Capital Budgeting 1 52

CHAPTER 7
INVESTMENT DECISIONS
LEARNING OUTCOMES
♦ State the objectives of capital investment decisions.

♦ Discuss the importance and purpose of Capital budgeting for
a business entity.
♦ Calculate cash flows in capital budgeting decisions and try to
explain the basic principles for measuring the same.
♦ Discuss the various investment evaluation techniques like
Payback Period, Accounting Rate of Return (ARR), Net
Present Value (NPV), Profitability Index (PI), Internal Rate of
Return (IRR), Discounted Payback Period, and Modified
Internal Rate of Return (MIRR).
♦ Apply the concepts of the various investment evaluation
techniques for capital investment in decision making.
♦ Discuss the advantages and disadvantages of the above-
mentioned evaluation techniques.
7.2 FINANCIAL MANAGEMENT
CHAPTER OVERVIEW
Investment Decisions
Types of Investment Capital Budgeting

Decisions Techniques:
• Pay-back period
• Accounting rate of
Basic Principles for
Return (ARR)
Measuring Project Cash
• Net Present Value
flows
(NPV)
• Profitability Index (PI)
• Internal rate of Return
Capital budgeting in (IRR)
special cases • Modified Internal rate
of Return (MIRR)
• Discounted Pay-back
period
1. INTRODUCTION
In the first chapter, we had discussed the three important functions of financial
management which are Investment Decisions, Financing Decisions and Dividend
Decisions. So far, we have studied Financing decisions in previous chapters. In this
chapter, we will discuss the second important decision area of financial
management which is Investment Decision. Investment decision is concerned with
optimum utilization of fund to maximize the wealth of the organization and
in turn the wealth of its shareholders. Investment decision is very crucial for an
organization to fulfil its objectives; in fact, it generates revenue and ensures long
term existence of the organization. Even the entities which exist not for profit are
also required to make investment decision though not to earn profit but to fulfil its
mission.
As we have seen in the Financing Decision chapter, each rupee of capital raised by
an entity bears some cost, commonly known as cost of capital. It is necessary that
each rupee raised is to be invested in a very prudent manner. It requires a proper
planning for capital, and it is done through a proper budgeting. A proper budgeting
INVESTMENT DECISIONS 7.31.3
requires all the characteristics of budget. Due to this feature, investment decisions
are very popularly known as Capital Budgeting, which means applying the
principles of budgeting for capital investment.
In simple terms, Capital Budgeting involves:
 Identification of investment projects that are strategic to business’ overall
objectives;
 Estimating and evaluating post-tax incremental cash flows for each of the
investment proposals; and
 Selection of an investment proposal that maximizes the return to the
investors.
2. PURPOSE OF CAPITAL BUDGETING

The capital budgeting decisions are important, crucial and critical business
decisions due to the following reasons:
(i) Substantial Investment : Investment decisions are related with fulfillment of
long-term objectives and existence of an organization. To invest in a project(s),
a substantial capital investment is required. Based on size of capital and timing
of cash flows, sources of finance are selected. Due to huge capital investments
and associated costs, it is therefore necessary for an entity to make such
decisions after a thorough study and planning.
(ii) 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.
(iii) Irreversibility: Most of the investment decisions are irreversible. Once the
decision is implemented, it is very difficult and reasonably and economically not
possible to reverse the decision. The reason may be upfront payment of amount,
contractual obligations, technological impossibilities etc.
(iv) Complex decisions: 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.
3. CAPITAL BUDGETING PROCESS

The extent to which the capital budgeting process needs to be formalised and
systematic procedures to be established depends on the size of the organisation;
number of projects to be considered; direct financial benefit of each project
considered by itself; the composition of the firm's existing assets and
management's desire to change that composition; timing of expenditures
associated with the projects that are finally accepted.
Implement
Planning Evaluation Selection Control Review
-ation
(i) Planning: The capital budgeting process begins with the identification of
potential investment opportunities. The opportunity then enters the planning
phase when the potential effect on the firm's fortunes is assessed and the ability
of the management of the firm to exploit the opportunity is determined.
Opportunities having little merit are rejected and promising opportunities are
advanced in the form of a proposal to enter the evaluation phase.
(ii) Evaluation: This phase involves the determination of proposal and its
investments, inflows and outflows. Investment appraisal techniques, ranging
from the simple payback method and accounting rate of return to the more
sophisticated discounted cash flow techniques, are used to appraise the
proposals. The technique selected should be the one that enables the manager
to make the best decision in the light of prevailing circumstances.
(iii) Selection: Considering the returns and risks associated with the individual
projects as well as the cost of capital to the organisation, the organisation will
choose among the projects which maximises the shareholders’ wealth.
(iv) Implementation: When the final selection is made, the firm must acquire the
necessary funds, purchase the assets, and begin the implementation of the
project.
(v) Control: The progress of the project is monitored with the aid of feedback
reports. These reports will include capital expenditure progress reports,
performance reports comparing actual performance against plans set and post
completion audits.
(vi) Review: When a project terminates, or even before, the organisation should
review the entire project to explain its success or failure. This phase may have
implication for firm's planning and evaluation procedures. Further, the review
may produce ideas for new proposals to be undertaken in the future.
4. TYPES OF CAPITAL INVESTMENT DECISIONS

There are many ways to classify the capital budgeting decision. Generally capital
investment decisions are classified in two ways. One way is to classify them on the
basis of firm’s existence. Another way is to classify them on the basis of decision
situation.
Replacement and
Modernisation decisions
On the basis of firm’s

Expansion decisions
Types of Capital Investment
existence
Diversification decisions
Decisions
Mutually exclusive
decisions
On the basis of
Accept-Reject decisions
situation
Contingent decisions
4.1 On the basis of firm’s existence

The capital budgeting decisions are taken by both newly incorporated firms as well
as by existing firms. The new firms may require decision making in respect of
selection of a plant to be installed. Whereas the existing firm may require taking
decisions to meet the requirement of new environment or to face the challenges of

competition. These decisions may be classified as follows:
(i) Replacement and Modernisation decisions: The replacement and

modernisation decisions aims to improve operating efficiency and reduce cost.
Generally, all types of plant and machinery require replacement either because
the economic life of the plant or machinery is over or because it has become
technologically outdated. The former decision is known as replacement decision
and latter is known as modernisation decision. Both replacement and
modernisation decisions are called as cost reduction decisions.
(ii) Expansion decisions: Existing successful firms may experience growth in
demand of their product line. If such firms experience shortage or delay in the
delivery of their products due to inadequate production facilities, they may
consider proposal to add capacity to existing product line.
(iii) Diversification decisions: These decisions require evaluation of proposals to
diversify into new product lines, new markets etc. for reducing the risk of failure
by dealing in different products or by operating in several markets.
Both expansion and diversification decisions are called revenue expansion
decisions.
4.2 On the basis of situations

The capital budgeting decisions on the basis of situations are classified as follows:
(i) Mutually exclusive decisions: The decisions are said to be mutually exclusive if
two or more alternative proposals are such that the acceptance of one proposal
will exclude the acceptance of the other alternative proposals. For instance, a
firm may be considering proposal to install a semi-automatic or highly automatic
machine. If the firm installs a semi-automatic machine, it excludes the
acceptance of proposal to install highly automatic machine.
(ii) Accept-Reject decisions: The accept-reject decisions occur when proposals are
independent and do not compete with each other. The firm may accept or reject
a proposal on the basis of a minimum return on the required investment. All
those proposals which give a higher return than certain desired rate of return
are accepted and the rest are rejected.
(iii) Contingent decisions: The contingent decisions are made when the proposals
are dependable proposals. The investment in one proposal requires investment
in one or more other proposals. For example, if a company accepts a proposal
to set up a factory in remote area, it will have to invest in infrastructure, like
building of roads, houses for employees etc. also.
4.3 Steps of Capital Budgeting Procedure

1. Estimation of Cash flows over the entire life for each of the projects under
consideration.
2. Evaluate each of the alternative, using different decision criteria.
3. Determining the minimum required rate of return (i.e., WACC) to be used as
discount rate.
Accordingly, this chapter is divided into two sections:
1. Estimation of Cash Flows
2. Capital Budgeting Techniques
SECTION 1
5. ESTIMATION OF PROJECT CASH FLOWS

Capital Budgeting analysis considers only incremental cash flows from an
investment likely to result due to acceptance of any project. Therefore, one of the
most important tasks in capital budgeting is estimating future cash flows for a
project. Though one of the techniques i.e., Accounting Rate of Return (ARR)
evaluates profitability of a project on the basis of accounting profit, but accounting
profit has its own limitations. Timings of cash flow may not match with the period
of profit. Further, non-cash items like depreciation have no immediate cash outflow.
The cash flows are estimated on the basis of inputs provided by various
departments such as Production department, Finance department, Marketing
department, etc.he project cash flow stream consists of cash outflows and cash
inflows. The costs are denoted as "cash outflows" whereas the benefits are denoted
as "cash inflows".
An investment decision implies the choice of an objective, an appraisal technique

and the project’s life. The objective and technique must be related to definite
period of time. The life of the project may be determined by taking into
consideration the following factors:
(i) Technological obsolescence;
(ii) Physical deterioration; and

