CAPITAL BUDGETING

What is Capital Expenditure?

Capital expenditure
o An expenditure that is incurred at one point of time o The benefits are realized at different points of time in future o Potential of making large profits in the future o Heavy expenditure, so high risk o Long term commitment of funds o Irreversible decision o Uncertain cash flows in future o Expansion, Diversification, R&D, Replacement of assets.

What is Capital Budgeting ?

- Decisions for capital investments

Capital Budgeting is the process of making investment decisions in capital asssets It is a process of planning, analysing and implementation of capital expenditure Very crucial decisions since heavy funds outlay and uncertain future Types of proposals Independent (accept / reject)

Dependent proposals
Mutually exclusive proposals

Factors affecting Capital Budgeting decisions Initial Investment

Cost of new project Installation costs Working capital requirements Proceeds from sale of old asset (post tax)

Cash Flow After Tax (CFAT)

Minimum Rate of Return expected to be earned on the project (discount rate) Project Life Time Value of Money Risk & Uncertainty competition, economy, technology, consumer pref.

Capital Budgeting appraisal methods

Pay-Back Period Discounted Pay-Back Period

Accounting Rate of Return (ARR)

Net Present Value (NPV) Internal Rate of Return (IRR)

Pay-Back Period
Pay-Back Period refers to the period in which the project will generate the necessary cash to recover its initial investment.
Pay-Back Period = Initial Investment (in case of even cash flows)
Annual cash flows

Pay-Back Period = Initial Investment (for uneven cash flows)

Proportionate cash flows

A project can be accepted/ rejected by comparing the estimated payback period with the managements expectations. In case of mutually exclusive projects, lowest pay-back period is selected.(i.e. early recovery of initial investments)

Pay-Back period measures the liquidity aspect of a project, rather than its profitability.

Pay-Back Period
Advantages Simple to understand, easy to use Useful in case of limited funds, liquidity crunch situations Practical for projects with high uncertainty Disadvantages Minimal stress on profitability aspect Ignores cash flows/ returns received after the pay-back period Ignores the concept of time value of money Incorrect results while comparing projects with uneven cash flows
Initial Investment Rs. 20,000 Annual Cash Flows Rs. 4,000 Pay-Back Period = 20,000 = 5 yrs 4,000

Year 1 2 3 4 5

Cash Inflow 6,000 8,000 5,000 4,000 4,000

Cumulative 6,000 14,000 19,000 23,000 27,000

Pay-Back Period = 3 yrs + 1,000 '4,000 Pay-Back Period = 3.25 yrs

Discounted Pay-Back Period

Discounted Pay-Back Period refers to the period where the project will generate necessary discounted cash flows to recover its initial investment. Pay-back period is computed after discounting the cash flows. A pre-determined rate is used for discounting the cash flows. This method is an improvement over the Pay-Back Period, since it recognizes the time value of money. Pay-Back Period = Initial Investment (in case of even cash flows)
Annual disc. cash flows

Pay-Back Period = Initial Investment (for uneven cash flows)

Proportionate disc. cash flows

Accounting Rate of Return (ARR)

Also known as Average Rate of Return (ARR) According to this method, capital investment proposals are judged on the basis of their relative profitability.

Capital employed and expected income are determined, as per accounting principles, for the entire economic life of the project. Average yield is calculated and this rate of return is termed as the Accounting/ Average Rate of Return (ARR) ARR = Annual Avg. Net Earnings = Annual Avg. Net Earnings Original Investment Average Investment Earnings are profits after depreciation and tax. Average Investment is the average of opening and closing (incl. w.cap reqd, scrap value) Any project expected to give a return below the minimum desired rate of return will be rejected. Higher the rate, better the project.

Accounting Rate of Return (ARR)

Advantages

Superior to pay-back period since it considers the total life of a project Unrelated projects can be compared Stresses on profitability over the period of the project

Particulars Cost (Rs.) Life of machine PAT p.a. (Rs.) ARR

Machine A 40,000 10 years 5,500 13.75%

Machine B 60,000 10 years 7,500 12.50%

Disadvantages

Ignores the time value of money

Earnings (profits) are compared, instead of cash-flows

Ignores the uncertainty in profits over the long period of the project

Net Present Value (NPV)

Net Present Value (NPV) is the difference between the present value of benefits and the present value of costs. Cash outflows and inflows are calculated and these are discounted using a suitable rate of return. Discounted cash flows are compared & decision taken accordingly. A positive NPV indicates a favourable position and the project should be approved. A negative NPV indicates rejection of project. Discount rate is the cut-off rate / rate of return expected by the management In case of mutually exclusive projects, higher NPV suggests acceptance of the project

Net Present Value (NPV)

Advantages Net Present Value (NPV) considers the time value of money All cash flows are considered, including post pay-back period NPV constitutes addition to the wealth of shareholders, hence objective of wealth maximazation is fulfilled Unrelated projects can be compared, since all projects are brought to a common platform of NPV Disadvantages Involves complex calculations

Forecasting of future cash flows

Deriving the discount rate, i.e. rate of return Size of projects may be ignored

Net Present Value (NPV)

Cost of vehicle = Rs. 400,000, Decide whether to buy the Life of vehicle - 5 years, vehicle ? Expected return on capital @ 15 %, Future expected cash flows given Year 0 1 2 3 4 5
Disc @ 15 % Present Values Cash Flows 1.0000 (400,000.00) (400,000) 0.8696 34,782.61 40,000 0.7561 75,614.37 100,000 0.6575 105,202.60 160,000 0.5718 102,915.58 180,000 0.4972 79,548.28 160,000 Total PV 398,063.43 NPV (1,936.57)

Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is the rate of return at which present value of cash outflows and present value of cash inflows is equal. Hence, IRR is the rate of return at which NPV = 0, i.e. investments are equal to the earnings. At IRR, discounted cash inflows = discounted cash outflows. Acceptance/ rejection of a project depends on the relationship between IRR and the expected rate of return (discounting rate) If IRR > discounting rate, accept the proposal and vice versa. In case of mutually exclusive proposals, higher the IRR, better. It is presumed that the company re-invests its cash inflows at the rate of IRR, to earn profits.

Internal Rate of Return (IRR)

Advantages Internal Rate of Return (IRR) considers the time value of money All cash flows are considered, including post pay-back period Decisions are taken immediately, by comparing IRR with the cost of capital (discount rate) Higher the IRR, higher the profitability. Hence, shareholders objectives are achieved Disadvantages Involves tedious calculations IRR may conflict with the NPV results Future cash flows cannot be re-invested at a high IRR