Capital investment involves a cash outflow in the immediate future in anticipation of returns at a
future date .The Planning and control of capital expenditure is termed as Capital budgeting.Capital
Budgeting is the art of finding assets that are worth more than they cost to achieve a predetermined
goal i.e., optimising the wealth of a business enterprise.
Capital investment involves a cash outflow in the immediate future in anticipation of returns at a
future date.
A capital investment decision involves a largely irreversible commitment of resources that is
generally subject to significant degree of risk. Such decisions have for reading efforts on an
enterprises profitability and flexibility over the long-term. Acceptance of non-viable propos-als acts
as a drag on the resources of an enterprise and may eventually lead to bankrupcy.
For making a rational decision regarding the capital investment proposals, the decision maker needs
some techniques to convert the cash outflows and cash inflows of a project into mean-ingful
yardsticks which can measure the economic worthiness of projects.
Merits
(1) This method considers all the years in the life of the project.
(2) It is based upon profits and not concerned with cash flows.
(3) Quick decision can be taken when a number of capital investment proposals are being
considered.
Demerits
(1) Time Value of Money is not considered.
(2) It is biased against short-term projects.
(3) The ARR is not an indicator of acceptance or rejection, unless the rates are compared with the
arbitrary management target.
(4) It fails to measure the rate of return on a project even if there are uniform cash flows.
1
The dicounting factors is given by : (1 i)n
Where i = rate of interest per annum
n = no. of years over which discounting is made.As Project A has a higher Net
Present Value, it has to be taken up.
Merits
(1) It recognises the Time Value of Money.
(2) It considers total benifits during the entire life of the Project.
(3) This is applicable in case of mutually exclusive Projects.
(4) Since it is based on the assumptions of cash flows, it helps in determining Shareholders Wealth.
Demerits
(1) This is not an absolute measure.
(2) Desired rate of return may vary from time to time due to changes in cost of capital.
(3) This Method is not effective when there is disparity in economic life of the projects.
(4) More emphasis on net present values. Initial investment is not given due importance.
110,000
Factor for the project 3.14 35,000
The factor will be located from the table P.V. of an Annuity of Rs. 1 representing number of years
corresponding to estimated useful life of the asset.
The approximate value of 3.14 is located against 10% in 4 years.
We will now apply 10% and 12% to get (+) NPV and () NPV [Which means IRR lies in between]
10% 12%
NPV 2,720 (1560)
IRR may be calculated in two ways :
Forward Method : Taking 10%, (+) NPV
NPV at 10%
IRR = 10% + Total Difference Difference in Rate
2720
= 10% + 4280 2%
= 10% + 1.27% = 11.27%
Backward Method : Taking 12%, () NPV
(1560)
IRR = 12% + 4280 2%
= 12% 0.73% = 11.27%
The decision rule for the internal rate of return is to invest in a project if its rate of returning greater
than its cost of capital.
For independent projects and situations involving no capital rationing, then :
Situation Signifies Decision
IRR = Cost of Capital The investment is expected Indifferent between
not to change shareholder Accepting & Rejecting
wealth
IRR > Cost of Capital The investment is expected Accept
to increase shareholders
wealth
IRR < Cost of Capital The investment is expected Reject
to decrease shareholders
Demerits
(i) Possibility of multiple IRR, interpretation may be difficult.
(ii) If two projects with different inflow/outflow patterns are compared, IRR will lead to peculiar
situations.
(iii) If mutually exclusive projects with different investments, a project with higher investment but
lower IRR contributes more in terms of absolute NPV and increases the shareholders wealth.
NPV-IRR Conflict
Let us consider two mutually exclusive projects A & B.
Decision-making
If the P.V. of Sum Total of the Compound reinvested cash flows is greater than the P.V. of the
outflows of the project under consideration, the project will be accepted otherwise not.
Illustration :
Original Investment Rs. 40,000
Life of the project 4 years
Cash Inflows Rs. 25,000 for 4 years
Cost of Capital 10% p.a.
1
= 2 years 8 2 months.