Capital Budgeting

PREPARED BY : Swapnil Keyur Nikhil Manjiri Nikita Asad (3) (10) (14) (18) (27) (30)

Outline
Meaning of Capital Budgeting Significance of Capital Budgeting Analysis Traditional Capital Budgeting Techniques
Payback Period Approach Discounted Payback Period Approach Discounted Cash Flow Techniques
Net Present Value Internal Rate of Return Profitability Index Net Present Value versus Internal Rate of Return

Meaning of Capital Budgeting

Capital budgeting addresses the issue of strategic long-term investment decisions. Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.

Significance of Capital Budgeting:

Considered to be the most important decision that a corporate treasurer has to make. So much is the significance of capital budgeting that many business schools offer a separate course on capital budgeting

Why Capital Budgeting is so Important?

Involve massive investment of resources Are not easily reversible Have long-term implications for the firm Involve uncertainty and risk for the firm

Due to the above factors, capital budgeting decisions become critical and must be evaluated very carefully. Any firm that does not follow the capital budgeting process will not be maximizing shareholder wealth and management will not be acting in the best interests of shareholders. RJR Nabisco s smokeless cigarette project example Similarly, Euro-Disney, Concorde Plane, Saturn of GM all faced problems due to bad capital budgeting, while Intel became global leader due to sound capital budgeting decisions in 1990s.

Classification Of Projects
The Capital budgeting process may be less or more ,it depends on the type of the projects :

NEW PROJECTS - Ex: establishment of a paper manufacturing company requires machinery to produce paper ,which may require investment of some crores of rupees. EXPANSION PROJECTS- Ex: same company which is currently producing 20,000 tones of paper may increase its plant capacity by 10,000 tonnes per year. DIVERSIFICATION PROJECTS- Ex: Reliance ,marketer of textiles, entering into petroleum business.

REPLACEMENT & MODERNISATION PROJECTS - Ex: A cement manufacturing concern is planning to go for modernization where it is changing its drying process from semi-automatic to fully automatic drying equipment or replacement of manually operated machinery by the fully automatic machinery.

R & D PROJECTS - Majority of the large firms are setting up their own R & D departments.

MISCELLANEOUS PROJECTS
Ex: Reliance ,marketer of textiles, entering into petroleum business.

Kinds Of Capital Budgeting

ACCEPT-REJECT DECISIONS -Basic decision in making capital expenditure decisions. Used for all independent projects.

MUTUALLY EXCLUSIVE INVESTMENTS

Projects do not depend upon each other ,one can be accepted and the other can be rejected. Ex: a company has an option of buying a component from an outside or manufacturing within the firm.(In this situation , the company may accept the most profitable decision, based on the purchase price or manufacturing cost whichever is less)

CAPITAL RATIONING DECISIONS-Arises when a firm has unlimited funds & several profitable investment projects.

CONTINGENT INVESTMENTS-Contingent projects are dependent investment, acceptance of one option needs to understand one or more other projects Ex: location of a factory in a backwards area, instead of industrial area or urban ,may need to construct roads, quarters for employees ,hospitals, schools, without which it is very difficult to attract employees.

Process Of Capital Budgeting

IDEA GENERATION EVALUATION or ANALYSIS SELECTION FINANCING THE SELECTED PROJECT EXECUTION or IMPLEMENTATION REVIEW OF THE PROJECT

Techniques of Capital Budgeting Analysis

Payback Period Approach Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index

Which Technique should we follow?

A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization. A technique is considered consistent with wealth maximization if
It is based on cash flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects

Pay Back Period

Pay Back Period may be defined as that period required to recover the original cash outflow invested in the project. Pay Back Period can be calculated in two ways : i. Using formula Pay Back Period = Original Investment / Constant Cash Flow After Taxes ii. Using Cumulative cash flow method PBP = Year before full recovery + (Unrecovered Amount of Investment, Cash flows during the year)

Decision Rule
Accept: Cal PBP < Standard PBP Reject: Cal PBP > Standard PBP

Advantages of PBP Very simple and easy to understand Cost involvement in calculating PBP is much less when
compared to modern methods.

Limitations of PBP It ignores cash flows after pay back period. It is not an appropriate method of measuring the profitability of a project, as it does not consider all cash inflows yielded by the investment. It does not take into consideration time value of money. There is no rationale basis for setting a minimum pay back period. It is not consistent with the objective of maximising shareholders wealth since share value does not depend on pay back periods of investments projects.

