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³CAPITAL BUDGETING & EVALUATION

TECHNIQUES´

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ACKNOWLEDGEMENT

With great pleasure, I express my heartiest thanks to Mr. MANISH SHAH for
giving me an opportunity to work under his guidance. He gave me the guidelines
that helped me a lot in the preparation of my research report.

I express my thanks to all the respondents to whom I visited, for their support and
valuable information, which helped me in the completion of my research project
work.

I express my sincere gratitude to my parents, friends and all others who have
directly or indirectly inspired and helped me to complete my project with
unremitting zeal and enthusiasm.


 
 




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 DECLARATION

I hereby state that this work is a result of study on the ³CAPITAL BUDGETING
& EVALUATION TECHNIQUES´. The findings & conclusion expressed in this
research report are genuine and for academic purpose. It is my own and it has
neither been submitted nor published anywhere before any resemblance to earlier
project or research work purely coincidental. It is totally based on my hard work
and creativity.


 
 




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 Certificate

This is to certify that the project work done on ³CAPITAL BUDGETING &
EVALUATION TECHNIQUES´ Submitted to Khar Education Society of
commerce & economics college by Priyank Visharia in partial fulfillment of the
requirement for the award of PG Diploma in International Business Management,
is a bonafide work carried out by her under my supervision and guidance. This
work has not been submitted anywhere else for any other degree/diploma.

Signature of guide signature of coordinator signature of principal

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Meaning & definition of Capital Budgeting:

6apital budgeting is vital in marketing decisions. Decisions on investment, which

take time to mature, have to be based on the returns which that investment will
make. Unless the project is for social reasons only, if the investment is unprofitable
in the long run, it is unwise to invest in it now.

Often, it would be good to know what the present value of the future investment is,
or how long it will take to mature (give returns). It could be much more profitable
putting the planned investment money in the bank and earning interest, or investing
in an alternative project.

Typical investment decisions include the decision to build another grain silo,
cotton gin or cold store or invest in a new distribution depot. At a lower level,
marketers may wish to evaluate whether to spend more on advertising or increase
the sales force, although it is difficult to measure the sales to advertising ratio.

Objectives:

· An understanding of the importance of capital budgeting in marketing decision

making

· An explanation of the different types of investment project

· An introduction to the economic evaluation of investment proposals

· The importance of the concept and calculation of net present value and internal
rate of return in decision making

· The advantages and disadvantages of the payback method as a technique for

initial screening of two or more competing projects.
Structure:

6apital budgeting is very obviously a vital activity in business. Vast sums of

money can be easily wasted if the investment turns out to be wrong or uneconomic.
The subject matter is difficult to grasp by nature of the topic covered and also
because of the mathematical content involved. However, it seeks to build on the
concept of the future value of money which may be spent now. It does this by
examining the techniques of net present value, internal rate of return and annuities.
The timing of cash flows are important in new investment decisions and so the
chapter looks at this "payback" concept. One problem which plagues developing
countries is "inflation rates" which can, in some cases, exceed 100% per annum.
The chapter ends by showing how marketers can take this in to account.

÷
 

 
 

