CAPITAL BUDGETING

Capital budgeting decisions relate to the allocation of investible funds to different long-term
assets. Such decision denotes a decision situation where the lump sum funds are invested in
the initial stages of a project and the returns are expected over a long period. Where current
outlays are involved in return for a stream of future benefits, decision making as to such
involvement of scare resources becomes difficult. Capital budgeting decision helps in such a
situation. In the words of I.M. Pandey, ‘a capital budgeting decision may be defined as the
firm’s decision to invest its current funds most efficiently in the long-term assets in
anticipation of an expected flow of benefits over a series of years’. Some of the capital
budgeting decisions are – expansion, acquisition, modernization and replacement of assets,
divestment etc.

Importance of capital budgeting decision:

There are several factors and considerations, which make such decision as the most
important decision of a finance manager. The relevance and significance of capital budgeting
decision are as follows:

1. Long term effects: such decisions affect the future position of the firm both in terms of
risk and in terms of return.

2. Substantial commitment: huge amount of funds are involved-resulting in huge loss in

case of incorrect decision.

3. Irreversibility: decision once taken cannot be reverted – outlays become sunk cost.

4. Influences firm’s growth: affects both direction and rate of growth – influences the
capacity and strength to compete.

5. Complexity: future risk and uncertainty in cash flows caused by economic, social,
political and technological forces makes such a decision situation as the most difficult
and challenging one.

Objectives and process of Capital Expenditure Decision:

 Increase in the wealth of the company
 Evaluation of the profitability of different investment avenue.
 Ensure ROI is higher than COC.
 Always considering the future uncertainties.
 Utilizing the firm resources in the most profitable way.

Concept of Cash Flow:

Capital budgeting decisions are evaluated in terms of their cash flows; cost and benefit are
measure in terms of cash outflows and cash inflows. Profit is not considered as relevant for
the purpose.

Concept of cash Flow is better than the concept of Accounting Profit:

 In capital budgeting we are concerned with the measurement of the economic values
created by a decision rather than book-entry value.
 Accounting profit varies with change in accounting policy or measurement basis , cash
flow are the actual flows and are therefore not affected by any change in accounting
policy.
 Accounting profit is affected by many non-cash items which are debited in profit and
loss a/c although there are not actual outflows.
 Accrual concept is followed in accounting profit.

Relationship between AP and Cash Flow:

R=Revenue for the year

E= Expenses for the year.
C=Capital Expenditure during the year.
D= Depreciation for the year.

AP=R-E-D
NCF= CASH INFLOWS- CASH OUTFLOWS
=R- (E+C)
=R-E-C
=R-E-D+D-C
=(R-E-D)+D-C
=AP+D-C P

Illustration 2: Calculate Net cash flow:

Sales: 25,000 units @ ₹ 10
Variable cost per unit ₹ 6 and Fixed cost ₹ 19,000
Depreciation as per book of accounts ₹ 22,000
As per income tax rules ₹ 25,000
Interest to finance the project: on short term loan ₹ 1,000 and on long term loans ₹ 8000.
Applicable tax rate 40%.
Evaluation methods
1. Accounting or Average rate of return (ARR)
ARR is based on the accounting concept of return on investment. This may be defined as the
annualized after-tax profit expressed as percentage of net investment and is calculated as –
Average annual aftertax profit
ARR   100 , *if opening and closing WC
Average investment in the project  Addl.WC *
differs, average to be taken
Decision rule –
If ARR  Predetermined rate of return, project should be accepted.
In case of mutually exclusive projects, project with highest ARR is to be accepted.

2. Pay back period (PBP)

PBP is the length of time required to recover the initial cost of investment. It is the break-even
period of the project. PBP may be calculated with reference to cumulative cash flows and by
using the concept of simple/linear interpolation.
Decision rule –
If PBP  target period, project is accepted
For mutually exclusive projects, a project having lowest PBP is to be accepted.
Alternative way of expressing the pay back period is to calculate payback reciprocal as –
PBP reciprocal = 1/PBP x 100 and the higher the reciprocal the better is the proposal.
3. Net Present Value (NPV) method
NPV is the sum of the discounted values of the cash flows (both outflows and inflows) of a
project. By discounting the cash flows of different periods it provides a common base for
comparison. This method explicitly recognizes time value of money.
The NPV method is a process of evaluating or calculating the present value of the project cash
flows, using the opportunity cost of capital as the discount rate, and finding out the NPV by
subtracting the initial investment from the present value of future cash flows.
Mathematically,
 C C2 C3 Cn  n
C
NPV   1    .......    C0 =  1  Kt t  C0 ,
1  K 1  K  1  K 3 1  K n 
2
t 1

where, Ct = net cash flows at the end of t-th period & C0 = initial investment.
Decision rule –
If NPV > 0, the project is profitable
In case of mutually exclusive projects, project having highest NPV is profitable.

