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S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s            WELINGKAR Institute of management development & research            Lakhamsi Nappo Road, Next t...
S. P. Mandali’s            WELINGKAR Institute of management development & research            Lakhamsi Nappo Road, Next t...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s            WELINGKAR Institute of management development & research            Lakhamsi Nappo Road, Next t...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s            WELINGKAR Institute of management development & research            Lakhamsi Nappo Road, Next t...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
S. P. Mandali’s           WELINGKAR Institute of management development & research           Lakhamsi Nappo Road, Next to ...
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Rathod capital budgeting 1

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  1. 1. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 CAPITAL BUDGETING OR CAPITAL EXPENDITURE PROJECT SYNOPSIS1. MEANING & DEFINATION2. FEATURES3. KINDS OF CAPITAL EXPENDITURE4. PROCESS OF CAPITAL BUDGETING5. METHODS OF EVALUATIONMEANING AND DEFINITION“Planning & Control of capital expenditure is termed as CapitalBudgeting”.“Capital Budgeting is an Art of Funding Assets that are worthmore than they cost to achieve a predetermined Goal” i.e.Optimising the wealth of the Business Enterprise.“Capital Budgeting is the process of Identifying Analysing andselecting investment projects whose returns are expected beyondone year”.The Capital Budgeting involves a current outlay or series ofoutlays of cash resources in return for an anticipated flow of futurebenefits. In other words, the system of Capital Budgeting isemployed to evaluate expenditure decisions which involves currentoutlays but are likely to produce benefits over a period of longerthan one year. These benefits may be either in the form ofincreased revenues or reduction in cost.Notes prepared by Prof. M. B. Thakoor Page 1
  2. 2. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 FEATURES1. HEAVY SUBSTANTIAL OUTLAY2. HIGH DEGREE OF RISK3. LARGE ANTICIPATED BENEFITS4. HIGH GESTATION PERIOD i.e. RELATIVE LONG TERM PERIOD BETWEEN INTIAL OUTLAY AND ANTICIPATED RETURN5. IRREVERSIBLE DECISION.KINDS OF CAPITAL BUDGETING PROPOSALS ORCAPITAL EXPENDITURE PROPOSALS 1. MANDATORY INVESTMENTS ex. A) Pollution control Equipments B) Medical Dispensary C) Fire fighting Equipments D) Creche in Factory 2. REPLACEMENT PROJECTS For cost reduction 3. EXPANSION PROJECT Ex. A) Increase the capacity B) Widen the distribution network 4. DIVERSIFICATION PROJECT Ex. Producing new product. 5. RESEARCH AND DEVELOPMENT 6. STRATEGIC INVESTMENT PROJECTSNotes prepared by Prof. M. B. Thakoor Page 2
  3. 3. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019PROCESS OF CAPITAL BUDGETING1. IDENTIFICATION OF POTENTIAL INVESTMENT OPPORTUNITIES. Here planning body (committee or individual) estimate future sales. A) They monitor external environment. B) Do swot analysis C) Motivate employee to make suggestion2. ASSEMBLING OF INVESTMENT PROPOSALS3. EVALUATING THE VARIOUS INVESTMENT PROPOSALS4. PREPARATION OF CAPITAL BUDGET5. IMPLEMENTATION6. FOLLOW-UPNotes prepared by Prof. M. B. Thakoor Page 3
  4. 4. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 METHODS OF EVALUATION METHODS OF EVALUATION TRADITIONAL MODERNPAY BACK A.R.R. (DISCOUNTED CASHFLOW) N.P.V. P/I I.R.R.PAY BACK PERIOD“It is the number of years required to recover the original costinvested in a project from the cash inflow.”By this method the investor will know how much time it will taketo recover its original cost i.e. How many years it will take for thecash benefits to pay the original cost of an investment, normallydisregarding the salvage value.(A) When cash inflows are equal/even/same every year.Example: Project A Project B Project CInitial Rs.10 Lacs Rs.20 Lacs Rs.25 LacsinvestmentCash flow Rs.3 Lacs Rs.5 Lacs Rs.10 Lacsevery yearLife of the 10 years 10 years 10 yearsprojectPay back 10/3 = 3 1/3 yrs. 20/5 = 4 yrs. 25/10 = 2½ yrs.periodNotes prepared by Prof. M. B. Thakoor Page 4
