1

UNIT-5
CAPITAL BUDGETING
The Capital budgeting as “the long-term planning and financing proposed Capital
outlay Capital Outlay”.

The Capital Budgeting decisions involve long-term planning for selection and
financing the investment proposal.

Capital budgeting is the process of evaluating the relative worth of long-term

investment proposals on the basis of their respective profitability.

Capital Budgeting Process:

The capital budgeting process involves generation of investment, proposal
estimation of cash-flows for the proposals, evaluation of cash-flows, selection of
projects based on acceptance criterion and finally the continues revaluation of
investment after their acceptance the steps involved in capital budgeting process are
as follows.

1. Project generation
2. Project evaluation
3. Project selection

4. Project execution

1. Project generation: In the project generation, the company has to identify the
proposal to be undertaken depending upon its future plans of activity. After
identification of the proposals they can be grouped according to the following
categories:

2. Replacement of equipment: In this case the existing outdated equipment and

machinery may be replaced by purchasing new and modern equipment.

3. Expansion: The Company can go for increasing additional capacity in the existing
product line by purchasing additional equipment.
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4. Diversification: The Company can diversify its product line by way of producing
various products and entering into different markets. For this purpose, It has to
acquire the fixed assets to enable producing new products.

[Link] and Development: Where the company can go for installation of

research and development suing by incurring heavy expenditure with a view to
innovate new methods of production new products etc.,

2. Project evaluation: In involves two steps.

Estimation of benefits and costs: These must be measured in terms of cash flows.
Benefits to be received are measured in terms of cash flows. Benefits to be received
are measured in terms of cash inflows, and costs to be incurred are measured in
terms of cash flows.

Selection of an appropriate criterion to judge the desirability of the project.

3. Project selection: There is no standard administrative procedure for approving

the investment decisions. The screening and selection procedure would differ from
firm to firm. Due to lot of importance of capital budgeting decision, the final approval
of the project may generally rest on the top management of the company. However
the proposals are scrutinized at multiple levels. Sometimes top management may
delegate authority to approve certain types of investment proposals. The top
management may do so by limiting the amount of cash out lay. Prescribing the
selection criteria and holding the lower management levels accountable for the
results.

4. Project Execution: In the project execution the top management or the project
execution committee is responsible for effective utilization of funds allocated for the
projects. It must see that the funds are spent in accordance with the appropriation
made in the capital budgeting plan. The funds for the purpose of the project
execution must be spent only after obtaining the approval of the finance controller.
Further to have an effective cont. It is necessary to prepare monthly budget reports
to show clearly the total amount appropriated, amount spent and to amount unspent.
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Significance of Capital budgeting

[Link] capital outlays: Capital Budgeting decisions involve

substantial capital outlays.
2. Long-Term implications: Capital budgeting proposals are of longer
duration and hence have long term implications. For ex: the cash flow for next
5 years to 15 years has to be forecast.
3. Strategic in nature: Capital budgeting decision can affect the future of the
company significantly as it constitutes the strategic determent for the success
of the company. A right investment decision is the secret of the success of
many business enterprises.
4. Irreversible: Once the fund was committed to a particular project, we
cannot take back the decision. If the decision is to be reversed, we may have
to lose a significant portion of the funds already committed. It may involve loss
of time and efforts. In other words, the capital budgeting decisions are
irreversible or may not be easily reversible.

Capital Budgeting Decisions

 Construction of a new building, or renovation capital budgeting

decisions.
 Interior decoration of a given building
 Purchase of technology from a foreign country
 Building a new delivery truck
 Building a bridge
 Buying an ailing
 Making a new product
 Starting a new business
 Expansion decision of existing planning and equipment
 Decision to expand into new products or markets such as R&D.
Kinds of Capital Budgeting Decisions
The above example can be classified as under.

 Replacement (to replace worn out or obsolete fixed assets/equipment).

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 Expansion ( to add capacity to existing product lines)

 Diversification ( to reduce the risk of failure by operating in more than
one market)
 Research and development (where technology is rapidly change.
Large sums need to be spent on research and development for
investing on new and innovative products or service)
 Other (which include miscellaneous proposals like acquiring a control
device or fire-fighting equipment or expenditure to comply with certain
health standards and so on).

