CAPITAL BUDGETING in finance sector.pptx

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1. Best Practices in Capital Budgeting

2. Importance of Capital Investments They have long-term consequences and these decisions have considerable impact on what the firm can do in future. It is difficult to reverse capital investments. These involve huge financial outlays.

3. Capital Budgeting Process Identification of Potential Investment Opportunities Assembling of Proposed Investments Decision Making Preparation of Capital budget Implementation Performance Review

4. Costs & benefits Once an investment project is proposed it needs to be evaluated and thus the costs and benefits associated with it need to estimated. In order to derive the relevant stream of costs and benefits from these projections , the finance manager must bear in mind the following principles: Cash Flow Principle Incremental principle Long term Funds Principle Interest Exclusion Principle Post tax principle

5. Cash Flow Principle Decisions are based on cash flows and not on accounting concepts such as net income. Thus, Cash flows are to be calculated as PAT + Non-Cash Expenses i.e. Depreciation

6. Incremental principle Consider all incidental benefits – The project may create synergies with existing projects or may cannibalize the existing revenue of the firm, hence these should be taken into account. Ignore Sunk Costs – These are costs which cannot be recovered. Lets assume a company has spent quite a sum of money as a preliminary study before deciding about the project, then this amount spent is a sunk cost. Include Opportunity Costs – Example , a project requires a vacant piece of land within the factory premises. The cost of the land even though is sunk cost but its opportunity cost should be considered as this land can be put some other use and can generate benefit.

7. Long term Funds Principle A project may be evaluated from various points of view i.e. Total Funds point of view , Long-term funds point of view or equity point of view. It is generally recommended that a project may be evaluated from a long-term funds point of view (i.e. funds which are provided by debenture holders, preference share holders, equity share holders and term lending institutions).

8. Interest Exclusion Principle When cash flows relating to long-term funds are being measured interest on long-term debt should not be considered. The WACC used for evaluating the cash flows takes into account the cost of long-term debt, thus double counting should be avoided. Therefore, Interest*(1-t) should be added to Profit after tax.

9. Post tax principle Cash flows are analyzed on an after-tax basis. Taxes have to be fully reflected in capital budgeting decisions.

10. Costs & Benefits – Round up The Costs and benefits stream is defined as : Post-tax incremental cash flow stream relating to long-term funds Initial Flows = (Outlay on machinery & other fixed assets ) – Tax shields relating to investment in P&M and other fixed assets + Outlays on Net Working Capital Operational Flows = PAT + Depreciation and other non-cash charges Terminal Flows = Cash flows expected from the disposal of assets when the project is terminated i.e. Post-tax salvage value of fixed assets + Post-tax salvage value of working capital

11. New Project - Example Bharat & Co is considering a new investment project about which the following information is available: The total outlay on the project will be Rs 100 lakhs. This consist s of Rs 60 lakhs on Plant & machinery and Rs 40 lakhs on gross working capital. The entire outlay will be incurred at the beginning of the project. The project will be financed with rs 40 lakhs of Equity capital, Rs 30 lakhs of long-term debt (in the form of debentures) . Rs 20 lakhs of short-term bank borrowings, and Rs 10 Lakhs of trade credit. This means that Rs 70 lakhs of long-term funds (equity + long-term debt) will be applied towards Plant & Equipment (Rs 60 lakhs) and working capital margin (Rs 10 lakhs) – working capital margin is defined as the contribution of long-term funds towards working capital. The interest rate on debentures will be 13.5% and the interest rate on STBB will be 20%.

12. 3. The life of the project is expected to be 5 years. At the end of 5 years , plant and equipment would fetch a salvage value of Rs 20 lakhs. The liquidation value of working capital will be equal to rs 40 lakhs, its book value. 4. The project will increase the revenues of the firm by Rs 80 lakhs per year. The increase in expenses on account of the project will be Rs 40 lakhs pe r year. (This includes all items of expenses othe rthan depreciation, interest on debentures and taxes). The effective tax rate will be 50%. 5. Plant & Equipment will be depreciated at the rate of 3.33% per ye3ar as per the WDV method. The depreciation charges are as: Year Depreciation (Rs Lakhs) 1 20 2 13.33 3 8.89 4 5.93 5 3.95

