MS 42 UNIT 5 Capital Budgeting Decisions.doc

MS-42 UNIT 5 CAPITAL BUDGETING DECISIONS

1. Explain the meaning and nature of Capital Budgeting Decisions?

Ans: The term capital budgeting refers to long-term planning for proposed capital outlays and their financing. Thus, it includes both raising of long-term funds as well as their utilisation. It may, thus, be defined as the “firm’s formal process for acquisition and investment of capital.” To be more precise, capital budgeting decision may be defined as “the firms' decision to invest its current fund more efficiently in long-term activities in anticipation of an expected flow of future benefit over a series of years.” The long-term activities are those activities which affect firms operation beyond the one year period. The basic feature of capital budgeting decisions is:

current funds are exchanged for future benefits; there is an investment in long-term activities; and the future benefits will occur to the firm over series of years.

Capital budgeting is a required managerial tool. One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

The term capital budgeting is the art of finding assets that are worth more than they cost, to achieve a predetermined goal.

A capital investment decision comprises:

Should we Build thisPlant?

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1. investment decision2. financing decisions3. dividend decisions

A capital investment decision involves a largely irreversible commitment of resources that is generally subject to significant degree of risk. For making a rational decision regarding the capital investment proposals at hand, the decision maker needs some techniques to convert the cash outflows and cash inflows of a project into meaning full yard sticks which can measure the economic worthiness of projects.

According to G. C. Philippalys, "Capital budgeting is concerned with the allocation of firm's scarce financial resources among the available market opportunities. The consideration of investment opportunities involves comparison of expected future streams of earnings from a project with immediate and subsequent streams of expenditure for it."

The capital investment decisions are important, crucial and critical business decisions due o following reasons:1. Substantial expenditure: Capital budgeting decisions

involves the investments of substantial amount of funds. It is therefore necessary for a firm to make such decisions after a thoughtful consideration so as to result in the profitable use of its scarce resources

2. Long period Time: The capital budgeting decisions has its effect over a long period of time. These decisions not only affect the future benefits and cost of the firm but also influences the rate and direction of growth of the Firm.

3. Irreversibility: Most of the investment decisions are irreversible. Once they are taken, the firm may not be in a position to reverse them back. This is because, as it is difficult to find a buyer for the second- hand capital items.

4. Complex decision: The capital investment decision involves an assessment of future events, which in fact is difficult to predict. Further it is quite difficult to estimate in quantitative terms all the benefits or the costs relating to a particular investment decision.

TYPES OF CAPITAL INVESTMENT DECISIONS

On the basis of firm’s existence

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1. Replacement and modernisation decisions: The Replacement and modernisation decisions aim at to improve operating efficiency and it to reduce cost. Generally all types of plants and machinery require replacement either because of the economic life of the plant or machinery is over or because it has become technologically outdated.2. Expansion decision: Existing successful firms may experience growth in demand of their product line. If such firms experience shortage or delay in the delivery of their products due to inadequate production facilities, they may consider proposal to add capacity to existing product line.3. Diversification decision: These decisions require evaluation of proposals of diversify into new product lines, new markets etc. for reducing the risk of failure by dealing in different products or by operating in several markets.

On the basis of decision situation

1. Mutually exclusive decisions: The decision are said to be mutually exclusive if two or more alternatives proposal are such that the acceptance of one proposal will exclude the acceptance of the other alternative proposals. 2. Accept reject decisions: The accept reject decision occurs when proposals are independent and do not compete with each other. The firm may accept or reject a proposal on the basis of a minimum return on the required investment. All those proposals which give a higher return than certain desired rate of return are accepted and the rest are rejected.3. Contingent decision: The contingent decisions are dependable proposals. The investment in one proposal requires investment in one or more other proposals.

2. Discuss the importance of Capital Budgeting Decisions. What are the steps to be taken while evaluating investment proposals?

Ans: IMPORTANCE OF CAPITAL BUDGETINGCapital budgeting decisions are of paramount importance in financial decision. So it needs special care on account of the following reasons:

Long-term Implications: A capital budgeting decision has its effect over a long time span and inevitably affects the company's future cost structure and growth. A wrong decision can prove disastrous for the long-term survival of firm. It leads unwanted expansion of assets, which results in heavy operating cost to the

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firm. On the other hand, lack of investment in asset would influence the competitive position of the firm. So the capital budgeting decisions determine the future destiny of the company.

