Capital Budgeting

Capital Budgeting- Meaning
Capital Budgeting refers to the expenditure on the capital assets. Spending money on capital assets is a very important decision that a finance manager is required to take. Capital investment expenditure may be on Plant, Machinery Equipment, Land, Building and Bridges Etc.
Dr. Gurendra Nath Bhardwaj 1
Significance
Although spending money on anything is important, but the capital expenditures are more important and the finance manager is therefore, required to be much more cautious in making such decision for the following reasons.-
Dr. Gurendra Nath Bhardwaj
Contd.
It involves substantially higher amounts than for other routine expenses. The decision is irreversible, i.e. it is not possible to withdraw your steps easily, once you have taken few steps in this regard. It has long term impact on the affairs of a company and it, infect, determines the future of a company.
Contd.
An expenditure made on a capital asset has a long term prospective. We spend today, to gain some advantages in future. This expenditure involves a big cash outflow of funds initially, compensated by small but recurring doses of inflow of funds in future for some time.
Contd.
The essence of the capital budgeting decision making is to determine, whether the initial expenditure of funds is duly compensated by the inflow of funds occurring in future. If greater values can be assigned to the inflow of funds than the present expenditure, then that the capital investment proposal must be accepted because that will add to the wealth of the company.
Nature of Capital Budgeting
The Capital Budgeting decision is a decision on an expenditure of capital nature (as against revenue expenditure) which is intended to create physical assets. The assets are return expected to reap benefits to the company for the years to come.
Contd.
The expenditure on monetary assets like purchase of Bonds, Shares, Treasury bills, Debentures etc.) is not to be treated as a capital budgeting expenditure. Only investment in physical assets is appraised in capital budgeting while investment in monetary and financial assets is appraised under portfolio analysis.
Types of Capital Budgeting Decision

It consists broadly following investment decisions. 1. New Projects 2. Expansion Project 3. Renewal Projects 4. Exploration Projects (Oil Well) 5. Research & Development (R & D) Projects. 6. Projects For Compliance of Certain Statutory Requirement.
Capital Budgeting Process

Generation of Investment Ideas. Estimating Cash Flows Evaluating Cash Flows Selecting Projects Execution and Monitoring
Cash Flow Concept & Estimation
Every investment proposal involves cash flows- large initial cash outflow followed by small but recurring inflows. The crux of the whole process is, to assess whether the value of inflows is greater then the outflows or not. If the greater value can be assigned to the inflows/ returns than the outflows/ expenditure, the proposal may be treated as profitable and therefore, acceptable.
Principles of Cash flows Estimation
Capital Budgeting should be based on cash flows. The reason is that cash flows are very certain amounts and are not subject to different interpretation by different people.
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Contd.
Accrual principle is considered better for the purpose of accounting (Probably because it calculates profit or loss for a given period), but for a long term investment decision making, cash principle will be better.
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Contd.
Every payment of cash, for whatever purpose is an outflow, While every receipt of cash, for whatever reason is an inflow. Any Non cash expenditure (like depreciation) will not be accounted for because it does not involve any cash out flows.
Contd.
Cash flow should be taken on After Tax basis. One should calculate Cash Flow After Tax (CFATs) Sunk Costs should be ignored. The cost which have already been incurred should not be taken in to account while calculating cash outflows for a period.
Contd.
Calculation of cash flow should also take in to account the opportunity cost, even no actual cash inflow or outflow takes place. A very important aspect of each cash flow calculation is that cash flow on account of interest payments are not to be considered, while making the calculation of cash flow, because the discounting of cash flow for their time value of money automatically takes in to account the interest cost of any investments.
Contd.
Cash needs for working capital should be treated as a cash outflow at the time of commencement of a project and should be treated as inflow when that cash is released at the time of closure or termination of projects. Increase or decrease of working capital should be treated as outflows and inflows respectively as and when they take place.
Requirements of Good Methods
It should be based on cash flows rather than on profits or expenditures. Cash flows to be recovered over the entire expected life of the asset rather than few years only. It should give absolute value of gain or loss. It should consider the time value of money. It should indicate relative profitability between different alternatives, so that a ranking can be made between different proposals. It should indicate the degree of risk and the chances of getting profit or loss in a given situation.
Example
A company desires to make an investment of Rs. 1,00,000 in a new machinery. Additional installation and transportation cost is Rs. 20,000. The Machine has a life of 5 years after which it is expected to fetch Rs. 10,000 as scrap value. The machine is expected to generate an output of 2000 units p.a. in the first 2 years and 3000 units p.a. for the last 3 years. The Product is expected to fetch Rs. 15 in the first 3 years and Rs. 18 in the last 2 years. The additional cost of operating a machine is expected to be Rs.5,000 p.a. for the first 3 years and Rs. 8,000 p.a. thereafter. Calculate Cash Flow After Tax (CFATs) for the above proposal on the assumption of Straight line depreciation and tax rate 30%.
Solution
Calculation of Depreciation
Cost of Machinery
Add: Transportation & Installation Cost
1,00,000
20,000 1,20,000 10,000
Less: Scrap Value
Total Amount to be depreciated Annual Depreciation= 1,10,000/5

