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Capital Budgeting
Introduction:
For company finance and its management is of at most important. In this competitive market the
company or organization must make wise decision of investing in right project to get back more
than what has been invested and sustain in the market.
Financial management has various options for this. Of these capital budgeting is one.
Purpose: This Report in particular has been addressed to Chief Financial Officer, Bayside Ltd
with reference to capital budgeting process and aim of my report is to concentrate on the process
and methodologies of capital budgeting that will be helpful in deciding about projects and which
project is implemented to get maximum returns.
Report:
Capital budgeting is the planning process used to determine whether a firm's long term
investments such as new machinery, replacement machinery, new plants, new products, and
research development projects are worth pursuing. It is budget for major capital, or investment,
expenditures.
Many formal methods are used in capital budgeting, including the techniques such as
These methods use the incremental cash flows from each potential investment, or project.
Importance:
Capital budgeting is of paramount importance in financial decision making. Special care should
be taken in making these decisions on account of the following reasons:Firstly capital
budgeting decisions affect the profitability of the firm and also have bearing on the competitive
position of the enterprise, mainly because of the fact that they relate to fixed assets. Capital
budgeting is also importance to avoid over-investment and under-investment in fixed assets.
Secondly, capital expenditure decision has its effect over a long time span and inevitably affects
the company's future cost structure. Long term investment decision are more difficult to take
because of decision extends to a series of years and beyond the current accounting period, due to
uncertainties of future and higher degree of risk.
Thirdly, Capital investment decision once made is not easily reversible without much financial
loss to the firm. It is because there may be no market for second hand plant and equipment and
their conversion to other uses may not be financially feasible.
Finding an exceptionally profitable project: Principle 5 says, “The curse of competitive markets
– Why it’s hard to find exceptionally profitable projects”, It is difficult to find exceptionally
profitable project because the market is very competitive. In the competitive market larger profits
cannot exist for a long period unless a industry can set up barriers to entry successfully. Usually
it so happen that when an industry is generating large profit in the market new entrants are
attracted as a result of this competition, the project will drive the profit margin down to the
required rate of return. To be exceptionally profitable project the industry has to invest in the
markets that are not perfectly competitive i.e. there is only one seller in the market and there is
no close substitutes for a good or services being produced by it. However it is hard to find such
project so the industry could either reduce competition by differentiating the products in some
way or by achieving a cost advantage over competitors.
Payback Period is a traditional method of capital budgeting. It is the simplest and most widely
employed quantitative method for appraising capital expenditure decisions. This method answers
the question - how many years will it take for cash benefits to pay the original cost of an
investment normally disregarding salvage value. However it ignores the time value of money and
does not discount the cash flows back to the present value.
In other words lesser the time to recover the initial cost of investing in project the better is the
project. According to the information provided by the Bayside Ltd maximum desired payback
period is three years for each project and initial cash outlay is $110000.
By calculating the payback period for each project A and B, It is observed that Project B has a
lesser payback period calculated as 2.75 years. As Bayside imposes an acceptable payback of
three years, project B is meeting the criteria in less the acceptable period. So it would be
beneficial to accept project B.
Although the payback period is used frequently, it does have some drawbacks. To overcome
these drawbacks, firm can use the discounted payback period method which is similar to the
traditional method except, that it uses discounted cash flows rather than actual annual cash flows.
Discounted payback period is defined as the number of years needed to recover the initial cost
from the discounted cash flows. Discounted Payback technique is that which takes into
consideration the time value of money while evaluating the cost and benefits of a project. In both
the projects, this method requires cash flows to be discounted at a certain rate of popularity
called cost of capital. Cost of capital or rate of return is the minimum discount rate that must be
earned on a project. It is used to discount to their present values, in order to explain that a rupee
received at a future date is worth less than a rupee received today.
By calculating the discounted payback for project A and project B, Project A recovers the initial
cost in 4.4 years (approx) in other words 4yrs and project B in 3.4years(approx) in other words 3
years . From the information given by Bayside LTD, it requires a maximum acceptable
discounted payback period of 3 years, so project B might be accepted because it is meeting
minimum criteria of 3 years.
Both the methods, Payback period and Discounted Payback period have certain limitations. To
start of both methods involve good amount of calculations and are complicated. They do not
correspond to the accounting concepts as they do not take into consideration cost and reserves.
These methods are not suitable while ranking projects with different capital outlays.
However discounted cash flow method is suitable for evaluating projects with uneven cash
flows. This method is quite valuable for long term capital decision.
