392 principles of Finance - oi 10.01 Introduction to Capital Bae Fle i \s thal investments represent sizable outlays. of fun ” an Conary ne fon needs procedures to analyze and properly select its long-term investments, It must be able to measure cash flows and apply appropriate Gecsions techniques ‘As time passes, fixed assets may become obsolete or may require an overhaul; at Hse Points, too, financial decisions may be required. Capital budgeting: is the process of evaluating ang selecting long-térm investments that are consistent with the firm's goal of maximizing owne,', wealth, Firms Typically Make a variety of lon-term investments, but the most contmoe for the firm is in fixed assets which include: land, property, plant and equipment. We begian by discussing the motives for cafital expenditure. (0,02 Definition of Capital Budgeting investment decisions of a firm are generally known as the capital budgeting oF capital expenditure decisions. A capital budgeting decision may be defined as the firm's decision io invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. Scholars? Views L.. Capital budgeting is the process of analyzing’ potential ‘fixed asset investments, - Brigham & Ehrhardt : . . Capital budgeting is the process of evaluating and selecting long-term investinents that are consistent with the firm's goal of maximizing owner's wealth, - L. J. Gitman 3. Capital budgeting is the process of identifying, analyzing and selecting investment Projects whose return’ (cash flows) are expected to extend beyond one year. - Van Home & Wachowicz 4. Capital budgeting is the evaluatin, and equipment. - Benton 5. Capital budgeting is the procedure by which long-term investments are general, ‘analyzed and placed on the capital budget. - G, E. Pinches commit a firm to some course. of 2. ig Jong-term investment proposals, ‘usually for plant From the above decisions we can say that, evaluating, determining and selecting long-ten over the one. year, The firm's Capital budget acquisition, modemization and replacement of ‘apital budgeting ‘is the process of identifying, m investment proposal whose retums are expected ing decisions would generally include expansion, the long-term assets, 10.03 Features/Importance/O| Capital budgeting plays a vital role i important is financial management bec: bjective/Advantage of Capital Budgeting in the future investment of a firm. C ‘pital budgeting is ause of the followings:saa Capital Budgeting 393 Proper Investment: Long-term asset is expanded in order to cope with future demand, so it js related to expect future earning, Capital budgeting is esiential before a decision to invest Jong-term asset is made. 2, Planning: Capital budgeting program would arrange it’s financing several years in advance to besure of having the funds required for the expansion, x To achieve Long-term Loan: Capital bitdgeting needs is accurate to achieve long-term financial goal. For this purpose, it is evaluating and selecting long-term investment. 4, Expansion: Capital budgeting is to expand the level of operation, usually through acquisition 5 6 of fixed assets. + Replacement: As a firm's growth slows and it reaches maturity, most capital budgeting will "be made to replace of new obsolete or worn-out assets. Renewal: Renewal, an alternative to replacement may involve rebuilding an existing fixed asset by capital budgeting. - 7, Acquistion: Capital budgeting results in the acquisition o¢ transferration of tangible fixed assets & Cost Minimize: It may be useful considering methods of reducing costs. A cost reduction ‘companion may necessitate the consideration of purchasing more up-io-date fixed asset. 9. Feasibility Study: The feasibility of replacing manual work by capital budgeting be seen from the capital forest. : : 10. Policy Formulation: If facilitates the ‘making of long-term plans and assists in the formulations of general policy: in the process of Capital Budgeting ial budgeting process consists of five distinct but interrelated steps: 1. Proposal Generation: Proposals are made at all levels within a business firm and are reviewed by financial manager. Proposals that require large outflows are more carefully scrutinized than less costly ones. 2 Review and Analysis: Formal review and analysis is performed to assess the appropriateness of proposals and evaluate their economic viability. Once the analysis is completed. a summary report is submitted to make decision, 4. Decision Making: Firms typically delegate capital budgeting decision making on the basis of capital: "limits. Generally the board of directors must authorize expenditures beyond a certain amount. 