In each of these cases, an efficient system is to be evolved to identify which of the

given project is viable or profitable.
Methods / Techniques of Capital Budgeting
1. Traditional Methods.
a. Payback period.
b. Accounting rate of return method / average rate of return method
(ARR).

2. Modern/Discounted cash flow method / Techniques.

a. Internal rate of return (IRR) method.
b. Net present value (NPV) method.
c. Profitable Index (PI)

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,
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as ‘the number of years required to recover the original cash out lay invested
in a project’.

Cash outlay (or) original cost of project

Pay-back 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.
3. It does not involve any cost for computation of the payback period
4. It is one of the widely used methods in small scale industry sector
5. 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 payback 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 inflows
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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 determined 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= ------------------------------------- X 100
Average Investment

Total Income after Taxes

Average net 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.
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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. Does not take into account the fact that the profits can be re-invested.

2. 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= Total Present cash inflows value – Total cash out flow value
/investment.
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CF1, CF2, CF3… CFn= cash inflows in different years.

K= Cost of the Capital (or) Discounting rate
n= 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.

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 cut off or handle rate. It is usually the
concern’s cost of capital.
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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.

When compared the IRR with the required rate of return (RRR), if the
IRR is more than RRR then the project is accepted else rejected. In case of more
than one project with IRR more than RRR, the one, which gives the highest IRR, is
selected.

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. Likewise 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.

L1= Lower discount rate

NPV@L1 = Present value of cash inflows at lower rate.
L2 = Higher discount rate
NPV@L2 = Present value of cash inflows at higher rate.
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.
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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

Total Cash Inflows / Present Value of Future Cash Inflow

Probability index = ----------------------------------------------------------------------------
Total Cash out flow /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.
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5. It takes into consideration the entire stream of cash flows generated during
the useful life of the asset.

Demerits:
1. It is somewhat 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.

1. Traditional Methods.

a. Payback period: Under this method, the decision to accepted or rejected

a proposal is based on its payback period. Payback period refers to the
period within which the original cost of the project is recovered. It is
calculated by dividing the cost of the project by the annual cash inflows.

Cost of project
Payback period = ––––––––––––––
Annual cash inflows

The shorter the length of the payback period, the better is the project in
terms of paying back the original investment. Particularly where the future is
uncertain, the companies favor this method. The earlier the original
investment is recovered, the better it is, in terms of safety and liquidity. Where
the cash flows are uniform throughout, they are said to even. Consider this
example.

When the cash flows are even:

The cost of a project is Rs. 50,000 the annual cash inflows for the next 4 year
are Rs.25, 000. What is the payback for the project?

Cost of project
Payback period = ––––––––––––––
Annual cash inflows
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50,000
Payback period = ––––––– = 2 years.
25,000

Where the cash flows are uneven:

Where the cash flows are not uniform, they are said to be uneven. In such
case take the cumulative cash inflows and see how much time it takes to go
back the original investment. Consider the following example.

Problem :1 The cost of a project is Rs. 50,000 which has an expected life of 5
years. The cash inflows for next 5 years are Rs 24,000: Rs. 26,000: Rs.20,
000 Rs.17, 000: and Rs.16, 000 respectively. Determine the payback period.

Cash Inflows and Cumulative Cash Inflows for the Project

Year Cash inflows(Rs) Cumulative cash
inflows (Rs)
1 24,000 24,000
2 26,000 50,000 ---2 year
3 20,000 70,000
4 17,000 87,000
5 16,000 1,03,000

Ans: payback period is 2 years.

Problem:2. Where the cash inflows are same, but timing is different

Two projects, costing Rs.20, 000 each. Have the following cash inflows. Both
have the same payback period. Which one do you choose and why?
Year Project A (Rs) Project B (RS)
1 8,000 12,000
2 12,000 ---2 years 8,000 – 2 years
3 10,000 12,000
4 9,000 7,000
5 7,000 7,000
Total 46,000 46,000

Two Projects duration is 2 years.

