Chapter 11 ee oe : . Capital Budgeting ce of Capital Budgeting; Capital i Proposals; Pay-back Period Method; y-Back Method: Disadvantages f “Approach to Payback Period; 4 Payback Period: Payback Reciprocal “1 Method; Merits of Net Present Value 4: Profitability Index Number; Capital retical Questions; Practical Problems Importan tment tages of Pa} Traditional Hicaning of Capital Budgeting Budgeting Process; Evaluation of Inve: Acceptance or Reject Criterion; ‘Advanl of Pay-Back Method; Improvement 10 Post Payback Profitability; Discounts Rote of Return Methods Time Adjust Method; Internal Rate of Return Meth Rationing; Objective Type Questions: Theo! of Capital Budgeting is the process 0! firm always moves a need for expanding making investment decisions in the capital expenditures. ahead, its fixed assets and other resources continue to them, Capital budgeting is actually the process of ture, or fixed assets. ‘A capital expenditure may be 4 to be received over a period of time exceeding tended to benefit future periods and normally Jopment projects. It is essentially a long-term ‘on Making, Capital Expenditure Meaning Capital budgeting [A progressive business expand or there comes ‘making investment decisions in capital expendi ean expenditure the benefits of which are expecte’ fone year. Capital expenditure is one which is int includes investments in fixed assets and other devel function. Capital budgeting is also known as Investment Decisi Decisions, Planning Capital Expenditure etc. Capital budgeting is the most important and complicated problem of managerial decisions. Because it is concemed with designing and carrying out through a systematic investmen! programme. It involves the planning of such expenditures which provide yields over a number of years. Charles T Homgreen has defined capital budgeting as, “Capital budgeting is long-tem™ planning for making and financing proposed capital outlays.” ‘According to Philippatos, “Capital budgeting is concerned w scare financial resources among the available market opportunities. TI opportunities involves the comparison of the expected future streams of ea with the immediate and subsequent streams of expenditure for it.” Richard and Green have defined “Capital budgeting as acquiring inp cation of the firm's investment project ith the allo the consideration of i mings from @ wuts with long" return.” ‘According to Lynch, “Capital budgeti ib t ly geting consist: f available capt! forthe purpose of maximising the Tongsterm ee i 600 a © Scanned with OKEN ScannerETING 601 INVESTMENT DECISIONS . ci e essenti jar al budgeting decisions are essentially a long-term function. Pi GF ‘are invested in long-term assets, ge fund a future benelits They involve the exchange of current funds forthe benefits to be achieved in futur. Thay have a significant effect on the profitability of the concerns ‘They are “strategic” investment decisions. They ate ireversible decisions. occur to the firm over a series of years. Capi budgeting has 0 vital role to play in the broader process of strategic planning and i! control. Capital budgeting systems should strive to create an atmosphere which foie te generation of new investment proposals and evaluates them as accurately as enti. However, loss-making proposals must be identified at the earliest possible moment. ortance of Capital Budgeting Capital budgeting means planning for capital assets. Capital budgeting decisions are among enon ercial and critical business decisions. ts the most important single area of decision- sete fr the management. Unsound investment decision may prove to be fatal to the very mavenee ofthe concern, The significance of capital budgeting arses mainly due to the following: () Large Investment Capital budgeting decisions, generally, involve large investment of funds. The funds available sits the firm are always limited and the demand for the funds far exceeds the resources. These fds are raised by the firm from various internal and external resources at substantial cost of dial, A wrong decision prove disastrous for the continued survival of the firm. Hence itis very inportant for a firm to plan and control its capital expenditure. (2) Long-term Commitment of Funds ‘The funds involved in capital expenditure are not only large but more or less permanently tHocked also in long-term investment. The longer the time, the greater the risk involved. Greater the risk involved, greater is the need for careful planning of capital expenditure i.e. capital tudgeting. The long-term commitment of funds increases the financial risk involved in the investment decision. Firm’s decision to invest in long-term assets has a decisive influence on the rae and direction of its growth. An unsound investment decision may prove to be fatal to the very caistence of the firm, Hence a careful planning is essential. (3) Irreversible in nature Most investment decisions are irreversible. Once the decision for acquiring a permanent aset is taken, it is very difficult to reverse that decision. Itis difficult to find a market of such capital goods once they have been acquired. The only alternative will be to serap the capital assets % purchased or sell them at a substantial loss in the event of the decision being proved! wrong (4) Complicacies of Investment Decisions __ The long-term investment decisions are more complicated in mature, The capital budgeting saison require an assessment of fature events which are uncer iis cally cl sk fo ipnale the probable future events. In most projects the investment of fiands has to be made mediately but the returns are expected over a number of future years. Both returns as well as the ‘ ae of the period over which they will accrue are uncertain. Long-term Effect on Profitability ae = Capital budgeting decisions have a long-term and significant effect on the profitability of a janeem. Capital budgeting is of utmost importance to avoid over-investment oF uunder-investment xed assets, An unwise decision may prove disastrous and fatal to the very existence of the mp ~ © Scanned with OKEN Scanner| MANAGEMENT a, Coo 602 Ng lity of the firm depends upon the iny wth and profitability of d stent cal arene projets exercise eeat impact onthe profabily riety for a very long. time. ©) National a