FINANCIAL MANAGEMENT

“CAPITAL BUDGETING AND

ITS TECHNIQUES”

Submitted by :
Shruti Pal (0076)
Sunmeet kaur (0060)
Sameer Aggarwal (0062)
B.B.S. IV semester

To :
Mr. Rakesh Kumar
Department of Business Studies

DEEN DAYAL UPADHYAYA COLLEGE

UNIVERSITY OF DELHI
 CERTIFICATE
This is to certify that Shruti Pal, Sunmeet Kaur and Sameer Aggarwal, Semester
IV, students of BBS, Deen Dayal Upadhyaya College, University of Delhi have
worked under my guidance for the topic titled “Capital Budgeting and its
Techniques”. To the best of my knowledge, this piece of work is original and the
student to any other Institute/University has submitted no part of this project
earlier.

Mr. Rakesh Kumar

 DECLARATION
We, Sunmeet kaur, Shruti Pal and Sameer Aggarwal, students of Bachelor of
Business Studies (IV semester), in Deen Dayal Upadhyaya College, University of
Delhi, hereby declare that we have made this academic project titled ‘Capital
Budgeting and its Techniques’ as a part of the internal assessment for the subject
‘Financial Accounting ’, for academic year 2010-2011. The project is submitted for
the first time and here only and the information submitted therein is true to the best of
our knowledge.

We sincerely thank Mr. Rakesh Kumar and our friends for the help extended by them
for the successful completion of the project report.

Date:

Countersigned

Signature
(Mr. Rakesh Kumar) (Sunmeet Kaur)

Signature
(Shruti Pal)

Signature
(Sameer
Aggarwal)
 TABLE OF
CONTENTS
S.no Topic Page no
1 Introduction 5

2 Origin 6

3 Concept 14

4 Elements of TQM 17
5
Tools and Techniques for quality improvement 19

6 Principles of TQM 21

7 Implementing TQM 22

8 Case Study 1 24

9 Case Study 2 29

10 Case Study 3 31

11 Case Study 4 33

12 Case Study 5 38

13 Bibliography 39

Capital budgeting
Capital Budgeting is the process by which the firm decides which long-term
investments to make. Capital Budgeting projects, i.e., potential long-term
investments, are expected to generate cash flows over several years. The decision
to accept or reject a Capital Budgeting project depends on an analysis of the
cash flows generated by the project and its cost.

It can be defined as a process in which a business determines whether projects such as

building a new plant or investing in a long-term venture are worth pursuing. Most
times, a prospective project’s lifetime cash inflow and outflows are assessed in order
to determine whether the returns generated meet a sufficient target benchmark.
Capital budgeting is also known as investment appraisal. Ideally, businesses should
pursue all projects and opportunities that enhance shareholder value. Generally,
businesses prefer to intricately study a project before taking it on, as it has a great
impact on the organization’s financial performance. Capital budgeting is an essential
managerial tool. One important duty of a financial manager is to choose investments
with satisfactory cash flows and rates of return. In essence a financial manager should
be able to decide if an investment is worth undertaking and should also have the
ability to choose intelligently given other alternatives. Capital budgeting is primarily
concerned with sizable investments in long-term assets. These assets can either be
tangible items such as property, plant or equipment or intangible ones such as new
technology, patents or trademarks. Investments in processes such as research, design
and development and testing – through which new technology and new products are
created may also be viewed as investments in tangible assets.

Sizable, long-term investments in tangible or intangible have long-term consequences.

An investment today will determine the firm’s strategic position in many years to
come. These investments also have a considerable impact on the organization’s future
cash flows and risk associated with those cash flows. Thus capital budgeting has a
long-range impact on the firm’s performance and it is crucial to the firm’s
success or failure. As such, capital budgeting decisions have a major effect on the
value of the firm and its shareholder’s wealth as a whole.

Financial management is largely concerning with financing, dividend and

investment decisions of the firm. Corporate finance theory has developed around a
goal of maximizing the market value of the firm to its shareholders, which is also
known as shareholder wealth maximization. Financial decisions deal with the firm’s
optimal capital structure in terms of debt and equity. Dividend decisions relate to the
form in which returns generated by the firm are passed on to equity-holders.
Investment decisions deal with the way funds raised in financial markets are
employed in productive activities to achieve the firm’s overall goal, in other words,
how much should be invested and what assets should be invested in.

