CAPITAL BUDGETING

Meaning of Capital Budgeting  Significance  Capital Budgeting process  Project classification and Investment Criteria Payback method  ARR Method  Net Present Value  IRR Method  Profitability Index.


Introduction:
One of the aspect of financial management is investment. investment. Investment means expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net inflow of cash or its equivalent in some future time periods. periods. Appraisal of Investment is essential to know that the investments will bring benefits or not. not. Investment Decision: Investment Proposal Decision: these are the terms associated with long term resources or assets Proposals involving investment of funds for a period of ten or more will fall in the category of investment. ( no hard and fast rules). investment. rules). Long term decisions regarding planning and development of available financial resources for wealth maximization

Why Investments are necessary ?

Expansion of the business.  Diversification of the business  Replacement of the Assets/ Technology  Research and Development


Capital Expenditure: Expenditure for Expenditure: longer period of time involving high risk. the benefit of these expenditure is spread over number of years. Right of Pre-emptive: The right of the Preequity share holders to receive the new issue on pro-rata basis pro-

Capital Budgeting: the process of Budgeting: planning for purchases of longlongterm assets.


example: example: Suppose our firm must decide whether to purchase a new plastic molding machine for Rs 2,500,000. How do we decide?  Will the machine be profitable?  Will our firm earn a high rate of return on the investment?

DecisionDecision-making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

DecisionDecision-making Criteria in Capital Budgeting

 The

Ideal Evaluation Method should:

a) include all cash flows that occur during the life of the project, b) consider the time value of money, money, c) incorporate the required rate of return on the project.

Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern Lynch  The main features of capital budgeting are a. potentially large anticipated benefits b. a relatively high degree of risk c. relatively long time period between the initial outlay and the anticipated return. - Oster Young



 

Meaning of Capital Budgeting:

Planning for capital assets Capital budgeting decision means deciding whether or not the investment is to be made. Capital budgeting is the process of allocating funds for long-term investment longprojects or proposals,


      

Importance of Capital Budgeting:

Includes huge amount therefore necessary to consider to generate profits. Relating to future period therefore affects the growth Once taken difficult to reverse Complex decisions Helps for long term financial planning Helps of proper replacement and research Helps to control capital expenditures

TYPES OF CAPITAL INVESTMENT DECISIONS

ON THE BASIS OF FIRMSS EXISTENCE  Replacement and Modernization Decision. (aim is to improve operating efficiency) Expansion Decision ( existing successful firms)
 

DECISION SITUATION Mutually Exclusive Decision(one taken other will be excluded).  Accept or Reject Decision.( when proposals are independent and do not compete with each other).  Contingent Decision (depending upon other) If want start a factory u have to build infra ( in remote area)


Diversification Decision

Capital Budgeting Process

Examine the various steeps involved in Capital Budgeting  Project Generation ( investment generation for the project)  Project Evaluation( evaluation of alternatives).  Project Selection (Best)  Project Execution ( implementation)  Follow-up of the Project( assessment of Followsubsequent results)


Capital budgeting process involves the following 1. Project generation: Generating the proposals for investment generation: is the first step. step. The investment proposal may fall into one of the following categories: categories:  Proposals to add new product to the product line,  proposals to expand production capacity in existing lines  proposals to reduce the costs of the output of the existing products without altering the scale of operation. operation.  Sales campaining, trade fairs people in the industry, R and D institutes, conferences and seminars will offer wide variety of innovations on capital assets for investment. investment.

2. 

Project Evaluation: it involves two steps Evaluation: Estimation of benefits and costs: the benefits and costs are measured in terms of cash flows. The estimation of the cash inflows and cash outflows mainly depends on future uncertainities. The risk associated with each project must be carefully analysed and sufficeint provision must be made for covering the different types of risks. Selection of an appropriate criteria to judge the desirability of the project: It must be consistent with the firms objective of maximising its market value. The technique of time value of money may come as a handy tool in evaluation such proposals.

3.

4.

Project Selection: Selection: No standard administrative procedure can be laid down for approving the investment proposal. The screening and selection proposal. procedures are different from firm to firm. firm. Project Evaluation: Once the proposal for capital Evaluation: expenditure is finalised, it is the duty of the finance manager to explore the different alternatives available for acquiring the funds. He has to prepare capital funds. budget. budget. Sufficient care must be taken to reduce the average cost of funds. He has to prepare periodical funds. reports and must seek prior permission from the top management. management. Systematic procedure should be developed to review the performance of projects during their lifetime and after completion. completion.

The follow up, comparison of actual performance with original estimates not only ensures better forecasting but also helps in sharpening the techniques for improving future forecasts. forecasts.

