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Capital Budgeting-theory and numericals

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Module-1

Definitions

According to the definition of Charles T. Hrongreen,

capital budgeting is a long-term planning for making and

financing proposed capital out lays.

According to the definition of Richard and Green law,

capital budgeting is acquiring inputs with long-term

return.

According to the definition of Lyrich,

capital budgeting consists in planning development of

available capital for the purpose of maximizing the longterm profitability of the concern.

Capital Budgeting

1. Huge investments

2. Long-term

3. Irreversible

4. Long Term Effect

Challenges of Capital

Budgeting

a)

Future Uncertainty

b)

Time Element

c)

Process

1. Identification

proposals

of

various

investments

3. Evaluation

Contd

4. Fixing priority

5. Final approval

6. Implementing

7. Performance review of feedback

Pay-back period is also termed as "Pay-out period" or

Pay-off period.

It is defined as the number of years required to recover

the initial investment in full with the help of the stream of

annual cash flows generated by the project.

Pay-back period can be calculated into the following two

different situations :

(a) In the case of constant annual cash inflows.

(b) In the case of uneven or unequal cash inflows.

Contd

(a) In the case of constant annual cash inflows :

Pay-back period is determined with the help of cumulative

cash inflow. It can be calculated by adding up the cash

inflows until the total is equal to the initial investment .

Contd

Accept or Reject Criterion

Among the mutually exclusive or alternative projects whose

pay-back periods are lower than the cut off period. The

project would be accepted. if not it would be rejected .

important guide to investment policy

simple to understand and easy to calculate

facilitates to determine the liquidity and solvency of a firm

helps to measure the profitable internal investment

opportunities

ensures reduction of cost of capital expenditure.

does not consider cost of capital and interest factor which are very

important factors in taking sound investment decisions.

Accounting Rate of Return Method

focuses on the average net income generated in a project

in relation to the project's average investment outlay.

involves accounting profits not cash flows.

Contd

Where,

Contd

Advantages

(1) It considers all the years involved in the life of a project

rather than only pay-back years.

(2) It applies accounting profit as a criterion of measurement

and not cash flow.

Disadvantages

(1) It applies profit as a measure of yardstick not cash flow.

(2) The time value of money is ignored in this method.

(3) Yearly profit determination may be a difficult task.

Adjusted Method

takes into account both the overall profitability of projects and also

the timing of return.

occurred at a single point in time so that they can be compared in

an appropriate way.

recognizes that the use of money has a cost, i.e., interest foregone.

by adjusting the discount rate or cut off rate.

Disadvantages

(1) There may be difficulty in accurately establishing rates of interest

over the cash flow period.

(2) Lack of adequate expertise in order to properly apply the

techniques and interpret results.

(3) These techniques are based on cash flows, whereas reported

earnings are based on profits.

This is one of the Discounted Cash Flow technique which

explicitly recognizes the time value of money.

In this method all cash inflows and outflows are converted into

present value (i.e., value at the present time) applying an

appropriate rate of interest (usually cost of capital).

Thus, the Net Present Value is obtained by subtracting the

present value of cash outflows from the present value of cash

inflows.

(1) In the case of conventional cash flows. i.e., all cash outflows are

entirely initial and all cash inflows are in future years, NPV may be

represented as follows:

Contd

(2) In the case of non-conventional cash inflows,

i.e., where there are a series of cash inflows as

well as cash outflows the equation for calculating

NPV is as :

Contd

Where:

NPV=Net Present Value

R=Future Cash Inflows at different times

K =Cost of Capital or Cut-off rate or Discounting Rate Cash outflows at

different times

I= cash outflows at different times

Rules of Acceptance:

NPV > Zero - Accept the proposal

NPV < Zero - Reject the Proposal

Contd

Advantages

1. It explicitly recognizes the time value of money.

2. It takes into account all the years cash flows arising out of the project over its

useful life.

3. It is an absolute measure of profitability.

4. A changing discount rate can be built into NPV calculation. This feature

becomes important as this rate normally changes because the longer the time

span, the lower the value of money & higher the discount rate

Disadvantages

1. This method is comparatively difficult to understand or use.

2. When the projects in consideration involve different amounts of investment, the

Net Present Value Method may not give satisfactory results.

Return Method.

It is defined as the rate which equates the present value of each cash

inflows with the present value of cash outflows of an investment.

In other words, it is the rate at which the net present value of the

investment is zero.

The Internal Rate of Return can be found out by Trial and Error Method.

First, compute the present value of the cash flow from an investment,

using an arbitrarily selected interest rate, for example 10%. Then

compare the present value so obtained with the investment cost.

Contd

The IRR is considered as the highest rate of interest

which a business is able to pay on the funds borrowed to

finance the project out of cash inflows generated by the

project.

The Interpolation formula can be used to measure the

Internal Rate of Return as follows :

Contd

Merits

1. It takes into account the time value of money.

2. It considers the cash flows over the entire life of the project.

3. It makes more meaningful and acceptable to users because it satisfies them in terms

of the rate of return on capital.

Limitations

1. The internal rate of return may not be uniquely defined.

2. The IRR is difficult to understand and involves complicated computational problems.

3. The internal rate of return figure cannot distinguish between lending and

borrowings .

4. When projects under consideration are mutually exclusive, IRR may give conflicting

results.

5. We may get multiple IRRs for the same project when there are nonconventional cash

flows especially.

terms of the percentage return a firm expects the capital project to

return;

total yield on investment, NPV method considers the total yield on

investment. Hence, in case of mutually exclusive projects, each

having a positive NPV the one with largest NPV will have the

maximum effect on shareholders wealth.

are changing cash flows(e.g., an initial outflow followed by in-flows

and a later out-flow, such as may be required in the case of land

reclamation by a mining firm);

Contd

advantage managers tend to better understand the concept of

returns stated in percentages and find it easy to compare to the

required cost of capital; and, finally,

recommendations. The IRR method always gives the same

recomendation.

Multiple IRR

A normal cash flow pattern for project is negative

initial outlay followed by positive cash flows (,

+, +, + )

(such as , +, ) there can be more than one

IRRs.

Contd

Accept if MIRR required rate of return

Reject if MIRR < required rate of return

ratio

It gives the present value of future benefits, computed at the

required rate of return on the initial investment.

Profitability Index may either be Gross Profitability Index or Net

Profitability Index. Net Profitability Index is the Gross Profitability

Index minus one.

than one should be accepted as it will have Positive Net Present

Value and vice versa.

(1) It duly recognizes the time value of money.

(2) For calculations when compared with internal rate of

return method it requires less time.

(3) It helps in ranking the project for investment decisions.

(4) As this method is capable of calculating incremental

benefit cost ratio, it can be used to choose between

mutually exclusive projects.

internal rate of return (IRR) approach to capital budgeting decisions.

It does not require the assumption that the project cash flows are

reinvested at the IRR; rather, it uses cost of capital for reinvestment.

over NPV because IRR is intuitively more appealing as it is a

percentage measure. The modified IRR or MIRR overcomes the

shortcomings of the regular IRR.

with the project, using cost of capital (r) as the discount rate :

expected from the project :

Contd

MIRR is a distinct improvement over the regular IRR but we need to

take note of the following:

If the mutually exclusive projects are of the same size, NPV and MIRR

lead to the same decision irrespective of variations in life.

If the mutually exclusive projects differ in size, there may be a

possibility of conflict between NPV and IRR.

MIRR is better than the regular IRR in measuring true rate of return.

However, for choosing among mutually exclusive projects of different

size, NPV is a better alternative in measuring the contribution of each

project to the value of the firm

Capital Rationing

Capital rationing is the process of putting restrictions on

the projects that can be undertaken by the company or

the capital that can be invested by the company.

This aims in choosing only the most

investments for capital investment decision.

profitable

the budget or selecting a higher cost of capital as the

hurdle rate for all the projects under consideration.

Capital rationing can be either hard or soft

Contd

Assumptions of Capital Rationing

restrictions on capital expenditures

optimal return on investment for the company

.

Advantages of Capital

Rationing

Budget

No Wastage

Fewer Projects

Higher Returns

More Stability

Cost of Capital

Un-Maximising Value

Small Projects

Intermediate Cash Flows

1. A project requires initial investment of Rs. 40,000 and it will generate an

annual cash inflows of Rs. 10,000 for 6 years. You are required to find

out pay-back period.

2. From the following information you are required to calculate pay-back

period : A project requires initial investment of Rs. 40,000 and generate

cash inflows of Rs. 16,000, Rs. 14,000, Rs. 8,000 and Rs. 6,000 in the

first, second, third, and fourth year respectively.

3. The company is considering investment of Rs. 1,00,000 in a project. The

following are the income forecasts, after depreciation and tax, 1st year

Rs. 10,000, 2nd year Rs. 40,000, 3rd year Rs. 60,000, 4 th year Rs.

20,000 and 5th year Rs. Nil.

From the above information you are required to calculate: (1) Pay-back

Period (2) Discounted Pay-back Period at 10% interest factor.

NPV

IRR

The cost of a project is Rs. 32,400. It is

expected to generate cash inflows of Rs.

16,000, Rs. 14,000 and Rs. 12,000

through it three year life period. Calculate

the Internal Rate of Return of the Project

Profitability Index

A project is in the consideration of a firm. The

initial outlay of the project is Rs. 10,000 and it is

expected to generate cash inflows of Rs. 4,000,

Rs. 3,000, Rs. 5,000 and Rs. 2,000 in four years

to follow. Assuming 10% rate of discount,

calculate the Net Present Value and Benefit Cost

Ratio of the project.

Problem

company. Both the projects have a life of 5 years and have initial cash

outlays of Rs. 1,00,000 each. The company pays tax at 50% rate and the

maximum required rate of the company has been given as 10%. The

straight line method of depreciation will be charged on the projects. The

projects are expected to generate a net cash inflow before taxes as

follows :

Contd

With the help of the above given information you are

required to calculate:

(a) The Pay-back Period of each project

(b) The Average Rate of Return for each project

(c) The Net Present Value and Profitability Index for each

project

(d) The Internal Rate of Return for each project

On the basis of your calculations advise the company

which project it should accept giving reasons.

THANKS

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