FINANCIAL MANAGEMENT
Semester 3
Unit 2 Long-Term Investment Decisions (30%)
Dr. Radha Vyas

CHAPTER OUTLINE
 Nature & Meaning of Capital Budgeting
 Principles & Techniques
 Estimation of Relevant Cash Flows & Terminal
Value
 Evaluation Techniques –
1. Accounting Rate of Return,
2. Net Present Value,
3. Internal Rate of Return,
4. Net Terminal Value,
5. Profitability Index Method
6. Pay Back Period 2

3

INTRODUCTION OF CAPITAL BUDGETING
 Capital budgeting is made up of two words ‘capital’ and
‘budgeting.’
 In this context, capital expenditure is the spending of
funds for large expenditures like purchasing fixed assets
and equipment, repairs to fixed assets or equipment,
research and development, expansion and the like.
 Budgeting is setting targets for projects to ensure
maximum profitability.
 Capital budgeting is the process a business undertakes
to evaluate potential major projects or investments.
 Construction of a new plant or a big investment in an
outside venture are examples of projects that would
require capital budgeting before they are approved or
rejected. 4

 Meaning of Capital Budgeting:
The process of taking decisions as to which assets should
be purchased and how to spend the funds for this purpose
is called Capital Budgeting.
 Definition of Capital Budgeting:
 According to I. M. Pandey, “Capital budgeting decision
may be defined as the firm’s decision to invest its
current funds most efficiently in long run activities in
anticipation of an expected flow of future benefits over
series of year.”
 According to Shall and Haley, “The process of
determining both how much to spend on capital assets
and which assets to acquire is called capital budgeting.
The plan for such expenditure is called a capital
budget.”
5

NATURE OF CAPITAL BUDGETING
 It is a long-term investment decision.
 It is irreversible in nature.
 It requires a large amount of funds.
 It is most critical and complicated decision for a
finance manager.
 It involves an element of risk as the investment is
to be recovered in future.
6

IMPORTANCE OF CAPITAL BUDGETING
1. Large Expenditure
2. Long Term Effects
3. Estimates and Uncertainty
4. Effect on Profitability
5. Irreversible Decisions
7

PROCESS OF CAPITAL BUDGETING
1. Origin of Investment Proposal
2. Evaluation of the Projects
3. Selection of the Project
4. Implementation and Follow - up
8

PRINCIPLES
Incremental
Cash flows
Opportunity
Cost
Sunk Costs
Financing
Costs
Tax
Considerations
Timing of Cash
flows
9

 Relevant Cash Flow
 Relevant cash flow is the incremental after – tax
cash outflow (investment) and resulting subsequent
inflows associated with a proposed capital
expenditure.
 Incremental Cash Flows
 Incremental cash flows are the additional cash
flows (outflows as well as inflows) expected to
result from a proposed capital expenditure.
 Sunk Costs
 Sunk costs are cash outflows that have already
been made and therefore have no effect on the
cash flows relevant to a current decision.
10

ESTIMATION OF RELEVANT CASH FLOWS
1. Single Proposal
 Cash Outflows of New Project
(1) Cost of new project
(2) + Installation cost of plant and equipments
(3) + Working capital requirements
 Determination of Cash Inflows
Cash sales revenues
Less: Cash operating cost
Cash inflows before taxes (CFBT)
Less: Depreciation
Taxable income
Less: Tax
Earning after taxes
Plus: Depreciation
Cash inflows after tax (CFAT)
Plus: Salvage value
Plus: Recovery of working capital 11

2. Replacement Situation
 Cash Outflows in a Replacement Situation
(1) Cost of the new machine
(2) + Installation cost
(3) + Working Capital
(4) - Sale proceeds of existing machine
 Depreciation Base of New Machine in a
Replacement Situation
(1) WDV of the existing machine
(2) + Cost of the acquisition of new machine (including
installation costs)
(3) - Sale proceeds of existing machine 12

3. Mutually Exclusive Situations
 In the case of mutually exclusive proposals, the
selection of one proposal exclude the choice of
other.
 The calculation of the cash outflows and inflows are
same as the replacement situations.
13

EVALUATION TECHNIQUES
Non-Discounted
Methods/Traditional
Methods
Accounting Rate of
Return
Payback Period
Discounted
Methods/Modern
Methods
Net Present Value
Internal Rate of
Return
Net Terminal Value
Profitability Index
14

ACCOUNTING RATE OF RETURN
 The accounting rate of return (ARR) method of
evaluating proposed capital expenditure is also
known as the average rate of return method.
 It is based on accounting information rather than
cash flows.
ARR =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡
X 100
Average investment = Net working capital + Salvage
value + ½ (Initial cost of machine – Salvage value)
15

