Capital Budgeting decision

Financial Managment Shanti business School

Capital budgeting
Capital budgeting is the process of making decision

regarding capital expenditure in projects or assets

Capital Expenditure For acquiring capital assets which are used in the business

and not for resale and such assets would give benefits for

long period
Example: Land, Plant & Equipments

Importance of capital Budgeting

Heavy Investment Permanent commitment of funds Long term Impact on profitability Irreversible in nature

Capital Budgeting process

Find Projects

Determine cash flows

Determine risk of those cash flows

Choose budget
Post audit

Cash Flow rules

Discount Cash flows not accounting profits

Time period of cash flows

Consider Opportunity cost

Consider Tax
Ignore Sunk cost

Session plan
First Half : Estimation Second Half:

of cash flows What is Cash flow ? How to calculate project cash flow ? Issues to look for while calculating Cash flows.

Techniques to evaluate projects cash flows Traditional methods for evaluating a project Discounted Methods of evaluating a project

Sound Investment Decision

Sound investment decisions should be based on

the net present value (NPV) of Cash flows . What should be discounted? In theory, the answer is obvious: We should always discount the cash flows. What rate should be used to discount cash flows? In principle, the opportunity cost of capital should be used as the discount rate

Cash flow Vs Profit

The words profit and cash flows are often used

interchangeably. Cash flow is different from profit because of mainly two reasons. Profit is calculated using accrual concept of accounting ( Which says record the revenue/expense even if cash is not Received/paid ) While calculating profit depreciation is deducted as expense. As deprecation does not result into any cash outflow it is added back as source of cash in cash flow statement. In other worlds, Cash flow = Profit + Depreciation

Cash Flows
The cash flow approach for measuring benefits is

theoretically superior to the accounting profit approach as it Avoids the ambiguities of the accounting profits concept, Measures the total benefits and Takes into account the time value of money.

How to Calculate Cash flow ?

Cash flow is equal to,

Revenues
Less: Expenses Less: Depreciation Profit Add back : Depreciation ( As it is Non-Cash Expense) Less : Capital expenditure Less : Working capital requirement (+/-)

Free Cash flow or Cash flow

Project Cash flows

When deciding whether or not to make an investment, we

must first estimate the cash flows that the investment will
provide
Generally, these cash flows can be categorized as follows: The initial outlay (IO) The annual after-tax cash flows (ATCF)

The terminal cash flow (TCF)

Relevant cash flows

Determining the relevant cash flows can sometimes

be difficult, here are some guidelines Cash flows must be: Incremental (i.e., in addition to what you already have) After-tax Ignore those cash flows that are: Sunk costs (money already spent, and not recoverable)

The Initial outlay

The initial outlay is the total up-front cost of the

investment The initial outlay can consist of many components, among these are: The cost of the investment Shipping and setup costs Training costs Any increase in net working capital When we are making a replacement decision, we also need to subtract the after-tax salvage value of the old machine (or land, building, etc.)

The Annual After tax cash flows

The annual after-tax cash flows (ATCF) are the

incremental after-tax cash flows that the investment will provide Generally, these cash flows fall into four categories: Incremental savings (positive cash flow) or expenses (negative cash flow) Incremental income (positive cash flow) The tax savings due to depreciation Lost cash flows (negative cash flow) from the existing project. This is an opportunity cost.

Terminal Cash flows

The terminal cash flow consists of those cash flows that

are unique to the last year of the life of the project

There may be a number of components of the TCF, but

three common categories are:

Estimated salvage value Shut-down costs

Recovery of the increase in net working capital

Types of Projects
Single proposal or new project

Replacement project
Mutually Exclusive projects

In case of single project cash flows would be.