(iii) Decline in demand for the product
No matter how good a company's maintenance policy, technological or demand
forecasting abilities are, uncertainty will always be there.
Calculating Cash Flows: Before we analyze how cash flow is computed in capital
budgeting decision, following items needs consideration:
(a) Depreciation: As mentioned earlier, depreciation is a non-cash item and

itself does not affect the cash flow. However, we must consider tax shield or benefit
from depreciation in our analysis. Since this benefit reduces cash outflow for taxes,
it is considered as cash inflow. To understand how depreciation acts as tax shield,
let us consider following example:
Example -1
X Ltd. manufactures electronic motors fitted in desert coolers. It has an annual
turnover of ` 30 crore and cash expenses to generate this much of sale is ` 25 crore.
Suppose applicable tax rate is 30% and depreciation is ` 1.50 crore p.a.
The table below is showing Tax shield due to depreciation under two scenarios i.e.,
with and without depreciation:
No Depreciation is Charged Depreciation is Charged

(` Crore) (` Crore)
Total Sales 30.00 30.00
Less: Cost of Goods Sold (25.00) (25.00)
5.00 5.00
Less: Depreciation - 1.50
Profit before tax 5.00 3.50
Less: Tax @ 30% 1.50 1.05
Profit after Tax 3.50 2.45

Add: Depreciation* - 1.50
Cash Flow 3.50 3.95
* Being non- cash expenditure depreciation has been added back while calculating
the cash flow.
As we can see in the above table that due to depreciation under the second
scenario, a tax saving of ` 0.45 crore (` 1.50 – ` 1.05) was made. This is called tax
shield. The tax shield is considered while estimating cash flows.
(b) Opportunity Cost: Opportunity cost is foregoing of a benefit due to
choosing an alternative investment option. For example, if a company owns a piece
of land acquired 10 years ago for ` 1 crore can be sold for ` 10 crore in today’s
value. If the company uses this piece of land for a project, then its sale value i.e.
` 10 crore forms the part of initial outlay as by using the land the company has
foregone ` 10 crore which could be earned by selling it. This opportunity cost can
occur both at the time of initial outlay and during the tenure of the project.
Opportunity costs are considered for estimation of cash outflows.
(c) Sunk Cost: Sunk cost is an outlay of cash that has already been incurred in
the past and cannot be reversed in present. Therefore, these costs do not have any
impact on decision making, hence should be excluded from capital budgeting
analysis. For example, if a company has paid a sum of ` 1,00,000 for consultancy
fees to a firm to prepare a Project Report for analysing a particular project ie.
Feasibility study or viability study. Then the consultancy fee paid is irrelevant and
is not considered for estimating cash flows as it has already been paid and shall not
affect our decision whether project should be undertaken or not.
(d) Working Capital: Every big project requires working capital because, for
every business, investment in working capital is must. Therefore, while evaluating
the projects, initial working capital requirement should be treated as cash
outflow and at the end of the project its release should be treated as cash
inflow. It is important to note that no depreciation is provided on working capital
though it might be possible that at the time of its release its value might have been
reduced. Further there may be also a possibility that additional working capital
may be required during the life of the project. In such cases the additional working
capital required is treated as cash outflow at that period of time. Similarly, any
reduction in working capital shall be treated as cash inflow. It may be noted that, if
nothing has been specifically mentioned for the release of working capital it is
assumed that full amount has been realized at the end of the project. However,
adjustment on account of increase or decrease in working capital needs to be
incorporated.
(e) Allocated Overheads: As discussed in the subject of Cost and Management
Accounting, allocated overheads are charged on the basis of some rational basis
such as machine hour, labour hour, direct material consumption etc. Since,
expenditures already incurred are allocated to new proposal, they should not be
considered as cash flows. However, if it is expected that overhead cost shall increase
due to acceptance of any proposal then incremental overhead cost shall be treated
as cash outflow.
(f) Additional Capital Investment: It is not necessary that capital investment
shall be required in the beginning of the project. It can also be required during the
continuance of the project. In such cases, it shall be treated as cash outflows at that
period of time.
Categories of Cash Flows: It is helpful to place project cash flows into three
categories:
(a) Initial Cash Outflow: The initial cash outflow for a project depends upon the
type of capital investment decision as follows:
(i) If decision is related to investment in a fresh proposal or an expansion decision,
then initial cash outflow shall be calculated as follows:
Amount Amount
Cost of new Asset(s) xxx
Add: Installation/Set-Up Costs xxx
Add: Investment in Working Capital xxx xxx
Initial Cash Outflow xxx
(ii) If decision is related to replacement decision, then initial cash outflow shall be
calculated as follows:
Amount Amount
Cost of new Asset(s) xxx
INVESTMENT DECISIONS 7.11
1.11
Add: Installation/Set-Up Costs xxx

Add/(less): Increase (Decrease) in net xxx
Working Capital level
Less: Net Proceeds from sale of (xxx)
old assets
Add/(less): Tax expense (saving/ loss) xxx xxx
due to sale of Old Asset
Initial Cash Outflow xxx
(b) Interim Cash Flows: After making the initial cash outflow that is necessary to
begin implementing a project, the firm hopes to get benefit from the future cash
inflows generated by the project. The initial cash outflow for a project depends
upon the type of capital investment decision as follows:
(i) If analysis is related to a fresh or completely a new project then interim cash
flow is calculated as follows:
Amount Amount
Profit after Tax (PAT) xxx
Add: Non-Cash expenses (e.g. xxx
Depreciation)
Add/(less): Net decrease (increase) in xxx xxx
Working Capital
Interim net cash flow for the xxx
period
(ii) Similarly, interim cash flow in case of replacement decision shall be calculated as
follows:
Amount Amount
Net increase (decrease) in xxx
Operating Revenue
Add/(less): Net decrease (increase) in xxx
operating expenses
Net changes in income before xxx
taxes
Add/(less): Net decrease (increase) in taxes xxx

Net change in income after taxes xxx
Add/(less): Net decrease (increase) in xxx
depreciation charges
Incremental net cash flow for xxx
the period
(c) Terminal-Year Net Cash Flow: For calculating the net cash flow at the
terminal year, we will first calculate the incremental net cash flow for the period as
calculated in point (b) above and further, we will make adjustments to it as follows:
Amount Amount
Final salvage value (disposal costs) of xxx
asset
Add: Interim Cash Flow xxx
Add/(less): Tax savings (tax expenses) due to sale xxx
or disposal of asset (Including
depreciation)
Add: Release of Net Working Capital xxx xxx
Terminal Year net cash flow xxx
6. BASIC PRINCIPLES FOR MEASURING

PROJECT CASH FLOWS
For developing the project cash flows, the following principles must be kept in
mind.
6.1 Block of Assets and Depreciation

From above discussion, it is clear that tax shield/ benefit from depreciation is
considered while calculating cash flows from the project. Taxable income is
calculated as per the provisions of Income Tax or similar Act of a country. The
treatment of deprecation is based on the concept of “Block of Assets”, which means
a group of assets falling within a particular class of assets. This class of assets can
be building, machinery, furniture etc. in respect of which depreciation is charged at
1.13
same rate. The treatment of tax depends on the fact whether block of asset consist
of one asset or several assets. To understand the concept of block of asset, let us
discuss an example as follows:
Example- 2
Suppose A Ltd. acquired new machinery for ` 1,00,000, depreciable at 20% as per
written down value (WDV) method. The machine has an expected life of 5 years
with salvage value of ` 10,000. The treatment of depreciation/ short term capital
loss in the 5th year in two cases shall be as follows:
Depreciation for initial 4 years shall be common and WDV at the beginning of the
5th year shall be computed as follows:
`
Purchase Price of Machinery 1,00,000
Less: Depreciation @ 20% for year 1 20,000
WDV at the end of year 1 80,000
(i) Case 1 - There is no other asset in the Block: When there is only one asset in
the block and block shall cease to exist at the end of 5th year, then no deprecation
shall be charged in 5th year and tax benefit/loss on short term capital loss/ gain
shall be calculated as follows:
`
WDV at the beginning of year 5 40,960
Less: Sale value of Machine 10,000
Short Term Capital Loss (STCL) 30,960
Tax Benefit on STCL @ 30% 9,288
(ii) Case 2 - More than one asset exists in the Block: When more than one asset
exists in the block, then deprecation shall be charged in the terminal year (5th
year) in which asset is sold. The WDV on which depreciation be charged shall be
calculated by deducting sale value from the WDV in the beginning of that year.
Tax benefit on depreciation shall be calculated as follows:
`
WDV 30,960
Depreciation @ 20% 6,192
Tax Benefit on Depreciation @ 30% 1,858
Now suppose if in above two cases, sale value of machine is ` 50,000, then no
depreciation shall be provided in Case 2 because the WDV at the beginning of 5th
year is only ` 40,960 i.e., less than sale value of ` 50,000 and tax loss on STCG in
Case 1 shall be computed as follows:
`
Short Term Capital Gain (STCG) 9,040
Tax outflow on STCG @ 30% 2,712
6.2 Exclusion of Financing Costs Principle

