CAPITAL BUDGETING DECISIONS

LEARNING OBJECTIVES
Understand the nature and importance of investment decisions
Explain the methods of calculating net present value (NPV)
and internal rate of return (IRR)
Show the implications of net present value (NPV) and
internal rate of return (IRR)
Describe the non-DCF evaluation criteria: payback and
accounting rate of return
Illustrate the computation of the discounted payback
Should we
build this
plant?
CAPITAL BUDGETING DEFINTION

CB : Capital budgeting is the long term planning for making and financing
proposed capital outlays

CB : CB involves the planning for assets, the returns from which will be
realized in future time periods

CB : consists in planning for development of available capital for the
purpose of maximizing the long term profitability.

CB : the capital expenditure budget represents the plans for the
appropriations and expenditures for fixed assets during the budget period

CB : the aspect of taking the financial decision with regard to fixed assets
is called capital budgeting.

CB : is the process of deciding whether or not to
commit resources in projects whose costs and benefits
are spread over several time periods.


CB: it involves a current investment in which the
benefits are expected to be received beyond one year in
the future.

CB: consists in planning for development of available capital
for the purpose of maximizing the long term profitability (
ROI ) of the firm.

CB : refers to the total process of generating, evaluating,
selecting and following up on capital expenditure alternatives


CB : is concerned with the allocation of the firms scarce
financial resources among the available market
opportunities. The consideration of investment
opportunities involves the comparison of the expected
future streams of earnings from a project with the
immediate and subsequent streams of expenditure for it.

CB : other names include capital expenditure
management / long-term investment decisions and
management of fixed assets are generally used
interchangeable.
Meaning of Capital Budgeting :
CB means planning the capital expenditure in acquisition of fixed (
capital )assets such as land, building, plant or new projects as a
whole.

CB includes replacing and modernizing a process, introducing a new
product and expansion of eth business.

CB involves the preparation of Detailed project report and cost &
revenue statements indicating eth profitability.

The project which gives the highest ROI is to be selected and then
investment is to be made in such a project as to maximize the
profitability of the firm.
Nature of Investment
Decisions
The investment decisions of a firm are generally known as the
capital budgeting, or capital expenditure decisions.

The firms investment decisions would generally include
expansion, acquisition, modernisation and replacement of the
long-term assets. Sale of a division or business (divestment) is also
as an investment decision.

Decisions like the change in the methods of sales distribution, or
an advertisement campaign or a research and development
programme have long-term implications for the firms
expenditures and benefits, and therefore, they should also be
evaluated as investment decisions.
FEATURES OF CAPITAL BUDGETING :
Investments capital expenditure plans involve a huge investment in
fixed assets

Long-term capital expenditure, once approved, represents long term
investment that cannot be reversed or withdrawn without sustaining a loss.

Forecasting preparation of capital budget plans involve forecasting of
several years profits in advance in order to judge the profitability of
projects

Serious consequences in view of the investment of large amount for a
fairly long period of time, any error in the evaluation of investment
projects may lead to serious consequences, financially and otherwise and
may adversely affect the other future plans of the organization
Features of Investment
Decisions
The exchange of current funds for future benefits.

The funds are invested in long-term assets.

The future benefits will occur to the firm over a
series of years.
NEED AND SIGNIFICANCE ( importance ) OF CAPITAL
BUDGETING :
substantial expenditure hasty & incorrect decisions losses & failure of the firm

Long term implications cost / future benefits / growth of the firm / profit

Irreversible decisions capital goods & their conversion use may not be
financially feasible

Complexity quantification of future events involves application of statistical &
probabilistic techniques careful judgment & application of mind is necessary

Risk longer time period of returns --. Greater risk & uncertainty si associated
with cash flows.

Surplus funds are raised with certain costs there is a need to obtain a surplus
over and above the cost of funds only then investment is justified.
Long-term commitment of funds this will increase in financial risk

Long-term impact on profitability CBDs will shape the future revenue
streams and the profitability of operations

Most difficult to make Long term investment decisions require an
assessment of future events which are uncertain it is very difficult to
predict the probable future events, the probable benefits & costs
accurately in quantitative terms because of political, social and
technological factors.

Wealth maximization of shareholders.

Cash forecasts


OBJECTIVES OF CAPITAL BUDGETING
CB aims at deciding the most profitable among the
numerous investment proposal available.

CB decides the most suitable among different sources of
finance on the basis of capital market constraints.

