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Investment Decision : Concept of Opportunity Cost, Cost of Debenture, Preference and Equity capital,
Composite Cost of Capital ,Cash Flows as Profit and components of Cash Flows , Capital Budgeting
Decisions, Calculation of NPV and IRR, Excel Application in Analyzing Projects.

INVESTMENT DECISION
The most important function of financial management is not only the procurement of external funds for the
business but also to make efficient and wise allocation of these funds. The allocation of funds means the
investment of funds in various assets and other activities. It is also known as „Investment Decision”, because a
choice is to be made regarding the assets in which funds will be invested. The assets which can be acquired
fall into two broad categories:
1) Short-term or Current Assets.
2) Long-term or Fixed Assets.
Accordingly, we have to take two types of investment decisions:
1) Short-term investment decisions: – This type of investment decisions related to the short-term assets.
These decisions are also called current assets management or Working Capital Management.
2) Long-term Investment Decisions or Capital Budgeting Decisions: – This type of investment decisions
related to long-term assets. These are widely known as capital budgeting or capital expenditure decisions.
Capital Budgeting is the technique of making decisions for investment in long term assets. It is a process
of deciding whether or not to invest the funds in a particular asset, the benefit of which will be available
over a period of time longer than one year.

CONCEPT OF OPPORTUNITY COST

The opportunity cost of any commodity is the amount of other good which has been given up (next best
alternative sacrificed) in order to produce that commodity.
According to Leftwitch, “Opportunity cost of a particular product is the value of the forgone alternative
product that the resources used in its production could have produced”.
The concept of opportunity cost is linked with the concept of scarcity of resources. If the resources are
unlimited, there can be no opportunity cost. However, the factors of production (resources) are scarce in
relation to demand for them. Further, these factors of production have many alternative uses. When a factor
unit is employed for one use, the next best use for which this factor could have been put, is forgone, because a
particular resource cannot be put to different uses simultaneously.
For example, a driver can be used to drive a taxi, a personal car, a highway truck, a tractor, etc. He cannot be
put to all these employments at the same time. His employment as a taxi driver means the loss of an
opportunity of employing him as a truck driver or other. The sacrifice of an alternative opportunity from the
viewpoint of the transport firm is an opportunity cost

IMPORTANCE OF THE CONCEPT OF OPPORTUNITY COST

1. Determination of Relative Prices of goods:-The concept is useful in the determination of the relative
prices of different goods. For example, if a given amount of factors can produce one table or three chairs, then
the price of one table will tend to be three times equal to that one chair.
2. Fixation of Remuneration to a Factor:-The concept is also useful in fixing the price of a factor. For
example, let us assume that the alternative employment of a college professor is work as an officer in an
insurance company at a salary of $4,000 per month. In such a case, he has to be paid at least $4,000 to
continue to retain him in the college.
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3. Efficient Allocation of Resources: The concept is also useful in allocating the resources efficiently.
Suppose, opportunity cost of 1 table is 3 chairs and the price of a chair is $100, while the price of a table is
$400. Under such circumstances, it is beneficial to produce one table rather than 3 chairs. Because, if he
produces 3 chairs, he will get only $300, whereas a table fetches him $400, that is, $100 more
LIMITATIONS OF OPPORTUNITY COST
The concept has the following drawbacks:
1. Specific: - If a factor‟s service is specific, it cannot be put to alternative uses. The transfer cost or
alternative cost in such a case is zero. This is pure rent, according to Mrs. Joan Robinson.
2. Inertia: - Sometimes, factors may be reluctant to move to alternative occupations. In such a case, a
payment exceeding the pure transfer cost will have to be made to induce it to take to an alternative
occupation.
3. Perfect Competition: - The concept rests on the assumption of perfect competition. However, perfect
competition is a myth, which seldom prevails.
4. Private and Social Costs: - A discrepancy is likely to arise between private and social costs. For example,
let us assume that a chemical factory discharges industrial refuse into a river. This causes serious health
hazards, which cannot be measured in money terms.
5. Alternatives are not clearly known: - The foregone opportunities are often not ascertainable. This also
poses a serious limitation of the concept.

CONCEPT OF COST OF CAPITAL

Cost of capital of a firm is the minimum rate of return expected by its investors. The capital used by a firm
may be in the form of equity shares, preference shares, debts and retained earnings. The cost of capital is the
weighted average cost of these sources of finance used by the firms. The concept of cost of capital occupies a
very important role in financial management because the investment decisions are based on it.
Definition:–
According to Milton H. Spencer “The cost of capital is the minimum rate of return which a firm requires as
a condition for undertaking an investment.”
According to M.J. Gordon “The cost of capital is the rate of return a company must earn on an investment to
maintain the value of the company.”

