Capital Budgeting

Long-term investment decisions - the key to long run

profitability and success!
Capital Expenditure

 Expenditure that generates a cash flow benefit for more than one year, is a
capital expenditure. Examples include the purchase of new equipment,
expansion of production facilities, buying another company, acquiring new
technologies, launching a research & development program.

 Capital Expenditure Decision is therefore company’s decision to invest its

current funds most efficiently in long term assets in anticipation of an expected
flow of benefits over a series of years.
Types of Capital Budgeting Decisions

 From the point of view of firm’s existence:

 New firm : A newly incorporated firm may be required to take decision such as selection of plant
to be installed, capacity utilization at installed stages
 Existing Firm :
 Replacement or Mordernisation Decision
 Expansion – Increasing the installed production capacity – Marginal costs and benefits to be
evaluated
 Diversification – diversify into new product lines, new markets etc - Marginal costs and
benefits to be evaluated along with effect of diversification on existing market share and
profitability

 From the point of view of Decision Situation

 Mutually Exclusive Decision : Two or more alternative proposals are said to be mutually
exclusive when acceptance of one would result in automatic rejection of all other proposals
 Accept – Reject Decision : An Accept – Reject decision occurs when a proposal is
independently accepted of rejected without regard to any other alternative proposal.
 Contingent decisions : Some times, a capital budgeting decision is contingent to some other
decision.
Difficulty in Doing Capital Budgeting Analysis

 Future Uncertainty : While the initial cost of a project may be known, future
cash flow benefits from the project are usually uncertain.
There are ways to understand the implications of risk, but no ways to eliminate
uncertainty

 Different Time Frame :Since Costs and benefits occur at different points of
time, for a proper analysis of the viability of the investment proposal, all these
have to be brought to a common time – frame.

 Measurement Problem : Finance manager usually faces difficulties in

measuring costs and benefits of a project in quantitative terms. For example, the
new product proposed to be launched by a firm may result in increase or decrease
in sale of other products already being sold by the firm. But How much? This is
very difficult because the sales of other products may increase of decrease due to
other factors also.
Stages within Capital Budgeting Analysis
 The investment decision starts with identification of investment
opportunities and culminates in performance review after the project is
implemented and operations are stabilized.

 Identification of potential investment opportunities

 Preliminary Screening
 Feasibility Study
 Implementation
 Performance review
Identification of Potential Investment
Opportunities
Potential sources for project ideas
 Market characteristics of different industries
 The supply and demand conditions prevailing in the different industries can be
analyzed to identify such industries which have unfulfilled demand .

Example: When Nestle India Ltd. introduced ‘Maggi ‘ noodles in the market in the
early eighties and the product gained a high degree of consumer acceptance , it
became evident that a huge unsatisfied demand exists for fast foods .We have seen a
number of new entrants in this industry since then.

 Imports and Exports

 The promoter might find it advantageous to analyze the trend in exports and
imports over the last five to six years, to identify potential investment opportunities
Example: Cold –rolled coils and many other steel derivatives worth 1500crore were
imported by India every year, Ispat Profiles India ltd identified an opportunity to
produce these items indigenously and their project have been doing extremely well
 Product Profiles of Various Industries
 A study of the end –products (including by – products ) of the various
industries can throw up new project ideas .
Example :Mini steel plants in the country were started with the
intention of using the steel scrap which was invariably discarded as
waste.

 An analysis of the inputs required for the various industries can also
help in the identification of new projects .

Ford Motors ,for example , at one time produced their own car window
frames but found it more suitable to contract this workout to benefit
from the economics open to the specialist firm.
Ashok Leyland and Maruti Udyog which depend upon a large network of
ancillary units for manufacturing specific components or parts .
 Emerging Technologies
 Analyzing the commercial viability of some of the indigenously developed or
foreign technologies to suit the local requirements can result in the
identification of potential investment opportunities

  Example : Xeroxography was invented in 1938 by Carlson but he could not sell the
technology to business firms successfully. Even IBM was not convinced that it is a
promising idea. Xerox Corporation adopted the idea in 1960, and launched photocopiers
with astounding success.

