Capital BudgetingBy Devansh Mehta

Faculty at ICRI

Capital Expenditure

• A Truck manufacturer is Considering investment in a New Plant.

• An airliner is planning to buy a fleet of jet aircrafts.

• A Commercial bank is thinking of an Ambitious computerization programme

All these situations Involves a Capital Expenditure Decision

• Capital budgeting from accounting point of view is an expenditure shown as an asset on the balance sheet.

• This asset, except in the case of a non-depreciable asset like land, is depreciated over its Life.

Capital expenditure represent the growing edge of a business• CE have three distinctive features

• They have long term Consequences

• They often involve substantial Outlays

• They may be difficult or expensive to reverse

How a firm finances its investments and how it manages its short term operations are definitely issues of concern

How it allocates its capital really reflects its strategy and its business

Overview of Capital Budgeting Techniques • Capital Budgeting Process• Project classification• Investment Criteria• Net present value• Benefit cost ratio• Internal rate of return• Modified internal rate of return• Payback period• Accounting rate of return• Investment appraisal in practice

Capital Budgeting Process

• It’s a complex process which may be divided into the following phases

• Identification of potential investment opportunities• Assembling of proposed investments• Decision Making• Preparation of capital budget and appropriations• Implementation• Performance review

Identification of Potential Investment Opportunities• Identification of investment ideas is helpful to, • Monitor external environment regularly to scout investment opportunities• Formulate well defined corporate strategy based on analysis of SWOT• Share Corporate strategy and perspective with persons who are involved in

the process of capital budgeting• Motivate employees to make suggestions

Assembling of investment Proposals

• Investment proposals identified by the production department and other departments are usually submitted in a standardized capital investment proposal firm.

• Investment proposals are usually classified into various categories for facilitating DECISION MAKING, BUDGETING, AND CONTROL• LIKE REPLACEMENT INVESTMENTS• EXPANSION INVESTMENTS• NEW PRODUCT INVESTMENTS• OBLIGATORY AND WELFARE INVESTMENTS

DECISION MAKING

• A SYSTEM OF RUPEE GATEWAYS USUALLY CHARACTERISES CAPITAL INVESTMENTS DECISION MAKING• FOR EG. IN ONE COMPANY THE PLANT SUPERINTENDENT CAN OKAY

INVESTMENT OUTLAYS UPTO RS 200000• THE WORKS MANAGER UPTO 500000• MANAGING DIRECTOR UPTO RS 20000000

• ABOVE 20000000 DECISION LIES WITH BOARD OF DIRECTORS

IMPLEMENTATION

• Translating an investment proposal into a concrete project is a complex time consuming and risk fraught task.

• For proper implementation need of an hour is • Adequate formulation of project• Use of Principle of responsibility accounting• Use of network techniques

• Using PERT (Program evaluation review techniques) and CPM ( Critical path Method)

Program Review

• Performance review or post completion audit is a feedback device.

• It is useful in several ways• It Throws light on how realistic were the assumptions underlying the project• It provides a documented log of experience that is highly valuable for decision

making, It helps in uncovering judgemental biases and it induces a desired caution among project sponsors

Project classification

• Mandatory Investments• Replacement projects• Expansion Projects• Diversification Projects

• Research and Development projects• Miscellaneous Projects

Investment criteria

Investment Criteria

Discounting Criteria

Net Present value

Benefit Cost ratio

Internal Rate of Return

Non-Discounting

Criteria

Payback period

Accounting Rate of Return

Net preset value

Σ Ct

n

( 1 + r)tt = 1

- Initial Investment

Where Ct is the cash flow at the end of year t, n is the life of the project and r is the discount rate

Properties of NPV

• The net present value of a package of projects is simply the sum of the net present values of the individual projects included in the package.

• Value of a Firm = Σ Present value of projects + Σ NPV of expected future of projects.

• Net Present values are Additive in Nature.

Properties of NPV

• Intermediate Cash flows are invested at the Cost of Capital: The NPV rule assumes that the intermediate cash flows of a project – that is, cash flows that occur between the initiation and the termination of the project are reinvested at a rate of return equal to the cost of capital

• NPV value calculation permits Time varying Discount rates: So far we assumed that the discount rate remains constant over time. This need not be always the case. The NPV can be calculated using time-varying discount rates

The General formula for NPV is;

Σ Ct

n

( 1 + r)tt = 1

- Initial Investment

Where Ct is the cash flow at the end of year t, n is the life of the project and r is the discount rate

NPV can be Expressed as follows;

NPV: Σ - Initial InvestementCt

Π( 1 + rj)

n

t = 1t

J = 1

Where Ct is the cash flow at the year end of year t, and rj is the one period discount

rate applicable to period j, and n is the life of the project.

What is Financing Mix

• links\financing mix.pdf

• The discount rate may change over time for the following reasons: • The level of interest rates may change over time – the term structure of

interest rates sheds light on expected rates in future, The risk characteristics of the project may change over time, the resulting in changes is the cost of capital, The financing mix of the project may vary over time, causing changes in the cost of capital

Benefit Cost Ratio

• BCR = PVB I

Net Benefit-cost ratio: NBCR = PVB – I = BCR - 1I

When BCR is Less than 1, Rule is accept; When BCR = 1, its Indifferent; when BCR is more than 1, then Reject it.

Internal rate of return

• The internal rate of return ( IRR) of a project is the discount rate which makes its NPV equal to zero. Put differently, it is the discount rate which equates the present value of future cash flows with the initial investment.

Same formula for NPV, but, where Ct is the cash flow at the end of the year t, r is the internal rate of return and n is the life of the project.

The decision rule for IRR is as follows; Accept: If the IRR is greater than the cost of the capital.Reject: If the IRR is less than the cost of the capital.