  5. 5. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019Therefore, Initial investmentPay back period = ------------------------ Annual cash inflowCash inflow = NPAT + Depreciation & Write OffsCONCLUSION:In the above example project C has the shortest pay back and ismore desirable.B) UNEVEN CASH INFLOWSIn case of uneven cash inflows the payback period is found outby adding the inflows i.e. cumulative cash inflows.ACCEPT / REJECT CRITERIA1) FOR SINGLE PROJECT If the pay back is less than the estimated life then accept it If the pay back is more than estimated life then reject it.2) FOR TWO OR MORE PROJECTS If 2 more projects – project with the Shortest pay back accept it.Notes prepared by Prof. M. B. Thakoor Page 5
  6. 6. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019ADVANTAGES1. SIMPLE METHOD This is the most simple method very easy and clear to understand. This does not involve tedious mathematical calculation.2. CUSHION / SHIELD FROM OBSOLESCENCE : This method reduces the possibility of loss on account of obsolescence as the method prefers investment in short term project.3. CONSERVATIVE PRINCIPLES This method makes it clear that no profit arises till the pay back period is over. This helps the new companies they should start paying dividends.4. PREFERRED BY EXECUTIVES WHO LIKES SNAP ANSWERS, FOR SELECTING THE PROPOSALS.Notes prepared by Prof. M. B. Thakoor Page 6
  7. 7. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 LIMITATIONS1. CASH FLOW AFTER THE PAY BACK PERIOD This method does not consider cash inflow generated after thepay back period. There are many capital intensive projects whichgenerate substantial cash inflows in the later years than the initialyears. In the above example ‘project B’ which is rejected now maygenerate huge cash inflows in later years but still it is rejected.FOR EXAMPLE:- Particulars Project A Project BInitial Investment Rs.10000 Rs.10000Cash inflowsYear 1 4000 3000Year 2 4000 3000Year 3 2000 3000Year 4 -- 3000Year 5 -- 3000Pay back period 3 years 3.3 yearsIn the above example project ‘A’ is having short pay back thatmust be accepted but is does not give return afterwards but project‘B’ gives constant returns even after its pay back period. So on thewhole project ‘B’ is profitable still ‘A’ is accepted under thismethod.Thus cash inflow after pay back period is ignore.2. TIMING AND MAGNITUDE NOT CONSIDERED.Cost Rs.15000 Rs.15000Cash flowYear 1 Rs.10000 RS.1000Year 2 Rs.4000 Rs.4000Year 3 Rs.1000 Rs.10,000Notes prepared by Prof. M. B. Thakoor Page 7
  8. 8. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 0193. PROFITABILITY The pay back period method does not take into account the measure of profitability. It is only concerned with the projects capital recovery.4. TIME VALUE OF MONEY This method does not consider time value of money i.e. it ignores the interest which is an important factor in making sound investment decisions. A rupee borrowed tomorrow is worth less than a rupees today. Ex. There are projects A & B the cost of the project is Rs.30000 in each case. Year Cashinflow Project ‘A’ Project ‘B’ 1 Rs.10000 Rs.2000 2 Rs.10000 Rs.4000 3 Rs.10000 Rs.24000 In both the cases the pay back period is 3 years however project ‘A’ should be preferred as compared to project ‘B’ because of speedy recovery of the initial investment.5. LIQUIDITY OF ONLY INITIAL INVESTMENT. It gives importance only to its liquidity of the initial investment. It does not consider the liquidity of the company’s total span of life.6. DOESN’T CONSIDER THE ENTIRE LIFE OF THE PROJECT.Notes prepared by Prof. M. B. Thakoor Page 8
  9. 9. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 USE1. FOR PROJECT HAVING HIGH RISK AND UNCERTAINTY / HAZY LONG TERM OUTLOOK This method is useful in evaluating those projects which involve high risk and uncertainty. For ex. Those projects which have the risk of rapid technological development of cheap substitute, political instability etc. for these projects these method is more suitable for e.g. fashion garment industry.2. FIRMS SUFFERING FROM LIQUIDITY CRISIS Firms which suffer from liquidity crisis are more interested in quick returns of funds rather than profitability pay back period method suits them most because it emphasizes on quick recovery of funds.3. FIRMS EMPHASIZING SHORT TERMS EARNING PERFORMANCE This method it suitable for firms which emphasize on short term earnings performance rather than its long term growth.4. USED FOR PROJECTS HAVING HIGH DEGREE OF OBSOLESCENCE.CONCLUSION:PAY BACK METHOD IS AMEASURE OF LIQUIDITY OFINVESTMENT THANPROFITABILITY.Notes prepared by Prof. M. B. Thakoor Page 9
