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Financial Management Unit 8

Sikkim Manipal University Page No. 146

Unit 8 Capital Budgeting

Structure:

8.1 Introduction

Learning objectives

8.2 Importance of Capital Budgeting

8.3 Complexities involved in Capital Budgeting Decisions

8.4 Phases of Capital Expenditure Decisions

8.5 Identification of Investment Opportunities

8.6 Rationale of Capital Budgeting Proposals

8.7 Capital Budgeting Process

Technical appraisal

Economic appraisal

Financial appraisal

8.8 Investment Evaluation

Estimation of cash flows

8.9 Appraisal Criteria

Traditional techniques

Pay back method

Accounting rate of return

Discounted pay-back period

Discounted cash flow period

8.10 Summary

8.11 Terminal Questions

8.12 Answers to SAQs and TQs

8.1 Introduction

Indian economy is growing at 9% per annum. New lines of business such as

retailing investment, investment advisory services and private banking are

emerging. All such businesses involve investment decisions. These

investment decisions that corporates take are known as capital budgeting

decisions. Such decisions help corporates reap the benefits arising out ofthe emerging business opportunities.

Capital budgeting decisions involve evaluation of specific investment

proposals. Here the word capital refers to the operating assets used in

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production of goods or rendering of services. Budgeting involves formulating

a plan of the expected cash flows during the future period.Capital budgeting is a blue-print of planned investments in operating assets.

Therefore, capital budgeting is the process of evaluating the profitability of

the projects under consideration and deciding on the proposal to be

included in the capital budget for implementation.

Capital budgeting decisions involve investment of current funds in

anticipation of cash flows occurring over a series of years in future. All these

decisions are strategic because they change the profile of the organisations.

Successful organisations have created wealth for their shareholders through

capital budgeting decisions. Investment of current funds in long term assetsfor generation of cash flows in future over a series of years characterises

the nature of capital budgeting decisions.

HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over

Bank of Madurai. The motive behind all these mergers is to grow because in

this era of globalisation the need of the hour is to grow as big as possible. In

all these, one could observe the desire of the management to create value

for shareholders as a motivating force.

Another way of growing is through branch expansion, expanding the product

mix and reducing cost through improved technology for deeper penetration

into the market for the companys products.

Investment of current funds in long-term assets for generation of cash flows

in future over a series of years characterises the nature of capital budgeting

decisions.

Example -1

A bank which is urban based, for expansion takes over a bank with rural

network because, urban based bank can open more urban branches

only when it meets the Reserve Bank of India guideline of having a

minimum number of rural branches. This is the motive of the merger of

urban based bank of ICICI with the rural based Bank of Madurai.

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8.1.1 Learning objectives

After studying this unit, you should be able to:

Explain the concept of capital budgeting.

Recoil the importance of capital budgeting.

Examine the complexity of capital budgeting procedures.

Discuss the various techniques of appraisal methods

Evaluate capital budgeting decision.

8.2 Importance of Capital Budgeting

Capital budgeting decisions are the most important decisions in corporate

financial management. These decisions make or mar a business

organisation. These decisions commit a firm to invest its current funds in the

operating assets (i.e. long-term assets) with the hope of employing them

most efficiently to generate a series of cash flows in future. These decisions

could be grouped into:

Decision to replace the equipments for maintenance of current level of

business or decisions aiming at cost reductions, known as replacement

decisions

Decisions on expenditure for increasing the present operating level or

expansion through improved network of distribution

Decisions for production of new goods or rendering of new services

Decisions on penetrating into new geographical area

Decisions to comply with the regulatory structure affecting the operations

of the company, like investments in assets to comply with the conditions

imposed by Environmental Protection Act

Decisions on investment to build township for providing residential

accommodation to employees working in a manufacturing plant

The reasons that make the capital budgeting decisions most crucial for finance

managers are:

These decisions involve large outlay of funds in anticipation of cash

flows in future For example, investment in plant and machinery. Theeconomic life of such assets has long periods. The projections of cash

flows anticipated involve forecasts of many financial variables. The most

crucial variable is the sales forecast.

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o For example, Metal Box spent large sums of money on expansion of

its production facilities based on its own sales forecast. During thisperiod, huge investments in R & D in packaging industry brought

about new packaging medium totally replacing metal as an important

component of packing boxes. At the end of the expansion Metal Box

Ltd found itself that the market for its metal boxes has declined

drastically.

The end result is that metal box became a sick company from the

position it enjoyed earlier prior to the execution of expansion as a

blue chip. Employees lost their jobs. It affected the standard of living

and cash flow position of its employees. This highlights the element

of risk involved in these type of decisions.o Equally we have empirical evidence of companies which took

decisions on expansion through the addition of new products and

adoption of the latest technology, creating wealth for share-holders.

The best example is the Reliance Group.

o Any serious error in forecasting sales, the amount of capital

expenditure can significantly affect the firm. An upward bias might

lead to a situation of the firm creating idle capacity, laying the path for

the cancer of sickness.

o Any downward bias in forecasting might lead the firm to a situation of

losing its market to its competitors.

Long time investments of the funds sometimes may change the risk

profile of the firm.

Example -2

A FMCG company decides to enter into a new business of power generation.

This decision will totally alter the risk profile of the business of the company.

Investors perception of risk of the new business to be taken up by the

company will change its required rate of return to invest in the company.

In this connection it is to be noted that the power pricing is a politicallysensitive area affecting the profitability of the organisation. Therefore, capital

budgeting decisions change the risk dimensions of the company and hence

the required rate of return that the investors want.

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Most of the capital budgeting decisions involve huge outlay. The funds

required during the phase of execution must be synchronised with theflow of funds. Failure to achieve the required coordination between the

inflow and outflow may cause time over run and cost over-run.

