1

CONCEPT OF CAPITAL BUDGETING

The term 'Capital Budgeting' refers to long-term

planning for proposed capital outlays and their
financing. Thus, it includes both raising of long-term
funds as well as their utilisation. It may thus be defined
as “the firm's formal process for the acquisition and
investment of capital”. It is the decision making process
by which the firms evaluate the purchase of major fixed
assets. It involves firm's decision to invest its current
funds for addition, disposition, modification and
replacement of long term or fixed assets. However, it
should be noted that investment in current assets
necessitated on account of investment in a fixed assets,
is also to be taken as a capital budgeting decision. For
example, a new distribution system may call for both a
new warehouse and an additional investment in
inventories. An investment proposal of this nature must
be taken as a capital budgeting decision and evaluated
as a single package, not as an investment in a fixed
asset (i.e. Warehouse) and in a current asset (i.e.,
inventory) separately.

Capital Budgeting is a many sided activity. It includes

searching for new and more profitable investment
proposals, investigating engineering and marketing
considerations to predict the consequences of accepting
the investment and making economic analysis to
determine the profit potential of each investment
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proposal. Its basic features can be summarised as

follows:

(i) It has the potentiality of making large anticipated

profits.
(ii) It involves a high degree of risk.
(iii) It involves a relatively long-time period between
the initial outlay and the anticipated return.

On the basis of the above discussion it can be concluded

that capital budgeting consists in planning the
development of available capital for the purpose of
maximising the long-term profitability (i.e. ROI) of the
firm.

Operating Budget and Capital Budget

Most largely firms prepare two different budgets each

year : (i) Operating Budget, and (ii) Capital Budget or
Capital Expenditure Budget. Operating Budget shows
planned operations for the forthcoming period and
includes sales, production, production cost and selling
and distribution overhead budgets. All these budgets
have already been discussed. Capital Budget deals
exclusively with major investment proposals. It assesses
the economics of capital expenditure and investment.

CAPITAL EXPENDITURE BUDGET

Capital expenditure Budget is a type of functional
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budget. It is the firm's formal plan for the expenditure

of money for purchase of fixed assets. It provides a
guidance as to the amount of capital that may be
required for procurement of capital assets during the
budget period. The budget is prepared after taking into
account the available production capacities, probable
reallocation of existing resources and possible
improvements in production techniques. If required,
separate budgets can be prepared for each item of
capital asset such as building budget, a plant and
machinery budget, etc.

Objectives of a Capital Expenditure Budget

The objectives of a capital expenditure budget are

follows:
(i) It determines the capital projects on which work
can be started during the budget period after taking
into account their urgency and the expected rate of
return on each project.
(ii) It estimates the expenditure that would have to be
incurred on capital projects approved by the
management together with the source or sources
from which the required funds would be obtained.
(iii) It restricts the capital expenditure on projects
within authorised limits.

Control over Expenditure through Capital Expenditure

Budget
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The capital expenditure budget primarily ensures that

only such projects are taken in hand which are either
expected to increase or maintain the rate of return on
capital employed. Each proposed project is appraised
and only essential project or projects likely to increase
the profitability of the organization are included in the
budget. In order to control expenditure on each project,
the following procedure is adopted:

(i) A project sheet is maintained for each project. It

contains columns for entering expenditure spent
according to different stages of development or
construction analysed under the heads : Direct
Material, Direct Labour and Overheads.
(ii) In order to ensure that the expenditure on different
projects is properly analyzed, the project number
and the project details are supplied in advance to
the concerned executives. These persons make
appropriate reference on all documents relating to
the project.
(iii) The expenditure incurred on the project is regularly
entered on the project sheets from various sources
such as invoices of assets purchased, bill for
delivery charges, etc.
(iv) The management is periodically informed about the
expenditure incurred in respect of each project
under appropriate heads.
(v) In case project cost is expected to increase, a
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supplementary sanction for the same is obtained.

(vi) In financial books the total expenditure incurred on
all the projects is separately recorded. This
expenditure recorded on the project sheets.

The above system has an important advantage. The

persons responsible for execution are constantly able to
compare the physical development of each project in
relation to the total expenditure incurred on the project.

TACTICAL VERSUS STRATEGIC

INVESTMENT DECISIONS

Investment decisions may be classified as (i) tactical

decisions and (ii) strategic decisions. A tactical decision
generally involves a relatively small amount of funds
and does not constitute a major departure from the past
practices of the company. For example, the decision of
Hindustan Motors to buy a new machine tool is a
tactical decision.

A strategic investment decision involves a large sum of

money and may also result in a major departure from
the past practices of the company. Acceptance of a
strategic investment decision involves a significant
change in the company's expected profits associated
with a high degree of risk. Such changes are likely to
result in shareholders and creditors revising their
evaluation of the company. For example, if the Indian
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Airlines running airbuses decides to go in for

supersonic aircrafts (costing billions of dollars), this
would be a strategic decision. If the Airlines falls to
develop these aircrafts, as economically feasible and
commercially viable, the very existence of the company
would be jeopardised.

IMPORTANCE OF CAPITAL BUDGETING

Capital Budgeting decisions are among the most crucial

and critical business decisions. Special care should be
taken in making these decisions on account of the
following reasons:
(i) Involvement of heavy funds: Capital budgeting
decisions require large capital outlays. It is,
therefore, absolutely necessary that the firm should
carefully plan its investment programme so that it
may get the finances at the right time and they are
put to most profitable use. An opportune
investment decisions can give spectacular results.
On the other hand, an ill-advised and incorrect
decision can jeopardise the survival of even the
biggest firm.

For example, if a company purchases a new plant

for manufacture of a new product, the company
commits itself to a sizeable amount of fixed cost in
terms of indirect labour such as supervisory staff salary
and indirect expenses such as rent, rates, insurance, etc.
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In case the product does not come out or comes out but
proves to be unprofitable, the company will have to
bear the burden of fixed-cost unless it decides to write
off the investment completely. A wrong decision,
therefore, can provide disastrous for the long-term
survival of the firm. Similarly, inadequate investment in
assets would make it difficult for the firm to run the
business in the long run just as an unwanted expansion
results in unnecessary heavy operating costs to the firm.

(iii) Irreversible decisions : In most cases, capital

budgeting decisions are irreversible. This is
because it is very difficult to find a market for the
capital assets. The only alternative will be to scrap
the capital assets so purchased or sell them at a
substantial loss in the event of the decision being
proved wrong.
(iv) Most difficult to make: The capital budgeting
decisions require an assessment of future events
which are uncertain. It is really a difficult task to
estimate the probable future events, the probable
benefits and costs accurately in quantitative terms
because of economic, political, social and
technological factors.

On account of these reasons, capital expenditure

decisions are among the class of decisions which are
best reserved for consideration by the highest level of
management. In case some parts of it are delegated, a
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system of effective control by the top management

should be evolved.

It has already been stated that the term capital

budgeting includes both planning for proposed capital
outlays and their financing. However, in this discussion
we are not discussing with the financing aspect. We are
mainly discussing with selection of a particular capital
project out of several alternative projects available.
Thus, our study is restricted of the process of deciding
whether or not to commit resources to a project whose
benefits would spread over several time period. The
objective is to correlate the benefits to costs in a manner
which is consistent with the profit maximisation
objective of the business.

RATIONALE OF CAPITAL EXPENDITURE

Efficiency is the rationale underlying all capital

decision. A firm has to continuously invest in new plant
or machinery for maintaining and improving its
efficient. The overall objective is to maximise the firm's
profits and thus optimising the return on investment.
This objective can be achieved either by increased
revenues or by cost reduction. Thus, capital expenditure
can be of two types:
(i) Expenditure increasing revenue
(ii) Expenditure reducing cost.
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Expenditure increasing revenue

Such a capital expenditure brings more revenue to the
firm either by expansion of present operations or
development of a new product line. In both cases new
fixed assets are required.

Expenditure reducing costs

Such a capital expenditure reduces the total cost and
thereby adds to the total earnings of the firm. For
example, when an assets is worn out or becomes
obsolete, the firm has to decide whether to continue
with it or replace it by a new machine. While taking
such decision the firm compares the required cash
outlay for the new machine with the benefit in the form
of reduction in operating costs as a result of
replacement of the old machine by a new one. The firm
will replace the asset only when it finds it beneficial.

There is a basic difference between capital expenditure

increasing revenue and capital expenditure reducing
cost. The former has more uncertainties attached to it as
compared to the latter. This is because in the latter case
the firm is already in the line and therefore make a
better estimate about the resultant savings. While in the
former case the product line being new, the estimates
made about revenues and costs may not be reliable.
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KINDS OF CAPITAL INVESTMENT PROPOSALS

A firm may have several investment proposals for its

consideration. It may adopt one of them, some of them
or all of them depending upon whether they are
independent, contingent or dependent or mutually
exclusively.

(i) Independent proposals

These are proposals which do not compete with one

another in a way that acceptance of one precludes the
possibility of acceptance of another. In case of such
proposals the firm may straightway “accept or reject” a
proposal on the basis of a minimum return on
investment required. All those proposals which give a
higher return than a certain desired rate of return are
accepted and the rest are rejected.

(ii) Contingent or dependent proposals

These are proposals whose acceptance depends on the

acceptance of one or more other proposals. For example
a new machine may have to be repurchased on account
of substantial expansion of plant. In this case
investment in the machine is dependent upon expansion
of plant. When a contingent investment proposal is
made, it should also contain the proposal on which it is
dependent in order to have a better perspective of the
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situation.

(iii) Mutually exclusive proposals

These are proposals which compete with each other in a

way that the acceptance of one predicts the acceptance
of other or others. For example, if a company is
considering investment in one of two temperature
control systems acceptance of one system will rule out
the acceptance of another. Thus, two or more mutually
exclusive proposals cannot both or all be accepted.
Some technique has to be used for selecting the better
or the best one. Once this is done, other alternatives
automatically get eliminated.

