CAPITAL BUDGETING

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CAPITAL BUDGETING

• Techniques of Capital Budgeting

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Introduction

• A truck manufacturer is considering investment in
  a new plant.
• An airliner is planning to buy a fleet of jet
  aircrafts
• A commercial bank is thinking of an ambitious
  computerization programme
• A pharmaceutical firm is evaluating a major RD
  programme.
• All these are the examples of situations
  involving capital expenditure decision.
• Essentially each of them represents a scheme for
  investing resources which can be analyzed and
  appraised reasonably independently.

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Understanding Capital Expenditure

• Also referred to as Capital Investment or Capital
  Project or just Project.
• The basic characteristic of Capital Expenditure
  is
• Typically involves a current outlay (or current
  and future outlays) of funds
• In the expectation of a stream of benefits
  extending far into the future.
• However, from accounting point of view, Capital
  Expenditure is the one shown as asset on the
  Balance Sheet. This assets, except in the case of
  non-depreciable asset like land, is depreciated
  over its life.

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Understanding Capital Expenditure

• In accounting, the classification of an
  expenditure as capital expenditure or revenue
  expenditure is governed by
• Certain conventions
• Provisions of law
• Managements desire to enhance or depress
  reported profits.
• Outlays on RD, major advertising campaign,
  reconditioning of PM may be treated as revenue
  expenditure for accounting purposes, even though
  they are expected to generate a stream of
  benefits in future.
• Therefore, such expenditures qualify for being
  capital expenditures as per our definition.

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Understanding Capital Expenditure

• Capital expenditures have three distinctive
  features
• They have long-term consequences
• They often involve substantial outlays.
• They may be difficult or expensive to reverse.
• How a firm allocates its capital (the capital
  budgeting decision) reflects its strategy and
  business. Thats why the process of capital
  budgeting is also referred to as strategic asset
  allocation.
• Techniques of Capital Budgeting are helpful in
  identifying valuable investment opportunities.

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What is Capital Budgeting?

• Capital budgeting refers to the process of
  deciding how to allocate the firms scarce
  capital resources (land, labor, and capital) to
  its various investment alternatives
• The process of planning for purchases of
  long-term assets.
• Nature of capital budgeting
• Evaluating and selecting long-term investments
  in
• tangible assets
• intangible assets
• Designed to carry out an organizations strategy

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Managing the Firms Resources
Competition, Life cycle effects, International
events, etc.
Resource Decisions
Cash Management Inventory Management Working
Capital Management Investment in Human
Capital Long-term Assets Accounts Receivable
Operating Decisions
Cash Inflows Earnings
Share- holder Value
Information Decisions
Risk-adjusted Discount Rate
Debt vs. Equity Financing Financial
Leverage Dividend Pay-out
Cost of Capital
Financial Markets
Financing Decisions
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General Steps in Capital Budgeting

• Translate strategy to capital needs
• Generate alternatives
• Project financial results
• Perform financial analysis
• Assess risks
• Consider non-financial factors
• Select projects
• Post-approval review

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Capital Budgeting Process

• Identification of potential investment
  opportunities. (Planning Body)
• Estimate the criteria of target.
• Monitor external environment regularly to scout
  investment opportunities.
• Formulate a well defined corporate strategy based
  on thorough SWOT analysis
• Share corporate strategy and perspectives with
  persons who are involved in the process of
  capital budgeting.
• Motivate employees to make suggestions.

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Capital Budgeting Process (contd..)

• Assembling of proposed investments.
• Investment proposal identified by the production
  department and other departments are submitted in
  a standardized capital investment proposal form.
• Routed through several persons before it arrives
  to Capital Budgeting Committee.
• Investment proposals are usually classified into
  various categories for facilitating decision
  making
• Replacement investment
• Expansion investments
• New product investments
• Obligatory and welfare investments

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Capital Budgeting Process (contd..)

