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Time value of money: valuation concept, future value of a single cash flow, multiple flows and annuity; present value of single cash flow, multiple flows and annuity (problems). Capital Budgeting Evaluation Techniques, pay back, ARR, NPV and IRR methods (problems). Time value of money: Money has time value. A rupee today is more valuable than a rupee a year hence. It is one of the basic concepts of finance. The term time value of money can be defined as the value derived from the use of money over time as a result of investment and reinvestment. This term may refer to either present value or future value calculations. The present value is the value today of an amount that would exist in the future with a stated investment rate called discount rate. There is time value of money due to the following reasons: a. Opportunity cost: There are alternative productive uses of money. The cost of any decision includes the cost of the next best alternative (opportunity) foregone. You can save and invest, get interest and spend. b. Inflation: It erodes the value of money. c. Risk: There are always financial and non-financial risks involved. The trade-off between money now and money later on depends on among other things, the rate of interest that can be earned by investing. Therefore, time value of money results from the concept of interest. Interest rate is the cost of borrowing money as a yearly percentage. Time value of money describes the effects of compounding. Compounding is the process by which interest is earned on interest. When a principal amount is invested, interest is earned on the principal during the first year. In the second year interest is earned on the principal amount plus interest earned in the first year. Over a time this reinvestment process can help an account grow significantly.

Capital Budgeting
Introduction: Capital budgeting is the process of making investment decisions in the capital expenditure. A capital expenditure decision may be defined as an expenditure the benefit of which is expected to be received over a period of time exceeding one year. Capital expenditure decisions are also called as long term investment decisions. In short capital budgeting is the process of making decisions regarding investment in fixed assets, the benefits of which are expected to be received over a number of years in future. Definitions: Capital Budgeting is long term planning for making and financing proposed capital out lays.- Horn green Capital budgeting consists in planning the development of available capital for the purpose of maximizing the long term profitability of the concern.. R M Lynch In view of the above it is clear that capital budgeting is the planning of available financial resources and their long term investment with a view to maximize the profitability of the firm. Features of Capital budgeting decisions: 1. It involves exchange of current funds for the benefit to be achieved I future, 2. The future benefits are expected to be received or realized over series of years. 3. The funds are invested in non0flexible and long term activities. 4. It involves huge funds. 5. They have a long term and significant effect on the profitability of the concern.

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Need and significance of Capital budgeting decisions: The following are the reasons for placing great importance on capital budgeting decisions: a. Large investment: Capital budgeting decisions generally involve huge amount of funds, but the funds available with the firm are always limited. Hence, it is very important for the firm to plan and control its capital expenditure. b. Irreversible decisions: The capital budgeting decisions are irreversible decisions and the amounts invested cannot be taken back without a substantial loss as it is difficult to dispose them off and its conversion into other uses may not be financially feasible. c. Long term effect on profitability: Capital budgeting decisions have a long term and significant effect on the profitability of a concern. Not only the present earnings of the firm are affected by the investment in fixed assets but also the future growth and profitability of the firm depends on the investment decisions taken today. d. Long term commitment of funds: Capital expenditure involves not only large amount of funds for long term and more or less on permanent basis. The long term commitment of funds increases the financial risk involved in the investment decisions. Greater the risk involved, greater the need for careful planning of capital expenditure. e. Effect on future capital structure: By taking a capital expenditure decision, a firm commits itself to a sizable amount of fixed costs in terms of labour, supervisors salary, insurance, rent of building etc., and if the investment in future turns out to be unsuccessful the firm will have to bear the burden of fixed costs unless asset is completely written off. f. National importance: Capital budgeting decisions are of national importance because it determines employment opportunities, economic activities and economic growth. g. Other factors: Such as uncertainties of future, higher degree of risk involved etc., TYPES OF INVESTMENT PROPOSALS: a. New projects. b. Expansion: that is increasing production. c. Diversification: diversifying production into other lines of business. d. Replacement: Replacing old worn-out machines and other assets which are outdated. e. Modernization: Using latest technology in various activities of organization. f. Research and development. ELEMENTS TO BE CONSIDERED WHILE SELECTING THE PROCESS AND CRITERIA FOR EVALUATION OF THE SPECIFIC PROJECT 1. Rationale: It is essential to look at the broad rationale of the project or proposal to ensure that the project is appropriate and justified. Ex.: Modernization and pollution control may be fully justified on the grounds of survival and environmental protection. Technology: The level of technology in terms of state-of-art or obsolescence, adaptability to the local conditions, sophistication etc., is to be considered. While assessing a technology proposed for the project relevance and appropriateness have to be looked, ridiculous. Ex.: Highly sophisticated technology seems to be ridiculous when electricity and other sources of power are in short supply. Plant and machinery to be installed. Raw materials required for the project Cost of project: Since each project is profit motivated it is important that the cost of the project is carefully assessed and evaluated. This depends on proper data collection and the approach & attitude the evaluation which influences the level of accuracy in the cost estimates. Means of financing: In the manner in which is acceptable with in the framework of the financial system, attractive and safe for the investor is to be evolved.

