Capital Budgeting

Neha Bhawna

Sudhir1

The term 'Capital Budgeting' refers to long term planning for proposed capital outlays & their financing.

• It may be defined as “ the firm’s formal process for the acquisition & investment of capital.”

• It is the decision making process by which the firm evaluate the purchase of major fixed assets.

• The investment in current assets necessitated on account of investment in a fixed assets, is also to be taken as a capital budgeting decision.

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CASES OF CAPITAL BUDGETING DECISION

1. Replacements

2. Expansion

3. Diversification

4. R & D

5. Miscellaneous

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Operating Budget & Capital Budget

OB CBIt shows planned operations It deals exclusively with the for the coming period. major investment proposal. It includes sales, production, It assesses the economics production cost & selling of capital expenditure & & distribution overhead investment.budgets.

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CAPITAL EXPENDITURE BUDGET

1. It is a type of functional budget.2. It is the firm’s formal plan.3. It provides a guidance as to the amount of

capital that may be required for procurement of capital assets during the budget period.

4. It is prepared after taking into account the available production capacities, probable reallocation of existing resources & possible improvements in production techniques.

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Objectives of a Capital Expenditure Budget

1. It determines the capital projects on which work can be started during the budget period.

2. It estimates the expenditure that would have to be incurred on capital projects.

3. It restricts the capital expenditure on projects within authorised limits.

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Types of Investment decisions

Tactical Investment Decisions

Strategic Investment Decisions

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Importance of Capital Budgeting

Involvement of heavy funds

Long-term implications

Irreversible decisions

Most difficult to make8

Rationale of Capital Expenditure

Expenditure increasing revenue

Expenditure reducing costs

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Kinds of Capital Investment Proposals

Independent proposals

Contingent or dependent proposals

Mutually exclusive proposals

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Factors affecting Capital Investment Decisions :

1.The amount of investment

Computation of capital investment required:

(i)Cost of new project

(ii) Installation cost

(iii)Working capital: Investment in a new project may also result in increase or decrease of net working capital requirements.

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(iv)Proceeds from sale of asset

(v)Tax effects

(vi)Investment allowance: this is allowed to encourage capital investment of the cost of new machined and equipment for calculating income tax allowances thus reduces the cost of the initial investment on the project.

2. Minimum rate of return on investment: It is basically decided on the basis of the cost of capital.

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3. Return expected from the investment

There are two ways to calculate:

*Accounting profit

*Cash flows

The cash flow approach for determination of benefit from a capital investment project is better as compared to accounting profit approach on account of following reasons:

o Determination of economic valueo Accounting ambiguitieso Time value of money

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4. Ranking of investment proposals: necessary in the following 2 circumstances:-

a) Where capital is rationed

b) Where two or more investment opportunities are mutually exclusive.

5. Risk and uncertainty

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Capital Budgeting Appraisal Methods

1. Pay back period method2. Discounted cash flow method

I. The net present value methodII. Present value index methodIII. Internal rate of return

3. Accounting rate of return method

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The term pay-back refers to the period in which the project will generate the necessary cash to regroup the initial investment

OrIn other words ,the payback period is the length of time required to recover the initial cost of the project.

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Pay-back period:

E.g. If a project requires Rs. 20,000 as initial investment and it will generate an annual cash inflows of Rs 5000 for 10yrs the pay-back will be 4 years.

Payback period = initial investment annual cash inflow = 20000/5000 = 4

Unadjusted rate of return = annual return * 100initial investment

= 5000 /20000 *100 = 25%

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When the annual cash inflows are un equal:

E.g. a proposal requires a cash outflow of Rs. 20,000 and is expected to generate cash inflow of Rs 8000,Rs 6000, Rs 4000, Rs 2,000 Rs 2,000 over next 5 yrs Sol:The payback period = 4

as the sum of cash inflow is 20,000

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year Annual CF Cumulative c f

1 8,000 8,000

2 6,000 14,000

3 4,000 18,000

4 2,000 20,000

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Que : A co. requires an initial investment of Rs 40,000 the estimated net cash flow are as follows

1 2 3 4 5 6 7 8 9 10

7,000 7,000 7,000 7,000 7,000 8,000 10,000 15,000 10,000 4,000

Calculate Pay back period

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Sol:

Pay back period Initial outlay Rs. 40,000

Cash outflows for 5 yrs

7000+7000+7000+7000+7000=35,000

Balance outlay=40,000-35,000=5000

Cash flow for 6 year=8,000

PBP = 5yrs+5,000/8,000=5.62 yrs

Decision rule: If the payback period is more than the target period , then the proposal should be rejected.

