Capital budgeting decisions:

02/05/2023 BCH 505 PROJECT FINANCE BY DR N R KIDWAI, INTEGRAL UNIVERSITY 1

Capital Budgeting DecisionsMeaning , Process and S ign ificance, Methods of Project Eva luation and Se lection: ARR, Payback And Discounted Payback , NPV, IRR, Benefit to Cost Ratio And Terminal Va lue Method, R i sk Ana lys i s In Investment , Sens itivi ty Ana lys i s .


Capital Budgeting In every business there are four basic financial decisions : • Which projects to take? (Investment decisions) • How to finance these projects? (Financing decisions) • How much to return to investors? (Dividend decisions) • How to manage working capital and its components? (Liquidity decisions) One duty of a financial manager is to choose investments with satisfactory cash flows and rates of return. Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives. To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called capital budgeting.

Investments decisions of a firm are generally known as Capital Budgeting or Capital expenditure decisions

• It have long-term consequences • It often involve substantial outlays • It may be difficult or expensive to reverse


Type of Proposals/ ProjectsReplacement projects: Replacement of equipment/ technologies with objective to reduce costs, increase efficiency , improve quality etc.Expansion projects: These investments are meant to increase production and operation capacity and/ or widen the distribution network. Such investments proposals require explicit forecast of growth and require more careful analysis than replacement projects. Strategic/ Diversification projects: These investments are aimed diversification into new products or services or new markets which are strategically important. It entail substantial risks, involve large outlays, and require considerable efforts and attention. Given their strategic importance, such projects require a very thorough evaluation, both quantitative and qualitative. Research and development projects: Traditionally, R&D projects shared a small proportion of capital budget. However, in modern era, more funds are allocated for R&D projects specially in knowledge intensive sectors.


Capital Budgeting ProcessEstablishing Priorities and objectives Identification of Investment Proposals Screening The Proposals Evaluation and selectionImplementationMonitoring and ControlPerformance audit


Cash FlowsIn capital budgeting, the cost and benefits of a proposal are measured in terms of cash flows.

The term cash flow is used to describe the amount of cash oriented investment and return generated over time period of the project.

Cash flows are useful approximations of outflow (investment) and inflow (return or benefits) based on available accounting data.

Components of Cashflows are

(i) Original or Initial cash outflow (Initial investment)

(ii) Operating cash flows (Annual cash flows)

(iii) Terminal cash flow.


Cash FlowsA firm buys an asset costing Rs. 1,00,000 and expects operating profits before depreciation @ 20% WDV and tax @ 30% of Rs. 30,000 p.a. for the next four years after which the asset would be disposed off for Rs. 45,000. Find out the each flow for different yearsYear Dippr. Asset Value Dippr. @20% PBDT PBT Tax @30% PAT Cash Inflow1 100000 20000 30000 10000 3000 7000 270002 80000 16000 30000 14000 4200 9800 258003 64000 12800 30000 17200 5160 12040 248404 51200 10240 30000 19760 5928 13832 24072

Depreciated Asset Value = 51200-10240 =40960/-Taxable Value of Scrap = 45000-40960 = 4040/-Tax on profit of Scrap =1212/-Terminal cash Flow = Scrap value- tax = 43788/-


Cash FlowsYear Out flow Inflow0 1000001 270002 258003 248404 67860 (24072+43788)


Tools for financial feasibility analysis

Non Discounted cash flow Criteria

Payback period analysis

At what point of time we are making more money than we are spending ?

Annual rate of Return

annualized net income earned on the average funds invested in a project.

Discounted cash flow Criteria

Benefit cost ratio analysis

For each rupee how much will be generated?

Net Present value analysis (NPV)

How much is future revenue (or expenditure) flow worth in today ?

Internal rate of return (IRR) analysis

rate of return on our investment for a fixed period, during which time we are spending money and making money


Accounting or Average rate of return (ARR)

The ARR is based on the accounting-concept of return on investment or rate of return. The ARR may be defined as the annualized net income earned on the average funds invested in a project.