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7. Anticipated return of the project: The project return is to be assessed in terms of cost of production, realizable selling price, financial charges etc. 8. Government and other statutory approvals required: Regarding import of capital goods, import of raw materials, pollution control etc. 9. Social and environmental conditions: Like safety, environmental protection etc. 10. National & economic significance: Like import substitution, export orientation etc. CAPITAL BUDGETING PROCESS Capital budgeting is a complex process and the following procedure may be adopted in the process of capital budgeting. 1. Identification of investment proposals: The idea or proposal about potential investment opportunities which may originate from the top management or from the rank and file workers of any department or from any officer of the organization are to be analysed by the departmental heads in the light of corporate strategies. After analysis suitable proposals are to be submitted to the capital expenditure planning committee or to the officer concerned with the process of long term investment decisions. 2. Screening the proposals: The committee or the officer concerned with long term decisions screen the proposals received from different departments, from carious angles to ensure that they are in accordance with the long range policy frame work of the organization or selection or selection criterion of the firm and also do not lead to departmental imbalances and profitable. 3. Evaluation of various proposals: The next step is to evaluate the profitability of the proposals in terms of cost of capital, expected return from alternative investment opportunities etc. The following methods of evaluation can be applied to evaluate the proposals: a) Traditional Methods. (i) Pay back period method. (ii) Accounting rate of return method. b) Discounted cash flow techniques: (i) Net present value method. (ii) Internal rate of return method. (iii) Profitability index method. 4. Fixing priorities: Uneconomical and unprofitable projects shall be rejected. The acceptable projects shall be ranked since it is not possible to invest all the proposals due to limitation of funds. Priorities are to be established on considering urgency, risk and profitability involved therein. 5. Final approval and preparation of capital expenditure budget: Proposals meeting evaluation criteria are finally approved and sent to budget committee to be included in the capital expenditure budget. Minor projects may be approved by the top management. 6. Implementing proposals: While implementing the project assign responsibilities for completing the project with in the given time frame and cost limit so as to avoid unnecessary delays and cost overruns. 7. Evaluation/ performance review: After implementing of the project in has to be evaluated by way of comparison of actual expenditure with the budgeted one, and also by comparing the actual return from the investment with the anticipated return. Unfavorable variances if any found, the same should be locked into and the causes of the same be identified so that action may be taken in future.

G Sai Krishna

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METHODS OF EVALUATION OF INVESTMENT PROPOSALS

TRADITIONAL METHODS: PAY-BACK PERIOD METHOD: It is the most popular and widely recognized method of evaluating capital

