UNIT- V

CAPITAL AND CAPITAL BUDGETING

OVER CAPITALIZATION
MEANING:

A company is said to be over capitalized when its earnings are not large enough to
yield or pay a fair return on the capital invested. Over capitalization signifies a state
of imbalance between capital invested and earning capacity. Over capitalization
does not necessarily mean excess or abundance of capital. It only means that the
capital as represented by assets are not effectively and profitably utilized for
productive purposes. Hence an over capitalized company cannot pay a fair dividend
on its shares. An over capitalized company may be short of capital.

Definition:

Gerstenberg defined over capitalization “ A company is over capitalized when its

earnings are not large enough to yield a fair return on the amount of stock and
bonds that have been issued, or when the amount of securities outstanding exceeds
the current value of the assets”.

Causes of Over Capitalization:

Over Capitalization may arise due to the following reasons:

1. Over issue of Capital: Shares and debentures may have been issued in
excess of requirements due to defective financial planning.

2. Purchasing Assets of Lower Value at High Prices: Firm is said to be over

capitalized, when the promoters of a company purchases the lower value
assets at high prices. This is due to the reason that the assets of lower value
will be shown as higher value items in the balance sheet.

3. Promotion, Formation or Development during Inflation : During

inflation, if firms undertake any developmental activity then they have to
invest huge amounts. Such high investments leads to over capitalization.

4. Incurring High Expenses on Promotion: If a firm incurs high promotional

expenses, high preliminary expenses beyond the normal limits then over
capitalization is observed.

5. In appropriate Depreciation: If a firm adopts and estimates inappropriate

depreciation then there might be no or less provisions available for the
replacement of such assets causing the origination of more capital than
required.
6. Liberal Dividend Policy: Most of the firms declare dividends at high rates in
spite of retaining and reinvesting a portion of profits. Such situation leads to
over capitalization.

7. Taxation Policy: Over capitalization is usually seen when the tax rates
begin to increase.

8. Constant Decline for Products: When the demand for the products
undergoes continuous decline, it also brings down both the profitability as
well as the returns on the capital employed leading to the development of an
over capitalized firm.

9. Payment of High Rate of Interest: Inefficient utilization of funds is

observed when they are procured at high interest rates.

10. Under Estimation of Capitalization Rate: When the capitalization

rate is under estimated, more funds can be generated leading to a situation
of over capitalization.

Effects of Over Capitalization:

Over capitalization influences the functioning of a company, its share holders as

well as the society in which the business is operating.
 Effects of over capitalization on Company--------
Over capitalization leads to ,
1. Loss of good will.
2. Reduction in the efficiency of the firm.
3. The generation of inflated profits.
4. The loss of market share.
5. The decline in the credit worthiness.
 Effects of over capitalization on Share holders------------
Over capitalization brings,
1. Reduction in dividends.
2. Decline in the value of shares.
3. Losses on speculation.
 Effects of over capitalization on Society-------
Over capitalization results into,
1. The loss of potential consumers due to the production of poor quality
products at high cost.
2. The reduction in the earnings of the workers.
3. The sub-optimal utilization of resources.
4. Economic recession due to increased losses, production of poor quality
products, un employment.
5. Gambling in shares.
Remedies for Over Capitalization:

1. Efficient Management: Management must become efficient and must

control the excess expenditure. Efficient management brings improvement in
the earning capacity of the firm.

2. Redemption of Preference Shares: Preference shares having high

dividend rates needs to be reduced. Such redemption must be done by
utilizing the retained earnings for increasing the shares of equity shares.

3. Reduction of funded debts: Long term borrowings carrying a high rate of

interest may be redeemed out of existing resources.

4. Re organization of the Equity Share Capital: Number of equity shares

can be decreased for avoiding over capitalization.

5. Conservative Policy: Management should follow a conservative policy in

declaring dividend and should take all measures to cut down un necessary
expenses on administration. It must take care to spend every single rupee in
the most profitable and economic manner.

---------------------------------------------------------------------------------------------

UNDER CAPITALIZATION

Meaning:

Under Capitalization is the opposite of Over Capitalization. A company is said to be

under capitalized when its earning capacity is more than the amount of capital
invested. In other words, the rate of earnings in the company is more than the rate
of earnings prevailing in the same industry. In such companies, the net value of
assets will be more than the value of securities.

