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capital budgeting
What is capital budgeting
• Analysis of potential projects.
• Long-term decisions; involve large
  expenditures.
• Very important to firm’s future.
importance of capital budgeting
• Capital budgeting decisions involve long-term implication for the firm,
  and influence its risk complexion.
• Capital budgeting involves commitment of large amount of funds.
• Capital decisions are required to assessment of future events which are
  uncertain.
• In most cases, capital budgeting decisions are irreversible. This is because
  it is very difficult to find a market for the capital goods. The only
  alternative available is to scrap the asset, and incur heavy loss.
• Capital budgeting ensures the selection of right source of finance at the
  right time.
• Many firms fail, because they have too much or too little capital
  equipment.
• Investment decision taken by individual concern is of national importance
  because it deter- mines employment, economic activities and economic
  growth.
Objective of capital budgeting
• To ensure the selection of the possible profitable capital project
• To ensure the effective control of capital expenditure in order to
  achieve by forecasting the long-term financial requirements.
• To make estimation of capital expenditure during the budget period
  and to see that the benefits and costs may be measured in terms of
  cash flow.
• Determining the required quantum takes place as per authorization
  and sanctions.
• To facilitate co-ordination of inter-departmental project funds
  among the competing capital projects.
• To ensure maximization of profit by allocating the available
  investible.
Steps in Capital Budgeting
• Identification Stage – determine which types of
  capital investments are necessary to accomplish
  organizational objectives and strategies
• Search Stage – Explore alternative capital
  investments that will achieve organization
  objectives
• Information-Acquisition Stage – consider the
  expected costs and benefits of alternative capital
  investments
• Selection Stage – choose projects for
  implementation
• Financing Stage – obtain project financing
• Implementation and Control Stage – get
  projects under way and monitor their
  performance
Types of Capital Expenditure
Capital Expenditure can be of two types :
Capital Expenditure Increases Revenue: It is the
 expenditure which brings more revenue to the firm
 either by expanding the existing production facilities
 or development of new production line.
Capital Expenditure Reduces Costs: Such a capital
 expenditure reduces the cost of present product and
 thereby increases the profitability of existing
 operations. It can be done by replacement of old
 machine by a new one.
Types Of Capital Investment Decisions

• On the basis of firm’s existence
  – Replacement and Modernization decisions
  – Expansion decisions
  – Diversification decisions

• On the Basis of Decision Situation
  – Mutually Exclusive Decision
  – Accept and Reject Decision
  – Contingent Decision
Cap Budgeting Evaluation Methods
• Traditional method
  – Payback method
  – Average accounting return


• Modern method
  – Net Present value method (N.P.V)
  – Internal rate of return method (I.R.R)
  – Profitability index method (P.I)
Pay-back Period Method
Pay-back period is also termed as "Pay-out period" or Pay-
off period. Payout Period Method is one of the most
popular and widely recognized traditional method of
evaluating investment proposals.
 It is defined as the number of years required to recover the
initial investment in full with the help of the stream of
annual cash flows generated by the project.

• Calculation of Pay-back Period: Pay-back period can
  be calculated into the following two different situations :
      (a) In the case of constant annual cash inflows.
      (b) In the case of uneven or unequal cash inflows.
(a) In the case of constant annual cash inflows : If the
project generates constant cash flow the Pay-back period can be computed by
dividing cash outlays (original investment) by annual cash inflows. The
following formula can be used to ascertain pay-back period :


Pay-back Period = Cash Outlays (Initial Investment) /Annual Cash
Inflows
Illustration

• A project requires initial investment of Rs. 40,000 and
  it will generate an annual cash inflows of Rs. 10,000 for
  6 years. You are required to find out pay-back period.
   Solution:
• Pay-back Period = Cash Outlays (Initial Investment)/
  Annual Cash Inflows
              = 40,000 / 10,000
              = 4 Years
Pay-back period is 4 years, the investment is fully
recovered in 4 years.
(b) In the case of Uneven or Unequal Cash Inflows: In
the case of uneven or unequal cash inflows, the Pay-back period
is determined with the help of cumulative cash inflow. It can be
calculated by adding up the cash inflows until the total is equal
to the initial investment.
Illustration
From the following information you are required to calculate pay-back period
A project requires initial investment of Rs. 40,000 and generate cash inflows of Rs.
16,000, Rs. 14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth year
respectively.
Solution:
• Calculation Pay-back Period with the help of "Cumulative Cash Inflows"
   Year              annual cash flow (rs)         cumulative cash inflows (rs)
   1                      16000                                     16000
   2                      14000                                     30000
   3                       8000                                     38000
   4                       6000                                     44000

