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1. FINANCIAL MANAGEMENT Section 3
Rushi Ahuja 1
SECTION 3 – CAPITAL BUDGETING & CASHFLOW INVESTMENT ANALYSIS
I. Concept of Capital Budgeting
Planning and control of capital expenditure is termed as Capital Budgeting. The total capital (long-term and short term ) of a
company is employed in fixed and current assets of the firm. Fixed assets include those assets which are not meant for sale such as
land, building, machinery etc. it is a challenging task before the management to take judicious regarding capital expenditures, i.e.,
investments in fixed assets to that the amount should not unnecessarily be locked up in capital goods which may have far-reaching
effects on the success or failure of an enterprise. A capital asset, once acquired, cannot be disposed of without any substantial loss
and if it is acquired on long term credit basis, a continuing liability is incurred over a long period of time, and will affect the
financial obligations of the company adversely. It, therefore, requires a long-range planning while taking decision regarding
investments in fixed assets. Such process of taking decisions regarding capital expenditure is generally known as capital budgeting.
In capital budgeting process, due consideration should b given to the following problems-
(1) Problem of ranking project, i.e., choice of one project over other project.
(2) Problem of capital rationing, i.e., limited budget resources.
(3) Limitations imposed by top management decision on the total volume of investments to be made.
In other words Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the
goals of Shareholders wealth maximization
II. Tools for Capital Budgeting/Evaluation Techniques
The methods of appraising capital expenditure proposals can be classified into two categories:
 Traditional /Non Discounting Techniques
 Time Adjusted / Discounting Techniques
Traditional /Non Discounting Techniques
1. Average Rate of Return (ARR)
This method is also known as Accounting Rate of Return. This method is based on accounting profits rather than the cash-flows.
ARR = Average Annual Profits after taxes/Average investment over the life of the project
Average Investment = (Initial Investment + Salvage Value)/2
Accept Reject Rule – ARR would be compared with the minimum required rate of return or cut off rate. If ARR is more than the
required rate of return then the project will be accepted else it will be rejected.
Example – A project with capital expenditure of Rs 5,00,000 is expected to generate following profits of Rs 40,000, Rs 80,000, Rs
90,000, Rs 30,000 in year 1,2,3,4 respectively
Average Annual Profits = (40,000+80,000+90,000+30,000)/4 = Rs 60,000
Average Investment = (5,00,000+0)/2 = 2,50,000
ARR = 60,000/2,50,000 = 0.24 0r 24%
Merits
 It is easy to calculate as it males use of readily available accounting information
 Unlike pay back period method, this method takes into account cash inflows generated after the payback period
 It doesn’t involve any unrealistic assumptions about the interest rates
Demerits
 It doesn’t take into account time value of money
 It fails to distinguish the size of the investment. Competing projects with same ARR may require different amounts of
investment
 Like payback period, it is biased towards short term projects

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2. Payback Period Method
It assesses how soon the initial investment can be recovered. In other words it measures number of years it takes the cash
inflows from the project to be equal to cash outflows. In case the cash inflows stream is nature of annuity or constant throughout
the life of the project, then payback period can be calculated as follows:
PB = Investment/Constant annual cash flow
Example #1 The Project with life of 5 years involves a total initial investment of Rs 2Lakhs, and has equal cash Inflows of Rs
50,000 each year.
This is the case of annuity or constant cash inflows hence Payback period will be calculated as follows:
PB = 2,00,000/50,000
PB = 4 Years
In case the Project Cash Inflows are not uniform, then PB is calculated by cumulating cash flows till the time when cumulative
cash flows become equal to original investment outlay.
Example #2 The Project with life of 5 years involves a total initial investment of Rs 2Lakhs, and has cash Inflows of Rs 45,000, Rs
50,000 , Rs 58,000 , Rs 72,000 , Rs 71,000 in the year 1, 2, 3,4 and 5 respectively.
In this case Payback period will be calculated by looking at cumulative cash inflows
Years Cash Inflows Cumulative Cash Inflows
1 45,000 45,000
2 50,000 95,000
3 58,000 1,53,000
4 72,000 2,25,000
5 71,000 2,96,000
From the cumulative cash inflows it is evident that by the end of 3 years Rs 1,53,000 has been recovered and rest Rs 47,000 is
recovered in the 4
th
year. To find out the number of months it took to recover Rs 47,000 in the 4
th
year, we will assume that the
cash inflows are equally distributed over the period of 12 months. Hence cash inflow for one month will be cash inflows of year 4
divided by 12 months, which is Rs 6,000 (i.e. 72,000/12). Now divide amount required to be recovered by the monthly cash
inflow to get number of months. In this case it is 7.83 months (47,000/6000) or approximately 8 months. Hence the payback
period is 3 years 8 months.
Accept /Reject Rule – Project or investment option with shorter payback period will be accepted
Merits
 It is simple to apply and easy to understand.
 It is useful for the business which lack appropriate skills necessary for more sophisticated techniques
 This method is most suitable when future is very uncertain. Shorter the payback period
 It is useful for the firms facing liquidity constraints
 It doesn’t involve any unrealistic assumptions about the interest rates
Demerits
 This method ignores cash inflows generated after the payback period
 It doesn’t take into account time value of money
 It doesn’t provide any indication on the returns of the project. Projects with lower payback period may not necessarily
be highly profitable
Discounting Techniques
1. Net Present Value (NPV) Method
NPV is calculated by deducting Present Value of Cash Inflows from the Cash Outflow or initial investment. Present value of
cash flows is calculated using entity’s weighted average cost of capital (WACC) as the discount rate. WACC is used as that is the
minimum required rate of return.
NPV = PV of Cash Inflows - PV of Cash Outflow or initial investment

