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PROJE

CT
REPOR
T ON
EVALU
ATION
OF
CAPITA
L
BUDGE
TING

Submitted By:
Itulung Kauring (13218)
Junu Dhanawat (13217)
Rajeev Taparia (13229)
Rahul Abujam (13222)
Raghav Bansal (13221)
Sanjog Choudhary (13263)

Project Report
On

Evaluation of Capital
Budgeting
[Corporate Finance]
Submitted for the partial completion of Bachelor in Management
Studies
Shaheed Sukhdev College of Business Studies
University of Delhi

Submitted By:
Itulung Kauring (13218)
Junu Dhanawat (13217)
Rajeev Taparia (13229)
Rahul Abujam (13222)
Raghav Bansal (13221)
Sanjog Choudhary (13263)

Certificate
This is to certify that the project entitled Evaluation of Capital
Budgeting, is submitted by Itulung Kauring(13218), Rahul
Abujam(13222), Rajeev Taparia(13229), Junu Dhanawat(13217),
Raghav Bansal(13221), Sanjog Choudhary(13263) of Third Semester
during the Three Years Undergraduate Programme in Bachelor in
Management Studies at Shaheed Sukhdev College of Business Studies,
University of Delhi, under the supervision of Mr. Amit Kumar during the
period of July 2014 to December 2014.
They have successfully completed the project within the stipulated
period of time.

Amit Kumar
(Project Guide)

Declaration
We hereby declare that the work presented in the project report
entitled Evaluation of Capital Budgeting, submitted for the partial
fulfilment of Bachelor in Management Studies, is an authentic record of
our own, carried out under the guidance of Mr. Amit Kumar, SSCBS, DU.

Itulung Kauring (13218)


25/10/2014

Junu Dhanawat (13217)

Rajeev Taparia (13229)

Rahul Abujam (13222)

Raghav Bansal (13221)

Sanjog Choudhary (13263)

Date:

Acknowledgement
First of all, we are very thankful to Shaheed Sukhdev College of
Business Studies, University of Delhi for giving us an opportunity to
work on this project.
Through this project we have acquired invaluable knowledge about
Evaluation of Capital Budgeting through online research study and
various books.
We express our sincere thanks to our project guide Mr. Amit Kumar,
who had given us a thorough knowledge of Corporate Finance and
guided us throughout the project.
Any flaws found in this project is deeply regretted

Table of Contents
Abstract................................................................................................ 1
Objective............................................................................................... 2
Research methodology.......................................................................... 3
Introduction........................................................................................... 4
Capital budgeting principle...................................................................5
Important Concepts in Capital Budgeting...........................................6
Capital Budgeting Process..................................................................... 8
Complexity of Capital Budgeting Process............................................9
Capital Budgeting Evaluation Methods................................................10
Understanding the Project Types.......................................................10
Net Present Value (NPV)....................................................................11
Internal Rate of Return...................................................................... 11
Payback Period.................................................................................11
Profitability Index.............................................................................. 12
Selection of method.......................................................................... 12
Capital Budgeting Classification..........................................................14
Case Study: Evaluating the desirability of an investment....................16
Conclusion.......................................................................................... 18
Bibliography........................................................................................ 19

Abstract
The term Capital Budgeting refers to long term planning for proposed
capital outlay and their finance. It includes raising long-term funds and
their utilization. It may be defined as a firm's formal process of
acquisition and investment of capital. Capital budgeting may also be
defined as "The decision making process by which a firm evaluates the
purchase of major fixed assets". It involves firm's decision to invest its
current funds for addition, disposition, modification and replacement of
fixed assets. It deals exclusively with investment proposals, which is
essentially long-term projects and is concerned with the allocation of
firm's scarce financial resources among the available market
opportunities.
Some of the examples of Capital Expenditure are
Cost of acquisition of permanent assets as land and buildings.
Cost of addition, expansion, improvement or alteration in the fixed
assets.
R&D project cost, etc.
Capital budgeting is concerned with allocation of the firm's scarce
financial resources among the available market opportunities. The
consideration of investment opportunities involves the comparison of
the expected future streams of earnings from a project with immediate
and subsequent streams of expenditure for it. In any growing concern,
capital budgeting is more or less a continuous process and it is carried
out by different functional areas of management such as production,
marketing, engineering, financial management etc. all the relevant
functional departments play a crucial role in the capital budgeting
decision are considered.
The role of a finance manager in the capital budgeting basically lies in
the process of critical and in-depth analysis and evaluation of various

alternative proposals, and then to select one out of them. As already


stated, the basic objectives of financial management is to maximize
the wealth of the shareholders, therefore the objectives of capital
budgeting is to select those long term investment projects that are
expected to make maximum contribution to the wealth of the
shareholders in the long run.

