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Capital Budgeting

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Published in: B.Com Tuition | Financial Management | MBA
14,090 Views

Explanation of Different Techniques of Capital Budgeting.

Dr.Amit G / Delhi

22 years of teaching experience

Qualification: Ph.D ( - 2012), M.Com ( - 2002), MBA/PGDM ( - 2010), B.Com ( - 2000)

Teaches: Accountancy, Economics, Costing, Financial Management, Statistics, BBA Subjects, Management Subjects

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  1. 1/10/2018 CAPITAL BUDGETING DECISIONS Dr. Amit Gupta 1
  2. Nature of Investment Decisions The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. The firm's 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 firm's expenditures and benefits, and therefore, they should also be evaluated as investment decisions. 1/10/2018 Dr. Amit Gupta 2
  3. 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. 1/10/2018 Dr. Amit Gupta
  4. Importance of Investment Decisions Growth Risk Funding Irreversibility ' Complexity 1/10/2018 Dr. Amit Gupta
  5. Types of Investment Decisions — Expansion of existing business — Expansion of new business — Replacement and modernisation 1/10/2018 Dr. Amit Gupta 5
  6. Investment Evaluation Criteria Three steps are involved in the evaluation of an investment: 1. 2. 3. 1/10/2018 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 Dr. Amit Gupta
  7. 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. 1/10/2018 Dr. Amit Gupta 7
  8. Evaluation Criteria 1. Non-discounted Cash Flow Criteria Payback Period (PB) Discounted payback period (DPB) Accounting Rate of Return (ARR) 2. Discounted Cash Flow (DCF) Criteria Net Present Value (N PV) — Internal Rate of Return (IRR) Profitability Index (PI) 1/10/2018 Dr. Amit Gupta
  9. 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: Initial Investnent Payback = co c 1/10/2018 AnnualCash Inflow Dr. Amit Gupta
  10. Example 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: 1/10/2018 Rs 50,000 = 4 years Rs 12,500 Dr. Amit Gupta 10
  11. PAYBACK 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. Suppose that a project requires a cash outlay of Rs 20,000, and generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000 during the next 4 years. What is the project's payback? 3 years + 12 x (1,000/3,000) months 3 years + 4 months 1/10/2018 Dr. Amit Gupta 11
  12. 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. 1/10/2018 Dr. Amit Gupta 12
  13. Evaluation of Payback ' Certain virtues: — Simplicity — Cost effective — Short-term effects — Risk shield — Liquidity ' Serious limitations: C] Cash flows after payback C] Cash flows ignored D Cash flow patterns EAdministrative difficulties C] Inconsistent with shareholder value 1/10/2018 Dr. Amit Gupta 13
  14. Payback Reciprocal and the Rate of Return The reciprocal of payback will be a close approximation of the internal rate of return if the following two conditions are satisfied: 1. The life of the project is large or at least twice the payback period. 2. The project generates equal annual cash inflows. 1/10/2018 Dr. Amit Gupta 14
  15. 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. Discounted Payback Illustrated Cash Flows Discounted NPV at PV of cash flows PV of cash flows co - 4,000 4,000 4,000 - 4,000 3,000 2,727 1,000 826 4,000 1,000 751 1,000 1,000 683 2,000 1,366 Simple 2 yrs 2 yrs 3,304mit Gupta 751 2.6 yrs 2.9 yrs 100/0 987 1,421 15
  16. 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. Average income Average investmnent 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. 1/10/2018 Dr. Amit Gupta 16
  17. The ARR is obtained dividing annual average profits after taxes by average investments. ' Average investment = 1/2 (Initial cost of machine — Salvage value) + Salvage value + net working capital. ' Annual average profits after taxes = Total expected after tax profits/Number of years The ARR is unsatisfactory method as it is based on accounting profits and ignores time value of money. 1/10/2018 Dr. Amit Gupta 17
