UNIT – IV CAPITAL BUDGETING

Capital Budgeting:

Capital budgeting is the process of making investment decision in long-term assets or courses of
action. Capital expenditure incurred today is expected to bring its benefits over a period of time.
These expenditures are related to the acquisition & improvement of fixes assets.

Capital budgeting is the planning of expenditure and the benefit, which spread over a number of
years. It is the process of deciding whether or not to invest in a particular project, as the
investment possibilities may not be rewarding. The manager has to choose a project, which gives
a rate of return, which is more than the cost of financing the project. For this the manager has to
evaluate the worth of the projects in-terms of cost and benefits. The benefits are the expected
cash inflows from the project, which are discounted against a standard, generally the cost of
capital.

Capital budgeting Techniques:

The capital budgeting appraisal methods are techniques of evaluation of investment proposal will
help the company to decide upon the desirability of an investment proposal depending upon
their; relative income generating capacity and rank them in order of their desirability. These
methods provide the company a set of norms on the basis of which either it has to accept or
reject the investment proposal. The most widely accepted techniques used in estimating the cost-
returns of investment projects can be grouped under two categories.

1. Traditional methods

2. Discounted Cash flow methods

1. Traditional methods These methods are based on the principles to determine the desirability
of an investment project on the basis of its useful life and expected returns. These methods
depend upon the accounting information available from the books of accounts of the company.
These will not take into account the concept of ‘time value of money’, which is a significant
factor to determine the desirability of a project in terms of present value.

A. Pay-back period method: It is the most popular and widely recognized traditional method
of evaluating the investment proposals. It can be defined, as ‘the number of years required to
recover the original cash out lay invested in a project’.

According to Weston & Brigham, “The pay back period is the number of years it takes the firm
to recover its original investment by net returns before depreciation, but after taxes”.

According to James. C. Vanhorne, “The payback period is the number of years required to
recover initial cash investment.
 Payback period = 𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒍𝒂𝒚 (𝑶𝑹)𝒈𝒊𝒏𝒂𝒍 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒑𝒓𝒐𝒋𝒆𝒄𝒕 /𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒂𝒔𝒉
𝒊𝒏𝒇𝒍𝒐𝒘

Merits:

1. It is one of the earliest methods of evaluating the investment projects.

2. It is simple to understand and to compute.

1. It dose not involve any cost for computation of the payback period

2. It is one of the widely used methods in small scale industry sector

3. It can be computed on the basis of accounting information available from the books.

Demerits

1. This method fails to take into account the cash flows received by the company after the pay
back period.

2. It doesn’t take into account the interest factor involved in an investment outlay.

3. It doesn’t take into account the interest factor involved in an investment outlay.

4. It is not consistent with the objective of maximizing the market value of the company’s share.

5. It fails to consider the pattern of cash inflows

i. e., the magnitude and timing of cash in flows.

B. Accounting (or) Average rate of return method (ARR):

It is an accounting method, which uses the accounting information repeated by the financial
statements to measure the probability of an investment proposal. It can be determine by dividing
the average income after taxes by the average investment i.e., the average book value after
depreciation.

According to ‘Soloman’, accounting rate of return on an investment can be calculated as the

ratio of accounting net income to the initial investment, i.e.

ARR= 𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒏𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙𝒆𝒔 /𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕 ×

𝟏𝟎𝟎

Average income after taxes= 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠/ 𝑛𝑜.𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
Average investment =𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 /2

On the basis of this method, the company can select all those projects who’s ARR is higher than
the minimum rate established by the company. It can reject the projects with an ARR lower than
the expected rate of return. This method can also help the management to rank the proposal on
the basis of ARR. A highest rank will be given to a project with highest ARR, where as a lowest
rank to a project with lowest ARR.

Merits

1. It is very simple to understand and calculate.

2. It can be readily computed with the help of the available accounting data.

3. It uses the entire stream of earning to calculate the ARR.

Demerits:

1. It is not based on cash flows generated by a project.

2. This method does not consider the objective of wealth maximization

3. IT ignores the length of the projects useful life.

4. It does not take into account the fact that the profits can be re-invested.

II: Discounted cash flow methods:

The traditional method does not take into consideration the time value of money. They give
equal weight age to the present and future flow of incomes. The DCF methods are based on the
concept that a rupee earned today is more worth than a rupee earned tomorrow. These methods
take into consideration the profitability and also time value of money.

A. Net present value method (NPV)

The NPV takes into consideration the time value of money. The cash flows of different years
and valued differently and made comparable in terms of present values for this the net cash
inflows of various period are discounted using required rate of return which is
predetermined.
According to Ezra Solomon, “It is a present value of future returns, discounted at the
required rate of return minus the present value of the cost of the investment.” NPV is the
difference between the present value of cash inflows of a project and the initial cost of the
project.
 According the NPV technique, only one project will be selected whose NPV is positive or
above zero. If a project(s) NPV is less than ‘Zero’. It gives negative NPV hence. It must be
rejected. If there are more than one project with positive NPV’s the project is selected whose
NPV is the highest.
The formula for NPV is

NPV= 𝒄𝟏 /𝟏+𝒌 + 𝒄𝟐 /(𝟏+𝒌) + 𝒄𝟑/ (𝟏+𝒌) + 𝒄𝒏 /(𝟏+𝑲)

NPV= Present value of cash inflows – investment.

Co- investment
C1, C2, C3… Cn= cash inflows in different years.
K= Cost of the Capital (or) Discounting rate
D= Years.

Merits:
1. It recognizes the time value of money.
2. It is based on the entire cash flows generated during the useful life of the asset
3. It is consistent with the objective of maximization of wealth of the owners.
4. The ranking of projects is independent of the discount rate used for determining the
present value.

