Capital Budgeting Notes

CAPITAL BUDGETING
By
HARSHIT AGARWAL
Asst. Professor
Email agarwal.harsh14@gmail.com
1. Introduction
As we discussed in first session that every business has four basic decisions to make:
Which projects to take? (Investment decisions)
Capital Budgeting Decisions
How to finance these projects? (Financing decisions)

How much to return to investors? (Dividend decisions)
How to manage working capital and its components? (Liquidity decisions)
Capital budgeting is a required managerial tool. One duty of a financial manager is to choose
investments with satisfactory cash flows and rates of return. Therefore, a financial manager must
be able to decide whether an investment is worth undertaking and be able to choose intelligently
between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select
projects is needed. This procedure is called capital budgeting.
Capital Budgeting process starts with the recognition that a good investment opportunity exists.
For example: a truck manufacturer is considering investment in a new plant; an airliner is
planning to buy a fleet of jet aircrafts; a commercial bank is thinking of an ambitious
computerization programme; a pharmaceutical firm is evaluating a major R&D programme. All
these situations involve capital expenditures/ investment decision.
Investments decisions of a firm are generally known as Capital Budgeting or Capital

expenditure decisions
IMPORTANT
Capital budgeting is the firms decision to invest its current funds most efficiently in the
long-term assets in the anticipation of an expected flow of benefits over a series of years.
Capital budgeting is investment decision-making as to whether a project is worth
undertaking. Capital budgeting is basically concerned with the justification of capital
expenditures.
2. NATURE OF INVESTMENT DECISIONS
From the above discussion, you must be clear about the distinctive features of capital investment:
They have long-term consequences
They often involve substantial outlays
They may be difficult or expensive to reverse
Now that you know the nature of investment decisions, lets discuss the various forms of
investment decisions:
1. Replacement projects: Firms routinely invest in equipments meant to replace obsolete and
inefficient equipments, even though they may in serviceable condition. The objective of such
investments is to reduce costs (of labour, raw material, and power), increase yield, and improve
quality. Replacement projects can be evaluated in a fairly straightforward manner; though at
times the analysis may be quite detailed.
1 | Page By - Harshit Agarwal - Asst.

Professor
Email-
agarwal.harsh14@gmail.com
2. Expansion projects: These investments are meant to increase capacity and/ or widen the
distribution network. Such investments call for an explicit forecast of growth. Since, this can be
risky and complex, expansion projects normally warrant more careful analysis than replacement
projects. Decisions relating to such projects are taken by the top management.
3. Diversification projects: These investments are aimed at producing new products or services
or entering into entirely new geographical areas. Often diversification projects entail substantial
risks, involve large outlays, and require considerable managerial efforts and attention. Given
their strategic importance, such projects call for a very thorough evaluation, both quantitative
and qualitative. Further, they require a significant involvement of the board of directors.
4. Research and development projects: Traditionally, R%D projects absorbed a very small
proportion of capital budget in most Indian companies. Things however are changing.
Companies are now allocating more funds to R&D projects, more so in knowledge intensive
industries. R&D projects are characterised by numerous uncertainties and typically involve
sequential decision-making. Hence the standard DCF analysis is not applicable to them. Such
projects are decided on the basis of managerial judgment. Firms, which rely more on quantitative
methods, use decision tree analysis and option analysis to evaluate R&D projects.
5. Mandatory investments: These are expenditure required to comply with statutory

requirements. e.g., pollution control equipment, medical dispensary, fire fitting equipment etc.
These are often non-revenue producing investments. In analysing such investments the focus is
mainly on finding the most cost-effective way of fulfilling a given statutory need.
Can you tell me why capital expenditures are deemed important?
As discussed by you Capital Budgeting is an extremely important aspect of a firm's financial

management. How a firm finances its investments and how it manages its short-term operations
are definitely issues of concerns but how it allocates its capital (the capital budgeting decision)
really affects the strategic asset allocation. That is why the process of capital budgeting is also
referred to as strategic asset allocation. Some of the special reasons of its importance can be
identified are as follows:
They influence the firms growth in the long run
A firms decision to invest in long-term assets has a decisive influence on the rate and direction
of its growth. A wrong decision can prove disastrous for the continued survival of the firm;
unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On
the other hand, inadequate investment in assets would make it difficult for the firm to compete
successfully and maintain its market share.
They affect the risk of the firm

Professor
Email-
A long-term commitment of funds may also change the risk complexity of the firm. If the
adoption of investment increases average gain but causes frequent fluctuations in its earnings, the
firm will become more risky
They involve commitment of large amount of funds
Investment decisions generally involve large amount of funds, which make it imperative for the
firm to plan its investment programmes very carefully and make an advance arrangement for
procuring finances internally or externally.
They are irreversible, and if reversible it is at substantial loss
Most investment decisions are irreversible. It is difficult to find a market for such capital items
once they have been acquired. The firm will incur heavy losses if such assets are scrapped.
They are among the most difficult decisions to make
Investments decisions are the most complex ones. They are an assessment of future events,
which are difficult to predict. It is really a complex problem to correctly estimate the future cash
flow of an investment. Economic, social, & technological forces cause the uncertainty in cash
flow.
3. Phases of Capital Budgeting Process

