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CAPITAL BUDGETING

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What is Capital Budgeting ?

Capital budgeting is the process of evaluating and

selecting long term investments that are consistent with the goal of shareholders wealth maximistion criterion. Capital Budgeting is employed to evaluate expenditure decisions which involve current outlays but are likely to produce benefits over a period of time longer than one year. These benefits may be in the form of increased revenue or decreased cost. Capital Exp Mgt. therefore addition, disposition, modification and replacement of FA.

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Basic Features of Capital Budgeting

Potentially large anticipated benefits A relatively high degree of risk Long gestation period

Importance of Capital Budgeting

Such decisions effect profitability of firm

They have an effect on competitive position of the firm as they relate to FA

and they enable firms to generate finished goods and thus profit They are strategic investment decisions as against tactical which involve relatively smaller amounts, thus a major departure may be a possibility leading to a significant impact on companies' expected profits. Has effect over a long time span & thus effects companies future cost structure. CExp Dec once made are not easily reversible without much financial loss Involves huge cost and thus prudent and thoughtful use becomes important.

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Difficulties
Benefits from investments are received in some future

period. Future is uncertain, therefore an element of risk is involved. Secondly: costs incurred and benefits received from the capital budgeting decisions occur in different time periods . They are not logically comparable because of time value of money. Thirdly, it is not often possible to calculate in strict quantitative terms all the benefits of the costs relating to a particular investment decision.

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Rationale:
The rationale underlying the capital budgeting

decision is efficiency. Thus replacement of obsolete or worn out P&M; acquiring of FA for current and new products are among the main objective of CB Decisions. Capital budgeting decisions can be of two types:

Decisions affecting revenues Decisions affecting costs

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Types of Investment Decision:

There are many ways to classify investment decisions; one such

way is as follows:

Expansion of Existing Business Expansion of New Business Replacement and Modernisation

Expansion and Diversification: To increase plant capacity is an

example of expansion and to venture into a completely new area is diversification. Replacement and Modernaisation: The main objective of R&M decisions is to improve operating efficiency and reduce costs.

Another way of classification is as follows:

Mutually exclusive investments Independent investments Contingent investments.

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Investment Evaluation Criteria:

Three steps are involved in the evaluation of an investment:

Estimation of Cash flows Estimation of the required rate of return (the opportunity cost of capital) Application of a decision rule for making the choice

Investment decision rule: A sound appraisal technique should be used to measure the economic worth of an investment project. The ultimate objective is to maximise the shareholders wealth. The following characteristics should be possessed by a sound investment evaluation criterion:

It should consider all cash flows to determine the true profitability of the project It should provide for an objective and an unambiguous way of separating good projects from bad projects It should help ranking of projects according to their true profitability

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It should recognize the fact that bigger and earlier cash flows are

preferable to smaller and delayed ones respectively. It should help to choose among mutually exclusive projects which maximizes shareholders wealth. It should be a criterion which is applicable to any conceivable investment project independent of others.

Accounting Profit Vs Cash Flow Approach

The cash flow approach for measuring benefits is theoretically superior

to the accounting profit approach because: Avoids the ambiguity of the accounting profits concept Measures the total benefit Takes into account the time value of money.

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Investment Evaluation Criteria

The methods of appraising capital expenditure proposals can be classified into two broad categories:
1)

Traditional (Non-Discounted Cash Flow Criteria) a) Average Rate of Return (ARR) b) Pay back period (PB)

2)

Time adjusted (Discounted Cash Flow Criteria DCF) a) Net Present Value Method b) Internal Rate of Return method c) Net Terminal Value Method d) Profitability Index (PI)

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TRADITIONAL TECHNIQUES
1.Average rate of return: (ARR)
This is also known as accounting rate of return method. It is based on accounting information rather than cash flows. There are a no. of methods for calculating ARR:
ARR= (Av Annual PAT / Av Inv over the life of the proj.)X 100

Av PAT = AfTx Pr expected for each yr / No of years Av Inv = Net Inv /2 The averaging process also assumes that the firm is using straight line method of depreciation. Book value of the asset declines at a constant rate from its purchase price to zero at the end of its depreciable life. This means that on an average firms will have of their initial purchase price in the books. And if the machine has a salvage value then only the depreciable cost of the machine should be divided by 2 in order to ascertain the average net investment as the salvage money will be recovered only at the end. Average investment = NWC + Salvage Val + (initial cost of machine salvage val)

