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Firms continuously invest in assets, these assets produce income and cash flows that the firm can than either reinvest in more asset or pay to the owners. This asset represents firm¶s capital. Capital is the firms¶ total asset. It includes all tangible and intangible assets. A firm¶s capital investment decisions are compromised of distinct decisions. The investment decision of the firm is known as capital budgeting decision. A capital budgeting may be defined as the firms decision to invest its current fund most efficiently in the long term asset in anticipation of expected flow of benefits over a series of year. An efficient allocation of capital is the most important finance function in modern times. Such decisions are of considerable importance to the firm since they tend to determine its value size by influencing its growth, risk and profitability.
Importance of Capital Budgeting because capital budgeting decisions impact the firm
for several years, they must be carefully planned. A bad decision can have a significant effect on the firm¶s future operations. In addition, the timing of the decisions is important. Many capital budgeting projects take years to implement. If firms do not plan accordingly, they might find that the timing of the capital budgeting decision is too late, thus costly with respect to competition. Decisions that are made too early can also be problematic because capital budgeting projects generally are very large investments, thus early decisions might generate unnecessary costs for the firm.
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Generating Ideas for Capital Budgeting²ideas for capital budgeting projects usually are generated by employees, customers, suppliers, and so forth, and are based on the needs and experiences of the firm and of these groups. For example, a sales representative might continue to hear from some of his or her customers that there is a need for products with particular characteristics that the firm¶s existing products do not possess.
The sales representative presents the idea to management, who in turn evaluates the viability of the idea. By consulting with engineers, production personnel, and perhaps by conducting a feasibility study. After the idea is confirmed to be viable in the sense it is saleable to customers, the financial manager must conduct a capital budgeting analysis to ensure the project will be beneficial to the firm with respect to its value.
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Capital is a limited resource
In the form of either debt or equity, capital is a very limited resource. There is a limit to the volume of credit that the banking system can create in the economy. Commercial banks and other lending institutions have limited deposits from which they can lend money to individuals, Corporations, and governments.
In addition, the Federal Reserve System requires each bank to maintain part of its deposits as reserves. Having limited resources to lend, lending institutions are selective in extending loans to their customers. But even if a bank were to extend unlimited loans to a company, the management of that company would need to consider the impact that increasing loans would have on the overall cost of financing.
In reality, any firm has limited borrowing resources that should be allocated among the best investment alternatives. One might argue that a company can issue an almost unlimited amount of common stock to raise capital. Increasing the number of shares of company stock, however, will serve only to distribute the same amount of equity among a greater number of shareholders.
In other words, as the number of shares of a company increases, the company ownership of the individual stockholder may proportionally decrease. The argument that capital is a limited resource is true of any form of capital, whether debt or equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on.
Even the best-known firm in an industry or a community can
increase it¶s the
company ownership of the individual stockholder may proportionally decrease. The argument that capital is a limited resource is true of any form of capital, whether debt or equity (short-term or long-term, common stock) or retained earnings, accounts payable or notes payable, and so on.
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Even the best-known firm in an industry or a community can increase its borrowing up to a certain limit. Once this point has been reached, the firm will either be denied more credit or be charged a higher interest rate, making borrowing a less desirable way to raise capital. Faced with limited sources of capital, management should carefully decide whether a particular project is economically acceptable. In the case of more than one project, management must identify the projects that will contribute most to profits and, consequently, to the value (or wealth) of the firm. This, in essence, is the basis of capital budgeting.
GOAL OF THE FIRM Maximize share holder wealth or value of the firm
Long term investment
Short term investment
As such capital budgeting decision have a major effect on the value of the firm and shareholder wealth.
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Features of capital budgeting
1.It involves the exchange of current funds for the benefits to be achieved in future. 2. The benefits are expected to be realized over a period of years.
3. Funds are invested in long term activities.
4. It involves generally huge funds.
5. They are irreversible decisions.
6. It has significant effect on the profitability of the concern.
7. A suitable administrative framework capable of transferring required information to the decision level.
The controlling of expenditures and careful monitoring of crucial aspects of project execution.
A set of decision rules which can differentiate acceptable from unacceptable alternatives is required.
10. A suitable administrative framework capable of transferring required information to the decision level.
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11. The controlling of expenditures and careful monitoring of crucial aspects of project execution.
12. A set of decision rules which can differentiate acceptable from unacceptable alternatives is required.
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Evolution of capital budgeting
Budgeting for capital expenditure has evolved over the decades and its importance has increased (or decreased) over time. Overall, six discernible stages of changes in capital budgeting practices and systems can be identified.12 The first stage is the Great Depression years during which efforts were mainly focused on designing ways to ensure economic recovery.
At the time, public borrowing for financing capital outlays, except for emergencies, was not favored. In a cautious approach, Sweden introduced a capital budget that was to be funded by public borrowing and used to finance the creation of durable and self-financing assets that would contribute to an expansion of net worth equivalent to the amount of borrowing. This so-called investment budget found extended application in other Nordic countries in following years.
The second stage took place during the late 1930s when the colonial government in India introduced a capital budget to reduce the budget deficit by shifting some items of expenditures from the current budget. It was believed that the introduction of this dual budget system would provide a convenient way to reduce deficits while justifying a rationale for borrowing. The third stage refers to the growing importance attached to capital budgets as a ³vehicle´ for development plans. Partly influenced by the Soviet-style planning, many low-income countries formulated comprehensive five-year plans and considered capital budgets the main impetus for economic development. Where capital budgets did not exist, a variant known as the development budget was introduced.
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Capital Budgeting in the 1960s to 1990s
The fourth stage reflects the importance of economic policy choices on the allocation of resources in government. Quantitative appraisal techniques were applied on a wider scale during the 1960s leading to more rigorous application of investment appraisal and financial planning.
In the 1960s and 1970s, it was widely believed that government budget a llocation, including investment expenditures, could be largely reduced to a ³scientific´ process by systems such as PPBS (planning, programming and budgeting system) or even ZBB (zerobased budgeting). Spackman believed that this turned out not to be true, for three main reasons. One reason was that, for most public policies, finding the best way forward depends not only on analysis but very largely on pragmatism, political intuition and windows of political opportunity.
Second, the information demands were equivalent to those required to run a centrally controlled economy. Third, the implied power structure within government was that of control in detail from the center, as opposed to delegated authority, incentive structures and local initiative.
A fifth stage saw a revival of the debate about the need for a capital budget in government, particularly in the United States. Along with the growing application of quantitative techniques during the 1960s came the view that the introduction of a capital budget could be advantageous. But this view did not gain much support. A president¶s commission in 1999 investigating budget concepts in the United States concluded that a capital budget could lead to greater outlays on bricks and mortar, and as a result, current outlays could suffer.
Having rejected the use of separate capital budgets, the commission advocated the introduction of accrual accounting in government accounts. The introduction of accrual accounting, which did not make any progress in the United States until the early 1990s, would have meant the division of expenditures into current and investment outlays.
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Meanwhile, however, a development cast more serious doubts on the need for capital budgets. Sweden (and other Nordic countries), which had made pioneering efforts in the 1930s, undertook a review of its budget system in the early 1970s. They found that excessive focus on capital budgets would need to be tempered by a recognition that the overall credibility and creditworthiness of a government depend more on its macroeconomic policy stance and less on a government¶s net worth. This shift in emphasis contributed to a decline in the popularity of the use of the capital budget until the late 1980s, when it came to be revived in a different form. By then, government officials recognized that the management of government finances required a new approach, and this approach was the application of accrual accounting.
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Component of Capital Budget
Initial Investment Outlay:
It includes the cash required to acquire the new equipment or build the new plant less any net cash proceeds from the disposal of the replaced equipment. The initial outlay also includes any additional working capital related to the new equipment. Only changes that occur at the beginning of the project are included as part of the initial investment outlay. Any additional working capital needed or no longer needed in a future period is accounted for as a cash outflow or cash inflow during that period.
Net Cash benefits or savings from the operations: This component is calculated as follow: The incremental change in operating revenues-The incremental change in the operating cost = Incremental net revenueTaxes ± Changes in the working capital and other adjustments
Terminal Cash flow
It includes the net cash generated from the sale of the assets, tax effects from the termination of the asset and the release of net working capital.
The Net Present Value technique
Although there are several methods used in Capital Budgeting, the Net Present Value technique is more commonly used. Under this method a project with a positive NPV implies that it is worth investing in.
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A company is studying the feasibility of acquiring a new machine. This machine will cost $350,000 and have a useful life of three years after which it will have no salvage value. It is estimated that the machine will generate operating revenues of $300,000 and incur $75,000 in annual operating expenses over the useful life of three years. The project requires an initial investment of $15,000 in working capital which will be recovered at the end of the three years. The firm¶s cost of capital is 16%. The firm¶s tax rate is 25%.
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Significance of capital budgeting
The key function of the financial management is the selection of the most profitable assortment of capital investment and it is the most important area of decision-making of the financial manger because any action taken by the manger in this area affects the working and the profitability of the firm for many years to come.
The need of capital budgeting can be emphasized taking into consideration the very nature of the capital expenditure such as heavy investment in capital projects, long- term implications for the firm, irreversible decisions and complicates of the decision making. Its importance can be illustrated well on the following other grounds:-
Indirect Forecast of Sales:
The investment in fixed assets is related to future sales of the
firm during the life
time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in over investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the firm to serious economic results.
Comparative Study of Alternative Projects:
Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in the replacement of assets. For this purpose, the profitability of each project is estimated.
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Timing of Assets-Acquisition:
Proper capital budgeting leads to proper timing of assets-acquisition and improvement in quality of assets purchased. It is due to the nature of demand and supply of capital goods. The demand of capital goods does not arise until sales impinge on productive capacity and such situations occur only intermittently. On the other hand, supply of capital goods with their availability is one of the functions of capital budgeting.
Capital investment requires substantial funds which can only be arranged by making determined efforts to ensure their availability at the right time. Thus it facilitates cash forecast.
Wealth-Maximization of Shareholders:
The impact of long-term capital Investment decisions are far reaching. It protects the
interests of the shareholders and of the enterprise because it avoids over-investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity share-holders
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Features which distinguish capital budgeting decisions from ordinary day to day business
1. Calculation is based on cash flow as it is the cash in hand that is important for immediate investment and not the profit which may not be entirely in cash (Cash flow = Accounting profit before depreciation, interest and tax interest tax + depreciation) depreciation
2. It involves the exchange of current funds for the benefits to be achieved in future.
3. The future benefits are expected to be realized over a series of years.
4. A significant period of time (more than one year) elapses between the investment outlay and the receipt of the benefits.
5. They influence the firm¶s growth in the long run as the effects of investment decision extend into the future.
6. They affect the risk of the firm as the investment is made now but the benefits occur in future and the future is uncertain.
7. The funds are invested in non-flexible and long-term activities.
8. They involve commitment of large amount of funds and therefore requires a careful planning to the taken beforehand.
9. It involves a long term and significant effect on the profitability of the concern.
10. They are irreversible, or reversible at substantial loss. Long term assets such as machinery once acquired are not easy to resell (dispose off) them unless otherwise.
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Capital budgeting process.
Identification of potential investment opportunities:
The capital budgeting process begins with the identification of potential investment opportunities. Typically the planning body develops estimates of future sales which serve as the basis for setting production target. This information in turn is helpful in identifying required investment in plant and equipment.
Assembling of investment proposals:
Investment proposal identified by the
production department and other
department are usually submitted in the standardized capital investment proposal firm. Generally most the proposal, before they reach the capital budgeting committee or somebody which assembles them, are routed through several persons. The purpose of routing a proposal through several persons is primarily to ensure that the proposal is viewed from different angles. It also helped in creating a climate for bringing about coordination of interrelated activities. Investment proposals are usually classified into various categories for facilitating decision making, budgeting, and controlling.
