Chapter - 10 - Capital Budgeting Decisions

Chapter - 10 – Capital Budgeting Decisions
I. Introduction
II. Capital Budgeting Process
III. Techniques of Capital Budgeting Evaluation

a. Payback Period and Discounted Payback Period Method
b. Profitability Index Method
c. Net Present Value Method
d. Internal Rate of Return Method
IV. Capital Rationing
V. Practice Questions
I. Introduction
Capital budgeting is the most important decision for a financial manager. Since it involves buying
expensive assets for long term use, capital budgeting decisions may have a role to play in the future
success of the company. The right decision made by the process of capital budgeting will help the
company to maximize the shareholder value which is the primary goal of any business.
II. Capital Budgeting Process

The capital budgeting process includes identifying and then evaluating capital projects for the company.
Capital projects are the ones where the cash flows are received by the company over long period of time
which exceeds a year.
The capital budgeting process has the following four steps :-
Generation of Ideas :- The generation of good quality project ideas is the most important capital
budgeting step. Ideas can be generated from a number of sources like senior management, employees and
functional divisions or even from outside the company.
Analysis of Proposals :- The basis of accepting or rejecting a capital project is the project’s expected cash
flows in the future. Hence, all the project proposals are analyzed by forecasting their cash flows to
determine expected profitability of each project.
Creating the Corporate Capital Budgeting :- Once the profitable projects are shortlisted, they are
prioritized according to the available company resources, a timing of the cash flows of the project and the
overall strategic plan of the company. Some projects may be attractive on their own, but may not be a fit to
the overall strategy.
Monitoring and Post-Audit :- A follow up on all decisions is equally important in the capital budgeting
process. The analysts compare the actual results of the projects to the projected ones and the project
managers are responsible if the projections match or do not match the actual results. A post-audit to
recognize systematic errors in the cash flow forecasting process is also essential as the capital budgeting
process is as good as the inputs estimates into the forecasting model.
1
III. Techniques of Capital Budgeting Evaluation
a. Payback Period and Discounted Payback Period Method
The payback is defined as the number of years required for the proposal’s cumulative cash inflow to be
equal to its cash outflow. In other words, the payback period is the length of time required to recover the
initial cost of the project. The payback period therefore, can be looked upon as the length of time required
for a proposal to ‘break even’ on its net investment.
Q.1.
A project requires an initial outflow of ₹ 1,00,000 which could generate an operating cash inflow of ₹
20,000 in a year. What will be the payback period?
Solution :-
Payback Period = 1,00,000 = 5 Years
20,000
Q.2.
A proposal requires a cash outflow of ₹ 40,000 and is expected to generate cash inflows as follows :-
Year 1 2 3 4 5
Inflow 16,000 12,000 8,000 4,000 4,000
Solution :-
Year Cash Inflow Cumulative Cash Inflow
1 16,000 16,000
2 12,000 28,000
3 8,000 36,000
4 4,000 40,000
5 4,000 44,000
Payback Period = 4 Years
2
Q.3.
Minda Industries is envisaging an investment of ₹ 5,00,000 which will yield an annual cash inflow as
follows :-
Year 1 2 3 4 5 6
Cash Inflow ₹ 50,000 ₹ 1,00,000 ₹ 1,40,000 ₹ 2,00,000 ₹ 2,00,000 ₹ 1,25,000
Calculate the payback period.
Solution :-
1 50,000 50,000
2 1,00,000 1,50,000
3 1,40,000 2,90,000
4 2,00,000 4,90,000
5 2,00,000 6,90,000
6 1,25,000 8,15,000
Outflow 5,00,000
Recovered Upto 4 Yearth 4,90,000
Recovered in 5 Year
th 10,000
₹ 2,00,000 - 12 Months
₹ 10,000 - ? Months i.e. 0.6 Months i.e. 18 Days
Therefore, Payback Period = 4 Years and 18 Days
Q.4.
LMN Industries is looking for an investment of ₹ 15,00,000 which will yield an annual cash inflow as
follows :-
Year 1 2 3 4 5 6
Cash Inflow 2,50,000 3,00,000 7,40,000 2,40,000 2,00,000 1,25,000
Calculate the payback period.
Solution :-

