CAPITAL BUDGETING

Significance of Capital Budgeting

(a) Long-term Applications: Implies that capital budgeting decisions are helpful for an
organization in the long run as these decisions have a direct impact on the cost structure and
future prospects of the organization. In addition, these decisions affect the organization’s
growth rate. Therefore, an organization needs to be careful while making capital decisions as
any wrong decision can prove to be fatal for the organization. For example, over-investment
in various assets can cause shortage of capital to the organization, whereas insufficient
investments may hamper the growth of the organization.
(b) Competitive Position of an Organization: Refers to the fact that an organization can
plan its investment in various fixed assets through capital budgeting. In addition, capital
investment decisions help the organization to determine its profits in future. All these
decisions of the organization have a major impact on the competitive position of an
organization.
(c) Cash Forecasting: Implies that an organization needs a large amount of funds for its
investment decisions. With the help of capital budgeting, an organization is aware of the
required amount of cash, thus, ensures the availability of cash at the right time. This further
helps the organization to achieve its long-term goals without any difficulty.
(d) Maximization of Wealth: Refers to the fact that the long-term investment decisions of an
organization helps in safeguarding the interest of shareholders in the organization. If an
organization has invested in a planned manner, shareholders would also be keen to invest in
the organization. This helps in maximizing the wealth of the organization. Capital budgeting
helps an organization in many ways. Thus, an organization needs to take into consideration
various aspects.
Capital Budgeting Process

The extent to which the capital budgeting process needs to be formalised and systematic
procedures established depends on the size of the organisation; number of projects to be
considered; direct financial benefit of each project considered by itself; the composition of
the firm's existing assets and management's desire to change that composition; timing of
expenditures associated with the projects that are finally accepted.
(i) Planning: The capital budgeting process begins with the identification of potential
investment opportunities. The opportunity then enters the planning phase when the
potential effect on the firm's fortunes is assessed and the ability of the management of
the firm to exploit the opportunity is determined. Opportunities having little merit are
rejected and promising opportunities are advanced in the form of a proposal to enter
the evaluation phase.
(ii) Evaluation: This phase involves the determination of proposal and its investments,
inflows and outflows. Investment appraisal techniques, ranging from the simple
payback method and accounting rate of return to the more sophisticated discounted
cash flow techniques, are used to appraise the proposals. The technique selected
should be the one that enables the manager to make the best decision in the light of
prevailing circumstances.
(iii) Selection: Considering the returns and risks associated with the individual projects as
well as the cost of capital to the organisation, the organisation will choose among projects so
as to maximise shareholders’ wealth.
(iv) Implementation: When the final selection has been made, the firm must acquire the
necessary funds, purchase the assets, and begin the implementation of the project.
(v) Control: The progress of the project is monitored with the aid of feedback reports. These
reports will include capital expenditure progress reports, performance reports comparing
actual performance against plans set and post completion audits.
(vi) Review: When a project terminates, or even before, the organisation should review the
entire project to explain its success or failure. This phase may have implication for firms
planning and evaluation procedures. Further, the review may produce ideas for new proposals
to be undertaken in the future.
Types of Capital Investment Decisions
Generally capital investment decisions are classified in two ways. One way is to classify
them on the basis of firm’s existence. Another way is to classify them on the basis of decision
situation.
On the basis of firm’s existence: The capital budgeting decisions are taken by both newly
incorporated firms as well as by existing firms. The new firms may be required to take
decision in respect of selection of a plant to be installed. The existing firm may be required to
take decisions to meet the requirement of new environment or to face the challenges of
competition. These decisions may be classified as follows:
(i) Replacement and Modernisation decisions: The replacement and modernisation
decisions aim at to improve operating efficiency and to reduce cost. Both replacement and
modernisation decisions are called cost reduction decisions.
(ii) Expansion decisions: Existing successful firms may experience growth in demand of
their product line. If such firms experience shortage or delay in the delivery of their products
due to inadequate production facilities, they may consider proposal to add capacity to existing
product line.
(iii) Diversification decisions: These decisions require evaluation of proposals to diversify
into new product lines, new markets etc. for reducing the risk of failure by dealing in
different products or by operating in several markets.
Both expansion and diversification decisions are called revenue expansion decisions.

