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- Capital Budgeting
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TECHNIQUES OF CAPITAL

BUDGETING

CAPITAL EXPENDITURES AND THEIR

IMPORTANCE

• The basic characteristics of a capital expenditure (also

referred to as a capital investment or just project) is that

it involves a current outlay (or current and future

outlays) of funds in receiving a stream of benefits in

future

**• Importance stems from
**

• Long-term consequences

• Substantial outlays

• Difficulty in reversing

Importance

Issues of concern in Corporate Finance

** Financing its Investments( cap. Structure)
**

Managing short term operations (WCM)

Allocation of capital( Cap. budgeting)

OUTLINE

• Importance

• Capital Budgeting Process

• Project Classification

• Investment Criteria

• Net Present Value

• Benefit Cost Ratio

• Internal Rate of Return

• Modified Internal Rate of Return

• Payback Period

• Accounting Rate of Return

CAPITAL BUDGETING PROCESS

1.Identification of Potential Investment Opportunities

•Develop estimates of future sales

•Monitor external environment

•Formulate well defined corporate strategy

•Thorough analysis of SWOT

2.Assembling of Investment Proposals

**For facilitating decision making, budgeting &
**

Process

3. Decision Making

**4.Preparation of Capital Budget and Appropriations
**

Funds position to be analyzed

5.Implementation

**Adequate implementation of projects
**

Use of Responsibility accounting

Use of Network techniques

6. Performance Review

PROJECT CLASSIFICATION

• Mandatory Investments

• Replacement Projects

• Expansion Projects

• Diversification Projects

• Research and Development Projects

• Miscellaneous Projects

INVESTMENT CRITERIA

INVESTMENT

CRITERIA

**DISCOUNTING NON-DISCOUNTING
**

CRITERIA CRITERIA

**NET BENEFIT INTERNAL ACCOUNTING
**

PAYBACK

PRESENT COST RATE OF RATE OF

PERIOD

VALUE RATIO RETURN RETURN

NET PRESENT VALUE

n Ct

NPV = ∑ – Initial investment

t=1 (1 + rt )t

NET PRESENT VALUE

The net present value of a project is the sum of the present value of all the cash

flows associated with it. The cash flows are discounted at an appropriate discount

rate (cost of capital)

Naveen Enterprise’s Capital Project

Year Cash flow Discount factor Present

value

0 -100.00 1.000 -100.00

1 34.00 0.870 29.58

2 32.50 0.756 24.57

3 31.37 0.658 20.64

4 30.53 0.572 17.46

5 79.90 0.497 39.71

Sum = 31.96

Pros Cons

• Reflects the time value of money • Is an absolute measure and not a relative

• Considers the cash flow in its entirely measure

• Squares with the objective of wealth maximisation

PROPERTIES OF THE NPV RULE

• NPVs ARE ADDITIVE

• INTERMEDIATE CASH FLOWS ARE INVESTED AT

COST OF CAPITAL

**• NPV CALCULATION PERMITS TIME-VARYING
**

DISCOUNT RATES

**• NPV OF A SIMPLE PROJECT AS THE DISCOUNT
**

RATE

BENEFIT COST RATIO

PVB

Benefit-cost Ratio : BCR =

I

PVB = present value of benefits

I = initial investment

To illustrate the calculation of these measures, let us consider a project which is being evaluated

by a firm that has a cost of capital of 12 percent.

Initial investment : Rs 100,000

Benefits: Year 1 25,000

Year 2 40,000

Year 3 40,000

Year 4 50,000

The benefit cost ratio measures for this project are:

25,000 40,000 40,000 50,000

(1.12)

+ (1.12)2

+ (1.12)3

+ (1.12)4

BCR = = 1.145

100,000

Pros Cons

Measures bang per buck Provides no means for aggregation

INTERNAL RATE OF RETURN

Net Present Value

Discount rate

**The internal rate of return (IRR) of a project is the discount rate that
**

makes its NPV equal to zero. It is represented by the point of intersection

in the above diagram

Net Present Value Internal Rate of Return

• Assumes that the • Assumes that the net

discount rate (cost present value is zero

of capital) is known.

• Calculates the net • Figures out the discount rate

present value, given that makes net present value zero

the discount rate.

