Capital budgeting

Capital Budgeting

1

CHAPTER – 1

CAPITAL BUDGETING

Capital budgeting, or investment appraisal, is the planning process used to

determine whether an organization's long term investments such as new

machinery, replacement machinery, new plants, new products, and research

development projects are worth the funding of cash through the firm's

capitalization structure (debt, equity or retained earnings). It is the process of

allocating resources for major capital, or investment, expenditures one of the

primary goals of capital budgeting investments is to increase the value of the

firm to the shareholders

The term Capital Budgeting refers to the long-term planning for proposed

capital outlays or expenditure for the purpose of maximizing return on

investments. The capital expenditure may be:

(1) Cost of mechanization, automation and replacement.

(2) Cost of acquisition of fixed assets. e.g., land, building and machinery etc.

(3) Investment on research and development.

(4) Cost of development and expansion of existing and new projects.

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DEFINITION OF CAPITAL BUDGETING

Capital Budget is also known as "Investment Decision Making or Capital

Expenditure Decisions" or "Planning Capital Expenditure" etc. Normally such

decisions where investment of money and expected benefits arising therefrom

are spread over more than one year, it includes both raising of long-term funds

as well as their utilization. Charles T. Hangmen has defined capital budgeting

as "Capital Budgeting is long- term planning for making and financing

proposed capital outlays."

In other words, capital budgeting is the decision making process by which a

firm evaluates the purchase of major fixed assets including building,

machinery and equipment. According to Hampton John.1. "Capital budgeting

is concerned with the firm's formal process, for the acquisition and investment

of capital."

From the above definitions, it may be concluded that capital budgeting relates

to the evaluation of several alternative capital projects for the purpose of

assessing those which have the highest rate of return on investment.

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CHAPTER -2

FEATURES OF CAPITAL BUDGETING

• Capital budgeting decisions are based on cash flows and not on accounting

income concept so for example if company spends $20000 on a project of 4

years then in normal accounting this expense would be accounted as $5000

every year assuming company uses straight line method of depreciation

whereas in case of capital budgeting it would be taken into account

immediately and shown as $20000 expense.

• Effects of acceptance of a project has on other project cash flows. For example

if a project has very good cash flow but if due to acceptance of that project

cash flows of current projects of the company are reduced than chances are that

project will not be undertaken and some other project will be selected.

• While making capital budgeting decision opportunity cost should be included

in project cost so for example if company has project which requires initial

outlay of $50000 and if the interest rate of fixed deposit is 8 % then while

making any decision company should take into account the loss of 8 % which

the company is incurring by not investing in fixed deposit.

• Time value of money is another important feature which should be taken into

account because while making capital budgeting decision company is likely to

favor those projects which start generating cash flows quickly because cash

flows received earlier are worth more than cash flow received later due to time

value of money.

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• Capital budgeting decision are taken by top level management because these

decisions are for long period of time usually more than a year and cost of asset

or project is very high and hence any mistake done can lead to locking of

capital of the company for long period of time and also can result in big losses

for the company in the long run.

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CHAPTER - 3

IMPORTANCE OF CAPITAL BUDGETING

Capital budgeting is important because of the following reasons:

• Develop and formulate long-term strategic goals:-

The ability to set long-term goals is essential to the growth

and prosperity of any business. The ability to appraise/value investment

projects via capital budgeting creates a framework for businesses to plan out

future long-term direction.

• Seek out new investment projects:-

Knowing how to evaluate investment projects gives a

business the model to seek and evaluate new projects, an important function

for all businesses as they seek to compete and profit in their industry.

• Estimate and forecast future cash flows:-

Future cash flows are what create value for businesses

overtime. Capital budgeting enables executives to take a potential project and

estimate its future cash flows, which then helps determine if such a project

should be accepted.

• Facilitate the transfer of information:-

From the time that a project starts off as an idea to the

time it is accepted or rejected, numerous decisions have to be made at various

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levels of authority. The capital budgeting process facilitates the transfer of

information to the appropriate decision makers within a company.

• Monitoring and Control of Expenditures:-

By definition a budget carefully identifies the necessary

expenditures and R&D required for an investment project. Since a good project

can turn bad if expenditures aren't carefully controlled or monitored, this step

is a crucial benefit of the capital budgeting process.

• Creation of Decision:-

When a capital budgeting process is in place, a company

is then able to create a set of decision rules that can categorize which projects

are acceptable and which projects are unacceptable. The result is a more

efficiently run business that is better equipped to quickly ascertain whether or

not to proceed further with a project or shut it down early in the process,

thereby saving a company both time and money.

