Study Note - 7

CAPITAL BUDGETING

This Study Note includes

7.1 Capital Budgeting
7.2 Need of Capital Budgeting Decision
7.3 Significance of Capital Budgeting Decision
7.4 Process of Capital Budgeting
7.5 Investment Criterian - Method of Appraisal

7.1 CAPITAL BUDGETING

One of the important aspects of Financial Management is proper decision making in respect of investment
of funds. Successful operation of any business depends upon the investment of resources in such a way
as to bring in benefits or best possible returns from any investment. An investment can be simply defined
as an expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying
a net inflow of cash or its equivalent in some future time period or periods. An appraisal of investment
proposals is necessary to ensure that the investment of resources will bring in desired benefits in future. If
the financial resources were in abundance, it would be possible to accept several investment proposals
which satisfy the norms of approval or acceptability. Since resources are limited a choice has to be
made among the various investment proposals by evaluating their comparative merit. It is apparent that
some techniques should be followed for making appraisal of investment proposals. Capital Budgeting
is one of the appraising techniques of investment decisions. Capital Budgeting is defined as the firm’s
decision to invest its current funds most efficiently in long term activities in anticipation of an expected
flow of future benefits over a series of years. It should be remembered that the investment proposal is
common both for fixed assets and current assets.
Capital budgeting decision may be defined as “Firms decisions to invest its current funds most efficiently
in long term activities in anticipation of an expected flow of future benefits over a series of year. The
firm’s capital budgeting decisions will include addition, disposition, modification and replacement of
fixed assets”.
Definitions: Charles. T.Horngreen defined capital budgeting as “Long term planning for making and
financing proposed capital out lay”.
According to Keller and Ferrara, “Capital Budgeting represents the plans for the appropriation and
expenditure for fixed asset during the budget period”.
Robert N. Anthony defined as “Capital Budget is essentially a list of what management believes to be
worthwhile projects for the acquisition of new capital assets together with the estimated cost of each
product”.

7.2 NEED OF CAPITAL BUDGETING DECISION

The selection of the most profitable project of capital investment is the key function of Financial Manager.
The decisions taken by the management in this area affect the operations of the firm for many years.
Capital budgeting decisions may be generally needed for the following purposes:

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Capital Budgeting

a) Expansion; b) Replacement; c) Diversification; d) Buy or lease and e) Research and Development.

a) Expansion: The firm requires additional funds to invest in fixed assets when it intends to expand the
production facilities in view of the increase in demand for their product in near future. Accordingly
the current assets will increase. In case of expansion the existing infrastructure – like plant, machinery
and other fixed assets is inadequate, to carry out the increased production volume. Thus the firm
needs funds for such project. This will include not only expenditure on fixed assets (infrastructure)
but also an increase in working capital (current assets).
b) Replacement: The machines and equipment used in production may either wear out or may be
rendered obsolet due to new technology. The productive capacity and competitive ability of the
firm may be adversely affected. The firm needs funds or modernisation of a certain machines or
for renovation of the entire plant etc., to make them more efficient and productive. Modernization
and renovation will be a substitute for total replacement, where renovation or modernization is not
desirable or feasible, funds will be needed for replacement.
c) Diversification: If the management of the firm decided to diversify its production into other lines
by adding a new line to its original line, the process of diversification would require large funds for
long-term investment. For example ITC and Philips company for their diversification.
d) Buy or Lease: This is a most important decision area in Financial Management whether the firm
acquire the desired equipment and building on lease or buy it”. If the asset is acquired on lease,
there have to be made a series of annual or monthly rental payments. If the asset is purchased,
there will be a large initial commitment of funds, but not further payments. The decision – making
area is which course of action will be better to follow? The costs and benefits of the two alternative
methods should be matched and compared to arrive at a conclusion.
e) Research and Development: The existing production and operations can be improved by the
application of new and more sophisticated production and operations management techniques.
New technology can be borrowed or developed in the laboratories. There is a greater need of
funds for continuous research and development of new technology for future benefits or returns
from such investments.

7.3 SIGNIFICANCE OF CAPITAL BUDGETING DECISIONS

Capital Budgeting decisions are considered important for a variety of reasons. Some of them are the
following:
1) Crucial decisions: Capital budgeting decisions are crucial, affecting all the departments of the
firm. So the capital budgeting decisions should be taken very carefully.
2) Long-run decisions: The implications of capital budgeting decisions extend to a longer period in
the future. The consequences of a wrong decision will be disastrous for the survival of the firm.
3) Large amount of funds: Capital budgeting decisions involve spending large amount of funds. As such
proper care should be exercised to see that these funds are invested in productive purchases.
4) Rigid: Capital budgeting decision can not be altered easily to suit the purpose. Because of this
reason, when once funds are committed in a project, they are to be coutinued till the end, loss or
profit no matter.

7.4 PROCESS OF CAPITAL BUDGETING

The major steps in the capital budgeting process are given below. They are a) Generation of project;
b) Evaluation of the project; c) Selection of the project and d) Execution of the project. The capital
budgeting process may include a few more steps. As each step is significant they are usually taken by
top management.

7.2 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

 PROCESS OF CAPITAL BUDGETING

Generation of Evaluation of the Selection of the Execution of the

Project project project project

Estimation of cash flows: Selection of evaluation technique

Cash outflows Cash inflows

Traditional methods Discounting Cash

With certainty Uncertainty flow methods

Risk Return

Trade off

Increase the market value of the share

a) Generation of Project: Depending upon the nature of the firm, investment proposals can emanate
from a variety of sources. Projects may be classified into five categories.
(i) New products or expansion of existing products.
(ii) Replacement of equipment or buildings.
(iii) Research and development.
(iv) Exploration.
(v) Others like acquisition of a pollution control device etc.
Investment proposals should be generated for the productive employment of firm’s funds. However,
a systematic procedure must be evolved for generating profitable proposals to keep the firm
healthy.
b) Evaluation of the project: The evaluation of the project may be done in two steps. First the costs
and benefits of the project are estimated in terms of cash flows and secondly the desirability of
the project is judged by an appropriate criterion. It is important that the project must be evaluated
without any prejudice on the part of the individual. While selecting a criterion to judge the desirability
of the project, due consideration must be given to the market value of the firm.

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Capital Budgeting

c) Selection of the project: After evaluation of the project, the project with highest return should
be selected. There is no hard and fast rule set for the purpose of selecting a project from many
alternative projects. Normally the projects are screened at various levels. However, the final selection
of the project vests with the top level management.
d) Execution of project: After selection of a project, the next step in capital budgeting process is to
implement the project. Thus the funds are appropriated for capital expenditures. The funds are spent
in accordance with appropriations made in the capital budget funds for the purpose of project
execution should be spent only after seeking format permission for the controller. The follow – up
comparison of actual performance with original estimates ensure better control.
Thus the top management should follow the above procedure before taking acaital expenditure
decision.