  18. Example A project will cost Rs 40,000. Its stream of earnings before depreciation, interest and taxes (EBDIT) during first year through five years is expected to be Rs 10,000, Rs 12,000, Rs 14,000, Rs 16,000 and Rs 20,000. Assume a 50 per cent tax rate and depreciation on straight-line basis. 1/10/2018 3,200 Accounting Rate of Return = X 100 16 per cent 20,000 Dr. Amit Gupta 18
  19. Calculation of Accounting Rate of Return IRS) 5 Average Period Eamings before depreciation, interest and taxes (EBDIT) Depreciation Eamings before interest and taxes (EBIT) Taxes at 50% Earnings before interest and after taxes [EBIT (1- 1)] Book value of investment: Beginning Ending Average 1/10/2018 1 10,000 8,000 2,000 1,000 1,000 40,000 32,000 36,000 2 12,000 8,000 4,000 2,000 2,000 32,000 24,000 28,000 3 14,000 8,000 6,000 3,000 3,000 24,000 16,000 20,000 4 16,000 8,000 8,000 4,000 4,000 16,000 8,000 12,000 20,000 8,000 12,000 6,000 6,000 8,000 4,000 Dr. Amit Gupta 14,400 8,000 6,400 3,200 3,200 20,000 19
  20. Example Determine the average machines, A and B. Particulars Cost Annual estimated income rate of return after depreciation and income tax: Year Estimated life (years) Estimated salvage value 1 2 3 4 5 from the following Machine A Rs 56,125 3,375 5,375 7,375 9,375 11 375 36 875 5 3,000 Depreciation has been charged on straight line basis. 1/10/2018 Dr. Amit Gupta data of two Machine B Rs 56,125 11,375 9,375 7,375 5,375 3 375 36 875 5 3,000 20
  21. Solution ARR = (Average income/Average investment) x 100. Average income of Machines A and B =(Rs 36,875/5) = Rs 7,375. Average investment = Salvage value + 1/2 (Cost of machine — Salvage value) = Rs 3,000 + 1/2 (Rs 56,125 - Rs 3,000) = Rs 29,562.50. ARR (for machines A and B) = (Rs 7,375/Rs 29,562.50) x 100 = 24.9 per cent. 1/10/2018 Dr. Amit Gupta 21
  22. 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. 1/10/2018 Dr. Amit Gupta 22
  23. Evaluation of ARR Method The ARR method may claim some merits Simplicity Accounting data Accounting profitability ' Serious shortcomings DCash flows ignored CITime value ignored DArbitrary cut-off 1/10/2018 Dr. Amit Gupta 23
  24. Conventional & Non-Conventional Cash Flows A conventional investment has cash flows the pattern of an initial cash outlay followed by cash inflows. Conventional projects have only one change in the sign of cash flows; for example, the initial outflow followed by inflows, i.e., A non-conventional investment, on the other hand, has cash outflows mingled with cash inflows throughout the life of the project. Non-conventional investments have more than one change in the signs of cash flows; for example, — + + + — ++ — 1/10/2018 Dr. Amit Gupta 24
  25. NPV vs. IRR ' Conventional Independent Projects: In case of conventional investments, which are economically independent of each other, NPV and IRR methods result in same accept-or-reject decision if the firm is not constrained for funds in accepting all profitable projects. 1/10/2018 Dr. Amit Gupta 25
  26. NPV vs, IRR 'Lending and borrowing-type projects: Project with initial outflow followed by inflows is a lending type project, and project with initial inflow followed by outflows is a lending type project, Both are conventional projects. Project x 1/10/2018 Cash Flows (Rs) co -e 100 100 120 120 Dr. Amit Gupta IRR 200/0 200/0 NPV at 9 —9 26
  27. Problem of Multiple IRRs A project may have both lending and borrowing features together. IRR method, when used to evaluate such non- conventional investment can yield multiple internal rates of return because of more than one change of signs in cash flows. NPV (Rs) 250 250 500 -750 50 NPV 63 IOO Discount Rate 150 200 Dr. Amit Gupta was@
