Capital budgeting decision

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Contents
Objective............................................................................................................................................ 3 Introduction ....................................................................................................................................... 3 Nature of investment decisions ........................................................................................................... 4 Importance of Investment Decisions ................................................................................................... 5 Types of investment decisions ............................................................................................................ 6 Net present value .............................................................................................................................. 10 Internal rate of return (IRR) .............................................................................................................. 12 Profitability Index ............................................................................................................................ 12 Payback Period Method .................................................................................................................... 13 Accounting Rate of Return Method .................................................................................................. 14 NPV versus IRR............................................................................................................................... 15 INFLATION AND CAPITAL BUDGETING DECISIONS.............................................................. 16 Conclusion ....................................................................................................................................... 22

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Objective
y y y y To understand the nature and importance of investment decisions. To explain the methods of calculating VPV and IRR. To describe the non-DCF evaluation criteria: payback and ARR To compare and contract NPV and IRR and emphasis the superiority of NPV rule.

Introduction
An efficient allocation of capital is the most important finance function in modern times. It involves decisions to commit the firms funds to the long term assets. Capital budgeting or investment decisions are of considerable importance to the firm since they tend to determine its value by influencing its growth, profitability and risk. In this term paper, focus on the nature and evaluation of capital budgeting decisions has been made.

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Nature of investment decisions

The investment decision of a firm are generally known as the capital budgeting, or capital expenditure decision. A capital budgeting decision may be defined as the firms decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. The long-term assets are those that affect the firms operation beyond the one-year period. The firms investment decisions would generally include expansion; acquisition decisions would generally include expansion, acquisition, modernization and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and capital. In this chapter, we assume that the investment projects opportunity cost of capital is known. The long term assets are those that affect the firms operations beyond the one year period. The firms investment decisions would generally include expansion, acquisition, modernization and replacement of the long term asset. Sale of division or business is also as an investment decision. Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programmed have long term implications for the firms expenditures and benefits, and therefore, they should also be evaluated as investment decisions. It is important to note that investment in the long term assets invariably requires large funds to be tied up in the current assets such as inventories and receivables. As such, investment in fixed and current assets is one single activity. The following are the features of investment decisions, The exchange of current funds for future benefits. The funds are invested in long term assets. The future benefits will occur to the firm over a series of years.

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Importance of Investment Decisions

Investment decisions require special attention because of the following reasons: They influence the firms growth in the long run They affect the risk of the firm They involve commitment of large amount of funds They are irreversible, or reversible at substantial loss They are among the most difficult decisions to make Growth The effects of investment decisions extend into the future and have to be endured for a longer period than the consequences of the current operating expenditure. A firms decision to invest in long term assets has decisive influence on the rate and direction of its growth. A wrong decision can prove disastrous for the continued survival of the firm; unwanted or unprofitable expansion of assets will result in heavy operating costs to the firm. On the other hand inadequate investment in assets would make it difficult for the firm to compete successfully and maintain its market share. Risk A long-term commitment of funds may also change the risk complexity of the firm. If the adoption of an investment increases average gain but causes frequent fluctuations in its earnings, the firm will become more risky. Thus, investment decisions shape the basic character of a firm. Funding Investment decisions generally involve large amount of funds, which make it imperative for the firm to plan its investment programmers very carefully and make an advance arrangement for procuring finances internally or externally.
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Irreversibility Most Investment decisions are irreversible. It is difficult to find a market for such capital items once they have been acquired. The firm will incur heavy losses if such assets are scrapped. Complexity Investment decisions are among the firms most difficult decisions. They are an assessment of future events, which are difficult to predict. It is really a complex problem to correctly estimate the future cash flows of an investment. Economic, political, social and technological forces cause the uncertainty in cash flow estimation.

Types of investment decisions

There are many ways to classify investments. One classification is as follows : y y
y

Expansion of existing business Expansion of new business Replacement and modernization

Expansion and Diversification A company may add capacity to its existing product lines to expand existing operation. For example, the Company Y may increase its plant capacity to manufacture more X. It is an example of related diversification. A firm may expand its activities in a new business. Expansion of a new business requires investment in new products and a new kind of production activity within the firm. If a packing manufacturing company invest in a new plant and machinery to produce ball bearings, which the firm has not manufacture before, this represents expansion of new business or unrelated diversification. Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment in the expectation of additional revenue. Investment in existing or new products may also be called as revenue expansion investment.

