Capital budgeting

Capital BudgetingCapital Budgeting

Meaning of capital budgetingMeaning of capital budgetingSignificanceSignificanceCapital budgeting processCapital budgeting processInvestment criteriaInvestment criteriaMethods of capital budgetingMethods of capital budgeting

Meaning Meaning The process through which different projects The process through which different projects

are evaluated is known as capital budgetingare evaluated is known as capital budgeting Capital budgeting is defined “as the firm’s Capital budgeting is defined “as the firm’s

formal process for the acquisition and formal process for the acquisition and investment of capital. It involves firm’s investment of capital. It involves firm’s decisions to invest its current funds for decisions to invest its current funds for addition, disposition, modification and addition, disposition, modification and replacement of fixed assets”.replacement of fixed assets”.

““Capital budgeting is long term planning for Capital budgeting is long term planning for making and financing proposed capital making and financing proposed capital outlays”- Charles T Horngreen.outlays”- Charles T Horngreen.

““Capital budgeting consists in planning Capital budgeting consists in planning development of available capital for the development of available capital for the purpose of maximising the long term purpose of maximising the long term profitability of the concern” – Lynchprofitability of the concern” – Lynch

The main features of capital budgeting are The main features of capital budgeting are

a. potentially large anticipated benefitsa. potentially large anticipated benefits

b. a relatively high degree of riskb. a relatively high degree of risk

c. relatively long time period between the initial c. relatively long time period between the initial outlay and the anticipated return. outlay and the anticipated return.

- Oster Young- Oster Young

Significance of capital budgetingSignificance of capital budgeting The success and failure of business mainly The success and failure of business mainly

depends on how the available resources are depends on how the available resources are being utilised. being utilised.

Main tool of financial managementMain tool of financial management All types of capital budgeting decisions are All types of capital budgeting decisions are

exposed to risk and uncertainty.exposed to risk and uncertainty. They are irreversible in nature.They are irreversible in nature. Capital rationing gives sufficient scope for the Capital rationing gives sufficient scope for the

financial manager to evaluate different proposals financial manager to evaluate different proposals and only viable project must be taken up for and only viable project must be taken up for investments.investments.

Capital budgeting offers effective control on cost Capital budgeting offers effective control on cost of capital expenditure projects.of capital expenditure projects.

It helps the management to avoid over investment It helps the management to avoid over investment and under investments. and under investments.

Capital budgeting process involves the followingCapital budgeting process involves the following

1. Project generation1. Project generation: Generating the proposals for : Generating the proposals for investment is the first step. investment is the first step.

The investment proposal may fall into one of the following The investment proposal may fall into one of the following categories: categories:

Proposals to add new product to the product line,Proposals to add new product to the product line, proposals to expand production capacity in existing proposals to expand production capacity in existing

lineslines proposals to reduce the costs of the output of the proposals to reduce the costs of the output of the

existing products without altering the scale of operation. existing products without altering the scale of operation.

Sales campaining, trade fairs people in the industry, R Sales campaining, trade fairs people in the industry, R and D institutes, conferences and seminars will offer and D institutes, conferences and seminars will offer wide variety of innovations on capital assets for wide variety of innovations on capital assets for investment. investment.

2.2. Project EvaluationProject Evaluation: it involves two steps: it involves two steps Estimation of benefits and costs: the benefits and Estimation of benefits and costs: the benefits and

costs are measured in terms of cash flows. The costs are measured in terms of cash flows. The estimation of the cash inflows and cash outflows estimation of the cash inflows and cash outflows mainly depends on future uncertainities. The risk mainly depends on future uncertainities. The risk associated with each project must be carefully associated with each project must be carefully analysed and sufficeint provision must be made analysed and sufficeint provision must be made for covering the different types of risks. for covering the different types of risks.

Selection of an appropriate criteria to judge the Selection of an appropriate criteria to judge the desirability of the project: It must be consistent desirability of the project: It must be consistent with the firm’s objective of maximising its market with the firm’s objective of maximising its market value. The technique of time value of money may value. The technique of time value of money may come as a handy tool in evaluation such come as a handy tool in evaluation such proposals.proposals.