Involvement of large amount of funds: Capital budgeting decisions need substantial amount of capital outlay. This underlines the need for thoughtful, wise and correct decisions as an incorrect decision would not only result in losses but also prevent the firm from earning profit from other investments which could not be undertaken.

Irreversible decisions: Capital budgeting decisions in most of the cases are irreversible because it is difficult to find a market for such assets. The only way out will be to scrap the capital assets so acquired and incur heavy losses.

Risk and uncertainty: Capital budgeting decision is surrounded by great number of uncertainties. Investment is present and investment is future. The future is uncertain and full of risks. Longer the period of project, greater may be the risk and uncertainty. The estimates about cost, revenues and profits may not come true.

Difficult to make: Capital budgeting decision making is a difficult and complicated exercise for the management. These decisions require an over all assessment of future events which are uncertain. It is really a marathon job to estimate the future benefits and cost correctly in quantitative terms subject to the uncertainties caused by economic-political social and technological factors.

Investment decision though taken by individual concerns is one of national importance because it determines employment, economic activities and economic growth.

CAPITAL INVESTMENT DECISION PROCESS

1. Search of investment opportunities: The first and probably most crucial stage in the process involves the recognition of opportunities. This involves a continuous search for investment opportunities which are compatible with the firm’s objective. Although business may pursue many goals, survivals and profitability are two most important objectives.2. Screening the alternatives: Each proposal is subjected to a preliminary screening process in order to assess whether it is technically feasible, resources required are available and the expected returns are adequate to compensate for the risk involved.

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It is required to determine whether such opportunities are worth further investigation.

3. Analysis of feasible Alternatives: It is a proposal satisfies the screening process it is then analysed in more detail by gathering technical, economic and other data. Projects are also classified into new products and ranked within such classification with respect to profitability and risk and degree of urgency.

4. Evaluation of alternatives: This stage will involve the determination of proposal and its investment, inflow and outflows.

5. Authorisation Once and evaluation is completed then proposal will be forwarded to a higher level of management for authorisation to take up the projects.

6. Implementation and control: if approved the project will be implemented and its progress is monitored with the aid of feedback reports. This report will be include the CPM techniques , Capex and progress reports, performance reports comparing actual performance against the plan set and forced completion Audits

Capital budgeting decisions commit companies to courses of action. The success or failure of a particular strategy, or even of the company itself, can hinge on one or a series of such decisions. In addition, capital budgeting decisions are generally riskier than short-term ones for the following reasons. The company expects to recoup its investment over a

longer period.

Reversing a capital budgeting decision is much more difficult than reversing a short-term decision.

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3. What are the techniques of Capital Budgeting Decisions?

Available of investment opportunities

Search for opportunities

Screening

Stakeholder Expectations

Rejection of Unviable proposals

Organisation goals

Selection

Authorization

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Evaluation

Review

Implementation

Market AnalysisTechnical AnalysisFinancial AnalysisEconomics Analysis

Investment Appraisal

Definition, analysis and generation of Feasible alternatives


Ans: The Capital Budgeting Decision Models

Discounted Cash Flow (DCF) Techniques:

Net present value (NPV) Internal rate of return (IRR) Profitability Index

Non discounted Cash Flow Techniques:

Payback period Accounting Rate of Return

4. What do you mean by pay back period? Explain Its merits and demerits.

Ans: The Payback MethodThis technique estimates the time required by the project to recover, through cash inflows, the firms initial outlay. Beginning with the project with the shortest payout period, different projects are arranged in order of time required to recapture their respective estimated initial outlays. The payback period for each investment proposal is compared with the maximum period acceptable to management and proposals are then ranked and selected in order of those having minimum payout period.

