chapter

2
Capital Budgeting

Capital is scarce. Hence it is expensive. It is not desirable to keep such a scarce and
pensive factor idle. On idle funds, the firm earns nothing. But the firm is required to give
eturns to investors on the funds borrowed. Hence, firms invest the ir capital or funds in the long
rm assets projects. Money is invested now. But the company will get benefits (returns) only
or

the future. Thus, long term investment decisions involve high risks. Hence, the investing company
hould take greater care while taking long term investment decisions. This means that money
hould be invested only in the most profitable assets or projects. For selecting the most profitable
rojects, it is necessary to consider the expected returns and risk. All these imply the fact that long
essential
angeplanningis decisions. Long term investment decisions
for taking long term investment
re otherwise known as capital budgeting decisions or simply capital budgeting.

leaning of Capital Budgeting

Capital budgeting simply means investment decisions. It is the process of allocating the
esources of the organisation in the long term investment projects to generate profits. It is the
rocess of selecting those investment proposals which are worthwhile to invest the available funds.
In the words of R.M.Lynch.Capital budgeting consists in planning the employment ofavailable
apital for the purpose of maximising the longterm profitability of the firm"J
According to Charles T. Horngren, "Capital budgeting is long term planning for making and
inancing proposed capital outlays".
Thus, capital budgeting is a process of long range planning involving investments of funds in
ong term activities whose benefits are expected over a series of years in future. lt is the process
f allocating financial capital (money) for the purchase of real capital (plant and machinery). In
hort, capital budgeting is the process of making capital investment decisions.
eatures (Nature) of Capital Budgeting
apital budgeting has its own features. The nature of capital budgeting may be understood
rom the following features
Funds are invested in long term activities.
2. It involves large outlays.
 28
Financial Management
3.
Tunds
benefits.
are
exchanged for future benefits. In other words, current funds yield future
4. The
benefits are
expected over a number
5. It of years in future.
involves a high degree of risk.
6. Capital budgeting decision is irreversible. Hence,
7 it requires careful planning
Oestation period is long. Gestation period is the period between the initial outlay and anticipated
return.
8. On account
of high initial cost and
This affects the firm's long gestation period, firms face long run consequences.
Role and profitability.
Importance Capital Budgeting
of
Capital budgeting
is concerned with
trom such heavy expenditure decisions. The benefits
expenditure is expected to be derived over in
or returns

budgeting decisions more many years future. This makes the

capital
Success or failure of an complex. These decisions affect the long term profitability of
enterprise is dependent upon the quality of the enterprise.
Therefore, proper planning and utmost care are needed capital budgeting decisions.
The capital budgeting decisions are while making capital budgeting decisions.
1. important, crucial and critical because of the following
Huge investment: Capital reasons:
Hence it requires careful budgeting decisions involve huge investment in
planning and appraisal. A mistake in permanent assets.
fatal to the enterprise. capital canbudgeting prove
2. Long term
implications: Capital budgeting decisions have long
profitability and cost structure of the firm. Aright decision term effects on the future
may bring
the firm. It reduces amazing returns, while
awrong decision may endanger the survival of
the returns in the long run. It the cost. It also
increases
brings about significant
This is made possible by
avoiding
changes in the profit of the
over-investment and company.
Irreversible decision: Capital budgeting decisions onceunder-investnment.
is not possible to abandon the made cannot be
project once the funds have reversed easily. It
been invested in it.
4. Risk: Long term commitment of funds
involve greater risk
period of project, the greater may be the risk and and
uncertainty. The longer is the
involve high degree of risk because (a) uncertainty. Capital budgeting decisions
huge
invested but benefits are realised over future unds are
involved, (b) current funds
irreversible, (d) gestation period is long. years, (c) capital budgeting decisions are
are
Crowth: The capital budgeting decisions allect the rate of
5.
decisions result in cash outflow immediate ly. Cash growth of a firm. Capital
budgeting
cash inflows are
generated n Tuture, the current inflows are generated in future, When
overall and long term prolitability will also be earnings will be improved, As
improve a result,
a c t firm's
6. on
competitive strength: 1he
capital budgeting
ctrernoth of a firm to face competnion. decisions
so because the capital affect the capacity
it is

investment decisions
Capital Budgeting 29

affect the future profits and costs ofthe firm. This will ultimately affect the firm's competitive
strength.
7. Most difficult decision: Capital budgeting decisions are very difficult to make. This is due
to (a) uncetainty of future, (b) decisions are based on future years' cash inflows, and ()
more risk. Moreover, the, benefits and costs are affected by economic, political and
technological forces. Therefore, such decisions are not so simple to be taken.
8. Cost control: In capital budgeting there is a regular comparison of budgeted and actual
expenditures. Thus cost control is facilitated through capital budgeting.
9. Wealth maximisation: The basic objective of financial management is to maximise the
wealth of the shareholders. Capital budgeting helps to achieve this basic objective.
10. Economic and social consequence because of large size: There is an ever increasing trend
towards the creation of larger business units by amalgamation and globalization. Hence, if the
investment decisions are bad, the economic and social consequences would be very serious.

Steps in Capital Budgeting (Capital Budgeting Process)

Capital budgeting is a complex process. It is a six-step process (six P°s ofcapital budgeting).
The following steps are involved in capital budgeting:

1. Project generation: The capital budgeting process begins with generation or identification
of investment proposals. This involves a continuous search for investment opportunities
which are compatible with the firm's objectives.
2. Project screening: Each proposal subject to a preliminary screening process in
is then
and the
order to assess whether it is technically feasible, resources required are available,
the risks involved.
expected return are adequate to compensate for
or investment proposals the next step
3. Project evaluation: After screening of project ideas
two steps: (a) estimation of
is to evaluate the profitability of each proposal. This involves
costs and benefits in terms of cash flows, and (b) selecting an appropriate criterion to judge
the desirability ofthe projects.
Project selection: After evaluation the next step is to select and approve the best proposal
4.
or proposals.

