Capital Budgeting

Capital Budgeting is the process by which companies allocate their capital for investments. The aim of Capital Budgeting is to assess whether it is worth while for a firm (in terms of returns) for making an investment. This investment can be in the form of new machinery, replacement machinery, new plants, new products, and research development projects. Capital Budgeting is a budget for major investment or e penditures. !ollowing methods are used"# 1. PAYBACK PERIOD METHOD $ayback period method comes under the traditional or non#time value techni%ue of appraising the investment proposals. The term pay#back refers to the period in which the project will generate the necessary cash to recoup the initial investment. Even cash l!"s# !or e ample, if a project re%uires &'(,((( as initial investment and it will generate an annual cash inflow of &),((( for ten years, the pay#back period will be * years calculated as follows" $ay#back period + ,nitial ,nvestment - .nnual cash inflows + &'(,((( - &),((( + * years. The annual cash inflow is calculated by taking into account the amount of net income on account of the asset or project before depreciation but after ta ation. The income so earned if e pressed as a percentage of initial investment, is termed as /0nadjusted rate of return/. ,n the above case, it will be calculated as follows" $nad%usted &ate ! &etu&n + .nnual returns - ,nitial investment 1 2(( + &),((( - &'(,((( 1 2(( + ')3 $neven Cash l!"s# ,n cases of uneven cash flows, the cumulative cash inflows will be calculated and by interpolation the e act pay#back period can be calculated. !or e ample, if the project re%uires an initial investment of &'(,((( and the annual cash inflows for ) years period are &4,(((, &5,(((, &),(((, &*,((( and &*,((( respectively, the pay#back period will be calculated as follows" 6ear 2 ' 7 * ) Cash inflows &4,((( &5,((( &),((( &*,((( &*,((( Cumulative Cash inflows &4,((( &2*,((( &28,((( &'7,((( &'9,(((

The above table shows that in 7 years, the project recovers &28(((. :o, &2((( is left out of the initial investment. ,n the *th year, the cash inflow is &*(((. This means that the pay#back period is between the 7rd and *th years, ascertained as follows" $ay#back period + 7 years ; &2,((( - &*,((( + 7.') years or 7 years and 7 months. Accept'Re%ect c&ite&i!n# . project will be accepted if its pay#back period is lesser than the cut#off rate pre#determined by the management. ,t would be rejected if the pay#back period is more than the cut#off rate. .mong

mutually e clusive or alternative projects, where the pay#back periods are lower than the cut#off period, the project with shorter pay#back period would be selected. ,n case there are budget constraints, the procedure would be to rank the projects in the ascending order of pay#back periods and select the first < number of projects which the budget provision permits. Me&its ! Pa()*ac+ pe&i!d# 2. This method is very useful in evaluation of those projects which involve high uncertainty. $olitical instability, rapid technological development of cheap substitutes etc., are some of the reasons which discourage one to take up projects having long gestation period. $ay#back period method is useful in such cases. '. This method makes it clear that no profit arises till the pay#back period is over. This helps companies in deciding when they should start paying dividends. 7. :imple to understand and easy to calculate. *. This method reduces the possibility of loss on account of obsolescence as the method prefers investment in short#term projects. De,e&its ! Pa()*ac+ pe&i!d# 2. This method ignores the returns generated by a project after its pay#back period. '. This method does not take into account the time value of money. -uita*ilit(# 2. !irms suffering from li%uidity crisis. '. !irms enhancing short#term earning performance. .. DI-CO$/TED PAY)BACK PERIOD METHOD# To overcome the de#merit of time#value being ignored, a more advanced method over the pay#back period method, called as discounted pay#back period method can be applied which considers the time value of money. E0a,ple# . project with initial investment of &'(,((( and cash inflows of &),((( for 2( years, if discounted at 2)3, the discounted pay#back period would be" 6ears 2 ' 7 * ) 4 9 Cash inflows &),((( &),((( &),((( &),((( &),((( &),((( &),((( $= factor > 2)3 (.5484 (.9)42 (.4)9) (.)925 (.*89' (.*7'7 (.79)8 $= of Cash Cumulative Cash inflows inflows &*,7*5.(( &*,7*5.(( &7,95(.)( &5,2'5.)( &7,'59.)( &22,*24.(( &',5)8.(( &2*,'9).(( &',*54.(( &24,942.(( &',242.)( &25,8''.)( &2,598.)( &'(,5('.((

