INTRODUCTION

TYPES OF CAPITAL & SOURCES OF CAPITAL

The Various sources of capital are summarized as follows :
NO. POINT EQUITY CAPITAL PREFERENCE DEBT
CAPITAL
1. Nature Risk capital Lass Risk No Risk
2. Dividend / Interest No Fixed Rate of Dividend Fixed rate of Fixed rate of Interest
dividend
3. Refund Not refundable except in Refundable Refundable
buyback
4. Right of Right of Management No right of No right of management
Management management
5. Security Not Secured Not secured Normally Secured
6. Tax Benefit No tax benefit No tax benefit Tax benefit
7. Status on Last Claimant Preference over Preference over
Liquidation quality Preference Share Capital

COST OF CAPITAL
It is also known as the risk adjusted discounted rate. It is the interest rate organization use for
discounting future cash flow.. The cost of capital is return the organization must earn on its investment to
meet its investors return requirements. From Financial perspective, when the organization expects to earn
less than its cost of capital from a proposed investment, it should return the funds. If the organization
expects to earn more than its cost of capital from a proposed investment, the investment is desirable, any
surplus earned increase shareholders wealth. Cost of capital is the benchmark of the organization uses to
evaluate the investment proposals. Cost of capital is reflect cost of enquiry and debt in its financial
structure. The most widely used concept is the weighed average cost of capital. The desired rate of return
is the waited average cost of capital of the opportunity cost whichever is higher. The desired rate of return
is called as the audit off rate or discount rate.
For example, X Ltd. Is financed 20% b debt with a pretax cost of 8% , 15% by
preferred shares with a pretax cost of 11% , 30% by equity with a pretax cost of 16% and 35% by
retained earning with a cost of 14% Tax Rate is 45%. The weighted average cost of capital is calculated
as follows :
1 PretaxCos Tax Post Tax Cost Weight Weighted Average cost
t 2 3 4 (2-3) 6 (4 x 5)
Dept .08 .036 .44 .20 .0088
Pre. Capital .11 - .11 .15 .0165
Equity Capital .16 - .16 .30 .48
Retained earning .14 - .14 .35 .49
.1223 i.e 12.%23
 MEANING OF CAPITAL BUDGETING

Capital Budgeting refers to planning the deployment of available capital form the
purpose of maximizing the long term profitability of the firm. It is to invest its current funds efficiently in
the long term activities in anticipation of flow of future benefit over a series of years. Capital budgeting is
the process to identify, Analyses and select investment projects whose returns (cash Flow) are expected
to extend beyond one year. Investment decision would include:
i) Expansion
ii) Acquisition
iii) Modernization
iv) Replacement of long Term assets

Thus, Capital Budgeting decision means a decision relating to planning for capital
assets as to whether or not money should be invested in long term projects. E. g. setting up a factory or
purchase of a new machine. It involve a financial analysis of the various proposals regarding a capital
expenditure and to choose the best out of the various alternatives. The Capital Budgeting decision
therefore, involve current year outflow or a series of the cash outflows over a number of years in return
for an anticipated flow of future return over a period of time longer than one year. There is a relatively
long time period between the initial outplay and the anticipated returns.

NATURE OF CAPITAL INVESTMENT

Capital Budgeting decision include acquisition, replacement, expansion and
modernization of assets. Any investment with long – term implication can be looked at as a capital
expenditure decision,. When a pharmaceutical firm decides to invest in R & D , a car manufacturer
considers investment in a few plant, an airline plans to buy a fleet of aircraft, a bank plans
computerization, a firm plans to launch a new products line. They are all capital Budgeting decisions.
These decision have the following features :
i) Usually involve huge outlays.
ii) Decisions are difficult.
iii) They have long – term consequences.
iv) Growth of an organization depends on the quality of such decisions.
v) Higher degree of risk is involved.
vi) They benefit future periods.
 vii) They have the effect of increasing the capacity, efficiency, span of life regarding future
benefits.
viii) Funds are invested in long terms activities.
STEPS INVOLVED IN DEVELOPMENT OF RELEVANT INFORMATION FOR CASH LOW
ANALYSIS
Steps :
1. Estimate Capital Expenditure :
Following information should be collected :
a) Cost of new Machine
b) Cost of Disposal of old machines lass scrap value
c) Cost of preparation of site and installation of new machines
d) Cost of ancillary services required for new machines for example new power suppliers, new
conveyors.
2. Estimate additional working capital :
Every long term investment requires additional working capital to finance
the increased level of activity. The need of working capital arise as the debtors, stock prepaid
expenses are to be maintained at higher level. On expiry of the life of the projects, the working
capital is released. It should be added to the cash flow of the last year and cash outflow. The
inflation factors should also be given consideration.
3. Estimate production Sale :
In this case following should be collected.
1. Each year’s production
2. Each Year’s sales
3. Selling price per unit.

