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Subject Name : Financial Management

Unit Title : Capital Budgeting
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Introduction
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All such businesses involve investment decisions. These investment
decisions that corporates take are known as capital budgeting
decisions.

Capital budgeting decisions involve evaluation of specific investment
proposals.

Capital budgeting is a blue-print of planned investments in operating
assets.

It 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.

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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Session Objectives:

To understand,
The concept of capital budgeting
The importance of capital budgeting
The complexity of capital budgeting procedures
Various techniques of appraisal methods
Evaluation of capital budgeting decision
Importance of Capital Budgeting
Grouping of Decisions
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
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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.

Long time investments of the funds sometimes may change the risk
profile of the firm.

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.



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The growth and survival of any firm in todays business environment
demands a firm to be pro-active. Capital budgeting decisions help in
this process.

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.


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Complexities involved
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.

The following are complexities involved in capital budgeting decisions:

Estimation of future cash flows

Commitment of funds on long-term basis

Problem of irreversibility of decisions

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Phases of Capital
Expenditure 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
Budgeting for capital expenditure for approval by the management
Implementation
Post-completion audit
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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.

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.

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Important Points for consideration

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.

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.

Public awareness of their rights compels many firms to initiate
projects from environmental protection angle.



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Rationale of Capital Budgeting
Proposals

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
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Capital Budgeting
Process
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

Economic Appraisal / social cost benefit analysis 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
Will the project materially alter the level of savings and investment in
the society?

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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.
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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

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

Estimation of cash flows

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.


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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.

Estimation of incremental cash flows

Incremental cash flows stream of a capital expenditure decision has
three components.

Initial cash outlay (Initial investment)

Operating cash inflows

Terminal cash inflows


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Basic principles of Cash Flow Estimation*













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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.

The rate of return expected on implementation if the project is arrived
at by the investment profile of the projects.

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)

Where, EBIT = earnings (profit) before interest and taxes, t = tax
rate





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Incremental principle : This principle states that cash flows of a
project are to be considered in incremental terms.

Following aspects have to be taken into account:

Ignore sunk costs
Consider opportunity costs
Need to take into account all incident effect
Cannibalisation

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.


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Appraisal Criteria
Discounted Cash Flow methods

Traditional Methods
Payback Method
Accounting Rate of
Return
Modern Techniques
Net Present Value
Internal Rate of Return
Modified Internal Rate of
Return
Profitability Index
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Payback period is defined as the length of time required to recover
the initial cash out lay.

(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) / Cash
inflow of the year in which full recovery takes place

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 at the beginning
+ Book Value of investment at the end of the life of the project or
investment) / 2

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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.

Accept or reject criterion can be summarised as given below:
NPV > Zero = accept
NPV < Zero = reject

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.

IRR can be determined by solving the following equation:




where t = 1 to n




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t
t
r
C
CF
) 1 (
0

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 inflow (1+r)
n-t



cash outflow / (1+r)
n-t



MIRR is obtained on solving the following equation.

PV of costs = TV/ (1 + MIRR)
n


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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.

PI = 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 PI = 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.


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Summary
You have learnt:

What is Capital Budgeting
Importance of Capital Budgeting
Complexities involved
Capital Budgeting process
Investment Evaluation
Appraisal techniques Traditional and modern methods



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