Introduction to fm finance management studies

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1. Chapter 9 – Capital Budgeting I: Principles and Techniques PROPRIETARY MATERIAL © 2019 The McGraw Hill Education, Inc. All rights reserved. No part of this PowerPoint slide may be displayed, reproduced or distributed in any form or by any means, without the prior written permission of the publisher, or used beyond the limited distribution to teachers and educators permitted by McGraw Hill for their individual course preparation. If you are a student using this PowerPoint slide, you are using it without permission. Copyright © 2019 McGraw Hill Education, All Rights Reserved.

2. Learning Objectives Discuss the nature of capital budgeting Explain the relevant data requirement for capital budgeting decisions Describe, evaluate and interpret the traditional and time-adjusted capital budgeting evaluation techniques Summarise capital budget practices by Corporates in India

3. Introduction Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the goal of shareholders (owners) wealth maximisation .

4. Nature of Capital Budgeting Meaning Capital budgeting decisions pertain to fixed/long-term assets. Fixed/long-term assets refer to assets which are in operation, and yield a return, over a period of time, usually, exceeding one year. Capital expenditure management, therefore, includes addition, disposition modification and replacement of fixed assets. The following are the basic features of capital budgeting: potentially large anticipated benefits; a relatively high degree of risk; and a relatively long time period between the initial outlay and the anticipated returns.

5. Importance In the first place, capital budgeting decisions decisions affect the profitability of a firm. Secondly, a capital expenditure decision has its effect over a long time span and inevitably affects the company’s future cost structure. Thirdly, capital investment decisions, once made, are not easily reversible. Finally, capital investment involves costs and the majority of the firms have scarce capital resources.

6. Difficulties Firstly, the benefits from investments are received in some future period. The future is uncertain. Secondly, costs incurred and benefits received from the capital budgeting decisions occur in different time periods. Thirdly, it is not often possible to calculate in strict quantitative terms all the benefits or the costs relating to a particular investment decision.

7. Rationale The rationale underlying the capital budgeting decision is efficiency. Capital budgeting decision can be of two types: those which expand revenues, and those which reduce costs.

8. Kinds Capital budgeting process refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. Basically, the firm may be confronted with three types of capital budgeting decisions: the accept-reject decision; the mutually exclusive choice decision; and the capital rationing decision.

9. Accept-reject Decision This is a fundamental decision in capital budgeting. If the project is accepted , the firm would invest in it; If the proposal is rejected , the firm does not invest in it.

10. Mutually Exclusive Project Decisions Mutually exclusive projects are those which compete with other projects in such a way that the acceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen.

11. Capital Rationing Decision In a situation where the firm has unlimited funds , all independent investment proposals yielding return greater than some predetermined level are accepted. Capital rationing refers to a situation in which a firm has more acceptable investments than it can finance.

12. Data Requirements: Identifying Relevant Cash Flows Cash Flows Vs Accounting Profit The cash flow approach of measuring future benefits of a project is superior to the accounting approach. First, while considering an investment proposal, a firm is interested in estimating its economic value determined by the economic outflows (costs) and inflows (benefits). Secondly, the use of cash flows avoids accounting ambiguities. Thirdly, the cash flow approach takes cognisance of the time value of money whereas the accounting approach ignores it.

13. Incremental Cash Flow Relevant cash flow is the incremental after-tax cash outflow (investment) and resulting subsequent inflows associated with a proposed capital expenditure. Incremental cash flows are the additional cash flows (outflows as well as inflows) expected to result from a proposed capital expenditure.

14. Effect of Taxes Finally, the incremental cash flows are adjusted for tax liability. In other words, taxes paid are deducted from the cash flows to estimate the benefits arising out of the investment decision.

15. Cash Flow Pattern Conventional cash flow pattern is an initial outflow followed by only a series of inflows. Non-conventional cash flow pattern only a series of inflows.

16. Cash Flow Estimates For capital budgeting cash flows have to be estimated. The following are the ingredients of cash flow streams: Tax Effect Effect on Other Projects Effect of Indirect Expenses Effect of Depreciation

17. Determination of Relevant Cashflows The data requirement for capital budgeting are cash flows, that is, outflows and inflows. Their computation depends on the nature of the proposal. Capital projects can be categorised into: single proposal, replacement situations and mutually exclusive

18. Evaluation Techniques The methods of appraising capital expenditure proposals can be classified into two broad categories: traditional, and time-adjusted. The latter are more popularly known as discounted cash flow (DCF) techniques as they take the time factor into account. The traditional techniques includes average rate of return method and pay back period method. The time-adjusted techniques includes net present value method, internal rate of return method, net terminal value method, and profitability index.

19. Traditional Techniques Average Rate of Return Computation : The average rate of return (ARR) method of evaluating proposed capital expenditure is also known as the accounting rate of return method. The average profits after taxes are determined by adding up the after-tax profits expected for each year of the project’s life and dividing the result by the number of years. The average investment is determined by dividing the net investment by two. Average investment = Net working capital + Salvage value + 1/2 (Initial cost of machine – Salvage value)  

20. Accept-reject Rule A project would qualify to be accepted if the actual ARR is higher than the minimum desired ARR. Otherwise, it is liable to be rejected . Alternatively, the ranking method can be used to select or reject proposals.

21. Evaluation of ARR Merits ARR method is easy to calculate. It is simple to understand and use. The total benefits associated with the project are taken into account while calculating the ARR. Drawbacks The principal shortcoming of the ARR approach arise from the use of accounting income instead of cash flows. The second principal shortcoming of ARR is that it does not take into account the time value of money. Thirdly, the ARR criterion of measuring the worth of investment does not differentiate between the size of the investment required for each project.