SIGNIFICANCE\ IMPORTANCE OF THE COST OF CAPITAL

(1) Helpful in Designing the Capital Structure: – The concept of cost of capital plays a vital role in
designing the capital structure of a company. Capital structure of a company is the ratio of debt and equity.
These sources differ from each other in terms of their respective costs. As such a company will have to design
such a capital structure which minimizes cost of capital.
(2) Helpful in taking capital Budgeting Decisions: – Capital budgeting is the process of decision making
regarding the investment of funds in long term projects of the company. The concept of cost of capital is very
useful in making capital budgeting decisions because cost of capital is the minimum required rate of return on
an investment project.
(3) Helpful in evaluation of financial efficiency of top management:–Concept of cost of capital can be
used to evaluate the financial efficiency of top management. Such an evaluation will involve a comparison of
projected overall cost of capital with the actual cost of capital incurred by the management. Lower the actual
cost of capital is the better financial performance of the management of the firm.
(4) Helpful in comparative analysis of various sources of finance: – Cost of capital to be raised from
various sources goes on changing from time to time. Calculation of cost of capital is helpful in analysis of
usefulness of various sources of finance.
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(5) Helpful in taking other financial decisions: – The cost of capital concept is also useful in making other
financial decisions such as:
(a) Dividend Policy
(b) Right Issue
(c) Working Capital Decisions
(d) Capitalization of profits.

Problems in Determination of Cost of Capital

1. Historic Cost and Future Cost: – One major problem in the determination of cost of capital arises due to
difference of opinion regarding the concept of cost itself. It is argued that book costs are historic costs and the
calculation of cost of capital on the basis of such costs is irrelevant for decision making.
2. Problems in Computation of Cost of Equity: – The computation of cost of equity capital depends upon
the rate of return expected by equity shareholders. But it is very difficult to assess the expectation of equity
shareholders because there are many factors which influence their expectations.
3. Problems in computation of cost of retained earnings: – Sometimes it may appear that retained earning
are free of cost because they have not been raised from outside.
4. Problems in Assigning Weights: – Weights have to be assigned to various sources of finance to compute
the weighted average cost of capital. The choice of using the book value weights or market value weights
places another problem in the computation of cost of capital.

Characteristics of Cost of Capital

Cost of capital is characterized by the following fundamental features:
1) Not necessary a cash cost: Cost of capital, which a company is required to pay, may not be in the form of
cash every time. Actually it is indicative of the expectation of the company‟s shareholders with regard to
returns from their investment
2) Minimum rate of return: Cost of capital indicates the minimum rate of return, which is needed for
maintaining the market value of a company‟s equity share
3) Consideration of Risk premium: The risk factor is taken care of during computation of cost of capital
which is likely to be high, if the number and degree of risk increase. In other word, the cost of capital is
directly proportional to the number/degree of risk involved. The concept would be more clear from the
following formula:
K = Rf + Rp
Where,
K = Cost of required return
Rf = Risk-free rate
Rp = Risk premium rate
In brief, the cost of capital to a company is equal to the equilibrium rate of return, demanded by investors in
the capital markets for securities at a given degree of risk.

TYPES/ CLASSIFICATION OF COST

The cost may be classified as follows
1. Explicit Cost:-The explicit cost of any sources of capital may be defined as the discount rate that equates
the present value of the cash inflows that are incremental to the taking of the financing opportunity with
the present value of its incremental cash outflow.
When a firm raises funds from different sources, it involves a series of cash flows. At its first stage, there
is only a cash inflow by the amount raised which is followed by a series of cash outflows in the form of
interest payments, repayment of principal or repayment of dividends.
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Therefore, if a firm issues, 1,000, 8% debentures of Rs. 100 each redeemable, after 10 years at par, there
will be an inflow of cash to the extent of Rs. 1,00,000 (1,000 x Rs. 100) at the beginning, but the annual
cash outflow will be Rs. 8,000 (Rs. 1,00,000 x 8/100) in the form of interest.
2. Future Cost and Historical Cost: Future Costs are the expected costs of funds for financing a particular
project. They are very significant while making financial decisions. For instance, at the time of taking
financial decisions about the capital expenditure, a comparison is to be made between the expected IRR
and the expected cost of funds for financing the same, i.e. the relevant costs here are future costs.
3. Average Cost and Marginal Cost: - The average cost of capital is the weighted average cost of each
component of the funds invested by the firm for a particular project, i.e. percentage or proportionate cost
of each element in the total investment. The weights are in proportion to the shares of each component of
capital in the total capital structure or investment.
4. Overall Cost or Composite or Combined Cost: It may be recalled that the term „cost of capital‟ has
been used to denote the overall composite cost of capital or weighted average of the cost of each specific
type of fund, i.e., weighted average cost. In other words, when specific costs are combined in order to find
out the overall cost of capital, it may be defined as the composite or weighted average cost of capital.

Factors affecting cost of capital

These are the factors affecting cost of capital are:-
1) Capital Structure Policy: - As we have been discussing above, a firm has control over its capital
structure, targeting an optimal capital structure. As more debt is issued, the cost of debt increases, and as
more equity is issued, the cost of equity increases.
2) Dividend Policy: - Given that the firm has control over its payout ratio; the breakpoint of the MCC
schedule can be changed. For example, as the payout ratio of the company increases the breakpoint
between lower-cost internally generated equity and newly issued equity is lowered.
3) Investment Policy: - It is assumed that, when making investment decisions, the company is making
investments with similar degrees of risk. If a company changes its investment policy relative to its risk,
both the cost of debt and cost of equity change.
4) Level of Interest Rates: - The level of interest rates will affect the cost of debt and, potentially, the cost
of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of
capital
5) Tax Rates: - Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases,
decreasing the cost of capital.

