OPERATIONAL

APPROACH TO
FINANCIAL
DECISION
 MEANING OF COST
Cost means Amount of all resources incurred by an entity for production
of goods and in rendering of services

ELEMENTS OF COST

MATERIAL LABOUR OTHER EXPENSES

Cost of All tangible Cost of All human

items used in resources used in All expenses other
production of goods production of goods or than Material and
or in rendering of in rendering of Labour
services services

Direct Indirect Direct Indirect Direct Indirect

Material Material Labour Labour Expenses expenses

▪ Direct Material + Direct Labour + Direct Expenses = Prime Cost

▪ Indirect Material + Indirect Labour + Indirect Expenses = Overhead

MATERIAL

DIRECT INDIRECT

Material which can be Material which generally can

identified in the products and not be identified in the
which is large in Qty are called products and which is small in
Direct Material Qty are called Indirect
E.g. Material
▪ Timber in furniture E.g.
▪ Cloth in dress making ▪ Fevicol, Gums, nails
▪ Bricks in Building ▪ Jhadu pochha
 LABOUR

DIRECT INDIRECT

Those cost of human

resources which are directly
related with production of Those cost of human
goods or rendering of services resources which are indirectly
are known Direct labour involved with production of
E.g. goods or rendering of services
▪ Carpenter in furniture E.g.
making ▪ Salary of supervisor
▪ Tailor in dress making ▪ Salary of Guard /sweeper
▪ Mason in Building etc.
construction

EXPENSES

DIRECT INDIRECT

Expenses which are directly

related with production of ▪ Expenses other than direct
goods or rendering of services ▪ These are normally known
are known Direct Expenses as Overhead
E.g. E.g.
▪ Royalty on production ▪ Rent, Electricity, Telephone,
▪ Power advertisement, printing &
▪ Fuel stationary, Depreciation on
▪ Hire charges or depreciation assets other than those
on Machine used in Production of goods.

▪ The Total of Indirect Material, Indirect Labour and Indirect Expenses

are called overhead.
▪ Overhead can be classified as under:
▪ Production overhead: overhead incurred in factory. These
overhead also called Factory overhead or Manufacturing
overhead or work overhead.
▪ Administrative overhead: overhead incurred office. These
overhead also called office overhead.
▪ Selling & Distribution overhead: overhead incurred for selling &
distribution of Goods
 COST ON THE BASIS OF BEHAVOIUR

SEMI – VARIABLE
VARIABLE COST FIXED COST
COST

Fixed cost remain

Per unit cost is same up to a given Up to a certain level,
fixed and total cost level of activity it remain same but
vary with (Total remain fixed but after that, it
production per unit change with becomes variable.
change in production)

MARGINAL COSTING

▪ Marginal cost means increase in variable cost due to increase in

production.

▪ Marginal cost technique is used in decision making

▪ This technique is used for cost volume profit (CVP) analysis

INCOME STATEMENT UNDER MARGINAL COSTING

Particulars Amounts
Sales xxx
Less: Variable cost xxx
Contribution xxx
Less: Fixed Cost xxx
Profit xxx

Note:
For CVP Analysis, we calculate PV Ratio under marginal costing

HOW TO CALCULATE PV RATIO

▪ FORMULA 1
Contribution per unit X 100
Sale price per unit

▪ FORMULA 2
Total Contribution X 100
Total Sale
▪ FORMULA 3
Change in contribution X 100
Change in Sales

▪ FORMULA 4
Change in Profit X 100
Change in Sales
Note:
Formula 3 & 4 will be applied only when two years figures are given.

Example 1
Particulars 2023 2024
(10,000 units) (15,000 units)
Sales (per unit Rs. 50) 50,000 75,000
Less: Variable cost (Rs. 30 per unit) 30,000 45,000
Contribution 20,000 30,000
Less: Fixed cost 14,000 14,000
Profit 6,000 16,000
Calculate PV Ratio by various formulas

Example 2
No of units 2,00,000
Sale price per unit Rs. 50
Variable cost per unit Rs. 37.50
Fixed Cost Rs. 15,00,000

Calculate Profit and PV Ratio by Different formulas

BREAK EVEN POINT /SALE (BEP)

▪ Break even point means that level of sale at which there is no profit or
no loss situation.
▪ BEP is calculated as under:
▪ BEP in Units = Fixed cost
contribution per unit

▪ BEP in Amount (Rs.) = Fixed cost

PV Ratio

▪ BEP in Amount can also be calculated as under:

BEP in units X Sale price per unit

▪ अगर किसी चीज़ िा calculation units में िरना है , then contribution per unit
से divide िरना है and अगर किसी चीज़ िा calculation Amounts में िरना है ,
then PV Ratio से divide िरना है
 MARGINE OF SAFETY (MOS)

▪ Sale over and above BEP sales is called Margin of safety

▪ Margin of safety is calculated as under:

