Financial Management

CAPITAL BUDGETING
Capital Budgeting
“Capital budgeting is long-term planning for making and financing proposed capital outlay”. - Charles T.
Horngreen

Capital Budgeting (CB) refers to the complete process of generating/initiating investment proposals, evaluating,
ranking and selecting the best alternative(s), monitoring and making follow up on investment(s) made.
• Provides assessment for the financial feasibility of investment options.

• Evaluates, how an investment opportunity is worthwhile and how it fits to the company’s strategy, goals and objectives?

• CB techniques are invariably used for all types of investment opportunities from the purchase of a new piece of
machinery to a whole factory. 
Nature
• CB Decisions have long-term impact on the business stability, growth & success

• CB Decisions involve huge investment of funds

• CB Decisions are more complicated from concerns of future cash flow estimates and their
evaluation at the time of making investment

• CB Decisions are not easily reversible mainly because of loss of investment

Importance
• Huge amount of resources are involved that has impact on business strategy, growth, and
survival.

• Difficult to “bail out”, once an investment is made.

• The capital investments are challenging and critical to the success of the company.

• An incorrect decision may end with the company’s closing-out from the market.
Concept
Investment refers to an outlay of funds on which management expects a return. An investment creates
value for shareowners when expected returns from investment exceed its cost.

Capital Expenditure refers to long term commitment of resources that provide future benefits to business.

Why investment is made?

• Expansion Plans, Growth Strategies, Capacity Increase

• Increase of efficiency of the manufacturing facilities

• Deploying or replacing latest technology

• Acquisition of Fixed Assets, Copy Rights, Franchises, Licenses, Patents

• Establishing new brands, new lines of business, new products

• Opening new offices, new factories, overseas branches

Relevant Concepts
• Independent Projects are projects where selection or rejection of one project does not have any impact
on the selection or rejection of the other project. Management can select any number of projects from
the given options.

• Mutually Exclusive Projects are projects that compete each other, acceptance of one project becomes
automatic rejection of the other or vice versa. The projects compete with each other based on the
superior financial performance. There can be any number of projects for a subject and competing with
each other. Management has to decide about one project from all alternatives or options.

• Decision Rules: The decision rules for independent and mutually exclusive projects slightly differ. The
way of looking at investment opportunities under both types varies.
 Process
CB is a five steps process that is followed by the investment managers in the order given as below:

1. Initiating, generating and gathering investments ideas.

2. Analyzing the costs and benefits for proposed investments by: – Forecasting costs and benefits for each
investment. – Evaluating the costs and benefits based on CB techniques.

3. Ranking the relative superiority of each investment alternative based on financial performance worked out and
choosing the best investment opportunity from the given set of opportunities.

4. Implementing the investment alternative chosen.

5. Monitoring & making follow-up on the investment made on regular basis to see how far this investment
opportunity has been effective in the given framework of the company to achieve its desired objectives.
Decision Matrix
Evaluation Techniques
A: Traditional Techniques
1. Payback period (PB)

2. Discounted Payback Period (DPB)

Important Note: These techniques
3. Accounting Rate of Return (ARR) provide reliable evaluation under
conditions of perfect certainty. They are,
B: Discounted Cash Flow (DCF)/ Time Adjusted (TA) Techniques nevertheless, widely used in practice in

1. Net Present Value (NPV) the face of uncertainty.

2. Internal Rate of Return (IRR)

3. Profitability Index (PI) or Benefit/Cost Ratio

Decision Rules
For All Capital Budgeting Techniques
# Tech. Accept or Reject Criteria for …
Single or Independent Project(s) Mutually Exclusive Projects

1. PB Less than the Target Period Shortest Payback Period

2. DPB Less than the Target Period Shortest Payback Period

3. ARR Above the Target Rate With the highest ARR

4. NPV A positive NPV With the highest positive NPV

5. IRR Higher than the Target Rate (Cost of Capital) With the highest IRR

6. PI (B/C Ratio) PI exceeding 1 Higher PI

Merits & Demerits
Traditional Techniques
Merits & Demerits
DCF Techniques
 NPV vs IRR
ISSUES RESOLUTION OF ISSUES
• When investment amount in given projects is different then the results from • The value of early cash flows depends on the return that
NPV and IRR techniques shall lead to different conclusions. is earned on those cash flows, i.e. the rate at which these

