67637056 8 capital budgeting

Financial Management Unit 8

Sikkim Manipal University 113

Unit 8 Capital Budgeting

Structure

8.1. Introduction

8.2. Importance of Capital budgeting

8.3. Complexities involved in Capital budgeting decisions

8.4. Phases of Capital expenditure decisions

8.5. Identification of investment opportunities

8.6. Rationale of Capital budgeting proposals

8.7. Capital Budgeting process

8.7.1 Technical appraisal

8.7.2 Economic Appraisal

8.8. Investment Evaluation

8.9. Appraisal criteria

8.9.1 Traditional techniques

8.9.2 Discounted pay back period

8.10. Summary

Terminal Questions

Answer to SAQs and TQs

8.1 Introduction HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over Bank of Madurai. The

motive behind all these mergers is to grow because in this era of globalization the need of the

hour is to grow as big as possible. In all these, one could observe that the desire of the

management to create value for shareholders is the motivating force.

Another way of growing is through branch expansion, expanding the product mix and reducing

cost through improved technology for deeper penetration into the market for the company’s

products. For example, a bank which is urban based, for expansion takes over a bank with rural

network. Here urban based bank can open more urban branches only when it meets the Reserve

Bank of India guideline of having a minimum number of rural branches. This is the motive for the

merger of urban based bank of ICICI with the rural based Bank of Madurai.



In this competitive arena proactive organization makes attempts to convert challenges into

opportunities. Indian economy is growing at 9%. It has far reaching implications. New lines of

business such as retailing, investment advisory services and private banking are emerging. All

these involve investment decisions. These investment decisions that corporates take to reap the

benefits arising out of the emerging business opportunities are known as Capital Budgeting

decisions. Capital budgeting decisions involve evaluation of specific investment proposals. Here

the word capital refers to the operating assets used in production of goods or rendering of

services. Budgeting involves formulating a plan of the expected cash flows during the future

period. When we combine Capital with budget we get Capital budget. Capital budget is a blue

print of planned investments in operating assets. Therefore, Capital budgeting is the process of

evaluating the profitability of the projects under consideration and deciding on the proposal to be

included in the Capital budget for implementation. Capital budgeting decisions involve investment

of current funds in anticipation of cash flows occurring over a series of years in future. All these

decisions are Strategic because they change the profile of the organizations. Successful

organizations have created wealth for their shareholders through Capital budgeting decisions.

Investment of current funds in longterm assets for generation of cash flows in future over a series

of years characterizes the nature of Capital Budgeting decisions.

Learning Objectives:

After studying this unit, you should be able to understand the following.

1. Explain the concept of capital budgeting.

2. Bring out the importance of capital budgeting.

3. Examine the complexity of capital budgeting procedures.

4. Discuss the various techniques of appraisal methods.

5. Evaluate capital budgeting decision

8.2 Importance of Capital budgeting Capital budgeting decisions are the most important decisions in Corporate financial management.

These decisions make or mar a business organization. These decisions commit a firm to invest

its current funds in the operating assets (i,e longterm assets) with the hope of employing them

most efficiently to generate a series of cash flows in future.

These decisions could be grouped into



1. Replacement decisions: These decisions may be decision to replace the equipments for

maintenance of current level of business or decisions aiming at cost reductions.

2. Decisions on expenditure for increasing the present operating level or expansion through

improved network of distribution.

3. Decisions for products of new goods or rendering of new services.

4. Decisions on penetrating into new geographical area.

5. Decisions to comply with the regulatory structure affecting the operations of the company.

Investments in assets to comply with the conditions imposed by Environmental Protection Act

come under this category.

6. Decisions on investment to build township for providing residential accommodation to

employees working in a manufacturing plant.

There are many reasons that make the Capital budgeting decisions the most crucial for finance

managers

1. These decisions involve large outlay of funds now in anticipation of cash flows in future. For

example, investment in plant and machinery. The economic life of such assets has long

periods. The projections of cash flows anticipated involve forecasts of many financial

variables. The most crucial variable is the sales forecast.

a. For example, Metal Box spent large sums of money on expansion of its production

facilities based on its own sales forecast. During this period, huge investments in R & D in

packaging industry brought about new packaging medium totally replacing metal as an

important component of packing boxes. At the end of the expansion Metal Box Ltd found

itself that the market for its metal boxes had declined drastically. The end result is that

Metal Box became a sick company from the position it enjoyed earlier prior to the

execution of expansion as a blue chip. Employees lost their jobs. It affected the standard

of lining and cash flow position of its employees.

This highlights the element of risk involved in these type of decisions.

b. Equally we have empirical evidence of companies which took decisions on expansion

through the addition of new products and adoption of the latest technology creating wealth

for shareholders. The best example is the Reliance group.

c. Any serious error in forecasting Sales and hence the amount of capital expenditure can

significantly affect the firm. An upward bias may lead to a situation of the firm creating idle

capacity, laying the path for the cancer of sickness.



d. Any downward bias in forecasting may lead the firm to a situation of losing its market to its

competitors. Both are risky fraught with grave consequences.

2. A long term investment of funds some times may change the risk profile of the firm. A FMCG

company with its core competencies in the business decided to enter into a new business of

power generation. This decision will totally alter the risk profile of the business of the

company. Investor’s perception of risk of the new business to be taken up by the company

will change his required rate of return to invest in the company. In this connection it is to be

noted that the power pricing is a politically sensitive area affecting the profitability of the

organization. Therefore, Capital budgeting decisions change the risk dimensions of the

company and hence the required rate of return that the investors want.

3. Most of the Capital budgeting decisions involve huge outlay. The funds requirements during

the phase of execution must be synchronized with the flow of funds. Failure to achieve the

required coordination between the inflow and outflow may cause time over run and cost over

run. These two problems of time over run and cost over run have to be prevented from

occurring in the beginning of execution of the project. Quite a lot empirical examples are

there in public sector in India in support of this argument that cost over run and time over run

can make a company’s operations unproductive. But the major challenge that the

management of a firm faces in managing the uncertain future cash inflows and out flows

associated with the plan and execution of Capital budgeting decisions.