ARR= Average Annual-Profit (after tax) / Average investment in the project ARR is a measure based on the accounting profit rather than the cash flows and is very similar to the measure of rate of return on capital employed which is generally used to measure the over all profitability of the firm•ARR ignores the time value of money•ARR also ignores the life of the proposal•ARR also ignores salvage value of the proposal•ARR also fails to recognize the size of the investment


Average rate of return (ARR) Annual rate of Return

ARR= 668/8000 = 0.0835 = 8.35%

A project is accepted if ARR is higher than minimum expected rate of return

ARR does not consider time value of money

year Investment Gross Profit Depreciation Net Profit

1 13334 2000 5332 -3332

2 8000 6000 5332 668

3 2666 1000 5332 4668

Average 8000 668


Payback Analysis

The payback period as name suggest is defined as the number of years required for the proposal's cumulative cash inflows to be equal to it cash outflows.

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

Payback method

• ignores the timing of the occurrence of the cash flows

• ignores the salvage value and the total economic life of the project

• more a method of capital recovery rather than a measure of profitability of a project


Payback Analysis

As per payback period, project A is more attractive

Project A

Year Outflows Cumulativeout flows Inflows Cumulative

In flows1 200 200 100 1002 200 400 300 4003 100 500 300 7004 500 300 10005 500 300 1300

Total 500 1300

Project BYear Outflows Cumulative

out flows Inflows CumulativeIn flows

1 200 200 100 1002 200 400 100 2003 100 500 200 4004 500 400 8005 500 500 1300

Total 500 1300


Payback Analysis A viable project is one that is able to pay back the original investment as early as possible.

Payback period indicates when, our investment is out of the woods ie When we are finally making more money in total than we have spent in total.

Projects with long payback are less attractive than those with short payback.

- they tie up capital longer, not enabling its use for other productive purposes.

- they are generally riskier than those with short payback periods

as over a long stretch of time, many things can go wrong.


Net Present Value (NPV) Analysis or Discounted cash flows analysis

the late 1970s, Americans experienced inflation rates in the 17% per annum range Inflation provides one example of what is called the time value of money i.e. A rupee today has a different value than a rupee one year from now.

There is more to time value of money than the force of inflation. Consider if no inflation, i.e a rupee today has the same purchasing power as a rupee one year later.

If you have an opportunity to lend Rs 1,000/- to a business at a 10% interest yearly then at year end you will receive a payment of Rs 1,100/- at the year end when the loan is paid off.

Your initial investment of Rs 1,000/- has grown by 10% over time.


Net Present Value (NPV) Analysis or Discounted cash flows analysis

FV =PV (1+r)n

where r is interest rate fraction and n is number of completed time slots Inflation provides one example of what is called the time value of money i.e. A rupee today has a different value than a rupee one year from now. There is more to time value of money than the force of inflation. Consider if no inflation, i.e a rupee today has the same purchasing power as a rupee one year later.

If you have an opportunity to lend Rs 1,000/- to a business at a 10% interest yearly then at year end you will receive a payment of Rs 1,100/- at the year end when the loan is paid off.

Your initial investment of Rs 1,000/- has grown by 10% over time.


Net Present Value (NPV) Analysis

Project A is more attractive than Project B, because its true, discounted profit (Rs 533.18) is greater than the discounted profit of Project B (Rs 485.24).

Project A

Year Outflows Inflows Discounting factor @ 10%

PV of out flows

PV of In flows

PV of Net flows

1 200 100 0.9091 181.82 90.91 -90.912 200 300 0.8264 165.28 247.92 82.643 100 300 0.7513 75.13 225.39 150.264 300 0.683 0 204.9 204.95 300 0.6209 0 186.27 186.27

Total 500 1300 422.23 955.39 533.16

Project B


PV of out flows

PV of In flows

PV of Net flows

1 200 100 0.9091 181.82 90.91 -90.912 200 100 0.8264 165.28 82.64 -82.643 100 200 0.7513 75.13 150.26 75.134 400 0.683 0 273.2 273.25 500 0.6209 0 310.45 310.45