• When length of the given projects in terms of time is different then the results funds are re-invested.

obtained from NPV and IRR techniques shall lead to different conclusions. • The NPV method implicitly assumes that the rate at

• When the interest rates of given projects are different then the results obtained which cash flows can be re- invested is the cost of capital,

from NPV and IRR shall lead to different conclusions. • The IRR method assumes that the company re-invest the

• When timing of cash flows is different i.e. timing of cash flows from the two funds at the IRR.

projects differs such that most of the cash flows from one project come in the • The best assumption is that projects cash flows is re-

early years while most of the cash flows from other project come in the later invested at the cost of capital, that goes for the

years, the results from NPV and IRR techniques shall lead to different recommendation of NPV method.

conclusions.
NPV vs IRR
• NPV and IRR always lead to the same accept/reject decision for independent projects.

• NPV and IRR may lead to different accept/reject decisions for mutually exclusive projects.

• Where NPV and IRR give different accept/reject decision then NPV results should be accepted.

• NPV assumes re-investment of cash inflows at r (opportunity cost of capital).

• IRR assumes reinvestment of cash inflows at IRR.

• IRR indicates the minimum rate expected by the investors to get their investment back from the project. They
definitely get idea from IRR that how much extra earnings are required to cover their cost of capital and net return
on their investment.

• Re-investment of cash inflows at opportunity cost, r, is more realistic, so NPV method is best. NPV should be used to
choose between mutually exclusive projects.
Crux Of All Capital Budgeting
Techniques
The purpose of evaluation under all capital budgeting techniques is to
estimate the monetary benefit arising out of investment made in a given
project. If a project is estimated to maximize shareholder’s wealth at the
end of a given period of time by returning surplus monetary benefit than
the investment made, then decision is made to take up the project for
investment.
Non-financial Factors
Management can reject a project based on non-financial factors though the financial performance of a project
is found satisfactory.
• Company Goodwill, Image & Reputation: Management may reject an investment opportunity, as it will reflect badly on
the company goodwill, image and reputation.

• Company Policies, Objectives & Culture: Management is bound to check, if the investment opportunity conforms to the
policies, objectives and culture of the company?

• Environmental, Social, Legal & Ethical Issues: Management is required to make sure that the investment opportunity
under consideration is, legally, environmentally, socially and ethically acceptable and viable.

• Impact on Stakeholder Relationships: Management appraises the impact of the investment on competitors,
shareholders, employees, buyers, bankers, suppliers and government institutions, etc.
Accounting Profit Compared To Cash
Flows
Most investment decision models use predicted cash flows instead of accounting profits.

Why investment managers pay more attention to cash flows rather than accounting profit in their all
calculations for investment decision-making?
• Accounting profits reflect the profitability of a company over a given period of time under the principles of accrual
accounting, whereas, cash flows tell about the cash position in a given period of time under cash basis of accounting.

• Cash flows reflect on the management of cash cycle of the company so that company would be able to pay-off its short
term obligations whenever they fall due.

• Investors emphasize at the cash flows because the project performance is based on reliable cash flow streams more
than profitability viz exposed to number of estimated amounts.
Normal Vs Non Normal Cash Flows
• Normal cash flow is the cash flow stream that comprises of initial investment outlay and then
positive net cash flow throughout the project life. It is also called conventional cash flow
stream.

• Whereas non-normal cash flows have investment injections during the project life as well,
this is also known as un-conventional cash flow stream.

• The nature of the cash flow pattern is important in capital budgeting. Because when the cash
flows stream is non-normal, multiple-IRR problem arises.
Capital Rationing
The management has not only to determine the profitable investment opportunities, but it has also to
decide about that combination of projects which delivers highest NPV within the available funds.

There are two types of capital rationing.

• External Capital Rationing -- Factors that are outside the company due to financial market conditions.

• Internal Capital Rationing -- Factors that are within the company due to policy, procedure or other constraints.

