SLM Unit 08 Mbf201

Financial Management
Unit 8
Unit 8
Capital Budgeting
Structure: 8.1 Introduction Learning objectives 8.2 Importance of Capital Budgeting 8.3 Complexities involved in Capital Budgeting Decisions 8.4 Phases of Capital Expenditure Decisions 8.5 Identification of Investment Opportunities 8.6 Rationale of Capital Budgeting Proposals 8.7 Capital Budgeting Process Technical appraisal Economic appraisal Financial appraisal 8.8 Investment Evaluation Estimation of cash flows 8.9 Appraisal Criteria Traditional techniques Pay back method Accounting rate of return Discounted pay-back period Discounted cash flow period 8.10 Summary 8.11 Terminal Questions 8.12 Answers to SAQs and TQs
8.1 Introduction
Indian economy is growing at 9% per annum. New lines of business such as retailing investment, investment advisory services and private banking are emerging. All such businesses involve investment decisions. These investment decisions that corporates take are known as capital budgeting decisions. Such decisions help corporates reap the benefits arising out of the emerging business opportunities. Capital budgeting decisions involve evaluation of specific investment proposals. Here the word capital refers to the operating assets used in
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production of goods or rendering of services. Budgeting involves formulating a plan of the expected cash flows during the future period. Capital budgeting is a blue-print of planned investments in operating assets. Therefore, capital budgeting is the process of evaluating the profitability of the projects under consideration and deciding on the proposal to be included in the capital budget for implementation. Capital budgeting decisions involve investment of current funds in anticipation of cash flows occurring over a series of years in future. All these decisions are strategic because they change the profile of the organisations. Successful organisations have created wealth for their shareholders through capital budgeting decisions. Investment of current funds in long term assets for generation of cash flows in future over a series of years characterises the nature of capital budgeting decisions. HDFC Bank takes over Centurion Bank of Punjab. ICICI Bank took over Bank of Madurai. The motive behind all these mergers is to grow because in this era of globalisation the need of the hour is to grow as big as possible. In all these, one could observe the desire of the management to create value for shareholders as a motivating force. Another way of growing is through branch expansion, expanding the product mix and reducing cost through improved technology for deeper penetration into the market for the companys products. Example -1 A bank which is urban based, for expansion takes over a bank with rural network because, urban based bank can open more urban branches only when it meets the Reserve Bank of India guideline of having a minimum number of rural branches. This is the motive of the merger of urban based bank of ICICI with the rural based Bank of Madurai. Investment of current funds in long-term assets for generation of cash flows in future over a series of years characterises the nature of capital budgeting decisions.
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8.1.1 Learning objectives

After studying this unit, you should be able to:
Explain the concept of capital budgeting. Recoil the importance of capital budgeting. Examine the complexity of capital budgeting procedures. Discuss the various techniques of appraisal methods Evaluate capital budgeting decision.
8.2 Importance of Capital Budgeting

Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organisation. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into: Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant
The reasons that make the capital budgeting decisions most crucial for finance managers are:
These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast.
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o For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes has declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions. o Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for share-holders. The best example is the Reliance Group. o Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness. o Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors. Long time investments of the funds sometimes may change the risk profile of the firm.
Example -2 A FMCA A FMCG company decides to enter into a new business of power generation. This decision will totally alter the risk profile of the business of the company. Investors perception of risk of the new business to be taken up by the company will change its required rate of return to invest in the company. In this connection it is to be noted that the power pricing is a politically sensitive area affecting the profitability of the organisation. Therefore, capital budgeting decisions change the risk dimensions of the company and hence the required rate of return that the investors want.
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Most of the capital budgeting decisions involve huge outlay. The funds required during the phase of execution must be synchronised with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a companys operation unproductive.
Capital budgeting decisions involve assessment of market for companys product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment. If a firm were to realise after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialised costly equipments. Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are: o cost o quality o timing Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken, will strategically affect the firms profitability.
Liberalisation and globalisation gave birth to economic institutions like world trade organisations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric company. Ability of GE to sell its products in India at
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a rate less than the rate at which Indian companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth. The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex. Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project.
Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today. Self Assessment Questions Fill in the blanks: 1. _______ make or mar a business. 2. _______ decisions involve large outlay of funds in anticipation of cash inflows in future. 3. Social, political, economical and technological forces make capital budgeting decisions ___________. 4. __________ are very expensive.
8.3 Complexities involved in Capital Budgeting Decisions

Capital expenditure decision involves forecasting of future operating cash flows. Forecasting the future cash flows demands certain assumptions about the behaviour of costs and revenues in future.
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Example -3 The arrival of mobile revolution made the pager technology obsolete. The firms which invested in pagers faced the problem of pagers losing its relevance as a means of communication. The firms with the ability to adapt the new know-how in mobile technology could survive the effect of this phase of technological obsolescence. Others who could not manage the effect of change in technology had a natural death and so most capital expenditure decisions are irreversible. However, there are complexities involved in capital budgeting decisions They are: Estimation of future cash flows Commitment of funds on long-term basis Problem of irreversibility of decisions Self Assessment Questions Fill in the blanks: 5. Capital expenditure decisions are _________. 6. Forecasting of future operating cash flows from ____________ because the future is________.
8.4 Phases of Capital Expenditure Decisions

