Capital Budgeting Decision- SBS

8/2/2019 Capital Budgeting Decision- SBS

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Financial Managment

Shanti business School

Capital Budgeting decision


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Capital budgeting

Capital budgeting is the process of making decision

regarding capital expenditure in projects or assets

Capital Expenditure

For acquiring capital assets which are usedin the business

and not for resale and such assets would give benefits for

long period

Example: Land, Plant & Equipments


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Importance of capital Budgeting

Heavy Investment

Permanent commitment of funds

Long term Impact on profitability

Irreversible in nature


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Capital Budgeting process

Find Projects

Determine cash flows

Determine risk of those cash flows

Choose budget

Post audit


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Session plan First Half : Estimation

of cash flows

What is Cash flow ?

How to calculateproject cash flow ?

Issues to look for whilecalculating Cash flows.

Second Half:Techniques to evaluateprojects cash flows

Traditional methods forevaluating a project

Discounted Methods ofevaluating a project


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Sound Investment Decision Sound investment decisions should be based on

the net present value (NPV) of Cash flows .

What should be discounted?

In theory, the answer is obvious: We shouldalways discount the cash flows.

What rate should be used to discount cash flows?

In principle, the opportunity cost of capital shouldbe used as the discount rate


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Cash flow Vs Profit The words profit and cash flows are often used

interchangeably. Cash flow is different from profitbecause of mainly two reasons.

Profit is calculated using accrual concept ofaccounting

( Which says record the revenue/expense even if cash isnot Received/paid)

While calculating profit depreciation is deducted asexpense.

As deprecation does not result into any cash outflow it isadded back as source of cash in cash flow statement.

In other worlds, Cash flow = Profit + Depreciation


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Cash Flows The cash flow approach for measuring benefits is

theoretically superior to the accounting profitapproach as it

Avoids the ambiguities of the accounting profitsconcept,

Measures the total benefits and

Takes into account the time value of money.


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How to Calculate Cash flow ? Cash flow is equal to,

Revenues

Less: Expenses

Less: Depreciation Profit

Add back : Depreciation ( As it is Non-Cash Expense)

Less : Capital expenditure

Less : Working capital requirement (+/-)

Free Cash flow or Cashflow


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Project Cash flows

When deciding whether or not to make an investment, we

must first estimate the cash flows that the investment will

provide

Generally, these cash flows can be categorized as follows:

The initial outlay (IO)

The annual after-tax cash flows (ATCF)

The terminal cash flow (TCF)


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Relevant cash flows Determining the relevant cash flows can sometimes

be difficult, here are some guidelines

Cash flows must be:

Incremental (i.e., in addition to what you alreadyhave)

After-tax

Ignore those cash flows that are:

Sunk costs (money already spent, and notrecoverable)


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The Initial outlay The initial outlay is the total up-front cost of the

investment

The initial outlay can consist of many components, amongthese are:

The cost of the investment

Shipping and setup costs

Training costs

Any increase in net working capital

When we are making a replacement decision, we alsoneed to subtract the after-tax salvage value of the oldmachine (or land, building, etc.)


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The Annual After tax cash flows The annual after-tax cash flows (ATCF) are the

incremental after-tax cash flows that the investment willprovide

Generally, these cash flows fall into four categories:

Incremental savings (positive cash flow) or expenses(negative cash flow)

Incremental income (positive cash flow)

The tax savings due to depreciation

Lost cash flows (negative cash flow) from the existingproject. This is an opportunity cost.


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Terminal Cash flows

The terminal cash flow consists of those cash flows that

are unique to the last year of the life of the project

There may be a number of components of the TCF, but

three common categories are:

Estimated salvage value

Shut-down costs

Recovery of the increase in net working capital


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Types of Projects

Single proposal or new project

Replacement project

Mutually Exclusive projects


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In case of single project cash flows would be.