The above table shows that at the end of 4th years the cumulative cash inflows
exceeds the investment of Rs. 40,000. Thus the pay-back period is as follows :

          Pay-back Period = 3 Years +( 40000 – 38000) / 6000
                           = 3 Years + 2000/6000
                           = 3.33 Years
Average Rate of Return Method (ARR)
• Average Rate of Return Method (ARR) : Average Rate of
  Return Method is also termed as Accounting Rate of Return Method. This
  method focuses on the average net income generated in a project in
  relation to the project's average investment outlay. This method involves
  accounting profits not cash flows and is similar to the pelformance
  measure of return on capital employed.
• Formulas
Average Rate of Return (ARR) = Average income / Average investment x 100
                                             or
                          cash inflow – (after dep and tax )/ original investment

Average Investment = Original Investment /2
Illustration
• From the following information you are required to find out Average Rate
   of Return   :
An investment with expenditure of Rs.l0,OO,OOO is expected to produce the
following profits (after deducting depreciation)
         year                                 rs
         1                                    80,000
         2                                    1,60,000
         3                                    1,80,000
         4                                    60,000
• Solution
Average Rate of Return =
Average Annual Profits – Depreciation and Taxes x 100
         Average Investments

Average Annual Profits = 80,000+1,60,000+1,80,000+60,000
                                             4
                                    = 1,20,000
Average Investments (Assuming Nil Scrap Value) = investment in beginning + investment in end
                                                                            2
                                                      = 10,00,000 + 0
                                                             2
                                                      = 5,00,000
Average Rate of Return         = 1,20,000 x 100
                                  5,00,000
                               = 24%
Net present value

• The difference between the market value of a project
  and its cost
• How much value is created from undertaking an
  investment?
   – The first step is to estimate the expected future cash flows.
   – The second step is to estimate the required return for
     projects of this risk level.
   – The third step is to find the present value of the cash flows
     and subtract the initial investment.
Illustration
•   Mr A planning to invest rs 50 lac in a innovative machinery , the expected cash
   flow for 5 years period of time given below
                     year                          cash inflow (rs)
                     1                              10,00,000
                     2                              12,00,000
                     3                              15,00,000
                     4                              18,00,000
                     5                              25,00,000
The cost of capital is @ 10%
• Solution
 year cash inflow (rs) dist rate present value
  1       10,00,000    ( 1/1.1) 0.9090     9,09,000
  2       12,00,000           0.8246      9,91,680
  3       15,00,000           0.7513     11,25,950
  4       18,00,000           0.6830      12,29,460
  5       25,00,000           0.6666      15,52,250
                                       = 58,09,340
              less orignal investment - 50,00,000
                               npv     = 8,09,340
Profitability index method (P.I)

• Ratio of the present value of a project's cash flows to the
  initial investment. A profitability index number greater than 1
  indicates an acceptable project, and is consistent with a net
  present value greater than 0



• Formula
Profitability Index
                                    Present Value of Future Cash Flows
                                       Initial Investment Required
Illustration
• Company C is undertaking a project at a cost of 50 million which is
  expected to generate future net cash flows with a present value of 65
   million. Calculate the profitability index.

• Solution

Profitability Index = PV of Future Net Cash Flows / Initial Investment Required

Profitability Index = 65M / 50M = 1.3 years
Internal rate of return method (I.R.R)




•    Internal Rate of Return Method is also called as "Time
    Adjusted Rate of Return Method." It is defined as the rate
    which equates the present value of each cash inflows with the
    present value of cash outflows of an investment. In other
    words, it is the rate at which the net present value of the
    investment is zero.
Illustration
• x firm is considering a project the details of
  which are ,
Investment                Rs 70000
Year                   Cash Inflow
 1                       15000
 2                       17000
 3                       19000
 4                       21000
 5                       26000
Compute 1.R.R of the project:
Solution :

Step I: Calculation of fack payback period on the basis of average cash inflows:
Average cash inflows of all periods =    15000+17000+ 19000+ 21000+ 26000
                                                      5
                                                = 98000
                                                    5
                                                = Rs 19600

Fack Payback period = Initial Cash outflow
                      Average cash inflow

                          = 7 0000
                            19600

                          = 3.57 years
.
Step 2 : Locate fack payback period in annuity table A-2 (given at the end of
       the chapter) against the row of number of year of the project:
•   We locate 3.517 in 5 year row. we find 3.517 which is annuity of Rs 1 at 13%
    rate. Therefore, our first discount rate is 13%

Step 3:
Now Find NPV at the first discount rate located above.

