CHAPTER 3
INVESTING DECISIONS –
CAPITAL BUDGETING AND
WORKING CAPITAL
MANAGEMENT
• Capital Budgeting - Estimation of Cash Flows, Criteria for
Capital Budgeting Decisions Pay back, ARR, Discounted
Payback NPV, IRR, PI, Issues Involved in Capital
Budgeting, Risk analysis in Capital Budgeting – An
Introduction
• Working C a pit a l M a na g em ent - F a c t o rs Inf lu enc ing
Working Capital Policy, Operating Cycle Analysis,
Management of Inventory, Management of Receivables,
Management of Cash and Marketable Securities, Financing
Capital Budgeting
• Capital budgeting is a method of analyzing and comparing substantial future
investments and expenditures to determine which ones are most worthwhile. In other
words, it’s a process that company management uses to identify what capital projects
will create the biggest return compared with the funds invested in the project. Each
project is ranked by its potential future return, so the company management can choose
which one to invest in first.
• Capital budgets or capital expenditure budgets are a way for a company’s management
to plan fixed asset sales and purchases. Usually these budgets help management
analyze different long-term strategies that the company can take to achieve its
expansion goals. In other words, the management can decide what assets it might need
to sell or buy in order to expand the company. To make this decision, management
typically uses these three main analyzes in the budgeting process: throughput analysis,
Importance of Capital Budgeting
• Long-term Implication
• Irreversible Decision
• Long-term Commitments of Funds
Capital Budgeting Processes
• Planning
• Evaluation
• Selection
• Implementation
• Control
• Review
Payback Period
• Payback method helps in revealing the payback period of an investment. Payback period
(PBP) is the time (number of years) it takes for the cash flows of incomes from a
particular project to cover the initial investment. When a CFO faces a choice, he will
prefer the project with the shortest payback period.
• Payback period = Cash outlay (investment) / Annual cash inflow
• Advantages of Payback Period
• Simple to Use and Easy to Understand
• Quick Solution
• Preference for Liquidity
• Useful in Case of Uncertainty
Disadvantages of Payback Period
• Ignores Time Value of Money
• Not All Cash Flows Covered
• Not Realistic
• Ignores Profitability
Net present value (NPV)
• N et p resen t val u e ( N P V ) i s a di s count ed t echni que, w h i c h c o n s i d e r s t h e t i m e v a l u e o f
money. NPV consider different period cash flow value differ in their values. So, estimated cash flow
must be converted into present value. It can be defined as the difference between total present
value and net cash outlay.
• Net present value (NPV) = Total present value – Net cash
outlay
• Advantages
1. NPV gives important to the time value of money.
2. In the calculation of NPV, both after cash flow and before cash flow over the life span of the project
are considered.
3. Profitability and risk of the projects are given high priority.
4. NPV helps in maximizing the firm’s value.
• Disadvantages
1. NPV is difficult to use.
2. NPV can not give accurate decision if the amount of investment of mutually exclusive projects are not
equal.
3. It is difficult to calculate the appropriate discount rate.
4. NPV may not give correct decision when the projects are of unequal life.
INTERNAL RATE OF RETURN
• The IRR is used when the cost of the investment and the annual cash flows are known and
the unknown rate of earnings to be determined. The IRR is described as that rate which
equates the present value of the future cash flows with the cost of the investment which
produce them. IRR method is also called yield on investments, marginal efficiency of
capital, time adjusted rate of return, rate of return and so on.
• The IRR is the discounted rate that equals the aggregate present value of CFAT (cash flow after tax)
with the aggregate present value of cash outflows required for a new investment. The project will be
accepted only if IRR is higher than cost of capital.
Advantages Of IRR
• IRR method considers the time value of money.
• IRR method discloses the maximum rate of return the project can give.
• IRR method considers and analysis all cash flows of entire project.
• IRR method ascertains the exact rate of return the project earns.
Disadvantages Of IRR
• IRR method is difficult to understand, complications due to trial and error method.
• The important drawback of IRR is that it recognizes the cash inflows generated by
project is reinvested to internal rate of project, but NPV recognizes such cash inflows are
reinvested to cost of capital of the organization.
• Single discount rate ignores the varying future interpret rate.
C - O
IRR = A+ -------------- X
B - A
C – D
A= LOWER TRAIL RATE OR INTEREST RATE
B= HIGHER TRAIL RATE OR INTEREST RATE
C= LOWER TRAIL RATE PV CASH FLOW
D= HIGHER TRAIL RATE PV CASH FLOW
Accounting rate of return (ARR)
• Accounting rate of return (ARR) is also known as average rate of return. ARR is based
upon accounting information rather than on cash flow. In other words, Accounting rate of
return (ARR) refers to the rate of earning or rate of net profit after tax on investment.
• ARR consider profitability rather than liquidity. Under ARR technique, the average annual
expected book income is divided by the average book investment in the project.
