CAPITAL BUDGETING

Meaning of Capital Budgeting ±  Significance ±  Capital Budgeting process ±  Project classification and Investment Criteria Payback method ±  ARR Method ±  Net Present Value ±  IRR Method ±  Profitability Index. 

Introduction:
One of the aspect of financial management is investment. investment. Investment means expenditure in cash or its equivalent during one or more time periods in anticipation of enjoying a net inflow of cash or its equivalent in some future time periods. periods. Appraisal of Investment is essential to know that the investments will bring benefits or not. not. Investment Decision: Investment Proposal Decision: these are the terms associated with long term resources or assets Proposals involving investment of funds for a period of ten or more will fall in the category of investment. ( no hard and fast rules). investment. rules). Long term decisions regarding planning and development of available financial resources for wealth maximization



Why Investments are necessary ?

Expansion of the business.  Diversification of the business  Replacement of the Assets/ Technology  Research and Development 

 Capital Expenditure: Expenditure for Expenditure: longer period of time involving high risk. Right of Pre-emptive: The right of the Preequity share holders to receive the new issue on pro-rata basis pro-  . the benefit of these expenditure is spread over number of years.

Capital Budgeting: the process of Budgeting: planning for purchases of longlongterm assets. How do we decide?  Will the machine be profitable?  Will our firm earn a high rate of return on the investment? .500.000.  example: example: Suppose our firm must decide whether to purchase a new plastic molding machine for Rs 2.

DecisionDecision-making Criteria in Capital Budgeting How do we decide if a capital investment project should be accepted or rejected? .

c) incorporate the required rate of return on the project.DecisionDecision-making Criteria in Capital Budgeting  The Ideal Evaluation Method should: a) include all cash flows that occur during the life of the project. b) consider the time value of money. . money.

Oster Young  . . potentially large anticipated benefits b.³Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern´ ± Lynch  The main features of capital budgeting are a. relatively long time period between the initial outlay and the anticipated return. a relatively high degree of risk c.

   Meaning of Capital Budgeting: Planning for capital assets Capital budgeting decision means deciding whether or not the investment is to be made.          Importance of Capital Budgeting: Includes huge amount therefore necessary to consider to generate profits. Relating to future period therefore affects the growth Once taken difficult to reverse Complex decisions Helps for long term financial planning Helps of proper replacement and research Helps to control capital expenditures . Capital budgeting is the process of allocating funds for long-term investment longprojects or proposals.

TYPES OF CAPITAL INVESTMENT DECISIONS ON THE BASIS OF FIRMS¶S EXISTENCE  Replacement and Modernization Decision. (aim is to improve operating efficiency) Expansion Decision ( existing successful firms)   DECISION SITUATION Mutually Exclusive Decision(one taken other will be excluded).  Accept or Reject Decision.( when proposals are independent and do not compete with each other).  Contingent Decision (depending upon other) If want start a factory u have to build infra ( in remote area)  Diversification Decision .

Capital Budgeting Process Examine the various steeps involved in Capital Budgeting  Project Generation ( investment generation for the project)  Project Evaluation( evaluation of alternatives).  Project Selection (Best)  Project Execution ( implementation)  Follow-up of the Project( assessment of Followsubsequent results)  .

step. conferences and seminars will offer wide variety of innovations on capital assets for investment. investment. Project generation: Generating the proposals for investment generation: is the first step. The investment proposal may fall into one of the following categories: categories:  Proposals to add new product to the product line. trade fairs people in the industry.  proposals to expand production capacity in existing lines  proposals to reduce the costs of the output of the existing products without altering the scale of operation. .Capital budgeting process involves the following 1. R and D institutes. operation.  Sales campaining.

2. The estimation of the cash inflows and cash outflows mainly depends on future uncertainities. The technique of time value of money may come as a handy tool in evaluation such proposals. . Selection of an appropriate criteria to judge the desirability of the project: It must be consistent with the firm¶s objective of maximising its market value. The risk associated with each project must be carefully analysed and sufficeint provision must be made for covering the different types of risks.   Project Evaluation: it involves two steps Evaluation: Estimation of benefits and costs: the benefits and costs are measured in terms of cash flows.

budget. completion. 4. He has to prepare capital funds. Project Selection: Selection: No standard administrative procedure can be laid down for approving the investment proposal. Sufficient care must be taken to reduce the average cost of funds. He has to prepare periodical funds.3. reports and must seek prior permission from the top management. Systematic procedure should be developed to review the performance of projects during their lifetime and after completion. budget. . management. it is the duty of the finance manager to explore the different alternatives available for acquiring the funds. The screening and selection proposal. firm. procedures are different from firm to firm. Project Evaluation: Once the proposal for capital Evaluation: expenditure is finalised.