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Eg:
Cost An Estimated inc (aft D & T) Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 Estimated Life Estimated Salvage Val Mch A 56,125 3375 5375 7375 9375 11375 36875 5yrs 3000 Mch B 56,125 11375 9375 7375 5375 3375 36875 5yrs 3000

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ARR = (Av Inc / Av Inv) X 100 Av Inc of Mch. A & B 36875 /5 = 7375 Av Inv = Salvage Val + (Cost of Mch. Salvage Val) Rs. 3000 + (Rs. 56,125 Rs 3000) = Rs. 29, 562.50 ARR for Mch. A& B = Rs. (7375/ 29562.50) X 100 = 24.9%

ACCEPT REJECT RULE ARR would be compared with a predetermined or a minimum required rate of return or cut off rate. A project would qualify to be accepted if the actual ARR is higher than that desired ARR. Alternatively the ranking method could be used.

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Evaluation of the ARR:

Machines Av An Earnings Average Inv Rs. 30,000 ARR %

Favorable Attributes : Figures are easily available Easy to understand

A B C

Rs 6000 2000 4000

20 20 20

10,000 20,000

Drawbacks: Uses the Accounting income instead of Cash flows. Does not take into a/c time value of money Does not take into a/c size of investment required for each project. Competing investment proposals may have the same ARR but may require different av. investments Method does not take into consideration any benefits which can accrue to the firm from the sale or abandonment of equipment which is replaced by the new investment. (The new inv From the pt of view of correct
financial decision making should be measured in terms of incremental cash outflows due to new investment i.e. new inv sale proceeds of existing equipment +/- tax adjustment)

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2. PAY BACK PERIOD

This method answers the question: how many years

will it take for the cash benefits to pay the original cost of an investment? (normally, disregarding salvage value) The pay back method measures the number of years required for the CFAT to pay back the original outlay required in an investment proposal.

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There are two ways of calculating PBP

1) When cash flow is in the nature of an annuity: PB=(Inv/Const. annual Cash Flows)
Eg: Inv of Rs. 40,000 in a mch is expected to produce a CFAT of Rs. 8000. PB = 40000/8000 = 5 yrs.

2) When cash flows are not uniform: (Mixed Stream)PB, here is determined by cumulating cash flows till the time when cumulative cash flows become equal to original investment outlay.

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Annual CFAT Yr. 1 2 3 4 5 Mch.A 14000 16000 18000 20000 25000 Mch.B 22000 20000 18000 16000 17000

Cumulative CFAT Mch.A 14000 30000 48000 68000 93000 Mch.B 22000 42000 60000 76000 93000

CFAT in the 5th yr includes Rs.3000 salvage val.

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Initial Inv of Rs.56,125 on Mch.A will be recovered

between 3rd & the 4th yr. 56,125-48,000 = 8,125/20,000 = 0.406 (CFAT) = 3.406 yrs. Similarly the other one is 2.785 yrs.
ACCEPT REJECT CRITERION:
Compare actual with predetermined if actual PB is < Predetermined PB the project will be accepted & vice-versa. Alternatively a ranking method can be used in case of mutually exclusive projects.

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MERITS / DEMERITS
MERITS:
1) Easy to Calculate & Simple to Understand 2) It is based on cash flow rather than Accounting Profits

DEMERITS:
1) Completely ignores cash flows after the pay back period 2) It does not measure correctly even the cash flows expected to be received within the pay back period as it does not differentiate between projects in terms of the timing or magnitude of cash flows. It considers only the recovery period as a whole. (it ignores the time value of money) 3) It does not take into consideration the entire life of the project during which cash flows are generated. As a result project with large cash inflows will be in the later part of their lives may be rejected in favour of less profitable projects.

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1. Net present Value Method

It is a DCF Technique that explicitly recognizes the

time value of money.

NPV may be described as the summation of Present

Values of Cash Proceeds (CFAT) in each year minus the summation of the present values of the net cash outflows in each yr.

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It is described as the summation of the present values of cash proceeds (CFAT) in each year minus the summation of present values of the net cash outflows in each year.

NPV
C= Cash Flows K= Opportunity cost of capital C0 = initial cost of inv. n= expected life of investment

=
t=1

CFt (1+K)t

Sn + Wn (1+K)n

CO0

COt (1+K)t

K = Discount Rate CFt = Cash Inflows at different time periods Sn, W n = (salvage val & Wkg Cap adjustments) CO0 = initial cash outlay

NPV =
t

Ct t 1 (1 + k )

C0

Summation of Pr.Val of Cash proceeds in each yr Summation of Pr Val of Cash outflows in each yr.

