UNIT - II

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L E S S O N

1
Capital Budgeting
Manju Gupta

STRUCTURE
1.1 Learning Objectives
1.2 Introduction
1.3
1.4
1.5
1.6
1.7
1.8
1.9
1.10
1.11
1.12

1.1 Learning Objectives

After studying this chapter students may be able to understand:—
The meaning of Capital Budgeting.
The relevance of investing in long-term projects.
Techniques of capital budgeting.
Various types of discounted cash flow techniques.

1.2 Introduction
Every financial manager has to take three important decisions i.e. financing decision,
investment decision and dividend decision. Investment decision is basically concerned with

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Notes financing of current and fixed assets of the firm. Financing of current
asset is known as working capital management decision while investment
in fixed assets is known as capital budgeting decision.
The capital budgeting decisions are related to the allocation of investible
funds to different long-term projects. Broadly speaking, the capital
budgeting decision denotes a decision where the lump sum funds are
invested in the initial stages of a projects and the return are expected
over a long period of time (i.e., more than a year). Capital budgeting
decisions are important for almost all types of organizations and involves
a huge commitment of funds.
In any growing concern, capital budgeting is more or less a continuous
process carried out by different functional areas of management such as
production, marketing etc. All the relevant functional departments play a
crucial role in the capital budgeting decision process of any organization.
The role of a finance manager in the capital budgeting basically lies in
the process of critical and in-depth analysis and evaluation of various
alternative proposals and then to select one out of these. As already
stated, the basic objective of financial management is to maximize the
wealth of the shareholders, therefore the objective of capital budgeting is
to select those long term investment projects that are expected to make
maximum contribution to the wealth of the shareholders in a long run.
Features of Capital Budgeting:
The exchange of current funds for future benefits.
The funds are invested in the long-term assets.
The future benefits will occur to the firm over a series of years.
Capital budgeting decisions are irreversible which means once taken,
cannot be change.
It involves commitment of huge amount of funds and therefore, are
risky.
Capital budgeting decisions are compulsorily to be made in following
cases:
(i) Replacements: Replacements of fixed assets may become necessary
either on account of their being worn out or becoming outdated on
account of new technology.

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 FINANCIAL MANAGEMENT

(ii) Expansion: A firm may have to expand its production capacity on Notes
account of high demand for its products and inadequate production
capacity which will require additional capital investment. In such
event, investment in fixed assets is necessary.
(iii) Diversification: A business may like to reduce its risk by operating
in several markets rather than in a single market. In such an event
capital investment may become necessary for purchase of new
machinery and facilities to handle the new products.
(iv) Research and Development: Large sums of money may have to be
expended for research and development in case of those industries
where technology is rapidly changing. In case large sums of money
are needed for equipment, these proposals will normally be included
in the capital budget.
(v) Miscellaneous: A firm may have to invest money in projects which
do not directly help in achieving profit oriented goals. For example,
installation of pollution control equipment may by necessary account
of legal requirements. Thus, funds will be required for such purposes
also.

1.3 Significance of Capital Budgeting Decisions

The capital budgeting decisions are often said to be the most important part
of financial management. Any decision that requires the use of financial
resources in capital projects is a capital budgeting decision. The capital
budgeting decisions affect the profitability of a firm for a long period;
therefore, the importance of these decisions is obvious. Even a single
wrong decision by a firm may endanger the existence of the firm for
example a profitable firm decision to diversify into a new product line if
not taken correctly, may convert that firm into a loss making firm. There
are several factors and considerations which make the capital budgeting
decisions as the most important decisions of a finance manager. The
relevance of capital budgeting may be stated as follows:
(a) Long Term decisions: Capital budgeting decisions have long term
effects on the risk and return composition of the firm. Since these
decisions have long term implications and consequences, thus it

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Notes affect the future position of the firm to a considerable extent.

