Capital Budgeting

SUBJECT:

Seminar

Submitted To:

Sir. Yasin Zia

Submitted By:

Amna Akram M.COM-ACCOUNTING

Department of Business Management & Sciences

University of Agriculture Faisalabad

INTRODUCTION
Long-term investments represent sizable outlays of funds that commit a firm to some course of action. Consequently, the firm needs procedure to analyze and properly select its long-term investments. It must be able to measure cash flows and apply appropriate decision techniques. As time passes, fixed asset may become absolute or may require an overhaul; at these points, too, financial decisions may be required.

Capital budgeting is the process of evaluating and selecting long-term investments that are consistent with the firms goal of maximizing owner wealth.
Firms typically make a variety of long-term investments, but the most common for the manufacturing firm is in fixed assets, which include property (land), plant, and equipment. These assets, often referred to as earning assets, generally provide the basis for the firms earning power and value.

Motives for Capital Expenditure

A Capital expenditure is an outlay of funds by the firm that is expected to produce benefit over a period of time greater than 1 year. Operating expenditure is an outlay resulting in benefits received within 1 year. Capital expenditure is made for many reasons. The basic motives for capital expenditure are: Expansion: The most common motives for capital expenditure is to expand the level of operationsthrough acquisition of fixed assets. A growing firm often needs to acquire new fixed assets rapidly, as in the purchase of property and plant facilities. Replacement: As a firms growth slows and reaches maturity, most capital expenditures will be made to replace or renew obsolete assets. Each time a machine requires

a major repair, the outlay for the repair should be compared to the outlay to replace the machine and the benefits of replacement. Renewal: Renewal, an alternative to replacement, may involve rebuilding, overhauling, or retrofitting an existing fixed asset. For example, an existing drill press could be renewed by replacing its motor and adding a numerical control system, or a physical facility could be renewed by rewiring and adding air conditioning. To improve efficiency, both replacement and renewal of existing machinery may be suitable solutions.

CAPITAL BUDGETING PROCESS

Steps for Capital budgeting process
The capital budgeting process consists of five distinct but interrelated steps: Proposal generation: Proposals are made at all levels within a business organization and are reviewed by finance personnel. Proposals that require large outlays are more carefully scrutinized than less costly ones. Review and analysis: Formal review and analysis is performed to assess appropriateness of proposal and evaluate their economic validity. Once the analysis is complete, a summary report is submitted to decision makers. Decision making: Firms typically delegate capital expenditure decision making on the basis of dollar limits. Generally, the board of directors must authorize expenditures beyond a certain amount. Often plant managers are given authority to make decisions necessary to keep the production line moving. Implementation: Following approval, expenditures are made and projects implemented. Expenditures for large projects occur in phases. Follow up:

Results are monitored and actual costs and benefits are compared with those that were expected. Action may be required if actual outcomes differ from projected ones.

Basic Terminology
Before we develop the concepts, techniques, and practices related to the capital budgeting process, we need to explain some basic terminology: Independent versus Mutually Exclusive projects: Independent projects are those whose cash flows are unrelated or independent of one another; the acceptance of one does not eliminate the others from further consideration. Mutually exclusive projects are those that have the same functions and therefore compete with one another. The acceptance of one eliminates from further considerations all other projects that serve a similar function. For example, a firm in need of increased production capacity could obtain it by (1) expanding its plant, (2) acquiring another company, or (3) contracting with another company for production. Clearly, accepting any one option eliminates the need for either of the others. Unlimited Funds versus Capital Rationing: The financial situation in which a firm is able to accept all independent projects that provide an acceptable return is called Unlimited finds. The financial situation in which a firm has only a fixed number of dollars available for capital expenditures, and numerous projects competes for those dollars. Accept-Reject versus Ranking Approaches: The accept-reject approach involves evaluating capital expenditure proposals to determine whether they meet the firms minimum acceptance criteria. This approach can be used when the firm has unlimited funds, as a preliminary step when evaluating mutually exclusive projects, or in a situation in which capital must be rationed. In these cases, only acceptable projects should be considered. The ranking approach involves ranking projects on the basis of some predetermined measure, such as the rate of return. The projects with the higher
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return is ranked first, and the projects with the lowest return is ranked last. Only acceptable projects should be ranked. Ranking is useful in selecting the best of a group of mutually exclusive projects and in evaluating projects with a view to capital rationing. Conventional versus Nonconventional Cash Flows Patterns: A conventional cash flow pattern consist of an initial outflow followed only by a series of cash inflows. For example, a firm may spend 10,000 today and as a result expect to receive equal annual cash inflows of 2,000 each year for the next 7 years, as shown in the following figure:
2000
Cash inflows 0