In reality, many firms have limited borrowing resources that should be allocated
among the best investment alternatives. One might argue that a company can issue
an almost unlimited amount of common stock to raise capital. Increasing the number
of shares of company stock, however, will serve only to distribute the same amount
of equity among a greater number of shareholders. In other words, as the number of
shares of a company increases, the company ownership of the individual stockholder
may proportionally decrease. The argument that capital is a limited resource is true of
any form of capital, whether debt or equity (short-term or long-term, common stock)
or retained earnings, accounts payable or notes payable, and so on. Even the best-
known firm in an industry or a community can increase its borrowing up to a certain
limit. Once this point has been reached, the firm will either be denied more credit or
be charged a higher interest rate, making borrowing a less desirable way to raise
capital. Faced with limited sources of capital, management should carefully decide
whether a particular project is economically acceptable. In the case of more than one
project, management must identify the projects that will contribute most to profits
and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis
of capital Budgeting.

Importance of capital budgeting to the

organization:
• Effective capital budgeting helps to improve the timing of asset acquisitions
and the quality of assets purchased.
• When asset acquisition is planned properly, the organization is able to acquire
and install in an orderly manner.
• Generally all organizations tend to order capital goods at the same time when
sales in a particular industry are increasing strongly, which often times leads
to backlogs and undelivered capital items on a timely basis

Procedure of Capital Budgeting

Capital investment decision of the firm have a pervasive influence on the entire
spectrum of entrepreneurial activities so the careful consideration should be regarded
to all aspects of financial management.

In capital budgeting process, main points to be borne in mind how much money will
be needed of implementing immediate plans, how much money is available for its
completion and how are the available funds going to be assigned tote various capital
projects under consideration. The financial policy and risk policy of the management
should be clear in mind before proceeding to the capital budgeting process. The
following procedure may be adopted in preparing capital budget :-

(1) Organisation of Investment Proposal. The first step in capital budgeting process
is the conception of a profit making idea. The proposals may come from rank and file
worker of any department or from any line officer. The department head collects all
the investment proposals and reviews them in the light of financial and risk policies of
the organisation in order to send them to the capital expenditure planning committee
for consideration.

(2) Screening the Proposals. In large organisations, a capital expenditure planning

committee is established for the screening of various proposals received by it from the
heads of various departments and the line officers of the company. The committee
screens the various proposals within the long-range policy-frame work of the
organisation. It is to be ascertained by the committee whether the proposals are within
the selection criterion of the firm, or they do no lead to department imbalances or they
are profitable.

(3) Evaluation of Projects. The next step in capital budgeting process is to evaluate
the different proposals in term of the cost of capital, the expected returns from
alternative investment opportunities and the life of the assets with evaluation
techniques.

(4) Establishing Priorities. After proper screening of the proposals, uneconomic or

unprofitable proposals are dropped. The profitable projects or in other words accepted
projects are then put in priority. It facilitates their acquisition or construction
according to the sources available and avoids unnecessary and costly delays and
serious cot-overruns. Generally, priority is fixed in the following order.

• Current and incomplete projects are given first priority.

• Safety projects ad projects necessary to carry on the legislative requirements.
• Projects of maintaining the present efficiency of the firm.
• Projects for supplementing the income
• Projects for the expansion of new product.
(5) Final Approval. Proposals finally recommended by the committee are sent to the
top management along with the detailed report, both o the capital expenditure and of
sources of funds to meet them. The management affirms its final seal to proposals
taking in view the urgency, profitability of the projects and the available financial
resources. Projects are then sent to the budget committee for incorporating them in the
capital budget.

(6) Evaluation. Last but not the least important step in the capital budgeting process
is an evaluation of the programme after it has been fully implemented. Budget
proposals and the net investment in the projects are compared periodically and on the
basis of such evaluation, the budget figures may be reviewer and presented in a more
realistic way.

Capital budgeting techniques

The requirement for relevant information and analysis of capital budgeting decisions
taken by management has paved way for a series of models to assist the organization
in amassing the best of the allocated resources.

Popular methods of capital budgeting techniques include:

• The Payback Period

• Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability index
• Accounting rate of return (ARR)

PAYBACK PERIOD
The payback period is defined as the time required to recover the initial investment in
a project from operations. The payback period method of financial appraisal is used
to evaluate capital projects and to calculate the return per year from the start of the
project until the accumulated returns are equal to the cost of the investment at which
time the investment is said to have been paid back and the time taken to achieve this
payback is referred to as the payback period.

