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Financial Management Unit 8
Sikkim Manipal University Page No. 146
Unit 8 Capital Budgeting
Structure:
8.1 Introduction
Learning objectives
8.2 Importance of Capital Budgeting
8.3 Complexities involved in Capital Budgeting Decisions
8.4 Phases of Capital Expenditure Decisions
8.5 Identification of Investment Opportunities
8.6 Rationale of Capital Budgeting Proposals
8.7 Capital Budgeting Process
Technical appraisal
Economic appraisal
Financial appraisal
8.8 Investment Evaluation
Estimation of cash flows
8.9 Appraisal Criteria
Traditional techniques
Pay back method
Accounting rate of return
Discounted pay-back period
Discounted cash flow period
8.10 Summary
8.11 Terminal Questions
8.12 Answers to SAQs and TQs
8.1 Introduction
Indian economy is growing at 9% per annum. New lines of business such as
retailing investment, investment advisory services and private banking are
emerging. All such businesses involve investment decisions. These
investment decisions that corporates take are known as capital budgeting
decisions. Such decisions help corporates reap the benefits arising out ofthe emerging business opportunities.
Capital budgeting decisions involve evaluation of specific investment
proposals. Here the word capital refers to the operating assets used in
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production of goods or rendering of services. Budgeting involves formulating
a plan of the expected cash flows during the future period.Capital budgeting is a blue-print of planned investments in operating assets.
Therefore, capital budgeting is the process of evaluating the profitability of
the projects under consideration and deciding on the proposal to be
included in the capital budget for implementation.
Capital budgeting decisions involve investment of current funds in
anticipation of cash flows occurring over a series of years in future. All these
decisions are strategic because they change the profile of the organisations.
Successful organisations have created wealth for their shareholders through
capital budgeting decisions. Investment of current funds in long term assetsfor generation of cash flows in future over a series of years characterises
the nature of capital budgeting decisions.
HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over
Bank of Madurai. The motive behind all these mergers is to grow because in
this era of globalisation the need of the hour is to grow as big as possible. In
all these, one could observe the desire of the management to create value
for shareholders as a motivating force.
Another way of growing is through branch expansion, expanding the product
mix and reducing cost through improved technology for deeper penetration
into the market for the companys products.
Investment of current funds in long-term assets for generation of cash flows
in future over a series of years characterises the nature of capital budgeting
decisions.
Example -1
A bank which is urban based, for expansion takes over a bank with rural
network because, urban based bank can open more urban branches
only when it meets the Reserve Bank of India guideline of having a
minimum number of rural branches. This is the motive of the merger of
urban based bank of ICICI with the rural based Bank of Madurai.
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8.1.1 Learning objectives
After studying this unit, you should be able to:
Explain the concept of capital budgeting.
Recoil the importance of capital budgeting.
Examine the complexity of capital budgeting procedures.
Discuss the various techniques of appraisal methods
Evaluate capital budgeting decision.
8.2 Importance of Capital Budgeting
Capital budgeting decisions are the most important decisions in corporate
financial management. These decisions make or mar a business
organisation. These decisions commit a firm to invest its current funds in the
operating assets (i.e. long-term assets) with the hope of employing them
most efficiently to generate a series of cash flows in future. These decisions
could be grouped into:
Decision to replace the equipments for maintenance of current level of
business or decisions aiming at cost reductions, known as replacement
decisions
Decisions on expenditure for increasing the present operating level or
expansion through improved network of distribution
Decisions for production of new goods or rendering of new services
Decisions on penetrating into new geographical area
Decisions to comply with the regulatory structure affecting the operations
of the company, like investments in assets to comply with the conditions
imposed by Environmental Protection Act
Decisions on investment to build township for providing residential
accommodation to employees working in a manufacturing plant
The reasons that make the capital budgeting decisions most crucial for finance
managers are:
These decisions involve large outlay of funds in anticipation of cash
flows in future For example, investment in plant and machinery. Theeconomic life of such assets has long periods. The projections of cash
flows anticipated involve forecasts of many financial variables. The most
crucial variable is the sales forecast.
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o For example, Metal Box spent large sums of money on expansion of
its production facilities based on its own sales forecast. During thisperiod, huge investments in R & D in packaging industry brought
about new packaging medium totally replacing metal as an important
component of packing boxes. At the end of the expansion Metal Box
Ltd found itself that the market for its metal boxes has declined
drastically.
The end result is that metal box became a sick company from the
position it enjoyed earlier prior to the execution of expansion as a
blue chip. Employees lost their jobs. It affected the standard of living
and cash flow position of its employees. This highlights the element
of risk involved in these type of decisions.o Equally we have empirical evidence of companies which took
decisions on expansion through the addition of new products and
adoption of the latest technology, creating wealth for share-holders.
The best example is the Reliance Group.
o Any serious error in forecasting sales, the amount of capital
expenditure can significantly affect the firm. An upward bias might
lead to a situation of the firm creating idle capacity, laying the path for
the cancer of sickness.
o Any downward bias in forecasting might lead the firm to a situation of
losing its market to its competitors.
Long time investments of the funds sometimes may change the risk
profile of the firm.
Example -2
A FMCG company decides to enter into a new business of power generation.
This decision will totally alter the risk profile of the business of the company.
Investors perception of risk of the new business to be taken up by the
company will change its required rate of return to invest in the company.
In this connection it is to be noted that the power pricing is a politicallysensitive area affecting the profitability of the organisation. Therefore, capital
budgeting decisions change the risk dimensions of the company and hence
the required rate of return that the investors want.
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Most of the capital budgeting decisions involve huge outlay. The funds
required during the phase of execution must be synchronised with theflow of funds. Failure to achieve the required coordination between the
inflow and outflow may cause time over run and cost over-run.
