.20 2,400 1,802
Total Present Value 6,494
Less: Cost of Investment 6,000
Net Present Value 494
 113

Risk Evaluation in Capital Budgeting

Solution : Project Y
Calutation of Net Present Value of the Two Projects

Year P.V.F @10% C.I (₹) Probability Monetary value P.V(₹)

1 0.909 7,000 0.20 1,400 1,273
2 0.826 8,000 0.60 4,800 3,965
3 0.751 9,000 0.20 1,800 1,352
Total Present Value 6,590
Less: Cost of Investment 6,000
Net Present Value 590
 114

Risk Evaluation in Capital Budgeting

Solution : Project Y
Calutation of Net Present Value of the Two Projects

Year P.V.F @10% C.I (₹) Probability Monetary value P.V(₹)

1 0.909 7,000 0.20 1,400 1,273
2 0.826 8,000 0.60 4,800 3,965
3 0.751 9,000 0.20 1,800 1,352
Total Present Value 6,590
Less: Cost of Investment 6,000
Net Present Value 590
 115

Risk Evaluation in Capital Budgeting

DECISION TREE ANALYSIS :
Quit often a firm may have to take a sequential decision i.e., the
present decision is affected by the decisions taken in the past or
it affects the future decision of the same firm
In the capital budgeting the evaluation of a project frequently
requires a sequential decision making process where the accept
or reject decision made in several stages.
Instead of making decision once for all, it is broken up into
several parts and stages.
At each stage there may be more then one option available and
the firm may have to decide every time that which option is to be
taken for.
 116

Risk Evaluation in Capital Budgeting

In modern business there are complex investment
decisions which involve a sequence of decisions over time.
Such sequential decisions can be handled by plotting
decisions tree.
A decision tree is graphic representation of the relationship
between a present decision and future event, future
decision and their consequence,
The sequence of events is mapped out over time in format
resembling branches of a tree and hence the analysis is
known as decision tree analysis .
 117

Risk Evaluation in Capital Budgeting

 Mr. wise is considering an investment proposal of ₹. 20,000. the expected
returns during the life of the investment are as under.

Year 1

Event Cash flows (₹) Probability

1 8,000 0.3
2 12,000 0.5
3 10,000 0.2
Year 2
Cash flows in year 1 are
₹.8,000 ₹.12,000 ₹.10,000
Event C.I (₹) Prob C.I (₹) Prob C.I Prob
1 15,000 0.2 20,000 0.1 25,000 0.2
2 20,000 0.6 30,000 0.8 40,000 0.5
3 25,000 0.2 40,000 0.1 60,000 0.3

 Using 10% as the cost capital, advise about the acceptability of the project.
 118

Calculation of Net Present Value of Cash Inflows

Cash inflows Discount
Discountfactor
factor10%10% Present
Present Values
Values Net Present
Alternatives Year I (₹) Year II (₹) Year I Year II Year I (₹) Year II (₹) Total (₹) Value (₹)
a) (i) 8,000 15,000 0.909 0.826 7,272 12,390 19,662 -338
(ii) 8,000 20,000 0.909 0.826 7,272 16,520 23,792 3,792
(iii) 8,000 25,000 0.909 0.826 7,272 20,650 27,922 7,922
b)(i) 12,000 20,000 0.909 0.826 10,908 16,520 24,428 7,428
(ii) 12,000 30,000 0.909 0.826 10,908 24,780 35,688 15,688
(iii) 12,000 40,000 0.909 0.826 10,908 33,040 43,948 23,948
c) (i) 10,000 25,000 0.909 0.826 9,090 20,650 29,740 9,740
(ii) 10,000 40,000 0.909 0.826 9,090 33,040 42,130 22,130
(iii) 10,000 60,000 0.909 0.826 9,090 49,560 58,650 38,650
 119

Decision Tree Analysis

1 2 3 4 5 6 = 4x5
Year 0 YearI Prob Year
earIIII Prob
ProbN.P.V Joint Expected
C.I (₹) C.I (₹) of inflow(₹) Probability N.P.V (₹)
.2 15,000 -338 0.06 -20.28
.6
.3 ₹.8,000 20,000 3,792 0.18 682.56
.2
25,000 7,922 0.06 475.32
Cash .1
outflow .5 ₹.12,000 20,000 7,428 0.05 371.4
₹.20,000 .8
30,000 15,688 0.4 6,275.20
.1
.2 40,000 23,948 0.05 1,197.40
.2
₹.10,000 25,000 9,740 0.04 389.60
.5

.3 40,000 22,130 0.1 221.30

60,000 38,650 0.06 2,319.00
Total : 1 11,911.50
 120

RISK ADJUSTED DISCOUNT RATE

The simplest method of accounting for risk in capital

budgeting is to increase the cut-off rate or discount factor
by certain percentage on account of risk.