By taking a capital budgeting decision, a finance manager in fact
makes a commitment into the future, both by committing to the
future needs of funds of the project and by committing to its future
implications.
(b) Heavy investment Outlays: The capital budgeting decisions generally
involve large commitment of funds and as a result substantial portion
of capital funds are blocked in the capital budgeting decisions.
In relative terms therefore, more attention is required for capital
budgeting decisions, otherwise the firm may suffer from the heavy
capital losses in time to come. It is possible that the return from
a project may not be sufficient enough to justify capital budgeting
decisions.
(c) Irreversible in nature: Most of the capital budgeting decisions are
irreversible decisions. Once decided firm may not be in a position
to revert back unless it is ready to absorb heavy losses which
may result due to abandoning a project in midway. Therefore, the
capital budgeting decisions should be taken only after considering
and evaluating each and every detail of the project, otherwise the
financial consequences may be far reaching.
(d) Complex decisions: Capital budgeting decisions are among the firm’s
most difficult decision as it involves future assessment of cash flows
which are difficult to predict it is really a complex problem to
correctly estimate the future cash flows of an investment. Because of
the prevalence of uncertainty associated with economic environment
forces.

1.4 Capital Budgeting Process

The process of capital budgeting involves a number of steps that follow
capital budgeting.
Identification of Organizational Long-term Goals: In the very beginning,
the finance manager has to find out whether strategic or tactical investment
will be more suitable for the firm from the viewpoint of its long-term

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 FINANCIAL MANAGEMENT

goals. Entering a new product market involves strategic investment. Such Notes
proposals cannot be evaluated solely in terms of their impact on the cash
flow. Intangible benefits that are in conformity with the firm’s long-term
goals should also be considered. On the contrary, tactical investments are
those which primarily influence the firm’s cash flow but do not necessarily
change the character of the firm. Establishment of new facilities in an
existing market for the purpose of manufacturing products related to the
current product may be an example of a tactical investment proposal. Such
investment proposals carry less risk as compared to the risk inherent in
strategic proposals.
Screening of Proposals: When the manager is satisfied that the proposal
conforms to the long-term goals of the firm, he or she proceeds on to
the second phase, that of screening the proposal. The second phase is
one in which the manager determines the impact of the proposal on the
firm. In large firms, it is the project analysis division that looks for new
ideas and qualitatively evaluates their potential impact on the firm’s
revenues and cost. It examines whether the proposal would reduce cost
and or increase revenue.
Estimation of Costs and Benefits of a Proposal: The most important
step required in the capital budgeting decision is to estimate the cost and
benefit associated with all the proposals being considered. The cost of a
proposal is generally the capital expenditure required to install a project
or to implement a decision. However, the benefits of a proposal may be
in the form of increased output, increased sales, reduction in labour cost,
reduction in wastages etc. Every proposal is to be examined in the light
of its cost and benefits.
Estimation of the Required Rate of Return: The rate of return expected
from a proposal is to be estimated in order to (i) adjust the future cost
and benefit of a proposal for time value of money, and (ii) thereafter,
determining the profitability of the proposal. This required rate return is
also known as Cost of Capital.
Using the capital budgeting decision criterion: A proper capital budgeting
technique is to be applied to select the best alternative. So, in the first

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Notes instance the technique itself is to be selected and then is to be applied

for a better decision making.
Project Implementation: In this phase, the firm makes the required
arrangements to take up the new project. This includes arrangement of
capital, training of personnel and other relevant works.
Control: After the project is implemented, the firm monitors whether
costs are incurred in accordance with the set standards. Minor deviations
are managed, however, if deviations are very large, the project may be
abandoned.
Project Audit: When the project is complete, the extent of success or
failure and the reasons thereof are carefully studied. In this way the audit
phase provides valuable information to the firm.
IN-TEXT QUESTIONS
1. The capital budgeting decisions are related to the allocation of
investible funds to different ________ assets.
(a) Long-term
(b) Short-term
(c) Both (a) and (b)
(d) None of the above
2. Any decision that requires the use of ___________ resources
is a capital budgeting decision.
3. Which of the following is not true about Capital Budgeting?
(a) Capital Budgeting decisions have an influence on the future
stability of an organisation
(b) Capital Budgeting decisions include investments to expand
the business
(c) Capital Budgeting decisions are of an irreversible nature
(d) Sunk cost is a part of Capital Budgeting
4. Which of the following would be the best example of a capital
budgeting decision?
(a) Purchasing new machinery to replace an existing one