Balance to be recovered in the 9th year + '(,((( # 25,8''.)( + &2(99.)( $ayback period + 4 years ; 2,(99.)( - ',242.)( + 4.) years. 1. /ET PRE-E/T 2A3$E METHOD ?$= may be defined as the e cess of present value of the project cash inflows over that of outflows. ,n case of this method, cash inflows and outflows associated with the project are first worked out. The present values of these cash inflows and outflows are then calculated at the rate of return acceptable to the management, generally the cost of capital. :ome points to note about ?$=" 2. Cash outflows represent the investment and commitments of cash in the project at various points of time. '. The working capital is taken as the cash outflow in the year the project starts commercial production and generally would be released at the end of the project life and taken as cash inflow. 7. $rofit after ta but before depreciation represents cash inflows. *. ,f there is any salvage value associated with the asset utili@ed for the project, it would be taken as cash inflow at the last year. ). Though opportunity costs do not represent real cash flows, it has to be treated as cash outflow for the purpose of capital decision appraisal because they represent the opportunity foregone. 4. ,f there is an e pected inflation, the future cash flows have to be adjusted for inflation and for discounting purpose the discount rate has to be multiplied by the general inflation rate for calculation of ?$=. 9. The ?$= is the difference between total present value of future cash inflows and the total present value of future cash outflows. The net present value ?$= method is an important criterion for project appraisal. $rofitability of a project is evaluated by this method. ,t is also called as present value method. ?et present value is calculated by using an appropriate rate of interest which is the capital cost of a firm. This is the minimum rate of e pected return likely to be earned by the firm on investment proposals. To find out the present value of cash flows e pected in future periods, all the cash outflows and cash inflows are discounted at the above rate. ?et present value is the difference between total present value of cash outflows and total present value of cash inflows occurring in periods over the entire life of project. Ahen the net present value is positive, the investment proposal is profitable and worth selecting. But if it is negative, the investment proposal is non#profitable and reject able. The method to compute the net present value inde of different investment proposals is as under. ?$= + Total $resent =alue of .ll Cash !lows ,nitial ,nvestment

?$= method considers the time value of money. ,t compares time value of cash flows. ?$= + $resent =alue of Bross Carnings D ?et Cash ,nvestment ?$= can be found out from the following"

?$=

.2 (2;r) 2

.' (2;r) '

EE ; .n (2;r) 7

#C

Ahere .2, .' are cash inflows at the end of first year and second year respectively, n is the e pected life of investment proposals, r is Fate of discount which is e%ual to the cost of capitalG C is present value of costs. Thus ?$= + :um of Hiscounted Bross Carnings # :um of Hiscounted =alue of Cost. Illust&ati!n 1 Iet us have the initial investment cost of a project as &'(( million, cash inflows in the forth coming years is &')( million and the market rate of interest is '( 3 pa. Hetermine the ?$= ?$= + + + Hence /P2 is 4.11 ,n case the ?$= is positive, the project should be accepted, otherwise rejected. ,f ?$= J Kero, .ccept the project ,f ?$= L Kero, Feject the project. C ample" :ay, a company is considering two alternativesG whether to procure Machine . or Machine B. The cost of both the machines is &)4,2') with e pected ) years of life and &7,((( salvage value for Machine . only. The cash inflows after ta ation are given below" 6ear 2 6ear ' 6ear 7 6ear * 6ear ) Machine ." &7,79) &),79) &9,79) &8,79) &22,79) Machine B" &22,79) &8,79) &9,79) &),79) &7,79) ')( (2;(.'()2 ')( 2.' '(5.77 # '(( # '(( # '(( + 5.77