1 2,50,000 2,50,000
2 3,00,000 5,50,000
3 7,40,000 12,90,000
4 2,40,000 15,30,000
5 2,00,000 17,30,000
6 1,25,000 18,55,000
Outflow 15,00,000
Recovered Upto 3rd Year 12,90,000
Recovered in 4th Year 2,10,000
₹ 2,40,000 - 12 Months
₹ 2,10,000 - ? Months i.e. 10.5 Months i.e. 10 Months and 15 Days
Therefore, Payback Period = 3 Years, 10 Months and 15 Days
3
Discounted Payback Period
This method is a combination of the original payback method and discounted cash flow technique. In this
method, the cash flows of the project are discounted to find their present values. The present value of the
cash inflows is then compared with the present value of the outflow.
Q.5.
Year 1 2 3 4 5
Inflow 16,000 12,000 18,000 10,100 4,000
Calculate the discounted payback period using discounting factor as 10%.
Solution :-
Year Cash Inflow DCF (10%) Discounted Cash Inflow Cumulative Discounted Cash Inflow
1 16,000 0.909 14,544 14,544
2 12,000 0.826 9,912 24,456
3 18,000 0.751 13,518 37,974
4 10,100 0.683 6,898 44,872
5 4,000 0.621 2,484 47,356
Outflow 40,000
Recovered Upto 3rd Year 37,974
Recovered in 4th Year 2,026
₹ 6898 - 12 Months
₹ 2,026 - ? Months i.e. 3.52 Months i.e. 3 Months and 16 Days
Therefore, Payback Period = 3 Years, 3 Months and 16 Days
4
b. Profitability Index Method
Profitability Index (PI) is defined as the benefits (in present value terms) per rupee invested in the
proposal. This technique which is a variant of the NPV technique, is also known as “Benefit-Cost Ratio” or
“Present Value Index”.
PI is calculated as follows :-
PI = Total Present Value of Cash Inflow

Total Present Value of Cash Outflow
Q.6.
Year 1 2 3 4 5
Inflow 16,000 12,000 18,000 10,100 4,000
Calculate the profitability index using discounting factor as 10%.
Solution :-
Year Cash Inflow DCF (10%) Discounted Cash Inflow

1 16,000 0.909 14,544
2 12,000 0.826 9,912
3 18,000 0.751 13,518
4 10,100 0.683 6,898.3
5 4,000 0.621 2,484
Total 47,356.3

PI = 47,356.3
40,000
PI = 1.18
5
c. Net Present Value Method
The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflows
less the sum of the present values of all the cash outflows associated with a proposal. In other words, the
NPV of any proposal, that involves cash inflows and outflows over a period of time, is equal to the net
present value of all the cash flows.
NPV is calculated as follows :-
NPV = Total Present Value of Cash Inflow - Total Present Value of Cash Outflow
Q.7.
Year 1 2 3 4 5
Inflow 16,000 12,000 18,000 10,100 4,000
Calculate the net present value using discounting factor as 10%.
Solution :-
Year Cash Inflow DCF (10%) Discounted Cash Inflow

1 16,000 0.909 14,544
2 12,000 0.826 9,912
3 18,000 0.751 13,518
4 10,100 0.683 6,898.3
5 4,000 0.621 2,484
Total 47,356.3
NPV = 47,356.30 – 40,000
NPV = 7,356.3
6
Q.8.
Minda Industries is envisaging an investment of ₹ 5,00,000 which will yield an annual cash inflow as
follows :-
Year Cash Inflow
1 1,50,000
2 1,00,000
3 1,40,000
4 2,00,000
5 2,00,000
6 1,25,000
Calculate the discounted payback period, profitability index and net present value considering
discounting rate as 15%.
Solution :-
Cash DCF Discounted Cash Cumulative Discounted Cash
Year
Inflow (15%) Inflow Inflow
1 1,50,000 0.870 130500.00 130,500.00
2 1,00,000 0.756 75600.00 206,100.00
3 1,40,000 0.658 92120.00 298,220.00
4 2,00,000 0.572 114400.00 412,620.00
5 2,00,000 0.497 99400.00 512,020.00
6 1,25,000 0.432 54000.00 566,020.00
Total 5,66,020.00

