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1. CAPITAL BUDGETING

2. MEANING Capital budgeting is the process of planning and evaluating long-term investment opportunities or projects that involve significant capital expenditure. It involves analyzing and selecting investment projects that are expected to yield returns that exceed their cost of capital. Capital budgeting is essential for businesses to allocate their financial resources efficiently and maximize shareholder wealth.

3. Key aspects of capital budgeting include: Identifying Investment Opportunities : Companies identify potential investment opportunities that align with their strategic objectives and long-term growth plans. These opportunities may include acquiring new assets, expanding existing operations, developing new products, or entering new markets. Estimating Cash Flows : Once investment opportunities are identified, companies estimate the expected cash flows associated with each project over its lifetime. This involves forecasting revenues, expenses, and other relevant cash inflows and outflows. Evaluating Risk : Capital budgeting involves assessing the risks associated with each investment project, including market risks, operational risks, and financial risks. Companies use various techniques, such as sensitivity analysis and scenario analysis, to evaluate the impact of different risk factors on project outcomes. Applying Capital Budgeting Techniques : Companies use a variety of capital budgeting techniques to evaluate investment opportunities and make informed decisions. Common techniques include net present value (NPV), internal rate of return (IRR), payback period, and profitability index. These techniques help companies compare the expected returns of different investment projects and prioritize them based on their financial viability. Making Investment Decisions : Based on the analysis and evaluation of investment opportunities, companies make investment decisions and allocate financial resources to projects that are expected to create long-term value for the organization and its stakeholders.

4. FEATURES AND SIGNIFICANCE Any decision that requires the use of resources is a capital budgeting decision; thus the capital budgeting decisions cover everything from broad strategic decisions at one extreme to say computerization of the office, at the other.

5. The relevance and significance of capital budgeting (a) Long-Term Effects : Perhaps, the most important fea tures of a capital budgeting decision and which makes the capital budgeting so significant is that these decisions have long term effects on the risk and return composition of the firm. These decision affect the future position of the firm to a considerable extent as the capital budgeting decisions have long term implications and consequences. By taking a capital budgeting decision, a finance manager in fact makes a commitment into the future, both by committing to the future needs of funds of the projects and by committing to its future implications. (b) Substantial Commitments : The capital budgeting deci sions generally involve large commitment of funds and as a result substantial portion of capital funds are blocked in the capital budgeting decisions. In relative terms there fore, more attention is required for capital budgeting decisions, otherwise the firm may suffer from the heavy capital losses in time to come. It is also possible that the return from a projects may not be sufficient enough to justify the capital budgeting decision. Irreversible Decisions : Most of the capital budgeting decisions are irreversible decisions. Once taken, the firm may not be in a position to revert back unless it is ready to absorb heavy losses which may result due to abandon ing a project in midway. Therefore, the capital budgeting decisions should be taken only after considering and evaluating each and every minute detail of the project, otherwise the financial consequences may be far-reaching. (d) Affect the Capacity and Strength to Compete : The capital budgeting decisions affect the capacity and strength of a firm to face the competition. A firm may loose competi tiveness if the decision to modernize is delayed or not rightly taken. Similarly, a timely decision to take over a minor competitor may ultimately result even in the mo nopolistic position of the firm.

6. PROBLEMS OF CAPITAL BUDGETING (a) Future Uncertainty : All capital budgeting decisions in volve long term which is uncertain. Even if every care is taken and the project is evaluated to every minute detail, still 100% correct and certain forecast is not possible. The finance manager dealing with the capital budgeting decisions, therefore, should try to be as analytical as possible. The uncertainty of the capital budgeting decisions may be with reference to cost of the project, future expected returns from the project, future competition, expected demand in future, legal provisions, political situation, etc. (b) Time Element : The implications of a capital budgeting decision are scattered over a long period. The cost and benefit of a decision may occur at different point of time. As a result, the cost and benefits of a capital budgeting decision are generally not comparable unless adjusted for time value of money. The cost of a project is incurred immediately, however, it is recovered in number of years. These total returns may be more than the cost incurred (in absolute terms), still the net benefit cannot be ascertained unless the future benefits are adjusted to make them comparable with the cost. Moreover, the longer the time period involved, the greater would be the uncertainty. (c) Measurement Problem : Sometimes a finance manager may also face difficulties in measuring the cost and benefits of a projects in quantitative terms. For example, the new product proposed to be launched by a firm may result in increase or decrease in sales of other products already being sold by the same firm. But how much ? This is very difficult to ascertain because the sales of other products may increase or decrease due to other factors also. involve

7. Types of capital budgeting decision In general, the projects can be categorized as follows: From the Point of view of Firm’s existence : The capital budgeting decisions may be taken by a newly incorporated firm or by an already existing firm. (a) New Firm : A newly incorporated firm may be required to take different decisions such as selection of a plant to be installed, capacity utilization at initial stages, to set up or not simultaneously the ancillary unit etc. (b) Existing Firm : A firm which is already existing may also be required to take various decisions from time to time to meet the challenges of competition or changing environment. These decision may be : ( i ) Replacement and Modernization Decision : Expansion : (iii) Diversification : Contingent Decisions :

8. From the Point of view of Decision situation : (a) Mutually Exclusive Decisions : Two or more alternative proposals are said to be mutually exclusive when acceptance of one alternative result in automatic rejection of all other proposals. Accept-Reject Decisions : An Accept-Reject decision occurs when a proposal is independently accepted or rejected without regard to any other alternative proposal. This type of decision is made when ( i ) proposal’s cost and benefit neither affect nor are affected by the cost and benefits of other proposals, (ii) accepting or rejecting one proposal has not impact on the desirability of other proposals, and (iii) the different proposals being considered are not competitive. In case of Accept-reject situation, the rule is : All the Good Ones.

