Financial Management I

9. Basics of Capital Expenditure Decisions

Dr. Suresh
suresh.suralkar@gmail.com
Phone: 40434399, 25783850

Course Content - Syllabus

Sr

Title

ICMR Ch.

PC Ch.

IMP Ch.

1 Introduction to Financial Management

1*

2 Overview of Financial Markets

2*

3 Sources of Long-Term Finance

10*

17

20, 21

18*

20, 21, 23

5 Introduction to Risk and Return

4*

8, 9

4, 5

6 Time Value of Money

3*

7 Valuation of Securities

5*

8 Cost of Capital

11*

14

of Capital Expenditure
9 Basics
Decisions

18*

11

10 Analysis of Project Cash Flows

12*

10, 11

4 Raising Long-term Finance

*Book preference

2 / 37

Basics of Capital Expenditure Decisions

Reference Books
1. Financial Management, ICMR Book, Chapter 18
2. Financial Management, Prasanna Chandra, 7th Edition,

Chapter 11
3. Financial Management, I. M. Pandey, 9th Edition,
Chapter 8
3 / 37

Syllabus Basics of Capital Expenditure Decisions

1. The Process of Capital Budgeting
2. Basic Principles in Estimating Cost and Benefits of
Investments

3. Appraisal Criteria: Discounted and Non Discounted

Methods (Pay-Back Period, Average Rate of Return,
Net Present Value, Benefit Cost Ratio, Internal Rate of
Return)
4 / 37

1. The Process of Capital Budgeting

Investment decisions has following steps
Identification of Potential Investment Opportunities

Potential sources of Project Ideas

Market Characteristics of Different Industries
Product Profiles of Various Industries
Imports and Exports
Emerging Technologies
Social and Economic Trends
Consumption Patterns in Foreign Countries
Revival of Sick Units
Backward and Forward Integration

Chance Factors
Regulatory Framework and Policies
5 / 37

1. The Process of Capital Budgeting

Preliminary Screening

Compatibility with the Promoter

Compatibility with the Government Priorities
Availability of Inputs
Size of the Potential Market
Reasonableness of Cost

Feasibility Study
Implementation
Project Delays

Performance Review
Aspects of Project Appraisal
Market Appraisal: Size of market, projects market share
Technical Appraisal: Technical aspects, implementation, technology
Financial Appraisal: Risk and returns, cost benefits analysis
Economic Appraisal: Social cost benefit analysis
6 / 37

2. Basic Principles in Estimating Cost and

Benefits of Investments
Basic principles in estimating cost (outflow) and benefits
(inflow) of investments are as follows
All costs and benefits must be measured in terms of cash
flows. This implies that all non-cash charges (expenses)
like depreciation which are considered for the purpose of
determining the profit after tax must be added back to
arrive at the net cash flows for our purpose.
Since the net cash flows relevant from the firms point of
view are what that accrue to the firm after paying tax,
cash flows for the purpose of appraisal must be defined
in post-tax terms.
7 / 37

2. Basic Principles in Estimating Cost and

Benefits of Investments
Usually the net cash flows are defined from the point of

view of the suppliers of long-term funds (i.e. suppliers of

equity capital and long-term loans).
Interest on long-term loans must not be included for
determining the net cash flows.
Cash flows must be measured in incremental terms. In

other words, the increments in the present levels of costs

and benefits that occur on account of the adoption of the
project are alone relevant for the purpose of determining

the net cash flows.

8 / 37

2. Basic Principles in Estimating Cost and

Benefits of Investments
Some implications of this principle are as follows
If the proposed project has a beneficial or detrimental
impact on say, other product lines of the firm, then such

impact must be quantified and considered for

ascertaining the net cash flows.
Sunk costs must be ignored. For example, the cost of

existing land must be ignored because money has already

been sunk in it and no additional or incremental money
is spent on it for the purpose of this project.
9 / 37

2. Basic Principles in Estimating Cost and

Benefits of Investments
Opportunity costs associated with the utilization of the

resources available with the firm must be considered

even though such utilization does not entail explicit cash
outflows. For example, while the sunk cost of land is
ignored, its opportunity cost i.e. the income it would have
generated if it had been utilized for some other purpose

or project must be considered.

The share of the existing overhead costs which is to be
borne by the end products of the proposed project must

be ignored.

