CAPITAL BUDGETING - INVESTMENT DECISION

Knowledge Session
 Introduction
Investment and financing of funds are two crucial functions of finance manager. The investment of
funds requires a number of decisions to be taken in a situation in which funds are invested and
benefits are expected over a long period. The finance manager of concern has to decide about the
asset composition of the firm. The assets of the firm are broadly classified into two categories viz.,
fixed and current. The aspect of taking the financial decision with regard to fixed assets is known as
capital budgeting.

 Meaning of Capital Budgeting

Capital Budgeting means planning for capital expenditure in acquisition of capital assets such as
new machinery, building, furniture etc., it includes mechanization of a process replacing and
modernizing a process introduction of a new product and expansion of the business. It includes
raising of long term and as well as its utilization.
As per R. N. Anthony Capital Budgeting means “Any investment involves the commitment of funds
with expectation of earning a satisfactory return on these funds over a period of time in future”.

According to Charles T. Hrongreen, “Capital budgeting is a long-term planning for making and
financing proposed capital out lays.”

 Process of Capital Budgeting

1. Identification of Potential Investment Opportunities –
The sales fore casting enables the firm to set the production targets, this in turn helps in
estimating the investment requirement in plant & equipment`s. For identification of sound
investment opportunities environmental scanning should be done regularly and corporate
strategy should be formulated after doing thorough analysis of the firm.

2. Assembling of Investment Proposals –

Investment proposals identified by various departments are submitted to the investment
committee or the capital budgeting committee. This done to ensure that the proposal is viewed
through different angles. These proposals are classified in to four categories –

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  Replacement investments
 Expansion investments
 New Products investments
 Obligatory and welfare investments.

3. Decision Making –
In this phase management has to sanction the investment proposals. The departmental heads
are given the authority to clear the proposals up to certain limits. Investment proposals requiring
heavy outlays need the approval of the top management or the board of directors.

4. Preparation of Capital Budget and Applications –

Projects involving smaller outlay and which can be decided by executives at lower levels are
often covered by a blanket appropriation for expeditious action. Projects involving larger outlays
are included in the capital budget after necessary approvals. The purpose of this check is mainly
to ensure that the funds position of the firm is satisfactory at the time of implementation.

5. Implementation –
Implementation of project is complex and time consuming task. Delay in implementation can lead
to increase the cost. For expeditious (Quick) implementation following methods are used –
 Adequate formulation of projects.
 Use of principal of responsibility accounting
 Use of network techniques.

6. Performance Review –
It is a comparison of actual performance with the projected performance. It is a feedback device.
It’s useful in several ways –
1. It through light on how realistic was the assumptions underlying the project.
2. It helps in uncovering judgmental biases.
It provides a documental log of experience that is highly valuable for decision making.

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 Need and Importance of Capital Budgeting
Capital budgeting decisions are critical and crucial business decisions because they involve:
 Substantial investment: Capital investment normally demands heavy volume of
investment which is met out by the firm either through external or internal source of financing.
Hence, the amount of capital raised by the firm should neither greater nor lesser than the
investment.
 Long time period: Capital budgeting involves decision of capital expenditures which are
for long period. It requires utmost rationality, otherwise it may result into overcapitalization.
 Locking up of capital: The amount invested requires long gestation for recovery. The
longer gestation relates to future horizon in getting back the investment. The future is uncertain
unlike the present. If the longer is the gestation in the future leads to greater risk involved.
 Nature of Irreversibility: The improper/ unwise capital expenditure decision cannot be
immediately corrected as soon as it was found. Once it is invested is invested which cannot be
reversed.
 Complexity: The expected benefit of an investment is generally unpredictable. The poor
investment decision will require the firm either to keep it as an idle in the form of investment or
to unnecessarily meet out fixed commitment charge of the capital which excessively rose more
than the requirement.
 Profitability of the enterprise: The profitability of the enterprise mainly depends on the
proper planning of the capital expenditure.

While capital expenditure decisions are extremely important, managers find it extremely difficult to
analyze the pros and cons and arrive at a decision because:
 Measuring costs and benefits of an investment proposal is difficult because all costs and benefits
cannot be expressed in tangible terms.
 The benefits of capital expenditure are expected to occur for several years in the future which is
highly uncertain.
 Because the costs and benefits occur at different points of time, investment proposal, for a proper
analysis of the viability of the all these must be brought to a common time frame. Hence time
value of money becomes very relevant here.
 Capital budgeting decisions are among the most difficult to make when the company is
 faced with various potentially viable investment opportunities.