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 FINANCIAL MANAGEMENT

(b) Transferring money to your creditor’s account Notes

(c) Payment of electricity bill for your factory

(d) None of the above

1.5 Capital Budgeting Techniques

The main objective of capital fund investment is to obtain sufficient
future economic return to deserve the original outlay i.e., sufficient cash
receipts over the life of the project to justify the investment made. There
are different techniques available for or non-discounted and time adjusted
or discounted cash flows.
Evaluation Criteria

Non-Discounting Methods Discounting Methods

Payback Period Accounting rate Net present Internal rate Profitability

of return value of return Index

1.6 The Payback Period

The payback period measures the length of time required to recover the
initial outlay in the project.
Initial Investment
Payment Period
Annual Cash Inflows

Example: If a project with a 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. Find the payback period of the project.
Solution: The payback period of the project is:
Initial Investment
Payment Period
Annual Cash Inflows

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Notes 20
2.5
8
In case the cash flows are different: If the project is expected to generate
different annual inflows of say Rs. 4 lakh, Rs. 6 lakh, Rs. 8 lakh. Rs.
10 lakh and Rs. 14 lakh over the 5 years period the payback period will
be find out by cumulating the cash flows.
Year Cash flows (lakhs) Cumulative cash inflows
1 4 4
2 6 10
3 8 18

4 10 28
5 14 42

Pay Back Period = 3 years + (20000 – 18,000) / (28,000 – 18,000) =

3.2 years
In order to use the payback period as a decision rule for accepting or
rejecting the projects, the firm has to decide upon an appropriate cut-off
period.*
*The cut-off point refers to the point below which a project would not
be accepted. For Example, if 10% is the desired rate of return, the cut-
off rate is 10%. The cut-off point may also be in terms of period. For
example, if the management desires that the investment in the project
should be recouped in three years, the period of three years would be
taken as the cut-off period. A project, incapable of generating necessary
cash to pay for the initial investment in the project within three years,
will not be accepted. Projects with payback periods less than or equal to
the cut-off period will be accepted and others will be rejected.
The payback period is a widely used investment appraisal criterion for
the following reasons:
It is simple in both concept and application.
It helps in weeding out risky projects by favoring only those projects
which generate substantial inflows in earlier years.

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The emphasis in payback is on the early recovery of investment. Notes

Thus, it gives insight into liquidity of the project. The funds so
released can be put to other uses.
Payback period method also deals with risk. The project with a shorter
payback period will be less risky as compared to projects with a
longer payback period, as the cash inflow which arises further will
be less certain.
The payback period criterion however, suffers from the following
shortcomings:
It fails to consider the concept of time value of money.
The payback period method ignores many of cash inflows which
occur after the payback period.
The cut-off period is chosen rather arbitrarily and applied uniformly
for evaluating projects regardless of their life spans. Consequently,
the firm may accept too many short-lived projects and only too few
long-lived ones.
Since the application of the payback criterion leads to discrimination
against projects which generate substantial cash inflows in later years,
the criterion cannot be considered as a measure of profitability.
Suitability of Payback Method: The use of payback period as a technique
of evaluating capital budgeting proposals is suitable in following cases:
During instability, the firm may have a primary consideration of
recovering the initial cost at the earliest opportunity.
When the firm has limited funds available and has no ability or
willingness to raise additional funds. In such as case, the firm
may wish to undertake those projects which ensure early liquidity/
recovery.
Accounting Rate of Return or Average Rate of Return (ARR): The ARR
is based upon the accounting concept of return on investment or rate of
return. The ARR may be defined as the annualized net income earned
on the average funds invested in a project. In other words, the annual
returns of a project are expressed as a percentage of the net investment
in the project.