Objective

To study the relevance of capital budgeting in an organization and


its evaluation
To study the technique of capital budgeting for decision making
To understand an item wise study of the organization financial
performance
To know about an organizations operation of using various capital
budgeting techniques
To know how the organization gets funds from various resources

Research methodology
The research design of this study is descriptive in nature. This study is
based on secondary data which was obtained from various sources
online as mentioned in the bibliography of this project report. With the
help of the secondary data we have studied about the detailed
evaluation of capital budgeting, capital budgeting principle, capital
budgeting process and capital budgeting classifications. We have also
done cases study of capital budgeting, evaluating the desirability of an
investment and discussed about the factors involved in decision
making.

Introduction
In todays ever changing world, the only thing that does not change is
change itself. Successful companies are always looking at ways in
which they can change and develop. Change can trigger corporate
growth and Growth is essential for sustaining the viability, dynamism
and value enhancing capability of a company, which lead to a higher
profit and better the shareholders value. To achieve the desired
growth, the firm has to be competitive in all functional areas especially
in financial management which is the back bone of any business.
Primarily growth can be measured in terms of change in investments or
sales. A progressive business firm continually needs to expand its fixed
assets and other resources to be competitive in the race. Investment in
fixed assets is an important indicator of corporate growth. The success
of the corporate in the long run depends upon the effectiveness with
which management makes capital expenditure decisions. The finance
manager should ensure that he has explored and identified potentially
lucrative investment opportunities and proposals and select the best
one based on the opportunities identified.
In dynamic business environment, making capital budgeting
decisions are among the most important and multifaceted of all
management decisions as it represents major commitments of
companys resources and have serious consequences on the
profitability and financial stability. Evaluation need to be done for the
extent of financial stability achieved by the firms capital budgeting
decisions over a period of time. In view of this, this study has made an
attempt to know the efficiency of the corporate sectors capital
budgeting decisions.

Capital budgeting principle


Capital budgeting is a complex process that involves careful analysis
and calculation especially for large projects. There are some basic
principles to take into consideration when performing capital
budgeting.
There are several key principles we need to follow:
Decisions are based on cash flows. The decisions are not based on
accounting concepts, such as net income. Furthermore, intangible
costs and benefits are often ignored because, if they are real,
they should result in cash flows at some other time.
Timing of cash flows is crucial. Analysts make an extraordinary
effort to detail precisely when cash flows occur. Cash flows are
based on opportunity costs. What are the incremental cash flows
that occur with an investment compared to what they would have
been without the investment?
Cash flows are analyzed on an after-tax basis. Taxes must be fully
reflected in all capital budgeting decisions.
Financing costs are ignored. This may be unrealistic. But it is not.
Most of the time, analysts want to know the after-tax operating
cash flows that result from a capital investment. Then, these
after-tax cash flows and the investment outlays are discounted at
the "required rate of return" to find the net present value (NPV).
Financing costs are reflected in the required rate of return. If we
included financing costs in the cash flows and in the discount
rate, we would be double-counting the financing costs. So even
though a project may be financed with some combination of debt
and equity, we ignore these costs, focusing on the operating cash
flows and capturing the costs of debt (and other capital) in the
discount rate. The required rate of return is the discount rate that

investors should require given the riskiness of the project. This


discount rate is frequently called the "opportunity cost of funds"
or the "cost of capital." If the company can invest elsewhere and
earn a return of r, or if the company can repay its sources of
capital and save a cost of r then it is the company's opportunity
cost of funds. If the company cannot earn more than its
opportunity cost of funds on an investment, it should not
undertake that investment. Unless an investment earns more
than the cost of funds from its suppliers of capital, the investment
should not be undertaken.
Capital budgeting cash flows are not accounting net income.
Accounting net income is reduced by non-cash charges such as
accounting depreciation. Furthermore, to reflect the cost of debt
financing, interest expenses are also subtracted from accounting
net income. Accounting net income also differs from economic
income, which is the cash inflow plus the change in the market
value of the company. Economic income does not subtract the
cost of debt financing, and it is based on the changes in the
market value of the company, not changes in its book value
(accounting depreciation).