These two problems of time over run and cost overrun have to be

prevented from occurring in the beginning of execution of the project.

Quite a lot of empirical examples are there in public sector in India in

support of this argument that cost overrun and time over run can make a

companys operation unproductive.

Capital budgeting decisions involve assessment of market for companys

product and services, deciding on the scale of operations, selection of

relevant technology and finally procurement of costly equipment.

If a firm were to realise after committing itself to considerable sums of

money in the process of implementing the capital budgeting decisions

taken that the decision to diversify or expand would become a wealth

destroyer to the company, then the firm would have experienced a

situation of inability to sell the equipments bought. Loss incurred by the

firm on account of this would be heavy if the firm were to scrap the

equipments bought specifically for implementing the decision taken.

Sometimes these equipments will be specialised costly equipments.

Therefore, capital budgeting decisions are irreversible. All capitalbudgeting decisions involves three elements. These three elements are:

o cost

o quality

o timing

Decisions must be taken at the right time which would enable the firm to

procure the assets at the least cost for producing products of required

quality for the customer. Any lapse on the part of the firm in

understanding the effect of these elements on implementation of capital

expenditure decision taken, will strategically affect the firms profitability.

Liberalisation and globalisation gave birth to economic institutions like

world trade organisations. General Electrical can expand its market into

India snatching the share already enjoyed by firms like Bajaj Electricals

or Kirloskar Electric company. Ability of GE to sell its products in India at

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a rate less than the rate at which Indian companies sell cannot be

ignored.Therefore, the growth and survival of any firm in todays business

environment demands a firm to be pro-active. Pro-active firms cannot

avoid the risk of taking challenging capital budgeting decisions for

growth.

The social, political, economic and technological forces generate high

level of uncertainty in future cash flow streams associated with capital

budgeting decisions. These factors make these decisions highly

complex.

Capital budgeting decisions are very expensive. To implement thesedecisions, firms will have to tap the capital market for funds. The

composition of debt and equity must be optimal keeping in view the

expectations of investors and risk profile of the selected project.

Therefore capital budgeting decisions for growth have become an essential

characteristic of successful firms today.

8.3 Complexities involved in Capital Budgeting Decisions

Capital expenditure decision involves forecasting of future operating cash

flows. Forecasting the future cash flows demands certain assumptionsabout the behaviour of costs and revenues in future.

Self Assessment Questions

Fill in the blanks:

1. _______ make or mar a business.

2. _______ decisions involve large outlay of funds in anticipation of cash

inflows in future.

3. Social, political, economical and technological forces make capital

budgeting decisions ___________.

4. __________ are very expensive.

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However, there are complexities involved in capital budgeting decisions

They are:

Estimation of future cash flows

Commitment of funds on long-term basis

Problem of irreversibility of decisions

8.4 Phases of Capital Expenditure Decisions

There are various phases involved in capital budgeting decisions.

Identification of investment opportunities.

Evaluation of each investment proposal

Examination of the investments required for each investment proposal

Preparation of the statements of costs and benefits of investment

proposals

Estimation and comparison of the net present values of the investment

proposals that have been cleared by the management on the basis ofscreening criteria

Examination of the government policies and regulatory guidelines, for

execution of each investment proposal screened and cleared based on

the criteria stipulated by the management


Fill in the blanks:

5. Capital expenditure decisions are _________.

6. Forecasting of future operating cash flows from ____________ because

the future is________.

Example -3

The arrival of mobile revolution made the pager technology obsolete. Thefirms which invested in pagers faced the problem of pagers losing its

relevance as a means of communication. The firms with the ability to

adapt the new know-how in mobile technology could survive the effect of

this phase of technological obsolescence. Others who could not manage

the effect of change in technology had a natural death and so most

capital expenditure decisions are irreversible.

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Budgeting for capital expenditure for approval by the management

Implementation Post-completion audit

8.5 Identification of Investment Opportunities

A firm is in a position to identify investment proposal only when it is

responsive to the ideas of capital projects emerging from various levels of

the organisation. The proposal may be to:

Add new products to the companys product line,

Expand capacity to meet the emerging market at demand for companys

products

Add new technology based process of manufacture that will reduce the

cost of production.


Fill in the blanks:

7. Post-completion audit is ________ in the phases of capital budgeting

decisions.

8. Identification of investment opportunities is the _____ in the phases of

capital budgeting decisions.

Caselet -1

A sales manager may come with a proposal to produce a new product as

per the requirements of companys consumers. Marketing manager,

based on the sales managers proposal, may conduct a market survey to

determine the expected demand for the new product under

consideration.

Once the marketing manager is convinced of the market potential for proposed

new product, the proposal goes to the engineers to examine the same with all

aspects of production process. Then the proposal goes to the cost accountant to

translate the entire gamut of the proposal into costs and revenues in terms of

incremental cash flows- both outflows and inflows. The cost-benefit statement

generated by cost accountant shall include all incremental costs and benefits

that the firm will incur and derive on commercialisation of the proposal under

consideration.

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Therefore, generation of ideas with the feasibility to convert the same into

investment proposals occupies a crucial place in the capital budgeting decisions.

Proactive organisations encourage a continuous flow of investment proposals from

all levels in the organisation.

In this connection following points deserve to be considered:

Analysing the demand and supply conditions of the market for the companys

product could be a fertile source of potential investment proposals.

Market surveys on customers perception of companys product could be a

potential investment proposal to redefine the companys products in terms of

customers expectations.

Companies which invest in Research and Development constantly get

exposure to the benefit of adapting the new technology quite relevant to

keep the firm competitive in the most dynamic business environment.

