MSL302

CAPITAL BUDGETING
DECISIONS
TERM PAPER REPORT

Submitted by
Nishant Agarwal
2014EE10464
Tarun Jain
2014EE30541

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Abstract

In today’s fast growing world, companies are faced with tough competitive and its survival
depends on its long term planning. A firm is successful only if it invests wisely by taking
informed decisions and earn profits. Capital budgeting decision are usually long term
decisions, so a firm needs to be much more cautious while taking the final decision whether
to go for a project or not. Here, we are going to discuss a case of hypothetical company in
which we get to learn different aspects of Capital Budgeting Decisions.

Introduction

Nowadays, everyone is looking for a quick bite. At present there are many companies
offering a variety of ready to eat snacks. But there have been many reports cautioning us
about the unhygienic and unhealthy constituents in these snacks. The growing demand of
snacks among youth and children and the absence of a healthier alternative, caught Baba
Ramdev’s attention. With the vision of providing better and healthier snacks he launched
his own company “Ramdev Khanpan Pvt. Ltd”. After three years of extensive research,
his team came up with a great product and is looking to start manufacturing it.

After month of research his team came up with two business proposals. The first proposal,
hereafter referred as ‘Project A’ proposes in-house production by setting up own
manufacturing plant which will involve huge capital investments. The other proposal,
hereafter referred as ‘Project B’ proposes outsourcing of production to a reputed
manufacturing firm, thus saving capital investments but affecting profit margins. Baba
Ramdev faced with these choices asked his CFO Kamlesh to evaluate these proposals and
find the better proposal. The CFO analyses the two proposals using capital budgeting
decisions by applying the concepts learned in MSL302 course taught by Prof Shveta.

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Relevant Data

1. Project A:

A) The proposal of setting up company’s own manufacturing plant involves initial investments as:
1) Buying a newly built factory building: Rs. 17.5 Cr.
2) Purchase of Machinery: Rs 125 Cr.
Total Starting Investment: Rs 142.5 Cr.
B) The newly set up factory will take some time in reaching its full production capacity. The Market
analyst forecasted the production volume as follows:
Year 1 2 3 4 5

Expected Production 5 10 25 30 35
(units)
Expected Sales Revenue
50 100 250 300 350
(Rs Cr.)

C) Cash Flows: The company is likely to bear fixed operation and maintenance expenses of Rs. 5
Cr. Per annum. The production cost for company is Rs 3 per unit while the price of each unit is
Rs 10. The Company is subjected to 35% tax on earnings and a straight line method of
depreciation.

Particulars Year 1 Year 2 Year 3 Year 4 Year 5

Sales Revenue 50 100 250 300 350
Less Fixed Cost 5 5 5 5 5
Less Variable cost 15 30 75 75 87.5
Less depreciation(0.20) 25 25 25 25 25
EBIT 5 40 145 195 232.5
Less Taxes(35%) 1.75 14 50.75 68.25 81.375
EAT 3.25 26 94.25 126.75 151.125
Add depreciation 25 25 25 25 25
CFAT 28.25 51 119.25 151.75 176.125
* All values in Rs Crore
D) Total Investment = Initial Investment + Operating Expenses = 142.5 + 25+282.5 = Rs 450 Cr
Total Earnings after taxes EAT = Rs 401.4 Cr.
Total Cash Flows after Taxes = Rs 523.4 Cr.

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2. Project B:

A) The proposal of outsourcing the production to another firm involved an initial investment for
tenders, legal expenses and advance payments of Rs 6 Crores.
B) The firm charged the following rates for production of snacks depending on the volumes:
Production (Cr. 0-20 20-50 50-100
units)
Charges per unit Rs 4 Rs 3.5 Rs 3

C) The Market analyst forecasted the demand volume for snacks as follows:
Year 1 2 3 4 5
Expected Demand (units) 10 14 20 30 40
Expected Sales Revenue
100 140 200 300 400
(Rs Cr.)

D) Cash Flows: The company is likely to bear distribution and processing charges of Rs 0.2 per
unit other than contract charges. The price per unit is Rs 10 and the Company is subjected to
35% tax on earnings.

Particulars Year 1 Year 2 Year 3 Year 4 Year 5

Sales Revenue 100 140 200 300 400
Contract cost 40 56 80 105 140
Distribution and processing
2 2.8 4 6 8
cost (2%)
EBIT 58 81.2 116 189 252
Less Taxes (35%) 20.3 28.42 40.6 66.15 88.2
EAT 37.7 52.78 75.4 122.85 163.8
CFAT 37.7 52.78 75.4 122.85 163.8

E) Total Investment = Initial Investment + Charges = Rs (6+ 421+23) Cr. = Rs 450 Cr

Total Earnings after taxes EAT = Rs 452.5 Cr.
Total Cash Flows after Taxes = Rs 452.5 Cr.