Outflow 5,00,000
Recovered Upto 4 Year
th 4,12,620
Recovered in 5 Year
th 87,380
₹ 99,400 - 12 Months
₹ 87,380 - ? Months i.e. 10.55 Months i.e. 10 Months 17 Days
Therefore, Discounted Payback Period = 4 Years, 10 Months 17 Days
Profitability Index
PI = 5,66,020
5,00,000
PI = 1.13
Net Present Value
NPV = 5,66,020 – 5,00,000
NPV = 66,020
7
Q.9.
LMN Industries is looking for an investment of ₹ 15,00,000 which will yield an annual cash inflow as
follows :-
Year Cash Inflow
1 3,00,000
2 3,80,000
3 7,40,000
4 3,40,000
5 2,50,000
6 1,25,000
Calculate the discounted payback period, profitability index and net present value considering
discounting rate as 12%.
Solution :-

Year
1 300,000 0.893 267,900 267,900
2 380000 0.797 302,860 570,760
3 740000 0.712 526,880 1,097,640
4 340000 0.636 216,240 1,313,880
5 250000 0.567 141,750 1,455,630
6 125000 0.507 63,375 1,519,005
Total 1,519,005

Outflow 15,00,000
Recovered Upto 5 Year
th 14,55,630
Recovered in 6 Year
th 44,370
₹ 63,375 - 12 Months
Profitability Index
PI = 15,19,005
15,00,000
PI = 1.01
Net Present Value
NPV = 15,19,005 – 15,00,000
NPV = 19,005
8
Q.10.
Machine Rambo costs ₹ 2,00,000 payable immediately. Machine Baaz costs ₹ 2,40,000 half payable
immediately in one year and half payable in one year’s time. The cash receipts expected are as follows :-
Year (at end) Machine Rambo (₹) Machine Baaz (₹)
1 40,000 -
2 1,20,000 1,20,000
3 80,000 1,20,000
4 60,000 1,60,000
5 40,000 -
At 6% opportunity cost, which machine should be selected on the basis of NPV method?
Solution :-
Calculation of Total Present Value of Cash Inflows

Machine Rambo Machine Baaz
Year Cash Inflow PVF (6%) PV (₹) Cash Inflow PVF (6%) PV (₹)
1 40,000 0.943 37,720 - 0.943 -
2 120,000 0.890 106,800 120,000 0.890 106,800
3 80,000 0.840 67,200 120,000 0.840 100,800
4 60,000 0.792 47,520 160,000 0.792 126,720
5 40,000 0.747 29,880 - 0.747 -
Total 289,120 334,320
Calculation of Total Present Value of Cash Outflows

Machine Rambo Machine Baaz
Year Cash Outflow PVF (6%) PV (₹) Cash Outflow PVF (6%) PV (₹)
0 200,000 1.000 200,000 120,000 1.000 120,000
1 - 0.943 - 120,000 0.943 113,160
Total 200,000 233,160
Machine Rambo = 2,89,120 - 2,00,000 = 89,120
Machine Baaz = 3,34,320 - 2,33,160 = 1,01,160
NPV of Machine Baaz is higher than Machine Rambo, hence Machine Baaz should be selected.
9
Q.11.
A company requires an initial investment of ₹ 1,20,000. The estimated net cash flows are as follows :-
Year 1 2 3 4 5 6 7 8 9 10
Net Cash Flows (₹) 21,000 21,000 21,000 21,000 21,000 24,000 30,000 45,000 30,000 12,000
Using 10% as the cost of capital, determine the following :-
1) Discounted Payback Period 2) Profitability Index 3) Net Present Value
Solution :-