1,10,000
22,000
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Year Output (Units) Price (Rs.) Revenue (Rs.) Operating Exp. (Rs.) Depreciation (Rs.) Profit Before Tax (Rs.) Tax @ 30% (Rs.) Profit After Tax (Rs.) CFAT (PAT + DEP.) Scrap Value
1 2,000 15 30,000 5,000 22,000 3,000 900 2,100 24,100
2 2,000 15 30,000 5,000 22,000 3,000 900 2,100 24,100
3 3,000 15 45,000 5,000 22,000 18,000 5,400 12,600 34,600
4 3,000 18 54,000 8,000 22,000 24,000 7,200 16,800 38,800
5 3,000 18 54,000 8,000 22,000 24,000 7,200 16,800 38,800 10,000
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Interpretation
As we have discussed earlier, that the non cash items like dep. Will not be taken in to account while calculating the CFATs, so the total value of Cash Inflow After Tax will be 24,100+24,100+34,600+40,800+40,800+10,000= Rs. 1,74,400. In the above solution we have not considered the time value of money.
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Methods of Project Evaluation and Selection
The project evaluation methods can be divided in to two categories.
Methods based on the assumption of certainty Methods which take in to consideration uncertainty of cash flows
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Methods based on the assumption of certainty
Simple Methods:

Accounting/ Average Rate of Return (ARR) Payback Period Discounted Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Benefit- Cost (B-C) Ratio or Profitability Index (PI)
Scientific Methods:

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Methods which take in to consideration uncertainty of cash flows

Conservative Estimates Certainty Equivalent Coefficient Risk Adjusted Discounted Rate Probability Distribution of Uncertainty Sensitive Analysis
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Simple Methods of Capital Budgeting

Accounting/ Average Rate of Return (ARR) Payback Period Discounted Payback Period
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Payback Period
The payback period is the time duration required to recover the initial cash outflows. This method is based on cash flows and not on accounting data like the ARR.
Initial cash outflow
Payback period =
Annual cash inflows
Contd.
If the cash inflows are not uniform then Payback period = time period in which the cumulative cash flows are equal to initial inflows.
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Example:
A company is considering a proposal to spend Rs. 1,00,000 on a new proposal. The cash inflows are expected as follows, year I Rs. 20,000, year II Rs. 30,000, year III Rs. 30,000, year IV Rs. 40,000, year V Rs. 40,000, Calculate Payback period for the above proposal.
Solution:
Year Cash Cumulative inflows Cash inflows (Rs.) (Rs.) 20,000 30,000 30,000 40,000 40,000 20,000 50,000 80,000 1,20,000 1,60,000
Payback period =
Initial cash outflow Annual cash inflows 20,000 =3+ 40,000 =3.5 Years
I II III IV V
Acceptance and Ranking Rule:
If the calculated payback is less than any predicted value then an investment proposal is acceptable, otherwise it will be rejected. So far as ranking is concerned, the lower the value of the payback, the higher will be the ranking of any investment proposal.
Evaluation of Payback Method:
It is a simple method in concept and understanding. Since its emphasis is on early recovery of investment, it automatically takes care of risk. Projects with smaller payback period is considered safer and secure as compared to the projects with longer payback.
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Drawbacks
It takes in to account only early cash flows which determine the payback and ignores those which come later. This may often leading to wrong conclusions. Let see the example.
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Example
Year 0 1 2 3 4 5 6
Total Cash Inflow
Project X - 50,000 15,000 20,000 30,000 20,000 0 0

Project Y - 50,000 10,000 15,000 20,000 30,000 40,000 30,000

1,45,000
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85,000
Interpretation:
If we calculate the payback period for the above projects it is 2.5 years for project Y whereas for project X it is 3 1/6 or 3 years two months. However a comprehensive analysis of projects would show the project Y is superior with greater value of inflows. Secondly, payback method ignores time value of money.
Example:
Payback period
Year Project X Project Y 0 -60,000 -60,000
=
Initial cash outflow Annual cash inflows = 3 years
1
2 3
10,000
20,000 30,000
30,000
20,000 10,000
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Interpretation:
The payback period for both the project is 3 years. On the basis of time value of money the project Y will be superior. Payback period is considered only a measure of capital recovery and it is not a perfect of measure for profitability.
Contd.
In spite of these limitations of the payback method, it is still widely used in modern project appraisal mainly because of its simplicity. However, it used only for a preliminary screening and not for final decision making.
Discounted Payback Period:
To overcome the limitation of the payback that it does not use time value of money, we may use the discounted cash flows in order to calculate the payback period. Obviously the discounted payback will be longer than the simple payback period.
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Example:
A company is considering a project with initial outflow of Rs. 1,00,000. The Cash inflows from the project are expected to be as follows. Find out the payback period by the traditional method as well as by discounted method @ 10% discount.
Year
1 2 3 4 5 6
Cash Flows (Rs. ) 20,000

