Post on 06-Apr-2018
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Capital Budgeting
PREPARED BY : Swapnil (3)
Keyur (10)
Nikhil (14)
Manjiri (18)
Nikita (27)
Asad (30)
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Outline
Meaning of Capital Budgeting
Significance of Capital Budgeting Analysis
Traditional Capital Budgeting TechniquesPayback Period Approach
Discounted Payback Period Approach
Discounted Cash Flow Techniques Net Present Value
Internal Rate of Return
Profitability Index
Net Present Value versus Internal Rate of Return
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Meaning of Capital Budgeting
Capital budgeting addresses the issue ofstrategic long-term investment decisions.
Capital budgeting can be defined as theprocess of analyzing, evaluating, and decidingwhether resources should be allocated to aproject or not.
Process of capital budgeting ensure optimalallocation of resources and helpsmanagement work towards the goal ofshareholder wealth maximization.
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Significance of Capital Budgeting:
Considered to be the most important
decision that a corporate treasurer hasto make.
So much is the significance of capitalbudgeting that many business schoolsoffer a separate course on capitalbudgeting
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Why Capital Budgeting is soImportant?Involve massive investment of
resourcesAre not easily reversible
Have long-term implications for the
firmInvolve uncertainty and risk for thefirm
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Due to the above factors, capital budgeting decisionsbecome critical and must be evaluated very carefully.Any firm that does not follow the capital budgetingprocess will not be maximizing shareholder wealthandmanagement will not be acting in the best interestsof shareholders.RJR Nabiscos smokeless cigarette project exampleSimilarly, Euro-Disney, Concorde Plane, Saturn of GMall faced problems due to bad capital budgeting,while Intel became global leader due to sound capital
budgeting decisions in 1990s.
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Classification Of Projects
The Capital budgeting process may be less or more ,it depends onthe type of the projects :
NEW PROJECTS -- Ex: establishment of a paper manufacturing company
requires machinery to produce paper ,which mayrequire investment of some crores of rupees.
EXPANSION PROJECTS-- Ex: same company which is currently producing
20,000 tones of paper may increase its plant capacityby 10,000 tonnes per year.
DIVERSIFICATION PROJECTS-- Ex: Reliance ,marketer of textiles, entering into
petroleum business.
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REPLACEMENT & MODERNISATION PROJECTS - - Ex: A cement manufacturing concern is planning to go for
modernization where it is changing its drying process fromsemi-automatic to fully automatic drying equipment orreplacement of manually operated machinery by the fully
automatic machinery.
R & D PROJECTS -- Majority of the large firms are setting up their own R & D
departments.
MISCELLANEOUS PROJECTS Ex: Reliance ,marketer of textiles, entering into petroleum
business.
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Kinds Of Capital BudgetingACCEPT-REJECT DECISIONS --
Basic decision in making capital expenditure decisions.
Used for all independent projects.
MUTUALLY EXCLUSIVE INVESTMENTSProjects do not depend upon each other ,one can be acceptedand the other can be rejected.
Ex: a company has an option of buying a component from anoutside or manufacturing within the firm.(In this situation , thecompany may accept the most profitable decision, based on thepurchase price or manufacturing cost whichever is less)
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CAPITAL RATIONING DECISIONS--
Arises when a firm has unlimited funds & several profitableinvestment projects.
CONTINGENT INVESTMENTS--
Contingent projects are dependent investment, acceptance ofone option needs to understand one or more other projects
Ex: location of a factory in a backwards area, instead ofindustrial area or urban ,may need to construct roads, quartersfor employees ,hospitals, schools, without which it is verydifficult to attract employees.
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Process Of Capital Budgeting
IDEA GENERATION
EVALUATION or ANALYSISSELECTION
FINANCING THE SELECTED PROJECT
EXECUTION or IMPLEMENTATIONREVIEW OF THE PROJECT
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Techniques of Capital
Budgeting Analysis
Payback Period Approach
Discounted Payback Period ApproachNet Present Value Approach
Internal Rate of Return
Profitability Index
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WhichTechnique should we
follow?
A technique that helps us in selecting projectsthat are consistent with the principle ofshareholder wealth maximization.
A technique is considered consistent withwealth maximization if
It is based on cash flowsConsiders all the cash flows
Considers time value of money
Is unbiased in selecting projects
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Pay Back Period
Pay Back Period may be defined as that period required to
recover the original cash outflow invested in the project.
Pay Back Period can be calculated in two ways :
i. Using formula
Pay Back Period = Original Investment / Constant Cash Flow
After Taxes
ii. Using Cumulative cash flow method
PBP = Year before full recovery + (Unrecovered Amount of
Investment, Cash flows during the year)
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Decision Rule
Accept: Cal PBP < Standard PBP
Reject: Cal PBP > Standard PBP
Advantages of PBP
Very simple and easy to understand
Cost involvement in calculating PBP is much less when
compared to modern methods.
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Limitations of PBP
It ignores cash flows after pay back period.
It is not an appropriate method of measuring the profitability of a
project, as it does not consider all cash inflows yielded by the
investment. It does not take into consideration time value of money.
There is no rationale basis for setting a minimum pay back
period.
It is not consistent with the objective of maximisingshareholders wealth since share value does not depend on pay
back periods of investments projects.
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Accounting Rate of Return (ARR)
Accounting rate of return method uses accounting
information as revealed by financial statements, to measure the
profitability of the investment proposals. It is also known as the
Return on Investment (ROI).