Reports emerging from R & D section could be a potential source of

investment proposal.

Economic growth of the country and the emerging middle class endowed

with purchasing power could generate new business opportunities in

existing firms. These new business opportunities could be potential

investment ideas.

Public awareness of their rights compels many firms to initiate projects

from environmental protection angle. If ignored, the firm may have to

face the public wrath through PILs entertained at the Supreme Court and

High courts.

Therefore project ideas that would improve the competitiveness of the firm by

constantly improving the production process with the sole objective of cost reduction

and customer welfare, are accepted by well managed firms.

8.6 Rationale of Capital Budgeting Proposals


Fill in the blanks:

9. Analysing the demand and supply conditions of the market for the

companys products could be _______ of potential investment proposal.

10. Generation of ideas for capital budgets and screening the same can be

considered _______ of capital budgetary decisions.

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The investors and the stake-holders expect a firm to function efficiently to

satisfy their expectations. The stake-holders expectation and theperformance of the company may clash among themselves, the one that

touches all these stake-holders expectation could be visualised in terms of

firms obligation to reduce the operating costs on a continuous basis and

increasing its revenues.

Therefore, capital budgeting decisions could be grouped into two categories:

Decisions on cost reduction programmes

Decisions on revenue generation through expansion of installed capacity

8.7 Capital Budgeting Process

Once the screening of proposals for potential involvement is over, the

company should take up the following aspects of capital budgeting process:

A proposal should be commercially viable. The following aspects are

examined to ascertain the commercial viability of any investmentproposal

o Market for the product

o Availability of raw materials

o Sources of raw materials

o The elements that influence the location of a plant i.e. the factors to

be considered in the site selection

Infrastructural facilities such as roads, communication facilities, financial

services such as banking and public transport services

Ascertaining the demand for the product or services is crucial. It is done by

market appraisal. In appraisal of market for the new product, the following

details are compiled and analysed.

Consumption trends

Competition and players in the market


Fill in the blanks:11. __________ decisions could be grouped into two categories.

12. ________ and revenue generation are the two important categories of

capital budgeting.

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Availability of substitutes

Purchasing power of consumers Regulations stipulated by Government on pricing the proposed products

or services

Production constraints

Relevant forecasting technologies are employed to get a realistic picture of

the potential demand for the proposed product or service. Many projects fail

to achieve the planned targets on profitability and cash flows if the firm could

not succeed in forecasting the demand for the product on a realistic basis.

Capital budgeting process involves three steps (see figure 8.1) Financial

appraisal, Technical appraisal and Economic appraisal.

Figure 8.1: Capital budgeting process

8.7.1 Technical appraisal

Technical appraisal ensures implementation of all the technical aspects of

the project. The technical aspects of the project are:

Selection of process know-how

Decision on determination of plant capacity

Selection of plant, equipment and scale of operation

Plant design and layout

General layout and material flow

Construction schedule

8.7.2 Economic appraisal

Economic appraisal examines the project from the social point of view. Hence, is

referred to as social cost benefit analysis. It examines:

The impact of the project on the environment

The impact of the project on the income distribution in the society

The impact of the project on fulfilment of certain social objective like

generation of employment and attainment of self sufficiency

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Examination of the risk profile of the project to be taken up and arriving

at the required rate of return Formulation of the decision criteria

8.8.1 Estimation of cash flows

Estimating the cash flows associated with the project under consideration is

the most difficult and crucial step in the evaluation of an investment

proposal. Estimation is the result of the team work of many professionals in

an organisation.

Capital outlays are estimated by engineering departments after

examining all aspects of production process

Marketing department on the basis of market survey forecasts the

expected sales revenue during the period of accrual of benefits from

project executions

Operating costs are estimated by cost accountants and production

engineers

Incremental cash flows and cash out flow statement is prepared by the

cost accountant on the basis of the details generated in the above steps

The ability of the firm to forecast the cash flows with reasonable accuracy

lies at the root of the success of the implementation of any capital

expenditure decision.

8.8.2 Estimation of incremental cash flowsInvestment (capital budgeting) decision requires the estimation of incremental cash

flow stream over the life of the investment. Incremental cash flows are estimated on

tax basis.

Incremental cash flows stream of a capital expenditure decision has three

components.

Initial cash outlay (Initial investment)

Initial cash outlay to be incurred is determined after considering any post

tax cash inflows. In replacement decisions existing old machinery is

disposed of and a new machinery incorporating the latest technology is

installed in its place.

On disposal of existing old machinery the firm has a cash inflow. This

cash inflow has to be computed on post tax basis. The net cash out flow

(total cash required for investment in capital assets minus post tax cash

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inflow on disposal of the old machinery being replaced by a new one)

therefore is the incremental cash outflow. Additional net working capitalrequired on implementation of new project is to be added to initial

investment.

Operating cash inflows

Operating cash inflows are estimated for the entire economic life of

investment (project). Operating cash inflows constitute a stream of

inflows and outflows over the life of the project. Here also incremental

inflows and outflows attributable to operating activities are considered.

Any savings in cost on installation of a new machinery in the place of the

old machinery will have to be accounted on post tax basis. In this

connection incremental cash flows refer to the change in cash flows onimplementation of a new proposal over the existing positions.

Terminal cash inflows

At the end of the economic life of the project, the operating assets

installed will be disposed off. It is normally known as salvage value of

equipments. This terminal cash inflows are computed on post tax basis.

Prof. Prasanna Chandra in his book Financial Management (Tata McGraw

Hill, published in 2007) has identified certain basic principles of cash flow

estimation. The knowledge of these principles will help a student in

understanding the basics of computing incremental cash flows.

