Unit IV

CAPITAL EXPENDITURE DECISIONS

 CAPITAL EXPENDITURE DECISIONS

OBJECTIVE :

•NATURE OF INVESTMENT DECISIONS

•PROCEDURE INVOLVED IN CAPITAL BUDGETING

DECISIONS

•TYPES OF APPRAISAL
 NATURE OF CAPITAL BUDGETING DECSIONS

• They influence the firm’s growth in the long run.

• They have an impact on the risk of the firm.
• They involve outflow of large amount of funds
• They are irreversible in nature
• They are complex in nature.

Jaideep Jadhav 3
 STEPS INVOLVED IN CAPITAL BUDGETING
DECISIONS
Step 1:
– Identification of potential investment opportunities
Step 2:
– Preliminary screening
Step 3:
– Feasibility study
Step 4:
– Project implementation
Step 5:
– Performance review

Jaideep Jadhav 4
 Step 1
Identification of Potential
Investment Opportunities

• Study the demand and supply position in

different industries.
• Evaluate the product profiles of various
industries.
• Analyze the trend in imports and exports to
identify potential opportunities.

Jaideep Jadhav 5
 Step 2
Preliminary Screening

The following criteria should be evaluated:

• Compatibility between the promoter’s
financial ability and the project’s
requirement.

• Compatibility of the project with

governmental guidelines and legislations.
Jaideep Jadhav 6
 Step 3:
Feasibility Study
The factors that are considered in feasibility
study are:
• Estimates of the project cost,
• Means of financing the project,
•Schedules of implementation,
•Estimates of costs and benefits associated
with the project.

Jaideep Jadhav 7
 Step 4:
Project Implementation
This phase involves conversion of the investment
proposal into a concrete project.

Activities in this phase:

•Preparation of blue prints
•Selection of machinery
•Arrangement of project finance,
•Installation of machinery,
•Trial run and actual production.

Jaideep Jadhav 8
 Step 5:
Performance Review

• Once the project has been implemented, it

is important to review the project in terms
of the performance that was expected in
the feasibility study.

• If there are deviations of the actual

performance of the project from the
planned performance, the causes for such
deviations should be checked.
Jaideep Jadhav 9
 TYPES OF PROJECT APPRAISAL

• MARKET APPRAISAL
– It aims at determining/forecasting the total market
demand for the product and the market share that the
product or service will occupy.

• TECHNICAL APPRAISAL
– It aims at analyzing the technical aspects of the
project like availability of required quality and quantity
of raw materials, other requirements like power, water
etc.

Jaideep Jadhav 10
 TYPES OF PROJECT APPRAISAL

• FINANCIAL APPRAISAL
– This appraisal helps in evaluating the financial costs
and benefits associated with a project.

• ECONOMIC APPRAISAL
– It helps in evaluating the extent to which the project is
beneficial to the society. Aspects like impact of the
project on the distribution of income, level of savings
etc.

Jaideep Jadhav 11
 Summary

 Nature of capital budgeting decisions

 Steps involved in capital budgeting decisions:

• 1: Identification of potential investment opportunities
• 2: Preliminary screening
• 3: Feasibility study
• 4: Project implementation
• 5: Performance review

 Types of project appraisal:

• Market, Technical, Financial & Economic appraisal
Jaideep Jadhav 12
 CAPITAL EXPENDITURE DECISIONS

Objectives
Financial Appraisal
•Pay back period
•Appraisal criteria ignoring time value of money
–Accounting rate of return

Jaideep Jadhav 13
 EVALUATION TECHNIQUES

APPRAISAL CRITERIA IGNORING TIME VALUE OF

MONEY
• Pay back Period
• Accounting Rate of Return

CRITERIA USING TIME VALUE OF MONEY CONCEPT

• Net Present Value
• Benefit-Cost Ratio
• Internal Rate of Return
• Annual Capital Charge

Jaideep Jadhav 14
 PAYBACK PERIOD
• Pay back Period: Length of time required to recover the initial
outlay of the project.