9. Capital budgeting decisions and funds availability Only those decisions are to be implemented which fulfil the following two conditions : ( i ) The cost of the project does not exceed the funds available, and (ii) The benefits expected from the project are more than the cost. The situation where the firm is not able to finance all the profitable investment opportunities is known as capital rationing . If the total funds required by the profitable opportunities at any particular point of time exceed the available funds with the firm, then the firm is said to be operating under conditions of capital rationing. The capital rationing implies that the firm is unable or unwilling to procure the additional funds needed to undertake all the capital budgeting proposals before it. The problem faced by a finance manager in this situation is as to how to allocate the available scarce capital among various proposal. Out of different independent proposals (accept reject decisions), only those may be accepted in order of priority which entails the total cost within the limit of avail able fund. In case of mutually exclusive proposals, the cost of selected proposal must not exceed the available fund.

10. Assumptions of capital Budgeting Certainty With Respect to Cost and Benefits : Profit Motive No Capital Rationing : there is no scarcity of capital funds and the firm

11. Process of capital budgeting (a) Estimation of Costs and Benefits of a Proposal : (b) Estimation of the Required Rate of Return : (c) Using the Capital Budgeting Decision Criterion:

12. Estimation of Cost & Benefit of a proposal Two alternatives are suggested for measuring the cost and benefits of a proposal i.e., the accounting profits and the cash flows: Accounting Profit : The benefits of a proposal may be measured in terms of the profit generated by it or in terms of a measure based on accounting profits . However, the accounting profit, which otherwise is a good, estimate of judging the efficiency of any firm, may not be a good measure to estimate the value/benefit created by a proposal. The accounting profit as a measure of benefits of a proposal is discarded on the following grounds : (a) The accounting profit is, to a large extent, affected by the discretionary accounting policies being followed by the firm. These policies, which usually differ from one firm to another or from one period to another, may be depreciation policy, inventory valuation policy, capital expenditure and revenue expense policy, etc. Thus, the accounting profit is not an objective figure. (b) The accounting profit is affected by so many non cash items such as depreciation, writing off the accumulated losses , etc. The balancing profit figure after these item is not a true measure of benefits contributed by a proposal. The accounting profit measures the profit of any particular year in terms of the money of that year. However, the cost and benefits of a proposal may occur over a period of number of year. The benefits if measured in terms of accounting profit, are expressed in monies of different time period and are not comparable. Similarly, if two mutually exclusive proposals have different economic lives, then the accounting profits emerging over different periods are not comparable. (d) The accounting profit is based on the accrual concepts . For example, the sales revenue and the expenses, both are recorded for the period in which they occur instead of the period in which they are actually received or paid.

13. Cash Flows : In capital budgeting, the cost and benefits of a proposal are measured in terms of cash flows. The term cash flow is used to describe the cash movement arising because of a proposal. Though it may not be possible to obtain exact cash-effect measurement, it is possible to generate useful approximations based on available accounting data. The costs are denoted as cash outflows whereas the benefit are denoted as cash inflows. It may be noted that the cash outflows represent outflows of purchasing power and cash inflow is an inflow of purchasing power.

14. Cash Flows versus Accounting Profit : (a) The accounting profit ignores the concept of time value of money , whereas the cash flow incorporates the time value of money also. (b) In capital budgeting, a finance manager is concerned with measuring the economic value created by a decision rather than book entry value. In cash flow analysis, the cost and benefits are measured in terms of actual cash inflows and outflows rather than profit figure . (c) The accounting profit may be influenced and affected by adopting one or the other accounting policy , however the cash flow are the actual flows and are not affected by any such discretionary policy of the firm.

