Analysis and Techniques of Capital

Budgeting

Prof. Anup Kumar Hazra

 Meaning of Capital Budgeting
Capital budgeting is a process that businesses use to evaluate potential major projector
investments.

Building a new plant or taking a large stake in an outside venture are examples of
initiatives that typically require capital budgeting before they are approved or rejected
by management. As part of capital budgeting
 Basics of Capital Budgeting
1. Capital budgeting is a crucial financial process that businesses and
organizations use to evaluate and make decisions about long-term
investments in projects, assets, or opportunities.
2. These investments typically involve significant amounts of money and are
expected to generate cash flows over an extended period.
3. The primary goal of capital budgeting is to determine whether the expected
benefits or returns from the investment justify the associated costs.
Identification of Investment Opportunities:
The capital budgeting process begins with the identification of potential investment opportunities.
These opportunities could include projects like acquiring new machinery, expanding facilities,
launching new product lines, or entering new markets.

Estimation of Cash Flows:

For each investment opportunity, cash flows need to be estimated. This involves forecasting the
expected cash inflows and outflows associated with the project over its entire lifespan. Cash inflows
typically include revenues, while cash outflows encompass operating expenses, maintenance costs, and
initial investment costs.

Time Horizon:
Capital budgeting decisions involve a long time horizon, often spanning several years or even decades.
The selection of the appropriate time period for analysis is crucial because it affects the accuracy of
cash flow estimations and the decision-making process.

Discounted Cash Flow:

Discounted cash flow (DCF) analysis looks at the initial cash outflow needed to fund a project, the
mix of cash inflows in the form of revenue, and other future outflows in the form of maintenance and
other costs. These cash flows, except for the initial outflow, are discounted back to the present date.
Net Present Value (NPV):
The Net Present Value is a fundamental capital budgeting metric. It represents the difference between
the present value of cash inflows and outflows. A positive NPV indicates that the investment is
expected to generate more cash than it costs, making it potentially worthwhile. Negative NPV suggests
the opposite.

Internal Rate of Return (IRR):

IRR is another critical metric. It represents the discount rate that makes the NPV of a project equal to
zero. In other words, it's the rate of return the project is expected to generate. If the IRR exceeds the
cost of capital, the investment may be considered.

Payback Period:
The payback period is the time it takes for an investment to generate cash flows equal to its initial
cost. A shorter payback period is often preferred, as it implies a quicker recovery of the investment.

Risk Assessment:
Capital budgeting decisions should consider the inherent risks associated with an investment. Risk
factors may include economic uncertainties, market volatility, competition, and project-specific risks.
Sensitivity analysis and scenario planning can help assess these risks.
 Types of capital budgeting decisions
Capital budgeting decisions are critical financial choices made by a company regarding its long-term
investments in projects, assets, or initiatives. These decisions involve allocating substantial financial
resources, and they are essential for a company's growth, profitability, and overall success.
1. Accept-Reject Decisions: In this type of decision, a company evaluates whether to accept or
reject a particular investment proposal. The decision is based on various financial metrics, such as
Net Present Value (NPV), Internal Rate of Return (IRR), Payback Period, and Profitability Index.
If the project's expected returns meet or exceed the company's required minimum criteria, it is
accepted; otherwise, it is rejected.

2. Mutually Exclusive Projects: Companies often face situations where they must choose between
multiple investment projects that serve a similar purpose or function. In this case, the decision
involves selecting the most financially attractive project among the competing alternatives. The
project with the highest NPV, IRR, or other relevant metrics is typically chosen.
3. Strategic Investment Decisions: These decisions are often long-term and involve significant resources.
They can include mergers and acquisitions, entering new markets, launching new product lines, or
developing entirely new businesses. These decisions require thorough due diligence and strategic planning to
assess their alignment with the company's overall goals.

4. Risk Analysis and Sensitivity Analysis: Evaluating the risk associated with an investment project is
crucial. Companies may conduct sensitivity analysis to understand how changes in key variables (e.g., sales
forecasts, cost estimates, interest rates) can impact the project's financial outcomes. This helps assess the
project's resilience to uncertainties.

5. Timing of Investment: Deciding when to make an investment is important. Sometimes, companies may
delay or accelerate projects based on economic conditions, market trends, or regulatory changes. The
timing can affect the project's potential returns and risks.

6. Capital Allocation: This decision involves determining how much capital to allocate to various business
units, divisions, or projects within the organization. It aims to optimize the allocation of financial resources
to maximize overall corporate performance.