4. Capital budgeting decisions involve assessment of market for company’s products and

services, deciding on the scale of operations, selection of relevant technology and finally

procurement of costly equipment. If a firm were to realize after committing itself considerable

sums of money in the process of implementing the Capital budgeting decisions taken that the

decision to diversify or expand would become a wealth destroyer to the company, then the

firm would have experienced a situation of inability to sell the equipments bought. Loss

incurred by the firm on account of this would be heavy if the firm were to scrap the

equipments bought specifically for implementing the decision taken. Sometimes these

equipments will be specialized costly equipments. Therefore, Capital budgeting decisions are

irreversible.

5. The most difficult aspect of Capital budgeting decisions is the influence of time. A firm incurs

Capital expenditure to build up capacity in anticipation of the expected boom in the demand

for its products. The timing of the Capital expenditure decision must match with the expected

boom in demand for company’s products. If it plans in advance it may effectively manage the



timing and the quality of asset acquisition. But many firms suffer from its inability to forecast

the future operations and formulate strategic decision to acquire the required assets in

advance at the competitive rates.

6. All Capital budgeting decisions have three strategic elements. These three elements are

cost, quality and timing. Decisions must be taken at the right time which would enable the

firm to procure the assets at the least cost for producing the products of required quality for

customer. Any lapse on the part of the firm in understanding the effect of these elements on

implementation of Capital expenditure decision taken will strategically affect the firm’s

profitability.

7. Liberalization and globalization gave birth to economic institutions like World Trade

organization. General Electrical can expand its market into India snatching the share already

enjoyed by firms like Bajaj Electricals or Kirloskar Electric Company. Ability of G E to sell its

products in India at a rate less than the rate at which Indian Companies sell cannot be

ignored. Therefore, the growth and survival of any firm in today’s business environment

demands a firm to be proactive. Proactive firms cannot avoid the risk of taking challenging

Capital budgeting decisions for growth.

Therefore, Capital budgeting decisions for growth have become an essential characteristics of

successful firms today.

8. The social, political, economic and technological forces generate high level of uncertainty in

future cash flows streams associated with Capital budgeting decisions. These factors make

these decisions highly complex.

9. Capital expenditure decisions are very expensive. To implement these decisions firm’s will

have to tap the Capital market for funds. The composition of debt and equity must be optimal

keeping in view the expectation of investors and risk profile of the selected project.

Self Assessment Questions 1

1. ______________ make or mar a business.

2. _____ decisions involve large outlay of funds now in anticipation of cash inflows in future.

3. Social, political, economic and technological forces make capital budgeting decisions

________________.

4. ________ are very expensive.



8.3 Complexities involved in Capital budgeting decisions Capital expenditure decision involves forecasting of future operating cash flows. Such forecasting

suffers from uncertainty because the future is highly uncertain. Forecasting the future cash flows

demands the necessity to make certain assumptions about the behaviour of costs and revenues

in future. Fast changing environment makes the technology considered for implementation many

times obsolete. For example, the arrival of mobile revolution totally made the pager technology

obsolete. The firm’s which invested in pagers faced the problem of pagers losing its relevance as

a means of communication. The firms with the ability to adapt the new knowhow in mobile

technology could survive the effect of this phase of technological obsolescence. Others who

could not manage the effect of change in technology had a natural death and so most Capital

expenditure decisions are irreversible. Estimation of future cash flows of Capital budgeting

decisions is really complex and difficult commitment of funds on long term basis along with the

associated problem of irreversibility of decisions and difficulty in estimating cash flows makes

Capital expenditure decisions complex in nature.

Self Assessment Questions 2 1. Capital expenditure decisions are ____________.

2. Forecasting of future operating cash flows suffers from ____ because the future is

____________________.

8.4 Phases of Capital expenditure decisions: The following steps are involved in Capital budgeting decisions:

1. Identification of investment opportunities.

2. Evaluation of each investment proposal.

3. Examine the investments required for each investment proposal.

4. Prepare the statements of Costs and benefits of investment proposals.

5. Estimate and compare the net present values of the investment proposals that have been

cleared by the management on the basis of screening criteria.

6. Examine the government policies and regulatory guidelines to be observed for execution of

each investment proposal screened and cleared based on the criteria stipulated by the

management.

7. Budgeting for capital expenditure for approval by the management.

8. Implementation.

9. Post_ completion audit.




1. Postcompletion audit is _____ in the phases of capital budgeting decisions.

2. Identification of investment opportunities is the ______ in the phases of capital budgeting

decisions.

8.5 Identification of investment opportunities: A firm is in a position to identify investment proposal only when it is responsive to the ideas for

capital projects emerging from various levels of the organization. The proposal may be adding

new products to the company’s product line, expansion of capacity to meet the emerging market

at demand for company’s products to meet the emerging market demand for company’s product

or new technology based process of manufacture that will reduce the cost of production.

For example, a sales manager may come with a proposal to produce a new product as per the

requirements of company’s consumers. Marketing manager, based on the sales managers

proposal may conduct a market survey to determine the expected demand for the new product

under consideration. Once the marketing manager is convinced of the market potential for

proposed new product the proposal goes to the engineers to examine the same with all aspects

of production process. Then the proposal goes to the cost accountant to translate the entire

gamut of the proposal into costs and revenues in terms of incremental cash flows both outflows

and inflows. The costbenefit statement generated by cost accountant shall include all

incremental costs and benefits that the firm will incur and derive on commercialization of the

proposal under consideration. Therefore, generation of ideas with the feasibility to convert the

same into investment proposals occupies a crucial place in the Capital budgeting decisions.

Proactive organizations encourage a continuous flow of investment proposals from all levels in

the organization.

