Working CapitalManagement 5

Workingcapital management is significant in Financial Management due to the fact that it plav
pivotal role in keeping the wheels of a business enterprise running. Working capital management
lays a
concerned with short-term financial decisions. Shortage of funds for working capital has Cau
many businesses to fail and in many cases, has retarded their growth. Lack of efficient and effect
utilization of working capital leads to low rate of return on capital employed or even compels
tive
sustain losses. The need for skilled working capital management has thus become greater in rece
years. A firm investsa part ofitspermanentcapital infixed assets and keeps a part of it for workina
capital ie, for meeting the day to day requirements. We will hardly find a firm which does r
King
require any amount of working capital for its normal operation. The requirement of working capit
varies from firm, to firm depending upon the nature of business, production policy, marke
conditions, seasonality of operations, conditions of supply etc. working capital to a company is like
the blood to human body. It is the most vital ingredient of a business. Working capital management
if carried out effectively, efficiently and consistently, will ensure the health of an organization.i A
company invests its funds for long-term purposes and for short-term operations (That portion of a
company's capital, invested in short-term or current assets to carry on its day to day operations
smoothly, is called the 'working capital'. Working capital refers to a firm's investment in short-term
assets viz, cash, short-term securities, amounts receivables and inventories of raw materials, work
in-process and finished goods. It refers to al aspects of current assets and currentliabilities The
management of working capital is no less important than the management of long-term financial
investment Sufficient liquidity is necessary and must be achieved and maintained to provide that
fund's topayoff obligation as they arise or mature.] The adequacy of cash and other current assets
together with their efficient handling virtually determine the survival of the company. The efficient
working capital management is necessary to maintain a balance of liquidity and profitability. If the
funds are tied-up in idle current assets represent poor and inefficient
working capital management
which affects the firm's liquidity as well as profitability.

Working capital is defined as 'the excess of current assets over current liabilities.1 All elements of
working capital are quick moving in nature and therefore, require constant
monitoring for proper
management. For proper management of working capital, it is required that a
proper assessment of
its requirement is made.
Working capital is also known as circulating capital, fluctuating
capital and
revolving capital. The magnitude and composition keep on
changing continuously in the course of
business. If the working capital level is not
properly maintained and managed, then it may result in
unnecessary blockage of scarce resources of the
company. Therefore, the Finance Managers should
give utmost care in management of
working capital.

CA-IPCC 5.1 CA. RAJ K AGRAWAL

 FINANCIAL MANAGEMENTT wORKING CAPITAL MANAGEMENT
of Working Capltal
Components
Current Assets

are
those assets which are convertible into cash within. a period of one year and are
tho
assets
Current
to meet the day to day operations of the business. The working capital
ace which are required
current assets. The current assets are cash or
nanagement, to be more precise the management of
resources. These include:
near cash
and bank balances
(a) Cash
(b) Temporary investments

(c) Short-term advances

expenses receivables
(d) Prepaid stores and
of raw materials, spares
(e) Inventory
Inventory of work-in-progress
Inventory of finished goods
(8)

Current Liabilities

expected to mature for payment within an

those claims of outsiders which are
Current liabilities are

accounting year. These include:

(1) Creditors for goods purchased
(2) Outstanding expenses
(3) Short-term borrowings
(4) Advances received against sales
(S) Taxes and dividends payable
(6) Other liabilities maturing within a year

Gross Working Capital

investment in current assets. According to this
The term 'gross working capital' refers to the firm's
firm's investment in current assets. The amount of current
concept working capital refers to a

liabilities is not deducted from the total of current assets.

Net Working Capital

to the of current assets over current liabilities. It refers
The term 'net working capital refers excess

to the difference between current assets and current liabilities. The net working capital is a
qualitative concept which indicates the liquidity position of a firm and the extent to which working

capital needs may be financed by permanent source of funds. The gross and net working capital are

ascertained as shown below:

XXX
Current assets:
Raw material stock XXX

Work-in-process stock XXX

Finished goods stock XXX

CA. RAJ KAGRAWAL

CA-IPCC 5.2
FINANCIALMANAGEMENT WORKING CAPITAL MANAGEM
Sundry debtors
Bills receivable
XXX MEA
XXx
Short-term investments
Xxx
Cash and bank balances
xxx
Gross working capital
Less: Current liabilities:
Creditors for materials XXX

Creditors for expenses XXX

Bills payable xxx

Tax liability XXX

Short-term loans XXX XXX

Net working capital xxx

Permanent and Temporary Working Capital

Considering time as the basis of classification, there are two types of working capital
permanent and 'temporary.