Year
1 21,000 0.909 19,089 19,089
2 21,000 0.826 17,346 36,435
3 21,000 0.751 15,771 52,206
4 21,000 0.683 14,343 66,549
5 21,000 0.621 13,041 79,590
6 24,000 0.564 13,536 93,126
7 30,000 0.513 15,390 108,516
8 45,000 0.467 21,015 129,531
9 30,000 0.424 12,720 142,251
10 12,000 0.386 4,632 146,883
Total 146,883
Q.11.
Outflow 1,20,000
Recovered Upto 7th Year 1,08,516
Recovered in 8th Year 11,484
₹ 21,015 - 12 Months
Profitability Index
PI = 1,46,883
1,20,000
PI = 1.22
Net Present Value
NPV = 1,46,883 – 1,20,000
NPV = 26,883
10
d. Internal Rate of Return Method
The IRR of a proposal is defined as the discount rate which produces a zero NPV i.e., IRR is the discount
rate at which the total present value of cash inflows will be equal to the total present value of cash
outflows.
In the IRR technique, the cash inflows are known but the discount rate is not known. This discount rate is
ascertained by the trial-and-error procedure.
IRR = L + NPVL X (H – L)
(NPVL – NPVH)
Where,
L = Lower Discount Rate at which NPV is Positive
H = Higher Discount Rate at which NPV is Negative
NPVL = NPV at Lower Discount Rate
NPVH = NPV at Higher Discount Rate
Q.12.
A firm is evaluating a proposal costing ₹ 1,60,000 and expected to generate cash inflows of ₹ 40,000, ₹
60,000, ₹ 50,000, ₹ 50,000 and ₹ 40,000 at the end of each of next 5 years respectively. Discount the given
cash flows at 15% and 16% and find out the IRR.
Solution :-
Calculation of Net Present Value
1 40,000 0.870 34,800 40,000 0.862 34,480
2 60,000 0.756 45,360 60,000 0.743 44,580
3 50,000 0.658 32,900 50,000 0.641 32,050
4 50,000 0.572 28,600 50,000 0.552 27,600
5 40,000 0.497 19,880 40,000 0.476 19,040
Total PV of Inflows 161,540 157,750
Total PV of Outflows 160,000 160,000
Net Present Value 1,540 (2,250)
(NPVL – NPVH)
IRR = 0.15 + 1,540 X (0.16 - 0.15)

[1,540 – (-2,250)]
IRR = 0.15 + 1,540 X 0.01
[1,540 + 2,250]
IRR = 0.15 + 15.4
3,790
IRR = 0.15 + 0.00406
IRR = 0.15406
IRR = 15.41%
11
Q.13.
A company has to consider the following project :-
Cost – ₹ 20,000
Year 1 2 3 4
Cash Inflow ₹ 2,000 ₹ 2,000 ₹ 4,000 ₹ 20,000
Compute the IRR and comment on the project if the opportunity cost is 14%. (Interpolate between 10% and
11%)
Solution :-
Calculation of Net Present Value

1 2,000 0.909 1,818 2,000 0.901 1,802
2 2,000 0.826 1,652 2,000 0.812 1,624
3 4,000 0.751 3,004 4,000 0.731 2,924
4 20,000 0.683 13,660 20,000 0.659 13,180
Net Present Value 134 (470)
(NPVL – NPVH)
IRR = 0.10 + 134 X (0.11 - 0.10)

[134 – (-470)]
IRR = 0.10 + 134 X 0.01

[134 + 470]
IRR = 0.10 + 1.34

604
IRR = 0.10 + 0.0022
IRR = 0.1022
IRR = 10.22%
As the opportunity cost of the firm is 14%, the project having IRR of 10.22% should be rejected.
12
Q.14.
A company requires an initial investment of ₹ 1,20,000. The estimated net cash flows are as follows :-
Year 1 2 3 4 5 6 7 8 9 10
Net Cash Flows (₹) 21,000 21,000 21,000 21,000 21,000 24,000 30,000 45,000 30,000 12,000
10% is the cost of capital, determine the project IRR. (Interpolate between 14% and 15%.)
Solution :-
1 21,000 0.877 18,417 21,000 0.870 18,270
2 21,000 0.769 16,149 21,000 0.756 15,876
3 21,000 0.675 14,175 21,000 0.658 13,818
4 21,000 0.592 12,432 21,000 0.572 12,012
5 21,000 0.519 10,899 21,000 0.497 10,437
6 24,000 0.456 10,944 24,000 0.432 10,368
7 30,000 0.400 12,000 30,000 0.376 11,280
8 45,000 0.351 15,795 45,000 0.327 14,715
9 30,000 0.308 9,240 30,000 0.284 8,520
10 12,000 0.270 3,240 12,000 0.247 2,964
(NPVL – NPVH)
IRR = 0.14 + 3,291 X (0.15 - 0.14)