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CHAPTER - 4

OBJECTIVES OF CAPITAL BUDGETING

The following are the important objectives of capital budgeting:

• Setting Priorities:-

You don't always spend capital on growth. Sometimes you have

to buy replacement equipment, for example. Your capital budget must clearly

define priorities, especially when you are faced with the choice between

maintaining current productivity and seeking additional income. Your capital

budget should make provisions for spending on assets that will keep your core

business operating, in addition to spending on new assets for growth.

• Purchasing Assets for Positive Returns:-

An asset produces income. An asset also costs money. One

objective of your capital budget should be to purchase assets whose net income

runs higher than the ongoing costs of the asset. For example, consider a printing

press that provides $500,000 of annual income and costs $200,000 in loan

interest plus $50,000 in maintenance. This purchase would meet the capital

budget objective of buying assets that produce positive returns.

• Alignment with Marketing Plan:-

If you buy income-producing assets, but have no marketing plan

for the products or services from those assets, they will go unused. An objective

of the capital budget is to support the marketing plan with strategic purchases.

The capital budget must clearly state criteria for meeting this objective. For

example, the budget could say, "No expenditure for assets shall be made

without a review of the marketing plan for that asset's output."

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• Keeping Pace with Projected Growth:-

Your growth projections depend on acquiring the assets that

contribute to that growth. The capital budget must be built around the objective

of making purchases that are timed with growth initiatives. For example, if you

anticipate increasing sales by 50 percent over the next year, your capital budget

must include money for assets that will help you produce or acquire more

products. This could be production equipment, for example, or warehouse

space to store additional inventory.

• Least-Cost Objective:-

The capital budget should contain an objective of keeping costs

low. For example, if you consider two assets that will both provide the same

income, the least expensive one fits in with the least-cost objective. Your

consideration must not focus on purchase or lease price only, but also on

maintenance costs.

• Keeping Debt in Line:-

Some capital expenditures require you to borrow money. The

budget can include loans as part of its resources, but the need for an asset does

not necessarily mean you can afford to service a loan for that asset. The capital

budget must set an objective of keeping your debt within the limits you set.

• Increased Retained Earnings:-

A capital budget should contain measures that will replenish the

capital expenditure account. In other words, when you buy an asset, part of the

income from that asset should go into retained earnings. Retained earnings do

not get paid out as dividends or other distributions. The capital budget can

Capital Budgeting

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earmark retained earnings from an asset for future capital expenditures.

Meeting the objective of using retained earnings for asset purchases can reduce

the need to borrow.

• Anticipating Inflation:-

A capital budget should set the objective of keeping up with

inflation. If you set a budget for an asset five years from the present, for

example, that budget should include expected price increases. These increases

will be estimates based on projected inflation rates, but estimates are better

than omissions. You will have rough price estimates in mind for future

purchases.

• Determine Product Scope:-

Capital budgeting lets project planners define the financial scope

of a project. Because capital budgeting begins long before the project begins,

it spells out how much money the business plans to spend on each individual

aspect of the project. For example, with a renovation, it determines how much

it is willing to spend on improving handicap accessibility or installing energy-

efficient heating units. Capital budgeting also determines the scope in terms of

the length of time the project will take as it also budgets for labor and potential

downtime.

• Determine Funding Sources:-

While capital budgeting spells out the details of project expenses,

it also details where the money is coming from to pay for the project. These

sources might include a capital investment account, cash, bank loans,

government or nonprofit grants or stock offerings. Most often, a project will

require a mix of those funding channels. The capital budgeting process

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identifies how much money will be needed from each source and the costs

associated with using that funding method.

• Determine Payback Method:-

An important element of capital budgeting is determining the

project's payback time. Most businesses expect a new building, new equipment

or renovation to eventually pay for itself. Some projects will pay for themselves

quicker than others. As there are several ways of calculating payback method,

some involving the present value of money and inflation, the capital budget

will have to identify which method the company plans to use. It will also

include an estimate of how long it will take for the business to realize a return

on their capital investment.

• Control Project Costs:-

Capital budgets act as control documents throughout the life of

the project. As the project progresses, the project managers track costs and try

to ensure that the project stays within budget. When there is an overage or a

significant underage, the project managers must provide explanations for the

variances and the business must make sure it has money to complete the

project. Typically a capital budget for a specific project is maintained until the

payback period is complete.

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CHAPTER - 5

CAPITAL BUDGETING PROCESS

The following procedure may be considered in the process of capital budgeting

decisions:-

(A) Identification of profitable investment proposals.

(B) Screening and selection of right proposals.

