Capital Budgeting-Part I SFM/DM

CAPITAL BUDGETING

 Capital budgeting is the process of evaluating and selecting long-term

investments that are consistent with the goal of shareholders (owners’) wealth
maximization.

 The process of planning significant outlays on projects that have long-term

implications is known as Capital Budgeting.

 Capital expenditure planning, evaluation, and control, sometimes called as the

capital budgeting.

 It involves long-term commitments of resources to realize future benefits. It

reflects basic company’s objectives and has a significant, long-term effect on the
economic well being of the firm.

CAPITAL BUDGETING PROCESS

1. Identifying the 2. Screening phase 3. Evaluating phase

impact on long-term Must identify potential Identifying projects, estimating CF
objectives investment proposals applying decision criteria

6. Audit phase 5. Controlling phase 4. Implementing phase

Identify the reason for Constantly monitor, if Take the necessary actions to start
failure or success. deviate take action the project

 Any idea under consideration is a proposal. A project is either a single proposal or a collection of
dependent proposals that is economically independent of all other proposals. Example: A soft drink
company willing to introduce the new product i.e. orange drink (proposal). It is considered as the new
project if and only if the cash flows from orange drink have no impact on the cash flows of the
existing product. Otherwise both the existing and orange drink will be considered as a single project.

IMPORTANCE

 It affects the profitability of a firm.

 Its effect over a long time spans and inevitably affects the company’s future cost
structure.

 Capital investment decision once made, are not easily reversible without much financial
loss to the firm.

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Capital Budgeting-Part I SFM/DM

 It involves costs and the majority of the firms have scarce (limited) capital resources.

DIFFICULTIES

 The benefits from investments are received in some future period and the future is
uncertain. (Risk Involvement)
 Cost incurred and benefits received from the capital budgeting decisions occur in
different time periods. (Time value of Money)
 It is not often possible to calculate in strict quantitative terms all the benefits or the costs
relating to a particular investment decision.

RATIONALE (Fundamental Reason)

Every decision is made either to
1. Enhance the Revenue, or to
2. Reduce the cost
Cost-reduction investment decisions are subject to less uncertainty in comparison to the revenue-affecting
investment decisions.

TYPES OF CB DECISIONS
An entity may be deal with the three types of capital budgeting decisions:
1. Accept-reject decision
2. Mutually exclusive Projects decisions
3. Capital Rationing decision
Accept-reject decision
In this decision, all those proposals, which yield a rate of return greater than a certain required
rate of return or cost of capital, are accepted and the rest are rejected. By applying this criterion,
all independent projects are accepted. Independent projects are those projects whose cash flows
are unrelated to one another; the acceptance of one does not eliminate the others from further
consideration.
Mutually exclusive projects decision
MEP decisions are those which compete with other projects in such a way that the acceptance of
one will exclude the others from further consideration

Capital rationing decision

Capital rationing is a financial situation in which a firm has only fixed amount to allocate among
competing capital expenditures.

Typical Capital Budgeting Decisions

--Expansion Decisions --Equipment selection decisions
--Lease or buy decisions --Equipment replacement decisions

IDENTIFYING THE “RELEVANT” CASH FLOWS

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Capital Budgeting-Part I SFM/DM

Not all cash flows are relevant in capital budgeting. The only relevant cash flows are the
incremental cash flows after tax. Incremental cash flows means only those cash flows that affect a
firm’s existing total cash flows should be considered.
Here are some examples of what is relevant to project cash flows:
1. Depreciation: Capital assets are subject to depreciation and we need to account for
depreciation twice in our calculations of cash flows. We deduct depreciation once to calculate
the taxes we pay on project revenues and we add back depreciation to arrive at cash flows
because depreciation is a non-cash item.

2. Working Capital: Major investments may require increases to working capital. For example,
new production facilities often require more inventories and higher salaries payable.
Therefore, we need to consider the net change in working capital associated with our project.
Changes in net working capital will sometimes release themselves at the end of the project.

3. Overhead: Many capital projects can result in increases to allocated overheads, therefore,
you need to assess the impact of your capital project on overhead and determine if these costs
are relevant.

4. Financing Costs: If we plan on financing a capital project, this will involve additional cash
flows to investors. The best way to account for financing costs is to include them within our
discount rate. This eliminates the possibility of double-counting the financing costs by
deducting them in our cash flows and discounting at our cost of capital which also includes
our financing costs.

We also need to ignore costs that are sunk; i.e. costs that will not change if we invest in the
project. For example, a new product line may require some preliminary marketing research. This
research is done regardless of the project and thus, it is sunk. The concept of sunk costs and
relevant costs applies to all types of financing decisions.

