CAPITAL BUDGETING TECHNIQUES

Capital budgeting consists in planning development of available capital for

the purpose of maximizing the long-term profitability of the concern.

The examples of capital expenditure:

1. Purchase of fixed assets such as land and building, plant and

machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement and
alteration to the fixed assets.
3. The replacement of fixed assets.
4. Research and development project

Capital budgeting is a long-term planning for making and financing

proposed capital out lays.

Need and Importance of Capital Budgeting

1. Huge investments: Capital budgeting requires huge investments of

funds, but the available funds are limited, therefore the firm before
investing projects, plan are control its capital expenditure.

2. Long-term: Capital expenditure is long-term in nature or permanent

in nature. Therefore financial risks involved in the investment decision
are more. If higher risks are involved, it needs careful planning of
capital budgeting.

3. Irreversible: The capital investment decisions are irreversible, are not

changed back. Once the decision is taken for purchasing a permanent
asset, it is very difficult to dispose off those assets without involving
huge losses.

4. Long-term effect: Capital budgeting not only reduces the cost but
also increases the revenue in long-term and will bring significant
changes in the profit of the company by avoiding over or more
investment or under investment.

CAPITAL BUDGETING PROCESS

1. Identification of various investments proposals: The capital

budgeting may have various investment proposals. The heads of
various department analyse the various investment decisions, and will
select proposals submitted to the planning committee of competent
authority
2. Screening or matching the proposals: The planning committee will
analyse the various proposals and screenings. The selected proposals
are considered with the available resources of the concern.

3. Evaluation: After screening, the proposals are evaluated with the help
of various methods, such as pay back period proposal, net discovered
present value method, accounting rate of return and risk analysis.

4. Fixing property: After the evolution, the planning committee will

predict which proposals will give more profit or economic
consideration.

5. Final approval: The planning committee approves the final proposals,

with the help of the following: (a) Profitability (b) Economic
constituents (c) Financial violability (d) Market conditions. The
planning committee prepares the cost estimation and submits to the
management.

6. Implementing: The competent authority spends the money and

implements the proposals. While implementing the proposals, assign
responsibilities to the proposals, assign responsibilities for completing
it, within the time allotted and reduce the cost for this purpose. The
network techniques used such as PERT and CPM.

7. Performance review of feedback: The final stage of capital budgeting

is actual results compared with the standard results. The adverse or
unfavourable results identified and removing the various difficulties of
the project. This is helpful for the future of the proposals.

PAY BACK PERIOD

CALCULATING PAY BACK PERIOD WHEN CASHFLOWS ARE EQUAL

01) Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life
of the project is 5 years. Calculate the pay-back period.

(Payback Period : 3 years)

02) Project cost is Rs. 90,000 and the cash inflows are Rs. 15,000, the life
of the project is 8 years. Calculate the pay-back period.

(Payback Period : 6 years)

03) Project cost is Rs. 80,000 and the cash inflows are Rs. 15,000, the life
of the project is 7 years. Calculate the pay-back period

(Payback Period : 5 years 3 months 29 days)

04) A project costs Rs. 20,00,000 and yields annually a profit of Rs.
3,00,000 after depreciation @ 12½% but before tax at 50%. Calculate
the pay-back period. (Payback Period : 5 years)

05) A project costs Rs. 16,00,000 and yields annually a profit of Rs.
4,00,000 after depreciation @ 15% but before tax at 50%. Calculate
the pay-back period.

(Payback Period : 3 years 7 months 20 days)

06) PQR Co., has got Rs. 2,50,000 to invest . The following proposals are
under consideration. Rank these projects in order of their desirability
under the Pay – back period method.