The growth and expansion of the firm and modernization
can be taken care of.
to evaluate the relative worth of capital projects and to rank
them in order of preferences
To ensure efficient control over large investments and
expenditures
To provide cash needs for meeting capital project programs
To analyze the impact of capital expenditure on profitability of
the enterprise
To facilitate long-range planning
To fix priorities on expenditure to make optimum use of
available resources.
Advantages Of Capital Budgeting :
At any given time, numerous investment proposals may be available. CB
evaluates them and ranks them as per merit. This enables management to decide
on implementing appropriate proposals.

The limited funds available can be most effectively used.

The timing and actual execution of each project can be adjusted to changes in
capital market.

Different sources of finance can be considered and judicious selection of sources
can reduce overall cost of capital.

CB can take care of the proportion of debt and equity in the capital structure and
the resulting capital gearing.

In tight money situations, capital rationing can be followed not to waste scarce
funds avilable.
FACTORS INFLUENCING CB DECISIONS :
Initial investment this equals the cash outflow at the initial stage &
net salvage value of old assets if any.
II = cost of new machines purchased + investment in WC salvage
value of old assets if any.
Cash flows after tax it indicates income generated by the projects at
various points of time.
CFAT = profit before depreciation after tax

Terminal cash inflows cash inflows at the end of the project e.g
recovery of working capital investment in the project & salvage value of
fixed assets

Time value of money PV of future cash inflows will have to be
ascertained by discounting the same at the appropriate discount rate.
Discount rate it is the cut-off rate for capital investment
evaluation. A project which does not earn at least the cutoff
rate should be rejected. Usually the rate used for discounting is
the WACC.

PV factor and Annuity factor tables these two tables are
used for calculation of PV of future cash inflows
PV annuity factor table can be used in case of uniform cash inflows
during the project life
PV factor table can be used if the cash inflows are not uniform.

TYPES OF CAPITAL BUDGETING DECISIONS :
1. On the basis of firms existence :
CBDS are taken by both newly incorporated firms as well as by existing
firms
These decisions may be :
A. replacement and modernization decisions these 2 decisions are also
known as cost reduction decisions.
B. Expansion decisions -> growth in the demand of product line firms
consider proposal to add capacity to existing product line
C. Diversification decision firms may be interested to diversify into
new product lines, new markets. The finance manager is required to
evaluate not only the marginal cost & benefits but also the effect of
diversification on the existing market share and profitability.
Both the expansion and diversification decision may also be known as revenue
increasing decisions.
2. On the basis of Decision situation :
1. Mutual exclusive decisions if two or more alternative
proposals are such that the acceptance of one proposal will
exclude acceptance of the other alternative proposal
2. Accept-Reject criterion when proposals are
independent and do not compete with each other. The firm
may accept or reject a proposal on the basis of a minimum
return on the required investment.
3. Contingent decision these are independent proposals,
the investment in one proposal requires investment in one or
more other proposals.
E.g : if the company decides to set up a factory in a remote area, it
may have to invest in infrastructure also, such as building of roads,
houses for employees.
3. Other capital expenditure projects :
Non profit projects fire fighting equipment , exhaust fans,
safety helmets for workers in business premises. ( nothing can
be expected as return on such projects )

Projects on which a return is difficult to measure :
Safety precautions
Welfare projects
Service department projects
Research and development
Educational projects
Types of Investment
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
Independent investments
Contingent investments
. An Example of Mutually
Exclusive Projects
BRIDGE vs. BOAT to get products across a river.
Projects are: mutually exclusive, if the cash flows of one can be adversely impacted by
the acceptance of the other.
Projects are: independent, if the cash flows of one are unaffected by the acceptance of
the other.
Investment Evaluation
Criteria
Three steps are involved in the evaluation of an
investment:
1. Estimation of cash flows
2. Estimation of the required rate of return (the
opportunity cost of capital)
3. 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 help to choose among mutually exclusive projects that project
which maximises the shareholders wealth.
It should be a criterion which is applicable to any conceivable
investment project independent of others.
CAPITAL BUDGETING PROCESS :
Identification of investment proposals in the light of
financial and risk policies of the organization send proposals
to the capital expenditure committee for consideration

Screening of proposals based upon corporate strategies or
selection criterion of the firm and also do not lead to
department imbalance

Evaluation of proposals in terms of cost of capital / ROI.
Various methods such as PBP, ARR, IRR, NPV are employed
to evaluate the proposals
Fixing priorities : only economic & profitable proposals are
given green signal to go ahead. All proposals are ranked and
priorities are ranked and priorities are given in the following
order :
Current & incomplete projects are given first priority
Safety projects and projects necessary to carry on the legal
requirements.
Projects for maintaining present efficiency of the firm
Projects for supplementing the income
Projects for the expansion of product line
Final approval : projects finally recommended by the committee are sent to
the top management along with the detailed report, both of capital
expenditure and of sources of funds to meet them.

