Dr.

Shailesh Mathur
Associate Professor
Department of Accountancy and Business Statistics
S. S. Jain Subodh P. G. Autonomous College, Jaipur
 Capital expenditure
Capital expenditure involves investment of substantial
funds for longer period and the benefits of such
investment are in the form of increasing revenues or
decreasing costs.
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.
 Capital Budgeting
“Capital budgeting involves planning of expenditure for
assets and return from them which will be realized in
future time period”
Milton
“Capital budgeting refers to the total process of
generating, evaluating, selecting and follow up of
capital expenditure alternative”
I.M. Pandey
Hence planning and control of capital expenditure is
termed as capital budgeting.
 Objects of Capital Budgeting
 Share holders wealth maximization
 Evaluation of proposed capital expenditure
 Controlling costs
 Select most profitable project.

Need and Importance of Capital Budgeting

Huge investments
Long-term
Irreversible
Long-term effect
 Capital Budgeting Process
 Identification of various investments proposals
 Screening or matching the proposals
 Evaluation of proposals
 Fixing property
 Final approval
 Implementing
 Performance review of feedback
 METHODS OF CAPITAL BUDGETING

Traditional methods Modern / Discount Methods

Pay-back Period Methods Net Present Value Method

Accounts Rate of Return Internal Rate of Return Method

Profitability Index Method

 Pay Back Period
Pay-back period is the time required to recover the initial
investment in a project.
Accept /Reject criteria:
If the actual pay-back period is less than the predetermined pay-
back period, the project would be accepted. If not, it would be
rejected.
It is calculated as follows:
A. When annual cash in flows are equal:

Initial investment
Pay Back Period =
Annual cash inflows
 Calculation of Annual Cash-in-Flow
Particular Amount
Sales XXX
Less: Total Cost (Excluding depreciation) - - -
Profit before depreciation and Tax ===
Less: Depreciation - - -
Profit before Tax ===
Less: Tax - - -
Profit after Depreciation and Tax ===
Add: Depreciation +++
Cash In Flow ===
Example 1:
Project cost is Rs. 30,000 and the cash inflows are Rs. 10,000, the life of the
project is 5 years. Calculate the pay-back period.

Solution:
Pay Back Period = 30,000 / 10,000 = 3 years

Example 2:
A project costs Rs. 20,00,000 and yields annually a profit of Rs. 3,00,000 after
depreciation @ 12½% but before tax at 50%. Calculate the pay-back period.
Solution: Calculation of Cash In Flow
Particular Amount
Profit after depreciation before tax 3,00,000
Less: Tax @ 50% 1,50,000
Profit after Depreciation and Tax 1,50,000
Add: Depreciation (12.5% of 20,00,000) 2,50,000
Cash In Flow 4,00,000
Pay Back Period = Initial Investment / Annual Cash In Flow
= 20,00,000 / 4,00,000 = 5 years
 B. When annual cash in flows are unequal:

Normally the projects are not having uniform cash inflows. In those
cases cumulative cash inflows will be calculated and then
interpreted the pay-back period as follows:

Year in which Investment – cumulative cash

Pay
cumulative cash in in flow of the year
Back = +
flow is just less than
Period Cash inflows of next year
amount of investment
Example 3:
Certain projects require an initial cash outflow of Rs. 25,000. The cash inflows
for 6 years are Rs. 5,000, Rs. 8,000, Rs. 10,000, Rs. 12,000, Rs. 7,000 and Rs.
3,000. Calculate pay back period.

Sloution:
Year Cash in flow Cumulative cash in flow
1 5,000 5,000
2 8,000 13,000
3 10,000 23,000
4 12,000 35,000
5 7,000 42,000
6 3,000 45,000
Pay Back Period = Year in which cumulative cash in flow is less than amount
of investment + (Investment Amount – Cumulative Cash in
Flow of the year) / Cash inflows of next year
= 3 + (25,000 – 23,000) / 12,000
= 3.17 years or 3 years 2 months
 Merits and Demerits of Pay-Back Method