13. Given the above details calculate the cash flows related to the project based on the long-term funds principle.

14. Cash Flows For The New Project 1 2 3 4 5 A. P&M (60.00) B. Working Capital Margin (10.00) C. Revenues 80 80 80 80 80 D. Costs (Other than depreciation and interest on debentures) 40 40 40 40 40 E. Depreciation 20 13.33 8.89 5.93 3.95 F. Profit Before Tax 20 26.67 31.11 34.07 36.05 G. Tax 10 13.33 15.55 17.03 18.02 H. Profit After tax 10 13.33 15.55 17.03 18.02 I. Net Salvage Value of P&M 20 J. Net Recovery of Working Capital margin 10 K. Initial Flow (A + B) (70.00) L. Operating Flow (H + E) 30 26.66 24.44 22.96 21.97 M. Terminal Flow (I + J) 30.00 N. Net Cash Flow (70.00) 30.00 26.66 24.44 22.96 51.97

15. Replacement Project Naveen Enterprises is interested in assessing the cash flows associated with the replacement of an old machine by a new machine. The old machine bought a few years ago has a book value of Rs 90,000 and it can be sold for Rs 90,000. It has a remaining life of 5 years after which its salvage value is expected to be nil. It is being depreciated annually at the rate of 20% (WDV). The new machine costs Rs 4,00,000. It is expected to fetch Rs 2,50,000 after 5 years when it will no longer be required. It will be depreciated annually at the rate of 33.33% (WDV). The new machine is expected to bring a saving of Rs 1,00,000 in manufacturing costs. Investment in working capital would remain unaffected. The tax rate applicable is 50%. Calculate the cash flows associated with the replacement project.

16. 1 2 3 4 5 A. Net Investment in Machine (310) B. Savings in Manufacturing Costs 100 100 100 100 100 C. Depreciation on Old Machine 18 14.4 11.5 9.2 7.4 D. Depreciation on New Machine 133.3 88.9 59.3 39.5 26.3 E. Incremental Depreciation on New Machine (C –D) 115.3 74.5 47.8 30.3 18.9 F. Incremental Taxable Profit (B – E) (15.3) 25.5 52.2 69.7 71.1 G. Incremental Tax (7.7) 12.8 26.1 34.9 35.6 H. Incremental Profits after tax (7.7) 12.7 26.1 34.8 35.5 I. Net incremental salvage value 250 J. Initial Flow (A) (310) K. Operating Flow (H + E) 107.6 87.2 73.9 65.1 54.5 L. Terminal Flow (I) 250.0 M. Net Cash Flow (J + K + L ) (310) 107.6 87.2 73.9 65.1 304.5

17. DL Laminates Ltd. is considering a proposal to replace one of its machines. The following data is available regarding the same: I. The machine was purchased 4 years ago for Rs.15 lakh and has been depreciated at 25% p.a. as per the WDV method. The machine has a remaining life of 5 years, after which its salvage value is expected to be Rs.0.80 lakh. Its present salvage value is Rs.6.0 lakh. II. The new machine costs Rs.22 lakh, and would be depreciated at 40% p.a. as per WDV method. Its expected life is 8 years and after 5 years, it is expected to fetch Rs.6 lakh. The installation of this machine will increase the annual revenue by Rs.5.0 lakh, apart from decreasing the operational costs by Rs.1.10 lakh per annum. If the company uses a discounting factor of 17% p.a. Marginal tax rate of the company is 20%. Calculate the depreciation on the old machine for 8 th year Depreciation on the new machine for 5 th year. Cash Flows for the replacement proposal.

18. Depreciation on new machine 1 2 3 4 5 Original Cost/Opening WDV 22.0 13.2 7.92 4.75 2.85 Depreciation 8.8 5.28 3.17 1.90 1.14 Depreciation on old machine (Rs. Lakh) 1 2 3 4 5 6 7 8 9 Original Cost/Opening WDV 15.0 11.25 8.44 6.33 4.75 3.56 2.67 2.00 1.62 Depreciation 3.75 2.81 2.11 1.58 1.19 0.89 0.67 0.50 0.38