FACTORS AFFECTING CAPITAL INVESTMENT

DECISIONS

The following are the four important factors which are

generally taken into account while making a capital
investment decision:-

1. The amount of investment : In case a firm has

unlimited funds for investment it can accept all capital
investment proposals which gave a rate of return higher
than the minimum acceptable or cut-off rte. However,
most firms have limited funds and therefore capital
rationing has to be imposed. In such an event a firm can
take only such project or projects which are within its
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means. In order to determine which project should be

taken up on this basis, the projects should be arranged
in an ascending order according to the amount of capital
investment required as shown below:

S.No. Project Description Required

investments
1 101 Purchase of new plant 100000
2 102 Expansion of the existing plant 130000
3 103 Purchase of New sales office 150000
4 104 Introduction of a new product line 200000

In case the funds available only Rs. 1,50,000, Project

104 cannot be taken up and it should, therefore, be
rejected outright.

Computation of capital investment required

The term 'capital investment required' refers to the net
cash outflow which is the sum of all outflows and
inflows occurring at zero time period. The net outflow
is determined by taken into account the following
factors:

(i) Cost of the new project

(ii) Installation Cost
(iii) Working capital: Investment in a new project may
also result in increase or decrease of net working
capital requirements. For example, if the new
project is expected to increase sales; investment in
accounts receivables. Inventories, cash balance,
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etc., is also likely to increase. A part of this increase

in current assets may be offset by increase in
current liabilities. For the balance additional funds
will have to be arranged. This amount should
therefore be taken as a part of the initial capital.
The investment required in the form of net working
capital will be recovered at the end of the life of the
project. This amount of working capital so
recovered will become part of cash inflow in the
last year of the life of the project. However,
investment in working capital and the recovery of
working capital will not balance each other on
account of time value of money.

It may further be noted that the amount of working

capital may show a continuous increase in each of the
subsequent years on account of continuous increase in
sales. Such increase in working capital should not be
taken as a part of initial cash investment. It should
rather be taken as an outflow of cash in the year in
which additional working capital is required.

Generally all capital investments proposal for

increasing revenue require additional working capital,
while almost all capital investment proposals for
reduction in costs result in saving of working capital by
increasing the firm's operational efficiency.

(iv) Proceeds from sale of asset: A new asset may be

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purchased for replacement of an old asset. The old asset

may therefore be sold away. The cash realized on
account of such sale will reduce the cost of new
investment.

(v) Tax effects: The amount of profit or loss on the sale

of the assets may affect the cash flows on account of tax
effects. The profit / loss is ascertained by taking into
account the cost of the asset. Its book value and the
amount realized on its sale. The tax liability of the
company will be different in each of the following
cases:
(a) when the asset is sold at its book value.
(b) when the asset is sold at a price higher than its
book value but lower than its cost.
(c) When the assets is sold at a price higher than its
cost.
(d) When the asset is sold at a price lower than its book
value.

This will be clear with the help of the following

illustration:

Illustration 1: A company purchased a machinery a few

years back for Rs. 10,000. It wants to replace this
machinery by a new one costing Rs. 15,000. The
company is subject to income tax @ 50% while capital
gains tax @ 30%. The present book value of the
machinery is Rs. 6,000. Calculate the net initial cash
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outflow if the company decides to purchase the new

machine, in each of the following cases, if the old
machine is sold for:
(a) Rs. 6000; (b) Rs. 8000 (c) Rs. 12,000 (d) Rs. 4000

Solution
(a) Cash required for the purchase of the Rs. 15,000
new machine
Less: Cash realised on sale of the old
machine 6,000
Net Cash Outflow 9,000
(b) Cash required for purchase of the new Rs. 15,000
machine
Less: Cash realised on sale of the old Rs. 8,000
machine
Rs. 7,000
Add: Income tax liability on profit made
on sale of machinery (2000 x 50/1000) 1,000
Net cash Outflow 8,000
(c) Cash required for purchase of the new Rs. 15,000
machine
Less: Cash realised on sale of the old 12,000
machine
3,000
Add: Income Tax Liability (6000x50/100) 3000
Capital Gains tax liability (2000x30/100) 600
3,600
Net Cash Outflow
6,600
(b) Cash required for purchase of the new Rs. 15,000
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machine
Less: Cash realised on sale of the old 4,000
machine 11,000

Add: Saving in tax liability on account of

loss on the sale of the old machine 1,000
(2000x50/100) *
Net Cash Outflow 10,000
* The loss can neither be adjusted against current
operational profits or be carried forward for 8 years,
under existing rules, for setting off against future
profits.

Note: It may be noted that the method of computing

depreciation under the Companies Act is different from
that under the Income tax Act. As per Section 350 of the
Companies Act, 1956, loss or profit on sale of
individual asset is to be taken to Profit and Loss
Account as a balancing charge. However, as per the
current income tax provisions, the profit and loss on
individual item of a fixed asset is not to be taken to
P&L Account. Depreciation is to be charged on a block
of assets account or accounting to Group Depreciation
Method. The total amount realized on sale of an
individual asset comprising a block, is to be credited to
the “block of assets account” and thus reducing the
written down value of the block of assets. Hence, there
can be a profit and loss only when the whole block of
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assets is sold or where the block of assets comprises

only of one individual assets which has been sold away.

The profit or loss computed in Illustration 1, as above

for “tax effect” has been computed on the presumption
that the sale is of entire block of assets comprising one
or more than on assets(s).

(vi) Investment allowance : This is allowed to

encourage capital investment in machinery and
equipment. In India this allowance was allowed at 20%
of the cost of new machinery and equipment for
calculating income tax liability for the year in which
such asset was put into service. Such allowance thus
reduces the cost of the initial investment on the project.

Thus, the net cash outflow on account of capital

investment proposal can be ascertained as shown
below:

Original Cost of the Asset Xxx

Add: Installation cost Xxx
Increase in working capital requirements xxx Xxx
Increase in Tax Liability xxx xxx
Less: Decrease in working capital requirements Xxx
Decrease in tax liability xxx
Investment allowance (if any) xxx Xxx
Net cash outflow xxx
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Illustration 2: A company intends to replace an old

machine with a new machine. From the following
information you are required to determine the net cash
required for such replacement:
Cost of the old machine Rs.50,000
Life of the old machine 5 years
Depreciation according to straight-line method
Remaining useful life 2 years
Cost of new machine 70,000
Installation charges 10,000
Amount realized on sale of old machine 25,000
Additional working capital required 5,000
Income-tax 50%
Capital gains tax 30%
Investment allowance 20%

Solution
ESTIMATION OF CASH REQUIREMENT FOR
REPLACEMENT
Cost of the new machine Rs.70000
Add: Installation charges 10,000
Additional working capital required 5,000
Additional tax liability ;
Income tax 5,000x50/1 00 2,500
Capital gains tax
87,500
Less: Amount realized on sale of old machine 25,000
Investment allowance [70,000 x 20/100] 14,000 39,000
Net Cash outflow 48,500

2. Minimum rate of return on investment: The

management expects a minimum rate of return on the
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capital investment. The minimum rate of return is

usually decided on the basis of the cost of capital. For
example, if the cost of capital is 10%, the management
will not like to accept a proposal which yields a rate of
return less than 10%. The project giving a yield below
the desired rate of return will, therefore, be rejected.

Cut-off point
The cut off point refers to the point below which a
project would not be accepted. For example, if 10% is
the desired rate of return, the cut-off rate is 10%. The
cut-off point may also be in terms of period. For
example, if the management desires that the investment
in the project should be recouped in three years, the
period of three years would be taken as the cut-off
period. A project, incapable of generating necessary
cash to pay for the initial investment in the project
within three years, will not be accepted.

3. Return expected from the investment: Capital

investment decisions are made in anticipation of
increased return in the future. It is therefore very
necessary to estimate the future return or benefits
accruing from the investment proposals. There are two
criteria available for quantifying benefits from capital
investment decisions. They are (i) accounting profit and
(ii) cash flows. The term accounting profit is identical
with income concept used in accounting. While in
estimating cash flows, depreciation charges and other
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amortization charges of fixed assets are not subtracted

from gross revenue, because no cash expenditure is
involved. The difference between the two will be clear
with the following example.

Benefit as per Benefit as per

Accounting Cash flow
approach approach
Sales (i) Rs. 10,000 Rs. 10,000
Less: Cost of Sales (ii):
Direct Material 3,000 3,000
Direct Labour 2,000 2,000
Depreciation 1,000 -
Indirect expenses 1,000 1,000
(ii) 7,000 6,000
Net Income/Cash Flow before tax (i)- 3,000 4,000
(ii)
Tax (say at 50% of Net Income of 1,500 1,500
Rs. 3,000)
Net Income/Cash after Tax 1,500 2,500

The above example shows that the amount of cash flow

is Rs. 1,000 more than the amount of accounting profit.
The accounting approach shows that only Rs. 1,500
is available after meeting expenses while the cash
flow approach shows that Rs.2,500 is available for
investment.

The cash flow approach for determination of benefit

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from a capital investment project is better as compared

to accounting profit approach on account of the
following reasons:

(i) Determination of economic value

While making capital budgeting decisions, a firm is

interested in determining the economic value of the
project which can only be determined by comparing the
cash inflows (benefit) with the cash outflows associated
with the project. The firm can by comparing them find
out for itself whether the future economic inflows are
sufficiently large to warrant the initial investment. The
accounting profit approach allocates the cost of
investment over the economic useful life of the asset in
the form of depreciation rather than at the time when
the cost is actually incurred. It, therefore, falls to reflect
the original need for cash at the time of investment. It
also does not bring out clearly the actual size of cash
inflows and outflows in later years. On account of these
reasons cash flow approach is more appropriate for
capital budgeting decisions.

(ii) Accounting ambiguities

Accounting profit approach is full of ambiguities on
account of different accounting policies and practices,
regarding valuation of inventory, allocation of costs,
calculation of depreciation, amortization of various
other expenses. The amount of profit may therefore
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vary according to accounting policies and practices

adopted while preparing the accounts. However, there
will be only one set of cash flows associated with a
project. Obviously, therefore, the cash flow approach is
superior to the accounting profit approach.

(iii) Time value of money

Under usual accounting practices revenue is considered
to be realized not at the time when the cash is received
but at the time the sale is made. It means the amount of
profit shown by the books may be simply a paper figure
if the sales are not realized. Similarly, expenditure is
recognized as being made not when the payment is
made out but at the time it is incurred. Thus, the time
taken in realizing or making payments is completely
ignored. The cash flow approach recognizes the time
value of money by comparing actual cash inflow:; and
cash outflows. Moreover, in order to have a better
picture even the future cash inflows arc discounted and
their present worth is found out.

