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By Prof. Anirban CCIM, Blore

Capital Budgeting

Capital Budgeting. What's that????

The investment decisions of a firm is generally known as the capital budgeting decisions and it consists of the Long Term planning for the proposed capital outlays and their financing. w C/B may be defined as the firms decision to invest its current funds most effective and efficient way in the long term assets in anticipation of an expected flow of benefits over a series of years.
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Prof. Anirban, CCIM, Blore, Capital Budgeting

Capital Budgeting Within The Firm

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Prof. Anirban, CCIM, Blore, Capital Budgeting

Examples of Long Term Assets

Prof. Anirban, CCIM, Blore, Capital Budgeting

Capital Budgeting. Features

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It has potentiality to anticipate a huge profit. It involves high degree of risk. Involves relatively a long period of time between the initial outlay and the anticipated returns. Involves the exchange of current funds (which are invested in long term assets) for the future benefits. Future benefits will occur to the firm over a series of time.
Prof. Anirban, CCIM, Blore, Capital Budgeting

Importance of C/B Decisions

Growth w Risk w Funding w Irreversibility w Complexity
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Prof. Anirban, CCIM, Blore, Capital Budgeting

Capital Budgeting. Process..

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Identification of the potential investment opportunities. Assembling of the proposed investments. Decision making. Preparation of the capital Budget and appropriation. Implementation
Adequate formulation of the project. Use of the principle of responsibility Use of network techniques

Performance Review

Prof. Anirban, CCIM, Blore, Capital Budgeting

Investment Evaluation Criteria

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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

Prof. Anirban, CCIM, Blore, Capital Budgeting

Traditional or Non Discounted Cash flow method

Modern or Discounted Cash flow method

NPV

ARR

C/B Techniques

IRR

PB
Prof. Anirban, CCIM, Blore, Capital Budgeting

PI

Net Present Value

NPV is the classic economic and generally considered to be the best method for evaluating capital investment proposals. w This is one of the discounted cash flow (DCF) techniques which explicitly recognize Time value of Money.
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Prof. Anirban, CCIM, Blore, Capital Budgeting

Steps in NPV calculation

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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 NPV is the difference between the Total present value of the Future Cash in Flows and Future cash outflows. The project should be accepted if NPV is positive (i.e., NPV > 0).
Prof. Anirban, CCIM, Blore, Capital Budgeting

Equation of NPV

C1 C C2 C3 n NPV = + + C0 L3 2 n + (1+ k ) (1 k )+ (1 k ) n Ct NPV = C0 t t = 1 (1+ k )

Prof. Anirban, CCIM, Blore, Capital Budgeting

Acceptance Rule
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Accept the project when NPV is positive NPV > 0 Reject the project when NPV is negative NPV < 0 May accept the project when NPV is zero NPV = 0 The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.

Prof. Anirban, CCIM, Blore, Capital Budgeting

Profitability Index
Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. w Criterion :
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PI > 0 Implies Accept the project PI < 0 Implies Reject the project PI = 0 Implies the decision is indifferent

Prof. Anirban, CCIM, Blore, Capital Budgeting

Internal Rate of Return Method

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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. i.e. PVCI PVCO = 0, i.e. PVCI = PVCO So IRR will be rate of return where NPV =0 This rate is also called as the rate at which the expected inflows break even with the cash outflows of the project. Some time IRR lies between two trial rates called Higher or Upper trial rate and Lower Trial rate. To calculate exact IRR we can use the following interpolation formula. NPV at HTR Exact IRR = LTR + x Diff. of trial NPV at HTR NPV at LTR
Prof. Anirban, CCIM, Blore, Capital Budgeting

rates

Acceptance Rule
Accept the project when r > k. w Reject the project when r < k. w May accept the project when r = k. w In case of independent projects, IRR and NPV rules will give the same results if the firm has no shortage of funds.
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Prof. Anirban, CCIM, Blore, Capital Budgeting

Average Rate of Return

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The accounting ratio and return also known as the ROI uses accounting information as revealed by financial statements to measure the profitability of the 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.

Prof. Anirban, CCIM, Blore, Capital Budgeting

Contd
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ARR = [Average Return (PAT) / Average Invt]

Where, AR = [Total Return / Time] AI = [{Cost - Scrap} / 2] or [{Cost - Scrap } / 2} + Net W/C + Scrap Value

Prof. Anirban, CCIM, Blore, Capital Budgeting

Payback Period
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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. PBP = [Initial Investment / Annual Cash Flows] 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: 50000 / 12500 = 4 years
Prof. Anirban, CCIM, Blore, Capital Budgeting

Payback Period
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. w Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the projects payback?
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3 years + 12 (1,000/3,000) months 3 years + 4 months

Prof. Anirban, CCIM, Blore, Capital Budgeting

Acceptance Rule
The project would be accepted if its payback period is less than the maximum or standard payback period set by management. w 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.
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Prof. Anirban, CCIM, Blore, Capital Budgeting

Payback Reciprocal and Rate of Return

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The reciprocal of payback will be a close approximation of the internal rate of return if the following two conditions are satisfied:
The life of the project is large or at least twice the payback period. The project generates equal annual cash inflows.

Prof. Anirban, CCIM, Blore, Capital Budgeting

Capital Rationing
Capital Rationing is the financial situation in which a firm has only fixed amount of allocate among competing capital expenditure. w It means a situation in which a firm has more acceptable investments than it can finance.
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Prof. Anirban, CCIM, Blore, Capital Budgeting

Risk & Sensitivity Analysis

Sensitivity analysis is a behavioral approach that uses a number of possible values for a given variable to assess its impact on a firms returns. w It provides different cash flow estimates under three assumptions:
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The worst i.e. most pessimistic The expected i.e. most likely The best i.e. the most optimistic

Prof. Anirban, CCIM, Blore, Capital Budgeting

Any Questions ????

Prof. Anirban, CCIM, Blore, Capital Budgeting