Professor
Email-
Step 1.
Identification of Investment Proposals
Investment opportunities have to be identified or searched for: they do not occur automat-ically.
The capital budgeting process begins with the identification of investment proposals. The first
step in capital budgeting process is the conception of a profit-making idea. Investment proposals
of various types may originate at different levels within a firm, depending on their nature. They
may originate from the level of workers to top management level. For example, most of the
proposals, in the nature of cost reduction or replacement or process for product improvement
take place at plant level, the proposal for adding new product may emanate from the marketing
department or from plant manager who thinks of a better way of utilising idle capacity.
Suggestions for replacing an old machine or improving the production techniques arise at the
factory level. The departmental head analyses the various proposals in the light of the corporate
strategies and submits suitable proposals to the capital expenditure planning committee in case of
large organisation or to the officers concerned with the process of term investment decisions. A
continuous flow of profitable capital expenditure proposals is itself an indication of a healthy and
vital business concern. Although business may pursue many goals, survivals and profitability
are the two of the most important objectives.
Step 2.
Screening the Proposals
Screening and selection procedures would differ from firm to firm. Each proposal is then
subjected to a preliminary screening process in order to assess whether it is technically feasible;
resources required are available and the expected returns are adequate to compensate for the risk
involved. In large organisations, a capital expenditure planning committee is established for
screening of various proposals received from different departments. The committee views these
proposals from various angles to ensure that these are in accordance with the corporate strategies
or selection criterion of the firm and also do not lead to departmental imbalances. All care must
be taken in selecting a criterion to judge the desirability of the projects. The criterion selected
should be a true measure of the investment projects profitability, and as far as possible, it must be
consistent with the firm's objective of maximising its market value. This stage involves the
comparison of the proposals with other projects according to criteria of the firm. This is done
either by financial manager or by a capital expenditure planning committee. Such criteria should
encompass the supply and cost of the expected returns from alternative investment opportunities.
Step 3.
Evaluation of Various Proposals
The next step in the capital budgeting process is to evaluate the profitability of various proposals.
If a proposal satisfies the screening process, it is then analysed in more detail by gathering
technical, economic and other data. Projects are also classified, for example, products or
expansion or improvement and ranked within each classification w.r.t. Profitability, risk and
degree of urgency. There are many methods which may be used for this purpose such as pay back
period method, rate of return method, net present value method etc.
Step 4.
Establishing Priorities
Professor
Email-
After evaluation of various proposals, the unprofitable or uneconomic proposals are rejected. The
accepted proposals i.e. profitable proposals are put in priority. It may not be possible for the firm
to invest immediately in all the acceptable proposals. Thus, it is essential to rank the various
proposals and to establish priorities after considering urgency, profitability involved therein.
Step 5.
Final Approval
Proposals finally recommended by the committee are sent to the top management along with a
detailed report, both of capital expenditures and of sources of capital. Financial manager will
present several alternative capital expenditure budgets. When capital expenditure proposals are
finally selected, funds are allocated for them. Projects are then sent to the committee for
incorporating them in the capital budget.
Step 6.
Implementing Proposals
Preparation of a capital expenditure budgeting and incorporation of a particular proposal in the
budget does not itself authorise to go ahead with the implementation of the project. A request for
the authority to spend the amount should further be made to the capital expenditure committee,
which may like to review the profitability of the project in the changed circumstances. Further,
while implementing the project, it is better to assign responsibilities for completing the project
within the given time frame and cost limit so as to avoid unnecessary delays and cost over runs.
Net work techniques used in the project management such as PERT and CPM can also be applied
to and monitor the implementation of the projects.
Step 7.
Performance Review
Last but not the least important step in the capital budgeting process is an evaluation of
performance of the project, after it has been fully implemented. It is the duty of the top
management or executive committee to ensure that funds are spent in accordance with the
allocation made in the capital budget. A control over such capital expenditure is very much
essential and for that purpose a monthly report showing the amount allocated, amount spent,
approved but not spent should be prepared and submitted to the controller. The evaluation is
made through post completion audit by way of comparison of actual expenditure on project with
the budgeted one, and also by comparing the actual return from the investment with the
anticipated return. The unfavorable variances, if any, should be looked into and the causes of the
same be identified so that corrective action may be taken in future.
4. CAPITAL BUDGETING:EVALUATION TECHNIQUES
In essence, capital funds are invested for one basic reason: To obtain sufficient future economic
returns to warrant the original outlay i.e., sufficient cash receipts over the life of the project to
justify the investment made. Analytical methods of evaluation of capital projects should take into

Professor
Email-
account in one way or another, this basic trade-off of current cash outflows against the future
cash inflows.
To judge the attractiveness of any investment proposal, the financial manager must consider the
following elements
(i) The amount expended i.e., The net investment,

(ii) The potential benefits i.e., the operating cash inflows, and
(iii) The time period over which these benefits will accrue i.e., economic life of the project.
A proper investment analysis must relate these three elements to provide an indication of
whether; the investment is worthy of being taken up or not.
How do these three basic elements i.e., the net investment, the operating cash flows and the
economic life can be related to determine the proposal's worthiness? There are different
techniques available for evaluation and selection of a proposal. These techniques can be grouped
into two categories as presented in the Figure.
TRADITIONAL OR NON-DISCOUNTING TECHNIQUES

As the name itself suggests, these techniques do not discount the cash flows to find out their
present worth.
There are two such techniques available i.e.,
(i) The Payback period method, and
(ii) The Accounting rate of return.
These are essentiality rules of thumb that intuitively grapples with the trade-off between net
investments are operating cash inflows.
Professor
Email-
Traditional evaluation criteria have been discussed as follows:
I. PAYBACK PERIOD
The payback period as name suggest is defined as the number of years required for the proposal's
cumulative cash inflows to be equal to it cash outflows. In other words, the payback period is the
length of time required to recover the initial cost of the project. The payback period therefore,
can be looked upon, as the-length of time required for a proposal to 'break even' on its net
investment.
Computation of the Payback period: The payback period can be calculated in two different
situations as follows:
Case A: When annual inflows are equal:
When the cash- inflows being generated by a proposal are equal per time period i.e. the cash
inflows are in the form of an annuity, the payback period can be computed by dividing the cash
outflow by the amount of annuity.
For example, a proposal requires a cash outflow of Rs. 1,00,000 and is expected to generate cash
inflows of Rs. 20000 p.a. for 6 years. In this case, the payback period is 5 years i.e., Rs. 1,00,000
/Rs. 20,000. The initial cash outflow of Rs. 1,00,000 will be fully recovered within a period of 5
years and the cash inflows occurring thereafter (i. e., in the 6th year) are ignored. In the above
case, if the annual cash inflow is Rs. 30,000 then the payback period lies between 3 years and 4
years and is 3.33 years i.e., Rs. 1,00,000/Rs 30,000.
Case B: When the annual cash inflows are unequal:

In case the cash inflows from the proposal are not in annuity form then the cumulative cash
inflows are used to compute the payback period.
For example, a proposal requires a cash outflow of Rs. 20,000 and is expected to generate cash
inflows of Rs. 8,000, Rs. 6,000, Rs. 4,000, Rs. 2,000 and Rs. 2,000 over next 5 years
respectively. The payback period is 4 years because the sum of cash inflows of first 4 years is Rs.
20,000 (i.e., Rs. 8,000 + Rs. 6,000 + 4,000 + Rs. 2,000). A measurement problem may occur
when the cumulative cash inflows do not exactly equal to proposal's cash outflow. In the same
case, if the cash outflow is only Rs. 18,500 then the payback period may be calculated as
follows:
Now, the required cumulative cash inflow is Rs. 18,500. At the end of 3rd year, the cumulative
cash inflow is Rs. 18,000. For the 4th year, the annual cash inflow is Rs. 2,000. Therefore, cash
Professor
Email-
inflow of Rs. 500 only during the 4th year will be sufficient to make the total cumulative case
inflows to be Rs. 18,500. The precise period required to earn a cash inflow of Rs. 500 during 4 th
year can be calculated (on the assumption that the cash inflows occur evenly throughout the
year) by linear interpolation i.e. the payback period is 3 years + (Rs. 500/Rs. 2,000) = 3.25 years
or 3 years and 3 months. However, it may be noted that the cash inflows occur at the end of a
year only. Therefore, the payback period of 3.25 years may be increased to next full year i.e. 4
years.
The Decision Rule:

The payback period does not give any clear indication of the decision rule. The payback period
calculated for a proposal is to be compared with some predetermined target period. If the
payback period is more than the target period, then the proposal should be rejected, otherwise-it-
may be accepted if the payback-period is less than the target period. There is no systematic or
accepted way of determination of target period and choosing a target period is subject to some
arbitrariness on the part of the decision maker. Further, if the different proposals are to be ranked
in order of priority, then the proposal with the shortest payback period will be first in the priority
list.
Critical Evaluation:
Out of all the available Capital budgeting technique (some of which are discussed later), the
payback period is the easiest to understand and apply. The payback period measures the direct
relationship between annual cash inflows from a proposal and the net investment required. . This
technique has been a popular method of evaluation of capital budgeting proposals merely
because of its simplicity. Yet, it is having its own problems and disadvantages. The payback
period as a technique of evaluation of capital budgeting proposals can be critically examined in
terms of its advantages and disadvantages as follows:
Advantages of payback method:

1. The payback period is simple and easy, in concept as well as in its applications. In particular,
a small firm having limited manpower, which does not have any special skill to apply other
sophisticated techniques, can adopt it.
2. It gives an indication of liquidity. In case a firm is having liquidity problems, then the
payback period is a good method to adopt as it emphasizes the earlier case inflows.
3. In a broader sense, the payback period deals with the risk also. The project with a shorter
payback period will be less risky as compared to project with a longer payback period, as the
cash inflows which arise further in the future will be less certain and hence more risky. So, the
payback period helps in weeding out the risky proposals by assigning lower priority.
Disadvantages of payback method:

1. The payback period entirely ignores many of the cash inflows, which occur after the payback
period. This could be misleading and could lead to discrimination against the proposal, which
generates substantial cash inflows in later years. By restricting itself to answering the question
when will this project make it initial investment? it ignores what happens after the initial
investment is recouped.
Professor
Email-
The payback criterion prefers A, which has a payback period of 3 years, in comparison to B,
which has a payback period of 4 years, even though B has very substantial cash inflows in years
5 and 6.
2. It ignores the timing of the occurrence of the cash flows. It considers the cash flows occurring
at different point of time as equal in money worth and ignores the time value of money. It gives
equal weights to all the cash flows before the payback date and no weight at all to cash flows
occurring thereafter. Impliedly, it also ignores the concept of required rate of return and the
discounting of future cash flows to find out their present values.
3. The payback period also ignores the salvage value and the total economic life of the project. A
project, which has substantial salvage value, may be ignored (though more profitable it may be
otherwise) in favor of a project with higher inflows in earlier years. It is insensitive to the
economic life span and thus not truly meaningful criterion for determining the economic viability
of a proposal. The speed with which the initial investment is recovered is not a sufficient way to
appraise the profitability.
4. The payback period is more a method of capital recovery rather than a measure of profitability
of a project. To recover the capital is not enough, of course, because from an economic viewpoint
one would hope to earn a profit on the funds while they are invested.
5. The payback period is designed to cover the conventional projects that involve large up-front
investment-followed by positive operating cash inflows. It breaks down, however, when the
investment is spread over time or where there is no initial investment.
Suitability of Payback Method:

The use of payback period as a technique of evaluation of capital budgeting proposals may
produce decisions contrary to decisions given by the other techniques based on time adjusted
value. Yet if has some practical suitability particularly when used in conjunction with some other
Professor
Email-
method of evaluation. Despite the shortcomings, the payback period method may be an
appropriate method under certain circumstances. For example, in a politically unstable country,
the firm may have a primary consideration of recovering the initial cost at the earliest
opportunity and thus the payback period may be a suitable technique. Further, the payback
period may be suitable if the firm has limited funds available and has no ability or willingness to
raise additional funds. In such as case, the firm may wish to undertake those projects, which
ensure early liquidity/recovery to undertake some other projects.
II. ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF

RETURN (ARR)
The ARR is based on the accounting-concept of return on investment or rate of return. The ARR
may be defined as the annualized net income earned on the average funds invested in a project.
In other words, the annual returns of a project are expressed as a percentage of the net investment
in the project.
Computation of ARR:
Symbolically,
This clearly shows that the ARR is a measure based on the accounting profit rather than the cash
flows and is very similar to the measure of rate of return on capital employed, which is generally
used to measure the over all profitability of the firm. The calculation of ARR may be further
discussed with reference to equal annual profits and unequal annual profits as follows:
Case A: Equal Profits:

In case the expected profits (after tax) generated by a project are equal for all the years than the
annual profit itself is the average profit. So, this annual profit will be compared with the average
investment to find out the ARR as follows:
Case B: Unequal Profits:

If the project is expected to generate unequal profits or uneven stream of profits over different
years, then the ARR may be calculated by finding out the average annual profits (by taking the
simple arithmetic mean of profits of different years) and then Comparing it with the average
investment of the project as follows:
10 | P a g e By - Harshit Agarwal - Asst.

