Capital

Budgeting

TATA motors plans to set up car plants at Bangalore, Nashik

TATA steel acquired Corus

King Fisher Airlines planning to buy 26 aircrafts

Bank planning to computerize all its Branches

Emcure planning to set up a R& D centre for treatment of HIV/ Aids

GMR Infra structure plan to raise Rs 3000 Crs through leasing

What is common in these statements ?

Capital Expenditure

It involves a current outlays (and future too) of funds in the expectation of a streamof benefits extending far into future

Capital Expenditure- features

Long term consequences

Involve substantial outlays

Difficult or expensive to reverse

Benefits/risk

spending

Typical Capital ExpenditureDecisions

Plant expansionPlant expansion

Equipment selectionEquipment selection Equipment replacement

Lease or buyLease or buy Cost reductionCost reduction

Production Marketing

FinanceHuman

Resource

Capital Budgeting

Strategic InvestmentsFinancing InvestmentsAllocating Capital

Capital Budgeting

Capital Budgeting Process

Project Classification

Investment Criteria

Capital Budgeting Process

Identification of potential investment opportunitiesAssembling of proposed investments Decision Making Preparation and appropriation of Capital Budgets Implementation Performance Review

Projects Classification

• Mandatory Investments• Replacement Projects• Expansion Projects• Diversification Projects• Research & Development Projects• Miscellaneous Projects

InvestmentCriteria

Non-DiscountingCriteria

DiscountingCriteria

NPV BCR IRR

DPB ARRPBP

Non Discounting Methods

1 1 The Payback Period Method. The Payback Period Method.

22 Discounted Payback period. Discounted Payback period.

3 3 Accounting Rate of Return Accounting Rate of Return

1 1 The Payback Period Method. The Payback Period Method.

22 Discounted Payback period. Discounted Payback period.

3 3 Accounting Rate of Return Accounting Rate of Return

The Payback Method

TheThe payback periodpayback period is the length of time is the length of time that it takes for a project to recover its that it takes for a project to recover its initial cost out of the cash receipts that initial cost out of the cash receipts that it generates.it generates.

TheThe payback periodpayback period is the length of time is the length of time that it takes for a project to recover its that it takes for a project to recover its initial cost out of the cash receipts that initial cost out of the cash receipts that it generates.it generates.

The Payback Method

When the net annual cash inflow is the same When the net annual cash inflow is the same each year, this formula can be used to each year, this formula can be used to compute the payback period:compute the payback period:

When the net annual cash inflow is the same When the net annual cash inflow is the same each year, this formula can be used to each year, this formula can be used to compute the payback period:compute the payback period:

Payback period = Investment required Net annual cash inflow

The Payback Method

Management at The Holiday Inn wants to Management at The Holiday Inn wants to install an espresso bar in its restaurantinstall an espresso bar in its restaurant..

The espresso bar:The espresso bar:1.1. Costs Rs140,000 and has a 10-year life.Costs Rs140,000 and has a 10-year life.2.2. Will generate net annual cash inflows of Will generate net annual cash inflows of

Rs35,000.Rs35,000.

Management requires a payback period Management requires a payback period of 5 years or less on all investments.of 5 years or less on all investments.

What is the payback period for the What is the payback period for the espresso bar?espresso bar?

Management at The Holiday Inn wants to Management at The Holiday Inn wants to install an espresso bar in its restaurantinstall an espresso bar in its restaurant..

The espresso bar:The espresso bar:1.1. Costs Rs140,000 and has a 10-year life.Costs Rs140,000 and has a 10-year life.2.2. Will generate net annual cash inflows of Will generate net annual cash inflows of

Rs35,000.Rs35,000.

Management requires a payback period Management requires a payback period of 5 years or less on all investments.of 5 years or less on all investments.

What is the payback period for the What is the payback period for the espresso bar?espresso bar?

The Payback Period Method

Payback period = Payback period = Investment required Investment required Net annual cash inflowNet annual cash inflow

Payback period = Payback period = Rs140,000 Rs140,000 Rs35,000Rs35,000

Payback period = Payback period = 4.0 years4.0 years

According to the company’s criterion, According to the company’s criterion, management would invest in the management would invest in the

espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.

According to the company’s criterion, According to the company’s criterion, management would invest in the management would invest in the

espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.

Evaluation of the Payback Method

Ignores the Ignores the time valuetime valueof money.of money.

Ignores cashIgnores cashflows after flows after the paybackthe payback

period.period.

ShortComings

Discounted Payback Period Method

Cash flow are first converted intotheir PV and than added to recoverthe initial outlay on the Project

Discounted Payback Period Method

Year Cash flow discounted factor PV 10%

0 -10000 1.000 -10000

1 3000 0.909 2727

2 3000 0.826 2478

3 4000 0.751 3004

4 4000 0.683 2732

5 5000 0.621 3105

6 2000 0.565 1130

7 3000 0.513 1539

Accounting Rate of Return (average rate of return)

Average Profit after Tax Average Book Value of the InvestmentARR=

Numerator may be measured as Average Annual Return over the life of the investment

Denominator may be measured is the average book value of fixed assets committed to the Project

Accounting Rate of Return (average rate of return) Average Profit after Tax Average Book Value of the InvestmentARR=

Year Book value of FA PAT

1 Rs 90000 RS200002 80000 220003 70000 240004 60000 260005 50000 28000

1/5 (20000+22000+24000+26000+28000)1/5 (90000+80000+70000+60000+50000)

=34%

ARR=34%

Discounting Cash flows techniques

Cash flows occurring at different point of time are not having same economic worth

Due to time value of Money

To make equal it must be discounted wrt to time gap

present value

npvof a project is the sum of thepresent value of all the cashflows- positive or negative-that are expected to occurover the life of the project

techniquesPresent Value or discounting

PV Tables Tables are available for various ranges of i and n

P= c (PVIF)WhereP is present valueC is future Cash flowPVIF is present value interest factor

PV of Mixed Stream of Cash flows

Year End Cash flows PV IF Present Value 10%

1 2 3 4

1 Rs 500 0.909 Rs 454.50

2 Rs 1,000 0.826 Rs 826.00

3 Rs 1,500 0.751 Rs 1,126.00

4 Rs 2,000 0.683 Rs 1,366.00

5 Rs 2,500 0.621 Rs 1,552.50

Rs 7,500 Rs 5,325.50

net present value

NPV of Project =

Ct=cash flow at the end of year t n= life of the project r= discount rate

n

∑ Ct

(1+r)tt=1

- Initial investment

net present value

Year cash flow

0 Rs (10,00,000)1 2,00,0002 2,00,000• 3,00,000• 3,00,000• 3,50,000

Cost of Capital is Rs 10,00,000,r for the firm is 10%

2,00,000+2,00,000+3,00,000 +3,00,000+3,50,000 (1.10)1 (1.10)2 ( 1.10)3 (1.104 (1.10)5NPV=

= 5273

- 1000000

net present value- decision rule

Year cash flow

-

NPV IS POSITIVE ACCEPT

NPV IS NEGATIVE REJECT

NPV IS ZERO INDIFFERENCE

Mutually Exclusive Proposals

Highest positive NPV TOP PRIORITYLowest NPV Low PriorityNegative NPV Rejected

Benefit Cost Ratio- profitability index

BCR= PVB I

NBCR=BCR-1

PVB= Present Value of Benefits I = Initial Investments

Initial investment Rs 100000Cost of Capital 12%Benefits Year 1 25000 year 2 40000 Year 3 40000 Year 4 50000

25000(if1)+40000(if2)+40000(if3)+50000(if4)=1.145 100000

BCR=

NBCR= BCR-1= 0.145When BCR or NBCR Rule is

>1 >0 Accept=1 =0 indifferent<1 <1 Reject

Internal Rate of Return

Internal Rate of Return Method

• The The IRRIRR is the rate of return is the rate of return expected expected from from an investment project over its an investment project over its useful life.useful life.

Internal Rate of Return Method

• The internal rate of return of a Project The internal rate of return of a Project is the discount rate that makes its is the discount rate that makes its net present value to be to be zero.

IRR

Investment = Ct(1+r)t

Ct =cash flow at the end of year t r = internal rate of Return n = life of the Project

∑nn

t=1

Example

Consider the cash flow of a company as follows

Year 0 1 2 3 4

Cash Flow (1,00,000) 30,000 30,000 40,000 45,000

For IRR

100,000 = 30000 + 30,000 + 40000 + 45,000 (1+r)1 (1+r)2 (1+r)3 (1+r)4

Let us take discount rate as 15%

100,802 = 30000 + 30,000 + 40000 + 45,000 (1+15) (1+15)2 (1+15)3 (1+15)4

Take R=16%

98,641= 30000 + 30,000 + 40000 + 45,000 (1+16) (1+16)2 (1+16)3 (1+16)4

Example Continued…..

Value lies between 15% and 16%

1 at 15% it is more by 8022 at 16% it is less by1359

Find sum of NPV value in absolute terms 802+1359 =2161

Ratio of smaller discount rate 802 2161

IRR= 15% + npv at 15%/Total difference x difference in rate

add the number to smaller discount rate

= 15.37%

=0.37

Q

The expected cash flows of a Project are as follows

Year Cash flows

0 -Rs 1000001 200002 300003 400004 500005 30000

The Cost of capital is 12%.Calculatea) NPVb) BCRc) IRRd) PBPe) DPBP

NPV=20000/(1.12)+30000/(1.12)2

+40000/(1.12)3 +50000/(1.12)4+30000/(1.12)

= 20000(.893)+30000(.797)+40000(.712)

+50000(.636) + 30000(.567)

=17860+23910+28480+31800+17010

= 119060

= 100000-119060

=19060

BCR= PVB I

=119060/100000 =1.19

IRR

At 18% of discount Rate the NPV IS Rs1750

At 19% of discount rate the NPV is –Rs 780

IRR IS

=18+1750/2530 =18.69%

Average Inflow 170000/5=34000PB =100000/34000 =2.9It lies between 18 &19% rate

Payback period

is slightly more than 3 years

Discounted Payback period

is slightly less than 4 years

thanks