30,000 30,000 40,000 30,000 20,000
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Solution:
Year Cash Flows Cumulative Cash flows
20,000 30,000 30,000 40,000
1 2 3 4
Discounted Discounted Cash flows Cumulative Cash flows @ 10% 20,000 18,182 18,182
50,000 80,000 24,793 22,539 27,321 42,975 65,514 92,835
1,20,000
5
6
30,000
20,000
1,50,000
18,628
11,289
1,11,463
1,22,752
40
1,70,000
Solution:
The Traditional Payback period = Initial cash outflow Annual cash inflows 1,00,000-80,000 = 1,20,000-80,000 = 3.5 Years The discounted Payback period = Initial cash outflow Annual discounted cash inflows 1,00,000-92,385 = 1,11,46392,385 = 4.38 Years
Accounting/ Average Rate of Return (ARR)
The Accounting Rate of Return also called the Average Rate of Return. It is the average rate of return for different years for the whole life of an asset. It is a ratio between the Net Profit After Tax and the amount of Initial Investment made in the Project.
Contd.
Average PAT ARR =
Initial Investment
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Example:
A company wishes to make an investment of Rs. 50,000 in a machine. The machine has a life of 5 years. The profit after tax on account of this machine for the next five years is Rs. 7,500, Rs. 8,200, Rs. 7,900, Rs. 8,900, and Rs. 6,500 respectively. Calculate the ARR for this investment Proposal.
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Solution:
( 7,500+ 8,200+7,900+8,900+6,500)/5 x100
ARR =
(39,000/5) x 100
50,000
50,000
= 15.6 %
Interpretation:
When it is evaluated for its suitability as a investment criteria for making long term investment decisions, we find it deficient in several aspects. Firstly, it is ill defined we don not know whether to use EBIT or PAT, Initial Investment or Average Investment. Each variable will give different results.
Scientific Methods:

Net Present Value (NPV) Internal Rate of Return (IRR) Benefit- Cost (B-C) Ratio or Profitability Index (PI)
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Net Present Value (NPV)
It is net present value of all the cash flows that occur during the entire life span of a project The outflows will have negative values while the inflows will have positive values. Obviously, if the present value of inflows is greater than outflows, we get a positive NPV and if the present value of outflows is greater than inflows, we get a negative NPV.
Contd.
The positive NPV means a net gain in value maximization and, therefore, any project which gives a positive NPV is an acceptable project and if it gives a negative NPV, then the project should not be accepted.
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Contd.
NPV can be expressed as follows; n Ct NPV = C0 t=1 (1+k)t Where Ct= Net Cash Inflows in different Years (t) k =The rate of interest or cost of capital at which funds are to be discounted C0 = Initial Investment, The initial amount spent on a project
Acceptance Rule & Ranking Rule:
The acceptance rule for NPV is that, if it is positive, then the proposal should be accepted and if it is negative then it can not be accepted. In case of same size projects, the higher the value of NPV the higher would be the ranking of a project.
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Example:
A firm is considering an investment proposal worth Rs.80,000. The CFATs (cash flows after tax) are expected to be as follows. The rate of discount is 10%. Find out whether the project is worthwhile or not.
Year 1 2 3 4 5
CFATs (Rs.) 15,000 22,000 27,000 29,000 21,000

