Capital Budgeting

Capital Budgeting Decisions
Three Decisions......
Investment
Financing
Dividend
Outflow Rs. 10 lacs
Inflow of cash .................profit.......
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CAPEX
Capital Budgeting
INTRODUCTION:
Usually, all business firms incur two types of expenditures. First, revenue expenditure,
the benefits of which are supposed to be exhausted with in the year concerned and their planning
and control is carried out through various functional budgets. Second, capital expenditure, the
Financial Management Page 1 of 68
benefits of which are expected to be received over a number of years in future. Such expenditure
is incurred to buy fixed assets like building, plant and machinery or two undertake a program on
research and development of a product, diversification into a new product line, replacement of
machines, expansion of production capacity, a promotional campaign etc. Capital expenditure
involves the investment opportunities of the firm.Therefore, long term planning of capital
expenditure and arriving at right decision to incur or not to incur such expenditure is the
foremost responsibility of the management, and is widely known as “Capital Budgeting”.
The word capital budgeting is used interchangeablywith “Capital Expenditure Decision” or
“Capital Expenditure Management” or “Long – term Investment Decision” or
“Management of Fixed Assets” and so on.
Capital budgeting is the process of making investment decisions in capital expenditures.

A capital expenditure may be defined as an expenditure the benefits of which are expected to be
received over a period of time exceeding one year. The main characteristic of a capital
expenditure is that the expenditure is incurred at one point of time whereas benefits of the
expenditure are realized at different points of time in future. In simple language, we may
say that a capital expenditure is an expenditure incurred for acquiring or improving the
fixed assets, the benefits of which are expected to be received over a period of time in
future.
The following are some of the examples of Capital Expenditure;
A. Cost of acquisition of permanent assets as land and buildings, plant and machinery,
goodwill etc.,’
B. Cost of addition, expansion, improvement or alteration in the fixed assets.
C. Cost of replacement of permanent assets.
D. Research and Development project, etc.,
Capital expenditure involves non flexible long term commitment of funds. Thus, capital
expenditure decisions are also called “Long Term Investment Decisions”. Capital
budgeting involves the planning and control of expenditure. It is the process of deciding
whether or not to commit resources to a particular long term project whose benefits are to
be realized over a period of time, longer than one year. Capital budgeting is also known

as “Investment Decision Making, Capital Expenditure Decisions, Planning Capital

Expenditure and Analysis of Capital Expenditure”.
Capital project planning is the process by which companies allocate funds to

various investment projects designed to ensure profitability and growth.
Evaluation of such projects involves estimating their future benefits to the company and
comparing these with their costs.
In a competitive economy, the economic viability and prosperity of a company depends

upon the effectiveness and adequacy of capital expenditure evaluation and fixed assets
management.
MEANING AND NATURE OF CAPITAL BUDGETING:
Capital budgeting refers to planning the deployment of available capital for the purpose
of maximizing the long term profitability of the firm. It is the firm’s decision to invest its current
funds most efficiently in long term activities in anticipation of flow of future benefits over a
series of years.
In other words, Capital Budgeting may be defined as the firm’s decision 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. Therefore, it involves a current outlay or series of outlays of cash
resources in return for an anticipated flow of future benefits. Capital budgeting is the process of
identifying, analyzing and selecting investment projects, whose returns (cash flows) are expected
to extend beyond one year. Firm’s investment decisions would generally include expansion,
acquisition, and modernization, replacement of fixed assets or long term assets. From the above
definition, we may identify the basic features of capital budgeting viz., potentially large
anticipated benefits, relatively a high degree risk, and a relatively long term period between the
initial outlay and anticipated return.
Capital Budgeting is the planning and control process of capital expenditure for the purpose of
maximizing the long term profitability of the firm. Capital budgeting is the process of analyzing
alternative proposals for the investment of available capital funds to a particular long term
project whose benefits are to be realized over a period of time longer than one year.

This will result in increased profitability of the firm in future. In this way, Capital
Budgeting refers to “the total process of generating, evaluating, selecting and following up of
capital expenditure alternatives”. The capital budgeting is defined by various experts as follows;
“Capital Budgeting is long term planning for making and financing proposed capital
outlays”
:- Charles T . Horngen
“Capital Budgeting decisions may be defined as the firm’s decision to invest its current
funds most efficiently in long term activities in anticipation of an expected flow of future benefits
over a series of years”.
:-Prof., I.M. Pandey
“”Capital Budgeting consists in planning the exployment of available capital for the
purpose of maximizing the long term profitability (return on investment) of the firm”.
:- R.M. Lynch
“Capital Budgeting is concerned with the allocation of the firm’s scarce financial
resources among the available market opportunities. The consideration of investment
opportunities involves the comparison of the expected future stream of earnings with the
immediate and subsequent stream of expenditure for it”
:- G.C. Philippatos
CAPITALBUDGETING INVOLVES:
A. The search for new and more profitable investment proposals.

B. The making of an economic analysis to determine the profit potential of each investment
proposal.
In simple, capital budgeting refers to the total process of generating, evaluating, selecting
and following upon capital expenditure alternatives.

Capital budgeting may be defined as the firm’s formal process for the acquisition and
investment of capital. In involves the firm’s decision to invest its current funds for
addition, disposition, modification and replacement of fixed assets.
FEATURES OF CAPITAL BUDGETING DECISIONS:
Capital Budgeting decisions have the following features;
1. They benefit future periods.

2. They have the effect of increasing the capacity, efficiency, span of life regarding future
benefits.
3. Funds are invested in long term activities.
4. Capital expenditure decisions involve the exchange of current funds for the benefits to be
achieved in future.
5. The future benefits are expected to be realized over a series of years.
6. The funds are invested in non – flexible and long term activities.
7. They involve, generally, huge funds.
8. They are irreversible decisions.
9. They are “strategic” investment decisions, involving large sums of money, major
departure from the past practices of the firm, significant change of the firm’s expected
earnings associated with high degree of risk, as compared to “tactical” investment
decisions which involve a relatively small amount of funds that do not result in a major
departure from the past practices of the firm.
Some of the examples of Capital Budgeting decisions are;
1. Introduction of new product.

2. Expansion of business by investing in plant and machinery.
3. Replacing and modernizing a process.
4. Mechanization of process.
5. Choice between alternative machines.
SIGNIFIANCE OF CAPITAL BUDGETING DECISIONS:
Capital Budgeting Decisions are significant due to the following reasons;

1. Growth
2. More risky
3. Huge investments
4. Irreversibility
5. Effect on other projects
6. Difficult Decision
1. Growth:
The fixed assets are earning assets, since they have decisive influence on the rate of
return and direction of firm’s growth. A wrong decision can affect the other projects,
which are already running under profits. In other words unwanted or unprofitable
investments will result in heavy operating costs.
2. More Risky:
Investment in long term assets increases average profits but it may lead to fluctuations in
its earnings, then firm will become more risky. Hence, investment decisions decide the
future of the business concern.
3. Huge Investments:
Long term assets involve more initial cash outflows, which make it imperative for the
firm to plan its investment programs very carefully and make an advance arrangement of
funds either from internal sources or external sources or from both the sources.
4. Irreversibility:
Long term assets investment decisions are not easily reversible and that too, with much
financial loss to the firm; due to difficulties in finding out market for such capital items
once they have been used. Hence, firm incur more loss in that type of capital assets.
5. Effect on Other Projects:
Whenever long term asset investment is a part of the expansion program, its cash flow
affects the projects under consideration, if it is not economically independent. The effect
may be increased in profits or decreased in profits. So, while lacking investment in long
term assets, the decision maker has to check the impact of this project on other projects, if
the effect is in terms of increase in profits then he / she has toaccept the project and vice
versa.

6. Difficult Decision:
Capital Budgeting decision is very difficult due to (a) decision involves future years cash
inflows, (b) uncertainty of future and more risk.
Other Reasons regarding the significance of Capital Budgeting:
1. The decision – maker loses some of his flexibility, for the results continue over an
extended period of time. He has to make a commitment for the future.
2. Asset expansion is related to future sales.
3. The availability of capital assets has to be phased properly.
4. Many firms fail, because they involve the allocation of substantial amount of funds.
5. Decisions relating to capital investment are among the most difficult and, at the same
time, most critical that a management has tom make. These decisions require an
assessment of the future events which are uncertain.
6. The most important reason for capital budgeting decisions is that, they have long term
implications for a firm. The effects of a capital budgeting decision extend into the
future and have to put up with, for a longer period than the consequences of current
operating expenditure.
7. CapitalBudgeting is an important function of the management because it is one of the
critical determinants of success or failure of the company, advised or excessive
capital spending may create excessive capacity and increase in operating costs limits
the viability of company funds and reduce its profit earning capacity.
OBSTACLES FOR CAPITAL BUDGETING:
Capital Budgeting decisions are very important, but they pose difficulties, which shoot
from three principle sources;
1. Measurement Problem
2. Uncertainty
3. Temporal Spread
1. Measurement Problem:

Evaluation of project requires identifying and measuring its costs and benefits, which is
difficult since they involve tedious calculations and lengthy process. Majority of
replacement or expansion programs have impact on some other activities of the company
(introduction of new product may result in the decrease in sales of the other existing
products) or have some intangible consequences (improving morale of the workers).
2. Uncertainty:
Selection or rejection of a capital expenditure project depends on expected costs and
benefits in the future. Future is uncertain, if anybody tries to predict the future, it will be
childish or foolish. Hence, it is impossible to predict the future cash inflows.
3. Temporal Spread:
The costs and benefits, which are expected, are associated with a particular capital
expenditure project spread out over a long period of time, which are 10 – 20 years for
industrial projects and 20 – 50 years for infrastructure projects. The temporal spread
creates some problems in estimating discount rates for conservation of future cash
inflows in present values and establishing equivalences.
CAPITAL BUDGETING PROCESS:

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1. Identification of Investment Proposals:

The capital budgeting process begins with the identification of investment proposals.
The proposal or the idea about potential investment opportunities may originate from the
top management or may come from the rank and file worker of any department or from
any officer of the organization. The departmental head analyses the various proposals in
the light of the corporate strategies and submit the suitable proposals to the Capital
Expenditure Planning Committee in case of large organizations or to the officers
concerned with the process of long term investment decisions.
2. Screening the Proposals:
The Expenditure Planning Committee screens the various proposals received from
different departments. The committee views these proposals from various angels to
ensure that these are in accordance with the corporate strategies or selection criterion of
the firm and also do not lead to departmental imbalances.
3. Evaluation of Various Proposals:

The next step in the Capital Budgeting process is to evaluate the profitability of various
proposals. There are many methods which may be used for this purpose such as pay back
method, rate of return method, net present value method, internal rate of return method
etc. All these methods of evaluating profitability of capital investment proposals have
been discussed in detail separately in the following pages of this chapter.
It should however, be noted that the various proposals to be evaluated may be classified
as;
A. Independent Proposals
B. Contingent or Dependent Proposals; and
C. Mutually exclusive proposals.
Independent proposals are those which do not compete with one another and the same
may be either accepted or rejected on the basis of a minimum return on investment
required. The contingent proposals are those whose acceptance depends upon the
acceptance of one or more other proposals, e.g., further investment in building or
machineries may have to be undertaken as a result of expansion program. Mutually
exclusive proposals are those which compete with each other and one of thse may
have to be selected at the cost of other.
4. Fixing Priorities:
After evaluating various proposals, the unprofitable or uneconomic proposals may be
rejected straight away. But it may not be possible for the firm to invest immediately in
all the acceptable proposals due to limitation of funds. Hence, it is very essential to rank
the various proposals and to establish priorities after considering urgency, risk and
profitability involved therein.
5. Final Approval and Preparation of Capital Expenditure Budget:
Proposals meeting the evaluation and other criteria are finally approved to be included in
the Capital Expenditure Budget. However, proposals involving smaller investment may
be decided at the lower levels for expeditious actions to be incurred on fixed assets
during the budget period.
6. Implementation of Proposals:

Preparation of a capital expenditure budgeting and incorporation of a particular proposal

in the budget does not itself authorize to go ahead with the implementation of the project.
A request for authority to spend the amount should further be made to the Capital
Expenditure Committee which may like to review the profitability of the project in the
changed circumstances.
Further, while implementing the project, it is better to assign responsibilities for
completing the project within the given time frame and cost limit so as to avoid
unnecessary delays and cost over runs. Network techniques used in the project
management such as PERT and CPM can also be applied to control and monitor the
implementation of the project.
7. Performance Review:
The last stage in the process of Capital Budgeting is the evaluation of the performance of
the project. The evaluation is made through post budgeted one, and also by comparing
the actual return from the investment with the anticipated return. The unfavorable
variances, if any should be looked and the causes of the same are identified so that
corrective actions may be taken in future.
While steps are essential to any capital budgeting process, but individual situations of
capital budgeting may demand other steps relevant to the situation to make the process an
effective one;
1. Project Generation
2. Project Evaluation
3. Project Selection
4. Project Execution

1. Project Generation:
Investment proposals of various types may originate at different levels within a firm. The
investment proposals may fall into one of the following categories;
1. Proposals to add new product to the product line.
2. Proposals to expand capacity in existing product lines.
3. Proposals to reduce the costs of the output of the existing at any level; from top
management level to the level of the workers. The proposals may originate
systematically or haphazardly.
2. Project Evaluation:
Project evaluation involves two steps;
 Estimation of benefits and costs. The benefits and costs must be measures in terms of
cash flows.
 Selection of an appropriate criterion to judge the desirability of the project.
3. Project Selection:
Since capital budgeting decisions are of considerable significance, the final approval of
the project ay generally rest on the top management. However, projects are screened at
multiple levels.
4. Project Execution:
The funds are appropriated for capital expenditure after the final selection of
investmentproposals. The formal planning for the appropriation of funds is called the
capital budgeting. The project execution committee or the management must ensure that
the funds are spent in accordance with appropriation made in the capital budgeting.
According to the financial manager, the Capital Budgeting Process is classified as under;
1. Planning/ Idea Generation
2. Evaluation / Analysis
3. Selection
4. Financing
5. Execution/ Implementation
6. Review
PROCESS / STEPS OF CAPITAL BUDGETING:

The process of Capital Budgeting may be divided into six broad phases/ steps, viz.,
planning or idea generation, evaluation/analysis, selection, financing, execution/implementation
and review.
1. Planning/Idea generation:
The search for promising project ideas is the first step in capital budgeting process. In
other words the planning phase of a firm’s capital budgeting process is concerned with
articulation of its broad investment strategy and the generation and preliminary search of
project proposals. Identifying a new worthwhile project is a complex problem. It
involves a careful study from many different angles. Ideas can be generated from the
sources like, performance analysis of existing industries, examination of input and output
of various industries, review of import and export data, study plans outlays and
government guidelines, looking at the suggestions of financial institutions and
developmental agencies, study of local materials and resources, analysis of economic and
social trends, study of new technological developments, draw clues from the
consumption abroad, explore the possibility of reviving sick units, identify unfulfilled
psychological needs, attending trade fairs, stimulate creativity for generating new product
ideas among the employees.
2. Evaluation / Analysis:
In the preliminary screening, when a project proposal suggests that the project is prima
facie worthwhile, then it is required to go for evaluation/analysis. Analysis has to
consider aspects like, marketing, technical, financial, economic and ecological analysis.
This phase focuses on gathering data, preparing, summarizing relevant information about
various alternative projects available, which are being considered for inclusion in the
capital budgeting process. Cost and benefits are determined based on the information
gathered about other alternative projects.
3. Selection:
Selection or rejection follows the analysis phase. If the project is worthwhile, after using
a wide range of evaluation techniques, which are divided into traditional/ not discounted
and modern/discounted. Selection and rejection of a project depends on the technique
used to evaluate and its rule of acceptance. The acceptance rules are different for each
and every method. Apart from the use of techniques of evaluation, there are few

techniques available for measurement (range, standard deviation, coefficient of variation)

and incorporation of risk (risk adjusted discount rate, certainty equivalent, probability
distribution approach and decision tree approach) in capital budgeting.
4. Financing of the Project:
After the selection of the project, the next step is financing, financing arrangements have
to be made. There are two broad sources available such as equity (shareholders’ funds –
paid up share capital, share premium and retained earnings) and debt (loan funds – term
loans, debentures and working capital advances). While deciding the capital structure,
the maker has to keep in mind some factors, which influence capital structure. The
factors are Flexibility, Risk, Income, Control and Tax Benefits (referred to by the
acronym FRICT). Capital should consist of debt and equity.
5. Execution / Implementation:
Planning of paper work and implementation is physically different in implementing the
selected project. Implementation of an industrial project involves the stages, project and
engineering designs, negotiations and contracting construction, training and plant
commissioning. Translating an investment proposal from paper work to concrete work is
complex, time consuming and a risky task. Adequate formulation of project, use of the
principle of responsibility accounting and use of network techniques like (PERT and
CPM) are very much helpful for the implementation of a project at reasonable cost.
6. Review of the Project:
Once the project is converted from paper work to concrete work, then, there is need to
review the project. Performance review should be done periodically under this
performance review, actual performance is compared with the predetermined or projected
performance.
PRINCIPLES OF CAPITAL BUDGETIG:
Capital expenditure decisions should be taken on the basis of the following factors;
1. Creative search for profitable opportunities: profitable investment opportunities should be

sought to supplement existing proposals.
2. Long range capital planning: It indicates sect oral demand for funds to stimulate
alternative proposals before the aggregate demand for funds is finalized.

3. Short – range capital budgeting: It indicatessect oral demand for funds to stimulate
alternative proposals before the aggregate demand for funds is finalized.
4. Measurement of project work: Here, the project is ranked with the other projects.
5. Screening and selection: the project is examined on the basis of selection criteria, such as
the supply cost of capital, expected returns alternative investment opportunities, etc.,
6. Retirement and disposal: The expiry of the life cycle of a project is marketed at this
stage.
7. Forms and procedures. These involve the preparation of reports necessary for any capital
expenditure program.
RANKING OF CAPITAL BUDGETING PROPOSALS/ CLASSIFICATION OF

INVESTMENT PROPOSALS:
The overall objective of Capital Budgeting is to maximise the profitability of a firm or

the return on investment. This objective can be achieved either by increasing the revenues or
by reducing costs.
Thus, Capital Budgeting decisions can be broadly classified into two categories;
A. Those which increase revenues; and

B. Those which reduce costs.
The first category of Capital Budgeting decisions are expected to increase revenue
of the firm through expansion of the production capacity or size of operations by adding a
new product line. The second category increases the earnings of the firm by reducing
costs and includes decisions relating to replacement of obsolete, out method or worn out
assets. In such cases, a firm has to decide whether to continue with the same asset or
replace it. Such a decision is taken by the firm by evaluating the benefit from
replacement of the asset in the form of reduction in operating costs and the cost/cash
outlay needed for replacement of the asset. Both categories of above decisions involve
investment in fixed assets but the basic difference between the two decisions lies in the
fact that increasing revenue investment decisions subject to more uncertainty as
compared to cost reducing investment decisions.

Further, in view of the investment proposals under consideration, capital budgeting

decisions may also be classified as;
A. Accept or Reject Decisions
B. Mutually Exclusive Project Decisions
C. Capital Rationing Decisions
A. Accept or Reject Decisions:
Accept – Reject decisions relate to independent projects which do not compete with
one another. Such decisions are generally taken on the basis of minimum return on
investment. All those proposals which yield a rate of return higher than the minimum
required rate of return or the cost of capital are accepted and the rest are rejected. If
the proposals is accepted the firm makes investment in it, and if it is rejected the firm
does not invest in the same.
B. Mutually Exclusive Project Decisions:
Such decisions relate to proposals which compete with one another in such way that
acceptance of one automatically excludes the acceptance of the other. Thus, one of
the proposals is selected at the cost of the other. For example, a company may have
the option of buying a new machine, or a second hand machine, or taking an old
machine on hire or selecting a machine out of more than one brand available in the
market. In such a case, the company may select one best alternative out of the
various options by adopting some suitable technique or method of capital budgeting.
Once one alternative is selected, the others are automatically rejected.
C. Capital Rationing Method:
A firm may have several profitable investment proposals, but only limited funds to
invest. In such a case, these various investment proposals compete for limited funds
and, thus, the firm has to ration them. The firm selects the combination of proposals
that will yield the greatest profitability by ranking them in decending order of their
profitability. The capital rationing decisions have been separately discussed in this
chapter.
A firm should select its own projects after considering the advantages and disadvantages
of each one of them. For this purpose, it should rank the proposals. Proposals are ranked on
the basis of the following considerations.

1. Mutually exclusive investment proposals.

2. Contingent investment proposals
3. Independent investment proposals
4. Replacement
1. Mutually Exclusive Investment Proposals:

This kind of proposal connotes those proposals which represent alternative methods of
doing the same job. In case one proposal is accepted, the need to accept the other is ruled
out. For example there are 5 pieces of equipment available in the market to carry out a
job. If the management chooses one piece of the equipment, other will not be required
because they are mutually exclusive projects.
2. contingent Investment Proposals:
Thereis certain projects utility which is contingent upon the acceptance of others. For
example, management of an enterprise may be contemplating to construct, employee’s
quarters and a cooperative shops. If it decides not to build quarters, the need for the shop
does not raise. If the management decides to construct quarters but not shops, the
employees will have no shop to make purchases. These are contingent projects.
3. Independent Investment Proposals:
It includes all such investment proposals as are being considered by the management for
performing different tasks within the organization. Investment in machinery,
automobiles, buildings, parking lot, and recreationcentre and so on are the examples of
the independent investment proposals. Acceptance of each of these projects is does on its
own merit without depending on other projects.
4. Replacement:
The investments, which are contemplated for replacing, old and antiquated equipment so
that the job could be performed more efficiently, are termed s replacement.
FACTORS INFLUENING CAPITAL EXPENDITURE DECISIONS:
There are many factors, financial as well as non financial, which influence the capital
expenditure decisions. The crucial factor that influences the capital expenditure decisions is the

profitability of the project. Yet, there are many other factors which have to be taken into
consideration while taking a capital expenditure decision.
These are;
1. Urgency
2. Degree of certainty
3. Intangibility
4. Legal factors
5. Availability of funds
6. Future earnings
7. Obsolescence
8. Research and Development Projects
9. Cost Consideration
1. Urgency:
Sometimes an investment is to be made due to urgency for the survival of the firm or to
avoid heavy losses. In such circumstances, the proper evaluation of the proposal cannot
be made through profitability tests. The examples of such an urgency are: breakdown of
some plant and machinery, fire, accidents etc.,
2. Degree of Certainty:
Profitability is directly related to risk, higher the profits, greater is the risk or uncertainty.
Sometimes, a project with some lower profitability may be selected due to constant flow
of income as compared to another project with an irregular and uncertain flow of
incomes.
3. Intangible Factors:
Sometimes a capital expenditure has to be made due to certain emotional intangible
factors such as safety and welfare of workers, prestigious project, social welfare,
goodwill of the firm etc.,
4. Legal Factors:
An investment which is required by the provisions of law is solely influenced by this
factor and although the project may not be profitable yet the investment has to be made.
5. Availability of funds:

As the capital expenditure, generally, requires large funds, the availability of funds is an
important factor that influences the capital budgeting decisions. A project, howsoever,
profitable, may not be taken for want of funds and a project with a lesser profitability
may be sometimes preferred due to lesser pay – back period for want of liquidity.
6. Future earnings:
A project may not be profitable as compared to another today, but it may promise better
future earnings. In such cases it may be preferred to increase earnings.
7. Obsolescence:
There are certain projects which have greater risk of obsolescence than others. In case of
projects with high rate of obsolescence, the project with a lesser payback period may be
preferred than one which may have higher profitability but still longer payback period.
8. Research and Development Projects:
It is necessary for the long term survival of the business to invest in research and
development projects through it may not look to be profitable investment.
9. Cost Consideration:
Cost of the Capital project, cost of production, opportunity cost of capital etc., are other
considerations involved in the capital budgeting decisions.
CAPITAL BUDGETING APPRAISAL METHODS:
In view of the significance of capital budgeting decisions, it is absolutely necessary that

the method adopted for appraisal of capital investment proposal is a sound one. Any
appraisal method should provide for the following;
1. A basis of distinguishing between acceptable and non – acceptable projects.

