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Introduction :
The capital budgeting decisions are related to the allocation of investible
funds to different long term assets.
Lump sum funds are invested in the initial stages of a projects and the returns
are expected over a long period.
The capital budgeting decision involve the entire process of decision making
relating to acquisition of long term assets whose return are expected to arise
over a period beyond one year.
Some of the capital budgeting decisions may be to buy land, building or
plants; or to undertake a program on R&D of a product, to diversify into a
new product line; a promotional campaign , etc.
Some of the decisions may directly affect the profit of the firm, e.g. launching
a new product, whereas some decisions may affect the profit by reducing the
costs, e.g. replacing an existing machine by a more efficient one.
In both cases the decision once taken set the profit line of the firm for several
years.
In any growing concern, capital budgeting is more or less a continuous
process and it is carried out by different functional areas of management such
as production, marketing, engineering, financial management, etc.
The role of finance manager in the capital budgeting lies in the process of
critical and in-depth analysis and evaluation of various alternative proposals
and then to select one of these.
The basic objective of financial management is to maximize the wealth of
shareholders, therefore the objective of capital budgeting is to select those
long term investment projects that are expected to maximum contribution to
the wealth of shareholders in the long run.
Features:
a) Long term effects
b) Substantial commitments
c) Irreversible decisions
d) Affect the capacity and strength to compete
The situation where the firm is not able to finance all the profitable
investment opportunities is known as capital rationing. If the total funds
required by the profitable opportunities at any particular point in time
exceed the available funds with the firm, then the firm is said to be operating
under conditions of capital rationing.
The capital rationing implies that a firm is unable to unwilling to procure the
additional funds needed to undertake all the capital budgeting proposals
before it.
The problem faced by a finance manager in this situation is as to how to
allocate the available scarce capital among various proposal. Out of different
independent proposals (accept-reject decisions), only those maybe accepted
in order of priority which entails the total cost within the limit of available
fund. In case of mutually exclusive proposals, the cost of selected proposals,
must not exceed the available fund.
Capital budgeting decisions: assumptions and procedure
Assumptions:
1) Certainty with respect to cost and benefits
2) Profit motive
3) No capital rationing
The finance manager should use the best information and techniques
available to take the capital budgeting decision. In the process, the finance
manager may take the following steps:
1. Estimation of costs and benefits of a proposal
2. Estimation of required rate of return
3. Using the capital budgeting decision criterion.
Estimation of costs and benefits of a proposal
Usually two alternatives are suggested for measuring the cost and benefits of
a proposal, i.e. the accounting profits and cash flows.
1. Accounting Profit: the benefits of a proposal may be measured in terms of
the profit generated by it or in terms of a measure based on accounting
profits. The accounting profit as a measure of benefits is discarded on the
following grounds:
a) The accounting profit is affected to a large extent by the accounting policies
being followed by the firm. e.g. depreciation policy, inventory policy etc.
b) Accounting profit is affected by so many non-cash items such as
depreciation, writing off the accumulated losses etc. the balancing profit
figure after these item is not a true measure of benefits contributed by a
proposal.
c) The accounting profit measures the profit of any particular year in terms of
money of that year. However, the cost and benefits of a proposal may occur
over a period of number of years. The benefits if measured in terms of
accounting profit, are expressed in monies of different time periods and are
not comparable. Similarly if two mutually exclusive projects have unequal
economic lives, then the accounting profits emerging over different periods
are not comparable.
d) Accounting profit is based on accrual concepts. E.g. the sales revenue and
expenses, both are recorded for the period in which they occur instead of
the period in which they are actually receive d or paid.
2. Cash flows: in capital budgeting, the cost and benefits of a proposal are
measured in terms of cash flows. The term cash flow is used to describe the
cash oriented measure of return generated by the proposal. The costs are
denoted as cash outflows whereas the benefit are denoted as cash inflows.
The cash outflows and inflows are used to denote the cost and benefit of a
proposal.
Cash flows associated with a proposal may be classified into (i) original or
Initial cash outflow, (ii) subsequent cash inflows and outflows and (iii)
terminal cash flow
1) Original or Initial cash outflow: this initial cash outflow is needed to get a
project operational. In most of the capital budgeting proposal, the initial cost
of the project , i.e. the initial investment cost is the cash outflow occurring in
the initial stages of the projects. It reflects the cash spent to acquire the
asset.
a) Installation cost
b) Sunk cost
c) Opportunity cost
d) Additional working capital requirement
2. Subsequent Inflows and Outflows: the original investment cost or the initial
cash outflow of the proposal is expected to generate a series of cash inflows
in the form of cash profits contributed by the project. These cash flows maybe
same every year throughout the life of the project or may vary from one year
to the other. The timings of the inflows may also be different. These cash
inflows generated during the life of the project may also be called operating
cash flows.
Sometimes the project require subsequent cash outflows also in the form of
periodic repairs etc. . All these cash inflows and outflows are to be considered
for the capital budgeting decision. Similarly, if additional working capital is
required in any of the subsequent years, then it should be considered as a
outflow for that year. However, if the working capital is released in any of the
subsequent years, then it should be considered as cash inflow for that year.
its important to recognize the timing of these subsequent cash inflows and
outflows, as these are to be adjusted for the time value of money. The more
quickly and earlier, the cash inflows occur, the more valuable these are.