When cash flows relating to long-term funds are being defined, financing costs of
long-term funds (interest on long-term debt and equity dividend) should be
excluded from the analysis. The interest and dividend payments are reflected in
the weighted average cost of capital. Hence, if interest on long-term debt and
dividend on equity capital are deducted in defining the cash flows, the cost of long-
term funds will be counted twice.
The exclusion of financing costs principle means that:

(i) The interest on long-term debt is ignored while computing profits and taxes.
(ii) The expected dividends are deemed irrelevant in cash flow analysis.
1.15
While dividends pose no difficulty as they come only from profit after taxes, interest
needs to be handled properly. Since interest is usually deducted in the process of
arriving at profit after tax, an amount equal to ‘Interest (1 − Tax rate)’ should be
added back to the figure of Profit after Tax as shown below:
= Profit Before Interest and Tax × (1 − Tax rate)
= (Profit Before Tax + Interest) (1 − Tax rate)

= (Profit Before Tax) (1 − Tax rate) + (Interest) (1 − Tax rate)
= Profit After Tax + Interest (1 − Tax rate)
Thus, whether the tax rate is applied directly to the profit before interest and tax
figure or whether the tax − adjusted interest, which is simply interest (1 − tax rate),
is added to profit after tax, we get the same result only.
Example- 3
Suppose XYZ Ltd.’s expected profit for the forthcoming 4 years is as follows:
Year 1 Year 2 Year 3 Year 4

Profit before Interest and Tax ` 10,000 ` 20,000 ` 40,000 ` 50,000
If interest payable is ` 5,000 and tax rate is 30%, then the profit after tax excluding
financing cost shall be as follows:

( `) ( `) ( `) ( `)
Profit before Interest and Tax 10,000 20,000 40,000 50,000

Less: Interest (5,000) (5,000) (5,000) (5,000)
5,000 15,000 35,000 45,000
Less: Tax @ 30% (1,500) (4,500) (10,500) (13,500)
Profit after Tax (PAT) 3,500 10,500 24,500 31,500
Add: Interest (1- t) 3,500 3,500 3,500 3,500
PAT excluding financing cost 7,000 14,000 28,000 35,000
Alternatively

(`) (`) (`) (`)
Profit before Interest and Tax 10,000 20,000 40,000 50,000
Less: Tax @ 30% 3,000 6,000 12,000 15,000
PAT excluding financing cost 7,000 14,000 28,000 35,000
6.3 Post-tax Principle

Tax payments like other payments must be properly deducted in deriving the cash
flows. That is, cash flows must be defined in post-tax terms. It is always better to
avoid using pre-tax cash flows and using pre-tax discounting rate. The discounting
rate and the cash flows, both must be post-tax only.
Statement showing the calculation of Cash Inflow After Tax (CFAT)
Particulars (`) (`)
Sales value xxx
Less: Variable Cost xxx
Contribution xxx
Less: Fixed Cost
(a) Fixed Cash Cost (excluding Interest) xxx
(b) Depreciation xxx xxx
Earning Before Tax (EBT) xxx
Less: Tax xxx
Earning After Tax (EAT) xxx
Add: Depreciation xxx
Cash Inflow After Tax (CFAT) xxx
ILLUSTRATION 1
ABC Ltd is evaluating the purchase of a new machinery with a depreciable base of
` 1,00,000; expected economic life of 4 years and change in earnings before taxes
and depreciation of ` 45,000 in year 1, ` 30,000 in year 2, ` 25,000 in year 3 and
` 35,000 in year 4. Assume straight-line depreciation and a 20% tax rate. You are
required to COMPUTE relevant cash flows.
1.17
SOLUTION
Depreciation = ` 1,00,000 ÷ 4 = ` 25,000
Amount in (`)
Years
1 2 3 4
Earnings before tax and depreciation 45,000 30,000 25,000 35,000
Less: Depreciation (25,000) (25,000) (25,000) (25,000)
Earnings before tax 20,000 5,000 0 10,000
Less: Tax @20% (4,000) (1,000) 0 (2,000)
Earnings after tax 16,000 4,000 0 8,000
Add: Depreciation 25,000 25,000 25,000 25,000
Net Cash flow 41,000 29,000 25,000 33,000
SECTION 2
7. CAPITAL BUDGETING TECHNIQUES

In order to maximise the return to the shareholders of a company, it is important
that the best or most profitable investment projects are selected. Results of making
a bad long-term investment decision can be devastating in both financial and
strategic terms. Proper care is required for investment project selection and
evaluation.
There are number of techniques available for the appraisal of investment proposals
and can be classified as presented below:
Payback Period
Traditional or
Non-
Discounting Accounting Rate of Return
(ARR)
Capital Budgeting Net Present Value (NPV)

Techniques
Profitability Index (PI)
Time adjusted
or Discounted Internal Rate of Return (IRR)
Cash Flows
Discounted Payback Period
Modified Internal Rate of

Return (MIRR)
Organisations may use one or more of capital investment evaluation techniques

from above. Some organisations use different methods for different types of
projects while others may use multiple methods for evaluating each project. The
techniques discussed below are Payback Period, Accounting Rate of Return (ARR),
Net Present Value (NPV), Profitability Index (PI), Internal Rate of Return (IRR),
Discounted Payback Period and Modified Internal Rate of Return (MIRR).
8. TRADITIONAL OR NON-DISCOUNTING
TECHNIQUES
These techniques of capital Budgeting does not discount the future cash flows.
There are two such traditional techniques namely Payback Period and Accounting
Rate of Return.
8.1 Payback Period

Time required to recover the initial cash-outflow is called pay-back period. The
payback period of an investment is the length of time required for the cumulative
total net cash flows from the investment to equal the total initial cash outlays. At
1.19
that point in time (payback period), the investor has recovered all the money
invested in the project.
Steps in Payback period technique:
(a) The first step in calculating the payback period is determining the total initial
capital investment (cash outflow).
(b) The second step is calculating/estimating the annual expected after-tax cash
flows over the useful life of the project.
1. Uniform Cash Flows: When the cash inflows are uniform over the useful life of
the project, the number of years in the payback period can be calculated using
the following equation:
Total initial capital investment

Payback period =
Annual expected after - tax net cash flow
Example- 4
Suppose a project costs ` 20,00,000 and yields annually a profit of ` 3,00,000
after depreciation @ 12½% (straight line method) but before tax at 50%.
The first step would be to calculate the cash inflow from this project. The cash
inflow is calculated as follows:
Particulars (`)
Profit before tax 3,00,000
Less: Tax @ 50% 1,50,000
Profit after tax 1,50,000
Add: Depreciation written off 2,50,000
Total cash inflow 4,00,000
While calculating cash inflow, depreciation is added back to profit after tax since
it does not result in cash outflow. The cash generated from a project therefore is
equal to profit after tax plus depreciation. The payback period of the project shall
be:
Payback period = ` 20,00,000 = 5 Years

4,00,000
Some Accountants calculate payback period after discounting the cash flows
by a predetermined rate and the payback period so calculated is called as
‘Discounted payback period’ (discussed later on in the chapter).
2. Non-Uniform Cash Flows: When the annual cash inflows are not uniform,
the cumulative cash inflow from operations must be calculated for each year.
The payback period shall be corresponding period when total of cumulative
cash inflows is equal to the initial capital investment. However, if exact sum
does not match, then the period in which it lies should be identified. After
that we need to compute the fraction of the year. This method can be
understood with the help of an example:
Example- 5
Suppose XYZ Ltd. is analyzing a project requiring an initial cash outlay of ` 2,00,000
and is expected to generate cash inflows as follows:
Year Annual Cash Inflows (`)

1 80,000
2 60,000
3 60,000
4 20,000
It’s payback period shall be computed by using cumulative cash flows as follows:
Year Annual Cash Cumulative Cash

Inflows (`) Inflows (`)
1 80,000 80,000
2 60,000 1,40,000
3 60,000 2,00,000
4 20,000 2,20,000
In 3rd year, cumulative cash inflows equal to initial cash outlay i.e., ` 2,00,000. Hence,
payback period is 3 years.
Suppose if in above example, the initial outlay is ` 2,05,000, then:
1.21
Payback period shall lie between 3 to 4 years. Since up to 3 years, a sum of

` 2,00,000 shall be recovered and balance of ` 5,000 shall be recovered in the part
(fraction) of 4th year, computation is as follows:
Balance Cash outlay ` 5,000 1
Part of 4th year =    year
Commulative Cash Inflow at 4 year ` 20,000 4
th
Thus, total cash outlay of ` 2,05,000 shall be recovered in 3¼ years’ time.

