Financial Management I

9. Basics of Capital Expenditure Decisions

suresh.suralkar@gmail.com, Phone: 40434399

 Course Content - Syllabus
Sr Title ICMR Ch. PC Ch. IMP Ch.
1 Introduction to Financial Management 1* 1 1
2 Overview of Financial Markets 2* 2 -
3 Sources of Long-Term Finance 10* 17 20, 21
4 Raising Long-term Finance - 18* 20, 21, 23
5 Introduction to Risk and Return 4* 8, 9 4, 5
6 Time Value of Money 3* 6 2
7 Valuation of Securities 5* 7 3
8 Cost of Capital 11* 14 9

9 Basics of Capital Expenditure

Decisions 18* 11 8

10 Analysis of Project Cash Flows - 12* 10, 11

11 Risk Analysis and Optimal Capital

Expenditure Decision - 13* 12
*Book preference 2 / 36
 Books

1. Financial Management, ICMR Book, Chapter 18

2. Financial Management, Prasanna Chandra, 7th Edition,

Chapter 11

3. Financial Management, I. M. Pandey, 9th Edition, Chapter

3 / 36
Syllabus – Basics of Capital Expenditure Decisions

1. The Process of Capital Budgeting

2. Basic Principles in Estimating Cost and Benefits of

Investments

3. Appraisal Criteria: Discounted and Non – Discounted

Methods (Pay-Back Period, Average Rate of Return, Net

Present Value, Benefit Cost Ratio, Internal Rate of

Return)
4 / 36
 1. The Process of Capital Budgeting
Investment decisions has following steps
Identification of Potential Investment Opportunities
• Potential sources of Project Ideas
• Market Characteristics of Different Industries
• Product Profiles of Various Industries
• Imports and Exports
• Emerging Technologies
• Social and Economic Trends
• Consumption Patterns in Foreign Countries
• Revival of Sick Units
• Backward and Forward Integration
Chance Factors
Regulatory Framework and Policies 5 / 36
 1. The Process of Capital Budgeting
Preliminary Screening
• Compatibility with the Promoter
• Compatibility with the Government Priorities
• Availability of Inputs
• Size of the Potential Market
• Reasonableness of Cost
Feasibility Study
Implementation
• Project Delays
Performance Review
Aspects of Project Appraisal
• Market Appraisal: Size of market, project’s market share
• Technical Appraisal: Technical aspects, implementation, technology
• Financial Appraisal: Risk and returns, cost benefits analysis
• Economic Appraisal: Social cost benefit analysis 6 / 36
 2. Basic Principles in Estimating Cost and
Benefits of Investments
Basic principles in estimating cost (outflow) and benefits
(inflow) of investments are as follows
• All costs and benefits must be measured in terms of cash
flows. This implies that all non-cash charges (expenses)
like depreciation which are considered for the purpose of
determining the profit after tax must be added back to
arrive at the net cash flows for our purpose.
• Since the net cash flows relevant from the firm’s point of
view are what that accrue to the firm after paying tax,
cash flows for the purpose of appraisal must be defined in
post-tax terms. 7 / 36
 2. Basic Principles in Estimating Cost and
Benefits of Investments
• Usually the net cash flows are defined from the point of
view of the suppliers of long-term funds (i.e. suppliers of
equity capital and long-term loans).
• Interest on long-term loans must not be included for
determining the net cash flows.
• Cash flows must be measured in incremental terms. In
other words, the increments in the present levels of costs
and benefits that occur on account of the adoption of the
project are alone relevant for the purpose of determining
the net cash flows. 8 / 36
 2. Basic Principles in Estimating Cost and
Benefits of Investments

Some implications of this principle are as follows

• If the proposed project has a beneficial or detrimental
impact on say, other product lines of the firm, then such
impact must be quantified and considered for ascertaining
the net cash flows.
• Sunk costs must be ignored. For example, the cost of
existing land must be ignored because money has already
been sunk in it and no additional or incremental money is
spent on it for the purpose of this project. 9 / 36
 2. Basic Principles in Estimating Cost and
Benefits of Investments
• Opportunity costs associated with the utilization of the
resources available with the firm must be considered even
though such utilization does not entail explicit cash
outflows. For example, while the sunk cost of land is
ignored, its opportunity cost i.e. the income it would have
generated if it had been utilized for some other purpose or
project must be considered.
• The share of the existing overhead costs which is to be
borne by the end products of the proposed project must be
ignored. 10 / 36
 3. Appraisal Criteria:
Discounted and Non - Discounted Methods