          Year     Cash in flow       Discount Factor     Present Value
          1        15000              .885                13275
          2        17000              .783                13311
          3        19000              .693                13167
          4        21000              .613                12873
          5        26000              .543                14118
                                                          66744
                            less original value           70000
                                       NPV              Rs-3256
•   The other discount rate should be more than 13% or less than 13% Since NPV is negative at
    13% discount rate the other discount rate should be less than 13% so that we can discount
    future cash inflows at lower rate and find a positive NPV. So, lets take the second discount
    rate at 11% NPV of the project at 11% discount rate :

           Year       Cash in flow          Discount Factor        Present Value
           1          15000                 .901                   13515
           2          17000                 .812                   13804
           3          19000                 .731                   13889
           4          21000                 .659                   13839
           5          26000                 .593                   15418
                                                                    70465
                                 less original value              - 70000
                                             NPV                     465
Step 4 : Apply the formula of IRR
= 11 + 465              x2   ( 2 = diff between intrest rates)
        465 - (-3256)

= 11 + 465 x2
         3721

= 11 + .2499
IRR = 11.25 %
Payback        Accounting        Net present   Internal rate
                   period       rate of return        value        of return
  Basis of          Cash           Accrual         Cash flows     Cash flows
measurement         flows          income          Profitability  Profitability
  Measure         Number           Percent           Rupees         Percent
expressed as      of years                           Amount
                  Easy to         Easy to        Considers time Considers time
                 Understand      Understand      value of money value of money

 Strengths         Allows          Allows      Accommodates          Allows
                 comparison     comparison      different risk   comparisons
               across projects across projects   levels over      of dissimilar
                                               a project's life     projects
                   Doesn't         Doesn't        Difficult to  Doesn't reflect
                consider time consider time        compare        varying risk
               value of money value of money      dissimilar    levels over the
 Limitations                                       projects       project's life

                   Doesn't       Doesn't give
                consider cash    annual rates
                 flows after     over the life
               payback period    of a project