5. Project execution and implementation: After the selection of projects (or finalisation of
proposal), funds are allocated for them and a capital budget is prepared. In this way, projects
are implemented. This means that the proposal in paper becomes a reality. Now the project

starts its functioning.

its must be
6. Performance review: After the start of the implementation ofa project, progress
actual
reviewed at periodical intervals. The follow-up or review is made by comparing
action.
performance with the budget estimates. This helps to take corrective
Factors Affecting Capital Budgeting Decisions

1. Availability offund
 30
Financial Management
2.
Utilisation of funds
3.
4.
Urgency of the project
5
Expectation of future earnings
Intangible factors
6. Risk and uncertainty
7. Minimum rate of return
investment.
on
Approaches to
Capital Budgeting Decisions
There are three
1.
approaches to capital budgeting decisions. They are:
DISaster approach: In
many cases, the capital expenditure decisions are taken by
oniy when a disaster management
occurs, e.g., a plant breaks down. Thus, this approach is a situation of
management by crisis.
2. Passive approach: Under this
Situation of
approach, the emphasis is only on present needs. It is a
"manage as we go". This is an improvement over the first approach.
3. Dynamic approach: This is the most modern and effective
In this approach to capital budgeting.
approach, the emphasis is on long range planning. In this case the
decisions are taken on the basis of market capital budgeting
research, technological changes etc. Thus, under
this approach the capital
expenditures are the results of advance planning.
Limitations of Capital Budgeting
1. The benefits from investments are received in future. These are uncertain.
element of risk is involved.
Therefore, an
Uncertainity and risk is the biggest problem in capital budgeting.
2. Some factors affecting investment proposals cannot be expressed in money value.
3. It is difficult to estimate the period for which investment is to be made and income will
generate.
4. It is difficult to estimate
the rate of return because future is uncertain.
5. Some factors such as employees' morale, firm's goodwill etc. influence
capital budgeting
decisions. But these factors cannot be quantified. Hence, these factors cannot be
rated in capital budgeting.
incorpo-
5. It is difficult to estimate the cost ofcapital.
6. If the capital budgeting decisions go wrong, it may create serious
consequence on the firm's
liquidity, profitability etc.
Information Required for Capital Budgeting / Investment Decision

The following data or informationrequired before using any technique of capital budgeting:
is

1. Cash flows: In capital budgeting decisions, the cost and benefit of a project are measured in
terms of cash flows. Cash tlow may be cash outflow or inflow. Costs are referred to as cash
outflows and benefits (from the project) are denoted as cash inflows,
Tynes of cash flows: There are three types of cash flows. They are:
 Financlat anugemen

32
XXX
B. Estimated Additional Costs
XXX
Additional cost ofmaintenance
Additional cost ofsupervision XXX

Add: Cost of indirect material XXX

Additional depreciation XXX

Total additional costs (b) XXX

Net savings before tax (a -b) XXX 29p6
Less: Income tax XXX

Net savings after tax XXX

Add: Additional depreciation
XXX
Cash inflows in order to:
return from a proposal is required
rate of return: The expected of rate
thereafter, determining
equired for time value of money, and (b)
adjust the future cash flows ofa project when the return
(a) of the proposal or project. An
investment proposal is accepted
cost of
ne protitability
it is more than the of return. This required rate of return is also called
Irom rate
required
capital or cut- off rate or hurdle rate.

3. Other information: (a) Economic life ofthe project (b)

available funds (c) risk of obsolescence etc.
INVESTMENT APPRAISAL METHODS
investment opportunity is most
important step in çapital budgeting is to determine which
An
is a tool
profitable. The procedure adopted for this is known as project appraisal. Project appraisal
to examine as to whether in the given situation, it would be most realistic, reliable and reasonable
to invest resources or not. It is a critical and analytical evaluation ofthe project from different
angles. In short, project appraisal is the assessment of a project to know whether it is worthwhile
to invest money in it.
Investment Appraisal Methods (Methods or Techniques of Capital Budgeting)
There are a number of appraisal criteria (or evaluation methods) tojudge the profitability of
capital projects. More than 30 criteria,have been proposed to guide investment decision making.
The more important and popular of these can be classified into two broad categories as follows:
1. Non- discounting Techniques or Traditional Methods
(a) Urgency Method
(b) Pay Back Method
(c) Average Rate of Return Method
2. Discounting Criteria or Modern Methods
(a) Discounted Pay Back Method
(b) Net Present Value Method
 Capital Budgeting 33
(c) Benefit Cost Ratio
(d) Internal Rate of Retum
(e) Net Terminal Value method
Apart from the above quantitative criteria, there are certain qualitative criteria for evaluating
projects. The important qualitative criteria are: (a) employee morale, (b) employee safety
(c) corporate image, (d) social responsibility, (e) market share, (O growth
Traditional Methods
Traditional methods do not take into consideration the time value of money. Important traditional
methods may be discussed as follows:
Urgency Method
Urgency isa criterion used to justify the acceptance of capital projects on the basis of emergency
requirements or under crisis conditions. Under this method, urgency or degree of necessity plays
an important role and the project that cannot be postponed is undertaken first. In short, the most
urgent project is taken up first.
Merits (Advantages)
1Itisavery simple technique.
2 It is useful in case of short term projects requiring lesserinvestment
Demerits (Disadvantages)
1. Itis not based on scientific analysis.
Sclection is not made on the basis of economical consideration but just on the basis of
situation.
3 Aproject, even though it is profitable, will not be accepted for the very simple reason that it
can be postponed.