.The follow up. comparison of actual performance with original estimates not only ensures better forecasting but also helps in sharpening the techniques for improving future forecasts. forecasts.

 Mention the factors influencing the capital budgeting .

1.000 and 25.000.000  The company has Rs 75.00.Direct impact on investment policy: policy--decisions. CuttCutt.       . surety etc play role Government policy: Economic policy--.000 to invest.Reject the Rate---project Capital return : How much time it takes to return the investments Taxation policy : Liberal ± helps for easy recovery of investment Structure of capital : Leveraged helps to earn more however risk is more Lending policies of financial institutions: Lending rate.   Immediate need of the project : Even if the projects may not earn immediately some of them need to be implemented urgently.Availability of Funds: Company has 3 projects which require 3 Rs 50.Off Rate: if estimated Return is < Cutt off Rate---.  Working Capital Requirements: Starting of new project may require modification in working capital requirements.

 Mutually Exclusive Proposals.Capital Investment Proposals  Independent Proposals: do not compete with another in a way of acceptance . .  Dependent or Contingent: acceptance dependence on another proposal. Straight way accepted or rejected directly by the firm.

safety--.returns± time-factors--.risk   Finance Manger is responsible to take the decision of selection .safety--benefits--.Techniques of Evaluating Investment Proposals Capital Budgeting Appraisal Techniques What are the techniques of evaluation of investment? Discuss  Number of Proposals  Which is to be selected  Number of factors--.returns± time-benefits--.

Methods of Appraisal Traditional Methods:  Pay Back Period  Accounting Rate of Return ( Return on Investment) Discounted Cash Flow Methods  Net Present Value Method  Internal Rate of Return Method  Profitability Index Method. .

best method for evaluating high risk projects. economic life of the project and original investment. . It involves simple calculation. It does not take the effect of time value of money. The selection of the project is based on the earning capacity of a project. selection or rejection of the project can be made easily. It emphasizes more on annual cash inflows. results obtained is more reliable.Pay back period method It refers to the period in which the project will generate the necessary cash to recover the initial investment.

 Does not consider profitability of the project.  Does not reflect all the relevant dimensions of profitability.  Does not recognize importance of time value of money. .Cons/ Demerits  It is based on principle of rule of thumb.  Does not recognize income beyond pay back period.

Payback Period The number of years needed to recover the initial cash outlay.  How long will it take for the project to generate enough cash to pay for itself?  PB = Initial cashoutlay Annual Cash Inflows .

Payback Period How long will it take for the project to generate enough cash to pay for itself?  ( CASH INFLOW is UNIFORM)  (500) 150 150 150 150 150 150 150 150 0 1 2 3 4 5 6 7 8 .

PBP = Initial cash outlay Annual Cash Inflows = 500/150= 3.33years .

33 years.Payback Period  How long will it take for the project to generate enough cash to pay for itself? 150 (500) 150 150 150 150 150 150 150 0 1 2 3 4 5 6 7 8 Payback period = 3. .

what would be our decision?  Accept the project.  If our senior management had set a cutcut-off of 5 years for projects like ours. . project.33 year payback period good?  Is it acceptable?  Firms that use this method will compare the payback calculation to some standard set by the firm. Is a 3.

 Does not consider all of the project¶s cash flows. return.  Does not consider any required rate of return.  Does not consider time value of money.  Firm . money.Drawbacks of Payback Period: subjective. flows. cutoffs are subjective.

0 (500) 150 150 150 150 150 (300) 0 0 1 2 3 4 5 6 7 8 Consider this cash flow stream! .Drawbacks of Payback Period:  Does not consider all of the project¶s cash flows.