7.5 INVESTMENT CRITERION-METHODS OF APPRAISAL

The capital budgeting appraisal methods or techniques for evaluation of investment proposals will help
the company to decide the desirability of an investment proposal, depending upon their relative income
generating capacity and rank them in order if their desirability. These methods provide the company a
set of normal method should enable to measure the real worth of the investment proposal. The appraisal
methods should posses several good characteristics, which are mentioned as under.
Characteristics of a Sound Appraisal Method
(i) It should help the company to rank the investment proposals in order of their desirability.
(ii) It should provide a technique for distinguishing between an acceptable and non-acceptable
project.
(iii) It should provide a criteria to solve the problem of choosing among alternative projects.
(iv) It should recognize the importance of time value of money i.e. bigger benefits are preferable to
smaller ones and early benefits are preferable to later benefits.
(v) It should provide the criteria for the selection of investment proposals.
(vi) It should take into account the pattern of cash flows.
APPRAISAL METHODS

Traditional
Traditional TimeAdjusted
Time Adjustedoror
methods
Method Discounted Cash
Discounted cash
flow Techniques
flow Techniques

1.
1. Net
Net Present Value Method
Present Value Method
1. Pay
1. Pay back
Back period
Period 2.
2. Profitability IndexMethod
Profitability Index method
2. Accounting
2. Accounting or Average
of Average 3.
3. Internal Rate
rate of ofreturn
Return
Rate of Return
rate of return 4.
4. Modified InternalRate
Modified Internal rate of
of return
Return
5.
5. Discounted pay
Discounted Pay back
Backperiod
Period

7.4 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

7.5.1 Traditional Methods
These methods are based on the principles to determine the desirability of an investment project on the
basis of its useful life and expected returns. These methods depend upon the accounting information
available from the books of accounts of the company. These will not take into account the concept
of ‘time value of money’ which is a signification factors to desirability of a project in terms of present
value.
1. Pay-back Period
It is the most popular and widely recognized traditional methods of evaluating the investment proposals. It
can be defined as “the number of years to recover the original capital invested in a project”. According
to Weston and Brigham, “the pay back period is the number of years it takes for the firm to recover its
original investment by net returns before depreciation, but after taxes:
a) When cash flows are uniform: If the proposed project’s cash inflows are uniform the following formula
can be used to calculate the payback period.
Initial Investment
Payback period =
Annual Cash inflows
b) When cash flows are not uniform
When the project’s cash inflows are not uniform, but vary from year to year pay back period is calculated
by the process of cumulating cash inflows till the time when cumulative cash flows become equal to
the original investment outlay.
The payback period can be used as an accept or reject criterion as well as a method of ranking projects.
The payback period is the number of years to recover the investment made in a project. If the payback
period calculated for a project is less than the maximum payback period set-up by the company, it can
be accepted. As a ranking method it gives the highest rank to a project which has the lowest payback
period, and the lowest rank to a project with the highest payback period. Whenever a company faces
the problem of choosing among two or more mutually exclusive projects, it can select a project on the
basis of payback period, which has shorter period than the other projects.
Merits: The following are the merits of the pay back period method:
(i) Easy to calculate: It is one of the easiest methods of evaluating the investment projects. It is simple
to understand and easy to compute.
(ii) Knowledge: The knowledge of payback period is useful in decision-making, the shorter the period
better the project.
(iii) Protection from loss due to obsolescence: This method is very suitable to such industries where
mechanical and technical changes are routine practice and hence, shorter payback period
practice avoids such losses.
(iv) Easily availability of information: It can be computed on the basis of accounting information, what
is available from the books.
Demerits: However, the payback period method has certain demerits:
(i) Failure in taking cash flows after payback period: This methods is not taking into account the cash
flows received by the company after the payback period.
(i) Not considering the time value of money: It does not take into account the time value of money.
(iii) Non-considering of interest factor: It does not take into account the interest factor involved in the
capital outlay.
(iv) Maximisation of market value not possible: It is not consistent with the objective of maximizing the
market value of share.

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Capital Budgeting

(v) Failure in taking magnitude and timing of cash inflows: It fails to consider the pattern of cash inflows
i.e. the magnitude and timing of cash inflows.
2. Accounting or Average Rate of Return (ARR)
This technique uses the accounting information revealed by the financial statements to measure the
profitability of an investment proposal. It can be determined by dividing the average income after taxes
by the average investment. According to Soloman, Accounting Rate of Return can be calculated as
the ratio, of average net income to the initial investment.
On the basis of this method, the company can select all those projects whose ARR is higher than the
minimum rate established by the company. It can reject the projects with an ARR lower than the expected
rate of return. This method also helps the management to rank the proposal on the basis of ARR.
Average Net Income
Accounting Rate of Return (ARR) =
Original Investment
OR
Average Net Income
Accounting Rate of Return (ARR) =
Average Investment
Acceptance Rule:
The project which gives the highest rate of return over the minimum required rate of return is
acceptable
Merits: The following are the merits of ARR method:
(i) It is very simple to understand and calculate;
(ii) It can be readily computed with the help of the available accounting data;
(iii) It uses the entire stream of earnings to calculate the ARR.
Demerits: This method has the following demerits:
(i) It is not based on cash flows generated by a project;
(ii) This method does not consider the objective of wealth maximization;
(iii) It ignore the length of the projects useful life;
(iv) If does not take into account the fact that the profile can be re-invested; and
(v) It ignores the time value of money.
7.5.2 Discounted Cash Flow Techniques:
The discounted cash flow methods provide a more objective basis for evaluating and selecting an
investment project. These methods consider the magnitude and timing of cash flows in each period
of a project’s life. Discounted Cash Flows methods enable us to isolate the differences in the timing of
cash flows of the project by discounting them to know the present value. The present value can be
analyses to determine the desirability of the project. These techniques adjust the cash flows over the
life of a project for the time value of money.
The popular discounted cash flows techniques are:
(a) Net Present Value
(b) Internal Rate of Return, and
(c) Profitability Index
Time Value of Money:
The value of money received today is more than the value of money received after some time in the
future due to the following reasons:
7.6 I COST ACCOUNTING AND FINANCIAL MANAGEMENT
(i) Inflation: Under inflationary conditions the value of money expressed in terms of its purchasing
power over goods and services declines.
(ii) Risk: Having one rupee now is certain where as one rupee receivable tomorrow is less certain. That
is a bird-in-the-hand principle is most important in the investment decisions.
(iii) Personal Consumption Preference: Many individuals have a strong preference for immediate rather
than delayed consumption. The promise of a bowl of rice next week counts for little to the starving
man.
(iv) Investment Opportunities: Money like any other commodity has a price. Given the choice of `
1000/- now or the same account in one year time, it is always preferable to take ` 1000/- now,
because it could be invested over the next year @ 12% interest, to produce ` 1,120/- at the end of
year. If the risk-free rate of return in 12%, then you would be indifferent in receiving ` 1000/- now or
`1120/- in ones year’s time. In other words, the present value of `1120/- receivable one year hence
is `1000/-.
Present Value:
The value of a firm depends upon the net cash inflows generated by the firm assets and also on future
returns. The amount of cash inflows and risk associated with the uncertainty of future returns forms the
basis of valuation. To get the present value, cash inflows are to be discounted at the required rate of
return i.e., minimum rate expected by the investor to account for their timing and risk. The cash inflows
and outflows of an investment decision are to be compared at zero time period or at the same value
by discounting them at required rate of return. The following formula can be used to discount the future
inflows of a project to compare with its cash outflows.
C1 C2 C3 Cn
I= + + + fff
^1 + Kh1 ^1 + Kh2 ^1 + Kh3 ^1 + Khn
Where V0= Present value of cash inflows of the project during its life time.
C1, C2, ----Cn =Expected cash inflows of the project during its life time.
K =Discount rate.
n =Expected life of the project.
1. Net Present Value (NPV):
The net present value method is a classic method of evaluating the investment proposals. It is one of
the methods of discounted cash flow techniques, which recognizes the importance of time value of
money. It correctly postulates that cash flows arising at time periods differ in value and are comparable
only with their equivalents i.e. present values.
It is a method of calculating the present value of cash flows (inflows and outflows) of an investment
proposal using the cost of capital as an appropriate discounting rate. The net present value will be
arrived at by subtracting the present value of cash outflows from the present value of cash inflows.
According to Ezra Soloman, “it is a present value of the cast of the investment.”
Steps to compute net present value:
(i) Estimation of future cash inflows
(ii) An appropriate rate of interest should be selected to discount the cash flows. Generally, this will
be the “cost of capital” of the company, or required rate of return.
(iii) The present value of inflows and outflows of an investment proposal has to be computed by
discounting them with an appropriate cost of capital.
(iv) The net value is the difference between the present value of cash inflows and the present value
of cash outflows.