There are various phases involved in capital budgeting decisions. Identification of investment opportunities. Evaluation of each investment proposal Examination of the investments required for each investment proposal Preparation of the statements of costs and benefits of investment proposals Estimation and comparison of the net present values of the investment proposals that have been cleared by the management on the basis of screening criteria Examination of the government policies and regulatory guidelines, for execution of each investment proposal screened and cleared based on the criteria stipulated by the management
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Budgeting for capital expenditure for approval by the management Implementation Post-completion audit
Self Assessment Questions Fill in the blanks: 7. Post-completion audit is ________ in the phases of capital budgeting decisions. 8. Identification of investment opportunities is the _____ in the phases of capital budgeting decisions.
8.5 Identification of Investment Opportunities

A firm is in a position to identify investment proposal only when it is responsive to the ideas of capital projects emerging from various levels of the organisation. The proposal may be to: Add new products to the companys product line, Expand capacity to meet the emerging market at demand for companys products Add new technology based process of manufacture that will reduce the cost of production. Caselet -1 A sales manager may come with a proposal to produce a new product as per the requirements of companys consumers. Marketing manager, based on the sales managers proposal, may conduct a market survey to determine the expected demand for the new product under consideration.
Once the marketing manager is convinced of the market potential for proposed new product, the proposal goes to the engineers to examine the same with all aspects of production process. Then the proposal goes to the cost accountant to translate the entire gamut of the proposal into costs and revenues in terms of incremental cash flows- both outflows and inflows. The cost-benefit statement generated by cost accountant shall include all incremental costs and benefits that the firm will incur and derive on commercialisation of the proposal under consideration.
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Therefore, generation of ideas with the feasibility to convert the same into investment proposals occupies a crucial place in the capital budgeting decisions. Proactive organisations encourage a continuous flow of investment proposals from all levels in the organisation. In this connection following points deserve to be considered: Analysing the demand and supply conditions of the market for the companys product could be a fertile source of potential investment proposals. Market surveys on customers perception of companys product could be a potential investment proposal to redefine the companys products in terms of customers expectations.
Companies which invest in Research and Development constantly get exposure to the benefit of adapting the new technology quite relevant to keep the firm competitive in the most dynamic business environment. Reports emerging from R & D section could be a potential source of investment proposal. Economic growth of the country and the emerging middle class endowed with purchasing power could generate new business opportunities in existing firms. These new business opportunities could be potential investment ideas. Public awareness of their rights compels many firms to initiate projects from environmental protection angle. If ignored, the firm may have to face the public wrath through PILs entertained at the Supreme Court and High courts.
Therefore project ideas that would improve the competitiveness of the firm by constantly improving the production process with the sole objective of cost reduction and customer welfare, are accepted by well managed firms.
Self Assessment Questions Fill in the blanks: 9. Analysing the demand and supply conditions of the market for the companys products could be _______ of potential investment proposal. 10. Generation of ideas for capital budgets and screening the same can be considered _______ of capital budgetary decisions.
8.6 Rationale of Capital Budgeting Proposals
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The investors and the stake-holders expect a firm to function efficiently to satisfy their expectations. The stake-holders expectation and the performance of the company may clash among themselves, the one that touches all these stake-holders expectation could be visualised in terms of firms obligation to reduce the operating costs on a continuous basis and increasing its revenues. Therefore, capital budgeting decisions could be grouped into two categories: Decisions on cost reduction programmes Decisions on revenue generation through expansion of installed capacity Self Assessment Questions Fill in the blanks: 11. __________ decisions could be grouped into two categories. 12. ________ and revenue generation are the two important categories of capital budgeting.
8.7 Capital Budgeting Process

Once the screening of proposals for potential involvement is over, the company should take up the following aspects of capital budgeting process: A proposal should be commercially viable. The following aspects are examined to ascertain the commercial viability of any investment proposal o Market for the product o Availability of raw materials o Sources of raw materials o The elements that influence the location of a plant i.e. the factors to be considered in the site selection Infrastructural facilities such as roads, communication facilities, financial services such as banking and public transport services Ascertaining the demand for the product or services is crucial. It is done by market appraisal. In appraisal of market for the new product, the following details are compiled and analysed. Consumption trends Competition and players in the market
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Availability of substitutes Purchasing power of consumers Regulations stipulated by Government on pricing the proposed products or services Production constraints
Relevant forecasting technologies are employed to get a realistic picture of the potential demand for the proposed product or service. Many projects fail to achieve the planned targets on profitability and cash flows if the firm could not succeed in forecasting the demand for the product on a realistic basis. Capital budgeting process involves three steps (see figure 8.1) Financial appraisal, Technical appraisal and Economic appraisal.
Figure 8.1: Capital budgeting process
8.7.1 Technical appraisal Technical appraisal ensures implementation of all the technical aspects of the project. The technical aspects of the project are: Selection of process know-how Decision on determination of plant capacity Selection of plant, equipment and scale of operation Plant design and layout General layout and material flow Construction schedule 8.7.2 Economic appraisal
Economic appraisal examines the project from the social point of view. Hence, is referred to as social cost benefit analysis. It examines:
The impact of the project on the environment The impact of the project on the income distribution in the society The impact of the project on fulfilment of certain social objective like generation of employment and attainment of self sufficiency
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Will the project materially alter the level of savings and investment in the society?
8.7.3 Financial appraisal Financial appraisal is to examine the financial viability of the project. Under this appraisal, the risk and returns at various stages of project execution are assessed. Besides, it examines whether the risk adjusted return from the project exceeds the cost of financing the project. Financial appraisal technique examines: Cost of the project Investment outlay Means of financing and the cost of capital Expected profitability Expected incremental cash flows from the project Break-even point Cash break-even point Risk dimensions of the project Will the project materially alter the risk profile of the company ? If the project is financed by debt, expected Debt Service Coverage Ratio Tax holiday benefits, if any. Self Assessment Questions Fill in the blanks: 13. ________ examines the project from the social point of view. 14. All technical aspects of the implementation of the project are considered in __________ 15. _________ of a project is examined by financial appraisal. 16. Among the elements that are to be examined under commercial appraisal, the most crucial one is the ______.
8.8 Investment Evaluation