In this connection following deserves to be considered:

1. Market Characteristics: Analysing the demand and supply conditions of the market for the

company’s product could be a fertile source of potential investment proposals.

2. Various reports submitted by production engineers coupled with the information obtained

through market surveys on customer’s perception of company’s product could be a potential

investment proposal to redefine the company’s products in terms of customer’s expectations.

3. Companies which invest in Research and Development constantly get exposure to the benefit

of adapting the new technology quite relevant to keep the firm competitive in the most

dynamic business environment. Reports emerging from R & D section could be a potential

source of investment proposal.



4. Economic growth of the country and the emerging middle class endowed with purchasing

power could generate new business opportunities to existing firms. These new business

opportunities could be potential investment ideas.

5. Public awareness of their rights compels many firm’s to initiate projects from environmental

protection angle. If ignored, the firm may have to face the public wrath through PILs

entertained at the Supreme court and High courts.

Therefore, project ideas that would improve the competitiveness of the firm by constantly

improving the production process with the sole objective of cost reduction and costumer

welfare are accepted by wellmanaged firms.

Therefore, generation of ideas for capital projects and screening the same can be considered

the most crucial phase of Capital budgeting decisions.


1. Analyzing the demand and supply conditions of the market for the company’s products could

be________ of potential investment proposal.

2. Generation of ideas for capital budgets and screening the same can be considered

__________ of capital budgetary decisions.

8.6 Rationale of Capital budgeting proposals: The investors and stake holders expect a firm to function efficiently to satisfy their expectations .

Through the stake holder’s expectation of the performance of the company may clash among

themselves, the one that touches all these stakeholder’s expectation could be visualized in terms

of the firms obligation to reduce the operating costs on a continuous basis and increasing its

revenues. These twin obligations of a firm form the basis of all Capital budgeting decisions.

Therefore, Capital budgeting decisions could be grouped into two categories:

1. Decisions on cost reduction programmes.

2. Decisions on revenue generation through expansion of installed capacity.

Self Assessment Questions 5 1. _________ decisions could be grouped into two categories.

2. ____________ and revenue generation are the two important categries of capital budgeting.

8.7 Capital Budgeting process: Once the screening of proposals for potential involvement is over the next. The company should take up the following aspects of Capital Budgeting process.



1. Commercial: A proposal should be commercially viable. The following aspects are

examined to ascertain the commercial viability of any investment proposal.

a. Market for the product

b. Availability of raw materials

c. Sources of raw materials

d. The elements that influence the location of a plant i,e, the factors to be considered in the site

selection.

2. Infrastructural facilities such as roads, communications facilities, financial services such as

banking, public transport services.

Among the aspects mentioned above the crucial one is the need to ascertain the demand for

the product or services. It is done by market appraisal. In appraisal of market for the new

product, the following details are compiled and analyzed.

a. Consumption trends.

b. Competition and players in the market

c. Availability of substitutes

d. Purchasing power of consumers

e. Regulations stipulated by Government on pricing the proposed products or services

f. Production constraints: Relevant forecasting technologies are employed to get a realistic

picture of the potential demand for the proposed product or service. Many projects fail to

achieve the planned targets on profitability and cash flows if the firm could not succeed in

forecasting the demand for the product on a realistic basis.

8.7.1 Technical appraisal: This appraisal is done to ensure that all technical aspects of the implementation of the project are considered.

The technical examination of the project considers the following:

a. Selection of process know how

b. Decision on determination of plant capacity

c. Selection of plant and equipment and scale of operation

d. Plant design and layout

e. General layout and maternal flow

f. Construction schedule

8.7.2 Economic Appraisal: This appraisal examines the project from the social point of

view. It is also known as social cost benefit analysis. It examines:



g. The impact of the project on the environment

h. The impact of the project on the income distribution in the society.

i. The impact of the project on fulfillment of certain social objective like generation of

employment, attainment of self sufficiency etc.

j. Will it materially alter the level of savings and investment in the society?

3. Financial appraisal: This appraisal is to examine the financial viability of the project. It assesses the risk and returns at various stages of project execution. Besides, it examines

whether the risk adjusted return from the project exceeds the cost of financing the project.

The following aspects are examined in the process of evaluating a project in financially terms.

a. Cost of the project

b. Investment outlay

c. Means of financing and the cost of capital

d. Expected profitability

e. Expected incremental cash flows from the project

f. Breakeven point

g. Cash break even point

h. Risk dimensions of the project

i. Will the project materially alter the risk profile of the company ?

j. If the project is financed by debt, expected “Debt Service Coverage Ratio”

k. Tax holiday benefits, if any


1. ______________ examines the project from the social point view.

2. All technical aspects of the implementation of the project are considered in _____.

3. ___ of a project is examined by financial appraisal.

4. Among the elements that are to be examined under commernal appraised the most crucial

one is the _________________.

8.8 Investment Evaluation: following steps are involved in the evaluation of any investment proposal:

1. Estimates of Cash flows both inflows and outflows occurring at different stages of project life

cycle.

2. Examination of the risk profile of the project to be taken up and arriving at the required rate of

return



3. Formulating the decision criteria.

Estimation of Cash flows: Estimating the cash flows associated with the project under

consideration is the most difficult and crucial step in the evaluation of an investment proposal. It

is the result of the team work of many professionals in an organization.

1. Capital outlays are estimated by engineering departments after examining all aspects of

production process.

2. Marketing department on the basis of market survey forecasts the expected sales revenue

during the period of accrual of benefits from project executions.

3. Operating costs are estimated by cost accountants and production engineers

4. Incremental cash flows and cash out flow statement is prepared by the cost accountant on the

basis of the details generated in the above steps. The ability of the firm to forecast the cash

flows with reasonable accuracy lies at the root of the success of the implementation of any

capital expenditure decision.

Investment (Capital budgeting) decision required the estimation of incremental cash flow

stream over the life of the investment. Incremental cash flows are estimated on after tax

basis.

