Capital Budgeting Techniques Independent and Mutually Exclusive Projects Understanding of classification of capital budgeting projects plays a crucial

l role while analyzing viability of projects. A Project whose cash flows have no impact on the acceptance or rejection of other projects is termed as Independent Project. Thus, all such Projects which meet this criterion should be accepted. A set of projects from which at most one will be accepted is termed as Mutually Exclusive Projects. In mutually exclusive projects, cash flows of one project can be adversely affected by the acceptance of the other project. In mutually exclusive projects, all projects are to accomplish the same task. Therefore, such projects cannot be undertaken simultaneously. Hence, while choosing among Mutually Exclusive Projects, more than one project may satisfy the Capital Budgeting criterion. However, only one project can be accepted. Which project should be accepted depends on different factors like initial investment, time period required for completion, strategic importance of the project, etc. usually the project which adds more value to the business in the long run will be selected. Capital budgeting techniques give same acceptance or rejection decisions regarding independent projects but conflict may arise in case of mutually exclusive projects. If conflicts arise while making decision regarding mutually exclusive projects, the Net Present Value method should be given priority due to its more conservative or realistic reinvestment rate assumption. The Net Present Value and Internal Rate of Return, both methods are superior to the payback period, but Net present Value is superior to even Internal Rate of Return. Internal Rate Of Return And Mutually Exclusive Projects. Whats the Concern? While considering the mutually exclusive projects, IRR technique can be misleading. Investment projects are said to be mutually exclusive if only one project could be accepted and others would have to be rejected. NPV and IRR methods for project evaluation leads to conflicting results under following conditions: 1. The pattern of cash inflows plays an important role in project evaluation while using IRR method. i.e. The cash flows of one project may increase over time, while those of others may decrease and vice versa. The major drawback with the IRR method is that for mutually exclusive projects, it can give contradictory investment decision when compared with NPV. Consider the following example.

In the above example A and B are mutually exclusive projects. Both projects require an initial outlay of $ 1,000,000.00 but the pattern of cash inflows is different. Cash inflows for Project A are increasing over the period of time while for Project B these are declining. IRR decision rule leads to select Project A as Project A IRR>Project B IRR. But decision on the basis of NPV evaluation implies that project B is more viable. Thus on the basis of mere IRR the company may select less profitable project. 1. The cash outflow of the projects may differ. i.e. a project may need capital outlay not only at the time of investment but after regular intervals during its expected life. Consider the following example:

Project A requires an initial outlay at the beginning of the project while Project B needs cash outflow in year 2 and year 4 also. Decision based on IRR method leads to select project B but NPV of project B is less than of Project A. again under such circumstances IRR method plays a deceive role. Summarizing the above discussion the timings and pattern of cash flows can produce conflicting results in the NPV and IRR methods of project evaluation. Capital Structure and Cash Flows On one hand, operations of the company may help in forecasting of future cash flows but in addition to this, future cash inflows and out flows can also be accessed through company capital structure. A corporation may use different combinations of equity, debt, or mixture of securities to finance its assets which is termed as Capital Structure. Companys capital structure is basically the composition of its liabilities i.e. how much the company owes to its share holders and how much to its creditors.

Stake holders can easily judge the managements mind-set, strategy of running business and businesss future prospects. A companys value is affected by the capital structure it employs, therefore; while deciding capital structure, management has to consider different important factors like bankruptcy costs, agency costs, taxes, and information asymmetry.

For example, if a company sells $100 billion in equity and $300 billion in debt, it is said to be 25% equity-financed and 75% debt-financed. The Companys ratio of debt to total financing, 75% in this example is referred to as the companys leverage. Capital structure may be highly complex and may include other sources of finances like short term loans, coalition etc. Cash Flow Success of any business can be determined through its capacity to generate positive cash flows. Therefore, Cash inflow and outflow is considered as one of the most essential elements which gives us as idea about the continued existence of a business in future. Therefore, the stakeholders focus on two things while investing in business: first, how does business generate funds and second, where does business invest those funds for generating more. Objectives of a cash flow statement: The main objective of a cash flow statement is to assist users: in assessing the businesss ability to generate positive cash flow . in assessing businesss ability to bridge the gap between out flow and inflow of funds. in assessing its ability to meet its short and long term obligations in assessing the rationale of differences between reported and related cash flows in assessing the effect on finances of major projects during the year. The statement of cash flow, therefore; shows increase and decrease in cash and cash equivalents rather than working capital. Profitability Index Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor. This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR). The ratio is calculated as follows:

Profitability Index = Present Value of Future Cash Flows / Initial Investment If project has positive NPV, then the PV of future cash flows must be higher than the initial investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV. This technique may be useful when available capital is limited and we can allocate funds to projects with the highest PIs. Decision Rule: Rules for the selection or rejection of a proposed project: If Profit Index is greater than 1, then project should be accepted. If Profit Index is less than 1, then reject the project. Present Value of Multiple Cash Flows We come across many cases where we have to determine the present value of series of multiple cash flows. There are two ways we can calculate present value of multiple cash flows. Either we discount back individual cash flow at a time, or we can just calculate the present values individually and add them up. Example: Suppose if we want $10,000 in one year and $15,000 more in two years. If we can earn 8% on this money, how much we need to invest today to exactly earn this much in the future? In other words, what is the present value of two cash flows at 8%. Present value of $15,000 in 2 years at 8 percent is: $15000/1.082 =$12860.082 Present value of $100 in 1 years at 8% is: $10,000/1.08 =$9259.259 The total present value is : $12860.082+$9259.259=$22119.341 Discounted Payback Period One of the limitations in using payback period is that it does not take into account the time value of money. Thus, future cash inflows are not discounted or adjusted for debt/equity used to undertake the project , inflation, etc. However, the discounted payback period solves this problem. It considers the time value of money, it shows the breakeven after covering such costs.

This technique is somewhat similar to payback period except that the expected future cash flows are discounted for computing payback period. Discounted payback period is how long an investments cash flows, discounted at projects cost of capital, will take to cover the initial cost of the project. In this approach, the PV of future cash inflows are cumulated up to time they cover the initial cost of the project. Discounted payback period is generally higher than payback period because it is money you will get in the future and will be less valuable than money today. For example, assume a company purchased a machine for $10000 which yields cash inflows of $8000, $2000, and $1000 in year 1, 2 and 3 respectively. The cost of capital is 15%. The regular payback period for this project is exactly 2 year. But the discounted payback period will be more than 2 years because the first 2 years cumulative discounted cash flow of $8695.66 is not sufficient to cover the initial investment of $10000. The discounted payback period is 3 years. Decision Rule of Discounted Payback: If discounted payback period is smaller than some pre-determined number of years then an investment is worth undertaking. Internal Rate of Return Internal Rate of Return is another important technique used in Capital Budgeting Analysis to access the viability of an investment proposal. This is considered to be most important alternative to Net Present Value (NPV). IRR is The Discount rate at which the costs of investment equal to the benefits of the investment. Or in other words IRR is the Required Rate that equates the NPV of an investment zero. NPV and IRR methods will always result identical accept/reject decisions for independent projects. The reason is that whenever NPV is positive , IRR must exceed Cost of Capital. However this is not true in case of mutually exclusive projects. The problem with IRR come about when Cash Flows are non-conventional or when we are looking for two projects which are mutually exclusive. Under such circumstances IRR can be misleading. Suppose we have to evaluate two mutually exclusive projects. One of the project requires a higher initial investment than the second project; the first project may have a lower IRR value, but a higher NPV and should thus be accepted over the second project (assuming no capital rationing constraint). Decision Rule of Internal Rate of Return: If Internal Rate of Return exceeds the required rate of Return, the investment should be accepted or should be rejected otherwise.

Payback Period Payback period is the first formal and basic capital budgeting technique used to assess the viability of the project. It is defined as the time period required for the investments returns to cover its cost. Payback period is easy to apply and easy to understand technique; therefore, widely used by investors. For example, an investment of $5000 which returns $1000 per year will have a five year payback period. Shorter payback periods are more desirable for the investors than longer payback periods. It is considered as a method of analysis with serious limitations and qualifications for its use. Because it does not properly account for the time value of money, risk and other important considerations such as opportunity cost. Capital Budgeting Process Evaluation of Capital budgeting project involves six steps:
y y y y y y

First, the cost of that particular project must be known. Second, estimates the expected cash out flows from the project, including residual value of the asset at the end of its useful life. Third, riskiness of the cash flows must be estimated. This requires information about the probability distribution of the cash outflows. Based on projects riskiness, Management find outs the cost of capital at which the cash out flows should be discounted. Next determine the present value of expected cash flows. Finally, compare the present value of expected cash flows with the required outlay. If the present value of the cash flows is greater than the cost, the project should be taken. Otherwise, it should be rejected. OR

If the expected rate of return on the project exceeds its cost of capital, that project is worth taking.