Cash benefits here represent cash flow after tax (CFAT) to pay back the original outlay required in an investment proposal

There are two ways of calculating the payback period. The first method can be applied when the cash flow stream is in the nature of annuity for each year of project's life, where cash flow adjusted techniques are uniform. In such a situation the initial cost of investment is divided by the constant annual cash flow. The second method is used when a project's cash flows are not equal, but vary from year to year. In such a situation payback is calculated by the process of accumulating cash flows till the time when cumulative cash flows are equal to original investment outlay.

Let us consider an example. Say, a project requires Rs. 30,000 as initial investment, and it will generate an annual cash inflow of Rs. 5,000 for ten years then pay back period will be five years, calculated as follows:

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Payback Period = Initial InvestmentsAnnual Cash Inflows

Payback Period = Rs.30,000 = 6 Years Rs.5,000

Accept / Reject criterion

The payback period can be used as a decision criterion to accept or reject an investment proposal. One application of this technique is to compare the actual payback period with a predetermined payback i.e., the payback set up by the management. If the actual payback period is less than the predetermined payback, the project will be accepted. If not, it will be rejected. Alternatively the payback can be used as a rationing method. When mutually exclusive projects are under one consideration, they may be ranked according to the length of payback period. Thus the project having the shortest payback may be assigned rank one followed in the order so that the project with longest payback might be ranked last. The term mutually exclusive refers to the proposals out of which only one can be accepted. Obviously project with shorter payback period will be selected.

Merits-The payback method has certain merits.

Its most outstanding merit is that it is easy to calculate and simple to understand.

The payback method is an improvement over the average rate of return approach. Its superiority arises due to the fact that it is based on cash flow analysis.

For a firm experiencing shortage of cash, the payback technique may be used with advantage to select investments involving minimum time to recapture the original investment.

Demerits The payback method however suffers from serious limitations. Its major shortcomings are as follows:

Ignores the time value of money. This weakness is eliminated with the discounted payback method.

It does not reflect all the relevant dimensions of profitability Ignores cash flows occurring after the payback period. This

could be very misleading in capital budgeting valuation Moreover, it does not take into account the salvage or residual

value, if any, of the long-term asset. The payback technique ignores the cost of capital as the cut-off

factor affecting selection of investment proposals.

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Suitability:Payback period method may be successfully applied in the following circumstances:

where the firms suffers from liquidity problem and is interested in quick recovery of fund than profitability;

high external financing cost of the project; for projects involving very uncertain return; and political and economic pressures.

It may, therefore, be said that payback period is defined as the measure of projects liquidity and capital recovery rather than its profitability.

5. Original cost of both the machines is Rs. 56,125. Cash flow of the fifth year includes RS 3,000 salvage value. Cash inflows are as under. Calculate payback period Under following cash flows:

Year Machine A (Cash Flow) Machine B (Cash Flow)

1 14,000 22,000

2 16,000 20,000

3 18,000 18,000

4 20,000 16,000

5 25,000 17,000Ans:

YearMachine A

(Cash Flow)Cumulative Cash

FlowsMachine B

(Cash Flow)Cumulative Cash

Flows

1 14,000 14,000 22,000 22,000

2 16,000 30,000 20,000 42,000

3 18,000 48,000 18,000 60,000

4 20,000 68,000 16,000 76,000

5 25,000 93,000 17,000 93,000

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Cash flow adjusted technique of fifth year includes Rs. 3,000 salvage value. The invested investment of Rs. 56,125 on Machine A will be received between 3 to 4 years. Payback period makes three years plus a fraction of a year.

Machine A56,125 - 48,000 = 8,125

(Balance of 8,125 >> received of fourth year)8,125 / 20,000 = 0.406 years + 3 preceding years = 3.406 years

Machine B2 years + (14,125 / 18,000) = 2.785 years

The average cash flows for both the machines under the average rate of return methods are the same. The payback period method shows that the payback period for Machine B should be preferred as it refunds the capital outlay earlier than Machine A.

6. What do you mean by Accounting Rate of Return? Explain its merits and demerits.

Ans: The Average Accounting Rate of Return MethodThis method is designated to consider the relative profitability of different capital investment proposals as the basis for ranking them - the fact neglected by the payout period technique. Since this method uses accounting rate of return, it is sometimes described as the financial statement method. Rate of return is calculated by dividing earnings by capital invested. The numerator, i.e., earnings can be interpreted in a number of ways. It might mean income after taxes and depreciation, income before taxes and depreciation, or income after taxes but before depreciation.

