Capital Budgeting RK 1

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INTRODUCTION:

For effective running of a business, management must

know:

where it intends to go , i.e. organizational objectives

how it intends to accomplish its objective, i.e. plans

whether individual plans fit in the overall

organizational objective. i.e. coordination

whether operations conform to the plan ofoperations relating to that period i.e. control

Budgetary control is the device that a company

uses for all these purposes.


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IntroductionIntroduction

A beer company is considering building a newA beer company is considering building a new

brewery.brewery.

An airline is deciding whether to add flights toAn airline is deciding whether to add flights to

its schedule.its schedule. An engineer at a high-tech company hasAn engineer at a high-tech company has

designed a new microchip and hopes todesigned a new microchip and hopes to

encourage the company to manufacture and sellencourage the company to manufacture and sell

it.it.

A small college contemplates buying a newA small college contemplates buying a new

photocopy machine.photocopy machine.

A nonprofit museum is toying with the idea ofA nonprofit museum is toying with the idea of

installing an education center for children.installing an education center for children.

Newl weds dream of bu in a house.Newlyweds dream of buying a house.33


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IntroductionIntroduction

What do these projects have in common? AllWhat do these projects have in common? All

of them entail aof them entail a commitment of capitalcommitment of capital andand

managerial effortmanagerial effort that may or may not bethat may or may not be

justified by later performance.justified by later performance. A common set of tools can be applied toA common set of tools can be applied to

assess these seemingly very differentassess these seemingly very different

propositions.propositions.

The financial analysis used to assess suchThe financial analysis used to assess suchprojects is known asprojects is known as capital budgeting.capital budgeting.

How should a limited supply of capital andHow should a limited supply of capital and

managerial talent be allocated among anmanagerial talent be allocated among an

unlimited number of possible projects andunlimited number of possible projects and

corporate initiatives?corporate initiatives?44


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Capital BudgetingCapital Budgeting

Capital budgeting is the processCapital budgeting is the process

of identifying, evaluating,of identifying, evaluating,

planning, and financing anplanning, and financing anorganizations major investmentorganizations major investment

projects.projects.

Decisions to expand productionDecisions to expand production

facilities, acquire new productionfacilities, acquire new productionmachinery, buy a new computer,machinery, buy a new computer,

or remodel the office building areor remodel the office building are

all examples of capital-all examples of capital-

expenditure decisions.expenditure decisions.55


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Capital-budgeting decisions made nowCapital-budgeting decisions made now

determine to a large degree howdetermine to a large degree how

successful an organization will be insuccessful an organization will be in

achieving its goals and objectives inachieving its goals and objectives in

the years ahead.the years ahead.

Capital budgeting plays an importantCapital budgeting plays an important

role in the long-range success of manyrole in the long-range success of many

organizations because of severalorganizations because of several

characteristics that differentiate itcharacteristics that differentiate it

from most other elements of thefrom most other elements of the66


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BASIC FEATURES OF CAPITAL

BUDGETING

Capital budgeting decisions have long-term

implications.

These decisions involve substantial commitment of

funds.

These decisions are irreversible and require analysis

of minute details.

These decisions determine and affect the future

growth of the firm.


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Capital budgeting projects require relativelyCapital budgeting projects require relatively

large commitments of resources. Majorlarge commitments of resources. Major

projects, such as plant expansion orprojects, such as plant expansion or

equipment replacement, may involveequipment replacement, may involveresource outlays in excess of annual netresource outlays in excess of annual net

income.income.

Relatively insignificant purchases are notRelatively insignificant purchases are not

treated as capital budgeting projects even iftreated as capital budgeting projects even if

the items purchased have long lives. Forthe items purchased have long lives. For

example, the purchase of 100 calculators atexample, the purchase of 100 calculators at

$15 each for use in the office would be$15 each for use in the office would be

treated as a period expensetreated as a period expense

by most firms, even though the calculatorsby most firms, even though the calculators88


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Most capital expenditure decisions are long-Most capital expenditure decisions are long-

term commitments.term commitments.

The projects last more than 1 year, with manyThe projects last more than 1 year, with many

extending over 5, 10, or even 20 years.extending over 5, 10, or even 20 years.

The longer the life of the project, the moreThe longer the life of the project, the more

difficult it is to predict revenues, expenses,difficult it is to predict revenues, expenses,

and cost savings.and cost savings.