Evaluation Criteria

Non-Discounting Criteria Discounting Criteria

Payback Accounting Net Benefit Internal Annual

Period Rate of Present Cost Rate of Capital
Return Value Ratio Return Charge
(ARR) (NPV) (BCR) (IRR)

11 / 36
 3.1 Pay-Back Period

Payback period measures the time required to recover the

initial outlay in the project. For example, if a project with
life of 5 years involves an initial outlay of Rs. 20 lakh and
is expected to generate a constant annual inflow of Rs. 8
lakh,
Payback period = 20 / 8 = 2.5 years.
If the same project is expected to generate annual inflows
of say Rs. 4 lakh, Rs. 6 lakh, Rs. 10 lakh, Rs. 12 lakh and
Rs. 14 lakh, then
Payback period = 3 years, because inflows in first three
years is equal to the initial outlay. 12 / 36
 3.1 Pay-Back Period

To use payback period method for accepting or rejecting the

projects, the firm has to decide an appropriate cut-off
period. Projects with payback period up to the cut-off
period are accepted and beyond the cut-off period are
rejected.
Advantages of cut-off period method
• It is simple in concept and application
• It helps in rejecting risky projects and accepting those
projects which generate substantial inflows in earlier
years. 13 / 36
 3.1 Pay-Back Period

Disadvantages of cut-off period method

• It does not consider the time value of money
• The cut-off period is chosen arbitrarily and applied for
evaluating projects regardless of their life spans.
Consequently the firm may accept too many short-lived
projects and too few long-lived ones.
• Payback period method leads to discrimination against
projects which generate substantial cash inflows in later
years, the criterion cannot be considered as a measure of
profitability. 14 / 36
 3.1 Pay-Back Period

To incorporate the time value of money, discounted payback

period is used. In this method, the firms discount the cash
flows before they compute the payback period. For
example, if a project involves an initial outlay of Rs. 20
lakh and is expected to generate a net annual inflow of Rs.
8 lakh for the next 4 years. Assuming cost of funds to be
12%, the discounted payback period is calculated as

8 x PVIFA(12,n) = 20

15 / 36
 3.1 Pay-Back Period
From PVIFA table, we find that
PVIFA(12,3) = 2.402
PVIFA(12,4) = 3.037
By linear interpolation
2.5 - 2.402
Payback Period  3  (4  3) x  3.15 years
3.037 - 2.402

We find that the discounted payback period is longer than

undiscounted payback period.
Discounted payback period considers the time value of
money, still it suffers from other disadvantages of payback
period method. Hence in practice, companies do not give
much importance to payback period as an appraisal
16 / 36
 3.2 Accounting Rate of Return (ARR)

Accounting rate of return (ARR) also called as book rate of

return is defined as

Average Profit After Tax

ARR 
Average Book Value of the investment

To use it as an appraisal criterion, ARR of a project is

compared with ARR of the firm as a whole or ARR of for
the industry sector as a whole.
To illustrate the calculation of ARR, consider the project
with the following data. 17 / 36
 3.2 Accounting Rate of Return (ARR)
(Amount in Rs.)
Year 0 1 2 3
Investment (90,000)
Sales Revenue 1,20,000 1,00,000 80,000
Operating Expenses
60,000 50,000 40,000
(excluding depreciation)
Depreciation 30,000 30,000 30,000
Annual Income 30,000 20,000 10,000

Average annual income= (30,000+20,000+10,000)/3 = 20,000

Average net book value of investment = (90,000+0)/2=45,000
Accounting rate of return = 20,000 / 45,000 x 100 = 44 %
The firm will accept the project if its target ARR is lower
18 / 36
 3.2 Accounting Rate of Return (ARR)

Advantages of ARR

• Like payback method, ARR is simple in concept and

application. It appeals to the businessmen who find the

concept of ARR familiar and easy to use.