These two problems of time over run and cost overrun have to be
prevented from occurring in the beginning of execution of the project.
Quite a lot of empirical examples are there in public sector in India in
support of this argument that cost overrun and time over run can make a
companys operation unproductive.
Capital budgeting decisions involve assessment of market for companys
product and services, deciding on the scale of operations, selection of
relevant technology and finally procurement of costly equipment.
If a firm were to realise after committing itself to considerable sums of
money in the process of implementing the capital budgeting decisions
taken that the decision to diversify or expand would become a wealth
destroyer to the company, then the firm would have experienced a
situation of inability to sell the equipments bought. Loss incurred by the
firm on account of this would be heavy if the firm were to scrap the
equipments bought specifically for implementing the decision taken.
Sometimes these equipments will be specialised costly equipments.
Therefore, capital budgeting decisions are irreversible. All capitalbudgeting decisions involves three elements. These three elements are:
o cost
o quality
o timing
Decisions must be taken at the right time which would enable the firm to
procure the assets at the least cost for producing products of required
quality for the customer. Any lapse on the part of the firm in
understanding the effect of these elements on implementation of capital
expenditure decision taken, will strategically affect the firms profitability.
Liberalisation and globalisation gave birth to economic institutions like
world trade organisations. General Electrical can expand its market into
India snatching the share already enjoyed by firms like Bajaj Electricals
or Kirloskar Electric company. Ability of GE to sell its products in India at
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a rate less than the rate at which Indian companies sell cannot be
ignored.Therefore, the growth and survival of any firm in todays business
environment demands a firm to be pro-active. Pro-active firms cannot
avoid the risk of taking challenging capital budgeting decisions for
growth.
The social, political, economic and technological forces generate high
level of uncertainty in future cash flow streams associated with capital
budgeting decisions. These factors make these decisions highly
complex.
Capital budgeting decisions are very expensive. To implement thesedecisions, firms will have to tap the capital market for funds. The
composition of debt and equity must be optimal keeping in view the
expectations of investors and risk profile of the selected project.
Therefore capital budgeting decisions for growth have become an essential
characteristic of successful firms today.
8.3 Complexities involved in Capital Budgeting Decisions
Capital expenditure decision involves forecasting of future operating cash
flows. Forecasting the future cash flows demands certain assumptionsabout the behaviour of costs and revenues in future.
Self Assessment Questions
Fill in the blanks:
1. _______ make or mar a business.
2. _______ decisions involve large outlay of funds in anticipation of cash
inflows in future.
3. Social, political, economical and technological forces make capital
budgeting decisions ___________.
4. __________ are very expensive.
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However, there are complexities involved in capital budgeting decisions
They are:
Estimation of future cash flows
Commitment of funds on long-term basis
Problem of irreversibility of decisions
8.4 Phases of Capital Expenditure Decisions
There are various phases involved in capital budgeting decisions.
Identification of investment opportunities.
Evaluation of each investment proposal
Examination of the investments required for each investment proposal
Preparation of the statements of costs and benefits of investment
proposals
Estimation and comparison of the net present values of the investment
proposals that have been cleared by the management on the basis ofscreening criteria
Examination of the government policies and regulatory guidelines, for
execution of each investment proposal screened and cleared based on
the criteria stipulated by the management
Self Assessment Questions
Fill in the blanks:
5. Capital expenditure decisions are _________.
6. Forecasting of future operating cash flows from ____________ because
the future is________.
Example -3
The arrival of mobile revolution made the pager technology obsolete. Thefirms which invested in pagers faced the problem of pagers losing its
relevance as a means of communication. The firms with the ability to
adapt the new know-how in mobile technology could survive the effect of
this phase of technological obsolescence. Others who could not manage
the effect of change in technology had a natural death and so most
capital expenditure decisions are irreversible.
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Budgeting for capital expenditure for approval by the management
Implementation Post-completion audit
8.5 Identification of Investment Opportunities
A firm is in a position to identify investment proposal only when it is
responsive to the ideas of capital projects emerging from various levels of
the organisation. The proposal may be to:
Add new products to the companys product line,
Expand capacity to meet the emerging market at demand for companys
products
Add new technology based process of manufacture that will reduce the
cost of production.
Self Assessment Questions
Fill in the blanks:
7. Post-completion audit is ________ in the phases of capital budgeting
decisions.
8. Identification of investment opportunities is the _____ in the phases of
capital budgeting decisions.
Caselet -1
A sales manager may come with a proposal to produce a new product as
per the requirements of companys consumers. Marketing manager,
based on the sales managers proposal, may conduct a market survey to
determine the expected demand for the new product under
consideration.
Once the marketing manager is convinced of the market potential for proposed
new product, the proposal goes to the engineers to examine the same with all
aspects of production process. Then the proposal goes to the cost accountant to
translate the entire gamut of the proposal into costs and revenues in terms of
incremental cash flows- both outflows and inflows. The cost-benefit statement
generated by cost accountant shall include all incremental costs and benefits
that the firm will incur and derive on commercialisation of the proposal under
consideration.
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Therefore, generation of ideas with the feasibility to convert the same into
investment proposals occupies a crucial place in the capital budgeting decisions.
Proactive organisations encourage a continuous flow of investment proposals from
all levels in the organisation.
In this connection following points deserve to be considered:
Analysing the demand and supply conditions of the market for the companys
product could be a fertile source of potential investment proposals.
Market surveys on customers perception of companys product could be a
potential investment proposal to redefine the companys products in terms of
customers expectations.
Companies which invest in Research and Development constantly get
exposure to the benefit of adapting the new technology quite relevant to
keep the firm competitive in the most dynamic business environment.
Reports emerging from R & D section could be a potential source of
investment proposal.