2. Ranking of projects in order of their desirability.
3. Choosing among several alternatives.
4. A criterion which is applicable to any conceivable projects.
5. Recognizing the fact, that bigger benefits are preferable to later ones.

Investing Rs 10 lacs……………. 1lacs as cash inflow

Initial Investment / Yearly Cash inflow
= 10 l / 1 l = 10 years
LOSS
Without considering TVM………….No profit and No

Loss…. situation
Considering TVM……………………………..
…………………Loss
At the rate of 5%........................after 5 years.................12.5
Lacs
Investing Rs 10 lacs……………. For next 5 years 3lacs

each as cash inflow
There are many methods for evaluating and ranking the capital investment proposals. In
all these methods is to compare the investments in the projects regarding the benefits
derived.

PROFIT AND LOSS ACCOUNT (INCOME STATEMENT)

Particulars Amount Amount
Net Sales XXX
Less: Cost of Goods Sold XXX
Gross Profit / Loss XXX
Less: Operating Expenses XXX
Net Operating Profit/Loss XXX
Net Non Operating Results
Non Operating Incomes XXX
Less: Non Operating Expenses XXX XXX
Net Profit / Loss (Taxable Profit) XXX
It should be kept in mind that different firms may use different methods, which is appropriate to
be a specific project of the firm, depends upon the relevant circumstances of the proposed project
under evaluation.
INVESTMENT EVALUATION CRITERIA:
A. Traditional Techniques or Non – Discounted Cash Flow Techniques:

The traditional techniques are further subdivided into two; such as
A. Payback Period Method
B. Accounting Rate of Return (or) Average Rate of Return (ARR)

1. Payback Period Method:

The “Payback” sometimes called as payout or payoff period method represents the period
in which the total investment in permanent assets pays back itself. This method is based
on the principle that every capital expenditure pays itself back within a certain period out
of the additional earnings generated from the capital assets. Thus, it measure the period
of time for the original cost of a project to be recovered from the additional earnings of
the project itself. Under this method, various investments are ranked according to the
length of their payback period in such a manner that the investment with a shorter
payback period is preferred to the one which has longer payback period.
In case of evaluation of a single project, it is accepted if it pays back for itself
within a period specified by the management and if the project does not payback itself
within the period specified by the management then it is rejected.
Payback Period is one of the most popular and widelyrecognized techniques of
evaluating investment proposals. Payback period may be defined as that period
required, recovering the original cash outflow invested in a project. In other words, it
is the minimum required number of years to recover the original cash outlay invested
in a project.The cash flow after taxes (CFATs) is used to compute payback period.
Payback Period can be calculated in two ways, (A) Using formula (B) Using Cumulative
Cash Flow Method. The first method can be applied when the cash flows streams of each
year is equal / annuity in all the years’ of projects life, i.e., uniform cash flows for all the
years. In this situation, the following formula is used to calculate payback period.
The Payback Period can be ascertained in the following manner:
1. Calculate annual net earnings (profits) before depreciation (EBDIT) and after taxes,
these are called Annual Cash Inflows (Cash Flows After Taxes)
2. Divide the initial outlay (Cost) of the project by the annual cash inflow, where the
project generates constant annual cash inflows.
3. Where the annual cash inflows (Profit before Depreciation and After Taxes) are
unequal, the payback period can be found by adding up the cash inflows until the
total is equal to the initial cash outlay of project or original cost of the asset.
Pay Back Period can be calculated in two ways;

1. Using the formula

2. Using Cumulative Cash flow method.
The first method can be applied when the cash flows stream of each year is equal /
annuity in all the years’ or project life, i.e., uniform cash flows for all the years. In
this situation the following formula is used to calculate payback period.
Original Investment (cash Outlay)

Pay Back Period =
Average Annual CIF
The second method is applied when; the cash flows after taxes are unequal or not uniform
over the projects’ life period. In this situation, payback period is calculated through the process
of cumulative cash flows, cumulative process goes up to the period where cumulative cash flows
equal to the actual cash outflows
Unrecovered amount of investment

Pay Back Period =Year Before Full Recovery +
cash flows∈then ext year
P A.............................. 5 years
P B............................... 3 years
P C..............................7 years
P D............................. 2 years
ACCEPT / REJECT RULE:
Acceptance or Rejection of the project is based on the comparison of the calculated PBP
with the maximum or standard Pay Back Period.

Accept: Calculated PBP < Standard PBP
Reject: Calculated PBP > Standard PBP
Consider: Calculated PBP = Standard PBP
Advantages:
1. Cost involvement in the calculating payback period is very less as compared to

sophisticated methods like NPV, IRR and PI.
2. It is an important guide to investment policy.
3. It lays great emphasis on liquidity.
4. The method which enables a firm to choose an investment which yields a quick return
on cash funds.
5. The rate, which capital is recouped has a positive significance.
6. It is easy to understand, calculate, and communicate to others.
7. Other than its simplicity, the main advantage claimed for the payback period is that,
it is a built in safeguard against risk.
8. It enables a firm to determine the period required to recover the original investment
with some percentage return and thus, arriving at the degree of risk associated with
the investment.
9. In this method, as a project with a shorter payback period is preferred to the one
having a longer payback period, it reduces the loss through obsolescence and is more
suited to the developing countries, like India, which are in the process of development
and have quick obsolescence.
10. Due to it short term approach, this method is particularly suited to a firm which has
shortage of cash or whose liquidity position is not particularly good.
Limitations of PBP:

Though Payback Period method is the simplest, oldest and most frequently used method, it
suffers from the following limitations;
1. It ignores cash flows after Pay Back Period.

2. It is not an appropriate method of measuring the profitability of an investment, as it
does not consider all cash inflows yielded by the investment.
3. It is not consistent with the objective of maximizing shareholders’ wealth. Share
value does not depend upon payback period of investment project.
4. It does not value the projects of different economic lives.
5. It is only a rule of thumb method. It is often difficult to judge objectively whether
one proposed project is superior to another and, if so, by how much.
6. No allowance is made for taxation nor is any capital allowance made.
7. It does not take into account the cash inflows earned after the payback period and
hence the true profitability of the projects cannot be correctly assessed.
8. This method ignores the time value of money and does not consider the magnitude
and timing of the cash inflows. It treats all cash flows as equal though they occur in
different periods. It ignores the fact that cash received today is more important than
the same amount of cash received after, say 3 years.
9. It does not take into consideration the cost of capital which is very important factor in
making sound investment decision.
10. It may be difficult to determine the minimum acceptable payback period; it is usually
a subjective matter.
11. It treats each asset individually in isolation with other assets which is not feasible in
real practice.
12. Payback period method does not measure the true profitability of the project as the
period consider under this method to a short period only and not the full life of the
asset.
In spite of the above mentioned limitations, this method can be used in evaluating the
profitability of short term and medium term capital investment proposals.
CALCULATING THE CASH FLOWS AFTER TAXES:

Profit before tax=============10 k
Tax rate is 50%
Depreciation = 20000
CF after tax but before depreciation=================10k – 5k

+ 20k = 25 k
Payback period = 1 lac / 25k = 4 years

1 year CFATBBD ======= 20 k

2 year...................................... 25 k
3 year......................................... 30 k
4 year................................ 20 k
5 year............................... 15k
Investment ===== 1 lac
Year CIF CCIF
1 20000 20000
2 25000 45000
3 30000 75000
4 20000 95000
5 15000 1,10,000
Pay back period = 4 years + {(100000 – 95000) / 15000}
= 4 years + 0.33 = 4 .33 years
Particulars Amount
(Rs)
Projected Sales Revenue XXX
Less: Variable Cost XXX
Contribution XXX
Less: Fixed Cost XXX
Earnings Before Depreciation, Interest and Taxes XXX
Less: Depreciation XXX
Earnings Before Interest and Taxes XXX
Less: Interest XXX
Earnings Before Tax XXX
Less: Tax XXX
Earnings After Taxes XXX
Add: Depreciation XXX
Cash Flows After Taxes but before XXX
depreciation

Illustration:
A project costs Rs 1,00,000 and yields an annual cash inflows of Rs 20,000 for 8 years.
Calculate the Payback Period?
Payback period = 1,00,000 / 20000 ===== 5 years
Solution:
CashOutlay of the Project ∨Original Cost of the Asset

Payback Period=
Annual Cash inflows
Payback Period=
1,00,000
20,000 = 5 years
Illustration: Determine the Payback Period for a project which requires

a cash outlay of Rs 10,000 and generates cash inflows of Rs 2,000, Rs
4,000, Rs 3,000 and Rs 2,000 in the first, second, third and fourth years
respectively.
Cash outlay or initial investment or cost of investment / project

Solution:
Yea Annual Cumulative

r Cash Flows Cash flows
1 2,000 2,000
2 4,000 6,000
3 3,000 9,000
4 2,000 11,000
Payback period = 3years + (1000 /
2000) = 3.5 years
Up to third year the total cost is not recovered but the total cash inflows for the four years are
Rs11,000 i.e., Rs 1,000 more than the cost of the project. So the pack back period is somewhere
between 3 and 4 years. Assuming that the cash inflows occur evenly throughout the year, the
time required to recover Rs 1,000 will be;

cash flows∈thenext year
1,000
Pay Back Period =3+
2,000
Pay Back Period =3+0.5
Pay Back Period =3.6 years
IMPROVEMENTS IN TRADITIONAL APPROACH TO PAYBACK PERIOD

METHOD:

A. Post Payback Period Profitability Method.

B. Payback Reciprocal Method
C. Payback Period Method
D. Discounted Payback Method
1. Post Payback Profitability Method:
One of the serious limitations of Payback Period Method is that it does not take into
account the cash inflows earned after payback period and hence the true profitability of
the project cannot be assessed. Hence, an improvement over this method can be made by
taking into account the returns receivable beyond the payback period. These returns are
called Post Payback Profits.
Post Payback Period Profits

Post Pay Back Profitability Index= X 100
Investment
Illustration:
For each of the following projects compute; (A) Payback period, (B) Post Payback Period
Profitability and (C) Post Payback Profitability Index;
Project - A
(A) Initial outlay 50,000
Annual cash inflows (after tax but before depreciation) 10,000
Estimated life 8 years
Project - B
(B) Initial Outlay 50,000
Annual Cash Inflows (after tax but before depreciation)
First three years 15,000……. 3 = 45000
Next five years 5,000…….. 5 = 25000
Estimated Life 8 years
Salvage Value 8,000
Project A
A. Payback Period:
CashOutlay of the Project∨Original Cost of the Asset
Payback Period =
Annual Cash inflows
50,000
Payback Period =
10,000
Payback Period =5 Years
Payback Reciprocal = Annual cash inflow / initial investment

