CAPITAL BUDGETING

Module: 01
MEANING
These are the decisions pertain to fixed/long term
assets.

Capital budgeting is the process of evaluating and
selecting long term investments that are consistent
with the goal of the shareholders wealth
maximization.

They involve a current outlay or series of outlays of
cash resources in return for an anticipated flow of
future cash inflows.



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2
CONTD.
Capital expenditure management therefore, includes
additions, disposition, modification and replacement of
fixed assets.

The basic features are:

Potentially large anticipated benefits
A relatively high degree of risk

And a relatively long time period between the initial
outlay and the anticipated returns.

The term capital budgeting is used interchangeably with
capital expenditure decision, capital expenditure
management, long term investment decision,
management of fixed assets etc.

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IN OTHER WORDS
Capital budgeting (or investment appraisal) is the
planning process used to determine whether an
organization's long term investments such as
new machinery,
replacement machinery,
new plants, new products,
research development projects
acquiring a new company
are worth the funding of cash through the firm's
capitalization structure (debt, equity or retained earnings).

It is the process of allocating resources for major capital,
or investment, expenditures. One of the primary goals of
capital budgeting investments is to increase the value of
the firm to the shareholders.
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IMPORTANCE OF CAPITAL BUDGETING
These are the strategic investment decisions.

Capital budgeting decisions affect the profitability
of a firm.

It have a bearing on the competitive position of the
enterprise.

These changes could lead stockholders and
creditors to revise their evaluation of the company.







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CONTD.

So, it is rightly said that the future destiny of the
company determined on these crucial decisions.

An opportune investment decision can yield
spectacular returns.

An ill-advised and incorrect decision can endanger
the very survival even of the large firms.



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CONTD.

A few wrong decisions and the firm may be forced
into bankruptcy.

Fixed asset employment Maintenance

Capital investment decisions, once made, are not
easily reversible.

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DIFFICULTIES
The benefits from investments are received in some
future period and the future is uncertain Cash
flow estimate for 15 plus years.

Risk of obsolesce.

Risk of change in the customer preferences and
tastes.
Difficulty in calculating in strict quantitative terms all
the benefits relating to a investment decision.



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RATIONALE
Capital budgeting projects may include a wide
variety of different types of investments, including
but not limited to, expansion policies, or acquisition
of companies.

When no such value can be added through the
capital budgeting process and excess cash surplus
exists and is not needed, then management is
expected to pay out some or all of those surplus
earnings in the form of cash dividends or to
repurchase the company's stock through a share
buyback program.


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CONTD.
These projects must also be financed appropriately.

If no positive NPV projects exist and excess cash
surplus is not needed to the firm, then financial
theory suggests that management should return
some or all of the excess cash to shareholders (i.e.,
distribution via dividends).

Corporate management seeks to maximize the
value of the firm by investing in projects which yield
a positive net present value when valued using an
appropriate discount rate in consideration of risk.


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TYPES OF CAPITAL BUDGETING DECISIONS
Those which expand revenues
Adding additional product lines
Expansion of present operations

Those which reduce costs
Replacement proposals

- Fundamental difference:
Cost reduction investment decisions are subject to
less uncertainty in comparison to the revenue
affecting investment decisions.
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KINDS
Accept-reject Decision
Mutually Exclusive Project Decisions
Capital Rationing Decision

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ACCEPT-REJECT DECISION

It is the evaluation of capital expenditure proposal
to determine whether they meet the minimum
acceptable criteria.

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MUTUALLY EXCLUSIVE PROJECT DECISIONS

These are the projects that compete with one
another; the acceptance of one eliminates the
others from further consideration.

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CAPITAL RATIONING DECISION

Capital rationing is the financial situation in which a
firm has only fixed amount to allocate among
competing capital expenditure.