On the basis of decision situation:

(i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if two or
more alternative proposals are such that the acceptance of one proposal will exclude the
acceptance of the other alternative proposals. For instance, a firm may be considering
proposal to install a semi-automatic or highly automatic machine. If the firm installs a semi-
automatic machine it excludes the acceptance of proposal to install highly automatic
machine.
(ii) Accept-reject decisions: The accept-reject decisions occur when proposals are
independent and do not compete with each other. The firm may accept or reject a proposal on
the basis of a minimum return on the required investment. All those proposals which give a
higher return than certain desired rate of return are accepted and the rest are rejected.
(iii) Capital Rationing Decisions - is normally applied to situations where the supply of
funds to the firm is limited in some way. As such, the term encompasses many different
situations ranging from that where the borrowing and lending rates faced by the firm differ, to
that where the funds available for investments are strictly limited. In other words, it occurs
when a firm has more acceptable proposals than it can finance. At this point, the firm ranks
the projects from highest to lowest priority and, as such, a cut-off point is considered.
Naturally, those proposals which are above the cut-off point will be accepted and those which
are below the cut-off point are rejected, i.e., ranking is necessary to choose the best
alternatives.

Depreciation Tax Shield

Depreciation is not a cash outflow but for income tax depreciation can be reduced from profit
and compute tax.
Depreciation tax shield is the tax benefit or tax saved that we derive from deducting
depreciation from profit. It is the reduction in tax liability that results from admissibility of
depreciation expense as a deduction under tax laws.
In capital budgeting calculations, net operating cash flows are reduced by the amount of
depreciation tax shield available each year. The Net Present Value and Internal Rate of
Return are calculated using the after-tax cash flows which are determined using either of the
following formula:
CF = (CI − CO − D) × (1 − t) + D
CF = CI − CO − (CI − CO − D) × t
Where CF is the after-tax operating cash flow, CI is the pre-tax cash inflow, CO is pre-tax
cash outflow, t is the tax rate and D is the depreciation expense.
These two equations are essentially the same. The expression (CI – CO – D) in the first
equation represents the taxable income which when multiplied with (1 – t) yields after-tax
income. Depreciation is added back because it is a non-cash expense and we need to work
with after-tax cash flows (instead of income). The second expression in the second equation
(CI – CO – D) × t calculates depreciation tax shield separately and subtracts it from pre-tax
net cash flows (CI – CO).
Problem: ABC Ltd is evaluating the purchase of a new project with a depreciable base of
₹1,00,000; expected economic life of 4 years and change in earnings before taxes and
depreciation of ₹45,000 in year 1, ₹30,000 in year 2, ₹25,000 in year 3 and ₹35,000 in year
4. Assume straight-line depreciation and a 20% tax rate. You are required to compute
relevant cashflows.
PAY-BACK PERIOD (PBP)
The Pay Back Period of an investment is the length of time required for the cumulative total
cash inflows from the investment to equal the initial cash outlay. At that point of time the
investor has recovered the money invested in the project.
Payback periods are an integral component of capital budgeting and should always be
incorporated when analyzing the value of projected investments and projects. The payback
period can prove especially useful for companies that focus on smaller investments, mainly
because smaller investments usually don’t involve overly complex calculations. Payments
made at a later date still have an opportunity cost attached to the time that is spent, but the
payback period disregards this in favor of simplicity.
Computation of PBP
The first step in calculating PBP is determining the total initial capital investment.
The second step is estimating the annual expected after tax net cash inflows over the useful
life of the investment.
The payback period can be calculated in two different situations
a) When annual cashflow is uniform
Initial Investment
PBP =
Constant Annual Cash inflows
b) When annual cashflows are not uniform
The Payback period = the point in time at which cash flows turn from negative to positive
Payback period = change in cash flow required to reach zero/total cash flow in year + year
in which cash flows turn from negative to positive
Pay Back Period
Advantages
 It is easy to compute.
 It is easy to understand as it provides a quick estimate of the time needed for the
organization to recoup the cash invested.
 The length of the payback period can also serve as an estimate of a project’s risk; the
longer the payback period, the riskier the project as long-term predictions are less
reliable. In some industries with high obsolescence risk like software industry or in
situations where an organization is short on cash, short payback periods often become
the determining factor for investments.
Limitations
 It ignores the time value of money. As long as the payback periods for two projects
are the same, the payback period technique considers them equal as investments, even
if one project generates most of its net cash inflows in the early years of the project
while the other project generates most of its net cash inflows in the latter years of the
payback period.
 A second limitation of this technique is its failure to consider an investment’s total
profitability; it only considers cash flows from the initiation of the project until its
payback period and ignores cash flows after the payback period.
  Lastly, use of the payback period technique may cause organizations to place too
much emphasis on short payback periods thereby ignoring the need to invest in long-
term projects that would enhance its competitive position.
Problem:
Project A Project B
Initial investment ₹ 100,000 ₹100,000
Cash inflows
Year 1 ₹45,000 ₹30,000
Year 2 ₹40,000 ₹30,000
Year 3 ₹35,000 ₹44,000
Year 4 ₹30,000 ₹46,000
The depreciation is ₹20,000 per year.
The residual value for both projects is the same, ₹20,000.
CALCULATE PBP
Payback Reciprocal
It is the reciprocal of payback period. A major drawback of the payback period method of
capital budgeting is that it does not indicate any cut off period for the purpose of investment
decision. It is, however, argued that the reciprocal of the payback would be a close
approximation of the internal rate of return if the life of the project is at least twice the
payback period and the project generates equal amount of the annual cash inflows. In
practice, the payback reciprocal is a helpful tool for quickly estimating the rate of return of a
project provided its life is at least twice the payback period.
The payback reciprocal can be calculated as follows:
Average annual cash in flow
× 100
Initial investment
Problem: Suppose a project requires an initial investment of ₹20,000 and it would give
annual cash inflow of ₹4,000. The useful life of the project is estimated to be 5 years.
Calculate Payback Reciprocal.

