Capital Budgeting

Satish Singh

Capital Budgeting

• It is a long term decision regarding the application of fund. It includes the decisions like purchase of new plant , machines mergers and amalgamation etc.

• Capital budgeting is the process of analyzing additions to fixed assets. Capital budgeting is important because, more than anything else, fixed asset investment decisions chart a company’s course for the future.

• Conceptually, the capital budgeting process is identical to the decision process used by individuals making investment decisions.

Role of capital budgeting

C ap ita l Bu d geting

Long T e rm A sse ts S hort T e rm A sse ts

Inv estm en t D ecis ion

D eb t/E qu ity M ix

F inanc ing D ecis ion

D iv idend P ayou t R a tio

D iv idend D ec is ion

Overall F inancial Goal:M aximize Shareholder W ealth

Continue

• it includes following steps :(1) Estimate the cash flows--interest and maturity value or dividends in the case of bonds and

stocks, operating cash flows in the case of capital projects.(2) Assess the riskiness of the cash flows.(3) Determine the appropriate discount rate, based on the riskiness of the cash flows and the

general level of interest rates. This is called the project cost of capital in capital budgeting. (4) Find (a) the PV of the expected cash flows and/or (b) the asset’s rate of return. (5) If the PV of the inflows is greater than the PV of the outflows (the NPV is positive), or if the calculated rate of return (the IRR) is higher than the project cost of capital, accept the

project.

•

Issues involve in capital budgeting

• Long term decision• Huge money is involve• This can not be reverse• They decide the future capability of the co.• These are strategic decision

Problems of capital budgeting

• Long term• Future is uncertain• Risk • Risk and return trade off.• Can not be reverse

Estimation of flows

• Initial outflow: it is the amount which incurred for the purchase of new machine , or a project. It also include the cost of installation expenditure. It is capital outflow.

• Subsequent flow: it is the revenue which will be received during the life of machine. It is revenue income.

• Terminal flow: it the amount which recovered at the end of life of machine. It is known as scrap value of machine.

Numerical problem

• X co. ltd. Wants to start a new project at cost of rs. 1,10,000. it will have life of 5 years and a scrape value of 10000 rs. It will generate revenue @ 25000 rs. Per year. Company use S.L.M of depriciation @20%. Tax rate is 50%.Find out the flow of funds from the project.

Solution of problem

• Solve it as explained earlier

Techniques of capital budgeting

Discounted techniques– NPV (Net present Value)– IRR (internal rate of return)– PI (profitability index method)/ BCR (Benefit cost

ratio )Non discounted techniques– Pay back period method– ARR method( Average rate of return method)

• Net present value (NPV) indicates the expected impact of the project on the value of the firm. The NPV is the present value of all expected cash flows including the investment dollars; both positive and negative cash flows are considered. A discount rate is chosen to get discounted net present value. The NPV decision rule specifies that all independent projects with a positive NPV should be accepted. When choosing among mutually exclusive projects and when capital is constrained, the projects with the largest positive NPV combination should be selected.

• Internal rate-of-return (IRR) is the discount rate at which the net present value (NPV) of a project equals zero. The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted when there are no capital constraints. When choosing mutually exclusive projects and when capital is constrained, the projects with the highest IRRs should be selected.

• Payback period represents the amount of time it takes for a project to recover its initial cost. The payback period decision rule specifies that all independent projects with a payback period less than a specified number of years should be accepted. When choosing among mutually exclusive projects and during certain times of tight capital constraint, the projects with the quickest paybacks are preferred.

• Profitability index (PI) is the ratio of the present value of change in operating cash inflows to the present value of investment cash outflows. A project that increases owners’ wealth has a PI greater than one. If PI is less than 1, a project should be rejected.

• ARR .

numerical• The XYZ co. ltd wants to choose among two projects “ A” and

“B”. The details are:Year A B0 25 401 0 102 5 143 20 164 14 175 6 8

The cost of capital or discounted rate is 16%. Find out Pay back, NPV,PI, IRR From the details and advice.

Pay back period

Year A CFa B CFb0 -25 -401 0 0 10 102 5 5 14 24

3 20 25 16 404 14 39 17 575 6 45 8 65

• Pay back period is 3 years.

NPVYear @16% A PV a B PVb

0 -25 -25 -40 -401 .862 0 0 10 8.6202 .743 5 3.715 14 10.4023 .641 20 12.820 16 10.2564 .552 14 7.728 17 9.3845 .476 6 2.856 8 3. 808

Total NPV 2.119 2.470

PI

• A27.119/25=1.085• B42.470/40=1.062

IRR A machine

Year inflow 18% P V 20% PV 1. 0 .847 0 .833 02. 5 .718 3.590 .694 3.4703. 20 .609 12.180 .579 11.5804. 14 .516 7.224 .482 6.7485. 6 .437 2.622 .402 2.412 Total P.V 25.616 24.210

NPV .616 -.790

A

• IRR= 18%+.616/.616+.790 *2= 18.88 %

IRR of Machine B

Year inflow 18% P V 20% PV 1. 10 .847 8.470 .833 8.3302. 14 .718 10.052 .694 9.7163. 16 .609 9.744 .579 9.2644. 17 .516 8.772 .482 8.194 5. 8 .437 3.496 .402 3.216

Total P.V 40.534 38.720NPV .534 -1.28

B

• Irr=• 18%+.534/.534+1.28*2%• =18.59

Analysis• Pay back 3 year 3 Year• NPV@16% 2.119 2.47• PI 1.085 1.062• IRR 18.88% 18.59%• In case of PI &IRR machine A is better but in

case of NPV B machine is better. However Payback is same for both. So A should be selected.