INVESTMENT

DECISIONS:
CAPITAL BUDGETING
INVESTMENT DECISIONS
 Modern financial manager’s function involves efficient
allocation of capital among available investments.

 Investment opportunities may be long term investment or short

term investment.

 Investment in long term assets is popularly termed as Capital

budgeting decisions, require comparison of cost against
benefits over long period.

 Investment in long term assets also known as capital

expenditure.
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 The firms decisions to invest its current funds most efficiently
in the long-term assets in anticipation of an expected flow of
benefits over a series of years is known as capital budgeting
decisions.

 Such investment decisions involve careful consideration of

various factors: Profitability, safety, liquidity and solvency.

 For example, the deployment of fund in additional plant and

equipment can not be recovered in the short run.

 Capital investment decisions involve decisions related to

investments in New Projects, Replacement, Expansion,
Diversification, Research and Development and Miscellaneous3
IMPORTANCE OF CAPITAL
BUDGETING DECISIONS
 Involvement of heavy funds

 Long term implications

 Irreversible decisions

 Most difficult decisions

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CAPITAL EXPENDITURE
 Capital Expenditure Increases Revenue:
It is the expenditure which brings more revenue to the
firm either by expanding the existing production
facilities or development of new production line.

 Capital Expenditure Reduces Costs:

Such a capital expenditure reduces the cost of present
product and thereby increases the profitability of existing
operations. It can be done by replacement of old machine
by a new one.
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KINDS OF CAPITAL BUDGETING
PROPOSALS
 Accept-Reject Decisions

 Contingent or Dependent Investments

 Mutually Exclusive Investments

 Capital Rationing Decisions

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CAPITAL BUDGETING
APPRAISAL METHODS
 Non-Discounted Cash flow methods:
 Payback period
 Accounting rate of return/Average rate of Return

 Discounted Cash flow methods:

 Discounted pay back period
 Net Present value
 Profitability Index
 Internal rate of return

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PAY BACK PERIOD
 Pay back period is also termed as “Pay-out period” or “Pay-off
period”. Pay back period is one of the most popular and
widely recognized traditional method of evaluating investment
proposal.

 It is defined as the number of years required to recover the

initial investment in full with the help of the stream of annual
cash flows generated by the project

 In other words, term pay back period refers to the period in

which the project will generate necessary cash to recover the8
initial investment.
CALCULATION OF PAY-BACK
PERIOD
 Pay-back period can be calculated in the following two different
situations:
 In the case of constant annual cash inflows
 In the case of uneven or unequal cash inflows

 In the case of constant annual cash inflows: If the project

generates constant cash flow the Pay-back period can be computed
by dividing cash outlays (original investment) by annual cash
inflows.

 The following formula can be used to ascertain pay-back period :

 Pay-back Period = Initial Investment .
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Constant Annual Cash Inflows
 In the case of Uneven or Unequal Cash Inflows: In the case
of uneven or unequal cash inflows, the Pay-back period is
determined with the help of cumulative cash inflow.

 It can be calculated by adding up the cash inflows until the

total is equal to the initial investment.

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Q.1. A project requires initial investment of Rs. 40,000 and it
will generate annual cash inflows of Rs. 10,000 for 6 years.
You are required to find out pay-back period.

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Q.2. From the following information you are required to
calculate pay-back period: A project requires initial investment
of Rs. 40,000 and generate cash inflows of Rs. 16,000, Rs.
14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and
fourth year respectively.

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Q.3. A machinery is costing Rs. 75,000; life of the machine is 5
years, depreciation is charged using SLM and tax rate
applicable to the company is 50%. Cash flows before
depreciation and taxes are given to you. Calculate Payback
period.
Year 1 2 3 4 5

CIF 30,000 28,000 20,000 15,000 15,000

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Q.4. A project costs Rs.20,00,000 and yields annual profits of
300,000 after depreciation but before taxes. Calculate Payback
period if tax rate is 50% and depreciation is charged at 12.5%.