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EVALUATION TECHNIQUES:

Traditional techniques
Discounted Cash Flow Technique (DCF)

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TRADITIONAL TECHNIQUE:

Average Rate of Return method (ARR)
Payback method

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AVERAGE RATE OF RETURN METHOD (ARR)

The ARR method of evaluating proposed capital
expenditure is also known as Accounting Rate of
Return method.

It is based upon the accounting information rather than
cash flows.
Formula:
ARR = Average annual profits after taxes / Average
investment over the life of the project * 100

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CONTD.
Average PAT = Adding up the after tax profits for each
year of projects life and dividing the result by the
number of years.

In the case of annuity, the average after tax profits is
equal to any year profits.

The average investment = Net working capital +
Salvage value + (Initial cost of machine Salvage
value)

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Determine the ARR from the following data of two
machines A and B.

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Particulars
Machine
A
Machine
B
Cost
Rs.
56,125
Rs.
56,125
Annual estimated income after
depreciation and income tax:
Rs. Rs.
Year 1 3,375 11,375
2 5,375 9,375
3 7,375 7,375
4 9,375 5,375
5 11,375 3,375
36,875 36,875
Estimated life (years) 5 5
Estimated salvage value 3,000 3,000
Depreciation has been charged on straight line basis.
ACCEPT-REJECTION RULE:
As an accept-reject criterion, the actual ARR would
be compared with a predetermined or a minimum
required rate of return or cut off rate.

A project would qualify to be accepted if the actual
ARR is higher than the minimum desired ARR,
otherwise; it is liable to be rejected.

Alternatively, the ranking method can be used to
select or reject proposals.

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CONTD.
The proposals under consideration may be
arranged in the descending order of magnitude,
starting with the proposal with the highest ARR and
ending with the proposal having the lowest ARR
Obviously, projects having highest ARR would
be preferred to the projects with lower ARR.

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EVALUATION OF ARR:
The most favorable attribute of the ARR method is its
easy calculation.

What is required is only the figure of accounting profits
after taxes which should be easily obtainable.
Moreover, it is simple to understand and use.

The total benefits associated with the project are taken
into account while calculating the ARR.

Some methods, pay back for instance, do not use the
entire stream of incomes.

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DEFICIENCIES
This approach uses accounting income instead of cash
flows as cash flow approach is markedly superior to
accounting earnings for project evaluation.

ARR ignores the time value of money. Whereby it treats
cash flows of earlier years and later years equally.

The ARR criterion of measuring the worth of investment
does not differentiate between the size of the
investments required for each project.
Competing investment proposals may have the same
ARR, but may require different average investments.
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CONTD.
This method does not take into consideration any
benefits which can accrue to the firm from the sale or
abandonment of equipment which is replaced by the
new investment.

The new investment, from the point of view of correct
financial decision making, should be measured in terms
of incremental cash outflows due to new investments,
that is, new investment minus sale proceeds of the
existing equipment +/- tax adjustment.

But ARR method does not make any adjustment in this
regard to determine the level of average investments.

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PAY BACK METHOD

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PAY-BACK METHOD (BP)
It is simplest and, perhaps, the most widely employed,
quantitative method for appraising capital expenditure
decisions.

This method answers the question:
How many years will it take for the cash benefits to pay
the original cost of an investment, normally disregarding
salvage value.
Cash benefits here represent CFAT ignoring interest
payment.
Thus, the pay back method measures the number of
years required for the CFAT to pay back the original
outlay required in an investment proposal.

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TWO WAYS OF CALCULATING PB
When cash flow stream is in the nature of annuity
for each year of the projects, i.e., CFATs are
uniform.
Formula:
PB= Investment / Constant annual cash flow

Eg:
An investment of Rs.40,000 in a machine is
expected to produce CFAT is Rs.8,000 for 10 years.


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CONTD.
The second method is used when a projects cash
flows are not uniform (mixed stream), but vary from
year to year.

In such situation, PB is calculated by the process of
cumulating cash flows till the time when cumulative
cash flows become equal to the original investment
outlay.