Evaluate Opportunities: Once you have identified the reasonable opportunities, you need to determine which ones are the best. Look at them in relation to your overall business strategy and mission. See which opportunities are actually realistic at the present time and which ones should be put off for later.
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Next, you need to determine how much cash flow it would take to implement a given project. You also need to estimate how much cash would be brought in by such a project. This process is truly one of estimating--it takes a bit of guesswork. You need to try to be as realistic as you can in this process. Do not use the best-case scenario for your numbers. Most of the time, you need to use a fraction of that number to be realistic. If the project takes off and the best-case scenario is reached, that is great. However, the odds of that happening are not the best on new projects.
After you look at all of the possible projects, it is time to choose the right project mix for your company. Evaluate all of the different projects separately on their own merits. You need to come up with the right combination of projects that will work for your company immediately. Choose only the projects that mesh with your company goals.
A system of rupee gate ways usually characterizes capital investment decision making. Under this system, executives are vested with the power to okay investment proposal up to certain limit. For example, in one company the plant superintendent can okay investment outlays up to Rs 2,000,000 the works manager up to Rs 5,000,000 and the managing director up to Rs 20,000,000. Investment requiring hire outlays need the approval of the board of directors.
Preparation of capital budget and appropriation:
Project involving smaller outlays and which can be decided by executive at lower
levels are often covered by the blanket appropriation for expeditious action projects involving larger outlays are included in the capital budget after necessary approvals. Before undertaking such projects an appropriation order
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in usually required. The purpose of this check is mainly to ensure that the fund position of firm is satisfactory at the time of implementation further, it provides an opportunity to review the project at the time of implementation.
Translating an investment proposal into concrete project is complex, time consuming, and risk fraught task. Delays in implementation, which are common, can lead to substantial cost over runs.
Performance Review: Performance review, post completion audit, is a feedback device. It is a measure for comparing actual performance with project performance. It may be conducted, most appropriately, when the operations of the project have established. It is useful in several ways:
It throws the light on how realistic were the assumptions underlying the project. It provides a documented log of experience that is highly valuable for decision making.
It helps in uncovering judgmental biases. It includes a desired caution among project sponsors.
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Rationale of Capital Expenditure decisions
The rationale underlying the capital budgeting decision is efficiency. Thus, the firm must replace worn and obsolete plants and machinery, acquire fixed asset for current and new products and make strategic investment decisions. This will enable the firm to achieve its objective of maximizing profits either by way of increased revenues or by cost reductions. The quality of these decisions is improved by capital budgeting. Capital budgeting decisions can be of two types: (i) those which expand revenue (ii) those which reduce costs.
Investment Decisions Affecting Revenue:
Such investment decisions are expected to bring in additional revenue, thereby raising the size of the firm¶s total revenue. They can be the result of either expansion of present operations or the development of a new product line. Both types of investment decisions involve acquisition of new fixed assets. Both types of investment decisions are income expansionary in nature.(e.g. Tata steel acquisition of Corus, RIL setting Oil and Gas exploration in K.G. basin etc.)
Investment Decisions Reducing Costs:
Such decisions by reducing costs, add to the total earnings of the firm. The classic example of such investment decisions is the replacement proposals. When an asset wears out or becomes outdated, the firm must decide whether to continue with the existing asset or replace it. The firm evaluates the benefit from the new machine in term of lower operating cost and the outlay that would be needed to replace the machine. An expenditure on a new machine may be quite justifiable in the light of the total cost savings that result.
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Replacement decision: by a newer version
A decision concerning whether an existing asset should replaced
of the same machine or even a different type of machine that does the same thing as the existing machine. Such replacements are generally made to maintain existing levels of operations, although profitability might change due to changes in expenses (that is, the new machine might be either more expensive or cheaper to operate than the existing machine).
A decision concerning whether the firm should increase operations by adding new products, additional machines, and so forth. Such decisions would expand operations
y Independent project: The acceptance of an independent project does not affect the accepta of any other nce project that is, the project does not affect other projects. For example, if you have a large sum of money in the bank that you would like to spend on yourself, say, $150,000. You decide you are going to buy a car that costs about $30,000 a a new stereo system for nd your house that costs less than $5,000. The decision to buy the car does not affect the decision to buy the stereo²they are independent decisions.
Mutually exclusive projects:
In this case, the decision to invest in one project affects other projects because only one project can be purchased. For example, if in the above example you decided you were going to buy only one automobile, but you were looking at two different types of cars, one is a Chevrolet and the other is a Ford. Once you make the decision to buy the Chevrolet, you have also decided you are not going to buy the Ford.
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y Mandatory investment:
These are expenditure required to comply with statutory requirements. Examples of such are pollution control equipment, medical dispensary, fire fitting equipment, crèche in factory premises and so on. These are often non revenue producing investments. In analyzing such investments the focus is mainly on finding the most cost effective way of fulfilling a given statutory need.
y Diversification projects:
These investments are meant to increase capacity and widen the distribution network. Such investment call for an explicit forecast of growth. Since this can be risky and complex, expansion projects normally warrant more careful analysis than replacement projects. Decisions relating to such projects are taken by the top management.
y Miscellaneous projects:
This is catch all category that includes items like interior decoration, recreational facilities, executive aircrafts, landscape garden, and so on. There is no standard approach for evaluating these project and decision regarding them are based on personal preferences of top management.
y Research and development project:
Traditionally, R&D projects absorbed a very small proportion of capital budget in most Indian companies. Things however are changing. Companies are now allocating more funds to R:&:D projects more so knowledge intensive industries. R&D are characterized by numerous uncertainties and typically involve sequential decision on the basis of managerial judgment.
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Capital budgeting technique
The capital budgeting decision has been a very typical issue in the sustenance of a company. Several companies have lost their identity or liquidated due to wrong capital budgeting decision they made at one particular time or the other. Based on these prevalent problems in industries and the effect of globalization on industries, it is important to use effective method to analyze investment before decision is made. Capital budgeting is extremely important because the decision made involve the direction and opportunity for future growth of the organization. One of the traditional methods commonly used for capital investment appraisal by some organizations is the payback method, although this method has been criticized by academicians that it does not include the future cash flow and do not measure profitability. The wide acceptance of this method by practicing managers, has called for investigation as why is the method is still popularly used in organization. Firms operating in a dynamic environment must continuously make changes in different areas of its operations in order to meet the needs of a challenging environment for growth and survival. Continuous change assists in improving the operational process, thereby putting the organization at an advantage over their competitors. Most changes involve capital expenditure decisions, which can invariably involve large sums of money. The expenditure might involve expansion in the current line of business, diversification or takeovers. Prior to the decision of appraising an investment opportunity, the organization must identify a strategic need for investment in the project. The need will determine aspects like, which of the many investment opportunities before the entity will best help to meet their strategic objectives, how much to commit to the project in terms of funds, human resource and the time towards the investment. Most of the strategic decisions which necessitate large investments require managers to undertake detailed project analysis before a final decision is made on whether or not to invest money in such a project. All investments will have one form of return or another and the investment decision would be dependent on the potential returns and their adequacy to justify the sacrifices,(opportunity cost) the investing entity would have to make.
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Organizations justify large capital investments decisions using different capital appraisal techniques. These techniques have been developed over the years from the insight and analysis of many researchers and practitioners and have become a standard practice in project appraisal. They can be broadly classified in traditional
methods and modern method.
Capital budgeting technique
Some of the traditional techniques that have been used over the decades by practitioners are payback period and accounting rate of return. Academics have argued that these techniques lack the sophistication for any conclusive analysis and have unanimously rejected their use for project appraisal. The main drawback in these techniques is their inability to consider the cash flow
timing and its dependence on book profits. Although severely criticized as theoretically unacceptable in valuing projects, surveys have found wide acceptance of its use mainly as a rule of thumb by executives. Some of the traditional approaches are as follows:
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y Payback period
y Payback period:
The payback method of investment appraisal, used for evaluating capital projects, calculates the annual returns from the initiation of the project until the accumulated returns are equal to the cost of the investment, at which time the investment is said to have been paid back. The time required to achieve this payback is termed the payback period. Under the PB method the required payback period sets the hurdle rate (threshold barrier) for project acceptance. (Lefley 1996) The PB method is generally used as a comparison of two or more projects and has a wide acceptance as a rule of thumb. In a survey in India, Cherukuri (1996) analyzed that payback was widely used as a ³supplementary decision criterion´. In a similar study of 151 firms by Petry and Sprow (1993), he finds the most firms used payback as a secondary measure of capital budgeting. The payback period is defined as the time required recovering the initial investment in a project from operations. The payback period method of financial appraisal is used to evaluate capital projects and to calculate the return per year from the start of the project until the accumulated returns are equal to the cost of the investment at which time the investment is said to have been paid back and the time taken to achieve this payback is referred to as the payback period. The payback decision rule states that acceptable projects must have less than some maximum payback period designated by management. Payback is said to emphasize the management¶s concern with liquidity and the need to minimize risk through a rapid recovery of the initial investment. It is often used for small expenditures that have obvious benefits that the use of more sophisticated capital budgeting methods is not required or justified. The payback period answers the question of how long does it takes the project to µpay back´ its initial
investment. One of the oldest and most widely used method to evaluate a capital investment proposal is the Payback Period, as the name implies it refers to the time
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required to recover the initial investment or the initial cash outlay as it is called in financial terms.
What is the formula for Payback Period?
Payback Period Example Let us illustrate finding payback period with an example investment proposal. Let us say you were offered a series of cash inflows at the end of each of the next four years as $5000, $4000, $3000, and $1000. Say the initial cash outlay for this proposal is $10,000.
Initial investment $10000
Year 1 2 3 4
Cash flows 5000 4000 3000 1000
Cumulative cash flow 5000 9000 12000 13000
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Payback Period Step by Step
We add up the cash inflows beginning after the initial cash outlay in the cumulative cash inflows column We keep an eye on this last column and track the last year for which the cumulative total does not exceed the initial cash outlay
We compute the part or fraction of the next year's cash inflow need to payback the initial cash outlay by taking the initial cash outlay less the cumulative total in the last step then divide this amount by the next years cash inflow.
E.g., ( $10,000 - $9,000 ) / $3,000 = 0.334
To now obtain the payback period in years , we take the figure from the last step and add it to the year from the step 2. Thus our payback period is 2 + .334 = 2.334 years
Instead of represent the years as decimal value we could represent the payback period in years and months this way We take the fraction 0.334 and multiply it by 12 to get the months which is 4.01 months. Thus our payback period is 2 years and 4 months
The earlier the investment is recovered, sooner the cash funds can be used for other purpose. The risk from loss of obsolesces and changed economic condition is less in a shorter payback period Minimum acceptance criteria: Whatever may be set by management?
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Arguments in favour of payback: The payback method is popular because of its simplicity. Studies by McIntyre and Coulthurst (1986) observe that the PB has shown a considerable capacity for survival despite an indication in the literature of the growing acceptance of the more sophisticated methods like the discounted cash flow. In another study, Fremgen (1973) shows that the use of PB is positively related to capital budget size of the firm. Firms with large budgets (i.e. over $100 million) made more use of PB than firms with smaller budgets.
Secondly, in a business environment of rapid technological change, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential in the appraisal of advanced manufacturing technology (AMT) projects in both the UK and USA
of 61 Arguments against payback Academics have identified two main deficiencies in the pay back period.
1) Omits cash flow:
The PB method doesn¶t take into account cash flows after the project's payback period. The method only takes into account project returns up to the payback period. Certain projects are, by their very nature, long-term projects, the benefits of which may not accrue until sometime in the future, usually well beyond the normal payback period. With such a profit profile the PB is said to be biased against the acceptance of such projects. These projects may, however, be vital for the long-term success of the business. It is therefore important to use the PB method more as a measure of project liquidity rather than project profitability.
