Evaluation of Evaluation of Capital Capital

budgeting budgeting techniquestechniquesBy: DhirenderBy: Dhirender

DevenderDevenderManishManishRakeshRakeshFanishFanish

AjayAjay

The Basics of Capital Budgeting

Should we

build this

plant?

IntroductionIntroductionFinancial management is largely concerned with Financial management is largely concerned with

financing, dividend and investment decisions of financing, dividend and investment decisions of the firm with some overall goal in mind.the firm with some overall goal in mind.

Capital budgeting is primarily concerned with Capital budgeting is primarily concerned with sizable investment in long term assets.sizable investment in long term assets.

What is capital What is capital budgetingbudgeting

The term capital budgeting refers to The term capital budgeting refers to planning for capital assets.planning for capital assets.

Capital budgeting is a process of planning Capital budgeting is a process of planning capital expenditure which is to be made to capital expenditure which is to be made to maximize the profitability of the maximize the profitability of the organization. organization.

Capital budgeting is a long-term planning Capital budgeting is a long-term planning exercise in selection of the projects which exercise in selection of the projects which generates returns over a number of years .generates returns over a number of years .

It includes a financial analysis of various It includes a financial analysis of various proposals regarding capital expenditure. proposals regarding capital expenditure.

Purpose of capital Purpose of capital investmentsinvestments

ExpansionExpansion ReplacementReplacement RenovationRenovation AcquisitionAcquisition

Importance of capital Importance of capital budgeting decisionbudgeting decision

They have long term effect on the They have long term effect on the firm.firm.

These are irreversible decisionThese are irreversible decision These are the base of all These are the base of all

organizational activities.organizational activities. These are decision of investing a These are decision of investing a

big amount of capital.big amount of capital.

Process of CB decisionsProcess of CB decisions

1. Determine the objective1. Determine the objective

2. Identify alternative investment proposal 2. Identify alternative investment proposal

3. Screening of each alternative3. Screening of each alternative• Cost of alternative projects

• Evolution of return on each alternatives

• Suitability with identified constraints4. Determine the cost of capital to be

employed

5. Choose the best one

6. Implementation & follow up

Investment appraisal Investment appraisal techniquestechniques

Payback period methodPayback period method Discounted payback period methodDiscounted payback period method Accounting rate of return methodAccounting rate of return method

Net present value methodNet present value method

IRR methodIRR method NPV vs. IRRNPV vs. IRR MIRR method MIRR method Profitability Index methodProfitability Index method

Payback period methodPayback period method

This method recognizes the recovery This method recognizes the recovery of original capital investment in of original capital investment in projects.projects.

This method specifies the recovery This method specifies the recovery time of the investmenttime of the investment

Project LExpected Net Cash Flow

Year Project L Project S

0123

(Rs100)106080

(Rs100)(90)(30)50

Payback L = 2 + Rs30/Rs80 years

= 2.4 years.Payback S = 1.6 years.

MeritsMerits It is simple to apply, easy to understand and of It is simple to apply, easy to understand and of

particular importance to business which lack the particular importance to business which lack the appropriate skills necessary for more sophisticated appropriate skills necessary for more sophisticated techniques.techniques.

In case of capital rationing, a company is compelled to In case of capital rationing, a company is compelled to invest in projects having shortest payback period.invest in projects having shortest payback period.

This method gives an indication to the prospective This method gives an indication to the prospective investors specifying when their funds are likely to be investors specifying when their funds are likely to be repaid.repaid.

Ranking projects according to their ability to repay Ranking projects according to their ability to repay quickly may be useful to firms when experiencing quickly may be useful to firms when experiencing liquidity constraints. They will need to exercise careful liquidity constraints. They will need to exercise careful control over cash requirements.control over cash requirements.

It does not involve assumptions about future interest It does not involve assumptions about future interest rates.rates.

DemeritsDemerits It does not indicate whether an investment should It does not indicate whether an investment should

be accepted or rejected, unless the payback period be accepted or rejected, unless the payback period is compared with an arbitrary managerial target.is compared with an arbitrary managerial target.

The method ignores cash generation beyond the The method ignores cash generation beyond the payback period and this can be seen more a payback period and this can be seen more a measure of liquidity than of profitability.measure of liquidity than of profitability.

It fails to take into account the timing of returns It fails to take into account the timing of returns and the cost of capital. It fails to consider the and the cost of capital. It fails to consider the whole life time of a project. whole life time of a project.