Formula 1
Total Sales – BEP Sales

Formula 2
▪ MOS in Units = Profit
contribution per unit

▪ MOS in Amount (Rs.) = Profit

PV Ratio

Example 3
No of units 4,00,000
Sale price per unit Rs. 100
Variable cost per unit Rs. 75
Fixed Cost Rs. 30,00,000

Calculate:
(i) PV Ratio
(ii) Break even sales in Amounts and in Units
(iii) Margin of safety in amounts and in units
 HOW TO CALCULATE DESIRED SALES TO CALCULATE
DESIRED PROFIT

Desired sales to earn a desired profit will be calculated as under:

▪ In Units = Fixed cost + Desired Profit
contribution per unit

▪ In Amount (Rs.) = Fixed cost + Desired Profit

PV Ratio

Example 4
No of units 3,00,000
Sale price per unit Rs. 80
Variable cost per unit Rs. 60
Fixed Cost Rs. 56,00,000

Calculate:
(i) PV Ratio
(ii) Profit
(iii) Break even sales in Amounts and in Units
(iv) Margin of safety in amounts and in units
(v) Sales to earn profit of Rs. 10,00,000

WHEN CAPACITY UTILISATION IS NOT 100%

Example 5
A Ltd is working on 80% Capacity and produced 1,00,000 units. A Ltd
gives you following details:
Sale price per unit Rs. 50
Variable cost per unit Rs. 30
Fixed Cost Rs. 12,00,000
Including Depreciation of Rs. 2,00,000)

Calculate:

(i) Profits
(ii) Variable cost to sales ratio
(iii) PV Ratio
(iv) Break even sales in Amounts and in Units
(v) Margin of safety and its % on sales
(vi) Activity level at BEP
(vii) Cash Break even point
(viii)Profit at 100% Capacity
(ix) Sales to earn same profit which we are currently earning (at 80%
Capacity) if sale price is reduced by 20%.
 COMPOSITE BREAK EVEN
▪ This concept will be applicable when more than one products are
produced by an organization.
▪ In this case, composite PV Ratio is calculated and then composite
Break even point is calculated
▪ Composite Break even unit will be distributed between all products in
the ratio of sale mix

Example 8
Products A B C

Sales Mix 5 3 2
Sale price per unit 200 250 275
Variable cost per unit 160 220 240
Total Fixed cost = Rs. 7,20,000
Calculate BEP for each Product
COST OF
CAPITAL
 SOURCES OF FINANCE

EQUITY DEBTS

EQUITY PREFERENCE
RETAINED
SHARE SHARE DEBENTURES BONDS LOAN
EARNING
CAPITAL CAPITAL

▪ Every source of finance has some cost, which is called cost of capital

▪ Cost of Equity share capital is called cost of equity. It is denoted as

▪ “ Ke ”
▪ Cost of Retained earning is called cost of Retained earning. It is
denoted as “ Kr ”

▪ Cost of Preference share capital is denoted as “ Kp ”

▪ Cost of all debts is called cost of Debts. It is denoted as “ Kd ”

▪ Overall cost of capital is called weighted cost of capital

(WACR)

HOW TO CALCULATE WEIGHTED AVERAGE COST

OF CAPITAL

Following steps are followed for calculation of WACC

Step 1 – Calculate Individual cost of capital

Step 2 – calculate weight of each capital in Total Capital

Step 3 – Multiply weight with Individual cost of Capital. Total of such

product will be WACC (Ko)
Example 1
A Ltd has following capital structure:
Equity share capital (Rs. 10) 5,00,000
Reserve & Surplus 2,50,000
Preference Share capital (Rs. 100) 3,00,000
Debentures (Rs. 100) 4,50,000

Individual cost of capital are:

Ke 15%, Kr 12%, Kp 11%, Kd 8%.

Calculate WACC

Components Rs. weight Individual K WACC (ko)

ES Capital 5,00,000 15%

Reserve & Surplus 2,50,000 12%
PS Capital 3,00,000 11%
Debentures 4,50,000 8%

Example 2
Calculate WACC in Example 1 by taking market value weight if market
price of equity shares is Rs. 60, Preference Shares is Rs. 150 and
Debentures is Rs. 90.

Components Rs. weight Individual K WACC (ko)

ES Capital 15%
Reserve & Surplus 12%
PS Capital 11%
Debentures 8%

Example 3
A Ltd has following capital structure:
Equity share capital (Rs. 10) 10,00,000
Reserve & Surplus 6,00,000
Preference Share capital (Rs. 100) 5,00,000
Debentures (Rs. 100) 15,00,000

Individual cost of capital are:

Ke 12%, Kr 11.5%, Kp 10%, Kd 9%.
Market price of equity shares is Rs. 80, Preference Shares is Rs. 160 and
Debentures is Rs. 80.

