Capital Budgeting

Introduction :
 The capital budgeting decisions are related to the allocation of investible
funds to different long term assets.
 Lump sum funds are invested in the initial stages of a projects and the returns
are expected over a long period.
 The capital budgeting decision involve the entire process of decision making
relating to acquisition of long term assets whose return are expected to arise
over a period beyond one year.
 Some of the capital budgeting decisions may be to buy land, building or
plants; or to undertake a program on R&D of a product, to diversify into a
new product line; a promotional campaign , etc.
 Some of the decisions may directly affect the profit of the firm, e.g. launching
a new product, whereas some decisions may affect the profit by reducing the
costs, e.g. replacing an existing machine by a more efficient one.
 In both cases the decision once taken set the profit line of the firm for several
years.
 In any growing concern, capital budgeting is more or less a continuous
process and it is carried out by different functional areas of management such
as production, marketing, engineering, financial management, etc.
 The role of finance manager in the capital budgeting lies in the process of
critical and in-depth analysis and evaluation of various alternative proposals
and then to select one of these.
 The basic objective of financial management is to maximize the wealth of
shareholders, therefore the objective of capital budgeting is to select those
long term investment projects that are expected to maximum contribution to
the wealth of shareholders in the long run.

 Features:
a) Long term effects
b) Substantial commitments
c) Irreversible decisions
d) Affect the capacity and strength to compete

 Problems and Difficulties in Capital Budgeting

a) Future uncertainty
b) Time element
c) Measurement problem
Types of Capital Budgeting Decisions
 From the point of view of firm’s existence
a) New firm
b) Existing firm
i. Replacement and modernization decision
ii. Expansion
iii. Diversification

 From the point of view of decision situation

a) Mutually exclusive decisions
b) Accept- reject decisions
c) Contingent decisions
Capital budgeting decisions and funds availability:
 Conditions to be fulfilled:
i. The cost of the project does not exceed the funds available
ii. The benefits expected from the project are more than the cost.

The situation where the firm is not able to finance all the profitable
investment opportunities is known as capital rationing. If the total funds
required by the profitable opportunities at any particular point in time
exceed the available funds with the firm, then the firm is said to be operating
under conditions of capital rationing.
The capital rationing implies that a firm is unable to unwilling to procure the
additional funds needed to undertake all the capital budgeting proposals
before it.
The problem faced by a finance manager in this situation is as to how to
allocate the available scarce capital among various proposal. Out of different
independent proposals (accept-reject decisions), only those maybe accepted
in order of priority which entails the total cost within the limit of available
fund. In case of mutually exclusive proposals, the cost of selected proposals,
must not exceed the available fund.
Capital budgeting decisions: assumptions and procedure
 Assumptions:
1) Certainty with respect to cost and benefits
2) Profit motive
3) No capital rationing

