Unit 5 Capital Budgeting (SPPU Uni Sub Prof Notes)

202 Financial Management
Unit 5 Capital Budgeting: Meaning, Definition of Capital Budgeting, Time value of money. Tools of
evaluation of the project based on traditional techniques and modern techniques - ARR, Payback Period,
Discounted Payback Period, NPV, PI & IRR
Meaning & Definition of Capital budgeting
Capital Budgeting is the art of finding assets that are worth more than they cost to achieve a
predetermined goal i.e., ‘optimizing the wealth of a business enterprise’.
Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context, capital expenditure
is the spending of funds for large expenditures like purchasing fixed assets and equipment, repairs to
fixed assets or equipment, research and development, expansion and the like. Budgeting is setting
targets for projects to ensure maximum profitability.
Definition:
According to the definition of Charles T. Horngreen, “Capital budgeting is a long-term planning for
making and financing proposed capital outlays”.
According to the definition of G. C. Philippatos, “Capital budgeting is concerned with the allocation of
the firms source financial resources among the available opportunities”.
The consideration of investment opportunities involves the comparison of the expected future, streams
of earnings from a project with the immediate and subsequent streams of earning from a project, with
the immediate and subsequent streams of expenditure”.
According to the definition of Richard and Green law, “Capital budgeting is acquiring inputs with long-
term return”.
According to the definition of Lyrich, “Capital budgeting consists of planning development of available
capital for the purpose of maximizing the long-term profitability of the concern”.
PURPOSE OF CAPITAL BUDGTETING

The capital budgeting decisions are important, crucial and critical business decisions due to following
reasons:
(i) Substantial expenditure: Investment decisions are related with fulfillment of long term objectives
and existence of an organization. To invest in a project or projects, a substantial capital investment is
required. Based on size of capital and timing of cash flows, sources of finance are selected. Due to huge
capital investments and associated costs, it is therefore necessary for an entity to make such decisions
after a thorough study and planning.
(ii) Long time period: The capital budgeting decision has its effect over a long period of time. These
decisions not only affect the future benefits and costs of the firm but also influence the rate and
direction of growth of the firm.
(iii) Irreversibility: Most of the investment decisions are irreversible. Once the decision implemented it is
very difficult and reasonably and economically not possible to reverse the decision. The reason may be
upfront payment of amount, contractual obligations, technological impossibilities etc.
(iv) Complex decisions: The capital investment decision involves an assessment of future events, which
in fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms all the benefits
or the costs relating to a particular investment decision.
IMPORTANCE OF CAPITAL BUDGETING: Capital budgeting decisions are of paramount importance in
financial decision. So it needs special care on account of the following reasons:
(1) Long-term Implications: A capital budgeting decision has its effect over a long time span and
inevitably affects the company’s future cost structure and growth. A wrong decision can prove
disastrous for the long-term survival of firm. It leads unwanted expansion of assets, which results in
Asst. Prof. Prakash Kankure Page 1

M Com, CWA(In), MBA, MPM,ADOA, DWD, DCM
heavy operating cost to the firm. On the other hand, lack of investment in asset would influence the
competitive position of the firm. So the capital budgeting decisions determine the future destiny of the
company.
(2) Involvement of large amount of funds: Capital budgeting decisions need substantial amount of
capital outlay. This underlines the need for thoughtful, wise and correct decisions as an incorrect
decision would not only result in losses but also prevent the firm from earning profit from other
investments which could not be undertaken.
(3) Irreversible decisions: Capital budgeting decisions in most of the cases are irreversible because it is
difficult to find a market for such assets. The only way out will be to scrap the capital assets so acquired
and incur heavy losses.
(4) Risk and uncertainty: Capital budgeting decision is surrounded by great number of uncertainties.
Investment is present and investment is future. The future is uncertain and full of risks. Longer the
period of project, greater may be the risk and uncertainty. The estimates about cost, revenues and
profits may not come true.
(5) Difficult to make: Capital budgeting decision making is a difficult and complicated exercise for the
management. These decisions require an overall assessment of future events which are uncertain. It is
really a marathon job to estimate the future benefits and cost correctly in quantitative terms subject to
the uncertainties caused by economic-political social and technological factors.
CAPITAL BUDGETING PROCESS
The extent to which the capital budgeting process needs to be formalized and systematic procedures
established depends on the size of the organization; number of projects to be considered; direct
financial benefit of each project considered by itself; the composition of the firm's existing assets and
management's desire to change that composition; timing of expenditures associated with the projects
that are finally accepted.
(i) 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
fortunes 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.
(ii) Evaluation: This phase involves the determination of proposal and its investments, inflows and
outflows. Investment appraisal techniques, ranging from the simple payback 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.
(iii) Selection: Considering the returns and risks associated with the individual projects as well as the
cost of capital to the organization, the organization will choose among projects so as to maximize
shareholders’ wealth.
(iv) 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.
(v) 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.
(vi) Review: When a project terminates, or even before, the organization should review the entire
project to explain its success or failure. This phase may have implication for firms planning and
evaluation procedures. Further, the review may produce ideas for new proposals to be undertaken in
the future.

TYPES OF CAPITAL INVESTMENT DECISIONS

There are many ways to classify the capital budgeting decision. Generally capital investment decisions
are classified in two ways. One way is to classify them on the basis of firm’s existence. Another way is to
classify them on the basis of decision situation.
Replacement and
Types of Capital Investment Modernisation decisions
On the basis of firm’s

Expansion decisions
existence
Diversification decisions
Mutualy exclusive
decisions
On the basis of decision

Accept-Reject decisions
situation
Contingent decisions
On the basis of firm’s existence: The capital budgeting decisions are taken by both newly incorporated
firms as well as by existing firms. The new firms may require taking decision in respect of selection of a
plant to be installed. The existing firm may require taking decisions to meet the requirement of new
environment or to face the challenges of competition. These decisions may be classified as follows:
(i) Replacement and Modernization decisions: The replacement and modernization decisions aim at to
improve operating efficiency and to reduce cost. Generally, all types of plant and machinery require
replacement either because of the economic life of the plant or machinery is over or because it has
become technologically outdated. The former decision is known as replacement decisions and latter is
known as modernization decisions. Both replacement and modernization decisions are called cost
reduction decisions.
(ii) Expansion decisions: Existing successful firms may experience growth in demand of their product
line. If such firms experience shortage or delay in the delivery of their products due to inadequate
production facilities, they may consider proposal to add capacity to existing product line.
(iii) Diversification decisions: These decisions require evaluation of proposals to diversify into new
product lines, new markets etc. for reducing the risk of failure by dealing in different products or by
operating in several markets.
Both expansion and diversification decisions are called revenue expansion decisions.
On the basis of decision situation: The capital budgeting decisions on the basis of decision situation are
classified as follows:
(i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or more
alternative proposals are such that the acceptance of one proposal will exclude the acceptance of the
other alternative proposals. For instance, a firm may be considering proposal to install a semi-automatic
or highly automatic machine. If the firm installs a semi-automatic machine it excludes the acceptance of
proposal to install highly automatic machine.

(ii) Accept-reject decisions: The accept-reject decisions occur when proposals are independent and do
not compete with each other. The firm may accept or reject a proposal on the basis of a minimum
return on the required investment. All those proposals which give a higher return than certain desired
rate of return are accepted and the rest are rejected.
(iii)Contingent decisions: The contingent decisions are dependable proposals. The investment in one
proposal requires investment in one or more other proposals. For example, if a company accepts a
proposal to set up a factory in remote area it may have to invest in infrastructure also e.g. building of
roads, houses for employees etc.
Time value of money: One of the most fundamental concepts in finance is that money has a “time
value.” That is to say that money in hand today is worth more than money that is expected to be
received in the future. The reason is straightforward:
A rupee that you receive today can be invested in such a way that you will have more than a rupee at
some future time.
Suppose “A” win a Prize in a contest and he has got two options.
A. Receive `10,000 now
OR
B. Receive `10,000 in three years
Which option should “A” choose?