• Decision making.
• A system of rupee gateways usually characterizes
  capital investment decision making.
• Executives at various levels are vested with the
  power to okay investment proposals up-to certain
  limits.
• Investment requiring higher outlays need the
  approval of the BoD.
• Preparation of Capital Budget and appropriations
• The purpose is to check in order to ensure that
  the fund position of the firm is satisfactory at
  the time of implementation.
• Provides an opportunity to review the project at
  the time of implementation.

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Capital Budgeting Process (contd..)

• Implementation
• Translating an investment proposal into a
  concrete proposal is complex, time-consuming, and
  risk-fraught task.
• For expeditious implementation at a reasonable
  cost, the following are helpful
• Adequate formulation of projects necessary
  homework and preliminary studies.
• Use of the Principle of Responsibility Accounting
• Use of Network Techniques CPM and PERT
• Performance review.
• Post-Completion Audit- provides feedback.
• Comparing actual performance with budgeted ones.

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Project Classification

1. Mandatory Investments
2. Replacement Projects
3. Expansion Projects
4. Diversification Projects
5. RD Projects
6. Miscellaneous Recreational Facilities, Executive
   Aircrafts, Landscaping etc.

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Investment Criteria
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Overview

• All of these techniques attempt to compare the
  costs and benefits of a project
• The over-riding rule of capital budgeting is to
  accept all projects for which the cost is less
  than, or equal to, the benefit
• Accept if Cost Benefit
• Reject if Cost gt Benefit

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The Example

• We will use the following example to demonstrate
  the techniques of capital budgeting
• Assume that your company is investigating a new
  labor-saving machine that will cost 10,000. The
  machine is expected to provide cost savings each
  year as shown in the following timeline

• If your required return is 12, should this
  machine be purchased?

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1. The Payback Period Method

• The payback period measures the time that it
  takes to recoup the cost of the investment.
• If the cash flows are an annuity, then we can
  simply divide the cost by the annual cash flow to
  determine the payback period
• Otherwise, as in the example, we subtract the
  cash flows from the cost until the remainder is
  zero
• The shorter the payback period, the better
• Generally, firms will have some maximum allowable
  payback period against which all investments are
  compared

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The Payback Period An Example

• For our example project, we will subtract the
  cash flows from the initial outlay until the
  entire cost is recovered

• Since it will take 0.7143 years ( 2500/3500) to
  recover the last 2,500, the payback period must
  be 3.7143 years

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Computation
Year Cash Flow Cumulative Net Cash Flow
0 -10,000 -10,000
1 2,000 -8,000
2 2,500 -5,500
3 3,000 -2,500
4 3,500 1,000
Hence, Payback Period lies between year 3 and 4
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Evaluation of Payback Period Method

• Simple both in concept and application.
• Has only few hidden assumptions.
• Rough and Ready method for dealing with risk.
• Favors projects which generate substantial cash
  inflows in earlier years and discriminates
  against project which bring substantial cash
  inflows in later years but not in earlier years.
• If risk tends to increase with futurity the
  payback criterion may be helpful in weeding out
  the risky projects.
• Since it emphasizes earlier cash inflows, it may
  be a sensible criterion when the firm is pressed
  with the problems of liquidity.

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Problems with the Payback Period

• It ignores the time value of money
• It ignores all cash flows beyond the payback
  period
• It is a measure of projects capital recovery,
  not profitability
• Though it measures a projects liquidity, it
  doesnt indicate the liquidity position of the
  firm as a whole, which is more important.
• The cutoff payback period is subjective.

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Example
Year Cash flow of A Cash flow of B
0 (100,000) (100,000)
1 50,000 20,000
2 30,000 20,000
3 20,000 20,000
4 10,000 40,000
5 10,000 50,000
6 - 60,000
Payback Criterion prefers A with payback period
of 3 years over B with payback period of 4
years. But B has very substantial cash inflows in
the years 5 and 6
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2. The Discounted Payback Period

• The discounted payback period is exactly the same
  as the regular payback period, except that we use
  the present values of the cash flows in the
  calculation
• Since our required return (WACC) is 12, the
  timeline with the PVs looks like this

• The discounted payback period is 4.82 years
• Note that the discounted payback period is always
  longer than the regular payback period