(D) Evaluation of measures of investment worth on the basis of profitability

and uncertainty or risk.

(E) Establishing priorities, i.e., uneconomical or unprofitable proposals may

be rejected.

(F) Final approval and preparation of capital expenditure budget.

(G) Implementing proposal, i.e., project execution.

(H) Review the performance of projects.

(I) Project identification and generation:-

The first step towards capital budgeting is to generate a proposal for

investments. There could be various reasons for taking up investments in a

business. It could be addition of a new product line or expanding the existing

one. It could be a proposal to either increase the production or reduce the costs

of outputs.

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(J) Project Screening and Evaluation:-

This step mainly involves selecting all correct criteria’s to judge the desirability

of a proposal. This has to match the objective of the firm to maximize its market

value. The tool of time value of money comes handy in this step.

Also the estimation of the benefits and the costs needs to be done. The total

cash inflow and outflow along with the uncertainties and risks associated with

the proposal has to be analyzed thoroughly and appropriate provisioning has to

be done for the same.

(K) Project Selection:-

There is no such defined method for the selection of a proposal for investments

as different businesses have different requirements. That is why, the approval

of an investment proposal is done based on the selection criteria and screening

process which is defined for every firm keeping in mind the objectives of the

investment being undertaken.

Once the proposal has been finalized, the different alternatives for raising or

acquiring funds have to be explored by the finance team. This is called

preparing the capital budget. The average cost of funds has to be reduced. A

detailed procedure for periodical reports and tracking the project for the

lifetime needs to be streamlined in the initial phase itself. The final approvals

are based profitability, Economic constituents, and viability and market

conditions.

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(L) Implementation:-

Money is spent and thus proposal is implemented. The different

responsibilities like implementing the proposals, completion of the project

within the requisite time period and reduction of cost are allotted. The

management then takes up the task of monitoring and containing the

implementation of the proposals.

(M) Performance review:-

The final stage of capital budgeting involves comparison of actual results with

the standard ones. The unfavorable results are identified and removing the

various difficulties of the projects helps for future selection and execution of

the proposals.

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CHAPTER - 6

CAPITAL BUDGETING DECISIONS

The crux of capital budgeting is profit maximization. There are two ways to it; either

increase the revenues or reduce the costs. The increase in revenues can be achieved

by expansion of operations by adding a new product line. Reducing costs means

representing obsolete return on assets.

• Accept / Reject decision:-

If a proposal is accepted, the firm invests in it and if

rejected the firm does not invest. Generally, proposals that yield a rate of return

greater than a certain required rate of return or cost of capital are accepted and

the others are rejected. All independent projects are accepted. Independent

projects are projects that do not compete with one another in such a way that

acceptance gives a fair possibility of acceptance of another.

• Mutually exclusive project decision:-

Mutually exclusive projects compete with

other projects in such a way that the acceptance of one will exclude the

acceptance of the other projects. Only one may be chosen. Mutually exclusive

investment decisions gain importance when more than one proposal is

acceptable under the accept / reject decision. The acceptance of the best

alternative eliminates the other alternatives.

• Capital rationing decision:-

In a situation where the firm has unlimited funds,

capital budgeting becomes a very simple process. In that, independent

investment proposals yielding a return greater than some predetermined level

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are accepted. But actual business has a different picture. They have fixed

capital budget with large number of investment proposals competing for it.

Capital rationing refers to the situation where the firm has more acceptable

investments requiring a greater amount of finance than that is available with

the firm. Ranking of the investment project is employed on the basis of some

predetermined criterion such as the rate of return. The project with highest

return is ranked first and the acceptable projects are ranked thereafter.

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CHAPTER – 7

ADVANTAGES AND DISADVANAGES OF CAPITAL

BUDGETING

Capital budgeting is a method of analyzing the possible risks and rewards of

an investment decision. Business managers utilize capital budgeting to assess

the potential costs of an investment over time. It helps managers determine

how investment costs correlate with business earnings. Capital budgeting has

many advantages. It serves as a financial-planning tool that, when used

correctly, can save a business from making poor and costly investment

decisions.

Multiple Budgeting Methods

An advantage of capital budgeting is that several budgeting techniques are

available to suit the varying needs of businesses. For example, the "net present

value" capital-budgeting technique measures an investment's profitability. This

method considers cash flows and analyzes the risk of future cash flows. The

"internal rate of return" capital-budgeting method helps a firm analyze which

investments or projects will yield the highest internal rate of return. A firm is

free to choose from the capital-budgeting techniques that will provide the most

complete and accurate information about a particular investment.

