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# Should we build this plant?

Capital budgeting is the process of making investment

decisions in capital expenditures. A capital expenditure may be define as an expenditure the benefits of which are expected to be received over period of time exceeding one year. EXP. Of capital expenditure:- Cost of acquisition of permanent assets - Cost of addition, expansion, improvement - Cost of replacement of permanent assets - Research and development project cost, etc.

Capital budgeting is long term planning for making and financing proposed capital outlays By Charles T. Horngreen

Risk uncertainty. Long term. Irreversible in nature. Complexity.

These are vital decisions to take. So a) Funds should be invested or not. b) Analyze the proposal for expansion,etc. c) To decide the replacement of permanent assets. d) Choosing best out of many alternatives.

o The main objective of capital budgeting is to maximize the profitability of a firm. o The return on investement.

**IMPORTANCE OF CAPITAL BUDGETING
**

1 LARGE INVESTMENTS

2

IRREVERSIBLE NATURE

3

LONG TERM EFFECT ON PROFITABILITY

4

DIFFICULTIES OF INVESTMENT DECISIONS

5

LONG TERM COMMITMENT OF FUNDS

**CAPITAL BUDGETING PROCESS
**

Investment proposals Text8 Screen Proposals

Evaluate proposals

Review Performance

C.B. Process

Fix priorities

Implement the Proposal. Final decision

TYPES OF INVESTMENT DECISION

MODERNISATION

**KINDS OF CAPITAL BUDGETING DECISIONS
**

Which increase revenue Which reduces cost.

**Further, in view of the investment proposals under consideration, Capital Budgeting decisions may also be classified as. . .
**

1 3

2

AcceptReject Decision . .. Mutually exclusive project decision... Capital rationing decisions . . .

Evaluation Criteria

CAPITAL BUDGETING

TRADITIONAL METHOD

MODERN METHOD

PBP

ARR

PI

NPV

IRR

**What is the payback period?
**

y Most easy method for evaluation of capital expenditure. It represents the period in which the total investment in permanent assets pays back itself. .i.e. the period in which we get the invested amount back. y Also, known as Pay-out & Pay-off method.

Simple to understand & easy to calculate. It saves in cost, requires lesser time & labour . Project with shorter PBP is preferred to the one having longer PBP, as it reduces the loss. That s why more suited to developing countries like INDIA.

True profitability cannot be correctly assessed. Ignores the time value of money. It does not take into consideration the cost of capital. It may be difficult to determine minimum PBP.

In this method the rate of return on investment is calculated & the time factor is not taken into consideration.

Simple to understand & easy to operate. Gives better view of profitability as compared to PBP. It can be readily calculated from the financial data.

Ignores time value of money. Cash flows are not considered. It cannot be applied to a situation where investment in a project is to be made in parts.

PI also called as Benefit-cost Ratio or Desirability factor is the

Relationship between present value of cash inflows and the present value of cash outflows. Advantages and Disadvantages of PI:- The net present value method has one major drawback that it is not easy to take projects on the basis of this method particularly when the costs of the projects differ significantly. To evaluate such project, the profitability index method is most suitable.

NPV Consider the time value

of money and attempt to calculate the return on investment by introducing the factors of time element.

It recognizes the time value of money and suitable to be applied

in a situation with uniform cash outflows and uneven cash inflows. It takes into account the earnings over the entire life of the project and the true profitability of the investment proposal can be evaluated. It takes into consideration the objective of maximum profitability.

NPV is more difficult to understand and operate. It may not give good results while comparing project with

unequal lives as the project having higher NPV In the same way as above, it may not give good results while comparing projects with unequal investment of funds. It is not easy to determine an appropriate discount rate.

IRR , the cash flows of a project are discounted at a suitable rate by hit

& trial method, which equates the net present value so calculated to the amount of the investment. Under this method, since the discount rate is determined initially.

IRR is define as that rate of discount at which the present value of

cash-inflows is equal to the present value of cash outflows.

It takes into account the time value of money. It considered the profitability of the project. The determine of cost of capital is not a pre-requisite for the use

of method. It provides for uniform ranking of various proposals due to the percentage rate of return. This method is also compatible with the objective of minimum profitability.

It is difficult to understand. This method is based upon the assumption. The result of NPV method & IRR method may differ when the

project under evolution differ in their size, life and timings of cash flows.

**Comparison between NPV & IRR
**

NPV

y Determined by discounting

IRR

y Determined by hit and trial

the future cash flows. y NPV method recognize the importance of market rate of interest or cost of capital. y NPV method is intermediate cash inflows are reinvented at the discount rate. y More reliable than the IRR for ranking 2 or more capital investment proposal.

method. y IRR method does not considered the importance of market rate of interest or cost of capital. y IRR method intermediate cash flows are presumed to be reinvented at the IRR. y Not more reliable than the NPV for ranking 2 or more capital investment proposal.