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EG:
Calculate PB from the following data:

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Year Annual CFATs
A (Rs.) B (Rs.)
1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000
Initial outlay is Rs.56,125. CFAT in the fifth year
includes Rs.3,000 salvage value as well.
ACCEPT REJECTION CRITERION
The payback period can be used as a decision
criterion to accept or reject investment proposals.

One application of this technique is to compare the
actual pay back with a predetermined pay back.
that is, the pay back set up by the management in
terms of the maximum period during which the
initial investment must be recovered.

If the actual payback period is less than the
predetermined pay back, the project would be
accepted; if not, it would be rejected.

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CONTD.
The pay back can be used as a ranking method.

When mutually exclusive projects are under
consideration they may be ranked according to the
length of the payback period.

Thus, the project having the shortest pay back may
be assigned rank one, followed in that order so that
the reject with the longest payback would be ranked
last.

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EVALUATION
Its failure lies in the fact that it does not consider the total
benefits accruing from the project.

It does not measure correctly even the cash flows expected to
be received within the payback period as it does not
differentiate between the projects in terms of the timing or the
magnitude of cash flows.

It considers only the recovery period as a whole.

This happens because it does not discount the future cash
inflows but rather treats a rupee received in the second or
third year as valuable as a rupee received in the first year.
To the extent the payback method fails to consider the pattern
of cash flows, it ignores time value of money.

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EG: 2
Particulars Project A Project B
Total cost of the project 15,000 15,000
Cash I/F (CFATs)
Year 1 10,000 4,000
2 4,000 10,000
3 1,000 1,000
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CONTD.
Another flaw of the pay back method is that it does
not take into consideration the entire life of the
project during which cash flows are generated.

As a result, projects with large cash inflows in the
later part of their lives may be rejected in favor of
less profitable projects which happen to generate a
larger proportion of their cash inflows in the earlier
part of their lives.


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EG:
Particulars Project A Project B
Total cost of the project 40,000 40,000
Cash I/F (CFATs)
Year 1 14,000 10,000
2 16,000 10,000
3 10,000 10,000
4 4,000 10,000
5 2,000 12,000
6 1,000 16,000
7 Nil 17,000
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CONTD.
In a politically unstable country, for instance, a
quick return to recover the investment is the
primary goal, and subsequent profits are almost
unexpected surprises.

After going through all these examples, we can
conclude that the PB method should more
appropriately be treated as a constraint to be
satisfied than as a profitability measure to be
maximized.

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DCF/ TIME-ADJUSTED TECHNIQUES
These techniques take into consideration of the time
value of money.

There is a discount rate at which the project future cash
inflows are discounted back..

They take into account all benefits and costs occurring
during the entire life of the project.
The techniques are:
NPV
IRR
MIRR
Terminal Value method
Profitability Index (PI)
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CONTD.
DCF techniques recognizes that cash flow streams
at different time periods differ in value and can be
compared only when they are expressed in terms of
a common denominator, that is, present values.

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NET PRESENT VALUE (NPV)
NPV is found by subtracting a projects initial
investment from the present value of its cash
inflows discounted at the firm's cost of capital.

Symbolically:


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COo = Cash outflow at t=0
CONTD.
If cash outflows is also expected to occur at some
time other than at initial investment:

Symbolically:

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JSW Steels is considering an investment proposal to
instal an equipment for its one of the plants at a cost of
Rs.30,00,000.
The facility has life expectancy of 6 years and no
salvage value. The tax rate is 35%. Assume the firm
uses straight line depreciation
and same is allowed for tax purposes. The estimated
cash flows before depreciation and tax (CFBT) from the
investment is as follows:
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COMPUTE NPV AT 12%
Year
CFBT
1
645000
2
668000
3
768000
4
840000
5
323000
6
634000
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Problems
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DECISION RULE
If NPV is > Zero Accept the project

If NPV is < Zero Reject the project.

