Capital Budgeting

-Aaditya Desai

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What is Capital Budgeting?
• Capital budgeting is the process in which a business determines and
evaluates potential large expenses or investments.
• These expenditures and investments include projects such as building
a new plant or investing in a long-term venture.
• Often, a company assesses a prospective project's lifetime cash
inflows and outflows to determine whether the potential returns
generated meet a sufficient target benchmark, also known as
"investment appraisal."

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Inputs for Capital Budgeting Decisions
• The most commonly used methods for capital budgeting are:
• the payback period,
• the net present value and
• an evaluation of the internal rate of return.

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Payback period
• The payback period method is popular because it's easy to calculate.
• Quite simply, the payback period is a calculation of how long it takes
to get your original investment back.

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Payback period
• Let's suppose you spent $24,000 to buy a machine that made blue widgets, and the profits from
selling these widgets would amount to $8,000 per year. Your payback period would be $24,000
divided by $8,000 or three years. Is that acceptable? It depends on your criteria for a required
payback period.
• The payback method has a flaw in that it does not consider the time value of money. Suppose you're
considering two projects and both have the same payback period of three years. However, Project A
returns most of your investment in the first one and one-half years whereas Project B returns most of
its cash flow return in years two and three.
• They both have the same payback period of three years, so which one would you choose? You would
select Project A, because you would get most of your money back in the early years, as opposed to
Project B, which has returns concentrated in the later years.
• Note that the payback method only considers the time required to return the original investment. But
suppose that Project A had zero cash flow beyond the third year, whereas the cash flow from Project B
continued to generate $10,000 per year in years four, five, six and beyond. Now, which project would
you choose?

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Net Present Value
• Net present value (NPV) is the difference between the present value of
cash inflows and the present value of cash outflows over a period of time.
• NPV is used in capital budgeting and investment planning to analyze the
profitability of a projected investment or project.
• NPV is the result of calculations that find the current value of a future
stream of payments, using the proper discount rate. In general, projects
with a positive NPV are worth undertaking while those with a negative
NPV are not.
• If the NPV of a project or investment is positive, it means its rate of return
will be above the discount rate.
• Getting your money back in the early years is preferable to receiving it 20
years from now. Inflation makes money worth less in future years than it
is worth today.
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Internal Rate of Return
• The internal rate of return method is a simpler variation of the net present value method. The
internal rate of return method uses a discount rate that makes the present value of future cash
flows equal to zero.
• This approach gives a method of comparing the attractiveness of several projects.
• The project with the highest rate of return wins the contest. However, the rate of return of the
winning project must also be higher than the investor's required rate of return. If the investor
says he wants to receive a 12 percent return on his money, and the winning project only has a
return of 9 percent, then the project would be rejected.
• The investor's cost of capital is the minimum return acceptable, when using the internal rate of
return method.
• As you can see, none of these methods are completely reliable by themselves. They all have
their flaws for making an intelligent analysis, when evaluating the worth of several projects.
• A project that has the highest internal rate of return may not have the best net present value of
future cash flows. Another project could have a short payback period, but it continues to
produce cash flows after the payback period ends.
• This means that all these methods of analysis should be used, and investment decisions made
with good business judgement.
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Accounting Rate of Return
• Accounting rate of return, also known as the Average rate of return, or ARR is
a financial ratio used in capital budgeting. 
• The ratio does not take into account the concept of time value of money.
• ARR calculates the return, generated from net income of the proposed
capital investment.
• The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is
expected to earn seven paise out of each rupee invested (yearly).
• If the ARR is equal to or greater than the required rate of return, the project is
acceptable. If it is less than the desired rate, it should be rejected.
• When comparing investments, the higher the ARR, the more attractive the
investment. More than half of large firms calculate ARR when appraising projects.

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Average Rate of Return

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Discounted Payback Period
• The discounted payback period is used as part of capital budgeting to
determine which projects to take on.
• More accurate than the standard payback period calculation, the
discounted payback period factors in the time value of money.
• The discounted payback period formula shows how long it will take to
recoup an investment based on observing the present value of the
project's projected cash flows.
• The shorter a discounted payback period is, means the sooner a
project or investment will generate cash flows to cover the initial cost.