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Notes Average Annual Profit (after tax)

=
Average investment in the project
This clearly shows that the ARR is a measure based on the accounting
profits rather than the cash flows. It is very similar to the measure of
rate of return on capital employed, which is generally used to measure
the overall profitability of the firm.
In case the expected profits (after tax) generated by a project are equal
for all the years than the annual profit itself is the average profit. So,
this annual profit will be compared with the average investment.
Annual Profit (after tax)
=
Average investment in the project
If the project is expected to generate unequal profits or uneven stream of
profits over different years, then the ARR may be calculated by finding
out the average annual profits.
Average Annual Pr ofit (after tax)
Average investment in the project

The average investment refers to the average quantum of funds that

remains invested or blocked in the proposal over its economic life.
Example: A project will cost Rs. 40000. Its stream of Earnings Before
Depreciation, Interest and Taxes (EBDIT) during first year through five
years is expected to be Rs. 10,000, Rs. 12,000, Rs. 14,000, Rs. 16,000
and Rs. 20,000. Assume a 50 per cent tax rate and depreciation on
straight-line basis.
Year EBDIT EBT PAT (50% tax)
1 10000 2000 1000
2 12000 4000 2000
3 14000 6000 3000
4 16000 8000 4000
Initial Investment
Life of Pr oject
40000
8000
5

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Total profit after tax is 16000 Notes

Average profit after tax = 16000/5=3200
Average Annual Pr ofit (after tax)
Average investment in the project
3200
1000 16%
20000
To use it as an appraisal criterion, the ARR of a project is compared with
the ARR of the firm as a whole or against some external yard-stick like
the average rate of return for the industry as a whole. To illustrate the
computation of ARR consider a project with the following data:
Ins (Amount in Rs.)
Year 0 1 2 3
Investment (90000)
Sales Revenue 120000 100000 80000
Operating expenses 60000 50000 40000
Depreciation 30000 30000 30000
Annual Income 30000 20000 10000
30, 000 20, 000 10, 000
Average annual income 20, 000
3
90, 000 0
Average net book value of investment 45, 000
2
20, 000
Account rate of return 100 44 per cent
45, 000

The firm will accept the project if its target average rate of return is
lower than 44 per cent.

1.7 Acceptance Rule

As an accept-or-reject criterion, this method will accept all those projects
whose ARR is higher than the minimum rate established by the management
and reject those projects which have ARR less than the minimum rate.
This method would rank a project as number one if it has highest ARR
and lowest rank would be assigned to the project having lowest ARR.

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Notes As an investment appraisal criterion, ARR has the following merits:

Like payback criterion, ARR is simple both in concept and application.
It appeals to businessmen who find the concept of rate of return
familiar and easy to work with rather than absolute quantities.
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 only a measure of capital recovery).
The ARR can be readily calculated from the accounting data; unlike
in the NPV and IRR methods, no adjustments are required to arrive
at cash flow of the project.
This criterion, however, suffers from several serious defects:
First, this criterion ignores the time value of money. Put differently, it
gives no allowance for the fact that immediate receipts are more valuable
than the distant flows and results giving too much weight to the more
distant flows.
Second, the ARR depends on accounting income and not on the cash
flows. Since cash flows and accounting income are often different and
investment appraisal emphasizes cash flows, a profitability measure based
on accounting income cannot be used as a reliable investment appraisal
criterion.
Finally, 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 unusually high
or low, then the firm can end up rejecting good projects or accepting
bad projects.
To conclude, the traditional methods of appraising capital investment
decisions, the major draw-backs are (1) they do not consider the total
benefits in terms of the magnitude and (2) the timing of cash flows. The
time adjusted techniques satisfy these requirements.

