Chapter 3: Long Run Investment Decision – Capital Budgeting – Questions & Answers

📌 Part A – 1 Mark Questions (Very Short Answer)

1. What is capital budgeting?
   Capital budgeting is the process of making decisions about long-term investments in fixed assets.
2. Give another name for capital budgeting.
   Long-term investment decision or capital expenditure decision.
3. What is Payback Period (PBP)?
   Payback Period is the time taken to recover the original cost of an investment.
4. What is ARR?
   ARR (Accounting Rate of Return) is the average annual profit divided by the average investment.
5. What is Net Present Value (NPV)?
   NPV is the difference between the present value of cash inflows and the present value of cash outflows.
6. Write the formula for Profitability Index (PI).
   PI = Total discounted cash inflows ÷ Initial cash outlay.
7. What is Internal Rate of Return (IRR)?
   IRR is the discount rate at which the Net Present Value of an investment becomes zero.
8. If NPV is greater than zero, should we accept or reject the project?
   Accept the project.
9. If PI is less than 1, should we accept or reject the project?
   Reject the project.
10. Name one traditional method of capital budgeting.
    Payback Period (or Accounting Rate of Return).
11. Name one modern method of capital budgeting.
    Net Present Value (or Internal Rate of Return, or Profitability Index).
12. Why is capital budgeting important? (Give one reason)
    Because it involves huge investments that are difficult to reverse.
13. Which method ignores the time value of money?
    Payback Period and ARR.
14. Which method considers the time value of money?
    Net Present Value (NPV), Profitability Index (PI), and Internal Rate of Return (IRR).
15. What is the decision rule for ARR?
    Accept the project if ARR is higher than the minimum required rate.
16. Complete the series: NPV = PV of inflows – PV outflows. If NPV = 0, then the discount rate is called ______.
    IRR (Internal Rate of Return).
17. Find the odd one out and state the reason: (a) NPV (b) IRR (c) ARR (d) Profitability Index
    ARR is odd because it is a traditional method, while the others are discounted cash flow methods.
18. What is the meaning of 'time value of money'?
    A rupee today is worth more than a rupee received in the future.

📌 Part B – 2/4 Marks Questions (Short Answer)

1. State any four reasons why capital budgeting is important.

   • Cost: Capital budgeting decisions involve huge amounts of money.
   • Time: The results or profits from these decisions come only after many years.
   • Irreversibility: Once made, these decisions cannot be changed easily without incurring big losses.
   • Risk: Because the returns are in the future, there is a higher risk of uncertainty.
   • Complexity: These decisions require careful planning and forecasting of future events.

   (Any four points are sufficient)

2. Explain the steps in the capital budgeting process.

   • Step 1 – Identify Projects: Find different long-term investment opportunities.
   • Step 2 – Evaluate Projects: Calculate the costs and future benefits of each project.
   • Step 3 – Select Project: Choose the best project that gives maximum return.
   • Step 4 – Execute Project: Implement the project by buying assets and starting the work.
   • Step 5 – Feedback: Monitor the project's performance and compare it with expectations.

3. What is the Payback Period method? State its advantages and disadvantages.

   Meaning: Payback Period is the time required to recover the initial investment from the project's cash inflows.

   Advantages: Simple to calculate and easy to understand. Good for risky projects where quick recovery is needed. Focuses on liquidity.

   Disadvantages: Ignores the time value of money. Ignores cash inflows received after the payback period. Does not measure overall profitability.

4. What is the Net Present Value (NPV) method? Write its decision rule.

   Meaning: NPV is the difference between the present value of all future cash inflows and the present value of the initial investment.

   Decision Rule:

   • If NPV is greater than 0 (positive) → Accept the project.
   • If NPV is less than 0 (negative) → Reject the project.
   • If NPV is exactly 0 → The project can be accepted or rejected (indifferent).

5. Distinguish between traditional methods and modern methods of capital budgeting.

   • Traditional Methods (like PBP, ARR): They are simple and easy to calculate. They ignore the time value of money. They are also called non-discounted methods.
   • Modern Methods (like NPV, IRR, PI): They are more complex. They consider the time value of money. They give a better picture of profitability and are also called discounted cash flow methods.

6. A project requires an initial investment of ₹1,00,000 and generates a constant annual cash inflow of ₹20,000. Calculate the Payback Period.

   PBP = Initial Investment ÷ Constant Annual Cash Inflow
   PBP = ₹1,00,000 ÷ ₹20,000 = 5 years.