  28. Case of Ranking Mutually Exclusive Projects Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded. Two independent projects may also be mutually exclusive if a financial constraint is imposed. The NPV and IRR rules give conflicting ranking to the projects under the following conditions: — The cash flow pattern of the projects may differ. That is, the cash flows of one project may increase over time, while those of others may decrease or vice-versa. — The cash outlays of the projects may differ. The projects may have different expected lives. 1/10/2018 Dr. Amit Gupta 28
  29. Timing of cash flows The most commonly found condition for the conflict between the NPV and IRR methods is the difference in the timing of cash flows. Let us consider the following two Projects, M and N. Cash -Flo vvs -Proje ct 1/10/2018 1-680 1 140 700 840 3 14 0 •1-510 IVPV at 0 0/+0 301 321 Dr. Amit Gupta IRR 230/0 170/0 29
  30. Discount Rate 1%) 5 10 15 20 25 30 Project M 560 409 276 159 54 -125 Project N 810 520 276 70 - 106 -257 -388 Cont... NPV 1000 800 600 400 200 200 400 Project M — Project N NPV Rs 276 1 00/0 N 209/0 Discount Rate NPV Profiles of Projects M and N NPV versus IRR The NPV profiles of two projects intersect at 10 per cent discount rate. 1/10/2018 This is called Fisher's intersection. Dr. Amit Gupta 30% 30
  31. Incremental approach ' It is argued that the IRR method can still be used to choose between mutually exclusive projects if we adapt it to calculate rate of return on the incremental cash flows. The incremental approach is a satisfactory way of salvaging the IRR rule. But the series of incremental cash flows may result in negative and positive cash flows. This would result in multiple rates of return and ultimately the NPV method will have to be used. Project 1/10/2018 co o Cash Flows (Rs) - 1,260 140 1,370 Dr. Amit Gupta NPV at 9% 20 IRR 100/0 31
  32. Scale of investment Projects 1/10/2018 Cash —e 1,000 100,000 Flo vv (Rs) 1 1,500 120,000 NPV at 364 9-091 IRR 500/0 20% Dr. Amit Gupta 32
  33. Project life span Cash Flows (Rs) Projects Co cm x Y 1/10/2018 — 10,000 -12,000 -u -10,000 o o o o NPV at 100/0 IRR 909 200/0 20,120 2,493 15% Dr. Amit Gupta 33
  34. REINVESTMENT ASSUMPTION The IRR method is assumed to imply that the cash flows generated by the project can be reinvested at its internal rate of return, whereas the NPV method is thought to assume that the cash flows are reinvested at the opportunity cost of capital. 1/10/2018 Dr. Amit Gupta 34
  35. MODIFIED INTERNAL RATE OF RETURN (MIRR) The modified internal rate of return (MIRR) is the compound average annual rate that is calculated with a reinvestment rate different than the project's IRR. 1/10/2018 Dr. Amit Gupta 35
  36. VARYING OPPORTUNITY COST OF CAPITAL There is no problem in using NPV method when the opportunity cost of capital varies over time. ' If the opportunity cost of capital varies over time, the use of the IRR rule creates problems, as there is not a unique benchmark opportunity cost of capital to compare with IRR. 1/10/2018 Dr. Amit Gupta 36
  37. NPV VERSUS PI A conflict may arise between the two methods if a choice between mutually exclusive projects has to be made. NPV method should be followed. PV of cash inflows (Rs) Initial cash outflow (Rs) NPV (Rs) Pro •ect C 100,000 50,000 Pro •ect D 50,000 20,000 30,000 2.50 Dr. Amit Gupta was@
  38. 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). 1/10/2018 Dr. Amit Gupta 38
  39. Net Present Value Method The formula for the net present value can be written as follows: NPV = -co 1/10/2018 NPV=E -co t=l (1 -k k) t Dr. Amit Gupta 39
  40. Calculating Net Present Value 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. Rs 900 Rs 800 Rs 700 Rs 600 NPV (1+0.10)T (1+0.10)2 (1+0.10)3 (1+0.10)4 Rs 500 Rs 2,500 (1+0.10)5 [Rs 900(PVF ')+Rs 800(PVF )+Rs 700(PVF ) 0.10 0.10 a, 0.10 +Rs 600 (PVF )+Rs 500(PVF J] —Rs 2,500 4, 0.10 0-10 [Rs 900 x O.909+Rs 800 x 0.826+Rs 700 x 0.751 +Rs 600 x 0.683+Rs 500 x 0.620] — Rs 2,500 Rs 2,725 —Rs +Rs 225 1/10/2018 Dr. Amit Gupta 40
