CAPITAL BUDGETING

Capital Budgeting: The total process of generating, evaluating, selecting and following up on capital expenditure alternatives. Capital Expenditure: An outlay made by a firm for a fixed or an intangible asset from which benefits are expected to be received over a period greater than a year. Independent Projects: Capital expenditure alternatives that compete with each other, but in such a way that the acceptance of one project does not eliminate the other projects from further consideration. Mutually Exclusive Projects: A group of capital budgeting projects that compete with one another in such a way that the acceptance of one eliminates all other in the group from further consideration. Capital Rationing: The allocation of limited amount of funds to a group of competing capital budgeting process. Ranking Approach: Evaluating the relative attractiveness of capital projects on the basis of some predetermined criterion. Present Value: The value of a future sum or stream of dollars discounted at a specified rate. The process of finding present value is actually the inverse of the compounding process. Future value: The value of a single sum or an annuity compounded at a given interest rate for a specified time period. Importance of Capital Budgeting: To achieve long-term goal of firm. Huge Capital Investment. Long Term Investment. Risky Investment. Balancing among liquidity, profitability and value of the firm. Searching for alternative investment opportunities. Ranking of projects and best use of limited capital. Types of Investment Decision Accept-Reject Decision Mutually Exclusive Projects Decision Capital Rationing Decision Steps in Capital Budgeting: Identification of investment projects Evaluation of alternative investment projects Selection of the best investment projects Implementation of the projects Continuous evaluation of the selected projects. Application of Capital Budgeting: Purchase of Fixed assets Mechanization of production method Selection from alternative equipments Introduction of new product Expansion of business Modernization and replacement Make or buy decision.

Related Issues in Capital Budgeting: Prospective Investment proposals Cost of the projects Life of the projects Cash inflows and outflows Salvage value of the projects Discounting rate Techniques of evaluation

Capital Budgeting Methods Formula: Average/Accounting Rate of Return (ARR) Method Formula 1: Based on original investment ARR = Net Profit After Tax Original Investment X 100

Formula 2: Based on Average investment ARR = Net Profit After Tax X 100 Average Investment *Average investment = Original Investment Salvage value 2 + Salvage value

Pay Back Period Methods of Capital Budgeting Formula 1: When Annual Cash Flows are uniform PBP = Investment Cash flow after tax Formula 1: When Annual Cash Flows are uniform PBP = A + NCO - C D Where, A = Year in which the accumulated cash flows are nearer to NCO NCO = Net Cash Outlay C = Accumulated cash outlay of the year A D = Cash flow of the succeeding year of the year A Formula: NPV
Where there is one single investment in the beginning n NPV = t = 1 CFt Sn + Wn + COo t (1 + K )n (1 + K )

n Or, NPV = t = 1

CFt COo (1 + K ) t Or, NPV = PV of NCB PV of NCO Here, NPV = Net Present Value CFt= Cash flow at different time period. Sn= Salvage value at N year. Wn= Working capital structure Coo= Initial cash out flow K = Cost of capital. Where there is a number of investments at interval n NPV = t = 1 n COt CFt Sn + Wn + t = 1 (1 + K ) t (1 + K ) n (1 + K ) t Or, NPV = PV of NCB PV of NCO Here, Cot= Cash out flow at different times.

Decision Rule at a glance

1. NPV>0 Accepted 2. TPV> NCO Accepted 3. NPV = O May accepted or rejected. 4. NPV < O Rejected 5. TPV < NCO Rejected

FORMULA: IRR
IRR = A + (B-A) Where, IRR = Internal Rate of Return A = Lower Discount Rate. B = Higher Discount Rate. C = NPV of Lower Discount Rate. D = NPV of Higher Discount Rate ILLUSTRATION (NPV) ABC co. has two projects for consideration Year 0 1 2 3 4 5 Salvage value Cash flows Project A (50,000) 10,000 15,000 12,000 20,000 10,000 5,000 Project B (50,000) 12,000 10,000 15,000 25,000 9,500 2,500

If the tax rate is 40% and the discount rate is 12%, which of the two projects will be accepted?

SOLUTION:

Depreciation = = = 9,000.
Year 1 2 3 4 5 S.V CFBT 10,000 15,000 12,000 20,000 10,000 5,000 Dep. 9,000 9,000 9,000 9,000 9,000 --EBT 1,000 6,000 3,000 11,000 1,000 5,000 Tax 40% 400 2,400 1,200 4,400 400 --EAT 600 3,600 1,800 6,600 600 5,000 CFAT 9,600 12,600 10,800 15,600 9,600 5,000 Factor 12% .892 .797 .712 .635 .567 .567 PV 8,563 10,042 7,690 9,906 5,443 2,835 44,479

NPV = PV of NCB PV of NCO = 44,479 50,000 = (5,521) Depreciation = = 9,500

Year 1 2 3 4 5 CFBT 12,000 10,000 15,000 25,000 9,500 Dep. 9,500 9,500 9,500 9,500 9,500 EBT 2,500 500 5,500 15,500 0 Tax 40% 1,000 200 2,200 15,500 0 EAT 1,500 300 3,300 9,300 0 CFAT 11,000 9,800 12,800 18,800 9,500 Factor 12% .892 .797 .712 .635 .567 PV 9,812 7,811 9,101 11,938 5,387 44,049

NPV = PV of NCB PV of NCO = 44,049 50,000 = (5,951) Decision: Both the companies have a negative NPV. So none of them would be considered for investment. FORMULA: IRR IRR = A + (B-A) Where, IRR = Internal Rate of Return A = Lower Discount Rate. B = Higher Discount Rate. C = NPV of Lower Discount Rate. D = NPV of Higher Discount Rate ILLUSTRATION: (IRR) The cost of a 3 year project is estimated as tk. 20,000. The estimated inflows for three years have been estimated as tk. 8,000 per year. If the cost of capital is 7% whether investment in the project is worthy or not? Year 1-3 Less : NCO CFAT 8,000 Calculation of IRR Factor 7% PV 2,624 20,992 20,000 992 Factor 10% 2,486 PV 19,888 20,000 -112

IRR = A + (B-A) = 7% + (10-7)% = 7% + 3% = 7% + 2.695% = 9.695% Illustration 1: ARR and PBP Nishat Enterprise wants to buy a machine costing tk. 1,50,000 for an expected life of 5 years. The projected net profit after tax is follows: Years Net Profit After Tax

1 2 3 4 5

Tk. 20,000 Tk. 18,000 Tk. 15,000 Tk.17,000 Tk. 15,000

Calculate the average rate of return (ARR) of Nishat Enterprise. Illustration 2: NPV A Company is considering an investment proposal to install new milling controls at a cost of tk. 50,000. The facility has a life expectancy of five years and no salvage value. The tax rate is 35 per cent. Assume the firm uses straight-line depreciation. The cost of capital is 10%. The Earnings before depreciation and taxes from the investment proposal are as follows: Years 1 2 3 4 5 EBDT Tk. 10,000 Tk. 10,692 Tk. 12,769 Tk.13,462 Tk. 20,385

Compute the following and suggest whether the proposal is to be accepted or not.