10 / 37

3. Appraisal Criteria:
Discounted and Non - Discounted Methods
Evaluation Criteria

Discounting Criteria

Non-Discounting Criteria

Payback
Period

Accounting
Rate of
Return
(ARR)

Net
Present
Value
(NPV)

Benefit
Cost
Ratio
(BCR)

Internal
Rate of
Return
(IRR)

Annual
Capital
Charge

11 / 37

3.1 Pay-Back Period

Payback period measures the time required to recover the
initial outlay in the project. For example, if a project
with life of 5 years involves an initial outlay of Rs. 20
lakh and is expected to generate a constant annual inflow
of Rs. 8 lakh,
Payback period = 20 / 8 = 2.5 years.
If the same project is expected to generate annual inflows
of say Rs. 4 lakh, Rs. 6 lakh, Rs. 10 lakh, Rs. 12 lakh and
Rs. 14 lakh, then
Payback period = 3 years, because inflows in first three
years is equal to the initial outlay.
12 / 37

3.1 Pay-Back Period

To use payback period method for accepting or rejecting

the projects, the firm has to decide an appropriate cutoff period. Projects with payback period up to the cut-off
period are accepted and beyond the cut-off period are
rejected.
Advantages of cut-off period method
It is simple in concept and application
It helps in rejecting risky projects and accepting those projects
which generate substantial inflows in earlier years.
13 / 37

3.1 Pay-Back Period

Disadvantages of cut-off period method
It does not consider the time value of money
The cut-off period is chosen arbitrarily and applied for
evaluating projects regardless of their life spans. Consequently

the firm may accept too many short-lived projects and too few
long-lived ones.
Payback period method leads to discrimination against projects
which generate substantial cash inflows in later years, the
criterion cannot be considered as a measure of profitability.
14 / 37

3.1 Pay-Back Period

To incorporate the time value of money, discounted
payback period is used. In this method, the firms
discount the cash flows before they compute the payback
period. For example, if a project involves an initial
outlay of Rs. 20 lakh and is expected to generate a net
annual inflow of Rs. 8 lakh for the next 4 years.
Assuming cost of funds to be 12%, the discounted

payback period is calculated as

8 x PVIFA(12,n) = 20
PVIFA(12,n) = 2.5
15 / 37

3.1 Pay-Back Period

From PVIFA table, we find that
PVIFA(12,3)
= 2.402
PVIFA(12,4)
= 3.037
By linear interpolation
Payback Period 3 (4 3) x

2.5 - 2.402
3.15 years
3.037 - 2.402

We find that the discounted payback period is longer

than undiscounted payback period.
Discounted payback period considers the time value of
money, still it suffers from other disadvantages of
payback period method. Hence in practice, companies do
not give much importance to payback period as an
appraisal criteria.
16 / 37

3.2 Accounting Rate of Return (ARR)

Accounting rate of return (ARR) also called as book rate
of return is defined as
Average Profit After Tax
ARR
Average Book Value of the investment

To use it as an appraisal criterion, ARR of a project is

compared with ARR of the firm as a whole or ARR of

for the industry sector as a whole.

To illustrate the calculation of ARR, consider the project
with the following data.
17 / 37

3.2 Accounting Rate of Return (ARR)

(Amount in Rs.)
Year

1,20,000

1,00,000

80,000

Operating Expenses
(excluding depreciation)

60,000

50,000

40,000

Depreciation

30,000

30,000

30,000

Annual Income

30,000

20,000

10,000

Investment
Sales Revenue

0
(90,000)

Average annual income = (30,000+20,000+10,000)/3 = 20,000

Average net book value of investment = (90,000+0)/2=45,000
Accounting rate of return = 20,000 / 45,000 x 100 = 44 %
The firm will accept the project if its target ARR is lower than
44%.
18 / 37

3.2 Accounting Rate of Return (ARR)

Advantages of ARR
Like payback method, ARR is simple in concept and
application. It appeals to the businessmen who find the concept
of ARR familiar and easy to use.
It considers the returns over the entire life of the project and
therefore serves as a measure of profitability(unlike the
payback period which is a measure of capital recovery)