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Capital budgeting

  • 2. What is capital budgeting • Analysis of potential projects. • Long-term decisions; involve large expenditures. • Very important to firm’s future.
  • 3. importance of capital budgeting • Capital budgeting decisions involve long-term implication for the firm, and influence its risk complexion. • Capital budgeting involves commitment of large amount of funds. • Capital decisions are required to assessment of future events which are uncertain. • In most cases, capital budgeting decisions are irreversible. This is because it is very difficult to find a market for the capital goods. The only alternative available is to scrap the asset, and incur heavy loss. • Capital budgeting ensures the selection of right source of finance at the right time. • Many firms fail, because they have too much or too little capital equipment. • Investment decision taken by individual concern is of national importance because it deter- mines employment, economic activities and economic growth.
  • 4. Objective of capital budgeting • To ensure the selection of the possible profitable capital project • To ensure the effective control of capital expenditure in order to achieve by forecasting the long-term financial requirements. • To make estimation of capital expenditure during the budget period and to see that the benefits and costs may be measured in terms of cash flow. • Determining the required quantum takes place as per authorization and sanctions. • To facilitate co-ordination of inter-departmental project funds among the competing capital projects. • To ensure maximization of profit by allocating the available investible.
  • 5. Steps in Capital Budgeting • Identification Stage – determine which types of capital investments are necessary to accomplish organizational objectives and strategies • Search Stage – Explore alternative capital investments that will achieve organization objectives • Information-Acquisition Stage – consider the expected costs and benefits of alternative capital investments
  • 6. • Selection Stage – choose projects for implementation • Financing Stage – obtain project financing • Implementation and Control Stage – get projects under way and monitor their performance
  • 7. Types of Capital Expenditure Capital Expenditure can be of two types : Capital Expenditure Increases Revenue: It is the expenditure which brings more revenue to the firm either by expanding the existing production facilities or development of new production line. Capital Expenditure Reduces Costs: Such a capital expenditure reduces the cost of present product and thereby increases the profitability of existing operations. It can be done by replacement of old machine by a new one.
  • 8. Types Of Capital Investment Decisions • On the basis of firm’s existence – Replacement and Modernization decisions – Expansion decisions – Diversification decisions • On the Basis of Decision Situation – Mutually Exclusive Decision – Accept and Reject Decision – Contingent Decision
  • 9. Cap Budgeting Evaluation Methods • Traditional method – Payback method – Average accounting return • Modern method – Net Present value method (N.P.V) – Internal rate of return method (I.R.R) – Profitability index method (P.I)
  • 10. Pay-back Period Method Pay-back period is also termed as "Pay-out period" or Pay- off period. Payout Period Method is one of the most popular and widely recognized traditional method of evaluating investment proposals. It is defined as the number of years required to recover the initial investment in full with the help of the stream of annual cash flows generated by the project. • Calculation of Pay-back Period: Pay-back period can be calculated into the following two different situations : (a) In the case of constant annual cash inflows. (b) In the case of uneven or unequal cash inflows.
  • 11. (a) In the case of constant annual cash inflows : If the project generates constant cash flow the Pay-back period can be computed by dividing cash outlays (original investment) by annual cash inflows. The following formula can be used to ascertain pay-back period : Pay-back Period = Cash Outlays (Initial Investment) /Annual Cash Inflows
  • 12. Illustration • A project requires initial investment of Rs. 40,000 and it will generate an annual cash inflows of Rs. 10,000 for 6 years. You are required to find out pay-back period. Solution: • Pay-back Period = Cash Outlays (Initial Investment)/ Annual Cash Inflows = 40,000 / 10,000 = 4 Years Pay-back period is 4 years, the investment is fully recovered in 4 years.
  • 13. (b) In the case of Uneven or Unequal Cash Inflows: In the case of uneven or unequal cash inflows, the Pay-back period is determined with the help of cumulative cash inflow. It can be calculated by adding up the cash inflows until the total is equal to the initial investment.
  • 14. Illustration From the following information you are required to calculate pay-back period A project requires initial investment of Rs. 40,000 and generate cash inflows of Rs. 16,000, Rs. 14,000, Rs. 8,000 and Rs. 6,000 in the first, second, third, and fourth year respectively. Solution: • Calculation Pay-back Period with the help of "Cumulative Cash Inflows" Year annual cash flow (rs) cumulative cash inflows (rs) 1 16000 16000 2 14000 30000 3 8000 38000 4 6000 44000 The above table shows that at the end of 4th years the cumulative cash inflows exceeds the investment of Rs. 40,000. Thus the pay-back period is as follows : Pay-back Period = 3 Years +( 40000 – 38000) / 6000 = 3 Years + 2000/6000 = 3.33 Years