nl individual concer is of rations impora oo tivities and economic growth, determines employment, economic 2 Capital Budgeting Se mee process as it involves decisions to the investnento¢ Capital budgeting pieved in future and te futures always uncertain capi jug fands for the le i oe eof steps depending upon the siz ofthe concer, nate ofp pers a Jexities and diversities etc. ‘That is, capital budgeting decisions of g fim their SE aes on the entire spectrum of entrepreneurial activities. Hence they eqn” 2 PE on and knowiedge of various disciplines fr thei effective adminiseaion ses aaeaoreial control, In order to teal these elements, a financial manager must keep in mind ye rar dimensions of capital budgeting programme — policy, plan and programme. These the py constitute a sound capital budgeting programme. ; Quinn G Davi has suggested that (2) project generation, (b) project evaluation, (Pig selection and (d) Project execution are the important steps involved in a capital budgeting proce However, the following procedure may be adopted in the process of capital budgeting, 8 becaie Identification of Investment Proposals Performance Review ‘Screening the Proposals Implementing?’ Captital Budgeting Process Evaluation of various proposals Establishing Priorities Capital Budgeting Process. (1) Identification of Investment Proposals ‘ Investment opportunities have tobe identified or searched for: they do not occur automaticly The capital budgeting process begins with the identification of investment proposals. The fist igs in capital budgeting process is the conception of a profit-making idea. Investment proposts © various types may originate at different levels within a firm, depending on their nature. THY M™®) originate from the level of workers to toy inthe nate f : !P management level. Most of the proposals, inthe of eost reduction or replacement or proc ess for ace at plant lev: Proposal for adding new product may a ea “ae mrketng deparmet or from * machen, Nhe thinks of a better way of utilising idle capacity. Suggestions for replace head analyss ovine the production techniques may arise atthe factory level. “ot analyses the various proposals in the light of the corporate strategies and submits SY! | © Scanned with OKEN Scannera GETING “al BUD! ol 603 1s to the capital expenditure planning committee in case of large organisation or to the re + aeemed with the process of long-term investment decisions. of ia continuous flow of profitable capital expenditure proposals is itself an indications of a and vital businesss concem. Although business may pursue many goals, survivals and verily are two of the most important objectives. @ screening the Proposals sereening and selection procedures would differ from firm to firm. Each proposal is then atjsted to @ preliminary screening process in order to assess whether itis technically feasible; Sources required are available and the expected retums are adequate to compensate for the risk {rolved. In large organisations, a capital expenditure planning committee is established for fereening of various proposals received from different departments. The committee views these rropostls from various angles to ensure that these are in accordance with the corporate strategies or pectin criterion of the firm and also do not lead to departmental imbalances. All care must be taken inselecting a criterion to judge the desirability of the projects. The criterion selected should be a true measure of the investment project's profitability, and as far as possible, it must be consistent with the fim's objective of maximising its market value. This stage involves the comparison of the proposals with other projects according to criteria of the firm. This is done either by financial manager or by a capital expenditure planning committe. Such criteria should encompass the supply and cost of capital and the expected returns from alternative investment opportunities. (3) Evaluation of Various Proposals The next step in the proposals. If a proposal s | budgeting process is to evaluate the profitability of various isfies the screening process, it is then analysed in more detail by gathering technical, economic and other data. Projects are also classified, for example, new products or expansion or improvement and ranked within each classification with respect to Profitability, risk and degree of urgency. There are many methods which may be used for this purpose such as pay back pei 1d method, rate of return method, net present value method etc. All these methods of evaluating profitability of capital investment proposals have been discussed in ‘etal separately in the following pages of this chapter. The various proposals of investments may be classified as: (a) Mutually exclusive proposals (b) Independent proposals (©) Contingent or dependent proposals. Mutually exclusive proposals serve the same purpose and compete with each other in a way at the acceptance of one precludes the acceptance of other or others. Thus, two or more mutally ‘Xclusive proposals cannot both or all be accepted. Some technique has to be used for selecting ‘he better or the best one. Once this is done, other alternatives automatically gets eliminated. A fmPany may, for instance, propose to use semi-automatic machine or highly automatic machine t production. Here choosing the highly automatic machine precludes the acceptance of the semi- Sulomatic machine. Independent proposals are those which do not compete with one another and the same may a er accepted or rejected on the basis of minimum return on investment required. For instance, ‘en there are two proposals, a firm can undertake both the proposals. of gg. omingent oF dependent proposals are those whose acceptance depends upon the asepiance it put OF More other proposals. For instance, a firm decides to build a factory in a = se my have to invest in houses, hospitals, roads etc. for the staff. Thus, building a factory ba ine investment in facilities for employees. The total investment will be treated as a sing] lent, © Scanned with OKEN ScannerMANAGEMENT accoyy NT 604 Ng 1 Ss esting a on me en rea Afi evalua profitable proposals PY Thus. itis essential to mage The accepted proposal Ly in all the acceptable propo: cy, risk and Fank the Yatioy, fi