Project Initial Outlay Annual Cash Life in Years

(Rs.) Flow (Rs.)
A 1,00,000 25,000 6
B 80,000 26,000 7
C 40,000 10,000 15
D 1,00,000 24,000 20
E 50,000 11,250 15
F 60,000 24,000 6
G 20,000 10,000 4
(Rank 4, 3, 4 ,5 ,6,2 and 1)

07) Delhi Machinery Manufacturing Company wants to replace the

manual operations by new machine. There are two alternative models
of X and Y for the new machine. Using payback period, suggest the
most profitable investment. Ignore taxation:
Machine X Machine Y
Original Investment 9,000 18,000
Estimated Life of the Machine (Years) 3 5
Estimated Savings in Scrap 500 800
Estimated Savings in Wages 6,000 8,000
Additional cost of Maintenance 800 1,000
Additional cost of Supervision 1,200 1,500
(Annual Cash flows: 4,500 and 6,300. PBP = 2years and 2.86 years)

08) Kathiravan Machinery Manufacturing Company wants to replace the

manual operations by new machine. There are two alternative models
of A and B for the new machine. Using payback period, suggest the
most profitable investment. Ignore taxation:
 Machine A Machine B
Original Investment 30,000 45,000
Estimated Life of the Machine (Years) 3 5
Estimated Savings in Scrap 2,000 5,000
Estimated Savings in Wages 13,000 20,000
Additional cost of Maintenance 1,500 3,000
Additional cost of Supervision 3,500 4,000
(Annual Cash flows: 10,000 and 18,000. PBP = 3years and 2.5 years)

CALCULATING PAY BACK PERIOD WHEN CASHFLOWS ARE UNEQUAL

09) Project PGK requires an initial cash outflow of Rs. 25,000. The cash
inflows for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000,
Rs. 7,000 and Rs. 3,000. Calculate Payback Period.(3 years 2 months)

10) Determine the Payback period for a project which requires a cash
outlay of Rs.10,000 and generates cash flows of Rs.3,000, Rs.6,000 ,
Rs.3,000 and Rs.2,000 in the first , second , third and fourth years
respectively. (Payback Period : 2 years 4 months)

11) The machine cost Rs. 1,00,000 and has scrap value of Rs. 10,000
after 5 years. The net profits before depreciation and taxes for the five
years period are to be projected that Rs. 20,000, Rs. 24,000, Rs.
30,000, Rs. 26,000 and Rs. 22,000. Taxes are 50%. Calculate pay-
back period. (Payback Period : 4 years 3 months)

Post Pay-back Profitability Method

12) From the following particulars, compute: (a) Payback period (b) Post
pay-back profitability and (c) post pay-back profitability index.

Cash outflow Rs. 1,00,000

Annual cash inflow Rs. 25,000

(After tax before depreciation)

Estimate Life 6 years

(Pay Back Period = 4 Years , Post Pay-back Profitability =Rs.

50,000, Post Pay-back Profitability index = 50 %)

13) From the following particulars, compute: (a) Payback period (b) Post
pay-back profitability and (c) post pay-backprofitability index.

Cash outflow Rs. 2,00,000

Annual cash inflow Rs. 40,000

 (After tax before depreciation)

Estimate Life 7 years

(Pay Back Period = 5 Years , Post Pay-back Profitability =Rs.

80,000, Post Pay-back Profitability index = 40 %)

14) From the following particulars, compute: (a) Payback period (b) Post
pay-back profitability and (c) post pay-backprofitability index.

Cash outflow Rs. 1,00,000

Annual cash inflow

(After tax but before depreciation)

First five years Rs. 20,000

Next five years Rs. 8,000

Estimated life 10 Years

Salvage value Rs. 16,000

(Pay Back Period = 5 Years , Post Pay-back Profitability =Rs.

40,000, Post Pay-back Profitability index = 40 %)

15) From the following particulars, compute: (a) Payback period (b) Post
pay-back profitability and (c) post pay-backprofitability index.

Cash outflow Rs. 2,40,000

Annual cash inflow

(After tax but before depreciation)

First Six years Rs. 40,000

Next four years Rs. 20,000

Estimated life 10 Years

Salvage value Rs. 10,000

(Pay Back Period =6 Years , Post Pay-back Profitability =Rs. 80,000,

Post Pay-back Profitability index = 33.33 %)

16) From the following particulars, compute: (a) Payback period (b) Post
pay-back profitability and (c) post pay-backprofitability index.

