CAPITAL BUDGETING

5. CAPITAL BUDGETING

BIRD EYE VIEW

Introduction.
Concept of Capital Budgeting
Importance of Capital Budgeting Decisions
Capital Budgeting Process
Type of Investment Proposals
Basic Factors for Project Evaluation
Determination of Initial Cash Flows, Interim Cash Flows &
Terminal Cash Flows
Techniques of Capital Budgeting – Payback Period, Payback
Reciprocal, Accounting Rate of Return Method, NPV Method,
Profitability Index Method, Internal Rate of Return Method,
Discounted Payback Period, Modified Internal Rate of Return

NPV V/S IRR

Projects With Varying Lives
Capital Rationing
Summary

INTRODUCTION

Capital investment involves a cash outflow in the immediate future in anticipation of

returns at future date. The investment of funds requires a number of decisions to be
taken in which funds are invested and benefits are expected over a long period. A
capital investment decision involves a largely irreversible commitment of resources
that is generally subject to significant degree of risk. The finance manager therefore

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is required to do proper planning of project to know in advance About the technical

feasibility of the project.

In simple terms, Capital Budgeting involves:

➢ Identification of investment projects that are strategic to business’ overall

objectives;

➢ Estimating and evaluating post-tax incremental cash flows for each of the
investment proposals; and

➢ Selection of an investment proposal that maximizes the return to the investors.

CONCEPT OF CAPITAL BUDGETING

1. Capital budgeting refers to the long-term planning of expenditure whose returns

stretch over future period.

2. It is the process of deciding whether or not to commit resources to a project whose

benefits would be spread over several time periods.

3. It considers proposed capital outlay and it's financing. Thus, it includes both
raising of long-term funds as well as the utilization.

4. The exercise involved in a capital budgeting is to co-relate the benefits to costs

in some reasonable manner that would be consistent with the profit maximizing
objectives of the business.

5. It is a managerial decision, since it involves more extended estimation and

prediction of things to come requiring high order of intellectual ability.

6. The economic justification for a capital expenditure programme requires a long

term estimates of profits, which in turn involves projection of sales and costs of
operation over a period of years.

IMPORTANCE OF CAPITAL BUDGETING DECISIONS

Capital budgeting decisions should be taken after careful analysis and review. The
importance of capital Budgeting can be understood from the following points.
1. Cost - Initial investment is substantial. Hence commitment of resources should
be made properly.

2. Time - The effect of decision is known only in the near future and not immediately

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3. Irreversibility - Decisions are irreversible and commitment should be made on

proper evaluation.

4. Complexity - Decisions are based on forecasting of future events and inflows.

Quantification of future involves application of statistical and probabilistic
techniques. Careful judgment and application of mind is necessary.

CAPITAL BUDGETING PROCESS

Implement
Planning Evaluation Selection Control Review
ation

I. Planning: The capital budgeting process begins with the identification of

potential investment opportunities. The opportunity then enters the planning
phase when the potential effect on the firm's fortunes is assessed and the ability
of the management of the firm to exploit the opportunity is determined.
Opportunities having little merit are rejected and promising opportunities are
advanced in the form of a proposal to enter the evaluation phase.

II. Evaluation: This phase involves the determination of proposal and its
investments, inflows and outflows. Investment appraisal techniques, ranging from
the simple payback method and accounting rate of return to the more
sophisticated discounted cash flow techniques, are used to appraise the proposals.
The technique selected should be the one that enables the manager to make the
best decision in the light of prevailing circumstances.

III. Selection: Considering the returns and risks associated with the individual
projects as well as the cost of capital to the organisation, the organisation will
choose among projects which maximises the shareholders' wealth.

IV. Implementation: When the final selection is made, the firm must acquire the
necessary funds, purchase the assets, and begin the implementation of the
project.

V. Control: The progress of the project is monitored with the aid of feedback
reports. These reports will include capital expenditure progress reports,

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performance reports comparing actual performance against plans set and post
completion audits.

VI. Review: When a project terminates, or even before, the organisation should
review the entire project to explain its success or failure. This phase may have
implication for firm's planning and evaluation procedures. Further, the review may
produce ideas for new proposals to be undertaken in the future.

TYPES OF INVESTMENT PROPOSAL

Replacement and
Modernisation
decisions.

On the basis of
Expansion decisions.
INVESTMENT DECISIONS

firm's existence.
TYPES OF CAPITAL

Diversification
decisions.

Mutually exclusive
decisions.

On the basis of Accept-Reject

decision situation. decisions.

Contingent decisions.

I. Replacement and Modernisation decisions: The replacement and

modernisation decisions aims to improve operating efficiency and reduce cost.
Generally, all types of plant and machinery require replacement either because
the economic life of the plant or machinery is over or because it has become
technologically outdated. The former decision is known as replacement decision
and latter is known as modernisation decision. Both replacement and
modernisation decisions are called as cost reduction decisions.

II. Expansion decisions: Existing successful firms may experience growth in

demand of their product line. If such firms experience shortage or delay in the

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delivery of their products due to inadequate production facilities, they may

consider proposal to add capacity to existing product line.

III. Diversification decisions: These decisions require evaluation of proposals to

diversify into new product lines, new markets etc. for reducing the risk of failure
by dealing in different products or by operating in several markets.
Both expansion and diversification decisions are called revenue expansion
decisions.

On the basis of decision situation

I. Mutually exclusive decisions: The decisions are said to be mutually exclusive
if two or more alternative proposals are such that the acceptance of one
proposal will exclude the acceptance of the other alternative proposals. For
instance, a firm may be considering proposal to install a semi-automatic or highly
automatic machine. If the firm installs a semi-automatic machine, it excludes the
acceptance of proposal to install highly automatic machine.

II. Accept-Reject decisions: The accept-reject decisions occur when proposals

are independent and do not compete with each other. The firm may accept or
reject a proposal on the basis of a minimum return on the required investment.
All those proposals which give a higher return than certain desired rate of return
are accepted and the rest are rejected.

III. Contingent decisions: The contingent decisions are made when the proposals
are dependable proposals. The investment in one proposal requires investment
in one or more other proposals. For example, if a company accepts a proposal to
set up a factory in remote area, it will have to invest in infrastructure, like building
of roads, houses for employees etc. also.

BASIC FACTORS FOR PROJECT EVALUATION

• Initial investment - This equals the cash outflow at the initial stage , net of
salvage value of old machinery if any. Initial Investment = Cost of new Asset
purchased less sale value of old Asset if any.

• Cash flow after taxes (CFAT) - This equals the cash inflows generated by the
projects at various points of time. Generally CFAT = PAT(profit after Tax) +
Depreciation and other amortization's.

• Project life - The time period during which the project generates positive cash
flow after taxes is called project life.

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• Time value of money - The value of money differs at different point of time. So
the present value of future cash flows will be computed by discounting the same
at the appropriate discount rate.

• Discount rate - It represents the cut-off rate for capital investment evaluation.
A project which does not earn at least the cut-off rate should not be accepted.
Generally, the rate used for discounting is the weighted average cost of capital of
the enterprise.

• PV factor and annuity factor tables - For the purpose of discounting future
cash flows, the PV factor (present value factor) and annuity factor tables are used.
The utility of tables is as under:
a) In case of uniform cash flows during the project life - annuity factor at the
end of the project life.

b) In case of differential cash flows during the project life - PV factors for each
year.