1.8 Discounted Cash Flow Techniques (DCF)

The distinguishing characteristic of the DCF capital budgeting techniques is
that they take into consideration the time value of money while evaluating

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the costs and benefits of a project. In one form or another, all these Notes
methods require cash flows to be discounted at a certain rate, that is,
the cost of capital. The cost of capital (k) is the minimum discount rate
earned on a project that leaves the market value unchanged. The second
commendable feature of these techniques is that they take into account
all benefits and the costs occurring during the entire life of the project.
The first method under this technique is NPV.
Net Present Value: The net present value is equal to the present value of
future cash flows and any immediate cash outflow. In case of a project
the immediate cash flow will be investment (cash outflow) and then net
present value will be defined as the sum of the present values of cash
inflows less initial investment.
1 2 3 n
1 2 3 0
(1 ) (1 ) (1 ) (1 )n

Example: A company is considering a new project with initial outlays of

Rs. 12500. Forecasted annual income before charging depreciation but,
after all other charges are as follows:
1st year 5100
2nd year 5100
3rd year 5100
4th year 7100
Calculate NPV at 12%.
Solution:
The net cash flows of the project and their present values are as follows:
Year 1 2 3 4
Net cash flow (Rs.) 5100 5100 5100 7100
PVIF @ k = 12% 0.893 0.797 0.712 0.636
Present value (Rs.) 4554 4065 363 4516
Net Present Value = (4,554 +4,065 +3,631 +4,516) - (12,500)
= Rs. (16766-12500) = Rs. 4,266
The decision rule based on the NPV criterion is obvious. A project will
be accepted if its NPV is positive and rejected if its NPV is negative.
Rarely in real life situations, we encounter a project with NPV exactly

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Notes equal to zero. If it happens, theoretically speaking, the decision-maker is

supposed to be either indifferent in accepting or rejecting the project. But
in practice, NPV in the neighbourhood of zero calls for a close review
of the projections made in respect of such parameters that are critical
to the viability of the project because even minor adverse variations can
affect the viability of viable projects.
As an investment appraisal criterion, NPV has the following merits:
The NPV is a conceptually sound criterion of investment appraisal
because it takes into account the time value of money.
NPV considers the cash flow stream in its entirety. In other words,
it considers the total benefits arising out of the proposal over its
lifetime.
Since net present value represents the contribution to the wealth of
the shareholders, maximization NPV is congruent with the objective
of investment decision making viz., maximization of shareholders’
wealth.
A changing discount rate can be built into the NPV calculations
by altering the denominator. This feature becomes important as this
rate normally changes because the longer the time span, the lower
is the value of money and the higher is the discount rate.
This method is particularly useful for the selection of mutually
exclusive projects.
This criterion, however, suffers from several serious defects:
The first problem in applying this criterion appears to be the difficulty
in comprehending the concept . Most non-financial executives and
businessmen find ‘Return on Capital Employed’ or ‘Average Rate of
Return’ easy to interpret compared to absolute values like NPV.
The second, and a more serious problem associated with the present value
method, involves the calculation of the required rate of return to discount
the cash flows. The discount rate is the most important element used in
the calculation of the present values because different discount rates will
give different present values. The relative desirability of a proposal will
change with a change in the discount rate.

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Another shortcoming of the NPV is that it is an absolute measure. Notes

between two projects, this method will favour the project which has
highest present value. But it is likely that this project may also involve a
larger initial outlay. Thus, in case of projects involving different outlays,
the present value method may not give dependable results.
Finally, the present value method may also not give satisfactory results
in the case of two projects having different effective lives. In general,
the project with a shorter economic life would be preferable, other things
being equal. A project which has a higher present value may also have
larger economic life so that the funds will remain invested for a longer
period, while the alternative proposal may have shorter life but smaller
present value. In such situations, the present value method may not reflect
the true worth of the alternative proposals.
Internal Rate of Return (IRR): The second Discounted Cash Flow (DCF)
or time-adjusted method for appraising capital investment decisions is
the Internal Rate of Return (IRR) method. This technique is also known
as yield on investment, marginal efficiency of capital. Like the present
value method the IRR method also considers the time value of money by
discounting the cash streams. The basis of the discount factor, however,
is different in both cases. In the case of the net present value method, the
discount rate is the required rate of return and being a predetermined rate,
usually the cost of capital; its determinants are external to the proposal
under consideration. The IRR, on other hand, is based on facts which are
internal to the proposal. In other words, while arriving at the required
rate of return for finding out present values the cash flows-inflows as
well as outflows are not considered. But, the IRR depends entirely on
the initial outlay and the cash proceeds of the project which is being
evaluated for acceptance or rejection. It is, therefore appropriately referred
to as internal rate of return.
The internal rate of return is usually the rate of return that a project
earns. It is defined as the discount rate(r) which equates the aggregate
present value of the net cash inflows with the aggregate present value
of cash outflows of a project. In other words, it is that rate which gives
the project NPV of zero.