• It considers the returns over the entire life of the project

and therefore serves as a measure of profitability(unlike

the payback period which is a measure of capital

recovery) 19 / 36
 3.2 Accounting Rate of Return (ARR)
Disadvantages of ARR
• This criterion ignores the time value of money. That is, it
gives no allowance for immediate receipts, which are more
valuable than the distant flows.
• ARR depends on accounting income and not on the cash
flows. A profitability measure based on accounting income
cannot be used as a reliable investment appraisal criterion.
• The firm using ARR as an appraisal criterion must decide
on a yard-stick for judging a project and this decision is
often arbitrary. Often firms use their current book return
as the yard-stick for comparison. In such cases, if the
current book return of a firm tends to be very high or low,
then the firm can end up rejecting good project or
accepting bad projects. 20 / 36
 3.3 Net Present Value (NPV)

Net present value (NPV) is equal to the present value of

future cash flows and any immediate cash outflows. In the
case of a project, NPV will be equal to the present value of
future cash inflows minus initial investment (cash
outflow). n
CFt
NPV    I0
t 1 (1  k) t

Where k= cost of funds

CFt = cash flows at the end of the period t
I = initial investment 21 / 36
 3.3 Net Present Value (NPV)
Example: Consider a project with cash flows as below. Cost
of funds to the firm is 12%. Calculate the NPV.
Year 0 1 2 3 4
Initial Investment (cash outflows) (12,500)
Cash inflows 5,100 5,100 5,100 7,100

Solution: Net cash flows of the project and their present

values are as follows.
Year 1 2 3 4
Net cash flow (Rs.) 5100 5100 5100 7100
PVIF @ k = 12% 0.893 0.797 0.712 0.636
Present value (Rs.) 4554 4065 3631 4516

Net present value = (-12,500) + (4,554 + 4,065+3,631+4,516)

= Rs. (-12,500 + 16,766) = Rs. 4,266 22 / 36
 3.3 Net Present Value (NPV)
A project will be accepted if its NPV is positive and rejected
if its NPV is negative. NPV is a conceptually sound
criterion of investment appraisal because it takes into
account the time value of money and considers the entire
cash flow stream.
NPV represents the contribution to the wealth of the
shareholders, maximizing NPV is congruent with the
objective of investment decision making viz. maximization
of shareholders’ wealth.
Only problem in applying this criterion appears to be the
difficulty in comprehending the concept. Most non-
financial executives and businessmen find ‘Return on
Capital Employed’ or ‘Accounting Rate of Return’ easy to
interpret compared to absolute value like NPV. 23 / 36
 3.4 Benefit Cost Ratio (BCR)
Benefit cost ratio (or the profitability index) is defined as
PV
BCR 
I
Where BCR = benefit cost ratio
PV = present value of future cash flows
I = initial investment
A variant of the BCR is net benefit cost ratio (NBCR) which
is defied as NPV
NBCR 
I
PV - I

I
PV
 1
I
 BCR  1 24 / 36
 3.4 Benefit Cost Ratio (BCR)

BCR and NBCR for the project described in earlier example

will be
BCR = 16,766 / 12,500 = 1.34
NBCR = 4,266 / 12,500 = 0.34

Decision rule based on BCR (or alternatively NBCR)

criterion will be as follows

If Decision Rule
BCR > 1 (NBCR > 0) Accept the project
BCR < 1 (NBCR < 0) Reject the project
25 / 36
 3.4 Benefit Cost Ratio (BCR)

BCR measures the present value per rupee of outlay, it is

considered to be useful criterion for ranking a set of
projects in the order of decreasingly efficient use of capital.
There are two serious limitations inhibiting the use of this
criterion.
First, it provides no means for aggregating several smaller
projects into a package that can be compared with a large
project.
Second, when the investment outlay is spread over more
than one period, this criterion cannot be used.
Following example illustrates the first limitation. 26 / 36
 3.4 Benefit Cost Ratio (BCR)

Example: Company is considering 4 projects A, B, C and D

with following characteristics
Initial investment Annual net cash flow
Project
(at year 0) (year 1 to 5)
A (20) 7.5
B (4.5) 1.5
C (7) 2.5
D (8) 3.5

The funds available for investment are limited to Rs. 20 lakh

and the cost of funds to the firm is 14%. Rank the 4
projects in terms of the NPV and BCR criteria. Determine
which project(s) will you recommend given the limited
supply of funds. 27 / 36
 3.4 Benefit Cost Ratio (BCR)
Solution: The NPVs of the 4 projects are
Project NPV (Rs. in lakh) Rank
A 7.5 x PVIFA(14,5) – 20 = (7.5 x 3.433) – 20 = 5.75 I
B 1.5 x PVIFA(14,5) – 4.5 = (1.5 x 3.433) – 4.5 = 0.65 IV
C 2.5 x PVIFA(14,5) – 7 = (2.5 x 3.433) – 7 = 1.58 III
D 3.5 x PVIFA(14,5) – 8 = (3.5 x 3.433) – 8 = 4.02 II

