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Capital Budgeting

Long-Term Investment Decision

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Investment Decision
Refers to commitments of resources made in
hope of realizing benefits that are expected to
occur over a reasonably long period of time in
the future.
Future success of a business depends on the
inv decisions made today.
It is of two types :
1. Investment decision affecting revenues.
2. Investment decision reducing costs.

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Classification of Projects :

Repair v/s Replacement proposal


Replacement or Modernisation proposal.
Make or buy proposal
Expansion of existing products or markets.
Expansion into new products or markets or
diversification.
Safety and/or environmental projects.

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Capital Budgeting :
Meaning

of capital budgeting
Significance
Capital budgeting process
Investment criteria
Techniques of capital
budgeting
Problems.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Meaning :
Pertains

to fixed or long term assets.


These involve a current outlay or a series
of outlays of cash resources.
In return for an anticipated flow of future
benefits.
Future Benefits : Increased revenues or
decreased costs.
The process through which different
projects are evaluated is known as
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Miss Kirti Kiran, Asst professor, DMC 07/13/15
capital
budgeting

Capital budgeting is defined as the firms


formal process for the acquisition and
investment of capital.
It involves firms decisions to invest its current
funds for addition, disposition, modification
and replacement of fixed assets.
Capital budgeting is long term planning for
making and
financing proposed capital
outlays- Charles T Horngreen.
Miss Kirti Kiran, Asst professor, DMC

07/13/15

Capital budgeting consists in planning


development of available capital for the purpose
of maximising the long term profitability of the
concern Lynch
The main features of capital budgeting are
a. potentially large anticipated benefits
b. a relatively high degree of risk
c. relatively long time period between the initial
outlay and the anticipated return.
- Oster Young
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Significance of capital budgeting

The success and failure of business mainly


depends on how the available resources are
being utilised.
Main tool of financial management
All types of capital budgeting decisions are
exposed to risk and uncertainty.
They are irreversible in nature.
Capital rationing gives sufficient scope for
the financial manager to evaluate different
proposals and only viable project must be
taken up for investments.
Capital budgeting offers effective control on
cost of capital expenditure projects.
It helps the management to avoid over
investment and
under investments.
Miss Kirti Kiran, Asst professor, DMC 07/13/15

Capital budgeting process :


1. Project generation: Generating the proposals for
investment is the first step.
The investment proposal may fall into one of the
following categories:
Proposals to add new product to the product line,
Proposals to expand production capacity in existing
lines
Proposals to reduce the costs of the output of the
existing products without altering the scale of
operation.
Sales campaigning, trade fairs people in the industry, R
and D institutes, conferences and seminars will offer
wide variety of innovations on capital assets for
investment.
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Miss Kirti Kiran, Asst professor, DMC 07/13/15

2.

Project Evaluation: it involves two steps


Estimation of benefits and costs: the benefits
and costs are measured in terms of cash flows.
The estimation of the cash inflows and cash
outflows mainly depends on future uncertainties.
The risk associated with each project must be
carefully analyzed and sufficient provision must
be made for covering the different types of risks.
Selection of an appropriate criteria to judge the
desirability of the project: It must be consistent
with the firms objective of maximizing its market
value. The technique of time value of money
may come as a handy tool in evaluation such
proposals.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

3.

4.

Project Selection: No standard administrative


procedure can be laid down for approving the
investment proposal.
The screening and
selection procedures are different from firm to
firm.
Project Evaluation:
Once the proposal for
capital expenditure is finalized, it is the duty of
the finance manager to explore the different
alternatives available for acquiring the funds.
He has to prepare capital budget. Sufficient care
must be taken to reduce the average cost of
funds. He has to prepare periodical reports and
must seek prior permission from the top
management. Systematic procedure should be
developed to review the performance of projects
during their lifetime and after completion.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

The
follow
up,
comparison
of
actual
performance with original estimates not
only ensures better forecasting but also
helps in sharpening the techniques for
improving future forecasts.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Types of Capital budgeting decisions :

Accept- Reject Decisions evaluation of capex


proposal to determine whether they meet the
minimum acceptance criterion. All the
independent project satisfying the investment
criterion can be selected.
Mutually Exclusive Project Decisions- Projects
that compete with each other, the acceptance of
one will eliminate the other from consideration.
Capital Rationing Decision Situation in which a
firm has more acceptable investments than it
can finance. The projects can be ranked in the
descending order of rate of return.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Factors influencing capital


budgeting

Availability of funds
Structure of capital
Taxation policy
Government policy
Immediate need of the project
Earnings
Capital return
Economical value of the project
Working capital
Accounting practice
Trend of earnings