The payback decision rule states that acceptable projects must have less than some
maximum payback period designated by management. Payback is said to emphasize
the management’s concern with liquidity and the need to minimize risk through a
rapid recovery of the initial investment.

It is often used for small expenditures that have obvious benefits that the use of more
sophisticated capital budgeting methods is not required or justified. It should be noted
that the required payback period sets the threshold barrier (hurdle rate) for the project
acceptance. It often appears that in many cases that the determination of the required
payback period is based on subjective assessments, taking into account past
experiences and the perceived level of project risk.

The payback method by definition, only takes into account project returns up to the
payback period. However, for certain projects which are long term by nature and
whose benefits will accrue some time in the future and well beyond the normal
payback may not be accepted based on the calculation used by the payback method,
although such projects may actually be vital for the long-term success of the business.
It is therefore important to use the payback method more as a measure of project
liquidity rather than project profitability.

The payback method (PB) is commonly used for appraisal of capital investments in
companies despite its deficiencies. In many companies, the payback period is used as
a measure of attractiveness of capital investments. Although the use of payback
period as a single criterion has decreased over time, its use as a secondary measure
has increased over time. This method is commonly used in pure profit evaluations as a
single criterion and also sometimes used when focusing on aspects such as liquidity
and project time risk. The obvious cases of profitable and unprofitable investments
are sorted out, when the payback method is used as the first screening device, leaving
only the investments that have survived the screening process in the middle group to
be scrutinized by means of more advanced and more time consuming calculation
methods based on discounted cash flows (DCF), such as the Internal Rate of Return
(IRR) and Net Present Value (NPV) methods.

However, it should be noted that there are many companies of considerable size,
where the payback period is used as the single criterion in investment evaluations.

Payback period = Expected number of years required to recover a

project’s cost.

Project L
Expected Net Cash Flow
Year Project L Project S
0 (Rs. 100) (Rs. 100)
1 10 (90)
2 60 (30)
3 80 50

PaybackL = 2 + 30/80 years

= 2.4 years.

PaybackS = 1.6 years.

Discounted payback period method (Payback DCF)

The payback method have gone through various development stages over the years,
with the different variations aimed at eliminating some of its disadvantages and at the
same time keeping the method as simple as possible. This method attempted to
overcome one of the drawbacks of the conventional payback calculation which failed
to take into account a company’s cost of capital.

It should be noted however that the payback method only indicates how quickly the
cost of an investment is recovered but does not measure its profitability. It is therefore
not designed to measure or reflect all the dimensions of profitability which are
relevant to capital expenditure decisions and it is neither inclusive nor sensitive
enough to be used as a company’s general investment worth. It is based on this, that
the academic writers have almost unanimously condemned the use of the payback
period as a misleading and worthless in making investment decisions.

Advantages of the payback period

 • It is widely used and easily understood.
• It favors capital projects that return large early cash flows.
• It allows a financial manager to cope with risk by examining how long it will
take to recoup initial investment, although it does not treat risk directly.
• It addresses capital rationing issues easily.
• The ease of use and interpretation permit decentralization of the capital
budgeting decision which enhances the chance of only worthwhile items
reaching the final budget.
• It contains a built-in safeguard against risk and uncertainty in that the earlier
the payback the lower the risk.
• It remains a major supplementary tool in investment analysis.

Disadvantages of the payback method

• It ignores any benefits that occur after the payback period i.e. it does not
measure total income. The time value of money is ignored.
• It is difficult to distinguish between projects of different size when initial
investment amounts are vastly divergent.
• It over-emphasizes short run profitability.
• The overall payback periods are shortened by postponing replacement of
depreciated plant and equipment. This policy may do more harm than good to
the production process.

NET PRESENT VALUE

The Net Present Value is defined as the different between the present value of the cost
inflows and the present value of the cash outflows. In other words, a project’s net
present value, usually computed as of the time of the initial investment is the present
value of project’s cash flows from operations and disinvestment less the amount of
the initial investment. For instance, in computing the projects net present value, the
cash flows occurring at different points in time are adjusted for the time value of
money usinrate that is the minimum rate of return required for the project to be
acceptable. Projects with positive net present values (or values at least equal to zero)
are acceptable and project negative net present values are unacceptable. In case the
project is rejected, it is rejected because cash flows will also be negative.

NPV is used in capital budgeting to analyze the profitability of an investment or

project and it is sensitive to the reliability of future cash flows that the investment or
project will yield. For instance, the NPV compares the value of the dollar today to the
value of that same dollar in the future taking inflation and returns into account.