 Backward and Forward integration

 Many units use their own output to make other products. The advantage is
that the output can be captively consumed to make better value added
products

  Example: Deepak Fertilisers & Petrochemicals Corporation Ltd – a leading producer of

Industrial chemicals was the only producer of ammonia in private sector. Since the
ammonia prices are administered by the government, the company was not able of
maintain profitability. It has therefore decided to set up a new project to manufacture
ammonia- based fertilizers and thereby improve its profit potential
Preliminary Screening

Compatibility with promoter

Entrepreneur promoting a new project must ensure that the physical, financial and human resources are available at his disposal
are adequate to meet the requirements of the project under review
 

Compatibility with Governmental Priorities

It is preferable that the project under review does not run counter to the government policies or priorities

Availability of Raw materials and Utilities

There had many case of project failure due to non-availability or scarcity of critical inputs. Apart from availability of inputs cost
involved in obtaining these inputs must also be examined because adverse variation in input costs can significantly affect the
viability of the project
 

Size of Potential Market

The size of domestic and export Markets, projected increase in consumption, competitors profile etc are also assessed while
subjecting the project to a preliminary evaluation
 

Reasonableness of Cost
The cost structure of the project must be examined to see whether the profit margin can be attained with a competitive price

Risk Inherent in the Project

The risk characterizing the project must be carefully evaluated taking into account the different sources of risk like technological
changes, availability of substitutes, competitive prices and cyclical effects.
Feasibility Study

Once a project opportunity is conceived and it is considered acceptable after the

preliminary screening, a detailed feasibility study has to be undertaken covering
all marketing, technical, financial and economic aspects of the project. The study
in the form of Detailed Project Report will contain fairly specific estimates of :

 Project Cost
 Means of financing
 Schedules of Implementation
 Estimates of profitability based on projected sales and production costs
 Estimates of costs and benefit in terms of cash flows
 Debt servicing capability of the project and
 Social Profitability

Main motive of feasibility study is to assess whether the project is technically

feasible, economically viable and financially sound
Implementation
The implementation of the project i.e. translating the investment proposal into
a concrete project entails a number of stages and activities which are highly
complicated, time consuming and a risky affair.

Performance Review
One of the most important steps in capital budgeting analysis is to follow-up and
compare your estimates to actual results. This post analysis or review can help identify
bias and errors within the overall process. A formal tracking system of capital projects
also keeps everyone honest. The purpose of post analysis and tracking is to collect
information that will lead to improvements within the capital budgeting process.
Defining Costs and Benefits

 All costs and benefits must be measured in terms of cash flows . This implies that all
non- cash charges (expenses ) must be added back to arrive at the net cash flows for
our purpose .
 Cash flows for the purpose of appraisal must be defined in post –tax terms .
 Interest on long –term loans must not be included for determining the net cash flows .
 The cash flows must be measured in incremental terms .
 If the proposed project has a beneficial or detrimental impact on , say the other product
lines of the firm, then such impact must be quantified and considered for ascertaining
the net cash flows .
 Sunk costs must be ignored .
 Opportunity costs associated with the utilization of the resources available with the
firm must be considered even though such utilization does not entail explicit cash
outflows .Example: While the sunk cost of the land is ignored , its opportunity cost
i.e., the income it would have generated if it had been utilized for some other purpose
or project must be considered .
 Allocation of existing overhead costs must be ignored.
Computation of Cash Flows
 XYZ Ltd decides on the a capital project which involves the following outlays :
(Rs. in lakhs)
Plant and machinery 250

Working Capital 100

 
The proposed scheme of financing is as follows :
(Rs. in lakhs)
Equity 150
Long-term loans 100
  Trade Credit 40
 Commercial Banks 60
 
The project has a life of 10 years. Plant and machinery are depreciated at the rate of 15 percent per annum as per the written
down value method. The expected annual net sales is Rs.300 lakhs .

Cost of sales (including depreciation ,but excluding interest )is expected to be Rs.200 lakhs a year . The tax rate of the
company is 30 percent .At the end of 10 years plant and machinery will fetch a value equal to their book value and the
investment in working capital will be fully recovered .The long- term loan carries an interest of 14 percent per annum .It is
repayable in eight equal annual installments starting from the end of the third year. Short –term advance from commercial
banks will be maintained at Rs. 60 lakhs and will carry interest at 15 percent per annum. It will be fully liquidated after 10
years .Trade credit will also be maintained uniformly at Rs. 40 lakhs and will be fully paid back at the end of the tenth year .