Zero NPV implies that the firm is indifferent to
accepting or rejecting the project.. However, in
practice it is rare if ever such a project will be
accepted..!!
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CASH FLOWS IN REPLACEMENT SITUATION
Cash outflows in a Replacement Situation:




Depreciation base of new machine in Replacement
Situation:
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CONTD.
Base for incremental Depreciation:

Depreciation base of new machine xxxxx
Less: Dep. Base of old machine xxxxx
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OR
Cost of New Machine xxxxx
Less: Present realizable value of
old machine xxxxx
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SALVAGE VALUE AND ITS TAX IMPLICATIONS

Salvage value (SV) < Book value (BV) Loss

Net proceeds= SV + Tax savings on STCL
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SALVAGE VALUE AND ITS TAX IMPLICATIONS
CONTD.

Salvage value (SV) > Book Value (BV) but
SV < Original Value (Investment Cost) Ord. profit

Net proceeds= Salvage value Tax on profit
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SALVAGE VALUE AND ITS TAX IMPLICATIONS
CONTD.
Salvage value (SV) > Original value Ordinary
profit and Capital Gain

Net proceeds= Salvage value Tax on ordinary profit
Tax on capital gain
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DECISION RULE CONTD.
As a decision criterion, this method can also be
used to make a choice between mutually exclusive
projects.

On the basis of the NPV method, the various
proposals would be ranked in order of the NPVs.

The project with the highest NPV would be
assigned the first rank, followed by others in the
descending order.

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EVALUATION
Merits of NPV:
The most significant, advantage is that it explicitly
recognizes the time value of money.

It also fulfills the second attribute of a sound method of
appraisal in that it considers the total benefits arising out
of the proposal over its lifetime.

A changing discount rate can be built into the NPV
calculations by altering the denominator.
As normally discount rate changes when the projects
duration is longer.

This method is particularly useful for selection of
mutually exclusive projects and for the mutually
exclusive projects NPV is the perfect technique.
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CONTD.
Drawbacks:
It is difficult to calculate as well as understand and
use in comparison with the traditional techniques.

Calculation of the required rate of return to discount
the cash flows.

NPV method is the absolute measure. This method
will favor the project which has higher PV (or NPV).
But it is likely that this project may also involve a
larger initial outlay.
Thus, in case of projects involving different outlays,
the PV method may not give dependable results..


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CONTD.
NPV method gives the same decision for two
different projects with different project life.

Eg: Project A: Life is 5 years, NPV is Rs.12,000
Project B: Life is 10 years, NPV is Rs.12,000
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INTERNAL RATE OF RETURN (IRR)
This method is also known as yield on investment,
marginal efficiency of capital, rate of return, time
adjusted rate of return and so on..

This method also considers the time value of money by
discounting the cash steams.

The basis of the discount factor, however, is different in
both cases.

In case of the NPV, the discount rate is the required rate
of return and being a predetermined rate, usually the
cost of the capital.

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CONTD.
So here in this case total benefits out of the project
is found out on a percentage basis, which is called
as internal rate of return of the project.
The IRR is usually the rate of return that a project earns.

IRR is the discount rate that equates the present
values of cash inflows with the initial investment
associated with a project, there by causing NPV=0.

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CONTD.
It is defined as the discount rate which equates the
aggregate present value of the net cash inflows
(CFAT) with the aggregate present value of cash
outflows of a project.
In other words, it is that rate which gives the project
NPV of zero.
Symbolically,

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CONTD.
For unconventional cash flows, the equation is
would be:

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EXAMPLE
A project costs Rs.36,000 and is expected to
generate cash inflows of Rs.11,200 annually for 5
years. Calculate the IRR of the project.


A project costs Rs.2,30,000 and is expected to
generate cash inflows of Rs.66,000 annually for 6
years. Calculate IRR of the project.

