Capital Budgeting

Techniques
Accounting Rate of Return
• The ARR is based on the accounting concept of return on investment
or rate of return.
• The ARR may be defined as the annualized net income earned on the
average funds invested in a project.
• In other words, the annual return of a project is expressed as a
percentage of the net investment in the project.
• Equal Profits : In case the expected profits (after tax) generat ed by a
project are equal for all the years than the annual profit itself is the
average profit.

• Unequal Profits : If the project is expected to generate unequal profits

or uneven stream of profits over different years , then the ARR may
be calculated by finding out the average annual profits (by taking the
simple arithmetic mean of profits of different years)
Average Investment
• The average investment refers to the average quantum of funds that
remains invested or blocked in the proposal over its economic life.
• The average investment of a proposal is affected by the method of
depreciation, salvage value and the additional working capital
required by the proposal.
Approaches to calculate Average
Investment
1. Initial cash outlay as average investment :
• The original cost of investment and the installation
expenses if any, is taken as the amount invested in the
project.
• For example, a project costing 10,00,000 is expected to
generate after tax profit of 1,50,000 every year.
• The ARR for the proposal would be 15% (i.e. 1,50,000/
10,00,000 × 100).
2. Average annual book value after depreciation as
aver age investment
• The average annual book value (after depreciation) of the
proposal is taken as the average investment of the proposal.
• First, find out the opening book values and the closing book
values of the project for all the years of its economic life.
• The difference in the opening and closing values for a particular
year will depend upon the amount of depreciation for that year.
• Second, find out the average book values for all the years by
taking the simple arithmetic mean of the opening and closing
book values.
• Third, find out the average of all the yearly averages. This
average will be the average investment of the proposal.
• ABC Ltd. takes a project costing 1,20,000 with expected life of 5-years
and the salvage value of 20,000. The average investment of the
proposal is :
Depreciation= (Cost of Project-Salvage Value)/ No. of years
=(120000-20000)/5= 20,000
• Short cut method to calculate Average investment when Straight line
method of depreciation is used
Additional Working Capital
• Some times, the project may also require additional working capital
for its smooth operations.
• Though this additional working capital will be released back, when the
proposal will be scrapped and terminated, yet this amount of
additional working capital is blocked through out the life of the
project.
• So, this additional working capital entails the investment of funds of
the firm and should also be added to the average investment
• To continue with the above example, the project requires an
additional working capital of ₹ 20,000 and is expected to generate
annual average profit (after tax) of ₹ 18,000, then the average
investment and the ARR can be calculated as follows:
Decision Rule for ARR:
• The ARR calculated is compared with the pre-specified rate of return.
• If the ARR > pre-specified rate of return, then the project is likely to
be accepted, otherwise not.
• For example, ARR of the proposal has been found to be 20%. In case,
the firm requires a rate of return of at least 18%, then this proposal is
acceptable.
• However, if the minimum rate of return of the firm is 22% then this
proposal is likely to be rejected.
• The ARR can also be used to rank various mutually exclusive
proposals. The project with the highest ARR will have the top priority
while the project with the lowest ARR will be assigned lowest priority.
Advantages of ARR
• The ARR is relatively simple to calculate and easy to apply.
• The relevant data and information required for its calculation is
readily available in the accounting records.
• Best project can be selected in mutually exclusive projects on basis of
ARR
Drawbacks of ARR
1. It ignores the time value of money and considers the profit earned in the 1st year as
equal to the profits earned in later years.
2. ARR is based on the accounting profits rather than the cash flows. Accounting profits
are affected by different accounting policies. A sound evaluation technique should be
based on the cash flows rather than the accounting profits.
3. ARR also ignores the life of the proposal. A proposal with a longer life may have the
same ARR as another proposal with a shorter life has. On the basis of ARR, both the
proposals may be placed at par, but the proposal with a longer life should be preferred
over the proposal with a shorter life (as the former proposal will generate the returns
for a longer period).
4. ARR technique also ignores the salvage value of the proposal. In real sense, the
salvage value is also a return from the proposal and should be considered.
5. ARR also fails to recognize the size of the investment required for the project.
Particularly, in case of mutually exclusive proposals, the two projects having
significantly different initial costs, may have same ARR.
Limitations of using Accounting
Profit as benefits
• The accounting profit is, to a large extent, affected by the
discretionary accounting policies being followed by the firm. These
policies, which usually differ from one firm to another or from one
period to another, may be depreciation policy, inventory valuation
policy, capital expenditure and revenue expense policy, etc. Thus, the
accounting profit is not an objective figure.
• The 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.
• The accounting profit measures the profit of any particular year in
terms of the money of that year. However, the cost and benefits of a
proposal may occur over a period of number of year. The benefits if
measured in terms of accounting profit, are ex pressed in monies of
different time period and are not comparable. Similarly, if two
mutually exclusive proposals have different economic lives, then the
accounting profits emerging over different periods are not comparable.
• The accounting profit is based on the accrual con cepts. For example,
the sales revenue and the ex penses, both are recorded for the period
in which they occur instead of the period in which they are actually
received or paid.
• Thus, in view of these flaws, the accounting profit as a measures of
benefits of a proposal is out rightly rejected. Instead, the cost and
benefits are measured in terms of cash flows.
Profit in ARR

Cash Flows
• If the firm has spent 5,000 on capital expenditure, then this will not
affect the profit figure but the cash flow will be reduced by 5,000 as
follows :
Cash Flows
• Cash Flows are at 3 stages
• Original or initial cash outflow
• Subsequent cash Inflows or outflows
• Terminal Cash flow
• Original or initial cash outflow:
• Includes initial investment in project;
• Replacing an existing machinery then sale of existing asset is inflow;
• Using a piece of land own, so opportunity cost will be included in this;
• Additional working capital required for proposal
• Subsequent Annual Inflows and Outflows :
• The proposal is expected to generate a series of cash inflows in the
form of cash profits contributed by the project.
• These cash inflows may be same every year throughout the life of the
project or may vary from one year to another.
• The timings of the inflows may also be different.
Important points
• Sometimes, the project may require some subsequent cash outflows also
in the form of periodic intensive repair, periodic shunting cost, etc. All
these cash inflows and outflows are to be considered for the capital
budgeting decision.
• If additional working capital is required by the proposal in any of the
subsequent years then it should be considered as 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. It is important to
recognize the timing of these subsequent cash inflows and outflows, as
these are to be adjusted for the time value of money.
• Subsequent annual cashflow can be described as :
Annual Inflow = PAT + Non-cash expenses – Capital expenditure ±
Change in Working Capital
Terminal Cash Flow
• 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 may occur in the last year.
• First, as already noted, the estimated 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. At the time of disbanding or termination of the project, the
market value of the land etc. also become cash inflows from the project.
• Second, as already noted, the working capital which was invested (tied up) in the
beginning will no longer be required as the project is being terminated. This working
capital released will be available back to the firm and is considered as a terminal cash
inflow.
Terminal CF = Sale Price of asset ± Tax effect of sale of asset +
Working Capital released
• A firm buys an asset costing ₹1,00,000 and expects operating profits
(before depreciation @ 20% WDV and tax @ 30%) of ₹30,000 p.a. for
the next four years after which the asset would be disposed off for
45,000. Find out the cash flows for different years
Summarized
Q1. RST Ltd. is planning to install a new machine costing ₹ 15,00,000
with a salvage value of 1,00,000 after 5 years of life. Following
information is available in respect of the machine: Annual Production :
1,00,000 Units for year 1 and to increase by 10,000 units p.a. over
immediate preceding year production for next 4 years. Selling Price : 16
per unit
Variable cost : 10 per unit Fixed cost : 2,00,000 p.a. Tax rate : 30%
Depreciation : 20% on Written Down Value Find out Initial, Subsequent
and Terminal cash flows from the machine.
Payback Period
• The payback period is defined as the number 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.
• The payback period therefore, can be looked upon as the length of
time required for a proposal to ‘break even’ on its net investment.
Computation of the Payback Period
Situation 1: 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.
• Ex, a proposal requires a cash outflow of 1,00,000 and is expected to
generate cash inflows of 20,000 p.a. for 6 years.
Payback Period= 1,00,000/ 20,000= 5 years
• In the above case, if the annual cash inflow is 30,000 then the payback
period lies between 3 years and 4 years and is 3.33 years i.e., 1,00,000/
30,000.
Situation 2: When annual inflows are unequal :
• In case the cash inflows from the proposal are not in annuity form
then the cumulative cash inflows are used to compute the payback
period.
• A project has cash outflow of ₹ 2,00,000 and cash inflows are as
follows
Year Cash inflow
1 30,000
2 20,000
3 80,000
4 70,000
5 30,000
 Year Cash inflow Cumulative Cash flow
1 30,000 30,000
2 20,000 50,000
3 80,000 1,30,000
4 70,000 2,00,000
5 30,000 2,30,000

• So cash outflow of ₹ 2,00,000 will be covered in 4 years, hence

payback period= 4 years
If cash inflows are different
Year Cash inflow
1 30,000 30,000
• In this case, since cash outflow is
2 20,000 50,000 covered in between 4th and 5th year,
3 60,000 1,10,000 then we can take assumption
4 70,000 1,80,000 inflows are evenly distributed over
5 30,000 2,10,000 year, hence payback period=
6 40,000 4+(20,000/30,000)= 4+0.66 years=
4.66 years
• In case inflows are end of the year,
then 5 years
The Decision Rule for Payback
Period
• The payback period calculated for a proposal is to be compared with
some predetermined target period.
• If the payback period is more than the target period, then the
proposal should be rejected, otherwise it may be accepted.
Advantages of Payback Method
1. The payback period is simple and easy, in concept as well as in its
applications.
2. It gives an indication of liquidity. In case a firm is having liquidity problems,
then the payback period is a good method to adopt as it emphasizes the
earlier cash inflows.
3. In a broader sense, the payback period deals with the risk also. The project
with a shorter payback period will be less risky as compared to project
with a longer payback period, as the cash inflows which arise further in the
future will be less certain and hence more risky. So, the payback period
helps in weeding out the risky proposals by assigning lower priority.
4. Can be used to give rankings to project
Disadvantages of Payback Method
1. The payback period entirely ignores many of the cash inflows which occur after the
payback period. It ignores what happens after the initial investment is recouped.
2. It ignores the timing of the occurrence of the cash flows. It considers the cash flows
occurring at different point of time as equal in money worth and ignores the time value
of money.
3. The payback period also ignores the salvage value and the total economic life of the
project. A project which has substantial salvage value may be ignored (though more
profitable it may be otherwise) in favour of a project with higher inflows in earlier
years. It is insensitive to the economic life span.
4. The payback period is more a method of capital recovery rather than a measure of
profitability of a project. To recover the capital is not enough, of course, because from
an economic view point one would hope to earn a profit on the funds while they are
invested
5. The payback period is designed to cover the conventional projects that involve large
up-front investment followed by positive operating cash inflows. It breaks down, how