MCCOM2005C04

Financial decision making

Prepared &presented
By
Dr Subramanian Shanmugam
Associate Professor, Dept. of
Commerce&BS,CUSB
UNIT -1 INVESTMENT DECISIONS

• Nature and significance of Capital Budgeting Decisions

• Process of capital budgeting
• Methods of project Evaluation
• Determing cash flows in a single proposal and in
replacement situations
• Selection of investment proposal using an evaluation
methods.
 CAPITAL BUDGETING
• Project involves large capital outlays and treated as capital
investment or capital budgeting decisions. It is incurred
for acquiring or improving fixed assets the benefits of
which are expected to be received over a number of years
in future. Financial analyst treat projects as capital
investment . These involve very substantial, large financial
outlays with long-term effects.
• Capital expenditure decisions full of uncertainty and risk
associated with long term permanent commitment funds.
Capital Budgeting
• Capital Budgeting is the process of making investment decision regarding
capital expenditure. A capital expenditure is an expenditure incured for
acquiring or improving the fixed assets, the benefits of which are expected to
be received over the number of years in future. Capital expenditutre involves
non-flexible long term committement of funds. Capital budgeting is also known
as long term planning for investment decisions.
• Charles T. Horngreen has defined capital budgeting as, “ a long term planning
for making and financing proposed capital outlays”. The technique are
available to analyze risk and return levels, using a number of methods.
• M. H.Spencer, “ Capital budgeing involves the planning of expenditure for
assets, the returns from which will be realised from the future period of time”.
Capital budgeting correlates the planning of available financial resource and their
long term investment with a view to maximise the profitability of the firm.
Nature and importance of capital Budgeting
• Capital expenditure decisions full of uncertainty and risk associated with
long term permanent commitment funds. Financial analyst treat projects
as capital investment .
• The importance of capital budgeting needs special care in making
decisions on account of the following reasons.
• Heavy investment
• Permanent commitment of funds
• Long term effect on profitability
• Irreversible in nature
• Different degree of Risk
• Wealth maximization to Shareholders
• Most difficult to make.
Objectives of Capital budgeting
• Capital expenditures are huge and have a long-term effect. Therefore, while
performing a capital budgeting analysis an organization must keep the following
objectives in mind:
1. Selecting profitable projects: An organization comes across various
profitable projects frequently. But due to capital restrictions, an organization needs to
select the right mix of profitable projects that will increase its shareholders’ wealth.
2. Capital expenditure control: Selecting the most profitable investment
is the main objective of capital budgeting. However, controlling capital costs is also an
important objective. Forecasting capital expenditure requirements and budgeting for it,
and ensuring no investment opportunities are lost is the crux of budgeting.
3. Finding the right sources for funds: Determining the quantum of
funds and the sources for procuring them is another important objective of capital
budgeting. Finding the balance between the cost of borrowing and returns on investment
is an important goal of Capital Budgeting.
 TYPES OF CAPITAL INVESTMENTS
1. Physical assets are tangible investments like land,
building, plant, machinery, vehicles and computer etc.,
2.Monetary assets are financial claims against some parties
like deposits, bonds, and equity share.
3.Intangible assets are not in the form of physical assets or
financial claims. They represent outlays on research and
development, training, market development.
 PROCSS OF CAPITAL BUDGETING

