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MC 9215 - ACCOUNTING AND FINANCIAL MANAGEMENT

UNIT - IV - CHAPTER - III
CAPITAL BUDGETING
Meaning of Capital Budgeting
Capital expenditure budget or capital budgeting is a process oI making decisions regarding
investments in Iixed assets which are not meant Ior sale such as land, building, machinery or Iurniture.
The word investment reIers to the expenditure which is required to be made in connection with the
acquisition and the development oI long-term Iacilities including Iixed assets. It reIers to process by
which management selects those investment proposals which are worthwhile Ior investing available
Iunds. Eor this purpose, management is to decide whether or not to acquire, or add to or replace Iixed
assets in the light oI overall objectives oI the Iirm.
What is capital expenditure, is a very diIIicult question to answer. The terms capital expenditure are
associated with accounting. Normally capital expenditure is one which is intended to beneIit Iuture
period i.e., in more than one year as opposed to revenue expenditure, the beneIit oI which is supposed
to be exhausted within the year concerned.
Nature of Capital Budgeting
Nature oI capital budgeting can be explained in brieI as under
Capital expenditure plans involve a huge investment in Iixed assets.
Capital expenditure once approved represents long-term investment that cannot be reserved or
withdrawn without sustaining a loss.
Preparation oI coital budget plans involve Iorecasting oI several years proIits in advance in
order to judge the proIitability oI projects.
It may be asserted here that decision regarding capital investment should be taken very careIully so
that the Iuture plans oI the company are not aIIected adversely.
Procedure of Capital Budgeting
Capital investment decision oI the Iirm have a pervasive inIluence on the entire spectrum oI
entrepreneurial activities so the careIul consideration should be regarded to all aspects oI Iinancial
management.
In capital budgeting process, main points to be borne in mind how much money will be needed oI
implementing immediate plans, how much money is available Ior its completion and how are the
available Iunds going to be assigned tote various capital projects under consideration. The Iinancial
policy and risk policy oI the management should be clear in mind beIore proceeding to the capital
budgeting process. The Iollowing procedure may be adopted in preparing capital budget :-
(1) Organisation of Investment Proposal. The Iirst step in capital budgeting process is the
conception oI a proIit making idea. The proposals may come Irom rank and Iile worker oI any
department or Irom any line oIIicer. The department head collects all the investment proposals and
reviews them in the light oI Iinancial and risk policies oI the organisation in order to send them to the
capital expenditure planning committee Ior consideration.
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(2) Screening the Proposals. In large organisations, a capital expenditure planning committee is
established Ior the screening oI various proposals received by it Irom the heads oI various departments
and the line oIIicers oI the company. The committee screens the various proposals within the long-
range policy-Irame work oI the organisation. It is to be ascertained by the committee whether the
proposals are within the selection criterion oI the Iirm, or they do no lead to department imbalances or
they are proIitable.
(3) Evaluation of Projects. The next step in capital budgeting process is to evaluate the diIIerent
proposals in term oI the cost oI capital, the expected returns Irom alternative investment opportunities
and the liIe oI the assets with any oI the Iollowing evaluation techniques:-
Degree oI Urgency Method (Accounting Rate oI return Method)
Pay-back Method
Return on investment Method
Discounted Cash Elow Method.
(4) Establishing Priorities. AIter proper screening oI the proposals, uneconomic or unproIitable
proposals are dropped. The proIitable projects or in other words accepted projects are then put in
priority. It Iacilitates their acquisition or construction according to the sources available and avoids
unnecessary and costly delays and serious cot-overruns. Generally, priority is Iixed in the Iollowing
order.
Current and incomplete projects are given Iirst priority.
SaIety projects ad projects necessary to carry on the legislative requirements.
Projects oI maintaining the present eIIiciency oI the Iirm.
Projects Ior supplementing the income
Projects Ior the expansion oI new product.
(5) Final Approval. Proposals Iinally recommended by the committee are sent to the top management
along with the detailed report, both o the capital expenditure and oI sources oI Iunds to meet them.