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Replacement and Modernization The main objective of modernization and replacement is to improve operating efficiency and reduce costs. Cost savings will reflect in the increased profits, but the firms revenue may remain unchanged. Assets become outdated and obsolete with technological changes. The firm must decide to replace those assets with new assets that operate more economically. If a Garment company changes from semi automatic washing equipment to fully automatic washing equipment, it is an example of modernization and replacement. Replacement decisions help to introduce more efficient and economical assets and therefore, are also called cost reduction investments. However, replacement decisions that involve substantial modernization and technological improvements expand revenues as well as reduce costs. Another useful way of classify investments is as follows Mutually exclusive investment Independent investment Contingent investment Mutually exclusive investment Mutually exclusive investments serve the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded. A company may, for example, either use a more labor intensive, semi automatic machine, or employ a more capital intensive, highly automatic machine for production. Choosing the semi-automatic machine precludes the acceptance of the highly automatic machine. Independent investment Independent investments serve different purposes and do not compete with each other. For example, a heavy engineering company may be considering expansion of its plant capacity to manufacture additional excavators and addition of new production facilities to manufacture a

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new product light commercial vehicles. Depending on their profitability and availability of funds, the company can undertake both investments. Contingent investment Contingent investments are dependent projects; the choice of one investment necessitates undertaking one or more other investment. For example, if a company decides to build a factory in a remote, backward area, it may have to invest in houses, roads, hospitals, and many more. For employees to attract the work force thus, building of factory also requires investment in facilities for employees. The total expenditure will be treated as one single investment. Three steps are involved in the evaluation of an investment: Estimation of cash flows Estimation of the required rate of return (the opportunity cost of capital) Application of a decision rule for decision rule for making the choice Investment decision rule The investment decision rules may be referred to as capital budgeting techniques, or investment criteria. A sound appraisal technique should be used to measure the economic worth of an investment project. The essential property of a sound technique is that is should maximize the shareholders wealth. The following other characteristics should also be possessed by a sound investment evaluation criterion: It should consider all cash flows to determine the true profitability of then project. It should provide for an objective and unambiguous way of separate good projects from bad projects. It should help ranking of projects according to their true profitability.

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 It should recognize the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. It should help to choose among mutually exclusive projects that project which maximizes the shareholders wealth. It should be a criterion which is applicable to any conceivable investment project independent of others. These conditions will be clarified as we discuss the features of various investment criteria in the following posts. Investment Appraisal Criteria A number of investment appraisal criteria or capital budgeting techniques are in use of practice. They may be grouped in the following two categories: 1. Discounted cash flow criteria Net present value Internal rate of return Profitability index (PI) 2. Not discounted cash flow criteria Payback period Accounting rate of return Discounted payback period Discounted payback is a variation of the payback method. It involves discounted method, but it is not a true measure of investment profitability. We will show in our following posts the

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net present value criterion is the most valid technique of evaluating an investment project. It is consistent with the objective of maximizing the shareholders wealth.

Net present value

Net Present Value (NPV), defined as the present value of the future net cash flows from an investment project, is one of the main ways to evaluate an investment. Net present value is one of the most used techniques and is a common term in the mind of any experienced business person. The net present value (NPV) method is the classic economic method of evaluating the investment proposals. It is discounted cash flow technique that explicitly recognizes the tine value of money. It correctly postulates that cash flows arising at different time periods differ in value and are comparable only when their equivalents present values are found out. The following steps involved in the calculation net present value (NPV):
y

Cash flows of the investment project should be forecast ed based on realistic assumptions.

Appropriate discount rate should be identified to discount the forecast ed cash flows. The appropriate discount rate is the projects opportunity cost of capital, which is equal to the required rate of return expected by investors on investments of equivalent risk.

Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate.

Net present value (NPV) should be found out by subtracting present value of cash outflows from present value of cash inflows. The project should be accepted if net present value (NPV) is positive.