If A is a rational person he would choose to receive `10,000 now. After all, three years is a long time to
wait. Why would any rational person defer payment into the future when he or she could have the same
amount of money now? For most of us, taking the money in the present is just natural. So at the most
basic level, the time value of money demonstrates the concept of time value:
“A rupee today is worth more than a rupee tomorrow.”
The time value of money serves as the foundation for all other notions in finance. It impacts business
finance, consumer finance, and government finance. Time value of money results from the concept of
interest.
Why ` 1 received today is worth more than ` 1 received after a time period.
There are four primary reasons why a rupees to be received in the future is worth less than a rupees to
be received immediately.
1. Presence of positive rates of inflation which reduce the purchasing power of rupees through time.
Suppose rate of petrol about one year back was ` 72 per liter and now it is ` 105.49 per liter. This may
be observed that in this example purchase power of rupee in terms of petrol purchased has decreased
from 1/72 to 1/105.49.
2. A rupee today is worth more today than in the future because of the opportunity cost of lost earnings
— that is, it could have been invested and earned a return between today and a point in time in the
future.
3. Thirdly, all future values are in some sense only promises, and contain some uncertainty about their
occurrence. As a result of the risk of default or non-performance of an investment, a rupee in hand
today is worth more than an expected rupee in the future.
4. Finally, human preferences typically involve impatience, or the preference to consume goods and
services now rather than in the future.
Use of Time Value of Money: Some standard calculations based on the time value of money are:
Present Value: Present value refers to the current worth of a future sum of money or stream of cash
flows given a specified rate of return. Present Value of a cash flow is calculated on the basis of formula
as given below

PV = Cash Flow ÷ (1+r)t

Here r refers to required rate of return and t refers to the time period.
Example: Find Present Value of ` 80,000 to be received after five years when required rate of return is
10%
Present Value = 80000÷(1+0.10)5
= ` 49,674
Assume in the same example, the rate of return is 15%,
Present Value will be = 80000÷ (1+0.15) 5
= ` 39,774
The above calculation shows, higher the discount rate, the lower the present value of the future cash
flows.
Future Value of a lump sum
Future value of a lump sum refers to the value after a certain period of time at the given rate of interest.
It may be calculated by using the following formula
FVt = CF0 x (1+r)t OR FVt = PV x (1+r) t
Where FVt = Future Value after a period t
r = Rate of return
PV= Present Value
Example: Find present value of maturity value of ` 10,000 which has been given on 15% interest for
five years while required rate of return is 10%.
FV of ` 10,000 @ 15% after five years = ` 10,000 (1+0.15)5 = ` 20,113.57
Present Value of ` 20,113.57 which is to be received after 5 years = `20,113.57÷(1+0.10)5 = `
12,488.94
Present Value of a Lump Sum
Fn
PV = -------- = Fn [(1+i)-n]
(1+i)n
The term in parenthesis i.e. (1+i)-n is the discount factor or present value factor (PVF), and it is always
less than 1 for positive I, indicating that a future amount has a smaller present value. We can rewrite the
above equation as under:
Present value = Future value × Present value factor of Rs. 1
PV = Fn × PVFn,i
PVFn,I is the present value factor for n periods at i rate of interest.
Annuity: An annuity is a stream of regular periodic payment made or received for a specified period of
time. In an ordinary annuity, payments or receipts occur at the end of each period.
Future Value of an Annuity: Expressed algebraically, FVAn is defined as future (compound) value of an
annuity, R the periodic receipt (or payment), and n is the length of the annuity and the formula for FVAn
is:-
FVAn = R(I + i) n-1 + R (1+i) n-2 + …… + R(I + i) 1 + R (1+i)0
As we can see, FVAn is simply equal to the periodic receipt (R) times the “sum of the future value
interest factors at i percent for time periods 0 to n-1. As a shortcut, If R be the periodic payments, the
amount FVAn of the annuity is given by:
(1+i)n - 1
FVAn = R ------------
i
Or

FVAn = R(FVIFAi,n)
Where FVIFAi,n stands for the future interest factor of an annuity at i% for n periods. Table for FVAn at
different rates of interest may be used conveniently, if available, to work out problems.
(1+i)n - 1
The value of expression ----------- or FVIFAi,n can easily be found through financial tables.
I
Example: Find the amount of an annuity if payment of `5,000 is made annually for 7 years at interest
rate of 14% compounded annually.
Here R = ` 5,000, n = 7, i = 0.14
FVA = ` 5000 x FVIFA (7, 0.14) = 5000 X 10.7304915 = ` 53,650.25
Example: A person is required to pay four equal annual payments of Rs.5,000 each in his deposit account
that pays 8% interest per year. Find out the future value of annuity at the end of 4 years
(1 + i)n - 1
FVA = R ---------------
i
(1+0.08)4 - 1
FVA = 5,000 ----------------
0.08
= ` 5,000 (4.507) = ` 22,535
Example: ` 2,000 is invested at the end of each month in an account paying interest 6% per year
compounded monthly. What is the amount of this annuity after 10th payment? Given that (1.005)10 =
1.0511 (1+i)n - 1
We have A(n,i) = -------------- R
i
‘i’ being the interest rate (in decimal) per payment period over n payment period.
Here, i = .06/12 = .005, n = 10
Required amount is given by A = P.A (10, .005) = 2,000 x 10.22 = ` 20,440
Present Value of an Annuity: Sometimes instead of a single cash flow the cash flows of the same
amount is received for a number of years. The present value of an annuity may be expressed as follows:
Where,
PVAn =Present value of annuity which has duration of n years
R= Constant periodic flow
i=Discount rate and,

(PVIFi,n) =Present value interest factor of an (ordinary) annuity at i percent for n periods.
Example: Find out the present value of a 4 year annuity of ` 20,000 discounted at 10 per cent.
PVA = Amount of annuity × Present value (r, n) Now, i = 10%, N = 4 years
Example: Determine the present value of `7000 each paid at the end of each of the next six years.
Assume an 8 per cent of interest.
Solution
As the present value of an annuity of ` 7000 has to be computed, the present value factor of an annuity
of Re. 1 at 8 per cent for 6 years is 4.623. Therefore, the present value of an annuity of ` 7000 will be:
4.623 ×7,000 = ` 32,361
Perpetuity: Perpetuity is an annuity in which the periodic payments or receipts begin on a fixed date
and continue indefinitely or perpetually. Fixed coupon payments on permanently invested
(irredeemable) sums of money are prime examples of perpetuities.
The formula for evaluating perpetuity is relatively straight forward. Two points which are important to
understand in this regard are:
a. The value of the perpetuity is finite because receipts that are anticipated far in the future have
extremely low present value (today’s value of the future cash flows).
b. Additionally, because the principal is never repaid, there is no present value for the principal.
c. Therefore the price of perpetuity is simply the coupon amount over the appropriate discount rate or
yield.
Calculation of Multi Period Perpetuity: The formula for determining the present value of multi-period
perpetuity is as follows:
Where
R = the payment or receipt each period
i = the interest rate per payment or receipt period
Example: Uday wants to retire and receive Rs. 3,000 a month. He wants to pass this monthly payment to
future generations after his death. He can earn an interest of 8% compounded annually. How much will
he need to set aside to achieve his perpetuity goal?
Solution
R = ` 3,000
i = 0.08/12 or 0.00667
Substituting these values in the above formula, we get
PVA = ` 3,000
0.00667
= ` 4,49,775
If he wanted the payments to start today, he must increase the size of the funds to handle the first
payment. This is achieved by depositing ` 4,52,775 (PV of normal perpetuity + perpetuity received in the