CALCULATION OF IRR

You have to try a few discount rates till you find the one that makes the

NPV zero

Year Cash Discounting Discounting Discounting

flow rate : 20% rate : 24% rate : 28%

Discount Present Discount Present Discount Present

factor Value factor Value factor Value

**0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00
**

1 34.00 0.833 28.32 0.806 27.40 0.781 26.55

2 32.50 0.694 22.56 0.650 21.13 0.610 19.83

3 31.37 0.579 18.16 0.524 16.44 0.477 14.96

4 30.53 0.482 14.72 0.423 12.91 0.373 11.39

5 79.90 0.402 32.12 0.341 27.25 0.291 23.25

**NPV = 15.88 NPV = 5.13 NPV = - 4.02
**

CALCULATION OF IRR

**Smaller NPV at the smaller rate Bigger Smaller
**

discount + X discount – discount

rate Sum of the absolute values of the rate rate

NPV at the smaller and the bigger

discount rates

5.13

24% + 28% - 24% = 26.24%

5.13 + 4.02

PROBLEMS WITH IRR

• NON-CONVENTIONAL CASH FLOWS

• MUTUALLY EXCLUSIVE PROJECTS

• LENDING VS. BORROWING

• DIFFERENCES BETWEEN SHORT-TERM AND

**LONG-TERM INTEREST RATES
**

NON-CONVENTIONAL CASH FLOWS

C0 C1 C2

-160 +1000 -1000

**TWO IRRs : 25% & 400%
**

NPV

25% 400%

NO IRR : C0 C1 C2

MUTUALLY EXCLUSIVE PROJECTS

C0 C1 IRR NPV

(12%)

P -10,000 20,000 100% 7,857

**Q -50,000 75,000 50% 16,964
**

LENDING VS BORROWING

C0 C1 IRR NPV

(10%)

A -4000 6000 50% 145

**B 4000 -7000 75% -236
**

MIRR

The procedure for calculating MIRR is

**Step.1. Calculate PVC associated with the project
**

using cost of capital (r) as the discount rate.

**Step.2. Calculate the terminal value (TV) of the cash
**

flows expected from the project.

**Step.3.Obtain MIRR using the equation.
**

MODIFIED IRR

0 1 2 3 4 5 6

-120 -80 20 60 80 100 120

r=15% 115

-69.6 r =15% r =15% 105.76

PVC = 189.6 r =15% 91.26

r =15% 34.98

Terminal value (TV) = 467

PV = 189.6 MIRR = 16.2%

of TV

NPV 0

PAYBACK PERIOD

Payback period is the length of time required to recover the initial

outlay on the project

Naveen Enterprise’s Capital Project

Year Cash flow Cumulative cash flow

0 -100 -100

1 34 - 66

2 32.5 -33.5

3 31.37 - 2.13

4 30.53 28.40

Pros Cons

• Simple • Fails to consider the time value

of money

• Rough and ready method • Ignores cash flows beyond the

for dealing with risk payback period

• Emphasises earlier cash inflows

AVERAGE RATE OF RETURN

Average PAT

Average Book Value of Investment (Beginning)

**Naveen Enterprise’s Capital Project
**

Year Book Value of PAT

Investment(Beg)

1 100 14

2 80 17.5

3 65 20.12

4 53.75 22.09

5 45.31 23.57

1/5 (14+17.5 +20.12+22.09+23.57)

ARR = 1/5(100+80+65+53.75+45.31) = 28.31%

Pros Cons

• Simple • Based on accounting profit,

• Based on accounting information not cash flow

businessmen are familiar with • Does not take into account the

• Considers benefits over the entire project life time value of money

INVESTMENT APPRAISAL

IN PRACTICE

**• Over time, discounted cash flow methods have gained in
**

importance and internal rate of return is the most

popular evaluation method.

• Firms typically use multiple evaluation methods.

**• Accounting rate of return and payback period are
**

widely employed as supplementary evaluation methods.

SUMMING UP

n Ct

• NPV = ∑ –I

t=1 (1 + r)t

PVB

• BCR =

I

• IRR is the value of r in the following equation

n Ct

I= ∑

t = 1 (1 + r)t

• MIRR is calculated as follows:

TV

PVC =

(1 + MIRR)n

• The payback period is the length of time required to recover the initial cash outlay on the

project

• The accounting rate is defined as:

Average profit after tax

Average book value of investment

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