On account of the above reasons, accounting profit

approach, though quite useful in measuring
performance of an enterprise, is less useful as a tool for
managerial decisions.

Conventional and non-conventional cash flows: In case

of conventional cash flows, an initial cash outflows is
followed by a series of cash inflows whether of uniform
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or of different amounts. Most of the capital budgeting

decisions follow this pattern. For example, a firm may
spend Rs.5,000 on capital asset in zero time period and
may receive Rs, 1,000 each year for 8 years.

In case of unconventional cash Hows, initial cash

outflow is not followed by a series of cash outflows
followed by a series of cash inflows. For example, a
firm may purchase a plant for a sum of Rs. 10,000. This
cash outflow may be followed by cash inflows of
Rs.3,000 each year for 5 years. However, after 5 years
the asset may need overhauling resulting in a cash
outflow of Rs.3,000. This may give a new lease of life
to the asset and it may be followed by a series of cash
inflows. This practice may continue in future years also.

4. Ranking of the investment proposals: When a

number of projects appear to be acceptable on the basis
of their profitability the projects will be ranked in order
of their profitability in order to determine the most
profitable project. Ranking of capital investment
proposals is particularly necessary in the following two
circumstances;

(a) Where capital is rationed, i.e., there is a limit on

funds available for investment.
(b) Where two or more investment opportunities are
mutually exclusive, i.e., only one of the opportunities
can be undertaken.
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Thus, the objective of ranking is to puf the capital

available to the best possible use. This will be clear
from the following illustration.

Illustration 3: A Ltd. is considering the following five

projects for capital expenditure. The company can spare
a sum of Rs. 1,50,000 and expect a minimum return of
15% before tax on the investment. The details of the
projects are as under:

Projects Capital Estimated Percentage

Expenditure Savings return on
(Before tax) investment
(i) (ii) (iii) (iv)
A Rs. 50,000 Rs. 5,000 20
B 75,000 9,000 24
C 1,00,000 8,000 16
D 1,25,000 25,000 40
E 1,50,000 28,000 37
Tax rate may be taken as 50%

Solution

On the basis of information given, project D seems to

be the most profitable, since it is giving the highest
 25

percentage return on investment. However, in case this

project is taken up Rs.25,000 will be the surplus amount
available with the company for alternative investment.
In case project E is taken up, the full amount of Rs.
1,50,000 would be used up. The difference between the
additional investment required and Rs.25,000 and
additional income is Rs. Rs 3,000 respectively over D
giving a return rise of 12% on the balance of Rs. 25,000
over D. In case such an opportunity is not available, the
company should take up project E.

5. Risk and uncertainty: Different capital investment

proposals have different degrees of risk and uncertainty.
There is a slight difference between risk and
uncertainty. Risk involves situations which the
probabilities of a particular event incurring are known
whereas in uncertainty, these probabilities are not
known. Of course in most oases these two terms are
used interchangeably. Risk in capital investment
decisions may be due to general economic conditions,
competition, technological developments, consumer
preferences, labour condition etc. On account of these
reasons the revenues, costs and economic life of a
particular investment are not certain. While evaluating
capital investment proposals, a proper adjustment
should therefore be made for risk and uncertainty.

Besides the above factors, various other non-monetary

considerations should also be weighed before taking a
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capital investment decision. For example, if a new

product is to be introduced in the market, its effect on
the state of existing product must also be seen.
Sometimes a heavy investment completely changes the
character of the firm. It may be felt by the investors that
the company has entirely changed its line of
manufacture and it may adversely affect the image of
the company. This may result in fall in the value of the
company's shares in the stock exchange. In other words,
all possible consequences must be seen and in no case
the image of the company should be allowed to be
lowered down.

CAPITAL BUDGETING APPRAISAL METHODS

In view of the significance of capital budgeting

decisions, it is absolutely necessary but that the method
adopted for appraisal of capital investment proposals is
a sound one. Any appraisal method should provide for
the following:

(i) a basis of distinguishing between acceptable and

non-acceptable projects;
(ii) ranking of projects in order of their desirability;
(iii) choosing among several alternatives;
(iv) a criterion which is applicable to any
conceivable project;
(v) recognizing the fact that bigger benefits are
preferable to smaller ones and early benefits are
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preferable to later ones.

There are several methods for evaluating and ranking

the capital investment proposals. In case of all these
methods the main emphasis is no the return which will
be derived on the capital invested in the project. In
other, words, the basic approach is to compare the
investment in the project with the benefits derived
therefrom.

Following are the main methods generally used:

1. Pay-back Period Method.
2. Discounted Cash Flow Method.
(a) The Net Present Value Method.
(b) Present Value Index Method.
3. Accounting Rate of Return Method.

Each of the above methods have been explained in

detail in the following pages.

Pay-back period method

The term pay-back (or pay-out or pay-off) refers to the

period in which the project will generate the necessary
cash to recoup the initial investment. For example, if a
project requires Rs.20,000 as initial investment and it
will generate an annual cash inflow of Rs.5,000 for ten
years, the pay-back period will be 4 years, calculated as
follows;
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Initial Investment
Pay-back period = Annual Cash Inflow
Rs.20,000
= Rs. 5,000

The annual cash inflow is calculated by taking into

account the amount of net income on account of the
asset (or project) before depreciation but after taxation.
The income so earned, if expressed as a percentage of
initial investment, is termed as "unadjusted rate of
return". In the above case, it will be calculated as
follows:

Annual Return X 100

Unadjusted rate of return = Initial Investment

= Rs.5,000 X 100
Rs.20,000 = 25%

Uneven cash inflows

In the above example, we have presumed that the
annual cash inflows are uniform. However, it may not
always be so. The cash flow each year may be different.
In such a case cumulative cash' inflows will be
calculated and by interpolation, the exact pay-back
period can be calculated. For example, if the project
requires an initial investment of Rs.20,000 and the
 29

annual cash inflows for 5 years are Rs.6,000, Rs.8,000,

Rs.5,000, Rs.4,000 and Rs.4,000 respectively, the pay-
back period will be calculated as follows:

Year Cash Inflows Cumulative Cash

Inflows
1 Rs. 6,000 Rs. 6,000
2 8,000 14,000
3 5,000 19,000
4 4,000 23,000
5 4,000 27,000
The above table shows that in three years Rs. 19,000
has been recovered. Rs. 1,000 is left out of initial
investment. In the fourth year the cash inflow is
Rs.4,000. It means the pay-back period is between three
to four years, ascertained as follows:
1,000
Pay-back period = 3 years + 4,000
= 3.25 years

Accept or reject criterion

The pay-back period can be used as a criterion to accept

or reject an investment proposal. A project whose actual
pay-back period is more than what has been pre-
determined by the management will be straightway
rejected, The fixation of the maximum acceptable pay-
 30

back period is generally done by taking into account the

reciprocal of the cost of capital. For example, if the cost
of capital is 20% the maximum acceptable pay-back
period would be fixed at 5 yeas. This can also be termed
as cut-off point. Usually projects having a pay-back
period of more than 5 years are not entertained because
of greater uncertainties.

The pay-back period can also be used as a method of

ranking in case of mutually exclusive projects. The
projects can be arranged in an ascending order
according to the length of their pay-back periods. The
project having the shortest pay-back period or highest
unadjusted rate of return will be preferred provided it
meets the minimum standard that has been established.
For example, if the pay-back period has been fixed as 4
years, and project A has a pay-back period of 3 years
and project B has a pay-back period of 4 years, project
A would be preferred.

Illustration 4: Payoff Ltd. is producing articles

mostly by manual labour and is considering to replace it
by a new machine. There are two alternative models M
and N of new machine. Prepare a statement of
profitability showing the pay-back period from the
following information:
 31

Machine M Machine N
Estimated life of machine 4 years 5 years
Cost of machine Rs.9,000 Rs. 1 8,000
Estimated saving in scrap 500 800
Estimated savings in direct wages 6,000 8,000
Additional cost of maintenance 800 1,000
Additional cost of supervision 1,200 1,800
Ignore taxation

Solution:
STATEMENT SHOWING ANNUAL CASH
INFLOWS
Machine M Machine N
Estimated saving in scrap Rs. 500 Rs. 800
Estimated savings in direct wages 6,000 8,000
Total Savings (i) 6,500 8,800
Additional cost of maintenance 800 1,000
Additional cost of supervision 1,200 1,800
Total Additional costs (ii) 2,000 2,800
Net Cash Inflow (i) - (ii) 4.500 6,000
Pay-back period =
Original Investment
Annual Average Cash Inflow Machine M
9,000
= 4,500
= 2 years

Machine M has a shorter pay-hack, hence it should be

preferred to Machine N.
 32

Illustration 5:

An Engineering company is considering the purchase of

a new machine for its immediate expansion programme.
There are three possible machines suitable for the
purpose. Their details are as follows:

Machine
1 2 3
(Rs.) (Rs.) (Rs.)
Capital Cost 3,00,000 3,00,000 3,00,000
Sales (at standard prices) 5,00,000 4,00,000 4,50,000
Net Cost of Production:
Direct Material 40,000 50,000 48,000
Direct Labour 50,000 30,000 36,000
Factory Overheads 60,000 50,000 58,000
Administrative Costs 20,000 10,000 15,000
Selling and Distribution 10,000 10,000 10,000
Costs

The economic life of machine No. l is 2 years, while it

is 3 years for the other two. The scrap values are
Rs.40,000, Rs.25,000 and Rs. 30,000 respectively.

Sales are expected to be at the rates shown for each year

during the full economic life of the machines. The costs
relate to annual expenditure resulting from each
machine.
 33

Tax to be paid is expected at 50% of the net earnings of

each year. It may be assumed that all payable and
receivables will be settled promptly, strictly on cash
basis with no outstanding from one accounting year to
another, Interest on capital has to be paid at 8% per
annum.

You are requested to show which machine would be the

most profitable investment on the principle of "pay-
back method".

