Dr.

Sunil M Rashinkar
MODULE 4
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Capital Budgeting
MEANING AND NATURE OF CAPITAL
BUDGETING:
 Capital budgeting, also known as investment
appraisal, is a process used by businesses to
evaluate and prioritize major investment projects

Dr. Sunil M Rashinkar

or expenditures.
 This process is critical for ensuring that the
resources are allocated efficiently and the
investments contribute to the company’s long-
term success.

2
MEANING:
 Capital budgeting refers to the decision-making
process that organizations use to evaluate
potential major projects or investments.

Dr. Sunil M Rashinkar

 These can include acquiring new machinery,
expanding a facility, launching a new product
line, or any other project requiring a significant
outlay of capital.
 The primary goal is to identify projects that will
yield the best return on investment over an
appropriate period.

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NATURE OF CAPITAL BUDGETING:
 Long-term Focus.
 Large Expenditures.

Dr. Sunil M Rashinkar

 Evaluation Methods
 Net Present Value (NPV)
 Internal Rate of Return (IRR
 Payback Period
 Profitability Index (PI)
 Accounting Rate of Return (ARR).
 Risk and Uncertainty.
 Strategic Alignment.
 Cash Flow Analysis..
 Post-implementation Review. 4
PROCESS OF CAPITAL BUDGETING:

1
Investment
Proposal

Dr. Sunil M Rashinkar

7 Review 2 Screen
Performance Proposals

Capital
Budgeting
6 Implement Process 3 Evaluate
the Various
Proposals Proposals

5 Final 4 Fix
Approval Priorities 5
Dr. Sunil M Rashinkar
6
Dr. Sunil M Rashinkar
7
PAY BACK PERIOD:
 The payback period is a capital budgeting metric
that measures the amount of time it takes for an
investment to generate cash flows sufficient to

Dr. Sunil M Rashinkar

recover the initial investment cost. It is a simple
and widely used method to evaluate the risk and
liquidity of a project.

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ADVANTAGES OF PAYBACK PERIOD
 Simplicity: Easy to understand and calculate.
 Risk Assessment: Provides a quick measure of

Dr. Sunil M Rashinkar

the project's liquidity and risk, as shorter
payback periods are generally less risky.
 Cash Flow Focus: Emphasizes the importance
of early cash flows, which is useful for companies
facing liquidity constraints.

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DISADVANTAGES OF PAYBACK PERIOD
 Ignores Time Value of Money: Does not
consider the time value of money, meaning it
treats all cash flows as if they occur at the same

Dr. Sunil M Rashinkar

time.
 Ignores Cash Flows Beyond Payback
Period: Does not consider any cash flows that
occur after the payback period, potentially
overlooking the overall profitability of the project.
 No Risk Adjustment: Does not account for the
varying risks associated with different projects.

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FORMULA:

𝑃𝑎𝑦 − 𝐵𝑎𝑐𝑘 𝑃𝑒𝑟𝑖𝑜𝑑

Dr. Sunil M Rashinkar

𝐷𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑐𝑒
= 𝑁𝑜. 𝑜𝑓 𝑦𝑒𝑎𝑟𝑠 +
𝑁𝑒𝑥𝑡 𝑦𝑒𝑎𝑟 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤

 Lesser the time better the project.

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PROBLEM NO. 1
 Determine the pay-back period for a project
which requires a cash outlay of Rs. 10,000 and
generate cash inflow of Rs. 2,000, Rs. 4,000, Rs.

Dr. Sunil M Rashinkar

3,000 and Rs. 2,000 in four year respectively.

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PROBLEM NO. 2
 A project cost Rs. 5,00,000 and yields annually a
profit of Rs. 80,000 after depreciation @ 12% p.a.
but before tax of 50%. Calculate the pay-back

Dr. Sunil M Rashinkar

period.