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Financial Analysis (Capital Budgeting Decisions)

For assessing the two proposals, company’s CFO Kamlesh looked at some popular methods and
compared the two projects.

1. Average Rate of Return (ARR) Method

Accounting rate of return is also called the simple rate of return and is a metric useful in the quick
calculation of a company’s profitability. ARR is used mainly as a general comparison between
multiple projects as it is a very basic look at how a project is doing.

Project A:

Average EAT = (Total EAT / Time Period) = Rs 401.38/5 Cr. = Rs 80.276 Cr.
Average Investment = Total Investment / 2 = Rs 450 /2 Cr. = Rs. 225 Cr.
ARR = (Average EAT ÷ Average Investment) *100 % = 80.276 / 225 * 100 = 35.67%

Project B:

Average EAT = (Total EAT / Time Period) = Rs. 452.53 / 5 Cr. = Rs 90.506 Cr.
Average Investment = Total Investment / 2 = Rs 450 /2 Cr. = Rs. 225 Cr.
ARR = (Average EAT ÷ Average Investment) *100 % = 90.506 / 225 * 100 = 40.22%

He observed that both of the projects have very good rate of return and project B has
slightly better ARR. But ARR does not consider the time value of money, which means
that returns taken in during later years may be worth less than those taken in now,
and does not consider cash flows, which can be an integral part of maintaining a
business. Thus, he must not solely depend on ARR as the method for selecting the
project.
Finally, accounting rate of return does not consider the increased risk of long-term
projects and the increased variability associated with long periods of time.

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2. Pay Back Method

This method indicates the time period required to recover the initial investment outlays of the
capital budgeting proposal. The earlier is the sum received, the better it is as per the payback period.

Year 1 2 3 4 5
Project A 28.25 51 119.25 151.75 176.125
Annual CFAT
Project B 37.7 52.78 75.4 122.85 163.8
Project A 28.25 79.25 198.5 350.25 526.375
Cumulative CFAT
Project B 37.7 90.48 165.88 288.73 452.53

* All values in Rs Crores

We need to recover our total Investment of Rs. 450 Cr, thus payback period for each project is
1. Project A:
CFAT at end of year 4 = 350.25, CFAT at end of year 5 = 526.375
Therefore, by interpolation, PB = 4.566 years
2. Project B:
CFAT at end of year 4 = 288.73, CFAT at end of year 5 = 452.53
Therefore, by interpolation, PB = 4.98 years

On evaluating on the basis of Payback Method he found that Project A is better

whereas project B has higher ARR. The payback period does not concern itself with
the time value of money. In fact, the time value of money is completely disregarded in
the payback method, which is calculated by counting the number of years it takes to
recover the cash invested.
So before taking the final decision he thought of doing more research and analysis as
he had heard that ARR and Payback period methods are the crude method of
evaluating capital budgeting proposals. He remembered about the time value of
money concept that he had studied in the course of MSL302, Financial Management
and Accounting. He realized that to get the true picture of the projects he needs to
discount the cash inflows. He now thought of using the internal rate of return method
which is quite popular in the corporate sector to identify the best proposal.

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 3. Internal Rate of Return (IRR) Method

This method indicates the expected rate of return likely to be provided by the capital budgeting
proposal. The project is accepted if the cost of capital is less than the IRR and rejected if it is more
than IRR. To calculate IRR, we use an approximate method where we first calculate fake payback
period to estimate the likely rate of return and then use Annuity table to find the best match.

1. Project A
Fake Annuity = (Total CFAT) ÷ (Total Time) = 526.38 / 5 = Rs. 105.27 Cr.
Fake Payback Period= (Total Investment) ÷ (Fake Annuity) = 440.5/105.27 = 4.18 years
Now he found the PVIF close to 4.18 years in the table giving present value of an annuity of One
Rupee for 5 years (Table A-2 of the course pack of MSL-302) to be between 6 and 7% as shown
below.

CFAT of PV PV PV PV at PV at
Year PV at 6%
Project A factor(5%) factor(6%) factor(7%) 5% 7%
1 28.25 0.95 0.94 0.94 26.89 26.64 26.41
2 51.00 0.91 0.89 0.87 46.26 45.39 44.52
3 119.25 0.86 0.84 0.82 103.03 100.17 97.31
4 151.75 0.82 0.79 0.76 124.89 120.19 115.79
5 176.13 0.78 0.75 0.71 138.08 131.57 125.58
Total Present Value 441.00 423.95 409.61
* All values in Rs Crores
He observed that the PVIF of 6% and 7% did not give the results, so he tried with 5%.
Now he used interpolation to find the IRR,
IRR = 5 + (441-440) / (441-424) = 5.06%