The management aIIirms its Iinal seal to proposals taking in view the urgency, proIitability oI the
projects and the available Iinancial resources. Projects are then sent to the budget committee Ior
incorporating them in the capital budget.
(6) Evaluation. Last but not the least important step in the capital budgeting process is an evaluation
oI the programme aIter it has been Iully implemented. Budget proposals and the net investment in the
projects are compared periodically and on the basis oI such evaluation, the budget Iigures may be
reviewer and presented in a more realistic way.
Significance of Capital Budgeting
The key Iunction oI the Iinancial management is the selection oI the most proIitable assortment oI
capital investment and it is the most important area oI decision-making oI the Iinancial manger
because any action taken by the manger in this area aIIects the working and the proIitability oI the
Iirm Ior many years to come.
The need oI capital budgeting can be emphasised taking into consideration the very nature oI the
capital expenditure such as heavy investment in capital projects, long-term implications Ior the Iirm,
irreversible decisions and complicates oI the decision making. Its importance can be illustrated well on
the Iollowing other grounds:-
(1) Indirect Forecast of Sales. The investment in Iixed assets is related to Iuture sales oI the Iirm
during the liIe time oI the assets purchased. It shows the possibility oI expanding the production
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Iacilities to cover additional sales shown in the sales budget. Any Iailure to make the sales Iorecast
accurately would result in over investment or under investment in Iixed assets and any erroneous
Iorecast oI asset needs may lead the Iirm to serious economic results.
(2) Comparative Study of Alternative Projects Capital budgeting makes a comparative study oI the
alternative projects Ior the replacement oI assets which are wearing out or are in danger oI becoming
obsolete so as to make the best possible investment in the replacement oI assets. Eor this purpose, the
proIitability oI each projects is estimated.
(3) Timing of Assets-Acquisition. Proper capital budgeting leads to proper timing oI assets-
acquisition and improvement in quality oI assets purchased. It is due to ht nature oI demand and
supply oI capital goods. The demand oI capital goods does not arise until sales impinge on productive
capacity and such situation occur only intermittently. On the other hand, supply oI capital goods with
their availability is one oI the Iunctions oI capital budgeting.
(4) Cash Forecast. Capital investment requires substantial Iunds which can only be arranged by
making determined eIIorts to ensure their availability at the right time. Thus it Iacilitates cash Iorecast.
(5) Worth-Maximization of Shareholders. The impact oI long-term capital investment decisions is
Iar reaching. It protects the interests oI the shareholders and oI the enterprise because it avoids over-
investment and under-investment in Iixed assets. By selecting the most proIitable projects, the
management Iacilitates the wealth maximization oI equity share-holders.
(6) Other Factors. The Iollowing other Iactors can also be considered Ior its signiIicance:-
It assist in Iormulating a sound depreciation and assets replacement policy.
It may be useIul n considering methods oI coast reduction. A reduction campaign may
necessitate the consideration oI purchasing most up-todate and modern equipment.
The Ieasibility oI replacing manual work by machinery may be seen Irom the capital Iorecast
be comparing the manual cost an the capital cost.
The capital cost oI improving working conditions or saIety can be obtained through capital
expenditure Iorecasting.
It Iacilitates the management in making oI the long-term plans an assists in the Iormulation oI
general policy.
It studies the impact oI capital investment on the revenue expenditure oI the Iirm such as
depreciation, insure and there Iixed assets.
CAPITAL BUDGETING TECHNIQUES
In order to maximize the return to the shareholders oI a company, it is important that the best or most proIitable
investment projects are selected. Because the results Ior making a bad long-term investment decision can be
both Iinancially and strategically devastating, particular care needs to be taken with investment project selection
and evaluation. There are a number oI techniques available Ior appraisal oI investment proposals and can be
classiIied as presented below:
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Organizations may use any or more oI capital investment evaluation techniques; some
organizations use diIIerent methods Ior diIIerent types oI projects while others may use multiple methods Ior
evaluating each project. These techniques have been discussed below net present value, proIitability index,
internal rate oI return, modiIied internal rate oI return, payback period, and accounting (book) rate oI return.
