INTRODUCTION:

Capital budgeting is the process by which the financial

manager decides whether to invest in specific capital projects or assets. In some
situations, the process may entail in acquiring assets that are completely new to the
firm. In other situations, it may mean replacing an existing obsolete asset to
maintain efficiency.

Capital budget may be defined as “the firm’s decision to invest its current funds
most efficiently in the long-term assets in anticipation if an expected flow of
benefits over a series of years. Therefore it involves a current outlay or series of
outlay of cash resources in return for an anticipated flow of future benefits. Capital
budgeting is the process of identifying, analyzing and selecting investment projects
whose returns (cash flow) are expected to extend beyond one year.

Long-term investments represent sizable outlays of funds that commit a

firm to some course of action. Consequently, the firm needs procedures to analyze
and properly select its long-term investments. It must be able to measure cash
flows and apply appropriate decision techniques. As time passes, fixed assets may
become obsolete or may require an overhaul; at these points, too, financial
decisions.
Capital budgeting is the process of evaluating and selecting long-term
investments that are consistent with the firm’s goal of maximizing owner wealth.
Firms typically make a variety of long-term investments, but the most common for
the manufacturing firm is in fixed assets, which include property (land), plant, and
equipment. These assets, often referred to as earning assets, generally provide the
basis for the firm’s earning power and value.

Features of capital budgeting:-

The capital budgeting consists the following:
The formulation of long-term goals
The creative search for and identification of new investment opportunities
Classification of projects and recognition of economically and/or statistically
dependent proposals
The estimation and forecasting of current and future cash flows
A suitable administrative framework capable of transferring the required
information to the decision level
The controlling of expenditures and careful monitoring of crucial aspects of project
execution
A set of decision rules which can differentiate acceptable from unacceptable
alternatives is required.

Capital Budgeting Techniques:

Discounting techniques
Net Present Value
Internal Rate of Return
Profitability Index
Non-Discounting techniques
Payback Period
Accounting Rate of Return

Net Present Value

Net present value represents the net benefit over and above the compensation for
time & risk. It is the sum of the present values of all the cash flows – positive as well
as negative – that are expected to occur over the life of the project. The general
formula of NPV is:

Where:
Ct = the net cash receipt at the end of year t
Io = the initial investment outlay
r = the discount rate/the required minimum rate of return on investment
n = the project/investment's duration in years.

Hence the decision rule associated with the net present value criterion is – accept
the project if the net present value is positive and reject the project if the net
present value is negative. If the net present value is zero, it is matter of
indifference.

If both the projects have positive value, the project with higher positive net present
value would be accepted, while the other would be rejected.

Advantages:
It ensures that the firm reaches an optimal scale of investment.

Disadvantages:
The NPV is expressed in absolute terms rather than relative terms and hence does
not factor in the scale of investment. Thus, project A may have an NPV of 5,000
while Project B has a NPV of 2,500, but project A may require an investment of
50,000 whereas project B may require an investment of just 10,000. Advocates of
NPV, however, argue that what matters is the surplus value, over and above the
investment, irrespective of what the investment is.
The NPV rule does not consider the life of the project. Hence, when mutually
exclusive projects with different lives are being considered, the NPV rule is biased in
favor of the longer term project.

Internal Rate of Return:-

The IRR is the discount rate at which the NPV for a project equals zero. This rate
means that the present value of the cash inflows for the project would equal the
present value of its outflows. The IRR is the break-even discount rate. The IRR is
found by trial and error.

If IRR exceeds cost of capital, project is worthwhile. If not, it is rejected.

Advantages:
It uses cash flows and recognized time value of money.
It is easy and understandable

Disadvantages:
It expresses the return in a percentage form rather than in terms of absolute dollar
returns, e.g. the IRR will prefer 500% of $1 to 20% return on $100. However, most
companies set their goals in absolute terms and not in % terms, e.g. target sales
figure of $2.5 million.

Profitability Index:-
The profitability index, or PI, method compares the present value of future cash
inflows with the initial investment on a relative basis. Therefore, the PI is the ratio
of the present value of cash flows (PVCF) to the initial investment of the project.

PVCF
PI =
Initial investment

In this method, a project with a PI greater than 1 is accepted, but a project is

rejected when its PI is less than 1. Note that the PI method is closely related to the
NPV approach. In fact, if the net present value of a project is positive, the PI will be
greater than 1.
On the other hand, if the net present value is negative, the project will have a PI of
less than 1. The same conclusion is reached, therefore, whether the net present
value or the PI is used. In other words, if the present value of cash flows exceeds
the initial investment, there is a positive net present value and a PI greater than 1,
indicating that the project is acceptable.

The proponents of benefit cost ratio argue that since this criterion measures net
present value per rupee of outlay, it can discriminate better between large and
small investments and hence is preferable to the net present value criterion.

Under constrained conditions, the benefit cost ratio criterion will accept and reject
the same projects as the net present value criterion. When the capital budget is
limited in the current period, the benefit-cost ratio criterion may rank projects
correctly in the order of decreasingly efficient use of capital. However, its use is not
recommended because it provides no means for aggregating several smaller
projects into a package that can be compared with a large project. When cash
outflows occur beyond the current period, the benefit-cost ratio criterion is
unsuitable as a selection criterion.

PI is also known as a benefit/cash ratio.

The conditions are - accept project if PI > 1 and reject if PI < 1.0.

Pay back period:-

Payback is defined as 'the time it takes the cash inflows from a capital investment
project to equal the cash outflows, usually expressed in years'. When deciding
between two or more competing projects, the usual decision is to accept the one
with the shortest payback.
Payback is often used as a "first screening method". By this, we mean that when a
capital investment project is being considered, the first question to ask is: 'How long
will it take to pay back its cost?' The company might have a target payback, and so
it would reject a capital project unless its payback period was less than a certain
number of years.

Advantages:
Payback can be important: long payback means capital tied up and high investment
risk. The method also has the advantage that it involves a quick, simple calculation
and an easily understood concept.

Disadvantages:
It ignores the timing of cash flows within the payback period, the cash flows after
the end of payback period and therefore the total project return.
It ignores the time value of money. This means that it does not take into account
the fact that $1 today is worth more than $1 in one year's time. An investor who has
$1 today can consume it immediately or alternatively can invest it at the prevailing
interest rate, say 30%, to get a return of $1.30 in a year's time.
It is unable to distinguish between projects with the same payback period.
It may lead to excessive investment in short-term projects.

Accounting rate of return:-

The ARR method (also called the return on capital employed (ROCE) or the return on
investment (ROI) method) of appraising a capital project is to estimate the
accounting rate of return that the project should yield. If it exceeds a target rate of
return, the project will be undertaken.

Note that net annual profit excludes depreciation.

Higher the accounting rate, better the project,

Advantages:
IT is simple to calculate.
It is based on accounting information which is readily available and familiar to
businessmen.

Disadvantages:
It does not take account of the timing of the profits from an investment.
It implicitly assumes stable cash receipts over time.
It is based on accounting profits and not cash flows. Accounting profits are subject
to a number of different accounting treatments.
It is a relative measure rather than an absolute measure and hence takes no
account of the size of the investment.
It takes no account of the length of the project.
It ignores the time value of money.
Despite the limitations of the payback method, it is the method most widely used in
practice. There are a number of reasons for this:
· It is a particularly useful approach for ranking projects where a firm faces liquidity
constraints and requires fast repayment of investments.
· It is appropriate in situations where risky investments are made in uncertain
markets that are subject to fast design and product changes or where future cash
flows are particularly difficult to predict.
· The method is often used in conjunction with NPV or IRR method and acts as a first
screening device to identify projects which are worthy of further investigation.
· It is easily understood by all levels of management.
· It provides an important summary method: how quickly will the initial investment
be recouped?

Decision Making:-
Virtually all general managers face capital-budgeting decisions in the course of their
careers. The most common of these is the simple “yes” versus “no” choice about a
capital investment. The following are some general guidelines to orient the decision
maker in these situations.

Focus on cash flows, not profits. One wants to get as close as possible to the
economic reality of the project. Accounting profits contain many kinds of economic
fiction. Flows of cash, on the other hand, are economic facts.

Focus on incremental cash flows. The point of the whole analytical exercise is to
judge whether the firm will be better off or worse off if it undertakes the project.
Thus one wants to focus on the changes in cash flows affected by the project. The
analysis may require some careful thought: a project decision identified as a simple
go/no-go question may hide a subtle substitution or choice among alternatives. For
instance, a proposal to invest in an automated machine should trigger many
questions: Will the machine expand capacity (and thus permit us to exploit demand
beyond our current limits)? Will the machine reduce costs (at the current level of
demand) and thus permit us to operate more efficiently than before we had the
machine? Will the machine create other benefits (e.g., higher quality, more
operational flexibility)? The key economic question asked of project proposals
should be, “How will things change (i.e., be better or worse) if we undertake the
project?”

Account for time. Time is money. We prefer to receive cash sooner rather than
later. Use NPV as the technique to summarize the quantitative attractiveness of the
project. Quite simply, NPV can be interpreted as the amount by which the market
value of the firm’s equity will change as a result of undertaking the project.

Account for risk. Not all projects present the same level or risk. One wants to be
compensated with a higher return for taking more risk. The way to control for
variations in risk from project to project is to use a discount rate to value a flow of
cash that is consistent with the risk of that flow.
CAPITAL BUDGETING

Capital budgeting is the process by which the financial manager decides whether to
invest in specific capital projects or assets. In some situations, the process may
entail in acquiring assets that are completely new to the firm. In other situations, it
may mean replacing an existing obsolete asset to maintain efficiency.

INTRODUCTION:
Capital budgeting is the process by which the financial
manager decides whether to invest in specific capital projects or assets. In some
situations, the process may entail in acquiring assets that are completely new to the
firm. In other situations, it may mean replacing an existing obsolete asset to
maintain efficiency.

Capital budget may be defined as “the firm’s decision to invest its current funds
most efficiently in the long-term assets in anticipation if an expected flow of
benefits over a series of years. Therefore it involves a current outlay or series of
outlay of cash resources in return for an anticipated flow of future benefits. Capital
budgeting is the process of identifying, analyzing and selecting investment projects
whose returns (cash flow) are expected to extend beyond one year.

Long-term investments represent sizable outlays of funds that commit a

firm to some course of action. Consequently, the firm needs procedures to analyze
and properly select its long-term investments. It must be able to measure cash
flows and apply appropriate decision techniques. As time passes, fixed assets may
become obsolete or may require an overhaul; at these points, too, financial
decisions.
Capital budgeting is the process of evaluating and selecting long-term
investments that are consistent with the firm’s goal of maximizing owner wealth.
Firms typically make a variety of long-term investments, but the most common for
the manufacturing firm is in fixed assets, which include property (land), plant, and
equipment. These assets, often referred to as earning assets, generally provide the
basis for the firm’s earning power and value.

Definition
According to Laurence J Gilman (Principles of Managerial Finance), “Capital
budgeting is the process of evaluating and selecting long-term investments that are
consistent with the firm’s goal of maximizing owner wealth.”

Capital budgeting is the process by which the financial manager decides whether to
invest in specific capital projects or assets. In some situations, the process may
entail in acquiring assets that are completely new to the firm. In other situations, it
may mean replacing an existing obsolete asset to maintain efficiency. The
investment decisions of a firm are generally known as the capital budgeting, or
capital expenditure decisions.

A capital budgeting decision may be defined as the firm’s decision to invest its
current funds most efficiently in the long-term assets ill anticipation of an expected
flow of benefits over a series of years.

Component of Capital Budget

Initial Investment Outlay
It includes the cash required to acquire the new equipment or build the new plant
less any net cash proceeds from the disposal of the replaced equipment. The initial
outlay also includes any additional working capital related to the new equipment.
Only changes that occur at the beginning of the project are included as part of the
initial investment outlay. Any additional working capital needed or no longer needed
in a future period is accounted for as a cash outflow or cash inflow during that
period.

Net Cash benefits or savings from the operations:

This component is calculated as follow:
The incremental change in operating revenues-The incremental change in the
operating cost = Incremental net revenue-Taxes ± Changes in the working capital
and other adjustments

Terminal Cash flow

It includes the net cash generated from the sale of the assets, tax effects from the
termination of the asset and the release of net working capital.

The Net Present Value technique

Although there are several methods used in Capital Budgeting, the Net Present
Value technique is more commonly used. Under this method a project with a
positive NPV implies that it is worth investing in.

Example: A company is studying the feasibility of acquiring a new machine. This

machine will cost $350,000 and have a useful life of three years after which it will
have no salvage value. It is estimated that the machine will generate operating
revenues of $300,000 and incur $75,000 in annual operating expenses over the
useful life of three years. The project requires an initial investment of $15,000 in
working capital which will be recovered at the end of the three years. The firm’s
cost of capital is 16%. The firm’s tax rate is 25%.

Steps in Capital Budgeting

Capital budgeting is the process of determining whether a big expenditure is in a
company's best interest. Here are the basics of capital budgeting and how it works.
Company undertakes capital budgeting in order to make the best decisions about
utilizing its limited capital. For example, if we are considering opening a distribution
center or investing in the development of a new product, capital budgeting will be
essential. It will help we decide if the proposed project or investment is actually
worth it in the long run.
Identification or Innovation of Investment Projects
The first step in the capital budgeting process is to identify the opportunities that
we have. Many times, there is more than one available path that a company could
take. We have to identify which projects we want to investigate further and which
ones do not make any sense for company. If we overlook a viable option, it could
end up costing us quite a bit of money in the long term.

Estimating Cash Flow

We need to determine how much cash flow it would take to implement a given
project. We also need to estimate how much cash would be brought in by such a
project. This process is truly one of estimating--it takes a bit of guesswork. We need
to try to be as realistic as we can in this process. Do not use the best-case scenario
for numbers. Most of the time, we need to use a fraction of that number to be
realistic. If the project takes off and the best-case scenario is reached, that is great.
However, the odds of that happening are not the best on new projects.