Lending policies of financial institutions

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Methods of capital budgeting


Traditional methods
Payback period
Accounting rate of return method
Discounted cash flow methods (DCF )
Net present value method
Discounted Payback
Profitability index method
Internal rate of return
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

I) Pay back period method :

It

refers to the period in which the project will


generate the necessary cash to recover the
initial investment.
It takes Profit after tax (PAT) into
consideration.
It emphasizes more on annual cash inflows,
economic life of the project and original
investment.
The selection of the project is based on the
earning capacity of a project.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

ABC LTD. Is considering a new five year


project. Its investment costs and annual
profits are projected as follows :
Year

Rs.

(250,000)

40,000

30,000

20,000

10,000

10,000

Investme
nt
Investme
nt
Profits
after tax.

The residual value at the end of the project is


expected to be Rs. 40,000 and the
depreciation on original investment is on SLM.
Calculate the PB period.

17

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Solution :

Profit should be after tax. And the depreciation should


be added back, since it does not result in outflow of
cash.
Annual depreciation : (250,000-40,000)/ 5 yrs. = 42,000
YEAR

PAT+ DEP

CFAT

CUM. CFAT

40,000+
42000

=82000 82000

30000+
42000

=72000 154,000

20,000+
42000

=62000 216,000

10,000+
=52000 268,000
THEREFORE
42000 PAYBACK PERIOD :

3YRS+
(34,000/52000)
= 3.65320,000
YEARS
5
10,000+
=52000
42000
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Decision criteria :

A project is accepted if its payback period is less


than the maximum payback period fixed by the
management.

Ranking of project is done keeping the PB period


in mind.
Least payback period gets 1 st rank.

If management has to choose between two or


more mutually exclusive projects the project with
least PB period will be chosen.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Cons :

Importance is given to liquidity rather than


profitability.
Does not recognize importance of time value of
money,
Does not consider profitability of economic life of
project,
Does not recognize pattern of cash flows,
Does not reflect all the relevant dimensions of
profitability.
Ignores the risk involved in project.
There is no rational basis for setting a PB period.
Its a subjective decision.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

II )Accounting Rate of Return method :

IT considers the earnings of the project of the


economic life.
This
method is based on conventional
accounting concepts.
Simple to understand and easy to use.
The profits under this method is calculated as
profit after depreciation and tax of the entire
life of the project.
Suitable for the analysis of long term projects
because it considers the whole life of the
project.
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Miss Kirti Kiran, Asst professor, DMC 07/13/15

ABC LTD. Is considering a new five year


project. Its investment costs and annual
profits are projected as follows :
Year

Rs.

(250,000)

40,000

30,000

20,000

10,000

10,000

Investme
nt
Investme
nt
Profits
after tax.

The residual value at the end of the project is


expected to be Rs. 40,000 and the
depreciation on original investment is on SLM.
Calculate ARR.

22

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Solution
Here profits are after depreciation and taxes.
ARR =
estimated avg.net annual income after dep&
tax X 100
Initial Investment
Or Average profits after tax
Avg. Investment.

22000 X 100 = 15.17%


145,000
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Accept or Reject Criterion:


Under the method, all project, having Accounting Rate of
return higher than the minimum rate establishment by
management will be considered and those having ARR less
than the pre-determined rate will e rejected.
This method ranks a Project as number one, if it has highest
ARR, and lowest rank is assigned to the project with the
lowest ARR.
Merits
It is very simple to understand and use.
This method takes into account saving over the entire
economic life of the project. Therefore, it provides a better
means of comparison of project than the pay back period.
This method through the concept of "net earnings" ensures
a compensation of expected profitability of the projects and
It can readily be calculated by using the accounting data.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Demerits :

It ignores time value of money.


Accounting profits are considered rather than cash
flows.
It ignores the fact that the profits earned can be
reinvested.
It is difficult to find out whether the rate of return
earned is fair or not. There is no rational basis for
setting a minimum ARR.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Homework Question :
Purchase price 80,000
2. Installation charges- 20,000
3. Estimated salvage value- 40,000
4. Useful life- 4 years
5. Working capital required- 10,000
6. Annual EBDT- 65,000
7. Tax Rate- 30%
Calculate ARR if the method of Depreciation is
a) SLM b)WDV
1.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Cash Flow Analysis -Before we


begin...