beginning = (` 4,49,775 + ` 3,000) which provides the immediate payment of ` 3,000 and leaves `
4,49,775 in the fund to provide the future ` 3,000 payments.
Calculation of Growing Perpetuity: A stream of cash flows that grows at a constant rate forever is
known as growing perpetuity. The formula for determining the present value of growing perpetuity is as
follows:
Example: Assuming that the discount rate is 7% per annum, how much would you pay to receive ` 500,
growing at 5%, annually, forever?
R 500
PVA = ------ = ---------------- = `25,000/-
i–g 0.07 – 0.05
Sinking Fund: It is the fund which is created for a specified purpose by way of sequence of periodic
payments over a time period at a specified interest rate. Size of the sinking fund deposit is computed by
using the formula i.e. FVA=R[FVIFA(i,n), where FVA is the amount to be saved, R, the periodic payment, n,
the payment period.
Example: ABCL Company has issued debentures of ` 50 lakhs to be repaid after 7 years. How much
should the company invest in a sinking fund earning 12 percent per annum in order to be able to repay
debentures?
Solution
A (CVFA r, t) = 50,00,000
50,00,000 50,00,000
A = --------------- = ------------------- = `4.96 lakh
(CVFA r, t) 10.089
KINDS OF CAPITAL BUDGETING DECISIONS

Generally the business firms are confronted with three types of capital budgeting decisions (i) the
accept-reject decisions; (ii) mutually exclusive decisions; and (iii) capital rationing decisions.
(i) Accept-reject decisions: Business firm is confronted with alternative investment proposals. If the
proposal is accepted, the firm incur the investment and not otherwise. Broadly, all those investment
proposals which yield a rate of return greater than cost of capital are accepted and the others are
rejected. Under this criterion, all the independent prospects are accepted.
(ii) Mutually exclusive decisions: It includes all those projects which compete with each other in a way
that acceptance of one precludes the acceptance of other or others. Thus, some technique has to be
used for selecting the best among all and eliminates other alternatives.
(iii) Capital rationing decisions: Capital budgeting decision is a simple process in those firms where fund
is not the constraint, but in majority of the cases, firms have fixed capital budget. So large number of
projects competes for these limited budget. So the firm rations them in a manner so as to maximize the
long run returns. Thus, capital rationing refers to the situations where the firms have more acceptable
investments requiring greater amount of finance than is available with the firm. It is concerned with the
selection of a group of investment out of many investment proposals ranked in the descending order of
the rate of return

CAPITAL BUDGETING TECHNIQUES: Tools of evaluation of the project based on traditional techniques
and modern techniques:
A wide variety of techniques are used for evaluating investment proposals. The most commonly used
techniques are as follows:
Pay Back method

Traditional or Non-
discounted cash
flow techniques Average Rate of
Return (ARR)
Method
CAPITAL
BUDGETING
TECHNIQUES Net Present Value
(NPV) Method
Modern or Internal Rate of

Discounted cash Return (IRR)
flow techniques Method
Profitability Index
(PI) or Benefit cost
ratio (BC) Method
Every method is designated with some purpose in view and as such different methods are not equally
useful to every firm and under all circumstances. However, proper understanding of these techniques
will help the management to determine the most suitable technique to be used and thus make better
investment decisions keeping in view the business situation, particular requirements of the firm and
nature of investment proposals.
Traditional or Non- Discounted Cash Flow Techniques
As the name suggested, these techniques do not discount the cash flows to find out their present worth.
There are two such techniques available i.e. (i) the Payback period method, and (ii) the Accounting rate
of Return method. These are essentially rules of thumb that intuitively grapple with the trade-off
between net investment and operating cash inflows.
1. The Payback Period Method: This technique estimates the time required by the project to recover,
through cash inflows, the firm’s initial outlay. Beginning with the project with the shortest payout
period, different projects are arranged in order of time required to recapture their respective estimated
initial outlays. The payback period for each investment proposal is compared with the maximum period
acceptable to management and proposals are then ranked and selected in order of those having
minimum payout period.
While estimating net cash inflows for each investment proposal, the following considerations should be
borne in mind:
(i) Cash inflows should be estimated on incremental basis so that only the difference between cash
inflows of the firm with and without the proposed investment project is considered.
(ii) Cash inflows for a project should be estimated on an after-tax basis.

(iii) Since non-cash expenses like depreciation do not involve any cash outflows, estimated cash inflows
form a project should be adjusted for such items.
Let us consider an example. Say, a project requires `25,000 as initial investment, and it will generate an
annual cash inflow of ` 5,000 for ten years then payback period will be five years, calculated as follows:
Initial Investment 25,000
Payback period = ------------------------- = -------------- = 5 years
Annual cash inflows 5,000
The annual cash inflow is calculated by taking into account the amount of net income on account of the
asset (or project) before depreciation but after taxation. Sometimes there are projects where the cash
inflows are not uniform. In such a case cumulative cash inflows will be calculated and by interpolation
exact payback period can be calculated. For example if the projects need an initial investment of `
25,000 and the annual cash inflow for five years are ` 6,000, ` 9,000, ` 7,000, ` 6,000 and ` 4,000
respectively. The payback period will be calculated as follows:
Year Cash in flow Cumulative cash-inflow

1 6,000 6,000
2 9,000 15,000
3 7,000 22,000
4 6,000 28,000
5 4,000 32,000
It is evident form the above table that in 3 years ` 22,000 has been recovered and ` 3,000 is left of
initial investment of ` 25,000. It indicates that payback period is between 3 to 4 years calculated as
follows:
3,000
Payback period = 3 years + --------- = 3.5 years
6,000
Decision Rule for Payback Method:

Accept the project if the payback period calculated for it is less than the maximum set by the
management. Reject the project if it is otherwise. In case of multiple projects, the project with shorter
payback period will be selected. In essence, payback period shows break-even point where cash inflows
are equal to cash out flows.
Any inflows beyond this period are surplus inflows.
Advantages of Payback Period Method:
1. It is easy to understand and calculate, thus, investment proposals can be ranked quickly.
2. For a firm experiencing shortage of cash, the payback technique may be used with advantage to
select investments involving minimum time to recapture the original investment.
3. The payback period method permits the firm to determine the length of time required to
recapture through cash flows, the capital expenditure incurred on a given project and thus helps
it to determine the degree of risk involved in each investment proposal.
4. This is ideal in deciding cash investment in a foreign country with volatile dynamic political
position where a long-term projection of political stability is difficult.

