Home » **CAPITAL BUDGETING II: ADDITIONAL ASPECTS**

TABLE
Real Cash Flows
INFLATION AND CAPITAL BUDGETING
a. Based on interpolation as per Table.
b. Difference in NPV of Rs 73 (Rs 3.28,073 – Rs 3,28.000) between the two discount rates (nominal and real) is on account of rounding off the values. Both the approaches provide the same answer.
It is important to note that real cash flows discounted at the real discount rate yield a identical amount of NPV

INFLATION AND CAPITAL BUDGETING
The capital budgeting results would be unrealistic if the impact of inflation is not correctly factored in the analysis. The cash flow estimate will not reflect the purchasing power. In other words, cash flows would as shown at inflated sums and, to that extent, cause distortion in capital budgeting decisions. The flows should be accommodate the inflation factor so that the capi

Fallout of Capital Rationing
Capital rationing limit is the amount to be spent on capital expenditure decisions. The firm may be such a limit primarily for two reasons : (i) there may be a paucity of funds and (ii) corporate managers/owners may be conservative and may be like to invest more than a specified/stated sum in capital projects at one point or time, they may like to accept projects with a greater ma

PROJECT SELECTION UNDER CAPITAL RATIONING
The capital rationing situation refers to the choice of investment proposal under financial constraints in terms of a given size of capital expenditure budget.The project selection under capital rationing involves two stages: (i) identification of the acceptable projects. (ii) selection of the combination of projects. In case the project is to be accepted/rejected in its en

Net Present Value Vs. Profitability Index
In most situations, the NPV and PI, as investment criteria, provide the same accept and reject decision, because both the methods ate closely related to each other. Under the PI method, the investment proposal will be acceptable if the PI is greater than one it will be greater than one only when the proposal has a positive net present value. Likewise, PI will be less

Computational Problems
Apart from inconsistency in the application or me reinvestment rate, the IRR method also suffers from computational problems. These may be discussed with reference to two aspects.
Computation in Conventional Cash Flows
It has been shown while computing the IRR that the calculation of the IRR involves a trial and error procedure as a result of which complicated computation has to be done.

Intermediate cash inflows
Will be compounded by using the cost of capital. The compounded sum so arrived at and the initial cost outflows can be used as the basis of determining the IRR. The limitation of IRR arising out of the inconsistency in the investment rate it can be obviated through the modified approach.
Thus, the assumption regarding the reinvestment rate of the cash inflows generated at the intermedi

Reinvestment Rate Assumption
The preceding discussions have revealed that in the case of mutually exclusive projects, the NPV and IRR methods would rank projects differently where (a) the projects have different cash outlays initially, (b) the pattern of cash inflows is different, and (c) the service lives of the projects are unequal. It has also been found that the ranking given by the NPV method in such cases

Decisions
Project A should be preferred to project B because or its NPV. If we had compared the two projects without incorporating the consequences of replacing the machine at the end of year 2 the decision would have been the revers, because the net present value of project A then would be Rs 3,054 (Rs 7.272 + Rs 5.782 – Rs 10,000).
The implicit assumption of this approach is that the investment which

Project With Unequal Lives
Another situation in which the IRR and NPV methods would give a conflicting ranking to mutually exclusive projects is when the projects have different expected lives.
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