Drawbacks of Payback Period:  Does not consider all of the project¶s cash flows. but we would accept it based on a 4-year payback criterion! . 0 (500) 150 150 150 150 150 (300) 0 0 1 2 3 4 5 6 7 8 This project is clearly unprofitable.

.  Problems: Problems:  Cutoffs are still subjective.  Payback period is calculated using these discounted net cash flows.Discounted Payback  Discounts the cash flows at the firm¶s required rate of return.  Still does not examine all cash flows.

Discounted Payback (500) 0 250 1 250 250 250 250 2 3 4 5 Discounted Year Cash Flow 0 1 -500 250 CF (14%) -500.00 219.30 .

00 219.70 1 year .Discounted Payback (500) 0 250 1 250 250 250 250 2 3 4 5 Discounted Year Cash Flow 0 1 -500 250 CF (14%) -500.30 280.

70 192.Discounted Payback (500) 0 250 1 250 250 250 250 2 3 4 5 Discounted Year Cash Flow 0 1 2 -500 250 250 CF (14%) -500.00 219.30 280.38 1 year .

30 280.32 1 year 2 years .Discounted Payback (500) 0 250 1 250 250 250 250 2 3 4 5 Discounted Year Cash Flow 0 1 2 -500 250 250 CF (14%) -500.00 219.70 192.38 88.

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow
0 1 2 3 -500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow
0 1 2 3 -500 250 250 250

CF (14%)
-500.00 219.30 280.70 192.38 88.32 168.75 1 year 2 years .52 years

Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5

Discounted

Year Cash Flow
0 1 2 3

The Discounted -500 -500.00 Payback 250 219.30 is 2.52 years
250 250 280.70 192.38 88.32 168.75

CF (14%)
1 year 2 years .52 years



Discounted PBP=
year of Max recovery + Balance to be recovered

Discounted Cash inflow of the year of Last recovery

Accounting Rate of Return method/ Average Rate of Return Method What is accounting rate of return? Briefly explain its limitations : Accounting ROR means the average annual yield on the project. . concepts. period.. life.. Profit after tax and depreciation as a percentage to the total investment is considered. This method has been introduced to overcome the disadvantage of pay back period. . Considers the earnings of the project of the economic life. Based on conventional accounting concepts.

 The cash flow advantage derived by adopting different kinds of depreciation is also not considered in this method. Because the method does to consider the heavy cash inflow during the project period as the earnings with be averaged.  .This method of ARR is not commonly accepted in assessing the profitability of capital expenditure.

use.  This method through the concept of "net earnings" ensures a compensation of expected profitability of the projects and  It can readily be calculated by using the accounting data. comparison of project than the pay back period.Accept or Reject Criterion: Under the method. all project.  This method takes into account saving over the entire economic life of the project. having Criterion: Accounting Rate of return higher than the minimum rate establishment by management will be considered and those having ARR less than the pre-determined rate. ARR. This method ranks a prerate. it provides a better means of project. period. . if it has highest ARR. Merits  It is very simple to understand and use. Therefore. data. and lowest rank is assigned to the project with the lowest ARR. Project as number one.

It is not consistent with the firm's objective of maximizing the market value of shares.  3.  2. It ignores time value of money. It does not consider the length of life of the projects.Demerits  1. - .  4. It ignores the fact that the profits earned can be reinvested.

ARR. Time is a crucial factor. An investment is essentially out flow of funds aiming at fair percentage of return in future. tomorrow. 'period. because. takes into account both the interest factor and the return after the payback 'period. investment.Give the meaning of discounted cash flow method. The presence of time as a factor in future. In evaluating investment projects it is important to consider the timing of returns on investment. A rupee received today has time. . Discounted cash flow technique investment. more value than a rupee received tomorrow. investment is fundamental for the purpose of evaluating investment. What are its advantages? Discounted cash flow method Time adjusted technique is an improvement over pay back method and ARR. the real value of money fluctuates over a period of time.

NPV 2.Discounted Cash Flow Technique It is based on time value of money. 2.  Therefore future income is to be discounted. IRR ( mention the merits of NPV and IRR)  . 1.  income is spread over a few years  Rupee today is more important.

 Discounting the cash flows by a discount factor  Aggregating the discounted cash inflows and comparing the total so obtained with the discounted out flows. . asset.Discounted cash flow technique involves the following steps: steps:  Calculation of cash inflow and out flows over the entire life of the asset. flows.

