CAPITAL BUDGETING

DECISIONS
Should we
build this
plant?
What is capital budgeting?

Capital Budgeting is the process of determining which real

investment projects should be accepted.

Capital budgeting is investing in long-lived assets

Shareholder wealth maximization should be kept in mind.

Also called Investment Appraisal

Importance of Investment Decisions
Involve commitment of large amount of funds

For a long time period

Usually not reversible

Types of Investment Decisions

Expansion of existing business

New business

Replacement of assets
The Capital Budgeting process
Step 1 Generating Ideas

Step 2 Analyzing Individual Proposals

Collect information and analyze the profitability of alternative projects

Step 3 Planning the Capital Budget

Analyze the fit of the proposed projects with the companys strategy and select them.

Step 4 Monitoring and Post Auditing

Compare expected and realized results and explain any deviations
Investment Evaluation Criteria

Estimation of cash flows

Estimation of the required rate of return (the opportunity

cost of capital)

Application of a decision rule for making the choice

Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria

Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Discounted Payback Period

2. Non-discounted Cash Flow Criteria

Payback Period (PB)
Accounting Rate of Return (ARR)
Net Present Value Method

NPV = PVinflows PVoutflows

If NPV > 0, then accept the project; otherwise reject

the project.
If NPV=0, we may accept, or reject.
Net Present Value Method

C1 C2 C3 Cn
NPV n
C0
(1 k ) (1 k ) (1 k ) (1 k )
2 3

n
Ct
NPV C0
t 1 (1 k )
t

C0 is the initial investment.

Calculating Net Present Value

Assume that a new plant costs Rs 2,500 crores now

It is expected to generate year-end cash inflows as follows:

Years 1 2 3 4 5
CFs 900 800 700 600 500
(Rs Crore)

The opportunity cost of the capital may be assumed to be

10 per cent.
Solution

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500

NPV 2
3
4
5
Rs 2,500
(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF1, 0.10 ) + Rs 800(PVF2, 0.10 ) + Rs 700(PVF3, 0.10 )
+ Rs 600(PVF4, 0.10 ) + Rs 500(PVF5, 0.10 )] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225

Or
= 225.53 (using calculator)
ACCEPT the project
Evaluation of the NPV Method

NPV is most acceptable investment rule for the following

reasons:
Considers time value
Cash flows used
Maximises Shareholder value

Limitations:
Difficult to estimate cash flows
Discount rate difficult to determine
Internal Rate of Return Method
IRR is the rate of return that a project generates.

Algebraically, IRR can be determined by setting up an NPV

equation and solving for a discount rate that makes the NPV
= 0.

Equivalently, IRR is solved by determining the rate that

equates the PV of cash inflows to the PV of cash outflows.

If IRR > opportunity cost of capital (or hurdle rate), then

accept the project; otherwise reject it.
 C1 C2 C3 Cn
C0
(1 r ) (1 r ) 2
(1 r ) 3
(1 r ) n
n
Ct
C0
t 1 (1 r )t
n
Ct
t 1 (1 r ) t
C0 0

You can get the IRR by solving the r in the equation

Calculation of IRR

By Trial and Error

The approach is to select any discount rate to compute the net present
value (NPV). If the calculated NPV is negative, a lower rate should be
tried.
On the other hand, a higher value should be tried if the NPV is positive.
This process will be repeated till the net present value becomes zero.
For interpolation:

OR,
Lower rate + [ ] x Difference in rates
Example
A project costs Rs 16000 crores and is expected to generate Rs 8000 cr, Rs
7000 cr and Rs 6000 cr at the end of each year for the next 3 years.
Evaluate the project using IRR. Cost of capital is 11%.
Using trial and error, method:
Select arbitrarily say 20%
NPV at this rate = (-)1004
Select a lower rate, say 16%
PV at 16% = 15943
NPV at 16% = (-)57
Select a lower rate, say 15%
PV at 15% = 16200
NPV at 15% = 200
The IRR must lie between 15 and 16%
Now use interpolation formula
 NPV at lower rate:200
NPV at higher rate: -57

15 + [200 / (200+57)]*1 = 15.78%

Calculations using Excel (Function called IRR) = 15.77%

Should you accept the project?