Capital budgeting is an important tool for leaders of a company when evaluating
multiple opportunities for investment of the firm¶s capital. Every company has
both a limited amount of capital available and a desire to deploy that capital in the
most effective way possible. When a company is looking at, for example,
acquisitions of other companies, development of new lines of business or major
purchases of plants or equipment, capital budgeting is the method used to
determine whether one option is better than another. There are several capital
budgeting methods, each with its pros and cons.
Capital Budgeting by Payback Period
The most-used method of capital budgeting is determining the payback period. The
company establishes an acceptable amount of time in which a successful
investment can repay the cost of capital to make it. Investment alternatives with
too long a payback period are rejected. Investment alternatives inside the payback
period are evaluated on the basis of the fastest payback.
Payback method disadvantages include that it does not account for the time value
of money.
Net Present Value Capital Budgeting
In net present value capital budgeting, each of the competing alternatives for a
firm¶s capital is assigned a discount rate to help determine the value today of
expected future returns. Stated another way, by determining the weighted average
cost of capital over time, also called the discount rate, a company can estimate the
value today of the expected cash flow from an investment of capital today. By
comparing this net present value of two or more possible uses of capital, the
opportunity with the highest net present value is the better alternative.
A disadvantage of the net present value method is the method's dependence on
correctly determining the discount rate. That calculation is subject to many
variables that must be estimated.
The Internal Rate of Return Method
An advantage of capital budgeting with the internal rate of return method is that
the initial calculations are easier to perform and understand for company
executives who may not have a financial background. Excel has an IRR calculation
function.
The disadvantage of the IRR method is that it can yield abnormally high rates of
return by overestimating the value of reinvesting cash flow over time.
A Modification of the Internal Rate of Return Method
The modified rate of return method overcomes the tendency to overestimate
returns by using the company¶s current cost of capital as the rate of return on
reinvested cash flow.
As with all methods of capital budgeting, the modified rate of return method is
only as good as the variables used to calculate it. However, by using the firm¶s cost
of capital as one variable, it has a figure that is grounded in a verifiable current
reality and is the same for all alternatives being evaluated.
The Accounting Rate of Return
Many financial professionals in a firm, as opposed to top management, prefer the
accounting rate of return because it is most grounded in actual numbers.
Determining an investment¶s accounting rate of return is a matter of dividing the
expected average profit after taxes from the investment by the average investment.
However, as with the payback period method, it does not account for the time
value of money.V

   
6
 6
 

 

The process of capital budgeting requires constant evaluation in order to make

sure that you are making the right decisions for your business. Here are a few of
the more popular methods of evaluation for capital budgeting.
 Net Present Value
6alculating the net present value is one of the most common ways to evaluate a
capital budgeting process. In order to perform this calculation, you will take the
value of the present benefits of the project and subtract the present costs. The
difference provides you with the net present value.
Internal Rate of Return
Another popular method of evaluation is referred to as the internal rate of return.
This is a discount rate that is commonly used to determine how much of a return an
investor can expect to realize from a particular project.
Payback Period
The payback period is another method that many businesses use to determine
whether to keep pursuing a project. With this method, you are basically
determining how long it will take to pay back the initial investment that is required
to undergo a project. In order to calculate this, you would take the total cost of the
project and divide it by how much cash inflow you expect to receive each year.
This will give you the total number of years or the payback period.

Investment involves the sacrifice of current consumption opportunities in order to

obtain the benefit of future consumption possibilities. The commitment of funds to
capital projects gives rise to a management decision problem, the solution of
which, if incorrectly arrived at, may seriously impair company profitability and
growth.

The proper use of evaluation techniques and criteria should enable management to
make more effective decisions which result in future success. The purpose of
investment appraisal is to evaluate whether or not the current sacrifice is
worthwhile.

6apital investment decisions have certain characteristics which are not always
present in other management decisions, and as a result, special techniques are
required to ensure that only the best information is available to the decision maker.

These characteristics are:

ÔV a significant outlay of cash;

ÔV long term involvement with greater risks and uncertainty because forecasts of the
future are less reliable;
ÔV irreversibility of some projects due to the specialized nature of, for example,
plant which having been bought with a specific project in mind may have little
or no scrap value;
ÔV a significant time lag between commitment of resources and the receipt of
benefits;
ÔV management¶s ability is often stretched with some projects demanding an
awareness of all relevant diverse factors;
ÔV limited resources require priorities on capital expenditure;
ÔV Project completion time requires adequate continuous control information as
costs can be exceeded by a significant amount.
„actors to consider with capital projects
When considering any capital investment project there are six factors to be
examined:

ÔV the initial cost of the project;

ÔV the phasing of the expenditure;
ÔV the estimated life of the investment;
ÔV the amount and timing of the resulting cash flow;
ÔV the effect, if any, on the rest of the undertaking;
ÔV The working capital required.
There are different/multiple objectives for a company, for example, survival. These
can change in priority at different stages of a companies life cycle, but the one
overriding objective is maximization of owner¶s wealth. Stated differently, it is the
present value of future cash flows. Therefore, all investment opportunities should
eventually be viewed in financial terms.

Evaluation techniques
There are a number of methods for evaluating capital expenditure projects but no
matter what method is used it is important to realize that the information used for
the evaluation has to be properly screened as it can materially affect the evaluation.