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 Significance of Capital Budgeting
 Capital budgeting is an essential tool in financial management
 Capital budgeting provides a wide scope for financial managers to evaluate different projects in
terms of their viability to be taken up for investments
 It helps in exposing the risk and uncertainty of different projects
 It helps in keeping a check on over or under investments
 The management is provided with an effective control on cost of capital expenditure projects
 Ultimately the fate of a business is decided on how optimally the available resources are used

 Capital Budgeting Techniques / Methods

There are different methods adopted for capital budgeting. The traditional methods or non-discount
methods include: Payback period and Accounting rate of return method. The discounted cash flow
method includes the NPV method, profitability index method and IRR.
A) Traditional Methods
1. Payback Period Method:
As the name suggests, this method refers to the period in which the proposal will generate cash to
recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the
project and the investment made in the project, with no consideration to time value of money.
Through this method selection of a proposal is based on the earning capacity of the project. With
simple calculations, selection or rejection of the project can be done, with results that will help gauge
the risks involved. However, as the method is based on thumb rule, it does not consider the
importance of time value of money and so the relevant dimensions of profitability.

Payback period = Cash outlay (investment) / Annual cash inflow

Payback period of project B is shorter than A, but project A provides higher returns. Hence,
project A is superior to B.
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2. Accounting rate of return method (ARR):
This method helps to overcome the disadvantages of the payback period method. The rate of return
is expressed as a percentage of the earnings of the investment in a particular project. It works on
the criteria that any project having ARR higher than the minimum rate established by the
management will be considered and those below the predetermined rate are rejected.
This method takes into account the entire economic life of a project providing a better means of
comparison. It also ensures compensation of expected profitability of projects through the concept
of net earnings. However, this method also ignores time value of money and doesn’t consider the
length of life of the projects. Also it is not consistent with the firm’s objective of maximizing the market
value of shares.

ARR= Average income/Average Investment

B) Time Adjusted / Discounted Methods

1. Discounted Cash Flow Method:

The discounted cash flow technique calculates the cash inflow and outflow through the life of an
asset. These are then discounted through a discounting factor. The discounted cash inflows and
outflows are then compared. This technique takes into account the interest factor and the return
after the payback period.

2. Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In this technique
the cash inflow that is expected at different periods of time is discounted at a particular rate. The
present values of the cash inflow are compared to the original investment. If the difference between
them is positive (+) then it is accepted or otherwise rejected. This method considers the time value
of money and is consistent with the objective of maximizing profits for the owners. However,
understanding the concept of cost of capital is not an easy task.
The equation for the net present value, assuming that all cash outflows are made in the initial year
(tg), will be:

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Where A1, A2…. represent cash inflows,
K is the firm’s cost of capital,
C is the cost of the investment proposal and
n is the expected life of the proposal.
It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present,
value cannot be known.

NPV = PVB – PVC

where,
PVB = Present value of benefits
PVC = Present value of Costs

3. Internal Rate of Return (IRR):

This is defined as the rate at which the net present value of the investment is zero. The discounted
cash inflow is equal to the discounted cash outflow. This method also considers time value of money.
It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the
cash inflows. However, computation of IRR is a tedious task.
It is called internal rate because it depends solely on the outlay and proceeds associated with the
project and not any rate determined outside the investment.
It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.

If IRR > k = accept
If IR < k = reject

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4. Profitability Index (PI):
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial
cash outflow of the investment. It may be gross or net, net being simply gross minus one. The
formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

5. Modified Internal Rate Of Return (MIRR):

The modified internal rate of return (MIRR) presumes that constructive cash flows are reinvested to
the company’s cost of capital and that the inceptive outlays are funded at the company’s financing
cost. It is a development over IRR and changes many things like: it deletes the different IRRs, checks
the reinvestment price issues and initiates outcome, which is in a link with the present value method.

Here are some points of difference between IRR and MIRR:

IRR MIRR
Definition
IRR is the discount amount for investment that MIRR is the price in the investment plan that
corresponds between the initial capital outlay and equalises the latest value of the cash inflow
the present value of predicted cash flows. to the first cash outflow.
What does it mean?
It is a discount rate at which the NPV of all the cash It is a modified form of IRR in which the NPV
flows from a project becomes zero. of the inflows (cash flows) is equal to the
outflows (investments).
Basis of assumption

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 It assumes that the positive cash flows from a It assumes that positive cash flows are
project are reinvested on the same rate of return as reinvested based on the cost of the capital
that of investments. of the firm.
Precision
IRR is comparatively less precise in calculating the MIRR is much more precise than IRR.
rate of return.