Cash outflow Year 0

Cost of new project

Cash inflows (total life)

Revenues Less: Expenses Less: depreciation Profit Add Depreciation

+ Installation cost of plant and equipment

Less: Working capital requirements Less : capital Expenditure

Incremental Cash flow

Incremental cash flow is the additional cash flow (

Cash inflow and outflow) that firm will incur if it takes a project. It is the difference between firm and projects cash flow
Firms cash flow + Project Cash flow

Firms Cash flow (Without project)

Incremental Cash Flow

Example
Following is Firm ABC Data

Rs.1,00,000, revenue, Rs,70,000 cost and Rs, 10,000

deprecation. There is a proposal of project Y. by taking project y firms new revenue would be Rs.1,30,000. cost Rs.90,000 and 15,000 depreciation. What would be the incremental cash flow. (Assume working capital and capital expenditure requirement is Zero)

Firm ABC Incremental Cash Flow

Particulars Firm + Project Y Firm without project Y 1,00,000 Incremental Cash Flow 30,000

Revenue

1,30,000

Less: Expenses
Less : Depreciation Profit

90.000
15.000 25.000

70,000
10,000 20,000 10,000

20,000
5,000 5,000 5,000

Add: Depreciation 15.000

Cash flows

40.000

30,000

10,000

Replacement Proposal
In the case of replacement situation, the sale

proceeds from the existing asset reduce the cash outflows required to purchase the new Asset. The relevant Cash flows are incremental after-tax cash inflows.
Cost of the new machine

+ Installation Cost Working Capital Sale proceeds of existing machine

Replacement proposal cash flows

Cash outflow (incremental)
Cost of the new machine

+ Installation Cost Working Capital Sale proceeds existing machine

of

Cash Inflow (incremental ) Revenues Less: Expenses Less: depreciation (Incremental Profit Add Depreciation Less: Working capital requirements Less : capital Expenditure Cash flow

Mutually exclusive projects

Projects are mutually exclusive if accepting one

implies that the other projects will be foregone. When projects are mutually exclusive and have equal lives, you have to rank the projects based on their Net present value of cash flows. Choose the best project, provided the projects NPV is positive With mutually exclusive projects, choosing the project with the highest NPV is always correct.

Example
Company X is considering a proposal of purchasing either

machine A or B. following are the cash flow associate with both machines.
Particulars Cost of machine Machine A 1,50,000 Machine B 2,50,000

Incremental Cash flow for 5 years

Salvage value Discount rate

18,000
25,000 10%

25,000
30,000 10%

Guide which machine should company choose if discount

rate is 10%

Solution
Step 1: Present Value Of Cash Inflow Discounted at 10% Machine A : $83,757 Machine B : $ 1,13,397
Step 2 : Deduct total PV of Cash outflow from

Cash Inflow Machine A : $83,757 75,000 = $8,757 Machine B : $ 1,13,397-1,00,00=$13,397

Methods of Capital Budgeting

Traditional methods
Pay back period method or pay out or pay off method Discounted pay back period method Rate of return method or accounting method

Time adjusted method or discounting method

Net present value method

Internal rate of return method

Profitability index method

Payback Method
Payback period is the length of time required to

recover initial cash outlay.

For Example
Initial outlay -6,00,000 Year 1 2,00,000
Cash flows Year 2 Year 3 1,50,000 1,50,000

Year 4 1,00,000

Year 5 1,50,000

Here the payback period is 4 years because sum

of cash flows during first four years equals to initial investment

Payback method
Decision criteria under payback method is

Accept the projects with shorter payback period.

Advantage:

1.Easy to calculate
Disadvantage:

1.Ignores the time value of money 2. Ignores the cash flows beyond payback period

Discounted Payback
All cash flows are calculated taking into consideration

appropriate discount rate

Initial outlay -4,00,000 Discounted D. payback Year 1 2,00,000 2,00,000/ 1.10 1,81,818 Cash flows Year 2 Year 3 1,50,000 1,50,000 1,50,000/ 1,50,000/ (1.10)^2 (1.10)^3 123967 112697 Year 4 1,00,000 1,00,000/ (1.10)^4 68301 Year 5 1,50,000 1,50,000/ (1.10)^5 93138