CASH FLOWS

Before we analyze how cash flow is computed in capital budgeting decision, following
items needs consideration:

a) Depreciation: As mentioned earlier, depreciation is a non-cash item and itself

does not affect the cash flow. However, we must consider tax shield or benefits
from depreciation in our analysis. Since this benefit reduces cash outflow for taxes
it is considered as cash inflow.

b) Opportunity Cost: Opportunity cost is foregoing of a benefit due to choosing an

alternative investment option. For example, if a company owns a piece of land
acquired 10 years ago for Rs.1 crore can be sold for 10 crore. If the company uses
this piece of land for a project, then its sale value i.e. Rs.10 crore forms the part
of initial outlay as by using the land the company has foregone Rs.10 crore which
could be earned by selling it. This opportunity cost can occur both at the time of
initial outlay and during the tenure of the project.

Opportunity costs are considered for estimation of cash outflows.

c) Sunk Cost: Sunk cost is an outlay of cash that has already been incurred in
the past and cannot be reversed in present. Therefore, these costs do not have
any impact on decision making, hence should be excluded from capital budgeting
analysis. For example, if a company has paid a sum of 1,00,000 for consultancy

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fees to a firm to prepare a Project Report for analysing a particular project. Then
the consultancy fee paid is irrelevant and is not considered for estimating cash
flows as it has already been paid and shall not affect our decision whether project
should be undertaken or not.

d) Working Capital: Every big project requires working capital because, for every
business, investment in working capital is must. Therefore, while evaluating the
projects, initial working capital requirement should be treated as cash
outflow and at the end of the project its release should be treated as cash
inflow. It is important to note that no depreciation is provided on working capital
though it might be possible that at the time of its release its value might have
been reduced. Further there may be also a possibility that additional working
capital may be required during the life of the project. In such cases the additional
working though it might be possible that at the time of its release its value might
have been reduced.In such cases the additional working capital required is treated
as cash outflow at that period of time. Similarly, any reduction in working capital
shall be treated as cash inflow. It may be noted that, if nothing has been
specifically mentioned for the release of working capital it is assumed that full
amount has been realized at the end of the project. However, adjustment on
account of increase or decrease in working capital needs to be incorporated.

e) Allocated Overheads: As discussed in the subject of Cost and Management

Accounting, allocated overheads are charged on the basis of some rational basis
such as machine hour, labour hour, direct material consumption etc. Since,
expenditures already incurred are allocated to new proposal, they should not be
considered as cash flows. However, if it is expected that overhead cost shall
increase due to acceptance of any proposal then incremental overhead cost shall
be treated as cash outflow.

f) Additional Capital Investment: It is not necessary that capital investment shall

be required in the beginning of the project. It can also be required during the
continuance of the project. In such cases, it shall be treated as cash outflows at
that period of time.

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INITITAL CASH FLOWS

PARTICULARS Rs.

Cost of New Asset XXX

Add-Installation/Set up costs XXX

Add/Less - Increase (Decrease) in Working capital level XXX

Less-Net proceeds after capital gain tax from sale of old Asset (If XXX

it is a replacement situation)

Less - Subsidy received from Government if any XXX

Initial Cash Outflow XXX

INTERIM CASH FLOWS – CFAT

PARTICULARS Rs.
Operating Revenue i.e. Sales XXX
Less - Cash Operating Expenses variable costs + cash fixed cost XXX
(excluding depreciation)
Cash inflow before taxes XXX

Less – Depreciation XXX

Profit after tax (PBT) XXX

Less - Amount of income tax XXX

Profit after tax (PAT) XXX

Add – Depreciation XXX

Cash flows after tax (CFAT) XXX

CFAT - IMPORTANT POINTS

• Depreciation is calculated on cost of asset after deduction of amount of subsidy

received if any.

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• If there is loss in any year such loss may be either carried forward or set off in
the same year. If it is carried forward then tax paid would be zero. If it is set off
in the same year against any other existing income then we will consider tax
saving in the above statement.

• Interest / preference dividend is not to be deducted because it is financial cost

and it is considered in the weighted average cost of capital i.e. discount rate.
TERMINAL CASH FLOWS

PARTICULARS Rs.

Final salvage value (disposal value) of asset after capital gain XXX

Add: Release of net working capital XXX

Terminal year net cash flow (cash flow at the end) XXX

1. Capital gain/loss from depreciable asset is short term capital gain/loss as per Sec
50 of Income Tax Act.
2. If nothing is given assume that amount of working capital is recovered completely
(100%) at the end of project life and write note to that effect.

EXAMPLE

I. X Ltd. manufactures electronic motors fitted in desert coolers. It has an

annual turnover of 30 crore and cash expenses to generate this much of sale
is RS 25 crore. Suppose applicable tax rate is 30% and depreciation is RS
1.50 crore p.a.
II. The table below is showing Tax shield due to depreciation under two
scenarios i.e., with and without depreciation.
No Depreciation is Depreciation is Charged
Charged (Rs. Crore) (Rs. Crore)
Total Sales 30.00 30.00
Less: Cost of Goods Sold (25.00) (25.00)
5.00 5.00
Less: Depreciation _ 1.50
Profit before tax 5.00 3.50
Less: Tax @ 30% 1.50 1.50
Profit after Tax 3.50 2.45
Add: Depreciation* _ 1.50
Cash Flow 3.50 3.95

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CONCEPT OF BLOCK OF ASSET & DEPRECIATION

Suppose A Ltd. acquired new machinery for RS 1,00,000, depreciable at 20% as per
written down value (WDV) method. The machine has an expected life of 5 years with
salvage value of RS 10,000. The treatment of depreciation/ short term capital loss in
the 5th year in two cases shall be as follows:

Depreciation for initial 4 years shall be common and WDV at the beginning of the 5th
year shall be computed as follows:

Rs.

Purchase Price of Machinery 1,00,000

Less: Depreciation @ 20% for year 1 20,000

WDV at the end of year 1 80,000

Less: Depreciation @ 20% for year 2 16,000

WDV at the end of year 2 64,000

Less: Depreciation @ 20% for year 3 12,800

WDV at the end of year 3 51,200

Less: Depreciation @ 20% for year 4 10,240

WDV at the end of year 4 40,960

Case 1 - There is no other asset in the Block:

When there is only one asset in the block and block shall cease to exist at the end of
5th year, then no deprecation shall be charged in 5th year and tax benefit/loss on
short term capital loss/ gain shall be calculated as follows:

Rs.

WDV at the beginning of year 5 40,960

Less: Sale value of Machine 10,000

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Short Term Capital Loss (STCL) 30,960

Tax Benefit on STCL @ 30% 9,288

Case 2 - More than one asset exists in the Block: When more than one asset
exists in the block, then deprecation shall be charged in the terminal year (5th year)
in which asset is sold. The WDV on which depreciation be charged shall be calculated
by deducting sale value from the WDV in the beginning of that year. Tax benefit on
depreciation shall be calculated as follows:

Rs.

WDV at the beginning of year 5 40,960

Less: Sale value of Machine 10,000

WDV 30,960

Depreciation @ 20% 6,192

Tax Benefit on Depreciation @ 30% 1,858

Now suppose if in above two cases, sale value of machine is RS 50,000, then no
depreciation shall be provided in Case 2 because the WDV at the beginning of 5th
year is only RS 40,960 i.e., less than sale value of RS 50,000 and tax loss on STCG
in Case 1 shall be computed as follows:

Rs.

WDV at the beginning of year 5 40,960

Less: Sale value of Machine 50,000

Short Term Capital Gain (STCG) 9,040

Tax Loss on STCG @ 30% 2,712

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ILLUSTRATION 1

ABC Ltd is evaluating the purchase of a new machinery with a depreciable base of
RS 1,00,000; expected economic life of 4 years and change in earnings before taxes
and depreciation of Rs 45,000 in year 1, Rs 30,000 in year 2, Rs 25,000 in year 3
and Rs 35,000 in year 4. Assume straight-line depreciation and a 20% tax rate. You
are required to COMPUTE relevant cash flows.