Capital Rationing is about selecting projects in a way that helps a company completing them within the
given financial resources. Financial resources are limited, therefore, should be used in way that is the
best combination from company’s wealth maximization point of view.
Illustrative Model
Question: There are two mutually exclusive projects A and B for the consideration of XYZ company. The data
for the initial investments and subsequent cash inflows is given on next slide. Calculate: – PB, DPB, ARR –
NPV, IRR & PI.

Provide recommendations based on the results of budgeting techniques to make the accept or reject
decision in relation to Project A or B?

Important note: Project A and Project B are competing each other and only one of them can be selected
(i.e. mutually exclusive projects). The project that has superior financial performance shall be selected. The
performance of these two mutually exclusive projects shall be evaluated under 6 capital budgeting
techniques.
CASH FLOWS FOR PROJECTS A & B
Year Project A: Net Cash flows Project B: Net Cash flows
in/(out) in/(out)
For the year Accumulated For the year Accumulated
Rs Rs Rs Rs
0 (100,000) (100,000) (100,000) (100,000)
1 45,000 (55,000) 30,000 (70,000)
2 40,000 (15,000) 30,000 (40,000)
3 35,000 20,000 44,000 4,000
4 50,000 70,000 66,000 70,000

The depreciation charge is Rs. 20,000 per annum.

The residual value for both projects is the same, Rs. 20,000
Interest rate is 10% per annum
There is no tax imposed on the incomes of these projects.
ASSUMPTIONS & FEATURES OF
THE MODEL
• The amounts of initial cash outlays (investments) are same,
• The project lives are equal i.e. 4 years
• Total amount of cash inflows over the entire lives of projects are equal,
• Residual values at the end of the projects are same,
• Interest rates are same,
• The total amount of depreciation expense on these projects over the lives of is same,
• There is no tax imposed on the incomes earned on both projects,
• There is no further investment after the initial one for the two projects,
• The Projects A and B have continuous stream of cash inflows during the entire period related to them i.e. normal cash flows,
• The cash inflows though normal but are unequal for both Projects A & B.
• It is assumed that non-financial factors relating to these two projects are satisfactory. And there is as such no qualification re the
non-financial factors.
• Projects A and B are mutually exclusive projects.

Note: Interest rate is used alternatively as discount rate, hurdle rate, cut-off rate, required rate, etc., etc.
1. PAY BACK PERIOD
Calculation for Project A
◦ = (change in cash flow required to reach zero/total cash flow in the year) + complete years
◦ = (15,000/35,000) + 2
◦ = 0.43 + 2 years = 2.43 years

Calculation for Project B

◦ = (40,000/44,000) + 2
◦ = 0.91 + 2 years = 2.91 years

Decision Rules Project A has recovered the initial investment in 2.43 year whereas Project B has
recovered initial investment in 2.91 years. Project A has recovered initial investment faster than Project
B, therefore Project A is SELECTED.
Important note: A variation of this technique that involves Present Values of cash inflows is known as
Discounted Payback Period. It gives exact idea about re-couping of original investment to the business.
2. DISCOUNTED PAY BACK PERIOD
CALCULATION FOR PROJECT A
Year Net Cash flows Discount Factor for Present Value
(1) Rs.1 @ 10% p.a. (2) 3= 1*2
0 (100000) 1.000 (100000)
1 45000 0.909 40,905
2 40000 0.826 33,040
3 35000 0.751 26,285
4 50000 0.683 34,150

Discounted Payback Period for Project A

= 2 yrs. + (26055/26,285)yr. = 2.991 yrs.
N.B.: The period indicates the recovery of initial investment plus cost of capital in 2.991 years.
2. DISCOUNTED PAY BACK PERIOD
CALCULATION FOR PROJECT B
Year Net Cash flows Discount Factor for Present Value
(1) Rs.1 @ 10% p.a. (2) 3= 1*2
0 (100000) 1.000 (100000)
1 30000 0.909 27,270
2 30000 0.826 24,780
3 44000 0.751 33,044
4 66000 0.683 45,078