Total 500 1300 422.23 907.46 485.23


Net Present Value (NPV) Analysis

Both projects have same NPV

Project A


PV of out flows

PV of In flows

PV of Net flows

1 200 0.9091 181.82 0 -181.822 200 0.8264 165.28 0 -165.283 100 100 0.7513 75.13 75.13 04 200 0.683 0 136.6 136.65 500 0.6209 0 310.45 310.45

Total 500 800 422.23 522.18 99.95

Project B


PV of out flows

PV of In flows

PV of Net flows

1 50 0.9091 45.455 0 -45.462 200 0.8264 165.28 0 -165.283 200 100 0.7513 150.26 75.13 -75.134 89.65 200 0.683 61.23095 136.6 75.375 500 0.6209 0 310.45 310.45

Total 539.65 800 422.226 522.18 99.95


Internal rate of return(IRR) Analysis

Both projects have same NPV

By Excel function IRR of project A is 14 % and Project B is 12 %

Project A


PV of out flows

PV of In flows

PV of Net flows

1 -200 0.9091 181.82 0 -181.822 -200 0.8264 165.28 0 -165.283 -100 100 0.7513 75.13 75.13 04 200 0.683 0 136.6 136.65 500 0.6209 0 310.45 310.45

Total -500 800 422.23 522.18 99.95

Project B


PV of out flows

PV of In flows

PV of Net flows

1 -50 0.9091 45.455 0 -45.462 -200 0.8264 165.28 0 -165.283 -200 100 0.7513 150.26 75.13 -75.134 -89.65 200 0.683 61.23095 136.6 75.375 500 0.6209 0 310.45 310.45

Total -539.65 800 422.226 522.18 99.95



Project A


PV of out flows

PV of In flows

PV of Net flows

1 200 0.8696 -173.92 0 -173.922 200 0.7561 -151.22 0 -151.223 100 100 0.6575 -65.75 65.75 04 200 0.5718 0 114.36 114.365 500 0.4972 0 248.6 248.6

Total 500 800 -390.89 428.71 37.82

Project BYear Outflows Inflows Discounting

factor @ 15%PV of

out flowsPV of

In flowsPV of

Net flows1 50 0.8696 -43.48 0 -43.482 200 0.7561 -151.22 0 -151.223 200 100 0.6575 -131.5 65.75 -65.754 89.65 200 0.5718 -51.2619 114.36 63.15 500 0.4972 0 248.6 248.6

Total 539.65 800 -377.462 428.71 51.25

Project A

Year Outflows Inflows Discounting

factor @ 20%PV of

out flowsPV of

In flowsPV of

Net flows

1 200 0.8333 -166.66 0 -166.662 200 0.6944 -138.88 0 -138.883 100 100 0.5787 -57.87 57.87 04 200 0.4823 0 96.46 96.465 500 0.4019 0 200.95 200.95

Total 500 800 -363.41 355.28 -8.13

Project B


PV of out flows

PV of In flows

PV of Net flows

1 50 0.8333 -41.665 0 -41.672 200 0.6944 -138.88 0 -138.883 200 100 0.5787 -115.74 57.87 -57.874 89.65 200 0.4823 -43.2382 96.46 53.225 500 0.4019 0 200.95 200.95

Total 539.65 800 -339.523 355.28 15.76



IRR of Project A is 19% and of Project B is 23 %

a project's IRR is higher than the prevailing interest rate, then it may be smart to invest in it.

IRR model assumes that money employed is utilized all the time and is not remain unutilized at all.

Project A


PV of out flows

PV of In flows

PV of Net flows

1 -200 0.8403 -168.06 0 -168.062 -200 0.7062 -141.24 0 -141.243 -100 100 0.5934 -59.34 59.34 04 200 0.4987 0 99.74 99.745 500 0.419 0 209.5 209.5

Total -500 800 -368.64 368.58 -0.06

Project B


PV of out flows

PV of In flows

PV of Net flows

1 -50 0.813 -40.65 0 -40.652 -200 0.661 -132.2 0 -132.23 -200 100 0.5374 -107.48 53.74 -53.744 -89.65 200 0.4369 -39.1681 87.38 48.215 500 0.3552 0 177.6 177.6

Total -539.65 800 -319.498 318.72 -0.78


Benefit to Cost ratioThe benefit-cost ratio is nothing more than a measure of benefit divided by a measure of cost.