Payback Period
Traditional or Non-
Discounting
Accounting Rate of
Return (ARR)

Net Present Value

TECHNIQUES OF (NPV)
CAPITAL BUDGETING
Profitability Index (PI)

Time adjusted or
Internal Rate of Return
Discounted Cash
(IRR)
Flows
Discounted Payback
Period

Modified Internal Rate of

Return (MIRR)

PAYBACK PERIOD CONCEPT

Payback period refers to the period in which the project will generate the necessary
cash to recoup the initial investment.

Formula -

• When the Annual Expected Cash Flow After taxes are uniform over the
useful life of the project

𝑡𝑜𝑡𝑎𝑙 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

Payback period=
𝑎𝑛𝑛𝑢𝑙 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 𝐴𝑓𝑡𝑒𝑟 𝑇𝑎𝑥𝑒𝑠

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• When the Annual Expected Cash Flow After taxes are not uniform over
the useful life of the project

The cumulative CFAT is to be calculated until the total is equal to the initial capital
investment the period in which cumulative CFAT is equal to initial outlay it is known
as payback period.

ACCEPT OR REJECT CRITERIA

A project whose actual pay-back period is more than what has been predetermined
by the management will be straightway rejected. The fixation of maximum acceptable
pay- back period is generally done by taking into account the reciprocal of the cost
of capital

The payback period can also be used in case of mutually exclusive projects. The
projects are then arranged in ascending order according to the length of their pay
back periods.

IMPORTANT POINTS

I. The payback period of an investment is the length of time required for the
cumulative total net cash flows from the investment to equal the total initial cash
outlays.

II. Payback period answers following question - at what point of time, the investor has
recovered the money invested in the project?

III. Go on calculating cumulative CFAT until cumulative CFAT matches with the initial
cash outflow.

IV. For the last year we need to compute the fraction of the year that is needed to
complete the total payback by using cross multiplication.

MERITS/ADVANTAGES

• This method is simple to understand and easy to operate

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• When funds are limited, projects having shorter payback periods should be selected,
since they can be rotated more number of times.

• This method is suitable in the case of industries where the risk of technologies
obsolescence is very high and hence those projects which have shorter payback
period should be financed

• This method focuses on projects which generates cash inflows in earlier years,
thereby eliminating projects bringing cash inflows in later years. As time period of
cash flows increases risk and uncertainty also increases. Thus payback period tries
to eliminate or minimize risk factor

DEMERITS/DISADVANTAGE
S
I. It stresses on capital recovery rather than profitability.

II. It does not consider the post-payback cash flows, i.e. returns from the project
after its payback period. Hence, it is not a good measure to evaluate where the
comparison is between two projects, one involving a long gestation period and
the other yield quick results but only for a short period.

III. This method becomes as inadequate measure of evaluating where the cash inflows
are uneven. There may be projects with heavy initial inflows and very less inflows
in later years. Other projects with moderately higher but uniform CFAT may be
rejected because of longer payback.

IV. This method ignores the time value of money. Cash flows occurring at all points
of time are treated equally.

EXAMPLE
Suppose A Project Costs Rs. 20,00,000 & yields Annually a profit of Rs. 3,00,000
after depreciation at 12.50% (SLM) But Before taxes at 50%. Calculate Payback
Period.

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EXAMPLE
XYZ Ltd is Analyzing A Project Requiring an initial cash Outlay of 2,00,000 and is
Expected to generate Cash Flows as Follows

Year Annual Cash Inflows (RS)

1 80,000
2 60,000
3 60,000
4 20,000
Calculate Payback Period

EXAMPLE
XYZ Ltd is Analyzing A Project Requiring an initial cash Outlay of 2,05,000 and is
Expected to generate Cash Flows as Follows

Year Annual Cash Inflows (RS)

1 80,000

2 60,000

3 60,000

4 20,000

Calculate Payback Period

PAYBACK RECIPROCAL

It is reciprocal of payback period, it is calculated as follows -

𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
= × 100
𝐼𝑛𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

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Payback period method does not indicate any cut off period for the purpose of
investment decision. The reciprocal of payback is a close approximation of the
internal rate of return.

EXAMPLE
Suppose a project requires an initial investment of 20,000 and it would give annual
cash inflow of t 4,000. The useful life of the project is estimated to be 5 years.

Calculate Payback Reciprocal

ACCOUNTING RATE OF RETURN (ARR) CONCEPT

According to this method, the capital investment proposals are judged on the basis
of their relative profitability for this purpose, capital employed and expected income
are determined according to commonly accepted accounting principles and practices
over the entire economic life of the project and then the average yield is calculated.
Such a rate is termed as accounting rate of return.

Formula 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒

Accounting rate of return =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

I. Average annual net income = accounting profit after

Term Used tax and depreciation

II. The denominator can be either the initial investment

or the average investment over the useful life of the
project.

Average investment = (Original Investment – Scrape

Value) additional working capital + scrap value

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ACCEPT OR REJECT CRITERIA

Any project expected to give a return below minimum desired rate of return will be
straightway rejected. In case of several projects, where a choice has to be made, the
different projects may be ranked in the descending order on the basis of their rate of
return

IMPORTANT POINTS

I. This formula does not consider time value of money

II. Project expected to give more return than the desired return would be selected.
III. Please note CFAT is not considered here. It is accounting profit that is considered

MERITS

I. The method is superior to payback period as it takes into account savings over the
entire economic life, even though estimates of distant future may be subject to wide
margin of errors.

II. The project differing widely in character can be compared properly.

III. The method embodies the concept of "net earnings "after allowing for depreciation
as it is of vital importance in the appraisal of a proposal.

DEMERITS

• The method suffers from the fundamental weakness as that of pay-back period
method i.e. it ignores the fact that receipts occur at different time intervals i.e.
ignores time of money. If earnings from different investments accrue at the same
time, this method can be safely used.

• The method has different variants, each of which emerge different rate return for
one proposal. This situational arises due to diverse concept of investments as well
as earnings.

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• Some analyst are of the opinion that as this method takes into account earning
after depreciation, it is gross error because it is only cash flows, that are relevant
for the decision making purpose.

EXAMPLE
Times Ltd. is going to invest in a project a sum of 3,00,000 having a life span of 3
years. Salvage value of machine is 90,000. The profit before depreciation for each
year is RS 1,50,000.

The Profit after Tax and value of Investment in the Beginning and at the End of
each year shall be as follows:

Year Profit Before Depreciation Profit after Value of investment

Depreciation (RS) Depreciation (RS)
(RS) (RS) Beginning End
1 1,50,000 70,000 80,000 3,00,000 2,30,000

2 1,50,000 70,000 80,000 2,30,000 1,60,000

3 1,50,000 70,000 80,000 1,60,000 90,000

Calculate ARR

ILLUSTRATION 2
A project requiring an investment of RS 10,00,000 and it yields profit after tax and
depreciation which is as follows:

Years Profit after tax and depreciation (RS)

1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000

Suppose further that at the end of the 5 year, the plant and machinery of the project
can be sold for 80,000. DETERMINE Average Rate of Return.

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NET PRESENT VALUE

An investment is essential outlay of funds in anticipation of future returns. The

presence of time as a factor in investment is fundamental rather than incidental for
the purpose of evaluation of investments.

