Capital Budgeting
Decisions
What is Capital
Budgeting?
The
process
of
identifying,
analyzing,
and
selecting
investment
projects
whose
returns
(cash
flows) are expected to
extend beyond one year.
Capital Expenditure includes:
Cost of acquisition of permanent assets as
land and building, plant and machinery,
goodwill etc.
Cost of addition, expansion, improvement
or alteration in fixed assets.
Cost of replacement of permanent assets.
Research and development project cost,
etc.
Few Definitions on CB:
Charles T. Horngreen
Capital Budgeting is long term
planning for making and financing
proposed capital outlays.
Richard and Greenlaw
Capital Budgeting as acquiring inputs
with long term returns.
Need and Importance of
Investment Decisions
Larger Investments
Long Term Commitments of Funds
Irreversible Nature
Long term effect on profitability
Difficulties of Investment Decisions
National Importance
Process
Capital Budgeting Process
Identification of Investment Proposal
Screening of Investment Proposal
Evaluation of various proposals
Independent proposals
Contingent or dependent proposals
Mutually exclusive proposals
Fixing Priorities
Final Approval and Preparation of capital
Expenditure Budget
Implementing Proposal
Performance Review
Types of Investment/Cap
Budgeting Decisions
One classification is as follows:
Expansion of existing business
Expansion of new business
Replacement and modernisation
Yet another useful way to classify
investments is as follows:
Mutually exclusive investments
Capital Rationing Decisions
Accept and Reject Decisions (Independent)
Investment Evaluation
Criteria
Three steps are involved in the
evaluation of an investment:
Estimation of cash flows
Estimation of the required rate of return (the
opportunity cost of capital)
Application of a decision rule for making the
choice
Investment Decision Rule
It should maximise the shareholders wealth.
It should consider all cash flows to determine the
true profitability of the project.
It should provide for an objective and unambiguous
way of separating good projects from bad projects.
It should help ranking of projects according to their
true profitability.
It should recognise the fact that bigger cash flows
are preferable to smaller ones and early cash flows
are preferable to later ones.
It should be a criterion which is applicable to any
conceivable investment project independent of
others.
Evaluation Criteria or Methods of Capital
Budgeting
Non-discounted (Traditional
Methods):
Payback Period (PB)
Discounted Payback Period (DPB)
Accounting Rate of Return (ARR)
Discounted (Time-adjusted
Methods):
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Payback Method
Payback is the number of years
required to recover the original cash
outlay invested in a project
If the project generates constant
annual cash inflows, the payback
period can be computed by dividing
cash outlay by the annual cash
inflow. That is:
Formula
C0
Initial Investment
Payback =
=
Annual Cash Inflow
C
Assume that a project requires an
outlay of Rs 50,000 and yields annual
cash inflow of Rs 12,500 for 7 years.
The payback period for the project is:
Payback=50000/12500
= 4 years
Payback Method
Unequal cash flows In case of
unequal cash inflows, the payback
period can be found out by adding up
the cash inflows until the total is
equal to the initial cash outlay.
Acceptance Rule
The project would be accepted if its
payback period is less than the
maximum or standard payback
period set by management.
As a ranking method, it gives highest
ranking to the project, which has the
shortest payback period and lowest
ranking to the project with highest
payback period.
Discounted Payback Period
The discounted payback period is
the number of periods taken in
recovering the investment outlay on
the present value basis.
The discounted payback period still
fails to consider the cash flows
occurring after the payback period.
Accounting Rate of Return
Method
The accounting rate of return is the ratio
of the average after-tax profit divided by
the average investment. The average
investment would be equal to half of the
original
investment
if
it
were
Average income
depreciated
constantly.
ARR =
Average investment
A variation of the ARR method is to
divide average earnings after taxes by
the original cost of the project instead
of the average cost.
Acceptance Rule
This method will accept all those
projects whose ARR is higher than the
minimum rate established by the
management and reject those projects
which have ARR less than the
minimum rate.
This method would rank a project as
number one if it has highest ARR and
lowest rank would be assigned to the
project with lowest ARR.
Net Present Value (NPV)
Cash flows of the investment project should
be
forecasted
based
on
realistic
assumptions.
Appropriate discount rate should be
identified to discount the forecasted cash
flows. The appropriate discount rate is the
projects opportunity cost of capital.
Present value of cash flows should be
calculated using the opportunity cost of
capital as the discount rate.
The project should be accepted if NPV is
positive (i.e., NPV > 0).
Net Present Value Method
Net present value should be found
out by subtracting present value of
cash outflows from present value of
cash inflows. The formula for the net
present value can be written as
follows
C3
Cn
C1
C2
C0
L
2
3
n
(1 k )
(1 k )
(1 k ) (1 k )
n
Ct
NPV
C0
t
t 1 (1 k )
NPV
Present value of Rupee one
Year
6%
7%
8%
9%
10 % 11 % 12 % 13%
14 %
.
9434
.
9345
.
9259
.
9174
0909
0
.
9009
0
.
8928
.
8850
.
8772
.
8900
0
.
8734
.
8573
.
8417
.
8265
.
8116
.
7972
.
7831
.
7695
.
8397
.
8163
.
7938
.
7722
.
7512
.
7318
.
7118
.