Pay Back Period = Initial outlay / Annual Cash Inflow Rate of Return Method:Average Rate of Return = Average profit (PAT&D)/ Net Investment in the Project * 100 Return per Unit of Investment = Total Profit (PAT&D)/ Net Investment in the Project *100 Return on Average Investment = Total Profit (PAT&D) / Average Investment in the Project * 100 Average Return on Average Investment = Average profit (PAT&D ) /Average Investment in the Project * 100

Net Present Value = Present Value of Cash inflows Present Value of Initial Investment Internal Rate of Return (IRR) Present Value Factor = Initial Outlay / Annual Cash Flow Consulting Present Value Annuity table for X years period at P.V. factor of Y IRR = Z%

( As We see from the that at 8% for 5 years period, the present value is 3.9927 which is nearly equal to 4) Profitability Index (PI)= Present Value of Cash Inflows or NPV/ Present Value of Initial Cash Outlay

Years

CFBT(Rs.)

Calculate:

60,000 (a) PBP 70,000 (b) ARR 90,000 (c) NPV & PI at 10% 1,00,000 5 1,50,000 1 2 3 4 5 P.V.factors @ 10% 0.909 0.826 0.751 0.683 0.621 1 2 3 4

**Calculation of Cash Inflows Years CFBTAD Tax(40%) CFATAD Depreciation CFATBD
**

(Rs) (Rs) (Rs) (Rs) (Rs)

1 2 3

60,000

24,000

36,000 42,000 54,000 60,000 90,000 2,82,000

50,000 50,000 50,000 50,000 50,000

86,000 92,000 1,04,000 1,10,000 1,40,000 5,32,000

70,000 28,000 90,000 36,000

4 1,00,000 40,000 5 1,50,000 60,000 Total

Cash Outlay of the Project (-)Total Cash inflows for the 2 years Balance of cash outlays left paid back in 3rd year Cash inflow for the 3rd year So, the pay back period is between 2nd and 3rd year , 2 years + 72,000/ 1,04,000 = 2.692 years Average Rate of Return = CFATAD / Net investment in the Project*100 2,82,000/5 * 100 2,50,000 = 22.56 %

Rs. 2,50,000 1,78,000 72,000 1,04,000

Year

Cash Inflows (Rs.)

P.V. Factor at 10%

Present Value(Rs.)

1 2 3 4 5 Total

80,000 92,000 1,04,000 1,10,000 1,40,000

0.909 0.826 0.751 0.683 0.621

78,174 75992 78,104 75,130 86,940 3,94,340

Net Present Value = Present Value of Cash Inflows Present Value of Cash Outflows = 3,94,340 2,50,000 = Rs. 1,44,340

(Gross) Profitability Index = Present Value Of Cash Inflows / Cost of Investment = 3,94,340 / 2,50,000 = 1.577 (Net) Profitability Index = Net Present Value of Cash Inflows / Cost of Investment = 0.577 = 1,44,340 / 2,50,000

Solution:Step:- 1 Calculate Pay back period cash outlay of the project Total cash inflow for the first 2 Years Balance of Outlay Left to be paid in the 3rd Year Cash inflow for the 3rd Year

Rs. 60,000 Rs. 35,000 Rs. 25,000 Rs. 30,000

So, the PBP is between 2nd & 3rd Year 2 Years + 25,000 / 30,000 = 2.833 (Years) Now we see in Table D (annuity table) 4th Year at the value 2.833 the percentage is 16 and at that the value is 2.7982. so exact percentage not getting for that we calculate as follows. (NPV) Cash Flow Table at Various Assumed Discount Rate of 14% & 15% Year Annual cash @ 14 % @ 15 %

flow (Rs.) P.V.F. P.V.(Rs) P.V.F. P.V.(Rs)

1 15,000 2 20,000 3 30,000 4 20,000 Total

0.877 0.769 0.674 0.592

13,155 15,380 20,220 11,840 60,595

0.869 0.756 0.657 0.571

13,035 15,120 19,710 11,420 59,285

The Present Value of net Cash flows at 14 % rate of discount is Rs. 60,595 and at 15 % rate of Discount it is Rs. 59,285. So the initial cost of investment which is Rs. 60,000 falls in between these two discount rates. At 14 % the NPV is + 595 but at 15% the NPV is -715, NPV at 14% 60,595 60,000 = + 595 at 15 % 59,285 60,000 = - 715 IRR = 14 % + 595 * (15 % - 14 %) 595 + 715 IRR = 14.45 %

Thank you