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# TERM PAPER

MBM-202 FINANCIAL MANAGEMENT

TOPIC

CAPITAL BUDGETING

SUBMITTED BY:KOMAL KHEMANI MBA-II SEMESTER D.E.I

CONTENTS

CAPITAL BUDGETING THE CONCEPT ......................................................................................... 3 Objectives of capital budgeting: .................................................................................................. 3 Scope of capital Budgeting: ......................................................................................................... 3 Evaluation of Capital Projects ........................................................................................................... 4 Capital Budgeting Process ................................................................................................................ 5 Traditional Methods ...................................................................................................................... 6 Discounted cash flow techniques................................................................................................. 10 CONCLUSION .............................................................................................................................. 19 REFERENCES ............................................................................................................................... 20

**CAPITAL BUDGETING THE CONCEPT
**

Capital budgeting is the technique of making long-term planning decisions for investment and their finance. Decisions on capital expenditure are difficult as future is uncertain. It includes current cash outlay or a series of cash outlays in return for an anticipated flow of future benefits. Capital budgeting is employed to evaluate long-term expenditure decisions which involve current outlays and the benefits that occur in the future years.

**Objectives of capital budgeting:
**

To help select projects that assist in maximizing the market value of the firm while rejecting projects which do not assist in maximizing value. Only by seeking and accepting projects that return an incremental amount above the opportunity cost of capital will the firm be adding to its value. To estimate the total change in the firm's cash flows that results because a project is undertaken. Hence indirect effects on the costs and/or revenues associated with a firm's other projects that occur as a result of the acceptance of a new project should be considered when evaluating the cash flows from a new project

**Scope of capital Budgeting:
**

Capital budgeting decision ultimately affects the profitability of the business. Scope of capital Budgeting may be summarised as follows: Investment in long term projects or fixed assets is undertaken with a view to expand, or to increase production or to reduce costs which will lead to increase profits. The benefits of such investment decisions are likely to accrue in the future after a long period of time. Apart from the costs of the fixed assets purchased, other costs also increase. Huge amount of capital outlay are involved when a decision to purchase fixed assets or invest in projects is take.

**Evaluation of Capital Projects
**

Evaluation of capital projects refers to the development and applications of basic theory, techniques and procedures for the appraisal of capital projects, bath as the time of their approval and in the course of their implementation.

Capital Budgeting Decision OR Investment decision

Project Generation

Project Evaluation

Project Screening and Selection

Project Execution

Control of Capital Expenditure

Cash Flow Estimates

Selection of Evaluation methods

Cash out Flow With Certainty

Cash in Flow

Uncertainty Risk Return

Trade Off

Market value Per Share

The following are the Evaluation methods:y y y y y y y y y y Payback period(PB) Post-payback profitability(PPP) Average Rate of Return(ARR) Minimum Unit Cost Net Present value(NPV) Profitability Index(PI) Internal Rate of Return(IRR) Net Terminal Value(NTV) Discounted payback period(DPP) Cut-off rate

**Capital Budgeting Process
**

Capital Budgeting process is very complex process. There would be conceptual idea about a project generation and it should be evaluated by measuring the projects worth in its economy, productivity and profitability. Project evaluation involves eight steps; (a) Estimation of cash flow i.e.; investment. (b) Estimation of benefits (c) Estimation of costs (d) Technical and flexibility evaluation, Project schedules, PERT and CPM charts (e) Estimation of cash inflows taking the depreciation and tax into account (f) Estimation of risk and uncertainty (g) Selection of suitable evaluation method (h) Finally, selection of project among the various alternatives

Various alternative items are to be screened and finally selected by application of a suitable appraisal method. Then the project is to be executed with strict control on capital expenditure sot that the authorized outlay is not exceeded. While execution of this project, the physical process of work and capital expenditure are to be matched. Time and cost-over runs should be avoided as this

will increase the cost of the project. There should be a point of equilibrium between the risk and return so that the market value per share is optimum.

Traditional Methods

y Payback Period:It indicates the number of years required to recover the initial cash outlay invested in a project. The payback period is one of the most popular and widely recognized traditional methods of evaluating investments proposals. It is defined as the number of years required to recover the original cash outlay invested in a project. The following are the formulas for calculating the payback period: if cash flows are even(uniform):If the cash flows are even (uniform) then the payback period is calculated by following formula;

Payback Period=

Investment Annual Cash Flow

if cash flows are uneven or not even:If cash flows are uneven or not even then the payback period is determined by adding up the cash flows till the total cash flow is equal to the amount of investment made.

