CAPITAL BUDGETING

TIME VALUE OF MONEY

A rupee today is more valuable than a rupee a year hence.
Why ?
• Preference for current consumption over future
consumption
• Productivity of capital
• Inflation
Many financial problems involve cash flows occurring at
different points of time. For evaluating such cash flows, an
explicit consideration of time value of money is required
X deposits Rs 4000 at the end of every year for 5 years in his saving account
paying 10% Interest compounded annually. He wants to determine how much
sum of money he will have at the end of 5th year?
4000FV 10% 5=4000x6.105=24420
Find the present value of Rs 4000 receivable 5 years hence if the rate of
discount is 5%
4000PV 5%5 =4000x.784=3136
Amount= Principal + Interest
Interest are of two types: Simple interest and compound interest

SI: Received at the end of every year and then total is added to the Principal
CI: Received at the end of every year on the year end amount that gives final amount
Eg. Rs. 100 based on simple interest will amount to Rs. 150 at the end of 5 years
Rs. 100 based on CI will amount to Rs. 161.051 at the end of 5 years
Usually, we consider CI in finance; so formula of Amount is
A= p (1+r)^n and P = A/ (1+r)^n
Based on which Time value table is prepared
What is capital budgeting?
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firm’s future.
Require heavy cash outlay/cash outflow
Helps in taking decision: Accept or Reject
Types: Independent (Standalone): Its decision doesn’t affect
other.
Mutually Exclusive: Option; select anyone. Eg. Opening a
new store in different location.
Methods: Conventional/ Traditional (non-discounted)
Non-Conventional (Discounted)
 INVESTMENT CRITERIA

INVESTMENT
CRITERIA

DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA

NET BENEFIT INTERNAL ACCOUNTING

PAYBACK
PRESENT COST RATE OF RATE OF
PERIOD
VALUE RATIO RETURN RETURN
 What is the payback period?

The number of years required to recover a project’s cost,

or how long does it take to get the business’s money back?

Cash Outflow is also known as: Initial investment/ cash outlay

Cash Inflow is also known as PAT + Dep. (Profit after Tax + depreciation)
Discount rate= r
Number of years = n
The payback method simply measures how long (in
years and/or months) it takes to recover the initial
investment.
The maximum acceptable payback period is
determined by management.
If the payback period is less than the maximum
acceptable payback period, accept the project.
If the payback period is greater than the maximum
acceptable payback period, reject the project.
 Strengths of Payback:

1. Provides an indication of a project’s risk and liquidity.

2. Easy to calculate and understand
Weaknesses of Payback
1. Ignores the TVM.
2. Ignores CFs occurring after the payback period.
 Practice question
• Julie Miller is evaluating a new project for her firm, Basket Wonders
(BW). She has determined that the after-tax cash flows for the
project will be $10,000; $12,000; $15,000; $10,000; and $7,000,
respectively, for each of the Years 1 through 5. The initial cash outlay
will be $40,000.
Net Present Value (NPV)
• When discounting it means we are finding Present value of the
Future cash inflow.
CHOICE BETWEEN PROJECTS OF
UNEQUAL LIFE

Machine A Machine B
• Investment Rs.75,000 Rs.50,000
• Life 5 years 3 years
• Annual operating costs Rs.12,000 Rs.20,000

Present Value of All Costs

A : 75,000 + 12,000 x PVIFA (5 yrs, 12%) = Rs.118,260

B : 50,000 + 15,000 x PVIFA (3 yrs, 12%) = Rs. 86,030
This comparison is flawed because it overlooks the fact that
machine B has a shorter life and has to be replaced earlier
 CHOICE BETWEEN PROJECTS OF
UNEQUAL LIFE
For a proper comparison of the two alternatives, that have different
lives, we have to convert the present value of costs into a uniform
annual equivalent (UAE) figure.
PV of Cost
UAE =
PVIFAr,n
118,260
Machine A : UAE = 3.605 = 32,804

86,030
Machine B : UAE = 2.402 = 35,816

Since UAE (A) < UAE (B), A is preferable.