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Accept /Reject Rule – If NPV is positive then the project will be selected else rejected. If NPV is positive In case of more than
one mutually exclusive projects, then the project with higher NPV should be selected.
Example #3 – A company is considering two investment proposals with initial investments of Rs 5,00,000 and 10,00,000 each.
Company’s overall cost of capital is 10%. Following are the cash inflows and calculation of NPV
.
Decision – In this case both the projects have positive NPV and since Project B has higher NPV, Project B will be selected
Merits
 This method is based on the assumptions that cash-flows determine shareholders wealth. As higher the cash flows,
higher would be the dividends and higher the shareholders wealth.
 It considers total benefits arising out of the investment proposal over its life time
 This method is useful for selecting mutually exclusive Projects. (In mutually exclusive projects, selection of one project
tantamount rejection of others)
 It considers Time Value of Money
Demerits
 This method is difficult to calculate as compared to traditional methods
 Calculation of discounting rate presents challenges as it based on the cost of capital which is complicated to calculate.
 This is an absolute method and will favor the project with higher NPV rather than the return of the project
 This method emphasizes comparison of NPV and disregards initial investment involved. In the above example Project A
is generating higher cash inflows as percentage of investment (24%) as compared to Project B (14%) but NPV method
selects the Project B instead of A
2. Profitability Index (PI) Method
This method is also known as Cost Benefit Ratio. PI is the PV of Cash Inflows divided by the PV of Cash Outflows or Initial
Investment.
PI = PV of Cash Inflows/ PV of Cash Outflows or Initial Investment
Accept /Reject Rule – If PI is greater than 1 then the project will be selected else rejected. If PI is greater than 1 in case of more
than one mutually exclusive projects then the project with higher PI will be selected
3. Internal Rate of Return Method
Internal rate of return is that discount rate at which PV of Cash Inflows is equal to the PV of Cash Outflows or Initial Investment.
In other words it is the discount rate at which NPV is zero. IRR is calculated using hit and trial method.
Years
Project A
(a)
Project B
(b)
PV Factor @ 10%
(c )
PV of Project A
(a x c)
PV of Project B
(b x c)
1 1,00,000 3,80,000 0.909 90,909 3,45,455
2 1,50,000 4,00,000 0.826 1,23,967 3,30,579
3 2,00,000 4,30,000 0.751 1,50,263 3,23,065
4 2,10,000 2,00,000 0.683 1,43,433 1,36,603
5 1,80,000 10,000 0.621 1,11,766 6,209
PV of Cash Inflows 6,20,338 11,41,910
Less: PV of Cash outflow 5,00,000 10,00,000
NPV 1,20,338 1,41,910

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Accept /Reject Rule –In case of mutually exclusive projects, the project with higher IRR will be selected
Example– Let look the above mentioned Example #3 for calculating IRR for Project A and B,
Project A - We know that PV of cash inflows is 6,20,338, whereas we need it to be 5,00,000. Since the formula for calculating
PV factor is 1/(1+i), this means that higher “i” higher will be the denominator, and higher the denominator lower will be PV.
Therefore lets try as higher discount rate lets say 20%. Following is the PV of Cash inflows using 20% discount rate. Now we an
use interpolation to find the exact IRR
PV required – 5,00,000
PV at 10% - 6,20,388variance + 1,20,388.
PV at 20% - 4,76,858 variance - 23,148
Exact IRR = 10 + 1,20,388 x10 = 10 +8.38 = 18.38%
1,20,388 - (-23,148)
Project B – Similar we calculate for project B
PV required – 10,00,000
PV at 10% - 11,41,910 variance + 1,41,190.
PV at 20% - 9,43,756 variance - 56,244
Exact IRR = 10 + 1,41,190 x10 = 10 +7.16 = 17.16%
1,41,190 - (-23,148)
Decision - Since Project A has higher IRR, project A will be selected
Merits
 This method is based on the assumptions that cash-flows determine shareholders wealth. As higher the cash flows,
higher would be the dividends and higher the shareholders wealth.
 It considers total benefits arising out of the investment proposal over its life time
 This method is useful for selecting mutually exclusive Projects. (In mutually exclusive projects, selection of one project
tantamount rejection of others)
 It considers Time Value of Money
Demerits
 This method is difficult to calculate as compared to traditional methods as it requires tedious calculations based on trial
and error method.
 It doesn’t use the concept of desired rate of return, whereas it provides the rate of return which is indicative of the
profitability of the project.
 Projects selected on the basis of higher IRR may not necessarily be profitable
4. Discounted Payback Period Method
This method is same as payback period method, except that instead of normal cash-flows, discounted cash-flows are used for
calculating payback period