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Discounted Payback Period
• Assume that Company A has a project requiring an initial cash outlay of $3,000.
• The project is expected to return $1,000 each period for the next five periods, and the
appropriate discount rate is 4%.
• The discounted payback period calculation begins with the -$3,000 cash outlay in the
starting period.
• The first period will experience a +$1,000 cash inflow.
• Using the present value discount calculation, this figure is $1,000/1.04 = $961.54.
• Thus, after the first period, the project still requires $3,000 - $961.54 = $2,038.46 to
break even.
• After the discounted cash flows of $1,000/(1.04)2 = $924.56 in period two, and
$1,000/(1.04)3 = $889.00 in period three, the net project balance is $3,000 - ($961.54 +
$924.56 + $889.00) = $224.90.
• Therefore, after receipt of the fourth payment, which is discounted to $854.80, the
project will have a positive balance of $629.90. Therefore, the discounted payback
period is sometime during the fourth period. 11
Profitability Index
• The PI is calculated by dividing the present value of future expected
cash flows by the initial investment amount in the project.
• through the use of a ratio calculated as:

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Profitability Index
• Profitability index calculations cannot be negative and must be
converted to a positive figure before they are useful.
• Calculations greater than 1.0 indicate the future anticipated
discounted cash inflows of the project are greater than the
anticipated discounted cash outflows.
• Calculations less than 1.0 indicate the deficit of the outflows is greater
than the discounted inflows, and the project should not be accepted.
• Calculations that equal 1.0 bring about situations of indifference
where any gains or losses from a project are minimal.

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Internal Rate of Return
• The internal rate of return (IRR) is a metric used in capital
budgeting to estimate the profitability of potential investments.
• The internal rate of return is a discount rate that makes the net
present value (NPV) of all cash flows from a particular project equal to
zero.
• IRR calculations rely on the same formula as NPV does.

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Internal Rate of Return
• But, as an example, let's assume that you want to open a pizzeria.
• You estimate all the costs and earnings for the next two years, and
then calculate the net present value for the business at various
discount rates.
• At 6%, you get an NPV of $2000.
• But, the NPV needs to be zero, so you try a higher discount rate, say
8% interest: At 8%, your NPV calculation gives you a net loss of −
$1600. Now it's negative.
• So you try a discount rate in between the two, say with 7% interest: At
7%, you get an NPV of $15.
• That is close enough to zero, so you can estimate that your IRR is just
slightly higher than 7%.
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Modified Internal Rate of Return
• The modified internal rate of return (MIRR) is a financial measure of
an investment's attractiveness.
• It is used in capital budgeting to rank alternative investments of equal
size.
• As the name implies, MIRR is a modification of the internal rate of
return (IRR) and as such aims to resolve some problems with the IRR.

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Modified Internal Rate of Return

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Working Capital
• Working capital, also known as net working capital (NWC), is the
difference between a company’s current assets, such as cash, accounts
receivable (customers’ unpaid bills) and inventories of raw materials and
finished goods, and its current liabilities, such as accounts payable.
• Working capital is a measure of a company's liquidity, operational
efficiency and its short-term financial health.
• If a company has substantial working capital, then it should have the
potential to invest and grow.
• If a company's current assets do not exceed its current liabilities, then it
may have trouble growing or paying back creditors, or even go
bankrupt.

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Importance of Working Capital
Management
1.Improve Liquidity and Business Valuation
2.Increasing Profitability and Returns on Capital
3.Capability to Face Financial Situations / Risks
4. Improve Solvency and Credit Rating
5. Calculating Ratio Analysis