7. Project Termination Decisions: In some cases, companies must decide whether to continue or terminate an
ongoing project. This decision considers factors like sunk costs, future expected cash flows, and any
changes in market conditions.
 Preparation of capital budgeting proposal
The preparation of a capital budgeting proposal involves a systematic process to evaluate and present
an investment opportunity to decision-makers within an organization. This proposal should provide a
clear and compelling case for why a particular project or investment should be undertaken.

1. Project Identification and Definition:

1. Clearly define the nature and scope of the proposed project or investment. Describe the purpose, objectives,
and expected outcomes.
2. Identify the need for the project, such as addressing a specific problem, exploiting an opportunity, or
meeting strategic goals.
2. Project Screening:
1. Conduct an initial screening to determine if the project aligns with the organization's strategic objectives and
financial criteria.
2. Eliminate projects that do not meet the organization's strategic priorities or minimum financial thresholds.
Cost Estimation:
1. Estimate all costs associated with the project, including initial capital expenditures (CAPEX), operating
expenses (OPEX), maintenance costs, and any other relevant expenses.
2. Consider both direct and indirect costs, as well as any ongoing expenses.

Revenue and Cash Flow Projections:

3. Develop detailed revenue projections based on realistic assumptions. Consider factors such as sales
volume, pricing, and market trends.
4. Create cash flow forecasts that outline the expected cash inflows and outflows over the life of the
project.
5. Account for depreciation and taxes in cash flow projections.

Risk Assessment:
6. Identify potential risks and uncertainties associated with the project. Assess the likelihood and impact of
these risks on the project's financial performance.
7. Consider conducting sensitivity analysis or scenario analysis to understand how variations in key
variables may affect project outcomes.
Capital Budgeting Techniques:
1. Apply appropriate capital budgeting techniques, such as Net Present Value (NPV), Internal Rate of Return
(IRR), Payback Period, or Profitability Index, to evaluate the financial viability of the project.
2. Present the results of these analyses, including the calculated financial metrics, to support the investment
decision.

Non-Financial Considerations:
3. Highlight any non-financial factors that may influence the decision, such as strategic alignment, regulatory
compliance, environmental impact, and social responsibility.

Alternative Analysis:
4. If applicable, compare the proposed project to alternative investment options or scenarios. Show why the chosen
project is superior to other alternatives.

Recommendation:
5. Provide a clear and well-justified recommendation for whether the project should be approved or rejected.
6. Include a summary of the key reasons for the recommendation.

Decision and Documentation:

1. After presenting the proposal, decision-makers will evaluate the information provided and make an informed
decision.
2. Document the decision, including any conditions or recommendations for implementation.
 Estimating cash flows for project appraisal
Estimating cash flows accurately is a critical step in project appraisal and capital budgeting.
Cash flows represent the inflows and outflows of cash that a project is expected to generate
over its life. These cash flows are essential for evaluating the financial viability of the project
using techniques such as Net Present Value (NPV) or Internal Rate of Return (IRR).
1. Identify Relevant Cash Flows:
1. Distinguish between relevant and irrelevant cash flows. Relevant cash flows are directly related
to the project and impact its financial performance. Irrelevant cash flows do not affect the
project's value and should be excluded.
2. Initial Investment (Year 0):
1. Determine the initial cash outlay required to start the project. This includes costs such as
equipment purchases, construction expenses, working capital requirements, and any other
upfront expenditures.
2. Include any salvage value of existing assets that will be disposed of due to the project.
Operating Cash Flows (Years 1 and Onward):
1. Estimate the annual operating cash inflows and outflows attributable to the project. These can include:
1. Revenues: Projected sales or revenue generated by the project.
2. Operating Expenses: Costs directly related to production, such as materials, labor, utilities, and
maintenance.
3. Depreciation: Non-cash expense that accounts for the wear and tear of assets. It reduces taxable
income but doesn't involve an actual cash outflow.
4. Taxes: Calculate taxes based on taxable income, considering any tax credits or incentives.
5. Working Capital Changes: Account for changes in working capital, including increases or decreases
in inventory, accounts receivable, and accounts payable.
6. Overhead Expenses: General and administrative expenses that support the project but are not
directly tied to production.