Mention the factors influencing the capital budgeting

Availability of Funds: Company has 3 projects which require 3 Rs 50,000, 1,00,000 and 25,000  The company has Rs 75,000 to invest.  Working Capital Requirements: Starting of new project may require modification in working capital requirements.
 

Immediate need of the project : Even if the projects may not earn immediately some of them need to be implemented urgently. CuttCutt- Off Rate: if estimated Return is < Cutt off Rate---- Reject the Rate---project Capital return : How much time it takes to return the investments Taxation policy : Liberal helps for easy recovery of investment Structure of capital : Leveraged helps to earn more however risk is more Lending policies of financial institutions: Lending rate, surety etc play role Government policy: Economic policy--- Direct impact on investment policy: policy--decisions.

     

Capital Investment Proposals



Independent Proposals: do not compete with another in a way of acceptance . Straight way accepted or rejected directly by the firm.  Dependent or Contingent: acceptance dependence on another proposal.


Mutually Exclusive Proposals.

Techniques of Evaluating Investment Proposals Capital Budgeting Appraisal Techniques

What are the techniques of evaluation of investment? Discuss  Number of Proposals  Which is to be selected  Number of factors--- returns time-factors--- returns time-benefits--- safety--benefits--- safety--- risk
 

Finance Manger is responsible to take the decision of selection

Methods of Appraisal
Traditional Methods:  Pay Back Period  Accounting Rate of Return ( Return on Investment) Discounted Cash Flow Methods  Net Present Value Method  Internal Rate of Return Method  Profitability Index Method.

Pay back period method It refers to the period in which the project will generate the necessary cash to recover the initial investment. It does not take the effect of time value of money. It emphasizes more on annual cash inflows, economic life of the project and original investment. The selection of the project is based on the earning capacity of a project. It involves simple calculation, selection or rejection of the project can be made easily, results obtained is more reliable, best method for evaluating high risk projects.

Cons/ Demerits  It is based on principle of rule of thumb,  Does not recognize importance of time value of money,  Does not consider profitability of the project,  Does not recognize income beyond pay back period.  Does not reflect all the relevant dimensions of profitability.

Payback Period
The number of years needed to recover the initial cash outlay.  How long will it take for the project to generate enough cash to pay for itself?


PB =

Initial cashoutlay Annual Cash Inflows

Payback Period
How long will it take for the project to generate enough cash to pay for itself?  ( CASH INFLOW is UNIFORM)


(500) 150 150 150 150 150 150 150

150

PBP =

Initial cash outlay Annual Cash Inflows = 500/150= 3.33years

Payback Period
 How

long will it take for the project to generate enough cash to pay for itself?
150

(500) 150 150 150 150 150 150 150

Payback period = 3.33 years.

 Is

a 3.33 year payback period good?  Is it acceptable?  Firms that use this method will compare the payback calculation to some standard set by the firm.  If our senior management had set a cutcut-off of 5 years for projects like ours, what would be our decision?  Accept the project. project.

Drawbacks of Payback Period:

subjective. cutoffs are subjective. money.  Does not consider time value of money.  Does not consider any required rate of return. return.  Does not consider all of the projects cash flows. flows.
 Firm

Drawbacks of Payback Period:

 Does

not consider all of the projects cash flows.

0

(500) 150 150 150 150 150 (300) 0

Consider this cash flow stream!

Drawbacks of Payback Period:

 Does

not consider all of the projects cash flows.

0

(500) 150 150 150 150 150 (300) 0

This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!

Discounted Payback
 Discounts

the cash flows at the firms required rate of return.  Payback period is calculated using these discounted net cash flows.  Problems: Problems:  Cutoffs are still subjective.  Still does not examine all cash flows.

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 -500 250

CF (14%)
-500.00 219.30

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 -500 250

CF (14%)
-500.00 219.30 280.70 1 year

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 -500 250 250

CF (14%)
-500.00 219.30 280.70 192.38 1 year

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 -500 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 1 year 2 years

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3 -500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3 -500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years .52 years

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow

0 1 2 3

The Discounted -500 -500.00 Payback 250 219.30 is 2.52 years

250 250 280.70 192.38 88.32 168.75

CF (14%)
1 year 2 years .52 years

Discounted PBP=
year of Max recovery + Balance to be recovered

Discounted Cash inflow of the year of Last recovery

Accounting Rate of Return method/ Average Rate of Return Method What is accounting rate of return? Briefly explain its limitations : Accounting ROR means the average annual yield on the project. Profit after tax and depreciation as a percentage to the total investment is considered.
. Considers the earnings of the project of the economic life. life. Based on conventional accounting concepts. concepts. This method has been introduced to overcome the disadvantage of pay back period.. period..

This method of ARR is not commonly accepted in assessing the profitability of capital expenditure. Because the method does to consider the heavy cash inflow during the project period as the earnings with be averaged.  The cash flow advantage derived by adopting different kinds of depreciation is also not considered in this method.


