Capital Budgeting-theory and numericals

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Capital Budgeting DecisionsCa

pital Budgeting DecisionsModule-1


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DefinitionsDefinitions• According to the definition of Charles T. Hrongreen,“capital budgeting is a long-term planning for making and

financing proposed capital out lays.

• According to the definition of Richard and Green law,“capital budgeting is acquiring inputs with long-termreturn”.

• According to the definition of L rich,“capital budgeting consists in planning development of

available capital for the purpose of maximi ing the long-term profitability of the concern”.


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!eed and "#portance of!eed and "#

portance of

Capital BudgetingCa

pital Budgeting!. "uge investments

#. $ong-term

%. &rreversible

'. $ong (erm )ffect


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Challenges of Capital

Challenges of Capital

BudgetingBud

getinga* +uture ,ncertainty

b* (ime )lement

c* ifficulty in uantification of &mpact


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Capital Budgeting Decision

Capital Budgeting Decision

$rocess$rocess!. &dentification of various investments

proposals

#. /creening or matching the proposals

%. )valuation


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Cont%dCont%d

'. +ixing priority

0. +inal approval

1. &mplementing

2. 3erformance review of feedback


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$a -&ac' $eriod Method

• 3ay-back period is also termed as 43ay-out period4 or3ay-off period.

• &t is defined as the number of years required to recoverthe initial investment in full with the help of the stream ofannual cash flows generated by the pro5ect.

3ay-back period can be calculated into the following twodifferent situations 6

7a* &n the case of constant annual cash inflows.7b* &n the case of uneven or unequal cash inflows.


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Cont%d

(a) "n the case of constant annual cash inflows *

(&) "n the case of +ne en or +ne ual Cash "nflows* 3ay-back period is determined with the help of cumulativecash inflow. &t can be calculated by adding up the cash

inflows until the total is equal to the initial investment .


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Cont%d

• ccept or Re/ect Criterion

Among the mutually exclusive or alternative pro5ects whose

pay-back periods are lower than the cut off period. (hepro5ect would be accepted. if not it would be re5ected .


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d antages of $a -&ac' $eriod Method

• important guide to investment policy

• simple to understand and easy to calculate

• facilitates to determine the liquidity and solvency of a firm

• helps to measure the profitable internal investmentopportunities

• ensures reduction of cost of capital expenditure.


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Disad antages of $a -&ac' $eriod Method

• does not measure the profitability of a pro5ect

• does not value pro5ects of different economic lives

• does not consider income beyond the pay-back period

• does not give proper weight to timing of cash flows

• does not consider cost of capital and interest factor which are veryimportant factors in taking sound investment decisions.


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erage Rate of Return Method ( RR) orccounting Rate of Return Method

• focuses on the average net income generated in a pro5ectin relation to the pro5ect8s average investment outlay.

• involves accounting profits not cash flows.


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9ont:d

;here<


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9ont:d

• d antages7!* &t considers all the years involved in the life of a pro5ect

rather than only pay-back years.

7#* &t applies accounting profit as a criterion of measurementand not cash flow.

• Disad antages

7!* &t applies profit as a measure of yardstick not cash flow.7#* (he time value of money is ignored in this method.7%* =early profit determination may be a difficult task.


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Discounted Cash 0low Method (or) Ti#ed/usted Method

• takes into account both the overall profitability of pro5ects and alsothe timing of return.

•helps to measure the cash inflow and outflow of a pro5ect as if theyoccurred at a single point in time so that they can be compared inan appropriate way.

• recogni es that the use of money has a cost< i.e.< interest foregone.

• risk can be incorporated into iscounted 9ash +low computationsby ad5usting the discount rate or cut off rate.


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Disad antages

7!* (here may be difficulty in accurately establishing rates of interestover the cash flow period.

7#* $ack of adequate expertise in order to properly apply thetechniques and interpret results.

7%* (hese techniques are based on cash flows< whereas reportedearnings are based on profits.


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!et $resent alue Method (!$ )

• (his is one of the iscounted 9ash +low technique whichexplicitly recogni es the time value of money.