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2. Project B
Fake Annuity = (Total CFAT) ÷ (Total Time) = 452.53 / 5 = Rs. 90.5 Cr.
Fake Payback Period= (Total Investment) ÷ (Fake Annuity) = 443.5/90.5 = 4.8 years

Similarly, he found the PVIF close to 4.8 years in the table giving present value of an annuity of One
Rupee for 5 years to be between 1% and 2% as shown below.
CFAT of PV
Year PV factor(2%) PV at 1% PV at 2%
Project B factor(1%)

1 37.70 0.99 0.98 37.32 36.95

2 52.78 0.98 0.96 51.72 50.72
3 75.40 0.97 0.94 73.21 70.88
4 122.85 0.96 0.92 118.07 113.51
5 163.80 0.95 0.91 155.77 148.40

Total Present Value 436.11 420.46

* All values in Rs Crores
Now he used interpolation to find the IRR,
IRR = 1 + (436-432)/ (436-420) = 1.25%

He observed that project A conclusively outperforms project B in terms of Internal Rate

of Return. On having a closer look he found out the reason for project A having higher
IRR has to do with higher CFAT on account of full capacity production in the later years.
So he was convinced that project A is better and going to convey this to Baba Ramdev
next day, but in the meantime he wanted to consult his professor Mrs. Shveta Singh
about the latest research in Financial Analysis of projects in capital budgeting. During
the conversation, he also discussed about his on-going case and his findings. After
listening to him, professor reminded him the importance of NPV in capital budgeting
decisions and stated that although IRR is an appealing metric to many, it should always
be used in conjunction with NPV for a clearer picture of the value represented by a
potential project a firm may undertake.
Thus before taking the final call he analyzed the projects using NPV method.

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4. Net Present Value (NPV) Method

Determining the value of a project is challenging because there are different ways to measure the
value of future cash flows. Because of the time value of money (TVM), money in the present is worth
more than the same amount in the future. This is both because of earnings that could potentially be
made using the money during the intervening time and because of inflation. In other words, a dollar
earned in the future won’t be worth as much as one earned in the present.
The discount rate element of the NPV formula is a way to account for this. Companies may often
have different ways of identifying the discount rate. He used the discount rate of 10% which was
close to the company’s expected rate of returns.

Here, PV = Present Value

CFAT of CFAT of PV of CFAT of PV of CFAT of
Year PV factor(10%)
Project A Project B Project A Project B
1 28.25 37.70 0.91 25.68 34.27
2 51.00 52.78 0.83 42.13 43.60
3 119.25 75.40 0.75 89.56 56.63
4 151.75 122.85 0.68 103.65 83.91
5 176.13 163.80 0.62 109.37 101.72
Total PV of cash inflow 370.38 320.12
Total PV of cash outflow 143.00 6.00
Net PV of Cash Flow 227.38 314.00
* All values in Rs Crores

Analysis with NPV gave some surprising results, both projects have NPV
positive and so both are good projects to invest in. But Project B had
significantly higher NPV than Project A, implying that project B is more
profitable. But this was completely opposite of what he got from the IRR
method where he got four times higher IRR from project A.
Faced with completely opposite result from the two methods he was unsure of
which project to recommend. So he decided to study the implications of both
the methods that would result in greater future value of the company and
came to the below conclusion.

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Conclusion

We have seen different methods used for capital budgeting proposals but sometimes we are faced
with situations where all methods give opposite results such as the situation of Kamlesh. He needs
to select the better of the two proposals by either relying on the results of IRR or NPV method. To
solve this dilemma, we closely look at both these methods find the better method.
The key differences between the two most popular methods NPV and IRR are
1. NPV is an absolute measure and is calculated in currency whereas IRR is a relative method
based on percentage return a firm expects the capital project to return.
2. NPV is suitable for projects with changing cash flows while IRR assumes consistent cash flows.
3. NPV method gives more importance to time value of money but its value is dependent on the
chosen discount rate.
4. IRR method has an advantage that Managers tend to better understand concepts in percentages
but for it to be a valid way, it needs to be compared to a discount rate.
5. A project is a good project if it has a positive NPV or if its IRR is higher than the discount rate.

Due to above reasons, academicians consider NPV to be a better option for evaluation than IRR.
Majority of companies use IRR and NPV, but some also use simple methods like Pay Back and ARR.
Based on the knowledge we have acquired after studying the MSL302 course, we will suggest
Kamlesh to recommend the project with higher NPV i.e project B of outsourcing the manufacturing
to company’s CEO Baba Ramdev.

Acknowledgement
We would like to acknowledge the support of Prof. Shveta Singh, Department of Management
Studies, IIT Delhi and help of various online resources for helping us in understanding of the
nuances of accounting and financial management and completion of this term paper.

References
 http://www.wallstreetmojo.com

 https://index.investopedia.com

 http://www.wikipedia.com

 MSL302 Course Pack

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