CAPITAL BUDGETING

CAPITAL BUDGETING

Pertains to fixed assets

Also Called :
Capital expenditure decision
Capital expenditure management
Management of fixed assets

Features :
1) Potentially large anticipated benefits
2) A relatively high degree of risk
3) Time gap between outlay and the anticipated return
 IMPORTANCE

 True earning assets /strategic investments

 Bearing on profitability
 Impact over a long period in terms of:
 fixed cost,
 variable cost etc.
 Huge investment- resources are scarce
 Not easily reversible without financial loss
 A single mistake can cost survival
 DIFFICULTIES

1) Future- uncertain - risk - estimates - may go wrong

Size of the market-depends on
Price, advertising, promotion
Shifts in consumer preferences
Competitors
Technological developments
2) Costs & benefits not comparable- different points of time
3) Costs and benefits are not strictly quantifiable
 WHY CAPITAL BUDGETING?
Rationale?
 Efficiency
 Maximum profits through increased revenues
Investment decision affecting revenue
 Expansion
Adding new product line
 Maximum profits through decreased costs
Investment decisions reducing cost
 Replacement of a worn out or
outdated asset, technology etc.
KINDS OF CAPITAL BUDGETING DECISIONS

1) Simple Accept-Reject Decisions :

 Minimum investment criteria e.g., rate of return
 All projects above it are accepted

2) Mutually Excusive Project Decisions :

 Taken after Accept- Reject Decision
 Taking up one project rules out another
 The best of the acceptable decisions

3) Capital Rationing Decisions :

 Limited funds
 More acceptable projects
 Ranking is done and capital is rationed
DATA NEEDED/USED FOR CAPITAL BUDGETING DECISIONS

1) Cash Flow
2) Accounting profit

Cost Benefit Analysis

• Cost  Cash Outlay  Cash outflow

• Benefit - Cash Inflows
- Accounting Profit
• Accounting Profit  presence of non-cash expenditure in
P&L a/c- e.g., Depreciation
• P&L requires adjustment to reflect the true benefit.
Therefore, Cash Flow better than actual profit
 MORE REASONS

1)Accounting does not tell you original need for cash & size of
subsequent cash inflows
 Maximizing Economic value not possible

2)Cash flows avoids accounting ambiguities

 Methods or inventory valuation

3)Cash flows recognize time value of money

 Accounting accrual concept may make paper figures

ACCOUNTING PROFIT – Measure of performance- Not a decision criteria

 Types of Cash Flows:

1.Conventional Cash Flows

Initial outlay
Subsequent inflows

2.Non- Conventional Cash Flows :

Initial & subsequent intermittent outlay and
subsequent Inflows
CASH FLOWS – POINTS TO REMEMBER

• Incremental Cash Flow

– Only differential cash flows are considered –
e.g., FOH are overlooked
• Effect of Taxes
 Reduced cash inflows
 Carry forward of losses
• Effect on other projects :
Allocated on common factor floor space , wages
Should be considered if they change on account of investment

• Effect of Depreciation :
Legitimate deductible expenditure
Reduces tax payable
So reduces outflows
Should be taken into account as there is no cash outflow on account
of it
• WORKING CAPITAL EFFECT
– Initial & subsequent outflows
– Terminal year-Inflow

• Assignment for students

 Determination of Relevant Cash Flows:
 Single Proposal
 Replacement Situation
 Mutually Exclusive Situations
 CAPITAL BUDGETING:
EVALUATION TECHNIQUES
• Two Categories
1) Traditional/Less sophisticated
2) Sophisticated/Time-adjusted/Discounted Cash Flow Techniques

• Traditional Methods
1) Pay Back Method
2) Average Rate of Return

• DCF Category
1) NPV Method
2) IRR Method
3) NTV Method
4) Profitability Index
 PAY-BACK METHOD

• Time taken by the project to pay back the investment.

Hence the name.
• Simplest, most widely used method.
• Tells how soon will the Cash Flow payback the
original investment.
 PROBLEM ON PAYBACK METHOD

1. Outlay on the project=100,000

Yield=annual inflow of Rs 25,000 for 5 years, Rs
34,000 for 4 years

Payback period=4years

Which means Payback Period :

Outlay/Annual cash inflows
Suitable for Annuity Cash flows
 PROBLEM ON PAYBACK METHOD –
Uneven Cashflows

• Outlay= Rs 1,00,000
Annual inflows:
I year - 20,000
II year - 25,000
III year - 35000
IV year - 40,000
V year - 35,000
VI year - 25,000
VII year - 20,000
Solution:
Year Inflow Cumulative Inflow

1 20,000 20,000

2 25,000 45,000

3 35,000 80,000

3&1/2 20,000 1,00,000

Payback period= 3&1/2 years

 Accept Reject Criterion

1) Compare with predetermined pay-back

2) 2) Ranking in case of Mutually exclusive

projects
 Evaluation of Payback Method
• Advantages:
1)Easy to calculate
2) Simple to understand
3) Uses better data - Based on Cash Flows

• Disadvantages:

1) Ignores Cash flows after payback period

2) Ignores time factor
3) Does not consider project over its entire life time
 Suitability

• Turbulent business climate

• Liquidity crisis
• Short run earning rather than long-term
net worth
• Affords further treatment
 AVERAGE RATE OF RETURN

• Based on Accounting information

• Also called Accounting Rate of return
Formula: ARR= Average Annual Profit after Taxes
* 100
Average Investment over the life of Project
Problem:
Year Book value of Investment PAT
1 150000 35000
2 135000 35000
3 120000 40000
4 105000 45000
5 90000 35000
6 75000 30000
Sum 675000 220000
• Solution:
Average Annual profits after Taxes = 220000/6 = 36666.67
Av. Investment over the life of project = 675000/6 = 112500

ARR = (36666.67/112500) * 100 = 32.59%

 ALTERNATIVE METHOD

Average Annual profits after Taxes

ARR = *100
Av. Investment over the life of project

Total PAT of useful years

Average Income =
Number of useful years

Average Investment = NWC+Salvage value+1/2 (Initial Cost-Salvage Value)

Some times original cost instead of average cost.

Problem:

I II
Rs. Rs.
Cost 1,12,250 1,12,250
Annual estimated PAT
1 6750 22750
2 10750 18750
3 14750 14750
4 18750 10750
5 22750 6750
Estimated Salvage Value 6000 6000
Estimated Life 5years 5years
 SOLUTION:

Average Annual PAT = Total PAT of useful years

Number of useful years
Average Annual PAT A & B = 73750 = 14750
5
Averge Investment = NWC+Salvage value+1/2 (Initial Cost-Salvage Value)

Average Investment= 6000+.5(112250-6000) = 6000+53125 = 59125

Average Annual Profits after Taxes

ARR=
Average Investment over the life of Project

ARR= 14750 *100 =24.95%

59125
 Accept Reject rule

Pre-determined minimum rate.

If the proposal is better accepted
Mutually Exclusive Decisions
 Ranking – highest is accepted
EVALUATION OF THE TECHNIQUE
• Advantages:
Easy Calculation
Data Easily obtainable-Accounting data
Easy to understand & use
Uses total benefits unlike Pay Back Method

• Disadvantages:
 Accounting income rather than cash flows-Reinvestment not considered
 Time value of money
 Does not differentiate size of investment
 Does not recognize benefits of replacement
 NET PRESENT VALUE METHOD

• Steps in calculating NPV

– 1) Select an appropriate rate of interest-
usually- Opportunity cost of capital i.e..
Minimum rate of return
2) Ascertain the discount factor for each inflow
3) Multiply discount factor with cash inflows to
obtain PVs of cash inflows
4) NPV= PV of cash inflows – PV of Cash
Outflows
 Decision Rules
Accept-Reject
NPV > 0- Accept
NPV < 0- Reject
NPV 0- Indifferent/ Neutral

Mutually Exclusive Projects

Rank & select the one in the highest NPV
Problems of NPV
1) Initial outlay 2500
Cash Inflows- 900, 800, 700, 600 and 500.
Opportunity cost of capital is 10%
Solution:
Year Inflow (Rs.) Discount Factor PV of Cash Inflow (RS.)
1 900 .90909 818
2 800 .82645 661
3 700 .75131 526
4 600 .68301 410
5 500 .62092 310
Total PV of Ci 2725
Less PV of outflows 2500
NPV 225
 2) Initial outlay- 2,000
Overhauling in 3 years - 300
Cash Inflows- I Year - 300 V year - 500
II year - 500 VI year - 400
III year - 600 VII year - 300
IV year - 600
Minimum expected Rate 12%

Year Inflow (Rs) Discount Factor PV of Cash Inflow(Rs)

I 300 .89286 268

II 500 .79719 399
III 600 .71178 427
IV 600 .63552 381
500 .56743 284
V 400 .50663 203
VI 300 .45235 136
VII

PV of CIF 2098
PV of outflows=2000 + 300*.71178=214 2214
NPV (116)
 EVALUATION OF THE TECHNIQUE
Advantages:
1) Recognizes time value of money
2) Considers total benefits of a project
3) Changing discount rate can be built
4) Shareholders wealth is maximized NPV>o
Disadvantages:
1)Difficult to calculate
2) Difficult to understand
3) Selection of discount rate is based on cost of capital - difficult no certainty
4) Comparison of projects with different outlays not possible
Because absolute measure = Higher outlay - Higher return - Higher NPV
5) Evaluating projects with varying life
 INTERNAL RATE OF RETURN

• The rate which equates PV of cash inflows

with the PV of cash outflows
or
• Rate of discount at which NPV=0
• Same as NPV, difference only
NPV - rate is assumed as Known
Whereas in
IRR - found out by trial & error method
 Steps for calculation of IRR

• Select any rate (discount rate) to compute

NPV
• If calculated NPV is lower than “0” use a
higher rate to discount
• If calculated NPV is higher than “0” use a
lower rate to discount
• Repeat the process until you arrive at rate
which gives NPV=0
Problem on IRR
Project Cost : Rs 16,000
Cash Inflows : Rs 8000, Rs 7000 and Rs 6000
Calculate IRR

Computation @ 18%
Year Cash inflows Discount Factor PV(Rs)

1 8000 .84746 6780

2 7000 .71818 5027
3 6000 .60863 3652

15459
Less cash outflow 16000
NPV (541)
Computation @ 16%
Year Cash inflows Discount PV(Rs)
Factor
1 8000 .86207 6897
2 7000 .74316 5202
3 6000 .64066 3844
15943
(-) COF 16000
NPV (57)

Computation @ 15%

Year Cash inflows Discount PV(Rs)

Factor
1 8000 .86957 6957
2 7000 .75614 5293
3 6000 .65752 3945
16195
Cash Outflow 16000
NPV 195
 Interpolation for precise IRR
• IRR lies between 15% and 16%
• Actual IRR lies between 15% and 16%

NPV at lower rate

Sum of NPVs

15+1 = 15+195/252 = 15.77

 ACCEPT- REJECT DECISION

Compare with required Rate of Return/cut-off

rate/hurdle rate
r > k accept
r < k reject
IRR lies between 15% and 16%
Actual IRR lies between 15% and 16%
NPV at lower rate
Therefore Precise IRR =Lower Rate + Difference in rates *
Sum of NPVs

= 15+1 195 = 15+195/252 = 15.77

195+57

ACCEPT- REJECT DECISION

1) Compare with required Rate of Return/cut-off rate/hurdle rate
r > kaccept
r < kreject
 EVALUATION OF IRR
Advantages:
1) Considers time value of money
2) Considers totality of cash flows
3) Easier to understand than NPV
4) Does not use the concept of
required rate of return / instead gives
its own rate
5) Consistent with objective of
maximizing shareholders wealth
 Disadvantages

1) 1) Tedious Calculations
2) Sometimes gives multiple rates leading to confusion in case of non-conventional flows
3) Ranking the one with highest IRR same times may not be profitable because it Considers rate
and not total yield
e.g.,

A B (A-B)
COF5000 7500 -2500
CIF 6250 9150 2900
IRR 25% 22%
k 10%
NPV681.25 817.85

4) Funds may not be invested at the same rate as IRR

 TERMINAL VALUE METHOD
Separates very distinctly the timing of inflows and outflows
Assumption - Each inflow - reinvested in another asset until terminal year
Problem:
Original Outlay: Rs 10,000
Life of the project: 5 years
Cash inflows: Rs 4000 annually for 5 years
Cost of Capital: 10%
Expected interest rate at which cash inflows will be reinvested are 6%, 6%, 8%, 8%
and 8% respectively
Solution
Year Cash inflow Rate of interest Years of Comp. factor Total
investment compounded
sum
1 4000 6% 4 1.262 5048
2 4000 6% 3 1.191 4764
3 4000 8% 2 1.166 4664
4 4000 8% 1 1.080 4320
5 4000 8% 0 1.000 4000
22796
 A
PV of compounded sum =
(1+ i )n

= 22796/(1+10%)^5 = 22796/(1.10)^5 = Rs. 14155

OR
22796*Discount Factor for 5 years at 10%
= 22796* .621 = Rs 14156
Accept-Reject Decision
PVTV > PVO
PV of cash inflows > Present Value of outflow

Modification NTV

NTV= PVTS-PVO

Accept-reject
NTV > 0 Accept
NTV < 0 Reject
 EVALUATION OF THE TECHNIQUE

• Advantages:
1) Assumption about re-investment of cash inflows- Avoid
influence of k
2) Easier
3) More appealing to Non-accounts and non- economics
people

• Disadvantages:
1) More tedious than NPV to calculate
2) More difficult than NPV to understand
 PROFITABILITY INDEX METHOD
• Based on time adjusted value of cash flows
Similar to NPV Method
However, NPV is absolute measure
PI or B/C Ratio is a Relative measure

PV of Cash Inflows
PI= PV of Cash Outflows
Problem: Initial outlay for both the Machines A & B =
Rs 56,125. The cost of capital is 10%
Inflows:

Year Machine A Machine B

1 14000 22000
2 16000 20000
3 18000 18000
4 20000 16000
5 25000 17000
Solution:
Year Machine A Machine B
Cash inflows Dfr PV Cash DFr PV
inflow
1 14000 0.909 12726 22000 0.909 19998
2 16000 0.826 13216 20000 0.826 16520
3 18000 0.751 13518 18000 0.751 13518
4 20000 0.683 13660 16000 0.683 10928
5 25000 0.621 15525 17000 0.621 10557
PV CFAT 68645 PV CFAT 71521

PV CFAT Benefits PV of inflows

PI = or or
PVco Costs PV of outflows
Machine A: Machine B:
68645 71521
=1.223 =1.272
56125 56215
 Decision criteria
• Accept-Reject Rule
– PV > 1 – Accept
– PV < 1 – Reject

• Mutually Exclusive : Higher PI is accepted

 EVALUATION OF THE TECHNIQUE

Advantages:
1) Considers time value of money
2) Totality of benefits
3) Better than NPV in Capital Rationing Situation

Disadvantages:
1) Like NPV- more calculations
2) More difficult to understand
 DISCOUNTED PAYBACK PERIOD
Overcomes the problem of time value in the basic payback method
Each Inflow is discounted at the appropriate rate and
The discounted cash inflows are used to calculate payback

Problem
Outlay= Rs 4000 k=10%

YEAR 1 2 3 4 PAYBACK
P 3000 1000 1000 1000 ?
Ci
Q - 4000 1000 2000 ?
 • Solution:
YEA 1 2 3 4 PAYBACK
R
P 3000 1000 1000 1000 2
Q - 4000 1000 2000 2
Ci
P 3000/(1+.1)^1 1000/(1.1)^2 1000/(1.1)^3 1000/(1.1)^4 =2year+(40
=2727 =826 =751 =683 000-2727-
826)/751
dCi =2.6 years
Q - 4000/(1.1)^2 1000/(1.1)^3 2000/(1.1)^4 =2year
=3304 =751 =1366 +(4000-
3304)/751
=2.9 years
 NPV Vs IRR
1) Independent projects: both give same decision

2) Mutually Exclusive projects

NPV and IRR may give conflicting result

Two basic reasons for such conflicting results:

- Difference in size of project

- Difference in time pattern of Inflows

 A B
Size- Disparity Example:
Cash outlays 5000 7500
CI 6250 9150
NPV 681.2 817.35
IRR 25% 22%

k=10%
NPV is better
Resolution:
Incremental approach
1) Find out differential cash flows between two proposals
2) Calculate IRR on incremental cash flows
3) If IRR > k accept project having greater undiscounted Cash inflow.
Differential IRR=16% should be accepted
 Time Disparity example
PROJECT A PROJECT B

Year Cash flow Year Cash flow

0 (48,000) 0 (46,500)
1 1,200 1 36,500
2 2,400 2 24,000
3 39,000 3 2,400
4 42,000 4 2,400

Required return= 12% Required return= 12%

IRR = 18.10% IRR = 25.51%
NPV = Rs.9,436 NPV = Rs.8,455
PI = 1.20 PI = 1.18
NPV is superior
 PROJECTS WITH UNEQUAL LIVES
Resolve by comparing over the same period of time by equalizing the lives
Problem:

Machine A (Rs) Machine B (Rs)

Initial outlay 10000 20000

Cash inflows after
Tax
1 year 8000 8000
2year 7000 9000
3year Nil 7000
4year Nil 6000

Service Life 2 years 4 years

Cost of capital 10$
SOLUTION

Year A B
Cash Flows PV Factor PV Cash Flows PV Factor PV
0 -10000 1.0 -10000 -20000 1.0 -20000
1 8000 0.909 7272 8000 0.909 7272
2 7000 0.826 5782 9000 0.826 7434
2 -10000* 0.826 (8260) - -
3 8000 0.751 6008 7000 0.751 5257
4 7000 0.683 4781 6000 0.683 4098

NPV 5583 NPV 4061

*Replaced @ end of 2nd year

 EQUIVALISED ANNUAL NPV
For projects with unequal lines
1) Calculate NPVs as usual
2) Divide the NPVs by their respective PV Annuity factors
Problem:
Project A: outlay Rs. 100000, C i Rs. 30000 per year for 5 years
Project B: outlay Rs. 125000, C i Rs. 27000 per year for 8 years
k= 10%, Advise
Solution:
Ci N PV of PV of NPV
Annuity inflows (Rs.)
Factor
Project A 30000 5 3.791 113730 13730

Project B 27000 8 5.335 144045 19045

NPV 13730
EANPV= A= =Rs. 3621.74
PV Annuity Factor 3.791

19045
B= = Rs. 3569.82
5.355
Accept A rather than B
OVERCOMING THE PROBLEM OF
REINVESTMENT RATE ASSUMPTION
MODIFIED IRR
The discount rate which equates the present value of project cost to the present
value of the terminal value where terminal value is the compounded value of Ci at a
given r.
TV
PV of cost=
(1+IRR*)n

PROBLEM
Year Cash flow
0 (1000)
1 500
2 400
3 300
4 100

r=10%
Solution: 500 (1.1)3+400(1.1)2+300(1.1)1+100(1.1)0
= 1579.5
1000=
(1+IRR*)4 (1+IRR)4

1579.5
(1+IRR*)4 = (1+IRR*)4 = (1.5795)1/4
1000

1+IRR*= 1.1210 IRR*= 1-1.1210

= 12.1%