The basic principles of cash flow estimation, by Prof. Prasanna Chandra,

are (see figure 8.2) Separation principle, Increment principle, Post-tax

principle and Consistency principle.

Figure 8.2: Principles of Prof. Prasanna Chandra

Separation principle

The essence of this principle is the necessity to treat investment element of

the project separately (i.e. independently) from that of financing element.

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The financing cost is computed by the cost of capital. Cost of capital is the

cut off rate and rate of return expected on implementation of the project.Therefore, we compute separately cost of funds for execution of project

through the financing mode. The rate of return expected on implementation

if the project is arrived at by the investment profile of the projects. Therefore,

interest on debt is ignored while arriving at operating cash inflows.

The following formula is used to calculate profit after tax

EBIT = earnings (profit) before interest and taxes

t = tax rate

Incremental principle

Incremental principle says that the cash flows of a project are to be

considered in incremental terms. Incremental cash flows are the changes in

the firms total cash flows arising directly from the implementation of the

project. Keep the following in mind while determining incremental cash

flows.

Ignore sunk costs

Sunk costs are costs that cannot be recovered once they have been

incurred. Therefore, sunk costs are ignored when the decisions on projectunder consideration is to be taken.

Opportunity costs

If the firm already owns an asset or a resource which could be used in the

execution of the project under consideration, the asset or resource has an

opportunity cost. The opportunity cost of such resources will have to be

taken into account in the evaluation of the project for acceptance or

rejection.

Incremental PAT = Incremental EBIT ( 1-t )

(Incremental) (Incremental)

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Need to take into account all incident effect

Effects of a project on the working of other parts of a firm also known as

externalities must be taken into account.

Cannibalisation

Another problem that a firm faces on introduction of a new product is the

reduction in the sale of an existing product. This is called cannibalisation.

The most challenging task is the handling the problems of cannibalisation.

Depending on the companys position with that of the competitors in the

market, appropriate strategy has to be followed. Correspondingly the cost of

cannibalisation will have to be treated either as relevant cost of the decision

or ignored.

Depending on the companys position with that of the competitors in the

market, appropriate strategy has to be followed. Correspondingly the cost ofcannibalisation will have to be treated either as relevant cost of the decision

or ignored. Product cannibalisation will affect the companys sales if the firm

is marketing its products in a market characterised by severe competition,

without any entry barriers. In this case costs are not relevant for decision.

Caselet -3

Expansion or establishment of a branch at a new place may increase the

profitability of existing branches because the branch at the new place

has a complementary relationship with the other existing branches or

reduce the profitability of existing branches because the branch at the

new place competes with the business of other existing branches or

takes away some business activities from the existing branches.

Caselet -2

A firm wants to open a branch in Chennai for expansion of its market inTamil Nadu. The firm already owns a building in Chennai. The building in

Chennai is let out to some other firm on an annual rent of Rs. 1 crore.

For opening the branch at Chennai the firm uses its own building by

sacrificing the rental income which it has been receiving. The opportunity

cost of the building at Chennai is Rs. 1 crore. This will have to be

considered in arriving at the operating cash flows associated with the

decision to open a branch at Chennai.

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However, if the firms sales are not affected by competitors activities due to

certain unique protection that it enjoys on account of brand positioning orpatent protection, the costs of cannibalisation cannot be ignored in taking

decisions.

Post tax principle

All cash flows should be computed on post tax basis

Consistency principle

Cash flows and discount rates used in project evaluation need to be

consistent with the investor group and inflation.

Solved Problem -1

A firm is considering replacement of its existing machine by a newmachine. The new machine will cost Rs 1,60,000 and have a life of five

years. The new machine will yield annual cash revenue of Rs 2,50,000

and incur annual cash expenses of Rs 1,30,000. The estimated salvage

of the new machine at the end of its economic life is Rs 8,000. The

existing machine has a book value of Rs 40,000 and can be sold for Rs

20,000. The existing machine, if used for the next five years is expected

to generate annual cash revenue of Rs 2,00,000 and involves annual

cash expenses of Rs 1,40,000. If sold after five years, the salvage value

of the existing machine will be negligible.

The company pays tax at 30%. It writes off depreciation at 25% on the

written down value. The companys cost of capital is 20% . Compute theincremental cash flows of replacement decisions.

Solution

Table 8.1 gives the initial investments and annual cash flows from

projects.

Table 8.1: Initial investments and annual cash flows

Initial investment

Gross investment for new machine (1, 60, 000)

Less: cash received from the sale of existing machine 20, 000

Net cash outlay (1, 40, 000)

Annual cash flows from operations

Incremental cash flows from revenue 50, 000

Incremental decrease in expenditure 10, 000

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Table 8.2 shows the incremental depreciation schedule:

Table 8.2: Incremental depreciation schedule

Year Depreciation(new machine)

Depreciation(old machine)

Incrementaldepreciation (Rs.)

1 45, 000 10,000 (35,000)

2 33, 750 7,500 (26,250)

3 25, 312 5,625 (19,687)

4 18, 984 4,219 (14,765)

5 14, 238 3,164 (11,074)

Table 8.3 shows the calculation of depreciation:

Table 8.3: Calculation of depreciation

Book value 40, 000

Add: cost of new machine 1, 60, 000

2, 00, 000

Less: sale proceeds of old machine 20, 000

1, 80, 000

Depreciation for 1 year 25% 45, 000

1, 35, 000


1, 01, 250Depreciation for 3 year 25% 25, 312

75, 938


56, 954


Book value after 5 years 42, 716

The computation of the incremental cash flows of replacement decisions

is briefly described in table 8.4.