Capital-budgeting decisions are long-termCapital-budgeting decisions are long-term

policy decisions and should reflect clearly anpolicy decisions and should reflect clearly an

organizations policies on growth, marketing,organizations policies on growth, marketing,

industry share, social responsibility, and otherindustry share, social responsibility, and other

goalsgoals 99


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CAPITAL BUDGETING DECISION INVOLVES

THREE STEPS:

1. Estimation of costs and benefits of a proposal or of

each alternative.

2. Estimation of the required rate of return, i.e., the cost

of capital

3. Selection and applying the decision criterion.


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Project Cash FlowsProject Cash Flows

A project creates wealth if it generates cash flowsA project creates wealth if it generates cash flows

over time that are worth more in present-valueover time that are worth more in present-value

terms than the initial setup cost. For example,terms than the initial setup cost. For example,

suppose a brewery costs $10 million to build, butsuppose a brewery costs $10 million to build, butonce built it generates a stream of cash flows thatonce built it generates a stream of cash flows that

is worth $11 million.is worth $11 million.

Building the brewery would create $1 million ofBuilding the brewery would create $1 million of

new wealth.new wealth. If there were no other proposed projects thatIf there were no other proposed projects that

would create more wealth than this, then the beerwould create more wealth than this, then the beer

company would be well advised to build the newcompany would be well advised to build the new

brewery.brewery. 1111


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DECISION CRITERIA

TECHNIQUES OF EVALUATION

Traditional or Time-adjusted or

Non-discounting Discounted cash flows

1. Payback period 1. Net Present Value

2. Accounting Rate of 2. Profitability Index

Return 3. Internal Rate of Return


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Proposed ProjectProposed Project

Bibba is evaluating a new projectBibba is evaluating a new project

for her firm, Bibbafor her firm, Bibba Bakery (BB)Bakery (BB)..

She has determined that theShe has determined that the

after-tax cash flows for the projectafter-tax cash flows for the project

will bewill be $10,000; $12,000;$10,000; $12,000;

$15,000; $10,000; and $7,000,$15,000; $10,000; and $7,000,

respectively, for each of therespectively, for each of theYearsYears

1 through 51 through 5. The initial cash. The initial cash

outlay will beoutlay will be $40,000$40,000..1313


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TRADITIONAL OR NON-DISCOUNTING

TECHNIQUES

I .PAYBACK PERIOD:

# The payback period is defined as the number of

years required for the proposals cumulative cash inflows to beequal to its cash outflows.

# The payback period is the length of time required

to recover the initial cost of the project.# The payback period may be suitable if the firm

has limited funds available and has no ability or willingness to

raise additional funds.


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Payback Period (PBP)Payback Period (PBP)

PBPPBP is the period of timeis the period of time

required for the cumulativerequired for the cumulative

expected cash flows from anexpected cash flows from aninvestment project to equal theinvestment project to equal the

initial cash outflow.initial cash outflow.

PBPPBP is the period of timeis the period of time

required for the cumulativerequired for the cumulative

expected cash flows from anexpected cash flows from aninvestment project to equal theinvestment project to equal the

initial cash outflow.initial cash outflow.

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7


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(c)10 K 22 K 37 K 47 K 54 K

Payback Solution (#1)Payback Solution (#1)

PBPPBP == aa + (+ ( bb -- cc ) /) / dd

== 33 + (+ (4040 -- 3737) /) / 1010

== 33 + (+ (33) /) / 1010

== 3.3 Years3.3 Years

0 1 2 3 4 5

-40 K 10 K 12 K 15 K 10 K 7

CumulativeInflows

(a)

(b) (d)


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PBP AcceptancePBP Acceptance

CriterionCriterion

Yes!Yes! The firm will receive back theThe firm will receive back theinitial cash outlay in less than 3.5initial cash outlay in less than 3.5

years. [years. [3.3 Years3.3 Years


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PBP StrengthsPBP Strengths

and Weaknessesand Weaknesses

StrengthsStrengths::

Easy to use andEasy to use and

understandunderstand

Easier toEasier to

forecastforecast ST thanST than

LT flowsLT flows

WeaknessesWeaknesses::

Does not considerDoes not consider

cash flows beyondcash flows beyond

the PBPthe PBP

Cutoff period isCutoff period is

subjectivesubjective


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Internal Rate of ReturnInternal Rate of Return

(IRR)(IRR)IRRIRR is the discount rate that equatesis the discount rate that equates

the present value of the future netthe present value of the future net

cash flows from an investmentcash flows from an investmentproject with the projects initial cashproject with the projects initial cash

outflow (ICO).outflow (ICO).