• Capital Budgeting is the technique of making decisions for investment

in long-term proposals. It is the complex process. Deciding whether or
not invest funds in a particular project proposal.
• It is a process of deciding whether or not to invest the funds in a
particular proposal, the benefit of which will be available over a
period of time longer than one year.
Capital budgeting process
***
1. Identifying investment opportunities
An organization needs to first identify an investment opportunity. An investment
opportunity can be anything from a new business line to product expansion to
purchasing a new asset. For example, a company finds two new products that they can
add to their product line.
2. Evaluating investment proposals
Once an investment opportunity has been recognized an organization needs to evaluate
its options for investment. That is to say, once it is decided that new product/products
should be added to the product line, the next step would be deciding on how to acquire
these products.
There might be multiple ways of acquiring them. Some of these products could be:
Manufactured In-house
Manufactured by Outsourcing manufacturing the process, or Purchased from the
market
***
3. Choosing a profitable investment:
Once the investment opportunities are identified and all proposals are evaluated
an organization needs to decide the most profitable investment and select it. While
selecting a particular project an organization may have to use the technique of capital
rationing to rank the projects as per returns and select the best option available.
• In an example, the company here has to decide what is more profitable for them.
Manufacturing or purchasing one or both of the products or scrapping the idea of
acquiring both.
4. Capital Budgeting and Apportionment
• After the project is selected an organization needs to fund this project. To fund the
project it needs to identify the sources of funds and allocate it accordingly.
• The sources of these funds could be reserves, investments, loans or any other
available channel.
***
5. Performance Review/post -completion audit:
The last step in the process of capital budgeting is reviewing the
investment. Initially, the organization had selected a particular
investment for a predicted return. So now, they will compare the
investments expected performance to the actual performance.
In our example, when the screening for the most profitable investment
happened, an expected return would have been worked out. Once the
investment is made, the products are released in the market, the profits
earned from its sales should be compared to the set expected returns.
This will help in the performance review.
SELECTION OF A PROJECT
• Choice of a project is a capital budgeting exercise aimed at
increasing the shareholder’s wealth.
• Different firms may use different methods for evaluating the
project proposals. While evaluating, two basic principles are kept
in view namely, the bigger the benefits are always preferable to
small ones and that early benefits are always better than the
deferred ones.
METHODS OR CRITERIA FOR CAPITAL BUDGETING

Before selection of a project the following methods are usually

followed for evaluation of capital investment decisions are:
I. Non-Discounted cash flow methods
a. Pay back period method,
b. Accounting rate of return method,
II. Discounted cash flow methods:
a.Net Present Value, b. Exces Present value Index method, and
c.Internal Rate Return.
a. Pay Back period method
The number of years required to recover the initial cash outlay
invested in the project.
Initial investment
PBP = Annual cash flows
If the annual cash flows are uniform, the pay back period can
be computed by dividing cash outlays (original investment).
annual cash inflows.
The annual Cash flows = Net income before depreciation but
after taxation.
i.e Net Profit after tax+ Depreciation
i) If the uniform annual cash inflows
Excercise 1 : A project requires Rs 20,000 as initial investment that
will be generate a cash inflow of Rs. 5,000 for 10 yeras.
Calculate pay back period.
PBP= Initial investment/ Annual cashflowsX100
= 20,000/5,000= 4 years
Exercise: 2
a. A project requires Rs 60,000 as initial Investment that will be
generate a cash inflow of Rs 10,000 for 10 years
= 60,000/10,000
= 6 years
b. A project require Rs 1,00,000 and yield an annual cash inflows
of Rs. 20,000 for 7 years. Calculate pay back period.

= 1,00,000/20,000
= 5years.
 ii) If annual cash inflows are not uniform

If cash flows are not uniform, the pay back period takes
cumulative form.
In this case, pay back period can be found out by adding
up the figure of net cash inflows until the total is equal to
the initial investment.
Excercies 3:
A project requires an initial investment of Rs 20,000 and annual cash inflows
for 5 years are Rs 8,000 Rs 7,000 Rs 5,000 Rs 6,000 and Rs 4,000 respectively.
Calculate pay back period.
Year Cash inflows (Rs) cumulative cash Inflows
1 8,000 -
2 7,000 15,000
3 5,000 20,000
4 6,000 26,000
5 4,000 30,000
Pay Back Period is 3 years.
But if there are two projects, the project which has a shorter pay back period
will be chosen.
Exercise 4:
• Calculate pay back period for a project whcih requires a cash outlays
of Rs 10,000 and generates cash inflows of Rs 2,000,Rs.4000,
Rs 3,000 Rs 2,000 in the first, second, third and fourth year
respectively.
Solution
year Cash inflows cumulative CF
1 2,000 2,000
2 4,000 6,000
3 3,000 9,000
4 2,000 11,000

