Capital Budgeting

Meaning of Capital Budgeting:

A business organization has to face quite often the problems of capital investments decisions
(popularly known as Capital Budgeting decisions). It refers to the investment in projects whose results would
be available only after a year. The investments in these projects are quite heavy and to be made immediately,
but the return will be available only after a period of time. The term ‘Capital Budgeting’ refers to long term
planning for proposed capital outlays and their financing. Thus it includes both raising of long term funds as
well as their utilization. It may thus be defined as the firm’s formal process for the acquisition and
investment of capital. It is the decision making process by which the firms evaluate the purchase of major
fixed assets, disposition, modification and replacement of long term or fixed assets. However, it should be
noted that investment in current assets necessitated on account of investment in a fixed assets, is also to be
taken as a capital budgeting decision.

Importance of Capital Budgeting:

Capital Budgeting decisions are among the most crucial and critical business decisions. Special care
should be taken in making these decisions on account of the following reasons:

(i) Involvement of heavy funds:

Capital Budgeting decisions require large capital outlays. It is therefore, absolutely necessary that
the firm should carefully plan its investment programme so that it may get the finances at the
right time and they are put to most profitable use.

(ii) Long term implications:

The effect of Capital Budgeting decisions will be felt by the firm over a long period, and,
therefore, they have a decisive influence on the rate and direction of the growth of the firm e.g. if
a company purchases a new plant for manufacture of a new product, the company commits itself
to a sizeable amount of fixed cost in terms of indirect labour such as supervisory staff salary and
indirect expenses such as rent, rates, insurance etc. In case the product does not come out or
comes out but proves to be unprofitable, the company will have to bear the burden of fixed cost
unless it decides to write off the investment completely. A wrong decision, therefore, can prove
disastrous for the long term survival of the firm.

(iii) Irreversible decisions:

In most cases, Capital Budgeting decisions are irreversible. This is because it is very difficult to
find a market for the capital assets. The only alternative will be to scrap the capital assets so
purchased or sell them at a substantial loss in the event of the decision being proved wrong.

(iv) Most difficult to make:

The Capital Budgeting decisions require an assessment of future events which are uncertain. It is
really a difficult task to estimate the probable future events, the probable benefits and costs
accurately in quantitative terms because of economic, political, social and technological factors.

On account of these decisions, capital expenditure decisions are amounting the class of decisions
which are best reserved for consideration by the highest level of management. In case some parts
of it are delegated, a system of effective control by the top management should be evolved.

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 Capital Budgeting is the technique for the analysis of investments decisions. These investments
decisions shall be taken with references to capital budgeting decision because the following are the reasons
about the importance of these decisions.

(i) Capital budgeting decisions can be applied only for those decisions, which are related to capital
investments.
(ii) Success or failure of any enterprise shall be based on the decision of enterprise, so failure of any
company or enterprise shall be based on capital budgeting decisions.
(iii) Capital budgeting decisions shall consider the profits or losses of every investment decision before
investing the amount.

Kinds of Capital Investment Proposals:

A firm may has several investment proposals for its consideration. It may adopt one of them, some of
them or all of them depending upon whether they are independent, contingent or dependent or mutually
exclusive.
(i) Independent Proposals:
These are proposals which do not compete with one another in a way that acceptance of one
preclude (stop) the possibility of acceptance of another. In case of such proposals the firm may
straightaway ’accept or reject’ a proposal on the basis of a minimum return on investment
required. All those proposals which give a higher return than a certain desired rate of return are
accepted and the rest are rejected.

(ii) Contingent or dependent Proposals:

These are proposals whose acceptance depends on the acceptance of one or more other proposals.
For example a new machine may have to be purchased on account of substantial expansion of
plant. In this case investment in the machine is dependent upon expansion of plant. When a
contingent investment proposal is made, it should also contain the proposal on which it is
dependent in order to have a better perspective of the situation.

