Rathod capital budgeting 1

S. P. Mandali’s
WELINGKAR Institute of management development & research
Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019

CAPITAL BUDGETING
OR CAPITAL EXPENDITURE PROJECT

SYNOPSIS

1. MEANING & DEFINATION
2. FEATURES
3. KINDS OF CAPITAL EXPENDITURE
4. PROCESS OF CAPITAL BUDGETING
5. METHODS OF EVALUATION

MEANING AND DEFINITION

“Planning & Control of capital expenditure is termed as Capital
Budgeting”.

“Capital Budgeting is an Art of Funding Assets that are worth
more than they cost to achieve a predetermined Goal” i.e.
Optimising the wealth of the Business Enterprise.

“Capital Budgeting is the process of Identifying Analysing and
selecting investment projects whose returns are expected beyond
one year”.

The Capital Budgeting involves a current outlay or series of
outlays of cash resources in return for an anticipated flow of future
benefits. In other words, the system of Capital Budgeting is
employed to evaluate expenditure decisions which involves current
outlays but are likely to produce benefits over a period of longer
than one year. These benefits may be either in the form of
increased revenues or reduction in cost.
Notes prepared by Prof. M. B. Thakoor Page 1

S. P. Mandali’s

FEATURES

1. HEAVY SUBSTANTIAL OUTLAY
2. HIGH DEGREE OF RISK
3. LARGE ANTICIPATED BENEFITS
4. HIGH GESTATION PERIOD i.e. RELATIVE LONG
TERM PERIOD BETWEEN INTIAL OUTLAY AND
ANTICIPATED RETURN
5. IRREVERSIBLE DECISION.

KINDS OF CAPITAL BUDGETING PROPOSALS OR
CAPITAL EXPENDITURE PROPOSALS
1. MANDATORY INVESTMENTS
ex. A) Pollution control Equipments
B) Medical Dispensary
C) Fire fighting Equipments
D) Creche in Factory
2. REPLACEMENT PROJECTS
For cost reduction
3. EXPANSION PROJECT
Ex. A) Increase the capacity
B) Widen the distribution network
4. DIVERSIFICATION PROJECT
Ex. Producing new product.
5. RESEARCH AND DEVELOPMENT
6. STRATEGIC INVESTMENT PROJECTS

S. P. Mandali’s

PROCESS OF CAPITAL BUDGETING

1. IDENTIFICATION OF POTENTIAL INVESTMENT
OPPORTUNITIES.
Here planning body (committee or individual) estimate future
sales.
A) They monitor external environment.
B) Do swot analysis
C) Motivate employee to make suggestion

2. ASSEMBLING OF INVESTMENT PROPOSALS

3. EVALUATING THE VARIOUS INVESTMENT
PROPOSALS

4. PREPARATION OF CAPITAL BUDGET

5. IMPLEMENTATION

6. FOLLOW-UP


S. P. Mandali’s

METHODS OF EVALUATION

METHODS OF EVALUATION

TRADITIONAL MODERN

PAY BACK A.R.R. (DISCOUNTED CASHFLOW)

N.P.V. P/I I.R.R.

PAY BACK PERIOD
“It is the number of years required to recover the original cost
invested in a project from the cash inflow.”
By this method the investor will know how much time it will take
to recover its original cost i.e. How many years it will take for the
cash benefits to pay the original cost of an investment, normally
disregarding the salvage value.

(A) When cash inflows are equal/even/same every year.
Example:
Project A Project B Project C
Initial Rs.10 Lacs Rs.20 Lacs Rs.25 Lacs
investment
Cash flow Rs.3 Lacs Rs.5 Lacs Rs.10 Lacs
every year
Life of the 10 years 10 years 10 years
project
Pay back 10/3 = 3 1/3 yrs. 20/5 = 4 yrs. 25/10 = 2½ yrs.
period


S. P. Mandali’s

Therefore,

Initial investment
Pay back period = ------------------------
Annual cash inflow

Cash inflow = NPAT + Depreciation & Write Offs

CONCLUSION:
In the above example project C has the shortest pay back and is
more desirable.

B) UNEVEN CASH INFLOWS
In case of uneven cash inflows the payback period is found out
by adding the inflows i.e. cumulative cash inflows.