Cash outflow Rs. 1,80,000

Annual cash inflow

 (After tax but before depreciation)

First Seven years Rs. 25,000

Next five years Rs. 12,000

Estimated life 12 Years

Salvage value Rs. 10,000

(Pay Back Period =7 Years, 5 months , Post Pay-back Profitability =Rs.

55,000, Post Pay-back Profitability index = 30.56 %)

DISCOUNTED PAYBACK PERIOD

17) An initial investment of Rs. 3,00,000 is expected to generate

Rs.80,000 per year for 6 years. Calculate the discounted payback
period of the investment if the discount rate is 10%.
( 4 Years 11 months and 7 days)

18) An initial investment of Rs. 4,00,000 is expected to generate

Rs.1,20,000 per year for 6 years. Calculate the discounted payback
period of the investment if the discount rate is 12%.
( 4 Years 6 months and 8 days)

19) A choice is to be made between two competing projects which require

an equal investment of Rs.50,000 and are expected to generate net
cash flow as under:
End of Year Project A Project B
1 Rs.25,000 Rs.10,000
2 Rs.15,000 Rs.12,000
3 Rs.10,000 Rs.18,000
4 ----- Rs.25,000
5 Rs.12,000 Rs.8,000
6 Rs.6,000 Rs.4,000
The Cost of Capital of the Company is 10%.
Which Project proposal should be chosen and why?
Evaluate the Project Proposals under Discounted payback period
method.
( Project A:4 Years 11 months and 26 days or 5 years approximately)
( ProjectB:4 Years and 29 days)
Project B should be chosen based on discounted Payback Period

20) A choice is to be made between two competing projects which require

an equal investment of Rs.80,000 and are expected to generate net
cash flow as under:
 End of Year Project G Project K
1 Rs.38,000 Rs.15,000
2 Rs.23,000 Rs.18,000
3 Rs.15,000 Rs.27,000
4 Rs.10,000 Rs.38,000
5 Rs.8,000 Rs.22,000
6 Rs.9,000 Rs.10,000
The Cost of Capital of the Company is 12%.
Which Project proposal should be chosen and why?
Evaluate the Project Proposals under Discounted payback period
method.
( ProjectG:3 Years and 17 days)
( ProjectK:4 Years 8 months and 16 days)
Project Gshould be chosen based on discounted Payback Period

ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF RETURN (ARR)

Average rate of return means the average rate of return or profit taken
for considering the project evaluation. This method is one of the
traditional methods for evaluating the project proposals:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑟𝑜𝑓𝑖𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 = 𝑋 100
𝑂𝑟𝑖𝑔𝑖𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 – 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒

𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 𝑜𝑓 ′𝑛′ 𝑦𝑒𝑎𝑟𝑠

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 =
𝑁 𝑦𝑒𝑎𝑟𝑠

Accept/Reject criteria:

If the actual accounting rate of return is more than the predetermined

required rate of return, the project would be accepted. If not it would
be rejected.

21) A project requires an investment of Rs.5, 00,000 and has a scrap

value of Rs.20,000 After 5 years. It is expected to yield profits after
depreciation and taxes during the 5 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. (ARR = 10%)

22) A project requires an investment of Rs.4,20,000 and has a scrap value

of Rs.20,000 After 5 years. It is expected to yield profits after
depreciation and taxes during the 5 years amounting to Rs. 40,000.
Rs. 55,000, Rs. 65,000, Rs. 35,000 and Rs.25,000. Calculate the
average rate of return on the investment. (ARR = 11%)
23) A project requires an investment of Rs.2,50,000 and has a scrap value
of Rs.10,000 After 6 years. It is expected to yield profits before
depreciation and taxes during the 6 years amounting to Rs. 50,000.
Rs. 70,000, Rs. 75,000, Rs. 85,000, 55,000 and Rs.45,000. Tax rate is
40%. Calculate the average rate of return on the investment.(5.83%)