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EG:
Calculate IRR from the following data:

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Year Annual CFATs
A (Rs.) B (Rs.)
1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000
Initial outlay is Rs.56,125.
INITIAL OUTLAY IS RS.30,00,000
Year
CFATs
1
645000
2
668000
3
768000
4
840000
5
323000
6
634000
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CALCULATE IRR FROM THE FOLLOWING DATA:
ACCEPT REJECTION DECISION
It involves comparison of the actual IRR with the
required rate of return also known as the cut-off
rate or hurdle rate.

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MODIFIED INTERNAL RATE OF RETURN
The Reinvestment rate assumption:

NPV assumes that the cash flows are reinvested at
the firms cost of capital.

IRR assumes that the intermediate cash flows are
reinvested at the IRR rate.

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EXAMPLE
Cash inflows
Project Initial Investment Year 1 Year 2
A Rs. 100 Rs. 200 0
B Rs. 100 0 Rs. 400
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Assume 10% cost of capital for calculation of NPV
MIRR
So, to eliminate this deficiency of the IRR, MIRR
has formulated where it is modified to the extent
that the intermediate cash inflows will be
compounded by the cost of capital rate.

Formula:




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CALCULATE MIRR FROM THE FOLLOWING:
Year Annual CFATs
1 14,000
2 16,000
3 18,000
4 20,000
5 25,000
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Initial investment is Rs.56,125 and
Cost of capital is 10%
PROFITABILITY INDEX (PI)
Another method in time adjusted technique.
It is also called as benefit-cost ratio.
It is similar to the NPV method.

The PI approach measures the PV of returns per
rupee invested, while the NPV is based on the
difference between the PV of future cash inflows
and PV of cash outlays.

NPV ignores the size of the investment in the
project while giving the conclusion.




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CONTD.
In other words, PI is a relative measure.

It is defied as the ratio which is obtained by dividing
the PV of cash future cash inflows by the PV of
cash outlays.

Symbolically,

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ACCEPT-REJECTION
Accept if PI>1
Reject if PI<1
Ranking method can also be adopted.

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EVALUATION
Projects with different initial investment would be
ranked same in NPV method (shortcoming).

But it is not in case of PI method.

It is appropriate to say that NPV and PI should be
used in combination to make investment decision.
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CAPITAL RATIONING
It is a process of making investment decisions on viable
projects where funds are limited. Investments decisions
are made given a fixed amount of capital to be invested
in viable projects.

If a company doesnt have sufficient funds to undertake
all projects with a positive NPV, this is a capital rationing
situation.

The project selection under this method involves two
stages:
Identification of the acceptable projects
Selection of the combination of projects

This can be done based on PI or IRR

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TYPES
Soft rationing
Hard rationing



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SOFT RATIONING
It is caused by internally generated factors of the
company. It is a self imposed capital rationing by the
management of the company.

Management may put a maximum budget limit to be
spent within a specific period.

Examples/causes of soft capital rationing a self imposed
budgetary limit where the management puts a ceiling on
the maximum amount to be spent on investments.

Management may decide against issuing more equity
finance in order to maintain control over the companys
affairs by existing shareholders.
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CONTD.
Management may opt not to raise more equity so
as to avoid dilution in the Earning per share.

Management may decide not to raise additional
debt due to the following reasons:
To avoid increase in interest payment commitment

To control the gearing or operating leverage so as to
minimize the financial risk or business risk.

If a company is small or family owned, its managers
may limit the investment funds available to maintain
constant growth through retained earnings as opposed
to rapid expansion.


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HARD RATIONING
Hard rationing refers to the situation when a
business firm cannot raise required finances to
execute all potential available profitable investment
projects.

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EXAMPLE
A company with 12% cost of funds and limited
investment funds of Rs.4,00,000 is evaluating the
desirability of several investment proposals.
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Project
Initial
investment
(Rs.)
Life (in
years)
Year end
inflows
A 300000 2 187600
B 200000 5 66000
C 200000 3 100000
D 100000 9 20000
E 300000 10 66000
CONTD.
1. Rank the projects according to the PI and NPV
2. Determine the optimal investment package.