3.3. Project SelectionProject Selection: No standard administrative : No standard administrative procedure can be laid down for approving the procedure can be laid down for approving the investment proposal. The screening and selection investment proposal. The screening and selection procedures are different from firm to firm. procedures are different from firm to firm.

4.4. Project EvaluationProject Evaluation: Once the proposal for capital : Once the proposal for capital expenditure is finalised, it is the duty of the finance expenditure is finalised, it is the duty of the finance manager to explore the different alternatives manager to explore the different alternatives available for acquiring the funds. He has to available for acquiring the funds. He has to prepare capital budget. Sufficient care must be prepare capital budget. Sufficient care must be taken to reduce the average cost of funds. He has taken to reduce the average cost of funds. He has to prepare periodical reports and must seek prior to prepare periodical reports and must seek prior permission from the top management. Systematic permission from the top management. Systematic procedure should be developed to review the procedure should be developed to review the performance of projects during their lifetime and performance of projects during their lifetime and after completion. after completion.

The follow up, comparison of actual performance with The follow up, comparison of actual performance with original estimates not only ensures better original estimates not only ensures better forecasting but also helps in sharpening the forecasting but also helps in sharpening the techniques for improving future forecasts. techniques for improving future forecasts.

Factors influencing capital budgeting Factors influencing capital budgeting Availability of fundsAvailability of funds Structure of capitalStructure of capital Taxation policyTaxation policy Government policyGovernment policy Lending policies of financial institutionsLending policies of financial institutions Immediate need of the projectImmediate need of the project EarningsEarnings Capital returnCapital return Economical value of the projectEconomical value of the project Working capital Working capital Accounting practiceAccounting practice Trend of earningsTrend of earnings

Methods of capital budgetingMethods of capital budgetingTraditional methodsTraditional methods Payback periodPayback period Accounting rate of return methodAccounting rate of return method

Discounted cash flow methodsDiscounted cash flow methods Net present value methodNet present value method Profitability index methodProfitability index method Internal rate of returnInternal rate of return

Pay back period methodPay back period method

It refers to the period in which the project will It refers to the period in which the project will generate the necessary cash to recover the initial generate the necessary cash to recover the initial investment. investment.

It does not take the effect of time value of money. It does not take the effect of time value of money.

It emphasizes more on annual cash inflows, It emphasizes more on annual cash inflows, economic life of the project and original investment. economic life of the project and original investment.

The selection of the project is based on the earning The selection of the project is based on the earning capacity of a project. capacity of a project.

It involves simple calcuation, selection or rejection of It involves simple calcuation, selection or rejection of the project can be made easily, results obtained is the project can be made easily, results obtained is more reliable, best method for evaluating high risk more reliable, best method for evaluating high risk projects. projects.

ConsCons It is based on principle of rule of thumb, It is based on principle of rule of thumb, Does not recognize importance of time value Does not recognize importance of time value

of money, of money, Does not consider profitability of economic Does not consider profitability of economic

life of project, life of project, Does not recognize pattern of cash flows,Does not recognize pattern of cash flows, Does not reflect all the relevant dimensions Does not reflect all the relevant dimensions

of profitability. of profitability.

Accounting Rate of Return methodAccounting Rate of Return methodIT considers the earnings of the project of the economic life. IT considers the earnings of the project of the economic life.

This method is based on conventional accounting concepts. This method is based on conventional accounting concepts. The rate of return is expressed as percentage of the The rate of return is expressed as percentage of the earnings of the investment in a particular project. This earnings of the investment in a particular project. This method has been introduced to overcome the disadvantage method has been introduced to overcome the disadvantage of pay back period. The profits under this method is of pay back period. The profits under this method is calculated as profit after depreciation and tax of the entire calculated as profit after depreciation and tax of the entire life of the project.life of the project.

This method of ARR is not commonly accepted in assessing This method of ARR is not commonly accepted in assessing the profitability of capital expenditure. Because the method the profitability of capital expenditure. Because the method does to consider the heavy cash inflow during the project does to consider the heavy cash inflow during the project period as the earnings with be averaged. The cash flow period as the earnings with be averaged. The cash flow advantage derived by adopting different kinds of advantage derived by adopting different kinds of depreciation is also not considered in this method.depreciation is also not considered in this method.