Risk Assessment

Capital budgeting is a unique decision-making and risk-assessment tool. It

gives businesses the opportunity to review potential investments and projects

individually and objectively. Capital budgeting allows businesses to compare

the value of a particular investment to the company's business plan and goals.

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It also offers the opportunity to determine if the investment or project makes

sense financially for the firm. Capital budgeting helps businesses understand

the anatomy of an investment, which in turn helps the firm understand the risks

involved.

Predict Potential Return

Many capital-budgeting methods allow a firm to predict the future value of an

investment by considering its current value. Capital budgeting also allows a

firm to determine how long it will take an investment to mature. Some

investment dollars could earn more in interest in a bank rather than in a

particular investment vehicle. Through capital budgeting, a firm is better

equipped to predict which investment tool will provide the best return.

Long-Term Planning

Capital budgeting is advantageous because it allows a firm to make long-term

investment decisions. Investment projects vary in size. Projects also have

different benefits to the business such as in increase in cash flow or a decrease

in risk. A firm typically cannot utilize current expenditures to evaluate a

capital-investment project because the project is often too large and requires a

significant amount of time to realize a return. Capital budgeting helps a firm

create long-term goals, analyze several investment opportunities and forecast

the results of the long-term project.

Capital budgeting is an important tool for leaders of a company when

evaluating multiple opportunities for investment of the firm’s capital. Every

company has both a limited amount of capital available and a desire to deploy

that capital in the most effective way possible. When a company is looking at,

for example, acquisitions of other companies, development of new lines of

business or major purchases of plants or equipment, capital budgeting is the

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method used to determine whether one option is better than another. There are

several capital budgeting methods, each with its pros and cons.

Capital Budgeting by Payback Period

The most-used method of capital budgeting is determining the payback period.

The company establishes an acceptable amount of time in which a successful

investment can repay the cost of capital to make it. Investment alternatives with

too long a payback period are rejected. Investment alternatives inside the

payback period are evaluated on the basis of the fastest payback.

Payback method disadvantages include that it does not account for the time

value of money.

Net Present Value Capital Budgeting

In net present value capital budgeting, each of the competing alternatives for a

firm’s capital is assigned a discount rate to help determine the value today of

expected future returns. Stated another way, by determining the weighted

average cost of capital over time, also called the discount rate, a company can

estimate the value today of the expected cash flow from an investment of

capital today. By comparing this net present value of two or more possible uses

of capital, the opportunity with the highest net present value is the better

alternative.

A disadvantage of the net present value method is the method's dependence on

correctly determining the discount rate. That calculation is subject to many

variables that must be estimated.

The Internal Rate of Return Method

An advantage of capital budgeting with the internal rate of return method is

that the initial calculations are easier to perform and understand for company

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executives who may not have a financial background. Excel has an IRR

calculation function.

The disadvantage of the IRR method is that it can yield abnormally high rates

of return by overestimating the value of reinvesting cash flow over time.

A Modification of the Internal Rate of Return Method

The modified rate of return method overcomes the tendency to overestimate

returns by using the company’s current cost of capital as the rate of return on

reinvested cash flow.

As with all methods of capital budgeting, the modified rate of return method is

only as good as the variables used to calculate it. However, by using the firm’s

cost of capital as one variable, it has a figure that is grounded in a verifiable

current reality and is the same for all alternatives being evaluated.

The Accounting Rate of Return

Many financial professionals in a firm, as opposed to top management, prefer

the accounting rate of return because it is most grounded in actual numbers.

Determining an investment’s accounting rate of return is a matter of dividing

the expected average profit after taxes from the investment by the average

investment. However, as with the payback period method, it does not account

for the time value of money.

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DISADVANTAGES OF CAPITAL BUDGETING

Companies looking to expand or introduce new product lines use capital

budgeting as a way to determine potential profits and losses associated with

particular projects. When deciding between different project options,

companies must determine which option will provide the best return on

investment. As the value of money may change with time, capital budgeting

methods have certain limitations in terms of anticipating the effects of future

economic conditions.

Capital Budgeting

Capital budgeting centers around+ capital expenditures, which involve large

outlays of money to finance potential projects. These types of projects --- such

as building expansions, advertising campaigns or research and development

plans --- typically last for more than a year and involve a range of different

variables within the planning process. As the number of variables increases,

the risk of miscalculations and lost revenues increases accordingly. In effect,

capital budgeting limitations become more pronounced as the number of

projects under consideration increases. Maximizing return on investment

requires companies to calculate current net profits and losses based on future

projections that may or may not play out.

