CAPITAL BUDGETING EVALUATION

TECHNIQUES
The important evaluation technique for appraising an investment
proposal are those which are based on economic costs and
benefits.

The methods of appraising capital expenditure proposals can be

classified into two broad categories:

1) Traditional methods

2) Time-adjusted method / discounted method.

TRADITIONAL METHODS

 Pay-back method

 Average rate of return method

Pay – back method:

Pay back method is the exact amount of time required

for a firm to recover its initial investment in a project
as calculated from cash flows.

It is calculated as:
capital investment
Pay – back period =
average annual cash inflows

Average annual cash flows are constant annual cash

flows in this case.
Cash flows for an investment over a period of time could
be as

Even cash flows:

When an investment generates cash flows which are
constant and fixed

Uneven cash flows:

when an investment generates cash flows which are not
regular and fixed
Let us take for an investment of 1,10,000 and the projected
cash inflows for 6 years are as follows

Even cash flows Uneven cash flows

Year Cash inflow Year Cash inflow
(Rs.) (Rs.)
1 10,000 1 10,000
2 10,000 2 20,000
3 10,000 3 30,000
4 10,000 4 10,000
5 10,000 5 5,000
6 10,000 6 35,000
1. An investment in a machinery requires Rs. 40,000 and is
expected to produce CFAT of Rs. 8,000 for 10 years.

2. A project requires an outlay of Rs. 2,00,000. and it can

generate during the next four years

CFAT
Rs. 80,000
Rs. 70,000
Rs. 40,000
Rs. 30,000

Using Pay- back period Method appraise the investment

proposal
A Cottage Gang is considering the purchase of
Rs.150,000 of equipment for its boat rentals.

The equipment is expected to last seven years and

have a Rs. 5,000 salvage value at the end of its life.

The annual cash inflows are expected to be Rs.250,000

and the annual cash outflows are estimated to be
Rs.200,000.
If the Turtles Co. has a project with a cost of Rs.1,50,000
and net annual cash inflows for the first seven years of
the project are:

Rs.30,000 in year one,

Rs.50,000 in year two,
Rs.55,000 in year three,
Rs.60,000 in year four,
Rs.60,000 in year five,
Rs.60,000 in year six, and
Rs.40,000 in year seven,
then its cash payback period would be ?
 Accounting Rate of Return

average annual profits after tax

ARR =
Average Investment over the life
of the project

Where,
Average investment = Net working capital+ salvage value +
½ ( initial cost of the asset – salvage
value)
Accept – reject criteria:

If, ARR > MRR Accept

ARR < MRR Reject

Alternative investment proposals will be ranked as

per their ARR.
The investment required for purchase of machine
is Rs. 11,00,000. salvage value Rs. 1,00,000,
working capital is Rs. 2,00,000. Service life is 5
years. Calculate Average investment for this
proposal.
 Assume the Cottage Gang has expected annual net income of
Rs.5,572 with an investment of Rs.150,000 and a salvage value
of Rs.5,000. what could be the annual rate of return for this
project?

Average investment = NWC + SV + ½(IC –SV)

= 0 + 5,000 + ½ ( 1,50,000 -5,000)
= 5,000 + 72,500 = 77,500

AAPAT
ARR =
AI

= ( 5,572 / 77,500) = 0.718 or 7.18%

DISCOUNTING TECHNIQUES

 NET PRESENT VALUE TECHNIQUE

 PROFITABILITY INDEX

 INTERNAL RATE OF RETURN

NET PRESENT VALUE
This technique enables to find out the
viability of project by comparing PVCI with PVCO.
Present value of cash outflows (PVCO)
with Present value of cash inflows (PVCI)

NPV = PVCI - PVCO

How to convert future cash inflows into present
value?

You require

1. Discounting rate

2. Estimated stream of cash flows

What is discounting rate?

It is the rate at which future cash flows are converted

into present values.

A projects MRR is taken as discounting rate.

MRR is minimum required rate of return

Eg: if debentures are issued to raise Rs.1,00,000
@ 12% to invest in an Asset for capacity
expansion,

then this asset should fetch at least 12%

returns.