Payback Reciprocal for Project A = 20000 / 50000 = 0.4
8750
Payback Reciprocal for Project B = =0.175
50000
B. Post Payback Profitability:
Post Payback Profitability= Annual Cash Inflows( Estimated Life−Payback Period )
Post Payback Profitability =10,000(8−5)

Post Payback Profitability =10,000 X 3
Post Payback Profitability =Rs 30,000
C. Post Payback Period Profitability Index:
Post Payback Period Profits
Investment
30,000
50,000
Post Pay Back Profitability Index=60 %
Project – B:
A. Payback Period
As the Cash inflows are not equal during the life of the investment, the payback period
can be calculated as;
Year Annual Cash Flows Cumulative Cash flows

1 15,000 15,000
2 15,000 30,000
3 15,000 45,000
4 5,000 50,000
Hence the payback period is 4 years.
B. Post Payback Period Profitability:
Post Payback Profitability = Annual Cash Inflows ¿
Post Payback Profitability =5,000(8−4 )

Post Payback Profitability =20,000

C. Post Payback Period Profitability Index:

Post Payback Period ProfitsX 100
Post Pay Back Profitability Index=
Investment
20,000
50,000
Post Pay Back Profitability Index=40 %
2. PAYBACK RECIPROCAL METHOD:
Sometimes, Payback Reciprocal Method is employed to estimate the internal rate of

return generated by a project;
Annual Cash Inflows

Total Investment
However, this method should be used only when the following two conditions are
satisfied;
A. Equal cash inflows are generated every year.

B. The project under consideration has a long life which must be at least wise the
payback period.
3. POST PAYBACK PERIOD METHOD:
One of the limitations of the Payback Period Method is that it ignores the life of the
project beyond the payback period. Post Payback Period Method takes into account the
period beyond the payback period. This method is also known as “Surplus Life Over
Payback Period Method”. According to this method, the project which gives the greatest
post payback period may be accepted. The method can be employed successfully where
the various projects under consideration do not differ significantly as to their size and the
expected cash inflows are even throughout the life of the project.
Post Payback Period= Annual Cash Inflows ( Estimated Life−Payback Period )
4. Discounted Payback Period Method:

Another serious limitation of the Payback Period Method is that it ignores the
time value of money. Hence, an improvement over this method can be made employing
the discounted payback period method. Under this method the present values of all cash
outflows and inflows are computed at an appropri9ate discount rate. The present values
of all inflows are cumulated in order to time. The time period at which the cumulated
present value of cash inflows equals the present value of cash outflows is known as
discounted payback period. The project which gives shorter discounted payback period
is accepted. The method has been explained with an illustration here;
Illustration:
Calculate the Discounted Payback Period from the following information given below;
Cost of the project Rs 6,00,000

Life of the project 5 years
Annual cash inflows Rs2,00,000
Cut off rate 10%
Solution:
Year Cash Inflows Present Value at 10% Present values of Cumulative Present
discount factor cash inflows values of Cash inflows
1 2,00,000 0.909 1,81,800 1,81,800
2 2,00,000 0.826 1,65,200 3,47,000
3 2,00,000 0.851 1,50,200 4,97,200
4 2,00,000 0.683 1,36,600 6,33,800
5 2,00,000 0.621 1,24,200 7,58,000
Cumulative present value of cash inflows at the end of the third year is Rs 4,97,200 and it is Rs
6,33,800 at the end of fourth year. Hence, discounted payback period falls in between 3 and 4
years to be exact;

cash flows∈thenext year
1,02,800
Pay Back Period =3+
1,36,600
3
Pay Back Period =3 year
4

RATE OF RETURN METHODS
This method takes into account earnings expected from the investment over there whole life.
It is known as Accounting Rate of Return methods for the reason that under this method, the
Accounting concept of profit (net profit after taxes and depreciation) is used rather than cash
inflows. According to this method, various projects are ranked in order of the rate of earnings or
rate of return. The project with the higher rate of return is selected as compared to the one with
lower rate of return. This method can also be used to make decision as to accepting or rejecting
a proposal. The expected return is determined and the project which has higher rate of return
than the minimum rate specified by the firm called the cut off rate, accepted and the one which
gives a lower expected rate of return than the minimum rate is rejected.
A. AVERAGE RATE OF
RETURN:
Accounting Rate of Return method uses accounting information as revealed by financial

statements, to measure the profitability of the investment proposals. It is also known as Return
on Investment (ROI). Sometimes it is known as Average Rate of Return (ARR). Average
annual earrings after depreciation and taxes are used to calculate ARR. It is measured in terms
of percentage. ARR can be calculated in two ways;
1. Whenever is clearly mentioned as Accounting Rate of Return.

If Accounting Rate of Return is given in the problem, return on original investment
method should be used to calculate Accounting Rate of Return.
Average Annual EATs∨PATs

Average Rate of Return= X100
Original Inve stment (OI )
Project A------------------- ARR = 20%

Project B------------------- ARR = 25%
Original Investment = Original Investment + Additional NWC + Transportation
charges + Installation Charges.
2. Whenever it is clearly mentioned as Average Rate of Return;

If Average Rate of Return is given in the illustration, return on average investment

method should be used to calculate average rate of return.
AverageAnnualEATsorPATs
AverageRateofReturn= X100
AverageInvestment ( AI )
Original Investment −scrap Value

Average Investment= + Additional NWC+ Scrap Value
2
3. If ARR is given in the problem, any one of the method can be used to calculate ARR
(Preferably return on average investment method).
ACCEPT – REJECT CRITERIA:
Acceptance or Rejection of the project is based on the comparison of calculated ARR

with the predetermined rate or cut of rate.
Accept: Calculated ARR > Predetermined ARR or Cut – Off Rate
Reject: Calculated ARR < Predetermined ARR or Cut – Off Rate
Consider: Calculated ARR = Predetermined ARR or Cut – Off Rate
Advantages:
The ARR method has some merits;
1. The most significant merit of ARR is that, it is very simple to understand and easy to
calculate.
2. It takes into account all projects of the projects’ life period.
3. Cost involvement in calculating payback period is very less in comparison to the
sophisticated methods, since it saves analysts’ time.
4. It is very simple to calculate and easy to understand.
5. It uses the entire earnings of a project in calculating the rate of return and not only the
earnings up to payback period and hence gives a view of profitability as compared tom
Payback Period Method.

6. As this method is based up on accounting concept of profits, it can be readily calculated

from the financial data.
Limitations:
ARR method suffers from serious demerits;
1. It uses accounting profits instead of actual cash flows after taxes, in evaluating the
projects. Accounting projects are inappropriate for evaluating and accepting projects,
since they are computed based on arbitrary assumptions and choices and also include non
– cash items.
2. It ignores the concept of time value of money.
3. It does not allow profits to be reinvested.
4. It does not differentiate between the sizes of the investment required for each project.
5. It does not take into consideration any benefits, which can accrue to the firm from the
sale of equipment, in abundance which is replaced by the new investment.
6. It feels that, 10% rate of return for 10 years is more beneficial than 8% rate of return for
25 years.
7. It is incompatible with the objective of wealth maximization to the equity shareholders.
8. It uses arbitrary cut off as yardstick or standard for acceptance or rejection rule.
9. This method also like Payback Period Method ignores the time value of money as the
profits earned at different points of time are given equal weight by averaging the profits.
It ignores the fact, that a rupee earned today is of more value than a rupee earned an year
after, or so.
10. It does not take into consideration the cash flows which are more important than the
accounting profits.
11. It ignores the period in which the profits are earned as a 20% rate of return in 2 ½ years
may be considered to be better than 18% rate of return for 12 years. This is not proper
because longer the term of the project, greater is the risk involved.
12. This method cannot be applied to a situation where investment in a project is to be made
in parts.
Illustration:

A project requires an investment of Rs 5,00,000 and has a scrap value of Rs 20,000 after five
years. It is expected to yield profits after depreciation and taxes during the five years amounting
to Rs 40,000, Rs 60,000, Rs 70,000, Rs 50,000 and Rs 20,000. Calculate the average rate of
return on the investment?
Solution:
AverageAnnual EATs∨PATs
AverageRateofReturn=
48,000
AverageRateofReturn= X 100
2,40,000
AverageRateofReturn=20 %
AverageAnnual EATs∨PATs
Rate of Return = = 48000 / 4, 80,000=¿10 %
Investment ( AI )
40,000+ 60,000+70,000+50,000+20,000
AverageProfits=
5 Years
2,40,000
AverageProfits= =48,000
5Years
Original Investment−scrap Value
Average Investmen= + Additional NWC + Scrap Value
2
5,00,000−20,000
Average Investment= +20,000
2
4,80,000
Average Investme nt = + 20,000
2
Average Investment=2,40,000+ 20,000
Average Investment=2,60,000
Illustration:
Calculate the Accounting Rate of Return for Projects A and B from the following;
Project A Project B
Investments 20,000 30,000
Expected Life (No salvage value) 4 years 5 years
Projected Net Income (After interest, depreciation and taxes)
1st Year 2,000 3,000
2nd Year 1,500 3,000
3rd Year 1,500 2,000
4th Year 1,000 1,000
5th Year ---- 1,000
Total 6,000 10,000

If the required rate of return is 12% which project should be undertaken?
Solution:
Particulars Project A Project B

Total Project (After Interest, Depreciation and Taxes) 6,000 10,000
Average Profit (Total Profit/No of years) = 10,000 / 5 years 1,500 2,000
Net investment on the project 20,000 30,000
Accounting Rate of Return 1500 / 20000 = 2000 / 30000
Average Annual E ATs∨PATs 7.5 % = 6.67%
Accounting Rate of Return=
Original Investment (OI )
But if we want to calculate the Average Rate of Return: 1500 / 10000 2000 / 15000
AverageAnnualEATsorPATs 15% = 13.33%
AverageRateofReturn=
The average rate of return on investment is higher in case of Project A and is also higher than the
required rate of return of 12% and hence Project A is suggested to be undertaken.
Return per unit of investment = Total profit after dep and tax / Net investment * 100
TIME VALUE OF MONEY
Years 0 1 2 3 4 5
- 10000 3000 5000 2500 4200 1000

10% …Cost of capital ……. Discount factor…. Cut off rate … hurdle rate …. Required
rate… Minimum rate of return…… capitalisation rate………………..
Year Cash inflow after tax but Present Value of Cash inflow
before dep @ 10%
1 3000 3000 / (1+0.10)1 = 2727
2 5000 5000 / (1+0.10)2 = 4132
3 2500 2500 / (1+0.10)3 = 1878
4 4200 4200 / (1+0.10)4 = 2868
5 1000 1000 / (1+0.10)5 = 621
Total of Present value of CIF 12226
CIF = Net Profit After tax but before deprecition
NPV = Present Value of future cash inflows – initial cost of the project
NPV = 12226 – 10,000 = 2226
If NPV is equal to or more than ZERO…………… ACCEPT THE PROJECT
IF NPV is less than ZERO ie, negative…………….. …………..REJECT THE PROJECT
All the Cash inflowsof future date are to be converted into present value so that we can
compare such cashinflows with the cash outflow/ investment
II . MODERN TECHNIQUES OR DISCOUNTED CASH FLOW TECHNIQUES:
Modern / Discounted Cash Flow Techniques take into consideration almost all the
deficiencies of the Traditional Methods and consider all benefits and cost occurring during the
projects’ entire life period. Modern techniques can be again subdivided into three viz., (1) Net
Present Value (2) Internal Rate of Return and (3) Profitability Index or Discounted Benefit Cost
Ratio (DBCR).

The traditional methods of capital budgeting i.e., Payback Period Method as well as
Accounting or Average Rate of Return Methods suffers from the serious limitations that give
equal weightage to present value and future value of cash inflows. These methods do not take
into consideration the time value of money, the fact that a rupee earned today has more value
than a rupee earned after five years. The time adjusted or discounted cash flow method takes
into account the profitability and also the time value of money. These methods also called
Modern Methods of Capital Budgeting are becoming increasingly popular day by day.
Following are the discounted cash flows models.
1. NET PRESENT VALUE METHOD:
The Net Present Value Method is one of the discounted cash flow methods. It is also
known as Discounted Benefit Cost Ratio method. NPV can be defined as present value of
benefits minus present value of costs. It is the process of calculating present values of cash
inflows using cost of capital as an appropriate rate of discount and subtracts present value of cash
outflows from the present value of cash inflows and finds the net present value, which may be
positive or negative. Positive net present value occurs when the present value of cash inflows is
higher than the present value of cash outflows and vice versa.
The Net Present value Method is a modern method of evaluating investment proposals.
This method takes into consideration the time value of money and attempts to calculate the
return on investments by introducing the factor of time element. It recognizes the fact that a
rupee earned today is worth more than the same rupee earned tomorrow. The net present value
of all inflows and outflows of cash occurring during the entire life of the project is determined
separately for each year by discounting these flows by the firm’s cost of capital or a pre
determined rate.
Steps involved in Computing of NPV are:
1. First of all determined an appropriate rate of interest that should be selected as the
minimum required rate of return called “Cut off Rate” or Discount Rate. The rate should
be a minimum rate of return below which the investor considers that it does not pay him
to invest. The discount rate should be either the actual rate of interest in the market on
long term loans or it should reflect the opportunity cost of capital of the investor.

2. Forecasting of cash inflows of the investment project based on realistic assumptions.

3. Computation of cost of capital, which is used as discounting factor for conversion of
future cash inflows into present values.
4. Calculation of cash flows using cost of capital as discounting rate / factor.
5. Finding out NPV by subtracting present value of cash outflows from present value of
cash inflows.
6. To select between mutually exclusive projects, projects should be ranked in order of net
present values i.e., the first preference should be given to the project having the
maximum positive net present value.
The present value of Rs 1 due in any number of years can be found with the use of the
following mathematical formula;
1
Present Value= n
(1+r )
PV = Present value of Rs 1
r = rate of interest / discounting factor
n = number of years
Accept or Reject Criteria:
Accept: NPV > Zero

Reject: NPV<Zero
Consider: NPV=Zero
Advantages of Net Present Value Method:
The merits of Net Present Value method are;’
1. It takes into account the time value of money.

2. It uses all cash inflows occurring over the entire life period of the project including scrap
value of the old project.
3. It is particularly useful for the selection of mutually exclusive projects.
4. It takes into consideration the changing discount rate.
5. It is consistent with the objective of maximization of shareholders’ wealth.

6. It recognizes the time value of money and is suitable to be applied in a situation with
uniform cash outflows and uneven cash inflows or cash outflows at different periods of
time.
7. It takes into account the earnings over the entire life of the project and the true
profitability of the investment proposals can be evaluated.
8. It takes into consideration the objective of maximum profitability.
Limitations of Net Present Value Method:
NPV is the most acceptable method in comparison with traditional methods.

Nevertheless, it has certain limitations also;
1. It is difficult to understand when compared with Payback Period Method and
Accounting / Average Rate of Method.
2. Calculation of required rate or discounting actor or cost of capital is difficult, which
involves a lengthy and time consuming process and present illustrations. At the same
time, calculation of cost of capital is based on different methods.
3. In case of projects involving different cash outlays, NPV method may not give
dependable results.
4. It does not give satisfactory results when comparing two projects with different life
projects. Generally, a project, having a shorter economic life would be preferable,
other things being equal.
5. As compared to the traditional methods, the net present value method is more difficult
to understand and operate.
6. It may not give goods results while comparing projects with unequal lives as the
project having higher net present value but realized in a longer life span may not be as
desirable as a project having something lesser net present value achieved in a much
shorter span of life of the asset.
7. In the same way as above, it may not give good results while comparing projects with
unequal investment of funds.
8. It is not easy to determine an appropriate discount rate.
Illustration:

NPV = Total of the present value of cash inflows – Initial investment or Present value of
cash outflows
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%.
Dep = Initial investment – Scrap value / no of years of the project
Project X Project Y
Initial Investment Rs 20,000 Rs 30,000
Estimated Life (in years) 5 5
Scrap value (Rs) Rs 1,000 Rs 2,000
The profits before depreciation and after taxes (Cash Flows) are as follows;
Project 1st Year 2nd Year 3rd Year 4th Year 5th Year
Project X 5,000 10,000 10,000 3,000 2,000
Project Y 20,000 10,000 5,000 3,000 2,000
Solution:
NPV = Present value of future CIFs – Initial Investment
Calculation of the Net Present Value of Project X

Project X
Present Value
Year Cash Inflows (Rs) PV Factor @10% of Cash
Inflows
1st 5,000 1/ (1 + 0.10)^1 = 5,000 * 0.909
0.909 = 4,545
2nd 10,000 1/ (1 + 0.10)^2 10,000 * 0.826
0.826 =8,260
3rd 10,000 1/ (1 + 0.10)^3 10,000 * 0.751
0.751 =7,510
4th 3,000 1/ (1 + 0.10)^4 3,000 *0.683
0.683 =2,049
5th 2,000 1/ (1 + 0.10)^5 2,000*0.621
0.621 =1,242
5th (Scrap value) 1,000 1/ (1 + 0.10)^5 1,000*0.621
0.621 =621

Present Value of Total Cash Inflows 24,227

Present value of Total Cash outflows (Less) 20,000
Net Present Value of project X = Rs. 4,227
Calculation of the Net Present Value of Project Y

Project Y
Present Value
Year Cash Inflows (Rs) PV Factor @10% of Cash
Inflows
1st 20,000 1/ (1 + 0.10)^1 = 20,000 *0.909
0.909 =18,180
2nd 10,000 1/ (1 + 0.10)^2 10,000*0.826
0.826 =8,260
3rd 5,000 1/ (1 + 0.10)^3 5,000*0.751
0.751 =3,755
4th 3,000 1/ (1 + 0.10)^4 3,000*0.683
0.683 =2,049
5th 2,000 1/ (1 + 0.10)^5 2,000*0.621
0.621 =1,242
5th (Scrap value) 2,000 1/ (1 + 0.10)^5 2,000*0.621
0.621 =1,242
Present Value of Total Cash Inflows 34,728
Present value of Total Cash outflows (Less) 30,000
Net Present Value of Project Y 4,728
Net Present Value of project X = Rs. 4,227
Net Present Value of Project Y = Rs.4,728
Suggestion: We find that Net Present Value of Project Y is higher than Project X, hence it is
suggested that Project Y should be preferred.
2. INTERNAL RATE OF RETURN METHOD:

The Internal Rate of Return Method is also a modern technique of capital budgeting that
takes into account the time value of money. It is also known as “Time Adjusted Rate of
Return”, “Discounted Cash Flow”, “Discounted Rate of Return”, “Yield Method, and

“Trial and Error Method”. In the Net Present Value Method the net present value is
determined by discounting the future cash flows of a project at a predetermined or
specified rate called the cut off rate. But under then internal rate of return method, the
cash flows of a project are discounted at a suitable rate by hit and trial method, which
equates the net present value so calculated to the amount of the investment. Under this
method, since the discount rate is determined internally, this method is called as the
Internal Rate of Return Method. The internal rate of return can be defined as that rate of
discount at which the present value of cash inflows is equal to the present value of cash
outflows.
This method advocated by Joel Dean, takes into account the magnitude and timing of
cash flows;
IRR is that rate at which the sum of Discounted Cash Inflow IDCF) equals the sum of
discounted cash outflow. It is the rate at which the net present value of the investment is
zero. It is called Internal Rate of Return because it depends mainly on the outlay and
proceeds associated with the project and not on any rate determined outside the
investment. This method is also known by the following;
1. Marginal Efficiency of Capital

2. Rate of Return over cost
3. Time Adjusted Rate of Return
4. Yield on Investment
Internal Rate of Return may be defined as that discounting factor at which the
present value of cash outflows. It takes into account the magnitude and timing of the
cash flows. In case of NPV method, the discount rate is the required rate of return and
that is predetermined, usually by cost of capital, which determines based on external
point of view, where as IRR is based on facts, which is internal to the proposal. It is the
best available concept. We shall see that although frequently a used concept in finance,
yet at times quite a misleading measure of investment worth.
Computation of IRR is based on the cash flows after taxes. IRR is

mathematically represented as “r”. It can be found by trial and error method. In this

method the evaluator selects any discount rate to compute present value of cash inflows.
Generally, the cost of capital is taken as first trial. If calculated present value of the cash
inflows is higher than the present value of cash outflows then evaluator has to try at
higher rate. On the other hand, if the present value of cash inflows is lower than the
present value of cash outflows then evaluator has to try lower discounting factor. This
process will be repeated till the present value of cash inflows equals to the present value
of cash outflows. Generally, IRR may lie between two discounting factors; in that case
analyst has to use interpolation formula for calculation f IRR.
The following steps are required to practice the Internal Rate of Return:
1. Determine the future net cash flows during the entire economic life of the project. The
cash inflows are estimated for future profits before depreciation but after taxes.
2. Determine the rate of discount at which the value of cash inflows is equal to the present
value of cash outflows. This may be determined as explained after step4.
3. Accept the proposal if the internal re of return is higher than or equal to the minimum
required rate of return, i.e., the cost of capital or cut off rate and reject the proposal if the
internal rate of return is lower than the cost of capital or cut off rate.
4. In case of alternative proposals select the proposal with the highest rate of return as long
as the rates are higher than the cost of capital of cut off rate.
The formula is as follows.

LDPV −OI
IRR=LDF %+[ ΔDF ]
LDPV −HDPV
Where;
` LDF = Lower Discount Factor

Δ DF = difference between Lower Discounting Factor and Higher Discounting Factor.
LDPV = Present Value of Cash Inflows at Lower Discounting Factor
HDPV = Present Value of Cash Inflows at Higher Discounting Factor
OI = Original Investment
Or
C−0
IRR=A + ¿ (B – A)
C−D
Where;

A = Discounting Factor at Lower Trial

B = Discounting Factor at Higher Trial
C = Present Value of cash Inflows in the lower trial
D = Present value of cash inflows in the higher trial
O = Original or Initial Investment
Accept / Reject Criteria:
Acceptance or rejection rule of the project decides based upon the calculated IRR and
Cost of Capital.
Accept: IRR > Cost of Capital
Reject: IRR < Cost of Capital
Consider: IRR = Cost of Capital
MERITS OF INTERNAL RATE OF RETURN:
1. IRR attempts to find the maximum rate of interest at which funds invested in the
project could be repaid out of the cash inflows arising from that project.
2. It considers the time value of money.
3. It considers cash flows throughout the life of the project.
4. It is not in conflict with the concept of maximizing the welfare of the equity
shareholders.
5. It is calculated by the method of trial and error, usually it gives more psychological
satisfaction to the user.
6. It is consistent with the objective of shareholders; wealth maximization.
7. Like the Net Present Value Method, it takes into account the time value of money and
can be usefully applied in situation with even as well as uneven cash flows at
different periods of time.
8. It considers the profitability of the project for its entire economic life and hence
enables evaluation of true profitability.
9. The determination of cost of capital is not a pre requisite for the use of this method
and hence it is better than Net Present Value Method where the Cost of Capital
cannot be determined easily.

10. It provides for uniform ranking of various proposals due to the percentage rate of
return.
11. This method is also compatible with the objective of maximum profitability and is
considered to be a more reliable technique of capital budgeting.
DEMERITS OF INTERNAL RATE OF RETURN:
1. Calculation of IRR is quire tedious and it is difficult to understand.

2. Both NPV and IRR assume that the cash inflows can be reinvested at the discounting
rate in the new project. However, reinvestment of fund at the cut – off rate is more
appropriate than at the IRR. Hence, NPV method is more reliable than IRR to
ranking two or more projects.
3. It implies that profits can be reinvested at internal rate of return, which is not logical.
4. It produces multiple rate of return which can be confusing.
5. It does not help in the evaluation of mutually exclusive projects, since a project with
highest IRR would be selected. However, in practice, it may not turn out to be the
one, that is the most profitable and consistent with the objective of shareholders i.e.,
wealth maximizations.
6. It may not give fruitful results in case of unequal projects life, unequal cash outflows
and difference in the timing of ash flows.
7. It may give results inconsistent with NPV method. This is especially true in case of
mutually exclusive projects, i.e., projects where acceptance of one would result in the
rejection of the other. Such conflict of results arises due to the following.
A. Differences in cash outlays.
B. Unequal lives of projects.
C. Different pattern of cash flows.
8. It is difficult to understand and is the most difficult method of evaluation of
investment proposals.
9. This method is based upon the assumption that the earnings are reinvested at the
internal rate of return for the remaining life of the project, which is not a justified
assumption particularly when the average rate of return earned by the firm is not close
to the internal rate of return. In this sense, Net Present Value Method seems to be

better as it assumes that the earnings are reinvested at the rate of firm’s cost of
capital.
10. The results of NPV Method and IRR Method may differ when the project under
evaluation differs in their size, life and timings of cash flows.
COMPARE AND CONTRAST OF “NPV” WITH “IRR”:
The Net Present Value Method and the Internal Rate of Return methods ae similar in the
sense that both are modern techniques of capital budgeting and both take into account the time
value of money. In fact, both these methods are discounted cash flows techniques.
NPV and IRR are the discounted cash flow methods available for evaluation of capital
budgeting projects. These are similar in certain respects. In certain situations, they would give
same (accept or reject) decision. But they differ in the sense that the results regarding the choice
of assets are under certain circumstances mutually contradictory. The comparison of these
methods is therefore, involves a discussion of (a) similarities between the methods and (b)
differences.
NPV and IRR: Similarities:
1. The two methods use cash inflows after tax (CFAT).

2. Both the methods take into consideration the time value of money.
3. They consider CFAT throughout the projects life period.
4. Both the methods give consistent results in terms of Acceptance or Rejection of
investment proposals in certain situations. That is, if a project is viable it will be
indicated by both the methods. If a project is not qualified, both the methods will indicate
that it should be rejected.
5. The situations in which the two methods will give a concurrent accept or reject decision
will be in respect of conventional and independent projects.
6. According to NPV the decision rule is that a project will be accepted if NPV is greater
than zero, the IRR would support projects where IRR is greater than the cost of capital.
NPV and IRR: Differences:

However, there are certain basic differencebetween Net Present Value and Internal Rate of
Return Methods:
1. In case of mutually exclusive projects, if NPV method accepts the project while IRR
rejects.
2. If there is a size disparity the NPV and the IRR will give different ranking.
3. When there is an incremental approach, the NPV method is superior to the IRR,
because the former supports projects, which are compatible with the goal of
shareholders wealth maximization while latter does not.
4. When there is time disparity the NPV would give results superior to the IRR method.
5. In projects with unequal lives, NV and IRR would give conflicting raking to mutually
exclusive projects.
6. In the Net Present Value Method, the present value is determined by discounting the
future cash flows of a project at a predetermined or specified rate called the cutoff
rate based on cost of capital. But under the internal rate of return method, the cash
flows are discounted at a suitable rate by hit and trial method which equates the
present value so calculated to the amount of the investment. Under the IRR Method
discount rate is not predetermined or known as is the case in NPT Method.
COMPARISON OF NPV AND IRR METHOD:
NPV METHOD IRR METHOD

1. Interest rate is a known factor. 1. Interest rate is an unknown factor.
2. It involves computation of the amount 2. It attempts to find out the maximum
that can be invested in a given project rate of interest at which funds are
so that the anticipated earnings will be invested in the project. Earnings from
sufficient to repay this amount with the project in the form of cash flow will
market rate of interest. help use to get back the funds already
invested.
3. It assumes that the cash inflows can be 3. It also assumes that the cash inflows
reinvested at the discounting rate in the can be reinvested at the discounting rate
new projects. in the new project.
4. Reinvestment is assumed to be at the 4. Reinvestment in funds is assumed to be
cut – off rate. at the IRR.

The Present Value Method always provides for correct ranking of mutually exclusive
investment projects, whereas, IRR method sometimes, does not. In the latter method, the
implied reinvestment rate will differ depending upon the cash flow for each investment proposal
under consideration. For proposal with a high internal rate of return, a high reinvestment rate is
assumed, for proposals with a low rate of return, a low reinvestment rate is assumed. The IRR
calculated, may rarely represents the relevant rate as assumed and the relevant rate for
reinvestment of intermediate cash flows.
3. PROFITABILITY INDEX / DISCOUNTED BENEFIT COST RATIO:

It is also a time adjusted method of evaluating the investment proposals. Profitability
Index also called as “Benefit Cost Ratio (B/C) or Desirability Factor” is the relationship
between present value of cash inflows and the present value f cash outflows. Thus,
This is another discounted cash flow method of evaluating investment proposals. It is
also known as Discounted Benefit Cost Ratio Method. It is similar to NPV Method. It is
the ratio of the present value of cash inflows, at the required rate of return, to the initial
cash outflow of the investment proposal. PI method measures the present value of future
cash per rupee, where as NPV is based on the difference between present value of cash
inflows and present value of cash outflows. NPV method is not reliable to evaluate
projects requiring unequal initial investments. PI Method provides solution to this
problem. PI is the ratio, which is derived by dividing present value of cash inflows by
present value of cash outflows.
PI is the ratio of present value of future cash benefits at the required rate of return
at the initial cash outflows of the investment.
PresentValueofCashInflows
ProfitabilityIndex=
InitialCashOutlay
Like IRR and NPV methods, Profitability Index is a conceptually sound method of
appraising investment projects. It provides ready comparisons between investment proposals of
different magnitudes.
The Net Profitability Index can also be found as Profitability Index (gross) minus one.
The proposal is accepted if the profitability index is more than one and is rejected in case the

profitability index is less than one. The various projects are ranked under this method in order of
their profitability index, in such a manner that one with higher profitability index is ranked
higher than the other with lower profitability index.
Accept / Reject Criteria:
Accept: PI>1
Reject: PI<1
Consider: PI=1
Characteristics of Sound Investment Criteria:
1. It should consider all cash flows to determine the profitability.

2. It should provide for an objective and unambiguous way of separating good projects
from bad projects.
3. It should help ranking of projects according to their true profitability.
4. It should recognize the fact that bigger cash flows are preferable to similar ones and
early cash flows are preferable to later ones.
5. It should help to choose among mutually exclusive projects that particular project
which maximizes the shareholders’ wealth.
6. It should be criteria, which is applicable to any conceivable investment project
independent of others.
Merits of Profitability Index: The Profitability Index satisfies all the requirements of a
sound investment criterion. The characteristic as we recollected are;
1. It gives due consideration to time value of money.

2. It considers all cash flows to determine PI.
3. It helps to rank projects according to their PI.
4. It recognizes the fact that bigger cash flows are better than smaller ones and early cash
flows are preferable to later ones.

5. It can also be used to choose mutually exclusive projects by calculating the incremental
benefit cost ratio.
6. The method is slightly modification of the Net Present Value Method. The Net Present
Value method has one major drawback that it is not easy to rank projects on the basis of
this method particularly when the costs of the projects differ significantly. To evaluate
such projects, the profitability index method is more suitable. The other advantages and
disadvantages of this method are the same as of Net Present value Method.
Illustration: The initial cash outlay of a project is Rs 50,000 and it generates cash inflows of
Rs 20,000, Rs 15,000, Rs 25,000 and Rs 10,000 in four years. Using present value index
method, appraise profitability of the proposed investment assuming 10% rate of discount?
Solution:
Calculation of Present Value and Profitability Index

Year Cash Inflows Present Value Factor @10% Present Value
1 20,000 0.909 18,180
2 15,000 0.826 12,390
3 25,000 0.751 18,775
4 10,000 0.683 6,830
Total Present Value of Inflows 56,175
Total Present Value of Outflows 50,000
Net Present Value 6,175
PresentValueofCashInflows
ProfitabilityIndex=
InitialCashOutlay
56,175
ProfitabilityIndex= =1.235
50,000
Net ProfitabilityIndex=1.235−1=0.235
As the net profitability index is positive, the proposal can be accepted.
NET PRESENT VALUE VS PROFITABILITY INDEX:
As NPV and PI techniques of capital investment decisions are closely related to each
other, both provide the same result as far as accept – reject decisions are concerned. This is so
because under NPV Method a proposal is acceptable if it gives positive net present value and

under PI Method a proposal is acceptable if the profitability index is greater than one. The PI
will be greater than one only when the NPV is positive and hence they give identical accept –
reject decisions. However, in case of mutually exclusive proposals having different scales of
investment i.e., where the initial investment in the alternative proposals is not the same, a
conflict in NPV and PI ranking may occur. Thus, the question may arise as to which proposal
should the firm accept? In case of such mutually exclusive decisions, the net present value
method (NPV) should be preferred for reasons explained for superiority of NPV over PI method.
TERMINAL VALUE METHOD:
The Terminal Value Method is an improvement over the Net Present Value Method of
making capital investment decisions. Under this method, it is assumed that each of the future
cash flows is immediately reinvested in another project at a certain (hurdle) rate of return until
the termination of the project. In other words, the net cash flows and outlays are compounded
forward rather than discounting them backward as followed in net present value (NPV) method.
In case of a single project, the project is accepted if the present value of the total of the
compounded reinvested cash inflows is greater than the present value of the outlays, otherwise it
is rejected. In case of mutually exclusive projects, the project with higher present value of the
total of the compounded cash flows is accepted.
The terminal value method can be further extended to calculate the “Terminal Rate of
Return (also called) Modified Internal Rate of Return” to overcome the shortcomings of the
internal rate of return (IRR) method. The terminal rate of return is the compounding rate of
return, that when applied to the initial outlays, accumulates to the terminal value. This method is
presently being used in advanced countries like USA. The following illustration explains the
terminal value method;
Illustration:
The following information relates to a project;

Initial Outlay Rs 20,000
Life of the project 4 years
Cash inflows Rs 10,000 p.a., for 4 years
Cost of capital (Ko) 12%
Expected interest (hurdle) rates at which cash inflows will be reinvested;

End of the year;
1st 7%
nd
2 7%
3rd 9%
th
4 9%
You are required to analyse the feasibility of the project using terminal value method;
Yea Cash Rate of Years for Compounding Compounding

r Inflows Interest (%) reinvestmen Factor Value
t
1 10,000 7 3 1.225 12,250
2 10,000 7 2 1.145 11,450
3 10,000 9 1 1.090 10,900
4 10,000 9 0 1.000 10,000
44,600
Present Value of the total of the compounded reinvested cash inflows;
Compounded Value of Cash Inflows

PV of Cash Inflows= n
(1+ K )
44,600
PV of Cash Inflows=
(1+ 0.12)4
44,600
PV of Cash Inflows= =28,371
1.573
As the present value of the compounded reinvested cash inflows are Rs 28,371 is greater
than the original cash outlay of Rs 20,000 (or terminal value) is positive i.e., Rs 8,371, the
project can be accepted.
RISK AND UNCERTAINITY IN CAPITAL BUDGETING:
All the techniques of capital budgeting require the estimation of future cash inflows and
cash outflows. The future cash flows re estimated based on the following factors;
1. Expected economic life of the project.

2. Salvage value of the asset at the end of he economic life
3. Capacity of the project

4. Selling price of the product

5. Production cost
6. Depreciation rate
7. Rate of taxation
8. Future demand of then product etc.,
But due to uncertainties about the future, the estimates of demand, production, sales,
costs, selling prices etc., cannot be exact. For example, a product may become obsolete
much earlier than anticipated due to expected technological developments. All these
elements of uncertainty have to be taken into account in the form of forcible risk while taking
a decision on investment proposals. It is perhaps the most difficult task while making an
investment decision. But some allowances for the element of risk have to be provided.
The following methods are suggested for accounting for risk in capital budgeting:
1. Risk – Adjusted Cutoff Rate or Method of Varying Discount Rate

2. Certainty Equivalent Method
3. Sensitivity Technique
4. Probability Technique
5. Standard Deviation
6. Co efficient of Variation Method
7. Decision Tree Analysis
1. Risk – Adjusted Discount Rate or Method of Varying Discount Rate:
The simple method of accounting for risk in capital budgeting is to increase the cutoff
rate or discount factor by certain percentage on account of risk. The projects which are
more risky and which have greater variability in expected returns should be discounted at
a higher rate as compared to the projects which are less risky and are expected to have
lesser variability in returns. The greatest drawback of this method is that it is not possible
to determine the risk premium rate appropriately and moreover it is the future cash flow
which is uncertain and requires adjustment and not the discount rate.
Illustration:

The Beta Company Limited is considering the purchase of a new investment. Two
alternative investments are available (A and B) each costing Rs 1, 00,000. Cash inflows are
expected to be as follows;
Cash Inflows
Investment –A Investment – B
Years Rs Rs
1st 40,000 50,000
2nd 35,000 40,000
3rd 25,000 30,000
4th 20,000 30,000
The company has a target rate of return on capital @10%. Risk premium rates are 2%
and 8% respectively for investments A and B. Which investment should be preferred?
Solution:
Investment - A Investment – B
Year Discount Cash Present Discount Cash Present
Factor @12% Inflows Values Rs Factor @12% Inflows Values Rs
(10+2) (10+2)
1 0.893 40,000 35,720, 0.847 50,000 42,350
2 0.797 35,000 27,895 0.718 40,000 28,720
3 0.712 25,000 17,800 0.609 30,000 18,270
4 0.635 20,000 12,700 0.516 30,000 15,480
Present Value of Cash Inflows 94,115 1,04,820
Present Value of Cash outflows 1,00,000 1,00,000
Net Present Value -5,885 4,820
As even at a higher discount rate investment B gives a higher Net Present value,
investment B should be preferred.
What is 'Certainty Equivalent'

2. CERTAINITY EQUIVALENT METHOD:
Anotherissimple
Certainty equivalent methodreturn
a guaranteed of accounting
that someone forwould
risk accept,
in capital budgeting
rather is to
than taking reduceonexpected
a chance a higher, but
uncertain, return. If you've ever thought about leaving your job to start your own business, and potentially make more
money, but cash flows
decided by and
to stay certain amounts.
continue drawing Ita can
salarybeinstead,
employed by amount
then the multiplying
of yourthe expected
salary is yourcash
certainty
equivalent. You might need to come up with a business idea with a higher potential payoff to be convinced to leave the
flows
security of your by certainty
existing job. equivalent coefficients as to convert the uncertain cash flos to certain
cash flows;
'Certainty Equivalent'
Investments must pay a risk premium to compensate investors for the possibility that they may not get their money back. If an
investor has a choice between a U.S. government bond paying 3% interest and a corporate bond paying 8% interest, and he
chooses the Financial
government Management offer57
Page
bond, the payoff is the certainty equivalent. The company would need to 68
thisofparticular investor
a potential return of more than 8% on its bonds, to convince him to buy. Thus, a company seeking investors can use the
certainty equivalent as a basis for determining how much more it needs to pay, to convince investors to consider the riskier
option. The certainty equivalent will vary, because each investor has a unique risk tolerance.
Illustration:
There are two projects X and Y. Each involves an investment of Rs 40,000. The
expected cash inflows and the certainty coefficients are as under;
Year Project X Project Y

Cash Flows Certainty Cash Flows Certainty
Coefficient Coefficient
1 25,000 0.8 20,000 0.9
2 20,000 0.7 30,000 0.8
3 20,000 0.9 20,000 0.7
The risk free cut off rate is 10%. Suggest which of the two projects should be preferred?
Solution:
Calculation of Cash Inflows with Certainty

Year Project X Project Y
Cash Certainty Certain Cash Certainty Certain
Inflows Coefficient Cash Inflows Coefficient Cash
Inflows Inflows
1 25,000 0.8 20,000 20,000 0.9 18,000
2 20,000 0.7 14,000 30,000 0.8 24,000
3 20,000 0.9 18,000 20,000 0.7 14,000
Calculation of Present Value of Cash Inflows
Year Discount Project X Project Y
Factor Cash Inflows Present value Cash Inflows Present value
@10% of cash inflows of cash

inflows
1 0.909 20,000 18,180 18,000 16,362
2 0.826 14,000 11,564 24,000 19,824
3 0.751 18,000 13,518 14,000 10,514
Total Present Value of Cash Inflows 43,262 46,700
Present value of cash outflows 40,000 40,000
Net Present Value 3,262 6,700
As the Net Present Value of Project Y is more than of Project X. Project Y should be preferred.
3. SENSITIVITY ANALYSIS:
Where cash inflows are very sensitive under different circumstances, more than one
forecast f the future cash inflows may be made. These inflows may be regarded as
“Optimistic”, “More Likely” and “Pessimistic”. Further, cash inflows may be discounted
to find out the Net Present Values under these three different situations. If the net present
values under the three situations differ widely it implies that there is a great risk in the
project and the investor’s decision to accept or reject a project will depend upon his risk
bearing abilities.
Illustration:
Mr. Risky is considering two mutually exclusive projects A and B. You are required to advise
him about the acceptability of the projects from the following information.
Project A Project B
Cost of the Investment 50,000 50,000
Forecast Cash Inflows per annum for 5 years:
Optimistic 30,000 40,000
Most Likely 20,000 20,000
Pessimistic 15,000 5,000
The cut off rate may be assumed to be 15%
Calculation of Net Present Values of Cash Inflows at a Discount Rate of 15% of Rs 1 for 5 years
Project A Project B
Annual Discount Present Net Present Annual Discount Present Net Present
cash Factor value Values (Rs) cash Factor value (Rs) Values (Rs)
inflows @15% (Rs) inflows @15%
Optimistic 30,000 3.3522 1,00,56 50,566 40,000 3.3522 1,34,088 84,088
6
Most Likely 20,000 3.3522 67,014 17,044 20,000 3.3522 67,044 17,044
Pessimistic 15,000 3.3522 50,283 283 5,000 3.3522 16,761 33,239

The net present values as calculated above indicate that Project – B is more risky as compared to
Project – A. But at the same time during favourable conditions, it is more profitable also. The
acceptability of the project will depend upon Mr.Risky’s attitude towards risk. If he would
afford to take higher risk, Project B may be more profitable.
4. PROBABILITY TECHNIQUE:
A probability is the relative frequency with which an event may occur in the future. When future
estimates of cash inflows have different probabilities the expected monetary values may be
computed by multiplying cash inflows with the probability assigned. The monetary values of the
inflows may further be discounted to find out the present values. The project that gives higher
net present value may be accepted.
Illustration:
Two mutually exclusive investment proposals are being considered. The following
information is available.
Project – X Project – Y
Cost of the project (Rs) 6,000 6,000
Cash inflows Rs Probability Rs Probability
1st Year 4,000 0.2 8,000 0.2
2nd Year 8,000 0.6 9,000 0.6
3rd Year 12,000 0.2 9,000 0.2
Assume that the cost of capital at 10%, advise the selection of the project.
Solution:
Calculation of Net Present Value of the Two Projects

Project X Project Y
Year P.V. Cash Probability Monetary Present Cash Probability Monetary Present
Factor Inflows value Values Inflows value Values
@10%
1 0.909 4,000 0.2 800 727 7,000 0.2 1,400 1,273
2 0.826 8,000 0.6 4,800 3,965 8,000 0.6 4,800 3,965
3 0.751 12,000 0.2 2,400 1,802 9,000 0.2 1,800 1,352
Total Present Values 6,494 6,590
Less: Cost of the Project 6,000 6,000
Net Present Value 494 590
As the Net Present Value of Project – Y is more than that of Project X after taking into
consideration the probabilities of cash flows, project – y is more profitable.

5. STANDARD DEVIATION METHOD:

If two projects have the same cost and their net present values are also the same, Standard
Deviation of the expected cash inflows of the two projects may be calculated to judge the
comparative risk of the projects. The projects having a higher standard deviation is said to be
more risky as compared to the other.
Illustration:
From the following information, ascertain which project is more risky on the basis of
Standard Deviation?
Project – A Project – B
Cash Inflows Probability Cash Inflows Probability
2,000 0.2 2,000 0.1
4,000 0.3 4,000 0.4
6,000 0.3 6,000 0.4
8,000 0.2 8,000 0.1
Solution:
Calculation of Standard Deviation

Project – A
Cash Inflows(Rs) Deviations from Square of Probability Weighted Square
2 2
Mean (Rs5,000) Deviations d Deviations (fd )
d
2,000 -3,000 90,00,000 0.2 18,00,000
4,000 -1,000 10,00,000 0.3 3,00,000
6,000 1,000 10,00,000 0.3 3,00,000
8,000 3,000 90,00,000 0.2 18,00,000
N=1 ∑(fd2) = 42,00,000
2
∑ ( fd )
SD=
√n
42,00,000
SD=
√ 1
SD=2,050
Calculation of Standard Deviation
Project – B
Cash Inflows(Rs) Deviations from Square of Probability Weighted Square
2 2
Mean (Rs5,000) Deviations d Deviations (fd )
d

2,000 -3,000 90,00,000 0.1 9,00,000

4,000 -1,000 10,00,000 0.4 4,00,000
6,000 1,000 10,00,000 0.4 4,00,000
8,000 3,000 90,00,000 0.1 9,00,000
N=1 ∑(fd2) = 26,00,000
2
∑ ( fd )
SD=
√n
26 ,00,000
SD=
√ 1
SD=1,612
As the Standard Deviation of Project – A is more than that of Project – B. Project – A is more
risky.
6. COEFFICIENT OF VARIATION METHOD:
Coefficient of Variation is a relative measure of dispersion. If the projects have the same
cost but different net present values, relative measures, i.e., coefficient of variation
should be computed to judge the relative position of risk involved. It can be calculated as
follows;
Standard Deviaiton
Coefficient of Variation= X 100
Mean
Illustration:
Using the figures of the above problem, calculate the Coefficient of Variaiton and suggest
which proposal should be accepted?
Standard Deviaiton
Coeffi cient of Variation= X 100
Mean
2,050
Coefficient of Variation of Project A= X 100
5,000
Coefficient of Variation of Project A=41 %
1,612
Coef ficient of Variation of Project A= X 100
5,000

Coefficient of Variation of Project A=32.24 %

As the Coefficient of Variation of Project – A is more than that of Project – B, Project – A is
more risky. Hence, Project – B should be selected.
TAXATIONAND CAPITAL BUDGETING:
Inflation – Its expectations and its effects:
When a manager evaluates a project, or when a shareholder evaluates his / her

investments, he/she can only guess what the rate of inflation will be. These guesses will be
wrong, at least to some extent, s it is extremely difficult to forecast the rate of inflation
accurately. The only way in which uncertainty about inflation can be allowed for in project
evaluation is by risk and uncertainty analysis. Inflation may be general, that is, affecting prices
of all kinds or specific to particular prices. Generalized inflation has the following effects;
A. Inflation will mean higher costs and higher selling prices. It is difficult to predict the
effect of higher selling prices on demand. A company that raises its prices by 30%,
because the general rate of inflation is 30%, might suffer a serious fall in demand.
B. Inflation as it affects financing needs, is also going to affect gearing, and so the cost of
capital.
C. Since fixed assets and stocks will increase in money value, the same quantities of assets
must be financed by increasing amounts of capital. If the future rate of inflation can be
predicted with some degree of accuracy, the management can work out how much extra
finance the company will need and take steps to obtain the same, e.g., by increasing
retention of earnings, or borrowings.

However, if the future rate of inflation cannot be predicted with a certain amount of
accuracy, then management should estimate what it is likely to be and accordingly make
plans to obtain the extra finance. Provisions should also be made to obtain access to
“contingency funds” should the rate of inflation exceed expectations, e.g., a higher bank
overdraft facility might be arranged, should the need arise.
Many different proposals have been made for account for inflation. Two systems
known as “Current Purchasing Power (CPP)” and “Current Cost Accounting (CCA)”
have been suggested.
Current Purchasing Power is a system of accounting that makes adjustments to
income and capital values to allow for the general rate of price inflation.
Current Cost Accounting (CCA) is a system that takes account of specific price
inflation (i.e., changes in the prices of specific assets or groups of assets, but not of
general price inflation. It involves adjusting accounts to reflect the current values of
assets owned and used.
At present, there is very little measure of agreement as to the best approach to the
problem of “Accounting for Inflation”. Accountancy bodies are still debating both these
approaches.
MULTINATIONAL COMPANIES AND CAPITAL BUDGETING:
Multinational Companies are constantly acquiring and disposing of assets globally in the
normal course of business. Shareholder wealth is created when the NMC makes an investment
that will return more (in resent value terms) than what it costs. Among the most important
decisions those NMC managers face is the choice of capital projects globally. These investments
will determine the firm’s competitive position in the marketplace, its overall profitability, and,
ultimately, its long run survival.
Multinational Company’s Capital Budgeting, like domestic Capital Budgeting focuses on the
cash flows of prospective long term investment projects. It is used both in traditional foreign
direct investment analysis, such as the construction of chain of retail stores in another country, as
well as cross border mergers and acquisitions activity. Capital Budgeting for a foreign project

uses the same Net Present Value (NPV) discounted cash flow model used in domestic capital
budgeting. However, multinational capital budgeting is considerably more complex due to a
number of additional factors that need to be considered.
Factors influencing Multinational Companies Capital Budgeting are as follows:
1. Parent Vs Project Cash Flows.

2. Financing Vs Operating Cash Flows
3. Foreign Currency Fluctuations
4. Long – term Inflation Rates
5. Subsidized Financing
6. Political Risk
7. Terminal Value
1. Parent Vs Project Cash Flows:

Parent (i.e., home country) cash flows must be distinguished from project (i.e., host
country) cash flows. While aren’t cash flows reflect all cash flow consequences for the
consolidated entity, project cash flows look only at the single country where the project is
located. For example, cash flows generated by an investment in Spain may be partly or
wholly taken away from one in Italy, with the end result that the net present value of the
investment is positive from the Spanish affiliate’s point of view, but contributes little to
the firm’s world – wide cash flows.
2. Financing Vs Operating Cash Flows:
In Multinational Investment projects, the type of financing package is often critical in
making otherwise unattractive projects attractive to the parent company. Thus, cash may
flows back to the parent because the project is structured to generate such flows via
royalties, licensing fees, dividends, and so on. Unlike in domestic capital budgeting,
operating cash flows cannot be kept separate from financing decisions.
3. Foreign Currency Fluctuations:
Another added complexity in multinational capital budgeting is the significant effect that
fluctuating exchange rates can have on the prospective cash flows generated by the

investment. From the parent’s perspective, future cash flows abroad have value only in
terms of the exchange rate at the date of repatriation. In conducting the analysis, it is
necessary to forecast future exchange rates and to conduct sensitive analysis of the
project’s viability under various exchange rates scenarios.
4. Long – term Inflation Rate:
Differing rats of national inflation and their potential effect on competitiveness must be
considered. Inflation will have the following effects on the value of the project:
A. It will impact the local operating cash flows both in terms of the prices of inputs and
outputs and also in terms of the sales volume depending on the price elasticity of the
product.
B. It will impact the parent’s cash flow by affecting the foreing exchange rates.
C. It will affect the real cost of financing choices between foreign and domestic sources
of capital.
5. Subsidized Financing:
In situations, where a host government provides subsidized project financing at below
market rates, the value of that subsidy must be explicitly considered in the capital
budgeting analysis. If a company uses the subsidized rates in the analysis, there is an
implicit assumption that the subsidy will exist throughout the life of the project. Another
approach might be to incorporate the subsidized interest rates into the analysis by
including the present value of the subsidy rather than adjusting the cost of capital.
6. Political Risk:
This is another factor that can significantly impact the viability and profitability of
foreign projects. Whether it be through democratic elections or as a result of sudden
developments such as political upheavals or military coups, changes in a country’s
government can affect the attitude in that country towards foreign investors and
investments. This can affect the future cash flows of a project in that country in a variety
of ways. Political developments may also affect the life and the terminal value of foreign
investments.
7. Terminal Values:
While terminal values of long term projects are difficult to estimate even in the domestic
context, they become far more difficult in the multinational context due to the added

complexity from some of the factors discussed above. An added dimension is that
potential acquirers may have widely divergent perspectives on the value to them of
acquiring the terminal assets. This is particularly relevant if the assets are located in a
country that is economically segmented due to a host of restrictions on cross border flow
of physical or financial assets.
In conducting multinational capital budgeting analysis from a parent’s
perspective, the additional risk arising from projects located aboard can be handled in at
least two ways. One possibility is to add a foreign risk premium to the discount rate that
would be used for a domestic project.
This higher rate is intended to capture the additional uncertainties arising from exchange
risk, political risk, inflation and such factors. The second possibility is to adjust the cash
flows for the foreign projects to reflect the additional risk. The discount rate stays the
same as for domestic projects. Thus, the additional complexities resulting from doing
business abroad must be incorporated in the analysis through adjustments to either the
discount rate or the projected cash flows. Rather than make these adjustments arbitrarily,
firms can use wide – ranging publicly available data, historical analysis and professional
advice to make reasonable decisions.
INCORPORATING COUNTRY RISK IN CAPITAL BUDGETING:
Adjustment of the discount rate;
1. The higher the perceived risk, the higher the discounted rate that should be applied to the
project’s cash flows.
Adjustment of the estimated cash flows:
1. By estimating how each form of risk could affect the cash flows, the MNCs can
determine the probability distribution of the net present value of the project.
REVIEW QUESTIONS:
1. Define Capital Budgeting?

2. What do you understand by Capital Budgeting?
3. What is Cut – Off Rate?
4. Bring out the differences between the NPV and IRR?

5. State the difference between mutually exclusive and independent proposals?

6. Explain the circumstances under which the Payback Period is useful?
7. List the stages of Capital Budgeting Process?
8. What do you mean by discounting of cash flows?
9. State the techniques of capital budgeting?
10. What do you mean by mutually exclusive project?
11. Explain the nature and concept of Capital Budgeting?
12. Discuss the process of Capital Budgeting?
13. Discuss the significance of Capital Budgeting?
14. Why Payback Period isis so popular?
15. How do you calculate the Accounting Rate of Return? What are its limitations?
16. Compare and contrast NPV and IRR?
17. Discuss the traditional techniques of capital budgeting evaluations?
18. What is NPV? Discuss the steps involved in computations of NPV?
19. How do you calculate Cash Flow after Taxes (CFATs)?
20. What is BCR? What are the merits?
21. How should working capital and sunk costs be treated in evaluating capital budgeting
decisions?
22. What is Profitability Index?
23. What are the limitations of Capital Budgeting?
24. What is Capital Budgeting? Discuss its nature, importance and deficiencies of Capital
Budgeting?

Capital Budgeting

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Capital Budgeting Decisions

Outflow Rs. 10 lacs

Inflow of cash .................profit.......

Capital budgeting is the process of making investment decisions in capital expenditures.

The following are some of the examples of Capital Expenditure;

Financial Management Page 2 of 68

as “Investment Decision Making, Capital Expenditure Decisions, Planning Capital

Capital project planning is the process by which companies allocate funds to

In a competitive economy, the economic viability and prosperity of a company depends

MEANING AND NATURE OF CAPITAL BUDGETING:

Financial Management Page 3 of 68

:-Prof., I.M. Pandey

A. The search for new and more profitable investment proposals.

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FEATURES OF CAPITAL BUDGETING DECISIONS:

Capital Budgeting decisions have the following features;

1. They benefit future periods.

Some of the examples of Capital Budgeting decisions are;

1. Introduction of new product.

SIGNIFIANCE OF CAPITAL BUDGETING DECISIONS:

Capital Budgeting Decisions are significant due to the following reasons;

Financial Management Page 5 of 68

Financial Management Page 6 of 68

OBSTACLES FOR CAPITAL BUDGETING:

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CAPITAL BUDGETING PROCESS:

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1. Identification of Investment Proposals:

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Preparation of a capital expenditure budgeting and incorporation of a particular proposal

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PROCESS / STEPS OF CAPITAL BUDGETING:

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techniques available for measurement (range, standard deviation, coefficient of variation)

PRINCIPLES OF CAPITAL BUDGETIG:

1. Creative search for profitable opportunities: profitable investment opportunities should be

Financial Management Page 14 of 68

RANKING OF CAPITAL BUDGETING PROPOSALS/ CLASSIFICATION OF

The overall objective of Capital Budgeting is to maximise the profitability of a firm or

A. Those which increase revenues; and

Financial Management Page 15 of 68

Further, in view of the investment proposals under consideration, capital budgeting

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1. Mutually exclusive investment proposals.

1. Mutually Exclusive Investment Proposals:

FACTORS INFLUENING CAPITAL EXPENDITURE DECISIONS:

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CAPITAL BUDGETING APPRAISAL METHODS:

In view of the significance of capital budgeting decisions, it is absolutely necessary that

1. A basis of distinguishing between acceptable and non – acceptable projects.

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Investing Rs 10 lacs……………. 1lacs as cash inflow

Without considering TVM………….No profit and No

Investing Rs 10 lacs……………. For next 5 years 3lacs

Financial Management Page 20 of 68

PROFIT AND LOSS ACCOUNT (INCOME STATEMENT)