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Q.5. X ltd is considering the purchase of a new machine, which will carry
out some operations at present performed by laborers. Two alternative
models, A and B are available for the purpose. From the following
information, prepare a profitability statement for submission to the
management and calculate Payback period. Depreciation is calculated under
straight line method. Taxation may be taken at 50% of net profit.

Particulars Machine A Machine B

Estimated life in years 5 6

Cost of Machine 80,000 1,50,000
Estimated additional cost:
Indirect Material (per annum) 2,000 3,000
Maintenance (per month) 500 750
Supervision (per quarter) 3,000 4,500
Estimated savings in Scrap (per annum) 8,000 12,000

Estimated Savings in direct wages:

A. Workers not required 10 15
B. Wages per worker (per annum) 7,200 7,200 15
AVERAGE RATE OF RETURN OR
ACCOUNTING RATE OF RETURN (ARR)
 Average Rate of Return Method is also termed as Accounting
Rate of Return Method.

 This method focuses on the average net income generated in a

project in relation to the project's average investment outlay.

 This method involves accounting profits not the cash flows

and is similar to the performance measure of return on capital
employed.

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 The average rate of return can be determined by the following formula:

 Average Rate of Return =

(Average Income / Average Investment) *100

Average Income = Total expected after tax profits

Number of years

Average investment = (Initial cost of machine + Salvage value) + Net WC

2

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Q.6. A project costs Rs.10,00,000 and has a scrap value of
Rs.1,00,000. Its streams of income before depreciation and
taxes during first year through five years is 2,00,000; 2,40,000;
2,80,000; 3,20,000 and 4,00,000. Assume a 50% tax rate and
depreciation on straight line basis. Calculate the accounting
rate of return for the project.

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Q.7. “A” limited company has under consideration following
two projects:
Particulars Project X Project Y

Investment in Machines 10,00,000 15,00,000

Working Capital 5,00,000 5,00,000
Life of Machines 4 years 6 years
Scrap value of Machine 10% 10%
Tax Rate 50% 50%

Income before depreciation and taxes at the end of the year:

Year 1 2 3 4 5 6

X 8,00,000 8,00,000 8,00,000 8,00,000 - -

Y 15,00,000 9,00,000 15,00,000 8,00,000 6,00,000 3,00,000
Calculate ARR for the project and suggest which one is better?
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DISCOUNTED CASH FLOW
METHODS
 Discounted cash flow is a method of capital investment
appraisal which takes into account both overall profitability
of projects and also the timing of return.

 This method recognizes that use of money has a cost i.e.

interest foregone.

 In this method risk can be incorporated into discounted cash

flow computation by adjusting discount rate.

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DISCOUNTED PAY-BACK METHOD
 This method is designed to overcome the limitation of the
payback period method.

 When savings are not leveled, it is better to calculate the pay-

back period by taking into consideration the present value of
cash inflows.

 Discounted pay-back method helps to measure the present value

of all cash inflows and outflows at an appropriate discount rate.

 The time period at which the cumulated present value of cash

inflows equals the present value of cash outflows is known as
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discounted pay-back period.
Q.8. The company is considering investment of Rs. 1,00,000 in
a project. The following are the forecast for cash flows after tax,
1st year Rs. 10,000, 2nd year Rs. 40,000, 3rd year Rs. 60,000,
4th year Rs. 20,000 and 5th year Rs.5000. From the above
information you are required to calculate: (1) Pay-back Period
(2) Discounted Pay-back Period if rate of discounting is 10%.

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NET PRESENT VALUE
 This is one of the discounted cash flow technique which
explicitly recognizes the time value of money.

 In this method all cash flows are converted into present value
applying an appropriate rate of interest.

 The Net Present Value is obtained by subtracting the present

value of cash outflows from the present value of cash inflows.

 NPV= Present Value of Cash Inflows - Present Value of Cash Outflows

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 If the project has a positive Net Present Value it is
considered to be viable because the present value of the
inflows exceeds the present value of outflows.

 If the projects are to be ranked or the decision is to select

one or other, the project with the greatest Net Present
Value should be chosen.