CF1 CF2 CFn

(1+IRR)1 (1+IRR)2 (1+IRR)n+ . . . ++ICO =


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IRR Solution (TryIRR Solution (Try

10%)10%)$40,000$40,000 == $10,000(PVIF$10,000(PVIF10%10%,,11) +) +

$12,000(PVIF$12,000(PVIF10%10%,,22) +) + $15,000(PVIF$15,000(PVIF10%10%,,33) +) +

$10,000(PVIF$10,000(PVIF10%10%,,44) +) + $ 7,000(PVIF$ 7,000(PVIF10%10%,,55))$40,000$40,000 == $10,000(.909) + $12,000(.826)$10,000(.909) + $12,000(.826)

++ $15,000(.751) +$15,000(.751) +

$10,000(.683) +$10,000(.683) + $$7,000(.621)7,000(.621)

$40,000$40,000 == $9,090 + $9,912 + $11,265 +$9,090 + $9,912 + $11,265 +

$6,830 + $4,347$6,830 + $4,347

== $41,444$41,444 [[Rate is tooRate is too


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IRR Solution (TryIRR Solution (Try

15%)15%)$40,000$40,000 == $10,000(PVIF$10,000(PVIF15%15%,,11) +) +

$12,000(PVIF$12,000(PVIF15%15%,,22) +) + $15,000(PVIF$15,000(PVIF15%15%,,33))

+ $10,000(PVIF+ $10,000(PVIF15%15%,,44) +) + $ 7,000(PVIF$ 7,000(PVIF15%15%,,55))$40,000$40,000 == $10,000(.870) + $12,000(.756)$10,000(.870) + $12,000(.756)

++ $15,000(.658) +$15,000(.658) +

$10,000(.572) +$10,000(.572) +

$$

7,000(.497)7,000(.497)

$40,000$40,000 == $8,700 + $9,072 + $9,870 +$8,700 + $9,072 + $9,870 +

$5,720 + $3,479$5,720 + $3,479

== $36,841$36,841 [[Rate is tooRate is too


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.10.10 $41,444$41,444

.05.05 ICOICO $40,000$40,000 $4,603$4,603

.15.15 $36,841$36,841

($1,444)(0.05)($1,444)(0.05)

$4,603$4,603

IRR SolutionIRR Solution

(Interpolate)(Interpolate)$1,444X

X = X = .0157

IRR = .10 + .0157 = .1157 or 11.57%


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Discount rateDiscount rate

TheThe discount ratediscount rate can mean ancan mean an

interest rate a centralinterest rate a central

bank charges depository institutions thatbank charges depository institutions that

borrow reserves from it, for example forborrow reserves from it, for example forthe use of the Federalthe use of the Federal

Reserve's discount window.Reserve's discount window.

the same as interest rate; the termthe same as interest rate; the term"discount" does not refer to the common"discount" does not refer to the common

meaning of the word, but to themeaning of the word, but to the

meaning in computations of presentmeaning in computations of present

value, e.g. net presentvalue, e.g. net present2424


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IRR AcceptanceIRR Acceptance

CriterionCriterion

No! The firm will receive 11.57%No! The firm will receive 11.57%for each dollar invested in thisfor each dollar invested in this

project at a cost of 13%. [ IRR


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$15,000 $10,000 $7,000

IRR SolutionIRR Solution

$10,000 $12,000

(1+IRR)1

(1+IRR)2

Find the interest rate (Find the interest rate (IRRIRR) that causes) that causes

the discounted cash flows to equalthe discounted cash flows to equal

$40,000$40,000..

+ +

++$40,000 =

(1+IRR)3 (1+IRR)4 (1+IRR)5


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DISCOUNTED CASH FLOWS OR TIME

ADJUSTED TECHNIQUES

These are based upon the fact that the cash flows occurring at

different point of time are not having same economic worth.