[3,291 – (-1,740)]
IRR = 0.14 + 3,291 X 0.01

[3,291 + 1,740]
IRR = 0.14 + 32.91

5,031
IRR = 0.14 + 0.0065
IRR = 0.1465
IRR = 14.65%
13
Q.15.
A firm whose cost of capital is 10% is considering two mutually exclusive projects Red and Brown, the
details of which are :-
Year Project Red (₹) Project Brown (₹)
Cost 0 2,00,000 2,00,000
1 20,000 1,00,000
2 40,000 80,000
Cash Inflow 3 60,000 40,000
4 90,000 20,000
5 1,20,000 20,000
Compute the Net Present Value at 10%, Profitability Index, an IRR for the two projects.
Interpolate between 13% and 15% for both the proposals.
Solution :-
Calculation of Net Present Value and Profitability Index
Project Red Project Brown
1 20,000 0.909 18,180 100,000 0.909 90,900
2 40,000 0.826 33,040 80,000 0.826 66,080
3 60,000 0.751 45,060 40,000 0.751 30,040
4 90,000 0.683 61,470 20,000 0.683 13,660
5 120,000 0.621 74,520 20,000 0.621 12,420
Net Present Value 32,270 13,100
PI (PV of Inflow / PV of Outflow) 1.16 1.07
Calculation of Net Present Value (Project Red)

1 20,000 0.885 17,700 20,000 0.870 17,400
2 40,000 0.783 31,320 40,000 0.756 30,240
3 60,000 0.693 41,580 60,000 0.658 39,480
4 90,000 0.613 55,170 90,000 0.572 51,480
5 120,000 0.543 65,160 120,000 0.497 59,640
14
(NPVL – NPVH)
IRR = 0.13 + 10,930 X (0.15 - 0.13)

[10,930 – (-1,760)]
IRR = 0.13 + 10,930 X 0.02

[10,930 + 1,760]
IRR = 0.13 + 218.6

12,690
IRR = 0.13 + 0.0172
IRR = 0.1472
IRR = 14.72%
Calculation of Net Present Value (Project Brown)

1 100,000 0.885 88,500 100,000 0.870 87,000
2 80,000 0.783 62,640 80,000 0.756 60,480
3 40,000 0.693 27,720 40,000 0.658 26,320
4 20,000 0.613 12,260 20,000 0.572 11,440
5 20,000 0.543 10,860 20,000 0.497 9,940
(NPVL – NPVH)
IRR = 0.13 + 1,980 X (0.15 - 0.13)