• ARR = (Average net income/Average investment) x 100
• Where,
• Average net income= Total net income/No. of years
• Average investment= Net investment/2
Advantages Of Accounting Rate Of Return (ARR)
• ARR is based on accounting information, therefore, other special reports are not
required for determining ARR.
• ARR method is easy to calculate and simple to understand.
• ARR method is based on accounting profit hence measures the profitability of investment.
Disadvantages Of Accounting Rate OF Return (ARR)
• ARR ignores the time value of money.
• ARR method ignores the cash flow from investment
• ARR method does not consider terminal value of the project.
Profitability Index
• The profitability index is known as benefit cost ratio. PI is similar
to the NPV approach. The profitability index approach measures the
present value of return per dollar invested, while the NPV is based
on the difference between the present value of the future cash
inflow and present value of cash outlay. PI is calculated by dividing
the present value of future cash inflow by present value of cash
outlay.
• Profitability Index (PI) = Total present value/Net cash
• It is the ratio of the present value of future cash benefits, at the required rate of
return to the initial cash outflow of the investment. It may be gross or net, net being
simply gross minus one. The formula to calculate profitability index (PI) or benefit cost
(BC) ratio is as follows.
• PI = PV cash inflows/Initial cash outlay
• Decision Rules of Profitability Index (PI)
[Link] projects are independent.
• Accept the project when PI is higher than 1.
• Reject the project when PI is less than 1.
2. If projects are mutually exclusive.
• Accept the project which has higher PI.(PI must be greater than one)
• Reject other project.
• Advantages Of Profitability Index (PI)
1. PI considers the time value of money.
2. PI considers analysis all cash flows of entire life.
3. PI makes the right in the case of different amount of cash outlay of different project.
4. PI ascertains the exact rate of return of the project.
• Disadvantages Of Profitability Index(PI)
1. It is difficult to understand interest rate or discount rate.
2. It is difficult to calculate profitability index if two projects having different useful life.
Working Capital Management
• Working Capital refers to the difference between a company’s
current assets (such as cash, accounts receivable, and inventory) and
its current liabilities (such as accounts payable and short-term
debts). It represents the funds available for day-to-day operations,
ensuring smooth business functioning. Adequate working capital is
essential for meeting short-term obligations, maintaining liquidity,
and supporting operational efficiency.
• A positive working capital indicates the company can cover its
short-term liabilities, while a negative working capital signals
potential financial strain. Effective management of working capital
• Gross Working Capital:
The sum total of all current assets of a business concern is termed as gross working
capital. So,
• Gross working capital = Stock + Debtors + Receivables + Cash.
Net Working Capital
The difference between current assets and current liabilities of a business concern
is termed as the Net working capital.
• Net Working Capital = Stock + Debtors + Receivables + Cash – Creditors – Payables.
Need for Working Capital
• Ensuring Smooth Operations
• Meeting Short-Term Obligations
• Maintaining Inventory Levels
• Managing Cash Flow
• Supporting Credit Sales
• Tackling Unexpected Expenses
• Financing Growth and Expansion
• Ensuring Financial Stability
Importance of Working Capital
• Ensures Business Continuity
• Enhances Liquidity
• Supports Customer Credit
• Facilitates Inventory Management
• Prepares for Contingencies
• Improves Creditworthiness
• Boosts Profitability
• Supports Business Growth
Types of working Capital
1. Permanent Working Capital
• This refers to the minimum level of current assets required to maintain the day-to-day
operations of a business. It remains constant over time, regardless of fluctuations in sales or
production levels.
• Fixed Permanent Working Capital: The portion of working capital that remains unchanged
even during seasonal variations or changes in business cycles.
• Variable Permanent Working Capital: The additional working capital required due to growth
in production and operations over time.
2. Temporary Working Capital
• Temporary working capital is required to meet short-term or seasonal demands. It
fluctuates depending on the level of business activity and market conditions.
• Seasonal Working Capital: Needed to manage increased demand during peak seasons.
• Special Working Capital: Required for non-recurring or special needs, such as promotional
campaigns or sudden bulk orders.
3. Gross Working Capital
Gross working capital represents the total investment in current assets, such as cash, accounts
receivable, and inventory. It emphasizes the importance of efficiently managing current assets
to maintain liquidity.
4. Net Working Capital
Net working capital is the difference between current assets and current liabilities. It indicates
the surplus or deficiency of current assets over liabilities and reflects the business’s ability to
meet short-term obligations.
5. Positive and Negative Working Capital
Positive Working Capital: Occurs when current assets exceed current liabilities, indicating
good liquidity and financial health.
• Negative Working Capital: Happens when current liabilities exceed current assets,
signaling potential financial strain and risk of insolvency.
6. Reserve Working Capital
Reserve working capital refers to the extra funds kept aside to handle unexpected
emergencies or contingencies, such as economic downturns or sudden increases in costs.
7. Regular Working Capital
This type of working capital is used to meet routine business operations, including the
purchase of raw materials, payment of wages, and covering operational expenses.
8. Special Working Capital
Special working capital is required for one-time projects or events, such as launching a new
product, entering a new market, or undertaking a merger or acquisition.