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Table 8.4: Statement of incremental cash flows

Particulars Year

0 1 2 3 4 5

1. Investment in newmachine

(1,60,000)

2. After tax salvagevalue of old machine

20,000

3. Net Cash Out lay (1,40,000)

4. Increase in revenue 50,000 50,000 50,000 50,000 50,000

5. Decrease inexpenses

10,000 10,000 10,000 10,000 10,000

6. Increase indepreciation

(35,000) (26,250) (19,687) (14,765) (11,074)

7. Increase in EBIT

(4+5 -6)

25,000 33,750 40,313 45,235 48,926

8. EBIT (1 T)

(1-.30)

17,500 23,625 28,219 31,665 34,248

9. Incremental Cashflows from operation(8 + 6)

EAT + Depreciation

52,500 49,875 47,906 46,430 45,322

10. Salvage value ofnew machine

8,000

11. Incremental Cashflows from operation(8 + 6)

EAT + Depreciation

(1,40,000)negative

52,500 49,875 47,906 46,430 53,322

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8.9 Appraisal Criteria

The methods of appraising an investment proposal can be grouped into

1. Traditional methods.

2. Modern methods.

Traditional methods are:

o Payback method

o Accounting rate of return

Modern techniques are:

o Net present value

o Internal rate of return

o Modified internal rate of return

o Profitability index

8.9.1 Traditional techniques

Traditional methods are of two types payback method and accounting rate

of return.

8.9.1.1 Payback method

Payback period is defined as the length of time required to recover the initial

cash out lay.


Fill in the blanks:

17. ______ is the third step in the evaluation of investment proposal.

18. A ________ is not a relevant cost for the project decision.

19. Effect of a project on the working of other parts of a firm is known as

__________.

20. The essence of separation principle is the necessity to treat _____ of a

project separately from that of ________.

21. Pay-back period __________ time value of money.

22. IRR gives a rate of return that reflects the ______ the project.

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Solved Problem -2

The following details shown in table 8.5, are in respect of the cash flowsof two projects A and B.

Table 8.5: Cash flows of A and B

Year Project A cash flows (Rs.) Project B cash flows (Rs.)

0 (4,00,000) (5,00,000)

1 2,00,000 1,00,000

2 1,75,000 2,00,000

3 25,000 3,00,000

4 2,00,000 4,00,0005 1,50,000 2,00,000

Compute pay-back period for A and B.

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8.9.1.1.1 Evaluation of payback period:

Simple in concept and application

Emphasis is on recovery of initial cash outlay. Pay-back period is the

best method for evaluation of projects with very high uncertainty

Solution

The cash flows and the cumulative cash flows of the projects A and B are

shown under in table 8.6

Table 8.6 Cash flows and cumulative cash flows of A and B

Year Project A Project B

Cash flows(Rs.)

CumulativeCash flows

Cash flows(Rs.)

Cumulative Cashflows

1 2,00,000 2,00,000 1,00,000 1,00,000

2 1,75,000 3,75,000 2,00,000 3,00,000

3 25,000 4,00,000 3,00,000 6,00,000

4 2,00,000 6,00,000 4,00,000 10,00,000

5 1,50,000 7,50,000 2,00,000 12,00,000

From the cumulative cash flows column, project A recovers the initial cash outlay

of Rs 4,00,000 at the end of the third year. Therefore, payback period of project

A is 3 years.

From the cumulative cash flow column the initial cash outlay of

Rs. 5,00,000 lies between 2nd year and 3rd year in respect of project B.

Therefore, payback period for project B is:

000,00,3

000,00,3000,00,52

= 2.67 years

Pay-back period for project B is 2.67 years

Merits

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With respect to accept or reject criterion, pay back method favours a

project which is less than or equal to the standard pay back set bythe management. In this process early cash flows get due

recognition than later cash flows. Therefore, pay-back period could

be used as a tool to deal with the ranking of projects on the basis of

risk criterion

For firms with short-age funds this is preferred because it measures

liquidity of the project

Pay-back period ignores time value of money.

It does not consider the cash flows that occur after the pay-back

period.

It does not measure the profitability of the project.

It does not throw any light on the firms liquidity position but just tells

about the ability of the project to return the cash out lay originally

made.

Project selected on the basis of pay back criterion may be in conflict

with the wealth maximisation goal of the firm.

Accept or reject criteria

If projects are mutually exclusive, select the project which has the leastpay-back period

In respect of other projects, select the project which have pay-back period

less than or equal to the standard pay back stipulated by the management

Illustration

Pay-back period:

Project A = 3 years

Project B = 2.5 years

Standard set up by management = 3 years

If projects are mutually exclusive, accept project B which has the least

pay-back period.

If projects are not mutually exclusive, accept both the projects because

both have pay-back period less than or equal to the standard pay-back

period set by the management

Demerits

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Pay-back formula

8.9.1.2 Accounting rate of return

Accounting rate of return (ARR) measures the profitability of investment

(project) using information taken from financial statements:

ARR = Average income / Average investment

ARR = Average of post tax operating profit / Average investment

Solved Problem -3

The following particulars shown in table 8.7 refers to two projects:Table 8.7: Particulars of two projects

X Y

Cost 40,000 60,000

Estimated life 5 years 5 years

Salvage value Rs. 3,000 Rs. 3,000

Estimate income

Table 8.8: After tax

Rs. Rs.

