Title: CAPITAL BUDGETING
1CAPITAL BUDGETING
- Techniques of Capital Budgeting
2Introduction
- A truck manufacturer is considering investment in
a new plant. - An airliner is planning to buy a fleet of jet
aircrafts - A commercial bank is thinking of an ambitious
computerization programme - A pharmaceutical firm is evaluating a major RD
programme. - All these are the examples of situations
involving capital expenditure decision. - Essentially each of them represents a scheme for
investing resources which can be analyzed and
appraised reasonably independently.
3Understanding Capital Expenditure
- Also referred to as Capital Investment or Capital
Project or just Project. - The basic characteristic of Capital Expenditure
is - Typically involves a current outlay (or current
and future outlays) of funds - In the expectation of a stream of benefits
extending far into the future. - However, from accounting point of view, Capital
Expenditure is the one shown as asset on the
Balance Sheet. This assets, except in the case of
non-depreciable asset like land, is depreciated
over its life.
4Understanding Capital Expenditure
- In accounting, the classification of an
expenditure as capital expenditure or revenue
expenditure is governed by - Certain conventions
- Provisions of law
- Managements desire to enhance or depress
reported profits. - Outlays on RD, major advertising campaign,
reconditioning of PM may be treated as revenue
expenditure for accounting purposes, even though
they are expected to generate a stream of
benefits in future. - Therefore, such expenditures qualify for being
capital expenditures as per our definition.
5Understanding Capital Expenditure
- Capital expenditures have three distinctive
features - They have long-term consequences
- They often involve substantial outlays.
- They may be difficult or expensive to reverse.
- How a firm allocates its capital (the capital
budgeting decision) reflects its strategy and
business. Thats why the process of capital
budgeting is also referred to as strategic asset
allocation. - Techniques of Capital Budgeting are helpful in
identifying valuable investment opportunities.
6What is Capital Budgeting?
- Capital budgeting refers to the process of
deciding how to allocate the firms scarce
capital resources (land, labor, and capital) to
its various investment alternatives - The process of planning for purchases of
long-term assets. - Nature of capital budgeting
- Evaluating and selecting long-term investments
in - tangible assets
- intangible assets
- Designed to carry out an organizations strategy
7Managing the Firms Resources
Competition, Life cycle effects, International
events, etc.
Resource Decisions
Cash Management Inventory Management Working
Capital Management Investment in Human
Capital Long-term Assets Accounts Receivable
Operating Decisions
Cash Inflows Earnings
Share- holder Value
Information Decisions
Risk-adjusted Discount Rate
Debt vs. Equity Financing Financial
Leverage Dividend Pay-out
Cost of Capital
Financial Markets
Financing Decisions
8General Steps in Capital Budgeting
- Translate strategy to capital needs
- Generate alternatives
- Project financial results
- Perform financial analysis
- Assess risks
- Consider non-financial factors
- Select projects
- Post-approval review
9Capital Budgeting Process
- Identification of potential investment
opportunities. (Planning Body) - Estimate the criteria of target.
- Monitor external environment regularly to scout
investment opportunities. - Formulate a well defined corporate strategy based
on thorough SWOT analysis - Share corporate strategy and perspectives with
persons who are involved in the process of
capital budgeting. - Motivate employees to make suggestions.
10Capital Budgeting Process (contd..)
- Assembling of proposed investments.
- Investment proposal identified by the production
department and other departments are submitted in
a standardized capital investment proposal form. - Routed through several persons before it arrives
to Capital Budgeting Committee. - Investment proposals are usually classified into
various categories for facilitating decision
making - Replacement investment
- Expansion investments
- New product investments
- Obligatory and welfare investments
11Capital Budgeting Process (contd..)
- Decision making.
- A system of rupee gateways usually characterizes
capital investment decision making. - Executives at various levels are vested with the
power to okay investment proposals up-to certain
limits. - Investment requiring higher outlays need the
approval of the BoD. - Preparation of Capital Budget and appropriations
- The purpose is to check in order to ensure that
the fund position of the firm is satisfactory at
the time of implementation. - Provides an opportunity to review the project at
the time of implementation.
12Capital Budgeting Process (contd..)
- Implementation
- Translating an investment proposal into a
concrete proposal is complex, time-consuming, and
risk-fraught task. - For expeditious implementation at a reasonable
cost, the following are helpful - Adequate formulation of projects necessary
homework and preliminary studies. - Use of the Principle of Responsibility Accounting
- Use of Network Techniques CPM and PERT
- Performance review.
- Post-Completion Audit- provides feedback.
- Comparing actual performance with budgeted ones.
13Project Classification
- Mandatory Investments
- Replacement Projects
- Expansion Projects
- Diversification Projects
- RD Projects
- Miscellaneous Recreational Facilities, Executive
Aircrafts, Landscaping etc.
14Investment Criteria
15Overview
- All of these techniques attempt to compare the
costs and benefits of a project - The over-riding rule of capital budgeting is to
accept all projects for which the cost is less
than, or equal to, the benefit - Accept if Cost Benefit
- Reject if Cost gt Benefit
16The Example
- We will use the following example to demonstrate
the techniques of capital budgeting - Assume that your company is investigating a new
labor-saving machine that will cost 10,000. The
machine is expected to provide cost savings each
year as shown in the following timeline
- If your required return is 12, should this
machine be purchased?