4. Implementation: Follawing approval, expenditures are made and projects are implemented. Expenditures for a large project often occur in phase, 5. Follow-up: Results are monitored and actual costs and benefits are compared with those that Were expected, Action may be required if actual outcomes differ from projected ones. Each step in the process is important, review, analysis and decision making consume the majority of time and effort. However, follow-up is an important but often ignored step aimed at allowing the firm to improve the accuracy of its cash flow estimates continuously, Nf ‘of Capital Budgeting Decision Capita ing process refers to the total process of generating, evaluating, selecting and following-up on capital expenditure alternatives. The firm allocates financial resources to new qLestient proposals. Basically, the firm may be canfronted with three types of capital budgeting Isions: Finance-50Prinetples of Finance in capital budgeting. If the proj if the proposal is rejected, the: firm docs not invest in Whose rates of retum are greater-than a certain Fequired rate of evaluated and rest are rejected. By applying these criteria, all inde; Independent projects are projects that do not compete with one another in such a way that acceptance of one precludes the possibility of acceptance of anther. Under the accept reject decision, all independent projects that satisfy the minimum investment criterion should b implemented, Mutually Exclusive Decision: 4 Mutually exclusive projects are those which compete with other project in such a ‘way that the! acceptance of one will exclude the acceptance of the other Projects. The alternatives are mutually: xelusive and only one may be chosen. It may be noted here that the mutually exclusive project decisions are not independent on the accept-reject decisions, Mutually exclusive invest Aecisions acquire significance When more than one proposal is acceptable under the accept-rej decision. Then, some technique has to be use to determine the best one. The acceptance af this best alternative automatically eliminates the other altematives, ‘Capital Rationing Decision: In a situation where the firm has unlimited funds, all independent investment proposals having Fetum greater than some predetermined level are accepted. They have a fixed capital. A | number of investment propasals compete for those limited funds. The firm must, therefore ratice » s investment projects, The project can be ranked on the basis of a predetermined criterion such as the rate of niques/ Methods of Capital Budgeting {important part of capital budgeting is evaluation techniques. Included in the methods off appraising an investment proposal are those which are objective, quantified and based on economic costs and benefits, The methods of evaluating capital. expenditure proposals can be lassified into two broad categories: (A) Traditional Methods and (B) Discounted Cash Flow Methods. . Traditional Methods a) Pay Back Period (PBP) b) Average Rate of Return (ARR) (Accounting Rate of Return) Net Present Value (NPV) b) Interna! Rate of Return (IRR) ©) Profitability Index (P1) d) Discounted Pay Back Period (DPBP)Bs Principles of Finance 6. The. payback period is defined'as the number of years required to recover the original cash outlay invested in a project. - LM. Pandey. ‘So, from above the discussion it is clear to say that, the payback period (PBP) is the time required for the firm to recover its initial investment in a project, as calculated from cash inflows, 10.08 Calculation of Pay Back Period (PBP} back period is the len; Seine to recover the initi BS shorter an investment propasal’s eer is the best, PP method is widely used for evaluating investment proposals because W is cay to calculate and easy to understand. PBP ig calculated in two ways: ’ A Gover ‘Cash Inflow: t t generates’ constant annual cash inflows, the PBP can be computed by dividing cas! Ifthe: Target PBP = Project is rejected. (if the PBP is greater than the maximum acceptable PBP, reject the project.) Many firms use the PBP as an accept-reject criterion as well as a method of ranking projects. Asa ranking method, it gives highest ranking to the project which has the shortest PBP and lowest ranking to the project with highest BPB. The length of the maximum acceptable PBP is determined by management. 10.11 Pros and Cons of Pay Back Period (PBP) Advantages: 7 A widely used investment method, the PBP seems to offer the following advantages: 1. Itis simple to calculate, in concept and application. 2. It is easy to understand and can be explained easily. 3. It provides a rough indicator of the riskiness of the project. 4. The emphasis in payback is on the easily recovery of the investment. 