Incremental cash flows stream of a capital expenditure decision has three components.

1. Initial Cash outlay (Initial investment): Initial cash outlay to be incurred is determined after considering any post tax cash inflows if any, In replacement decisions existing old machinery

is disposed of and a new machinery incorporating the latest technology is installed in its

place. On disposal of existing old machinery the firm has a cash inflow. This cash inflow has

to be computed on post tax basis. The net cash out flow (total cash required for investment in

capital assets minus post tax cash inflow on disposal of the old machinery being replaced by

a new one) therefore is the incremental cash outflow. Additional net working capital required

on implementation of new project is to be added to initial investment.

2. Operating Cash inflows: Operating Cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over

the life of the project. Here also incremental inflows and outflows attributable to operating

activities are considered. Any savings in cost on installation of a new machinery in the place

of the old machinery will have to be accounted to on post tax basis. In this connection

incremental cash flows refer to the change in cash flows on implementation of a new proposal

over the existing positions.



3. Terminal Cash inflows: At the end of the economic life of the project, the operating assets

installed now will be disposed off. It is normally known as salvage value of equipments. This

terminal cash inflows is computed on post tax basis.

Prof. Prasanna Chandra in his book Financial Management has identified certain basic

principles of cash flow estimation. The knowledge of these principles will help a student in

understanding the basis of computing incremental cash flows.

These principles, as given by Prof. Prasanna Chandra are:

a. Separation principle

b. Incremental principle

c. Post tax principle

d. Consistency principle

a. Separation principle: The essence of this principle is the necessity to treat investment element of the project separately (i,e independently) from that of financing element. The

financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of

return expected on implementation of the project is compared with the cost of capital. Therefore,

we compute separately cost of funds for execution of project through the financing mode. The

rate of return expected on implementation if the project is arrived at by the investment profile of

the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows.

The following formulae is used to calculate profit after tax.

Incremental PAT = Incremental EBIT ( 1t )

(Incremental) (Incremental)

EBIT = Earnings (Profit) before interest and taxes.

t = tax rate

EBIT infact represents incremental earnings before interest and tax

When depreciation charges on computing incremental post tax profit is added back to incremental

profit after tax, we get incremental operating cash inflow.

b. Incremental principle: Incremental principle says that the cash flows of a project are to

be considered in incremental terms. Incremental cash flows are the changes in the firms

total cash flows arising directly from the implementation of the project.

The following are to be kept in mind in determining incremental cash flows.

1. Ignore Sunk costs: A sunk cost means an outlay already incurred. It is not a relevant cost

for the project decisions to be taken now. It is ignored when the decisions on project now

under consideration is to be taken.



2. Opportunity Costs: If the firm already owns an asset or resource which could be used in the

execution of the project under consideration the asset or resource has an opportunity cost.

The opportunity of cost of such resources will have to be taken into account in the evaluation

of the project for acceptance or rejection. For example, the firm wants to open a branch in

Chennai for expansion of its market in Tamil Nadu. The firm already owns a building in

Chennai. The building in Chennai is let out to some other firm on an annual rent of Rs.1

Crore. The firm takes a decision to open a brands at Chennai. For opening the branch at

Chennai the firm uses the building it owns by sacrificing the rental income which it receives

now. The opportunity cost of the building at Chennai is Rs.1 crores. This will have to be

considered in arriving at the operating cash flows associated with the decision to open a

branch at Chennai.

3. Need to take into account all incident effect: Effects of a project on the working of other parts of a firm also known as externalities must be taken into account. For example,

expansion or establishment of a branch at a new place may increase the profitability of

existing branches because the branch at the new place has a complementary relationship

with the other existing branches or reduce the profitability of existing branches because the

branch at the new place competes with the business of other existing branches or takes away

some business activities from the existing branches.

Cannibalization: Another problem that a firm faces on introduction of a new product is the

reduction in the sale of an existing product. This is called cannibalization. The most challenging

task is the handling of problems of cannibalization. Depending on the company’s position with

that of the competitors in the market, appropriate strategy has to follow. Correspondingly the

cost of cannibalization will have to be treated either as revelent cost of the decision or ignored.

Product cannibalization will affect the company’s sales if the firm is marketing its products in a

market characterized by severe competition, without any entry barriers.

In this case costs are not relevant for decision. On the other hand if the firm’s sales are not

affected by competitor’s activities due to certain unique protection that it enjoys on account of

brand positioning or patent protection the costs of cannibalization cannot be ignored in taking

decisions

c.Post Tax Principle: all cash flows should be computed on post tax basis d. Consistency principle: cash flows and discount rates used in project evaluation need to consistent with the investor group and inflation.



In capital budgeting, the cash flows applicable to all investors (i.e equity, preference share

holders and debt holders) and weighted average cost of capital are considered. Nominal cash

flows and nominal discounts are considered in capital budgeting decision. Example (illustration) A firm considering replacement of its existing machine by a new machine. The new machine will

cost Rs 1,60,000 and have a life of five years. The new machine will yield annual cash revenue

of Rs 2,50,000 and incur annual cash expenses of Rs 1,30,000. The estimated salvage of the

new machine at the end of its economic life is Rs 8,000. The existing machine has a book value

of Rs 40,000 and can be sold for Rs 20,000. The existing machine, if used for the next five years

is expected to generate annual cash revenue of Rs 2,00,000 and to involve annual cash

expenses of Rs 1,40,000. If sold after five years, the salvage value of the existing machine will

be negligible.

The company pays tax at 30%. It writes off depreciation act 25% on the written down value. The

company’s lost of capital is 20%

Compute the incremental cash flows of replacement decisions.

Solution:

Initial Investment:

Gross investment for the new machine (1,60,000)

Less: Cash received from the sale of

Existing machine 20,000

Net cash out lay (1,40,000)

Annual Cash flows from operations

Incremental cash flows from revenue 50,000

Incremental decrease in expenditure (10,000)

Incremental Depreciation Schedule

Year Depreciation (New Machine (Rs.)