Acceptance rule:
If Payback period ≤ Cut-off rate: Accept
( Cut Off Rate is the Maximum / Standard Payback Period set by
Management )
• Limitations:
- Does not consider time value of money
- Gives more importance to cash flows in earlier years
Computation of pay back period
Incase the cash flows are even then it is computed as
Initial Investment
Annual Cash Outlay
Jaideep Jadhav 15
 PAYBACK PERIOD (cntd…)
Incase the cash flows are uneven then it is computed as
Step1 : Calculate the cumulative cash flows
Step 2 : Substitute the values in the following formula.
Base year + Required Cash Flow After Tax
Next Year Cash Flow After Tax
Where
base year = The year in which the cumulative cash flow is nearest
and less than the initial investment.
Required Cash Flow After Tax (CFAT)
=initial investment – cumulative cash flow of the base year
Next year CFAT = the CFAT after the base year.

Jaideep Jadhav 16
From the following information calculate
Pay Back Period of Project A and B.
Year Cash flows
Project A Project B
0 -100000 -100000
1 50000 20000
2 30000 20000
3 20000 20000
4 10000 30000
5 10000 40000
6 ------ 50000
Jaideep Jadhav 17
 Solution
Yr A B Project A Project B
Cash Flow Cash Flow Cumu.CF Cumu. CF
1 50,000 20,000 50,000 20,000
2 30,000 20,000 80,000 40,000
3 20,000 20,000 1,00,000 60,000
4 10,000 30,000 1,10,000 90,000
5 10,000 40,000 1,20,000 1,30,000
6 --- 50,000 ---- 1,80,000

Jaideep Jadhav 18
 Continued
• Pay Back Period
= Base year + Required Cash Flow After Tax
Next Year Cash Flow After Tax
Pay Back Period of Project A = 3years

Pay Back Period of Project B

= 4 year + 1,00,000-90,000
40,000
= 4.25 Years

Jaideep Jadhav 19
ABC Ltd. is considering two Projects. Each requires an investment of Rs. 10,000. The
net cash inflows from investment in the two projects A’ and Y are as follows:

Year Project X Project Y

1 5,000 1,000
2 4,000 2,000
3 3,000 3,000
4 1,000 4,000
5 ---- 5,000
6 ---- 6,000

The company has fixed three years pay-back period as the cut-off point.

Jaideep Jadhav 20
 ACCOUNTING RATE OF RETURN
• Accounting Rate of Return (ARR) measures the rate of return
on the project using accounting information.
• It is computed as:
Average Profit after tax
Average value of investment
• Avg Value of Investment =Book Value of Investment in the
beginning + Book Value at the end of n years /2
• Acceptance Rule:
Accept the project if ARR> Required rate of return

• Limitations:
-Ignores time value of money
-Uses accounting profits and not cash flows in evaluating the
project

Jaideep Jadhav 21
 Example: A Ltd. is planning to invest in project B. The initial
investment required for project B is Rs. 55,000. The profit after
tax associated with the project, for a period of four years is given
below:
Year PAT for Project A (in Rs.)
1 10,800
2 9,830
3 4,230
4 3,320

Should the firm accept this project, if the minimum accounting

rate of return required by the company is 22.34%?

Jaideep Jadhav 22
Solution: Average Profit after tax
• Accounting Rate of Return =
Average value of investment
• Average Profit After Tax = (10,800 + 9,830 + 4,230 + 3,320)/ 4
• = Rs. 7045.
• Average value of investment = = Rs. 27,500.
• Accounting Rate of Return = = 0.2562 or 25.62%.
• The company can accept this project, as its ARR is greater than
the minimum or standard ARR.

Jaideep Jadhav 23
Summary

Financial appraisal are divided into

• Appraisal criteria ignoring time value of money
• Criteria using time value of money concept
Pay back Period
Appraisal criteria ignoring time value of money.
Accounting rate of return :
Concept
Problem
Jaideep Jadhav 24
 Objectives of the session
To understand the

• Appraisal criteria using the time value of money

concept
- Net Present Value
• APPRAISAL CRITERIA USING THE TIME
VALUE OF MONEY CONCEPT -
PROFITABILITY INDEX

Jaideep Jadhav MITSOT Pune 25

 NET PRESENT VALUE
• Net Present Value (NPV): It is the difference between present
value of cash inflows and present value of outflows.

• NPV = PV of cash inflows – PV of cash outflows

Acceptance Rule:
Accept the project if NPV>0

Limitations:
-Gives inconsistent results while comparing projects with
unequal lives.
- Difficult to determine the precise discount rate.
Jaideep Jadhav MITSOT Pune 26
Example: X Ltd. is planning to buy machinery for manufacturing a
coolant needed for refrigerators. The cost of the machine is Rs.
50,400. Following are the cash flows associated with the project
over its life period of 5 years.