Advantages of Payback period
 It is easy to compute.
 It is easy to understand as it provides a quick estimate of the time needed
for the organization to recoup the cash invested.
 The length of the payback period can also serve as an estimate of a project’s
risk; the longer the payback period, the riskier the project as long-term
predictions are less reliable. In some industries with high obsolescence risk
like software industry or in situations where an organization is short on cash,
short payback periods often become the determining factor for investments.
Limitations of Payback period
 It ignores the time value of money. As long as the payback periods for two
projects are the same, the payback period technique considers them equal as
investments, even if one project generates most of its net cash inflows in the
early years of the project while the other project generates most of its net
cash inflows in the latter years of the payback period.
 A second limitation of this technique is its failure to consider an investment’s
total profitability; it only considers cash inflows up-to the period in which
initial investment is fully recovered and ignores cash flows after the
payback period.
 Payback technique places much emphasis on short payback periods thereby
ignoring long-term projects.
8.1.1 Payback Reciprocal

As the name indicates, it is the reciprocal of payback period. A major drawback of
the payback period method of capital budgeting is that it does not indicate any cut
off period for the purpose of investment decision. It is, however, argued that the
reciprocal of the payback would be a close approximation of the Internal Rate of

Return (later discussed in detail) if the life of the project is at least twice the payback
period and the project generates equal amount of the annual cash inflows. In
practice, the payback reciprocal is a helpful tool for quick estimation of rate of
return of a project provided its life is at least twice the payback period.
The payback reciprocal can be calculated as follows:
Average annual cash in flow
Payback Reciprocal =
Initial investment
Example- 6
Suppose a project requires an initial investment of ` 20,000 and it would give
annual cash inflow of ` 4,000. The useful life of the project is estimated
to be 10 years.
` 4,000×100
In this example, payback reciprocal = = 20%
` 20,000
The above payback reciprocal provides a reasonable approximation of the internal

rate of return, i.e. 20%.
8.2 Accounting (Book) Rate of Return (ARR) or Average

Rate of Return (ARR)
The accounting rate of return of an investment measures the average annual net
income of the project (incremental income) as a percentage of the investment.
Average annual net income
Accounting Rate of Return (ARR) =
Investment
The numerator is the average annual net income generated by the project over its
useful life. The denominator can be either the initial investment (including
installation cost) or the average investment over the useful life of the project.
Average investment means the average amount of fund remained blocked during
the lifetime of the project under consideration. Further, ARR can be calculated in a
number of ways as shown in the following example:
1.23
Example- 7
Suppose Times Ltd. is going to invest in a project a sum of ` 3,00,000 having a life
span of 3 years. Salvage value of machine is ` 90,000. The profit before depreciation
for each year is ` 1,50,000.
The Profit after Tax and value of Investment in the Beginning and at the End of each
year shall be as follows:
Year Profit Before Depreciation Profit after Value of Investment in

Depreciation Depreciation
(`) (`) (`) (`)
Beginning End
1 1,50,000 70,000 80,000 3,00,000 2,30,000
2 1,50,000 70,000 80,000 2,30,000 1,60,000
3 1,50,000 70,000 80,000 1,60,000 90,000
The ARR can be computed by following methods as follows:

(a) Version 1: Annual Basis
ProfitafterDepreciation
ARR = x100
Investmentinthebeginingof the year
Year
1 80,000
= 26.67%
3,00,000
2 80,000
= 34.78%
2,30,000
3 80,000
=50%
1,60,000
26.67%+34.78%+50.00%
Average ARR = = 37.15%
3
(b) Version 2: Total Investment Basis

Average Annual Profit
ARR = ×100
Investment in the begining
(80,000+80,000+80,000) / 3
= ×100 = 26.67%
3,00,000
(c) Version 3: Average Investment Basis

Average Annual Profit
ARR = ×100
Average Investment
Average Investment = (` 3,00,000 + ` 90,000)/2 = ` 1,95,000

Or, Average Investment = ½ (Initial Investment – Salvage Value) + Salvage Value
= ½ (` 3,00,000 – ` 90,000) + ` 90,000 = ` 1,95,000
80,000
ARR = ×100 = 41.03%
1,95,000
Further, it is important to note that project may also require additional working
capital during its life in addition to initial working capital. In such situation, formula
for the calculation of average investment shall be modified as follows:
½(Initial Investment – Salvage Value) + Salvage Value + Additional Working Capital
Continuing above example, suppose a sum of ` 45,000 is required as additional
working capital during the project life, then average investment shall be:
= ½ (` 3,00,000 – ` 90,000) + ` 90,000 + ` 45,000 = ` 2,40,000 and
80,000
ARR = ×100 = 33.33%
2, 40,000
Some organizations prefer the initial investment because it is objectively

determined and is not influenced by either the choice of the depreciation method
or the estimation of the salvage value. Either of these amounts is used in practice
but it is important that the same method be used for all investments under
consideration.
Advantages of ARR
 This technique uses readily available data that is routinely generated for
financial reports and does not require any special procedures to generate data.
 This method may also mirror the method used to evaluate performance on the
operating results of an investment and management performance. Using the
same procedure in both decision-making and performance evaluation ensures
consistency.
1.25
 Calculation of the accounting rate of return method considers all net incomes
over the entire life of the project and provides a measure of the investment’s
profitability.
Limitations of ARR
 The accounting rate of return technique, like the payback period technique,
ignores the time value of money and considers the value of all cash flows to
be equal.
 The technique uses accounting numbers that are dependent on the
organization’s choice of accounting procedures, and different accounting
procedures, e.g., depreciation methods, can lead to substantially different
amounts for an investment’s net income and book values.
 The method ignores cash flows; while net income is a useful measure of
profitability, the net cash flow is a better measure of an investment’s
performance.
 Furthermore, inclusion of only the book value of the invested asset ignores the
fact that a project can require commitments of working capital and other
outlays that are not included in the book value of the project.
ILLUSTRATION 2
A project requiring an investment of ` 10,00,000 and it yields profit after tax and
depreciation which is as follows:
Years Profit after tax and depreciation (`)

1 50,000
2 75,000
3 1,25,000
4 1,30,000
5 80,000
Total 4,60,000
Suppose further that at the end of the 5th year, the plant and machinery of the project
can be sold for ` 80,000. DETERMINE Average Rate of Return.
SOLUTION
In this case the rate of return can be calculated as follows:
Total Profit÷No. of years
×100
Average investment / Initial Investment
(a) If Initial Investment is considered then,
= ` 4,60,000÷ 5 years ×100 = ` 92,000 ×100 = 9.2%

` 10,00,000 ` 10,00,000
This rate is compared with the rate expected on other projects, had the same
funds been invested alternatively in those projects. Sometimes, the management
compares this rate with the minimum rate (called-cut off rate). For example,
management may decide that they will not undertake any project which has an
average annual yield after tax less than 20%. Any capital expenditure proposal
which has an average annual yield of less than 20%, will be automatically
rejected.
(b) If Average investment is considered, then,
` 92,000 ` 92,000
= ×100 = ×100 = 17.04%
Average Investment ` 5, 40,000
Where,
Average Investment = ½ (Initial investment – Salvage value) + Salvage value
= ½ (` 10,00,000 – ` 80,000) + ` 80,000
= ` 4,60,000 + ` 80,000 = ` 5,40,000
9. DISCOUNTING TECHNIQUES
Discounting techniques consider time value of money and discount the cash flows
to their Present Value. These techniques are also known as Present Value
techniques. These are namely Net Present Value (NPV), Internal Rate of Return (IRR)
and Profitability Index (PI), Discounted Payback Period. First, let us discuss about
Determination of Discount rate and it will be followed by the four techniques.
Determining Discount Rate
Theoretically, the discount rate or desired / expected rate of return on an
investment is the rate of return the firm would have earned by investing the same
1.27
funds in the best available alternative investment that has the same risk.
Determining the best alternative opportunity available is difficult in practical terms
so rather than using the true opportunity cost, organizations often use an
alternative measure for the desired rate of return. An organization may establish a
minimum rate of return that all capital projects must meet; this minimum could be
based on an industry average or the cost of other investment opportunities. Many
organizations choose to use the overall cost of capital or Weighted Average Cost
of Capital (WACC) that an organization has incurred in raising funds or expects to
incur in raising the funds needed for an investment.
9.1 Net Present Value Technique (NPV)