vest immedi irs afer considering UBETES Probl ight proposals and t0 es therein. al to the top m: (5) Final Approv: the committee are sent P Management al ¢ Proposals finally recommended PY 1d of sources of capital. Financial may ‘dies 0 Ong with inure ag 1 dotailed report, both of api penditre ‘budgets. When capital expenditure props il POsals ve ca psent sever aera carl fr tem, Projects ae then sent 10 the Budget comming finally selected, incorporating them in the capital rl als (6) implemen el epets budgeting and incorporation of 8 particular propos ¢ or elf authorise to go ahead withthe implementation ofthe project A req the budget does no end the amount should further be made to the capital expenditure commits to review the profitability of the project in the changed circumstances, Futher vile implementing the project. it is better to assign responsibilities bo completing the projet vnithin the given time frame and cost limit so as to avoid unnecessary delays and cost ove Network techniques used inthe project management such as PERT and CPM can also be appli {o control and monitor the implementation of the projects (7) Performance Review Last but not the least important step in the capital budgeting process is an evaluation of the performance of the project. ated. It is the duty of the top or executive committee to ens are spent in accordance with the de in the capital budget. A co capital expenditure is very much essential and for that purpose a monthly report showing the amount allocated, amount spent, amount approved but not spent should be prepared and submitted to the controller. The evaluation is made through post completion audit by way of comparison of actual expenditure on the project with the budgeted one, and also by comparing im from the investment with the anticipated return. The unfavourable variances, if any, should be looked into and the causes of the same be identified so that corrective action may be taken in future Evaluation of Investment Proposals . The funds available with the firm are always limited and it is not possible to invest funds in all the proposals at a time. Therefore, it is very essential to select from amongst the various competing Proposals, those which give the highest benefit. A firm may face a situation where more investment proposals may be available than investible funds. Some proposals may be good, som! ‘moderate and some may be poor, The management has to select the most profitable project ot © {ake up the most Profitable project first. There are many considerations, economic as well a5 10%. the ume. Which influence the capital budgeting decisions. Because of the utmost imporan © Capital budgeting decision, a sound appraisal method should be adopted to m=ssu ‘economic worth of each inv gear A I e estment project. i 7 so in the sense that current investm< ras beset th ve cal ler it has been full ¢ actual © Scanned with OKEN Scanner605 ate those projects which deserve first priority in terms of their profitability. While wo wo basic principles are kept in mind, namely, the bigger benefits are always ant to small ones and that early benefits are always better than the deferred ones. The jee operty of sound evaluation technique is that it should maximise the shareholders ome ‘the following other characteristic should also be possessed by a sound investment vet ton criterion: ; : coiatot Should provide @ means of distinguishing between acceptable and unacceptable rojects. ait ‘Should provide clear cut ranking of the projects in order of the profitability or desirability. 4, It should also solve the problem of choosing among alternative projects. 4. tt should be @ criterion which is applicable to any conceivable investment project. 5. It should emphasize upon early and bigger cash benefits in comparison to distant and smaller benefits. 6, The method should be suitable according to the nature and size of capital project to be ed yethods of Evaluating Capital Investment Proposals ‘A number of appraisal methods may be recommended for evaluating the capital expenditure joposls. The most important and commonly used methods a TRADITIONAL METHODS: 1. Pay-back period Method or Pay-out or Pay-off Method. 2. Improvements in Traditional Approach to Pay-back period Method. 3, Rate of Return Method or counting Method. Time Adjusted Methods or Accounting Methods 4. Net Present Value Method. 5. Internal Rate of Retum Method. 6. Profitability Index Method. Traditional Methods (1) Pay-back Period Method The term pay-back (or pay out or pay off or break-even period or recoupment period) refers ‘othe period in which the project will generate the necessary cash to recoup the initial investment, Business units, while selecting investment projects, would consider the recovery of cost as the first 2d foremost concern even though earning maximum profits is their ultimate goal. This method scribes in terms of period of time the relationship between annual savings (cash inflow) and total Mount of capital expenditure (investment), pay-back period is defined as the number of years "quired for the savings in costs or net cash inflow (after tax but before depreciation) to reCouP ie Original cost of the project. In simple sentence, it represents the number of years in which i ‘stment is expected to “pay for itself”. Under this method, various investments are nit ‘cording tothe length of their pay-back period in such a manner that the investment with a shorter ae Period is preferred to the one which has longer pay-back period. ation of pay-back period In the case of even cash inflows — the annual cash inflows are constant, the pay-back period can be computed By diving Hogqtt4y (original investment) by annual cash inflows. For instance, ifa facie elroe 1200 as inital investment and it will generate an annual cash inflow of Rs. 2,500 for ten Yeats, Pay-back period will be 4 years, calculated as follows: © Scanned with OKEN Scanner606 Coy Initial Investment Pay-back period = Fal Cash Inflow Rs.10,000 *"Rs.2,500 ven inflows farm the alvlton of pay-back Ptid takes cums, the payback period can be found out by adding up the figure of pet gf need oul cal to initial investment. For instance, if a project requires an initial ion at ae sd and the annual inflows for 5 years are Rs. 3,000; Rs. 4,000; Rs, 2500; nea, ood #2000 respenively the pay-back period will be calculated as follows,” RS. =4 years, (b) In the case of unevé If cash inflows are not uni Year ‘Annual Cash Cumulative Cash Inflows Inflows Rs. Rs. 1 3,000 3,000 2 4,000 7,000 3 2,500 9,500 4. 