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Capital Budgeting Decisions

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.

Need and Importance of


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)

Difficulty in Quantification of Impact

Capital Budgeting Decision


Process
1. Identification
proposals

of

various

investments

2. Screening or matching the proposals


3. Evaluation

Contd
4. Fixing priority
5. Final approval
6. Implementing
7. Performance review of feedback

Pay-back Period Method


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 :

(b) In the case of Uneven or Unequal 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 .

Advantages of Pay-back Period Method


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.

Disadvantages of Pay-back Period Method

does not measure the profitability of a project

does not value projects of different economic lives

does not consider income beyond the pay-back period

does not give proper weight to timing of cash flows

does not consider cost of capital and interest factor which are very
important factors in taking sound investment decisions.

Average Rate of Return Method (ARR) or


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.

Discounted Cash Flow Method (or) Time


Adjusted Method

takes into account both the overall profitability of projects and also
the timing of return.

helps to measure the cash inflow and outflow of a project as if they


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.

risk can be incorporated into Discounted Cash Flow computations


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.

Net Present Value Method (NPV)


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.

Equation for Calculating Net Present Value


(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.

Internal Rate of Return Method (IRR)

Internal Rate of Return Method is also called as "Time Adjusted Rate of


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.

NPV Vs. IRR

NPV is calculated in terms of currency while IRR is expressed in


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

IRR method is concerned with rate of return on investment rather than


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.

The IRR Method cannot be used to evaluate projects where there


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

However, the IRR Method does have one significant


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,

Applying NPV using different discount rates will result in different


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 (,
+, +, + )

However, if the cash flow pattern is not normal


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

Contd
Accept if MIRR required rate of return
Reject if MIRR < required rate of return

Profitability Index Method/Benefit Cost


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.

Rule of Acceptance: A project with Profitability Index greater


than one should be accepted as it will have Positive Net Present
Value and vice versa.

Advantages of Profitability Index


(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.

Modified Internal Rate of Return

Modified internal rate of return (MIRR) is an improved version of the


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.

Despite NPV's conceptual superiority, managers seem to prefer IRR


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.

The problem of multiple rates does not exist with MIRR.

Steps for calculating MIRR

Step 1 : Calculate the present value of the costs (PVC) associated


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

Step 2 : Calculate the terminal value (TV) of the cash inflows


expected from the project :

Step 3 : Obtain MIRR by solving the following equation :

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

This can be accomplished by putting restrictive limits on


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

Disadvantages of Capital Rationing

Efficient Capital Markets


Cost of Capital
Un-Maximising Value
Small Projects
Intermediate Cash Flows

Pay Back Period


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.

Average Rate of Return

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

There are two mutually exclusive projects under active consideration of a


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