171. The Payback Period Method
- The payback period measures the time that it
takes to recoup the cost of the investment. - If the cash flows are an annuity, then we can
simply divide the cost by the annual cash flow to
determine the payback period - Otherwise, as in the example, we subtract the
cash flows from the cost until the remainder is
zero - The shorter the payback period, the better
- Generally, firms will have some maximum allowable
payback period against which all investments are
compared
18The Payback Period An Example
- For our example project, we will subtract the
cash flows from the initial outlay until the
entire cost is recovered
- Since it will take 0.7143 years ( 2500/3500) to
recover the last 2,500, the payback period must
be 3.7143 years
19Computation
Year Cash Flow Cumulative Net Cash Flow
0 -10,000 -10,000
1 2,000 -8,000
2 2,500 -5,500
3 3,000 -2,500
4 3,500 1,000
Hence, Payback Period lies between year 3 and 4
20Evaluation of Payback Period Method
- Simple both in concept and application.
- Has only few hidden assumptions.
- Rough and Ready method for dealing with risk.
- Favors projects which generate substantial cash
inflows in earlier years and discriminates
against project which bring substantial cash
inflows in later years but not in earlier years. - If risk tends to increase with futurity the
payback criterion may be helpful in weeding out
the risky projects. - Since it emphasizes earlier cash inflows, it may
be a sensible criterion when the firm is pressed
with the problems of liquidity.
21Problems with the Payback Period
- It ignores the time value of money
- It ignores all cash flows beyond the payback
period - It is a measure of projects capital recovery,
not profitability - Though it measures a projects liquidity, it
doesnt indicate the liquidity position of the
firm as a whole, which is more important. - The cutoff payback period is subjective.
22Example
Year Cash flow of A Cash flow of B
0 (100,000) (100,000)
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 - 60,000
Payback Criterion prefers A with payback period
of 3 years over B with payback period of 4
years. But B has very substantial cash inflows in
the years 5 and 6
232. The Discounted Payback Period
- The discounted payback period is exactly the same
as the regular payback period, except that we use
the present values of the cash flows in the
calculation - Since our required return (WACC) is 12, the
timeline with the PVs looks like this
- The discounted payback period is 4.82 years
- Note that the discounted payback period is always
longer than the regular payback period
24Computations
Year Cash Flow Discounting factor _at_ 12 Present Value Cumulative net cash flow
0 -10,000 1.000 -10,000 -10,000
1 2,000 0.893 1,786 -8214
2 2,500 0.797 1992.5 -6221.5
3 3,000 0.712 2136 -4085.5
4 3,500 0.636 2226 -1859.5
5 4,000 0.567 2268 408.5
Payback Period 4.1 years
25Problems with Discounted Payback
- The discounted payback period solves the time
value problem, but it still ignores the cash
flows beyond the payback period - Therefore, you may reject projects that have
large cash flows in the outlying years that make
it very profitable - In other words, any measure of payback can lead
to a focus on short-run profits at the expense of
larger long-term profits
263. Accounting Rate of Return (ARR)
- Also called Average Rate of Return
- Also called Average Accounting Return (AAR)
- There are many different definitions of the ARR.
- However, in one form or other, ARR is always
defined as
- Measure of accounting profit can be PAT or N
- Measure of accounting value is Book Value
27Example
- Suppose we are deciding whether or not to open a
store in a new shopping mall. The required
investment in improvements is 500,000. The
store would have a five-year life because
everything reverts to the mall owners after that
time. The required investment would be 100
depreciated over five years. So the depreciation
would be 500,000 / 5 100,000 per year. The
tax rate is 25 . - Table ahead shows the projected revenues and
expenses
28Computation
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue 433,333 450,000 266,667 200,000 133,000
Expenses 200,000 150,000 100,000 100,000 100,000
EBDT 233,333
Depreciation 100,000
EBT 133,333
Tax _at_ 25 33,333
NI 100,000 150,000 50,000 0 50,000
29Solution
The project is acceptable if the ARR exceeds the
target ARR
30Evaluation of ARR method
- It is simple to calculate
- It is based on accounting information, which is
readily available and familiar to businessmen. - While it considers benefits over the entire life
of the project, it can be used even with the
limited data.
31Problems with ARR method
- ARR is not the rate of return in any meaningful
economic sense. It is just the ratio of two
accounting numbers, and is not comparable to the
returns actually offered. - It is based upon accounting profit, not cash
flow. - It does not take into account the time value of
money. - The ARR measure is internally inconsistent. While
the numerator represents profit belonging to
equity and preference stockholders, its
denominator represents fixed investments, which
is rarely, if ever, equal to the contributions of
equity and preference stockholders.
32The Net Present Value
- The net present value (NPV) is the difference
between the present value of the cash flows (the
benefit) and the cost of the investment (IO)
- In other words, this is the increase in wealth
that the shareholders will receive if the project
is accepted - All projects with NPV greater than or equal to
zero should be accepted
33NPV Decision Rule
Present value of future cash flows Profitability Index
Investment Cost Profitability Index
34The NPV An Example
- NPV is calculated by subtracting the initial
outlay (cost) from the present value of the cash
flows - Note that the discount rate is the WACC (12 in
this example)
- Since the NPV is positive, the project is
acceptable - Note that a positive NPV also means that the IRR
is greater than the WACC
35The Internal Rate of Return
- The internal rate of return (IRR) is the discount
rate that equates the present value of the cash
flows and the cost of the investment - Usually, we cannot calculate the IRR directly,
instead we must use a trial and error process - For our example, the IRR is found by solving the
following
- In this case, the solution is 13.45
36IRR Decision Rule
37Problems with the IRR
- The IRR is a popular technique primarily because
it is a percentage which is easily compared to
the WACC - However, it suffers from a couple of flaws
- The calculation of the IRR implicitly assumes
that the cash flows are reinvested at the IRR.
This may not always be realistic. - Percentages can be misleading (would you rather
earn 100 on a 100 investment, or 10 on a
10,000 investment?)
38The Profitability Index
- The profitability index is the same as the NPV,
except that we divide the PVCF by the initial
outlay
- Accept all projects with PI greater than or equal
to 1.00 - For the example, the PI is