Solution

STATEMENT SHOWING THE NET CASH FLOW

OF THREE MACHINES

Machine
1 2 3
(Rs.) (Rs.) (Rs.)
Capital Cost 3,00,000 3,00,000 3,00,000
Sales (i) 5,00,000 4,00,000 4,50,000
Cost of Production 1,50,000 1,30,000 1,42,000
Administrative Costs 20,000 10,000 15,000
Selling and Distribution 10,000 10,000 10,000
Costs
Total Cost (ii) 1,80,000 1,50,000 1,67,000
 34

Profit before depreciation and 3,20,000 2,50,000 2,83,000

interest (i)-(ii)=(iii)
Cost less scrap value 1,30,000 91,667 90,000
Economic life
Interest on Borrowings 24,000 24,000 24,000
Depreciation and Interest (iv) 1,54,000 1,15,667 1,14,000
Profit before tax (iii)-(iv) 1,66,000 1,34,333 1,69,000
Taxation (50%) 83,000 67,167 84,500
Add: Depreciation 1,30,000 91,667 90,000
Net Cash Inflow 2,13,000 1,58,833 1,74,000
Pay-back period 1.41 1.89 1.72
years years years
Machine No,. 1 is most profitable.

Notes:
(i) It has been presumed that interest on borrowings
will have to be paid throughout the economic life of the
assets.
(ii) Factory overheads do not include depreciation.
(iii) No borrowings will be required for working capital.

Merits
The pay-back method has the following merits:
1. The method is very useful in evaluation of those
projects which involve high uncertainty. Political
instability, rapid technological development of
cheap substitutes, etc., are some of the reasons
 35

which discourage one to take up projects having

long gestation period. Pay-back method is useful in
such cases.
2. The method makes it clear that no profit arises till
the pay-back period is over. This helps new
companies in deciding when they should start
paying dividends.
3. The method is simple to understand and easy to
work out.
4. The method reduces the possibility of loss on
account of obsolescence a the method prefers
investment in short-term projects.

Demerits

The method has the following demerits:

1. The method ignores the returns generated by a
project after its pay-back period, projects having long
gestation period will never be taken up if this method is
followed though they may yield high returns for a long
period. Consider the following example.
 36

Example:
Initial Investment Project A Project B
Cash Inflows; Rs. 1 0,000 Rs. 10,000
Year 1
2 4,000 3,000
3 4,000 3,000
4 2,000 3,000
5 ------ 3,000
Pay-back period 3yrs. 3.33 yrs.
In the above ease Project A has a shorter payback period
and therefore it should be preferred over B. But his may
not be rational decision since project B continues to
give return after the pay-back period which fact has
been completely ignored. As a matter of fact, on the
whole Project B is more profitable as compared to
Project A.

2. The method does not take into account the time

value of money. In other words, it ignores the interest
which is an important factor in making sound
investment decisions. A rupee tomorrow is worth less
than a rupee today. The following example makes this
point clear:

Example: There are two projects A and B. The cost

of the project is Rs.30,000 in each case. The cash
 37

inflows are as under:

Cash Inflows
Year Project 'A' Project 'B'
1 Rs. 10,000 Rs. 2,000
2 10,000 4,000
3 10,000 24,000
The pay-back period is 3 years in both the cases.
However, project 'A' should be preferred as compared to
project CB' because of speedy recovery of the initial
investment.

Suitability
In spite the above limitations, ,the pay-back method can
profitability be used in each of the following cases:

(i) Hazy long-term outlook: Where an account of

political or other conditions, long-term outlook
(say, exceeding three years) seems to be quite hazy,
pay-back method is appropriate.
(ii) Firms suffering from liquidity crisis: A firm which
suffers from liquidity crisis is more interested in
quick return of funds rather than profitability. Pay-
back method suits them most because it also
Emphasizes on quick recovery of funds.
(iii) Firms emphasizing short-term earning
performance. Pay back method is also suitable for a
firm which emphasizes on short-term earning
 38

performance of the firm rather its long-term

growth.

It may, therefore, be said that pay-back period is a

measure of liquidity of investment rather than their
probability. It should more appropriate of be treated as a
constraint to be satisfied than as a profitability measure
to be maximised.

Discount Pay-Back Period method: The method

discussed above is Traditional Pay-Back Period
Method. However in order to overcome the criticism
that this method does take into account the time value
of money, the discounted pay-back period method is
recommended. In case of this method, the present value
of cash inflows arising at different time intervals at the
desired rate of interest (depending upon the cost of
capital) are found out. The present values so calculated
are not taken as the real cash inflows for determination
of the pay-back period, This technique can better be
understood by the students after studying NPV Method
discussed later.

2. Discounted Cash Flow (DCF) Method or Time

Adjusted Technique
The discounted cash flow technique is an improvement
on the pay-back period method. It takes into account
both the interest factor as well as the return after the
pay-back period, the method involves three stages:
 39

(i) Calculation of cash flows, i.e., both inflows and

outflows (preferably after tax) over the full life of
the assets,
(ii) Discounting the cash flows so calculated by a
discount factor,
(iii) Aggregating of discounted cash inflows and
collaring the total with the discounted cash
outflows.
(iv) Aggregating of discounted cash inflows and
comparing the total with the discounted cash
outflows.

Discounted cash flow technique thus recognizes that

Re. 4 of today (the cash outflow) is worth more than
Re. 1 received at a future date (cash inflow).

Discounted cash flow methods for evaluation capital

investment proposals are of three types as explained
below:
(a) The Net Present Value (NPV) Method
This is generally considered to be the best method for
evaluating the capital investment proposals. In case of
this method cash inflows and cash outflows associated
with each project are first worked out. The present
value of these cash inflows and outflows is then
calculated at the rate of return acceptable to the
management. This rate of return is considered as the
 40

cut-off rate and is generally determined on the basis of

cost of capital suitably adjusted to allow for the risk
element involved in the project. Cash outflows
represent the investment and commitments of cash in
the project at various points of time. The working
capital is taken as a cash outflow in the year the project
starts commercial production. Profit after tax but before
depreciation represents cash inflows. The Net Present
Value (NPV) is the difference between the total present
value of future cash inflows and the total present value
of future cash outflows.

The equation for calculating NPV in case of

conventional cash flows can be put as follows:

In case of non-conventional cash inflows (i.e. where

there are a series of cash inflows as well cash outflows)
the equation for calculating NPV is as follows:
 41

Where: NPV = Net Present Value, R = Cash Inflows at

different time periods. K = Cost of Capital or Cut-off
Rate, I = Cash Outflows at different time periods.

Accept or reject criterion

The Net Present Value can be used as an 'accept or

reject' criterion, In cash the NPV is positive (i.e. present
value of cash inflows is more than present value of cash
outflows) the project should be accepted. However, if
the NPV is negative (i.e., present value of cash inflows
is less than the present value of cash outflows) the
project should be rejected. Symbolically, the
accept/reject criterion can be put as follows:

NPV > Zero accept the proposal

NPV < Zero reject the proposal
Or where PV > C accept the proposal
PV < C reject the proposal

PV stands for Present Value of Cash Inflows and C for

Present Value of Cash Outflows (or outlays).

Illustration 6: Calculate the net present value for a

small sized project requiring an' initial investment of
Rs.20,000, and which provides a net cash inflow of
Rs.6,000 each year for six years. Assume the cost of
funds to be 8% p.a. and that there is no scrap value.
 42

Solution: The present value of an annuity of Re. 1 for 6

years at 8% p.a. interest is Rs. 4,623
Hence, the present value of Rs. 6.000 comes to:
6,000 x 4.623 = Rs. 27.738
Less: Initial Investment Rs. 20,000
Net Present Value (NPV) Rs. 7,738

Illustration 7: The Alpha Co. Ltd. is considering the

purchase of a new machine. Two alternative machines
[A and B] have been suggested, each having an initial
cost of Rs.4,00,000 and requiring Rs.20,000 as
additional working capital at the end of the 1st year.
Earnings after taxation are expected to be as follows:
Cash Inflows
Year Machine A Machine B
1 Rs. 40,000 Rs. 1,20,000
2 1,20,000 1,60,000
3 1,60,000 2,00,000
4 2,40,000 1,20,000
5 1,60,000 80,000
The company has target of return on capital of 10% and
on this basis, you are required to compare the
profitability of the machine and state which alternative
you consider financially preferable.

Note: the following table gives the present value of

Re.l due in 'n' number of years:
 43

Year Present Value at 10%

1 0.91
2 0.83
3 0.75
4 0.68
5 0.62

Solution
The Alpha Company
STATEMENT SHOWING THE PROFITABILITY OF
THE TWO MACHINES
Year Discount Machine A Machine B
Factor
Cash Present Cash Present
Inflow Value Rs. Inflow Value Rs.
Rs. Rs.
1 0.91 40,000 36,400 1,20,000 1,09,200
2 0.83 1,20,000 99,600 1,60,000 1,32,800
3 0.75 1,60,000 1,20,000 2,00,000 1,50,000
4 0.68 2,40,000 1,63,200 1,20,000 81,600
5 0.62 1,60,000 99,200 80,000 49,600
Total Present Value 5,18,400 5,23,200
of Cash Inflows
Total Present Value
of Cash Outflows
(Rs. 4,00,000 +
20,000 x 0.91) 4,18,200 4,18,200
Net Present Value 1,00,200 1,05,000
 44

Recommendations: Machine B is preferable to

Machine A. Though total cash inflow of Machine A is
more than that of Machine B by Rs.40,G00, the net
present value of the cash inflows of Machine B is more
that of Machine A. Moreover, in case of Machine B
cash inflow in the earlier years is comparatively higher
than that in case of Machine A.

It is to be noted that the present value method (on the

basis of discounted cash inflows) assumes that the
available funds would immediately be reinvested at the
chosen rate of interest. 10% in the above case. If this
assumption is not valid, the decision should be on the
basis of gross cash inflows and not according to
discounted cash inflows. In that case Machine A would
be preferable to Machine B.

