Capital Budgeting

What is capital budgeting?

• The investment decisions of a firm are generally known as the capital
budgeting, or capital expenditure decisions.
• A capital budgeting decision may be defined as the firm’s decision to invest
its current funds most efficiently in the long-term assets in anticipation of
an expected flow of benefits over a series of years. The long term assets are
those that affect the firm’s operations beyond the one-year period. The
firm’s investment decisions would generally include expansion, acquisition,
modernization and replacement of the long-term assets.
• Sale of a division or business (disinvestment) is also an investment decision.
• Decisions like change in sales distribution, an advertisement campaign or a
research development is also capital budgeting.
Features of investment decisions
• The exchange of current funds for future benefits.
• The funds are invested in long-term assets.
• The future benefits will occur to the firm over a series of years.
How can I evaluate my benefits?
• I have to evaluate all my future revenues, expenditures, future and
present investments at present time.
• Hence I have to discount all my future revenues, expenditures and
future and present investments or I have to find the present value of
everything.
• To find out the present value, what do I have to consider?
• Future Profits
• Future Cash flows
Can we consider profit for discounting?
• Profit, as measured by an accountant, is based on accrual concept.
Revenue (sales) is recognised when it is earned, rather than when
cash is received and expenses is recognised when it is incurred rather
than when cash is paid.
• In other words, profit includes cash revenues as well as receivable and
excludes cash expenses as well as payable.
• For computing profit, expenditures are arbitrarily divided into revenue
and capital expenditure.
• Revenue expenditures are entirely charged to profits while capital
expenditures are not.
Continued
• It is significant to emphasize that expenditures and benefits of an
investment should be measured in cash. In investment analysis it is
cashflow, which is important and not the accounting profit.
• Investment should take care off the share holder’s value
maximization.
Importance of investment decision
• They influence the firm’s growth in long run.
• They effect the risk of the firm.
• They involve commitment of large amount of funds.
• They are irreversible, or reversible at substantial loss.
• They are among the most difficult decisions of make.
Types of investment decisions
• One classification is as follows:
• Expansion of existing business
• Expansion of new business
• Replacement and modernization
Continued
• Yet another useful way to classify investments is as follows:
• Mutually exclusive investments: These projects serve the same purpose and
compete with each other. If one is included other will be excluded. A company
may for example, either use a more labour intensive, semi automatic machine, or
employ a more capital intensive, highly automatic machine for production.
• Independent investments: Independent investment serve different purposes and
do not compete with each other. ITC is a tobacco and tobacco related product
manufacturing company but they have hotel business.
• Contingent investments : Contingent investment are dependent projects, the
choice of one investment necessitates undertaking one or more other
investments. For example if a company decides to build a company in remote area
then it has to build houses, roads, hospitals and schools etc. Total expenditure will
be treated as a single investment.
Investment evaluation criteria
• Three steps are involved in the evaluation of an investment:
• Estimation of cash flows
• Estimation of the required rate of return (the opportunity cost of capital)
• Application of a decision rule for making the choice
• We have to estimate the cash flow properly. This is the not the same
cash-flow what you have studied in financial accounting.
• In reality estimating cash flows arises because of uncertainty and
accounting ambiguities.
Components of the cash flow
• Initial investment
• Annual net cash flow
• Terminal Cash flow
Initial Investment
• Initial investment is the net cash outlay in the period in which an asset
is purchased.
• A major element of the initial investment is gross outlay or original
value(OV) of the asset, which comprises of its cost (including
accessories and spare parts) and freight and installation charges.
• Thus initial investment is equal to: Gross investment + increase in net
working capital.
Continued
• In case of replacement decision, the existing asset will have to be sold
for new asset. Sale of existing asset will provide the cash inflow.
Hence that needs to be subtracted from the new asset price.
Example of new project
Continued
• Miscellaneous capital expenditure includes expenditure on
electrification, water supply, vehicles and fire-fighting.
• Preliminary and pre-operative expenses include legal and promotional
expenses and brokerage and commission. These expenses may have
to be incurred before the company’s actual operations start.
• Contingencies are ad hoc in nature and are provided for any possible
delay in say land acquisition and development, or installation of plant
or any other activity. It is important to note that contingencies do not
account for the uncertainties in the estimates of cash flow; the cash
flow uncertainties should be handled differently.
Depreciation and Taxes
• Depreciation calculated as per the income tax rules, is a deductible
expense for computing tax. In itself it has no direct impact on cash
flows, but it indirectly influences cash flow since it reduces the firms
tax liability. Cash outflow for taxes saved is in fact an inflow of cash.
The saving resulting from depreciation is called depreciation tax
shield.
Problem-1
• Bharat Foods Limited is a consumer goods manufacturing company. It is
considering a proposal for marketing a new food product. The project will
require an investment of ₹ 1000 million in plant and machinery. It is
estimated that the machinery can be sold for ₹ 100 million at the end of its
economic life of 6 years. The company can charge annual written-down
value depreciation at 25% for the purpose of tax computation. Assume that
the company’s tax rate is 35%.
• A. Prepare the cash flow for investment purpose.
• A. Should Bharat Foods Limited accept the project? Opportunity cost of
capital is 18%. Calculate based of Net Present Value and Payback period.
• Calculate Internal Rate of Return and Profitability Index.
Continued

Year 0 1 2 3 4 5 6
Revenue 550 890 1890 2020 1680 1300
Less: Expenses 300 472 958 1075 890 680
Less: Dep. 250 188 141 105 79 59
Taxable Profit 0 230 791 840 711 561