 The finance manager should use the best information and techniques
available to take the capital budgeting decision. In the process, the finance
manager may take the following steps:
1. Estimation of costs and benefits of a proposal
2. Estimation of required rate of return
3. Using the capital budgeting decision criterion.
Estimation of costs and benefits of a proposal
 Usually two alternatives are suggested for measuring the cost and benefits of
a proposal, i.e. the accounting profits and cash flows.
1. Accounting Profit: the benefits of a proposal may be measured in terms of
the profit generated by it or in terms of a measure based on accounting
profits. The accounting profit as a measure of benefits is discarded on the
following grounds:
a) The accounting profit is affected to a large extent by the accounting policies
being followed by the firm. e.g. depreciation policy, inventory policy etc.
b) Accounting profit is affected by so many non-cash items such as
depreciation, writing off the accumulated losses etc. the balancing profit
figure after these item is not a true measure of benefits contributed by a
proposal.
c) The accounting profit measures the profit of any particular year in terms of
money of that year. However, the cost and benefits of a proposal may occur
over a period of number of years. The benefits if measured in terms of
accounting profit, are expressed in monies of different time periods and are
not comparable. Similarly if two mutually exclusive projects have unequal
economic lives, then the accounting profits emerging over different periods
are not comparable.
d) Accounting profit is based on accrual concepts. E.g. the sales revenue and
expenses, both are recorded for the period in which they occur instead of
the period in which they are actually receive d or paid.
2. Cash flows: in capital budgeting, the cost and benefits of a proposal are
measured in terms of cash flows. The term cash flow is used to describe the
cash oriented measure of return generated by the proposal. The costs are
denoted as cash outflows whereas the benefit are denoted as cash inflows.
The cash outflows and inflows are used to denote the cost and benefit of a
proposal.
Cash flows associated with a proposal may be classified into (i) original or
Initial cash outflow, (ii) subsequent cash inflows and outflows and (iii)
terminal cash flow
1) Original or Initial cash outflow: this initial cash outflow is needed to get a
project operational. In most of the capital budgeting proposal, the initial cost
of the project , i.e. the initial investment cost is the cash outflow occurring in
the initial stages of the projects. It reflects the cash spent to acquire the
asset.
a) Installation cost
b) Sunk cost
c) Opportunity cost
d) Additional working capital requirement
2. Subsequent Inflows and Outflows: the original investment cost or the initial
cash outflow of the proposal is expected to generate a series of cash inflows
in the form of cash profits contributed by the project. These cash flows maybe
same every year throughout the life of the project or may vary from one year
to the other. The timings of the inflows may also be different. These cash
inflows generated during the life of the project may also be called operating
cash flows.
Sometimes the project require subsequent cash outflows also in the form of
periodic repairs etc. . All these cash inflows and outflows are to be considered
for the capital budgeting decision. Similarly, if additional working capital is
required in any of the subsequent years, then it should be considered as a
outflow for that year. However, if the working capital is released in any of the
subsequent years, then it should be considered as cash inflow for that year.
its important to recognize the timing of these subsequent cash inflows and
outflows, as these are to be adjusted for the time value of money. The more
quickly and earlier, the cash inflows occur, the more valuable these are.
3. Terminal cash inflows: the cash inflows for the last year will also include the
terminal cash flows in addition to annual cash inflows. Two common terminal
cash inflows: (i) salvage or scrap value of the project realizable at the end of
the economic life of the project or at the time of its termination is the cash
inflow for the last year. (ii) working capital which was invested (tied up) in
the beginning will no longer be required as the project is being terminated.
This WC released will be available back to the firm and is considered as a
terminal cash inflow.

• Depreciation, Non- cash items and cash flows:

Every capital budgeting decision should consider the depreciation tax shield
i.e. reduction in tax liability as a result of depreciation. The depreciation is
added back to the figure of profit after taxes to arrive at the cash inflows
from the project. Similarly, any other non cash expense which has already
been deducted to arrive at the figure of profit after tax, is added back to
ascertain the cash inflows even though they may not provide any tax benefit
to the firm. E.g. amortization of goodwill is not tax deductible but it
depressed the reported income and hence is added back.
• Taxation and cash flows:
the cash flows related to the capital budgeting decisions are the after tax cash
flows only. The after tax cash flows resulting from a project are in fact the
relevant incremental cash flows. These after tax cash flows would not occur if
the project is not undertaken.
The annual cash inflow from a project will result in increase in the taxable
profit. So the cash flow from a project would also affect the tax liability of the
firm. The increase in tax liability will be equal to the cash inflow multiplied by
the tax rate. Or the net cash inflow will be equal to cash inflow (before tax)
multiplied by (1- tax rate). Therefore the relevant cash flow for a capital
budgeting decision is the cash flow net of incremental tax liability.
Capital budgeting decisions should be in after tax terms only.
 Question 1:
• N Ltd. Is considering an investment proposal for which the relevant information is
as follows:

Purchase price of the new asset Rs.10,00,000

Installation cost 2,00,000
Increase in WC in year zero 2,50,000
Scrap value of the new asset after 4 years 3,50,000
Revenues from new asset (annual) 21,50,000
Cash expenses of the new asset (annual ) 9,50,000
Current book value (old asset) 4,00,000
Present scrap value (old asset) 5,00,000
Revenue from old asset (annual 19,25,000
Cash expenses on old asset (annual) 11,25,000
Planning period 4 years

• Depreciation on new asset:92% of the cost is to be depreciated in the ratio of

5:8:6:4 over 4 years. Existing asset is depreciated @ Rs.1,00,000 p.a Tax rate 40%
Techniques of evaluation:

Capital budgeting techniques

Traditional or Time adjusted, or

non-discounting discounted cash flows

Net present value

Pay back period
Profitability Index
Accounting rate of return
Internal rate of
return