Cost and benefits of the project should be


measured in the terms of cash flows and not
accounting profit.
Accounting profit is affected by discretionary
accounting policies of management- eg.
amortisation of expenditure, depreciation etc.
Cash flows should be considered after tax
because tax on earnings is a cash outflow and tax
saving on loss/cost is considered as cash inflow.
Allowed Non cash expenses in companys Profit
and loss account results in tax saving. It reduces
the tax liability.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Depreciation and Cash Flow...

I- depreciation has been deducted from the earnings to reduce the tax
liability and then added back to determine the CFAT.
II- dep has not been added or subtracted only tax saving is added
since it results in cash inflow.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Steps in developing relevant information


for Cash flow Analysis :
Step 1- Estimation of Capital expenditure
:
a. Cost of new equipments
b. Cost of removal and disposal of old equipment
less scrap value.
c. Cost of preparing the site and mounting of
new equipment.
d. Cost of ancillary services required for new
equipment such as new conveyors or new
power suppliers.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Step II- Estimation of Working Capital :

a. Every

project requires additional WC to


finance the increase in level of activity.
b. At the time of starting the project WC is a
cash outflow.
c. At the end of the life of the project WC is
released and is therefore a cash inflow at that
time.
d. In an inflationary economy inflation should be
taken into account because the cost of WC
can increase even when there is no activity.
Eg MV of stock may increase.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Step II1- Estimation of Production &


Sales :

a. Each

years production units during the life of


the project.
b. Each years sales units during the life of the
project.
c. Selling price.
d. Cash inflows tend to increase considerably
after the sales are above break even point.
Initial years the company may have cash
outflows in terms of losses.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Step IV : Estimation of Cash Expenses :

a. Variable

cost : manufacturing ,
administrative , selling and distribution
expenses.
b.Incremental fixed cost.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Step V Estimation of Cash Outflows :


Cost of project/asset
Transportation/installation charges
xxxx
Working capital
Cash outflow
xxxx

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Miss Kirti Kiran, Asst professor, DMC

xxxx

xxxx

07/13/15

Step VI Estimation of Cash Inflows :

A.

Sales units

B.

SP per units

C.

Total Sales

D.

(Variable Costs)

E.

Contribution

F.

(fixed costs- cash cost & depreciation)

G.

EBT (E-F)

H.

(tax)

I.

EAT (G-H)

J.

Add Depreciation

K.

CFAT (I+J)

L.

+Release of WC

M.
N.

+ net cash salvage value of asset


+ tax saving on loss of sale of asset / (tax on profit of sale of
asset)

O.34Total

MissYear.
Kirti Kiran, Asst professor, DMC
CFAT For the last

07/13/15

Discounted cash flow method :

Time adjusted technique is an improvement over pay back


method and ARR (Traditional methods).
An investment is essentially out flow of funds aiming at
fair percentage of return in future.
The presence of time as a factor in investment is
fundamental for the purpose of evaluating investment.
Time is a crucial factor, because, the real value of money
fluctuates over a period of time.
A rupee received today has more value than a rupee
received tomorrow. In evaluating investment projects it is
important to consider the timing of returns on investment.
Discounted cash flow technique takes into account both
the interest factor and the return after the payback
'period.
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Miss Kirti Kiran, Asst professor, DMC

07/13/15

Discounted cash flow technique involves the


following steps:
Calculation of cash inflow and out flows over
the entire life of the asset.
Discounting the cash flows by a discount
factor
Aggregating the discounted cash inflows and
comparing the total so obtained with the
discounted out flows.

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Miss Kirti Kiran, Asst professor, DMC

07/13/15

I)Net present value method


It recognizes the impact of time value of money
and is considered as the best method of
evaluating the capital investment proposal. It is
widely used in practice.
The cash inflow to be received at different period
of time will be discounted at a particular discount
rate.
The present values of the cash inflow are
compared with the original investment.
The difference between the two will be used for
accept or reject criteria. If the difference yields
(+) positive value , the proposal is selected for
investment. If the difference shows (-) negative
values, it will be rejected.
37

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Pros:
It recognizes the time value of money.
It considers the cash inflow of the entire project.
It estimates the present value of their cash
inflows by using a discount rate equal to the
cost of capital.
It is consistent with the objective of maximizing
the welfare of owners.
Cons:
It is very difficult to find and understand the
concept of cost of capital
It may not give reliable answers when dealing
with alternative projects under the conditions of
unequal lives of project.
38

Miss Kirti Kiran, Asst professor, DMC

07/13/15

NPV = PVCO- PVCI


STEPS :
1. Calculate all cash outflows associated with the
project (t=0).
2. Calculate PV of cash outflows (t>0).
3. Calculate the Individual CFAT during the life of
the project.
4. Discount these CFATs to get the Present
values of Cash Inflows (PVCI)
5. Deduct Cash inflows from cash outflows.
There fore : NPV = PVCO- PVCI

39

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Question on NPV

T ltd provides you the following information:


1.