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2) Time value of money:
The method ignores the time value of money. Academics have severely criticized this flaw in evaluating investment projects. However a solution to this deficiency has been suggested through modification of the simple PB method into a discounted payback period (DPB), thereby searching the payback period when the accumulated present value of the cash flows covers the initial investment outlay. He further argues that the PB method fails to reflect all the dimensions of profitability relevant to capital expenditure decisions, and it is not inclusive for investment evaluation purposes.
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ARR Accounting Rate Return Rule:
A measure of the return on an investment over a given period, equal to average projected earnings minus taxes, divided by average book value over the duration of the investment. This measure can also be calculated using average projected earnings without excluding taxes, or average projected earnings less taxes and depreciation. This ratio measures how well investment assets are being used to generate income. The accounting rate of return (ARR), computed from the financial statements, is a periodic and an ex post indicator. Vatter (1966) ascertains that ARR is a figure based only on the data related to a given year, and is not referenced to other parts of the project except the year to which it applies. It is commonly defined as the ratio of accounting profit earned in a particular period to the book value of the capital employed in the period. According to the different numerators and denominators applied to calculate ARR, there are several kinds of definitions used in analysis. For the numerator of ARR, it is usually financial annual accounting profit or income, while the denominator is often determined by book value of assets or book value of equity. Employing the µclean surplus¶ concept, Peasnell (1982) defines ARR as the ratio of the accounting profit to the book value of assets at the beginning of the period.
Average Net Income Average Book Value of Investment
Case Example Initial Investment =$8000
Life = 15 years
Cash inflows per year = $1,300
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Calculation: Depreciation = [Cost - Salvage Value]/Life = $8,000/15 = $533 ARR = [cash Inflows per year Depreciation]/Initial Investment
= [$1,300 - $533]/$8,000 = $767/$8,000 = 9.6% If you use average investment, ARR is:
ARR = $767/[$8,000/2] = $767/$4,000 = 19.2%
Note: When average investment is used, rather than the initial investment, accounting rate of return is doubled
Arguments in favour of ARR:
1) Uses readily available information:
The advantage in ARR is the easy availability of information for the computation of results. The accounting data can be readily obtained from annual reports.
2) Easily understood:
The method was favored by managers due to the ease in understanding the process and results. It has also been preferred as it is easy to convey to non-financial executives.
ARR is most often used internally when selecting projects. It can also be used to measure the performance of projects and subsidiaries within an organization.
Arguments against ARR:
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The ARR method lacks general acceptance as an investment criterion because: 1) When analyzing investment / projects the managers are interested in the cash flows earning over the life of the project and since ARR is based on numbers that include non-cash items, it doesn¶t give a true picture of project quality.
2) The ARR method does not take into account the time value of money. Unlike the other modern techniques which account for the timing of the cash flows, ARR values £1 today as similar to £1 at the end of the year.
3) Although the ARR is simple to calculate the other methods of capital investment valuation are not very difficult to calculate given the availability of computing power. The data may also be unreliable due to problems of creative accounting.
Conclusion of traditional approach in capital budgeting
We can conclude on the basis of previous literature and criticism that since ARR and PB method does not take into account the time value of money, and is wholly unadjusted for non-cash items, any investment decision based on it is necessarily seriously flawed. Its only advantage is that it is very easy to calculate. It only uses the comparison of the cash inflow and cash out flow which is not an appropriate method for long term investment therefore modern methods have been introduced and are being used greatly for healthy decision for capital investment.
Modern methods have come up to be widely used for project appraisal purposes
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in recent years. These techniques mainly classified as discounted cash flow (DCF) Techniques have received support from academics due to its theoretical completeness and accuracy. The DCF techniques covers up all the major drawbacks of the payback and accounting rate of return and hence are considered the best tools for value maximization. The two DCF techniques we will analyze in detail are the Net present value (NPV) and the Internal Rate of return (IRR).
y NPV y IRR y Discounted Cash Flow y Profitability Index NPV:
The net present value method is the classic economic method of evaluating the investment proposals. It is a DCF technique that explicitly recognizes the time value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents- present value are found out. The primary capital budgeting method that uses discounted cash flow techniques is called the Net Present Value (NPV). Under the NPV net cash flows are discounted to their present value and then compared with the capital outlay required by the investment. The difference between these two amounts is referred to as the NPV. The interest rate used to discount the future cash flow is the required rate of return. A project is accepted when the net present value is zero or positive the key inputs of the calculation of NPV are the interest rate or ³discount rate´ which is used to compute present values of future cash flows. If the discount rate exceeds the shareholder¶s required rate of return, and the project has a positive NPV at this rate, then shareholders will expect an additional profit that has a present value equal to the NPV. Thus if the goal of the corporation is to maximize shareholder wealth, managers would undertake all projects that have a positive NPV, or choose the higher NPV project if faced with two or more mutually exclusive positive NPV projects. NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.
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Net Present Value =Total PV of the future CF¶s- Initial investment
Example1 Initial investment of Rs100 Years Cash flows DCF Present value of cash flows 1 2 3 4 5 40 30 30 20 15 0.909 0.826 0.753 0.683 0.621 36 24 23 17 9
Net Present Value= Present value of Inflows Steps involved in the calculation of NPV:
Present value of investment Project
1. Cash flows of the investment project should before casted based on realistic assumptions.
2. Appropriate discounted rate should be identified. This appropriate rate is the opportunity cost of capital of a project which is equal to the required rate of return expected by investors on investments of equivalent risk.
3. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.
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4. Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows.
Arguments in favour of NPV Method: 1. Time Value:
It recognizes time value of money while evaluating an investment proposal. A
rupee received today is worth more than a rupee received tomorrow. The NPV technique recognizes the time value of an investment opportunity. The time value states that a pound today is more valuable than a pound tomorrow. Techniques which fail to consider this primary criterion must be flawed in their valuation.
2. Measure of true Profitability :
It uses all cash flows occurring over the entire
life of project in calculating its
worth. Hence, it is a measure of the project¶s true profitability. The NPV method relies on estimated cash flows and the discount rate rather than any arbitrary assumptions, or subjective consideration. the accounting practice like depreciation and non-cash expenditures, managements taste and profits from existing business don¶t affect the decision.
Additives: The discounting process facilitate measuring cash flows in terms of present values; that is, in terms of equivalent, current rupees. Therefore, the NPVs of projects can be added. Since the present values are a measure of future returns, they can be easily added up. Hence incase of two projects even with different time horizon, the present value of the combines investment is the sum of the parts. The
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additivity property assists in recognizing suboptimal opportunities which are packaged with good projects.
5. Shareholder¶s value:
The NPV method is always consistent with the objective of the shareholder value maximization. This is the greatest virtue of the method.
Arguments against NPV methods: 1. Changes in net annual flows:
If a project NPV exhibits inconsistent behavior of annual net benefits or net cash flow from a project due to change in sign more than once over the planning
horizon, the method becomes unsuitable for certain types of investment decisions. This makes NPV technique less useful in valuing highly technical and risky projects.
NPV systematically undervalues all investment projects. This is due to the strong implicit assumptions made that no decisions would be taken in the future after the investment decision. The technique ignores the managerial flexibility and the availability of options in the decision making process once the investments has been made. Managers are known to undertake negative NPV projects in many cases
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because they are armed with the options of expansion, delay, abandonment and contracting (shrink) the project which has value.
3. Only mutually exclusive alternatives:
NPV technique treats some options as mutually exclusive from others. Consider a deferral option where a project can be deferred for one or two years. NPV would value the two cases separately to seek the option with higher value. It forces to conceive of false mutually exclusive alternatives when confronted with decisions that could be made in the future.
The relationship between the advantages and disadvantages of NPV and its use:
For the relationship between the degree of using NPV and its advantages, all conducted tests produced coefficients that have positive sign and strong relationship; no less than 0.50 and these results are statistically significant at 0.05 level. This means that the perception of respondents to the advantages of the NPV positively and strongly affect its use. While for the relationship between the degree of using NPV and its disadvantages, the results showed a very small relationship; less than 0.10 and these result are statistically insignificant at 0.05 level. We can say that the perception of the respondents to the disadvantages of the NPV does not affect its use. This finding agrees with the previous finding about the importance of the NPV techniques¶ advantages, agrees with the finding that NPV is the second most used technique, and agrees with the finding that advantages of NPV techniques were perceived to be important by the respondents. Also the finding agrees with perception of the respondents to the disadvantages of the NPV, where the respondents perceive them a less than moderately important
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The Discounted Payback Period:
The payback method based on discounted cash flow figures was proposed by Rappaport (1965) which related the opportunity investment rate notion to the payback period measurement. This method attempted to overcome one of the drawbacks of the conventional payback calculation which failed to take into account a company¶s cost of capital. The discounted payback period method proposed by Rappaport is an improved measure of liquidity and project time risk over the conventional payback method and not a substitute for profitability measurement because it still ignores the returns after the payback period. He stated that, the proper role for the discounted payback period analysis is as a supplement to profitability measures and thus highlighting the supportive nature of the payback method, whether conventional or discounted payback period How long does it take the project to Pay Back its initial investment taking the time value of money into account? Payback Period does not consider time value of money when providing an answer whereas with Discounted Payback Period we get to see the real value of cash inflows when they are measured in today's amount of money as these are discounted at an interest rate called the Discount Rate. We get to see the number of years required to recoup the initial cash outlay or our investment.
Discounted payback period= year before recovery +unrecovered cost at the start of the year
Cash flow during the year
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Discounted Payback Period Example Let us illustrate finding Discounted Payback Period with an example investment proposal. Let us say you were offered a series of cash inflows at the end of each of the next four years as Rs 6000, Rs2000, Rs1000, and Rs5000 Say the Initial Cost Outlay for this proposal is Rs8000
PV ratio @12 %
Cumulative cash flow
1 2 3 4
6000 2000 1000 5000
0.893 0.797 0.712 0.636
5358 1594 712 3180
5385 6952 7664 10844
Discounted payback period = 3+336 3180 =3.105yrs.
Discounted Payback Period Step by Step
We add up the discounted cash inflows beginning after the initial cash outlay in the cumulative cash inflows column
We keep an eye on this last column and track the last year for which the cumulative total does not exceed the initial cash outlay.
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We compute the part or fraction of the next year's cash inflow need to payback the initial cash outlay by taking the initial cash outlay less the cumulative total in the last step then divide this amount by the next years cash inflow.
To know obtain the discounted payback period we take the figure from the last step and add it to the year thus the discounted payback period is 3+.105=3.105yrs
Instead of represent the years as decimal value we could represent the Discounted Payback Period in years and months this way. We take the fraction o105 and multiply it by 12 to get the months which is 1.26 months.
Arguments in favour of Discounted cash flow:
Theoretically, the DCF is arguably the most sound method of valuation.
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2. The DCF method is forward-looking and depends more future expectations rather than historical results.
3. The DCF method is more inward-looking, relying on the fundamental expectations of the business or asset, and is influenced to a lesser extent by volatile external factors.
4. The DCF analysis is focused on cash flow generation and is less affected by accounting practices and assumptions.
5. The DCF method allows expected (and different) operating strategies to be factored into the valuation.
6. The DCF analysis also allows different components of a business or synergies to be valued separately.
Arguments against Discounted cash flow:
1. The accuracy of the valuation determined using the DCF method is highly dependent on the quality of the assumptions regarding FCF, TV, and discount rate. As a result, DCF valuations are usually expressed as a range of values rather than a single value by using a range of values for key inputs. It is also common to run the DCF analysis for different scenarios, such as a base case, an optimistic case, and a pessimistic case to gauge the sensitivity of the valuation to various operating assumptions. While the inputs come from a variety of sources, they must be viewed objectively in the aggregate before finalizing the DCF valuation. 2. The TV often represents a large percentage of the total DCF valuation. Valuation, in such cases, is largely dependent on TV assumptions rather than operating assumptions for the business or the asset.