4. Estimate Cash expenses :

The next step is to estimate cash expenses that will be incurred in running the
projects. The information regarding following items is necessary:

Variable Cost Fixed Cash Cost

a) Manufacturing Overheads a) Manufacturing Overheads
b) Administration Overheads b) Administration Overheads
c) Selling & Overhead Overheads c) Selling & Overhead Overheads

5. Estimate Cash Inflow :

It is estimated by projecting the income statement as given earlier.
IMPORTANCE
Capital budgeting is important due to the following :
Bird's Eye View
1. Affects financial stability
2. Shapes destiny of a company
3. Not easily reversible
4. Difficult to take
5. Maximise returns
6. Risk and uncertainty
7. Improves profitability
8. Effect on other projects

1. Affects financial stability :

The capital budgeting decision involves acquisition of fixed assets, which
are relatively costly, and therefore the decision affects the financial stability and
condition of any organisation to a greater extent.
2. Shapes destiny of a company :
The decision and its correctness shape the destiny of a company's financial
health. A wrong decision can endanger the very survival of the organisation.
3. Not easily reversible :
The decision, once taken is not easily reversible since the fixed asset
bought may not be suitable for any alternative usage. In this case the firm will incur more
loss.
4. Difficult to take :
This decision is not very easy to make as its benefits accrue only in the
future. The future being uncertain, an element of risk is involved. A failure to estimate
future cash inflows accurately can lead the entire organisation into a financial crunch.
Adding to this risk are the possibilities of shifts in consumer preference, technological
advancement which cannot be predicted.
5. Maximise returns :
Most of the organisations have a limited Capital Budget and a large number of
projects compete for these limited funds. The firm must, therefore, ration them in a way
to maximise long-term returns. Projects are therefore, to be ranked on the basis of criteria
like rate of return, risks involved and the number of years over which its return is
 expected to accrue. Thus, the decision gathers even more importance in times of Capital
Rationing.
6. Risk and uncertainty :
It involves huge amount of risk and uncertainty due to time factor. The
amount of capital expenditure is recoverable over a very long period.
7. Improve profitability :
Finance is the life blood of an organisation. Most of the firms face difficulties
in getting adequate finance. Hence, available finance has to be used in such a manner that
it will improve profitability of the organisation.
8. Effect on other projects :
Long term decisions affect the cash flow of other projects. Hence, the
impact on other projects should be considered.

Classification of Investment Proposals

1. Mutually Exclusive proposals
In. the case of mutually exclusive proposals, the selection of one proposal precludes
the choice of other proposals. The calculation of cash outflow and inflows are similar
to that of replacement situations.
These proposals compete with each other. For example, X Ltd is considering
the purchase of machine X or machine Y. if the company has decided to purchase machine x,
it will exclude the acceptance of machine Y.
2. Independent Investment Proposals :
It includes all such investments which are being considered by
the management for performance of different types of tasks. Investment in
machinery, automobiles, buildings, recreation centre are the examples of independent
investment proposals. Acceptance of each of these projects is done on its merits
without depending on the other projects.
3. Contingent Investment Proposals :
There are certain projects which are contingent upon the acceptance
of the others. For example, the management of a company may contemplate to build
employees quarters and a Consumers Cooperative Stores. If it decides not to
construct the quarters, the need of consumers stores does not arise. If only the
quarters are constructed, the employees will have problems in shopping. Such
projects are called as Contingent projects.
 4. Replacement Proposals
The investments which are contemplated for replacing old equipment
so that the job can be performed more efficiently are replacements. In the case of
replacement of an existing machine by a new one, the relevant cash out flows after
tax should be considered. If the new machine is to replace the existing machine, the
amount received from the sale proceeds reduces the cash outflow required to
purchase the new machine. Calculation of cash outflow in such a case is illustrated as
follows.

RS
Cost of the new machine XX
+ Cost of installation XX
+ Working Capital XX
- Sale proceeds of existing machine XX

Depreciation base of the New Machine

Rs
WDV of the existing machine XX
+ Cost of acquisition of new machine XX
XX
- Sale proceeds of existing machine XX
XX

5. Modernisation Decisions
Replacement of a fixed asset due to technological obsolescence is
known as modernization decision. The purpose is to improve the efficiency and
reduce cost. For example, replacement of a Pentium IV computer by Intel Centrino
Duo Computer.
6. Expansion Decisions
Increasing the existing production capacity is known as expansion
decision. The Purpose is to avoid delay in delivery of goods/services to customers
and increase revenue.
7. Diversification Decision
Commencement of new product/services lines is known as
diversification decision. The purpose is to reduce the risk of reduction in revenues of
existing products! services. For example : starting an insurance business by L & T
Ltd.
 EVALUATION TECHNIQUES / METHODS