15. The cash flows associated with a proposal may be classified into : 1. Original or Initial Cash Outflow : All the capital projects require a sizeable initial cash outflow before any future inflow is realized. This initial cash outflow is needed to get a project operational. There are several points worth noting here as follows : (a) Installation cost : The initial cash outflow includes the total cost of the project in order to bring it in workable condition. Thus, the initial cash outflow includes not only the cost of plant, but also the transportation cost, installation cost and any other incidental cost. (b) Sunk cost : Sunk cost is that cost which the firm has already incurred and thus has no effect on the present or future decisions. If a firm which owns a plot of land which is lying idle for the time being, is now considering to construct a factory at this plot, then the cost of the plot is a sunk cost for the factory proposal, and is irrelevant. However, if the plot of land is to be purchased now, then the cost of the land will be included in the initial cost of the project. (c) Salvage value of Existing Asset : In case of replacement decisions, the salvage value of the existing asset is an inflow. If the firm decides to replace the existing asset then the outflow would occur on the new asset and simultaneously, an inflow would occur from the sale of the old. This salvage value is deducted from the outflow to find out the net initial outflow. (d) Opportunity Cost: In some cases, the finance manager may overlook some of the costs of proposal. Such costs may be the opportunity costs of some resources which are already available or being procured in the firm. Using of some resources, such as office space, for a new proposal by divesting them from some other existing use, causes the opportunity costs. This opportunity cost may be a significant portion of the total cost of the proposal. The general framework for analyzing the opportunity costs begins by asking the question, “Is there any other use for this resource right now ?” For many resources, there will be an alternative use if the project being analyzed is not undertaken. The opportunity cost may occur as follows : ( i ) The resource might be rented out, in which case the rental revenue is the opportunity lost by taking this project. (ii) The resource could be sold, in which case the sales price (net of tax liability and lost depreciation tax benefits) would be the opportunity cost of taking this project. (iii) The resource might be used elsewhere in the firm, in which case the cost of replacing the resource is considered as the opportunity cost. (e) Additional Working Capital Requirement: Another item that needs consideration to ascertain the initial cash outflow is the working capital required for the proposal or more precisely, the change in working capital due to the proposal. Since the change in working capital affects the cash flows, it is important that the working capital requirement of every alternative proposal be analyzed and considered for the capital budgeting decision.

16. 2. Subsequent Annual Inflows and Outflows : The original investment cost or the initial cash outflow of the proposal is expected to generate a series of cash inflows in the form of cash profits contributed by the project. These cash inflows may be same every year throughout the life of the project or may vary from one year to another. The timings of the inflows may also be different. The cash inflows mostly occur annually, but in some cases may occur half yearly or biannually also. These cash inflows generated during the life of the project may also be called operating cash flows. Page 69

17. So, subsequent annual cashflow can be described as : Annual Inflow = PAT + Non-cash expenses – Capital expenditure ± Change in Working Capital

18. 3. Terminal Cash Inflows : The cash inflows for the last year will also include the terminal cash flows in addition to annual cash inflows. Two common terminal cash inflows may occur in the last year. First, as already noted, the estimated salvage or scrap value of the project realizable at the end of the economic life of the project or at the time of its termination is the cash inflow for the last year. Terminal CF = Sale Price of asset ± Tax effect of sale of asset + Working Capital released

19. 3. Terminal Cash Inflows : The cash inflows for the last year will also include the terminal cash flows in addition to annual cash inflows. Two common terminal cash inflows may occur in the last year. First, as already noted, the estimated salvage or scrap value of the project realizable at the end of the economic life of the project or at the time of its termination is the cash inflow for the last year. At the time of disbanding or termination of the project, the market value of the land etc. also become cash inflows from the project. Second, as already noted, the working capital which was invested (tied up) in the beginning will no longer be required as the project is being terminated. This working capital released will be available back to the firm and is considered as a terminal cash inflow

20. Incremental approach of cash flow In capital budgeting, the cash flows are measured in the incremental terms i.e., only those cash flows are considered, that differ or occur as a result of undertaking/accepting the particular proposal. These incremental cash flows are also known as relevant cash flows . These refer to those cash flows which can be associated and attributed to adoption of a particular proposal.

21. what is a relevant cash flow ? In general, a relevant cash flow for a project is a change (in the firm’s future cash flows) that occurs as a direct consequence of the decision to accept that project. As the relevant cash flows are defined in terms of changes in a increments to the existing cash flows, these are called incremental cash flows. The concept of incremental cash flows is central to the process of capital budgeting. Any cash flows that exists or is expected to occur regardless of whether a project is taken up or not, is not a relevant cash flow and is ignored in capital budgeting. Following points are worth nothing about incremental cash flows :

22. Stand Alone Principle : If an existing firm is taking up a new project, then it would be very tedious and cumber some to actually calculate the total future cash flows of the firm with or without that project. In order to avoid this situation, the stand alone principle is applied and only the effect of project’s cash flows on the firm’s otherwise cash flows is identified. ‘Stand Alone Principle’ implies that each project is a ‘ minifirm ’ within the larger firm. Each ‘ minifirm ’ has its costs, revenues and cash flows. Co-existence with the proposal : The incremental cash flows are those which co-exist with a proposal i.e., the particular cash flows may appear only if the project is undertaken. For example, ABC & Co. is evaluating project X and project Y. The project X requires an intensive repairs costing 1,00,000 at the end of 5th year, while the project Y necessitates an annual service contract for 25,000 p.a. In this case, the repair cost of 1,00,000 is relevant for project X only, while the annual cash outflow of 25,000 is relevant for project Y only. The repair cost is not required if project Y is implemented and the service contract is not required if the project X is installed.