Average Rate of Return in Original Investment:

= Net earnings after Depreciation and taxes X 100Original investment

Average Rate of Return on Average Investment:

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= Net earnings after Depreciation and taxes X 100Average investment

Average investment = ½ [Initial cost + installation Expenses – Salvage Value] + Salvage Value + Additional Working Capital

Normally business firm determine rate of return. So accept the proposal ifARR > Minimum rate of return (cut off rate) andReject the project ifARR < Minimum rate of return (cut off rate)In case of more than one project, where a choice has to be made, the different projects may be ranked in descending or ascending order of their rate of return. Project below the minimum rate will be dropped. In case of project yielding rate of return higher than minimum rate, it is obvious that project yielding a higher rate of return will be preferred to all.Advantages:

Earnings over the entire life of the project are considered. This method is easy to understand, simple to follow. It is based on the accounting concepts of profit which are easily

calculated for financial data Disadvantages:

Like the payback technique, the average return on investment method also ignores the time value of funds. Consideration to distribution of earnings over time is important. It is to be accepted that current income is more valuable than income received at a later date.

The method ignores the shrinkage of original investment through the process of charging depreciation allowances against earnings. Even the assumption of regular recovery of capital over time as implied in average investment approach is not well founded.

The average rate of return on original investment approach cannot be applied to a situation where part of the investment is to be made after the beginning of the project.

Suitability:If the project life is not long, then the method can be used to have a rough assessment of the internal rate of return. The present method is generally used as supplementary tool only.

7. What do you mean by Net Present Value? Explain its merits and demerits.

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Ans: Net Present Value Method:

The net present value method is understood to be the best available method for evaluating the capital investment proposals. Under this method, the cash outflows and inflows associated with each project are ascertained first. Cash inflows are worked out by adding depreciation to profit after tax arising to each project*. Since the cash outflows and inflows arise at different point of time and cannot be compared, so both are reduced to the present values at the rate of return acceptable to the management. The rate of return is either cost of capital of the firm or the opportunity cost of capital to be invested in the project. The assumption under this method remain that cash inflows are reinvested at the same discount rate.

In essence, Net Present Value is the difference between the sum total of present values of all the future cash inflows and outflows

Merits

1. The most significant advantage is that it explicitly recognizes the time value of money, e.g., total cash flows pertaining to two machines are equal but the net present value are different because of differences of pattern of cash streams. The need for recognizing the total value of money is thus satisfied.

2. It also fulfills the second attribute of a sound method of appraisal. In that it considers the total benefits arising out of proposal over its life time.

3. It is particularly useful for selection of mutually exclusive projects.

4. This method of asset selection is instrumental for achieving the objective of financial management, which is the maximization of the shareholder's wealth. In brief the present value method is a theoretically correct technique in the selection of investment proposals.

Demerits

1. It is difficult to calculate as well as to understand and use, in comparison with payback method or average return method.

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2. The second and more serious problem associated with present value method is that it involves calculations of the required rate of return to discount the cash flows. The discount rate is the most important element used in the calculation of the present value because different discount rates will give different present values. The relative desirability of a proposal will change with the change of discount rate. The importance of the discount rate is thus obvious. But the calculation of required rate of return pursuits serious problem. The cost of capital is generally the basis of the firm's discount rate. The calculation of cost of capital is very complicated. In fact there is a difference of opinion even regarding the exact method of calculating it.

3. Another shortcoming is that it is an absolute measure. This method will accept the project which has higher present value. But it is likely that this project may also involve a larger initial outlay. Thus, in case of projects involving different outlays, the present value may not give dependable results.

4. The present value method may also give satisfactory results in case of two projects having different effective lives. The project with a shorter economic life is preferable, other things being equal. It may be that, a project which has a higher present value may also have a larger economic life, so that the funds will remain invested for longer period while the alternative proposal may have shorter life but smaller present value. In such situations the present value method may not reflect the true worth of alternative proposals. This method is suitable for evaluating projects whose capital outlays or costs differ significantly.