The BCR of the 4 projects are

Project BCR Rank
A 25.75 / 20 = 1.27 II
B 5.15 / 4.5 = 1.14 IV
C 8.58 / 7 = 1.23 III
D 12.02 / 8 = 1.50 I
28 / 36
 3.4 Benefit Cost Ratio (BCR)
Based on the NPV and BCR criterion, all 4 projects are
acceptable because NPVs are positive and BCRs are
greater than one for each project.
But all 4 projects cannot be taken by the firm because of the
limited availability of funds. Company has to accept
project A or a package consisting of projects B, C and D
but not both. The decision depend on which option
maximizes the shareholders’ wealth. In this situation, BCR
becomes inapplicable because there is no way by which we
can aggregate the BCRs of projects B, C and D. On the
other hand NPVs of projects B, C and D can be aggregated
and compared with the NPV of project A to arrive at a
decision. 29 / 36
 3.4 Benefit Cost Ratio (BCR)

NPV(B+C+D) = NPV(B) + NPV(C) + NPV(D)

= 0.65 + 1.58 + 4.02

= 6.25

This is more than NPV(A) which is 5.75.

Therefore the package comprising projects B, C an D

must be accepted.

30 / 36
 3.5 Internal Rate of Return (IRR)

Internal rate of return (IRR) is that rate of interest at which

the net present value of a project is equal to zero. In other
words, IRR is the rate which equates the present value of
the cash inflows to the present value of the cash outflows.
n
CFt
I0  
t 1 (1  k) t
n
CF t
Where k = IRR, is that rate of return where  (1 k)t  I0  0
t 1

CFt = cash flows at the end of period t

I0 = initial investment
31 / 36
 3.5 Internal Rate of Return (IRR)

While under NPV method the rate of discounting is known

(firm’s cost of capital), under IRR this rate which makes
NPV zero has to be found out. Following example
illustrates this concept.
Example: A project has the following pattern of cash flows.
Calculate the IRR of this project.
Year Cash flow (Rs. in lakh)
0 (10)
1 5
2 4
3 3
4 2
32 / 36
 3.5 Internal Rate of Return (IRR)

Solution
To determine the IRR, we have to compute the NPV of the
project for different rates of interest until we find that rate
of interest at which the sum of present values of all cash
flows is equal to the initial investment. Number of
iterations are involved in this trial and error method.
10 = 5 x PVIF(k,1) + 4 x PVIF(k,2) +3 x PVIF(k,3) +2 xPVIF(k,4)
With k=18%,
5 xPVIF(0.18,1)+ 4 xPVIF(0.18,2)+ 3 xPVIF(0.18,3)+ 2xPVIF(0.18,4)
= 5 x 0.847 + 4 x 0.718 + 3 x 0.609 + 2 x 0.516 = 9.966
33 / 36
 3.5 Internal Rate of Return (IRR)

5 xPVIF(0.17,1)+ 4 xPVIF(0.17,2)+ 3 xPVIF(0.17,3)+2 xPVIF(0.17,4)

= 5 x 0.855 + 4 x 0.731 + 3 x 0.624 + 2 x 0.534

= 10.139
∴ k lies between 17% and 18%
By linear interpolation

10.139 - 10
k  17  (18  17) x
∴ 10.139 - 9.967

= 17 + 0.80
34 / 36
 3.5 Internal Rate of Return (IRR)

To use IRR as an appraisal criterion, the decision rule based

on IRR will be: Accept the project if the IRR is greater
than the cost of funds employed, else reject the project.
IRR is a popular method of investment appraisal.
Advantages of IRR method
• It takes into account the time value of money
• It considers the entire cash flow stream over the
investment horizon
• Like ARR, it makes sense to businessmen who prefer to
think in terms of rate of return on capital employed. 35 / 36
 3.5 Internal Rate of Return (IRR)

IRR method suffers from following limitations

IRR is uniquely defined only for a project whose cash flow
pattern is characterized by cash outflow(s) followed by
cash inflows (such projects are called simple investments).
If the cash flow stream has one or more cash outflows
interspersed (at intervals) with cash inflows, there can be
multiple IIRs.
In spite of these defects, IRR is still the best criterion today
to appraise a project financially.
36 / 36