24) A project requires an investment of Rs.4,20,000 and has a scrap value

of Rs.20,000 After 5 years. It is expected to yield profits before
depreciation and taxes during the 5 years amounting to Rs. 80,000.
Rs. 90,000, Rs. 95,000, Rs. 1,00,000, and Rs.80,000. Tax rate is 50%.
Calculate the average rate of return on the investment. (15%)

25) A choice is to be made between two competing projects which require

an investment of Rs.90,000 and Rs.1,10,000 respectively. They are
expected to generate net profits as under:

Net Profit at the Project X ( Cost Project Y ( Cost

End of Year Rs.90,000) Rs.1,10,000)
1 Rs.20,000 Rs.10,000

2 Rs.30,000 Rs.20,000

3 Rs.40,000 Rs.40,000

4 Rs.20,000 Rs.60,000

5 Rs.20,000 Rs.50,000
Suggest the suitable project based on ARR. (X = 28.9%, Y = 32.7%)

26) A company has two alternative proposals. The details are as follows

Proposal I Proposal II
Automatic Machine Ordinary Machine
Cost of the
Rs. 2,20,000 Rs. 60,000
machine
Estimated life 5½ years 8 years
Estimated
Rs. 1,50,000 Rs. 1,50,000
sales p.a.
Costs :
Rs.50,000 Rs.50,000
Material
Labour Rs.12,000 Rs.60,000
Variable
Rs.24,000 Rs.20,000
Overheads
Suggest the suitable project based on Average Rate of Return
 (ARR : Automatic =10.91%, Ordinary = 20.83%)

Comment : Ordinary machine is more profitable than the Automatic

machine

NET PRESENT VALUE

Net present value method is one of the modern methods for evaluating
the project proposals

In this method cash inflows are considered with the time value of the
money.

Net present value describes as the summation of the present value of

cash inflow and present value of cash outflow.

Net present value is the difference between the total present value of
future cash inflows and the total present value of future cash outflows

Rs
Present Value of Cash Inflow xxx
Less : (xxx)
Cash outflow
Net Present Value xxx

Accept/Reject criteria:

If the present value of cash inflows is more than the present value of
cash outflows, it would be accepted. If not, it would be rejected.

MERITS AND DEMERITS OF NET PRESENT VALUE:

MERITS OF NET PRESENT VALUE DEMERITS OF NET PRESENT VALUE

It recognizes the time value of It is difficult to understand and
money calculate
It considers the total benefits It needs the discount factors for
arising out of the proposal calculation of present values
It is the best method for the It is not suitable for the projects
selection of mutually exclusive having different effective lives..
projects.
It helps to achieve the
maximization of shareholders’
wealth.
PROBLEMS

27) An initial investment of Rs. 3,00,000 is expected to generate

Rs.80,000 per year as Cash Flow after tax but before depreciation for
5 years. Calculate Net Present Value if the discount rate is 10%.

(Net Present Value Rs.3,200)

28) An initial investment of Rs. 2,50,000 is expected to generate

Rs.70,000 per year as Cash Flow after tax but before depreciation for
5 years. Calculate Net Present Value if the discount rate is 12%.

(Net Present Value Rs.2,350)

29) From the following information, calculate the net present value of the
two project and suggest which of the two projects should be accepted.
Discount factor is 12%

Project A Project B
Initial Investment Rs.1,50,000 Rs.1,00,000
Estimated Life 5 Years 5 Years
Scrap Value Rs.10,000 Rs.5,000
Cash Flow after taxation but before
depreciation
Year 1 Rs.1,00,000 Rs.25,000
Year 2 Rs.50,000 Rs.50,000
Year 3 Rs.25,000 Rs.50,000
Year 4 Rs.15,000 Rs.15,000
Year 5 Rs.10,000 Rs.10,000
(Net Present Value for A: Rs.17,830, NPV for B = Rs.15,520)

30) Calculate Net Present Value if the discount rate is 10%.