Terminal Cash Flows (End of Project Life):

2. Consider the cash flows associated with the end of the project's life, including the disposal or salvage
value of assets, final working capital adjustments, and any additional costs or revenues.
Inflation and Discount Rates:
1. Account for inflation in both revenues and expenses to ensure cash flows are in real terms. Use nominal cash flows
when applying discount rates.
2. Choose an appropriate discount rate (cost of capital) based on the project's risk profile. The discount rate should
reflect the required rate of return expected by investors.

Cash Flow Timing:

3. Ensure that cash flows are correctly timed. In other words, calculate when cash inflows and outflows are expected
to occur during each year of the project.

Consistency:
4. Maintain consistency in estimating cash flows. Ensure that assumptions, data, and methodologies used to estimate
cash flows align with the project's objectives and context.

Documentation:
5. Document all assumptions, calculations, and data sources used in estimating cash flows. Transparent documentation
helps stakeholders understand and validate the estimates.

Validation and Review:

6. Seek input and validation from relevant experts and stakeholders to ensure the accuracy and credibility of cash flow
estimates.
Presentation:
1. Present the cash flow estimates in a clear and organized format within the project appraisal documentation, along
with explanations of key assumptions and methodologies.

CONCLUSION

Remember that estimating cash flows is an iterative process that may require adjustments as more
information becomes available or as the project progresses.

Regularly reviewing and updating cash flow projections can help ensure that the project remains on track
and aligned with its financial objectives.
 Green capital budgeting
1. Green capital budgeting, also known as sustainable or environmentally responsible capital
budgeting, is a framework used by organizations to evaluate and prioritize investment
projects that have environmental sustainability considerations.
2. It involves assessing the environmental impact of potential projects and integrating these
considerations into the decision-making process.
3. The goal of green capital budgeting is to promote environmentally responsible investments
and align business practices with sustainability goals.
Environmental Assessment:
1. Identify and assess the environmental impacts of proposed projects. This includes evaluating factors such as
resource consumption, emissions, waste generation, and potential harm to ecosystems.

Life Cycle Analysis (LCA):

2. Conduct a life cycle analysis to evaluate the environmental impact of a project from its inception to its end-
of-life stage. This includes considering the environmental effects of raw material extraction, manufacturing,
transportation, use, and disposal or recycling.

Economic Evaluation:
3. Incorporate environmental costs and benefits into the economic evaluation of projects. This may involve
quantifying the costs of pollution, waste management, and resource depletion, as well as the potential savings
from energy efficiency and reduced emissions.

Environmental Criteria:
4. Define specific environmental criteria or key performance indicators (KPIs) that projects must meet to be
considered for approval. These criteria may include reductions in greenhouse gas emissions, water
conservation goals, or adherence to environmental regulations.
Sustainability Goals:
1. Ensure that green capital budgeting aligns with the organization's sustainability goals and commitments.
These goals may include achieving carbon neutrality, reducing environmental impacts, or promoting
circular economy practices.

Stakeholder Engagement:
2. Engage with relevant stakeholders, including employees, customers, suppliers, and environmental
organizations, to gather input and address concerns related to sustainability and green initiatives.

Cost-Benefit Analysis:
1. Conduct a comprehensive cost-benefit analysis that considers not only financial metrics (e.g., NPV,
IRR) but also environmental and social benefits. Evaluate whether the long-term environmental benefits
outweigh any additional costs.

Reporting and Transparency:

1. Maintain transparency by reporting on the environmental performance and impact of projects to
stakeholders and the public. Compliance with sustainability reporting standards, such as the Global
Reporting Initiative (GRI) or the Task Force on Climate-related Financial Disclosures (TCFD), may be
required.
Continuous Improvement:
1. Promote a culture of continuous improvement in environmental performance. Evaluate and refine green
capital budgeting processes and practices based on feedback, changing regulations, and emerging best
practices.

CONCLUSION
1. Green capital budgeting reflects a growing awareness of the environmental
challenges facing businesses and society.

2. By integrating sustainability considerations into the decision-making process,

organizations can make more responsible investments that contribute to a more
sustainable and resilient future.
Non-discounted Cash Flow Techniques:

Payback Period
ARR (Accounting Rate of Return)
Non-discounted cash flow, also known as undiscounted cash flow, refers to a method of evaluating the
financial performance or viability of an investment or project without applying any discounting or time
value of money principles. In other words, it involves examining the cash flows associated with an investment
or project at their nominal or face values without adjusting them for the time value of money.