Calculate the cash flow stream of this project from the long term investors’ point of view.
Solution
Cash Flows Relating to Long Term Funds

Depreciation Calculation
Year P&M Dep WDV
0 250   250
1   37.50 212.50
2   31.88 180.63
3   27.09 153.53
4   23.03 130.50
5   19.58 110.93
6   16.64 94.29
7   14.14 80.14
8   12.02 68.12
9   10.22 57.90
10   8.69 49.22
Techniques of Evaluation
Investment Criteria

Discounting Non-Discounting
Criteria Criteria

Accounting
Net Present Benefit Cost Internal Rate Payback Rate of
Value Ratio of return period return
Payback Period Method
 Payback period of the project is the amount of time required to recover
the original investment.

 When done on discounted cash flow basis it is called discounted payback

period.

Illustration

Initial Cash Outlay 10,00,000

Cash inflows 1st year 3,00,000
2nd Year 5,00,000
3rd Year 4,00,000
4th year 5,00,000
 If payback period/ Discounted payback period of the project is
< the predetermined cut-off: Accept
> the predetermined cut-off: Reject

Advantages of payback method

 The payback period is simple and easy, can be adopted by small firms.
 It gives an indication of liquidity. Good method for firm facing liquidity problems
as it emphasizes on earlier cash flows
 Payback period deals with risk also. The project with a shorter payback
period will be less risky as compared to project with longer payback period
Disadvantages of payback method
 Ignores cash inflows which occur after the payback period
 Ignores timing of occurrence of the cash flows
 Ignores salvage value and total economic value of the project
 It is more a method of capital recovery than a measure of profitability of project
Accounting Rate of Return
Accounting Rate of Return is defined as average profit as % of average investment
over the life of the project

 Accounting Rate of Return = Average Profit after tax

Average Investment
 It is based on ‘Accounting Profits’ and not cash flows

 Average Investment = ½(Initial Cost + Installation Expenses – Salvage Value) +

Salvage Value + Additional working Capital

Advantages of Accounting Rate of Return

 Simple both in concept and application
 It considers the returns over the entire life of the project and therefore serves as a
measure of profitability
Disadvantages of Accounting Rate of Return

 Ignores time value of money

 ARR is based on the accounting profits rather than cash flows
 Ignores life of proposal
 Ignores the salvage value of the proposal. A proposal with a longer life may
have the same ARR as another proposal with a shorter life
Net present value (NPV)
• The net present value is equal to the present value of all future cash inflows minus
the present value of all the cash outflows associated with the proposal. In the case of
a project ,the immediate cash flow will be investment (cash outflow )and the net
present value will be therefore equal to the present value of future cash inflows
minus the initial investment .

 NPV = PV of Future Benefits - PV of the Cost

 if NPV > 0, benefits exceed costs, and the project should be accepted. And
 If NPV < 0, the project should be rejected.

 NPV is value created by the acceptance of the project. It reflects the increase in the
market value of the firm. Net present value represents the contribution to the wealth
of the shareholders, maximizing NPV is congruent with the objective of investment
decision making viz., maximization of shareholders ‘ wealth
Steps for computing NPV
1) Estimate the initial cost/investment to implement the project, CF0.

2) Estimate the cash flows of the project for each period over its life, CFt.

3) Discount the each of the estimated cash flows at an appropriate rate to arrive at
present value of the cash flows, and add them up.

4) Subtract the initial investment from the present value to get the Net Present Value
of the project.

Properties of NPV
 NPVs are ADDITIVE.

 Intermediate cash flows are invested at cost of capital.

 NPV calculations permit time-varying discount rates.

Benefit –Cost Ratio / Profitability Index
• Benefit cost ratio provides the ratio of sum of the discounted net cash inflows to the
initial cash outlay.