Computation of Cost of Capital

Cost of capital of a firm is the minimum rate of return expected by its investors. The capital used by a firm
may be in the form of equity shares, preference shares, debts and retained earnings. The cost of capital is the
weighted average cost of these sources of finance used by the firms. The concept of cost of capital occupies a
very important role in financial management because the investment decisions are based on it.
Computation of Cost of Capital: – Computation of cost of capital includes:
(A) Computation of cost of specific sources of finance
(B) Computation of weighted average cost of capital
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(A) Computation of cost of specific sources of finance it’s including:

1. COST OFDEBT CAPITAL (KD)

Cost of Debt Capital: – A company may raise the debt in a number of ways. It may borrow funds from the
financial institutions or public either in the form of public deposits or debentures for a specified period of time
at a specified rate of interest. A debenture or bond may be issued at par, at a discount or at a premium.
Debt may either be irredeemable or redeemable after a certain period.
(I) Cost of Irredeemable Debt-
 Cost of Irredeemable Debt, before tax: – Formula for calculating cost of debt before tax is:

 Cost of Irredeemable Debt, after tax: – When a company uses debt as a source of finance then it saves a
considerable amount in payment of tax because the amount of interest paid on the debts is a deductible
expense in computation of tax. Formula for calculating cost of debt after tax is:

(II) Cost of Irredeemable Debt-

 Cost of redeemable Debt: – Normally a company issues a debt which is redeemable after a certain
period during its life-time. Such a debt is termed as Redeemable Debt. Cost of redeemable debt may
also be calculated before tax and after tax:
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Kd = Cost of debt before tax

I = Annual Interest Charges
NP = Net Proceeds from the issue of Debt
n = Number of years in which debt is to be redeemed
RV = Redeemable Value of Debt redeemed.

2. COST OF PREFERENCE SHARE CAPITAL (KP)

Cost of Preference Share Capital: – A fixed rate of dividend is payable on preference shares. But, unlike
debt, the dividend is payable at the discretion of the Board of Directors and there is no legal binding to pay the
dividend. Preference Shares may either be irredeemable or redeemable after a certain period.
(i) Cost of Irredeemable Preference Share Capital: – Formula for calculating cost of Irredeemable
Preference Share Capital is:

K = Cost of Irredeemable Preference Share Capital P

D = Annual Preference Dividend
NP = Net Proceeds of Preference Share Capital
(ii) Cost of Redeemable Preference Share Capital: – Redeemable preference capital has to be
returned to the preference shareholders after a stipulated period. The cost of redeemable preference
share capital is calculated as follows:

Kp = Cost of Redeemable Preference Capital

D = Annual Preference Dividend
NP = Net Proceeds of Preference Share Capital
n = Number of years
RV = Redeemable Value of Preference Share Capital
3. COST OF EQUITY SHARE CAPITAL (KE)
Cost of Equity Share Capital: – The cost of equity is the „maximum rate of return‟ that the company must
earn on equity financed position of its investments in order to leave unchanged the market price of its stock.
The cost of equity capital is a function of the expected return by its investors. The cost of equity share capital
can be computed in the following ways:
(i) Dividend Yield Method :– This method is based on the assumption that when an investor invests in the
equity shares of a company he expects to get a payment at least equal to the rate of return prevailing in the
market. The equation is:

Ke = Cost of Equity Capital

DPS = Dividend per Share
MP = Market Price per Share
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 Dividend Yield plus Growth in Dividend Method: – This method is used to compute the cost of
equity capital when the dividends of a firm are expected to grow at a constant rate.

(ii) Earning Yield Method: – As per this method, cost of equity capital is calculated by establishing a
relationship between earning per share and the current market price of the share. The equation is:

 Earning Yield plus Growth in Earning Method: – If the EPS of a company is expected to grow at a
constant rate of growth, the cost of equity capital can be computed as follows:

4. COST OF RETAINED EARNINGS

Cost of Retained Earnings: – It is sometimes argued that retained earnings carry no cost since a firm is not
required to pay dividend on retained earnings. However, this is not true. Though retained earnings do not have
any explicit cost to the firm but they involve an opportunity cost. The cost of retained earning can be
calculated as follows:
Kr = Ke (1-Percentage Brokerage or Flotation Cost)
Where
Kr = Cost of Retained Earnings
Ke = Cost of Equity Capital
(B). COMPUTATION OF WEIGHTED AVERAGE COST OF CAPITAL
Weighted Average Cost of Capital: – Capital structure of a company consists of different sources of capital.
Cost of these different sources of capital is also calculated by different methods. Hence, after the calculation
of cost of capital of these different sources of capital a practical difficulty arise as to what is the cost of overall
capital structure of the firm. In order to solve this problem finance managers developed the concept of
Weighted Average Cost of capital. It is also known as Composite Cost or Overall Cost.
Computation of Weighted Average Cost of Capital: – The computation of weighted cost of capital
involves the following steps:
(a) Compute the cost of each source of funds.
(b) Assign weights to specific costs
(c) Multiply the cost of each of the sources by the assigned weights
(d) Divide the total weighted cost by the total weights

