Meaning & Objective of Capital Budgeting

Capital budgeting decision is perhaps the single most important corporate decision that consumes a
major part of the management’s time and money. Capital budgeting deals with the question of what
assets should a firm acquire. It refers to the desirability of acceptance or rejection of a project based on
systematic evaluation of the project parameters that are translated in financial terms and weighed
against a decision making rule, which determines the growth and survival of a firm in this competitive
world.

Features of Capital Budgeting Decision

Since the capital budgeting decisions concern the acquisition of assets, they should encompass broader
strategic aspects like:

∙ launching of new products

∙ Renovations of Machineries

∙ Buying a new Technology

∙ Initiating R&D program

It is an intricate decision posing many issues that are difficult and are characterized by the following
features:

∙ Involve Substantial Expenditure

∙ Long Term decisions

∙ Decisions are generally irreversible

∙ Generally complex as they involve lot of Future estimates

Capital Budgeting Approach-

▪ All the capital budgeting decisions are based on the incremental cash flows of the project, and
not on the accounting income generated by it. Sunk costs are not considered in the analysis. The
external factors that can impact the implementation of the project and eventually the cash flow of
company has to be fully considered while preparing / planning the capital budgeting.

▪ All the cash flows of the project should be based on the opportunity costs. Opportunity costs
account for the money that the company will lose by implementing the project under analysis.
These are the existing cash flows already generated by an asset of the company that will be
forgone if the project under analysis is undertaken.

▪ The timing of the receipt of the cash flows is important. As per the time value of money concept,
 cash flows of the project received earlier has more value than the cash flows received later.

▪ All the cash flows from the project should be analyzed on an after-tax basis. The company
should evaluate only those cash flows that they will keep, not those that they will pay to the
government.
ITC CASE

ITC ltd. is a well-diversified conglomerate operating in many different segments like tobacco, hospitality,
food etc. In the food segment, they are the market leaders in Packaged wheat flour segment with their
brand name of Aashirvaad. To have the synergy in operations the company has already gone for
forward integration by entering into Packaged Biscuits segment with the brand name of Sunfeast and in
a very short period they have become a major player in this segment. To further enhance this segment
the company wants to come out with the branded breads.

Mr. Sanjiv Puri the current Chief Operating officer and Director for FMCG segment called for the
meeting of the top management to discuss the above issue and also requested Mr. Rajiv Tandon the
Chief Financial Officer of the company and his team to prepare the financial estimates.

On the day of the meeting Mr. Vineeth the head of Marketing, foods division started with his
presentation and showed the available market and the market feasibility of launching the Breads
segment. Next was the turn of the finance team to present the proposed investment for the project and
also present the financial feasibility of the project.

Finance team - Seeing to the demand supply gap and easy availability of raw material the company plans
to set up a plant in northern part of the country. The state government has agreed to give the land on
10 years lease with a subsidized annual rental of $5000000. The installed capacity of the plant would be
400000 loaves of 500 grams each per day with an expected life of 10 years. The proposed Investment
details for the project is as below:

Investment Details
Particulars Amount
Building with prefabricated structure 50000000
Equipment 75000000
Total Capital Expenditure 125000000
Working Capital 25000000
Total Investment 150000000

The plant will have an annual installed capacity of 120000000 loaves of 500 grams each (400000 loaves
per day * 300 operational working days per year). Seeing to the market forecast the capacity utilization
during the 10-year working life of the project is expected to be given below:

Capacity Utilisation over 10 years working life

% of
Capacity
Years utilized
 1-2 50%
3-5 75%
6-10 100%

Seeing to the current competition in the market the per 500 gms loaf expected price would not be more
than $1 netting a contribution of 60%. The annual Fixed cost, excluding depreciation, are estimated to
be $20000000 from the 6th year onwards for the first two years it would be $10000000 per annum and
for the third to fifth year it would be $15000000 annually. The annual rate of depreciation being 10% of
cost of Fixed Assets.

The estimated terminal value of the Fixed assets at the end of 10-year life would be 10% and 100% for
Working Capital. The Finance team has estimated 12% as the opportunity cost of capital to be invested
in the project and the Corporate Tax rate prevailing in the country being 30%.