  41. 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. 1/10/2018 Dr. Amit Gupta 41
  42. Acceptance Rule ' Accept the project when NPV is positive NPV > o ' Reject the project when NPV is negative NPV < o May accept the project when NPV is zero NPV = o The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected. 1/10/2018 Dr. Amit Gupta 42
  43. Q: X Ltd. Is planning to purchase a machine for Rss which is likely to accrue following CFATs in the next five years: Year CFAT 20,000 25,000 24,000 32,000 35,000 Using NPV method suggest whether the machine be purchased if the cost of capital is 1/10/2018 Dr. Amit Gupta 43
  44. Q: X Ltd. Is planning to purchase a machine for Rss 90,000 which is likely to generate the following earnings in the next five years: Year Earnings 25,000 30,000 35,000 40,000 45,000 The machine will be depreciated on straight line method basis. The company is subject to tax at the rate of 50%. Find out NPV if the cost of capital is 12%. 1/10/2018 Dr. Amit Gupta 44
  45. Q: X Ltd. Is planning to purchase a machine for Rss which is likely to generate following earnings in the next five years: Year Earnings 50,000 55,000 60,000 62,000 65,000 The purchase of machinery has resulted in increase of working capital by Rss 15,000. The machine will be depreciated on straight line method basis and has a salvage value of Rss 25,000. The company is subject to tax at the rate of 50%. Should the machine be purchased if the cost of capital is 12%. 1/10/2018 Dr. Amit Gupta 45
  46. 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 1/10/2018 Dr. Amit Gupta 46
  47. 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 = co co co 1/10/2018 o Dr. Amit Gupta 47
  48. IRR= 1/10/2018 Formula for IRR LDR+ NPV at LDR NPV at LDR-NPV at I-IDR Dr. Amit Gupta x (HDR-LDR) 48
  49. Acceptance Rule ' Accept the project when r > k ' Reject the project when r < k May accept the project when r = k ' In case of independent projects, IRR and NPV rules will give the same results if the firm has no shortage of funds. 1/10/2018 Dr. Amit Gupta 49
  50. Q: A project costs Rss 38,000 and it is expected to generate cash inflows of Rss 11,500 annualy for five years. Calculate the IRR of the project. 1/10/2018 Dr. Amit Gupta 50
  51. Q: A project costs Rss 50,000 and is expected to generate following cash inflows annually for next five years: Year CFAT 10,000 11,000 14,500 14,500 15,000 Calculate Internal rate of return. 1/10/2018 Dr. Amit Gupta 51
  52. Evaluation of IRR Method ' IRR method has following merits: V Time value V Profitability measure V Acceptance rule V Shareholder value ' IRR method may suffer from Multiple rates Mutually exclusive projects DValue additivity 1/10/2018 Dr. Amit Gupta 52
  53. 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: 1/10/2018 PV of cash inflows Initial cash outlay Co Dr. Amit Gupta 53
  54. PROFITABILITY INDEX The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 percent rate of discount. The PV of cash inflows at 10 percent discount rate is: 1/10/2018 PV=Rs 40,000 30,000 XO.826 + Rs 50,OOOxO.751+Rs NPV= 112,350-Rs 100,000 12,350 Rs 112,350 -1.1235. Rs 100,000 Dr. Amit Gupta 54
  55. Acceptance Rule The following are the PI acceptance rules: — Accept the project when PI is greater than one. PI — Reject the project when PI is less than one. PI < 1 — May accept the project when PI is equal to one. PI The project with positive NPV will have PI greater than one. PI less than means that the project's NPV is negative. 1/10/2018 Dr. Amit Gupta 55
  56. Evaluation of PI Method ' Time value:lt 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:ln the PI method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a project's 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. 1/10/2018 Dr. Amit Gupta 56

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