Definition:

In the words of C.W.Gerstenberg “ a company may be under capitalized when the

rate of profits it is making on the total capital is exceptionally high in relation to the
return enjoyed by similarly situated companies in the same industry or when it has
too little capital with which to conduct its business”.

Causes of Under Capitalization:

Under Capitalization may be caused by the following factors:

1. Under Estimation of Capital Requirements: Due to under estimation of
the future capital requirements the firm has to face problem of non-
availability of adequate capital for later stages.
 2. Under Estimation of Future Earnings: While developing the financial plan,
if the future earnings of the firm are under estimated and if the actual
earnings are more than the estimated figure then the firm tends to face the
situation of under capitalization.

3. Promotion During Depression: The firm which are promoted during the
period of depression have to experience under capitalization.

4. Conservative Dividend Policy: When the management of a firm makes

use of conservative dividend policy under capitalization is observed.

5. Highly Efficient Management: The firm that are characterized by the

presence of efficient management generates high rate of returns on their
investment when compared to other companies of the same industry leading
to the emergence of under capitalization.

6. Trading through Equity Shares: When the funds are required companies
will be raised by trading through equities which have lower rate of interest
than earnings causing the situation of under capitalization.

Effects of Under Capitalization:

Under capitalization effects the company, its share holders and the society at
large. The disadvantages of under capitalization are:
1. High share prices may encourage the management to speculate in the
companies shares through manipulation of share prices. This may result in
the exploitation of un informed share holders.
2. High rate of earnings may encourage the employees to demand higher
wages and bonus.
3. Consumers may be led to believe that they are being exploited and may
agitate for a reduction in prices.
4. Heavy profits may attract heavier taxes and other controls by the
government.
5. Heavy earnings may encourage the management complacent(satisfied).
6. High earnings may encourage competitors to enter into a cut-throat
competition amongst themselves.
7. Under capitalization concern has to borrow money at higher rates of interest.
8. Sometimes under capitalization results in over capitalization due to the
generation of excessive profits, retained earnings and long-term debt
financing.

Remedies of Under Capitalization:

Under capitalization is easily remedied. It may be done by one or more of the

following methods.
1. New Issue of Bonus Shares: For correcting under capitalization, the firms
may issue bonus shares from its accumulated earnings. These issue brings
down the value of Earnings Per Share.
 2. New Issue of Shares: If a firm is having inadequate capital then the
required amount of capital can be made available either by the issue of new
shares.

3. Increasing the Par Value of Shares: For over coming the situation of
under capitalization, the firm can revalue its assets which brings increased
value causing the reduction in the earnings per rupee of share value.

Capital Structure

Meaning of Capital:

Capital refers to the total amount of finance the business requires to meet its
business operations both in the short-run and long-run. It is the basic necessity
required for starting, running the business. It is also called as owner’s equity. It is
given by ,
Capital = Assets – Liabilities

Need for Capital:

Capital is the basic foundation of every business. Capital is needed for the following
reasons:
1. Capital is essential to start a business.
2. It is needed for carrying out business activities and to run the business
smoothly.
3. Capital is required by a firm for expansion and diversification of its business.
4. A firm needs capital to meet the unpredictable situations.
5. It is required for the payment of taxes.
6. To pay dividends and interests to share holders and financial institutions, a
firm needs capital.
7. Capital is essential to support welfare under takings.
8. Even at wind up stage, capital is essential for meeting the requirements of
liquidation etc.

Types of Capital:

Capital required for a business can be classified under two main categories.
1. Fixed Capital
2. Working Capital
1. Fixed Capital: Fixed capital is that portion of capital which is invested in
acquiring long-term assets such as land and buildings, plant and machinery,
furniture and fixtures and so on. Fixed capital is the skeleton of the business.
It provides the business assets as per the business needs. These assets are
 not meant for resale. For this reason fixed capital is also known as ‘Block
Capital’.