Problem : Where the cash inflows are same, but timing is different
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Two projects, costing Rs.25, 000 each. Have the following cash inflows.
Both have the same payback period. Which one do you choose and why?
Year Project A (Rs) Project B (RS)
1 8,000 12,000
2 12,000 8,000
3 10,000 12,000
4 9,000 7,000
5 7,000 7,000
Total 46,000 46,000

Project A: Ans: Rs 8000 + 12000 = Rs.20000 (2 years) but the total capital is
Rs.25, 000/-, if you reach the total capital you need Rs.5000/- but the next
cash inflow is Rs.10, 000/-, the amount is greater than Rs.5000 in this
situation you have to follow under the formula .

Required amount
No. of years + –––––––––––––––– x 12 months
Next Cash inflow

Rs.5000
2 years + –––––––––––––––– x 12 months = 6.6 Months
Rs. 9000

Ans: 2years 6 months.

Project B: Ans: Rs 12000 + 8000 = Rs.20000 (2 years) but the total capital is
Rs.25, 000/-, if you reach the total capital you need Rs.5000/- but the next
cash inflow is Rs.12, 000/- so you have greater than Rs.5000 in this situation
you have to follow under the formula.

Required amount
No. of years + –––––––––––––––– x 12 months
Next Cash inflow
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Rs.5000
2 years + –––––––––––––––– x 12 months = 8.5 Months
Rs. 7000

Ans: 2years 8 months.

B. Accounting Rate of Return/ Average rate of Return

Account rate of return refers to the ratio of annual profits after taxes to
the average investment. The average investment is equal to half of the
original investment. Account rate of return is also called average rate of
return.

Average annual profit after taxes / Earning after taxes (EAT)

ARR = ––––––––––––––––––––––––––––––––––––––––––––––– x 100
Average Investment

Where average investment is half of the capital outlay (that is, Capital outlay
divided by 2). Average capital employed is calculated to the usual accounting
convention that the original investment gets exhausted steadily to zero over
the life of the project.

It is assumed that the asset is depreciated as per straight line method. Usually
it is expressed in terms of percentage. The higher the ARR is, the better is the
profitability and hence the project with higher accounting rate of return is
short-listed for implementation.

The above formula can be changed as per the needs of the appraisal.
Average profits can be considered before or after depreciation, interest or
taxes. At times, ARR is determined considering the original cost of the project
as the denominator.

EBDIT = Earnings before depreciation interest and tax

Less: Depreciation
–––––––––––––
EBIT = Earnings before interest and tax
Less: Interest
–––––––––––––
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EBT = Earnings before tax

Less: Tax
––––––––––––––
EAT = Earnings After tax
Add: Depreciation
––––––––––––––––
CFAT = Cash flow after tax

ARR Problem: 1

A firm is considering two projects each with an initial investment of Rs. 20,000
and a life of 4 years. The following is the list of estimated cash inflows after
taxes.
Year Proposal Proposal Proposal
1 2 3
1 12,500 11,750 13,500
2 12,500 12,250 12,500
3 12,500 12,500 12,250
4 12,500 13,500 11,750
Total 50,000 50,000 50,000
Determine accounting rate of return on!
Average Capital b. Original capital Employed

ARR on average Capital:

Average annual profit after taxes / Earning after taxes (EAT)

ARR = –––––––––––––––––––––––––––––––––––––––––––––––– x 100
Average Investment

Total Investment
ARR = –––––––––––––– = 20,000 / 2 = Rs. 10,000/-
2
Proposal 1 Proposal 2 Proposal 3
12,500 / 10,000 12,500 / 10,000 12,500 / 10,000
x 100 =125% x 100 =125% x 100 =125%
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Original Capital Employed:

Average annual profit after taxes / Earning after taxes (EAT)

ARR = –––––––––––––––––––––––––––––––––––––––––––––––– x 100
Original Investment

Proposal 1 Proposal 2 Proposal 3

12,500 / 20,000 12,500 / 20,000 x 100 12,500 / 20,000x
x 100 =62.5% =62.5% 100 =62.5%

Problem: 2

If there is working Capital and Scrap, How is ARR Computed?

