Unit -6

Capital Budgeting
Meaning of investment decisions:

Investment decision is concerned with the selection of assets in which funds will be
invested by a firm or organization. The assets of a business firm include long term assets (fixed
assets, projects) and short-term assets (current assets), long term assets will yield a return over a
period of time in future, whereas short term assets are those assets which are easily convertible
into cash with in an accounting period of a year. The long term investment decisions is known as
a capital budgeting and the short term investment decisions is identified as a working capital
management.

Capital budgeting is main aspect of investment decision. Capital budgeting is the long
range planning of allocation of funds among the various investment proposals. Another
important element of capital budgeting is the analysis of risk and uncertainty.

Meaning and Definition:

Capital budgeting is the planning of capital expenditure which provides yields over a
number of years.

According to Charles [Link],

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

capital outlays.

According to Hampton John J,

“Capital budgeting is a decision-making process through which a business concern

evaluates the purchase of various fixed assets for expansion, replacement etc.

Nature of Capital budgeting decisions:

Capital budgeting decisions have the following features:

a) It involves exchanges of current funds for future benefits.

b) They benefit future periods.
c) They have the effect of increasing the capacity, efficiency, span of life regarding future
benefits.
d) Funds are invested in long term activities.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
Some examples of Capital budgeting decisions are:

➢ Construction of new buildings.

➢ Purchasing of technology.
➢ Building a production facility.
➢ Producing a new product.
➢ Starting new business.
➢ Expansion of plant and machinery equipment’s.
➢ Advertising the company products.

Process of Capital budgeting:

The various steps involved in capital budgeting process depend upon large number of
factors such as size of the concern, nature of projects, and their numbers, complexities and
diversities and so on.

According to Quinine G. David,

The following five steps are involved in the process of capital budgeting.

project Generation

project evaluation

project selection

project Execution

Follow-up

I.) Project Generation: A continuous generation of capital expenditure proposals like

proposals expanding the revenues and proposals reducing the cost is highly essential to
make efficient and full use of funds of the concern. If the proposals expanding the
revenues relate to the proposals to add new products and to expand the capacity in
existing lines. The proposals reducing the costs are designed to bring savings in cost in
existing lines without changing the scale of operations.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 II.) Project evaluation: The process deals with judging the suitability and desirability of a
project by applying various criteria. Thus the process of project evaluation involves
estimating the cost and benefits in terms of cash flows, and selecting on appropriate
criterion for judging the desirability of the projects.
III.) Project selection: This step deals with screening and selecting the projects. Usually,
projects under consideration can be screened at various levels of management. But the
final approval of them should be given by the top management.
IV.) Project execution: After the projects are selected, the funds are to be allocated for
them. Such a formal plan for the allocation of fund is known as capital budget. The top
management or execute committee should ensure that funds are spend as per the
allocation made in the capital budgets.
V.) Follow up: follow up deals with comparison of actual performance with the budgeted
data. This will ensure better forecasting and also help in sharpening the technique of
forecasting.

Techniques of capital budgeting:

Traditional Technique or modern or discounted

Non Discounted cash flow techniques cash flow techniques

➢ Pay back method. (a) Net present value

➢ Accounting rate of return. Method.
(b) Internal rate of return

(c) Profitability index

(d) Excess present value Index

Techniques or Methods of Capital Budgeting

The methods of capital budgeting are classified into two methods.

 Traditional techniques.
 Modern techniques.

Traditional technique or non-discounted cash flow techniques:

The Traditional techniques are divided into two types. They are

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 a) Payback period
b) Accounting Rate of Return or Average Rate of Return (ARR).

Pay Back Period:

Pay Back Period is one of the most popular and widely recognized techniques of
evaluating investment proposals. Pay Back Period may be defined as that period required, to
recover the original cash out flow 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 is used to compute payback period.