I.NET PRESENT VALUE (NPV) METHOD:

The NPV of an investment proposal may be defined as the sum

of the present values of all the cash inflows less the sum of present

values of all the cash outflows associated with the proposal.

The decision rule is Accept the proposal if its NPV is positive

and reject the proposal if the NPV is negative.


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Net Present ValueNet Present Value

(NPV)(NPV) (NPV) is the difference between the(NPV) is the difference between the

setup cost of a project and the value ofsetup cost of a project and the value of

the project once it is set up.the project once it is set up. If that difference is positive, then theIf that difference is positive, then the

NPV is positive and the project createsNPV is positive and the project creates

wealth.wealth.

If a firm must choose from severalIf a firm must choose from severalproposed projects, the one with theproposed projects, the one with the

highest NPV will create the most wealth,highest NPV will create the most wealth,

and so it should be the one adopted.and so it should be the one adopted. 2828


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Net Present ValueNet Present Value For example, suppose the car company can eitherFor example, suppose the car company can either

build the new plant or, alternatively, can introducebuild the new plant or, alternatively, can introduce

a new product a mid segment car.a new product a mid segment car.

There is not enough managerial talent to overseeThere is not enough managerial talent to oversee

more than one new project, or maybe there are notmore than one new project, or maybe there are not

enough funds to start both.enough funds to start both.

Let us assume that both projects create wealth:Let us assume that both projects create wealth:

The NPV of the new plant is $1 million, and theThe NPV of the new plant is $1 million, and the

NPV of the new-product project is $500,000.NPV of the new-product project is $500,000.

If it could, the car company should undertake bothIf it could, the car company should undertake both

projects; but since it has to choose, building theprojects; but since it has to choose, building the

new plant would be the right option because it hasnew plant would be the right option because it has

the higher NPV.the higher NPV.

CAPITAL BUDGETING PRACTICES IN INDIA


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CAPITAL BUDGETING PRACTICES IN INDIA

Capital budgeting decisions are undertaken at the topmanagement level and are planned in advance. The Corporates

follow mostly top-down approach in this regard.

Discounted cash flow techniques are more popular now.

High growth firms use IRR more frequently whereas Payback

period is more widely used by small firms.

PI technique is used more by public sector units than by

private sector units.

Capital budgeting decisions are of paramountimportance as they affect the profitability of a firm, and

are the major determinants of its efficiency and

competing power.


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ADVANTAGES ANDADVANTAGES AND

DISADVANTAGES OF IRR AND NPVDISADVANTAGES OF IRR AND NPV

A number of surveys have shown that, inA number of surveys have shown that, in

practice, the IRR method is more popularpractice, the IRR method is more popular

than the NPV approach.than the NPV approach.

The reason may be that the IRR isThe reason may be that the IRR isstraightforward, but it uses cash flows andstraightforward, but it uses cash flows and

recognizes the time value of money, likerecognizes the time value of money, like

the NPV.the NPV.

In other words, while the IRR method isIn other words, while the IRR method is

easy and understandable, it does not haveeasy and understandable, it does not have

the drawbacks of the payback period,the drawbacks of the payback period,

which ignores the time value of money.which ignores the time value of money.3131


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DISADVANTAGES OF IRR ANDDISADVANTAGES OF IRR AND

NPVNPV The main problem with the IRR method isThe main problem with the IRR method isthat it often gives unrealistic rates ofthat it often gives unrealistic rates of

return.return.

Suppose the cutoff rate is 11% and theSuppose the cutoff rate is 11% and theIRR is calculated as 40%. Does this meanIRR is calculated as 40%. Does this mean

that the management shouldthat the management should

immediately accept the project becauseimmediately accept the project because

its IRR is 40%.its IRR is 40%. The answer isThe answer is nono! An IRR of 40%! An IRR of 40%

assumes that a firm has the opportunityassumes that a firm has the opportunity

to reinvest future cash flows at 40%. Ifto reinvest future cash flows at 40%. If

past experience and the economypast experience and the economy3232


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DISADVANTAGES OF IRR ANDDISADVANTAGES OF IRR AND

NPVNPV Another problem with the IRR method is thatAnother problem with the IRR method is thatit may give different rates of return.it may give different rates of return.