Advantages•It is simple and easy and adopted by a small firm having limited manpower.• It gives the indication of liquidity . In case a firm is having liquidity problem , this method is good to adopt as it emphasizes earlier cash inflows.• It deals with risk too. The project with a shorter payback period will be less risky as compared to project with a longer payback period.

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Disadvantages :

• It ignores the time value of money.

e.g. There are 2 projects a and b , the cost of project is 30,000 in each case. The cash inflows are as :

• It ignores the return generated by a project after its payback period.

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year Project A Project B

1 10,000 2,000

2 10,000 4,000

3 10,000 24,000

Discounted Cash Flow Method Or Time Adjusted Technique

A method of evaluating an investment by estimating  future cash flows and taking into consideration the time value of money also called capitalization of income.

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DCF method for evaluating capital investment proposal are of three types

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The net present value method Excess present value index. Internal rate of return.

1. Net present value :

The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.

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• NPV= [R1/(I + k)+ R2/(1+k)2…………..+R n/(1+k)n]-I

where:

NPV=Net Present Value,

R= Cash Inflows At Different Time Periods,

K= Cost Of Capital 0r Cut Off Rate,

I= Cash Outflows At Different Time Period

ACCEPT OR REJECT CRETERIANPV> ZERO ACCEPT THE PROPOSAL

NPV< ZERO REJECT THE PROPOSAL

OR WHERE

PV>C ACCEPT

PV<C REJECT

PV Stands For Present Value Of Cash InflowsC Stands For Present Value Of Cash OutfLows

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Merit

It is based on the entire cash flow stream rather than accounting profit and thus help in analyzing the effect of the effect of the proposal on the wealth of the shareholders in a better way.

Demerit

Involves difficult calculation.

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1. A co. requires an initial investment of rs 40,000 the estimated net cash flow are as follows:

Using 10% cost of capital (discount)determine

Net present value?

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1 2 3 4 5 6 7 8 9 10

7,000 7,000 7,000 7,000 7,000 8,000 10,000 15,000 10,000 4,000

Sol:

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Year Cash flows Present value

1 7,000 6363

2 7,000 5782

3 7,000 5257

4 7,000 4781

5 7,000 7347

6 8,000 4512

7 10,000 5130

8 15,000 7005

9 10,000 4240

10 4,000 1544

Total 48,961

Initial outlay(-) 40,000

Net present value 8,961

b. Excess present value index

•This is refinement of NPV method.

•A present value index is found out by comparing the total of present value of future cash inflows and total of present value of future outflows.

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Excess present value index formula

= present value of future cash in flows X 100 present value of future outflows

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Excess present value provides ready comparison between investment proposal of different magnitudes.

for example: project ‘A’ requiring an investment of Rs.100000 shows excess present value of Rs.20000,while another project ‘B’ requiring an investment of Rs.10000 shows a present value of Rs.5000.If absolute figures of net present value are compared, Project ‘A’ seems to b profitable.

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From excess present value index method view

Present value index for ‘A’=(120000/100000)*100=120%.

Present value index for ‘B’=(15000/10000)*100=150%.

Now ‘B’ is profitable34

(c) Internal rate of return method

IRR is that rate @ which the sum of discounted cash inflows equals the sum of discounted cash out flows.In other words, it is the rate which discounts the cash flows to zero.It can b stated in the form of a ratio: (cash inflows/cash outflows)=1

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In this method the discount rate Is not known but the cash out flow and cash inflow are known.