Pay Back Method (Pay Back Period or PBP)

When an individual invests an amount in any ype of investment, he or she always worries
about the lengthoftime for getting the money (invested) back. Same happens in a tirm too. When

a firm goes to invest an amount in purchasing any fixed asset, it will explore the alternatives which
may give money back soon. Herethe best method to evaluatetheinvestment decision is payback
period method.
Pay back pcriod method is one of the commonly used tochniques of evaluating capital expenditure
to
proposals. Itis a cash based technique. Pay back period is the length oftime period required
or
of duringwhich
ecover the initial cost (investment) of the project. It is the expected number years accumulated
where the
c oniginal investment is recovered, It is the break even point of the project, also called
method is pay-out
curns (cash inflows) cqual investment (cash outflow). Pay back
or 'pay-offperiod' or 'recoupment period' or 'replacement period.
 Financial Management
34
follOws:
situations as
TC be calculated in two different
payback period can
Dy a project
inflows or benefits generatca
w h e n annual cash inflows a r e eaual: When
cash
is computed by dividing
cash inflows), the payback period
r areequal orconstant (i.e., even

annual cash inflows. It is expressed

as follows:
c
v C s t m e n t or cash outlay by the net

Original cost of project (cash outlay) or

Pay backperiod Annual net cash inflow (net earnings)
ifa involves a cash outlay of 5,00,000 and generates cash inflowof
ror example, project
1,00,000 annually for 7 years
Payback = ,00,00o
=5 years
1,00,000
1he whole cost of the original investment, i.e., 7 5,00,000 is recovered with 5 years.

2. When annual cash inflows are unequal: When cash inflows in different years are
unequal
(uneven), the computation of payback period is not so easy as in the case of even cash inflows.
In such
case, pay back period is calculated by
a
investment is recovered. It is ascertained
cumulating the cash inflows until the original
by cumulating cash inflows till the time when the
cumulative cash inflows become
equal to initial investment. For example, if the cost of the
is 1,00,000 and the cash
inflows are: 1st year 10,000, second
project
4th year 30,000, and 5th year 15,000, 3rd year 25,000,
year T 30,000. Pay back period to recover
, 1,00,000 comes to 4 years and 8 months original investment of
balance
(R 80,000 is recovered in 4
years and to recover the
20,000,
8 months are required).
20,000 2
30,000 years
3
or 8 months
Pay back period can also be calculated
by the following formula:
Pay back period E+
where, E
No. of years
=

immediately preceding the year of final

B-Balance amount still to be recovered. recovery
C Cash inflow
during the year of final
Under payback method the cash recovery
inflow (benefit or
depreciation and amortisation of intangible assets return) means the
Decision Rule (or Selection but after tax operating profit before
pa back, the better
Criterion): According to the
the projcct. nis means a project pay back
Advantages of Pay back Method having shorter pay eriterion, the shorter the
back period is
Advantages pay back period are:
of chosen.
1. It is simple to understand and
easy to apply
2. It is very important for cash forecasting,
budgeting and cash flow
analysis.
 Capital Budgeting 35

3. The method can be used profitably for short term capital project which start yielding returns in
the initial years.
4. It minimises the possibility of losses through obsolescer
5. It takes into account liquidity.
6. This method can also be used for projects with high uncertainty.
Disadvantages
Disdvantages of pay back period are:
1. It ignores the time value of money.
2. It completely ignores cash inflows after the
payback period.
3 Sometimes a project having higher pay back period may be better than lower
pay back period
owing to higher return after pay back period. This is true in the case of long term project.
4. It does not measure profitability of projects. It insists only on recovery of the cost of the
project.
5. It does not measure the rate of return.
Suitability of Payback Method
Payback method is an appropriate method under the following circumstances
(a) When the cost of the project is comparatively small.
(b) When the project is likely to be completed in short period.
(c) When only limited funds are available.
(d) When the cash earning capacity of the company is low
(e) When there is chance of obsolescence due to technological development.
Modern Payback Period Methods: The popularity of payback period has promoted efforts to
eliminate some of its major drawbacks. The following are some of the more popular improvements
to traditional payback period concept:

(a) Post payback profitability method: A serious limitation payback period is that it ignores the
cash inflows after the payback period. The post method has been developed to overcome
payback
this limitation. Under post pay back method, the entire cash inflows generated from a project during
its working life are taken into account. The post payback profitability is calculated as under:
Post Payback Profitability= Total cash inflows in life - Initial cost
or

Annual cash inflows x (Total life Pay back period)

-

Note: The second (alternate) formula is useful only when annual cash inflows are equal.
Example 1
For each of the following projects, compute (a) pay back period, and (b) post pay back
profitability.
 36 Financial Management
Project AA
Initial outlay 1,00,000
Annual cash inflows (after tax but before depreciation) 20,000
Estimated life 8 years.
Project B
Initial outlay
Annual cash inflows
1,00,00o
(after tax but before depreciation):
First 3 years
30,000
Next 5 years
Estimated life 8 years 10,000
Solution
Project A
Initial investment
Pay back period 1,00,000
= 5 years
Annual cash inflows
Post pay back profitability= Total cash inflows in 20,000
life Initial cost
=1,60,000 1,00,000 60,000
or
20,000 x (8-5)T60,000
Note: Total cash inflows in life =
20,000 x 8 =

Project B 1,60,000
Cash inflows are not equal.
First year cash inflow
Therefore, pay back period is
30,000
calculated as follows:
Second year cash inflow
Third year cash inflow 30,000
Fourth year cash inflow 30,000
10,000
1,00,000
Thus, pay back period is 4 years
Post pay back
profitability1Total cash intlows in life -
initial cost
Note: Total cash inflows in life= 1,40,000-1,00,000 R40,000
If cost of various (30,000 x3)+(10,000 x
projects differs 5)- 1,40,000
calculated assess
to the relauve substantially, post pay back
proitability of the projects. It is profitability
calculated as below
index may be
Post pay back profitability index Post pay back profit
OSt pay profit x 100
Investment
 Capital Budgeting 37

(b) Post pay back period method: This method takes into account the period beyond a project's
payback period.This method is also known as surplus life over pay back method'. Under this
method projects with longer post pay back periods with significant cash flows are preferred.

(c) Payback reciprocals: The major limitation of payback method is that it ignores the time factor
and does not consider the rate of return. This weakness is removed by calculating the reciprocal
of payback period. The formula for computing payback reciprocal is as follows:

Payback reciprocal Payback period

or x100
Payback period
This method can be used only when: (a) equal cash inflows are generated every year, and (b)
the life of the asset is at least double the payback period.
When the payback reciprocal is converted into percentage (1/Payback period x 100) it tends
to approach to time adjusted rate of return (or IRR). M.J.Gordon has said, "The reciprocal of the
payback period is in fact, an estimate of proposal's rate of profit.
Some people calculate the ratio of life to the payback period. For example, the pay back period
is 4 years and the life ofthe project is 10 years. In this case the ratio is 2.5 (i.e., 10/4). This indicates
that the life of the project is 2.5 times the pay back period. In this way it indicates profitability.
Suppose ratio of another project is 3. This is higher than the ratio of the first project. Hence the
second project is more profitable. Thus, when the life increases, the ratio also increases and vice
versa. Similarly, when the pay back period is higher the ratio decreases and vice versa.
(d) Modified pay back period method (MPBP) : If salvage value is considered during the pay
back period, it is called modified pay back period method. Suppose cash inflows ofa project for
years (life) are 7 20,000, 30,000, 7 45,000, 7 20,000,7 20,000 and 18,000 respectively. The
initial cost of the project is 1,00,000. In this case the pay back period is 3years and 3 months. We
assume that at the end of the third year the machine can be sold at 5,000. Now the modified pay
back period is 3 years because the total of? 1,00,000 is recovered (including salvage value) in 3
years. Thus, if salvage value is incorporated, the pay back period can be attained earlier.
Average Rate of Return Method/ Accounting Rate of Retun Method (ARR)
ARR inethod is a simple technique of averaging returns over investments. The ARR represents
the ratio of the average annual profts to the average investment in the project. It is based on
accounting profits and not cash flows, This method is also known as Accoumting Rate of Return
method or Return on investment method or unadusted rate of return method. Under this
method average annual profit (after tax) is expressed as percentage of investment. Thus this
method takes into account the earnings expected from the investment over its whole life. ARRis
found out by dividing average income by the average investment. ARR is calculated with the help
ofthe following formula:
 Financial Managemem
38
return
income o r
Average
ARR Average investment

earnings and diVIding them by project's lie.

all the
c average return is computed by adding the earnigs after depreciation and tav
ARR method the cash inflow (i.e., return) means
Average investment is found in two alternative ways as follows:
+ Scrap Value
Original Investment
Average Investment =

2
Or

Original Investment -Scrap valucScrap Value

2
The amount of scrap value is first deducted and then added back. It is deducted to find out
the annual amount of depreciation. However, this amount is blocked throughout the life ofthe
project and is released only at the end of its economic life. That is why it is added back to find out
the average investment.

Sometimes, the project may also require additional working capital for its smooth operation.
This additional working capital will be blocked throughout the life of the project. Hence it is added
to the average investment. Thus in this case average investment is ascertained as follows:
Original investment-Scrap value
2 Scrap value + Additional working capital
Decision Rule (or Selection Criterion): The higher the
average rate of
return, the better the
project. If the projects are mutually exclusive, the
project with the highest rate of
Ifthe calculated ARR is equal to or more than the company's return is selected.
be accepted. If the calculated ARR is less target rate of return, the project will
than the company's
totally rejected. target rate of return, the is
project
Examplee2
Projects
X

Capital cost
40,000
Earnings after depreciation: 1st year 60,000
5,000
Ind year 8,000
7,000
IlIrd year 10,000
6,000
IVth year 7,000
6,000
5,000
The average earnings of Project X = 24,000 = 6,000
4
Capital Budgeting 39

C t at thebeginning+Cost at the end of the life

Theaverage investment=

40,000--Rs.20,000
2
6,000
Therefore, ARR 20,000x 100=30%

Similarly,
30,000
Average earnings of project Y Rs.7,500
4

Average investment ==
60,000+0-Rs.30,000
2
= Rs.30,000

7500
Therefore, ARR = x100=25%
30,000
On the basis of ARR, project X will be selected as its ARR is higher than that of project Y (if
the projects are mutually exclusive).
Advantages of ARR
1. It is simple to understand and easy to apply.
2. It takes into consideration earnings over the entire life of the project.
3. It considers profitability ofthe investment.
4. Projects of different character can be compared.

5. Rate of return may be readily calculated with the help of accounting data.

Disadvantages of ARR
1. It ignores the time value of money.
2. It does not differentiate between the size of the investment required for each project.

3. It is based upon accounting profit, instead of cash flow.

4. It considers only the rate of return and not the life ofthe project.
be reinvested.
5. It ignores the fact that profit can
Discounted Cash Flow Techniques (Time adjusted cash flow techniques)
the time value of money.
Pay back method and average rate of return method do not consider
and income received
The initial amount incurred for acquisition of assets to implement a project
the project in future is given equal importance under the
above two methods. But in fact the
rom
value of money received in future is not equivalent to the value of money invested today (already
rupeethan a to be
aiscussed in Chapter 1). words, a rupee in hand now is more valuable
In other
received in future because casih in hand can be invested elsewhere
and interest can be earned on

annual interes of 10%, it will increase as under:

It. For example, if R 100 is invested at the
 40
Financial Management
100 today is equal to
110 after one
year (R100+ of 10
121 after two years 110+R1l ofinterest)
133.1 after three interest)
years ( 121 + 12.1 of
h e above interest)
example gives an idea of the compounding
c OppoSite of compounding is called increase of the present value n future
discounting
Tuture sum, we have to discount the future If we want to know the present sum
Tuture cash flows. It is the sum. irom the
Discounting involves finding the present values
technique used of
Taking the above example, it can be said that for110finding the present value of future cash flows.
anter after one year is equal to 100
be
two years is equal to 100 today or 133.1 after three years is
today or k 121
expressed as under. equal to 100 today.
It can
110 after 1year
is equal to
100 today.
or 1
after 1 year is equal to 1 100
0.909 today
R121 after 2 years is equal to 100 today
or 1 after 2 years is 100
equal to R1
121 0.826 today
133.1 after 3 years is equal to 100 today.
orI after 3 years is 100
equal to
133.1 0.751 today
If rate of returnis 10 per cent 0.909, 0.826 and
0.751 are the
the present value of future sums after 1,2,and 3 discounting factors to know
years respectively. When we
sumswith discounting factor, we shall get the present value. multiply the future
Thus
multiply by the passage of time. This function ot money is called money has the ability to
words, the concept thatR 1 in the future is worth less than RI time value of money. In other
of money. today is known as the time value
While calculating present value or ruture cash ntlow, take the
discounting tables according to the period and rate of reum and discounting factor from
multiply the future sum by
factor to get the present value. disoounting
In short, the discount factor ot any year can be found by the following
ormula:
where 'r' is discount rate and 'n' is number of vears
Value Methods
(1+1
Features of Present

1. All present value are based discounted cash flows.

methods on

to ascertain their present value

Both cash inflows and
outflows are discounted cash
 Capital Budgeting 41

2. These use cash flows and not

accounting concept of profit. That is, cash inflow after tax but
before depreciation are taken.
3. They take into consideration the interest factor by recognising the value of earlier cash flowsS
compared to later cash flows.
4 They consider the entire cash flows of a project throughout its economic life.
Important discounted techniques are discounted pay back period method, net present value
method, profitablity index method, internal rate of return method, net terminal value method etc.
Discounted Pay back Period
A major shortcoming of the conventional
pay back period method is that it does not take into
account the time value of money. To overcome this
limitation, the discounted pay back period
method is suggested. In this modified method, cash flows are first converted into their
present
values (by applying suitable discounting factors) and then added to ascertain the period of time
required to recover the initial outlay on the project.
Net Present Value Method (NPV)
NPV method involves discounting future cash flows to present values. Under this method,
the present value of all cash inflows (stream of benefits) is compared against the present value of
all cash outflows (cash outlays or cost of investment). The difference between the present value of
cash inflows and present value of cash outflow is called the net present value In other words, the
cashoutflow (i.e., initial investment whose present value is the same) is deducted from the sumof
the present values of future cash inflows (returns or benefits). The balance amount is the NPV.
The NPV may be either positive or negative. If the NPV is positive, it means that the actual rate
of retum is more than the discount rate. A negative NPV indicates that the project is not even
covering the cost of capital. It means that the actual rate of return is less than the discount rate.
The discount rate for obtaining the present value is some desired rate of return which may be
equal to the cost of capital. If the discount rate represents the company's cost of capital, then the
NPV represents the returns to the company's shareholders over and above the cost of capital. As
a result, we may say that a positive NPV contributes to the wealth of the shareholders. NPPV
method is also known as investor S method.
Computation Procedure of NPV
The following steps are involved in the computation of NPV:
(a) Determination of minimum rate ofreturn: To discount the cash flows a minimum rate of
interest should be selected. This is generally the firm's cost of capital (i.e., the minimum rate of
return an investor expects from the firm to earn on the proposed investment).
(b) Computation of PV of cash inflows and outflows: With the help of the minimum rate of
return, the present value of cash inflows (returm or benefit) and the present value of cash outflows
(cost or amount of investment) should be computed. As investment in the project is made at the
beginning of the period, its cost (cash outflows) itself is the present value. The present values of
Cash flows for different years may be calculated with the help of the following formula:
 42
Financial Management
PV C
C3
1+7) (1+r? (1+r . ****** Cp
where, C1, C2, 1+r)
Cn Cash inflows for n
years,
r=Discount factor or interest rate
Note: In n
Number of years
=

Pre practice, the

Present Value Table" present values are not computed with the help of above formula. For
is used. The formula for this,
PV=Cash inflow computation of present value is as follows:
x
Discount factor of the concerned
(CComputation of NPV: The difference period.
present value of cash
between total present value of cash inflows and total
value (NPV). outflows should be found out. The
resulting amount is the net present
Decision Rule (or
Selection
(where only one project is to beCriterion): In the case of mutually exclusive or alternative
of selected) accept a project that has the project,
independent investment, accept highest
project if its NPV is positive. If the NPVpositive
a
NPV. In the case
Example 3 is negative,
reject it.
Project A
Yrs Investment Projeet B
Discount Present
& cash flow factor at 15%
Investment Discount Present
value &cash flow factor at 15% value
-1,00,000
1,00,000 -1,00,000
+30,000 0.870 +26,100 1,00,000
2
20,000 0.870
+40,000 0.756 +30,240 +30,000 +17,400
+40,000 0.756
0.658 +26,320 +50,000
+22,680
4 0.658
+30,000 0.572 +17,160 +40,000 +32,900
+30,000 0.497 0.572 +22,880
+14,910 +30,000 0.497
+1,70,000
+14,910
+1,14,730 +1,70,000
PV of cash outflow -1,00,000 +1,10,770
NPV 14,730 -1,00,000
It is presumed that life of both the project is 10,770
years. Erntire investment of 1,.00.000 is done
in one year of construction period.
In the above example, project A is better because the NPV is hioher
eive method: If the cash intlows
are cqual, the present values can be
nuuify table. An annuity 1s a
series cqual and consecutive cash flows. The
or found easily by
is calculated as follows:
(PV) of an annuity present value
Annual net cash flow x Annuity factor
 Capital Budgeting 43

For
example, a project is expected to produce net cash flows ofT 10,000 per year for each ofthe
next four years. The discount rate is 10%. In this case, the annuity factor@10% against the 4h year
ismethod
3.17(as(thepermethod
annuityfollowed
table).The
present value is 31,700 (ie, 10,000 x 3.17). Accordingto
the first
in example 3) also, we shall get the same present value as follows:
Year Cash Flows D.F @ 10% PV
10,000 0.909 9,090
10,000 0.826 8,260
10,000 0.751 7,510
10,000 0.683 6,830
3.169 (or 3.17) 31,690 (or 31,700)
The alternative method is the short cut method. This method can be used only when the
cash inflows are uniform over the different years.
Advantages of NPV
1. It takes into account the time value of money.
2 It considers the cash flow stream over the entire life of the project.
3. It focuses attention on the objective of maximisation of the wealth of the firm.
4 This method is most suitable when cash inflows are not uniform.
5 This method is generally preferred by economists.
6. It is highly useful in case of mutually exclusive proj
7. It is the true measure of profitability.
Disadvantages of NPV
1. This method may not provide satisfactory results in case of two projects having different
useful lives.
2. This method is not suitable in case of projects involving different amounts of investment.
3.
3. Different discount rates will give different present values. As such, the relative desirability of
projects will change with a change in the discount rate.
4. It is difficult to select the discount rate
5. Itinvolvescomplicated calcutations.
Treatment of Working Capital Requirement of the Project

Ifadditional working capital is required for the project in the beginning, it should be added to
the initial investment. Ifit is required during the life of the project, say, in thebeginning ofthe third
year, the present value of the additional working capital should be calculated (on the basis of the
PV factor for the 3rd year). Then this present value is added to the initial investment. This is done
because we assume that funds initially tied up in working capital at the time of investment would be
released only in the last year when the investment is terminated.
 44

Benefit Cost Ratio Financial Management

Two projects (Profitability Index Method)
Tw
method because it having different investment
in outlay cannot be compared by net present value
initial investment indicates the NPV in absolute terms. For
of 50,000 and example, projects X and Y are having
ing
1,00,000 respectively.
respectively. Their
Their NPV
NPV isIS as
as under:
unacr
Project X Project Y
Present Value of
Investment (cost)
Present Value of Cash -50,000 -1,00,000
Inflows (benefits)
+60,000 +1,12,000
NPV
+10,000 +12,000
According to
But in
the absolute
figure of net present value,
fact
project X is
better
because project Y appears better than project X.
10,000 whereas in in project X, an
investment of 50,000 provides an
12,000 only. In suchproject Y an investment
of twice that amount provides a net NPV of
(cash inflows) to cost
a
situation, benefit cost ratio should
be applied. It is present value of
value of cash outflows.(cash outflow). It is the ratio of the ratio of benefits
Thus, it present value of cash inflows to the
called measures the
profitability index or present
having different investment
present value of returns.
value index. It is Benefit cost ratiopresent
is also
outlays. particularly useful to compare the
Benefit cost ratio is projects
computed as follows:
Benefit cost ratio Present value of cash
inflows
Present value of cash
outflows
Profitability index of project X = 50,000 50,0001.20

Profitability index of project Y = ,12,000

1,00,0001.12

As profitability index of project X is more than

project X is better than that of
project Y. projectY, it can be concluded
Profitability index method may also be that
NPV
expressed as follows:
PV of cash outflows
(i.e., investment)
Then it is called Net Present Value
Thus, NPVI or EPVI is the ratio of NPV toIndex (NPVI) or Excess
cash outflow Present Value Index
the initial
nortant feature of PI is that it of the lex (EPVI).
(EPVI),
can also
ifPI equal one then NPV will be equal to
is to explain the NPV project.
zero, If it position of an
positive. Ifit is less than one, then NPV will be is
greater than one, investment,
that is
projects on the basis negative. Pl is then NPV will be
of their profitability. This is because
the particularly useful for
against its investment.
present value of a appraising
ng the
project is npared
the
compare
Capital Budgeting 45

Decision Rule (or Selection Criterion): Under Pl method the decision rule is "accept the
project if its Pl is more than one and reject the project if Pl is less than one". In the case of
mutually exclusive projects, the project with higher PI is to be selected. Higher the profitability
index better is the project.
Advantages Profitability Index
1. Itis very scientific and logical.
2. It considers the fair rate of return.
3. It is useful in case of capital rationing.
4. It is very useful to compare the projects having different inv
5. It reflects time value of money.
6. It considers all cash flows during the life of the project.
Disadvantages Profitability Index
1. This method is not in accordance with accounting principles and concepts.
2. It iscomparatively difficult to understand and follow.
3. It is difficult to estimate the effective life of a project.
4. It cannot be used for comparing those projects having unequal lives.
5. Itis not useful when many small projects have to be aggregated and compared with a large project.

Comparison of NPV and Profitability Index

Profitability index method is based on the NPV method.
There are many similarities and differences between NPV and Pl
It is an extension of NPV method.