Another assumption while deciding in favour of

Machine B is that, in both cases, one is equally sure that
these cash inflows will arise. In other words, the
probability of cash inflows as given in die question for
both the machines is the same. In case one is not sure
about the cash inflows one should have adjusted the
discounted cash inflows of the machine's with the
probability factor and then only a proper comparison
would be possible.
 45

Illustration 8: A choice is to be made between two

competing projects which require an equal investment
of Rs.50,000 and are expected to generate net cash
flows as under;
Project 1 Project 2
End of year 1 Rs. 25,000 Rs. 10,000
End of year 2 15,000 12,000
End of year 3 10,000 18,000
End of year 4 Nil 25,000
End of year 5 12,000 8,000
End of year 6 6,000 4,000

The cost of capital of the company is 10 percent. The

following are the Present Value Factors @ 10% per
annum;
Year P. V. Factors @ 10% p.a.
1 0.909
2 0.826
3 0.751
4 0,683
5 0,621
6 0.564
Which project proposal should be chosen and why?
Evaluate the project proposals under:
 46

(a) Pay-back Period, and

(b) Discounted Cash Flow methods, pointing out their
relative merits and demerits.

Solution
PAY-BACK PERIOD METHOD
Project I Project II
Cash Cum. Cash Cum. Cash-
inflows Cash- inflows inflows
inflows
End of year 1 Rs. 25,000 Rs. 25,000 Rs. 10,000 Rs. 10,000
End of year 2 15,000 40,000 12,000 22,000
End of year 3 10,000 50,000 18,000 40,000
End of year 4 Nil 50,000 25,000 65,000
End of year 5 12,000 62,000 8,000 73,000
End of year 6 6,000 68,000 4,000 77,000

Project I has the pay-back period of 3 years while

project II has a pay-back period of 3-4 years [i.e.
Rs.40,000 in 3 years and Rs. 10,000 in the 4th year].
Thus, Project I has to be preferred because it has a
shorter pay-back period.
 47

Project I Cash Inflow Discount Present Value

Year Factor at 10%
p.a.
1 Rs. 25,000 .909 Rs. 22,725
2 15,000 .826 12,390
3 10,000 .751 7,510
4 Nil .683 --
5 12,000 .621 7,452
6 6,000 .564 3,384
Total Present value of Future 53,461
cash inflow
Initial Investment 50,000
Net Present value 3,461

Project II Cash Inflow Discount Present Value

Year Factor at 10%
p.a.
1 10,000 .909 9,090
2 12,000 .826 9,912
3 18,000 .751 13,518
4 25,000 .683 17,075
5 8,000 .621 4,968
6 4,000 .564 2,256
Total Present value of Future 56,819
cash inflow
Initial Investment 50,000
Net Present value 6,819
 48

Both projects need the same investment of Rs,50,000.

However, in case of Project I, there is a surplus of
Rs,3,461, while in case of Project II, there is a surplus
of Rs.6,819. Hence Project II is to be preferred.

Relative merits and demerits of the two methods:

Pay-back period method is relatively simple to

understand and may easy to work out as compared to
the discounted cash flow method. However, it does not
take into account the return after the pay-back period.
Moreover, pay-back period ignores the time value of
money, Discounted cash flow method does not have
these disadvantages. It takes into account the returns
over the effective life of the asset besides considering
the future cash inflows. The method is, therefore, more
scientific and dependable.

Illustration 9: Home Gadgets Company is considering

building an assembly plan. The decision has been
narrowed down to two possibilities. The company
desires to choose the best plant at a level of operation of
10,000 gadgets a month. Both plants have an expected
life of 10 years and are expected not to have any
salvage value at the time of their retirement. The cost of
capital is 10 per cent. Assuming a zero income-tax rate,
suggest what would be the desirable choice?
 49

Cost of 10,000 gadgets per Month Output Level

Large Plant Small Plant
(Rs.) (Rs.)
Initial Cost 30,00,000 p.a. 22,93,500 p.a.
Direct Labour: First Shift 15,00,000 p.a. 7,80,000 p.a.
Second Shift --- p.a. 9,00,000 p.a.
Overheads 2,40,000 p.a. 2,10,000 p.a.

The Present Value of an ordinary annuity of Re. 1, for

10 years at 10 per cent, is 6.1446.

Solution
SAVING PER ANNUM OF INSTALLING LARGE
PLANT
Saving in Direct labour (both shifts) Rs. 1,80,000
Savings in Overhead costs (-) 30,000
Savings per annum of using large plant 1,50,000
Present value of recurring annual savings of
Rs. 1,50,000 per year, at 10 per cent
opportunity rate = 1,50,000 x 6,1446 Rs. 9,21,690
Cost of Large Plant Rs. 30,00,000
Cost of Small Plant Rs. 22,93,500
Additional outlay for large plant Rs. 7,06,500

The present value of savings, Rs.9,21,690 resulting

from the use of the large plant is substantially higher
than the extra capital initial outlay of Rs.7,06,500
required for its. Therefore, it is advisable to go in for the
large plant.
 50

(b) Excess Present Value Index

This is a refinement of the net present value method.
Instead of working out the net present value, a present
value index is found out by comparing the total of
present value of future-cash inflows and the total of the
present value of future cash outflows. This can be put in
the form of the following formula;

Excess Present Value Index

[Or Benefits Cost (B/C) Ratio]
Present value of future cash inflows x 100
= Present value of future cash outflows

Excess Present Value provides ready comparison

between investment proposals of different magnitudes.
For example, Project 'A' requiring an investment of Rs.
1,00,000 shows excess present value of Rs.20,000 while
another project 'B' requiring an investment of Rs.
10,000 shown an excess on present value of Rs. 5,000.
If absolute figures of net present values are computed,
Project 'A' may seem to be profitable.

However, if excess present value index method is

followed Project 4B' would prove to be profitable.

1,20,000 X100
Present Value Index for Project A =1,00,000
= 120%
 51

15,000 X 100
Present Value Index for Project B =10,000

Illustration 10: On the basis of figures given in the

illustration 8, state which project is profitable according
to the Present Value Index Method.

Solution

Present Value Index =

Present value of future cash inflows x 100

Present value of future cash outflows

53,461 X 100
Project I = 50,000 = 107% (approx.)
56,819 X 100
Project II = 50,000 = 114% (approx.)

Since, Project II has a higher Present Value Index hence

it is more profitable as compared to Project I.

Illustration 11: S Ltd. has Rs, 10,00,000 allocated for

capital budgeting purposes. The following proposals
and associated profitability indices have been
determined:
 52

Project Amount Rs. Profitability Index

1 3,00,000 1.22
2 1,50,000 0.95
3 3,50,000 1.20
4 4,50,000 1.18
5 2,00,000 1.20
6 4,00,000 1.05
Which of the above investments should be undertaken?
Assume that projects are indivisible and there is no
alternative use of the money allocated for capital
budgeting.

Solution
STATEMENT RANKING OF PROJECTS ON THE
BASIS OF PROFITABILITY INDEX
Project Amount Rs. Profitability Rank
Index
1 3,00,000 1.22 1
2 1,50,000 0.95 5
3 3,50,000 1,20 2
4 4,50,000 1.18 3
5 2,00,000 1.20 2
6 4,00,000 1.05 4
Since projects are indivisible and there is no alternative
 53

use of the money allocated for capital budgeting on the

basis of P.I., hence S Ltd. is advised to undertake
investment in projects 1,3 and 5.

However, in case of alternative projects, the allocation

should be made to the project which adds the most to
the shareholders' wealth. The NPV method in such a
case will give the best results.

Project Amount Profitability Cash Inflows of N.P.V. of

Rs. Index Projects Rs. Project Rs.
(i) (ii) (iii) (iv) = [(ii) x (iii)] (v)-[(iv)-(ii)]
1 3,00,000 1.22 3,66,000 66,000
2 1,50,000 0.95 1,42,500 (-) 7,500
3 3,50,000 1.20 4,20,000 70,000
4 4,50,000 1.18 5,31,000 81,000
5 2,00,000 1.20 2,40,000 40,000
6 4,00,000 1.05 4,20,000 20,000

The above table shows that allocation of funds to the

projects 1, 3 and 5 (as selected according to P.I.) will
give NPV of Rs. 1,76,000 and Rs. 1150,000 will remain
unspent.

However, the NPV of the project 3,4 and 5 is Rs.

1,91,000 which is more than the NPV of projects 1,3
and 5. Moreover, by undertaking projects 3, 4 and 5 no
money will remain unspent. Hence S Ltd. is advised to
undertake investments in project 3, 4 and 5.
 54

(c) Internal Rate of Return

Internal Rate of Return is that rate at which the sum of
discounted cash inflows equals the sum of discounted
cash outflows. In other words, it is the rate which
discounts the cash flows to zero. It can be stated in the
form of a ratio as follows:

Cash Inflows
Cash Outflows =1

Thus, in case of this method the discount rate is not

known but the cash outflows and cash inflows are
known. For example, if a sum or Rs.800 invested in a
project becomes Rs. 1,000 at the end of a year, the rate
of return comes to 25%, calculated as follows:
R
I = I+r

Where
I = Cash Outflow i.e., initial investment
R = Cash Inflow
r = Rate of return yielded by the Investment (or IRR)

Thus:
800=l,000/l+r
or 800 r +800 =1,000
or 800 r = 200
or r = 200/800 = .25 or 25%
 55

In case of return is over a number of years, the

calculation would take the following pattern in case of
conventional cash flows:

In case of return is over a number of years, the equation

would be as follows:

where
I = Cash Outflow (or outflow) at different time
periods.
R = Cash Inflows at different time periods.
r = Rate of return yielded by the Investment (or
IRR).

Since I and R are known factors, r is the only factor to

the calculated. However, calculations will become very
difficult over a long period if worked out according to
the above equations. Tabular values are therefore, used.
 56

Accept/Reject criterion

Internal Rate of return is the maximum rate of interest

which an organisation can afford to pay on the capital
invested in a project. A project would qualify to be
accepted if IRR exceeds the cut-off rate. While
evaluating two or more projects, a project giving higher
internal rate of return would be preferred. This is
because the higher the rate of return, the more profitable
is the investment.

(l) Where cash inflows are uniform: In the case of those

projects which result in uniform cash inflows, the
internal rate of return can be calculated by locating the
Factor in Annuity Table II. The factor is calculated as
follows:
I
F = C
where
F = Factor to be located
I = Original Investment
C = Cash Inflow per year

Illustration 12: An equipment requires an initial

investment of Rs. 6,000. The annual gash flow is
estimated at Rs.2,000 for 5 years.

Calculate the internal rate or return.