Cash flows for 3 years = 9,000

Time required for revovery of remaining Rs 1000:
= 12/2000 X1000=6 months
Pay back period = 3 years & 6 Months.
Excersice 5: A project requires Rs 5,00,000 and yields annuallly a profit of Rs
80,000( after depreciation at 12% p.a) but before tax of 50%.
Calculate pay back period
• Pay back period = Initial Investment/ Annual Cash inflow
= Initial investment=Rs 5,00,000
Annual cash inflows= Profit after tax plus depreciation
Rs
Profit before tax 80,000
Less Tax @50% 40,000
Profit after tax 40,000
Add Depreciation (Rs 5,00,000X12%) 60,000
Annual cash inflows 1,00,000
Pay back period =Initial investment/Annual cash Flow
= 5,00,000/1,00,00=5 years
Exercise 6
There are two projects A&B .The cost of the project is Rs 30,000 in
each case.
The cash inflows are as under:
Year Cash inflows(Rs)
Project A Project B
1 10,000 2,000
2 10,000 4,000
3 10,000 24,000
Calculate pay back period.
Solution
• Year Project A Project B
Cashinflows Cum. CF Cashinflows Cum.CF
1 10,000 10,000 2,000 2,000
2 10,000 20,000 4,000 6,000
3 10,000 30,000 24,000 30,000
The pay back period is 3 years in both cases.
However, Project A is better compared to project B because cash
inflows are greater in the initial years.
Excercise 7
• Calculate Pay back period of Ram &Co is considering three
alternatives items of a plant. Estimated cashinflows are:
Year Plant A Plant B Plant C

0 (Initial Investment) 20,000 20,000 40,000

1 6,000 12,000 -

2 6,000 14,000 15,000

3 6,000 14,000 15,000

4 to 10 6,000(p.a) - 12,000(p.a)
Pay back period
Project A(plant-A): Cash flows are uniform:
Pay back period = Initial investment/Annual cash inflow
=20,000/6,000= 3 yr& 4 months
Project B&C(plant B&C) : Cash inflows are not uniform.Hence
cumulative. Cashflows are to be considered for finding out the pay back
period.
year Project B Project C
Cash inflows Cum.CF Cash Inflows Cum.CF

1 12,000 12,000 - -
2 14,000 26,000 15,000 15,000
3 14,000 40,000 15,000 30,000
4 - 40,000 12,000 42,000
***
For project B:Investment is Rs 20,000
Rs 12,000 is recovered in the first year.The remaining Rs 8000 is to be recovered in
the second year.
For recovery of Rs 14,000 time is required =12 months , for recovery of Rs 8,000
time required =12/14,000X 8000= 6.85 months i.e 7 months
Pay back period of Project B=1 year 7 months.
For Project C: Investment is Rs 40,000.
For recovery of Rs 30,000 is recovered in 3 years.The remaining Rs 10,000 is to be
recovered in the fourth year.
for recovery of Rs12,000=12 month, Remaining Rs 10,000 time is required :
12/12,000X10000=10 months
Pay back period of Project C =3 years and 10 months.
Plant B is shoter pay back period which is preferable tan others.
Exercise 8
• An organization has a cut off pay back period of 3 years and 6 months.
Advise the company with regard to the following exclusive projects
project Total Invest(Rs) Annual CF(Rs) Period of Inflow(yr)
A 50,000 15,000 4
B 80,000 24,000 5
C 80,000 20,000 6
D 40,000 12,000 5
E 10,000 1800 7
Solution
Note: Cash inflows of ech projects are uniform
Pay back period = Initial investment/Annual cash Inflows
A=50,000/15,000 = 3Y 4M
B=80,000/24,000 =3Y4M
C=80,000/20,000 =4Y
D=40,000/12,000 =3Y4M
E=10,000/1800 =5Y7M
ADVISE OF THE COMPANY:
The cut off pay back period is 3 years and 6 months.
Project A,B &D may be considered as they have a shorter pay-back period of 3years and 4
months. but Of these D& B are better as post -pay back cash inflows is available for 1 year and 8
months (5-3y&4m) But in case of A, post pay back cash inflow is available only for 8 months
(4y- 3y&4m).
Excercise 8
A company proposed to expand its production can go in either for an
automatic machine costing Rs 2,24,000 with an estimated life of 5 and
half years or an ordinary machine costing Rs 60,000 having an estimated
life of 8 years. The annual sales and costs are estimated as follows:
Automatic machine(Rs) Ordinary machine(Rs)
Sales 1,50,000 1,50,000
Costs:
Maerial 50,000 50,000
Labour 12,000 60,000
Variable OH 24,000 20,000
Compute the comparative profitability of the proposals under pay- back
period Method. Ignore Taxation.
Solution
Annual cash inflows i.e Profit= Sale - Cost
Profitability statement
Automatic Machine(Rs) Ordinary Machine(Rs)
Cost of the Machine 2,24,000 60,000
Sales 1,50,000 1,50,000
Less Costs: (maerial,Labour,OH) 86,000 1,30,000
Annual Cash inflows 64,000 20,000
Pay back period = 2,24,000/64,000=3&Half yr 60,000/20,000= 3 years
Profitability beyond pay back:
Automatic machine = 64,000 X 2 (5y&6M - 3y&6m) =Rs 1,28,000
Ordinary machine = 20,000 X 5 ( 8y- 3y) =Rs. 1,00,000
Comments: From the view point of pay back period alone, ordinary machine having a shorter PBP
should be recommeded. But if we consider the full serviceable life of the asset, automatic machine is
preferable becauses it gives a surplus of Rs 1,28,000 in 5&Half years while the ordinary machine gives
a surplus of only Rs. 1,00,000 in 8 yeras.
Exercise 9
A Ltd is producing articles mostly by manual labour and is considering to replace it
by a new machine. There are two alternatives models X and Y of the new machine.
Prepare a statement of profitability showing the pay back period from the following
information.
Machines
X Y
Estimated life of machine 4 years 5 years
Cost of machine Rs. 9,000 18,000
Estimated saving in scrap Rs. 500 Rs. 800
Estimated saving in Direct wages Rs. 6,000 Rs. 8,000
Addtional cost of maintenance Rs. 800 Rs 1,000
Addtional cost of Supervision Rs. 1,200 Rs.1,800
Ignore taxation.
Solution: profitability statement
Particulars Machine X Machine Y
Estimated saving in scrap 500 800
estimated saving in direct wages 6,000 8000
Total Saving 6,5000 8,800
Addtional cost of Maintenence 800 1000
Addtional cost of supervision 1200 1800
Net cash inflow(saving -Cost) 4500 6000