Time is always crucial for the investor, so that a sum received today is worth more
than the same sum to be received tomorrow. Thus in evaluating investment projects,
it is important to consider the timing of return on investment

Assumptions of discounting table

1. Opportunity for investment is available at any time for any amount

2. interest will accrue at the same rate
3. Interest will be received at the end of the year
4. Interest will be reinvested at the same opportunity rate
5. Price level remains the same.

The net present value is the difference between present value of benefits and present
Value of costs. If the net present value is positive the conclusion is favorable to the
decision to go ahead with the project but if it is negative, the project is rejected. The
analyst who uses this method feels that gives desired indication with the least
confusion.

Formula

NPV = PV of cash inflow-PV of cash outflow

YEAR CASH FLOW DISCOUNTING DISCOUNTED

FACTOR AT… % CASH FLOW

ACCEPT OR REJECT CRITERIA

Where NPV > Zero = accept the proposal

NPV = indifference point

NPV <Zero = Reject the proposal

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IMPORTANT TERMS

a) Cash outflows - generally, cash outflows consist of (a) intial investment which
occurs at time "O" and (b) special payments and outflows e.g. working capital
outflow which arises in the year of commercial production Tax paid on capital gain
made by sale of old assets, if any.

b) Cash inflows - cash flows = CFAT = PAT + depreciation. Also specific cash inflows
like salvage value of new assets and recovery of working capital at the end of the
project tax savings on loss due to sale of old asset, should be carefully considered.
The general assumption is that all cash inflows occur at the end of each year.

c) Discounting cash inflow and outflows - each item of cash inflows and outflows
is discounted to ascertain its present value. For this purpose the discounting rate
generally taken as the cost of capital. The present value tables are used to
calculate the present value of various cash flows.

d) Use of discounting rate - instead of using the PV factor tables, the relevant
discount factor can be computed as

1
= ( 1+𝐾)𝑛

Where, k = cost of capital, N = year in which the inflow or outflow takes place

Hence, PV factor at 10% after one year = 1/1.10 = 0.9091

Similarly, PV factor at the end of two years = 1 / ( 1.10)2 = 0.8264 and so on

IMPORTANT POINTS

I. if there is only proposal it would be selected if NPV is zero or positive, in case of

mutually exclusive proposal, the proposal having highest NPV would be selected for
implementation.

II. NPV indicates value addition to the wealth of company

III. NPV is calculated by discounting cash flows at discount rate which is equal to cost
of capital

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 CAPITAL BUDGETING

IV. If NPV is positive, it means that project is expected to earn more than the
expectations of Investors.

V. In case of annuity of cash flows, the annuity factor would be written in the
discounting factor column.

VI. If some cash flows are given at the beginning of some year, then take the
discounting factor of the previous year. Eg for cash flows taking place at the
beginning of 3rd year discounting factor of 2nd year would be applied.

VII. Discounting factor is one for initial investment.

VIII. Please remember the terminal cash flows i.e. sale value of asset and recovery of
working capital.

MERITS

1. It considers the time value of money. Hence it satisfies the basic criterion for
project evaluation.

2. Unlike payback period, all cash flows are considered.

3. NPV constitutes addition to the wealth of shareholders and thus focuses on the
basic objective of financial management.

Since all cash flows are converted into present value (current rupees) different
projects can be compared on NPV basis. Thus, each project can be evaluated
independent of others on its own merit.

DEMERITS

• It involves complex calculations

• It involves forecasting cash flows which may be quite difficult in practice.

• NPV and ranking or project may differ at different discount rates, causing
inconsistency in decision making

It ignores the difference in initial outflow, size of different proposals etc. while
evaluating mutually exclusive Projects.

CA CS DARSHAN JAIN 21
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ILLUSTRATION 3
COMPUTE the net present value for a project with a net investment of RS 1,00,000
and net cash flows for year one is RS 55,000 for year two is RS 80,000 and for year
three is RS 15,000. Further, the company's cost of capital is 10%

[PVIF @ 10% for three years are 0.909. 0.826 and 0.751]

ILLUSTRATION 4
ABC Ltd. is a small company that is currently analyzing capital expenditure
proposals for the purchase of equipment; the company uses the net present value
technique to evaluate projects. The capital budget is limited to RS 5,00,000 which
ABC Ltd. believes is the maximum capital it can raise. The initial investment and
projected net cash flows for each project are shown below. The cost of capital of
ABC Ltd is 12%. You are required to COMPUTE the NPV of the different projects

Project A Project B Project C Project D

(₹) (₹) (₹) (₹)
Initial Investment 200000 190000 250000 210000
Project Cash Inflows 50,000 40,000 75,000 75,000
Year 1
2 50,000 50,000 75,000 75,000

3 50,000 70,000 60,000 60,000

4 50,000 75,000 80,000 40,000

5 50,000 75,000 1,00,000 20,000

CA CS DARSHAN JAIN 22
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ILLUSTRATION 5
Cello Limited is considering buying a new machine which would have a useful
economic life of five years, a cost of ₹ 1,25,000 and a scrap value of ₹ 30,000, with
80 per cent of the cost being payable at the start of the project and 20- cent at the
end of the first year. The machine would produce 50,000 units per annum of a new
product with an estimated selling price of ₹ 3 per unit. costs would be ₹ 1.75 per
unit and annual fixed costs, including depreciation calculated on a straight-line
basis, would be ₹ 40,000 per annum.

In the first year and the second year, special sales promotion expenditure, included
in the above costs, would be incurred, amounting to ₹ 10,000 and ₹ 15,000
respectively

CALCULATE NPV of the project for investment appraisal assuming that the
company's cost of capital is 10 percent.

PROFITABILITY INDEX/DESIRABILITY FACTOR - CONCEPT

If the present value method is used, the present value of the earrings of one project
cannot be compared directly with the present value of earnings of another, unless
the investment are of the same size. In order to compare proposals of different size,
the cash inflows must be related to Initial Investment. This is done by dividing the
present value of earnings by the amount of investment, to give a ratio i.e. called the
profitability index / ratio or desirability factor

𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤

Profitability index =
Formula 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
OR
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
Profitability ratio= × 100
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤

ACCEPT REJECT CRITERIA

PI> 1 = Accept the proposal

PI= 1 = Accept the proposal

PI < 1 = Reject the proposal

CA CS DARSHAN JAIN 23
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IMPORTANT POINTS

1. If NPV is positive , PI is greater than one

2. PI is used when projects involving different cash outflow are to be compared
3. PI indicates amount of cash inflow for every one rupee of cash outflow
4. If cash outflow takes place at multiple points of time then total of all cash outflow
is required to be taken
5. PI is calculated by discounting cash flow at discount rate which is equal to cost of
capital.

ADVANTAGES

1. This method considers the time value of money

2. It is a better project evaluation technique then NPV and helps in ranking projects
where NPV is positive.
3. It focuses on maximum return per rupee of investment and hence is used in case
of investment in divisible projects, when funds are not fully available.

DISADVANTAGES

1. It helps as a guide in resolving capital rationing when projects are indivisible. If

One single Large project with high NPV is selected then Possibility of accepting
several small projects which together may have higher NPV than the single project
is excluded.

2. Situations may arise where a project with a lower profitability index selected may
generate cash flows in such a way that a project can be taken up one or two years.
Later, the total NPV in such case being more than the one with a project with
highest profitability index.

ILLUSTRATION 6
Suppose we have three projects involving discounted cash outflow of ₹ 5,50,000, ₹
75,000 and ₹ 1,00,20,000 respectively. Suppose further that the sum of discounted
cash inflows for these projects are ₹ 6,50,000, ₹ 95,000 and 1,00,30,000
respectively. Calculate the desirability factors for the three projects.

