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Capital Budgeting
Capital Budgeting
Prof. R.Madumathi
MODULE 2
Capital Budgeting
Capital budgeting uses tools such as pay back period, net present
value, internal rate of return, profitability index to select projects.
Payback Period
Profitability Index
Payback Period
Payback period is the time duration required to recoup the investment
committed to a project. Business enterprises following payback period use
"stipulated payback period", which acts as a standard for screening the
project.
Management Science-II
Prof. R.Madumathi
When the cash inflows are uneven, the cumulative cash inflows are to
be arrived at and then the payback period has to be calculated through
interpolation.
Here payback period is the time when cumulative cash inflows are
equal to the outflows. i.e.,
Management Science-II
Prof. R.Madumathi
Decision Rules
A. Capital Rationing Situation
Select those projects from the top of the list till the capital
Budget is exhausted.
Decision Rules
C. Mutually Exclusive Projects
In the case of two mutually exclusive projects, the one
with a lower payback period is accepted, when the respective payback
periods are less than or equivalent to the stipulated payback period.
Management Science-II
Prof. R.Madumathi
The time value of money is ignored. For example, in the case of project
A Rs.500 received at the end of 2nd and 3rd years are given same
weightage. Broadly a rupee received in the first year and during any
other year within the payback period is given same weight. But it is
common knowledge that a rupee received today has higher value than
a rupee to be received in future.
But this drawback can be set right by using the discounted payback
period method. The discounted payback period method looks at
recovery of initial investment after considering the time value of
inflows.
Management Science-II
Prof. R.Madumathi
Example
There ARE TWO PROJECTS (Project A AND B) AVAILABLE FOR A
COMPANY, WITH A LIFE OF 6 YEARS EACH AND REQUIRING A
CAPITAL OUTLAY OF Rs.9,000/- EACH; AND ADDITIONAL WORKING
CAPITAL OF Rs.1000/- EACH.
Management Science-II
Prof. R.Madumathi
Example Data
Project A
Project B
Investment
10,000
10,000
Cash inflow
6-years
6-years
Year -1
3,000
2,000
Year -2
3,500
2,500
Year -3
3,500
2,500
Year -4
1,500
2,500
Year -5
1,500
3,000
Year -6
3,000
5,500
16,000
18,000
3 years
Payback period
Management Science-II
Prof. R.Madumathi
Example
Cumulative
Project A cash inflows
of Project A
Cumulative
Project B cash inflows
of Project B
Year -1
3,000
3,000
2,000
2,000
Year -2
3,500
6,500
2,500
4,500
Year -3
3,500
10,000
2,500
7,000
Year -4
1,500
11,000
2,500
9,500
Year -5
1,500
13,000
3,000
12,500
Year -6
3,000
16,000
5,500
18,000
Example
Management Science-II
Prof. R.Madumathi
or
Sometimes average rate of return is calculated by using the following
formula:
Management Science-II
Prof. R.Madumathi
Decision Rules
A. Capital Rationing Situation
Select the projects whose rates of return are higher than the cut-off
rate
Select projects starting from the top of the list till the capital available
is exhausted.
It Is Easy To Calculate.
Management Science-II
Prof. R.Madumathi
Example
The Profit (after tax) component of the cash inflows for each project
are given in the next slide.
Example
Net Profit After Tax
Year
Project A
Project B
1,580
280
2,080
1,080
2,080
1,080
80
1,080
80
2,580
80
1,880
5,980
7,980
5,980/6 = 996.6
7,980/6 = 1330
Management Science-II
Prof. R.Madumathi
Example
Taking into account the working capital released in the 6th year and
salvage value of the investment, the total investment will be (10,0001,500) Rs.8500 and the average investment will be (8500/2) Rs.4250
for each project.
Project A
Project B
Management Science-II
Prof. R.Madumathi
Then
Management Science-II
Prof. R.Madumathi
When the cash outflow is required for only one year i.e., in the
present year, then the Net present value is calculated as follows:
Decision Rules
A. "Capital Rationing" situation
Select projects whose NPV is positive or equivalent to zero.
Arrange in the descending order of NPVs.
Select Projects starting from the list till the capital budget allows.
Management Science-II
Prof. R.Madumathi
following equation:
Management Science-II
Prof. R.Madumathi
Management Science-II
Prof. R.Madumathi
Decision Rules
A. "Capital Rationing" Situation
Select those projects whose IRR (r) = k, where k is the cost of capital.
Arrange all the projects in the descending order of their Internal Rate of
Return.
Select projects from the top till the capital budget allows.
B. "No Capital Rationing" Situation
Accept every project whose IRR (r) = k,
where k is the cost of capital.
A new machinery costs Rs.8,200 and generates cash inflow (after tax)
per annum of Rs.2,000 during its life of 5 years.
IRR method involves trial and error in the sense that one has to
experiment with different rates of discount before arriving at the
appropriate rate at which the equation 1 and 2 are satisfied. But when
the cash inflows are by way of annuities the relevant interest factor is:
The present value of cash inflows = Rs.8200 and the present value
of cash outflow = Rs.8200
Management Science-II
Prof. R.Madumathi
Through the trial and error method, we can begin with a 10% discount
rate. The net present value assuming a 10% discount rate is
(2000 x 3.7908) - 8200 = 7581.6 - 8200 = -618.4.
Now, we have to interpolate the IRR which lies between these two
positive and negative NPV i.e., the discount rate that results in a 0
NPV.
Such projects whose IRR is equivalent to the cost of capital are called
marginal projects since the company on accepting them, will neither be
worse off nor better off. They will just pay for themselves.
Where the cash inflows are not uniform series and/or where cash
outflows occur at other periods besides the initial period, it is
necessary to experiment different rates and the appropriate rate could
be found out through interpolation.
Management Science-II
Prof. R.Madumathi
k0 is cost of capital
a0 is initial investment.
Management Science-II
Prof. R.Madumathi
Decision Rule
A. "Capital Rationing" Situation
Select all projects whose profitability index is greater than
or equivalent to 1.
Rank them in the descending order of their profitability indices and
Select projects starting from the top of the list till the capital budget
amount is exhausted.
A new machinery costs Rs.8,200 and generates cash inflow (after tax)
per annum of Rs.2,000 during its life of 5 years. Let us assume that the
cost of capital for the company is 6%.
Management Science-II
Prof. R.Madumathi