projects. This method is also known as pay-out or pay-off method. Pay back period represents, the period of time required to recover the original cash out-lay invested in the project. It is based on the principal that every capital expenditure pays itself back with in a certain period out of additional earnings generated from the capital assets. In other words, pay-back period is that period where total earnings (net cash inflows) from capital investment equal the total outflow. Calculation: Uniform cash flows: Every year the project yields same amount of cash flows. Calculate annual cash inflows after tax before depreciation (CFAT). Calculate payback period of the project. Payback period = Investment in the project / Annual CFAT Unequal cash flows: The project yields different amounts of cash flows in different years. Calculate CFAT for each year of life of project. Calculate cumulative cash flows. Calculate payback period: The year in which the cumulative cash inflow is equal to the investment in the project, that year shall be taken as the payback period of the project. If the cumulative cash inflows is not equal to investment in the project in any year, the payback period may be calculated as below: Payback period = E + (B/C) Where E is the year preceding the year of Final recovery, B is the balance amount to be recovered in the year of final recovery, C is cash inflow in the year of Final recovery. Decision Criteria: In case of evaluation of single project, accept the project, if the payback period is within the period specified by the management, otherwise reject the project. Accept if PB < Minimum Pay-Back Period Reject if PB > Minimum Pay-Back Period In case of number of mutually exclusive projects, which satisfy the above criteria individually, rank them according to the length of the payback period in such a way that the investment with shorter pay-back period is preferred to one which has a longer pay-back period. Advantages: 1. This method is simple to understand and easy to calculate. 2. It saves in cost as it requires less time and labor as compared to other methods of capital budgeting. 3. It is suitable to a firm which has shortage of cash or whose liquidity position is not goods. 4. Since a project with shorter payback period is preferred to the one having longer payback period, it reduces loss through obsolescence. Disadvantages: 1. This method does not take in to account cash inflows earned after the payback period and hence the true profitability of the projects cannot be correctly assessed. 2. It ignores the time value of money and does not consider the pattern of cash flows, the magnitude and timing of cash flows. 3. It does not take in to account the cost of capital which is very important factor in making sound investment decisions. 4. There is no rational basis for determining the minimum payback period that is acceptable. 5. Profitability is completely by having over emphasis on the importance of liquidity.

G Sai Krishna

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RATE OF RETURN METHOD (ARR): This method is also known as Accounting rate of return method as it

takes into account the accounting profit (Net profit after tax) rather than cash inflows. Accounting to this method various projects are ranked in the order of return. Under this method the Rate of return is sometimes calculated using average investment and hence is also called as Average rate of return. Calculation: Uniform cash flows: a. Calculate annual Net profit after tax. b. Calculate average investment in the project. Average investment = [(Original investment in the project Scrap)/2] + scrap c. Calculate ARR of the project. ARR = (Net profit after Tax/ Average Investment in the project)*100 Unequal cash flows: a. Calculate Net profit after tax for each year of life of Project. b. Calculate average annual net profit after tax. Average annual profit after tax= Net profit after tax of given years/Number of years c. Calculate average investment in the project. Average investment = [(Original investment in the project Scrap)/2] + WC+ scrap d. Calculate ARR of the project. ARR= (Average annual profit after tax / average investment in the project)*100 Evaluation: The company determines acceptable rate of return and such return is known is Cut off rate. In case of a single project, accept the project if the calculated ARR is greater than the cut off rate determined by the management. In case of mutually exclusive projects, rank the projects in such an order that the project with highest rate of return is given the first rank and the project with ARR greater than cut off rate and highest is to be accepted. Advantages: 1. It is simple to understand and easy to calculate. 2. It can be readily calculated as this method is based on accounting concept of profit. 3. It gives a better view of profitability as it uses the entire earnings of the project in calculating the rate of return, when compared to payback period method which considers earnings up to the payback period. Disadvantages: 1. Like payback period method it ignores time value of money, as equal weight is given to the profits earned at different point of time by averaging profits. 2. It does not take into consideration the cash inflows which are important than accounting profits. 3. It considers only the rate of return and not the length of the project. 4. It cannot be applied to situation where investment in project is to be made in parts. 5. Determination of rate of return is left to the discretion of the management.

Improvement in traditional approach to payback period Method:

1. Post payback profitability: One of the serious limitations of payback period is that it does not take in consideration the cash inflows earned after the payback period and hence, the profitability of the project cannot be assessed. Hence an improvement over this method can be made by taking into consideration the returns receivable beyond the payback period. These returns are called post payback profits. Post payback profitability = (Post payback profitability / Investment) * 100 2. Post payback period method: In evaluating various projects which do not differ significantly as to size and the expected cash inflows are even throughout the life of project, the projects with greatest post payback period may be accepted.