Budgeting Methods

Companies may choose between different methods of capital budgeting based

on the types of criteria used to determine projected profits and costs. Capital

budgeting methods vary according to the type of criteria a company uses to

gauge profits and losses. One method, known as the pay-back period, bases

project selections on the length of time it takes a company to recover its initial

investment. Another method, known as the internal rate of return, bases project

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selections on the actual rate of return investors can expect to receive. The net

present value method calculates a project's current value based on the net result

from anticipated profits and losses.

With each method, companies must consider the cost outlay, time investment

and profit earnings based on the time investment for of resources --- such as

equipment and supplies for new product lines versus manpower for advertising

campaigns --- companies must determine which budget method will provide

the most effective or accurate calculations when selecting among different

projects.

Discounted Cash Flows

As economic markets change over time, capital budgeting decisions must

incorporate the effects of market changes to realize the real value of the

projects under consideration. Capital budgeting processes use discounted cash-

flow calculations to assess each project's present-day value. To do this,

managers must adjust a project's future cash-flow values in present-day cash-

value terms. In effect, managers discount future cash values based on

anticipated inflation effects and opportunity losses in terms of investing

available capital now versus letting the money earn interest on its own. This

focus on present-day values may place limitations on a company's ability to

choose the most cost-effective project in cases where miscalculations in

expected profit or cost margins occur.

Time Value of Money

Supply and demand levels within an economic market determine the time value

of money as interest rates rise and fall. High interest rates result in value

increases, while low interest rates lead to decreases in money value. Capital

budgeting calculations can't anticipate the changes that occur within economic

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markets or the conditions that trigger these changes. As a result, calculations

used to determine future profits and costs can only estimate money values

within different points in times.

• The technique of capital budgeting requires estimation of future cash flows and

outflows. The future is always uncertain and the data collected for future may

not be exact. Obviously, the results based upon wrong data can be good.

• There are certain factors like morale of the employees, good-will of the firm

etc.’ which cannot be correctly quantified but which otherwise substantially

influence the capital decision.

• Uncertainty and risk pose the biggest limitations to the techniques of capital

budgeting.

• The payback method ignores the time value of money. The cash inflows from

a project may be irregular, with most of the return not occurring until well into

the future. A project could have an acceptable rate of return but still not meet

the company's required minimum payback period. The payback model does

not consider cash inflows from a project that may occur after the initial

investment has been recovered. Most major capital expenditures have a long

life span and continue to provide income long after the payback period. Since

the payback method focuses on short-term profitability, an attractive project

could be overlooked if the payback period is the only consideration.

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CHAPTER – 8

METHODS AND IMPLEMENTATION

These methods use the incremental cash flows from each potential investment,

or project. Techniques based on accounting earnings and accounting rules are

sometimes used - though economists consider this to be improper - such as the

accounting rate of return, and "return on investment." Simplified and hybrid

methods are used as well, such as payback period and discounted payback

period.

Net Present Value (NPV),

Internal Rate of Return (IRR),

Payback Period,

Discounted Payback Period,

Average Accounting Rate of Return (AAR), and

Profitability Index (PI)

Net Present Value:-

Net present value is a widely used method of capital budgeting that determines

costs. Firms should always ensure that their rate of return of their investment

is always higher than their cost of capital and the premium that they place on

the risk of the investment. This concept is known as the hurdle rate. Net present

value is calculated by subtracting the present value of the costs from the present

value of the benefits of the capital project.

NPV = [ R1

(1+K)1 +

R2

(1+K)2 +

R3

(1+K)3 +

Rn

(1+K)n]-Initial investment

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Decision Rule

In case of standalone projects, accept a project only if it’s NPV is positive,

reject it if its NPV is negative and stay indifferent between accepting and

rejecting if NPV is zero.

In case of mutually exclusive projects (i.e. competing projects), accept the

project with higher NPV.

Example:- An initial investment of $8,320 thousand on plant and machinery

is expected to generate cash inflows of $3,411 thousand, $4,070 thousand,

$5,824 thousand and $2,065 thousand at the end of first, second, third and

fourth year respectively. At the end of the fourth year, the machinery will be

sold for $900 thousand. Calculate the net present value of the investment if the

discount rate is 18%. Round your answer to nearest thousand dollars.