(iii) Mutually exclusive Proposals:

These are proposals which compete with each other in a way that the acceptance of one precludes
(stop) the acceptance of other or others. For example, if a company is considering investment in
one of two temperature control systems, acceptance of one system will rule out the acceptance of
another. Thus, two or more mutually exclusive proposals cannot both or all be accepted. Some
technique has to be used for selecting the better or the best one. Once this is done, other
alternative automatically get eliminated.

Cash Flow:
Cash Flows relating to a Capital Budgeting Proposal can be classified into:
(i) Cash Inflows:
Cash flows received by the firm are known as Cash Inflows. For example, Sale Revenue,
Sale Price of Asset etc. are cash inflows. Cash Inflows means cash profits which are generated
after tax but before depreciation. This is in addition to all those amount which are expected to
be realized in future such as salvage value of the project, working capital or any other amount.

(ii) Cash Outflows:

Cash flows occurring out of payment by the firm are known as Cash Outflows. For example
Cash payment for purchase of machine, Goods purchase, expensed, taxes etc. are cash
outflows. Cash Outflows never indicates the cost of project but it means the Net Cash
Investment in the project after adjusting all the savings.
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Computation of capital investment required:
The term ‘capital investment required’ refers to the net cash outflow which is the sum of all outflows
and inflows occurring at zero time period. The net outflow is determined by taking into account the
following factors:
(i) Cost of the new project

(ii) Installation Cost / Erection Cost

(iii) Working Capital

Investment in a new project may also result in increase or decrease of net working capital
requirements (Working Capital = Current Assets – Current Liabilities). For example, if the new
project is expected to increase sales; investment in accounts receivables, inventories, cash
balance, etc., is also likely to increase. A part of this increase in current asset may be offset by
increase in current liabilities. For the balance additional funds will have to be arranged. This
amount should therefore be taken as a pert of the initial capital. The investment required in the
form of net working capital will be recovered at the end of the life of the project. This amount of
working capital so recovered will become part of cash inflow in the last year of the life of the
project. However, investment in working capital and the recovery of working capital will not
balance each other on account of time value of money.
Generally all capital investment proposals for increasing revenue require additional working
capital, while almost all capital investment proposals for reduction in costs result in saving of
working capital by increasing the firm’s operational efficiency.

(iv) Proceeds from sale of asset:

A new asset may be purchased for replacement of an old asset. The old asset may therefore be
sold away. The cash realized on account of such sale will reduce the cost of new investment.

(v) Tax effects:

The amount of profit or loss on the sale of the assets may affect the cash flows on account
of tax affects. The profit/loss is ascertained by taking into account the cost of the asset, its book
value and the amount realized on its sale. The tax liability of the company will be different in
each of the following cases:
(a) when the asset is sold at its book value.
(b) when the asset is sold at a price higher than its book value but lower than its cost.
(c) when the asset is sold at a price higher than its cost.
(d) when the asset is sold at a price lower than its book value.

Initial Cash Outflow = Cost of new Plant + Installation Expenses + Other Capital Expenditure + Additional
Working Capital – Tax benefit on account of Capital Loss on sale of old plant
(if any) – Salvage value of old plant + Tax liability on account of Capital gain on
sale of old plant (if any)

Subsequent Cash Inflow = Profit after tax + Depreciation – Repairs (if any)

Terminal Cash Inflow=Annual Cash inflow +Working Capital released & Scarp value of the proposal (if any)

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Calculation of Tax Savings / Tax Liability on Replacement Decisions:

A company purchase a machinery a few years back for Rs.10,000. It wants to replace this machinery by a
new one costing Rs.15,000. The company is subject to income tax @50% while capital gain tax @30%. The
present book value of the machinery is Rs.6,000. Calculate the net initial cash outflow if the company
decides to purchase the new machinery, in each of the following cases, if the old machine is sole for:

(a) Rs.6,000 (b) Rs.8,000 (c) Rs. 12,000 (d) Rs.4,000

Ans:
(a) Cash required for purchase of new machine Rs.15,000
Less cash realized on sale of the old machine (Rs. 6,000)
Net Cash Outflow: Rs.9,000