1 3,000 10,000

2 4,000 8,0003 7,000 2,000

4 6,000 6,000

5 8,000 5,000

Total 28,000 31,000

Average investment =

2

investmentorprojecttheoflifethebeginningthein

ofendtheatinvestmentofvalueBookinvestmenttheofValueBook

Year Prior to full recovery + Balance of initial out lay to be recoveredOf initial out lay at the beginning of the year in which full

placetakesrecoveryfullw hichinyeartheofflowinCash

placetakeserycovRe

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It is based on accounting information Simple to understand

It considers the profits of entire economic life of the project

Since it is based on accounting information, the business executives

familiar with the accounting information understand it

ARR is based on accounting income not on cash flows, as the cash

flow approach is considered superior to accounting information

based approach

ARR does not consider the time value of money

Different investment proposals which require different amounts of

investment may have the same accounting rate of return. The ARR

fails to differentiate projects on the basis of the amount required for

investment

ARR is based on the investment required for the project. There are

many approaches for the calculation of denominator of average

investment. Existence of more than one basis for arriving at the

denominator of average investment may result in adoption of many

arbitrary bases

Due to this the reliability of ARR as a technique of appraisal is reduced

when two projects with the same ARR but with differing investment amounts

are to be evaluated.

Average 5,600 6,200

Average investment 21,500 31,500

500,31

200,6

500,21

600,5ARR

= 26 % (Firm X) 19.7% (Firm Y)

Merits of accountin rate of return

Demerits of accounting rate of return

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In any project which has an excess ARR, the minimum rate fixed by themanagement is accepted.

If actual ARR is less than the cut-off rate (minimum rate specified by the

management ) then that project is rejected.

When projects are to be ranked for deciding on the allocation of capital

on account of the need for capital rationing, project with higher ARR are

preferred to the ones with lower ARR.

8.9.2 Discounted pay-back period

The length in years required to recover the initial cash out lay on the present value

basis is called the discounted pay-back period. The opportunity cost of capital is

used for calculating present values of the cash inflows. Discounted pay-back periodfor a project will be always higher than simple pay-back period because the

calculation of discounted pay-back period is based on discounted cash flows.

8.9.3 Discounted cash flow method

Solved Problem -4

Table 8.9 shows the cash flows of project A for different years at a rate of

10% p.a.

Table 8.9: Cash flows of project A

YearProject A

Cash flowsPV factor at 10%

PV of Cashflows

Cumulativepositive

Cash flows0 (4,00,000) 1 (4,00,000)

1 2,00,000 0.909 1,81,800 1,81,800

2 1,75,000 0.826 1,44,550 3,26,350

3 25,000 0.751 18,775 3,45,125

4 2,00,000 0.683 1,36,600 4,81,725

5 1,50,000 0.621 93,150 5,74,875

Discounted pay-back period

years4.3

600,36,1

125,45,3000,00,43

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Discounted cash flow method or time adjusted technique is an improvement

over the traditional techniques. In evaluation of the projects the need to giveweight-age to the timing of return is effectively considered in all DCF

methods. DCF methods are cash flow based and take the cognisance of

both the interest factors and cash flow after the pay-back period.

DCF technique involves:

Estimation of cash flows, both inflows and outflows of a project over the

entire life of the project

Discounting the cash flows by an appropriate interest factor (discount

factor)

Deducting the sum of the present value of cash outflows from the sum

of present value of cash inflows to arrive at net present value of cashflows

The most popular techniques of DCF methods are:

The net present value

The internal rate of return

Profitability index

Net present value

Net present value (NPV) method recognises the time value of money. It

correctly admits that cash flows occurring at different time periods differ in

value. Therefore, there is the need to find out the present values of all cash

flows. NPV method is the most widely used technique among the DCF

methods.

Steps involved in NPV method involve:

Forecasting the cash flows, both inflows and outflows of the projects to

be taken up for execution

Decisions on discount factor or interest factor. The appropriate discount

rate is the firms cost of capital or required rate of return expected by the

investors

Computation of the present value of cash inflows and outflows using the

discount factor selected Calculation of NPV by subtracting the PV of cash outflows from the

present value of cash inflows.

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If NPV is positive, the project should be accepted. If NPV is negative theproject should be rejected.

Accept or reject criterion can be summarised as given below:

NPV > Zero = accept

NPV < Zero = reject

NPV method can be used to select between mutually exclusive projects by

examining whether incremental investment generates a positive net present value.

It takes into account the time value of money.

It considers cash flows occurring over the entire life of the project.

NPV method is consistent with the goal of maximising the net wealth

of the company.

It analyses the merits of relative capital investments.

Since cost of capital of the firm is the hurdle rate, the NPV ensures

that the project generates profits from the investment made for it.

Forecasting of cash flows is difficult as it involves dealing with the

effect of elements of uncertainties on operating activities of the firm.

To decide on the discounting factor, there is the need to assess the

investors required rate of return. But it is not possible to compute

the discount rate precisely.

There are practical problems associated with the evaluation of

projects with unequal lives or under funds constraints

For ranking of projects under NPV approach, the project with the highest positive

NPV is preferred to that with a lower NPV.

Merits of NPV method

Demerits of NPV method

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Solved Problem -5

A project costs Rs.25000 and is expected to generate cash inflows asshown in table 8.10

Table 8.10: Cash inflows

Year Cash inflows

1 10,000

2 8,000

3 9,000

4 6,000

5 7,000

The cost of capital is 12%. The present value factors are as shown in the

table 8.11. Table 8.11: Present value factors

Year PV factor at 12%

1 0.893

2 0.797

3 0.712

4 0.636

5 0.567

Compute the NPV of the project

Solution

The present value of the cash flows are computed based on theinformation given in tables 8.8 and 8.9, at a rate of interest of 12% per

annum, in the table 8.12 shown under:

Table 8.12: PV of cash flows

Year Cash flowsPV factor at

12%PV of cash flows

1 10,000 0.893 8,930

2 8,000 0.797 6,376

3 9,000 0.712 6,408

4 6,000 0.636 3,816

5 7,000 0.567 3,969

Total 29,499Sum of the present value of the cash outflows = 25,000

NPV = 4,499

The project generates a positive NPV of Rs. 4,499. Therefore, project

should be accepted.