 Advantages:
1) It is easy to understand and convenient to use.
2) The figures of incomes are to be obtained from
profit and loss account; no other calculations are
required.
3) The entire income of the project is taken into
account.
4) It points to different alternative avenues of
investment.
5) It takes into consideration the savings over the
whole working life of the project.
6) With the help of this method, the most profitable
investment project can be selected from among the
various proposals. 16

 Limitations:
1) It does not consider cash flow.
2) Project yields different amounts of income at
different points of time is ignored in this method. In
short, the time element is not given importance.
Only total income of the project is taken into
account.
3) The difference in investment outlays is not taken
into account under this method.
4) It ignores the fact that useful life of different projects
may be different.
5) It does not take note of all factors affecting rate of
profit.
6) It does not suggest whether a project should be
accepted or not, unless it is compared with a cut off
rate decided by management.
17

EXAMPLE
 Determine the average rate of return from the following for
Machine A;
Cost Rs. 56,125
Annual estimated income after depreciation and income tax:
Year Amount
1 3375
2 5375
3 7375
4 9375
5 11,375
36,875
Estimated life 5 years
Estimated salvage value Rs. 3000
Depreciation has been charged on straight line basis.
18

 ARR = Average Annual PAT/ Average Investment X
100
 Average Annual PAT = Total PAT/No. of Years
 = 36,875/5
 = Rs. 7375
 Average Investment = Net working capital +
Salvage value + ½(Cost of machine – Salvage
value)
 = 0 + 3000 + ½ (56,125 – 3000)
 = 3000 + 26, 562.5
 = Rs. 29, 562.5
 ARR = 7375/29,562.5 X 100
 = 24.95% 19

PAYBACK PERIOD
 Payback period is the exact amount of time required
for a firm to recover its initial investment in a project
as calculated from cash inflows.
 Payback period is calculated as;
(1) In the case of annuity CFAT:
PB =
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
(2) In the case of mixed CFAT:
It is obtained by cumulating CFAT till the cumulative
CFAT equal the initial investment.
20

 Advantages:
1) It is simple to understand and easy to calculate.
2) It is highly useful for a firm facing liquidity problem.
3) It gives protection against risk of obsolescence in
the modern age where technology is changing very
fast.
4) The profitability of a project does not depend on
total return only, but on when it is available and how
speedily it is available.
5) The cost and sales price can be easily estimated if
the pay – back period is short.
6) It is an useful guide to investment policy.
7) It is most suitable when the future is very uncertain.
21

 Limitations:
1) It fails to take into account time factor. It gives
equal weight to cash flows received at different
points of time. For example;
Project Investment CFAT CFAT Total
(Year 1) (Year 2)
X Rs. 11,000 Rs. 4,000 Rs. 7,000 = Rs. 11,000
Y Rs. 11,000 Rs. 6,000 Rs. 5,000 = Rs. 11,000
2) This method does not give a correct idea of the
profitability of a project as it does not take into
account cash proceeds received after the pay-back
period. 22

3) This method prefers only those projects which
have short pay-back period, hence, it rejects
modern machines and equipments which may be
highly profitable but may give profits in the long
run.
4) It ignores the time value of money. It gives equal
weight to cash flow at different points of time. It
does not discount the cash inflows.
5) It does not take note of the cost of capital which is
the basis of investment decisions. 23

EXAMPLE
 Determine the pay-back period from the following for
Machine A;
Cost Rs. 56,125
Annual estimated income after depreciation and income
tax:
Year Amount
1 3375
2 5375
3 7375
4 9375
5 11,375
36,875
Estimated life 5 years
Estimated salvage value Rs. 3000
Depreciation has been charged on straight line basis. 24

D = C –S
N
= 56,125 – 3000
5
= RS. 10,625
YEAR PAT DEPRECIATI
ON
CFAT CUMULATIVE
CFAT
1 3375 10,625 14,000 14,000
2 5375 10,625 16,000 30,000
3 7375 10,625 18,000 48,000
4 9375 10,625 20,000 68,000
5 11375 10,625 22,000+3000
=25,000
93,000
25
Initial Investment = Rs. 56,125
PB = 3 years + 8125/20,000
PB = 3 + 0.41 = 3.41 Years