Depreciation (Old Machine)

Incremental Depreciation (Rs.)

1 45,000 10,000 35,000

2 33,750 7,500 26,250

3 25,312 5,625 19,687



4 18,984 4,219 14,765

5 14,238 3,164 11,074

Depreciation is calculated as under

Book Value 40,000

Add: Cost of new machine 1,60,000

2,00,000

Less: Sale proceeds of Old Machine 20,000

1,80,000

Depreciation for I year 25 % 45,000

1,35,000

Depreciation for II year 25% 33,750

1,01,250

Depreciation for III year 25% 25,312

75,938

Depreciation for IV year 25% 18,984

56,954

Depreciation for V year 25% 14,238

Book value after 5 years 42,716

Statement of incremental Cash flows

Particulars Year

0 Rs 1 Rs 2 Rs 3 Rs 4 Rs 5 Rs

1. Investment in new

machine

(1,60,000)

2. After tax salvage value

of old machine

20,000

3. Net Cash Out lay (1,40,000)



4. Increase in revenue 50,000 50,000 50,000 50,000 50,000

5. Decrease in expenses 10,000 10,000 10,000 10,000 10,000

6. Increase in depreciation 35,000 26,250 19,687 14,765 11,074

7. Increase in EBIT 25,000 33,750 40,313 45,235 48,926

8. EBIT (1 – T) 17,500 23,625 28,219 31,665 34,248

9. Incremental Cash flows

from operation (8 + 6)

52,500 49,875 47,906 46,430 45,322

10. Salvage value of new

machine

8,000

11. Incremental Cash

flows

(1,40,000)

negative

52,500 49,875 47,906 46,430 53,322

The following points to be kept in deciding on the appraisal technique:

1. Appraisal technique should measure the economic worth of the project.

2. Wealth maximization of share holders shall be the guiding principle.

3. It shall consider all cash flows over the entire life of the project to ascertain the profitability of

the project.

4. It shall rank the projects on a scientific basis.

5. It should ensure an accepted criterion when faced with the need to select from among the

projects which are mutually exclusive so as to make a correct choice.

6. It should recognize the fact that initial higher cash flows are to be preferred to smaller ones.

7. Earlier cash flows are preferred to that occurring later.

Self Assessment Questions 7 1. Formulating _ is the third step in the evaluation of investment proposal.

2. A _____________ is not a relevant cost for the project decision.

3. Effect of a project on the working of other parts of a firm is know as ________.

4. The essence of separation principle is the necessity to treat ________ of a project separately

from that of ________.

5. Payback period ________ time value of money.

6. IRR gives a rate of return that reflects the __ the project.



8.9 Appraisal Criteria: The methods of appraising an investment proposal can be grouped into

1. Traditional methods.

2. Modern methods.

Traditional Method are:

i. Payback method.

ii. Accounting Rate of Return.

Modern techniques are:

a. Net present value.

b. Internal Rate of Rate.

c. Modified internal rate of return.

d. Profitability index.

8.9.1 Traditional Techniques: a. Payback method: payback period is defined as the length of time required to recover the

initial cash out lay.

Example: The following details are available in respect of the cash flows of two projects A & B

Year Project A Project B

Cash flows (Rs.) Cash flows (Rs.)

0 (4,00,000) (5,00,000)

1 2,00,000 1,00,000

2 1,75,000 2,00,000

3 25,000 3,00,000

4 2,00,000 4,00,000

5 1,50,000 2,00,000

Compute pay back period for A and B Solution:

Year Project A Project B

Cash flows (Rs.) Cumulative

Cash flows

Cash flows (Rs.) Cumulative

Cash flows

1 2,00,000 2,00,000 1,00,000 1,00,000

2 1,75,000 3,75,000 2,00,000 3,00,000



3 25,000 4,00,000 3,00,000 6,00,000

4 2,00,000 6,00,000 4,00,000 10,00,000

5 1,50,000 7,50,000 2,00,000 12,00,000

From the cumulative cash flows column project A recovers the initial cash outlay of Rs

4,00,000 at the end of the third year. Therefore, payback period of project A is 3 years.

From the cumulative cash flow column the initial cash outlay of Rs 5,00,000 lies between

2 nd year and 3 rd year in respect of project B. Therefore, payback period for project B is:

5,00,000 3,00,000

3,00,000

= 2.67 years

Evaluation of payback period: Merits:

1. Simple in concept and application.

2. Since emphasis is on recovery of initial cash outlay it is the best method for evaluation of

projects with very high uncertainty.

3. With respect to accept or reject criterion pay back method favors a project which is less than

or equal to the standard pay back set by the management. In this process early cash flows

get due recognition than later cash flows. Therefore, pay back period could be used as a tool

to deal with the ranking of projects on the basis of risk criterion.

4. For firms with shortage funds this is preferred because it measures liquidity of the project. Demerits:

1. It ignores time value of money.

2. It does not consider the cash flows that occur after the pay back period.

3. It does not measure the profitability of the project.

4. It does not throw any light on the firm’s liquidity position but just tells about the ability of the

project to return the cash out lay originally made.

5. Project selected on the basis of pay back criterion may be in conflict with the wealth

maximization goal of the firm. Accept or reject criterion:

a. If projects are mutually exclusive, select the project which has the least pay back period.

b. In respect of other projects, select the project which have pay back period less than or equal

to the standard pay back stipulated by the management. Illustration:

2 +



Following details are available

Pay back period:

Project A = 3 years

Project B = 2.5 years

Standard set up by management = 3 years

If projects are mutually exclusive, accept project B which has the least pay back period.