Discounted Payback period for Project B

= 3 yrs. + (14,906/45,078)yr. = 3.331 yrs. 
Decision Rule: The project that has longer discounted payback period shall be rejected. The Project B has longer
period to recoup the investment than Project A, therefore, Project B is rejected and Project A is selected. This
technique is the refinement of the Pay Back Method.
3. ACCOUNTING RATE OF RETURN
Calculate annual profit
◦ Annual Profit = Income - Depreciation :

Calculate average profit

◦ Average Accounting Profit = Total Profits / No of Yrs. :

Calculate average capital invested

◦ Average Capital = (Initial Investment + Residual Value)/2 :

Calculate Accounting Rate of Return

◦ ARR = (Average Profit/Average Capital) x 100

Annual Profit in the context of this model refers to the earnings from the project less all other expenses including
depreciation. The model used here gave us only depreciation expense, therefore, it is deducted from the income given in
each year. This is for the reason of simplicity of the model. Further, cash inflows are the income in the absence of any
other expense for example, only depreciation is the expense to be charged against these earnings In practice, we take
net profit after tax for this working.
ARR CALCULATION
Project A
Average Accounting Profit = (Income – Depreciation)/4
Average Accounting Profit = (170,000 - 80,000)/4 = 22,500
Average investment = (Initial Investment + Residual Value)/2
= (100,000 + 20,000)/2 = 60,000
ARR = 22,500/60,000 x 100 = 37.50%
Project B
Average Accounting Profit = (170,000-80,000)/4 = 22,500
Average Investment = (100,000 + 20,000)/2 = 60,000
ARR = (22,500/60,000) x 100 = 37.50%
ACCOUNTING RATE OF RETURN
Decision Rules
For Independent Projects: Ranking shall be made of all independent projects based on their estimated
ARR. The projects that have higher estimated ARR than the minimum required ARR shall be selected and
all other projects shall be rejected.
For Mutually Exclusive Projects: The project with higher ARR is to be selected for mutually exclusive
projects.
There are two check points for mutually exclusive projects.
◦ All the competing projects should have higher ARR than the minimum required.
◦ The project with higher ARR shall be selected and the other shall be rejected.

In this model, both projects have same ARR i.e 37.50%, So first, management shall see if the estimated
ARR for both Projects A and B is higher than the minimum required ARR. For example, minimum ARR is
25%. Then management shall be indifferent, as to select which of these two projects. Management shall
extend their studies further into the results of other capital budgeting techniques.
4. NET PRESENT VALUE
The XYZ company’s interest rate is 10% p.a.
Discount Factors @ 10% p.a. for Rs. 1 are as given below:
• Year 1 = 0.909
• Year 2 = 0.826
• Year 3 = 0.751
• Year 4 = 0.683

Formula to calculate Discount Factor @ 10% p.a. for Rs. 1 is given as follows:
Discount Factor = 1/(1+10%)n
Where .
◦ NPV = Net Present Value .
◦ Ct = Cash in-flows for given periods
◦ Co = Initial Investment .
◦ K or r = Discount Rate .
NPV CALCULATION FOR PROJECT
A
Year Net Cash flows Discount Factor for Present Value
(1) Rs.1 @ 10% p.a. (2) 3= 1*2
0 (100000) 1.000 (100000)
1 45000 0.909 40,905
2 40000 0.826 33,040
3 35000 0.751 26,285
4 50000 0.683 34,150
Total=(1+2+3+4) 134,380
NPV =(134,380-100000) 34,380
NPV CALCULATION FOR PROJECT
B
Year Net Cash flows Discount Factor for Present Value
(1) Rs.1 @ 10% p.a. (2) 3= 1*2
0 (100000) 1.000 (100000)
1 30000 0.909 27,270
2 30000 0.826 24,780
3 44000 0.751 33,044
4 66000 0.683 45,078
Total=(1+2+3+4) 1,30,172
NPV=1,30,172-100000 30,172
NPV DECISION RULES
Results of the working
◦ Project A has NPV of Rs. 34,380
◦ Project B has NPV of Rs. 30,172

Decision Rules
◦ The project that has higher NPV is superior in terms of its financial performance and is therefore should
be selected.

Conclusion
◦ Project A has higher NPV than that of Project B. Therefore Project A should be selected.

