CA.CS.CMA.

MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

CAPITAL BUDGETING
1. MEANING
Capital budgeting or investment appraisal, is the planning process used to determine whether an
organization's long term investments such as investment in new machinery, investment in new plants,
new products are worth the funding of cash through the firm's capitalization structure (debt, equity or
retained earnings). It is the process of allocating resources for major capital or investment. One of the
primary goals of capital budgeting investments is to increase the value of the firm to the
shareholders.
It is the process in which a business determines whether projects such as building a new plant or
investing in a long-term venture are worth pursuing. Often, a prospective project's lifetime cash
inflows and outflows are assessed in order to determine whether the returns generated meet a
sufficient target benchmark. It is also known as "investment appraisal."
Ideally, businesses should pursue all projects and opportunities that enhance shareholder value.
However, because the amount of capital available at any given time for new projects is limited,
management needs to use capital budgeting techniques to determine which projects will yield the
most return over an applicable period of time.

Capital budgeting is vital to a business because it creates a structured step by step process that
enables a company to:
1. Develop and formulate long-term strategic goals – The ability to set long-term goals is
essential to the growth and prosperity of any business. The ability to appraise/value investment
projects via capital budgeting creates a framework for businesses to plan out future long-term
direction.
2. Seek out new investment projects – Knowing how to evaluate investment projects gives a
business the model to seek and evaluate new projects, an important function for all businesses as
they seek to compete and profit in their industry.
3. Estimate and forecast future cash flows – Capital budgeting enables executives to take a
potential project and estimate its future cash flows, which then helps to determine if such a
project should be accepted.
4. Facilitate the transfer of information – From the time that a project starts off as an idea to the
time it is accepted or rejected, numerous decisions have to be made at various levels of
authority. The capital budgeting process facilitates the transfer of information to the appropriate
decision makers within a company.
5. Monitoring and Control of Expenditures – By definition a budget carefully identifies the
necessary expenditures and R&D required for an investment project. Since a good project can
turn bad if expenditures aren't carefully controlled or monitored, this step is crucial for the
benefit of the capital budgeting process.

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CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

6. Creation of Decision – When a capital budgeting process is in place, a company is then able to
create a set of decision rules that can categorize which projects are acceptable and which
projects are unacceptable. The result is a more efficiently run business that is better equipped to
quickly ascertain whether or not to proceed further with a project or shut it down early in the
process.
7. Maximization of Wealth: If an organization has invested in a planned manner, shareholders
would also be keen to invest in the organization. This helps in maximizing the wealth of the
organization. Capital budgeting helps an organization in many ways. Thus, an organization
needs to take into consideration various aspects.

1. Planning: The capital budgeting process begins with the identification of potential investment
opportunities. The opportunity then enters the planning phase when the potential effect on the
firm's future is assessed and the ability of the management of the firm to exploit the opportunity
is determined. Opportunities having little merit are rejected and promising opportunities are
advanced in the form of a proposal to enter the evaluation phase.
2. Evaluation: This phase involves the determination of proposal and its investments, inflows and
outflows. Investment appraisal techniques, ranging from the simple pay back method and
accounting rate of return to the more sophisticated discounted cash flow techniques, are used to
appraise the proposals. The technique selected should be the one that enables the manager to
make the best decision in the light of prevailing circumstances.
3. Selection: Considering the returns and risk associated with the individual project as well as the
cost of capital to the organization, the organization will choose among projects so as to
maximize shareholders wealth.
4. Implementation: When the final selection has been made, the firm must acquire the necessary
funds, purchase the assets, and begin the implementation of the project.
5. Control : The progress of the project is monitored with the aid of feedback reports. These
reports will include capital expenditure progress reports, performance reports, comparing actual
performance against plans set and post completion audits.
6. Review: When a project terminates or even before, the organization should review the entire
project to explain its success or failure. The review may produce ideas for new proposal to be
undertaken in the future.