G Sai Krishna

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3. Discounted payback period Method: The traditional ay period method does not take n to consideration, the time value of money. Hence, under this method the present values of all cash flows are computed at appropriate discount rate. Using the discounted cash flows payback period is calculated. Procedure: a. Calculate the present value of annual CFAT in case of cumulative cash inflows and in case of uneven cash inflows calculate present value of each year of life of project. b. Remaining procedure will be the same except that instead of normal cash inflows, discounted cash inflows are to be used. Time adjusted or Discounted cash flow techniques A traditional method does not take into account the time value of money i.e gives equal weight to present and future flows of incomes. However, discounted cash flows take in to account the profitability and also time value of money. The following discounted cash flow techniques can be used in evaluating the projects: Net present value method: It is the modern method of evaluating investment proposals which calculates the rate of return giving due consideration to the time value of money. The present values of all inflows and out flows of cash occurring during the entire life of project is determined separately for each year by discounting these cash flows by the firms cost of capital or predetermined rate. The net present value is calculated by subtracting the present value of cash out flows from the present value of cash inflows. Procedure for calculating NPV of projects: Even cash flows: 1. Calculate annual CFAT of the project. 2. Calculate present value of cash inflows: a. In case present value table is available, refer to present value of Annuity table and identify the present value of annuity of Rupee one by looking in to the row of life of project and corresponding column of discounting factor (cost of capital), and multiply the cash inflow with the present value of annuity of rupee one identified. b. In case present value table is not available, it may be calculated as below: PV of annuity = FV {1 / (1+r) } Calculate NPV of the project: NPV = Present value of cash inflows present value of cash out flows. Uneven cash flows: In case Present value table is available: 1. Calculate CFAT for each year of life of project. 2. Calculate Present value of cash inflow for each year of life of project, by multiplying the cash inflow of each year with the present value of rupee one of corresponding year by taking present value of rupee one by referring to the Present value table in the column of discounting factor. 3. Total the present value of cash inflows. 4. Calculate NPV of the project: NPV = Present value of cash inflows present value of cash out flows. In case present value table is not available: NPV = {A1/ (1+r) + A2 /(1+r)2+ A3/(1+r)3 + --------- +An/(1+r)n} -- Co Where A, A1, A2--------An = Annual cash inflows in year I, 2---------up to n years r= Discounting factor; Co= cash out flow. Evaluation: In case of single projects accept the project whose NPV is greater than zero and highest. In case of mutually exclusive projects accept the project whose NPV is greater than zero and the highest. If NPV > 0 accept the project If NPV < 0 reject the project 3.
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G Sai Krishna

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Advantages: 1. This method recognizes the time value of money. 2. It takes in to account the total benefits of the proposed project over its entire life and hence true profitability of the investment proposal can be evaluated. 3. This method takes in to consideration the objective of maximization of shareholders wealth, since the acceptance of proposals with maximum positive net present values are expected to have positive impact on the market values of shares. Disadvantages: 1. Compared to traditional methods of evaluation, NPV method is difficult to calculate and understand. 2. It is difficult to determine appropriate discounting rate to be used in calculating the present values. 3. It may not give good results while comparing the projects with unequal lives. 4. It may not give good results while comparing the projects with unequal investment of funds. Internal Rate of Return method: This method is also is known as adjusted rate of return, discounted rate of return, discounted cash flow or trial & error method. Under this method the discounting rate is determined internally and hence, this method is also known as internal rate of return method. Internal rate of return is that rate of discount at which the present value of cash inflow is equal to the present values of cash outflows. Co = {A1/ (1+r) + A2 /(1+r)2+ A3/(1+r)3 + --------- +An/(1+r)n} Where Co= is initial outlay; A, A1, A2--------An = Annual cash inflows in year I, 2---------up to n years r= the rate of discount of internal rate of return Determination of IRR: Select an arbitrary rate and the present values of cash inflows and outflows and compare the present values of inflows with investment. If present values of inflows is not equal to the present values of out flows, try another rate of return and repeat the process until the present values of inflows is equal to the cost of investment. Even cash inflows: 1. Calculate annual CFAT. 2. Calculate fake payback period. Fake payback period= Investment in the project / annual CFAT 3. Calculate present value of cash inflows as below: a. Look in to present value of annuity table in the row of life of project, and identify two discounting factors (lower and higher discounting factors) at which the present value of annuity is nearer to the fake payback period. b. Multiply the cash inflow with Lower discounting factor to obtain Present value of cash inflow at lower discounting factor (PVCFAT@rL), and Multiply the cash inflow with Higher discounting factor, to obtain Present value of cash inflow at higher discounting factor(PVCFAT@rH), 4. Calculate exact IRR of the project, by applying the interpolation technique: IRR =[ rL +{ (PVCFAT@rL PVCFAT@rH) /NPV of CFAT}*(rH-rL)] Uneven Cash inflows: 1. Calculate CFAT for each year of life of Project. 2. Calculate Fake payback period. Fake payback period= Average annual CFAT/ Original investment 3. Calculate Present value of cash inflows as below: a. Look in to present value of annuity table in the row of life of project, and identify two discounting factors (lower and higher discounting factors) at which the present value of annuity is nearer to the fake payback period. b. Calculate present value of cash inflows at Lower discounting factor (PVCFAT@rL) and higher discounting factor (PVCFAT@rH), by referring to the present value of Rupee table at the discounting factors identified in step above. 4. IRR =[ rL +{ (PVCFAT@rL PVCFAT@rH) /NPV of CFAT}*(rH-rL)]

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rL = Lower discounting factor; H= Higher discounter factor PVCFAT@rL = Present value of cash inflows at lower discounting factor PVCFAT@rH = Present value of cash inflows at Higher discounting factor NPV of CFAT = Difference between Present value of cash inflows at lower discounting factor and the Present value of cash flows. Advantages: 1. This method takes in to account the time value of money and hence can be used in evaluating the projects with even as well as uneven cash inflows at different points of time. 2. It considers the profitability of the project over its economic life and hence enables in evaluation of true profitability. 3. It is superior to NPV method, as it does not require determination of discount rate and the method itself provides a rate of return. 4. Selection of projects with IRR greater than the required rate of return would lead to realization of the objective of maximization of wealth of shareholders. Disadvantages: 1. It is difficult to understand and requires tedious calculations. 2. The reinvestment of cash flows at two different rates with in the same company sound unrealistic. 3. The results of IRR and NPV methods may differ when the projects under evaluation differ in their size, life and timings of flows. Profitability Index method: This method is also is known as Benefit- cost ratio or desirability factor. This method establishes the relationship between present value of cash inflows and the present value of cash outflows. Even and unequal cash flows: Calculate present value of cash inflows as in the case of NPV method. Then calculate profitability index as below: Profitability index = Present value of cash inflows / Present value of cash out flows Decision criteria: Accept if PI >1 Reject if PI >1 In case of mutually exclusive projects rank the projects in the order of profitability index, in such a way that the proposal with profitability index greater than 1 and highest is given first rank and chosen. Advantages: 1. This method is suitable to evaluate the projects whose costs differ significantly, where NPV method is not suitable. 2. It recognizes the time value of money. 3. It takes in to consideration the earnings of the proposal over its entire economic life and the objective of maximum profitability. Factors influencing Capital expenditure decisions: There are many factors, financial as well as non- financial which influences the capital expenditure decisions, some of which are as follows: 1. Urgency: Due to urgency of the survival of the firm or to avoid heavy losses proper evaluation of the proposal cannot be made through profitability tests. 2. Degree of certainty: Profitability is directly related to the risk. Higher the risk, greater is the profitability. Therefore, sometimes the project with low profitability may be selected due to constant flow of income as compared to another project with an irregular and uncertain flow of income. 3. Intangible factors: Like safety and welfare of the workers, social welfare, good will of the firm, prestigious projects etc., influence capital expenditure decisions. 4. Legal factors: An investment which is required by provisions of law is solely influenced by this factor, though not profitable. Example: Pollution control equipment under pollution control acts. 5. Availability of funds: Capital budgeting decisions require large funds. Since several projects with higher profitability cannot be taken up due to shortage of funds. However, the projects with shorter payback period may be undertaken to increase the liquidity. 6. Future earnings: A project may not be profitable on comparison with existing project, but may have better future earnings, in such a case it may be preferred to increase earnings.

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Obsolescence: In case of projects with higher risk of obsolescence, a project with lesser payback period may be preferred than which has a higher profitability but longer pay back period. Research and development: For the future survival of the firm an investment in research and development, may be necessary, though it may not look so profitable. Other considerations: Such as cost of capital, cost of capital of the project, opportunity cost of capital etc., are the other considerations involved in capital budgeting decisions. *********************