It fails to determine the payback period required It fails to determine the payback period required in order to recover the initial outlay if things go in order to recover the initial outlay if things go wrong.wrong.

This method makes no attempt to measure a This method makes no attempt to measure a percentage return on the capital invested and is percentage return on the capital invested and is often used in conjunction with other methods.often used in conjunction with other methods.

Discounted PaybackDiscounted Payback

In this method the cash flows In this method the cash flows involved in a project are discounted involved in a project are discounted back to present value terms back to present value terms

The cash inflows are then directly The cash inflows are then directly compared to the original investment compared to the original investment in order to identify the period taken in order to identify the period taken to payback the original investment to payback the original investment in present values terms. in present values terms.

It ensures the achievement of at It ensures the achievement of at least the minimum required return least the minimum required return

ARR methodARR method

This method employing the normal This method employing the normal accounting technique to measure the accounting technique to measure the increase in profit expected to result increase in profit expected to result from an investment by expressing from an investment by expressing the net accounting profit arising the net accounting profit arising from the investment as a percentage from the investment as a percentage of that capital investment. of that capital investment.

Accounting rate of return = Average annual profit after tax X 100

Average or initial investment

Average investment = Initial investment + salvage value

2

MeritsMerits It is easy to calculate because it makes use of It is easy to calculate because it makes use of

readily available accounting information.readily available accounting information. It is not concerned with cash flows but rather It is not concerned with cash flows but rather

based upon profits which are reported in annual based upon profits which are reported in annual accounts and sent to shareholders.accounts and sent to shareholders.

Unlike payback period method, this method does Unlike payback period method, this method does take into consideration all the years involved in take into consideration all the years involved in the life of a project.the life of a project.

Where a number of capital investment proposals Where a number of capital investment proposals are being considered, a quick decision can be are being considered, a quick decision can be taken by use of ranking the investment proposals.taken by use of ranking the investment proposals.

If high profits are required, this is certainly a way If high profits are required, this is certainly a way of achieving them.of achieving them.

DemeritsDemerits It does not take into accounting time value of It does not take into accounting time value of

money.money. If fails to measure properly the rates of return If fails to measure properly the rates of return

on a project even if the cash flows are even on a project even if the cash flows are even over the project life.over the project life.

It uses the straight line method of depreciation. It uses the straight line method of depreciation. It is biased against short-term projects in the It is biased against short-term projects in the

same way that payback is biased against longer-same way that payback is biased against longer-term ones.term ones.

The accounting rate of return does not indicate The accounting rate of return does not indicate whether an investment should be accepted or whether an investment should be accepted or rejected, unless the rate is compared with the rejected, unless the rate is compared with the arbitrary management target.arbitrary management target.

Profitability indexProfitability index

The PI method compares the present The PI method compares the present value of future cash inflows with the value of future cash inflows with the initial investment.initial investment.

PI =PI = Present value of cash inflow Present value of cash inflow

Present value of cash outflowPresent value of cash outflow

If PI>1, the project is acceptedIf PI>1, the project is accepted

If PI<1, the project is rejectedIf PI<1, the project is rejected

investmentInitialPVCFPI investmentInitialPVCFPI investmentInitialPVCFPI investmentInitialPVCFPI

PI method is closely related to the NPV PI method is closely related to the NPV approach. , if the NPV is positive, the approach. , if the NPV is positive, the PI>1, if the NPV is negative, PI<1. PI>1, if the NPV is negative, PI<1.

The only difference between the NPV The only difference between the NPV and PI is that, in NPV the initially and PI is that, in NPV the initially outlay is deducted from the present outlay is deducted from the present value of cash inflows, whereas with value of cash inflows, whereas with PI approach the initial outlay is used PI approach the initial outlay is used as a divisor.as a divisor.

NPV methodNPV method The net present value(NPV) of an investment is The net present value(NPV) of an investment is

the present value of the cash inflows minus the the present value of the cash inflows minus the present value of the cash outflows.present value of the cash outflows.

NPV = PVB – PVCNPV = PVB – PVC

Therefore, if the NPV is:Therefore, if the NPV is:PositivePositive, , the benefits are large enough to repay the the benefits are large enough to repay the

company for the asset's cost company for the asset's cost ZeroZero, the benefits are barely enough to cover all , the benefits are barely enough to cover all

three but you are at breakeven three but you are at breakeven NegativeNegative, the benefits are not large enough to , the benefits are not large enough to

cover all costs, and therefore the project should cover all costs, and therefore the project should be rejected. be rejected.