ACCEPT, as the IRR>Cost of capital

Evaluation of IRR Method

IRR method has following merits:

Time value
Shareholder value

IRR method may suffer from:

Multiple rates
Reinvestment assumption
Profitability Index
Profitability index is the ratio of the present value of cash
inflows, at the required rate of return, to the initial cash
outflow of the investment.
Also called BENEFIT COST RATIO

If PI > 1, then accept the project; otherwise reject the

project
Profitability Index
The initial cash outlay of a project is Rs 100,000 and it can
generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000
and Rs 20,000 in year 1 through 4.

Assume a 10 per cent rate of discount. Find the PI index or

BCR.
Solution

PV = 40,000/(1.1^1) + 30,000/(1.1^2) + 50,000/(1.1^3) +

20,000/(1.1^4)
=112383

PI = 1,12,383/1,00,000 = 1.12383

NPV = 1,12,383 1,00,000 = 12,383

Evaluation of PI Method

It recognises the time value of money.

It is consistent with the shareholder value maximisation

principle.

It is a relative measure of a projects profitability.

Like NPV method, PI criterion also requires calculation of

cash flows and estimate of the discount rate. In practice,
estimation of cash flows and discount rate pose problems.
Payback

Payback is the number of years required to recover the

original cash outlay invested in a project.

The project would be accepted

if its payback period is less than the maximum or standard payback
period set by management.

It gives highest ranking to the project, which has the shortest

payback period and

lowest ranking to the project with highest payback period.

Example
Assume that a project requires an outlay of Rs 50,000 and
yields cash inflow of Rs 12,500 each year for 7 years. The
payback period for the project is:

Rs 50,000
PB 4 years
Rs 12,500
 Suppose that a project requires a cash outlay of Rs 20,000, and generates
cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; Rs 3,000 and Rs 2500
during the next 5 years. What is the projects payback?

3 years + (1,000/3,000) years

3 1/3 years
Evaluation of Payback

Certain virtues:
Simple and easy to implement

Serious limitations:
Cash flows after payback ignored
Timing of Cash flow ignored
Standard payback period is subjective in nature
Inconsistent with shareholder value

Can be used with NPV rule as a first step in roughly

screening the projects
Discounted Payback Period
The discounted payback period is the number of periods taken in
recovering the investment outlay on the present value basis.

Project ABC Project XYZ

0 -4000 -4000
1 3000 0
2 1000 4000
3 1000 1000
4 1000 2000
Cost of capital
10%
Simple PB ? ?
Discounted PB ? ?
Discounted Payback Period
Discount the CFs at 10%

Project ABC PV Project XYZ PV

0 -4000 -4000
1 3000 2727.27 0 0.00
2 1000 826.45 4000 3305.79
3 1000 751.31 1000 751.31
4 1000 683.01 2000 1366.03

Simple PB 2 years 2 years

Discounted PB 2.59 years 2.92 years
Discounted Payback Period
The discounted payback period still fails to
consider the cash flows occurring after the
payback period.
Accounting Rate of Return Method

It is the ratio of the average after-tax profit divided by the average

investment.

average annual net income

ARR=
average book value of investment

Accept all those projects whose ARR is higher than the minimum rate
established by the management
Example
A project will cost Rs 40,000. It is depreciated using straight line method during its
life of 5 years. Its stream of income after taxes from first year through five years is
expected to be Rs 1,000, Rs 2,000, Rs 3,000, Rs 4,000 and Rs 6,000.
(Depreciation: 40000/5 = 8000)D
Average income =
(1,000 + 2,000 + 3,000 + 4,000 + 6,000)/5 = 3200
Average book value = (Beginning value + Ending value)/2
= (40000+0)/2 = 20000
not constant, then take the average of beginning and end BV each year and then yearly e
1 2 3 4 5
Beginning Value 40000 32000 24000 16000 8000
Ending Value 32000 24000 16000 8000 0
Average BV each year 36000 28000 20000 12000 4000
Average BV 20000 =(36000+28000+20000+12000+4000) / 5

ARR = 3200/20000 = 16%

Another example

Year 0 Year 1 Year 2 Year 3

Investment 300,000 200,000 100,000 0
(Book Value)
Net Income 30,000 40,000 20,000

Income= (30000+40000+20000)/3 = 30000

Average Investment = (300000+0)/2=150000

ARR = 30000/150000=20%
Evaluation of ARR Method

The ARR method may claim some merits

Simplicity

Uses accounting data

Shortcomings
Cash flows ignored

Time value ignored

Arbitrary cut-off
CAPITAL BUDGETING IN PRACTICE

Over time, discounted cash flow methods have gained in

importance and internal rate of return is the most popular
evaluation method, followed by NPV.