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Solution:
n NPV = t=1 Ct
C0
(1+k)
t
= 15,000/ (1.1) + 22,000/ (1.1) + 27,000/ (1.1) + 29,000 / (1.1)4 + 21,000/ (1.1)5 80,000 = 13,636.36 + 18,181.82 + 20,285.50 + 19807.39 + 13039.43 80,000 = 84,950.50 80,000 = Rs. 4,950.50
Interpretations:
In this project the PV of inflows is Rs. 84,950.50 while the PV of outflows is Rs. 80,000. Hence the NPV is Rs. 4,950.50 which makes the project an acceptable project because NPV is positive.
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Interpretations of NPV:
NPV is the absolute value of a net gain in future. This may be treated as a net addition to the value of the firm and therefore, it is also called unrealized capital gain. Another interpretation of NPV is that it represents the maximum price that a firm should pay for foregoing the right to undertake the project or to sell the project to some other party.
Contd.
It also represents the amount that a firm could raise from the market at given rate of inertest, in addition to the initial cost of the project, and ensure that this will be paid off from the receipts of the project. For example; A firm is undertaking a project at a cost of Rs. 50,000 with a positive NPV of Rs. 10,000. In this case, the firm can not borrow merely Rs. 50,000 to meet the initial cost, but can also raise Rs. 10,000 (for any other purpose) and be rest assured that this sum with interest can be paid off from the proceeds of the given project.
Properties of NPV:
The NPV method is a very scientific and appropriate technique of capital budgeting and is therefore, widely used for investment decision making. The following properties can be identified. It is based on cash flows over the entire life of project. It considers time value of money. It is an absolute value. It possesses the property of additions, i.e. the total NPV of two projects is the summation of their individual NPVs. NPV for different rates of interest can be found separately, and It allows different rates of interest for different time period in the life of a project.
Limitations of NPV:
It gives the absolute value and therefore, comparison between two different projects is not easy, especially when they are of different sizes. Many a times, it is not possible to know in advance the rate of interest at which discounting is to be done. Similarly a given NPV may not be appropriate if the rate of interest has changed. It may lead to wrong decision making especially when limited funds are available and we have to choose between different options.
Benefit- Cost (B-C) Ratio or Profitability Index (PI)

NPV is an absolute value and therefore it is not appropriate for comparing the relative profitability between different projects. In order to overcome this limitation of NPV, we make one modification in it to make it a relative measurement. This is called Profitability Index (P.I.) or Benefit Cost Ratio (B-C Ratio). The P.I. is as follows. Present value of inflows P.I. = Present value of outflows
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Acceptance and Ranking Rule:
If the P.I. is greater than 1, then the project is to be accepted and if it is less than 1 then it is to be rejected. However, if we have, several projects then the project with a higher P.I. or B.C. ratio should have a higher ranking.
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NPV & PI :
The NPV and PI are both based on a given rate of discount and, therefore, the NPV and PI values change as soon as the rate of discount is changing. Hence, any project which is acceptable at, say, 10% rate of discount may not be the same at, say, 12% rate. Therefore, there is need to find out a technique which is autonomous in itself and not dependent upon any externally determined rate of interest.
Internal Rate of Return (IRR)

IRR is that rate of discount at which NPV is zero. It can be expressed as follows. n Ct 0= t=0 (1+k) t
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Contd.
The relationship between discount rate and rate of discount for the previous illustration of NPV is calculated as follows.
Rate of Interest (%) 9 10

11 12 13 14
NPV (Rs.)
7,320.67 4,950.50
2,677.54 496.06 1600.02 3611.29 63
Contd.
This table shows that as the discount rate increase the NPV goes on diminishing. It can therefore be understood that a project which is acceptable at a given rate of discount, say 11% may not be accepted at 13% or 14%. It is therefore essential to know, the cut-off rate where positive NPV converts into a negative NPV. This cut off rate is the Internal Rate of Return (IRR) where NPV is zero.
It can be expressed as follows The Internal Rate of Return IRR can be calculated by use of log or by a scientific calculator or by computer instantly. However, the following method can be used for the purpose. x IRR = r + xy Where r = the closest rate at which NPV is positive x = value of positive NPV at that level y = value of negative NPV at next higher rate
For example, in the above illustration, the value of r = 12%, the value of x = 496.06 and the value of y = 1600.02. Hence the IRR is 496.06 = 12 + 2096.08 = 12 + .2367 = 12.2367%
Acceptance and Ranking Rule for IRR:
The IRR should be greater than the given discount rate (cost of capital) to make a project acceptable. If IRR is less than the cost of capital then, the proposal can not be accepted as it will lead to a negative NPV. Since, IRR is a rate of return, the project with a higher IRR should be ranked higher than the other project which has a lower IRR.
Properties of IRR:
It considers cash flows of projects in their entirety. It takes into account time value of money. It is useful in ranking of projects because it is a rate and not any absolute value. It is independent of any externally determined rate (discount rate or cost of capital), and hence ranking of projects will not change with variation in cost of capital. It is particularly useful as it helps a businessman and also a financer in assessing the margin of safety in a project. It is more appealing to the businessmen who are used to thinking in terms of cost and return.
NPV Vs IRR:
Both NPV and IRR are considered scientific techniques of a projects financial appraisal and both are commonly used. The NPV is an absolute value of a gain or loss, while IRR is a rate of return from a given investment and, therefore, more appropriate for comparison between different project proposals as well as between a given IRR and different costs of capital. In this respect IRR seems to be having an advantage. This, however, may not always be so.
Contd.
Thanks
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Capital Budgeting

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Capital Budgeting

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Capital Budgeting- Meaning

Dr. Gurendra Nath Bhardwaj

Nature of Capital Budgeting

Dr. Gurendra Nath Bhardwaj

Types of Capital Budgeting Decision