 INTERRELATIONSHIP BETWEEN INVESTMENT
AND FINANCING ASPECTS

Projects tend to differ in their debt capacity and other

features like availability of subsidies. Hence financing and

investment decisions are likely to be interrelated. When

this is so, we must take into account the financing impact

of an investment decision. This may be done by calculating

the adjusted NPV.

 ADJUSTED NPV

Adjusted Base case NPV of financing

= + decisions associated with
NPV NPV the project

Base case NPV is the NPV under the assumption that the

project is all-equity financed.

 ADJUSTED NPV
Investment : Rs.5 million
Net cash flow : Rs.1 million per year for 8 years
Opportunity cost of capital : 15 percent
Cost of issuing equity : 5 percent
Debt finance : Rs.2.4 million
Interest rate : 14 percent
Repayment period : 8 equal annual instalment
Tax rate : 60 percent

Base Case NPV

8
1,000,000
- 5,000,000 +  (1.15)t = - Rs.512,700
t=1
 ADJUSTMENT FOR ISSUE COST

Equity finance : Rs.2,600,000

Since issue costs would absorb 5 percent of the gross

proceeds, the firm will have to issue Rs.2,736,842
(Rs.2,600,000/0.95) of equity stock in order to realise a net
amount of Rs.2,600,000. So, issue costs = Rs.136,842.

Adjusted NPV = - Rs.512,700 – Rs.136,842

= - Rs.649,542
 ADJUSTMENT FOR TAX SHIELD
ASSOCIATED WITH DEBT
(Rs in '000)
Year Debt outstanding at Interest Tax shield Present value of tax shield
the beginning 14% discount rate
1 2400 336 202 177
2 2100 294 176 135
3 1800 252 151 102
4 1500 210 126 75
5 1200 168 101 52
6 900 126 76 34
7 600 84 50 20
8 300 42 25 9
Total 604
Adjusted NPV = Base case NPV – Issue cost + PV of tax shield
= - Rs 512,700 – Rs.136,842 + Rs.604,000
= - Rs.45,542
 CAPITAL BUDGETING UNDER CONSTRAINTS
FEASIBLE COMBINATIONS APPROACH

1. Define all combinations of projects which are feasible,

given the capital budget restrictions and project
interdependencies.

2. Choose the feasible combination that has the highest

NPV.
 REAL OPTIONS

• Investment timing option

• Expansion option

• Growth option

• Shutdown option

• Abandonment option

• Flexibility option
 SOURCES OF POSITIVE NPV

• Economies of scale

• Product differentiation

• Cost advantage

• Marketing reach

• Technological edge

• Government policy
 QUALITATIVE INFLUENCES

• Intuition

• Vision

• Superstition

• Politics

• Sponsorship

• Intangible benefits
AN APPROACH TO DECISION-MAKING

Consistency with No
Strategy ?

Yes

Yes
Accept Positive NPV ? Reject

No

Significant
Yes No
Intangibles ?
 ORGANISATIONAL CONSIDERATIONS

• Compatibility with resources

• Controllability

• Executive management endorsement

 CAPITAL BUDGETING IN PUBLIC
SECTOR UNDERTAKINGS

• Role of the Public Investment Board

• Guidelines Provided by the Government

 SUMMING UP
• For a proper comparison of alternate projects with
different lives we have to look at the UAE figure.
• When investment and financing aspects of a project are
inter-related, adjusted NPV is defined as:
Base case NPV + NPV of the ‘financing aspects’
• Mathematical programming models are helpful in
coping with the problem of capital budgeting under
constraints
• There are several options found in capital projects such
as investment timing option, expansion option, growth
option, shutdown option, abandonment option and
flexibility option.
• The important entry barriers that result in positive NPV
projects are as follows: economies of scale, product
differentiation, cost advantage, marketing reach,
technological edge, and governmental policy.
• Intuition, vision, superstition, politics, project
sponsorship, and intangible benefits are key qualitative
influences bearing on capital expenditure decisions.
• Since the resource allocation strategy of a firm shapes,
guides, and circumscribes individual project decisions,
the desirability of a project cannot be assessed without
considering the strategy of the firm.