Welingkar Institute of Management Development and Research

CAPITAL BUDGETING OR CAPITAL EXPENDITURE

SYNOPSIS

1. MEANING & DEFINITION

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.

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

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Eg. A) Increase the capacity

B) Widen the distribution network
4. DIVERSIFICATION PROJECT
Eg. Producing new product
5. RESEARCH AND DEVELOPMENT
6. STRATEGIC INVESTMENT PROJECTS

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

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METHODS OF EVALUATION

METHODS OF EVALUATION

TRADITIONALMODERN

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 every Rs.3 Lacs Rs.5 Lacs Rs.10 Lacs
year
Life of the 10 years 10 years 10 years
project
Pay back period 10/3 = 3 1/3 yrs. 20/5 = 4 yrs. 25/10 = 2½ yrs.

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.

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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.

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.

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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.10000

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

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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.

USES AND APPLICATION:

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 eg. 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

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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.

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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

Interest for the year 110
(10/100*1100)
principal at the end 1210

Third Year Principal at the beginning 1210

Interest for the year 121
(10/100*1210)
principal at the end Rs.1331

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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
n
F.V. = P.V. (1 + r)

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

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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

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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”

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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

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.

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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

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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 / REJECT CRITERIA:

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

ADVANTAGES:
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.

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DISADVANTAGES:
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.

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TERMINAL VALUE (TV)

• 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 year P.V. factor Compounded
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.

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INTERNAL RATE OF RETURN (IRR)

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 Eg
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

(1 = r)

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

r = 200 = 1 = 0.25 = 25%

800 4

ACCEPT / REJECT CRITERIA

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.

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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.

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.

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