Capital Budgeting Decisions

What is Capital Budgeting?

The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

Capital Expenditure includes:

Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill etc.

Cost of addition, expansion, improvement or alteration in fixed assets.

Cost of replacement of permanent assets. Research and development project cost, etc.

Few Definitions on CB:

Charles T. Horngreen“ Capital Budgeting is long term planning for

making and financing proposed capital outlays”.

Richard and Greenlaw“ Capital Budgeting as acquiring inputs with long

term returns”.

Need and Importance of Investment Decisions

• Larger Investments• Long Term Commitments of Funds• Irreversible Nature• Long term effect on profitability• Difficulties of Investment Decisions• National Importance

Process

Capital Budgeting Process• Identification of Investment Proposal• Screening of Investment Proposal• Evaluation of various proposals– Independent proposals– Contingent or dependent proposals– Mutually exclusive proposals

• Fixing Priorities• Final Approval and Preparation of capital Expenditure

Budget• Implementing Proposal• Performance Review

Types of Investment/Cap Budgeting Decisions

• One classification is as follows:– Expansion of existing business– Expansion of new business– Replacement and modernisation

• Yet another useful way to classify investments is as follows:– Mutually exclusive investments– Capital Rationing Decisions– Accept and Reject Decisions (Independent)

Investment Evaluation Criteria

• Three steps are involved in the evaluation of an investment:– Estimation of cash flows– Estimation of the required rate of return (the opportunity

cost of capital)– Application of a decision rule for making the choice

Investment Decision Rule• It should maximise the shareholders’ wealth.• It should consider all cash flows to determine the true

profitability of the project.• It should provide for an objective and unambiguous

way of separating good projects from bad projects.• It should help ranking of projects according to their

true profitability.• It should recognise the fact that bigger cash flows are

preferable to smaller ones and early cash flows are preferable to later ones.

• It should be a criterion which is applicable to any conceivable investment project independent of others.

Evaluation Criteria or Methods of Capital Budgeting

• Non-discounted (Traditional Methods):– Payback Period (PB)– Discounted Payback Period (DPB)– Accounting Rate of Return (ARR)

• Discounted (Time-adjusted Methods):– Net Present Value (NPV)– Internal Rate of Return (IRR)– Profitability Index (PI)

Payback Method

• Payback is the number of years required to recover the original cash outlay invested in a project

• If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:

Formula

0Initial InvestmentPayback = =

Annual Cash Inflow

C

C

Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is:

Payback=50000/12500 = 4 years

Payback Method

• Unequal cash flows In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay.

Acceptance Rule

• The project would be accepted if its payback period is less than the maximum or standard payback period set by management.

• As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.

Discounted Payback Period

• The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis.

• The discounted payback period still fails to consider the cash flows occurring after the payback period.

Accounting Rate of Return Method

Average incomeARR =

Average investment

The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.

A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost.

Acceptance Rule

• This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.

• This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

Net Present Value (NPV)• Cash flows of the investment project should be

forecasted based on realistic assumptions.• Appropriate discount rate should be identified to

discount the forecasted cash flows. The appropriate discount rate is the project’s opportunity cost of capital.

• Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

• The project should be accepted if NPV is positive (i.e., NPV > 0).

Net Present Value Method

31 202 3

01

NPV(1 ) (1 ) (1 ) (1 )

NPV(1 )

nn

nt

tt

C CC CC

k k k k

CC

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Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The formula for the net present value can be written as follows

Present value of Rupee oneYear 6 % 7 % 8 % 9 % 10 % 11 % 12 % 13% 14 %

1 .9434 .9345 .9259 .9174 09090 .90090 .8928 .8850 .8772

2 .89000 .8734 .8573 .8417 .8265 .8116 .7972 .7831 .7695

3 .8397 .8163 .7938 .7722 .7512 .7318 .7118 .6930 .6750

4 .7920 .7629 .7350 .7084 .6830 .6587 .6355 .6133 .5921

5 .7472 .7130 .6806 .6499 .6209 .5934 .5674 .5428 .5194

Calculating Net Present Value

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs 500(PVF

10)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent.

Acceptance Rule

• Accept the project when NPV is positiveNPV > 0

• Reject the project when NPV is negativeNPV < 0

• May accept the project when NPV is zeroNPV = 0

• The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.

Problem :• A company has to consider the following

project:• Cash inflows: – Year 1 1000– Year 2 1000– Year 3 2000– Year 4 10000

Compute the net present value if the opportunity cost is 14 %

Calculation of NPVYear Cash inflows Present value PV of inflows

1 1000 0.877 877

2 1000 0.769 769

3 2000 0.675 1350

4 10000 0.592 5920

Total PV of inflows

8916

Less: outflows 10000

NPV - 1084

• A Firm whose cost of capital is 10 % is considering 2 mutually exclusive projects X and Y. the details of which are as follows:

• Compute the net present value at 10 %, profitability index and IRR of the two projects.

Year Project X Project Y

Cost 0 100000 100000

Cash inflows 1 10000 50000

2 20000 40000

3 30000 20000

4 45000 10000

5 60000 10000

Delhi machinery manufacturing company wants to replace the manual operations by new machine. There are two alternative models X and Y of the new machine. Using payback period, suggest the most profitable investment. Ignore taxation.

Machine X Machine Y

Original investment 9000 18000

Estimated life 4 5

Estimated savings in cost 500 800

Estimated savings in wages 6000 8000

Additional cost of maintenance

800 1000

Additional cost of supervision

1200 1800

Solution:Machine X Machine Y

Estimated savings in cost 500 800

Wages 6000 8000

Total savings 6500 8800Additional cost of maintenance

800 1000

Supervision 1200 1800

Total cost 2000 2800

Net inflows (annual) 4500 6000

Outflows 9000 18000

Payback period 2 Years 3 Years

SolutionCash flows PVF(10 %,n) Total PV

Year Project X Project Y . X Y

1 10000 50000 0.909 9090 45450

2 20000 40000 .827 16520 33040

3 30000 20000 .751 22530 15020

4 45000 10000 .683 30735 6830

5 60000 10000 .621 37260 6210

Total PV 116135 106550

Less: Cash Inflows

100000 100000

Net Present Value

16135 6550

`

• Machine A costs Rs 100000 payable immediately. Machine B costs 120000 half payable immediately and half payable in one year’s time. The cash receipts are as follows:

At 7 % opportunity cost, which machine

should be selected on the basis of NPV.

Year Machine A Machine B

1 20000 -

2 60000 60000

3 40000 60000

4 30000 80000

5 20000 -

Solution (machine B is better)Machine A

Machine B

Year Cash flows PVF(7%) PV(rs) Cash flows PVF(7%) PV(rs)

0 -100000 1.000 -100000 -60000 1.000 -60000

1 20000 0.935 18700 -60000 0.935 56100

2 60000 0.873 52380 60000 0.873 52380

3 40000 0.816 32640 60000 0.816 48960

4 30000 0.763 22890 80000 0.763 61040

5 20000 0.713 14260 - - -

NPV 40870 46280

NPV

StrengthsStrengths::• Time ValueTime Value• Considers all cash Considers all cash

flowsflows• Based on cash Based on cash

flowsflows

Weaknesses:Weaknesses:• Discount rate Discount rate

difficult to determinedifficult to determine• Ignores the Ignores the

difference in initial difference in initial cash outflowscash outflows

• Difficult calculationDifficult calculation

Internal Rate of Return Method

• The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implies that the rate of return is the discount rate which makes NPV = 0.

31 20 2 3

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(1 )

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r r r r

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IRR Solution

• Minimum Rate + NPV at lower rate Diff of both rates

NPV at higher –NPV at lower

X

Internal Rate of Return

StrengthsStrengths: : – Accounts for

TVM– Considers all

cash flows– Less

subjectivity

WeaknessesWeaknesses: : Assumes all cash flows reinvested at

the IRR– Difficulties with

project rankings and Multiple IRRs

Profitability Index Method It is also called as Benefit-Cost Ratio. It is the

relationship between present value of cash inflows and the present value of cash outflows.

Profitability Index = Present Value of Cash Inflows Present Value of Cash Outflows