1. Payback Period: The payback period oI an investment is the length oI time required Ior the cumulative total
net cash Ilows Irom the investment to equal the total initial cash outlays. At that point in time, the investor has
recovered the money invested in the project.
Steps:-
(a) The Iirst steps in calculating the payback period is determining the total initial capital investment and (b)
The second step is calculating/estimating the annual expected aIter-tax net cash Ilows over the useIul liIe oI the
investment.
1. When the net cash Ilows are uniIorm over the useIul liIe oI the project, the number oI years in the payback
period can be calculated using the Iollowing equation:
Payback period Annual expected aIter - tax net cash Ilow / Total initial capital
investment
2. When the annual expected aIter-tax net cash Ilows are not uniIorm, the cumulative cash inIlow Irom
operations must be calculated Ior each year by subtracting cash outlays Ior operations and taxes Irom cash
inIlows and summing the results until the total is equal to the initial capital investment. Eor the last year we
need to compute the Iraction oI the year that is needed to complete the total payback.
Modllled lnternal
8ate ol 8eturn
ulscounted ayback
lnternal 8ate ol 8eturn
rolltablllty lndex
net resent value
CAl1AL 8uuCL1lnC 1LCPnlCuLS
1radltlonal or non-ulscountlng
1echnlques
1lme-ad[usted or
ulscounted Cash llows
ayback erlod
Accountlng 8ate ol
8eturn
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Advantages:
(1) It is easy to calculate an simple to understand. It is an improvement over the criterion oI urgency.
(2) It is preIerred by executives who like snap answers Ior the selection oI the proposal.
(3) It is useIul where the Iirm is suIIering Irom cash deIiciency. The management may like to use pay-back
method to emphasis those proposals which produce an early return oI liquid Iunds. In other words,
it stresses the liquidity objective.
(4) Industries which are subject to uncertainty, instability or rapid technological charges may adopt the pay-
back method Ior a simple reason that the Iuture uncertainty does not permit projection oI annual cash inIlows
beyond a limited period. in this way, it reduces the possibility oI loss through obsolescence.
(5) It is a handy device Ior evaluating investment proposals, where precision in estimates oI proIitability is not
important.
Limitations:
(1) It completely ignores the annual cash inIlows aIter the pay-back period.
(2) The method considers only the period oI a pay back. It does not consider the pattern oI cash
inIlows, i.e., the magnitude and timing oI cash inIlows. Eor example, iI two projects involve
equal cash outlay and yield equal cash inIlows over equal time periods, it means both proposals
are equally good. But the proposal with larger cash inIlows in earlier years shall be preIerred
over the proposal which generated larger cash inIlows in later years.
(3) It overlooks the cost oI capital; i.e., interest Iactor which is a important consideration in
making sound investment decisions.
(4) The methods is delicate and rigid. A slight change in operation cost will aIIect the cash
inIlows and as such pay-back period shall also be aIIected.
(5) It over-emphasizes the importance oI liquidity as a goal oI capital expenditure decisions.
The proIitability oI t project is completely ignored. Undermining the importune oI proIitability
can in no way be justiIied.
Despite its weaknesses, the method is very popular in American and British industries Ior selecting
investment proposals.
2. Accounting (Book) Rate of Return Method: The accounting rate oI return oI an investment measures the
average annual net income oI the project (incremental income) as a percentage oI the investment.
Various proposals are ranked in order to rate oI earnings on the investment in the projects concerned. The
project which shows highest rate oI return is selected and others are ruled out.
The Accounting rate oI Return is Iound out by dividing the average income aIter taxed by the average
investment, i.e., average net value aIter depreciation. The accounting rate oI return, thus, is an average rate and
can be determined by the Iollowing equation.
Accounting Rate of Return (ARR) Average income / Average investment
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There are two variants oI the accounting rate oI return (a) Original Investment Method, and (b) Average
Investment Method.
(a) Original Investment Method. Under this method average annual earnings or proIits over the liIe oI the
project are divided by the total outlay oI capital project, i.e., the original investment. Thus ARR under this
method is the ratio between average annual proIits and original investment established. We can express the
ARR in the Iollowing way.