Evaluate the Investment Projects

Once have identified the reasonable opportunities, we need to determine which
ones are the best. Look at them in relation to overall business strategy and mission.
See which opportunities are actually realistic at the present time and which ones
should be put off for later.
Selection the Best Investment Project
After we look at all of the possible projects, it is time to choose the right project mix
for company. Evaluate all of the different projects separately on their own merits.
We need to come up with the right combination of projects that will work for
company immediately. Choose only the projects that mesh with company goals.
Implementation of the Project
Once the decisions have been made, it is time to implement the projects.
Implementation is not really a budgeting issue, but we will have to oversee
everything to be sure it is done correctly. After the project gets started, we will need
to review everything to make sure the finances still make sense.
Continuous Evaluation of the Selected Project
Here, project manager has to see the performance of the selected project. He has to
check the any one error and calculate the profit as per cash flow.
Application/Grounds of Capital Budgeting
Have already discussed capital budgeting is used to talk decision for
future financial investment for big amount.

Purchases of Fixed Assets

Capital budgeting is used to take decision for new investment to purchases land,
equipment, building for any company.

Modernization of Production Process

Here need to distinguish a new production method and old. Need to

compare administrative disbursement, life time of projects, salvage value,
market price etc by financial investment method and determine which is
best one and which method need to continuation of old method or set new
production method?

Expansion of business

When a company wants to expanse business, he needs to take decision for such
reason. Such needs to set a machine for production. In this case, company
production manager need to calculate the total net cash outlet for machine setup
and the total profit from this machine for selected year.

Introduction of new product

When a firm invent a new product and going to enter the market. The firm needs to
know the public demand, production cost, administrative cost, profit etc. By
calculating all things, firm will decide, they will enter market or not?

Importance of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial decision. So it

needs special care on account of the following reasons:

Long-term Implications
A capital budgeting decision has its effect over a long time span and inevitably
affects the company’s future cost structure and growth. A wrong decision can prove
disastrous for the long-term survival of firm. On the other hand, lack of investment
in asset would influence the competitive position of the firm. So the capital
budgeting decisions determine the future destiny of the company.

Involvement of large amount of funds

Capital budgeting decisions need substantial amount of capital outlay. This
underlines the need for thoughtful, wise and correct decisions as an incorrect
decision would not only result in losses but also prevent the firm from earning profit
from other investments which could not be undertaken.

Irreversible decisions
Capital budgeting decisions in most of the cases are irreversible because it is
difficult to find a market for such assets. The only way out will be scrap the capital
assets so acquired and incur heavy losses.

Risk and uncertainty

Capital budgeting decision is surrounded by great number of uncertainties.
Investment is present and investment is future. The future is uncertain and full of
risks. Longer the period of project, greater may be the risk and uncertainty. The
estimates about cost, revenues and profits may not come true.

Difficult to make
Capital budgeting decision making is a difficult and complicated exercise for the
management. These decisions require an over all assessment of future events
which are uncertain. It is really a marathon job to estimate the future benefits and
cost correctly in quantitative terms subject to the uncertainties caused by
economic-political social and technological factors.

Kinds of capital budgeting decisions

Generally the business firms are confronted with three types of capital budgeting
decisions.

Accept-reject decisions
Business firm is confronted with alternative investment proposals. If the proposal is
accepted, the firm incur the investment and not otherwise. Broadly, all those
investment proposals which yield a rate of return greater than cost of capital are
accepted and the others are rejected. Under this criterion, all the independent
proposals are accepted.

Mutually exclusive decisions

It includes all those projects which compete with each other in a way that
acceptance of one precludes the acceptance of other or others. Thus, some
technique has to be used for selecting the best among all and eliminates other
alternatives.

Capital rationing decisions

Capital budgeting decision is a simple process in those firms where fund is not the
constraint, but in majority of the cases, firms have fixed capital budget. So large
amount of projects compete for these limited budgets. So the firm rations them in a
manner so as to maximize the long run returns. Thus, capital rationing refers to the
situations where the firm has more acceptable investment requiring greater amount
of finance than is available with the firm. It is concerned with the selection of a
group of investment out of many investment proposals ranked in the descending
order of the rate or return.
Limitation of Capital Budget

Capital budgeting is very important to take future financial decision. Because future
profit and loss depends of capital budgeting. But capital budgeting has some
limitations. Such:
Lack of Adequate Data, Lack of Reliability of the Data, Problem of Measuring Future,
Timing of the Projects, Problems of Quantification, Personal Judgment of the
Decision.

RESEARCH METHODOLOGY
Methodology: Methodology may be a description of process, or may be expanded
to include a philosophically coherent collection of theories, concepts or ideas as
they relate to a particular discipline or field of inquiry
Methodology may refer to nothing more than a simple set of methods or
procedures, or it may refer to the rationale and the philosophical assumptions that
underlie a particular study relative to the scientific method. For example, scholarly
literature often includes a section on the methodology of the researchers.
RESEARCH: Research is defined as human activity based on the intellectual
application in the investigation of matter. The primary purpose for applied research
is discovering, interpreting, and the development of the methods and systems for
the advancement of human knowledge on a wide variety of scientific matters of our
world and the universe. Research can use the scientific method, but need not do so.
SCOPE OF RESEARCH: Research needs valuable resources such as money, time,
materials, manpower and machines to get the work done effectively to minimize
input value for a unit value of output and the return-on-investment.
Aim of the research
The assigned task was to conduct a survey for a well reputed company. Research is
concerned with the systematic and objective collection, analysis and evaluation of
information about specific aspects in order to help management make effective
decisions.
Once the aspect is identified and defined it is the responsibility of the researcher to
chalk out a comprehensive plan explaining each step required to conduct the
research in a successful manner.

OBJECTIVES OF RESEARCH: The principal objective of research it to find solutions

to problems in a systematic way. In general, the objectives of research can be
specified as:
•To acquire familiarity with a phenomenon.
•To study the frequency of connection or independence of any activity or
occurrence.
•To determine the characteristics of an individual or a group of activities and the
frequency
of the occurrence of these activities.
•To test a hypothesis about a causal relationship that exists between variables.

The first step in research is setting the objectives for which their study is to be
undertaken. It is essential that objectives are set before hand. The objectives must
be hierarchical, quantifiable, realism and verifiable. The main objective of this study
is to study how the employees value for rewards and recognition (non-monetary
rewards) in Tata Consultant.

Period of study:
The time period was three months for the study, starting from January to March _ _ _
_.

DataUsed:
The type of data collected comprises of Primary data and Secondary data.
Primary data is the first hand data collected from the employees. It was collected
through questionnaire.

Secondary data for the study has been compiled from the reports and official
publication of the organization, which have been helped in getting an insight of the
present scenario existing in the operation of the company.

Method and Research Design

PURPOSE
The method section answers these two main questions:
1. How was the data collected or generated?
2. How was it analyzed?
In other words, it shows your reader how you obtained your results.
But why do you need to explain how you obtained your results?
We need to know how the data was obtained because the method affects the
results. For instance, if you are investigating users' perceptions of the efficiency of
public transport in Bangkok, you will obtain different results if you use a multiple
choice questionnaire than if you conduct interviews. Knowing how the data was
collected helps the reader evaluate the validity and reliability of your results, and
the conclusions you draw from them.

Often there are different methods that we can use to investigate a

research problem. Your methodology should make clear the reasons why you chose
a particular method or procedure.
The reader wants to know that the data was collected or generated in a
way that is consistent with accepted practice in the field of study. For example, if
you are using a questionnaire, readers need to know that it offered your
respondents a reasonable range of answers to choose from (asking if the efficiency
of public transport in Bangkok is "a. excellent, b. very good or c. good" would
obviously not be acceptable as it does not allow respondents to give negative
answers).
The research methods must be appropriate to the objectives of the study.
If you perform a case study of one commuter in order to investigate users'
perceptions of the efficiency of public transport in Bangkok, your method is
obviously unsuited to your objectives.
The methodology should also discuss the problems that were
anticipated and explain the steps taken to prevent them from occurring, and the
problems that did occur and the ways their impact was minimized.
In some cases, it is useful for other researchers to adapt or replicate
your methodology, so often sufficient information is given to allow others to use the
work. This is particularly the case when a new method had been developed, or an
innovative adaptation used.

During the capital budgeting process answers to the following questions are sought:
What projects are good investment opportunities to the firm?
From this group which assets are the most desirable to acquire?
How much should the firm invest in each of these assets

WHAT IS CAPITAL BUDGETING?

Capital budgeting is a required managerial tool. One duty of a financial manager is
to choose investments with satisfactory cash flows and rates of return. Therefore, a
financial manager must be able to decide whether an investment is worth
undertaking and be able to choose intelligently between two or more alternatives.
To do this, a sound procedure to evaluate, compare, and select projects is needed.
This procedure is called capital budgeting.
Capital budgeting is investment decision-making as to whether a project is worth
undertaking. Capital budgeting is basically concerned with the justification of
capital expenditures.
Current expenditures are short-term and are completely written off in the
same year that expenses occur. Capital expenditures are long-term and are
amortized over a period of years are required by the IRS.

CAPITAL IS A LIMITED RESOURCE

In the form of either debt or equity, capital is a very limited resource. There is a
limit to the volume of credit that the banking system can create in the economy.
Commercial banks and other lending institutions have limited deposits from which
they can lend money to individuals, corporations, and governments. In addition, the
Federal Reserve System requires each bank to maintain part of its deposits as
reserves. Having limited resources to lend, lending institutions are selective in
extending loans to their customers. But even if a bank were to extend unlimited
loans to a company, the management of that company would need to consider the
impact that increasing loans would have on the overall cost of financing.

In reality, any firm has limited borrowing resources that should be allocated
among the best investment alternatives. One might argue that a company can
issue an almost unlimited amount of common stock to raise capital. Increasing the
number of shares of company stock, however, will serve only to distribute the same
amount of equity among a greater number of shareholders. In other words, as the
number of shares of a company increases, the company ownership of the individual
stockholder may proportionally decrease.

The argument that capital is a limited resource is true of any form of capital,
whether debt or equity (short-term or long-term, common stock) or retained
earnings, accounts payable or notes payable, and so on. Even the best-known firm
in an industry or a community can increase its borrowing up to a certain limit. Once
this point has been reached, the firm will either be denied more credit or be
charged a higher interest rate, making borrowing a less desirable way to raise
capital.
 Faced with limited sources of capital, management should carefully decide
whether a particular project is economically acceptable. In the case of more than
one project, management must identify the projects that will contribute most to
profits and, consequently, to the value (or wealth) of the firm. This, in essence, is
the basis of capital budgeting
Capital expenditures are the allocation of resources to large, long term projects. The
capital budget is a statement of the planned capital expenditures. It is more than a
simple listing, however, and is not a "budget" in the usual sense. Given the nature
of capital expenditures, the capital budget is best thought of as an expression of the
goals and strategy of the firm. Creation of the capital budget is a central task that
affects, and is affected by, all others areas of decision making. The "capital
budgeting process" can be envisioned as shown in Figure 1. Present and anticipated
business conditions are the opportunities and constraints from which the goals of
the firm are developed. The goals drive the strategic decisions of capital budget and
financing, but feasibility and consistency with the interdependent financing and
capital budget decisions must be considered in setting the goals. Operating
decisions may be thought of as the tactical choices driven by strategy, but again
feasibility and consistency of operating decisions must be considered in setting
strategy. The process is in actuality part simultaneous, part iterative. Given the
interdependency of goals, strategy, and tactics in a changing environment, the
capital budget is properly

considered as an active planning document, rather than a fixed conclusion.

From a narrow economic viewpoint creating the capital budget is relatively simple:
a project should be accepted if the return is greater than the cost. Projects are
listed in order of decreasing return, and investment should continue until the
marginal return (roughly, the return to the next dollar spent) is greater than
marginal cost (roughly, the required rate of return on the next dollar spent). This
simple, elegant statement of the problem masks a number of complications.
Projects of different risk will likely have different required returns, will be of
different sizes and have different lives, and may be mutually exclusive or
interdependent.
The rule of accepting projects until marginal return no longer exceeds marginal cost
also assumes unlimited funds. This assumption is theoretically justified by the
argument that if marginal return exceeds marginal cost, increasing the capital
budget will return more than it costs, and more funds should be acquired. There
are, however, a number of reasons for limiting the size of the capital budget. Project
analysis is often based on individual projects, but overall firm performance will be
degraded if too many new projects are attempted in a short space of time.
Externally, lenders or investors may be unwilling to provide funds or may require
added return or limitations on an overly ambitious management. Further, some
attractive projects may simply not fit the goals and strategy of the firm. Investors
and creditors may react adversely to new projects if they are inconsistent with the
perceived nature of the firm. Since capital budgeting is the concrete expression of
the goals and strategy of the firm, capital budgeting must often consider factors
that defy exact measurement or even definition.
REQUIRED RATE OF RETURN
The marginal cost of the project is expressed as a required rate of return
(sometimes called the "hurdle rate"). Estimation of the required rate is integral to
evaluating projects and setting the capital budget. The controlling concept is that of
opportunity cost. Opportunity cost reflects the idea that the relevant cost of using
a resource is the rate of return on forgone alternative opportunities of similar risk.
For projects that are extensions of or similar to the normal operations of the firm,
and so have a similar risk profile, a readily available comparable use of funds is
reinvesting in the firm itself. For these projects, the opportunity cost/required rate
of return/hurdle rate can be approximated by the firm's weighted average cost of
capital (WACC). The WACC is the rate of return that just meets investor
expectations, leaving the value of the shares of the firm unchanged. WACC is
computed by first estimating the rate of return required to meet the obligations for
each source of capital. These required rates are then weighted according to the
target capital structure of the firm to obtain the overall rate of return required to
meet the combined obligations—the WACC. This is the return that could be obtained
by reinvesting the funds within the firm (downsizing).
Where the project is outside the normal operations of the firm or has a different risk
profile, the WACC is not be a good estimate of the required rate of return on the
project. The required rate of return may be estimated by using the WACC for firms
similar in nature to the project, or by applying capital asset pricing model at the
estimated systematic risk of the project. These comparison-based estimates are
satisfactory for projects of standardized technology that does not require that the
firm develop new expertise. Where the project is nonstandard or innovative, or
requires developing new expertise, such comparison may underestimate the risk. In
such cases the required return on the new project must be arrived at by ad hoc
adjustment. Decision tree, Monte Carlo, or other risk analysis tools are helpful.