(i) Accept/Reject criteria:Many firms use the payback period as an accept/reject criteria as well as a method of ranking projects. If the payback period calculated for a project is less than the maximum or standard payback period set by management, it would be accepted; if not, it would be rejected.

(ii) Ranking method:As a ranking method, it gives highest ranking to the project which has the shortest payback period and lowest ranking to the project with highest payback period.

(iii) Mutually exclusively Projects:If the firm has to choose among the two mutually exclusive projects, the project with shorter payback period will be selected.

Advantages of Payback period:(a) (b) (c) (d) It is very simple measure of economic feasibility (possibility). It is very easy to apply, calculate and interpret. It is easy to understand. The emphasis is on early recovery of the investment. Thus, it gives importance to liquidity aspect. The funds so released can be put to the other uses .i.e.; it emphasizes only on liquidity and solvency of the firm. (e) It costs less than most of the sophisticated technique which require a lot of the analysis time and use of computers. (f) The payback period is a meaningful indicator of economic feasibility in case of the firms where the risk of obsolescence is high in comparison to other projects is expected to pay for them faster. (g) It takes less time to calculate and hence the cost of analysis is low.

Disadvantages of Payback period:In spite of its simplicity, the payback may not be a desirable investment criterion since it suffers from a number of serious limitations;

(a)

The main limitation is that this method fails to take into account the time, value and money.

Cash flows of equal amounts are considered to be the same even though they occur in different time periods.

(b)

It does not take into account the cash flows over the entire life of project. Cash flows after the

payback period are ignored.

(c)

Administrative difficulties may be faced in determining the maximum acceptable payback

period. There is no scientific basis for setting up a maximum payback period. It is a subjective decision.

(d)

It does not show the economic return on investment.

(e)

This method is not consistent with the objective of maximizing the market value per share.

(f)

It may choose highly risk projects because of having a shorter standard payback period as it

may ensure guarantee against loss.

y

Accounting Rate of Return(ARR):Accounting rate of return is compared with predetermined or minimum required rate

of return.

Formula:-

ARR=

Average profits after taxes Average Investment

100

Net Investment 2

Average Investment =

Net Investment = Book value of investment at beginning ± Book value of investment at the end.

If salvage value is there:-

Average investment = Salvage value + ½(cost ± salvage value)

(i) Accept/Reject criteria:As ARR is compared with predetermined or minimum required rate of return, if ARR > minimum required rate if return, then accept the project and if the ARR < minimum required rate of return then reject the project.

(ii) Ranking method:As a method of ranking the projects, highest rank is given to projects with highest ARR and lowest rank is given to project with lowest ARR.

Merits of ARR:(a) It is very much simple to understand. (b) It is calculated from accounting data which is readily available from books of accounts. (c) It tales into account the entire stream of income in calculating the projects profitability.

Demerits of ARR:(a) (b) As the decision criterion is concerned, it suffers from serious shortcomings. It uses accounting profits and not cash flows. Accounting profits are based upon arbitory assumptions and includes non-cash items. Accounting profits are considered to be inappropriate for measuring the projects profitability. (c) It ignores time, value and money. It gives equal weightage to benefits receivable in different time periods.

Discounted cash flow techniques

y Net Present Value(NPV):Definitions:-

o

The future stream of benefits and costs converted into equivalent values today. This is done by assigning monetary values to benefits and costs, discounting future benefits and costs using an appropriate discount rate, and subtracting the sum total of discounted costs from the sum total of discounted benefits.

o

The present value of an investment's future net cash flows minus the initial investment. If positive, the investment should be made (unless an even better investment exists), otherwise it should not.

Formula:-

There are three main reasons why NPV is usually the best choice for measuring project value. 1. NPV assumes that project cash flows are reinvested at the company's required rate of return; the IRR assumes that they are reinvested at the IRR. Since IRR is higher than the required rate of return, in order for the IRR to be accurate, the company would have to keep finding projects that would reinvest the cash flow at this higher rate. It would be difficult for a company to keep this up forever, thus NPV is more accurate.

2. NPV measures project value more directly than IRR. This is because NPV actually calculates the project's value. If there is more than one project lined up, the manager can simply add the values together to get a total. 3. Often times, during the life of a project, cash flows must be reinvested to cover depreciation. This will give a negative cash flow for that period, thus leading to more than one IRR. If there is more than one IRR, than calculating only 1 IRR for the project is not reliable. NPV must be used for this type of project.

D Advantages of NPV:Net Present Value (NPV) is one of the most robust financial tools available to value any type of investment or activity. NPV analysis incorporates four key benefits or elements to establish the value of an investment: Î Time Value of Money: - Recognizes the time value of money concept that says a dollar earned today is worth more than a dollar earned five years from now. Î Cash Flows: - Calculates the expected cash flows generated from the project and incorporates the unique risks of obtaining those cash flows. NPV also eliminates accounting inconsistencies as the cash flows are representative of the benefits of the project not accounting profits.