Pay back period 9000/4500= 2y 18,000/6,000=3 y

=original invets/annual Cash
Inflows
Machine X should be referred because it has a shorter pay
back period
 Merits of pay back period

The pay back period has the following merits:

1. It is easy to calculate and simple to understand
2. It is preferred by excutives who like quick answer for selection of the proposal.
3. It si useful where the business is suffering from shortage of funds as quick
recovery is essential for repayment.
4. It is useful for industries subject to uncertainty,instability or repid technological
changes.
5. It is useful where profitability is not important.
 Demerits

This method has the following demerits:

1. This method is delicate and rigid. Aslight change in the operation
cost will affect the cash inflows and the pay back period.
2. It does not take into account the life of the
project,depreciation,scrap value,interest factor etc.
3 It completely ignores cash inflows after the pay back period.
4 The probability of the project is completely ignored.
5. It gives more importance to liquidity as a goal of capital
expenditure decisions which is not justifiable.
6. It ignore time value of money, Cash flows eceived in different
years are treated equally.
b. Accounting or Average rate of return(ARR)
• ARR takes into account the accounting concept of profit (i.e profit after depreciation
and tax) and not cash inflows. The project which yield highest rate of return is
selected.
The accounting rate return may be calculated by any of the following methods.
i. ARR= Average annual profit
Original investment X 100 (OR)
ii. ARR= Average annual profit/average investmentX 100
The term average annual profit refer to average profit after depreciation and tax over
the life of the project.
The average investment can be calculated by any of the following methods
AI= Original investment/ 2
OR Original Investment-Scrap value/2
Merits of ARR
The following are the merits of ARR method.
1. it is simple to understand and easy to calculate
2. This method gives due weightage to the profitability of the project.
3. It takes into consideration the total earning from the project during
tits life time.
4. Rate of return may be readily calculated with the help of accounting
data.
Demerits of ARR
• This methods suffers from the following weakness:
1. It uses accounting profits and not the cash inflows in appraising the
project.
2.It ignores the time value of money. Profits earned in different periods are
valued equally.
3. It considers only the rate of return and not the life of the project.
4. It ignores the fact that profits can be reinvested.
5. This method does not determine the fair rate of return on investment.
6. There are different methods for calculating the accounting rate of return
due to many concepts of investment as well as profit. Each method gives
different results. This reduces the reliability of the method.
Exercise: 11
Calculate the ARR for projects A and B from the following:

Project A Project B
Investments Rs 20,000 Rs 30,000
Expected life(no salvage value) 4 years 5 years
Projected Net Income(after Interest,
dep and Taxes)
Years Project A Project B