  • 15. Average Rate of Return Method (ARR) • Average Rate of Return Method (ARR) : Average Rate of Return Method is also termed as Accounting Rate of Return Method. This method focuses on the average net income generated in a project in relation to the project's average investment outlay. This method involves accounting profits not cash flows and is similar to the pelformance measure of return on capital employed. • Formulas Average Rate of Return (ARR) = Average income / Average investment x 100 or cash inflow – (after dep and tax )/ original investment Average Investment = Original Investment /2
  • 16. Illustration • From the following information you are required to find out Average Rate of Return : An investment with expenditure of Rs.l0,OO,OOO is expected to produce the following profits (after deducting depreciation) year rs 1 80,000 2 1,60,000 3 1,80,000 4 60,000
  • 17. • Solution Average Rate of Return = Average Annual Profits – Depreciation and Taxes x 100 Average Investments Average Annual Profits = 80,000+1,60,000+1,80,000+60,000 4 = 1,20,000 Average Investments (Assuming Nil Scrap Value) = investment in beginning + investment in end 2 = 10,00,000 + 0 2 = 5,00,000 Average Rate of Return = 1,20,000 x 100 5,00,000 = 24%
  • 18. Net present value • The difference between the market value of a project and its cost • How much value is created from undertaking an investment? – The first step is to estimate the expected future cash flows. – The second step is to estimate the required return for projects of this risk level. – The third step is to find the present value of the cash flows and subtract the initial investment.
  • 19. Illustration • Mr A planning to invest rs 50 lac in a innovative machinery , the expected cash flow for 5 years period of time given below year cash inflow (rs) 1 10,00,000 2 12,00,000 3 15,00,000 4 18,00,000 5 25,00,000 The cost of capital is @ 10%
  • 20. • Solution year cash inflow (rs) dist rate present value 1 10,00,000 ( 1/1.1) 0.9090 9,09,000 2 12,00,000 0.8246 9,91,680 3 15,00,000 0.7513 11,25,950 4 18,00,000 0.6830 12,29,460 5 25,00,000 0.6666 15,52,250 = 58,09,340 less orignal investment - 50,00,000 npv = 8,09,340
  • 21. Profitability index method (P.I) • Ratio of the present value of a project's cash flows to the initial investment. A profitability index number greater than 1 indicates an acceptable project, and is consistent with a net present value greater than 0 • Formula Profitability Index Present Value of Future Cash Flows Initial Investment Required
  • 22. Illustration • Company C is undertaking a project at a cost of 50 million which is expected to generate future net cash flows with a present value of 65 million. Calculate the profitability index. • Solution Profitability Index = PV of Future Net Cash Flows / Initial Investment Required Profitability Index = 65M / 50M = 1.3 years
  • 23. Internal rate of return method (I.R.R) • Internal Rate of Return Method is also called as "Time Adjusted Rate of Return Method." It is defined as the rate which equates the present value of each cash inflows with the present value of cash outflows of an investment. In other words, it is the rate at which the net present value of the investment is zero.
  • 24. Illustration • x firm is considering a project the details of which are , Investment Rs 70000 Year Cash Inflow 1 15000 2 17000 3 19000 4 21000 5 26000 Compute 1.R.R of the project:
  • 25. Solution : Step I: Calculation of fack payback period on the basis of average cash inflows: Average cash inflows of all periods = 15000+17000+ 19000+ 21000+ 26000 5 = 98000 5 = Rs 19600 Fack Payback period = Initial Cash outflow Average cash inflow = 7 0000 19600 = 3.57 years .
  • 26. Step 2 : Locate fack payback period in annuity table A-2 (given at the end of the chapter) against the row of number of year of the project:
  • 27. We locate 3.517 in 5 year row. we find 3.517 which is annuity of Rs 1 at 13% rate. Therefore, our first discount rate is 13% Step 3: Now Find NPV at the first discount rate located above. Year Cash in flow Discount Factor Present Value 1 15000 .885 13275 2 17000 .783 13311 3 19000 .693 13167 4 21000 .613 12873 5 26000 .543 14118 66744 less original value 70000 NPV Rs-3256
  • 28. The other discount rate should be more than 13% or less than 13% Since NPV is negative at 13% discount rate the other discount rate should be less than 13% so that we can discount future cash inflows at lower rate and find a positive NPV. So, lets take the second discount rate at 11% NPV of the project at 11% discount rate : Year Cash in flow Discount Factor Present Value 1 15000 .901 13515 2 17000 .812 13804 3 19000 .731 13889 4 21000 .659 13839 5 26000 .593 15418 70465 less original value - 70000 NPV 465
  • 29. Step 4 : Apply the formula of IRR
  • 30. = 11 + 465 x2 ( 2 = diff between intrest rates) 465 - (-3256) = 11 + 465 x2 3721 = 11 + .2499 IRR = 11.25 %
  • 31. Payback Accounting Net present Internal rate period rate of return value of return Basis of Cash Accrual Cash flows Cash flows measurement flows income Profitability Profitability Measure Number Percent Rupees Percent expressed as of years Amount Easy to Easy to Considers time Considers time Understand Understand value of money value of money Strengths Allows Allows Accommodates Allows comparison comparison different risk comparisons across projects across projects levels over of dissimilar a project's life projects Doesn't Doesn't Difficult to Doesn't reflect consider time consider time compare varying risk value of money value of money dissimilar levels over the Limitations projects project's life Doesn't Doesn't give consider cash annual rates flows after over the life payback period of a project