NET PRESENT VALUE
 Net present value is found by subtracting a project’s
initial investment from the present value of its cash
inflows discounted at the firm’s cost of capital.
 NPV = PV of Cash Inflows – PV of Cash Outflow
 The accept – reject criteria:
 If NPV is positive or NPV > 0, accept project.
 If NPV is negative or NPV < 0, reject project.
 If NPV = 0, the firm is indifferent between accepting
or rejecting the project.
26

 Advantages:
1) Since this method recognizes the time value of money, it is
the best guide in long term decision – making.
2) The cash flow over the whole working life of the project is
taken into consideration in this method.
3) This method is consistent with the shareholders’ objective
of maximizing the wealth as if a project which gives
maximum present value of cash flows is accepted, the
market price of the shares will be favorably affected.
4) Under this method, a comparison is possible among
different projects with different working lives as also
yielding different incomes in different years.
5) It takes into account the risk and uncertainties of business.
6) It takes into account cash flows and not profit, which is
more logical.
27

 Year CFAT PVIF@10%
 1 120000 0.909
 2 170000 0.826
 3 150000
28

 Limitations:
1) It necessitates calculations which are complicated
and difficult to understand.
2) It is difficult to determine the rate of discount to be
used in this method.
3) Under this method the present value of cash flows
of different projects are compared. Thus, no
absolute criteria is provided to judge the desirability
of investment projects.
4) The result may be misleading when the lengths of
working life of two investment projects are unequal.
29

EXAMPLE
 Determine the Net present value from the following for
Machine A;
Cost Rs. 56,125; Discount rate is 10%
Annual estimated income after depreciation and income
tax:
Year Amount
1 3375
2 5375
3 7375
4 9375
5 11,375
36,875
Estimated life 5 years
Estimated salvage value Rs. 3000
Depreciation has been charged on straight line basis.
30

Year PAT Deprecia
tion
CFAT PVIF@
10%
PV of CFAT
1 3375 10625 14,000 0.909 12,726
2 5375 10625 16,000 0.826 13,216
3 7375 10625 18,000 0.751 13,518
4 9375 10625 20,000 0.683 13,660
5 11375 10625 22,000 +
3000 =
25,000
0.621 15,525
Total PV of CFAT 68,645
Less: PV of Cash Outflow 56,125
NPV 12,520 31

INTERNAL RATE OF RETURN
 Internal rate of return (IRR) is the discount rate that
equates the present values of cash inflows with the
initial investment associated with a project, thereby
causing NPV = 0.
 If the IRR ( r ) exceeds the cut-off rate (k), accept
the project.
 Calculation of IRR:
1) Calculate the average annual cash inflow.
2) Determine pay back period dividing the initial
outlay by the average annual CFAT determined in
step 1.
3) Look for the factor in Table A-4, closest to the pay
back value. 32

4) If the actual cash inflows are higher in the initial
years of the project’s life than the average CFAT,
adjust IRR a few percentage points upward.
5) If in the early years the actual cash inflows are
below the average CFAT, adjust IRR a few
percentage points downward.
6) If the average CFAT seems fairly close to the
actual cash flows, no adjustment is to be made.
7) Find out the present value (using Table A-3),
taking discount rates as estimated earlier.
8) If the PV of CFAT equals the initial outlay, NPV is
zero, it is the IRR. Otherwise, repeat step 7 till two
consecutive discount rates that cause the NPV to be
positive and negative respectively.
33

9) The actual value can be calculated by the method
of interpolation as;
IRR = A +
C
C −D
X (B – A)
Where A = Lower Rate of Discount at first trial
B = Higher Rate of Discount at second trial
C = Excess of PV of trial at lower rate
D = Shortfall in PV of trial at higher rate
34

 Advantages:
1) It considers time value of money.
2) The cash flow available for the whole life of the
project is taken into account.
3) It is easier to understand by management and other
non-technical personnel as here the rate of interest
is computed which is better understood than
present value.
4) There is no need to fix the rate of return in advance
because the method itself is used to determine the
rate.
5) The objective of any business is to maximise the
owners’ wealth and this method satisfies it.
35

 Limitations:
1) The calculations are complicated because they are
based on trial and error method.
2) Uniform internal rate is not available under this
method. It may give multiple rates which become
confusing.
3) In certain situations, ranking of mutually exclusive
projects may be different by IRR method and NPV
methods.
36

EXAMPLE
 By investing Rs. 60,000 in a project, the cash flow
available for 5 years is as follows:
1st year Rs. 22,000
2nd year Rs. 18,000
3rd year Rs. 14,000
4th year Rs. 16,000
5th year Rs. 10,000
Calculate Internal Rate of Return (IRR).
37