Types of Fixed Assets: Fixed assets can be divided into three types.
 Tangible Fixed Assets: These are physical items which can be seen and
touched. Most of the common fixed assets are land, buildings, machinery,
motor vehicle, furniture and so on.
 Intangible Fixed Assets: These do not have physical form. They cannot be
seen or touched. But these are very valuable to business. Ex. Goodwill,
Brand name, Trade marks, Patents, Copy rights etc.
 Financial Fixed Assets: These are investments in shares, foreign currency
deposits, government bonds, shares held by the business in other companies
etc.

2. Working Capital: Working capital is the flesh and bold of the business. It is
also the portion of capital that makes a company work. It is nor just possible
to carry on the business with only fixed assets, working capital is a must. It
is used to meet regular needs of the business. The needs refer to the
purchase of material, payment of wages and salaries, expenses like rent,
advertising, power and so on. Funds, thus, invested in current assets keep
revolving fast and are being constantly converted in to cash and this cash
flows out again in exchange for other current assets. Hence, it is also known
as Revolving or Circulating or Short-term capital.

Types of Working Capital: Working capital can be divided into two types.
 Fixed or Permanent Working Capital: The minimum amount which is
required continuously to carry out business activity is referred as Fixed
working capital.
 Variable or Temporary Working Capital: The amount required to meet
seasonal demand and special purposes are referred as Variable Working
Capital. The variable Working capital fluctuates from time to time on the
basis of seasonal trends. Temporary working capital is generally financed
from short-term sources.

Y variable working capital

Fixed working capital

0 x
Influencing Factors of Working Capital:

The size of working capital required for the business is determined by a number of
factors. They are:
1. At Initial Stage: If the business is in the formation stage, it may require
more funds for launching the project.
2. Nature of Business: The working capital of a firm depends on the nature of
business. In general, manufacturing companies require less working capital
when compared to the trading organizations. For ex. Super markets require
larger working capital.

3. Operating Efficiency: The higher the degree of operating efficiency, the

lower could be the volume of working capital and vice versa. Operating
efficiency can be attained by these strategies such as cost reduction and cost
control, improvement in layout, waste elimination, zeroing the idle time,
inventory control, reserves, dividends and profits and so on.

4. Procedure for Manufacturing: The procedure of manufacturing business

relies on the length of manufacturing period and process. Longer procedure
requires more working capital and shorter the procedure , lesser the working
capital.

5. Seasonal Fluctuations: Seasonal fluctuations are common phenomenon for

most of the type of business. In busy seasons large amount of working
capital is required, because there will be high demand season and they need
to maintain big inventories. In slack season, less working capital is required
because of low demand in that season.

6. Operating Cycle: Operating cycle refers to the time taken to convert raw
materials into cash. If the time taken for completing an operation is more,
than the working capital required will also be more and vice-versa.

7. Availability of Raw materials: Easy availability of raw material helps the

firm to carry out its operations smoothly as time required in loading will be
less and working capital needs will be reduced.

8. Terms of purchase and sale: If the firm buys raw materials and other
resources for credit and sells the finished goods for cash, it can manage with
lower volumes of working capital. On the other hand, if the firm buys raw
materials on cash basis but sells finished products on cash it requires more
working capital. Thus, the period of credit and the efficiency in collection of
debts also influence the amount of working capital in a firm.

9. Velocity of Turnover: Firms which sell their goods quickly, require less
amount of working capital. And the firms with intensive nature require more
amount of working capital.

10. Dividend policy: The dividend policy of a concern also influence the
requirement of its working capital. A firm that maintains a study high rate of
cash dividend irrespective of its generation profit needs more working capital.
Than the firm that retains larger part of its profits and does not pay so high
rate of cash dividend.
 11. Degree of Competition: Where there is a high degree of
competition, products of larger variety have to be offered at competitive
terms and conditions. Allow credit for more period, maintain variety of
stocks, spend more on advertising to catch the customers attention – all
these points influence the working capital.

12. Price Level Change: Changes in the price level also affect the
working capital requirements. Generally, the rising prices will require the firm
to maintain larger amount of working capital as more will be required to
maintain the same current assets. Otherwise, it requires less working capital.