'Following are the various methods and criteria involved in a Capital Budgeting
decision. They can be broadly classified into three broad categories :
1. Techniques which recognise Payback of Capital employed.
2. Techniques which consider Accounting Profit.
3. Techniques which consider Time Value of Money.
Investment Appraisal Techniques
1. Techniques which recognise Payback of Capital employed
Payback Method
2. Techniques which consider Accounting Profit
Accounting Rate of Return Method

3. Techniques which consider Time Value of Money

Net Present Value Method
Internal Rate of Return Method
Profitability Index Method
Discounted Payback Period Method
1. Pay-Back Method (PB) :
This is the simplest quantitative method for appraising capital
expenditure .decisions. This method evaluates the number of years it takes far the
future cash inflows by back the initial cash outflow i.e. the original cost of an
investment. It is the time by which the initial investment will be paid by the
project. It is the time required for the projects to break even. The cash inflows
here mean the annual profits after tax but before depreciation. Depreciation is
first reduced from the profits given since it is a valid allowable expenditure. This
will give us the profit before tax from which the tax liability for the year is
deducted to get the Profits Post Tax. However, depreciation does not involve any
outflow of cash since it is not to be paid and is bnly an accounting charge.
thereefore, in order to find the actual effective cash inflow it is then added back
to the profit post-tax before comparing the same with the initial outflow to take
the capital budgeting decision.
 Cash Flow Estimates :
Following are the ingredient of cash flow :
i) Tax effect : Cash flow for capital budgeting has to be net of taxes.
Hence, tax effect has to be given special consideration. In cases of loss,
they can be carried forward and set off against future income. Hence, the
benefit of tax savings will arise in future.
ii) Effect of depreciation : Depreciation is a non-cost item. It is deductible
for determination of taxable income. Depreciation has an effect on
taxable income and also the tax liability. Amount of depreciation in
capital budgeting is deducted to calculate profit and it is added back to
the profit after tax to calculate cash inflow. For capital budgeting
proposal, depreciation is calculated as per Income Tax Act.
iii) Effect on other projects : Cash flow effects of the project under
consideration must be considered. For example, a company is
manufacturing a new product which competes with the existing product,
it is likely that the cash flow of the existing product may be affected by
the cash flow of the new product. In such a case, the cash flow of the
new product should be adjusted. If the cash flow of the product should
be deducted by the reduction in cash flow of the existing product.
iv) Effect of Working Capital : Working capital is the difference between
current assets and current liabilities. When a new project is started, the
requirement of cash, inventory and the liabilities of creditors may arise.
The increase in current assets may not match with current liabilities. The
increase in working capital is added as an initial cost. Increase in
working capital has a positive effect on the future cash inflows. Working
capital has to be adjusted in the beginning as cash outflow.

Release of Net Working Capital

When the project comes to an end, the working capital that was tied up in the project
is assumed to be fully released at its face value.
v) Salvage Value : It is the price of an investment realised at the time of its
termination. These cash proceeds are treated as cash inflows in the last
year. In case of replacement decisions, in addition to the salvage value of
 the new investment, the salvage value of the existing investment now and
at the end of its life are also to be considered.
vi) Additional capital expenditure : In addition to initial cash outflow in
long term assets at the start of the project the project, may need
additional capital investment. Such additional expenditures are cash
outflows taking place in later years. It has to be considered while
calculating net cash flow during the life of the project.

Therefore, cash inflow for this method is calculated as under :

RS
Net Profit before depreciation and tax xx
Less : Depreciation xx
Net Profit after Depreciation but before Tax xx
Less : Tax Provision xx
Net Profit after Depreciation and Tax xx
Add : Depreciation xx
Net Profit after Tax but before Depreciation xx

Alternatively :
Rs
Sales Revenue XX
Less : Cash Operating Cost XX
Cash Inflow before Tax XX
Less : Depreciation XX
Taxable Income XX
Less : Tax XX
Earning after Tax XX
Add : Depreciation XX
Cash Inflow after Tax XX

Cash inflow for the last year

Cash Inflow after Tax XX
Add : Release of Working Capital XX
Add : Net Cash Salvage Value of Assets XX
Add : Tax Savings on Loss on Sale of Asset XX
Less : Tax on Profit on Sale of Assets XX
Cash Flow after Tax XX
 Sometimes the cash flow may be considered in terms of net savings in
cost. In such a case, saving in cost will be the starting point. Cash flow in such a case
will be calculated as follows :
Rs
Savings in Cost other than Depreciation XX
Less : Depreciation XX
Net Saving in Cost XX
Less : Income Tax XX
Net Saving after Tax XX
Add : Depreciation XX
Cash Inflow XX