Economic growth of the country and the emerging middle class endowed
with purchasing power could generate new business opportunities in
existing firms. These new business opportunities could be potential
investment ideas.
Public awareness of their rights compels many firms to initiate projects
from environmental protection angle. If ignored, the firm may have to
face the public wrath through PILs entertained at the Supreme Court and
High courts.
Therefore project ideas that would improve the competitiveness of the firm by
constantly improving the production process with the sole objective of cost reduction
and customer welfare, are accepted by well managed firms.
8.6 Rationale of Capital Budgeting Proposals
Self Assessment Questions
Fill in the blanks:
9. Analysing the demand and supply conditions of the market for the
companys products could be _______ of potential investment proposal.
10. Generation of ideas for capital budgets and screening the same can be
considered _______ of capital budgetary decisions.
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The investors and the stake-holders expect a firm to function efficiently to
satisfy their expectations. The stake-holders expectation and theperformance of the company may clash among themselves, the one that
touches all these stake-holders expectation could be visualised in terms of
firms obligation to reduce the operating costs on a continuous basis and
increasing its revenues.
Therefore, capital budgeting decisions could be grouped into two categories:
Decisions on cost reduction programmes
Decisions on revenue generation through expansion of installed capacity
8.7 Capital Budgeting Process
Once the screening of proposals for potential involvement is over, the
company should take up the following aspects of capital budgeting process:
A proposal should be commercially viable. The following aspects are
examined to ascertain the commercial viability of any investmentproposal
o Market for the product
o Availability of raw materials
o Sources of raw materials
o The elements that influence the location of a plant i.e. the factors to
be considered in the site selection
Infrastructural facilities such as roads, communication facilities, financial
services such as banking and public transport services
Ascertaining the demand for the product or services is crucial. It is done by
market appraisal. In appraisal of market for the new product, the following
details are compiled and analysed.
Consumption trends
Competition and players in the market
Self Assessment Questions
Fill in the blanks:11. __________ decisions could be grouped into two categories.
12. ________ and revenue generation are the two important categories of
capital budgeting.
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Availability of substitutes
Purchasing power of consumers Regulations stipulated by Government on pricing the proposed products
or services
Production constraints
Relevant forecasting technologies are employed to get a realistic picture of
the potential demand for the proposed product or service. Many projects fail
to achieve the planned targets on profitability and cash flows if the firm could
not succeed in forecasting the demand for the product on a realistic basis.
Capital budgeting process involves three steps (see figure 8.1) Financial
appraisal, Technical appraisal and Economic appraisal.
Figure 8.1: Capital budgeting process
8.7.1 Technical appraisal
Technical appraisal ensures implementation of all the technical aspects of
the project. The technical aspects of the project are:
Selection of process know-how
Decision on determination of plant capacity
Selection of plant, equipment and scale of operation
Plant design and layout
General layout and material flow
Construction schedule
8.7.2 Economic appraisal
Economic appraisal examines the project from the social point of view. Hence, is
referred to as social cost benefit analysis. It examines:
The impact of the project on the environment
The impact of the project on the income distribution in the society
The impact of the project on fulfilment of certain social objective like
generation of employment and attainment of self sufficiency
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Examination of the risk profile of the project to be taken up and arriving
at the required rate of return Formulation of the decision criteria
8.8.1 Estimation of cash flows
Estimating the cash flows associated with the project under consideration is
the most difficult and crucial step in the evaluation of an investment
proposal. Estimation is the result of the team work of many professionals in
an organisation.
Capital outlays are estimated by engineering departments after
examining all aspects of production process
Marketing department on the basis of market survey forecasts the
expected sales revenue during the period of accrual of benefits from
project executions
Operating costs are estimated by cost accountants and production
engineers
Incremental cash flows and cash out flow statement is prepared by the
cost accountant on the basis of the details generated in the above steps
The ability of the firm to forecast the cash flows with reasonable accuracy
lies at the root of the success of the implementation of any capital
expenditure decision.
8.8.2 Estimation of incremental cash flowsInvestment (capital budgeting) decision requires the estimation of incremental cash
flow stream over the life of the investment. Incremental cash flows are estimated on
tax basis.
Incremental cash flows stream of a capital expenditure decision has three
components.
Initial cash outlay (Initial investment)
Initial cash outlay to be incurred is determined after considering any post
tax cash inflows. In replacement decisions existing old machinery is
disposed of and a new machinery incorporating the latest technology is
installed in its place.
On disposal of existing old machinery the firm has a cash inflow. This
cash inflow has to be computed on post tax basis. The net cash out flow
(total cash required for investment in capital assets minus post tax cash
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inflow on disposal of the old machinery being replaced by a new one)
therefore is the incremental cash outflow. Additional net working capitalrequired on implementation of new project is to be added to initial
investment.
Operating cash inflows
Operating cash inflows are estimated for the entire economic life of
investment (project). Operating cash inflows constitute a stream of
inflows and outflows over the life of the project. Here also incremental
inflows and outflows attributable to operating activities are considered.
Any savings in cost on installation of a new machinery in the place of the
old machinery will have to be accounted on post tax basis. In this
connection incremental cash flows refer to the change in cash flows onimplementation of a new proposal over the existing positions.
Terminal cash inflows
At the end of the economic life of the project, the operating assets
installed will be disposed off. It is normally known as salvage value of
equipments. This terminal cash inflows are computed on post tax basis.
Prof. Prasanna Chandra in his book Financial Management (Tata McGraw
Hill, published in 2007) has identified certain basic principles of cash flow
estimation. The knowledge of these principles will help a student in
understanding the basics of computing incremental cash flows.
The basic principles of cash flow estimation, by Prof. Prasanna Chandra,
are (see figure 8.2) Separation principle, Increment principle, Post-tax
principle and Consistency principle.