MeritsMerits It is based on the assumption that cash It is based on the assumption that cash

flows, and hence dividends, determine flows, and hence dividends, determine shareholders’ wealth.shareholders’ wealth.

It recognizes the time value of money.It recognizes the time value of money. It considers the total benefits arising out of It considers the total benefits arising out of

proposals over its life time.proposals over its life time. The future discount rate normally varies due The future discount rate normally varies due

to longer time span. This rate can be applied to longer time span. This rate can be applied in calculating the NPV by altering the in calculating the NPV by altering the denominator.denominator.

This method is particularly useful for the This method is particularly useful for the selection of mutually exclusive projects. selection of mutually exclusive projects.

DemeritsDemerits It is difficult to calculate as well as It is difficult to calculate as well as

understand it as compared to accounting understand it as compared to accounting rate of return or payback period method.rate of return or payback period method.

Calculation of the desired rates of return Calculation of the desired rates of return presents serious problems, as desired rates presents serious problems, as desired rates of return will vary from year to year.of return will vary from year to year.

This method is an absolute measure. When This method is an absolute measure. When two projects are being considered, this two projects are being considered, this method will favor the project which has method will favor the project which has higher NPV.higher NPV.

This method may not give satisfactory This method may not give satisfactory results where two projects having different results where two projects having different effective lives are being compared. effective lives are being compared.

This method may not give dependable This method may not give dependable results.results.

IRR methodIRR method

The Internal Rate of Return (IRR) is the rate The Internal Rate of Return (IRR) is the rate of return that an investor can expect to of return that an investor can expect to earn on the investment. earn on the investment.

IRR is a percentage discount rate used in IRR is a percentage discount rate used in capital investment appraisals which brings capital investment appraisals which brings the cost of a project and its future cash the cost of a project and its future cash inflows into equality. inflows into equality.

IRR is a rate which equates the present IRR is a rate which equates the present value of anticipated net cash with the value of anticipated net cash with the initial outlay.initial outlay.

MeritsMerits

It considers the time value of It considers the time value of money.money.

It takes into account the total cash It takes into account the total cash inflows and cash outflows.inflows and cash outflows.

It is easier to understand. For It is easier to understand. For example if told that IRR of an example if told that IRR of an investment is 20% as against the investment is 20% as against the desired return on an investment is desired return on an investment is Rs 15,396.Rs 15,396.

DemeritsDemerits It does not use the concept of desired rate It does not use the concept of desired rate

of return, whereas it provides the rate of of return, whereas it provides the rate of return which is indicative of the return which is indicative of the profitability of investment proposal.profitability of investment proposal.

It involves tedious calculations, based on It involves tedious calculations, based on trial and error method.trial and error method.

It produces multiple rates which can be It produces multiple rates which can be confusing.confusing.

Project selected based on higher IRR may Project selected based on higher IRR may not be profitable.not be profitable.

Unless the life of the project can be Unless the life of the project can be accurately estimated, assessment of cash accurately estimated, assessment of cash flows cannot be correctly made.flows cannot be correctly made.

MIRR methodMIRR method

The MIRR is similar to the IRR, but is The MIRR is similar to the IRR, but is theoretically superior in that it theoretically superior in that it overcomes two weaknesses of the overcomes two weaknesses of the IRR;IRR;

MIRR correctly assumes MIRR correctly assumes reinvestment at project’s cost of reinvestment at project’s cost of capital.capital.

MIRR avoids the problem of MIRR avoids the problem of multiple IRRs.multiple IRRs.

3 basic steps of the 3 basic steps of the MIRRMIRR

Estimate all cash flows as in IRR.Estimate all cash flows as in IRR. Calculate the future value of all cash Calculate the future value of all cash

inflows at the last year of the project’s inflows at the last year of the project’s life.life.

Determine the discount rate that Determine the discount rate that causes the future value of all cash causes the future value of all cash inflows determined in step 2, to be inflows determined in step 2, to be equal to the firm’s investment at time equal to the firm’s investment at time zero. This discount rate is known as zero. This discount rate is known as the MIRR.the MIRR.

