SBBA FINANCIAL MANAGEMENT UNIT -II

Question NO : 1 ) What is Capital Budgeting ? Discuss its significance in business.

Ans : MEANING OF CAPITAL BUDGETIGN : The term capital means certain sum of money contributed by the promoter at the time of initiating the business. It
may be classified as fixed capital and working capital. Fixed capital is the capital which is obtained by the firm from the owner , in the form of share capital and it
also obtained from the balances of retained earnings and surpluses. Some times it may be borrowed from the public through issue of debentures, shares public
deposits and loans. It is otherwise called as long term funds of the organization. The amount of the fixed capital is still in the organization for very long period.
The term capital Budgeting refers to long term planning for the proposed capital outlays and their financing. In other words it is the decision making process
by which the firms to evaluate their activities specifically for the acquisition of major fixed assets whose benefits would spread some specified future periods.
Capital budgeting is also known as investment decision making, planning capital expenditure,

Capital budgeting consists in planning, development of available capital for the purpose of maximizing the long-term profitability of the concern . [
Lynch ]

“Capital budgeting is long term planning for making and financing proposed capital outlays” [Charles T. Horngreen ]

NEED AND IMPORTANCE OF CAPITAL BUDGETING :

Each and every business organisaion has to meet out various business decisions. Among these capital budgeting is the most crucial and critical business
decisions, because of the following grounds :

i.REQUIREMENTS OF HEAVY FUNDS : In any capital expenditure decision taken by organization it requires huge amount of capital for their execution. These
funds raised by the organization from various internal and external sources. So it must take correct decision for identifying most profitable scheme of investment.

ii. LONG PERIOD COMMITMENT : The amount involved in capital expenditure budget not only for heavy but more or less permanently blocked in the business
under this aspect it involve longer the time and greater risk, so careful planning is essential.

iii. NATIONAL IMPORTANCE : In general the fund position in India is limited. But these limited funds are properly invested in those capital projects which are
helpful in increasing productivity and contributing economic growth of the country in whole.

iv. MEET OUT THE OBSOLESCENCE : The organization could take proper steps in order to over come the losses arising due to absolescence of fixed assets on
account of growth of technological changes. At the time of preparation of capital budgeting it should be considered by the organization .

v. SUPPORTING TO OTHER FINANCIAL DECISIONS : Specifically capital investment decisions related to some other important financial matter of the firm i.e.
correct investment decision will help the organization with regard to financial decisions and dividend decision.

vi. IRREVERSIBLE DECISIONS : In most of the cases capital budgeting decisions are irreversible . Once a firm takes decision for acquiring fixed assets it should
be treated as permanent nature. It is really very difficult to reverse the decision because it is difficult to find out the market for the capital assets. Even find the
market it should be sold at very low value at a substantial loss in the event of decision being proved wrong.

Question No : 2 ) Write a detail note on the type of capital budgeting decision ?

Ans : TYPES OF INVESTMENT DECISIONS : There are many ways to classify investments . One classify investments. One classification is as follows :

 Expansion of existing business or expansion of new business.

 Replacement and modernization.

EXPANSION AND DIVERSIFICATION : A company may add capacity to its existing product lines to expand existing operations. For example : the Gujarat State
Fertiliser Company (GSFC) may increase its plant capacity to manufacture more urea. It is an example of related diversification. A firm may expand its activities in
a new business. Expansion of a new business requires investment in new products and a new kind of production activity within the firm. If a packaging
manufacturing company invests in a new plant and machinery to produce ball bearings, which the firm has not manufactured before, this represents expansion of
new business or unrelated diversification. Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment in
expectation of additional revenue. Investments in existing or new products may also be called as revenue-expansion investments.

REPLACEMENT AND MODERNIZATION : The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost
savings will reflect in the increased profits, but the firm’s revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The
firm must decide to replace those assets with new assets that operate more economically. If a cement company changes from semi-automatic drying equipment to
fully automatic drying equipment, it is an example of modernization and replacement. Replacement decisions help to introduce more efficient and economical

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assets and therefore, are also called cost-reduction investments. However, replacement decisions that involve substantial modernization and technological
improvements expand revenues as well as reduce costs.
Another useful ways to classify investments is as follows :
 Mutually exclusive investments
 Independent investments
 Contingent investments

MUTUALLY EXCLUSIVE INVESTMENTS :

Mutually exclusive investments serve the same purpose and complete with each other. If one investment is undertaken, others will have to be excluded. A company
may, for example, either use a more labour-intensive, semi-automatic machine, or employ a more capital-intensive highly automatic machine for production.
Choosing the semi-automatic machine produces the acceptance of the highly automatic machine.

