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CAPITAL BUDGETING OF CANTEEN WALA
INTRODUCTION
Irreversible nature
A long term commitment of fund may also change the risk complexity of the
firm. If the adoption of an investment increases average gain but causes
frequent fluctuation in its earnings, the firm would become more risky.
A company may add capacity to its existing product lines to expand existing
operations. For example Gujrat State Fertilizer Company may increase its
plant capacity to manufacture more urea it is an example of related
diversification.
The Expansion of New Business
PROCESS
CAPITAL BUDGETING TECHNIQUES
It is the method of evaluating project that recognizes that the dollar received
immediately is preferable to a dollar received at some future date. It
discounts the cash flow to take into the account the time value of money.
This approach finds the present value of expected net cash flows of an
investment, discounted at cost of capital and subtract from it the initial cash
outlay of the project.
In case the present value is positive, the project will be accepted; if negative,
it should be rejected. If the projects under consideration are mutually
exclusive the one with the highest net present value should be chosen.
Where,
∑ = Summation
Ft = Net cash flow at time t
k = cost of capital
Io = Initial cash flow
The NPV profile is a graphical plot of the inverse relationship between the
discount rate, k, and a project’s NPV.
ADVANTAGES:
• Measure of true profitability: It uses all cash flows occurring over the
entire life of the project in calculating its worth. Hence it is a true
measure of the projects profitability.
DISADVANTAGES:
The Internal Rate of Return (IRR) is the discount rate that generates a
zero net present value for a series of future cash flows. This essentially
means that IRR is the rate of return that makes the sum of present value of
future cash flows and the final market value of a project (or an investment)
equal its current market value.
Internal Rate of Return provides a simple ‘hurdle rate’, whereby any project
should be avoided if the cost of capital exceeds this rate. Usually a financial
calculator has to be used to calculate this IRR, though it can also be
mathematically calculated using the following formula:
In the above formula, CF is the Cash Flow generated in the specific period
(the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by
employing trial and error method.
Internal Rate of Return is the flip side of Net Present Value (NPV), where
NPV is the discounted value of a stream of cash flows, generated from an
investment. IRR thus computes the break-even rate of return showing the
discount rate, below which an investment results in a positive NPV.
In the context of savings and loans the IRR is also called effective interest
rate
ADVANTAGES;
• Time value: The IRR method recognizes the time value of money.
• Profitability Holder: It considers all cash flows occurring over the
entire life of the project to calculate its rate of return.
• Acceptance rule: its generally gives the same acceptance rules as the
NPV method.
• Shareholder value: it is consistent with shareholders wealth
maximization objective .whenever a project’s IRR is greater than
opportunity cost of capital, the shareholders wealth will be enhanced.
DISADVANTAGES
• Multiple rates: A project may have multiple rates, or it may not have a
unique rate of return. These problems arise because of the
mathematics of IRR computation.
• Mutually Exclusive Projects: it may also fail to indicate a correct
choice between mutually exclusive projects under certain situations.
• Value Additivity: Unlike in the case of NPV method, the value
additivity principle doesn’t hold when the IRR method is used-IRRs
of projects do not add. Thus, projects A and B, IRR(A)+IRR(B) need
not be equal to IRR(A+B)
Analysis
For our project, we went to Mr. Reddy the owner of Jaipuria Institute of
Management canteen. He give us the data of the canteen in the begning he
said that he invested Rs. 200000 in the canteen as fixed cost. He deposited
Rs. 50000 to the Jaipuria Institute of Management as security management.
Return on investment for the 5 year as follows:-
1st year -> Rs. 80000
2nd year -> Rs. 82000
3rd year -> Rs. 88000
4th year -> Rs. 86000
5th year -> Rs. 90000
IRR can be determined by solving the following equation for r :
Where
C0 = project cost
C =return on n year
r =discount rate
=- Rs 29000
The project’s NPV is negative at 40%,a rate lower than 40% should be tried .
we select 30% , the projects NPV is
= Rs 4414
The true rate of return should lies between 30-40 percent. We can find out a
close approximation of the rate of return by the method of linear
interpolation as follows:-
Di
fference
PV required Rs. 200000
Rs. 4414
PV at lower rate 30% Rs. 204414
Rs. 34342
PV at higher rate 40% Rs. 170072
While asking question to Mr.Reddy , he said that he can’t more return from
Jaipuria Institute of Management because there is less margin in mess of
hostel. He get more return due to selling of food products to Jaipuria school.
For seeing the project, whether it is feasible or not. We compare it with other
project. We went to Mr. Reddy and ask if you invest Rs.200000 to other
institute in the same business what will be your expected return. He gave the
return on investment for 5 years are as under:-
= -200000 +196624
= -Rs.3376
Since, the project’s NPV negative at 25%, a rate lower then 25% is tried.
When we select 24% as The trial rate, we find that the project’s NPV is RS
574.
NPV= -200000 +75,000*PVF(1,0.24) +70000*PVF(2,0.24)
+73000*PVF(3,0.24) +72000*PVF(4,0.24)+76000*PVF(5,0.24)
The true rate of return should lie between 24-25%. We can find out a close
approximation of the rate of return by the method of linear interpolation
follows:-
Differenc
e
PV required 200000
574
PV at lower rate, 24% 200574
3950
PV at higher rate, 25% 196624
The accept and reject rule using IRR methode is to accept the project if its
internal rate of return is higher then the opportunity cost of capital( r>k ).K
is required rate of return or the cut-off or hurdle rate.
Accept the project when r>k
Reject the project when r<k
May accept the project when r=k