Kw = Weighted Average Cost of Capital

X = Cost of specific source of finance
W = Weight of specific source of finance.
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Assignment of Weights: – For computing weighted average cost of capital, it is necessary to determine the
proportion of each source of finance in the total capitalization. For this purpose weights will have to be
assigned to various sources of finance. Weights may be assigned by any of the following methods:
(i) Book Value Weights
(ii) Market Value Weights
(I) BOOK VALUE WEIGHTS: – Book value weights are computed form the values taken from the balance
sheet. The weight to be assigned to each source of finance is the book value of that source of finance divided
by the book value of total sources of finance.
ADVANTAGES OF BOOK VALUE WEIGHTS:
 Book values are readily available from the published records pf the firm.
 Book value weights are more realistic because the firms set their capital structure targets in terms of book
values rather than market values.
 Book value weights are not affected by the fluctuations in the capital market.
 In the case of those companies whose securities are not listed, only book value weights can be used.
LIMITATIONS OF BOOK VALUE WEIGHTS:–
 The costs of various sources of finance are calculated using prevailing market prices. Hence weights
should also be assigned according to market values.
 The present economic values of various sources of capital may be totally different from their book values.

(ii) MARKET VALUE WEIGHTS: – As per market value scheme of weighting, the weights to different
sources of finance are assigned on the basis of their market values.
ADVANTAGES OF MARKET VALUE WEIGHTS:–
 The costs of various sources of finance are calculated using prevailing market prices. Hence, it is proper to
use market value weights
 Weights assigned according to market values of the sources of finance represent the true economic values
of various sources of finance.
LIMITATIONS OF MARKET VALUE WEIGHTS:–
 Market value weights may not be available as securities of all the companies are not actively traded.
 It is very difficult to use market value weights because the market prices of securities fluctuate widely and
frequently.
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CAPITAL BUDGETING
The word Capital refers to be the total investment of a company of firm in money, tangible and intangible
assets. Whereas budgeting defined by the “Rowland and William” it may be said to be the art of building
budgets. Budgets are a blue print of a plan and action expressed in quantities and manners. The examples of
capital expenditure:

1. Purchase of fixed assets such as land and building, plant and machinery, good will, etc.
2. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets.
3. The replacement of fixed assets.
4. Research and development project.

DEFINITIONS
According to the definition of Charles T. Hrongreen, “capital budgeting is a long-term planning for making
and financing proposed capital out lays”
According to the definition of Richard and Green law, “capital budgeting is acquiring inputs with long-term
return”.
According to the definition of Lyrich, “capital budgeting consists in planning development of available
capital for the purpose of maximizing the long-term profitability of the concern”
It is clearly explained in the above definitions that a firm‟s scarce financial resources are utilizing the
available opportunities. The overall objective of the company from is to maximize the profits and minimize
the expenditure of cost.

IMPORTANCE OF CAPITAL BUDGETING

1. Huge investments: Capital budgeting requires huge investments of funds, but the available funds are
limited, therefore the firm before investing projects, plan are control its capital expenditure.
2. Long-term: Capital expenditure is long-term in nature or permanent in nature. Therefore financial risks
involved in the investment decision are more. If higher risks are involved, it needs careful planning of capital
budgeting.
3. Irreversible: The capital investment decisions are irreversible, are not changed back. Once the decision is
taken for purchasing a permanent asset, it is very difficult to dispose of those assets without involving huge
losses.
4. Long-term effect: Capital budgeting not only reduces the cost but also increases the revenue in long-term
and will bring significant changes in the profit of the company by avoiding over or more investment or under
investment. Over investments leads to be unable to utilize assets or over utilization of fixed assets, Therefore
before making the investment, it is required carefully planning and analysis of the project thoroughly.

CAPITAL BUDGETING PROCESS

Capital budgeting is a difficult process to the investment of available funds. The benefit will attain only in the
near future but, the future is uncertain. However, the following steps followed for capital budgeting, then the
process may be easier are.
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1. Identification of various investments proposals: The capital budgeting may have various investment
proposals. The proposal for the investment opportunities may be defined from the top management or may be
even from the lower rank. The heads of various departments analyze the various investment decisions, and
will select proposals submitted to the planning committee of competent authority.
2. Screening or matching the proposals: The planning committee will analyze the various proposals and
screenings. The selected proposals are considered with the available resources of the concern. Here resources
referred as the financial part of the proposal. This reduces the gap between the resources and the investment
cost.
3. Evaluation: After screening, the proposals are evaluated with the help of various methods, such as pay-
back period proposal, net discovered present value method, accounting rate of return and risk analysis. Each
method of evaluation used in detail in the later part of this chapter. The proposals are evaluated by.
(a) Independent proposals
(b) Contingent of dependent proposals
(c) Partially exclusive proposals.
4. Fixing property: After the evolution, the planning committee will predict which proposals will give more
profit or economic consideration. If the projects or proposals are not suitable for the concern‟s financial
condition, the projects are rejected without considering other nature of the proposals.
5. Final approval: The planning committee approves the final proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions.
The planning committee prepares the cost estimation and submits to the management.
6. Implementing: The competent authority spends the money and implements the proposals. While
implementing the proposals, assign responsibilities to the proposals, assign responsibilities for completing it,
within the time allotted and reduce the cost for this purpose. The network techniques used such as PERT and
CPM. It helps the management for monitoring and containing the implementation of the proposals.