23. Allocated Overhead costs : The overhead costs are those which are not directly related to a product. These are allocated to a product on some rational basis such as machine-hour rate etc. These overhead costs which are already being incurred by the firm and perhaps also being charged from the goods produced presently, are irrele vant from the point of view of new project. If therefore, some existing overhead cost is allocated to the new proposal, then this is not to be considered for finding out relevant cash flows of the proposal. Moreover, it is not incremental. However, if the overhead costs is expected to increase after the new project is implemented, then only this incremental overhead cost will be considered as costs and the cash outflow for the proposal. Product Cannibalization : This refer to the phenomenon whereby a new product introduced by a firm competes with and reduces sales of some other existing product of the same firm. The product cannibalization refers to the sales generated by one product, which come at the expense of other products being sold by the same firm. It can be argued that this is a negative effect of the new product, and the lost cash flows or profit from the existing products should be treated as costs in analyzing whether or not to introduce the product

24. Taxation & cashflow The cash flows that are related to capital budgeting decisions are the after-tax cash flows only. The after-tax cash flows resulting from a project are in fact the relevant incremental cash flows. These after-tax cash flows would not occur if the project is not undertaken. The annual cash inflow from a project will result in increase in the taxable profit. So, the cash flow from a project would also affect the tax liability of the firm. The increase in tax liability will be equal to the cash inflow multiplied by the tax rate. Or, the net cash inflow will be equal to cash inflow (before tax) multiplied by (1-tax rate). Therefore, the relevant cash flow for a capital budgeting decision is the cash flow net of incremental tax liability.

25. Depreciation, non cash items and cash flow The fixed assets acquired as a result of capital budgeting decision would be depreciated in the usual way. The depreciation of the assets would reduce the expected profit being generated by the project, reducing the tax liability. Even though this depreciation does not involve any cash flow as such, it definitely affects the cash outflows by affecting the tax liability. One consequence of dealing with after tax cash flows in capital budgeting decision process is that non-cash charges can have a significant impact on the cash flows, if they affect the tax liability. Some non-cash charges, particularly depreciation, reduces the taxable income and hence reduces the tax liability, without however affecting the cash flows. Every capital budgeting decision should therefore, consider this depreciation tax-shield i.e., reduction in tax liability as a result of depreciation. The depreciation is added back to the figure of profit after taxes to arrive at the cash inflows from the project. Similarly, any other non-cash expense which has already been deducted to arrive at the figure of profit after tax, is added back to ascertain the cash inflows even though they may not provide any tax benefit to the firm.

26. Treatment of depreciation and profit/ loss on sale/ Scrapping of an Asset The tax-effect of depreciation and scrap value may be incorporated in the capital budgeting evaluation procedure in any of the following two ways : 1) Accounting Treatment: In accounting, an asset can be depreciated as per any of several methods of depreciation. The depreciation charge for a particular year is deducted from the opening written down value of the asset to get the closing written down value. The depreciation is provided for the entire period for which the asset has been used. At the time of scrapping of an assets, its salvage value is compared with the written down value till date. The difference between the two i.e., capital gain (when salvage value is more than the written down value) or the capital loss (when the salvage value is less than the written down value) is adjusted in the income of the year in which the asset is discarded.

27. 2) Treatment under the Income-tax Act, 1961 The taxable income of an assessee in India is calculated as per the provisions contained in the Income-tax Act, 1961. The relevant pThe treatment under the Income-tax Act may be summarised as follows : Block of Assets : The provisions of the Act introduces the concept of block of assets. The block of assets means a group of assets falling within a class of assets being buildings, machinery, furniture etc., in respect of which the same rate of depreciation is admissible. Depreciation is allowed on the basis of block of assets. A block of assets may consist of one asset or several assets.rovisions are given in Sections 32 and 43 of the Act.

28. Block consisting of one asset only : If there is only one asset in a particular block of assets then the following provisions are worth noting : (a) In the terminal year (i.e., the year in which the asset is discarded/sold or scrapped away), no depreciation is allowed. (b) The selling price/scrap value will be compared with the written down value. The difference between the two is treated as short term capital gain or loss and is treated as ordinary income/loss. Block consisting of more than one asset : In case, there are more than one asset in a block, the following provisions are worth noting : ( i ) When a new asset is purchased and is added to the existing block of asset, the cost of new asset is added to the opening written down value of the block and depre ciation for that year is provided on the total value. (ii) If at the time of acquisition of new asset or even other wise, any part of the block is sold or scrapped away, then the scrap value ( realised from sale) is deducted from the opening written down value. The depreciation for the year is provided on the net balance only. For example, if the opening written down balance of a block of asset is 10,00,000. During the year, assets costing 7,50,000 are added to the block. The depreciation for the year will be provided on 17,50,000. However, if a part of this block is sold away for 3,50,000 (irrespective of the WDV), the depreciation for the year would be provided on 14,00,000 only. (iii) There will not be any capital gain/loss on sale of asset unless the entire block of asset is scrapped away. In such a case, the difference between the written down value and the scrap value will be the short term capital gain/ loss and treated accordingly.

29. Capital budgeting decision process involves three steps ( i ) estimation of cost and benefits of a proposal, (ii) estimation of required rate of return, and (iii) evaluation of different proposals in order to select one.

30. The finance manager at this stage is faced with the questions like ‘Is the proposal worthwhile’ ? ‘Should it be accepted’ ? ‘Is it going to be beneficial for the firm’ ? And many others. Any attempt by a finance manager to answer these question must be made in the light of the objective of maximization of shareholders wealth

31. Following are some of the features which a capital budgeting evaluation technique should possess : 1. The criterion must be able to incorporate all the cash flows associated with the proposal. 2. It should also incorporate the time value of money i.e., the cash flows arising at different point of time must be differentiated in respect of their worth to the firm. 3. It should be capable of ranking different proposals in order of their worth to the firm. 4. It should be objective and unambiguous in its approach. There should not be any scope for subjectivity of the decision maker. 5. The last but not the least, the technique must be in line with the objective of maximization of shareholders wealth .