Therefore 12% is considered as MRR.

So all future cash flows will be discounted at this

rate to ascertain present value
Therefore discounting rate is
the Minimum required rate of
return (MRR) that a firm should
earn to keep its market value
unchanged
Eg: A hypothetical company has a market value
of Rs. 2,50,000. It is planning to invest in an
asset to increase its productivity.

The asset cost is Rs. 50,000 and its life is 5

years.

So the market value of the firm is ( 2,50,000 +

50,000)
Rs.3,00,000 now.

This 50,000 can be raised from market at a

rate of 12%
12% is MRR for this investment project.

Cash flows after tax are expected as follows

1. 10,000
2. 12,000
3. 12.000
4. 13,000
5. 14,000

Calculate NPV and determine the market value of the

firm
Hence if,

NPV is positive accept the investment proposal

NPV is negative reject the investment proposal

Because,

a positive NPV increases the MV of a firm, and

a negative NPV reduces the MV of a firm
Accept – Reject criterion:

If NPV is + Accept
If NPV is - Reject
 A1 A2 A 3 Sn + Wn

NPV = ------------ + ------------- + -------------- + ------------------ - PV Co

(1+k)1 (1 +k)2 (1+K)3 (1+k)n

NPV = PVCI – PVCO

Where,

A1., A2,…..are future cash flows

K is the discounting rate
Sn salvage value at the end of life of project
Wn is working capital released at the end of the
project
PROFITABLITY INDEX
This is also called as Benefit – Cost ratio.

The profitability index measure the present value

of returns per rupee invested.

It helps in evaluating projects requiring different

initial investments.
It is a technique which helps to overcome the
drawbacks of NPV that are encountered while trying
to evaluate mutually exclusive investment
proposals when the initial investments are
different for each proposal.
The decision criteria for PI is:

Accept the Proposal : PI > 1

Reject the proposal : PI < 1

PI is calculated as :

PVCI
PI = -------------
PVCO
INTERNAL RATE OF RETURN( IRR)
IRR is usually the rate of return that project
should earn.

It is the rate at which the present value of cash

inflows will be equal to the present value of cash
outflows (PVCI = PVCO).

In other words at IRR the NPV will be equal to

zero.
At IRR, PVCI = PVCO

Or

At IRR, NPV = 0
If the company wants to know as to what
rate of return should the company earn so
that its PVCI will be equal to its PVCO,
IRR technique is used.
Procedure for finding IRR:

There are two ways through which IRR need be

calculated

1) Through Trial and error method

2) Through interpolation.
Through interpolation

PVCIL - PVCO
_______________ ( RH –RL)
IRR = RL +
PVCIL – PVCIH

PVCO = present value of Cash outflows

PVCI = present value of Cash inflows
R = discount rates
Procedure for calculating IRR

1. Determine artificial Pay-Back Period

2. Refer Table A4 to find the value of Payback

period closest to the life of the project

3. Note down two discounting rates closer to the Pay

back period in Table A4

4. Determine IRR by interpolation

WORKING CAPITAL MANAGEMENT

Working capital management is concerned with the

problems that arise in attempting to manage the
current assets, current liabilities, and
the interrelationship that exists between them.
Current assets

refers to those assets which in the ordinary

course of business can be, or will be converted into
cash, within one year.

Eg: cash, marketable securities, accounts

receivables ( debtors, bills receivables etc.,) and
inventory
Current liabilities

are those liabilities which are intended, at their

inception to be paid in the ordinary course of business,
within a year, out of the current assets or earnings of the
concern.

Eg: accounts payables( creditors, bills payables etc.,),

bank overdraft and outstanding expenses.
Concept and definition of working
capital:

There are two concepts of working capital:

Gross working capital – “ the current assets which

represent the proportion of investment that circulates
from one form to another in the ordinary conduct of
business”

The term gross working capital , also referred to as

working capital, means the total current assets.
Net working capital – “ is the difference between
current assets and current liabilities”

NWC helps in comparing the liquidity of the same firm

over time.