1. Nominal Values: Non-discounted cash flow analysis uses nominal or face values of cash flows. This
means that future cash inflows and outflows are considered as they are, without considering the fact that
money received or paid in the future is generally worth less than the same amount of money received or paid
today due to factors like inflation and the opportunity cost of using the funds elsewhere.

2. Simple Evaluation: Non-discounted cash flow analysis is straightforward and easy to understand. It
involves summing up all the cash inflows and outflows associated with an investment or project over its
entire life.

3. Lack of Time Value of Money Consideration: One of the limitations of non-discounted cash flow analysis
is that it doesn't take into account the time value of money, which is the concept that a dollar received today is
worth more than a dollar received in the future. As a result, it may not provide an accurate representation of
the true economic value of an investment, especially for long-term projects.
4. Comparison to Discounted Cash Flow (DCF): In contrast to non-discounted cash flow analysis,
discounted cash flow (DCF) analysis adjusts cash flows by applying a discount rate to account for the time
value of money. DCF is generally considered a more comprehensive and accurate method for evaluating the
economic viability of investments or projects, especially those with longer time horizons.

In summary, non-discounted cash flow analysis is a basic method for evaluating investments or projects by
simply adding up the nominal cash flows over time.

While it lacks consideration for the time value of money, it can still be useful for making quick assessments
of short-term projects or when the impact of discounting is negligible.

However, for more accurate and comprehensive evaluations, discounted cash flow analysis is typically
preferred.
Let's work through a numerical example to calculate the payback period for an investment. Suppose you are considering
investing $50,000 in a project, and the expected annual cash flows from the project are as follows:

•Year 1: $10,000
•Year 2: $15,000
•Year 3: $20,000
•Year 4: $12,000
•Year 5: $8,000

To calculate the payback period, you'll add up the cash flows year by year until you recover the initial investment:
Year 1: $10,000 Year 2: $10,000 (Cumulative: $10,000 + $15,000 = $25,000) Year 3: $10,000 (Cumulative: $25,000 +
$20,000 = $45,000) Year 4: $12,000 (Cumulative: $45,000 + $12,000 = $57,000)

At the end of Year 4, you have recovered a total of $57,000, which is more than the initial investment of $50,000.
Therefore, the payback period for this investment is less than 4 years. To calculate the exact payback period, you can
determine how much time it takes to recover the remaining amount in Year 5

Remaining amount to recover in Year 5: $57,000 (cumulative cash flow) - $50,000 (initial investment) = $7,000
The payback period in Year 5 is:
Payback period in Year 5 = Remaining amount / Cash flow in Year 5 Payback period in Year 5 = $7,000 / $8,000 = 0.875
years (approximately 10.5 months)
So, the total payback period for this investment is approximately 4.875 years, which is 4 years and 10.5 months.
You're considering investing in a project that requires an initial investment of Rs 10,000. The project is
expected to generate the following annual cash inflows:
•Year 1: Rs 2,000
•Year 2: Rs 3,500
•Year 3: Rs 3,000
•Year 4: Rs 2,500

Ans: 1st year = 2000/- ; 2nd year = 2000+3500 = 5,500/-; 3rd year = 5,500+3000 = 8,500/-
Remaining Amount = Initial Investment – Amount recovered
x = 10,000- 8,500 = 1,500/-

1500/2500 = 0.6 ; 0.6*12 = 7.2 months

Therefore total year for recovery is 3 years 7.2 months

Que : Suppose a company is considering investing $100,000 in a new project. The project is expected to generate annual
cash flows of $30,000 for the next five years. We want to calculate the payback period for this investment.
ARR (Accounting Rate of Return)
The Accounting Rate of Return (ARR), also known as the Average Accounting Return or Return on Average Investment, is
a financial metric used to evaluate the profitability of an investment or project.

Suppose a company is considering investing $50,000 in a project that is expected to generate the following annual
accounting profits over a 5-year period:
Year 1: $10,000 Year 2: $12,000 Year 3: $15,000 Year 4: $18,000 Year 5: $20,000

Ans = 0.30 or 30%

Suppose a company is considering purchasing a machine for $100,000. The machine has a useful life of 5 years, after
which it will have no resale value. The company expects the machine to generate additional profits (after all expenses) of
$30,000 in Year 1, $28,000 in Year 2, $26,000 in Year 3, $24,000 in Year 4, and $22,000 in Year 5.