5. This is, likewise, more preferred in case of industries where technological obsolescence comes
within short period; say electronic industries.
6. This method is a good indicator of liquidity. If an entrepreneur is interested to have greater
liquidity for the firm, he can choose the proposal, which will provide early cash inflows.
Disadvantages of Payback Method:

1. The payback method ignores the time value of money and treats all cash flows at par. Thus, projects A
and B with the following cash flows are treated equally:
Cash Flows
Years Project A ` Project B `
1 5,000 2,000
2 4,000 3,000
3 3,000 4,000
4 2,000 5,000
Investment 14,000 14,000
Although Pay Back period is 4 years for both the projects, project A is preferable since it recovers
larger amount of money during the initial years.
The pay back method, therefore, ignores the fact that amount of cash received today is more
important than the same amount received after say, 2 years.
2. The payback method does not consider cash flows and income that may be earned beyond the
payout period so it is not good measure of profitability. It gives misleading results.
3. Moreover, it does not take into account the salvage or residual value, if any, of the long-term
asset.
4. The payback technique ignores the cost of capital as the cut-off factor affecting selection of
investment proposals.
Suitability of using Payback Period of Method:
Payback period method may be successfully applied in the following circumstances:
i. where the firms suffers from liquidity problem and is interested in quick recovery of fund
than profitability;
ii. high external financing cost of the project;
iii. for projects involving very uncertain return; and
iv. Political and economic pressures.
It may, therefore, be said that payback period is defined as the measure of project’s liquidity and
capital recovery rather than its profitability.
1. The Average Accounting Rate of Return (ARR) Method: This method is designated to consider
the relative profitability of different capital investment proposals as the basis for ranking them –
the fact neglected by the payout period technique. Since this method uses accounting rate of
return, it is sometimes described as the financial statement method. Rate of return is calculated
by dividing earnings by capital invested. The numerator, i.e., earnings can be interpreted in a
number of ways. It might mean income after taxes and depreciation, income before taxes and
depreciation, or income after taxes but before depreciation. Since both numerator and
denominator carry different meanings. It is not surprising if one comes across a number of
variations of the average rate of return method. However, the two common variations are:

(a) Average Rate of Return in Original Investment:

Net earnings after Depreciation and Taxes
= --------------------------------------------------------- ÷ Original Investment
No. of years project will last
(b) Average Rate of Return on Average Investment:
Net earnings after Depreciation and Taxes

= --------------------------------------------------------- ÷ Average Investment
No. of years project will last
Average investment is estimated by dividing the total of original investment and investment in
the project at the end of its economic life by 2. The approach of dividing average annual after-
tax earnings of the project by its original investment makes no attempt to incorporate the fact
of gradual recovery of investment over time, hence tends to undertake the average rate of
return. The average investment approach on the other hand, gives best result when original
investment is evenly recovered over the economic life of the project which may not always be
the case.
Decision Rule for Average of Rate of Return Method:
Normally, business firm determine rate of return. So accept the proposal if
ARR > Minimum rate of return (cut off rate)
and Reject the project if
ARR < Minimum rate of return (cut off rate)
In case of more than one project, where a choice has to be made, the different projects may be
ranked in descending or ascending order of their rate of return. Project below the minimum rate
will be dropped. In case of project yielding rate of return higher than minimum rate, it is obvious
that project yielding a higher rate of return will be preferred to all.
Advantages of Average Rate of Return Method:
(i) Earnings over the entire life of the project are considered.
(ii) This method is easy to understand, simple to follow. Accounting concept of income after
taxes is known to every student of accountancy.
Disadvantages of Average Rate of Return Method:
(i) Like the payback technique, the average return on investment method also ignores the time
value of money. Consideration to distribution of earnings over time is important. It is to be
accepted that current income is more valuable than income received at a later date.
(ii) The method ignores the shrinkage of original investment through the process of charging
depreciation allowances against earnings. Even the assumption of regular recovery of capital
over time as implied in average investment approach is not well founded.
(iii) The average rate of return on original investment approach cannot be applied to a situation
where part
of the investment is to be made after the beginning of the project.
(iv) Since ARR can be calculated by using different methods, so results are not the same. Thus,
the
identification of right method to compare with cut of rate is difficult to apply.
(v) Its major limitation is that ARR is based on accounting principle and not on cash flow analysis.
Suitability of using ARR Method:

If the project life is not long, then the method can be used to have a rough assessment of the
internal rate of return. The present method is generally used as supplementary tool only.
Comparison between Average Rate of Return and Payback Method: The average rate of return
method and its comparison with payback method may be illustrated as follows:
Suppose there are two investment proposals A and B each with capital investment of ` 20,000
and depreciable life of 4 years. Assume that following are the estimated profit and cash inflows
when annual straight line depreciation charged is ` 5,000.
Period Project A Project B
Book Profits Book Profits
` Net Cash Inflows` ` Net Cash Inflows`
1 4000 9000 1000 6000
2 3000 8000 2000 7000
3 2000 7000 3000 8000
4 1000 6000 4000 9000
Total 10000 30000 10000 30000
ARR on
Original 12.50% 12.50%
investment
If evaluated in terms of average rate of return method, the two projects are equally favourable.
However, project A is more favourable than project B since it provides larger cash inflows in the
initial period (i.e. Quicker Payback).
Discounted Cash Flow (DCF) Method
The traditional techniques like the Payback period or Accounting rate of return takes no account of the
time value of the money. But money received today is much more valuable than the some money
received later. Present inflationary conditions magnify the difference. This is the principal fact that
modern analysis technique like Discounted Cash flow have incorporated to improve on the past
procedures. Under this method, the cash flow discounted at the projects discount rate to the present
time, is a present value. Analysis concentrates on the incremental cash flow of a project. Discounted
cash flow method involves following steps:
1. Computation of cash flows i.e. both inflows and out flows (preferably after tax) over the life of the
project.
2. Applying the discount factor to the cash flows.
3. Totaling discounted cash-inflows and comparing it with discounted cash outflows.
Broadly, there are three discounted cash flow methods for evaluating capital investment proposals i.e.
A. Net Present Value Method
B. Internal Rate of Return Method
C. Profitability Index or Benefit Cost (B/C) Ratio Method.
A) Discounted Payback Period: In Traditional Payback period, the time value of money is not
considered. Under discounted payback period, the expected future cash flows are discounted by
applying the appropriate rate, i.e., the cost of capital.
Illustration:
Initial Investment Rs. 1,00,000
Cost of Capital @ 12% p.a.
Expected Cash Inflows
Yr. 1 Rs. 25,000
Yr. 2 Rs. 50,000

Yr. 3 Rs. 75,000

Yr. 4 Rs. 1,00,000
Yr. 5 Rs. 1,50,000
Calculate Discounted Payback Period.
B. Net Present Value Method (NPV): The net present value method is understood to be the best
available method for evaluating the capital investment proposals. Under this method, the cash outflows
and inflows associated with each project are ascertained first. Cash inflows are worked out by adding
depreciation to profit after tax arising to each project. Since the cash outflows and inflows arise at
different point of time and cannot be compared, so both are reduced to the present values at the rate of
return acceptable to the management. The rate of return is either cost of capital of the firm or the
opportunity cost of capital to be invested in the project. The assumption under this method remain that
cash inflows are reinvested at the same discount rate. In essence, Net Present Value is the difference
between the sum total of present values of all the future cash inflows and outflows:
Algebraically:
If cash outflow is also expected to occur at some time other than initial investment (non-conventional
cash flows) then formula would be
NPV = Net Present Value

R=Cash inflow at different time period
k=Rate of discount or cost capital
t=1 = first period in the sum
n=The last period in the sum
Sn =Salvage value

Wn =Working capital
C=Cost of investment plus Working Capital
Decision Rule of using NPV Method:

If NPV > Zero : Accept the project
NPV < Zero : Reject the project
NPV = Zero : Firm is indifferent to accept or reject the project
Advantages of NPV Method:
i. Income over the entire life of the project is considered.
ii. The method takes into account time value of money.
iii. The method provides clear acceptance so interpretation is easy.
iv. When projects involves different amount of investment, the method may not provide
satisfactory answers.
v. This method considers the firm objective of wealth maximization concept for the shareholders.
Disadvantages of NPV Method:
(i) As compared with the first two methods, the present value approach is certainly more difficult to
understand and apply. It requires special skill for calculation.
(ii) An additional difficulty in this approach is encountered when projects with unequal lives are to be
evaluated.
(iii) It is difficult to determine the firm cost of capital or appropriate rate of discount.
Suitability of NPV Method: Net present value is the most suitable method in those circumstances where
availability of resources is not a constraint. The management authority can accept all those projects
having Net Present Value either Zero or positive. This method shall maximize shareholders wealth and
market value of share which is the sole aim of any business enterprise.
C. Internal Rate of Return (IRR): The internal rate of return refers to the rate which equates the present
value of cash inflows and present value of cash outflows. In other words, it is the rate at which net
present value of the investment is zero. If the Net Present Value is positive, a higher discount rate may
be used to bring it down to equalize the discount cash inflows and vice versa. That is why Internal Rate
of Return is defined as the break even financing rate for the project.
The necessary steps to be followed in applying this method are:
(i) Project the net cash benefit of an investment during the whole of its economic life. Future cash flows
should be estimated after taxes, but before depreciation and interest.
(ii) Determine the rate of discount that equates the present value of its future cash benefits to its
present investment. The rate of discount is determined by the method of trial and error.
(iii) Compare the rate of discount as determined above with the cost of capital or any other cut-off rate,
and select proposals with the highest rate of return as long as the rate is higher than the cost of capital
or cut off rate.
Assuming conventional cash flows, mathematically the Internal Rate of Return is represented by that
rate of, such that

r = the internal rate of return

CFt = cash inflows at different time periods
Sn = salvage value in period n
Wn = working capital adjustment in period n
C = cash outlays at different time periods
k = cut off rate, the rate below which a project will not be accepted, which is normally the cost of capital
n = life of the project
Decision Rule:
If Internal Rate of Return i.e.
r > k (cut off rate) Accept the investment proposal
r < k Reject the investment proposal
r = k Indifferent
In case of several investment proposals the projects may be ranked according to their Internal Rate of
Return, the project with highest Internal Rate of Return, is ranked first and so on. Acceptance of more
than one project may follow in order of priority.
Computation of Internal Rate of Return:
The computation of Internal Rate of Return is relatively complicated and difficult compared to Net
Present Value. One has to follow trial and error exercise to ascertain Internal Rate of Return (r) which
equates the cash inflows and outflows of the investment proposals. Under net present value, k is
known, but under this method it is worked out.
Initially the Internal rate of return (r) may give
NPV > 0 r > k (higher rate will be tried)
NPV = 0 r = k
NPV < 0 r < k (lower rate will be tried)
To calculate the exact figure, we use the method of interpolation i.e.

DPV = Difference in calculated present value.

Dr = Difference in rate of interest.
rH = The higher rate of discount.
Decision Rule:
If Internal Rate of Return i.e.
r > k (cut off rate) Accept the investment proposal
r < k Reject the investment proposal
r = k Indifferent
In case of several investment proposals the projects may be ranked according to their Internal Rate of
Return, the project with highest Internal Rate of Return, is ranked first and so on. Acceptance of more
than one project may follow in order of priority
Let us illustrate the method in two different situations:
(i) Uniform cash inflows
(ii) Non-uniform cash inflows.
Example: Let us consider a project where initial investment is ` 18,000. The annual cash flow will be `
5,600 for a period of 5 years. The internal rate of return can be computed by computing the factor as
under
F = I/C
where,
F = Factor to be located
I = Initial investment
C = Average cash inflow
18,000
= ---------- = 3.214
5,600
After the factor is calculated as above, it is located in the different Annuity table on the line representing
the number of years corresponding to the economic life of the project.
In above example, according to annuity table, factor closest to 3.21 for five years are 3.2 (16% discount
rate) and 3.199 (17% discount rate). Net Present Value for both the rates is as follows:
Rate of Discount 16% 17%

Total Present Value `5600x3.274 = `18,334.40 ` 5,600 x 3.199 = ` 17,914.40
Less: initial outlay ` 18,000.00 ` 18,000.00
NPV + ` 334.40 (–)` 85.60
Since Net Present Value is greater than zero i.e. ` 334.40 at 16% rate of discount, we need a higher rate
of discount to equalise Net Present Value with total outlay. On other hand, Net Present Value is less
than zero i.e. (–)` 85.60 at 17% rate of discount we need lower rate. So the above exercise shows that
internal Rate of Return lies between 16% and 17%. To find out the exact figure, the interpolation can be
used i.e.
PVCFAT = + ` 18,334.40
PVC = ` 18,000
ΔPV = ` 420
Δr = 1

`420
IRR 16 + --------- x 1 = = 16+.8
` 334
= 16.8%
Alternatively it can be worked out by using higher rate of return also.
Under uneven cash inflow, the calculation of internal rate of return is a tedious job. The process of
Internal Rate of Return can be understood with the help of following illustration i.e. Company A is
proposed to install a new machine costing ` 16,200 having an economic life of 3 years. The annual Cash
inflow shall be ` 8,000, 7,000 and 6,000 in the respective 3 years. Calculate Internal Rate of Return.
To compute internal rate of return, the trial and error method has been followed.
` 8,000 + 7,000 + 6,000
Average cash inflow = -------------------------------- = ` 7,000
3
I `16,200
F = --- = ------------- = 2.314
C `7,000
According to annuity table factor closest to 2.314 for 3 years are 2.322 (14%) and 2.246 (16%). Broad
results are given in the following table:
Cash Rate of PV (`) Rate of PV (`) Rate of PV (`)
inflow (`) Discount Discount Discount
Year (14%) (16%) (15%)
1 8,000 0.877 7,018 0.862 6,897 0.870 6,957
2 7,000 0.769 5,386 0.743 5,202 0.756 5,293
3 6,000 0.675 4,050 0.641 3,844 0.658 3,945
16,454 15,943 16,195
Less Cash Outlay 16,200 16,200 16,200
NPV 254 (257) (5)
From the above table, it is quite clear that net present value is zero with 15% rate of discount, so it is the
true internal rate of return.
Advantages of IRR Method:
i. The discounted cash flow (IRR) takes into account the time value of money.
ii. It considers cash benefits, i.e. profitability of the project for the whole of its economic life.
iii. The rate of discount at which the present value of cash flows is equated to capital outlay on a
project is shown as a percentage figure. Evidently, this method provides for uniform ranking and
quick comparison of relative efficiency of different projects.
iv. This method is considered to be a sophisticated and more reliable technique of evaluating capital
investment proposals.
v. The objective of maximizing of owner’s wealth is met.
Disadvantages of IRR Method:
i. The discounted cash flow is the most difficult of all the methods of project evaluation discussed
above.
ii. An important assumption implied in this method is that incomes are reinvested (compounding)
over the projects economic life at the rate earned by the investment. This assumption is correct
and justified only when the internal rate of return is very close to the average rate of return
earned by the company on its total investments. To the extent internal rate of return departs from
the typical rate of earnings of the company, results of this method will be misleading. Thus, when