Accept or Reject CriterionAccept or Reject Criterion: : Under the method, all project, Under the method, all project, having Accounting Rate of return higher than the minimum having Accounting Rate of return higher than the minimum rate establishment by management will be considered and rate establishment by management will be considered and those having ARR less than the pre-determined rate. This those having ARR less than the pre-determined rate. This method ranks a Project as number one, if it has highest method ranks a Project as number one, if it has highest ARR, and lowest rank is assigned to the project with the ARR, and lowest rank is assigned to the project with the lowest ARR.lowest ARR.

MeritsMerits It is very simple to understand and use.It is very simple to understand and use. This method takes into account saving over the entire This method takes into account saving over the entire

economic life of the project. Therefore, it provides a better economic life of the project. Therefore, it provides a better means of comparison of project than the pay back period.means of comparison of project than the pay back period.

This method through the concept of "net earnings" ensures a This method through the concept of "net earnings" ensures a compensation of expected profitability of the projects andcompensation of expected profitability of the projects and

It can readily be calculated by using the accounting data.It can readily be calculated by using the accounting data.

DemeritsDemerits 1. It ignores time value of money.1. It ignores time value of money. 2. It does not consider the length of life of the projects.2. It does not consider the length of life of the projects. 3. It is not consistent with the firm's objective of maximizing 3. It is not consistent with the firm's objective of maximizing

the market value of shares.the market value of shares. 4. It ignores the fact that the profits earned can be 4. It ignores the fact that the profits earned can be

reinvested. -reinvested. -

Discounted cash flow methodDiscounted cash flow method

Time adjusted technique is an improvement over pay Time adjusted technique is an improvement over pay back method and ARR. An investment is essentially back method and ARR. An investment is essentially out flow of funds aiming at fair percentage of return out flow of funds aiming at fair percentage of return in future. The presence of time as a factor in in future. The presence of time as a factor in investment is fundamental for the purpose of investment is fundamental for the purpose of evaluating investment. Time is a crucial factor, evaluating investment. Time is a crucial factor, because, the real value of money fluctuates over a because, the real value of money fluctuates over a period of time. A rupee received today has more period of time. A rupee received today has more value than a rupee received tomorrow. In evaluating value than a rupee received tomorrow. In evaluating investment projects it is important to consider the investment projects it is important to consider the timing of returns on investment. Discounted cash timing of returns on investment. Discounted cash flow technique takes into account both the interest flow technique takes into account both the interest factor and the return after the payback 'period.factor and the return after the payback 'period.

Discounted cash flow technique involves the following Discounted cash flow technique involves the following steps:steps:

Calculation of cash inflow and out flows over the Calculation of cash inflow and out flows over the entire life of the asset.entire life of the asset.

Discounting the cash flows by a discount factorDiscounting the cash flows by a discount factor Aggregating the discounted cash inflows and Aggregating the discounted cash inflows and

comparing the total so obtained with the discounted comparing the total so obtained with the discounted out flows. out flows.

Net present value methodNet present value method

It recognises the impact of time value of money. It is It recognises the impact of time value of money. It is considered as the best method of evaluating the considered as the best method of evaluating the capital investment proposal.capital investment proposal.

It is widely used in practice. The cash inflow to be It is widely used in practice. The cash inflow to be received at different period of time will be received at different period of time will be discounted at a particular discount rate. The discounted at a particular discount rate. The present values of the cash inflow are compared present values of the cash inflow are compared with the original investment. The difference with the original investment. The difference between the two will be used for accept or reject between the two will be used for accept or reject criteria. If the different yields (+) positive value , criteria. If the different yields (+) positive value , the proposal is selected for invesment. If the the proposal is selected for invesment. If the difference shows (-) negative values, it will be difference shows (-) negative values, it will be rejected. rejected.

Pros: Pros: It recognizes the time value of money.It recognizes the time value of money.It considers the cash inflow of the entire project.It considers the cash inflow of the entire project.It estimates the present value of their cash inflows by It estimates the present value of their cash inflows by

using a discount rate equal to the cost of capital.using a discount rate equal to the cost of capital.It is consistent with the objective of maximizing the It is consistent with the objective of maximizing the

welfare of owners. welfare of owners. Cons:Cons:It is very difficult to find and understand the concept It is very difficult to find and understand the concept

of cost of capitalof cost of capitalIt may not give reliable answers when dealing with It may not give reliable answers when dealing with

alternative projects under the conditions of unequal alternative projects under the conditions of unequal lives of project. lives of project.