Proposal M Proposal S
Initial Outlay Rs. 1,00,000 Rs. 5,00,000
Estimated life 5 Years 5 Years
Scrap Value Rs. 10,000 Rs. 50,000
Profit after tax : year 1 Rs. 6,000 Rs. 30,000
Year 2 Rs. 14,000 Rs. 70,000
Year 3 Rs.24,000 Rs.1,20,000
Year 4 Rs.16,000 Rs.60,000
Year 5 Nil Rs.20,000
(Net Present Value M: Rs.20,400, NPV for S = Rs.70,320)
31) From the following information, calculate the net present value of the
two project and suggest which of the two projects should be accepted.
Discount factor is 10%

Project X Project Y
Initial Investment Rs.20,000 Rs.30,000
Estimated Life 5 Years 5 Years
Scrap Value Rs.1,000 Rs.2,000
Cash Flow After depreciation and after
taxation
Year 1 Rs.1,200 Rs.14,400
Year 2 Rs.6,200 Rs.4,400
Year 3 Rs.6,200 (Rs.600)
Year 4 (Rs.800) (Rs.2,600)
Year 5 (Rs.1,800) (Rs.3,600)
(Net Present Value for X: Rs.4,227, NPV for S = Rs.4,728)

32) Cost of Project is Rs.5,400. Cash flow after tax but before depreciation
is Rs.3,600 in the first year and Rs.14,400 in the second year. Find
the Net present value if the discount factor is (a) 0% (b) 10% (c) 40%
(d) 50% and (e) 100%

(Answer :NPV(a)12,600 (b)9,774 (c) 4,518 (d) 3,400 (e)0

33) Cost of a Machinery is Rs.1,00,000 and it provides Rs.30,000 every

year as Cash flow after tax but before depreciation for 6 years. Find
the Net present value if the discount factor is (a) 15% (b) 19% (c) 20%

(Answer : NPV (a)Rs.13,534 (b)Rs.2,293 (c) Rs.(-)235 )

34) From the following information, calculate the net present value of the
two project andsuggest which of the two projects should be accepted a
discount rate of the two.
Project X Project Y

Initial Investment Rs. 20,000 Rs. 30,000

Estimated Life 5 years 5 years
Scrap Value Rs. 1,000 Rs. 2,000
 Cash flows before depreciation and after taxation are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

Rs. Rs. Rs. Rs. Rs.
Project X 5,000 10,000 10,000 3,000 2,000
Project Y 20,000 10,000 5,000 3,000 2,000

Note : The following are the present value factors @ 10% p.a.

Year 1 2 3 4 5 6
Factor 0.909 0.826 0.751 0.683 0.621 0.564

(Answer :Net present value X : Rs.4,227 Y: Rs.4,728

Project Y should be selected as net present value of project Y is higher)

35) From the following information, calculate the net present value of the
two project andsuggest which of the two projects should be accepted a
discount rate of the two.
Project G Project K

Initial Investment Rs. 30,000 Rs. 45,000

Estimated Life 5 years 5 years
Scrap Value Rs. 1,500 Rs. 3,000

Cash flows before depreciation and after taxation are as follows:

Year 1 Year 2 Year 3 Year 4 Year 5

Rs. Rs. Rs. Rs. Rs.
Project G 10,000 15,000 20,000 15,000 6,000
Project K 30,000 20,000 15,000 10,000 4,000

Note : The following are the present value factors @ 12% p.a.