Demerits:
1. It is different to understand and use.
2. The NPV is calculated by using the cost of capital as a discount rate. But the concept of
cost of capital. If self is difficult to understood and determine.
3. It does not give solutions when the comparable projects are involved in different amounts
of investment.
4. It does not give correct answer to a question whether alternative projects or limited funds
are available with unequal lines.

B. Internal Rate of Return Method (IRR)

The IRR for an investment proposal is that discount rate which equates the present value of
cash inflows with the present value of cash out flows of an investment. The IRR is also
known as cutoff or handle rate. It is usually the concern’s cost of capital.

According to Weston and Brigham “The internal rate is the interest rate that equates the
present value of the expected future receipts to the cost of the investment outlay.

The IRR is not a predetermine rate, rather it is to be trial and error method. It implies that
one has to start with a discounting rate to calculate the present value of cash inflows. If the
obtained present value is higher than the initial cost of the project one has to try with a
 higher rate. Like wise if the present value of expected cash inflows obtained is lower than the
present value of cash flow. Lower rate is to be taken up. The process is continued till the net
present value becomes Zero. As this discount rate is determined internally, this method is
called internal rate of return method.

IRR= L+ 𝑷𝟏−𝑸 /𝑷𝟏−𝒑𝟐 × 𝑫

L- Lower discount rate

P1 - Present value of cash inflows at lower rate.
P2 - Present value of cash inflows at higher rate.
Q- Actual investment
D- Difference in Discount rates.

Merits:
1. It consider the time value of money
2. It takes into account the cash flows over the entire useful life of the asset.
3. It has a psychological appear to the user because when the highest rate of return projects
are selected, it satisfies the investors in terms of the rate of return an capital
4. It always suggests accepting to projects with maximum rate of return.
5. It is inconformity with the firm’s objective of maximum owner’s welfare.

Demerits:
1. It is very difficult to understand and use.
2. It involves a very complicated computational work.
3. It may not give unique answer in all situations.

C. Probability Index Method (PI)

The method is also called benefit cost ration. This method is obtained cloth a slight
modification of the NPV method.
In case of NPV the present value of cash out flows are profitability index (PI), the present
value of cash inflows are divide by the present value of cash out flows, while NPV is a
absolute measure, the PI is a relative measure.
It the PI is more than one (>1), the proposal is accepted else rejected. If there are more than
one investment proposal with the more than one PI the one with the highest PI will be
selected. This method is more useful incase of projects with different cash outlays cash
outlays and hence is superior to the NPV method.

Probability Index = 𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒇𝒖𝒕𝒖𝒓𝒆 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘/

The formula for PI is

𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
 Merits:
1. It requires less computational work then IRR method
2. It helps to accept / reject investment proposal on the basis of value of the index.
3. It is useful to rank the proposals on the basis of the highest/lowest value of the index.
4. It is useful to tank the proposals on the basis of the highest/lowest value of the index.
5. It takes into consideration the entire stream of cash flows generated during the useful life
of the asset.

Demerits:
1. It is some what difficult to understand
2. Some people may feel no limitation for index number due to several limitation involved
in their competitions
3. It is very difficult to understand the analytical part of the decision on the basis of
probability index.

Capital rationing
Introduction:
In the intricate realm of finance, businesses are often confronted with the challenge of allocating
capital judiciously. This challenge is further compounded by the concept of capital rationing, a
strategic framework aimed at optimizing the allocation of limited financial resources to
maximize returns. Understanding the intricacies of capital rationing is paramount for financial
decision-makers, as it empowers them to navigate resource constraints effectively while pursuing
sustained growth and profitability.

Definition:
Capital rationing can be defined as the deliberate allocation of scarce financial resources among
competing investment opportunities to achieve optimal returns. It arises when businesses
encounter constraints on available capital, whether due to internal budgetary limitations,
borrowing constraints, or strategic considerations. Instead of having an unlimited pool of funds
for investment, companies must prioritize and allocate capital strategically to projects or
investments offering the highest potential returns.

Advantages:
Embracing capital rationing offers several advantages for businesses striving to optimize their
financial performance:

 Resource Optimization: By directing resources towards projects with the highest

expected returns, capital rationing ensures that limited funds are allocated efficiently
to initiatives that generate maximum value for the organization.

 Risk Mitigation: Prioritizing investments based on their risk-return profiles helps

mitigate overall risk exposure, reducing the likelihood of financial losses.
  Strategic Alignment: Capital rationing encourages alignment with the company's
strategic objectives by directing investments towards projects that support long-term
growth and sustainability.

 Enhanced Financial Discipline: The process of capital rationing instills financial

discipline within the organization, fostering a more prudent approach to resource
allocation and investment decision-making.

Types of Rationing:
Capital rationing manifests in various forms, each with distinct characteristics and implications:

 Hard Rationing: In hard rationing, constraints on capital are externally imposed,

such as limitations imposed by lenders or regulatory authorities. Businesses must
adhere strictly to these constraints, leaving minimal room for flexibility in
investment decisions.

 Soft Rationing: Soft rationing occurs when internal factors, such as budgetary
constraints or management decisions, limit the availability of capital for investment.
While not as rigid as hard rationing, soft rationing still necessitates careful
prioritization of investment opportunities based on available resources.

 Implicit Rationing: Implicit rationing arises when resource constraints are not
explicitly defined but are implied through the organization's financial performance
or strategic priorities. In such cases, financial decision-makers must discern and
navigate implicit constraints to optimize resource allocation effectively.