Where there is scrap resulting from the sale of the old asset and there is
working capital, these two are added to the average investment. There are shown in
the following formula:

Average investment = (Cost – Scrap)/2 + Scrap of old asset + Working Capital.

Find out the average rate of return from the following data relating to CNC Machine 1
and 2.

Cost Rs. 3,00,000 Each

Estimated Life 3 years each
Estimated Scrap 60,000 each
Income tax rate 50%
Additional working capital required 2,50,000 for each machine
The estimated cash inflows after taxes for each machine are as given below:

year CNC Machine -1 (Rs) CNC Machine -2 (Rs)

1 1,50,000 2,00,000
2 3,00,000 3,00,000
3 1,50,000 2,50,000
4 Nil 1,50,000
Total 6,00,000 9,00,000
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Solution:
The average cash inflows after taxes for CNC Machine 1 = Rs.2, 00,000 that
is, (6, 00,000/3)
The average cash inflows after taxes for CNC Machine 2 = Rs.2, 25,000 that
is, (9, 00,000/4)

Average investment = (Cost – Scrap)/2 + Scrap of old asset + Working Capital.

= (3, 00,000 – 60,000)
–––––––––––––––––– + 2, 50,000 + 60,000
2

= (2, 40, 000 / 2) + 2, 50,000 + 60,000

= 1, 20,000 + 2, 50,000 + 60,000 = Rs. 4, 30,000/-

Average annual profit after taxes

ARR for Machine 1 = ––––––––––––––––––––––––––– x 100
Average Investment

2, 00,000
ARR for Machine 1 = –––––––––– x 100 = 46.5%
4, 30,000

2, 25,000
ARR for Machine 2 = –––––––––– x 100 = 52.32%
4, 30,000
Based on the accounting rate of return, the machine 2 is profitable.

Problem:3
Cash flow after taxes to find out ARR Total investment /outlay
proposal 1 Rs. 2, 50,000. Give the ranks to projects.
Years Proposal 1 Proposal 2 Proposal 3
1 90,000 1,60,000 1,20,000
2 1,60,000 1,20,000 90,000
3 1,20,000 90,000 1,60,000
4 70,000 50,000 30,000
Total 4,40,000 4,20,000 4,00,000
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Solution:

Proposal 1:

ARR = Average net profit after taxes / Average investment x 100

Average Profit for proposal 1 = (4, 40,000/4Years) = Rs. 1, 10,000

Average investment is = Total Investment / 2.
Average investment = (2, 50,000 / 2 = Rs. 1, 25,000).

ARR = (1, 10,000 / 1, 25,000) x 100 = 88%.

Proposal 2:

Average Profit for proposal 1 = (4, 20,000/4Years) = Rs. 1, 05,000

Average investment is = Total Investment / 2.
Average investment = (2, 50,000 / 2 = Rs. 1, 25,000).

ARR = (1, 00,000 / 1, 25,000) x 100 = 84%.

Proposal 3:

Average Profit for proposal 3 = (4, 00,000/4Years) = Rs. 1, 10,000

Average investment is = Total Investment / 2.
Average investment = (2, 50,000 / 2 = Rs. 1, 25,000).

ARR = (1, 10,000 / 1, 25,000) x 100 = 84%.

The rank under ARR method is: 1, 2 and 3.

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Time value of money (TVM)

Time value of money (TVM) is the idea that money that is available at the present
time is worth more than the same amount in the future, due to its potential earning
capacity. This core principle of finance holds that provided money can earn interest,
any amount of money is worth more the sooner it is received. One of the most
fundamental concepts in finance is that money has a time value attached to it. In
simpler terms, it would be safe to say that a dollar was worth more yesterday than
today and a dollar today is worth more than a dollar tomorrow.

Or

Present one rupee value always greater then to future one rupee value.

There are five (5) variables that you need to know:

1. Present value (PV) - This is your current starting amount. It is the money you
have in your hand at the present time, your initial investment for your future.
2. Future value (FV) - This is your ending amount at a point in time in the future.
It should be worth more than the present value, provided it is earning interest
and growing over time.
3. The number of periods (N) - This is the timeline for your investment (or
debts). It is usually measured in years, but it could be any scale of time such
as quarterly, monthly, or even daily.
4. Interest rate (I) - This is the growth rate of your money over the lifetime of the
investment. It is stated in a percentage value, such as 8%.
5. Payment amount (PMT) - These are a series of equal, evenly-spaced cash
flows.