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Notes IRR can be determined by solving the following equation for r:

1 2 3 n
0
(1 r )1 (1 r ) 2 (1 r )3 (1 r ) n

where r = Internal rate of return

CF = Cash inflows at different time periods
= Cash outflow at 0 time period
SV = Salvage value
WC = Working capital adjustments
Example: A firm is evaluating a proposal costing Rs. 100000 and having
annual cash inflow of Rs. 25000 occurring at the end of each of next six
years. There is no salvage value. Compute IRR for the project.
Solution: The annual cash inflow is uniform at Rs. 25000 for the six years.
Hence, the pay back is 4 years for the project. The IRR is calculated:
1
F
C
where F = Factor to be located
I = Initial investment
C = Cash inflow per year
1, 00,000
F Rs. 4
25,000

This factor 4 should be located in present value annuity in the lines of

6 years. The discount percentage will be somewhere between 12% and
13%. This means that the IRR is more than 12% but less than 13%.
In order to find out the exact IRR, the NPV of the project for both these
rates are calculated.
At 12% NPV = (Rs. 25000 PVAF*) – 100000
= (Rs. 25000 × 4.111) - 100000
= (Rs. 102775-100000) = 2775
*The present annuity value of Rs. 1 at 12% for 6 years is 4.111.

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At 13% NPV = (Rs. 25000 PVAF) - 100000 Notes

= (Rs. 25000 3.998*)-100000
= (Rs. 99950-100000)=-50
*The present annuity value of Rs. 1 at 13% for 6 years is 3.998.
Difference in calculated present Value and required net cash outlays

1, 02,775 1, 00, 000

IRR 12% 1% = 12.98%
1, 02, 775 99, 950

Accept-Reject Decision: The use of the IRR, as a criterion to accept

capital investment decision, involves a comparison of the actual IRR
with the required rate of return also known as the cut off rate or hurdle
rate. The project would quantify to be accepted if the IRR (r) exceeds
the cut off rate ( ). If the IRR and the required rate of return are equal,
the firm is indifferent as to whether accept or reject the project.
IRR is a popular method of investment appraisal and has a number of
merits like:
It takes into account the time value of money.
It considers the cash flow stream over the entire investment horizon.
Like ARR, it makes sense to businessmen who prefer to think in
terms of rate of return on capital employed.
This criterion however suffers from the following limitation:
It involves tedious calculations. It generally involves complicated
computation problems.
Secondly it produces multiple rates which can be confusing.
Thirdly in evaluating mutually exclusive proposals, the project with
the highest IRR would be picked up to the exclusion of all others.
However, in practice it may not turn out to be the one hotel which
is the most profitable and consistent with the objectives of the firm,
that is, maximization of the shareholders’ wealth.
Finally, under the IRR method, it is assumed that all intermediate
cash flows are reinvested at the IRR.

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Notes Profitability Index: Another time-adjusted method of evaluating the

investment proposals is the Benefit-Cost (BC) ratio or Profitability
Index (PI). Profitability index is the ratio of the present value of cash
inflows, at the required rate of return, to the initial cash outflow of the
investment. The formula for calculating benefit-cost or profitability index
is as follows:
PI = Present value of cash inflows/Present value of cash outflows
Example: The initial cash outlay of a project is Rs. 1,00,000 and it can
generate cash inflow of Rs. 40,000, Rs. 30,000, Rs. 50,000 and Rs. 20,000
in year 1 through 4. Assume a 10 per cent rate of discount. Calculate
PI for the project.
Solution: The PV of cash inflows at 10 per cent discount rate is:
PV = Rs. 40,000 (PVF) + Rs. 30,000 (PVF) + Rs. 50,000 (PVF) + Rs.
20,000 (PVF)
= Rs. 40,000 × 0.909 + Rs. 30,000 × 0.826 + Rs. 50,000 × 0.751
+ Rs. 20,000 × 0.68
NPV = Rs. 1,12,350- Rs. 1,00,000 = Rs. 12,350
PV of cash flows = Rs. 1,12,350
1,12,350
1 1.1235.
1, 00, 000

The project will be accepted as the PI>1.