(b) Cash required for purchase of new machine Rs.15,000

Less cash realized on sale of the old machine (Rs. 8,000)
Add income tax liability on profit made on sale
of machinery (2,000 × 50 / 100) Rs.1000
Net Cash Outflow: Rs.8,000

(c) Cash required for purchase of new machine Rs.15,000

Less cash realized on sale of the old machine (Rs.12,000)
Add Income tax liability (4,000 × 50/100) Rs.2000
Add Capital gains tax liability (2,000 × 30/100) Rs.600
Net Cash Outflow: Rs.5,600

(d) Cash required for purchase of new machine Rs.15,000

Less cash realized on sale of the old machine (Rs. 4,000)

Less Saving in tax liability on account of loss on sale of

The old machine (2,000 × 50 /100) (Rs.1000)
Net Cash Outflow: Rs.10,000

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Time Value of Money:

The concept of Time Value of Money refers to the fact that the money received today is different in
its worth from the money receivable at some other time in future. In other words, the same principle can be
stated as: the money receivable in future is less valuable than the money received today. Every individual or
a firm definitely has a preference to receive money today against the money receivable tomorrow. For
example if an individual is given an option to receive Rs.1,000 today or to receive the same amount after one
year, he will definitely choose to receive the amount today. The obvious reason for this preference for
receiving the money today is that the rupee received today has a higher value than the rupee receivable in
future. This preference for current money as against future money is known as the time preference for money
or simply Time Value of Money.

In case of most of the decisions particularly those taken by a firm, the financial implications may
occur over a period of time and quite often over a long period of time even upto ten years or more.
Therefore, Time Value of Money becomes an important consideration for any financial decisions.

Cost of Capital:

The term cost of capital refers to the minimum rate of return a firm must earn on its investment so
that the market value of the company’s equity shares does not fall. This is possible only when the firm earns
a return on the projects financed by equity shareholders funds at a rate which is at least equal to the rate of
return expected by them. If a firm fails to earn return at the expected rate, the market value of the shares
would fall and thus result in reduction of overall wealth of the shareholders.

Thus, a firm’s cost of capital may be defined as ‘the rate of return the firm requires from investment
in order to increase the value of the firm in the market place’.

In capital budgeting, the cost of capital is often used as a discount rate on the basis of which the
firm’s future cash flows are discounted to find out their present values. Thus, the cost of capital is the very
basis for financial appraisal of new capital expenditure proposals. The decision of the finance manager will
be irrational and wrong in case the cost of capital is not correctly determined. This is because the business
must earn at least at a rate, which equals to the cost of capital in order to make at least a break-even.

Capital Budgeting Techniques of Evaluation:

Capital Budgeting Techniques

Traditional or Non Discounting Time Adjusted or Discounted Cash Flows

ARR Pay Back Period Discounted Pay back Period NPV PI IRR

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Traditional or Non-Discounting Techniques:
These techniques to not discount the cash flows to find out their present worth. There are two
techniques available (i) Pay Back Period and (ii) ARR (Average/Accounting Rate of Return).
(i) Pay Back Period: Pay back period method calculates the period of returning the amount of
investment and such proposals may be accepted at which pay back period will be lower to the
enterprise. In other words the pay back period is the length of time required to recover the initial cost
of the project. Under such method only such period will be taken as the base, which is related to
returning the amount of investment.
(a) When the annual inflows are equal:
Original Investment
Pay Back period =
Annual cash inlow
e.g. Investments = 10,00,000
Return (Annually) = 2,00,000
Pay Back Period = 10,00,000 / 2,00,000 = 5 years

(b) When the annual inflows are unequal:

Ex. Initial Cash Outflow = 18,500
Year Cash Inflow
1 8,000
2 6,000
3 4,000
4 2,000
5 2,000 Calculate Pay Back Period.
Sol:
Year Cash Inflow Cumulative Cash Inflow Pay Back Period
1 8,000 8,000
2 6,000 14,000 3 + 500 / 2,000 = 3.25 Yrs,
3 4,000 18,000
4 2,000 20,000
5 2,000 22,000

Merits of Payback Period method:

The following are the merits of Pay Back Period:
(i) Simple to calculate
(ii) Important methods for cash shortage firms
(iii) Very useful in risk of obsolescence
(iv) More accurate estimates.