1 2,000 3,000
2 1,500 3,000
3 1,500 2,000
4 1,000 1,000
5 - 1,000
If the required rate of return is 6,000 10,000
12% ,which project should be
undertaken?
Solution
Project A Project B
Total Profit 6,000 10,000
Life of the project 4 yrs 5 yrs
Average annual profit 6,000/4=Rs 1500 10,000/5= Rs. 2,000
ARR= AAP/OI X100= 1500/20,000X100=7.5% 2,000/30,000X100=6.67%
Aternatively,
ARR=AAP/AIX100
AI= Invetment at the beginning+Investment at the end/2
Project A :
AI= 20,000+ 0/2= 10,000 , project B = 30,000+0/2= 15,000

Project A = 1500/10,000 = 15%, Project B = 2,000/15,000= 13.33%

Project A preferable than project B
II. Discounted cash flows method or Time adjusted
technique
The discounted cash flows method is an improvement on the pay back
period method. It takes into account both the profitability and the time value of
money. This method is based on the fact that future value of money will not be
equal to the present value of money.
For example , a sum of Rs 100 received today is more valuable than a sum of
Rs 100 receved after one year because by receiving the amount now and
investing it somewhere a firm can get Rs 110(say including 10% interest) after
one year.
Discounted cashflow methods for evaluating capital investment proposals
are of three types.
1. Net presnt value method(NPV)
2. Excess present value index
3. Internal rate of return(IRR)
a. Net present value
• NPV takes into account both time value of money and
profitability of the project. It is based on the fact that future
value of the money will not be equal to present value of
money.
• Under this method, present value of cash inflows is
calculated at the required rate of return and compared with
original investment. If present value is higher than original
investment, the project can be selected, otherwise rejected.
I. Net Present Value method
Project X initially costs Rs 25,000 .It generates the following cash
inflows:

Year Cash inflows(Rs) PV of Re 1 at 10%

1 9,000 0.909

2 8,000 0.826

3 7,000 0.751

4 6,000 0.683

5 5,000 0.621

Taking the cut-off rate 10%, suggest whether the project should be accepted or not.
as
Calculation of NPV
Year Cashflows Present value Re 1 @10% PV of cash flows(Rs)
(Rs)
1 9,000 0.909 8,181
2 8,000 0.826 6,608
3 7,000 0.751 5,257
4 6,000 0.683 4,089
5 5,000 0.621 3,105
Total PV of Cash inflows 27,249

LESS Total PV of cash outflows(investement) 25,000

Net present value + 2,249
As NPV is positive , the project is
recommended
Excercise13: The Ram&co Ltd, is considering the purchase of a new machine. Two
alternative machies(A&B)have been sugessted, each having an initial cost of Rs.40,00,000 and
requiring Rs 20,000 as addtional working capital at the end of FIRST year. Earning after
taxation are expected to be as follows:

Year Cash flows (Rs)

Machine A Machine B

1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000
The comapny has a target of return on capital of 10% and on this basis, .You are
required to compare the profitability of the machines and state whcih alternative
you consider financially preferable? (PV @10% .91, .83, .75, .68, .62 from first to
fifth year respectively.
Ram&Co Ltd statement of NPV
Year Doscoun Machine A Machine B
t Factor Cash inflows Present Value(Rs) Cash inflows(Rs) PV(Rs)
1 0.91 40,000 36,400 1,20,000 1,09,200
2 0.83 1,20,000 99,600 1,60,000 1,32,800
3 0.75 1,60,000 1,20,000 2,00,000 1,50,000
4 0.68 2,40,000 1,63,000 1,20,000 81,600
5 0.62 1,60,000 99,200 80,000 49,600
Toatl NP value of Inflows 5,18,400 5,23,200
LESS Total NP vlue of ourflows 4,18,200 4,18,200
( 4,00,000+(20,000X.91))
Net present value 1,00,200 1,05,000
Machine B is positive as it has a higher net pesent value
b. EXCESS PRESENT VALUE INDEX METHOD
One of the major disadvantage of the PV method is that it is not
easy to rank the projects on the basis of NPV when the cost of the
project may differ. To compare such project the present value index
is prepared. It can be calculated with the help of the following
formula.
• Excess P V Index=
Total present value of cash inflows X100
Total present value of cash outflows
Higher the profitability index , more desirable the investment.
Excercise14
• REFER PREVIOUS EXERCISE***

