Capital BudgetingKiran Thapa

Concept of Capital Budgeting

The process of planning investments in assets whose cash flows are expected to extend beyond one year

Term capital refers to long term assets used in production, while budget is a plan which details projected inflows and outflows during some future period.

Capital budget is the planned expenditure on long term assets and capital budgeting is the process of evaluating and selecting long term investments.

Irreversible decisions Growth Large amount of funds Risk Complex National importance

Importance

Classification of capital projects

Independent projects

Contingent projects

Mutually exclusive projects

Replacement projects

Expansion of business

Diversification projects

Cash flow is a process of income and expenditure of a

certain investment.

A series of income and expenditure over the life of the

investment project is known as cash flow stream.

Cash flow is of two types.

Cash inflows: Income, increase on an income, and

saving on expenditure.

Cash outflows: Expenditure, increase on an

expenditure, and investment.

Determination of cash flows

Finding initial investment Initial investment refers to the incremental

cash flows that occur only at the start of a project’s life.

Calculation of Initial investment Installed cost of new asset = -Change in working capital: Increase or decrease = - or +Investment tax credit = +Proceeds from sale of old asset = +Tax liability from gain = -Tax savings on loss = + Initial Investment = -

Finding the annual net cash flows Annual after tax cash flows from a capital

expenditure project. Calculation Sales revenue =…..Less: Cash expenses = …..EBDT Or savings =……Less: Depreciation = ……Earnings before taxes = …….Less: Income taxes = …….Earnings after taxes = …….Add: Depreciation = …….Cash flow after taxes (CFAT) =……..

Finding the final years net cash flow Terminal cash flow (final year CFAT) is the net

cash flow that occurs at the end of the life of a project.

Calculation

Differential Cash salvage value = ……..

Tax on gain = -…….

Tax save on loss = +…….

Working capital release in 0 year = -……

Terminal cash flow = ………

Rules for estimating CFAT

• Include only incremental costs

• Disregard sunk costs

• Include opportunity costs

• Always adjust for taxes

• Ignore financing cost

Traditional Methods Payback period Accounting rate of return

Discounted Cash Flow Methods Discounted Payback period Net Present value Profitability Index Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR)

Capital Budgeting Decision Rules

Time to recovered Initial Investment Calculation of Payback period Even Cash flows

PBP = Initial investment /Annual CFAT Uneven Cash flows

PBP = Minimum year + Amount to recover/CFAT of maximum year

Where, Amount to recover = Initial investment – Minimum year’s cumulative cash flow

Payback Period (PBP)

If PBP > Target payback period ↔ Reject the project

If PBP < Target payback period ↔ Accept the project

For Independent projects: Lower PBP is better

For mutually exclusive projects: Lower PBP is better

Advantages of PBP

1.Simple and easy to understand.

2.Measure the liquidity.

3.Deals with the risk.

Decision rules

Payback period contd.

Disadvantages

1.Ignores the time value of money

2.Ignores cash inflows after the payback period.

3.Difficultives in determining target PBP.

4.Not consistent with wealth maximization goal.

ARR is the annualized net income earned on the

average funds invested in a project.

ARR = Average earning after tax /Initial outlay or

average initial outlay

Decision rule:

ARR > target ARR = Accept the project.

ARR< target ARR = Reject the project

Accounting rate of return (ARR)

ARR contd. Advantages

1.Simple and easy to understand.

2.Consider the profitability.

3.Based on accounting data

Disadvantages

1.Ignores time value of money.

2.Based on accounting profits rather CFAT.

Discounted PBP (DPBP) Same as regular PBP except that it discounts

cash flow at the project’s cost of capital. Calculation

PBP = Min. year + Amount to recover /PV of CFAT of maximum year

Decision rule: Same as PBP

Net present value NPV is the present value of all the cash inflows

less present value of all cash outflows. NPV = TPV – NCO Or CF0

Decision rule

NPV > 0 , Accept the project

NPV< 0, Reject the project

For independent projects: Positive NPV project should be accepted.

For mutually exclusive projects: High positive NPV project should be accepted.

NPV contd. Advantages

1.Consider TVM

2.Uses Cash flows

3.Consistent with wealth maximization goal

Disadvantages

1.Involves difficult calculation

2.Difficult to determine required rate of return.

Profitability Index Ratio of Total present value and net cash outlay PI = TPV/NCO

Decision rule

PI > 1, Accepted

PI< 1, Rejected

Same accept and reject decision as NPV but ranking may be different.

Merit and demerits are same as NPV method.

Internal Rate of return (IRR) Discount rate that equates the present value of

cash inflows with the initial investment associated with a project.

IRR formula is same as NPV formula except it sets the NPV equal to zero and solves for the discount rate.

