Capital Budgeting-Part I

SFM/DM

CAPITAL BUDGETING
Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of shareholders (owners) wealth maximization. The process of planning significant outlays on pro ects that have long-term implications is !nown as Capital "udgeting. Capital expenditure planning# evaluation# and control# sometimes called as the capital budgeting. $t involves long-term commitments of resources to realize future benefits. $t reflects basic companys ob ectives and has a significant# long-term effect on the economic well being of the firm.

CAPITAL BUDGETING PROCESS

1. Identifying the impact on long-term objectives

!. "creening phase (ust identify potential investment proposals

#. Eval ating phase $dentifying pro ects# estimating C) applying decision criteria

6. A dit phase $dentify the reason for failure or success.

5. Controlling phase Constantly monitor# if deviate ta!e action

$. Implementing phase Ta!e the necessary actions to start the pro ect

%ny idea under consideration is a proposal. % project is either a single proposal or a collection of dependent proposals that is economically independent of all other proposals. Example& % soft drin! company willing to introduce the new product i.e. orange drin! (proposal). $t is considered as the new pro ect if and only if the cash flows from orange drin! have no impact on the cash flows of the existing product. 'therwise both the existing and orange drin! will be considered as a single pro ect.

IMPORTANCE
$t affects the profitability of a firm. $ts effect over a long time spans and inevitably affects the companys future cost structure. Capital investment decision once made# are not easily reversible without much financial loss to the firm. $t involves costs and the ma ority of the firms have scarce (limited) capital resources.

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Capital Budgeting-Part I

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DIFFICULTIES
The benefits from investments are received in some future period and the future is uncertain. (*is! $nvolvement) Cost incurred and benefits received from the capital budgeting decisions occur in different time periods. (Time value of (oney) $t is not often possible to calculate in strict +uantitative terms all the benefits or the costs relating to a particular investment decision.

RATIONALE (Fundamental Reason)

,very decision is made either to -. ,nhance the *evenue# or to .. *educe the cost
Cost-reduction investment decisions are sub ect to less uncertainty in comparison to the revenue-affecting investment decisions.

TYPES OF CB DECISIONS
%n entity may be deal with the three types of capital budgeting decisions& -. %ccept-re ect decision .. (utually exclusive /ro ects decisions 0. Capital *ationing decision Accept-reject decision $n this decision# all those proposals# which yield a rate of return greater than a certain re+uired rate of return or cost of capital# are accepted and the rest are re ected. "y applying this criterion# all independent pro ects are accepted. $ndependent pro ects are those pro ects whose cash flows are unrelated to one another1 the acceptance of one does not eliminate the others from further consideration. Mutually exclusive projects decision (,/ decisions are those which compete with other pro ects in such a way that the acceptance of one will exclude the others from further consideration Capital rationing decision Capital rationing is a financial situation in which a firm has only fixed amount to allocate among competing capital expenditures.
%ypical Capital & dgeting 'ecisions --,xpansion 2ecisions --3ease or buy decisions --,+uipment selection decisions --,+uipment replacement decisions