Professor
Email-
In both the cases, the average investment of the 'project, which is used as the denominator of the
ARR formula, is to be calculated. Are you aware what is this average investment and how is it to
be calculated?
Average investment:
The average investment refers to the average quantum of funds that remains invested or blocked
in the proposal over its economic life. The average investment of a proposal is affected by the
method of depreciation, salvage value and the additional working capital required by the
proposal. The following two approaches are available to calculate the average investment.
Initial cash outlay as average investment:

In this case, the original cost of investment and the installation expenses if any, is taken as the
amount invested in the project. For example, a project costing Rs. 10,00,000 is expected to
generate after tax profit of Rs. 1,50,000 every year. The ARR for the proposal; would be 15%(i.e.
Rs. 1,50,000/ Rs. 10,00,000 x 100). Theoretically, this approach of average investment seems to
be good but taking the initial cost as the average investment is definitely not correct on logical
and technical grounds.
Average annual book value after depreciation as average investment

In this case, the average annual book allure (after depreciation) of the proposal is taken as the
average investment of the proposal. The following procedure may be adopted for this. First, find
out the opening book values and the closing book values of the project for all the years of its
economic life. The difference in the opening and closing values for a particular year will depend
upon the amount of depreciation for that year. Second, find out the average book values for all
the years by taking the simple arithmetic mean of the opening and closing book values. Third,
find out the average of all the yearly averages. This average will be the average investment of the
proposal. However, the following points regarding depreciation are worth noting.
In case the firm has adopted a method of depreciation other than the straight-line method, then
the above procedure of finding out the average investment (i.e., by taking the average of the
yearly average book value) may be adopted. However, if the firm has adopted the straight-line
method of depreciation to write off the project over its useful economic life, then a shortcut
method is also available as follows.
Short-cut method to find out the average investment:

If the firm provides depreciation as per straight line method then the amount of depreciation for
all the year would be same and is equal to (initial cost + installation expenses salvage value)/
number of years. This amount of depreciation will be deducted from the opening book values to
find out the closing book values for different years. The average of these opening and closing

Professor
Email-
book values will also decrease gradually every year by the amount of annual depreciation such a
case, the average investment of the proposal over its economic life can now be calculated as:
Average investment = 1/2(Initial Cost + Installation Expenses - Salvage value) + Salvage

value.
It may be noted that in the above equation, the amount of salvage value has been first deducted
and later added back. The salvage value has been deducted to find out the annual amount of
depreciation. However, this amount of salvage value remains blocked in the proposal and is
released only at the end of the economic life of proposal. Therefore, the amount of salvage value
has been added back to find out the average investment. For example, ABC Ltd. takes a project
costing Rs. 1,20,000 with expected life of 5-years and the salvage value of Rs. 20,000. The
average investment of the proposal is:
The additional working capital:
Some times, the project may also require additional working capital for its smooth operations.
Though this additional working capital will be released back, when the proposal will be scrapped
and terminated, yet this amount of additional working capital is blocked through out the life of
the project. So, this additional working capital entails the investment of funds of the firm and
should also be 'added to the average investment calculated as above. The average investment in
any-proposal (required to find out the ARR) may therefore, be calculated as follows

Professor
Email-
Average investment = 1/2(Initial Cost + Installation Expenses - Salvage value) + Salvage

value + Additional Working Capital
To continue with the above example, the project requires an additional working capital of Rs
20,000and is expected to generate annual average profit (after tax) of Rs. 18,000, then the
average investment and the ARR can be calculated as follows:
The decision rule:
The ARR calculated as above is compared with the pre-specified rate of return. Obviously, if the
ARR is more than the pre-specified rate of return, then the project is likely to be accepted,
otherwise not. For example, in the above case the ARR of the proposal has been found to be
20%. In case, the firm requires a rate of return of at least 18%, then this proposal is acceptable.
However, if the minimum rate of return of the firm is 22% then this proposal is likely to be
rejected. The ARR can also be used to rank various mutually exclusive proposals. The project
with the highest ARR will have the top priority while the project with the lowest ARR will be
assigned lowest priority.
The Critical Evaluation:
No doubt, the ARR is relatively simple to calculate and easy to apply. The relevant data and
information required for its calculation is readily available in the accounting records. The ARR
state the economic desirability of an investment in terms of a percentage return on the original
outlay. Unlike the payback period, the ARR considers all the benefits arising out of the proposal
through out its economic life.
However, the ARR has certain limitations and drawbacks when used as a technique of project
evaluation as follows.
1. It ignores the time value of money and considers the profit earned in the 1 st year as equal to
the profits earned in later years. It does not discount the future profits.

Professor
Email-
2. The ARR is based on the accounting profits rather than the cash flows. It has already been
noted in the previous chapter that accounting profits are affected by different accounting policies.
It has also been noted earlier that a sound evaluation technique should be based on the cash flows
rather than the accounting profits.
3. The ARR also ignores the life of the proposal. A proposal with a longer life may have the
same ARR as another proposal with a shorter life has. On the basis of ARR, both the proposals
may be placed at par, but the proposal with a longer life should be preferred over the proposal
with a shorter life (as the former proposal will generate the returns for a longer period).
However, the ARR method fails to distinguish between the two.
4. The ARR technique also ignores the salvage value of the proposal. In real sense, the salvage
value is also a return from the proposal and should be considered.
5. The ARR also fails to recognize the size of the investment required for the project.
Particularly, in case of mutually exclusive proposals, the two projects having significantly
different initial costs may have same ARR.
On the basis of the above discussion on ARR, it can be concluded that the ARR is simple but
crude method of evaluation of capital budgeting proposals. As it is based on the accounting
profits (and not on the cash flows), it does not understand the contribution of the proposal
towards maximization of the wealth of the shareholders. In fact, the ARR lacks much to be a
sound technique for evaluation of capital budgeting proposals. The method shares all of the
shortcomings of the payback period method as the ARR also relates only two of the three two of
the critical aspects of any project.
To conclude the discussion on the traditional methods of evaluation, it can be said that these
techniques (both the PB and ARR) fail to be sound and efficient techniques.
In particular these techniques suffer from