Calculate WACC

Ans. Book value weight 10.38%, Market value weight 11.33%

 INDIVIDUAL COST OF CAPITAL

COST OF DEBTS

COST OF IRREDEEMABLE DEBTS COST OF REDEEMABLE

(PERPETUAL) DEBTS

COST OF IRREDEEMABLE DEBTS

COST OF DEBTS BEFORTAX COST OF DEBTS AFTER TAX

i i (1 − t)
Kd = Kd =
Net Proceeds Net Proceeds
▪ i = Interest ▪ i = Interest
▪ Net Proceeds = ▪ t = tax rate
Issue Amount Less Floatation ▪ Net Proceeds =
cost Issue Amount Less Floatation
cost

Note:
Floatation cost is calculated on Face value if Issue price is different
from face value

Example 4
A Ltd. Issued Irredeemable Debentures of Rs. 100 at par. Rate of
Interest 16% p.a. Floatation cost is 2%. Tax Rate 40%. Calculate Kd
after and Before Tax

Example 5
A Ltd. Issued Irredeemable Debentures of Rs. 100 at 20% Premium. Rate
of Interest 18% p.a. Floatation cost is 5%. Tax Rate 30%. Calculate Kd
after and Before Tax

Example 6
A Ltd. Issued Irredeemable Debentures of Rs. 100 at 10% discount. Rate
of Interest 20% p.a. Floatation cost is 4%. Tax Rate 40%. Calculate Kd
after and Before Tax
Example 7
A Ltd. Issued 10,000 Irredeemable 15% Debentures of Rs. 100 at 120 per
Debentures.
Underwriting commission; 2%
Brokerage 1%
Other Expense on issue 5 per Debenture
Tax Rate 40%. Calculate Kd after and Before Tax

COST OF REDEEMABLE DEBTS

Redemption value − Net Proceeds

Kd = i (1 – t) +
Redemption Period
X 100
Redemption value + Net Proceeds
2

This Method is called Approximation Method

Example 8
A Ltd. Issued 10,000 redeemable Debentures of Rs. 100 at Rs. 110
Redeemable after 5 years at 20% Premium. Rate of Interest 16% p.a.
Floatation cost is Rs. 30,000. Tax Rate 40%. Calculate Kd after Tax

Example 9
A Ltd. Issued 50,000 redeemable Debentures of Rs. 100 at Rs. 105
Redeemable after 10 years at 50% Premium. Rate of Interest 12% p.a.
Floatation cost is 2%. Tax Rate 30%. Calculate Kd after Tax

YIELD TO MATURITY (YTM) METHOD

Under YTM Method, Cost of Debts means effective Rate of Interest

which is also called IRR (Internal Rate of Return)

Example 10
A Ltd. Issued 20,000 redeemable Debentures of Rs. 100 at Rs. 110
Redeemable after 5 years at 20% Premium. Rate of Interest 16% p.a.
Floatation cost is Rs. 60,000. Tax Rate 40%. Calculate Kd by YTM
Method
Example 11
A Ltd. Issued 50,000 redeemable Debentures of Rs. 100 at Rs. 120
Redeemable after 5 years at 10% Premium. Rate of Interest 15% p.a.
Fluctuation cost is Rs. 2,00,000. Tax Rate 40%. Calculate Kd by YTM
Method

COST OF ZERO COUPON BOND

OR DEEP DISCOUNT BOND

▪ Zero coupon bond or Deep Discount bonds means a bond on which

Interest is not payable during the redemption period.

▪ Company issued such Bonds at a high discount price or it is repayable

at high premium.

▪ Kd for such Bonds is IRR which is calculated as under:

𝐟𝐮𝐭𝐮𝐫𝐞 𝐯𝐚𝐥𝐮𝐞
Kd = 1 – 1/n X100
𝐩𝐫𝐞𝐬𝐞𝐧𝐭 𝐯𝐚𝐥𝐮

▪ By the above formula, we apply 12 steps model on calculator to

calculate Kd for such bonds

Example 12
A Ltd. Issued Zero coupon Bond in which it received Rs. 1,00,000 and
repayable amount is 2,50,000 after 5 years. Calculate Kd

Example 13
A Ltd. Issued Zero coupon Bond in which it received Rs. 5,00,000 and
repayable amount is 25,00,000 after 15 years. Calculate Kd
 COST OF PREFERENCE SHARE CAPITAL

COST OF IRREDEEMABLE PREF

COST OF REDEEMABLE
SHARES
PREFERENCE SHARES
(PERPETUAL)

COST OF IRREDEEMABLE PREF SHARES

PD
KP =
Net Proceeds

▪ PD = Preference Dividend
▪ Net Proceeds =
Issue Amount Less Floatation
cost

COST OF REDEEMABLE PREF SHARES

Redemption value − Net Proceeds

Kp = PD +
Redemption Period
X 100
Redemption value + Net Proceeds
2

Example 14
A Ltd. Issued 10,000 10% irredeemable Preference shares of Rs. 100 at
Rs. 120. Fluctuation cost is 5%. Tax Rate 40%. Calculate Kp before and
after Tax