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Computations
Year Cash Flow Discounting factor _at_ 12 Present Value Cumulative net cash flow
0 -10,000 1.000 -10,000 -10,000
1 2,000 0.893 1,786 -8214
2 2,500 0.797 1992.5 -6221.5
3 3,000 0.712 2136 -4085.5
4 3,500 0.636 2226 -1859.5
5 4,000 0.567 2268 408.5
Payback Period 4.1 years
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Problems with Discounted Payback

• The discounted payback period solves the time
  value problem, but it still ignores the cash
  flows beyond the payback period
• Therefore, you may reject projects that have
  large cash flows in the outlying years that make
  it very profitable
• In other words, any measure of payback can lead
  to a focus on short-run profits at the expense of
  larger long-term profits

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3. Accounting Rate of Return (ARR)

• Also called Average Rate of Return
• Also called Average Accounting Return (AAR)
• There are many different definitions of the ARR.
• However, in one form or other, ARR is always
  defined as

• Measure of accounting profit can be PAT or N
• Measure of accounting value is Book Value

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Example

• Suppose we are deciding whether or not to open a
  store in a new shopping mall. The required
  investment in improvements is 500,000. The
  store would have a five-year life because
  everything reverts to the mall owners after that
  time. The required investment would be 100
  depreciated over five years. So the depreciation
  would be 500,000 / 5 100,000 per year. The
  tax rate is 25 .
• Table ahead shows the projected revenues and
  expenses

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Computation
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue 433,333 450,000 266,667 200,000 133,000
Expenses 200,000 150,000 100,000 100,000 100,000
EBDT 233,333
Depreciation 100,000
EBT 133,333
Tax _at_ 25 33,333
NI 100,000 150,000 50,000 0 50,000
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Solution
The project is acceptable if the ARR exceeds the
target ARR
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Evaluation of ARR method

• It is simple to calculate
• It is based on accounting information, which is
  readily available and familiar to businessmen.
• While it considers benefits over the entire life
  of the project, it can be used even with the
  limited data.

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Problems with ARR method

• ARR is not the rate of return in any meaningful
  economic sense. It is just the ratio of two
  accounting numbers, and is not comparable to the
  returns actually offered.
• It is based upon accounting profit, not cash
  flow.
• It does not take into account the time value of
  money.
• The ARR measure is internally inconsistent. While
  the numerator represents profit belonging to
  equity and preference stockholders, its
  denominator represents fixed investments, which
  is rarely, if ever, equal to the contributions of
  equity and preference stockholders.

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The Net Present Value

• The net present value (NPV) is the difference
  between the present value of the cash flows (the
  benefit) and the cost of the investment (IO)

• In other words, this is the increase in wealth
  that the shareholders will receive if the project
  is accepted
• All projects with NPV greater than or equal to
  zero should be accepted

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NPV Decision Rule
Present value of future cash flows Profitability Index
Investment Cost Profitability Index
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The NPV An Example

• NPV is calculated by subtracting the initial
  outlay (cost) from the present value of the cash
  flows
• Note that the discount rate is the WACC (12 in
  this example)

• Since the NPV is positive, the project is
  acceptable
• Note that a positive NPV also means that the IRR
  is greater than the WACC

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The Internal Rate of Return

• The internal rate of return (IRR) is the discount
  rate that equates the present value of the cash
  flows and the cost of the investment
• Usually, we cannot calculate the IRR directly,
  instead we must use a trial and error process
• For our example, the IRR is found by solving the
  following

• In this case, the solution is 13.45

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IRR Decision Rule
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Problems with the IRR

• The IRR is a popular technique primarily because
  it is a percentage which is easily compared to
  the WACC
• However, it suffers from a couple of flaws
• The calculation of the IRR implicitly assumes
  that the cash flows are reinvested at the IRR.
  This may not always be realistic.
• Percentages can be misleading (would you rather
  earn 100 on a 100 investment, or 10 on a
  10,000 investment?)

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The Profitability Index

• The profitability index is the same as the NPV,
  except that we divide the PVCF by the initial
  outlay

• Accept all projects with PI greater than or equal
  to 1.00
• For the example, the PI is