Figure 8.2: Principles of Prof. Prasanna Chandra
Separation principle
The essence of this principle is the necessity to treat investment element of
the project separately (i.e. independently) from that of financing element.
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The financing cost is computed by the cost of capital. Cost of capital is the
cut off rate and rate of return expected on implementation of the project.Therefore, we compute separately cost of funds for execution of project
through the financing mode. The rate of return expected on implementation
if the project is arrived at by the investment profile of the projects. Therefore,
interest on debt is ignored while arriving at operating cash inflows.
The following formula is used to calculate profit after tax
EBIT = earnings (profit) before interest and taxes
t = tax rate
Incremental principle
Incremental principle says that the cash flows of a project are to be
considered in incremental terms. Incremental cash flows are the changes in
the firms total cash flows arising directly from the implementation of the
project. Keep the following in mind while determining incremental cash
flows.
Ignore sunk costs
Sunk costs are costs that cannot be recovered once they have been
incurred. Therefore, sunk costs are ignored when the decisions on projectunder consideration is to be taken.
Opportunity costs
If the firm already owns an asset or a resource which could be used in the
execution of the project under consideration, the asset or resource has an
opportunity cost. The opportunity cost of such resources will have to be
taken into account in the evaluation of the project for acceptance or
rejection.
Incremental PAT = Incremental EBIT ( 1-t )
(Incremental) (Incremental)
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Need to take into account all incident effect
Effects of a project on the working of other parts of a firm also known as
externalities must be taken into account.
Cannibalisation
Another problem that a firm faces on introduction of a new product is the
reduction in the sale of an existing product. This is called cannibalisation.
The most challenging task is the handling the problems of cannibalisation.
Depending on the companys position with that of the competitors in the
market, appropriate strategy has to be followed. Correspondingly the cost of
cannibalisation will have to be treated either as relevant cost of the decision
or ignored.
Depending on the companys position with that of the competitors in the
market, appropriate strategy has to be followed. Correspondingly the cost ofcannibalisation will have to be treated either as relevant cost of the decision
or ignored. Product cannibalisation will affect the companys sales if the firm
is marketing its products in a market characterised by severe competition,
without any entry barriers. In this case costs are not relevant for decision.
Caselet -3
Expansion or establishment of a branch at a new place may increase the
profitability of existing branches because the branch at the new place
has a complementary relationship with the other existing branches or
reduce the profitability of existing branches because the branch at the
new place competes with the business of other existing branches or
takes away some business activities from the existing branches.
Caselet -2
A firm wants to open a branch in Chennai for expansion of its market inTamil Nadu. The firm already owns a building in Chennai. The building in
Chennai is let out to some other firm on an annual rent of Rs. 1 crore.
For opening the branch at Chennai the firm uses its own building by
sacrificing the rental income which it has been receiving. The opportunity
cost of the building at Chennai is Rs. 1 crore. This will have to be
considered in arriving at the operating cash flows associated with the
decision to open a branch at Chennai.
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However, if the firms sales are not affected by competitors activities due to
certain unique protection that it enjoys on account of brand positioning orpatent protection, the costs of cannibalisation cannot be ignored in taking
decisions.
Post tax principle
All cash flows should be computed on post tax basis
Consistency principle
Cash flows and discount rates used in project evaluation need to be
consistent with the investor group and inflation.
Solved Problem -1
A firm is considering replacement of its existing machine by a newmachine. The new machine will cost Rs 1,60,000 and have a life of five
years. The new machine will yield annual cash revenue of Rs 2,50,000
and incur annual cash expenses of Rs 1,30,000. The estimated salvage
of the new machine at the end of its economic life is Rs 8,000. The
existing machine has a book value of Rs 40,000 and can be sold for Rs
20,000. The existing machine, if used for the next five years is expected
to generate annual cash revenue of Rs 2,00,000 and involves annual
cash expenses of Rs 1,40,000. If sold after five years, the salvage value
of the existing machine will be negligible.
The company pays tax at 30%. It writes off depreciation at 25% on the
written down value. The companys cost of capital is 20% . Compute theincremental cash flows of replacement decisions.
Solution
Table 8.1 gives the initial investments and annual cash flows from
projects.
Table 8.1: Initial investments and annual cash flows
Initial investment
Gross investment for new machine (1, 60, 000)
Less: cash received from the sale of existing machine 20, 000
Net cash outlay (1, 40, 000)
Annual cash flows from operations
Incremental cash flows from revenue 50, 000
Incremental decrease in expenditure 10, 000
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Table 8.2 shows the incremental depreciation schedule:
Table 8.2: Incremental depreciation schedule
Year Depreciation(new machine)
Depreciation(old machine)
Incrementaldepreciation (Rs.)
1 45, 000 10,000 (35,000)
2 33, 750 7,500 (26,250)
3 25, 312 5,625 (19,687)
4 18, 984 4,219 (14,765)
5 14, 238 3,164 (11,074)
Table 8.3 shows the calculation of depreciation:
Table 8.3: Calculation of depreciation
Book value 40, 000
Add: cost of new machine 1, 60, 000
2, 00, 000
Less: sale proceeds of old machine 20, 000
1, 80, 000
Depreciation for 1 year 25% 45, 000
1, 35, 000
Depreciation for 2 year 25% 33, 750
1, 01, 250Depreciation for 3 year 25% 25, 312
75, 938
Depreciation for 4 year 25% 18, 894
56, 954
Depreciation for 5 year 25% 14, 238
Book value after 5 years 42, 716
The computation of the incremental cash flows of replacement decisions
is briefly described in table 8.4.