Ans =2.6 or 26%

Suppose a company is considering an investment in a new project that requires an initial investment of $50,000. The
project is expected to generate the following annual accounting profits over its five-year life:
Year 1: $12,000 Year 2: $14,000 Year 3: $16,000 Year 4: $18,000 Year 5: $20,000

Ans = 0.32 or 32%

Discounted Cash Flow Techniques

NPV (Net Present Value)

IRR (Internal Rate of Return)
Modified IRR
PI (Profitability Index) and
Capital Rationing
Que: Considering investing in a project that requires an initial investment of $100,000. You expect the project to generate
cash inflows of $30,000 per year for the next five years. The discount rate (the rate used to bring future cash flows to their
present value) is 10%.

Ans: 13,722/-

Step 1 : Write down all cash inflow

Step 2 : PV = Present Value ; CF = Cash Flow in that year; r = Discount Rate; n = Number of years in the future
Step 3: Find out the PV for each year
Step 4: Sum up all the PV – Initial Investment

Interpretation : Net Present Value (NPV) of this project is $13,722. Since the NPV is positive, it suggests that the project
is expected to generate a profit, and it may be a worthwhile investment given the assumptions made.

Que: A company is considering an investment project that requires an initial outlay of $1000 . The project is expected to
generate the following cash flows over the next 3 years: Year 1 (t=1): $500 Year 2 (t=2): $400 Year 3 (t=3): $300. If the
discount rate is 10%

Ans: 10.52
Que: Suppose you are considering an investment in a project that requires an initial investment of $100,000. The
project is expected to generate cash flows of $30,000 at the end of Year 1, $40,000 at the end of Year 2, and $50,000 at
the end of Year 3. The discount rate (required rate of return) for this project is 10%.

Ans: 1,909/-

Que: Considering an investment in a project that requires an initial investment of $10,000, and it is expected to
generate the following cash flows over the next four years:
Year 1: $3,000 Year 2: $4,000 Year 3: $5,000 Year 4: $6,000. The discount rate is 8%. Calculate the NPV of this
investment.

Ans: 6,050.07/-

Que: NPV calculation involving uneven cash flows and a different discount rate.
Year 0 (Initial Investment): -$50,000
Consider a project with the following cash flows over a 5-year period:
Year 1: $10,000 Year 2: $12,000 Year 3: $15,000 Year 4: $18,000 Year 5: $22,000
The discount rates for each year are as follows: Year 0: 10% Year 1: 9% Year 2: 8% Year 3: 7% Year 4: 6% Year 5: 5%
Calculate the NPV of this investment.

Ans: 13,669/-
 Internal Rate of Return
Que: You are evaluating an investment project with the following cash flows: Year 0 (Initial
Investment): -$50,000 Year 1: $15,000 Year 2: $20,000 Year 3: $25,000 Year 4: $30,000.
Additionally, you have a specified discount rate (required rate of return) of 12%. Determine whether
this investment has an IRR higher or lower than the specified discount rate.
Ans:
Step 1: Find out the NPV
Step 2: Now, we compare the NPV to the initial investment:
• If NPV > Initial Investment, it means the IRR is higher than the discount rate.
• If NPV < Initial Investment, it means the IRR is lower than the discount rate.
In this case, NPV ($11,248.03) is greater than the Initial Investment ($50,000). Therefore, the
investment's IRR is higher than the specified discount rate of 12%. This suggests that the investment
is expected to yield a rate of return higher than the required rate of return, making it an attractive
investment opportunity.
Que: It's the rate at which an investment breaks even in terms of NPV. The IRR can be a helpful tool in determining
whether to pursue an investment or project.

Let's work through a numerical example to calculate IRR:

Problem:
Assume you're considering an investment that requires an initial outlay of $1,000 today. You expect the investment
to generate cash inflows of $500 at the end of the first year, $400 at the end of the second year, and $300 at the end
of the third year. Calculate the IRR of this investment.

Assume IRR as 10%, later by 15%

The IRR lies somewhere between 10% and 15%. To get a precise IRR, you'd typically use financial calculators,
spreadsheet software like Excel (using the IRR function), or specialized financial software. For this example, the
IRR will likely be around 12-13%, but you'd need more precise tools to get the exact rate.
Que: Considering an investment that costs $10,000 today, and you expect to receive the following cash flows over the next
five years:

Year 1: $2,000 Year 2: $3,000 Year 3: $4,000 Year 4: $2,500 Year 5: $3,500

Ans: 10% to 15%

MODIFIED IRR
Modified IRR should be more than “Discounted Rate of Return” (recommend for
investing into that project).

