CAPITAL BUDGETING

CAPITAL BUDGETING

• Capital budgeting is the process of identifying , analysing, and selecting investment projects whose returns (cashflows) are expected to extend beyond one year.

CAPITAL BUDGETING

process of making LT planning decisions for investments.

Investment decision making process Involves identifying, evaluating and

implementing LT investment opportunities Investment in real assets as well as other

assets like bonds, equities , leases, M&As , LT savings plans.

Investment decisions

- Mechanisation of a Process

- Replacing and modernising a process

- Choosing between alternative machines

- NPI : R&D Dept

- Expansion

Capital Budgeting

.... Process of deciding whether or not to commit the resources to projects whose Costs & Benefits are spread over several time periods

…. Process by which firm’s evaluate the purchase of major Fixed Assets.

….CB decision

….the firm’s decision to invest its current funds in long term activities in anticipation of future benefits

Features of CB Decisions

Heavy investment (Substantial Exp.) Long term implications Irreversible (difficult & costly to reverse

out) Difficult to make (Intangible costs and

benefits) Risk Complexion

• Why

INVESTMENT DECISIONS or

“CAPEX” Decisions ??

- Sustain competitive advantage

- Expansion & Growth

- Replacement

- Renewal

- M & A s

- FDI s

- R & D

- Exploration Expenses

Motives of Capital Expenditure Expansion: A growing firm often needs to acquire new fixed assets to expand the level of operations. Replacement: To do a major require or replace the asset. Renewal : Rebuilding or overhauling an existing asset to improve efficiency. It is an alternative to replace

Capital Budgeting Process

Generation of Investment proposals Estimation of Cash Flows Evaluation of Cash Flows Selection of Projects based on an

acceptance criterion (decision making ) Implementation (project management) Continual Re-evaluation of investment

projects (Follow-up & control)

Incremental CFAT years 1 2 ………. N Cash Flows Before Tax (Sales – Cash Op.cost) Proposed / New – existing / old Surplus (deficiency) Less Taxes (a) Incremental CFAT Depreciation Proposed/New- Existing depreciation (b) Tax Saving on excess depreciation (a+b) Inc.CFAT + WC Recovery (Terminal yr) + Salvage Value (Terminal yr)

• CAPITAL EXPENDITURE APPRAISAL METHODS

• Traditional or conventional methods:

Average Rate of Return,

Payback period

• DCF Methods

N P V,

I R R ,

Profitability Index

PAYBACK PERIOD

• Period it takes for cash inflows to recoup or recover the investments or the cash outlay

• Uses cash inflows and cash outflows(investment) information to compute the period in years

Pay Back Period

• Simple, easy to calculate

Intuitively appealing

• Early recovery of inv. Liquidity is emphasised.

risk screening device

• Favourable short-run effects.

Project B

PB is suitable for conventional projects involving large up-front investments

Project CF (Rs.) NPV PB

C0 C1 C2 C3 @ 10% yrs

B -2000 +1000 +1000 +5000 3492 2

C -2000 0 +2000 +5000 3409 2

D -2000 +1000 +1000 +100000 74867 2

Payback: Project cost Rs.10000 cash inflow year Project A Project B 1 Rs.1000 Rs.5000 2 2000 4000 3 3000 3000 4 4000 4000 5 5000 - 6 6000 -Determine the Payback periodA : 4 years B : 5000 + 4000 + 1000:

2 years + 1000 = 2 1/3 years 3000

• Fails to consider CF after pay back period.

• Magnitude & timing of CF

• What is the acceptable payback period?

• Time value of money is not considered.

DCF Techniques

• Considers Time value of money.• Consider all the benefits & costs occurring

during the entire life of the project.• Cashflows are discounted at COST OF

CAPITAL to arrive at PVs• Cashflows are expressed in terms of

PRESENT VALUES i.e. PV of Cash outflows, PV of cash inflows

N P V• NPV : Sum of the PV of the expected CFs on the project, net of initial investment

• N P V = PV of Cash Inflows –

PV of Cash outflows

Cash inflows arise in future at different points in time. Therefore discounting is done to find the present values

NET PRESENT VALUE (NPV)

t=n

NPV = ∑ CFt Initial

t=1 (1+r)t Investment

Where, CFt = Cashflow in period ‘t’ r = discount rate N = life of the project

IRR

Internal Rate of Return

• At IRR, the NPV shall be Zero

• IRR is that discount rate that equates the cash inflows and cash outflows of a project

• IRR is a profitability rate and hence compared with cost of capital to arrive at

decisions

IRR

Example:

Project X

Outflow Rs.(100)

Inflow Rs. 110

NPV = -100 + 110

1+r

( r = discount rate)

what must be the discount rate to make NPV of the project equal to Zero?