5. A company can have more favorable short-run effects on earning per share by setting UP * shorter standard PBP. The riskiness of the project can be tackled by having a shorter standard PBP as it may ensure guarantee against loss. a Scanned with CamScanner10.16 Net Present Value (NPV) Method The net present value (NPV) method is the classic economic method of evaluating the investment proposals. It is one of the most important discounted cash flow (DCF) techniques explicitly recognizing the time value of money. It correctly assumes that future cash flows arising at different time periods differ in value and comparable only when their equivalents present values are found out. Scholars’ View: 1, The NPV is found by subtracting a projects initial investment from the present value of its cash inflows discounted at a rate equal to the firm's cost of capital. - L. J. Gitman 2. NPV is the present value of an investment projects net cashflows minus the project initial cash outflows. - Van Horne & Wachowicz 3. | NPV represents the difference between the present value of future cash flows associated with a project and the present value of the initial investments to acquire that project. - Khan & Jain 4. NPV is the present value of cash flows discounted at the cost of capital less the { investment outlay. - Benton / 5. The NPV of a project is the present value of the future benefits minus the cost. < Henderson Berets So, from the above discussion it is easy to say that, the NPV of a project is the sum of the present values of all the future cash flows that are expected to occur over the life of the project minus the V of a project is the sum of the present value of all the cash flow- initial cash outlay. The NP : . . Positive as well as negative; that during expected occur the life of the project less investment. 10.17 Calculation of Net Present Value (NPV) The NPV is found by subtracting a project’s initial investment from the present value of its cash inflows discounted at a cost of capital. The following steps are involved in calculating of NPV: Finance-51 Scanned with CamScanner402 Principles of Finance > Cash flows of the investment project should be forecasted based on realistic assumptions. Appropriate discount rate should be identified to discount the forecasted cash flows. Present value of cash flows should be calculated using cost of capital as the discount rate. D. NPV should be found out by subtracting present value of cash outflows from present value of cash inflows. E. The equation for calculation of NPV is as follows: NPV = Present Value of Cash Inflows — Initial Investment - c. npv-|—Ay Ar Aw Vg (+K)' UK KS Where; NPV = Net Present Value A= Amount of Net Cash Inflow K = Discount Rate/Cost of Capital N= Year of the Cashflow’s C= Cash Outflow/Initial Investment Sowda Trading Corporation has invested Tk. 25 lac in a new project. The expected cash inflows from the project are Tk. 10, 9, 8, 7 and 6 lac per year respectively: If the discount rate is 10%, what is the NPV of the project? NPV AL Ago yieAn oe [as "GK KS 10,00,000 , 900,000 , 800,000 , + Ot 2500000 (a. “C10; ee 10)? 10)? (.10)* 1.10) =| toneee, onde, soaene + 100,000 , :600,000] _ 55 99,000 1.10 121 1.331 1.4641 1.6105 | = [9,09,090.909 + 7,43,801.653 + 6,01,051.84 + 4,78,109.419 + 3,72,555.107] - 25,00,000 | = 31,04,608.92 - 25,00,000 = 6,04,608.92 Tk. Answer. 10.18 The Decision Criteria of NPV When NPV is used to make accept-reject decisions, the decision criteria are as follows: 1. If the NPV is positive (NPV > 0), accept project. It should be clear that the accepratrs om using the NPV method is to accept the investment project if it's NPV is positive (NP es The positive NPV will result only if the project generates cash inflows at a rate higher cost of capital. ‘ oe 2. If the NPV is negative (NPV < 0), reject the project. The NPV method is to reje investment project if it's NPV is negative (NPV <0). ‘Scanned with CamScannerCapital Budgeting 403 3. Te Rael = 0), accept the project too. A project may be accepted if NPV = 0. 4. The NPV ei a a oe atana: Cash flows at a rate just equal to the cost of capital. § N 10 select betw i i i higher NPV should be selected. een mutually exclusive Projects, the one with the 5, Using the NPV method, projects would be ranked in order of NPV, that is- first rank will be given to the Project with highest positive NPV and so on. 10.19 Pros and Cons of Net Present Value (NPV) Advantages: NPV is the true measure ofan investment’s profitability. The NPV provides most acceptable investment rule as given below: 1. It recognizes the time value of money. 2. It uses all cash flows occurring over the entire life of the project in calculating its worth. 3. The discounting process facilitates measuring cash flows in terms of present values. 4, NPV method can be modified to consider risk. 5. The NPV method is always consistent with the objective of maximizing shareholders’ wealth. Disadvantages: NPV is a theoretically correct technique for the selection of investment Project, but it has certain limitations also: I. Itis difficult to understand, calculate and use in comparison with PBP or ARR. 2. Problem associated with the NPV, involves the calculation of the required rate of retum to discount the cash flows. 3. Caution needs to be applied in using the NPV when alternative projects with unequal life. Scanned with CamScanner