Steps involved in the evaluation of any investment proposal are: Estimation of cash flows both inflows and outflows occurring at different stages of project life cycle
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Examination of the risk profile of the project to be taken up and arriving at the required rate of return Formulation of the decision criteria
8.8.1 Estimation of cash flows Estimating the cash flows associated with the project under consideration is the most difficult and crucial step in the evaluation of an investment proposal. Estimation is the result of the team work of many professionals in an organisation. Capital outlays are estimated by engineering departments after examining all aspects of production process Marketing department on the basis of market survey forecasts the expected sales revenue during the period of accrual of benefits from project executions Operating costs are estimated by cost accountants and production engineers Incremental cash flows and cash out flow statement is prepared by the cost accountant on the basis of the details generated in the above steps The ability of the firm to forecast the cash flows with reasonable accuracy lies at the root of the success of the implementation of any capital expenditure decision.
8.8.2 Estimation of incremental cash flows Investment (capital budgeting) decision requires the estimation of incremental cash flow stream over the life of the investment. Incremental cash flows are estimated on tax basis.
Incremental cash flows stream of a capital expenditure decision has three components. Initial cash outlay (Initial investment) Initial cash outlay to be incurred is determined after considering any post tax cash inflows. In replacement decisions existing old machinery is disposed of and a new machinery incorporating the latest technology is installed in its place. On disposal of existing old machinery the firm has a cash inflow. This cash inflow has to be computed on post tax basis. The net cash out flow (total cash required for investment in capital assets minus post tax cash
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inflow on disposal of the old machinery being replaced by a new one) therefore is the incremental cash outflow. Additional net working capital required on implementation of new project is to be added to initial investment. Operating cash inflows Operating cash inflows are estimated for the entire economic life of investment (project). Operating cash inflows constitute a stream of inflows and outflows over the life of the project. Here also incremental inflows and outflows attributable to operating activities are considered. Any savings in cost on installation of a new machinery in the place of the old machinery will have to be accounted on post tax basis. In this connection incremental cash flows refer to the change in cash flows on implementation of a new proposal over the existing positions. Terminal cash inflows At the end of the economic life of the project, the operating assets installed will be disposed off. It is normally known as salvage value of equipments. This terminal cash inflows are computed on post tax basis.
Prof. Prasanna Chandra in his book Financial Management (Tata McGraw Hill, published in 2007) has identified certain basic principles of cash flow estimation. The knowledge of these principles will help a student in understanding the basics of computing incremental cash flows. The basic principles of cash flow estimation, by Prof. Prasanna Chandra, are (see figure 8.2) Separation principle, Increment principle, Post-tax principle and Consistency principle.
Figure 8.2: Principles of Prof. Prasanna Chandra
Separation principle The essence of this principle is the necessity to treat investment element of the project separately (i.e. independently) from that of financing element.
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The financing cost is computed by the cost of capital. Cost of capital is the cut off rate and rate of return expected on implementation of the project. Therefore, we compute separately cost of funds for execution of project through the financing mode. The rate of return expected on implementation if the project is arrived at by the investment profile of the projects. Therefore, interest on debt is ignored while arriving at operating cash inflows. The following formula is used to calculate profit after tax Incremental PAT = Incremental EBIT ( 1-t ) (Incremental) (Incremental) EBIT = earnings (profit) before interest and taxes t = tax rate Incremental principle Incremental principle says that the cash flows of a project are to be considered in incremental terms. Incremental cash flows are the changes in the firms total cash flows arising directly from the implementation of the project. Keep the following in mind while determining incremental cash flows. Ignore sunk costs Sunk costs are costs that cannot be recovered once they have been incurred. Therefore, sunk costs are ignored when the decisions on project under consideration is to be taken. Opportunity costs If the firm already owns an asset or a resource which could be used in the execution of the project under consideration, the asset or resource has an opportunity cost. The opportunity cost of such resources will have to be taken into account in the evaluation of the project for acceptance or rejection.
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Caselet -2 A firm wants to open a branch in Chennai for expansion of its market in Tamil Nadu. The firm already owns a building in Chennai. The building in Chennai is let out to some other firm on an annual rent of Rs. 1 crore. For opening the branch at Chennai the firm uses its own building by sacrificing the rental income which it has been receiving. The opportunity cost of the building at Chennai is Rs. 1 crore. This will have to be considered in arriving at the operating cash flows associated with the decision to open a branch at Chennai. Need to take into account all incident effect Effects of a project on the working of other parts of a firm also known as externalities must be taken into account. Caselet -3 Expansion or establishment of a branch at a new place may increase the profitability of existing branches because the branch at the new place has a complementary relationship with the other existing branches or reduce the profitability of existing branches because the branch at the new place competes with the business of other existing branches or takes away some business activities from the existing branches. Cannibalisation Another problem that a firm faces on introduction of a new product is the reduction in the sale of an existing product. This is called cannibalisation. The most challenging task is the handling the problems of cannibalisation. Depending on the companys position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored. Depending on the companys position with that of the competitors in the market, appropriate strategy has to be followed. Correspondingly the cost of cannibalisation will have to be treated either as relevant cost of the decision or ignored. Product cannibalisation will affect the companys sales if the firm is marketing its products in a market characterised by severe competition, without any entry barriers. In this case costs are not relevant for decision.
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However, if the firms sales are not affected by competitors activities due to certain unique protection that it enjoys on account of brand positioning or patent protection, the costs of cannibalisation cannot be ignored in taking decisions. Post tax principle All cash flows should be computed on post tax basis Consistency principle Cash flows and discount rates used in project evaluation need to be consistent with the investor group and inflation. Solved Problem -1 A firm is considering replacement of its existing machine by a new machine. The new machine will cost Rs 1,60,000 and have a life of five years. The new machine will yield annual cash revenue of Rs 2,50,000 and incur annual cash expenses of Rs 1,30,000. The estimated salvage of the new machine at the end of its economic life is Rs 8,000. The existing machine has a book value of Rs 40,000 and can be sold for Rs 20,000. The existing machine, if used for the next five years is expected to generate annual cash revenue of Rs 2,00,000 and involves annual cash expenses of Rs 1,40,000. If sold after five years, the salvage value of the existing machine will be negligible. The company pays tax at 30%. It writes off depreciation at 25% on the written down value. The companys cost of capital is 20%. Compute the incremental cash flows of replacement decisions.
Solution
Table 8.1 gives the initial investments and annual cash flows from projects.
Table 8.1: Initial investments and annual cash flows Initial investment Gross investment for new machine Less: cash received from the sale of existing machine Net cash outlay Annual cash flows from operations Incremental cash flows from revenue Incremental decrease in expenditure 50, 000 10, 000 (1, 60, 000) 20, 000 (1, 40, 000)
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Table 8.2 shows the incremental depreciation schedule:

Table 8.2: Incremental depreciation schedule Year 1 2 3 4 5 Depreciation (new machine) 45, 000 33, 750 25, 312 18, 984 14, 238 Depreciation (old machine) 10,000 7,500 5,625 4,219 3,164 Incremental depreciation (Rs.) (35,000) (26,250) (19,687) (14,765) (11,074)
Table 8.3 shows the calculation of depreciation:

Table 8.3: Calculation of depreciation Book value Add: cost of new machine Less: sale proceeds of old machine Depreciation for 1 year 25% Depreciation for 2 year 25% Depreciation for 3 year 25% Depreciation for 4 year 25% Depreciation for 5 year 25% Book value after 5 years 40, 000 1, 60, 000 2, 00, 000 20, 000 1, 80, 000 45, 000 1, 35, 000 33, 750 1, 01, 250 25, 312 75, 938 18, 894 56, 954 14, 238 42, 716
The computation of the incremental cash flows of replacement decisions is briefly described in table 8.4.
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Table 8.4: Statement of incremental cash flows

Particulars 0 1. Investment in new machine 2. After tax salvage value of old machine 3. Net Cash Out lay 4. Increase in revenue 5. Decrease in expenses 6. Increase in depreciation 7. Increase in EBIT (4+5 -6) 8. EBIT (1 T) (1-.30) 9. Incremental Cash flows from operation (8 + 6) EAT + Depreciation 10. Salvage value of new machine 11. Incremental Cash flows from operation (8 + 6) EAT + Depreciation (1,40,000) negative 52,500 49,875 47,906 46,430 (1,60,000) 20,000 1 2 Year 3 4 5
(1,40,000) 50,000 10,000 50,000 10,000 50,000 10,000 50,000 10,000 50,000 10,000 (11,074)
(35,000) (26,250) (19,687) (14,765)
25,000 17,500 52,500
33,750 23,625 49,875
40,313 28,219 47,906
45,235 31,665 46,430
48,926 34,248 45,322
8,000 53,322
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Self Assessment Questions Fill in the blanks: 17. ______ is the third step in the evaluation of investment proposal. 18. A ________ is not a relevant cost for the project decision. 19. Effect of a project on the working of other parts of a firm is known as __________. 20. The essence of separation principle is the necessity to treat _____ of a project separately from that of ________. 21. Pay-back period __________ time value of money. 22. IRR gives a rate of return that reflects the ______ the project.
8.9 Appraisal Criteria

