Module -3

Time Value of Money

‘Time value of money’ is central to the concept of finance. It recognizes that the value of
money is different at different points of time. Since money can be put to productive use, its
value is different depending upon when it is received or paid.
In simpler terms, the value of a certain amount of money today is more valuable than its
value tomorrow. It is not because of the uncertainty involved with time but purely on account
of timing. The difference in the value of money today and tomorrow is referred to as the time
value of money.
1. Meaning of Time Value of Money
The time value of money is one of the basic theories of financial management, it states that
‘the value of money you have now is greater than a reliable promise to receive the same
amount of money at a future date’.
The time value of money (TVM) is the idea that money available at the present time is worth
more than the same amount in the future due to its potential earning capacity. This core
principle of finance holds that, provided money can earn interest, any amount of money is
worth more the sooner it is received.
The time value of money is the greater benefit of receiving money now rather than receiving
later. It is founded on time preference. The principle of the time value of money explains why
interest is paid or earned? Interest, whether it is on a bank deposit or debt, compensates the
depositor or lender for the time value of money.
2. Concept of Time Value of Money
Important terms or concepts used in computing the time value of money are-
(1) Cash-flow
(2) Cash inflow
(3) Cash outflow
(4) Discounted Cash flow
(5) Even cash flows /Annuity cash flows
(6) Uneven/mixed streams of cash flows
(7) Single cash flows
(8) Multiple cash flows
(9) Future value
(10) Present value
(11) Compounding
(12) Discounting
(13) Effective interest rate / Time preference rate
(14) Risks and types of risks
(15) Uncertainty, and
(16) Doubling Period.
The above concepts are briefly explained below:
(1) Cash-Flow:
Cash flow is either a single sum or the series of receipts or payments occurring over a
specified period of time. Cash flows are of two types namely, cash inflow and cash outflow
and cash flow may be of much variety namely; single cash flow, mixed cash flow streams,
even cash flows or uneven cash flows.
(2) Cash Inflow:
Cash inflows refer to the receipts of cash, for the investment made on the asset/project, which
comes into the hands of an individual or into the business organisation account at a point of
time/s. Cash inflow may be a single sum or series of sums (even or uneven/mixed) over a
period of time.
(3) Cash Outflow:
Cash outflow is just opposite to cash inflow, which is the original investment made on the
project or the asset, which results in the payment/s made towards the acquisition of asset or
getting the project over a period of time/s.
(4) Discounted Cash Flow- The Mechanics of Time Value:
The present value of a future cash flow (inflows or outflows) is the amount of current cash
that is of equivalent value to the decision maker today. The process of determining present
value of a future payment (or receipts) or a series of future payments (or receipts) is called
discounting. The compound interest rate used for discounting cash flows is called discount
rate.
(5) Even Cash Flows /Annuity Cash Flows:
Even cash flows, also known as annuities, are the existence of equal/even/fixed streams of
cash flows may be a cash inflow or outflow over a specified period of time, which exists from
the beginning of the year.
Annuities are also defined as ‘a series of uniform receipts or payments occurring over a
number of years, which results from an initial deposit.’
In simple words, constant periodic sums are called annuities.
Annuity Aspects:
It is essential to discuss some of the aspects related to annuities, which are discussed as
below:
1. Annuitant
2. Status
3. Perpetuity
4. Various types of Annuity-
i. Annuity Certain
ii. Annuity Contingent
iii. Immediate or Ordinary annuity
iv. Annuity due
v. Perpetual annuity
vi. Deferred annuity
5. Annuity factor-
(i) Present Value Annuity factor, and
(ii) Compound value annuity factor.
A brief description each of the above aspects is as follows:
i. Annuitant is a person or an institution, who receives the annuity.
ii. Status refers to the period for which the annuity is payable or receivable.
iii. Perpetuity is an infinite or indefinite period for which the amount exists.
iv. a. Annuity Certain refers to an annuity which is payable or receivable for a fixed number
of years.
b. Annuity Contingent refers to the payment/receipt of an annuity till the happening of a
certain event/incident.
c. Immediate annuities are those receipts or payments, which are made at the end of the each
period.
d. A series of cash flows (i.e., receipts or payments) starting at the beginning of each period
for a specified number of periods is called an Annuity due. This implies that the first cash
flow has occurred today.
e. Perpetual annuities when, annuities payments are made for ever or for an indefinite or
infinite periods.
f. Deferred annuities are those receipts or payments, which starts after a certain number of
years.
v. (a) Present Value of Annuity factor is the sum of the present value of Re. 1 for the given
period of time duration at the given rate of interest;
(b) Compound value/Future value of annuity factor is the sum of the future value of Re. 1 for
the given period of time duration at the given rate of interest. This is the reciprocal of the
present value annuity discount factor.
Note – When the interest rate rises, the present value of a lump sum or an annuity declines.
The present value factor declines with higher interest rate, other things remaining the same.
vi. Sinking fund is a fund which is created out of fixed payments each period (annuities) to
accumulate to a future some after a specified period. The compound value of an annuity can
be used to calculate an annuity to be deposited to a sinking fund for ‘n’ period at ‘i’ rate of
interest to accumulate to a given sum.
(6) Uneven/Mixed Streams of Cash Flows:
Uneven cash flows, as the concept itself states, is the existence of un-equal or mixed streams
of cash inflows emanating from the investment made on the assets or the project.
(7) Single Cash Inflows:
A single cash inflow is a single sum of receipt of cash generated from the project during the
given period, for which the present value is ascertained by multiplying the cash inflow by the
discount factor.
(8) Multiple Cash Inflows:
Multiple cash inflows (even or mixed cash inflows) are the series of cash flows, may be
annuities/mixed streams of cash inflows which are generated from the project over the entire
life of the asset.
(9) Future Value/Compound Value [FV/CV]:
The future value concept states as to how much is the value of current cash flow or streams of
cash flows at the end of specified time periods at a given discount rate or interest rate. Future
value refers to the worth of the current sum or series of cash flows invested or lent at a
specified rate of return or rate of interest at the end of specified period.
In simple terms, future value refers to the value of a cash flow or series of cash flows at some
specified future time at specified time preference rate for money.
(10) Compounding:
The process of determining the future value of present money is called compounding. In
other words, compounding is a process of investing money, reinvesting the interest earned &
finding value at the end of specified period is called compounding.
In simple words, calculation of maturity value of an investment from the amount of
investment made is called compounding.
Under compounding technique the interest earned on the initial principal become part of
principal at the end of compounding period. Since interest goes on earning interest over the
life of the asset, this technique of time value of money is also known as ‘compounding’.
The simple formula to calculate Compound Value in different interest time periods is-
(a) If Interest is added at the end of each year or compounded annually-
FV or CV = PV (1 + i)n
Where, FV or CV = Future Value or Compound Value, PV= Present Value,
(1 + i)n = Compound Value factor of Re.1 at a given interest rate for a certain number of
years.
(b) If Interest is added/computed semi-annually and other compounding periods/multi-
compounding-
Say for example;
(i) When Compounding is made semi-annually, then m=2 (because two half years in one
year).
(ii) When Compounding is made quarterly, then m= 4 (because, 4 quarter years in one year).
(iii) When Compounding is made monthly, then m= 12 (because, 12 months in one year).
(11) Present Value:
The present value is just opposite to the future value. Present value refers to the present worth
of a future sum of money or streams of cash flows at a specified interest rate or rate of return.
It is also called a discounted value.
In simple terms it refers to the current value of a future cash flow or series of cash flows.
(12) Discounting:
The inverse of the compounding process is discounting technique. The process of
determining the present value of future cash flows is called discounting.
Discounting or Present Value technique is more popular than compounding technique, since
every individual or an organisation intends to have/hold present sums, rather than getting
some amount of money after some time, because of time preference for money.

(13) Effective Interest Rate / Time Preference Rate:

Time preference rate is used to translate the different amounts received at different time
periods; to amounts equivalent in value to the firm/individual in the present at common point
reference. This time preference rate is normally expressed in ‘percent’ to find out the value of
money at present or in future.
(14) Risk:
In business, the finance manager is supposed to take number of decisions under different
situations. In all such decisions, there is an existence of risk and uncertainty.
Risk is the ‘variability of returns’ or the ‘chance of financial losses’ associated with the given
asset. Assets that are having higher chances of loss or the higher rate of variability in returns
are viewed as ‘risky assets’ and vice versa. Hence care should be taken to recognize and to
measure the extent of risk associated with the assets, before taking the decision to invest on
such risky assets.
3. Importance of Time Value of Money
The Consideration of time is important and its adjustment in financial decision making is also
equally important and inevitable. Most financial decisions, such as the procurement of funds,
purchase of assets, maintenance of liquidity and distribution of profits etc., affect the firm’s
cash flows/movement of cash in and out of the organization in different time periods.
Cash flows occurring in different time periods are not comparable, but they should be
properly measurable. Hence, it is required to adjust the cash flows for their differences in
timing and risk. The value of cash flows to a common time point should be calculated.
To maximize the owner’s equity, it’s extremely vital to consider the timing and risk of cash
flows. The choice of the risk adjusted discount rate (interest rate) is important for calculating
the present value of cash flows.
For instance, if the time preference rate is 10 percent, it implies that an investor can accept
receiving Rs.1000 if he is offered Rs.1100 after one year. Rs.1100 is the future value of
Rs.1000 today at 10% interest rate.
Thus, the individual is indifferent between Rs.1000 and Rs.1100 a year from now as he/she
considers these two amounts equivalent in value. You can also say that Rs.1000 today is the
present value of Rs.1100 after a year at 10% interest rate.
Time value adjustment is important for both short-term and long-term decisions. If the
amounts involved are very large, time value adjustment even for a short period will have
significant implications.
However, other things being same, adjustment of time is relatively more important for
financial decisions with long range implications than with short range implications. Present
value of sums far in the future will be less than the present value of sums in the near future.
The concept of time value of money is of immense use in all financial decisions.
The time value concept is used
1. To compare the investment alternatives to judge the feasibility of proposals.
2. In choosing the best investment proposals to accept or to reject the proposal for
investment.
3. In determining the interest rates, thereby solving the problems involving loans, mortgages,
leases, savings and annuities.
4. To find the feasible time period to get back the original investment or to earn the expected
rate of return.
5. Helps in wage and price fixation.
4. Reasons for Time Preference of Money / Reasons for Time Value of Money
There are three primary reasons for the time value of money- reinvestment opportunities;
uncertainty and risk; preference for current consumption.
These reasons are explained below:
1. Reinvestment Opportunities:
The main fundamental reason for Time value of money is reinvestment opportunities.
Funds which are received early can be reinvested in order to earn money on them. The basic
premise here is that the money which is received today can be deposited in a bank account so
as to earn some return in terms of income.
In India saving bank rate is about 4% while fixed deposit rate is about 7% for one year
deposit in public sector banks. Therefore even if the person does not have any other profitable
investment opportunity to invest his funds, he can simply put his money in a savings bank
account and earn interest income on it.
Let us assume that Mr. X receives Rs.100000 in cash today. He can invest or deposit this
Rs.100000 in fixed deposit account and earn 7% interest p.a. Therefore at the end of one year
his money of Rs.100000 grows to Rs.107000 without any efforts on the part of Mr. X.
If he deposits Rs.100000 in two years fixed deposit providing interest rate 7% p.a. then at the
end of second year his money will grow to Rs.114490 (i.e. Rs.107000+ 7% of Rs.107000).
Here we assume that interest is compounded annually i.e. we do not have a simple interest
rate but compounded interest rate of 7%.
Thus Time value of money is the compensation for time.
2. Uncertainty and Risk:
Another reason for Time value of money is that funds which are received early resolves
uncertainty and risk surmounting future cash flows. All of us know that the future is uncertain
and unpredictable. At best we can make best guesses about the future with some probabilities
that can be assigned to expected outcomes in the future.
Therefore given a choice between Rs.100 to be received today or Rs.100 to be received in
future say one year later, every rational person will opt for Rs.100 today. This is because the
future is uncertain. It is better to get money as early as possible rather than keep waiting for
it.
The underlying principle is “A bird in hand is better than two in the bush.”
It must be noted that there is a difference between risk and uncertainty.
In a Risky situation we can assign probabilities to the expected outcomes. Probability is the
chance of occurrence of an event or outcome. For example I may get Rs.100 with 90%
probability in future. Therefore there is 10% probability of not getting it at all. In a risky
situation outcomes are predictable with probabilities.
In case of an uncertain situation it is not possible to assign probabilities to the expected
outcomes. In such a situation the outcomes are not predictable.
3. Preference for Current Consumption:
The third fundamental reason for Time value of money is preference for current consumption.
Everybody prefers to spend money today on necessities or luxuries rather than in future,
unless he is sure that in future he will get more money to spend.
Let us take an example, Your father gives you two options – to get Wagon R today on your
20th birthday OR to get Wagon R on your 21st birthday which is one year later.
Which one would you choose? Obviously you would prefer Wagon R today rather than one
year later. So every rational person has a preference for current consumption. Those who save
for future, do so to get higher money and hence higher consumption in future.
In the above example of a car if your father says that he can give you a bigger car, say Honda
City on your 21st birthday, then you may opt for this option if you think that it is better to wait
and get a bigger car next year rather than settling for a small car this year.
Thus we can say that the amount of money which is received early (or today) carries more
value than the same amount of money which is received later (or in future). This is Time
Value of Money.
5. Valuation Concepts
There are the following two valuation concepts:
1) Compound Value Concept (Future Value or Compounding)
2) Present Value Concept (Discounting)
1) Compound Value Concept:
The compound value concept is used to find out the Future Value (FV) of present money. A
Future Value means that a given quantity of money today is worth more than what will be
received at some point of time in future.
It is the same as the concept of compound interest, wherein the interest earned in a preceding
year is reinvested at the prevailing rate of interest for the remaining period. Thus, the
accumulated amount (principal + interest) at the end of a period becomes the principal
amount for calculating the interest for the next period.

The compounding technique to find out the FV to present money can be explained with
reference to:
i) The FV of a single present cash flow,
ii) The FV of a series of equal cash flows and
iii) The FV of multiple flows.
i) FV of a Single Present Cash Flow: The future value of a single cash flow is defined in
term of equation as follows:
Illustration:
Mr. A makes a deposit of Rs. 10,000 in a bank which pays 10% interest compounded
annually for 5 years. You are required to find out the amount to be received by him after 5
years.
Solution:

ii) Future Value of Series of Equal Cash Flows or Annuity of Cash Flows:
Quite often a decision may result in the occurrence of cash flows of the same amount every
year for a number of years consecutively, instead of a single cash flow. For example, a
deposit of Rs. 1,000 each year is to be made at the end of each of the next 3 years from
today.
This may be referred to as an annuity of deposit of Rs. 1,000 for 3 years. An annuity is thus, a
finite series of equal cash flows made at regular intervals.
In general terms, the future value of an annuity is given as:

It is evident from the above that future value of an annuity depends upon three variables, A, r
and n. The future value will vary if any of these three variables changes. For computation
purposes, tables or calculators can be made use of.
Illustration:
Mr. A is required to pay five equal annual payments of Rs. 10,000 each in his deposit account
that pays 10% interest per year. Find out the future value of annuity at the end of four years.
Solution:

iii) Future Value of Multiple Flows:

Illustration:
Suppose the investment is Rs. 1,000 now (beginning of year 1), Rs.2,000 at the beginning of
year 2 and Rs.3,000 at the beginning of year 3, how much will these flows accumulate at the
end of year 3 at a rate of interest of 12 percent per annum?
Solution:
To determine the accumulated sum at the end of year, add the future compounded
values of Rs. 1,000, Rs.2, 000 and Rs.3, 000 respectively:

2) Present Value Concept:

Present values allow us to place all the figures on a current footing so that comparisons may
be made in terms of today’s rupees. Present value concept is the reverse of compounding
technique and is known as the discounting technique.
As there are FVs of sums invested now, calculated as per the compounding techniques, there
are also the present values of a cash flow scheduled to occur in future.
The present value is calculated by discounting technique by applying the following
equation:

The discounting technique to find out the PV can be explained in terms of:
i) Present Value of a Future Sum:
The present value of a future sum will be worth less than the future sum because one forgoes
the opportunity to invest and thus forgoes the opportunity to earn interest during that period.
In order to find out the PV of future money, this opportunity cost of the money is to be
deducted from the future money.
The present value of a single cash flow can be computed with the help of following
formula:
Illustration:
Find out the present value of Rs.3, 000 received after 10 years hence, if the discount rate
is 10%.
Solution:

Illustration:
Mr. A makes a deposit of Rs. 5000 in a bank which pays 10% interest compounded annually.
You are required to find out the amount to be received after 5 years.
Solution:

ii) PV of a Series of Equal Future Cash Flows or Annuity:

A decision taken today may result in a series of future cash flows of the same amount over a
period of number of years.
For example, a service agency offers the following options for a 3-year contract:
a) Pay only Rs.2, 500 now and no more payment during next 3 years, or
b) Pay Rs.900 each at the end of first year, second year and third year from now. A client
having a rate of interest at 10% p.a. can choose an option on the basis of the present values of
both options as follows:
Option I:
The payment of Rs.2, 500 now is already in terms of the present value and therefore does not
require any adjustment.
Option II:
The customer has to pay an annuity of Rs.900 for 3 years.

In order to find out the PV of a series of payments, the PVs of different amounts accruing at
different times are to be calculated and then added. For the above example, the total PV is
Rs.2, 238. In this case, the client should select option B, as he is paying a lower amount of
Rs.2, 238 in real terms as against Rs.2, 500 payable in option A.
The present value of an annuity may be expressed as follows:

Illustration:
Find out the present value of a 5 years annuity of Rs.50, 000 discounted at 8%.
Solution:

6. Techniques Used to Understand the Concept of Time Value of Money

Basically two techniques are used to find the time value of money.
They are:
1. Compounding Technique or Future Value Technique
2. Discounting Technique or Present Value technique
1. Compounding Technique:
Compounding technique is just reverse of the discounting technique, where the present sum
of money is converted into future sum of money by multiplying the present value by the
compound value factor for the required rate of interest and the period.
Hence Future Value or Compound Value is the ‘product’ of the present value of a given sum
of money and the factor.
The simple formulas are used to calculate the Compound value of a single sum:
(a) If interest is compounded annually is-
FV = PV (1 + i)n = PV (CVFni)
Note- (1 + i)n is the formula for future value or compound value factor and
CVFni = Compound Value factor for the given number of years at required rate of interest.
(b) If Interest is added semi-annually and other compounding periods-

2. Discounting Technique or Present Value Technique:

Discounting technique or present value technique is the process of converting the future cash
flows into present cash flows by using an interest rate/time preference rate/discount rate.
The simple formula used to calculate the Present Value of a single sum is:

Where;
P= Present Value, PVF= Present value factor of Re.1, DF= Discount factor of Re.1, A=
Future Value or Compound Value, i = interest rate & n= number of years or time period given
for 1 to n years and (1 + i)n = The compound value factor.
So from the above formula, it is very clear that the present value of future cash flows is the
product of the ‘future sum of money and the discount factor’ or ‘the quotient of the future
sum of money and the compound value factor (1 + i)1-n.
Note – Present value can be computed for all types of cash flows, say single sum/ multiple
sums, even / annuity sums and mixed/un-even sums.
Alternatively, PVF/DF, CVF of a rupee and also the annuity discount factor (PADF) and the
compound value annuity factor (CVAF) at the given rate of interest for the expected period
can be referred through the tables also.
7. Present Value Technique or Discounting Technique
It is a process of computing the present value of cash flow (or a series of cash flows) that is to
be received in the future. Since money in hand has the capacity to earn interest, a rupee is
worth more today than it would be worth tomorrow.
Discounting is one of the core principles of finance and is the primary factor used in pricing a
stream of future receipts. As a method, discounting is used to determine how much these
future receipts are worth today.
It is just the opposite of compounding where compound interest rates are used in determining
the present value corresponding to a future value. For example, Rs. 1,000 compounded at an
annual interest rate of 10% becomes Rs. 1,771.56 in six years.
Conversely, the present value of Rs. 1,771.56 realized after six years of investment is Rs.
1,000 when discounted at an annual rate of 10%. This present value is computed by
multiplying the future value by a discount rate. This discount rate is computed as reciprocal
of compounding.
Present value calculations determine what the value of a cash flow received in the future
would be worth today (that is at time zero). The process of finding a present value is called
discounting; the discounted value of a rupee to be received in future gets smaller as it is
applied to a distant future.
The interest rate used to discount cash flows is generally called the discount rate. How much
would Rs.100 received five years from now be worth today if the current interest rate is 10%?
Let us draw a timeline.