Measure of benefit can be anything: financial profit/ cost savings, happiness, error reduction, throughput time, and so on.

Practically, the measure of benefit is revenue - or in non- revenue generating situations, cost savings.

Benefit-cost ratio (B/C) > 1.0 Revenue is greater than expenditures. i.e. investment is profitable.

Benefit-cost ratio (B/C) = 1.0. Revenue and expenditures offset each other. Consequently, you are facing a breakeven situation.

Benefit-cost ratio (BE) < 1.0. In this case, expenditures outstrip revenue. You are losing money. Example: BIC = Rs 40,000/Rs 50,000 = 0.8 Interpretation: For each dollar you are spending on this project, you are only gaining 80 cents of revenue. Thus you are losing money.


Benefit to Cost ratioDiscounted B/C for project A

= 428.71/390.89 =1.09

Discounted B/C for project B

= 428.71/377.46 =1.14

B/C for project A = 800/500 =1.6

B/C for project B = 800/539.65 =1.48

Benefit-cost ratio analysis using discounted cash flow data, the computing what in finance is called the profitability index.

Project A


PV of out flows

PV of In flows

PV of Net flows

1 200 0.8696 173.92 0 -173.922 200 0.7561 151.22 0 -151.223 100 100 0.6575 65.75 65.75 04 200 0.5718 0 114.36 114.365 500 0.4972 0 248.6 248.6

Total 500 800 390.89 428.71 37.82

Project BYear Outflows Inflows Discounting

factor @ 15%PV of

out flowsPV of

In flowsPV of

Net flows1 50 0.8696 43.48 0 -43.482 200 0.7561 151.22 0 -151.223 200 100 0.6575 131.5 65.75 -65.754 89.65 200 0.5718 51.26 114.36 63.15 500 0.4972 0 248.6 248.6

Total 539.65 800 377.46 428.71 51.25


Benefit to Cost ratio for non-revenue generating project

Many projects that are carried out are not revenue generating

Ex. . a typical information technology (IT) project in an organization

This can improve revenue performance indirectly, as the organization reduces operating costs. But it is not directly tied to generating revenue

Benefit-cost ratio analysis for this involves cost saving instead of revenue generation.


B/C ratio : pitfallsThere are a number of pitfalls associated with benefit-cost analyses that are important to know. B/C ratios do not provide information on the size of the numbers being reviewed. EX: Project A BIC = 3.1 Project B BIC = 2.7 Project A's is better Project A BIC = 3100/1000 = 3.1 Project B BIC = 2,700,000/1,000,000 = 2.7 Since B/C is a ratio, sense of the size of the numbers vanishes. . For most organizations, Project B is more attractive than A, as B has substantial revenue. For valid comparisons among the B/C ratios of different projects, One must know the actual size of the numbers that are used to compute the ratios.


B/C ratio : pitfalls2. B/C ratios do not provide information on when payback occurs. Consider the following two ratios:

Project A B/C = 3.1 Project B B/C = 2.7 Again, Project A appears to be more attractive than Project B. If Project A realizes a B/C of 3.1 after five years, it is less attractive than Project B, if B realizes its B/C ratio in two years.

3. The easiest quantitative data to acquire is basic business data derived from estimated budgets and, possibly, on anticipated revenues. Hard-to-measure factors are often ignored when computing the ratios. For example, the main benefit of a project may be what is called a second-order benefit - e.g., this project, while not profitable in itself, will provide the groundwork for major revenue streams generated on future projects.

Another benefit might be improved public perceptions of the company's activities.

None of these pitfalls is fatal. With B/C, analysts should be aware of their existence and should strive to deal with them so that the analyses are valid.


Return on Investment (ROI)The ROI is nothing more than a measure of NPV expressed as percentage of present value of cost.