Short Notes –
1) Payback Period
This technique estimates the time required by the project to recover, through cash inflows the firm’s
initial outlay. Beginning with the project with the shortest layout period, different projects are
arranged in order of time required to recapture their respective estimated initial outlays. The payback
period for each investment proposal is compared with the maximum period acceptable to the
management and proposals than ranked and selected in order of those having minimum pay-out
period.
In order to use the payback period as a decision rate for accepting or rejecting the projects the firms
has to decide upon an appropriate cutoff date. Projects with payback periods less than or equal to
the cutoff date will be accepted and other will be rejected. The payback is a widely used investment
appraisal criterion.
Advantages –
a. It is easy to calculate. It can be understood easily by non-financial executive also.
b. The risk element involved in capital budgeting will be taken care of by the pay-back method,
as it prefers a project, which recoups the investment in the shortest possible period.
c. The guess work and uncertainties are quite limited in calculations, because it is not necessary
to forecast cash flows throughout the life of the project.
Limitation –
a. It fails to consider the time value of money.
b. This method does not take into account the salvage or residual value if any, of long term asset.
c. The cash flows generated throughout the life of the project are not considered ignores the cash
flows which arise after the pay-back period.

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Practical Session
1) Algol Enterprise having the following two proposal of investment:
Particulars Proposal Proposal
‘A’ ‘B’
Cost of Investment (Rs.) 2,00,000 2,80,000
Life of the Assets (Years) 4 5
Scrap Value NIL NIL
Net Income after tax before depreciation :
Year Rs. Rs.
2020 30,000 70,000
2021 70,000 70,000
2022 90,000 70,000
2023 1,00,000 70,000
2024 – 70,000
The present value of Re. 1 to be received at the end of each year at 10% p.a. is given below :
Year Present Value Year Present Value
1 0.909 2 0.826
3 0.751 4 0.683
5 0.621
You are required to assess the profitability of the projects on the basis of the following methods :
(a) Return on Investment (c) Discounted Payback Period
(b) Payback Period (d) Profitability Index

2) Alcor Limited, Pune wants to purchase a new machine for the Company. There are three
alternative machines available, the details of which are as follows :
Particulars Machine A Machine B Machine C
Cost Rs. 6,00,000 5,00,000 6,00,000
Life 5 Years 5 Years 5 Years
Year Net profit after depreciation and tax
1st 70,000 10,000 (Loss) 1,50,000
2nd 60,000 30,000 1,00,000
3rd 50,000 50,000 50,000
4th 60,000 1,00,000 30,000
5th 70,000 1,50,000 20,000

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Depreciation has been charged by straight line method. The Company expects minimum rate of
return at 10% at which the present value of Rupee one to be received at the end of each year is
given below :
Year 1 2 3 4 5
Present Value 0.909 0.826 0.751 0.683 0.621
You are required advise the management which of the alternative machines is the best on the basis
of the following methods appraisal :
a) Pay back method b) Average return on average investment c) Net Present Value d) Profitability
Index.

3) Sirius Limited, Pune wants to purchase a new machine for the Company. There are two
alternative machines available, the details of which are as follows :
Particulars Machine A Machine B
Cost Rs. 10,00,000 Rs. 10,00,000
Life 5 Years 5 Years
Year Net Profit after Depreciation and Tax (Rs.)
1st 2,00,000 50,000 (loss)
2nd 1,50,000 50,000
3rd 1,00,000 1,00,000
4th 50,000 1,60,000
5th 50,000 (loss) 2,00,000
Depreciation is to be charged by Straight Line Method. The Company expects minimum rate of
return at 10% at which the present value of Rupee One to be received at the end of each year is
given below :
Year 1 2 3 4 5
Present Value 0.909 0.826 0.751 0.683 0.621

You are required to advise management as to which of the alternative machines is the best on the
basis of the following appraisal methods:
(a) Average Return on Average Investment (b) Discounted Pay Back Period (c) Net Present Value
(d) Profitability Index

4) Albireo Limited, Pune wants to purchase a new machine for the Company. There are two
alternative machines available, the details of which are as follows :
Particulars Machine A Machine B
Cost Rs. 4,00,000 Rs. 5,00,000

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Life 5 years 5 years
Year Net profit after depreciation and tax (Rs.)
1st 90,000 10,000 (Loss)
2nd 80,000 40,000
3rd 60,000 60,000
4th 40,000 80,000
5th 10,000 (loss) 90,000
Depreciation is to be charged by straight line method. The Company expects minimum rate of return
at 10%. You are required to advise the management as to which of the alternative machines is the
best on the basis of the following methods of appraisal :
a) Payback period method b) Average return on average investment c) Net Present Value d)
Profitability Index.