Present value Formula

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For Example: If it is invested Rs.1000 with bank or a building society at an interest

rate of 10% per annum, it will increase as follows.

Particulars Amount
Original Investment 1000.00
Interest at 10% on Rs. 1000 for the first year (1000 / 10 X100) 100.00
Value at the end of first year 1100.00
Interest at 10% on Rs.1100 for the second year(1100/10X100) 110.00
Value at the end of 2nd year (1,100 + 110) 1210.00

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.

Problem: 1

A firm has many projects. It was earning at least 6% annum on this project with
following cash flows. Do you recommend?

Year End 0 1 2 3 4 5 6
Cash Inflows Nil Nil 30,000 40,000 40,000 40,000 50,000
Cash Outflow 60,000 20,000

Solution:
Year Cash Inflow 6% PV Present Value of
factor the future cash
flows
0 (60,000) 1.000 (60,000)
1 (20,000) (0.943) (18,860)
2 30,000 0.890 26,700
3 40,000 0.839 33,560
4 40,000 0.792 31,680
5 40,000 0.746 29,840
6 50,000 0.704 35,200
Total 1,56,980
Present
Value
Less: PV of 78,860
Original
Investment
NPV 78,120
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Note: Working Note about 6% PV Factor;

Formula: 6/100 = 0.06

1+0.06 = 1.06
1/ 1.06 = 0.943 ------1 Year
2 Year: 0.943 X 0.943 = 0.890
3 year: 0.943 X 0.890 = 0.839
4 year: 0.943 X 0.839 =0.792
5 year: 0.943 X 0.792 = 0.746
6 year: 0.943 X 0.746 = 0.704

NPV is Positive, the project can be recommended.

Problem: 2
Find out Present value of future Cash inflows from below cash inflow, the
interest rate or discount rate is 10%.
Year Cash in PV factor Present
flows 10% value of
cash
inflows
1 1,20,000 0.909 1,09,080
2 90,000 0.826 74,340
3 1,60,000 0.751 1,20,160
4 30,000 0.683 20,490
PV Total 3,24,070
Cash inflows
Less: 2,20,000
Original cost
NPV 1,04,070
NPV positive.

Note: PV factors find out: 10%

1 year: 10/100 = 0.10
1 + 0.10 = 1.10
1/ 1.10 = 0.909 -----1 year.

2 year: 0.909 X0.909 = 0.826

3 year: 0.909 X 0.826 =0.751
4 year: 0.909 X 0.751= 0.683
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Problem: 3
Total outlay / original investment Rs. 2, 50,000 /- find out PV of Cash inflows
from the below Cash inflows.
year Cash in PV factor PV of cash
flows 25% inflow
1 1,20,000 0.962 1,15,440
2 90,000 0.924 83,160
3 1,60,000 0.888 1,42,080
4 30,000 0.854 25,620
Total PV of 3,66,300
future cash
inflows
Less: 2,50,000
original
investment
NPV 1,16,300

NPV Positive.

Problem: 4
Initial Outlay Rs. 80,000 and initial working Rs.20, 000.
Years Cash Flows (CF)
1 35,000
2 35,000
3 30,000
4 30,000

Additional Information:

1. Salvage value Rs.20, 000/-.

2. Tax rate assumed to be 50%.
3. The project depreciation on Straight Line Method(SLM). If the ewquired rate
of return is 10%
4. is the project acceptable order the NPV method.