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Capital Budgeting

The formula for the net present value can be written as:
C1 C2 C3 Cn
NPV = + + + ff −I
^1 + Kh1 ^1 + Kh2 ^1 + Kh3 ^1 + Khn
Where
C = Annual Cash inflows,
Cn = Cash inflow in the year n
K = Cost of Capital
I = Initial Investment
Acceptance Rule:
If the NPV is positive or atleast equal to zero, the project can be accepted. If it is negative, the proposal
can be rejected. Among the various alternatives, the project which gives the highest positive NPV
should be selected.
NPV is positive = Cash inflows are generated at a rate higher than the minimum required by the firm.
NPV is zero = Cash inflows are generated at a rate equal to the minimum required.
NPV is negative = Cash inflows are generated at a rate lower than the minimum required by the firm.
The market value per share will increase if the project with positive NPV is selected.
The accept/reject criterion under the NPV method can also be put as:
NPV>Zero Accept
NPV<Zero Reject
NPV=0 May accept or reject
Merits: The following are the merits of the net present value (NPV) methods:
(i) Consideration to total Cash Inflows: The NPV methods considers the total cash inflows of investment
opportunities over the entire life-time of the projects unlike the payback period methods.
(ii) Recognition to the Time Value of Money: This methods explicitly recognizes the time value of money,
which is investable for making meaningful financial decisions.
(iii) Changing Discount Rate: Due to change in the risk pattern of the investor different discount rates
can be used.
(iv) Best decision criteria for Mutually Exclusive Projects: This Method is particularly useful for the selection
of mutually exclusive projects. It serves as the best decision criteria for mutually exclusive choice
proposals.
(v) Maximisation of the Shareholders Wealth: Finally, the NPV method is instrumental in achieving the
objective of the maximization of the shareholders’ wealth. This method is logically consistent with
the company’s objective of maximizing shareholders’ wealth in terms of maximizing market value
of shares, and theoretically correct for the selections of investment proposals.
Demerits: The following are the demerits of the net present value method:
(i) It is difficult to understand and use.
(ii) The NPV is calculated by using the cost of capital as a discount rate. But the concept of cost of
capital itself is difficult to understand and determine.
(iii) It does not give solutions when the comparable projects are involved in different amounts of
investment.

7.8 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

(iv) It does not give correct answer to a question when alternative projects of limited funds are available,
with unequal lives.
2. Profitability Index (PI)
This method is also known as ‘Benefit Cost Ratio’. According to Van Horne, the profitability Index of
a project is “the ratio of the present value of future net cash inflows to the present value of cash
outflows”.
Present value of cash inf lows
Profitability Index =
Present value of cash outflows

Decision criteria: If the Profitability Index is greater than or equal to one, the project should be accepted
otherwise reject.
Merits: The merits of this method are:
(i) It takes into account the time value of money
(ii) It helps to accept / reject investment proposal on the basis of value of the index.
(iii) It is useful to rank the proposals on the basis of the highest /lowest value of the index.
(iv) It takes into consideration the entire stream of cash flows generated during the life of the asset.
Demerits: However, this technique suffers from the following limitations:
(v) It is some what difficult to compute.
(vi) It is difficult to understand the analytical of the decision on the basis of profitability index.
3. Internal Rate of Return (IRR):
IRR method follows discounted cash flow technique which takes into account the time value of money.
The internal rate of return is the interest rate which equates the present value of expected future cash
inflows with the initial capital outlay. In other words, it is the rate at which NPV is equal zero.
Whenever a project report is prepared, IRR is to be worked out in order to ascertain the viability of the
project. This is also an important guiding factor to financial institutions and investors.
Formula:
A1 A2 A3 An
C= + + + ff
^1 + r h ^1 + r h2 ^1 + Kh3 ^1 + Rhn
Where
C = Initial Capital outlay.
A1, A2, A3 etc. = Expected future cash inflows at the end of year 1, 2, 3 and so on.
r = Rate of interest
n = Number of years of project
In the above equation ‘r’ is to be solved in order to find out IRR.
Computation of IRR
The Internal rate of return is to be determined by trial and error method. The following steps can be
used for its computation.
(i) Compute the present value of the cash flows from an investment, by using arbitrari by selected
interest rate.
(ii) Then compare the present value so obtained with capital outlay.
(iii) If the present value is higher than the cost, then the present value of inflows is to be determined
by using higher rate.

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Capital Budgeting

(iv) This procedure is to be continued until the present value of the inflows from the investment are
approximately equal to its outflow.
(v) The interest rate that bring about equality is the internal rate if return.
In order to find out the exact IRR between two near rates, the following formula is to be used.
P1 − C0
IRR = L+ ×D
P1 − P2
Where,
L = Lower rate of interest
P1 = Present value at lower rate of interest
P2 = Present value at higher rate of interest
Co = Cash outlay
D = Difference in rate of interest
Acceptance Rule
If the internal rate of return exceeds the required rate of return, then the project will be accepted. If the
project’s IRR is less than the required rate of return, it should be rejected. In case of ranking the proposals
the technique of IRR is significantly used. The projects with highest rate of return will be ranked as first
compared to the lowest rate of return projects.
Thus, the IRR acceptance rules are
Accept if IRR > k
Reject if IRR < k
May accept or reject if IRR = k
Where
K is the cost of capital.
MERITS
The following are the merits of the IRR method:
(i) Consideration of Time of Money: It considers the time value of money.
(ii) Consideration of total Cash Flows: It taken into account the cash flows over the entire useful life of
the asset.
(iii) Maximising of shareholders’ wealth: It is in conformity with the firm’s objective of maximizing owner
welfare.
(iv) Provision for risk and uncertainty: This method automatically gives weight to money values which
are nearer to the present period than those which are distant from it. Conversely, in case of other
methods like ‘Payback Period’ and ‘Accounting Rate of Return’, all money units are given the same
weight which is unrealistic. Thus the IRR is more realistic method of project valuation. This method
improves the quality of estimates reducing the uncertainty to minimum.
(v) Elimination of pre-determined discount rate: Unlike the NPV method, the IRR method eliminates
the use of the required rate of return which is usually a pre-determined rate of cost of capital for
discounting the cash flow consistent with the cost of capital. Therefore, the IRR is more reliable
measure of the profitability of the investment proposals.

7.10 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

DEMERITS
The following are the demerits of the IRR:
(i) It is very difficult to understand and use
(ii) It involves a very complicated computational work
(iii) It may not give unique answer in all situations.
(iv) The assumption of re-investment of cash flows may not be possible in practice.
(v) In evaluating the mutually exclusive proposals, this method fails to select the most profitable project
which is consistent with the objective of maximization of shareholders wealthy.
The result of this method may be inconsistent compare to NPV method, if the projects differ in their (a)
expected lives (b) investment or (c) timing of cash inflows.
IRR vs. NPV:
Comparison of both the techniques
(i) Both techniques use Discounted Cash Flow (DCF) method.
(ii) Both recognize the time value of money.
(iii) Both take into account the cash flows over the entire life of the project.
(iv) Both are consistent with the objective of maximizing the wealth of shareholders.
(v) Both are difficult to calculate.
(vi) Both techniques may often give contradictory result in the case of alternative proposals which are
mutually exclusive.
Contrast, i.e. Points of difference
(i) Interest Rate: NPV uses the firm’s cost of capital as Interest Rate. Unless the cost of capital is known,
NPV method cannot be used. Calculating cost of capital is not required for computing IRR.
(ii) NPV may mislead when dealing with alternative projects or limited funds under the conditions of
unequal lives. IRR allows a sound comparison of the project having different lives and different
timings of cash inflows.
(iii) NPV may give different ranking in case of complicated projects as compared to IRR method.
(iv) NPV assumes that intermediate cash flows are re-invested at firm’s cost of capital whereas IRR
assumes that intermediate cash inflows are reinvested at the internal rate of the project.
(v) The results of IRR method may be inconsistent compared to NPV method, if the projects differ in
their (a) expected lives or (b) investment or (c) timing of cash inflow.
(vi) IRR method favours short-lived project so long as it promises return in excess of cut-off rate whereas
NPV method favours long-lived projects.
(vii) Some times IRR may give negative rate or multiple rates. NPV does not suffer from the limitation of
multiple rates.
Recommendation
The NPV method is generally considered to be superior theoretically because:
(i) It is simple to calculate as compared to IRR.
(ii) It does not suffer from the limitation of multiple rates.