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Rs.

Rs.

Mch-A Yr CFAT PV Factor

(0.10) (rate of disc 10%)

56,125 PV CFAT

Mch-B PV Factor
(0.10)

56,125
PV

1 2 3

14000 16000 18000

0.909 0.826 0.751

12726 13216 13518

22000 20000 18000

0.909 0.826 0.751

19998 16520 13518

4
5

20000
25000

0.683
0.621

14660
15525 69,645

16000
17000

0.683
0.621

10928
10557 71,521

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The decision rule for a project under NPV is to accept

the project if the NPV is positive and reject if it is negative. IF NPV>0 Accept & if NPV<0 Reject & a firm with NPV=0 is also practically rejected.
Evaluation: The method has several MERITS:

1. It recognizes time value of money. (For e.g. the total cash inflows (CFAT) of both machines are equal, but the PV as well as the NPV are different. (This is because of the difference in pattern of cash flows magnitude of cash fl. CFAT for machine A is lower than B in the initial years.

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2)

It also fulfills the second attribute of a sound method of appraisal as it considers the total benefit arising out of the proposals over its life. A changing discount rate can be built into the NPV calculations by altering the denominator. (This feature becomes important as this rate normally changes because the longer the time span, the lower is the value of money and the higher is the discount rate.) The Present Value method is logically consistent with the goal of maximizing share holders wealth. (If NPV = O, the ROI just equals the expected or required rate by investors but if PV exceeds the outlay of NPV the return would be higher than expected and as such lead to an increase in share prices)

3)

4)

DEMERITS:
1)

It is difficult to compute and understand as compared to the PB or the ARR method.

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2)

It involves the calculation of the required rate of return to discount cash flows. The discount rate is very important as different disc. Rates will give different PVs. (The cost of capital k is generally the basis of the discount rate.) It is an absolute measure (The method favours projects with higher PV / NPV) but some projects may involve a large initial outlay. So NPV method is not suitable where projects involve different outlays. The result is not very dependable. Also this method is not suitable in case of projects having different effective lives. (Projects with shorter economic life would be preferable.) But Projects having a high PV may also have a larger economic life and the funds will remain invested for a longer time while the alternative proposal may have a shorter time period but a lower PV too.

3)

4)

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2. IRR - Method
It is defined as the discount rate (r) which equates the aggregate present value of the net cash inflows (CFAT) with the aggregate PV of cash outflows of a project. It is the rate that equates the investment outlay with the For PV of cash inflows received after 1 period.
Conventional Cash flows
n

For Unconventional Cash flows

n

=
t=1

CFt (1+r)t

Sn + W n (1+r)n

CO0

=
t=1

CFt (1+r)t

Sn + W n (1+r)n

- t=0

COt (1+r)t

R = internal rate of return CFt = Cash Inflow at different Time periods Sn = Salvage Value Wn = Working Capital Adj Cot = Cash Outlay at Different time periods Co0 = Initial Outlay

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In case of NPV the discount rate is the required rate of return

and being a predetermined rate usually the cost of capital, its determinants are external to the proposal under consideration. The IRR on the other hand are based on facts which are internal to the proposal. In other words while arriving at the required rate of return for finding out present value: the cash flows - inflows as well as outflows are not considered. But the IRR depends entirely on the initial outlay and the cash proceeds of the project which is being evaluated for acceptance or rejection. Therefore it is called internal rate of return.

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Point of difference between NPV & IRR

(k) Here is not calculated on the basis of cash inflow and cash outflow but

rather on initial outlay and cash proceeds of the project under consideration.
The basis of discounting factor is different in both cases: in NPV the disc rate is

the required rate of return and is predetermined. (on the basis of factors external to the proposal)

Computation
The calculation procedure depends on whether the cash flow is in the nature of an annuity or mixed stream

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Calculation in case of an annuity

STEPS REQUIRED 1. Determine the pay back period of the proposed investment 2. From the present value table of an annuity look for the pay back period that is equal to or closest to the life of the project 3. In the year row find two PV values or discount factors closest to PB period but one bigger and the other smaller than it 4. From the table note the corresponding PV values 5. Determine actual IRR by interpolation.
PB - DFr IRR = r ----------------------------------DFrL DFrH
PB = Pay Back Period DFr= Discount Factor for Interest rate r DFrL = Discount Factor for lower interest rate DFrH = Discount Factor for higher interest rate r = either of the 2 interest rates used in the formula. OR

PVco PVCFAT IRR = r ----------------------------------- X r PV

PVco = Present Value of Cash Outlay PVCFAT = Present Value of Cash Inflows (DFr r = Difference in interest rates PV = Difference in calculated PV of inflows.
X Annuity)

r = either of the 2 interest rates used in the formula.