CA CS DARSHAN JAIN 24
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INTERNAL RATE OF RETURN (IRR)

CONCEPT

In the net present value method the required earnings rate is selected in advance.
There is an alternative method which finds the earnings rate at which the present
value of the earnings equals the amount of the investments. This rate is called the
time - adjusted rate of return. DCF rate of return, internal rate of return, yield rate,
marginal efficiency of capital etc. IRR is the rate which brings the sum of the future
cash flows to the same level as the original investment. Thus IRR is the rate of
return at which the sum of discounted cash inflows equals the sum of
discounted cash outflows.

The IRR is calculated under two situations –

Formula 1. When cash flow are uniform
2. When cash flow are not uniform

WHEN CASH FLOWS ARE UNIFORM

In case of those projects which generate uniform cash inflows, the IRR can be
calculated by locating the factor in annuity table II

Steps for calculation of IRR

1. Divide the investment by the annual cash inflow. The result is called the 'Factor'
or ‘Payback'.

2. Go across the row of the year (equivalent to the project) of table II and check up
the closed figures to the fact (as determined in step (1) above) and ascertain the
rate.

3. If IRR is greater or equal to minimum desired rate of return accept the project, if
IRR is less than minimum desired rate of return reject the project.

CA CS DARSHAN JAIN 25
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WHEN CASH FLOWS ARE NOT UNIFORM

The IRR can be found out by trial calculations. The cash flows of project for each year
and its residual value are listed and various discount rates are applied to these
amounts until closest rate is found that makes their total present value equal to the
amount of investment. The indication for discounting at higher or lower rate can be
considered on the following basis.

With the discounting rate (where there is positive NPV i.e. start rate and negative
NPV i.e. end rate) IRR is obtained by interpolation as under -
𝑆𝑢𝑟𝑝𝑙𝑢𝑠
Start rate + x difference in start and end rate
𝑆𝑢𝑟𝑝𝑙𝑢𝑠+𝐷𝑒𝑓𝑖𝑐𝑖𝑡

Surplus = surplus at start rate

Deficit = deficit at End rate

Under this method it is presumed that cash flows can be reinvested at internal rate
of return. IRR calculations are based upon the investment rate assumptions i.e. IRR
method assume reinvestment at IRR.

ACCEPT REJECT CRITERIA

IRR > cut off rate = Accept the proposal

IRR = cut off rate = Accept the proposal

IRR < cut off rate = Reject the proposal

IMPORTANT POINTS
1. Unlike the net present value method, the internal rate of return method does not
use the cost of capital at discount rate but calculates discount rate which makes
NPV as zero.

2. If IRR is more than cost of capital then project is accepted and vice-versa.

3. This IRR is compared with organization's desired rate of return of evaluating

capital Investments

IRR assumes that the intermediate cash flows received during the continuance of the
project are reinvested at the IRR itself. This assumption is not practical

CA CS DARSHAN JAIN 26
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ADVANTAGES

1. Time value of money is taken into account.

2. All cash inflow of the project, arising at different point of time are considered

3. Decisions are immediately taken by comparing IRR with the cost of capital

4. It helps in achieving the basic objective of maximization of shareholders' wealth.

DISADVANTAGES

• It is tedious to compute in case of multiple cash outflows. Multiple IRR's may

result, leading to difficulty in interpretation.

• It may conflict with NPV in case inflow/outflow patterns are different in alternative
proposals.

• The presumption that all the future cash inflow of proposal is reinvested at a rate
equal to the IRR may not be practically valid.

ILLUSTRATION 7
A Ltd is evaluating a project involving an outlay of ₹ 10,00,000 resulting in an
annual cash inflow of ₹ 2,50,000 for 6 years. Assuming salvage value of the project
is zero DETERMINE the IRR of the project.

CA CS DARSHAN JAIN 27
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ILLUSTRATION 8

CALCULATE the internal rate of return of an investment of ₹ 1,36,000 which yields

the following cash inflows

Year Cash Inflows (₹)

1 30,000
2 40,000
3 60,000
4 30,000
5 20,000

ILLUSTRATION 9
A company proposes to install machine involving a capital cost of ₹ 3,60,000. The
life of the machine is 5 years and its salvage value at the end of the life is nil. The
machine will produce the net operating income after depreciation of ₹ 68,000 per
annum. The company's tax rate is 45%

The Net Present Value factors for 5 years are as under:

Discounting rate 14 15 16 17 18

Cumulative factor 3.43 3.35 3.27 3.20 3.13

You are required to COMPUTE the internal rate of return of the proposal

DISCOUNTED PAYBACK PERIOD

When the payback period is computed after discounting the cash flows by a
predetermined rate. It is called as the 'Discounted payback period’.

The formula remains the same as in payback period.

CA CS DARSHAN JAIN 28
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The following format may be adopted for presentation of the answer

YEAR CFAT PV FACTOR DCFAT = CFAT CUMULATIVE

x PV FACTOR DCFAT

MODIFIED INTERNAL RATE OF RETURN

As mentioned earlier, there are several limitations attached with the concept of the
conventional Internal Rate of Return (IRR). The MIRR addresses some of these
deficiencies e.g., it eliminates multiple IRR rates it addresses the reinvestment rate
issue and produces results which are consistent with the Net Present Value method.
This method is also called Terminal Value method.

Under this method, all cash flows, apart from the initial investment are brought to
the terminal value using an appropriate discount rate (usually the Cost of Capital).
This results in a single stream of cash inflow in the terminal year. The MIRR is
obtained by assuming a single outflow in the zeroth year and the terminal cash inflow
as mentioned above. The discount rate which equates the present value of the
terminal cash inflow to the zeroth-year outflow is called the MIRR

The decision criterion of MIRR is same as IRR i.e. you accept an investment if MIRR
is larger than required rate of return and reject if it is lower than the required rate of
return

ILLUSTRATION 10

An investment of 1,36,000 yields the following cash inflows (profits before

depreciation but after tax). DETERMINE MIRR considering 8% as cost of capital

Year (₹)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000

CA CS DARSHAN JAIN 29
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NPV V/S IRR

NPV Versus IRR - Higher the NPV, higher will be the IRR However, NPV and IRR
may give conflicting results in certain cases particularly when

➢ Case outflows arise at different point of time, rather than as initial investment
only.
➢ There is a huge difference between initial CFAT and later CFAT

• A project with heavy initial CFAT than compared to later years will have higher
IRR and vice versa.

• The presumption in IRR is that intermediate cash inflows will be reinvested at

that rate (IRR); Whereas in the case of NPV method, intermediate cash inflows
are presumed to be reinvested at the Cut-off rate. The latter presumption viz.
Reinvestment is at the Cut-off rate is more realistic than reinvestment at IRR.
Hence, in case of conflicting decisions based on NPV And IRR , The NPV
Method must prevail.