5) MBA April 2019

Rigel Limited whose cost of capital is 10% is considering two mutually exclusive projects X & Y as
per details :

Particulars Year Project X Project Y

Cost 0 Rs. 70,000 Rs. 70,000
Cash Inflows 1 10,000 50,000
2 20,000 40,000
3 30,000 20,000
4 45,000 10,000
5 60,000 10,000
Compute the net present value at 12%, profitability index & discounted pay-back period for the two
projects.

6) A) A project has an initial investment of Rs. 1,00,000. It will produce cash flows after tax of
Rs. 25,000 per annum for seven years. Compute the payback period for the project.
B) Alpha Corvi Ltd has an initial investment of Rs. 10 lakhs. Its cash flows for five years are
Rs. 3,00,000, Rs.3,60,000 , Rs.3,00,000, Rs. 2,64,000 & Rs.2,40,000. Determine the
payback Period.

7) Gamma Cancri Ltd., Project K has an initial investment of Rs. 10 lakhs. Its cash flows for five
years are Rs. 3,00,000, Rs.3,60,000 , Rs.3,00,000, Rs. 2,64,000 & Rs.2,40,000. Determine the
payback period assuming a discount rate of 10% p.a.

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8) a) Compute ARR if cost of assets is Rs. 2,00,000., useful Life is 5 years, cash flows after
taxes 86,000 p.a.
b) Project Delta Draconis requires an investment of Rs. 10 lakhs and yields profit after tax
and depreciation as follows-
Year 1 2 3 4 5
Profit after tax and depreciation 50,000 75,000 1,25,000 1,30,000 80,000
At the end of 5 years, the plant can be sold for Rs. 80,000. You are required to calculate ARR.

9) Zeta Sagittarii Ltd. is considering a new 5-years project. Its investment costs and annual profits
are projected as follows-
Investment Profits
Year 0 1 2 3 4 5
Amount Rs. (2,50,000) 40,000 30,000 20,000 10,000 10,000
Residential value at the end of the project is expected to be Rs. 40,000 and depreciation of the
original investment is on straight line basis. Using average profits and average capital employed,
ARR for the project and also the payback period.

10) Nu Capricorni Company is evaluation an investment proposal of Rs. 3,06,000 with expected
cash flows-
Year 1 2 3 4
CFAT Rs. 1, 00,000 1, 20,000 1, 50,000 1, 00,000
The company’s cost of capital is 10% compute the NPV and PI for this project.

11) Alnilam Ltd. Whose cost of capital is 10% is considering 2 mutually exclusive proposals X
and Y, the details are as follows –
Particulars Project X (Rs.) Project Y (Rs.)
Investment (out flow) 15,00,000 15,00,000
Cash inflows at the end of
1 1,00,000 6,50,000
2 2,50,000 6,00,000
3 3,50,000 6,00,000
4 5,50,000 5,75,000
5 7,50,000 5,25,000
1. Pay Back Period 4. Internal Rate of Return
2. NPV @ 10% 5. Profitability Index
3. Profitability Index @ 10%

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12) Taurus Ltd. Whose cost of capital is 10% is considering 2 mutually exclusive proposals X and
Y, the details are as follows –
Particulars Project X (Rs.) Project Y (Rs.)
Investment (out flow) 30,00,000 30,00,000
Cash inflows at the end of
1 2,00,000 13,00,000
2 5,00,000 12,00,000
3 7,00,000 12,00,000
4 11,00,000 11,50,000
5 15,00,000 10,50,000
1. Pay Back Period 4. Internal Rate of Return
2. NPV @ 10% 5. Profitability Index
3. Profitability Index @ 10%

13) Draco Ltd, Project K has an initial investment of Rs. 10 lakhs. Its cash flows for five years are
Rs. 2,00,000, Rs.4,60,000 , Rs.4,00,000, Rs. 2,64,000 & Rs.3,40,000. Determine the
payback period assuming a discount rate of 12% p.a.

