Capital Budgeting-Meaning, Features, ptx

Capital Budgeting

1. Capital Budgeting

2. Meaning & Definition of Capital Budgeting Capital refers to be the total investment of a company of firm in money, tangible and intangible assets. Budgets are a blue print of a plan and action expressed in quantities and manners. Capital budgeting is a long-term planning for making and financing proposed capital out lays. Capital budgeting consists in planning development of available capital for the purpose of maximizing the long-term profitability of the concern”. Capital is the total investment of the company and budgeting is the art of building budgets.

3. Examples of Capital Expenditures Purchase of fixed assets such as land and building, plant and machinery, good will, etc. The expenditure relating to addition, expansion, improvement and alteration to the fixed assets. The replacement of fixed assets. Research and development project.

4. Features of Capital Budgeting Capital Budgeting is a tool for maximizing a company's future profits since most companies are able to manage only a limited number of large projects at any one time.  It involves high risk Large profits are estimated Long time period between the initial investments and estimated returns

5. Need and Importance of Capital Budgeting (CB) Huge Investments – CB involves huge expenditures and hence require control to manage its expenditures Long Term - CB is long-term in nature or permanent in nature. Financial risks involved in the investment decision are more. Irreversible – Once committed cannot be changed back. Long term effect – Increases the revenue in long-term and will bring significant changes in the profit of the company. Therefore before making the investment, it is required carefully planning and analysis of the project thoroughly.

6. Features of Capital Budgeting Benefits for future: Capital is invested with a view to gain benefits for future. Huge Funds: Generally capital budgeting involves huge amount of funds. Irreversible Decisions: Decisions once taken cannot be changed, if we have already started work on our decision. Investment of funds: Capital budgeting is mainly related with the investment of capital for long term profit. Non-flexible Activities:  Funds are invested for non-flexible activities. Decision for long term: In capital budgeting decisions are taken for long term profit or for long term commitment of funds

7. Capital Budgeting Process Identification of various investments proposals - Various department analyse the various investment decisions, and will select proposals submitted to the planning committee of competent authority. Matching the proposals - planning committee will analyse the various proposals and screenings. The selected proposals are considered with the available resources of the concern. Evaluation - Proposals are evaluated with the help of various methods, such as pay back period proposal, net discovered present value method, accounting rate of return and risk analysis Fixing Property - The planning committee approves the final proposals, with the help of the following: (a) Profitability (b) Economic constituents (c) Financial violability (d) Market conditions . Implementing - It helps the management for monitoring and containing the implementation of the proposals (use of PERT and CPM) Performance Review and Feedback – Actual results compared with the standard results.

8. Capital Budgeting decisions The crux of capital budgeting is profit maximization. There are two ways to it; either increase the revenues or reduce the costs. The increase in revenues can be achieved by expansion of operations by adding a new product line. Reducing costs means representing obsolete return on assets. 1. Accept / Reject decision  -  If a proposal is accepted, the firm invests in it and if rejected the firm does not invest. Generally, proposals that yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the others are rejected.

9. Capital Budgeting decisions 2. Mutually exclusive project decision  -  Mutually exclusive projects compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. Only one may be chosen. 3. Capital rationing decision  -  Capital rationing refers to the situation where the firm has more acceptable investments requiring a greater amount of finance than that is available with the firm. Ranking of the investment project is employed on the basis of some predetermined criterion such as the rate of return. 