The project which are more risky and which have greater
variability in expected returns should be discounted at
higher rate as compared to the projects which are less
risky and expected to have lesser variability in returns.
 121

RISK ADJUSTED DISCOUNT RATE

 Beta company Ltd. Is considering the purchase a new investment .
Two alternative investment are available (A & B ) each costing
₹. 1,00,000.Cash inflows are expected to be as follows :
Cash flows

Ye ar Investment A (₹
. .) Investment B (₹
. .)

1 40,000 50,000
2 35,000 40,000

3 25,000 30,000

4 20,000 30,000

 The company has a great return on capital of 10%. Risk premium

rates are 2% and 8% respectively for investment A & B.
 Which investment should be preferred?
 122

RISK ADJUSTED DISCOUNT RATE

Solution :
The profitability of the investment can be compared on the basis of net
present values cash inflows adjusted for risk premium rates as follows:
Investment A

Years Discount factor @ Cash Present

10%+2%=12% Inflows (₹) Value (₹)
1 0.893 40,000 35,720
2 0.797 35,000 27,895
3 0.712 25,000 17,800
4 0.635 20,000 12,700
Total : 94,115

Net Present Value ₹.94,115-1,00,000 = (5,885)

 123

RISK ADJUSTED DISCOUNT RATE

Investment B

Years Discount factor @ Cash Present

10%+8%= 18% Inflows (₹) Value (₹)
1 0.847 50,000 42,350
2 0.718 40,000 28,720
3 0.609 30,000 18,270
4 0.516 30,000 15,480
Total : 1,04,820
Net Present Value ₹.1,04,820-1,00,000 = ₹4,820
As at even higher discount rate B gives a higher net present value,
investment B should be preferred.
 124

SENSITIVITY TECHNIQUE
SENSITIVITY TECHNIQUE :
Where cash inflows are very sensitive under different
circumstance, more than one forecast of the future cash inflows
may be made.
These inflows may be regarded as “Optimistic”, “Most likely” and
“Pessimistic”.
further cash inflows may be discounted to find out the net
present values under these three different situations.
If the net present values under the three situation differ widely it
implies that there three different situations.
If the net present values under the three situation differ widely it
implies that there is a great risk in the project and the investor’s
decisions to accept or reject a project will depends upon his risk
bearing abilities.
 125

SENSITIVITY TECHNIQUE
Example : Mr. risky is considering two mutually exclusive projects A and B.
You are required to advise him about the acceptability of the projects from
the following information.

Project A Project B
Cost of the investment 50,000 50,000
forcast Cash Inflows per annum for 5 years
Optimistic 30,000 50,000
Most Likely 20,000 40,000
Pessimistic 15,000 20,000

(The cu-off rate may be assumed to be 15%)

 126

SENSITIVITY TECHNIQUE
Calucation of Net present value of Cash Inflows at a Discount
Rate of 15% ( annuity of Re. 1 for 5 years)
Project A Project B
Annual Discount P.V N.P.V Annual Discount P.V N.P.V
cash flows ₹. factor 15% ₹. ₹. cash flows ₹. factor 15% ₹. ₹.
Optimistic 30,000 3.3522 1,00,566 50,566 40,000 3.3522 1,34,088 84,088
Most likely 20,000 3.3522 67,014 17,044 20,000 3.3522 67,044 17,044
Pessimistic 15,000 3.3522 50,283 283 5,000 3.3522 16,761 -33,239

The net present value as calculated above indicate that Project B is more
risky as compared to Project A. But at the same time during favorable
conditions, it is more profitable also. The acceptability of the project will
depend upon Mr. Risky’s attitude towards risk.
If he could afford to take higher risk, project b may be more profitable.
 127

Conflict between NPV & IRR results

• In case of mutually exclusive investment proposals, which
compete with one another in such a manner that acceptance
of one automatically excludes the acceptance of the other.
• The NPV method and IRR method may give contradictory
result.
• The NPV may suggest acceptance of one proposal where
as, the internal rate of return may favor another proposal.
 128

Conflict between NPV & IRR results

• Such conflict in ranking may be caused by any one or more
of the following problems:
I. Significant difference in the size ( amount ) of cash outlays
of the various proposal under consideration.
II. Problem of difference in the cash flows patterns or timings
of the various proposals.
III. Difference in service life or unequal expected lives of the
projects.
In such case, while choosing among mutually exclusive
projects, one should always select the project giving the
largest positive net present value using appropriate cost of
capital or predetermined cut off rate.
 129

Conflict between NPV & IRR results

The reason for the same lies in the fact that the objective of
an firm is to maximize shareholder’s wealth and the project
with the largest NPV has the most beneficial effect on shares
prices and shareholder’s wealth.
Thus, the NPV method is more reliable as compared to the
IRR method in ranking the mutually exclusive projects.
In fact, NPV is the best operational criterion for ranking
mutually exclusive investment proposals.
 130

Conflict between NPV & IRR results

A firm whose cost of capital is 10% is considering two
mutually exclusive projects A and B, the cash flows of which
are as below:
Year Project A Project B
₹. ₹.