Solution

PV Factors:

Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475

Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182

Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086

Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158

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The rest of the calculation is summarized below:

Year 1 2 3 4

Net Cash

Inflow $3,411 $4,070 $5,824 $2,065

Salvage Value 900

Total Cash

Inflow $3,411 $4,070 $5,824 $2,965

× Present Value

Factor 0.8475 0.7182 0.6086 0.5158

Present Value

of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31

Total PV of

Cash Inflows $10,888

− Initial

Investment − 8,320

Net Present

Value $2,568 thousand

Internal Rate of Return:-

Internal rate of return is a complex capital budgeting method. The internal rate

of return is the discount or interest rate that makes the income stream of an

investment sum to zero. The income stream of an investment is calculated by

adding the total cash flows of the project. The initial cash outflow begins as a

negative, with the interest, or benefits, received each year listed as a positive.

When the project is completed, the value of the investment is also added to the

negative initial investment figure and the yearly interest amount. Internal rate

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of return is the discount percent that makes these figures total to zero, and it is

helpful when comparing alternative investments or capital projects.

The Interpolation formula can be used to measure the Internal Rate of Return

as follows:

Lower Interest Rate + 𝑁𝑃𝑉 𝑜𝑓 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒

𝑁𝑃𝑉 𝑜𝑓 𝑙𝑜𝑤𝑒𝑟 𝑟𝑎𝑡𝑒 (−) 𝑁𝑃𝑉 𝑜𝑓 ℎ𝑖𝑔ℎ𝑒𝑟 𝑟𝑎𝑡𝑒 × (Higher rate

– Lower rate)

Decision Rule

A project should only be accepted if its IRR is NOT less than the target internal

rate of return. When comparing two or more mutually exclusive projects, the

project having highest value of IRR should be accepted.

Example;-

Speed age company ltd. Is considering a project which cost

Rs.5,00,000. The estimated Savage value is Zero tax rate 55%. The company

usages straight line depreciation and the proposed project has cash inflows

before depreciation and tax as follows:-

Year end Cash inflows (Rs.)

1 1,50,000

2 2,50,000

3 2,50,000

4 2,00,000

5 1,50,000

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Solution

YEA

R

CFBD

T

DEP NET

EARNI

G

TAX

55%

EAT CFAT

1 150000 10000

0

50000 2750

0

2250

0

12250

0

2 250000 10000

0

150000 8250

0

6750

0

16750

0

3 250000 10000

0

150000 8250

0

6750

0

16750

0

4 250000 10000

0

100000 5500

0

4500

0

14500

0

5 150000 10000 50000 2750

0

2250

0

12250

0

72500

0

Payback period = Cash Outlays (Initial Investment)

Annual Cash Inflows

= 500000725000

5𝑦𝑟𝑠

= 3.448

Capital Budgeting

28

Yea

r

CFAT PV

FACTO

R

PV OF

CFAT

PV

FACTOR

S

PV OF

CFAT

1 12250

0

0.893 109392.50 0.877 107432.5

0

2 16750

0

0.797 133497.50 0.769 128807.5

0

3 16750

0

0.712 119260.00 0.675 113062.5

0

4 14500

0

0.636 92220.00 0.592 85840.00

5 12200

0

0.567 69457.50 0.519 63577.50

5,23,827.5

0

498720.0

0

IRR=Lower Interest Rate + 𝑵𝑷𝑽 𝒐𝒇 𝒍𝒐𝒘𝒆𝒓 𝒓𝒂𝒕𝒆

𝑵𝑷𝑽 𝒐𝒇 𝒍𝒐𝒘𝒆𝒓 𝒓𝒂𝒕𝒆 (−) 𝑵𝑷𝑽 𝒐𝒇 𝒉𝒊𝒈𝒉𝒆𝒓 𝒓𝒂𝒕𝒆× (Higher rate – Lower

rate)

=12% + 𝟓𝟐𝟑𝟖𝟐𝟕.𝟓𝟎−𝟓𝟎𝟎𝟎𝟎𝟎

𝟓𝟐𝟑𝟖𝟐𝟕.𝟓𝟎−𝟒𝟗𝟖𝟕𝟐𝟎× (14% – 12%)

IRR =13.89%

Capital Budgeting

29

Payback Period:-

Payback period is perhaps the most simple method of capital budgeting. The

basic premise of this method is to determine the amount of time that is required

to recoup the funds spent on the capital project or equipment expenditure. The

payback period is calculated by dividing the total expenditure amount by a

desired time frame for investment recovery. Payback period doesn't take into

consideration the time value of money and therefore may not present the true

picture when it comes to evaluating cash flows of a project. Payback also

ignores the cash flows beyond the payback period. Most major capital

expenditures have a long life span and continue to provide cash flows even

after the payback period. Since the payback period focuses on short term

profitability, a valuable project may be overlooked if the payback period is the

only consideration. This method is not a recommended means of capital

budgeting due to its simplistic concept.