The net present value technique is a discounted cash flow method that considers
the time value of money in evaluating capital investments. An investment has cash
flows throughout its life, and it is assumed that an amount of cash flow in the early
years of an investment is worth more than an amount of cash flow in a later year.
The net present value method uses a specified discount rate to bring all subsequent
cash inflows after the initial investment to their present values (the time of the
initial investment is year 0).
The net present value of a project is the amount, in current value of amount, the
investment earns after paying cost of capital in each period.
Net present value = Present value of net cash inflow - Total net initial investment
Since it might be possible that some additional investment may also be required
during the life time of the project, then appropriate formula shall be:
Net present value = Present value of cash inflows - Present value of cash outflows
It can be expressed as below:
 C C C C 
NPV =  1 + 2 2 + 3 3 +......+ n n  -I
 (1+k) (1+k) (1+k) (1+k) 
n Ct
NPV = ∑ -I
t =1 (1+k)t
Where,
C = Cash flow of various years
k = Discount rate
N = Life of the project
I = Investment
Steps for calculating Net Present Value (NPV):
The steps for calculating net present value are:
1. Determine the net cash inflow in each year of the investment.
2. Select the desired rate of return or discounting rate or Weighted Average Cost
of Capital.
3. Find the discount factor for each year based on the desired rate of return
selected.
4. Determine the present values of the net cash flows by multiplying the cash flows
by respective discount factors of respective period called Present Value (PV) of
Cash flows
5. Total the amounts of all PVs of Cash Flows.
Decision Rule:
If NPV ≥ 0 Accept the Proposal
If NPV < 0 Reject the Proposal
The NPV method can be used to select between mutually exclusive projects; the
one with the higher NPV should be selected.
ILLUSTRATION 3
COMPUTE the net present value for a project with a net investment of ` 1,00,000 and
net cash flows for year one is ` 55,000; for year two is ` 80,000 and for year three is
` 15,000. Further, the company’s cost of capital is 10%.
[PVIF @ 10% for three years are 0.909, 0.826 and 0.751]
1.29
SOLUTION
Year Net Cash PVIF @ 10% Discounted Cash

Flows (`) Flows (`)
0 (1,00,000) 1.000 (1,00,000)
1 55,000 0.909 49,995
2 80,000 0.826 66,080
3 15,000 0.751 11,265
Net Present Value 27,340
Recommendation: Since the net present value of the project is positive, the
company should accept the project.
ILLUSTRATION 4
ABC Ltd. is a small company that is currently analyzing capital expenditure proposals
for the purchase of equipment; the company uses the net present value technique to
evaluate projects. The capital budget is limited to ` 500,000 which ABC Ltd. believes
is the maximum capital it can raise. The initial investment and projected net cash
flows for each project are shown below. The cost of capital of ABC Ltd is 12%. You
are required to COMPUTE the NPV of the different projects.
Project A Project B Project C Project D

(`) (`) (`) (`)
Initial Investment 200,000 190,000 250,000 210,000
Project Cash Inflows:
Year 1 50,000 40,000 75,000 75,000
2 50,000 50,000 75,000 75,000
3 50,000 70,000 60,000 60,000
4 50,000 75,000 80,000 40,000
5 50,000 75,000 100,000 20,000
SOLUTION
Calculation of net present value:
Period PV factor Project A Project B Project C Project D

( `) ( `) ( `) ( `)
0 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000)
1 0.893 44,650 35,720 66,975 66,975
2 0.797 39,850 39,850 59,775 59,775
3 0.712 35,600 49,840 42,720 42,720
4 0.636 31,800 47,700 50,880 25,440
5 0.567 28,350 42,525 56,700 11,340
Net Present Value (19,750) 25,635 27,050 (3,750)
Advantages of NPV
 NPV method takes into account the time value of money.
 The whole stream of cash flows is considered.
 The net present value can be seen as the addition to the wealth of
shareholders. The criterion of NPV is thus in conformity with basic financial
objectives.
 The NPV uses the discounted cash flows i.e., expresses cash flows in terms
of current rupees. The NPVs of different projects therefore can be compared.
It implies that each project can be evaluated independent of others on its
own merit.
Limitations of NPV
 It involves difficult calculations.
 The application of this method necessitates forecasting cash flows and the
discount rate. Thus, accuracy of NPV depends on accurate estimation of
these two factors which may be quite difficult in practice.
 The decision under NPV method is based on absolute measure. It ignores
the difference in initial outflows, size of different proposals etc. while
evaluating mutually exclusive projects.
1.31
9.2 Profitability Index/Desirability Factor/Present Value

Index Method (PI)
The students may have seen how with the help of discounted cash flow technique,
the two alternative proposals for capital expenditure can be compared. In certain
cases, we have to compare a number of proposals, each involving different amounts
of cash inflows.
One of the methods of comparing such proposals is to work out what is known as
the ‘Desirability factor’, or ‘Profitability Index’ or ‘Present Value Index Method’.
Mathematically:
The Profitability Index (PI) is calculated as below:
Profitability Index (PI)= Sum of discounted cash in flows

Initial cash outlay or Total discounted cash outflow (as the case may)
Decision Rule:
If PI ≥ 1 Accept the Proposal

If PI < 1 Reject the Proposal
In case of mutually exclusive projects, project with higher PI should be selected.
ILLUSTRATION 5
Suppose we have three projects involving discounted cash outflow of ` 5,50,000,
` 75,000 and ` 1,00,20,000 respectively. Suppose further that the sum of discounted
cash inflows for these projects are ` 6,50,000, ` 95,000 and ` 1,00,30,000 respectively.
CALCULATE the desirability factors for the three projects.
SOLUTION
The desirability factors for the three projects would be as follows:
1. = `6,50,000 =1.18
`5,50,000
2. = `95,000 =1.27
`75,000
3. = `1,00,30,000 =1.001
`1,00,20,000
It can be seen that in absolute terms, project 3 gives the highest cash inflows yet
its desirability factor is low. This is because the outflow is also very high. The
Desirability/ Profitability Index factor helps us in ranking various projects.
Since PI is an extension of NPV, it has same advantages and limitation.
Advantages of PI
 The method also uses the concept of time value of money.
 In the PI method, since the present value of cash inflows is divided by the
present value of cash outflow, it is a relative measure of a project’s
profitability.
Limitations of PI
 Profitability index fails as a guide in resolving capital rationing where projects
are indivisible.
 Once a single large project with high NPV is selected, possibility of accepting
several small projects which together may have higher NPV than the single
project is excluded.
 Also, situations may arise where a project with a lower profitability index
selected may generate cash flows in such a way that another project can be
taken up one or two years later, the total NPV in such case being more than
the one with a project with highest Profitability Index.
The Profitability Index approach thus cannot be used indiscriminately but all
other type of alternatives of projects will have to be worked out.
9.3 Internal Rate of Return Method (IRR)

The internal rate of return method considers the time value of money, the initial
cash investment, and all cash flows from the investment. But unlike the net present
value method, the internal rate of return method does not use the desired rate of
return but estimates the discount rate that makes the present value of subsequent
cash inflows equal to the initial investment. This discount rate is called IRR.
IRR Definition: Internal rate of return for an investment proposal is the discount
rate that equates the present value of the expected cash inflows with the
initial cash outflow.
1.33
This IRR is then compared to a criterion rate of return that can be the organization’s
desired rate of return for evaluating capital investments.
Calculation of IRR: The procedures for computing the internal rate of return vary
with the pattern of net cash flows over the useful life of an investment.
Scenario 1: For an investment with uniform cash flows over its life, the following
equation is used:
Step 1: Total initial investment = Annual cash inflow × Annuity discount factor of
the discount rate for the number of periods of the investment’s useful life
If A is the annuity discount factor, then:
Total initial cash disbursements and commitments for the investment
A=
Annual (equal) cash inflows from the investment
Step 2: Once A is calculated, the interest rate corresponding to project’s life, the
value of A is searched in Present Value Annuity Factor (PVAF) table. If exact value
of ‘A’ is found the respective interest rate shall be IRR. However, it rarely happens
therefore we follow the steps discussed below:
Step 1: Compute approximate payback period also called fake payback period.
Step 2: Locate this value in PVAF table corresponding to period of life of the project.
The value may be falling between two discounting rates.
Step 3: Discount cash flows using these two discounting rates.
Step 4: Use following Interpolation Formula:
NPV at LR
LR + ×(HR -LR)
NPV at LR - NPV at HR
Or
PV at LR -CI
LR+ ×(HR -LR)
PV at LR - PV at HR
Where,
LR = Lower Rate
HR = Higher Rate
CI = Capital Investment
ILLUSTRATION 6
A Ltd. is evaluating a project involving an outlay of ` 10,00,000 resulting in an annual
cash inflow of ` 2,50,000 for 6 years. Assuming salvage value of the project is zero;
DETERMINE the IRR of the project.
SOLUTION
First of all, we shall find an approximation of the payback period:
10,00,000
= =4
2,50,000
Now, we shall search this figure in the PVAF table corresponding to 6-year row.
The value 4 lies between values 4.111 and 3.998, correspondingly discounting rates
are 12% and 13% respectively
NPV @ 12% and 13% is:

NPV12%= (10,00,000) + 4.111 × 2,50,000 = +27,750
NPV13%= (10,00,000) + 3.998 × 2,50,000 = -500
The internal rate of return is, thus, more than 12% but less than 13%. The exact rate
can be obtained by interpolation:
27,750
IRR =12%+ ×(13%-12%)
27,750 - (-500)
= 12% + 27,750 = 12.978%

28,250
IRR = 12.978%
Scenario 2: When the cash inflows are not uniform over the life of the investment,
the determination of the discount rate can involve trial and error and interpolation
between discounting rates as mentioned above. However, IRR can also be found
out by using following procedure:
Step 1: Discount the cash flow at any random rate, say 10%, 15% or 20%.
Step 2: If resultant NPV is negative, then discount cash flows again by lower
discounting rate to make NPV positive. Conversely, if resultant NPV is positive, then
again discount cash flows by higher discounting rate to make NPV negative.
Step 3: Use following Interpolation Formula:
1.35
NPV at LR
LR+ ×(HR -LR)
Where
LR = Lower Rate
HR = Higher Rate
ILLUSTRATION 7
CALCULATE the internal rate of return of an investment of ` 1,36,000 which yields
the following cash inflows:
Year Cash Inflows (` )
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
SOLUTION
Let us discount cash flows by 10%.
Year Cash Inflows (`) Discounting factor at 10% Present Value (`)
1 30,000 0.909 27,270
2 40,000 0.826 33,040
3 60,000 0.751 45,060
4 30,000 0.683 20,490
5 20,000 0.621 12,420
Total present value 1,38,280
Less: Initial Investment 1,36,000
NPV +2,280
The NPV calculated @ 10% is positive. Therefore, a higher discount rate is

suggested, say, 12%.
Year Cash Inflows (`) Discounting factor at 12% Present Value (`)
1 30,000 0.893 26,790
2 40,000 0.797 31,880
3 60,000 0.712 42,720
4 30,000 0.636 19,080
5 20,000 0.567 11,340
Total present value 1,31,810
Less: Initial Investment 1,36,000
NPV - 4,190
NPV at LR
IRR =LR + ×(HR -LR)
`2,280
=10+ ×(12-10)
`2,280 - (-4,190)
`2,280
=10+ ×(12-10) =10 + 0.704
`6, 470
IRR = 10.704%
ILLUSTRATION 8
A company proposes to install machine involving a capital cost of ` 3,60,000. The life
of the machine is 5 years and its salvage value at the end of the life is nil. The machine
will produce the net operating income after depreciation of ` 68,000 per annum. The
company's tax rate is 45%.
The Net Present Value factors for 5 years are as under:
Discounting rate 14 15 16 17 18
Cumulative factor 3.43 3.35 3.27 3.20 3.13
You are required to COMPUTE the internal rate of return of the proposal.
1.37
SOLUTION
Computation of Cash inflow per annum `
Particulars (`)
Net operating income per annum 68,000
Less: Tax @ 45% (30,600)
Profit after tax 37,400
Add: Depreciation (` 3,60,000 / 5 years) 72,000
Cash inflow 1,09,400
The IRR of the investment can be found as follows:

NPV = − ` 3,60,000 + ` 1,09,400 (PVAF5, r) = 0
or PVAF5,r (Cumulative factor) = `3,60,000 = 3.29

`1,09, 400
As 3.29 falls between Discounted rate 15 & 16, the computation is as below :
Computation of Internal Rate of Return
Discounting Rate
15% 16%
Cumulative factor 3.35 3.27
PV of Inflows (`) 3,66,490 3,57,738
(` 1,09,400×3.35) (` 1,09,400×3.27)
Less: Initial outlay (`) 3,60,000 3,60,000
NPV (`) 6,490 (2,262)
IRR = 15 +
 6,490  × (16 -15) = 15 + 0.74 = 15.74%.
 6,490+2,262 
 
9.3.1 Acceptance Rule
The use of IRR, as a criterion to accept capital investment decision involves a
comparison of IRR with the required rate of return known as cut-off rate. The
project should the accepted if IRR is greater than cut-off rate. If IRR is equal to cut-
off rate the firm is indifferent. If IRR less than cut off rate the project is rejected.
Thus,
If IRR ≥ Cut-off Rate or WACC Accept the Proposal
If IRR < Cut-off Rate or WACC Reject the Proposal
9.3.2 Internal Rate of Return (IRR) and Mutually Exclusive Projects

Projects are called mutually exclusive, when the selection of one precludes the
selection of others e.g. in case a company owns a piece of land which can be put
to use either for project S or L, such projects are mutually exclusive to each other
i.e. the selection of one project necessarily means the rejection of the other. Refer
to the figure below:
As long as the cost of capital is greater than the crossover rate of 7%, (1) NPVS is
larger than NPVL and (2) IRRS exceeds IRRL. Hence, if the cut- off rate or the cost of
capital is greater than 7%, both the methods shall lead to selection of project S.
However, if the cost of capital is less than 7%, the NPV method ranks Project L
higher, but the IRR method indicates that the Project S is better.
As can be seen above, mutually exclusive projects can create problem with the IRR
technique as IRR is expressed in percentage and does not take into account the
scale of investment or the quantum of money earned.
1.39
Let us consider another example of two mutually exclusive projects A and B with
the following details:
Example - 8
Cash flows
Year 0 Year 1 IRR NPV at 10%

Project A (` 1,00,000) ` 1,50,000 50% ` 36,360
Project B (` 5,00,000) ` 6,25,000 25% ` 68,180
Project A earns a return of 50% which is more than what Project B earns; however,
the NPV of Project B is more than of Project A. Acceptance of Project A means
rejection of Project B since the two Projects are mutually exclusive. Acceptance of
Project A also implies that the total investment will be ` 4,00,000 less had the
Project B been accepted, ` 4,00,000 being the difference between the initial
investment of the two projects. Assuming that the funds are freely available at 10%,
the total capital expenditure of the company should ideally be equal to sum total
of all outflows provided they earn more than 10% return along with the chosen
mutually exclusive project. Selection of Project A implies rejection of an opportunity
to earn an additional amount of ` 31,820 (` 68,180 - ` 36,360) for the shareholders,
thus reduction in the shareholders’ wealth.
In the above example, the larger project had lower IRR, but maximises the
shareholders’ wealth. It is not safe to assume that a choice can be made between
mutually exclusive projects using IRR in cases where the larger project also happens
to have the higher IRR. Consider the following two Projects A and B with their
relevant cash flows:
Example- 9
Year Project A Project B

(`) (`)
0 (9,00,000) (8,00,000)
1 7,00,000 62,500
2 6,00,000 6,00,000
3 4,00,000 6,00,000
4 50,000 6,00,000
In this case, Project A has the larger investment and also has a higher IRR as shown
below,
Year (`) r = 46% PV (`) (`) r = 35% PV (`)

0 (9,00,000) 1.0000 (9,00,000) (8,00,000) 1.0000 (8,00,000)
1 7,00,000 0.6849 4,79,430 62,500 0.7407 46,294
2 6,00,000 0.4691 2,81,460 6,00,000 0.5487 3,29,220
3 4,00,000 0.3213 1,28,520 6,00,000 0.4064 2,43,840
4 50,000 0.2201 11,005 6,00,000 0.3011 1,80,660
415 14
IRR of Project A = 46%
IRR of Project B = 35%
However, in case the relevant discounting factor is taken as 5%, the NPV of the two
projects provides a different picture as follows:
Year Project A (`) Project B (`)
(`) r= 5% PV (`) (`) r= 5% PV (`)

0 (9,00,000) 1.0 (9,00,000) (8,00,000) 1.0 (8,00,000)
1 7,00,000 0.9524 6,66,680 62,500 0.9524 59,525
2 6,00,000 0.9070 5,44,200 6,00,000 0.9070 5,44,200
3 4,00,000 0.8638 3,45,520 6,00,000 0.8638 5,18,280
4 50,000 0.8227 41,135 6,00,000 0.8227 4,93,620
NPV 6,97,535 8,15,625
It can be seen from the above, Project B should be the one to be selected even
though its IRR is lower than that of Project A. This decision shall need to be taken
in spite of the fact that Project A has a larger investment coupled with a higher IRR
as compared with Project B. This type of anomalous situation arises due to
reinvestment assumptions implicit in the two evaluation methods of NPV and
IRR.
9.3.3 The Reinvestment Assumption
The Net Present Value technique assumes that all cash flows can be reinvested at
the discount rate used for calculating the NPV. This is a logical assumption since
1.41
the use of the NPV technique implies that all projects which provide a higher return
than the discounting factor are accepted.
In contrast, IRR technique assumes that all cash flows are reinvested at project’s
IRR. This assumption means that projects with heavy cash flows in the early years
will be favoured by the IRR method vis-à-vis projects which have larger cash flows
in the later years. This implicit reinvestment assumption means that Projects like
A, with cash flows concentrated in the earlier years of life will be preferred by the
method relative to Projects such as B.
9.3.4 Multiple Internal Rate of Return
In cases, where project cash flows change signs or reverse during the life of a
project e.g. an initial cash outflow is followed by cash inflows and subsequently
followed by a major cash outflow, there may be more than one IRR. The following
graph of discount rate versus NPV may be used as an illustration:
NPV
In such situations. if the cost of capital is less than the two IRR’s, a decision can be
made easily, however otherwise the IRR decision rule may turn out to be misleading
as the project should only be invested if the cost of capital is between IRR1 and
IRR2.To understand the concept of multiple IRR, it is necessary to understand the
implicit re-investment assumption in both NPV and IRR techniques.
Advantages of IRR
 This method makes use of the concept of time value of money.
 All the cash flows in the project are considered.
 IRR is easier to use as instantaneous understanding of desirability can be

