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Capital Budgeting



topics



CAPITAL



CAPITAL

y Capital is the money you have got, or the money you

could raise by selling your possessions.

Thus, the cash is your wallet is capital.

In business terms, it means the cash in the bank, less

money owed. Plus the value of the building, computers,

furniture, vehicles, etc.. It is anything that can be

converted into cash.



Budget



BUDGET

y A budget is a description of a financial plan.

y It is a list of estimates of revenues and expenditures for astated period of time.

y

Normally a budget describes a period in the future not thepast.

y Budget is a financial tool of control

y Enable the actual financial operation of the business to be

measured against the forecast.y Types of budget



Indian School of Petroleum

The Basics of Capital Budgeting:

Should we

build this

plant?



Capital Budgeting

y Capital budgeting is the planning process used todetermine whether a firm's long term investments such asnew machinery, replacement machinery, new plants, new products, and research development projects are worthpursuing. It is budget for major capital, investment,expenditures

y Its an investment for long period of time

y Identifying potential investment (allocation of fund)

y Choose which investment to make

y Following up & monitoring investment



Examples

Replacement decision

Expansion decision

Diversification decision



POSITION OF CAPITAL BUDGETING

The Position of Capital Budgeting

Capital Budgeting

Long Term Assets Short Term Assets

Investment Decison

Debt/Equity Mix

Financing Decision

Divi end Payout Ratio

Dividend Decision

Financial Goal of the Firm:

Wealth Maximisation



Features & significance

y Long term effects :-

Long term effects on the risk & return composition of the firm

y substantial commitments :-

Large amount of money involve in project

Substantial portion of fund blocked in capital budgeting

y Irreversible decision:-

y

Affect the capacity & strength to compete :-



CAPITAL BUDGETING

Where do I investmy money?



CapitalBudgeting decision & fund availability

COSTBENEFITS



Capital Budgeting decision & fund availability

y No business firm can possibly afford to undertake all the

profitable all the profitable proposal

Why?

y

No firms has unlimited fundsy What are the sources of fund ?

Only those decision are to be implemented

The cost of the project does not exceeds the fund available

The benefits ex pected from the project is more than the cost



Assumptions & Procedures

y Assumptions:-

1. Certainty with respect to cost & benefits

2. Profit motives

3. No capital rationing

y Process:-

1. Estimation of cost-benefit of a proposal

2. Estimation of required rate of return

3. Using capital budgeting decision criterion



Capital Budgeting Techniques Of Evaluation

NPV

IRR ARR

PAYBACK PERIOD

P I



TraditionalTraditionalDiscounted cashflow/ Time adjustedDiscounted cashflow/ Time adjusted

y Pay back period

y Accounting rate of

return(ARR)

y Net present value(NPV)

y

Profitability index (PI)y Internal rate of return

(IRR)

TECHNIQUES OF CAPITALBUDGETING



PAY BACK PERIOD

y The number of years required to recover a project¶s cost, or³How long does it take to get our money back?´

y This is the most simple & easy, concept as well as in itsapplications

EXAMPLES

A. When annual cash flows are equal

Project life time 5 years

Initial investment Rs. 20,00,000

Expected constant annual inflow Rs. 8,00,000

Pay back period = (20,00,000/8,00,000) = 2.5 years



Example

B. when annual cash flows are unequal

Y ear Project X Project Y

Cashflow

Cumul.cash flow

Cashflow

Cumul.Cash flow

0 (100000) (100000)

1 25000 25000 15000 15000

2 35000 60000 20000 350003 40000 100000 25000 60000

4 47000 147000 40000 100000

5 50000 197000 42000 142000



Discounted payback period

y Uses discounted cash flows rather than raw CFs.