The NPV is computed as follows:

n CFt
NPV = ∑
t = 0 (1 + k) t

Higher NPVs are more desirable. The specific decision rule for NPV is as follows:

NPV < 0, reject project

NPV > 0, accept project

Project L:

0 1 2 3

-100.00 10 60 80
9.09

49.59

60.11
NPVL = Rs. 18.79

NPVS =Rs. 19.98

• If the projects are independent, accept both.

• If the projects are mutually exclusive, accept Project S since NPVS >
NPVL.
Note: NPV declines as k increases, and NPV rises as k decreases.

Advantages of net present value (NPV)

• It is considered to be conceptually superior to other methods.

• It does not ignore any period in the project life or any cash flows.
• It is mindful of the time value of money.
• It is easier to apply NPV than IRR.
• It prefers early cash flows compared to other methods.

Disadvantages of net present value (NPV)

• The NPV calculations unlike IRR method, expects the management to know
the true cost of capital.
• NPV gives distorted comparisons between projects of unequal size or unequal
economic life. In other to overcome this limitation, NPV is used with the
profitability index.

Internal rate of return (IRR)

The internal rate of return (IRR) is the discount rate often used in capital budgeting
that makes the net present value of all cash flows from a certain project equal to zero.
This in essence means that IRR is the rate of return that makes the sum of present
value of future cash flows and the final market value of a project (or investment)
equals its current market value. The higher a project’s internal rate of return, the more
desirable it is to undertake the project. As a result, it is used to rank several
prospective projects a firm is considering. As such the internal rate of return provides
a simple hurdle, whereby any project should be avoided if the cost of capital exceeds
this rate. IRR is also referred to as economic rate of return (ERR). A simple decision
making criteria can be to accept a project if its internal rate of return exceeds the cost
of capital and rejected if the IRR is less than the cost of capital. Although it should be
noted that the use of IRR could result in a number of complexities such as a project
with multiple IRRs or no IRR and also that IRR neglects the size of the project and
assumes that cash flows are reinvested at a constant rate. Internal rate of return is the
flip side of net present value (NPV), where NPV is discounted value of a stream of
cash flows, generated from investment. IRR computes the break-even rate of return
showing the discount rate.

IRR can be calculated using the following formula:

n CFt
IRR : ∑ = $0 = NPV .
t = 0 (1 + IRR ) t

Project L:

0 1 2 3

−100.00 10 60 80
8.47 18.1%
43.02 18.1%
48.57 18.1%
0.06 ≈ 0

IRRL = 18.1%
IRRS = 23.6%

• If the projects are independent, accept both because IRR > k.

• If the projects are mutually exclusive, accept Project S since IRRS > IRRL.

Note: IRR is independent of the cost of capital.

k NPVL NPVS
 0% $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5

Advantages of internal rate of return (IRR)

• It is considered to be straight forward and easy to understand.

• It recognizes the time value of money.
• It is uses cash flows.

Disadvantages of internal rate of return (IRR)

• It often gives unrealistic rates of return and unless the calculated IRR gives a
reasonable rate of reinvestment of future cash flows, it should not be used as a
yardstick to accept or reject a project.
• It may give different rates of return; in essence it entails more problems than a
practitioner may think.
• It could be quite misleading if there is no large initial cash outflow.
 WHY THE NPV AND IRR SOMETIMES SELECT
DIFFERENT PROJECTS
When comparing two projects, the use of the NPV and the IRR methods may give
different results. A project selected according to the NPV may be rejected if the IRR
method is used.
Suppose there are two alternative projects, X and Y. The initial investment in
each project is $2,500. Project X will provide annual cash flows of $500 for the next
10 years. Project Y has annual cash flows of Rs.100, 200, 300, 400, 500, 600, 700,
800, 900, and 1,000 in the same period. Using the trial and error method explained
before, you find that the IRR of Project X is 17% and the IRR of Project Y is around
13%. If you use the IRR, Project X should be preferred because its IRR is 4% more
than the IRR of Project Y. But what happens to your decision if the NPV method is
used? The answer is that the decision will change depending on the discount rate you
use. For instance, at a 5% discount rate, Project Y has a higher NPV than X does.
But at a discount rate of 8%, Project X is preferred because of a higher NPV.
The purpose of this numerical example is to illustrate an important distinction:
The use of the IRR always leads to the selection of the same project, whereas project
selection using the NPV method depends on the discount rate chosen.

