DEPARTMENT OF COMMERCE

A CASE STUDY ON CAPITAL BUDGETING

SUBMITTED BY: -

CHINTAMANI MOHANTY

ROLL NO: - 16DCO171

B.COM Honors (3RD year Comm.)

A dissertation submitted to Ravenshaw University for the fulfillment of the degree
of Bachelor in Commerce

GUIDED BY: -

Dr. Shriti mazumdar

1
UNDER GRADUATE DEPARTMENT OF COMMERCE
RAVENSHAW UNIVERSITY,COLLEGE SQUARE,
CUTTACK – 753001

Dr. Shriti Mazumdar

Reader
U.G. Department of Commerce,
Ravenshaw University, College Square, Cuttack

CERTIFICATE
This is to certify that the dissertation entitled “A Case study of
Capital Budgeting” submitted to Ravenshaw University in the partial
fulfilment of the requirements for the award of Bachelor of Commerce (B.Com.)
degree in Commerce by Chintamani Mohanty under my guidance and supervision.

It is further certified that such help and sources of information as have been
availed of in this dissertation have been duly acknowledged by him and no part of
this work has been submitted for any other degree or published in any other form.

Dr. Shriti Mazumdar

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 DECLARATION

I, Chintamani Mohanty, hereby declare that the dissertation on

topic “ A Case Study of Capital Budgeting ” submitted by me to the U.G.

Department of Commerce, Ravenshaw University, College Square, is of my own

labour and has not been submitted to any other University or published at any time

before .

Place : Chintamani Mohanty

Date : Roll No. : 16DCO171

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 ACKNOWLEDGEMENT

First of all, I render my deep sense of gratitude to my respected guide Dr.

Shriti Mazumdar (Reader, U.G. Dept. of Commerce) for approving my
topic “A Case study of Capital Budgeting”.

From the core of my heart I express a deep sense of gratitude to

Dr. Tushar Kanta Pani (H.O.D. & Reader, Dept. of Commerce) for his
sympathy and advice and also recommended me as a regular and sincere
student of this department.

I am very much thankful to all the staff of Dept. office for their
kind co-operation.

I take the opportunity of expressing my sincere thanks and

gratitude to most of my known fellows, mates who had helped a lot and
made me enlightenment, encouragement and enthusiastic for advancing
on the long run of my life. They are Radharaman (Sunny), Akash, Jiten.

Chintamani Mohanty
Student of B. Com
Ravenshaw University,
College Square, Cuttack

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 CONTENTS

Page
No.

Certificate 2
Declaration 3
Acknowledgement 4

CHAPTER-1 INTRODUCTION 6-14

➢ Importance of Capital Budgeting
➢ Objectives of Capital Budgeting
➢ Scope of Capital Budgeting Decision
➢ Process of Capital Budgeting

CHAPTER-2 RESEARCH METHODOLOGY 15-32

➢ Cash Flow for Project Appraisal
a. Initial investment or cash outflow
b. Operating cash flow or Net annual
Cash inflow
c. Terminal cash flow
➢ Methods of Capital Budgeting
A. Traditional Methods:
a. Payback Period Method
i. Simple Payback.
ii. Discounted Payback.
b. Accounting Rate of return Method
B. Modern Methods
a. Net Present Value Method.
b. Internal Rate of Return Method.
c. Profitability Index Method.

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 Chapter – 1
INTRODUCTION OF CAPITAL BUDGETING

1.1 Introduction: -
The word capital Budgeting is basically the combination of
two words i.e. “Capital” and “Budgeting”. So, before we discuss about
the concept of capital budgeting, first we have to know what is Capital?
And what is budgeting also.
The amount of money which is invested or contributed by the
businessman at the time of commencement of the business is called
Capital. (Chawla, 2013) No one can start any business without investing
any capital in that particular business. So, here the word capital is the
primary foundation of any business. In this case the businessman may
invest his own money as capital or he can take a loan from any financial
institution or from any other source for the initial investment. Normally
the investors invest capital in the business for a longer project.

Everyone has its own Budget. In spite of that, every country are also
prepare their own budget in every year. Recently the Government of
India has prepared his budget for the year 2019. So, what is the meaning
of this word budget actually?
Budgeting refers to the process of determining how the company is
going to spend his money. It is the process of making plan that how
much amount of money the company is going to spend as per his need,
out of the total income of the company. This plan is generally called
Budget. So, preparing a budget always helps to determine in advance,
that whether the company have enough money to do the things which he
need/want to do.
In the budgeting process every companies generally compare their
expenditure with their actual income. Due to this comparison the
companies are able to know how much amount of money they should
expend on which products or anything else.