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Table 8.4: Statement of incremental cash flows
Particulars Year
0 1 2 3 4 5
1. Investment in newmachine
(1,60,000)
2. After tax salvagevalue of old machine
20,000
3. Net Cash Out lay (1,40,000)
4. Increase in revenue 50,000 50,000 50,000 50,000 50,000
5. Decrease inexpenses
10,000 10,000 10,000 10,000 10,000
6. Increase indepreciation
(35,000) (26,250) (19,687) (14,765) (11,074)
7. Increase in EBIT
(4+5 -6)
25,000 33,750 40,313 45,235 48,926
8. EBIT (1 T)
(1-.30)
17,500 23,625 28,219 31,665 34,248
9. Incremental Cashflows from operation(8 + 6)
EAT + Depreciation
52,500 49,875 47,906 46,430 45,322
10. Salvage value ofnew machine
8,000
11. Incremental Cashflows from operation(8 + 6)
EAT + Depreciation
(1,40,000)negative
52,500 49,875 47,906 46,430 53,322
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8.9 Appraisal Criteria
The methods of appraising an investment proposal can be grouped into
1. Traditional methods.
2. Modern methods.
Traditional methods are:
o Payback method
o Accounting rate of return
Modern techniques are:
o Net present value
o Internal rate of return
o Modified internal rate of return
o Profitability index
8.9.1 Traditional techniques
Traditional methods are of two types payback method and accounting rate
of return.
8.9.1.1 Payback method
Payback period is defined as the length of time required to recover the initial
cash out lay.
Self Assessment Questions
Fill in the blanks:
17. ______ is the third step in the evaluation of investment proposal.
18. A ________ is not a relevant cost for the project decision.
19. Effect of a project on the working of other parts of a firm is known as
__________.
20. The essence of separation principle is the necessity to treat _____ of a
project separately from that of ________.
21. Pay-back period __________ time value of money.
22. IRR gives a rate of return that reflects the ______ the project.
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Solved Problem -2
The following details shown in table 8.5, are in respect of the cash flowsof two projects A and B.
Table 8.5: Cash flows of A and B
Year Project A cash flows (Rs.) Project B cash flows (Rs.)
0 (4,00,000) (5,00,000)
1 2,00,000 1,00,000
2 1,75,000 2,00,000
3 25,000 3,00,000
4 2,00,000 4,00,0005 1,50,000 2,00,000
Compute pay-back period for A and B.
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8.9.1.1.1 Evaluation of payback period:
Simple in concept and application
Emphasis is on recovery of initial cash outlay. Pay-back period is the
best method for evaluation of projects with very high uncertainty
Solution
The cash flows and the cumulative cash flows of the projects A and B are
shown under in table 8.6
Table 8.6 Cash flows and cumulative cash flows of A and B
Year Project A Project B
Cash flows(Rs.)
CumulativeCash flows
Cash flows(Rs.)
Cumulative Cashflows
1 2,00,000 2,00,000 1,00,000 1,00,000
2 1,75,000 3,75,000 2,00,000 3,00,000
3 25,000 4,00,000 3,00,000 6,00,000
4 2,00,000 6,00,000 4,00,000 10,00,000
5 1,50,000 7,50,000 2,00,000 12,00,000
From the cumulative cash flows column, project A recovers the initial cash outlay
of Rs 4,00,000 at the end of the third year. Therefore, payback period of project
A is 3 years.
From the cumulative cash flow column the initial cash outlay of
Rs. 5,00,000 lies between 2nd year and 3rd year in respect of project B.
Therefore, payback period for project B is:
000,00,3
000,00,3000,00,52
= 2.67 years
Pay-back period for project B is 2.67 years
Merits
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With respect to accept or reject criterion, pay back method favours a
project which is less than or equal to the standard pay back set bythe management. In this process early cash flows get due
recognition than later cash flows. Therefore, pay-back period could
be used as a tool to deal with the ranking of projects on the basis of
risk criterion
For firms with short-age funds this is preferred because it measures
liquidity of the project
Pay-back period ignores time value of money.
It does not consider the cash flows that occur after the pay-back
period.
It does not measure the profitability of the project.
It does not throw any light on the firms liquidity position but just tells
about the ability of the project to return the cash out lay originally
made.
Project selected on the basis of pay back criterion may be in conflict
with the wealth maximisation goal of the firm.
Accept or reject criteria
If projects are mutually exclusive, select the project which has the leastpay-back period
In respect of other projects, select the project which have pay-back period
less than or equal to the standard pay back stipulated by the management
Illustration
Pay-back period:
Project A = 3 years
Project B = 2.5 years
Standard set up by management = 3 years
If projects are mutually exclusive, accept project B which has the least
pay-back period.
If projects are not mutually exclusive, accept both the projects because
both have pay-back period less than or equal to the standard pay-back
period set by the management
Demerits
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Pay-back formula
8.9.1.2 Accounting rate of return
Accounting rate of return (ARR) measures the profitability of investment
(project) using information taken from financial statements:
ARR = Average income / Average investment
ARR = Average of post tax operating profit / Average investment
Solved Problem -3
The following particulars shown in table 8.7 refers to two projects:Table 8.7: Particulars of two projects
X Y
Cost 40,000 60,000
Estimated life 5 years 5 years
Salvage value Rs. 3,000 Rs. 3,000
Estimate income
Table 8.8: After tax
Rs. Rs.