CAPITAL BUDGETING TECHNIQUES

Various techniques have been developed for application to individual projects. The
simplest individual technique is the payback period—the time required for total cash
inflows to equal total cash outflows. Projects are ranked according to payback
period, and accepted if the payback period is below some maximum length. While
simple to compute, there is no generally accepted method to set the maximum
payback period, the time value of money is not considered, and cash flows past the
payback period are ignored. An alternative is the accounting rate of return—the
average annual change in accounting earnings due to the project expressed as a
percent of the initial cost. This technique also has no generally accepted standard,
fails to consider the time value of money, and is based on accounting earnings
rather than on actual cash flows.
Discounted cash flow (DCF) techniques are preferable because they consider the
time value of money, are based on actual cash flows rather than accounting profits,
and have a definite standard. These techniques compare the rate of return from a
project to the rate of return available on other investments of similar risk—a
comparison of marginal return to marginal cost. The two widely used DCF
techniques are based on the concept of present value. The present value of a series
of cash flows is the amount that, if invested at the required rate of return for the
project, will re-create the expected cash flows from the project.
The net present value (NPV) is computed as the present value of the project cash
flows minus the cost of the project. If NPV is negative, the present value of the cash
flows from the project is less than the cost of the project—i.e., it would be cheaper
to generate the cash flows by investing at the required rate than by undertaking the
project. Since the cash flows could be created more cheaply by investing at the
required rate, the project rate of return is below the required rate, and rejection is
indicated. Alternately stated, rejecting the project and investing the cost of the
project elsewhere would create larger cash flows than accepting the project. Where
NPV is positive, it is cheaper to generate the cash flows by undertaking the project
than by investing at the required rate of return—i.e., the project rate of return is
greater than the required return, and acceptance is indicated. Alternately stated,
investing the project creates larger cash flows than investing elsewhere. NPV is
sometimes described as the change in the value of the firm if the project is
accepted.
The internal rate of return (IRR) is the rate of return that would be required to
exactly re-create the cash flows from an investment equal to the cost of the project.
The IRR is the rate of return provided by the project if accepted. If the IRR is greater
than the required rate of return, acceptance is indicated. If the IRR is below the
required rate of return, rejection is indicated.
While the IRR technique appears simpler to understand and apply, it can be
misleading if there is a limit to the number of projects that can be accepted or if
projects are mutually exclusive, so that a ranking technique is necessary. While IRR
and NPV will always give the same accept/reject decision, the ranking of projects on
IRR may differ from the ranking on NPV. This difference arises because of
differences in the implicit assumptions about the rate of return on cash flows from
the project. The NPV technique implicitly assumes reinvestment of cash flows at the
required rate of return, while the IRR implicitly assumes reinvestment of cash flows
at the IRR. The NPV criterion is considered superior because it is likely that the
actual reinvestment rate will be close to the required rate. The IRR, on the other
hand, may depart widely from the actual reinvestment rate. The reinvestment rate
is also important when considering projects of different lives. It is possible that a
long project of lower return may be preferable to a short project of high return if the
cash flows from the short project will be reinvested at a low rate. Where information
about the actual reinvestment rate is obtainable, however, both NPV and IRR can be
modified to reflect this rate. This is accomplished by compounding all cash flows
forward until the end of the project.
A further potential problem is that, where net cash inflows are required at some
point during the life of the project, IRR becomes ambiguous because multiple
solutions exist.
LIMITATIONS OF QUANTITATIVE TECHNIQUES
An accept or reject indication on the above criteria does not mean that a project
should be automatically accepted or rejected. Many other factors need to be
considered. First, the criteria are based on estimated cash flows and an estimated
required rate. The estimates are themselves subject to uncertainty and this may
lead to an increase or safety factor in the "hurdle." Second, as noted, the estimates
proceed on an individual project basis, and there may be an interaction between
projects. Third, and perhaps most important, the criteria consider only cash flows,
and some factors cannot be reduced to a monetary basis. It must be remembered
that a capital budget is in reality the strategy chosen to reach the goals of the firm.
The indications of the quantitative economic analysis are only a part of the strategic
planning process and are subsidiary to overall strategic considerations. Unless a
project is compatible with the goals of the firm, it will not be accepted. Conversely,
if a project has nonmonetary benefits or interaction with other projects, it may be
accepted despite a negative indication. Again, the capital budget is a planning
document. The greatest contribution of the application of the capital budgeting
techniques is not the indicated decision, but the heuristic benefits of greater
understanding.
Finally, ethical standards are a vital part of the strategic considerations. An
otherwise acceptable project may be unacceptable on ethical grounds. The social
impact of projects has become increasingly important. It is necessary to consider
the externalities —the effects of the project that are not felt by the firm.
Externalities include such items as environmental impact and required increase in
infrastructure.

Summary
The federal budget, which presents the government’s expenditures and revenues
for each fiscal year, serves many purposes. It enables policymakers to allocate
resources to serve national objectives, provides the basis for agencies’
management of federal programs, gives the Treasury needed information for its
management of cash and the public debt, and provides businesses and individuals
with information to make an informed assessment about the government’s
stewardship of the public’s money and resources. Inflows and outflows are recorded
mostly on a cash basis because those transactions are readily verifiable and they
provide policymakers and the public with a close approximation of the
government’s annual cash deficit or surplus.
Some observers have proposed modifying the budgeting system by implementing a
capital budget for the federal government, which would distinguish certain types of
investments from other expenditures in the budget. One commonly discussed
approach would segregate cash spending on capital projects in a capital budget and
report in the regular budget the depreciation on federal capital assets, thus
allocating current costs to future time periods. Such an approach—which would
move from the current, primarily cash-based budgeting system to one that relies
more on accrual-based accounting—would be similar to private-sector accounting in
that it would spread capital costs over the period when benefits are accruing from
the investment.
Proponents of capital budgeting assert that the current budgetary treatment of
capital investment creates a bias against capital spending and that additional
spending would benefit the economy by boosting productivity. They note that
capital budgeting could better match budgetary costs with benefit flows and
eliminate some of the spikes in programs’ budgets from new investments. The
existence and extent of any such bias, however, depends on how differently
policymakers would behave with a capital budget instead of the existing budgetary
treatment of capital investments. Furthermore, although evidence suggests that
additional capital spending could have larger economic benefits than costs, the
economic benefits of increasing capital spending by the federal government would
partly depend on how well the additional funds were targeted to high-value projects
and on the extent to which they would displace spending that would otherwise be
undertaken by the private sector or other levels of government.
Moving to a budget that is more reliant on accrual-based accounting could increase
complexity, diminish transparency, and make the federal budget process more
sensitive to small changes in assumed parameters, such as depreciation rates.
(Indeed, other nations have considered adopting capital budgets, but generally
decided against it for those same reasons.) Adopting an accrual approach to only
one aspect of the budget could raise concerns as to whether the budgeting system
would provide a fair basis for allocating the government’s resources among
competing priorities. In addition, providing special treatment to certain areas of the
budget, such as capital spending, could make the process more prone to
manipulation. Furthermore, simply arriving at a definition of capital for budgeting
purposes could be a significant challenge. Concerns about such issues largely
explain why previous groups charged with exploring budgetary concept issues—
including the 1967 President’s Commission on Budget Concepts and the 1999
President’s Commission to Study Capital Budgeting—have rejected the idea of a
separate capital budget for the federal government.

Capital Budgeting Objectives

To explain how a company makes decisions to invest in new capital assets, new
products and
other projects requiring expenditures in the present to obtain returns over a period
of time.
To discuss the variables a company must consider in making capital budgeting
decisions.
o develop a measurement for a company’s cost of funds.

Capital Budgeting Basics

A company undertakes capital budgeting in order to make the best decisions about
utilizing its limited capital. For example, if you are considering opening a
distribution center or investing in the development of a new product, capital
budgeting will be essential. It will help you decide if the proposed project or
investment is actually worth it in the long run.
Identify Potential Opportunities
The first step in the capital budgeting process is to identify the opportunities that
you have. Many times, there is more than one available path that your company
could take. You have to identify which projects you want to investigate further and
which ones do not make any sense for your company. If you overlook a viable
option, it could end up costing you quite a bit of money in the long term.
Evaluate Opportunities
Once you have identified the reasonable opportunities, you need to determine
which ones are the best. Look at them in relation to your overall business strategy
and mission. See which opportunities are actually realistic at the present time and
which ones should be put off for later.
Cash Flow
Next, you need to determine how much cash flow it would take to implement a
given project. You also need to estimate how much cash would be brought in by
such a project. This process is truly one of estimating--it takes a bit of guesswork.
You need to try to be as realistic as you can in this process. Do not use the best-
case scenario for your numbers. Most of the time, you need to use a fraction of that
number to be realistic. If the project takes off and the best-case scenario is reached,
that is great. However, the odds of that happening are not the best on new projects.

Select Projects
After you look at all of the possible projects, it is time to choose the right project
mix for your company. Evaluate all of the different projects separately on their own
merits. You need to come up with the right combination of projects that will work for
your company immediately. Choose only the projects that mesh with your company
goals.
Implementation
Once the decisions have been made, it is time to implement the projects.
Implementation is not really a budgeting issue, but you will have to oversee
everything to be sure it is done correctly. After the project gets started, you will
need to review everything to make sure the finances still make sense.
Capital Budgeting: eight steps
Introduction
Until now, this web site has broken one of the cardinal rules of financial
management. This page corrects for that problem and presents now, the first part
of the subject of Capital Budgeting.
Many books and chapters and web pages purport to discuss capital budgeting when
in reality all they do is discuss CAPITAL INVESTMENT APPRAISAL. There's nothing
wrong with a discussion of the CIA methods except that authors have a duty to
point out that CIA methods are only one part of a multi stage process: the capital
budgeting process.
A discussion of CIA and nothing else means that capital budgeting decisions are
being discussed out of context. That is, by ignoring the earlier and later parts of
capital budgeting, we are never assess where capital budgeting project come from,
how alternatives are found and evaluated, how we really choose which project to
choose … and then we never review the projects and how they have been
implemented.

Kinds of Capital Budgeting Decisions:

Capital budgeting refers to the total process of generating, evaluating, selecting,
implementing and following up on capital expenditure alternatives. The firm
allocates or budgets financial resources to new investment proposals. Basically
the firm may be confronted with three types of capital decisions: (i) the
accept – reject decision; (ii) the capital rationing decision; and (iii)the mutually
exclusive project accepted.
(i) The Accept-Reject Decision
This is a fundamental decision in capital budgeting. If the project is accepted, the
firm invests in it;
if the proposal is rejected, the firm does not invest in it. In general, all those
proposals, which yield a rate of return greater than a certain required rate of return
or cost of capital is accepted and the rest, are rejected. Under the accept-reject
decision, all the independent projects that satisfy the minimum investment criterion
should be implemented.

(ii) Capital Rationing Decision:

In a situation where the firm has unlimited funds, capital budgeting becomes a very
simple process
in that all independent investment proposals yielding return greater than some
predetermined level are accepted. However, this is not the situation prevailing in
most of the business firms in the real world. They have a fix capital budget or
limitation of availability of funds at a given point of time.
A large number of investment proposals compete for these limited funds. The firm
must, therefore, ration them. The firm allocates funds to projects in a manner that it
maximizes long-run returns. Thus, capital rationing refers to the situation in which
the firm has more acceptable investments, requiring a greater amount of finance
than is available with the firm. Ranking of the investment projects is employed in
capital rationing. Projects can be ranked on the basis of some pre-
determined criterion such as the rate of return. The project with the highest return
is ranked first and the project with the lowest acceptable return last. The projects
are ranked in the descending order of the rate of return. It may be noted that only
acceptable projects should be ranked and higher Ranked projects till funds are
available should be selected for implementation.
(iii)Mutually Excusive Project Decisions
Mutually exclusive projects are projects, 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. Suppose a
company is intending to buy a new folding machine. There are three competing
brands, each with different initial investment and operating cost. The three
machines represent mutually exclusive alternatives, as only one of the three
machines can be selected. Mutually exclusive investment decisions acquire
significance when more than one proposal is acceptable. Then some techniques
have to be used to determine the “best” one. The acceptance of this “best”
alternative automatically eliminates the other alternatives.

COMPONENTS OF CAPITAL BUDGETING

 Initial Investment Outlay:
It includes the cash required to acquire the new equipment
or build the new plant less any net cash proceeds from the
disposal of the replaced equipment. The initial outlay also
includes any additional working capital related to the new
equipment. Only changes that occur at the beginning of
the project are included as part of the initial investment
outlay. Any additional working capital needed or no longer
needed in a future period is accounted for as a cash
outflow or cash inflow during that period.
Net Cash benefits or savings from the operations:
This component is calculated as under:-
(The incremental change in operating revenues minus the incremental change in
the operating cost = Incremental net revenue) minus (taxes) plus or minus
(changes in the working capital and other adjustments).
Terminal Cash flow:
It includes the net cash generated from the sale of the assets, tax effects from the
termination of the asset and the release of net working capital.
The Net Present Value technique:
Although there are several methods used in Capital Budgeting, the Net Present
Value technique is more commonly used. Under this method a project with a
positive NPV implies that it is worth investing in.
Example:
A company is studying the feasibility of acquiring a new machine. This machine will
cost $350,000 and have a useful life of three years after which it will have no
salvage value. It is estimated that the machine will generate operating revenues of
$300,000 and incur $75,000 in annual operating expenses over the useful life of
three years. The project requires an initial investment of $15,000 in working capital
which will be recovered at the end of the three years. The firm’s cost of capital is
16%. The firm’s tax rate is 25%.
To simplify the problem, depreciation is not considered.
Capital budgeting versus current expenditures
A capital investment project can be distinguished from current expenditures by two
features:
a) such projects are relatively large
b) a significant period of time (more than one year) elapses between the investment
outlay and the receipt of the benefits..
As a result, most medium-sized and large organisations have developed special
procedures and methods for dealing with these decisions. A systematic approach to
capital budgeting implies:
a) the formulation of long-term goals
b) the creative search for and identification of new investment opportunities
c) classification of projects and recognition of economically and/or statistically
dependent proposals
d) the estimation and forecasting of current and future cash flows
e) a suitable administrative framework capable of transferring the required
information to the decision level
f) the controlling of expenditures and careful monitoring of crucial aspects of project
execution
g) a set of decision rules which can differentiate acceptable from unacceptable
alternatives is required.