Important Concepts in Capital Budgeting


When performing capital budgeting, you need to know the following
concepts:
A sunk cost is one that has already been incurred. You cannot
change a sunk cost. Today's decisions, on the other hand, should
be based on current and future cash flows and should not be
affected by prior, or sunk, costs.
An opportunity cost is what a resource is worth in its next-best
use. For example, if a company uses some idle property, what
should it record as the investment outlay: the purchase price

several years ago, the current market value, or nothing? If you


replace an old machine with a new one, what is the opportunity
cost? If you invest $10 million, what is the opportunity cost? The
answers to these three questions are, respectively: the current
market value, the cash' flows the old machine would generate,
and $10 million (which you could invest elsewhere). An
incremental cash flow is the cash flow that is realized because of
a decision: the cash flow with a decision minus the cash flow
without tb.at decision. If opportunity costs are correctly assessed,
the incremental cash flows provide a sound basis for capital
budgeting.
An externality is the effect on other things besides the investment
itself. Frequently, an investment affects the cash flows of other
parts of the company, and these externalities can be positive or
negative. If possible, these should be part of the investment
decision. Sometimes externalities occur outside of the company.
An investment might benefit (or harm) other companies or society
at large, and yet the company is not compensated for these
benefits (or charged for the costs). Cannibalization is one
externality. Cannibalization occurs when an investment takes
customers and sales away from another part of the company.

Capital Budgeting Process


Capital budgeting is the process that companies use for decision
making on capital project. The capital project lasts for longer time,
usually more than one year. As the project is usually large and has
important impact on the long term success of the business, it is crucial
for the business to make the right decision.
The specific capital budgeting procedures that the manager uses
depend on the manger's level in the organization and the complexities
of the organization and the size of the projects. The typical steps in the
capital budgeting process are as follows:
Brainstorming: Investment ideas can come from anywhere, from
the top or the bottom of the organization, from any department or
functional area, or from outside the company. Generating good
investment ideas to consider is the most important step in the
process.
Project analysis: This step involves gathering the information to
forecast cash flows for each project and then evaluating the
project's profitability.
Capital budget planning: The Company must organize the
profitable proposals into a coordinated whole that fits within the
company's overall strategies, and it also must consider the
projects' timing. Some projects that look good when considered in
isolation may be undesirable strategically. Because of financial
and real resource issues, the scheduling and prioritizing of
projects is important.
Performance monitoring: In a post-audit, actual results are
compared to planned or predicted results, and any differences
must be explained. For example, how do the revenues, expenses,
and cash flows realized from an investment compare to the

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predictions? Post-auditing capital projects is important for several


reasons. First, it helps monitor the forecasts and analysis that
underlie the capital budgeting process. Systematic errors, such as
overly optimistic forecasts, become apparent. Second, it helps
improve business operations. If sales or costs are out of line, it will
focus attention on bringing performance closer to expectations if
at all possible. Finally, monitoring and post-auditing recent capital
investments will produce concrete ideas for future investments.
Managers can decide to invest more heavily in profitable areas
and scale down or cancel investments in areas that are
disappointing.

Complexity of Capital Budgeting Process


The budgeting process needs the involvement of different departments
in the business. Planning for capital investments can be very complex,
often involving many persons inside and outside of the company.
Information about marketing, science, engineering, regulation,
taxation, finance, production, and behavioral issues must be
systematically gathered and evaluated.
The authority to make capital decisions depends on the size and
complexity of the project. Lower-level managers may have discretion to
make decisions that involve less than a given amount of money, or
that do not exceed a given capital budget. Larger and more complex
decisions are reserved for top management, and some are so
significant that the company's board of directors ultimately has the
decision-making authority. Like everything else, capital budgeting is a
cost-benefit exercise. At the margin, the benefits from the improved
decision making should exceed the costs of the capital budgeting
efforts.