[1,980 – (-4,820)]
IRR = 0.13 + 1,980 X 0.02

[1,980 + 4,820]
IRR = 0.13 + 39.6

6,800
IRR = 0.13 + 0.0058
IRR = 0.1358
IRR = 13.58%
15
IV. Capital Rationing
Capital Rationing is a common practice in most of the companies as they have more profitable projects
available for investment as compared to capital available. Majority of the companies follow capital
rationing as a way to pick up the best project under the existing restrictions of funds.
Capital rationing is the process of putting restrictions on the projects that can be undertaken by the
company. This aims in choosing only the most profitable investment for the capital investment decision.
Advantages of Capital Rationing
Capital rationing is a very prevalent situation in companies. There are few advantages of practicing capital
rationing :-
➢ Budget :- The first and an important advantage are that capital rationing introduces a sense of strict
budgeting of corporate resources of a company. Whether there is an injunction of capital in the form of
more borrowings or stock issuance capital, the resources are properly handled and invested in
profitable projects.
➢ No Wastage :- Capital rationing prevents wastage of resources by not investing in each and every new
project available for investment.
➢ Fewer Projects :- Capital rationing ensures that less number of projects are selected by imposing capital
restrictions. This helps in keeping the number of active projects to a minimum and thus manage them
well.
➢ Higher Returns :- Through capital rationing companies invest only in projects where the expected
return is high, thus eliminating projects with lower returns on capital.
➢ More Stability :- As the company is not investing in every project, the finances are not over-extended.
This helps in having adequate finances for tough times and ensures more stability and increase in the
stock price of the company.
16
V. Practice Questions
Q.16.
A company is considering an investment proposal to install new milling controls. The project will cost ₹
50,000. The facility has a life expectancy of 5 years and no salvage value. The cost of capital for the
company is 10%. The estimated profits are as follows :-
Year 1 2 3 4 5
Profit ₹ 10,000 ₹ 11,000 ₹ 14,000 ₹ 15,000 25,000
Compute the following :-
a. Discounted Pay Back Period [Ans. :- 4 Years 8 Months and 17 Days]
b. Net Present Value [Ans :- ₹ 4,460]
c. Profitability Index [Ans :- 1.09]
d. Internal Rate of Return (Interpolate between 10% and 13%) [Ans :- 12.96%]
Q.17.
Machine A costs ₹ 1,00,000 payable immediately, Machine B costs ₹ 1,20,000, half payable immediately and
half payable in one year’s time. The cash receipts expected are as follows :-
Year (at end) Machine A (₹) Machine B (₹)
1 20,000 -
2 60,000 60,000
3 40,000 60,000
4 30,000 80,000
5 20,000 -
With 7% cost of capital, which machine should be selected on the basis of NPV?
[Ans :- NPV Machine A – ₹ 40,870, NPV Machine B – ₹ 46,280, Selection – Machine B]
Q.18.
Pioneer Steels Ltd. is considering two mutually exclusive projects. Both require an initial cash outlay of ₹
10,000 each and have a life of five years. The company’s required rate of return is 10%. The profits
expected to be generated by the projects are as follows :-
Particulars Year 1 Year 2 Year 3 Year 4 Year 5
Project 1 ₹ 4,000 ₹ 4,000 ₹ 4,000 ₹ 4,000 ₹ 4,000
Project 2 ₹ 6,000 ₹ 3,000 ₹ 2,000 ₹ 5,000 ₹ 5,000
Compute the following :-
a. Discounted Pay Back Period
b. Net Present Value
c. Profitability Index
d. Internal Rate of Return
(Interpolate between 28% and 29% for Project 1 and between 32% and 33% for Project B)
Ans :-
Project 1 Project 2
Discounted Pay Back Period 3 Years and 8 Days 3 Years and 2 Months
Net Present Value ₹ 5,160 ₹ 5,954
Profitability Index 1.52 1.60
Internal Rate of Return 28.65% 32.20%
17

Chapter - 10 - Capital Budgeting Decisions

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Chapter - 10 - Capital Budgeting Decisions

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Chapter - 10 – Capital Budgeting Decisions

II. Capital Budgeting Process

III. Techniques of Capital Budgeting Evaluation

IV. Capital Rationing

II. Capital Budgeting Process

The capital budgeting process has the following four steps :-

Year Cash Inflow Cumulative Cash Inflow

PI = Total Present Value of Cash Inflow

Year Cash Inflow DCF (10%) Discounted Cash Inflow

PI = Total Present Value of Cash Inflow

NPV is calculated as follows :-

Year Cash Inflow DCF (10%) Discounted Cash Inflow

NPV = 47,356.30 – 40,000

Discounted Payback Period

Cash DCF Discounted Cash Cumulative Discounted Cash

Discounted Payback Period

Calculation of Total Present Value of Cash Inflows

Calculation of Total Present Value of Cash Outflows

1) Discounted Payback Period 2) Profitability Index 3) Net Present Value

Cash DCF Discounted Cash Cumulative Discounted Cash

IRR = 0.15 + 1,540 X (0.16 - 0.15)

Calculation of Net Present Value

IRR = 0.10 + 134 X (0.11 - 0.10)

IRR = 0.10 + 134 X 0.01

IRR = 0.10 + 1.34

IRR = 0.10 + 0.0022

IRR = 0.14 + 3,291 X (0.15 - 0.14)

IRR = 0.14 + 3,291 X 0.01

IRR = 0.14 + 32.91

IRR = 0.14 + 0.0065

Calculation of Net Present Value (Project Red)

IRR = 0.13 + 10,930 X (0.15 - 0.13)

IRR = 0.13 + 10,930 X 0.02

IRR = 0.13 + 218.6

IRR = 0.13 + 0.0172

Calculation of Net Present Value (Project Brown)

IRR = 0.13 + 1,980 X (0.15 - 0.13)

IRR = 0.13 + 1,980 X 0.02

IRR = 0.13 + 39.6

IRR = 0.13 + 0.0058

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