ARR Average annual profits over the life of the project / Original Investment
(b) Average Investment Method: Under average investment method, average annual earnings are divided by
the average amount oI investment. Average investment is calculated, by dividing the original investment by two
or by a Iigure representing the mid-point between the original outlay and the salvage oI the investment.
Generally accounting rate oI return method is represented by the average investment method.
Rate of return. Rate oI Return, as the term is used in our Ioregoing discussion, may be calculated by
taking (a) income beIore taxes and depreciation, (b) income beIore tax and aIter depreciation. (c) income beIore
depreciation an aIter tax, and (d) income aIter tax an depreciation, as the numerator. The use oI diIIerent
concepts oI income or earnings as well as oI investment is made. Original investment or average investment
will give diIIerent measures oI the accounting rate oI return.
Merits of Accounting Rate of Return Method
The Iollowing are the merits oI the accounting rate oI Return method
(1) It is very simple to understand and use.
(2) Rate oI return may readily be calculated with the help oI accounting data.
(3) They system gives due weight age to the proIitability oI the project iI based on average rate oI
Return. Projects having higher rate oI Return will be accepted and are comparable with the returns on
similar investment derived by other Iirm.
(4) It takes investments and the total earnings Irom the project during its liIe time.
Demerits of Rate of Return Method
The method suIIers Irom the Iollowing weaknesses
(1) It uses accounting proIits and not the cash-inIlows in appraising the projects.
(2) It ignores the time-value oI money which is an important Iactor in capital expenditure decisions.
ProIits occurring in diIIerent periods are valued equally.
(3) It considers only the rate oI return and not the length oI project lives.
(4) The method ignores the Iact that proIits can be reinvested.
(5) The method does not determine the Iair rate oI return on investment. It is leIt at the discretion oI the
management. So, use oI arbitrary rate oI return cause serious distortion in the selection oI capital
projects.
(6) The method has diIIerent variants, each oI which produces a diIIerent rate oI return Ior one proposal
due to the diverse version oI the concepts oI investment and earnings.
It is clear Irom the above discussion that the system is not much useIul except in evaluating the long-term
capital proposals.
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3. Net Present Value Technique: The net present value technique is a discounted cash Ilow method that
considers the time value oI money in evaluating capital investments. An investment has cash Ilows throughout
its liIe, and it is assumed that a rupee oI cash Ilow in the early years oI an investment is worth more than a rupee
oI cash Ilow in a later year. The net present value method uses a speciIied discount rate to bring all subsequent
net cash inIlows aIter the initial investment to their present values (the time oI the initial investment or year 0).
Determining Discount Rate
Theoretically, the discount rate or desired rate oI return on an investment is the rate oI return the Iirm would
have earned by investing the same Iunds in the best available alternative investment that has the same risk.
Determining the best alternative opportunity available is diIIicult in practical terms so rather than using the true
opportunity cost, organizations oIten use an alternative measure Ior the desired rate oI return.
An organization may establish a minimum rate oI return that all capital projects must meet; this minimum could
be based on an industry average or the cost oI other investment opportunities. Many organizations choose to use
the overall cost oI capital as the desired rate oI return; the cost oI capital is the cost that an organization has
incurred in raising Iunds or expects to incur in raising the Iunds needed Ior an investment.
The net present value oI a project is the amount, in current rupees, the investment earns aIter yielding the
desired rate oI return in each period.
Net present value Present value oI net cash Ilow - Total net initial investment
The steps to calculating net present value are:-
Determine the net cash inIlow in each year oI the investment
Select the desired rate oI return
Eind the discount Iactor Ior each year based on the desired rate oI return selected
Determine the present values oI the net cash Ilows by multiplying the cash Ilows by the discount Iactors
Total the amounts Ior all years in the liIe oI the project
Lastly subtract the total net initial investment.
Advantages
NPV method takes into account the time value oI money.
The whole stream oI cash Ilows is considered.

The criterion oI NPV is thus in conIormity with basic Iinancial objectives.