Project acceptance rule using net present value

It should be clear that the acceptance rule using the net present value (NPV) method is to accept the investment project if its net present value (NPV) is positive and to reject it if the net
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present value (NPV) is negative. Positive net present value (NPV) contributes to the net wealth of the shareholders, which should result in the increased price of a firms share. The positive net present value (NPV) will result only if the project generates cash inflows at a rate higher than the opportunity cost of capital. A project with zero net present value (NPV) may be accepted. A zero net present value (NPV) implies that project generates cash flow at a rate just equal to the opportunity cost of capital. The net present value (NPV) acceptance rules are:
y y y

Accept the project net present value (NPV) is positive Reject the project net present value (NPV) is negative May accept the project when net present (NPV) is zero

The net present value (NPV) can be used to select between mutually exclusive projects; the one with the higher net present value (NPV) should be selected. Using the net present value (NPV) method, projects would be ranked in order of net present values; that is, first rank will be given to the project with higher positive net present value (NPV) and so on. Net present value can be explained quite simply, though the process of applying NPV may be considerably more difficult. Net present value analysis eliminates the time element in comparing alternative investments. The NPV method usually provides better decisions than other methods when making capital investments. Consequently, it is the more popular evaluation method of capital budgeting projects. When choosing between competing investments using the net present value calculation you should select the one with the highest present value. If: NPV > 0, accept the investment. NPV < 0, reject the investment. NPV = 0, the investment is marginal

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Internal rate of return (IRR)

The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implied that the rate of return is the discount rate which makes net present value (NPV) =0. There is no satisfactory way of defining the true rate of return of a long term asset. Internal rate of return (IRR) is the best available concept. We shall see that although it is very frequently used concept in finance, yet at times it can be a misleading measure of investment worth.

The internal rate of return (IRR) method is another discounted cash flow method for investment appraisal, which takes account of the magnitude and timing of cash flows. Other terms used to describe the internal rate of return (IRR) method are yield on an investment, marginally efficiency of capital, rate of return over cost, time adjusted rate of internal return and so on.

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Profitability Index
Profitability index is the ration of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment. Profitability index is another time adjusted method of evaluating the investment proposals is the benefit-cost (B/C) ratio or profitability index (PI).

PI = Present value of cash inflows/ Initial cash outflow

Acceptance Rule

The following are the profitability index (PI) acceptance rules:

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y y y

Accept the project when profitability index is grater than one Rejected the project when profitability index is less than one May accept the project when profitability index equal one

The project with positive net present value will have profitability index grater than one. Profitability index less than one means that the projects net present value is negative Evaluation of profitability index (PI) method

Profitability index (PI) is a conceptually sound method of appraising investment projects. It is a variation of the net present value (NPV) method, and requires the same computations as the net present value (NPV) method.
y y

Time value. It recognizes the time value of money. Value maximization. It is consistent with the shareholder value maximization principle. A project with profitability index grater than one will have positive net present value (NPV) and if accepted, it will increase shareholders wealth.

Relative profitability. In the profitability index (PI) method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a projects profitability.

Like the net present value (NPV) method, this criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.

Payback Period Method

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.

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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.

Accounting Rate of Return Method

The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly. A variation of the ARR method is to divide average earnings after taxes by the original cost of the project instead of the average cost. ARR= Average income/Average investment Acceptance Rule  This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate.  This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR. Evaluation of ARR Method  The ARR method may claim some merits

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 Simplicity : The ARR method is simple to understand and use. It does not invlve complicated computations.  Accounting data: The ARR can be readily calculated from the accounting data; unlike in the NPV and IRR method, no adjustments are required to arrive at cash flows of the project.  Accounting profitability: The ARR rule incorporates the entire stream of income in calculating the projects profitability.  Serious shortcoming  Cash flows ignored: The ARR method uses accounting profits, not cash flows, in appraising the projects. Accounting profits are based on arbitrary assumptions and choices and also include non cash items. It is therefore in appropriate to rely on them for measuring acceptability of the investment projects.  Time value ignored: the averaging of income ignores the time value of money. In fact this procedure gives more weight age to the distant receipts.  Arbitrary cut-off: The first employing the ARR rule uses and arbitrary cut-off yard stick. Generally, the yard stick is the firms current return on its assets (BOOK VALUE). Because of this the growth companies earning very high rates on their existing assets may reject profitable projects (i.e., with positive NPVs). And the less profitable companies may accept that projects (i.e., with negative NPVs).