FormulaEach cash inflow/outflow is discounted back to its present value (PV). Then they are summed.

The equation for the net present value can be written as follows:NPV = _ C1___ + C2 + C3 + Cn - C0

(I + k) (1 + k) 2 (1 + k) 3 (1 + k) n

nor NPV = ∑ Ct__ _ C0

t =1 (1 +k)'

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Where, C1 C2 represents net cash inflows in year 1, 2 are the opportunity cost of capital. C0 is the initial cost of the investment and n is the expected life of the investment. It should be noted that the cost of capital. k, is assumed to be known and is constant. t = 1 = first period in the sum.

Decision Rule:

If NPV > Zero: Accept the project

NPV < Zero: Reject the project

NPV = Zero: Firm is indifferent to accept or reject the project.

Suitability:

Net present value is the most suitable method in those circumstances where availability of resources is not a constraint. The management authority can accept all those projects having Net Present Value either Zero or positive. This method shall maximise shareholders wealth and market value of share which is the sole aim of any business enterprise.

8. The following two projects A and B require an investment of Rs. 2, 00,000 each. The income after taxes for these projects is as follows

Year Project A (in Rs.) Project B (in Rs.)

1 80,000 20,0002 80,000 40,0003 40,000 40,0004 20,000 40,0005 ------- 60,0006 ----- 60,000

Using the following criteria, determine which of the project is preferable:

(i) 8 years pay back; (ii) Average Rate of Return iii) Present value approach if the company’s cost of capital is 10 per cent

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Ans: Note 1: Depreciation = Initial cost – Salvage value ÷ Life period

Project A: (Rs.2,00,000 – 0) ÷ 4 = Rs.50,000; Project B: (Rs.2,00,000 – 0) ÷ 6 = Rs.33,333

Calculation of Cash inflowsYear Project A Project B

EAT Cash inflow (Rs.)

Cumulative EAT Cash inflow

Cumulative

(Rs.) CFAT (Rs.) (Rs.) (Rs.) CFAT (Rs.)

1 80,000 1,30,000 1,30,000 20,000 53,333 53,3332 80,000 1,30,000 2,60,000 40,000 73,333 1,26,6663 40,000 90,000 3,50,000 40,000 73,333 1,99,9994 20,000 70,000 4,20,000 40,000 73,333 2,73,3325 ------- -------- -------- 60,000 93,333 3,66,6656 ------- -------- -------- 60,000 93,333 4,59,998

i) Initial investment = 2, 00,000

PBP: Project A: 1+ (70,000¸1,30,000) = 1.76 Years; Project B = 3 yearsDecision: Based on 8 years pay back both the projects should be selected Project A should be selected since their PBP is less than the 8 years pay back period which is to considered as standard pay back period. But Project A’ should be selected because its pay back period is less than the Project B.

ii) Computation of Average Rate of Return = (Annual Avg. IAT / Average investment) 100

Annual Average Income (AAI) = Total Earning after Taxes ÷ No. of years

Project A: 2,20,000 ÷ 4 = Rs.55,000;

Average Investment = 2,00,000 ÷ 2 = Rs.1,00,000

Average rate of return = (55,000 / 1,00,000)100 = 55 per cent

Project B: AAI = 2,60,000 ÷ 6 = Rs. 36,667

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Average investment = 2,00,000 ÷ 2 = Rs. 1,00,000

Average rate of return = (36,667 / 1,00,000 )100 = 36.67 per cent

Decision: Project A should be selected since its ARR is greater than the Project B.

c) Computation of Net Present Value (NPV)

Year CFAT (in Rs.) DF PV’s (in Rs.)Project A Project B 10 % Project

AProject

B

1 1,30,000 53,333 0.909 1,18,170 48,4802 1,30,000 73,333 0.826 1,07,380 60,5733 90,000 73,333 0.751 67,590 55,0734 70,000 73,333 0.683 48,181 50,0865 -------- 93,333 0.621 -------- 57,9606 -------- 93,333 0.564 ------ 52,640

Present Value of cash inflows 3,41,321 3,24,812

Less: Cash outflows 2,00,000 2,00,000

Net Present Values (NPV) 1,41,321 1,24,812

Decision: Based on the NPV both the Projects A and B eligible to accept. However, Project A is preferable since its NPV is more than that of Project B.