Demerits of Payback Period method:

The following are the demerits of Pay Back Period:
(i) More importance is given to pay back of invested funds rather than profitability which is not right.
(ii) Does not consider the income received after pay back period.
(iii) Ignores cost of capital which is the strong basis for investment decisions.
(iv) Does not consider the time factor which is quite important to know the present value of future cash
inflows.

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Calculation of Cash Inflow:

PBDT or CFBT Depreciation PBT or Tax PAT Cash Inflow or

or Profit Before Tax Profit After Tax CFAT
Profit Before Profit After Tax but
Depreciation & Before Depreciation
Tax
(PBDT – (PBT – Tax) (PAT + Depreciation)
Depreciation)

OR

PBDT = Profit Before Depreciation & Tax = ------------

Less Depreciation = ------------
PBT = Profit Before Tax = ------------
Less Tax = ------------
PAT = Profit After Tax = ------------
Add Depreciation = ------------
Cash Inflow (i.e. PAT + Depreciation) = ------------

Cash Inflow means Profit After Tax but before Depreciation.

Ex. If Profit Before Depreciation & Tax is Rs.1,40,000, Depreciation is Rs.20,000 and Tax Rate is 30%,
calculate Cash Inflow.

PBDT (Profit Depreciation PBT or Tax PAT or Cash Inflow or

Before Profit Before @30% Profit After Tax CFAT
Depreciation & Tax
Tax) or CFBT
(PBDT – (PBT – Tax) (PAT + Depreciation)
Depreciation)
1,40,000 20,000 1,20,000 36,000 84,000 1,04,000

OR

PBD&T = 1,40,000
Less depreciation = 20,000
PBT = 1,20,000
Less: Tax @ 30 % = 36,000
PAT = 84,000
Add Depreciation = 20,000
Cash Inflow = 1,04,000

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Accounting Rate of Return OR Average Rate of Return (ARR):

The Accounting Rate of Return / Average Rate of Return (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
average funds, invested in a project and is shown as a percentage. It is calculated by dividing the average
income after taxes or Profit after taxes (PAT) by the initial investment or average investment and is
represented by the following formula:

Average Profit After Tax

ARR=  100
Average Investment

Where Average Profit = Average Profit After Tax (Average PAT) and

Original Investment  Scrap Value

Avg. Investments =
2

In case Scrap Value and Working Capital is also given

 Original Investment  Scrap value 

Avg. Investment =    Scarp value  Working capital
 2 

Decision Rule for ARR:

The ARR calculated as is compared with the pre-specified rate of return and if the ARR is more than
the pre-specified rate of return, then the project is likely to be accepted otherwise not e.g. if the firm requires
a rate of return of at least 18%, and ARR comes to 20% then this proposal is likely to be accepted, but if the
minimum rate of return is 22% then this proposal is likely to be rejected. It can 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.

e.g. Profit for each year is Rs.90,000 Initial investment is Rs.18 lacs. What is ARR?

Annual proift
Ans: ARR =  100 = 90,000 × 100 / 18,00,000 = 5%
Initial Investment

Merits of Accounting Rate of Return (ARR) Method:

The following are the merits of the ARR method:

(i) It is very simple to use and understand.
(ii) It considers whole life of the project.
(iii) The net income after deprecation is used hence it is theoretically very sound.
(iv) More useful for analysis of long term projects as it considers whole life of the project.
(v) This method can be used by business for the investment of his wealth in the most profitable project.

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Demerits of Accounting Rate of Return (ARR) Method:
The following are the merits of the ARR method:
(i) It does not consider the Time Value of Money. The comparative study is essential for the evaluation
of different projects and for this purpose the calculation of Present Value of Cash Inflow of different
projects is necessary, which is not done in this method.
(ii) Only accounting profits and not the net cash flows are considered in appraising projects.
(iii) The ARR 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. This
method fails to distinguish between them.
(iv) It fails to recognize the size of the investment required for the project. In case of mutually exclusive
projects, the two projects having significantly different costs may have same ARR.