Cash Flow
Success of any business can be determined through its capacity to generate
positive cash flows. Therefore, Cash inflow and outflow is considered as one of the
most essential elements which gives us as idea about the continued existence of a
business in future. Therefore, the stake-holders focus on two things while investing
in business: first, how does business generate funds and second, where does
business invest those funds for generating more.
Objectives of a cash flow statement:
The main objective of a cash flow statement is to assist users:
· in assessing the business’s ability to generate positive cash flow
. In assessing business’s ability to bridge the gap between out flow and inflow of
funds.
· In assessing its ability to meet its short and long term obligations
· In assessing the rationale of differences between reported and related cash flows
· In assessing the effect on finances of major projects during the year.
The statement of cash flow, therefore; shows increase and decrease in cash and
cash equivalents rather than working capital.

Needs of capital Budgeting

The first step is to identify the need or opportunity. This is usually done at the mid-
management level and is the result of a shared vision of company goals and
strategies coupled with a "where the rubber meets the road" perspective of "local"
clients needs, tastes and behavior. They see a need or opportunity and
communicate it to senior management, usually in the form of proposals which both
include identification of the need or opportunity, and potential solutions and/or
recommendations. Senior management then evaluates the merit of each proposed
opportunity and makes a determination of whether or not to look into it further.

While project need identification is usually a de-centralized function, capital

initiation and allocation decisions tend to remain a highly centralized undertaking.
The reason for this revolves around the need for capital rationing, especially when
funds are limited and upper-management wishes to maximize its returns/benefits
from any capital projects undertaken.

The information needed to make this determination usually comes from both
internal and external sources, and is based on both financial and non-financial
considerations. Interestingly enough, the factors examined in this process can be
both firm-specific and market-based in nature. It is that this point that companies
should be seeking qualified financial guidance since the consequences of both a
poor decision and of the implementation of a good decision can be far-reaching.

Capital Expenditures
Whenever we make an expenditure that generates a cash flow benefit for more
than one year, this is a capital expenditure. Examples include the purchase of new
equipment, expansion of production facilities, buying another company, acquiring
new technologies, launching a research & development program, etc., etc., etc.
Capital expenditures often involve large cash outlays with major implications on the
future values of the company. Additionally, once we commit to making a capital
expenditure it is sometimes difficult to back-out. Therefore, we need to carefully
analyze and evaluate proposed capital expenditures.
The Three Stages of Capital Budgeting Analysis
Capital Budgeting Analysis is a process of evaluating how we invest in capital
assets; i.e. assets that provide cash flow benefits for more than one year. We are
trying to answer the following question:
Will the future benefits of this project be large enough to justify the
investment given the risk involved?
It has been said that how we spend our money today determines what our value will
be tomorrow. Therefore, we will focus much of our attention on present values so
that we can understand how expenditures today influence values in the future. A
very popular approach to looking at present values of projects is discounted cash
flows or DCF. However, we will learn that this approach is too narrow for properly
evaluating a project. We will include three stages within Capital Budgeting Analysis:
Decision Analysis for Knowledge Building
Option Pricing to Establish Position
Discounted Cash Flow (DCF) for making the Investment Decision
KEY POINT → Do not forces decisions to fit into Discounted Cash Flows! You need to
go through a three-stage process: Decision Analysis, Option Pricing, and Discounted
Cash Flow. This is one of the biggest mistakes made in financial management.

T hree Stages of Capital Budgeting

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Investment Amount

Stage 1: Decision Analysis

Decision-making is increasingly more complex today because of uncertainty.
Additionally, most capital projects will involve numerous variables and possible
outcomes. For example, estimating cash flows associated with a project involves
working capital requirements, project risk, tax considerations, expected rates of
inflation, and disposal values. We have to understand existing markets to forecast
project revenues, assess competitive impacts of the project, and determine the life
cycle of the project. If our capital project involves production, we have to
understand operating costs, additional overheads, capacity utilization, and start-up
costs. Consequently, we can not manage capital projects by simply looking at the
numbers; i.e. discounted cash flows. We must look at the entire decision and assess
all relevant variables and outcomes within an analytical hierarchy.
In financial management, we refer to this analytical hierarchy as the Multiple
Attribute Decision Model (MADM). Multiple attributes are involved in capital projects
and each attribute in the decision needs to be weighed differently. We will use an
analytical hierarchy to structure the decision and derive the importance of
attributes in relation to one another. We can think of MADM as a decision tree which
breaks down a complex decision into component parts. This decision tree approach
offers several advantages:
We systematically consider both financial and non-financial criteria.
Judgments and assumptions are included within the decision based on expected
values.
We focus more of our attention on those parts of the decision that are important.
We include the opinions and ideas of others into the decision. Group or team
decision making is usually much better than one person analyzing the decision.
Therefore, our first real step in capital budgeting is to obtain knowledge about the
project and organize this knowledge into a decision tree. We can use software

programs such as Expert Choice or Decision Pro to help us build a decision tree.
Simple Example of a Decision Tree:

Stage 2: Option Pricing

The uncertainty about our project is first reduced by obtaining knowledge and
working the decision through a decision tree. The second stage in this process is to
consider all options or choices we have or should have for the project. Therefore,
before we proceed to discounted cash flows we need to build a set of options into
our project for managing unexpected changes.
In financial management, consideration of options within capital budgeting is called
contingent claims analysis or option pricing. For example, suppose you have a
choice between two boiler units for your factory. Boiler A uses oil and Boiler B can
use either oil or natural gas. Based on traditional approaches to capital budgeting,
the least costs boiler was selected for purchase, namely Boiler A. However, if we
consider option pricing Boiler B may be the best choice because we have a choice
or option on what fuel we can use. Suppose we expect rising oil prices in the next
five years. This will result in higher operating costs for Boiler A, but Boiler B can
switch to a second fuel to better control operating costs. Consequently, we want to
assess the options of capital projects.
Options can take many forms; ability to delay, defer, postpone, alter, change, etc.
These options give us more opportunities for creating value within capital projects.
We need to think of capital projects as a bundle of options. Three common sources
of options are:
Timing Options: The ability to delay our investment in the project.
Abandonment Options: The ability to abandon or get out of a project that has gone
bad.
Growth Options: The ability of a project to provide long-term growth despite
negative values. For example, a new research program may appear negative, but it
might lead to new product innovations and market growth. We need to consider the
growth options of projects.
Option pricing is the additional value that we recognize within a project because it
has flexibilities over similar projects. These flexibilities help us manage capital
projects and therefore, failure to recognize option values can result in an under-
valuation of a project.
Stage 3: Discounted Cash Flows
So we have completed the first two stages of capital budgeting analysis: (1) Build
and organize knowledge within a decision tree and (2) Recognize and build options
within our capital projects. We can now make an investment decision based on
Discounted Cash Flows or DCF.
Unlike accounting, financial management is concerned with the values of assets
today; i.e. present values. Since capital projects provide benefits into the future and
since we want to determine the present value of the project, we will discount the
future cash flows of a project to the present.
Discounting refers to taking a future amount and finding its value today. Future
values differ from present values because of the time value of money. Financial
management recognizes the time value of money because:
Inflation reduces values over time; i.e. $ 1,000 today will have less value five years
from now due to rising prices (inflation).
Uncertainty in the future; i.e. we think we will receive $ 1,000 five years from now,
but a lot can happen over the next five years.

Risk Analysis in Capital Budgeting:

Sensitivity Analysis:
This is also known as a "what if analysis". Because of the uncertainty of the future, if
an entrepreneur wants to know about the feasibility of a project in variable
quantities, for example investments or sales change from the anticipated value,
sensitivity analysis can be a useful method. This is calculated in terms of NPV, or
net present value.
Scenario Analysis:
In the case of scenario analysis, the focus is on the deviation of a number of
interconnected variables. It is different from sensitivity analysis, which usually
concentrates on the change in one particular variable at a specific point of time.
Break Even Analysis:
The Break Even Analysis allows a company to determine the minimum production
and sales amounts for a project to avoid losing money. The lowest possible quantity
at which no loss occurs is called the break-even point. The break-even point can be
delineated both in financial or accounting terms.
Hillier Model:
In particular situations, the anticipated NPV and the standard deviation of NPV can
be incurred with the help of analytical derivation. This was first realized by F.S.
Hillier. There are situations where correlation between cash flows is either complete
or nonexistent.

Simulation Analysis: Simulation analysis is utilized for formulating the probability

analysis for a criterion of merit with the help of random blending of variable values
that carry a relationship with the selected criterion.

Decision Tree Analysis: The principal steps of decision tree analysis are the
definition of the decision tree and the assessment of the alternatives.

Corporate Risk Analysis: Corporate risk analysis focuses on the analysis of risk
that may influence the project in terms of the entire cash flow of the firm. The
corporate risk of a project refers to its share of the total risk of a company.

Risk Management: Risk management focuses on factors such as pricing strategy,

fixed and variable costs, sequential investment, insurance, financial leverage, long
term arrangements, derivatives, strategic alliance and improvement of information.

Selection of project under risk: This involves procedures such as payback period
requirement, risk adjusted discount rate, judgmental evaluation and certainty
equivalent method.

Practical Risk Analysis: The techniques involved include the Acceptable Overall
Certainty Index, Margin of Safety in Cost Figures, Conservative Revenue Estimation,
Flexible Investment Yardsticks and Judgment on Three Point Estimates.
Evaluating Risk of Capital Projects
Risk also needs to be analyzed carefully, regardless of which valuation method is
used to evaluate the project. The more popular risk-assessment techniques include
Sensitivity Analysis, Simple Probability Analysis, Decision-Tree Analysis, Monte Carlo
Simulations and Economic Value Added (EVA):
• Sensitivity Analysis considers what will happen if key assumptions change and
identifies the range of change within which the project will remain profitable;
• Simple Profitability Analysis assesses risk by calculating an expected value for
future cash flows based on their probability of success to future cash flows;
• Decision-tree Analysis builds on Simple Profitability Analysis by graphically
outlining potential scenarios and then calculating each scenario's expected
profitability based on the project’s cash flow/net income; this technique allows
managers to visualize the project and make more informed decisions, although
decision trees can become very complicated considering all the scenarios that
should be considered (e.g., inflation, regulation, interest rates, etc.);
• Monte Carlo Simulations use econometric/statistical probability analyses to
calculate risk; and,
• EVA, which is growing in popularity, is a performance measure that adjusts
residual income for "accounting distortions" that decrease short-term income but
have long-term effects on shareholder wealth (e.g., marketing programs and R&D
would be capitalized rather than expensed under EVA).
Capital Budgeting Procedures
Table 2 displays the functional segments responsible for making capital budgeting
decisions. More than half of the firms use a team that consists of accounting,
management and marketing personnel to make capital budgeting decisions.
Approximately 21 percent of the respondents chose the "other" category. An
analysis of their written responses indicates that those who chose the "other
category also used a team approach. The composition of the team varied across
firms. The majority of the firms used teams that at least, included accounting,
manufacturing, and/or operational personnel. In some firms, finance and technical
services personnel were included in the team. Thus, approximately 73 percent of
the respondents use some type of team to make capital budgeting decisions.
Apparently, the great majority of the respondents believe that it is necessary to
draw on the diverse expertise of the many functional areas to make sound capital
budgeting decisions.
The results show a change in the capital budgeting philosophy since the Gilman and
Forrester study in which the researchers found that 60 percent of the firms utilized
only the finance department in making capital budgeting decisions.
Stages of the Capital Budgeting Process
Capital Budgeting Process
Evaluation of Capital budgeting project involves six steps:
First, the cost of that particular project must be known.
Second, estimates the expected cash out flows from the project, including residual
value of the asset at the end of its useful life.
Third, riskiness of the cash flows must be estimated. This requires information about
the probability distribution of the cash outflows.
Based on project’s riskiness, Management find outs the cost of capital at which the
cash out flows should be discounted.
Next determine the present value of expected cash flows.
Finally, compare the present value of expected cash flows with the required outlay.
If the present value of the cash flows is greater than the cost, the project should be
taken. Otherwise, it should be rejected.

Capital budgeting Project Evaluation Methods

The four most popular methods are:

• The Payback Period Method, which favors earlier cash flows and selects
projects based on the time it takes to recover the firm's investment; weaknesses in
this method include the facts it does not consider cash flows after the payback
period and it does not consider the time values of money; a common practice is to
use this method to select from projects with similar rates of return that have been
evaluated using a discounted cash flow (DCF) method (e.g., this is often referred to
as the Payback Method based on Discounted Cash Flows or Break-Even Time
Method)

• The Accounting Rate of Return (ARR) Method, which uses accounting

income/GAAP information, is calculated as the average annual income divided by
the initial or average investment; the projected return is normally compared to a
target ARR based on the firm's cost of capital, the company's past performance
and/or the riskiness of the project.

• The Net Present Value(NPV) Method, which is based on the time value of
money and is a popular DCF method; the NPV Method discounts future cash flows
(both in- and out-flows) using a minimum acceptable cost of capital (usually based
on the weighted average cost of capital or WACC, adjusted for perceived risk) that is
referred to as the "hurdle rate"; the NPV is as the difference between the present
value of net cash inflows and cash outflows, and a $0 answer implies that the
project is profitable and that the firm recovered its cost of capital.