Acceptance Rule:
The following are the PI acceptance rules:
Accept the project when PI is greater than i.e., PI > 1.
Reject the project when PI is less than i.e., PI < 1.
May accept the project when PI is equal to i.e., PI = 1.
The project with positive NPV will have PI greater than 1. PI less than
one means that the project’s NPV is negative.
Evaluation of PI Method: Like the NPV and IRR rules, PI is a conceptually
sound method of appraising investment projects. It is a variation of the
NPV method, and requires the same computations as the NPV method.

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 FINANCIAL MANAGEMENT

It recognizes the concept of time value of money. Notes

It is consistent with the shareholders value maximization principle.
In the PI method, since the present value of cash inflows is divided
by the initial cash outflows, hence it is a relative measure of a
project’s profitability.
But 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.
Thirdly like NPV method PI also need calculation of cash flows and
estimation of discount rate. In practice, the estimation of cash flows and
discount rate is difficult to compute.
IN-TEXT QUESTIONS
5. Which of the following is a Non-Discounting Technique of
Capital Budgeting?
(a) Payback period
(b) IRR
(c) NPV
(d) PI
6. The __________ period measures the length of time required
to recover the initial outlay in the project.
7. The net present value is equal to the present value of future
cash flows and any immediate cash outflow. (True/False)
8. Profitability Index is also known as yield on investment, marginal
efficiency of capital. (True/False)
9. _________ is the ratio of the present value of cash inflows, at
the required rate of return, to the initial cash outflow of the
investment.
10. Which of the following is true?
(a) Accept the project when PI is greater than one PI > 1

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 B.COM. (PROGRAMME)/B.COM. (HONS.)

Notes (b) Accept the project when PI is less than one PI < 1
(c) Accept the project when PI is less than one PI =1
(d) None of the above

1.9 Summary
The chapter explain the concept and significance of capital budgeting
projects as well as the techniques for the evaluation of such projects.
The techniques involved in the capital budgeting are Payback Period
Method, Discounted Payback Period Method, Accounting Rate of Return,
Net Present Value (NPV), Internal Rate of Return (IRR) and Profitability
Index. The lesson discusses all the techniques along with its advantages
and limitations followed by a numerical illustration.

1.10 Answers to In-Text Questions

1. (a) Long-term
2. Financial
3. (d) Sunk Cost is a part of Capital Budgeting
4. (a) Purchasing new machinery to replace an existing one
5. (a) Payback Period
6. Payback
7. True
8. False
9. Profitability Index
10. (a) Accept the project when PI is Greater than one PI > 1

1.11 Self-Assessment Questions

1. What are the various types of capital budgeting.
2. What is the difference between Non-discounting and discounting
methods of capital budgeting.

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FINANCIAL MANAGEMENT

1.12 Suggested Readings Notes

J.C.Van Horne, Financial Management and Policy, Prentice Hall of

India.
I.M. Pandey, Financial Management, Vikas Publishing House Pvt.
Ltd.
Shrutika Kesar, Financial Management, Sumit Enterprises.
Keown, Martin, Petty, Scott, Jr. Financial Management Principles
and Applications, Prentice Hall of India.
M.Y. Khan and P.K. Jain, Financial Management, Text and Problems,
Tata McGraw Hill, New Delhi.
R.P. Rastogi, Fundamentals of Financial Management, Galgotia,
Publications, New Delhi.
V. K. Bhalla, Financial Management & Policy, Anmol Publications,
Delhi.
Prasanna Chandra, Financial Management - Theory and Practice, Tata
McGraw Hill.

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