Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the goal of shareholders (owners) wealth maximization.
Capital budgeting decisions pertain to fixed/long term assets which, by definition, refers to assets which are in operation, and yield a return, over a period of time, usually, exceeding one year.
Type of decisions
Investment decisions affecting revenues
Investment decisions reducing costs
Capital Budgeting process
Independent projects (whose cash flows are independent of one another and the acceptance of one does not eliminate the other from further consideration).
Mutually exclusive projects (those compete with each other and the acceptance of one eliminates the other from further consideration)
Capital rationing (the firm has fixed amount to allocate among competing capital expenditures)
B. An Example of Mutually Exclusive Projects BRIDGE vs. BOAT to get products across a river. Projects are: mutually exclusive , if the cash flows of one can be adversely impacted by the acceptance of the other. Projects are: independent , if the cash flows of one are unaffected by the acceptance of the other.
Cash Flows v/s Accounting profit
Causes of differences:
Ambiguity in the estimation of stock , depreciation
Effect of taxes
Time value of money
X enterprise is determining the cash flow for a project involving replacement of an old machine by a new machine. The old machine, bought a few years ago, has a book value of Rs. 4 lac and it can be sold to realize a salvage value of Rs. 3 lac. It has a remaining life of 5 years after which its net salvage value is expected to be Rs. 160000. it is being depreciated annually at a rate of 25 percent under the written value method. The working Capital required for the old machine is 4 lac.
The new machine costs Rs. 16 lac. It is expected to fetch a net salvage of Rs. 8 lac after 5 years when it will no longer be required. The depreciation rate applicable to it is 25 percent under the written value method. The new working capital required for the new machine is Rs. 5 lac. The new machine is expected to bring a saving of Rs. 3 lac annually in manufacturing costs (other than depreciation). The tax rate applicable to the firm is 40 percent. The machine belongs to same asset class.
Calculate the incremental after tax cash flow associated with the project.
Pay Back Method
Net Present value Method
Internal Rate of return Method
What is the payback period?
The number of years required to recover a project’s cost,
or how long does it take to get the business’s money back?
Constant Annual Cash Flow
Payback for Project L 10 80 60 0 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback 2 + 30/80 = 2.375 years 0 100 2.4
Project S 70 20 50 0 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback S 1 + 30/50 = 1.6 years 100 0 1.6 =
C.2. Strengths of Payback: 1. Provides an indication of a project’s risk and liquidity . 2. Easy to calculate and understand. C.2. Weaknesses of Payback: 1. Ignores the TVM (time value of money) . 2. Ignores CFs occurring after the payback period.
Where is it useful?
In a political unstable country.
A firm with limited liquid assets and no ability to raise additional funds
The firms which lay more emphasis on short run earning performance rather than its long term growth
The pay back method is a good approximation of the internal rate of return.
10 80 60 0 1 2 3 CF t Cumulative -100 -90.91 -41.32 18.79 Discounted payback 2 + 41.32/60.11 = 2.7 yrs Discounted Payback: Uses discounted rather than raw CFs. PVCF t -100 -100 10% 9.09 49.59 60.11 = Recover invest. + cap. costs in 2.7 yrs.
NPV: Sum of the PVs of inflows and outflows. Cost often is CF 0 and is negative.
Rationale for the NPV Method NPV = PV inflows - Cost = Net gain in wealth. Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.
NPV : An Evaluation
It recognizes the time value of money.
It considers the total benefits arising out of the proposal.
A changing discount rate can be used accordingly.
Particularly useful in mutually exclusive projects
Somewhat difficult to calculate as well as to understand
Calculation of discount rate in the real world is somewhat difficult.
Internal Rate of Return: IRR 0 1 2 3 CF 0 CF 1 CF 2 CF 3 outflow Inflows IRR is the discount rate that equates the present value of cash inflows and present value of cash outflow. This is the same as forcing NPV = 0.
NPV: Enter k, solve for NPV. IRR: Enter NPV = 0, solve for IRR.
Rationale for the IRR Method If IRR > WACC, then the project’s rate of return is greater than its cost-some return is left over to boost stockholders’ returns. Example : WACC = 10%, IRR = 15%. Profitable.
IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.
If CFs are constant
A project costs Rs. 36000 and is expected to generate cash inflows of Rs. 11200 annually for 5 years. Calculate the IRR of the project.
For a mixed stream of cash flows
If the cash flows are not constant, in that case , the trial-and-error method is used to calculate the IRR.
Year Machine A Machine B
0 56125 56125
1 14000 22000
2 16000 18000
3 18000 18000
4 20000 16000
5 25000 17000
The ratio of the present value of a projects future net cash inflows to the present value of project's cash outflow.
PV of cash inflows
PV of cash outflows
A company is contemplating the introduction of a new machine. From the following information given to you, determine the profitability of the project, assuming 10 percent as cost of capital.