It is calculated in two ways:
i. Whenever it is clearly mentioned as Accounting Rate of Return
Accounting Rate of Return(ARR)= Average Annual EAT or PAT100
Original Investment (OI)
OI= Original investment + additional NWC + Installation Charges +
Transportation Charge
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ii. Whenever it is clearly mentioned as Average Rate of Return
Average Rate of Return = Average Annual EAT 100
Average Investment (AI)
AI = (Original investment Scrap value)1/2+Additional NWC
+ Scrap Value
Decision Rule
Accept: Cal ARR > Predetermined ARR or Cut-off rate
Reject: Cal ARR < Predetermined ARR or Cut-off rate
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Advantages of ARR method
Very simple to understand and easy to calculate.
Information can easily can be drawn from accounting records.
It takes into account all profits of the projects life period.
Cost involvement in calculating ARR is much less is comparisionwith the modern methods, since it saves analysts time
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Limitations of ARR method
Accounting profits are inappropriate for evaluating and accepting
projects, Since they are computed based on arbitrary assumptions
and choices and also include non-cash items.
It ignores the concept of time value of money.
It does not allow the fact that the profits can be reinvested. It does not differentiate between the size of the investment
required for each project.
It does not take into consideration any benefits, which can accrue
to the firm from the sale of abundance of equipment, which isreplaced by the new investment.
It feels that 10% rate of return for 10 years is more beneficial
than 8% rate of return for 25 years.
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Discounted Payback Period
Similar to payback period approach with onedifference that it considers time value ofmoney
The amount of time needed to recover initialinvestment given the present value of cashinflows
Keep adding the discounted cash flows till thesum equals initial investment
All other drawbacks of the payback periodremains in this approach
Not consistent with wealth maximization
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Net Present Value Approach
NPV defined as preset value of benefits minuspreset value of costs
It may be positive or negative
Accept a project if NPV 0
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Steps involved in computation of
Net Present Value
Forecasting of cash inflow of the
project based on realistic assumptionscomputation of cost of capital
calculation of PV cash flows using cost
of capital as discounting rateFinding out NPV
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Advantages
It takes in to account the time value of money
It is particularly useful for the selection of mutually exclusive project
it is consistent with the objective of maximization of shareholderswealth
It takes into consideration the changing discount rate
Disadvantages
It is difficult to understand when compared with PBR and ARR
It does not give satisfactory result s when comparing two projects
with different life periodIn cash of project involving different cash outlays NPV method maynot give dependable results
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Internal Rate of Return
Internal rate of return may be definedas that discounting factor at which thepresent value of cash inflow is equal topresent value of cash outflows
Projects promised rate of return given
initial investment and cash flowsConsistent with wealth maximization
Accept a project if IRR Cost of Capital
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Advantages
It takes in to account the time value if money
It considers cash flows throughout the project life
It gives more psychological satisfaction to the user
It is consistent with the objective of shareholders wealthmaximization
Disadvantages
It is difficult to understand and to calculate since it involvestedious calculation
It implies that profits can be reinvested at internal rate ofreturn which is not logical
It produce multiple rate of return which can be confusing
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NPV versus IRR
Usually, NPV and IRR are consistent witheach other. If IRR says accept the project,
NPV will also say accept the projectIRR can be in conflict with NPV if
Investing or Financing Decisions
Projects are mutually exclusive
Projects differ in scale of investment Cash flow patterns of projects is different
If cash flows alternate in signproblem ofmultiple IRR
If IRR and NPV conflict, use NPV approach
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Profitability Index (PI)
PI is also known as discounted benefit costratio
PI measures the present value of future cashper rupee of investment
PI is the ratio which derived by dividingpresent value of cash inflow by present value
of cash outflows.PI=present vale of cash inflow /present valueof cash out flows
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Advantages
It gives due consideration to time value of money.
It considers all cash flows to determine PI.It will help to rank projects according to their PI.
It can also be used to choose mutually exclusive projects bycalculating the incremental benefit cost ratio.
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Evaluating Projects with
Unequal Lives
Replacement Chain Analysis
Equivalent Annual Cost MethodIf two machines are unequal in life, weneed to make adjustment beforecomputing NPV.
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Which technique is superior?
Although our decision should be based onNPV, but each technique contributes in itsown way.
Payback period is a rough measure ofriskiness. The longer the payback period,more risky a project is
IRR is a measure of safety margin in a
project. Higher IRR means more safetymargin in the projects estimated cash flows
PI is a measure of cost-benefit analysis. Howmuch NPV for every dollar of initial
investment
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Q) A Project costs rs. 20 lakhs and yields annually profit of Rs. 3
lakhs after depreciation at 12.5% but before tax at 50%. Calc PayBack Period & suggest whether it should be accepted or rejectedbased on 6-year standard pay back period.
Q) A company is considering expanding its production. It can go
either for an automatic machine costing Rs 2,24,000 with anestimated life of 5 years or an ordinary machine costing Rs60,000 having an estimated life of 8 years. The annual sales andcosts are estimated as follows:
Sales Auto machine Ordinary mach
1,50,000 1,50,000Costs:
Materials: 50,000 50,000
Labour: 12,000 60,000
Variable overHs: 24,000 20,000
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Risk analysis in capital budgeting
Project specific riskCompetitive risk
Industry specific risk
Market riskInternational risk
Sources of risk
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Three different perspectives
Standalone risk - It refers to the risk of a
project when it is viewed in isolation.
Firm risk It is the projects risk to thecorporation , that affects firms earnings.
Market risk It refers to the risk of a projectfrom the viewpoint of a diversified investor.
Perspectives of risk
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Thank You!