Example 15
A Ltd. Issued 10,000 12% redeemable Preference shares of Rs. 100 at
Rs. 110 Redeemable after 5 years at 20% Premium. Rate of Interest 16%
p.a. Expenses on issue is Rs 8 per share. Tax Rate 40%. Calculate cost
of preference shares.
 COST OF EQUITY

CAPITAL ASSETS
DIVIDEND PRICE EARNING PRICE
PRICE MODEL
MODEL MODEL
(CAPM)

CAPITAL ASSETS PRICE MODEL (CAPM)

▪ Ke = Risk Free Rate + β (Market rate – Risk Free Rate)

▪ Difference between market rate and Risk free rate is called Risk
Premium.

Example 16
Rate Free Rate 6%
Market rate 18%
Beta (β) 1.5
Calculate Ke

Example 17
Rate Free Rate 10%
Market Premium 8%
Beta (β) 2
Calculate Ke

DIVIDEND PRICE MODEL

WITHOUT GROWTH WITH GROWTH

MODEL MODEL

D D1
Ke = Ke = +g
P0 P0
D = Dividend per shares D 1 = Expected Dividend per
P0 = Current market price of shares
shares P0 = Current market price of
shares
g = Growth Rate
 EARNING PRICE MODEL

WITHOUT GROWTH WITH GROWTH

MODEL MODEL

E E1
Ke = Ke = +g
P0 P0
D = Earning per shares D 1 = Expected Earning per
P0 = Current market price of shares
shares P0 = Current market price of
shares
g = Growth Rate

Example 18
A Ltd earn Rs. 30 per share in current year and distributed 60% of its
earning. The current market price is Rs. 90. Calculate Cost of Equity by
Earning Price Model and Dividend Price Model in following cases:
Case I – when there is No Growth
Case I – when there is Growth Rate of 10%

COST OF RETAINED EARNING

▪ If Nothing specified about cost of retained earning, then cost of equity
will be taken as cost of retained earning. Ke = Kr

▪ But sometimes, we required to calculate cost of retained earning as

under:

Kr = D 1 − pt (1 − B)
MP x (1 − ct)
▪ D = Dividend per share
▪ Pt = Personal Income tax
▪ Ct = capital Gain Tax

Example 19
Dividend Per shares Rs. 50
Personal Tax Rate 30%
Capital gain Tax 20%
Brokerage 3%
Market Price share Rs. 400
Calculate Ke and Kr
 MARGINAL COST OF CAPITAL
▪ Marginal Cost of Capital means Increase in cost of capital due to
Introduction of fresh capital in existing capital structure at a higher
rate.

▪ Assume existing WACC of the entity is 15%, and after introducing

additional capital, overall cost of capital comes to 16%, the increase
of such 1% is called marginal cost of capital which is due to
introducing of additional fund

Example 20
A Ltd has following capital structure:
Equity share capital (Rs. 10) 50,00,000
Reserve & Surplus 15,00,000
Preference Share capital (Rs. 100) 10,00,000
Debentures (Rs. 100) 5,00,000

Individual cost of capital are:

Ke 15%, Kr 14%, Kp 12%, Kd 8%.

Now A Ltd want to raise Funds of Rs. 50,00,000. this fund will be raised
as under:
Equity 20,00,000 (Required rate at 18%)
Preference 20,00,000 (New Rate 15%)
Debts 10,00,000( New Rate 10%)

Calculate WACC and Marginal Cost of Capital

Components Rs. weight Individual WACC

K (ko)
ES Capital 15%
Reserve & Surplus 14%
PS Capital 12%
Debentures 8%

Components Rs. weight Individual WACC

K (ko)
ES Capital
Old
New
Reserve & Surplus
PS Capital
Old
New
Debentures
Old
New
 WHEN TARGET WEIGHT IS GIVEN
▪ If a firm has determined the capital structure which it believes
most consistent with its goal of owner’s wealth maximization and it
is directing its financing policies toward achievement of this
“optimal” capital structure, then the use of these target capital
structure weights may be appropriate.

Example 20
A Ltd has following capital structure:
Equity share capital (Rs. 10) 50,00,000
Reserve & Surplus 15,00,000
Preference Share capital (Rs. 100) 10,00,000
Debentures (Rs. 100) 5,00,000

Individual cost of capital are:

Ke 15%, Kr 14%, Kp 12%, Kd 8%.
Target weight Equity 40%, Retained earning 15%, Preference share
capital 25% and Debts 20%

Calculate WACC

Components Rs. weight Individual K WACC (ko)

ES Capital 15%
Reserve & Surplus 14%
PS Capital 12%
Debentures 8%
DIVIDEND
DECISION
 MEANING OF DIVIDEND AND DIVIDEND POLICY

▪ Dividend means a part of profit earned by company which is

distributed to Shareholders of company

▪ Dividend policy means a policy in which it is decided whether

dividend is distributed or not and if Distributed, then what will
be the Quantum of dividend so that shareholders wealth can be
maximized.

