INTRODUCTION TO FINANCE SECTION 3 CAPITAL BUDGETING I.

Concept of Capital Budgeting

Section 3

Planning and control of capital expenditure is termed as Capital Budgeting. The total capital (long-term and short term ) of a company is employed in fixed and current assets of the firm. Fixed assets include those assets which are not meant for sale such as land, building, machinery etc. it is a challenging task before the management to take judicious regarding capital expenditures, i.e., investments in fixed assets to that the amount should not unnecessarily be locked up in capital goods which may have far-reaching effects on the success or failure of an enterprise. A capital asset, once acquired, cannot be disposed of without any substantial loss and if it is acquired on long term credit basis, a continuing liability is incurred over a long period of time, and will affect the financial obligations of the company adversely. It, therefore, requires a long-range planning while taking decision regarding investments in fixed assets. Such process of taking decisions regarding capital expenditure is generally known as capital budgeting. In capital budgeting process, due consideration should b given to the following problems(1) Problem of ranking project, i.e., choice of one project over other project. (2) Problem of capital rationing, i.e., limited budget resources. (3) Limitations imposed by top management decision on the total volume of investments to be made. In other words Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the goals of Shareholders wealth maximization

II. Tools for Capital Budgeting/Evaluation Techniques

The methods of appraising capital expenditure proposals can be classified into two categories: Traditional /Non Discounting Techniques Time Adjusted / Discounting Techniques

Traditional /Non Discounting Techniques 1. Average Rate of Return (ARR)

This method is also known as Accounting Rate of Return. This method is based on accounting profits rather than the cash-flows.

ARR = Average Annual Profits after taxes/Average investment over the life of the project Average Investment = (Initial Investment + Salvage Value)/2
Accept Reject Rule ARR would be compared with the minimum required rate of return or cut off rate. If ARR is more than the required rate of return then the project will be accepted else it will be rejected. Example A project with capital expenditure of Rs 5,00,000 is expected to generate following profits of Rs 40,000, Rs 80,000, Rs 90,000, Rs 30,000 in year 1,2,3,4 respectively Average Annual Profits = (40,000+80,000+90,000+30,000)/4 = Rs 60,000 Average Investment = (5,00,000+0)/2 = 2,50,000 ARR = 60,000/2,50,000 = 0.24 0r 24% Merits It is easy to calculate as it males use of readily available accounting information Unlike pay back period method, this method takes into account cash inflows generated after the payback period It doesnt involve any unrealistic assumptions about the interest rates Demerits It doesnt take into account time value of money It fails to distinguish the size of the investment. Competing projects with same ARR may require different amounts of investment Like payback period, it is biased towards short term projects

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INTRODUCTION TO FINANCE 2. Payback Period Method

Section 3

It assesses how soon the initial investment can be recovered. In other words it measures number of years it takes the cash inflows from the project to be equal to cash outflows. In case the cash inflows stream is nature of annuity or constant throughout the life of the project, then payback period can be calculated as follows:

PB = Investment/Constant annual cash flow

Example #1 The Project with life of 5 years involves a total initial investment of Rs 2Lakhs, and has equal cash Inflows of Rs 50,000 each year. This is the case of annuity or constant cash inflows hence Payback period will be calculated as follows:

PB = 2,00,000/50,000 PB = 4 Years
In case the Project Cash Inflows are not uniform, then PB is calculated by cumulating cash flows till the time when cumulative cash flows become equal to original investment outlay. Example #2 The Project with life of 5 years involves a total initial investment of Rs 2Lakhs, and has cash Inflows of Rs 45,000, Rs 50,000 , Rs 58,000 , Rs 72,000 , Rs 71,000 in the year 1, 2, 3,4 and 5 respectively. In this case Payback period will be calculated by looking at cumulative cash inflows

Years 1 2 3 4 5

Cash Inflows 45,000 50,000 58,000 72,000 71,000

Cumulative Cash Inflows 45,000 95,000 1,53,000 2,25,000 2,96,000

From the cumulative cash inflows it is evident that by the end of 3 years Rs 1,53,000 has been recovered and rest Rs 47,000 is th th recovered in the 4 year. To find out the number of months it took to recover Rs 47,000 in the 4 year, we will assume that the cash inflows are equally distributed over the period of 12 months. Hence cash inflow for one month will be cash inflows of year 4 divided by 12 months, which is Rs 6,000 (i.e. 72,000/12). Now divide amount required to be recovered by the monthly cash inflow to get number of months. In this case it is 7.83 months (47,000/6000) or approximately 8 months. Hence the payback period is 3 years 8 months. Accept /Reject Rule Project or investment option with shorter payback period will be accepted Merits It is simple to apply and easy to understand. It is useful for the business which lack appropriate skills necessary for more sophisticated techniques This method is most suitable when future is very uncertain. Shorter the payback period It is useful for the firms facing liquidity constraints It doesnt involve any unrealistic assumptions about the interest rates Demerits This method ignores cash inflows generated after the payback period It doesnt take into account time value of money It doesnt provide any indication on the returns of the project. Projects with lower payback period may not necessarily be highly profitable

Discounting Techniques 1. Net Present Value (NPV) Method

NPV is calculated by deducting Present Value of Cash Inflows from the Cash Outflow or initial investment. Present value of cash flows is calculated using entitys weighted average cost of capital (WACC) as the discount rate. WACC is used as that is the minimum required rate of return.