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Solved Problem

A company is evaluating two alternatives for distribution within the plant.

Two alternatives are

C system with a high initial cost but low annual operating costs.

F system which costs less but have considerably higher operating

costs.

The decision to construct the plant has already been made, and the

choice here will have no effect on the overall revenues of the project. The

cost of capital of the plant is 12% and the projects expected net cash

costs are listed in table 8.13.

Table 8.13: Expected net cash

YearExpected net cash costs

C systems F systems

0 (3,00,000) (1,20,000)

1 (66,000) (96,000)

2 (66,000) (96,000)

3 (66,000) (96,000)

4 (66,000) (96,000)

5 (66,000) (96,000)

What is the present value of costs of each alternative?

Which method should be chosen?

Solution

What is the present value of costs of each alternative?

Which method should be chosen?

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Properties of the NPV

NPVs are additive. If two projects A and B have NPV (A) and NPV (B)

then by additive rule the net present value of the combined investment is

NPV (A + B)

Intermediate cash inflows are reinvested at a rate of return equal to the

cost of capital.

Internal rate of return (IRR)

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the

NPV of any project equal to zero. IRR is the rate of interest which equates

the PV of cash inflows with the PV of cash outflows.

Solution

Computation of present value is done in table 8.14Table 8.14: Computation of PV

Year C systems F systems Incremental

1 (66,000) (96,000) 30,000

2 (66,000) (96,000) 30,000

3 (66,000) (96,000) 30,000

4 (66,000) (96,000) 30,000

5 (66,000) (96,000) 30,000

Present value of incremental savings =30,0000 x PV IFA (12%, 5)= 30,000 x 3.605 = 1,08,150

Initial cash outlay [C system F system] = 3,00,000 1,20,000

Incremental cash outlay = 1,80,000 108150 =71850

Since the present value of incremental net cash inflows of C system over F

system is negative. C system is not recommended.

Therefore, F system is recommended .

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IRR is also called as yield on investment, managerial efficiency of capital, marginal

productivity of capital, rate of return and time adjusted rate of return. IRR is the rate

of return that a project earns.

IRR takes into account the time value of money

IRR calculates the rate of return of the project, taking into account

the cash flows over the entire life of the project.

It gives a rate of return that reflects the profitability of the project.

It is consistent with the goal of financial management i.e.

maximisation of net wealth of share holders IRR can be compared with the firms cost of capital.

To calculate the NPV the discount rate normally used is cost of

capital. But to calculate IRR, there is no need to calculate and

employ the cost of capital for discounting because the project is

evaluated at the rate of return generated by the project. The rate of

return is internal to the project.

IRR does not satisfy the additive principle.

Multiple rate of returns or absence of a unique rate of return in

certain projects will affect the utility of this technique as a tool of

decision making in project evaluation.

In project evaluation, the projects with the highest IRR are given

preference to the ones with low internal rates.

Application of this criterion to mutually exclusive projects may lead

under certain situations to acceptance of projects of low profitability

at the cost of high profitability projects.

IRR computation is quite tedious.


If the projects internal rate of return is greater than the firms cost of capital,

accept the proposal, otherwise reject the proposal.

Merits of IRR

Demerits of IRR

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IRR can be determined by solving the following equation for

Sum of the present values of cash inflows at the rate of interest of r :-

t

t0

)r1(

CCF

where t = 1 to n

r =t

t0

)r1(

CCF

where t = 1 to n

CF0 = Investment

Solved Problem

A project requires an initial outlay of Rs. 1,00,000. It is expected togenerate the following cash inflows shown in table 8.15

Table 8.15: Cash inflows

Year Cash inflows

1 50,000

2 50,000

3 30,000

4 40,000

What is the IRR of the project?

SolutionStep 1

The average of annual cash inflows is computed as shown under in table

8.16Table 8.16:Average of cash inflows

Year Cash inflows

1 50,000

2 50,000

3 30,000

4 40,000

Total 1,70,000

500,42.Rs4

000,70,1Average

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Step 2

Divide the initial investment by the average of annual cash inflows

35.2500,42

000,00,1

Step 3

From the PVIFA table for 4 years, the annuity factor very near 2.35 is

25%. Therefore the first initial rate is 25% as shown in table 8.17

Table 8.17: Trial rate at 25%

Year Cash flows PV factor at 25 % PV of Cash flows

1 50,000 0.800 40,000

2 50,000 0.640 32,0003 30,000 0.512 15,360

4 40,000 0.410 16,400

Total 1,03,760

Since the initial investment of Rs.1,00,000 is less than the computed

value at 25% of Rs.1,03,760 the next trial rate is 26%.

Hence the changes in the calculations are as shown in table 8.18



1 50,000 0.7937 39,685

2 50,000 0.6299 31,495

3 30,000 0.4999 14,997

4 40,000 0.3968 15,872

Total 1,02,049

The next trial rate is 27%, the changes are as shown under in table 8.19.



1 50,000 0.7874 39,370

2 50,000 0.6200 31,000

3 30,000 0.4882 14,646

4 40,000 0.3844 15,376

Total 1,00,392

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Modified Internal Rate of Return (MIRR)

Modified internal rate of return (MIRR) is a distinct improvement over the

IRR. Managers find IRR intuitively more appealing than the rupees of NPV

because IRR is expressed on a percentage rate of return. MIRR modifies

IRR. MIRR is a better indicator of relative profitability of the projects. MIRR

is defined as

PV of Costs = PV of terminal value

cash outflow t

(1+r) t

cash inflow (1+r) n-t

The next trial rate is 28%, the changes are as shown under in

table 8.20Table 8.20: Trial rate at 28%


1 50,000 0.7813 39,065

2 50,000 0.6104 30,520

3 30,000 0.4768 14,3047

4 40,000 0.3725 14,900

Total 98,789

Since initial investment of Rs.1,00,000 lies between 98789 (28 %) and 1,00,392(27%) the IRR by interpolation.