Incremental cash flows after taxes are those periodic cash flows and inflows that occur if and only if an
investment project is accepted.

CLASSIFICATION OF CASH FLOWS AFTER TAX

For systematic estimation of cash flows, we classify the expenses and benefits into three
categories:
1. Initial CF
2. Operating CF
3. Terminal CF

Initial Cash Flows

The initial investments are the one-time expenditures at the time of acquisition to the running
condition of the assets. Examples: Accession of property, plant, equipment, installation, training
cost. Initial cash flows may be occurred in the form of direct and indirect cash flows.

Initial Cash Flows

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Direct Cash Flows Indirect Cash flows

- Capital Expenditure - After tax proceeds of old assets
- Operating Expenditure - Change in net working capital

Capital expenditures are those cash outflows that are expected to produce future benefits extending
beyond one year, therefore classified as an asset on the balance sheet. While operating expenditure are
those cash outlays that provide no benefits beyond the current period, hence it is classified as an expense
against the current revenue

Operating Cash Flow

The cash flows generated by an asset are called operating cash flows, which do not depend on the
amount of debt or interest payments being made by the company.

The PV of any asset is equivalent to the future cash flows generated by that asset discounted at
the appropriate RRR.

In terms of incremental cash flows:

Operating CF = (S – C – D) (1 – t) + D
Where S = Incremental sales
C = Incremental expenditures
D = Incremental depreciation
t = tax rate

Terminal Cash Flows

The cash flows that are expected to occur at the point when project’s useful life ends are the
terminal cash flows. Two types of cash inflows influence the capital budgeting decision:
1. Salvage value of the asset(s)
2. Recovery of the working capital

EVALUATING TECHNIQUES
1. Traditional Technique
2. Time-adjusted Technique

1. TRADITIONAL TECHNIQUE
o Payback Method
o Accounting rate of return

PAYBACK METHOD
Payback period is the length of time that it takes for a project to fully recover its initial cost out
of the cash receipts that it generates.

Payback period = Expected number of years required to recover a project’s cost.

Merits
 Simple to calculate.

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Capital Budgeting-Part I SFM/DM

 Easy to understand.
 It saves time because if proposal does not provide the payback within specified period
then there may be no need to consider it further.
 Useful in those industries where products become obsolete very rapidly.

Demerits
 It is not a true measure of the profitability of an investment.
 Ignores the time value of money.
 Ignores cash flows occurring after the payback period.

Decision Criteria
Shortest payback period project will be preferred over the rest.

Example
For uniform cash flows

Payback period = Investment required / Net annual cash inflow

York Company needs a new milling machine. The company is considering two machines:
Machine A costs RS.15000 and will reduce costs by Rs.5000 per year. While machine B costs
only Rs.12000 but will reduce costs by Rs.5000 per year. Which company should purchase
according to payback method?

Solution:

Machine A payback period = 15000 / 5000

= 3 years

Machine B payback period = 12000 / 5000

= 2.4 years

Recommendation: Machine B should be purchased because it has a shorter payback period

than machine A.

For un-even cash flows

Consider the two projects and recommend which project should be adopted according to payback
method?
Project L
Expected Net Cash Flow
Year Project L Project S
0 (Rs.100) (Rs.100)
1 10 70
2 60 40
3 80 20

PaybackL = 2 + Rs.30/ Rs.80 years

= 2.4 years

PaybackS = 1 + Rs.30 / Rs.40

=1.75 years

Recommendation

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Capital Budgeting-Part I SFM/DM

Project S should be adopted because its payback period is shorter than that of project L.

ACCOUNTING RATE OF RETURN (ARR) METHOD

• The rate of return on accounting profit which is generated by the investment is termed as
accounting rate of return.

• It focuses on accounting profit rather than cash flows. It is computed as:

Avg .Net .Income

ARR =
Avg .Investment

• Average Net Income is determined by adding all profit after taxes and dividing it by
number of years. In the case of annuity, the average net income is equal to the any year’s
profit.

• Average investment is determined by dividing the investment by 2.

• If Salvage value is zero, then,

Avg. Investment = Total Investment / 2

• If Salvage value is greater than zero, then

 Investment − Salvage .Value 

Avg .Investment =   + Salvage .Value
 2 

Investment

Average Investment

Salvage Value

Time (Years)

The logic behind the averaging is that the firm is using straight line depreciation and its assets book value
declines constantly. This means that on the average, firms will have one-half of their initial purchase prices
in the books. If the machine has salvage value then only the depreciable cost will be averaged out. It has
not been taken in average computation because salvage value remains constant throughout the investment
life therefore no logic to average out of salvage value. The reason to add the salvage value is because it
remains tied up in the project and will be recovered only at the end of the project.