For example , if a sum of Rs.800 invested in project becomes Rs.1000 at the end of a year, the rate of return comes 25%, calculated as follows I= R/(I + r),Where,I=cash out flow i.e., initial investment.R=cash inflows.R= rate of return yielding by the investment (or IRR)

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ACCEPT/REJECT CRITERION•Since IRR is the maximum rate of interest which an organization can afford to pay on capital investment in a project, thus

•A project would qualify to be accepted if IRR exceeds the cut-off rate.

•Higher the rate of return, greater the profitability. 37

When cash flows are uniform.

In case the two projects show uniform cash inflows, the internal rate of return can be calculated by locating the factor in annuity table II.The factor is calculated as follows: F=I/C, Where, F = factor to be locatedI= original investment C= cash flow per year

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When cash inflows are not uniform

•The IRR is calculated by making trial calculations in an attempt to compute the correct interest rate which equates the present value of the cash inflows with present value of cash outflows.

•In the process the cash inflows are to be discounted by a number of trial rates.

•The first trial rate can b calculated by the same formula which is used for determining the internal rate if return when cash inflows are uniform.

•But, here C stands for ‘annual average cash inflows’ 39

Comparison of the rate of return approach and present value

approach

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The chief point of difference b/w the two are as follows

•The NPV method takes the interest rate as a known factor while IRR method take it as unknown factor.

•The NPV seeks to find out the amount that can be invested in a given project so that its anticipated earnings will exactly suffice to repay this amount with interest at the market rate. while the IRR method seeks to find the maximum rate of interest at which the funds invested in a project could be repaid out the cash inflows arising out of that project.

•Both the NPV and IRR method proceed on the presumption that the cash inflows can be reinvested at the discounting rate in the new projects. however the of the of funds at the cut-off rate is more possible than at the internal rate of return. hence ,NPV is more reliable than IRR for ranking two or more capital intensive projects. 41

Similarities in the result under NPV and IRR

Both NPV & IRR will give same result regarding an investment proposal in the following cases:

(I) project involving conventional cash inflows, i.e., when an initial outflow is followed by a series of inflows. (II) Independent investment proposals ,i.e., proposals the acceptance of which does not preclude the acceptance of others

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Conflict in results under NPV & IRR

NPV & IRR give conflicting results in case of mutually exclusive projects, where acceptance of one project result in non-acceptance of the other project.

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Conflicting results may be due to any one or more of the following reasons:

•The projects require different cash outlays .

•The projects have unequal lives.

•The projects have different patterns of cash flows.

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Accounting or average rate of return (ARR) method.

This method judge the investment proposal on the basis of their relative profitability.Capital employed and relative income are determined according to commonly accepted accounting principals and practices aver the entire economic life of the project and then the average yield is calculated.This rate is termed as ARR.

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Calculation of ARR

1. (Annual avg net earnings/original investment) * 100.

2. (annual avg net earnings/avg investments)*100.( avg of earnings after dep and tax).

3. (Increase in expected future annual net earnings/initial increase in required investments)*100

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The amount of average investment can be calculated according to any of the following methods

4. (a) original investment/2 (b) (original investment-scrap value of asset)/2. (c) (original investment + scrap value of asset)/2. (d) (original investment-scrap value of

asset)/2+addl.networking cap+ scrap value

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Accept or reject criterion

The different projects may be ranked in the ascending or descending order of their rate of return.Projects below the minimum rate will be rejected.Projects giving rates of return higher than the minimum rate are preferred.

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Replacement of existing asset

An asset or equipment may have eto be replaced before its useful life because a more economic alternative is available in view of constant technological development.This help in reducing the costs and increasing the operational efficiency.In this case it is necessary to determine the most opportune time for replacement of the asset.

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CAPITAL RATIONINGCapital rationing is a situation where a firm has more investment proposals than it can finance.

It can be defined as a situation where a constraints is placed on the total size of capital investment during a particular period.

In such an event the firm has to select combination of investment proposals that provide the highest NPV subject to the budget constraints for the period.

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Selecting of projects require the taking of the following steps

•Ranking of the projects according to profitability index or internal rate of return.

•Selecting projects in descending order of profitability until the budget figures are exhausted keeping in view the objective of maximizing the value of the firm.

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