Permanent Working Capital

The magnitude of investment in working capital may increase or decrease over a period of tim
according to the level of production. But, there is a need for minimum level of working capital
carry its business irrespective of change in level of sales or production. Such minimum level
working capital is called 'permanent working capital or "fixed working capital'. The minimumlevel
investment in current assets is permanently locked-up in business and it is also referred to
a
'regular working capital'. It represents the assets required on continuing basis over the entire ye
Tondon committee has referred to this type of working capital as 'core current assets'

Temporary Working Capital

It is also called as 'fluctuating working capital"'. It depends upon the changes in production and sales
and above the permanent
over working capital. It is the extra working capital needed to support th
changing business activities. A firm will finance its seasonal and current fluctuations in busine:
operations through short-term debt financing. For example, in peak seasons, more raw materials t
be purchased, more manufacturing expense to be incurred, more funds will be locked in debtor
balances etc.

Operating Cycle Concept

Working capital circulates in the business, and the current assets change from one form to the othe
Cash is used for procurement of raw materials and stores items and for
payment of operat
expenses, then converted into work-in-progress, then to finished
goods. When the finished goo
are sold on credit terms receivables balances will be formed. When the receivables are collected, t
again converted into cash. The need for working capital arises because of time eap betwe
CA-IPCcC 5.3 CA. RAJ K AGRAWAL
FINANCIAL MANAGEMENT WORKNG CAPITAL MANAGEMENT
oroduction
of goods and their actual realization after sales. This time gap is technically called
as
operating cycle'
'operating cycle' or
or working capital cycle'. The operating cycle of a company consists of time period
Atween the procurement of inventory and the collection of cash from receivables. The operating
betw

cycle is the length of time between the company's outlay on raw materials, wages and other
vnenses and inflow of cash from sale of goods. Operating cycle is an important concept in
management of cash and management of working capital. The operating cycle reveals the time that
manag

laoses between outlay of cash and inflow of cash. Quicker the operating cycle less amount of
investment in working capital is needed and it improves the profitability. The duration of the
nerating ycle depends on the nature of industry and the efficiency in working capital
management.

Cash received from

debtors/raw
material purchased

Sale of goods Raw materials

on credit introduced into
process

60

Finished goods
Completed

Now, the Period of Operating cycle can be ascertained as follows:

Raw material holding period XX

Work-in-process period xx

Finished goods holding period XX

Receivables collection period

Gross Operating Cycle x*
Less: Creditors payment period
Net operating Cycle XX

Operating Cycle R+W+ F+ D-C

=

Where,
R Raw Material storage period Average stock ofraw material
Average cost of raw material consumption per day

CA-IPCcC 5.4 CA. RAJ KAGRAWAL

 FINANCIAL MANAGEMENT
W = Work-in-progress holding period
F= Finished goods storage period
D Debtors Collection period
C Credit period availed
WORKING CAPITAL MANAGEM.
Average WIP inventory
Average cost of production per day
Average stock.offinished goods
Average cost of goods sold per day
Average Book debts
Average Credit sales per day
Average tradecreditors
Average credit purchases per day

llustration 1: The following information has been extracted from the records of a Company:
Product cost sheet
Raw materials 45
Direct labour 20
Overheads 40
Total 105
Profit 15
Selling price 120
Raw materials are in stock on an average for two months.
The materials are in process on an
respect of all elements of cost.
averageforone month. The degree of completion is Soxy

Finished goods stock on an average is for one month.

Time lag in payment of wages and overheads is 1% weeks.
Time lag in receipt of proceeds from debtors is 2 months.
Credit allowed-by supplieris ene month-
20% of the output is sold against cash.
The company expects to keep a Cash balance
of 1,00,000.
The Company is poised for a manufacture of 1,44,000 units in the next
year.
You are required to a statement
prepare showing
the Working Capital requirements of the Company
Solution: Statement showing the Working Capital
requirement of the company
Current assets:
Stock of Raw materials (12,000 X 2 X
T45) 10,80,00o
Work-in-progress (12,000 X1 X 105) X50%
6,30,000
Finished goods (12,000X 1XT 105)
12,60,000
Debtors (12,000 X 2X* 105 X
80%) 20,16,000
Cash balances
Current Liabilities
1,00,000 50,86,000
Creditors of materials (12,000 X 1 x 45)
raw
5,40,000
Creditors for wages & overheads (12,000
X60 4) 1.5 2,70,000 8,10,000
Net Working capital (C.A C.L) 42,76,000
CA-IPCC 5.5 CA. RAJ K AGRAWAL
FINANCAL MANAGEMENT WORKING CAPITAL MANAGEMENT

Working Notes:

Debtors have been taken at cost.