4. Profitability Index (PI) may be used which is a variation of the NPV rule. PI is the ratio of the
present value of cash inflows to initial cash outflow. It is also called benefit-cost ratio and is
calculated as –
Ct
PI   C0 ; if PI > 1, it is accepted.
1  K t
It represents relative measure of profitability. However, it fails to indicate correct choice
between mutually exclusive projects.
5. Internal Rate of Return (IRR)
IRR is based on the discounting technique and gives the projects own rate of return. IRR can be
defined as that rate of discount at which the NPV of the project is zero. In other words,
IRR is that value of ‘r’ for which the following equation holds true –

C C2 C3 Cn 
C0   1    .......  
1  r 1  r  1  r 3 1  r n 
2

n
C
or,  1  tr t  C0 = 0
t 1
Decision rule –
If IRR > K, the project is profitable.
For mutually exclusive projects, project with highest IRR is to be accepted.

 In short, the techniques may be of two types, viz., methods based

on profit (i.e., ARR) and methods based on cash flows. Cash flow
techniques may or may not (e.g., traditional PBP) consider the
time value of money. When we consider time value of money we
call it discounted technique. Examples of discounted cash flow
techniques are:-
 Discounted PBP
 NPV, PI
 IRR.
1. SRK Ltd wants to invest in a business opportunity and the initial outflow ₹ 3,20,000 .The net
cash in-flow per year is ₹ 90,000 for 5 years. Cost of Capital is 15%.
Calculate (a) Pay Back Period (PBP)
(b) Pay Back Profitability
(c) Net Present Value
(d) Profitability Index (PI)

2. HRK Ltd wants to invest in a business opportunity and the initial outflow ₹ 3,20,000 . The net
cash inflow is ₹ 72,000; ₹ 125,000; ₹ 1,35,000; ₹ 95,000; ₹ 80,000. Cost of Capital is 15%.
Calculate- (a) Pay Back Period (PBP) (b) Net Present Value

3. A company is considering an investment proposal to install new milling controls at a cost of ₹

35,000. The facility has a life expectancy of 5 years with ₹ 5,000 salvage value. For the
project additional working capital of ₹ 10,000 will also be required. The tax rate is 30%. The
company charges depreciation under SLM; but as per I.T. Rule 20% is allowed under WDV
method. The estimated cash flows before depreciation and tax from the proposal are: ₹
10,000; ₹ 12,000; ₹ 19,000; ₹17,000 and ₹ 24,000. Company’s cost of capital is 10%.

Compute the following:

(i) Payback period, (ii) Discounted Pay Back Period; (iii) Average rate of return, (iv) IRR,
(v) NPV and (vi) PI.

4. A project requires initial investment of ₹ 6,00,000 and its expected life is 5 years. It will
generate cash inflows of ₹ 1,45,000; ₹ 1,80,000; ₹ 2,00,000; ₹ 2,50,000 and ₹ 1,00,000 in
next 5 years. Calculate IRR. If the required rate of return is 10%, should the project be
accepted?
 5. The management of PK Ltd proposes to purchase a new Machine, the two alternative
machine Alpha and Beta are available each having a value of ₹ 99,000. From the following
information state which alternative you consider financially preferable:
Particulars Machine Alpha Machine Beta
Estimated Life 5 5
Year Cash Inflow Cash Inflow
1 25000 10000
2 30000 15000
3 35000 25000
4 40000 25000
5 40000 25000
The rate of return may be taken as 15%.

6. A machine require an investment of ₹ 85,000 and the cash inflow during the life-span of 4
year of machine is as follows
Year Cash Inflow
1 20000
2 30000
3 35000
4 40000 Calculate the internal rate of return.

7. From the following figures, calculate net cash flow:

Year 0 1 2 3 4
Initial cost of Asset 2,50,000
EBDIT 80,000 90,000 1,45,000 1,20,000
Depreciation 75,000 52,000 36,000 25,000
Working capital required 60,000 10,000
Sale of scrap (at the beginning) 30,000
Working capital received 66,000

Cost of capital 12% and tax rate 40%.

Calculate also NPV and IRR.

8. A company is considering two mutually exclusive projects having equal life of 5 years and
initial cash outflow of ₹ 20,000 each. The company’s cost of capital is 10% and it pays tax @
40%. Depreciation is allowed at 20% on cost for tax purposes.

