Project Capital Budgeting - 1 PDF

Welcome to the Session
on
Project Financial Analysis
Dr. Md. Mamunur Rashid
Bangladesh Institute of Management
September 1, 2014
Dr.. Md. Mamunur Rashid, www.bim.org.bd, 2014
Definition of Project
A project is a set of inter-related
activities having a specific objectives
of producing some socio-economic
return in the form of goods and/or
services, through employment of
scarce resources within a definite time
period.
Example of Project
Furniture
received
SF-Select Furniture
LF-Locate
facilities
S 1
0 0 0
0 0 0
S-Begin or start
of the project
LF 2
SF 5
8 8
0 8
8
1
0
R
8
8
I
0
6
6
11
0
3
4
6
R-Remodel
6 14
2 16
4
10
7
3
17
16
19
M-Move in
19
19
(I-interview)
Fr
14
H
4
10
19
20
19
20
4 Hire and train

9
13
6
19
Gantt Charts
Duration weeks
8
0
Cod
Activity
Lf
Sf
Fr
20
14
10
12
16
18
Project Management
Project management is the art of
managing the tasks, resources and
costs used in a project to ensure
that it is completed satisfactorily,
on time and within budget.
Project Management
Project management on the other
hand, can be defined as the
Planning, organizing, directing and
controlling of resource for a specific
time period to meet a specific set of
one time objectives.
Project Management
A project exhibits most of the
following conditions:
It is likely to be a unique ,one time
program. It has a life cycle, with a
specific start and end. It has a work
scope that can be categorized into
definable tasks.
Project Management
A project exhibits most of the following
conditions:
It has a budget, It many require the use of
multiple resources. Many of these resource
may be in short supply and many have to be
shared with other projects. It may require the
establishment of a special organization or the
crossing of traditional organizational
boundaries.
Transformations Process
Input
Transformation
Process
Output
(Value Creation)
Transformation is
enabled by
The 5 Ps of OM:
Dr. Md. Mamunur Rashid, 2014
People
Plants
Parts
Processes
Planning and Control
Understanding Project
Projects and operations differ
primarily in that operations are
ongoing and repetitive, while projects
are a temporary endeavor undertaken
to create a unique product, service, or
result.
Project Concept
Projects are basic building blocks in
the development process. They are
vehicles for socio-economic change in
developing countries.
Project Concept
In
economic
development
projects
contribute to the integration of needs by
linking productive activities, provide the
organization
and
technology
for
transforming resources into socially and
economically useful goods and services and
construct necessary infrastructure for
increasing exchange among organizations
and geographical areas.
Project Concept
Projects provide channels for public and
private investment , facilitates deployment
of unused or under used resources into
effective transformation process. They can
create capacity to expedite growth and
progress for change and development of
sector/region/country.
Concept of Project
Management
A project is very different from a set of
day-to-day function. Project management
is a process that is very different from
general business management. A project
is a group of tasks performed in a
definable time period in order to meet a
specific set of objectives.
Project Management Concept

A Project may be defined as a series of related
jobs usually directed toward some major output
and requiring a significant period of time to
perform.
Project management
can be defined as
planning, directing and controlling resources
(people, equipment, material) to meet the
technical, cost, and time constraints of the
project.
Basic ingredients for a Project

Management.
Special
knowledge
domains
General
Management
Project
Management
Supporting Disciplines
Capital Budgeting Process
1. Project Generation
2. Project Evaluation
3. Project Selection
4. Project Execution
21

1. Project Generation
Project generation implies the gathering of
proposals from the different sources.
The investment proposals may fall into one of the
following categories:
1. a. to add new products
b. to expand the capacity in existing
product line.
2. To reduce costs in the output of existing products
without altering the scale of operations.
22
What is Product
Development?
Product Development is the
study of activities of a
product life-cycle in a
concurrent manner.
Dr. Md. Mamunur Rashid, Bangladesh Institute of Management, 2014
23
Conceptual Phase
Percentage, %
100
Knowledge of the problem