Accept or Reject Criterion: Under the method, all project, having Criterion: Accounting Rate of return higher than the minimum rate establishment by management will be considered and those having ARR less than the pre-determined rate. This method ranks a prerate. Project as number one, if it has highest ARR, and lowest rank is assigned to the project with the lowest ARR. ARR. Merits  It is very simple to understand and use. use.  This method takes into account saving over the entire economic life of the project. Therefore, it provides a better means of project. comparison of project than the pay back period. period.  This method through the concept of "net earnings" ensures a compensation of expected profitability of the projects and  It can readily be calculated by using the accounting data. data.

Demerits  1. It ignores time value of money.  2. It does not consider the length of life of the projects.  3. It is not consistent with the firm's objective of maximizing the market value of shares.  4. It ignores the fact that the profits earned can be reinvested. -

Give the meaning of discounted cash flow method. What are its advantages?
Discounted cash flow method Time adjusted technique is an improvement over pay back method and ARR. ARR. An investment is essentially out flow of funds aiming at fair percentage of return in future. The presence of time as a factor in future. investment is fundamental for the purpose of evaluating investment. investment. Time is a crucial factor, because, the real value of money fluctuates over a period of time. A rupee received today has time. more value than a rupee received tomorrow. tomorrow. In evaluating investment projects it is important to consider the timing of returns on investment. Discounted cash flow technique investment. takes into account both the interest factor and the return after the payback 'period. 'period.

Discounted Cash Flow Technique

It is based on time value of money,  income is spread over a few years  Rupee today is more important.  Therefore future income is to be discounted. 1. NPV 2. 2. IRR ( mention the merits of NPV and IRR)


Discounted cash flow technique involves the following steps: steps:  Calculation of cash inflow and out flows over the entire life of the asset. asset.  Discounting the cash flows by a discount factor  Aggregating the discounted cash inflows and comparing the total so obtained with the discounted out flows. flows.

Net present value method : Sum of the present values of all the cash inflows less the sum of the present values of all the cash outflows associated with the proposal. It recognizes the impact of time value of money. It is considered as the best method It is widely used in practice.

The cash inflow to be received at different period of time will be discounted at a particular discount rate. The present values of the cash inflow are compared with the original investment. The difference between the two will be used for accept or reject criteria. If the different yields (+) positive value , the proposal is selected for investment. If the difference shows (-) (negative values, it will be rejected.

Pros: Pros: It recognizes the time value of money. money. It considers the cash inflow of the entire project. project. It estimates the present value of their cash inflows by using a discount rate equal to the cost of capital. capital. It is consistent with the objective of maximizing the welfare of owners. owners. Cons: Cons: It is very difficult to find and understand the concept of cost of capital It may not give reliable answers when dealing with alternative projects under the conditions of unequal lives of project. project.

Net Present Value

y NPV = the total PV of the annual net cash flows - the initial outlay. n

NPV =

7
t=1

CFt (1 + k) t

- IO

Net Present Value

Decision Rule: Rule:

If NPV is positive, ACCEPT. ACCEPT. REJECT. y If NPV is negative, REJECT.

y

NPV Example


Suppose we are considering a capital investment that costs Rs 56,000 and provides annual net cash flows of Rs.4,000, Rs 16,000 , Rs 18,000, Rs 20,000 and Rs 25,000 in 1st , 2nd, 3rd, 4th and 5th year. The firms cost of capital is 10%.Determine whether firm should accept the proposal or not?

NPV Calculation
Year 1 2 3 4 5 Total Less Annual PV Factor Cash Flow 4,000 16,000 18,000 20,000 25,000 83,000 Initial Investment 0.909 0.826 0.751 0.683 0.621 PV of Cash Flows 3,636 13216 13518 13660 15525 68,645 56,000

NPV CALCULATION:

y NPV = the total PV of the annual net cash flows - the initial outlay.

Internal Rate of Return

It is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows for the proposal. It is the rate at which the net present value of the investment is zero. It is the rate of discount which reduces the NPV of an investment to zero. It is called internal rate because it depends mainly on the outlay and proceeds associated with the project and not on any rate determined outside the investment.

Merits of IRR method  It consider the time value of money  Calculation of casot of capital is not a prerequisite for adopting IRR  IRR attempts to find the maximum rate of interest at which funds invested in the project could be repaid out of the cash inflows arising from the project. project.  It is not in conflict with the concept of maximising the welfare of the equity shareholders. shareholders.  It considers cash inflows throughout the life of the project. project.

Cons  Computation of IRR is tedious and difficult to understand  Both NPV and IRR assume that the cash inflows can be reinvested at the discounting rate in the new projects. However, reinvestment of funds at the cut off rate is more appropriate than at the IRR.  IT may give results inconsistent with NPV method. This is especially true in case of mutually exclusive project.