• The Internal Rate of Return (IRR) Method, which is based on the time value of
money, calculates the interest rate that equates the present value of cash outflows
and cash inflows; this calculated rate of return is then compared to the required
rate of return, or hurdle rate, to determine the viability of the capital projects.
Benefits of Capital Budgeting
Other considerations the firm/you should consider as part of the valuation process
are "soft" costs and benefits. Soft costs and benefits are difficult to quantify by are
real non-the-less. Examples of soft costs might be a capital investment in a
manufacturing process that results in added pollution to the atmosphere. A soft
benefit might be the enhancement of a firm's overall image as a result of investing
in R&D for high-tech products. Ignoring soft benefits and costs can lead to strategic
mistakes, especially if you are taking about investments in advanced manufacturing
technology. Soft benefits and costs need to be estimated and then included as part
of the method used to determine if a capital project is desirable.
Post Completion Project Evaluation
Once the project has been chosen and put into operation, a post completion audit of
the project should be undertaken by a qualified financial services firm, such as
yours, which can evaluate the project objectively. This audit by an independent
party will function as a control mechanism to ensure that the capital project is
performing as expected and, in the event it is not, to make it easier to terminate the
project by eliminating any bias of those involved in the project. It will also serve as a
learning mechanism for upper management as they compare actual performance to
expected results, and improve the processes and estimates they use in future
investment
It should be noted that this control mechanism, which can be expensive, is essential
to the success of future capital investment decisions, especially considering the
long life of

One final word regarding implementation of this control mechanism; successful

post-completion auditing processes require that upper management understand
that the purpose of the audit is to learn from past experiences,. Managers should
not be penalized for the decisions they made but should, instead, be given the
opportunity to learn from them
Payback period
Payback period in capital budgeting refers to the period of time required for the return
on an investment to "repay" the sum of the original investment. For example, a
$1000 investment which returned $500 per year would have a two year payback
period. The time value of money is not taken into account. Payback period intuitively
measures how long something takes to "pay for itself." All else being equal, shorter
payback periods are preferable to longer payback periods. Payback period is widely
used due to its ease of use despite recognized limitations, described below.
The term is also widely used in other types of investment areas, often with respect
to energy efficiency technologies, maintenance, upgrades, or other changes. For
example, a compact fluorescent light bulb may be described as having a payback
period of a certain number of years or operating hours, assuming certain costs.
Here, the return to the investment consists of reduced operating costs. Although
primarily a financial term, the concept of a payback period is occasionally extended
to other uses, such as energy payback period (the period of time over which the
energy savings of a project equal the amount of energy expended since project
inception); these other terms may not be standardized or widely used.
Payback period as a tool of analysis is often used because it is easy to apply and
easy to understand for most individuals, regardless of academic training or field of
endeavor. When used carefully or to compare similar investments, it can be quite
useful. As a stand-alone tool to compare an investment with "doing nothing,"
payback period has no explicit criteria for decision-making (except, perhaps, that
the payback period should be less than infinity).
The payback period is considered a method of analysis with serious limitations and
qualifications for its use, because it does not properly account for the time value of
money risk financing or other important considerations, such as the opportunity
cost Whilst the time value of money can be rectified by applying a weight average
cost of capital discount, it is generally agreed that this tool for investment decisions
should not be used in isolation. Alternative measures of "return" preferred by
economists are net present value and internal rate of return. An implicit assumption
in the use of payback period is that returns to the investment continue after the
payback period. Payback period does not specify any required comparison to other
investments or even to not making an investment.
There is no formula to calculate the payback period, excepting the simple and non-
realistic case of the initial cash outlay and further constant cash inflows or constant
growing cash inflows. To calculate the payback period an algorithm is needed. It is
easily applied in spreadsheets. The typical algorithm reduces to the calculation of
cumulative cash flow and the moment in which it turns to positive from negative.
Additional complexity arises when the cash flow changes sign several times, that is
it contains outflows in the midst or at the end of the project lifetime. The modified
payback period algorithm may be applied then. Firstly, the sum of all of the cash
flows is calculated. Then the cumulative positive cash flows are determined for each
period. The modified payback period is calculated as the moment in which the
cumulative positive cash flow exceeds the total cash outflow

Payback is the number of years required to recover the original cash flow outlay
investment in a project. The payback is one of the most popular and widely
recognized traditional methods of evaluating investment proposals. If the project
generates consistent annual cash inflows, the payback period can be computed by
dividing cash outlay by the annual cash inflow. That is:
Payback = Initial investment / Annual Cash inflow
Acceptance Rule
Many firms use the payback period as an investment evaluation criterion and
method of ranking projects. They compare the projects payback with a
predetermined, standard payback. The project would be accepted if its payback
period is less than the maximum or standard payback period set by management.
As a ranking method, it gives highest ranking to the project, which has the shortest
payback period and lowest ranking to the project with highest payback period. Thus,
if the firm has to choose between two mutually exclusive projects, the project with
shorter payback period will be selected.

Advantages of Payback
Payback is a popular investment criterion in practice. It is considered to have
certain virtues.
• Simplicity. The most significant merit of payback is that it is simple to understand
and easy to calculate. The business executives consider the simplicity of method as
a virtue. This is evident from their heavy reliance on it for appraising investment
proposals in practice.
• Cost effective. Payback method costs less than most of the sophisticated
techniques that require a lot of the analysts' time and the use of computers.
• Short term effect. An investor can have more favorable short term effects on
earnings per share by setting up a shorter standard payback period. It should,
however, be remembered that this may not be a wise long term policy as the
investor may have to sacrifice its future growth for current earnings.
• Risk shield. The risk of the project can be talked by having a shorter standard
payback period as it may ensure guarantee against loss. An investor has to invest in
many projects where the cash inflows are and life expectancies are highly
uncertain. Under such circumstances, payback may become important, not as much
as a measure of profitability but as a means of establishing an upper bound on the
acceptable degree of risk.
• Liquidity. The emphasis in payback is on the early recovery of the investment.
Thus, it gives an insight into the liquidity of the project. The funds so released can
be put to other uses’

Disengages of Payback
In spirit of its simplicity and the so-called virtues, the payback may not be a
desirable investment criterion since it suffers from a number of serious limitations:
• Cash flows after payback. Payback fails to take account of the cash inflows earned
after the payback period.
• Cash flows ignored. Payback is not an appropriate method of measuring the
profitability of an investment projects as it does not consider all cash inflows yielded
by the project.
• Cash flow patterns. Payback fails to consider the pattern of cash inflows. I.e.
magnitude and timing of cash inflows. In other words, it gives equal weights to
return of equal amounts even though they occur in different time periods.
• Administrative difficulties. A firm may face difficulties in determining the
maximum acceptable payback period. There is no rational basis for setting a
maximum payback period. It is generally subjective decision.
• Inconsistent with shareholder value. Payback is not consistent with the objective
of maximizing the market value of firm’s shares. Share values do not depend on
payback periods of investment projects.
Let us re-emphasize that the payback is not a valid method for evaluating the
acceptability of the investment projects. It can, however, be used along with net
present value rules as a first step in roughly screening the projects. In practice, the
use of discounted cash flow techniques has been increasing but payback continues
to remain a popular and primary method of investment evaluation.
Payback is considered theoretically useful in few situations. One significant
argument in favor of payback is that its reciprocal is a good approximation of the
rate of return under certain conditions.
http://professional-edu.blogspot.com/2010/01/132-payback-
period.html
Article Source: http://EzineArticles.com/?
expert=Randika_Lalith_Abeysinghe

Average rate of return

Average rate of return is a financial term that refers to the average amount of
money earned or lost on an investment over time, as compared to the amount
actually invested. It is commonly also called return on investment (ROI), and is
usually expressed as a percentage, representing the total profit or loss relative to
the initial capital. Since it essentially shows what kind of profit may be expected, an
average rate of return projection is a key component in any investment strategy.

There are two basic ways of calculating an average rate of return — one which is
limited to short term estimates, and one that is more suited for longer term
projections. The arithmetic mean provides an average short term rate of return,
while what is known as the geometric mean is used for rates with a longer term.
The latter includes a variable for a given number of years, and therefore can be
used to project out into the future.
The farther out into the future an arithmetic average rate of return is calculated, the
less accurate it becomes. This discrepancy occurs because, unlike geometric mean,
arithmetic mean does not account equally for positive and negative earnings as
years go by. For example, if the average rate of return on $50 US Dollars' (USD)
worth of capital, over two years, is 25% in the first year and -25% in the second
year, the arithmetically calculated result will be $37.5 USD, which is incorrect. Using
the geometric formula yields the correct result of $50 USD, as the amount of the
initial investment never changed.
Though the formulas for calculating average rate of return are somewhat complex,
the results are fairly easy to interpret. The rate will represent the percentage of the
capital either gained or lost. A percentage greater than zero indicates a profit, while
a number less than zero indicates a loss. Neither method of average rate of return
is totally comprehensive, and both make certain assumptions regarding market and
economic conditions. Nevertheless, with these assumptions in mind, they can offer
guidance on anything from personal finance to major corporate and business
transactions. Often, a mutual fund or similar investment program will offer a
prospectus to potential investors that includes statistics, such as historic and
projected future average rates of return. Consumers may use this as a comparative
tool for estimated profitability in choosing between various funds. Since they offer
results in relative percentages, the very same equations can be used to estimate
profits and cash flow associated with the acquisition of entire companies.
A profitability index (PI)
A profitability index (PI), alternatively referred to as a profit investment ratio or a
value investment ratio, is a method for discerning the relationship between the
costs and benefits of investing in a possible project. It calculates the cost/benefit
ratio of the present value (PV) of a project’s future cash flow over the price of the
project’s initial investment. This formula is commonly written as PI = PV of future
cash flows ÷ initial investment. The figure this formula yields helps investors decide
on whether or not a project is financially attractive enough to pursue.

A profitability index of 1 designates the lowest measure by which it is logically

acceptable to pursue a project. A value lower than 1 suggests that the project's
possible value is lower than the initial investment. This means that the investor
does not make a profit and should not invest in the project. A value exceeding 1
indicates financial gain, and as the number goes up, the investment becomes more
attractive.
Aside from individual cases, many companies and investors use the profitability
index as a way of ranking a group of potential projects. Any project below one is
excluded from the list altogether; those with a PI rating of one or higher are
considered. The profitability index is thought to be useful for this task because it
allows for the measurement and comparison of two or more separate projects, each
of which require completely different investment amounts.
The number the profitability index yields projects the amount returned on each
dollar invested. So, if the profitability index yields a 1.5, an investor can expect to
get a return of $1.50 US Dollar (USD) for each dollar invested. Alternatively, a
profitability index yields a 0.9, an investor can expect to get $0.90 USD back for
each dollar spent, which results in negative returns.
The profitability index is related to another common financial formula called the net
present value (NPV) indicator. These two formulas are often confused because they
are both used for a similar purpose. However, while the profitability index measures
the relative value of an investment, the net present value indicator measures the
absolute value of an investment.
The profitability index is considered somewhat limited, in that it would instruct us to
accept all investments above 1. However, it assumes that investors do not have to
ration their capital and thus can invest as much as needs to be invested. However,
if capital is scarce, an investor needs to consider the size of the investment itself, as
investing large amounts of capital in just one project involves a large amount of
risk.
A profitability index (PI), alternatively referred to as a profit investment ratio or a
value investment ratio, is a method for discerning the relationship between the
costs and benefits of investing in a possible project. It calculates the cost/benefit
ratio of the present value (PV) of a project’s future cash flow over the price of the
project’s initial investment. This formula is commonly written as PI = PV of future
cash flows ÷ initial investment. The figure this formula yields helps investors decide
on whether or not a project is financially attractive enough to pursue.

A profitability index of 1 designates the lowest measure by which it is logically

acceptable to pursue a project. A value lower than 1 suggests that the project's
possible value is lower than the initial investment. This means that the investor
does not make a profit and should not invest in the project. A value exceeding 1
indicates financial gain, and as the number goes up, the investment becomes more
attractive.
Aside from individual cases, many companies and investors use the profitability
index as a way of ranking a group of potential projects. Any project below one is
excluded from the list altogether; those with a PI rating of one or higher are
considered. The profitability index is thought to be useful for this task because it
allows for the measurement and comparison of two or more separate projects, each
of which require completely different investment amounts.
The number the profitability index yields projects the amount returned on each
dollar invested. So, if the profitability index yields a 1.5, an investor can expect to
get a return of $1.50 US Dollar (USD) for each dollar invested. Alternatively, a
profitability index yields a 0.9, an investor can expect to get $0.90 USD back for
each dollar spent, which results in negative returns.
The profitability index is related to another common financial formula called the net
present value (NPV) indicator. These two formulas are often confused because they
are both used for a similar purpose. However, while the profitability index measures
the relative value of an investment, the net present value indicator measures the
absolute value of an investment.
The profitability index is considered somewhat limited, in that it would instruct us to
accept all investments above 1. However, it assumes that investors do not have to
ration their capital and thus can invest as much as needs to be invested. However,
if capital is scarce, an investor needs to consider the size of the investment itself, as
investing large amounts of capital in just one project involves a large amount of
risk.
Internal Rate of Return:
The internal rate of return (IRR) is the discount rate computed such that the net
present value of the project equals zero. Software spreadsheet applications and
financial calculators usually include a function that calculates the IRR. The following
example illustrates how the IRR was approximated prior to the widespread
availability of these electronic tools.

Example: The Sunrise Bakery is considering an expansion to its outdoor dining

space that would require an initial cash outlay of $26,000 and increase net cash
inflows by $8,000 per year for four years. The owner of the bakery does not
anticipate any benefit from this expansion after year four, because at that time she
hopes to finance a major renovation of the building that would expand the indoor
dining area into the location of the patio. What is the IRR of the proposed expansion
to the current outdoor dining space?
Setting the NPV equal to zero in the NPV equation, and solving for the present
value factor:
0 = ($8,000 x the present value factor) – $26,000
→ present value factor = 3.25
Looking in Row 4 of Table 2 (since the life of the annuity is four years), the closest
factor to 3.25 is 3.2397 in the column for 9%. Therefore, the IRR is approximately
9%.
Relative to NPV, the advantage of IRR is that it provides a performance measure
that is independent of the size of the project. Hence, IRR can be used to compare
projects that require significantly different initial investments.
 An important drawback of IRR is that it can induce managers to reject proposed
projects that shareholders would like the company to accept. For example, if the
manager is evaluated based on the average IRR of all capital projects undertaken,
and if a proposed capital project offers an IRR that is above the company’s cost of
capital, but below the average of all capital projects undertaken thus far, the
proposed project would adversely affect the manager’s performance measure,
although it would increase economic returns to shareholders.
IRR implicitly assumes that free cash flows can be reinvested at the computed
internal rate of return. This assumption is analogous to the assumption imbedded in
the NPV calculation that free cash flows can be reinvested at the discount rate.
However, in the context of IRR, the assumption is more problematic than in the
context of NPV if the IRR is unusually high or low.