3. Which projects should be selected, if the company
has Rs.5,00,000 as the size of its capital budget?
4. Determine the optimal investment package in the
above situations, assuming that the projects are
divisible.
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RISK ANALYSIS OF PROJECTS CASH-FLOWS
A project with high profitability is assumed to have
high perceived risk.

So there should be trade off between risk and
profitability to the investors.

If the acceptance of a proposal, for instance, makes
a firm more risky, the investors would not look to it
with favor.

This may have adverse implication on the market
price of shares, total valuation of the firm and its
goal.


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RISK
Risk is the variability in the actual returns in ration
to the estimated returns.

Risk refers to a set of unique outcomes for a given
event which can be assigned probabilities, while
uncertainty refers to the outcomes of a given event
which are too unsure to be assigned probabilities.






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SENSITIVITY ANALYSIS
It provides information as to how sensitive the
estimated project parameters, namely, the expected
cash flow, the discount rate and the project life are
to estimation errors.

The analysis on these lines is important as the
future is always uncertain and there will always be
estimation errors.

Sensitivity analysis takes care of estimation errors
by using a number of possible outcomes in
evaluation a project.


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CONTD.

The method evaluate a project using a number of
estimated cash flows to provide to the decision
maker an insight into the variability of the
outcomes.

This provides different cash flow estimates under 3
assumptions:
The worst (pessimistic),
The expected (most likely), and
The best (most optimistic) outcomes associates
with the project

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SENSITIVITY ANALYSIS CONTD.
This analysis can also be used to ascertain how
change in key variables such as sales volume,
sales price, variable costs, fixed costs cost, cost of
capital and so on affect the expected outcome of
the proposed investment project.

For the purpose of analysis, only one variable is
considered, holding the effect of other variables
constant, at a point of time.

Like impact of sales price +/- 5% on NPV.
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CONTD.
Like wise, this analysis can be used to see the
effect of increase in variable costs, say 5% increase
in variable costs converts the status of positive NPV
to negative NPV.

The project is said to be highly sensitive if the small
change brings out a magnified change in NPV.

So ideally this technique will help in the assessing
the risk associated with proposed project.


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SCENARIO ANALYSIS
Scenario analysis is akin to sensitivity analysis but
is broader in scope.

Sensitivity analysis analyses the impact of only one
variable at a time, the scenario analysis evaluates
the impact on the projects profitability of
simultaneous changes in more than one variable at
a time.

Such as cash inflows, cash outflows and cost of
capital.
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CONTD.
The decision maker begins with the base case i.e.,
with most likely scenario and then to worst case
scenario and lastly the best case scenario.

Each scenario will affect the firms cash inflows,
cash outflows, cost of capital and NPV.


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SIMULATION
It attempts to answer what if questions.

Simulation model is akin to sensitivity analysis but
its more comprehensive than sensitivity.

Instead of showing the impact on the NPV for
change in one key variable say, change in sales
price or cost of capital at one point of time in
sensitivity analysis,

simulation enables the distribution of probable
values of NPV, for change in all the key variables, in
one iteration/run only.
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CONTD.
So it provides more information and better
understanding about the risk associated with
investment decisions to the finance manger.

To be effective, simulation requires a sophisticated
computing package as it then enables to try out a
large no. of outcomes with much ease.


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RISK EVALUATION APPROACHES
Risk adjusted discount rate approach
Certainty equivalent approach
Probability distribution approach
Decision tree approach
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REFERENCES
Financial Management MY Khan and PK Jain, TMH,
6
th
Edition

Financial Management IM Panday, Vikas, 10
th
Edition
Principles of Corporate Finance Brealey, Myres, Allen
and Mohanty, TMH, 8
th
Edition

Fundamentals of Financial Management Van Horne &
Wachowicz Pearson, LPE
http://forio.com/simulation/harvard-capital-demo/#


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