1 3,000 10,000
2 4,000 8,0003 7,000 2,000
4 6,000 6,000
5 8,000 5,000
Total 28,000 31,000
Average investment =
2
investmentorprojecttheoflifethebeginningthein
ofendtheatinvestmentofvalueBookinvestmenttheofValueBook
Year Prior to full recovery + Balance of initial out lay to be recoveredOf initial out lay at the beginning of the year in which full
placetakesrecoveryfullw hichinyeartheofflowinCash
placetakeserycovRe
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It is based on accounting information Simple to understand
It considers the profits of entire economic life of the project
Since it is based on accounting information, the business executives
familiar with the accounting information understand it
ARR is based on accounting income not on cash flows, as the cash
flow approach is considered superior to accounting information
based approach
ARR does not consider the time value of money
Different investment proposals which require different amounts of
investment may have the same accounting rate of return. The ARR
fails to differentiate projects on the basis of the amount required for
investment
ARR is based on the investment required for the project. There are
many approaches for the calculation of denominator of average
investment. Existence of more than one basis for arriving at the
denominator of average investment may result in adoption of many
arbitrary bases
Due to this the reliability of ARR as a technique of appraisal is reduced
when two projects with the same ARR but with differing investment amounts
are to be evaluated.
Average 5,600 6,200
Average investment 21,500 31,500
500,31
200,6
500,21
600,5ARR
= 26 % (Firm X) 19.7% (Firm Y)
Merits of accountin rate of return
Demerits of accounting rate of return
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Accept or reject criteria
In any project which has an excess ARR, the minimum rate fixed by themanagement is accepted.
If actual ARR is less than the cut-off rate (minimum rate specified by the
management ) then that project is rejected.
When projects are to be ranked for deciding on the allocation of capital
on account of the need for capital rationing, project with higher ARR are
preferred to the ones with lower ARR.
8.9.2 Discounted pay-back period
The length in years required to recover the initial cash out lay on the present value
basis is called the discounted pay-back period. The opportunity cost of capital is
used for calculating present values of the cash inflows. Discounted pay-back periodfor a project will be always higher than simple pay-back period because the
calculation of discounted pay-back period is based on discounted cash flows.
8.9.3 Discounted cash flow method
Solved Problem -4
Table 8.9 shows the cash flows of project A for different years at a rate of
10% p.a.
Table 8.9: Cash flows of project A
YearProject A
Cash flowsPV factor at 10%
PV of Cashflows
Cumulativepositive
Cash flows0 (4,00,000) 1 (4,00,000)
1 2,00,000 0.909 1,81,800 1,81,800
2 1,75,000 0.826 1,44,550 3,26,350
3 25,000 0.751 18,775 3,45,125
4 2,00,000 0.683 1,36,600 4,81,725
5 1,50,000 0.621 93,150 5,74,875
Discounted pay-back period
years4.3
600,36,1
125,45,3000,00,43
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Discounted cash flow method or time adjusted technique is an improvement
over the traditional techniques. In evaluation of the projects the need to giveweight-age to the timing of return is effectively considered in all DCF
methods. DCF methods are cash flow based and take the cognisance of
both the interest factors and cash flow after the pay-back period.
DCF technique involves:
Estimation of cash flows, both inflows and outflows of a project over the
entire life of the project
Discounting the cash flows by an appropriate interest factor (discount
factor)
Deducting the sum of the present value of cash outflows from the sum
of present value of cash inflows to arrive at net present value of cashflows
The most popular techniques of DCF methods are:
The net present value
The internal rate of return
Profitability index
Net present value
Net present value (NPV) method recognises the time value of money. It
correctly admits that cash flows occurring at different time periods differ in
value. Therefore, there is the need to find out the present values of all cash
flows. NPV method is the most widely used technique among the DCF
methods.
Steps involved in NPV method involve:
Forecasting the cash flows, both inflows and outflows of the projects to
be taken up for execution
Decisions on discount factor or interest factor. The appropriate discount
rate is the firms cost of capital or required rate of return expected by the
investors
Computation of the present value of cash inflows and outflows using the
discount factor selected Calculation of NPV by subtracting the PV of cash outflows from the
present value of cash inflows.
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Accept or reject criteria
If NPV is positive, the project should be accepted. If NPV is negative theproject should be rejected.
Accept or reject criterion can be summarised as given below:
NPV > Zero = accept
NPV < Zero = reject
NPV method can be used to select between mutually exclusive projects by
examining whether incremental investment generates a positive net present value.
It takes into account the time value of money.
It considers cash flows occurring over the entire life of the project.
NPV method is consistent with the goal of maximising the net wealth
of the company.
It analyses the merits of relative capital investments.
Since cost of capital of the firm is the hurdle rate, the NPV ensures
that the project generates profits from the investment made for it.
Forecasting of cash flows is difficult as it involves dealing with the
effect of elements of uncertainties on operating activities of the firm.
To decide on the discounting factor, there is the need to assess the
investors required rate of return. But it is not possible to compute
the discount rate precisely.
There are practical problems associated with the evaluation of
projects with unequal lives or under funds constraints
For ranking of projects under NPV approach, the project with the highest positive
NPV is preferred to that with a lower NPV.
Merits of NPV method
Demerits of NPV method
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Solved Problem -5
A project costs Rs.25000 and is expected to generate cash inflows asshown in table 8.10
Table 8.10: Cash inflows
Year Cash inflows
1 10,000
2 8,000
3 9,000
4 6,000
5 7,000
The cost of capital is 12%. The present value factors are as shown in the
table 8.11. Table 8.11: Present value factors
Year PV factor at 12%
1 0.893
2 0.797
3 0.712
4 0.636
5 0.567
Compute the NPV of the project
Solution
The present value of the cash flows are computed based on theinformation given in tables 8.8 and 8.9, at a rate of interest of 12% per
annum, in the table 8.12 shown under:
Table 8.12: PV of cash flows
Year Cash flowsPV factor at
12%PV of cash flows
1 10,000 0.893 8,930
2 8,000 0.797 6,376
3 9,000 0.712 6,408
4 6,000 0.636 3,816
5 7,000 0.567 3,969
Total 29,499Sum of the present value of the cash outflows = 25,000
NPV = 4,499
The project generates a positive NPV of Rs. 4,499. Therefore, project
should be accepted.
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Solved Problem
A company is evaluating two alternatives for distribution within the plant.