Cash Flow After Tax

Year
1 Rs. 10,000
2 Rs. 14,000
3 Rs. 14,000
4 Rs. 12,500
5 Rs. 9,800

Based on the NPV criterion, determine whether the new

machine should be bought or not?
Jaideep Jadhav MITSOT Pune 27
Solution:
• Net Present Value = Present value of inflows – Present value
of outflows
• Present value of inflows =
10,000 14,000 14,000 12,500 9,800
   
(10.12) (10.12)2 (10.12)3 (10.12)4 (10.12)5

= 8,928.57 + 11,160.71 + 9,964.92 + 7,943.98 + 5,560.78 = Rs.

43,558.96.
Hence, NPV = 43,558.96 – 50,400 = - Rs 6,841.04

Jaideep Jadhav MITSOT Pune 28

• The company should not go in for the
machinery as the NPV is negative, in other
words the benefits associated with the
machinery are less than the costs associated
with it.

Jaideep Jadhav MITSOT Pune 29

Project X initially cost Ks, 25,000. It generates the following cash flows:

Year Cash Inflows Present Value of Re.1 at 10%

1 9,000 .909
2 8,000 .826
3 7,000 .751
4 6,000 .683
5 5,000 .621

Taking the cut-off rate as 10% suggest whether the project should be
accepted or not

( Ans. NPV Ks. 2,249, the project should he accepted)

Jaideep Jadhav MITSOT Pune 30
 BENEFIT-COST RATIO
• Benefit-Cost Ratio (BCR) or Profitability Index (PI): It is
the ratio of present value of cash inflows at the required rate
of return and the initial cash outflow of the investment.
Present va lue of cash inflows
PI 
Initial investment
• Acceptance Rule:
Accept the project if BCR> 1
• Limitations:
-Does not give valid results when cash outlay is spread over
a number of years.
- Is not useful when multiple projects are acceptable but
budget constraint exists.
Jaideep Jadhav MITSOT Pune 31
 Problem
Cash flows of a certain project are as follows:
Calculate Benefit Cost ratio of the project by assuming cost
of capital is 10%.
Year Cash Outflow Cash inflow
0 1,50,000 ------
1 30,000 20,000
2 30,000
3 60,000
4 80,000
5 30,000
6 40,000
Jaideep Jadhav MITSOT Pune 32
 Solution
Year Cash PVIF PV Cash PVIF PV
outflow Inflow
1 150000 1.000 150000 20000 0.909 18180
2 30000 0.909 27270 30000 0.826 24780
3 60000 0.751 45060
4 80000 0.683 54640
5 30000 0.621 18640
6 30000 0.564 16920
177270 178180

Jaideep Jadhav MITSOT Pune 33

 Solution (Continued)
Present value of cash inflows
PI 
Initial investment

= 178180/177270
= 1.005

Accept the project as Profitability index > 1

Jaideep Jadhav MITSOT Pune 34

Summary of the session
• APPRAISAL CRITERIA USING THE TIME
VALUE OF MONEY CONCEPT
• - NET PRESENT VALUE
Concept and Problem
• APPRAISAL CRITERIA USING THE TIME
VALUE OF MONEY CONCEPT
PROFITABILITY INDEX
• Concept and problem

Jaideep Jadhav MITSOT Pune 35

 CAPITAL EXPENDITURE DECISIONS

Objective
APPRAISAL CRITERIA USING THE TIME VALUE OF
MONEY CONCEPT
- INTERNAL RATE OF RETURN
- ANNUAL CAPITAL CHARGE

Jaideep Jadhav MITSOT Pune 36

 INTERNAL RATE OF RETURN
• Internal Rate of Return (IRR): Rate of return that equates the
present value of cash inflows to cash outflows.
• IRR is the rate at which NPV is zero

• Acceptance Rule:
Accept the project if IRR> required rate of return

• Limitations:
• It gives multiple values while dealing with projects having one
or more cash outflows interspersed with cash inflows.

Jaideep Jadhav MITSOT Pune 37

Example:
Swastik Industries Ltd. wants to expand its business by
investing either in project A or in project B. Both the
projects involve an outlay of Rs. 10,000 and have a life-span
of three years. The cash flows after tax associated with
projects A and B are as follows:

Year Project A Project B

(Amount in Rs.)
1 2000 4000
2 4000 4000
3 6000 4000

Based on the IRR criterion, determine which project should the

company invest in?