Cash outflow Year 0 Cash inflows (total life)

Cost of new project

+ Installation cost of

plant and equipment

Revenues

Less: Expenses

Less: depreciation

Profit

Add Depreciation

Less: Working capitalrequirements

Less : capital Expenditure


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Incremental Cash flow Incremental cash flow is the additional cash flow (

Cash inflow and outflow) that firm will incur if it takesa project.

It is the difference between firm and projects cash

flow

Firms

Cash flow(Withoutproject)

Firms cash

flow+

ProjectCash flow

IncrementalCash Flow


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Example Following is Firm ABC Data

Rs.1,00,000, revenue, Rs,70,000 cost and Rs, 10,000deprecation.

There is a proposal of project Y. by taking project yfirms new revenue would be Rs.1,30,000. costRs.90,000 and 15,000 depreciation.

What would be the incremental cash flow. (Assume

working capital and capital expenditure requirementis Zero)


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Firm ABC Incremental CashFlow

Particulars Firm + Project Y Firm withoutproject Y

Incremental CashFlow

Revenue 1,30,000 1,00,000 30,000

Less: Expenses 90.000 70,000 20,000

Less :Depreciation

15.000 10,000 5,000

Profit 25.000 20,000 5,000

Add: Depreciation 15.000 10,000 5,000

Cash flows 40.000 30,000 10,000


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Replacement Proposal In the case of replacement situation, the sale

proceeds from the existing asset reduce the cashoutflows required to purchase the new Asset. Therelevant Cash flows are incremental after-tax cash

inflows.

Cost of the new machine

+ Installation Cost

Working Capital

Sale proceeds of existing machine


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Replacement proposal cashflows

Cash outflow (incremental) Cash Inflow (incremental )

Cost of the new machine

+ Installation Cost

Working Capital

Sale proceeds ofexisting machine

Revenues

Less: Expenses

Less: depreciation(Incremental

Profit

Add Depreciation

Less: Working capital

requirementsLess : capital Expenditure

Cash flow


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Mutually exclusive projects Projects are mutually exclusive if accepting one

implies that the other projects will be foregone.

When projects are mutually exclusive and have equallives, you have to rank the projects based on their Net

present value of cash flows.

Choose the best project, provided the projects NPV ispositive

With mutually exclusive projects, choosing theproject with the highest NPV is always correct.


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Example Company X is considering a proposal of purchasing either

machine A or B. following are the cash flow associate withboth machines.

Guide which machine should company choose if discountrate is 10%

Particulars Machine A Machine B

Cost of machine 1,50,000 2,50,000

Incremental Cash flow for5 years

18,000 25,000

Salvage value 25,000 30,000

Discount rate 10% 10%


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Solution

Step 1: Present Value Of Cash Inflow Discounted at10%

Machine A : $83,757

Machine B : $ 1,13,397

Step 2 : Deduct total PV of Cash outflow fromCash Inflow

Machine A : $83,757 75,000 = $8,757 Machine B : $ 1,13,397-1,00,00=$13,397


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Methods of Capital Budgeting

Traditional methods

Pay back period method or pay out or pay off method

Discounted pay back period method

Rate of return method or accounting method

Time adjusted method or discounting method

Net present value method

Internal rate of return method

Profitability index method


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Payback Method

Payback period is the length of time required torecover initial cash outlay.

For Example

Here the payback period is 4 years because sumof cash flows during first four years equals toinitial investment

Cash flows

Initial outlay Year 1 Year 2 Year 3 Year 4 Year 5

-6,00,000 2,00,000 1,50,000 1,50,000 1,00,000 1,50,000


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Payback method

Decision criteria under payback method isAccept the projects with shorter payback period.