Advantages:
It takes into consideration time value of money

Accounting or Average Rate of Return Method

ARR = Average annual profit / original investment * 100 For example
Initial outlay -6,00,000 Year 1 2,00,000
Cash flows Year 2 Year 3 1,50,000 1,50,000

Year 4 1,00,000

Year 5 1,50,000

Average annual profit = (1,50,000 / 6,00,000) * 100

Here the ARR is 25%

Decision criteria: Accept the projects which gives you the ARR higher then the return required by company

Accounting or Average Rate of Return Method

Advantages:
Simple to calculate
No estimation Required

Disadvantages:
It is based on accounting profit not cash flow It does not take into account time value of money

Net present value [NPV] method

Decide appropriate discounting rate

Present value of estimated cash inflows and outflows

should also be computed

Equation for calculating NPV is as follows

NPV = P.V cash inflows P.V cash out flows

Criteria for Selection

Accept when NPV > zero

Reject when NPV < zero

Net present value [NPV] method

For example
Initial outlay -1,00,000 Year 1 20,000

Cash flows Year 2 Year 3 25,000 30,000

Year 4 35,000

Year 5 40,000

Find the NPV if Required rate of return is 10% NPV is Rs. 10124.74

Net present value [NPV] method

Advantage:
Takes into account time value of money Additive property: NPV (A+B) = NPV of project A +

NPV of project B

Limitations:
Its in Absolute terms not relative terms Biased to long term projects in case projects are

mutually exclusive.

Profitability index [PI] or excess present value index method

P.I = Present value future cash inflow / Present value of future

cash outflow For Example: Initial outlay -1,00,000 Year 1 22,000 Cash flows Year 2 24,200 Year 3 39,930 Year 4 58,564

At 10% discount rate, Profitability index for the project is 1,10,000 / 1,00,000 = 1.1 Criteria for decision Accept the project in P.I >1 Reject the project if P.I <1

Profitability index [PI] or excess present value index method

Advantages:
Takes in to account Time value of money
Takes into account Scale on investment

Used when capital is scare

Internal Rate of Return

Rate which makes present value of all future cash flows equals to

values of initial outlay or which makes NPV=0 (PV of Inflows = PV of outflow)

IRR=Cash Inflows/ Cash outflows=1 Methods of finding IRR Trial and Error Excel Example

Initial outlay -1,00,000

Year 1 25,000

Cash flows Year 2 30,000

Year 3 40,000

Year 4 40,000

IRR = 12%

Internal Rate of Return

Decision criteria
Accept the project If IRR is greater than required

rate of return by the investor.

Advantages
It takes into consideration Time value of money It gives the same result as given by NPV

Internal Rate of Return

Disadvantages: Projects with negative cash flows For example Cash flows Year 0 Year 1 -16,000 10,000
Mutually exclusive projects
Project A B Initial investment -10,000 -50,000 Cash flow 20,000 75,000 IRR 100% 50% NPV 7,857.14 16,964.29

Year 2 -10,000

Which one to choose?

Capital Budgeting Techniques
NPV Methods IRR Payback ARR 20% 12%
0% 20% 40% 60% 80%

75%
76% 57%

Profitability Index

Survey evidence on percentage of CFOs using particular technique

for evaluating investment projects

Source: J. R. Graham and C. R. Harvey, The Theory and Practice of Finance: Evidence from the Field, Journal of Financial Economics 61 (2001)

In class exercise
Suppose you buy a land at Rs 10 lac and you

construct a building which costs Rs 5. you can

rent it to a hotel with annual rent of Rs 4 lac per year for 5 years. If the Rate of interest is 10%
Will you invest in the project ? In case the rate of interest increases to 12%

would it impact your decision?

In class Exercise
Project A Initial Investment -100,000 Cash Flows 1st Year 20000 2nd Year 30000 3rd Year 40000 4th year 40000 5th year 50000

-75000

15000

15000

15000

15000

15000

-150,000

50000

60000

40000

40000

50000

-200,000

80000

70000

40000

40000

30000

Decision
Based on each criteria which project would you

select
Payback ARR NPV IRR P.I.