Hepreciation per year is &2(,4') for Machine . and &22,'') for Machine B. .ssume the discount factor is 2(3. :tep 2" To calculate Cash flows after ta (i.e., add back depreciation to get real cash flows). :tep '" Iocate the $= factors for 2(3 for years 2 to ) in the $resent value table. :tep 7" Multiply the cash flows after ta with $= factors and add up all the $=Ns to get the total $resent value of future cash inflows. :tep *" Calculate ?$= by subtracting $= of cash inflows by $= of cash outflows. :tep )" Hecision making based on ?$=.

6ears 2 ' 7 * )

$= factor > 2(3 (.8(82 (.5'4* (.9)27 (.457( (.4'(8 T!tal P2

C!.T $= Machine Machine . . 2*,(((.(( 2',9'9.*( 24,(((.(( 27,'''.*( 25,(((.(( 27,)'7.*( '(,(((.(( 27,44(.(( '),(((.(( (incl. 2),)''.)( salvage) 546577.89

C!.T $= Machine Machine B B '',4((.(( '(,)*).44 '(,4((.(( 29,('7.5* 25,4((.(( 27,89*.25 24,4((.(( 22,779.5( 2*,4((.(( 8,(4).2* 816:;5.5.

?$= of Machine . + &45,4)).9( # &)4,2') #J &2',)7(.9( ?$= of Machine B + &92,8*4.4' # &)4,2') #J &2),5'2.4' .ccept-Feject Hecision" ,n this e ample, both of the ?$=s are positive. .mong choosing alternative projects, the project which has the highest ?$= should be chosen. ,n this case, Machine B has the highest ?$= and hence it will be chosen. This is a perfect example which gives importance to time value of money. If these calculations were not done, one would simply total all the cash flows which would be the same for both the machines if adjustment for depreciation is not made. And further, Machine A gives a salvage value of $ !!! and would be straight away preferred and a wrong decision would have been made. Thus the calculation of time value of money is significant. ;. I/TER/A3 RATE O< RET$R/ METHOD This method refers to the percentage rate of return implicit in the flows of benefits and costs of projects .. Margin defines the internal rate of return ,FF Oas the discount rate at which the present value of return minus costs is @eroP. ,n other words, the discount rate which e%uates the present value of project with @ero, is known as ,FF. Thus, ,FF is the discounted rate which e%uates the present value of cash inflows with the present value of cash outflows. ,FF is also based on discount techni%ue like ?$= method. 0nder this techni%ue, the future cash inflows are discounted in such a way that their total present value is just e%ual to the present value of total cash outflows. ,t is assumed that the management has knowledge of the time schedule of occurrence of future cash flows but not of the rate of discount. ,FF can be measured as" ,FF + .2 (2;r) 2 ; .' (2;r) ' EE ; .n (2;r) 7 #C +(

Ahere, .1, .' are the cash inflows at the end of the first and second years respectively. .nd the rate of return is computed as follows. C + .2 (2 ; r) n

Ahere, 2 is the cash outflow or initial capital investment, .2 is the cash inflow at the end of first year, r is the rate of return from investment.

Illust&ati!n ; Iet us assume Capital invested in a project as &2(( million. They become &2)( million at the end of first year. Hetermine the rate of return. 2(( + 2)( (2;r) 2 + + + + 2)( )( )( 2(( )(3

2(( ; 2((r 2((r r

Hence the &ate ! &etu&n is 79= The Ce&taint( E>uivalent Meth!d This method helps to ascertain the uncertainty in the investments of the project. .ccording to this method, the estimated cash flows are reduced to a conservative level by applying a correction factor termed as certainty e%uivalent co#efficient. The correction factor is the ration of riskless cash flow to risky cash flow. Certainty C%uivalent Co#efficient Illust&ati!n 7 :uppose if a project is e pected to generate a cash of &'*,((( and the project is risky. But the management senses that it will get at least a cash flow of &24,5((. Hetermine the Certainty e%uivalent co# efficient. Certainty C%uivalent Co#efficient + + 24,5(( '*,((( (.9 + Fiskless Cash !low Fisky Cash !low