ACCEPT / REJECT CRITERIA
1) FOR SINGLE PROJECT
If the pay back is less than the estimated life then accept it
If the pay back is more than estimated life then reject it.

2) FOR TWO OR MORE PROJECTS
If 2 more projects – project with the
Shortest pay back accept it.


S. P. Mandali’s

ADVANTAGES

1. SIMPLE METHOD
This is the most simple method very easy and clear to
understand. This does not involve tedious mathematical
calculation.

2. CUSHION / SHIELD FROM OBSOLESCENCE :
This method reduces the possibility of loss on account of
obsolescence as the method prefers investment in short term
project.

3. CONSERVATIVE PRINCIPLES
This method makes it clear that no profit arises till the pay
back period is over. This helps the new companies they
should start paying dividends.

4. PREFERRED BY EXECUTIVES WHO LIKES SNAP
ANSWERS, FOR SELECTING THE PROPOSALS.


S. P. Mandali’s

LIMITATIONS

1. CASH FLOW AFTER THE PAY BACK PERIOD
This method does not consider cash inflow generated after the
pay back period. There are many capital intensive projects which
generate substantial cash inflows in the later years than the initial
years. In the above example ‘project B’ which is rejected now may
generate huge cash inflows in later years but still it is rejected.

FOR EXAMPLE:-
Particulars Project A Project B
Initial Investment Rs.10000 Rs.10000
Cash inflows
Year 1 4000 3000
Year 2 4000 3000
Year 3 2000 3000
Year 4 -- 3000
Year 5 -- 3000
Pay back period 3 years 3.3 years

In the above example project ‘A’ is having short pay back that
must be accepted but is does not give return afterwards but project
‘B’ gives constant returns even after its pay back period. So on the
whole project ‘B’ is profitable still ‘A’ is accepted under this
method.
Thus cash inflow after pay back period is ignore.

2. TIMING AND MAGNITUDE NOT CONSIDERED.
Cost Rs.15000 Rs.15000
Cash flow
Year 1 Rs.10000 RS.1000
Year 2 Rs.4000 Rs.4000
Year 3 Rs.1000 Rs.10,000

S. P. Mandali’s

3. PROFITABILITY
The pay back period method does not take into account the
measure of profitability. It is only concerned with the projects
capital recovery.

4. TIME VALUE OF MONEY
This method does not consider time value of money i.e. it
ignores the interest which is an important factor in making
sound investment decisions. A rupee borrowed tomorrow is
worth less than a rupees today.

Ex. There are projects A & B the cost of the project is
Rs.30000 in each case.

Year Cashinflow
Project ‘A’ Project ‘B’
1 Rs.10000 Rs.2000
2 Rs.10000 Rs.4000
3 Rs.10000 Rs.24000

In both the cases the pay back period is 3 years however
project ‘A’ should be preferred as compared to project ‘B’
because of speedy recovery of the initial investment.

5. LIQUIDITY OF ONLY INITIAL INVESTMENT.
It gives importance only to its liquidity of the initial
investment. It does not consider the liquidity of the
company’s total span of life.

6. DOESN’T CONSIDER THE ENTIRE LIFE OF THE
PROJECT.


S. P. Mandali’s

USE

1. FOR PROJECT HAVING HIGH RISK AND
UNCERTAINTY / HAZY LONG TERM OUTLOOK
This method is useful in evaluating those projects which
involve high risk and uncertainty. For ex. Those projects
which have the risk of rapid technological development of
cheap substitute, political instability etc. for these projects
these method is more suitable for e.g. fashion garment
industry.

2. FIRMS SUFFERING FROM LIQUIDITY CRISIS
Firms which suffer from liquidity crisis are more interested in
quick returns of funds rather than profitability pay back period
method suits them most because it emphasizes on quick
recovery of funds.

3. FIRMS EMPHASIZING SHORT TERMS EARNING
PERFORMANCE
This method it suitable for firms which emphasize on short
term earnings performance rather than its long term growth.

4. USED FOR PROJECTS HAVING HIGH DEGREE OF
OBSOLESCENCE.

CONCLUSION:
PAY BACK METHOD IS A
MEASURE OF LIQUIDITY OF
INVESTMENT THAN
PROFITABILITY.

S. P. Mandali’s

ACCOUNTING RATE OF RETURN (A.R.R.)