Two alternatives are
C system with a high initial cost but low annual operating costs.
F system which costs less but have considerably higher operating
costs.
The decision to construct the plant has already been made, and the
choice here will have no effect on the overall revenues of the project. The
cost of capital of the plant is 12% and the projects expected net cash
costs are listed in table 8.13.
Table 8.13: Expected net cash
YearExpected net cash costs
C systems F systems
0 (3,00,000) (1,20,000)
1 (66,000) (96,000)
2 (66,000) (96,000)
3 (66,000) (96,000)
4 (66,000) (96,000)
5 (66,000) (96,000)
What is the present value of costs of each alternative?
Which method should be chosen?
Solution
What is the present value of costs of each alternative?
Which method should be chosen?
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Properties of the NPV
NPVs are additive. If two projects A and B have NPV (A) and NPV (B)
then by additive rule the net present value of the combined investment is
NPV (A + B)
Intermediate cash inflows are reinvested at a rate of return equal to the
cost of capital.
Internal rate of return (IRR)
Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the
NPV of any project equal to zero. IRR is the rate of interest which equates
the PV of cash inflows with the PV of cash outflows.
Solution
Computation of present value is done in table 8.14Table 8.14: Computation of PV
Year C systems F systems Incremental
1 (66,000) (96,000) 30,000
2 (66,000) (96,000) 30,000
3 (66,000) (96,000) 30,000
4 (66,000) (96,000) 30,000
5 (66,000) (96,000) 30,000
Present value of incremental savings =30,0000 x PV IFA (12%, 5)= 30,000 x 3.605 = 1,08,150
Initial cash outlay [C system F system] = 3,00,000 1,20,000
Incremental cash outlay = 1,80,000 108150 =71850
Since the present value of incremental net cash inflows of C system over F
system is negative. C system is not recommended.
Therefore, F system is recommended .
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IRR is also called as yield on investment, managerial efficiency of capital, marginal
productivity of capital, rate of return and time adjusted rate of return. IRR is the rate
of return that a project earns.
IRR takes into account the time value of money
IRR calculates the rate of return of the project, taking into account
the cash flows over the entire life of the project.
It gives a rate of return that reflects the profitability of the project.
It is consistent with the goal of financial management i.e.
maximisation of net wealth of share holders IRR can be compared with the firms cost of capital.
To calculate the NPV the discount rate normally used is cost of
capital. But to calculate IRR, there is no need to calculate and
employ the cost of capital for discounting because the project is
evaluated at the rate of return generated by the project. The rate of
return is internal to the project.
IRR does not satisfy the additive principle.
Multiple rate of returns or absence of a unique rate of return in
certain projects will affect the utility of this technique as a tool of
decision making in project evaluation.
In project evaluation, the projects with the highest IRR are given
preference to the ones with low internal rates.
Application of this criterion to mutually exclusive projects may lead
under certain situations to acceptance of projects of low profitability
at the cost of high profitability projects.
IRR computation is quite tedious.
Accept or reject criteria
If the projects internal rate of return is greater than the firms cost of capital,
accept the proposal, otherwise reject the proposal.
Merits of IRR
Demerits of IRR
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IRR can be determined by solving the following equation for
Sum of the present values of cash inflows at the rate of interest of r :-
t
t0
)r1(
CCF
where t = 1 to n
r =t
t0
)r1(
CCF
where t = 1 to n
CF0 = Investment
Solved Problem
A project requires an initial outlay of Rs. 1,00,000. It is expected togenerate the following cash inflows shown in table 8.15
Table 8.15: Cash inflows
Year Cash inflows
1 50,000
2 50,000
3 30,000
4 40,000
What is the IRR of the project?
SolutionStep 1
The average of annual cash inflows is computed as shown under in table
8.16Table 8.16:Average of cash inflows
Year Cash inflows
1 50,000
2 50,000
3 30,000
4 40,000
Total 1,70,000
500,42.Rs4
000,70,1Average
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Step 2
Divide the initial investment by the average of annual cash inflows
35.2500,42
000,00,1
Step 3
From the PVIFA table for 4 years, the annuity factor very near 2.35 is
25%. Therefore the first initial rate is 25% as shown in table 8.17
Table 8.17: Trial rate at 25%
Year Cash flows PV factor at 25 % PV of Cash flows
1 50,000 0.800 40,000
2 50,000 0.640 32,0003 30,000 0.512 15,360
4 40,000 0.410 16,400
Total 1,03,760
Since the initial investment of Rs.1,00,000 is less than the computed
value at 25% of Rs.1,03,760 the next trial rate is 26%.
Hence the changes in the calculations are as shown in table 8.18
Table 8.18: Trial rate at 26%
Year Cash flows PV factor at 26 % PV of Cash flows
1 50,000 0.7937 39,685
2 50,000 0.6299 31,495
3 30,000 0.4999 14,997
4 40,000 0.3968 15,872
Total 1,02,049
The next trial rate is 27%, the changes are as shown under in table 8.19.
Table 8.19: Trial rate at 27%
Year Cash flows PV factor at 27 % PV of Cash flows
1 50,000 0.7874 39,370
2 50,000 0.6200 31,000
3 30,000 0.4882 14,646
4 40,000 0.3844 15,376
Total 1,00,392
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Modified Internal Rate of Return (MIRR)
Modified internal rate of return (MIRR) is a distinct improvement over the
IRR. Managers find IRR intuitively more appealing than the rupees of NPV
because IRR is expressed on a percentage rate of return. MIRR modifies
IRR. MIRR is a better indicator of relative profitability of the projects. MIRR
is defined as
PV of Costs = PV of terminal value
cash outflow t
(1+r) t
cash inflow (1+r) n-t
The next trial rate is 28%, the changes are as shown under in
table 8.20Table 8.20: Trial rate at 28%
Year Cash flows PV factor at 26 % PV of Cash flows
1 50,000 0.7813 39,065
2 50,000 0.6104 30,520
3 30,000 0.4768 14,3047
4 40,000 0.3725 14,900
Total 98,789
Since initial investment of Rs.1,00,000 lies between 98789 (28 %) and 1,00,392(27%) the IRR by interpolation.