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PROBLEM NO. 3
 There are two projects X and Y. Each project
requires an investment of Rs. 2,00,000. you are
required to rank these projects according to the

Dr. Sunil M Rashinkar

pay-back method from the following information:
Year Project X Project Y
1 10,000 20,000
2 20,000 40,000
3 40,000 60,000
4 50,000 80,000
5 80,000 -

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ACCOUNTING RATE OF RETURN (ARR):
 The Accounting Rate of Return (ARR) is a capital
budgeting metric that measures the expected
annual accounting profit from an investment as a

Dr. Sunil M Rashinkar

percentage of the initial investment. It is also
known as the Average Rate of Return. ARR
provides a straightforward method for evaluating
the profitability of an investment project based
on accounting information rather than cash
flows.

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ADVANTAGES OF ARR
 Simplicity: Easy to understand and calculate
using readily available accounting information.

Dr. Sunil M Rashinkar

 Profitability Focus: Directly relates to
accounting profits, making it useful for
companies focusing on profitability as per
accounting standards.
 Comparative Measure: Useful for comparing
the profitability of different projects.

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DISADVANTAGES OF ARR:
 Ignores Time Value of Money: Does not
account for the time value of money, which
means it treats future profits the same as current

Dr. Sunil M Rashinkar

profits.
 Based on Accounting Profits: Relies on
accounting profits rather than cash flows, which
may be influenced by non-cash items such as
depreciation and amortization.
 No Risk Adjustment: Does not consider the risk
or uncertainty associated with the project.

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USE IN DECISION-MAKING
 ARR is often used in conjunction with other
capital budgeting metrics that account for cash
flows and the time value of money, such as Net

Dr. Sunil M Rashinkar

Present Value (NPV) and Internal Rate of Return
(IRR), to provide a more comprehensive
evaluation of investment projects.
 In summary, the Accounting Rate of Return
(ARR) is a simple and useful metric for
evaluating the profitability of an investment
based on accounting information. However, its
limitations mean it should be used alongside
other metrics for a well-rounded analysis.
 Higher the ARR is better the project. 18
FORMULA:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑓𝑖𝑡

Dr. Sunil M Rashinkar

𝐴𝑅𝑅 = 𝑋 100
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑃𝑟𝑜𝑓𝑖𝑡 =
𝑁𝑜.𝑜𝑓 𝑦𝑒𝑎𝑟𝑠
 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
1
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑆𝑐𝑟𝑎𝑝 𝑉𝑎𝑙𝑢𝑒 +
2
𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑆𝑐𝑟𝑎𝑝 𝑜𝑟 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑉𝑎𝑙𝑢𝑒
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PROBLEM NO. 1
 A project requires an investment of Rs. 5,00,000
and has a scrap value of Rs. 20,000 after five
years. It is expected to yield profits after

Dr. Sunil M Rashinkar

depreciation and taxes during the five years
amounting to as follows:
Year Cash flow
1 40,000
2 60,000
3 70,000
4 50,000
5 20,000
 Calculate the ARR on the investment. 20
PROBLEM NO. 2
 Calculate the ARR for projects A and B from the
following:

Dr. Sunil M Rashinkar

Project A Project B
Investments 2,00,000 3,00,000
Expected Life 4 years 5 years
Projected Net Income
1 20,000 30,000
2 15,000 30,000
3 15,000 20,000
4 10,000 10,000
5 - 10,000
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PROBLEM NO. 3
 ONGC Ltd is considering the purchase of a
machine. Two machines are available A and B.
the cost of each machine is Rs. 6,00,000. each

Dr. Sunil M Rashinkar

machine has an expected life of 5 years. Net
profit before tax and after depreciation during he
expected life of the machines are given below:
Year Machine A Machine B
1 1,50,000 50,000
2 2,00,000 1,50,000
3 2,50,000 2,00,000
4 1,50,000 3,00,000
5 1,00,000 2,00,000
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DISCOUNTED TECHNIQUES:
 Discounted techniques in capital budgeting are
methods that take into account the time value of
money when evaluating investment projects.

Dr. Sunil M Rashinkar

These techniques discount future cash flows to
their present value, making it possible to
compare the value of money received or paid at
different times.

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NET PRESENT VALUE (NPV):
 NPV is the sum of the present values of all cash
inflows and outflows associated with a project,
discounted at the project's cost of capital. It

Dr. Sunil M Rashinkar

represents the net value added to the firm by
undertaking the project.