Net working
Capital 20 30 50 70 70 30 0
Net Present Value
• The net present value method is the classic economic method of
evaluating the investment proposals. It is a DCF technique that
explicitly recognizes the time value of money. It correctly postulates
that cash flows arising at different time periods differ in value and are
comparable only when their equivalents – present values are found
out. The following steps are involved in calculation of NPV:
Continued
• Cash-flows of the investment project should be forecasted based on
realistic assumptions.
• Appropriate discount rate should be identified to discount the
forecasted cash-flows.
• Present value of cash-flows should be calculated using the
opportunity cost of capital as the discount rate.
• Net present value should be found out by subtracting present value of
cash out-flows from present value of cash in-flows. The project should
be accepted if NPV is positive (i.e.,NPV>0).
Acceptance Rule
• Accept the project when NPV is positive NPV>0
• Reject the project when NPV is negative NPV<0
• May accept the project when NPV is zero NPV=0

• The NPV method can be used to select between mutually exclusive

projects; the one with higher NPV should be selected. Using the NPV
method, projects would be ranked in order of net present values; that
is first rank will be given to the project with highest positive net
present value and so on.
Advantage of NPV
• Time Value: It recognizes the time value of money – a rupee received
today is worth more than a rupee received tomorrow.
• Measure of true profitability: It uses all cash flows occurring over the
entire life of the project in calculating its worth. Hence, it is a measure
of true profitability. The NPV method relies on estimated cash flows
and the discount rate rather than any arbitrary assumptions or
subjective considerations.
• Value - additivity: NPV(A+B) = NPV(A) + NPV(B)
• Share-holder value maximization: It consider the share-holder value
maximization.
Limitations of NPV method
• Cash flow estimation: The NPV method is easy to use if we know the
cash-flow properly. In practice it is very difficult to predict the cash-
flow.
• Discount rate: It is also difficult in practice to precisely measure the
discount rate.
• Mutually exclusive projects: Further caution needs to be applied in
using the NPV method when alternative (mutually exclusive) projects
with unequal lives, or under fund constrain are evaluated.
• Ranking of the project: It should be noted that ranking of the project
based on NPV are not independent of the discount rate.
Acceptance rule Using IRR
• Accept the project when Internal rate of return > Cost of capital
• Reject the project when Internal rate of return < Cost of capital
• May accept the project when Internal rate of return = Cost of capital
• In case of independent projects, IRR and NPV rules will give the same
results if the firm has no shortage of funds.
Evaluation of IRR method
• Advantages of IRR method
• Time value of money: Like NPV method it also takes into account the time value of
money and can be applied for even and uneven cash-flow methods.
• Profitability index: It contains the profitability for entire life of the project and
hence enables evaluation of true profitability.
• Acceptance rule: Acceptance rule are very easy to understand.
• Shareholder value
• Disadvantages
• Multiple rate can exist
• It is assumed that cash-flows are reinvested in the same IRR, which is not possible.
• Value additivity
Comparison between NPV vs IRR
• Both methods consider the time value of money and both are
discounted cash flow method. Still there are some differences
between these two:
• In NPV cash-flows are discounted by a determined or specified rate called the
cost of capital. But under internal rate of return the cash flows are discounted
by a suitable interest rate selected by hit and trial method. Hence in IRR the
discount rate is not predetermined.
• The NPV considered the market interest rate as a discount rate where as IRR
does not considered market interest rate for discounting.
• Under NPV method the cash-flows are reinvested in cost of capital but in IRR
it is reinvested at different rate.
Problem - 2
• Television Ltd. is a highly profitable firm, it has a proposal for
manufacturing car televisions. The project would involve the cost of
plant of ₹500 lakh (or ₹50 million), installation cost of ₹100 lakh and
working capital of ₹125 lakh. The annual capacity of the plant is to
manufacturing 20,000 sets. The price per set in the first year would be
₹12,000. The variable cost is expected to be 65% for the sales. The fixed
cost per annum would be ₹300 lakh (excluding depreciation). The
company would have to incur promotion expenditure of ₹120 lakh in the
first year. The written-down depreciation rate for tax purposes is 25%.
Working capital requirement is estimated to be 25% of sales. The
company expects that the plant’s capacity utilization over its economic
life of 7 years will be as follows:
Continued Problem 2
Year 1 2 3 4 5 6 7
Capacity
Utilization % 40 40 50 75 100 100 100

• The terminal value of the project is expected to be 20% of its original

cost.
• Calculate the Cash-flow of the project.
• Calculate the project’s NPV assuming a target rate of return is 14%.
Calculate Payback period also.
• Calculate Internal Rate of Return and Profitability Index.
Problem 3
• Excel Engineering Company is considering the replacement of one of its
existing fabrication machine by a new machine, which is expected to cost
₹1,60,000. The existing machine has a book value of ₹40,000 and can be
sold for ₹20,000 now. It is good for next five years and is estimated to
generate annual cash revenues of ₹200,000 and incur annual cash
expenses of ₹140,000. If sold after 5 years, the salvage value of the
existing machine can be expected to be ₹2,000. The new machine will
have a life of 5 years. It is expected to save costs and improve the quality
of the product that would help to increase sales. The new machine will
yield annual cash revenues of ₹250,000 and incur annual cash expenses
of ₹130,000. The estimated salvage value of the new machine is ₹8,000.
Problem 3 continued
• Excel company pays tax at 35%, and can write off depreciation at 25%
on the written-down value of the asset. The company’s opportunity
cost of the capital is 20%.
• Should Excel replace the existing machine? Assume that there is no
inflation. Provide your decision based on NPV and Payback period.
• Calculate Internal Rate of Return and Profitability Index.