Date post: | 03-Jan-2016 |
Category: |
Documents |
Upload: | simon-mcintosh |
View: | 36 times |
Download: | 0 times |
Capital Budgeting Decisions
What is Capital Budgeting?
The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.
The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.
Capital Expenditure includes:
Cost of acquisition of permanent assets as land and building, plant and machinery, goodwill etc.
Cost of addition, expansion, improvement or alteration in fixed assets.
Cost of replacement of permanent assets. Research and development project cost, etc.
Few Definitions on CB:
Charles T. Horngreen“ Capital Budgeting is long term planning for
making and financing proposed capital outlays”.
Richard and Greenlaw“ Capital Budgeting as acquiring inputs with long
term returns”.
Need and Importance of Investment Decisions
• Larger Investments• Long Term Commitments of Funds• Irreversible Nature• Long term effect on profitability• Difficulties of Investment Decisions• National Importance
Process
Capital Budgeting Process• Identification of Investment Proposal• Screening of Investment Proposal• Evaluation of various proposals– Independent proposals– Contingent or dependent proposals– Mutually exclusive proposals
• Fixing Priorities• Final Approval and Preparation of capital Expenditure
Budget• Implementing Proposal• Performance Review
Types of Investment/Cap Budgeting Decisions
• One classification is as follows:– Expansion of existing business– Expansion of new business– Replacement and modernisation
• Yet another useful way to classify investments is as follows:– Mutually exclusive investments– Capital Rationing Decisions– Accept and Reject Decisions (Independent)
Investment Evaluation Criteria
• Three steps are involved in the evaluation of an investment:– Estimation of cash flows– Estimation of the required rate of return (the opportunity
cost of capital)– Application of a decision rule for making the choice
Investment Decision Rule• It should maximise the shareholders’ wealth.• It should consider all cash flows to determine the true
profitability of the project.• It should provide for an objective and unambiguous
way of separating good projects from bad projects.• It should help ranking of projects according to their
true profitability.• It should recognise the fact that bigger cash flows are
preferable to smaller ones and early cash flows are preferable to later ones.
• It should be a criterion which is applicable to any conceivable investment project independent of others.
Evaluation Criteria or Methods of Capital Budgeting
• Non-discounted (Traditional Methods):– Payback Period (PB)– Discounted Payback Period (DPB)– Accounting Rate of Return (ARR)
• Discounted (Time-adjusted Methods):– Net Present Value (NPV)– Internal Rate of Return (IRR)– Profitability Index (PI)
Payback Method
• Payback is the number of years required to recover the original cash outlay invested in a project
• If the project generates constant annual cash inflows, the payback period can be computed by dividing cash outlay by the annual cash inflow. That is:
Formula
0Initial InvestmentPayback = =
Annual Cash Inflow
C
C
Assume that a project requires an outlay of Rs 50,000 and yields annual cash inflow of Rs 12,500 for 7 years. The payback period for the project is:
Payback=50000/12500 = 4 years
Payback Method
• Unequal cash flows In case of unequal cash inflows, the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay.
Acceptance Rule
• The project would be accepted if its payback period is less than the maximum or standard payback period set by management.
• As a ranking method, it gives highest ranking to the project, which has the shortest payback period and lowest ranking to the project with highest payback period.
Discounted Payback Period
• The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis.
• The discounted payback period still fails to consider the cash flows occurring after the payback period.
Accounting Rate of Return Method
Average incomeARR =
Average investment
The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly.
A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost.
Acceptance Rule
• This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.
• This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.
Net Present Value (NPV)• Cash flows of the investment project should be
forecasted based on realistic assumptions.• Appropriate discount rate should be identified to
discount the forecasted cash flows. The appropriate discount rate is the project’s opportunity cost of capital.
• Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.
• The project should be accepted if NPV is positive (i.e., NPV > 0).
Net Present Value Method
31 202 3
01
NPV(1 ) (1 ) (1 ) (1 )
NPV(1 )
nn
nt
tt
C CC CC
k k k k
CC
k
Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows. The formula for the net present value can be written as follows
Present value of Rupee oneYear 6 % 7 % 8 % 9 % 10 % 11 % 12 % 13% 14 %
1 .9434 .9345 .9259 .9174 09090 .90090 .8928 .8850 .8772
2 .89000 .8734 .8573 .8417 .8265 .8116 .7972 .7831 .7695
3 .8397 .8163 .7938 .7722 .7512 .7318 .7118 .6930 .6750
4 .7920 .7629 .7350 .7084 .6830 .6587 .6355 .6133 .5921
5 .7472 .7130 .6806 .6499 .6209 .5934 .5674 .5428 .5194
Calculating Net Present Value
2 3 4 5
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )
+ Rs 600(PVF ) + Rs 500(PVF
10)] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225
Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent.
