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.

𝒄𝒂𝒔𝒉 𝒐𝒖𝒕𝒍𝒂𝒚 (𝑶𝑹)𝑶𝒓𝒊𝒈𝒊𝒏𝒂𝒍 𝒄𝒐𝒔𝒕 𝒐𝒇 𝒑𝒓𝒐𝒋𝒆𝒄𝒕

Payback period =
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.,

𝑨𝒗𝒆𝒓𝒂𝒈𝒆 𝒏𝒆𝒕 𝒊𝒏𝒄𝒐𝒎𝒆 𝒂𝒇𝒕𝒆𝒓 𝒕𝒂𝒙𝒆𝒔

ARR= 𝒂𝒗𝒆𝒓𝒂𝒈𝒆 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
× 𝟏𝟎𝟎

𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑐𝑜𝑚𝑒 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠

Average income after taxes=
𝑛𝑜.𝑜𝑓 𝑦𝑒𝑎𝑟𝑠

𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Average 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= Present value of cash inflows – investment.

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

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.
5. 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.

𝑷𝟏−𝑸
IRR= L+ ×𝑫
𝑷𝟏−𝒑𝟐

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.

The formula for PI is

𝑷𝒓𝒆𝒔𝒆𝒏𝒕 𝒗𝒂𝒍𝒖𝒆 𝒐𝒇 𝒇𝒖𝒕𝒖𝒓𝒆 𝒄𝒂𝒔𝒉 𝒊𝒏𝒇𝒍𝒐𝒘

Probability Index =
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.