10. Time Value of Money Evaluation of capital expenditures involve comparison between cash inflow and outflow Capex decision to be taken today Is the value of flows arising in future the same as in terms of today? There is an element of uncertainty Purchasing power will be less if received the amount after one year Investment opportunities available Value of both cash inflows and outflows to be expressed in terms of today

11. Techniques Compounding – Interest is compounded and becomes part of the initial principal at the end of the compounding period FV = PV (1 + r)^n Discounting – This is opposite of compounding. It tries to find out the present value of Rs. 1 if received or spent after n years , provided that the interest rate can be earned on investment. PV = FV / (1 + r)^n

12. Techniques for evaluation of capital expenditure proposal Techniques not considering time value of money Pay back period Accounting Rate of Return Techniques considering time value of money Discounted pay back period Net Present Value (NPV) Internal Rate of Return Profitability Index or Benefit Cost Ratio (B/C Ratio)

13. Payback Period Payback period = Cash outlay / Annual cash inflow Example – A project requires an outlay of Rs. 500000 and earns an annual cash inflow of Rs. 100000 for 8 years. Calculate pay back period. Solution – Payback period = 500000/100000 = 5 years Example – A project requires an outlay of Rs. 100000 and earns annual cash inflow of Rs. 25000, Rs. 30,000, Rs. 20,000 and Rs. 50,000. Calculate pay back period. Solution – Rs. 75000 in 3 years and balance of Rs. 25000 is 12 X 25000/50000 = 6 months. Hence payback period is 3 years and 6 months.

14. Acceptance Rule – Payback Period If the payback period computed for a project is more than the maximum pay back period estimated by the management it would be rejected or vice versa. As a ranking method, the projects having shortest pay back period will be ranked highest.

15. Accounting Rate of Return (ARR) ARR computes the average annual yield on the net investment in the project. ARR is computed by dividing the average profits after depreciation and taxes by net investments in the project. Thus ARR can be computed as – Total Profits / Net investments in projects X No. of years in profits ( expressed at percentages)

16. Example A project involves the investment of Rs. 500000 which yields profit after depreciation and tax as stated below : At the end of the 5 years , the machineries in the project can be sold for Rs. 40000. Find the ARR Years Profits after depreciation and taxes 1 25000 2 37500 3 62500 4 65000 5 40000 Total 230000

17. Solution Total profits after depreciation and taxes are Rs. 230000. The net investment in the projects will be original costs less salvage value i.e. Rs 500000- Rs. 40000 = Rs. 460000 Hence ARR = 230000/460000X 5 X 100 = 10%

18. Acceptance Rule Projects having the ARR more than the minimum rate prescribed by the management will be accepted and vice versa. As a ranking method, the projects having maximum ARR will be ranked highest.

19. Discounted pay back period This is an improvement over the pay back period method in the sense that it considers time value of money. Thus discounted pay back period indicates that period within which the discounted cash inflows equal to the discounted cash outflows involved in a project. Discounted payback period = PV of total cash outflow – Cumulative PV of CFAT f the year in which cumulative PV of CFAT is less than PV of cash outflow / PV of CFAT in next year following the year for which cumulative PV of CFAT was considered in numerator. Acceptance Rule – Same as in case of pay back period method except the fact that it considers time value of money

20. Net Present Value (NPV) NPV is a method of calculating present value of cash inflows and cash outflows in a investment project, by using cost of capital as the discount rate, and finding out NPV by subtracting present value of cash outflows from present values of cash inflows. Thus – NPV = Discounted Cash Inflows Less Discounted Cash Outflows Acceptance Rule – As accept or reject criteria, all the projects which involve positive NPV i.e. NPV>0, will be accepted and vice versa. As a ranking method, the projects having maximum positive NPV, will be ranked highest.

21. Internal Rate of Return Internal rate of return (IRR)  is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected. Formula = NPV at lower rate Lower discount rate + --------------------------- X (higher rate – lower rate) NPV at lower rate – NPV at higher rate

22. Problem on IRR A project cost Rs. 384000 and generates annual cash inflow of Rs. 150000, Rs. 125000, Rs. 100000 and Rs. 75000 and Rs. 50000 over its life of 5 years. Calculate IRR. Steps to calculate – Calculate average annual cash inflow Calculate Approx Pay back period Find discount factors corresponding to approx. pay back period Calculate NPV at two discount factors (one positive and one negative) Apply the formula