Firms typically use multiple evaluation methods

Accounting rate of return and payback period are widely

employed as supplementary evaluation methods
ESTIMATING CASH FLOWS
ELEMENTS OF THE CASH FLOW STREAM

Initial Investment
Operating Cash Inflows
Terminal Cash Inflow
Basic principles of Capital Budgeting

Decisions are based The timing of cash

on cash flows. flows is crucial.

Cash flows are Cash flows are on

incremental. an after-tax basis.

Financing costs are

ignored.
Some guidelines for Cash Flows

Non cash charges or income not to be considered.

As PAT is calculated after reducing depreciation (non cash charge)
amount, add it back to get cash flows
Financing costs should not be considered because they will be
reflected in the cost of capital figure. If we subtract them from
cash flows, we would be double counting capital costs.

To ascertain a projects incremental cash flows you have to

look at what happens to the cash flows of the firm with the
project and without the project
 Ignore sunk costs like R&D expenses

Opportunity costs are included

A plant space could be leased out for Rs 5,00,000 a year.
Accepting the project means we will not receive the rentals.
This is an opportunity cost and it should be charged to the
project.

Cash flows should be measured on a post-tax basis

Investment will be required for Working Capital and will be
returned by the end of the projects life
Illustration

Following information is available for a project:

Initial investment outlay is 100m i.e. 80m on Plant and
Machinery and 20m on working capital
Project will be financed with 45m of equity capital, 5m of
preference capital, 50m of debt capital.
Preference capital has a cost of 15%, debt has after-tax cost
of 8.4%
For Equity Capital we have the following information: Beta of
the company and the project is 1.2; the market risk premium is
12% and the risk free rate of return is 8%.
Expected life of the project is 5 years
 At the end of 5 years, fixed assets will fetch a value of 30m
and Working Capital will be liquidated at book value
Project is expected to increase the revenues by 120m per year
and increase the costs by 80m per year. The costs do not
include depreciation, interest and tax
Effective tax rate will be 30%
Plant and Machinery will be depreciated by 25% per year on
WDV method
Estimate the project cash flows and find out its NPV and IRR.
Should the project be accepted?
 (` IN MILLION)
0 1 2 3 4 5
A. FIXED ASSETS -80
B. NET WORKING CAPITAL -20
C. REVENUES 120.00 120.00 120.00 120.00 120.00
D. COST (OTHER THAN DEPRN AND INT) 80.00 80.00 80.00 80.00 80.00
E. DEPRECIATION 20.00 15.00 11.25 8.44 6.33
F. PROFIT BEFORE TAX 20.00 25.00 28.75 31.56 33.67
G. TAX 6.00 7.50 8.63 9.47 10.10
H. PROFIT AFTER TAX 14.00 17.50 20.13 22.09 23.57
I. NET SALVAGE VALUE OF FIXED ASSETS 26.69
J. RECOVERY OF NET WORKING CAPITAL 20.00
K. INITIAL OUTLAY -100
L. OPERATING CASH FLOW (H+E) 34.00 32.50 31.38 30.53 29.90
M. TERMINAL CASH FLOW (I+J) 46.69
N. NET CASH FLOW (K+L+M) -100 34.00 32.50 31.37 30.53 76.59

Sale price 30
cap gain 11.02
tax payable 3.305

net proceeds 26.695

Depreciation Schedule
Beginning Balance 80.00 Sale price asset 30
Depreciation 20.00
BV of asset 18.98
Ending Balance 60.00
Profit on sale 11.02
Depreciation 15.00
Tax on profit 3.31
Ending Balance 45.00
Depreciation 11.25
Ending Balance 33.75 SP 30
Depreciation 8.44 Less tax 3.31
Ending Balance 25.31 Net 26.69
Depreciation 6.33
Ending Balance 18.98
 NPV `30.20 million Accept

IRR 25.72% Accept

Cost of Equity capital .08+(1.2*0.12) =0.224 = 22.4%

Cost of capital 0.224*0.45 + 0.084*0.5 + 0.15*0.05 = 15.03%