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 1.2 Capital Budgeting: -
(Gupta, 2018) Every Businessman always start their business by
investing capital on fixed assets, such as land, labour, plant & machinery
etc. So, Capital Budgeting is the process of making investment decision
in capital assets / fixed assets / capital expenditure.
A capital expenditure may be defined as an expenditure the benefits of
which are expected to be received over a period of time exceeding one
year. It means the expenditure will be incurred at one point of time but
the benefits of that expenditure will be realized at different point of time
in future. Examples of capital expenditures are
• Cost of acquisition of permanent assets as land and building, plant
& machinery, goodwill etc.
• Cost of addition, expansion and alteration in the fixed assets.
• Research and development project cost etc.
So, capital budgeting is the process in which businessman determines
and evaluates the potential investments that are large in nature. Through
this process the business man also decides whether we should invest our
capital on that particular fixed asset or not. The business man can also
determine that whether this project will provide benefits in future or not;
that’s why it indirectly helps the businessman to decide whether he
should go forward with this project or cancel it.
This process is also called as long-term investment decision or capital
expenditure decision etc.
Here the word decision is used, because the future of a business is
completely depend upon the decision of the businessman.
It is rightly says that, “Your future results are always depends on your
present decisions”.
According to “Charles T. Horngreen”, ‘Capital Budgeting is long term
planning for making and financing proposed capital outlays’
So, every businessman should take appropriate decision by considering
all the pros. and cons. of a particular subject.

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1.3 IMPAORTANCE OF CAPITAL BUDEGTING
For a normal person it is very important to identify the project
on which he/she is going to invest his/her funds as per their fixed
budget. Here one question may arise in our mind that, why someone
wants to invest money on any project? Or what is the object behind this
investment?
The answer is that every investor always wants to get adequate return on
their respective investment. If it will not provide the same then why
should someone like to invest his/her funds in that particulars project.
The same process is also followed in business matter.
Every businessman always follows the capital budgeting process which
helps them to identify whether they should invest the funds in a
particular project or not and the same project will be beneficial for them
or not.
The importance of capital budgeting can be well understood from the
fact that an unsound investment decision may prove to be wrong for the
existence concern. The need, significance or importance of capital
budgeting arises mainly for the following points discussed below.

I. Large Investment
Capital budgeting process generally involves investment in
long term activities or we can say large investment of funds are involved
in that process. But we know that the funds which are available with the
firm are always limited. Hence, it is very important for a firm to plan
and control its capital expenditure, because one wrong decision can
affect the future destiny of the firm.

II. Irreversible Nature

The capital budgeting decisions are of irreversible in nature;
because it is very difficult to take back these decisions.
For example: - when you are going to purchase a shirt, then its may easy
for you to decide which shirt you will purchase without any further
8
investigation or analysis; but when you are going to buy a car, then in
that case you have to think about that car more frequently, because you
are going to purchase a long term asset i.e. ‘Car’ on which you are going
to invest a very big amount and you will use that product for a longer
period of time. So, in case of long term investment or capital asset, we
have to take the decision very carefully by analyzing and identifying
about that product or project; because once you decide to purchase the
car, then you can’t return it back to the company.
Similarly, in case of business, every businessman should keep this point
in mind before take any capital expenditure decision.

III. Difficulties of Investment Decisions

Capital budgeting decision are difficult to be taken because
these are based upon future and we know future is always uncertain.
No one can predict the future that what actually happen in future. As we
don’t know the future, so this decision involves high degree of risk also.

IV. Long- term Commitment of funds

Capital expenditure involves not only the large amount of
funds but also funds for long term on permanent basis. The long-term
commitment of funds increases the financial risk involved in the
investment decision. Greater the risk involved, greater is the need for
careful planning of capital expenditure.

1.4 OBJECTIVES OF CAPITAL BUDGETING

The main objective of capital budgeting is to protect the
investors from the wrong decision of investment on any capital asset or
project. Some of the other important objective of capital budgeting are
given below.