At 8%:

NPV = (100) + 110 = 1.85

1.08

NPV is positive. Try a higher rate

At 12%:

NPV = (100) + 110 = -1.79

1.12

NPV is negative, therefore, lower the

discount rate, say, 10%

NPV = (100) + 110 = 0

1.10

r = 10% = IRR

IRR

• rate of discount which makes NPV = 0

• For a project lasting T years, we must solve for IRR in the following Equation:

NPV = C0 + C1 + C2 + …. CT = 0

1+IRR (1+IRR)2 (1+IRR)T

IRR Initial Investment - Rs.3000

Cost of capital - 14%

Cash inflows:

Year After tax Cash inflows

1 Rs.1000

2 2500

3 1500

1. Compute the NPV at cost of capital

Yr cashflow PVIF @ 14% Total PV

1 1000 0.8772 Rs.877

2 2500 0.7695 1924

3 1500 0.675 1013

2937

NPV = 3814 - 3000 = Rs.814.

2. Since the NPV is positive, a much higher rate can be tried say 30%

Yr Cash inflow PVIF (30%) Total PV

1 1000 0.7694 769

2 2500 0.5921 1480

3 1500 0.4558 684

2933

NPV = 2933 - 3000 = - 67 Rs.

Interpolation NPV14% 814 814IRR 0 30% - -(-67)Difference 814 881Therefore IRR = 14% + 814 (30%-14%) 881 = 14% + 0.924(16%) = 14% + 14.78 = 28.78%

IRR (annuity example) Initial Investment : Rs.12950 Estimated life : 10 years Annual cash inflows : Rs. 3000 Cost of capital :12% At IRR, Initial investment = PV of cash inflows 12950 = 3000 x PVIFA PVIFA = 12950 = 4.317 30004.317 stands between 18% & 20%

Interpolation: PV Factor 18% 4.494 4.494IRR 4.317 -20% - 4.192Difference 0.177 0.302Therefore IRR = 18% + 0.177 (20% - 18%) 0.302 = 18% + 0.586 (2%) = 18% + 1.17% = 19.17%

Other major expenses:

Some capital expenditures do not result in creation of fixed assets. Instead, it is incurred with an expectation of future returns. Examples include outlays on advertising campaigns, research and development new product introduced etc.,

Cash flows:Replacement Decisions

i. Cash flows Cost of new machine + Installation Cost + Working Capital Sales proceeds of existing machine

ii. Depreciation Base of New Machine WDV of existing machine + Cost of acquisition of new machine sale proceeds of existing machine

Properties of NPV rule

• NPVs are additive – value Implications – Acquisition price / Divestiture price vs Value.

• Intermediate Cashflows invested at COST OF CAPITAL

• NPV allows for changes in discount rates in future.

(Time varying discount rates)

Limitations

• Does not factor in the scale of projects

• Does not control for life of the project

In comparing mutually exclusive projects with different lifetimes NPV is biased towards longer term projects.

Multiple IRR

Cash flows (100), 230, (132) Negative, Positive, Negative at 10% discount rate NPV = (-) 100 + 230 _ 132 = 0 1.1 (1.1)2

at 20% discount rate NPV = (-) 100 + 230 _ 132 = 0 1.2 (1.2)2

INTERPOLATION

IRR = r1 + NPV1 (r2 - r1)

NPV1 + NPV2

where,

r1 = lower discount rate used

r2 = higher discount rate used

NPV1 = NPV of Cashflows at r1 %

NPV2 = NPV of Cashflows at r2 %

Year 0 1 2 3 4 5

Cashflow (31000) 10000 20000 10000 10000 5000

Compute (1) Payback period (2) NPV at 14%

Cost of Capital and (3) IRR

year Cashflow Reqd PB period

1 10,000 21000 21000 1

2 20,000 21000 1000 1

3 10,000 1000 0.1

2.1 years

NPV 0 (31,000) 1.00 (31,000)