𝑛
𝐶𝐼𝐹
𝑁𝑃𝑉 = − 𝐶𝑂𝐹
(1 + 𝑟)𝑛
𝑡=1

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DECISION RULE:
 NPV > 0: Accept the project (expected to add
value to the firm).

Dr. Sunil M Rashinkar

 NPV < 0: Reject the project (expected to destroy
value).
 NPV = 0: Indifferent (project breaks even).

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ADVANTAGES OF NPV:
 NPV accounts for the time value of money,
providing a more accurate measure of a project's
value by discounting future cash flows to their

Dr. Sunil M Rashinkar

present value.
 It offers a clear and straightforward decision
rule: projects with a positive NPV should be
accepted, as they add value, while those with a
negative NPV should be rejected.
 NPV provides a comprehensive measure of
profitability by considering all cash inflows and
outflows over the project's life, aligning with the
goal of maximizing shareholder wealth. 26
DISADVANTAGES OF NPV:
 NPV requires accurate estimation of future cash
flows and an appropriate discount rate, which
can be challenging and prone to significant

Dr. Sunil M Rashinkar

errors.
 The method is highly sensitive to the chosen
discount rate; small changes in the rate can lead
to vastly different NPV results, affecting the
reliability of the decision.
 NPV focuses solely on financial metrics, ignoring
qualitative factors such as strategic alignment,
market conditions, and regulatory impacts, which
may also influence a project's viability. 27
PROBLEM NO. 1
 Seimens Ltd has provide the following information
calculate the NPV of the two projects and suggest which of
the two projects should be accepted assuming a discount

Dr. Sunil M Rashinkar

rate of 10%.
Particulars Project X Project Y
Initial Investment 2,00,000 3,00,000
Estimated Life 5 years 5 years
Scrap Value 10,000 20,000
The profits before depreciation and after taxes (cash flows) are
as follows:
Year Project X Project Y
1 50,000 2,00,000
2 1,00,000 1,00,000
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3 1,00,000 50,000
4 30,000 30,000
5 20,000 20,000
PROBLEM NO. 2
 One97 Communication Ltd is considering investment in a
project that costs Rs. 2,00,000. the project has an expected
life of 5 years and zero salvage value. The company uses

Dr. Sunil M Rashinkar

straight line method of depreciation. The company’s tax
rate is 40%. The estimated earnings before depreciation
and before tax from the project are as follows:
 Year Earnings before Dep and
Tax
1 70,000
2 80,000
3 1,20,000
4 90,000
5 60,000

 You are required to calculate the NPV at 10% and advise 29

the company.
PROBLEM NO. 3
 No project is acceptable unless the yield is 10%.
Cash inflows of a certain project along with cash
outflows are give below:

Dr. Sunil M Rashinkar

Years Outflow Inflows
0 1,50,000 -
1 30,000 20,000
2 30,000
3 60,000
4 80,000
5 30,000
 The salvage value at the end of the 5th is Rs.
40,000. Calculate NPV.
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INTERNAL RATE OF RETURN (IRR)
 IRR, or internal rate of return, is a metric used in
financial analysis to estimate the profitability of
potential investments. IRR is a discount rate that

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makes the net present value (NPV) of all cash
flows equal to zero in a discounted cash flow
analysis.

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FORMULA:

Dr. Sunil M Rashinkar

𝐶 −𝑂
𝐼𝑅𝑅 = 𝐴 + 𝑋 (𝐵 − 𝐴)
𝐶 −𝐷
 Where,
 A – Lower Interest Rate
 B – Higher Interest Rate
 C – Value of Lower Interest Rate
 D – Value of Higher Interest Rate
 O – Original Investment
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PROBLEM NO. 1
Perticulars
Initial Investment Rs. 60,000
Life of the Assets 4 years

Dr. Sunil M Rashinkar

Estimated Net Annual Cash Flows: Rs.
1 year 15,000
2 year 20,000
3 year 30,000
4 year 20,000
Calculate IRR

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PROBLEM NO. 2
 Aurobindo Pharma Ltd. has currently under
examination a project which will yield the
following returns over the life of the project:

Dr. Sunil M Rashinkar

Year Gross Yield
1 80,000
2 80,000
3 90,000
4 90,000
5 83,000
 Cost of machinery to be amounts to Rs. 2L and
machine is to be depreciated at 20% p.a. at WDV
basis. Income tax rate is 50%. The salvage value
of machine is zero. If the average cost of raising
capital is 11%, would you recommend accepting 34
the project under the IRR method?
PROFITABILITY INDEX OR BENEFIT COST
RATIO:
 It is also a time adjusted method of evaluating
the investment proposals. Profitability index also
called as Benefit Cost Ratio or Desirability factor

Dr. Sunil M Rashinkar

is the relationship between present value of cash
inflows and the present value of cash outflows.