Finished goods and
1.
has been taken at 12,000 units. For payment of wages and overheads,
,Production per month
of 4 weeks.
month is taken as consisting

the following data:

The cost sheet of PQR Ltd. provides
lustration 2: Cost per unit
50
Raw material
20
Direct Labour
Overheads (including depreciation ofT 10) 40
110
Total cost
Profits
20
130
Selling price
is for half
material in stock is for one month. Average material in work-in-progress
Average raw
time
one month; credit allowed to debtors: one month. Average
month. Credit allowed by suppliers:
30 days. 25% of the
of wages: 10 days; average time lag in payment of overheads
lag in payment lie in the warehouse
to be 1,00,000. Finished goods
on cash basis. Cash balance expected
salesare
for one month.
a level of the
You are required to working capital needed to finance
prepare a statement of the
Production is carried on evenly throughout
the year and wages
activity of 54,000 units of output.
overheads accrue similarly. State your assumptions any, clearly.
if
and

turnover
at 54,000 units, it means that the monthly
Solution: As the annual level of activity is given
monthly turnover can
for this
would be 54,000/12 4,500 units. The working capital requirement
now be estimated as follows:

Estimation of Working Capital Requirement

Amount Amount
| 1. Current Assets:
Minimum Cash Balance 71,00,000
Inventories:
Raw Materials (4,500xT 50) 2,25,000

Work-in-progress:
Materials (4,500 X 50)/2 1,12,500
Wages 50% of (4,500 X 20)/2 22,500

Overheads 50% of (4,500 X* 30)/2 33,750

Finished Goods (4,500x? 100) 4,50,000
Debtors (4,500 X R 100X 75%) 3,37,500
12,81,250 12,81,250
Gross Working capital

CA-IPCC 5.6 CA. RAJ K AGRAWAL

 WORKING CAPITAL MANAGEML
FINANCIAL MANAGEMENT .
2. Current Llabilties:
50) 2,25,000
Creditors for Materials (4,500 X

Wages (4,500 x t 20)/3

30,000
Creditors for
300 1,35,000
Creditors for Overheads (4,500 x
Total Current Liabilities 3,90,000 3,90,000
Net Working Capital 8,91,250

Working Notes:
unit include a depreciation of 10 per unit, which is a non-cach
1 The overheads of ? 40 per iten
This depreciation cost has been ignored for valuation of work-in-progress, finished ods
ar

has been taken only at 30 per unit.

debtors. The overhead cost, therefore,
the raw materials have been taken at full requirement.
2. In the valuation of work-in-progress,
15 days; but the wages and overheads have been taken only at S0% on the assumption that on

are 50% complete.

average all units in work-in-progress
3. Since, the wages are paid with a time lag of 10 days, the working capital provided by wages h
been taken by dividing the monthly wages by 3 (assuming a month to consist of 30 days)

Ilustration 3: Hi-tech Ltd. plans to sell 30,000 units next year. The expected cost of goods sold is,

follows:
(Per Unit)
Raw material 100
30
Manufacturing expenses
Selling, administration and financial expenses 20
Selling price 200
The duration at various stages of the operating cycle is expected ta be as follows:

Raw material 2 months

Work-in-progress 1 month
Finished Goods % month
Debtors 1 month

Assuming the monthly sales level of 2,500 units, estimate the gross working capital requirement
the desired cash balance is 5% of the gross
working capital and
requirement, work-in-progress
25% complete with respect to manufacturing expenses.

Solution:
Statement of Working Capital Requirement
Current Assets: Amount ()|Amount(R)
Stock of Raw Material (2,500 X 2 X 100) 5,00,000
Work-in-progress:
CA-IPCC 5.7 CA. RAJKAGRAWAL
Capital
Budgeting 8
.Ladgeting is
budgeting
is aa process of planning capital expenditure which is to be made to maximize the
proCe

capital arofitability of the organization. Capital budgeting is a long-term planning exercise in

of the projects which generates returns over a number of years in future and the heavy
selectionof
e i to be incurred in the initial years of the project to generate returns over the life of the
expeno

The term capit.