the internal rate of return on a project is computed to be 30% while company’s average rate of
return is 15%, the assumption of earning income on income at the rate of 30% is highly unrealistic.
From this point of view the assumption of the net present value method that incomes are
reinvested at the rate of discount (cost of capital) seems to be more reasonable.
iii. The rate may be negative or one or may be multiple rates as per calculations. When a project has
a sequence of changes in sign of cash flow, there may be more than one internal rate of return.
C. Profitability Index (PI) Method
Profitability Index is defined as the rate of present value of the future cash benefits at the required rate
of return to the initial cash outflow of the investment. symbolically, Profitability Index is expressed as :
PV index of Future cash flows
Profitability = ----------------------------------------
Initial cash investment
The above ratio is an indicator of the profitability of the project. If the ratio is equal to or greater than
one, it shows that project has an expected yield equal to or greater than the discount rate. If the index is
less than one, it indicates that project has an expected yield less than the discount rate.
Decision Rule:
If PI > 1 Accept the Project, PI = 1 indifferent, PI < 1 Reject the project.
In the event of more than one alternative, projects may be ranked according to their ratio – the project
with the highest ratio should be ranked first and vice versa.
Advantages of PI Method:
(1) Profitability Index method gives due consideration to the time value of money.
(2) Profitability Index method satisfies almost all the requirements of a sound investment criterion.
(3) This method can be successfully employed to rank projects of varying cash and benefits in order of
their profitability.
(4) This method is consistent with the principle of shareholders wealth maximization.
Disadvantages of PI Method:
(1) This method is more difficult to understand and compute.
(2) This method does not take into account the size of investment.
(3) When cash outflows occur beyond the cement period Profitability Index Ratio criterion is unsuitable
as a selection criterion.
COMPARISON OF NET PRESENT VALUE AND INTERNAL RATE OF RETURN METHODS
The net present value and internal rate of return, two widely used methods are the species of the same
genus i.e. Discount cash flow method, yet they are different from each other on various points.
The broad points of difference between the two are as follows:
Points of Differences
1. Interest Rate: Under the net present value method rate of interest is assumed as the known factor
whereas it is unknown in case of internal rate of return method.
2. Reinvestment Axiom: Under both the methods, it is assumed that cash inflows can be re-invested at
the discount rate in the new projects. However, reinvestment of funds, at cut-off rate is more possible

than internal rate of return. So the net present value method is more reliable than internal rate of
return method for ranking two or more projects.
3. Objective: The net present value method took to ascertain the amount which can be invested in a
project so that its expected yields will exactly match to repay this amount with interest at the market
rate. On the other hand, internal rate of return method attempts to find out the rate of interest which is
maximum to repay the invested fund out of the cash inflows.
Problems & solutions
Payback Period
Illustration 1: Initial Investment = Rs. 1,00,000
Expected future cash inflows Rs. 20,000, Rs. 40,000, Rs. 60,000, Rs. 70,000
Solution
Calculation of Pay Back period
Year Cash Inflows (Rs.) Cumulative Cash Inflows (Rs.)
1 20,000 20,000
2 40,000 60,000
3 60,000 120,000
4 70,000 190,000
The initial investment is recovered between the 2nd and the 3rd year.
Balance of Unrecovered Initial Investment
∴ Payback Period = 2 years + -------------------------------------------------------- x 12
Cash Inflows during the year
Initial Investment - Cumulative

Cash Inflows at the end of 2nd year 1,00,000 – 60,000
= 2 years+ ---------------------------------------------- x 12 = 2years+ ----------------------x 12 =
Cash Inflows in the 3rd year 60,000
40,000
= 2 years + ----------- x 12 = 2 years 8 months
60,000
Illustration 2: Victory Ltd. decided to purchase a machine to increase the installed capacity. The
company has four machines under consideration. The relevant details including estimated yearly
expenditure and sales are given below. All sales are for cash. Corporate Tax Rate @ 33.99% (inclusive of
Surcharge @ 10%, Deduction cess @ 2% and Secondary & Higher Education cess @ 1%)
Particulars M1 M2 M3 M4
Initial Investment (Rs. lacs) 30.00 30.00 40.00 35.00
Estimated Annual Sales (Rs. lacs) 50.00 40.00 45.00 48.00
Cost of Production (Estd) (Rs. lacs) 18.00 14.00 16.70 21.00
Economic Life (yrs) 2 3 3 4
Scrap Values (Rs. lacs) 4.00 2.50 3.00 5.00
Calculate Payback Period

Solution: Statement Showing Payback for four machines
Particulars M1 M2 M3 M4
(1) Initial Investment (Rs. lacs) 30.00 30.00 40.00 35.00
(2) Estd. Annual Sales (Rs. Lacs) 50.00 40.00 45.00 48.00
(3) Estd. Cost of Production (Rs. lacs) 18.00 14.00 16.70 21.00
(4) Depreciation (Rs. lacs) 13.00 9.17 12.33 7.50

(5) Profit Before Tax (PBT) [2–3–4] 19.00 16.83 15.97 19.50
(6) Tax @ 33.99% (Rs. lacs) 6.4581 5.721 5.428 6.628
(7) Profit After Tax (PAT) [5–6] (Rs. lacs) 12.5419 11.109 10.542 12.872
(8) Net Cash Flow [7+4] 25.5419 20.279 22.872 20.372
M1 M2 M3 M4
Payback Period (Years) 30.00 30.00 40.00 35.00

25.5419 20.279 22.872 20.372
Initial Investment
------------------------ = 1.17 = 1.48 = 1.75 = 1.72
Net Annual Cash Flow
Analysis: Machine 1 is more profitable, as it has the lowest payback period.
ARR
Illustration3. A project costing Rs. 10 lacs. EBITD (Earnings before Depreciation, Interest and Taxes)
during the first five years is expected to be Rs. 2,50,000; Rs. 3,00,000; Rs. 3,50,000; Rs. 4,00,000 and Rs.
5,00,000. Assume 33.99% tax and 30% depreciation on WDV Method.
Computation of Project ARR
Particulars Year 1 Year 2 Year 3 Year 4 Year 5 Average
EBITD 250,000 300,000 350,000 400,000 500,000 360,000

Less Depreciation 30% of 10 L 300,000 210,000 147,000 102,900 72,030 166,386
EBIT (50,000) 90,000 203,000 297,100 427,970 193,614
Less Set off previous year loss (50,000)
40,000
Less Tax 33.99% - 13,596 69,000 100,984 145,467 65,809
EAT (50,000) 76,404 134,000 196,116 282,503 127,805
Book Value of Investment

Beginning 1,000,000 700,000 490,000 343,000 240,100
Less Depreciation 30% WDV 300,000 210,000 147,000 102,900 72,030
End 700,000 490,000 343,000 240,100 168,070
Average 850,000 595,000 416,500 291,550 204,085 471,427
Average EBIT (1 - t) 127,805
ARR = --------------------------- x 100 = ----------------------- x100 = 27.11%
Average Investment 421,427
Note : Unabsorbed depreciation of Yr. 1 is carried forward and set-off against profits of Yr. 2. Tax is
calculated on the balance of profits
= 33.99% (90,000 – 50,000)
= 13,596/

Illustration 4: Z Ltd. has two projects under consideration A & B, each costing Rs. 60 lacs. The projects
are mutually exclusive. Life for project A is 4 years & project B is 3 years. Salvage value NIL for both the
projects. Tax Rate 33.99%. Cost of Capital is 15%.
Net Cash Inflow (Rs. Lakhs)
At the end of the year Project A Project B P.V. @ 15%
1 60 100 0.870
2 110 130 0.756
3 120 50 0.685
4 50 — 0.572
Solution :
Computation of Net Present Value of the Projects
(Rs. Lakhs)
Project A
Particulars Year 1 Year 2 Year 3 Year 4
1. Net Cash flow 60.00 110.00 120.00 50.00
2. Depreciation 15.00 15.00 15.00 15.00
3. PBT (1-2) 45.00 95.00 105.00 35.00
4. Less Tax 33.99% 15.30 32.29 35.69 11.90
5. PAT (3-4) 29.70 62.71 69.31 23.10
6. Net Cash Flow (PAT+DEP) 44.70 77.71 84.31 38.10
7. Discounting Factor 0.870 0.756 0.685 0.572
8. PV of Net Cash flow (6x7) 38.89 58.75 57.75 21.80
9. Total P.V. of Net Cash flow 177.19
PV of Cash Outflow 60.00
Net Present Value 117.19
(Rs. Lakhs)
Project B
Particulars Year 1 Year 2 Year 3
1. Net Cash flow 100.00 130.00 50.00
2. Depreciation 20.00 20.00 20.00
3. PBT (1-2) 80.00 110.00 30.00
4. Less Tax 33.99% 27.19 37.39 10.20
5. PAT (3-4) 52.81 72.61 19.80
6. Net Cash Flow (PAT+DEP) 72.81 92.61 39.80
7. Discounting Factor 0.870 0.756 0.685
8. PV of Net Cash flow (6x7) 63.343 70.014 27.265
9. Total P.V. of Net Cash flow 160.622
PV of Cash Outflow 60.00
Net Present Value 100.622
Comment: As Project “A” has a higher Net Present Value, it has to be taken up.