NPV versus IRR

 Conventional Independent Projects: In case of conventional investments, which are economically independent of each other, NPV and IRR methods result in same accept-or-reject decision if the firm is not constrained for funds in accepting all profitable projects. Conventional and Non-conventional Cash Flows
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 A conventional investment has cash flows the pattern of an initial cash outlay followed by cash inflows. Conventional projects have only one change in the sign of cash flows; for example, the initial outflow followed by inflows .i.e., + + +.  A non-conventional investment, on the other hand, has cash outflows mingled with cash inflows throughout the life of the project. Non-conventional investments have more than one change in the signs of cash flows; for example, + + + ++ +. Lending and borrowing-type projects: Project with initial outflow followed by inflows is a lending type project, and project with initial inflow followed by outflows is a lending type project, Both are conventional projects.
Cash Flows (Rs) Project X Y C0 -100 100 C1 120 -120 IRR 20% 20% NPV at 10% 9 -9

INFLATION AND CAPITAL BUDGETING DECISIONS

Capital budgeting results would be unrealistic if the effects of inflation are not correctly factored in the analysis. 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 decision-making. 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. The Managerial Accountants task is to design the organizations information system or Management Accounting System (MAS) in order to facilitate managerial decision making. MAS 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 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
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organizational structure variables are not associated with an executives 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 proposal is 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 Particulars Revenue Less: Expenses Cash Expenses
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Cash flow Approach Rs. 1000 Particulars Revenue Less: Expenses Cash Expenses Rs. Rs. 1000 400

Rs.

400

Depreciation Earnings before Tax Tax @ 50% Earning after Tax

200

600 400 200 200

Depreciation Earnings before Tax Tax Earning after Tax Add: Depreciation Cash flow

200 600 400 200 200 200 400

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 is 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 a nominal 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 invested Rs.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 per cent 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 managers nominal rate of return is Rs. 1000, but only Rs. 476 is real return. The same has been discussed with capital budgeting.

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ABC Ltd is considering a new project for manufacturing of toys involving a 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 Capacity Utilization 1 60 2 75 3 100

The 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 Sales Revenue Less: Variable Cost Depreciation Fixed Cost Earnings before Tax Tax @ 50% Profit after tax Real Cash flow Inflation Adjustment Nominal Cash flow 1 360000 216000 120000 28000 4000 116000 (1.05)1 121800 2 450000 270000 120000 28000 32000 16000 16000 136000 (1.05)2 149940 3 600000 360000 120000 28000 100000 50000 50000 170000 (1.05)3 196796

Therefore, the finance manager should be consistent in treating inflation as the discount rate is market determined. In addition to this, a companys output price should be more than the expected inflation rate. Otherwise there is every possibility is to forego the good investment proposal, because of low profitability. And also, future is 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
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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 Nominal Cash flow Real cash flow

Discount rate Nominal discount rate Real discount rate

Yields Present Value 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 experienced sooner. The higher the discount rate, the lower is the present value of future cash flows. 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.

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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 consistent and 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 managers nominal rate of return is 10 per cent, but only 4.76 percent 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), expected inflation rate ( ). This relationship is known as Fishers effect, which may be stated as follows: r = (1-K) (1- ) -1 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 rare.

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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 internal adjustments through careful management of working capital. c. With respect of discount rate, the adjustment should be made through capital

structure.

Conclusion
When a manager evaluates a project, or when a shareholder evaluates his/her investments, he/she should consider various options before making any decisions. These decisions will probably be wrong, at least to some extent, as it is extremely difficult to forecast the accurate decision. The only way in which uncertainty can be reduced is to emphasis that the expenditure and benefits of an investment should be measured in terms of cash. Thus investment should be evaluated on the basis on the criterion, which compatible with the objective of shareholders wealth maximization.

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Reference

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