CAPITAL BUDGETING

Capital Budgeting: The total process of generating, evaluating, selecting and following up on capital expenditure alternatives.

Capital Expenditure: An outlay made by a firm for a fixed or an intangible asset from which benefits are expected to be received over a period greater than a year.

Independent Projects: Capital expenditure alternatives that compete with each other, but in such a way that the acceptance of one project does not eliminate the other projects from further consideration.

Mutually Exclusive Projects: A group of capital budgeting projects that compete with one another in such a way that the acceptance of one eliminates all other in the group from further consideration.

Capital Rationing: The allocation of limited,.bn amount of funds to a group of competing capital budgeting process.

Ranking Approach: Evaluating the relative attractiveness of capital projects on the basis of some predetermined criterion.

Present Value: The value of a future sum or stream of dollars discounted at a specified rate. The process of finding present value is actually the inverse of the compounding process.

Future value: The value of a single sum or an annuity compounded at a given interest rate for a specified time period.

Importance of Capital Budgeting:

1. To achieve long-term goal of firm.2. Huge Capital Investment.

3. Long Term Investment.

4. Risky Investment.

5. Balancing amomg liquidity, profitability and value of the firm.

6. Searching for alternative investment opportunities.

7. Ranking of projects and best use of limited capital.

Types of Investment Decision

1. Accept-Reject Decision2. Mutually Exclusive Projects Decision

3. Capital Rationing Decision

Steps in Capital Budgeting:

1. Identification of investment projects2. Evaluation of alternative investment projects

3. Selection of the best investment projects

4. Implementation of the projects

5. Continuous evaluation of the selected projects.

Application of Capital Budgeting:

1. Purchase of Fixed assets2. Mechanisation of production method

3. Selection from alternative equipments

4. Introduction of new product

5. Expansion of business

6. Modernization and replacement

7. Make or buy decision.

Related Issues in Capital Budgeting:

Prospective Investment porposals

1. Cost of the projects2. Life of the projects

3. Cash inflows and outflows

4. Salvage value of the projects

5. Dsicounting rate

6. Techniques of evaluation

Capital Budgeting Methods

1. Average/Accounting Rate of Return Methods of Capital Budgeting

Formula 1: Based on original investment

ARR = Annual Net Profit After Tax X 100 Original Investment

Formula 2: Based on Average investment

ARR = Net Profit After Tax X 100 Average Investment

*Average investment= Original Investment – Salvage value + Salvage value

2

2. Pay Back Period Methods of Capital Budgeting

Formula 1: When Annual Cash Flows are uniform

PBP = Investment Cash flow after tax

Formula 1: When Annual Cash Flows are uniform

PBP = A + NCO - C D

Where, A = Year in which the accumulated cash flows are nearer to NCO NCO = Net Cash Outlay C = Accumulated cash outlay of the year ‘A’ D = Cash flow of the succeeding year of the year ‘A’

Formula : NPV

Where there is one single investment in the beginning

NPV =

Or, NPV =

Or, NPV = PV of NCB – PV of NCO

Here,NPV = Net Present ValueCFt= Cash flow at different time period. Sn= Salvage value at N year.Wn= Working capital structureCoo= Initial cash out flowK = Cost of capital.

Where there is a number of investment at interval

NPV =

Or, NPV = PV of NCB – PV of NCO

Here, Cot= Cash out flow at different times.

Decision Rule at a glance1. NPV>0 → Accepted2. TPV> NCO → Accepted3. NPV = O → May accepted or rejected.4. NPV < O → Rejected5. TPV < NCO → Rejected

FORMULA : IRRIRR = A + × (B-A)Where, IRR = Internal Rate of Return

A = Lower Discount Rate.B = Higher Discount Rate.C = NPV of Lower Discount Rate.D = NPV of Higher Discount Rate

ILLUSTRATION (NPV)ABC co. has two projects for consideration

Year EBDT

012345

Salvage value

Project A Project B(50,000)10,00015,00012,00020,00010,0005,000

(50,000)12,00010,00015,00025,0009,5002,500

If the tax rate is 40% and the discount rate is 12%, which of the two projects will be accepted ?

SOLUTION: Depreciation = = = 9,000.

Year EBDT Dep. EBT Tax 40% EAT NCF Factor 12% PV12345

S.V

10,00015,00012,00020,00010,0005,000

9,0009,0009,0009,0009,000

---

1,0006,0003,00011,0001,0005,000

4002,4001,2004,400400---

6003,6001,8006,600600

5,000

9,60012,60010,80015,6009,6005,000

.892

.797

.712

.635

.567

.567

8,56310,0427,6909,9065,4432,83544,479

NPV = PV of NCB – PV of NCO= 44,479 – 50,000= (5,521)

Depreciation = = 9,500Year CFBT Dep. EBT Tax 40% EAT CFAT Factor 12% PV

12345

12,00010,00015,00025,0009,500

9,5009,5009,5009,5009,500

2,500500

5,50015,500

0

1,000200

2,20015,500

0

1,500300

3,3009,300

0

11,0009,80012,80018,8009,500

.892

.797

.712

.635

.567

9,8127,8119,10111,9385,38744,049

NPV = PV of NCB – PV of NCO= 44,049 – 50,000= (5,951)Decision: Both the companies have a negative NPV. So none of them would be considered for investment.

FORMULA : IRRIRR = A + × (B-A)Where, IRR = Internal Rate of Return

A = Lower Discount Rate.B = Higher Discount Rate.C = NPV of Lower Discount Rate.D = NPV of Higher Discount Rate

ILLUSTRATION: (IRR)The cost of a 3 year project is estimated as tk. 20,000. The estimated inflows for three years have been estimated as tk. 8,000 per year. If the cost of capital is 7% whether investment in the project is worthy or not?

Calculation of IRRYear CFAT Factor 7% PV Factor 10% PV1-3

Less : NCO8,000 2,624 20,992

20,0002,486 19,888

20,000992 -112

IRR = A + × (B-A)= 7% + (10-7)%= 7% + × 3%= 7% + 2.695%= 9.695%

Illustration 1 : ARR and PBP

Nishat Enterprise wants to buy a machine costing tk. 1,50,000 for an expected life of 5 years. The projected net profit after tax is follows:

Years Net Profit After Tax12345

Tk. 20,000Tk. 18,000Tk. 15,000Tk.17,000Tk. 15,000

Calculate the average rate of return (ARR) of Nishat Enterprise

Illustration 2 : NPV

A Company is considering an investment proposal to install new milling controls at a cost of tk. 50,000. The facility has a life expectancy of five years and no salvage value. The tax rate is 35 per cent. Assume the firm uses straight-line depreciation. The cost of capital is 10%. The Earnings before depreciation and taxes from the investment proposal are as follows.

Years EBDT12345

Tk. 10,000Tk. 10,692Tk. 12,769Tk.13,462Tk. 20,385

Compute the following and suggest whether the proposal is to be accepted or not