Disc PaybackL = 2 + / = 2.7 years

CFt -100 10 60 80

Cumulative -100 -90.91 18.79

0 1 2 3

=

2.7

60.11

-41.32

PV of CFt -100 9.09 49.59

41.32 60.11

10%



Limitations

y Pay back period does not give any clear picture of decisionrules.

y

It helps to compare with some predetermine target periody It fails to considered time value of money

y It over looks cash flow beyond payback period

y It ignore salvage value



EXAMPLE

Years 0 1 2 3

a. Investment

b. Sales

c. Operatingexpenses

d. Depreciation

e. PBT

f. Tax

g. PAT

(90000)120000

60000

30000

30000

2000

28000

100000

50000

30000

20000

2000

18000

80000

40000

30000

10000

2000

8000



y Average profit after tax

= (28000+18000+8000)/3 = 18000

y Average book value of investment

= 90000 ARR= ( 18000/90000) * 100 = 20%

Decision criteria:-

y Firm¶s required rate of return 18% (ARR accepted)

y Firm¶s required rate of return 22% (ARR rejected)



Discounted cash flow / time adjusted technique



Decision rules

y Accepted : if NPV of the project is positive.

y Rejected : if NPV is negative

y If NPV is zero: it is indifference

y If there are two and more mutually exclusiveprojects, the project with higher NPV should bechosen



Example

NPV= (45543+40647+36312+45156) ±100000

= 67658

Y ear 0 1 2 3 4Net CashFlow

(100000) 51000 51000 51000 71000

PVIF@12%

0.893 0.797 0.712 0.636

Present value

45543 40647 36312 45156



Profitability Index

y Benefits - Cost Ratio (BCR) :-It is define as a benefit per rupee invested in aproposal

y It is based on basic concept of discounting the futurecash flows

y Calculation of BCR = PV/I Where, PV = present value of future cash flows

I = initial investment



ACCEPT / REJECT RULES

y If PI is greater than or equal to 1, ACCEPT.

y If PI is less than 1, R EJECT

y In case of ranking mutually exclusive proposal , theproposal with the highest positive PI will be given toppriority & lowest will be given less priority



Examples

y Duration of the project 5 years

y Cost of fund 14%

Projec

ts

Initial

investment

Annual net cash

flow (1-5 YE ARS)

A (20) 7.5

B (4.5) 1.2

C (7) 2.5

D (8) 3.5



SOLUTIONS

PROJECTS BCR RANK

A 7.5 X PVIFA (14%, 5 YEARS)/ 20

=(7.5 X 3.433)/20 = 1.27

2

B (1.5 X 3.433) / 4.5 = 1.14 4

C (2.5 X 3.433)/ 7 = 1.23 3

D (3.5 X 3.433)/ 8 = 1.50 1



INTERNAL RATE OF RETURN (IRR)

y IRR is a rate of interest which makes all present valueof net cash flow equal to ³zero´.

y It is the rate, which equates the present value of the cashinflows to the present value of cash outflows.

y Decision rules:-

if IRR (r) is greater than cost of capital (k)

ACCEPT :- r>k



Calculation of IRR



EXAMPLE

yNPV at r=15% = 0.84

yNPV at r= 18% = 0.33

yNPV at r= 20% = 0

YEAR 0 1 2 3 4

CASH

FLOW

(1000000) 500000 500000 308000 120000



NPV vs. IRR



NPV ± IRR PROFILE



NPV vs. IRR

SUPERIORITY OF IRR OVER NPV

1. IRR gives percentage return while NPV gives

absolute return.

2. For IRR, the availability of required rate of return is not a pre-requisite while for NPV it ismust.



Selecting the appropriate technique

y Pay back Period

Immediate decision making

When two mutually exclusive project have equal

returny ARR ±objective of a firm is profit maximization

y NPV/IRR:- firms which are working for wealthmaximization

y PI :- benefit ± cost analysis



Problems in capital budgeting

y Future Uncertainty

y Time Element

y Measurement Problem



Points to be remember

1. Capital budgeting concern with investment for

long- term period

2. Two types of techniques

3. All discounted cash flow techniques allow ³ Time value of money´

4. NPV & IRR , maximizing share holders wealth

5. Capital budgeting can not avoid risk & uncertainty

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