PROJECT WITH VARYING LIVES

In appraising projects with varying lives, due thought must be given to the
reinvestment opportunities existing at the end of the different economic lives of the
project. A Simple Comparison of NPV is Not Justifiable. The problem can be handled
by annualizing the respective cash flow patterns of the alternative projects under
study. The process of annualizing the net present value of the cash inflow or outflow
of an investment proposal involves conversion of the present value into an annuity
over the economic life of the proposal at suitable opportunity Cost.
𝑁𝑃𝑉
Annualized net Cost/ benefit/ NFV =
𝑃𝑉 𝐴𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 𝑙𝑖𝑓𝑒

NPV x capital recovery factor over the project life

CA CS DARSHAN JAIN 30
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ACCEPT REJECT CRITERIA

1. If the proposals are cost proposal, the proposal with minimum annualized cost
shall be selected.

2. If the proposals are cost & benefit proposals, the proposal with maximum
annualized NPV shall be selected.

ILLUSTRATION 11
R Pvt. Ltd. is considering modernizing its production facilities and it has two
proposals under consideration. The expected cash flows associated with these
projects and their NPV as per discounting rate of 12% and IRR is as follows:

Year Cash Flow

Project A (₹) Project B (₹)
0 (40,00,000) (20,00,000)
1 8,00,000 7,00,000
2 14,00,000 13,00,000
3 13,00,000 12,00,000
4 12,00,000 0
5 11,00,000 0
6 10,00,000 0
NPV @12% 6,49,094 5,15,488
IRR 17.47% 25.20%

IDENTIFY which project should R Pvt. Ltd. accept?

CA CS DARSHAN JAIN 31
 CAPITAL BUDGETING

ILLUSTRATION 12

Ae Bee Cee Ltd. is planning to invest in machinery, for which it has to make a choice
between the two identical machines, in terms of Capacity, 'X' and 'Y’. Despite being
designed differently, both machines do the same job. Further, details regarding
both the machines are given below.

Particulars Machine X Machine Y

Purchase Cost of the Machine (₹) 15,00,000 10,00,000

Life (years) 3 2

Running cost per year (₹) 4,00,000 6,00,000

The opportunity cost of capital is 9%.

You are required to IDENTIFY the machine which the company should buy?

The present value (PV) factors at 9% are:

Year t1 t2 t3

PVIF0.09.t 0.917 0.842 0.772

CAPITAL RATIONING

A firm normally fixes up maximum amount that can be invested in capital projects
during a given period of time. The firm then attempts to select a combination of
investment proposals, that will within the specific limits provide maximum
profitability and put them in descending order according to their rate of return. Such
a situation is called Capital Rationing. The situation may arise due to-

➢ Financing capital expenditure only by way of retained earnings.

➢ Allocation of specified departmental limits
➢ Restricted availability of own funds and thereby restrictions on borrowings.

CA CS DARSHAN JAIN 32
 CAPITAL BUDGETING

The investment proposals are classified as under

NATURE OF PROJECT INDIVISIBLE DIVISIBLE

Meaning Investment should be Partial investment is
made in full, Partial or possible & proportionate
proportionate investment NPV can be generated.
is not possible
Steps involved in decision Determine the Compute Pl of various
making combination of projects to projects & rank them
utilize amount Available. Projects are selected
Compute NPV of each based on maximum
combination with Profitability Index.
maximum NPV

ILLUSTRATION 13

Shiva Limited is planning its capital investment programme for next year. It has
five projects all of which give a positive NPV at the company cut-off rate of 15
percent, the investment outflows and present values being as follows:

Project Investment (₹) NPV @ 15% (₹)

A (50,000) 15,400

B (40,000) 18,700

C (25,000) 10,100

D (30,000) 11,200

E (35,000) 19,300

The company is limited to a capital spending of ₹ 1,20,000. You are required to

ILLUSTRATE the returns from a package of projects within the capital spending
limit. The projects are independent of each other and are divisible (ie, part- project
is possible).

CA CS DARSHAN JAIN 33
 CAPITAL BUDGETING

ILLUSTRATION 14
Elite Cooker Company is evaluating three investment situations:

(1) Produce a new line of aluminum skillets,

(2) Expand its existing cooker line to include several new sizes, and

(3) Develop a new, higher-quality line of cookers.

If only the project in question is undertaken, the expected present values and the
amounts of investment required are:

Project Investment required Present value of Future Cash-Flows

₹ ₹
1 2,00,000 2,90,000
2 1,15,000 1,85,000
3 2,70,000 4,00,000

If projects 1 and 2 are jointly undertaken, there will be no economies: the

investments required and present values will simply be the sum of the parts. With
projects 1 and 3, economies are possible in investment because one of the machines
acquired can be used in both production processes. The total investment required
for projects 1 and 3 combined is ₹ 4,40,000. If projects 2 and 3 are undertaken,
there are economies to be achieved in marketing and producing the products but
not in investment. The expected present value of future cash flows for projects 2
and 3 is ₹ 6,20,000. If all three projects are undertaken simultaneously, the
economies noted will still hold. However, a ₹ 1,25,000 extension on the plant will
be necessary, as space is not available for all three projects.

CALCULATE NPV of the projects and STATE which project or projects should be
chosen?

CA CS DARSHAN JAIN 34
 CAPITAL BUDGETING

SUMMARY

➢ Capital budgeting is the process of evaluating and selecting long-term

investments that are in line with the goal of investor's wealth maximization

➢ The capital budgeting decisions are important & crucial business decisions due to
substantial expenditure involved, long period for the recovery of benefits,
irreversibility of decisions and the complexity involved in capital investment
decisions.

➢ Tax payments like other payments must be properly deducted in deriving the cash
flows. That is cash flows must be defined in post-tax terms.

➢ There are various techniques available for evaluating capital budgeting proposals.
Some techniques use concept of time value of money, e.g. net present value
technique, profitability index, internal rate of return method and discounted
payback period.

➢ Some techniques don't use concept of time value money. Eg payback period and
accounting rate of return.

➢ Capital rationing-it is a situation where there is restriction on availability of funds.

In capital rationing the firm attempts to select a combination and ranks them in
descending order according to their rate of return.

➢ Whenever amount of tax is given depreciation can be ignored & we can get CFAT
directly by deducting amount of tax there is no need to deduct depreciation and
add back the depreciation .

➢ In calculation of payback period, cash flows are considered without discounting

and in calculation of discounted payback period discounted cash flows are
considered.

➢ While calculating Pl, discount rate considered is cost of capital.

➢ If NPV is positive, it indicates that company is earning more than expectations.

IRR indicates how much company is earning in terms of percentage.

➢ With increase in discount rate, NPV decreases and vice versa.

CA CS DARSHAN JAIN 35
 CAPITAL BUDGETING

➢ Inflows are achieved by two ways.

-By increasing the output level

-By reducing the costs (hence tax saving is treated as inflow)

➢ In case inflows are not given, project which has lower present value of cash
outflow should be selected. We assume that inflows are same for both the
projects.

➢ Whenever life of proposals is different, investment decisions should be taken on

basis of equalized annual NPV calculated as follows
𝑁𝑃𝑉
Equalized annual NPV =
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑎𝑛𝑛𝑢𝑖𝑡𝑦 𝑓𝑎𝑐𝑡𝑜𝑟 𝑜𝑣𝑒𝑟 𝑜𝑓 𝑝𝑟𝑜𝑗𝑒𝑐𝑡

➢ Idle funds (funds which are raised but not invested) have cost. Hence firm should
try to invest maximum of its funds in the projects.

➢ PV of initial outflows is same at all discount rates as discounting factor is always

1 for initial cash outflow.

➢ Discounted payback period is always more than payback period since discounted
payback period considers the discounted cash flows which are always lesser than
undiscounted cash flows and hence discounted payback period increases.

➢ Depreciation is not provided on amount of working capital

➢ While calculating IRR we have to consider all types of inflows i.e. annual CFAT,
scrap value, recovery of working capital, tax saving etc.