7. Performance review of feedback: The final stage of capital budgeting is actual results compared with the
standard results. The adverse or unfavorable results identified and removing the various difficulties of the
project. This is helpful for the future of the proposals.
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NATURE /FEATURES OF CAPITAL BUDGETING

1. Capital budgeting decisions involve the exchange of current funds for the benefits to be achieved in future.
2. The future benefits are expected to be realized over a series of years.
3. The funds are invested in non- flexible and long term activates.
4. They have a long term and significant effect on the profitability of the concern.
5. They involve generally huge funds.

NEED FOR CAPITAL BUDGETING

The need for capital budgeting arises on account of the following reasons:
1. Maintaining Firm’s Competitive position: - The firm can compete in the market only when the plants are
modernized from time to time. Obsolete plants require timely replacement. This involves capital expenditure
for which proper planning is essential.
2. Planning for the future needs of the firm: Capital budget provide a plan of action which enables
management to forecast the quantity and timing of the production factors required to yield the desired result.
3. Coordinating: - The requirements of various departments are budgeted. Unified and harmonized efforts
can be ensured during the process. It results in greater efficiency and productivity.
4. Cost control: - Control over expenditure is facilitated, since there is a regular comparison of the budgeted
and the actual expenditure.
5. Organizational Effectiveness: - Successful the capital budgeting leads to maximization of organizational
effectiveness. Proper allocation of the projected expenditure to appropriate cost centers and profit centers
helps creation of a framework which enables management to achieve its objectives.
COMPONENTS OF CAPITAL BUDGETING
The exercise of capital budgeting analysis involves following essential components:
1) Cash Inflows: - Cash inflows represent all receipts a company will receive from the asset acquisition. In
most cases, the inflows represent extra money earned through increased operating activity. Cash flows
usually are specified for each year in a specific time period. For example, a company may have a five-year
plan for repaying the costs associated with the asset acquisition. The cash inflows for these five years are
part of the capital budget.
2) Budgeting Mode: - Businesses can choose from among several capital budget models. These include the
payback period, rate of return and net present value. Companies often select one model for this process.
The payback period determines the number of months or years it takes to recoup cash outflows. The rate
of return presents the average return for the asset's entire life. Net present value discounts future dollars
earned into today's dollar value for comparison.
3) Cash Outflows: - In the capital budget, cash outflows are any cost a company must pay for the asset
acquisition. For example, the purchase price, freight and handling and similar costs are part of the cash
outflows. Training and costs for changing current facilities also fall under this category. Another term for
cash outflows may be cash payments, which clarifies what falls under this category.
4) Non-Monetary View: - Beside the monetary view of a project, there are certain non-monetary view also
(e.g. goodwill, and reputation of the company in the market), which may lead to erroneous conclusions, if
they are not taken into consideration, while evaluating a project.
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5) Risk and Uncertainty :- The corporate life, therefore, can be healthy only when the elements of risk and
uncertainty are properly assessed and suitable steps are taken to evaluate the profitability on the basis of
assessment of inherent risk and uncertainty.

Types of Capital Budgeting Decision

The technique of capital budgeting is applied in respect of following types of investments:

1. Expansion and Diversification: - A company may add capacity to its existing product lines to expand
existing operations. For example, the Gujarat State Fertilizer Company (GSFC) may increase its plant
capacity to manufacture more urea. It is an example of related diversification. A firm may expand its
activities in a new business. Expansion of a new business requires investment in new products and a new
kind of production activity within the firm. If a packaging manufacturing company invests in a new plant
and machinery to produce ball bearings, which the firm has not manufactured before, this represents
expansion of new business or unrelated diversification. Sometimes a company acquires existing firms to
expand its business. In either case, the firm makes investment in the expectation of additional revenue.
Investments in existing or new products may also be called as revenue-expansion investments.
2. Replacement and Modernization: - The main objective of modernization and replacement is to improve
operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firm's
revenue may remain unchanged. Asset - become outdated and obsolete with technological changes. The
firm must decide to replace, those assets with new assets that operate more economically. If a cement
company changes from semi-automatic drying equipment lo fully automatic drying equipment, it is an
example of modernization and replacement. Replacement decisions help lo introduce more efficient and
economical assets and therefore, are also called cost-reduction investments. However, replacement
decisions that involve substantial modernization and loch no logical improvements expand revenues as
well as reduce costs.
3. Mutually Exclusive Investments: - Mutually exclusive investments serve the same purpose and compete
with each other. If one investment is undertaken, others will have to be excluded. A company may. For
example, either use a more labor-intensive, semi-automatic machine, or employ a more capital-intensive,
highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance
of the highly automatic machine.
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4. Independent Investments: - Independent investments servo different purposes and do not compete with
each other. For example, a heavy engineering company may be considering expansion of its plant capacity
to manufacture additional excavators and addition of new production facilities to manufacture a new
product—light commercial vehicles. Depending on their profitability and availability of funds, the
company can undertake both investments.
5. Contingent Investments:-Contingent investments arc dependent projects; the choice of one investment
necessitates undertaking one or more other investments. For example, if a company decides to build a
factory in a remote, backward area, it may have to invest in houses, roads, hospitals, schools, etc., for the
employees to attract the work force. Thus, building of factory also requires investment in facilities for
employees. The total expenditure will be treated as one single investment.
6. Research and Development Projects: - Most of the Indian companies conventionally believe that
investing in Research and Development (R&D) project is a waste of money. If at all they decide to make
investment in R&D, it forms a very small percentage to total capital-budget.
7. Miscellaneous Project:- Decisions to invest in projects such as recreational facilities, interior decoration,
executive aircrafts, landscaped gardens, etc are taken generally on the basis of Top management‟s
personnel choice. There are no specific techniques to evaluate these projects.
PURPOSE OF CAPITAL BUDGETING
The capital budgeting decisions are important, crucial and critical business decisions due to following
reasons:
1. Substantial expenditure: Capital budgeting decisions involves the investment of substantial amount of
funds. It is therefore necessary for a firm to make such decisions after a thoughtful consideration so as to
result in the profitable use of its scarce resources. The hasty and incorrect decisions would not only result
into huge losses but may also account for the failure of the firm.
2. Long time period: The capital budgeting decision has its effect over a long period of time. These
decisions not only affect the future benefits and costs of the firm but also influence the rate and direction
of growth of the firm.
3. Irreversibility: Most of the investment decisions are irreversible. Once they are taken, the firm may not
be in a position to reverse them back. This is because, as it is difficult to find a buyer for the second-hand
capital items.
4. Complex decision: The capital investment decision involves an assessment of future events, which in
fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms all the benefits or the
costs relating to a particular investment decision.
FACTORS INFLUENCING CAPITAL BUDGETING
1. Urgency: Sometimes an investment is to be made due to urgency for the survival of the firm or to avoid
heavy losses. In such circumstances, the proper evaluation of the proposal cannot be made through
profitability test.
2. Degree of certainty: Profitability is directly related to risk, higher the profits, greater is the risk of
uncertainty.
3. Intangible Factors: Sometimes a capital expenditure has to be made due to certain emotional and
intangible factors such as safety and welfare of workers, social welfare, and goodwill of the firm.
4. Legal Factors: An investment which is required by the provisions of law is solely influenced by this
factor and although the project may not be profitable yet the investment has to be made
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5. Availability of funds: As the capital expenditure, generally requires large funds, the availability of funds
is an important factor that influences the capital budgeting decisions.
6. Future Earnings: A project may not be profitable as compared to another today, but is may promise
better future earnings. In such cases it may be preferred to increase earnings.
7. Obsolescence: There are certain projects which have greater risk of obsolescence than others.
8. Research and development Projects: It is necessary for the long term survival of the business to invest
in R&D projects through it may not look to be profitable investment.

TECHNIQUES/METHODS OF CAPITAL BUDGETING OF EVALUATION

By matching the available resources and projects it can be invested. The funds available are always living
funds. There are many considerations taken for investment decision process such as environment and
economic conditions. The methods of evaluations are classified as follows:

(A) TRADITIONAL METHODS (OR NON-DISCOUNT METHODS)

(i) Pay-back Period Methods
(ii) Post Pay-back Methods
(iii)Accounts Rate of Return
(B) MODERN METHODS (OR DISCOUNT METHODS)
(i) Net Present Value Method
(ii) Internal Rate of Return Method
(iii)Profitability Index Method
1. Pay-back Period Methods: - The payback method is the simplest method. This method calculates the
number of years required to pay back the original investment in a project. There are two methods of
calculating the Payback Period:
First Method: – This method is adopted when the project generates equal cash inflow each year. In such a
case payback period is calculated as follows:

Second Method: – This method is adopted when the project generates unequal cash inflow each year. Under
this method, payback period is calculated by adding up the cash inflows till the time they become equal to the
original investment.
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MERITS OF PAY BACK METHOD:–

a) Simple: – The most significant merit of this method is that it is simple to understand and easy to calculate.
b) Appropriate for Firms Suffering from Liquidity: – This method is very appropriate for firms suffering
from shortage of cash because emphasis in this method is on quick recovery of the original investment.
c) Appropriate in case of Uncertain Conditions: – This method is very suitable where the long term
outlook is extremely uncertain and risky.
d) Importance to Short-Term Earnings: – This method is beneficial for firms which lay more emphasis on
short-term earnings rather than the long-term growth.
e) Superior to ARR Method: – It is superior to ARR method because it is based on cash flow analysis.
DEMERITS OF PAY BACK METHOD
a) It ignores the Cash Flows after the Pay Back Period: – The major shortcoming of this method is that it
completely ignores all cash inflows after the payback period.
b) It ignores the Time Value of Money: – Another deficiency of the payback method is that it ignores the
time value of money. This method treats a rupee received in the second or third year as valuable as a rupee
received in the first year.
c) It does not give the Accept-Reject Decision in case of single project: – If suppose the payback period is
4 years, the method does not provide an answer as to whether the project will be accepted or rejected.
d) It ignores cost of Capital: – Cost of capital is not taken into consideration under this method.
e) It ignores the Profitability of a Project.

2. Post Pay-back Period Methods: - The Post payback method is the simplest method. This method
calculates the number of years remaining the after payback period
Post Payback Period = Total life of Project – payback period

3. Accounts Rate of Return: - Accounting rate of return, also known as the Average rate of return or ARR is
a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of
money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is
a percentage return.

MERITS OF ARR METHOD

1. It is easy to calculate and simple to understand.
2. It is based on the accounting information rather than cash inflow.
3. It is not based on the time value of money.
4. It considers the total benefits associated with the project.
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DEMERITS OF ARR METHOD

1. It ignores the time value of money.
2. It ignores the reinvestment potential of a project.
3. Different methods are used for accounting profit. So, it leads to some difficulties in the calculation of the
project.
ACCEPT/REJECT CRITERIA
If the actual accounting rate of return is more than the predetermined required rate of return, the project would
be accepted. If not it would be rejected

(B) MODERN METHODS (OR DISCOUNT METHODS)

1. NET PRESENT VALUE METHOD: - Net present value uses discounted cash flows in the analysis
which makes net present value the most correct of any of the capital budgeting method as it considers both the
risk and time variables. This means that a net present value analysis evaluates the cash flows forecasted to be
delivered by a project by discounting them back to the present using the time span of the project and the
firm's weighted average cost of capital. If the result is positive, then the firm should invest in the project. If
negative, the firm should not invest in the project.
In other words we can say that this method measures the Present value of returns per rupee invested. Under
this method, present value of cash outflows and cash inflows is calculated and the present value of cash
outflow is subtracted from the present value of cash inflows. The difference is called NPV.

NPV = [(CIF1yr x PVF) + (CIF in 2 year x PVF) + (CIF in 3rdyear x PVF) + (CIF in N year X PVF)]

MERITS OF NPV METHOD

a) Time value of money is taken into consideration: – Because this method takes into account the time
value of money, it is the best method to use for long range decisions.
b) Full Life of the project is taken into consideration: – This method takes into account the fall life of the
project and not only the payback period.
c) Wealth Maximization: – Wealth maximization object of the business is achieved by this method. By
accepting the project with highest NPV, the wealth of the business is maximized. Demerits of
DEMERITS OF NPV
a) Difficult to understand and Implement: – This method is difficult to understand as well as implement in
comparison to the payback and the ARR method.
b) Difficulty in fixing the required rate of return: – Required rate or discount rate is the most important in
calculating the NPV because different discount rates will give different present values.
c) In case of two projects with unequal initial investment, this method may not give satisfactory result.
d) In case of two projects with different lives, this method may not give satisfactory result.
2. INTERNAL RATE OF RETURN METHOD (IRR):– IRR method is also known as time adjusted rate
of return, marginal efficiency of capital, marginal productivity of capital and yield on investment. Like the
NPV method the IRR method also takes into consideration the time value of money by discounting the cash
flows. IRR is the discount rate at which present value of cash inflows is equal to the present value of cash
outflows.
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MERITS OF IRR METHOD

a) Like the other DCF methods, IRR methods also take into consideration the time value of money.
b) It takes into account all cash inflows and outflows occurring over the entire life time of the project.
c) Although the calculation of IRR involves tedious calculation, its meaning is easier to understand in
comparison to the concept of NPV.
DEMERITS OF IRR METHOD
a) Calculation of IRR involves tedious calculations.
b) Sometimes, this method produces more than one IRR. In such a case, it becomes difficult to accept or
reject the proposal.
c) It is assumed under the IRR method that all cash inflows of the project are reinvested at IRR rate. This
assumption is not valid.

3. PROFITABILITY INDEX OR (PI):– Second method of evaluating a project through discounted cash
flows is profitability index method. This method is also called Benefit-Cost Ratio.
This method is similar to NPV approach. A major drawback of the NPV method was that it does not give
satisfactory results while evaluating the projects requiring different initial investments. PI method provides a
solution to this problem.