  10. 10. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 ACCOUNTING RATE OF RETURN (A.R.R.)THIS METHOD IS BASED ON AVERAGE ANNUALACCOUNTING PROFITS OF A PROJECT. IT IS EXPRESSED ASNET ACCOUNTING PROFIT AS A% OF CAPITAL INVESTED. A.R.R. = Average Annual Profits AFTER TAX ------------------------------- x 100 AVERAGE OR INITIAL INVESTMENTAverage Investment = COST – SALVAGE ------------------------- + SALVAGE 2Average Investment = COST – SALVAGE Release of ----------------------- + SALVAGE + working 2 capitalNOTE: If the sum states that return is to be calculated on the original investment them instead of Average Investment, cost itself is to be considered.MERITS:1) SIMPLE AND EASY TO CALCULATE.2) Consider income from the project throughout its life & not just the initial years unlike payback period.3) When a number of capital investments proposals are considered, a quick decision can be taken by use of ranking the investment.DEMERITS:1) It does not consider the time value of money.2) This method do not differentiate the projects with different size of investment may have the same A.R.R. and the firm will not be able to take the required decision.Notes prepared by Prof. M. B. Thakoor Page 10
  11. 11. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 NET PRESENT VALUE METHODPRESENT VALUE : If you invest Rs.1000/- for 3 years in a savings A/c. that pays10% interest per year. If you let your interest income bereinvested, your investment will grow as follows. Rs.First Year Principal at the beginning 1000 Interest for the year 100 (10/100*1000) principal at the end 1100Second Year Principal at the beginning 1100 Interest for the year 110 (10/100*1100) principal at the end 1210Third Year Principal at the beginning 1210 Interest for the year 121 (10/100*1210) principal at the end Rs.1331Notes prepared by Prof. M. B. Thakoor Page 11
  12. 12. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019The process of investing Money as well as reinvesting the interestearned thereon is called compounding. The future value orcompounded value of an investment after ‘n’ years when theinterest rate is ‘r’ is F.V. = P.V. (1 + r)nWhere, r = Rate of Interest N = No. of Years P.V. = Present Value F.V. = Future ValueEx. You deposit Rs.1000 today in a bank which pays 10% interest compounded annually, how much will the deposit grow to after 8 years & 12 years?F.V. 8 yrs. hence = 1000 (1.10)8 = 1000 (2.144) = Rs.2144F.V. 12 yrs. hence = 1000 (1.10)12 = 1000 (3.138) = Rs.3138Notes prepared by Prof. M. B. Thakoor Page 12
  13. 13. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019Q. A firm can invest Rs.10,000 in a project with a life of 3 years. The projected cash inflows are Years Rs. 1 4000 2 5000 3 4000The cost of capital is 10% p.a. should the investment be made?Answer:- The discount factor can be calculated based on Re. 1 receivedin with ‘r’ rate of interest in 3 years. 1 . (1 + r)nYear 1 = Re. 1 = 1/(1.10)1 = 0.909 (1+10/100)1Year 2 = Re. 1 = 1/(1.10)2 = 0.826 (1+10/100)2Year 3 = Re. 1 = 1/(1.10)3 = 0.751 (1+10/100)3 Year Cash Inflow (Rs.) Discount Factor Present Value 1 4000 0.909 3,636 2 5000 0.826 4,130 3 4000 0.751 3,004 Total P.V. 10,770Notes prepared by Prof. M. B. Thakoor Page 13
  14. 14. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019NET PRESENT VALUE (NPV) METHOD This method recognizes that the cash flows at different pointof time differ in value and are comparable only when they are firstbrought down to a common denominator. i.e. Present Values. Forthis purpose every cash inflow and cash outflow are firstdiscounted to bring them down to their present value. Thediscounting rate normally equals to its opportunity cost of capital. The NPV is the DIFFERENCE BETWEEN the presentvalues of cash inflows and the present values of cash outflows. NPV = Σ PV of inflow – Σ PV of outflowDECISION RULEACCEPT : if NPV is positive i.e. NPV > 0REJECT : if NPV is negative i.e. NPV < 0DEFINITION: The NPV of an investment proposal may be defined as “Thesum of the Present Values of all the cash inflows – The sum ofthe Present Values of all the cash outflows”Notes prepared by Prof. M. B. Thakoor Page 14