23. Problem No. 2 - IRR Project X and Project Y costs Rs. 50,000 and Rs. 25,000 respectively. Their cash flows are given below. You are required to find out the internal rate of return for each project and decide on that basis which project is more profitable. Cash Inflows Years Project X ( Rs.) Project Y (Rs.) 1 5000 10000 2 15000 10000 3 30000 10000 4 20000 10000 5 10000 -

24. Profitability Index It is the ratio between total discounted cash inflows and total discounted cash outflows. Thus PI can be computed as : PI = Sum of discounted cash inflows / Sum of discounted cash outflows Acceptance Rule – The projects having PI of more than 1 will be accepted and vice versa. As a ranking method, the projects having highest PI will be ranked highest.

25. Problem 1 A company has to make a choice between two projects namely A and B. The initial capital outlay of two projects are Rs. 135000 and Rs. 240000respectively for A and B. There will be no scrap value at the end of the life of both the projects. The opportunity cost of capital of the company is 16%. The annual income are as under – You are required to calculate for each project – 1 ) Discounted pay back period 2) Profitability Index and c) Net Present Value Year Project A (Rs) Project B (Rs) 1 - 60000 2 30000 84000 3 132000 96000 4 84000 102000 5 84000 90000

26. Problem 5 Machine A costs Rs. 1,00,000 payable immediately. Machine B costs Rs. 1,20,000 half payable immediately and half payable in one years time. The cash receipt expected are as follows – At 7% opportunity cost which machine should be selected on the basis of NPV? Year Machine A (Rs.) Machine B (Rs.) 1 20000 - 2 60000 60000 3 40000 60000 4 30000 80000 5 20000 -

27. Problem 6 ( Continued on next slide) ITC Ltd had decided to purchase a machine to augment the company’s installed capacity to meet the growing demand for its products. There are three machines under consideration of the management . The relevant details including estimated yearly expenditures and sales are given below. All sales are on cash. Corporate income tax is 40%. The economic life of machine 1 is 2 years while it is 3 years for other two. The scrap value are Rs. 40,000, Rs. 25,000 and Rs. 30,000 respectively. You are required to find out the most profitable investments based on Pay Back Period.

28. Problem 6 Machine 1 (Rs) Machine 2 (Rs) Machine 3 (Rs) Initial Investment required 300000 300000 300000 Estimated annual sales 500000 400000 450000 Estimated Cost of Production: Direct Material 40000 50000 48000 Direct Labour 50000 30000 36000 Factory Overheads 60000 50000 58000 Administration cost 20000 10000 15000 Selling & Distribution cost 10000 10000 10000

29. Problem 7 A company is considering an investment proposal to install a new milling control at a cost of Rs.50,000. The facility has a life expectancy of 5 years without any salvage value. The firm uses SLM of depreciation and the same is used for tax purposes. The tax rate is assumed to be 35%. The estimated cash flows before depreciation and tax (CFBDT) from the investment proposal are as follows – Compute: a) Payback period 2) Average rate of return 3) NPV at 10% discount rate4) Profitability Index at 10% discount rate Years 1 2 3 4 5 CFBDT (Rs) 10000 10692 12769 13462 20385

30. Problem 8 The companies initial investment in a project was Rs. 1,00,000 and the expected cash inflows during the project are as follows – The cost of capital is 12%. Calculate the following – a) NPV b) Benefit cost ratio c) IRR and d) Payback period Years 1 2 3 4 5 Cash Inflow 20,000 30,000 40,000 50,000 30,000

31. Problem 9

32. Problem 10

33. Problem 11

34. Capital Rationing Capital rationing is a process whereby the limited funds available are allocated amongst the financially viable projects which are not mutually exclusive under consideration so as to maximize the wealth of the shareholders. Thus capital rationing is said to exists – Limited funds are available for investments More than one financially viable projects which are not mutually exclusive are under considerations.