Suppose there are two discount rates (twoSuppose there are two discount rates (two

IRRs) that make the present value equal toIRRs) that make the present value equal tothe initial investment. In this case, whichthe initial investment. In this case, which

rate should be used for comparison with therate should be used for comparison with the

cutoff rate? The purpose of this question iscutoff rate? The purpose of this question is

not to resolve the cases where there arenot to resolve the cases where there aredifferent IRRs.different IRRs.

The purpose is to let you know that the IRRThe purpose is to let you know that the IRR

method, despite its popularity in the businessmethod, despite its popularity in the business3333


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WHY THE NPV AND IRRWHY THE NPV AND IRR

SOMETIMES SELECTSOMETIMES SELECT

DIFFERENT PROJECTSDIFFERENT PROJECTS When comparing two projects, the use ofWhen comparing two projects, the use of

the NPV and the IRR methods may givethe NPV and the IRR methods may give

different results. A project selecteddifferent results. A project selectedaccording to the NPV may be rejected ifaccording to the NPV may be rejected if

the IRR method is used.the IRR method is used.

Suppose there are two alternativeSuppose there are two alternative

projects, X and Y. The initial investmentprojects, X and Y. The initial investmentin each project is $2,500. Project X willin each project is $2,500. Project X will

provide annual cash flows of $500 for theprovide annual cash flows of $500 for the

next 10 years. Project Y has annual cashnext 10 years. Project Y has annual cash

flows of $100, $200, $300, $400, $500,flows of $100, $200, $300, $400, $500,3434


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Using the trial and error method you findUsing the trial and error method you find

that the IRR of Project X is 17% and thethat the IRR of Project X is 17% and the

IRR of Project Y is around 13%.IRR of Project Y is around 13%. If you use the IRR, Project X should beIf you use the IRR, Project X should be

preferred because its IRR is 4% morepreferred because its IRR is 4% more

than the IRR of Project Y.than the IRR of Project Y.

But what happens to your decision if theBut what happens to your decision if theNPV method is used?NPV method is used?

The answer is that the decision willThe answer is that the decision will

change depending on the discount ratechange depending on the discount rate


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For instance, at a 5% discount rate,For instance, at a 5% discount rate,

Project Y has a higher NPV than XProject Y has a higher NPV than X

does. But at a discount rate of 8%,does. But at a discount rate of 8%,Project X is preferred because of aProject X is preferred because of a

higher NPV.higher NPV.

The purpose of this numericalThe purpose of this numerical

example is to illustrate an importantexample is to illustrate an importantdistinction: The use of the IRR alwaysdistinction: The use of the IRR always

leads to the selection of the sameleads to the selection of the same

project, whereas project selectionproject, whereas project selection

using the NPV method depends on theusing the NPV method depends on the


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II .ACCOUNTING RATE OF RETURN (OR) AVERAGE

RATE OF RETURN

(ARR)

# The ARR may be defined as the annualized net

income earned on the average funds invested in a project.

# The annual returns of a project are expressed as a

percentage of the net investment in the project.

COMPUTATION OF ARR:

Average Annual profit (after tax)

ARR = x 100


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Accounting Rate of Return (Or) AverageAccounting Rate of Return (Or) Average

Rate Of Return (ARR)Rate Of Return (ARR)

A comparison of the profitA comparison of the profit

generated by the investment withgenerated by the investment with

the cost of the investmentthe cost of the investment Denominator is Book Value ofDenominator is Book Value of

Fixed InvestmentFixed Investment

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A ti R t f R tAcco nting Rate of Ret rn


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Accounting Rate of ReturnAccounting Rate of Return

(Or) Average Rate Of Return(Or) Average Rate Of Return

(ARR)(ARR)Year Book Value of

Fixed InvestmentProfit After Tax

1 90000 20000

2 80000 22000

3 70000 24000

4 60000 26000

5 50000 28000

3939

A ti R t f R tAccounting Rate of Return


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(ARR)(ARR) 1/ 5 ( 20000+ 22000+ 24000+26000+1/ 5 ( 20000+ 22000+ 24000+26000+

28000)/ 1/5( 90000+80000+70000+28000)/ 1/5( 90000+80000+70000+

60000+ 50000)60000+ 50000) = 34 per cent= 34 per cent

4040

A ti R t f R tAccounting Rate of Return


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(ARR)(ARR) Shows ProfitabilityShows Profitability

This method allows comparison inThis method allows comparison in

betweenbetween Based on Accounting Profit &Based on Accounting Profit &

Income streams not time relatedIncome streams not time related

Doesnt take into account timeDoesnt take into account timevalue of money.value of money.