Years
Particulars 1 2 3 4 5 6 7 8 9 10
Sales Revenue 60000000 60000000 90000000 90000000 90000000 120000000 120000000 120000000 120000000 120000000 (Variable Cost) 24000000 24000000 36000000
36000000 36000000 48000000 48000000 48000000 48000000 48000000 (Fixed Cost including annual lease Rent) 15000000 15000000 20000000 20000000 20000000
25000000 25000000 25000000 25000000 25000000 (Depreciation) 12500000 12500000 12500000 12500000 12500000 12500000 12500000 12500000 12500000 12500000
EBT 8500000 8500000 21500000 21500000 21500000 34500000 34500000 34500000 34500000 34500000 (Taxes @ 30%) 2550000 2550000 6450000 6450000 6450000
10350000 10350000 10350000 10350000 10350000 EAT 5950000 5950000 15050000 15050000 15050000 24150000 24150000 24150000 24150000 24150000 CFAT
18450000 18450000 27550000 27550000 27550000 36650000 36650000 36650000 36650000 36650000 Recovery of w.c 25000000 sale proceed of F.A. 8750000

Techniques of capital Budgeting

There are different methods adopted for capital budgeting. The traditional methods or non discount
methods include: Payback period and Accounting rate of return method. The discounted cash flow
method includes the NPV method, profitability index method and IRR.

∙ Payback period method:

As the name suggests, this method refers to the period in which the proposal will generate cash to
recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the
project and the investment made in the project, with no consideration to time value of money. Through
this method selection of a proposal is based on the earning capacity of the project. With simple
calculations, selection or rejection of the project can be done, with results that will help gauge the risks
involved. However, as the method is based on thumb rule, it does not consider the importance of time
value of money and so the relevant dimensions of profitability.

Payback period = Cash outlay (investment) / Annual cash inflow

Payback
Period 6 Years & 10 Months
Years CFAT Cumulative CFAT
1 18450000 18450000
 2 18450000 36900000
3 27550000 64450000
4 27550000 92000000
5 27550000 119550000
6 36650000 156200000
7 36650000
8 36650000
9 36650000
10 70400000

∙ Accounting rate of return method (ARR):

This method helps to overcome the disadvantages of the payback period method. The rate of return is
expressed as a percentage of the earnings of the investment in a particular project. It works on the
criteria that any project having ARR higher than the minimum rate established by the management will
be considered and those below the predetermined rate are rejected.

This method takes into account the entire economic life of a project providing a better means of
comparison. It also ensures compensation of expected profitability of projects through the concept of
net earnings. However, this method also ignores time value of money and doesn't consider the length of
life of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of
shares.

ARR= Average income/Average Investment

ARR Average PAT/Initial Investment

ARR 17780000 150000000
ARR 11.85%

∙ Discounted cash flow method:

The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset.
These are then discounted through a discounting factor. The discounted cash inflows and outflows are
then compared. This technique takes into account the interest factor and the return after the payback
period.

∙ Net present Value (NPV) Method:

This is one of the widely used methods for evaluating capital investment proposals. In this technique the
cash inflow that is expected at different periods of time is discounted at a particular rate. The present
values of the cash inflow are compared to the original investment. If the difference between them is
positive (+) then it is accepted or otherwise rejected. This method considers the time value of money
and is consistent with the objective of maximizing profits for the owners. However, understanding the
concept of cost of capital is not an easy task.

The equation for the net present value, assuming that all cash outflows are made in the initial year (tg),
will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment
proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is
assumed to be known, otherwise the net present, value cannot be known.

NPV = PVB – PVC

where,

PVB = Present value of benefits

PVC = Present value of Costs

PV factor 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 present value of cash i/f 16473214 14708227 19609546 17508523 15632610 18568031 16578599
14802320 13216357 22666916

Total pv of cash i/f NPV 19764343

∙ Internal Rate of Return (IRR): 169764343

This is defined as the rate at which the net present value of the investment is zero. The discounted cash
inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries
to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash
inflows. However, computation of IRR is a tedious task.

It is called internal rate because it depends solely on the outlay and proceeds associated with the project
and not any rate determined outside the investment.

It can be determined by solving the following equation:

If IRR > WACC then the project is profitable.
If IRR > k = accept

If IR < k = reject

Cash Flows
-150000000
18450000
18450000
27550000
27550000
27550000
36650000
36650000
36650000
36650000
70400000
IRR 14.56%

∙ Profitability Index (PI):

It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash
outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to
calculate profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A,

PI = NPV (benefits) / NPV (Costs)

All projects with PI > 1.0 is accepted.

PI = PV of Cash Inflow / PV of cash outflow

PI= 1.13
 ∙ Discounted Payback Period :

One of the criticism levelled against simple payback period method is that it does not take the time
value of future cash flows into consideration. To overcome this criticism, future cash flows are
discounted at the cost of capital and the payback period is calculated using the present value of future
cash flows.
Discounted Payback Period 9 Years & 2 Months
Years CFAT CFAT Discounted Cumulative 1 18450000 16473214 16473214 2
18450000 14708227 31181441 3 27550000 19609546 50790987 4 27550000
17508523 68299510 5 27550000 15632610 83932120 6 36650000 18568031
102500151 7 36650000 16578599 119078749 8 36650000 14802320
133881070 9 36650000 13216357 147097427 10 70400000 22666916
169764343