ACCEPT-REJECT CRITERIA
a) If PI is more than one, the project will be accepted
b) If PI is less than one, the project will be rejected.
c) If PI is one, project may be accepted only on the basis of non-financial considerations.
MERITS OF PROFITABILITY INDEX METHOD
a) Like the other DCF techniques, the PI method also takes into account the time value of money.
b) It considers all cash flows during the life-time of the project
c) PI method is a reliable method in comparison to the NPV method when the initial investments in various
projects are different.
DEMERITS OF PROFITABILITY INDEX METHOD
a) This method is difficult to understand and implement
b) Calculations under this method are complex.

CASH FLOW
Cash flow is a dynamic process, in which the money moves into and out of a business. Its significance lines
in its timing, especially in the case of small entrepreneurs, who have to concentrate more on the „Cash
Management‟ rather than profitability. A carefully monitoring of the flow of cash is extremely important, as
poor „Cash Management‟ leads to negative „Cash inflow‟ (inflows not matching with the outflows)
Cash flow in concerned with:
1. Cash outflow: - The investment to be made in a project at the beginning stage and at various stages form
time to time needs to be estimated with all most care. Besides the cost the core assets required for the project,
other miscellaneous expenses involved in the project implementation, like transportation charges, installation
cost, working capital requirements, etc. are equally significant and are required to be estimated in a cautious
manner.
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2. Cash Inflows:- This is the most important aspect of a project, as the viability of a project hinges upon the
stream of cash inflows accruing as the return of the investment made in the project. As the cash inflows can
only be projected on the basis of certain historical data. Its estimation requires an extremely cautious
approach. The benefits reaped by the investing entity depend upon the difference between the cash outflows
and the estimated cash inflows likely to accrue during the life time of the project.
Accounting method based on „accrual‟ principle facilitates transforming „accrual Profit‟ into the „cash flow
profit‟.
Cash Flows as Profit: - Cash flow of a company is altogether different form its profit. Broadly speaking,
cash flow is the amount of money, which moves into (inflow) a business organization, during various
operational activities, like production, financing, investment. Etc. profit (net income), on the other hand, is the
balance of sales income, which remains after deducting the total of the expenditure incurred by the business
organization. For the calculation of „accounting profit‟ certain adjustment, relating to non cash-cash item like
interest, tax, depreciation, etc; are required to be made in the „net income‟

When a company maintains its books of account on the basis of accrual principle, in order to arrive of the
actual cash flow, certain adjustment are required to be made. Such adjustment are essential because of the
fact that at the time of determining the accrual net profit, certain expenses were taken into consideration,
though these expenses do not currently require a cash outlay. A company requires balance sheet under
assessment for the conversion of the accrual net profit to cash flow profit.
CASH FLOW STATEMENT COMPONENTS:
a) Cash Flow from Operating Activities: - The net amount of cash coming in or leaving from the day to
day business operations of an entity is called Cash Flow from Operations. Basically it is the operating
income plus non-cash items such as depreciation added. Since accounting profits are reduced by non-cash
items (i.e. depreciation and amortization) they must be added back to accounting profits to calculate cash
flow.
b) Cash flow from operations:- An important measurement because it tells the analyst about the viability of
an entities current business plan and operations. In the long run, cash flow from operations must be cash
inflows in order for an entity to be solvent and provide for the normal outflows from investing and finance
activities.
c) Cash Flow from Investing Activities: - Cash flow from investing activities would include the outflow of
cash for long term assets such as land, buildings, equipment, etc., and the inflows from the sale of assets,
businesses, securities, etc. Most cash flow investing activities are cash out flows because most entities
make long term investments for operations and future growth.
d) Cash Flow from Finance Activities: - Cash flow from finance activities is the cash out flow to the
entities investors (i.e. interest to bondholders) and shareholders (i.e. dividends and stock buybacks) and
cash inflows from sales of bonds or issuance of stock equity. Most cash flow finance activities are cash
outflows since most entities only issue bonds and stocks occasionally.
DIFFICULTIES IN DETERMINING CASH FLOWS
1. Sunk Costs: - These are the initial outlays required to analyze a project that cannot be recovered even if a
project is accepted. As such, these costs will not affect the future cash flows of the project and should not be
considered when making capital-budgeting decisions.
2. Opportunity Cost: - This is the cost of not going forward with a project or the cash outflows that will not
be earned as a result of utilizing an asset for another alternative. For example, the opportunity cost of Newco's
new addition considered above is the cost of the land on which the company is considering putting the new
plant addition. As such, it should be included in the analysis of the project.
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3. Externality:-In the consideration of incremental cash flows of a new project, there may be effects on the
existing operations of the company to consider, known as "externalities." For example, the addition to
Newco‟s plant is for the purpose of producing a new product. It must be considered whether the new product
may actually take away or add to sales of the existing product.
4. Cannibalization:- Cannibalization is the type of externality where the new project takes sales away from
the existing product.
5. Changes in Net Working Capital: - A change in net working capital is essentially the changes in current
assets minus changes in current liabilities. Within the capital-budgeting process, a project typically adds to
current assets given additional inventories or potential increases in accounts receivables from new sales. The
increases to current assets, however, are offset by current liabilities needed to finance the new project.

Thanks for completion of second unit