PROJECT SIZE AND LIFE

There are reasons why the NPV and the IRR are sometimes in conflict: the size and
life of the project being studied are the most common ones. A 10-year project with an
initial investment of $100,000 can hardly be compared with a small 3-year project
costing $10,000. Actually, the large project could be thought of as ten small projects.
So if you insist on using the IRR and the NPV methods to compare a big, long-term
project with a small, short-term project, don’t be surprised if you get different
selection results. (See the equivalent annual annuity discussed later for a good way to
compare projects with unequal lives.)

DIFFERENT CASH FLOWS

Furthermore, even two projects of the same length may have different patterns of cash
flow. The cash flow of one project may continuously increase over time, while the
cash flows of the other project may increase, decrease, stop, or become negative.
These two projects have completely different forms of cash flow, and if the discount
rate is changed when using the NPV approach, the result will probably be different
orders of ranking. For example, at 10% the NPV of Project A may be higher than that
of Project B. As soon as you change the discount rate to 15%, Project B may be more
attractive.
 PROFITABILITY INDEX (PI)
The profitability index, or PI, method compares the present value of future cash
inflows with the initial investment on a relative basis. Therefore, the PI is the ratio
of the present value of cash flows (PVCF) to the initial investment of the project.

PVCF
PI =
Initial investment

In this method, a project with a PI greater than 1 is accepted, but a project is

rejected when its PI is less than 1. Note that the PI method is closely related to the
NPV approach. In fact, if the net present value of a project is positive, the PI will
be greater than 1. On the other hand, if the net present value is negative, the
project will have a PI of less than 1. The same conclusion is reached, therefore,
whether the net present value or the PI is used. In other words, if the present value
of cash flows exceeds the initial investment, there is a positive net present value
and a PI greater than 1, indicating that the project is acceptable. PI is also know as
a benefit/cash ratio.

Project L

0 10% 1 2 3

-100.00 10 60 80
PV1 9.09
PV2 49.59
PV3 60.11
118.79
PV of cash flows
PI =
initial coast

118 .79
= =1.10
100

• Accept project if PI > 1.

• Reject if PI < 1.0
 ACCOUNTING RATE OF RETURN
Various proposals are ranked in order to rate of earnings on the investment in the
projects concerned. The project which shows highest rate of return is selected and
others are ruled out.

The Accounting rate of Return is found out by dividing the average income after
taxed by the average investment, i.e., average net value after depreciation. The
accounting rate of return, thus, is an average rate and can be determined by the
following equation.

Accounting Rate of Return (ARR) = Average income / Average investment

There are two variants of the accounting rate of return :

(a) Original Investment Method, and
(b) Average Investment Method.

(a) Original Investment Method.

Under this method average annual earnings or profits over the life of the project
are divided by the total outlay of capital project, i.e., the original investment. Thus
ARR under this method is the ratio between average annual profits and original
investment established. We can express the ARR in the following way.

ARR= Average annual profits over the life of the project / Original Investment

(b) Average Investment Method: Under average investment method, average

annual earnings are divided by the average amount of investment. Average
investment is calculated, by dividing the original investment by two or by a figure
representing the mid-point between the original outlay and the salvage of the
investment. Generally accounting rate of return method is represented by the
average investment method.

Advantages of Accounting Rate of Return Method

• It is very simple to understand and use.

• Rate of return may readily be calculated with the help of accounting data.
• They system gives due weight age to the profitability of the project if based
on average rate of Return. Projects having higher rate of Return will be
accepted and are comparable with the returns on similar investment derived
by other firm.
• It takes investments and the total earnings from the project during its life
time.

Disadvantages of Return Method

• It uses accounting profits and not the cash-inflows in appraising the projects.
• It ignores the time-value of money which is an important factor in capital
expenditure decisions. Profits occurring in different periods are valued
equally.
• It considers only the rate of return and not the length of project lives.
• The method ignores the fact that profits can be reinvested.
• The method does not determine the fair rate of return on investment. It is left
at the discretion of the management. So, use of arbitrary rate of return cause
serious distortion in the selection of capital projects.
• The method has different variants, each of which produces a different rate of
return for one proposal due to the diverse version of the concepts of
investment and earnings.
 BIBLIOGRAPHY

WEBSITES USED:

• www.bth.se.pdf
• www.studyfinance.com
• www.zenwealth.com
• www.wikipedia.org
• www.moneyterms.co.uk/arr
• www.mbaknol.com