Pay Back Period can be calculated in two ways.

i. When there is equal cash flows :

ii. When cash flow are unequal cash flows :

Pay Back Period may be calculated by adding the cash inflows until the total is equal
to the initial investment payback period.

Accept – Reject Rule:

Acceptance or rejection of the project is based on the comparison of calculated PBP with the
maximum or standard payback period.

Accept: cal PBP < Standard PBP

Reject: cal PBP >Standard PBP

Considered: cal PBP= Standard PBP

Advantages of Pay Back Period:

The Advantages of Pay Back Period are,

• It is very simple and easy to understand.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 • Cost involvement in calculating payback period is very less as compared to
sophisticated methods.
Limitations of Pay Back Period:

• It ignores cash flows after payback period.

• 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.
• It does not take into consideration time value of money.
• There is no rational basis for setting a minimum payback period.
• It is not consistent with the objective of maximizing shareholders wealth. Share value
does not depend on payback period of investment projects.
Merits:

1. It is an important guide to investment policy.

2. The rate which capital is recouped has a positive significance.
3. The method enables a firm to choose an investment which yields a quick return on cash
funds.
4. It is easy to understand, calculate and communicate to others.
5. Other than its simplicity, the main advantage claimed for the payback period is, that it is a
built- in safe guard against risk.
6. 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.
Demerits:

[Link] does not measure the profitability of a project.

[Link] time value of money is ignored.
[Link] does not value projects of different economic lives.
[Link] 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.
5. No allowance is made for taxation nor is any capital allowance made.
Accounting Rate of Return or Average Rate of Return (ARR):

Accounting rate of return method uses accounting information as revealed by

financial statements, to measure the profitability of the investment proposals. It is known as the
return on investment (ROI). Sometimes it is known as average rate of return (ARR). Average
annual earnings 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 it is clearly mentioned as accounting rate of return:

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 If accounting rate of return is given in the problem, return on original investment method
should be used to calculate accounting rate of return.

OI = Original investment + Additional NWC + Installation Charges + Transportation Charge.

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.

AI = (Original investment - scrap) 1/2 + Additional NWC + Scrap value

If ARR is given in the problem, any one of the above method can be used to calculate
ARR.

Accept – Reject Rule

Acceptance or rejection of the project is based on the comparison of calculated ARR with the
predetermined rate or cut of rate.

Accept: cal ARR > Predetermined ARR or Cut-off rate.

Reject: cal ARR < Predetermined ARR or Cut-off rate.

Considered: cal ARR = predetermined ARR or Cut-off rate.

Advantages of ARR Method:

The ARR method has some merits

• The most significant merit of ARR is that, it is very simple to understand and easy to
calculate.
• Information can easily be drawn from accounting records.
• It takes into account all profits of the projects life period.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 • Cost involvement in calculating payback period is very less in comparison to the
sophisticated methods, since it saves analysts time.
Limitations of ARR method:

ARR method suffers from serious demerits.

• It uses accounting profits instead of actual cash flows after taxes, in evaluating the
projects. Accounting profits are inappropriate for evaluating and accepting projects,
since they are computed based on arbitrary assumptions and choices and also include
non – cash items.
• It ignores the concept of time value of money.
• It does not allow profits to be reinvested.
• It does not differentiate between the sizes of the investment required for each project.

MODERN TECHNIQUES OR DISCOUNTED CASH FLOW (DCF)

TECHNIQUES:-

Modern / discounted cash flow techniques take into consideration all most all the

Deficiencies of the traditional methods and consider all benefits and occurring during the project
entire life period.

Modern techniques can be again subdivided into three types:

➢ Net present value(NPV)

➢ Internal rate of return(IRR)
➢ Profitability index (PI) or Discounted Benefit cost Ratio(DBCR)
➢ Excess present value index (EPVI)

A) NET PRESENT VALUE METHOD (NPV):

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 inflow is higher than the present value of cash outflows
and vice versa.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
STEPS INVOLVED IN COMPUTATIONOF NPV ARE:

(1) Forecasting of cash inflows of the investment project based on realistic

assumptions.

