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LUCKNOW

CAPITAL BUDGETING OF CANTEEN WALA

INTRODUCTION

times. It involves decisions to commit the firms funds to the long term assets

capital budgeting decisions or investment decisions are of considerable

importance to the firm since they tend to determine its value by influencing

its growth profitability and risk.

the purpose of maximizing the long term profitability of the firm.

It is the firm’s decision to invest its current funds most efficiently in the long

term activities in anticipation of flow of future benefits over a series of

years.

• Search of new and more profitable investment proposals

• The making of an economic analysis to determine the profit potential

of each investment proposals.

events, which are difficult to predict.

Long term effect on profitability (Growth)

the rate & the direction of its growth.

Irreversible nature

capital item once they have been acquired.

A long term commitment of fund may also change the risk complexity of the

firm. If the adoption of an investment increases average gain but causes

frequent fluctuation in its earnings, the firm would become more risky.

it imperative for the firm to plan its investment programs very carefully and

make an advance arrangement for procuring finances internally or

externally.

follows:

A company may add capacity to its existing product lines to expand existing

operations. For example Gujrat State Fertilizer Company may increase its

plant capacity to manufacture more urea it is an example of related

diversification.

The Expansion of New Business

business requires investment in new products and new kind of production

activities with in a firm. This type of expansion is unrelated diversification.

operating efficiency and reduce cost. Cost saving will reflect in increased

profits but the firm’s revenue may remain unchanged the firm must decide to

replace those assets with new assets that operate more economically.

Example if a cement company changes from semi automatic drawing

equipment to fully automatic drawing equipment it is an example of

modernization and replacement.

PROCESS

CAPITAL BUDGETING TECHNIQUES

following two categories:

Discounted cash flow techniques

Net Present Value (NPV)

Internal rate of return (IRR)

Pay back period (PB)

Accounting rate of return (ARR)

It is the method of evaluating project that recognizes that the dollar received

immediately is preferable to a dollar received at some future date. It

discounts the cash flow to take into the account the time value of money.

This approach finds the present value of expected net cash flows of an

investment, discounted at cost of capital and subtract from it the initial cash

outlay of the project.

In case the present value is positive, the project will be accepted; if negative,

it should be rejected. If the projects under consideration are mutually

exclusive the one with the highest net present value should be chosen.

Where,

∑ = Summation

Ft = Net cash flow at time t

k = cost of capital

Io = Initial cash flow

Independent Project: Accept all the projects where NPV 0, reject

otherwise. Mutually Exclusive Project: Rank projects from highest to

lowest NPV and choose the project with highest (positive) NPV.

The NPV profile is a graphical plot of the inverse relationship between the

discount rate, k, and a project’s NPV.

• When NPV > 0, k < the firm’s required rate of return on invested

capital

• When NPV = 0, k = the firm’s required rate of return on invested

capital

• When NPV < 0, k > the firm’s required rate of return on invested

capital

ADVANTAGES:

today is worth more than a rupee received tomorrow.

• Measure of true profitability: It uses all cash flows occurring over the

entire life of the project in calculating its worth. Hence it is a true

measure of the projects profitability.

flows in terms of present value: that is, in terms of equivalent, current

rupees. Therefore, the NPVs of projects can be added.

objective of the shareholder value maximization.

DISADVANTAGES:

cash flows are known. It is quite difficult to obtain the estimates of

cash flows due to uncertainty.

• Mutually exclusive projects: When alternative projects with unequal

lives, or under funds constraints are evaluated. The NPV rule may not

give unambiguous results in these situations.

NPV rule is not independent of the discount rates.

The Internal Rate of Return (IRR) is the discount rate that generates a

zero net present value for a series of future cash flows. This essentially

means that IRR is the rate of return that makes the sum of present value of

future cash flows and the final market value of a project (or an investment)

equal its current market value.

Internal Rate of Return provides a simple ‘hurdle rate’, whereby any project

should be avoided if the cost of capital exceeds this rate. Usually a financial

calculator has to be used to calculate this IRR, though it can also be

mathematically calculated using the following formula:

In the above formula, CF is the Cash Flow generated in the specific period

(the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by

employing trial and error method.

Internal Rate of Return is the flip side of Net Present Value (NPV), where

NPV is the discounted value of a stream of cash flows, generated from an

investment. IRR thus computes the break-even rate of return showing the

discount rate, below which an investment results in a positive NPV.

Internal Rate of Return exceeds the cost of capital and rejected if this IRR is

less than the cost of capital

In the context of savings and loans the IRR is also called effective interest

rate

ADVANTAGES;

• Time value: The IRR method recognizes the time value of money.