The methods of appraising an investment proposal can be grouped into 1. Traditional methods. 2. Modern methods.
Traditional methods are:
o o
Payback method Accounting rate of return Net present value Internal rate of return Modified internal rate of return Profitability index
Modern techniques are:
o o o o
8.9.1 Traditional techniques Traditional methods are of two types payback method and accounting rate of return. 8.9.1.1 Payback method Payback period is defined as the length of time required to recover the initial cash out lay.
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Solved Problem -2 The following details shown in table 8.5, are in respect of the cash flows of two projects A and B.
Table 8.5: Cash flows of A and B Year 0 1 2 3 4 5 Project A cash flows (Rs.) (4,00,000) 2,00,000 1,75,000 25,000 2,00,000 1,50,000 Project B cash flows (Rs.) (5,00,000) 1,00,000 2,00,000 3,00,000 4,00,000 2,00,000
Compute pay-back period for A and B.
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Solution The cash flows and the cumulative cash flows of the projects A and B are shown under in table 8.6
Table 8.6 Cash flows and cumulative cash flows of A and B Year Project A Cash flows (Rs.) 1 2 3 4 5 2,00,000 1,75,000 25,000 2,00,000 1,50,000 Cumulative Cash flows 2,00,000 3,75,000 4,00,000 6,00,000 7,50,000 Project B Cash flows (Rs.) 1,00,000 2,00,000 3,00,000 4,00,000 2,00,000 Cumulative Cash flows 1,00,000 3,00,000 6,00,000 10,00,000 12,00,000
From the cumulative cash flows column, project A recovers the initial cash outlay of Rs 4,00,000 at the end of the third year. Therefore, payback period of project A is 3 years.
From the cumulative cash flow column the initial cash outlay of Rs. 5,00,000 lies between 2nd year and 3rd year in respect of project B. Therefore, payback period for project B is:
2 5,00,000 3,00,000 3,00,000
= 2.67 years Pay-back period for project B is 2.67 years
8.9.1.1.1 Evaluation of payback period: Merits Simple in concept and application Emphasis is on recovery of initial cash outlay. Pay-back period is the best method for evaluation of projects with very high uncertainty
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With respect to accept or reject criterion, pay back method favours a project which is less than or equal to the standard pay back set by the management. In this process early cash flows get due recognition than later cash flows. Therefore, pay-back period could be used as a tool to deal with the ranking of projects on the basis of risk criterion For firms with short-age funds this is preferred because it measures liquidity of the project
Demerits
Pay-back period ignores time value of money. It does not consider the cash flows that occur after the pay-back period. It does not measure the profitability of the project. It does not throw any light on the firms liquidity position but just tells about the ability of the project to return the cash out lay originally made. Project selected on the basis of pay back criterion may be in conflict with the wealth maximisation goal of the firm.
Accept or reject criteria If projects are mutually exclusive, select the project which has the least pay-back period In respect of other projects, select the project which have pay-back period less than or equal to the standard pay back stipulated by the management Illustration Pay-back period: Project A = 3 years Project B = 2.5 years Standard set up by management = 3 years If projects are mutually exclusive, accept project B which has the least pay-back period. If projects are not mutually exclusive, accept both the projects because both have pay-back period less than or equal to the standard pay-back period set by the management
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Pay-back formula Year Prior to full recovery + Balance of initial out lay to be recovered Of initial out lay at the beginning of the year in which full
Re cov ery takes place Cash in flow of the year in w hich full recovery takes place
8.9.1.2 Accounting rate of return Accounting rate of return (ARR) measures the profitability of investment (project) using information taken from financial statements: ARR = Average income / Average investment ARR = Average of post tax operating profit / Average investment Average investment = Book Value of the investment Book value of investment at the end of in the beginning the life of the project or investment 2 Solved Problem -3 The following particulars shown in table 8.7 refers to two projects:
Table 8.7: Particulars of two projects Cost Estimated life Salvage value X 40,000 5 years Rs. 3,000 Table 8.8: After tax 1 2 3 4 5 Total Sikkim Manipal University Rs. 3,000 4,000 7,000 6,000 8,000 28,000 Rs. 10,000 8,000 2,000 6,000 5,000 31,000 Page No. 169 Y 60,000 5 years Rs. 3,000
Estimate income
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Average 5,600 Average investment 21,500
6,200 31,500
ARR
5,600 6,200 21,500 31,500

19.7% (Firm Y)
= 26 % (Firm X)
Merits of accounting rate of return It is based on accounting information Simple to understand It considers the profits of entire economic life of the project Since it is based on accounting information, the business executives familiar with the accounting information understand it
Demerits of accounting rate of return
ARR is based on accounting income not on cash flows, as the cash flow approach is considered superior to accounting information based approach ARR does not consider the time value of money Different investment proposals which require different amounts of investment may have the same accounting rate of return. The ARR fails to differentiate projects on the basis of the amount required for investment ARR is based on the investment required for the project. There are many approaches for the calculation of denominator of average investment. Existence of more than one basis for arriving at the denominator of average investment may result in adoption of many arbitrary bases
Due to this the reliability of ARR as a technique of appraisal is reduced when two projects with the same ARR but with differing investment amounts are to be evaluated.
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Accept or reject criteria In any project which has an excess ARR, the minimum rate fixed by the management is accepted. If actual ARR is less than the cut-off rate (minimum rate specified by the management ) then that project is rejected. When projects are to be ranked for deciding on the allocation of capital on account of the need for capital rationing, project with higher ARR are preferred to the ones with lower ARR. 8.9.2 Discounted pay-back period
The length in years required to recover the initial cash out lay on the present value basis is called the discounted pay-back period. The opportunity cost of capital is used for calculating present values of the cash inflows. Discounted pay-back period for a project will be always higher than simple pay-back period because the calculation of discounted pay-back period is based on discounted cash flows.
Solved Problem -4 Table 8.9 shows the cash flows of project A for different years at a rate of 10% p.a.
Table 8.9: Cash flows of project A Year 0 1 2 3 4 5 Project A Cash flows (4,00,000) 2,00,000 1,75,000 25,000 2,00,000 1,50,000 PV factor at 10% 1 0.909 0.826 0.751 0.683 0.621 PV of Cash flows (4,00,000) 1,81,800 1,44,550 18,775 1,36,600 93,150 Cumulative positive Cash flows 1,81,800 3,26,350 3,45,125 4,81,725 5,74,875
Discounted pay-back period