22. Pay Back Method Computation : Payback (period) method is the exact amount of time required for a firm to recover its initial investment in a project as calculated from cash inflows. Original/initial investment (outlay) is the relevant cash outflow for a proposed project at time zero (t = 0). Annuity is a stream of equal cash inflows. Mixed stream is a series of cash inflows exhibiting any pattern other than that of an annuity  

23. Accept-Reject Criterion If the actual pay back period is less than the predetermined pay back, the project would be accepted ; If not, it would be rejected . Alternatively, the pay back can be used as a ranking method.

24. Evaluation Merits It is easy to calculate and simple to understand. It is based on cash flow analysis. Drawbacks It completely ignores all cash inflows after the pay back period. It does not measure correctly even the cash flows expected to be received within the pay back period. It does not take into consideration the entire life of the project during which cash flows are generated.

25. Discounted Cashflow (DCF)/Time-Adjusted (TA) Techniques The distinguishing characteristics of the DCF capital budgeting techniques is that they take into consideration the time value of money while evaluating the costs and benefits of a project. The second commendable feature of these techniques is that they take into account all benefits and costs occurring during the entire life of the project.

26. Present Value (PV)/Discounted Cash Flow(DCF) General Procedure : The present value or discounted cash flow procedure recognizes that cash flow streams at different time periods differ in value and can be compared only when they are expressed in terms of a common denominator, that is, present values. It, thus, takes into account the time value of money. In this method, all cash flows are expressed in terms of their present values.

27. Net Present Value (NPV) Method Net present value (NPV) is found by subtracting a projects initial investment from the present value of its cash inflows discounted at the firm's cost of capital. Symbolically, the NPV for projects having conventional cash flows would be: If cash outflow is also expected to occur at some time other than at initial investment (non-conventional cash flows) the formula would be:  

28. Accept-Reject Criterion The decision rule for a project under NPV is to accept the project if the NPV is positive and reject if it is negative. Symbolically, NPV > zero, accept NPV < zero, reject Zero NPV implies that the firm is indifferent to accepting or rejecting the project.

29. Evaluation Merits It explicitly recognises the time value of money. It considers the total benefits arising out of the proposal over its lifetime. A changing discount rate can be built into the NPV calculations by altering the denominator. It useful for the selection of mutually exclusive projects. It is instrumental in achieving the maximisation of the shareholders’ wealth objective.

30. Drawbacks It is difficult to calculate as well as understand and use in comparison with the pay back method or even the ARR method. The calculation of the required rate of return to discount the cash flows is a serious problem. It is that it is an absolute measure. It may not give satisfactory results in the case of two projects having different effective lives.

31. Profitability Index (PI) or Benefit-Cost Ratio (B/C Ratio) Profitability index measures the present value of returns per rupee invested. Symbolically,  

32. Accept-Reject Rule Using the B/C ratio or the PI, a project will qualify for acceptance if its PI exceeds one. When PI equals 1, the firm is indifferent to the project.

33. Evaluation Merits It satisfies almost all the requirements of a sound investment criterion. It considers all the elements of capital budgeting, such as the time value of money, totality of benefits and so on. It is a better evaluation technique than NPV in a situation of capital rationing Drawbacks It is more difficult to understand. It involves more computation than the traditional methods but less than IRR.

34. Internal Rate of Return (IRR) Method It is the discount rate that equates the present values of cash inflows with the initial investment associated with a project, thereby causing NPV = 0. Assuming conventional cash flows, mathematically, the IRR is represented by the rate, r, such that:  

35. For unconventional cash flows, the equation would be: where, r = The internal rate of return; CFt = Cash inflows at different time periods; Sn = Salvage value, Wn = Working capital adjustments and COt = Cash outlay at different time periods  

36. Accept-Reject Decision The project would qualify to be accepted if the IRR (r) exceeds the cut-off rate (k). If the IRR and the required rate of return are equal, the firm is indifferent as to whether to accept or reject the project. Computation : Unlike the NPV method, calculating the value of IRR is more difficult. where, PB = Pay back period, DFr = Discount factor for interest rate r, DFrL = Discount factor for lower interest rate, DFrH = Discount factor for higher interest rate and r = Either of the two interest rates used in the formula  

37. Evaluation of IRR Merits It considers the time value of money. It takes into account the total cash inflows and outflows. It is easier to understand. It does not use the concept of the required rate of return/the cost of capital. It is consistent with the overall objective of maximising shareholders’ wealth. Drawbacks It involves tedious calculations. It produces multiple rates which can be confusing. In evaluating mutually exclusive proposals, the project with the highest IRR would be picked up to the exclusion of all others. Under the IRR method, it is assumed that all intermediate cash flows are reinvested at the IRR

38. Terminal Value Method The terminal value approach (TV) even more distinctly separates the timing of the cash inflows and outflows. The assumption behind the TV approach is that each cash inflow is reinvested in another asset at a certain rate of return from the moment it is received until the termination of the project.

39. Accept-reject Rule The decision rule is that if the present value of the sum total of the compounded reinvested cash inflows (PVTS) is greater than the present value of the outflows (PVO), the proposed project is accepted otherwise not. Symbolically, PVTS > PVO accept PVTS < PVO reject

40. Evaluation Merits It incorporates the assumption about how the cash flows are reinvested once they are received. It is mathematically easier. This method is easier to understand for business executives who are not trained in accountancy or economics than NPV for IRR. It is better suited to cash budgeting requirements. Drawbacks The major practical problem of this method lies in projecting the future rates of interest at which the intermediate cash inflows received will be reinvested.