Capital Budgeting Techniques

KAPIL AGARWAL

DEFINITION
Planning significant investments in projects that have long term implications comes under Capital Budgeting Capital Budgeting decisions include

Cost reduction Expansion Diversification Equipment selection Lease/ buy Equipment replacement

WHY INVESTMENT DECISIONS IMPORTANT

Have long term implications Large amount of funds Irreversible in nature Difficult decisions

CHARACTERISTICS OF TECHNIQUE
It should consider all cash flows to determine true profitability of the project It should provide objective & unambiguous way of separating projects It should help in ranking of projects It should recognize that bigger & early cash flows are preferable It should help to choose among mutually exclusive projects

TECHNIQUES

Discounted cash flows

Profitability

Index Net present value Internal rate of return

Non Discounted cash flow criteria

Payback

period Accounting rate of return

NPV
Present value of net cash inflows NPV = {CF/(1+k)n } Io

CF=

expected after tax cash flow Io =Initial investment K= risk adjusted discount rate N = life span of project

NPV

Project involves initial investment of Rs.50lacs Net cash inflow during first 3 yrs= 30lacs, 35lacs, 20lacs Scrap value at end of 3rd yr is 10lacs Reqd rate of return 10% Check feasibility of project?
First year Second Third scrap value 1.1 1.21 1.331 1.331 3,000,000 3,500,000 2,000,000 1,000,000 2,727,273 2,892,562 1,502,630 751,315 7,873,779 5,000,000 2,873,779

Initial Investment

5,000,000

NPV

Buying a new machine costing Rs.1lakh. It will last for 5 yrs. Scrap value=0, It will result saving of Rs.36,000 annually. Company requires min return of 20%. Shall the company go ahead with investment?

NPV

If value of NPV is
Positive---

acceptable, it promises return greater than required rate of return Zero--- acceptable, it promises return equal than required rate of return Negative--- Not acceptable, it promises return less than required rate of return

NPV
Minimum required rate of return = Cost of capital Avg Rate of return company must pay to its long term creditors & shareholders Assumptions

All

cash flows other than the initial investment occur at the end of periods All cash flows are immediately reinvested at rate of return equal to discount rate

EVALUATION OF NPV METHOD

NPV is true measure of an investments profitability

It recognizes time value of money It uses all cash flows occurring over entire life of project in calculating its worth Discounting process facilitates measuring cash flows in terms of present values NPV is always consistent with objective of maximizing shareholders wealth

Value additivity principle

NPVs of projects can be added: NPV(A+B) = NPV(A) + NPV(B)

APPROACHES OF NPV
Total cost approach Incremental cost approach

TOTAL COST APPROACH

Company PQR Waterways has a catamaran. One of its catamaran is in poor condition. Two options are available. Which option company should exercise? Company requires ROR of at least 14%.

TOTAL COST APPROACH

INCREMENTAL COST APPROACH

Consider those costs and revenues that differ between two alternatives

INTERNAL RATE OF RETURN

IRR is the rate which equates present value of cash inflows with the present value of cash outflows of an investment It is the rate at which present value of investment is zero It is the rate of return promised by an investment over its useful life Referred as Yield on project Factor of IRR = Investment required
Net annual cash inflow

IRR

IRR=> Companys min required rate of return

Project

is viable
is rejected

IRR < Companys min required rate of return

Project

min reqd rate of return = Cost of Capital

IRR

A project cost Rs.16000 & is expected to generate cash inflows of Rs.8000, 7000 & 6000 at end of each year for next 3 years. Find rate at which NPV is zero NPV (20%) = 8000*PVF1,20+7000*PVF2,20+6000*PVF3,20 NPV =-1004 NPV (16%)= 8000*PVF1,16+7000*PVF2,16+6000*PVF3,16 NPV = -57 NPV (15%)= 8000*PVF1,15+7000*PVF2,15+6000*PVF3,15 NPV =200 True rate of return is between 15 & 16%

CATEGORIES OF CAPITAL BUDGETING DECISIONS

Screening

Preference

Whether proposed project is acceptable Comes first

Selecting from various acceptable alternatives Comes after screening Also called rationing decision/ ranking decision

SCREENING TOOL

IRR
Cost

of capital is used as hurdle rate IRR> cost of capital

NPV
Cost

of capital is discount rate ie rate used to compute NPV of a proposed project NPV = +ve

PROFITABILITY INDEX
Present value of net cash inflows PI = [CF/(1+k)n ]/ Io

CF=

expected after tax cash flow Io = Initial investment K= risk adjusted discount rate N = life span of project

PROFITABILITY INDEX
Initial cash outlay of a project is Rs.100,000 and it can generate cash inflow of Rs.40000, Rs.30000 Rs.50000 & Rs.20000 in year 1 through 4 Assume 10% rate of discount PV of cash flows PV (10%) = 40000*PVF1,10+30000*PVF2,10+50000*PVF3,10+ 20000*PVF4,10 PV = 112350-100000 PI= 112350/100000 ==1.1235

PROFITABILITY INDEX
Acceptance rule Accept PI > 1 Reject PI <1 May Accept PI=1

THANK YOU