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 i. To find out whether the investment made on capital expenditure
will give benefit in the future or not.
ii. To know whether the replacement of any existing fixed asset gives
more return than earlier or not.
iii. To decide whether we should select the project or not.
iv. It helps in finding out the amount of funds required for the capital
expenditure.
v. Its also helps in finding out various sources of finance from which
an investor can raise funds.
vi. It helps in evaluating the merits of each proposal in order to decide
which project is best.

1.5 SCOPE OF CAPITAL BUDGETING DECISIONS

The general scope of capital budgeting decisions are
discussed below.

i. Mechanization of process: -
Earlier in every business organization the production process
is done through manually basis, but now it is replaced by mechanization
of process. The purpose behind this type of change is to reduce the cost
of production to some extent. As a result, the difference between future
cash inflows and operating costs will be higher than earlier.
So, greater the difference, greater will be the benefits for the
organization. That’s why every business organization are now interested
in the mechanization process of doing production instead of manual
process.

ii. Expansion Decisions: -

Every businessman wants to expand his area of business by
increasing the production and sales of that particular business. So, in
order to expand the business, a company required to purchase new

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machinery, construct additional building, merger or take over of other
business etc.
So, for these above purposes the company requires huge amount of
capital and it is very much necessary to evaluate the future earning also.

iii. Replacement Decision: -

Now a days the innovation in technology is growing at a very
faster rate. That’s why the old things or machines are going to be
outdated right now. New or innovative technology helps the
businessman to bring down the operating expenses/cost and to increase
the productivity. So, it will create a big different in between the future
cash inflows and operating costs, which is beneficial for the business.
So, every businessman should replace their old and outdated machine
into innovative one.

iv. Buy or Lease Decisions: -

The fixed assets can be acquired by the businessman in two
way. Either he can purchase the fixed asset or he can get that asset on
lease basis. The purchase of fixed assets requires huge amount of funds
at the initial stage, but on the other hand the company require less
amount of funds if the asset is acquired on lease basis.
Hence, a comparative study can be made with reference to future
benefits from these two mutually exclusive alternatives.

V. Choice of Equipment: -
Two type of Machines are available to perform a same work.
The cost of each machine is different from one another. Moreover,
every businessman should carefully evaluate the pros. and cons. of
buying each machine and then select the best one. So, capital budgeting
process helps a lot in such type of selections tasks.

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1.6 Process of Capital Budgeting
The process of Capital Budgeting is little bit complex, because
in this case the business man is going to invest his/her money whose
benefit will be received in future. We all know that future is always
uncertain. So, due to this uncertain future the process of this concept is
little bit complex for the businessman. However, the following procedure
may be adopted in the process of capital budgeting. (Gupta, 2018)

➢ Identification of Investment Proposal

The first process of capital budgeting is identification of
Investment proposal. The idea regarding potential investment
opportunities may come from the top management or from the file worker
of any department or from any officer of the organization. After that all
the investment proposals are collects by the departmental head and
reviews by them in the knowledge of risk and financial policies of the
organization, in order to send them to the capital expenditure planning
committee for consideration.

➢ Screening the Proposal

In case of large business organization, a capital expenditure
planning committee is established for the screening of various proposal
received by them from the heads of various department and line officer of
the company. So, here the word screening means the evaluation or
investigation of something for a particular purpose. So, this committee
analyze these proposals from various angles to ensure that these
investment proposals are actually exists in accordance with the corporate
strategies or not.

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 ➢ Evaluation of Various Proposal
The next step in the capital budgeting process is to evaluate
the benefits of various proposals. There are many methods which may be
used for this purpose such as payback period method, rate of return
method, net present value method and internal rate of return method etc.
These methods are very much useful for evaluating whether the project
will be beneficial for the company in future or not.

➢ Fixing Priorities
After evaluating various proposals, now it’s the time to reject
the unprofitable or uneconomic projects for going forward in business
line. But it may not be possible for the firm to invest in any suitable project
immediately due to limitation of funds. Hence, it is very much essential
for the business man to provide ranks to various proposal and give them
priorities according to the rank and after considering urgency, risk and
profitability involved therein.

➢ Final Approval and preparation of capital expenditure budget

After completion of all the above process, now the proposal is
finally recommended by the committee and sent to the top management
along with the detailed report i.e. both the capital expenditure and the
source of funds to meet the initial requirement of the project. Then the
project is sent to the budget committee for incorporating them in the
capital budget. The capital expenditure budget lays down the amount of
estimated expenditure to be incurred on fixed assets during the budget
period.