📌 Part C – 6/8 Marks Questions (Long Answer)

1. Explain in detail any two methods of capital budgeting with examples.

   Method 1: Payback Period (PBP)

   • Definition: PBP is the time taken to recover the initial investment.
   • Example (Equal Cash Flows): Investment = ₹1,00,000, Yearly cash inflow = ₹20,000. PBP = 1,00,000 ÷ 20,000 = 5 years.
   • Example (Unequal Cash Flows): Investment = ₹20,000. Cash inflows: Year1: ₹6,000, Year2: ₹8,000, Year3: ₹5,000, Year4: ₹4,000, Year5: ₹4,000.
     After 3 years, cumulative inflow = ₹19,000. Remaining = ₹1,000.
     In year 4, inflow is ₹4,000. Time for ₹1,000 = (1000/4000) × 12 months = 3 months.
     So, PBP = 3 years and 3 months.
   • Decision: Accept if PBP is less than the target period.

   Method 2: Net Present Value (NPV)

   • Definition: NPV is the present value of cash inflows minus the initial investment.
   • Example: Project cost = ₹2,50,000. Cost of capital = 10%. Cash inflows: Year1: ₹90,000, Year2: ₹80,000, Year3: ₹70,000, Year4: ₹60,000, Year5: ₹50,000.
     Present Value (PV) factors @10%: Year1: 0.909, Year2: 0.826, Year3: 0.751, Year4: 0.683, Year5: 0.621.
     PV of inflows = (90,000×0.909) + (80,000×0.826) + (70,000×0.751) + (60,000×0.683) + (50,000×0.621) = ₹2,72,490.
     NPV = ₹2,72,490 – ₹2,50,000 = ₹22,490 (Positive).
   • Decision: Since NPV > 0, accept the project.

2. Calculate the Payback Period for a project requiring an initial cash outflow of ₹20,000 and annual cash inflows of ₹6,000, ₹8,000, ₹5,000, ₹4,000, and ₹4,000 for five years.

   Step-by-step solution:

   • Year 1: Inflow = ₹6,000, Cumulative = ₹6,000. Amount left to recover = ₹14,000.
   • Year 2: Inflow = ₹8,000, Cumulative = ₹14,000. Amount left to recover = ₹6,000.
   • Year 3: Inflow = ₹5,000, Cumulative = ₹19,000. Amount left to recover = ₹1,000.
   • In Year 4, the inflow is ₹4,000. We need only ₹1,000 to recover the full investment.
   • Fraction of year 4 needed = (1,000 ÷ 4,000) = 0.25 years.
   • 0.25 years × 12 months = 3 months.

   Answer: The Payback Period is 3 years and 3 months.

3. Calculate the Accounting Rate of Return (ARR) for a project with an initial investment of ₹10,00,000 and a scrap value of ₹80,000 after 5 years. The profits after tax are: Year1: ₹1,50,000, Year2: ₹2,00,000, Year3: ₹2,50,000, Year4: ₹1,50,000, Year5: ₹1,00,000.

   Step 1: Calculate Average Annual Profit
   Total Profit = 1,50,000 + 2,00,000 + 2,50,000 + 1,50,000 + 1,00,000 = ₹8,50,000
   Average Annual Profit = ₹8,50,000 ÷ 5 = ₹1,70,000

   Step 2: Calculate Average Investment
   Average Investment = (Initial Investment + Scrap Value) ÷ 2
   = (10,00,000 + 80,000) ÷ 2 = 10,80,000 ÷ 2 = ₹5,40,000

   Step 3: Calculate ARR
   ARR = (Average Annual Profit ÷ Average Investment) × 100
   = (1,70,000 ÷ 5,40,000) × 100
   = 0.3148 × 100 = 31.48%

   Answer: The Accounting Rate of Return for the project is 31.48%.

4. Calculate the Net Present Value (NPV) for Project X with an initial cost of ₹2,50,000 and a 10% cost of capital. Cash flows: Year1: ₹90,000, Year2: ₹80,000, Year3: ₹70,000, Year4: ₹60,000, Year5: ₹50,000. State whether the project should be accepted.

   Step 1: Identify Present Value (PV) factors @10%
   Year 1: 0.909, Year 2: 0.826, Year 3: 0.751, Year 4: 0.683, Year 5: 0.621

   Step 2: Calculate Present Value of Cash Inflows
   Year 1: 90,000 × 0.909 = ₹81,810
   Year 2: 80,000 × 0.826 = ₹66,080
   Year 3: 70,000 × 0.751 = ₹52,570
   Year 4: 60,000 × 0.683 = ₹40,980
   Year 5: 50,000 × 0.621 = ₹31,050
   Total PV of Inflows = 81,810 + 66,080 + 52,570 + 40,980 + 31,050 = ₹2,72,490

   Step 3: Calculate NPV
   NPV = PV of Inflows – Initial Investment
   NPV = ₹2,72,490 – ₹2,50,000 = ₹22,490

   Step 4: Decision Rule
   Since the NPV is positive (₹22,490 > 0), the project should be accepted.