Similarities
1. Both satisfy the principle of time value of money.
2 Both are discounted cash flow techniques.
3 Both will give the same accept/reject decision.
Differences
1. The NPV is an absolute measure ofa project's acceptability, whereas, Pl is a relative measure.
2. NPV and PI may give different evaluation results when initial costs and the monetary
benefits are different.
3. Intimes of capitalrationing (or in case ofmutually exclusive projects) PI would give superior results.
4. In all cases except in capital rationing (or in case ofmutually exclusive projects) NPV technique
is superior to the PI technique.
Internal Rate of Return (IRR)
Net present value method indicates the net present value of the cash flows of a project at a
pre-determined interest rate, but it does not indicate the rate ofreturnof the project. In order to find
Out the rate of return of a project, estimated net cash inflows of each year are discounted at
 Financial Managemem
46
inflow is equal
to the initi
present value of cash of return o
the internal rate
atcs till a rate is obtained at which a rate is called
in value to zero. Such called so
because it give-
or the net present
comes
It is
nt
time adjusted
rate ofreturn.
It is also called Joel Dean.
a r a t e ofreturn. IRR was first introduced by
aue importance to the time value of money. the discount
rate at which
discount rates until we reach
i k we try discounting at different outflow( investment). Thus
the present value of cash
to
present
value
of cash inflows is equal value of future
cash inflow is equal

nternal rate of return is the

rate of return at which total presentNPV is
zero. This rate Is called the
at which
investment. In other words, it is the rate assocated with
to nitial depends on the initial outlay
and cash proceeds
it
ernal rate because exclusively the investment.
the project and not on any other rate outside
Calculation of IRR
(a) When cash flows are equal
of IRR is simple. This can be
equal, the calculation
IT the cash inflows are uniform or
explained with the help of an example:
Example4
inflow of 2,000 over its life of 5 years.
A project cost6,000 and is expected to generate cash
In this case IRR may be calculated by taking the following steps:
with reference to PV factor (or payback
Step 1: First of alla rough approximation may be made
period). This is calculated by the following formula:
Initial Investment 6,000
3
P.Vfactor Annual Cash Inflow 2,000

The P.V factor in the given example is 3.

Step 2: Search for a value nearest to P.V factor (3) in the 5th year row of cumulative present
value table (Table II). The rate given in the column of the PV factor will be the IRR. But, usually

the same P.V factor as calculated by the above formula (i.e., 3 in this example) is not available in
the cumulative present value table. we shall get closest rates from the table. In the given example,
one rate is 18% (3.127 present value of Ki in the 5h year row). The other closest rate is 20%
o 9000 nresent value of T1 in the 5th year row).
This implies that IRR is more
than 18% but less
than 20%. In other worlds, IRR is expected to lie in between 18% and 20%

Ston 3: In order to make a precise estimation of the lkR, find out the present values of the project
is calcu lated as follows:
for both these rates. It
P.V at 18% 72,000 x 3.127 =6,254
=

P.Vat 20%= 72,000 x 2.9000 5,800

exact IRR by interpolation. The interpolation
Step 4: Find out the should be made
ct discount rates having a positve Nry and a
negative NPV. The
between two
interpolation formula is as
follows:
Capital Budgeting 47

Interpolation formula: L+ (H-L)

P-P2
where,
L Lower discount rate
H-Higher discount rate
P-Present value at lower rate
P,= Present value at higher rate.
Q Net cash outlay.
In the given example, the actual IRR will be: 18% +
6,254-6,000 x (20%-18%)
6,254-5,800
254
=
18% + 454 x2=18%+1.12%= 19.12%
Alternatively,
= 18%+.
3.127-3.00
3.127-2.900
x (20-18) =19.12%
In the alternative method, step 3 can be avoided.
(b) When cash flows are unequal
When cash inflows are uneven, the IRR is calculated by Trial and Error Method. In this
method, present values of cash inflows are computed at different rates. In the last, the rate at
which the total P.V of cash inflows is equal to the cost ofthe project is treated as the IRR. The
following steps are required:
1. Calculate average cash inflow and establish first trial rate: It is difficult to decide the rate
at which the trial should be commenced. However, the first-trial rate can be calculated on the
basis of average annual cash inflow. To get the first trail rate, the following formula may be used:

Initial Investment
P.V factor Average annual cash inflows
Now, search for a value nearest to PV factor (as calculated above) in the row of year of life
in the cumulative present value table (Table II). The rate given in the column against this value will
be the first trail rate. The present value of cash inflows of all the years will be computed at this
rate using the present value table (Table II).
Alternatively, various discounting rates are applied to the net cash flows until the rate is found
that reduces NPV to zero, Usually cut-off rate is at the starting point. If it is not given, first rate is
computed as follows:
Average carning p.d x 100
Investments
 48 Financial Management

2. Try the second trial rate: The total of the present value of cash inflows for all years calculated
by first trial rate will be compared with the cost of the project.
If the NPV at the first rate comes positive, a higher rate should be tried. If the NPV comes

negative, a lower rate should be tried. This exercise is done till the NPV comes to zero

3. Compute actual IRR: It is tedious to find the discount rate where NPV becomes zero
Hence interpolation will be applied after arriving at a range between which the IRR lies. It should
be noted that we should not try to interpolate between a range of more than 5%.
Example 5
From the following information, calculate IRR:
Cost 22,000
Cash inflows:
Year 12,000
4,000
2,000
10,000
Solution

Average cash inflow: = 12.000+4,000+2,000+10,000_7.000

4
=7,000

P.V Factor 22,000-3.14

7,000
The closest present value to 3.14 from Annuity Table (Table II) is 3.170 at 10%. Thus, the
first trial rate is 10%. At this rate, the present values (Table ) may be calculated as follows:
Year Cash inflow ( ) Dis. Factor 10% PV )
12,000 0.909 10,908
4,000 0.826 3,304
2,000 0.751 1,502
10,000 0.683 6,830
Total 22,544
Cost of the project 22,000
NPV +544
Since the NPV is positive, let us try a higher rate, say, 12%.
Year Cash inflow () Dis. Factor 12% PV ()
12,000 0.893 10,716
2 4,000 0.797 3,188
Capital Budgeting 49