 57

Solution
The annual cash flow is uniform at Rs.2,000 for five
years. Hence, the 'Factor' or the 'Pay-back' is 3,
calculated as follows:

I
F = C
where
F = Factor to be located
I = Initial Investment
C = Cash Inflow per year

6,000
F =Rs. 2,000 =3

The discount percentage would be somewhere between

18% [Rs.3.127 present value of annuity of Re.l) and
20% (Rs. 2.99 present value of annuity of Re.l). It
indicates that the internal rate of return is more than
18% but less than 20%. A more exact interpolation can
be done (as explained in the next illustration).

However, such an effort may not be very useful in the

present case since Rs.2.99 is very near to 3 and hence
the internal rate of returns can be taken as 20%.

Rs.2.99 is as a matter of fact the present value of Re. l

received annuity for five years at 20% interest rate. In
case this amount is multiplied by the annual cash
 58

inflows it will be equal to the initial investment as

shown below:

Rs. 2,000 x 2.99 = Rs.5,980 (or say Rs.6,000)

Relationship between pay-back reciprocal and rate

of return

Pay-back reciprocal is exactly equal to the unadjusted

rate of return, Unadjusted rate means a rate which has
not been adjusted by taking into account the time value
of money. For example, in the illustration given above
the pay-back period comes to 3 years. Its reciprocal is
1/3 or .33 or 33%. The annual return is Rs.2,000 on an
investment of Rs.6,000. It also comes to 33%.

Pay-back reciprocal also gives a reasonable

approximation of the time adjusted rate of return as is
proved by the above illustration. Of course, for
calculating the discounted rate. However, there are two
assumptions to the use of pay-back reciprocal:
(i) The useful life of project/asset should be at least
twice the pay-back reciprocal. In any case the pay-back
reciprocal will always exceed the true or the discounted
rate of return,
(ii) The cash inflows should be uniform over the life of
the project/asset.

(2) Where cash inflows are not uniform: When cash

 59

inflows are not uniform, the internal rate of return is

calculated by making trial calculations in an attempt to
compute the correct interest rate which equates the
present value of cash inflows with the present value of
cash outflows. In the process, cash inflows are to be
discounted by a number of trial rates. The first trial rate
may be calculated on the basis of the same formula
which is used for determining the internal rate of return
when cash inflows are uniform, as explained above.
However, in this case 'C' stands for 'annual average cash
inflow', in place of 'annual cash inflow'.

After applying the first trial rate the second trial rate is
determined when the total present value of cash inflows
is greater or less than the total present value of cash
outflows. In case the total present value of cash inflows
is less than the total present value of cash outflows, the
second trial taken will be lower than the first rate. In
case the present total value of cash inflows exceeds the
present total value of cash outflows, a trial higher than
first trial rate will be used. This process will continue
till the two flows more or less set off each other. This
will be the 'internal rates of return'.
 60

Illustration 13. A company has to select one of the

following two projects:
Project A Project B
Cost Rs.l 1,000 10,000
Cash inflows:
Year l 6,000 1,000
Year 2 2,000 1,000
Year 3 1,000 2,000
Year 4 5,000 10,000
Using the Internal Rate of Return Method suggest
which project is preferable.

Solution
The cash inflows are not uniform and hence the Internal
Rate of Return will have to be calculated by the Trial
and Error Method. In order to have an approximate idea
about such rate it will be better to find out the "Factor".
The factor reflects the same relationships of investment
and 'cash inflows' as in case of pay-back calculations:
Thus.
I
F= C
where
F = Factor to be located
I = Original Investment
C = Average cash flow per year
 61

The 'factor' in case of project A would be;

11,000
F= Rs. 3,000 = 3.14

The 'factor' in case of project B would be;

10,000
F = Rs. 3,000 = 2.86

In case of project A, the rate comes to 10% while in

case of project B it comes to 15%.

Project A:
Year Cash Inflows Discounting Present value
Factor at 10%
1 Rs. 6000 0.893 Rs. 5454
2 2000 0.826 1652
3 1000 0.751 751
4 5000 0.683 3415
Total Present value 11272

The present value at 10% comes to Rs. 11,272. The

initial investment is Rs. 11,000. Internal rate of Return
may be taker, approximately at 10%.

In case more exactness is required another trial rate

which is slightly higher than 10% (since at this rate the
present value is more than initial investment) may be
 62

taken, Taking a rate of 12%, the following results would

emerge:

Year Cash Inflows Discounting Present value

Factor at 10%
1 Rs. 6000 0.893 Rs. 5,358
2 2000 0.797 1,594
3 1000 0.712 712
4 5000 0.636 3,180
Total Present value 10,844

The internal rate of return is thus more than 10% but

less than 12%. The exact rate may be calculated as
follows:

Internal Rate of Return =

Difference in calculated
present value and required
net cash outlay
Difference in calculated X Difference in rate
present values

11,272-11,000 X 2
= 100% + 11,272-10,844

272 X 2
= 100% + 428 = 11.3%
 63

The exact internal rate of return can also be calculated

as follows:
At 10% the present value is + 272
At 12% the present value is - 156.

The internal rate would, therefore, be between 10% and

12% calculated as follows:

= 10 + 272 x 2
272+156
= 10+1.3= 11.3%

Project B

Year Cash Inflows Discounting Present value

Factor at 10%
1 Rs. 1,000 0.870 Rs. 870
2 1,000 0.756 756
3 2,000 0.658 1,316
4 10,000 0.572 5,720
Total Present value 8,662

Since the present value at 15% comes only to Rs.8,662,

a lower rate of discount should be taken. Taking a i#e of
10%, the following will be the result:
 64

Year Cash Inflows Discounting Present value

Factor at 10%
1 Rs. 1,000 0.909 Rs. 909
2 1,000 0.826 826
3 2,000 0.751 1,502
4 10,000 0.683 6,830
Total Present value 10,067

The present value at 10% comes to Rs. 10,067 which is

more or less equal to the initial investment. Hence, the
internal rate of return may be taken as 10%.

In order to have exactness, the internal rate of return

can be interpolated as done in case of project A.

At 10% the present value is + 67

At 12% the present value is - 1,338

67 x 5
= 10 + 67+1,338
67 x 5
= 10 + 1,405

= 10+ .24 = 10.24%

Thus, Internal Rate of Return in case of Project 'A' is

higher as compared to Project 'B'. Hence, Project 'A' is
preferable.
 65

Illustration 14: M/s Diwali Traders install plant and

machinery is rented premises for the production of a
luxury article, the demand for which is expected to last
for only 5 years. The total capital put in by the firm is
an under:

Plant and Machinery Rs. 2,70,500

Working Capital 40,000
Total Rs. 3,10,500

The working capital will be fully realised at the end of

1990. The scrap value of the plant expected to the
realised at the end of 1990 is only Rs.5,500.

The earnings of M/s Diwali Traders are expected to be

as under:
Year Cash Profit Tax Payable
(Before
depreciation and
tax)
1986 90,000 20,000
1987 1,30,000 30,000
1988 1,70,000 40,000
1989 1,16,000 26,000
1990 19,500 5,000
Present value factors at various rates of interest are
given below:
 66

11% 12% 13% 14% 15%

0.9009 0.8920 0.8850 0.8772 0.8696
0.8116 0.7972 0.7831 0.7695 0.7561
0.7312 0.7118 0.6931 0.6750 0.6575
0.6587 0.6355 0.6133 0.5921 0.5718
0.5935 0.5674 0.5428 0.5194 0.4972
You are required to compute the present value of cash
inflows discounted at the various rates of interest given
above and state the return from the project.

Solution

Year Cash 11% 12% 13% 14% 15%

Inflows
1986 70,000 63,063 62,503 61,950 61,404 60,872
1987 1,00,000 81,160 79,720 78,310 76,950 75,610
1988 1,30,000 95,056 92,534 90,103 87,750 85,475
1989 90,000 59,283 57,195 55,197 53,289 51,462
1990 60,000 35,610 34,044 32,568 31,164 29,832
Total 3,34,172 3,25,996 3,18,128 3,10,557 3,03,251

Note: Cash inflows in years 1986 to 1989 are profits are

given less tax. In 1990 the amount also includes
Rs.5,500 the expected scrap value and Rs. 40,000, the
working capital to be released. At 14% the inflows are
almost equal to the outflow. The project, therefore,
yields an internal rate of return of 14%.
 67

Comparison of the Internal Rate of Return

Approach with the Present Value Approach

Though both Net Present Value Method (NPV) and

Internal Rate of Return Method (IRR) are the species of
the same sequence, i.e., discounted cash flow method,
yet they are different from each other in several
respects. The chief points of difference between the two
are as fellows:

1. The Net Present Value Method takes the interest

rate as a known factor while Internal Rate of Return
Method takes it as an unknown factor.
2. The Net Present Value Method seeks to find out the
amount that can be invested in a given project so that its
anticipated earnings will exactly suffice to repay this
amount with interest at the market rate. On the other
hand, Internal Rate of Return Method seeks to find the
maximum rate of interest at which the funds invested in
the project could be repaid out the cash inflows arising
out of that project.
3. Both the Net Present Value Method and Internal
Rate of Return Method proceed on this presumption
that cash inflows can be-reinvested at the discounting
rate in the new projects. However, reinvestment of
funds at the cut-off rate is more possible than at the
internal rate of return. Hence, Net Present Value
Method is more reliable than the Internal Rate of Return
Method for ranking two or more capital investment
 68

projects.

Similarities in results under NPV and IRR

Both NPV and IRR will give the same result (i.e.,
acceptance or rejection) regarding an investments
proposal in following cases:

(i) Projects involving conventional cash flows, i.e.,

when an initial outflow is followed by a series of
inflows;
(ii) Independent investment proposals, i.e., proposals
the acceptance of which does not preclude the
acceptance of others.

The reason for similarity in results in the above cases is

simple. In case of NPV method, a proposal is acceptable
if its NPV is positive. NPV will be positive only when
the actual return on investment is more than the cut-off
rate. In case of IRR method a proposal is acceptable
only when the IRR is higher than the cutoff rate. Thus,
both methods will give consistent results since the
Acceptance or rejection of these proposal under both of
them is based on the actual return being higher than the
cut-off rate.
 69

Conflict in results under NPV and IRR

NPV and IRR methods may give conflicting results in

case of mutually exclusive projects, i.e., projects where
acceptance of one would result in non-acceptance of the
other. Such conflict may be due to any one or more of
the following reasons:

(i) The projects require different cash outlays,

(ii) The projects have unequal lives,
(iii) The projects have different patterns of cash flows.