Accounting Rate of Return (ARR)

The accounting rate of return of an investment measures the average annual net income of the
project (incremental income) as a percentage of the investment.
Average annual net income
Accounting rate of return (ARR) = × 100
Investment
The numerator is the average annual net income generated by the project over its useful life.
The denominator can be either the initial investment or the average investment over the
useful life of the project.
Some organizations prefer the initial investment because it is objectively determined and is
not influenced by either the choice of the depreciation method or the estimation of the
salvage value. Either of these amounts is used in practice but it is important that the same
method be used for all investments under consideration.
The accounting rate of return is quite useful for providing a clear picture of a project’s
potential profitability, satisfying a firm’s desire to have a clear idea of the expected return on
investment. This method also acknowledges earnings after tax and depreciation, making it
effective for benchmarking a firm’s current level of performance.
Advantages
 This technique uses readily available data that is routinely generated for financial
reports and does not require any special procedures to generate data.
 This method may also mirror the method used to evaluate performance on the
operating results of an investment and management performance. Using the same
procedure in both decision-making and performance evaluation ensures consistency.
 Lastly, the calculation of the accounting rate of return method considers all net
incomes over the entire life of the project and provides a measure of the investment’s
profitability.
Limitations
 The accounting rate of return technique, like the payback period technique, ignores
the time value of money and considers the value of all cash flows to be equal.
 The technique uses accounting numbers that are dependent on the organization’s
choice of accounting procedures, and different accounting procedures, e.g.,
depreciation methods, can lead to substantially different amounts for an investment’s
net income and book values.
 The method uses net income rather than cash flows; while net income is a useful
measure of profitability, the net cash flow is a better measure of an investment’s
performance.
 Furthermore, inclusion of only the book value of the invested asset ignores the fact
that a project can require commitments of working capital and other outlays that are
not included in the book value of the project.
COMPUTATION OF ARR
Step 1: Calculate Annual Profit
Annual Profit = Net Cash Inflow - Depreciation
Step 2: Calculate Average Profit
Average Profit = Total Profits / Number of Years
Step 3: Calculate Average Capital Invested
 Average capital invested = {(Initial Cost - Residual Value) / 2} + Salvage Value +
Net Working Capital
Step 4: Calculate ARR
ARR = Average Profit/Average Capital Invested × 100
Problem:
Project A Project B
Initial investment ₹ 100,000 ₹100,000
Cash inflows
Year 1 ₹45,000 ₹30,000
Year 2 ₹40,000 ₹30,000
Year 3 ₹35,000 ₹44,000
Year 4 ₹30,000 ₹46,000
The depreciation is ₹20,000 per year.
The residual value for both projects is the same, ₹20,000.
CALCULATE ARR

NET PRESENT VALUE (NPV)

Net present value (NPV) is used for analyzing the projected returns for a potential investment
or project. The net present value represents the difference between the current value of
money flowing into the project and the current value of money being spent. The value can be
calculated as positive or negative, with a positive net present value implying that the earnings
generated by a project or investment will exceed the expected costs of the venture and should
be pursued. Also, unlike other capital budgeting methods, like the ARR and Payback Period,
NPV accounts for the time value of money, so opportunity costs and inflation are not ignored
in the calculation. To achieve this, the net present value formula identifies a discount rate
based on the costs of financing an investment or calculates the rates of return expected for
similar investment options.
Unlike some capital budgeting methods, NPV also factors in the risk of making long-term
investments. Therefore, the formula for net present value is longstanding and effective, but
professionals in the industry must still recognize the potential room for error that arises when
relying on calculations like investment costs, rates of discount, and projected returns, all of
which rely heavily on assumptions and estimates. As accounting for unexpected expenses can
be difficult when budgeting for capital investments, it is important to consider using payback
period metrics and the internal rate of return as possible alternatives to net present value
calculations when evaluating a project or investment.
NPV is computed as the difference between the Present Value of the Cash Inflows and
the Cash Outflows (Initial Investment)
Advantages
 NPV method takes into account the time value of money.
  The whole stream of cash flows is considered.
 The net present value can be seen as the addition to the wealth of share holders. The
criterion of NPV is thus in conformity with basic financial objectives.
 The NPV uses the discounted cash flows i.e., expresses cash flows in terms of current
rupees. The NPVs of different projects therefore can be compared. It implies that each
project can be evaluated independent of others on its own merit.
Limitations
 It involves difficult calculations.
 The application of this method necessitates forecasting cash flows and the discount
rate.
 Thus accuracy of NPV depends on accurate estimation of these two factors which
may be quite difficult in practice.
 The ranking of projects depends on the discount rate.

INTERNAL RATE OF RETURN (IRR)

Internal rate of return for an investment proposal is the discount rate that equates the present
value of the expected net cash flows with the initial cash outflow.
This IRR is then compared to a criterion rate of return that can be the organization’s desired
rate of return for evaluating capital investments.
The internal rate of return calculation is used to determine whether a particular investment is
worthwhile by assessing the interest that should be yielded over the course of a capital
investment. It is determined by using a particular formula that must be calculated
through trial-and-error (SIMPLE INTERPOLATION). As the internal rate of return
helps aid investors in measuring the profitability of their potential investments, the ideal
internal rate of return for a project should be greater than the Cost of Capital required for the
project, as it can be assumed that the project will be a profitable one.
Acceptance Rule: The use of IRR, as a criterion to accept capital investment decision
involves a comparison of IRR with the required rate of return known as cut off rate . Then
project should be accepted if IRR is greater than cut-off rate. If IRR is equal to cut off rate the
firm is indifferent. If IRR less than cut off rate the project is rejected.
The Reinvestment Assumption: The Net Present Value technique assumes that all cash
flows can be reinvested at the discount rate used for calculating the NPV. This is a logical
assumption since the use of the NPV technique implies that all projects which provide a
higher return than the discounting factor are accepted. In contrast, IRR technique assumes
that all cash flows are reinvested at the projects IRR. This assumption means that projects
with heavy cash flows in the early years will be favoured by the IRR method vis-à-vis
projects which have got heavy cash flows in the later years.
Advantages
  This method makes use of the concept of time value of money.
 All the cash flows in the project are considered.
 IRR is easier to use as instantaneous understanding of desirability can be determined
by comparing it with the cost of capital
 IRR technique helps in achieving the objective of maximisation of shareholders
wealth.
Limitations
 The calculation process is tedious, the interpretation of which is difficult.
 The IRR approach creates a peculiar situation if we compare two projects with
different inflow/outflow patterns.
 It is assumed that under this method all the future cash inflows of a proposal are
reinvested at a rate equal to the IRR. It is ridiculous to imagine that the same firm has
a ability to reinvest the cash flows at a rate equal to IRR.
 If mutually exclusive projects are considered as investment options which have
considerably different cash outlays. A project with a larger fund commitment but
lower IRR contributes more in terms of absolute NPV and increases the shareholders’
wealth. In such situation decisions based only on IRR criterion may not be correct.
IRR tells us…
• How much risk (inflation, rise in interest rates, delays in project implementation,
delays in getting accounts receivables) a business can absorb.
• More the IRR, it is better for business as it can survive even during bad times
Relationship between NPV and IRR
In NPV, the present value of all future expectant cash flows are discounted at the firms cost
of capital. The decision rule under NPV is that the project yielding negative NPV is rejected.
However, in case of IRR no such discount rate is pre-determined. It is to be determined in
such a way, so that the present value of all future cash inflows is exactly equal to the initial
investment amount. A project whose IRR is less than the Cost of Capital, is rejected.
Actually, if IRR is less than the Cost of Capital, the NPV in that case happens to be negative.
Thus the project will be rejected under both the methods and there happens to be no conflict
in decision making.
However, in case of ranking of multiple mutually exclusive projects, there may arise a
conflict in decision between NPV and IRR.
Conflict between NPV AND IRR
NPV assumes that all intermediate cash flows are re-invested at its cost of capital while IRR
assumes all intermediate cash flows earned, are re-invested at the IRR. Of these two
assumptions, the assumption of NPV about re-investment is more logical and realistic.
Cost of Capital represents the opportunity cost where one can borrow and lend at that rate;
while IRR is the projects own rate of return and there is no guarantee that the cash flow will
be re-invested at that rate. Moreover the NPV method maximises wealth which is in line with
the objective of shareholder wealth maximisation. Thus when there is a conflict under both
these methods, the decision will be taken on the basis of NPV. The main reason for this is the
difference in the new investment rate.
PROFITABILITY INDEX (PI)
The profitability index is a capital budgeting tool designed to identify the relationship
between the cost of a proposed investment and the benefits that could be produced if the
venture was successful. The profitability index employs a ratio that consists of the
present value of future cash flows over the initial investment. As this ratio increases
beyond 1.0, the proposed investment becomes more desirable to companies. When this ratio
does not exceed 1.0, the investment should be rejected, as the project’s present value is less
than the initial investment.
Sum of discounted cash in flows
Profitability Index (PI) =
Initial cash outlay or Total discounted cash outflow
Advantages
 The method also uses the concept of time value of money and is a better project
evaluation technique than NPV.
Limitations
 Profitability index fails as a guide in resolving capital rationing where projects are
indivisible.
 Once a single large project with high NPV is selected, possibility of accepting several
small projects which together may have higher NPV than the single project is
excluded.
 Also situations may arise where a project with a lower profitability index selected
may generate cash flows in such a way that another project can be taken up one or
two years later, the total NPV in such case being more than the one with a project
with highest Profitability Index.
Discounted Payback Period Method
Some accountants prefer to calculate payback period after discounting the cash flow by a
predetermined rate and the payback period so calculated is called, ‘Discounted payback
period’. One of the most popular economic criteria for evaluating capital projects also is the
payback period. Payback period is the time required for cumulative cash inflows to recover
the cash outflows of the project.
Problem: X Ltd. wants to replace its old machine with a new one. Two models, A and B, are
available at the same cost of ₹5,00,000 each. Salvage value of the old machinery is
₹1,00,000. The utilities of the existing machine can be used, if X Ltd. purchases Machine A.
Additional cost of utilities to be purchased in that case where the amount is ₹1,00,000. If the
company purchases Machine B, all the existing utilities are to be replaced with new utilities
costing ₹2,00,000. The salvage value of the old utilities will be ₹20,000. The salvage value
at the end of 5 years for machine A will be ₹50,000 and that of machine B will be ₹60,000.
The cash inflows that are expected, are as follows:
Year Machine A Machine B
1 1,00,000 2,00,000
2 1,50,000 2,10,000
3 1,80,000 1,80,000
4 2,00,000 1,70,000
5 1,70,000 40,000
Find out which machine is more profitable (Under NPV, Discounted Payback and
Desirability Factor method . Given, cost of capital = 15%.
Problem: B Ltd. has a machine having an additional life of 5 years which cost ₹10,00,000
and has a book value of ₹4,00,000. A new machine costing ₹20,00,000 is available. Its
capacity is same as the old machine but will result in a savings of variable cost of ₹7,00,000
p.a. The life of this machine will be 5 years, at the end of which it will have a scrap value of
₹ 2,00,000. Tax rate is 40% and the cost of capital is 12%. The old machine if sold today will
realise ₹1,00,000 and it will have no salvage value at the end of the fifth year.
i. Ignoring income tax on additional depreciation and capital gain tax, decide whether
the machine will be purchased or not.
ii. What will be the difference if additional depreciation and capital gains, both are
subject to 40% tax and the scrap value of the new machine is ₹3,00,000.

CAPITAL RATIONING
In case of resource constraints, a firm maybe forced to accept only those projects that seem
more profitable, rather than accepting all the projects, as accepting all projects will lead to
exceeding the maximum available funds.
Thus, when funds are limited and as a result of which only the most profitable projects are
accepted, it is referred to as Capital Rationing.
Mutually Exclusive Projects
In Capital Budgeting Decisions, mutually exclusive projects refer to those projects whereby
two projects cannot be selected simultaneously. This means that a decision to undertake one
project from among the mutually exclusive projects excludes all the other projects from
consideration.
For example: If Projects A and B are mutually exclusive, they cannot be selected together, as
if they are selected together one project will have an adverse impact on the investment of the
other project. Thus either Project A or Project B is selected, based on the profitability they
generate.
Problem: A company considering 5 capital projects for the year 2017-2020. It is financed
entirely out of equity shares and the cost of capital is 12%. The expected cash flow from the
projects are:
 Projects 2017 (₹ in 2018 (₹ 2019 (₹ 2020 (₹
‘000) ‘000) ‘000) ‘000)
A -70 35 35 20
B -40 -30 45 55
C -50 -60 70 80
D - -90 55 65
E -60 20 40 50
The capital available for investment in 2017 is ₹1,10,000 and with no limitations in the
subsequent years. All projects are divisible, that is, the size of the investment can be reduced
if required. Discounting factors @ 12% at ₹1 for 2017 = 1, 2018 = 0.89, 2019 = 0.80, 2020 =
0.71. Calculate which of the projects the company should undertake.
Indivisible projects
In case where the projects are indivisible, it implies that, even though there is a budgetary
restriction, the Investment value of the projects cannot be adjusted, given the resource
constraint. This means that, either a project is completely selected in its full value or not
selected at all.
In such a case, the combination that maximises the use of the budgeted funds will be
considered the most profitable.
Problem: The following information is available for selection:
Projects Investments P.I
A 25,000 1.13
B 35,000 1.11
C 40,000 1.15
D 30,000 1.08
E 20,000 1.50
All projects are indivisible. Budgeted funds amount to ₹60,000. Projects A and B are
mutually exclusive and the unutilised part of the investment involves a notional loss of 10%.
i. Select the most profitable project within the budgeted cost.
ii. Assuming all the above points hold good except that P.I of E is 0.98, select the most
profitable project.
Terminal value (TV)
It is defined as the value of an investment at the end of a specific period. It helps in
estimating the value of a business beyond the explicit forecast period. Therefore, it is
basically the Present Value (PV) of all future cash flows and mostly used in discounted cash
flow analysis.
 First we compute the total TV, followed by the PV of TV.
 If Net Terminal Value (NTV) is positive, we accept the project.
 Therefore,

 TV = Cash Inflow × [ (1+ R)(n−1) ¿

 Where, R: re-investment rate
n: number of years
PV of TV = Σ TV/ (1+i)n
Where, i: required rate of return
NTV = PV of TV – Initial Investment
Problem: Initial cost of the project is ₹1,20,000 and its life is 5 years. The project will yield
for the 1st year = ₹60,000, 2nd year = ₹50,000 , 3rd year = ₹40,000 , 4th year = ₹30,000 , 5th
year = ₹20,000. The cash inflows for the 1st two years can be re-invested @ 8% compound
interest and the last three years at a compound interest rate of 10%. If the required rate of
return is 12%, should the project be accepted?