Hence the Ce&taint( E>uivalent C!)e icient is 9.8 ,nternal rate of return is that rate at which the sum of discounted cash inflows e%uals the sum of discounted cash outflows. ,n other words, it is that rate which discounts the cash flows to @ero. ,t can be stated in the form of a ratio as follows" Cash inflows + 2 Cash outflows

Thus in case of this method, the discount rate is not known but the cash outflows and inflows are known. !or e ample, if a sum of &5(( invested in a project becomes &2,((( at the end of a year, the rate of return comes to ')3 calculated as follows" CQ! + C,! - (2 ; r) Ahere, CQ!+Cash outflow C,! +Cash inflow r +,nternal rate of return 5(( + 2((( - (2 ; r)G 2 ; r + 2((( - 5((G 2 ; r + 2.')G r + (.') or ')3. ,n case if the return is over number of years, the calculation would take the following pattern" ,n case of conventional initial investment"

Ahere, C! +Cash inflows CQ!+Cash outflow (initial) r +,nternal rate of return n +last year of the project

,n case of non#conventional cash flows (i.e., when there are a series of cash outflows and inflows)

+ (CR0.TC)

Accept'Re%ect C&ite&i!n# . project would be %ualified to be accepted if ,FF e ceeds the cut#off rate pre#determined by the management. Benerally the cut#off rate would be the cost of capital of the company. Ahile evaluating two or more projects, a project giving a higher ,FF would be preferred.

Meth!d ! calculati!n# ,FF is calculated according to two methods on the basis of Tabular values as follows" 2. Ahere cash inflows are uniform" ,FF can be calculated locating the !actor in .nnuity Table ,,. !actor is calculated as ,nitial investment - Cash inflow per year. '. Ahere cash inflows are not uniform" ,FF is calculated by trial calculations in an attempt to compute the correct interest rate. Cash inflows are to be discounted by a number of trial rates. The first trial rate may be calculated on the basis of factor calculation which is done when cash inflows are uniform. But in this case, factor is calculated by dividing the initial investment by average annual cash inflows. ,n case the $= of cash inflows e ceeds the $= of cash outflows, a trial rate higher than the first trial rate will be used and this process will continue will the two flows are more or less set off each other and this rate will be the ,FF. E0a,ple# Iet us calculate the ,FF of e%uipment which re%uires an initial investment of &4,(((. The annual cash inflow is estimated as &',((( for ) years. -!luti!n# .nnual cash inflows are uniform. :o, factor + &4,(((-&',(((+ 7. This factor of 7 should be located in Table ,, in the line of ) years. The discount percentage would be somewhere between 253 (&7.2'9 $= of annuity &2) and '(3 (&'.88 $= of annuity of &2). By e act interpolation, we can find out the e act rate. But in this case, we can straight away take ,FF as '(3 as &'.88 is closer to factor 7. 7. PRO<ITABI3ITY I/DE? METHOD This is a refinement of the ?et $resent =alue method. ,nstead of working out the net present value, a present value inde is found. ,t can be put up in the form of the following formula" <!&,ula# $rofitability inde + $resent value of future cash inflows 1 2(( $resent value of future cash outflows De initi!n# $rofitability inde is yet another time#adjusted method which measures the present value of returns per rupee invested. The profitability inde is also called as Benefit#cost ratio or e cess present value inde . ,t may be defined as the ratio which is obtained by dividing the $= of the future cash inflows by the present value of cash outflows. Accept'Re%ect C&ite&i!n# 0nder this method, a project would be %ualified to be accepted if its $, e ceeds one. ,f $, e%uals one, the firm is indifferent to the project. ,f $, is lesser than one, the project would be rejected. Ahen two or more projects are compared, the project which has the highest $, will be considered. This is because, higher the $,, greater is the profitability of the project. I,p!&tance ! PI in evaluati!n ! p&!%ects# $rofitability ,nde method has got similar benefits like the ?et $resent value method. 2. ,t considers time value of money. '. ,t takes into account the cash inflows and outflows throughout the economic life of the project.