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A project cost Rs. 36,000 and is expected to generate cash inflows of Rs. 11,200 annually for 5 years. Calculate the IRR of the project.
Step I: Determine the Pay Back Period
Rs.36,000/Rs.11,200 = 3.214

Step II: Refer to PV table for annuity

Disc factor closest to 3.214 for 5 yrs are 3.274(16%) and 3.199 at (17%)

Step III: Now determine the actual ARR lying between the two values.
IRR = r- [ (PB DFr) / (DFrl - DFrh) ] = 16 + [ (3.274 -3.214)/ (3.274-3.199)] = 16.8% alternatively, 17 [(3.214 3.199)/(3.274-3.199)] = 16.8% Can also use the interpolation formula: PV CFAT = (0.16) = Rs. 11,200 X 3.274 = Rs. 36,668.8 PV CFAT = (0.17) = Rs. 11,200 X 3.199 = Rs. 35,828.8 IRR = 16+ [(36,668.8 36,000)/ (36,668.8-35,828.8)]X 1 = 16.8% IRR = 17- [(36,000 35,828.8)/ (36,668.8-35,828.8)]X 1 = 16.8%

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For a Mixed Stream of Cash Flows: STEPS

1) Calculate the average annual cash inflow to get a fake annuity 2) Determine fake PB period dividing the initial outlay by the average annual CFAT 3)

4)

5) 6)

7)

determined in step 1 Look for the factor in the annuity table closest to the fake PB value in the same manner as in the case of annuity. The result will be a rough approximation of the IRR, based on the assumption that the mixed stream is an annuity (fake annuity) Adjust subjectively the IRR obtained in step 3 by comparing the pattern of average annual cash inflows as per step 1 to the actual mixed stream of cash flows. If the actual cash flow stream happens to be higher in the initial years of the projects life than the average stream, adjust the IRR a few % point upwards. (Reason: the greater recovery of funds in the earlier years are likely to give a higher yield rate. Find out the PV of the mixed cash flows using the PV table taking the IRR as the discount rate as estimated in step 4 Calculate the PV using the discount rate. If the PV of CFAT equals the initial outlay, i.e. NPV=0, it is the IRR, otherwise repeat step 5. Stop as soon as the two consecutive discount rates that causes the NPV to be +ve & -ve is arrived at. Whichever of these two rates causes the NPV to be closest to 0 is the IRR to the nearest 1% The actual value can be ascertained by the method of interpolation as in the case of an annuity.

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The same example taken earlier:

Cost An Estimated inc (aft D & T) Yr. 1 Yr. 2 Yr. 3 Yr. 4 Yr. 5 Estimated Life Estimated Salvage Val
Annual CFAT Yr. 1 2 3 4 5 Mch.A 14000 16000 18000 20000 25000 Mch.B 22000 20000 18000 16000 17000

Mch A 56,125

Mch B 56,125

3375 11375 5375 9375 7375 7375 9375 5375 11375 3375 36875 36875 5yrs 5yrs 3000 3000

Cash Flows

Cumulative CFAT Mch.A 14000 30000 48000 68000 93000 Mch.B 22000 42000 60000 76000 93000

CFAT in the 5th yr includes Rs.3000 salvage val.

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Sol. using IRR:

The sum of cash inflows of both machines is Rs. 93,000 5 yrs (ec. life) = 18,600 fake annuity 2) Fake av. PB period: 56,125 (initial outlay) 18,600 = 3.017 yrs. 3) From the PV table of Annuity the factor closest to 3.017 for 5 yrs is 2.991 for a rate of 20% 4) Since the actual cash flows in the earlier years are greater than the average cash flows of Rs. 18,600 in machinery B a subjective increase of say 1% is made. This makes an estimated IRR of 21% for machinery B. In case of machinery A since cash inflows in the initial years are smaller than the average cash flows, a subjective decrease of say 2% is made. This makes the estimated IRR for machinery A at 18%
1)

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5)

Using the PV factor of 21% for M-B and 18% for M-A, the PVs are calculated as follows by referring to the PV table.
Rs. Rs.