Modified IRR is less than “Discounted Rate of Return” (not recommend for
investing into that project).
Que:
Let's calculate the MIRR for an investment project with the following information:
Initial investment (Year 0): -$100,000 Cash flows: Year 1: $30,000 Year 2: $40,000 Year 3: $50,000
The cost of capital (discount rate) is 10%, and the cost of borrowing is 6%.

Step 1: Calculate the future value of all positive cash flows using the cost of capital (reinvestment rate).
Step 2: Calculate the future value of the initial investment (outflows) using the cost of borrowing (finance rate).
Step 3: Now, calculate the MIRR by finding the discount rate that equates the future value of the initial investment to the
future value of the positive cash flows.
Step 4: MIRR = (Future Value of Positive Cash Flows / Future Value of Initial Investment)^(1/n) – 1

Ans: MIRR = ($81,600 / -$119,101.60)^(1/3) – 1

 Profitability Index
 The Profitability Index (PI), also known as the Profit Investment Ratio (PIR) or Value
Investment Ratio (VIR), is a financial metric used to evaluate the attractiveness of an
investment or project.
 It helps assess the potential profitability of an investment by comparing the present value of
its expected future cash flows to the initial investment cost.
 The Profitability Index is particularly useful in capital budgeting and project evaluation.

The formula for calculating the Profitability Index is as follows:

 Profitability Index (PI) = Present Value of Cash Inflows / Initial Investment
The Profitability Index provides a ratio or index value that is greater than 1 if the project is expected to be
profitable, and less than 1 if the project is not expected to be profitable. Here's how to interpret the results:

•PI > 1: A PI greater than 1 indicates that the present value of expected cash inflows exceeds the initial
investment, suggesting that the project is potentially a profitable one. A higher PI is generally considered more
attractive.
•PI = 1: A PI equal to 1 means that the present value of cash inflows is equal to the initial investment. This
suggests that the project will break even, with no additional profit.
•PI < 1: A PI less than 1 indicates that the present value of cash inflows is less than the initial investment,
implying that the project may not be financially viable.

In capital budgeting and investment analysis, managers and decision-makers often use the Profitability Index
to compare and prioritize different investment options. When comparing multiple projects, the one with the
highest Profitability Index is usually considered the most attractive, as it is expected to generate the greatest
return relative to its initial cost.
Que: Consider a hypothetical project with expected cash flows over a five-year period and an initial investment cost. We'll
calculate the PI to determine whether the project is potentially profitable.

Suppose you are evaluating a project with the following cash flows:

•Year 0 (Initial Investment): $100,000

•Year 1: $30,000
•Year 2: $25,000
•Year 3: $20,000
•Year 4: $15,000
•Year 5: $10,000

We will calculate the PI for this project.

Ans: 1.854

The calculated Profitability Index (PI) is approximately 1.854. Since the PI is greater than 1, it indicates that the
project is potentially profitable. A PI greater than 1 suggests that the present value of expected cash inflows is greater
than the initial investment, making the project attractive from a financial perspective.
 IRR vs PI
The choice between using the Internal Rate of Return (IRR) or the Profitability Index (PI) as a decision criterion
for evaluating investment projects depends on the specific characteristics of the projects and the goals of the
analysis. Both IRR and PI have their advantages and limitations, and the better metric to use depends on the
context of the analysis:
1. IRR (Internal Rate of Return):
1. IRR is a percentage value that represents the discount rate at which the Net Present Value (NPV) of a project is zero.
In other words, it provides the rate of return that an investment is expected to generate.
2. IRR is often favored when you want to assess the project's potential return on investment, and it is a good metric for
comparing projects to see which one offers the highest return.
3. IRR is effective when the project's cash flows are expected to be reinvested at the project's IRR rate.
2. PI (Profitability Index):
1. PI is a ratio that represents the present value of expected cash inflows relative to the initial investment cost. It helps
assess the project's potential profitability.
2. PI is advantageous when you want to compare the relative attractiveness of projects, especially when the projects
have different initial investment amounts.
3. PI can be a better metric when projects have different lifespans or when you have budget constraints.
 Summary
The choice between IRR and PI depends on the goals and characteristics of the projects being evaluated. Both
metrics can be valuable, but they provide different insights:

• Use IRR when you want to evaluate the return on investment and compare projects based on their returns. If
you have to choose one project from a list based on return, IRR can help you identify the project with the
highest expected return.