NOTE: In the case of both Projects A and B, NPV is reducing when discount rates are increasing.
To generalize, when discount rate increases, NPV decreases and vice versa.
 5.INTERNAL RATE OF RETURN
IRR is the discount rate which delivers a zero NPV for a given project. That means a rate at which PV of all
cash inflows equals to total investment at a given point in time.
IRR Calculation for Project A Year Net Cash Discount Present
flows Factor for Value
◦ NPV = 34,380 when the discount rate is 10% (1) Rs.1 @ 25% 3= 1*2
◦ NPV = ??? When the discount rate is 25% p.a. (2)
0 (100000) 1.000 (100000)
1 45000 0.800 36,000
2 40000 0.640 25,600
3 35000 0.512 17,920
4 50000 0.410 20,500
NPV (20)

N.B. : If we reduce the IRR to get the NPV exactly equal to zero. Then after rounding off it shall be again
equal to 25%. Therefore, IRR for Project A is 25%.
5.INTERNAL RATE OF RETURN
IRR Calculation for Project B
◦ NPV = Rs. 30,172 when the discount rate is 10%
◦ NPV = ??? When the discount rate is 25%
Year Net Cash flows Discount Factor for Present Value
(1) Rs.1 @ 25% p.a. (2) 3= 1*2
0 (100000) 1.000 (100000)
1 30000 0.800 24,000
2 30000 0.640 19,200
3 44000 0.512 22,528
4 66000 0.410 27,060
NPV (7,212)

NOTE NPV of Project B is negative @ 25% discount rate. The higher the discount rate, the lesser is the NPV .
In order to have zero NPV, we have to reduce the discount rate from 25% to 22%.
 Calculating IRR by using Interpolation
Formula
Project B: IRR Calculation by using Interpolation Formula
◦ Total change in NPV = 30,172 – (– 7,212) = 37,384
◦ Total change in discount rate = 25% – 10% = 15%

IRR = 10% + 30,172/37,384 x 15% = 22%

The discount rate is chosen by hit and trial method. In this example, we have reduced discount rate from 25% to 10% to find out the
exact rate that shall make the project NPV equal to Zero. And we found the exact rate of 22% that gives NPV equal to zero by using
Interpolation Formula.

Decision Rules
• If Project A’s IRR>Project B’s IRR then select Project A , & 

• If Project B’s IRR>Project A’s IRR then select Project B 

• In this case Project A’s IRR>Project B’s IRR, therefore, Project A is selected. Because its IRR 25% which is higher than that of Project B’s 22%. 

• It is also worth noting here that IRR>Discount Rate of 10%. If these two projects were not competing each other (i.e. independent projects),
then both would have been selected. If IRR<Discount rate of 10%, then both project would have been rejected.
8. Profitability Index
(PI) 53 Profitability Index (PI) or Benefit/Cost Ratio (B/C Ratio) measures Present Value per rupee
invested. It is a ratio of PV of future cash inflows by PV of cash outlays (ie net investment).
PI = PV of expected cash inflows /PV of cash outflows
We calculate here PI for Projects A & B.
PI for Project A = 134,380/100,000 = 1.344
PI for Project B = 130,172/100,000 = 1.302
Decision Rules for PI
Decision Rules

If PI for any single project exceeds 1, the project can be accepted. For the mutually exclusive
projects, the project that has higher PI should be considered for investment.

Conclusion

In the given illustration of two Projects A and B, Project A has higher PI than that of Project B.
Management should select Project A out of the proposed investment opportunities.
SUMMARY OF RESULTS

A Final Conclusion Based on the results of all CB techniques used in this illustration, we
recommend the management of XYZ company to go for Project A.
Reference
Financial Management by I.M. Pandey, Vikas Publication

Rajiv Srivastava, Anil Misra, Financial Management, Oxford Publication

Khan and Jain, Financial Management, McGraw Hill

Brigham and Ehrhardt, Financial Management, Cengage Learning

R M Srivastava, Financial Management and Policy, Himalaya Publishing House

Prasanna Chandra, Financial Management Theory and Practice, McGraw Hill