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 ➢ Performance Review
The last stage in the capital budgeting process is the review of
performance of the project. This review is made by way of comparison
of actual expenditure on the project with the budgeted one; and by
comparing the actual return from the investment with the budgeted return.
If any discrepancy is there then the same should be analyze and identified
carefully, so that corrective action may be taken in future.

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 Chapter – 2
METHODS/TECHNIQUES OF CAPITAL BUDGETING

2.1 CASH FLOW FOR PROJECT APPRAISAL

The investment in any project is usually involves three different types
of cash flow, which are given below. (Gupta, 2018)
a. Initial investment or cash outflow
b. Operating cash flow or Net annual cash inflow
c. Terminal Cash flow

a. Initial Investment or Cash outflow: -

The initial investment is the amount of money that is invested
by the businessman at the time of commencement of business. As we all
know that no one can start anything without adequate funds and it is
very difficult for the businessman to run a business without any working
capital. So, this initial investment is generally used by the businessman
for the operating activities of the business, like purchase of new assets,
land, building and machinery etc. including expenses on insurance,
freight, loading and unloading, installation cost and expenses on
modification and repairs cost etc. that are based on the purchase of the
fixed asset also.
In addition to the cost of the asset, new investment in capital assets may
also require to increase the investment in working capital, i.e. the excess
of current assets over current liabilities. Thus, the increase in net
working capital also added with the cash outflow or cost of the asset.
Further, in case of replacement decision the new asset is purchased by
selling out the existing asset of the business. So, the sale proceeds of the
discarded assets should be deducted while determining the amount of
initial investment.

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 Computation of Initial Investment

Purchase price of the assets

(Including duties and taxes if any) XXX
Add – Insurance, freight, loading, unloading and installation
Costs XXX
Add – Net increase in Working capital XXX

XXX
Less – Cash inflows in the form of sale proceeds (of the old
Asset in case of replacement decisions) (XXX)
Less – Investment Allowance (XXX)

b. Operating cash flows or Net Annual cash inflows: -

As we already know that every businessman invests their
money on any project or on any capital asset for the purpose of getting
adequate return in the form of net annual cash inflow in future. These
annual cash inflows should be estimated on an after-tax basis. In simple
words net annual cash flows refers to the annual net earnings (profits)
before depreciation and after taxes. Depreciation being a non-cash
charge, it is added back to the earning after tax, but tax being a cash
expense, it has to be deducted to determine the net annual cash flows.
The net annual cash flows can be determined as below.

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 Computation of Net Annual cash inflow

Cash Revenues (Sales) XXX

Less – Cash Expenses (Operating Cost) (XXX)

Earnings before Depreciation and Tax (CFBT) XXX

Less – Depreciation (XXX)

Earnings before Tax XXX

Less – Tax (XXX)

Earnings after Tax XXX

Add- Depreciation XXX

Cash inflow after tax (CFAT) XXX

c. Terminal Cash Flow: -

At the end of the economic life of a capital asset i.e. the last
year when the asset is terminated, there is usually some value in the
asset left. The asset may be sold at that point of time as scrap or it may
fetch some salvage value. This inflow to a firm in the last year is called
terminal cash flow.

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2.2 METHODS/TECHNIQUES OF CAPITAL
BUDGETING
There are many methods of evaluating profitability of capital
investment proposals. The most common methods used by the
businessman are given below.
A. Traditional Methods:
a. Payback Period Method.
i. Simple Payback.
ii. Discounted Payback.
b. Accounting Rate of Return Methods:
B. Modern Methods
a. Net present Value Method.
b. Internal Rate of Return Method.
c. Profitability Index Method.

A. TRADITIONAL METHODS
Simple Payback Period: -
The payback period is a method which helps to determine the
length of time required to recover the initial cash outlay in the
project. (Gupta, 2018) In simple word it is the time period under
which our cash investment comes to us through the successive cash
inflows.
Under this method, various investments are ranked according to
the length of their payback period in such a manner that investment
with a shorter payback period is preferred to the one which has
longer payback period.
The payback period can be ascertained in the following manner.
a) If the project generates constant annual cash inflows, then
divide the initial outflow of the project by the annual cash
inflow. Here the annual cash flow means the net annual
earnings (profits) before depreciation and after taxes.

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 Cash outflow of the project or original cost
So, payback period = of the assets
Annual cash inflow

b) But, where the annual cash inflow are unequal, then the
payback period can be found by adding up the cash inflows
until the total is equal to the initial cash outlay of project or
original cost of asset.