Advantage:1.Easy to calculate

Disadvantage:

1.Ignores the time value of money

2. Ignores the cash flows beyond payback period


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Discounted Payback

All cash flows are calculated taking into consideration

appropriate discount rate

Advantages:

It takes into consideration time value of money

Cash flows


-4,00,000 2,00,000 1,50,000 1,50,000 1,00,000 1,50,000

Discounted2,00,000/

1.101,50,000/(1.10)^2

1,50,000/(1.10)^3

1,00,000/(1.10)^4

1,50,000/(1.10)^5

D. payback 1,81,818 123967 112697 68301 93138

A i A R f R


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Accounting or Average Rate of ReturnMethod

ARR = Average annual profit / original investment * 100

For example

Average annual profit = (1,50,000 / 6,00,000) * 100

Here the ARR is 25%

Decision criteria: Accept the projects which gives you the

ARR higherthen the return required by company

Cash flows


-6,00,000 2,00,000 1,50,000 1,50,000 1,00,000 1,50,000


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Accounting or Average Rate ofReturn Method

Advantages:

Simple to calculate

No estimation Required

Disadvantages:

It is based on accounting profit not cash flow

It does not take into account time value of money


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Net present value [NPV] method

Decide appropriate discounting rate

Present value of estimated cash inflows and outflows

should also be computed

Equation for calculating NPV is as follows

NPV = P.V cash inflows P.V cash out flows

Criteria for Selection

Accept when NPV > zero

Reject when NPV < zero


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For example

Find the NPV if Required rate of return is 10%

NPV is Rs. 10124.74

Cash flows


-1,00,000 20,000 25,000 30,000 35,000 40,000


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Advantage:

Takes into account time value of money

Additive property: NPV (A+B) = NPV of project A +

NPV of project B

Limitations:

Its in Absolute terms not relative terms

Biased to long term projects in case projects are

mutually exclusive.


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P.I = Present value future cash inflow / Present value of futurecash outflow

For Example:

At 10% discount rate,

Profitability index for the project is 1,10,000 / 1,00,000 = 1.1Criteria for decision

Accept the project in P.I >1

Reject the project if P.I


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Profitability index [PI] or excesspresent value index method

Advantages:

Takes in to account Time value of money

Takes into account Scale on investment

Used when capital is scare


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Internal Rate of Return

Rate which makes present value of all future cash flows equals to

values of initial outlay or which makes NPV=0 (PV of Inflows = PV of

outflow)

IRR=Cash Inflows/ Cash outflows=1

Methods of finding IRR

Trial and Error

Excel

Example

IRR = 12%

Cash flowsInitial outlay Year 1 Year 2 Year 3 Year 4

-1,00,000 25,000 30,000 40,000 40,000


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Decision criteria

Accept the project If IRR is greaterthan required

rate of return by the investor.

Advantages

It takes into consideration Time value of money

It gives the same result as given by NPV


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Disadvantages: Projects with negative cash flows

For example

Cash flows Year 0 Year 1 Year 2-16,000 10,000 -10,000

Mutually exclusive projects

Project Initial investment Cash flow IRR NPV

A -10,000 20,000 100% 7,857.14

B -50,000 75,000 50% 16,964.29


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Which one to choose?

Survey evidence on percentage of CFOs using particular techniquefor evaluating investment projects

Source:J. R. Graham and C. R. Harvey, The Theory and Practice of Finance: Evidence from the Field, Journal ofFinancial Economics 61 (2001)

12%

20%

57%

76%

75%

0% 20% 40% 60% 80%

Profitability Index

ARR

Payback

IRR

NPV

Methods

Capital Budgeting Techniques


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In class exercise

Suppose you buy a land at Rs 10 lac and you

construct a building which costs Rs 5. you can

rent it to a hotel with annual rent of Rs 4 lac per

year for 5 years. If the Rate of interest is 10%

Will you invest in the project ?

In case the rate of interest increases to 12%

would it impact your decision?


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In class Exercise

Project InitialInvestment

Cash Flows1st Year 2nd Year 3rd Year 4th year 5th year

A -100,000 20000 30000 40000 40000 50000

B -75000 15000 15000 15000 15000 15000

C -150,000 50000 60000 40000 40000 50000

D -200,000 80000 70000 40000 40000 30000


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Decision

Based on each criteria which project would you

select

Payback

ARR

NPV

IRR

P.I.

Capital Budgeting Decision- SBS

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