Capital Budgeting:

The capital budgeting is one of the important decisions of the financial management of the enterprise. The decisions pertaining to the financial management of the firm are following:

Financial management is not only concerned with sourcing or procurement of funds, effective utilization of such funds is equally important to successfully achieve the corporate objective of wealth maximization. Effective utilization of funds can be achieved by investing them in productive activities or assets. Such decisions of selecting the right avenue of investment for relatively longer term are called investment decisions. Business assets can be broadly classified into two categories namely short-term or current assets and long-term or fixed assets. Investment decisions are mainly concerned with the latter i.e. long term assets or fixed assets which generally involve big cash flows and big initial capital investment. Investment decisions are also known as capital investment decisions, capital budgeting, capital expenditure budgeting, and capital investment budgeting. The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions are long-term choices about which projects receive investment, whether to finance that investment with equity or debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and shortterm borrowing and lending (such as the terms on credit extended to customers). Management must allocate limited resources between competing opportunities (projects) in a process known as capital budgeting. Making this investment, or capital allocation, decision requires estimating the value of each opportunity or project, which is a function of the size, timing and predictability of future cash flows.

Why the capital budgeting is considered as most important decision over the others? The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets. The importance of the capital budgeting is only due to the benefits of the long term assets stretched to many number of years in the future. It is a tool of analysis which mainly focuses on the quality of earning pattern of the fixed assets. The capital budgeting decision is a decision of capital expenditure or long term investment or long term commitment of funds on the fixed assets. Charles T. Horngreen A long-term planning for making and financing proposed capital outlays. AIM OF CAPITAL BUDGETING To make rational investment: The study of capital budgeting on capital expenditures evades not only over capitalization but also under capitalization. The long-term investment normally demands heavy volume of investment which is met out by the firm either through external or internal source of financing. Hence, the amount of capital raised by the firm should neither greater nor lesser than the investment. Locking up of capital: The amount invested is requiring longer gestation to recover. The longer gestation is connected with future horizon in getting back the investment. The future is uncertain unlike the present. If the longer is the gestation in the future leads to greater risk involved. Effect on the profitability of the enterprise: The profitability of the enterprise is mainly depending on the proper planning of the capital expenditure. Nature of Irreversibility: The improper/ unwise capital expenditure decision cannot be immediately corrected as soon as it was found. Once it is invested is invested which cannot be reversed. The poor investment decision will require the firm either to keep it as an idle in the form of investment or to unnecessarily meet out fixed commitment charge of the capital which excessively raised more than the requirement.

METHODS OF CAPITAL BUDGETING

The methods are the nothing but the instruments of the capital budgeting to study the quality of the investments/fixed assets. The investments are studied by the firms in the following angles:

Based on the number of years taken for getting back the investment Pay Back Period Method Based on the profits accrued out of the investment Accounting Rate of Return/ Average Rate of Return Based on the timing of benefits Present value of future benefits of the investment Discounted cash flow methods Based on the comparison in between the cash outlay and receipts discounted with the help of minimum rate of return - Net present value method Based on the identification of maximum rate of return, in between the initial cash outlay and discounted expected future receipts - Internal Rate of return method Based on the ration in between the present values of cash inflows and outflows Present value index method The classification of methods is generally in two categories:

Traditional methods Pay Back Period method Accounting Rate of Return Discounted cash flow methods Net present value method Internal Rate of Return method Present value index method Discounted payback period method

1. Pay Back Period Method:

What is payback period? The payback period is the period taken by the firm to get back the investment. The payback period is nothing but number of years/months/days required by the firm to get back its investment invested in the project. To find out the payback period, the following are two important covenants required: Initial outlay / Initial investment/ Original investment Cash inflows

How the payback period is calculated?

The payback period is calculated by way of establishing the relationship between the volume of investment and the annual earnings While calculating the payback period, the nature of annual earnings should be identified. The nature of the annual earnings can be classified into two categories: Cash flows are equivalent or constant Cash flows are not equivalent or constant If the cash flows are equivalent, How the payback period is to be calculated ? The cost of the project is Rs.1,00,000. The annual earnings of the project is Rs.20,000. Calculate the payback period.

It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5 years time period to get back the original volume of the investment. If the cash flows are not equivalent, How the payback period is to be calculated ? The cost of the project is Rs.1,00,000. The annual earnings of the project are as follows

The ultimate aim of determining the cumulative cash inflows to find out how many number of years taken by the firm to recover the initial investment. The next step under this method is to determine the cumulative cash flows:

The uncollected portion of the investment is Rs,10,000. This Rs.10,000 is collected from the 4th year Net income / cash inflows of the enterprise. During the 4th year the total earnings amounted Rs.20,000 but the amount required to recover is only Rs.10,000. For earning Rs.20,000 one full year is required but the amount required to collect it back is amounted Rs.10,000. How many months the firm may require to collect Rs.10,000 out of the entire earnings Rs.20,000? Payback period consists of two different components: Payback period for the major portion of the investment collection in full course - E.g.: 3 years Payback period for the left /uncollected portion of the investment

Criterion for selection: If two or more projects are given for appraisal, considered to be mutually exclusive to each other for selection, the payback period of the projects should tabulated in accordance with the ascending order. The project which has lesser payback period only to be selected over the other projects given for scrutiny. Why lesser pay back has to be chosen? The reason behind is that the project which has lesser payback period got faster recovery of the initial investment through cash inflows/Net income. Selection criterion: Lesser the payback period is better for acceptance of the project Merits It is a simple method to calculate and understand It is a method in terms of years for easier appraisal Demerits: It is a method rigid It has completely discarded the principle of time value of money It has not given any due weight age to cash inflows after the payback period It has sidelined the profitability of the project.

2. Accounting or Average Rate of Return:

Under this method, the profits are extracted from the book of accounts to denominate the rate of return. The profits which are extracted are nothing but after depreciation and taxation and not cash inflows. Selection criterion of the projects: Highest rate of return of the project only is given appropriate weightage.

Merits It is simple method to compute the rate of return Average return is calculated from the total earnings of the enterprise throughout the life of the firm The entire rate of return is being computed on the basis of the available accounting data Demerits Under this method, the rate of return is calculated on the basis of profits extracted from the books but not on the basis of cash inflows The time value of money is not considered It does not consider the life period of the project The accounting profits are different from one concept to another which leads to greater confusion in determining the accounting rate of return of the projects

Discounted Cash Flows Method

The discounted cash flows method is the only method nullifies the drawbacks associated with the traditional methods viz pay back period method and Accounting rate of return method. The underlying principle of the method is time value of money. The value of 1 Re which is going to be received on today bears greater value than that of 1 Re expected to receive on one month or one year later. The main reason is that "Earlier the benefits better the principle". It means that the benefits whatever are going to be accrued during the present will be immediately reinvested again to maximize the earnings, so that the earlier benefits are weighed greater than the later benefits. The later benefits are expected to receive only during the future which is connected with the future i.e., future is uncertain. It means that there is greater uncertainty involved in the receipt of the benefits connected with the future. Why the time value of money concept is inserted on the capital budgeting tools? The main reason is that the capital expenditure is expected to extend the benefits for many numbers of years. The 1 Re is expected to receive one year later cannot be treated at par with the 1 Re of 2 years later. This is the only method considers the profitability as well as the timing of benefits. This method gives an appropriate qualitative consideration to the benefits of various time periods. The time value of money principle is used for an analysis to study about the quality of the investments in receiving the future benefits. There are general classifications which are as follows Net present value method Present value index method Internal rate of return method

NET PRESENT VALUE METHOD: Under this method, the initial outlay or initial investment available in terms of present value is compared with the present value of future earnings of the enterprise. Why the present value of the future earnings are found out? The ultimate reason to find out the present value future earnings is that the comparison in between inflows and outflows should be meaningful as well as effective. The present value of the initial outlay cannot be converted into the future value for comparison, even otherwise the conversion takes place, the comparison cannot be meaningful. To be meaningful comparison, the future earnings are converted into the present value which is known as discounting process through the discount rate. The rate at which the future earnings are discounted is known as required rate of return. Selection criterion of Net present value method: If the present value of future cash inflows are greater than the present value of initial investment; the proposal has to be accepted. If the present value of future cash inflows are lesser than the present value of initial investment; the proposal has to be rejected.

PRESENT VALUE INDEX?

The major lacuna of the Net present value method is unable to rank the projects one after the another, only due to the volume of the investment involved. To rank the projects meaningfully, the present value index method is adopted. The present value index of the investment can be calculated with the help of following formula:

Selection criterion: If the present value index is greater than one, accept the proposal; otherwise vice versa

INTERNAL RATE OF RETURN METHOD?

IRR is the rate at which initial investment is equal to the Present Value of future case in flows. Under this method, while matching, these two are known but the rate which is taken for equation not given or known. The rate of discounting for matching should be determined through trial and error method. Once the Internal rate of return is found out, the found IRR should be compared with the required rate of return. Decision criterion If the IRR is more than the Required rate of return, the project has to be accepted If the IRR is less than the Required rate of return, the project has to be rejected Merits of DCF methods: It is only the best method incorporates the timing of benefits - time value of money It considers the economic life of the project It is a best method for both even and uneven cash inflows Demerits of DCF methods: It involves with tedious method of computation It is very difficult to locate or identify the exact discounting factor It never performs functions of discounting to the tune of accounting concepts.

Illustration:
XYZ company is considering an investment proposal to install new drilling controls at a cost of Rs.1,00,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume the firm uses straight line depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax form the investment proposal are as follows:

Calculate the following 1. Payback period 2. Average rate of return 3. Net present value at 10 percent discount rate 4. Profitability index at 10 percent discount rate

Sol:
The first and foremost step is to find out the Cash Flows After Taxation (CFAT) For finding out the Cash flows after taxation, the amount of depreciation i.e non recurring expenditure should be appropriately considered for calculation. The depreciation has to be computed in accordance with the stipulation given in the problem. The depreciation charged by the firm is nothing but straight line method.

The depreciation has to be deducted initially from the cash flows before taxation, after the deduction of taxation, the earnings after taxation should be added with the depreciation which was already deducted in order to find out the total cash flows after taxation. The purpose of deducting the depreciation is nothing but an amount to be charged under the Profit & Loss account against the total revenue. Being as a non-recurring expenditure not created any outflow cash resources. When there is no cash outflow, the amount of depreciation should be added finally to derive CFAT(Col 7)

1. Payback period method: Under this, method most important step is to identify the nature of the cash flows after taxation. Are they uniform? No, they are not even cash flows. Hence, the cumulative cash flows after taxation has to be found n order to find out the payback period of the investment.

2. Average rate of return (ARR):

Average Income is the average of earnings after taxation of the entire duration. Why earnings after taxation has to be taken into consideration? Why not the cash flows after taxation to be taken for consideration? The main purpose of considering the earnings after taxation is that the amount extracted from the book of accounts and taken for the computation of ARR, and immediately after the payment of taxation.

Average investment is the average of opening and closing investment. If the depreciation charge given is nothing but straight line method, automatically final value of the asset will become equivalent to zero. The closing balance of the asset /investment is zero. How the closing balance of the investment could be adjudged as equivalent to zero?

At the end of the year, the closing balance amounted Rs.0 after charging the depreciation year after year constantly in volume

3. Net present value method: Under this method, the future cash flow after taxation should be discounted at the rate 10%

The net present value is negative due to excessive investment more that of the present value of future earnings of the enterprise. Under this method, the investment is not advisable to procure for the firm's requirements.

4. Profitability Index: The profitability index method is more useful in the case of more number of investments, having uneven investment outlays, but this problem comes with only one investment proposal It is much easier to assess even in the case of Net present value method.

The present value index quotient is less than that of the norms which should be greater than one but it secures only 90704. It means that the present value earnings are not sufficient to meet the initial cost of the machine.

Illustration for IRR:

project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annually for 5 years. Calculate the IRR of the project.

Sol:
First step is to find out the fake pay back quotient

The next step is to locate the pay back quotient in the table M-4. The present value of 1Re should be computed for 5 number of years. The location of the pay back quotient is in between the values of table M-4 The value 3.214 which lies in between 3.274 of 16% and 3.199 of 17% The next step in the IRR calculation is that locating the maximum rate of return which equates the initial outlay with the cash inflows of various time periods. While equating the initial outlay with discounted cash inflows at certain percentage will derive the original rate of return. The process may be started from two different angles viz

Low discount rate High discount rate

The computation of IRR can be had through either low discount rate or high discount rate. This is further extended to different methods of calculation., which are as follows On the basis of values extracted from the table On the basis of volume Calculation on the basis of discount rate table value

On the basis of Lower % of discount rate:

Alternately, on the basis of volume, the methodology to be adopted for the determination of IRR The cash inflows of Rs.11,200 for 5 years are discounted @ 16% which amounted Rs.36,668.8. Likewise the cash inflows of the same should be discounted at the rate of 17% which amounted Rs.35,828.8 The next step is to find out the IRR. The IRR can be found out either on the basis of lower discounted cash inflows or higher discounted cash inflows.

RISK ANALYSIS IN CAPITAL BUDGETING

In capital budgeting decisions, the risk component of the investment is not taken into consideration. The risk which is nothing but the business risk of the investment varies from one to another, to be considered in the real world situations. The risk which is nothing but the variability in between the actual returns and expected returns. The risk in the investment has to be incorporated in the discount rate for studying the worth of the project. To incorporate the risk in the discount rate, the meaning of the term risk should be known and distinguished from the uncertainty. The risk situation is one in which the probabilities of one particular event are known but the uncertainty is the situation in which the probabilities are not known. In the case of risk situation, the future losses can be foreseen unlike the uncertainty situation. The incorporation of the risk factor in the discount rate in accordance with the variability of the returns. If the variability of the returns are more, the investor may prefer higher return in the form of risk premium for risky project unlike in the case of government securities. The government securities are not having any variability in the returns which require the risk free return to discount only in order to know the worth of the investment but the risky projects are to be discounted only with the help of higher discount rates. There quite number of techniques available for incorporating the risk component in the capital budgeting are follows: Sensitivity analysis Standard deviation Coefficient of variation and so on.