It recognizes the impact of time value of money. .Net present value method : Sum of the present values of all the cash inflows less the sum of the present values of all the cash outflows associated with the proposal. It is considered as the best method It is widely used in practice.

 The cash inflow to be received at different period of time will be discounted at a particular discount rate. . The present values of the cash inflow are compared with the original investment. If the difference shows (-) (negative values. If the different yields (+) positive value . The difference between the two will be used for accept or reject criteria. the proposal is selected for investment. it will be rejected.

money. Cons: Cons: It is very difficult to find and understand the concept of cost of capital It may not give reliable answers when dealing with alternative projects under the conditions of unequal lives of project. owners. project. It considers the cash inflow of the entire project. . It estimates the present value of their cash inflows by using a discount rate equal to the cost of capital. project.Pros: Pros: It recognizes the time value of money. capital. It is consistent with the objective of maximizing the welfare of owners.

n NPV = 7 t=1 CFt (1 + k) t .Net Present Value y NPV = the total PV of the annual net cash flows .the initial outlay.IO .

ACCEPT. y . REJECT. REJECT. y If NPV is negative.Net Present Value y Decision Rule: Rule: If NPV is positive. ACCEPT.

000 and Rs 25.000 and provides annual net cash flows of Rs.000.Determine whether firm should accept the proposal or not? . 2nd. Rs 18.000 in 1st . Rs 20.4. 3rd. The firm¶s cost of capital is 10%. 4th and 5th year. Rs 16.000.000 .NPV Example  Suppose we are considering a capital investment that costs Rs 56.

000 83.826 0.000 .NPV Calculation Year 1 2 3 4 5 Total Less Annual PV Factor Cash Flow 4.000 18.000 20.000 16.000 Initial Investment 0.909 0.621 PV of Cash Flows 3.000 25.751 0.645 56.636 13216 13518 13660 15525 68.683 0.

NPV CALCULATION: y NPV = the total PV of the annual net cash flows .the initial outlay. .

It is the rate of discount which reduces the NPV of an investment to zero. It is the rate at which the net present value of the investment is zero. .Internal Rate of Return It is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows for the proposal. It is called internal rate because it depends mainly on the outlay and proceeds associated with the project and not on any rate determined outside the investment.

Merits of IRR method  It consider the time value of money  Calculation of casot of capital is not a prerequisite for adopting IRR  IRR attempts to find the maximum rate of interest at which funds invested in the project could be repaid out of the cash inflows arising from the project. project. project.  It is not in conflict with the concept of maximising the welfare of the equity shareholders. shareholders. .  It considers cash inflows throughout the life of the project.

This is especially true in case of mutually exclusive project.Cons  Computation of IRR is tedious and difficult to understand  Both NPV and IRR assume that the cash inflows can be reinvested at the discounting rate in the new projects. However. . reinvestment of funds at the cut off rate is more appropriate than at the IRR.  IT may give results inconsistent with NPV method.

Step 1:Calculation of cash outflow Cost of project/asset Transportation/installation charges Working capital Cash outflow xxxx xxxx xxxx xxxx .

Step 2: Calculation of cash inflow Sales Less: Cash expenses PBDT Less: Depreciation PBT less: Tax PAT Add: Depreciation Cash inflow p.a xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx xxxx .

Scrap and working capital must be inflowadded.Note:  Depreciation = St.Line method  PBDT ± Tax is Cash inflow ( if the tax amount is given)  PATBD = Cash inflow  Cash inflow. .

Find IRR range PV of Cash inflows for IRR range and then calculate IRR .  ARR = Average Profits after tax/ Net investment x 100  NPV= PV of cash inflows ± PV of cash outflows  Profitability index = PV of cash inflows/ PV of cash outflows  IRR : Pay back factor: Cash outflow/ Avg cash inflow p. of years + Amt to recover/ total cash of next years.a.Step 3: Apply the different techniques  Pay back period= No.

.Internal Rate of Return (IRR) IRR:  IRR: the return on the firm¶s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.

Internal Rate of Return (IRR) n NPV = 7 t=1 ACFt (1 + k) t .IO .