Freedom of making choices
0
Time
Dr. Md. Mamunur Rashid, Bangladesh Institute of Management, 2014
25
2. Project Evaluation
a) Estimation of benefits and costs ; the
benefits must be measured in terms of
cash flow.
b) Selection of an appropriate criterion
to judge the desirability of the projects
26
3. Project Selection
No standard administrative procedure can
be laid down for approving the
investment proposal. The screening and
selection procedures would differ from
firm to firm. Usually
the normal
approval has been given by top
management. However, projects are
screened
at
different
level
of
management.
27
4. Project Execution
This is the final step wherein the funds
are allocated among the selected
projects
28
The Triple Constraint of Project

Management
30
Project Management
Framework
An Example of a Work Breakdown

Structure
A work breakdown structure defines the hierarchy of
project tasks, subtasks, and work packages
Level
Program
Project 1
Project 2
Task 1.1
Task 1.2
Subtask 1.1.1
Work Package 1.1.1.1
Subtask 1.1.2
Work Package 1.1.1.2
Example
For a larger project, the levels can be as
follows:
level
Pro
gra
m
1
Poverty Alleviation
Project
2
3
4
Assroyan project
Task
House building for the

land less poor
Subtask Construction activities
Work
Land Development &
Package construction of house
Project Cost Management
34
Measurement of Cash Flows
The cash flow is the series of cash

receipts and expenditures over the life
of investment projects.
For Purposes of evaluating investment
proposals, the very crucial information
to be collected in estimating the cash
flow.
35
Measurement of Cash Flows
All operating expenditures and receipts

should be considered. Besides the tax,
depreciation, capital gains, loss set off
and
carry
forward,
investment
allowance, tax holiday etc. factors
should be carefully taken in mind while
determining cash flow. The estimate of
cash flow can be done on differential or
incremental basis.
36
Tax Effect of Depreciation Policy
The after tax cash inflow will be

equal to gross cash proceeds of
the investment minus the cash
expenses of operation and the
income
tax,
excluding
depreciation as it is a nonexpense item.
37
Salvage Value and Capital Gain Tax

The salvage value affects the
depreciation so as to tax. The salvage
value has another impact on cash flow.
The difference between cash salvage
and book salvage value is either capital
gain or loss. Therefore, Capital
gains=Sale/Cash Salvage Value- Selling
expenses-Actual Cost or Book Salvage
Value-Any additions.
38
Characteristics of Capital Budgeting

It should provide a means of distinguishing between
acceptable and unacceptable projects.
It should provide a valuing of projects in order to
their desirability.
It should also solve the problem of choosing
among any alternatives projects.
It should be a criterion which is applicable to any
conceivable investment project.
In should recognize the fact that bigger benefits are
preferable to small ones and early benefits are
preferably to latter benefits.
39
Importance of Capital Budgeting

for Project Management
Capital budgeting is important for the following purposes:
Achieve long term goal of the organization
Long Term Investment
Huge Capital Investment
Balancing between liquidity, profitability and value of the
company
Discover alternative investment opportunity
Uncertainty.
Related to other decisions
40
Related Issues in Capital Budgeting

In capital budgeting following issues are very
important because these affect the whole process:
Prospective investment proposal
Cost of the project
Life of the project
Cost of Capital
Cash flow
Salvage value
Risk of the project
Discounting rate
Techniques of Evaluation
41
Limitations of Capital Budgeting
Lack of adequate data

Lack of reliability of data
Problem of measuring future risk
Timing of the projects
Problems of quantification
Personal judgment of the decision maker
Lag in implementation.
Dr.Md. Mamunur Rashid, 2014
42
Methods of Evaluation of
Capital Expenditure
(A) Traditional Methods
i) Payback period method
ii) Accounting rate of return
(B) i) Discount Cash Flow Method
iii) Net present value method (NPV)
iv) Internal rate of return method (IRR)
v) Profitability index method (PI)
43
Payback Period (PBP)