Some of the methods available are:

ÔV accounting rate of return (ARR or RO6E or ROI);

ÔV payback or discounted payback;
ÔV discounted cash flow net present value (NPV);
ÔV Internal rate of return (IRR).
Each of these methods will be described in turn and an example given of the
calculations involved. Then the acceptance criterion for each will be stated:
ÔV when there is only one project under consideration; and
ÔV When there are two mutually exclusive projects under review.
6alculations are performed for Project A only. Space is left for you to duplicate the
calculations for Project B. Answers for Project B appear at the end of the article for
your reference.

Project A B

Capital 75,000 75,000

expenditure

Accounting
profit/(loss)

Year 1 30,000 43,000

Year 2 30,000 6,000

Year 3 20,000 25,000

Year 4 (10,000) (1,000)

Year 5 (10,000) (13,000)

TOTAL PRO„IT 60,000 60,000

Equipment estimated resale value at the end of 5 years will be:

Project A B
Resale value 5,000 5,000
Depreciation is calculated on the straight line method.

Solution

The Accounting Rate of Return (ARR) model uses A66OUNTING

PROFIT/LOSS.

For Payback and the Discount methods i.e., NPV or IRR models accounting
profits/losses must be converted to 6ASHFLOWS.
 A66OUNTING RATE OF RETURN Õ calculates the average annual profits as a
percentage of the cost of the project.

RO6E/ARR/ROI = average annual profits * 100

average investment 1

Average investment equals initial investment plus residual value (if any) divided
by 2.

ÔV Advantages
- uses readily available accounting information.
- More readily understood by managers.
ÔV Disadvantages
- deals with accounting profit, rather than cash flow.
- Different methods for calculating depreciation/stock values.
- fails to take account of time value of money.
ÔV Acceptance
- One project
- accepts if above management acceptable return cut-off point.
- Mutually exclusive projects
- whichever offers the highest return.
Cash flows
Firstly, convert accounting profits to cash flows. This is done by adding the annual
depreciation charge to the profit/loss each year. Remember straight line
depreciation equals:

6ost less residual value

number of years expected use
Project Project

A B
6apital expenditure 75,000

Residual value 5,000

Total depreciation
chargeable 70,000

No. of years expected use 5

Annual depreciation 14,000

Project A Project B

Year Profit after depreciation Cash flow Profit after Cash

depreciation flow

1 30,000 44,000

2 30,000 44,000

3 20,000 34,000

4 (10,000) 4,000

5 (10,000) 4,000

60,000 130,000

Payback
The length of time which is required for a stream of cash flows (proceeds) from an
investment to recover the original cash outlay. An assumption can be made that
cash flows accrue evenly throughout the year in the case of payback occurring
some part way through a year.

Project A Project B

Year Net cash inflow Cumulative cash Net cash Cumulative

inflow inflow cash inflow
 1 44,000 44,000

2 44,000 88,000

Project A s outlay was £75,000. Of this only £44,000 was got back in year 1 and
another £44,000 was got back in year 2. Therefore, payback took place somewhere
between years 1 and 2. After the first year £31,000 was still needed. £44,000 was
received in year 2 so payback equals:

Project Bs payback equals:

ÔV Advantages
simple to use and understand;
useful when liquidity is important when early recovery of funds is required;
promotes a policy of caution;
favored by risk adverse people.
ÔV Disadvantages
disregards total contribution;
cash flows after payback are ignored;
fails to take account of the time value of money;
fails to take account of the magnitude of cash flows during the payback
period.
ÔV Acceptance
One project
accept as long as within managements acceptable payback period;
mutually exclusive projects
whichever pays back first.
Payback is usually expressed with no adjustment to the cash flows for the time
value of money. It is proper and consistent with the other cash flow methods to
express payback as a discounted payback figure. Therefore, Projects payback
period is 2.166 years.

Discounted cash flow

these methods use the technique of discounting to take into account the time value
of money. These refer to the fact that money can now be invested for a period of
time and earn a return.

In capital budgeting we are concerned with finding the value now, i.e., its present
day value, of a sum to be received in the future given the interest rate to be X%.
The discount factor can be found using a calculator but it is normal to use discount
tables which give the rate to be applied each year.