The term
capital budgeting refers to planning for capital assets. The capital budgeting
project. a decision as to whether or not money should be invested in long-term projects such
ecisionmeans
nachinery or creating additional capacities to manufacture a part which at present
75tatmga mac
from outside. It includes a financial analysis of various proposals regarding capital
m a yb e p u r c h a s e d

iture, The Finance manager has various tools and techniques by means of which he assists
anagement in taking a proper capital investment decision. For purposes of investment
the
aisal, the cashflow is the incremental cash receipts less the incremental cash expenditures solely
rhutable to the investment in question. The future costs and revenues associated with each
iavestment alternative are - (a) Capital costs, (b} Operating costs, (c) Revenue (d) Depreciation, and

in
(e) Residual value.

Investment Appraisal Techniques

The techniques available for appraisal of investment proposals are discussed below:

Payback Period Method

The payback period is usually expressed in years, which it takes to make the cash inflows from a
capital investment project equal the cash outflows. The method recognizes the recovery of original
capital invested in a project. At payback period the cash inflows from a project will be equal to the
project's cash outflows. This method specifies the recovery time, by accumulation of the cash
inflows (inclusive of depreciation) year by year until the cash inflows equal to the amount of the
original investment. The length of time this process takes gives the 'payback period' for the project.
In simple terms it can be defined as the number of years required to recover the cost of the
investment. In case of capital rationing situations, a company is compelled to invest in projects
having shortest payback period. When deciding between two or more competing projects the usual
decision is to accept the one with the shortest payback. Payback is commonly used as a first
Screening method. It is a rough measure of liquidity and rate of profitability. This method is simple to
understand and easy to apply and it is used as an initial screening technique. This method recognizes
the recovery of the original capital invested in a project.

ration 1: The project involves a total initial expenditure of 7 2,00,000 and it is estimated to

generate future cash inflow of 30,000, 38,000, 25,000R 22,000, ? 36,000 40,000, ?40,000,
8,000,R 24,000 and 24,000 in its last year. Calculate Payback Period.

CA-IPCC 8.1 CA. RAJ KAGRAWAL

FINANCIAL MANAGEMENTT CAPITAL BUDGET
Solution: Calculation of Payback Period
Years Cash inflows Cumulative cash inflows
1 30,000 30,000
2 38,000 68,000
3 25,000 93,000
4 22,000 1,15,000
5 36,000 1,51,000
6 40,000 1,91,000
7 40,000 2,31,000
8 28,000 2,59,000
9 24,000 2,83,000
10 24,000 3,07,000
In six years,
1,91,000 are recovered.
Payback period =6 years+ 9,000/ 40,000 x 12 months =6 years 3 months

Accounting Rate of Return Method

The accounting rate of return is also known as 'return on investment' or 'return on
method capital employer
employing the normal accounting technique to measure the increase in
result from an investment profit expected
by expressing the net accounting profit arising from the
percentage of tat capital investment. The method does not investment as
take into consideration all the
involved in the life o the project. In this
method, most often the following formula is
year
accounting rate of return. applied to the

Accounting Rate of Return Average Annual Profit

After 1ax
Average or Initial Investment x 100

Average Investment Initial Investment+Salvage Value

Sometimes, initial investment is used in place of

average investment. Of the
of return on different various accounting rate
alternative proposals, the one having highest
best investment proposal. For rate of
example, in three aiternative proposals return is taken to be the
accounting rates of return of 10%, 20% and 18% A, B and C with
C and A. If the
respectively. Projects will be selected in
expected
prevailing rates of interest is taken to De 13% p.a., only proposals
order of B
for consideration and in that order. B and C will
quali
Illustration 2: Consider the
following investment opportunity:
A machine is available for purchaseat a cost of
We expect it to have
80,000
life of five years and to have a scrap value
a
ofR
year period. We have estimated that it will 10,000 at the end of the
generate additional profits over its tive
life as
follows:
CA-IPCC 8.2
CA. RAJ K
AGRAWA
 NCIAL MANAGEMENT
CAPITAL BUDGETING
FINANCIA
Year 2 3 4 5
20,000 40,000 30,000 15,000 5,000
Amount
required to calculate the return on
before depreciation. You
are

timates
are of profits
T h e s e

c a p i t a le m p l o y e d .

