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CAPITAL BUDGETING<br />Capital budgeting is a decision situation where large funds are committed (invested) in the initial stages of the project and the returns are expected over a long period of time. These decisions are related to allocation of investible funds to different long-term assets. <br />Capital budgeting is a continuous process and it is carried out by different functional areas of management such as production, marketing, engineering, financial management etc.<br />
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Classification of capital budgeting project<br />Capital expenditure projects can be classified in Replacement, Modernization, Expansion, Diversification, New project, Cost reduction, Statutory projects, etc. statutory projects are like a waste recycling plant in case of chemical plant.<br />
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BASIC FEATURES OF CAPITAL BUDGETING<br /><ul><li>Capital budgeting decisions have long-term implications.
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These decisions involve substantial commitment of funds.
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These decisions are irreversible and require analysis of minute details.
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These decisions determine and affect the future growth of the firm.</li></li></ul><li>Capital Budgeting Process<br />There are six steps to the Capital Budgeting Process.<br />Identification of potential investment opportunities <br />Assembling of investment proposal<br />Decision making,<br />Preparation of capital budget and appropriation<br />Implementation, and<br />Performance Review.<br />
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Capital Budgeting Decision Process<br />Capital Budgeting is the process of evaluating and selecting long-term investment projects that achieve the goal of owner wealth maximization.<br />Capital budgeting decisions are treated separately from the related financing decisions.<br />
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Basic Steps of Capital Budgeting<br /> <br />1. Estimate the cash flows<br /> <br />2. Assess the riskiness of the cash flows.<br /> <br />3. Determine the appropriate discount rate.<br /> <br />4. Find the PV of the expected cash flows.<br /> <br />5. Accept the project if PV of inflows > costs. IRR > Hurdle Rate and/or payback < policy<br />
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CAPITAL BUDGETING DECISION INVOLVES THREE STEPS:<br />Estimation of costs and benefits of a proposal or of each alternative.<br />Estimation of the required rate of return, i.e., the cost of capital <br />Selection and applying the decision criterion. <br />
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Capital Rationing Situation <br />Select the projects which have payback periods lower than or <br />equivalent to the stipulated payback period. <br />Arrange these selected projects in increasing order of their <br />respective payback periods. <br />Select those projects from the top of the list till the capital <br />Budget is exhausted. <br />
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Mutually Exclusive Projects <br />In the case of two mutually exclusive projects, the one with a lower payback period is accepted, when the respective payback periods are less than or equivalent to the stipulated payback period. <br />
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ESTIMATION OF CASH FLOWS<br />The costs and benefits for a capital budgeting decision situation are measured in terms of cash flows.<br />An important point is that all cash flows are considered on after tax basis. The rule is that all financial decisions are subservient to tax laws.<br />The cash flow from the project are compared with the cost of acquiring the project. <br />
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The cash flows may be grouped into relevant and irrelevant cash flows as follows:<br />Relevant cash flows Irrelevant cash flows<br /><ul><li> Cost of new project Sunk cost
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Scrap value of old / new plant Allocated </li></ul> overheads<br /><ul><li> Trade-in-value of oldplant Financial cash flows
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Tax benefit of incremental </li></ul> depreciation<br />
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TAX Shield<br />Tax shield is like a capital saving. Expenses which are deductible before tax lower the PBT and therefore lower tax payable. A tax shield is the reduction in income tax that results from taking an allowable deduction from taxable income. For e.g, because interest on debt is a tax deductible expenses , taking on debt creates a tax shiled. Since tax shield is a way to save cash flows, it increases the value of business, and it is an important aspect of financial management.<br />
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Sunk Costs, Opportunity Costs<br />Sunk Costs: outlays that have already been made and therefore have no effect on the cash flows relevant to a current decision.<br />Opportunity Costs: cash flows that could be realized from the best alternative use of an owned asset.<br />
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Operational and Financial Cash Flows<br />Operational items that affect EBIT should be considered relevant, while financial costs like interest, lease payments, and dividends are ignored.<br />Financial costs are considered in the discounting process of calculating NPV.<br />
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Calculating Cash Flows<br />Only incremental amounts are considered; compare the new asset with the old.<br />Ignore sunk costs but include opportunity costs.<br />Only include operational items; ignore financial costs.<br />Cash inflows must be after-tax; the firm only receives benefits after paying appropriate taxes.<br />
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Determining Initial Investment<br />The Initial Investment is the relevant cash outflows incurred if a capital budgeting project is implemented.<br />This often includes installation costs, and incremental costs of getting the asset to the point of generating cash inflows, less proceeds from the sale of old assets when replacement is taking place.<br />