Illustration 5: Zenith Industrial Ltd., are thinking of investing in a project costing Rs. 20 lakhs. The life of
the project is five years and the estimated salvage value of the project is zero. Straight line method of
charging depreciation is followed. The tax rate is 50%. The expected cash flows before tax are as follows:
Year 1 2 3 4 5
Estimated Cash flow before depreciation and tax (Rs. lakhs) 4 6 8 8 10
You are required to determine the : (i) Payback Period for the investment, (ii) Average Rate of Return on
the investment, (iii) Net Present Value at 10% Cost of Capital, (iv) Benefit-Cost Ratio.
Solution:
Calculation of Annual Cash Inflow after Tax
(Rs. lakhs)
Year 1 2 3 4 5
Estimated Cash flow before
4.00 6.00 8.00 8.00 10.00
depreciation and tax (Rs. lakhs)
Less Depreciation 4.00 4.00 4.00 4.00 4.00
EBT - 2.00 4.00 4.00 6.00
Less Tax - 1.00 2.00 2.00 3.00
EAT - 1.00 2.00 2.00 3.00
Add Depreciation 4.00 4.00 4.00 4.00 4.00
Cash inflow after tax 4.00 5.00 6.00 6.00 7.00
(i) Pay Back Period : Rs. In lakhs

Year Cash inflow after tax Cumulative cash inflow after tax
1 4.00 4.00
2 5.00 9.00
3 6.00 15.00
4 6.00 21.00
5 7.00 28.00
Rs. 5 lakhs
Pay Back Period = 3 years+ -------------- x 12 months = 3 years 10 months
Rs. 6 lakhs
(ii) Average Rate of Return:
Average return(EAT) = [ 0+ 1+2+2+3]/5 = 8/5 = 1.60

Average Investment = 20.00/2 = 10 lakhs
Average Return 1.60
ARR = -----------------------x 100 = --------- x 100 = 16%
Average Investment 10
(iii) Net Present Value at 10% Cost of Capital
Rs. In lakhs
Year Cash inflow after tax Discount Factor @10% Present Value
1 4.00 0.909 3.636

2 5.00 0.826 4.132

3 6.00 0.751 4.508
4 6.00 0.683 4.098
5 7.00 0.621 4.346
P. V. of Cash inflows 20.721
Less Initial Investment 20.000
NPV 0.721
P. V. of cash inflow 20.721
(iv) Benefit-Cost Ratio = ------------------------- = --------- = 1.036
P.V. of cash outflow 20.000
Illustration 6 : The relevant information for two alternative systems of internal transportation are given
below :
(Rs. Million)
Particulars System 1 System 2
Initial investment 6 4
Annual operating costs 1 0.9
Life 6 years 4 years
Salvage value at the end 2 1.5
Which system would you prefer if the cost of capital is 6%? Justify your recommendation with
appropriate analysis.
[Present value of annuity at 6% for 6 years = 4.917 and for 4 years = 3.465. Present value of
Rs. 1.00 at 6% at the end of 6the year 0.705 and that at the end of 4th year 0.792].
Solution:
P.V. of Costs of Internal Transportation - System 1 (Rs. Million)
Initial investment (6×1.000) 6.000
Add : Annual operating cost (1×4.917) 4.917
10.917
Less : Salvage value at the end of 6 years (2×0.705) 1.410
P.V. cash outflow 9.507
P.V. of Costs of Internal Transportation - System 2 (Rs. Million)

Initial investment (4×1.000) 4.0000
Add : Annual operating cost (0.9×3.465) 3.1185
7.1185
Less : Salvage value at the end of 4 years (1.5×0.792) 1.188
P.V. cash outflow 5.9305

Equivalent Annual Cost

9.507 5.9305
System 1 = --------- = Rs. 1.93 million; System 2 = ---------- = Rs. 1.71 million
4.917 3.465
Analysis: The equivalent annual cost of System 2 is less than System 1. Hence, System 2 is suggested to
take-up.
Illustration 7: A company is considering which of two mutually exclusive projects is should undertake.
The Finance Director thinks that the project with the higher NPV should be chosen whereas the
Managing Director thinks that the one with the higher IRR should be undertaken especially as both
projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10%
and the net after-tax cash flows of the projects are as follows:
Year 0 1 2 3 4 5
Cash Flows :
Project X (200) 35 80 90 75 20
Project Y (200) 218 10 10 4 3
Required:
(a) Calculate the NPV and IRR of each project.
(b) Sate, with reasons, which project you would recommend.
(c) Explain the inconsistency in the ranking of the two projects.
The discount factors are as follows:

Year 0 1 2 3 4 5
Discount Factors: (10%) 1 0.91 0.83 0.75 0.68 0.62
Discount Factors: (20%) 1 0.83 0.69 0.58 0.48 0.41
Solution:
(a) Calculation of the NPV and IRR of each Project
NPV of Project X
Cash Discount Factors @ Discounted Discount Factors @ Discounted
Year Flows 10% Values 20% Values
0 (200.00) 1.00 (200.00) 1.00 (200.00)
1 35.00 0.91 31.85 0.83 29.05
2 80.00 0.83 66.40 0.69 55.20
3 90.00 0.75 67.50 0.58 52.20
4 75.00 0.68 51.00 0.48 36.00

5 20.00 0.62 12.40 0.41 8.20

NPV 29.15 (19.35)
IRR of Project X
At 20% NPV is – 19.35
At 10% NPV is + 29.15
29.15 29.15
IRR = 0.10+ ------------ x 0.10 = 0.10 + ---------- x0.10 = .1601 or 16.01%
29.15+19.35 48.50
NPV of Project Y
Cash Discount Factors @ Discounted Discount Factors @ Discounted

Year Flows 10% Values 20% Values
0 (200.00) 1.00 (200.00) 1.00 (200.00)
1 218.00 0.91 198.38 0.83 180.94
2 10.00 0.83 8.30 0.69 6.90
3 10.00 0.75 7.50 0.58 5.80
4 4.00 0.68 2.72 0.48 1.92
5 3.00 0.62 1.86 0.41 1.23
NPV 18.76 (3.21)
At 20% NPV is – 3.21
At 10% NPV is + 18.76
IRR of Project Y
At 20% NPV is – 03.21
At 10% NPV is + 18.76
18.76 18.76
IRR = 0.10+ ------------ x 0.10 = 0.10 + ---------- x0.10 = .1854 or 18.54%
18.76+3.21 21.97
(b) Both the projects are acceptable because they generate the positive NPV at the company’s cost of
Capital at 10%. However, the Company will have to select Project X because it has a higher NPV. If the
company follows IRR method, then Project Y should be selected because of higher internal rate of return
(IRR). But when NPV and IRR give contradictory results, a project with higher NPV is generally preferred
because of higher return in absolute terms. Hence, Project X should be selected.
(c) The inconsistency in the ranking of the projects arises because of the difference in the pattern of cash
flows. Project X’s major cash flows occur mainly in the middle three years, whereas Y generates the
major cash flows in the first itself.
Illustration 8: Projects X and Y are analyzed and you have determined the following parameters. Advice
the investor on the choice of a project:
Particulars Project X Project Y
Invest Rs. 7 cr. Rs. 5 cr.
Project life 8 years 10 years
Construction period 3 years 3 years
Cost of capital 15% 18%
N.P.V. @ 12% Rs. 3,700 Rs. 4,565
N.P.V. @ 18% Rs. 325 Rs. 325