(i) Ignoring the time value of money and
(ii) Non-consideration of total benefits emanating from a proposal.
Both these aspects are taken into account by the discounted cash flow techniques of evaluation of
capital budgeting proposals.
DISCOUNTED CASH FLOWS OR TIME ADJUSTED TECHNIQUES
As discussed in the previous unit that money has time value - cash flows that occur earlier in
time are worth more than cash flows that occur later, differences are accentuated as inflation and
interest rate increase. Investment decision techniques based on discounted cash flows not only
replace accounting income with cash flows but also explicitly consider the time value of money.
The discounted cash flow techniques or the \ time adjusted cash flow techniques, as against the
traditional techniques already disclosed, are based upon the fact that the cash flows occurring at
different point of time are not having some economic worth. In order to make these cash flows
Professor
Email-
equal in economic worth, these must be discounted with reference to the time gap between
differences flows and a pre-determined discount rate. These methods, which involve the time
value of money, more accurately reflect the true economic trade-off and returns. These
techniques are also called the present values techniques and fulfill all the requisites of a good
evaluation technique
All the discounted cash flow techniques, discussed in the following paragraphs, have one
ingredient in common i.e., that all these technique are based upon the discounting procedure by
which the future cash flows are discounted to find out their present economic worth. This
discounting procedure has been explained as follows:
Discounting Procedure:
A common ingredient to discounted cash flow techniques

Suppose, a firm is considering a capital budgeting proposal having initial cost of Rs. 1,50;000
(including installation expenses) besides requiring additional working capital of Rs. 20,000. The
project is expected to generate annual cash flows of Rs. 20,000, Rs. 50,000, Rs. 60,000, Rs.
40,000 and Rs. 30,000 respectively during next five years. Thereafter the project is expected to
be scrapped away for Rs. 25,000. In this case, the initial cost of Rs. 1,50,000 and the additional
working capital of Rs. 20,000 are to be incurred now i.e., at To and are therefore have been
expressed in terms of money of To. But the other cash inflows which will occur after 1-year from
today i.e., at T1 after 2 year from today i.e., T2 etc. are expressed in terms of money of that year
in which the cash inflows occur. Intuitively, the cash flow in terms of money of To is not
comparable with the cash flows in terms of money of T1, T2 T5. However, these can be made
comparable by converting all these cash flows in terms of money of the same date. Generally, it
is done by converting all the future cash flows in terms of money of today i.e., To
Now, in order to convert these cash flows, what is required is the time gap and the discount rate.
The time gap is the gap between the present date and the future date when a particular cash flow
is expected to occur. This time gap is known together with the cash flow. The other variable, that
is the discount rate, is presumed to have been given for the time being. However, this discount
rate may be defined as the minimum rate of return, which a firm wants to earn on the amount
invested in any capital budgeting proposal. The determination of this discount rate, i.e., the
minimum rate of return, or the cost of capital is already been discussed.
A few basic points are worth noting here.
First, the cash flow at To have been discounted by present value factor l, as it is already
expressed in terms of present mb1ey.
Second, the PVF gradually declines as the time gap increases. The present values given in the
last column are expressed in terms of present money and hence are now comparable.
Based on the above discounting procedure, there are two basic discounted cash flow tech-niques
to evaluate capital budgeting proposals.
These are the Net Present Value Method and the Internal Rate of Return method.
Professor
Email-
However, there are two variants of the Net present Value method, known as the Profitability
Index method and the terminal Value method.
NET PRESENT VALUE (NPV) METHOD
The NPV is the first and the foremost of the discounted cash flow techniques. NPV is used
simply to weigh the elements of trade-off between investment outlays and the future benefits in
equivalent terms, and to determine whether the net balance of the present values is favorable or
not. The NPV of an investment proposal may be defined as the sum of the present values of all
the cash inflows less the sum of present values of all the cash outflows associated with a
proposal. In other words, the NPV of any proposal, that involves cash inflows and outflow over a
period of time, is equal to the net present value of all the cash flows. Thus, the NPV is the sum of
the discounted values of the cash flows of a proposal. In case, the cash outflows i.e. the
investment in the proposal occur only in the beginning at time 0, then NPV may be defined as the
sum, of the present values of cash inflows less the initial investment.
A rate of discount must be specified and applied to both inflows and outflows in order to find out
their present values. When the present values of all inflows and. outflows are added, the resultant
figure is denoted as net present value. The figure can be positive or negative, depending on
whether there is a net inflow or outflow from the project. A word should be said about the rate of
discount. From an economic point of view, this rate of discount should be the rate of return, the
investor normally enjoys from investments of similar nature and risk. In effect, it is opportunity
rate of return. In case of a firm, the choice of a discount rate is complicated by the variety of
investments available and by the type of financing provided by both the shareholders and the
debt investors. The rate so employed is the overall cost of capital, which takes into account
shareholders expectations, business risk and the leverage.
Calculation of NPV:
On the basis of the definition of the NPV, it may be defined as
Where NPV = Net present value,

CF1= Cash flows occurring at time 0, 1, 2,---------- n
k = The discount rate, and
n = Life of the Project in years

Professor
Email-
In the above equation, the common factor 1/(1 + k) is in fact the PVF for a particular
combination of the rate of discount and the n and is also defined as PVF(r, n) The above
equation is the basic equation of the NPV, however, it can also be written as
Where Co = Initial cost of the proposal at time To
The above equation can be used only when the cost of the project is incurred in the beginning
and there is no other cash outflow. To continue with the above example, the NPV can be
calculated as follows:
The above equation can also be presented in form of a Table.
The total cash inflow for the year T5 is Rs. 75,000 (consisting of the annual inflow of Rs. 30,000
+ working capital released of Rs. 20,000 + salvage of Rs. 25,000). In the same case, if the total
initial cost is taken at Rs. 1,80,000 instead of Rs. 1,70,000, then the NPV of project will be Rs.
-1,565. Further, if the initial cost happens to be Rs. 1,61,565, then the NPV will be 0.