13. Other Factors: Certain other factors such as, operating efficiency,
management ability, irregularities of supply, import policy, importance of
labour, banking facilities etc., also influence the requirements of working
capital.

Influencing factors / Features / Determinants of Fixed Capital:

1. Characteristics of Business: Large manufacturing firms need huge amount

while for other firms like trading, banking and financial firms require less
capital. The requirement of capital varies from industry to industry.

2. Business Size: In manufacturing company, usually it requires a large size of

fixed capital when compared to other small service oriented organization.

3. Type of Business: Capital investment also depends on the type of business.

If business is for labour intensive method, the capital needed is less, whereas
if business takes capital intensive method, the capital needed in huge.

4. Method of Production: The production function in business requires fixed

capital for different purpose. The amount taken for business depends on the
method of production. If the technique is automated, it requires large
amount of capital and if simple technique is adopted, it may need less or
small amount of fixed capital.

Sources of short-term, Middle-term and Long-term Capital

Introduction : write introduction of capital.

Based on the time, the financial resources may be classified into 3 types.
 Long-term finance
 Medium-term finance
 Short-term finance

Sources of Long-term Finance:

Following are the different sources of finance,
1. Owner’s Capital: This is the capital that is invested by the owners of the
companies from their own sources. This amount is permanent and stays with
the business throughout the life of the business.

2. Share Capital: This is the capital generated by issuing the shares to the
general public. Share is the part of capital. Dividends are paid to the
shareholders from the profits. Shares are generally of two types.
 Preference Share Capital: This is the capital that is raised by issuing the
preference shares. Preference share holders have preference in payment of
dividend and repayment of capital.
 Equity Share Capital: This is the capital raised by issuing equity shares.
Equity shareholders are the real owners of the company.

3. Retained Profits: These are the profits retained after meeting all the
expenses and obligations. Working capital can be financed with the retained
earnings.

4. Loans from Financial Institutions: A number of financial institutions have

been set up by government with the main object of promoting industrial
development. These institutions play an important role as source of company
finance.

5. Debentures: These are the loans taken from the public. The company has to
pay a fixed rate of interest to the debenture holders. There are different
types of debentures. They are,
 Convertible Debentures
 Partly convertible Debentures
 Secured Debentures
 Unsecured Debentures
 Redeemable Debentures
 Irredeemable Debentures etc.

6. Government Grants and Loans: These are the loans borrowed directly or
indirectly from the government. Government gives loans only when certain
conditions are fulfilled like project is established in a specified area or the
project is useful for the whole society.

Sources of Middle Term Finance:

These are the sources of finance repayable between 1 to 3 years

1. Bank Loans: These are the loans borrowed from the bank at a fixed rate of
interest. The time of repayment and interest to be paid are decided at the
beginning and the amount is debited to the current account of the borrower.

2. Hire-purchase: In this facility, the asset can be purchased by paying price

as down payment. The remaining amount can be paid in the pre agreed
 number of installments. The buyer can get the right of ownership only after
the last installment is paid.

3. Leasing or Renting: If the firm requires fixed assets, then it is better to

take for lease instead of purchasing the asset. The asset bought for one
particular operation may not be used further. The agreement between the
owner (lesser) and the buyer (lessee) is called lease agreement.

4. Venture Capital: A venture capitalist finances a project based on the

potentialities of a new project. Finance is provided in the form of “Start-up
capital” and “development capital” by the financial intermediary.

Sources of Short term Finance:

If the firm facilitate funds for a duration of one year, then it is termed as
short-term finance. The following are the sources of short-term finance.
1. Commercial Paper(CP): It is a short term instrument of raising funds by
corporate. It is a sort of unsecured promissory note sold by the issuer to
the investor, the maturity of the CPs is flexible.

2. Bank over draft: This is a special agreement with the banker where the
customer can draw more than what he has in his savings/current account
subject to a maximum limit. Interest is charged on the actual amount
over drawn.

3. Trade Credit: This is a short term credit facility extended by the

creditors to the debtors. Normally, it is a common for the traders to buy
the materials and other supplies from the suppliers on credit basis. After
selling the stocks, the traders pay the cash and buy fresh stocks again on
credit. sometimes, the suppliers may insist on the buyer to sign a bill.
This bill is called ‘Bills Payable’.