ROI = (NPV/PV of cost)x 100= (discounted B/C -1)x 100

ROI> 0 Revenue is greater than expenditures. i.e. investment is profitable.

ROI= 0. Revenue and expenditures offset each other. Consequently, you are facing a breakeven situation.

ROI< 0. In this case, expenditures outstrip revenue. You are losing money.


Terminal Value (TV) The other variant of the NPV technique is known as the TV technique. In this case, a new dimension is added to the NPV technique. As already discussed in the NPV technique, the future cash flows are discounted to make them comparable.

In the TV technique, the future cash flows are first compounded at the expected rate of interest for the period from their occurrence till the end of the economic life of the project. The compounded values are then discounted at an appropriate discount rate to find out the present value. This present value is compared with the initial outflow to find, out the suitability of the proposal.


Terminal Value (TV) Project A

Year Outflows Inflows Net flowCompounding factor @ 8%

Compounded Net flow @ 8%

TV=PV of compounded Netflow (discounted @ 8%)

Discounting factor @ 10%

PV of Net flows

0 100 -100 1.4693 -146.93 1 1 200 100 -100 1.3605 -136.05 0.9091 -90.912 200 300 100 1.2597 125.97 0.8264 82.643 100 300 200 1.1664 233.28 0.7513 150.264 300 300 1.08 324 0.683 204.95 300 300 1 300 0.6209 186.27

Total 600 1300 700.27 434.8 433.16

Project B

Year Outflows Inflows Net flowCompounding factor @ 8%

Compounded Net flow @ 8%

TV=PV of compounded Net flow (discounted @ 8%)

Discounting factor @ 10%

PV of Net flows

0 100 -100 1.4693 -146.93 1 1 200 100 -100 1.3605 -136.05 0.9091 -90.912 200 100 -100 1.2597 -125.97 0.8264 -82.643 100 200 100 1.1664 116.64 0.7513 75.134 400 400 1.08 432 0.683 273.25 500 500 1 500 0.6209 310.45

Total 500 1300 639.69 397.18 385.23


Discounted Payback PeriodThis method is a combination of the original payback method and the discounted cash flow technique. In this method, the cash flows of the project are discounted to find their present values. The present value of the cash inflows is then compared with the present value of the outflow, in order to identify the period taken to recover the initial cost or the present value of outflow. This method thus, takes care of the main drawback of the pay back period method and allows the consideration of the time value of money of cash flows. However, it still does not take into account those cash inflows, which occur subsequent to the payback period


Risk Analysis Risk is inherent in almost every business decision Risk refers to variability Capital budgeting decision involves cost and benefits over a long period of time Financial analysis has two phases

feasibility analysis Risk analysis

Sources of Risk Project Specific Risk: factors specific to project like quality, production Corporate Risk: action of competitors Industry specific Risk: technological developments and regulatory charges Market risk: Changes in microeconomic factors have impact project International risk: in case of foreign projects or political risk


Techniques of Risk AnalysisTechniques for risk

analysis

Analysis of Stand alone Project

Analysis of Contextual Risk

Sensitivity Analysis Scenario Analysis

Break Even Analysis Hillier Model

Simulation Analysis Decision tree analysis

Corporate Risk Analysis Market Risk Analysis


Measures of RiskRange : Range of variance is difference of maximum and minimum valueMean or average Standard deviation : standard deviation () is defined as Coefficient of Variation: standard deviation () is not adjusted for scale. Coefficient of variation is adjusted for scale and is defined as Semi Variance: since investors are concerned with negative variations only so computing variance with only negative errors (outcome less than mean) gives semi variancestandard deviation () is defined as


Measures of Risk

NPY ( thousands) x Probability p px x- p x sq. error200 0.3 60 -340 115600 34680600 0.5 300 60 3600 1800900 0.2 180 360 129600 25920

mean NPV () 540 Sq. variance 62400std deviation 249.8

For the example, Range = 900-200 = 700 K Coefficient of Variation, Semi standard deviation=


