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PGTRB - UNIT – IV – CAIPITAL BUDGETING

Capital Expenditure decisions – Marginal Costing and Break-even analysis – Managerial
Uses – Working Capital Forecast – Zero Base Budgeting.
1 Capital Expenditure Decisions
 Capital budgeting decisions pertain to fixed/long-term assets.
 Refer to assets which are in operation, and yield a return, over a period of time, usually,
exceeding one year.
 It involves a current outlay or series of outlays of cash resources in return for an
anticipated flow of future benefits.
 Current outlays but are likely to produce benefits over a period of time longer than one
year.
 These benefits may be either in the form of increased revenues or reduced costs.
Basic features of capital budgeting
(i) potentially large anticipated benefits;
(ii) a relatively high degree of risk; and
(iii) a relatively long time period between the initial outlay and the anticipated returns.
The examples of capital expenditure:
 Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
 The expenditure relating to addition, expansion, improvement and alteration to the fixed
assets.
 The replacement of fixed assets.
 Research and development project.
Definition
Charles T. Hrongreen, “capital budgeting is a long-term planning for making and
financing proposed capital out lays.
Richard and Green law, “capital budgeting is acquiring inputs with long-term return”.
Lyrich, “capital budgeting consists in planning development of available capital for the
purpose of maximizing the long-term profitability of the concern”.

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1.1 Need and Importance of Capital Budgeting

1. Huge investments: Capital budgeting requires huge investments of funds, but the
available funds are limited, therefore the firm before investing projects, plan are control
its capital expenditure.
2. Long-term: Capital expenditure is long-term in nature or permanent in nature.
Therefore financial risks involved in the investment decision are more. If higher risks are
involved, it needs careful planning of capital budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed back.
Once the decision is taken for purchasing a permanent asset, it is very difficult to dispose
off those assets without involving huge losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also increases the
revenue in long-term. Over investments leads to be unable to utilize assets or over
utilization of fixed assets.
1.2 Capital budgeting process
 It refers to the total process of generating, evaluating, selecting and following up on
capital expenditure alternatives.
 The firm allocates or budgets financial resources to new investment proposals.
 Basically, the firm may be confronted with three types of capital budgeting decisions:
o the accept-reject decision;
o the mutually exclusive choice decision; and
o the capital rationing decision.
Accept-reject Decision
 This is a fundamental decision in capital budgeting.
 If the project is accepted, the firm would invest in it;
 If the proposal is rejected, the firm does not invest in it.
 Rate of return > Required Rate of Return (Cost of Capital) – Accepted and the rest
are rejected. By applying this criterion, all independent projects are accepted.
 Independent projects are projects that do not compete with one another in such a
way that the acceptance of one precludes the possibility of acceptance of another.
Under the accept reject decision, all independent projects that satisfy the minimum
investment criterion should be implemented.

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Mutually Exclusive Project Decisions

 Those projects which compete with other projects.
 Mutually exclusive project decisions are not independent of the accept-reject
decisions.
 It acquires significance when more than one proposal is acceptable
 Ex. There are three competing brands, each with a different initial investment and
operating costs. The three machines represent mutually exclusive alternatives, as
only one of these can be selected.
Capital Rationing Decision
 It refers to a situation in which a firm has more acceptable investments than it can
finance.
 It is concerned with the selection of a group of investment proposals out of many
investment proposals acceptable under the accept-reject decision.
 Capital rationing employs ranking of the acceptable investment projects.
1.3 Investment Criteria
 A wide range of criteria has been suggested to judge the worthwhileness of
investment projects. two broad categories
 Discounting criteria - Take into account the time value of money
Non-discounting criteria - ignore the time value of money

1.4 Pay-back Period

o It is called as Pay-out or Pay-off period.
o It will generate necessary cash to recoup the initial investment.

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o Pay-back period is the time required to recover the initial investment in a project.
o (It is one of the non-discounted cash flow methods of capital budgeting).

− =
ℎ
The annual cash inflow is calculated by taking into account the amount of net come on
account of the assets (or project) before depreciation but after taxation.
Annual Cash inflow = Net income (Net Profit) – Taxation + Depreciation
It is expressed as a percentage of initial investment is termed as “Unadjusted rate of
Return”.