=71,10,000
the life of the machine
Solution:

over
depreciation
Total
ofit before ={1,10,000/5 Years =22,000
Average profit p.a. = 70,000
the macine ( 80,000 F 10,000)
-

over the life of

TAtal depreciation =14,000
= 70,000/5 years
depreciation
p.a. 78,000
Average
deprecation = R 22,000 -R 14,000
annual profit after = 80,000
Average
original investment required
10%
of return (R8,000/ 80,000) X 100
Accounting rate 7 45,000
Average investment
= (T 80,000+7 10,000)/2
17.78%
= (T 8,000 /R45,000) X 100
of return
Accounting rate

Method
Nét Present Value to produce goods
by using existing and future
resources
the firm is to create wealth
The objective of value of all anticipated cash
wealth, inflows must exceed the present
services. To create attributable to a
obtained by discountingall cash outflows and inflows
outflows. Net present value is
entity's weighted average cost capital.
of
investment project by a chosen percentage e.g, the
capital investment by the minimum required
rate of
method discounts the net cash flows from the
The
to give the yield from the
funds invested. If yield is
return, and deducts the initial investment
for itself and is thus
the project is acceptable. If it is negative the project in unable to pay
positive
is known as 'discounting' and
The exercise involved in calculating the present value
unacceptable.
cash flows are known as the 'discount factors'
the factors by which we have multiplied the

cash
llustration 3: A firm can project with a life of three years. The projected
invest 10,000 in a

and Year 3 -R 4,000.

infloware: Year 1-7 4,000, Year 2 -T5,000 investment be made?
Ihe cost of capital is 10% p.a. Should the

be calculated based on 1 received in with 'r rate of

Solution: Firstly the discount factors can

interest in 3 years.
1 1 = 0.909
Year 1
(1+10/ 100) (1.10)
= 0.826
Year 2 1+10/100)2 1/(1.10)

= 0.751
1/(1.10)
Year 3 (1+10/100)3

8.3 CA. RAJK AGRAWAL

CA-1PCC
 FINANCIAL MANAGEMENT CAPITAL BUDGETIN
Year Cash flow Discount factor Present value

0 (10,000) 1.000 (10,000)

4,000 0.909 3,636
2 5,000 826 4,130
3 4,000 0.751 3,004
NPV 770
Analysis-Since the net present value is positive, investment in the project can be made.

Internal Rate of Return Method

Internal rate of return (IRR) is a percentage discount rate used in capital investment appraisals
which
brings the cost of a project and its future cash inflows into equality. It is the rate of return whi
equates the present value of anticipated net cash flows with the initial outlay. The lIRR is also defin
as the rate at which the net present value is zero. The rate for computing IRR depends on
bank
lending rate or opportunity cost of funds to invest which is often called as personal discounting ata
te
or accounting rate.

llustration 4: Acompany has to select one of the following two projects:

Particulars Project A Project B
Cash 11,000 10,000
Cash inflowS
Year 1 6,000 1,000
2 2,000 1,000
3 1,000 2,000
5,000 10,000
Using the internal rate of return method, suggest which project is
preferable.
Solution:
Project A
Year Cash inflows Discounting Present value
factor at 10%
6,000 0.909 5,454
2 2,000 0.826 1,652
3 1,000 0.751 751
4
5,000 0.683 3,415
Total present value
The present 11,272
value at 10% comes to 11,272. The initial investment is
return may be taken 11,000. Internal re
approximately at 10%

CA IPCC 8.4 CA. RAJK AGRAN AL

 ANCIAL MANAGEMENT CAPITAL BUDGETING
/FI
more
exactness is required another trial rate which
exa is slightly higher than 10% (since at this
case
In
she poresent
resent
value is more than initial investment) may be taken. Taking a rate of 12%, the
value
the
rate
results would emerge:
following
Year Cashinflow Discounting factor at 12% Present value
6,000 0.893 5,358
2 2,000 0.797 1,594

3 1,000 0.712 712

4 5,000 0.636 3,180

10,844
Total present value
return is thus than 10% but less than 12%. The exact rate may be
The internal rate of
more

calculated as follows:

P.V. required 11,000

P.V. at 10% 11,272 (+) 272
P.V. at 12% 10,844 (156

Actual IRR 272

10 272-(-156) X2 11.27%

Project B
Year Cash inflows Discounting Present value
factor at 15%
1,000 0.870 870
2 1,000 0.756 756

3 2,000 0.658 1,316

4 10,000 0.572 5.720
Total present value 8,662
8,662, lower rate of discount should be taken. Taking a
Since present value at 15% comes only to a

rate of 10% the following will be the result.

Year Cash inflows DiscountingfactorPresent value

at10%
1,000 0.909 909
1,000 0.826 826

3 2,000 0.751 1,502

4 10,000 0.683 6,830
Total present valuee 10,067

The present value at 10% comes to 10,067 which is more or less equal to the initial investment.
of return may be taken as 10%.
Hence, the internal rate
In order to have more exactness to internal rate of return, can be interpolated as done in case of

project 'A.
CA-IPCC 8.5 CA. RAJKAGRAWAL
FINANCIAL MANAGEMENT CAPITAL IBUDGET
P.V. required 10,000
P.V.at 10% 10,067 (+) 67

P.V. at 15% 8,662 ()1,338

67
10.24%
Actual IRR
10+61-(1338)
of return in case of Project 'A' is higher as comparer
Analysis Thus, internal rate

Hence, Project A is preferable.

Project

Relative Ranking of Projects: IRR vs. NPV

The relative ranking of projects, using the diferent DCF methods will be considered initially in
accept/reject situations. This will be extended later to a detaled assessment of situations
choice has to be made between two or more alternatives. In simple accept/ reject situations.
ons a firm
is able to implement all projects showing a return at or above the firms cost of capital. Both NP
IRR would appear to be equally valid in the sense that they will both lead to accept or
and
ect the
same projects. Using NPV, ll projects with a positive net present value, when discounted at
firm's cost of capital, will be accepted. Using IRR all projects which yield an internal rate of returnthe
excess ofthe firms cost of capital will be chosen. Although IRR and NPV lead to the Sameconclusi
regarding project acceptability, the ranking of a set of projects obtained from IRR does
not
necessarily agree with that produced using NPV. Since, in the latter case, the ranking may va
according to particular discount rate used. Argument about the merits of the relative ranlking
simple accept/ reject situations is thus concerned with the question of value. It is argued that the IRR
measures only the quality of the investment while NPV takes into account both the quality and the
scale. This is because the IRR provides a relative measure of value (% IRR} while the NPV
provides an
absolute measure (Surplus). The IRR would rank, for example, a 100% return on an investment
of 1
considerably higher thana 20% return on an investment of 10 lakhs, whereas the reserve would be
true using NPV (as long as the cost of capital is below
20%).

While one project may have a igher rate of profit per unit of capital invested than another, if itr
fewer units of capital invested in it, it may make a smaller contribution to the wealth of the tirm
Thus if the objective is to maximize the firms wealth, then the ranking of project NPV s provides the
correct measure. If the objective is to maximize the rate of profitability per unit of capital invested
then IRR would provide the correct ranking of projects, but this objective could be achieved
rejecting all
but the most highly profitable projects. This is clearly unrealistic and, therefore, o
would conclude that NPV
ranking is correct and IRR unsatisfactory as a measure of relative pro
value. When two investment
proposals are mutually exclusive, both methods will give contradl
results.
When two mutually exclusive projects are not expected to have the same life, NPV an R
methods will give conflicting
ranking.

CA-IPCC 8.6 CA. RAJ K AGRAWA

 AL MANAGEMENT CAPITAL BUDGETING
INANCIAL

iustration5 :

Particulars ProjectAProject8
Year 0
(7 14,000) R25,000)
Year 1-5 5,000 p.a.8,000 p.a.
23% 18%
IRR
of capital) 4,950 5,320
NPV (at 10% cost
Ranking
Using IRR
Using NPV

to be made between Project A and Project

B because they are operationally mutually
fa choice has
the appraisal method used, because conflicting
ehe. the project chosen will depend upon NPV method,
illustration, Project B would be preferred based
e x c u s i v

on
In the above
ating will occur.
involves investment of an extra 11,000
lower percentage return on average, it
rankin

iecoite offering a increase in the NPV)

sufficient to generate a further profit surplus (i.e., an
des

return on which is
the
discounted at 10%.
when

of Project A and Project B

Diferential cashflows = (11,00O)
Year 0 Differential investment

Year 1-5 Differential cash inflow =3,000 p.a.

11%
IRR
NPV (at 10%) =370(i.e. 75,320 -R 4,950)
a differential return in excess of
Analysis-Using IRR, Project A would be chosen because provides
it
observation of IRR between two projects, A will
the minimum required return. But with the simple
be selected because of its higher IRR of 23%.

Multiple Internal Rates of Return

In some projects there will be initial cash outflow followed by cash inflow. In the middle of the
outflow which may resultin getting more than one
project life there would be another major cash
IRR. This situation is called 'multiple internal rate of returns'.
When multiple IRRs arises, the capital project will be selected only when its cost of capital is below
the multiple IRRS.

Modlified Internal Rate of Return (MIRR)

Ihe MiRR is a refined method of calculating IRR. The MIRR overcomes the weaknesses of IRR. MIRR
correct
AY assumes the reinvestment at the project's cost of capital and eliminates the problem of
Betting multiple IRRS
he
steps in calculating MIRR are as follows:
la) Estimate all the cash flows
as in IRR.
r u r e value of all cash inflows are calculated to the terminal year of the project life.