Calculation of cash outflow :

Cash outflow is the amount outgoing on account of investment. It is calculated by the
following formula :
RS
Purchase Price of Machine XX
Add : Cost of Installation XX
Add : Carriage XX
Less : Subsidy from Govt. XX
Add : Additional Working Capital Requirements XX
Add : Retrenchment compensation XX
Less : Tax Savings on Retrenchment compensation XX
Add : Workers' Training Expenses XX
Net Cash Outflow XX

Steps :
1. Estimate the Cash Inflow
2. Estimate the Cash Inflow for every year.
3. Apply the following equation

a) When the cash inflow is equal for every year

Initial Cash outflow

Payback period = Annual cash inflow

b) When the annual cash Inflow is unequal

i) Calculate the cumulative cash inflow till the cumulative cash inflow
becomes equal to the initial cash outflow
ii) Apply the following equation :

Payback Period = (year upto which the cuulutative cash flow is less than total Cash outflow)
+
Total cash outflow - cumulative cash flow of the year in which the
cumulative cash flow is less than total cash outflow

CFAT in the next year following the year for which cumulative CFAT
has been considered in numerator
There are two ways of calculating Pay-Back (PB) periods.

Explanatory Notes
While calculating Cash Flows depreciation and tax should be ignored in the following cases :
 If the tax rate is not given
 If the question says, Ignore tax
 If the company is a zero tax company or it enjoys tax holiday

In absence of Information
i) Same amount of working capital invested earlier is assumed to have been released in the last year
of the life of the project.
ii) Salvage value estimated earlier is assumed to be realized in the last year of the project.
iii) The sales assumed to have been realised at the end of respective year
iv) The fixed cost and variable cost are assumed to have been incurred at the end of the respective
year.
v) Any saving of tax on negative profit before tax (i.e. loss) should be calculated assuming that the
company has taxable income from other sources against which such loss can be set off.
If any amount is paid or received at the beginning of any year, then the P.V. factor of the year of
payment/receipt preceding should be used.
a. When the Cash inflows are uniform every year : Here the initial cost of
investment is divided by the constant annual cash inflow as defined above to
get the Pay-Back period.
Initial Investment
Payback period = Normal cash inflow

For example, an investment of Z 40,000 in a machine is expected to produce a cash inflow of 8,000 p.a.
then
40 000 = 5Years
Pay-Back period = 8,000

It would take 5 years for the inflows to payback the cost.

b. When the projected cash inflows are not equal every year : In such a
situation, Pay-Back is calculated by a process of cumulating cash inflows till
they equate the original investment outlay.
Payback period = Year before full recovery + (Unrecovered amount of investment
+ Cash Flow during the year)

e.g. Suppose initial cost is 50,000.

Annual Inflows after tax

but before depreciation RS

Year I = 10,000
Year II = 15,000
Year III = 20,000
Year IV = 25,000

Table

Year Inflows Cumulative Inflows

RS RS
1 10,000 10,000
2 15,000 25,000
3 20,000 45,000
4 25,000 70,000

The initial cost of 50,000 will be recovered betvt4en year 3 and 4. Therefore, Pay.
Back period will be 3 years plus a fraction of the 4th year. By the 3rd year, 45,000 is
recovered. The remaining 5,000 would...be recovered in,the 4th year whose annual
inflow in 25,000. Therefore the fraction of the 4th year needed to reach the cost
would
be {5000/25000} i. e. 1/5.
Pay-Back period = 3 1/5 years.
The project or expenditure with a lower pay-back period is normally
preferred. An alternative way of expressing the payback period is the payback period
reciprocal which is expressed as : 1 / Payback period x 100.

Higher the reciprocal, more profitable will be the project.

Merits :
i) This method is quite simple and easy to calculate. It clarifies that there is no
profit in any project unless the pay-back period is over as till then, only the
cost is recovered.
ii) It favours projects with shorter pay-back periods since risks normally stand
to be greater in long-term projects as future is uncertain.
 iii) The method is very useful in situations of Liquidity Crunch and high cost of
capital as faster recovery of initial investment is necessary.
iv) It is most suitable when the future is uncertain.
v) It indicates to the prospective investors when their funds are likely to be
repaid.
vi) It does not involve assumptions about the future interest rates.
Limitations :
i) The method stresses on capital recovery ignoring the overall profitability. It fails to
consider the returns which accrue after the Pay-Back period is over. Two projects
with equal Pay-Back periods will be given the same rankings although their
inflows after the Pay-Back period may be different both in terms of years and
quantum.
ii) This method ignores the time value of money since the cash inflows are not
discounted for the decision making process.
iii) It fails to consider the cash inflows over the entire life of the project. As a result,
projects with larger cash inflows in the latter years may be rejected in favour of
projects with larger inflows in their earlier years.
iv) It does not consider the salvage value of an investment.
v) It makes no attempt to measure the percentage return on capital employed.