Index method = Present value of future cash inflows X100

Present value of cash outflows
Machine A= 5,18,400/4,18,200X100=123.96%
Machine B=5,23,200/4,18,400 X100=125.11%
Higher the profitability index Machine B is more desirable for the
investment.
Excersise15: A choice is to be made between two competing proposals
which require an equal investment of Rs 50,000 and are expected to generate net
cashflows
Year
as under: project I(Rs) Project II(Rs)

1 25,000 10,000

2 15,000 12,000

3 10,000 18,000

4 Nil 25,000

5 12,000 8,000

6 6,000 4,000

The cost of capital of the company is 10% .The PV factor @ 10% p.a .909,.826, .751,.683, .621, .564 respectively
from the first year to sixth years.
Evaluate the project proposals under i)Pay back period ,ii) Discounted cash flow method
and Excess present value index method.
Solution
i) Pay back epriod :(project I preferable)
Project I: 3 years Project II- 3yrs 5ms (40,000 -3 year 10,000- 5 months)

ii) Discounted cash flows method i.e NPV :(project II preferable)

Project I = 3,461 project II= 6,819

iii) Excess present value index( Project II preferable)

project I- 53,461/50,000X100=107%
PeojectII= 5,819/50,000X100=114%
Exercise 16: The Initil cost of a machine is Rs 6,000. Cash inflows for 5 years are
estimated to be Rs 2,000 per year. The mangement's desired minimum rate of return is 15%.
Calculate NPV & excess present value index. (PV of Re 1 @ 15% for 5 years= 3.352)

i. PV Rs 2,000 received annually for 5 years:

= 3.352X2,000=Rs.6,704
• NPV= Rs.6704-6000=704
ii. Excess PV Index method= 6704/6000X100=111.7%
 C. INTERNAL RATE OF RETURN(IRR)
• IRR is the rate of return at which total present value of future
cash flows is equal to initial investment.
• This method is used when the amount of investment and cash
inflows are known but rate of return is not known.
• The rate of return is generally found by trial and error
method.

IRR is the rate at which the NPV becomes zero. The project
with higher IRR is usually selected.
Excercise 1:
i. When cashflows are uniform: i.e locating the present factor with reference to annuity table.

Initial outlay Rs 50,000

Life of the assets 5 years
Estimated cash flow Rs. 12,500
Calculate IRR.

Present value factor = Initial investment/Annual Cash flows

50,000/12,500= 4
The present value factor is to be located in the Present value Annuity table in the
columnfor 5 years (life of the asset). The figure 3.9927(nearest to 4) is found in the
row of 8%. Hence IRR is 8%(check 3.99X12,500=50,000)
Excercise2
Initial outlay Rs 60,000
Life of the assets 5 years
Estimated cash flow Rs 20,000
CALCULATE IRR

PVF=60,000/20,000=3
18%= 3.127
20% = 2.89
IRR =20%(nearest to 3 )
ii.When cash flows are not uniform(Trial and Error method)

• Initial investment Rs 60,000

• Life of the asset 4 years
Estimated net annual cash flows:
Rs
1 year 15,000
2 20,000
3 30,000
4 20,000
Calculate Internal rate of return.
Solution
Cash flow table at discount rates of 10% 12% 14% and 15%

Year Annual PVF PV(Rs) PVF@ PV(Rs) PVF@ PV(Rs) PVF PV(Rs)
CF (Rs) F@10 12% 14% @15