𝑃𝑉𝐶𝐼𝐹
𝑃𝐼 =
𝑃𝑉𝐶𝑂𝐹

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INTERPRETATION:
 PI > 1: The project is considered profitable and
should be accepted.

Dr. Sunil M Rashinkar

 PI = 1: The project breaks even, meaning it
neither gains nor loses value.
 PI < 1: The project is unprofitable and should be
rejected.

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ADVANTAGES:
 Considers the time value of money (unlike
simple return ratios).

Dr. Sunil M Rashinkar

 Helps in capital rationing by ranking projects
when funds are limited.
 Easy to interpret—a higher PI indicates a more
attractive investment.

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LIMITATIONS:
 It may not always give the best decision when
projects are mutually exclusive (in such cases,
Net Present Value (NPV) is preferred).

Dr. Sunil M Rashinkar

 Requires accurate estimation of future cash flows
and discount rates.

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PROBLEM NO. 1
 Titan Ltd. is evaluating a project that requires an
initial investment of ₹1,00,000. The present
value (PV) of expected future cash inflows is

Dr. Sunil M Rashinkar

₹1,50,000. Calculate the Profitability Index
(PI) and determine whether the project should be
accepted.

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 A company has limited funds and is considering
two projects:

Dr. Sunil M Rashinkar

Present Value
Initial
Project of Future Cash
Investment (₹)
Flows (₹)
A 2,00,000 3,00,000
B 1,50,000 2,00,000

 Which project should the company choose based

on the Profitability Index?

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MODIFIED INTERNAL RATE OF RETURN
(MIRR):
 The Modified Internal Rate of Return
(MIRR) is an improved version of the Internal
Rate of Return (IRR) that addresses its

Dr. Sunil M Rashinkar

limitations. MIRR assumes that:
 Positive cash flows are reinvested at the cost of
capital (rather than the IRR).
 Negative cash flows are discounted at the
financing rate (cost of borrowing).

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FORMULA:

1
𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝑉𝑎𝑙𝑢𝑒 𝑛

Dr. Sunil M Rashinkar

𝑀𝐼𝑅𝑅 = −1
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒

 Where:
 Terminal Value = Future Value of all positive cash
flows, compounded at the reinvestment rate.
 Present Value = Present Value of all negative cash
flows, discounted at the financing rate.
 n = Number of years.

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STEPS TO CALCULATE MIRR:
 Find the Future Value (FV) of all positive
cash flows using the reinvestment rate.

Dr. Sunil M Rashinkar

 Find the Present Value (PV) of all negative
cash flows using the financing rate.
 Use the MIRR formula to compute the return.

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ADVANTAGES:
 Overcomes multiple IRR problem (which
happens when cash flows change signs multiple
times).

Dr. Sunil M Rashinkar

 Assumes reinvestment at a realistic rate (cost
of capital) rather than IRR.
 Better reflects the actual return of a project.

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PROBLEM NO. 13
 A project has the following cash flows, with a
financing rate of 10% and a reinvestment
rate of 12%.

Dr. Sunil M Rashinkar

Year Cash Flow (₹)
0 -1,00,000
1 20,000
2 30,000
3 40,000
4 50,000

 Determine the MIRR.

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PROBLEM NO. -
 A project has the following cash flows:
Year Cash Flow (₹)

Dr. Sunil M Rashinkar

0 -50,000
1 10,000
2 -5,000
3 20,000
4 30,000

 The cost of capital is 10%, and the

reinvestment rate is 12%. Find the MIRR.

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Dr. Sunil M Rashinkar
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