Accept-Reject Criterion :
The project with shorter payback period should be accepted.
Accept : Cal PBP < Standard PBP
Reject : Cal PBP > Standard PBP
Considered : Cal PBP = Standard PBP

2. Average Rate of Return (ARR) :

This method is also called Accounting Rate of Return. It is
based on average annual accounting yield of a project. The average profit after
tax and depreciation as a percentage of total investment is considered. Here the
depreciation is not added back to the annual profits.
Amount of additional working capital required in the initial year
is likely to be released only at the end of the life of the project. It is blocked
through out the life of the project. Hence, it should be added to the average
investment.
Merits :
i) The method is simple and easy to calculate.
ii) It considers the incomes from the project throughout its life and not just
the initial years unlike Pay-Back method.
iii) When a number of investment proposals are considered a quick decision
can be taken on the basis of this method.
iv) It is certainly a way of achieving higher profits.
Limitations :
i) It considers only the accounting return after depreciation and not the
actual cash flows which neutralises the effect of a non-cash item like
depreciation.
ii) It also doesn't consider the time value of money & thereby suffers
from the same element as discussed under Pay-Back method to that
extent.
iii) This method doesn't differentiate the projects on their size of
investments required. It is likely that different projects with different
sized investments may have the same ARR and therefore, the firm
would not be able to take the required decision under such a situation.
iv) It is biased against short term projects.
v) There is no full agreement on the proper measure of the term
investment.
vi) It does not indicate whether an investment should be accepted or
rejected unless the rates are considered with the target.
vii) Problems can arise in determination of profit which depends on
several factors.
CALCULATION OF ARR

Step :
1. Calculate Average Annual Profit after Tax
Total expected earnings after depreciation and taxes but before
interest on long term loan during the project period
Total Period of the Project

2. Calculate Average Investment

Average Investment = Opening Investment + Closing Investment /
2
If straight line method of depreciation is used :

Average Investment = ½ (Original Salvage - Salvage Value) + Salvage Value

+ Working Capital
3. Calculate ARR

Average Annual Profit after taxes X 100

Average Investment

If method of depreciation is WDV :

Step :
1. Calculate Annual Depreciation
2. Calculate Annual Average earnings after tax.
3. Calculate Average investment

Average Investment = Opening Investment + Closing Investment

2

4. Calculate ARR

Annual Average Earning after tax x 100

Average Investment

Accept-Reject Decision :
Accept project when ARR is higher than the minimum acceptable rate. Reject project
when ARR is lower than the minimum acceptable rate.
Accept : Cal ARR > Cut off Rate
Reject : Cal ARR < Cut off Rate
Considered : Cal ARR = Cut off Rate

Working Capital :
When working capital is required, it 'will-be added to find-out the average
investment.
 Salvage Value :
The amount of salvage value is first deducted and later added back.
Salvage value is added to find out annual depreciation. Since this value is released at
the end of the economic life, it is added back to find out average investment.
Techniques which recognize time value of money :
These methods consider the fluctuations in the value of money due
to efflux of time and here the cash inflows are first discounted at the rate as per the
Present value table. If you have Z 100 and deposit it into bank and the rate of interest
is 15%, it will become 115 at the end of the first year. In this case Z 100 is the
Present value and Z 115 is the future value after one year. It can be decided from the
present value tables. There are four methods under this criteria :

I) Net Present Value (NPV) Method.

II) Internal Rate of Return (IRR) Method.
III) Profitability Index Method.
IV) Discounted Payback Period Method.

I) Net Present Value (NPV) Method :

This method recognizes that cash flows at different points of time differ in
value and are comparable only when they are first brought down to a common denominator
Le present values. For this purpose every cash inflow and outflow are first discounted to
bring them down to their present value. The discounting rate normally equals the opportunity
cost of capital. The Net Present Value (NPV) is the difference between the present value of
cash inflow and the Present Value of cash outflow.