Î Risks: - Incorporates the risks associated with the project via the expected cash flows and/or discount rate.

Î Flexibility: - Provides flexibility and depth as the NPV equation can adjust for inflation as well as incorporate other financial analysis tools such as scenario analysis, Monte Carlo simulation, etc.

Î Objective maximizing market price:- It is consistent with the objective of maximizing the market price of shares. If NPV is positive, the return is higher than the return expected by the shareholders. This increases the share prices. If NPV is negative, it has a negative impact on share prices. The NPV concept is consistent with maximizing the value of the firm and is used by investors in the evaluation of a company or in capital budgeting decisions when comparing the value of different projects. For these reasons, the NPV concept is being used more and more in corporate America as substitute to other financial evaluation tools such as Internal Rate of Return (IRR) and Total Cost of Ownership (TCO). D Disadvantages:1. It is difficult to use. 2. The calculation of the NPV presupposes (assumes) that discount rate is known but the cost of capital is a difficult concept to understand and measure in practice. The success of capital budgeting techniques depends upon the correctness with which the cost of capital is determined. 3. It does not give satisfactory answers when projects are being compared involved different amount of investment. The limitation of NPV method is that the NPV doe not correlate the NPV of project with its investment. 4. It does not give satisfactory answers when we are comparing projects with unequal life¶s. The alternative with high NPV may involve larger economic life and it would be less desirable as the funds remain invested for a long period. The alternative having shorter life may have less NPV. In general project with short economic life should be preferred.

y Profitability Index:Yet another time adjusted method of evaluating the investment proposals is the benefit cost (B/C) ratio or profitability index (PI). It is the ratio of present value of cash inflows, at their required rate of return, to the initial cash outflows of the investment. It may be gross or net; net being simply gross minus one. The formula to calculate the profitability index is as follows:-

Formula:-

Profitability Index = Present value of cash inflows / Present value of cash outflows

N

Problem for calculating Profitability Index:-

(By taking into consideration the industrial visit)

y

Siyaram silk mills ltd. Is considering the two projects namely Project Fabric and Project Garment. Projects are available at cost of Rs. 14000 lakhs each and have a life of 5 years. The cash flows of this company are as follows:Amount in Lakhs««

Years 2001 2002 2003 2004 2005

Proj.Garment 2254 5000 3065 3908 3005

Proj. Fabric 2150 5410 3070 1507 5623

Calculate Profitability Index (PI) method [cash flows are given after deducting depreciation and taxes]. Also write which project is accepted and which is rejected.

Solution:As discount rate is not mentioned we assume the discount rate as 7%.

y

Evaluation of PI for Project Garment Amt. in lakhs««.

Years 2001 2002 2003 2004 2005

Cash

Flow

after Present value factor @7% discount Present value of rate 1/(1+0.07)1 = 0.934 1/(1+0.07)2 = 0.877 1/(1+0.07) = 0.819 1/(1+0.07)4 = 0.763 1/(1+0.07)5 = 0.714 Present value of cash inflows=

3

depreciation and tax 2254 5000 3065 3908 3005

cash inflows 2105.23 4385.00 2510.23 2981.80 2145.57 14127.83

So, Profitability Index = Present value of cash inflows / Present value of cash outflows = 14127.83/14000

PI = 1.009.

y

Evaluation of PI for Project Fabric Amt. in lakhs««.

Years 2001 2002 2003 2004 2005

Cash

Flow

after Present value factor @7% discount Present value of rate 1/(1+0.07)1 = 0.934 1/(1+0.07)2 = 0.877 1/(1+0.07)3 = 0.819 1/(1+0.07) = 0.763 1/(1+0.07)5 = 0.714 Present value of cash inflows=

4

depreciation and tax 2150 5410 3070 1507 5623

cash inflows 2008.17 4744.57 2514.33 1149.84 4014.82 14431.66

So, Profitability Index = Present value of cash inflows / Present value of cash outflows = 14431.66/14000

PI

= 1.030.

As the method of the accepting and rejecting criteria is concerned then, Project Garment will be accepted and Project Fabric will be rejected. Because Project garment¶s period compared to Project Fabric is less.