INDEPENDENT INVESTMENTS :
Independent investments serve different purposes and do not compete with each other. For example, a heavy engineering company may be considering expansion
of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture a new product—light commercial vehicles .
Depending on their profitability and availability of funds, the company can undertake both investments.

CONTINGENT INVESTMENTS :
Contingent investments are dependent projects ; the choice of one investment necessitates undertaking one or more other investments. For example, if a company
decides to build a factory in a remote, backward area, it may have to invest in houses, roads, hospitals, schools, etc. , for the employees to attract the work force.
Thus, building of factory also requires investment in facilities for employees. The total expenditure will be treated as one single investment.

Question No : 3 ) What are the capital budgeting appraisal methods ? Discuss in detail What are the various types of discounting techniques being
followed at the time of capital budgeting decisions.
Ans :

CAPITAL BUDGETING APPRAISAL METHODS :

Most of the organization may face a situation when and where they identified the various investment proposals. After this situation it has to meet out the problem
for identifying best proposal among the alternatives either for shortage funds in profitability or social profitability. Different firms may use different methods for
evaluating the profitability of the project proposals. The following techniques which are commonly employed by the firms to evaluate the profitability of the projects
:
1.Pay Back period method
2. Accounting or Average Rate of Return method
i. Return on original investment method
ii. Return or average investment method
3. Discount cash flow Techniques
i. Net present value method
ii. Profitability index or Benefit cost Ratio method
iii.Internal Rate of Return method (IRR)
iv.Terminal value method.

1. PAYBACK PERIOD METHOD : The Pay back period method represents number of years required to recover the original investment of the particular fixed
assets. It should be calculated by dividing the total cost of the fixed assets by the annual savings in costs or additional earnings after tax but before
depreciation.

Original investment
Pay back period =
Savings∨Net cash inflow per year
MERITS OF PAY BACK METHOD : The pay back method has the following merits.
i. It is easy to workout and simple to understand
ii. It is assist for some specified industries subject to rapid technological changes or uncertainty.
iii. It is more helpful for those project where profitability is not important.
iv. This is very useful to a firm which is suffering from shortage of funds and quick recovery of cash is essential to meet out the project cost.

DEMERITS OF PACK BACK METHOD : The method has the following drawbacks :
i. It ignore the profitability of the project
ii. It ignores the time value of money.

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iii. It is more rigidity.

2. ACCOUNTING OR AVERAGE RATE OF RETURN METHOD : According to this method the average yield is calculated based upon the income earned by the
project during entire economic life. The project which yields a highest rate of return is normally selected.

Return
i. Rate of return on original investment method = x 100
Original investment

Return
ii. Rate of return on average investment method = x 100
Average investment

Average Annual Profit

iii. Average Return on average investment method = x 100
Average Investment

MERITS OF “ARR” METHOD : The following are the merits of this method :

i. It is easy to understand and simple to workout.

ii. It gives the due weightage to the profitability of the project.
iii. It takes into consider the total earnings over the entire economic life of the project.

DEMERITS OF “ARR” METHOD : This method suffers from the following drawbacks.
i. It ignores the time value of money.
ii. It ignores the risk and uncertainty factors.
iii. There are different techniques applied for calculating the Accounting Rate of Return.

3. DISCOUNTED CASH FLOW TECHNIQUES : The Discounted cash flow technique is an improvement of the pay back technique. This method gives the time
value of money. Because in any economy capital or funds that should be invested in various projects it has certain value under expectation of future return.
The organization has to very much interest to find out time value of money. In this respect discounting factor as applied against the cash inflow to determine
present value of future income. Discounted cash flow method for evaluating capital investment proposals are of four types
a ) Net present value method
b. ) Profitability index method
c. ) Internal rate of Return method
d ) Terminal value method.
NET PRESENT VALUE METHOD (NPV) : Under this method present value of cash inflow is calculated i.e. applying the discount factor as against in the cash
inflow and compared with the original investment. If the present value is higher than the original investment the project should be recommended otherwise it may
be rejected
Ascertainment of NPV :
YEAR CASH INFLOW (RS.) P/V DCF ( RS.)
1 XXX XX XXX
2 XXX XX XXX
3 XXX XX XXX
Sum of DCF ----- XXX
Less original invest ----- XXX
Net Present Value -- XXX
The present value can be taken from the present value table or it will be calculated by the following formula :

I
= PV = n
( I +r )

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DECISION PROCEDURE :
I. Only one project means if it has a positive net present value that should be accepted.
II. Suppose more than one project means, which one is the highest net present value that project should be recommended.

