MBM-202

8/9/2019 MBM-202

1/20

TERM PAPER

MBM-202

FINANCIAL MANAGEMENT

TOPIC

CAPITAL BUDGETING

SUBMITTED BY:-

KOMAL KHEMANI

MBA-II SEMESTER

D.E.I

8/9/2019 MBM-202

2/20

CONTENTS

CAPITAL BUDGETING THE CONCEPT ......................................................................................... 3Objectives of capital budgeting: .................................................................................................. 3Scope of capital Budgeting: ......................................................................................................... 3

Evaluation of Capital Projects ........................................................................................................... 4Capital Budgeting Process ................................................................................................................ 5

Traditional Methods ...................................................................................................................... 6Discounted cash flow techniques................................................................................................. 10

CONCLUSION .............................................................................................................................. 19REFERENCES ............................................................................................................................... 20

8/9/2019 MBM-202

3/20

CAPITAL BUDGETING THE CONCEPT

Capital budgeting is the technique of making long-term planning decisions for investment and their

finance. Decisions on capital expenditure are difficult as future is uncertain. It includes current cash

outlay or a series of cash outlays in return for an anticipated flow of future benefits. Capital

budgeting is employed to evaluate long-term expenditure decisions which involve current outlays

and the benefits that occur in the future years.

Objectives of capital budgeting:

To help select projects that assist in maximizing the market value of the firm while rejectingprojects which do not assist in maximizing value. Only by seeking and accepting projects

that return an incremental amount above the opportunity cost of capital will the firm be

adding to its value.

To estimate the total change in the firm's cash flows that results because a project isundertaken. Hence indirect effects on the costs and/or revenues associated with a firm's other

projects that occur as a result of the acceptance of a new project should be considered when

evaluating the cash flows from a new project

Scope of capital Budgeting:

Capital budgeting decision ultimately affects the profitability of the business. Scope of capital

Budgeting may be summarised as follows:

Investment in long term projects or fixed assets is undertaken with a view to expand, or toincrease production or to reduce costs which will lead to increase profits.

The benefits of such investment decisions are likely to accrue in the future after a long periodof time. Apart from the costs of the fixed assets purchased, other costs also increase.

Huge amount of capital outlay are involved when a decision to purchase fixed assets orinvest in projects is take.

8/9/2019 MBM-202

4/20

Evaluation of Capital Projects

Evaluation of capital projects refers to the development and applications of basic

theory, techniques and procedures for the appraisal of capital projects, bath as the time of their

approval and in the course of their implementation.

Capital Budgeting Decision

OR

Investment decision

Project

Generation

Project

Evaluation

Project Screening

and Selection

Project

Execution

Control of Capital

Expenditure

Cash Flow

E timate

Selection of

Evaluati n meth d

Cash out

Fl w

Cash in

Fl w

With

CertaintyUncertainty

Risk Return

Trade Off

Market value Per

Share

8/9/2019 MBM-202

5/20

The following are the Evaluation methods:-

y Payback period(PB)y Post-payback profitability(PPP)y Average Rate of Return(ARR)y Minimum Unit Costy Net Present value(NPV)y Profitability Index(PI)y Internal Rate of Return(IRR)y Net Terminal Value(NTV)y Discounted payback period(DPP)y Cut-off rate

Capital Budgeting Process

Capital Budgeting process is very complex process. There would be conceptual idea

about a project generation and it should be evaluated by measuring the projects worth in its

economy, productivity and profitability. Project evaluation involves eight steps;

(a)Estimation of cash flow i.e.; investment.