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Q.9. The GE Company is considering an investment that will
result in a $2,000 cash flow in year one, a $3,000 cash flow in
year two, and $7,000 cash flow in year three. What is the
present value of this investment if all cash flows are to be
discounted at an 8% rate? Should GE Company management be
willing to pay $10,000 for this investment?

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PROFITABILITY INDEX METHOD
 Profitability Index is also known as Benefit to Cost Ratio.

 It gives the present value of future benefits, computed at the

required rate of return on the initial investment.

 The Profitability Index can be calculated by the following

equation:
Profitability Index = Present Value of Cash Inflows
Present Value of Cash Outflows

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 As per the Benefit Cost Ratio or Profitability Index a project
with Profitability Index greater than one should be accepted as
it will have Positive Net Present Value.

 Likewise if Profitability Index is less than one the project is

not beneficial and should not be accepted.

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Q.10. A project cost Rs. 25,000 and it generates cash inflows
through a period of five years Rs. 9,000, Rs. 8,000, Rs. 7,000,
Rs. 6,000 and Rs. 5,000. If the required rate of return is
assumed to be 10%. Find out the Net Present Value and
Profitability Index of the project.

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Q.11. A project costing Rs. 5,00,000 has a life of 10 years at the
end of which its scrap value is likely to be Rs. 50,000. The
firms’ cut-off rate is 12%. The project is expected to yield an
annual profit after tax of Rs. 1,00,000; Depreciation being
charged on straight line basis. At 12% per annum the present
value of the rupee received annually for 10 years is Rs. 5.65 and
the value of one rupee received at the end of 10th year is Re.
0.322. Ascertain the Net Present Value of the project.

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Q.12. A project is under consideration of a firm. The initial
outlay of the project is Rs. 10,000 and it is expected to generate
cash inflows of Rs. 4,000, Rs. 3,000, Rs. 5,000 and Rs. 2,000 in
four years to follow. Assuming 10% rate of discount, calculate
the Net Present Value and Benefit Cost Ratio of the project.
(HW)

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INTERNAL RATE OF RETURN METHOD
 Internal Rate of Return Method is also called as "Time Adjusted
Rate of Return Method."

 It is defined as the rate which equates the present value of each

cash inflows with the present value of cash outflows of an
investment.

 In other words, it is the rate at which the net present value of the
investment is zero.

 Horngren and Foster define Internal Rate of Return as the rate of

interest at which the present value of expected cash inflows from
a project equals the present value of expected cash outflows 31 of
the project.
 The Internal Rate of Return can be found out by Trial and Error
Method.

 First, compute the present value of the cash flow from an investment,
using an arbitrarily selected interest rate, for example 10% then
compare the present value so obtained with the investment cost.

 If the present value is higher than the cost of capital, try a higher
interest rate and go through the procedure again.

 On the other hand if the calculated present value of the expected cash
inflows is lower than the present value of cash outflows, a lower rate
should be tried.

 This process will be repeated until and unless the Net Present Value
becomes zero. The interest rate that brings about this equality32is
defined as the Internal Rate of Return.
 Alternatively, the internal rate can be obtained by Interpolation
Method when we come across 2 rates. One with positive Net
Present Value and other with negative Net Present Value.

 The IRR is considered as the highest rate of interest which a

business is able to pay on the funds borrowed to finance the
project out of cash inflows generated by the project.

 The Interpolation formula can be used to measure the Internal

Rate of Return as follows:
Lower Interest Rate + NPV of Lower Rate x (Higher Rate- Lower Rate)
NPV Lower Rate (-) NPV Higher Rate

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DIFFERENCE BETWEEN NPV AND IRR
 As IRR is expressed as a percentage, IRR makes it easy for
companies to compare and decide which project or
investment will generate the highest percentage return on
investment (ROI).

 By contrast, Net Present Value measures how much value a

project or investment could add in absolute rupee amounts.

 Using both IRR and NPV can give analysts a clearer picture
of which project or investment can add the most value to an
organization.
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Q.13. The cost of a project is Rs. 32,400. It is expected to
generate cash inflows of Rs. 16,000, Rs. 14,000 and Rs.
12,000 through its three years’ life period. Calculate the
Internal Rate of Return of the Project.