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Capital Budgeting Evaluation


Methods
When evaluating a project or long term investment of company, it is
important to reach right decisions based on the capital budgeting
methods. Analysts often use several important criteria to evaluate
capital investments. The two most comprehensive measures of
whether a project is profitable or unprofitable are the net present value
(NPV) and internal rate of return (IRR). In addition to these, there are
four other criteria that are frequently used: the payback period. The
article gives instructions on each of the evaluation methods.

Understanding the Project Types


One of the key things in evaluating the project is to estimate the future
cash flow of the projects, however, several types of project interactions
make the future cash flow analysis challenging. The following are some
of these interactions:
Independent versus mutually exclusive projects: Independent projects
are projects whose cash flows are independent of each other. Mutually
exclusive projects compete directly with each other. For example, if
Projects A and B are mutually exclusive, you can choose A or B, but
you cannot choose both. Sometimes there are several mutually
exclusive projects, and you can choose only one from the group.
Project sequencing. Many projects are sequenced through time, so that
investing in a project creates the option to invest in future projects. For
example, you might invest in a project today and then in one year
invest in a second project if the financial results of the first project or
new economic conditions are favorable. If the results of the first project
or new economic conditions are not favorable, you do not invest in the
second project.
Unlimited funds versus capital rationing. -An unlimited funds
environment assumes that the company can raise the funds it wants

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for all profitable projects simply by paying the required rate of return.
Capital rationing exists when the company has a fixed amount of funds
to invest If the company has more profitable projects than it has funds
for, it must allocate the funds to achieve the maximum shareholder
value subject to the funding constraints.

Net Present Value (NPV)


For a project with one investment outlay, made initially, the net
present value (NPV) is the present value of the future after-tax cash
flows minus the investment outlay.
Because the NPV is the amount by which the investor's wealth
increases as a result of the investment, the decision rule for the NPV is
as follows:
Invest if: NPV>0;
Do not invest if NPV<O NPV

Internal Rate of Return


The internal rate of return (IRR) is one of the most frequently used
concepts in capital budgeting and in security analysis. The IRR
definition is one that all analysts know by heart. For a project with one
investment outlay, made initially, the IRR is the discount rate that
makes the present value of the future after-tax cash flows equal that
investment outlay.
The decision rule for the IRR is to invest if the IRR exceeds the required
rate of return for a project.

Payback Period
The payback period is the number of years required to recover the
original investment in a project. The payback is based on cash flows.
For example, if you invest $10 million in a project, how long will it be
until you recover the full original investment?
Payback period methods is simple and easy to understand, however, it
has many drawbacks. First, it is a measure of payback and not a

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measure of profitability. By itself the payback period would be a


dangerous criterion for evaluating capital projects.
The payback period may also be used as an indicator of project
liquidity. A project with a two-year payback may be more liquid than
another project with a longer payback.
Because it is not economically sound, the payback period has no
decision rule like that of the NPV or IRR. If the payback period is being
used (perhaps as a measure of liquidity), analysts should also use an
NPV or IRR to ensure that their decisions also reflect the profitability of
the projects being considered.

Profitability Index
Profitability index is also called benefit/cost ratio. It is calculated as
ratio of present value of benefits of investment to cost of investment
PI = NPV (benefits) / NPV (costs)
General rule: All projects with PI > 1.0 should be accepted. Between
two or more mutually exclusive projects having different costs, we
must choose project with highest profitability index. Investment
decisions based on profitability index will be same as decisions made
using net present value. All projects having net present value have
profitability index larger than 1.0 and therefore are acceptable.

Selection of method
All 3 methods (net present value, internal rate of return, profitability
index) result in same accept-reject decision for given investment
opportunity. There are three important circumstances under which
methods may yield conflicting decisions:
1. Choosing from among mutually exclusive investment projects
with similar costs, but radically differing time patterns of cash
inflows.
Example: One project provides large cash flows in early
years and small cash flows in later years compared with

