Financial

Management

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An Insight to

Capital Budgeting

Financial

Management

OVERVIEW

Capital budgeting is a decision involving selection of capital expenditure proposals.

It involves the allocation of funds to projects that will have a life of at least one year and usually much longer.

Eg. Purchase of plant and equipment Introduce new product in the market

Essentially its goal is to determine whether the future benefits are sufficiently large enough to justify the current outlays.

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Financial

Management

IMPORTANCE

Long time period, i.e. endured for a longer period whether decision is good or bad

Substantial expenditure

Irreversibility

Over and under capacity

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Financial

Management

DIFFICULTIES

Uncertainties of Future.

Difficult to measure the benefit in quantitative terms.

Time Element: the problem of phasing properly the availability of capital assets in order to have them come ‘on stream’ at the correct time.

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SELECTION PHASE

Financial

Management

CAPITAL BUDGETING PROCESS

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PLANNING PHASE

PROPOSALS

ONLINE PROJECTS

PROJECTS

ACCEPTED PROJECTS

PROJECT TERMINATION

PROPOSALSIM

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REJECTED

OPPORTUNITIES

EVALUATION PHASE

IMPLEMENTATION PHASE

CONTROL PHASE

AUDITING PHASE

REJECTED

PROPOSALS

REJECTED

PROJECTS

Financial

Management

WHY CASH FLOW METHOD OF EVALUATION?

Accrual basis of Accounting.

Cash flow approach takes in to account ‘time value of money’.

In the absence of real performance improvement accountants may accelerate revenues and defer costs.

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Financial

Management

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EVALUATION CRITERIA

DISCOUNTING CRITERIA

NON DISCOUNTING CRITERIA

NET PRESENT

VALUE

INTERNAL RATE OF RETURN

DISC. PAYBACK PERIOD

ACC. RATE OF

RETURN

PAYBACK PERIOD

PR’ABLTY INDEX

(PI)

Financial

Management

PAYBACK PERIOD• ips

Defined as the numbers of years required to cover the original cost outlay.

PAYBACK PERIOD INITIAL INVESTMENTANNUAL CASH FLOW

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Financial

Management

ADVANTAGES AND DISADVANTAGES OF PAYBACK PERIOD

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Simple.

Emphasizes on earlier cash flows.

Rough and ready method or dealing with risk.

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ADVA

NTA

GES

DIS

ADVA

NTA

GES Ignores cash after

the payback period.

Fails to consider ‘time value of the

money’

Financial

Management

AVERAGE RATE OF RETURN

Investment project is judged by looking at its rate of return on book value.

Evaluates return on accounting profits. i.e. on accrual basis

Annual returns are expressed in percentage of net investment.

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AVERAGE PROFIT AFTER TAX

AVERAGE INVESTMENT

AVERAGE RATE OF RETURN 100

Financial

Management

ADVANTAGES AND DISADVANTAGES OF ACCOUNTING RATE OF RETURN

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Simple.

Considers value of project to its economic life.

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ADVA

NTA

GES

DIS

ADVA

NTA

GES

Ignores the life of the project.

Fails to consider ‘time value of the

money’. Ignores the size of investment required.

Financial

Management

ADVANTAGES AND DISADVANTAGES OF ACCOUNTING RATE OF RETURN

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Based on accounting profits; no separate calculation required.

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ADVA

NTA

GES

DIS

ADVA

NTA

GES

Affected by accounting practices; changes in method of depreciation and inventory costing affects earnings and hence ARR

Financial

Management

WHY ?... TIME VALUE OF MONEY

Opportunity cost of the money.

Inflationary pressures.

Uncertainty of the future. i.e. preference of current consumption than future consumption.

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Financial

Management

WHY ?... TIME VALUE OF MONEY

In 1624, the Red Indians sold Manhattan Island at the ridiculously low figure of $24.

Was the amount really ridiculous?

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Financial

Management

WHY ?... TIME VALUE OF MONEY

If the Red Indians had merely taken the $24 (Rs.1200) and reinvested it at 6 percent annual interest up to 1992, they would have had $50 billion (Rs. 25 lakh crore ), an amount sufficient to repurchase most of New York City.

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Financial

Management

DISCOUNTED PAYBACK METHOD

Improvement over ‘payback period method’, considers ‘time value of money’.

It surmounts the objection that equal weight is given to all flows starting year one to the cut off date.

In other words, it discounts the cash inflow by applying the present value factors for different periods.

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Financial

Management

DISCOUNTED PAYBACK METHOD

The discounted payback rule asks, “How many periods does the project have to last in order to make sense in terms of net present value?”

Calculated by counting the years the discounted cash flows add up to the initial investment.

Still takes no account of cash flow after the cut-off date.

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Financial

Management

NET PRESENT VALUE METHOD

Its the difference between the total discounted inflows and outflows.

Depends solely on the forecasted cash flows and the opportunity cost of capital.

Opportunity cost of capital is the expected rate of return on investment of equivalent risks.

Present value of cash flows is calculated using opportunity cost of capital at discount rate.

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Financial

Management

NET PRESENT VALUE METHOD

Ideal for mutually exclusive projects. Projects are ranked in the order of highest

‘Net Present Values'

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Difficult to ascertain future cash flows.

Biased towards longer term projects.

Financial

Management

ADVANTAGES AND DISADVANTAGES OFNET PRESENT VALUE METHOD

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Considers‘time value of money’.

Relies on discount rate and estimated cash flows.

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ADVA

NTA

GES

DIS

ADVA

NTA

GES

Financial

Management

INTERNAL RATE OF RETURN METHOD Also known as the ‘Marginal Rate of Return’

or ‘Time Adjusted Rate of Return’. It is the discount rate at which the present

value of cash flows equals the present value of cash outflows. i.e. NPV = 0

In other words, IRR is the rate of return the project earns.

The rate of discount is determined by the ‘trial and error method’ .

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Financial

Management

The point of intersection represents the IRR; where NPV is equal to zero.

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NET

PRE

SEN

T VA

LUES

DISC. RATE

Lengthy, based on ‘trial and error method’.

Assumes that future cash flows are reinvested at a rate equal to IRR.

Financial

Management

ADVANTAGES AND DISADVANTAGES OF INTERNAL RATE OF RETURN METHOD

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Considers Working Capital and Scrape Value

Considers cash flows during the whole economic life.

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ADVA

NTA

GES

DIS

ADVA

NTA

GES

Financial

Management

DIFFERENCE BETWEEN NPV METHOD ANDIRR METHOD

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Assumes that cost of capital is known.

Calculates NPV, given the discount rate.

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NET

PRE

SEN

T VA

LUE

INTE

RNAL

RAT

E O

F RE

TURN Assumes that NPV

is zero.

Figures out discount rate that makes NPV zero.

Financial

Management

PROFITABILITY INDEX

The profitability index (or the benefit cost ratio) is the present value of forecasted future cash flows divided by the initial investment:

The profitability index rule tells us to accept all projects with an index greater than 1. If the profitability index is greater than 1, the present value PV of Ci is greater than the initial investment - C0 and so the project must have a positive net present value.

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PROFITABILITY INDEX

P/V OF CASH INFLOW

INITIAL CASH OUTFLOW

Financial

Management

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Thank You