Mch-A Yr CFAT PV Factor

(0.18)

56,125 Total PV CFAT

Mch-B
PV Factor (0.21)

56,125
Total PV

1 2 3 4 5 Total PV

14000 16000 18000 20000 25000

0.847 0.718 0.609 0.516 0.437

11,858 11,488 10.962 10,320 10,925 55,553 56,125 -572

22000 20000 18000 16000 17000

0.826 0.683 0.564 0.467 0.386

18,172 13,660 10,152 7,472 6,562 56,018 56,125 -107

Less Initial Inv: NPV

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6)

7)

Since NPV is negative for both the machines the discount rate should subsequently be lowered. In case of machinery A the difference is Rs. 572 whereas in machinery B the difference is Rs. 107. Therefore in the former case the discount rate is lowered by 1% in both the cases. The new disc rate is : 17% for A and 20% for B. Now do fresh calculations at the above rates:
Mch-A Yr CFAT PV Factor
(0.17)

56,125 Total PV CFAT

Mch-B
PV Factor (0.20)

56,125
Total PV

1 2 3 4

14000 16000 18000 20000

0.855 0.731 0.624 0.534

11,970 11,696 10,232 10,680

22000 20000 18000 16000

0.833 0.694 0.579 0.484

18,326 13.880 10,422 7,712

25000

0.456

11.400
56,978 56,125 853

17000

0.442

6,834
57,174 56,125 1,049

Total PV Less Initial Inv: NPV

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8) For M-A, 17 & 18% discount rates consecutively gives +ve & -ve NPVs. Applying method of interpolation we get:

M-A : IRR = 17+ [(56978-56125)/56978-55553)]X 1= 17.6% M-B : IRR = 20+ [(57174-56125)/57174-56018)] X 1 = 20.9%

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Evaluation of IRR:
Merits:
It considers the time value of money It takes into a/c total cash inflows and outflows

It is easier to understand for lay people as they may have difficulties in

understanding NPV It also is consistent with shareholders objective Demerits: First it involves tedious calculations Next it produces multiple rates which is confusing Thirdly in evaluating mutually exclusive proposals the project with the highest IRR would be picked up to the exclusion of all others. But practically it may not be so.. Finally under the IRR it is assumed that all intermediate cash flows are reinvested at the IRR . In the example above we saw M-A & M-B has an IRR of 17.6 and 20.9 % rsp. and as such can be reinvested at these rates, which is ridiculous that the same firm has the ability to reinvest the cash flows at different rates.

There is no difference in quality of cash received from project A & B. Moreover, it is not that all cash may be reinvested, they may be retained back or distributed as dividends.

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3. TERMINAL VALUE METHOD

The terminal value approach even more distinctly

separates the timing of cash inflows and outflows. The assumption behind the TV approach is that each cash inflow is reinvested in another asset at a certain rate of return from the moment it is received until the termination of the project.

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Accept/Reject Rule:
The decision rule is that the PV of the sum total of the compounded

reinvested cash inflows (PVTS) is greater than the PV of the outflows(PVO) PVTS>PVO = Accept PVTS<PVO = Reject

Advantage:

1) It explicitly incorporates the assumption about how the cash inflows are reinvested once they are received and avoid any influence of cost of capital on cash inflow stream itself. 2) It is mathematically easier 3) Is easier to understand 4) it is better suited to cash budgeting requirements

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4. Profitability Index Method

Yet another time adjusted Capital budgeting technique is the PI

or the Benefit Cost Ratio (B/C) method. It is similar to NPV approach. It measures the PV of returns per rupee invested, while the NPV is based on the PV of future cash inflows and PV of future cash outflows. A major shortcoming of the NPV method is that being an absolute measure it is not a reliable method to evaluate projects requiring different initial investments. The PI method provides a solution to this kind of a problem. PI= (PV of Cash Infl/PV of Cash Outfl) Numerator measures benefit and denominator Costs. Therefore B/C method. Accept Reject Rule: PI >1 accept otherwise reject

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Capital Budgeting Practices in India

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Example 1:

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Example 2:

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Capital Rationing:
Capital Rationing refers to the choice of investment proposals

under financial constraints in terms of a given size of capital expenditure budget. The objective to select the combination of projects would be the maximisation of total NPV. Project selection under capital rationing involves 2 stages: (1) identification of the acceptable projects (2) Selection of the combination of projects. The acceptability of projects can be based either on PI or IRR. The method of selecting investment projects under capital rationing situation will depend upon whether the projects are indivisible or divisible. In case the project is to be accepted or rejected in its entirety, it is called an indivisible project ; a divisible project on the other hand can be accepted/rejected in part.

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Exercises on capital rationing

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iiheh

Q3

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