Capital Budgeting

Page 1 of 5 CAPITAL BUDGETING Prof. S. P. DAS

INTRODUCTION TO CAPITAL BUDGETING

Organization has to take decisions regarding investments in Fixed Assets such decisions are technically in the form of ‘Capital Budgeting. Thus, capital budgeting decisions are decisions as to whether or not money should be invested in long-term projects. It includes analysis of various proposals regarding capital expenditure to evaluate there impact on the financial situation of the organization and to choose the best alternative.

IMPORTANCEa) Capital Decisions have a long term impact on the operations of the business, wrong decisions

may affect the survival of the companyb) Investment in Fixed Assets in excess of requirement increases the operating cost of the

company. Capital budgeting decisions enables to control such operating cost.c) Investments in long-term projects involve huge capital outlay. Investments in unnecessary

Fixed Assets may increase the cost of the project. Capital budgeting decisions enables to keep the cost of capital at low levels.

d) Investments in Fixed Assets is a sunk cost i.e. sale of such assets at latter stage is difficult. Hence, capital budgeting decision facilitates reduction of sunk cost through right decision making.

CAPITAL BUDGETING TECHNIQUES.

The Capital Budgeting Techniques can be broadly divided into two Categories:

A) Techniques not considering Time Value1) Pay Back Period2) Accounting Rate of Return (ARR)

B) Techniques considering Time Value1) Discounted Pay Back Period2) Net Present Value (NPV)3) Internal Rate of Return (IRR)4) Profitability Index (PI)

TIME VALUE OF MONEY:

If Ms Karishma Kapoor is given an option to receive Rs. 10,000 either today or after one year, she shall opt to receive it today than receiving it after one year. Because if receives it today and deposit it in the bank she shall be receiving Rs. 11,000 after one year (Assuming interest rate of 10%). If she has to receive Rs. 10,000/- after one year, the real value of the same in terms of today is not Rs. 10,000/- this is due to inflation. If Television is costing Rs. 10,000/- today and Rs. 10,500/- after one year, she will not be able to buy if choose the second option of receiving Rs. 10,000/- after one year, but if she chooses to receive Rs. 10,000/- today then she shall be able to buy the T.V. set. This concept is called Time Value of Money.

To compute Present Value of future receipts discounting techniques are use. To simply the process Present Value Tables may be used.

ILLUSTRATION:

Year

Cash Inflows (Rs.) Present Value Factor at 15%

Total Present Value

a b c d = b x c1 10,000 0.870 8,7002 12,000 0.756 9,0723 15,000 0.658 9,8704 20,000 0.572 11,440

39,082

Pay Back Period:

Page 2 of 5 CAPITAL BUDGETING Prof. S. P. DAS

Pay back period indicates the period within which the cost of the project will be completely recovered. In other words it indicates the period within which the total cash outflows equal to total cash inflows.

Pay back period = Cash Outlays / Annual cash Inflow

Suppose a project requires total investment of Rs. 5,00,000/- and annual cash Inflow is Rs. 1,00,000/- then pay back Period

= 5,00,000 / 1,00,000 = 5 years.

Conclusion:– Shorter the pay back period better the project

Accounting Rate of Return:ARR computes the average annual yield on the net investment in the project.

ARR = [Total Profits After Tax / (Net Investment x No. of Years of Profits)] x 100

ILLUSTRATION:A project involves investment of Rs. 5,00,000/- and has a salvage value of Rs. 40,000 the end of five year. It has following profit after tax for five years.

Year P.A.T. (Rs.)

1 25,0002 37,5003 62,5004 65,0005 40,000

Total 2,30,000

Net Investment = Total Investment- Salvage Value = 5,00,000 – 40,000 = Rs. 4,60,000

ARR = [Rs. 2,30,000 / (Rs. 4,60,000 x 5 years)] x 100 = 10% Conclusion:- If ARR is more than the cost of financing investment, accept the project. If ARR is less than the cost of finance, reject the project.

Discounted Pay Back Period:Under this method the cash inflows are discounted by appropriate discounting factor and pay back period is computed

ILLUSTRATION:

Year

Cash Inflows (Rs.)

Present Value Factor at 15%

Present Value (Discounted Cash Inflows) - DCF

CumulativeDCF

a b C d = b x c e1 10,000 0.870 8,700 8,7002 12,000 0.756 9,072 17,7723 15,000 0.658 9,870 27,6424 20,000 0.572 11,440 39,082

39,082

If Project outlay is Rs. 25,000 then discounted pay back period will be as under.