Implementing proposals : when proposals are finally selected funds are
allocated to them , such formal plan for the allocation of funds is called the
capital budget. A monthly report showing the amount allocated, amount
spent, amount approved but not spent should be prepared and submitted to
the controller

Follow- up : finally a system of following up the results of completed
projects should be established. Such follow up comparison of actual
performance with budgeted data will ensure better forecasting and will also
help in sharpening the technique of forecasting.
RELEVANT DATA :
Amount of investment outlays that may include initial investment outlays
and subsequent investment outlays

The economic life of the project duration of the earnings or cash flow
generated by the project

Revenues and cost to estimate the future profits or cash flows

The marginal tax rate of the firm applicable to the project

Scrap or realizable value if any at the end of the project life

Required rate of return or cost of capital of the firm to take it as a decision
criterion
Additional working capital fro supporting the project.
FORMAT OF CAPITAL BUDGETING : Specimen of
capital budget is given as under :
Date------
Company ---Ltd
Proposal No :-------
From :-------------------
Division /Section -----------------

REPORT TO THE COMMITTEE ( Rs)
Introduction
Need / importance of the project
Duration of the project
Timing : commencement ----------, Completion ------------------
Prepaid expenditures :
Cost of assets Rs---------------
Freight & delivery charges Rs-----------------
Cost of installation Rs-------------------
Miscelleaneous expenses Rs--------------------
Total cost : Rs----------------------------

Increased in earnings ( estimated ) : Rs ------------------------
Scheduled profitability :
Initial rate of return
Payback period
Discounted payback period
Accounting rate of return
Remarks of capital expenditure committee

Dated :----------------------
Chairman of the committee :---------------------------
TECHNIQUES OF CAPITAL BUDGETING :
TECHNIQUES
Traditional /
Non discounting
Discounted cash flow /
Time adjusted methods
Payback period ARR NPV IRR PIM
Evaluation Criteria
1. Discounted Cash Flow (DCF) Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
2. Non-discounted Cash Flow Criteria
Payback Period (PB)
Discounted payback period (DPB)
Accounting Rate of Return (ARR)
Pay back period method :
Sometimes called as pay-off or payout
PBP determines the length of time required to recover the intial outlay of a
project
It is the period within which the total cash inflows from the project equals
the cost of investment in the project.
The management sets a Standard PBP to be maintained in all investment
projects.
Individual projects could be ranked based on the PBP for necessary
considerations.
Decision on project selection is as follows:
PBP ( specified project ) < PBP standard accept the project
PBP ( specified project ) > PBP standard Reject
PAYBACK
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:



C
C
Inflow Cash Annual
Investment Initial
= Payback
0
=
Formula :

In case of uniform CFAT ( profit after tax & depreciation ) :
PBP= Initial investment / CFAT p.a

Incase of differential CFAT for various years :
Compute cumulative CFAT at the end of each year
Find out the year in which cumulative CFAT exceeds initial investment
Payback period = time at which cumulative CFAT=initial investment
Merits of PBP :
It is very easy to apply , calculate and interpret
It is most useful when cost is not high and the capital project
is completed in a short period
It focuses on earlier returns and ignores distant returns
It is useful in evaluating those projects which involve high
uncertainty.
It considers the liquidity as well as solvency of a firm as a
guiding principle in the CBDs.
It gives an indication to a company facing shortage of funds to
invest in projects with small payback period.
Limitations of Pay back period :
This method fails to take into account the time value
of money
It does not measures the profitability of the project
It does not indicate any cut-off period for the purpose
of investment decision
Neither allowance is made fro taxation nor any capital
allowance made.
Evaluation of Payback
Certain virtues:
Simplicity
Cost effective
Short-term effects
Risk shield
Liquidity
Serious limitations:
Cash flows after payback
Cash flows ignored
Cash flow patterns
Administrative difficulties
Inconsistent with shareholder value
ARR / Average rate of return method / Total income
method :

ARR is the annualized net income earned on the average
funds invested in a project

It is a measure based on the accounting profit ( profit after
depreciation and tax )rather than the cash flows and is
similar to the measure of rate of return on capital employed