3 4,00,000 3, 45,125 1,36,600 3.4 years
8.9.3 Discounted cash flow method

Unit 8
Discounted cash flow method or time adjusted technique is an improvement over the traditional techniques. In evaluation of the projects the need to give weight-age to the timing of return is effectively considered in all DCF methods. DCF methods are cash flow based and take the cognisance of both the interest factors and cash flow after the pay-back period. DCF technique involves: Estimation of cash flows, both inflows and outflows of a project over the entire life of the project Discounting the cash flows by an appropriate interest factor (discount factor) Deducting the sum of the present value of cash outflows from the sum of present value of cash inflows to arrive at net present value of cash flows The most popular techniques of DCF methods are: The net present value The internal rate of return Profitability index Net present value Net present value (NPV) method recognises the time value of money. It correctly admits that cash flows occurring at different time periods differ in value. Therefore, there is the need to find out the present values of all cash flows. NPV method is the most widely used technique among the DCF methods. Steps involved in NPV method involve: Forecasting the cash flows, both inflows and outflows of the projects to be taken up for execution Decisions on discount factor or interest factor. The appropriate discount rate is the firms cost of capital or required rate of return expected by the investors Computation of the present value of cash inflows and outflows using the discount factor selected Calculation of NPV by subtracting the PV of cash outflows from the present value of cash inflows.
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Accept or reject criteria If NPV is positive, the project should be accepted. If NPV is negative the project should be rejected. Accept or reject criterion can be summarised as given below: NPV > Zero = accept NPV < Zero = reject
NPV method can be used to select between mutually exclusive projects by examining whether incremental investment generates a positive net present value.
Merits of NPV method It takes into account the time value of money. It considers cash flows occurring over the entire life of the project. NPV method is consistent with the goal of maximising the net wealth of the company. It analyses the merits of relative capital investments. Since cost of capital of the firm is the hurdle rate, the NPV ensures that the project generates profits from the investment made for it.
Demerits of NPV method
Forecasting of cash flows is difficult as it involves dealing with the effect of elements of uncertainties on operating activities of the firm. To decide on the discounting factor, there is the need to assess the investors required rate of return. But it is not possible to compute the discount rate precisely. There are practical problems associated with the evaluation of projects with unequal lives or under funds constraints
For ranking of projects under NPV approach, the project with the highest positive NPV is preferred to that with a lower NPV.
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Solved Problem -5 A project costs Rs.25000 and is expected to generate cash inflows as shown in table 8.10
Table 8.10: Cash inflows Year 1 2 3 4 5 Cash inflows 10,000 8,000 9,000 6,000 7,000
The cost of capital is 12%. The present value factors are as shown in the table 8.11.
Table 8.11: Present value factors Year 1 2 3 4 5 PV factor at 12% 0.893 0.797 0.712 0.636 0.567
Compute the NPV of the project Solution The present value of the cash flows are computed based on the information given in tables 8.8 and 8.9, at a rate of interest of 12% per annum, in the table 8.12 shown under:
Table 8.12: PV of cash flows Year 1 2 3 4 5 Cash flows 10,000 8,000 9,000 6,000 7,000 PV factor at 12% 0.893 0.797 0.712 0.636 0.567 Total PV of cash flows 8,930 6,376 6,408 3,816 3,969 29,499
Sum of the present value of the cash outflows = 25,000 NPV = 4,499 The project generates a positive NPV of Rs. 4,499. Therefore, project should be accepted.
Unit 8
Solved Problem A company is evaluating two alternatives for distribution within the plant. Two alternatives are C system with a high initial cost but low annual operating costs. F system which costs less but have considerably higher operating costs. The decision to construct the plant has already been made, and the choice here will have no effect on the overall revenues of the project. The cost of capital of the plant is 12% and the projects expected net cash costs are listed in table 8.13.
Table 8.13: Expected net cash Year 0 1 2 3 4 5 Expected net cash costs C systems (3,00,000) (66,000) (66,000) (66,000) (66,000) (66,000) F systems (1,20,000) (96,000) (96,000) (96,000) (96,000) (96,000)
What is the present value of costs of each alternative?
Which method should be chosen? Solution

What is the present value of costs of each alternative?
Which method should be chosen?
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Unit 8
Solution Computation of present value is done in table 8.14

Table 8.14: Computation of PV Year 1 2 3 4 5 C systems (66,000) (66,000) (66,000) (66,000) (66,000) F systems (96,000) (96,000) (96,000) (96,000) (96,000) Incremental 30,000 30,000 30,000 30,000 30,000
Present value of incremental savings =

30,0000 x PV IFA (12%, 5)= 30,000 x 3.605 = 1,08,150 Initial cash outlay [C system F system] = 3,00,000 1,20,000
Incremental cash outlay = 1,80,000 108150 =71850