Incrementa lNetOperat ingIncome

ARR =
InitialInv estment

If cost reduction project is involved then

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 Capital Budgeting-Part I SFM/DM

CostSaving −Depreciati onOnNewEqu ipment

ARR =
InitialInv estment

• Initial investment should be reduce by any salvage value from the sale of old
equipment
Merits
• Simple to calculate
• Easy to understand.
• Used for demonstration purposes.

Demerits
• Ignores the time value of money.
• It focuses on accounting profit rather than cash flows.
• It may be desirable in some years and undesirable in the other years because of variation
in accounting profit over the life of the project.

Decision Criteria
 If ARR > RRR Accept
 If ARR < RRR Reject

Required Rate of Return (RRR) is the minimum rate which investors expect on their investments.

Example
Raak Amusement Corporation is investigating the purchase of a new electronic game called IGI-
4. The manufacturer will sell 20 games to Raak Amusements for Rs.180000.
Raak Amusement has determined the following additional information:
i. The game life would have 5 years with no salvage value. (Straight line Depreciation)
ii. The game would replace other unpopular games. These games would be sold for Rs.30000.
iii. It is estimated that IGI-4 would generate incremental revenues of Rs.200000 per year.
Incremental out of pocket costs each year would be in total: maintenance Rs.50000; and
insurance Rs.10000. In addition, would have to pay a 40% commission & other outlets to the
supermarkets.
Required: Compute the ARR. Will the game be purchased if Raak Amusement accepts the
project with ARR greater than 1?
Solution

Income Statement Rs.

Sales 200000
Commission 80000
Contribution Margin 120000
Fixed Expenses
Maintenance 50000
Insurance 10000
Depreciation 36000
Total Fixed Expenses 96000
Net Operating Income 24000

Depreciation: 180000/5 = Rs.36000

Incrementa lNetOperat ingIncome
ARR =
InitialInv estment − SalvageVal ueofOldEqu ipment

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Capital Budgeting-Part I SFM/DM

24000
ARR = A
R R =16 %

180000 − 30000

Recommendation
Because the return exceeds the 14% therefore, it should be accepted to purchase the games.
ARR 16% > RRR 14%------- Accept the project
2. TIME-ADJUSTED TECHNIQUE
Unlike accounting, financial management is concerned with the values of assets today; i.e.
present values. Since capital projects provide benefits into the future and since we want to
determine the present value of the project, we will discount the future cash flows of a project to
the present.
Discounting refers to taking a future amount and finding its value today. Future values differ
from present values because of the time value of money. Financial management recognizes the
time value of money because:

 Inflation reduces values over time; i.e. Rs. 1,000 today will have less value five years from
now due to rising prices (inflation).
 Uncertainty in the future; i.e. we think we will receivers Rs. 1,000 five years from now,
but a lot can happen over the next five years.
 Opportunity Costs of money; Rs. 1,000 today is worth more to us than Rs. 1,000 five
years from now because we can invest Rs. 1,000 today and earn a return.

Following are the time adjusted technique to evaluate the projects:

 Discounted Payback period Method
 Net Present Value Method
 Internal Rate of Return (IRR) Method
 Modified IRR Method
 Profitability Index Method

DISCOUNTED PAYBACK METHOD

Discounted payback period is the length of time that it takes for a project to fully recover its
initial cost out of the present value of cash receipts that it generates.

Decision Criteria
Shortest payback period project will be preferred over the rest.

Example
Examine the following example and recommend the company about the acceptance of the
project. The required payback period is 5 years.
PV RECOVERY
Cash Payback
Year Factor PV of CF
Flow Years
@10% Needed Balance
0 -10000 1 -10000 10000 10000 1
1 3000 0.909 2727 10000 7273 1
2 2500 0.826 2065 7273 5208 1
3 2000 0.751 1502 5208 3706 1
4 2000 0.683 1366 3706 2340 1
5 2000 0.621 1242 2340 1098 1
6 2500 0.564 1410 1098 - 0.78

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 Capital Budgeting-Part I SFM/DM

Discounted Payback Period 6.78

Recommendation
Because discounted payback period is more than the required, the company should not to accept
that project.
NET PRESENT VALUE (NPV) METHOD

Present value of cash inflows minus present value of cash outflows is termed as Net Present
Value

NPT = PV of Cash Inflows – PV of Cash Outflows

Procedure
 Find the PV of each cash flow, including both inflows and outflows, discounted at the
project’s cost of capital.
 Match the discounted cash inflows with the discounted cash outflows, the result will be
the NPV of the project.

