Capital Budgeting

Introduction: It has many others names. Such as: 1.Capital Budgeting Decision, 2.Capital Expenditure Decision, 3.Long-Term Investment Decision, 4.Management & Fixed Assets Investments Decisions. Capital Budgeting Capital Budgeting

Capital means centre point of an organization. Capital are two types.aDebt capital. b. Equity capital Budgeting means futute activities diagram or design. It means controlling of functions and operating of functions The term capital Budgeting is used to describe actions relating to the planning and financing of capital outlays for such purpose as the purchase of new equipment, the introduction of new product lines and the moderization of plant facilities. As such capital budgeting decision are a key factors in the long-run profitability of a firm. The long run profitablility of the firm will depend on the skill of the manager. Definition: 1.The process of determining both how much to spend on capital assets & which assets to acquire, is called Capital Budgeting.L D Shall & C/ W. Haley. 2.Capital Budgeting refers tothe total process of generating, evaluating, selecting & following up on capital expenditure alternative. L Gitman. 3. It is a process for analyzing and selecting appropriate long-term investment projects. 4. Capital Budgeting is the process or evaluating and selecting long term investment consistent with the firms goal of owners wealth maximization. Types of Capital Budgeting Decisions: It is divided into four parts: 1. Accept Rejection Decision: By this decision, which project is profitable (more), only that project should take and others will reject. Suppose, if cost of capital 18%. and the projects average return 19% , then the project will accept , but if it is 17%,then it will reject. 2. Mutually Exclusive Decision: Mutually exclusive projects are the projects , which competed each other in such a way, that the acceptance of one will exclude the acceptance of other projects.If the company keeps the old assets, it will not buy the new one, if the new one is purchase, the old assets will be sold. Thus the two assets are mutually exclusive. 3. Mutually Inclusive Decision: Management may consider certain investments that are all related to a primary projects or mutually inclusive projects. In a mutually inclusive situation, if the primary projects is choosen, all related project are also selected. Alternatively, rejection of the primary project will dictate rejection of the others 4. Capital Rationing Decision: Capital rationing occurs whenever a contrants is placed on total capital investments that results in rejection of any proposed independent projects that would otherwise be acceptable under conventional NPV or IRR criteria.

Features: 1. Capital investments have potentially long anticipated benefits 2. It involves a relating high degree of risk. 3. It is also a relationg long period of time between the initial outlay and the anticipated return. Importance: Capital budgeting decision are of paramount importance in financial decisin making for the following reasons:-1. Capital budgetig decision fix-up the future destiny of the company 2. A capital budgeting decision has its affect over a long period of time and affects the future cost structure of the company. 3. Capital investmetn decision once made are not easily changed without much financial loss to the firm. 4. Capital expenditure decision involves costs and the majority of the have scare capital resource. 5. It is a long term decison, not flexible and not easily changed. OR 1. Ensuring Proper Investment 2. Balancing in long-term investmetn 3. Advance plan for securing funds 4. Facing Competition 5. Good capital budgeting improves the timing of asset acquisition 6. It improve quality of assets 7. Expanding of production facilities 8. Considering methods of reducing cost 9. Expansion programme in time without losing market. Problems fo Capital Budgeting In Bangladesh 1.Shortage of Funds 2.Difficulties in feasibility study 3.Study of available alternative 4.Problem of measuring of cash proceeds 5.Lack of necessary data 6.Impact of Investment Policy 7.Unfavourable Investment Climate 8.Instability in prices

Process: Many companies follow a carefully prescribed in capital budgeting. At least once a year proposals for projects are requested from each deparment. The proposals are scanned by a capital budgeting committee, which submits its findings to the officer of the company. The officers, intern select the projects they believe to be most worthy of funding and submit them to the board Of directors approve the capital expenditure budget. The involvement of management and board of directors in the process demonstrates the importance of capital budgeting decision.

Methods/ Techniques of Capital Budgeting:

The economic validity of the project can be assessed by the following methods.The methods of appraising capital expenditure proposal can be callsified into two broad catagories:1. Traditional Method (Unsophisticated) a. PBP (Pay Back Period). b. ARR(Average/Accounting Rate of Return) c. PBR(Pay Back Reciprocal) d. ROI (Return investment) 2. Cash Flow Method/Discounted (Sophisticated ) a. NPV (Net Present Value) b. IRR (Internal Rate of Return) c. PI (Profitability Index) PBP: Pay back period is a commonly used criterion for evaluating proposed investments. The pay back period is exact amount of time required for the firm to recover it s initial investment in a project as calculated from cash inflows. In the case of annuity (even cash flows), the pay back period can be found by dividing the initial investment by the annual cash inflows. But for a mixed stream (un-even cash inflows), the yearly cash inflows must be accumulated until the initial investment is revovered. ARR: ARR is determined by dividing the average accounting profit after taxes, expected from the project by the investment in the project. NPV: Because net present value gives explicit consideration to the time value of the money. It is considered a sophisticated capital budgeting technique. All such techniques in one way or another discount the firms cash flows at a specific rate. This rate often called the discount rate, opportunity cost or cost of capital refers to the minimum return that must be earned on a project to leave the firms maket value unchanged. IRR: The internal rate of return (IRR) , although considerably more difficult to calculate by han than NPV , is probably the most used sophisticated capital budgeting technique for evaluating investment alternatives. The internal rate of return(IRR) is defined as the discount rate that equates the present value of cash inflows wiht the initial investment associated with a project. Some important things:

ARR> Cost of Capital-----Accepted

ARR< Cost of Capital-----Rejected IRR> Cost of Capital----Accepted IRR< Cost of Capital----Rejected

Capital Budgeting Problems

Problem No: 1 The initial investments of the projects A, B and C are Tk 1,00,000; 1,50,000 and 2,00,000 respectively. Cash inflows of the projects in each year are Tk 25,000, 50,000 and 1,00,000 respectively. What will be PBP of the three prjects?--Give your opinion. Problem No: 2 Mr. Shaz has taken a project of Tk 4,00,000. Life time of the project is 5 years. It is estimated that no salvage value will be found. Expected cas flows in different years are as follows: Year Cash Inflows (CFAT) Tk. Year 1 Tk 50,000 Year 2 1,20,000 Year- 3 1,50,000 Year- 4 1,40,000 Year- 5 160,000 Calculate the PBP of the project. Problem No : 3. A company is considering following two projects: Year Project-A Project-B Initial Investment Tk 50,000 Tk 40,000 Cash Inflow: Year-1 Tk 15,000 Tk 13,000 Year-2 Tk 18,000 Tk 15,000 Year-3 Tk 22,000 Tk 22,000 Year-4 Tk 20,000 Tk 18,000 Year-5 Tk 16,000 Tk 13,000 Salvage Value Tk 6,000 Tk 9,000 Cost Of capital 11% 11% You are required to select the best project from above the two project, by applying all capital budgeting techniques i. PBP, ii. PBR, iii PV, iv. NPV, v. IRR Problem No: 4. XYZ company is thinking to purchase a machine. Cost price of the instrument is Tk 35,000 and installation cost is Tk 1,000. Effective lifetime is 6 years. Expected cash flow before tax (CFBT) is Tk 12,000 . Income tax is 40%. Find out the PBP and ARR?

Problem No: 5. Micro solt corporation estimates that it can save Tk 5,000 a year in cash operating costs for the next 8 years. If it can buy a special purpose machine at a cost of Tk 18,000 .No salvage value is expected . Assume that income tax rate is 40% and the minimum desired rate of return after tax is 10%. Assmuming straight line depreciation method, find out the following: (a) PBP, (b) ARR Problem No: 5 A chemical company is considering investing in a project that costs Tk 5,00,000. The estimated salvage value is zero. Tax rate is 55%. The company uses straight line depreciation and the proposed project cash flows before tax(CFBT) as follows: Year CFBT (Tk) Year 1 1,00,000 Year 2 1,00,000 Year 3 1,50,000 Year 4 1,50,000 Year 5 2,50,000 Determine the following: i) Payback period (PBP) ii) Average Rate of Return (ARR) Problem No: 6. Problem No: 6 A large sized chemical company is considering investing in a project that costs Tk 4,00,000. The estimated salvage value is zero. Tax rate is 55%. The company uses straight line depreciation method and the proposed projects estimated cash flow before tax(CF|BT) is as follows: Year CFBT (Tk) Year- 1 1,00,000 Year-2 1,00,000 Year-3 1,50,000 Year-4 1,50,000 Year-5 2,50,000 Determine the following: (i) PBP, (ii) ARR (iii) IRR (iv) NVP (v) PI at 15% Problem No: 7 A product of Sapura Pharmacuticlas company is doing poorly & is being considered for replacement . Three mutually exclusive projects are A, B & C have been proposed. The projects are expected to require Tk 2,00,000 each have an estimated life of 5 years., 4 years and 3 years respcetively and have no salvage value. The companys requird rate of return is 10%. The anticipated cash flow after tax(CFAT) for the threee projects are as follows: CFAT Year A B C Year 1 50,000 80,000 1,00,000 Year 2 50,000 80,000 1,00,000 Year 3 50,000 80,000 10,000 Year 4 50,000 30,000 Year 5 1,90,000 --------

Rank the projects applying the follwoing methods of PBP, ARR, NPV, IRR, PI. . Problem No: 8 A company is considering a new project for which thr investment data are as follows: Capital outlay----Tk 2,00,000 Depreciation -----Tk 20% per annum Forecasted annual income before changing depreciation but after all other changes as follows: Year CFBT (Tk) Year 1 1,00,000 Year 2 1,00,000 Year 3 80,000 Year 4 80,000 Year 5 40,000 4,00,0000 On the basis of availabe data, set out the following calculations: (i) PBP (ii) Rate of Return on original investment (iii) Discounted cash flow(IRR) Problem No: 9 XYZ co. Ltd is considering the purchasing of one of the following machines, whose relevant data are given below: Machine X Machine Y Estimated Life 3 years 3 years Capital Cost Tk90,000 TK 90,000 Earning After Tax: Year 1 40,000 20,000 Year 2 50,000 70,000 Year 3 40,000 50,000 The company follows the straight line method of depreciation . The estimated salvage value of both the types of machines is zero. Show the most profitable investment based on (i) PBP (ii) ARR (iii) NPV assuming a 10% cost of capital. Problem No: 10 A company is considering following two projects: Project-A Initial Investment Tk 50,000 Cash Inflow: Year-1 Tk 15,000 Year-2 Tk 18,000 Year-3 Tk 22,000 Year-4 Tk 20,000 Year-5 Tk 16,000 Salvage Value Tk 6,000 Cost of Capital 11%

Project-B Tk. 40,000 Tk 13,000 Tk 15,000 Tk 22,000 Tk 18,000 Tk 13,000 Tk 9,000 11%

You are required to select the best project from above the two projects, by applying all capital budgeting techniques: i. PBP ii. PBR iii. PV iv. NPV v. IRR