1 10,000PVIF @14%

0.8772 8,772

2 20,000 0.7695 15,390

3 10,000 0.6750 6,750

4 10,000 0.5921 5,921

5 5,000 0.5194 2,597

NPV 8,430

At IRR = PV of cash flow = Investment or NPV = 0 From above NPV at 14% 8430Positive, Try at 30% NPV

(31000) 14% - 8430 8430

10000 x 0.7694 7694

20000 x 0.5921 11842 30% (-)(-2046)

10000 x 0.4558 4558 -8430 10476

10000 x 0.3509 3509

5000 x 0.2702 1351 14% + 8430 (16%)

(-)2046 10476

= 26.17%

Capital rationing

A firm faces capital rationing when it finds itself unable to take on projects that earn returns greater then the hurdle rate because it does not have capital on hand or the capacity to raise the capital needed to finance these projects. In NPV terms, capital rationing means that the firm does not have or cannot raise the capital to take all the positive NPV projects that are available.

Projects Available (Rs. In Million)

Project Investment NPV

ABCDEFG

25605

100507035

10305

25152020

• All projects have NPVs firm would have accepted them had there been no CR constraint.

• Under a CR constraint, use of Profitability Index is advocated

• PI= NPV/Initial Investment

(Alternatively, PI could be computed by

PV of cash inflows

PV of cash outflows

2. Using a higher hurdle rate a convenient way to deal with CR constraint is

to raise the hurdle rate to reflect the severity of the constraint.

At higher cost of capital fewer projects will have positive NPVs.

Limitations * Firm may fail to correct it for shift in the severity of the constraint * Increasing the hurdle rate, will yield the NPVs that do not convey the same information as those using original discount rates. * Penalises all projects equally, whether or not they are capital intensive

PI for ProjectsProject Initial

InvestmentNPV PI Ranking

ABCDEFG

25605

100507035

10305

25152020

0.400.501.000.250.300.290.57

4317562

Based on PI, projects B,C and G should be accepted. This would exhaust the Capital budget of Rs.100 million while maximising the NPV of the projects accepted..

Cost of CR constraint = NPV of projects

rejected due to CR constraint

= Rs.70 million

Sources of Capital Rationing1. Lack of Credibility Capacity of a firm to raise funds for good

projects and avoid a capital rationing problem depends largely on the firm’s credibility with financial markets.

- delivering results consistent with its claims. - knows how to take on & manage projects. - small vs. large firms - firms that often go to financial markets. - Firms that had recent problems in terms of project choice vs. firms with recent successes.

2. Underpricing of Securities Because firms with severely underpriced securities

face more CR constraints, the efficiency of the markets will affect the prevalence of capital rationing.

For firms which provide Significant More less or poorer quality error in CR information pricing constraints3. Flotation costs Large the cost of issuing external securities the

greater the chance that a firm will face CR- small firms, equity dependent firms – CR is high.

Risk Analysis CFAT : we assumed it to be known with

certainty but in real life it is not the case

: Investment decisions involve RISK.

: RA techniques

- RA is not an exact science no perfect

answer to decline with risk in Investment

decision making.

-Techniques are only aids to decision

making

1. What is Risk?

Chance that actual outcome will differ from expected outcome

In statistical terms RISK is measured by standard deviation ‘σ’ - Greater the dispersion….

In Investment, we are concerned with evaluating the projects future cashflows (CAFT)

Potential variability of future cashflows

Analysing a Project’s stand alone risk SENSITIVITY ANALYSIS - A base case / best estimate - SA to test how changes in selected cost & revenue

items will alter the base case CFAT. Specifically SA involves 1. Testing how the overall expected outcome of the

project (its NPV / possible IRR) is likely to alter in response to changes in any of the input variables (initial outlay, selling prices, sales volumes project lifespan, asset residual values and so forth); and

2. Identifying the key or critical variables in the base case appraisal. These are the input variables which, even if they change by a small amount, will have a magnified effect on project’s expected outcomes (NPV / IRR)

SA: ‘what if ?’ questions; ‘what – if’ analysis. What if RM costs are 10% higher than expected? Objective of SA: how sensitive the NPV is to

changes in any of the key variables & to identify which variable has the most significant impact on NPV.