The pay back period is between 2 years and 3 years.

Internal Rate of Return (IRR):Internal Rate of Return (IRR) is that rate at which the discounted cash inflows match with discounted cash out flows. The indication given by IRR is that this is the maximum rate at which the company will be able to pay towards the interest on amounts borrowed for investing in the project.. Thus, IRR may be called as the “break-even rate”. In other words, IRR indicates the discounting rate at which NPV is Zero.

Page 3 of 5 CAPITAL BUDGETING Prof. S. P. DAS

ILLUSTRATION:A project costs Rs. 1,00,000/- and generates annual cash inflows of Rs. 35,000; Rs. 40,000; Rs. 30,000 and Rs. 50,000 over its life of 4 years. Compute IRR.

Year Cash Inflows

15% P.V. Factor 15% P.V. Factor 15% P.V. FactorFactor P.V.

(Rs.)Factor P.V.

(Rs.)Factor P.V.

(Rs.)1 35,000 0.870 30,450 0.847 29,645 0.833 29,1552 40,000 0.756 30,240 0.718 28,720 0.694 27,7603 30,000 0.658 19,740 0.609 18,270 0.579 17,3704 50,000 0.572 28,600 0.516 25,800 0.482 24,100

1,09,030 1,02,435 98,385Less : Investment 1,00,000 1,00,000 1,00,000

N.P.V. 9,030 2,435 -1,615

Thus, at 18% discounting rate, NPV is Rs. 2,435 and at 20% discounting rate, NPV is (-) Rs. 1,615. Hence IRR is between 18 % and 20%.

By simple interpolation IRR will be as under

IRR = 20% - [(1,615 x 2)/(2,435+1,615)] = 19.20% appx.

Profitability Index / Benefit Cost Ratio (B/C Ratio or PI):It is a ratio between total discounted cash inflows and total discounted cash outflows. Thus Profitability index is calculated as under.

PI = Sum of Discounted Cash Inflows / Sum of Discounted Cash Outflows

ILLUSTRATIONA project costs Rs. 1,00,000/- and generates annual cash inflows of Rs. 35,000; Rs. 40,000; Rs. 30,000 and Rs. 50,000 over its life of 4 years. Compute B/C Ratio

Year Cash Inflows 15% P.V. FactorFactor P.V. (Rs.)

1 35,000 0.870 30,4502 40,000 0.756 30,2403 30,000 0.658 19,7404 50,000 0.572 28,600

1,09,030Less : Cash Out Flow -1,00,000

N.P.V. 9,030

PI = 1,09,030 / 1,00,000 = 1.09

Thus, when B/C is more than 1, accept the project and if it is less than 1 reject the project.

Page 4 of 5 CAPITAL BUDGETING Prof. S. P. DAS

Problems:

P1. Dinku & co. is considering a proposal to replace one of its plants costing RS. 60,000 and having a Book value of Rs. 24,000. The remaining economic life of the plant is four years after which it will have no salvage value. However, If sold today, It has a Salvage value of RS 20,000. The new machine costing Rs. 1,30,000, also expected to have a life for four years with a salvage Value of RS 18,000. The new machine, due to its technological superiority, is expected to contribute additional annual benefit before depreciation and tax of Rs. 60,000. Find out the cash flows associated with this decision given that the tax rate applicable to the firm is 40 percent. Ignore tax on capital gain.

P2. Pinku & Co. is interested in assessing the cash flows associated with the replacement of an old machine by a new machine. The old machine bought a few years ago has a book value of rupees 90,000 and it can be sold for rupees 90,000. It has remaining life 0f five years after which it’s salvage Value is expected to be Nil. It is being depreciated annually at the rate of twenty percent on WDV basis. The new machine costs rupees 400,000. It is expected to fetch rupees 250,000 After five years when it will no longer be required. It will be depreciated annually at the rate of 33.33 % on WDV Basis. The new machine is expected to bring savings of Rs. 100,000 In manufacturing costs. Investment in working capital would remain unaffected. The tax rate applicable to the firm is 50 percent. Find out the Vienna and cash flow for this Replacement decision. Ignore capital gain tax.

P3. Tinku & Co. is considering the manufacture of a range of pocket calculators. Expenditure on

plant and machinery is Rs. 3,00,000. The other relevant information is given below.