For example: - If a project costs ₹ 1,00,000 and yields an annual cash

inflow of ₹ 20,000 for 8 years, then the payback period is

Example: - 2
Determine the payback period for a project which requires a cash
outlay of ₹ 2,000, 4,000, 3,000 and2,000 in the first, second, third and
fourth year respectively.

Ans. Total Cash Outlay = ₹ 10,000

Total cash inflow for the first 3 years =2,000 + 4,000 + 3,000= ₹ 9,000
Up to the third year the total cost is not recovered but the total cash
inflows for the four years are 9,000 + 2,000 = ₹ 11,000. But we need to

19
recover 10,000 only, so, our payback period is somewhere in between 3
and 4 years. So, in order to calculate the actual payback period we have
to use the interpolating method.

For the recovery of ₹ 2,000 Time = 12 months

So, for the recovery of ₹ 1,000 Time =

Hence, payback period is 3 years and 6 months.

❖ Discounted Payback period method: -

Due to the limitation of the payback period method i.e. it
ignores the time value of money; hence, an improvement over this
method can be made by employing the discounted payback period
method. Under this method the present value of all cash outflows
and inflows are computed at an appropriate discount rate. The
present value of all inflows are cumulated in order of time.
The time period at which the cumulated present value of cash
inflows equals the present value of cash outflows is know as
Discounted payback period. The project which gives a shorter
discounted payback period is accepted.

For example: -

Cost of project : ₹ 60,000

Life of the Project : 5 years

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 Annual Cash Inflow : ₹ 2,00,000
Cut off Rate 10%
Note: The cut off rate is also known as the minimum desire return
Or Time Value of Money.
Solution:
Calculation of Present Values of Cash Inflows
B C Cumulative Present
A Inflows P.V.F at 10% B*C Value
Years ₹ Discount Factor Present Value ₹
1. 2,00,000 0.909 1,81,800 1,81,800
2. 2,00,000 0.826 1,65,200 3,47,000
3. 2,00,000 0.751 1,50,200 4,97,200
4. 2,00,000 0.683 1,36,600 6,33,800
5. 2,00,000 0.621 1,24,200 7,58,000

Cumulative present value of cash inflows at the end of the third year is
₹ 4,97,200 and it is ₹ 6,33,800 at the end of fourth year. But we need to
recovered only ₹ 6,00,000. Hence, discounted payback period falls in
between 3 and 4 years. So, in order to calculate the actual discounted
payback period, we have to use the interpolating method.

For the recovery of ₹ 1,36,600 Time = 12 months

So, for the recovery of ₹ 1,02,800 Time =

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 3
Hence, Discounted payback period is 3 years.
4
❖ Accounting Rate of Return Method
This method is further subdivided into 4 parts, such as,
a. Average Rate of Return Method.
b. Return per unit of Investment Method.
c. Return on Average Investment Method.
d. Average Return on Average Investment Method.
This method is popularly known as Accounting Rate of Return Method
because, under this method, the accounting concept of profit (i.e. Net
profit is calculated by deducting tax as well as depreciation also) is used
rather than cash inflows profit. According to this method, various project
are ranked as per their rate of return. The project with the higher rate of
return is selected as compare to the one with lower rate of return.

a. Average Rate of Return Method

Under this method the average profit after tax and
depreciation is calculated and then it is divided by the total capital
outlay or total investment in the project. In other words, it establishes the
relationship between average annual profits to total investments.
Thus,

Total Profits (after Depreciation & Tax)

Average Rate of Return = Number of years of profits X 100
Net Investment in the Project

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For Example
Investment in Project = ₹ 5,00,000
It is expected to earn profits after depreciation and taxes during 5
yeas amounting to ₹ 40,000, ₹ 70,000, ₹ 50,000 and ₹ 20,000. So, here
the average rate of return on investment will be
Ans. Total Profit = 40,000+70,000+50,000+20,000 = 2,40,000
2,40,000
Average Profit = = 48,000
5
Net Investment of Project = 5,00,000
48,000
So, average rate of return = ×100 = 9.6%
5,00,000

b. Return per unit of Investment Method

This method is the small variation of the average rate of
return method. In this method the total profit after tax and
depreciation is divided by the total investment.