“The goal of WCM is to manage the current assets and

current liabilities in such a way that an acceptable level
of NWC is maintained.”
 PLANNING OF WORKING CAPITAL
A successful sales programme is in other words necessary
for any business to earn profits.

However sales do not convert into cash instantly, there is

invariable a time lag between the sale of goods and the
receipt of cash.

Therefore sufficient working capital is necessary to sustain

the sales activity.
Technically, this is refereed to as Operating cycle.
“The continuing flow of cash to suppliers, to
inventory, to accounts receivables and back into
cash is what is called as operating cycle”
In other words the it talks about the length of time
taken to at each.

cash INVENTORY

RECEIVABLES
 CASH

RAW MATERIAL
DEBTORS / BR

WORK IN PROGRESS
SALES

FINISHED GOODS
Determinants of working capital

Total working capital requirements are determined by a

wide variety of factors:
1. Nature of business
2. Production cycle
3. Business cycle
4. Production policy
5. Credit policy
6. Growth and expansion
7. Vagaries in availability of Raw material
8. Profit level
 CASH MANAGEMENT

It is one of the key areas in working capital management.

It is most liquid current asset because all other current

assets such as debtors and inventory gets eventually
converted into cash.

This underlines the significance of cash management.

 A distinguishing feature of cash as an asset is that it has
no earning power. But there are four primary motives
for maintaining cash balances:

1) Transaction motive

2) Precautionary motive

3) Speculative motive

4) Compensating motive
Objectives of cash management

The basic objective of cash management are two fold:

a) To meet cash disbursement needs

b) To minimize funds committed to cash balances.

INVENTORY MANAGEMENT
The term inventory refers to the stockpile of the
products a firm is offering for sale and the
components that make up the product.

In other words, inventory is composed of assets

that will be sold in future in the normal course of
business operations.
The assets which firms store as inventory in anticipation
of need are:

i) Raw material

ii) Work in progress

iii) Finished goods

Efficient management of inventory should ultimately result
in the maximization of the owners wealth.

Objective of inventory management consists of two counter

balancing parts.

i) To minimize investments in inventory

ii) To meet a demand for the product by efficiently

organizing the production and sales operations.
Costs of holding inventory:

The costs associated with inventory fall into two

basic categories.

a) Ordering costs

a) Carrying costs
 RECEIVABLES MANAGEMENT

The term receivables is defined as “ debt owned to the firm

by customers arising from sale of goods or services in the
ordinary course of business”.

When firm makes sales and does not receive payment it

extends trade credit and creates accounts receivables.
The objective of receivables management is to
‘ promote sales and profits’
until that point is reached where the return on
investment in further funding receivables is less than
the cost of capital.
The major categories of cost associated with extension of
credit (accounts receivables) are:

 Collection cost: the administrative cost incurred in

collecting receivables.
 Capital cost: cost of use of additional capital to
support credit sales which alternatively could have
been employed elsewhere.
 Delinquency cost: is cost arising out of failure of

customers to pay on due date.

 Default cost: are the over dues that cannot be

recovered.
Benefits:

1. It is oriented to sales expansion.

2. Protect its sales from emerging competition.

Account receivable management aim is to set a trade-

off between profit (benefit) and risk (cost).
Credit policy:

It provides a framework to determine

a) Whether or not to extend credit to a customer

b) How much credit to extend

It has two dimensions

1) Credit standards(minimum requirement for the

evaluation of credit to its customers)
2) Credit analysis (analyisng the creditworthiness of a
business)
Credit terms: specify the repayment terms
required of credit customers.
It has three components:

a) Credit period: time for which trade credit is

extended to customer.

b) Cash discount: is the incentive to customer to

make early payment of sum due

a) Cash discount period: is the duration of the

period in which discount can be availed of.
Collection policies: it involves procedures for
collecting accounts receivables when they are
due.
These policies cover two aspects:

i) Degree of effort to collect the over dues: (strict

or lenient)

ii) Type of collection effort: it talks about steps

should be taken to collect
1) letters 2) telephone calls 3) personal
visits 4) help of collection agencies and
lastly 5) legal action