What is capital budgeting• Analysis of potential projects.• Long-term decisions; involve large expenditures.• Very important to firm’s future.
importance of capital budgeting• Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion.• Capital budgeting involves commitment of large amount of funds.• Capital decisions are required to assessment of future events which are uncertain.• In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss.• Capital budgeting ensures the selection of right source of finance at the right time.• Many firms fail, because they have too much or too little capital equipment.• Investment decision taken by individual concern is of national importance because it deter- mines employment, economic activities and economic growth.
Objective of capital budgeting• To ensure the selection of the possible profitable capital project• To ensure the effective control of capital expenditure in order to achieve by forecasting the long-term financial requirements.• To make estimation of capital expenditure during the budget period and to see that the benefits and costs may be measured in terms of cash flow.• Determining the required quantum takes place as per authorization and sanctions.• To facilitate co-ordination of inter-departmental project funds among the competing capital projects.• To ensure maximization of profit by allocating the available investible.
Steps in Capital Budgeting• Identification Stage – determine which types of capital investments are necessary to accomplish organizational objectives and strategies• Search Stage – Explore alternative capital investments that will achieve organization objectives• Information-Acquisition Stage – consider the expected costs and benefits of alternative capital investments
• Selection Stage – choose projects for implementation• Financing Stage – obtain project financing• Implementation and Control Stage – get projects under way and monitor their performance
Types of Capital ExpenditureCapital Expenditure can be of two types :Capital Expenditure Increases Revenue: It is the expenditure which brings more revenue to the firm either by expanding the existing production facilities or development of new production line.Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of present product and thereby increases the profitability of existing operations. It can be done by replacement of old machine by a new one.
Types Of Capital Investment Decisions• On the basis of firm’s existence – Replacement and Modernization decisions – Expansion decisions – Diversification decisions• On the Basis of Decision Situation – Mutually Exclusive Decision – Accept and Reject Decision – Contingent Decision
Cap Budgeting Evaluation Methods• Traditional method – Payback method – Average accounting return• Modern method – Net Present value method (N.P.V) – Internal rate of return method (I.R.R) – Profitability index method (P.I)
Pay-back Period MethodPay-back period is also termed as "Pay-out period" or Pay-off period. Payout Period Method is one of the mostpopular and widely recognized traditional method ofevaluating investment proposals. It is defined as the number of years required to recover theinitial investment in full with the help of the stream ofannual cash flows generated by the project.• Calculation of Pay-back Period: Pay-back period can be calculated into the following two different situations : (a) In the case of constant annual cash inflows. (b) In the case of uneven or unequal cash inflows.
(a) In the case of constant annual cash inflows : If theproject generates constant cash flow the Pay-back period can be computed bydividing cash outlays (original investment) by annual cash inflows. Thefollowing formula can be used to ascertain pay-back period :Pay-back Period = Cash Outlays (Initial Investment) /Annual CashInflows
Illustration• A project requires initial investment of Rs. 40,000 and it will generate an annual cash inflows of Rs. 10,000 for 6 years. You are required to find out pay-back period. Solution:• Pay-back Period = Cash Outlays (Initial Investment)/ Annual Cash Inflows = 40,000 / 10,000 = 4 YearsPay-back period is 4 years, the investment is fullyrecovered in 4 years.
(b) In the case of Uneven or Unequal Cash Inflows: Inthe case of uneven or unequal cash inflows, the Pay-back periodis determined with the help of cumulative cash inflow. It can becalculated by adding up the cash inflows until the total is equalto the initial investment.