2,000 11,500 5. 2,000 13,500 The above workings show that in 3 yeas Rs 9,500 has been recovered. RS. 500 isle gg of inal investment Inthe fourth year the eash inflow is Rs. 2,000 It means the pay-tsk pn is between 3 to 4 years, calculated as follows: Pay-back period = 3 years + 5 = 3.25 years Ilustration 1. Payoff Lid. is producing articles mostly by manual labour and is considering replace it by a new machine, There are two alternative models M and N of the new mactine Prepare a statement of profitability showing the pay-back period from the following inforntne Machine M Machine N Estimated life of machine 4 years 5 years Cost of machine Rs. 9,000 Rs. 18,000 Estimated savings in scrap Rs. 500 Rs. 800 Estimated savings in direct wages Rs, 6,000 Rs. 8,000 Additional cost of maintenance Rs. 800 Rs. 1,000 Additional cost of supervision Rs. 1.200 Rs. 1,800 (M.Com. Madurai) Solution: Statement showing annual cash inflows Machine Wf ‘Machine N Bs. Bs Estimated savings in scrap 300 800 Estimated savings in direct wages 6,000 000 Total savings (A) 6,500 8,800 Additional cost of maintenance “300 1,000 Additional cost of supervision 1,200 1,800 Total additional cost (B) 2,000 2,800 | © Scanned with OKEN Scannerr | pA — d ; Original Investment pay-back period = “Annual Average Cash Inflow Rs. 9,000 Rs. 18,000 - = 000 _ Rs. 4,500 "> “Re 099 73 Years Machine M should be preferred because it has a shorter pay-back period. eceptance OF reject criterion Many firms use the pay-back period as an accept or reject criterion as well as a method of sxing projects. Ifthe pay-back period calculated for a project is less than the maximum pay-back wrid set by management, it would be accepted; if not, it would be rejected. As a ranking method, fives highest ranking to the project which has shortest pay-back period and lowest ranking to the project with highest pay-back period. Thus, if the firm has to choose among two mutually ‘aclusive projects, project with shorter pay-back period will be selected. Advantages of pay-back method 1, It is easy to calculate and simple to understand. 2. It saves in cost, a it requires lesser times and labour as compared to other methods. 3. Under this method, a shorter pay-back period is preferred to the one having a longer pay- back period, and 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 obsolescen 4, This method is useful to a concern which is short of cash and is eager to get back the cash invested in a capital expenditure project. 5. As the method considers the cash flows during the pay-back period of the project, the estimates would be reliable and the result may be comparatively more accurate. Disadvantages of pay-back method 1. Itdoes not take into account the cash inflows earned after the pay back period and hence the true profitability of the project cannot be correctly assessed. 2. This method does not consider the amount of profit eared on investment after the recovery of cost of investment. 3 3. It does not take into consideration the cost of capital which is a very important factor in making a sound investment decisions. i 4. It may be difficult to determine the minimum acceptable pay-back period, it is ‘usually, a subjective decision. + 5. It ignores interest factor which is considered to be a very significant factor in taking ¢, umd investment decision. ‘Too much emphasis on the “liquidity of the investment”, ignoring the “profitability of investment” may not be justified in a number of situations. seul 1. Iignores time value of money. Cash flows received indifferent years are treated equally. 8. It does not take into account the life of the project, depreciation, scrap-value, interest factor etc. Because, a rupee tomorrow is worth less than a rupee today: &) Improvement in Traditional .Approach to pay-back period cpomptuatn the One of the most commonly used techniques for evaluating capital investment Props’ 1 ca Pay-back or pay-back method. Some authorities on accountancy, 9 order to make up fi itiencies of the pay-back period method, evolved new concepts. The improvements are “Scussed below. | © Scanned with OKEN Scanner608 itability (A) Post pay-back profitabi “ One of the limitations of the pay-back period investment beyond the pay-b a | MANAGEMENT ACCOU ING method is that i period. This method is also known a Surplus Life oye hod the project which gives the greatest post pay-back per it neglects the Profit of Pay-agt ; a ¥ : period. Aecoding to his Mer plained in the following illustration: 0d Prof, may be accepted. It has been Post pay-back profitability = Ar Further, post pay-back profitabil formula with 100. Mlustratic respect of them: ‘nnual Cash Inflow (Estimated Life ~ pay-back lity index can also be calculated by multiply Project X Cost (Rs.) 1,40,000 Economic Life (in years) 10 Estimated scrap (in Rs.) 10,000 Annual Savings 25,000 Petiog) 18 he above on 2, A Concem is considering two projects X and Y. Following are the partculay : : Project Y 1,40,000 10 14,000 20,000 Ignoring income-ax, recommend the best of these projets using (a) pay-back pig, post pay-back profit, and (c) Index of post payback profit. Solution Cost Savings Pay-back period Economic Life Surplus Life Post pay-back profit (2 « 5) ayeepe 7. Index of post pay-back profit Project X 1,40,000 25,000 5.6 years 10 years 44 years Rs. 1,10,000 1,10,000 1,40,000 = 78.6% «100 Project X is the best one by all the methods of ranking. (B) Discounted Pay-back Period Project Y 140,000 20,000 7 years 10 years 3 years Rs. 60,000 60,000 1,40,000 12.9% 100 Another serious limitation of pay-back period method is that it ignores the time value o money. This method can be improved or modified to consider the time value of ‘money. Under this method the present values of ll cash outflows and inflows are computed at an appropriate discount rate, The number of periods taken in recovering the investment outlay on the present value bss is called the discounted pay-back period. The present values of all inflows are cumulated