DIVIDEND THEORIES

IRRELEVANT THEORY RELEVANT THEORY

AS PER THIS THEORY,

AS PER THIS THEORY,
DIVIDEND DECISION
DIVIDEND DECISION DOES NOT
AFFECT THE VALUE OF
AFFECT THE VALUE OF FIRM
FIRM

MODIGILIANI AND MILLER (MM) WALTER THEORY AND

APPROCH GARDEN THEORY

IRRELEVANT THEORY
MODIGILIANI AND MILLER THEORY

▪ This theory is given by Modigliani & Miller in 1961 and this

theory is called MM Approach.

▪ As per this approach, there is no effect on value of firm whether

dividend is paid or not.

▪ This approach says that if firm is fulfilling the requirement of

shareholders either in the form of dividend or by way of
Increasing share price, then there is no change in shareholders
perception.
 PROCEDURE UNDER MM APPROACH

▪ Under MM Approach, Following procedure is adopted:

(1) Calculate Market Value of shares at the end period (P1)
P 1 = P0 x (1 + Ke) – D1

P1 = Market value of shares at the end of the period

P0 = Market value of shares as on today
Ke = Cost of Equity (Capitalization Rate)
D1 = Expected Dividend

(2) Calculate Fund required for any new project

Total Investment Required xxx
Less: Retained earning* (xxx)
Fund Required xxx

* Retained Earning = Total Earning – Dividend Distributed

(3) Calculate new share issued for new project = Fund Required
P1

(4) Calculate Value of Firm (vof) =

(Old shares X P1) + (New shares X P1) + E - I
1 + Ke

P1 = Market value of shares at the end of the period

E = Total Earning
I = Investments

Example 1
Present No of Shares ₹ 1,20,000
Capitalization Rate (Ke) 10%
Current Market Price ₹ 160
Total Earning ₹ 12,00,000
Investments Required for new project ₹ 24,00,000
Expected Dividend ₹8

Calculate:
Calculate Value of firm as per MM Approach in following cases:
(1) When Dividend Paid
(2) when Dividend not Paid
When Dividend Paid
(1) Calculate Market Value of shares at the end period (P1)
P 1 = P0 x (1 + Ke) – D1
160 X (1 + 0.10) – 8 = 168

(2) Calculate Fund required for any new project

Total Investment Required 24,00,000
Less: Retained earning* (2,40,000)
Fund Required 21,60,000

* Retained Earning = Total Earning – Dividend Distributed

(3) Calculate new share issued for new project = Fund Required
P1
21,60,000
168

12,857.1428

(4) Calculate Value of Firm (vof) =

(1,20,000 X 168) + (12,857.14 X 168 ) + 12,00,000 – 24,00,000
1 + 0.1
Rs. 1,92,00,000

When Dividend Not Paid

(1) Calculate Market Value of shares at the end period (P1)
P 1 = P0 x (1 + Ke) – D1
160 X (1 + 0.10) – 0 = 176

(2) Calculate Fund required for any new project

Total Investment Required 24,00,000
Less: Retained earning* (12,0,000)
Fund Required 12,00,000

(3) Calculate new share issued for new project = Fund Required
P1
12,00,000
176

6818.1818181818

(4) Calculate Value of Firm (vof) =

(1,20,000 X 176) + (6818.1818 X 176 ) + 12,00,000 – 24,00,000
1 + 0.1

Rs. 1,92,00,000
 ASSUMPTIONS AS PER MM APPROACH
▪ Market is perfect. It means:
▪ Informations are freely available
▪ There is no transaction cost
▪ Investor is not able to affect the market Individually.

▪ Investor is rational (Logical)

▪ There is no tax
▪ There is no risk & uncertainty.

RELEVANT THEORIES
1. WALTER APPROACH
▪ As per this approach, Dividend affect value of firm.
▪ Walter has classified entities into 3 categories.