Merits:
 It is easy to calculate and simple to understand.
 Pay-back method provides further improvement over the
accounting rate return.
 Pay-back method reduces the possibility of loss on account of
obsolescence.
Demerits
 It ignores the time value of money.
 It ignores all cash inflows after the pay-back period.
 It is one of the misleading evaluations of capital budgeting
 Post Pay-back Profitability Method
One of the major limitations of pay-back period method is that it does not
consider the cash inflows earned after pay-back period and if the real
profitability of the project cannot be assessed. To improve over this
method, it can be made by considering the receivable after the pay-back
period. These returns are called post pay-back profits.
Post pay-back profitability
= Cash inflow (Estimated life – Pay-back period)
OR
= Total Cash in flow – Initial Investment

Post pay-back profitability index

= (Total Cash in flow – Initial Investment) x 100 / Initial Investment
OR
= Post pay-back profitability x 100 / Initial Investment
Example 4:
From the following particulars, compute Payback period; Post pay-back
profitability and post pay-back profitability index:
Cash outflow Rs. 1,00,000; Annual cash inflow (After tax before depreciation)
Rs. 25,000 and Estimate Life 6 years.

Solution:
a) Pay Back Period = Initial Investment / Annual cash in flow
= 1,00,000 / 25,000 = 4 years

b) Post pay-back profitability

= Cash inflow (Estimated life – Pay-back period)
= 25,000 (6 – 4) = Rs. 50,000

c) Post pay-back profitability index

= Post pay-back profitability x 100 / Initial Investment
= 50,000 x 100 / 1,00,000 = 50%
Accounting Rate of Return or Average Rate of Return
Average rate of return means the average annual earning on the
project. under this method profit after tax and depreciation is
considered.
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.
The average rate of return can be calculated in the following two
ways:
Average annual profit after tax
ARR on Average and depreciation
= x 100
Investment Average Investment
Average annual profit after tax
ARR on Initial and depreciation
= x 100
Investment Initial Investment
Average annual profit after tax & depreciation and Average
investment are calculated as follows:
a) Average annual profit after tax & depreciation
= Total profit after tax and depreciation / no. of year

b) Average investment
= (Initial Investment + Scrap Value) / 2
OR
= [(Initial Investment - Scrap Value) / 2] + Scrap Value + Working
Capital
Example 5:
The machine cost Rs. 1,00,000 and has scrap value of Rs. 10,000 after 5 years. The net
profits before depreciation and taxes for the five years period are to be projected that Rs.
20,000, Rs. 24,000, Rs. 30,000, Rs. 26,000 and Rs. 22,000. Taxes are 50%. Calculate
accounting rate of return
Solution: Calculation of Cash In Flow
Particular Amount
1Y 2Y 3Y 4Y 5Y
Profit before depreciation & tax 20,000 24,000 30,000 26,000 22,000
Less: Depreciation (1,00,000-10,000) / 5 18,000 18,000 18,000 18,000 18,000
Profit after Depreciation and Tax 2,000 6,000 12,000 8,000 4,000
Less: Tax @ 50% 1,000 3,000 6,000 4,000 2,000
Profit after depreciation & tax 1,000 3,000 6,000 4,000 2,000