Decision rule:

IRR> cost of capital = Accept

IRR< cost of capital = Reject

IRR contdMerits

1.Consider the time value of money.

2.Consider the all cash flows

3.Consistent with wealth maximization goal.

Demerits

1.Involves tedious and complicated calculation

2.Produces multiple IRR

3.Future cash inflows are reinvested at IRR rate.

Modified IRR (MIRR)• The discount rate at which the present value of

a project’s cost is equal to the present value of its terminal value.

• Calculation

PV costs = Future value / (1 + MIRR)n

• Decision rule

MIRR> cost of capital = Accepted

MIRR < cost of capital = Rejected

MIRR contdMerits

1.MIRR gives single correct answer

2.Cash flows are reinvested at cost of capital.

3.Consider the TVM.

Demerits

1.It involves difficult calculations

2.MIRR suffer from some other drawbacks of IRR.

Any queries?

Thank You

?

NPV vs IRR IRR and NPV give same accept and reject

decisions IRR and NPV methods may rank projects

differently if the projects are of different costs, timing of cash flows differ, or have unequal lives.

NPV gives clear cut decision, while IRR may give multiple results.

NPV gives better ranking as compared to the IRR

NPV vs IRR contd. If two projects are independent, then the NPV

and IRR criteria always lead to the same accept and reject decision

When IRR and NPV methods give conflicting results, the NPV method should be relied upon since it gives the incremental addition to the value of the firm.

Projects with unequal lives If a company is choosing between two mutually

exclusive alternatives with significantly different lives, an adjustment may be necessary.

Equivalent Annual Annuity (EAA) method

Step 1: Calculate each project’s NPV at project’s required rate of return

Step 2: Find out the equivalent annual annuity (EAA)

EAA = NPV/PVIFAk,n

Unequal lives contd…Step 3: Find out the infinite horizon NPVs

Infinite horizon NPV = EAA/k

Step 4: Decision

Select the project with higher infinite horizon NPV.

Problems ABC company needs a car. There are two car options. Each type of car will cost Rs 50,000. The life of first car is 10 years and provide an after tax cash flow of Rs 9,500 per year. The second car will last for 15 years, and their annual after tax cash flow is estimated as Rs 8,140. The required rate of return of the company is 10 percent. Which car is better buy?

Ans: Infinity horizon NPV1 = Rs 13,630 and NPV 2 = 15,660

Problems contd. Janak Products, Inc., is considering purchasing new machine

which costs Rs 300,000 including installation and shipping. The machine is expected to generate Rs 100,000 sales revenue for 10 years and its operating cost will be Rs 50,000. At the end of 10 years, the book value of machine will be Rs 0, and it is anticipated that the machine will be sold for Rs 100,000. The investment tax credit is 10 percent Company will follow straight line depreciation. If the machine is undertaken, company will have to increase its net working capital by Rs 75,000. Janak requires a 12 percent annual return on this type of project and its margin tax rate is 40 percent. a. Calculate the initial investment outlay.

b. Calculate annual depreciation. c. Calculate the operating cash flows. d. Calculate the terminal cash flow. e. Is the project acceptable?

Contd. Ans: a. - 345,000 b. 30,000; c. 42,000; d. 135,000; e. – 64,221.6

A firm is considering purchasing a replacement machine. The existing machine can run for 5 more years producing annual revenues of Rs 60,000 with cash expenses of Rs 30,000. Its current book value is Rs 20,000 and it is being depreciated at Rs 4,000 per year down to a zero book value. The machine could be sold today to net Rs 8,000 it could be sold in 5 years to net Rs 5,000. The replacement machine will cost Rs 50,000 plus an additional Rs 20,000 to transport it to the factory and install it. It will generate revenues of Rs 90,000 but will have cash expenses of Rs 40,000. It will be depreciated using the straight-line method over a 5-year period at which time it will have a book value of Rs 20,000 and cash salvage value of Rs 25,000. The replacement machine will require additional working capital of Rs 5,000 to be permanently tied up. The firm decides to finance the cost of the machine by taking loans and the cost of transportation and installation, and the working capital by using its equity. The loan is available from the bank at 15% interest rate. The cost of equity of the firm at present is 18%. The firm uses its weighted average cost of capital to evaluate the investment proposals. The firm is in 40% tax bracket. The tax on capital gain/ loss is the same as in the case of ordinary income. Should the firm make the replacement? Base your answer on the payback period, NPV and IRR.

Ans: Ans: NCO = - 62,200 Diff. Dep = 6,000 CFAT = 14,400 for 4 years 5th year = 14,400 + 20,000 + 5000 = 39,400 K = 11.97% or 12% NPV = 3,894.12 PBP = 4.12 years IRR = 14.116%

Problems