1) Average CFAT =
22000+18000+14000+16000+10000
5
= Rs. 16000
2) PB = Investment/Average CFAT
= 60000/16000
= 3.75
3) At 10% = Factor 3.79, We will try at 11% & 12% as
initial years cash inflows are higher than average
CFAT Rs. 16,000
38

Year CFAT PVIF@11% PV of CFAT
1 22000 0.901 19,822
2 18000 0.812 14,616
3 14000 0.731 10,234
4 16000 0.659 10,544
5 10000 0.593 5930
Total PV of CFAT 61,146
Less: PV of Cash Outflow 60,000
NPV 1146
39

Year CFAT PVIF@12% PV of CFAT
1 22000 0.893 19,646
2 18000 0.797 14,346
3 14000 0.712 9968
4 16000 0.636 10,176
5 10000 0.567 5670
Total PV of CFAT 59,806
Less: PV of Cash Outflow 60,000
NPV (194)
40

 By using interpolation
 IRR = A +
C
C −D
X (B – A)
 = 11 + 1146 X (12-11)
 1146 + 194
 = 11 + 0.86 X 1
 = 11.86%
41

NET TERMINAL VALUE
 This method assumes that each cash inflow received
is reinvested in another asset at a certain rate of
interest.
 It is reinvested from the time it is received until the
completion of the project.
 NTV = PVTS – PVO
Where, PVTS = Present value of the sum total of
the compounded reinvested cash inflows
PVO = Present value of the outflows
 If the NTV is positive, accept the project
 If the NTV is negative, reject the project 42

 Advantages:
1) It has the advantage of cash inflow being
reinvested, once they are received.
2) It is mathematically easier to compute than the IRR
method.
3) The business executives who are not trained in
Accountancy and Statistics can understand this
compounding technique better than discounting
technique.
4) It is more suitable for cash budgeting requirements
as it also considers interest earnings.
43

 Limitation:
 The major practical problem of this method lies in
determining the future rates of interest at which the
intermediate cash inflows received will be reinvested.
 Example:
Original outlay Rs. 10,000; Life of the project 5 years;
Cash inflows Rs. 4000 each for 5 years and cost of
capital (k) 10 per cent. Calculate NTV.
Expected interest rates at which cash inflows will be
reinvested;
Year-end Per cent
1 6
2 6
3 8
4 8
5 8 44

Year Cash
Inflows
Rate of
Interest
for
Investmen
t (%)
Years for
Investme
nt
Compou
nding
Factor
(CVIF)
Compound
ing Value
1 4000 6 4 1.262 5048
2 4000 6 3 1.191 4764
3 4000 8 2 1.166 4664
4 4000 8 1 1.080 4320
5 4000 8 0 1.000 4000
20,000 Sum Total of Compounding Value 22,796
45
PV of Sum Total of Compound Value of Cash Inflow
= (22,796 X PVIFi,n)
= 22,796 X PVIF10%,5)
= 22,796 X 0.621
= 14,156.32
NTV = 14,156.32 – 10,000
= Rs. 4156.32

PROFITABILITY INDEX OR BENEFIT COST RATIO
 It gives a proportion of present value of cash inflow
and present value of cash outflow or investment.
 It is also known as Benefit – Cost Ratio as it is the
ratio of future cash benefit to initial cash outflow.
 PI =
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤
𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤
 If the index is greater than 1, the project becomes
acceptable as it indicates that the present value of
cash inflow is more.
 If PI or BC > 1, accept project
 If PI or BC < 1, reject project
46

 Advantages:
1) It gives due importance to time factor.
2) It considers the cash inflow during the whole life of
the project.
3) PI method gives a better indication of the project
to be selected in case there is scarcity of funds
available for investment.
47

EXAMPLE
 Determine the Benefit – Cost Ratio from the following for
Machine A;
Cost Rs. 56,125; Discount rate is 10%
Annual estimated income after depreciation and income tax:
Year Amount
1 3375
2 5375
3 7375
4 9375
5 11,375
36,875
Estimated life 5 years
Estimated salvage value Rs. 3000
Depreciation has been charged on straight line basis. 48

Year PAT Depreciat
ion
CFAT PVIF
@10%
PV of
CFAT
1 3375 10,625 14,000 0.909 12,726
2 5375 10,625 16,000 0.826 13,216
3 7375 10,625 18,000 0.751 13,518
4 9375 10,625 20,000 0.683 13,660
5 11,375 10,625 25,000 0.621 15,525
Total PV of CFAT 68,645
49
BC = PV of Cash Inflow
PV of Cash Outflow
= 68,645
56,125
= 1.22

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