To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand

to another until it finally disappears.10020241111 Capital Budgeting Meaning:- refers to long term planning for proposed capital outlays and their financing - raising of long term funds as well as their utilization - the firms formal process for the acquisition and investment of capital - involves firms decision to invest its current funds for addition, disposition, modification and replacement of long term or fixed assets Importance: -involvement of heavy funds -long term implications ( purchase a new plant) -Irreversible decisions- cannot be change -Most difficulty to make future estimate Techniques 1. Payback Period Method -refers to the period in which the project will generate the necessary cash to recoup the initial investment a) When the cash inflows are uniform every year Payback period = Initial investment / Annual cash inflow* indicates before depreciation but after taxation. b) When the cash inflows are not equal every year Cumulative years + remaining amount needed to reach the initial investment / that year cash inflows 2. Discounted Cash Flow Method or Time Adjusted Techniques: a) Net Present Value Method - under this method cash inflow and outflows associated with the project are first worked out - then the cash inflows and outflows are then calculated at the rate of return acceptable to the management - this rate of return is considered as the cut off rate and is generally determined on the basis of cost of capital suitably adjusted to allow for the risk element involved in the project. b) Internal Rate of Return. - is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows. In other words it is the rate which discounts the cash flows to zero. Cash Inflows / Cash Outflows =1 iWhen cash inflows are uniform F= I / C Where F= Factor to be located I = Original investment C= Cash inflow per year iiwhen cash inflows are not uniform then instead of cash inflow per year average cash inflow will be considered. c) Net Present Value method-= present value of future cash inflows / present value of future cash outflows 100

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111

3. Accounting or Average Rate of Return Method (ARR) The capital investment proposals are judged on the basis of their relative profitability. For this purpose, capital employed and related income are determined according to commonly accepted accounting principles and practices over the entire economic life of the project and then the average yield is calculated. i) ARR = Annual average net earnings */ Original Investment 100 ii) ARR = Annual average net earnings / Average Investment 100 iii) ARR = Increase in expected future annual net earnings/ Initial increase in required investment 100 * is the average of the earnings ( after depreciation and tax) Capital budgeting Problems and its Solutions 1. An engineering company is considering the purchase of a new machine for its immediate expansion programme. There are three possible machines suitable for the purpose. Their details are as follows: Machine Machine Machine 1 2 3 Capital cost Sales Cost of Production: Direct material Direct labour Factory o/h Admn. Costs Selling & Distribution costs 3,00,000 5,00,000 40,000 50,000 60,000 20,000 10,000 3,00,000 4,00,000 50,000 30,000 50,000 10,000 10,000 3,00,000 4,50,000 48,000 36,000 58,000 15,000 10,000

The economic life of machine No.1 is 2 years, while it is 3 years for the other two. The scrap values are Rs.40,000, Rs.25,000 and Rs.30,000 respectively. Sales are expected to be at the rates shown for each year during the full economic life of the machines. The costs relate to annual expenditure resulting from each machine. Tax to be paid is expected at 50% of the net earnings of each year. It may be assumed that all payables and receivables will be settled promptly, strictly on cash basis with no outstanding from one accounting year to another. Interest on capital has to be paid at 8% per annum. You are requested to show which machine would be the most profitable investment on the principle of payback method. Ans: Statement showing the net cash flow of three Machines Machine Machine Machine 1 2 3 Capital Cost 3,00,000 3,00,000 3,00,000

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111

Sales Cost of Production: Administration Expenses Selling & Distribution Expenses Total Cost Profit before Depn. And Interest Depreciation Interest on Borrowings Profit before Tax Taxation 50% Profit after Tax Add: Depreciation NETCASH FLOW

5,00,000 1,50,000 20,000 10,000 1,80,000 3,20,000 1,30,000 24,000 1,66,000 83,000 83,000 1,30,000 2,13,000

4,00,000 1,30,000 10,000 10,000 1,50,000 2,50,000 91,667 24,000 1,34,333 67,167 67,167 91,667 1,58,833

4,50,000 1,42,000 15,000 10,000 1,67,000

2,83,000 A-B=C 90,000 24,000 D 1,69,000 C-D=E 84,500 84,500 90,000 1,74,500

Payback period 1.41 Years 1.89 Years 1.72 Years Machine 1 is most profitable and that can be advisable to place an order for the first type of machine. 2. Alpha Co. Ltd , is considering the purchase of a new machine. Two alternative machines (A and B ) have been suggested, each having an initial cost of Rs.4,00,000 and requiring Rs.20,000 as additional working capital at the end of 1st Year. Earnings after taxation are expected to be as follows: Cash Inflows Year Machine A Machine B 1 Rs.40, 000 Rs.1,20,000 2 1,20,000 1,60,000 3 1,60,000 2,00,000 4 2,40,000 1,20,000 5 1,60,000 80,000 The company has a target of return on capital of 10% and on this basis, you are required to compare the profitability of the machines and state which alternative you consider financially preferable. ( the P.V factor at 10% level of 1 rupee is as follows, .909, .826, .751, .683,.621, ) Ans: Statement showing the profitability of the two machines Year Discount Factor Machine-A Cash Inflow Present value Machine -B Cash Inflow Present value

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111 1 2 3 4 5 36,360 99,120 1,20,160 1,63,920 99,360 5,18,920 Total present value of cash inflows =5,18,920 Total present value of cash outflows = 4,18,180 ( 4,00,000+ 20,000 .909 ) Net Present Value 1,00,740 .909 .826 .751 .683 .621 40,000 1,20,000 1,60,000 2,40,000 1,60,000 1,20,000 1,60,000 2,00,000 1,20,000 80,000 5,23,080 4,18,180 1,04,900 B is Advisable 1,09,080 1,32,160 1,50,200 81,960 49,680 5,23,080

3. A company has to select one of the following two projects; Project A Project B Cost Rs.11,000 Rs.10,000 Cash Inflows: Year 1 6,000 1,000 Year 2 2,000 1,000 Year 3 1,000 2,000 Year 4 5,000 10,000 Using the Internal Rate of Return method suggest which project is preferable.

Ans Year Discount Factor Cash Inflow 1 2 3 4 .909 .826 .751 .683 6,000 2,000 1,000 5,000

Project-A Present value 5,454 1,652 751 3,415 11,272

Cash Inflow 1,000 1,000 2,000 10,000

Project -B Present value 909 826 1,502 6,830 10,067

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111 The present value at 10% comes to Rs.11,272 and 10,067 respectively. Project B is more or less equal to the initial investment. Hence the internal rate of return may be taken as 10%. The present value at 10% comes to Rs.11,272 and 10,067 respectively. Project B is more or less equal to the initial investment. Hence the internal rate of return may be taken as 10%. In order to have more exactness, the internal rate of return can be interpolated as below: At 10% level the present value is + 67 At 15% level the present value is 1,338 (if calculate by taking 15% value) Then the IRR = 10% + 67 /67+ 1,338 5* * = difference between 15-10 percent = 10+.24 = 10.24% 4.Determine the Average Rate of Return from the following data of two Machines A and B Machine A Machine B Original Cost Rs.56,125 Rs.56,125 Addl. Invt. In net working capital 5000 6000 Estimated life in years 5 5 Estimated salvage value 3000 3000 Average income tax rate 55% 55% Annual estimated income after depreciation and tax: 1st Year 3,375 11,375 2nd Year 5,375 9,375 rd 3 Year 7.375 7,375 4th Year 9,375 5,375 th 5 Year 11.375 3,375 36,875 36,875 Depreciation has been charged on straight line basis. Ans: ARR= Average earnings / Average Investment 100 Average income = Total income /Number of years Machine A = 36,875 / 5 = 7,375 Machine B = 36,875 / 5 = 7,375 Average investment = original investment scrap value/ 2 + addl. Net working capital+ scrap value Machine A = 56,125-3000 /2 + 5,000+ 3,000 26,562.50+ 8,000 = 34,562.50 Machine B = 56,125- 3000 /2 + 6,000+ 3,000 26,562.50 + 9,000 = 35,562.50 ARR for Machine A = 7,375/ 34,562.50 100= 21.34% ARR for Machine B = 7,375 /35,562.50 100 = 20.74%

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111

5. A limited company is considering investing in a project requiring a capital outlay of Rs.2,00,000. Forecast for annual income after depreciation but before tax us as follows; Year 1 2 3 4 5 Rs. 1,00,000 1,00,000 80,000 80,000 40,000 Depreciation may be taken as 20% on original cost and taxation at 50% of net income. a) b) c) d) e) f) You are required to evaluate the project according to each of the following method. Payback method Rate of return on original investment method Rate of return on average investment method Discounted cash flow method taking cost of capital as 10%. Net present value index method Internal rate of return method.

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111 Ans : A) Payback Method Year 1 2 3 4 5 Profit after depreciation 1,00,000 1,00,000 80,000 80,000 40,000 Statement of Net Cash Inflow Profit before Depreciation but after Tax 50,000 90,000 ( 50,000+40,000) 50,000 90,000 (50,000+40,000) 40,000 80,000 (40,000+40,000) 40,000 80,000 ( 40,000+40,000) 20,000 60,000 (20,000+ 40,000) Tax

The payback period .Rs1,80,000 is recovered in 2 years. The balance of Rs. 20,000 will be recovered in 20,000/ 80,000 = 0.25 year. Hence the payback period is 2.25 years.

B) Rate of Return on Original Investment Method Year 1 2 3 4 5 Net profit after Tax and depreciation Rs.50,000 Rs.50,000 Rs.40,000 Rs.40,000 Rs.20,000 Rs.2,00,000 Average annual return= 2,00,000/ 5= 40,000 Rate of return = 40,000/ 2,00,000 100 = 20% C) Rate of Return on Average Investment Method = 40,000/ 1,00,000 100 = 40% D) Discounted Cash Flow Method Year Net profit before Depn. After Tax Discount Factor @ 10% 0.909 0.826 0.751 0.683 0.621 Present Value 81,810 74,340 60,080 54,640 37,260 3,08,130 2,00,000

1 90,000 2 90,000 3 80,000 4 80,000 5 60,000 Present value of cash inflows Initial investment

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111 Excess Cash inflow 1,08,130

E) Net Present Value Index = Total present value of cash inflows / Total present value of cash outflows 3,08,130 /2,00,000 = 1.541 or 154% F) Internal Rate of Return Method Since the annual cash inflows are not uniform, the factor will have to be located for determining the approximate rate of return: F= I /C Where F= Factor to be located I = Initial Investment C= Average annual cash inflow F= 2,00,000 / 80,000 = 2.5 Table II discloses at this factor rate of return in the column for 5 years as 28%. Present Value at 28% Cash Inflow Discount Net cash Factor Inflow 1 90,000 0.781 70,290 2 90,000 0.610 54,900 3 80,000 0.477 38,160 4 80,000 0.373 29,840 5 60,000 0.291 17,460 Total present value 2,10,650 Initial Investment 2,00,000 Excess Present Value 10,650 Year Present Value at 30% Discount Net Cash Factor Inflow 0.769 69,210 0.592 53,280 0.455 36,400 0.350 28,000 0.269 16,140 2,03,030 2,00,000 3,030

The present value at 30% is higher by 3,030. The internal rate of return will, therefore, be slightly higher than 30%. Though exact interpolation can be done, it would not affect much the management decision. Hecne, the rate may be taken as 30%. Capital Budgeting (Points to be rembered) Capital investment decision Capital investments involve increase in the fixed assets of a company.

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111 (Expansion / diversification / Green field / takeover / merger) Characteristics of investments

Capital outlay needs to be made up front returns come later Capital Budgeting Certain amount of risk is involved Capital investment tend to be indivisible. (difficult to phase out). Financial techniques

The purpose of financial techniques is to enable the making of investment acceptance / rejection decisions. Capital Budgeting Evaluation Criteria Discounted Cash Flow (DCF) Criteria Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Non-discounted Cash Flow Criteria Payback Period (PB) Discounted Payback Period (DPB) Accounting Rate of Return (ARR) Capital Budgeting NPV Method 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 projects 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).

Capital Budgeting NPV Method 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 Capital Budgeting NPV Method 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.

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111

Capital Budgeting NPV Method Accept the project when NPV is positive Reject the project when NPV is negative May accept the project when NPV is zero

NPV > 0 NPV < 0 NPV = 0

The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected. Capital Budgeting NPV Method NPV is most acceptable investment rule for the following reasons Time value Measure of true profitability Value-additively Shareholder value Limitations Involved cash flow estimation Discount rate difficult to determine Mutually exclusive projects Ranking of projects

Capital Budgeting I.R.R 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 Capital Budgeting I.R.R Method Level Cash Flows Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 years. The IRR of the investment can be found out as follows At PVFA the 3.683 one will find at 6th year row column 16 % ,hence IRR is 16 % Capital Budgeting I.R.R Method Level Cash Flows Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 years. The IRR of the investment can be found out as follows Capital Budgeting I.R.R Method

To all finance geeks - Always remember : Finance is the art and Science of channeling money from one hand to another until it finally disappears.10020241111 Level Cash Flows Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 years. The IRR of the investment can be found out as follows Capital Budgeting I.R.R Method Level Cash Flows To Get NPV Zero one has to do the close approximation of the rate of return by the method of linear interpolation