If projects are not mutually exclusive, accept both the project because both have pay back period

less than or equal to original to the standard pay back period set by the management

Pay back period formula

Year Prior to full recovery + Balance of initial out lay to be recovered

Of initial out lay at the beginning of the year in which full

Recovery takes place

Cash in flow of the year in which full recovery

takes place

8.9.2 Discounted Pay Back Period: The length in years required to recover the initial cash out lay on the present value basis is called

the discounted pay back period. The opportunity cost of capital is used for calculating present

values of cash inflows.

Discounted pay back period for a project will be always higher than simple pay back period

because the calculation of discounted pay back period is based on discounted cash flows.

For example:

Year Project A Cash flows

PV factor at 10 %

PV of Cash flows

Cumulative positive Cash flows

0 (4,00,000) 1 (4,00,000)

1 2,00,000 0.909 1,81,800 1,81,800

2 1,75,000 0.826 1,44,550 3,26,350

3 25,000 0.751 18,775 3,45,125

4 2,00,000 0.683 1,36,600 4,81,725

5 1,50,000 0.621 93,150 5,74,875

Discounted Pay back period:



4,00,000 3,45,125

1,36,600 = 3.4 years

Accounting rate of returns: ARR measures the profitability of investment (project) using information taken from financial

statements:

Average income

Average investment

Average of post tax operating profits

Average investment

Average investment =

Book value of the investment + Book value of investment at the end of

In the beginning the life of the project or investment

2 Illustration: The following particular refer to two projects :

X Y

Cost 40,000 60,000

Estimated life 5 years 5 years

Salvage value Rs.3,000 Rs.3,000

Estimate income

After tax

Rs Rs

1 3,000 10,000

2 4,000 8,000

3 7,000 2,000

4 6,000 6,000

5 8,000 5,000

Total 28,000 31,000

Average 5,600 6,200

3 +

ARR =

=



Average investment 21,500 31,500

ARR 5,600 6,200

21,500 31,500

= 26 % 19.7%

Merits of Accounting rate of return: 1. It is based on accounting information.

2. Simple to understand.

3. It considers the profits of entire economic life of the project.

4. Since it is based on accounting information the business executives familiar with the

accounting information under stand this technique. Demerits:

1. It is based on accounting income and not based on cash flows, as the cash flow approach is

considered superior to accounting information based approach.

2. It does not consider the time value of money.

3. Different investment proposals which require different amounts of investment may have the

same accounting rate of return. The ARR fails to differentiate projects on the basis of the

amount required for investment.

4. ARR is based on the investment required for the project. There are many approaches for the

calculation of denominator of average investment. Existence of more than one basis for

arriving at the denominator of average investment may result in adoption of many arbitary

bases.

Because of this the reliability of ARR as a technique of appraisal is reduced when two projects

with the same ARR but with differing investment amounts are to be evaluated. Accept or reject criterion:

Any project which has an ARR more the minimum rate fixed by the management is accepted. If

actual ARR is less than the cuff rate (minimum rate specified by the management ) then that

project is rejected). When projects are to be ranked for deciding on the allocation of capital on

account of the need for capital rationing, project with higher ARR are preferred to the ones with

lower ARR.



Discounted cash flow method:

Discounted cash flow method or time adjusted technique is an improvement over the traditional

techniques. In evaluation of the projects the need to give weight age to the timing of return is

effectively considered in all DCF methods. DCF methods are cash flow based and take the

cognizance of both the interest factors and cash flow after the pay back period.

DCF technique involves the following. 1. Estimation of cash flows, both inflows and outflows of a project over the entire life of the

project.

2. Discounting the cash flows by an appropriate interest factor (discount factor).

3. Sum of the present value of cash outflows is deducted from the sum of present value of cash

inflows to arrive at net present value of cash flows, the most popular techniques of DCF

methods.

DCF methods are of 3 types:

1. The net present value.

2. The internal rate of return.

3. Profitability index.

The net present value: NPV method recognizes the time value of money. It correctly admits that cash flows occurring at

different time periods differ in value. Therefore, there is the need to find out the present values of

all cash flows.

NPV method is the most widely used technique among the DCF methods.

Steps involved in NPV method:

1. Forecast the cash flows, both inflows and outflows of the projects to be taken up for

execution.

2. Decisions on discount factor or interest factor. The appropriate discount rate is the firms cost

of capital or required rate of return expected by the investors.

3. Compute the present value of cash inflows and outflows using the discount factor selected.

4. NPV is calculated by subtracting the PV of cash outflows from the present value of cash

inflows.

Accept or reject criterion:

If NPV is positive, the project should be accepted. If NPV is negative the project should be

rejected.



Accept or reject criterion can be summarized as given below:

1. NPV > Zero = accept

2. NPV < Zero = reject

NPV method can be used to select between mutually exclusive projects by examining whether

incremental investment generates a positive net present value.

Merits of NPV method: 1. It takes into account the time value of money.

2. It considers cash flows occurring over the entire life of the project.

3. NPV method is consistent the goal of maximizing the net wealth of the company.

4. It analyses the merits of relative capital investments.

5. Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project generates

profits from the investment made for it. Demerits:

1. Forecasting of cash flows in difficult as it involves dealing with the effect of elements of

uncertainties on operating activities of the firm.

2. To decide on the discounting factor, there is the need to assess the investor’s required rate of

return But it is not possible to compute the discount rate precisely.

3. There are practical problems associated with the evaluation of projects with unequal lives or

under funds constraints.

For ranking of projects under NPV approach the project with the highest positive NPV is

preferred to that with lower NPV.

Example: A project t costs Rs.25000 and is expected to generate cash in flows as Year Cash in flows

1 10,000

2 8,000

3 9,000

4 6,000

5 7,000

The cost of capital is 12 %. The present value factors are:

Year PV factor at 12 %

1 0.893

2 0.797

3 0.712



4 0.636

5 0.567

Compute the NPV of the project

Solution:

Year Cash flows PV factor at 12

%

PV of Cash

flows

1 10,000 0.893 8,930

2 8,000 0.797 6,376

3 9,000 0.712 6,408

4 6,000 0.636 3,816

5 7,000 0.567 3,969

29,499

Sum of the present value of cash inflows

Less: Sum of the present value of cash outflows 25,500

NPV 4,499

The project generates a positive NPV of Rs.4499. Therefore, project should be accepted.

