UNIT-V: Introduction to Accounting & Financing Analysis:

Capital and Capital Budgeting: Capital Budgeting: Meaning of Capital-Capitalization- Meaning of

Capital Budgeting-Time value of money- Methods of appraising Project profitability: Traditional
Methods(pay back period, accounting rate of return) and modern methods(Discounted cash flow
method, Net Present Value method, Internal Rate of Return Method and Profitability Index)

Topic Video source Duration

Introduction https://youtu.be/bXAB9KMNsLU?si=Lf6EMhbWvcCzehgJ 17 minutes
https://youtu.be/NTHwQwDdQmA?si=ksJaxrc0KWau_BV8 17 minute
Pay Back Period https://youtu.be/G-TuVG7Ji5Q?si=gg1UILY37-GiLsY9 20 minutes
ARR https://youtu.be/BaPWesZftT0?si=4pItAvPDhjQCLgKW 13 minutes
NPV https://youtu.be/Pcc9GLK60YI?si=lWt1OruFkLOhoL4- 21 minutes
IRR https://youtu.be/n5hc5Q0wyoY?si=9d1NKGg_RTMjOkzj 14 minutes
PI https://youtu.be/xY0Jq7aXyNU?si=ZiKM-jRqcUA88gRb 10 minutes

Working Capital

Finance is required for two purpose viz. for it establishment and to carry out the day-to-day operations
of a business. Funds are required to purchase the fixed assets such as plant, machinery, land, building,
furniture, etc, on long-term basis. Investments in these assets represent that part of firm’s capital,
which is blocked on a permanent of fixed basis and is called fixed capital. Funds are also needed for
short-term purposes such as the purchase of raw materials, payment of wages and other day-to-day
expenses, etc. and these funds are known as working capital. In simple words working capital refers
that part of the firm’s capital, which is required for financing short term or current assets such as cash,
marketable securities, debtors and inventories. The investment in these current assets keeps revolving
and being constantly converted into cash and which in turn financed to acquire current assets. Thus the
working capital is also known as revolving or circulating capital or short-term capital.

Concept of working capital

There are two concepts of working capital:

1. Gross working capital

2. Net working capital
Gross working capital:

In the broader sense, the term working capital refers to the gross working capital. The notion of the
gross working capital refers to the capital invested in total current assets of the enterprise. Current
assets are those assets, which in the ordinary course of business, can be converted into cash within a
short period, normally one accounting year.

Examples of current assets:

1. Cash in hand and bank balance

2. Bills receivables or Accounts Receivables
3. Sundry Debtors (less provision for bad debts)
4. Short-term loans and advances.
5. Inventories of stocks, such as:
 (a) Raw materials
(b) Work – in process
(c) Stores and spares
(d) Finished goods
6. Temporary Investments of surplus funds.
7. Prepaid Expenses
8. Accrued Incomes etc.
Net working capital:

In a narrow sense, the term working capital refers to the net working capital. Networking capital
represents the excess of current assets over current liabilities.

Current liabilities are those liabilities, which are intend to be paid in the ordinary course of business
within a short period, normally one accounting year out of the current assets or the income of the
business. Net working capital may be positive or negative. When the current assets exceed the current
liabilities net working capital is positive and the negative net working capital results when the
liabilities are more then the current assets.

Examples of current liabilities:

1. Bills payable
2. Sundry Creditors or Accounts Payable.
3. Accrued or Outstanding Expanses.
4. Short term loans, advances and deposits.
5. Dividends payable
6. Bank overdraft
7. Provision for taxation etc.