32. The attractiveness of any investment proposal depends on the following elements ( i ) the amount expended i.e., the net investment, (ii) the potential benefits i.e., the operating cash inflows, and (iii) the time period over which these benefits will accrue i.e., economic life of the project.

33. Capital budgeting techniques Capital budgeting techniques can be broadly categorized into two main groups: Traditional (non-discounted) techniques and Discounted cash flow (DCF) techniques.

34. Traditional (Non-discounted) Techniques Traditional capital budgeting techniques do not take into account the time value of money. They focus solely on the cash flows associated with the investment project, without discounting them back to their present value. The main traditional techniques include: a. Payback Period: Payback period calculates the time required for the project to recoup its initial investment. It measures the time it takes for the cumulative cash inflows to equal the initial cash outlay. Projects with shorter payback periods are generally preferred as they recover the initial investment more quickly. b. Accounting Rate of Return (ARR): ARR calculates the average accounting profit generated by the project as a percentage of the initial investment. It compares the average annual profit to the average investment over the project's life. Projects with higher ARR are typically considered more desirable.

35. Discounted Cash Flow (DCF) Techniques: DCF techniques take into account the time value of money by discounting future cash flows back to their present value. These techniques provide a more accurate measure of the profitability and value of an investment project. The main DCF techniques include: a. Net Present Value (NPV): NPV calculates the present value of all cash inflows and outflows associated with the project, discounted at the project's cost of capital (or required rate of return). A positive NPV indicates that the project is expected to generate value and increase shareholder wealth. Projects with higher NPVs are generally preferred. b. Internal Rate of Return (IRR): IRR is the discount rate at which the NPV of the project equals zero. It represents the project's expected rate of return, and it measures the profitability of the investment. Projects with higher IRRs are typically more desirable, as they offer higher returns relative to their cost of capital. c. Profitability Index (PI): PI calculates the ratio of the present value of cash inflows to the present value of cash outflows. It measures the value created per unit of investment. Projects with PI greater than 1 are considered acceptable, as they generate positive value for every unit of investment.

36. Payback Period The payback period is defined as the number of years re quired for the proposal’s cumulative cash inflows to be equal to its cash outflows. In other words, the payback period is the length of time required to recover the initial cost of the project. The payback period therefore, can be looked upon as the length of time required for a proposal to ‘break even’ on its net investment. Computation of the Payback Period : The payback period can be calculated in two different situations : (a) When annual inflows are equal : When the cash inflows being generated by a proposal are equal per time period i.e., the cash inflows are in the form of an annuity, the payback period can be computed by dividing the cash outflow by the amount of annuity. For example, a pro posal requires a cash outflow of 1,00,000 and is expected to generate cash inflows of 20,000 p.a. for 6 years. In this case, the payback period is 5 years i.e., 1,00,000/ 20,000. The initial cash outflow of 1,00,000 will be fully recov ered within a period of 5 years and the cash inflows occurring thereafter (i.e., in the 6th year) are ignored

37. (b) When the annual cash inflows are unequal: In case the cash inflows from the proposal are not in annuity form then the cumulative cash inflows are used to compute the payback period. For example, a proposal requires a cash outflow of 20,000 and is expected to generate cash inflows of 8,000, 6,000, 4,000, 2,000 and 2,000 over next 5 years respectively. The payback period is 4 years because the sum of cash inflows of first 4 years is 20,000 (i.e., 8,000 + 6,000 + 4,000 + 2,000).

38. The Decision Rule : The payback period calculated for a proposal is to be compared with some predetermined target period. If the payback period is more than the target period, then the proposal should be rejected, otherwise it may be accepted. Critical Evaluation : Out of all the available capital budgeting technique (some of which are discussed later), the payback period is the easiest to understand and apply. The payback period measures the direct relationship between annual cash inflows from a proposal and the net investment required. This technique has been a popular method of evaluation of capital budgeting proposals merely because of its simplicity.

39. Advantages of Payback Method : 1. The payback period is simple and easy, in concept as well as in its applications. In particular, it can be adopted by a small firm having limited man-power which does not have any special skill to apply other sophisticated techniques. 2. It gives an indication of liquidity. In case a firm is having liquidity problems, then the payback period is a good method to adopt as it emphasizes the earlier cash inflows. 3. In a broader sense, the payback period deals with the risk also. The project with a shorter payback period will be less risky as compared to project with a longer payback pe riod , as the cash inflows which arise further in the future will be less certain and hence more risky. So, the payback period helps in weeding out the risky proposals by assign ing lower priority.

40. Disadvantages of Payback Method : 1. The payback period entirely ignores many of the cash inflows which occur after the payback period. It ignores what happens after the initial investment is recouped. 2. It ignores the timing of the occurrence of the cash flows. It considers the cash flows occurring at different point of time as equal in money worth and ignores the time value of money. 3. The payback period also ignores the salvage value and the total economic life of the project. A project which has substantial salvage value may be ignored (though more profitable it may be otherwise) in favour of a project with higher inflows in earlier years. It is insensitive to the economic life span. 4. The payback period is more a method of capital recovery rather than a measure of profitability of a project. To recover the capital is not enough, of course, because from an economic view point one would hope to earn a profit on the funds while they are invested. 5. The payback period is designed to cover the conventional projects that involve large up-front investment followed by positive operating cash inflows. It breaks down, how ever, when the investment is spread over time or where there is no initial investment.