(Rs. 000)Years 1 2 3 4Sales 400 500 500 300Opening Stock 30 30 40 30Purchases 120 160 140 70Closing Stock 30 40 30 0Wages 80 140 140 120Overheads 60 80 80 80Interest 20 30 30 20Depreciation 75 75 75 75

Other information:a) The position to be provided @ 25 percent on straight line basis and there is no Salvage

value of the planb) Opening stock is purchased in the beginning and assume that all other annual cash flows

occur at the end of each year.c) Included in Overheads are allocated Fixed expenses equal to 25 percent of wages. All

other Overheads and Wages are incremental cash flows.d) Assume No credit is granted on received on sales or purchases.

Find out the Cash flows for this investment taking income tax rate at 40%.

P4. Pappu & Co. has an opportunity to replace an existing machine with the new machine that performs a particular manufacturing operation with more efficiency. Given the following information, Determine the cash flows associated with the replacement given that Revenue profits as well as capital gains / losses are subject to same tax rates. At present two full time machine operators Are paid salary of Rs. 25,000 each per year, Cost of maintenance is RS 25,000 per year, Cost defects are Rs. 20,000 per year. Original cost of old machine is RS 37,500. The expected life is 15 years And age 5 years. No salvage value. Depreciation method is SLM. Tax rate is 40 percent. Current market value of the old machine is RS 37,500. The new machine shall be fully automatic and no operator is required. The cost of new machine is Rs. 75,000, Installation fee Rs.7,500, transportation fee Rs. 5,000, Maintenance cost Rs. 12,500, cost of defects Rs. 7,500, expected life 10 years, additional working capital needed Rs. 12,500.

P5. Appu & Co. is considering investing in a project requiring a capital outlay of Rs. 2,00,000. Forecast for annual income after depreciation but before tax is as follows.

Year 1 2 3 4 5

Page 5 of 5 CAPITAL BUDGETING Prof. S. P. DAS

EBT 100000 100000 80000 80000 40000Depreciation is 20% on Straight Line Basis

You are required to evaluate the project according to each of the following methods.

a) Pay Back Periodb) Accounting Rate of Returnc) Discounted Pay back periodd) Net Present Value taking 14% discounting factore) Internal Rate of Return

P6. Champu & Co. is considering two mutually exclusive projects. Both require an initial investment of Rs. 50,000 each and have a life of five years. The cost of capital of the company is 10% and Tax rate is 50 percent. The depreciation is charged on straight line basis. The estimated net cash inflows before depreciation and tax of the two projects are as follows.

Year 1 2 3 4 5Project A 20000 22000 28000 25000 30000Project B 30000 27000 22000 25000 20000

Which project should be accepted as per net present value and internal rate of return methods?

P7. Laddu & Co. is setting up a project At the cost of Rs. 300 lacs. It has to decide whether to locate the plant in of forward area or Backward area. Locating in backward area Means the cash subsidy of s. 15 lacs From the central government. Besides, the taxable profits to the extent of twenty percent is exempt for 10 years. The project envisages a borrowing of Rs. 200 lacs in either case. The cost of borrowing will be 12 percent In forward area And 10% In backward area. However the revenue costs are bound to be higher in backward Region. The borrowings have to be repaid in 4 equal Annual installments beginning from the end of the fourth year. With the help of following information and by using DCF Method taking 15% discounting factor, you are required to suggest the proper location for the project. Year 1 2 3 4 5 6 7 8 9 10EBDIT – FA (Rs. in Lacs) (6) 34 54 74 108 142 156 230 330 430EBDIT – BA (Rs. in lacs) (50) (20) 10 20 45 100 155 190 230 330The annual depreciation may be taken at Rs. 30 Lacs. Average tax rate is 50%.

P8. Tattoo & Co. has following investment opportunities. The available funds are Rs. 300,000. Which proposal the firm should accept?

P9. You are required to calculate ARR and suggest which project is to be preferred based on the following information.

Project X Project YInvestment (Rs.) 1000000 1500000Working Capital (Rs.) 500000 500000Life (Years) 4 6Salvage Value 10% 10%Tax Rate 50% 50%

Proposals A B C DInvestment (Rs.) 200000 125000 175000 150000PV Index 1.15 1.13 1.11 0.08

Years 1 2 3 4 5 6EBDT - Project X 800000 800000 800000 800000 0 0EBDT - Project Y 1500000 900000 1500000 800000 600000 300000