Some of the major techniques used in capital budgeting are as follows:

1. Payback period (Traditional technique)
2. Accounting Rate of Return method (Traditional technique)
3. Net present value method (Discounted cash flow technique)
4. Profitability index (Discounted cash flow technique)
5. Internal Rate of Return Method (Discounted cash flow technique)

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CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

1. Payback period:
The payback (or payout) period is one of the most popular and widely recognized traditional
methods of evaluating investment proposals. It is defined as the number of years required to recover
the original cash outlay invested in a project. The projects with shortest payback period should be
selected.
Formula for calculating Pay Back Period

Payback Period = (After tax before Depreciation)

Advantages:
 A company can have more favourable short-run effects on earnings per share by setting up a
shorter payback period.
 The risk of the project can be tackled by having a shorter payback period as it may ensure
guarantee against loss.
 As the emphasis in pay back is on the early recovery of investment, it gives an insight to the
liquidity of the project.
Limitations:
 It fails to take account of the cash inflows earned after the payback period.
 It is not an appropriate method of measuring the profitability of an investment project, as it does
not consider the entire cash inflows yielded by the project.
 It fails to consider the pattern of cash inflows, i.e., magnitude and timing of cash inflows.
 Administrative difficulties may be faced in determining the maximum acceptable payback
period.
2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information, as revealed by
financial statements, to measure the profit abilities of the investment proposals. It is also known as
return on investment or return on capital employed method.
 If ARR > minimum rate then accept proposal.
 If ARR < minimum rate then reject proposal.
Formula:

Accounting rate of return = x 100

Average investment =
Advantages:
1. It is very simple to understand and use.
2. It can be readily calculated using the accounting data.
3. It uses the entire stream of incomes in calculating the accounting rate.

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CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

Limitations:
1. It uses accounting profits, not cash flows in appraising the projects.
2. It ignores the time value of money; profits occurring in different periods are valued equally.
3. I t does not consider the lengths of projects lives.
3. Net present value method:
The net present value (NPV) method is a process of calculating the present value of cash flows
(inflows and outflows) of an investment proposal, using the cost of capital as the appropriate
discounting rate, and finding out the net profit value, by subtracting the present value of cash
outflows from the present value of cash inflows.
NPV = PVCI-PVCO
Where,
PVCI = present value of cash inflows
PVCO = present value of cash outflows
IF NPV is Negative Reject the project.
IF NPV is Positive Accept the project.
IF NPV = 0 it can be accepted.
Advantages:
1. It recognizes the time value of money
2. It considers all cash flows over the entire life of the project in its calculations.
3. It is consistent with the objective of maximizing the welfare of the owners.
Limitations:
1. It is difficult to use
2. It estimates that the discount rate which is usually the firm’s cost of capital is known. But in
practice, to understand cost of capital is quite a difficult concept.
3. It may not give satisfactory answer when the projects being compared involve different amounts
of investment.
4. Profitability Index (PI)
 It is method of assessing Capital expenditure opportunities in the profitability index, sometimes
called the cost-benefit ratio.
 The PI is present value of an anticipated net future cash inflows divided by the Initial Outlay.
 The only difference between NPV and PI is that, when using NPV technique the initial outlay is
deducted from present value of anticipated cash flows, whereas with the profitability index
approach the initial outlay is used as a decision.
 A project is acceptable of PI > 1, rejected if PV < 1.
Formula :
Profitability Index PI =
 This method is also called as Cost benefit or desirability ratio method.
5. Internal Rate of Return : IRR
 It is the discounting rate where PV (O) = PV (I)

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CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

 At IRR, NPV = O.
 The Company’s Cost of Capital should be less than IRR, so that a positive profit can be
achieved
 IRR is expressed in %
 Steps to Solve Problem
(1) Consider a Discounting Factor such that NPV is Positive.
(2) Consider a discounting factor such that NPV is Negative.
(3) Apply Formula
IRR = LOWER IRR% RATE +  difference in IRR %
(discounting factor) (Positive + Negative)

Illustration 1 : A company wants to buy a machine. There are two alternative model X and Y
whose particulars are:
Particulars Amount Amount
(X) (Y)
Cost 5,00,000 6,00,000
Life in years 5 5
Profit before tax
Year 1 60,000 75,000
Year 2 45,000 60,000
Year 3 55,000 65,000
Year 4 40,000 55,000
Year 5 40,000 50,000
Tax rate 35%.
Calculate payback period, payback profitability and average rate of return.
Illustration 2: Excel Trading co. Ltd. is considering the purchase of a New Machine for the
immediate expansion programme. There are three types of machines in the market for this
purpose. Their details are as follows:

Particulars Machine Machine Machine

A B C
Cost of machine 17,500 12,500 9,000
Estimated savings in scrap per year 400 750 250
Estimated savings in direct wages per year 2,750 6,000 2,250
Additional cost of indirect materials per -- 400 --
year
Expected savings in indirect materials per 100 -- 250
annum

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CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

Additional cost of maintenance per year 750 550 500

-- 800 ---
Additional cost of Supervision per year 10 6 5
Estimated life of machine (Yrs.)
Taxation at 40% of profit
You are required to advise the management which type of machine should be purchased on the basis
of payback period?
Illustration 3: Calculate (i) Payback period (ii) Payback profitability (iii) Average rate of
return if you are given that:
Cost of machine is ` 2,00,000, Salvage Value `20,000, Rate of depreciation@ 10% under
W.D.V basis. Effective Income Tax Rate is 40% and Annual profit before depreciation and
Income Tax for the first 6 years are ` 70,000, ` 90,000, ` 96,000, ` 78,000, ` 62,000 and `
50,000.

Illustration 4 Company, Maharaja Private Limited is planning an investment in new project.

The investment budget of the company is ` 30,00,000. The company has following two
investment alternatives
Particulars Project A Project B
Investment 30,00,000 30,00,000
Useful Life 5 Years 6 Years
Cost of Capital 12% 12%
Cash Inflows at the end of the Year
Year 1 7,00,000 8,00,000
Year 2 10,00,000 8,00,000
Year 3 9,00,000 8,00,000
Year 4 8,00,000 8,00,000
Year 5 4,00,000 6,00,000
Year 6 – 2,00,000
Find which project the company should select on basis of
(a) Payback Period Method
(b) Net Present Value Method.
Discount factor @12%
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
0.893 0.797 0.712 0.636 0.567 0.507

Illustration 5: Modern electronics wants to take up a new project for the

manufacture of electronic device which has good market. Further details
are given below
i. Cost of the project as estimated :
` In Lacs

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CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

Land 2.00
Building 3.00
Machinery 10.00
Working capital 5.00
ii. The project will go into production immediately and will be operational for 5 years.
The annual working results are estimated as follows :
` In Lacs
Sales 20.00
Less : Variable Cost 8.00
Fixed cost(excluding depreciation) 4.00
Depreciation of assets 2.00
ii. At the end of the operational period, it is expected the fixed assets can be sold for ` 5 lacs
(without any profit)
iii. Cost of capital of the firm is 10% Applicable tax rate is 40%.
Note :
i) The present value of an annuity of Re. 1 at 10% rate of discount for 5 years is 3.791.
ii) The present value of Re. 1 at 10% rate of discount for year one is Re. 0.909 and for
year 5 is Re. 0.621.
You are required to evaluate the proposal by working out the Net present Value and
advice the firm for taking investment decision.

Illustration 6 : Three Dee Co. is thinking of replacing a manually done process with a process
handled by computers. They conducted a research, spending ` 50,000 to find out how they
could proceed with this idea. They arrived at the following analysis :
Manual Process: It requires four clerks with salary of ` 3,000 p.m. one supervisor for 12 months and
another supervisor for 8 months at ` 5,000 p.m. for each of them. Electricity bill under this process is
normally ` 2.500 p.m.
Computerized Process: it can be managed with 1 computer professional earning ` 11,500 p.m. each.
Electricity bill under this process will be ` 4,000 p.m. the computer system will required a cash
outflow of ` 2, 00,000 and will be outdated in the next five years. Salvage value after 5 years will be `
5,000.
Assuming that the cost of capital is 10% help the company in arriving at the
replacement decision based on NPV method. Tax rate 35%.