I.R.R. 45% 32%

Rate of return 18% 25%
Payback 4 years 6 years
B.E.P. 45% 30%
Profitability index 1.76 1.35
Solution:
Relative Ranking of Project X and Project Y
Particulars Rank
Project X Project Y
IRR I II
Rate of return II I
Pay back I II
Profitability index I II
NPV @ 12% II I
NPV @ 18% Equal Equal
B.E.P. II I
Cost of Capital I II
Analysis: The major criterion i.e., IRR, Pay back and Profitability Index in which Project X is ranking first
and hence it could be selected.
Illustration 9: A company is contemplating to purchase a machine. Two machine A and B are available,
each costing Rs. 5 lakhs. In comparing the profitability of the machines, a discounting rate of 10% is to
be used and machine is to be written off in five years by straight line method of depreciation with nil
residual value. Cash inflows after tax are expected as follows:
(Rs. in lakhs)
Year Machine A Machine B
1 1.5 0.5
2 2.0 1.5
3 2.5 2.0
4 1.5 3.0
5 1.0 2.0
Indicate which machine would be profitable using the following methods of ranking investment
proposals :
(i) Pay back method: (ii) Net present value method; (iii) Profitability index method; and (iv) Average rate
of return method.
The discounting factors at 10% are—

Year 1 2 3 4 5
Discount factors 0.909 0.826 0.751 0.683 0.621
Solution :
(i) Payback Period (PB) =
Machine A Machine B
Cash Inflows Cumulative Cash Inflows Cash Inflows Cumulative Cash Inflows
Year
(Rs.) (Rs.) (Rs.) (Rs.)
1 1.50 1.50 0.50 0.50
2 2.00 3.50 1.50 2.00
3 2.50 6.00 2.00 4.00
4 1.50 7.50 3.00 7.00
5 1.00 8.50 2.00 9.00
Machine A
Initial Investment - Cumulative
Cash Inflows at the end of 2nd year 5,00,000 – 3,50,000
= 2 years+ ---------------------------------------------- x 12 = 2years+ ----------------------x 12 = 2.72 years
Cash Inflows in the 3rd year 2,50,000
5,00,000 – 4,00,000
Machine B = 3 years + -------------------------- x 12 = 3 years 4 months
3,00,000
Rank : Machine-A-I, Machine-B-II; Machine A is more profitable.
(ii) Calculation of Net Present Value of cash inflows for Machine A & Machine B.
Year Cash Inflows Discount P. V. of cash inflows
Machine A Machine B Factor @10% Machine A Machine B
1 1.50 0.50 0.909 1.36 0.45
2 2.00 1.50 0.826 1.65 1.24
3 2.50 2.00 0.751 1.88 1.50
4 1.50 3.00 0.683 1.02 2.05
5 1.00 2.00 0.621 0.62 1.24
Total PV 6.54 6.49
Initial Investment 5.00 5.00
Net Present Value 1.54 1.49
Rank: Machine-A - I, Machine-B - II
Since Machine A has greater NPV compared to Machine B, Machine A is more profitable.
(iii) Calculation of Profitability Index

(Rs. lakhs)

Machine A Machine B
Present value of Cash Inflows 6.53 6.48
Profitability Index = -------------------------------------------- ------- = 1.306 ------- = 1.296
Present value of Cash Outflows 5.00 5.00
Rank I II
Machine A is more profitable.

Average annual earnings
(iv) Calculation of Average Rate of Return = ------------------------------------x 100
Initial cost
Year Cash Inflows
Machine A Machine B
1 1.50 0.50
2 2.00 1.50
3 2.50 2.00
4 1.50 3.00
5 1.00 2.00
Total 8.50 9.00
Less : Depreciation for 5 years 5.00 5.00
Net earnings after tax and depreciation 3.50 4.00
Life of machine (yrs.) 5 5
Average earnings per year (a) 0.70 0.80
Initial cost (b) 5.00 5.00
ARR (a÷b) x100 14.00% 16.00%
Rank II I
Machine B is more profitable


Unit 5 Capital Budgeting (SPPU Uni Sub Prof Notes)

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Unit 5 Capital Budgeting (SPPU Uni Sub Prof Notes)

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202 Financial Management

PURPOSE OF CAPITAL BUDGTETING

Asst. Prof. Prakash Kankure Page 1

Asst. Prof. Prakash Kankure Page 2

TYPES OF CAPITAL INVESTMENT DECISIONS

On the basis of firm’s

On the basis of decision

Asst. Prof. Prakash Kankure Page 3

Which option should “A” choose?

Asst. Prof. Prakash Kankure Page 4

PV = Cash Flow ÷ (1+r)t

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Asst. Prof. Prakash Kankure Page 6

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KINDS OF CAPITAL BUDGETING DECISIONS

Asst. Prof. Prakash Kankure Page 8

Pay Back method

Modern or Internal Rate of

Asst. Prof. Prakash Kankure Page 9

Year Cash in flow Cumulative cash-inflow

Decision Rule for Payback Method:

Asst. Prof. Prakash Kankure Page 10

Disadvantages of Payback Method:

Asst. Prof. Prakash Kankure Page 11

(a) Average Rate of Return in Original Investment:

(b) Average Rate of Return on Average Investment:

Net earnings after Depreciation and Taxes

Asst. Prof. Prakash Kankure Page 12

Asst. Prof. Prakash Kankure Page 13

Yr. 3 Rs. 75,000

NPV = Net Present Value

Asst. Prof. Prakash Kankure Page 14

Decision Rule of using NPV Method:

Asst. Prof. Prakash Kankure Page 15

r = the internal rate of return

Asst. Prof. Prakash Kankure Page 16

DPV = Difference in calculated present value.

Rate of Discount 16% 17%

Asst. Prof. Prakash Kankure Page 17

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Asst. Prof. Prakash Kankure Page 19

Initial Investment - Cumulative

Calculate Payback Period

(4) Depreciation (Rs. lacs) 13.00 9.17 12.33 7.50

Payback Period (Years) 30.00 30.00 40.00 35.00

Analysis: Machine 1 is more profitable, as it has the lowest payback period.

EBITD 250,000 300,000 350,000 400,000 500,000 360,000

Book Value of Investment

Asst. Prof. Prakash Kankure Page 21

Asst. Prof. Prakash Kankure Page 22

Estimated Cash flow before depreciation and tax (Rs. lakhs) 4 6 8 8 10

(i) Pay Back Period : Rs. In lakhs

Average return(EAT) = [ 0+ 1+2+2+3]/5 = 8/5 = 1.60

Asst. Prof. Prakash Kankure Page 23

2 5.00 0.826 4.132

Add : Annual operating cost (1×4.917) 4.917

Less : Salvage value at the end of 6 years (2×0.705) 1.410

P.V. cash outflow 9.507

P.V. of Costs of Internal Transportation - System 2 (Rs. Million)

Add : Annual operating cost (0.9×3.465) 3.1185

Less : Salvage value at the end of 4 years (1.5×0.792) 1.188

P.V. cash outflow 5.9305

Asst. Prof. Prakash Kankure Page 24