Internal Rate of ReturnInternal Rate of Return

It is that rate at which the sum of discounted It is that rate at which the sum of discounted cash inflows equals the sum of discounted cash inflows equals the sum of discounted cash outflows. It is the rate at which the net cash outflows. It is the rate at which the net present value of the investment is zero. present value of the investment is zero.

It is the rate of discount which reduces the NPV It is the rate of discount which reduces the NPV of an investment to zero. It is called internal of an investment to zero. It is called internal rate because it depends mainly on the outlay rate because it depends mainly on the outlay and proceeds associated with the project and and proceeds associated with the project and not on any rate determined outside the not on any rate determined outside the investment. investment.

Merits of IRR methodMerits of IRR method It consider the time value of moneyIt consider the time value of money Calculation of casot of capital is not a Calculation of casot of capital is not a

prerequisite for adopting IRRprerequisite for adopting IRR IRR attempts to find the maximum rate of IRR attempts to find the maximum rate of

interest at which funds invested in the project interest at which funds invested in the project could be repaid out of the cash inflows could be repaid out of the cash inflows arising from the project.arising from the project.

It is not in conflict with the concept of It is not in conflict with the concept of maximising the welfare of the equity maximising the welfare of the equity shareholders.shareholders.

It considers cash inflows throughout the life It considers cash inflows throughout the life of the project. of the project.

ConsCons Computation of IRR is tedious and difficult to Computation of IRR is tedious and difficult to

understandunderstand Both NPV and IRR assume that the cash Both NPV and IRR assume that the cash

inflows can be reinvested at the discounting inflows can be reinvested at the discounting rate in the new projects. However, rate in the new projects. However, reinvestment of funds at the cut off rate is reinvestment of funds at the cut off rate is more appropriate than at the IRR.more appropriate than at the IRR.

IT may give results inconsistent with NPV IT may give results inconsistent with NPV method. This is especially true in case of method. This is especially true in case of mutually exclusive project. mutually exclusive project.

Step 1:Calculation of cash outflowStep 1:Calculation of cash outflow

Cost of project/assetCost of project/asset xxxxxxxx

Transportation/installation chargesTransportation/installation charges xxxxxxxx

Working capitalWorking capital xxxxxxxx

Cash outflowCash outflow xxxxxxxx

Step 2: Calculation of cash inflowStep 2: Calculation of cash inflow

SalesSales xxxxxxxx

Less: Cash expensesLess: Cash expenses xxxxxxxx

PBDTPBDT xxxxxxxx

Less: DepreciationLess: Depreciation xxxxxxxx

PBTPBT xxxxxxxx

less: Taxless: Tax xxxxxxxx

PATPAT xxxxxxxx

Add: DepreciationAdd: Depreciation xxxxxxxx

Cash inflow p.aCash inflow p.a xxxxxxxx

Note: Note: Depreciation = St.Line methodDepreciation = St.Line method PBDT – Tax is Cash inflow ( if the tax PBDT – Tax is Cash inflow ( if the tax

amount is given)amount is given) PATBD = Cash inflowPATBD = Cash inflow Cash inflow- Scrap and working capital must Cash inflow- Scrap and working capital must

be added. be added.

Step 3: Apply the different techniquesStep 3: Apply the different techniques Pay back period= No. of years + Amt to recover/ Pay back period= No. of years + Amt to recover/

total cash of next years.total cash of next years. ARR = Average Profits after tax/ Net investment x ARR = Average Profits after tax/ Net investment x

100100 NPV= PV of cash inflows – PV of cash outflowsNPV= PV of cash inflows – PV of cash outflows Profitability index = PV of cash inflows/ PV of cash Profitability index = PV of cash inflows/ PV of cash

outflowsoutflows IRR : IRR :

Pay back factor: Cash outflow/ Avg cash inflow p.a.Pay back factor: Cash outflow/ Avg cash inflow p.a.Find IRR rangeFind IRR rangePV of Cash inflows for IRR range and then calculate PV of Cash inflows for IRR range and then calculate

IRRIRR

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