Terminal Value methodTerminal Value method

Under this method it is assumed that Under this method it is assumed that each cash flow is reinvested in another each cash flow is reinvested in another project at a predetermined rate of project at a predetermined rate of interest. It is also assumed that each interest. It is also assumed that each cash inflow is reinvested elsewhere cash inflow is reinvested elsewhere immediately until the termination of immediately until the termination of the project. If the present value of the the project. If the present value of the outflows the proposed project is outflows the proposed project is accepted otherwise not.accepted otherwise not.

MeritsMerits

Cash inflows reinvested once they are Cash inflows reinvested once they are received.received.

Easier to compute as compared to IRREasier to compute as compared to IRR It is better suited to cash budgeting It is better suited to cash budgeting

requirement.requirement.

However, the major problem of this method However, the major problem of this method lies in projecting the future rates of lies in projecting the future rates of interest at which the cash inflows will be interest at which the cash inflows will be reinvested.reinvested.

Cost of CapitalCost of Capital

Cost of capital is the rate that must Cost of capital is the rate that must be earned in order to satisfy the be earned in order to satisfy the required rate of return of the firm’s required rate of return of the firm’s investors.investors.

It can be define as rate of return on It can be define as rate of return on investment at which the price of investment at which the price of firm’s equity share will remain firm’s equity share will remain unchanged.unchanged.

Computing the cost of Computing the cost of capitalcapital

Determine the capital structure mixDetermine the capital structure mix

Determine individual cost of capitalDetermine individual cost of capital Determine total cost of capitalDetermine total cost of capital

• Equity Shares

• Preference Share

• Debentures

• Loans

Factors affecting the cost Factors affecting the cost of capitalof capital

General economic conditionGeneral economic condition Market conditionMarket condition Amount of finance requiredAmount of finance required Firms operating & financial Firms operating & financial

decisionsdecisions

Impact of inflation on Impact of inflation on capital budgetingcapital budgeting

Inflation can simply be defined as an Inflation can simply be defined as an increase in the average price of goods and increase in the average price of goods and services. The changes in price of the services. The changes in price of the various factors which may increase the various factors which may increase the project cost e.g. wage rates, sales prices, project cost e.g. wage rates, sales prices, material costs, energy costs, transportation material costs, energy costs, transportation charges and so on. charges and so on.

Synchronized and Differential InflationSynchronized and Differential Inflation Money Cash Flows and Real Cash FlowsMoney Cash Flows and Real Cash Flows

Impact of Taxation on Impact of Taxation on capital budgetingcapital budgeting

Taxation causes a change in cash flows, it Taxation causes a change in cash flows, it is a factor to be considered in project is a factor to be considered in project appraisal.appraisal.

Taxation affects a project in numerous Taxation affects a project in numerous ways, but probably the most significant ways, but probably the most significant three effects are:three effects are:

Corporate taxes on project profits and lossesCorporate taxes on project profits and losses Investment incentives, where applicableInvestment incentives, where applicable The reduction of WACC, because interest The reduction of WACC, because interest

payments are allowable against tax. payments are allowable against tax.

Impact of investment Impact of investment incentives on capital incentives on capital

budgetingbudgetingInvestment incentives take a variety of Investment incentives take a variety of

forms, including rates relief, rent-free forms, including rates relief, rent-free periods for land and buildings, and lump-periods for land and buildings, and lump-sum grants towards the costs of an sum grants towards the costs of an investment project. Therefore, the effect of investment project. Therefore, the effect of such incentives is to change the cash flow such incentives is to change the cash flow pattern of an investment. Any reduction in pattern of an investment. Any reduction in cash outflows resulting from investment cash outflows resulting from investment incentives can serve to convert a negative incentives can serve to convert a negative NPV into a positive one.NPV into a positive one.

There are two basic types of investment There are two basic types of investment incentives; cash grants and accelerated incentives; cash grants and accelerated depreciation allowances.depreciation allowances.

Cash grants: When these are receivable they Cash grants: When these are receivable they should be brought into the project appraisal in should be brought into the project appraisal in the period in which they are receivable.the period in which they are receivable.

Capital allowances: These allowances have an Capital allowances: These allowances have an equivalent cash inflow value of assuming equivalent cash inflow value of assuming sufficient profits are being earned to cover all sufficient profits are being earned to cover all the allowances. The cash inflow effect will be the allowances. The cash inflow effect will be lagged to an appropriate period. One year lagged to an appropriate period. One year should be assumed unless stated to the should be assumed unless stated to the contrary.contrary.