41. Suitability of Payback Method : Despite the shortcomings, the payback period method may be an appropriate method under certain circumstances. For example, in a politically unstable country, the firm may have a primary consideration of recovering the initial cost at the earliest opportunity and thus the payback period may be a suitable technique. Further, the payback period may be suitable if the firm has limited funds available and has no ability or willingness to raise additional funds. In such a case, the firm may wish to under take those projects which ensure early liquidity/recovery to undertake some other projects.

42. ARR The ARR is based on the accounting concept of return on investment or rate of return. The ARR may be defined as the annualized net income earned on the average funds invested in a project. In other words, the annual return of a project is expressed as a percentage of computation of ARR: Symbolically, Average Annual Profit (after tax) ARR / Average Investment in the Project × 100 This clearly shows that the ARR is a measure based on the accounting profit rather than the cash flows and is very similar to the measure of rate of return on capital employed, which is generally used to measure the over all profitability of the firm. The calculation of ARR may be further discussed with reference to equal annual profits and unequal annual profits as follows

43. Equal Profits : In case the expected profits (after tax) generat ed by a project are equal for all the years than the annual profit itself is the average profit. So, this annual profit will be compared with the average investment to find out the ARR as follows : Unequal Profits : If the project is expected to generate unequal profits or uneven stream of profits over different years , then the ARR may be calculated by finding out the average annual profits (by taking the simple arithmetic mean of profits of different years) and then comparing it with the average investment of the project as follows :

44. What is this average investment and how is it to be calculated ? The average investment refers to the average quantum of funds that remains invested or blocked in the proposal over its economic life. The average investment of a proposal is affected by the method of depreciation, salvage value and the additional working capital required by the proposal. The following two approaches are available to calculate the average investment. ( i ) Initial cash outlay as average investment : In this case, the original cost of investment and the installation expenses if any, is taken as the amount invested in the project. For example, a project costing 10,00,000 is expected to generate after tax profit of 1,50,000 every year. The ARR for the proposal would be 15% (i.e. 1,50,000/ 10,00,000 × 100).

45. (ii) Average annual book value after depreciation as aver age investment : In this case, the average annual book value (after depreciation) of the proposal is taken as the average investment of the proposal. The following proce dure may be adopted for this. First, find out the opening book values and the closing book values of the project for all the years of its economic life. The difference in the opening and closing values for a particular year will depend upon the amount of depreciation for that year. Second, find out the average book values for all the years by taking the simple arithmetic mean of the opening and closing book values. Third, find out the average of all the yearly averages. This average will be the average investment of the proposal.

46. Short-cut method to find out the average investment: If the firm provides depreciation as per straight line method then the amount of depreciation for all the year would be same and is equal to (initial cost + installation expenses – salvage value)/number of years. This amount of depreciation will be deducted from the opening book values to find out the closing book values for different years. The average of these opening and closing book values will also decrease gradually every year by the amount of annual depreciation. In such a case, the average investment of the proposal over its economic life can now be calculated as: Average investment = ½(Initial Cost + Installation Ex penses – Salvage value) + Salvage value

47. For example, ABC Ltd. takes a project costing 1,20,000 with expected life of 5-years and the salvage value of 20,000. The average investment of the proposal is Average investment = ½(1,20,000 – 20,000) + 20,000 = 70,000.

48. Additional Working Capital: this additional working capital entails the investment of funds of the firm and should also be added to the average investment calculated as above. The average investment in any proposal (required to find out the ARR) may therefore, be calculated as follows : Average investment = ½(Initial Cost + Installation Expenses – Salvage value) + Salvage value + Additional Working Capital

49. The Decision Rule : The ARR calculated as above is compared with the pre-specified rate of return. Obviously, if the ARR is more than the pre-specified rate of return, then the project is likely to be accepted, otherwise not

50. The Critical Evaluation : The ARR is relatively simple to calculate and easy to apply. The relevant data and information required for its calculation is readily available in the accounting records. limitations and drawbacks when used as a technique of project evaluation as follows : 1. It ignores the time value of money and considers the profit earned in the 1st year as equal to the profits earned in later years. 2. The ARR is based on the accounting profits rather than the cash flows. It has already been noted in the previous chapter that accounting profits are affected by different accounting policies. A sound evaluation technique should be based on the cash flows rather than the accounting profits. 3. The ARR also ignores the life of the proposal . A proposal with a longer life may have the same ARR as another proposal with a shorter life has. On the basis of ARR, both the proposals may be placed at par, but the proposal with a longer life should be preferred over the proposal with a shorter life (as the former proposal will generate the returns for a longer period). 4. The ARR technique also ignores the salvage value of the proposal. In real sense, the salvage value is also a return from the proposal and should be considered. 5. The ARR also fails to recognize the size of the investment required for the project . Particularly, in case of mutually exclusive proposals, the two projects having significantly different initial costs, may have same ARR.

51. Discounted cash flow techniques, There are two basic discounted cash flow techniques to evaluate capital budgeting proposals. These are the Net Present Value method and the Internal Rate of Return method. However, there are several variants known as the Profitability Index, the Modified IRR and Discounted Payback Period.