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Capital Budgeting

(iii) NPV assumes that intermediate cash flows are reinvested at firm’s cost of capital. The reinvestment
assumption of NPV is more realistic than IRR method.
But IRR method is favoured by some scholars because:
(i) It is easier to visualize and to interpret as compared to NPV.
(ii) Even in the absence of cost of capital, IRR gives an idea of project’s profitability.
Note:
Unless the cost of capital is known, NPV cannot be used.
(iii) IRR method is preferable to NPV in the evaluation of risky projects.
6. Modified Internal Rate of Returns (MIRR)
IRR assumes that interim positives cash flows are reinvested at the rate of returns as that of the project
that generated them. This is usually an unrealistic scenario.. To overcome this draw back a new
technique emerges. Under MIRR the earlier cash flows are reinvested at firm’s rate of return and finding
out the terminal value. MIRR is the rate at which present value of terminal values equal to outflow
(Investment).
The procedure for calculating MIRR is as follows:
Step I: Calculate the present value of the costs (PVC) associated with the project, using cost of capital
(r) as the discount rate.
Cash outflowt
PVC = / n

^1 + r ht
t=0

Step 2: Calculate the future value (FV) of the cash inflows expected from the project:
FV = / t = 0 Cash outflowt ^1 + r h
n n-t

Step 3: Obtain MIRR by solving the following equation:

FV FV ^positive cash flows reinvestment rate h
PVC = or MIRR = n −1
(1 + MIRR) N PV ^negative cash flows rateh
n = Numbers of periods over which cashflows Occured

5. Discounted Pay Back Method:

Under this method the discounted cash inflows are calculated and where the discounted cash flows
are equal to original investment then the period which is required is called discounting pay back period.
While calculating discounting cash inflows the firm’s cost of capital has been used.
Formula:
Investment
Discounted payback period (DPP) =
Discounted Annual cash in flow
DECISION CRITERIA: Out of two projects, selection should be based on the period of discounting pay
back period (Lesser pay back period should be preferred.)
Illustration 1
The directors of Alpha Limited are contemplating the purchase of a new machine to replace a machine
which has been in operation in the factory for the last 5 years.
Ignoring interest but considering tax at 50% of net earnings, suggest which of the two alternatives should
be preferred. The following are the details:

7.12 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

 OLD MACHINE NEW MACHINE
Purchase price `40,000 `60,000
Estimated life of machine 10 years 10 years
Machine running hours per annum 2,000 2,000
Units per hour 24 36
Wages per running hour 3 5.25
Power per annum 2,000 4,500
Consumables stores per annum 6,000 7,500
All other charges per annum 8,000 9,000
Materials cost per unit 0.50 0.50
Selling price per unit 1.25 1.25
You may assume that the above information regarding sales and cost of sales will hold good throughout
the economic life of each of the machines. Depreciation has to be charged according to straight-line
method.
Solution:
Appraisal of replacement decision under Average Rate of Return Method (ARR)

Particulars Existing New

Machine Machine
Cost of Machine (`) 40,000 60,000
Life of Machine 10 years 10 Years
Machine running hours 2,000 2,000
Depreciation [40,000 / 10] [60,000 / 10](`) 4,000 6,000
Production in units [2,000 x 24] [2000 x 36] 48,000 72,000
`
Sales [48,000 x 1.25] [72,000 x 1.25] [A] 60,000 90,000
Cost of sales:
Depreciation 4,000 6,000
Wages [2000 x 3] [2000 x 5.25] 6,000 10,500
Power 2,000 4,500
Consumables 6,000 7,500
Other charges 8,000 9,000
Material [48,000 x 0.50] [72,000 x 0.50] 24,000 36,000
Total Cost [B] 50,000 73,500
Profit Before Tax [A-B] 10,000 16,500
Less: Tax at 50% 5,000 8,250
Profit after tax 5,000 8,250

Investment 40,000 60,000

Average rate of return [On investment] 5,000 x 100 8,250 x 100
= Profit after tax/original investment x 100 40,000 60,000
= 12.5% = 13.75%
Comment:
From the above computation, it is clear that new machine can be replaced in place of old machine
because it has higher ARR.

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.13

Capital Budgeting

Illustration 2
A limited company is considering investing a project requiring a capital outlay of ` 2,00,000. Forecast
for annual income after depreciation but before tax is as follows:

Year `
1 1,00,000
2 1,00,000
3 80,000
4 80,000
5 40,000
Depreciation may be taken as 20% on original cost and taxation at 50% of net income.
You are required to evaluate the project according to each of the following methods:
(a) Pay-back method
(b) Rate of return on original investment method
(c) Rate of return on average investment method
(d) Discounted cash flow method taking cost of capital as 10%
(e) Net present value index method
(f) Internal rate of return method.
(g) Modified internal rate of return method.
Solution:
Working Notes:
Year Profit Profit Cash inflows Cumulative Discounting Present Discounting Present Discounting Present Discounting Present
before after tax after tax [PAT cash factor @ Value factor @ value factor @ Value factor @ 32% value
tax @ 50% + Dep] inflows 10% 20% @20% 30% @30% @32%
1 1,00,000 50,000 90,000 90,000 0.9091 81,819 0.8333 74,997 0.7692 69,228 0.7576 68,184
2 1,00,000 50,000 90,000 1,80,000 0.8264 74,376 0.6944 62,496 0.5917 53,253 0.5739 51,651
3 80,000 40,000 80,000 2,60,000 0.7513 60,104 0.5787 46,296 0.4552 36,416 0.4348 34,784
4 80,000 40,000 80,000 3,40,000 0.6830 54,640 0.4823 38,584 0.3501 28,008 0.3294 26,352
5 40,000 20,000 60,000 4,00,000 0.6209 37,254 0.4019 24,114 0.2693 16,158 0.2495 14,970
3,08,193 2,46,487 2,03,063 1,95,941
(a) Pay Back Method:
Pay back period = 2 + 20,000/80,000
= 2.25 years (or) 2 years 3 months
(b) Rate of Return on Original Investment Method.
ARR = Average Profit after Tax / Investment x 100
= 40,000 / 2,00,000 x 100
= 20%
(c) Rate of Return on Average Investment Method
ARR = Average Profit after tax / Average investment x 100
= 40,000 / [2,00,000 + 0/2] x 100
= 40%

7.14 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

(d) Discounted Cash Flow Method taking Cost of Capital as 10%
`
Present value of cash inflows after tax 3,08,193
Less: Outflow 2,00,000
Net Present Value 1,08,193
(e) Profitability Index
Profitability Index = P.V of Cash Inflows / Cash Outflow
= 3,08,193 / 2,00,000
= 1.54
Since PI is more than 1 it can accept the project.
(f) Internal Rate of Return Method
IRR = L + [P1 – I / P1 – P2] x d
= 30 + [2,03,063 – 2,00,000 / 2,03,063 – 1,95,941] x 2
= 30 + 0.8602
= 30.8602%
(g) MIRR `