2000

2000

2000

2000

2000

2000

1
Cash outflow 10,000

End of year
A nonconventional cash flow pattern consist of an initial outflow followed by a series of cash inflows and cash outflows. For example, a firm may spend 20,000 today for purchase of machinery and as a result expect to receive 5,000 each year for the next 4 years. In the 5th year after purchase, an outflow of 8,000 may be required to overhaul the machine, after what it generates inflow if 5,000 each year for 4 more years, as shown in the following figure:

$
Cash inflows 0

5000

5000

5000

5000

5000

5000

5000

5000

1
Cash outflow

5
8,000

20,000

End of year

CAPITAL BUDGETING TECHNIQUES

1. Payback period
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2. Net present value (NPV) 3. Internal rate of return (IRR)

4. Profitability index (PI)

1) Payback Period
Payback periods are commonly used to evaluate proposed investments. The payback period is the amount of time required for the firm to recover its initial investment as a project, as calculated from cash inflows. In the case of an annuity, the payback period can be found by dividing the initial investment by the annual cash inflow. For a mixed stream of cash inflows, the yearly cash inflows must be accumulated until the initial investment is recovered. Although popular, the payback period in generally viewed as an unsophisticated capital budgeting technique, because it does not explicitly consider the time value of money.

1.1) The Decision Criteria

When the pay back period is used to make accept-reject decisions, the decision criteria are as follows: If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project. If there are two mutually exclusive projects, then select that project which have less payback period.

1.2) Example
Rashid Company, a software developer, has two investment opportunities which are mutually exclusive, X and Y. Data for X and Y are given in Table: Table: Calculation of the Payback Period for Rashid Companys Two Alternative Investment Projects
Project X $ 10,000 Operating Cash Inflows $ 5,000 5,000 Project Y $ 10,000 Operating Cash Inflows $ 3,000 4,000

Initial Investment Year 1 2

3 4 5 Payback Period

1,000 100 100 2 Years

3,000 4,000 3,000 3 Years

Decision: The payback period for Project X is 2 years; for project Y it is 3 years. The payback approach suggests that project X is preferable to project Y.

1.3) Advantages of Payback Periods

The payback period is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. Its popularity results from its computational simplicity and intuitive appeal. It is also appealing in that it considers cash flows rather than accounting profits. By measuring how quickly the firm recovers its initial investment, the payback period also gives implicit consideration to the timing of cash flows and therefore to the time value of money.Therefore, the shorter the payback period, the lower the firms exposure to such risk.

1.4) Disadvantages of Payback Periods

The major weakness of the payback period is that the appropriate payback period is merely a subjectively determined number. It cannot be specified in light of the wealth maximization goal because it is not based on discounting cash flows to determine whether they add to the firms value. Instead, the appropriate payback period is simply the maximum acceptable period of time over which management decides that a projects cash flows must break even (that is, just equal the initial investment).

2) Net Present Value (NPV)

Because net present value (NPV) gives explicit consideration to the time value of money, it is considered a sophisticated capital budgeting technique. All such techniques in one way or another discount the firms cash flows at a specified rate. This rate-often called the Discount Rate, Required Return, Cost of Capital, or opportunity costis the minimum return that must be earned on a project to leaves the firms market value unchanged. The net present value (NPV) is found by subtracting a projects initial investment (CF0) from the present value of its cash inflows (CF1) discounted at a rate equal to the firms cost of capital. NPV = Present Value of Cash Inflows Initial Investment

CFt n NPV = t = 0 (1 + k) t

When NPV is used, both inflows and outflows are measured in terms of present dollars. Because we are dealing only with investments that have conventional cash flow patterns, the initial investment is automatically stated in terms of todays dollars. If it were not, the present value of a project would be found by subtracting the present value of outflows from the present value of inflows.

2.1) The Decision Criteria

When NPV is used to make accept-reject decisions, the decision criteria are as follow: If the NPV is greater than $ 0, accept the project. If the NPV is less than $ 0, reject the project. If the NPV is greater than $ 0, the firm will earn a return greater than its cost of capital. Such action should enhance the market value of the firm and therefore the wealth of its owners. If projects are mutually exclusive, accept that one with the highest NPV

2.2) Example
We can illustrate the net present value (NPV) approach by using XYZ Company data presented in Table:

Year 0 1 2 3 Project L 0 100.00 9.09 49.59

Expected Net Cash Flow Project L Project S ($100) ($100) 10 70 60 50 80 20

If the firm has a 10 % cost of capital, the net present value (NPV) for project L and S can be calculated as shown on the time lines:

1 10

2 60

3 80

60.11 NPVL = $ 18.79

Project S 0 100.00 63.63 41.30 15.02 NPVS = $ 19.95

If the projects are independent, accept both. If the projects are mutually exclusive, accept Project S since NPVS > NPVL. Note: NPV declines as cost of capital increases, and NPV rises as cost of capital decreases.