For example, • If a small change in the project is key variable, such as, sales probably volume say less + 5% produces Risky a substantial change in NPV• Conversely, if a large change in project is key variable in say + 10%, the NPV having remains positive low risk

illustrationLimitations of Sensitivity Analysis:• Treats variables as if they are independent and

does not consider the inter relationships that might exists between key variables.

• Does not formally attempt to quantify risk - No assessment of the probability of changes in

any of the variables occurring • Does not provided any clear- cut decision rule Managers do not know if their decisions should

be altered as a result of SA still have to exercise managerial

judgment in arriving at accept/ Reject decision.

SCENARIO ANALYSIS Extends SA by creating a range of different business case

scenarios Its focus is much broader

THREE Broader Scenarios will be produced

In each case, an estimate is made of the

PROJECT’S most likely outcomes

(in terms of NPV or IRR)

Optimistic Assumptions Pessimistic Assumption

about economic /

marketing/ competitive

conditions and about key

variables. E.g.. High estimates

for selling price/ Sales volumes

Best Case Most likely case Worst caseBMW

Approach

SC Analysis subjective

(NPV) Exp.outcome nonetheless allows

Optimistic 180000 managers to develop an

Most Likely 120000 appreciation and awareness

Pessimistic (10000) of degree of Variability (Risk)

Range 190000 of project outcomes

will give the Range a

useful risk measure.

NPV for Optimistic

NPV for Pessimistic

SIMULATION ANALYSIS

A more complex and elaborate version of scenario analysis

Statistically based approach which makes use of Random numbers and pre assigned probabilities to simulate a project’s outcome or return.

RADR – Risk Adjusted Discount Rate differ from previous approaches – instead of adjusting a project’s

outflows for risk, a project’s discount rate is modified to incorporate a risk premium

average risk premium = avg.cost of capital – risk free rate

average risk projects / normal projects normal or

average discount rate , ra – avg.cost of capital RADR : is the return that the project is required to earn in the situation under analysis Firm could use a differ discount rate than Avg.cost of capital to avg. disc rate incorporate Risk avg. cost of capital

Firm

project project projectRADR

NPV & IRR

• Generally yield similar conclusions in most cases

• However, while choosing between mutually exclusive projects , the differences are most visible.

• Differences in Scale NPV is stated in rupee terms and does not factor in the scale of the project. IRR, by contrast , is a percentage return, which is standardised for the scale of the project

Which rule yields the better decisions?

• Answer depends on the capital rationing constraints faced by the company.

• When there are no capital constraints, NPV rule provides the right answer.

• If there are capital rationing constraints, however, then taking project B may lead to rejection of good projects later on.

In those cases, IRR rule may provide better solution.

• Use of profitability index

Difference in reinvestment rate assumption

• reinvestment rate applicable to intermediate cashflows

• IRR assumes that the intermediate cashflows are reinvested at IRR.

• NPV assumes that the CFs are invested at the discount rate.

Modified IRR Example: Cashflow Rs.300 Rs.400 Rs.500 Rs.600

Investment Rs.600 (Rs.1000) Rs.500 (1.15) Rs.575 Rs.400(1.15)2 Rs.529 Rs.300(1.15)3 Rs.456 Terminal Value Rs.2160 Modified IRR = (2160/1000)1/4 – 1 = 21.23%

Projects with Unequal Lives

• NPV – measured in Re.Terms – likely to be higher for longer term projects.

• Example:

Shorter Life project

Rs.400 Rs.400 Rs.400 Rs.400 Rs.400

(Re.1000) 1 2 3 4 5

NPV = 442

Longer Life Project

350 350 350 350 350 350 350 350 350 350

(Rs.1500) 1 2 3 4 5 6 7 8 9 10

NPV = 478

• NPV Basis – Second Project. But this fails to factor in the additional NPV that the firm could make from years 6 – 10 is the project with five year life.