CA-IPCC 8.7 CA. RAJK AGRAWAL

| FINANCIAL MANAGEMENT
(c) Determine the discount rate that causes the future value of all cash inflows detoa
CAPITAL BUDGETINY
step (b), to be equal to the firm's investment at time zero. Such discount rate oh determined n
unt rate
called MIRR. obtained i
The computation of MIRR is not widely used in practice. IRR is more popularly adopted in
investment decisions. project
Profitability Index Method
t is method of assessing capital expenditure opportunities in the profitability indey
a

profitability index (PI) is the present value of an anticipated future cash inflows divided by the
outlay. The only difference between the net present value method and profitability index methoa.
od is
that when using the NPV technique the initial outlay is deducted from the present vale
of
anticipated cash infiows, whereas with the proftability index approach the initial outlay is
divisor. In 8general terms, a project is acceptable if its profitability index value is a
used
greater than
1
Clearly, a project offering a profitability index greater than 1 must also offer a net present
which is positive. When more than one project proposals are evaluated, for selection of alue
one
them, the project with higher profitability index will be selected. Mathematically, PI mong
index) can be expressed as follows:
(profitabit

Profitability Index (PI) Present Value of Cash Inflows

Present Value of Cash Outlay
This method is also called 'cost-benefit ratio' or 'desirability ratio' method.

llustration 6: The following mutually exclusively projects can be considered:

Particulars Project A| Project B
P.V. of cash inflos i) 20,000 8,000
Initial cash outlay (i) 15,000 5,000
Net presentvalue 5,000 3,000
Profitability Index ()/ti) 1.33 60
Analysis According to the NPV method, Project A would be preferred, whereas
according to
profitability index Project B would be preferred. Although Pl method is based on NPV, it is a
better
evaluation technique than NPV in a situationo capital rationing. For example two projects may have
the same NPV of 10,000 but Project A requires initial outlay of T 1,00,000 whereas B only 50,000.
Project B would be preferred as per the year stick of Pl method.

Discounted Payback Period Method

In this method thecashflows involved in a project are discounted back to present value terms as
discussed above. The cash inflows are then
directly compared to the original investment in
order
identify the period taken to
payback the original investment in present values terms. This
Overcomes one of the main
metnou
objections to the original payback method, in that it now fully alloWS
the timing of the cashflows, but it still does
not take into account those cashflows which Cur

subsequent to the
o
payback period and which may be substantial. The method is a of
variatiO
CA- IPCC 8.8 CA. RAJ K AGRAIVAL
 CLAL MANAGEMENT CAPITAL BUDGETING
od, which can be used if DCF methods are employed. This is calculated in rmuch
p e r i o dm e t h o d ,
F I N A

payback as the payback, except that the cashflows accumulated are the base year value
t h es e m e w a y a discounted at the discount rate used in the NPV method (ie., the
which have been
hflows estment). Thus, in addition to the recovery of cash investment, the cost of
equired.
return o n

vestment during the time that part of the investment remains unrecovered is also
ensures the achievement of at least the
financns t thus, unlike the ordinary payback method,
untoward happen after the payback period.
provrequired return, as long as nothing

Ltd. is implementing a project with an initial capital outlay of 7,600. Its cash
lhustration
n 7: Geeta
intflowsa r ea s

1 2 4
Year

6,000 2,000 1,000 5,000

rate of return on the capital invested is 129% p.a. calculate the discounted payback
a PXDected
the project.
periodof
of Present Value of Cash Flows
colution Computation
Year Cash inflow Discount factor @ 12% Present value
6,000 0.893 5,358
2 2,000 0.797 1,594
3 1,000 0.712 712

4 5,000 0.636 3,180

Total present value 10,844
the discounted cash inflows
Analysis The discounted payback period of the project is 3 years i.e.,
forthefirst three years (i.e., 5,358 + 1,594 +R 712) is equivalent to the initial outlay of 7,600.
Terminal Value Method
Under this method it is assumed that each cashflow is reinvested in another project at a
predetermined rate of interest. t is also assumed that each cash inflow is reinvested elsewhere
inmediately until the termination of the project. If the present value o the sum total of the
compounded reinvested cashflows is greater than the present value of the outflows the proposed
project is accepted otherwise not.

lNustration 8:
Original outlay 8,000
Life of the
project 3 years
Cash inflows 4,000 p.a. for 3 years
Cost of capital
10% p.a.
Expect interest rates at which the cash inflows will be reinvested:
Year end 1 2 3
% 8 8 8