➢ Capital gain on transfer of capital asset is deemed to be short term capital gain

➢ Remember to take recovery of working capital and scrap value in Last year
(dessert items)

CA CS DARSHAN JAIN 36
 CAPITAL BUDGETING

ILLUSTRATION 15
X Limited is considering purchasing of new plant worth ₹ 80,00,000. The expected
net cash flows after taxes and before depreciation are as follows:

Year Net Cash Flows (₹)

1 14,00,000
2 14,00,000
3 14,00,000
4 14,00,000
5 14,00,000
6 16,00,000
7 20,00,000
8 30,00,000
9 20,00,000
10 8,00,000
The rate of cost of capital is 10%

You are required to CALCULATE:

(i) Pay-back period

(ii) Net present value at 10 discount factors
(iii) Profitability index at 10 discount factors
(iv) Internal rate of return with the help of 10% and 15% discount factor

The following present value table is given for you:

Year Present value of ₹ 1 at 10% Present value of ₹ 1 at 15%

discount rate discount rate
1 0.909 0.87
2 0.826 0.756
3 0.751 0.658
4 0.683 0.572
5 0.621 0.497
6 0.564 0.432
7 0.513 0.376
8 0.467 0.327
9 0.424 0.284
10 0.386 0.247

CA CS DARSHAN JAIN 37
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ILLUSTRATION 16

Following data has been available for a capital project:

Annual cash inflows 1,00,000

Useful life 4 years

Salvage value 0

Internal rate of return 12%

Profitability index 1.064

You are required to CALCULATE the following for this project:

(i) Cost of project

(ii) Cost of capital

(iii) Net present value

(iv) Payback period

PV factors at different rates are given below.

Discount 12% 11% 10% 9%

factor
1 year 0.893 0.901 0.909 0.917
2 year 0.797 0.812 0.826 0.842
3 year 0.712 0.731 0.751 0.772
4 year 0.636 0.659 0.683 0.708

CA CS DARSHAN JAIN 38
 CAPITAL BUDGETING

ILLUSTRATION 17
Lockwood Limited wants to replace its old machine with a new automatic machine.
Two models A and B are available at the same cost of ₹ 5 lakhs each. Salvage value
of the old machine is 1 lakh. The utilities of the existing machine can be used if the
company purchases model A. Additional cost of utilities to be purchased in this case
will be 1 lakh. If the company purchases B, then all the existing utilities will have
to be replaced with new utilities costing ₹ 2 lakhs. The salvage value of the old
utilities will be ₹ 0.20 lakhs. The earnings after taxation are expected to be:

Year Cash inflows of A Cash inflows of B P.V. Factor @

(₹) (₹) 15%
1 1,00,000 2,00,000 0.870
2 1,50,000 2,10,000 0.756
3 1,80,000 1,80,000 0.658
4 1,70,000 0.572
5 1,70,000 40,000 0.497
Salvage Value at 50,000 60,000
the end of Year 5

The targeted return on capital is 15%. You are required to (i) COMPUTE, for the two
machines separately, net present value, discounted payback period and desirability
factor and (ii) STATE which of the machines is to be selected?

CA CS DARSHAN JAIN 39
 CAPITAL BUDGETING

ILLUSTRATION 18
Hindlever Company is considering a new product line to supplement its range of
products. It is anticipated that the new product line will involve cash investments
of ₹ 7,00,000 at time 0 and ₹ 10,00,000 in year 1. After-tax cash inflows of ₹
2,50,000 are expected in year 2, ₹ 3,00,000 in year 3, ₹ 3,50,000 in year 4 and ₹
4,00,000 each year thereafter through year 10. Although the product line might be
viable even after year 10, the company prefers to be conservative and end all
calculations at that time.

1. if the required rate of return is 15 per cent. COMPUTE net present value of the
project. Is it acceptable?
2. ANALYSE what would be the case if the required rate of return were 10 per cent?
3. CALCULATE its internal rate of return.
4. COMPUTE the project's payback period.

ILLUSTRATION 19
Alley Pvt. Ltd. is planning to invest in a machinery that would cost ₹ 1,00,000 at
the beginning of year 1. Net cash inflows from operations have been estimated at
₹ 36,000 per annum for 3 years. The company has two options for smooth
functioning of the machinery - one is service, and another is replacement of parts.
If the company opts to service a part of the machinery at the end of year 1 at ₹
20,000, in such a case, the scrap value at the end of year 3 will be ₹ 25,000.
However, if the company decides not to service the part, then it will have to be
replaced at the end of year 2 at ₹ 30,800, and in this case, the machinery will work
for the 4th year also and get operational cash inflow of ₹ 36,000 for the 4th year.
It will have to be scrapped at the end of year 4 at 18,000.

Assuming cost of capital at 10% and ignoring taxes, DETERMINE the purchase of
this machinery based on the net present value of its cash flows.

If the supplier gives a discount of 10,000 for purchase, what would be your decision?

Note: The PV factors at 10% are:

Year 0 1 2 3 4 5 6
PV Factor 1 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645

CA CS DARSHAN JAIN 40
 CAPITAL BUDGETING

ILLUSTRATION 20
Navjeevani hospital is considering to purchase a machine for medical protectional
radiography which is priced at ₹ 2,00,000. The projected life of the machine is 8
years and has an expected salvage value of ₹ 18,000 at the end of 8th year. The
annual operating cost of the machine is ₹ 22,500. It is expected to generate
revenues of ₹ 1,20,000 per year for eight years.

Presently, the hospital is outsourcing the radiography work to its neighbour Test
Center and is earning commission income of 36,000 per annum, net of taxes.

Required:

ANALYSE whether it would be profitable for the hospital to purchase the machine.
Give your recommendation under:

(i) Net Present Value method

(ii) Profitability Index method

Consider tax 30% PV factors at 10% are given below:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

CA CS DARSHAN JAIN 41
 CAPITAL BUDGETING

ILLUSTRATION 21

XYZ Ltd. is planning to introduce a new product with a project life of 8 years. Initial
equipment cost will be ₹ 3.5 crores. Additional equipment costing ₹ 25,00,000 will
be purchased at the end of the third year from the cash inflow of this year. At the
end of 8 years, the original equipment will have no resale value, but additional
equipment can be sold for ₹ 2,50,000. A working capital of ₹ 40,00,000 will be
needed and it will be released at the end of eighth year. The project will be financed
with sufficient amount of equity capital.

The sales volumes over eight years have been estimated as follows:

Year 1 2 3 4-5 6-8

Units per year 72,000 1,08,000 2,60,000 2,70,000 1,80,000

A sales price of ₹ 240 per unit is expected and variable expenses will amount to
60% of sales revenue. Fixed cash operating costs will amount ₹ 36,00,000 per year.
The loss of any year will be set off from the profits of subsequent two years. The
company is subject to 30 per cent tax rate and considers 12 per cent to be an
appropriate after-tax cost of capital for this project. The company follows straight
line method of depreciation.

CALCULATE the net present value of the project and advise the management to
take appropriate decision.

The PV factors at 12% are

Year 1 2 3 4 5 6 7 8
PV 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404
Factor

CA CS DARSHAN JAIN 42
 CAPITAL BUDGETING

ILLUSTRATION 22

A large profit making company is considering the installation of a machine to

process the waste produced by one of its existing manufacturing process to be
converted into a marketable product. At present, the waste is removed by a
contractor for disposal on payment by the company of ₹150 lakh per annum for the
next four years. The contract can be terminated upon installation of the aforesaid
machine on payment of a compensation of ₹ 90 lakh before the processing operation
starts. This compensation is not allowed as deduction for tax purposes.

The machine required for carrying out the processing will cost ₹ 600 lakh. At the
end of the 4th year, the machine can be sold for ₹60 lakh and the cost of dismantling
and removal will be ₹ 45 lakh.

Sales and direct costs of the product emerging from waste processing for 4 years
are estimated as under.

(in lakh)

Year 1 2 3 4
966 966 1254 1254
Material consumption 90 120 255 255
Wages 225 225 255 300
Other expenses 120 135 162 210
Factory overheads 165 180 330 435
Depreciation (as per 150 114 84 63
income tax rules)

Initial stock of materials required before commencement of the processing

operations is ₹ 60 lakh at the start of year 1. The stock levels of materials to be
maintained at the end of year 1, 2 and 3 will be ₹ 165 lakh and the stocks at the
end of year 4 will be nil. The storage of materials will utilize space which would
otherwise have been rented out for ₹ 30 lakh per annum. Labour costs include
wages of 40 workers, whose transfer to this process will reduce idle time payments
of ₹ 45 lakh in the year- 1 and ₹ 30 lakh in the year- 2. Factory overheads include
apportionment of general factory overheads except to the extent of insurance
charges of ₹ 90 lakh per annum payable on this venture. The company's tax rate is
30%.

CA CS DARSHAN JAIN 43
 CAPITAL BUDGETING

Consider cost of capital @ 14%, the present value factors of which is given below for
four years:

Year 1 2 3 4
PV factors @14% 0.877 0.769 0.674 0.592

ADVISE the management on the desirability of installing the machine for processing
the waste. All calculations should form part of the answer.

CA CS DARSHAN JAIN 44
 CAPITAL BUDGETING

ILLUSTRATION 23

Xavly Ltd, has a machine which has been in operation for 3 years. The machine has
a remaining estimated useful life of 5 years with no salvage value in the end. Its
current market value is ₹ 2,00,000. The company is considering a proposal to
purchase a new model of machine to replace the existing machine. The relevant
information is as follows:

Existing Machine New Machine

Cost of machine ₹ 3,30,000 ₹ 10,00,000
Estimated life 8 years 5 years
Salvage value Nil ₹ 40,000
Annual output 30,000 units 75,000 units
Selling price per unit ₹ 15 ₹ 15
Annual operating hours 3,000 3,000
Material cost per unit ₹4 ₹4
Labour cost per hour ₹ 40 ₹ 70
Indirect cash cost per ₹ 50,000 ₹ 65,000
annum

The company uses written down value of depreciation @ 20% and it has several
other machines in the block of assets. The Income tax rate is 30 per cent and Xavly
Ltd. does not make any investment, if it yields less than 12 per cent.

ADVISE Xavly Ltd. whether the existing machine should be replaced or not.

PV factors @12%

Year 1 2 3 4 5

PV Factor 0.893 0.797 0.712 0.636 0.567

CA CS DARSHAN JAIN 45
 CAPITAL BUDGETING

ILLUSTRATION 24

HMR Ltd. is considering replacing a manually operated old machine with a fully
automatic new machine. The old machine had been fully depreciated for tax purpose
but has a book value of ₹ 2,40,000 on 31 March 2021. The machine has begun
causing problems with breakdowns and it cannot fetch more than ₹ 30,000 if sold
in the market at present. It will have no realizable value after 10 years. The
company has been offered 1,00,000 for the old machine as a trade in on the new
machine which has a price (before allowance for trade in) of ₹ 4,50,000. The
expected life of new machine is 10 years with salvage value of ₹ 35,000.

Further, the company follows straight line depreciation method but for tax purpose
written down value method depreciation @ 7.5% is allowed taking that this is the
only machine in the block of assets.

Given below are the expected sales and costs from both old and new machine:

Old machine (₹) New machine (₹)

Sales 8,10,000 8,10,000
Material cost 1,80,000 1,26,250
Labor cost 1,35,000 1,10,000
Variable overhead 56,250 47,500
Fixed overhead 90,000 97,500
Depreciation 24,000 41,500
PBT 3,24,750 3,87,250
Tax@ 30% 97,425 1,16,175
PAT 2,27,325 2,71,075

From the above information, ANALYSE whether the old machine should be replaced
or not if required rate of return is 10%? Ignore capital gain tax

PV factors @ 10%:

Year 1 2 3 4 5 6 7 8 9 10

PVF 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

CA CS DARSHAN JAIN 46
 CAPITAL BUDGETING

ILLUSTRATION 25

A & Co. is contemplating whether to replace an existing machine or to spend money

on overhauling it. A & Co. currently pays no taxes. The replacement machine costs
₹ 90,000 now and requires maintenance of ₹ 10,000 at the end of every year for
eight years. At the end of eight years it would have a salvage value of ₹ 20,000 and
would be sold. The existing machine requires increasing amounts of maintenance
each year and its salvage value falls each year as follows:

Year Maintenance (₹) Salvage (₹)

Present 0 40,000
1 10,000 25,000
2 20,000 15,000
3 30,000 10,000
4 40,000 0
The opportunity cost of capital for A & Co. is 15%

REQUIRED:

When should the company replace the machine?

(Note: Present value of an annuity of Re. 1 per period for 8 years at interest rate
of 15% : 4.4873; present value of Re. 1 to be received after 8 years at interest rate
of 15% : 0.3269).

ILLUSTRATION 26

A chemical company is presently paying an outside firm ₹ 1 per gallon to dispose

off the waste resulting from its manufacturing operations. At normal operating
capacity, the waste is about 50,000 gallons per year.

After spending ₹ 60,000 on research, the company discovered that the waste could
be sold for ₹ 10 per gallon if it was processed further. Additional processing would,
however, require an investment of ₹ 6,00,000 in new equipment, which would have
an estimated life of 10 years with no salvage value. Depreciation would be
calculated by straight line method.

CA CS DARSHAN JAIN 47
 CAPITAL BUDGETING

Except for the costs incurred in advertising ₹ 20,000 per year, no change in the
present selling and administrative expenses is expected, if the new product is sold.
The details of additional processing costs are as follows:

Variable : ₹ 5 per gallon of waste put into process.

Fixed : (Excluding Depreciation) ₹30,000 per year.

There will be no losses in processing, and it is assumed that the total waste
processed in a given year will be sold in the same year. Estimates indicate that
50,000 gallons of the product could be sold each year.

The management when confronted with the choice of disposing off the waste or
processing it further and selling it, seeks your ADVICE. Which alternative would you
recommend? Assume that the firm's cost of capital is 15% and it pays on an average
50% Tax on its income.

You should consider Present value of Annuity of ₹ 1 per year @ 15% p.a. for 10
years as 5.019.

ILLUSTRATION 27

XYZ Ltd, is presently all equity financed. The directors of the company have been
evaluating investment in a project which will require ₹ 270 lakhs capital expenditure
on new machinery. They expect the capital investment to provide annual cash flows
of ₹ 42 lakhs indefinitely which is net of all tax adjustments. The discount rate which
it applies to such investment decisions is 14% net.

The directors of the company believe that the current capital structure fails to take
advantage of tax benefits of debt and propose to finance the new project with
undated perpetual debt secured on the company's assets. The company intends to
issue sufficient debt to cover the cost of capital expenditure and the after tax cost
of issue.

The current annual gross rate of interest required by the market on corporate
undated debt of similar risk is 10%. The after tax costs of issue are expected to be
₹ 10 lakhs. Company's tax rate is 30% You are REQUIRED to:

CA CS DARSHAN JAIN 48
 CAPITAL BUDGETING

(i) Calculate the adjusted present value of the investment.

(ii) Calculate the adjusted discount rate and
(iii) Explain the circumstances under which this adjusted discount rate may
be used to evaluate future investments.

CA CS DARSHAN JAIN 49