determined by comparing it with the cost of capital
 IRR technique helps in achieving the objective of maximisation of
shareholder’s wealth.
Limitations of IRR
 The calculation process is tedious if there is more than one cash outflow
interspersed between the cash inflows; there can be multiple IRR, the
interpretation of which is difficult.
 The IRR approach creates a peculiar situation if we compare two projects with
different inflow/outflow patterns.
 It is assumed that under this method all the future cash inflows of a proposal are
reinvested at a rate equal to the IRR. It ignores a firm’s ability to re-invest in
portfolio of different rates.
 If mutually exclusive projects are considered as investment options which
have considerably different cash outlays. A project with a larger fund
commitment but lower IRR contributes more in terms of absolute NPV and
increases the shareholders’ wealth. In such situation decisions based only on
IRR criterion may not be correct.
9.4 Discounted Payback Period Method

This is similar to Payback period as discussed in 7.8.1 under the non-discounting
method except that the cash flows here are discounted at predetermined rate and
the payback period so calculated is called Discounted payback period. One of the
most popular economic criteria for evaluating capital projects is the payback
period. Payback period is the time required for cumulative cash inflows to recover
the cash outflows of the project.
This technique is considered superior to simple payback period method because it
takes into account time value of money.
Example- 10
For example, a ` 30,000 cash outlay for a project with annual cash inflows of
` 6,000 would have a payback period of 5 years (` 30,000 / ` 6,000).
1.43
The problem with the Payback Period is that it ignores the time value of money. In
order to correct this, we can use discounted cash flows in calculating the payback
period. Referring back to our example, if we discount the cash inflows at 15%
required rate of return, we have:
Year Cash Flow (`) PVF@15% PV (`) Cumulative PV (`)

1 6,000 0.870 5,220 5,220
2 6,000 0.756 4,536 9,756
3 6,000 0.658 3,948 13,704
4 6,000 0.572 3,432 17,136
5 6,000 0.497 2,982 20,118
6 6,000 0.432 2,592 22,710
7 6,000 0.376 2,256 24,966
8 6,000 0.327 1,962 26,928
9 6,000 0.284 1,704 28,632
10 6,000 0.247 1,482 30,114
The cumulative total of discounted cash flows after ten years is ` 30,114. Therefore,
our discounted payback is approximately 10 years as opposed to 5 years under
simple payback. It should be noted that as the required rate of return increases,
the distortion between simple payback and discounted payback grows.
9.5 Modified Internal Rate of Return (MIRR)

As mentioned earlier, there are several limitations attached with the concept of the
conventional Internal Rate of Return (IRR). The MIRR addresses some of these
deficiencies e.g., it eliminates multiple IRR rates; it addresses the reinvestment
rate issue and produces results which are consistent with the Net Present Value
method. This method is also called Terminal Value method.
Under this method, all cash flows, apart from the initial investment, are brought to
the terminal value using an appropriate discount rate (usually the Cost of Capital).
This results in a single stream of cash inflow in the terminal year. The MIRR is
obtained by assuming a single outflow in the zeroth year and the terminal
cash inflow as mentioned above. The discount rate which equates the present
value of the terminal cash inflow to the zero year outflow is called the MIRR.
The decision criterion of MIRR is same as IRR i.e. you accept an investment if MIRR
is larger than required rate of return and reject if it is lower than the required rate
of return.
ILLUSTRATION 9
An investment of ` 1,36,000 yields the following cash inflows (profits before
depreciation but after tax). DETERMINE MIRR considering 8% as cost of capital.
Year (`)
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000
1,80,000
SOLUTION
Year 0 – Cash outflow = ` 1,36,000
The MIRR is calculated on the basis of investing the inflows at the cost of capital. The
table below shows the value of the inflows, if they are immediately reinvested at 8%.
Year Cash flow @ 8% reinvestment rate factor (`)

1 30,000 1.3605* 40,815
2 40,000 1.2597 50,388
3 60,000 1.1664 69,984
4 30,000 1.0800 32,400
5 20,000 1.0000 20,000
2,13,587
* Investment of ` 1 at the end of the year 1 is reinvested for 4 years (at the end of
5 years) shall become 1(1.08)4 = 1.3605. Similarly, reinvestment rate factor for
remaining years shall be calculated. Please note that the investment at the end of
5th year shall be reinvested for zero year, hence, reinvestment rate factor shall be 1.
1.45
The total cash outflow in year 0 (` 1,36,000) is compared with the possible inflow
1,36,000
at year 5 and the resulting figure = = 0.6367 is the discount factor in year
2,13,587
5. By looking at the year 5 row in the present value tables, you will see that this
gives a return of 9%. This means that the ` 2,13,587 received in year 5 is equivalent
to ` 1,36,000 in year 0 if the discount rate is 9%. Alternatively, we can compute
MIRR as follows:
2,13,587
Total return = = 1.5705
1,36,000
MIRR = 1/ 5 1.5705 - 1 = 9%.
9.6 Comparison of Net Present Value and Internal Rate of

Return Methods
Similarity
 Both the net present value (NPV) and the internal rate of return (IRR) methods are
discounted cash flow methods which consider the time value of money.
 Both the techniques consider all cash flows over the expected useful life of the
investment.
9.7 Different conclusion in the following scenarios

There are circumstances/scenarios under which the net present value method and
the internal rate of return methods will reach different conclusions. Let us discuss
these scenarios:
Scenario 1 – Scale or Size Disparity
Being IRR a relative measure and NPV an absolute measure in case of disparity
in scale or size both may give contradicting ranking. This can be understood with
the help of following illustration:
ILLUSTRATION 10
Suppose there are two Project A and Project B are under consideration. The cash flows
associated with these projects are as follows:

0 (1,00,000) (3,00,000)
1 50,000 1,40,000
2 60,000 1,90,000
3 40,000 1,00,000
Assuming Cost of Capital equal to 10%, IDENTIFY which project should be accepted
as per NPV Method and IRR Method.
SOLUTION
Net Present Value (NPV) of Projects
Year Cash Cash Present PV of PV of

Inflows of Inflows of Value Project A Project B
Project A Project B Factor @
(`) (`) 10% (`) (`)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.909 45,450 1,27,260
2 60,000 1,90,000 0.826 49,560 1,56,940
3 40,000 1,00,000 0.751 30,040 75,100
NPV 25,050 59,300
Internal Rate of Returns (IRR) of projects

Since by discounting cash flows at 10%, we are getting values very far from zero.
Therefore, let us discount cash flows using 20% discounting rate.

(`) (`) 20% (`) (`)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.833 41,650 1,16,620
2 60,000 1,90,000 0.694 41,640 1,31,860
3 40,000 1,00,000 0.579 23,160 57,900
NPV 6,450 6,380
1.47
Even by discounting cash flows at 20%, we are getting values far from zero.

(`) (`) 25% (`) (`)
0 (1,00,000) (3,00,000) 1.000 (1,00,000) (3,00,000)
1 50,000 1,40,000 0.800 40,000 1,12,000
2 60,000 1,90,000 0.640 38,400 1,21,600
3 40,000 1,00,000 0.512 20,480 51,200
NPV (1,120) (15,200)
IRRA = 20%+ 6, 450  6, 450

×(25% -20%) =20% +  × 5%  = 24.26%

6, 450 - (1,120)  7,570 
IRRB = 20%+ 6,380  6,380

×(25% -20%) =20% +  ×5%  = 21.48%

6,380 - (15,200)  21,580 
Overall Position
Project A Project B
NPV @ 10% ` 25,050 ` 59,300
IRR 24.26% 21.48%
Thus, there is contradiction in ranking by two methods.