Professor
Email-
The Decision Rule
The decision rule under the NPV method is:
Accept the proposal if its NPV is positive and reject the proposal if the NPV is negative.
The positive NPV of a proposal signifies that the present worth of its inflows is more than the
present worth of its outflows. Thus, the NPV represents the excess of benefits over the costs in
real terms. The NPV therefore, is the change expected in the wealth of the shareholder as a result
of the acceptance of a particular proposal.
In case of ranking of mutually exclusive proposals, the proposal with the highest Positive NPV is
given the top priority and the proposal with the lowest positive NPV is assigned the lowest
priority. The proposals with negative NPV should out rightly be rejected as these entail decrease
in the wealth of the shareholders.
However, if the NPV of the proposal is 0, than the firm may be indifferent between acceptance
and rejection of the proposal.
The properties of the NVP criterion:

The NPV technique has several important properties that make it an attractive decision rule.
1. The NPVs are additive: The NPVs of different projects can be added to arrive at a
cumulative NPV for a business. The other techniques do not have this property.
2. Intermediate cash flows are reinvested at discount rate: Implicit in all the NPV
calculations is the assumption that all the intermediate cash inflows are reinvested at the discount
rate i.e., cash flows that occur between the initiation and the end of the project get reinvested at
the discount rate.
3. The NPV calculations allow for the expected change in the discount rate: It has been
assumed in the above calculations of the NPV that the discount rate remains unchanged over
time. This is not always the case, however, then the NPV can be computed by using time varying
discount rates. The discount rate may change for three reasons:
(i) The level of interest rate may change over time,
(ii) The risk characteristics of the projects may change over time, and
(iii) The financing mix of the proposal may change over time.
All these three factors may result in change in the discount rate.
The capital budgeting decision is perhaps the most important and crucial decision of a finance
manager because the capital budgeting is the main lever to increase or rather maximise the
wealth of the shareholders. The central goal of the capital budgeting is to find out the proposal
whose inflows have greater values than the outflows. The NPV as a technique of evaluation of
Professor
Email-
capital budgeting proposals helps a finance manger in achieving this objective. If the firm
invests its funds in those proposals whose NPV is either 0 or negative, then the proposal is not
going to contribute anything to the wealth of the shareholders. Rather, it may even decrease the
wealth. In as much as, the present value depends on both timing and the date of discount, a
positive NPV indicates that over its economic life, the cash floes generated by the investment
will recover the original outlay, earn the desired return, and in addition provide a cushion of
excess value. Conversely, a negative NPV indicates that the project is not achieving the date of
return and will this cause a loss. Obviously, the rate of return, the timing of the cash flows and
the relative magnitude of cash flows will al effect the NPV.
The merits of the NPV technique can be enumerated as follows.
1. It recognizes the time value of money. It helps evaluation of proposals involving cash flows
over a period of several years. The cash flows occurring at different point of time are not directly
comparable, but they can be made comparable by the application of the discounting procedure.
2. The NPV technique considers the entire cash flow stream and all the cash inflows and
outflows, irrespective of the timing of their occurrence, are incorporated in the calculation of the
NPV.
3. The NPV technique is based on the cash flows rather than the accounting profit and thus helps
in analysing the effect of the proposal on the wealth of the shareholders in a better way.
4. The discount rate, k, applied for discounting the future cash flows is in fact, the minimum
required rate of return, which incorporates both the pure return as well as the premium required
to set off the risk.
5. The NPV technique represents the net contribution of a proposal towards the wealth of the
firm and is therefore, in full conformity with the objective of maximization of the wealth of the
shareholders. The NPV concept has a built in earnings requirements in addition to the recovery
of the investment. Thus, the cushion implicit in the positive NPV is truly an economic gain that
goes beyond satisfying the required rate of return.
The above merits of the NPV technique make it a popular technique of evaluation of capital
Budgeting proposals. The NPV technique appears to correctly reflect the trade-off of equivalent
cash outlays and inflows, while allowing for both the recovery of the initial investment
(principal) and the earnings at a pre-stipulated rate. The best use of NPV is as a screening device
that indicates whether the minimum rate of return can be met by the proposal or not. When the
NPV is positive, there is a potential for returns in excess of the minimum required return; when
the NPV is negative, the minimum return and the capital recovery both cannot be achieved.
When the-NPV is close to or approximately zero, the minimum required return is just met. The
very fact that this technique is capable of evaluating the proposals that are profit seeking and
involve cash flows over a period of several years makes it a preferred technique of evaluation of
capital budgeting proposals. But this does not mean that it is free from shortcomings.
The NPV technique has the following shortcomings:

Professor
Email-
i. It involves difficult calculations. Moreover, it may not be able to overcome the uncertainty
involve with cash flows occurring after a sizeable time gap. It fails to answer questions such as:
How to quantify the potential error inherent in the cash flow estimates, and how does the
measure help making investment choices if such errors are significant?
ii. The NPV technique requires the predetermination of the required rate of return, k, which itself
is a difficult job. If the value of the 'k' is not correctly taken, then the whole exercise of the NPV
may give wrong results.
iii. The NPV technique does not provide a measure of project's own rate of return; rather it
evaluates a proposal against an external variable i.e. the minimum required rate of return.
iv. The decision under the NPV technique is based on a value, which is an absolute measure. It
ignores the difference in initial outflows, size of different proposals etc. while evaluating
mutually exclusive proposals.
PROFITABILITY INDEX (PI)
Quite often one may be faced with a choice involving several alternative investment of different
size. In such a case, he cannot be indifferent to the fact that even though the NPV of different
alternatives may be close or even equal, these involve commitments of widely ranging amounts.
In other words, it does make a difference whether an investment proposal promises a NPV of Rs.
1,000 for an outlay of Rs. 10,000; or whether an outlay of Rs. 25,000 is required to get the same
NPV of Rs. 1,000, even if the lives of the, projects are assumed to be same. In the first case, the
NPV is much larger fraction (Rs. 1,000/10,000) then what it is in the second case i.e., (Rs. 1,000/
25,000), which makes the first proposal clearly more attractive. The PI technique is a formal way
of expressing this cost/benefit relationship.
This technique which is a variant of the NPV technique, is also known as Benefit- cost ratio, or
preset Value index. The PI is also based upon the basic concept of discounting the future cash
flows and is ascertained by comparing the present value of the future cash inflows with the
present value of the future cash outflows. The PI is calculated by dividing the former by the
latter.
Calculation:
The PI is calculated as follows:

Professor
Email-
Example
A firm is evaluating a proposal, which requires a cash outlay of Rs. 40,000 at present and of Rs.
20,000 and at the end of third from now. It is expected to generate cash inflows of Rs. 20,000,
Rs. 40,000 and Rs. 20,000 at the end of 1st year 2nd year and 4th year respectively. Given the rate of
discount of 10%, Calculate PI.
Solution
Present value of cash outflows = Rs. 40,000 + 15,020 = 55,020.
Present value of cash inflows = Rs. 18,180 + 33,040 + 13,660 = 64,880.
The PI of 1.18 can be interpreted as follows: in present worth terms, for every Re. 1 invested, the
proposal is expected to give a return of Rs. 1.18. So, in case of PI, the question is simply. How
much present value benefits are being created for each rupee of net investment.
The Decision Rule:
Under the PI technique, the decision rule is:

Professor
Email-
'Accept the project if its PI is more then I and reject the proposal if the PI is less than 1.
However, if the PI is equal to 1, then the firm may be indifferent because the present value of
inflows is expected to be just equal to the present value of the outflows. In case of ranking of
mutually exclusive proposals, the proposal with the highest positive PI will be given top priority
while the proposal with the lowest PI will be assigned lowest priority. The proposals having PI of
less than 1 are likely to be out rightly rejected.
The PI technique, as already noted is an extension of the NPV technique: the NPV technique, the
difference between the present value of inflows and the present value of outflows was the
yardstick. Therefore, the PI as a technique of evaluation of capital budgeting proposals has the
same merits and shortcomings, which the NPV has.
DISCOUNTED PAYBACK PERIOD
This method is a combination of the original payback method and the discounted cash flow
technique. In this method, the cash flows of the project are discounted to find their present
values. The present value of the cash inflows is then compared with the present value of the
outflow, in order to identify the period taken to recover the initial cost or the present value of
outflow. This method thus, takes care of the main drawback of the pay back period method and
allows the consideration of the time value of money of cash flows. However, it still does not take
into account those cash inflows, which occur subsequent to the payback period, and sometimes
these cash inflows may be substantial. Since, it is a variant of the original payback period
method, the discounted payback period method is also calculated in the same way as the payback
period, except that the future cash inflows are first discounted and then the payback is calculated.
However the discounted payback method is superior as, in addition to the recovery of original
investment, the time value of money is also considered.
INTERNAL RATE OF RETURN (IRR)
The other important discounted cash flow technique of evaluation of capital budgeting proposals
is known as IRR technique. The IRR of a proposal is defined as the discount rate, which
produces a zero NPV i. e., the IRR is the discount rate which will quite the present value of cash
inflows with the present value of cash outflow. The IRR is also known as Marginal Rate of
Return or Time Adjusted Rate of Return. Like the NPV, the IRR is also based on the discounting
technique. In the IRR technique, the future cash inflows are discounted in such a way that their
total present value is just equal to the present value of total cash outflows. The time-schedule of
occurrence of the future cash flows is known but the rate of discount is not. Rather this discount
rate is ascertained, by the trial and error procedure. This rate of discount so calculated, which
equates the present value of future cash inflows with the present value of outflows, is known as
the IRR.
Calculation:
Professor
Email-
Symbolically, the IRR is equal to the value of 'r' in the Equation
Where COO = cash outflow at time 0,

CFi = cash inflow at different point of time,
N = life of the project, and
r = rate of discount (yet to be calculated)
SV&WC = salvage value and working capital at the end of the n years
The above Equation can also be written as
It may be noted in the Equation that this equation to be solved to ascertain the value of 'r'.
Unfortunately, the value of 'r' can only be ascertained by the trial and error procedure together
with linear interpolation.
Successive application of different discount rates to all cash flows must be made until a close
approximation of a zero NPV is found. With some experience, an analyst will find that usually
no more than two trials are necessary, because the first result will show the direction of any
refinement needed. A positive NPV indicates the need for a higher discount rate, while a negative
NPV calls for lowering the discount rate.
The specific procedure to find out the value of r implies finding out the net present value of the
proposal at two different assumed values of 'r' within which the IRR is expected to lie.
Thereafter, the two rates are interpolated to make the net present value equal to zero.
The detailed procedure for the calculation of IRR can be explained in two different situations i.e.
(i) When future cash flows are equal and take a form of annuity, and
(ii) When future cash flows are unequal. Both the situations have been taken up as follows:
Case A: When future cash flows are equal:

Professor
Email-
A firm is evaluating a proposal costing Rs. 1,00,000 and having annual inflows of Rs. 25,000
Occurring at the end of each of next six years: There is no salvage value. The IRR of the
proposal may be calculated as follows:
Step 1:
Make an approximation of the IRR on the basis of cash flows data. A rough approxima-tion may
be made with reference to the payback period. The payback period in the given case is 4 years.
Now, search for a value nearest to 4 in the 6th year row of the PVAF table. The closest figures
are given in rate 12% (4.111) and the rate 13% (3.998). This means that the IRR of the proposal
is expected to lie between 12% and 13%.
Step 2:
In order to make a precise estimate of the IRR, find out the NPV of the project for both these
rates as follows:
Step 3:
Find out the exact IRR by interpolating between 12% and 13%. It may be noted that IRR is the
rate of discount at which the NPV is zero. At 12%, the NPV is Rs. 2,775 and at 13% the NPV is
Rs. -50. Therefore, the rate at which the NPV is zero will be higher than 12% but less than 13%.
By interpolating difference of 1 %(13% - 12%), over NPV difference of Rs. 2,825 [Rs: 2,775 -(-
50)],
So, the IRR of the project is 12.98%. The IRR can also be ascertained by starting from
13%.
In such as case, the IRR is

Professor
Email-
Case B: When future flows are not equal:
In case when the project is expected to generate an uneven stream of cash flows, the calculation
of the IRR is complicated. In order to minimize the number of calculations, IRR can be
calculated as follows.
I will explain this with the help of an example.
Example
Suppose a firm is evaluating a proposal costing Rs. 1,60,000 and expected to generate cash
inflows of Rs. 40,000, Rs. 60,000, Rs. 50,000, Rs. 50,000 and Rs. 40,000 at the end of each of
next 5 years respectively. There is no salvage value thereafter. In this case, there is an uneven
stream of cash inflows and the IRR can be approximated as follows.
Step 1:
Find out the average annual cash inflow to get a Fake annuity.
Step 2:
Divide the initial outlay with the average cash inflows 1,60,000/48,000 = 3.33 yrs
Step 3:

Professor
Email-
Now, search for a value nearest to 3.33 in 5 years row of the PVAF table. The closest figures
given in table are at 15% (3.352) and at 16% (3.274). This means that the IRR of the proposal is
expected to lie between 15% and 16%.
Step 4:
Find out the NPV of the proposal for both of these approximate rates as follows.
Step 5:
Find out the exact IRR by interpolating between 15% and 16%. At 15% the NPV is Rs. 1,540
and at 16% the NPY is Rs. -2,250. Therefore, the rate at which NPV is zero will be more than
15%-but less than 16%. By interpolating the difference of 1% (i.e. 16% -15%rover the NPV
difference of Rs. 3,790 [i.e. Rs_ 2,250 - (- 1,540)]
The Decision Rule:
In order to make a decision on the basis of IRR technique; the firm has to determine, in the first
instance, its own required rate of return. This rate, k, is also known as the cut-off rate or the
hurdle rate. A particular proposal may be accepted if its IRR, r, is more than the minimum rate i.
e., k, otherwise rejected. However, if the IRR is just equal to the minimum rate, k, then the firm
may be indifferent. In case of ranking of mutually exclusive proposals, the proposal with the
highest IRR is given the top priority while the project with the lowest IRR is given the lowest
Professor
Email-
priority. Proposals whose IRR is less than the minimum required rate, k, may altogether be
rejected.
This decision rule is based on the fact that the NPV of the project is zero if its cash flows are
discounted at the minimum' required rate i. e., k. If the proposal can give a return higher than this
minimum required rate, then it is expected to contribute to the wealth of the shareholders. It may
be noted however, that the IRR, r, of the proposal is internal to the project while the minimum
required rate, k, is external to the project.
Besides the NPV technique, the IRR technique is the other important discounted cash flow
technique of evaluation of capital budgeting proposals. The IRR technique has been compared
with the NPV technique at a later stage.
However, the merits of the IRR technique can be summarized as follows:
i. The IRR technique takes into account the time value of money and the cash flows occurring at
different point of time are adjusted for time value of money to make them comparable.
ii. It is a profit-oriented concept and helps selecting those proposals which are expected to earn
more than the minimum required rate of return. So, the IRR technique helps achieving the
objective of maximization of shareholders wealth.
iii. The IRR of a proposal is expressed as a percentage and is compared with the cut-off rate,
which is also expressed as a percentage. Thus, the IRR has an appeal for those who want to
analyze proposal in terms of its percentage return.
iv. Like NPV technique, the IRR technique is also based on the consideration of all the cash
flows occurring at any time. The salvage value, the working capital used and released etc. are
also considered.
v. The IRR technique is based on the cash flows rather than the accounting profit.
Thus, it can be stated that the IRR technique possesses all the ingredients of a sound evaluation
technique. Still it has, on the other hand, some draw backs, as follows:
a) As far as the calculation of IRR is concerned, it involves a tedious and complicated trial and
error procedure.
b) An important drawback of the IRR technique is that it makes an implied assumption that the
future cash inflows of a proposal are reinvested at a rate equal to the IRR. Say, in case of
mutually exclusive proposals, say A and B having IRR of 18% and 16%, the IRR technique
makes an implied assumption that the future cash inflows of project A will be reinvested at 18%
while the cash inflows of project B will be reinvested at 16%. It is imaginary to think that the
same firm will have different reinvestment opportunities depending upon the proposal accepted.

Professor
Email-
c) Since, the IRR is a scaled measure, it tends to be biased towards the smaller projects which are
much more likely to yield high percentage returns over the larger projects.

Professor
Email-

Capital Budgeting Notes

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Capital Budgeting Notes

Uploaded by

Copyright:

Available Formats

CAPITAL BUDGETING

How to finance these projects? (Financing decisions)

Investments decisions of a firm are generally known as Capital Budgeting or Capital

2. NATURE OF INVESTMENT DECISIONS

1 | Page By - Harshit Agarwal - Asst.

5. Mandatory investments: These are expenditure required to comply with statutory

Can you tell me why capital expenditures are deemed important?

As discussed by you Capital Budgeting is an extremely important aspect of a firm's financial

They influence the firms growth in the long run

They affect the risk of the firm

2 | Page By - Harshit Agarwal - Asst.

They involve commitment of large amount of funds

They are irreversible, and if reversible it is at substantial loss

They are among the most difficult decisions to make

3. Phases of Capital Budgeting Process

3 | Page By - Harshit Agarwal - Asst.

4. CAPITAL BUDGETING:EVALUATION TECHNIQUES

5 | Page By - Harshit Agarwal - Asst.

(i) The amount expended i.e., The net investment,

TRADITIONAL OR NON-DISCOUNTING TECHNIQUES

Traditional evaluation criteria have been discussed as follows:

Case B: When the annual cash inflows are unequal:

The Decision Rule:

Advantages of payback method:

Disadvantages of payback method:

Suitability of Payback Method:

II. ACCOUNTING RATE OF RETURN OR AVERAGE RATE OF

Case A: Equal Profits:

Case B: Unequal Profits:

10 | P a g e By - Harshit Agarwal - Asst.

Initial cash outlay as average investment:

Average annual book value after depreciation as average investment

Short-cut method to find out the average investment:

11 | P a g e By - Harshit Agarwal - Asst.

Average investment = 1/2(Initial Cost + Installation Expenses - Salvage value) + Salvage

The additional working capital:

12 | P a g e By - Harshit Agarwal - Asst.

Average investment = 1/2(Initial Cost + Installation Expenses - Salvage value) + Salvage

The decision rule:

The Critical Evaluation:

13 | P a g e By - Harshit Agarwal - Asst.

In particular these techniques suffer from

DISCOUNTED CASH FLOWS OR TIME ADJUSTED TECHNIQUES

A common ingredient to discounted cash flow techniques

A few basic points are worth noting here.

NET PRESENT VALUE (NPV) METHOD

Where NPV = Net present value,

16 | P a g e By - Harshit Agarwal - Asst.

Where Co = Initial cost of the proposal at time To

The above equation can also be presented in form of a Table.

17 | P a g e By - Harshit Agarwal - Asst.

The Decision Rule

The decision rule under the NPV method is:

The properties of the NVP criterion:

The Critical Evaluation:

The merits of the NPV technique can be enumerated as follows.

The NPV technique has the following shortcomings:

PROFITABILITY INDEX (PI)

20 | P a g e By - Harshit Agarwal - Asst.

Present value of cash outflows = Rs. 40,000 + 15,020 = 55,020.

Present value of cash inflows = Rs. 18,180 + 33,040 + 13,660 = 64,880.

The Decision Rule:

Under the PI technique, the decision rule is:

21 | P a g e By - Harshit Agarwal - Asst.