Solution : Equivalent Annuity Approach.• NPVs of projects can be converted into an

equivalent annuity, which can be considered the annualised Net Present Value; because the NPV is annualised, it can be compared legitimately across projects with different lives.

• Equivalent Annuity = NPV [ A(PV,r,n)] where r = Project discount rate n = Project life time A(PV,r,n ) = Annuity factor

Project Replication

Projects can be replicated until they have the same lives. Thus, instead of comparing a 5 year to 10 year project, an estimate of the NPV can be obtained from the during from doing the 5 year project twice and compared to the NPV of the 10 year project.

Relationship among DCF criteria

When projects are independent & there is no Cap.Budget constraint, set of projects selected by the DCF criteria would be the same – differences may be there in internal rankingIn the real world, firms are faced with mutually exclusive projects & limited availability of funds.Due to these imperfections not all projects with NPV > 0 can be accepted - conflicts in project ranking may arise because of * Size disparity * Time disparity * Life disparity

When When When

NPV > 0IRR > KPI > 1

NPV = 0IRR = KPI = 1

NPV < 0IRR < KPI < 1

SIZE Disparity

Project A & B – mutually exclusiveCost of Capital of the co. 10% Project A Project BOriginal Investment Rs.4,00,000 16,00,000Cash inflow per year 1,00,000 3,00,000Useful Life 10 yrs 10 yrs

NPV , IRR and PI for projects Project A Project BPV of inflows 6,14,460 18,43,380 NPV 2,14,460 2,43,380 IRR 22% 13% PI 1.536 1.152 NPV of B is higher than the NPV of A IRR & PI of A are higher than that of BResolution of capital depends on the circumstances of the firms. 1. if the firm has enough funds available to it the cost of capital , Project B

is preferable to A because it contributes more NPV of the firm.

CONFLICT

TIME DisparitySequence of pattern of cash inflows may differ it leads to conflicts to ranking

Project X & Y , cost of capital 10% Project X Project YInitial outlay 1,10,000 1,10,000Cash inflows : Year 1 31,000 71,000 2 40,000 40,000 3 50,000 40,000 4 70,000 20,000

PV of Inflows 1,46,613 1,41,314 NPV 36,613 31,314 IRR 22% 25% PI 1.333 1.235

Conflict : NPV of PI of project X higher than that of B IRR of project X is lower than YReason: IRR method assumes that intermediate cash inflows can be re-invested at the IRR. Hence favours Project Y with higher earlier cash inflows NPV & PI assume that intermediate cash inflows

can be reinvested at the firm’s cost of capital ( a lower rate)

How this conflict is resolved?

By defining the reinvestment rate that are

applicable to the cash flows of the firm and

calculating modified versions of NPV & PI.

LIFE Disparity: Projects P & Q Cost of Capital 12% Project P Project Q Outlay 2,00,000 2,00,000 Cash inflows: 1 - 3,00,000 80,000 2 - - 80,000 3 - - 2,80,000

PV of inflows 2,67,857 3,34,512 NPV 67,857 1,34,512 PI 1.339 1.623 IRR 50% 40% Which project should be selected?

Size Disparity

How to resolve the problem? All depends on capital rationing constraints

faced by the firm When there are no CR constraints, NPV

provides the right answer When there are CR constraints, IRR may

provide better solution

Feasible Combinations Approach1. Define all combinations of Projects which are feasible,

given the capital budget restriction and Project interdependencies

2. Choose the feasible combination that has the highest NPV

Illustration: Co.ABL Ltd Cap. Budget Constraint of Rs.30,00,000

Project B & C are mutually exclusive other projects areinterdependent. - Feasible combinations have to be developed

Project Outlay NPV

ABCDE

18,00,00015,00,00012,00,000 7,50,000 6,00,000

7,50,0006,00,0005,00,0003,60,0003,00,000

2. If the firm has limited availability of firms

If B is chosen, Project A and some other projects are

sacrificed

NPV of project B is to be compared with

NPV of project B & other projects which may be

sacrificed

Assume Project C with an outlay of 12,00,000 and a NPV

of Rs.1,00,000

Project Project

A & C B

Outlay of A & C 16 16,00,000

NPV of B & C 3,14,460 2,43,380

A & C can be selected.