IllustrationFrom the following information you are required to calculate pay-back periodA project requires initial investment of Rs. 40,000 and generate cash inflows of Rs.16,000, Rs. 14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth yearrespectively.Solution:• Calculation Pay-back Period with the help of "Cumulative Cash Inflows" Year annual cash flow (rs) cumulative cash inflows (rs) 1 16000 16000 2 14000 30000 3 8000 38000 4 6000 44000The above table shows that at the end of 4th years the cumulative cash inflowsexceeds the investment of Rs. 40,000. Thus the pay-back period is as follows : Pay-back Period = 3 Years +( 40000 – 38000) / 6000 = 3 Years + 2000/6000 = 3.33 Years
Average Rate of Return Method (ARR)• Average Rate of Return Method (ARR) : Average Rate of Return Method is also termed as Accounting Rate of Return Method. This method focuses on the average net income generated in a project in relation to the projects average investment outlay. This method involves accounting profits not cash flows and is similar to the pelformance measure of return on capital employed.• FormulasAverage Rate of Return (ARR) = Average income / Average investment x 100 or cash inflow – (after dep and tax )/ original investmentAverage Investment = Original Investment /2
Illustration• From the following information you are required to find out Average Rate of Return :An investment with expenditure of Rs.l0,OO,OOO is expected to produce thefollowing profits (after deducting depreciation) year rs 1 80,000 2 1,60,000 3 1,80,000 4 60,000
• SolutionAverage Rate of Return =Average Annual Profits – Depreciation and Taxes x 100 Average InvestmentsAverage Annual Profits = 80,000+1,60,000+1,80,000+60,000 4 = 1,20,000Average Investments (Assuming Nil Scrap Value) = investment in beginning + investment in end 2 = 10,00,000 + 0 2 = 5,00,000Average Rate of Return = 1,20,000 x 100 5,00,000 = 24%
Net present value• The difference between the market value of a project and its cost• How much value is created from undertaking an investment? – The first step is to estimate the expected future cash flows. – The second step is to estimate the required return for projects of this risk level. – The third step is to find the present value of the cash flows and subtract the initial investment.
Illustration• Mr A planning to invest rs 50 lac in a innovative machinery , the expected cash flow for 5 years period of time given below year cash inflow (rs) 1 10,00,000 2 12,00,000 3 15,00,000 4 18,00,000 5 25,00,000The cost of capital is @ 10%
Profitability index method (P.I)• Ratio of the present value of a projects cash flows to the initial investment. A profitability index number greater than 1 indicates an acceptable project, and is consistent with a net present value greater than 0• FormulaProfitability Index Present Value of Future Cash Flows Initial Investment Required
Illustration• 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.• SolutionProfitability Index = PV of Future Net Cash Flows / Initial Investment RequiredProfitability Index = 65M / 50M = 1.3 years
Internal rate of return method (I.R.R)• Internal Rate of Return Method is also called as "Time Adjusted Rate of Return Method." It is defined as the rate which equates the present value of each cash inflows with the present value of cash outflows of an investment. In other words, it is the rate at which the net present value of the investment is zero.
Illustration• x firm is considering a project the details of which are ,Investment Rs 70000Year Cash Inflow 1 15000 2 17000 3 19000 4 21000 5 26000Compute 1.R.R of the project:
Solution :Step I: Calculation of fack payback period on the basis of average cash inflows:Average cash inflows of all periods = 15000+17000+ 19000+ 21000+ 26000 5 = 98000 5 = Rs 19600Fack Payback period = Initial Cash outflow Average cash inflow = 7 0000 19600 = 3.57 years.
Step 2 : Locate fack payback period in annuity table A-2 (given at the end of the chapter) against the row of number of year of the project:
• We locate 3.517 in 5 year row. we find 3.517 which is annuity of Rs 1 at 13% rate. Therefore, our first discount rate is 13%Step 3:Now Find NPV at the first discount rate located above. Year Cash in flow Discount Factor Present Value 1 15000 .885 13275 2 17000 .783 13311 3 19000 .693 13167 4 21000 .613 12873 5 26000 .543 14118 66744 less original value 70000 NPV Rs-3256
• The other discount rate should be more than 13% or less than 13% Since NPV is negative at 13% discount rate the other discount rate should be less than 13% so that we can discount future cash inflows at lower rate and find a positive NPV. So, lets take the second discount rate at 11% NPV of the project at 11% discount rate : Year Cash in flow Discount Factor Present Value 1 15000 .901 13515 2 17000 .812 13804 3 19000 .731 13889 4 21000 .659 13839 5 26000 .593 15418 70465 less original value - 70000 NPV 465
Payback Accounting Net present Internal rate period rate of return value of return Basis of Cash Accrual Cash flows Cash flowsmeasurement flows income Profitability Profitability Measure Number Percent Rupees Percentexpressed as of years Amount Easy to Easy to Considers time Considers time Understand Understand value of money value of money Strengths Allows Allows Accommodates Allows comparison comparison different risk comparisons across projects across projects levels over of dissimilar a projects life projects Doesnt Doesnt Difficult to Doesnt reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the Limitations projects projects life Doesnt Doesnt give consider cash annual rates flows after over the life payback period of a project