52. NPV The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with a proposal. In case, the cash outflows i.e. the investment in the proposal occur only in the beginning at time 0, then NPV may be defined as the sum of the present values of cash inflows less the initial investment. Calculation of NPV : On the basis of the definition of the NPV, it may be defined as : NPV = Excess of PV of Inflows over PV of Outflows = PV of Cash Inflows – PV of Outflows CF1 = NPV = + (1 + k)1 CF2 + (1 + k)2 n ∑ i =0 i i CF (1+k) where, NPV = Net Present Value, CFn (1 + k)n– CF0

53. The Decision Rule: ( i ) ‘Accept the proposal if its NPV is positive and reject the proposal if the NPV is negative’. The proposals with negative NPV should outrightly be rejected as these entail decrease in the wealth of the shareholders. (ii) In case of Accept-Reject situation, all proposals which have positive NPV are qualified for being accepted. (iii) In case of ranking of mutually exclusive proposals, the proposal with the highest positive NPV is given the top priority and the proposal with the lowest positive NPV is assigned the lowest priority. (iv) However, if the NPV is the proposal is 0, than the firm may be indifferent between acceptance and rejection of the proposal.

54. Machine A costs 1,00,000 payable immediately. Machine B costs 1,20,000 half payable immediately and half payable in one year’s time. The cash receipts expected are as follows: Year (at end) Machine A Machine B 1 20,000 — 2 60,000 60,000 3 40,000 60,000 4 30,000 80,000 5 20,000 — At 7% opportunity cost, which machine should be selected on the basis of NPV?

55. A company is considering which of two mutually exclusive projects it should undertake. The finance director thinks that the project with higher NPV should be chosen as both projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10% and the net after tax cash flows of the project are as follows : ( ’000) Year 0 1 2 3 4 5 Project X–210 40 80 90 75 25 Project Y–210 222 10 10 6 6 Compute : ( i ) The NPV and PI of each project. (ii) State with reasons which project you would recommend. [ B.Com .(H), D.U. 2011]

56. The Critical Evaluation : The merits of the NPV technique can be enumerated as follows : 1. The first and the foremost merit of the NPV technique is that it recognizes the time value of money . It helps evaluation of proposals involving cash flows over a period of several years. 2. The NPV technique considers the entire cash flow stream and all the cash inflows and outflows, irrespective of the timing of their occurrence, are incorporated in the calculation of the NPV. 3. The NPV technique is based on the cash flows rather than the accounting profit and thus helps in analyzing the effect of the proposal on the wealth of the shareholders in a better way. 4. The discount rate, k, applied for discounting the future cash flows is in fact, the minimum required rate of return which incorporates both the pure return as well as the premium required to set off the risk . 5. The NPV technique represents the net contribution of a proposal towards the wealth of the firm and is therefore, in full conformity with the objective of maximization of the wealth of the shareholders.

57. The NPV technique has the following shortcomings. ( i ) It involves difficult calculations . Moreover, it may not be able to overcome the uncertainty involve with cash flows occurring after a sizeable time gap. It fails to answer questions such as : How to quantify the potential error inherent in the cash flow estimates, and how does the measure help making investment choices if such errors are significant ? (ii) The NPV technique requires the predetermination of the required rate of return , k, which itself is a difficult job. If the value of the ‘k’ is not correctly taken, then the whole exercise of the NPV may give wrong results, (iii)The NPV technique does not provide a measure of project’s own rate of return, rather it evaluates a proposal against an external variable i.e. the minimum required rate of return, (iv)The decision under the NPV technique is based on a value which is an absolute measure . It ignores the difference in initial outflows, size of different proposals etc . while evaluating mutually exclusive proposals.

58. Profitability Index PI is defined as the benefits (in present value terms) per rupee invested in the proposal. This technique which is a variant of the NPV technique, is also known as Benefit-cost ratio, or Present Value index. The PI is based upon the basic concept of discounting the future cash flows and is ascertained by comparing the present value of the future cash inflows with the present value of the future cash outflows. The PI is calculated by dividing the former by the latter. Calculation : The PI is calculated as follows : Total Present Value of Cash Inflows PI/ Total Present Value of Cash Outflows

59. The Decision Rule : Under the PI technique, the decision rule is : ‘Accept the project if its PI is more than 1 and reject the proposal if the PI is less than 1’. However, if the PI is equal to 1, then the firm may be indifferent because the present value of inflows is expected to be just equal to the present value of the outflows. In case of ranking of mutually exclusive proposals, the proposal with the highest positive PI will be given top priority while the proposal with the lowest PI will be assigned lowest priority. The proposals having PI of less than 1 are likely to be outrightly rejected.

60. NPV vs. PI — A comparison As far as, the accept-reject decision is concerned, both the NPV and the PI will give the same decision. The reasons for this are obvious. The PI will be greater than 1 only for that project which has a positive NPV, the project will be acceptable under both the techniques. On the other hand, if the PI is equal to 1 then the NPV would also be 0. Similarly, a proposal having PI of less than 1 will also have the negative NPV. However, a conflict between the NPV and the PI may arise in case of evaluation of mutually exclusive proposals.