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The Internal Rate of Return rule:
IRR is the discount rate that sets NPV to zero. The IRR differs from the NPV in that it results in finding the internal yield of the potential investment. The IRR is calculated by discounting the net cash flows using different discount rates till it gives a net present value of zero. However it may be easily calculated financial calculators or excel program. Internal Rate of Return or IRR is the investor's required rate of return which equates the initial cash outlay with the present value of series of expected cash flows. In other words, IRR is the rate at which the difference between initial cash outlay and present value of cash inflows in zero The internal rate of Return (IRR) is the discount rate that equals the present value of a future steam of cash flows to the initial investment. In simple terms, discount rate is the rate at which the Net present value of a project equals zero. It can be thought of as the annualized rate of return (in percent) of an investment using compound interest rate calculations. Graphically
The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted. When choosing among mutually exclusive
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projects, the project with the highest IRR should be selected (as long as the IRR is greater than the cost of capital).
IRR Example Let us illustrate finding Internal Rate of return with an example investment proposal. Let us say you were offered a series of cash inflows at the end of each of the next four years as $5000, $4000, $3000, and $1000. Say the initial cash outlay for this proposal is $10,000.
1 2 3 4
Net Cash Flows
5000 4000 3000 1000
PVIF @ 10%
0.909 0.826 0.751 0.683
$4,545 $3,304 $2,253 $683 $10,785
NPV = $785
Minimum acceptance criteria:
Accept if the IRR exceeds the required rate. Select the alternative with highest IRR.
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Arguments in favor of IRR technique:
1) Present value method:
The IRR technique computes the present value of investment opportunities cash flows and hence takes into account the time value of money. This value states that a pound today is more valuable than a pound tomorrow. This is a primary condition in the choice of investment of investment appraisal techniques.
2) Based on cash flows:
The IRR is based on the expected net cash flows from the project. These cash flows are computed as total cash inflow less total cash outflow. Hence the accounting practice like depreciation and profits from existing business don¶t affect the decision making process.
3) Easy to understand:
Returns expressed in terms of percentage are easier to understand and communicate for managers and shareholders compared to NPV, due to unfamiliarity with the details of the appraisal techniques.
4) Maximum profitability of Shareholder
If there is only project which we have to select, if we check its IRR and it is higher than its cut off rate, then it will give maximum profitability to shareholder
Arguments against IRR technique:
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1) Reinvestment rate assumption:
The IRR assumes that the time value of money is the project specific IRR, as it doesn¶t discount the cash flows at the opportunity cost of capital. The method assumes that the intermediate cash flows can earn the same rate of returns as the original project, and this creates unrealistic returns to the management and shareholders. It can be very unreasonable to expect the returns to remain stable over the life of the project and hence can give a misleading view of a proposed investment.
2) Not absolute size:
The IRR method is unsuccessful in measuring returns in terms of absolute amounts of wealth changes. It only gives a percentage measure of returnsand this may cause difficulties in ranking projects where there are conditions of mutual exclusivity.
3) Additivity not possible:
The IRR technique fails to supports the additivity principle when evaluating multiple projects as the returns are expressed in percentage terms. The additivity principle is particularly necessary when evaluating project of different time horizons.
NPV vs IRR Methods:
Key differences between the most popular methods, the NPV (Net Present Value) Method and IRR (Internal Rate of Return) Method, include:
NPV is calculated in terms of currency while IRR is expressed in terms of the
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Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not;
The IRR Method cannot be used to evaluate projects where there are changing cash flows (e.g., an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm);
However, the IRR Method does have one significant advantage -- managers tend to better understand the concept of returns stated in percentages and find it easy to compare to the required cost of capital; and, finally,
While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows, is preferable to a larger project that will generate more cash.
Applying NPV using
different discount rates will result in different
recommendations. The IRR method always gives the same recommendation.
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The Profitability Index rule:
A Profitability index (PI), alternatively referred to as a profit investment ratio or a value investment ratio, is a method for discerning the relationship between the costs and benefits of investing in a possible project. It calculates the cost/benefit ratio of the present value(PV) of a project¶s future cash flow over the price of the project¶s initial investment. This formula is commonly written as PI = PV of future cash flows ÷ initial investment. The figure this formula yields helps investors decide on whether or not a project is financially attractive enough to pursue. The profitability index, also known as the benefit-cost ratio, is another measure that uses a simple rule to evaluate cash flow results for a given project. In this case, the profitability index rule would tell managers and executives to accept all projects that have an index value that is equal to or greater than 1.
Calculating Profitability Index
The calculation of profitability index is based on a simple relationship between a project's costs and the discounted after tax cash flow it produces. The formula for profitability index is as follows: Profitability Index = Present Value of Cash Flows / Cost of Project So the rule of thumb for profitability index would state that we accept all projects that produce benefits (present value) that are in excess of the project's cost.
Profitability Index Example
We'll use the following discounted cash flows to illustrate how profitability index is calculated:
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DCF Method -1,000
Based on the above information we know: Present Value of Cash Flows = 459 + 421 + 387 = 1,267
Cost of Project = 1,000 So the profitability index in this example would be 1,267 / 1,000 or 1.267 which is greater than one. Therefore we would accept this project as a good
Arguments in the favour of profitability index: y
One of the strengths of profitability index is that it will provide us with the same result as the net present value method. If the NPV of cash flows is positive, then Profitability Index will be greater than one
May be useful when available investment funds are limited.
Easy to understand and communicate.
Correct decision when evaluating independent projects.
Arguments against profitability index:
Problems with mutually exclusive investment.
Minimum acceptance criteria: Accept if PI >1
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NPV V/S PI
The NPV method and PI yield same accept or reject rules, because PI can be greater than one only when the project net present value is positive. In case of marginal project, NPV will be zero and PI will be equal to one. But a conflict may arise between the two methods if a choice between mutually exclusive projects has to be made. Consider the following illustration.
Project c PV cash inflow Initially cash outflow NPV PI 100000 50000 50000 100000 =2.0 500000
Project d 50000 20000 30000 50000 =2.5 20000
Project c should be accepted if we use NPV method, but project d is preferable according to PI method.
The NPV method should be preferred expect under capital rationing, because the net present value represent the net increase in the firms wealth. In our illustration, project c contributes all that project d contributes plus additional net present value of Rs 20000 (Rs50000-Rs30000) at an incremental cost of Rs 50000 (Rs100000-Rs50000). As the net present value of project c incremental outlay is positive, it should be
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accepted. Project c is also applicable if we calculate the incremental profitability index.
Project c PV of cash inflows Initial cash outflow NPV 100000 (50000) 50000
Project d 50000 (20000) 30000
Incremental flow 50000 (30000) 20000
Because the incremental investment has positive net present value, Rs 20000 and a PI greater than one, project c should be accepted. If we consider a different situation where two mutually exclusive projects return Rs 100000 each in terms of net present value and one project costs twice as much as another, the profitability index will obviously give a logical answer. The net present value method will indicate that both are equally desirable in absolute terms. However the profitability index will evaluate these two projects relatively and will give correct answers. Between two mutually exclusive projects with same NPV, the one with lower initial cost will be selected.
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Capital budgeting analysis:
Capital Budgeting Analysis is a process of evaluating how we invest in capital assets,i.e. assets that provide cash flow benefits for more than one year. It has been said that how we spend our money today determines what our value will be
tomorrow. Therefore, we will focus much of our attention on present values so that we can understand how expenditures today influence values in the future. A very popular approach to looking at present values of projects is discounted cash flows or DCF. However, we will learn that this approach is too narrow for properly evaluating a project.
There are three types of analysis done:
y Decision analysis.
y Option pricing.
y Discounted cash flow
Decision analysis :
Decision-making is increasingly more complex today because of uncertainty. Additionally, most capital projects will involve numerous variables and possible outcome. For example, estimating cash flows associated with a project involves working capital requirements, project risk, tax considerations, expected rates of inflation, and disposal values. We have to understand existing markets to forecast project revenues, assess competitive impacts of the project, and determine the life cycle of the project. If our capital project involves production, we have to understand operating costs, additional overheads, capacity utilization, and startup costs. Consequently, we cannot manage capital projects by simply looking at the numbers; i.e. discounted cash flows. We must look at the entire decision and
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assess all relevant variables and outcomes within an analytical hierarchy. In financial management, we refer to this analytical hierarchy as the Multiple Attribute Decision Model (MADM). Multiple attributes are involved in capital projects and each attribute in the decision needs to be weighed differently. Therefore analytical hierarchy is used to structure the decision derive the importance of attributes in relation to one another. We can think of MADM as a decision tree which breaks down a complex decision into component parts. This decision tree approach offers several advantages.
Both financial and non financial criteria are systematically considered.
Judgments and assumptions are included within the decision based on expected values.
The opinions and ideas of others into the decision. Group or team decision making is usually much better than one person analyzing the decision.
Therefore, our first real step in capital budgeting is to obtain knowledge about the project and organize this knowledge into a decision tree.
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The second stage in this process is to consider all options or choices we have or should have for the project. Therefore, before proceeding to discounted cash flows we need to build a set of options into our project for managing unexpected changes. In financial management, consideration of options
within capital budgeting is called contingent claims analysis or option pricing. For example, suppose you have a choice between two boiler units for your factory. Boiler A uses oil and Boiler B can use either oil or natural gas. Based on traditional approaches to capital budgeting, the least costs boiler was selected for purchase, namely Boiler A. However, if we consider option pricing Boiler B may be the best choice because we have a choice or option on what fuel we can use.
Suppose we expect rising oil prices in the next five years. This will result in higher operating costs for Boiler A, but Boiler B can switch to a second fuel to better control operating costs. Consequently, we want to assess the options of capital projects.
Options can take many forms; ability to delay, defer, postpone, alter, change, etc. These options give us more opportunities for creating value within capital projects. Capital need to thought as a bundle of option. Three common source of option are:
The ability to delay our investment in the project.
The ability to abandon or get out of a project that has gone bad.
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The ability of a project to provide long-term growth despite negative
values. For example, a new research program may appear negative, but it might lead to new product innovations and market growth. We need to consider the growth options of projects.
Option pricing is the additional value that we recognize within a project because it has flexibilities over similar projects. These flexibilities help us manage capital projects and therefore, failure to recognize option values can result in an under-valuation of a project.
Discounted cash flow
Discounting refers to taking a future amount and finding its value today. Future values differ from present values because of the time value of money. Financial management recognizes the time value of money because: Inflation reduces values over time; i.e. Rs 1,000 today will have less value five years from now due to rising prices (inflation). Uncertainty in the future; i.e. we think we will receive Rs1, 000 five years from now, but a lot can happen over the next five years. Opportunity Costs of money; $ 1,000 today is worth more to us than $ 1,000 five years from now because we can invest $ 1,000 today and earn a return.
The Discounted cash flow uses the Time Value of Money to discount the Total project cash flow with the assumed Discount Rate. Total project cash flow is calculated as follows:
Total project cash flow = Operating cash flow + Net Working Capital cash flow + Net Capital Spending
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Risk analysis in capital budgeting
Systematic risk refers to the variation in return of the company due to systematic factors like industrial production, GDP, inflation, forex rate, interest rate. Impact of
systematic risk cannot be diversified.
Unsystematic risk refer to the variation in return of the company due to company specific factor like dividend, capital structure, management etc. Risk exists because of the inability of the decision maker to make perfect forecasts.