Steps in Net Present Value Method :

1. Draw a Table showing relevant Outflows associated with the project.

2. Calculate cash inflows associated with the project.
3. Calculate the Present Value Figures by multiplying Discount Factor by the Cash
Flows.
4. Make a Total of the present Values obtained.
5. Calculate Present Value of Cash inflows
6. Calculate the Net Present Value. >
 N P V = P.V. of all Cash Inflows - P. V. of all Cash Outflows.
7. Apply the criteria :
a) NPV > 0 Accept
b) NPV < 0 Reject
c) NPV = 0 May be accepted

Calculation of P.V. of Cash Outflow

Year P.V. Factor Rs PV

1. Cost of new machinery 0 1 XX XX
2. Fright, carriage & 0 1 XX XX
installation expenses
3. Worker's Training 0 1 XX XX
expenses
4. Less subsidy from Govt. year of receipt P.V. factor (XX) (XX)
5. Working capital at the 0 1 XX XX
initial stage
6. Additional working capital year of P. V. factor of XX XX
introduced introduction respective year
7. Retrenchment 0 1 XX XX
compensation
8. Less Saving of tax on 1 P.V. factor of (XX) (XX)
retrenchment compensation year 1 Total P.V -
XX

Calculation of P.V. of Cash Inflow

Year (1) Cash Inflow (2) P.V. factor (3) P.V. (4) (2x3)
1 XX XX XX
2 XX XX XX
3 XX XX XX
4 XX XX XX
5 XX XX XX
TOTAL XX

Interpretation of NPV
It indicates immediate increase in firm's wealth on acceptance of the
project. It indicates that the firm could raise at the cost of capital.
Merits :
i) It explicitly considers the time value of money.
ii) It considers the cash inflows over the entire life of a project.
 iii) This is the best method for decision making for mutually exclusive
projects.
iv) It leads to maximization of Shareholder's wealth. The market price of the
shares will be affected by the trends of future expected inflows and the
present value of these inflows will reflect a more accurate prediction for
example, if NPV > 0 means that the return would be higher than invested
for by the shareholders which might lead to the increases in share prices.
v) It considers the total benefits arising out of proposal over its life.
vi) It is useful for selection of mutually exclusive projects.
vii) It is instrumental in achievement of financial objective.
Limitations :
i) It is more difficult to calculate than the Pay-Back or ARR Method.
ii) The accuracy of this method depends on the authenticity of the
discounting rate for calculating the present values. There is a lot of
difference of opinion regarding the method of calculating it.
iii) This method may not give satisfactory results where two projects having
different effective lives are being compared.
iv) It emphasizes the comparison of net present value and disregards the
initial investment involved. Thus, it may not give dependable results.

II) Internal Rate of Return (IRR) Method :

This is the second time-adjusted rate of return method for
appraising capital expenditure decisions. It is the discount rate at which the aggregate
present value of inflows equal the aggregate present value of outflows i.e. the rate at
which NPV = 0. In the Net Present Value Method, the discount rate is normally equal
to the cost of capital which is external to the project under consideration. But in this
method, the discount rate depends on the initial outlay and cash inflows of the project
under consideration. It is therefore, called the Internal Rate of Return. The IRR, once
calculated is then compared to the required rate of return known as cut-off rate. The
project is accepted if the IRR exceeds the cut-off rate. Otherwise, it is rejected.
Steps :
1. Select a Discount Rate and calculate NPV of the Project using the Discount Rate
2. If the NPV is less than zero, try a lower Discount Rate. If the NPV is greater than
zero, try a higher Discount Rate.
3. Fix up the two discount rates so as to have one negative NPV and one positive
NPV
4. Apply the formula of interpolation
5. Accept the Project if the ERR exceeds the required Rate of Return.

IRR = Lower Discount Rate + NPV at lower rate

NPV at lower rate - NPV at Higher rate
x (Higher rate - Lower rate)

Merits :
i) It also considers the time value of money.
ii) It considers the cash flows over the entire life of a project.
iii) It does not use the cost of capital to determine the present value. It itself
provides a rate of return indicative of the profitability of the proposal.
iv) It would also lead to a rise in share prices and to maximisaton of
shareholder's wealth in the same way as Net Present Value Method.

Limitations :
i) The procedure for its calculation is complicated & at times tedious.
ii) Sometimes it leads to multiple rates which further complicate its
calculation.
iii) In case of more than one project, the project with the maximum IRR may
be selected which may not turn out to be one which is the most profitable
in the long run.
iv) Projects selected on the basis of higher IRR may not be profitable.
v) Unless the life of the project can be accurately estimated, assessment of
cash flows cannot be done.
 III) Profitability Index Method : (Discounted Benefit Cost Ratio)
It is also called as benefit cost ratio. It is the proportion between
PV of cash inflow at the required rate of return and the initial cash outflow. It measures
the PV of the returns which have been invested. It is based on NFV Method. NPV
Method is not suitable to those projects which require different initial investment. PI is
the ratio between PV of cash inflow and present value of cash outflow.
Profitability Index (PI) shows the net benefits expected from the
project per rupee of investment. It is also known as Present Value Index or Desirability
Ratio.