in onder of time. The time period at which the cumulated present value of cash inflows equals the pres! value of cash outflows is known as discounted payback period, Mlustration 3, The following are the Particulars relating to a project. Cost of the project Operating Savings: Ist year 2nd year 3rd year 4th year Sth year Bs. 50,000 5,000 20,000 30,000 30,000 10,000 | © Scanned with OKEN Scannery ral guDGETING sa if of Fea sane : ay-back period ignoring interest factor and (6) discount pay-back peri se factor at 10%. seit tra o oe it ray-back period @ Year Annual Savings Cumulative Savings Rs. Rs, 1 5,000 5,000 2 20,000 25,000 3 30,000 55,000 Upto second year, Rs. 25,000 recovered se Rs. 50,000 — Rs. 25,000 fore, pay-back period = 2 years + $8-20.000— Rs. 25,000. ee Rs. 30,000 __ Rs.25,000 Rs. 30,000 = 2 years 10 months (#) Discounted pay-back period at 10% interest factor Savings PV Factor Discounted Savings _ Cumulative Discounted Savings Rs Rs. Bs. 1 5,000 0.9091 4.546 4,546 2 20,000 0.8265 16,530 21,076 3 30,000 0.7513 22,539 43,615 4 30,000 0.6830 20,490 64,105 Meme _, Rs.50,000~ 43,615 uunted pay-back pe years mae years 4 months () Pay-back Reciprocal : Sometimes, pay-back reciprocal method is employed to estimate the internal rate of return Benerated by a project. Annual Cash Inflow Total Investment However, this method of ranking investment proposals should be used only when: (@) Annual savings are even for the entire period. a (®) The economic life of the project is at least twice of the pay-back period. ) Rate of Return Method (Accounting Method) ee is method is also known as Accounting Rate of Return method or Renum on Mihi or ye ee Rate of Return method. According to this method, various projects are id other,“ Of earnings or rate or return. Projects which yield the highest eamings are cam an *S are ruled out. The retum on investment can be expressed in several ways, as 5: Avera ige Rate of Return Method eae toy lets average profit, after tax and depreciation, is ealeulated and ee is divided by 7 ave tPital outlay or total investment in the project. This method establishes the ra e '8€ annual profits to total outlay. Pay-back Reciprocal = 1 © Scanned with OKEN Scanner> | MANAGEMENT, Accoy i 610 Ng Average Rate of Return = lay of Projet giving a higher rate of return will be preferred over those giving lower rage nt Method turn Per unit of Investme! Bee 7 rns method, the total profit after tax and depreciation is divided by the tot invey This ges us the average rate of return per unit of amount invested inthe proje, "en ; Total Profit Return Per unit of Investment = Yor tavestment OF eta 100 (c) Return on Average Investment Method ; : Under this method the percentage return on average amount of investment is cal calculate the average investment, the outlay of the project is divided by two, Total Profit after Depre. & Taxes Return on Average Investment = Total Net Investment? leulated, 7, (d) Average Return on Average Investment Method Under this method, average profit after depreciation and taxes is divided by th amount of investment. This is an appropriate method of rate of return on investment, 1 average : = Average Annual Profit 5 Average Retum on Average Investment = Syn Mlustration 4. Calculate the average rate of return for projects A and B from the following: Project A Project B Investment Rs, 20,000 Rs, 30,000 Expected Life (no salvage value) 4 years 5 years Projected Net Income, after interest, depreciation and taxes: Years Project A Project B Rs. Bs. 1 2,000 3,000 2 1,500 3,000 3 1,500 2,000 4 1,000 1,000 5 i 1,000 Total: 6000 ™10,000— If the required rate of return is 12% which project should be undertaken? Solution: Project A Project B Bs Re Total profit, after interest, depre- 6,000 10,000 ciation and taxes Expected Life - 5 years mee Profit 1300 ps 2000 Investment Rs, 20,000 Rs, 30,000 ‘Avert ; 1500 oy 2,000 499 =66% ge Rate of Return 2.009 *100= 7.5% =y0 Average Return on Average | 1500 _ 199 1504 0B Investment 20,000/2 © Scanned with OKEN Scanner- qx. BUDGETING 611 average return on average investment is higher in the case of project A, besides it is also The ine required rate of return of 12%. Project Ais suggested to be undertaken. ig of Rate of Return Method ee following are the merits: 1 itis simple to understand and easy to calculate 2, takes into consideration the total earnings from the project during its life time. Thus this method gives a better view of profitability as compared to pay-back period method. 3, It is based upon accounting concept of profit. It can be calculated from the financial data. merits of Rate of Return method ‘This method suffers from the following demerits: 1. Itignores the time value of money. Profits earned in different periods are valued equally. 2. This method may not reveal true and fair view in the case of long-term investments. 3. It does not take into consideration the cash flows which is more important than the accounting profits. ores the fact that profits can be reinvested. ‘There are different methods for calculating the Accounting Rate of Retum. Each method gives different results. This reduces the reliability of the method. Time Adjusted Method (Discounted Cash Flow Method) Discounting is just opposite of compounding. In compound rate of interest, the future value ofthe present money is ascertained whereas in discounting, the present value of future money is aikulated, The rate at which the future cash flows are reduced to their present value is termed as dscount rate, Discount rate, otherwise called time value of money, is some interest rate which fapresses the time preference for a particular future cash flow. The discounted cash flow method is an improvement on the pay-back method as well as ‘counting rate of return, This method is based on the fact that future value of money will not be ‘wal tthe present value of money. That is, discounted cash flow technique recognises that Re. ®e of today (cash outflow) is worth more than Re.one received at a future date (cash inflow). The ‘ie adjusted or discounted cash flow method take into account the profitability and also the time ‘she of money. The discounted cash flow method for evaluating capital investment Proposals are pes: ' Net Present Value Method oo This method