  15. 15. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019Accept / Reject Criteria:If NPV of inflow > NPV of outflowThen Accept the project.i.e. If NPV of a project is positive Accept the project & If NPV ofa project is negative reject the project.MERITS:1. Considers Time Value of Money.2. Considers Total Cash Inflows. i.e. entire life.3. Best Decision Criteria for Mutually Exclusive Project.4. NPV technique is based on the cash flows rather than the Accounting profits and thus helps in analyzing the effect of the proposal on the wealth of the shareholders in a better way. Thus, it satisfies one of the basic objective of Financial Management i.e. Wealth MaximizationNotes prepared by Prof. M. B. Thakoor Page 15
  16. 16. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019LIMITATIONS:1. It is more difficult method than the Pay Back or ARR method.2. Consider only Initial Investment: The NPV is expressed in absolute terms rather than relative term. Project A may have a NPV of Rs.5000/- while project B has a NPV of Rs.2,500/-, but project a may require an investment of Rs.50,000 whereas project B may require an investment of just Rs.10,000. Advocate of NPV argue that what maths is the surplus value irrespective of what the investment outlay is.3. Life of the project is not considered: The NPV method do not consider the life of the project. Hence when mutually exclusive projects with different lives are being considered, the NPV rule is biased in favour of long-term project.4. Calculation of the desired rate of return presents serious problems. Generally cost of Capital is the basis of determining the desired rate. The calculation of cost of Capital is itself complicated. Moreover desired rate of return will vary term year to year.Notes prepared by Prof. M. B. Thakoor Page 16
  17. 17. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019The following are the steps in Calculating NPV:1) Calculation of cash flows i.e. both Inflow & Outflow (preferably after tax) over the full life of the Asset.2) Discounting the Cash flows by the disc factor.3) Aggregating of discounted Cash inflow4) Sept 3 – Outflow (i.e. total present value of cash inflow – total present value of cash outflow) a. If positive in step 4. Accept the project b. If negative in step 4. Reject the projectNotes prepared by Prof. M. B. Thakoor Page 17
  18. 18. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 PROFITABILITY INDEX (P/I)THIS IS THE REFINEMENT OF NPV METHODIT IS A VARIANT OF NPV TECHNIQUE WHICH IS ALSOKNOWN AS BENEFIT COST RATIO OR PRESENT VALUEINDEX OR EXCESS PRESENT VALUE INDEX. TOTAL OF P.V. OF CASH INFLOWP/I = --------------------------------------------------- TOTAL OF P.V. OF CASH OUTFLOWACCEPT / REJECT CRITERIAACCEPT THE PROJECT IF P/I > 1REJECT THE PROJECT IF P/I < 1Notes prepared by Prof. M. B. Thakoor Page 18
  19. 19. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019ADVANTAGE1. THE NPV DO NOT GIVE TRUE PICTURE WHEN SELECTION AMONG THE PROJECTS HAS TO BE MADE AND THE INVESTMENT SIZE IS DIFFERENT. A PROJECT A & B HAVING COST RS.1,00,000 AND 80,000 RESPECTIVELY. PRESENT VALUE OF INFLOW OF THE PROJECT ARE RS.1,20,000 & RS.1,00,000 BOTH HAVE NPV OF RS.20,000 AND AS PER NPV THEY ALIKE.HERE P/I TECHNIQUE SEEMS TO GIVE A BETTER RESULT. 1,20,000 1,00,000P/I (A) = --------------- = 1.20 P/I (B) = ----------- = 1.25 1,00,000 80,000CONCLUSION: IN TERMS OF NPV BOTH PROJECT AREEQUAL BUT IN TERM OF P/I ACCEPT PROJECT B.2. IT CONSIDERS TIME VALUE OF MONEY.3. IT CONSIDERS THE ENTIRE CASH INFLOW AND ALL CASH OUTFLOW IRRESPECTIVE OF THE TIMING OF THE OCCURRENCE.4. IT IS BASED ON CASH OUTFLOW RATHER THAN THE ACCOUNTING PROFIT AND THUS HELPS IN ANALYZING THE EFFECT OF THE PROPOSAL ON THE WEALTH OF THE SHAREHOLDER.Notes prepared by Prof. M. B. Thakoor Page 19