IDENTIFYING T E !RELE"ANT# CAS

FLO$S

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Capital Budgeting-Part I

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4ot all cash flows are relevant in capital budgeting. The only relevant cash flows are the incremental cash flows after tax. $ncremental cash flows means only those cash flows that affect a firms existing total cash flows should be considered. 5ere are some examples of what is relevant to pro ect cash flows& -. 'epreciation& Capital assets are sub ect to depreciation and we need to account for depreciation twice in our calculations of cash flows. 6e deduct depreciation once to calculate the taxes we pay on pro ect revenues and we add bac! depreciation to arrive at cash flows because depreciation is a non-cash item. .. (or)ing Capital& (a or investments may re+uire increases to wor!ing capital. )or example# new production facilities often re+uire more inventories and higher salaries payable. Therefore# we need to consider the net change in wor!ing capital associated with our pro ect. Changes in net wor!ing capital will sometimes release themselves at the end of the pro ect. 0. *verhead+ (any capital pro ects can result in increases to allocated overheads# therefore# you need to assess the impact of your capital pro ect on overhead and determine if these costs are relevant. 7. ,inancing Costs& $f we plan on financing a capital pro ect# this will involve additional cash flows to investors. The best way to account for financing costs is to include them within our discount rate. This eliminates the possibility of double-counting the financing costs by deducting them in our cash flows and discounting at our cost of capital which also includes our financing costs. 6e also need to ignore costs that are s n)1 i.e. costs that will not change if we invest in the pro ect. )or example# a new product line may re+uire some preliminary mar!eting research. This research is done regardless of the pro ect and thus# it is sun!. The concept of sun! costs and relevant costs applies to all types of financing decisions.
Incremental cash flo-s after taxes are those periodic cash flows and inflows that occur if and only if an investment pro ect is accepted.

CLASSIFICATION OF CAS

FLO$S AFTER TA%

)or systematic estimation of cash flows# we classify the expenses and benefits into three categories& -. $nitial C) .. 'perating C) 0. Terminal C)

Initial Cash Flo s

The initial investments are the one-time expenditures at the time of ac+uisition to the running condition of the assets. ,xamples& %ccession of property# plant# e+uipment# installation# training cost. $nitial cash flows may be occurred in the form of direct and indirect cash flows. Initial Cash ,lo-s

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Capital Budgeting-Part I
Direct Cash Flows - Capital ,xpenditure - 'perating ,xpenditure

SFM/DM
Indirect Cash flows - %fter tax proceeds of old assets - Change in net wor!ing capital

Capital expendit res are those cash outflows that are expected to produce future benefits extending beyond one year# therefore classified as an asset on the balance sheet. 6hile operating expendit re are those cash outlays that provide no benefits beyond the current period# hence it is classified as an expense against the current revenue

!perating Cash Flo

The cash flows generated by an asset are called operating cash flows# which do not depend on the amount of debt or interest payments being made by the company. The ./ of any asset is e+uivalent to the future cash flows generated by that asset discounted at the appropriate ***. In terms of incremental cash flows: 'perating C) 6here 9 C 2 t 8 (9 : C : 2) (- : t) ; 2 8 $ncremental sales 8 $ncremental expenditures 8 $ncremental depreciation 8 tax rate

"erminal Cash Flo s

The cash flows that are expected to occur at the point when pro ects useful life ends are the terminal cash flows. Two types of cash inflows influence the capital budgeting decision& -. 9alvage value of the asset(s) .. *ecovery of the wor!ing capital

EVALUATING TECHNIQUES
-. .. Traditional Techni+ue Time-ad usted Techni+ue

1. TRADITIONAL TECHNIQUE
o o /aybac! (ethod %ccounting rate of return

#A$%AC& M'"(!)
Payback period is the length of time that it takes for a project to fully recover its initial cost out of the cash receipts that it generates. .aybac) period 8 ,xpected number of years re+uired to recover a pro ects cost. Merits 9imple to calculate.

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Capital Budgeting-Part I

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,asy to understand. $t saves time because if proposal does not provide the paybac! within specified period then there may be no need to consider it further. <seful in those industries where products become obsolete very rapidly. Demerits $t is not a true measure of the profitability of an investment. $gnores the time value of money. $gnores cash flows occurring after the paybac! period. Decision Criteria 9hortest paybac! period pro ect will be preferred over the rest. Example For uniform cash flows /aybac! period 8 $nvestment re+uired = 4et annual cash inflow 0or) Company needs a new milling machine. The company is considering two machines& (achine % costs *9.->??? and will reduce costs by *s.>??? per year. 6hile machine " costs only *s.-.??? but will reduce costs by *s.>??? per year. 6hich company should purchase according to paybac! method@ Solution& (achine % paybac! period (achine " paybac! period Recommendation& 8 8 8 8 ->??? = >??? 0 years -.??? = >??? ..7 years

(achine " should be purchased because it has a shorter paybac! period than machine %.