1 2 3 4 5 Total
Cash inflow after tax 90,000 90,000 80,000 80,000 60,000 --
Re-investment period 4 3 2 1 0
Re-investment at 10% 10% 10% 10% 10%
Future value factor (1.1)4 (1.1)3 (1.1)2 (1.1) 1
Future value 1,31,769 1,19,790 96,800 88,000 60,000 4,96,359
At MIRR = 2,00,000 [1 + MIRR] = 4,96,359
5

= [1 + MIRR]5 = 4,96,359 / 2,00,000 = 2.48

MIRR = 20% (Refer Annuity tables)
Illustration 3
A company has just installed a machine Model A for the manufacture of a new product at capital cost
of `.1,00,000. The annual operating costs are estimated at `.50,000 (excluding depreciation) and these
costs are estimat­ed on the basis of an annual volume of 1,00,000 units of production. The fixed costs
at this volume of 1,00,000 units of output will amount to `.4,00,000 p.a. The selling price is `.5 per unit of
output. The machine has a five year life with no residual value.
The company has now come across another machine called Super Model which is capable of giving, the
same volume of production at an estimated annual operating costs of `.30,000 exclusive of depreciation.
The fixed costs will however, remain the same in value. This machine also will have a five year life with
no residual value. The capital cost of this machine is `.1,50,000.
The company has an offer for the sale of the machine Model A (which has just been installed) at `.50,000
and the cost of removal thereof will amount to `.10,000. Ignore tax.
In view of the lower operating cost, the company is desirous of dismantling of the machine Model A and
installing the Super Model Machine. Assume that Model A has not yet started commercial production
and that the time lag in the removal thereof and the installation of the Super Model machine is not
material.

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.15

Capital Budgeting

The cost of capital is 14% and the P.V. Factors for each of the five years respectively are 0.877, 0.769,
0.675, 0.592 and 0.519.
State whether the company should replace Model A machine by installing the Super Model machine.
Will there be any change in your decision if the Model A machine has not been installed and the
company is in the process of con­sideration of selection of either of the two models of the machine?
Present suitable statement to illustrate your answer.
Solution:
A) Appraisal of replacement decision under NPV method
Step 1:
Calculation of Present value of net cash outflow or net investment required.
Cost of super model 1,50,000
Less: Sale proceeds of Model A 50,000
(-) Cost of removal 10,000 40,000
Net investment required 1,10,000
Step 2:
Calculation of present value of incremental operating cash flows:

Particulars Model A Super Model Incremental

Sales p.a. (units) 1,00,000 1,00,000
Sales p.a. [`] [1,00,000 x 5] [a] 5,00,000 5,00,000
Less: Expenses
Operating cost 50,000 30,000
Fixed cost 4,00,000 4,00,000
Total Cost [b] 4,50,000 4,30,000
Cash Inflows [a-b] 50,000 70,000 20,000
Step 3:
Present value of terminal cash inflow [Salvage value] - NIL
Step 4:
Calculation of NPV `
*Present value of total cash inflows* = 68,660
(Recurring + Salvage)
Less: Outflow = 1,10,000
Net Present Value = (41,340)
Comment:
As net present value is negative, the replacement decision is not financially feasible.

7.16 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

Working Notes:
* 1. Total incremental cash inflows = ` 20,000
Present value of incremental recurring cash inflows for 5 years
= 20,000 x PVAF 5 years 14%
= 20,000 x 3.433
P.V of cash flows = ` 68,660
B) Appraisal of mutually exclusive decision under NPV method
Alternative I – Model A
Calculation of NPV under Alternative I
Step 1:
Calculation of Present value of cash outflow
Cost of machine = `. 1,00,000
Step 2:
Calculation of present value of recurring cash inflows or operating cash inflows
Cash inflows after tax (as above) – `. 50,000
PV of operating cash inflows for 5 years = 50,000 x PVAF 5 years 14%
= 50,000 x 3.433
= ` 1,71,650
Step 3:
Calculation of PV of terminal cash inflows = Nil
Step 4:
Calculation of NPV `
PV of total cash inflows = 1,71,650
Less: Outflow = 1,00,000
Net Present Value (under alternative I) = 71,650
Alternative 2:- Super Model
Calculation of NPV under Alternative II
Step 1:
Calculation of Present value of cash outflow
Cost of Machine = ` 1,50,000
Step 2:
Calculation of operating cash inflows or PV of recurring cash inflows
PV of operating cash inflows for 5 years = 70,000 x PVAF 5 years 14%
= 70,000 x 3.433
= ` 2,40,310

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.17

Capital Budgeting

Step 3:
Calculation of PV of terminal cash inflow – NIL
Step 4:
Calculation of NPV `
PV of total cash inflow = 2,40,310
[2,40,310 + 0]
Less: Outflow = 1,50,000
Net Present Value (under alternative II) = 90,310
Comment:
As NPV of Super Model is more [`. 90,310] than that of Model A [`. 71,650], it is advised to Select
Super Model.
Illustration 4
Techtronics Ltd., an existing company, is considering a new project for manufacture of pocket video
games involving a capital expenditure of `.600 lakhs and working capital of `.150 lakhs. The capacity of
the plant is for an annual production of 12 lakh units and capacity utilisation during the 6-year working
life of the project is expected to be as indicated below.

Year Capacity utilisation (%)

1 33 1/3 %
2 66 2/3 %
3 90 %
4-6 100 %
The average price per unit of the product is expected to be `.200 netting a contribution of 40%. Annual
fixed costs, excluding depreciation, are esti­mated to be `.480 lakhs per annum from the third year
onwards; for the first and second year it would be `.240lakhs and `.360 lakhs respectively. The average
rate of depreciation for tax purposes is 33 1/3% on the capital assets. No other tax reliefs are anticipated.
The rate of income-tax may be taken at 50%.
At the end of the third year, an additional investment of `.100 lakhs would be required for working
capital.
The company, without taking into account the effects of financial leverage, has targeted for a rate of
return of 15%.
You are required to indicate whether the proposal is viable, giving your working notes and analysis.
Terminal value for the fixed assets may be taken at 10% and for the current assets at 100%. Calculation
may be rounded off to lakhs of rupees. For the purpose of your calculations, the recent amendments
to tax laws with regard to balancing charge may be ignored.

7.18 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

Solution:
Evaluation of Expansion decision under NPV method
Step 1: ` In lakhs
Calculation of PV of cash outflow
Cost of fixed asset at [t0] – 600 x 1 = ` 600
Cost of working capital at [t0] – 150 x 1 = ` 150
Additional WC required at [t3] – 100 x PVF 3yrs 15%
- 100 x 0.66 = ` 66
PV of cash outflow = ` 816
Step 2:
Calculation of PV of operating cash inflow for six years (working notes) = ` 826 lakhs
Step 3:
Calculation of PV of terminal cash inflow
Salvage value of fixed assets[600 x 10/100] = 60
Less: Tax on profit at 50% [60-53] x 50/100 = 3.5(rounded off) =4
56
WC recovered [100%] [100 + 150] = 250
= 306
Its present value = 306 x PVAF 6 yrs 15%
= 306 x 0.432
= `. 132 lakhs
Step 4:
Calculation of NPV
PV of total cash inflows = `. 958
[Recurring + Terminal i.e., 826 + 132]
Less: Outflow = `. 816
NPV = `. 142 Lakhs
Comment:
As NPV is positive, it is advised to implement the new project.
Working Notes:
1. Calculation of Operating Cash Inflows