PROFITABILITY INDEX METHOD : It should be calculated only after the computation of Net present value. It should be found out by comparing the total of
present value of future cash inflows and the total of present value of future cash outflows.

present value of future cash inflows

Profitability Index (PI) = x 100
present value of future cash outflows
present value of future inflows
PI = x 100
initial cash outlay
NPV
PI = x 100
Intial cash outlay

The proposal is accepted if PI is more than one or 100%

INTERNAL RATE OF RETURN : Internal rate of return may be defined as the rate of return at which total present value of future cash inflows is equal to intial
investment. Simply it is the rate at wihich sum of discounted cash inflows equalize the sum of discounted cash outflows. The rate of return is generally found by
trial and error method, It can be calculated in the following formula :

Cashinflows
=I
Cash outflows
Procedure for Calculation :
i. When cash inflows are uniform it should be find out its IRR with help of the factor to be located in the annuity table. The factor is calculated in the following
way :

I
F=
C
Where , F = Factor to be located
I = Intitial investment
C = Cash inflow per year.
Actually after calculation of the factor, to find where it will be located in the Present value Table No II on the line representing number of years corresponding to
estimated useful of the asset

ii. Where cash inflows are not uniform : if uneven cash inflow given in the problem we have to find the internal rate of return by the trial and error
method

PROCEDURE FOR COMPUTATION OF TRIAL AND ERROR METHOD :

i. Calculation of first trial rate : For the purpose of finding the trial rate better we have to find out the factor to located in the following formula :

I
F =
C
Computed value form the above formula is treated as first trial rate.
ii. Second trial rate and third rate may be determined (Assumed)
iii.If we want the exact IRR we have to apply the following formula even after applying the last trail rate.

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NPV at lower rate

IRR = lower trail rate + x difference between higher and lower rate.
NPV at lower rate−NPV at higher rate

TERMINAL VALUE METHOD : According to this method it is assumed that each of the future cash flows is immediately reinvested in another project at a certain
desired rate of return until the termination of the project. Simply it is net cash flows and outflows are compounded forward rather than discounting them backward
as followed in NPV method. Base upon the nature of projects and the level of present value the project should be accepted.

compounded value of cas h inflows

Present value = n
(I + K )
Here K = Cost of Capital
n = Life of the Project
ADVANTAGES OF DISCOUNTED CASH FLOW METHOD :
i. It is superior to other methods because it considers the earnings of a project over the entire economic life of the project.
ii. It gives the due to the time value of money flows.
iii. It is more suitable method where cash inflows are uneven.
iv. It provides guidance for the comparison between projects.

DISADVANTAGES OF DISCOUNTED CASH FLOW METHOD :

i. It is difficult to understand and workout.
ii. Difficult to determine the economic life of any project accurately.
iii. Difficult to determine the appropriate rate of interest.
iv. It should be worked out certain assumption. Always these assumptions may not good because it depends upon the available investment opportunities.

Question No : 4 ) The following are the cash inflows and outflows of a certain project of ZENX Ltd.
Year Outflows Cash inflow

0 150000 -
1 30000 30000
2 - 30000
3 - 50000
4 - 60000
5 - 40000

The salvage value at the end of 5 years is Rs. 40,000 . Taking the 4 years cut off rate as 10% , Calculate net present value

Year 1 2 3 4 5
P.V. factor @ 10% 0.909 0.826 0.751 0.683 0.621

Solution :
Year Cash inflows Present Value Present Value
Rs
Factor @ 10% Of cash inflows (Rs.)
1 30,000 0.909 27,270
2 30,000 0.826 24,780
3 50,000 0.751 37,550
4 60,000 0.683 40,980
5 40,000 0.621 24,840
5 40,000 0.621 24,840
(Salvage value) 1,80,260

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Total present value of cash inflows --------------------------------- 1,80,260

Less : Total present value of outflows
Cash outflow at the beginning ------ 1,50,000
Cash outflow at the end of
First year 30,000 x 0.909 ------------ 27,270 1,77,270
2,990

Net present Value

Result :the NPV is positive the project should be accepted
Question No : 5 ) Narmadha Ltd. considers the purchase of one of the two machines As the basis for selection the
following data was developed.