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 FINANCIAL MANAGEMENT
CAPITAL BUDGETN
Solution: First of all, it is find out the total compounded
necessary to sum which will
which will be dice.
back to the present value.
discountet
YearCash Rate Years for Compounding Total compounding
inflowinterest% investment factor
sum
4,000 .166
2 4,664
4,000 1.080
4,000
4,320
0 1.000
4,000
NOw, we have to find out the
12,984
present value of 12,984 by applying the discount rate of 10%.
12,984
12,984 X0.7513* 9,755
(1.10)3 =

(0.7513 being the P.V. of 1 received after 3

Here, since the present value of years.)
reinvested cashflows i.e., { 9,755 is greater than the
outlay of 8,000, the project would be original cah
accepted under the terminal value criterion.
Capital Rationing
Capital rationing is
situation where a constraint or
a
capital expenditures during a budget ceiling is placed on the total size
particular period. Often firms draw up their capital of
assumption that the availability of financial budget under the
resources is limited. Capital
selection of the investment rationing refers to the
proposals in a situation of constraint on availability of
maximize the wealth of the capital funds, to
company by selecting those projects which will
the concern. In maximize overall NPV
capital rationing situation a company may have to of
IRR is above the overall forego some of the
projects
cost of the firm due to
ceiling on budget allocation for the whose
eligible for capital investment. Capital projects which are
rationing refers to a situation where a
undertake all positive NPV projects it has company cannot
identified because for
situation, a decision maker is compelled to shortage of capital. Under this
reject some of the viable
present value because of shortage of funds. It is known projects having positive net
as a situation
terms of financing investment
projects, the following important involving capital rationing. In
()What would be the requirement of questions is to be answered.

planning period?
funds for capital
investment decisions in the
forthcoming
(ii) How much quantum of funds available for capital
(ii) How to assign the available funds to the
investment?
acceptable proposals which
are available? require more funds than
The answer the first and second questions are
to
EIven with
appraisal decisions made by the top management. ine third reference to the capital inves tment
reference to the appraisal of investment decision from the
question is answered
with specific
angle of capital ration
ratianinn

Factors Leading to Capital Rationing

Two different types of capital rationing situation can be
identified, distinguished hu t
capital expenditure constraint. ce of the

CA- IPcC 8.1

CA. RAJK AGRAWAL
 FINANCAL MANAGEMENT
CAPITAL BUDGETING
External Factors

ing Capital rationing may arise due to external factors like

Capital rationi

temarket information which might have for the imperfections capital market or deficiencies
of

narket itself or the Government will not supplyavailability capital. Generally, either the capital
of
64 mar

unlimited amounts of investment capital toa

20 company, even though the company has identified
investment opportunities which would be able to
00 nroduce the required return. Because of these
of capital funds to carry out all the profitable imperfections the firm may not get necessary amount
projects.
Internal Factors

Capital rationing is also caused by internal factors

which
follows: are as
(i)Reluctanceto take resort to financing by external equities in order to avoid
further risk. assumption of

() Reluctance to broaden the

equity share base for fear of losing control.
(ii) Reluctance to accept some viable
scale of projects because of its inability to manage the firm in the
operation resulting from inclusion of all the
al size i The second question is answered viable projects.
by a reference to the capital
nder t will tend to depend on the budget. The level of capital budget
rs to t
quality of investment proposals submitted to
addition it will also tend to depend on the top management, in
following factors:
funds (a) Top management philosophy towards
capital spending.
(b) The outlook for future investment
opportunities that may be unavailable if extensive current
ts Whog commitments are undertaken.
hich a (c) The funds provided by current
operations
Cana (d) The feasibility of
acquiring additional capital through
der t Under capital rationing, the borrowing or share issues.
management has to determine not only the
itive n opportunities but also decide to obtain that combination of profitable investment
the profitable
ning, highest NPV within the available funds by projects which yield
raking them according to their relative
Theoretically, projects should be undertaken to the point where profitability.
of financing these the return is just
comiIE projects. If safety and the maintaining of, say, equal to the cost
more
important than additional profits, there may be a market family control are considered to be
financing, and hence alimit will be placed on the amounts available unwillingness to engage in external
for investment, even
ds the enterprise may wish to raise external finance for its though the
investment program, there
why it be unable to do this. Examples include: are many reasons
stmen (a) The enterprise's past record and its
present capital structure may make it
extremely costly to raise additional debt impossible or
capital.
(6) Its record may make it impossible to raise new equity capital because
of lw
yield. yields or even no

(c) Covenants in
existing loan agreements may restrict future
borrowing. Furthermore, in the
of t typical company, one would expect capital rationing to be
largely self imposed. -

CA-IPCc 8.11 CA. RAJ K AGRAWAL