(2) Computation of cost of capital, which is used as discounting factor for conversion of future
cash inflows into present values.

(3) Calculation of cash flows using cost capital as discounting rate / factor.

(4) Finding out NPV by subtracting present value of cash outflows from present value of
cash inflows.

ACCEPT (OR) REJECT RULE:

Acceptance or reject rule of the project is decided on the NPV.

Accept: NPV > Zero

Reject: NPV < Zero

Consider: NPV = Zero

Advantages of NPV method: The MERITS of NPV are

• It takes into account the time value of money.

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

Limitations of NPV method: NPV is the most acceptable method in comparison with
traditional method. Nevertheless, it has certain limitations also.
• It is difficult to understand when compared with PBP and ARR.
• Calculation of required rate or discounting factor or cost of capital is difficult,
which involves a lengthy and time consuming process and presents illustrations. At
the same time calculation cost of capital is based on different methods.
• In case of projects involving different cash outlays, NPV method may not give
dependable results.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 • It does not give satisfactory results when comparing two projects with different life
periods. Generally a project, having a shorter economic life would be preferable,
other things being equal.

(B) Internal rate of return (IRR):

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 inflows (DCF) 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 know by
following names:

• Marginal affiance of capital.

• Rate of returns over cost.
• time adjusted rate of return.
• Yield on investment.
computation of IRR is based on the cash flows after taxes>ITT is mathematically represented as
‘r’ .It can be found by trial and error method .in this method evaluator selects any discount rate to
compute present value of cash inflow. Generally the cost of capital is taken as first trail. If
calculated present value of cash inflows is higher than the present value 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 of IRR. The formula is as follows:

Where

LDF =Discount factor of low trail

ΔDF =Difference between low discounting factor and High discounting factor.

PVLDF=PV of cash inflows at low discounting factor trail.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 COF =Cash out flows.

PVHDF=PV of cash inflows at high discounting factor trail.

Accept- Reject Rule:

Acceptance or reject rule of the project decides based upon the calculated IRR and Cost of
capital (Ko).

Accepted: IRR > Cost of capital (Ko)

Reject: IRR < Cost of capital (Ko)

Consider: IRR = Cost of capital (Ko)

Merits of IRR

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 thought out 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.

DEMERITS OF IRR:

1) Calculation of IRR is quite 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 funds at the cut-off rate is more appropriate
then at the IRR.
3) It implies that profits can be reinvested at internal rate of, which is not logical.
4) It produces multiple rate of returns which can be confusing.
5) It may not give fruitful results in case of unequal projects life, unequal cash outflows, and
difference in the timing of cash flows.
NPV WITH IRR: Difference

➢ In case of mutually exclusive projects, if NPV method accepts the project while IRR
rejects.
➢ If there is a size disparity the NPV and the IRR will give different rankings.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 ➢ Where there is an incremental approach, the NPV method is superior to the IRR,
because the former supports projects, which are compatible with the goal shareholders
wealth maximization while the latter does not.
➢ When there is time disparity the NPV would give results superior to the IRR method.
➢ In projects with unequal lives, NPV and IRR would give conflicting ranking to
mutually exclusive projects.
(C) Profitability Index (PI) / Discounted Benefit Cost Ratio (DBCR)

This is another discounted cash flow method of evaluating investment proposals. It is

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 rate of return, to the initial cash outflow of the investment
proposal. PI method measures the present value of future cash per rupee, whereas 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 outflow of the investment.

PI = PV of cash inflows / Initial cash outlay

Like IRR and NPV methods, profitability index is a conceptually sound method of appraising
investment projects. It provides ready comparison between investment proposals of different
magnitudes.

Accept- Reject Rule

→ Accept: PI > 1

→ Reject: PI < 1

→ Considered: PI = 1

Characteristics of sound Investment Criterion

The characteristics should be possessed by a sound investment criterion.