19. Cash flows of the Replacement Project: Cash flows of the Replacement Project: 0 1 2 3 4 5 1. Net investment in new machine (16.0) 2. Increase in revenues 5.00 5.00 5.00 5.00 5.00 3. Savings in Costs 1.10 1.10 1.10 1.10 1.10 4. Depreciation on old machine* 1.19 0.89 0.67 0.50 0.38 5. Depreciation on new machine 8.80 5.28 3.17 1.90 1.14 6. Incremental depreciation (5) – (4) 7.61 4.39 2.50 1.40 0.76 7. Net incremental salvage value 5.20 8. Incremental profit before tax [(2) + (3) – (6)] (1.51) 1.71 3.60 4.70 5.34 9. Incremental profit after tax [(8) (1 – 0.2)] (1.21) 1.37 2.88 3.76 4.27 10. Operating Cash Flow (6) + (9) 6.40 5.76 5.38 5.16 5.03 11. Net Cash Flow [(1) + (7) + (10)] (16.0) 6.40 5.76 5.38 5.16 10.23

20. APPRAISAL CRITERIA APPRAISAL CRITERIA NON- DCF CRITERIA PAYBACK PERIOD ACCOUNTING RATE OF RETURN DCF CRITERIA NET PRESENT VALUE INTERNAL RATE OF RETURN BENEFIT COST RATIO

21. PAYBACK PERIOD Payback Period – It is the length of time required to recover the initial cash outlay on the project. Ex: Cash Outlay on the Project = 6,00,000 Cash Inflows are: Year 1 = 1,00,000 Year 2 = 1,50,000 Year 3 = 1,50,000 Year 4 = 2,00,000 Thus, the payback period is 4 years in this case. As per this criteria, the shorter the payback period the more desirable is the project. Note: Firms using this criterion, generally specify the maximum acceptable payback period. If it is n years , then projects with payback period of n years or less are acceptable.

22. ADVANTAGES OF PAYBACK PERIOD It is simple in concept and application It favors projects which generate substantial cash inflows in earlier years and discriminates against projects which bring substantial cash inflows in later years. Since it favours projects with initial cash inflows hence it may be a sensible criteria when the firm is pressed with problems of liquidity.

23. LIMITATIONS OF PAYBACK PERIOD It fails to consider the time value of money It ignores cash flows beyond the payback period. This leads to discrimination against projects which generate substantial cash inflows in later years. It is a measure of the project’s capital recovery and not the profitability. Though it measures a project’s liquidity, it does not indicate the liquidity position of the firm as a whole.

24. ACCOUNTING RATE OF RETURN ARR = Profit After Tax / Book Value of Investment Average Rate of Return = Avg Profit / Avg Book Value of Fixed Investment Avg Profit = 24000 / 70000 = 34.28% Note : Higher the ARR, the better it is. In general projects which have an ARR equal to greater than a pre-specified cut-off rate of return are accepted and others are rejected. YEAR BOOK VALUE OF FIXED INVESTMENT PROFIT AFTER TAX 1 90,000 20,000 2 80,000 22,000 3 70,000 24,000 4 60,000 26,000 5 50,000 28,000

25. NET PRESENT VALUE The net present value of a project is equal to the sum of the present value of all the cash flows associated with the project. NPV = CF / (1+k) + CF 1 / (1+k) 1 + CF 2 / (1+k) 2 +…… CF n / (1+k) n NPV = Net Present Value CF t = Cash Flow at the end of year t n = Life of the project K = Discount rate

26. Example YEAR CASH FLOW (10,00,000) 1 2,00,000 2 2,00,000 3 3,00,000 4 3,00,000 5 3,50,000 The cost of capital for the firm is 10%. Calculate the NPV of the proposal?

27. NPV = -10,00,000 / (1+k) + 2,00,000 / (1+k) 1 + 2,00,000 / (1+k) 2 + 3,00,000 / (1+k) 3 + 3,00,000 / (1+k) 4 + 3,50,000 / (1+k) 5 = -5273 The net present value represents the net benefit over and above the compensation for time and risk. Hence thed ecision rule associated with the NPV is : Accept the project if the NPV is positive Reject the project if the NPV is negative Neutral or Indifferent if the NPV is zero

28. Advantages of NPV It takes into account the time value for money It considers the cash flow stream in entirety It squares neatly with the financial objective of maximization of the wealth of stockholders. The NPV of various projects , can be added. For e.g. the NPV of package of two projects A and B, will simply be the sum of the NPV of these projects individually NPV ( A + B) = NPV (A) + NPV (B) Therefore this enables that a poor project i.e. with negative NPV will not be accepted just because it is combined with a positive NPV project.

29. IRR – Internal rate of return The IRR of a project is the discount rate which makes its NPV equal to zero. It is the discount arte in the equation: 0 = CF / (1+k) + CF 1 / (1+k) 1 + CF 2 / (1+k) 2 +…… CF n / (1+k) n CF t = Cash Flow at the end of year t n = Life of the project K = Discount rate Note : In the NPV calculation we assume that the discount is known and determine the NPV wherein in the caes of IRR we set the NPV equal to zero and determine the discount rate which satisfies this condition.

30. Example YEAR 1 2 3 4 CASH FLOW -1,00,000 30,000 30,000 40,000 45,000 Calculate the IRR for the cash flows of the project?

31. 1,00,000 = 30,000/(1+r)1 + 30,000/(1+r)2 + 40,000/(1+r)3 + 45,000/(1+r)4 At r = 15% RHS = 1,00,802 At r = 16% RHS = 98,641 Therefore r = 15% + (16-15) * [(100000 – 98641) / (100802 – 98641)] = 15.37%

32. Advantages It takes into account the time value of money. It considers the cash flow stream in its entirety. It makes sense to businessmen who prefer to think in terms of percentage instaed of absolute quantity.

33. Limitations The IRR may not be uniquely defined. There may be multiple IRRs if a project has more then one change in sign. The IRR cannot distinguish between lending and borrowing and hence a high IRR need not necessarily be a desireable feature.

34. Benefit Cost Ratio Benefit Cost ratio (BCR) = PVB / I PVB = present Value of benefits I = Initial Investment Net Benefit Cost ratio (NBCR) = (PVB – I) / I

35. Example Initial Investment 1,00,000 Benefits Year 1 25000 Year 2 40000 Year 3 40000 Year 4 50000 Ans : First Calculate the PVB i.e. PVB / I = [25000/(1.12) + 40000 / (1.12) 2 + 40000 / (1.12) 3 + 50000 / (1.12) 4 ] / 100000 = 1.145 NBCR = BCR – 1 = 1.145 – 1 = 0.145 When BCR or NBCR Rule is 1 > 0 Accept =1 = 0 Indifferent < = 1 < 0 Reject

36. Questions Perch limited is considering 4 projects A, B, C, D with the following characteristics: Q.1. The funds available for investment are limited to Rs.21 lakh and the cost of funds to the firm is 17%. Rank the projects in terms of the NPV respectively Projects Initial Investment (Year 0) Annual Net Cash Flow (Years 1 to 5) A 18 6.5 B 5 2 C 6.5 3.5 D 9 4.5

37. Q.2. Rank the projects according to BCR criteria respectively. Q.3. Which projects will you recommend based on NPV and BCR criteria, given the limited supply of funds? (648)(735)

38. The NPVs of the 4 projects are as follows: Project NPV Rs. in Lakh @ 17% Rank A 6.5 × 3.199 – 18 = 2.79 III B 2.0 × 3.199 – 5 = 1.39 IV C 3.5 × 3.199 – 6.5 = 4.69 II D 4.5 × 3.199 – 9 = 5.39 I

39. The BCR of the 4 projects are as follows: Project BCR Rank A 20.79/18 = 1.15 IV B 6.39/5 = 1.27 III C 11.19/6.5 = 1.72 I D 14.39/9 = 1.59 II

40. Question The cash flow stream for the four alternative investments A,B,C,D are: Year A B C D (2,00,000) (3,00,000) (2,10,000) (3,20,000) 1 40,000 40,000 80,000 2,00,000 2 40,000 40,000 60,000 20,000 3 40,000 40,000 80,000 - 4 40,000 40,000 60,000 - 5 40,000 40,000 80,000 - 6 40,000 30,000 60,000 - 7 40,000 30,000 40,000 - 8 40,000 20,000 40,000 - 9 40,000 20,000 40,000 2,00,000 10 40,000 20,000 40,000 50,000

41. Calculate the following for all the projects: Q.1. Calculate the Payback Period? Q.2. Calculate the NPV? (Discount rate = 9%) Q.3. Calculate the IRR ? Which would you choose and why?