For un-even cash flows Consider the two pro ects and recommend which pro ect should be adopted according to paybac! method@ .roject 1 Expected 2et Cash ,lo0ear .roject 1 .roject " ? (*s.-??) (*s.-??) -? C? . A? 7? 0 B? .? /aybac!1 /aybac!" 8 . ; *s.0?= *s.B? years 8 ..7 years 8 - ; *s.0? = *s.7? 8-.C> years

Recommendation

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Capital Budgeting-Part I

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/ro ect 9 should be adopted because its paybac! period is shorter than that of pro ect 3.

ACC!*+"I+, -A"' !F -'"*-+ .A--/ M'"(!)

The rate of return on accounting profit which is generated by the investment is termed as accounting rate of return. $t focuses on accounting profit rather than cash flows. $t is computed as&
ARR = Avg.Net.Income Avg.Investment

%verage 4et $ncome is determined by adding all profit after taxes and dividing it by number of years. $n the case of annuity# the average net income is e+ual to the any years profit. %verage investment is determined by dividing the investment by .. $f 9alvage value is zero# then# %vg. $nvestment 8 Total $nvestment = . $f 9alvage value is greater than zero# then Investment !alvage. alue Avg .Investment = + !alvage. alue .

$nvestment %verage $nvestment 9alvage Dalue Time (Eears) The logic behind the averaging is that the firm is using straight line depreciation and its assets boo! value declines constantly. This means that on the average# firms will have one-half of their initial purchase prices in the boo!s. $f the machine has salvage value then only the depreciable cost will be averaged out. $t has not been ta!en in average computation because salvage value remains constant throughout the investment life therefore no logic to average out of salvage value. The reason to add the salvage value is because it remains tied up in the pro ect and will be recovered only at the end of the pro ect.
IncrementalNet"peratingIncome InitialInvestment

ARR =

If cost reduction project is involved then

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Capital Budgeting-Part I
ARR = &ost!aving %epreciation"nNew#$uipment InitialInvestment

SFM/DM

Initial investment sho ld be red ce by any salvage val e from the sale of old e3 ipment Merits 9imple to calculate ,asy to understand. <sed for demonstration purposes. Demerits $gnores the time value of money. $t focuses on accounting profit rather than cash flows. $t may be desirable in some years and undesirable in the other years because of variation in accounting profit over the life of the pro ect. Decision Criteria $f %** F *** $f %** G *** %ccept *e ect

4e3 ired 4ate of 4et rn (***) is the minimum rate which investors expect on their investments.

Example *aa! %musement Corporation is investigating the purchase of a new electronic game called $H$7. The manufacturer will sell .? games to *aa! %musements for *s.-B????. *aa! %musement has determined the following additional information& i. The game life would have > years with no salvage value. (9traight line 2epreciation) ii. The game would replace other unpopular games. These games would be sold for *s.0????. iii. $t is estimated that $H$-7 would generate incremental revenues of *s..????? per year. $ncremental out of poc!et costs each year would be in total& maintenance *s.>????1 and insurance *s.-????. $n addition# would have to pay a 7?I commission J other outlets to the supermar!ets. 4e3 ired& Compute the %**. 6ill the game be purchased if *aa! %musement accepts the pro ect with %** greater than -@ Solution
Income Statement Sales Commission Contribution Margin Fixed Expenses Maintenance 50000 Insurance 10000 Depreciation 3 000 !otal Fixed Expenses Net Operating Income Rs. 200000 80000 120000

" 000 24000

2epreciation& -B????=> 8 *s.0A???

ARR = IncrementalNet"peratingIncome InitialInvestment !alvage alueof"ld#$uipment

From the desk of M. Azam

Capital Budgeting-Part I
ARR = .7??? -B???? 0????
ARR =-AI

SFM/DM

Recommendation "ecause the return exceeds the -7I therefore# it should be accepted to purchase the games. A44 166 7 444 1$6------- Accept the project

2. TIME-ADJUSTED TECHNIQUE
<nli!e accounting# financial management is concerned with the values of assets today1 i.e. present values. 9ince capital pro ects provide benefits into the future and since we want to determine the present value of the pro ect# we will discount the future cash flows of a pro ect to the present. 2iscounting refers to ta!ing a future amount and finding its value today. )uture values differ from present values because of the time value of money. )inancial management recognizes the time value of money because& Inflation reduces values over time1 i.e. *s. -#??? today will have less value five years from now due to rising prices (inflation). Uncertainty in the future1 i.e. we thin! we will receivers *s. -#??? five years from now# but a lot can happen over the next five years. Opportunity Costs of money1 *s. -#??? today is worth more to us than *s. -#??? five years from now because we can invest *s. -#??? today and earn a return.

'ollowing are the time adjusted techni$ue to evaluate the projects: 2iscounted /aybac! period (ethod 4et /resent Dalue (ethod $nternal *ate of *eturn ($**) (ethod (odified $** (ethod /rofitability $ndex (ethod

)I0C!*+"') #A$%AC& M'"(!)

%iscounted payback period is the length of time that it takes for a project to fully recover its initial cost out of the present value of cash receipts that it generates. Decision Criteria 9hortest paybac! period pro ect will be preferred over the rest. Example ,xamine the following example and recommend the company about the acceptance of the pro ect. The re+uired paybac! period is > years.
Year 0 1 2 3 % 5 Cash Flow #10000 3000 2500 2000 2000 2000 PV Factor @10% 1 0."0" 0.82 0.$51 0. 83 0. 21 PV o CF #10000 2$2$ 20 5 1502 13 12%2 !"COV"!Y Nee&e& 10000 10000 $2$3 5208 3$0 23%0 'alance 10000 $2$3 5208 3$0 23%0 10"8 Pa#$ac% Years 1 1 1 1 1 1

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Capital Budgeting-Part I
2500 0.5 % 1%10 (isco)nte& Pa#$ac% Perio& 10"8 # 0.$8 *+,-

SFM/DM

Recommendation "ecause discounted paybac! period is more than the re+uired# the company should not to accept that pro ect.

+'" #-'0'+" 1A2*' .+#1/ M'"(!)

Present value of cash inflows minus present value of cash outflows is termed as Net Present alue
NPT = PV of Cash Inflows PV of Cash !utflows

Procedure )ind the /D of each cash flow# including both inflows and outflows# discounted at the pro ects cost of capital. (atch the discounted cash inflows with the discounted cash outflows# the result will be the 4/D of the pro ect. Formulae )or discounting the )uture value to the /resent Dalue& 'or (n)even &ash flows *!ingle+
/D = ' (- +i)

'or Annuity *!ame !i,e+ 3here * 8 i 8 n 8

- (- + i ) /D = R i

%nnuity (%mount of any - year) $nterest rate 4umber of periods

Annuity is a constant cash flow for a number of years. Perpetuity is a constant cash flow forever.

Merits $t recognizes the time value of money. $t considers the total benefit arising out of the pro ect over its life time. $t is particularly useful for the selection of mutually exclusive pro ects. This method of asset selection is instrumental in achieving the ob ective of the financial management. Demerits $t is difficult to calculate and understand. 2ifficult to use in comparison with the paybac! method and %** method. $t involves the calculation of discount rate of return to discount the cash flows. Decision Criteria $f 4/D is ;ve $f 4/D is :ve %ccept the /ro ect *e ect the /ro ect

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Capital Budgeting-Part I

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Example Consider the two pro ects /ro ect 3 and /ro ect *. $nitial $nvestments of both are *s.-??.
Year 0 1 2 3 Pro.ect / PV Factor Cash Flows PV 1 #100 #100 0."0" 10 ".0" 0.82 % 0 %".58% 0.$513 80 0.10% Net Present Val)e 1-+,,Pro.ect S Cash lows PV #100 #100 $0 3. 3 %0 33.05 20 15.02 11+,12

Recommendation $f the pro ects are independent# accept both $f the pro ects are mutually exclusive# accept /ro ect 3 since 4/D 9 F 4/D3 The rationale 4/D method is straight forward. $f an entity ta!es on a pro ect with a zero 4/D# the
wealth of its current shareholders will be unchanged. 5owever# it ta!es on a pro ect with positive 4/D1 the wealth of its current shareholders will be increased.