61. Discounted Payback Period This method is a combination of the original payback method and the discounted cash flow technique. In this method, the cash flows of the project are discounted to find their present values The total present value of the cash inflows is then compared with the present value of the outflows, in order to identify the period taken to recover the initial cost or the present value of outflows.

62. Internal Rate of Return (IRR) The IRR of a proposal is defined as the discount rate which produces a zero NPV i.e., the IRR is the discount rate which will equate the present value of cash inflows with the present value of cash outflows. In the IRR technique, the time-schedule of occurrence of the future cash flows is known but the rate of discount is not. Rather this discount rate is ascertained by the trial and error procedure. Symbolically, page 90

63. The detailed proce dure for the calculation of IRR can be explained in two different situations i.e., ( i ) when future cash flows are equal and take a form of annuity, and (ii) when future cash flows are unequal.

64. Merits of IRR The IRR technique takes into account the time value of money and the cash flows occurring at different point of time are adjusted for time value of money to make them comparable, (ii) It is a profit oriented concept and helps selecting those proposals which are expected to earn more than the minimum required rate of return. As discussed in Chap ter 10, this minimum required rate of return is the cost of capital of the firm. So, the IRR technique helps achieving the objective of maximization of shareholders wealth. (iii) The IRR of a proposal is expressed as a percentage and is compared with the cut-off rate which is also expressed as a percentage. Thus, the IRR has an appeal for those who want to analyze a proposal in terms of its percentage return, (iv) Like NPV technique, the IRR technique is also based on the consideration of all the cash flows occurring at any time. The salvage value, the working capital used and released etc. are also considered, (v) The IRR technique is based on the cash flows rather than the accounting profit .

65. Demerits (a) As far as the calculation of IRR is concerned, it involves a tedious and complicated trial and error procedure. (b) IRR technique makes an implied assumption that the future cash inflows of a proposal are reinvested at a rate equal to the IRR. Say, in case of mutually exclusive proposals, say A and B, having IRR of 18% and 16%, the IRR technique makes an implied assumption that the future cash inflows of project A will be reinvested at 18%, while the cash inflows of project B will be reinvested at 16%. It is imaginary to think that the same firm will have different reinvestment opportunities depending upon the proposal accepted. (c) Since, the IRR is a scaled measure, it tends to be biased towards the smaller projects which are much more likely to yield high percentage returns over the larger projects. (d) There are a number of scenarios when, the IRR tech nique may give dubious results. The first occurs when there is more than one IRR for a project and it is not clear which one the decision maker should use and second, occurs when IRR cannot be computed or if computed, is likely to be meaningless. This may be explained as fol lows : ( i ) There is a mathematical possibility that a complex pro posal with varied cash inflows and outflows may result in two different IRR because of the pattern and timing of the inflows and outflows.

66. NPV versus IRR: The IRR approach solves for a rate unique to each project, while the NPV approach solves for the trade off cash inflows and outflows using a general required rate of return. On the basis of the above discussion of NPV and IRR, a comparison between the two may be attempted as follows: (a) Superiority of IRR over NPV : IRR may be considered superior to the NPV for the following reasons : ( i ) IRR gives percentage return while the NPV gives absolute return. (ii) For IRR, the availability of required rate of return is not a pre-requisite while for NPV it is must. (b) Superiority of NPV over IRR : The NPV is said to have superiority over IRR for ( i ) NPV shows expected increase in the wealth of the shareholders. (ii) NPV gives clear cut accept-reject decision rule, while the IRR may give multiple results also. (iii) The NPV of different projects are additive while the IRRs cannot be added. (iv) NPV gives better ranking as compared to the IRR

67. Technique Description Advantages Disadvantages Payback Period (PBP) Measures the time it takes to recover the initial investment of a project. - Simple to calculate. - Provides quick insight into project liquidity. - Ignores cash flows after the payback period. - Doesn't consider the time value of money. Discounted Payback Period (DPBP) Similar to PBP, but considers the time value of money by discounting future cash flows. - Addresses the limitations of PBP by incorporating time value. - May be complex to calculate for projects with uneven cash flows. - Doesn't provide information about overall project profitability. Net Present Value (NPV) Discounts all future cash flows of a project to their present value and subtracts the initial investment. A positive NPV indicates the project creates value. - Considers the time value of money and total project profitability. - Straightforward to compare projects of different sizes. - Requires an estimate of the discount rate, which can be subjective. - Ignores the project's payback period. Internal Rate of Return (IRR) The discount rate that makes the NPV of a project equal to zero. Represents the minimum acceptable rate of return for the project. - Considers the time value of money and project's inherent profitability. - Can have multiple IRRs for projects with uneven cash flows. - Doesn't provide information about the project's cash flow over time. Profitability Index (PI) Ratio of the project's NPV to the initial investment. A PI greater than 1 indicates the project creates value. - Provides a quick profitability assessment relative to the initial investment. - Shares limitations of NPV, including the need for a discount rate. - Doesn't consider the project's payback period or cash flow distribution. Modified Internal Rate of Return (MIRR) Similar to IRR, but considers the cost of capital (reinvestment rate) for the project's cash inflows. - Addresses a limitation of IRR by incorporating the cost of capital. - Shares limitations of IRR, including potential for multiple solutions. - Less commonly used than other techniques.