The arrow represents the flow of money and the numbers under the timeline represent the
time period. It may be noted that time period zero is today, corresponding to which the value
is called present value.
A generalized procedure for calculating the future value of a single amount
compounded annually is as given below:

I. Ascertaining the Present Value (PV):

The discounting technique that facilitates the ascertainment of present value of a future
cash flow may be applied in the following specific situations:
(a) Present Value of a Single Future Cash Flow:
The future value of a single cash flow may be ascertained by applying the usual
compound interest formula as given below:

Let us understand the computation of present value with the help of an example that
follows:
Example:
Mr. Aman shall receive Rs.25,000 after 4 years. What is the present value of this future
receipt, if the rate of interest is 12% p.a.?

(b) Present Value of Series of Equal Cash Flows (Annuity):

An annuity is a series of equal cash flows that occur at regular intervals for a finite period of
time. These are essentially a series of constant cash flows that are received at a specified
frequency over the course of a fixed time period. The most common payment frequencies are
yearly, semi-annually, quarterly and monthly.
There are two types of annuities – ordinary annuity and annuity due. Ordinary annuities are
payments (or receipts) that are required at the end of each period. Issuers of coupon bonds,
for example, usually pay interest at the end of every six months until the maturity date.
Annuity due are payments (or receipts) that are required in the beginning of each period.
Payment of rent, lease etc., are examples of annuity due. Since the present and future value
calculations for ordinary annuities and annuities due are slightly different, we will first
discuss the present value calculation for ordinary annuities.
The formula for calculating the present value of a single future cash flow may be
extended to compute present value of series of equal cash flow as given below:

Example:
An LED TV can be purchased by paying Rs.50,000 now or Rs.20,000 each at the end of first,
second and third year respectively. To pay cash now, the buyer would have to withdraw the
money from an investment, earning interest at 10% p.a. compounded annually. Which option
is better and by how much, in present value terms?
Solution:
Let paying Rs.50,000 now be Option I and payment in three equal installments of
Rs.20,000 each be Option II, the present value of cash outflows of Option II is computed
as:
(c) Present Value of a Series of Unequal Cash Flows:
The formula for computing present value of an annuity is based on the assumption that cash
flows at each time period are equal.
However, quite often cash flows are unequal because profits of a firm, for instance, which
culminate into cash flows, are not constant year after year.
The formula for calculating the present value of a single future cash flow may be
extended to compute present value of series of unequal cash flows as given below:

Example:
Ms. Ameeta shall receive Rs.30,000, Rs.20,000, Rs.12,000 and Rs.6,000 at the end of first,
second, third and fourth year from an investment proposal. Calculate the present value of her
future cash flows from this proposal, given that the rate of interest is 12% p.a.
Solution:
Implication:
If Ms. Ameeta lends Rs.55,086 @ 12%p.a, the borrower may settle the loan by paying
Rs.30,000, Rs.20,000, Rs.12,000 and Rs.6,000 at the end of first, second, third and fourth
year.
(d) Perpetuity:
It refers to a stream of equal cash flows that occur and last forever. This implies that the
annuity that occurs for an infinite period of time turns it to perpetuity. Although it may seem a
bit illogical, yet an infinite series of cash flows have a finite present value.
Examples of Perpetuity:
(i) Local governments set aside funds so that certain cultural activities are carried on a regular
basis.
(ii) A fund is set-up to provide scholarship to meritorious needy students on a regular basis.
(iii) A charity club sets up a fund to provide a flow of regular payments forever to needy
children.
The present value of perpetuity is computed as:

Example:
A philanthropist wishes to institute a scholarship of Rs.25,000 p.a., payable to a meritorious
student in an educational institution. How this amount should he invest @ 8% p.a. so that the
required amount of scholarship becomes available as yield of investment in perpetuity.
8. Valuation of Preference Shares and Equity Shares
Valuation of Preference Shares:
Preference shares have preference over ordinary shares in terms of payment or dividend and
repayment of capital if the company is wound up. They may be issued with or without a
maturity period.
The preference shares unlike bonds has an investment value as it resembles both bond as well
as common stock. It is a hybrid between the bond and the equity stock. It resembles a bond as
it has a prior claim on the assets of the firm at the time of liquidations.
Like the common stock the preference shareholders receive dividend and have similar
features as common stock and liabilities at the time of liquidation of a firm.
Types of Preference Shares:
a. Redeemable preference shares are shares with maturity.
b. Irredeemable preference shares are shares without any maturity.
Features of Preference Shares:
i. Dividend
The dividend rate is fixed in the case of preference shares.
ii. Claims
Preference shareholders have a claim on assets and income prior to ordinary shareholders.
iii. Redemptions
Redeemable preference shares have a maturity date while irredeemable preference shares are
perpetual.
iv. Conversions
A company can issue convertible preference shares and can be converted as per the norms.
Valuation of Equity Shares
Equity Shares:
Equity shares are also referred to as common stock, unlike bonds, equity shares are
instruments that do not assure a fixed return.
Equity is fundamentally different from debt. Debt is commonly issued by security known as
bond/debenture. Financial markets deal with the transfer of these securities from one person
to another. The price at which such transfer takes place is determined by market forces.
Features of equity share:
(a) Ownership and management,
(b) Entitlement to residual cash flows,
(c) Limited liability,
(d) Infinite life,
(e) Substantially different risk profile.
Challenges in Valuation of Equity:
The valuation of equity shares is relatively more difficult.
The difficulty arises because of two factors:
(i) Rate of Dividend on Equity Shares is not known.
(ii) Estimates of the Amount and timing of the cash flows expected by equity shareholders are
more uncertain.
9. Risk and Return Analysis
What is risk?
Risk is the variability which may likely to accrue in future between the expected returns and
the actual returns. So, the risk may also be considered as a chance of variation or chance of
loss.
Types of Risk:
Risk can be classified in the following two parts:
1. Systematic Risk or Market Risk:
Systematic risk is that part of total risk which cannot be eliminated by diversification.
Diversification means investing in different types of securities. No investor can avoid or
eliminate this risk, whatsoever precautions or diversification may be resorted to. So, it is also
called non diversifiable risk, or the market risk.
This part of the risk arises because every security has a built in tendency to move in line with
the fluctuations in the market. The systematic risk arises due to general factors in the market
such as money supply, inflation, economic recession, industrial policy, interest rate policy of
the government, credit policy, tax policy etc. These are the factors which affect almost every
firm.
2.Unsystematic Risk:
The unsystematic risk is one which can be eliminated by diversification. This risk represents
the fluctuation in returns of a security due to factors specific to the particular firm only and
not the market as a whole.
These factors may be such as worker’s unrest, strike, change in market demand, change in
consumer preference etc. This risk is also called diversifiable risk and can be reduced by
diversification. Diversification is the act of holding many securities in order to lessen the risk.
The effect of diversification on the risk of a portfolio is represented graphically in the
below figure:

The above diagram shows that the systematic risk remains the same and is constant
irrespective of the number of securities in the portfolio as shown by OA in the above diagram
and is fixed for any number of securities.
For only security it is OA & for 20 security also it is OA. However, the unsystematic risk is
reduced when more and more securities are added to the portfolio. As from the above
diagram we can see that earlier it was OD & by increasing the number of securities it
decreases to C.
10. Methods of Risk Management
Risk is inherent in business and hence there is no escape from the risk for a businessman.
However, he may face this problem with greater confidence if he adopts a scientific approach
by dealing with risk. Risk management may, therefore, be defined as adoption of a scientific
approach to the problem dealing with risk faced by a business firm or an individual.
Broadly, there are five methods in general for risk management:
i) Avoidance of Risk
A business firm can avoid risk by not accepting any assignment or any transaction which
involves any type of risk whatsoever. This will naturally mean a very low volume of business
activities and losing of too many profitable activities.
ii) Prevention of Risk
In case of this method, the business avoids risk by taking appropriate steps for prevention of
business risk or avoiding loss, such steps include adaptation of safety programmes,
employment of night security guard, arranging for medical care, disposal of waste material
etc.
iii) Retention of Risk
In the case of this method, the organization voluntarily accepts the risk since either the risk is
insignificant or its acceptance will be cheaper as compared to avoiding it.
iv) Transfer of Risk
In case of this method, risk is transferred to some other person or organization. In other
words, under this method, a person who is subject to risk may induce another person to
assume the risk. Some of the techniques used for transfer of risk are hedging, sub-contracting,
getting surety bonds, entering into indemnity contracts etc.
v) Insurance
This is done by creating a common fund out of the contribution (known as premium) from
several persons who are equally exposed to the same loss. Fund so created is used for
compensating the persons who might have suffered financial loss on account of the risks
insured against.
11. Types of Investors
There are three types of investor which may be classified as:
a) Risk Averse
Under this category those investors appear who avoid taking risk and prefer only the
investments which have zero or relatively lower risk. These investors ignore the return from
the investment. Generally risk averse investors are – Retired persons, Old age persons and
Pensioners.
b) Risk Seekers
Under this category those investors are nominated who are ready to take risk if the return is
sufficient enough (according to their expectations). These investors may be ready to take –
Income risk, Capital risk or both.
c) Neutrals
Under this category those investors lie who do not care much about the risk. Their
investments decisions are based on consideration other than risk and return.
What is return?
Return is the amount received by the investor from their investment. Everyone needs high
returns over invested amounts. Each and every investor who invests or wants to invest their
amount in any type of project, first expects some return which encourages them to take risk.
Risk and Return Trade Off:
The principle that potential “return rises with an increase in risk”. Low levels of uncertainty
(low risk) are associated with low potential returns, whereas high levels of uncertainty (high
risk) are associated with high potential returns. According to the risk-return tradeoff, invested
money can render higher profits only if it is subject to the possibility of being lost.
Because of the risk- return tradeoff, you must be aware of your personal risk tolerance when
choosing investments for your portfolio. Taking on some risk is the price of achieving
returns; therefore, if you want to make money, you can’t cut out all risk. The goal instead is to
find an appropriate balance – one that generates some profit, but still allows you to sleep at
night.
We can see this in the following figure:

Risk and return analysis emphasizes over the following characteristics:

(i) Risk and Return have parallel relations.
(ii) Return is fully associated with risk.
(iii) Risk and return concepts are basic to the understanding of the valuation of assets or
securities.
(iv) The expected rate of return is an average rate of return. This average may deviate from
the possible outcomes (rates of return).
Capital Budgeting
1. Introduction to Capital Budgeting
Every business entity has to continuously incur expenses on certain resources or assets which
help it not only to produce but also grow. This expenditure has to be made on raw materials,
labour, fuel and power, spares and stores as well as certain essential maintenance expenses.
These expenses are the routine and recurring expenses which help an enterprise to
continuously produce at the current level of output.
However, enterprises also want to expand their productive capacities or to set up new
ventures for which also they have to incur expenses which are not routine or regular. These
expenses are occasional and are made when an enterprise sees a new opportunity and wants
to exploit it in the foreseeable future. These expenses are on fixed assets like land, building,
machinery, equipment etc. They are called ‘capital expenditure’.
Expenditure on fixed assets is entirely different from expenditure on current or variable
assets. The implications of expenditure on fixed assets like plant, machinery, equipment, land,
building or any such expenditure like research, brand building etc. extend into the future,
whereas expenditure on variable inputs like raw material, labour, power or other current
outlays belong to the same time period.
In this way, expenditure on fixed assets has inter temporal implications, i.e., expenditures are
being done now but benefits will be received in future. That is why, they are treated as
investment or capital expenditure decisions and the process of this decision making is called
‘capital budgeting’.
2. Meaning of Capital Budgeting
The investment decisions are commonly known as capital budgeting or capital expenditure
decisions. Capital budgeting means planning for capital expenditure in acquisition of capital
assets such as new building, new machinery or a new project as a whole. It refers to long term
planning for proposed capital outlays and their financing.
It includes mechanization of a process replacing and modernizing a process introduction of a
new product and expansion of the business. It includes both raising of long-term funds as
well as their utilization. It contains the preparation of Detailed Project Reports (DPR) and
cost and revenue statements indicating the profitability.
3. Need for Capital Budgeting
The need for Capital budgeting arises due to the following reasons:
1. Capital budgeting is necessary because large sums of money are involved for acquiring
fixed assets.
2. Large sums of money involved on capital assets are permanently blocked. Capital
investment decisions once taken cannot be reversed easily without heavy loss. This
necessitates capital budgeting.
3. Funds invested in capital projects or fixed assets are recovered over a long period.
Therefore, there is risk and uncertainty in the recovery of funds. So it necessitates capital
budgeting.
4. Capital investment decisions require an assessment of future events, which are uncertain.
This necessitates capital budgeting.
5. Excessive capital investment would increase the operating cost of the firm. So, careful
planning of the capital budgeting is quite necessary.
4. Features of Capital Budgeting Decisions
Basic Features of Capital Budgeting decisions are:
(1) Current funds are exchanged for future benefits
(2) There is an investment in long-term activities; and
(3) The future benefits will occur to the firm over a series of years.
5. Significance of Capital Budgeting
Capital budgeting decisions are of paramount importance in the financial decision-making
process of an organization.
It provides the following benefits:
1. Capital budgeting decisions affect the profitability of a firm.
2. Capital budgeting decisions determine the destiny of the company. A few wrong decisions
affect the survival of firms.
3. Capital budgeting decisions affect a company’s future cost structures.
4. Capital budgeting decisions provide a basis for long term financial planning.
5. Capital budgeting is helpful for taking proper decisions on Capital expenditure.
6. Majority of the firms have scarce capital resources. Therefore, proper Capital budgeting
decisions are helpful in allocating such scarce means in an economical way, keeping in mind
the objective of the company.
6. Project Classification
Capital budgeting decisions involve more time and cost. The costs incurred in this process
must be justifiable by the benefits from it. The capital budgeting process may be less or more,
it depends on the type of the project. So firms normally classify the projects into different
categories.
The categorisation may differ from one firm to another firm, but the following are the
most important classification of projects:
1. New Projects:
New manufacturing concerns require investing in fixed assets, without which there is no
manufacturing process. For example – establishment of a paper manufacturing company
requires machinery to produce paper, which may require investment of some crores of rupees.
Purchase of long-term assets requires efficient decision-making.
2. Expansion Projects:
Expansion projects generally increase existing capacity, or addition of new features to the
existing product or widen the distribution network. These types of investments call for an
explicit forecast of growth.
Project expansion generally requires more careful analysis than the other types of projects.
For example – a paper manufacturing company which is currently producing 20,000 tonnes
of paper per year may increase its plant capacity by 10,000 tonnes per year.
A Home Appliance Product Company that is producing semi-automatic washing machines
now is planning to produce fully automatic washing machines.
3. Diversification Projects:
Diversification is the spread of risk across a number of assets of investments. Here it is
necessary to recollect the proverb, “don’t put all eggs in one basket”. Diversification may be
concentric or conglomerate. For example – a company producing toilet soaps is planning to
enter into detergent soaps, is known as concentric diversification.
Conglomerate diversification is entering into a new business area. For example -Reliance,
marketer of textiles, entering into petroleum business. Often diversification projects entail
substantial risks, involve large initial cash outflows, and require considerable managerial
effort and attention. They require more analysis not only in the form of quantitative but also
in qualitative aspects.
4. Replacement and Modernisation Projects:
In the competitive world, companies have to improve their operating efficiency and reduce
costs, for which they are required to go for either modernisation of the existing machines or
replacement of the obsolete and inefficient machinery, even though they may be in good
condition. In other words, replacing or modernisation is to reduce costs, increase yield and
improve quality of the product.
For example – a cement manufacturing concern is planning to go for modernisation where it
is changing its drying process from semi-automatic to fully automatic drying equipment or
replacement of manually operated machinery by fully automatic machinery.
5. Research and Development (R&D) Projects:
Nowadays, the majority of the large firms are setting up their own R&D departments.
Organisations require more funds to set up R&D departments. R&D projects are
characterised by numerous uncertainties and typically involve sequential decision-making.
For this type of projects, discounted cash flow analysis is not applicable, but these projects
are decided on the basis of managerial judgment.
6. Miscellaneous Projects:
Apart from the above-discussed types of projects, there are some other projects like interior
decoration, recreational facilities, executive aircrafts, and landscaped gardens and so on. For
evaluation of these projects there is no standard approach and the decisions with regard to
such projects are based on the top management’s preferences and their judgement.
7. Capital Budgeting Techniques
The ultimate objective of the capital budgeting process is to achieve maximum benefit from
the project.

For this purpose, there are various techniques of capital budgeting which are as follows:
Technique # 1. Payback Period Method:
When one invests an amount in any type of investment, he/she always worries about the
length of time for getting invested money back, same happens in a firm too. When a firm
goes to invest an amount in purchasing any fixed asset, it explores the alternatives available
which may provide cash back soon.
The payback period is the duration to recover the initial cost of the project. In this process,
the payback period is the most identified and popular method of capital budgeting to evaluate
the proposals for the purpose of capital expenditure. Payback period is that time period in
which net cash inflow from investment recovers the cost of investment.
Under this method, the proposal is to be selected which is time conscious i.e. the project
which will take least time to pay back the amount invested will be preferred. If numbers of
proposals are available then these will be ranked on the basis of their estimated time
consumption and selected accordingly.
Advantages or Merits of Payback Method:
i. It is simple to calculate and easy to understand, apply and interpret.
ii. It is realistic in approach as businessmen want speedy recovery of their money in capital
assets.
iii. It weights early returns heavily and ignores distant returns and thus a short payback period
acts as a hedge against a boon decision.
iv. It is safe since it avoids incalculable risk and uncertainty in the long run.
Limitations or Demerits of Payback Method:
Major shortcomings of this method are as follows:
i. This method is a ‘crude rule of thumb’ and over-emphasizes early recovery of invested
funds of course, liquidity in itself is an important factor but ignoring ‘profitability of
investment’ and concentrating, only on ‘liquidity of investment’ can in no way be justified in
most of the situation.
ii. It concentrates only on the ‘recovery of the cost of investment’ and does not consider the
earnings after the payback period.
iii. It considers only the payback period of the project and not its whole life. It doesn’t
include the cash inflows which occur after the payback period.
iv. This method ignores the risk factor in investments. Hence, projects with higher risk but
lower payback period will be accepted as compared to a project with lower risk and higher
payback period.
v. This method does not consider the ‘cost of capital’ which is an important base of sound
investment decisions.
vi. This method ignores the time value of money. It fails to consider varying cash flow
patterns. All cash flows are treated and weighted equally, regardless of the time period of
their occurrence.
vii. It focuses on recovery of capital only rather than measuring the profitability of a firm.
viii. This method ignores the salvage value of the asset.
ix. It is not possible to calculate the rate of return by this method.
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.
The payback period is calculated as follows:
i. In the Case of Even Cash Inflows:
If cash inflows from investment are uniform throughout the life of investment, payback
period is calculated by dividing the cost of investment with the amount of annual cash inflow.
As per formula:

ii. In the Case of Uneven Cash Inflows:

If cash inflows from investment are not uniform each year, payback period will be calculated
by taking cumulative total of each year’s cash inflows and the exact payback period will be
calculated by interpolation.
Payback period will be calculated as:

Note – The Answer will be in years. If we will multiply B/C with 12 or 365 then this part will
be converted into months or days respectively.
Technique # 2. Post Payback Profitability (P.P.B. Profit):
One of the major limitations of the 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.
It is calculated as follows:
Note: Salvage value of assets will be included in the earnings of last year.
Accept/Reject Criteria:
Other things being equal, the project with the highest post-payback profitability will be the
best. Higher the post-payback profitability, more attractive will be the project. If cost of
various projects differs substantially, a post payback profitability index may be calculated to
assess the relative profitability of the projects.

