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BUDGETING
PROJECT
APPRAISAL
TECHNIQUES
RATIONALE BEHIND
CAPITAL EXPENDITURE
Benefits expected over a longer period.
Far reaching effects on the success or failure
Assets once acquired can not be disposed off except at a
substantial loss.
If capital assets are purchased on long term credit basis, a
continuing liability is incurred over a longer period.
If earnings are not increased commensurate with the
purchase of the additional capital assets, the ability of the
enterprise to discharge its financial obligations may be
affected adversely.
RATIONALE BEHIND
CAPITAL EXPENDITURE
Expansion of capital facilities by means of the issue
of shares may dilute holding in the company and if
not carefully planned and controlled, it can result in
the loss of control by the management.
It influences long-term prospects and future
earning capacity of the firm.
In this context the forecasting and budgeting of
capital expenditure becomes a vital part of policy
making and management function.
CONCEPT OF CAPITAL
BUDGETING
Long term planning of expenditure whose returns stretch
themselves over a future period
A process of deciding whether or not to commit resources
to a project, whose benefits would be spread over several
time periods.
It considers proposed capital outlay and its financing.
The exercise involved in capital budgeting is to co-relate
the benefits to costs in some reasonable manner which
would be consistent with the profit maximising objectives of
the business.
CONCEPT OF CAPITAL
BUDGETING
It is a managerial decision, since it involves more
extended estimation and prediction of things to come
requiring high order of intellectual ability.
The economic justification for a capital expenditure
programme requires a long term estimates of profits,
which in turn involves projection of sales and cost of
operation over a period of years
It includes searching for new and more profitable
investment proposals, investigation, engineering and
marketing considerations to predict the consequences of
accepting the investment and making economic analysis
to determine the profit potential of each investment
proposal.
A Screening process.
ASPECTS OF CAPITAL
BUDGETING
It ranks various proposals by measuring their profitability
( before considering cost of capital ) in descending order.
One of the most vital aspects of the capital budgeting process is the
accuracy of these three major estimates involved. In fact these
aspects receive less attention in the evaluation tests.
FACTORS AFFECTING
CAPITAL INVESTMENT
DECISIONS
1. Amount of investment
3. Choice of horizons
1. AMOUNT OF
INVESTMENTS
Covers amount of funds committed to project -
– Cost of purchase of land, building, plant etc.
– Increase in level of working capital
– Salvages value from old assets (in case of replacement) or write
off of assets not fully depreciated.
– Cost of installation and other incidental costs
– Opportunity cost of using existing resources
– Tax impact on sale of old assets
– Residue / Terminal / Salvage value of capital expenditure
– Realisable value of working capital at the end of economic life
– Deferred Investment
– Capital subsidy
2. OPERATING CASH FLOWS
– Cash Receipts
– Cash Disbursements
– Timing of cash receipts and disbursements
– Range of estimates - highest and lowest
estimates considering the uncertainties
– After tax and without tax proceeds
– Absolute and relative cash Flows
3. CHOICE OF HORIZONS
Selection of the time period is important for the decision
makers for evaluating benefits and costs. The most
practical way of resolving the horizon problems is to let the
discount rate take care of it. In fact, many companies
impose a shorter limit of benefits and costs, considered for
many type of projects.
Life of the project may be divided into -
– Physical life
– Economical life
The relevant period in Investment Analysis is economic life
as investment are made for the economic benefits.
METHODS OF RANKING
There are several techniques for evaluation and ranking
of the capital investment proposals. In case of all these
methods the main emphasis is the return which will be
derived on the capital investment in the project.
Fundamental Principles :
– “BIGGER THE BETTER PRINCIPLE”, which means that, other
things being equal, bigger benefits are preferable to small ones.
– “BIRD IN HAND PRINCIPLE”, which means that other things
being equal, early benefits are preferable to latter benefits.
– Mean has to be found for considering both of them in a single
yardstick.
1. PAYBACK PERIOD
Payback period refers to the period in which the project
will generate the necessary cash to recoup the initial
investment
Initial Investment
Payback Period = ————————————
Annual Cash inflows
Annual cash inflows = Estimated cash inflows resulting
from the proposed investment ( i.e. net income on account
of investment before depreciation but after taxation )
In case of uneven cash inflows , by calculating cumulative
cash in Flows, the pay-back period can be calculated.
PAYBACK PERIOD
Accept or reject criterion :
– A project whose actual pay-back period is more than what has been
predetermined by the management will be straight way rejected. The
fixation of maximum acceptable pay-back period is generally done by
taking into account the reciprocal of the cost of capital ( i.e. maximum
acceptable pay-back period = 100 divided by desired rate of return )
– The payback period can also be used in case of mutually exclusive
projects. The projects are then arranged in ascending order according to
the length of their pay back periods.
2. ACCOUNTING OR AVERAGE
RATE OF RETURN ( ARR )
According to this method, the capital investment proposals
are judged on the basis of their relative profitability. For
this purpose, capital employed and expected income are
determined according to commonly accepted accounting
principles and practices over the entire economic life of the
project and then the average yield is calculated. Such a
rate is termed as Accounting rate of return. It may be
calculated, according to either of the following formula –
L
Original Investment - Scrap Value O
M P
N 2 Q+ Additional Net Working Capital + Scrap Value
ACCOUNTING OR
AVERAGE RATE OF
RETURN ( ARR )
Accept / Reject Criterion -
Any project expected to give a return below minimum
desired rate of return will be straight way rejected. In
case of several project, where a choice has to be made,
the different projects may be ranked in the descending
order on the basis of their rate of return.