THIS METHOD IS BASED ON AVERAGE ANNUAL
ACCOUNTING PROFITS OF A PROJECT. IT IS EXPRESSED AS
NET ACCOUNTING PROFIT AS A% OF CAPITAL INVESTED.
A.R.R. = Average Annual Profits
AFTER TAX
------------------------------- x 100
AVERAGE OR
INITIAL INVESTMENT
Average Investment = COST – SALVAGE
------------------------- + SALVAGE
2
Average Investment = COST – SALVAGE Release of
----------------------- + SALVAGE + working
2 capital
NOTE: If the sum states that return is to be calculated on the
original investment them instead of Average Investment,
cost itself is to be considered.
MERITS:
1) SIMPLE AND EASY TO CALCULATE.
2) Consider income from the project throughout its life & not
just the initial years unlike payback period.
3) When a number of capital investments proposals are
considered, a quick decision can be taken by use of ranking
the investment.
DEMERITS:
1) It does not consider the time value of money.
2) This method do not differentiate the projects with different
size of investment may have the same A.R.R. and the firm
will not be able to take the required decision.

S. P. Mandali’s

NET PRESENT VALUE METHOD

PRESENT VALUE :
If you invest Rs.1000/- for 3 years in a savings A/c. that pays
10% interest per year. If you let your interest income be
reinvested, your investment will grow as follows.

Rs.
First Year Principal at the beginning 1000
Interest for the year 100
(10/100*1000)
principal at the end 1100

Second Year Principal at the beginning 1100
(10/100*1100)
principal at the end 1210

Third Year Principal at the beginning 1210
(10/100*1210)
principal at the end Rs.1331


S. P. Mandali’s

The process of investing Money as well as reinvesting the interest
earned thereon is called compounding. The future value or
compounded value of an investment after ‘n’ years when the
interest rate is ‘r’ is
F.V. = P.V. (1 + r)n

Where, r = Rate of Interest
N = No. of Years
P.V. = Present Value
F.V. = Future Value

Ex. You deposit Rs.1000 today in a bank which pays 10% interest
compounded annually, how much will the deposit grow to
after 8 years & 12 years?

F.V. 8 yrs. hence = 1000 (1.10)8
= 1000 (2.144)
= Rs.2144

F.V. 12 yrs. hence = 1000 (1.10)12
= 1000 (3.138)
= Rs.3138


S. P. Mandali’s

Q. A firm can invest Rs.10,000 in a project with a life of 3 years.
The projected cash inflows are
Years Rs.
1 4000
2 5000
3 4000

The cost of capital is 10% p.a. should the investment be made?

Answer:-
The discount factor can be calculated based on Re. 1 received
in with ‘r’ rate of interest in 3 years.
1 .
(1 + r)n

Year 1 = Re. 1 = 1/(1.10)1 = 0.909
(1+10/100)1

Year 2 = Re. 1 = 1/(1.10)2 = 0.826
(1+10/100)2

Year 3 = Re. 1 = 1/(1.10)3 = 0.751
(1+10/100)3

Year Cash Inflow (Rs.) Discount Factor Present Value
1 4000 0.909 3,636
2 5000 0.826 4,130
3 4000 0.751 3,004
Total P.V. 10,770


S. P. Mandali’s

NET PRESENT VALUE (NPV) METHOD
This method recognizes that the cash flows at different point
of time differ in value and are comparable only when they are first
brought down to a common denominator. i.e. Present Values. For
this purpose every cash inflow and cash outflow are first
discounted to bring them down to their present value. The
discounting rate normally equals to its opportunity cost of capital.

The NPV is the DIFFERENCE BETWEEN the present
values of cash inflows and the present values of cash outflows.
NPV = Σ PV of inflow – Σ PV of outflow

DECISION RULE
ACCEPT : if NPV is positive i.e. NPV > 0
REJECT : if NPV is negative i.e. NPV < 0

DEFINITION:
The NPV of an investment proposal may be defined as “The
sum of the Present Values of all the cash inflows – The sum of
the Present Values of all the cash outflows”


S. P. Mandali’s

Accept / Reject Criteria:
If NPV of inflow > NPV of outflow
Then Accept the project.
i.e. If NPV of a project is positive Accept the project & If NPV of
a project is negative reject the project.