CLASSIFICATION OF FIRMS

GROWING FIRMS DECLINING FIRMS NORMAL FIRM

Rate of Return (r) Rate of Return (r) is Rate of Return (r) is

is higher than Ke lower than Ke equal to Ke

No effect of
Optimum Dividend Optimum Dividend
Dividend
payout is 0% payout is 100%
distribution

r = return on Investments or Internal Rate of Return or

productivity on retained earning.
ke = Capitalization rate
Value of shares under Walter Approach (P) = D + (E - D) X R/ke
Ke

P = Market value of shares

E = Earning per share
R = Rate of return
Ke = Capitalization rate or cost of equity

Example 2
EPS ₹ 30
Rate of Return 18%
Capitalization Rate (Ke) 15%
Calculate Maximum Value of Share as per Walter Approach

Example 3
EPS ₹ 50
Rate of Return 15%
Capitalization Rate (Ke) 18%
Calculate Maximum Value of Share as per Walter Approach

Example 4
EPS ₹ 80
Rate of Return 15%
Capitalization Rate (Ke) 15%
Calculate Value of Share as per Walter Approach

Example 5
EPS ₹ 20
Rate of Return 24%
Capitalization Rate (Ke) 12%
Company want to maintain market price ₹ 240. calculate Payout
ratio to maintain such Market price
 2. GORDEN MODEL

WITHOUT GROWTH WITH GROWTH

P0 = D1 P0 = D1
Ke Ke - g

P0 = Current market value

D1 = Expected Dividend per share
Ke = Cost of Equity or Capitalization Rate
G = Growth Rate

Note: If Growth Rate is not given, the it will be calculated as

under:
G=bXr

B = Retention Ratio
R = Return on Investments or Productivity on retained earning

Example 6
Net Profit ₹ 10,00,000
12% Preference Share Capital ₹ 20,00,000
No of Equity shares 1,20,000
Dividend payout Ratio 60%
Rate of Return 20%
Capitalization Rate (Ke) 15%
Calculate value of shares by Gordan Model
 CAPITAL
BUDGETING
 MEANING OF CAPITAL BUDGETING
Capital budgeting is the process by which businesses evaluate and
decide on potential long-term investments or projects. These
investments often involve substantial capital outlay and can include
things like
▪ Purchasing new machinery
▪ Expanding production capacity
▪ Entering new markets, or
▪ Developing new products.

CAPITAL BUDGETING TECHNIQUE

TRADITIONAL/UNDISCOUNTED MODERN /DISCOUNTED CASH

CASH FLOW TECHNIQUE FLOW TECHNIQUE

ACCOUNTING
PAYBACK
RATE OF
PERIOD
RETURN (ARR)
METHOD
METHOD

NPV PV INDEX IRR

METHOD METHOD METHOD

PAYBACK PERIOD METHOD

▪ The Payback Period Method is a capital budgeting technique used to

determine how long it will take for an investment to generate cash
flows sufficient to recover its initial cost. In simpler terms, it's the
amount of time it takes for the project or investment to "pay back" its
initial investment.

▪ Payback period is calculated as: Initial Investments

(When Annual Cash Flows are Equal)
Annual Cash Flows
Example 1
R Ltd Invested Rs. 20,00,000 in a Project. The Annual Cash flow from the
projects are expected Rs. 5,00,000 for each of 7 years. Calculate
following:
(1) Payback Period
(2) Post Payback profit
(3) Post payback profitability Index

Important Notes:

▪ If there is more than one project and we have to select any one of
them, then Project with shorter payback period and higher post
payback profit should be adopted

▪ If Annual cash flows are not given, then they are calculated as under:
Sales xxx
Less: Operating cost (Including Depreciation) xxx

EBIT xxx
Less: Interest (xxx)
EBT xxx
Less: Tax (xxx)
EAT xxx
Add: Depreciation xxx
Cash flows xxx

Example 2
R Ltd Invested Rs. 50,00,000 in a Machine. Machine has useful life of 5
years. Profit after Tax is Rs . 12,50,000 every year by using this machine
and Tax Rate is 40%. Calculate Following:
(1) Payback Period
(2) Post Payback profit
(3) Post payback profitability Index

Example 3
R Ltd Invested Rs. 48,00,000 in a Machine. Machine has useful life of 5
years. EBITDA is Rs . 22,00,000 every year by using this machine and
Tax Rate is 30%. Calculate Following:
(1) Payback Period
(2) Post Payback profit
(3) Post payback profitability Index
 When Annual Cash Flows are not Equal

When cash flows are uneven (i.e., different cash inflows each year), the
payback period is calculated by adding the cash flows year by year until
the initial investment is fully recovered.

Steps to calculate the payback period with uneven cash flows:

▪ List the cash inflows: List the expected cash inflows for each year.

▪ Cumulative cash inflows: Add the cash inflows year by year until the
total equals or exceeds the initial investment.

▪ Fractional year (if needed): If the cumulative cash inflow doesn't

match the initial investment exactly at the end of a year, calculate the
fractional year needed to recover the remaining amount.