 Benefit Cost ratio = Sum of discounted net cash inflows (PV of future benifits)
PV of cash outlay
This is particularly useful in case a comparison is to be made for number of projects
involving different cash inflows.
The decision rules based on the BCR(or alternatively the NBCR) criterion will be as
follows :
If - Decision Rule
 BCR >1 (NBCR >0 ) Accept the project
 BCR <1 (NBCR <0 ) Reject the project
 
Since the BCR measures the present value per rupee of outlay ,it is considered to be a
useful criterion for ranking a set of projects in the order of decreasingly efficient use
of capital.
Limitations of Benefit Cost Ratio
 Benefit cost ratio does not have additive property. Hence where a large project is to
be compared with set of several small projects this ratio is not suitable. This
limitation can be avoided by adding the cash flows of small projects

 Benefit cost ratio can be used to rank the projects in case the capital budget is
limited. However, it should be used with caution due to above limitations.
Internal Rate of Return
 The Internal rate of return is that rate of interest at which the net present value of a
project is equal to zero.

IRR = the rate of return earned on the project

OR, rate at which
PV of cash inflows = PV of cash outflows

Decision Rule under IRR

 Accept if IRR > Cost of Capital
 Reject if IRR < Cost of Capital
Calculation of IRR – Trial and Error
Method
Method of Calculating IRR

1. Compute NPV taking any rate.

2. If the NPV so computed is positive (NPV > 0), then take a higher rate and compute NPV again
such that the second NPV is negative.

3. If NPV computed in step 1 is negative, take a lower rate and compute NPV again such that the
second NPV is positive.

4. Apply the below formula to arrive at IRR:

IRR = Smaller discount rate + NPV at smaller rate x (Higher rate – Smaller rate)
Sum of absolute values of
NPV at smaller and higher
discount rates
An investment of Rs.1,36,000 yields the following cash flows :

Year Rs.
1 30,000
2 40,000
3 60,000
4 30,000
5 20,000

Compute IRR of the investment.

NPV @ 10% = Rs.2,318

NPV @ 12% = (Rs.4,205)

IRR = 10 + 2,318 x (12-10)

2,318 + 4,205

= 10.7%
Advantages of NPV
 Simplicity of NPV

 Re-investment rate
 The implied assumption of IRR method is that interim cash flows are reinvested
at IRR itself.
 NPV method assumes reinvestment at discount rate. This assumption of IRR is
challenged as it defies conservatism

 Flexibility in choosing discount rate

 Measuring wealth creation

 Ranking of the project in capital rationing situation

 Unambiguous acceptance and rejection criterion makes NPV rule superior to IRR
rule
Advantages of IRR method
 IRR remains a popular method of evaluation of projects because of :
 Its ability to compare projects without the consideration of discount rate.
 Easier comprehension

 Cost of capital not required to find IRR

 Priority for early cash flows

Primary Assumption

 IRR has an implicit assumption that the interim cash flows are re-invested at IRR
only.

 On the other hand NPV assumes that interim cash flows are re-invested at the cost
of capital.
 Illustration
Assume a manufacturer could invest $250,000 in new machines to speed up its production
lines.

The new machines would allow sales to increase by $75,000 per year over their useful life
of 8 years.

The annual cash operating cost of the new machines is $10,000. The annual depreciation
expense would be $31,250 (using straight-line depreciation method). The corporate tax rate
is 30%.

 Answer

Annual cash flow benefits = ($75,000 - $10,000 - $31,250)x(1 - .3) + $31,250 = $54,875.
The present value of these cash flows over eight years at cost of capital @ 12% = PV of an
annuity = $272,600.
NPV = $272,600 - $250,000 = $22,600.

If the projected cash flows are accurate, then the acceptance of this project should increase
stockholders’ wealth by $22,600. The NPV represents the benefit to stockholders from
accepting the project. In this case, the positive NPV indicates an attractive investment.
Summary:

 Either the NPV, IRR, or PI methods can be used to make good decisions about
capital budgeting investments.

 Uncertainty about the future cash flow estimates is problematic.

 Payback period is often calculated for investment projects, but it should not be used
by itself to make accept/reject decisions.
THANK YOU FOR YOUR PATIENCE 

Mayank Bajaj
Senior Manager
Financial Reporting
Bharti Airtel Limited
Email: mayank.bajaj@airtel.in