How to use NPV (Net Present Value) in capital budgeting

The typical capital investmentis composed of a string of cash flows, both in and out, that
will continue until the investment is eventually liquidated at some point in the future. These
cash flows are comprised of many things: the initial payment for equipment, continuing
maintenance costs, salvage value of the equipment when it is eventually sold, tax payments,
receipt from product sold, and so on. The trouble is, since the cash flows are coming in and
going out over a period of many years, how do we make them comparable for an analysis
that is done in the present? This post tries to simply explain with an example on how to
use NPV (Net Present Value in capital budgeting.
This requires the use of a discount rate (usually based on the cost of capital) to
reduce the value of a future cash flow into what it would be worth right now. By
applying the discount rate to each anticipated cash flow, we can reduce and then
add them together, which yields a single combined figure that represents the
current value of the entire proposed capital investment. This is known as “its net
present value”.
Example: Below exhibit lists the cash flows, both in and out, for a capital investment
that is expected to last for five years.

The year is listed in the first column, the amount of the cash flow in the second
column, and the discount rate in the third column. The final column multiplies the
cash flow from the second column by the discount rate in the third column to yield
the present value of each cash flow. The grand total cash flow is listed in the lower-
right corner of the table.
Notice that the discount factor in the above exhibit becomes progressively smaller in later years,
since cash flows further in the future are worth less than those that will be received sooner. The
discount factor is published in present value tables, which are listed in many
accounting and finance textbooks. They are also a standard feature in midrange
hand-held calculators.
Another variation is to use the following formula to manually compute a present value:
Present value of a future cash flow:
(Future cash flow) / [1+Discount rate] (squared by number of periods of
Discounting)
Using the above formula, if we expect to receive $75,000 in one year, and the
discount rate is 15 percent, then the calculation is:

Here are the most common cash flow line items to include in a net present value analysis:
Cash inflows from sales - If a capital investment results in added sales, then all gross
margins attributable to that investment must be included in the analysis
Cash inflows and outflows for equipment purchases and sales - There should be a cash
outflow when a product is purchased, as well as a cash inflow when the equipment
is no longer needed and is sold off.
Cash inflows and outflows for working capital - When a capital investment occurs, it
normally involves the use of some additional inventory. If there are added sales,
then there will probably be additional accounts receivable. In either case, these are
additional investments that must be included in the analysis as cash outflows. Also,
if the investment is ever terminated, then the inventory will presumably be sold off
and the accounts receivable collected, so there should be line items in the analysis,
located at the end of the project timeline, showing the cash inflows from the
liquidation of working capital.
Cash outflows for maintenance - If there is production equipment involved, then there
will be periodic maintenance needed to ensure that it runs properly.
Cash outflows for taxes - If there is a profit from new sales that are attributable to the
capital investment, then the incremental income tax that can be traced to those
incremental sales must be included in the analysis. Also, if there is a significant
quantity of production equipment involved, the annual personal property taxes that
can be traced to that equipment should also be included.
Cash inflows for the tax effect of depreciation- Depreciation is an allowable tax
deduction. Accordingly, the depreciation created by the purchase of capital
equipment should be offset against the cash outflow caused by income taxes.
Though depreciation is really just an accrual, it does have a net cash flow impact caused by a
reduction in taxes, and so should be included in the net present value calculation. The net present
value approach is the best way to see if a proposed capital investment has a sufficient rate of
return to justify the use of any required funds. Also, because it reveals the amount of cash
created in excess of the cost of capital, it allows management to rank projects by
the amount of cash they can potentially spin off.
When comparing two mutually exclusive proposals using both the net present value method and
the internal rate of return method, you will find cases where one project is preferable to the other
using one method, and the reverse is true using the other method. It is important to
understand how and why this happens. The result is obtained because the two
projects will have differing cash flows in different periods. Therefore, the
compounding effect of the discount rate and the time value of money will produce
different results.
Notes:
The NPV at 15 percent discount rate is $918.71. The IRR is 22 percent.
The project returns $9,750 total and a break-even in 2 years and 4 months.
Which project is a better investment?
This example shows how similar cash flows in different periods will affect your decision-making
process. Thus reliance on any one method, without understanding how it works may
result in a distorted decision-making process.
Some people prefer the NPV method as superior to the IRR, because the IRR method implies
reinvestment rates that will differ depending on the cash flow stream for each investment
proposal under consideration. With the NPV method, however, the implied reinvestment
rate, namely the required rate of return or hurdle rate, is the same for each
proposal. In essence, this reinvestment rate presents the minimum return on
opportunities available to you. You must employ judgment in evaluating what each
model generates as a decision. Factors other than the rate of return may alter the choice of
one proposal or the other. For instance: long term tax planning may favor one cash flow
projection over the other in order to optimize long-term tax liabilities. Therefore, evaluate
the expected cash flows and their timing.
Capital budgeting in the ongoing system of planning, evaluation, and execution of the
business is itself a process. It starts with a determination of where you are, then where you want
to be, then how you intend to get there. Even if you do not institute capital budgeting as an
ongoing process, simply going through the exercise of setting up a process is a valuable endeavor
of self-examination.
It gets people to think through how prudent investments in capital-intensive
projects may help the business grow, diversify, or replace existing plant and
equipment. Capital budgeting is a four-step process of (1) proposal solicitation or
generation, (2) evaluation, (3) implementation, and (4) follow-up. In the evaluation
step, various alternative proposals have various related returns associated with the
investment. With this expected return is a probable risk of loss of all or part of the
invested funds. In any endeavor, the decision must be based on balancing the
return against the associated risk. The problem, of course, is that no certainty, even
in the estimates of risk and return, exists. In order to minimize the risk, you should
consider the method by which estimates, projections, and other numbers are
generated.
You should be cautious when only one solution is proposed because there is seldom a problem
without several possible solutions. When preparing a capital budgeting plan, develop
contingency plans and scenarios after asking many what-if questions. As part of your
contingency planning, do not put your head in the sand. Consider the dark side of
the project: “What if it goes sour?” For such a proposition, you should be ready for
bailout as a planned withdrawal; you should not be forced into mindless panic if a
project faces immediate failure.
Distinction between NPV and IRR
There is an important and close relationship between NPV and IRR. The NPV is
greater than zero if and only if the IRR is greater than the discount rate. This
relationship implies that if a single proposed capital investment is considered in
isolation, both NPV and IRR will provide the same answer to the question of whether
or not the investment should be undertaken.
However, NPV and IRR need not provide the same answer if projects that require
different investments are compared. Consider the following example, comparing
two projects each with a one-year life. Assume a 10% discount rate in the NPV
calculation. In this simple setting with a one-year life, the IRR is easily calculated as
the profit divided by the initial investment.

Project Initial Payout at end Net Present Value Internal Rate of

Investment of year Return
A $1,000 $1,200 $91 [(1,200 ÷ 1.1) – 20%
1,000]
B $100 $200 $82 [(200 ÷ 1.1) – 100] 100%

Hence, NPV favors Project A, while IRR favors Project B. What is the “correct”
answer? The answer depends on the opportunity cost associated with the additional
$900 required to finance Project a compared with financing Project B. For example,
if the company has $1,000 to invest and can replicate Project B ten times, doing so
would clearly be preferable to Project A. On the other hand, if the company can earn
only 1% on the $900 additional funds available if Project B is chosen over Project A,
then the company prefers Project A, calculated as follows:

Project NPV IRR

A $91, as determined above 20%, as determined above
B plus $900 $8 [($1,109 ÷ 1.1) – ($1,109  $1,000) ÷ $1,000
invested at $1,000] = 1.1%
1%

The $1,109 in the bottom row is the total payout at the end of the year from this
option, calculated as $200 from Project B plus $909 from the $900 investment that
earns 1%. The NPV of $8 is actually less than the NPV from Project B alone, because
the NPV of the $900 invested at 1% is negative.

In conclusion, NPV and IRR need not rank projects equivalently, if the projects differ
in size.

The Discount Rate:

The discount rate is critical in determining whether the NPV of a project is positive
or negative (and equivalently, whether the project IRR is greater or less than the
discount rate). However, the choice of discount rate is seldom obvious.

In most situations, the appropriate discount rate is the company’s cost of capital.
The cost of capital is a weighted average of the company’s cost of debt and its cost
of equity. Interest rates on borrowings provide information about the cost of debt.
Determining the cost of equity is more difficult, and constitutes an important topic
in the area of finance. The Weighted Average Cost of Capital (WACC) is a concept
from corporate finance that frequently serves as an appropriate discount rate for
capital budgeting decisions. In some cases, however, the company would benefit
from distinguishing between the existing average cost of capital, and
the marginal cost of capital, because the cost of debt generally increases as
companies become more highly leveraged.

Many companies establish a company-wide hurdle rate, to communicate to

managers the appropriate discount rate for investment decisions. Often, the hurdle
rate seems to exceed the company’s cost of capital, which encourages managers to
act conservatively in their capital budgeting decisions: an outcome that is difficult
to justify with finance theory.

Another option for the discount rate is the opportunity cost associated with the
funds required for the capital project. In most cases, the cost of capital and the
opportunity cost should be approximately equal. However, most of us pay a higher
rate to borrow funds than we earn on our financial investments. Hence, if a
decision-maker has cash to either invest in a capital project or invest in the financial
markets, an appropriate discount rate for the capital project is the opportunity cost
of the earnings the decision-maker would have earned in the financial markets. This
rate is probably lower than the cost of raising additional financing for the project.

Measurements Used in Capital Budgets

The purpose of the evaluation phase is to predict how well a new asset will benefit
the firm. Possible measures, which you should help the firm develop, that should be
considered include: • Net income managers evaluate the incremental increase in
accounting net income between alternatives;
• Net cash flow this is the most widely used measure; this measure looks at the
actual cash flows (out and then in) resulting from the capital investment for each
alternative; these need to be evaluated for both overall value (several techniques
will be discussed next) and from the standpoint of the effect on daily cash flow and
the ability of the firm to meet its financial obligations in a timely manner; projects
with high projected future returns may not be as attractive when adjusted for the
time value of money or the costs involved in borrowing funds to meet operating
obligations such as payrolls and accounts payable;
• Cost savings many capital investments are not designed to generate revenues
directly but are, instead, designed to save costs and increase productivity; these
projects are best evaluated on the basis of incremental savings generated;
• Equality of cash flows cash flows tend to vary from year to year; the timing of
cash flows may be an important consideration to the firm;
• Salvage value and functionality of an existing asset when replacing it with a new
asset while the historical cost of an existing asset is not relevant to a capital
budgeting decision, the net proceeds from disposal of the existing equipment is; so
is the question of how well existing equipment operates given that capital
budgeting decisions are only concerned with incremental costs and incremental
savings/profits;
• Depreciation, earnings and income tax effects need to be considered based on the
form of the firm (sole proprietorship, partnership, corporation, etc.), and the
differences in the financial and tax accounting treatments available to the firm,
especially as they apply to salvage value, useful lives and allowed depreciation
methods, and, consideration of the marginal tax rate (which may vary from country
to country); most firms fail to consider this cost or choose a tax or financial
accounting treatment that does not maximize the firm's return on invested capital;
• Inflation the effects of inflation need to be considered in estimating cash flows as
well, especially if is projected to increase in future periods and varies between
capital projects being considered;
• Risk considerations political risk, monetary risk, access to cash flows, economic
stability, and inflation should all be considered in the evaluation process since all
are hidden costs in the capital budgeting process; and,
• Interest and the cost of capital the venture has to have a return that is greater
than its cost of capital, adjusted for tax benefits,

The firm should also make a subjective decision as to its preferences in terms of
characteristics of projects in addition to the regular selection criteria it has set. For
example, does the firm prefer:
• Projects with small initial investments? Earlier cash flows? Or, perhaps, shorter
payback times?
• New projects or expansion of the existing operations?
• Domestic projects or foreign operations?
• If the firm is risk neutral, would the prospects of additional potential cash flows in
riskier investments make a capital project more attractive?

Post Completion Project Evaluation

Once the project has been chosen and put into operation, a post completion audit of
the project should be undertaken by a qualified financial services firm, such as
yours, which can evaluate the project objectively. This audit by an independent
party will function as a control mechanism to ensure that the capital project is
performing as expected and, in the event it is not, to make it easier to terminate the
project by eliminating any bias of those involved in the project. It will also serve as a
learning mechanism for upper management as they compare actual performance to
expected results, and improve the processes and estimates they use in future
investment decisions.

Success of any

One final word regarding implementation of this control mechanism; successful

post-completion auditing processes require that upper management understand
that the purpose of the audit is to learn from past experiences, Managers should not
be penalized for the decisions they made but should, instead, be given the
opportunity to learn from them.

Capital Budgeting: eight steps

Introduction
Until now, this web site has broken one of the cardinal rules of financial
management. This page corrects for that problem and presents now, the first part
of the subject of Capital Budgeting.
Many books and chapters and web pages purport to discuss capital budgeting when
in reality all they do is discuss CAPITAL INVESTMENT APPRAISAL. There's nothing
wrong with a discussion of the CIA methods except that authors have a duty to
point out that CIA methods are only one part of a multi stage process: the capital
budgeting process.
A discussion of CIA and nothing else means that capital budgeting decisions are
being discussed out of context. That is, by ignoring the earlier and later parts of
capital budgeting, we are never assess where capital budgeting project come from,
how alternatives are found and evaluated, how we really choose which project to
choose … and then we never review the projects and how they have been
implemented.

Capital Budgeting: eight steps

Working down the diagram, we can see eight different steps to the capital
budgeting process. If nothing else, this diagram shows that CIA is only one of those
eight different steps. Whenever we talk about a project, we might just as well talk
about an asset or a group of assets.
In line with our definition of capital budgeting, the term project refers to all
investments (resource allocation) of significant size decided and implemented by an
enterprise in order to shape its future. All projects are considered to be the result of
a capital budgeting decision.
Let's look at each step in turn.

1 Have a good idea

Projects don't just fall out of thin air: someone has to have them. The main point
here is that successful, dynamic and growing companies are constantly on the
lookout for new projects to consider. In the largest organsiations there are entire
departments looking for alternatives and opportunities.