is also known as Excess Present Value or Net Gain Method or Time Adjusted Ntods. Under this method, cash inflows and cash outflows associated with each project are first Out. The present values of these cash inflows and outflows are then caleulated at the - ble to the management. This rate of return is considered as the cut-off rate and is generally i : ; : involved ‘ tees on the basis of cost of capital suitably adjusted to allow for the risk element inv yect, De - sh ay, The present values of total of cash inflows should be compared with present values = ve of caja’ I the present value ofeach inflows are arate than (or equal f) the present value of jitlows (or initial investment, the project would be accepted. If itis es, then Propossl wi “ ith the followi ‘qin S. A Company is considering the purchase of the two machines with the following k f © Scanned with OKEN Scannerfe. "| MANAGEMENT Acco, 612 hg Machine I Machine wr ‘ Life Estimated 5 years ine si r 2, Capital Cost 10,000 10,000 -apil Net earning ater 00 _ mt dep 7,000 i 4,000 10,000 3rd year You are required to suggest whieh machine should be preferred. fou a Solutio Value (10%) Se ra aT Machine Tear Cash Present Value | Cash | Preven Inflow Rs. Inflow be Rs. Rs. T 0.905 3000 T2T 2000 TE 2 0.826 6,000 4,956 7,000 578 3 0.751 4,000 3,004 10,000 Isi0 15,232 15,110 Less: Cost of Net Present value 10,000 10,000 3,232 5110 Machine I should be preferred as net present value is Rs. 5,232 which is higher than Rs 5,110 in case of Machine II. Merits of Net Present Value Method The merits of this method of evaluating investment proposal are as follows: 1. This method considers the entire economic life of the project. 2. It takes into account the objective of maximum profitability. 3. It recognises the time value of money. 4, This method can be applied where cash inflows are uneven. 5. It facilitates comparison between projects. Demerits of this method are as follows: 1. It is not easy to determine an appropriate discount rate. 2. It involves a great deal of calculations. It is more difficult to understand and operat 3. Its very difficult to forecast the economic life of any investment exactly. 4. Itmay not give good results while comparing projects with unequal investment of funds 2. Internal Rate of Return Method yi stv rie mals pops known as time adjusted rate of return method of scum vale ofthe expose itera hen of return is defined as the interest rate that cant eof i found by tal ead ne ees 0 the cost of the investment outlay. This nerne A Fm a , we compute the present value of the cas! i es bain a an arbitrarily selected interest rate, Then, we compare the prs ef rate of interes tment cost. Ifthe present value is higher than the cost Figures NE es the cost lower ne thtoueh the procedure again. Conversely, if the present valle equality is defined cn reSt 1 and repeat the process. The interest rate that BM. cat fined as the internal rate of return, This rate of return is compared '° | © Scanned with OKEN Scannery 1 et BuDGETING 613 roject having higher difference, if they are i oo med {As this determination of intemal Seca nee cone resebe preset value of earnings equal to the investment, this approach is also called the Trial ° eth : a Initial Investment Rs. 60,000 gusta of the Asset 4 years timated net annual cash-flows: Ist year Rs. 15,000 and year Rs. 20,000 j 3rd year Rs, 30,000 4th year Rs. 20,000 Calculate Internal Rate of Return, solution: Calculation of Internal Rate of Return ie Amal PYF PVE PVF Ta cashflow __10°6 py |_ 12% | pv _| 14% 15% | PY i 15,000 0.909 13,635 | 0.892 [13380 | 0.877 0.869 | 13,035 a 20,000 0.826 16,520 | 0.797 | 15,940 | 0.769 0.756 | 15,120 4 30,000 0,751 22,530 | 0.711 | 21,330. | 0.674 0.657 | 19,710 4 20,000 0.683 13,660] 0.635 | 12. 0.592 osm {11,420 Thal of PV of Cash inflow 66.345 63.350 59,285 Initial investment is Rs. 60,000, Hence internal rate of return must be between 14% and 15% (Rs, 60,595 and Rs, 59,285). The difference comes to Rs. 1,310 (Rs. 60,595 — Rs. 59,285). For a difference of 1,310, difference in rate = 1% (Excess PV: 60595 — 60,000 = 595) Therefore, exact Internal Rate of Retum = 14% + 7375%1% 14% + 0.45% 4.45% 3. Profitability Index Number Itis also a time adjusted method of evaluating the investment proposals. Profitability index 4k called Benefit Cost Ratio or Desirability factor. It is the ratio of the present value of cash infows, at the required rate of return to the initial cash outflow of the investment. The proposal ‘accepted if the profitability index is more than one and is rejected in case the profitability index ‘sles than one. By computing profitability indices for various projects, the financial manager can ‘mk them in order of their respective ratio of profitability. PV of Cash Inflows Tastes Initial Cost Qutlay “Stration 7, The initial cash outlay of a project is Rs. 50,000. Estimated cash inflows: Ist year Rs, 20,000 2nd year Rs. 15,000 3rd year Rs, 25,000 ._ ath year Rs. 10,000 Compute profitability Index Profitability Inde m © Scanned with OKEN Scanneros" MANAGEMENT Acco, 614 hy ee Calculation of Profitability Index Year Cash Inflows | PV Factor at 10% + Rs. 7 T 20,000 0.909 18,189 2 15,000 0.826 12399 3 25,000 0.751 8s 4 10,000 0.683, 683 Total 36175 Total Present Value = Rs. 56,175 Less: Initial Outlay Net Present Value s. 50,000 6,175 PY of Cash Inflow Initial Cash Outflow Profitability Index (gross) = ~ 30175 hans 50,000 Profitability Index is higher than 1, the proposal can be accepted, NPV Rs. 6,175 iit ST eh eS = 0.1235 Net Profitability Indox Initial Cash Outlay Rs. 50,000 - "13 or NPI = 1.1235 - 1 = 0.12 Net Profitability Index is positive, the proposal can be accepted. Capital Rationing Capital rationing is situation where a firm has more investment proposals than it an finance. Many concems have limited funds. Therefore, all profitable investment proposal may nt be accepted at a time. In such event the firm has to select from amongst the various competing Proposals, those which give the highest benefits, There comes the problem of rationing them. Ths capital rationing may be defined as a situation where the management has more profitable investment proposals requiring more amount of finance than the funds available tthe fm, @ situation, the firm has not only to select Profitable investment proposals but also to rank the Projects from the highest to lowest priority, Mlustration 8. X Ltd. is considering and B. The cost of each machine is Profits before tax but after depreciat A ig the purchase of a machine. Two machines are axa? Rs. 60,000. Each machine has an expected life of 5 inte tion during the expected life of the machine are given Year Machine A Machine B Rs Rs. 1 15,000 5,000 2 20,000 15,000 3 25,000 20,000 4 15,000 30,000 5 10,000 20,000 wil Following the method of retum on investment ascertain which of the alterat¥® more profitable. The average rate of tax may be taken at 50%, 4 © Scanned with OKEN ScannerING ann BUDGET 615 ont 8 Computation of Profit After Tax a ‘Machine A Wacko F = @ W Profit | Tax at 50% | Profit | Profit before | Tax at 50% | — Profi before Tax after Tax Tax fate Rs. Rs. Rs. Bs. i 7 a 15,000 7,500 7,500 5,000 2,500 2,500 ; 20,000 10,000. 