Ilows in terms oI current rupees. The
NPVs oI diIIerent projects thereIore can be compared. It implies that each project can be evaluated
independent oI others on its own merit.
Limitations
It involves diIIicult calculations.
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The application oI this method necessitates Iorecasting cash Ilows and the discount rate. Thus accuracy
oI NPV depends on accurate estimation oI these two Iactors which may be quite diIIicult in practice.
The ranking oI projects depends on the discount rate. The decision under NPV method is based on
absolute measure. It ignores the diIIerence in initial outIlows, size oI diIIerent proposals etc. while
evaluating mutually exclusive projects.
4. Desirability Factor/Profitability Index: In above NPV Technique we may have seen how with the help oI
iscounted cash Ilow technique, the two alternative proposals Ior capital expenditure can be compared. In certain
cases we have to compare a number oI proposals each involving diIIerent amounts oI cash inIlows.
One oI the methods oI comparing such proposals is to workout what is known as the Desirability Iactor`, or
ProIitability index`. In general terms a project is acceptable iI its proIitability index value is greater than 1.
Advantages
The method also uses the concept oI time value oI money and is a better project evaluation technique
than NPV.
Limitations
ProIitability index Iails as a guide in resolving capital rationing where projects are indivisible. Once a
single large project with high NPV is selected, possibility oI accepting several small projects which
together may have higher NPV than the single project is excluded. Also situations may arise where a
project with alower proIitability index selected may generate cash Ilows in such a way that another
project can be taken up one or two years later, the total NPV in such case being more than the one with
a project with highest ProIitability Index.
The ProIitability Index approach thus cannot be used indiscriminately but all other type oI alternatives
oI projects will have to be worked out.
5. Internal Rate of Return Method: The internal rate oI return method considers the time value oI money, the
initial cash investment, and all cash Ilows Irom the investment. But unlike the net present value method, the
internal rate oI return method does not use the desired rate oI return but estimates the discount rate that makes
the present value oI subsequent net cash Ilows equal to the initial investment. This discount rate is called as
IRR.
IRR Definition: Internal rate oI return Ior an investment proposal is the discount rate that equates the present
value oI the expected net cash Ilows with the initial cash outIlow. This IRR is then compared to a criterion rate
oI return that can be the organization`s desired rate oI return Ior evaluating capital investments.
Calculating IRR:
The procedures Ior computing the internal rate oI return vary with the pattern oI net cash Ilows over the useIul
liIe oI an investment.
Scenario 1: Eor an investment with uniIorm cash Ilows over its liIe, the Iollowing equation is used:
Step 1: Total initial investment Annual net cash Ilow x Annuity discount Iactor oI the discount rate Ior the
number oI periods oI the investment`s useIul liIe II A is the annuity discount Iactor, then
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A Annual (equal) net cash Ilows Irom the investment / Total initial cash disbursements and
commitments Ior the investment
Step 2: Once A has been calculated, the discount rate is the interest rate that has the same discount Iactor as A
in the annuity table along the row Ior the number oI periods oI the useIul liIe oI the investment. This computed
discount rate or the internal rate oI return will be compared to the criterion rate the organization has selected to
assess the investment`s
desirability.
Scenario 2: When the net cash Ilows are not uniIorm over the liIe oI the investment, the determination oI the
discount rate can involve trial and error and interpolation between interest rates. It should be noted that there are
several spreadsheet programs available Ior computing both net present value and internal rate oI return that
Iacilitate the capital budgeting process.
Advantages
(i) This method makes use oI the concept oI time value oI money.
(ii) All the cash Ilows in the project are considered.
(iii) IRR is easier to use as instantaneous understanding oI desirability can be determined by comparing it with
the cost oI capital.
(iv) IRR technique helps in achieving the objective oI minimization oI shareholders wealth.
Limitations
(i) The calculation process is tedious iI there are more than one cash outIlows interspersed between the cash
inIlows, there can be multiple IRRs, the interpretation oI which is diIIicult.
(ii) The IRR approach creates a peculiar situation iI we compare two projects with diIIerent inIlow/outIlow
patterns.