Average profit after depreciation & tax = (1,000+3,000+6,000+4,000+2,000) / 5

= Rs. 3,200
Average Investment = (1,00,000 + 10,000) / 2 = Rs. 55,000

ARR on Average Investment = (3,200 / 55,000) x 100 = 5.82%

ARR on Initial Investment = (3,200 / 1,00,000) x 100 = 3.2%

 Merits and Demerits of Average Rate of Return

Merits:
 It is easy to calculate and simple to understand.
 It is based on the accounting information rather than cash
inflow.
 It is not based on the time value of money.
 It considers the total benefits associated with the project..
Demerits
 It ignores the time value of money.
 It ignores the reinvestment potential of a project.
 Different methods are used for accounting profit. So, it leads to
some difficulties in the calculation of the project.
 Net Present value
Net present value method is one of the modern methods for
evaluating the project proposals. In this method cash inflows are
considered with the time value of the money. Net present value is
the difference between the total present value of future cash inflows
and the total present value of future cash outflows.
Accept/Reject criteria
If the present value of cash inflows is more than the present value
of cash outflows, it would be accepted. If not, it would be rejected.
It is calculated as follows:
Net Present value = Present value of cash in flow – Present
value of cash outflow
Present value of cash in flow = Σ(Annual cash inflow x Present
value of Rs. 1 for ‘n’ year)
Present value of cash outflow = Σ(Cash outflow x Present value of Rs.
1 for ‘n’ year)
Present value of Rs. 1 for ‘n’ year = 1 / (1+r)n
where: r = Cost of the Capital (or) Discounting rate
n = No of year
For example if Cost of the Capital (or) Discounting rate is 10% then
present value of Rs. 1 for;
1st year = 1 / (1+0.10)1 = 0.909;
2nd year = 1 / (1+0.10)2 = 0.826 and
3rd year = 1 / (1+0.10)3 = 0.751
If cash inflows for 3 years are Rs. 5,000, Rs. 8,000 and Rs. 10,000, then
the present value of cash inflow will be:
=Σ(Annual cash inflow x Present value of Rs. 1 for ‘n’ year)
= Σ[(5,000 x 0.909) + (8,000 x 0.826) + (10,000 x 0.751)]
=Σ(4,545 + 6,608 + 7,510) = Rs. 18,663
Example 6:
From the following information, calculate the net present value of the two project and
suggest which of the two projects should be accepted, a discount rate of the two project is
10%. Other details are as follows:
Initial Investment Estimated Life Scrap Value
Project X Rs. 20,000 5 years Rs. 1,000
Project Y Rs. 30,000 5 years Rs. 2,000

The profits before depreciation and after taxation (cash flows) are as follows:
Year 1 (Rs.) Year 2 (Rs.) Year 3 (Rs.) Year 4 (Rs.) Year 5(Rs.)
Project X 5,000 10,000 10,000 3,000 2,000
Project Y 20,000 10,000 5,000 3,000 2,000
The following are the present value factors @ 10% p.a.:

Year 1 2 3 4 5
Factors 0.909 0.826 0.751 0.683 0.621
Solution:

Cash Inflow Present value of PV of CIF

Year
Project X Project Y Rs. 1 @ 10% Project X Project Y
1 5,000 20,000 0.909 4,545 18,180
2 10,000 10,000 0.826 8,260 8,260
3 10,000 5,000 0.751 7,510 3,755
4 3,000 3,000 0.683 2,049 2,049
5 2,000 2,000 0.621 1,242 1,242
Scrap Value 1,000 2,000 0.621 621 1,242
Present value of cash inflow 24,227 34,728
Less: Present value of cash outflow 20,000 30,000
Net Present Value 4,227 4,728

Project Y should be selected as net present value of project Y is higher.

 Merits and Demerits of Net Present Value

Merits:
 It recognizes the time value of money.
 It considers the total benefits arising out of the proposal.
 It is the best method for the selection of mutually exclusive
projects.
 It helps to achieve the maximization of shareholders’ wealth.
Demerits
 It is difficult to understand and calculate.
 It needs the discount factors for calculation of present values.
 It is not suitable for the projects having different effective lives.
 Internal Rate of Return
The Internal Rate of Return for an investment proposal is that discount
rate which equates the present value of cash inflows with the present
value of cash out flows of an investment. In other words it is a rate at
which discount cash flows to zero.
It is calculated as follows:
Step 1: Find out present value factor as follows:
= Cash Outlay or Initial Investment / Average Cash Inflow
Step 2: Find out positive net present value and negative net present
value:
Find out discount rate with the help of PV factor and calculate
net present value, if net present value is positive (negative) then
calculate negative (positive) present value with the help of higher
(lower) discounting rate.
Step 3: Calculate Internal Rate of Return:
Positive NPV
IRR = LDR + x (HDR – LDR)
Positive NPV - Negative NPV
Where:
IRR = Internal Rate of Return; LDR = Lower Discounting Rate;
HDR = Higher Discounting Rate; NPV = Net Present Value