10,000 15,000 7,500 7500 | } 25,000 12,500 12,500 20,000 10,000 10,000 i: 15,000 7,500 7,500 30,000 15,000 15,000 ; 10,000 5,000 5,000 20,000 10,000 10,000 “erat [_ 85,000 42,500 42,500 90,000 45,000 45,000 Machine A Machine B Average profit after tax Rs.8,500 eae =Rs.9,000 investment Rs. 60,000 Rs. 60,000 Average Investment, = =Rs.30,000 | R8:60.000 _ 630,000 8, y, | Rs.9,000 : Average Return on Investment =o gn MOOR IEIT% | Eg x10 = 15% Rs. 8,500 og | RS9:000 100 ano Average Return on Average Investment | ~36 gq *100=28:34% | “39 ggg %100=30% Machine B is more profitable. lbsteation 9. A Ltd. Company is considering the purchase of a new machine which will carry out some operations performed by labour. X and Y are altemative models. From the following information, you are required to prepare a profitability statement and work out the pay-back period ‘or each model. Estimated Life Cost of Machine Cost of indirect materials Estimated savings in scrap Additional cost of maintenance Estimated savings in direct wages: Employees not required Wages per employee Taxation to be regarded 50% of profit before charging ‘commend? S Model X Rs. 5 years 1,50,000 6,000 10,000 19,000 150 600 depreciat Model Y Rs. 6 years 2,50,000 8,000 15,000 27,000 200 600 jon. Which model would you (CA final) © Scanned with OKEN Scanner616 Profitability Suse Rs. Tea} Rs ‘Esnmated saving per er 19,00 * Wages (50 * Oe 7,00,000 ae Less: Additional Cost: i Cost of indirect materials 6,000 Cost of Maintenance 19000 ‘Additional Earnings Less: Tax @50% Cash flow (annual) 27,000] 2,50,000 + 6 Net Increase in earnings Cost of Machine Pay-back period: (erat Cash flow | 37.500 8,333 Rate of Return on Investment T0000 ‘ Zena 10-39% ‘As pay-back period of Model X is less than that of Model Y, and also the retum on Investment is higher in respect of X, Model X is recommended. Illustration 10. A Company proposing to expand its production can go either for an automatic machine costing Rs. 2,24,000 with an estimated life of cars or an ordinary machine costing Rs, 60,000 having an estimated life of 8 years. Automatic Ordinary Machine Machine Rs Bs. The annual sales and costs are es- timated as follows: a 1,50,000 1,50,000 Costs: Materials 50,000 50,000 Labour 12,000 60,000 Variable Overhead 24000 20,000 Compute the iv . ra) Pn comparative profitability under pay-back method. (Com. Madi ia Automatic: es Machine a ‘Rnnual Sales i 750.000 Less: Variable Cost 1,50,000 a Materials 50, 000 50,000 A © Scanned with OKEN Scannere OGETING ern pour 12,000 bverheads 24,000 igal Profit ww 24,000 _ py toek period: “64,000 y-back profitability | 64,000) 5 Post pa = Rs. 1,28,000 60,000 20,000 0,000 (8 ~ 3 yrs) = Rs. 1,00,000 sration 11. The Tamil Nadu Fertilizers Led. is considering a proposal for the investment of ft 300,000 on product development which is expected to generate net cash inflows for 6 years asunder: Year Net Cash Flows ('000) Nil 2 100 3 160 4 240 5 300 6 600 The following are the present value fac’ a1S% pa Year 1 3 4 5 6 Factor Os? 066 057 0.50 043 (M.Com. Madras) Solution: Calculation of Net Present Value Year Cash Inflows PY Factor Present Values 000) 000) Rs. Rs 1 Nil Nil 2 100 76.0 3 160 105.60 4 240 136.80 $s 300 0.50 150.00 6 600 0.43 258.00 Toual 726.40 Less: Cash Outlay Net Present Value As the net present value is positive, the proposal i strat Station 12. The Financial Manager of a company has to a 8 between two compelling project proposals which require an equal Soi "0,00 Nand are expected to generate cash flows as under: Project I Rs. End of year 1 48,000 2 32,000 me s acceptable. .dvise the Board of Directors on | investment of Rs. Project It Rs. 20,000 24,000 © Scanned with OKEN Scanner618 20,000 Nil 24,000 12,000 anew Which project proposal should be recommended and why? Assume the cost of ca 7 MANAGEMENT. AccOUN NG 36,000 48,000 16,000 8,000 10% p.a. The following are the present value factor at 10% pe ital toby 1 2 3 Foor 0.909 0.826 1 0.683 0.621 0 : (Com. Nan Solution: | Calculation of Net Present Value Year Project 1 Net | Project Il Net | PV Factor @ | PV of Project 1] PV of Project Cash Inflows | Cash Inflows 10% Te Te ae | 48,000 + 20,000 0.909 =i Tein 2 32,000 24,000 0.826 19,824 a 20,000 36,000 0.7: 27,036 4 Nil 48,000 0.683 Nil um 5 | 24,000 16,000 0621 14.904 tans 6 12,000 8,000 0.564 6.768 asia 1,06,756 12272 Less: Cash Outlay [1.00.00 [Long Net Present 6.156 127 Project II should be accepted as the NPV is more Mlustration 13, From the following informatio and suggest which of the two profits should be as than that of Project 1 late the net present value of the two projects suming a discount rate of 10% Profit X Profit ¥ Rs.+ Initial Investment 20,000 30,000 mated Life years 5 years p Value 1,000 2,000 Profits before depreciation and after taxes are as follows: Year Profit X Profit ¥ Rs Rs 1 5,000 20,000 2 10,000 10,000 3 10,000 5,000 4 3,000 3,000 5 2,000 2,000 (Com, Madr) Solution: Year Cash Flows PV of Re 1 @ | _ Present Value of Net 10% Cash Flow Prayer X| Project Pract —] rae cm RS. Bs. a 1 $,000 20,000 0.909 4545 110 | © Scanned with OKEN Scannerara BUDGETING 619 3 | 10,000 10,000 0.826 8,260 in 10,000 5,000 0.751 : 3 | 3,000 3,000 : pled 3,755 i x f 0.683 2,049 21049 5 eora acon 0.621 1,242 1242 a 0.621 621 1.242 24,227 34,728 20,000 30,000 4,227 4,728 Project Y should be selected as NPV of Project Y is higher. ysration 14. A Firm is considering the purchase of a machine, Two machines A and B are ing Rs. 50,000. In comparing th it sailable, each costing , iparing the profitability of those machi di ‘isto be used. Earnings after taxation are expected to be as follows: Year Machine A Cash Inflow, Machine B Cash Inflow Rs. Rs 1 15,000 5,000 2 20,000 15,000 3 25,000 20,000 4 15,000 30,000 5 10,000 20,000 You are also given the following data: Year PV Factor @ 10% discount 1 0.909 2 0.826 3 0.751 4 0.683 5 0.621 Evaluate the projects using: (@) the pay-back period (6) the accounting rate of return (0) the net present value (@) the profitability index (Com. Madurai) lution: (a) Machine A Year Cash Inflow ‘Cumulative cash Inflow Rs. Rs. 1 15,000 15,000 2 20,000 35,000 3 25,000 60,000 4 15,000 75,000 5 10,000 85,000 en recovered. Rs. 15,000 ‘lage Above calculation shows that in two years Rs. 35,000 has boon MANE A ut of initial investment. In the 3rd year cash inflow is Rs. 25,000. |S between 2nd and 3rd year, thus: 15,000 25,000 Paysback Period = 2 + = 2.6 years u . © Scanned with OKEN ScannerMANAGE ME yy ACO, 620 Mh Cumulative Cx Machine B Cash Inflow ‘ash Iny ue” tate Rs. i 5,000 5,000 1 15,000 20,000 2 20,000 40,000 3 30,000 70,000 4 20,000 90,000 sd. The balance left out of jr; 000 has been recovere Ut OF ini a0. ye Ry bck period is between 3rd and 4th year, this. Mey 9s, 10,000. i r 10,000 _ 3.33 years Pay-back Period = 3 * 30,000 Machine A should be purchased. Because pay-back period is less, ja Accounting Rate of Return ‘Machine A Le Total Retumns = Rs. 85, ‘Average Return = Rs. 85,000 + 5 = Rs. 17,000 17,000 199 _ 440 ‘Average Rate of Return = 55-999 %100= 34% Machine B ie Total Returns = Rs. 90,000 “Average return = 90,000 + 5 = Rs. 18,000 Average Rate of Retum = 18000 ae 50,000 Machine B should be preferred as it gives a higher average rate of return Net Present Value Calculation of Net Present Value 100 = 36% Year PV Factor | Cash Inflows | Cash Inflow | PV Machine A | PV Machine} at 10% Machine A Machine B Rs. Rs. Rs. Bs. i 0.909 15,000 5,000 13,635 4,545, 2 0.826 20,000 15,000 16,520 12390 3 0751 25,000 20,000 18,775 1.020 7 0.683 15,000 30,000 10,245 29490 0.621 10,000 20,000 6,210 12,420 65,385 eases Less: Cash Outlay 50,000 50,000 Net Present Value 15,385 sts The Net Preser Fi gpl eee nt Value of Machine A is more than that of Machine B, So, noche * Profitability Index Machine 4 = Present Values _ 65,385 Cost of Investment — 50,000 Machine B= > — 50,000 1297 x 308 Probability Inde) should be preferred. © °* M@ehine A is more than that of Machine B and theel™ © Scanned with OKEN ScannerYears 5% 6% 8% 10% 12% 14% % 16% 18% 20% 22% 24% 25% 28% 30% 0.952 0.913 0.926 0.909 0.893 0.877 0.870 0.862 0.847 0.833 0.820 0.806 0.800 0.781 0.769 0.907 0.890 0.857 0.826 0.797 0.769 0.756 0.743 0.718 0.694 0.672 0.650 0.640 0.610 0.592 0.840 0.794 0.751 0.712 0.675 0.658 0.641 0.609 0.579 0.551 0.524 0.512 0.477 (0.450 0.823 0.792 0.735 0.683 0.636 0.592 0.572 0.552 0.516 0.482 0.451 0.423 0.410 0.373 0.350 0.784 0.747 0.681 0.621 0.567 0.519 0.497 0.476 0.437 0.402 0.370 0.341. 0.328 0.291 0.269 y PRUE RS i ~ > E : : ¢ f ¢ 0.746 0.705 0.630 0.564 0.507 0.456 0.432 0.410 0.370 0.335 0.303 0.275 0.262 0.227 0.207 6 = 0.711 0.665 0.583 0.513 0.452 0.400 0.376 0.354 0.314 0.279 0.249 0.222. 0.210 0.170 0.159 8 0.677 0.627 0.540 0.467 0.404 0.351 0.327 0.305 0.266 0.233 0.204 0.179 0.118 0.139 0.123 9 0.645 0.592 0.500 0.424 0.361 0.308 0.284 0.263 0.225 0.193 0.167 0.144 0.134 0.108 = 0.094 10 0.614 0.558 0.463 0.386 0.322 0.270 0.247 0.227 0.191 0.162 0.137 0.116 0.107 0.085 0.073 11 0.585 0.527 0.429 (0.350 0.287 0.237 0.215 0.195 0.162 0.135 0.112 0.094 0.087 0.066 0.056 12 0.557 0.497 0.397 0.319 0.257 0.208 0.187 0.168 0.137 0.112 0.092 0.076 0.069 0.062 0.043 13 0.530 0.469 0.368 0.290 0.229 0.182 0.163 0.145 0.116 0.093 0.075 0.061 0.055 0.040 0.033 14 0.505 0.442 0.340 (0.263 «-:0.205-—«0.160 0.141 0.125 0.099 0.078 0.062 0.049 0.044 0.032 0.025 0417 0.315 0.239 0.183 0.140 0.123 0.108 0.084 0.065 0.051 0.040 0.035 0.025 0.020 0.458 0.394 0.292 0.218 0.163 0.123 0.107 0.093 0.071 0.054 0.042 (0.032 :0.028 0.019 0.015 17 0.436 0.371 0.270 0.198 0.146 0.108 0.093 0.80 0.060 0.045 0.034 0.026 0.023 0.015 0.012 18 0.416 0.350 0.250 0.180 0.130 0.095 0.081 0.069 0.051 0.038 + :0.028 0.021 «0.018 0.012 0.009 0.232 0.164 0.116 0.83 0.070 0.060 0.043 0.031 + —:0.023-0.017 «0.014 0.009 0.007 0.073 0.061 0.051 0.037 0.026 0.019 0.014 0.012-0.007, 0.005 19 0.396 0.331 20. 0.377 0.312 0.215 0.149 0.104 leg aa @ scanned with OKEN Scanner79 7 TABLE II resent Value of Re. 1 Received Annually for % 5 5; 5 > = years Years 5% 6% 8% 0% “12% 14% % 16% 18 I 0% 1 0,952 0,943 0,926 0.909 0 > 7 7 | | aaeo| lnese! [4 on 0.893 0.877 0.870 0.862 0.847 0.820 0781 0.769 2 : ‘ : 1.736 1.690 1.647 1.646 1.605 1.566 1.492 1392 1361 3 2.723 2.676 2.577 2.487 2.402 2322 2283 2.174 2.042 1868 1.816 4 3.546 3.465 3.312 3.170 3.037 2.914 2855 2.690 2.494 2241 2.166 5 4,330 4.212 3.993 3,791 3.605 3.433 3.127 2.864 2.532 2.346 6 5.076 4.917 4.623 4,335 4.111 3.889 3498 3.326 3.167 2.759 2.643 7 5,786 5.582 5,206 4.868 4.504 4.288 2 3.605 3.416 2.937 2.802 8 6.463 6.210 5.747 5.335 4.968 4.639 4078 3.837 3.619 3.076 2.925 9 7.109 6,802 6.247 $5,759 5.328 4.946 4303 4.031 3.786 3.184 3,019 07 7.360 6,710 6.145 5.050 4216 S494 4.192 3.923 5.269 3,092 1 8.306 7.887 6A9S 5.937 S483 5 $029 4.656 4327 4.035 3.776 3.656 3.335 3.147 12 8863 8.3847, ONI4 6.194 S660 5 S197 4.793 4439 4.127 3.851 3.725 3.387 3.190 13 9,304 8.853 7,904 7.103 S842 S342 4.910 4533 4.203 3.912 3.780 3.427. 3.223, 149,899 9,295 8.244 7,307 6.002 S468 5.008 4.611 4.265 3.962 3.824 3.459 3.249 E 15 10,380 9.712 8.559 7,606 6.142 S575 5.092 4.675 4.315 4.001 3.859 3.483 3,268 Z oD 16 10.838 10,106 7824 6.974 6.265 s 5.162 4.730 4,357 4.033 3.887 3.503 3,283 z 17 10.274 10,477 8.022 7.120 6.373 6.047 5.222 4.775 4.391 4.059 3.910 3.518 3.295 3 Ww 11,690 10.828. 8.201 7.250 6.467 5.128 4.273 4.812 4.419 4.080 3.928 3.529 3,304 ” \2.085 11,158, 8.365 7.366 6.550 6.198 5.316 4.844 4.442 4.097 3.942 3.539 3.311 8 20 12.462 11.470 8.514 7.469 6.623 6.259 5.353, 4.870 4.660 4.110 3.954 3.546 3316 s s @ scanned with OKEN Scanner