Accounting Rate of Return (ARR) Accounting rate of return method uses accounting information as revealed by financial statements, to measure the profitability of the investment proposals. It is also known as the Return on Investment (ROI). It is calculated in two ways: i. Whenever it is clearly mentioned as Accounting Rate of Return

Accounting Rate of Return(ARR)= Average Annual EAT or PAT 100 Original Investment (OI) OI= Original investment + additional NWC + Installation Charges + Transportation Charge

ii. Whenever it is clearly mentioned as Average Rate of Return Average Rate of Return = Average Annual EAT 100 Average Investment (AI) AI = (Original investment Scrap value)1/2+Additional NWC + Scrap Value

Decision Rule Accept: Cal ARR > Predetermined ARR or Cut-off rate Reject: Cal ARR < Predetermined ARR or Cut-off rate

Advantages of ARR method Very simple to understand and easy to calculate. Information can easily can be drawn from accounting records. It takes into account all profits of the projects life period. Cost involvement in calculating ARR is much less is comparision with the modern methods, since it saves analysts time

Limitations of ARR method Accounting profits are inappropriate for evaluating and accepting projects, Since they are computed based on arbitrary assumptions and choices and also include non-cash items. It ignores the concept of time value of money. It does not allow the fact that the profits can be reinvested. It does not differentiate between the size of the investment required for each project. It does not take into consideration any benefits, which can accrue to the firm from the sale of abundance of equipment, which is replaced by the new investment. It feels that 10% rate of return for 10 years is more beneficial than 8% rate of return for 25 years.

Discounted Payback Period

Similar to payback period approach with one difference that it considers time value of money The amount of time needed to recover initial investment given the present value of cash inflows Keep adding the discounted cash flows till the sum equals initial investment All other drawbacks of the payback period remains in this approach Not consistent with wealth maximization

Net Present Value Approach

NPV defined as preset value of benefits minus preset value of costs It may be positive or negative Accept a project if NPV 0

Steps involved in computation of Net Present Value

Forecasting of cash inflow of the project based on realistic assumptions computation of cost of capital calculation of PV cash flows using cost of capital as discounting rate Finding out NPV

Advantages
It takes in to account the time value of money It is particularly useful for the selection of mutually exclusive project it is consistent with the objective of maximization of shareholders wealth It takes into consideration the changing discount rate

Disadvantages
It is difficult to understand when compared with PBR and ARR It does not give satisfactory result s when comparing two projects with different life period In cash of project involving different cash outlays NPV method may not give dependable results

Internal Rate of Return

Internal rate of return may be defined as that discounting factor at which the present value of cash inflow is equal to present value of cash outflows Project s promised rate of return given initial investment and cash flows Consistent with wealth maximization Accept a project if IRR Cost of Capital

Advantages
It takes in to account the time value if money It considers cash flows throughout the project life It gives more psychological satisfaction to the user It is consistent with the objective of shareholders wealth maximization

Disadvantages
It is difficult to understand and to calculate since it involves tedious calculation It implies that profits can be reinvested at internal rate of return which is not logical It produce multiple rate of return which can be confusing

NPV versus IRR

Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project IRR can be in conflict with NPV if
Investing or Financing Decisions Projects are mutually exclusive
Projects differ in scale of investment Cash flow patterns of projects is different

If cash flows alternate in sign problem of multiple IRR

If IRR and NPV conflict, use NPV approach

Profitability Index (PI)

PI is also known as discounted benefit cost ratio PI measures the present value of future cash per rupee of investment PI is the ratio which derived by dividing present value of cash inflow by present value of cash outflows. PI=present vale of cash inflow /present value of cash out flows

Advantages
It gives due consideration to time value of money. It considers all cash flows to determine PI. It will help to rank projects according to their PI. It can also be used to choose mutually exclusive projects by calculating the incremental benefit cost ratio.

Evaluating Projects with Unequal Lives

Replacement Chain Analysis Equivalent Annual Cost Method If two machines are unequal in life, we need to make adjustment before computing NPV.

Which technique is superior?

Although our decision should be based on NPV, but each technique contributes in its own way. Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the project s estimated cash flows PI is a measure of cost-benefit analysis. How much NPV for every dollar of initial investment

Q) A Project costs rs. 20 lakhs and yields annually profit of Rs. 3 lakhs after depreciation at 12.5% but before tax at 50%. Calc Pay Back Period & suggest whether it should be accepted or rejected based on 6-year standard pay back period. Q) A company is considering expanding its production. It can go either for an automatic machine costing Rs 2,24,000 with an estimated life of 5 years or an ordinary machine costing Rs 60,000 having an estimated life of 8 years. The annual sales and costs are estimated as follows:
Sales Costs: Materials: Labour: Variable overHs: 50,000 12,000 24,000 50,000 60,000 20,000 Auto machine 1,50,000 Ordinary mach 1,50,000

Risk analysis in capital budgeting Sources of risk

Project specific risk Competitive risk Industry specific risk Market risk International risk

Perspectives of risk
Three different perspectives
Standalone risk - It refers to the risk of a project when it is viewed in isolation. Firm risk It is the project s risk to the corporation , that affects firm s earnings. Market risk It refers to the risk of a project from the viewpoint of a diversified investor.

Thank You!