14) (Practice)
Leo Ltd. whose cost of capital is 10% is considering two mutually exclusive projects X & Y as per
details :
Particulars Year Project X Project Y
Cost 0 1,40,000 1,40,000
Cash Inflows 1 20,000 1,00,000
2 40,000 80,000
3 60,000 40,000
4 90,000 20,000
5 1,20,000 20,000
Compute the net present value at 10%, profitability index & discounted pay-back period for the two
projects. (P.V. factors @ 10% = 0.909, 0.826, 0.751, 0.683 & 0.621 for the year 1 to 5 resp.)

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15) (Practice)
Gemini Enterprises a firm’s whose cost of capital is 12% is considering project X
Particulars Year Project X
Cost 0 Rs. 1, 40,000
Cash Inflows 1 30,000
2 40,000
3 65,000
4 80,000
5 1, 20,000
Compute the net present value at 12%, profitability index & discounted pay-back period, IRR.

16) Project Orion requires an investment of Rs. 20 lakhs and yields profit after tax and depreciation
as follows-
Year 1 2 3 4 5
profit after tax and depreciation 2,00,000 3,50,000 5,50,000 5,60,000 3,60,000
At the end of 5 years, the plant can be sold for Rs. 1, 60,000.
1) NPV @ 12% 4) IRR
2) Pay Back Period 5) Profitability Index
3) Discounted Payback Period 6) ARR.

17) Vela Ltd.

Particulars Rs.
Initial Outflow (Machinery Purchase) 1,00,000
Cash Inflows (before Depreciation & Tax)
1st Year 29,000
2nd Year 38,400
3rd Year 43,500
4th Year 47,600
5th Year 52,300
Tax Rate 50%
Life of Machinery 5 Years
Salvage Value 10,000
Cost of Capital 12%
Calculate
1. NPV 2. Pay Back Period
3. Profitability Index 4. Actual Rate of Return (ARR)

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18) Company Bootes Private Limited is planning an investment in new project. The investment
budget of the company is 30,00,000. The company has following two investment alternatives.

Particulars Project A Project B

Investment 30,00,000 30,00,000
Useful life 5 years 6 years
Cost of capital 12% 12%
Cash inflows at the end of the year
Year 1 7,00,000 8,00,000
Year 2 10,00,000 8,00,000
Year 3 9,00,000 8,00,000
Year 4 8,00,000 8,00,000
Year 5 4,00,000 6,00,000
Year 6 - 2,00,000

Find which project the company should select on the basis of:
a) Payback period method
b) Net present value method

Discount factor @ 12%

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
0.893 0.797 0.712 0.636 0.567 0.507

19) Mensa Company is considering an investment proposal to install a new machine. This project
will cost Rs. 1, 00,000 and will have 5 years life with no salvage value. Tax rate is 50 per cent ; the
company follows straight line method of depreciation. The earnings before depreciation and tax as
follows:

Years 1 2 3 4 5
EBDT (Rs.) 20,000 22,000 28,000 30,000 50,000
Evaluate the project using:
1) Payback period
2) Profitability index at 10%

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20) Cassiopeia is considering a project the details of which are: Investment – 70,000.
Year Cash flow
1 10,000
2 20,000
3 30,000
4 45,000
5 40,000
Determine the payback period. Cost of capital 10%. Compute NPV, PI and IRR

21) Lyra Company is considering an investment proposal to install a new milling controls at a cost
of Rs. 50,000. The facility has life expectancy of 5 years without any salvage value. The firm uses
SLM of depreciation and the same is used for tax purpose. The tax rate is assumed to be 35%. The
estimated cash flows before depreciation and tax (CFBT) from the investment proposal are as
follows:
Years 1 2 3 4 5
CFBT (Rs.) 10,000 10,692 12,769 13,462 20,385
Compute:
1) Payback Period
2) Average rate of return
3) NPV at 10% discount rate
4) profitability index at 10% discount rate

22) Tucana Enterprise having the following two proposal of investment :

Particulars Proposal A Proposal B
Cost of Investment (Rs.) 2,00,000 2,80,000
Life of the Assets (Years) 4 5
Scrap Value NIL NIL
Net Income after depreciation and tax ₹ ₹
2020 5,000 34,000
2021 20,000 34,000
2022 35,000 34,000
2023 25,000 34,000
2024 --- 34,000
It is estimated that each of the project will require an additional working capital of Rs. 2,000 which
will be received back in full after the expiry of each project life. Depreciation is to be provided under
Straight Line Method.

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