In such a situation, the result given by the NPV method

should be relied upon. This is because the objective of a
company is to maximise its shareholders' wealth IRR
method is concerned with the rate of return on
investment rather than total yield on investment hence it
is not compatible with the goal of wealth maximisation.
NPV method considers the total yield on investment.
Hence, in case of mutually exclusive projects, each
having a positive NPV, the one with the largest NPV
will have the most beneficial effect on shareholders'
wealth.

In case of projects requiring different cash outlays, the

problem can also be resolved by adopting incremental
approach, a modified form of IRR method. According
to this approach in case of two mutually exclusive
'projects requiring different cash outlays, the IRR of
 70

incremental outlay of the project requiring a higher

investment is calculated. In case this IRR is higher than
the required rate of return, the project having greater
non-discounted cash flows should be accepted
otherwise it should be rejected.

Illustration I5: A firm has to make a choice between two

projects A and B which are mutually exclusive. The
cash flows are as follows:
Year Project A Project B
0 Rs. 5,000 Rs. 7,500
1 Rs. 6,000 Rs. 8,800

The cost of capital is 10%. Suggest which project

should be taken up using (i) NPV Method and (ii) IRR
Method.
Solution NPV Method

Project A B
Present value of cash Rs. Rs.
Inflows 5,454 (8,800 x.909) 7,999
(6,000 x .909) 5,000 7,500
Initial Investment 454 499
NPV IRR
Method

Project
Internal Rate of A B
Return 20% 17.33%
 71

Thus, according to NPV method, Project B is superior

to Project A since its NPV is higher than that of B. But
according to IRR method, Project A is superior to
Project B since it has a higher IRR. Since acceptance of
Project B would result in maximisation of wealth of the
shareholders as indicated by NPV, it will be appropriate
to reject Project A.

The same conclusion can be drawn by adopting the

Incremental Approach, as shown below:

Project A B B-A
Cash Outlays Rs. 5,000 Rs. 7,500 Rs. 2,500
Cash Inflows Rs. 6,000 Rs. 8,800 Rs. 2,800
IRR for Incremental cash
inflows

The IRR of differential cash outlay of Project B comes

to 12% while the required return is 10%. Project B is
therefore better than Project A inspite of its having a
lower IRR. This is because it offers the benefits offered
by the Project A and also a return in excess of the
required rate of return on incremental investment of
Rs.2,500.

Merits
The merits of discounted cash flow method are as
follows:
 72

(i) Discounted cash flow technique takes into account

the time value of money. Conceptually, it is better
than other techniques such as payback or
accounting rate of return.
(ii) The method takes into account directly the amount
of expense and revenues over the project's life. In
case of other methods simply their average are
taken.
(iii) The method automatically gives more weight to
those money values which are nearer to the present
period than those which are farther from it. While
in case of other methods, all money units are given
the same weights which seems to be unrealistic.
(iv) The method makes possible comparison of projects
requiring different capital outlay, having different
lives and different timings of cash flows, at a
particular moment of time because of discounting
of all cash flows.

Demerits
The following are the demerits of discounted cash flow
method:
(i) The method is difficult to understand and work out
as compared to other methods of ranking capital
investment proposals.
(ii) The method takes into account only the cash
inflows on account of a capital investment decisions. As
a matter of fact the profitability or otherwise of a capital
investment proposal can be judged only when the net
 73

income (and not the cash inflow) on account of

operations is considered.
(iii) The method is based on the presumption that cash
inflows can be reinvested at the discounting rate in the
new projects. However, upon the available investment
opportunities.

Accounting or Average Rate of Return (ARR)

Method
According to this method, the capital investment
proposals are judged on the basis of their relative
profitability. For this purpose, capital employed and
related income are determined according to commonly
accepted accounting principles and practices over the
entire economic life of the project and then the average
yield is calculated. Such a rate is termed as Accounting
Rate of Return. It may be calculated according to any of
the following method:

Annual Average Net Earnings X 100

(i) Original Investment
Annual Average Net Earnings X 100
(ii) Average Investment

The term "average annual net earnings" is the average

of the earnings (after depreciation and tax) over the
whole of the economic life of the project.
Increase in expected .future annual net earnings X 100
(iii) Initial increase in required investment
 74

The amount of "average investment" can be calculated

according to any of the following methods:

Original investment
(iv) (a) 2

Original investment - Scrap value of the asset

(b) 2

Original investment + Scrap value of the asset

(c) 2

Original investment - Scrap value + Add. Net + Scrap

(d) 2 Working Capital Value

Out of the four methods of calculating average

investment, method (d) seems to be theoretically more
logical on account of the following reasons:

(i) Presuming that depreciation is charged according to

fixed instalment method, the average investment in the
asset is only 50% of original cost less scrap value.
(ii) The amount required for additional net working
capital (current assets - current liabilities) remains tied
up during the lifetime of the asset. Its entire amount is
therefore a pert of investment in the assets.
(iii) Scrap value is realised only at the end of the life of
the asset. Depreciation is charged on the asset after
 75

deducting scrap value. Hence, the whole amount of

scrap value remains tied up in the project throughout its
lifetime.

It may be noted that results obtained under each of

above methods will be quite different from each other.
It is, therefore, necessary that while evaluating capita
investment proposals, the same method is followed in
each case.

Accept/reject criterion

Normally, business enterprises fix a minimum rat of

return. Any project expected to give a return below this
rate will be straightway rejected.

In case of several projects, where a choice has to be

made, the different projects may be ranked in the
ascending or descending order of their rate of return.
Projects below the minimum rate will be rejected. In
case of projects giving rates of return higher than the
minimum rate, obviously projects giving a higher rate
of return will be preferred over those giving a lower rate
of return.

Illustration 16: The directors of Alpha Limited are

contemplating the purchase of a new machine to replace
a machine which has been in operation in the factory for
the last 5 years.
 76

Ignoring interest but considering tax at 50% of net

earnings, suggest which of the two alternatives should
be preferred. The following are the details:

Old New
Machine Machine
Purchase price 40,000 60,000
Estimated life of machine 10 years 10 years
Machine running hours per annum 2,000 2,000
Units per hour 24 36
Wages per running hour 3 5.25
Power per annum 2,000 4,500
Consumable stores per annum 6,000 7,500
All other charges per annum 8,000 9,000
Material cost per unit 0.50 0.50
Selling price per unit 1.25 1.25

You may assume that the above information regarding

sales and cost of sales will hold good throughout the
economic life of each of the machines. Depreciation has
to be charged according to straight-line method.
 77

Solution:
PROFITABILITY STATEMENT

Old New
Machine Machine
Cost of the Machine 40,000 60,000
(Rs.) 10 10
Life of Machine (yrs.) 48,000 72,000
Output (Units) 60,000 90,000
Sales Value (Rs.)
Less: Cost of Sales: 36,000
Direct Material 24,000 10,500
Wages 6,000 4,500
Power 2,000 7,500
Consumable stores 6,000 9,000
Other charges 8,000
Depredation 4,000 50,000 6,000 73,500
Profit before tax 10,000 16,500
Tax at 50% 5,000 8,250
Profit after tax 5,000 8,250

Accounting Rate of return

Old Machine New Machine

Average Net Earnings X 100
(i) Original Investment
= 5,000/40,000 x 100 = 12.5% 8,250 x 100
60,000
= 13.75%
 78

Average Net Earnings X 100

(ii) Average Investment
= 5,000/20,000 x 100 = 25% 8,250 x 100
30,000
= 27.50%

Incremental Earnings X 100

(iii) Incremental Investment
3,250 X 100
= Rs.60,000 - Rs,20,000
3,250 X 100 = 8%(approx)
= 40,000

Thus, replacement of the old machine by a new

machine (ignoring interest) is profitable.

Illustration 17: Determine the average rate of return

form the following data of two machines A and B.
Machine A Machine B
Original Cost Rs. 56,125 Rs. 56,125
Addl. Investment in net working capital 5,000 6,000
Estimated life in years 5 5
Estimated salvage value 3,000 3,000
Average Income-tax rate 55% 55%
Annual estimated income after depr.
and tax: 3,375 11,375
1st year 5,375 9,375
2nd year 7,375 7,375
3rd year 9,375 5,375
4th year 11,375 3,375
5th year 36,875 36,875
 79

Depreciation has been charged on straight line basis.

Solution
Average Earnings X 100
ARR = Average Investment
Total Income
Average Income = Number of years

Rs. 36,875
Machine A = 5 = Rs. 7,375

Rs.36,875
Machine B = 5 = Rs. 7,375

Original investment-Scrap value

Average Investment = 2

Add.Net Scrap
+ Working Capital + Value

56,125-3,000 + Rs. 5,000 + Rs. 3,000

Machine A = 2

= 26,562.50 + 8,000 = Rs.34,562.50

56,125-3,000 + Rs. 6,000 + Rs. 3,000

Machine B = 2

= 26,562.50 + 9,000 = Rs.35,562,50

 80

Rs.7,375 X 100
ARR for Machine A = 34,562,50
= 21.34%

Rs.7,375 X 100
ARR for Machine B = 35,562.50
= 20.74%

Illustration 18: M/s Bharat Industries Limited purchased

a machine five years ago. A proposal is under
consideration to replace it by a new machine. The life of
the machine is estimated to be 10 years. The existing
machine can be sold at its written-down value. As the
cost accountant of the Company, you are required to
submit your recommendations based on the following
information:

Existing New
Machine Machine
Initial cost Rs. 25,000 Rs. 50,000
Machine hours per annum 2,000 2,000
Wages per running hour 1.25 1.25
Power per hour 0.50 2.00
Indirect material per annum 3,000 5,000
Other expenses per annum 12,000 15,000
Cost of materials per unit 1 1
Number of units produced per hour 12 18
Selling price per unit 2 2
Interest to be paid at 10% on fresh capital invested.
 81

Solution
STATEMENT OF PROFIT

Existing New
Machine Machine
Production per annum 24,000 36,000
(Units) Rs. 2 Rs. 2
Selling price per unit Rs. 48,000 Rs. 72,000
Cost of Sales: Rs. 24,000 Rs. 36,000
Materials 2,500 2,500
Wages 1,000 4,000
Power 3,000 5,000
Indirect Materials 12,000 15,000
Other Expenses 2,500 5,000
Depreciation -- 3,750
Interest 45,000 71,250
Rs.3,000 Rs. 750
Total profit Re. 1.87 Re. 1.98
Cost per unit Re. 0.13 Re. 0.02
Profit per unit

The above analysis shows that it will be better to

continue with the existing machine than replacing it by
a new machine.

