Project management is an essential aspect of management.

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CAPITAL BUDGETING
 Capital budgeting is a decision situation where large
funds are committed (invested) in the initial stages of the
project and the returns are expected over a long period of
time. These decisions are related to allocation of investible
funds to different long-term assets.
 Capital budgeting is a continuous process and it is
carried out by different functional areas of management
such as production, marketing, engineering, financial
management etc.

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BASIC FEATURES OF CAPITAL
BUDGETING
 Capital budgeting decisions have long-term
implications.
 These decisions involve substantial commitment of
funds.
 These decisions are irreversible and require analysis
of minute details.
 These decisions determine and affect the future
growth of the firm.

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CAPITAL BUDGETING
DECISION INVOLVES
THREE STEPS
1. Estimation of costs and benefits of a proposal or of
each alternative.
2. Estimation of the required rate of return, i.e., the cost
of capital
3. Selection and applying the decision criterion.

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1. ESTIMATION OF CASH FLOWS
The costs and benefits for a capital budgeting
decision situation are measured in terms of cash
flows.
An important point is that all cash flows are
considered on after tax basis. The rule is that all
financial decisions are subservient to tax laws.
The cash flow from the project are compared with
the cost of acquiring the project.

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The cash flows may be grouped into relevant and
irrelevant cash flows as follows:
Relevant cash flows Irrelevant cash flows
• Cost of new project Sunk cost
• Scrap value of old / new plant Allocated overheads
• Trade-in-value of old plant Financial cash flows
• Cost reduction / savings
• Effect on tax liability
• Incremental repairs
• Working capital flows
• Revenue from new proposal
• Tax benefit of incremental
depreciation

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Calculation of different cash flows may be summarized as
follows:
INITIAL CASH OUTFLOW:
Cost of new plant
+ Installation expenses
+ Other Capital expenditure
+ Additional working capital
– Tax benefit on account of capital loss on sale of old
plant (if any)
– Salvage value of old plant
+ Tax liability on account of capital gain on sale of old
plant (if any).

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SUBSEQUENT ANNUAL INFLOWS:
Profit after tax
+ Depreciation
+ Financial charge ( 1-t)
– Repairs (if any)
– Capital Expenditure (if any).
TERMINAL CASH FLOW:
Annual cash inflow
+ Working capital released
+ Scrap value of the plant (if any).

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2. DECISION CRITERIA
TECHNIQUES OF EVALUATION
Traditional or Time-adjusted or
Non-discounting Discounted cash flows
1. Payback period 1. Net Present Value
2. Accounting Rate of 2. Profitability Index
Return 3. Internal Rate of Return

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TRADITIONAL OR NON-DISCOUNTING
TECHNIQUES
I . PAYBACK PERIOD:
• The payback period is defined as “the number of years required for
the proposal’s cumulative cash inflows to be equal to its cash
outflows.”
• The payback period is the length of time required to recover the
initial cost of the project.
• The payback period may be suitable if the firm has limited funds
available and has no ability or willingness to raise additional funds.
Pay back period = Initial investment / Annual cash flow

11. Merits
 It involves simple calculation, selection or rejection of the
project can be made easily, results obtained is more
reliable, best method for evaluating high risk projects.
Demerits
 It is based on principle of rule of thumb,
 Does not recognize importance of time value of money,
 Does not consider profitability of economic life of
project,
 Does not recognize pattern of cash flows,
 Does not reflect all the relevant dimensions of
profitability.
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II . ACCOUNTING RATE OF RETURN (OR) AVERAGE
RATE OF RETURN (ARR)
• The ARR may be defined as “the annualized net income earned
on the average funds invested in a project.”
• The annual returns of a project are expressed as a percentage
of the net investment in the project.
COMPUTATION OF ARR:
Average Annual profit (after tax)
ARR = x 100
Average Investment in the Project

13. Merits
 It is very simple to understand and use.
 This method takes into account saving over the entire economic life of
the project. Therefore, it provides a better means of comparison of
project than the pay back period.
 This method through the concept of "net earnings" ensures a
compensation of expected profitability of the projects and
 It can readily be calculated by using the accounting data.
Demerits
 It ignores time value of money.
 It does not consider the length of life of the projects.
 It is not consistent with the firm's objective of maximizing the market
value of shares.
 It ignores the fact that the profits earned can be reinvested.
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DISCOUNTED CASH FLOWS OR TIME
ADJUSTED TECHNIQUES
These are based upon the fact that the cash flows occurring
at different point of time are not having same economic worth.
I. NET PRESENT VALUE (NPV) METHOD:
 The NPV of an investment proposal may be defined as the sum of
the present values of all the cash inflows less the sum of present values
of all the cash outflows associated with the proposal.
 The decision rule is “ Accept the proposal if its NPV is positive and
reject the proposal if the NPV is negative”.
NPV = Total present value of all cash flows / Initial investment