Jaideep Jadhav MITSOT Pune 38

 Calculation of IRR
• Uneven Cash Flows
• Trial and Error Method
• Select any discount rate to compute the present value of
cash inflows
• If the calculated present value of the expected cash inflow is
lower than the present value of cash outflows, a lower rate
should be tried.
• A higher value should be tried if the present value of inflows
is higher than the present value of outflows
• This process will be repeated unless the net present value
becomes zero.
 Solution:
Project A
Let r represent the IRR of project A:
10,000 = 2000  4000  6000
(1  r ) (1  r ) 2 (1  r ) 3
i.e. 10,000 = 2000 x PVIF(r%, 1 year) + 4000 x PVIF(r%, 2 years) + 6,000 x
PVIF(r%, 3 years)

The value of the right hand side of the equation at 9% is = Rs.

9,834.
The value of the right hand side of the equation at 8% is = Rs.
10,044.
Hence, r will lie between 8% and 9%. Interpolating these two
values we get, (10044  10000) = 8.21%
s = 8% + (9%-8%) (10044  9834)

Jaideep Jadhav MITSOT Pune 40

Project B
Let s represent the IRR of project A:
10,000 = 4000  40002  40003
(1  s ) (1  s ) (1  s)

i.e. 10,000 = 4000 x PVIFA(s%, 1 year)

10000
PVIFA(s%, 1 year) = = 2.50
4000
The PVIFA at 9% is 2.531 and PVIFA at 10% is 2.487.
Hence ‘s’ will lie between these two values.
Interpolating the two values we get,
( 2 . 531  2 . 50 )
s = 9% + (10%-9%)
( 2 . 531  2 . 487 )
= 9.71%
Hence, the company should invest in project B as the IRR for
project B is greater than the IRR for project A.
Jaideep Jadhav MITSOT Pune 41
 ANNUAL CAPITAL CHARGE
• Used for evaluating projects providing similar services but
having different cost patterns.
• It is computed as:
Present value of costs associated with the project
PVIFA (k%, n years)

where, n is the lifespan of the project and

k is the cost of capital of the firm

• Acceptance Rule: Project having the lowest annual capital

charge should be accepted

Jaideep Jadhav MITSOT Pune 42

 Example: RK Ltd. has to make a choice between two projects
X and Y having life spans of 5 years and 4 years respectively.
Both the projects provide similar services. The initial
investment and the subsequent costs associated with the two
projects are given below:
X Y
Year
0 4,00,000 3,85,000
1 10,000 15,000
2 8,000 12,000
3 12,000 16,000
4 4,000 14,000
5 3,000

Which project should the company select if the cost of capital is 9%?
Jaideep Jadhav MITSOT Pune 43
Solution:
Present value of costs associated with project X =
= 4,00,000 + 10,000 x PVIF(9%, 1 year) + 8,000 x PVIF(9%, 2
years) + 12,000 x PVIF(9%, 3 years) + 4,000 x PVIF(9%, 4
years) + 3,000 x PVIF(9%, 5 years)

= 4,00,000 + 10,000 x 0.917 + 8,000 x 0.842 + 12,000 x 0.772 +

4,000 x 0.708 + 3,000 x 0.650 = Rs. 4,29,952.

4 , 29 ,952
Annual Capital Charge for project X = 4,29,952 =
PVIFA (9%,5) 3 . 89
= Rs. 1,10,527.51.
Present value of costs associated with project Y =
= 3,85,000 + 15,000 x PVIF(9%, 1 year) + 12,000 x PVIF(9%, 2
years) + 16,000 x PVIF(9%, 3 years) + 14,000 x PVIF(9%, 4
years)
= 3,85,000 + 15,000 x 0.917 + 12,000 x 0.842 + 16,000 x 0.772 +
14,000 x 0.708
= Rs. 4,31,123.
4,31,123
Annual Capital Charge for project Y =
PVIFA (9%,4)

4 , 31 ,123
= = Rs. 1,33,062.65.
3 . 24

Since the annual capital charge associated with project X is less

than that for project Y, project X should be selected.
 Summary

• Internal rate of return

– Concept
– Problems
• Annual capital charge
– Concept
– Problems

Jaideep Jadhav MITSOT Pune 46