1789,98392,00,1
000,00,1392,00,127
11603
39227
= 27 + 0.2445
= 27.2445 = 27.24 %
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PVC = PV of costs
To calculate PVC, the discount rate used is the cost of capital. To calculatethe terminal value, the future value factor is based on the cost of capital
MIRR is obtained on solving the following equation.
Superiority of MIRR over IRR
MIRR assumes that cash flows from the project are reinvested at the
cost of capital. The IRR assumes that the cash flows from the project are
reinvested at the projects own IRR. Since reinvestment at the cost of
capital is considered realistic and correct, the MIRR measures the
projects true profitability
MIRR does not have the problem of multiple rates which we come
across in IRR
Solved Problem
The cash flows for respective years at a cost of capital of 12% is as shown
in table 8.21.
Table 8.21: Cost of capital
Year 0 1 2 3 4 5 6
Cash flows (Rs. in millions) (100) (100) 30 60 90 120 130
Present value of cost = 100 +12.1
100
= 100 + 89.29 = 189.29
Terminal value of cash flows:
cash inflow (1+r) n-t
Where r = 0.12, n= 6 , t=2 for the 2nd year, t=3 for 3rd year, t=4 for 4th year
and so on.
= 30 (1.12)4 + 60 (1.12)3 + 90 (1.12)2 + 120 (1.12) + 130
= 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130
= 47.205 + 84.294 + 112.896 + 134.4 + 130
= 508.80
PV of costs = TV/ (1 + MIRR)n
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Profitability Index
Profitability index is also known as benefit cost ratio. Profitability index is the
ratio of the present value of cash inflows to initial cash outlay. The discount
factor based on the required rate of return is used to discount the cash
inflows.
Accept or reject criteria
Accept the project if PI is greater than 1
Reject the project if PI is less than 1
If profitability index is 1 then the management may accept the project because the
sum of the present value of cash inflows is equal to the sum of present value of
cash outflows. It neither adds nor reduces the existing wealth of the company.
It takes into account the time value of money
It is consistent with the principle of maximisation of share holderswealth
It measures the relative profitability
P1= Present value of cash inflows / initial cash outlay
MIRR is obtained on solving the following equation:
6)MIRR1(
80.50829.189
29.189
80.508)MIRR1( 6
(1 + MIRR)6 = 2.6879
MIRR = 17.9 %
Modified internal rate of return = 17.9%
Merits of PI
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Estimation of cash flows and discount rate cannot be done
accurately with certainty
A conflict may arise between NPV and profitability index if a choice
between mutually exclusive projects has to be made.
Solved Problem
A firm is considering an investment proposal which requires an initial
cash outlay of Rs 8lakhs now and Rs 2lakhs at the end of the third year.
It is expected to generate cash flows as shown in table 8.22
Table 8.22 Cash inflows
Year Cash inflows
1 3,50,000
2 8,00,000
3 2,50,000
Apply the discount rate of 12% and calculate profitability index
Demerits of PI
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8.10 Summary
Capital investment proposals involve current outlay of funds in the
expectation of a stream of cash inflow in future. Various techniques are
available for evaluating investment projects. They are grouped into
traditional and modern techniques. The major traditional techniques are
payback period and accounting rate of return.
The important discounting criteria are net present value, internal rate of
return and profitability index. A major deficiency of payback period is that it
does not take into account the time value of money. DCF techniquesovercome this limitation. Each method has both positive and negative
aspects. The most popular method for large project is the internal rate of
return. Payback period and accounting rate of return are popular for
evaluating small projects.
Solution
Table 8.23: Present value of cash outflowsYear PV factor at 12 % Cash out flows PV of Cash flows
1 Rs.8lakhs Rs.8lakhs
2
3 0.712 2lakhs 1.424lakhs
Total 9.424lakhs
Table 8.24: Present value of cash inflows
Year PVIF (12%) Cash inflows PV of Cash flows
1 0.893 3,50,000 3.1255 lakhs
2 0.797 8,00,000 6.376 lakhs4 0.636 2,50,000 1.5900 lakhs
Total 11.0915 lakhs
outflowscashofvaluepresentofTotal
lowsinfcashofvaluepresentofTotalPI
177.1424.9
0915.11
For every Re.1 invested the project is expected to give a cash inflow of
Rs. 1.177 i.e. for every rupee invested a profit of Rs.0.177 is obtained.
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8.11 Terminal Questions
1. Examine the importance of capital budgeting.2. Briefly examine the significance of identification of investment
opportunities in capital budgeting process.
3. Critically examine the pay-back period as a technique of approval of
projects.
4. Summarise the features of DCF techniques.
8.12 Answers to SAQs and TQs
Answers to Self Assessment Questions
1. Capital budgeting
2. Capital budgeting
3. Highly complex
4. Capital budgeting decisions
5. Irreversible
6. Uncertainty, highly uncertain.
7. Final step
8. First step
9. A fertile source
10. The most crucial phase
11. Capital budgeting
12. Cost reduction
13. Economic appraisal
14. Technical appraisal
15. Financial viability
16. Demand for the product or service.
17. Decision criteria
18. Sunk cost
19. Externalities
20. Investment element; Financing element
21. Ignores
22. Profitability of
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Answers to Terminal Questions
1. Refer to 8.22. Refer to 8.5
3. Refer to 8.8.1
4. Refer to 8.8.2