I+"'-+A2 -A"' !F -'"*-+ .I--/ M'"(!)

:%lternative terms 8 yield on investment# marginal efficiency of capital# marginal productivity of capital ; Definition An asset-s internal rate of return *time adjusted rate of return+ is the true economic return earned by the asset over its life. IRR is that discounted rate which forces the P of a project-s e.pected cash inflows to e$ual the present value of the project-s e.pected costs. Merits $t considers the time value of money $t ta!es into account the total cash outflows and inflows $t is easier to understand. "usiness executives and non-technical peoples can understand it more easily as compare to 4/D. $t does not use the concept of *** rather it itself provides a rate which is indicative of the profitability of the proposal. Demerits $t generally involves complicated and boring calculations. $t produces multiple rates which can be confusing. $n evaluating mutually exclusive proposals# the pro ect with the highest $** would be pic!ed up to the exclusion of all others which are more consistent with the goal. $t is based on the assumption that all cash inflows are reinvested at the $**

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Capital Budgeting-Part I

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Two pro ects have different $**. $t means reinvestment by the same firm at different rates is totally
illogical.

Decision Criteria $f $** $f $** F8 5urdle *ate (***) G 5urdle *ate (***) %ccept the /roposal *e ect the /roposal

Example )ollowing data is related to the two machines % and ". %ssuming cost of capital is -.I. Calculate the $**.
Years 0 1 2 3 % 5 0achine 1 CF12 #5 125 1%000 1 000 18000 20000 25000 0achine ' CF12 #5 125 22000 20000 18000 1 000 1$000

Solution /y 0rial 1 #rror 2ethod:

Years 0 1 2 3 % 5 PV Factor @ 1,% 1 0.855 0.$31 0. 2% 0.53% 0.%5 0achine 1 CF12 #5 125 1%000 1 000 18000 20000 25000 PV o CF12 #5 125 11"$0 11 " 11232 10 80 11%00 -34 PV Factor @20% 1 0.833 0. "% 0.5$" 0.%82 0.%02 0achine ' CF12 #5 125 22000 20000 18000 1 000 1$000 PV o CF12 #5 125 1832 13880 10%22 $$12 83% 1045

4/D of both machine are positive so increase the discount rate and try again.
Years 0 1 2 3 % 5 PV Factor @ 1-% 1 0.8%$ 0.$18 0. 0" 0.51 0.%3$ 0achine 1 CF12 #5 125 1%000 1 000 18000 20000 25000 PV o CF12 #5 125 11858 11%88 10" 2 10320 10"25 63,2 PV Factor @21% 1 0.82 0. 83 0.5 % 0.% $ 0.38 0achine ' PV o CF12 CF12 #5 125 #5 125 22000 181$2 20000 13 0 18000 10152 1 000 $%$2 1$000 5 2 610,

Interpolation

Machine A

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Capital Budgeting-Part I

SFM/DM

B>0 IRR = -CI + B>0 K >C.)

IRR = -C.AI

IRR = -CI + ?.>LBI

Machine %

-?7L IRR = .?I + -?7L K -?C)

IRR = -C.LI

IRR = -CI + ?.LI

Recommendation "ecause# (achine " $** is greater than (achine % $**# so firm should accept the proposal of (achine ".
The rationale of $** is that if $** exceeds the cost of finance# it will increase the shareholders wealth# therefore accepted otherwise re ected. "ecause of this brea!even characteristic of $**# it is useful in evaluating capital pro ects.