• Use PI when you want to assess the potential profitability of projects and compare projects based on the
present value of cash flows relative to the initial investment. If you have budget constraints or projects with
varying initial investments, PI can help you make more informed decisions.

In practice, it's often a good idea to consider both IRR and PI, along with other financial metrics like Net
Present Value (NPV), to gain a comprehensive understanding of the financial aspects of an investment or
project. Ultimately, the choice between IRR and PI should align with your specific investment goals and
constraints.
 Capital Rationing
Capital rationing is a financial management strategy used by businesses to limit the amount of
capital (funds) that is allocated to various projects or investments, even when there are
potentially profitable opportunities available. This practice involves setting a maximum limit
on the total capital expenditure for a specific period, despite the existence of positive Net
Present Value (NPV) projects that could potentially generate returns exceeding the company's
cost of capital.
1. Resource Constraints: Capital rationing is often employed when a company faces
limitations on the availability of funds. This might be due to factors like a tight budget,
limited access to external financing, or a desire to maintain financial stability.
2. Risk Mitigation: By placing constraints on capital allocation, a company can mitigate the
risk of overextending itself financially. This approach helps avoid financial distress and
reduces the risk of defaulting on debt obligations.
Project Prioritization: Capital rationing forces a company to prioritize among various projects and investments. This can
lead to the selection of projects that offer the highest return relative to the amount of capital invested.

Risk-Adjusted Return: Capital rationing encourages companies to evaluate projects not just on their raw return potential
but also on their risk-adjusted return. It can result in the selection of projects that provide the best balance between risk
and return.

Strategic Objectives: It allows companies to align their capital allocation decisions with strategic objectives. Certain
projects might be favored due to their strategic importance or alignment with long-term goals.

There are different approaches to capital rationing:

1. Hard Rationing: In hard rationing, the company strictly adheres to a fixed capital budget, and projects are funded only
up to the limit of available capital. If a project's capital requirement exceeds the budget, it is rejected.

2. Soft Rationing: Soft rationing allows for some flexibility in capital allocation. If a project has a positive NPV and is
considered highly valuable, the company might seek additional funds or defer other lower-priority projects to
accommodate it.
Que: Suppose a company has a capital budget of $1,000,000, and it is considering three potential projects, each
with a different capital requirement and expected Net Present Value (NPV). Here are the details of the projects:

Project A:
•Capital Requirement: $400,000
•Expected NPV: $300,000

Project B:
•Capital Requirement: $300,000
•Expected NPV: $250,000

Project C:
•Capital Requirement: $600,000
•Expected NPV: $500,000
To implement capital rationing and maximize the company's returns, we need to compare the expected return
(NPV) of each project to its capital requirement. We'll prioritize projects based on their NPV-to-capital ratio, which
is a form of Profitability Index (PI). The NPV-to-capital ratio for each project is calculated as follows:

NPV-to-Capital Ratio = Expected NPV / Capital Requirement

Now, let's calculate the NPV-to-capital ratio for each project:

Project A: NPV-to-Capital Ratio = $300,000 / $400,000 = 0.75

Project B: NPV-to-Capital Ratio = $250,000 / $300,000 ≈ 0.833
Project C: NPV-to-Capital Ratio = $500,000 / $600,000 ≈ 0.833

Next, we'll prioritize the projects based on their NPV-to-capital ratios, starting with the highest ratios:
1.Project B (NPV-to-Capital Ratio: 0.833)
2.Project C (NPV-to-Capital Ratio: 0.833)
3.Project A (NPV-to-Capital Ratio: 0.75)
Since the company has a capital budget of $1,000,000, it can choose either Project B or Project C. Let's say
the company selects Project B, which requires $300,000 in capital.

After selecting Project B, the available capital budget is reduced to $1,000,000 - $300,000 = $700,000.

Now, the company can allocate the remaining capital to another project. In this case, Project C has the next
highest NPV-to-capital ratio, so it can be funded with the remaining budget. The company allocates $600,000
to Project C.

With Project B and Project C chosen, the company has fully utilized its capital budget, and both projects are
expected to generate a total NPV of $250,000 + $500,000 = $750,000.

This is a simplified example of how capital rationing can help a company make investment decisions when it
has limited funds. The company prioritizes projects based on their NPV-to-capital ratio and allocates the
capital to projects with the highest ratios until the budget is fully utilized.