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another project providing small cash flows in early years but


large cash flows in later years.
o Project having highest net present value and
profitability may have lowers internal rate of return.
Choice of methods depends on which assumption is closest
to reality.
Choice should be based on which reinvestment rate is
closest to rate that firm will be able to earn on cash flows
generated by project.
o If cash flows can be reinvested at cost of capital, select
project with higher net present value.
o If cash inflows can be reinvested at cost of capital,
select project with higher net present value.
o If cash inflows can be reinvested at IRR of project,
select project with higher IRR.
General rule: NPV methods should be preferred if conflicts
arises because projects with very high IRRs relative to firms
cost of capital are rare. In most cases, reinvestment rate will
be closer to cost of capital than to IRR and thus, NPV method
is normally preferred to IRR method.
2. Choosing from among mutually exclusive projects with widely
differing costs.
If project with highest NPV has lowest PI and IRR, in general,
give preference to project with highest NPV since this will
maximize value of firm.
If project with highest PI and IRR is substantially less
expensive than competing project, former is selected
because low cost project may be perceived as less risky than
higher cost project.
3. Capital rationing where insufficient capital is available to accept
all projects having positive NPVs.
Rank order projects from highest IRR to lowest and select
projects that firm has sufficient capital to accept.
In general, NPV method preferred over IRR and PI methods.

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In practice uncertainty is often dealt with through simple mechanism of


assigning higher discount rate to riskier projects. How much higher
depends on managements perception of degree of risk and additional
compensation required because of that risk.

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Capital Budgeting Classification


Companies often put capital budgeting projects into some rough
categories for analysis. One such classification would be: replacement
projects, expansion projects, new product and service, Regulatory,
safety, and environmental projects and others. The below is the details
of each category:
Replacement projects: These are among the easier capital
budgeting decisions. If a piece of equipment breaks down or
wears out, whether to replace it may not require careful analysis.
If the expenditure is modest and if not investing has significant
implications for production, operations, or sales, it would be a
waste of resources to over-analyze the decision. Just make the
replacement. Other replacement decisions involve replacing
existing equipment with newer, more efficient equipment, or
perhaps choosing one type of equipment over another. These
replacement decisions are often amenable to very detailed
analysis, and you might have a lot of confidence in the final
decision.
Expansion projects: Instead of merely maintaining a company's
existing business activities, expansion projects increase the size
of the business. These expansion decisions may involve more
uncertainties than replacement decisions, and these decisions
may be more carefully considered.
New products and services: These investments expose the
company to even more uncertainties than expansion projects.
These decisions are more complex and will involve more people in
the decision-making process.
Regulatory, safety, and environmental projects: These projects
are frequently required by a governmental agency, an insurance
company, or some other external party. They may generate no
revenue and might not be undertaken by a company maximizing

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its own private interests. Often, the company will accept the
required investment and continue to operate. Occasionally,
however, the cost of the project is sufficiently high that the
company would do better to cease operating altogether or to shut
down any part of the business that is related to the project.
Other: The projects above are all susceptible to capital budgeting
analysis, and tl1ey can be accepted or rejected using tl1e net
present value (NPV) or some other criterion. Some projects
escape such analysis. These are either pet projects of someone in
the company (such as the CEO buying a new aircraft) or so risky
that they are difficult to analyze by the usual methods (such as
some research and development decisions).

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Case Study: Evaluating the


desirability of an investment
In sum, the capital budgeting process is the tool by which a company
administers its investment opportunities in additional fixed
assets by evaluating the cash inflows and outflows of such
opportunities. Once such opportunities have been identified or
selected, management is then tasked with evaluating whether or not
the project is desirable.
Depending on the business, the competitive environment and industry
forces, companies will certainly have some unique desirability criteria.
As noted earlier, it's very crucial to remember that the capital
budgeting process involves two sets of decisions, investment decisions
and financial decisions; given the unique business and market
environments that exist at the time, each decision may not initially be
seen as worthwhile individually, but could be worthwhile if both were
to be undertaken.
Consider an example involving the coffee chain Starbucks. On Nov. 14,
2012, Starbucks announced its intent to acquire Teavana, a high-end
specialty retailer of tea, for $620 million. The offer price for Teavana
represented a 50% premium over the then market value of Teavana.
Based on the acquisition price, Starbucks would paying over 36 times
earnings for Teavana. Looking at this capital investment today, one can
suggest that the financial decision paying $620 million for a company
that generated $167 and $18 million in sales and profits in 2011 was
not a desirable one for Starbucks.
On the other hand, from an investment perspective, Starbucks is
paying $620 million for ownership of a fast-growing, leading tea
retailer. Teavana gives Starbucks direct access to the fast-growing
underpenetrated tea market. In addition, Teavana instantly gives
Starbucks approximately 200 high-traffic retail locations and, more
importantly, a very visible, high-quality tea brand to complement its
coffee offerings. Had Starbucks merely evaluated Teavana from a