Problem: A company is evaluating two alternatives for distribution within the plant. Two

alternatives are

1. C system with a high initial cost but low annual operating costs.

2. F system which costs less but have considerably higher operating costs.

The decision to construct the plant has already been made, and the choice here will have no

effect on the overall revenues of the project. The cost of capital of the plant is 12% and the

projects expected net costs are listed below: Year Expected Net Cash Costs

C Systems F Systems

0 (3,00,000) (1,20,000)

1 (66,000) (96,000)

2 (66,000) (96,000)

3 (66,000) (96,000)

4 (66,000) (96,000)

5 (66,000) (96,000)



What is the present value of costs of each alternative?

Which method should be chosen.? Solution: Computation of present value

Year

C Systems F Systems Incremental

1 (66,000) (96,000) 30,000

2 (66,000) (96,000) 30,000

3 (66,000) (96,000) 30,000

4 (66,000) (96,000) 30,000

5 (66,000) (96,000) 30,000

Present value of incremental savings = 30,0000 x PV IFA (12%, 5)

= 30,000 x 3.605 = 1,08,150

Incremental cash out lay = 1,80,000

(71,850)

Since the present value of incremental net cash inflows of C system over F system is negative. C

system is not recommended.

Therefore, F system is recommended . Properties of the NPV

1. NPVs are additive. If two projects A and B have NPV (A) and NPV (B) then by additive rule

the net present value of the combined investment is NPV (A + B)

2. Intermediate cash inflows are reinvested at a rate of return equal to the cost of capital. Demerits of NPV:

1. NPV expresses the absolute positive or negative present value of net cash flows. Therefore,

it fails to capture the scale of investment.

2. In the application of NPV rule in the evaluation of mutually exclusive projects with different

lives, bias occurs in favour of the long term projects.

Internal Rate of Return: It is the rate of return (i,e discount rate) which makes the NPV of any project equal to zero. IRR is the rate of interest which equates the PV of cash inflows with the PV

of cash flows.

IRR is also called yield on investment, managerial efficiency of capital, marginal productivity of

capital, rate of return, time adjusted rate of return. IRR is the rate of return that a project earns.



Evaluation of IRR: 1. IRR takes into account the time value of money

2. IRR calculates the rate of return of the project, taking into account the cash flows over the

entire life of the project.

3. It gives a rate of return that reflects the profitability of the project.

4. It is consistent with the goal of financial management i,e maximization of net wealth of share

holders

5. IRR can be compared with the firm’s cost of capital.

6. To calculate the NPV the discount rate normally used is cost of capital. But to calculate IRR,

there is no need to calculate and employ the cost of capital for discounting because the

project is evaluated at the rate of return generated by the project. The rate of return is internal

to the project.

Demerits: 1. IRR does not satisfy the additive principle.

2. Multiple rates of return or absence of a unique rate of return in certain projects will affect the

utility of this techniques as a tool of decision making in project evaluation.

3. In project evaluation, the projects with the highest IRR are given preference to the ones with

low internal rates.

Application of this criterion to mutually exclusive projects may lead under certain situations to

acceptance of projects of low profitability at the cost of high profitability projects.

4. IRR computation is quite tedious.

Accept or Reject Criterion: If the project’s internal rate of return is greater than the firm’s cost of capital, accept the proposal.

Otherwise reject the proposal.

IRR can be determined by solving the following equation for r =

Ct where t = 1 to n

(1 + r) t

CF0 = Investment

Sum of the present values of cash inflows at the rate of interest of r :

Ct where t = 1 to n

(1 + r) t

CF0 = ∑

∑



Example: A project requires an initial out lay of Rs.1,00,000. It is expected to generate the

following cash inflows: Year Cash inflows 1 50,000

2 50,000

3 30,000

4 40,000

What is the IRR of the project?

Step I

Compute the average of annual cash inflows Year Cash inflows 1 50,000

2 50,000

3 30,000

4 40,000

Total 1,70,000

Average = 1,70,000 = Rs.42,500

4

Step II: Divide the initial investment by the average of annual cash inflows:

= 1,00,000 = 2.35

42,500

Step III: From the PVIFA table for 4 years, the annuity factor very near 2.35 is 25%. Therefore

the first initial rate is 25%


%

PV of Cash

flows

1 50,000 0.800 40,000

2 50,000 0.640 32,000

3 30,000 0.512 15,360

4 40,000 0.410 16,400

Total 1,03,760

Since the initial investment of Rs.1,00,000 is less than the computed value at 25% of Rs.1,03,760

the next trial rate is 26%.




%

PV of Cash

flows

1 50,000 0.7937 39,685

2 50,000 0.6299 31,495

3 30,000 0.4999 14,997

4 40,000 0.3968 15,872

Total 1,02,049

The next trial rate is 27%

Year Cash flows PV factor at 27 %

PV of Cash flows

1 50,000 0.7874 39,370

2 50,000 0.6200 31,000

3 30,000 0.4882 14,646

4 40,000 0.3844 15,376

Total 1,00,392

The next trial rate is 28%

Year Cash flows PV factor at 26 %

PV of Cash flows

1 50,000 0.7813 39,065

2 50,000 0.6104 30,520

3 30,000 0.4768 14,3047

4 40,000 0.3725 14,900

Total 98,789

Since initial investment of Rs.1,00,000 lies between 98789 (28 %) and 1,00,392 (27%) the IRR by

interpolation.

1,00,392 1,00,000

1,00,392 – 98,789

.