19 / 37

3.2 Accounting Rate of Return (ARR)

Disadvantages of ARR
This criterion ignores the time value of money. That is, it gives
no allowance for immediate receipts, which are more valuable
than the distant flows.
ARR depends on accounting income and not on the cash flows.
A profitability measure based on accounting income cannot be
used as a reliable investment appraisal criterion.
The firm using ARR as an appraisal criterion must decide on a
yard-stick for judging a project and this decision is often
arbitrary. Often firms use their current book return as the
yard-stick for comparison. In such cases, if the current book
return of a firm tends to be very high or low, then the firm can
end up rejecting good project or accepting bad projects.
20 / 37

3.3 Net Present Value (NPV)

Net present value (NPV) is equal to the present value of
future cash flows and any immediate cash outflows. In
the case of a project, NPV will be equal to the present
value of future cash inflows minus initial investment
(cash outflow).
n

CF t
NPV
I0
t
t 1 (1 k)

Where k = cost of funds

CFt = cash flows at the end of the period t
I0 = initial investment

n = life of the investment

21 / 37

3.3 Net Present Value (NPV)

Example: Consider a project with cash flows as below.

Cost of funds to the firm is 12%.

Year
Initial Investment
(cash outflows)
Cash inflows

5,100

5,100

5,100

7,100

(12,500)

Calculate the NPV.

22 / 37

3.3 Net Present Value (NPV)

Solution: Net cash flows of the project and their present
values are as follows.
Year

Net cash flow (Rs.)

5100

5100

5100

7100

PVIF @ k = 12%

0.893

0.797

0.712

0.636

Present value (Rs.)

4554

4065

3631

4516

Net present value = (-12,500)+(4,554+4,065+3,631+4,516)

= Rs. (-12,500 + 16,766)
= Rs. 4,266
23 / 37

3.3 Net Present Value (NPV)

A project will be accepted if its NPV is positive and
rejected if its NPV is negative. NPV is a conceptually
sound criterion of investment appraisal because it takes
into account the time value of money and considers the
entire cash flow stream.
NPV represents the contribution to the wealth of the
shareholders, maximizing NPV is congruent with the
objective of investment decision making viz.
maximization of shareholders wealth.
Only problem in applying this criterion appears to be the
difficulty in comprehending the concept. Most nonfinancial executives and businessmen find Return on
Capital Employed or Accounting Rate of Return easy
to interpret compared to absolute value like NPV.
24 / 37

3.4 Benefit Cost Ratio (BCR)

Benefit cost ratio (or the profitability index) is defined as
PV
BCR
I

Where BCR = benefit cost ratio

PV = present value of future cash flows
I = initial investment
A variant of the BCR is net benefit cost ratio (NBCR)
which is defied as NBCR NPV
I
PV - I

I
PV

1
I
BCR 1

25 / 37

3.4 Benefit Cost Ratio (BCR)

BCR and NBCR for the project described in earlier
example will be
BCR
= 16,766 / 12,500 = 1.34
NBCR
= 4,266 / 12,500 = 0.34

Decision rule based on BCR (or alternatively NBCR)

criterion will be as follows
If

Decision Rule

BCR > 1 (NBCR > 0)

Accept the project

BCR < 1 (NBCR < 0)

Reject the project

26 / 37

3.4 Benefit Cost Ratio (BCR)

BCR measures the present value per rupee of outlay, it is
considered to be useful criterion for ranking a set of
projects in the order of decreasingly efficient use of
capital.
There are two serious limitations inhibiting the use of this
criterion.
First, it provides no means for aggregating several
smaller projects into a package that can be compared
with a large project.
Second, when the investment outlay is spread over more
than one period, this criterion cannot be used.
Following example illustrates the first limitation.
27 / 37

3.4 Benefit Cost Ratio (BCR)

Example: Company is considering 4 projects A, B, C and
D with following characteristics
Project

Initial investment
(at year 0)

Annual net cash flow

(year 1 to 5)

(20)

7.5

(4.5)

1.5

(7)

2.5

(8)

3.5

The funds available for investment are limited to Rs. 20

lakh and the cost of funds to the firm is 14%. Rank the 4
projects in terms of the NPV and BCR criteria.
Determine which project(s) will you recommend given
the limited supply of funds.
28 / 37

3.4 Benefit Cost Ratio (BCR)

Solution: The NPVs of the 4 projects are
Project

NPV (Rs. In lakh)