1 70

2 50

3 20

3) Internal Rate of Return (IRR)

The internal rate of return (IRR) is probably the most widely used sophisticated capital budgeting technique. However, it is considerably more difficult than NPV to calculate by hand. The internal rate of return (IRR) is defined as the
discounted rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The internal rate of return (IRR) is the discount rate

that equates the NPV of an investment opportunity with $ 0 (because the present value of cash inflows equals the initial investment). It is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflows. Mathematically, the IRR is the value of k in equation 1 that causes NPV to equal $ 0.

3.1) The Decision Criteria

When IRR is used to make accept-reject decisions, the decision criteria are as follows: If the IRR is greater than the cost of capital, accept the project. If the IRR is less than the cost of capital, reject the project.

These criteria guarantee that the firm earns at least its required return. Such an outcome should enhance the market value of the firm and therefore the wealth of its owners. If projects are mutually exclusive, the decision rule of taking the project with the highest IRR or may select a project with a lower NPV In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations. Figure: NPV vs. IRR Independent projects

If cash flows are discounted at k1, NPV is positive and IRR > k1: accept project. If cash flows are discounted at k2, NPV is negative and IRR < k2: reject the project. Mathematical proof: for a project to be acceptable, the NPV must be positive
IRR : CFt n = $0 = NPV . t = 0 (1 + IRR ) t

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3.2) Example
We can illustrate the net present value (NPV) approach by using XYZ Company data presented in Table:

Year 0 1 2 3

Expected Net Cash Flow Project L Project S ($100) ($100) 10 70 60 50 80 20

Project L

1 10
18.1%

2 60
18.1%

3 80

8.47 18.1% 43.02 48.57 $ 0.06 $0

100.00

IRRL = 18.1% IRRS = 23.6%

If the projects are independent, accept both because IRR > k

If the projects are mutually exclusive, accept Project S because IRRS > IRRL

3.3) Disadvantages of IRR

The main problem with the IRR method is that it often gives unrealistic rates of return.

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Which Approach Is Better in NPV and IRR

It is difficult to choose one approach over the other, because the theoretical and practical strengths of the approaches differ. It is therefore wise to view both NPV and IRR techniques in each of these dimensions.
Theoretical View

On a purely theoretical basis, NPV is better approach to capital budgeting as a result of several factors. Most important is that the use of NPV implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firms cost of capital. The use of IRR assumes reinvestment at the often high rate specified by IRR. Because the cost of capital tends to be a reasonable estimate of the rate at which the firm could actually reinvest intermediate cash inflows, the use of NPV, with its more conservative and realistic reinvestment rate, is in theory preferable. In addition, certain mathematical properties may cause a project with a non conventional cash flow pattern to have zero or more than one real IRR; this problem does not occur with the NPV approach. Practical View Evidence suggests that in spit of theoretical superiority of NPV, financial managers prefer to use IRR. The preference for IRR is due to the general disposition of businesspeople toward rates of return rather than actual dollar returns. Because interest rates, profitability and so on are most often expressed as annual rates of return, the use of IRR makes sense to financial decision makers. They tend to find NPV less intuitive because it does not measure benefits relative to the amount invested. Because a variety of techniques are available for avoiding the pitfalls of the IRR, its widespread use does not imply a lack of sophistication on the part of financial decision makers.

4) Profitability index (PI)

The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis. Therefore, the PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project. PI is also known as a benefit/cash ratio.
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PI =

PVCF Initial investment

4.1) The Decision Criteria

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

4.2) Example
We can illustrate the net present value (NPV) approach by using XYZ Company data presented in Table:

Year 0 1 2 3

Expected Net Cash Flow Project L Project S ($100) ($100) 10 70 60 50 80 20

If the firm has a 10 % cost of capital, the net present value (NPV) for project L and S can be calculated as shown on the time lines:

Project L 0 100.00 9.09 49.59 60.11 PVL = $ 118.79 1 10 2 60 3 80

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PI =

PV of cash flows initial coast

PIL = 1.1879

Project S 0 100.00 63.63 41.30 15.02 PVS = $ 119.95

PI = PV of cash flows initial coast

1 70

2 50

3 20

PIS = 1.1995

If the projects are independent, accept both because PI > 1 If the projects are mutually exclusive, accept Project S because PIS > PIL

Conclusion:
The capital budgeting literature over the past twenty years has focused on sophisticated financial appraisal approaches, corporate reality suggests increasing importance for managers in considering the strategic benefits of long-term assets. NPV techniques are complemented by a broader strategic cost management accounting approach such as value chain analyses, cost driver analysis, and competitive advantage analysis. It is found that companies pay less attention to traditional capital budgeting techniques, while others suggest that traditional appraisal techniques are no longer appropriate for intangible investments given their non-financial benefits and cost complexity.

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