Remaining Amount to be Recovered

Fractional year: Cash Inflows in next year

Example 4
A Ltd Invested Rs. 24,00,000 in Project. And Annual Cash flows are as
follows:
Y1 4,50,000
Y2 3,75,000
Y3 8,25,000
Y4 6,00,000
Y5 10,50,000
Y6 7,50,000

Calculate Following:
(1) Payback Period
(2) Post Payback profit
(3) Post payback profitability Index

DISCOUNTED PAYBACK PERIOD METHOD

▪ Under this case, Present value of Cash Flows are considered for
Calculating Payback period

▪ Present Value of Cash Flows = Cash Flows X PVF @ a Interest Rate

Given
Example 5
A Ltd Invested Rs. 40,00,000 in Project. And Annual Cash flows are as
follows:
Y1 8,00,000
Y2 8,40,000
Y3 22,00,000
Y4 16,00,000
Y5 14,00,000

Rate of Interest is 12%.

Calculate Payback Period

ACCOUNTING RATE OF RETURN METHOD

(ARR MRTHOD)

▪ This method is called Unadjusted Return Method. (Financial

Statement Method)

▪ In this Method, An Accounting Rate of Return (ARR) is calculated

and such ARR is compared with pre specified rate of return on
Investments (Cut off Rate)

▪ If ARR is higher than or equal to cut off rate, the Project should
be accepted. Otherwise, it will be rejected.

▪ ARR is calculated as under:

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐈𝐧𝐜𝐨𝐦𝐞 (𝐒𝐚𝐯𝐢𝐧𝐠)
X 100
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭𝐬

▪ Average Annual Income is calculated as under:

Average Annual Cash Flow xxx
Less: Annual Depreciation (xxx)
Average Annual Income xxx

▪ Average Investments is calculated as under:

𝐈𝐧𝐢𝐭𝐢𝐚𝐥 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭𝒔 + 𝐒𝐜𝐫𝐚𝐩 𝐕𝐚𝐥𝐮𝐞

𝟐
Example 6
Cost of Projects 20,00,000
Scrap Value 4,00,000
Useful Life 5 Years
Annual Cash Flows are:
Y1 4,00,000
Y2 3,00,000
Y3 6,40,000
Y4 8,00,000
Y5 6,00,000

Cut off rate 10%. Calculate ARR and Give Advice whether to accept the
project or not

PRESENT VALUE METHOD

▪ Under this Method, we calculate Present value of Inflows & Outflows

and Calculate Net Present Value (NPV)

▪ NPV is calculated as under:

Present Value of Inflows xxx
Less: Present value of outflows (xxx)
NPV xxx

▪ If NPV is either Zero or Positive, then Project should be accepted.

▪ But if NPV is Negative, then project should be Rejected.

▪ Present Value is calculated by taking a cut off rate as follows:

▪ Cash Flows X PVF

▪ Sometimes, when there is more than one project are there for
evaluation, then we take decision on the basis of Present value Index
(PVI) which is calculated as under:

𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐈𝐧𝐟𝐥𝐨𝐰𝐬

𝐏𝐫𝐞𝐬𝐞𝐧𝐭 𝐕𝐚𝐥𝐮𝐞 𝐨𝐟 𝐨𝐮𝐭 𝐟𝐥𝐨𝐰𝐬

Example 7
A Ltd is considering to Purchase a Machine. There is two machines
available each costing Rs. 2,50,000 and Scrap value is Rs. 15,000 and
10,000 respectively.
Annual Cash Flows are: Y1 Y2 Y3 Y4 Y5
Machine 1 75,000 1,00,000 1,25,000 75,000 50,000
Machine 2 25,000 75,000 1,00,000 1,50,000 1,00,000

Advice which Machine should be selected. Rate of Discount is 10%

 INTERNAL RATE OF RETURN (IRR) METHOD
(TIME ADJUSTED RATE OF RETURN METHOD)

▪ IRR is a rate at which present value of cash inflows are equal to

present value of out flows.

▪ In other words, the rate at which net present value is Zero is called
IRR

▪ IRR is calculated by Trail and Error Method.

Example 9
Initial Outflows 40,00,000
Cash Inflows:
Y1 12,00,000 Y2 15,00,000 Y3 17,50,000 Y4 12,50,000

Take rate 15% and 20% for Interpolation

PVF are
At 15% = 0.8695, 0.7561, 0.6575, 0.5717
At 20% = 0.8333, 0.6944, 0.5787, 0.4822

Calculate IRR

INTERNAL RATE OF RETURN (IRR) WHEN THERE

IS SINGLE CASH OUT FLOWS AND INFLOWS

Example 10
Initial Outflows 20,00,000
Cash Inflows after 10 years 50,00,000

Calculate IRR

Ans.
In this case, Answer will be calculated on Calculator by 12 step
Method
 MODIFIED INTERNAL RATE OF RETURN (MIRR)

▪ MIRR is Calculated by assuming that cash flows of each year are

Reinvested at cost of capital Rate.

