CAPITAL BUDGETING III

Traditional Methods of capital

Budgeting
Illustration 1. Calculate pay back period and suggest which project should
be selected.

Project Project
A B
Initial Investment Rs. Rs.
2,00,000 3,00,000

Estimated Life [in years] 5 years 6 years

Estimated scrap value Rs. Rs.

10000 30000

Annual Net earnings before tax but after Rs. Rs.

depreciation 24,000 30000
Tax Rate 50% 50%
Solution:
Calculation of Cash In flows

Project A Project B

Rs. Rs.
Net Earnings Be for e Ta x 24 ,000 3 0,000
Less : Income Ta x @ 50% 12 ,000 1 5,000

Ne t Earnings Aft e r Ta x 12 ,000 1 5,000

Add : Depreciation 38 ,000 4 5,000

Annual Cash Inflow s 50000 60000

 Pay Back Period =

Payback Period for Project A = 4 ye a r s

Pay back Period for Project B = 5 ye a rs

Suggestion : According to pay back period method project A will be

selected because it has shorter pay back period.
Suggestion : According to pay back period method project A will be selected
because it has shorter pay back period.
Illustration 2 : Mehta Engineering Company is considering purchase of a new
machine for its expansion programme. There are possible machines suitable for the
purpose. Their details are as follows:

Machine Machine Machine

Pa rticula rs
X Y Z
Rs. Rs. Rs.
Cap ital Cost 1,00 ,000 1,00,000 1,0 0,000
Sales at standard price 1,80 ,000 1,60,000 1,5 0,000
Net Cost o f Production :
Direct Material 12 ,000 10,000 9 0,000
Direct Labour 13 ,000 14,000 1 6,000
Factory Overhead s 20 ,000 18,000 1 9,000
Administration Overheads 16 ,000 22,500 1 7,000
Selling and Distribution 14 ,000 8,000 2 4,000
Overhead s
Solution: Statement Showing the Cash Inflows of Three Machines

Machin e Machine Machine

Particu lars
X Y Z
Rs. Rs. Rs.
Sales at Standard Price (i) 1 ,80,0 00 1,6 0,00 0 1,5 0,00 0

Less : Cost of Production :

D irect Material 12,0 00 10,000 9, 000
D irect Labour 13,0 00 14,000 16, 000
Factory Overheads 20,5 00 18,000 19, 000
Administration Overheads 16,0 00 2,500 17, 000
D istribution Overheads 14,0 00 8,000 24, 000
Depreciation 19,0 00 22,500 24, 000
Total Co st (ii) 94,0 00 95,000 1 ,09, 000
Profit before Tax (i) - (ii) 86,0 00 65,000 41, 000
Less : Income Tax 50 % 43,0 00 32,500 20, 500
Profit aft er T ax 43,0 00 32,500 20, 500
Add : Depreciation 19,0 00 22,500 24, 000
Annual Cash In flows 62,0 00 55,000 44, 500
 Pay Back Period =

Machine X = = 1.61 years

Machine Y =

Machine Z =

Machine ‘X’ is maximum profitable because its pay back period is

minimum
Illustration 3 : Raja Industries Limited is producing articles mostly on hand labour
and is considering to replace it by a new machine. There are two alternative models
A and B of the new machine. Prepare a statement of profitability showing the pay
back period from the following information :
Machine A Machine B
4 years 5 years
Estimated Life of Machine

Cost of Machine Rs. 90,000 Rs. 1,80,000

Estimated Savings in Scrap Rs. 5,000 Rs. 8,000
Estimated Savings in Direct Wages Rs. 60,000 Rs. 80,000
Additional Cost of Maintenance Rs. 8,000 Rs. 10,000
Additional Cost of Supervision Ignore taxation. Rs. 12,000 Rs.10,000
Solution :
Statement Showing Annual Cash Inflows
Machine A Machin e B
Rs. Rs.
Estimated Savings in Scrap 5. 000 8,000
Estimated Savings in Direct Wages 50 .000 80000
Total Savings (a) 65 .000 88 ,000
Additional Cost of maintenance 8, 000 10,00 0
Additional Cost of Supervision 12 .000 18000

Total Additional Cost (b) 20 ,000 28 ,000

Net Cash Inflow (a) - (b) 45 ,000 60 ,000

 Pay Back Period =

Machine A = = 2 years

Machine B = = 3 years

Machine A has shorter pay back period, hence it should be

preferred.
(b) Uneven Cash Inflows : If the annual cash inflows are uneven then the
calculation of pay back period takes a cumulative form. We accumulate
the annual cash inflows till the recovery of initial investment. In case the
investment is recovered in between a year, it is presumed that cash
inflows accrue evenly throughout the year. In such a case pay back
period is calculated on proportionate basis.
The pay back period can be calculated as follows:

No. of completed Years +

Evaluation of the Project : The pay back period can be used as an accept
or reject criterion. It can be used as a method of ranking projects. It
gives highest ranking to the project which has the shortest pay back
period and the lowest ranking to the project which has the highest pay
back period.
In case of evaluation of a single project, it may be accepted if the pay
back period is less than the period fixed by the management.
Merits of Pay back Period :
Pay back period is the most popular and widely recognized traditional
method of evaluating capital projects. Some merits of this method are as
follows:
1. Easy and Simple : It is easy to calculate and simple to understand. The
simplicity of pay back period is considered as a virtue by business executives
which is evident from their heavy reliance on it for appraising investment
proposals in practice.
2. Fear of Obsolescence : This method is useful in the projects with short
economic lives and those with high rate of obsolescence.
3. Liquidity : This method gives importance to the speedy recovery of
investment in capital assets. It stresses the liquidity as well as solvency of a
firm as a guiding principle in the capital budgeting decisions.
4. Uncertainty: It is useful in the industries which are subject to uncertainty,
instability or rapid technological changes because the future uncertainty
does not permit projection of annual cash inflows beyond a limited period.
5. Handy Device : It is handy device for evaluating investment proposals,
where precision in estimates of profitability is not important.
Demerits of Pay back Period :
1. Considers only period of Pay back :A major limitation of pay back period method isthat it
ignores all cash flows after the pay back period. It ignores, the fact that projects may have
different profit stream after the pay back period is over and may lead to serious under-
investment as the post pay back period profitability is not considered.
2. Ignores Profitability: It does not an appropriate method of measuring the profitability of
an investment project, as it does not consider the entire cash inflows generated by the
project.
3. Overlooks Capital Cost: This method overlooks the cost of capital which is an important
consideration in making sound investment decisions.
4. Over Emphasis on Liquidity: This method gives undue weight age to short-term
considerations to the exclusion of long-term objects. A project with long pay back period
may be preferable if its economic life is also longer and the total surplus during the entire
life of the projects is substantial.
5. Determination of Minimum Pay Back Period : There is no rational basis of determining
the minimum acceptable pay back period. It is generally a subjective decision of the
management which creates so many administrative difficulties.
6. Ignores Present Value of Cash Flows: Pay back period ignores the present value of future
cash flows. It gives equal weight to returns of a equal amounts even though they occur in
different periods.
7. Ignores Size and Cost of Project :This method ignores the size and cost of the projects
because it gives emphasis on pack back period only.
Improvement in Pay-back Period :
In spite of many limitations, pay back period method is much popular in western countries.
To increase the utility of pay back period, the following refinements should be applied:
(i) Post Pay Back Profitability : It considers returns receivable beyond the pay back period
It recognizes the entire life of the project and quantum of profits. According to this
method the project which has greatest post back profitability may be accepted.

Computation of Post Pay Back Profitability :

(a) When cash inflows accrue evenly throughout the life of project:
Post pay back profitability
= Annual Cash inflow (Estimated life of project – Pay back period) + Scrap value

(b) When cash inflows accrue unevenly throughout the life of project.

Post pay back profitability

= Total Cash inflow in life of project +Scrap value - Initial Investment
Illustration 5 : Two projects X and Y are before consideration of the management of Syntex Ltd.
The particulars are as under:

Project X Project Y
Initial Investment Rs. 1,00,000 Rs. 1,00,000
Estimated Life in 5 6
years
Net Earnings after tax before
depreciation

Year Rs. Rs.

1 50,000 25,000
2 40,000 30,000
3 35,000 34,500
4 23,000 40,500
5 12,000 50,000
6 — 30,000
 Rs1,00,000-Rs. 90,0 00
Pay b ack Perio d (Pro ject X) = Rs 35000
2+

= 2.86 Years
Rs1,00,000-Rs.895 00
Pay b ack Period (Project Y)= 3+ Rs 40500

= 3+ = 3.259 years
According to pay back period project X is better because it has shorter period
than project Y.
(ii) Calculation of Post Pay back Profitability :
Post pay back Profit = Total Cash inflows in life - Initial Investment Project X = Rs.
1,60,000 - Rs. 1,00,000 = Rs. 60,000
Project Y = Rs. 2,10,000 - Rs. 1,00,000 = Rs. 1,10,000
Project Y shows greater post pay back profitability than project X. Hence, it may be
preferred.
(ii) Pay back Reciprocal Method : Pay back reciprocal is the time adjusted rate of return on investment. It is
used as a method of evaluating capital expenditure proposals. It gives a rough approximation of the internal rate of
return. It can be expressed as follows :

𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠 h 𝐼𝑛𝑓𝑙𝑜𝑤𝑠

Pay back Reciprocal = × 100
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
OR
1 x 100
Pay back Period
This method is used when the project generates even cash inflows and the project has
a long economic life it must be at least twice the pay back period.
(c)Average Rate of Return Method: The average rate of return is defined as the ratio of
average profit to average investment. The general aim of investment is to maximize net profit
after tax, it is appropriate to consider net profit after tax for the purpose of accounting rate of
return. Average rate of return method is also known as accounting method, unadjusted rate of
return method and return on investment method. According to this method capital projects are
ranked in order of their earnings. Project which yields the highest earnings is selected The return
on investment can be expressed in two ways :
(i) Rate of Return on Original Investment : Under this method average annual earnings is
divided by original investment. It is expressed in percentage. It can be calculated as
follows:
Average Annual Earnings after tax x 100 Original
Investment
(ii)Rate of Return on Average Investment : This is most appropriate method of rate of
return on investment. Under this method, average profit after depreciation and tax is divided
by the average investment. The rate of return on average investment can be computed as
follows:
ARR =
Average Annual Earnings: Average annualearnings is computed
by adding whole earnings over the entire economic life of the
project and dividing the total by number of years of economic
life of the project. Net earnings or earnings are taken after tax and
depreciation. Average Investment : Average investment is
calculated by dividing original investment by two or by a figure
representing the mid point between the original outlay and the
salvage value of the investment. It can be calculated as follows :

Average Investment =

OR
Illustration 7 : Finolex Pipes Ltd. is contemplating an investment of Rs. 1,00,000 in a new
plant, which will provide a salvage value of Rs. 8,000 at the end of its economic life of 5
years. The profits after depreciation and tax are estimated to be as under:
Year Rs.
1 5,000
2 7,500
3 12,500
4 13,000
5 8,000
Calculate accounting rate of return.
So lution :
ARR =
= x 100 = 17.04%
Average Annual Profits =
= Rs. 9,200
Average Investment = =

=Rs 5400 0
Illustration 8 : A project costs Rs. 1,50,000 and has a scrap value of Rs. 30,000.
Its streams of income before depreciation and taxes during first five years is Rs.
30,000; Rs. 36,000; Rs. 42,000; Rs. 48,000 and Rs. 60,000. Assuming tax rate at
50% and depreciation on straight line basis.
Calculate the average rate of return (ARR) for the project.
Solution :
(i) Computation of Average Net Income after tax
Average Net Income before Depreciation and Tax = = 43200
Less: Depreciation (Annual) = = 24,000
Average Net Income before tax 19,200
Less : Income tax 50% 9,600
Average Net Income after tax 9,600
(ii) Computation of Average Investment :

= = 90,000

ARR = x 100

= x 100 = 10.67%
Illustration 9 : From the following particulars of a capital project, calculate
unadjusted rate of return :
Initial Capital outlay Rs. 1,20,000
Salvage Value Nil
Annual Cash inflows Rs. 30,000
Life in years 8
Solution :
Unadjusted Rate of Return = x 100
= x 100 = 25%

Average Investment = = = 60000

Merits of Average Rate of Return (ARR)
The following are the merits of the average rate of return
method :
1. Simple : It is very simple and easy to understand and to use
2. Considers Profitability : It gives due weightage to the
profitability of the project.
Under this method projects having higher rate of return will be
accepted. These are
comparable with returns on similar investment derived by other
firms.
3. Appropriate Method : This method takes into account savings
over the entire economic life of the project. Therefore, it
provides a better means of comparison of projects than pay back
method.
Demerits of Average Rate of Return :
The following are demerits of the average rate of return method :
1. Ignores Time Factor : It ignores the time value of money. A project
having low initial inflows and high future inflows would have the same
average return as a project having the inflows in the reverse order.
2. Use of Accounting Profit : It uses accounting profits and not the cash
inflows in appraising the investment projects.
3. Ignores Re-investment of Profits : This method ignores the fact that
profits can be reinvested and profits can be earned on such reinvestment,
which in turn will affect the rate nof return.
4. Determination of Fair Rate of Return : The method does not determine
the fair rate of return on investment. The use of arbitrary rate of return
may cause serious distortions in the selection of capital projects
5. Incremental Cash Outflows : It considers only net investment and not
the incremental cash outflows i.e. new investment minus the sale proceeds
of the old equipment. The concept of incremental cash outflows should be
taken to arrive at a correct financial decision.