Payback period = Cash Outlays (Initial Investment)

Annual Cash Inflows

Decision Rule

Accept the project only if it’s payback period is LESS than the target payback period.

Example: - Mimosa company ltd has invested in a machine at a cost of Rs.

9,00,000. Following details are estimated:

Retrenchment in staff 4 staff @ salary of Rs. 20,000

Additional staff required 1 staff @ salary of Rs. 40,000

Capital Budgeting

30

Savings in wastages Rs.40,000

Savings in maintenance Rs.10,000

Additional electricity bill Rs.15,000

Calculate: pay-back period. Ignore Taxation and Depreciation.

Solution

rupees

Salary 4 staff @ rs. 20,000 80,000

Savings in maintenance 10,000

Savings in wastage 40,000

Total savings (1) 1,30,000

Additional costs:

rupees

Additional staff required 1 staff @ rs. 40,000 40,000

Additional electricity bill 15,000

Total additional expenses (2) 55,000

Capital Budgeting

31

Hence Net Cash Inflows/ ((1)-(2))

Net savings

Pay-back period = Cash Outlays (Initial Investment)

Annual Cash Inflows

= 900000

75000

= 12 years.

Discounted Pay-Back:-

This method is designed to overcome the limitation of the pay- back period

method. When saving are not leveled , it is better to calculate pay - back period

by taking into consideration the present value of cash inflows. Discounted pay-

back method helps to measure the present value of all cash inflows and

outflows at an appropriate discount rate. The time period at which the

cumulated present value of cash inflows equals the present value of cash

outflow is known as discounted pay-back period.

Discounted pay-back period = A + 𝐵

𝐶

Where,

A = last period with a negative discounted cumulative cash flow

B = absolute value of discounted cumulative cash flow end of period A

C = Discounted cash flow during the period after A

Capital Budgeting

32

Decision Rule

If the discounted payback period is less that the target period, accept the

project. Otherwise reject.

Example:-

An initial investment of $2,324,000 is expected to generate $600,000 per year

for 6 years. Calculate the discounted payback period of the investment if the

discount rate is 11%.

Solution

Step 1: Prepare a table to calculate discounted cash flow of each period by

multiplying the actual cash flows by present value factor. Create a cumulative

discounted cash flow column.

Year

n

Cash Flow

CF

Present Value

Factor

PV$1=1/(1+i)n

Discounted

Cash Flow

CF×PV$1

Cumulative

Discounted

Cash Flow

0 $

−2,324,000 1.0000 $ −2,324,000 $ −2,324,000

1 600,000 0.9009 540,541 − 1,783,459

2 600,000 0.8116 486,973 − 1,296,486

3 600,000 0.7312 438,715 − 857,771

4 600,000 0.6587 395,239 − 462,533

5 600,000 0.5935 356,071 − 106,462

6 600,000 0.5346 320,785 214,323

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years.

Capital Budgeting

33

Accounting Rate of Return (ARR):-

AAR calculated by using average net income and average book value during

the life of the project.

Unlike the other capital budgeting criteria AAR is based on accounting

numbers, not on cash flows. This is an important conceptual and practical

limitation.

The AAR also does not account for the time value of money, and there is no

conceptually sound cutoff for the AAR that distinguishes between profitable

and unprofitable investments.

The AAR is frequently calculated in different ways, so the analyst should

verify the formula behind any AAR numbers that are supplied by someone

else.

Analysts should know the AAR and its potential limitations in practice, but

they should rely on more economically sound methods like the NPV and IRR.

First, determine the average net income of each year of the project's life.

Second, determine the average investment, taking depreciation into account.

Third, determine the AAR by dividing the average net income by the average

investment.

Average accounting return does have a disadvantage; it does not take time

value of money into account. Therefore, there is no clear indication of

profitability.

ARR = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒

Capital Budgeting

34

Decision Rule

Accept the project only if it’s ARR is equal to or greater than the required

accounting rate of return. In case of mutually exclusive projects, accept the one

with highest ARR.

Examples:-

An initial investment of $130,000 is expected to generate annual cash inflow

of $32,000 for 6 years. Depreciation is allowed on the straight line basis. It is

estimated that the project will generate scrap value of $10,500 at end of the 6th

year. Calculate its accounting rate of return assuming that there are no other

expenses on the project.

Solution

Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in

Years

Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917

Average Accounting Income = $32,000 − $19,917 = $12,083

Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%

Profitability Index (PI)

The profitability index (PI) is the present value of a project’s future cash flows

divided by the initial investment.