Terminal value
 Traditional or non-discounting techniques
• Payback period: is defined as the no. of years required for the proposal’s
cumulative cash inflows to be equal to its cash outflows. In other words, the
payback period is the length of time required to recover the initial cost of the
project.
• Computation of payback period:
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. E.g. a proposal requires a cash outflow of Rs. 1,00,000
and is expected to generate cash inflows of Rs.20,000 p.a. for 6 years. In this
case 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.
b) When the cash inflows are unequal: incase the cash inflows from the proposal
are not in the annuity form then the cumulative cash inflows are used to
compute the payback period. E.g. a proposal requires a cash outflow of
Rs.20,000 and is expected to generate cash inflows are 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.
The following case is also a possibility when the cumulative cash inflows are
not exactly equal to proposal’s cash outflow. In the case above case if the cash
outflow is only Rs.18,500 then payback period will be calculated as:

Year Annual CF Cumulative CF

1 Rs.8,000 Rs.8,000
2 6,000 14,000
3 4,000 18,000
4 2,000 20,000
Required cumulative cash inflows is Rs.18,500. At the end of the 3rd year
cumulative cash inflows is Rs.18,000. For the 4th year the annual cash inflow is
Rs.2,000. cash flow of Rs.500 only during 4th year will be sufficient to make
the total cumulative cash inflows to be Rs.18,500. the precise period required
to earn the cash inflow of Rs.500 during 4th year can be calculated as: (3 yrs +
Rs.500/Rs.2,000) = 3.25 years.
• 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 maybe increased to the next full
year i.e.4 years.
• The decision rule: if the payback period is more than the target period, then the
proposal should be rejected otherwise accepted if the payback period is less
than the target period.
• payback period reciprocal = (1/payback period) *100
• For e.g. if a proposal has a payback period of 4 years then its payback reciprocal
is 25%. The higher the payback period reciprocal (and hence lower the payback
period ) the more worth while the proposal is.
Question :
• ITC Ltd. Has decided to purchase a machine to augment the company’s installed
capacity to meet the growing demand of its products. There are 3 machines
under consideration. Details below: corporate income rate @ 40%

Machine 1 Machine 2 Machine 3

Initial investment required Rs.3,00,000 Rs.3,00,000 Rs.3,00,000
Estimated annual sales 5,00,000 4,00,000 4,50,000
Cost of production (estimated)
Direct materials 40,000 50,000 48,000
Direct labor 50,000 30,000 36,000
Factory overheads 60,000 50,000 58,000
Administration costs 20,000 10,000 15,000
Selling &distribution costs 10,000 10,000 10,000
• The economic life of machine 1 is 2 years, while it is 3 years for the other two.
The scrap values are Rs.40,000, Rs.25,000and Rs.30,000 respectively
• Find out the most profitable investment based on pay back period.
• Accounting rate of return : is based on the accounting concept of return on
investment or rate of return. The ARR maybe 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:
ARR = average annual profit (after tax) 100
average investment in the project
• The calculation of ARR can be with reference to equal annual profits and
unequal annual profits as follows:
• Equal profits: incase the expected profits (after tax) generated by a project are
equal for all the years then 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:
ARR = annual profit (after tax) 100
average investment in the project
• Unequal profits: if the project is expected to generate unequal profits or uneven
stream of profits over different years, then the ARR would 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:
ARR = average annual profits (after tax) 100
average investment in the project

• Avg. inv = ½ (initial cost +installation expenses – salvage value) + salvage value
• E.g. ABC Ltd. Takes a project costing Rs.1,20,000 with an expected life of 5 years
and the salvage value of Rs.20,000. average investment in the proposal is :
Avg. inv = ½ (1,20,000- 20,000) +20,000
=Rs.70,000
• The average investment can also be calculated as:

Year Opening BV Closing BV Average BV

1 Rs.1,20,000 1,00,000 1,10,000
2 1,00,000 80,000 90,000
3 80,000 60,000 70,000
4 60,000 40,000 50,000
5 40,000 20,000 30,000
3,50,000
• Average investment = Rs.3,50,000/5 = Rs.70,000
• Additional working capital: sometimes the project may require additional
working capital for its smooth operations. Though this additional working
capital will be released back, when the proposal may 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 be added to the average investment calculated
as above.
• ARR = ½ (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.20,000 and is expected to generate annual average profit (after
tax) of Rs.18,000, then the average investment and ARR can be calculated as
follows:
• average investment = ½ (1,20,000-20,000) +20,000+20,000
= Rs.90,000
ARR = annual profit (after tax) 100
average investment in the project
= 18,000 100 =20%
90,000

• Decision rule.
Discounted cash flows or time adjusted techniques

• The discounted cash flow techniques or the time adjusted cash flow techniques,
as against the traditional techniques are based upon the fact that the cash flows
occurring at different points in time are not having the same economic worth. In
order to make these cash flows equal in economic worth these must be
discounted with reference to the time gap between different cash flows and a
predetermined discount rate .