Year Production Contribution Fixed Depreciation PBT PAT CIAT PV at 15% PV

expenses (WDV)
1 400 320 240 200 (120) (60) 140 0.870 121.80
2 800 640 360 133 147 74 207 0.756 156.49
3 1080 864 480 89 295 148 237 0.658 155.95
4 1200 960 480 59 421 210 269 0.572 153.87
5 1200 960 480 40 440 220 260 0.497 129.22
6 1200 960 480 26 454 227 253 0.432 109.29
PV of operating cash inflows for 6 years 826.62

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.19

Capital Budgeting

Illustration 5
A chemical company is considering replacing an existing machine with one costing `65,000. The
existing machine was originally purchased two years ago for `28,000 and is being depreciated by the
straight line method over its seven-year life period. It can currently be sold for `30,000 with no removal
costs. The new machine would cost `10,000 to install and would be depreciate over five years. The
management believes that the new machine would have a salvage value of `5,000 at the end of year
5. The management also estimates an increase in net working capital requirement of `10,000 as a result
of expanded operations with the new machine. The firm is taxed at a rate of 55% on normal income and
30% on capital gains. The company’s expected after-tax profits for next 5 years with existing machine
and with new machine are given as follows:
`
Expected after-tax profits
Year With existing machine With new machine
1 2,00,000 2,16,000
2 1,50,000 1,50,000
3 1,80,000 2,00,000
4 2,10,000 2,40,000
5 2,20,000 2,30,000
a) Calculate the net investment required by the new machine.
b) If the company’s cost of capital is 15%, determine whether the new machine should be
purchased.
Solution:
Appraisal of replacement decision under NPV method
Step 1:
Calculation of present value of net investment required: `
Cost of new asset 65,000
Add: Installation cost 10,000
75,000
Add: Additional WC 10,000
85,000
Less: Sale proceeds of old machine 30,000
Less: Tax 5,000
[8,000 x 55/100 + 2000 x 30/100] 25,000
Net Investment required 60,000
Step 2:
Calculation of Present Value of Incremental Operating cash inflows for 5 years.
Year CIAT New Incremental PV factor at Present Value
(PAT + Dep) 15%
1 2,04,000 2,30,000 26,000 0.8696 22,609
2 1,54,000 1,64,000 10,000 0.7561 7,561
3 1,84,000 2,14,000 30,000 0.6575 19,725
4 2,14,000 2,54,000 40,000 0.5718 22,872
5 2,24,000 2,44,000 20,000 0.4972 9,944
PV of cash inflows for 5 years 82,711

7.20 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

Step 3:
Calculation of PV of terminal cash inflow `
Salvage value of asset 5,000
[No tax because book value and salvage value are equal]
Working capital recovered [100% recovered] 10,000
Terminal cash inflows 15,000
Its PV at the end of 5th year = 15,000 x 0.4972 = 7,458
Step 4:
Calculation of NPV `
PV of total cash inflows = 90,169
[82,711 + 7,458]
(–) Outflow = 60,000
NPV = 30,169
Comment:
As NPV is positive, it is advised to replace.
Note 1:
Depreciation for old Machine = 28,000 / 7 = ` 4,000

Depreciation for new Machine 65, 000 + 10, 000 - 5, 000 = ` 14,000
5
Illustration 6
A Company is considering two mutually exclusive projects. Project K will require an initial cash investment
in machinery of ` 2,68,000. It is anticipated that the machinery will have a useful life of ten years at the
end of which its salvage will realise `20,500. The project will also require an additional investment in cash,
Sundry debtors and stock of `40,000. At the end of five years from the commencement of the project
balancing equipment for `45,000 has to be installed to make the unit workable. The cost of additional
machinery will be written off to deprecia­tion over the balance life of the project. The project is expected
to yield a net cash flow (before depreciation) of `1,00,000 annually.
Project R, which is the alternative one under consideration, requires an investment of `3,00,000 in
machinery and as in Project K investment in current assets of `40,000. The residual salvage value of the
machinery at the end of its useful life of ten years is expected to be `25,000. The annual cash inflow
(before depreciation) from the project is worked at `80,000 p.a. for the first five years and `1,80,000 per
annum for the next five years.
Depreciation is written off by the Company on sum-of-the years’ digits method, (i.e., if the life of the
asset is 10 years, then in the ratio of 10,9,8 and so on). Income tax rate is 50%. A minimum rate of return
has been calculated at 16%. The present value of Re. 1 at interest of 16% p.a. is 0.86, 0.74, 0.64, 0.55,
0.48, 0.41, 0.35, 0.30, 0.26 and 0.23 for years 1 to 10 respectively.
Which Project is better? Assuming no capital gains taxes, calculate the Net Present Value of each
Project.

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.21

Capital Budgeting

Solution:
Appraisal of mutually exclusive decision under NPV method
Alternative 1: Project K
Calculation of NPV under alternative I
Step 1:
Calculation of present value of cash outflow `
Cost of machine at (t0) (2,68,000 x 1) = 2,68,000
Additional working capital at (t0) [40,000 x 1] = 40,000
PV of additional asset at (t5) [45,000 x 0.48] = 21,600
PV of total cash outflow = 3,29,600
Step 2:
Calculation of PV of operating cash inflows for 10 years `

Year Cash profit Dep. on Dep. on PBT PAT at CIAT PV factor PV

before dep original asset additional asset 50% at 16%
1 1,00,000 45,000 -- 55,000 27,500 72,500 0.86 62,350
2 1,00,000 40,500 -- 59,500 29,750 70,250 0.74 51,985
3 1,00,000 36,000 -- 64,000 32,000 68,000 0.64 43,250
4 1,00,000 31,500 -- 68,500 34,250 65,750 0.55 36,163
5 1,00,000 27,000 -- 73,000 36,500 63,500 0.48 30,480
6 1,00,000 22,500 15,000 62,500 31,250 68,750 0.41 28,188
7 1,00,000 18,000 12,000 70,000 35,000 65,000 0.35 22,750
8 1,00,000 13,500 9,000 77,500 38,750 61,250 0.30 18,375
9 1,00,000 9,000 6,000 85,000 42,500 57,500 0.26 14,950
10 1,00,000 4,500 3,000 92,500 46,250 53,750 0.23 12,363
3,21,123
Note 1: Calculation of depreciation under sum of the years digits method:

Cost of asset − Scrap

Depreciation = # 10/9/8f and so on
Sum of the year

= 2, 68, 000 20, 500 # 10/9/8f and so on as follows:

-

55
1 2 3 4 5 6 7 8 9 10
4500x 10 4500 x 9 4500 x 8 4500 x 7 4500 x 6 4500 x 5 4500 x 4 4500 x 3 4500 x 2 4500 x 1
45,000 40,500 36,000 31,500 27,000 22,500 18,000 13,500 9,000 4,500
Note 2: Calculation of depreciation on additional asset
Cost of asset − Scrap
Depreciation =
Sum of the year
45, 000 − 0
=
15
= 3,000

7.22 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

 6 7 8 9 10
3000 x 5 3000 x 4 3000 x 3 3000 x 2 3000 x 1
15,000 12,000 9,000 6,000 3,000
Step 3: Calculation of present value of terminal cash inflows:
`
Realizable value of asset = 20,500
WC recovered (100%) = 40,000
= 60,500
Its present value = 60,500 x 0.23 = 13,915
Step 4: Calculation of NPV
PV of total cash inflows 3,35,038
[3, 22,123 + 13,915]
Less: outflow 3,29,600
NPV 5,438
Alternative II – Project R
Calculation of NPV under alternative II
Step 1:
Calculation of initial investment `
Cost of asset = 3,00,000
(+) Working capital = 40,000
Initial investment = 3,40,000
Step 2:
Calculation of PV of recurring cash inflows for 10 years.