392

1603

27 + X 1

27 + X 1



= 27 + 0.2445

= 27 .2445 = 27.24 %

Modified Internal Rate of Return:

MIRR is a distinct improvement over the IRR. Managers find IRR intuitively more appealing than

the rupees of NPV because IRR is expressed on a percentage rates of return. MIRR modifies

IRR. MIRR is a better indicator of relative profitability of the projects.

MIRR is defined as

PV of Costs = PV of terminal value

TV

(1 + MIRR) n

PVC = PV of costs

To calculate PVC, the discount rate used is the cost of capital.

To calculate the terminal value, the future value factor is based on the cost of capital

Then obtain MIRR on solving the following equation.

TV

(1 + MIRR) n

Superiority of MIRR over IRR 1. MIRR assumes that cash flows from the project are reinvested at the cost of capital. The

IRR assumes that the cash flows from the project are reinvested at the projects own IRR.

Since reinvestment at the cost of capital is considered realistic and correct, the MIRR

measures the project’s true profitability

2. MIRR does not have the problem of multiple rates which we come across in IRR.

Illustration:

Year 0 1 2 3 4 5 6

Cash flows (100) (100) 30 60 90 120 130

(Rs in million)

Cost of Capital is 12 %

Present value of cost = 100 + 100

1.12

= 100 + 89.29 = 189.29

PVC =

PV of Costs =



Terminal value of cash flows:

= 30 (1.12) 4 + 60 (1.12) 3 + 90 (1.12) 2 + 120 (1.12) + 130

= 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130

= 47.205 + 84.294 + 112.896 + 134.4 + 130

= 508.80

MIRR is obtained on solving the following equation

508.80

(1 + MIRR) 6

508.80

189.29

(1 + MIRR) 6 = 2.6879

MIRR = 17.9 % Profitability Index: it is also known as Benefit cost ratio.

Profitability index is the ratio of the present value of cash inflows to initial cash outlay.The

discount factor based on the required rate of return is used to discount the cash in flows.

Present value of cash inflows

Initial Cash outlay

Accept or Reject Criterion:

1. Accept the project if PI is greater than 1

2. Reject the project if PI is less than 1

If profitability index is 1 then the management may accept the project because the sum of the

present value of cash inflows is equal to the sum of present value of cash outflows. It neither

adds nor reduces the existing wealth of the company.

Merits of PI: 1. It takes into account the time value of money

2. It is consistent with the principle of maximization of share holders wealth.

3. It measures the relative profitability.

Demerits:

1. Estimation of cash flows and discount rate cannot be done accurately with certainty.

189.29 =

(1 + MIRR) 6 =

PI =



2. A conflict may arise between NPV and profitability index if a choice between mutually

exclusive projects has to be made.

Example

X Y

PV of Cash inflows 4,00,000 2,00,000

Initial cash outlay 2,00,000 80,000

NPV 2,00,000 1,20,000

Profitability Index 2 2.5

As per NPV method project X should be accepted. As per profitability index project Y should be

accepted. This leads to a conflicting situation. The NPV method is to be preferred to profitability

index because the NPV represents the net increase in the firm’s wealth.

Example: A firm is considering an investment proposal which requires an intial cash outlay of Rs

8 lakh now and Rs 2 lakh at the end of the third year. It is expected to generate cash flows as

under: Year Cash inflows

1 3,50,000

2 8,00,000

3 2,50,000

Apply the discount rate of 12% calculate profitability index Solution: Present Value of Cash out flows

Year PV factor at 12 %

Cash out flows PV of Cash flows

1 Rs.8 lakhs Rs.8 lakhs

2

3 0.712 2 lakhs 1.424 lakhs

Total 9.424 lakhs



Present Value of Cash inflows

Year PVIF (12%) Cash inflows PV of Cash flows

1 0.893 3,50,000 3.1255 lakhs

2 0.797 8,00,000 6.376 lakhs

4 0.636 2,50,000 1.5900 lakhs

Total 11.0915 lakhs

PI = Total of present value of cash inflows

Total of present value of cash outflows

= 11.0915 = 1.177

9.424

For every Re.1 invested the project is expected to give a cash inflow of Rs.1.177 i,e for every

rupee invested a profit of Rs.0.177 is obtained.

8.10 Summary Capital investment proposals involve current outlay of funds in the expectation of a stream of

cash in flow in future. Various techniques are available for evaluating investment projects. They

are grouped into traditional and modern techniques. The major traditional techniques are payback

period and accounting rate of return. The important discounting criteria are net present value,

internal rate of return and profitability index. A major deficiency of payback period is that it does

not take into account the time value of money. DCF techniques overcome this limitation. Each

method has both positive and negative aspect. The most popular method for large project is the

internal rate of return. Payback period and accounting rate of return are popular for evaluating

small projects.

Terminal Questions 1. Examine the importance of capital budgeting.

2. Briefly examine the significance of identification of investment opportunities in capital

budgeting process.

3. Critically examine the pay back period as a technique of approval of projects.

4. Summaries the features of DCF techniques.



Answer for Self Assessment Questions

Self Assessment Questions 1 1. Capital budgeting

2. Capital budgeting

3. Highly complex

4. Capital budgeting decisions


1. Irreversible.

2. Uncertainty, highly uncertain.

Self Assessment Questions 3 1. Final step.

2. First step Self Assessment Questions 4 1. A fertile source

2. The most crucial phase

Self Assessment Questions 5 1. Capital budgeting

2. Cost reduction.

Self Assessment Questions 6 1. Economic appraisal

2. Technical appraisal

3. Financial viability

4. Demand for the product or service.

Self Assessment Questions 7 1. Decision criteria

2. Sunk cost

3. Externalities.

4. Investment element.

5. Ignores.



6. Profitability of

Answer for Terminal Questions. 1. Refer to unit 8.2

2. Refer to unit 8.5

3. Refer to unit 8.8.1

4. Refer to unit 8.8.2

67637056 8 capital budgeting

Documents