• The methods which involve 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.
• Net Present Value Method: 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 cash outflows associated with a proposal. The figure can be positive
or negative depending on whether there is a net inflow or outflow from the
project.
• The rate of discount used to discount the cash flows should reflect the
minimum return requirement that will leave the shareholders as well as before ,
while taking the advantage of financial leverage. The rate so employed is the
overall cost of capital, which takes into account shareholders expectations,
business risk and the leverage.
• Calculation of NPV:
NPV = excess of PV of inflows over PV of outflows.
NPV = PV of cash inflows – PV of cash outflows.
• E.g.:

Time Cash flows (Rs.) PVF @10% PV (Rs.)

T0 -1,70,000 1.00 -1,70,000
T1 20,000 .909 18,180
T2 50,000 .826 41,300
T3 60,000 .751 45,060
T4 40,000 .683 27,320
T5 75,000 .621 46,575
Total 8,435

• The total cash inflow for the year T5 is Rs.75,000 (consisting of annual inflow of
Rs.30,000 + working capital released of Rs.20,000 + salvage value of Rs.25,000).

• Decision Rule
Profitability Index (PI)
• 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 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 project are assumed to be same.
In the first case, the NPV is much larger fraction (Rs.1000/10,000) then what it
is in the second case, i.e. (Rs.1,000/25,000), which makes the first proposal
more attractive .
• The PI technique is a formal way of expressing this cost/benefit relationship.
• PI is a variant of NPV technique, is also known as Benefit-cost ratio, or present
value index.
• PI = Total Present value of cash inflows
Total Present value of cash outflows
• E.g. a firm is evaluating a proposal which requires a cash outlay of Rs.40,000 a present
and of Rs.20,000 at the end of third year 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 discount rate of 10%, calculate PI.

YEAR CASH FLOWS (Rs.) PVF (10%,N) PV(Rs.)

0 -40,000 1.00 -40,000
1 20,000 .909 18,180
2 40,000 .826 33,040
3 -20,000 .751 -15,020
4 20,000 .683 13,660

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

• Present value of cash inflows = Rs.18,180 +33,040 +13,660 = 64,880
PI = Rs.64,880 = 1.18
Rs.55,020
• The PI of 1.18 can be interpreted as: in present worth terms, for every Re.1 invested,
the proposal is expected to give a return of Rs.1.18.
• Decision rule:
 Internal rate of return
• 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 equate the present value of cash inflows with the
present value of cash outflows.
• IRR is also known as Marginal Rate of Return or Time Adjusted Rate of Return.
• Future cash flows are discounted in such a way that their total present value is just
equal to the present value of total cash outflows.
• Time schedule of occurrence of future cash flows is known but the rate of discount is
not known.
• The rate of discount which equates the present value of future cash inflows with the
present value of outflows, is known as the IRR.
• When cash flows are equal: use interpolation
• When cash flows unequal: e.g. Suppose a fir 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 :
 Year Cash inflow (CF) Weight (W) CF *W

1 Rs. 40,000 5 Rs.2,00,000

2 60,000 4 2,40,000
3 50,000 3 1,50,000
4 50,000 2 1,00,000
5 40,000 1 40,000
Total 15 7,30,000
•Weighted average = 7,30,000/ 15 = Rs.48,667
•The weights are stated in reverse order in order to give maximum weight to the earliest
cash flow.
•Consider the weighted average as the annuity of cash inflows and find out the payback
period. For the above case, the PVAF(r,5) period is Rs.1,60,000/48,667 = 3.228
•Search for a value closest to 3.288 in 5 years row of the PVAF table. The closest figure
given in the 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%.
•Find out the NPV of the proposal for both of these approximate rates .
Year Cash inflows PVF (16%,n) PVF (15%,n) PV (16%) PV (15%)

1 Rs. 40,000 .862 .870 Rs.34,480 Rs.34,800

2 60,000 .743 .756 44,580 45,360
3 50,000 .641 .658 32,050 32,900
4 50,000 .552 .572 27,600 28,600
5 40,000 .476 .497 19,040 19,800
Total 1,57,750 1,61,540
•At 16%, NPV = Rs. 1,57,750 – Rs.1,60,000 = Rs.-2,250
•At 15%, NPV = Rs.1,61,540 – Rs.1,60,000 = Rs.1,540

•By interpolating BETWEEN 15% AND 16%, find out the exact IRR:
IRR = 15% 1,540 (16-15)
1,540 – (-2,250)
IRR of the project is 15.40%

•Decision Rule.