Purchase price of the new machine- 10,00,000

2.

Installation Expenses 150,000

3.

Workers Training Exp 50,000

4.

Subsidy Receivable from govt 50% now and 10% at the end of
1st year.

5.

WC requirement at the beginning of 1 st year, 2yr and 3rd year


respectively = 200,000 ; 300,000 ; and 250,000.

6.

Useful life of the Machine-5 yrs.

7.

Book SV- 10% of PP ; Cash Salvage Value : 80,000.

8.

Additional equipment costing Rs 300,000 will be needed at the


begenning of 3rd year (useful life 3 yrs , nil salvage value)

9.

Method of depreciation SLM

10.

Tax Rate- 30%

11.

WACC- 10%

12.

EBDT- 1yr NiL , 2nd 3rd 4th year- 500,000 each3 5th year Nil.

Advise the company whether the machine should be purchased or


not?

T ltd provides you the following information:


1.

Purchase price of the new machine- 10,00,000

2.

Installation Expenses 150,000

3.

Workers Training Exp 50,000

4.

Subsidy Receivable from govt 50% now and 10% at the end of 1st year.

5.

WC requirement at the beginning of 1st year, 2yr and 3rd year respectively
= 200,000 ; 300,000 ; and 250,000.

6.

Useful life of the Machine-5 yrs.

7.

Book SV- 10% of PP ; Cash Salvage Value : 80,000.

8.

Additional equipment costing Rs 300,000 will be needed at the begenning


of 3rd year (useful life 3 yrs , nil salvage value)

9.

Retrenchment compensation payable to the workers due to installation


100,000 (tax deductible)

10.

Depreciation will be 100% of the cost of the machine ( including additional


machine) in the year of purchase. Allowed as tax deduction.

11.

Tax Rate- 30%

12.

WACC- 10%

13.

EBDT- 1yr Nil , 2nd 3rd 4th year- 500,000 each3 5th year Nil.

Advise the company whether the machine should be purchased or not


41

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Internal Rate of Return


It is that rate at which the sum of discounted cash
inflows equals the sum of discounted cash
outflows. It is the rate at which the net present
value of the investment is zero.
It is the rate of discount which reduces the NPV of
an investment to zero. It is called internal rate
because it depends mainly on the outlay and
proceeds associated with the project and not on
any rate determined outside the investment.

42

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Merits of IRR method


It consider the time value of money
Calculation
of casot of capital is not a
prerequisite for adopting IRR
IRR attempts to find the maximum rate of
interest at which funds invested in the project
could be repaid out of the cash inflows arising
from the project.
It is not in conflict with the concept of
maximising
the
welfare
of
the
equity
shareholders.
It considers cash inflows throughout the life of
the project.

43

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Cons
Computation of IRR is tedious and difficult to
understand
Both NPV and IRR assume that the cash inflows
can be reinvested at the discounting rate in the
new projects. However, reinvestment of funds at
the cut off rate is more appropriate than at the
IRR.
IT may give results inconsistent with NPV
method. This is especially true in case of
mutually exclusive project.

44

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Step 2: Calculation of cash inflow


Sales
xxxx
Less: Cash expenses
xxxx
PBDT
xxxx
Less: Depreciation
xxxx
PBT
xxxx
less: Tax
xxxx
PAT
xxxx
Add: Depreciation
xxxx
Cash inflow p.a
xxxx

45

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Note:
Depreciation = St.Line method
PBDT Tax is Cash inflow ( if the tax amount is
given)
PATBD = Cash inflow
Cash inflow- Scrap and working capital must be
added.

46

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Step 3: Apply the different techniques


Pay back period= No. of years + Amt to
recover/ total cash of next years.
ARR = Average Profits after tax/ Net
investment x 100
NPV= PV of cash inflows PV of cash outflows
Profitability index = PV of cash inflows/ PV of
cash outflows
IRR :
Pay back factor: Cash outflow/ Avg cash inflow
p.a.
Find IRR range
PV of Cash inflows for IRR range and then
calculate IRR
47

Miss Kirti Kiran, Asst professor, DMC

07/13/15

Thank You

48

Miss Kirti Kiran, Asst professor, DMC

07/13/15

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