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 CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

P. V. factor @ 10% for 5 years is 0.909, 0.826, 0.751, 0.683, and 0.621 respectively

llustration 7
Suhail Enterprice Ltd. Is a manufacturer of high quality running shoes. Ms. Poonam, president,
is considering computerizing the company’s ordering, inventory and billing procedures. She
estimates that the annual savings from computerization include a reduction of ten clerical
employees with annual salaries of 15,000 each, ₹ 8,000 from reduced production delays
caused by raw materials inventory problems, ₹ 12,000 from lost sales due to inventory stock
outs and Rs 3,000 associated with timely billing procedure. The purchase price of the system is
₹ 2,00,000 and installation costs are ₹ 50,000. These outlays will be capitalized (depreciated)
on a straight line basis to a zero book (salvage) value which is also its market value at the end
of five years. Operation of the new system requires two computer specialists with annual
salaries of ₹ 40,000 per person. Also annual maintenance and operation (cash) expenses of
₹ 12,000 are estimated to be required. The company’s tax rate is 30% and its required rate of
return (cost of capital) for this project is 12%.
You are required to:
a. Find the project’s initial net cash outlay.
b. Find the project’s operating and terminal value cash flows over its 5 years life.
c. Evaluate the project using NPV method.
d. Evaluate the project using PI method.
e. Evaluate project’s simple payback period.
Note:
i. Present value of annuity of Rs 1 at 12% rate of discount for 5 years is 3.605.
ii. Present value of Rs 1 at 12% rate of discount, received at the end of 5 years is 0.567.
Illustration 8
Swastik Ltd is manufacturers of special purpose machine tools have two divisions which are
periodically assisted by visiting teams of consultants. The management is worried about the steady
increase of expense in this regard over years. An analysis of last years expenses reveals the:
Consultant remuneration

Particulars Rs
Travel and conveyance Rs 1,50,000
Accommodation expenses Rs 6,00,000
Travel charges Rs 2,00,000

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 CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

Special allowances Rs 50,000

The management estimates accommodation expenses to increase by Rs 2,00,000 annually.
As part of a cost reduction drive, Swastik Ltd are proposing to conduct a consultancy to take of
accommodation requirements of the consultants. This centre will additionally save the company
accommodation charges and Rs 2,00,000 in the cost executive training programmes hitherto
conducted outside the company premises every year.

The following details are available regarding the construction and maintenance of the new centre :
(a) Land at a cost of Rs 8,00,000 already owned by the company will be used. The land was given
on rent of Rs 50,000 per year
(b) Construction cost Rs 15,00,000 including special furnishings
(c ) Cost of annual maintenance Rs 1,50,000
(d) Construction cost will be written off over 5 years being the useful life.
Assuming that write off of construction cost as aforesaid will be accepted for tax purpose, the tax rate
will be 35% and required rate of return is 12%. Calculate NPV.

Illustration 9:

SCL Limited is a highly profitable company; it is engaged in the manufacture of power .The
company want to make a wind mill. The details of the scheme are as follows:
1) Cost of windmill Rs 600 Lacs.
2) Cost of the land Rs 15 Lacs. Working capital required is Rs 50 Lacs
3) Subsidy from the state government to be received at the end of the first year of installation Rs 15
Lac
4) Selling price of electricity will be 2.25 unit per year 1. This will increase by 0.25 per unit every
year till year 7. After that it will increase by 0.50 per unit.
5) Maintenance cost will be Rs 4 Lacs in the year 1 and the same will increase by Rs 2 Lacs every
year.
6) Estimated life 10 years.
7) Cost of capital 12%.
8) Residual value of the windmill will be nil. However land will go up Rs 60 Lacs at the end of the
year 10.
9) As the wind mill are expected to work on wind velocity, the efficiency expected to be an average
of 30%. Gross electricity generated at this level will be 25 Lacs units p.a. 4% of the electricity
generated will be committed free to state electricity board as per the agreement.
10) Tax rate 35%.
Illustration 10:

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CA.CS.CMA. MBA : Naveen Rohatgi NMIMS SCHOOL OF LAW FINANCE 11

ABC Ltd. Is considering three projects the expected cash flows are as follows.
Year A B C
0 (1,00,000) (1,00,000) (1,00,000)
1 50,000 10,000 10,000
2 50,000 10,000 50,000
3 10,000 50,000 40,000
4 10,000 30,000 70,000
5 10,000 1,00,000 10,000
Determine for each project  internal rate of return.

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