Since the present value of incremental net cash inflows of C system over F system is negative. C system is not recommended.
Therefore, F system is recommended .
Properties of the NPV NPVs are additive. If two projects A and B have NPV (A) and NPV (B) then by additive rule the net present value of the combined investment is NPV (A + B) Intermediate cash inflows are reinvested at a rate of return equal to the cost of capital. Internal rate of return (IRR) Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the NPV of any project equal to zero. IRR is the rate of interest which equates the PV of cash inflows with the PV of cash outflows.
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IRR is also called as yield on investment, managerial efficiency of capital, marginal productivity of capital, rate of return and time adjusted rate of return. IRR is the rate of return that a project earns.
Merits of IRR IRR takes into account the time value of money IRR calculates the rate of return of the project, taking into account the cash flows over the entire life of the project. It gives a rate of return that reflects the profitability of the project. It is consistent with the goal of financial management i.e. maximisation of net wealth of share holders IRR can be compared with the firms cost of capital. To calculate the NPV the discount rate normally used is cost of capital. But to calculate IRR, there is no need to calculate and employ the cost of capital for discounting because the project is evaluated at the rate of return generated by the project. The rate of return is internal to the project.
Demerits of IRR
IRR does not satisfy the additive principle. Multiple rate of returns or absence of a unique rate of return in certain projects will affect the utility of this technique as a tool of decision making in project evaluation. In project evaluation, the projects with the highest IRR are given preference to the ones with low internal rates. Application of this criterion to mutually exclusive projects may lead under certain situations to acceptance of projects of low profitability at the cost of high profitability projects. IRR computation is quite tedious.
Accept or reject criteria If the projects internal rate of return is greater than the firms cost of capital, accept the proposal, otherwise reject the proposal.
Unit 8
IRR can be determined by solving the following equation for r = CF 0

Ct (1 r ) t
where t = 1 to n
CF0 = Investment Sum of the present values of cash inflows at the rate of interest of r :CF 0 Ct (1 r ) t
where t = 1 to n
Solved Problem A project requires an initial outlay of Rs. 1,00,000. It is expected to generate the following cash inflows shown in table 8.15
Table 8.15: Cash inflows Year 1 2 3 4 Cash inflows 50,000 50,000 30,000 40,000
What is the IRR of the project? Solution Step 1 The average of annual cash inflows is computed as shown under in table 8.16
Table 8.16:Average of cash inflows Year 1 2 3 4 Total Cash inflows 50,000 50,000 30,000 40,000 1,70,000
Average
1,70,000 4
Rs . 42,500
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Step 2 Divide the initial investment by the average of annual cash inflows 1,00,000 2.35 42,500 Step 3 From the PVIFA table for 4 years, the annuity factor very near 2.35 is 25%. Therefore the first initial rate is 25% as shown in table 8.17
Table 8.17: Trial rate at 25% Year 1 2 3 4 Cash flows 50,000 50,000 30,000 40,000 PV factor at 25 % 0.800 0.640 0.512 0.410 Total PV of Cash flows 40,000 32,000 15,360 16,400 1,03,760
Since the initial investment of Rs.1,00,000 is less than the computed value at 25% of Rs.1,03,760 the next trial rate is 26%.
Hence the changes in the calculations are as shown in table 8.18 Table 8.18: Trial rate at 26% Year 1 2 3 4 Cash flows 50,000 50,000 30,000 40,000 PV factor at 26 % 0.7937 0.6299 0.4999 0.3968 Total PV of Cash flows 39,685 31,495 14,997 15,872 1,02,049
The next trial rate is 27%, the changes are as shown under in table 8.19.
Table 8.19: Trial rate at 27% Year 1 2 3 4 Cash flows 50,000 50,000 30,000 40,000 PV factor at 27 % 0.7874 0.6200 0.4882 0.3844 Total PV of Cash flows 39,370 31,000 14,646 15,376 1,00,392
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The next trial rate is 28%, the changes are as shown under in table 8.20
Table 8.20: Trial rate at 28% Year 1 2 3 4 Cash flows 50,000 50,000 30,000 40,000 PV factor at 26 % 0.7813 0.6104 0.4768 0.3725 Total PV of Cash flows 39,065 30,520 14,3047 14,900 98,789
Since initial investment of Rs.1,00,000 lies between 98789 (28 %) and 1,00,392 (27%) the IRR by interpolation.
27
1,00,392 1,00,000 1,00,392 98,789
27
392 1 1603
= 27 + 0.2445 = 27.2445 = 27.24 %
Modified Internal Rate of Return (MIRR) Modified internal rate of return (MIRR) is a distinct improvement over the IRR. Managers find IRR intuitively more appealing than the rupees of NPV because IRR is expressed on a percentage rate of return. MIRR modifies IRR. MIRR is a better indicator of relative profitability of the projects. MIRR is defined as PV of Costs = PV of terminal value cash outflow t (1+r) t cash inflow (1+r) n-t
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PVC = PV of costs To calculate PVC, the discount rate used is the cost of capital. To calculate the terminal value, the future value factor is based on the cost of capital MIRR is obtained on solving the following equation. PV of costs = TV/ (1 + MIRR)n Superiority of MIRR over IRR MIRR assumes that cash flows from the project are reinvested at the cost of capital. The IRR assumes that the cash flows from the project are reinvested at the projects own IRR. Since reinvestment at the cost of capital is considered realistic and correct, the MIRR measures the projects true profitability MIRR does not have the problem of multiple rates which we come across in IRR Solved Problem The cash flows for respective years at a cost of capital of 12% is as shown in table 8.21.
Table 8.21: Cost of capital
Year Cash flows (Rs. in millions) 0 (100) 1 (100) 2 30 3 60 4 90 5 120 6 130
Present value of cost = 100 +
100
1.12 = 100 + 89.29 = 189.29
Terminal value of cash flows: cash inflow (1+r) n-t Where r = 0.12, n= 6 , t=2 for the 2nd year, t=3 for 3rd year, t=4 for 4th year and so on. = 30 (1.12)4 + 60 (1.12)3 + 90 (1.12)2 + 120 (1.12) + 130 = 30 x 1.5735 + 60 x 1.4049 + 90 x 1.2544 + 120 x 1.12 + 130 = 47.205 + 84.294 + 112.896 + 134.4 + 130 = 508.80
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MIRR is obtained on solving the following equation:
189.29
508.80 (1 MIRR ) 6
(1 MIRR ) 6
508.80 189.29
(1 + MIRR)6 = 2.6879 MIRR = 17.9 % Modified internal rate of return = 17.9% Profitability Index Profitability index is also known as benefit cost ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows. P1= Present value of cash inflows / initial cash outlay Accept or reject criteria Accept the project if PI is greater than 1 Reject the project if PI is less than 1
If profitability index is 1 then the management may accept the project because the sum of the present value of cash inflows is equal to the sum of present value of cash outflows. It neither adds nor reduces the existing wealth of the company.
Merits of PI It takes into account the time value of money It is consistent with the principle of maximisation of share holders wealth It measures the relative profitability
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Demerits of PI
Estimation of cash flows and discount rate cannot be done accurately with certainty A conflict may arise between NPV and profitability index if a choice between mutually exclusive projects has to be made.
Solved Problem A firm is considering an investment proposal which requires an initial cash outlay of Rs 8lakhs now and Rs 2lakhs at the end of the third year. It is expected to generate cash flows as shown in table 8.22
Table 8.22 Cash inflows Year 1 2 3 Cash inflows 3,50,000 8,00,000 2,50,000
Apply the discount rate of 12% and calculate profitability index
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Unit 8
Solution Table 8.23: Present value of cash outflows Year 1 2 3 0.712 2lakhs Total Table 8.24: Present value of cash inflows Year 1 2 4 PVIF (12%) 0.893 0.797 0.636 Cash inflows 3,50,000 8,00,000 2,50,000 Total PV of Cash flows 3.1255 lakhs 6.376 lakhs 1.5900 lakhs 11.0915 lakhs 1.424lakhs 9.424lakhs PV factor at 12 % Cash out flows Rs.8lakhs PV of Cash flows Rs.8lakhs
PI
Total of present value of cashinf low s Total of present value of cashoutflow s