3. DISCOUNTED CASH FLOWS
(DCF) METHOD
An investment is essential outlay of funds in anticipation of
future returns, the presence of time as a factor in
investment is fundamental rather than incidental to the
purpose of evaluation of investments. Time is always
crucial for the investor, so that a sum received today is
worth more than the same sum to be received tomorrow.
Thus in evaluating investment projects, it is important to
consider the timings of return on investments.
DCF METHOD
Assumptions of Discounting Table :
1. Opportunity for investment is available at any time for any
amount.
2. Interest will accrue at the same rate.
3. Interest will be received at the end of the year.
4. Interest will be reinvested at the same opportunity rate
5. Price level remains the same
Positive Relationship
Risk Return
2.Uncertainty
3.Certainty
Returns.
the project.
MEASUREMENT OF RISK
Example:
Project NPV(Rs.) Probability
X 320 1.0
Y 400 0.8
0 0.2
Both the projects have equal expected NPV i.e. Rs.320.
However the risk profile of project Y is greater than project X ,
Hence Project Y is risky.
Project X with lesser risk is expected to have same returns as of
Project Y, hence Project X is the better choice.
1. HILLER’S MODEL – Risk
Evaluation
Hiller argues that uncertainty or risk associated with a capital
expenditure proposal is shown by Standard Deviation of expected cash
flows.
A=Capital cost
B=Working Capital
C= Opeartional cash inflow
D= Salvage Value
Depreciation on plant and Machinery
Depreciation
WDV @25%
Year Rs.Lakhs Rs.Lakhs
1 100.00 25.00
2 75.00 18.75
3 56.25 14.06
4 42.19 10.55
5 31.64 7.91
WDV 23.73
Operational Cash inflow
Contribution Fixed
@Rs.60/unit overheads Operation
(For 1 lakh (excluding Depreciati al cash
units) Dep.) Rs. on PBT Tax inflow
Year Rs.Lakhs Lakhs Rs.Lakhs Rs. Lakhs Rs. Lakhs Rs.Lakhs
1 60 15 25.00 20.00 8.00 37.00
2 60 15 18.75 26.25 10.50 34.50
3 60 15 14.06 30.94 12.38 32.63
4 60 15 10.55 34.45 13.78 31.22
5 60 15 7.91 37.09 14.84 30.16
Sensitivity Analysis
Revised
Sr. No. Change Calculation NPV Result
(1 X - 12) X
Decrease in selling (1-.40) X Negative
1 Price by 10 % 3.61 -8.80 NPV
(1 X -3) X Still
Increase in Variable (1-.40) X positive
2 cost by 5 % 3.61 10.70 NPV
(1 X- 6) X Still
Increase in Variable (1-.40) X positive
3 cost by 10 % 3.61 4.20 NPV
4. ASSIGNING PROBABILITY
Sensitivity Analysis provides more than one estimate
of future return of a project. It is therefore superior to
single figure forecast as it gives more precise ideas
regarding variability of the returns. But, it has a
limitation in that it does not disclose chances of these
occurrences of these variations.
Remedy is to provide more accurate forecast by
considering probability of occurrences.
ASSIGNING PROBABILITY
The Concept of probability is helpful as it indicates the
percentage chance of occurrence of each possible cash
flow.
The quantification of variability of returns involves two
steps.
1. Depending upon chance of occurrences of a particular cash
flow estimate, probabilities are assigned.
Assignment of probabilities can be objective (large number of
observations under independent and identical situations and
past experience) and subjective (personal probability
assignment).
ASSIGNING PROBABILITY
2. To estimate the expected return on the project the
returns are expressed in terms of expected monetary
values. The expected value of a project is a weighted
average return, where the weights are probabilities
assigned to the various expected cash flows.
EXAMPLE
A new project Cost Rs.7,000 lakhs. The following information is
available regarding the cash flows generated, and their probability for
XYZ Ltd. What is expected return on the project? Assume 10% discount
rate and calculate present value of expected monetary values.
decision .
– IRR method :
IRR Acceptable
IRR < Reject
EXAMPLE
A textile company is considering two mutually exclusive
investment proposals. Their expected cash flow streams
(CFAT) are given as follows.
Required rate
Project payback of return(%)
Less than 1 year 8
1 to 5 years 10
5 to 10 years 12
Over 10 years 15
Which proposal should be acceptable to the company?
6. CERTAINTY EQUIVALENT
APPROACH (CEA)
CEA is an alternative to the risk adjusted rate
method, which overcome the weaknesses of the
latter method. Under CEA approach the riskiness
of the project is taken into consideration by
adjusting the expected cash flows, while under
RAD approach the discount rate is adjusted.
STEPS INVOLVED IN CEA
1. Modify the expected cash flows to adjust the risk. The risk adjustment
factor is expected in terms of Certainty Equivalent co-efficient.
– IRR
method :
IRR Acceptable
IRR < Reject
EXAMPLE
A company employs certainty-equivalent of risky
investments. The capital budgeting department of the
company has developed the following information regarding
a new project:
Expected Certainty-
Year CFAT equivalent
(Rs.Thousand)
0 -200 1.0
1 160 0.8
2 140 0.7
3 130 0.6
4 120 0.4
5 80 0.3
Discounting Discounted
Year Cash Flow Factor Cash Flow
0 -200000 1 -200000
1 80000 0.893 71440
2 40000 0.797 31880
NPV -96680
Sensitivity analysis.
SIMULATION
Instead of showing the impact on the NPV for change in
one key variable (Say change in selling price, change in
variable cost) in Sensitivity analysis, Simulation enables
the distribution of probable values(NPV) for change in all
the key variables in one iteration/run only.
The technique provides more information and better
understanding about the risk associated with the
investment decision.
SIMULATION