0 -50,000 -80,000
1 62,500 96,170

Suggest which project should be taken up using

I. Net Present Value Method, and
II. The Internal Rate of return Method.
 131

Conflict between NPV & IRR results

Solution :

(I) Calucation of Net PresentValue (NPV)

Project A Project B

YEAR P.V. factor Cash flows (₹.) P.V (₹) Cash flows (₹.) P.V (₹)
0 1 -50,000 -50,000 -80,000 -80,000
1 0.909 62,500 56,812 96,170 87,418
Net Present Value (NPV) 6812 7418

(II)Calculation of Internal Rate of Return

Project A Project B
 132

Conflict between NPV & IRR results

Suggestion :
According to the NPV Method, investment in project B is
better because of its Higher positive NPV; but according to
the IRR method project A is better investment because of
higher internal rate of Return.
Thus, there is a conflict in ranking of the two mutually
exclusive proposal according to the two methods.
Under these circumstances, we would suggest to take up
Project B which give a higher Net present Value because in
doing so the firm will be able to maximize the wealth of the
shareholders.
 133

Spontaneous sources :
The spontaneous sources are those sources which occur
and result from the normal business activities.
In the usual course of business operations, a firm might be
getting goods and services for which payments are to be
made at a later stage. i.e., with a time gap.
To extent, payment is delayed, the funds are available to
firm.
These sources are generally unsecured and vary in line with
the change in sales level.
There are also known as trade liabilities or simply as current
liabilities. cont…
 134

Two important spontaneous sources of short term financing

are:

i. Trade credit.

ii. Accrued expenses .

 135

Trade credit :
When firm buys goods from another, it may bot be required
to pay for these goods immediately.
During this period, before the payment become due, the
purchaser has a debt outstanding to the supplier.
This debt is recorded in the buyer’s balance sheet as
creditors; and the corresponding account for the supplier is
that of debtors.
The trade credit may be define as the credit available in
connection with goods and services purchased for resale.
 136

It’s the resale which distinguish trade credit from other

sources.
For example :
• A fixed asset may be purchased on credit, but since these
are to be used in the production process rather then for
resale, such credit purchase of fixed asset is not called the
trade credit. The credit extended in connection with the
goods purchased for resale by a retailer or a wholesaler of
raw material used by manufacturer in producing its products
is called the trade credit.
 137

Accrued expenses :
o The accrued expenses refer to the services availed by the
firm, but the payment for which has not yet been made.
o It is built –in and an automatic source of finance as most of
the service i.e., labor etc. are paid only at the end of a
period.
 138

Credit terms:
The credit term refer to the set of conditions on which a seller
sells goods and services to the buyer and in particular, on
which the buyer has to make the payment to the seller. These
include
The size of the cash discount, if any from the net invoice
price which is given for making cash payment within a
specified period.
The period within which payment must be made if the cash
discount Is to be availed.
The maximum period that can elapse before payment of net
invoice price should be made if the discount is not taken.
 139

Credit terms:
For example:
A credit term may be expressed as 2/10 net 30.
It means that a cash discount of 2% is allowed if the invoice
amount is paid within 10days otherwise full payment must be
paid within 30 days.
In simple terms :
2 is percentage of discount.
10 is number days to avail discount.
30 is number days allowed by supplier .
 140

Firm buys ₹.100 Cash discount Credit period

goods period ends ends

June 10 June 30
June1
OR

Pay
Credit period ₹.98
begins Cost of additional 20 days ₹. 2 Pay
₹.100
 141

Cost of trade credit or Annual Interest Rate :

𝑑 365
Cost of Trade Credit = × × 100
1−𝑑 𝑛−𝑝
Where :
d = % Cash discount
n = Net period in days
p = Discount period in days
 142

What is the annual percentage interest cost associated with

the following credit terms?
I. 2/10 net 50
II. 2/15 net 40
III. 1/15 net 30
IV. 1/10 net 30
Assume that the firm does not avail of the cash discount but
pay on the last day of net period. Assume 360 days to a year.
 143

Question : Solution:

0.02 360
I. 2/20 net 50 I. cost = × = 24.5%
1−0.02 50−20

0.02 360
II. cost = × = 29.4%
II. 2/15 net 40 1−0.02 40−15

0.01 360
III. 1 /15 net 30 III. cost = × = 24.2%
1−0.01 30−15
 144

Question : Solution:

iv) 1/10 net 30 0.01 360

iv) cost = × = 18.2%
1−0.01 30−10
145