11.0915
1.177 9.424 For every Re.1 invested the project is expected to give a cash inflow of Rs. 1.177 i.e. for every rupee invested a profit of Rs.0.177 is obtained.
8.10 Summary
Capital investment proposals involve current outlay of funds in expectation of a stream of cash inflow in future. Various techniques available for evaluating investment projects. They are grouped traditional and modern techniques. The major traditional techniques payback period and accounting rate of return. the are into are
The important discounting criteria are net present value, internal rate of return and profitability index. A major deficiency of payback period is that it does not take into account the time value of money. DCF techniques overcome this limitation. Each method has both positive and negative aspects. The most popular method for large project is the internal rate of return. Payback period and accounting rate of return are popular for evaluating small projects.
Unit 8
8.11 Terminal Questions

1. Examine the importance of capital budgeting. 2. Briefly examine the significance of identification of investment opportunities in capital budgeting process. 3. Critically examine the pay-back period as a technique of approval of projects. 4. Summarise the features of DCF techniques.
8.12 Answers to SAQs and TQs

Answers to Self Assessment Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. Capital budgeting Capital budgeting Highly complex Capital budgeting decisions Irreversible Uncertainty, highly uncertain. Final step First step A fertile source The most crucial phase Capital budgeting Cost reduction Economic appraisal Technical appraisal Financial viability Demand for the product or service. Decision criteria Sunk cost Externalities Investment element; Financing element Ignores Profitability of
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Answers to Terminal Questions 1. 2. 3. 4. Refer to 8.2 Refer to 8.5 Refer to 8.8.1 Refer to 8.8.2
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Financial Management

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8.1.1 Learning objectives

8.2 Importance of Capital Budgeting

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8.3 Complexities involved in Capital Budgeting Decisions

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8.4 Phases of Capital Expenditure Decisions

8.5 Identification of Investment Opportunities

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8.6 Rationale of Capital Budgeting Proposals

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8.7 Capital Budgeting Process

Figure 8.1: Capital budgeting process

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8.8 Investment Evaluation

Figure 8.2: Principles of Prof. Prasanna Chandra

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Table 8.2 shows the incremental depreciation schedule:

Table 8.3 shows the calculation of depreciation:

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Table 8.4: Statement of incremental cash flows

(35,000) (26,250) (19,687) (14,765)

25,000 17,500 52,500

33,750 23,625 49,875

40,313 28,219 47,906

45,235 31,665 46,430

48,926 34,248 45,322

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8.9 Appraisal Criteria

Modern techniques are:

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Compute pay-back period for A and B.

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= 2.67 years Pay-back period for project B is 2.67 years

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Average 5,600 Average investment 21,500

5,600 6,200 21,500 31,500

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Discounted pay-back period

8.9.3 Discounted cash flow method

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