1789,98392,00,1

000,00,1392,00,127

11603

39227

= 27 + 0.2445

= 27.2445 = 27.24 %

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PVC = PV of costs

To calculate PVC, the discount rate used is the cost of capital. To calculatethe terminal value, the future value factor is based on the cost of capital

MIRR is obtained on solving the following equation.

Superiority of MIRR over IRR

MIRR assumes that cash flows from the project are reinvested at the

cost of capital. The IRR assumes that the cash flows from the project are

reinvested at the projects own IRR. Since reinvestment at the cost of

capital is considered realistic and correct, the MIRR measures the

projects true profitability

MIRR does not have the problem of multiple rates which we come

across in IRR

Solved Problem

The cash flows for respective years at a cost of capital of 12% is as shown

in table 8.21.

Table 8.21: Cost of capital

Year 0 1 2 3 4 5 6

Cash flows (Rs. in millions) (100) (100) 30 60 90 120 130

Present value of cost = 100 +12.1

100

= 100 + 89.29 = 189.29

Terminal value of cash flows:

cash inflow (1+r) n-t

Where r = 0.12, n= 6 , t=2 for the 2nd year, t=3 for 3rd year, t=4 for 4th year

and so on.

= 30 (1.12)4 + 60 (1.12)3 + 90 (1.12)2 + 120 (1.12) + 130

= 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130

= 47.205 + 84.294 + 112.896 + 134.4 + 130

= 508.80

PV of costs = TV/ (1 + MIRR)n

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Profitability Index

Profitability index is also known as benefit cost ratio. Profitability index is the

ratio of the present value of cash inflows to initial cash outlay. The discount

factor based on the required rate of return is used to discount the cash

inflows.


Accept the project if PI is greater than 1

Reject the project if PI is less than 1

If profitability index is 1 then the management may accept the project because the

sum of the present value of cash inflows is equal to the sum of present value of

cash outflows. It neither adds nor reduces the existing wealth of the company.

It takes into account the time value of money

It is consistent with the principle of maximisation of share holderswealth

It measures the relative profitability

P1= Present value of cash inflows / initial cash outlay

MIRR is obtained on solving the following equation:

6)MIRR1(

80.50829.189

29.189

80.508)MIRR1( 6

(1 + MIRR)6 = 2.6879

MIRR = 17.9 %

Modified internal rate of return = 17.9%

Merits of PI

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Estimation of cash flows and discount rate cannot be done

accurately with certainty

A conflict may arise between NPV and profitability index if a choice

between mutually exclusive projects has to be made.

Solved Problem

A firm is considering an investment proposal which requires an initial

cash outlay of Rs 8lakhs now and Rs 2lakhs at the end of the third year.

It is expected to generate cash flows as shown in table 8.22

Table 8.22 Cash inflows

Year Cash inflows

1 3,50,000

2 8,00,000

3 2,50,000

Apply the discount rate of 12% and calculate profitability index

Demerits of PI

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8.10 Summary

Capital investment proposals involve current outlay of funds in the

expectation of a stream of cash inflow in future. Various techniques are

available for evaluating investment projects. They are grouped into

traditional and modern techniques. The major traditional techniques are

payback period and accounting rate of return.

The important discounting criteria are net present value, internal rate of

return and profitability index. A major deficiency of payback period is that it

does not take into account the time value of money. DCF techniquesovercome this limitation. Each method has both positive and negative

aspects. The most popular method for large project is the internal rate of

return. Payback period and accounting rate of return are popular for

evaluating small projects.

Solution

Table 8.23: Present value of cash outflowsYear PV factor at 12 % Cash out flows PV of Cash flows

1 Rs.8lakhs Rs.8lakhs

2

3 0.712 2lakhs 1.424lakhs

Total 9.424lakhs

Table 8.24: Present value of cash inflows

Year PVIF (12%) Cash inflows PV of Cash flows

1 0.893 3,50,000 3.1255 lakhs

2 0.797 8,00,000 6.376 lakhs4 0.636 2,50,000 1.5900 lakhs

Total 11.0915 lakhs

outflowscashofvaluepresentofTotal

lowsinfcashofvaluepresentofTotalPI

177.1424.9

0915.11

For every Re.1 invested the project is expected to give a cash inflow of

Rs. 1.177 i.e. for every rupee invested a profit of Rs.0.177 is obtained.

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8.11 Terminal Questions

1. Examine the importance of capital budgeting.2. Briefly examine the significance of identification of investment

opportunities in capital budgeting process.

3. Critically examine the pay-back period as a technique of approval of

projects.

4. Summarise the features of DCF techniques.

8.12 Answers to SAQs and TQs

Answers to Self Assessment Questions

1. Capital budgeting


3. Highly complex

4. Capital budgeting decisions

5. Irreversible

6. Uncertainty, highly uncertain.

7. Final step

8. First step

9. A fertile source

10. The most crucial phase


12. Cost reduction

13. Economic appraisal

14. Technical appraisal

15. Financial viability

16. Demand for the product or service.

17. Decision criteria

18. Sunk cost

19. Externalities

20. Investment element; Financing element

21. Ignores

22. Profitability of

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Sikki M i l U i i P N 186

Answers to Terminal Questions

1. Refer to 8.22. Refer to 8.5

3. Refer to 8.8.1

4. Refer to 8.8.2

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