1. Explain the Importance of working capital briefly

Working capital is refereed to be the lifeblood and nerve center of a business. Working capital is as
essential to maintain the smooth functioning of a business as blood circulation in a human body. No
business can run successfully with out an adequate amount of working capital. The main advantages of
maintaining adequate amount of working capital are as follows:

a. Solvency of the business: Adequate working capital helps in maintaining solvency of

the business by providing uninterrupted flow of production.
b. Good will: Sufficient working capital enables a business concern to make prompt
payment and hence helps in creating and maintaining good will.
c. Easy loans: A concern having adequate working capital, high solvency and good credit
standing can arrange loans from banks and others on easy and favorable terms.
d. Cash Discounts: Adequate working capital also enables a concern to avail cash
discounts on the purchases and hence it reduces costs.
e. Regular supply of raw materials: Sufficient working capital ensures regular supply of
raw materials and continuous production.
f. Regular payments of salaries wages and other day to day commitments: A
company which has ample working capital can make regular payment of salaries,
 wages and other day to day commitments which raises the morale of its employees,
increases their efficiency, reduces wastage and cost and enhances production and
profits.
g. Exploitation of favorable market conditions: The concerns with adequate working
capital only can exploit favorable market conditions such as purchasing its
requirements in bulk when the prices are lower.
h. Ability to face crisis: Adequate working capital enables a concern to face business
crisis in emergencies.
i. Quick and regular return on Investments: Every investor wants a quick and regular
return on his investment. Sufficiency of working capital enables a concern to pay quick
and regular dividends to its investors, as there may not be much pressure to plough
back profits. This gains the confidence of its investors and creates a favorable market to
raise additional funds in the future.
j. High morale: Adequacy of working capital creates an environment of security,
confidence, and high morale and creates overall efficiency in a business. Every
business concern should have adequate working capital to run its business operations. It
should have neither redundant excess working capital nor inadequate shortage of
working capital. Both, excess as well as short working capital positions are bad for any
business. However, out of the two, it is the inadequacy of working capital which is
more dangerous from the point of view of the firm.

2. Explain the Capital budgeting Techniques briefly.

The capital budgeting appraisal methods are techniques of evaluation of investment proposal will help
the company to decide upon the desirability of an investment proposal depending upon their; relative
income generating capacity and rank them in order of their desirability. These methods provide the
company a set of norms on the basis of which either it has to accept or reject the investment proposal.
The most widely accepted techniques used in estimating the cost-returns of investment projects can be
grouped under two categories.

1. Traditional methods
2. Discounted Cash flow methods
1. Traditional methods

These methods are based on the principles to determine the desirability of an investment project on the
basis of its useful life and expected returns. These methods depend upon the accounting information
available from the books of accounts of the company. These will not take into account the concept of
‘time value of money’, which is a significant factor to determine the desirability of a project in terms
of present value.
A. Pay-back period method: It is the most popular and widely recognized traditional method of
evaluating the investment proposals. It can be defined, as ‘the number of years required to recover the
original cash out lay invested in a project’.

According to Weston & Brigham, “The pay back period is the number of years it takes the firm to
recover its original investment by net returns before depreciation, but after taxes”.
According to James. C. Vanhorne, “The payback period is the number of years required to recover
initial cash investment.

The pay back period is also called payout or payoff period. This period is calculated by dividing the
cost of the project by the annual earnings after tax but before depreciation under this method the
projects are ranked on the basis of the length of the payback period. A project with the shortest
payback period will be given the highest rank and taken as the best investment. The shorter the
payback period, the less risky the investment is the formula for payback period is

Cash outlay (or) original cost of project

Pay-back period = -------------------------------------------
Annual cash inflow
Merits:

1. It is one of the earliest methods of evaluating the investment projects.

2. It is simple to understand and to compute.

3. It dose not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. It can be computed on the basis of accounting information available from the books.
Demerits:

1. This method fails to take into account the cash flows received by the
company after the pay back period.

2. It doesn’t take into account the interest factor involved in an investment outlay.
3. It doesn’t take into account the interest factor involved in an investment outlay.
4. It is not consistent with the objective of maximizing the market value of the company’s
share.
5. It fails to consider the pattern of cash inflows i. e., the magnitude and timing of cash in flows.