PI is closely related to the NPV. The PI is the ratio of the PV of future cash

flows to the initial investment, while an NPV is the difference between the PV

of future cash-flows and the initial investment.

Whenever the NPV is positive, the PI will be greater than 1.0, and conversely,

whenever the NPV is negative, the PI will be less than 1.0

Capital Budgeting

35

Investment Rule:

Invest if PI >1.0

Do not invest if PI

<1.0

Assuming that the cash flow calculated does not include the investment made

in the project, a profitability index of 1 indicates breakeven. Any value lower

than one would indicate that the project's present value (PV) is less than the

initial investment. As the value of the profitability index increases, so does the

financial attractiveness of the proposed project.

PI = 𝑷𝑽 𝒐𝒇 𝒇𝒖𝒕𝒖𝒆 𝒄𝒂𝒔𝒉 𝒇𝒍𝒐𝒘𝒔

𝒊𝒏𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

= 1+ 𝑵𝑷𝑽

𝒊𝒏𝒕𝒊𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕

Decision Rule

Accept a project if the profitability index is greater than 1, stay indifferent if

the profitability index is zero and don't accept a project if the profitability index

is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in

capital rationing since it helps in ranking projects based on their per dollar

return.

Capital Budgeting

36

Example:-

Company C is undertaking a project at a cost of $50 million which is expected

to generate future net cash flows with a present value of $65 million. Calculate

the profitability index.

Solution

Profitability Index = PV of Future Net Cash Flows / Initial Investment

Required

Profitability Index = $65M / $50M = 1.3

Net Present Value = PV of Net Future Cash Flows − Initial Investment

Required

Net Present Value = $65M-$50M = $15M.

The information about NPV and initial investment can be used to calculate

profitability index as follows:-

Profitability Index = 1 + (Net Present Value / Initial Investment Required)

Profitability Index = 1 + $15M/$50M = 1.3

Capital Budgeting

37

CHAPTER - 9

CASE STUDY

• Droppit Parcel Company is considering purchasing new equipment to

replace existing equipment that has book value of zero and market value of

$15,000.

• New equipment costs $90,000 and is expected to provide production savings

and increased profits of $20,000 per year for the next 10 years.

• New equipment has expected useful life of 10 years, after which its estimated

salvage value would be $10,000.

• Straight-line depreciation

Effective tax rate: 34%

Cost of capital: 12%

• “Machinery Replacement” Problem: Should Droppit replace current

equipment?

1. Effective cost of new equipment: $80,100

– Droppits trades its old equipment in for new equipment by selling it and

applying sale proceeds to new equipment.

2. Calculate present value of expected benefits of new equipment.

– All benefits have been converted to after-tax basis before present values are

calculated.

– Profit increase is multiplied by 0.66 (1.00 – tax rate) to determine increased

profit remaining after tax.

– Calculate tax benefit resulting from effect of depreciation by multiplying

annual depreciation deduction by effective tax rate.

– Reflects salvage value of new equipment at end of its expected useful life.

Capital Budgeting

38

3. NPV: $13,068

4. IRR (solved by trial and error using electronic calculator): 15.7%

5. New machine should be purchased to replace old machine since NPV is

positive and IRR exceeds cost of capital.

Capital Budgeting

39

CHAPTER – 10

CONCLUSION

The DCF techniques, NPV, IRR, and PI are all good techniques. For capital

budgeting and allow us to accept or reject investment project. Consistent with

the goal of shareholder wealth maximization.

Beware, however there are times when one techniques output is better for some

decision or when a technique has to be modified given certain circumstances.

Due to the complexity and numerous issues related to the operating budget, our

scope focused primarily on the operating budget and less on the capital budget.

However, this section provides conclusions we derived from our review and

some areas designated for further study. The overall process of developing

requests and allocating funds for capital projects seems to work well, especially

given the complexities of construction funding, planning and management.

Despite FPCM’s strong management, there are still problems in the capital

project process that should be addressed. However, these problems are driven

as much by inefficiencies in resource allocation as by issues with the actual

construction management process.

Many campuses also find it difficult to fund the operating and ongoing

maintenance of new buildings with existing operating budget; while central

Administration often allocates new funds- through lump sum allocations, there

is great concern that these funds are not sufficient to keep up new buildings.

Also, many campuses have reallocated facilities dollars to fund other priorities;

at many campuses this led to costly repairs of buildings that have not been

properly maintained.

Capital Budgeting

40

CHAPTER - 11

BIBLIOGRAPHY

Books:

International Finance – V.A. Avadhani

Sites:

• www.shodganga.com

• www.investopedia.com

• www.infomedia.com

• www.rbi.org.in