capital budgeting

What is capital budgeting

• Analysis of potential projects.• Long-term decisions; involve large

expenditures.• Very important to firm’s future.

importance of capital budgeting• Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion. • Capital budgeting involves commitment of large amount of funds. • Capital decisions are required to assessment of future events which are

uncertain. • In most cases, capital budgeting decisions are irreversible. This is because it is

very difficult to find a market for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.

• Capital budgeting ensures the selection of right source of finance at the right time.

• Many firms fail, because they have too much or too little capital equipment. • Investment decision taken by individual concern is of national importance

because it deter- mines employment, economic activities and economic growth.

Objective of capital budgeting• To ensure the selection of the possible profitable capital project• To ensure the effective control of capital expenditure in order to

achieve by forecasting the long-term financial requirements. • To make estimation of capital expenditure during the budget

period and to see that the benefits and costs may be measured in terms of cash flow.

• Determining the required quantum takes place as per authorization and sanctions.

• To facilitate co-ordination of inter-departmental project funds among the competing capital projects.

• To ensure maximization of profit by allocating the available investible.

Steps in Capital Budgeting

• Identification Stage – determine which types of capital investments are necessary to accomplish organizational objectives and strategies

• Search Stage – Explore alternative capital investments that will achieve organization objectives

• Information-Acquisition Stage – consider the expected costs and benefits of alternative capital investments

• Selection Stage – choose projects for implementation

• Financing Stage – obtain project financing• Implementation and Control Stage – get

projects under way and monitor their performance

Types of Capital Expenditure

Capital Expenditure can be of two types : Capital Expenditure Increases Revenue: It is the

expenditure which brings more revenue to the firm either by expanding the existing production facilities or development of new production line.

Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of present product and thereby increases the profitability of existing operations. It can be done by replacement of old machine by a new one.

Types Of Capital Investment Decisions

• On the basis of firm’s existence– Replacement and Modernization decisions– Expansion decisions– Diversification decisions

• On the Basis of Decision Situation – Mutually Exclusive Decision– Accept and Reject Decision– Contingent Decision

Cap Budgeting Evaluation Methods

• Traditional method– Payback method– Average accounting return

• Modern method– Net Present value method (N.P.V)– Internal rate of return method (I.R.R)– Profitability index method (P.I)

Pay-back Period Method

Pay-back period is also termed as "Pay-out period" or Pay-off period. Payout Period Method is one of the most popular and widely recognized traditional method of evaluating investment proposals. It is defined as the number of years required to recover the initial investment in full with the help of the stream of annual cash flows generated by the project.

• Calculation of Pay-back Period: Pay-back period can be calculated into the following two different situations :

(a) In the case of constant annual cash inflows. (b) In the case of uneven or unequal cash inflows.

(a) In the case of constant annual cash inflows : If the project generates constant cash flow the Pay-back period can be computed by dividing cash outlays (original investment) by annual cash inflows. The following formula can be used to ascertain pay-back period :

Pay-back Period = Cash Outlays (Initial Investment) /Annual Cash Inflows

Illustration

• A project requires initial investment of Rs. 40,000 and it will generate an annual cash inflows of Rs. 10,000 for 6 years. You are required to find out pay-back period.

Solution: • Pay-back Period = Cash Outlays (Initial Investment)/

Annual Cash Inflows = 40,000 / 10,000

= 4 Years Pay-back period is 4 years, the investment is fully recovered in 4 years.

(b) In the case of Uneven or Unequal Cash Inflows: In the case of uneven or unequal cash inflows, the Pay-back period is determined with the help of cumulative cash inflow. It can be calculated by adding up the cash inflows until the total is equal to the initial investment.

Illustration

From the following information you are required to calculate pay-back period A project requires initial investment of Rs. 40,000 and generate cash inflows of Rs. 16,000, Rs. 14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth year respectively. Solution: • Calculation Pay-back Period with the help of "Cumulative Cash Inflows" Year annual cash flow (rs) cumulative cash inflows (rs) 1 16000 16000 2 14000 30000 3 8000 38000 4 6000 44000

The above table shows that at the end of 4th years the cumulative cash inflows exceeds the investment of Rs. 40,000. Thus the pay-back period is as follows :

Pay-back Period = 3 Years +( 40000 – 38000) / 6000 = 3 Years + 2000/6000 = 3.33 Years

Average Rate of Return Method (ARR)

• Average Rate of Return Method (ARR) : Average Rate of Return Method is also termed as Accounting Rate of Return Method. This method focuses on the average net income generated in a project in relation to the project's average investment outlay. This method involves accounting profits not cash flows and is similar to the pelformance measure of return on capital employed.