Acceptance Rule
• Accept the project when NPV is positiveNPV > 0
• Reject the project when NPV is negativeNPV < 0
• May accept the project when NPV is zeroNPV = 0
• The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.
Problem :• A company has to consider the following
project:• Cash inflows: – Year 1 1000– Year 2 1000– Year 3 2000– Year 4 10000
Compute the net present value if the opportunity cost is 14 %
Calculation of NPVYear Cash inflows Present value PV of inflows
1 1000 0.877 877
2 1000 0.769 769
3 2000 0.675 1350
4 10000 0.592 5920
Total PV of inflows
8916
Less: outflows 10000
NPV - 1084
• A Firm whose cost of capital is 10 % is considering 2 mutually exclusive projects X and Y. the details of which are as follows:
• Compute the net present value at 10 %, profitability index and IRR of the two projects.
Year Project X Project Y
Cost 0 100000 100000
Cash inflows 1 10000 50000
2 20000 40000
3 30000 20000
4 45000 10000
5 60000 10000
Delhi machinery manufacturing company wants to replace the manual operations by new machine. There are two alternative models X and Y of the new machine. Using payback period, suggest the most profitable investment. Ignore taxation.
Machine X Machine Y
Original investment 9000 18000
Estimated life 4 5
Estimated savings in cost 500 800
Estimated savings in wages 6000 8000
Additional cost of maintenance
800 1000
Additional cost of supervision
1200 1800
Solution:Machine X Machine Y
Estimated savings in cost 500 800
Wages 6000 8000
Total savings 6500 8800Additional cost of maintenance
800 1000
Supervision 1200 1800
Total cost 2000 2800
Net inflows (annual) 4500 6000
Outflows 9000 18000
Payback period 2 Years 3 Years
SolutionCash flows PVF(10 %,n) Total PV
Year Project X Project Y . X Y
1 10000 50000 0.909 9090 45450
2 20000 40000 .827 16520 33040
3 30000 20000 .751 22530 15020
4 45000 10000 .683 30735 6830
5 60000 10000 .621 37260 6210
Total PV 116135 106550
Less: Cash Inflows
100000 100000
Net Present Value
16135 6550
`
• Machine A costs Rs 100000 payable immediately. Machine B costs 120000 half payable immediately and half payable in one year’s time. The cash receipts are as follows:
At 7 % opportunity cost, which machine
should be selected on the basis of NPV.
Year Machine A Machine B
1 20000 -
2 60000 60000
3 40000 60000
4 30000 80000
5 20000 -
Solution (machine B is better)Machine A
Machine B
Year Cash flows PVF(7%) PV(rs) Cash flows PVF(7%) PV(rs)
0 -100000 1.000 -100000 -60000 1.000 -60000
1 20000 0.935 18700 -60000 0.935 56100
2 60000 0.873 52380 60000 0.873 52380
3 40000 0.816 32640 60000 0.816 48960
4 30000 0.763 22890 80000 0.763 61040
5 20000 0.713 14260 - - -
NPV 40870 46280
NPV
StrengthsStrengths::• Time ValueTime Value• Considers all cash Considers all cash
flowsflows• Based on cash Based on cash
flowsflows
Weaknesses:Weaknesses:• Discount rate Discount rate
difficult to determinedifficult to determine• Ignores the Ignores the
difference in initial difference in initial cash outflowscash outflows
• Difficult calculationDifficult calculation
Internal Rate of Return Method
• The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implies that the rate of return is the discount rate which makes NPV = 0.
31 20 2 3
01
01
(1 ) (1 ) (1 ) (1 )
(1 )
0(1 )
nn
ntt
t
ntt
t
C CC CC
r r r r
CC
r
CC
r
IRR Solution
• Minimum Rate + NPV at lower rate Diff of both rates
NPV at higher –NPV at lower
X
Internal Rate of Return
StrengthsStrengths: : – Accounts for
TVM– Considers all
cash flows– Less
subjectivity
WeaknessesWeaknesses: : Assumes all cash flows reinvested at
the IRR– Difficulties with
project rankings and Multiple IRRs
Profitability Index Method It is also called as Benefit-Cost Ratio. It is the
relationship between present value of cash inflows and the present value of cash outflows.
Profitability Index = Present Value of Cash Inflows Present Value of Cash Outflows