6930
.
6750
.
7920
.
7629
.
7350
.
7084
.
6830
.
6587
.
6355
.
6133
.
5921
.
7472
.
7130
.
6806
.
6499
.
6209
.
5934
.
5674
.
5428
.
5194
Calculating Net Present Value
Assume that Project X costs Rs 2,500
now and is expected to generate yearend cash inflows of Rs 900, Rs 800, Rs
700, RsRs
Rs Rs500
in
years
1
900 600
Rs 800 and
Rs 700
600
Rs 500
NPV
The opportunity
cost of
Rs 2,500
through
5.
the
(1+0.10) (1+0.10)
(1+0.10)
(1+0.10) (1+0.10)
capital
may ) be
assumed
to be ) 10 per
NPV [Rs 900(PVF
+ Rs 800(PVF
) + Rs 700(PVF
cent.+ Rs 600(PVF ) + Rs 500(PVF )] Rs 2,500
2
1, 0.10
4, 0.10
2, 0.10
3, 0.10
5, 0.10
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225
Acceptance Rule
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV < 0
May accept the project when NPV is
zero
NPV = 0
The NPV method can be used to select
between mutually exclusive projects;
the one with the higher NPV should be
selected.
Problem :
A company has to consider the
following project:
Cash inflows:
Year
Year
Year
Year
1
2
3
4
1000
1000
2000
10000
Compute the net present value if the
opportunity cost is 14 %
Calculation of NPV
Year
Cash
inflows
Present
value
PV of
inflows
1000
0.877
877
1000
0.769
769
2000
0.675
1350
10000
0.592
5920
Total PV of
inflows
8916
Less:
outflows
10000
NPV
- 1084
A Firm whose cost of capital is 10 % is
considering 2 mutually exclusive projects
X and Y. the details of which are as
follows:
Year
Project X
Project Y
Cost
100000
100000
Cash
inflows
10000
50000
20000
40000
30000
20000
45000
10000
60000
10000
Compute the net present value at 10 %,
profitability index and IRR of the two
projects.
Delhi machinery manufacturing company
wants to replace the manual operations by
new machine. There are two alternative
models X and Y of the new machine. Using
payback period, suggest the most
profitable investment.
taxation
Machine X Ignore Machine
Y .
Original investment
9000
18000
Estimated life
Estimated savings in
cost
500
800
Estimated savings in
wages
6000
8000
Additional cost of
maintenance
800
1000
Additional cost of
supervision
1200
1800
Solution:
Machine X
Machine Y
Estimated savings in
cost
500
800
Wages
6000
8000
Total savings
6500
8800
Additional cost of
maintenance
800
1000
Supervision
1200
1800
Total cost
2000
2800
Net inflows
(annual)
4500
6000
Outflows
9000
18000
Payback period
2 Years
3 Years
Solution
Cash flows
PVF(10
%,n)
Total PV
Year
Project X
Project Y
10000
50000
0.909
9090
45450
20000
40000
.827
16520
33040
30000
20000
.751
22530
15020
45000
10000
.683
30735
6830
60000
10000
.621
37260
6210
Total PV
116135
106550
Less:
Cash
Inflows
100000
100000
Net
Present
Value
16135
6550
Machine A costs Rs 100000 payable
immediately. Machine B costs 120000
half payable immediately and half
payable in one years time. The cash
receipts are as follows:
Year
Machine A
Machine B
20000
60000
60000
40000
60000
30000
80000
20000
At 7 % opportunity cost, which machine
should be selected on the basis of NPV.
Solution (machine B is better)
Machin
eA
Machin
eB
Year
Cash
flows
-100000 1.000
-100000 -60000
1.000
-60000
20000
0.935
18700
-60000
0.935
56100
60000
0.873
52380
60000
0.873
52380
40000
0.816
32640
60000
0.816
48960
30000
0.763
22890
80000
0.763
61040
20000
0.713
14260
NPV
PVF(7%) PV(rs)
4087
0
Cash
flows
PVF(7%) PV(rs)
4628
0
NPV
Strengths:
Time Value
Considers all
cash flows
Based on cash
flows
Weaknesses:
Discount rate
difficult to
determine
Ignores the
difference in initial
cash outflows
Difficult calculation
Internal Rate of Return
Method
The internal rate of return (IRR) is the
rate that equates the investment
outlay with the present value of cash
inflow received after one period. This
also implies
thatC the rate
of return is
C
C
C
L makes NPV =
theC discount
rate
which
(1 r ) (1 r )
(1 r )
(1 r )
0.
C
C
(1 r )
1
t 1
n
t 1
Ct
C0 0
t
(1 r )
IRR Solution
X rate Diff of
Minimum Rate + NPV at lower
both rates
NPV at higher NPV
at lower
Internal Rate of Return
Strengths:
Accounts for
TVM
Considers all
cash
flows
Less
subjectivity
Weaknesses:
Assumes all cash
flows reinvested
at the IRR
Difficulties
with
project
rankings
and
Multiple
IRRs
Profitability Index Method
It is also called as Benefit-Cost Ratio.
It is the relationship between present
value of cash inflows and the present
value of cash outflows.
Profitability Index
= Present Value of Cash
Inflows
Present Value of Cash
Outflows