= 100

Merits of Pay-back method

The following are the important merits of the pay-back method:
1. It is easy to calculate and simple to understand.
2. It provides further improvement over the accounting rate return.
3. It reduces the possibility of loss on account of obsolescence.
Demerits
1. It ignores the time value of money.
2. It ignores all cash inflows after the pay-back period.
3. It is one of the misleading evaluations of capital budgeting.
Accept /Reject criteria
 If the actual pay-back period is less than the predetermined pay-back period, the
project would be accepted. If not, it would be rejected.
 A project whose actual pay-back period is more than what has been pre-determined
by the management will be staightaway rejected.
 The fixation of the maximum acceptable pay-beck period is generally done is taking
into account the reciprocal of the cost of capital.
 − =
 . ℎ 20% ℎ − =
.
5

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 For mutually exclusive projects by applying ranking method, - The shortest pay-back
period or highest unadjusted rate of return will be preferable to accept.
1.5 Accounting Rate of Return or Average Rate of Return
 The capital investment proposals are judged on the basis of their relative profitability.
 It is based on commonly accepted accounting principles (For calculation of capital
employed and related income) and practices over the entire economic life of project and
then average yield is calculated.
 This method is one of the traditional methods for evaluating the project proposals:

= 100

= 100

1. Annual Net Earning = Earnings after depreciation and Tax

2. Average Investment is calculated
1.
2.
3.
4. + . +

Merits
1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.
Demerits
1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some
difficulties in the calculation of the project.

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Accept/Reject criteria
o Normally, business enterprises fix a minimum rate of return. Any project expected to
give a return below this rate will be straightaway rejected.
o If the actual accounting rate of return is more than the predetermined required rate of
return, the project would be accepted. If not it would be rejected.
1.6 Net Present Value
 It is the most important concept of finance. Net present value method is one of the
modern methods for evaluating the project proposals.
 NPV is the difference between total present value of future cash inflows and the
total present value of future cash outflows.
 It is used to evaluate investment and financing decisions that involve cash flows
occurring over multiple periods.
 The net present value (NPV) of a project is the sum of the present values of all the
cash flows positive as well as negative - that are expected to occur over the life of
the project. The general formula of NPV is:

 r – Cut-off rate / Cost of capital

 It represents the net benefit over and above the compensation for time and risk.
Hence the decision rule associated with the net present value criterion is:
o Accept the project if the net present value is positive and
o reject the project if the net present value is negative.
o (If the net present value is zero, it is a matter of indifference.)
NPV > Zero | PV > C– Accept the proposal
NPV < Zero | PV < C – Reject the proposal
Note: PV – Present Value of Cash Inflows C – Present Value Cash Outflows (or outlays)

 In this method cash inflows are considered with the time value of the money. Net
present value describes as the summation of the present value of cash inflow and
present value of cash outflow.
 Net present value is the difference between the total present value of future cash
inflows and the total present value of future cash outflows.

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1. Merits
1. It recognizes the time value of money.
2. It considers the total benefits arising out of the proposal.
3. It is the best method for the selection of mutually exclusive projects.
4. It helps to achieve the maximization of shareholders’ wealth.
2. Demerits
1. It is difficult to understand and calculate.
2. It needs the discount factors for calculation of present values.
3. It is not suitable for the projects having different effective lives.
3. Accept/Reject criteria
If the present value of cash inflows is more than the present value of cash
outflows, it would be accepted. If not, it would be rejected.
 Limitations
o Expressed in absolute terms rather than relative terms and hence does not
factor in the scale of investment.
o The NPV rule does not consider the life of the project.
1.7 Benefit-Cost Ratio (Profitability Index)
 It is present value index method.
 The refinement of the net present value method.
 Benefit-cost ratio, also called profitability index may be defined in two ways:

= − 1
(OR)
ℎ
= 100
ℎ

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The proponents of benefit-cost ratio argue that since this criterion measures net present
value per rupee of outlay, it can discriminate better between large and small investments
and hence is preferable to the net present value criterion.
(i) Under unconstrained conditions, the benefit-cost ratio criterion will accept and
reject the same projects as the net present value criterion,
(ii) When the capital budget is limited in the current period, the benefit-cost ratio
criterion may rank projects correctly in the order of decreasingly efficient use of
capital.
(iii) When cash outflows occur beyond the current period, the benefit-cost ratio criterion
is unsuitable as a selection criterion.
1.8 Internal Rate of Return (IRR)
 It is the discount rate which makes its NPV equal to zero.
 It is the discount rate which equates the present value of future cash flows with the
initial investment.
 IRR is that rate at which the sum discounted cash inflows equals the sum of
discounted cash outflows.
ℎ
=1
ℎ

=
+
Accept / Reject Criterion
A project will qualify to be accepted if IRR exceeds the cut-off rate. While evaluating two
or more projects, a project giving a higher IRR would be preferred.

 In the NPV calculation we assume that the discount rate (cost of capital) is known
and determine the NPV.
 In the IRR calculation, we set the NPV equal to zero and determine the discount rate
that satisfies this condition.
 Internal rate of return is time adjusted technique and covers the disadvantages of the
traditional techniques.

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 In other words it is a rate at which discount cash flows to zero. It is expected by the
following ratio:

Base factor = Positive discount rate, DP = Difference in percentage

Merits
1. It consider the time value of money.
2. It takes into account the total cash inflow and outflow.
3. It does not use the concept of the required rate of return.
4. It gives the approximate/nearest rate of return.
Demerits
1. It involves complicated computational method.
2. It produces multiple rates which may be confusing for taking decisions.
3. It is assume that all intermediate cash flows are reinvested at the internal rate
4. of return.

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