MERITS:
1. Considers Time Value of Money.
2. Considers Total Cash Inflows. i.e. entire life.
3. Best Decision Criteria for Mutually Exclusive Project.
4. NPV technique is based on the cash flows rather than the
Accounting profits and thus helps in analyzing the effect of
the proposal on the wealth of the shareholders in a better way.
Thus, it satisfies one of the basic objective of Financial
Management i.e. Wealth Maximization


S. P. Mandali’s

LIMITATIONS:

1. It is more difficult method than the Pay Back or ARR method.

2. Consider only Initial Investment:
The NPV is expressed in absolute terms rather than relative
term. Project A may have a NPV of Rs.5000/- while project
B has a NPV of Rs.2,500/-, but project a may require an
investment of Rs.50,000 whereas project B may require an
investment of just Rs.10,000. Advocate of NPV argue that
what maths is the surplus value irrespective of what the
investment outlay is.

3. Life of the project is not considered:
The NPV method do not consider the life of the project.
Hence when mutually exclusive projects with different lives
are being considered, the NPV rule is biased in favour of
long-term project.

4. Calculation of the desired rate of return presents serious
problems. Generally cost of Capital is the basis of
determining the desired rate. The calculation of cost of
Capital is itself complicated. Moreover desired rate of return
will vary term year to year.


S. P. Mandali’s

The following are the steps in Calculating NPV:
1) Calculation of cash flows i.e. both Inflow & Outflow
(preferably after tax) over the full life of the Asset.
2) Discounting the Cash flows by the disc factor.
3) Aggregating of discounted Cash inflow
4) Sept 3 – Outflow (i.e. total present value of cash inflow – total
present value of cash outflow)
a. If positive in step 4. Accept the project
b. If negative in step 4. Reject the project


S. P. Mandali’s

PROFITABILITY INDEX (P/I)

THIS IS THE REFINEMENT OF NPV METHOD
IT IS A VARIANT OF NPV TECHNIQUE WHICH IS ALSO
KNOWN AS BENEFIT COST RATIO OR PRESENT VALUE
INDEX OR EXCESS PRESENT VALUE INDEX.
TOTAL OF P.V. OF CASH INFLOW
P/I = ---------------------------------------------------
TOTAL OF P.V. OF CASH OUTFLOW

ACCEPT THE PROJECT IF P/I > 1
REJECT THE PROJECT IF P/I < 1


S. P. Mandali’s

ADVANTAGE
1. THE NPV DO NOT GIVE TRUE PICTURE WHEN
SELECTION AMONG THE PROJECTS HAS TO BE
MADE AND THE INVESTMENT SIZE IS DIFFERENT.
A PROJECT A & B HAVING COST RS.1,00,000 AND
80,000 RESPECTIVELY. PRESENT VALUE OF INFLOW
OF THE PROJECT ARE RS.1,20,000 & RS.1,00,000 BOTH
HAVE NPV OF RS.20,000 AND AS PER NPV THEY
ALIKE.
HERE P/I TECHNIQUE SEEMS TO GIVE A BETTER RESULT.
1,20,000 1,00,000
P/I (A) = --------------- = 1.20 P/I (B) = ----------- = 1.25
1,00,000 80,000

CONCLUSION: IN TERMS OF NPV BOTH PROJECT ARE
EQUAL BUT IN TERM OF P/I ACCEPT PROJECT B.
2. IT CONSIDERS TIME VALUE OF MONEY.
3. IT CONSIDERS THE ENTIRE CASH INFLOW AND ALL
CASH OUTFLOW IRRESPECTIVE OF THE TIMING OF
THE OCCURRENCE.
4. IT IS BASED ON CASH OUTFLOW RATHER THAN THE
ACCOUNTING PROFIT AND THUS HELPS IN
ANALYZING THE EFFECT OF THE PROPOSAL ON THE
WEALTH OF THE SHAREHOLDER.

S. P. Mandali’s

DISADVANTAGE:
1. IT INVOLVES DIFFICULT CALCULATION.
2. THIS BEING AN EXTENTION OF NPV WHERE THE PREDETERMINATION OF THE
REQUIRED RATE OF RETURN ‘K’ ITSELF IS A DIFFICULT JOB. IF THE VALUE OF
‘K’ IS NOT CORRECTLY TAKEN THEN WHOLE EXERCISE OF NPV MAY GO
WRONG.