Accept/Reject criteria
If the internal rate of return is greater than the normal rate of discount,
then the proposed project is accepted, otherwise it would be rejected.
Example 6:
A company has to select one of the following two projects:
Cash Inflow
Cost (Rs.)
Year 1 (Rs.) Year 2 (Rs.) Year 3 (Rs.) Year 4 (Rs.)
Project X 22,000 12,000 4,000 2,000 10,000
Project Y 20,000 2,000 2,000 4,000 20,000
Using the Internal Rate of Return method suggest which is Preferable.
The following are the cumulative and annually present value factors:

Cumulative present value of Rs. 1 per Present value of Rs. 1 receivable or

annum, Receivable or Payable at the payable for ‘n’ year payment or
Year end of each year for n years receipt.
10% 12% 15% 10% 12% 15%
1 0.909 0.893 0.870 0.909 0.893 0.870
2 1.736 1.690 1.626 0.826 0.797 0.756
3 2.487 2.402 2.283 0.751 0.712 0.658
4 3.170 3.037 2.855 0.683 0.636 0.572
Solution:
Present value factor for project X = Initial Investment / Average Cash Inflow
= 22,000 / (28,000 /4) = 22,000 / 7,000 = 3.143
The estimated discounting rate of project A will be 10% , as in Cumulative present value
table, the value at 10% in 4th year (3.170) is nearest to PV factor value (3.143).
Calculation of negative and positive Net Present value of Project X:
Cash Inflow Present value of Rs. 1 PV of CIF
Year
Project X @ 10% @ 12% @ 10% @ 12%
1 12,000 0.909 0.893 10,908 10,716
2 4,000 0.826 0.797 3,304 3,188
3 2,000 0.751 0.712 1,502 1,424
4 10,000 0.683 0.636 6,830 6,360
Present value of cash inflow 22,544 21,688
Less: Present value of cash outflow 22,000 22,000
Net Present Value 544 -312

Calculate Internal Rate of Return of Project X:

Positive NPV
IRR = LDR + x (HDR – LDR)
Positive NPV - Negative NPV
= 10 + {544 / [544 – (-312)]} x (12 -10)
= 10 + 1.27 =11.27%
Present value factor for project Y = Initial Investment / Average Cash Inflow
= 20,000 / (28,000 /4) = 20,000 / 7,000 = 2.857
The estimated discounting rate of project A will be 15% , as in Cumulative present value
table, the value at 15% in 4th year (2.855) is nearest to PV factor value (2.857).
Calculation of negative and positive Net Present value of Project Y:
Cash Inflow Present value of Rs. 1 PV of CIF
Year
Project X @ 15% @ 10% @ 15% @ 10%
1 2,000 0.870 0.909 1,740 1,818
2 2,000 0.756 0.826 1,512 1,652
3 4,000 0.658 0.751 2,632 3,004
4 20,000 0.572 0.683 11,440 13,660
Present value of cash inflow 17,324 20,134
Less: Present value of cash outflow 20,000 20,000
Net Present Value -2,676 134
Calculate Internal Rate of Return of Project Y:
IRR = 10 + {134 / [134 – (-2676)]} x (15 -10)
= 10 + 0.24 =10.24%
Thus, internal rate of return in project X (11.27%) is higher as compared to project Y
10.24%. Therefore project X is preferable.
 Merits and Demerits of Internal Rate of Return

Merits:
 It consider the time value of money.
 It takes into account the total cash inflow and outflow.
 It does not use the concept of the required rate of return.
 It gives the approximate/nearest rate of return.
Demerits
 It involves complicated computational method.
 It produces multiple rates which may be confusing for taking
decisions.
 It is assume that all intermediate cash flows are reinvested at the
internal rate of return.
 Profitability Index Method
Profitability index is the time adjusted method of evaluating the
investment proposal. This method is also called Benefit Cost Ratio.
It is the ratio of present value of cash inflow at the required rate of
return to the initial cash outflow of the investment.
Accept /Reject criteria:
If the PI is more than 1 (PI>1), the project would be accepted. If
the PI is less than 1 (PI<1), it would be rejected.
It is calculated as follows:

Profitability Present value of cash inflow

=
Index Present value of cash outflow
 Merits and Demerits of Profitability Index
Merits:
 It tells about an investment increasing or decreasing the firm
value.
 It takes into consideration all cash flows of the project
 It takes time value of money into consideration.
 It is also helpful in ranking and picking project while rationing
of capital.
Demerits
 It is not easy to determine an appropriate discount rate.
 The profitability index of a firm might not sometimes, provide
the correct decision while being used to compare mutually
excusive project under consideration.
Example 7:
SP Limited company is having a project, requiring a capital outflow of Rs. 3,00,000. The
expected annual income after depreciation but before tax is as follows:

Year 1 2 3 4 5
Amount 9,000 80,000 70,000 60,000 50,000

Depreciation may be taken as 20% of original cost and taxation at 50% of net income.
You are required to calculated: (a) Pay-back period; (b) According rate of return; (c) Net
present value at 10% discounting rate; (d) Internal rate of return and (e) Profitability
index.
The following are the cumulative and annually present value factors:
Cumulative present value of Rs. 1 per Present value of Rs. 1 receivable or
annum, Receivable or Payable at the payable for ‘n’ year payment or
Year end of each year for n years receipt.
10% 12% 15% 10% 12% 15%
1 0.909 0.893 0.870 0.909 0.893 0.870
2 1.736 1.690 1.626 0.826 0.797 0.756
3 2.487 2.402 2.283 0.751 0.712 0.658
4 3.170 3.037 2.855 0.683 0.636 0.572
5 3.791 3.605 3.352 0.621 0.567 0.497
Solution: Calculation of Annual Cash-in-Flow

Amount (Rs.)
Particular
1st Year 2nd Year 3rd Year 4th Year 5th Year
Profit before depreciation and Tax 69,000 1,40,000 1,30,000 1,20,000 1,10,000
Less: Depreciation (@ 20% of 3,00,000) 60,000 60,000 60,000 60,000 60,000
Profit before Tax 9,000 80,000 70,000 60,000 50,000
Less: Tax @ 50% 4,500 40,000 35,000 30,000 25,000
Profit after Depreciation and Tax 4,500 40,000 35,000 30,000 25,000
Add: Depreciation (@ 20% of 3,00,000) 60,000 60,000 60,000 60,000 60,000
Cash Inflow 64,500 1,00,000 95,000 90,000 85,000
Cumulative Cash Inflow 64,500 1,64,500 2,59,500 3,49,500 4,34,500

(a) Pay Back Period = Year in which cumulative cash in flow is less than amount of
investment + (Investment Amount – Cumulative Cash in Flow of
the year) / Cash inflows of next year
= 3 + (3,00,000 – 2,59,500) / 90,000
= 3.45 years
(b) According rate of return = (Average profit after tax and depreciation / Average
Investment) x 100
= (26,900 / 1,50,000) x 100
= 17.93%
Average profit after tax & depreciation = (4,500+40,000+35,000+30,000+25,000) / 5
= Rs. 26,900
Average Investment = 3,00,000 / 2 = Rs. 1,50,000

(c) Net present value

Present value Present value of
Year Cash Inflow PV of CIF PV of CIF
of Rs. 1 @ 10% Rs. 1 @ 15%
1 64,500 0.909 58,631 0.870 56,115
2 1,00,000 0.826 82,600 0.756 75,600
3 95,000 0.751 71,345 0.658 62,510
4 90,000 0.683 61,470 0.572 51,480
5 85,000 0.621 52,785 0.497 42,245
Present value of cash inflow 3,26,831 2,87,950
Less: Present value of cash outflow 3,00,000 3,00,000
Net Present Value 26,831 -12,050
(d) Internal Rate of Return
Calculate of PV factor = 3,00,000 / 86,900 = 3.452
The estimated discounting rate of project will be 15% , as in Cumulative present value
table, the value at 15% in 5th year (3.352) is nearest to PV factor value (3.452).
Calculate Internal Rate of Return:
Positive NPV
IRR = LDR + x (HDR – LDR)
Positive NPV - Negative NPV

= 10 + {26,831 / [26,831 – (-12,050]} x (15 -10)

= 10 + 3.45 =13.45%

(e) Profitability Index = Present value of Cash Inflow / Present value of Cash Outflow
= 3,26,831 / 3,00,000
= 1.089