Forecasts cannot be made with perfection or certainty since the future events on which they depend are uncertain. An investment is not risky if, we can specify a unique sequence of cash flows for it. But whole trouble is that cash flows cannot be
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forecast accurately, and alternative sequences of cash flows can occur depending on the future events. Thus, risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future events with certainty and consequently, cannot, make are correct prediction about the cash flow sequence. To illustrate, let us suppose that a firm is considering a proposal to commit its funds in a machine, which will help to produce a new product. The demand for this product may be very sensitive to the general economic conditions. It may be very high under favorable economic conditions and very low under unfavorable economic conditions. Thus, the investment would be profitable in the former situation and unprofitable in the later case. But, it is quite difficult to predict the future state of economic conditions, uncertainty about the cash flows associated with the investment derives. A number of techniques to handle risk are used by managers in practice. They range from simple rules of thumb to sophisticated statistical techniques. The following are the popular, not-conventional techniques of handling risk in capital budgeting.
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y Payback period:
Payback is one of the oldest and commonly used methods or explicitly recognizing risk associated with an investment project. This method, as applied in practice, is more an attempt to allow for risk in capital budgeting decision rather than a method to measure profitability. Business firms using this method usually prefer short payback to longer ones, and often establish guidelines that a firm should accept investments with some maximum payback period, say three or five years. The merit of payback is its simplicity. Also payback makes an allowance for risk by focusing attention on the near term future and thereby emphasizing the liquidity of the firm through recovery of capital, and by favoring short term projects over what may be riskier, longer term projects. It should be realized, however, that the payback period, as a method of risk analysis, is useful only in allowing for a special type of risk, the risk that a project will go exactly as planned for a certain period and will then suddenly cease altogether and be worth nothing. It is essentially suited to the assessment of risks of time nature. Once a payback period has been calculated, the decision maker would compare it with his own assessment of the projects likely, and if the letter exceeds the former, he would accept the project. This is a useful procedure, economic only if the forecasts of cash flows associated with the project are likely to be unimpaired for a certain period. The risk that a project will suddenly cease altogether after a certain period life may arise due to reasons such as civil war in a country, closure of the business due to an indefinite strike by the workers, introduction of a new product b a competitor which captures the whole market and nature disasters such as flood or fire. Such risks undoubtedly exist but they, by no means, constitute a large proportion of the commonly encountered business risks. The usual risk in business is not that a project will go
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as forecast for a period and then collapse altogether; rather the normal business risk is that the forecasts of cash flows will go wrong due to lower sales, higher cost.
y Risk adjusted discount rate:
For a long time, economic theorists have assumed that, to allow for risk, the businessman required a premium over and above an alternative, which was riskfree. Accordingly, the more uncertain the returns in the future, the greater the risk and grater the premium required. Based on this reasoning, it is proposed that the risk premium be incorporated into the capital budgeting analysis through the discount rate. That is, if the time preference for money is to be recognized by discounting estimated future cash flows, at some risk free rate, to their present value, then, to allow for the riskiness, of those future cash flows a risk premium rate may be added to risk-free discount rate. Such a composite discount rate, called the risk-adjusted discount rate, will allow for both time preference and risk preference and will be a sum of the risk-free rate and risk-premium rate reflecting the investors¶ attitude towards risk. The risk-adjusted discount rate method can be formally expressed as follows: Risk-adjusted discount rate = Risk free rate + Risk premium Under capital asset pricing model, the risk premium is the difference between the market rate of return and the risk free rate multiplied by the beta of the project. The risk adjusted discount rate accounts for risk by varying the discount rate depending on the degree of risk of investment projects. A higher rate will be used for riskier projects and a lower rate for less risky projects. The net present value will decrease with increasing risk adjusted rate, indicating that the riskier a project is perceived,
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the less likely it will be accepted. If the risk free rate is assumed to be 10%, some rate would be added to it, say 5%, as compensation for the risk of the investment, and the composite 15% rate would be used to discount the cash flows.
Advantages of risk adjusted discount rate
y y y
It is simple and can be easily understood. It has a great deal of intuitive appeal for risk-averse businessman. It incorporates an attitude towards uncertainty
There is no easy way deriving a risk adjusted discount rate. Capital asset pricing model provides a basis of calculating the risk adjusted discount rate. Its use has yet to pick up in practice.
It does not make any risk adjusted in the numerator for the cash flows that are forecast over the future years.
It is based on the assumption that investor are risk-averse. Through it is generally true, there exists a category of risk seekers who do not demand premium for assuming risks; they are willing to pay premium to take risks. Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.
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Steps of risk adjusted discounted rate:
y y y
Simply adjust the discount rate to reflect higher risk. Riskier project will use higher risk adjusted discounted rates. Calculate NPV using the new risk adjusted discounted rate.
y Certainty equivalent:
Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash flows to some conservative levels. For example, if an investor, according to his ³best estimate´ expects a cash flow of Rs.60000 next year, he will apply an intuitive correction factor and may work with Rs.40000 to be on safe side. There is a certainty-equivalent cash flow. In formal way, the certainty equivalent approach may be expressed as Net present value = (the risk adjusted factor X the forecasts of net cash flow) / (1 + Risk free rate) The certainty equivalent coefficient, the risk adjustment factor assumes a value between zero and one, and varies inversely with risk. A lower risk adjustment rate will be used if lower risk is anticipated. The decision maker subjectively or objectively establishes the coefficients. These coefficients reflect the decision makers¶ confidence in obtaining a particular cash flow in period. For example, a cash flow of 20000$ may be estimated in the next year, but if the investor feels that only 80% of it is a certain amount, then the certainty-equivalent coefficient will be 0.8. That is, he consider only 16000$ as the certain cash flow. Thus, to obtain certain cash flows, we will multiply estimated cash flows by the certaintyequivalent coefficients. The certainty equivalent approach explicitly recognizes risk, but the procedure for reducing the forecasts of cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made in
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his forecasts, may inflate them in anticipation. This will no longer give forecasts according to ³best estimate´. Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate the original forecast or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy outcomes, chances are increased for passing by some good investments
Steps of certainty equivalent:
Adjust all after cash flows by certainty equivalent factors to get certain cash flows.
Discount the certain cash flows by risk free rate of interest.
To conduct a sensitivity analysis, hold all projections constant except one, alter that one, and see how sensitive cash flow is to that one when it changes - the point is to get a fix on where forecasting risk may be especially severe.
In the evaluation of an investment project, we work with the forecast of cash flows. Forecasted cash flow depend on the expected revenue and cost. Further, expected revenue is the function of sales volume and unit selling price. Similarly sales volume will depend upon the market size and the firms market are. Costs include variable cost which depend upon sales volume and unit variable cost and fixed cost. The net present value and the internal rate of return of the project are determined by analyzing the after tax cash flow arrived at combining forecast of various variable. It is difficult to arrive at arrive at an accurate and unbiased forecast of each variable. We can¶t be certain about the outcome of any of these variables. The reliability of the NPV or IRR of the project will depend on the reliability of the forecast of variables underlying the estimates of net cash flows. To determine the reliability of the project NPV or IRR we can work out how much difference it makes if any of the forecasts goes wrong. The NPV of the
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project is recalculated under these different assumptions. This method of recalculating NPV and IRR by changing each forecast is called sensitivity analysis
Estimating the cash flow of a project is typically very difficult and requires many carefully thought of assumptions. A wrong assumption on the number of units sold or the fixed costs might result in an entirely different decision made. It is thus prudent and useful to perform a Scenario Analysis during Capital Budgeting. Scenario Analysis basically involves estimating the cash flows on a Base Case, Worst Case and Best Case scenario. The Project Cash Flow Scenario Analysis worksheet allows Scenario Analysis to be performed easily. It allows the inputs of the Base Case scenario, Worst Case scenario and Best Case scenario to be entered into the same worksheet. After which, the cash flow is automatically projected based on the scenario selected and the Net Present Value and Internal Rate of Return is calculated for the selected scenario.
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Determinants of capital budgeting:
y Companies tax exposure:
Debt payments are tax deductible. As such, if a company's tax rate is high, using debt as a means of financing a project is attractive because the tax deductibility of the debt payments protects some income from taxes.
y Financial Flexibility:
This is essentially the firm's ability to raise capital in bad times. It should come as no surprise that companies typically have no problem raising capital when sales are growing and earnings are strong. However, given a company's strong cash flow in the good times, raising capital is not as hard. Companies should make an effort to be prudent when raising capital in the good times, not stretching its capabilities too far. The lower a company's debt level, the more financial flexibility a company has.
The airline industry is a good example. In good times, the industry generate significant amounts of sales and thus cash flow. However, in bad times, that situation is reversed and the industry is in a position where it needs to borrow funds. If an airline becomes too debt ridden, it may have a decreased ability to raise debt capital during these bad times because investors may doubt the airline's ability to service its existing debt when it has new debt loaded on the top.
y Management Style :
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Management styles range from aggressive to conservative. The more conservative a management's approach is, the less inclined it is to use debt to increase profits. An aggressive management may try to grow the firm quickly, using significant amounts of debt to ramp up the growth of the company's earnings per share (EPS)
y Growth Rate:
Firms that are in the growth stage of their cycle typically finance that growth
through debt, borrowing money to grow faster. The conflict that arises with this method is that the revenues of growth firms are typically unstable and unproven. As such, a high debt load is usually not appropriate. More stable and mature firms typically need less debt to finance growth as its revenues are stable and proven. These firms also generate cash flow, which can be used to finance projects when they arise.
y Market Conditions:
Market conditions can have a significant impact on a company's capital-structure condition. Suppose a firm needs to borrow funds for a new plant. If the market is struggling, meaning investors are limiting companies' access to capital because of market concerns, the interest rate to borrow may be higher than a company would want to pay. In that situation, it may be prudent for a company to wait until market conditions return to a more normal state before the company tries to access funds for the plant.
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A firm whose sales are relatively stable can safely take on more debt and incur higher fixed charges than a company with unstable stables; this factor has generally been observed in terms of sales or earning variability as capital budgeting is concern.
Factors influencing capital budgeting practices:
y Project ranking y Size disparity
If a company imposes capital rationing on investmen projects, the appropriate cision criterion is to select those projects with the highest net present value. This may prevent the acceptance of those projects that ranked highest in terms of their
internal rate of return.
The size disparity problem occurs when mutually exclusive projects of unequal size are being considered. If there is no capital rationing then the project, which provides for the largest net present value will be selected. When capital rationing exists, the company should select the set of projects with the largest net present value.
The time disparity problem results from the differing reinvestment assumptions made by the net present value and internal rate of return decision criteria. The NPV criterion implicitly assumes that cash flows over the life of the project can be reinvested at the required rate of return or cost of capital. The IRR method assumes that the cash flows over the life of the project can be reinvested at the internal rate of return.
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Capital budgeting and inflation
Doesn't inflation have an impact in a capital budgeting analysis? The answer is qualified yes in that inflation does have an impact on the numbers that are used in capital budgeting analysis. But it does not have impact on the results of the analysis if certain conditions are satisfied. To show what we mean by this statement, we will use the following data. Example: Martin company wants to purchase a new machine that costs $36,000. The machine would provide annual cost savings of $20,000, and it would have a three-year life with no salvage value. For each of the next three years, the company expects a 10% inflation rate in the cash flows associated with the new machine. If the company's cost of capital is 23.2%, should the new machine be purchased? To answer this question, it is important to know how the cost of capital was derived. Ordinarily, it is based on the market rates of return on the company's various sources of financing - both debt and equity. This market rate of return includes expected inflation; the higher the expected rate of inflation, the higher the market rate of return on debt and equity. When the inflationary effect is removed from the market rate of return, the result is called a real rate of return. For example if the inflation rate of 10% is removed from the Martin's cost of capital of 23.2% the real cost of capital is only 12% as shown below:
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Capital budgeting and inflation:
Reconciliation of the Market -Based and Real Costs of Capital The real cost of capital The inflation factor The combined effect (12% 10% = 1.2%) 12.0% 10.0 1.2
The market based cost of capital
Solution A: Inflation Not Considered: Amount of Cash Item Initial investment Annual cost savings Year(s) Now 1-3 Flows $(36,000) 20,000 12% Factor 1.000 2.402 Present Value of Cash Flows $(36,000) 48,040
Net present value
Solution B: Inflation Considered: Amount Item Initial investment Annual cost savings Year(s) Now 1 2 3 Cash Flows $(36,000) 20,000 20,000 20,000 of Price Index Price Adjusted 23.2% Factor*** 1.000 0.812 0.659 0.535 Present Value of Cash Flows $(36,000) 17,864 15,948 14,242
Number** 1.000 1.100 1.210 1.331
Cash Flows $(36,000) 22,000 24,200 26,620
Net present value
*These amounts are different only because of rounding errors **Computation of the price index numbers, assuming a 10% inflation rate each year: Year 1, (1.10) = 1.10; Year 2, (1.10) 1.331
= 1.21; Year 3, (1.10) 3 =
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***Discount formulas are computed using the formula 1/(1 + r) n , where r is the discount factor and n is the number of years. The computations are 1/1.232 = 0.812 for year 1; 1/(1.232) 2 = 0.659 for year 2; and 1/(1.232)3 = 0.535 for year 3.