PROJECT A PROJECT B
Initial cash outflow 1,50,000 1,10,000
P.V. of cash inflow 2,10,000 1,65,000
NPV 60,000 55,000
AS PER NPV ACCEPT PROJECT A
P/I 2,10,000 = 1.4:1 1,65,000 = 1.5:1
1,50,000 1,10,000
AS PER P/I ACCEPT PROJECT B

IN SUCH A CASE FOLLOW NPV UNLESS THERE IS
CAPITAL RATIONING. THIS IS BECAUSE IF THE FIRM
HAS FUNDS OF RS.1,50,000 TO INVEST THEN AS PER NPV
TECHNIQUE PROJECT A IS TO BE ACCEPTED BECAUSE IT
WILL RESULT IN INCREASE IN SHAREHOLDERS
WEALTH TO THE EXTENT OF RS.60,000 AGAINST
PROJECT B WHICH WILL INCREASE IN SHAREHOLDERS
WEALTH ONLY BY RS.55,000.
THE BETTER PROJECT IS ONE, WHICH ADDS MORE TO
THE WEALTH OF THE SHARE HOLDER.

TERMINAL VALUE (TV)


S. P. Mandali’s

The other variant of the NPV technique is known as terminal
value technique.
Here the future cash inflows are discounted to make them
comparable.
In terminal value technique the future cash flows are first
compounded at the expected rate of interest for the period from
their occurrence till the end of the economic life of the project.
The compound values are then discounted at an appropriate
discount rate to find out the present value.
Then the present value is compared with initial outflow to find
out the suitability of the project.
Steps:
1. Find the compounded value
Year Cash inflow Remaining P.V. factor Compounded
year value
1 3
2 2
3 1
4 0
Σ
2. The above compound value to be discounted at a discount
factor and the P.V. is to be found out.
3. The above (2) to be compared with initial investment to get
NPV.
INTERNAL RATE OF RETURN (IRR)


S. P. Mandali’s

The IRR is that rate at which the sum of discounted cash inflows
equals to the sum of discounted cash outflows.
In other words, it is the rate at which it discounts the cash flow to
zero.
Σ Cash inflow
Or =1
Σ Cash outflow
Thus I.R.R. is also known as marginal rate of return or time
adjusted rate or return.
Thus under this method the discount rate is not known but the
cash inflow and cash outflow are known.

For E.g.
IF a sum of Rs.800 is invested in a project and become Rs.1000 at
the end of a year, the rate of return come to 25% which is
calculated as under:
I= C
(1 + r)

I = Initial investment
C = Cash inflow
R = I.R.R.

i.e. 800 = 1000

S. P. Mandali’s

(1 = r)

800 (1 + r) = 1000
800 + 800r = 1000
800r = 200

r = 200 = 1 = 0.25 = 25%
800 4

In order to make a decision on the basis of IRR technique the firm
has to determine in the first instance, its own required rate of
return.

This rate ‘K’ is also known as cut off rate or the hurdle rate. A
particular proposal may be accepted.

If its IRR ‘r’ is MORE THAN the MINIMUM REQUIRED
RATE ‘K’ ACCEPT IT.

IF the IRR ‘r’ is just Equal To the Minimum Required Rate ‘K’
than the firm may be INDIFFERENT.

If the IRR ‘r’ is LESS THAN the MINIMUM REQUIRED
RATE ‘K’ the project is altogether rejected.

In case of mutually exclusive project the project with highest
IRR is given top priority.


S. P. Mandali’s

MERITS:
1. The method considers the entire economic life of the project.
2. It gives due weightage to time factor. I.e. It consider time
value of money.
3. Like NPV technique, the IRR technique is also based on the
consideration of all the cashflows occurring at any time. The
salvage value, the working capital used and released etc. are
also considered.
4. IRR is based on cashflows rather than accounting profit.

DEMERITS:
1. It involves complicated trial and error procedure.
2. It makes an implied assumption that the future cash inflows of
a proposal are reinvested at a rate equal to IRR for ex. In case
of mutual exclusive proposal say A & B, having IRR of 18%
and 16% respectively, the IRR technique make an implied
assumption that the future cash inflows of project A will be
reinvested at 18% while the cash inflow of project B will
reinvested at 16%.
3. It is imaginary to think that the same firm will have different
reinvestment opportunities depending upon the proposal
accepted.


Rathod capital budgeting 1

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