9. What do you mean by profitability index? Explain its merits and demerits.

Ans: The profitability index (PI) is the ratio of the present value of future expected cash flows subsequent to initial investment divided by the amount of the initial investment. This measure shows the relative profitability of any investment by showing the ratio of the benefit from

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an investment (the present value of cash inflows) to the cost (the present value of cash outflows). Thus, the PI indicates the value for each Rupee invested.

(PV of future cash flows) / (PV Initial investment) = Profitability Index

The above ratio is an indicator of the profitability of the project. If the ratio is equal to or greater than one, it shows that project has an expected yield equal to or greater than the discount rate. If the index is less than one, it indicates that project has an expected yield less than the discount rate.Decision Rule:If PI > 1 Accept the Project, PI = 1 indifferent, PI < 1 Reject the project.In the event of more than one alternatives, projects may be ranked according to their ratio - the project with the highest ratio should be ranked first and vice versa.

Advantages:

Profitability Index method gives due consideration to the time value of money.

Profitability Index method satisfies almost all the requirements of a sound investment criterion.

This method can be successfully employed to rank projects of varying cash and benefits in order of their profitability.

Disadvantages:

This method is more difficult to understand and compute. This method does not take into account the size of investment. When cash outflows occur beyond the cement period

Profitability Index Ratio criterion is unsuitable as a selection criterion

For Example

Given: Investment = 40,000 life of the Machine = 5 Years

Year CFAT

1 18000

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2 120003 100004 90005 6000

Calculate NPV @10% and PIAns:

YEAR CFAT PV 10% PV

1 18,000.00 0.909 16,362.00

2 12,000.00 0.827 9,924.00 3 10,000.00 0.752 7,520.00 4 9,000.00 0.683 6,147.00 5 6,000.00 0.621 3,726.00

Total present value 43,679.00 Less Investment 40,000.00

NPV 3,679.00

PI = 43679 / 40000 = 1.091 = >1

= so accept the project

10. What do you mean by Internal Rate of return? Explain its merits and demerits.

Ans: The internal rate of return (IRR) is defined as the interest rate that equates the present value of the expected future cash flows, or receipts, to the initial costoutlay. The equation for calculating the internal rate of return is : Here we know the value of Io and also the values of CF1,CF2,.....CFn, but we do not know the value of IRR. IRR = _ CF1___ + CF2 + CFn - I0

(I + IRR) (1 + IRR) 2 (1 + IRR) n

nor IRR = ∑ CFt__ _ I0 = 0

t =1 (1 +IRR) t

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Thus, we have an equation with one unknown, and we can solve for the value of IRR. Some value of IRR will cause the sum of the discounted receipts to equal the initial cost of the project, making the equation equal to zero, and that value of IRR is defined as the internal rate of return.

TABLE 1

YEAR CASH FLOW PV 10% PV VALUE 0 -1500 1 (1,500.00)1 150 0.909 136.35 2 300 0.826 247.80 3 450 0.751 337.95 4 600 0.683 409.80 5 1875 0.621 1,164.38

1875 796.28

The internal rate of return may be found by trial and error. First, compute the present value of the cash flows from an investment, using an arbitrarily selected interest rate - for example, 10 percent. Then compare the present value so obtained with the investment’s cost. If the present value is higher than the cost figure, try a higher interest rate and go through the procedure again. Conversely, if the present value is lower than the cost, lower the interest rate and repeat the process. Continue until the present value of the flows from the investment is approximately equal to its cost. The interest rate that brings about this equality is defined as the internal rate of return.Table-2 shows computation for the IRR for Project D in Table 1 and Figure 1 graphs the relationship between the discount rate and the NPV of the project.