2 Look for suitable projects

Once someone has had the idea to invest, the next step is to look at suitable
projects: projects that complement current business, projects that are completely
different to current business and so on. Initially, all possibilities will be considered:
along the lines of a brainstorming exercise.
As time goes by, and as corporate objectives allow, the initial list of potential
projects will be whittled down to a more manageable number.
3 Identify and consider alternatives
Having found a few projects to consider, the organization will investigate any
number of different ways of carrying them out. After all, the first idea probably
won't either be the last or the best. Creativity is the order of the day here, as
organizations attempt to start off on the best footing.
As the diagram suggests, at each of these first three stages, we need to consider
whether what we are proposing fits in with corporate objectives. There is no point in
thinking of a project that conflicts with, say, the growth objective or the profitability
objective or even an environmental objective.
A lot of data will be generated in this stage and this data will be fed into stage four:
Capital Investment Appraisal.
4 Capital Investment Appraisals
This is the number crunching stage in which we use some or all of the following
methods
 Payback (PB)
 accounting rate of return (ARR)
 Net present value (NPV)
 Internal rate of return (IRR)
 Profitability Index (PI)
There are other techniques of course; but the technique to be used will depend on a
range of things, including the knowledge and sophistication of the management of
the organisation, the availability of computers and the size and complexity of the
project under review.
For more information here, go to my page on CIA once you have finished this page.

5 Analysis of feasibility
Stage four is the number crunching stage. This stage is where the decision is made
as to which project is to be assessed as acceptable. That is, which project is
feasible?
In order to choose the project, management needs some hurdles:
 What must the payback be
 what rate of ARR is acceptable
 what is the NPV cut off
 what IRR is the least that we can accept
 what PI is the least that we can accept
And so on.
Some projects will be discarded as a result of this stage. For example, if the PB cut
off is, say, 2 years, and a project has a PB of 3 years, it will be rejected. The same is
true of the ARR, NPV, IRR and PI.
Capital rationing might be a problem here, too, if the organization has general cash
flow problems.
Capital Budgeting Policy Manual
Let's pause at this point to make the point that what we have just said about cut off
rates and so on come from formal procedures and documents. One such formal
document is the Capital Budgeting Policy Manual, in which formal procedures and
rules are established to assure that all proposals are reviewed fairly and
consistently. The manual helps to ensure that managers and supervisors who make
proposals need to know what the organization expects the proposals to contain, and
on what basis their proposed projects will be judged.
The managers who have the authority to approve specific projects need to exercise
that responsibility in the context of an overall organizational capital expenditure
policy.
In outline, the policy manual should include specifications for:
an annually updated forecast of capital expenditures
the appropriation steps
the appraisal method(s) to be used to evaluate proposals
the minimum acceptable rate(s) of return on projects of various risk
The limits of authority
The control of capital expenditures
The procedure to be followed when accepted projects will be subject to an actual
performance review after implementation
(See IFAC document The Capital Expenditure Decision October 1989 for full details
of the manual)
6 Choose the project
Once we have determined the feasible/acceptable projects, we then have to make a
decision of which to accept.
If we have capital rationing problems, we might be restricted to one project only. If
we have no cash problems, we might choose two or more.
Whatever the cash position, we would like to invest in all projects that have a
positive NPV, whose IRR is greater than our cut off rate and so on.
7 Monitor the project
As with any part of the organization, the project must be monitored as it progresses.
If the project can be kept as a separate part of the business, it might be classed as
its own department or division and it might have its own performance reports
prepared for it. If it's to be absorbed within one or more parts of the organization
then it could be difficult to monitor it separately: this is something that
management has to decide as they implement their new projects.
8 Post completion audit
The final stage: once the project has been up and running for six months or a year
or so, there must be a post completion audit or a post audit. A post audit looks at
the project from start to finish: stages 1 - 7 and looks at how it was thought of,
analysed, chosen, implemented, and monitored and so on.
The purpose of the post audit is to test whether capital budgeting procedures have
been fully and fairly applied to the project under review.
Of course, any weaknesses that might be found during the post audit might be
specific to one project or they might relate to capital budgeting systems for the
organization as a whole. In the latter case, the auditor will report back to his
superiors and to management that systems need to be overhauled as a result of
what has been found.

Conclusions
In brief, this page has demonstrated that capital budgeting involves a lot more than
just carrying out a few calculations for payback, ARR and so on.
The capital budgeting process involves expenditures and investments that are
relatively large and that must then be undertaken and controlled in a serious,
professional way.

EFFECTS OF INFLATION ON CAPITAL BUDGETING DECISIONS -

AN ANALYTICAL STUDY

INTRODUCTION

In today’s complex business environment, making capital budgeting decisions are

Among the most important and multifaceted of all management decisions as it
represents
Major commitments of company’s resources and have serious consequences on the
Profitability and financial stability of a company. It is important to evaluate the
proposals
Rationally with respect to both the economic feasibility of individual projects and
the relative
Net benefits of alternative and mutually exclusive projects. It has inspired much
research
Scholars and is primarily concerned with sizable investments in long-term assets,
with long-term
Life.
The growing internationalization of business brings stiff competition which requires
a
proper evaluation and weight age on capital budgeting appraisal issues viz. differing
project
Life cycle, impact of inflation, analysis and allowance for risk. Therefore financial
managers
Must consider these issues carefully when making capital budgeting decisions.
Inflation is
one of the important parameters that govern the financial issues on capital
budgeting
decisions.
Managers evaluate the estimated future returns of competing investment
alternatives.
Some of the alternatives considered may involve more risk than others. For
example, one
alternative may fairly assure future cash flows, whereas another may have a chance
of
Yielding higher cash flows but May also result in lower returns. It is because, apart
from other
Things, inflation plays a vital role on capital budgeting decisions and is a common
fact of life
All over the world. Inflation is a common problem faced by every finance manager
which
Complicates the practical investment decision making than others. Most of the
managers are
Concerned about the effects of inflation on the project’s profitability. Though a
double digit
Rate of inflation is a common feature in developing countries like India, the
manager should
Consider this factor carefully while taking such decisions.
2
In practice, the managers do recognize that inflation exists but rarely incorporate
Inflation in the analysis of capital budgeting, because it is assumed that with
inflation, both
Net revenues and the project cost will rise proportionately; therefore it will not have
much
Impact. However, this is not true; inflation influences two aspects viz. Cash Flow,
Discount
Rate and hence this study is an attempt to analyse the issues in the area of effects
of inflation
On capital budgeting decisions for optimum utilisation of scarce resources. In
discussing how
the inflation effects on capital budgeting decisions, this paper has been divided into
two parts.
In the first part, discussion is about inflation, how to measure the inflation and the
effects of
inflation on GDP. In the second part, effects on inflation on capital budgeting
decisions,
comprising how to deal with expected and unexpected inflation while forecasting
cash flows
and determining the discount rate in particular.

1. OVERVIEW OF INFLATION

Everyone is familiar with the term ‘Inflation’ as rising prices. This means the
same thing as fall in the value of money. For example, a person would like to buy
5kgs
of apple with Rs. 100, at the present rate of inflation, say, zero. Now when the
inflation rate is 5%, then the person would require Rs. 105 to buy the same quantity
of
apples. This is because there is more money chasing the same produce. Thus,
Inflation
is a monetary aliment in an economy and it has been defined in so many ways,
which
Can be defined as “the change in purchasing power in a currency from period to
period
Relative to some basket of goods and services.”1.
When analysing Capital Budgeting Decisions with inflation, it is required to
distinguish between expected and unexpected inflation. The difference between
unexpected and expected inflation is of crucial importance as the effects of
inflation,
especially its redistributive effect, depend on whether it is expected or not.
Expected
inflation refers to the loss the manager anticipates in buying power over time
whereas
unexpected inflation refers to the difference between actual and expected inflation.
If
rate of inflation is expected, then the manager take steps to make suitable
adjustments
in their proposals to avoid the adverse effects which could bring to them.
3
Measuring Inflation: Inflation is measured by observing the change in the price of
a
large number of goods and services in an economy, usually based on data collected
by
government agencies. The prices of goods and services are combined to give a
price
index or average price level, the average price of the basket of products. The
inflation
rate is the rate of increase in this index; while the price level might be seen as
measuring the size of a balloon, inflation refers to the increase in its size. There is
no
single true measure of inflation, because the value of inflation will depend on the
weight given to each good in the index. The common measures of inflation
include2: Consumer price indexes (CPIs), Producer price indexes (PPIs), Wholsale
price indexes (WPIs), commodity price indexes, GDP deflator, and Employment cost
index. Table showing the rate of inflation in India (1995-2003)3 based on WPI, based
on CPI and growth rate in GDP is given table 1.

TABLE 1
RATE OF INFLATION IN INDIA (1995-2003)
Year
1995-96 4.4 8.9 6.5
1996-97 5.4 10 4.8
1997-98 4.5 8.3 7.8
1998-99 5.3 8.9 7.3
1999- 6.5 4.8 6.1
2000- 4.9 2.5 4.4
2001- 1.6 5.2 5.6
2002- 4.4 3.2 4.4
4
Inflation and Gross Domestic Product (GDP): Inflation and GDP growth are
probablys the two most important macroeconomic variables. The Gross Domestic
Product (GDP) is the key indicator used to measure the health of a country's
economy. The GDP of a country is defined as the market value of all final goods and
services produced within a country in a given period of time. Usually, GDP is
expressed as comparison to the previous quarter or year. For example, if the year-
to-year GDP wasp by 3%, it means that the economy has grown by 3% over the last
year. A significant change in GDP, whether increase or decrease, usually reflects on
the stock market. The reason behind this is that, a bad economy usually means
lower profits for companies, which in turn means lower stock prices. Investors really
worry about negative GDP growth. Therefore growth in GDP reflects both on growth
in the economy and price changes (inflation). GDP deflator is based on calculations
of third: it is based on the ratio of the total amount of money spent on GDP
(nominalGDP) to the inflation corrected measure of GDP (constant price or real
GDP). It is the broadest measure of the price level. Deflators are calculated by using
the following
formula4: Current price figures measure value of transactions in the prices relating
to the period being measured. On the other hand, Constant price figures express
value using the average prices of a selected year, this year is known as the base
year. Constant price series can be used to show how the quantity or volume of
goods has changed, and are often referred to as volume measures. The ratio of the
current and constant price series is therefore a measure of price movements, and
this forms the basis for third deflator. The GDP deflator shows how much a change
in the base year's GDPrelies upon changes in the price level. It is also known as the
"GDP implicit price deflator".
Nominal GDP
GDP Deflator = X 100
Real GDP
5 Because it isn't based on a fixed basket of goods and services, the GDP deflator
has an advantage over the Consumer Price Index. Changes in consumption patterns
orthe introduction of new goods and services are automatically reflected in the
deflator5.

2. INFLATION AND CAPITAL BUDGETING DECISIONS

Capital budgeting results would be unrealistic if the effects of inflation are not
correctly factored in the analysis6.For evaluating the capital budgeting decisions;
we require information about cash flows-inflows as well as outflows. In the capital
budgeting procedure, estimating the cash flows is the first step which requires the
estimation of cost and benefits of different proposals being considered for
decisionmaking.The estimation of cost and benefits may be made on the basis of
input data being provided by experts in production, marketing, accounting or any
other department. Mostly accounting information is the basis for estimating cash
flows. TheManagerial Accountant’s task is to design the organization’s information
system or Management Accounting System (MAS) in order to facilitate managerial
decision-making. MA’s parameters have to be designed on the basis for
commonalities in the decision process of executives involved in strategic capital
budgeting decisions. This has been emphasized by David F Larcker7 and examined
whether executives have similar preferences regarding information which may be
used in making strategic capital budgeting decisions. The results indicate that
executives have similar informational preferences, the preferred information
characteristics depend upon the stage of the decision, and environmental and
organizational structure variables are not associated with an executive’s
informational preferences.
Inflation and Cash Flows: As mentioned above, estimating the cash flows is the
first step which requires the estimation of cost and benefits of different proposals
being considered for decision-making. Usually, two alternatives are suggested for
measuring the 'Cost and benefits of a proposal i.e., the accounting profits and the
cash flows. In reality, estimating the cash flows is most important as well as difficult
task. It is because of uncertainty and accounting ambiguity.
Accounting profit is the resultant figure on the basis of several accounting concepts
and policies. Adequate care should be taken while adjusting the accounting data,
otherwise errors would arise in estimating cash flows. The term cash flow is used to
describe the cash oriented measures of return, generated by a proposal. Though it
may not be possible to obtain exact cash-effect measurement, it is possible to
generate useful approximations based on available accounting data. The costs are
denoted as cash outflows whereas the benefits are denoted as cash inflows. The
relation between cash flows and Accounting Profit is discussed in the subsequent
Para, before a detailed discussion on effect of Inflation and cash flows is done.

Cash Flows Vs Accounting Profit: The evaluation of any capital investment

proposals based on the future benefits accruing for the investment proposal. For
this, two alternative criteria are available to quantify the benefits namely,
Accounting Profit and Cash flows. This basic difference between them is primarily
due to the inclusion of certain non-cash items like depreciation. This can be
illustrated in the Table2:

TABLE 2
A COMPARISON OF
CASH FLOW AND ACCOUNTING PROFIT APPROACHES
Accounting Approach Cash flow Approach
Particulars Rs. Rs. Particulars Rs. Rs.
Revenue 1000 Revenue 1000
Less: Expenses Less: Expenses
Cash Expenses 400 Cash Expenses 400
Depreciation 200 600 Depreciation 200 600
Earnings before Tax 400 Earnings before Tax 400
Tax @ 50% 200 Taxes 200
Earning after Tax 200 Earning after Tax 200
Add: Depreciation 200
Cash flow 400
7
Effects of Inflation on Cash Flows: Often there is a tendency to assume
erroneously that, when, both net revenues and the project cost rise proportionately,
the inflation would not have much impact. These lines of arguments seem to be
convincing, and it’s correct for two reasons. First, the rate used for discounting cash
flows is generally expressed in nominal terms. It would be inappropriate and
inconsistent to use adnominal rate to discount cash flows which are not adjusted for
the impact of inflation. Second, selling prices and costs show different degrees of
responsiveness to inflation9.Estimating the cash flows is a constant challenge to all
levels of financial managers. To examine the effects of inflation on cash flows, it is
important to note the difference between nominal cash flow and real cash flow. It is
the change in the general price level that creates crucial difference between the
two. A nominal cash flow means the income received in terms rupees. On the other
hand, a real cash flow means purchasing power of your income. The manager
investedRs.10000 in anticipation of 10 per cent rate of return at the end of the year.
It means that the manager will get Rs.11000 after a year irrespective of changes in
purchasing power of money towards goods or services. The sum of Rs.11000 is
known as nominal terms, which includes the impact of inflation. Thus, Rs. 1000 is a
nominal return on
Investment of the manager. On the other hand, (Let us assume the inflation rate is
5 percent in next year. Rs.11000 next year and Rs.10476.19 today are equivalent in
terms of the purchasing power if the rate of inflation is 5 per cent.) Rs.476.19 is in
real terms as it adjusted for the effect of inflation. Though the manager’s nominal
rate of return is Rs. 1000, but only Rs. 476 is real return. The same has been
discussed with

Capital budgeting problem.