IO IRR: 7 t=1 ACFt t (1 + IRR) = IO .Internal Rate of Return (IRR) n NPV = 7 t=1 n ACFt (1 + k) t .

 This looks very similar to our Yield to Maturity formula for bonds. YTM is the IRR of a bond. In fact. .Internal Rate of Return (IRR) n IRR:  IRR 7 t=1 ACFt t (1 + IRR) = IO is the rate of return that makes the PV of the cash flows equal to the initial outlay.

83.000 (276.000 83.Calculating IRR  Looking again at our problem:  The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.000 116.400) 83.000 83.000 0 1 2 3 4 5 .

000 (PVIFA 4.000 116.000 (PVIF 5.000 (276.000 83.400 . IRR) = 276.000 0 1 2 3 4  This is what we are actually doing: 5 83.000 83. IRR) + 116.400) 83.83.

000 (PVIFA 4.400  This way. .000 116.000 (276.83.000 83.000 0  This 1 2 3 4 5 is what we are actually doing: 83. IRR) + 116.400) 83. IRR) = 276. we have to solve for IRR by trial and error.000 (PVIF 5.000 83.

 Just enter the cash flows as you did with the NPV problem and solve for IRR.  You should get IRR = 17.63%!  IRR .IRR with your Calculator is easy to find with your financial calculator.

If IRR is less than the required rate of return. ACCEPT. REJECT. y . ACCEPT.IRR y y Decision Rule: Rule: If IRR is greater than or equal to the required rate of return. REJECT.

(.+ +) . we could get multiple IRRs.+ + + + +)  Problem: If there are multiple sign changes in the cash flow stream. (. IRR is a good decision-making decisiontool as long as cash flows are conventional.+ + . conventional.

(. conventional. IRR is a good decision-making decisiontool as long as cash flows are conventional. we could get multiple IRRs. (.+ +) (500) 200 0 1 100 2 (200) 3 400 4 300 5 .+ + + + +)  Problem: If there are multiple sign changes in the cash flow stream.+ + .

+ + . we could get multiple IRRs.+ +) (500) 200 0 1 100 2 (200) 3 400 4 300 5 . conventional.+ + + + +)  Problem: If there are multiple sign changes in the cash flow stream. (. (. IRR is a good decision-making decisiontool as long as cash flows are conventional.

(.+ +)  We could find 3 different IRRs! 1 (500) 200 0 1 100 2 2 (200) 3 3 400 4 300 5 .+ + . we could get multiple IRRs. Problem: If there are multiple sign changes in the cash flow stream.

(900) 300 0 1 400 2 400 3 500 4 600 5  Enter .  Find the IRR.  Using a discount rate of 15%. NPV.Summary Problem: the cash flows only once. find NPV.  Add back IO and divide by IO to get PI. PI. IRR.

57.  Using a discount rate of 15%.  PI = 1.37%.Summary Problem: = 34. NPV = $510. (900) 300 0 1 400 2 400 3 500 4 600 5  IRR .52.

Profitability Index n NPV = 7 t=1 ACFt t (1 + k) .IO .

IO PI = 7 t=1 ACFt t (1 + k) IO .Profitability Index n NPV = 7 t=1 n ACFt t (1 + k) .

REJECT. ACCEPT. REJECT. y . ACCEPT. y If PI is less than 1.Profitability Index y Decision Rule: Rule: If PI is greater than or equal to 1.

if index value = 1 project is accepted otherwise rejected.  .Profitability Index Method/ Benefit Cost Ratio Method/ Desirability Factor  Method for comparing the proposals each involving different amount of cash inflows. PI is worked out .

 .  Better than NPV  Demerits:  Fails to as a guide in resolving capital rationing.Merits:  Uses the concept of time value.  Project with a lower profitability index may be selected which may generate cash flow which can be used for another project.

It may be defined as a situation where a constraint is placed on the total sixe of capital investment during a particular period.Capital Rationing: A situation where a firm has more investment proposals than it can finance.  .  firm to select combination of investments proposals that provide the highest NPV subject to the budget constraint for the period.

 . They maintain required records and render advisory service to the clients. It is usually based on cost of capital.  Factoring: a factor is a financial institution which provides the management and financial services like financing of debt arising out of credit sales.Cut ±of ± Rate: Minimum rate which the management wishes to have from any project.

Thank You .