1 15,000 .909 13,635 .892 13,380 .877 13,155 .869 13,035

2 20,000 .826 16,520 .797 1,940 .969 15,380 .756 15,120

3 30,000 .751 22,530 .711 21330 .674 29,220 .657 19,710

4 20,000 .683 13,660 .635 12,700 .592 11,840 .571 11420

Total value of cash flows 66,345 63,350 60,595 59,285

Internal rate of return = 14.45%
Working
• At IRR ,total PV of cash inflows is equal to initial investment.
• Initial Investment is Rs. 60,000. Hence, IRR must be in between 14%
and 15% (i.e between s 60,595 ans Rs 59,285).
The exact IRR is calculate as follows:
• At 14% Total Present value =60,595
• At 15% total present value = 59,285
1,310
The difference of 1310 in rate =1%
Fo a difference of 565, the difference in rate (60595-60,000)
=1/1310X595= 0.45%
IRR= 14+0.45=14.45%
Merits and demerits of Discounted cash flow method
Merits:
1. This method considers the entire life of the project.
2. It gives due weightage to time fator. That is, time value of money is considered.
3. It facilate comparision between projects.
4. This approach by recognising time factor, makes sufficient provision for
uncertainty and risk.
5. It is best method where cash inflows are uneven.
Demerits:
1. It involves a great deal of calculations. Hence it is difficult and complicated .
2. It is very dfficult to forecost the economic life of any investment exactly.
3. The selection of an appropriate rate of interest is also difficult.
4. It does not correspond to accounting concepts for recording costs and revenues.
DETERMINING CASHFLOWS
The data requirement for capital budgeting are cash flows i.e, Outflows and
inflows.Their computation depends on the nature of the proposal.Capital projects
can be categorized into:
i.Single proposal, ii. Replacement situations iii. Mutually exclusive
i.Single proposal: The cash outflows, comprising cash outlays required to carry
out the proposed capital expenditure are:
Capital outflows of New project(beginning at Zero(t=0)
Cost of the project XXX
+ Installation cost of Plant &equiments XXX
+/- Working capital requirement XXX
Cash Outflows XXXX
Determination Inflows of single proposal(t=1-N)
No.of Years
Cash sales revenues XXX 1 2 3 4 ........N
Less Cash operating cost xxx
Cash flows before tax XXX
Less Depreciation xxx
Taxable Income XXX
Less Tax xxx
EAT xxx
Plus Depreciation xxx
Cash flows afte tax xxx
plus salvage value (in nth year) xxx
Plus Recovery of Working capital xxxx
CASH INFLOWS xxxx
Determinining cashflow- in Replacement situation
• In case of replacement of an existing machine(asset) by a new one , the relevant cash
outflows are after-tax -incremental cash flows. If a new machine is intended to replace
an existing machine,the proceeds so obtained from its sale reduce cash outflows
required to purchase the new machine and, hence, part of relevant cash flows.
Cash outflows in a replacement situations
Cost of the new machine
+ installation cost
+- Working capital
-sale proceeds of existing machine
Dep base of new machine in a replacement situations:
WDV of the existing machine
+cost of the acquisition of new machine (including installation charges)
-Sale proceeds of existing machine .
RANKING THE PROPOSALS

• Once the capital budget is nearing completion and a variety of different projects
has been identified, the firm must select the projects it will finance.Among
problems that arise are the following:
1. Mutually Exclusive Projects: If the firm accept one project, it may rule out the
need for another.There are called mutually exclusive projects. An example of this
kind of project would be the need to transport supplies from a loading dock/harbour
to the warehouse.The firm may be considering two proposals-Forklifts to pick up
the goods and move them, or a conveyor belt connecting the dock and warehouse. If
the firm accept one proposal, it eliminates the need for the other.
2. Contingent Projects: The utility of some proposals is contingent upon the
acceptance of others. For example, a firm may be considering the construction of
new headquarters building and a new employee parking lot. If it decides not to build
the headquarters,the need for the lot is gone. At the same time, if the firm builds the
headquarters and not the lot, the employees will have no place to park. These are
contingent policies.
***
• 3. Capital Rationing: Firms normally have more proposals than can be
funded properly. In this case, only one desirable, projects receive
approval. Capital Rationing occurs when the firm has more acceptable
proposals than it can finance.
• In this sitation, the firm should rank the projects from higest to lowest
priority. Then, a cut off point is selected. Proposals above the cut-off
will be funded, those below will be rejected or delayed. The cuttoff
point is selected after carefully considering the number of projects,the
goals of the firm, and the availability of capital for finance the capital
budget.
Complex Investment decisions
• The simple accept or reject investment decisions with conventional cash flows
may not be quite common in practice. Generally, a firm faces complex
investment situations and has to choose among alternatives. The use of the
NPV rule can be extended to handle complicated investment decisions.
• The choice between mutually exclusive projects is a simple example of project
interaction. The following important complex investment problems,
i. How shall choice be made between investments with different lives?
ii. Should a firm make investment now or should it wait and invest later?
iii.When should an existing asset be replaced?
iv. How shall choice be made between investments under capital Rationing?
Project Decisions with different lives
• The correct way of choosing between mutually exclusive
projects with the same lives is to compare their NPVs and
choose the project with a higher NPV.The two mutually
exclusive projects being compared, however, may have
different lives.The use of the NPV rule without accounting
for the difference in the projects' lives may fail to indicate
correct choice.
• In analysing such projects, we should choice between
projects with different lives should be made by evaluating
them for equal periods of time.
Example:
• A firm has to choose between two projects X&Y, Which are designed
differently but perform essentially the same function. X would
involves an Initial cash outlay of Rs.1,20,000 and operating cash
expenses of Rs 30,000 per year for 4 years. On otherhand, Y would
involve an initial cash outlay of Rs.60,000 and operating cash
expenses of Rs 40,000 per year for 2 years. Since the two projects do
exactly the same job, we can choose between them on the basis of cost
comparision. Cash flows of projects are in real terms, and the real
discount rate is 10% .
0 1 2 3 4
• The present value of costs are shown below: ('000) NPV.10%
X Cash flows
120 30 (Rs'000)
30 30 30 215.10