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Q.14. There are two mutually exclusive projects under active
consideration of a company. Both the projects have a life of 5
years and have initial cash outlays of Rs. 1,00,000 each. The
company pays tax at 50% rate and the maximum required rate of
the company has been given as 10%. The straight line method of
depreciation will be charged on the projects. The project X is
expected to generate a net cash inflow before depreciation and
taxes of Rs. 40,000 throughout its life and project Y is expected to
generate a net cash inflow before depreciation and taxes of Rs.
60,000, 30,000, 20,000, 50,000 and 50,000 from one to five years
respectively. Compute: PBP, ARR, NPV, PI, and IRR. (HW)

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Q.15. The Alpha co. ltd. is considering the purchase of a new
machine. Two alternative machine A and B have been
suggested, each having an initial cost of Rs. 4,00,000 and
requiring Rs. 20,000 as additional working capital at the end of
1st year. Cash flows after taxes are expected to be as follows:

Year Machine A Machine B

1 40,000 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000

The company has target of return on capital of 10% and on this

basis, you are required to compare the profitability of the
machines and state which alternative you consider financially
preferable. 37
Q.16. After conducting a survey that cost Rs. 2,00,000, X ltd,
decided to undertake a project for placing a new product in the
market. It was estimated that the project would cost Rs.40,00,000
in plant and machinery in addition to working capital of
Rs.10,00,000. The scrap value of plant and machinery at the end
of 5 years estimated at 5,00,000. After providing for depreciation
on straight line basis, profit after tax was estimated as follows:

Year 1 2 3 4 5

 Ascertain,
PAT Net
3,00,000 Present
8,00,000Value of the 5,00,000
13,00,000 project if4,00,000
cost of capital is
12%.

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Q.17. M/s Pandey Ltd. is contemplating to purchase a
machine A or B each costing Rs. 5,00,000. Profits before
depreciation are as follows:

Year Machine A Machine B

1 1,50,000 1,00,000
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

Assuming a 10% discount rate indicate which of the

machine would be profitable using NPV method if
depreciation is charged at 20% using written down value
method. Taxes to be assumed at 40%.

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Q.18. Calculate the NPV of the following project requiring an
initial cash outlay of Rs. 20,000 and has no scrap value after 6
years. The net cash flows after taxes for each year of Rs. 6,000
for six years. Assume the present value of an annuity of Re. 1
for 6 years at 8% p. a. interest is 4.623. (HW)

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 Q.19. An MNC is planning to install a manufacturing unit to
produce 50,000 units. Setting up of the manufacturing plant
will involve an investment outlay of Rs. 50,00,000. The plant
is expected to have useful life 5 years with Rs.10,00,000
salvage value. The MNC follows the straight line method of
depreciation. To support additional level of activity,
investment will require additional working capital of Rs.
500,000.

 Variable cost of production and sales would be Rs. 20 per unit.

Additional fixed costs per annum are estimated at Rs.
2,00,000. Further, the forecasted selling price is Rs. 70 per
unit. The MNC is subjected to 40% tax rate and its cost of
capital is 15%.
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 Advice the MNC regarding the viability of the project.
 Q.20. Merito Ltd is considering buying a new equipment
which would have a useful life of 3 years, a cost of Rs.
5,00,000 and scrap value of Rs 50,000 with 80% of the cost
being payable at the start of the project and 20% at the end of
the 1st year.

 The machine would produce 500,000 unit p.a. of a new

product with an estimated selling price of 3 per unit. Variable
cost would be Rs. 1.75 per unit and annual fixed cost
excluding depreciation would be Rs. 100,000. In the 1 st and
2nd year, special sales promotion expenditure not included in
the above costs would incurred amounting to Rs. 10,000 and
Rs. 15,000 respectively. Tax rate is 40%.

 Calculate NPV of the project for investment appraisal, 42

assuming that the company’s cost of capital is 10%. Is it
worth investing in the equipment? Justify.