Calculation of Profitability Index

Step
1. Calculate cash outflows of the project.
2. Calculate cash inflows of the project.
3. Calculate present value of cash outflows relating to the project.
4. Calculate present value of cash inflows relating to the project.
5. Calculate profitability index or desirability factor by the following equation :

P.I = P.V. of Cash Inflows

P.V. of Cash Outflows

Accept-Reject Criteria :
a) When PI is more than 1, accept the project. PI > 1
b) When PI is less than 1, reject the project. PI < 1
c) When PI is equal to 1, it is indifferent, the project may or may not be accepted. PI
=1

Merits :
i. It is very simple to understand.
ii. It considers time value of money.
iii. It takes into account all cash flows during the life of the project.
iv. It gives emphasis on wealth maximisation.
v. It is in tune with the principles of financial management.
 Demerits :
i. Cost of capital may create error in calculation.
ii. It is of no use when a small project is compared with a large project.
iii. When investment outlay is spread over than period, this criterion cannot
be used.

Comparison between NPV and IRR Techniques

Profitability of a company depends on the decision regarding the choice of the asset.
It also helps to maximise wealth of the shareholders. The investment projects can be
classified into three categories :
a) Accept-Reject Decisions.
b) Replacement Decisions.
c) Mutually Exclusive Decisions.

a) Accept-Reject Decisions. : It is the most simple decision of all the capital

budgeting decisions. Such a decision Occurs :
i) when different projects are economically independent;
ii) when an individual project is accepted or rejected without any regard to
any other project;
iii) when accepting or rejecting a project has no impact on desirability of
other projects;
iv) when there are no two projects which are competing each other.
In most of the Accept-Reject Decisions, both the NPV and IRR produce identical results.
b) Replacement Decisions. :
Replacement decisions occurs when one asset is proposed to be
replaced with another. The objective of a replacement decision may be to
increase output to decrease cost. Replacement decisions are not very different
from other capital budgeting decisions. These decisions require measurement of
cost and benefit.
In case of replacement decisions, both NPV and IRR techniques
produce the same results. In this case, the NPV will be positive and the IRR will
be more than the cut off rate or NW will be negative and the IRR will be less
than the desired rate.
 c) Mutually Exclusive Decisions :
Two or more capital projects are said to be mutually exclusive
when the acceptance of one of them results in automatic rejection of all others.
This type of decision arises when a choice is to be made between two or more
competing projects. In the case of mutually exclusive decisions, the result given
by IRR and NPV may be either identical or different.
The ranking of alternative projects and the decision regarding
selection of a project based on NPV and IRR may not always be the same.
Conflict between the two may arise under the following situations :
(i) size disparity,
(ii) time disparity and
(iii) life disparity.
NPV Method is superior to IRR due to the following reasons :
i) NPV Method gives absolute addition to the wealth of the shareholders.
ii) NPV always ranks mutually exclusive proposals correctly but IRR may not
give correct ranking.
iii) NPV Method accepts project which have reinvestment rate higher than the
cost of capital. But IRR accepts when the rate of return is more or equal to
implied reinvestment rate.
iv) NPV always ranks mutually exclusive projects correctly but IRR may not
be able to give correct ranking.

(Profitability index)

Following are two mutually exclusive projects :

Project X Rs Project Y Rs
Present Value of Cash Inflows 20,000 8,000
Initial Cash Outlay 15,000 5 000
Net Present Value 5,000 3000
Profitability Index 1.33 1.60

According to Net Present Value Method, Project X is more profitable whereas according to profitability
Index, Project Y is more profitable.
Discounted Payback Period Method :
Under this method cash flows involved in a project are discounted
back to present value terms. Then the cash flows are compared with the original
investment to find out the payback period. This method allows for timing of the cash
flows but it does not take into account the cash flows after the payback period.
Steps :

1. Calculate cash inflows after tax.

2. Calculate cash outflows.
3. Calculate P.V. of all cash Inflows.
4. Calculate P.V. of all cash outflow.
5. Calculate cumulative cash flow after tax.
6. Find out Discounted payback period.
7. Accept the project if Discounted payback period < Maximum Acceptable
payback period.
Reject if Discounted payback period is > Maximum Acceptable payback period.
 CAPITAL RATIONING

Meaning :

It is a process of allocating limited funds amongst the financially viable projects which
are not mutually exclusive under consideration with a view to maximize the wealth of the shareholders.
Thus capital rationing is done when :

i) Limited funds are available for investment

ii) More than one financially viable projects which are not mutually exclusive are under
consideration

Techniques used under the situation of capital rationing :

1) Profitability Index :
P.I. should be used to rank the financially viable projects under the following
conditions :
i) Funds are scare today and not thereafter in subsequent years.
ii) Projects are infinitely divisible.
iii) None of the projects can be delayed.
iv) None of the projects can be undertaken more than once.
v) All cash outflows are made today.