15. Merits
 It recognizes the time value of money.
 It considers the cash inflow of the entire project.
 It estimates the present value of their cash inflows by using a
discount rate equal to the cost of capital.
 It is consistent with the objective of maximizing the welfare of
owners.
Demerits
 It is very difficult to find and understand the concept of cost of
capital
 It may not give reliable answers when dealing with alternative
projects under the conditions of unequal lives of project
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II. PROFITABILITY INDEX METHOD:
This technique is a variant of the NPV technique and is also
known as BENEFIT - COST RATIO or PRESENT VALUE
INDEX.
Total present value of cash inflows
PI =
Total present value of cash outflows.
Accept the project if its PI is more than 1 and reject
the proposal if the PI is less than 1.

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III. INTERNAL RATE OF RETURN (IRR) METHOD:
 The IRR of a proposal is defined as the discount rate which
produces a zero NPV, i.e., the IRR is the discount rate which will
equate the present value of cash inflows with the present value of
cash outflows.
 The IRR is also known as Marginal Rate of Return or Time
Adjusted Rate of Return.
 The time-schedule of occurrence of future cash flows is
known but the rate of discount is not.
 The discount rate calculated will equate the present value of
cash inflows with the present value of cash outflows.

18. Merits of IRR method
 It consider the time value of money
 Calculation of cost of capital is not a prerequisite for
adopting IRR
 IRR attempts to find the maximum rate of interest at
which funds invested in the project could be repaid
out of the cash inflows arising from the project.
 It is not in conflict with the concept of maximising
the welfare of the equity shareholders.
 It considers cash inflows throughout the life of the
project.
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19. Cons
 Computation of IRR is tedious and difficult to
understand
 Both NPV and IRR assume that the cash inflows can be
reinvested at the discounting rate in the new projects.
However, reinvestment of funds at the cut off rate is
more appropriate than at the IRR.
 IT may give results inconsistent with NPV method.
This is especially true in case of mutually exclusive
project.
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20.  Capital budgeting methods which analyse investment
proposals are based on the assumption that the cash
flows predicted for each proposal will materialise in
future.
 The estimated or forecasted cash flows are the
foundation for each and every method of investment
analysis.
 However there is ample risk and uncertainty attached to
the predicted cash flows.
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21.  Demand for the product
 Production and selling cost
 Selling price
 Project capacity
 Investment needed
 Salvage value
 Economic life of the project
 Depreciation rates
 Rates of taxation
 Competition
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22.  Risk is defined as the divergence between the estimated
and actual returns. It is also described as the variability
which is likely to occur in future between the
forecasted and actual returns.
 Depending on the likely variation projects may be
classified into Nil risk, Moderate risk and high risk
project.
 Uncertainty refers to situation where the probabilities
of future events occurring are not known.
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23.  Conservative methods
 Risk adjusted Discount Rate
 Conservative Forecasts or Certainty Equivalents
 Modern methods
 Sensitivity analysis
 Probability analysis
 Decision Tree analysis.
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24.  Sensitivity analysis is a simulation technique
in which key variables are changed and the
resulting change in the rate of return or the
NPV is observed.
 The common operating mechanism would be
to vary each strategic variable by certain fixed
percentages in both positive as well as
negative directions.
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25.  Probability is the relative frequency with
which an event may occur in future.
 Assigning probabilities can be objective or
subjective.
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26.  Under this method, the cut off rate or
minimum required rate of return is raised by
adding what is called risk premium to it.
 When the risk is greater, the premium to be
added would be greater.
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27.  Under this method, employing intuitive
correction factor or certainty equivalent
coefficient, which is calculated by the
decision-maker subjectively or objectively,
reduces the estimated risks from cash flows.
 Certainty Equivalents Coefficient = Desirable
cash flows/Estimated cash flows.
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28.  It is a graphic display of the relationship
between a present decision and future events,
and future decisions and their consequences.
 The major steps involved are
◦ Investment decision is defined clearly
◦ Decision alternatives are identified
◦ Decision tree graph indicates decision points,
chance events and other data
◦ Data such as projected cash flow, probability
distribution are shown on the decision tree
branches.
◦ Choosing the best alternatives.
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