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Unit 3 of 4 · B.Com Sem 5

Unit 3: Capital budgeting & dividend decisions

Financial Management notes · PTU syllabus (BCOM 501-18)

3 min read5 topics10 exam questions
On this page
  1. Unit summary
  2. Capital budgeting: meaning and process
  3. Evaluation methods
  4. Capital rationing
  5. Dividend policy: determinants and types
  6. Walter, Gordon and MM models
  7. Key terms
  8. Quick revision
  9. Important questions

Unit summary

Capital budgeting commits large funds for many years, so methods of evaluation matter; dividend policy decides how earnings are shared. This unit covers the meaning and process of capital budgeting, non-discounted and discounted evaluation methods, capital rationing, and dividend policy — determinants, types, and the Walter, Gordon and MM models.

After this unit you can

  • Explain the meaning, importance and process of capital budgeting
  • Evaluate projects using payback, ARR, NPV, PI and IRR
  • Explain capital rationing
  • Explain dividend policy and the Walter, Gordon and MM models

PTU syllabus topics

  • Meaning and process of capital budgeting
  • discounted and non-discounted evaluation methods (payback period, ARR, NPV, benefit-cost ratio, IRR)
  • capital rationing
  • determinants and types of dividend policy
  • Walter's Model
  • Gordon's Model
  • MM Hypothesis
ComparisonCapital budgeting methods
Rule
Weakness

Payback period

Accept if payback is within the target

Ignores time value and later cash flows

ARR

Accept if above the target return

Uses accounting profit, not cash

NPV

Accept if NPV > 0

Needs a discount rate

IRR

Accept if IRR > cost of capital

Can give multiple rates

1

Topic 1

Capital budgeting: meaning and process

Capital budgeting is the process of planning and evaluating long-term investment proposals — new plant, expansion, replacement, R&D.

  • Importance: large funds, long-term effects, irreversible, affects risk and growth.
ProcessCapital budgeting process
  1. 1

    Identify investment opportunities

  2. 2

    Estimate cash flows

    Incremental, after-tax

  3. 3

    Evaluate proposals

    Payback, ARR, NPV, IRR, PI

  4. 4

    Select projects

  5. 5

    Implement

  6. 6

    Post-completion audit

  • Cash flow after tax (CFAT) = Profit after tax + Depreciation (non-cash).
2

Topic 2

Evaluation methods

ClassificationMethods of capital budgeting
Evaluation methods

  • Non-discounted

    Payback period, accounting rate of return (ARR)

  • Discounted

    Net present value, profitability index (benefit–cost ratio), internal rate of return, discounted payback

Key formulasCapital budgeting formulas

  • Payback period

    Initial investment ÷ Annual CFAT (equal flows); cumulative method for unequal flows

  • ARR

    Average annual profit after tax ÷ Average investment × 100

  • Average investment

    (Initial cost − Salvage) ÷ 2 + Salvage + Working capital

  • NPV

    PV of cash inflows − PV of outflows

  • Profitability index

    PV of inflows ÷ PV of outflows

  • IRR

    Rate at which NPV = 0 (by interpolation)

Example

Project cost ₹1,00,000; CFAT ₹30,000, ₹40,000, ₹50,000, ₹30,000 for 4 years; cost of capital 10%. Payback = 2 years + 30,000/50,000 = 2.6 years. PV factors 0.909, 0.826, 0.751, 0.683 → PV = 27,270 + 33,040 + 37,550 + 20,490 = ₹1,18,350. NPV = ₹18,350 (accept). PI = 1.18.

MethodMeritsDemerits
PaybackSimple; emphasises liquidityIgnores time value and post-payback cash flows
ARRUses accounting data; considers whole lifeIgnores time value; uses profit not cash
NPVTime value; maximises wealth; additiveNeeds cost of capital; ignores size differences
IRRTime value; easy to compare with costMultiple IRRs possible; reinvestment assumption at IRR
PIUseful under capital rationingMay conflict with NPV for mutually exclusive projects

Exam tip

For mutually exclusive projects, if NPV and IRR conflict, prefer NPV — it assumes reinvestment at the cost of capital, which is more realistic.

3

Topic 3

Capital rationing

Capital rationing occurs when funds are limited and the firm cannot accept all profitable (positive NPV) projects.

  • External rationing: market imperfections, inability to raise funds. Internal rationing: self-imposed budget limits.
  • Divisible projects: rank by PI and accept in order until funds run out (partly accept the last).
  • Indivisible projects: try feasible combinations and choose the one with the highest total NPV.
4

Topic 4

Dividend policy: determinants and types

Dividend policy decides the proportion of earnings paid as dividend (payout) vs retained (retention).

  • Determinants: profitability and stability of earnings, liquidity, growth needs, cost of external funds, shareholders' preference, taxation, legal restrictions (Section 123), loan covenants, control, inflation, market conditions.
  • Types of dividend policy: stable dividend per share, stable payout ratio, regular + extra dividend, irregular, no dividend.
  • Forms of dividend: cash, bonus shares (stock dividend), interim and final; buy-back as an alternative.
5

Topic 5

Walter, Gordon and MM models

Key formulasDividend models

  • Walter's model

    P = [D + (r ÷ k)(E − D)] ÷ k

  • Gordon's model

    P0 = E (1 − b) ÷ (k − br), where g = br

  • MM irrelevance

    P0 = (D1 + P1) ÷ (1 + ke)

  • Walter: if r > k (growth firm) — retain all (payout 0%); r < k (declining firm) — pay out 100%; r = k (normal firm) — dividend policy irrelevant.
  • Gordon ("bird-in-hand"): investors value current dividends more than uncertain future gains; with r > k, retention raises price; with r = k, irrelevant; with r < k, payout raises price.
  • MM hypothesis (1961): in perfect markets, dividend policy is irrelevant — value depends on earning power of assets; what shareholders gain in dividends they lose in share price (home-made dividends).

Example

Walter: E = ₹10, D = ₹4, r = 15%, k = 10%. P = [4 + (0.15 ÷ 0.10)(6)] ÷ 0.10 = (4 + 9) ÷ 0.10 = ₹130. At D = 0, P = [0 + 1.5 × 10] ÷ 0.10 = ₹150 — so a growth firm should retain.

ComparisonRelevance vs irrelevance theories
Relevance (Walter, Gordon)
Irrelevance (MM)

View

Dividend policy affects share value

Dividend policy does not affect value

Key argument

Bird-in-hand, internal financing

Arbitrage; investors can create home-made dividends

Assumptions criticised

Constant r and k, all-equity firm

Perfect markets, no taxes, no transaction costs

Key terms

Capital budgeting
Planning long-term investment decisions
NPV
Present value of inflows minus outflows
IRR
Discount rate at which NPV is zero
Capital rationing
Limiting investment because funds are scarce
Payout ratio
Proportion of earnings paid as dividend

Quick revision

  • CFAT = PAT + depreciation.
  • Payback, ARR ignore time value; NPV, IRR, PI consider it.
  • Accept NPV > 0, IRR > k, PI > 1.
  • Capital rationing: rank by PI (divisible) or best combination (indivisible).
  • Walter: r > k retain; Gordon bird-in-hand; MM irrelevance.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.Define capital budgeting.
  2. Q2.What is the payback period?
  3. Q3.Distinguish NPV and IRR.
  4. Q4.What is profitability index?
  5. Q5.What is capital rationing?
  6. Q6.State Walter's conclusion for a growth firm.

Long-answer questions

  1. Q1.Explain the process and importance of capital budgeting.
  2. Q2.Explain discounted and non-discounted methods of project evaluation with illustrations.
  3. Q3.Explain the determinants and types of dividend policy.
  4. Q4.Explain the Walter, Gordon and MM models of dividend.

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