3. Terminal cash inflows: the cash inflows for the last year will also include the
terminal cash flows in addition to annual cash inflows. Two common terminal
cash inflows: (i) salvage or scrap value of the project realizable at the end of
the economic life of the project or at the time of its termination is the cash
inflow for the last year. (ii) working capital which was invested (tied up) in
the beginning will no longer be required as the project is being terminated.
This WC released will be available back to the firm and is considered as a
terminal cash inflow.
Terminal value
Traditional or non-discounting techniques
• Payback period: is defined as the no. of years required for the proposal’s
cumulative cash inflows to be equal to its cash outflows. In other words, the
payback period is the length of time required to recover the initial cost of the
project.
• Computation of payback period:
a) When annual inflows are equal: when the cash inflows being generated by a
proposal are equal per time period i.e. the cash inflows are in the form of an
annuity, the payback period can be computed by dividing the cash outflow by
the amount of annuity. E.g. a proposal requires a cash outflow of Rs. 1,00,000
and is expected to generate cash inflows of Rs.20,000 p.a. for 6 years. In this
case payback period is 5 years, i.e. Rs.1,00,000/Rs.20,000. The initial cash
outflow of Rs.1,00,000 will be fully recovered within a period of 5 years and
the cash inflows occurring thereafter ( i.e. in the 6th year) are ignored. In the
above case if the annual cash inflow is Rs.30,000, then the payback period lies
between 3 years and 4 years and is 3.33 years i.e. Rs.1,00,000/ Rs.30,000.
b) When the cash inflows are unequal: incase the cash inflows from the proposal
are not in the annuity form then the cumulative cash inflows are used to
compute the payback period. E.g. a proposal requires a cash outflow of
Rs.20,000 and is expected to generate cash inflows are of Rs.8,000, Rs.6,000,
Rs.4,000, Rs.2,000 and Rs.2,000 over next 5 years respectively. The payback
period is 4 years because the sum of cash inflows of first 4 years is Rs.20,000.
The following case is also a possibility when the cumulative cash inflows are
not exactly equal to proposal’s cash outflow. In the case above case if the cash
outflow is only Rs.18,500 then payback period will be calculated as:
• Avg. inv = ½ (initial cost +installation expenses – salvage value) + salvage value
• E.g. ABC Ltd. Takes a project costing Rs.1,20,000 with an expected life of 5 years
and the salvage value of Rs.20,000. average investment in the proposal is :
Avg. inv = ½ (1,20,000- 20,000) +20,000
=Rs.70,000
• The average investment can also be calculated as:
• Decision rule.
Discounted cash flows or time adjusted techniques
• The discounted cash flow techniques or the time adjusted cash flow techniques,
as against the traditional techniques are based upon the fact that the cash flows
occurring at different points in time are not having the same economic worth. In
order to make these cash flows equal in economic worth these must be
discounted with reference to the time gap between different cash flows and a
predetermined discount rate .
• The methods which involve time value of money, more accurately reflect the
true economic trade-off and returns. These techniques are also called the
present values techniques and fulfill all the requisites of a good evaluation
technique.
• Net Present Value Method: the NPV of an investment proposal may be defined
as the sum of the present values of all the cash inflows less the sum of present
values of all cash outflows associated with a proposal. The figure can be positive
or negative depending on whether there is a net inflow or outflow from the
project.
• The rate of discount used to discount the cash flows should reflect the
minimum return requirement that will leave the shareholders as well as before ,
while taking the advantage of financial leverage. The rate so employed is the
overall cost of capital, which takes into account shareholders expectations,
business risk and the leverage.
• Calculation of NPV:
NPV = excess of PV of inflows over PV of outflows.
NPV = PV of cash inflows – PV of cash outflows.
• E.g.:
• The total cash inflow for the year T5 is Rs.75,000 (consisting of annual inflow of
Rs.30,000 + working capital released of Rs.20,000 + salvage value of Rs.25,000).
• Decision Rule
Profitability Index (PI)
• One may be faced with a choice involving several alternative investment of
different size. In such a case, he cannot be indifferent to the fact that even
though NPV of different alternatives may be close or even equal, these involve
commitments of widely ranging amounts. In other words, it does make a
difference whether an investment proposal promises a NPV of Rs.1,000 for an
outlay of Rs.10,000; or whether an outlay of Rs.25,000 is required to get the
same NPV of Rs.1,000 even if the lives of the project are assumed to be same.
In the first case, the NPV is much larger fraction (Rs.1000/10,000) then what it
is in the second case, i.e. (Rs.1,000/25,000), which makes the first proposal
more attractive .
• The PI technique is a formal way of expressing this cost/benefit relationship.
• PI is a variant of NPV technique, is also known as Benefit-cost ratio, or present
value index.
• PI = Total Present value of cash inflows
Total Present value of cash outflows
• E.g. a firm is evaluating a proposal which requires a cash outlay of Rs.40,000 a present
and of Rs.20,000 at the end of third year from now. It is expected to generate cash
inflows of Rs.20,000, Rs.40,000 and Rs.20,000 at the end of 1st year, 2nd year and 4th
year respectively. Given the discount rate of 10%, calculate PI.
•By interpolating BETWEEN 15% AND 16%, find out the exact IRR:
IRR = 15% 1,540 (16-15)
1,540 – (-2,250)
IRR of the project is 15.40%
•Decision Rule.