2,000 0.712 1,424

10,000 0.636 6,360
Total 21,688
Cost of the project 22,000
NPV -312

Thus, IRR lies in between 10% and 12%. The actual IRR can be interpolated as follows:
IRR =10+,44-22,000

22,544-2168 12-10) =104

856
=
10+ 1.27 11.27%
or
Positive NPV -x (Higher rate - Lower rate)
Lower rate
Positive NPV +Negative NPV
= 10 + 544+312
544
312(12-10) = 11.27%

Alternatively, IRR can be calculated from the higher rate as follows:

12
22,000-21,688 x (12-10)
22,544-21,68
12-4 2 =12-0.73=11.27%
856
Decision Rule (or Acceptance Criterion): The calculated internal rate of return is compared
with the desired minimum rate of return (cut-off rate). If IRR is equal to or greater than the desired
minimum rate of return, then the project is accepted. If it is less than the desired minimum rate of
return, then the project is rejected.
Advantages of IRR
1 This method considers all the cash flows over the entire life ofthe project.
2 It takes into account the time value of money.
3 Cost ofcapital need not be calculated.
4 IRR gives a true picture of the profitability ofthe project even in the absence of costof capital.
5. Projects having different degrees of risk can easily be compared.
Disadvantages of IRR
1. The IRR method is difficult to understand and use in practice because it involves tedious and
complicated calculation.
2. Under certain conditions it becomes very difficult to take any decision. For example, under
conditions of irregular cashflows, IRR may give two or more answers.
3. Sometimes it may yield negative rate or multiple rate which is rather confusing.
 50 Financial Management
4. It yields results inconsistent with the NPV methodif projects differ in their expected life span,
investment timing of cashflows.
5. It is applicable mainly in large projects.
Comparison Between NPV and IRR
Similarities
Both consider time value of money
Both lead to the same acceptance or rejection decision rule when there is a single project
Both methods use cash inflows after tax.
Both consider cash inflows
throughout the life of the project.
Differences
NPV IRR
1. The minimum desired rate of return (cost of 1. The minimum desired rate of return is to
capital) is assumed to be known. be determined.
2. It implies
that the cash inflows are invest- 2. It implies that cash inflows are reinvested at
ed at the rate of firm's cost of capital. the IRR of the project.
3. It gives absolute return. 3. It gives percentage return.
4. The NPV of different projects can be
added. 4. The IRR of different projects cannot be added.
Now, after comparing the two methods, the question arises, which of the method is better.
The NPV method is comparatively better because of the following reasons:
1 NPV provides an absolute amount of
net addition to the shareholders' wealth.
2. In NPV method, reinvestment rate for each
project is the same. But IRR provides different
different projects.
rates for
3 NPV always ranks mutually exclusive projects
correct ranking.
correctly, but IRR may not be able to give
In short, IRR provides the rate of return
the investment and not the
on
But NPV provides yield
the on investment yield on investment.
which is more
management, i.e., maximisation of shareholders' wealth. compatible
with the objective of
financial
Very Important Note: In all capital budgeting
techniques (except ARR), the cash inflow is the
operating profit after tax but before depreciation. Only in ARR method, the cash
after depreciation and tax. inflow is the profit
Risk Analysis in Capital Budgeting
We have already seen that
capital expenditure decisions involve
long term decisions. Moreover, (he benefits large investments. These ar
All these points indicate that likely to be obtained from
capital investments are predicted.
high degree of risk and uncertainty is associated with
capital expenditure
Capital Budgeting 51

decisions. Ifaninvestment proposal has high profitability, the risk associated with it will also be high.
Ifthe risk is high then investor's money is unsafe. Therefore, it becomes very essential to make rnisk
analysis of investment proposals before the management goes ahead with the project.
Risk Analysis
The acceptability of projects mainly depends upon their returns and risk. A firm should

consider risk
while estimating the required rate of return on a project. Generally, there is a
positive correlation between risk and return. If the return is high, the risk is also high and vice
versa. Before investing funds in a project, it is necessary to consider the risk and return associated
with all the alternative investment options. The process of comparing the risk and returns to
select the most profitable investment proposal is known as risk-return analysis. Thus, the objective
of risk-return analysis is to select the best project or investment proposal. The best project is
one which has highest return and lowest risk.
Need for Risk Analysis in Capital Budgeting
Risk in an investment refers to the variability that is likely to arise in future between the
estimated returns and the actual returns from the investment proposal. The actual return from
an investment proposal shall be different from the estimated returns due to a number of reasons.
Some of the important reasons are technical, economic, political, cyclical fluctuations, financial,
foreign exchange, taxation etc. Thus, risk is involved in every capital budgeting decisions. As
risk is involved in every investment proposal, it is necessary to take into account the risk factor,
while taking the capital budgeting decisions. If this risk is not considered, the firm cannot
maximise its returns.
Risk cannot be eliminated completely from any financial or investment decision. However, it
can be minimised through proper risk-return analysis. We know that investment decisions always
involve a trade-off between risk and return. Assessing risk and incorporating the same in the final
decision is an integral part of financial analysis.
Methods or Techniques of Risk Analysis
All methods of risk analysis can be classified into two-general or traditional methods and
modern or quantitative methods
General or Traditional Techniques
Under these techniques some appropriate adjustments are made to the estimated cash flows
to make them more reliable. The following are the important traditional techniques:
1. Risk adjusted discount rate: Generally a firm is ready to accept a lower rate of return
from a project if the risk involved is less. If there is more risk in an investment proposal, a higher
rate of return shall be expected.
Under the risk adjusted discount rate technique some adjustment will be made in the discount
rate. This is done according to the degree of risk associated with the project. Ifthe risk is high the
discount rate is raised (adding risk premium to discount rate). How much to add depends upon the
degree of risk. Suppose the management desires a rate of return of 12%. If the project is risky, a