Y 60 40 40 - - 129.42
***
• If the difference in the projects' life is disregarded/ignore, One may choose project
Y since it has a lower present value of costs. But this need not necessarily be the
best decision for them. X will perform the job for 4 years. If Y is chosen, it will
expire after 2 years and therefore, it will have to be replaced at the end of year.
• Let us call Y undertaken today as Y1 and Y replaced after 2 years as Y2.The
comparision should be between the PV of costs of Y1+Y2(i.e PV (Y1+Y2)) and
the PV of costs of X.Thus, the cash flows of two alternative investments would be
as follows:
Cash flows (Rs'000)
0 1 2 3 4 NPV,10%
Y1 60 40 40 00 00 129.42
Y2 0 0 60 40 40 106.96
Y=Y1+Y2 60 40 100 40 40 236.38
X 120 30 30 30 30 215.10
***
• By the end of 4th year, Project X wears out while Project Y wears out
twice. At this point, a decision has to be made to choose between X
and Y(or other versions) regardless of the initial choice of X or Y.
When we compare the PV of costs of X with that of the chain of Y
lasting same period of time as X, we would choose X since the PV of
its costs is lower.
• Thus, the use of simple NPV rule would give incorrect results in the
case of projects with different lives. The correct procedure is compare
NPVs of the projects for equal periods of time.
Investment decision under capital rationing
• Firms may have to choose among profitable investment opportunities
because of the limited financial resources. The method of solving
Capital budgeting problems under capital rationing,we shall show that
the NPV is the most valid selection rule even under capital rationing
situations.
• A firm should accept all investment projects with positive. NPV in
order to maximise the wealth of sharholders. The NPV rule tells us to
spend funds in the projects until the NPV of the last(marginal) project
is Zero.
Capital rationing under profitability Index(PI)
• Under capital rationing ,we need a method of selecting that portfolio
of projects which yields highest possible NPV within the available
funds.Let us consider PI, a firm investment with 10% Cost of capital.
• There is a budget limit of Rs 50,000 in year . Project M&N have first
and second rank in terms of PI.They together have highest NPV(Rs
15,870) and also exhaust the budget in year 0, so, the firm would
choose them. Thus, decision choices today are as follows:
Cash flows (Rs'000)
Project C0 C1 C2 C3 NPV, 10% PI Rank

L -50 30 25 20 12.94 1.26 III

M -25 10 20 10 8.12 1.32 I

N -25 10 15 15 7.75 1.31 II

***
If the firm no capital constraints, it should undertake all three projects
because they all have positive NPVs. Suppose there is a capital constraints
and the firm can spend only Rs 50,000 in year zero. What should the firm do?
If the firm strictly follows the NPV accept the highest NPV project L,
which will exhaust entire budget and M& N together have higher NPV (Rs
15,870) than project L (Rs12,940) and their outlays are within the budget
ceiling. The firm should, therefore, undertake M and N rather noted that the
firm could not select projects solely on the basis of individual NPVs when
funds are limited. The firm should intends to get the largest benefit for the
available funds. i.e ,those projects should be selected that give the highest
ratio of PV to initial outlay. This ratio is the PI .
In the above example, M has the highest PI followed by N and L. If the
budget limit is Rs 50,000, we should choose M and N following the PI rule.
END OF UNIT 1
THANK YOU TO ALL