Procedure to use P.I.

1. Calculate P.I. for each of the divisible project.
2. Rank the projects in descending order of P.I.
3. Select the combination of the projects ranked in descending order of P.I. which involves
funds upto a given limit.
1. NPV Index or Excess Present Value Index (i.e. NPV + Initial cash outflow)
This Method should be used to rank the financially viable projects
under the following conditions :
i) Funds are scare today and thereafter in subsequent years.
ii) Projects are infinitely divisible.
 iii) None of the projects can be delayed.
iv) None of the projects can be under taken more than once.
v) Cash Outflow are made not only today but also in future.

Procedure To use :

Steps:

1. Calculate NPVI for each of the divisible projects as follows :

NPVI = NPV
Inicial Cash outflow

2. Rank the projects in descending order of NPV.

3. Select the combination of projects ranked in descending order of NPVI which involves funds
upto a given limit.

2. NPV Method

This method should be used to rank the financially viable projects in other cases The
combination which gives the maximum overall NPV should be selected.
Procedure :

Steps :

1. Calculate NPV for each of the indivisible projects.

2. Rank the projects in descending order of NPV.
3. Select the combination of projects ranked in descending order of NPV involving funds upto a
given limit.

REPLACEMENT DECISION

In Replacement decision incremental approach should be adopted.

Computation of Incremental Contribution

Existing Machine New Machine increments (New – Old)

Units Produced XX XX
S.P. Per Unit XX XX
Less : Direct Material XX XX
Direct Labour XX XX
Variable Overheads XX XX
Contribution Per Unit XX XX
Total Contribution XX XX

Computation of Incremental Depreciation

Existing Machine New Machine Incremental

Cost of Machine XX XX
Freight XX XX
Erection Charges Training Cost XX XX
Less : Subsidy from Government XX XX
Less : Salvage Value XX XX
Depreciation Cost XX XX
Life XX XX
Depreciation XX XX

Computation of Incremental Salvage Value

Existing Machine New Machine Incremental

BV. at the end of the Life XX XX
Less : Cash Salvage XX XX XX
Short Term Capital Loss / Government XX XX
Tax on Loss & Profit XX XX XX

Computation of Incremental Cash Out Flow

 Rs
Purchase Price of New Machine XX
Freight Charge, Erection Charges XX
Cost of Training XX
XX
Less : Subsidy from Government XX
Incremental Working Capital XX
Less : Net Sale Proceeds of Existing Machine XX
XX
Less : Tax Saving on Loss on Sale of Existing Machine XX
(B.V. - Net Realisable Value)
Add : Tax on Profit on Sale of Existing Machine XX
Incremental Cash outflow XX

Important Points to be Remembered Replacement Decision

Sr No. Item Treatment

1 Consultation fees to study the problem.
2 Fixed over heads allocated.
3 Book value of existing machine.
(Undepreciated).
4 Loss on sale of existing machine
5 Tax saving on loss on sale of existing
machines.
6 Market value of existing machine.
7 Exchange value offered by the supplier
of new machine.
8 Expenses of disposal and dismantling
machine.
9 existing Release of working capital on
It should be treated as sunk cost.
It should be ignored as it is not relevant for the
decision.
It should be ignored as it is not relevant for the
decision.
It should be ignored as it is not relevant for the
decision.
It should be treated as cash inflow.
It should be treated as cash inflow if market value is
more than the exchange value offered by the supplier
of new machine.
It should be treated as cash inflow if exchange value
is more than the current Market value of existing
machine.
It should be treated as cash outflow.
It should be treated as cash outflow.
 sale of machine.
10 cost of new machine. It should be treated as cash outflow.
11 Expenses on carriage and installation It should be treated as cash outflow.
of new machine.
12 Cost of training the workers for new It should be treated as cash outflow.
machine.
13 Requirement of working capital for It should be treated as cash outflow.
new machine.
14 Retrenchment compensation paid. It should be treated as cash outflow
15 Saving of tax on Retrenchment It should be treated as cash inflow.
compensation.

NPV of the Replacement Decision = Total P.V. of Incremental Cash Inflow - Total P.V.

of Incremental Cash outflow

IRR of the Replacement Decision

= Lower Rate + NPV of Lower Rate

NPV of Lower Rate - NPV of Higher Rate x (Higher Rate - Lower Rate)

PI of Replacement Decision = Total PV of Incremental Cash Inflow

Total PV of Incremental Cash Outflow