PAYBACK PERIOD:
1. A project requires an initial investment of Rs. 20,000/- with a useful life of 5 years. The
projected cash inflows for each year are as follows
Year: 1 2 3 4 5
CIF : 8,000 8,000 10,000 12,000 10,000
Calculate the Payback period of the project.
A. Pay Back Period:
Year Cash inflows Cumulative cash
inflows (CCIF)
1 8,000 8,000
2 8,000 16,000
3 10,000 26,000
 4 12,000 38000
5 10,000 48,000

Investment laid in between 2nd and 3rd years.

Therefore Pay Back Period =
Initial Investment - CCIF of L1
L1 + -------------------------------------
CCIF of L2 - CCIF of L1

20,000 – 16,000
= 2 + ------------------------
26,000– 16,000
4,,000
= 2 + --------------
10,000
= 2.4 Years

2. A manufacturing company has two project proposals. Each project costs Rs. 2,00,000/- The
expected annual returns from the two projects are given below. Advise the company manager
which project is acceptable by using payback period method.

Year Project-A Project-B

1 40,000 60,000
2 60,000 70,000
3 80,000 80,000
4 70,000 50,000
5 50,000 40,000

Solution: Cost of each project is Rs.2,00,000/-

Year Project A Cumulative Project B Cumulative

Cash Inflows Cash Inflows
1 40,000 40,000 60,000 60,000
2 60,000 1,00,000 70,000 1,30,000
3 80,000 1,80,000 80,000 2,10,000
4 70,000 2,50,000 50,000 2,60,000
5 50,000 3,00,000 40,000 3,00,000

Project – A Project-B
Investment laid in between 3rd and 4rd years. Investment laid in between 2nd and 3rd years.
Therefore Pay Back Period = Therefore Pay Back Period =
 Initial Investment - CCIF of L1 Initial Investment - CCIF ofL1
L1 + ------------------------------------- L1 + -------------------------------------
CCIF of L2 - CCIF of L1 CCIF of L2 - CCIF of L1
2,00,000 – 1,80,000
= 3+ --------------------------- 2,00,000 – 1,30,000
2,50,000– 1,80,000 = 2 + ------------------------
2,10,000– 1,30,000
20000
= 3+ ----------- 70,000
70,000 = 2 + ------------ = 2 +0.875
=3+0.285 80,000
=3.285 years =2.875 years

Note: Pay back period of Project A is 3.285 years and pay back period of Project B is 2.875.
Hence project B is acceptable.

B. Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated by the financial statements
to measure the probability of an investment proposal. It can be determine by dividing the average
income after taxes by the average investment i.e., the average book value after depreciation.

According to ‘Soloman’, accounting rate of return on an investment can be calculated as the ratio of
accounting net income to the initial investment, i.e.,

Average net income after taxes

ARR= ----]--------------------------------- X 100
Average Investment

Total Income after Taxes

Average net income after taxes = -----------------------------
No. Of Years
Total Investment
Average investment = ----------------------
2
On the basis of this method, the company can select all those projects who’s ARR is higher than the
minimum rate established by the company. It can reject the projects with an ARR lower than the
expected rate of return. This method can also help the management to rank the proposal on the basis of
ARR. A highest rank will be given to a project with highest ARR, where as a lowest rank to a project
with lowest ARR.

Merits:

1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.
3. It uses the entire stream of earning to calculate the ARR.
Demerits:
 1. It is not based on cash flows generated by a project.
2. This method does not consider the objective of wealth maximization
3. IT ignores the length of the projects useful life.
4. It does not take into account the fact that the profits can be re-invested.
AVERAGE RATE OF RETURN:

1. Two project proposals require an initial investment of Rs.1,50,000/- each. The firm
estimates the returns as follows:
Year 1 2 3 4
Project-X 40,000 50,000 80,000 70,000
Project-Y 50,000 60,000 70,000 80,000
Calculate the Average Rate of Return of each project and suggest the best project.
A. Project-X:
Average Returns = Total returns / No. Of years
Total Profits = 40,000 + 50,000 + 80,000 + 70,000 = 2,40,000
No. Of years = 4 Years
Average Returns = 2,40,000/4 = 60,000
Average investment = Investment / 2
= 1,50,000 / 2 = 75,000
Average Rate of Return = Average Returns / Average Investment X 100
= 60,000/ 75,000 X 100
= 80%
B. Project-Y:
Average Returs = Total returns / No. Of years
Total Profits = 50,000 + 60,000 + 70,000 + 80,000 = 2,60,000
No. Of years = 4 Years
Average Returns = 2,60,000/4 = 65,000
Average investment = Investment / 2
= 1,50,000 / 2 = 75,000
Average Rate of Return = Average Returns / Average Investment X 100
= 65,000/ 75,000 X 100
= 86.67%
Note: As project Y gets higher returns than Project X, Project Y is acceptable.

2. Arora enterprises has a project proposal with a cost of Rs.5,00,000/- which has an expected life
span of of 5 years. The cash inflows for next 5 years are 2,40,000/-, 2,60,000/- 2,00,000/-
 1,70,000/- and 1,60,000/- respectively. The firm estimates the salvage of Rs.30,000/- at the
end of the 5th year. Calculate the Average Rate of Return of the project.
A. Average Returns = Total returns / No. Of years
Total Profits = 2,40,000 + 2,60,000 + 2,00,000 + 1,70,000 + 1,60,000 = 10,30,000
No. Of years = 5 Years
Average Returns = 10,30,000/5 = 2,06,000
Average investment =1/2( Investment – Salvage value) + Salvage value
= ½(5,00,000-30,000)+30,000 = 2,65,000
Average Rate of Return = Average Returns / Average Investment X 100
= 2,06,000/ 2,65,000 X 100
= 77.73%

II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They give equal
weight age to the present and future flow of incomes. The DCF methods are based on the concept that
a rupee earned today is more worth than a rupee earned tomorrow. These methods take into
consideration the profitability and also time value of money.

A. Net present value method (NPV)

The NPV takes into consideration the time value of money. The cash flows of different years and
valued differently and made comparable in terms of present values for this the net cash inflows of
various period are discounted using required rate of return which is predetermined.

According to Ezra Solomon, “It is a present value of future returns, discounted at the required rate of
return minus the present value of the cost of the investment.”

NPV is the difference between the present value of cash inflows of a project and the initial cost of the
project.

According the NPV technique, only one project will be selected whose NPV is positive or above zero.
If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be rejected. If there are
more than one project with positive NPV’s the project is selected whose NPV is the highest.

Merits:

1.It recognizes the time value of money.

2.It is based on the entire cash flows generated during the useful life of the asset.
3.It is consistent with the objective of maximization of wealth of the owners.
4.The ranking of projects is independent of the discount rate used for determining the present
value.
Demerits:

1. It is different to understand and use.

 2. The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of
capital. If self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different amounts of
investment.
4. It does not give correct answer to a question whether alternative projects or limited funds are
available with unequal lines.

NET PRESENT VALUE (NPV):

1. Costal software Ltd. Is proposing to mechanise their operations. Two proposals M and N in
form of quotations have been received from two different vendors. The proposal in each case
costs Rs.5,00,000/-. A discount factor of 12% is used to compare the proposals. The estimated
cash outflows are likely to be as under:

Year Proposal-M Proposal-N

1 1,50,000 50,000
2 2,00,000 1,50,000
3 2,50,000 2,00,000
4 1,50,000 3,00,000
5 1,00,000 2,00,000

Which one do you recommend under Present Value Method?