M!)IFI') I+"'-+A2 -A"' !F -'"*-+ .MI--/ M'"(!)

0he discount rate at which the P of a project-s cost is e$ual to the P of its terminal value. PV costs = PV terminal value $** based on reinvestment rate assumption. $n order to eliminate the reinvestment rate assumption# we will modify the $nternal *ate of *eturn so that the reinvestment rate is our cost of capital or the rate which is expected to earn on investment. This will give a more accurate $** for our pro ect. Decision Criteria $f ($** $f ($** 7= 5urdle *ate (***) G 5urdle *ate (***) *4 /D of 9um of Terminal Dalue 7 /D of Cash 'utflows /D of 9um of Terminal Dalue G /D of Cash 'utflows "ccept the Proposal Reject the Proposal "ccept the Proposal Reject the Proposal

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Capital Budgeting-Part I

SFM/DM

9election among various alternatives# the one with highest rate of return is preferable. Example Consider a pro ect which original outlay *s.-???? and the 3ife is > years. Cash inflows *s.7??? for each year and cost of capital is -?I. ,xpected *ate of *eturn at which cash inflows will be re-invested& )or - and . year AI )or 0 to > year BI
Year 1 2 3 % 5 Cash In lows %000 %000 %000 %000 %000 !ate Years o In7estment % 3 2 1 0 Compo)n&ing Factor 1.2 2 1.1"1 1.1 1.08 1 2otal Compo)n&e& S)m 50%8 %$ % % % %320 %000 22$"

8 8 8

&' o( Cas) *ut(lo+s &' o( Cas) In(lo+s 22$" ,0. 21 Net Present Val)e

#10000 1%15 .3 413*+4

0o achieve NP 3 4ero5 apply 678 discount Rate

&' o( Cas) *ut(lo+s &' o( Cas) In(lo+s -1$./ 22$" ,0.%5 1 Net Present Val)e #10000 103"$.25 45,+23

0o achieve NP 3 4ero5 now apply 698 discount Rate

&' o( Cas) *ut(lo+s &' o( Cas) In(lo+s -18./ 22$" ,0.%3$1 Net Present Val)e #10000 "" %.13 643+-,

Interpolation

0L C . > 2IRR = -CI + 0LC. > K0>.BC)

2IRR = -C.L-CI

2IRR = -CI + ?.L-CI

Recommendation "ecause ($** F Cost of Capital so# accept the pro ect. 15.9156 7 1<6 --------------- Accept the .roject

Com&a'(son )et*een IRR and MIRR

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Capital Budgeting-Part I

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The modified $** has a significant advantage over the regular $**. (odified $** assumes the cash flows from all pro ects are reinvested at the cost of capital# whereas regular $** assumes that cash flows from each pro ect are reinvested at the pro ects own $**. $ts mean different pro ects have different $** and hence at the same time they are reinvested at the different rate# which is illogical. Therefore reinvestment at ! is generally more logical and correct# thats why ($** is a better indicator of a pro ects true profitability.

#-!FI"A%I2I"$ I+)'4 .#I/ 5%enefit-Cost -atio6

Profitability inde. measures the present value of returns per rupee invested. Formula
PI = P of&ashInflows P of&ash"utflows

Decision Criteria $f /$ F $f /$ G 6hen /$ 8 %ccept *e ect *emains indifferent (4/D ;De) (4/D :De) (4/D Mero)

Example Consider two (achines % J ". /resent value of cash inflows *s.ABA7> J *s.C->.- of % J " respectively and present value of cash outflows of both machines *s.>A.->.

Solution
>achine A
PI = P of&ashInflows P of&ash"utflows

PI =

ABA7> >A-.>

PI = -...

>achine &
PI = P of&ashInflows P of&ash"utflows

PI =

C->.>A-.>

PI = -..C

Recommendation 9ince the /$ of both the machines is greater than -# both the machines are acceptable. 5owever# (achine " /$ is greater than (achine %# therefore (achine " is preferable.

Capital & dgeting Contin e-----ait for next part

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