𝐓𝐨𝐭𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 (𝐚𝐟𝐭𝐞𝐫 𝐝𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 & 𝐭𝐚𝐱𝐞𝐬)

Return per unit of investment = × 100
𝐍𝐞𝐭 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 𝐢𝐧 𝐭𝐡𝐞 𝐩𝐫𝐨𝐣𝐞𝐜𝐭

c. Return on Average Investment Method

Under this method the total profit after tax and depreciation
is divided by the net average investment of the project.
Total Investment
So, average investment =
2

𝐓𝐨𝐭𝐚𝐥 𝐩𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐝𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐚𝐧𝐝 𝐓𝐚𝐱𝐞𝐬

Hence, the Return on Average Investment =
𝐓𝐨𝐭𝐚𝐥 𝐍𝐞𝐭 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭 ÷𝟐

23
 d. Average Return on Average Investment Method
This is the most appropriate method of rate of return on
investment. Under this method, average profit after depreciation
and taxes is divided by the average amount of investment. Thus;

𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐀𝐧𝐧𝐮𝐚𝐥 𝐏𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐝𝐞𝐩.& 𝐭𝐚𝐱𝐞𝐬

Average Return on Average Investment = × 𝟏𝟎𝟎
𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐈𝐧𝐯𝐞𝐬𝐭𝐦𝐞𝐧𝐭

B. Modern Methods

a. Net present Value Method (NPV)

The net present value method is a modern method of
evaluating investment proposals. This method takes into consideration
the time value of money and attempts to calculate the return on
investment by introducing the factor of time element. It recognizes the
fact that a rupee earn today is more valuable than the same rupee earned
tomorrow. In this case the net present value of all cash inflows and
outflows of cash occurring during the entire life of the project is
determined separately for each year by discounting these flows by the
firm’s minimum desire returns. In simple word NPV means, it is the
amount of cash inflows that remains in the organization after subtracting
(https://youtu.be/40D1_ReWz1E, 09-02-2019)
i. Minimum Desire Return
ii. Present value of cash outflows
Higher NPV is always favorable for a company.

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So, NPV = PV of cash inflow – PV of cash outflow

NPV

= +ve = -ve =0

It Means, when In this case it

NPV is positive Here, in this indicates that
then we are case our actual we are earning
earning more return is less exactly same
than our than our rate of return
minimum desire minimum desire as minimum
return. return desire return
In this case we Project should be We may accept
should accept our rejected or reject the
Project project
`
For Example: -
Initial Investment ₹ 20,000
Estimated Life 5 years
Scrap Value ₹ 1,000
Discount rate 10%

25
Profits for year Amount
1 ₹ 5,000
2 ₹ 10,000
3 ₹ 10,000
4 ₹ 3,000
5 ₹ 2,000

Calculations for Net Present Value

Present value of Re 1
Years Cash Flows @10% (discount Present Value of
factors) By using Net Cash Flows
present value tables
1. 5,000 0.909 4,545
2. 10,000 0.826 8,260
3. 10,000 0.751 7,510
4. 3,000 0.683 2,049
5. 2,000 0.621 1,242
5.(Scrap 1,000 0.621 621
Value) 24,227

Present value of all cash inflows : 24,227

Less: Present value of initial investment : (20,000)
Net Present Value (NPV) 4,227

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 b. Internal Rate of Return Method (IRR)
The internal rate of return method is also a modern technique
of capital budgeting that considers the time value of money.
In the net present value method, the net present value is determined by
discounting the future cashflow of a project at a predetermined or
specified rate called the cut off rate or minimum desire return rate. But
under the internal rate of return method, the cash flow of a project are
discounted at a suitable rate by hit and trail method. Since the discount
rate is determined internally, this method is called Internal Rate of
Return Method. It can be defined as the rate at which the present value
of cash inflows is equal to the present value of cash outflows.

PV of cash inflows = PV of cash outflows

or
In other words, it is the rate at which our NPV = 0. We can also say that
IRR is the rate which is actually earned by the organization through
investment in the project.

Determination of Internal Rate of Return

a. When the annual net cash inflow are equal over the life of the asset
In this case first of all we have to find out the present value
factor by dividing the initial outlay by annual cash flow i.e.