Net present value calculates the present value of the future cash flows generated
by the project and compares this present value of the cash inflow with the present
value of any outflows. If the PV of the cash inflow is greater than the PV of the
cash outflow the project will have a positive net present value (NPV).

A positive NPV indicates that the investment earns more for the firm than it has to
pay for its funds.

Project A Project B

Year Net cash Discount Present Net cash Present

flow factor value flow value
15%

1 44,000 0.869 38,236

2 44,000 0.756 33,264

3 34,000 0.657 22,338

4 4,000 0.571 2,284

5 4,000 0.497 1,988

5 5,000 0.497 2,485

Total of 100,595
present values
Less initial 75,000
outlay
 Net present
value 25,595

ÔV Advantages
uses cash flow information;
takes into account both the magnitude and timing of cash flows;
maximizes shareholder wealth.
ÔV Disadvantages
cost and time involved in gathering information and making calculations may
not be merited;
although uses D6F the results can conflict with what IRR recommends.
ÔV Acceptance
One project
accept if NPV positive;
Mutual exclusive projects whichever offers the highest NPV.
Internal rate of return is the discount rate used by the company which gives a
zero NPV. At this point the PV of the cash inflows will exactly equal the PV of the
cash outflow.
IRR can be solved by using linear interpolation or graphs.

Linear interpolation calculate two NPVs, choosing a discount rate which will
make one positive and one negative.

using the following formula:

Where:

ÔV lower is the lower rate of return;

ÔV pos is the amount of the positive NPV;
ÔV neg is the amount of the negative NPV;
ÔV Higher is the higher rate of return.
Project A

Year Net cash Lower Present Higher Present

flow discount value discount value

15% 35%
 1 44,000 0.869 38,236 0.741 32,604

2 44,000 0.756 33,264 0.549 24,156

3 34,000 0.657 22,338 0.406 13,804

4 4,000 0.571 2,284 0.301 1,204

5 4,000 0.497 1,988 0.223 892

5 5,000 0.497 2,485 0.223 1,115

Total of 100,595 73,775

present values

less initial 75,000 75,000

outlay

Net present
value 25,595 (1,225)

IRR = 15% + ( 25,595 * (35 - 15) = 34.09%

( 25,595 + 1,225)

ÔV Advantages
takes into account both the magnitude and timing of cash flows.
ÔV Disadvantages
in some cases there may be more than one IRR e.g., if there are net cash
outflows in more than one period, and the outflows are separated by one or more
 periods of net cash inflows;
although uses D6F the results can conflict with what NPV recommends.
ÔV Acceptance
one project accept if IRR is above managements return cut-off point;
mutually exclusive projects whichever offers the highest IRR.
Project B answers:

ARR/RO6E/ROI 30% Accept A or

B
Payback 1.90 Accept A
years
Discounted 2.40years Accept A
payback
NPV 25,681 Accept B
IRR 34.47% Accept B

Surveys of practice
Drury presents a table of Evaluation techniques used by UK companies . In the
table, reproduced below, payback is the most frequent method used by evaluators
at present, as evidenced by all researchers quoted and also over time as evidenced
by Pike and Wolfe at three points in time from 1975 through to 1986.

Table 1: Evaluation techniques used by UK companies

* Pike and Wolfe¶s survey focused on the largest UK companies, whereas

McIntyre and 6oulthurt s survey focused on medium sized companies. The study
by Drury et al is based on the replies of 300 UK manufacturing companies with an
annual sales turnover in excess of £20 million.
 Pike and Wolfe¶s research also highlights that the discounted cash flow methods
are rapidly increasing in popularity, none more so than NPV which has increased
in use by 2.125 times over the survey periods.

Points to note
NPV questions can be set in two contexts:

ÔV profit situation (take highest or most positive NPV);

ÔV 6ost reduction situation (take lowest NPV).
6onversion of cash flows back to accounting profits is done by deducting the
depreciation from the cash flow figure.

6ash flow 44,000

Depreciation 14,000
Accounting
profit 30,000

For such a calculation to be performed the depreciation charged per annum would
have to be given in the question.
V