To calculate NPV@ 12%

Year NPV @ 12% NPV

1 1 X 100/112 0.893

2 0.893 X 100/112 0.797

3 0.793 X 100/112 0.712

4 0.712 X 100/112 0.636

5 0.636 X 100/112 0.567

A. NPV Determination
Year Proposal –M Proposal –N
 Cash NPV@ Net present Cash NPV@ Net present
inflows value inflows value
12% 12%

1 1,50,000 0.893 1,33,950 50,000 0.893 44,650

2 2,00,000 0.797 1,59,400 1,50,000 0.797 1,19,550

3 2,50,000 0.712 1,78,000 2,00,000 0.712 1,42,400

4 1,50,000 0.636 95,400 3,00,000 0.636 1,90,800

5 1,00,000 0.567 56,700 2,00,000 0.567 1,13,400

Total NPV of inflows 6,23.450 Total NPV of inflows 6,10,800

Less: Actual investment 5,00,000 Less: Actual investment 5,00,000

------------- -----------

1,23,450 1,10,800

Proposal – M is expected to high yielding than Proposal N, Proposal M is acceptable.

From the following information, calculate the net present value of the two projects and suggest which
of the two projects should be accepted assuming a discount rate of 10%

Particulars Project-X Project-Y

Initial Investment 2,00,000 3,00,000

Estimated life 5 years 5 years

Scrap value 10,000 20,000

Profit before depreciation and after taxes.

Year 1 2 3 4 5

Project-X 50,000 1,00,000 1,00,000 30,000 20,000

Project-Y 2,00,000 1,00,000 50,000 30,000 20,000

To calculate NPV@ 10%

 Year NPV @ 10% NPV

1 1 X 100/110 0.909

2 0.909 X 100/110 0.826

3 0.826 X 100/110 0.751

4 0.751 X 100/110 0..683

5 0.683 X 100/110 0.621

A. Calculation of NPVs of cash inflows

Year Project X Project –Y

Cash NPV@ Net Cash Inflows NPV@10% Net Present

Inflows 10% Present
Value
Value

1 50,000 0.909 45,450 2,00,000 0.909 1,81,800

2 1,00,000 0.826 82,600 1,00,000 0.826 82,600

3 1,00,000 0.751 75,100 50,000 0.751 37,550

4 30,000 0..683 20,490 30,000 0..683 20,490

5 20,000 0.621 12,420 20,000 0.621 12,420

Scrap 10,000 0.621 6,210 20,000 0.621 12,420

NPV of total cash inflows 2,42,270 NPV of total cash inflows 3,47,280

Less: NPV of investment 2,00,000 Less: NPV of investment 3,00,000

42,270 47,280

Note: Both the projects are yielding positive returns. So both are acceptable. Based on outflow and
inflow rate Project X is desirable.

B. Internal Rate of Return Method (IRR)

The IRR for an investment proposal is that discount rate which equates the present value of cash
inflows with the present value of cash out flows of an investment. The IRR is also known as cut off or
handle rate. It is usually the concern’s cost of capital.

According to Weston and Brigham “The internal rate is the interest rate that equates the present value
of the expected future receipts to the cost of the investment outlay.

When compared the IRR with the required rate of return (RRR), if the IRR is more than RRR then the
project is accepted else rejected. In case of more than one project with IRR more than RRR, the one,
which gives the highest IRR, is selected.

The IRR is not a predetermine rate, rather it is to be trial and error method. It implies that one has to
start with a discounting rate to calculate the present value of cash inflows. If the obtained present value
is higher than the initial cost of the project one has to try with a higher rate. Like wise if the present
value of expected cash inflows obtained is lower than the present value of cash flow. Lower rate is to
be taken up. The process is continued till the net present value becomes Zero. As this discount rate is
determined internally, this method is called internal rate of return method.

P1 – Q
IRR = L+ --------- X D
P1 –P2
L- Lower discount rate

P1 - Present value of cash inflows at lower rate.

P2 - Present value of cash inflows at higher rate.

Q- Actual investment

D- Difference in Discount rates.

Merits:

1. It consider the time value of money

2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return projects are
selected, it satisfies the investors in terms of the rate of return an capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm’s objective of maximum owner’s welfare.
Demerits:

1. It is very difficult to understand and use.

2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.