4. Debt Factoring or Credit Factoring: Debt factoring is the arrangement

with factor where the trader agrees to sell its accounts receivable or
debtors at discount to the specialized dealers called factor. In the case of
credit factoring, the trader agrees to sell his accounts payables at
premium.

5. Advance from customers: To accomplish the needs of working capital,

it is mandatory for every firm to collect either complete or at least partial
amount in advance from the end-users.
6. Internal Funds: Internal funds are generated by the firm itself by way
of secret reserves, depreciation provisions, taxation provisions, retained
profits and so on and these can be utilized to meet the urgencies.
7. Short-term Deposits from the customers, Sister Companies and
Outsiders: It is normal to find the supermarkets and other trading
organizations inviting deposits of 6 months to one year duration. As an
incentive, such deposit holders may be given 5 – 10 percent discount on
the purchases.
 CAPITAL BUDGETING

Capital Budgeting:

Efficient allocation of capital is of the most important functions of the financial

management in modern times. The capital budgeting refers to the investment of
various fixed assets whose returns would be available only after a year. The investment
decision of a company are commonly called as the’ Capital Budgeting Decisions or
Capital Expenditure Decisions’.

Definition:
“Capital Budgeting involves the entire process of planning expenditures whose returns
are expected to extend beyond one year”.

Nature or Features of Capital Budgeting Decisions:

Generally, the companies’ capital budgeting decisions include additions, disposition,
modification and replacement of fixed assets. The capital budgeting decisions include
the following proposals.
1. Replacement: Replacement of fixed assets on account of existing assets, either
being worn out or become out dated.
2. Expansion: The Company may to expand its production capacities on account of
high demand for its products or inadequate production capacity. This will need
additional capital investment.
3. Diversification: A company may intend to reduce its risk by operating several
markets. In such cases, capital investment may become necessary for purchase
of new machinery and facilitates to handle the new products.
4. Research and Development: Large sums of money may have to spent for
Research and Development, in case of those industries where technology is
rapidly changing. In such cases, large sums of money are needed for these
proposals.
5. Miscellaneous Proposals: A company may have to invest money in projects.
Which do not directly help in achieving profit oriented goals. For example,
installation of pollution control equipment, may be necessary on account of legal
requirements. Hence funds will be required for such proposals also.

Need for Capital Budgeting:

The following are some of the reasons for an effective and proper capital budgeting.
 1. Large Investment: Capital Budgeting decisions, usually involve huge funds
which cannot be raised easily. Finance should be arranged well in advance. So
that it will available for capital budgeting.
2. Irreversible Nature: A capital budgeting decision once taken cannot be
changed easily. A fixed asset acquired can be disposed only at huge loss.
3. Difficulties of Investment Decision : Expansion of an existing asset or
acquisition of a new asset may be to meet the future demand of the product. If
the future sales forecast is not accurate, there can be an over invested or under
invested in fixed assets. As the future is uncertain, a higher degree of risk is
involved in this duration.
4. Long-term effect on profitability: The investment decision taken today not
only offers present profit but also the future growth and profitability of the
business.
5. Timely Acquisition of Assets: Proper capital budgeting helps better timing of
assets acquisition and improvement in quality of assets purchased.

Capital Budgeting Process:

The capital budgeting process involves generation of investment, proposal estimation of

cash-flows for the proposals, evaluation of cash-flows, selection of projects based on
acceptance criterion and finally the continues revaluation of investment after their
acceptance the steps involved in capital budgeting process are as follows.

1. Project generation
2. Project evaluation
3. Project selection
4. Project execution

1. Project generation: In the project generation, the company has to identify the
proposal to be undertaken depending upon its future plans of activity. After
identification of the proposals they can be grouped according to the following
categories:

a. Replacement of equipment: In this case the existing outdated

equipment and machinery may be replaced by purchasing new and
modern equipment.
b. Expansion: The Company can go for increasing additional capacity in the
existing product line by purchasing additional equipment.
 c. Diversification: The Company can diversify its product line by way of
producing various products and entering into different markets. For this
purpose, It has to acquire the fixed assets to enable producing new
products.
d. Research and Development: Where the company can go for installation of
research and development suing by incurring heavy expenditure with a
view to innovate new methods of production new products etc.,

2. Project evaluation: In involves two steps.

a. Estimation of benefits and costs: These must be measured in terms of

cash flows. Benefits to be received are measured in terms of cash flows.
Benefits to be received are measured in terms of cash inflows, and costs
to be incurred are measured in terms of cash flows.
b. Selection of an appropriate criterion to judge the desirability of the
project.

3. Project selection: There is no standard administrative procedure for approving the

investment decisions. The screening and selection procedure would differ from firm to
firm. Due to lot of importance of capital budgeting decision, the final approval of the
project may generally rest on the top management of the company. However the
proposals are scrutinized at multiple levels. Sometimes top management may delegate
authority to approve certain types of investment proposals. The top management may
do so by limiting the amount of cash out lay. Prescribing the selection criteria and
holding the lower management levels accountable for the results.

4. Project Execution: In the project execution the top management or the project
execution committee is responsible for effective utilization of funds allocated for the
projects. It must see that the funds are spent in accordance with the appropriation
made in the capital budgeting plan. The funds for the purpose of the project execution
must be spent only after obtaining the approval of the finance controller. Further to
have an effective cont. It is necessary to prepare monthly budget reports to show
clearly the total amount appropriated, amount spent and to amount unspent.

Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of evaluation of investment

proposal will help the company to decide upon the desirability of an investment
proposal depending upon their; relative income generating capacity and rank them in
order of their desirability. These methods provide the company a set of norms on the
basis of which either it has to accept or reject the investment proposal. The most widely
accepted techniques used in estimating the cost-returns of investment projects can be
grouped under two categories.

1. Traditional methods
2. Discounted Cash flow methods

1. Traditional methods

These methods are based on the principles to determine the desirability of an

investment project on the basis of its useful life and expected returns. These methods
depend upon the accounting information available from the books of accounts of the
company. These will not take into account the concept of ‘time value of money’, which
is a significant factor to determine the desirability of a project in terms of present
value.

A. Pay-back period method: It is the most popular and widely recognized traditional
method of evaluating the investment proposals. It can be defined, as ‘the number of
years required to recover the original cash out lay invested in a project’.
According to Weston & Brigham, “The payback period is the number of years it
takes the firm to recover its original investment by net returns before depreciation, but
after taxes”.

According to James. C. Vanhorne, “The payback period is the number of years required
to recover initial cash investment.

The payback period is also called payout or payoff period. This period is
calculated by dividing the cost of the project by the annual earnings after tax but before
depreciation under this method the projects are ranked on the basis of the length of the
payback period. A project with the shortest payback period will be given the highest
rank and taken as the best investment. The shorter the payback period, the less risky
the investment is the formula for payback period is

Cash outlay (or) original cost of project

Pay-back period = -------------------------------------------
Annual cash inflow

Merits:
1. It is one of the earliest methods of evaluating the investment projects.
2. It is simple to understand and to compute.
 3. It does not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the
books.

Demerits:
1. This method fails to take into account the cash flows received by the
company after the payback period.
2. It doesn’t take into account the interest factor involved in an investment
outlay.
3. It doesn’t take into account the interest factor involved in an investment
outlay.
4. It is not consistent with the objective of maximizing the market value of
the company’s share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing
of cash inflows.

B. Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated by the

financial statements to measure the probability of an investment proposal. It can be
determined by dividing the average income after taxes by the average investment i.e.,
the average book value after depreciation.

According to ‘Soloman’, accounting rate of return on an investment can be calculated as

the ratio of accounting net income to the initial investment, i.e.,

Average net income after taxes

ARR= ---- ]--------------------------------- X 100
Average Investment

Total Income after Taxes

Average net income after taxes = -----------------------------
No. Of Years
Total Investment
Average investment = ----------------------
2

On the basis of this method, the company can select all those projects who’s ARR is
higher than the minimum rate established by the company. It can reject the projects
with an ARR lower than the expected rate of return. This method can also help the
management to rank the proposal on the basis of ARR. A highest rank will be given to a
project with highest ARR, where as a lowest rank to a project with lowest ARR.

Merits:

1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.

Demerits:

1. It is not based on cash flows generated by a project.

2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.

II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They
give equal weight age to the present and future flow of incomes. The DCF methods are
based on the concept that a rupee earned today is more worth than a rupee earned
tomorrow. These methods take into consideration the profitability and also time value
of money.

A. Net present value method (NPV)

The NPV takes into consideration the time value of money. The cash flows of different
years and valued differently and made comparable in terms of present values for this
the net cash inflows of various period are discounted using required rate of return
which is predetermined.

According to Ezra Solomon, “It is a present value of future returns, discounted at the
required rate of return minus the present value of the cost of the investment.”

NPV is the difference between the present value of cash inflows of a project and the
initial cost of the project.
According the NPV technique, only one project will be selected whose NPV is positive or
above zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must
be rejected. If there are more than one project with positive NPV’s the project is
selected whose NPV is the highest.
The formula for NPV is

NPV= Present value of cash inflows – investment.

C1 C2 C3 Cn
NPV = ------ + ------- + -------- + -------
(1+K)
Co- investment
C1, C2, C3… Cn= cash inflows in different years.
K= Cost of the Capital (or) Discounting rate
D= Years.

Merits:

1. It recognizes the time value of money.

2. It is based on the entire cash flows generated during the useful life of the asset.
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining
the present value.

Demerits:

1. It is different to understand and use.

2. The NPV is calculated by using the cost of capital as a discount rate. But the
concept of cost of capital. If self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different
amounts of investment.
4. It does not give correct answer to a question whether alternative projects or
limited funds are available with unequal lines.

B. Internal Rate of Return Method (IRR)

The IRR for an investment proposal is that discount rate which equates the present
value of cash inflows with the present value of cash out flows of an investment. The IRR
is also known as cutoff or handle rate. It is usually the concern’s cost of capital.
According to Weston and Brigham “The internal rate is the interest rate that equates
the present value of the expected future receipts to the cost of the investment outlay.

When compared the IRR with the required rate of return (RRR), if the IRR is more than
RRR then the project is accepted else rejected. In case of more than one project with
IRR more than RRR, the one, which gives the highest IRR, is selected.

The IRR is not a predetermine rate, rather it is to be trial and error method. It implies
that one has to start with a discounting rate to calculate the present value of cash
inflows. If the obtained present value is higher than the initial cost of the project one
has to try with a higher rate. Likewise if the present value of expected cash inflows
obtained is lower than the present value of cash flow. Lower rate is to be taken up. The
process is continued till the net present value becomes Zero. As this discount rate is
determined internally, this method is called internal rate of return method.

P1 - Q
IRR = L+ --------- X D
P1 –P2

L- Lower discount rate

P1 - Present value of cash inflows at lower rate.
P2 - Present value of cash inflows at higher rate.
Q- Actual investment
D- Difference in Discount rates.

Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of
return projects are selected, it satisfies the investors in terms of the rate of
return an capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm’s objective of maximum owner’s welfare.

Demerits:

1. It is very difficult to understand and use.

2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.
C. Probability Index Method (PI)

The method is also called benefit cost ration. This method is obtained cloth a slight
modification of the NPV method. In case of NPV the present value of cash out flows are
profitability index (PI), the present value of cash inflows are divide by the present value
of cash out flows, while NPV is a absolute measure, the PI is a relative measure.

It the PI is more than one (>1), the proposal is accepted else rejected. If there are
more than one investment proposal with the more than one PI the one with the highest
PI will be selected. This method is more useful incase of projects with different cash
outlays cash outlays and hence is superior to the NPV method.

The formula for PI is

Present Value of Future Cash Inflow

Probability index = ----------------------------------------
Investment

Merits:
1. It requires less computational work then IRR method
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the
index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the
index.
5. It takes into consideration the entire stream of cash flows generated during the
useful life of the asset.

Demerits:

1. It is some what difficult to understand

2. Some people may feel no limitation for index number due to several limitation
involved in their competitions
3. It is very difficult to understand the analytical part of the decision on the basis of
probability index.