Table 2: IRR for Project D

YEARCASH FLOW PV 10%

PV VALUE PV 20%

PV VALUE PV 25%

PV VALUE

PV 25.4%

PV VALUE

0 -1500 1 (1,500.00) 1 -1500 1

(1,500.00) 1 -1500

1 300 0.909 272.70 0.833 249.9 0.8 240.00 0.797 239.12 450 0.826 371.70 0.694 312.3 0.64 288.00 0.636 286.23 750 0.751 563.25 0.579 434.25 0.512 384.00 0.507 380.254 750 0.683 512.25 0.482 361.5 0.41 307.50 0.404 3035 900 0.621 558.90 0.402 361.8 0.328 295.20 0.322 289.8

1650 778.80 14.70

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219.75 (1.65) (00’S)

IRR = 25.4%

IF K ∞, THEN NPV RS.-1,500

In Figure1 the NPV of Project D’s cash flows decreases as the discount rate is increased. If the discount rate is zero, there is no time value of money and the NPV of a project is simply the sum of its cash flows. For Project D, the NPV equals Rs.1,650 when the discount rate is zero. At the opposite extreme, if the discount rate is infinite, then the future cash flows are valueless and the NPV of Project D is its current cash flow, –Rs.1,500. Somewhere between these two extremes is a discount rate which makes the NPV equal to zero. In Figure 5.1, we see that the IRR for Project D is 25.4 per cent.

The computation of Internal Rate of Return is relatively complicated and difficult compared to Net Present Value. One has to follow trial and error exercise to ascertain Internal Rate of Return (r) which equates the cash inflows and outflows of the investment proposals. Under net present value, k is known, but under this method it is worked out.

20

50

40

30

20

10

0

-10

10 20 30 40 50 k (%)


Starting with a guess at the IRR, r, the process is as follows:

1. The NPV is calculated using r. 2. If the NPV is close to zero then r is the IRR. 3. If the NPV is positive r is increased. 4. If the NPV is negative r is decreased. 5. Go back to step 1.

Initially the Internal rate of return (r) may giveNPV > 0 r > k (higher rate will be tried)NPV = 0 r = kNPV < 0 r < k (lower rate will be tried)

To calculate the exact figure, we use the method of interpolation i.e.

IRR (r) = L + A (H – L) OR A-B

IRR (r) = H + B (H – L) A-B

L = The lower rate of discount.A = NPV AT LOWER DISCOUNT RATE.B = NPV AT HIGHER DISCOUNT RATEH = The higher rate of discount.

Let us illustrate the method in two different situations:Uniform cash inflows Non-uniform cash inflows.

Let us consider a project where initial investment is Rs. 18,000. The annual cash flow will be Rs. 5,600 for a period of 5 years. The internal rate of return can be computed by computing the factor as underF = I/Cwhere,F = Factor to be locatedI = Initial investmentC = Average cash inflow

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After the factor is calculated as above, it is located in the different Annuity table on the line representing the number of years corresponding to the economic life of the project.In above example, according to annuity table, factor closest to 3.21 for five years are 3.2 (16% discount rate) and 3.199 (17% discount rate). Net Present Value for both the rates are as follows:

CASH FLOW( RS)

CLOSEST VALUE

TOTAL PV AT 16% RATE OF DISCOUNT

CASH FLOW( RS)

CLOSEST VALUE

TOTAL PV AT 17% RATE OF DISCOUNT

5,600.00 3.274 18,334.40 5600 3.199 17,914.40 Less: initial Outlay 18,000.00 18,000.00 NPV 334.40 (85.60)

Since Net Present Value is greater than zero i.e. Rs. 334.40 at 16% rate of discount, we need a higher rate of discount to equalise Net Present Value with total outlay. On other hand, Net Present Value is less than zero i.e. Rs. -85.60 at 17% rate of discount we need lower rate. So the above exercise shows that internal Rate of Return lies between 16% and 17%. To find out the exact figure, the interpolation can be used i.e.

IRR (r) = L + A (H – L) A-B

L = 16.A = 334.40.B = -85.60H = 17

IRR = 16 + 334.40/ 420 X 1 =16.80

Alternatively it can be worked out by using higher rate of return.

Accept / Reject decision

The use of IRR as a criterion to accept capital investment decision involves a comparison of actual IRR with required rate of return, also known as cut off rate or hurdle rate. The project should qualify to be

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accepted if the internal rate of return exceeds the cut off rate. If the internal rate of return and the required rate of return be equal, the firm is indifferent as to accept or reject the project. In case of mutually exclusive or alternative projects, the project which has the highest IRR will be selected provided its IRR is more than the cut off rate. In case there are budget constraints, the projects are ranked in descending order of their IRR and are selected subject to provisions.