Machine R Machine P
Rs. Rs

Original cost 25,565 25,565

Profit after tax :
Year 1 687 4,687
Year 2 1,687 3,687
Year 3 2,687 2,687
Year 4 3,687 1,687
Year 5 4,687 687

13,435 13,435

The expected rate of return for the company is 16% . Both the machines have a life of five years and will not have any salvage value. The company is in the
40% tax bracket, you are required to calculate NPV and P.I. index . suggest the most profitable machine

Year 1 2 3 4 5

P. V. factor @ 0.862 0.743 0.641 0.551 0.476

SOLUTION :
To ascertain Present value, Cash flows are to be taken into account.
Cash flows = Profit after Tax + Depreciation
Depreciation = Profit after Tax + life
Machine R Machine P
Depreciation = Rs.25,565 + 5 Rs.25,565 + 5
= Rs. 5113 = Rs. 5113

Calculation of cash Inflows

Year Machine R Machine p

PAT DEPN Cash Inflows PAT Depn Cash inflows
Rs. Rs. Rs. Rs Rs. Rs.

1 687 5113 5800 4687 5113 9800

2 1687 5113 6800 3687 5113 8800
3 2687 5113 7800 2687 5113 7800
4 3687 5113 8800 1687 5113 6800
5 4687 5113 9800 687 5113 5800

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Calculation of Net present values

Year Machine R Machine P

P.V. Factor Cash inflows P.V. of Cash Cash inflows P.V. of Cash inflows
@ 16% Rs. Rs. Rs. Rs. Rs.

1 0.862 5800 5000 9800 8443

2 0.743 6800 5052 8800 6538
3 0.641 7800 5000 7800 5000
4 0.552 8800 4858 6800 3754
5 0.476 9800 4665 5800 2761
Total present value of Cash inflow 24575 26,501
Present Value of outflow (original cost) 25565 25565
Net present Value ( -) 990 936

The net present Value is negative in the case of machine R. Machine P has a higher NPV Index of Rs. 936. NPV Index is also high for Machine P. Hence
Machine P is recommended.

Total present value of cash inflows

Profitability Index : = x 100
Total present value of cash outflows
Machine R Machine P
24575 26501
x 100 = 96.11 % x 100 = 103.66 %
25567 25565

Result : Profitability index is high in case of P is recommended.

Question No:6)Himalaya ltd.has rs.2,00,000 to invest in a certain project. The following proposals are
under consideration. The cost of capital of the company is estimated to be 15%

Project initial outlay cash inflows life

Rs. Rs. (years)
A 100,000 25,000 10
B 70,0000 20,000 8
C 30,000 6,000 20
D 50,000 15,000 10
Rank the project on the basis of:
A) Profitability index method B) Net present value method

Note: P.V of the annuity of Re.1 received discounted at 15% is given below:
8 years-4.487
10years-5.019

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Solution:
Total P .V cash of inflows
(a)Profitability index = × 100
Total P .V cash of inflows

1, 25,475
Project A = ×100=125.48 %
1, 00,000

Rs .89,740
Project B = ×100=128.2 %
Rs .70,000

Rs .37,554
Project C = × 100=125.18 %
Rs .30,000

Rs .75,285
Project D = ×100=155.57 %
Rs .50,000

b) Net present value method

Ranking the projects according to NPV and profitability index
1 2 3 4 5 (4-5) Rank Profitability Rank
Project Cash P.V of P.V of Investment NPV Index%
inflows annuity cashflow Rs. Rs.
Rs. @15 Rs.
A 25,000 5.019 1,25,475 1,00,000 25,475 1 125.48 3
B 20,000 4.487 89,740 70,000 19,740 3 128.2 2
C 6,000 6.259 37,554 30,000 7.554 4 125.18 4
D 15,000 5.019 75,285 50,000 25.285 2 150.57 1

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