If average investment ( capital ) is being considered for the
purpose of calculation is called ARR.
ACCOUNTING RATE OF
RETURN METHOD
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.
Formula :
Annual return on original investment method:
ARR= annual average net earnings X100
---------------------------------------
initial investment
Annual return on average investment method :
ARR= annual average net earnings X100
---------------------------------------
average investment
Investment = capital cost of the equipment minus salvage
value of the old equipment
Average investment = initial investment / 2
Average investment = II scrap value of the asset / 2

Average investment =

Original investment scrap value
------------------------------------------------------- + AWC + scrap value
2

Merits it considers the total earnings from the project, it emphasis on the
profitability of the project, it can be calculated by using the accounting data
Demerits it does not consider the length of project life , it ignores the time
value of money, it fails to recognize the size of investment
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.
Evaluation of ARR Method
The ARR method may claim some merits
Simplicity
Accounting data
Accounting profitability
Serious shortcomings
Cash flows ignored
Time value ignored
Arbitrary cut-off
Net Present Value Method
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.
Present value of cash flows should be calculated using the
opportunity cost of capital as the discount rate.
Net present value should be found out by subtracting present
value of cash outflows from present value of cash inflows. The
project should be accepted if NPV is positive (i.e., NPV > 0).

Net Present Value Method
The formula for the net present value can be written
as follows:

=

+
=

(
(

+
+ +
+
+
+
+
+
=
n
1 t
0
t
t
0
n
n
3
3
2
2 1
C
) k 1 (
C
NPV
C
) k 1 (
C
) k 1 (
C
) k 1 (
C
) k 1 (
C
NPV
Why is NPV Important?
Positive net present value of an investment represents the maximum
amount a firm would be ready to pay for purchasing the opportunity
of making investment, or the amount at which the firm would be
willing to sell the right to invest without being financially worse-
off.

The net present value can also be interpreted to represent the
amount the firm could raise at the required rate of return, in addition
to the initial cash outlay, to distribute immediately to its
shareholders and by the end of the projects life, to have paid off all
the capital raised and return on it.
Acceptance Rule
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV < 0
May accept the project when NPV is zero
NPV = 0

The NPV method can be used to select between mutually
exclusive projects; the one with the higher NPV should be
selected.
Evaluation of the NPV Method
NPV is most acceptable investment rule for the
following reasons:
Time value
Measure of true profitability
Value-additivity
Shareholder value
Limitations:
Involved cash flow estimation
Discount rate difficult to determine
Mutually exclusive projects
Ranking of projects
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.
Calculation of IRR Cash inflows
are even for all the years

Factor to be located = I /C

I original investment
C annual cash inflows

The calculated factor is located in the annuity table
to find out the relevant percentage of diScount
that represents the IRR
52
CALCULATION OF IRR
Uneven Cash Flows: Calculating IRR by Trial and
Error
The approach is to select any discount rate to compute
the present value of cash inflows.
If the calculated present value of the expected cash
inflow is lower than the present value of cash outflows, a
lower rate should be tried.
On the other hand, a higher value should be tried if the
present value of inflows is higher than the present value
of outflows.
This process will be repeated unless the net present
value becomes zero.
IRR can be interpolated by trial
& error procedure :


IRR = Lower rate + positive NPV X diff in rate
-------------------
Diff in calculated PVs
54
NPV Profile and IRR
NPV Profile
Acceptance Rule
Accept the project when IRR > Cutoff rate

Reject the project when IRR < Cutoffrate


In case of independent projects, IRR and NPV rules
will give the same results if the firm has no shortage
of funds.
Evaluation of IRR Method
IRR method has following merits:
Time value
Profitability measure
Acceptance rule
Shareholder value
IRR method may suffer from
Multiple rates
Mutually exclusive projects
Value additivity
PROFITABILITY INDEX
Profitability index is the ratio of the present value of
cash inflows, at the required rate of return, to the
initial cash outflow of the investment.
The formula for calculating benefit-cost ratio or
profitability index is as follows:
Acceptance Rule
The following are the PI acceptance rules:
Accept the project when PI is greater than one. PI > 1
Reject the project when PI is less than one. PI < 1
May accept the project when PI is equal to one. PI = 1
The project with positive NPV will have PI greater
than one. PI less than means that the projects NPV
is negative.
Evaluation of PI Method
Time value:It recognises the time value of money.

Value maximization: It is consistent with the shareholder
value maximisation principle. A project with PI greater than
one will have positive NPV and if accepted, it will increase
shareholders wealth.

Relative profitability:In the PI method, since the present value
of cash inflows is divided by the initial cash outflow, it is a
relative measure of a projects profitability.

Like NPV method, PI criterion also requires calculation of
cash flows and estimate of the discount rate. In practice,
estimation of cash flows and discount rate pose problems.