Discounting Cash Flow Techniques or Time Adjusted Techniques:

Investment decision techniques based on discounted cash flow not only replace accounting income
with cash flows but also explicitly consider the time value of money. These are based on the facts that the
cash flows occurring at different points of time are not having 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 at a predetermined discount rate. These techniques are also called the present value
techniques and fulfill all the requisites of a good valuation technique.

Suppose a firm is considering a capital budgeting proposal having initial cost of Rs.1,00,000 and the
project is expected to generate annual cash flows of Rs.20,000, Rs.50,000 and Rs.60,000 respectively during
the next three years. In this case the initial cost of Rs.1,00,000 is incurred now i.e. T 0 but the other cash
inflows which occur after 1 year from today i.e. T1 and 2 year from today i.e. T2 etc. are expressed in terms
of money of that year in which the cash flows occur. The money of T 0 not comparable with the cash flows in
terms of money of T1, T2 …. etc. However, these can be made comparable by converting all these cash flows
in terms of money of the same date. Generally, it is done by converting all the future cash flows in terms of
money of today i.e. T0.

Now in order to convert these cash flows, what is required is the time gap and the discount rate. The
time gap is the gap between the present date and the future date when a particular cash flow is expected to
occur. This time gap is known together with the cash flow and the discount rate is presumed to be given.
This discount rate is defined as the minimum rate of return which a firm wants to earn on the amount
invested in any capital budgeting proposal.

Discounting procedure to find out the Present Value of Cash Inflow:

Time Cash Flows PVF (@10%,T) P.V. of Cash Inflow

T0 (-) 1,00,000 1.00 (-) 1,00,000
T1 20,000 0.909 18,180
T2 50,000 0.826 41,380
T3 60,000 0.751 45,060

The above figures show the present value of different future cash flows. The cash flow at T 0 has been
discounted by present value factor I, as it is already expressed in terms of present money. Second, the PVF
(Present Value Factor) gradually declines as the time gap increases. The present values given in the last
column are expressed in terms of present money and hence are now comparable.

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Net Present Value Method (NPV Method):
NPV method is the best method for analyzing results of any decision. The following statement shall
be prepared while calculating results.

Present Value of Cash Inflow ---

Less: Present Value of Cash Outflow ---
________________
Net Present Value (NPV) ---
(Note: NPV can be Positive or Negative)

Net Present Value (NPV) = Present Value of Cash Inflow – Present Value of Cash Outflow

Decision Rule:
If the NPV of the project is positive then project may be accepted but in case it is negative project
may not be accepted.

NPV method is based on Present value of Cash Inflow or Cash Outflow and the present value can be
calculated by the following equation.

PV of Cash Inflow = Cash inflow × PV factor of related year

PV factor can be calculated by the following formula

n
 1 
PV Factor: =  
 1  rate 
n
 
 1 
n n
 1   1 
=     
 1  10%   10   1  0.10 
1 
 100 
n
 1 
= 
 1.10 

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 Ex. If earning rate is 10%, calculate PV Factor for first 5 years?
1 1
  0.909
10 1.1
1
100
1 2 3
 1   1   1 
   0.909    0.826    0.751
1 r  1 r  1 r 

P.V. Factor: 1st = 0.909; 2nd = 0.826; 3rd = 0.751; 4th =0.683; 5th 0.621

or P.V.F (10%, n) is 0.909; 0.826; 0.751; 0.683; 0.621

PVAF (10%, 5) = 3.791 (PVAF is known as P.V. Factor of Annuity)

Note On Discounting Factor or P.V. Factor:

Whenever the value of P.V. Factor given in questions then those values should be used instead of
calculating the values by formula. e.g. if in question value of PVF is given as 0.9091 then 0.909 should not
be used.