Cost of Project
Payback Period (PBP) = ---------------------Annual Cash inflow
The length of time required to recover the cost of

an investment. The payback period of a given
investment or project is an important determinant
of whether to undertake the position or project, as
longer payback periods are typically not desirable
for investment positions.
44

Example-1
The Project Cost taka 60,000/- .The following are the cash inflows of
a project having a life of 7 years. Find out the PBP ?
Year
1
2
3
4
5
6
7
Cash inflow in Taka

8,000/12,000/25,000/20,000/21,000/24,000/25,000/45

Solutions:
PBP = 3 Years +
60000 45000
20000
15000
= 3 + 20000
= 3 + 0.75
= 3.75 years.
46

Calculate PBP ?
Year
0
1
2
3
4
5
6
Project-A
Project-B
Project-C
Project-D
Cash
Cumulat Cash flow Cumulative Cash
Cumulativ Cash
Cumulative
flow
ive
flow
e
flow
(60000) (60000)
(60000) (60000)
(60000
(60000)
(60000)
(60000)
)
8000
8000
10000 10000
15000
15000
10000
10000
12000
20000
15000 25000
25000
40000
10000
20000
25000
45000
20000 45000
30000
70000
15000
35000
20000
65000
25000 70000
10000
80000
15000
50000
25000
90000
30000 100000
5000
85000
2000
70000
22000 112000
28000 128000
5000
90000
3000
100000
47

Advantage of PBP
Simple to understand and easy to calculate
Less expensive than sophisticated techniques
Disadvantages
This method does not consider cash flows after PBP
It fails to consider the pattern of cash flows i.e., the
magnitude and timing of cash flows.
It fails to consider the total cash flows over the project
life.
There is no rational basis for setting maximum PBP. It
is generally a subjective decision.
PBP method is not consistent with the objective of
maximizing the market value of the firms shares.
48
Accounting Rate of Return (ARR)

Average Accounting Return (AAR)
The Accounting rate of return (ARR)
method uses accounting information, as
revealed by financial statements, to
measures the profit abilities of the
investment proposals. The ARR is found
out by dividing the average income after
taxes by average investment i.e. average
book value after depreciation.
49

An investments average net income divided by its average
book value.
Accounting rate of return (ARR)
Average Annual Net Profit/income X 100
= ------------------------------------Average Capital/book value
Accept Rule: ARR should be greater than expected rate of
return on investment.
50

Example-1:
Initial investment in a project is Tk. 50,000 and
scrap value is Tk. 10,000/- income from the project
before depreciation and tax during 5 year life are:
Tk. 10,000 Tk. 12,000, Tk. 14,000/- Tk. 16,000/Tk. 20,000/- respectively Tax rate is 50%.
Using straight-line method of depreciation find out
ARR of the project.
51

Year-1 Year-2
Year-3
Year-4 Year-5 Average
Income before
10,000 12,000
depreciation &
Tax
Less
8,000 8,000
depreciation
Net
income 2,000 4,000
before Tax
Less Tax 50%
1,000 2,000
Net
income 1,000 2,000
after tax
14,000
16,000 20,000
14,400
8,000
8,000
8,000
8,000
6,000
8,000 12,000
6,400
3,000
3,000
4,000
4,000
3,200
3, 200
6,000
6,000
52

=
Year depreciation = Pr oject
Cost - Salvage Value

Pr oject Life
Tk . 50,000 - 10,000
=
5
= 8,000/-
Average Capital = Initial Cpaital + Salvage Value

2
Tk . 50,000 + 10,000
=
= Tk .30,000
2
53

Accounting rate of return (ARR)
Average Annual Net Profit/income X 100
= ------------------------------------Average Capital/book value
3,200 100
ARR =
= 10.67%
30,000
54

Example-2 (ARR)
X group of company has 4 alternative projects.
The following is the information about these projects.
Year
0
1
2
3
4
5
6
Residual Value
Project-A
(60,000)
8,000
12,000
25,000
20,000
25,000
22,000
6,000
Cash flow in Taka