Scenario 2 – Time Disparity in Cash Flows
It might be possible that overall cash flows may be more or less same in the projects
but there may be disparity in their flows i.e. larger part of cash inflows may be
occurred in the beginning or end of the project. In such situation there may be
difference in the ranking of projects as per two methods. This can be understood
with the help of following illustration:
ILLUSTRATION 11
Suppose ABC Ltd. is considering two Project X and Project Y for investment. The cash
flows associated with these projects are as follows:
Year Project X (`) Project Y (`)

0 (2,50,000) (3,00,000)
1 2,00,000 50,000
2 1,00,000 1,00,000
3 50,000 3,00,000
Assuming Cost of Capital be 10%, IDENTIFY which project should be accepted as per
NPV Method and IRR Method.
SOLUTION
Net Present Value of Projects
Year Cash Inflows Cash Inflows Present Value PV of PV of

of Project X of Project Y Factor @ 10% Project X Project Y
(`) (`) (`) (`)
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)

1 2,00,000 50,000 0.909 1,81,800 45,450
2 1,00,000 1,00,000 0.826 82,600 82,600
3 50,000 3,00,000 0.751 37,550 2,25,300
NPV 51,950 53,350
Internal Rate of Returns of projects

Since, by discounting cash flows at 10%, we are getting values far from zero.
Year Cash Inflows Cash Inflows Present PV of PV of

of Project X of Project Y Value Factor Project X Project Y
(`) (`) @ 20% (`) (`)
0 (2,50,000) (3,00,000) 1.000 (2,50,000) (3,00,000)
1 2,00,000 50,000 0.833 1,66,600 41,650
2 1,00,000 1,00,000 0.694 69,400 69,400
3 50,000 3,00,000 0.579 28,950 1,73,700
NPV 14,950 (15,250)
1.49
Since, by discounting cash flows at 20% we are getting that value of Project X is
positive and value of Project Y is negative. Therefore, let us discount cash flows of
Project X using 25% discounting rate and Project Y using discount rate of 15%.
Year Cash Present PV of Cash Present PV of

Inflows of Value Factor Project X Inflows of Value Project Y
Project X @ 25% (`) Project Y Factor (`)
(`) (`) @ 15%
0 (2,50,000) 1.000 (2,50,000) (3,00,000) 1.000 (3,00,000)
1 2,00,000 0.800 1,60,000 50,000 0.870 43,500
2 1,00,000 0.640 64,000 1,00,000 0.756 75,600
3 50,000 0.512 25,600 3,00,000 0.658 1,97,400
NPV (400) 16,500
The internal rate can be obtained by interpolation:
IRRX = 20%+ 14,950

×(25% -20%)
14,950 - (400)
= 20% +  14,950 × 5%  = 24.87%

 15,350 
16,500
IRRB =15%+ ×(20% -15%)
16,500 - (15,250)
=15% +  16,500 ×5%  = 17.60%

 31,750 
Overall Position
Project A Project B
NPV @ 10% ` 51,950 ` 53,350
IRR 24.87% 17.60%
Scenario 3 – Disparity in life of Proposals (Unequal Lives)

Conflict in ranking may also arise if we are comparing two projects (especially
mutually exclusive) having unequal lives. This can be understood with the help of
following illustration:
ILLUSTRATION 12
Suppose MVA Ltd. is considering two Project A and Project B for investment. The cash
flows associated with these projects are as follows:
0 (5,00,000) (5,00,000)
1 7,50,000 2,00,000
2 0 2,00,000
3 0 7,00,000
Assuming Cost of Capital equal to 12%, ANALYSE which project should be accepted
as per NPV Method and IRR Method?
SOLUTION
Net Present Value of Projects
Year Cash Inflows Cash Inflows Present PV of PV of

of of Value Factor Project A Project B
Project A (`) Project B (`) @ 12% (`) (`)
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)

1 7,50,000 2,00,000 0.893 6,69,750 1,78,600
2 0 2,00,000 0.797 0 1,59,400
3 0 7,00,000 0.712 0 4,98,400
NPV 1,69,750 3,36,400
Internal Rate of Returns of projects

Let us discount cash flows using 50% discounting rate.

(`) (`) 50% (`) (`)
0 (5,00,000) (5,00,000) 1.000 (5,00,000) (5,00,000)

1.51
1 7,50,000 2,00,000 0.667 5,00,250 1,33,400
2 0 2,00,000 0.444 0 88,800
3 0 7,00,000 0.296 0 2,07,200
NPV 250 (70,600)
Since, IRR of project A shall be 50% as NPV is very small. Further, by discounting
cash flows at 50%, we are getting NPV of Project B negative. Therefore, let us
discount cash flows of Project B using 15% discounting rate.
Year Cash Inflows of Present Value PV of

Project B (`) Factor @ 15% Project B (`)
0 (5,00,000) 1.000 (5,00,000)
1 2,00,000 0.870 1,74,000
2 2,00,000 0.756 1,51,200
3 7,00,000 0.658 4,60,600
NPV 2,85,800
The internal rate can be obtained by interpolation:

2,85,800
IRRB =15%+ ×(50% -15%)
2,85,800 - (70,600)
= 15% +  2,85,800 ×35%  = 43.07%

 3,56, 400 
Overall Position
Project A Project B
NPV @ 12% ` 1,69,750 ` 3,36,400
IRR 50.00% 43.07%

10. SUMMARY OF DECISION CRITERIA OF

CAPITAL BUDGETING TECHNIQUES
Techniques For Independent Project For Mutually
Exclusive
Projects
Non- Pay Back (i) When Payback period ≤ Project with least
Discounted Maximum Acceptable Payback period
Payback period: should be
Accepted selected
(ii) When Payback period >
Maximum Acceptable
Payback period:
Rejected
Accounting (i) When ARR≥ Minimum Project with the
Rate of Acceptable Rate of maximum ARR
Return Return: Accepted should be
(ARR) (ii) When ARR < Minimum selected.
Acceptable Rate of
Return: Rejected
Discounted Net Present (i) When NPV≥ 0: Accepted Project with the
Value (NPV) (ii) When NPV< 0: Rejected highest positive
NPV should be
selected
Profitability (i) When PI ≥ 1: Accepted When Net Present
Index (PI) (ii) When PI < 1: Rejected Value is same
project with
Highest PI should
be selected
Internal (i) When IRR ≥K: Accepted Project with the
Rate of (ii) When IRR <K: Rejected maximum IRR
Return (IRR) should be
selected

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CHAPTER 7

♦ State the objectives of capital investment decisions.

Types of Investment Capital Budgeting

2. PURPOSE OF CAPITAL BUDGETING

3. CAPITAL BUDGETING PROCESS

4. TYPES OF CAPITAL INVESTMENT DECISIONS

On the basis of firm’s

4.1 On the basis of firm’s existence

decisions to meet the requirement of new environment or to face the challenges of

(i) Replacement and Modernisation decisions: The replacement and

4.2 On the basis of situations

4.3 Steps of Capital Budgeting Procedure

5. ESTIMATION OF PROJECT CASH FLOWS

An investment decision implies the choice of an objective, an appraisal technique

(ii) Physical deterioration; and

(a) Depreciation: As mentioned earlier, depreciation is a non-cash item and

No Depreciation is Charged Depreciation is Charged

Profit after Tax 3.50 2.45

Add: Installation/Set-Up Costs xxx

Add/(less): Net decrease (increase) in taxes xxx

6. BASIC PRINCIPLES FOR MEASURING

6.1 Block of Assets and Depreciation

6.2 Exclusion of Financing Costs Principle

The exclusion of financing costs principle means that:

= (Profit Before Tax + Interest) (1 − Tax rate)

Year 1 Year 2 Year 3 Year 4

Year 1 Year 2 Year 3 Year 4

Profit before Interest and Tax 10,000 20,000 40,000 50,000

Year 1 Year 2 Year 3 Year 4

6.3 Post-tax Principle

Earnings before tax and depreciation 45,000 30,000 25,000 35,000

Less: Depreciation (25,000) (25,000) (25,000) (25,000)

Earnings before tax 20,000 5,000 0 10,000

Less: Tax @20% (4,000) (1,000) 0 (2,000)

Earnings after tax 16,000 4,000 0 8,000

Add: Depreciation 25,000 25,000 25,000 25,000

Net Cash flow 41,000 29,000 25,000 33,000

7. CAPITAL BUDGETING TECHNIQUES

Capital Budgeting Net Present Value (NPV)

Discounted Payback Period

Modified Internal Rate of

Organisations may use one or more of capital investment evaluation techniques

8.1 Payback Period

Total initial capital investment

Payback period = ` 20,00,000 = 5 Years

Year Annual Cash Inflows (`)

Year Annual Cash Cumulative Cash

Payback period shall lie between 3 to 4 years. Since up to 3 years, a sum of

Thus, total cash outlay of ` 2,05,000 shall be recovered in 3¼ years’ time.

8.1.1 Payback Reciprocal

reciprocal of the payback would be a close approximation of the Internal Rate of

The above payback reciprocal provides a reasonable approximation of the internal

8.2 Accounting (Book) Rate of Return (ARR) or Average

Year Profit Before Depreciation Profit after Value of Investment in

The ARR can be computed by following methods as follows:

(b) Version 2: Total Investment Basis

(c) Version 3: Average Investment Basis

Average Investment = (` 3,00,000 + ` 90,000)/2 = ` 1,95,000

Some organizations prefer the initial investment because it is objectively

Years Profit after tax and depreciation (`)