(iii) It is assumed that under this method all the Iuture cash inIlows oI a proposal are reinvested at a rate equal
to the IRR. It is ridiculous to imagine that the same Iirm has a ability to reinvest the cash Ilows at a rate equal to
IRR.
(iv) II mutually exclusive projects are considered as investment options which have considerably diIIerent cash
outlays. A project with a larger Iund commitment but lower IRR contributes more in terms oI absolute NPV and
increases the shareholders` wealth. In such situation decisions based only on IRR criterion may not be correct.
6. Modified Internal Rate of Return (MIRR): As mentioned earlier, there are several limitations attached
with the concept oI the conventional Internal Rate oI Return. The MIRR addresses some oI these deIiciencies
e.g, it eliminates multiple IRR rates; it addresses the reinvestment rate issue and produces results which are
consistent with the Net Present
Value method. Under this method , all cash Ilows , apart Irom the initial investment , are brought to the terminal
value using an appropriate discount rate(usually the Cost oI Capital). This results in a single stream oI cash
inIlow in the terminal year. The MIRR is obtained by assuming a single outIlow in the zeroth year and the
terminal cash inIlow as mentioned above. The discount rate which equates the present value oI the terminal
cash in Ilow to the zeroth year outIlow is called the MIRR.
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7. Discounted Pay back period Method : Some accountants preIers to calculate payback period aIter
discounting the cash Ilow by a predetermined rate and the payback period so calculated is called, Discounted
payback period`. One oI the most popular economic criteria Ior evaluating capital projects also is the payback
period. Payback period is the time required Ior cumulative cash inIlows to recover the cash outIlows oI the
project.
Eor example, a Rs. 30,000 cash outlay Ior a project with annual cash inIlows oI Rs. 6,000 would have a
payback oI 5 years ( Rs. 30,000 / Rs. 6,000).
The problem with the Payback Period is that it ignores the time value oI money. In order to correct this, we can
use discounted cash Ilows in calculating the payback period. ReIerring back to our example, iI we discount the
cash inIlows at 15 required rate oI return we have:
Year 1 - Rs. 6,000 x 0.870 Rs. 5,220 Year 6 - Rs. 6,000 x 0.432 Rs. 2,592
Year 2 - Rs. 6,000 x 0.756 Rs. 4,536 Year 7 - Rs. 6,000 x 0.376 Rs. 2,256
Year 3 - Rs. 6,000 x 0.658 Rs. 3,948 Year 8 - Rs. 6,000 x 0.327 Rs. 1,962
Year 4 - Rs. 6,000 x 0.572 Rs. 3,432 Year 9 - Rs. 6,000 x 0.284 Rs. 1,704
Year 5 - Rs. 6,000 x 0.497 Rs. 2,982 Year 10 - Rs. 6,000 x 0.247 Rs. 1,482
The cumulative total oI discounted cash Ilows aIter ten years is Rs. 30,114. ThereIore, our discounted payback
is approximately 10 years as opposed to 5 years under simple payback. It should be noted that as the required
rate oI return increases, the distortion between simple payback and discounted payback grows. Discounted
Payback is more appropriate way oI measuring the payback period since it considers the time value oI money.
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TIME VALUE OF MONEY
The time value of money is the value oI money Iiguring in a given amount oI interest earned over a
given amount oI time. The time value oI money is the central concept in finance theory.
Time value oI money is a Iundamental Iinancial principle that asserts that money now is worth more
than money received in the Iuture. This is due to the potential earning power oI money held in the
present. The Iurther into the Iuture cash is to be received, the less it is worth today. Eor example, $100
invested today at a 7 interest rate will be worth $107 in one year. However, given the same 7 rate,
$100 received in one year is worth only $93.46 today (calculated by dividing $100 by 1.07).
Eor example, $100 oI today's money invested Ior one year and earning 5 interest will be worth $105
aIter one year. ThereIore, $100 paid now or $105 paid exactly one year Irom now both have the same
value to the recipient who assumes 5 interest; using time value of money terminology, $100
invested Ior one year at 5 interest has a future value oI $105.
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