7. The benefits of considering cash flows rather than accounting profit also applies to this method. *. ,t is capable of handling any discount rate to determine the present value of cash flows to suit the prevailing market condition. ). Though $, method is almost similar to ?$= method and has got the same advantages, the former is still a better measure because $, measures the relative profitability and ?$=, being an absolute measure. E0a,ple# C cess present value inde provides ready comparison between investment proposals of different magnitudes. !or e ample, $roject . re%uiring an investment of &2((,((( shows e cess present value of &'(,((( while another project B re%uiring an investment of &2(,((( shows an e cess present value of &),(((. ,f absolute figures of net present values are compared, project . may seem to be profitable. Sowever, if e cess present value inde method is followed, project B would prove to be profitable. $resent value inde for $roject . + &2'(,((( - &2((,((( 1 2(( + 2'(3 $resent value inde for $roject B + &2),((( - &2(,((( 1 2(( + 2)(3. MOD$3E)7 7.1 Invest,ent App&aisal Techni>ues Most businesses have a choice of a range of investment projects and they need to have a basis for comparing them to evaluate which is the best. Sere are the most widely used methods for assessing candidate projects in terms of their return performances. Pa(*ac+ pe&i!d The payback period is the simplest tools for appraising different investment projects. To be able to compare projects we need to have information on how much the project costs and the e pected net cash flows or income streams that it is likely to generate over its lifetime. !ollowing is an e ample to this method. IetTs say that a firm is planning to install a new computeri@ed stock control system. The e pected net cash flow (income less e penses) from the system is as follows and the e penses to be incurred for this system is U')(,(((. 6ear ?et cash flow 2 )(,((( ' 4),((( 7 4),((( * 9(,((( ) 9),(((

Ae can see that the payback period on this system is e actly four years. This is because cumulative returns for the first * years of this project is e%ual to the cost of it. Qne can do this analysis in terms of months as well, if the figure does not come out as an e act number of years. Ave&age &ate ! &etu&n

The average rate of return, like the payback period method, looks at the e pected net cash flows (income # e penses) of the investment project. ,t then measures the average net return each year as a percentage of the initial cost of the investment. IetTs look at an e ample. . firm is looking at buying a new automatic painting machine. The cost of the machine is '((,((( and the e pected net cash flows are" 6ear ?et cash flow 2 )(,((( ' )),((( 7 4),((( * 9),((( ) 9),(((

The total return from the project over the five years is 7'(,((( (the sum of the five years). ,f we subtract the original cost of '((,((( from this, we get the net return from the investment to be 2'(,(((. This took ) years to earn and so the annual return is 2'(,((( divided by ) which is '*,((( per annum. To get the average rate of return, we use the following formula" ?et return per annum .verage rate of return + ###################### 2(( Capital cost !rom the figures above this gives us" .verage rate of return + '*,((( 2(( - '((,((( + 2'3 This suggests that every U2 worth of investment yields an average 2'p return each year Disc!unted cash l!" Hiscounted cash flow (HC!) is the most realistic of the three methods, but has the main advantage that it takes account of the fact that returns in the future may be worth less than the same return now. .s a result of this it may gives us far less amount of return than the other methods are projecting. To use this to value an investment project, we would go through the following steps"

Choose an estimated discount rates for the years that project is run (this may depend on e pected future interest rates in the market). !ind the present values by multiplying the e pected net cash flows with their discount factor. .dd together all the present values from step ' and subtract the capital cost to give us the net present value.