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purely financial perspective, the decision would have ignored that


highly-valuable benefit of combining the most well-known coffee brand
with the highest-quality tea brand.
Generally speaking however, businesses will consider the following
questions when evaluating whether or not a project is desirable and
should be pursued.
What Will the Project Cost?
This is the first and most basic question a company must answer
before pursuing a project. Identifying the cost, which includes the
actual purchase price of the assets along with any future investment
costs, determines whether or not the business can afford to take on
such a project.
How Long Will It Take to Re-coup the Investment?
Once the costs have been identified, management must determine the
cash return on that investment. An affordable project that has little
chance of recouping the initial investment, in a reasonable period of
time, would likely be rejected unless there were some unique strategic
decisions involved. For Starbucks, it is counting on the fact that when
Teavana's brand is matched with Starbucks vast distribution network,
the rapid growth in sales of tea and tea related projects will deliver
tremendous cash flows to Starbucks. Of course, there is no guarantee
that management's forecast will prove accurate or correct;
nevertheless, forecasting future cash inflows and outflows are a vital
exercise in the capital budgeting process.
Mutually Exclusive or Independent?
All investment projects are considered to be mutually exclusive or
independent. An independent project is one where the decision to
accept or reject the project has no effect on any other projects being
considered by the company. The cash flows of an independent project
have no effect on the cash flows of other projects or divisions of the

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business. For example the decision to replace a company's computer


system would be considered independent of a decision to build a new
factory.
A mutually-exclusive project is one where acceptance of such a project
will have an effect on the acceptance of another project. In mutually
exclusive projects, the cash flows of one project can have an impact on
the cash flows of another. Most business investment decisions fall into
this category. Starbucks decision to buy Teavana will most certainly
have a profound effect on the future cash flows of the coffee business
as well as influence the decision making process of other future
projects undertaken by Starbucks.

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Conclusion
Capital budgeting decision involves the exchange of current funds for
the benefit to be achieved in future. The future benefits are expected
and are to be realized over a series of years. The funds are invested in
non-flexible long-term funds. They have a long term and significant
effect on the profitability of the concern. They involve huge funds. They
are irreversible decisions. They are strategic decision associated with
high degree of risk.
Through this project we can conclude the importance of capital
budgeting as follows:
Capital budgeting decision, generally involves large investment of
funds. But the funds available with the firm are scarce and the
demand for funds for exceeds resources. Hence, it is very
important for a firm to plan and control its capital expenditure.
Capital expenditure involves not only large amount of funds but
also funds for long-term or a permanent basis. The long-term
commitment of funds increases the financial risk involved in the
investment decision.
The capital expenditure decisions are of irreversible nature. Once,
the decision for acquiring a permanent asset is taken, it becomes
very difficult to impose of these assets without incurring heavy
losses.
Capital budgeting decision has a long term and significant effect
on the profitability of a concern. Not only the present earnings of
the firm are affected by the investment in capital assets but also
the future growth and profitability of the firm depends up to the
investment decision taken today. Capital budgeting decision has
utmost has importance to avoid over or under investment in fixed
assets.
The long-term investment decision are difficult to be taken
because uncertainties of future and higher degree of risk.

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Investment decision though taken by individual concern is of


national importance because it determines employment,
economic activities and economic growth.

Bibliography
http://www.slideshare.net/infinite_7/case-studycapital-budgeting
http://www.investopedia.com/university/capitalbudgeting/evaluating-desirability.asp
http://www.myinvestment101.com/capital-budgeting/capitalbudgeting-evaluation-methods.html
http://www.myinvestment101.com/capital-budgeting/capitalbudgeting-principle.html
http://www.myinvestment101.com/capital-budgeting/capitalbudgeting-process.html
http://www.myinvestment101.com/capital-budgeting/capitalbugeting-classification.html