Merits1. Is a theoretically correct technique to evaluate capital expenditure decision. It possesses the advantages which are offered by the NPV criterion such as, it considers the time value of money and takes into account the total cash inflows and outflows.

2. In addition, the IRR is easier to understand. Business executives and non-technical people understand the concept of IRR much more readily than they understand the concept of NPV. For instance, Business X will understand the investment proposal in a better way if it is said that the total IRR of Machine B is 21% and cost of capital is 10% instead of saying that NPV of Machine B is Rs. 15,396.

3. It itself provides a rate of return which is indicative of profitability of proposal. The cost of capital enters the calculation later on.

4. It is consistent with overall objective of maximizing shareholders wealth. According to IRR, the acceptance / rejection of a project is based on a comparison of IRR with required rate of return. The required rate of return is the minimum rate which investors expect on their investment. In other words, if the actual IRR of an investment proposal is equal to the rate expected by the investors, the share prices will remain unchanged. Since, with IRR, only such projects are accepted which have IRR of the required rate, therefore, the share prices will tend to rise. This will naturally lead of maximization of shareholders wealth. ^

The IRR suffers from serious limitations:

1. It involves tedious calculations. It involves complicated computation problems.

2. It produces multiple rates which can be confusing. This situation arises in the case of non-conventional projects.

3. In evaluating mutually exclusive proposals, the project with highest IRR would be picked up in exclusion of all others. However in practice

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it may not turn out to be the most profitable and consistent with the objective of the firm i.e., maximization of shareholders wealth.

4. Under IRR, it is assumed that all intermediate cash flows are reinvested at the IRR. It is rather ridiculous to think that the same firm has the ability to reinvest the cash flows at different rates. The reinvestment rate assumption under the IRR is therefore very unrealistic. Moreover it is not safe to assume always that intermediate cash flows from the project may be reinvested at all. A portion of cash inflows may be paid out as dividends, a portion may be tied up with current assets such as stock, cash, etc. Clearly, the firm will get a wrong picture of the project if it assumes that it invests the entire intermediate cash proceeds.

Further it is not safe to assume that they will be reinvested at the same rate of return as the company is currently earning on its capital (IRR) or at the current cost of capital (k).

Summary

Capital Budget Decision

Capital budgeting refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Basically the firm may be confronted with three types of capital budgeting decisions1. Accept / Reject decision - This is the fundamental decision in capital budgeting. If the project is accepted, the firm invests in it. If the proposal is rejected the firm does not invest. In general all those

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proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are rejected. By applying this criteria, all independent projects are accepted. Independent projects are projects that do not compete with one another in such a way that acceptance of one precludes the possibility of acceptance of another. Under the acceptance decision, all the independent projects that satisfy the minimum investment criteria are implemented.

2. Mutually exclusive project decision - Mutually exclusive projects are projects which compete with other projects in such a way that the acceptance of one will exclude the acceptance of other projects. The alternatives are mutually exclusive and only one may be chosen. It may be noted that the mutually exclusive project decisions are not independent of accept / reject decision. Mutually exclusive investment decisions acquire significance when more than one proposal is acceptable under the accept / reject decision. Then some techniques have to be used to determine the best one. The acceptance of 'best' alternative automatically eliminates the other alternatives.

3. 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 are accepted. However, this is not the situation prevailing in most of the business firm's of real world. They have fixed capital budget. A large number of investment proposals compete in these limited funds. The firm allocates funds to projects in a manner that it maximizes long run returns. Thus capital rationing refers to the situation where the firm has more acceptable investments requiring a greater amount of finance than is available with the firm. It is concerned with the selection of a group of investment proposals acceptable under the accept / reject decision. Ranking of the investment project is employed. In capital rationing, projects can be ranked 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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MS 42 UNIT 5 Capital Budgeting Decisions.doc

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investment of capital

capital investment decisions

term capital budgeting

capital investment proposals

financing decisions

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proposed capital outlays

firms decision