Ex.: Cost of Capital = 10%

Cash outflow at 0 yrs. = 4 lacs

Year Cash Inflow P.V. Factor 10% Present value of inflow

1 1,50,000 0.909 1,36,350

2 1,10,000 0.826 90,860
3 1,20,000 0.751 90,120
4 1,30,000 0.683 88,790
5 1,40,000 0.621 86,940
Present Value of Cash Inflow: 4,93,060

Net Present Value (NPV) = Present Value of Cash Inflow – Present Value of Cash Outflow
= 4,93,060 – 4,00,000 = 93,060

Ex. Cost of Capital = 10%, Cash Outflow = 10,00,000

Year Cash Inflow P.V. Factor 10% Present value of inflow

1 2,00,000 0.909 1,81,800
2 3,00,000 0.826 2,47,800
3 5,00,000 0.751. 3,75,500
4 6,00,000 0.683 4,09,800
5 8,00,000 0.620 4,96,000
Present Value of Cash Inflow: 17,10,900

Net Present Value (NPV) = Present Value of Cash Inflow – Present Value of Cash Outflow
= 17,10,900 – 10,00,000
= 7,10,900

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Profitability Index Method (P.I. Method) / Present Value Index / Benefit Cost Ratio:
Sometimes 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 the 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 projects
are assumed to be same. In the first case, the NPV is much larger fraction (Rs.1,000 / 10,000) then what it is
in the second case i.e. (Rs.1,000 / 25,000), which makes the first proposal clearly more attractive. The PI
technique is a formal way of expressing this cost/benefits relationship.

Present Value of Cash Inflow

P.I. =
Present Value of Cash Outflow

Results of P.I. method are totally same which are calculated under N.P.V. method. The following
points may be considerable before giving decisions:
(i) If PI is greater than 1 than project may be accepted.
(ii) If PI is less than 1 than project may be rejected.
(iii) If PI = 1 than the project may be accepted or rejected on the choice of management.

NPV versus PI:

As far as, the accept-reject decision is concerned, both the NPV and the PI will give the same
decision. The reason for this are obvious. The PI will be greater than 1 only for the project which has a
positive NPV, the project will be acceptable under both the techniques. On the other hand, if the PI is equal
to 1 than NPV would be 1. Similarly a proposal having PI of less than 1 will also have the negative NPV.
However, a conflict between the NPV and the PI may arise in case of evaluation of mutually exclusive
proposals.
e.g. a firm is evaluating two proposals, A and B having costs of Rs.1,00,000 and Rs.80,000 respectively. The
present value of the inflows of these projects are Rs.1,20,000 and Rs.1,00,000. Consequently, both the
proposals have NPV of Rs.20,000 and therefore, are alike. In this case, the PI technique seems to give a
better result. The PI of both the projects can be calculated as follows:

Present Value of Cash Inflow

P.I. =
Present Value of Cash Outflow

P.I. (A) = 1,20,000 / 1,00,000 = 1.20

P.I. (B) = 1,00,000 / 80,000 = 1.25

Thus, in terms of the NPV technique, both projects are alike, but in terms of the PI technique, the
project B is better. The reason being that the project B entails lesser cash outflows of Rs.80,000 only and still
generating net benefits of Rs.20,000 (i.e. Rs.1,00,000 – Rs.80,000), against the project A which is also
generating net benefits of Rs.20,000 but requires a larger outlay of Rs.1,00,000.

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Discounted Pay Back Period Method:

Ex.: Cost of Capital = 10%, Cash Outflow = Rs.5 Lacs, find Discounted Pay Back Period.

Year Cash Inflow P.V. Factor 10% Present value of inflow Progressive (Cumulative)
Present value of inflow
1 1,00,000 0.909 90,900 90,900
2 2,00,000 0.826 1,65,200 2,56,100
3 3,00,000 0.751 2,25,300 4,81,400
4 1,00,000 0.683 68,300 5,49,700

5,00,000  4,81,400
Discounted Pay Back Period = 3 +
68,300
= 3.27 years

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