  20. 20. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019DISADVANTAGE:1. IT INVOLVES DIFFICULT CALCULATION.2. THIS BEING AN EXTENTION OF NPV WHERE THE PREDETERMINATION OF THE REQUIRED RATE OF RETURN ‘K’ ITSELF IS A DIFFICULT JOB. IF THE VALUE OF ‘K’ IS NOT CORRECTLY TAKEN THEN WHOLE EXERCISE OF NPV MAY GO WRONG. PROJECT A PROJECT BInitial cash outflow 1,50,000 1,10,000P.V. of cash inflow 2,10,000 1,65,000NPV 60,000 55,000AS PER NPV ACCEPT PROJECT AP/I 2,10,000 = 1.4:1 1,65,000 = 1.5:1 1,50,000 1,10,000AS PER P/I ACCEPT PROJECT BIN SUCH A CASE FOLLOW NPV UNLESS THERE ISCAPITAL RATIONING. THIS IS BECAUSE IF THE FIRMHAS FUNDS OF RS.1,50,000 TO INVEST THEN AS PER NPVTECHNIQUE PROJECT A IS TO BE ACCEPTED BECAUSE ITWILL RESULT IN INCREASE IN SHAREHOLDERSWEALTH TO THE EXTENT OF RS.60,000 AGAINSTPROJECT B WHICH WILL INCREASE IN SHAREHOLDERSWEALTH ONLY BY RS.55,000.THE BETTER PROJECT IS ONE, WHICH ADDS MORE TOTHE WEALTH OF THE SHARE HOLDER. TERMINAL VALUE (TV)Notes prepared by Prof. M. B. Thakoor Page 20
  21. 21. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 The other variant of the NPV technique is known as terminalvalue technique. Here the future cash inflows are discounted to make themcomparable. In terminal value technique the future cash flows are firstcompounded at the expected rate of interest for the period fromtheir occurrence till the end of the economic life of the project. The compound values are then discounted at an appropriatediscount rate to find out the present value. Then the present value is compared with initial outflow to findout the suitability of the project.Steps:1. Find the compounded value Year Cash inflow Remaining P.V. factor Compounded year value 1 3 2 2 3 1 4 0 Σ2. The above compound value to be discounted at a discount factor and the P.V. is to be found out.3. The above (2) to be compared with initial investment to get NPV. INTERNAL RATE OF RETURN (IRR)Notes prepared by Prof. M. B. Thakoor Page 21
  22. 22. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019The IRR is that rate at which the sum of discounted cash inflowsequals to the sum of discounted cash outflows.In other words, it is the rate at which it discounts the cash flow tozero. Σ Cash inflowOr =1 Σ Cash outflowThus I.R.R. is also known as marginal rate of return or timeadjusted rate or return.Thus under this method the discount rate is not known but thecash inflow and cash outflow are known.For E.g.IF a sum of Rs.800 is invested in a project and become Rs.1000 atthe end of a year, the rate of return come to 25% which iscalculated as under:I= C (1 + r)I = Initial investmentC = Cash inflowR = I.R.R.i.e. 800 = 1000Notes prepared by Prof. M. B. Thakoor Page 22
  23. 23. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019 (1 = r)800 (1 + r) = 1000800 + 800r = 1000800r = 200r = 200 = 1 = 0.25 = 25% 800 4ACCEPT / REJECT CRITERIAIn order to make a decision on the basis of IRR technique the firmhas to determine in the first instance, its own required rate ofreturn.This rate ‘K’ is also known as cut off rate or the hurdle rate. Aparticular proposal may be accepted.If its IRR ‘r’ is MORE THAN the MINIMUM REQUIREDRATE ‘K’ ACCEPT IT.IF the IRR ‘r’ is just Equal To the Minimum Required Rate ‘K’than the firm may be INDIFFERENT.If the IRR ‘r’ is LESS THAN the MINIMUM REQUIREDRATE ‘K’ the project is altogether rejected.In case of mutually exclusive project the project with highestIRR is given top priority.Notes prepared by Prof. M. B. Thakoor Page 23
  24. 24. S. P. Mandali’s WELINGKAR Institute of management development & research Lakhamsi Nappo Road, Next to R. A. Podar College, Matunga, Mumbai – 400 019MERITS:1. The method considers the entire economic life of the project.2. It gives due weightage to time factor. I.e. It consider time value of money.3. Like NPV technique, the IRR technique is also based on the consideration of all the cashflows occurring at any time. The salvage value, the working capital used and released etc. are also considered.4. IRR is based on cashflows rather than accounting profit.DEMERITS:1. It involves complicated trial and error procedure.2. It makes an implied assumption that the future cash inflows of a proposal are reinvested at a rate equal to IRR for ex. In case of mutual exclusive proposal say A & B, having IRR of 18% and 16% respectively, the IRR technique make an implied assumption that the future cash inflows of project A will be reinvested at 18% while the cash inflow of project B will reinvested at 16%.3. It is imaginary to think that the same firm will have different reinvestment opportunities depending upon the proposal accepted.Notes prepared by Prof. M. B. Thakoor Page 24

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