Firms stock price directly depends how effective are the firms capital budgeting procedures. If the firm finds or creates an investment opportunity with a present value higher than its cost of capital, this would effect firms value positively. How to Calculate Net Present Value using Excel: The calculation of net present value is useful when a business has to identify a viable investment opportunity. There are many ways to calculate the NPV. The simplest way is: By Use of NPV function in Excel:

The NPV function consists of the following arguments: =NPV (Rate, FCF 1, FCF 2 FCF n)

This function gives the NPV of an investment based on a discount rate and a series on cash outflows (future payments) and cash inflows (income).

The calculation of NPV is based on expected future cash flows of a project. For example, if cash flows occur at the beginning of the period, the first value should be added to the NPV result, should not include in the values arguments. Example: Consider the following example to understand how NPV function works. Suppose a company AtlanticWorld Co. is considering an investment in a machine that costs $150,000 and the additional cash inflows from the machine will be $80,000, $ 50,500, and $76,600 over the next three years. The firms cost of capital is 12%. Consider the following example to understand how NPV function works. DATA (A) 1 2 3 4 5 12% (150,000) 80,000 50,500 76,600 DESCRIPTION (B) Annual Discount Rate (Cost of Capital) Initial Cost of Investment Return from First Year Return from second Year Return from Third Year

FORMULA =NPV(A1,A2,A3,A4,A5) =14,472.53 Net Present Value of the Investment is $14,472.53 As NPV of the purposed investment is positive so the company should invest in the machine.

Net Present Value Net Present Value measures the difference between present value of future cash inflows generated by a project and cash outflows during a specific period of time. With a help of net present value we can figure out an investment that is expected to generate positive cash flows. In order to calculate net present value (NPV), we first estimate the expected future cash flows from a project under consideration. The next step is to calculate the present value of these cash flows by applying the discounted cash flow (DCF) valuation procedures. Once we have the estimated figures then we will estimate NPV as the difference between present value of cash inflows and the cost of investment. NPV Formula:

NPV=Present Value of Future Cash Inflows Cash Outflows (Investment Cost) In addition to this formula, there are various tools available to calculate the net present value e.g. by using tables and spreadsheets such as Microsoft Excel. Decision Rule: A prospective investment should be accepted if its Net Present Value is positive and rejected if it is negative. Importance of Capital Budgeting Decisions

Capital budgeting is a process used to determine whether a firms proposed investments or projects are worth undertaking or not. The process of allocating budget for fixed investment opportunities is crucial because they are generally long lived and not easily reversed once they are made. So we can say that this is a strategic asset allocation process and management needs to use capital budgeting techniques to determine which project will yield more return over a period of time.

The question arises why capital budgeting decisions are critical? The foremost importance is that the capital is a limited resource which is true of any form of capital, whether it is raised through debt or equity. The firms always face the constraint of capital rationing. This may result in the selection of less profitable investment proposals if the budget allocation and utilization is the primary consideration. So the management should make a careful decision whether a particular project is economically acceptable and within the specified limits of the investments to be made during a specified period of time. In the case of more than one project, management must identify the combination of investment projects that will contribute to the value of the firm and profitability. This, in essence, is the basis of capital budgeting.

Following are the capital budgeting techniques:

y y y y

Net Present Value Internal Rate of Return Profitability Index Payback Period

Capital Budgeting and Financial Management

Businesses look for opportunities that increase their share holders value. In capital budgeting, the managers try to figure out investment opportunities that are worth more to the business than they cost to acquire. Ideally, firms should peruse all such projects that have good potential to increase the business worth. Since the available amount of capital at any given time is limited; therefore, it restricts the management to pick out only certain projects by using capital budgeting techniques in order to determine which project has potential to yield the most return over an applicable period of time. Capital budgeting is the process which enables the management to decide which, when and where to make long-term investments. With the help of Capital Budgeting Techniques, management decide whether to accept or reject a particular project by making analysis of the cash flows generated by the project over a period of time and its cost. Management decides in favor of project if the value of cash flows generated by the project exceeds the cost of undertaking that project.

A Capital Budgeting Decision rules likely to satisfy the following criteria:

y y y

Must give consideration to all cash flows generated by the project. Must take into account Time Value of Money concept. Must always lead to the correct decision when choosing among mutually exclusive projects.

Regardless of the specific nature of an investment opportunity under consideration, management must be concerned not only with how much cash they are expecting to receive, but also when they expect to receive it and how likely they are to receive it. Evaluating the size of investment, timing; when to take that investment, and the risk involve in taking particular investment is the essence of capital budgeting.