CAPITAL BUDGETING

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CAPITAL BUDGETINGCAPITAL BUDGETING

Techniques of Capital Budgeting

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IntroductionIntroduction

A truck manufacturer is considering investment in a new plant.

An airliner is planning to buy a fleet of jet aircrafts A commercial bank is thinking of an ambitious

computerization programme A pharmaceutical firm is evaluating a major R&D

programme.

All these are the examples of situations involving capital expenditure decision.

Essentially each of them represents a scheme for investing resources which can be analyzed and appraised reasonably independently.

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Understanding Capital Understanding Capital ExpenditureExpenditure

Also referred to as Capital Investment or Capital Project or just Project.

The basic characteristic of Capital Expenditure is :• Typically involves a current outlay (or current and

future outlays) of funds• In the expectation of a stream of benefits

extending far into the future. However, from accounting point of view, Capital

Expenditure is the one shown as asset on the Balance Sheet. This assets, except in the case of non-depreciable asset like land, is depreciated over its life.

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In accounting, the classification of an expenditure as capital expenditure or revenue expenditure is governed by:• Certain conventions• Provisions of law• Management’s desire to enhance or depress reported

profits. Outlays on R&D, major advertising campaign,

reconditioning of P&M may be treated as revenue expenditure for accounting purposes, even though they are expected to generate a stream of benefits in future.

Therefore, such expenditures qualify for being capital expenditures as per our definition.

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Capital expenditures have three distinctive features:1. They have long-term consequences2. They often involve substantial outlays.3. They may be difficult or expensive to reverse.

How a firm allocates its capital (the capital budgeting decision) reflects its strategy and business. That’s why the process of capital budgeting is also referred to as strategic asset allocation.

Techniques of Capital Budgeting are helpful in identifying valuable investment opportunities.

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What is Capital Budgeting? What is Capital Budgeting?

Capital budgeting refers to the process of deciding how to allocate the firm’s scarce capital resources (land, labor, and capital) to its various investment alternatives

The process of planning for purchases of long-term assets.

Nature of capital budgeting:Evaluating and selecting long-term investments in: • tangible assets• intangible assets

Designed to carry out an organization’s strategy

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The Manager

Resource Decisions

Information Decisions

Financing Decisions

Investment Decisions

Human ResourcesDecisions

Managing the Firm’s Resources

Cash ManagementInventory ManagementWorking Capital ManagementInvestment in Human CapitalLong-term AssetsAccounts Receivable

Economics of InformationDatabase ManagementData ModelingIS Planning & Development

Debt vs. Equity FinancingFinancial LeverageDividend Pay-out

Cost ofCapital

Risk-adjustedDiscount Rate

Share-holderValue

FinancialMarkets

Cash Inflows& Earnings

OperatingDecisions

Recruitment, SelectionTraining, ProductivityPerformance AppraisalCompensationUnions & Labor Relations

Competition,Life cycle effects,International events,etc.

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General Steps in Capital General Steps in Capital BudgetingBudgeting

1. Translate strategy to capital needs2. Generate alternatives3. Project financial results4. Perform financial analysis5. Assess risks6. Consider non-financial factors7. Select projects8. Post-approval review

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Capital Budgeting ProcessCapital Budgeting Process

1. Identification of potential investment opportunities. (Planning Body)• Estimate the criteria of target.• Monitor external environment regularly to scout

investment opportunities.• Formulate a well defined corporate strategy

based on thorough SWOT analysis• Share corporate strategy and perspectives with

persons who are involved in the process of capital budgeting.

• Motivate employees to make suggestions.

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Capital Budgeting Process Capital Budgeting Process (contd..)(contd..)

2. Assembling of proposed investments.• Investment proposal identified by the production

department and other departments are submitted in a standardized capital investment proposal form.

• Routed through several persons before it arrives to Capital Budgeting Committee.

• Investment proposals are usually classified into various categories for facilitating decision making:• Replacement investment• Expansion investments• New product investments• Obligatory and welfare investments

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3. Decision making.• A system of rupee gateways usually characterizes

capital investment decision making.• Executives at various levels are vested with the power

to okay investment proposals up-to certain limits.• Investment requiring higher outlays need the approval

of the BoD.

4. Preparation of Capital Budget and appropriations• The purpose is to check in order to ensure that the

fund position of the firm is satisfactory at the time of implementation.

• Provides an opportunity to review the project at the time of implementation.

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4. Implementation • Translating an investment proposal into a concrete

proposal is complex, time-consuming, and risk-fraught task.

• For expeditious implementation at a reasonable cost, the following are helpful:• Adequate formulation of projects – necessary homework

and preliminary studies.• Use of the Principle of Responsibility Accounting• Use of Network Techniques – CPM and PERT

5. Performance review.• Post-Completion Audit- provides feedback.• Comparing actual performance with budgeted ones.

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Project ClassificationProject Classification

1. Mandatory Investments2. Replacement Projects3. Expansion Projects4. Diversification Projects5. R&D Projects6. Miscellaneous: Recreational Facilities,

Executive Aircrafts, Landscaping etc.

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Investment CriteriaInvestment Criteria

Investment Criteria

Discounting Method Non-Discounting Methods

NPV

Benefit-Cost Ratio

IRR

Discounted Payback

Payback Period

ARR

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Overview Overview

All of these techniques attempt to compare the costs and benefits of a project

The over-riding rule of capital budgeting is to accept all projects for which the cost is less than, or equal to, the benefit:• Accept if: Cost Benefit• Reject if: Cost > Benefit

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The ExampleThe Example

We will use the following example to demonstrate the techniques of capital budgeting

Assume that your company is investigating a new labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline:

0 1 2 3 4 5

2000 2500 3000 3500 4000-10,000

If your required return is 12%, should this machine be purchased?

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1. The Payback Period 1. The Payback Period MethodMethod

The payback period measures the time that it takes to recoup the cost of the investment.

If the cash flows are an annuity, then we can simply divide the cost by the annual cash flow to determine the payback period

Otherwise, as in the example, we subtract the cash flows from the cost until the remainder is zero

The shorter the payback period, the better Generally, firms will have some maximum

allowable payback period against which all investments are compared

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The Payback Period: An The Payback Period: An ExampleExample

For our example project, we will subtract the cash flows from the initial outlay until the entire cost is recovered:

Since it will take 0.7143 years (= 2500/3500) to recover the last 2,500, the payback period must be 3.7143 years

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ComputationComputation

Year Cash Flow Cumulative Net Cash Flow

0 -10,000 -10,000

1 2,000 -8,000

2 2,500 -5,500

3 3,000 -2,500

4 3,500 1,000

Hence, Payback Period lies between year 3 and 4

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Evaluation of Payback Period Evaluation of Payback Period MethodMethod

Simple; both in concept and application. Has only few hidden assumptions. Rough and Ready method for dealing with risk. Favors projects which generate substantial cash

inflows in earlier years and discriminates against project which bring substantial cash inflows in later years but not in earlier years.

If risk tends to increase with futurity – the payback criterion may be helpful in weeding out the risky projects.

Since it emphasizes earlier cash inflows, it may be a sensible criterion when the firm is pressed with the problems of liquidity.

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Problems with the Payback Problems with the Payback PeriodPeriod

It ignores the time value of money It ignores all cash flows beyond the payback

period It is a measure of project’s capital recovery,

not profitability Though it measures a project’s liquidity, it

doesn’t indicate the liquidity position of the firm as a whole, which is more important.

The cutoff payback period is subjective.

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ExampleExample

Year Cash flow of A Cash flow of B

0 (100,000) (100,000)

1 50,000 20,000

2 30,000 20,000

3 20,000 20,000

4 10,000 40,000

5 10,000 50,000

6 - 60,000

Payback Criterion prefers A with payback period of 3 years over B with payback period of 4 years.

But B has very substantial cash inflows in the years 5 and 6

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2. The Discounted Payback 2. The Discounted Payback PeriodPeriod

The discounted payback period is exactly the same as the regular payback period, except that we use the present values of the cash flows in the calculation

Since our required return (WACC) is 12%, the timeline with the PVs looks like this:

The discounted payback period is 4.82 years Note that the discounted payback period is

always longer than the regular payback period

0 1 2 3 4 5

1785.711992.982135.342224.312269.71-10,000

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ComputationsComputations

Year Cash Flow Discounting factor @ 12

%

Present Value

Cumulative net cash

flow

0 -10,000 1.000 -10,000 -10,000

1 2,000 0.893 1,786 -8214

2 2,500 0.797 1992.5 -6221.5

3 3,000 0.712 2136 -4085.5

4 3,500 0.636 2226 -1859.5

5 4,000 0.567 2268 408.5

Payback Period = 4.1 years

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Problems with Discounted Problems with Discounted PaybackPayback

The discounted payback period solves the time value problem, but it still ignores the cash flows beyond the payback period

Therefore, you may reject projects that have large cash flows in the outlying years that make it very profitable

In other words, any measure of payback can lead to a focus on short-run profits at the expense of larger long-term profits

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3. Accounting Rate of Return 3. Accounting Rate of Return (ARR)(ARR)

Also called Average Rate of Return Also called Average Accounting Return (AAR) There are many different definitions of the ARR. However, in one form or other, ARR is always

defined as

valueaccounting average of measure Some

profit accounting average of measure SomeARR

• Measure of accounting profit can be PAT or N

• Measure of accounting value is Book Value

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ExampleExample

Suppose we are deciding whether or not to open a store in a new shopping mall. The required investment in improvements is $ 500,000. The store would have a five-year life because everything reverts to the mall owners after that time. The required investment would be 100 % depreciated over five years. So the depreciation would be $ 500,000 / 5 = $ 100,000 per year. The tax rate is 25 %.

Table ahead shows the projected revenues and expenses

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ComputationComputation

Year 1 Year 2 Year 3 Year 4 Year 5

Revenue 433,333 450,000 266,667 200,000 133,000

Expenses 200,000 150,000 100,000 100,000 100,000

EBDT 233,333

Depreciation

100,000

EBT 133,333

Tax @ 25 % 33,333

NI 100,000 150,000 50,000 0 50,000

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SolutionSolution

%20000,250

000,50ARR

000,2502

0500,000 Investment of BV Average

000,505

50,000-050,000150,000100,000 NI verageA

The project is acceptable if the ARR exceeds the target ARR

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Evaluation of ARR methodEvaluation of ARR method

It is simple to calculate It is based on accounting information,

which is readily available and familiar to businessmen.

While it considers benefits over the entire life of the project, it can be used even with the limited data.

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Problems with ARR methodProblems with ARR method

ARR is not the rate of return in any meaningful economic sense. It is just the ratio of two accounting numbers, and is not comparable to the returns actually offered.

It is based upon accounting profit, not cash flow. It does not take into account the time value of money. The ARR measure is internally inconsistent. While the

numerator represents profit belonging to equity and preference stockholders, its denominator represents fixed investments, which is rarely, if ever, equal to the contributions of equity and preference stockholders.

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The Net Present ValueThe Net Present Value

The net present value (NPV) is the difference between the present value of the cash flows (the benefit) and the cost of the investment (IO):

In other words, this is the increase in wealth that the shareholders will receive if the project is accepted

All projects with NPV greater than or equal to zero should be accepted

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NPV Decision RuleNPV Decision Rule

Does Project Produce Revenues

(Positive Net Cash Inflows?)

Yes

MINIMIZE COSTS

Net Present Values Will Be Negative

Project selection is based on project with LOWEST

absolute value for NPV

No

Project Is Acceptable

(Positive NPV)

Yes

No

Is PV of cash inflows ³ PV of cash outflows?

Reject Project

Does Not Satisfy Hurdle Rate

Rank Projects Using Profitability Index

Maximize Net Revenues

Present value of

future cash flows =

Profitability Index

Investment Cost

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The NPV: An ExampleThe NPV: An Example

NPV is calculated by subtracting the initial outlay (cost) from the present value of the cash flows

Note that the discount rate is the WACC (12% in this example)

Since the NPV is positive, the project is acceptable

Note that a positive NPV also means that the IRR is greater than the WACC

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The Internal Rate of ReturnThe Internal Rate of Return

The internal rate of return (IRR) is the discount rate that equates the present value of the cash flows and the cost of the investment

Usually, we cannot calculate the IRR directly, instead we must use a trial and error process

For our example, the IRR is found by solving the following:

In this case, the solution is 13.45%

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IRR Decision RuleIRR Decision Rule

Does Project Produce Revenues? (Positive Net Cash

Inflows)

Yes

MINIMIZE COSTS

Internal Rate of Return will be Negative or Impossible to

Compute

Project selection is based on project with LOWEST

absolute value for IRR

OR use NPV technique

No

Project Is Acceptable

Yes

No

Is IRR ³ Hurdle Rate?

Reject Project

Capital Rationing May Use IRRs to

Rank Projects from Lowest to Highest

Maximize Net Revenues

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Problems with the IRRProblems with the IRR

The IRR is a popular technique primarily because it is a percentage which is easily compared to the WACC

However, it suffers from a couple of flaws:• The calculation of the IRR implicitly assumes that the

cash flows are reinvested at the IRR. This may not always be realistic.

• Percentages can be misleading (would you rather earn 100% on a $100 investment, or 10% on a $10,000 investment?)

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The Profitability IndexThe Profitability Index

The profitability index is the same as the NPV, except that we divide the PVCF by the initial outlay:

Accept all projects with PI greater than or equal to 1.00

For the example, the PI is:

CAPITAL BUDGETING

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