You cannot simply subtract the inflation rate from the market cost of capital to obtain the real cost of capital. The computations are bit more complex than that. When performing a net present value analysis, one must be consistentThe market based cost of capital reflects inflation. Therefore, if a market based cost of capital is used to discount cash flows, then the cash flows should be adjusted upwards to reflect the effects of inflation in forthcoming periods. Computations of Martin Company under this approach are given in solution B Above. On the other hand, there is no need to adjust the cash flows upward if the "real cost of capital" is used in the analysis (Since the inflationary effects have been taken out of the discount rate). Computation of the martin under this approach are given in solution A above. Note that under solution A and B that the answer will be the same (within rounding error) regardless of which approach is used, so long as one is consistent and all of the cash flows associated with the project are effected in the same way by inflation. Several points should be noted about solution B, where the effects of inflation are explicitly taken into account, First, not that the annual cost savings are adjusted for the effects of inflation by multiplying each year's cash savings by a price index number that reflects a 10% inflation rate. (observe from the foot notes to the solution how the index number is computed for each year.) Second, note that the net present value obtained in solution B, where inflation is explicitly taken into account, is the same, within rounding error, to that obtained in solution A, where the inflation effects are ignored. This result may seem surprising, but it is logical. The reason is that we have adjusted both the cash flows and the discount rate so that they are consistent, and these adjustments cancel each other out across the two solutions.
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Throughout this section of the website (Capital Budgeting Decisions) we assume for simplicity that there is no inflation. In that case, the market-based and real costs of capital are the same, and there is no reason to adjust the cash flow for inflation since there is none. When there is inflation, the unadjusted cash flows can be used in the analysis if all of the cash flows are affected identically by inflation and the real cost of capital is used to discount the cash flows. Otherwise, the cash flows should be adjusted for inflation and the market-based cost of capital should be used in the analysis.
Utility Theory and Capital Budgeting:
On the basis of figures of the expected values and standard deviations, it is difficult to say whether a decision maker should choose a project with a high expected value and a high standard deviation or a project with a comparatively low expected value and a low standard deviation. The decision makers¶ choice would depend upon his risk preference. Individuals and firms differ in their attitudes towards risk. In contrast to the approaches for handling risk, utility theory aims at incorporation of decision makers¶ risk preference explicitly into the decision procedure. In fact, a rational decision maker would maximize his utility. Thus, he would accept the investment project, which yields maximum utility to him.
Risk adverse investors attach lower utility for increasing wealth. For them the value of the potential increasing wealth is less than the possible loss from the decreasing wealth. In other words, for a given wealth they prefer less risk to more risk.
y Risk neutral:
Risk neutral attaches same utility to increasing or decreasing wealth they are indifferent to less or more risk for a given wealth.
Benefits and limitation of utility theory
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Utility approach to risk analysis in capital budgeting has certain advantages 1. The risk preferences of the decision maker are directly incorporated in capital budgeting analysis. 2. It facilitates the process of delegating the authority for decision. If it is possible to specify the utility function of the superior-the decision maker, the subordinate can b asked to take risk consistent with the risk preference of the superior.
Utility approach to risk analysis in capital budgeting has certain disadvantages:
1. In practice difficulty is encountered in specifying a utility function. Whose utility function should be used as a guide in making decision? For small firms the utility function of the owner or one dominant shareholder may be used to guide the decision making process of the firm.
2. Even if the owner or a dominant shareholder utility function is being used as a guide, the derived utility function at a point of time is valid only for that one point of time.
3. It is quite difficult to specify the utility function if the decisions are taken by group of persons. Individual differ in their risk preferences. As a result, it is very difficult to derive a consistent utility function of group.
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Probability Distribution Approaches:
In this situation, the decision maker faces several states of nature. But he is supposed to have believable evidential information, knowledge, experience or judgment to enable him to assign probability values to the likelihood of occurrence of each state of nature. Probabilities could be assigned to future events by reference to similar previous experience and information. Sometimes past experience, or past records often enable the decision-maker to assign probability values to the likely possible occurrence of each state of nature. Knowing the probability distribution of the states of nature, the best decision is to select that course of action that has the largest expected payoff value. Probability theory is the rational way to think about uncertainty. It is the branch of mathematics devoted to measuring quantitatively the likelihood that a given event will occur. These two definitions derive from two different approaches to the concept of probability: subjective versus objective.
Independence of cash flows overtime:
The independence of cash flows overtime means that the probability distributions for future periods are not dependent on each other.
Example on Expected Cash Flows
Example Suppose there is a project which involves initial cost of Rs 20,000 (cost at t = 0). It is expected to generate net cash flows during the first 3 years with the probability as shown in Table.
Net Probability Cash Flows
Net Probability Cash Flows
Net Probability Cash Flows
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TABLE: Expected Cash Flows
0.10 0.25 0.30 0.25 0.10
Rs. 6000 8000
Rs. 4000 6000 8000
0.10 0.25 0.30
Rs. 2000 4000 6000 8000 10,000
10,000 0.30 12,000 0.25 14,000 0.10
10,000 0.25 12,000 0.10
Solution (i) Expected Values: For the calculation of standard deviation for different periods, the expected
values are to be calculated first. These are calculated in Table.
Thus, the standard deviation for period 1 is:
When calculated on similar lines the standard deviations for periods 2 and 3 (cr2 and (T3) also work out to Rs 2,280.
(iii) NPV = Rs 10,000(0.0909) + Rs8, 000(0.826) +Rs6, 000(0.751)-Rs20, 000= Rs204
TABLE Calculations of Expected Values of Each Period Year 1
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Probability (1) 0.10 0.25 0.30 0.25 0.10 Net cash flow (2) 6000 8000 10000 12000 14000 (3) 600 2000 3000 3000 14000 Expected value (1x2)
Probability (1) 0.10 0.25 0.30 0.25 0.10
Net cash flow (2) 4000 6000 8000 10000 12000 (3) 400 1500 2400 2500 1200
Expected value (1x2)
Year 3 Probability (1) 0.10 0.25 0.30 0.25 0.10 Net cash flow (2) 4000 6000 8000 10000 12000 (3) 200 1000 1800 2000 1000 Expected value (1x2)
The standard deviation under the assumption of independence of cash flows over time:
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Normal Probability Distribution:
The normal probability distribution can be used to further analysis the risk element in capital budgeting. The normal probability distribution is a smooth, symmetric, continues bell shaped curve. In probability theory and statistics, the normal distribution or Gaussian distribution is a continuous probability distribution that describes data that clusters around a mean or average. The graph of the associated probability density function is bell-shaped, with a peak at the mean, and is known as the Gaussian function or bell curve. The normal distribution can be used to describe, at least approximately, any variable that tends to cluster around the mean. For example, the heights of adult males in the United States are roughly normally distributed, with a mean of about 70 inches. Most men have a height close to the mean, though a small number of outliers have a height significantly above or below the mean. A histogram of male heights will appear similar to a bell curve, with the correspondence becoming closer if more data is used.
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Capital budgeting in small and large firm
Capital budgeting is one of the most important areas of finance literature. The decision of capital budgeting, or the allocation of fund in assets for a long term, is obvious for both the large and small business. Existing theory of capital budgeting explains the investment decision-making pattern of large businesses very well. This paper discusses whether the capital budgeting theory of large business is well applicable for the small ones or not. If it is not, further development of theory becomes necessary. Followed by the analysis of some theoretical and empirical studies, this paper suggests specific factors to consider in future researches on capital budgeting theory for small businesses.
Understanding the pattern of capital budgeting in small businesses is important. Small business is a significant portion of total businesses in an economy. Also, small business constitutes the starting point for the entrepreneurs. According to Deek (1973), small business is an important asset within an advanced industrial economy. But they cannot make possible contribution for the economy if they are held back by managerial and entrepreneurial limitations. According to FitzRoy (1989), evidences are there to support that small firms are more innovative. Furthermore, it is observed that the overall demand for customized goods and services increase than the increase of mass-produced goods (Carlsson, 1989). Thus, worldwide experience shows that equitable development from economic and social context is enhanced by the contribution of small businesses (Jeppesen, 2005). All these studies indicate that successful small business is important for an economy. And, the success of small business depends on optimal capital budgeting decision. This is why small business capital budgeting demands special attention for complete theoretical development
The theory of capital budgeting supports Net Present Value (NPV) method most, which involves discounting all relevant cash flows at a market determined discount rate such as the cost of capital. Determination of cost of capital requires the separation principle that requires that the investment decision can be made independent of shareholders¶ (owners¶) tastes and preferences. Since the ownership is not readily marketable, separation principle, and thus the market- determined discount rate are inappropriate for closely held and small businesses Therefore, there is some degree of complexity and inappropriateness employing existing capital budgeting theory for small business investment decisions.
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In case of small businesses, the owner will have to make decisions concerning production, sales, finance and administration without any specialist management support or advice which is not the same at all for large incorporated firms. Danielson and Scott (2007) have worked on the agency problem in small firm investments. Their result shows that agency conflicts affect a firm¶s investment decisions in different ways before and after the separation of ownership and control.
Therefore, there is a need to address the problem of decision-making in small business, and some scholars have been working in this field. For example, McMahon and Stanger (1995) suggest that small business financial objective function is sympathetic to existing financial thought, but capture complexities arising in small business. They also argue that the small business financial objective function should reflect the kinds of enterprise-specific risk that typically exist in small businesses arising from liquidity, diversification, transferability, flexibility, control, and accountability considerations
In other words, the capital budgeting process of small business is likely to be different from that of a large business. The size and availability of capital, investment opportunities, and the nature of the decision makers being different for small businesses may partially explain this difference.
There are several reasons small and large firms might use different criteria to evaluate projects. First, small business owners may balance wealth maximization (the goal of a firm in capital budgeting theory) against other objectives²such as maintaining the independence of the business when making investment decisions. Second, small firms lack the personnel resources of larger firms, and therefore may not have the time or the expertise to analyze projects in the same depth as larger firms. Finally, some small firms face capital constraints, making project liquidity a prime concern.
While large firms tend to rely on the discounted cash flow calculations favored by capital budgeting theory small firms most often cite ³gut feel´ and the payback period as their primary project evaluation tools.
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Many small-business owners have limited formal education, and their firms may have incomplete management teams. Therefore, a lack of financial sophistication is an important reason why the capital budgeting practices of small firms differ so dramatically from the recommendations of theory. Small staff sizes also constrain the amount of capital budgeting analyses the firms can perform. Beyond this, there are also substantive reasons a small firm might choose to use methods other than discounted cash flow analysis to evaluate projects.
The primary reason is that many small businesses do not operate in the perfect capital markets that capital budgeting theory assumes. Most of the firms in our sample are very small they have short operating histories and their owners do not have college education These characteristics may limit their bank credit, posing credit constraints. If so, these firms may be required to finance some future investments using internally generated funds, and it would not be surprising for the owners to consider measures of project liquidity (such as the payback period) when making investment decisions
FIRM A: RELOCATING A PRODUCTION FACILITY Firm A produces sisal matting for sale as floor coverings. It has two production facilities one in Johannesburg, Gauteng; and the other in Polokwane, which is approximately 330 kilometers further north. The latter facility is the larger of the two. The focus of this analysis is the decision to relocate this plant. Figure 1 provides an overview of the decision-making process followed by this firm. Throughout the decision-making process, the management of Firm A expressed a commitment to two (sometimes conflicting) strategies4: export promotion and cost minimization. The first strategy reflected the firm¶s belief that the export market represented a better opportunity for sustained growth than the domestic market. The current proportion of domestic to international sales was 70:30. The stated commitment was to reverse this proportion within 10 years. Given the perceived limited potential for product diversification in the sisal carpeting market, the other strategic commitment was that of maintaining competitiveness through minimizing costs.
Step 1: Recognition of the need to move Management reported three reasons for the consideration of a move from the Polokwane production facility: the loss of relative cost advantages, the low levels of productivity at Polokwane and the increasing importance of export sales. The original decision to locate the
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factory in Polokwane was in response to government incentives both direct (e.g. rent) and indirect (production of sisal in the area was subsidised). These have since been discontinued. The existence of significant negative productivity differentials between the Polokwane and Johannesburg factories is a continued management challenge. Finally, export sales, once nonexistent, now comprise thirty percent of the firm¶s total sales. As both the raw materials and the finished product are relatively bulky and raw materials need to be imported and the final product exported (both by sea) Polokwane¶s inland position counts heavily against it. These reasons clearly reflect the firm¶s strategic considerations.
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Overview of firm A¶s decision-making process
1. Recognition of the need to move.
2. Identify the possible location
3. Identify preferred location 1. Best inland location (Johannesburg) 2. Best costal location (Durban /pine town) 3. Best foreign location (Mauritius)
4. Identify optimal location (Mauritius)
5. Final decision (set up plant in Mauritius)
Step 2: Identify possible locations
The first step in the decision-making process was to identify a list of possible alternative locations. This list was composed in terms of the following criteria: 1. Access to reliable, flexible and cheap transport networks closely linked to a port (for the imports of sisal and exports of finished goods);
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2. Availability of adequate production premises; 3. Presence of supporting infrastructure of sufficient quality, such as engineering facilities, and access to other vital inputs, and
4. Access to staff (preferably experienced/skilled in manufacturing).
Step 3: Identify preferred locations
The company felt that a complete analysis of the list of possible locations identified was not cost-effective. The second step in the decision-making process consisted of selecting three sites from the initial list (the eventual choices made are in brackets):
1. The best domestic inland location (Gauteng/Johannesburg);
2. The best domestic coastal location (Durban/Pinetown); and
3. The best foreign location (Mauritius).
It was felt that these three categories captured the essential strategic choices. An inland centre would be closer to the existing market (mainly Gauteng) which would be better as domestic sales remained dominant in the short to medium term. A coastal venue would be superior in terms of reducing transport costs for the export market the long term strategic goal. Finally it was believed that a foreign location might be even more attractive in terms of achieving the long-term strategy of increased export promotion. Throughout the evaluation exercise, it was decided to retain Polokwane as a benchmark case. The influence of the two strategic goals can be clearly seen at this point.
The destinations on the short list were selected on the basis of a series of comparative, nonformal analyses concentrating on qualitative differences: two locations were compared and the lack of a particular factor in one of the two locations, ceteris paribus, was deemed enough to warrant its exclusion. For example, Port Elizabeth was excluded (when compared to Durban) on the grounds of:
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It was further to Johannesburg than Durban. This would lead to higher transport cost.
There were fewer road transport companies on the route as compared to Durban. There would be less flexibility in terms of the number of alternatives available and (probably) higher costs per kilometer.
Shipping lines stopped less often in Port Elizabeth than Durban. This would again limit the flexibility and increase cost of the transport in, of raw materials, and out, of finished products
Step 4: Identify optimal location
For each of the three locations a comparison of estimated direct costs for each location to current direct costs at Polokwane was completed as was an estimated profit/loss statement. Two scenarios, based on differing assumptions regarding the rates of growth of the domestic and foreign components of their current demand, were used in these exercises. The first assumed an annual (compounded) rate of growth (in real terms) of the export market of 15 percent and the second, a growth in export demand of 7 percent5. In both cases, demand in the domestic market was assumed to grow by 5 percent (also in real terms). These rates of growth were identified as being the two most likely scenarios representing µgood¶ or µbad¶ future outcomes. These exercises indicated that the Mauritius option clearly represented a superior choice to all the domestic alternatives in terms of both relative costs and expected profits. The quantified benefits of significantly lower wages, the absence of any company taxation, and significantly reduced internal transport costs outweighed the quantified negatives of higher rental costs, higher transport costs to the South African market; and the unquantified problems of managing across borders and over such a distance.
The Polokwane region presented the most profitable domestic site due to the significantly cheaper current rental charge used. Two qualifications to this result were immediately raised by management. Firstly, the low rental charge used for Polokwane in the calculations was not likely to last for the period covered by the model. Secondly, the exercise assumed that the increases in output were to be produced with the existing labour and capital stocks which
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Gauteng/Johannesburg site was considered to be the best domestic alternative.
This penultimate stage of the decision-making process provides the first application of a formal evaluation technique. Identification of relative cost differences is consistent (in part) with the traditional model of decision-making and the choice of the final location was determined by the results of this technique.
The formal evaluation exercise allowed management to identify what the probable relative production costs would be (in present terms) at the various locations not the expected value of the alternative sites. This was sufficient as it dealt with what the decision makers believed was their key strategic objective minimizing production costs.
Step 5: The final decision
In spite of Mauritius¶ overwhelming advantage over the domestic locations in terms of relative costs and expected profit, the potential risks of doing business in a completely new cultural and economic environment were perceived to be very large. Consequently, management decided to keep the production facility in Polokwane running for another year at least to allow for a pilot plant to be set up in Mauritius to make products forexport to the European market. This deferred the decision to move the entire production facility from Polokwane for a year. Moreover, the experience of running the pilot plant would give management the experience to more accurately evaluate the viability of running a production plant in Mauritius.
The nature of the final decision suggests that that management recognised the limitations of the formal evaluation exercise. It allowed them to identify Mauritius as their first choice for a future production facility. However, they decided to limit their exposure by setting up a pilot plant in Mauritius and deferring the decision to move for a year. While the results of the formal evaluation exercise were seen to be directionally correct, they were deemed not to be sufficiently accurate to allow management to commit to the choice suggested by the evaluation exercise. This suggests that the formal evaluation exercise had a limited impact on the eventual decision. However their to invest in a pilot plant only is entirely consistent with
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the conclusions of Real Options theory which recognizes that delaying an investment decision until key uncertainties have been resolved is a valuable source of flexibility.
In summary, this case study highlights a role for the formal (financial) evaluation exercise different to that proposed by the traditional model. Rather than being the basis for this entire decision-making process, it can be seen as a mechanism which ena bled the firm to identify the lowest cost alternative site from a pre-selected group. It is an important step in the overall process but the importance of the strategic factors was far greater especially in terms of defining the need for the capital investment decision and the criteria by which alternatives should be chosen for further analysis. They determined which locations should be (imperfectly) formally evaluated. Moreover, whilst guided by the results of the formal evaluation exercise the final decision taken was directly affected by the uncertainty regarding the accuracy of the formal evaluation exercise and thus its conclusions. Even at this late stage in the decision-making process, the results of the valuation exercise did not provide the managers of Firm A with a sufficiently strong foundation for them to commit to their final choice of location as was evidenced by the choice to build a pilot plant.
In terms of process, decision makers seemed to follow a filtering process rather than a onceoff comparison of estimates of value. Initially, a broad µmesh¶ or filter is applied to eliminate unwanted choices and then finer and finer filters are applied as the process continues. The (truncated) value-related estimation exercise was effectively the final mesh used to identify the optimal location.
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FIRM B¶S DECISION TO EXPAND ITS CAPACITY
Firm B is a large South African paper manufacturing company and the decision analysed in this section was taken by the Tissue Paper Division. Capital expenditure proposals are motivated at the divisional level but permission has to be obtained at the group level if the amount to be spent is above R1 million. This is formally done through a presentation to Firm B¶s Board of Directors.
1. Recognition of the need for additional capital.
2. Identify first list option: Option A Selected
3. Identify revised list of option: Option H selected
4. Pre-engineering study: Option H rejected, Option E selected
5. Board presentation: Option E accepted
An overview of firm B¶s capital expenditure decision -making process
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Firm B¶s Tissue Division held the largest market share of 37 percent. Management viewed the market as essentially a commodity market with little room for product differentiation. Consequently they believed that long term profitability could only be achieved through high operating efficiencies and continued market dominance. This implied that, firstly, the division must produce at the lowest possible overall cost (i.e. it must not over-capitalize itself); and secondly, it must maintain a level of excess capacity to block potential entrants. A key challenge for management was seen to be one of balancing the two competing aims and this conflict becomes apparent at almost every stage of the process.
Step 1: Recognition of the need for additional capacity
Two reasons were given by the division¶s management for the need to consider additional production capacity. Firstly, the rate of growth of market demand was expected to increase; and secondly, they believed it to be a strategic necessity to continue to maintain sufficient excess capacity to protect the firm¶s dominant market position from potential new entrants.
The change (increase) to the expected rate of growth of market demand (sales) for tissue products was largely the result of the personal input of the group managing director. In July 1995 he indicated to the Division that they should base their capital expenditure planning on three scenarios: five, ten and fifteen percent annual growth in levels of market demand (sales). Prior to this the Tissue Division had considered three alternative scenarios of five, seven and a half and ten percent. It was estimated that the division¶s capacity constraints would be reached in 1998, 1997 and 1996, under the three new scenarios respectively. The division thus proceeded to look for alternative ways to supply the perceived need for an increase in productive capacity.
Step 2: Identify first list of options
Option C was rejected as only offering a short-term solution. It was then argued that the lack of in-house technical resources meant that it could only manage one of the remaining three alternatives at a time. The required level (and timing) of the additional capacity required was very sensitive to the accuracy of the expectation regarding the rates of growth in future demand. It was felt that the highly significant increase in demand (50 percent or greater) which would necessitate the consideration of a new plant was not certain enough to take the
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risk of over-capitalizing the division. Options A and B could provide sufficient breathing space (in terms of additional capacity) to confirm accuracy of these expectations. The upgrading options (A and B) should thus be considered first as they would provide incremental tonnage at the lowest cost (and risk). Moreover these options would allow the Division to correct for the lack of adequate investment in the past which was constraining its current and future operating efficiency levels. The first set of option considered by the division Option Action Additional capacity (000¶s tons p.a) A Rebuilding of paper machine 3(PM3)at the site K factory B Upgrading of paper machine four (PM4) 9000 at the site B factory C Renegotiate the supply contract with 4000 SAPPL D Build a new paper machine 27000 2000
Further consideration of Option D
building a new paper machine
was effectively stopped
at this stage on the basis that the risk of over-capitalisation was too great due to both the higher cost of investment in a new machine and the significant additional capacity it would bring. However, there was no formal analysis of the risk of the rate of growth in reaching the levels necessary to justify this investment. The reasons given for the decision taken to focus on options A and B were that it would allow the Division to use its existing assets more efficiently and avoid over capitalizing the division. The decision to exclude Options C and D was thus made on their inability to meet the Division¶s strategic goals of alternatives. Outside consultants were briefed with the aim of identifying whether options A and B were feasible and what the potential associated costs might be. This led to the next set of alternatives considered in November. not through a comparison of the expected value of the range
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Step 3. Identify revised list of options
The outside consultants advised that further consideration of option A was not required as option B provided clearly superior output and cost advantages. Five alternative forms of option B were presented for consideration (see options E, F, G, H and I in Table 2 these are mutually exclusive alternatives). At this stage, the technical director, again on the advice of the consultants, introduced two additional proposals for expenditure on projects of a replacement/upgrade nature (Options One and Two in Table 2). Of these alternatives, Option H, One and Two were selected for further analysis. The total expected increase in capacity would be approximately 6 000 tons per annum. The process for deciding between these options is seemingly based on criteria similar to those proposed by the traditional value based approach discussed above. As shown in Table Two, each option was presented with its expected benefit (additional output added), its relative (estimated) capital costs, and finally, its Internal Rate of Return (IRR) measure. Furthermore, the option with the highest IRR was the one selected (Option H).