Formulae
For discounting the Future value to the Present Value:

FV
For Un-even Cash flows (Single) PV =
(1 +i )

1 −(1 +i) 
For Annuity (Same Size) PV = R  
 i 

Where
R = Annuity (Amount of any 1 year)
i = Interest rate
n = Number of periods

Annuity is a constant cash flow for a number of years. Perpetuity is a constant cash flow forever.

Merits
 It recognizes the time value of money.
 It considers the total benefit arising out of the project over its life time.
 It is particularly useful for the selection of mutually exclusive projects.
 This method of asset selection is instrumental in achieving the objective of the
financial management.

Demerits
 It is difficult to calculate and understand.
 Difficult to use in comparison with the payback method and ARR method.
 It involves the calculation of discount rate of return to discount the cash flows.

Decision Criteria

 If NPV is +ve Accept the Project

 If NPV is –ve Reject the Project

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 Capital Budgeting-Part I SFM/DM

Example
Consider the two projects Project L and Project R. Initial Investments of both are Rs.100.

Project L Project S
Year PV Factor Cash Flows PV Cash flows PV
0 1 -100 -100 -100 -100
1 0.909 10 9.09 70 63.63
2 0.8264 60 49.584 40 33.056
3 0.7513 80 60.104 20 15.026
Net Present Value 18.778 11.712

Recommendation
 If the projects are independent, accept both
 If the projects are mutually exclusive, accept Project L since NPVS > NPVL

 The rationale NPV method is straight forward. If an entity takes on a project with a zero NPV, the
wealth of its current shareholders will be unchanged. However, it takes on a project with positive
NPV; the wealth of its current shareholders will be increased.

INTERNAL RATE OF RETURN (IRR) METHOD

(Alternative terms = yield on investment, marginal efficiency of capital, marginal productivity of capital)
Definition
An asset’s internal rate of return (time adjusted rate of return) is the true economic return
earned by the asset over its life.
IRR is that discounted rate which forces the PV of a project’s expected cash inflows to equal the
present value of the project’s expected costs.

Merits
 It considers the time value of money
 It takes into account the total cash outflows and inflows
 It is easier to understand. Business executives and non-technical peoples can understand it
more easily as compare to NPV.
 It does not use the concept of RRR rather it itself provides a rate which is indicative of the
profitability of the proposal.
Demerits
 It generally involves complicated and boring calculations.
 It produces multiple rates which can be confusing.
 In evaluating mutually exclusive proposals, the project with the highest IRR would be picked
up to the exclusion of all others which are more consistent with the goal.
 It is based on the assumption that all cash inflows are reinvested at the IRR

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Capital Budgeting-Part I SFM/DM

 Two projects have different IRR. It means reinvestment by the same firm at different rates is totally
illogical.

Decision Criteria
• If IRR >= Hurdle Rate (RRR) Accept the Proposal
• If IRR < Hurdle Rate (RRR) Reject the Proposal

Example
Following data is related to the two machines A and B. Assuming cost of capital is 12%.
Calculate the IRR.

Machine Machine
Years A B
CFAT CFAT
0 -56125 -56125
1 14000 22000
2 16000 20000
3 18000 18000
4 20000 16000
5 25000 17000

Solution
By Trial & Error Method:

PV Machine A PV Machine B
Years Factor Factor
@ 17% CFAT PV of CFAT @20% CFAT PV of CFAT
0 1 -56125 -56125 1 -56125 -56125
1 0.855 14000 11970 0.833 22000 18326
2 0.731 16000 11696 0.694 20000 13880
3 0.624 18000 11232 0.579 18000 10422
4 0.534 20000 10680 0.482 16000 7712
5 0.456 25000 11400 0.402 17000 6834
853 1049

NPV of both machine are positive so increase the discount rate and try again.