Before tax cash flows (in ₹.) as expected are given below:

Project Year -1 Year -2 Year -3 Year -4 Year -5

A 8,000 8,000 8,000 8,000 8,000
B 12,000 6,000 4,000 10,000 10,000
Calculate for each project: (a) PBP; (b) ARR; (c) NPV; (d) PI

Which project should be accepted and why?

 9. KK Ltd is considering two mutually exclusive projects. The cash flows of the projects are
given below:

Net Cash Flow (₹.) Year 0 Year 1 Year 2 Year 3 Year 4

Project – A (-) 1,50,000 50,000 70,000 70,000 70,000

Project – B (-) 1,00,000 60,000 80,000

Discount rate is 10%. Which project should be selected and why?

10. Calculate NPV and IRR for the following project:

Initial cost (Fixed Asset) – ₹ 2,00,000; Working Capital required – ₹ 60,000 (75% is expected
to realize at the end). Projected PAT (dep charged under SLM) – ₹ 18,000; ₹ 42,000; ₹
66,000; ₹ 48,000 & ₹30,000. Tax rate – 40%; Cost of capital – 10% and Depreciation as per
IT Rule – 25% (wdv).
 11. Given below are the information relating to some projects:

Projects A B C D E F

NPV (₹) 1,10,000 (7,500) 70,000 81,000 38,000 32,000

Profitability Index 1.22 0.95 1.20 1.18 1.19 1.16

Suppose the firm has a budget ceiling of ₹10,00,000. Advise the firm on selection of projects
assuming:

(a) Projects are divisible.

(b) Projects are not divisible

12. X ltd wants to undertake a project for which following alternatives are available:

Projects Initial outflow (₹) Annual NCF (₹) Life of projects

A 60,000 14,000 8

B 1,00,000 20,000 10

C 80,000 18,000 8

D 1,50,000 26,000 20

E 1,20,000 24,000 10

(a) Which of the above projects should be accepted, when funds are limited?
(b) Which of the above projects should be accepted, when sufficient fund is available to
invest?
(c) Which of the above project or projects it should accept, when ₹3,00,000 is available
to invest?
[ given, cost of capital is 15%; PVAF(8,15%) = 4.6586, PVAF(10,15%) = 5.1790 and
PVAF(20,15%) = 6.3345]

14. PM has under consideration the production of high quality PG. The necessary equipment
would cost ₹ 1,00,000 and would last for 5 years. Depreciation – 25% on WDV and there is
no asset in the block. The expected salvage value is ₹ 10,000. The PG could be sold at ₹ 4
p.u. The variable cost of production is ₹ 2 per PG. Regardless of the level, the
manufacturer will incur a cash cost of ₹ 25,000 each year; the overhead cost allocated not for
the new line is ₹ 5,000. The manufacturer estimates to sell 75,000 units per year. Assume,
tax rate – 35%; cost of capital – 20% and additional working capital requirement – ₹
50,000.
Should the proposed equipment be purchased?
 13.PK Ltd is considering two mutually exclusive projects. The cash flows of the projects are
given below:

Net Cash Flow (₹.) Year 0 Year 1 Year 2 Year 3

Project – A (-) 3,36,000 2,80,000 140000 28,000

Project – B (-) 3,36,000 28,000 168,000 3,02,000

Discounting factor=9%

15. A company is to select one of the two alternative projects whose particulars are given
below:
Net Cash Flow (Rs.) Year 0 Year 1 Year 2 Year 3 Year 4
Project – E (-) 11,872 10,000 2,000 1,000 1,000
Project – F (-) 10,067 1,000 1,000 2,000 10,000
The company can arrange the necessary fund at 8%. Compute the NPV and IRR of each project and
comment on the results.
Is there any contradiction in the above results? If so, state the reasons for contradiction. How would
you propose to resolve such a contradiction?

16. A project costing ₹5,60,000 is expected to produce annual net cash benefits of ₹80,000
over a period of 15 years. Calculate IRR and PBP. Estimate IRR by using PBP. (given,
PV of annuity for 15 years are 7.191 and 6.811 at 12% and 11% rate.)
 17. An investor facing two mutually exclusive investment proposals having life span
of four years each furnishes the following instructions.

Proposal X Proposal Y

Initial Investment needed ₹ 79,999 ₹ 23,999

Net after tax inflows expected at the end of year

1 ₹28,000 ₹9,800

2 ₹27,500 ₹9,900

3 ₹27,900 ₹9,950

4 ₹28,000 ₹9,800

You are asked to rank the two proposals by the NPV method and the IRR method assuming
cost of capital to be 10%. Explain the reasons for contradiction in ranking, if any, and state
with reasons which of the two methods the investor should rely upon in making his final
choice.