Initial Outlay
Present Value factor =
Annual Cash Flow

Then consult the present value annuity table with the number of years
equal to the life of the asset and find out the rate at which the calculated
present value factor is equal to the present value given in the table.
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For example: -
Initial outlay : ₹ 1,00,000
Life of the asset : 10 years
Estimated Annual cash flow : ₹ 15,500
So, the Internal Rate of Return =
1,00,000
Ans. Present value Factor = = 6.451
15,500
By consulting Present Value Annuity tables for 10 years periods at
Present value factor 6.451, the IRR is = 9%.

b. When the annual cash flows are unequal over the life of the asset:
In case when the annual cash inflows are unequal over the life
of the asset; the internal rate of return is calculated by the hit and trial
method. That’s why this method is also known as Hit and Trial yield
method. In this case we may start with any assumed discount rate and
find out the total present value of cash inflows which is equal to the cost
of the initial investment. The rate at which the total present value of all
cash inflows is equals with the initial outlay, is called the internal rate of
return. Several discount rates may have to be tried until the appropriate
rate is found. We can clearly understand the above sentences with the
following example.

Example: -
Initial Investment : ₹ 60,000
Life of the asset : 4 years
Estimated Net Annual Cash Flows
1st year : ₹ 15,000
2nd year : ₹ 20,000
3rd year : ₹ 30,000
4th year : ₹ 20,000
Find out the IRR.

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 Cash Flow Table at various assumed Discount Rates of 10%,12%,14% & 15%
Annual Discount 12% 14% 15%
Year Cash Rate 10%
Flow P. V. F P. V P.V. F P. V P.V. F P. V P.V. F P. V

1. 15,000 0.909 13,635 0.829 13,380 0.877 13,155 0.869 13,035

2. 20,000 0.826 16,520 0.797 15,940 0.769 15,380 0.756 15,120
3. 30,000 0.751 22,530 0.711 21,330 0.674 20,220 0.657 19,710
4 20,000 0.683 13,660 0.635 12,700 0.592 11,840 0.571 11,420
66,345 63,350 60,595 59,285

The present value of net cash flows at 14% rate of discount is 60,595
and at 15% rate of discount it is 59,285. So, the initial cost of investment
which is 60,000 falls in between these two discount rates. In order to
find out the IRR we have to use the Interpolating or unitary method.

So, for the recovery of 1,310 rate is = 1%

i.e. (60,595−59,285) i.e. (15%−14%)
1%
For the recovery of 1 rate =
1,310
For the recovery of 595
1%
i.e. (60,595−60,000) rate = × 595
1,310
= 0.45%
Hence, the IRR = 14% + 0.45% = 14.45%

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iii. Profitability Index Method (P.I)
Profitability Index is the relationship between present
value of cash inflows and the present value of cash outflows.
It means it shows that how much amount of cash will be inflow
if we invest ₹ 1 in a project. This method is also called as benefit
cost ratio because it establishes the relationship between the
benefits and cost of the project.
Its helps in giving ranks to the projects on the basis of its value,
the higher the value the top rank the project gets. Therefore, this
method helps in the capital rationing.
Thus,

Present Value of Cash Inflow

Gross profitability index = Present Value of Cash Outflow

or

NPV
Net P.I = Initial Cash Outlay

The proposal is accepted if the profitability index is more than one and is
rejected if that is less than one.

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 NPV = − Ve

PI < 1

Profitability

PI > 1 Index
PI = 1

NPV = +Ve NPV = 0

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For Example: -
The initial cash outlay of a project is ₹ 50,000 and it generates cash
inflows of ₹ 20,000, ₹ 15,000, ₹ 25,000 and ₹ 10,000 in four years.
Find out the Profitability index, if the discount rate is 10%.
Solution: -
Calculation of Present Values and Profitability Index
Year Cash Inflows Present Value Present Value
₹ Factors @ 10% ₹
1. 20,000 0.909 18,180
2. 15,000 0.826 12,390
3. 25,000 0.751 18,775
4. 10,000 0.683 6,830
56,175

₹
Total Present Value 56,175
Less: Initial Outlay (50,000)
Net Present Value 6,175

𝟓𝟔,𝟏𝟕𝟓
Gross Profitability Index = = 1.1235
𝟓𝟎,𝟎𝟎𝟎
Here the P.I is higher than 1, So, the proposal should be accepted.

𝟔,𝟏𝟕𝟓
Net Profitability Index = = 0.1235
𝟓𝟎,𝟎𝟎𝟎
or
Hence, Net P.I = 1.1235 −1 = 0.1235
As the Net Profitability Index is positive, the proposal can be accepted.
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