Step 1:Calculation of cash outflow

Cost of project/asset Transportation/installation charges Working capital Cash outflow xxxx xxxx xxxx xxxx

Step 2: Calculation of cash inflow Sales Less: Cash expenses PBDT Less: Depreciation PBT less: Tax PAT Add: Depreciation Cash inflow p.a

xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx

Note:  Depreciation = St.Line method  PBDT Tax is Cash inflow ( if the tax amount is given)  PATBD = Cash inflow  Cash inflow- Scrap and working capital must be inflowadded.

Step 3: Apply the different techniques  Pay back period= No. of years + Amt to recover/ total cash of next years.  ARR = Average Profits after tax/ Net investment x 100  NPV= PV of cash inflows PV of cash outflows  Profitability index = PV of cash inflows/ PV of cash outflows  IRR : Pay back factor: Cash outflow/ Avg cash inflow p.a. Find IRR range PV of Cash inflows for IRR range and then calculate IRR

Internal Rate of Return (IRR)

IRR:  IRR: the return on the firms invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

Internal Rate of Return (IRR)

n

NPV =

7
t=1

ACFt (1 + k) t

- IO

Internal Rate of Return (IRR)

n

NPV =

7
t=1 n

ACFt (1 + k) t

- IO

IRR:

7
t=1

ACFt t (1 + IRR)

= IO

Internal Rate of Return (IRR)

n

IRR:
 IRR

7
t=1

ACFt t (1 + IRR)

= IO

is the rate of return that makes the PV of the cash flows equal to the initial outlay.  This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.

Calculating IRR
 Looking again

at our problem:  The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.
83,000 83,000 83,000 (276,400) 83,000 116,000

83,000 83,000 83,000 (276,400)

83,000 116,000

0 1 2 3 4  This is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

83,000 83,000 83,000 (276,400)

83,000 116,000

0
 This

is what we are actually doing:

83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

 This

way, we have to solve for IRR by trial and error.

IRR with your Calculator

is easy to find with your financial calculator.  Just enter the cash flows as you did with the NPV problem and solve for IRR.  You should get IRR = 17.63%!
 IRR

IRR
y y

Decision Rule: Rule: If IRR is greater than or equal to the required rate of return, ACCEPT. ACCEPT. If IRR is less than the required rate of return, REJECT. REJECT.

 IRR

is a good decision-making decisiontool as long as cash flows are conventional. conventional. (- + + + + +)  Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)

 IRR

is a good decision-making decisiontool as long as cash flows are conventional. conventional. (- + + + + +)  Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
(500) 200 0 1 100 2 (200) 3 400 4 300 5

 IRR

is a good decision-making decisiontool as long as cash flows are conventional. conventional. (- + + + + +)  Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
(500) 200 0 1 100 2 (200) 3 400 4 300 5

 Problem:

If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)  We could find 3 different IRRs!
1 (500) 200 0 1 100 2 2 (200) 3 3 400 4 300 5

Summary Problem:
the cash flows only once. IRR.  Find the IRR. NPV.  Using a discount rate of 15%, find NPV. PI.  Add back IO and divide by IO to get PI. (900) 300 0 1 400 2 400 3 500 4 600 5
 Enter

Summary Problem:
= 34.37%.  Using a discount rate of 15%, NPV = $510.52.  PI = 1.57. (900) 300 0 1 400 2 400 3 500 4 600 5
 IRR

Profitability Index
n

NPV =

7
t=1

ACFt t (1 + k)

- IO

Profitability Index
n

NPV =

7
t=1 n

ACFt t (1 + k)

- IO

PI =

7
t=1

ACFt t (1 + k)

IO

Profitability Index
y

Decision Rule: Rule:

If PI is greater than or equal to 1, ACCEPT. ACCEPT. REJECT. y If PI is less than 1, REJECT.

y

Profitability Index Method/ Benefit Cost Ratio Method/ Desirability Factor



Method for comparing the proposals each involving different amount of cash inflows. PI is worked out , if index value = 1 project is accepted otherwise rejected.

Merits:  Uses the concept of time value.  Better than NPV



Demerits:  Fails to as a guide in resolving capital rationing.  Project with a lower profitability index may be selected which may generate cash flow which can be used for another project.


Capital Rationing: A situation where a firm has more investment proposals than it can finance. It may be defined as a situation where a constraint is placed on the total sixe of capital investment during a particular period.  firm to select combination of investments proposals that provide the highest NPV subject to the budget constraint for the period.


Cut of Rate: Minimum rate which the management wishes to have from any project. It is usually based on cost of capital.  Factoring: a factor is a financial institution which provides the management and financial services like financing of debt arising out of credit sales. They maintain required records and render advisory service to the clients.


Thank You