Solution:
Initial capital or original investment = 80,000 + 20,000 = Rs. 1, 00,000
Depreciation Calculation: Initial investment / No. of years
80,000 / 4 = Rs.20, 000.
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Years 1 2 3 4
Cash Flows(CF) 35,000 35,000 30,000 30,000

EBDIT LESS:DEP EBIT LESS:TAX EAT ADD:DEP CFAT DIS.10% PVFCF

35,000 20,000 15,000 7,500 7,500 20,000 27,500 0.909 24,997.5
35,000 20,000 15,000 7,500 7,500 20,000 27,500 0.826 22,715.0
30,000 20,000 10,000 5,000 5,000 20,000 25,000 0.751 18775.0
30,000 20,000 10,000 5,000 5,000 20,000 25,000 0.683 17075.0
NPV 83,562.5

Total NPV = 83,562.5

Add: Solvage / scrap value = 13,660.0
After 4 years (20,000 x 0.683) –––––––––
93,637.5
Less: Initial out lay 1, 00,000
–––––––––––
(-) 2,777.5
––––––––––––

Note: NPV Negative, so project rejected.

2. Internal Rate of return (IRR)

The IRR is the rate of return at which the present value of expected
cash flows of a project exactly equals the Original investment. In other words, the
income equals to expenditure other investment break even.

At IRR, the net present value of a project is Zero. The NPV refers to the
excess of the present value of future cash flows over and above the original
investment. IRR is denoted by ‘r’. it is computed as show below.
24

If we have scrap value and working capital adjustments, the above formula will
change to!

“The IRR shows, the different between the present value of cash inflows and the
original cost are equal to zero.”

Evaluation of IRR:- The IRR is compared with the cost of capital(discount rate). If
the IRR is more than the cost of capital, the project is profitable. Otherwise it is not.
Where there are two projects with different IRRs, select the project with higher IRR.

 The PI is more than one for the profitable project.

 If the PI profitable index is less than one, proposal rejected.
 If the PI is equal the one, the project is just breakeven.

Problem: 1 (IRR from Un-event Cash inflows).

Given that a project yields the following cash inflows from six years at an original
cost of Rs.50, 000 determine IRR.

Years Cash inflows after taxes (Rs)

1 0
2 10,000
3 16,000
4 24,000
5 30,000
6 30,000
Solution: Here cash inflows are not even. So determine the IRR by trial and error
process by attempting two possible different rates of interest 18% and say 20%.

year Cash Flows PV Factor PV of the 20% PV factor PV of the

18% future cash future cash
inflows inflows
1 0 0 0 0 0
2 10,000 0.718 7,180 0.694 6,940
3 16,000 0.609 9,744 0.579 9,264
4 24,000 0.516 12,384 0.482 11,568
5 30,000 0.437 13,110 0.402 12,060
6 30,000 0.370 11,100 0.335 10,050
Total Inflows 53,518 Total Inflows 49,882
Less: 50,000 Less: 50,000
Original Original
Investment Investment
NPV (+) 3,518 NPV (-) 118
25

Working Note: 18% factor:

18/100 = 0.18
1+0.18 = 1.18
1/1.18 = 0.847 ------1 year
2 year = 0.847 X 0.847 =0.718
3 year = 0.847 X 0.718 = 0.609
4 year = 0.847 X 0.609 = 0.516
5 year = 0.847 X0.516 = 0.437
6 year = 0.847 X 0.437 = 0.370
Formula:

L1= Lower rate of interest, L2 = Higher rate of Interest

NPV@L1 Lower discount value of NPV
NPV@L2 Higher discount value of NPV

L1= 18% L2= 20%

3518
18 + –––––––––––– X 20 - 18
3518 – (- 118)

3518
18 + ––––––––––– X 2
3636
18 + 1.935 = 19.935 or 20%.
26

Problem: 2
The cash flows are not even, so determine the IRR by trial and error process by
attempting two possible different rates of interest 25% and say 30%. The cost of the
project is Rs. 2, 50,000/-

Years 1 2 3 4
Cash Flows (CF) 90,000 1,60,000 1,20,000 70,000

Solution:

Years Cash Flows Dis.25% PV of Future CF

1 90,000 0.800 72,000
2 1,60,000 0.640 1,02,400
3 1,20,000 0.512 61,440
4 70,000 0.410 28,700
Total Inflows 2,64,540
Less: Original 2,50,000
Amount
NPV (+) 14,540

Years Cash Flows Dis.30% PV of Future CF

1 90,000 0.769 69,210
2 1,60,000 0.591 94,560
3 1,20,000 0.455 54,600
4 70,000 0.350 24,500
Total Inflows 2,42,870
Less: Original 2,50,000
Amount
NPV (-) 7130
27