ABC Ltd is considering a new project for manufacturing of toys involving capital
outlay of Rs.6 Lakhs. The capacity of the plant is for an annual production capacity
60000 toys and the capacity utilization is during the 3 years working life of the
project is indicated below:
Year 1 2 3 Capacity Utilization 60 75 100The selling price per toy is Rs.15 and
contribution is 40 per cent. The annual fixed costs, excluding depreciation are to be
estimated Rs.28000 per annum. The depreciation is 20 per cent and straight line
method. Let us assume that in our example the rate of inflation is expected to be 5
per cent.

TABLE 3
A COMPARISON OF REAL CASH FLOW AND NOMINAL CASH
FLOW
(Figures in Rupees)
Particulars/ Year 1 2 3
Sales Revenue 360000 450000 600000
Less: Variable Cost 216000 270000 360000
Depreciation 120000 120000 120000
Fixed Cost 28000 28000 28000
Earnings before Tax 4000 32000 100000
Tax @ 50% - 16000 50000
Profit after tax - 16000 50000
Real Cash flow 116000 136000 170000
Inflation Adjustment (1.05)1 (1.05)2 (1.05)3
Nominal Cash flow 121800 149940 1967969
Therefore, the finance manager should be consistent in treating inflation as the
discount rate is market determined. In addition to this, a company’s output price
should be more than the expected inflation rate. Otherwise there is every possibility
into forego the good investment proposal, because of low profitability. And also,
futures always unexpected, what will be the real inflation rate (may be more or
less). Thus, in estimating cash flows, along with output price, expected inflation
must be taken into account. In dealing with expected inflation in capital budgeting
analysis, the finance manager has to be very careful for correct analysis. A
mismatch can cause significant errors in decision making. Therefore the finance
manager should always remember to match the cash flows and discount rate as
mentioned below table 4.

TABLE 4
MATCH UP CASH FLOWS AND DISCOUNT RATE10
Cash flows Discount rate Yields
Nominal Cash flow Nominal discount rate Present Value Real cash flow Real
discount rate Present Value

Inflation and Discount Rate: The discount rate has become one of the central
concepts of finance. Some of its manifestations include familiar concepts such as
opportunity cost, capital cost, borrowing rate, lending rate and the rate of return on
stocks or bonds11. It is greatly influenced in computing NPV. The selection of proper
rate is critical which helps for making correct decision. In order to compute net
present value, it is necessary to discount future benefits and costs. This discounting
reflects the time value of money. Benefits and costs are worth more if they are
experience sooner. The higher the discount rate, the lower is the present value of
future cashflows.For typical investments, with costs concentrated in early periods
and benefits
Following in later periods, raising the discount rate tends to reduce the net present
value.
10 Thus, discount rate means the minimum requisite rate of return on funds
Committed to the project. The primary purpose of measuring the cost of capital is
its
use as a financial standard for evaluating investment projects.

Effects of Inflation on Discount Rate: Using of proper discount rate, depends on

whether the benefits and costs are measured in real or nominal terms. To be
consistentand free from inflation bias, the cash flows should match with discount
rate. Considering the above example, 10 per cent is a nominal rate of return on
investment of the manager. On the other hand, (Let us assume the inflation rate is
5 per cent, in next year), though the manager’s nominal rate of return is 10 per
cent, but only 4.76percent is real rate of return. In order to receive 10 per cent real
rate of return, in view of 5 per cent expected inflation rate, the nominal required
rate of return would be
15.5%. The nominal discount rate (r) is a combination of real rate (K), expect
inflation rate (α). This relationship is known as Fisher’s effect, which may be
stated as follows: The relationship between the rate of return and inflation in the
real world is a\tough task to explain than the theoretical relationship described
above. Experience shows that deflation of any series of interest rates over time by
any popular price index does not yield relatively constant real rates of interest.
However, this should not be interpreted as the current rate of interest is properly
adjusted for the actual rate of inflation, but only that it will contain some expected
rate of inflation. Furthermore, the ability of accurately forecasting the rate of
inflation is very rare12.
r = (1-K) (1- α) -111
IMPLICATIONS
It is noted from the above analysis; effects of inflation significantly influence the
capital budgeting decision making process. If the prices of outputs and the discount
rates are expected to rise at the same rate, capital budgeting decision will not be
neutral. The implications of expected rate of inflation on the capital budgeting
process and decision making are as follows: a. The company should raise the output
price above the expected rate of inflation.Unless it has lower Net Present Value
which may lead to forego the proposals
And vice versa.
b. If the company is unable to raise the output price, it can make some
internaladjustments through careful management of working capital.
c. With respect of discount rate, the adjustment should be made through capital
structure.

CONCLUSION
It could be inferred from the above analysis that, effects of inflation are significantly
influenced on capital budgeting decision making process. Though the inflation is a
common problem, every finance manager encounters during their capital
Budgeting decision making process for optimum utilisation of scarce resources
especially in two major aspects namely cash flow and discount rate. To examine the
effects of inflation on cash flows, it is important to note the difference between
nominal cash flow and real cash flow. It is the change in the general price level that
creates crucial difference between these two. Therefore, the finance manager
should take into cognizance the effect of inflation. Otherwise possibilities are more
to forego the good investment proposal, because of low profitability.
12
Using of the proper discount rate depends on whether the benefits and costs are
measured in real or nominal cash flows. To be consistent, the cash flows should
match with discount rate. A mismatch can cause significant errors in decision
making. There should be consistency in treating the inflation in the cash flows and
the discount rate. It’s very difficult to take decision, free from effect of inflation as it
is highly uncertain. Therefore, use of Gross Domestic Product deflator may be ideal
while taking CBDsince, it would be more rational and scientific and not on pick and
choose method for projects or programs that extend beyond the six-year budget
horizon, the inflation assumption can be extended by using the inflation rate for the
sixth year of the budget forecast. The Administration's economic forecast is updated
twice annually, at the time the budget is published in January or February and at the
time of the Mid-Session Review of the Budget in July. Alternative inflation estimates,
based on credible private sector forecasts, may be used for sensitivity analysis.

Modified Internal Rate of Return – MIRR

Modified Internal Rate of Return - MIRR - Is basically the same as the IRR,
except it assumes that the revenue (cash flows) from the project are reinvested
back into the company, and are compounded by the company's cost of capital, but
are not directly invested back into the project from which they came.
The formula for MIRR is:
WHAT?
OK, MIRR assumes that the revenue is not invested back into the same project, but
is put back into the general "money fund" for the company, where it earns interest.
We don't know exactly how much interest it will earn, so we use the company's cost
of capital as a good guess.
Why use the Cost of Capital?
Because we know the company wouldn't do a project which earned profits below
the cost of capital. That would be stupid. The company would lose money. Hopefully
the company would do projects which earn much more than the cost of capital, but,
to play it safe, we just use the cost of capital instead. (We also use this number
because sometimes the cash flows in some years might be negative, and we would
need to 'borrow'. That would be done at our cost of capital.)

How to get MIRR - OK, we've got these cash flows coming in, right? The money is
going to be invested back into the company, and we assume it will then get at least
the company's-cost-of-capital's interest on it. So we have to figure out the future
value (not the present value) of the sum of all the cash flows. This, by the way is
called the Terminal Value. Assume, again, that the company's cost of capital is
10%. Here goes...
Future Value
Cash Time
= of that years cash Note
Flow s
flow.
(1+.1
7000 X = 10249 compounded for 4 years
)4
(1+.1
6000 X = 7986 compounded for 3 years
)3
(1+.1
3000 X = 3630 compounded for 2 years
)2
(1+.1
2000 X = 2200 compounded for 1 years
)1
not compounded at all
(1+.1
1000 X = 1000 because
)0
this is the final cash flow
TOTAL = 25065 this is the Terminal Value
OK, now get our your financial calculator again. Do this.
Why all those zeros? Because the calculator needs to know how many years go by.
But you don't enter the money from the sum of the cash flows until the end, until
the last year. Is MIRR kind of weird? Yep. You have to understand that the cash
flows are received from the project, and then get used by the company, and
increase because the company makes profit on them, and then, in the end, all that
money gets 'credited' back to the project. Anyhow, the final MIRR is 10.81%.
Decision Time- Do we approve the project? Well, let's review.
Decision Approv
Result Why?
Method e?
2.66
Payback Yes well, cause we get our money back
years
Discounted 4.195 Because we get our money back, even after
Yes
Payback years discounting our cost of capital.
because NPV is positive (reject the project if NPV is
NPV $500 Yes
negative)
Profitability
1.003 Yes cause we make money
Index
IRR 12.02% Yes because the IRR is more than the cost of capital
MIRR 10.81% Yes because the MIRR is more than the cost of capital

What Does Modify Internal Rate Of Return - MIRR Mean?

While the internal rate of return (IRR) assumes the cash flows from a project are
reinvested at the IRR, the modified IRR assumes that postive cash flows are
reinvested at the firm's cost of capital, and the intial outlays are financed at the
firm's financing cost. Therefore, MIRR more accurately reflects the cost and
profitability of a project.

Investopedia explains Modified Internal Rate of Return - MIRR

For example, say a two-year project with an initial outlay of $195 and a cost of
capital of 12% will return $121 in the first year and $131 in the second year. To find
the IRR of the project so that the net present value (NPV) = 0:

NPV = 0 = -195 + 121/ (1+ IRR) + 131/ (1 + IRR) 2 NPV = 0 when IRR = 18.66%

to calculate the MIRR of the project, we have to assume that the positive cash flows
will be reinvested at the 12% cost of capital. So the future value of the positive cash
flows is computed as:

$121(1.12) + $131 = $266.52 = Future Value of positive cash flows at t = 2

Now you divide the future value of the cash flows by the present value of the initial
outlay, which was $195, and find the geometric return for 2 periods.

=sqrt ($266.52/195) -1 = 16.91% MIRR

You can see here that the 16.91% MIRR is materially lower than the IRR of 18.66%.
In this case, the IRR gives a too optimistic picture of the potential of the project,
while the MIRR gives a more realistic evaluation of the project
Capital Structure - What It Is and Why It Matters
The term capital structure refers to the percentage of capital (money) at work in a
business by type. Broadly speaking, there are two forms of capital: equity capital
and debt capital. Each has its own benefits and drawbacks and a substantial part of
wise corporate stewardship and management is attempting to find the perfect
capital structure in terms of risk / reward payoff for shareholders. This is true for
Fortune 500 companies and for small business owners trying to determine how
much of their startup money should come from a bank loan without endangering
the business.
Let's look at each in detail:
Equity Capital: This refers to money put up and owned by the shareholders
(owners). Typically, equity capital consists of two types: 1.) contributed capital,
which is the money that was originally invested in the business in exchange for
shares of stock or ownership and 2.) Retained earnings, which represents profits from
past years that have been kept by the company and used to strengthen the balance
sheet or fund growth, acquisitions, or expansion.
Many consider equity capital to be the most expensive type of capital a company
can utilize because it’s "cost" is the return the firm must earn to attract investment.
A speculative mining company that is looking for silver in a remote region of Africa
may require a much higher return on equity to get investors to purchase the stock
than a firm such as Procter & Gamble, which sells everything from toothpaste and
shampoo to detergent and beauty products.
Debt Capital: The debt capital in a company's capital structure refers to borrowed
money that is at work in the business. The safest type is generally considered long-
term bonds because the company has years, if not decades, to come up with the
principal, while paying interest only in the meantime.
Other types of debt capital can include short-term commercial paper utilized by
giants such as Wal-Mart and General Electric that amount to billions of dollars in 24-
hour loans from the capital markets to meet day-to-day working capital
requirements such as payroll and utility bills. The cost of debt capital in the capital
structure depends on the health of the company's balance sheet - a triple AAA rated
firm is going to be able to borrow at extremely low rates versus a speculative
company with tons of debt, which may have to pay 15% or more in exchange for
debt capital.
Other Forms of Capital: There are actually other forms of capital, such as vendor
financing where a company can sell goods before they have to pay the bill to the
vendor that can drastically increase return on equity but don't cost the company
anything. This was one of the secrets to Sam Walton's success at Wal-Mart. He was
often able to sell Tide detergent before having to pay the bill to Procter & Gamble,
in effect, using PG's money to grow his retailer. In the case of an insurance
company, the policyholder "float" represents money that doesn't belong to the firm
but that it gets to use and earn an investment on until it has to pay it out for
accidents or medical bills, in the case of an auto insurer. The cost of other forms of
capital in the capital structure varies greatly on a case-by-case basis and often
comes down to the talent and discipline of managers.
Seeking the Optimal Capital Structure
Many middle class individuals believe that the goal in life is to be debt-free
(see Should I Pay off My Debt or Invest?). When you reach the upper echelons of
finance, however, that idea is almost anathema. Many of the most successful
companies in the world base their capital structure on one simple consideration: the
cost of capital. If you can borrow money at 7% for 30 years in a world of 3%
inflation and reinvest it in core operations at 15%, you would be wise to consider at
least 40% to 50% in debt capital in your overall capital structure.
Of course, how much debt you take on comes down to how secure the revenues
your business generates are - if you sell an indispensable product that people
simply must have, the debt will be much lower risk than if you operate a theme park
in a tourist town at the height of a boom market. Again, this is where managerial
talent, experience, and wisdom come into play. The great managers have a knack
for consistently lowering their weighted average cost of capital by increasing
productivity, seeking out higher return products, and more.
To truly understand the idea of capital structure, you need to take a few moments
to read Return to understand how the capital structure represents one of the three
components in determining the rate of return a company will earn on the money its
owners have invested in it. Whether you own a doughnut shop or are considering
investing in publicly traded stocks, its knowledge you simply must have.