Rank

7.5 x PVIFA(14,5) 20 = (7.5 x 3.433) 20 = 5.75

1.5 x PVIFA(14,5) 4.5 = (1.5 x 3.433) 4.5 = 0.65

IV

2.5 x PVIFA(14,5) 7

= (2.5 x 3.433) 7

= 1.58

III

3.5 x PVIFA(14,5) 8

= (3.5 x 3.433) 8 = 4.02

II

The BCR of the 4 projects are

Project

BCR

Rank

25.75 / 20 = 1.27

II

5.15 / 4.5 = 1.14

IV

8.58 / 7

III

12.02 / 8 = 1.50

= 1.23

29 / 37

3.4 Benefit Cost Ratio (BCR)

Based on the NPV and BCR criterion, all 4 projects are
acceptable because NPVs are positive and BCRs are
greater than one for each project.
But all 4 projects cannot be taken by the firm because of
the limited availability of funds. Company has to accept
project A or a package consisting of projects B, C and D
but not both. The decision depend on which option
maximizes the shareholders wealth. In this situation,
BCR becomes inapplicable because there is no way by
which we can aggregate the BCRs of projects B, C and
D. On the other hand NPVs of projects B, C and D can
be aggregated and compared with the NPV of project A
to arrive at a decision.
30 / 37

3.4 Benefit Cost Ratio (BCR)

NPV(B+C+D) = NPV(B) + NPV(C) + NPV(D)

= 0.65 + 1.58 + 4.02

= 6.25
This is more than NPV(A) which is 5.75.
Therefore the package comprising projects B, C an D
must be accepted.

31 / 37

3.5 Internal Rate of Return (IRR)

Internal rate of return (IRR) is that rate of interest at
which the net present value of a project is equal to zero.
In other words, IRR is the rate which equates the present
value of the cash inflows to the present value of the cash
outflows.
n

CF t
I0
t
t 1 (1 k)
n

Where k = IRR, is that rate of return where

CFt = cash flows at the end of period t
I0 = initial investment
n = life of the investment

CF t
I0 0

t
t 1 (1 k)

32 / 37

3.5 Internal Rate of Return (IRR)

While under NPV method the rate of discounting is known
(firms cost of capital), under IRR this rate which makes
NPV zero has to be found out. Following example
illustrates this concept.

Example: A project has the following pattern of cash

flows. Calculate the IRR of this project.
Year

Cash flow (Rs. in lakh)

(10)

33 / 37

3.5 Internal Rate of Return (IRR)

Solution: To determine the IRR, we have to compute the
NPV of the project for different rates of interest until we
find that rate of interest at which the sum of present
values of all cash flows is equal to the initial investment.
Number of iterations are involved in this trial and error
method.
10 = 5 x PVIF(k,1) + 4 x PVIF(k,2) + 3 x PVIF(k,3) + 2 x PVIF(k,4)

With k=18%,
5 xPVIF(0.18,1)+ 4 xPVIF(0.18,2)+ 3 xPVIF(0.18,3)+ 2 xPVIF(0.18,4)
= 5 x 0.847 + 4 x 0.718 + 3 x 0.609 + 2 x 0.516
= 9.966
Next trial with 17%
34 / 37

3.5 Internal Rate of Return (IRR)

5 xPVIF(0.17,1)+ 4 xPVIF(0.17,2)+ 3 xPVIF(0.17,3)+ 2 xPVIF(0.17,4)

= 5 x 0.855 + 4 x 0.731 + 3 x 0.624 + 2 x 0.534

= 10.139

k lies between 17% and 18%

By linear interpolation

10.139 - 10
k 17 (18 17) x
10.139 - 9.967

= 17 + 0.80
= 17.80 %
35 / 37

3.5 Internal Rate of Return (IRR)

To use IRR as an appraisal criterion, the decision rule
based on IRR will be: Accept the project if the IRR is
greater than the cost of funds employed, else reject the
project. IRR is a popular method of investment

appraisal.
Advantages of IRR method
It takes into account the time value of money

It considers the entire cash flow stream over the investment

horizon
Like ARR, it makes sense to businessmen who prefer to think
in terms of rate of return on capital employed.
36 / 37

3.5 Internal Rate of Return (IRR)

IRR method suffers from following limitations
IRR is uniquely defined only for a project whose cash flow
pattern is characterized by cash outflow(s) followed by cash
inflows (such projects are called simple investments). If the

cash flow stream has one or more cash outflows interspersed

(at intervals) with cash inflows, there can be multiple IIRs.

In spite of these defects, IRR is still the best criterion today

to appraise a project financially.

*****
37 / 37