Measures of Risk• Standard deviation is most commonly employed as measure of risk in finance.• For computing mean and dispersion variables, probability distribution is required, • If sufficient records for similar ventures are available, probability distribution is

quite ‘objective, • If sufficient records are not available, probability distribution is quite ‘subjective’,

Prospective on risk There are three perspectives of the risk• Stand alone risk: risk of the project when viewed in isolation• Firm risk or Corporate risk: contribution of a project to the risk of the firm• Systematic risk or market risk: risk of a project from view point of diversified

investor


Sensitivity analysisSensitivity analysis is ‘what if’ analysis

NPV = -20000+4000 x PVIFA= -20000+4000 x 5.65= 2600 K

Cash flows depends on various factors and can vary widely.

So optimistic and pessimistic estimates for variables defined and NPV calculated

Cash Flow of ABC LTD project(in thousands) Year 0 year 1-10

1Investment 200002Sales 18000

3Variable cost ( 2/3 of sales) 12000

4Fixed cost 10005Depreciation 20006Pre tax profit 30007Taxes (@ 33.3 %) 10008PAT 2000

9cash flow from operation(PAT+ depreciation) 4000

10Net cash flow 2000 4000

Cost of capital 12%Accumulated PV indexing factor (PVIFA) @ 12 % 5.65


Sensitivity analysis

• NPV calculated by varying one variable at a time• NPV is more sensitive to sales and least sensitive to fixed cost. For more sensitive variable, it

may be explored how variability of the factor can be contained. • In real situation, many variable may change at a time so interpretation of results is subjective

Sensitivity of NPV to variations in the value of key variables in ABC LTD projectRange (in thousands) NPV

Pessimistic Expected Optimistic Pessimistic Expected Optimistic Variation1 Investment 24000 20000 18000 -1400 2600 4600 60002 Sales 15000 18000 21000 -1147 2600 6366 7513

3 Variable cost as percentage 70 66.67 65 340 2600 3730 3390

4 Fixed cost 1300 1000 800 1470 2600 3353 1883


Break-Even analysis• It tells what is minimum value of key variables/

revenues so that project does not ‘lose money’• Variable cost to sales ratio= 12/18= 0.667 • Contribution to margin ratio =0.333• Accounting break even=

=• For sales 0f 9000 K , PBT, PAT will be zero • At accounting break even project gives zero % return

Cash Flow of ABC LTD project

(in thousands) Year 0year 1-10








Financial Break-Even analysis• Focus is on NPV and not on accounting profit• Variable cost =0.667 x sales Contribution = 0.333 x sales Fixed cost = 1000 Depreciation =2000 PBT = 0.333 x sales-3000 Tax = 0.333 x (0.333 x sales-3000)=0.111 x sales - 1000 PAT = 0.667 x (0.333 x sales-3000)=0.222 x sales - 2000 Cash flows = PAT+ depreciation= 0.222 x sales PV of cash flows= Cash flows x PVIFA= 1.255 x sales Breakeven NPV = 20000- 1.255 x sales= 0 so Breakeven sales= 15936 K

Cash Flow of ABC LTD project

(in thousands) Year 0year 1-10








Hiller Model : Un correlated cash flows

interest rate = 12 %Expected NPV, +Standard deviation Analytical derivation to find expected NPV and standard deviation of NPV

Year 1 Year 2 Year 3Net Cash flow (Rs) Probability Net Cash flow (Rs) Probability Net Cash flow (Rs) Probability

3000 0.3 2000 0.2 3000 0.35000 0.4 4000 0.6 5000 0.47000 0.3 6000 0.2 7000 0.3Mean 5000 4000 5000

Standard variance 2400000 Standard variance 1600000 Standard variance 2400000


Project selection under risk• Judgemental Evaluation: Accept or reject the project based on the risk and return

characteristics without any formal method for incorporating risk in decision making• Payback period requirement: payback period requirement is applied to control risk.• Risk adjusted discount method:

• If the risk of the project is equal to risk of existing investment, discount rate is average cost of capital

• If the risk of the project is greater than risk of existing investment, discount rate is higher than average cost of capital

Economy & Finance

Capital budgeting decisions: