I. M. Pandey, Financial Management, 9th I. M. Pandey, Financial Management, 9th ed., Vikas.ed., Vikas.

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Business BazigarBusiness Bazigar

Capital Budgeting and Capital Budgeting and Financial ManagementFinancial Management

By-Rahul JainBy-Rahul Jain

I. M. Pandey, Financial Management, 9th I. M. Pandey, Financial Management, 9th ed., Vikas.ed., Vikas.

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MeaningMeaning

Financial management is a systematic Financial management is a systematic process that provides the necessary process that provides the necessary financial information to help a financial information to help a business produce and distribute business produce and distribute goods and services in a way that will goods and services in a way that will make the most profit. It also provides make the most profit. It also provides feedback about how well the feedback about how well the organization is doing. organization is doing.

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Finance FunctionsFinance Functions

Investment or Long Term Asset Mix Investment or Long Term Asset Mix DecisionDecision

Financing or Capital Mix DecisionFinancing or Capital Mix Decision

Dividend or Profit Allocation Dividend or Profit Allocation DecisionDecision

Liquidity or Short Term Asset Mix Liquidity or Short Term Asset Mix DecisionDecision

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Financial accounting and Financial Financial accounting and Financial ManagementManagement

Financial accounting gives the Financial accounting gives the financial status of the company to financial status of the company to people outside the company. It is people outside the company. It is recording and reporting the recording and reporting the activities and events that lead to activities and events that lead to cash inflow and outflow.cash inflow and outflow.

Financial management means Financial management means efficiently managing the various efficiently managing the various resources of the company.resources of the company.

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Financial accounting and Financial Financial accounting and Financial ManagementManagement

CertaintyCertainty Accounting is maintenance of financial Accounting is maintenance of financial records. So, it deals with what has already records. So, it deals with what has already occurred. This makes it more certain. occurred. This makes it more certain. A finance manager is concerned with what A finance manager is concerned with what is going to happen in the future. He takes is going to happen in the future. He takes critical decisions that will affect the future critical decisions that will affect the future of the company. These are based on of the company. These are based on various calculations and assessments. This various calculations and assessments. This is not easy because there are many is not easy because there are many uncertainties in financial management. uncertainties in financial management.

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Time Value of MoneyTime Value of MoneyTime preference for moneyTime preference for money is an is an individual’s preference for possession individual’s preference for possession of a given amount of money of a given amount of money nownow, , rather than the same amount at rather than the same amount at some future time.some future time.Three reasons may be attributed to Three reasons may be attributed to the individual’s time preference for the individual’s time preference for money:money:–   riskrisk–   preference for consumptionpreference for consumption–   investment opportunitiesinvestment opportunities

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Future ValueFuture ValueCompoundingCompounding is the process of finding the is the process of finding the future values of cash flows by applying the future values of cash flows by applying the concept of compound interest.concept of compound interest.

Compound interestCompound interest is the interest that is is the interest that is received on the original amount (principal) as received on the original amount (principal) as well as on any interest earned but not well as on any interest earned but not withdrawn during earlier periods.withdrawn during earlier periods.

Simple interestSimple interest is the interest that is is the interest that is calculated only on the original amount calculated only on the original amount (principal), and thus, no compounding of (principal), and thus, no compounding of interest takes place. interest takes place.

1010

ExampleExampleIf you deposited Rs 55,650 in a bank, which If you deposited Rs 55,650 in a bank, which was paying a 15 per cent rate of interest on a was paying a 15 per cent rate of interest on a ten-year time deposit, how much would the ten-year time deposit, how much would the deposit grow at the end of ten years? deposit grow at the end of ten years?

nn iPF )1(

1111

Present ValuePresent ValuePresent valuePresent value of a future cash flow of a future cash flow (inflow or outflow) is the amount of (inflow or outflow) is the amount of current cash that is of equivalent value current cash that is of equivalent value to the decision-maker. to the decision-maker. DiscountingDiscounting is the process of is the process of determining present value of a series of determining present value of a series of future cash flows. future cash flows. The The interest rateinterest rate used for discounting used for discounting cash flows is also called the cash flows is also called the discount discount raterate..

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Present Value of a Single Cash Present Value of a Single Cash FlowFlow

The following general formula can be The following general formula can be employed to calculate the present value of a employed to calculate the present value of a lump sum to be received after some future lump sum to be received after some future periods:periods:

(1 )(1 )

nnnn

FP F i

i

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ExercisesExercisesWhat's the present value of:What's the present value of:

A. $10000000 in 1 years at 16 percent? A. $10000000 in 1 years at 16 percent?

B $9,000 in 2 years at 8 percent?B $9,000 in 2 years at 8 percent?

What is Capital Budgeting?What is Capital Budgeting?

• Analysis of potential projects.Analysis of potential projects.• Long-term decisions; involve large Long-term decisions; involve large

expenditures.expenditures.• Very important to firm’s future.Very important to firm’s future.

Nature of Capital Budgeting Nature of Capital Budgeting DecisionsDecisions

The investment decisions of a firm are The investment decisions of a firm are generally known as the capital budgeting, or generally known as the capital budgeting, or capital expenditure decisions.capital expenditure decisions.The firm’s investment decisions would The firm’s investment decisions would generally include expansion, acquisition, generally include expansion, acquisition, modernisation and replacement of the long-modernisation and replacement of the long-term assets. Sale of a division or business term assets. Sale of a division or business (divestment) is also as an investment decision. (divestment) is also as an investment decision. Decisions like the change in the methods of Decisions like the change in the methods of sales distribution, or an advertisement sales distribution, or an advertisement campaign or a research and development campaign or a research and development programme have long-term implications for programme have long-term implications for the firm’s expenditures and benefits, and the firm’s expenditures and benefits, and therefore, they should also be evaluated as therefore, they should also be evaluated as investment decisions.investment decisions.

Steps in Capital BudgetingSteps in Capital Budgeting• Estimate cash flows (inflows & Estimate cash flows (inflows &

outflows).outflows).• Determine r = WACC for project.Determine r = WACC for project.• Evaluate cash flows.Evaluate cash flows.

Cash Flow Estimation Of ProjectCash Flow Estimation Of Project

0 1 2 3 4 5 n6 . . .

TerminalTerminalCash flowCash flow

Annual Cash FlowsAnnual Cash Flows

InitialInitialoutlayoutlay

0 1 2 3 4 5 n6 . . .

Features of Investment Features of Investment DecisionsDecisions

The exchange of current funds for The exchange of current funds for future benefits.future benefits.

The funds are invested in long-The funds are invested in long-term assets.term assets.

The future benefits will occur to The future benefits will occur to the firm over a series of years.the firm over a series of years.

Evaluation CriteriaEvaluation Criteria

1. 1. Discounted Cash Flow (DCF) Discounted Cash Flow (DCF) CriteriaCriteria–     Net Present Value (NPV)Net Present Value (NPV)

2. 2. Non-discounted Cash Flow Non-discounted Cash Flow CriteriaCriteria

–     Payback Period (PB)Payback Period (PB)–     Accounting Rate of Return (ARR)Accounting Rate of Return (ARR)

PaybackPayback

Payback Payback is the number of years is the number of years required to recover the original cash required to recover the original cash outlay invested in a project. outlay invested in a project.

That is:That is:

Assume that a project requires an Assume that a project requires an outlay of Rs 50,000 and yields outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for annual cash inflow of Rs 12,500 for 7 years. The payback period for the 7 years. The payback period for the project is:project is:

0Initial InvestmentPayback = =

Annual Cash Inflow

C

C

Rs 50,000PB = = 4 years

Rs 12,000

PaybackPaybackUnequal cash flowsUnequal cash flows In case of unequal cash In case of unequal cash inflows, the payback period can be found out by inflows, the payback period can be found out by adding up the cash inflows until the total is equal adding up the cash inflows until the total is equal to the initial cash outlay.to the initial cash outlay.

Suppose that a project requires a cash outlay of Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project’s payback? the next 4 years. What is the project’s payback?

3 years + 12 3 years + 12 × (1,000/3,000) months× (1,000/3,000) months

3 years + 4 months3 years + 4 months

Payback for Franchise LPayback for Franchise L(Long: Most CFs in out years)(Long: Most CFs in out years)

10 8060

0 1 2 3

-100

=

CFt

Cumulative -100 -90 -30 50

PaybackL 2 + 30/80 = 2.375 years

0100

2.4

Franchise S (Short: CFs come Franchise S (Short: CFs come quickly)quickly)

70 2050

0 1 2 3

-100CFt

Cumulative -100 -30 20 40

PaybackS 1 + 30/50 = 1.6 years

100

0

1.6

=

Acceptance RuleAcceptance Rule

The project would be accepted if its The project would be accepted if its payback period is less than the payback period is less than the maximum or maximum or standard paybackstandard payback period period set by management. set by management.

As a ranking method, it gives highest As a ranking method, it gives highest ranking to the project, which has the ranking to the project, which has the shortest payback period and lowest shortest payback period and lowest ranking to the project with highest ranking to the project with highest payback period.payback period.

Evaluation of PaybackEvaluation of Payback

Certain virtues:Certain virtues:– Simplicity Simplicity – Cost effective Cost effective – Short-term effects Short-term effects – Risk shield Risk shield – LiquidityLiquidity

Serious limitations: Serious limitations: – Cash flows after payback Cash flows after payback – Cash flows ignored Cash flows ignored – Cash flow patterns Cash flow patterns – Administrative difficulties Administrative difficulties – Inconsistent with shareholder valueInconsistent with shareholder value

Accounting Rate of Return Accounting Rate of Return MethodMethod

The accounting rate of return is the ratio of The accounting rate of return is the ratio of the average after-tax profit divided by the the average after-tax profit divided by the average investment. The average average investment. The average investment would be equal to half of the investment would be equal to half of the original investment if it were depreciated original investment if it were depreciated constantly.constantly.

A variation of the ARR method is to divide average A variation of the ARR method is to divide average earnings after taxes by the original cost of the earnings after taxes by the original cost of the

project instead of the average cost.project instead of the average cost.

Average incomeARR =

Average investment

Acceptance RuleAcceptance RuleThis method will accept all those This method will accept all those projects whose ARR is higher than projects whose ARR is higher than the minimum rate established by the minimum rate established by the management and reject those the management and reject those projects which have ARR less than projects which have ARR less than the minimum rate.the minimum rate.This method would rank a project This method would rank a project as number one if it has highest ARR as number one if it has highest ARR and lowest rank would be assigned and lowest rank would be assigned to the project with lowest ARR.to the project with lowest ARR.

Evaluation of ARR MethodEvaluation of ARR Method

The ARR method may claim some The ARR method may claim some meritsmerits– Simplicity Simplicity – Accounting data Accounting data

– Accounting profitabilityAccounting profitability

Serious shortcomingSerious shortcoming– Cash flows ignored Cash flows ignored – Time value ignored Time value ignored – Arbitrary cut-off Arbitrary cut-off