On the basis of accounting rate of return also, it will be

better to continue with the existing machine. This has
been shown as under:
 82

Profit on installation of new machine before charging

interest = Rs. 750 + 3,750
= Rs, 4,500
Incremental profit = Rs.4,500 - Rs. 3,000
= Rs. 1,500
Incremental Investment = Rs.37,500
Rs. 1,500 X 100
Rate of Return = 37,500 = 4%

Working Notes:
Interest has been calculated as follows:
Investment in New Machine Rs.50,000
Less: Sale value of the old machine
(Rs. 25,000 -Dep. Rs. 12,500
on fixed instalment basis) Rs. 12,500
Interest at 10% p.a. on Rs. 37,500 =
Rs.3,750 Rs. 37,500

In case the rate of return is calculated on average

investment (i.e, ½ of Rs.37,500) the rate of return will
be 8%. This is not even sufficient to pay interest at 10%
on additional investment required. Thus, it will be
advisable to continue with the existing machine.

Illustration 19: Balrampur Engineering Works

manufactures a part A which is used in the air-coolers
which it sells. The quantity required is 7,000 units per
year. The direct cost of manufacturing this part is Rs.4
 83

per unit. It has received a proposal from a Cuttack firm

offering to meet the entire heeds @ Rs.5 per unit. If the
Balrampur Works discontinues making this part, it can
expand its existing facilities for manufacturing a new
product for sale which would involve the following:

Investment on new machine (Life of Rs.40,000

40,000 hrs)
Material Cost Rs. 3 per unit
Direct Labour Rs. 2 per unit
Indirect Expenses (other than depreciation)
for 8,000 hours Rs. 12,000
Estimated volume of sales 8,000 units
at Rs. 9 per
State whether the proposal of the Cuttak firm should be
accepted or not if:
(i) The current cut-offrate is 25%.
(ii) The current cut-off rate is 30%.
 84

Solution
PROTABILITY OF NEW PRODUCT
Sales (8,000 units x Rs.9) Rs.72,000
Less: Cost of Production; Rs.
Materials Cost (8,000 x Rs.3) 24,000
Direct Labour (8,000 x Rs.2) 16,000
Indirect Expenses 12,000
Depreciation (8,000 hrs. x Re.l) 8,000 60,000
12,000
Extra cost for Part 'A' payable to
Cuttak Firm 7,000
5,000
Average investment in the new project 20,000
Rate of return at 25% cut-off rate 5,000
Rate of return at 30% cut-off rate 6,000
The proposal may be accepted at cut-off rate of 25%.
However, it is not acceptable at cut-off rate at 30%.

Advantages

The following are the advantages of this method:

(i) The method takes into account savings over the
entire economic life of the asset. Hence, it provides a
better comparison of the projects as compared to the
pay-back method,
(ii) The method embodies the concept of 'net earnings'
while evaluation capital investment projects which is
absent in case of all other methods.
 85

Disadvantages

The method suffers from the following disadvantages:

(i) The method does not take into account the time
value of money. Thus, it has the same fundamental
defect as that of the pay-back method.
(ii) There are different methods for calculating the
Accounting Rate of Return due to diverse concepts of
the investments as well as earnings. Each method gives
different results, This reduces the reliability of the
method.

On account of the above disadvantages, the Accounting

Rate of Return Method is not much in use of these days,

REPLACEMENT OF EXISTING ASSET

It has already been explained, that capital budgeting

decisions have to be taken because the assets require
constant replacements. In the illustrations discussed so
far we have assumed that the assets are replaced only at
the end of their useful lives. However, it is not always
so in practice. An equipment or asset may have to be
replaced before its useful life because a more economic
alternative is available in view of the constant
technological developments. This helps in reducing the
costs and increasing the operational efficiency. In such a
case, it will be necessary to determine the most
 86

opportune time for replacement of the asset. This can be

understood with the following illustrations:

Illustration 20: A machine used on a production line

must be replace at least every four years, The costs
incurred in running the machine according to its age
are:

Age of machine
(years)
0 1 2 3 4
Rs. Rs. Rs. Rs. Rs.
Purchase price 3,000
Maintenance 800 900 1,000 1,000
Repairs 200 400 800
Net realisable value 1,600 1,200 800 400

Future replacement will be identical machines with the

same costs. Revenue is unaffected by the age of the
machine.

Assume there is no inflation of the machine.

The cost of capital is 15%,
Determine the optimum replacement cycle.

Present value factors at 15% for years 1,2,3 and 4 are

0.8696, 0.7591, 0.6575 and 0.5718 respectively. Present
value of annuity at 15% for years 1, 2, 3 and 4 are
0.8696, 1.6257, 2.2832 and 2.8550 respectively.
 87

Solution

The possible replacement of the machine could be after

every one or two or three or four years.

The annual equivalent cost of each of the replacement

policies is as follows:

Policy I: Replacement every year

Beginning of At the end
the year Rs. of 1st year
Rs.
Cost of Machine Rs.
Maintenance Cost (3,000)
Resale Value (800)
______ 1,600
Discounting Factor at 15% (3,000) 800
1.0 0.8696
(3,000) 696
Total PV of Costs = Rs. (2,304)
Annual Equivalent Cost = (2,304) Rs.(2,649)
(0.8696)
 88

Policy II: Replacement every year

Beginni At the At the
ng of the end of end of
year Rs. 1st year 1st year
Rs. Rs.
Cost of Machine
Maintenance Cost (3,000)
Repairs (800) (900)
Resale Value _______ 1,600 (200)
(3,000) (800) 1,200
Discounting Factor at 15% 1.0 0.8696 100
(3,000) 696 0.7561
(3,620) 76
Total PV of Costs (3,620)
Annual Equivalent Cost = 16,257 (2,227)

In a similar manner:

Policy III: Replacement every three years Annual

Equivalent Cost is = Rs.(2,l 56)
Policy IV: Replacement every four years Annual
Equivalent Cost is = Rs.(2,189)

The optimum replacement cycle is, therefore, three

years.

Comprehensive Illustrations
 89

Illustration 21: A Limited company is considering

investing in a project requiring a capital outlay of
Rs.2,00,000. Forecast for annual income after
depreciation but before tax is as follows:

Year Rs.
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000

Depreciation may be taken as 20% on original cost and

taxation at 50% of net income.

You are required to evaluate the project according to

each of the following methods:
(a) Pay-back method.
(b) Rate of return on original investment method.
(c) Rate of return on average investment method.
(d) Discounted cash flow method taking cost of capital
as 10%.
(e) Net present value index method.
(f) Internal rate of return method.
 90

Solution
(a) Pay-back Method
STATEMENT NET CASH INFLOW

Year Profit after Tax Profit before

depreciation depreciation
but after tax
1 Rs. 1,00,000 Rs. 50,000 Rs. 90,000
2 1,00,000 50,000 90,000
3 80,000 40,000 80,000
4 80,000 40,000 80,000
5 40,000 20,000 60,000
Pay-back Period

Rs. 1,80,000 is recovered in 2 years. The balance of Rs.

20,000 will be recovered in 20,000/80,000 or .25 year.
Hence, pay-back period is 2.25 years.

(b) Rate of Return on Original Investment Method

Year Net Profit after tax and
depreciation
1 Rs. 50,000
2 50,000
3 40,000
4 40,000
5 20,000
Total return 2,00,000
Average Annual Return 40,000
 91

40,000 X 100
Rate of return = 2,00,000
= 20%

(c) Rate of Return on Average Investment Method

= 40,000/1,00,000x100
= 40%

(d) Discounted Cash Flow Method

COMPUTATION OF NPV

Year Net Profit before Discount Present

dep. But after tax Factor @ Value
10%
1 90,000 0.909 Rs. 81,810
2 90,000 0.826 74,340
3 80,000 0.751 60,080
4 80,000 0.683 54,640
5 60,000 0.621 37,260
Present Value of 3,08,130
Cash inflow
Initial Investment 2,00,000
Excess Cash Inflow 1,08,130
(or NPV)
 92

(e) Net Present Value Index

Total present value of cash inflows
Total present value of cash outflows

3,08,130
= 2,00,000 =1.541 or 154%

(f) Internal Rate of Return Method

Since the annual cash inflows are not uniform, the

factor will have to be located for determining the
approximate rate of return:
I
F = C
where
F = Factor to be located
I = Initial Investment
C = Average annual cash inflow

2,00,000
F = 80,000 = 2.5
 93

The present value at 28% rate:

Year Cash inflow Discount Present
Factor Value
1 Rs.90,000 0.781 Rs. 70,092
2 90,000 0.610 54,900
3 80,000 0.477 38,160
4 80,000 0.373 29,840
5 60,000 0.291 17,460
Total Present Value 2,10,650
Initial Investment 2,00,000
Excess Present Value 10,650
At 28% discounting rate, the present value is higher by
Rs. 10,650. Hence, a higher discounting rate should be
taken. Taking it at 30%.
Year Cash inflow Discount Present
Factor Value
1 Rs.90,000 0.769 69,210
2 90,000 0.592 53,280
3 80,000 0.455 36,400
4 80,000 0.350 28,000
5 60,000 0.269 16,140
Total Present Value 2,03,030
Initial Investment 2,00,000
Excess Present Value 3,030
 94

The present value at 30% is higher by Rs.3,030. The

internal rate of return will, therefore, by slightly higher
than 30%. Though exact interpolation can b? done, it
would not affect much the management decision.
Hence, the rate may be taken as 30%.

Judging from all angles, the investment in the new

project seems to be fairly attractive.