• &n this method all cash inflows and outflows are converted into

present value 7i.e.< value at the present time* applying anappropriate rate of interest 7usually cost of capital*.

• (hus< the >et 3resent ?alue is obtained by subtracting thepresent value of cash outflows from the present value of cash

inflows.


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Cont%d;here6•>3?@>et 3resent ?alue• @+uture 9ash &nflows at different times•B @9ost of 9apital or 9ut-off rate or iscounting ate 9ash outflows at

different times•&@ cash outflows at different times

Rules of cceptance*•>3? C Dero - Accept the proposal•>3? E Dero - e5ect the 3roposal


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Cont%d• Advantages1. It explicitly recognizes the time value of money.2. It takes into account all the years cash flows arising out of the project over its

useful life.3. It is an absolute measure of profitability.

. ! changing "iscount rate can be built into #$% calculation. &his feature becomes important as this rate normally changes because the longer the timespan' the lower the value of money ( higher the "iscount rate

• Disadvantages1. &his metho" is comparatively "ifficult to un"erstan" or use.2. )hen the projects in consi"eration involve "ifferent amounts of investment' the

#et $resent %alue *etho" may not give satisfactory results.


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"nternal Rate of Return Method ("RR)• &nternal ate of eturn Fethod is also called as 4(ime Ad5usted ate of

eturn Fethod.“ • &t is defined as the rate which equates the present value of each cash

inflows with the present value of cash outflows of an investment. • &n other words< it is the rate at which the net present value of the

investment is ero .

• (he &nternal ate of eturn can be found out by (rial and )rror Fethod.+irst< compute the present value of the cash flow from an investment<using an arbitrarily selected interest rate< for example !GH. (hencompare the present value so obtained with the investment cost.


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9ont:d

• (he & is considered as the highest rate of interestwhich a business is able to pay on the funds borrowed tofinance the pro5ect out of cash inflows generated by thepro5ect.

• (he &nterpolation formula can be used to measure the&nternal ate of eturn as follows 6


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9ont:d• Merits

1. It takes into account the time value of money.2. It consi"ers the cash flows over the entire life of the project.3. It makes more meaningful an" acceptable to users because it satisfies them in terms

of the rate of return on capital.• Limitations

1. &he internal rate of return may not be uni+uely "efine".2. &he I,, is "ifficult to un"erstan" an" involves complicate" computational problems.3. &he internal rate of return figure cannot "istinguish between len"ing an"

borrowings .. )hen projects un"er consi"eration are mutually exclusive' I,, may give conflicting

results.-. )e may get multiple I,,s for the same project when there are nonconventional cash

flows especially.


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!$ s. "RR• !$ is calculated in terms of currency while "RR is expressed in

terms of the percentage return a firm expects the capital pro5ect toreturnI

• & method is concerned with rate of return on investment rather than

total yield on investment< >3? method considers the total yield oninvestment. "ence< in case of mutually exclusive pro5ects< eachhaving a positive >3? the one with largest >3? will have the#a3i#u# effect on shareholders wealth .

• (he & Fethod cannot be used to evaluate pro5ects where thereare changing cash flows 7e.g.< an initial outflow followed by in-flowsand a later out-flow< such as may be required in the case of landreclamation by a mining firm*I


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9ont:d• "owever< the "RR Method does ha e one significant

ad antage J managers tend to better understand the concept ofreturns stated in percentages and find it easy to compare to therequired cost of capitalI and< finally<

• Applying >3? using different discount rates will result in differentrecommendations. (he "RR #ethod alwa s gi es the sa#ereco#endation.


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Multiple "RR

A normal cash flow pattern for pro5ect is negativeinitial outlay followed by positive cash flows 7K<L< L< L M*

"owever< if the cash flow pattern is not normal7such as K< L< K* there can be more than one& s.


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Cont%d

Accept if F& ≥ required rate of return

e5ect if F& E required rate of return


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$rofita&ilit "nde3 Method4Benefit Cost$rofita&ilit "nde3 Method4Benefit Costratioratio

• &t gives the present value of future benefits< computed at therequired rate of return on the initial investment.