N Problem for calculation of NPV (Net Present Value) and PI (Profitability Index):{by taking into consideration of Industry visit}

Siyaram Silk Mills Ltd. Is considering the two new projects which would carryout some operations that present performed manually. The two alternative projects are namely Project Fabric and Project Garment. The company¶s cash outlay is of Rs.1310.89 lakhs. The rate of return is 10% and pays tax at 50% rate. Project will be depreciated as on straight line basis. The net cash flows given below are before depreciation and taxes. Amt. in lakhs««. Years 2005 2004 Proj.Fabric 30235.84 29833.51 Proj. Garment 28008.65 26352.61

Which of the above projects should be accepted according to the following methods:Î NPV method (Net Present Value) Î Profitability Index (P I )

The present value of Re.1/- at 10% for different years is as follows:Year 2005 2004 Present Value Factor 0.909 0.826

Solution:-

Calculation for Project Fabric:Years (1) 2005 2004 CFBDAT (2) 30235.84 29833.51 -dep (3) 655.44 655.44 CFADBT (4) 29580.4 29178.07 Tax(50%) (5) 14790.2 14589.03 CFAT (6) 14790.2 14589.04 CFATAD (7) 15445.64 15244.47 PV @10%(8) 0.909 0.826 PVCIF (9) 14040.08 12591.93

PVCIF PVCOF

26632.01 -1310.89

NPV

25321.12

CFBDAT ---------- Cash Flow before Depreciation and Tax {(given)} CFADBT ---------- Cash Flow after Depreciation before Tax {(2) ± (3)} CFAT ---------- Cash Flow after Tax {50 % of CFADBT}

CFATAD ---------- Cash Flow after Tax and Depreciation {(7) + (3)} PVCIF PVCOF NPV ---------- Present Value of Cash Inflow {(8) * (7)} ---------- Present Value of Cash Outflow {(given)} ---------- Net Present Value {(CIF ± COF)}

Depreciation = Investment / years given = 1310.89 / 2 = 655.44

NPV = PVCIF - PVCOF = 26632.01 ± 1310.89. = 25321.12

Net Present Value has a positive value Profitability Index = Present value of cash inflows / Present value of cash outflows = 26632.01 / 1310.89

PI

= 20.31.

Years (1) 2005 2004

CFBDAT (2) 28008.65 26352.61

-dep (3) 655.44 655.44

CFADBT (4) 27353.21 25697.17

Tax(50%) (5) 13676.60 12848.58

CFAT (6) 13676.61 12848.59

CFATAD (7) 14332.04 13504.02

PV @10%(8) 0.909 0.826 PVCIF PVCOF NPV

PVCIF (9) 13027.82 11154.32 24182.14 - 1310.89 +22871.25

Calculation for Project Garment:CFBDAT ---------- Cash Flow before Depreciation and Tax {(given)} CFADBT ---------- Cash Flow after Depreciation before Tax {(2) ± (3)} CFAT ---------- Cash Flow after Tax {50 % of CFADBT}

CFATAD ---------- Cash Flow after Tax and Depreciation {(7) + (3)} PVCIF PVCOF NPV ---------- Present Value of Cash Inflow {(8) * (7)} ---------- Present Value of Cash Outflow {(given)} ---------- Net Present Value {(CIF ± COF)}

Depreciation = Investment / years given = 1310.89 / 2 = 655.44

NPV = PVCIF - PVCOF = 24182.14 ± 1310.89. = 22871.25

Net Present Value has a positive value

Profitability Index = Present value of cash inflows / Present value of cash outflows = 24182.14 / 1310.89

PI

= 18.44.

In case of NPV, both the projects have positive value so both the projects are accepted. In case of PI method, Project Garment has got less number of period so this project is accepted other than project fabric.

CONCLUSION

The long-term investments we make today determines the value we will have tomorrow. Therefore, capital budgeting analysis is critical to creating value within financial management. And the only certainty within capital budgeting is uncertainty. Therefore, one of the biggest challenges in capital budgeting is to manage uncertainty. We deal with uncertainty through a three-stage process: 1. Build knowledge through decision analysis. 2. Recognize and encourage options within projects. 3. Invest based on economic criteria that have realistic economic assumptions. Once we have completed the three-stage process (as outlined above), we evaluate capital projects using a mix of economic criteria that adheres to the principles of financial management. Three good economic criteria are Net Present Value, Modified Internal Rate of Return, and Discounted Payback. Additionally, we need to manage project risk differently than we would manage uncertainty. We have several tools to help us manage risks, such as increasing the discount rate. Finally, we want to implement post analysis and tracking of projects after we have made the investment. This helps eliminate bias and errors in the capital budgeting process.

REFERENCES

WEBSITES

y y y y y

BOOKS

en.wikipedia.org www.teachmefinance.com www.investopedia.com www.studyfinance.com www.investorwords.com

y y

Financial management by I M Panday Basic Financial Management by M. Y. Khan & P K Jain