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Estimated cost 45million
Upgrading PM4¶s stock 5700tons preparation using latest technology p.a
with 5300tons p.a
essential equipment only G Upgrade
&combine 5000tons p.a
PM3 & PM 4 stock separation H Utilize existing
PM3 4000tons p.a
stock preparation with upgrade PM4 stock
preparation I Start up of PM3 4700tons p.a of 817tons p.a 8million 24.05 4yrs5 months -
machine One Implementation distributed control system Two Fittings of gas fired drying hood
The IRR and Payback Period calculated for options F and G were identical. When questioned about this highly unlikely outcome the Technical Director for the Division (who prepared the document) said that these results were correct and any similarity was simply a coincidence.
There are two problems with this conclusion, however. Firstly, the results of the supposedly redundant payback period (PP) measure were presented for all of the options considered. When interviewed, management regularly referred to the PP results when explaining the relative attractiveness of that alternative. This indicates that decision-makers do not agree with the theoretical redundancy of the PP measure and do not feel comfortable with the use of
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DCF techniques in isolation10. Secondly, while the choice of Option H is justified (as it had the highest IRR), options One and Two were also selected for further analysis even with their very ordinary IRR (and PP) figures. This suggests that the IRR (or even PP) measures were not the primary basis for the decision at this point. When asked about this choice, the Divisional Managing Director indicated that because of his (personally) pessimistic outlook regarding future demand, he had wanted the smallest possible investment of additional assets into the production process. He felt that anything more would have been unnecessary and would have led to the division over-capitalizing itself. Option H, One and Two offered this combination. The importance of the division¶s strategic aims in this decision-making process reemphasized at this point as the inclusion of options One and Two only makes sense as they maximizing management¶s ability to implement their strategy of µsweating the Assets The next stage of the capital expenditure process was a pre-engineering study to determine a more accurate estimation of the costs of options H, One and Two for budgeting purposes.
Step 4: Pre-engineering study
The significant results of this study were that the chosen option (H) was discarded on the advice of the consultants11. Option G was also excluded on the same basis while option I was rejected on the basis that it did not present a long term solution. The choice was thus between Options E and F. Option F, while offering a higher IRR, suffered from the problems of technology obsolescence in the future which would negatively affect the productivity of all the associated machinery and lead to lower quality levels. On the other hand, option E would allow PM4 to run at its designed capacity. It would correct for the original lack of support processes and thus would increase both levels of output and improve the efficiency of the existing capital stock. While significantly more expensive (R45 million as compared to R15 million), its use of new technology would mean that it would require replacement much later than any other alternative. The importance of these efficiency gains would be multiplied by their relative longevity. In spite of it having a lower IRR (and a longer PP) than option F, option E was selected. The basis for this decision was that it would supply sufficient additional capacity for the (downgraded) expected needs of the Division as well as prolong the life of the PM4 machine and improve its operating efficiency measures over this period. This suggests that either these benefits either not fully reflected in the IRR calculations completed in
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the previous stage, or alternatively, that the IRR measures, if accurate, are not important in the decision-making process. Management indicated that these benefits were not initially included because they were judged to be unquantifiable and it was only after the preengineering study that this data was available. However it is important to remember that the choice of focus of the pre-engineering study was option H. Consequently it was effectively only an accident this data on Option E became available. Furthermore, new IRR estimates were not estimated and presented in support of this choice. This stage of the process highlights a significant problem with the implementation of a model of decision-making based on the comparison of estimates of value. The data required to accurately estimate the value of the competing alternatives is very expensive either in terms of management time (or consultants¶ fees). As a result, managers need to priorities options for further consideration and in this case, they did it on qualitative and strategic grounds (the ability of Option E to minimize additional investment while leveraging the unused production capacity of the existing assets). The process of elimination outlined in this step clearly highlights the continued importance of qualitative variables in the decision-making process in spite of the apparent use of DCF techniques. Each alternative was carefully evaluated judged in terms of its alignment with the strategic goals in spite of there being estimates of the projects¶ IRRs. The estimate of value
produced by a DCF evaluation technique depends on the accuracy of their assumptions regarding the future values of all relevant factors. The above example suggests that these techniques produce estimates that are not accurate enough to provide decision makers with an adequate basis for deciding between alternatives. The DCF evaluation techniques are either somehow incapable of accurately capturing the value of the alternative¶s alignment with these goals, or, alternatively, it may be that the costs of acquiring information required for the use of the traditional decision-making approach are too great to allow for its use in comparing alternative courses of action. The fact that this type of analysis is completed for the presentation to the board suggests that the latter reason is correct in this case. The final stage of the decision-making process was to present the results to the Capital Expenditure Committee of the Group¶s Board of Directors in August 1996.
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Step 5: Board presentation
The proposal to upgrade PM4 consisted of the Division¶s request for permission to carry out their planned course of action (Options E, One and Two). The upgrading of PM4 was presented as a viable short-term alternative until the installation of a new machine could be seen to be µstrategically appropriate¶. The division¶s management clearly communicated this choice as an opportunity to improve the efficiency of its capital stock and reduce the need for additional future non-productive investment expenditure. This alternative allowed it revitalized the capital stock of its existing production facility and avoided the gradual decline in its long term capacity. The board approved the application and the changes to PM4 took place. Some formal evaluations of the proposed alternatives (IRR; PP) were included but these results were not used to justify the course of action selected by indicating how these were the best results available. The only other course of action mentioned in this presentation was to bring the installation of a new paper machine forward. No analysis of the expected value of this alternative was presented. This suggests that the only role of the formal evaluation included in this presentation was to confirm the viability of the proposed plan of action to the board rather than its necessary superiority over competing alternatives.
summary, the decision that Firm B took was initially prompted by a change of
expectations, modified by the division¶s existing competitive strategies and then justified by the formal analysis of a limited number of alternative solutions. The key choices throughout the process were made with the aim of balancing the competing strategic aim. These choices made were justified on the grounds of qualitative, and not quantitative, criteria. When used the DCF techniques provided support for the decision taken on other grounds.
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Financial Performance of Vizag Steel Plan
VSP had to bear the brunt of huge project cost right from the day of its inception. This has affected the company¶s balance sheet due to very high interest burden. The company, in spite of making operating profit every year had to report net loss during all financial years. This on the other hand had resulted in making VSP to take great care in planning the financial resources.
Financial Performance (In crores)
Year 2000-2001 2001-2002 2002-2003 2003-2004 2004-2005 2005-2006 2006-2007 2007-2008 2008-2009
Gross margin 504 690 1049 2073 3271 2383 2633 3515 2356
Cash profit 153 400 915 2024 3260 2383 2548 3483 2267
Net profit -291 -75 521 1547 2008 1252 1363 1943 1336
An efficient allocation of capital is the most important finance function in the modern times. It involves decisions to commit the firm¶s funds to the long - term assets. Capital budgeting for investment decisions is of considerable importance to the firm since they tend to determine its value by influencing its growth, evaluation of capital budgeting decisions
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Capital Budgeting Process of Vizag Steel Plant
1. 2. Identification of investment proposal. Screening the proposal.
Evaluation of various proposals. Fixing priorities.
5. Final approval & preparation of capital expenditure
budget. 6. Implementing proposal. 7. Performance review
Identification of investment proposal
The capital budgeting process begins with the identification of investment proposal. The proposal or idea about potential investment opportunities may originate from the top of management or may come from the rank and file workers of any department or from any officers of the organization. The departmental head analyses the various proposals in the light of the corporate strategies and submits the suitable proposals to the capital expenditures planning committee in case of large organization or to the officers a concerned with the corporate strategies and submits the suitable proposals to the capital expenditures. Capital expenditures planning committee in the case of large organization or the officers concerned with the process of long-term investment decision.
Screening the proposal
The expenditures planning committee screens the various proposals received from different departments. The committee view these proposals form various angles to ensure that these are in accordance with the corporate strategies or selection criterion of the firm and also do not lead to the department imbalances.
y Evaluation of various proposals:The next step in the capital budgeting process is to evaluate the profitability of various
proposals. There are many method which may be used for this purpose such as pay back period method, rate of return method, net present value method, internal rate of return, etc.
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All these method of evaluating profitability of capital investment proposals have been classified as below. i. Independent proposals. ii. Contingent or dependent proposals and iii. Mutually exclusive proposals.
y Fixing priorities:After evaluating various proposals, the unprofitable proposals may be rejected straight away.
But it may not be possible for the firm to invest immediately in the all the acceptable proposals due to limitation of funds. Hence, it is very essentials to rank the various proposals and to establish priorities after considering urgency, risk and profitability involved there in.
Final approval & preparation of capital expenditure budget
Proposals meeting the evaluation and other criteria are finally approved to be included in the capital expenditure budget. However, a proposal involving smaller investment may be decides at the lower levels for expenditure action. The capital expenditures a budget lays down the amount of the estimation expenditures to be incurred on fixed assets during the budget period.
Implementing proposals Translating an investment proposal into a concrete project is a complex, time consuming, and risk- fraught task. 1. Adequate formulation of projects The major reason for delay is insinuate formulation of projects put differently, if necessary homework in terms of preliminary comprehensive and detailed formulation of the project. 2. Use of the principle of responsibility accounting Assigning specific responsibility to project managers for completing the project within the defined time-frame and cost limits is helpful for expeditious execution and cost control. 4. Use of Network Techniques For project planning and control several network techniques like PERT (Programme Evaluation Review Techniques) and CPM (Critical Path Method)are available.
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Performance Review:Performance review, or post completion audit, is a feedback device. It is a means for comparing actual performance with projected performance. It may be conducted, most appropriately. When the operations of the project have stabilized. It is useful several ways. I. It throws light on how realistic were the assumptions underlying the project. II. It provided a documented log of experience that is highly valuable for decision making.
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Capital budgeting is one of the important techniques of Financial Management to evaluate the project efficiency. So that purchasing of new machinery, starting business, expansion, replacement of old machinery with new etc. Comparatively modern method is more effective over the traditional method because the modern method is considering the time value of money. Capital budgeting has its own disadvantage but its advantages overshadow its disadvantages with its usage. But in India capital budgeting technique is not properly utilized in corporate as well as government administrative level.
After studying this topic, I realize the importance of capital budgeting. I feel this that capital technique can be utilized in corporate as well as government administration project such as public utility service, public transportation service etc. Local authority services such as MAHDA, BMC can use this technique to evaluate the prospective project.
I personally feel that due to lack of knowledge public is not willing to utilize this technique in the prospective way. Capital budgeting can be utilize from domestic level to MNCs and this sentence can express the importance of capital budgeting.
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Short forms NPV IRR ARR PI DCF PB Net present value
Internal rate of return Accounting rate of return Profitability index Discounted cash flow Pay back
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Bibliography Financial management ±I.M.Pandey Financial management-Prasanna Chandra www.google.com www.scribd.com www.docstock.com www.wisemind.com www.thinkinghats.com
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