• Profitability Holder: It considers all cash flows occurring over the

entire life of the project to calculate its rate of return.

• Acceptance rule: its generally gives the same acceptance rules as the

NPV method.

• Shareholder value: it is consistent with shareholders wealth

maximization objective .whenever a project’s IRR is greater than

opportunity cost of capital, the shareholders wealth will be enhanced.

DISADVANTAGES

• Multiple rates: A project may have multiple rates, or it may not have a

unique rate of return. These problems arise because of the

mathematics of IRR computation.

• Mutually Exclusive Projects: it may also fail to indicate a correct

choice between mutually exclusive projects under certain situations.

• Value Additivity: Unlike in the case of NPV method, the value

additivity principle doesn’t hold when the IRR method is used-IRRs

of projects do not add. Thus, projects A and B, IRR(A)+IRR(B) need

not be equal to IRR(A+B)

executives prefer IRR over NPV. Apparently, managers find it easier to

compare investments of different sizes in terms of percentage rates of return

than by dollars of NPV. However, NPV remains the "more accurate"

reflection of value to the business. IRR, as a measure of investment

efficiency may give better insights in capital constrained situations.

Analysis

For our project, we went to Mr. Reddy the owner of Jaipuria Institute of

Management canteen. He give us the data of the canteen in the begning he

said that he invested Rs. 200000 in the canteen as fixed cost. He deposited

Rs. 50000 to the Jaipuria Institute of Management as security management.

Return on investment for the 5 year as follows:-

1st year -> Rs. 80000

2nd year -> Rs. 82000

3rd year -> Rs. 88000

4th year -> Rs. 86000

5th year -> Rs. 90000

IRR can be determined by solving the following equation for r :

Where

C0 = project cost

C =return on n year

r =discount rate

‚0.04) + 86000(PVF4‚0.04) +

90000(PVF5‚0.04)

90000*0.186

=- Rs 29000

The project’s NPV is negative at 40%,a rate lower than 40% should be tried .

we select 30% , the projects NPV is

88000(PVF3‚0.03) + 86000(PVF4‚0.03) +90000(PVF5‚0.03)

90000*0.269

= Rs 4414

The true rate of return should lies between 30-40 percent. We can find out a

close approximation of the rate of return by the method of linear

interpolation as follows:-

Di

fference

PV required Rs. 200000

Rs. 4414

PV at lower rate 30% Rs. 204414

Rs. 34342

PV at higher rate 40% Rs. 170072

= 30% +1.285%

= 31.285%

While asking question to Mr.Reddy , he said that he can’t more return from

Jaipuria Institute of Management because there is less margin in mess of

hostel. He get more return due to selling of food products to Jaipuria school.

For seeing the project, whether it is feasible or not. We compare it with other

project. We went to Mr. Reddy and ask if you invest Rs.200000 to other

institute in the same business what will be your expected return. He gave the

return on investment for 5 years are as under:-

2nd year: Rs.70000

3rd year: Rs.73000

4th year: Rs.72000

5th year: Rs.76000

NPV= -200000 + 75000*PVF(1,0.25) +70000*PVF(2,0.25)

+73000*PVF(3,0.25) + 72000*PVF(4,0.25) + 76000*PVF(5,0.25)

+76000*0.328

= -200000 +60000 +44800 +37376 +29520 +24928

= -200000 +196624

= -Rs.3376

Since, the project’s NPV negative at 25%, a rate lower then 25% is tried.

When we select 24% as The trial rate, we find that the project’s NPV is RS

574.

NPV= -200000 +75,000*PVF(1,0.24) +70000*PVF(2,0.24)

+73000*PVF(3,0.24) +72000*PVF(4,0.24)+76000*PVF(5,0.24)

720000*0.423+76000*0.341

= -200000 +200574

= Rs.574

The true rate of return should lie between 24-25%. We can find out a close

approximation of the rate of return by the method of linear interpolation

follows:-

Differenc

e

PV required 200000

574

PV at lower rate, 24% 200574

3950

PV at higher rate, 25% 196624

= 24% + 0.1453%

= 24.1453%

Acceptance rule:

The accept and reject rule using IRR methode is to accept the project if its

internal rate of return is higher then the opportunity cost of capital( r>k ).K

is required rate of return or the cut-off or hurdle rate.

Accept the project when r>k

Reject the project when r<k

May accept the project when r=k

i.e. 31.285> 24.145

Hence we accept the project.

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