Capital Budgeting

Nature or Features of Capital Budgeting Decisions

Long- Term Effects High Degree of Risk Huge Funds Irreversible Decisions Impact on Firms Competitive Strength Impact on Cost Structure

Information Required For Capital Budgeting

Costs and Benefits of Proposal Required rate of Return Economic Life of the Project Available Funds Risk of Obsolescence

Kinds of Capital Budgeting Decisions

Accept- Reject Decisions Mutually Exclusive Decisions Capital Rationing Decision

 Accept- Reject Decision This is a fundamental decision in capital budgeting. If the project is accepted, the firm would invest in it; if the proposal is rejected, the firm does not invest in it. Proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected. This criteria is applied to all independent projects. Independent projects are projects that do not compete with one another in such a way that the acceptance of one precludes the possibility of acceptance of another. Under this type of decision, all independent projects that satisfy the minimum investment criterion should be implemented.

 Mutually Exclusive Project Decisions Projects which compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen. These decisions acquire significance when more than one proposal is acceptable under the accept- reject decision. Then some technique has to be used to determine the best one. The acceptance of this best alternative automatically eliminates the other alternatives.

 Capital Rationing Decision

Funds are usually limited in nature and a large number of investment proposals compete for these limited funds. The firm must therefore ration them. The firm allocates funds to projects in a manner that it maximizes long term returns.

 In Capital Budgeting Decisions, the costs and benefits of a proposal are measured in terms of cash flows. Cash flows refer to a cash revenue minus cash expenses or cash oriented measures of return generated by a proposal. The costs are denoted as cash outflows whereas the benefits are denoted as cash inflows.

The cash flows associated with a proposal , usually, involves the following three types of cash flows: Initial Investment or Cash Outflows Net Annual Cash inflows Terminal Cash Inflows

Computation of Initial Investment

Purchase Price of the Asset (including duties and taxes, if any) Add: Insurance, Freight and Installation Costs

Opportunity Cost (if any)

Increase in Working Capital (if required) Less: Cash Inflows in the form of scrap or salvage value of the old assets (in case of replacing decisions) Decrease in Working Capital Initial Investment or Cash Outlay

Net Annual Cash Inflows or Operating Cash Flows

Profitability Statement (in revenue increasing decisions)

Annual Sales Revenue Less: Operating Expenses including depreciation

Income Before Tax

Less: Income Tax Net Income After Tax Add: Depreciation Net Cash Inflows

Profitability Statement (in cost reduction decisions)

(A) Estimated Savings Estimated Savings in Direct Wages Estimated Savings in Scrap

Total Savings (a)

(B) Estimated Additional Costs Additional Cost of Maintenance Additional Cost of Supervision

Add: Cost of indirect material

Additional Depreciation Total Additional Costs (b) Net Savings before tax (a-b)

Less: Income Tax

Net Savings after Tax Add: Additional Depreciation Net Savings after tax or cash inflows

Terminal Cash Inflows

Estimated Salvage or Scrap Value Working Capital Released

Conventional Cash Flows When an initial investment or cash outflows is followed by a series of inflow of uniform or unequal amounts, it is called conventional cash flows.

Non- Conventional Cash Flows- refers to the cash flow pattern where not one but a series of cash outflows are followed by a series of cash inflows of equal or unequal amounts.

Depreciation
Depreciation is a non- cash item, hence it is not a concept of financial management, because it does not directly affect the firm in terms of a cash resource. It has the effect of reducing taxable income and also the tax liability. The treatment of depreciation is done as per the accounting standards. Every asset will be depreciated and it can be deducted according to different methods. Two main methods of depreciation are straight line method and the written down value method.

Capital Budgeting Methods/ Techniques

Pay- Back Period Method

It is the most popular and widely recognized traditional method of evaluating capital expenditure proposals. It considers that recovery of the original investment in the shortest period is an important element while appraising capital expenditure decisions. The pay back period is the length of time required to recover the initial cost of the project. The pay- back period can be calculated in two different situations.

 When Annual Cash Inflows are Equal In this case, the pay back period is computed by dividing the initial investment or cash outlay by the net annual cash inflows. Pay- Back Period = Initial Investments Net Annual Cash Inflows

 When Annual Cash Inflows are Unequal In this case, the pay back period is calculated by the process of cumulating the cash inflows till the time cumulative cash inflows become equal to the initial investment outlay.

 Decision Criterion Under pay- back period method that project will be treated as the best whose pay- back period is the shortest. A project will be accepted if the pay back period calculated is less than its economic life or the maximum pay back period calculated is less than its economic life or the maximum pay- back period set by the management. In case of alternative projects, they may be ranked according to the length of the pay- back period. The projects having the shortest pay- back period may be assigned one followed in that order so that the project with the longest pay back period be ranked the lowest.

Advantages of the Pay- Back Period Method

Simple Low Cost Risk of Obsolescence Liquidity Oriented Risk Curtailment

Limitations of Pay- Back Period Method

Ignores the profitability of the project Ignores Post Pay- Back Cash Inflow Ignores the magnitude and timing of cash inflows Ignores present value of cash inflows Ignores the cost of capital

 Post Pay- Back Profitability = Total Cash Inflows in Life Initial Cost Or Annual Cash Inflows (Total Life Pay Back Period)

 Bail- Out Pay Back Period Pay- Back Reciprocal = Annual Cash Inflows * 100 Investment

Average Rate of Return

If profits after tax and depreciation are given ARR = Average Annual Income After Tax and Depreciation Average Investment If annual cash inflows are given ARR = Average Annual Cash Inflows- Annual Depreciation Average Investment If value of original investment is used ARR = Average Annual Income After Tax and Depreciation Original Investment * 100

* 100

* 100

 Average Investment = (Initial Investment- Salvage Value) + Salvage Value Or = (Initial Investment + Salvage Value) Therefore, ARR= Average Annual Income after tax and depreciation * 100 (Initial Investment + Salvage Value)

Internal Rate of Return Method

Step 1 Calculate P V Factor P V Factor = Initial Investment Average Annual Cash Inflow

Step 2 Locate this P V Factor in the annuity table of present value of Rs. 1 in the row, corresponding to the life of asset. If exact P V Factor is located in the table than the rate corresponding to the value ( P V Factor value) is the IRR

 Step 3 If exact value is not there than write down the rates between which the P V Factor value lies i.e LDR (Lower Discount Rate) and HDR ( Higher Discount Rate) and apply the following formula IRR = LDR + PV C * (HDR- LDR) PV - PV Here, C = Initial Investment PV = Total PV of Cash Inflow at LDR PV = Total PV of Cash Inflow at HDR