▪ Following Steps are followed for calculation of MIRR:

▪ Calculate future value of all cash Inflows at cost of capital rate

▪ Calculate present value of Cash out flows at cost of capital rate

▪ Now calculate IRR by using 12 Steps Model at calculator and

such IRR will be MIRR

Example 11
Initial Investments 15,00,000
Cash Inflows:
Y1 3,00,000 Y2 3,50,000 Y3 4,00,000 Y4 5,00,000
Y 5 6,00,000

Cost of Capital 12%

Calculate MIRR

Example 12
Initial Investments today 40,00,000
Investments at end of Year 1 10,00,000
Cash Inflows:
Y2 10,00,000 Y3 12,00,000 Y4 11,00,000 Y5 20,00,000
Y 6 16,00,000

Cost of Capital 10%

Calculate MIRR and Whether should we accept the Project.

 RISK ANALYSIS IN CAPITAL BUDGETING

CASE I CASE II

▪ When Decision is taken

on the basis of Risk in
When Decision is taken
the Project.
on the basis of Expected
Cash Flows calculated
▪ Risk is analyzed by
by Probability/ Certainty
standard Deviation or
Factor technique
coefficient of variation

CASE I
WHEN EXPECTED CASH FLOWS ARE CALCULATED ON
THE BASIS OF PROBABILITY OR CERTAINTY

▪ In this case, first of all, we have to calculate Expected Cash Flow as

under:
Estimated Cash Flows X Probability / Certainty Factors

▪ NPV is calculated on the basis of Expected Cash flows calculated

above.

Example 13
A Ltd is considering Two projects A and B. Initial Investments in both
project is 20,000.
Annual Cash Flows are: Y1 Y2 Y3 Y4 Y5
Project A 20,000 30,000 50,000 40,000 80,000
Probability Factor s 0.3 0.2 0.16 0.24 0.10

Project B 36,000 50,000 60,000 32,000 1,00,000

Probability Factor s 0.2 0.4 0.10 0.15 0.15

Advice which Project should be selected. Rate of Discount is 20%

 CASE II
WHEN DECISION IS TAKEN ON THE BASIS OF RISK IN
PROJECT

▪ In this case, Project will be selected on the basis of Risk in the

Project.

▪ Project which is Less Risky will be Accepted

▪ Risk is calculated on the basis of Standard Deviation or coefficient of

Variation.

Following Steps are Followed:

Step 1 – Calculate Average Cash flows (Mean) (x̄) as under:
Each Cash flows X Probability Factors

Step 2 – Calculation Variation (V) is as Under:

(Each Cash Flows – average Cash flows)2 X Probability
Factors

Step 3 – Calculate Standard Deviation = 𝐕𝐚𝐫𝐢𝐚𝐭𝐢𝐨𝐧

𝐒𝐭𝐚𝐧𝐝𝐚𝐫𝐝 𝐃𝐞𝐯𝐢𝐚𝐭𝐢𝐨𝐧
Step 4 - Calculate coefficient of variation =
(If Required) 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐂𝐚𝐬𝐡 𝐅𝐥𝐨𝐰𝐬

▪ How to select the project:

▪ Project with Higher risk = Rejected
▪ Project with Lower Risk = Accepted

▪ A project will be risky when Standard Deviation / Coefficient of

Variation is higher than other project

Example 14
In Example 13, Analyzed the Project A and B on the basis of Standard
Deviation and Coefficient of Variation (Which project is riskier)
 SENSITIVITY ANALYSIS / TECHNIQUE

Example 15
Initial Investments 20,00,000
Annual Cash Flows 4,00,000
Project Life 9 Years
Discount Rate 12 %

Make Sensitivity Analysis if there is adverse effects @ 10% on:

(i) Initial Investments
(ii) Annual Cash Flows

CAPITAL RATIONING
▪ Capital Rationing is a situation which arise when there is insufficient
fund with Entity.

▪ Insufficient Fund may be due to following reasons:

(1) Soft Capital Rationing (Internal Restrictions)
(2) Hard Capital Rationing (External Restrictions)

▪ Available fund will be Invested in such a way that Entity get Maximum
Benefits.

HOW TO TAKE DECISION

WHEN PROJECT IS NOT

WHEN PROJECT IS DIVISIBLE
DIVISIBLE
(PARTIAL INVESTMENTS
(PARTIAL INVESTMENTS NOT
ALLOWED)
ALLOWED)

Decision will be taken on Decision will be taken on

the basis of Present the basis of Net Present
Value of Index (PVI) Value (NPV)
Example 16
Following are projects A,B,C and D in which there is Investments is Rs.
3,20,000, 6,00,000, 2,80,000 and 5,20,000 and Present value of Cash
Inflows are 4,00,000, 7,60,000, 4,56,000 and 8,00,000 respectively.

Available Fund with Entity is Rs. 12,00,000.

How Decision will be taken if:

Case 1 – Projects are Divisible
Case 2 – Projects are not Divisible