6. Inventory Management

7. Cash Management

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Factors Affecting an Entity’s Working
Capital Needs
1. Length of Operating Cycle
2. Nature of Business
3. Scale of Operation
4. Business Cycle Fluctuation
5. Seasonal Factors
6. Technology and Production Cycle
7. Credit Allowed
8. Credit Avail
9. Operating Efficiency
10. Availability of Raw Materials
11. Level of Competition
12. Inflation
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13. Growth Prospects
Estimation of Working Capital
Requirements
1. Percentage of Sales Method:
• This method of estimating working capital requirements is based on
the assumption that the level of working capital for any firm is directly
related to its sales value.
• If past experience indicates a stable relationship between the amount
of sales and working capital, then this basis may be used to determine
the requirements of working capital for future period.
• Thus, if sales for the year 2007 amounted to Rs 30,00,000 and
working capital required was Rs 6,00,000; the requirement of working
capital for the year 2008 on an estimated sales of Rs 40,00,000 shall
be Rs 8,00,000; i.e. 20% of Rs 40,00,000.
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 Estimation of Working Capital Requirements
2. Regression Analysis Method (Average Relationship between Sales
and Working Capital):
• This method of forecasting working capital requirements is based
upon the statistical technique of estimating or predicting the
unknown value of a dependent variable from the known value of an
independent variable.
• It is the measure of the average relationship between two or more
variables, i.e.; sales and working capital, in terms of the original units
of the data.

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Estimation of Working Capital
Requirements
3. Cash Forecasting Method:
• This method of estimating working capital requirements involves
forecasting of cash receipts and disbursements during a future period of
time.
• Cash forecast will include all possible sources from which cash will be
received and the channels in which payments are to be made so that a
consolidated cash position is determined.
• This method is similar to the preparation of a cash budget.
• The excess of receipts over payments represents surplus of cash and the
excess of payments over receipts causes deficit of cash or the amount of
working capital required.
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Estimation of Working Capital
Requirements
4. Operating Cycle Method:
• This method of estimating working capital requirements is based upon the
operating cycle concept of working capital.
• The cycle starts with the purchase of raw material and other resources and
ends with the realization of cash from the sale of finished goods.
• It involves purchase of raw materials and stores, its conversion into stock of
finished goods through work-in-process with progressive increment of labour
and service costs, conversion of finished stock into sales, debtors and
receivables, realization of cash and this cycle continues again from cash to
purchase of raw material and so on.
• The speed/time duration required to complete one cycle determines the
requirement of working capital – longer the period of cycle, larger is the
requirement of working capital and vice-versa.
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Management of Inventories
• Inventory management refers to the process of ordering, storing and
using a company's inventory: raw materials, components and finished
products.
• Just-In-Time
• Materials Requirement Planning

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Management of Receivables
• Receivables, also referred to as accounts receivable, are debts owed to a
company by its customers for goods or services that have been delivered or
used but not yet paid for.
• If a company sells widgets and sells 30% of them on credit, it means 30% of
the company's receipts are receivables.
• That is, the cash has not been received but is still recorded on the books as
revenue. Instead of an increase in cash, the company credits accounts
receivable.
• They are both considered an asset, but a receivable is not considered cash
until it is paid.
• If the customer pays the bill in six months, on the seventh month the
receivable is turned into cash and the same amount of cash received is
deducted from receivables.
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Management of Cash
• Cash management refers to a broad area of finance involving the collection,
handling, and usage of cash.
• It involves assessing market liquidity, cash flow, and investments.
• In banking, cash management, or treasury management, is a marketing term for
certain services related to cash flow offered primarily to larger business customers.
• It may be used to describe all bank accounts (such as checking accounts) provided
to businesses of a certain size, but it is more often used to describe specific
services such as cash concentration, zero balance accounting, and clearing
house facilities.
• Sometimes, private banking customers are given cash management services.
• Financial instruments involved in cash management include money market
funds, treasury bills, and certificates of deposit.

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Marketable Securities
• Marketable securities are liquid financial instruments that can be quickly
converted into cash at a reasonable price.
• The liquidity of marketable securities comes from the fact that the
maturities tend to be less than one year, and that the rates at which they
can be bought or sold have little effect on prices.
• Marketable securities are defined as any unrestricted financial instrument
that can be bought or sold on a public stock exchange or a public bond
exchange.
• Therefore, marketable securities are classified as either a marketable
equity security or a marketable debt security. 
• Examples of marketable securities include common stock, commercial
paper, banker's acceptances, Treasury bills, and other money
market instruments.
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