NPV = PV of Cash Inflows - PV of Cash Outflow or initial investment

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INTRODUCTION TO FINANCE

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Accept /Reject Rule If NPV is positive then the project will be selected else rejected. If NPV is positive In case of more than one mutually exclusive projects, then the project with higher NPV should be selected. Example #3 A company is considering two investment proposals with initial investments of Rs 5,00,000 and 10,00,000 each. Companys overall cost of capital is 10%. Following are the cash inflows and calculation of NPV

Years 1 2 3 4 5

Project A (a) 1,00,000 1,50,000 2,00,000 2,10,000 1,80,000

Project B (b) 3,80,000 4,00,000 4,30,000 2,00,000 10,000

PV Factor @ 10% (c ) 0.909 0.826 0.751 0.683 0.621 PV of Cash Inflows Less: PV of Cash outflow NPV

PV of Project A (a x c) 90,909 1,23,967 1,50,263 1,43,433 1,11,766 6,20,338 5,00,000 1,20,338

PV of Project B (b x c) 3,45,455 3,30,579 3,23,065 1,36,603 6,209 11,41,910 10,00,000 1,41,910

Decision In this case both the projects have positive NPV and since Project B has higher NPV, Project B will be selected Merits This method is based on the assumptions that cash-flows determine shareholders wealth. As higher the cash flows, higher would be the dividends and higher the shareholders wealth. It considers total benefits arising out of the investment proposal over its life time This method is useful for selecting mutually exclusive Projects. (In mutually exclusive projects, selection of one project tantamount rejection of others) It considers Time Value of Money Demerits This method is difficult to calculate as compared to traditional methods Calculation of discounting rate presents challenges as it based on the cost of capital which is complicated to calculate. This is an absolute method and will favor the project with higher NPV rather than the return of the project This method emphasizes comparison of NPV and disregards initial investment involved. In the above example Project A is generating higher cash inflows as percentage of investment (24%) as compared to Project B (14%) but NPV method selects the Project B instead of A

2. Profitability Index (PI) Method

This method is also known as Cost Benefit Ratio. PI is the PV of Cash Inflows divided by the PV of Cash Outflows or Initial Investment.

PI = PV of Cash Inflows/ PV of Cash Outflows or Initial Investment

Accept /Reject Rule If PI is greater than 1 then the project will be selected else rejected. If PI is greater than 1 in case of more than one mutually exclusive projects then the project with higher PI will be selected

3. Internal Rate of Return Method

Internal rate of return is that discount rate at which PV of Cash Inflows is equal to the PV of Cash Outflows or Initial Investment. In other words it is the discount rate at which NPV is zero. IRR is calculated using hit and trial method.

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INTRODUCTION TO FINANCE

Section 3

Accept /Reject Rule In case of mutually exclusive projects, the project with higher IRR will be selected Example Let look the above mentioned Example #3 for calculating IRR for Project A and B, Project A - We know that PV of cash inflows is 6,20,338, whereas we need it to be 5,00,000. Since the formula for calculating PV factor is 1/(1+i), this means that higher i higher will be the denominator, and higher the denominator lower will be PV. Therefore lets try as higher discount rate lets say 20%. Following is the PV of Cash inflows using 20% discount rate. Now we an use interpolation to find the exact IRR PV required 5,00,000 PV at 10% - 6,20,388 variance + 1,20,388. PV at 20% - 4,76,858 variance - 23,148

Exact IRR = 10 +

1,20,388 1,20,388 - (-23,148)

x10 = 10 +8.38 = 18.38%

Project B Similar we calculate for project B PV required 10,00,000 PV at 10% - 11,41,910 variance + 1,41,190. PV at 20% - 9,43,756 variance - 56,244

Exact IRR = 10 +

1,41,190 1,41,190 - (-23,148)

x10 = 10 +7.16 = 17.16%

Decision - Since Project A has higher IRR, project A will be selected Merits This method is based on the assumptions that cash-flows determine shareholders wealth. As higher the cash flows, higher would be the dividends and higher the shareholders wealth. It considers total benefits arising out of the investment proposal over its life time This method is useful for selecting mutually exclusive Projects. (In mutually exclusive projects, selection of one project tantamount rejection of others) It considers Time Value of Money Demerits This method is difficult to calculate as compared to traditional methods as it requires tedious calculations based on trial and error method. It doesnt use the concept of desired rate of return, whereas it provides the rate of return which is indicative of the profitability of the project. Projects selected on the basis of higher IRR may not necessarily be profitable

4. Discounted Payback Period Method

This method is same as payback period method, except that instead of normal cash-flows, discounted cash-flows are used for calculating payback period

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