Technique # 3. Accounting Rate of Return Method (ARR Method):

This method is also known as the unadjusted rate of return method or Financial Statement
Method because the main figures used in the calculation are derived from accounting
statements. Under this method, the percentage rate of return of the annual net profit on
investment is calculated.
If it is calculated on initial investment, it is called Return on Investment (ROI) and if it is
calculated on average investment, it is called as Average Rate of Return. Usually, it is
calculated on average investment in the project. If annual net income fluctuates then average
annual net income is used into the calculation.
Thus, the formula for calculating this return is as follows:

Note:
1. Average investment we can say average value of investment (opening value + closing
value)/2
2. Average investment refers to the average funds that remain invested or blocked over its
economical life.
Average investment = 1/2(Initial cost +installation exps. – salvage value) + salvage value.
Evaluation of Project under ARR Method:
Rate of return calculated as above is compared with the cutoff or the pre-specified rate of
return. If the return is more than the cut-off rate, the project would be accepted, if not, it
would be rejected.
In the evaluation of mutually exclusive projects, only such projects are considered, whose
accounting rates of returns are more than the cut-off rate and the project with the highest rate
is selected. The larger is the rate, better is the project.
Advantages or Merits of Unadjusted Rate of Return Method:
a. It is simple to compute and easy to understand and interpret.
b. It takes into consideration the total earnings from the project during the entire economic
life.
c. This method gives due weight to the profitability of the project.
d. This method duly recognizes the concept of net earnings, i.e., earnings after providing for
depreciation on capital assets. In fact, this is the correct way of income determination.
e. This method ignores the life of the project for determining the cost of investment. Hence,
the amount of initial investment and average investment remain the same.
Limitations or Demerits of Unadjusted Rate of Return Method:
a. It is simply an averaging technique, which does not take into account the impact of various
external factors on overall profits of the firm.
b. It ignores the life of the project and differentiates against the projects of lower economic
life. Two projects can have the same ARR, A proposal with a longer life may have the same
ARR with a shorter life proposal. On the basis of ARR both the projects are equally good, but
the proposal with longer life would be preferred.
c. It ignores the time value of earnings. In other words, this method does not discount the
future earnings to present value.
d. The method does not determine the fair rate of return on investments. It is left at the
discretion of management.
e. This method does not give consideration to the risk factor in respect of each project. Risk
analysis should be the integral part of a project evaluation technique.
f. This method is based on accounting profits rather than cash flows. We know that
accounting profits are affected by different accounting policies.
Technique # 4. Present Value Method:
This is the method which follows the concept of real time factor. It involves the value of time
in transactions. This method is popularly known as ‘discounted cash flow method’ because in
this method all future cash flows (inflows and outflows both) of an investment project which
occur at different times are discounted at a given rate to bring them at a common denominator
and make them comparable.
Discounting is a procedure of bringing future inflows and outflows of cash to their present
values. In general, money received today is valued more than money receivable tomorrow. “A
bird in hand is worth more than the two in the bush” is rightly applicable to the management
of capital.
Therefore, in this technique, all future inflows and outflows of cash of an investment project
are brought to technique, all future inflows and outflows of cash of an investment project are
brought to their present values by applying a discounting rate (i.e., cost of capital or interest
rate).
What you have today is more worthy than what you will have in future.
Calculating Present Value:
The present value of future cash flows is found out with the help of the following
algebraic formula:

Net Present Value Method (NPV Method):

This is also known as Excess Present Value Method or Net Gain Method. This method is used
when the management has prescribed a minimum (or target) rate of return or cut-off rate.
Following steps are involved in this method:
(i) Determine the present value of all cash inflows from investments at different periods at
required earnings rate.
The formula is:

Note:
It should be remembered that salvage value and working capital released at the end of the
project’s life are considered as cash inflows of the last year and are duly discounted to present
values.
(ii) Determine the present value of all cash outflows at different periods at the same earnings
rate. Cash outflows at zero period of time (initial investment including working capital
needed, if any) are not discounted.
For this amount, the present value factor is taken as 1. However, cash outflows at subsequent
periods are discounted by the relevant present value factor.
(iii) Find out the present value. For this, the total of present values of all cash inflows is
compared with the total of present values of all cash outflows.
As per formula:

Accept/Reject Criteria:
(a) If NPV is positive, the project is accepted.
(b) If NPV is zero, the project is accepted or rejected on non-economic considerations.
(c) If NPV is negative, the project is rejected.
Higher the NPV, more attractive will be the project. Hence, in mutually exclusive projects, (if
cost of investment is similar), the project which gives the higher positive NPV will be
preferred.
Merits of NPV Method:
a. The NPV method recognizes the time value of money and takes into consideration the cost
of capital.
b. It is very easy to calculate and simple to understand and interpret.
c. It takes care of the entire life of the project and its entire earnings including salvage of
asset.
d. It can be applied to both types of cash inflow patterns – even and uneven cash inflows.
e. The economists generally prefer this method as it is consistent with the objective of
maximizing owners’ wealth.
Limitations or Demerits of NPV Method:
a. Compared to the payback or accounting rate of return methods, NPV methods are difficult
and complicated.
b. The greatest problem of this method is determination of desired rate of return. Due to the
difference in the state of risk and uncertainty of different business, no uniform rate can be
used.
c. Keeping in view the time-span of different projects and the difference of risk inherent in
them, use of a common discounting rate is not correct.
d. It may also not give satisfactory results where the projects under competition have different
lives. NPV method favours long-lived projects.
e. It assumes that intermediate cash inflows are reinvested at the firm’s cost of capital, which
is always not true.
f. The results from this method may contradict those under the internal rate of return method,
even in the case of alternative proposals, which are mutually exclusive.
g. Net present value is sensitive to discount rates. With a change in rate, a desirable project
may turn into an undesirable one and vice-versa.
Profitability Index Method or Present Value Index Method:
The Profitability index method is a variant of NPV method and is called benefit-cost ratio. It
is preferable to the NPV method where capital costs of mutually exclusive projects differ
substantially. It expresses the relationship between present values of cash inflows and the
present value of cash outflows (i.e., cost of investment).
The formula is:

The main object of the use of present value index is to provide ready comparability between
investment proposals of different magnitude. A proposal can be accepted only if the
profitability index is greater than or at least equal to unity. Higher the index, more desirable is
the investment.
The proposal is rejected if its profitability index is less than one. But, it is to be noted that a
profitability index of less than one does not indicate loss. It simply means that the firm’s cost
of capital exceeds the rate of return making it imperative for the proposal to be rejected.
Technique # 5. Time Adjusted Rate of Return Method (TAR Method) or Internal Rate
of Return Method (IRR Method):
This rate is also known as ‘Marginal Efficiency of Investment’, ‘Internal Rate of Project’ and
‘Breakeven Rate’. It follows the discounted cash flow technique, which takes into account the
time value of money. This is why this rate is called a time adjusted rate. This method is used
when the management does not prescribe a desirable rate of return.
Under this method, such a rate of return (or discounting rate) is derived at which the
aggregate of the present values of all future cash inflows from investment equals the present
value of cash outflows for the proposal (i.e., initial investment outlay). In other words, IRR is
the maximum rate of interest that could be paid for the capital employed over the life of an
investment without loss on the project.
It is the rate of discount at which net present value is zero. Higher the IRR, more attractive is
the proposal. A proposal is accepted only when IRR is higher than the required rate of return
(cut-off rate). If it is lower, the proposal is rejected; if it is just an equal decision is taken on
the basis of other considerations. In case of mutually exclusive projects, the project with the
highest IRR is selected.
Computation of IRR:
a) In The Case Of Even Cash Inflows:
If cash inflows are uniform each year, the computation of IRR involves the following
two steps:
i) Calculate Present Value Factor (or Payback Reciprocal):
The following formula is applied for this purpose:

ii) Finding Rate of Return:

Locate the factor closest to the factor calculated above in the compound present value in the
row of year corresponding the life span of investment in years. The interest rate of the column
of that factor will be the required IRR.
For example, if an investment outlay of Rs. 10,432 yields cash earnings of Rs. 2,000 each
year for 10 years, IRR is calculated as follows:

Locating this factor in the compound P.V. Table in the row corresponding to the life span of
investment in years (i.e., tenth year), the factor is an interest rate of 14%s. Hence, IRR in this
case is 14%.
Note:
It is always not possible that the same factor as calculated in (i) above is there in the present
value table. It may exist between any two factors in the table. In such a case, IRR is
determined on the basis of the closest factor. The actual rate can, however, be calculated by
applying interpolation technique, although such accuracy is usually not required in the
appraisal of the projects.
b) In the Case of Uneven Cash Inflows:
The calculation of IRR under such circumstances is a little bit difficult. In this case, ‘trial and
error’ procedure is followed to find out IRR. Here also the object is the same.
We have to determine the rate at which the total present value of irregular and uneven cash
inflows equals the cost of investment (or total present value of cash outflows), i.e., where
NPV is zero.
The following procedure may be followed in such a case:
i) Calculate the average annual cash inflows to get a fake annuity.
ii) Determine ‘fake payback factor’ by dividing the initial outlay with the average annual cash
inflows.
iii) Locate the factor in compound P.V. Table closest to the fake present value factor in the
same manner as in the case of annuity and determine the fake IRR.
iv) Calculate present value of cash inflows at the fake rate determined above and compare the
total present value of cash inflows with the cost of investment. If NPV is positive, a higher
rate should be tried to calculate NPV. Conversely, if NPV is negative, a lower rate should be
tried. The procedure will go on till we find the rate at which NPV is zero.
Alternatively, two discounting rates may be selected in such a way that the NPV result of the
lower rate of discount is a positive amount and the NPV result of the higher discounting rate
is a negative amount. Then the interpolation technique should be applied to arrive at the
correct IRR.
Criteria for Acceptance:
(1) Accept the project of IRR>k,
(2) Reject the project of IRR<k
(3) k is the cost of capital
Merits of TAR or IRR Method:
(a) Like NPV, IRR method takes into consideration time value of money and also the total
cash inflows and outflows over the entire life of the project.
(b) The pre-determination of earnings rate is not a precondition for the use of this method.
(c) For a manager, it is easier to understand and interpret the ‘rate’ than an absolute amount.
Demerits of TAR or IRR Method:
(a) Its computation is difficult. IRR requires tedious calculations based on trial and error
procedure or interpolation.
(b) The assumption that cash flows are reinvested for the remaining life of the project at the
IRR is unrealistic. In some cases, it remains idle in the business.
(c) This method requires the determination of minimum required rate of return to know the
acceptability of IRR, which is a difficult task.
(d) If cash inflows in any years are negative then it may give more than one solution.
(e) This method does not differentiate satisfactorily between projects of different lives.
Comparison between NPV and IRR (NPV vs. IRR):
Net Present value method and the Internal Rate of Return Method are similar in the sense that
both are modern techniques of capital budgeting and both take into account the time value of
money. In fact, both these methods are discounted cash flow techniques.
However, there are certain basic differences between these two methods of capital
budgeting:
1) In the net present value method the present value is determined by discounting the future
cash flows of a project at a predetermined or specified rate called the cut-off rate based on
cost of capital.
But under the internal rate of return method, the cash flows are discounted at a suitable rate
by hit and trial method which equates the present value so calculated to the amount of the
investment. Under the IRR method, discount rate is not predetermined or known as is the
case in NPV method.
2) The NPV method recognizes the importance of market rate of interest or cost of capital. It
arrives at the amount to be invested in a given project so that its anticipated earnings would
recover the amount invested in the project at market rate.
Contrary to this, the IRR method does not consider the market rate of interest and seeks to
determine the maximum rate of interest at which funds invested in any project could be
repaid with the earnings generated by the project.
3) The basic presumption of NPV method is that intermediate cash inflows are reinvested at
the cut off rate, whereas, in the case of IRR method, intermediate cash flows are presumed to
be reinvested at the internal rate of return.
4) The results shown by NPV method are similar to that of IRR method under certain
situations, whereas, the two give contradictory results under some other circumstances.
However, it must be remembered that NPV method using a predetermined cut-off rate is more
reliable than the IRR method for ranking two or more capital investment proposals.
8. Factors Affecting Capital Budgeting Decisions
Capital budgeting decisions are affected by a number of factors.
Such factors are listed and explained briefly as follows:
1. Availability of funds
This is one of the important factors affecting capital budgeting decisions. If the firm has more
funds, it may invest in many projects. At the same time, limited funds lead to choose between
the available projects.
2. Amount of capital investment
This is another factor affecting capital budgeting decisions. Some of the project requires more
capital investment and some of the project requires less capital investment.
3. Earnings of the project
Earnings of the project would affect the capital budgeting decisions. If the earnings of the
projects are good that project would be taken for implementation, otherwise it may be
rejected straightway.
4. Get investment early/Payback policy
This is also one of the factors affecting capital budgeting decisions. If a project helps a firm
to get back its investment early, that project is selected and vice versa.
5. Day to day Capital/Working Capital requirement
Capital budgeting decisions are also affected by day-to-day capital. If the project requires
more additional capital then do not select such project for implementation. If it requires less
additional capital it may be selected for implementation.
9. Kinds of Capital Budgeting Decisions
Capital budgeting decisions are of three types:
(1) Accept-Reject Decisions
(2) Mutually Exclusive Investment Decisions
(3) Capital Rationing Decisions
(1) Accept-Reject Decisions:
This is a basic decision in capital budgeting. If a project is accepted, the firm will make
investment in it. And if it is rejected, no investment will be made by the firm. Generally, all
these proposals are accepted in which the available rate of return is more than the cost of
capital or standard rate or predetermined rate.
On this basis all independent proposals are accepted or rejected. Independent proposals are
those which are not competitive with each other and all proposals can be accepted
simultaneously. Thus, under accept-reject yardstick, all those proposals are accepted which
fulfil the minimum standards.
(2) Mutually Exclusive Investment Decisions:
Mutually exclusive investment decisions are those which compete with each other. In such a
case to accept one project, others have to be rejected. Thus, out of certain projects only one
has to be selected.
For example- to manufacture a product necessary equipment is available under different
brand names of different companies.
But only one of such equipment will be selected. It may be observed here that only that
equipment/project will be accepted which provides, atleast, a minimum predetermined rate of
return as per accept-reject rule.
(3) Capital Rationing Decisions:
When the funds available with a firm are unlimited, all those independent projects can be
accepted from which better rate of return is available as against predetermined rates. But in
actual life, it is not so. Firms have limited funds. In such a situation, these funds should be
utilised by way of maximum profitable investment.
Certain projects may not be mutually exclusive and all of them are giving more returns than
the predetermined rates. In such a case, the limited capital budget will be allocated in a
manner that the long-term returns of firm are maximised. The priority of these profitable
projects will be determined on the basis of their rates of return.
Accordingly, only the maximum profitable projects as per limited availability of funds will be
selected and all others will be rejected.
10. Steps Involved in Capital Budgeting Decisions
(1) Consideration of investment proposals including alternatives
(2) Application of a suitable evaluation technique for selecting the project
(3) Estimation of profits, cash flows and analysis of cost benefit of the project or scheme
(4) Estimation of available funds and their utilization
(5) The objective is to maximize the profits with the utilization of available funds.
11. Data Required for Capital Budgeting Decisions
While taking Capital budgeting decisions, the decision to invest capital on the acquisition of
fixed assets, which suitable data, financial or accounting data/information has to be taken to
frame the decision criterion and to follow all the stages to call it as a capital budgeting
decision.
Among the various concepts, some of the prominent concepts are:
(a) Accounting Profit data or Cash flow data – which one is suitable aspect for CB Decisions?
(b) Techniques for analysis and ranking the projects – Traditional or Discounted techniques
are suitable?
A brief description of the above two key aspects are given below:
(a) Accounting Profit or Cash Flows:
Any capital investment proposal is to be evaluated by taking the future benefits accruing from
the investment proposal. There are two alternatives available for ascertaining future economic
benefits of an investment proposal. They are accounting profit and cash flows.
Accounting profit – means profits earned during the year shown by the profit and loss
account for the given accounting period.
Cash flow – refers to the cash profit after tax but before depreciation expected to be generated
from the project in future years till the life of the asset. Such Cash flow patterns associated
with capital investment projects can be classified as conventional or non-conventional and
incremental cash flow.
(i) Conventional Cash flows:
The initial cash outlay (original investment made at the beginning of the year of investment)
followed by a series of future cash inflows generated from the asset is called conventional
cash flows.
(ii) Non-Conventional Cash Flows:
Non-conventional cash flows refer to the cash flow pattern in which an initial cash outlay is
not followed by a series of future inflows.
(iii) Incremental/Differential Cash Flow:
The second aspect of the data required for capital budgeting relates to the basis on which the
relevant cash outflows and cash inflows associated with proposed capital expenditure are to
be estimated.
For the purposes of estimating cash flows in the analysis of investments we consider
incremental cash flows. Incremental cash flows are those cash flows that are directly
attributable to the investment. It is also known as differential cash flow because it is the
difference in the cash flows of two acceptable alternatives.
12. Process of Capital Budgeting
A capital budgeting process may involve a number of steps depending upon the size of the
concern, nature of projects, complexities and diversities.
Following steps are necessary for a comprehensive capital budgeting process:
1. Identification of Various Investments Proposals:
The capital budgeting may have various investment proposals. The proposal for the
investment opportunities may be defined from the top management or may be even from the
lower rank. The heads of various departments analyze the various investment decisions, and
will select proposals submitted to the planning committee of competent authority.
2. Screening or Matching the Proposals:
The planning committee will analyze the various proposals and screenings. The selected
proposals are considered with the available resources of the concern. Here resources are
referred to as the financial part of the proposal. This reduces the gap between the resources
and the investment cost.
3. Evaluation:
After screening, the proposals are evaluated with the help of various methods, such as
payback period proposal, net discovered present value method, accounting rate of return and
risk analysis.
The proposals are evaluated by:
(a) Independent proposals
(b) Contingent of dependent proposals
(c) Partially exclusive proposals.
Independent proposals are not compared with other proposals and the same may be accepted
or rejected. Whereas higher proposals acceptance depends upon the other one or more
proposals. For example, the expansion of plant machinery leads to constructing of new
buildings, additional manpower etc.
Mutually exclusive projects are those which are compared with other proposals and to
implement the proposals after considering the risk and return, market demand etc.
4. Fixing Property:
After the evolution, the planning committee will predict which proposals will give more
profit or economic consideration. If the projects or proposals are not suitable for the
concern’s financial condition, the projects are rejected without considering other nature of the
proposals.
5. Final Approval:
The planning committee approves the final proposals, with the help of the following:
(a) Profitability
(b) Economic constituents
(c) Financial violability
(d) Market conditions.
The planning committee prepares the cost estimation and submits to the management.
6. Implementing:
The competent authority spends the money and implements the proposals. While
implementing the proposals, assign responsibilities to the proposals, assign responsibilities
for completing it, within the time allotted and reduce the cost for this purpose. The network
techniques used are such as PERT and CPM. It helps the management for monitoring and
containing the implementation of the proposals.
7. Performance Review of Feedback:
The final stage of capital budgeting is actual results compared with the standard results. The
adverse or unfavorable results identified and removing the various difficulties of the project.
This is helpful for the future of the proposals.
13. Capital Budgeting under Capital Rationing
Capital Rationing is a situation where the firm has limited funds available for new
investment. Many profitable and financially able proposals may be available but all the
proposals cannot be undertaken by the firm due to lack of finance.
Thus a firm has to drop some proposal so capital rationing means distributing the available
scarce and limited capital funds among competitive proposals.
There can be two types of project:
(a) Divisible Projects
These can be taken full or can be taken in part also for example a building having five floors
can be constructed at a cost of Rs.5core however if the fund is not adequate we can construct
only two floors.
(b) Individuals Projects
These projects are not divisible. A firm has to take it full or not take it at all. For example a
proposal to prepare the bridge of 10 km cannot be accepted in part.
Methods of Capital Rationing:
i. Aggregation of projects or feasible set approach (on the basis of NPV we will select the
combination which has the maximum total NPV).
ii. Analysis based on IRR (Decision will be taken on the basis of IRR).
iii. Profitability index (Decision will be taken on the basis of Profitability index)
14. Suitability of Different Methods
1. Payback Method:
Though this method ignores profitability and hence its conclusions are not very
accurate, even then use of this device is desirable in the following circumstances:
i. Where precision in estimates of profitability is not very significant.
ii. Where preliminary screening of several proposals is required.
iii. Where there is scarcity of cash in the firm or where the project is to be financed by
borrowings.
iv. Where the project under consideration is very risky. For example, there is possibility of
obsolescence of the project due to rapid technological developments.
v. Where investment is for short term or medium term. This method is always unsuitable for
the evaluation of long-term investment proposals.
2. Unadjusted Rate of Return Method:
i. From a simplicity point of view use of this method is desirable for appraising the long-
period projects, but due to ignoring the time factor of cost and earnings of investment, this
method loss its utility.
ii. If reinvestment of earnings from investment is not possible then decision can be made on
the basis of rate of return calculated by this method.
3. Present Value Method or Discounted Cash Flow Method:
This method gives due weights to the time value of money. Hence, it is considered to be the
best method. If annual cash inflows are uneven then this is definitely the only method of
objective and accurate appraisal of investment projects.
If the required earnings rate is not prescribed then the time-adjusted rate of return method
should be applied and if the required earnings rate has been prescribed by the management
then the net present value method should be applied. However, if the difference in the outlay
of different proposals is very significant, then a decision should be made by calculating the
present value index.
Consideration Other than Profitability in Managerial Decisions:
Managerial decisions on capital projects are very difficult and complicated problems. Though
profitability of the proposal is the crucial factor that influences the capital expenditure
decisions this cannot be the sole determinant for these decisions. In practice there are many
other factors which make the profitability base subsidiary or less important.
These factors are as follows:
i. Urgency of the Project:
Sometimes an investment is made due to urgency to avoid heavy losses. For example, on
breakdown of machinery, management may decide to replace it by any available machine
suitable for the work without proper evaluation of its cost and benefits so as to avoid heavy
losses due to the stoppage of production process. In such a case, the basis of managerial
decision is urgency and not the profitability.
ii. Funds Available:
The availability of funds is an important factor that influences the capital budgeting
decisions. Sometimes, a more profitable project is not taken up for want of sufficient funds
and a lesser profitable project of lower payback period is approved, if the firm is short of
funds.
iii. Available Technical Know-how and Managerial Capability:
Before approving a project, the management will have to consider whether their firm has got
the necessary technical know-how and managerial capability to implement that project and if
not, whether it could be acquired.
iv. Availability of Additional Funds:
If the management is capable of arranging additional funds in future, then all the funds
available at present may be utilized for the capital projects; if not, working capital needs will
have to be arranged out of the funds available with the firm.
v. Fuller Utilization of Funds:
The ultimate goal of managerial policy is to maximize the owner’s wealth. Hence, if the firm
has ample funds for investment then a project yielding the highest rate of return and requiring
lesser outlay may not be approved by the management if no other profitable investment of
spare funds is possible. In such a situation, it may be better to select the next best project if
total funds of the concern could be invested in the project, so that total profits of the firm are
maximized.
vi. Future Expectations of Earnings:
Expected earnings on future investments may also influence current capital investment
decisions. If more profitable investments are possible in future, then at present management
would select the project of lower useful life so that the funds invested may be taken back
early and could be invested in future in more profitable projects.
On the contrary, if there is possibility of rate of return on investment to go down then long
economic life projects would be better even if rate of return on this project is lower to a short
live project.
vii. Degree of Certainty of Net Income:
Certainty of income on the project also influences the selection of the project. Although
future business operations are uncertain, even then the management may select a lower
income project in place of a higher but uncertain income project.
viii. Risk of Obsolescence:
In case of rapid technological development, the project with a lesser payback period may be
preferred in comparison to one which may have higher profitability but still longer payback
period.
ix. Maintaining Market Share:
Sometimes, the management may take a decision in favor of a project though yielding a
lower return but necessary to maintain earning capacity and existing market share of the firm.
Some Important Notes:
The following are few points to be considered in capital budgeting:
1. Working Capital Requirement of the Project:
If there is any requirement of additional working capital for the project in the beginning, the
amount of working capital is added to the initial investment and of the requirement of
working capital arise during the life of the machine say in the beginning of 3rd year, then
calculate the present value of that and add in the initial investment.
In the last year of the project add the amount of working capital in the cash flow. It is because
we assume that funds initially tied up in working capital at the time of investment would be
released in the last year when the investment is terminated.
2. Treatment of Salvage Value:
a) Salvage value of new Assets – This will increase the cash flow of the last year.
b) Salvage value of existing Assets – This will reduce the initial investment of the new assets.
3. Treatment of Profit or Loss on Sale of Assets:
a) If there is gain on sale of old Assets we will charge tax and will be added in the initial
investment
b) If there is loss on sale of old Assets we will get the benefit of tax and will deduct it from
initial investment.
15. Risk and Uncertainty
Risk Meaning:
Risk is inevitable, more so in the field of Business. Risk is factored in from the trial stage of
investment evaluation of a business right until the winding up of the business entity. Business
in these days allocate large amounts of money from time to time in developing strategies to
help manage risks associated with their business and investment dealings.
Their major role in the risk management process is assessing risk, which involves the
determination of the risks both internal and external to their business or investment.
Risk occurs when the probability of future outcomes is unknown but there exists some basic
information of past experience which helps predict future course of action like consumer’s
preference, level of competition & so on.
Emmett J Vaughan, “Risk is a condition in which there is a possibility of adverse deviation
from a desired outcome that is expected or hoped so far”.
Irving Fisher, “risk may be defined as a combination of hazards measured by probability”.
Warren Buffett, “Risk comes from not knowing what you’re doing.”
Uncertainty Meaning:
Uncertainty refers to those future events whose probability of occurrence cannot be
accurately predicted. Uncertainty arises due to lack of information to accurately make future
predictions. The lack of complete certainty like political factors, government policies, natural
calamities & terrorists attack.
16. Discounted Cash Flow Techniques
1. Net Present Value Method (NPV):
The Net Present Value Method (NPV) is understood to be the best available method for
evaluating the capital investment proposals. Under this method Cash outflows and inflows
associated with each project are ascertained.
First Cash inflows are worked out by adding depreciation to profit after tax arising to each
project. Since the cash outflows and inflows arise at different points of time and cannot be
compared so both are reduced to the present values at the rate of return acceptable to the
management. The rate of return is either cost of capital of the firm or the opportunity cost to
be invested in the project.
The Net Present Value of expected inflows can be express as under-
Acceptance Rule:
If the NPV is positive or at least equal to zero the Project can be accepted. If it is negative the
proposal can be rejected. Among the Various alternatives the project which gives the highest
positive NPV should be selected.
NPV is positive = Cash inflows are generated at a rate higher than the minimum required by
the firm.
NPV is zero = Cash inflows are generated at a rate equal to the minimum required
NPV is negative = Cash inflows are generated at a rate lower than the minimum required by
the firm
The market value per share will increase if the project with positive NPV is selected.
Advantages:
i. Firstly the NPV method recognizes the time value of money. This is the most significant
advantage since the payback method and the ARR method have ignored this factor.
ii. It considers all Cash-Flows over the entire life of the project.
iii. Selection of projects by this method results in achieving the financial objective i.e.
maximization of profits and Net Worth.
iv. The changing discount rate can be built into the NPV calculations by altering the
denominator. This method is used for the selection of mutually exclusive projects.
v. This method is consistent with the objective of maximizing the wealth of the shareholders
of the company.
Limitations:
i. It is difficult to calculate
ii. It is difficult to work out the cost of capital especially the cost of equity capital
iii. This method may not provide satisfactory solutions when the projects compared involve
different amounts of investment. For a project with a higher net present value may not be
desirable since it may involve huge initial capital outlay.
iv. It may mislead when dealing with alternative projects or limited funds under the
conditions of unequal lives.
v. This method favours long lived projects.
vi. It assumes that intermediate cash inflows are reinvested at the firm’s cost of capital which
is not always true.
2. Internal Rate of Return Method (IRR):
The internal rate of return or yield for an investment project is the discount rate at which the
present value of expected cash outflows are equal to the value of the expected cash inflow. In
other words, it is the rate which gives the projects NPV as zero.
This method is also known as yield on investment, marginal productivity of capital rate of
return time adjusted rate of return or trial and error method. The internal rate of return method
like the present value method takes into consideration the time value of money by
discounting the various cash flows.
The internal rate of return is represented by that rate such that –