(i) It should be consider all cash flows to determine the true profitability,
(ii) It should provide for an objective and unambiguous way of separating good projects
from bad projects,
(iii) It should help ranking of projects according to their true profitability,

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 (iv) It should recognize the fact bigger cash flows are preferable to smaller ones and really
cash flows are preferable to later ones,
(v) It should help to choose among mutually exclusive projects that particular project which
maximizes the shareholder’s wealth,

Merits of PI

The PI method satisfies almost all the requirements of a sound investment criterion. The
characteristic, as we recollect are:

➢ It gives the consideration to time value of money.

➢ It considers all cash flows to determine PI.
➢ It helps to rank projects according to their PI.
➢ It recognizes the fact that bigger cash flows are better than smaller ones and really cash
flows are preferable to later ones.
➢ It can also use to choose mutually exclusive projects by calculating the incremental
benefits cost ratio.
➢ It is consistent with the objectives maximization of shareholder’s wealth.

D.) EXECESS PRESENT VALUE INDEX:

It is the method of allocation of the limited funds available for financing the capital
projects to only some of the profitable projects in such a manner that the long-term returns are
maximized it is also called capital rationing. It results in the selection of some of the profitable
investments proposals out of the several profitable investment projects available.

The main objective of this technique is ensuring the selection of those profitable
investment projects that will provide the maximum long term returns there by maximizing the
value of the firm.

STEPS INVOLVED IN EXCESS PRESENT VALUE INDEX TECHNIQUES:

Capital rationing involves two important steps they are:

1) Ranking of the different investment proposals

2) Selection of some of the profitable investment proposals.

1) Ranking of the different investment proposals:

The different investment proposals (or) capital projects available should be ranked on
the bases of their profitability (i.e. on the basis of their net present value (or) profitability
index(or) The internal rate of return) in the descending order.

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
2) Selection of some the profitable investment proposals:

Then on the basis of their profitability in the descending order, the selection of that combination
of profitable investment proposals, which would provide the highest profitability should be made
subject to the budget constraint for the period

Capital budgeting problems (PBP, NPV, PI)

1) A company considering an investment proposal to install a new machine .the
project will cost 50,000 and you have a life of 5 years. No scrap value. Tax is 50% the
company follows straight line method of depreciation the net earnings before tax is as
follows:

Year 1 2 3 4 5
EBDT 10,000 11,000 14,000 15,000 25,000

Evaluate the value of project by using A) payback period

B) Net present value at 10%

C) Profitability index at 10%

Solution:

Calculation of depreciation

Depreciation = Total Asset value-scrap value/ Life of the asset

Depreciation= 50,000/5=10,000

Calculation of cash flow after tax

Year EBDT EBT EAT CFAT Cumulative

(EBDT-dep) (EBT-TAX) (EAT+dep) of CFAT
1 10,000 0 0 10,000 10,000
2 11,000 1,000 500 10,500 20,500
3 14,000 4,000 2,000 12,000 32,500
4 15,000 5,000 2,500 12,500 45,000
5 25,000 15,000 7,500 17,500 62,500

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering
 Payback period (PBP)

= Year before fully recovered + unrecovered amount/cash in flow during final recovery

PBP=4+5,000/17,500

PBP=4.285

Calculation of net present value (NPV)

Year EFAT Discounting factor Present value

1 10,000 0.909 9,909
2 10,500 0.826 8,673
3 12,000 0.751 9,012
4 12,500 0.683 8,537
5 17,500 0.621 10,867
Present value of cash inflow 46,180

[-]Present value cash out flow 50,000

NET PRESENT VALUE(NPV) -3,820

Calculation of Profitability index (PI)

PI= present value of cash inflow/present value of cash outflow

PI = 46,180/50,000

PI=0.923%

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K. CHANDRASEKAHR, [Link], Dept of ECE, Sir CR Reddy College of Engineering