PV Machine A PV Machine B
Years Factor Factor PV of
@ 18% CFAT PV of CFAT @21% CFAT CFAT
0 1 -56125 -56125 1 -56125 -56125
1 0.847 14000 11858 0.826 22000 18172
2 0.718 16000 11488 0.683 20000 13660
3 0.609 18000 10962 0.564 18000 10152
4 0.516 20000 10320 0.467 16000 7472
5 0.437 25000 10925 0.386 17000 6562
-572 -107

Interpolation

Machine A

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Capital Budgeting-Part I SFM/DM

 8 5 3
I =R1 % + 7R  IRR = 17% + 0.598%

 8 − {− 5 ) 37 2
IR
R =1
7 . 6%

Machine B

 1 0 4 9
I =R2 % +  R0  IRR = 17% + 0.9%

 1 {0−− 1 ) 40 97
IR
R =1
7 .9%

Recommendation
Because, Machine B IRR is greater than Machine A IRR, so firm should accept the proposal of
Machine B.

The rationale of IRR is that if IRR exceeds the cost of finance, it will increase the shareholders wealth,
therefore accepted otherwise rejected. Because of this breakeven characteristic of IRR, it is useful in
evaluating capital projects.

MODIFIED INTERNAL RATE OF RETURN (MIRR)

METHOD

The discount rate at which the PV of a project’s cost is equal to the PV of its terminal value.

PV costs = PV terminal value

IRR based on reinvestment rate assumption. In order to eliminate the reinvestment rate
assumption, we will modify the Internal Rate of Return so that the reinvestment rate is our cost of
capital or the rate which is expected to earn on investment. This will give a more accurate IRR
for our project.

Decision Criteria
• If MIRR >= Hurdle Rate (RRR) Accept the Proposal
• If MIRR < Hurdle Rate (RRR) Reject the Proposal
OR
• PV of Sum of Terminal Value > PV of Cash Outflows Accept the Proposal
• PV of Sum of Terminal Value < PV of Cash Outflows Reject the Proposal

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Capital Budgeting-Part I SFM/DM

Selection among various alternatives, the one with highest rate of return is preferable.

Example
Consider a project which original outlay Rs.10000 and the Life is 5 years. Cash inflows Rs.4000
for each year and cost of capital is 10%.
Expected Rate of Return at which cash inflows will be re-invested:
For 1 and 2 year 6%
For 3 to 5 year 8%

Total
Cash Years of Compounding
Year Rate Compounded
Inflows Investment Factor
Sum
1 4000 6 4 1.262 5048
2 4000 6 3 1.191 4764
3 4000 8 2 1.166 4664
4 4000 8 1 1.08 4320
5 4000 8 0 1 4000
22796

PV of Cash Outflows -10000

PV of Cash Inflows 22796@0.621 14156.3
Net Present Value 4156.3

To achieve NPV = Zero, apply 17% discount Rate

PV of Cash Outflows -10000

PV of Cash Inflows (17%) 22796@0.4561 10397.25
Net Present Value 397.25

To achieve NPV = Zero, now apply 18% discount Rate

PV of Cash Outflows -10000

PV of Cash Inflows (18%) 22796@0.4371 9964.13
Net Present Value -35.87

Interpolation

 3 .2 9 5 7
M = 1 %I+  7 R R  MIRR = 17% + 0.917%

 3 .2 −9{3 5.8 7) 5 7

M
IR
R =1
7 .9
17 %

Recommendation
Because MIRR > Cost of Capital so, accept the project.
17.917% > 10% --------------- Accept the Project

Comparison between IRR and MIRR

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The modified IRR has a significant advantage over the regular IRR. Modified IRR assumes the
cash flows from all projects are reinvested at the cost of capital, whereas regular IRR assumes
that cash flows from each project are reinvested at the project’s own IRR. Its mean different
projects have different IRR and hence at the same time they are reinvested at the different rate,
which is illogical. Therefore reinvestment at k is generally more logical and correct, that’s why
MIRR is a better indicator of a project’s true profitability.

PROFITABILITY INDEX (PI) [Benefit-Cost Ratio]

Profitability index measures the present value of returns per rupee invested.

Formula
PVofCashIn flows
PI =
PVofCashOu tflows

Decision Criteria
 If PI > 1 Accept (NPV +Ve)
 If PI < 1 Reject (NPV –Ve)
 When PI = 1 Remains indifferent (NPV Zero)

Example
Consider two Machines A & B. Present value of cash inflows Rs.68645 & Rs.71521 of A & B
respectively and present value of cash outflows of both machines Rs.56215.

Solution
Machine A

PVofCashIn flows 68645

PI = PI = P
I =1.2
2

PVofCashOu tflows 56125

Machine B

PVofCashIn flows 71521

PI = PI = P
I =1.2
7

PVofCashOu tflows 56125

Recommendation
 Since the PI of both the machines is greater than 1, both the machines are acceptable.
 However, Machine B PI is greater than Machine A, therefore Machine B is preferable.

Capital Budgeting Continue----wait for next part

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