• 3rofitability &ndex may either be Nross 3rofitability &ndex or >et3rofitability &ndex. >et 3rofitability &ndex is the Nross 3rofitability

&ndex minus one.

• Rule of cceptance* A pro5ect with 3rofitability &ndex greaterthan one should be accepted as it will have 3ositive >et 3resent?alue and vice versa.


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Advantages of 3rofitability &ndex

7!* &t duly recogni es the ti#e alue of #one .7#* +or calculations when compared with internal rate ofreturn method it re uires less ti#e.7%* &t helps inran'ing the pro/ect for investment decisions.7'* As this method is capable of calculating incrementalbenefit cost ratio< it can be used to choose &etween#utuall e3clusi e pro/ects.


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• Fodified internal rate of return 7F& * is an improved version of theinternal rate of return 7& * approach to capital budgeting decisions.

• &t does not require the assumption that the pro5ect cash flows are

reinvested at the & I rather< it uses cost of capital for reinvestment.

• espite >3?8s conceptual superiority< managers seem to prefer &over >3? because & is intuitively more appealing as it is apercentage measure. (he modified & or F& overcomes the

shortcomings of the regular & .

• (he problem of multiple rates does not exist with F& .

Modified "nternal Rate of ReturnModified "nternal Rate of Return


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/teps for calculating F&• 5tep 1 * 9alculate the present value of the costs 73?9* associated

with the pro5ect< using cost of capital 7r* as the discount rate 6

• 5tep 6 * 9alculate the terminal value 7(?* of the cash inflowsexpected from the pro5ect 6

• 5tep 7 * Obtain F& by solving the following equation 6


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9ont:dF& is a distinct improvement over the regular & but we need totake note of the following6

•&f the mutually exclusive pro5ects are of the same si e< >3? and F&

lead to the same decision irrespective of variations in life.

•&f the mutually exclusive pro5ects differ in si e< there may be apossibility of conflict between >3? and & .

•F& is better than the regular & in measuring true rate of return."owever< for choosing among mutually exclusive pro5ects of differentsi e< >3? is a better alternative in measuring the contribution of eachpro5ect to the value of the firm


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• 9apital rationing is the process of putting restrictions onthe pro5ects that can be undertaken by the company orthe capital that can be invested by the company.

• (his aims in choosing only the most profitableinvestments for capital investment decision.

• (his can be accomplished by putting restrictive limits on

the budget or selecting a higher cost of capital as thehurdle rate for all the pro5ects under consideration.

• 9apital rationing can be either hard or soft

Capital RationingCa pital Rationing


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ssu#ptions of Capital Rationing•restrictions on capital expenditures

•optimal return on investment for the company.

Cont%dCont%d


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d antages of Capital

Rationing• Pudget

• >o ;astage

• +ewer 3ro5ects

• "igher eturns

• Fore /tability


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• )fficient 9apital Farkets• 9ost of 9apital

• ,n-Faximising ?alue• /mall 3ro5ects• &ntermediate 9ash +lows

Disad antages of Capital Rationing


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3ay Pack 3eriod!. A pro5ect requires initial investment of s. 'G


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Average ate of eturn


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&

• (he cost of a pro5ect is s. %#


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3rofitability &ndex

• A pro5ect is in the consideration of a firm. (heinitial outlay of the pro5ect is s. !G


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3roblem• (here are two mutually exclusive pro5ects under active consideration of a

company. Poth the pro5ects have a life of 0 years and have initial cashoutlays of s. !


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9ont:d

;ith the help of the above given information you arerequired to calculate67a* (he 3ay-back 3eriod of each pro5ect7b* (he Average ate of eturn for each pro5ect7c* (he >et 3resent ?alue and 3rofitability &ndex for eachpro5ect7d* (he &nternal ate of eturn for each pro5ect

On the basis of your calculations advise the companywhich pro5ect it should accept giving reasons.


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TH !85TH !85

Capital Budgeting-theory and numericals

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