Year 1 2 3 4 5 6
Factor 0.893 0.797 0.712 0.636 0.567 0.507

(Answer :Net present value G : Rs.18,060 K: Rs.17,033

Project G should be selected as net present value of project G is
higher)

INTERNAL RATE OF RETURN

Steps to be followed:

Step1. find out factor

Factor is calculated as follows:

𝐶𝑎𝑠𝑕 𝑜𝑢𝑡𝑙𝑎𝑦 (𝑜𝑟 ) 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐹= Cash inflow
Step 2. Find out positive net present value

Step 3. Find out negative net present value

Step 4. Find out IRR by using the formula

𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑛𝑒𝑡 𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒

𝐼𝑅𝑅 = Base % + 𝑋 𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 %
𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒 𝑖𝑛 𝑃𝑜𝑠𝑖𝑡𝑖𝑣𝑒 𝑁𝑃𝑉 𝑎𝑛𝑑 𝑁𝑒𝑔𝑎𝑡𝑖𝑣𝑒 𝑁𝑃𝑉

36) A project costs Rs. 16,000 and is expected to generate cash inflows of
Rs. 4,000 each 5years. Calculate the Interest Rate of Return.

(IRR = 7.91%)

37) A project costs Rs. 24,000 and is expected to generate cash inflows of
Rs. 6,000 each 5years. Calculate the Interest Rate of Return.

(IRR = %)

38) A company has to select one of the following two projects:

Project A Project B

Cost 22,000 20,000

Cash inflows:

Year 1 12,000 2,000

Year 2 4,000 2,000

Year 3 2,000 4,000

Year 4 10,000 20,000

Using the Internal Rate of Return method, suggest which is Preferable.

(IRR for A = 11.27 % , IRR for B = 10.24 %))

Comprehensive Problems

39) Which project will be selected under NPV and IRR?

Project A Project B
Cash outflow 2,00,000 3,00,000
Cash inflows at the end of1 Year 60,000 40,000
2 Year 50,000 50,000
 3 Year 50,000 60,000
4 Year 40,000 90,000
5 Year 30,000 1,00,000
Cost of capital is 10%.

40) KM Limited company is having two projects, requiring a capital

outflow ofRs. 2,00,000. The expected annual income after depreciation
but before tax isas follows:

Year 1 2 3 4 5
Rs. 1,00,000 1,00,000 80,000 80,000 40,000

Depreciation may be taken as 20% of original cost and taxation at

50% of net income. You are required to calculate (a) Pay-back period
(b) Rate of return on Original Investment(c) Rate of return on Average
Investment (d) Discounted Cash flow method taking cost of capital at
10% (e) Excess present value index.

(Ans. 2.25 years, 20%, 40%, Rs.1,08,130 and 154%)

41) GK Limited company is having two projects, requiring a capital

outflow ofRs. 3,00,000. The expected annual income after depreciation
but before tax isas follows:

Year 1 2 3 4 5
Rs. 9,000 80,000 70,000 60,000 50,000
Depreciation may be taken as 20% of original cost and taxation at
50% of net income. You are required to calculate (a) Pay-back period
(b) Net present value by taking 10% as present value factor(c)
Accounting rate of return (d) Net present value index.(e) Internal rate
of return.

(Ans. 3.5 years, Rs. 25,745, 43.437%, 108.58%, 13.87%)

42) A company is contemplating to purchase a machine. Twomachine A

and B are available, each costing Rs. 5 lakhs. Incomparing the
profitability of the machines, a discounting rate of10% is to be used
and machine is to be written off in five years bystraight-line method of
depreciation with nil residual value. Cashinflows after tax but before
depreciation are expected as follows:
 (Rs. in lakhs)

Year Machine A Machine B

1 1.5 0.5

2 2.0 1.5

3 2.5 2.0

4 1.5 3.0

5 1.0 2.0

Indicate which machine would be profitable using the

followingmethods of ranking investment proposals:(a) Pay back
method : (b) Net present value method; (c) Profitabilityindex method;
and (d) Average rate of return method.

The discounting factors at 10% are:

Year 1 2 3 4 5

Discount factors .909 .826 .751 .683 .621

(Answers:

(a) Payback period for Machine A = 2 years 7.2 months

Payback period for Machine B = 3 years 4 months
(b) NPV for Machine A = Rs.1,53,000
NPV for Machine B = Rs.1,48,000
(c) Profitability Index for Machine A = 1.306
Profitability Index for Machine B = 1.296
(d) ARR for Machine A = 14%
ARR for Machine B = 16% )