The internal rate of return, so arrived at is compared with the predetermined rate of return
known as required rate, cut-off rate, hurdle rate or expected rate. If the IRR exceeds such cut-
off rate, the investment proposal is accepted; if not; the proposal shall be rejected. If the IRR
and the required rate of return are equal it means that the unit is indifferent by either adopting
or rejecting the proposal.
Advantages:
i. It takes into account the time value of money.
ii. It considers the cash flow stream over the entire investment horizon
iii. Business executives and non-technical people understand the concept of IRR much better
than that of NPV. Even if they do not follow the definition of IRR in terms of the equation,
they are well aware of the usual meaning in terms of the rate of return on investment.
iv. The calculation of the cost of capital is not a prerequisite for using the IRR method of
evaluating investment projects unlike the HPV method.
v. This method is considered to be a sophisticated and more reliable technique of evaluating
capital investment proposals.
Limitations:
i. The IRR method is difficult to understand as well as apply in practice as it involves tedious
and complicated calculations
ii. The IRR method does not give unique answers in all situations. It yields negative rate or
multiple rate under certain circumstances which is rather confusing
iii. It yields results inconsistent with the NPV method if projects differ in their expected life
span, cash outlays or timing of cash flows.
iv. The assumption that all cash flows are reinvested at IRR is very unrealistic moreover, all
cash flows are not normally invested. A share of it is paid out of dividend to shareholders etc.
or a portion may be tied in current assets such as debtors or cash or unfold stock.
3. Discounted Pay- Back Period (DPP):
In This method the cash inflows are discounted at a rate which is equal to cost of capital and
then the payback period is worked out. This is better than the ordinary payback period
method as DPP considers the time value of money.
The discounted pay-back period is expressed in years and as long as the DPP is lesser than
the estimated life of the project, the project is economically feasible and it can be accepted.
Sometimes the two projects may have the same DPP although the estimated life of the project
may be different.
In such a case it will better to calculate the relative payback index (RPI) as –

17. Profitability Index/Discounted Benefit Cost Ratio

Profitability Index is defined as the rate of present value of the future cash benefits at the
required rate of return to the initial cash outflow of the investment. This is yet another
method of evaluating the investment proposals. It is also known as the Benefit Cost Ratio
(B/C).
The PI approach measures the present Value of returns per rupee invested. This is similar to
the NPV approach. Where projects with different initial investments are to be evaluated the
PI method proves to be the best technique.
Formula:

The above ratio is an indicator of the profitability of the Project. If the ratio is equal to or
greater than one it shows that project has an expected yield equal to or greater than the
discounted rate. If the index is less than one it indicates that the project has an expected yield
less than the discount rate.
18. Limitations of Capital Budgeting
(i) Capital Budgeting helps in selection of profitable projects. In case the income, cost or
lifetime of the project is wrongly estimated, it is possible that a less profitable project may be
selected. For it management should be experienced.
(ii) There are some factors which affect profitability and productivity of the company, but it is
difficult to measure them.
For example- a project may directly or indirectly affect the morale of employees. Project may
also have an adverse effect on society. But while using capital budgeting techniques, these
factors are ignored.
19. Difficulties in Capital Budgeting
Capital budgeting decisions are very important, but they pose difficulties, which shoot
from three principal sources:
1. Measurement Problem:
Evaluation of a project requires identifying and measuring its costs and benefits of that
project, which are difficult since they involve tedious calculations and lengthy processes.
Majority of the replacement or expansion programmes have an impact on some other
activities of the company (introduction of new products may result in decrease in sales of the
other existing product) or have some intangible consequences (improving morale of workers).
2. Uncertainty:
Selection or rejection of a capital expenditure project depends on expected costs and benefits
that involve into the future. Future is uncertain, if anybody tries to predict the future it will be
childish or foolish. Hence, it is impossible to predict the future cash inflows.
3. Temporal Spread:The costs and benefits, which are expected to be associated with a
particular capital expenditure project is spread out over a long period of time, which is 10-20
years for industrial projects and 20-50 years for infrastructure projects. The temporal spread
creates some problems in estimating discount rates for conversation of the future cash inflows
in present values and establishing equivalences.
Evaluation of Investment Proposals: 7 Methods
The following points highlight the top seven methods used for the evaluation of investment
proposals. The methods are:- 1. Urgency Method 2. Pay-Back Period Method 3. Unadjusted
Return on Investment Method 4. Net Present Value Method 5. Internal Rate of Return
Method 6. Terminal Value Method 7. Benefit-Cost Ratio Method.
1. Urgency Method:
In many situations in the life of a business concern an ad hoc decision is needed in respect of
an investment expenditure. For instance, if a part of machine stops working leading to
complete breakdown and disruption in the production process, it will be justified to replace it
immediately by new one even without comparing the cost and future profit. Any decision on
investment expenditure on the basis of urgency should be taken only if it is fully warranted
and justified.
2. Pay-Back Period Method:
This is also known as ‘payoff and pay out’ method. This method is employed to determine the
number of years in which the capital expenditure incurred is expected to pay for itself. This
method describes in terms of period of time, the relationship between cash inflow and total
amount of investment.
The pay-back period is the number of years during which the income is expected. The
criterion here is that the average income from a proposed investment be sufficient to cover
investment within a period of time. It is calculated by dividing investment by the amount of
return per annum after charging taxation but before charging depreciation.
This period may be calculated by the following formula:
Pay-back Period = Net Investment/Cash Inflow
3. Unadjusted Return on Investment Method:
This method is also called Accounting Rate of Return Method or Financial Statement Method
or Return on Investment or Average Rate of Return Method. Here the main feature is that the
rate of return is based on the figures for income and investment which are determined
according to conventional accounting concepts.
The rate of return is expressed as a percentage of the earnings to the investment in a
particular project. There is no general agreement as to what constitutes investment and
income. Income may be taken as the average annual earnings, normal earnings or the
earnings of the first year of the project. Investments may be taken as the initial investment or
the average outlay over the life of the investment.
The rate of return on investment refers to the rate of interest that will make the present value
of future earnings just equal to the cost of investment.
It may be calculated according to any one of the following methods:
(i) Annual Average Net Earning/Original Investment x 100
(ii) Annual Average over Earning/Average Investment x 100
The term average annual net earnings is the average of the earning over the whole of the
economic life of the project.
(iii) Increase in Expected Future Annual Net Earnings/Initial Increase in required Investment
x 100
The amount of average investment can be calculated according to any one of the
following methods:
(i) Original Investment/2
(ii) Original Investment – Scrap Value of the Asset/2
(iii) Original Investment + Scrap Value of the Asset/2
4. Net Present Value Method:
The net present value method is one of the discounted cash flow or time adjusted method.
This is generally considered to be the best method for evaluating capital investment
proposals. In case of this method, cash inflows and cash outflows associated with each
project are first worked out. The net present value is the difference between the total present
value of future cash inflows and the total present value of future cash outflows.
The equation for calculating net profit value in case of conventional cash flows can be as
follows:
where NPV = Net present value
R = Cash inflows at different time periods
K = Cost of capital
I = Cash outflows at different time periods.
5. Internal Rate of Return Method:
This method is also called Time Adjusted Return on Investment or Discounted Rate of
Return. This method measures the rate of return which earnings are expected to yield on
investments. Internal rate of return is defined as the maximum rate of interest that could be
paid for the capital employed over the life of an investment without loss on the projects.
The rate is similar to the effective rate of interest calculated on debentures purchased or sold.
This is calculated on the basis of the funds utilised from time to time as opposed to the
investment made at the beginning. This method incorporates the time value of money in the
investment calculation.
The formula for the discounted rate of return is:

C = the supply price of the asset.

F = the future cash flows.
S = the salvage value of the asset in years,
r = the discounted rate of return.
6. Terminal Value Method:
This method is based on the assumption that operating saving of each year is invested in
another outlet at a certain rate of return from the moment of its receipt till the end of the
economic life of the projects. This method incorporates the assumption about how the cash
inflows are reinvested once they are received and thus avoids any influence of the cost of
capital on cash inflows. However, cash inflows of the last year of the project will not be
reinvested.
As such, the compounded values of cash inflows should be determined as the basis of
compounding factor which may be obtained from compound interest table or by the
following formula:
A =P (1+i)n where P=1
7. Benefit-Cost Ratio Method:
This method is based on time adjusted techniques and is also called Profitability Index or
Desirability Factor. The procedure of deriving the benefit cost ratio criterion is the same as
that of NPV. What is done is to divide the present value of benefit by the present value of
cost. The ratio between the two would give us the benefit-cost ratio which indicates benefit
per rupee of cost.
The calculation of benefit-cost ratio is shown as follows:
Benefit Cost Ratio (BCR) = Present Value of Benefits/Present Value of Cost
What is Capital Rationing?
Capital rationing is a strategy used by companies or investors to limit the number of projects
they take on at a time. If there is a pool of available investments that are all expected to be
profitable, capital rationing helps the investor or business owner choose the most profitable
ones to pursue.
Companies that employ a capital rationing strategy typically produce a relatively
higher return on investment (ROI). This is simply because the company invests its resources
where it identifies the highest profit potential.
Capital Rationing Example
Capital rationing is about putting restrictions on investments and projects taken on by a
business. To illustrate this better, let’s consider the following example:
VV Construction is looking at five possible projects to invest in, as shown below:

To determine which project offers the greatest potential profitability, we compute each
project using the following formula:
Profitability = NPV / Investment Capital
Based on the table above, we can conclude that projects 1 and 2 offer the greatest potential
profit. Therefore, VV Construction will likely invest in those two projects.
Types of Capital Rationing
There are two types of capital rationing – hard and soft rationing.
1. Hard capital rationing
Hard capital rationing represents rationing that is being imposed on a company by
circumstances beyond its control. For example, a company may be restricted from borrowing
money to finance new projects because it has suffered a downgrade in its credit rating. Thus,
it may be difficult or effectively impossible for the company to secure financing, or it may
only be able to do so at exorbitant interest rates.
2. Soft capital rationing
In contrast, soft capital rationing refers to a situation where a company has freely chosen to
impose some restrictions on its capital expenditures, even though it may have the ability to
make much higher capital investments than it chooses to. The company may choose from any
of a number of methods for imposing investment restrictions on itself. For example, it may
temporarily require that a project offer a higher rate of return than is usually required in order
for the company to consider pursuing it. Or the company may simply impose a limit on the
number of new projects that it will take on during the next 12 months.
Why is Capital Rationing Used? – Benefits
Capital rationing is used by many investors and companies in order to ensure that only the
most feasible investments are made. It helps ensure that businesses will invest only in those
projects that offer the highest returns. It may appear that all investments with high projected
returns should be taken.
However, there are times when funds are low or when a company or an individual investor
merely want to improve their cash flows before making any more investments. It may also be
the case that the investor has reason to believe that they can make the investment under more
favorable terms by waiting a bit longer before pursuing it. For example, the company’s
management may expect a significant drop in interest rates within the next six months, which
would make for less expensive financing costs.
Limited Numbers of Projects are Easier to Manage
When a company invests in a large number of projects simultaneously, the sharing of funds
means less capital available for each individual project. This typically translates to more time
and effort being required to monitor and manage each project. Also, allocating limited
resources across several projects may actually threaten the success of the projects, if, for
example, the projected budget for one or more projects turns out to have significantly
underestimated costs. Wise capital rationing can help a company avoid such problems.
Capital Rationing Offers Increased Investment Flexibility
Investment opportunities are constantly changing. Portfolio managers usually keep a
significant portion of available investment funds in the form of cash. Maintaining a ready
supply of excess cash, first of all, provides greater financial stability and makes it easier for
investors to adjust to sudden adverse circumstances that may arise.
Keeping some excess cash in reserve accomplishes something else as well. It ensures that if a
particularly attractive unseen golden opportunity should suddenly arise, the investor has
funds available to take immediate advantage of the situation. The ability to act quickly may
be the difference between a good investment opportunity and a great one.
Potential Disadvantages of Capital Rationing
Capital rationing also comes with its own set of potential disadvantages, including the
following:
1. High capital requirements
Because only the most profitable investments are taken on under a capital rationing scenario,
rationing can also spell high capital requirements.
2. Goes against the efficient capital markets theory
Instead of investing in all projects that offer high profits, capital rationing only allows for
selecting the projects with the highest estimated returns on investment. But the efficient
markets theory holds that it is virtually impossible, over time, to continually select superior
investments that significantly outperform others. Capital rationing may, in fact, expose an
investor to greater risk by failing to hold a diversified investment portfolio.