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Key considerations forKey considerations for


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Key considerations forKey considerations for

firms in consideringfirms in considering

useuse Ease of use/degree of simplicity requiredEase of use/degree of simplicity required

Degree of accuracy requiredDegree of accuracy required

Extent to which future cash flows can beExtent to which future cash flows can bemeasured accuratelymeasured accurately

Extent to which future interest rateExtent to which future interest ratemovements can be factored in andmovements can be factored in and

predictedpredicted Necessity of factoring in effects of inflationNecessity of factoring in effects of inflation

4242


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Payback Accounting Net present Internal rate

period rate of return value of return

Basis of Cash Actual Cash flows Cash flows

measurement flows income Profitability Profitability

Measure Number Percent Rs Percent

expressed as of years Amount

Easy to Easy to Considers time Considers time

Understand Understand value of money value of money

Strengths Allows Allows Accommodates Allows

comparison comparison different risk comparisons

across projects across projects levels over of dissimilar

a project's life projects

Doesn't Doesn't Difficult to Doesn't reflect

consider time consider time compare varying riskvalue of money value of money dissimilar levels over the

Limitations projects project's life

Doesn't Doesn't give

consider cash annual rates

flows after over the lifepayback period of a project

Comparing MethodsComparing Methods


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WORKING CAPITAL MANAGEMENT

Working capital management is concerned with the

problems that arise in managing the current assets,

current liabilities and the interrelationships between

them.

GOAL:

To manage the firms current assets and liabilities in

such a way that a satisfactory level of working capital

is maintained.


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CONCEPTS:

GROSS WORKING CAPITAL The current assets which

represent the proportion of investment that circulates

from one form to another in the ordinary conduct of

business.

NET WORKING CAPITAL The portion of current

assets financed with long term funds orcurrent assets current liabilities

PURPOSE


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PURPOSE:

The NWC is necessary because the cash outflows and inflows do not

coincide.

The purpose of NWC is to measure the liquidity of the firm.

DETERMINING FINANCING MIX:

Financing mix is the choice of sources of financing of current assets.

SOURCES OF ASSET FINANCE:

1. Short term sources (Current liabilities)

2. Long term sources (Share capital, long term borrowings).


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INSTRUMENTS OF SHORT TERM

FINANCING

Trade Credit

Bill Discounting

Inter Corporate Deposits

Public deposits

Commercial papers

Factoring


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APPROACHES TO DETERMINE

FINANCING MIX:

1. Hedging approach

2. Conservative approach

3. Trade off between the above

mentioned two approaches.


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HEDGING APPROACH (MATCHING

APPROACH):

This is the process of matching maturities of debt with the

maturities of financial needs.

According to Hedging approach, the permanentportion

of funds required should be financed with long term funds

and the seasonal portion withshort term funds.

Under this approach working capital = 0 since CA are not financed

by long term funds (CA = CL).


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CONSERVATIVE FINANCING APPROACH:

This is a strategy by which the firm finances all funds

requirement, with long term funds and uses short termfunds for emergencies or unexpected outflows.

TRADE OFF BETWEEN HEDGING ANDCONSERVATIVE APPROACHES:

One possible trade off could be equal to the average of the

minimum and maximum monthly requirements of funds

during the given period of time. This level of requirement

of funds may be financed through long run sources and

for any additional financing need, short termfunds may be

used.

FACTORS DETERMINING AMOUNT OF WORKING CAPITAL


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Purchase Payment for Sell product Receive

resources resource purchase on credit cash

Inventory Receivableconversion conversion

period period

Payables Cash

period Conversion

period

Operating cycle

The length of the operating cycle is the most


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The length of the operating cycle is the most

widely used method to determine working capital need.

The longer the production cycle, the larger is the

working capital need or vice versa.

Manufacturing and trading enterprises require fairly

large amount of working capital to support their

production and sales activity. Service enterprises like

hotels, restaurants etc., need less working capital.

During boom conditions need for working capital is

more.

Growth industries and firms need more workingcapital.

Working capital requirement are to be determined

on the basis of cash cost i.e excluding depreciation.


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Documents

Capital Budgeting RK 1