L1= Lower rate of interest, L2 = Higher rate of Interest

NPV@L1 Lower discount value of NPV
NPV@L2 Higher discount value of NPV

L1= 25% L2= 30%

14,540
25 + –––––––––––– X 30 - 25
14,540 – (- 7130)

14,540
25 + ––––––––––– X 5
21,670
= 25 + 0.671 X 5
= 25 + 3.35 = 28.35%. Project is Accepted

C. Profitable Index (PI)

This is ratio between the present value of cash flows and the present
value of cash outflows. It is used to indicate the profitability at a glance.

“The PI approach measures the present value of returns per rupee

invested.” The NPV based on the different between the present value of future cash
inflows and the present value of cash outflows. PI also known as benefit cost Ratio.
It is similar to NPV approach.
28

Sum of present value of cash Inflows

PI = –––––––––––––––––––––––––––––––––––––
Sum of present value of cash Outflows

EX: The sum of present value of cash inflows = Rs. 1, 57,070

The sum of present value of cash outflows = Rs. 1, 38,860

1, 57,070
PI = –––––––––––––––– = 1.13.
1, 38,860
The PI of 1.13 shows the proposal is profitable, because PI is more than one.

Interpretation:
1. The PI is more than one for the profitable projects.
2. If the profitable index is less than one, proposal rejected.
3. If the profitability index is equal to one, the proposal is just break even.

Accepted and Rejected project:

PI > 1 Accepted
PI < 1 Rejected.

Problem: 2
The cash flows are not even, so determine the IRR by trial and error process by
attempting two possible different rates of interest 25%. The cost of the project is
Rs. 2, 50,000/-
29

Years 1 2 3 4
Cash Flows (CF) 90,000 1,60,000 1,20,000 70,000
Solution:

Years Cash Flows Dis.25% PV of Future CF

1 90,000 0.800 72,000
2 1,60,000 0.640 1,02,400
3 1,20,000 0.512 61,440
4 70,000 0.410 28,700
Total Inflows 2,64,540

Sum of present value of cash Inflows

PI = –––––––––––––––––––––––––––––––––––––
Sum of present value of cash Outflows

2, 64,540
PI = –––––––––––––––– = 1.05.
2, 50,000
The PI of 1.05 shows the proposal is profitable, because PI is more than one.

Problem: 3 Find out PI from Un-event Cash inflows).

Given that a project yields the following cash inflows from six years at an original
cost of Rs.50, 000 determine IRR.

Years Cash inflows after taxes (Rs)

1 0
2 10,000
3 16,000
4 24,000
5 30,000
6 30,000
Solution: Here cash inflows are not even. So determine the PI by trial and error
process by attempting two possible different rates of interest 18%.
30

year Cash PV Factor PV of the

Flows 18% future cash
inflows
1 0 0 0
2 10,000 0.718 7,180
3 16,000 0.609 9,744
4 24,000 0.516 12,384
5 30,000 0.437 13,110
6 30,000 0.370 11,100
Total Inflows 53,518

Sum of present value of cash Inflows

PI = –––––––––––––––––––––––––––––––––––––
Sum of present value of cash Outflows

53,518
PI = –––––––––––––––– = 1.07.
50,000
The PI of 1.07 shows the proposal is profitable, because PI is more than one.

♣♣♣♣The End♣♣♣♣
Important Questions

1. What do you know about Capital budgeting? Explain significance, kinds,

process of Capital budgeting.
2. Explain difference between Traditional and Modern Teachings and
explain,
a. Payback period meaning features, advantages and disadvantages.
b. Accounting Rate of return (ARR) method meaning features,
advantages and disadvantages.
c. Net present Value (NPV) meaning features, advantages and
disadvantages.
d. Internal Rate of Return (IRR) meaning features, advantages and
disadvantages.
31

e. Profitable Index method (PI) meaning features, advantages and

disadvantages.
f. All Problems Like: Payback period, ARR, NPV, IRR, PI and rule and
regulations project Accepted or rejected