Project-B Project-C
(60,000)
(60,000)
10,000
15,000
15,000
25,000
20,000
30,000
25,000
10,000
30,000
5,000
28,000
5,000
3,000
6,000
Project-D
(60,000)
10,000
10,000
15,000
15,000
20,000
30,000
12,000
Companys tax rate is 40% and uses straight line method of depreciation, find out ARR of the projects.
55

Merits. The following are the advantage of the
accounting rate of return method.
It is very simple to understand and use.
It can be readily calculated using the accounting
data.
It uses the entire stream of incomes in calculating
the accounting rate.
56

Demerits:
The accounting rate of return method suffers from
the following weaknesses:
It uses accounting profits, not cash flows in
appraising the projects.
It ignores the time value of money. Profits
occurring in different periods are valued equally.
57

(Contd)
Demerits:
It does not consider the lengths of projects lives. For
example, it assumes that 25 percent accounting rate for ten
years is better than 20 per cent for twenty years.
It does not allow for the fact that the profits can be
reinvested.
It is incompatible with the firms objective of
maximizing the market value of shares. Share values do
not depend upon account rates.
58
Net Present Value (NPV)

n
NPV =
t =1
An
C
t
(1 + k )
A1
An
A2
+
+ ................. +
NPV =
C
n
2
(1 + k )
(1 + k ) (1 + k )
K= Cost of Capital/ Discounting rate
A= Net Cash Benefits
C= Initial Capital Investment
n= Project Life in Years.
Accept rule : NPV 0.
59
IRR
An
C=
t or
t =1 (1 + k )
n
An
C
0 =
t
t =1 (1 + k )
n
C
(B A)
IRR = A +
D
IRR
A
B
C
D
= Internal Rate of Return

= Lower Discounting Rate
= Higher Discounting Rate
= Net Present Value at Lower Discounting Rate
= Difference between the NPV at higher discounting
Rate and at lower discounting rate.
Accept rule : IRR Cost of capital.
60
Calculate
NPV
and
IRR
X Group of companies has 3 investment proposals in hand.
The cash flows before tax & depreciation is given below. The
initial investment and the project life is same in all the 4
projects. Tax rate is 40% discounting rate- 10%.
Cash Flows in Taka
Project life in Project-A
years
0
(60,000)
1
2
3
4
5
6
(Salvage value)
8,000
12,000
25,000
20,000
25,000
22,000
6,000
Project-B
Project-C
Project-D
(60,000)
(60,000)
(60,000)
10,000
15,000
20,000
25,000
30,000
28,000
3,000
15,000
25,00
30,000
10,000
5,000
5,000
6,000
10,000
10,000
15,000
15,000
20,000
30,000
12,000
61
Cash Flow of Project A

Year Cash flow Dep.
Net
Tax
Income 40%
1
2
3
4
5
6
(1,000)
3,000
16,000
11,000
16,000
13,000
8,000
12,000
25,000
20,000
25,000
22,000
9,000
9,000
9,000
9,000
9,000
9,000
(400)
1200
6,400
4,400
6,400
5,200
Net
income
after tax
(600)
1,800
9,600
6,600
9,600
7,800
Add.
Dep.
Net cash
flow
9,000
8,400
9,000 10,800
9,000 18,600
9,000 15,600
9,000 18,600
9,000 16,800+
6000
Salvage
Value
62
Project A NPV @
Discounting rate10%
8400 10800 18600 15600 18600 16800 + 6000
NPV =
+
+
+
+
+
60,000
2
3
4
5
6
(1.10)
1.10 (1.10) (1.10) (1.10) (1.10)
8400 10800 18600

15600
18600
22800
=
+
+
+
+
+
60,000
1.10 (1.21) (1.331) (1.4641) (1.6105) (1.7716)
[7,363 + 8925 + 13,975+10,655+11,549+12,870]- 60,000