IetTs do an e ample to see how this works. . firm is thinking of buying a machine costing U'((,((( and the e pected net cash flows are" 6ear ?et cash flow 2 )(,((( ' )),((( 7 4),((( * 9),((( ) 9),(((

,f we follow the three steps above, we will get"

-tep 1 IetTs choose a discount rate of 2(3. This means that our discount factors are" 6ears in future 2(3 -tep . ,f we multiply the e pected net cash flow by the discount factor, we get" 6ear ?et cash flow 2(3 $resent value (U) -tep 1 ,f we add all these present values together and subtract the capital cost, we get" U'79,*8) # U'((,((( + ?et present value of U79,*8) This represents %uite a small return of 25.93 (79,*8)-'((,((() over 7 (ea&s on the original investment. The average rate of return calculation gives us a result of 2'3 pe& annu, on these same figures and so discounting the future value of returns does give a very different picture. $.6B.CV Aorks out how long it takes to repay the initial investment. e.g. ,nvestment .. costs U2((. .nnual return of U') Iength ) years YEAR ( 2 ' 7 * ) /ET CA-H <3O@ C$M$3ATI2E CA-H <3O@ AA//$A3 RET$R/B ACA-H I/ <3O@B #2(( ') ') ') ') ') #2(( #9) #)( #') ( ') 2 )(,((( (.8(8 *),*)( ' )),((( (.5'4 *),*7( 7 4),((( (.9)2 *5,52) * 9),((( (.457 )2,'') ) 9),((( (.4'2 *4,)9) 2 (.8(8 ' (.5'4 7 (.9)2 * (.457 ) (.4'2

$ayback is * years.

:ometimes it is necessary to calculate the month of payback when the figure is reached part way through the year. To do this you would you use formula"

AD2A/TACE

Casy to calculate Casy to understand Most relevant to businesses with cashflow problems Cmphasises speed of return D good in rapidly changing markets

DI-AD2A/TACE

,gnores money received after payback Can be difficult to establish a target payback period HoesnNt consider the future value of money :hort term approach

.=CF.BC F.TC Q! FCT0F? Compares profit with money invested.

To work this out, break it down into stages.

Calculate lifetime profit + total inflows D outflow Hivide by the number of years 0se the formula

e.g. ,nvestment . cost U2(( U') return for ) years

2. ,nflow D outflow U2') # U2(( + U')

'. Hivide by the number of years. ')-) + )

7. 0se formula ) - 2(( < 2(( + )3 return

AD2A/TACE

$ercentage provides easy comparisons across projects :hows the profitability of a project

DI-AD2A/TACE

Sarder and more time consuming ,gnores time value of money

?CT $FC:C?T =.I0C (H,:CQ0?TCH C.:S !IQA) This takes into account the time value of money. ,t is based on the principle that money is worth more than it is in the future. The principle e ists for two reasons"

Fisk D money in the future is uncertain Qpportunity cost D Money could be in an interest account earning interest.

Disc!unting This is the process of adjusting the value of money from its present value to its value in the future. The key to discounting is the rate of interest. The business chooses the most appropriate rate for the life of the project. ,t then identifies the discounting factor. The amount of money is then multiplied by the discounting factors to convert it to its net present value.

e.g. $roject . U2(( U') return ) years

YEAR /ET RET$R/ DI-CO$/T <ACTOR /ET PRE-E/T 2A3$E ( 2 ' 7 * ) #2(( ') ') ') ') ') ( (.8)' (.8(9 (.54* (.5'7 (.95* #2(( '7.5 ''.49) '2.4 '(.)9) 28.4 + U2(5.')

U2(5.') M,?0: ,?,T,.I CQ:T (U2(() + U5.') $rofit + U5.') AD2A/TACE

Considers the time value of money Feducing discounting rate reduces future monies more heavily Qnly one method that gives a definitive answer $ositive return D it is worth doing

DI-AD2A/TACE

Time consuming More difficult to understand Based on an arbitrary choice of interest rate

R0.I,.T,=C !.CTQF: ,nvestment appraisal techni%ues consider the financial results but there are other factors to be considered. These will be different for every organisation.

The aims of the business The reliability of the date The economy ,mage :AQT (strengths, weakness, opportunities, threats) analysis $C:T analysis SFM issues :takeholder analysis .nything else that needs to be considered