(b)Estimation of benefits(c)Estimation of costs(d)Technical and flexibility evaluation, Project schedules, PERT and CPM charts(e)Estimation of cash inflows taking the depreciation and tax into account(f) Estimation of risk and uncertainty(g)Selection of suitable evaluation method(h)Finally, selection of project among the various alternatives

Various alternative items are to be screened and finally selected by application of a suitable

appraisal method. Then the project is to be executed with strict control on capital expenditure sot

that the authorized outlay is not exceeded. While execution of this project, the physical process of

work and capital expenditure are to be matched. Time and cost-over runs should be avoided as this

8/9/2019 MBM-202

6/20

will increase the cost of the project. There should be a point of equilibrium between the risk and

return so that the market value per share is optimum.

Traditional Methodsy Payback Period:-

It indicates the number of years required to recover the initial cash outlay invested in a

project. The payback period is one of the most popular and widely recognized traditional methods of

evaluating investments proposals. It is defined as the number of years required to recover the

original cash outlay invested in a project. The following are the formulas for calculating the payback

period:-

if cash flows are even(uniform):-If the cash flows are even (uniform) then the payback period is

calculated by following formula;

Payback Period= Investment

Annual Cash Flow

if cash flows are uneven or not even:-If cash flows are uneven or not even then the payback period is

determined by adding up the cash flows till the total cash flow is equal to the amount of

investment made.

(i) Accept/Reject criteria:-Many firms use the payback period as an accept/reject criteria as well as a method of

ranking projects. If the payback period calculated for a project is less than the maximum or standard

payback period set by management, it would be accepted; if not, it would be rejected.

(ii) Ranking method:-

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.

8/9/2019 MBM-202

7/20

(iii)Mutually exclusively Projects:-

If the firm has to choose among the two mutually exclusive projects, the project with

shorter payback period will be selected.

Advantages of Payback period:-(a) It is very simple measure of economic feasibility (possibility).(b) It is very easy to apply, calculate and interpret.(c) It is easy to understand.(d) The emphasis is on early recovery of the investment. Thus, it gives importance to liquidity

aspect. The funds so released can be put to the other uses .i.e.; it emphasizes only on liquidity

and solvency of the firm.

(e) It costs less than most of the sophisticated technique which require a lot of the analysis timeand use of computers.

(f) The payback period is a meaningful indicator of economic feasibility in case of the firms wherethe risk of obsolescence is high in comparison to other projects is expected to pay for them

faster.

(g) It takes less time to calculate and hence the cost of analysis is low.

Disadvantages of Payback period:-In spite of its simplicity, the payback may not be a desirable investment criterion

since it suffers from a number of serious limitations;

(a) The main limitation is that this method fails to take into account the time, value and money.Cash flows of equal amounts are considered to be the same even though they occur in different time

periods.

(b) It does not take into account the cash flows over the entire life of project. Cash flows after thepayback period are ignored.

8/9/2019 MBM-202

8/20

(c) Administrative difficulties may be faced in determining the maximum acceptable payback period. There is no scientific basis for setting up a maximum payback period. It is a subjective

decision.

(d) It does not show the economic return on investment.

(e) This method is not consistent with the objective of maximizing the market value per share.

(f) It may choose highly risk projects because of having a shorter standard payback period as itmay ensure guarantee against loss.

y Accounting Rate of Return(ARR):-Accounting rate of return is compared with predetermined or minimum required rate

of return.

Formula:-

ARR= Average profits after taxes

Average Investment

Average Investment = Net Investment

2

Net Investment = Book value of investment at beginning Book value of

investment at the end.

If salvage value is there:-

Average investment = Salvage value + (cost salvage value)

100

8/9/2019 MBM-202

9/20

(i)Accept/Reject criteria:-As ARR is compared with predetermined or minimum required rate of return, if ARR

> minimum required rate if return, then accept the project and if the ARR < minimum required rate

of return then reject the project.

(ii) Ranking method:-

As a method of ranking the projects, highest rank is given to projects with highest

ARR and lowest rank is given to project with lowest ARR.

Merits of ARR:-(a) It is very much simple to understand.(b)It is calculated from accounting data which is readily available from books of accounts.(c) It tales into account the entire stream of income in calculating the projects profitability.