=65,611-60,000
=5,611/=
63
Project A NPV @
Discounting rate14%
8400 10800 18600 15600 18600 16800 + 6000
NPV =
+
+
+
+
+
60,000
2
3
4
5
6
(1.14)
1.14 (1.14) (1.14) (1.14) (1.14)
= 7,368+8310+12,555+9,236+9,660+10,387-60000
= 57,516-60,000
=-2484
64
IRR
By Interpolation Method
C
IRR = A + ( B A)
D
Where,
A
B
C
D
= Lower discounting rate

= Higher Discounting rate
= NPV at lower discounting rate
= Difference between the at higher discounting
rate and at lower discounting rate
65
IRR of Project A
5611 (0.14 0.10.)
IRR = 0.10 +
5611 (2484)
5611
IRR = 0.10 +
(0.14 0.10)
8095
= 0.10 + (0.69320.04)
= 0.10 + 0.0277
= 0.1277 or 12.77%
66
Ranking of Projects
Ranking In order of preference:
Ranking
IRR
Project
1st
15.13% B
2nd
12.77% A
3rd
10.78% D
4th
10.50% C
67
Profitability Index(PI)/
Benefit Cost Ratio
n
An
t
(
1
)
+
K
t =1
PI =
Where :
65,611
=
= 1.093
60,000
An = Net Cash inflow at time t

n = Total Time
C = NPV of initial investment
Accept rule: PI 1
68
Thanks for your attentions !
69

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Welcome to the Session

4 Hire and train

Dr.. Md. Mamunur Rashid, www.bim.org.bd, 2014

Dr. Md. Mamunur Rashid, 2014

Dr.. Md. Mamunur Rashid, www.bim.org.bd, 2014

Dr.. Md. Mamunur Rashid, www.bim.org.bd, 2014

Dr.. Md. Mamunur Rashid, www.bim.org.bd, 2014

Project Management Concept

Dr. Md. Mamunur Rashid, 2014

Dr.. Md. Mamunur Rashid, www.bim.org.bd, 2014

Dr.. Md. Mamunur Rashid, www.bim.org.bd, 2014

Basic ingredients for a Project

Capital Budgeting Process

Dr. Md. Mamunur Rashid, 2014

Capital Budgeting Process

Dr. Md. Mamunur Rashid, 2014

Knowledge of the problem

Dr. Md. Mamunur Rashid, Bangladesh Institute of Management, 2014

Capital Budgeting Process

Capital Budgeting Process

Capital Budgeting Process

Dr. Md. Mamunur Rashid, 2014

The Triple Constraint of Project

Dr. Md. Mamunur Rashid, 2014

Dr. Md. Mamunur Rashid, 2014

Dr. Md. Mamunur Rashid, 2014

An Example of a Work Breakdown

Work Package 1.1.1.1

Dr. Md. Mamunur Rashid, 2014

Work Package 1.1.1.2

House building for the

Project Cost Management

Dr. Md. Mamunur Rashid, 2014

Measurement of Cash Flows

The cash flow is the series of cash

Measurement of Cash Flows

All operating expenditures and receipts

Tax Effect of Depreciation Policy

The after tax cash inflow will be

Salvage Value and Capital Gain Tax

Characteristics of Capital Budgeting

Importance of Capital Budgeting

Related Issues in Capital Budgeting

Limitations of Capital Budgeting

Lack of adequate data

Payback Period (PBP)

The length of time required to recover the cost of

Payback Period (PBP)

Cash inflow in Taka

Payback Period (PBP)

Payback Period (PBP)

Dr. Md. Mamunur Rashid, 2014

Payback Period (PBP)

Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR)

Dr. Md. Mamunur Rashid, 2013

Accounting Rate of Return (ARR)

Accounting Rate of Return (ARR)

Year-4 Year-5 Average

Dr. Md. Mamunur Rashid, 2013

Accounting Rate of Return (ARR)

Year depreciation = Pr oject