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III. Cash Flow Estimation
Cash flows of a project is divided into 3 parts namely Initial Cash flows, Operating Cash Flows and Terminal Cash flows. Initial Cash
flows are those cash flows which occur in year zero. Operating Cash Flows occur throughout the life of the project and terminal
cash flows occur at the end of the life of the project.
Following are the steps for estimating cash flows:
Particulars Year 0 Year 1 Year n
Initial Cash Flows
A Cost Fixed Assets (Plant, Machinery etc) (xxxx)
B Working Capital required (xxxx)
C Total Initial Cash Flows (A+B) (xxxx) - -
Operating Cash Flows
D Sales/Revenue xxxx xxxx xxxx
E Costs (including Depreciation) xxxx xxxx xxxx
F Profits (D-E) xxxx xxxx xxxx
G Taxes xxxx xxxx xxxx
H Profit After Taxes (F-G) xxxx xxxx xxxx
I Add: Non Cash Expenses (Like Depreciation, Bad Debts, provisions etc) xxxx xxxx xxxx
J Funds from Operations (H+I) xxxx xxxx xxxx
Working Capital Adjustments xxxx xxxx xxxx
K Add: Increase in current liabilities/Decrease in current assets/Decrease in working
capital
xxxx xxxx xxxx
L Less: Decrease in current liabilities/Increase in current assets/increase in working
capital
xxxx xxxx xxxx
M Operating Cash Flows (J+K-L) xxxx xxxx xxxx
Terminal Cash Flows
N Salvage value of assets (Plant, Machinery etc) xxxx
O Working Capital liquidated xxxx
P Total Terminal Cash Flows (N+O) xxxx
Q Total Cash Flows (C+M+P)
R PV Factor xxxx xxxx xxxx
S Present Value of Cash Flows (RxS) xxxx xxxx xxxx
T NPV (PV of Cash Inflows from year 1 to n minus PV of Cash Outflows in Year 0) xxxx
Points to be noted:
 In case of projects, only relevant expenses are taken into consideration. For example if a project doesn’t lead to increase in
overhead expenses, but has been allocated overhead expenses then such overhead allocation should not be taken into
consideration
 If a project leads to discontinuation of other business then loss of contribution of other business should be treated as
expense and charged to the project

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Cash flows of Replacement Projects
In case of projects involving replacement of old machine with new machine, only incremental cash flows are considered.
Following are the steps:
Particulars Year 0 Year 1 Year n
Initial Incremental Cash Flows
A Cost new Machinery (xxxx)
B Salvage value of old machine(this would be an inflow) xxxx
C Incremental Working Capital required
(working capital required by the new machine minus the working capital required
for the old machine)
(xxxx)
D Total Initial Incremental Cash Flows (A+B+C) (xxxx) - -
Operating Cash Flows
E Savings in costs xxxx xxxx xxxx
F Incremental costs xxxx xxxx xxxx
G Depreciation on New Machine xxxx xxxx xxxx
H Depreciation on Old Machine xxxx xxxx xxxx
I Incremental Depreciation (G-H) xxxx xxxx xxxx
J Incremental Profits (E-F-I) xxxx xxxx xxxx
K Taxes on Incremental Profits xxxx xxxx xxxx
L Incremental Profit After Taxes (J-K) xxxx xxxx xxxx
M Add: Non Cash Incremental Expenses (Like Depreciation, Bad Debts, provisions etc) xxxx xxxx xxxx
N Operating Incremental Cash Flows (L+M) xxxx xxxx xxxx
Terminal Incremental Cash Flows
O Salvage value of New Machinery xxxx
P Salvage value of Old Machinery if it was continued to be used xxxx
Q Incremental Working Capital liquidated xxxx
R Total Terminal Cash Flows (O-R+Q) xxxx
S Total Incremental Cash Flows (D+N+R) xxxx
R PV Factor xx xx xx
S Present Value of Cash Flows (RxS) xxxx xxxx xxxx
T NPV (PV of Cash Inflows from year 1 to n minus PV of Cash Outflows in Year 0) xxxx
For practice questions refer the separate hand out on Capital Budgeting