INTERNAL RATE OF RETURN (IRR):

1. .Arunodaya Traders has a project proposal. The estimated project cost is Rs.50,000/-. Its cash
inflows for the six years are as follows:
 Year 1 2 3 4 5 6

Profits 0 10,000 16,000 24,000 30,000 30,000

The assumed IRR lies between 18% and 20%. Calculate the Internal Rate of Return.

A. Calculation of NPV of cash inflows

Year Cash NPV@ NPV of Cash NPV@20% NPV of
inflows 18% inflows inflows inflows

1 0 0.847 0 0 0.833 0

2 10,000 0.718 7,180 10,000 0.694 6,940

3 16,000 0.609 9,744 16,000 0.579 9,264

4 24,000 0.516 12,384 24,000 0.482 11,568

5 30,000 0.437 13,110 30,000 0.402 12,060

6 30,000 0.370 11,100 30,000 0.335 10,050

NPV of total cash inflows 53,418 NPV of total cash inflows 39,082

Less: NPV of investment 50,000 Less: NPV of investment 50,000

3,418 -10918

P1 – Q
IRR = L+ --------- X D
P1 –P2

53,418 – 50,000
IRR = 18+ ------------------------ X 2
53,418 - 39,082

3418
IRR = 18+ ---------- X 2
14,336

=18 + 0.477
= 18.477%
 2. It is estimated that an investment in a new process will yield the following cash flows.

Year 0 1 2 3 4 5 6

Profits 0 0 30,000 40,000 40,000 40,000 50,000

Investment 1,20,000 20,000

The firm wishes to earn at least 12%on this project. Determine the IRR. The firm believes
that the discount rate lays between 8% and 12%.

A. Calculation of NPV of cash inflows

Yea Cash NPV@8 Net Cash NPV@12% Net
r % Present Present
Inflows Inflows
Value Value

0 (1,20,000) 1.000 (1,20,000) (1,20,000) 1.000 (1,20,000)

1 (20,000) 0.926 ( 18,520) (20,000) 0.893 (17,860)

2 30,000 0.857 25,710 30,000 0.797 23,910

3 40,000 0.794 31,760 40,000 0.712 28,480

4 40,000 0.735 29,400 40,000 0.636 25,440

5 40,000 0.681 27,240 40,000 0.567 22,680

6 50,000 0.630 31,500 50,000 0.507 20,280

NPV of total cash inflows 1,45,610 NPV of total cash inflows 1,20,790

Less: NPV of investment 1,38,520 Less: NPV of investment 1,37,860

7,090 -17,070

P1 – Q
IRR = L+ --------- X D
P1 –P2

1,45,610 – 1,38,520
 IRR = 8+ --------------------------- X 4
1,45,610 – 1,20,790

7,090
IRR = 8+ ------------ X 4
24,820
= 8 + 1.14

= 9.14%

C. Probability Index Method (PI)

This method is also called benefit cost ration. This method is obtained cloth a slight modification of
the NPV method. In case of NPV the present value of cash out flows are profitability index (PI), the
present value of cash inflows are divide by the present value of cash out flows, while NPV is a
absolute measure, the PI is a relative measure.

If the PI is more than one (>1), the proposal is accepted else rejected. If there are more than one
investment proposal with the more than one PI the one with the highest PI will be selected. This
method is more useful in case of projects with different cash outlays cash outlays and hence is superior
to the NPV method.

The formula for PI is

Present Value of Future Cash Inflow
Probability index = ----------------------------------------
Investment
Merits:

1.It requires less computational work than IRR method

2.It helps to accept / reject investment proposal on the basis of value of the index.
3.It is useful to rank the proposals on the basis of the highest/lowest value of the index.
4.It is useful to rank the proposals on the basis of the highest/lowest value of the index.
5.It takes into consideration of the entire stream of cash flows generated during the useful life of
the asset.
Demerits:

1. It is some what difficult to understand

2. Some people may feel no limitation for index number due to several limitation involved in
their competitions
It is very difficult to understand the analytical part of the decision on the basis of probability
indeA