The only major problem with the discounted payback period is setting the firm’s maximum
desired discounted payback period. This decision tells which project to accept and which one to
reject. Although the discounted payback period takes into account the concept of time value of
money in which it calculates the present value, its use is limited by the subjective process used to
select the maximum discounted payback period. In order to overcome this limitation we can use
net present value. As it can be observed that the net present value criterion is theoretically
superior and it is not much difficult to calculate.
Net Present Value (NPV) is defined as the total present value (PV) of a time series of cash flows.
It is a standard method for using Time Value of Money. The net present value of an investment
proposal is equal to the present value of its annual net cash flows less the investment’s initial
cost. The equation discounts each year’s cash flows to the present value, and then deducts the
initial cost, thus giving a net value to the investment in today’s dollar.
The rule of thumb with this method is that whenever the project’s NPV is greater than zero, the
project will be accepted and if it is less than zero it rejects the project. In case of mutually
exclusive projects, the project with higher NPV is accepted.
With the Bayside Ltd, it is observed that both are mutually exclusive alternative projects. NPV
of each project is calculated. According to calculations NPV of Project A $31740 and B is $
34191 respectively. As mentioned above since these are mutually exclusive projects, the project
with higher net present value is optimal .So it might be feasible to accept Project B which gives
the higher net present value.
There are also other methods which can used in capital budgeting in order to select the optimal
project which is beneficial to the company. One such method is Internal Rate of Return. IRR is
defined as the discount rate that equates the present value of the project’s future net cash flows
with the project’s initial cash outlay. The decision rule with IRR is, accept a project which is
greater than rate of return and reject when it is less than rate of return.
It is observed from calculation of IRR for Project A and B, it is beneficial to accept project B.
The IRR for project A is 20.96% and for Project B it is 23.9%. As per calculation Internal Rate
of Return (IRR) for project B is greater than Project A. Hence, as per the rule it might be optimal
for the Bayside Ltd to go with Project B.
Since it can be observed that cash out flow for both the projects are same and at given cost of
capital i.e. 12% we see that according to both the methods IRR and NPV , Project B is better
than that of Project A.
If by some reason company can afford to invest in both the projects, It would recommend that
both should be accepted, because both of the projects have one Positive NPV, IRR is greater than
required rate if return and also the Net difference between both the NPV’s is negligible.
Another technique that be used in deciding the feasible of project is Profitability Index (PI). This
Profitability index is also known as Profit investment ratio. It is also one of the tool for ranking
projects because it allows us to identify the amount of value created per unit of investment.
PI is the ratio of the present value of the future net cash flows to the initial outlay. The NPV
investment criterion gives a measure of the absolute dollar desirability of a project, whereas the
profitability index provides a relative measure of an investment proposal’s desirability. It
calculates the ratio of the present value of its future net benefits to its initial cost, in other words
the number of dollars of benefits per dollar of outlays.
According to capital budgeting rule it says that accept the project if profitability index is greater
than one and reject if it is less than one. According to calculations Project A, PI is 1.1981 and
Project B, PI is 1.311. From calculations of PI it can be concluded that Project B is more
beneficial than Project A. It should be noted that though both project’s PI is greater than one,
project B’s dollar value in return is more than that of Project A. It implies that project B gives
more returns than Project A.
Sometimes it is beneficial for the company to project calculations at different rate of returns so
that it can get a better picture about the individual projects. Also, an it helps in understanding the
relationship with rise and fall in rate of returns with in same projects. The below table represents
what happen when rate of return increases or decreases and its effect on NPV & PI both projects
separately and within the individual projects.
Change in the required rate of return affect the project’s internal rate of return?
No, the change in the required rate of return will not affect the project’s internal rate of return, as
IRR is the rate at which the PV (cash out flow) is equal to PV (Cash Inflows). That is NPV is
equal to zero at this rate. And required rate of return is the cost of the project or cost of financing
the project.
But the Change in Required rate of return can be compared with the IRR, as long as the Required
rate of return is less than that of the IRR, Required rate of Returns can be modified,
The only way IRR will change is by way of change is expected cash flows, i.e. increase or
decrease in expected cash flows will change the IRR
Modified Internal Rate is better option if the company is prepared to reinvest them at the rate of
cost of capital. But not all company’s can afford to do this as cash inflows are mapped to repay
the debt or capital that is borrowed,
Also, there shall be one IRR for one set of cash flows, but not all projects have same cash flows
as expected, there fore we think IRR is better option, as we assume no reinvestment plan.
Conclusion:
At the end of the report, I would like to conclude that irrespective of whichever methodologies
the Bayside company chooses to implement, Project B is found to be the most feasible option. As
it is observed from the above presentation that project B is meeting all the requisite criteria of
different methodologies. So it is optimal for the company to invest in Project B first and later on,
if financial permits could go for the other project.