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Change in Net Working Capital<br />The difference between the change in current assets and current liabilities associated with an investment project.<br />Changes in new working capital are not taxable because they merely involve the net buildup or reduction of current accounts.<br />
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Calculation of different cash flows may be summarized as follows:<br />INITIAL CASH OUTFLOW:<br />Cost of new plant<br /> + Installation expenses <br /> + Other Capital expenditure<br /> + Additional working capital <br /> – Tax benefit on account of capital loss on sale of old<br /> plant (if any)<br /> – Salvage value of old plant + Tax liability on account of<br /> capital gain on sale of old plant (if any).<br />
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SUBSEQUENT ANNUAL INFLOWS:<br />Profit after tax <br /> + Depreciation <br /> + Financial charge <br /> – Repairs (if any) <br /> – Capital Expenditure (if any).<br />TERMINAL CASH FLOW:<br /> Annual cash inflow <br /> + Working capital released <br /> + Scrap value of the plant (if any).<br />
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2. DECISION CRITERIA<br />TECHNIQUES OF EVALUATION<br />Traditional or Time-adjusted or <br /> Non-discounting Discounted cash flows<br /> 1. Payback period 1. Net Present Value<br /> 2. Accounting Rate of 2. Profitability Index<br /> Return 3. Internal Rate of Return<br />
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TRADITIONAL OR NON-DISCOUNTING TECHNIQUES<br />I . PAYBACK PERIOD:<br /># The payback period is defined as “the number of years required for the proposal’s cumulative cash inflows to be equal to its cash outflows.”<br /> # The payback period is the length of time required to recover the initial cost of the project.<br /> # The payback period may be suitable if the firm has limited funds available and has no ability or willingness to raise additional funds.<br />
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II . ACCOUNTING RATE OF RETURN (OR) AVERAGE RATE OF RETURN (ARR)<br /> # The ARR may be defined as “the annualized net income earned on the average funds invested in a project.”<br /> # The annual returns of a project are expressed as a percentage of the net investment in the project.<br /> COMPUTATION OF ARR:<br /> Average Annual profit (after tax)<br /> ARR = x 100<br /> Average Investment in the Project <br />
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DISCOUNTED CASH FLOWS OR TIME ADJUSTED TECHNIQUES<br /> These are based upon the fact that the cash flows occurring at different point of time are not having same economic worth.<br /> I.NET PRESENT VALUE (NPV) METHOD:<br /> The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with the proposal.<br /> The decision rule is “ Accept the proposal if its NPV is positive and reject the proposal if the NPV is negative”.<br />
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Net Present Value Method<br />Initial valuation should consider the present value of the asset’s incremental after-tax cash inflows.<br />Adding consideration for initial costs (C0), we have the Net Present Value of the project:<br /> NPV= PV. OF INFLOWS – PV OFOUTFLOWS <br />
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II. PROFITABILITY INDEX METHOD:<br />This technique is a variant of the NPV technique and is also known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.<br />Total present value of cash inflows<br /> PI = <br /> Total present value of cash outflows.<br /> Accept the project if its PI is more than 1 and reject the proposal if the PI is less than 1.<br />
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III. INTERNAL RATE OF RETURN (IRR) METHOD:<br /><ul><li> The IRR of a proposal is defined as the discount rate which produces a zero NPV, i.e., the IRR is the discount rate which will equate the present value of cash inflows with the present value of cash outflows.
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The IRR is also known as Marginal Rate of Return or Time Adjusted Rate of Return.
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The time-schedule of occurrence of future cash flows is known but the rate of discount is not.
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The discount rate calculated will equate the present value of cash inflows with the present value of cash outflows.</li></ul>IRR= <br />LOWER RATE+ NPV AT LOWER RATE x HIGHER RATE –LOWER RATE NPV AT LOWER RATE – NPV AT HIGHER RATE<br />
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Evaluating Projects<br />Capital budgeting techniques that integrate time value procedures, risk and return considerations, and valuation concepts to select capital expenditures that are consistent with the firm’s goal of maximizing owner’s wealth.<br />
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Issues with Calculating Cash Inflows Each Year<br />Assets with very long lives requires different calculations for each year’s CCA tax shield, since CCA is calculated on a declining balance of UCC.<br />A related problem is that the declining balance of UCC never reaches zero, so even at the end of a long lived project, the assets may still have a positive UCC value.<br />
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Capital Expenditure Motives<br />Capital Expenditures are an outlay of funds that are expected to produce benefits over a period of time greater than one year.<br />Operating Expenditures are an outlay of funds resulting in benefits received within one year.<br />The basic motives for capital expenditures are to expand, replace, or renew fixed assets over a long period.<br />
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CAPITAL BUDGETING PRACTICES IN INDIA<br /><ul><li>Capital budgeting decisions are undertaken at the top management level and are planned in advance. The Corporates follow mostly top-down approach in this regard.
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Discounted cash flow techniques are more popular now.
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High growth firms use IRR more frequently whereas Payback period is more widely used by small firms.
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PI technique is used more by public sector units than by private sector units.</li></ul>Capital budgeting decisions are of paramount importance as they affect the profitability of a firm, and are the major determinants of its efficiency and competing power.<br />
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