• Formulas Average Rate of Return (ARR) = Average income / Average investment x 100

or cash inflow – (after dep and tax )/ original investment

Average Investment = Original Investment /2

Illustration• From the following information you are required to find out Average Rate

of Return : An investment with expenditure of Rs.l0,OO,OOO is expected to produce the following profits (after deducting depreciation)

year rs1 80,0002 1,60,0003 1,80,0004 60,000

• SolutionAverage Rate of Return =

Average Annual Profits – Depreciation and Taxes x 100 Average Investments

Average Annual Profits = 80,000+1,60,000+1,80,000+60,0004 = 1,20,000

Average Investments (Assuming Nil Scrap Value) = investment in beginning + investment in end2= 10,00,000 + 0 2= 5,00,000

Average Rate of Return = 1,20,000 x 100 5,00,000= 24%

Net present value

• The difference between the market value of a project and its cost

• How much value is created from undertaking an investment?– The first step is to estimate the expected future cash flows.– The second step is to estimate the required return for

projects of this risk level.– The third step is to find the present value of the cash flows

and subtract the initial investment.

Illustration

• Mr A planning to invest rs 50 lac in a innovative machinery , the expected cash flow for 5 years period of time given below

year cash inflow (rs)1 10,00,0002 12,00,0003 15,00,0004 18,00,0005 25,00,000

The cost of capital is @ 10%

• Solution year cash inflow (rs) dist rate present value 1 10,00,000 ( 1/1.1) 0.9090 9,09,000 2 12,00,000 0.8246 9,91,680 3 15,00,000 0.7513 11,25,950 4 18,00,000 0.6830 12,29,460 5 25,00,000 0.6666 15,52,250

= 58,09,340 less orignal investment - 50,00,000

npv = 8,09,340

Profitability index method (P.I)

• Ratio of the present value of a project's cash flows to the initial investment. A profitability index number greater than 1 indicates an acceptable project, and is consistent with a net present value greater than 0

• Formula Profitability Index

Present Value of Future Cash FlowsInitial Investment Required

Illustration• Company C is undertaking a project at a cost of 50 million which is

expected to generate future net cash flows with a present value of 65

million. Calculate the profitability index.• Solution

Profitability Index = PV of Future Net Cash Flows / Initial Investment Required

Profitability Index = 65M / 50M = 1.3 years

Internal rate of return method (I.R.R)

• Internal Rate of Return Method is also called as "Time Adjusted Rate of Return Method." It is defined as the rate which equates the present value of each cash inflows with the present value of cash outflows of an investment. In other words, it is the rate at which the net present value of the investment is zero.

Illustration

• x firm is considering a project the details of which are ,

Investment Rs 70000Year Cash Inflow 1 15000 2 17000 3 19000 4 21000 5 26000

Compute 1.R.R of the project:

Solution :

Step I: Calculation of fack payback period on the basis of average cash inflows:

Average cash inflows of all periods = 15000+17000+ 19000+ 21000+ 26000

5 = 98000

5 = Rs 19600

Fack Payback period = Initial Cash outflow Average cash inflow

= 7 0000 19600

= 3.57 years

.

Step 2 : Locate fack payback period in annuity table A-2 (given at the end of the chapter) against the row of number of year of the project:

• We locate 3.517 in 5 year row. we find 3.517 which is annuity of Rs 1 at 13% rate. Therefore, our first discount rate is 13%

Step 3: Now Find NPV at the first discount rate located above.

Year Cash in flow Discount Factor Present Value 1 15000 .885 13275 2 17000 .783 13311 3 19000 .693 13167 4 21000 .613 12873 5 26000 .543 14118

66744less original value 70000

NPV Rs-3256

• The other discount rate should be more than 13% or less than 13% Since NPV is negative at 13% discount rate the other discount rate should be less than 13% so that we can discount future cash inflows at lower rate and find a positive NPV. So, lets take the second discount rate at 11% NPV of the project at 11% discount rate :

Year Cash in flow Discount Factor Present Value1 15000 .901 13515 2 17000 .812 13804 3 19000 .731 13889 4 21000 .659 13839 5 26000 .593 15418

70465less original value - 70000

NPV 465

Step 4 : Apply the formula of IRR

= 11 + 465 x 2 ( 2 = diff between intrest rates) 465 - (-3256)

= 11 + 465 x2 3721

= 11 + .2499

IRR = 11.25 %

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