Year Cash profit before tax Dep PBT PAT at 50% CIAT PV factor at 16% PV
1 80,000 50,000 30,000 15,000 65,000 0.86 55,900
2 80,000 45,000 35,000 17,500 62,500 0.74 46,250
3 80,000 40,000 40,000 20,000 60,000 0.64 38,400
4 80,000 35,000 45,000 22,500 57,500 0.55 31,625
5 80,000 30,000 50,000 25,000 55,000 0.48 26,400
6 1,80,000 25,000 1,55,000 77,500 1,02,500 0.41 42,025
7 1,80,000 20,000 1,60,000 80,000 1,00,000 0.35 35,000
8 1,80,000 15,000 1,65,000 82,500 97,500 0.30 29,250
9 1,80,000 10,000 1,70,000 85,000 95,000 0.26 24,700
10 1,80,000 5,000 1,75,000 87,500 92,500 0.23 21,275
3,50,825

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.23

Capital Budgeting

Step 3:
Calculation of PV of terminal cash inflows
`
Scrap value = 25,000
WC = 40,000
= 65,000
Its PV = 65,000 x 0.23 = 14,950
Step 4:
`
PV of total cash inflows = 3,65,775
[3,50,825 + 14,950]
Less: Outflow = 3,40,000
NPV = 25,775
Comment:
Project R is better compared to project K because it has higher NPV.
Illustration 7
A product is currently manufactured on a machine that is not fully depreciated for tax purposes and
has a book value of `70,000. It was purchased for `2,10,000 twenty years ago. The cost of the product
are as follows:

Unit Cost
Direct Labour `28.00
Indirect labour 14.00
Other variable overhead 10.50
Fixed overhead 17.50
70.00
In the past year 10,000 units were produced. It is expected that with suitable repairs the old machine
can be used indefinitely in future. The repairs are expected to average ` 75,000 per year.
An equipment manufacturer has offered to accept the old machine as a trade in for a new equipment.
The new machine would cost `4,20,000 before allowing for `1,05,000 for the old equipment. The Project
costs associat­ed with the new machine are as follows:

Unit Cost
Direct Labour `14.00
Indirect labour 21.00
Other variable overhead 7.00
Fixed overhead 22.75
64.75
The fixed overhead costs are allocations for other departments plus the depreciation of the equipment.
The old machine can be sold now for `50,000 in the open market. The new machine has an expected life
of 10 years and salvage value of `20,000 at that time. The current corporate income tax rate is assumed
to be 50%. For tax purposes cost of the new machine and the book value of the old machine may be
depreciated in 10 years. The minimum required rate is 10%. It is expected that the future demand of the

7.24 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

product will stay at 10,000 units per year. The present value of an annuity of ` 1 for 9 years @ 10% discount
factor = 5.759. The present value of `1 received at the end of 10th year @10% discount factor is = 0.386.
Should the new equipment is purchased?
Solution:
Evaluation of replacement decision under NPV Method
Step 1: Calculation of PV of net cash outflow
Cost of new machine 4,20,000
Less: Exchange price for old machine 1,05,000
3,15,000
Add: Tax on profit on exchange
[1,05,000 – 70,000]
[35,000 x 50%] = 17,500
Net Investment = 3,32,500
Step 2: Calculation of PV of incremental operating cash inflows for 10 years

Existing New Incremental

Number of units 10,000 10,000 --
Variable cost per unit 52.5 42
Variable Cost 5,25,000 4,20,000 1,05,000
Repairs 75,000 -- 75,000
Depreciation 7,000 40,000 [33,000]
[2,10,000 – 70,000]/20
[4,20,000 – 20,000]/10
Total Savings before tax 1,47,000
Less: Tax at 50% 73,500
Savings after tax 73,500
Add: Depreciation 33,000
CIAT 1,06,500
Note: The allocations from other department are irrelevant for decision making.
Step 3: Calculation of terminal cash inflows
Salvage value of machine = `20,000
Step 4: Calculation of NPV:
Operating cash inflow from 1 to 9 years `
[1,06,500 x 5.759] = 6,13,334
PV of cash inflow for 10th year = 48,829
(1,06,500 + 20,000) x 0.386
PV of total cash inflow = 6,62,163
Less: Outflow = 3,32,500
NPV = 3,29,663

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.25

Capital Budgeting

Comment:
Since NPV is positive, it is advised to replace the machine.
Note:
Since the exchange value is greater than open market value, the open market value is irrelevant.
Illustration 8
Electromatic Excellers Ltd. specialise in the manufacture of novel transistors. They have recently
developed technology to design a new radio transistor capable of being used as an emergency lamp
also. They are quite confident of selling all the 8,000 units that they would be making in a year. The
capital equipment that would be required will cost `.25 lakhs. It will have an economic life of 4 years
and no significant terminal salvage value.
During each of the first four years promotional expenses are planned as under:
`
1st Year 1 2 3 4
Advertisement 1,00,000 75,000 60,000 30,000
Others 50,000 75,000 90,000 1,20,000
Variable cost of production and selling expenses: `250 per unit
Additional fixed operating costs incurred because of this new product are budgeted at `.75,000 per
year.
The company’s profit goals call for a discounted rate of return of 15% after taxes on investments on new
products. The income tax rate on an average works out to 40%. You can assume that the straight line
method of deprecia­tion will be used for tax and reporting.
Work out an initial selling price per unit of the product that may be fixed for obtaining the desired rate
of return on investment.
Present value of annuity of Re. 1 received or paid in a steady stream throughout 4 years in the future
at 15% is 3.0079.
Solution:
Calculation of Selling Price
Let x be the selling price.
Evaluation under NPV method
Step 1:
Initial Investment = 25,00,000
Step 2:
PV of operating cash inflows per annum
A. Sales p.a. = 8,000 X
B. Expenses
Depreciation [(25,00,000 – 0) / 4] = 6,25,000
Promotion Expenses = 1, 50,000
Variable costs = 20, 00,000
Fixed costs = 75,000
`28,50,000

7.26 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

 PBT (A-B) = 8,000 X-28,50,000
Less: Tax at 40% = 3,200 X-11,40,000
PAT = 4,800 X-17,10,000
Add: Depreciation 6,25,000
Cash inflow after tax = 4,800 X-10,85,000
At required return at 15%
PV of total cash inflow = outflow
[4,800 X – 10,85,000] x 3.0079 = 25,00,000
14,437.92 X – 32,63,572 = 25,00,000
14,437.92 X = 32,63,572 + 25,00,000
X = 32,63,572 + 25,00,000
14,437.92
= 399.196
= 400
Initial selling Price = ` 400
Illustration 9
Bisk-Farm Biscuits Ltd is considering the purchase of a delivery van, and is evaluating the following two
choices:
(a) The company can buy a used van for ` 20,000 and after 4 years sell the same for ` 2,500 (net of
taxes) and replace it with another used van which is expected to cost ` 30,000 and has 6 years life
with no terminating value,
(b) The company can buy a new van for ` 40,000. The projected life of the van is 10 years and has an
expected salvage value (net of taxes) of ` 5,000 at the end of 10 years.
The services provided by the vans under both the choices are the same. Assuming the cost of capital
at 10 percent, which choice is preferable?
Solution:
Calculation of mutually exclusive decision
Alternative I : Company purchased a used van
Calculation of PV of cash outflow: `

Year Cash outflow PV factor at 10% Present Value

t0 20,000 1 20,000
t4 27,500 0.6830 18,783
(30,000-2,500)
PV of total cash outflow under Alternative I 38,783
Alternative II : Company purchased a new van

Year Cash outflow PV factor at 10% Present Value

t0 40,000 1 40,000
t10 (5,000) 0.3855 (1,928)
PV of net cash outflow 38,072

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.27

Capital Budgeting

Comment:
It is advised to select alternative II as it involves lower cash outflows.
Illustration 10
Following are the data on a capital project being evaluated by the management of X Ltd.:

Project M
Annual cost saving ` 40,000
Useful life 4 years
I.R.R 15%
Profitability Index (PI) 1.064
NPV ?
Cost of capital ?
Cost of project ?
Pay back ?
Salvage value 0
Find the missing values considering the following table of discount factor only:

Discount Factor 15% 14% 13% 12%

1 year 0.869 0.877 0.885 0.893
2 years 0.756 0.769 0.783 0.797
3 years 0.658 0.675 0.693 0.712
4 years 0.572 0.592 0.613 0.636
2.855 2.913 2.974 3.038
Solution:
CIAT = 40,000
Life = 4 years
IRR = 15%
PI = 1.064
At 15% IRR
PV of cash inflow = Cost of project
40,000 PVAF 4 yrs 15% = Cost of project
Cost of Project = 40,000 x 2.855
= 1,14,200
PI = PV of cash inflow
Initial outflow
= 1.064
1.064 = PV of cash inflow
1,14,200
PV of cash inflow = 1,21,509
Less: Outflow = 1,14,200
NPV = 7,309

7.28 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

 At cost of capital
Let r be the Cost of Capital (Ko)
PV of cash inflow
40,000 PVAF r% 4 yrs = 1,21,509
PVAF n% 4 yrs = 1,21,509 / 40,000 = 3.038
r = 12%
Pay back period = Initial Investment
Annual cash flow
= 1,14,200
40,000
= 2.855
Illustration 11
Projects X and Y are analysed and you have determined the following parameters. Advise the investor
on the choice of a project:

Particulars Project X Project Y

Investment `7 Cr. `5 Cr.
Project life 8 years 10 years
Construction period 3 years 3 years
Cost of capital 15% 18%
N.P.V. @ 12% `3,700 `4,565
N.P.V. @ 18% ` 325 `325
I.R.R. 45% 32%
Rate of return 18% 25%
Payback 4 years 6 years
B.E.P. 45% 30%
Profitability index 1.76 1.35
Solution:
Determination of Priority of the Project

X Y
NPV at 12% II I
NPV at 18% Same Same
IRR I II
ARR II I
Pay back I II
PI I II
Decision:
1. As the outlays in the projects are different, NPV is not suitable for evaluation.
2. As there is different life periods, ARR is not appropriate method for evaluation.
On the basis of remaining evaluation methods [IRR, PBP, PI] Project X is occupied first priority. Hence, it
is advised to choose project X.

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.29

Capital Budgeting

SELF EXAMINATION QUESTIONS:

1. What do you mean by Capital Budgeting? Explain its importance.
2. Explain various Capital Budgeting techniques.
3. Write short notes on:
a) Internal Rate of Return.
b) Average Rate of Return.
c) Net Present Value
d) IRR vs. NPV
e) Discounted Payback Period
f) Modified Internal Rate of Return
PRACTICAL PROBLEMS:
4. Zenith Industries Ltd. are thinking of investing in a project cost ` 20 lakhs. The life of the project is
five years and the estimated salvage value of the project is zero. Straight line method of charging
depreciation is followed. The tax rate is 50%. The expected cash-flows before tax are as follows:

Year 1 2 3 4 5
Estimated Cash flow before depreciation and tax (` Lakhs) 4 6 8 8 10
You are required to determined the:
i) Pay back period for the investment
ii) Average rate of return on the investment
iii) NPV at 10% cost of capital
iv) Benefit – Cost Ratio
Ans:
i) Pay back period = 3 years 10 months
ii) ARR = 16%
iii) NPV = ` 0.717 lakhs
iv) Benefit Cost Ratio = 1.036
5. Indo Plastics Ltd. is a manufacturer of high quality plastic products, Rasik, President, is considering
computerizing the company’s ordering, inventory and billing procedures. He estimates that the
annual savings from computerization include a reduction of 4 clerical employees with annual salaries
of ` 50,000 each, ` 30,000 from reduced production delays caused by raw materials inventory
problems ` 25,000 from lost sales due to inventory stock outs and ` 18,000 associated with timely
billing procedures.
The purchase price of the system is ` 2,50,000 and installation costs are ` 50,000. These outlays will
be capitalized (depreciated) on a straight line basis to a zero books salvage value which is also
its market annual salaries of ` 80,000 per person. Also annual maintenance and operating (cash)
expenses of ` 22,000 are estimated to be required. The company’s tax rate is 40% and its required
rate of return (cost of capital) for this project is 12%.
You are required to:
i) Evaluate the project using NPV method.
ii) Evaluate the project using PI method
iii) Calculate the Project’s payback period.

7.30 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

 Note:
a) Present value of annuity of Re. 1 at 12% rate of discount for 5 years is 3.605
b) Present value of Re.1 at 12% rate of discount, received at the end of 5 years is 0.567.
Ans:
i) NPV = ` (16,647)
ii) PI = ` 0.945
iii) Pay back period = 3 years 9.8 months
6. United Industries Ltd. has an investment budget of ` 100 lakhs for 2011-12. It has short listed two
projects A and B after completing the market and technical appraisals. The management wants
to complete the financial appraisal before making the investment. Further particulars regarding
the two projects are given below:

(` Lakhs)
Particulars A B
Investment required 100 90
Average annual cash inflow before depreciation and tax (estimate) 28 24
Salvage value: Nil for both projects. Estimate life – 19 years for both projects.
The company follows straight line method of charging depreciation. Its tax rate is 50%.
You are required to calculate i) Payback period and ii) IRR for the 2 projects.
Note: P.V of an annuity of Re. 1 for ten years at different discount rate is given below:

Rate % 10 11 12 13 14
Annuity Value of return 6.1446 5.8992 5.6502 5.462 5.2161 5.01
Ans:

Project A Project B
i) Payback period 5.26 years 5.45 years
ii) IRR 13.78% 12.89%
7. Precision Instruments is considering two mutually exclusive Projects X and Y. The following details
are made available to you:

(` Lakhs)
Particulars Project X Project Y
Project Cost 700 700
Cash inflows: Year 1 100 400
Year 2 200 400
Year 3 300 200
Year 4 450 100
Year 5 600 100
Total 1,650 1,300
Assume no residual values at the end of the fifth year. The firm’s cost of capital is 10%. Required, in
respect of each of the two projects: i) Net present value, using 10% discounting, ii) Internal rate of return
iii) profitability Index.

COST ACCOUNTING AND FINANCIAL MANAGEMENT I 7.31

Capital Budgeting

Ans:

Project X Project Y
i) NPV 461.35 lakhs 365.5 lakhs
ii) IRR 27.21% 37.63%
iii) PI 1.659 1.522
8. XYZ Ltd. has decided to diversity its production and wants to invest its surplus funds on the most
profitable project. It has under consideration only two projects. ‘A’ and ‘B’. The cost of project ‘A’
is ` 100 lakhs and that of ‘B’ is ` 150 lakhs. Both projects are expected to have a life of 8 years only
and at the end of this period ‘A’ will have a salvage value of ` 4 lakhs and ‘B’ ` 14 lakhs. The running
expenses of ‘A’ will be ` 35 lakhs per year and that of ‘B’ ` 20 lakhs per year. In either case the
company expects a rate of return of 10%. The company’s tax rate is 50%. Depreciation is charged
on straight line basis. Which project should the company take up?
Note: Present value of annuity of Re. 1 for eight years at 10% is 5.335 and present value of Re.1
received at the end of the eighth year is 0.467.
Ans: NPV of Project A = ` 19.238 lakhs; Project B = ` 27.258 lakhs

7.32 I COST ACCOUNTING AND FINANCIAL MANAGEMENT

Notes
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Notes