Demerits of ARR:-(a) As the decision criterion is concerned, it suffers from serious shortcomings.(b) It uses accounting profits and not cash flows. Accounting profits are based upon arbitory

assumptions and includes non-cash items. Accounting profits are considered to be

inappropriate for measuring the projects profitability.

(c) It ignores time, value and money. It gives equal weightage to benefits receivable in differenttime periods.

8/9/2019 MBM-202

10/20

Discounted cash flow techniques

yNet Present Value(NPV):-Definitions:-

o The future stream of benefits and costs converted into equivalent values today. This is done byassigning monetary values to benefits and costs, discounting future benefits and costs using an

appropriate discount rate, and subtracting the sum total of discounted costs from the sum total of

discounted benefits.

o The present value of an investment's future net cash flows minus the initial investment. Ifpositive, the investment should be made (unless an even better investment exists), otherwise it

should not.

Formula:-

There are three main reasons why NPV is usually the best choice for measuring project value.

1. NPV assumes that project cash flows are reinvested at the company's required rate of return; the

IRR assumes that they are reinvested at the IRR. Since IRR is higher than the required rate of return,

in order for the IRR to be accurate, the company would have to keep finding projects that wouldreinvest the cash flow at this higher rate. It would be difficult for a company to keep this up forever,

thus NPV is more accurate.

8/9/2019 MBM-202

11/20

2. NPV measures project value more directly than IRR. This is because NPV actually calculates the

project's value. If there is more than one project lined up, the manager can simply add the values

together to get a total.

3. Often times, during the life of a project, cash flows must be reinvested to cover depreciation. This

will give a negative cash flow for that period, thus leading to more than one IRR. If there is more

than one IRR, than calculating only 1 IRR for the project is not reliable. NPV must be used for this

type of project.

DAdvantages ofNPV:-Net Present Value (NPV) is one of the most robust financial tools available to value

any type of investment or activity. NPV analysis incorporates four key benefits or elements to

establish the value of an investment:

Time Value of Money: - Recognizes the time value of money concept that says a dollar earnedtoday is worth more than a dollar earned five years from now.

Cash Flows: - Calculates the expected cash flows generated from the project and incorporatesthe unique risks of obtaining those cash flows. NPV also eliminates accounting inconsistenciesas the cash flows are representative of the benefits of the project not accounting profits.

Risks: - Incorporates the risks associated with the project via the expected cash flows and/ordiscount rate.

Flexibility: - Provides flexibility and depth as the NPV equation can adjust for inflation as wellas incorporate other financial analysis tools such as scenario analysis, Monte Carlo simulation,

etc.

8/9/2019 MBM-202

12/20

Objective maximizing market price:- It is consistent with the objective of maximizing themarket price of shares. If NPV is positive, the return is higher than the return expected by the

shareholders. This increases the share prices. If NPV is negative, it has a negative impact on

share prices.

The NPV concept is consistent with maximizing the value of the firm

and is used by investors in the evaluation of a company or in capital budgeting decisions when

comparing the value of different projects. For these reasons, the NPV concept is being used more

and more in corporate America as substitute to other financial evaluation tools such as Internal Rate

of Return (IRR) and Total Cost of Ownership (TCO).

D Disadvantages:-1. It is difficult to use.2. The calculation of the NPV presupposes (assumes) that discount rate is known but the cost of

capital is a difficult concept to understand and measure in practice. The success of capital

budgeting techniques depends upon the correctness with which the cost of capital is determined.

3. It does not give satisfactory answers when projects are being compared involved differentamount of investment. The limitation of NPV method is that the NPV doe not correlate the NPV

of project with its investment.4. It does not give satisfactory answers when we are comparing projects with unequal lifes. The

alternative with high NPV may involve larger economic life and it would be less desirable as the

funds remain invested for a long period. The alternative having shorter life may have less NPV.

In general project with short economic life should be preferred.

yProfitability Index:-Yet another time adjusted method of evaluating the investment proposals is

the benefit cost (B/C) ratio or profitability index (PI). It is the ratio of present value of cash inflows,

at their required rate of return, to the initial cash outflows of the investment. It may be gross or net;

net being simply gross minus one. The formula to calculate the profitability index is as follows:-

8/9/2019 MBM-202

13/20

Formula:-

Profitability Index = Present value of cash inflows / Present value of cash outflows

NProblem for calculating Profitability Index:-(By taking into consideration the industrial visit)

y Siyaram silk mills ltd. Is considering the two projects namely Project Fabric and ProjectGarment. Projects are available at cost of Rs. 14000 lakhs each and have a life of 5 years. The

cash flows of this company are as follows:-

Amount in LakhsYears Proj.Garment Proj. Fabric

2001 2254 2150

2002 5000 5410

2003 3065 3070

2004 3908 1507

2005 3005 5623

Calculate Profitability Index (PI) method [cash flows are

given after deducting depreciation and taxes]. Also write which project is accepted and which is

rejected.

8/9/2019 MBM-202

14/20

Solution:-

As discount rate is not mentioned we assume the discount rate as 7%.

y Evaluation of PI for Project GarmentAmt. in lakhs.

Years Cash Flow after

depreciation and tax

Present value factor @7% discount

rate

Present value of

cash inflows

2001 2254 1/(1+0.07)1

= 0.934 2105.23

2002 5000 1/(1+0.07)2 = 0.877 4385.00

2003 3065 1/(1+0.07)3

= 0.819 2510.23

2004 3908 1/(1+0.07)4

= 0.763 2981.80

2005 3005 1/(1+0.07)5

= 0.714 2145.57

Present value of cash inflows= 14127.83

So,


= 14127.83/14000

PI = 1.009.

y Evaluation of PI for Project FabricAmt. in lakhs.

Years Cash Flow after

depreciation and tax

Present value factor @7% discount

rate

Present value of

cash inflows

2001 2150 1/(1+0.07)1

= 0.934 2008.17

2002 5410 1/(1+0.07)2

= 0.877 4744.57

2003 3070 1/(1+0.07)3 = 0.819 2514.33

2004 1507 1/(1+0.07)4

= 0.763 1149.84

2005 5623 1/(1+0.07)5 = 0.714 4014.82

Present value of cash inflows= 14431.66

8/9/2019 MBM-202

15/20

So,


= 14431.66/14000

PI = 1.030.

As the method of the accepting and rejecting criteria is concerned

then, Project Garment will be acceptedand Project Fabric will be rejected. Because Project

garments period compared to Project Fabric is less.

N Problem for calculation ofNPV (Net Present Value) and PI (Profitability Index):-{by taking into consideration of Industry visit}

Siyaram Silk Mills Ltd. Is considering the two new projects

which would carryout some operations that present performed manually. The two alternative

projects are namely Project Fabric and Project Garment. The companys cash outlay is of

Rs.1310.89 lakhs. The rate of return is 10% and pays tax at 50% rate. Project will be depreciated as

on straight line basis. The net cash flows given below are before depreciation and taxes.

Amt. in lakhs.Years Proj.Fabric Proj. Garment

2005 30235.84 28008.65

2004 29833.51 26352.61

Which of the above projects should be accepted according to the

following methods:-

NPV method (Net Present Value)

Profitability Index (P I )

8/9/2019 MBM-202

16/20

The present value of Re.1/- at 10% for different years is as

follows:-

Year Present Value Factor

2005 0.909

2004 0.826

Solution:-

Calculation for Project Fabric:-

CFBDAT ---------- Cash Flow before Depreciation and Tax {(given)}

CFADBT ---------- Cash Flow after Depreciation before Tax {(2) (3)}

CFAT ---------- Cash Flow after Tax {50 % of CFADBT}

CFATAD ---------- Cash Flow after Tax and Depreciation {(7) + (3)}

PVCIF ---------- Present Value of Cash Inflow {(8) * (7)}

PVCOF ---------- Present Value of Cash Outflow {(given)}

NPV ---------- Net Present Value {(CIF COF)}

Years

(1)

CFBDAT

(2)

-dep

(3)

CFADBT

(4)

Tax(50%)

(5)

CFAT

(6)

CFATAD

(7)

PV

@10%(8)

PVCIF

(9)

2005 30235.84 655.44 29580.4 14790.2 14790.2 15445.64 0.909 14040.08

2004 29833.51 655.44 29178.07 14589.03 14589.04 15244.47 0.826 12591.93

PVCIF 26632.01

PVCOF -1310.89

NPV 25321.12

8/9/2019 MBM-202

17/20

Depreciation = Investment / years given

= 1310.89 / 2

= 655.44

NPV = PVCIF - PVCOF

= 26632.01 1310.89.

= 25321.12

Net Present Value has a positive value


= 26632.01 / 1310.89

PI = 20.31.

Calculation for Project Garment:-

CFBDAT ---------- Cash Flow before Depreciation and Tax {(given)}

CFADBT ---------- Cash Flow after Depreciation before Tax {(2) (3)}

CFAT ---------- Cash Flow after Tax {50 % of CFADBT}

CFATAD ---------- Cash Flow after Tax and Depreciation {(7) + (3)}

PVCIF ---------- Present Value of Cash Inflow {(8) * (7)}

PVCOF ---------- Present Value of Cash Outflow {(given)}

NPV ---------- Net Present Value {(CIF COF)}

Years

(1)

CFBDAT

(2)

-dep

(3)

CFADBT

(4)

Tax(50%)

(5)

CFAT

(6)

CFATAD

(7)

PV

@10%(8)

PVCIF

(9)

2005 28008.65 655.44 27353.21 13676.60 13676.61 14332.04 0.909 13027.82

2004 26352.61 655.44 25697.17 12848.58 12848.59 13504.02 0.826 11154.32

PVCIF 24182.14

PVCOF - 1310.89

NPV +22871.25

8/9/2019 MBM-202

18/20

Depreciation = Investment / years given

= 1310.89 / 2

= 655.44

NPV = PVCIF - PVCOF

= 24182.14 1310.89.

= 22871.25

Net Present Value has a positive value


= 24182.14 / 1310.89

PI = 18.44.

In case of NPV, both the projects have positive value so both the

projects are accepted.

In case of PI method, Project Garment has got less number of period

so this project is accepted other than project fabric.

8/9/2019 MBM-202

19/20

CONCLUSION

The long-term investments we make today determines the value we will have tomorrow. Therefore,capital budgeting analysis is critical to creating value within financial management. And the only certainty

within capital budgeting is uncertainty. Therefore, one of the biggest challenges in capital budgeting is to

manage uncertainty. We deal with uncertainty through a three-stage process:

1. Build knowledge through decision analysis.2. Recognize and encourage options within projects.3. Invest based on economic criteria that have realistic economic assumptions.Once we have completed the three-stage process (as outlined above), we evaluate capital projects using a

mix of economic criteria that adheres to the principles of financial management. Three good economiccriteria are Net Present Value, Modified Internal Rate of Return, and Discounted Payback.

Additionally, we need to manage project risk differently than we would manage uncertainty. We haveseveral tools to help us manage risks, such as increasing the discount rate. Finally, we want to implement

post analysis and tracking of projects after we have made the investment. This helps eliminate bias anderrors in the capital budgeting process.

8/9/2019 MBM-202

20/20

REFERENCES

WEBSITES

y en.wikipedia.orgy www.teachmefinance.comy www.investopedia.comy www.studyfinance.comy www.investorwords.com

BOOKS

y Financial management by I M Pandayy Basic Financial Management by M. Y. Khan & P K Jain

MBM-202

Documents

Transcript of MBM-202