Capital Bud ..Updated Final

8/3/2019 Capital Bud ..Updated Final

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Capital Budgeting

PREPARED BY : Swapnil (3)

Keyur (10)

Nikhil (14)

Manjiri (18)

Nikita (27)

Asad (30)


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Outline

Meaning of Capital Budgeting

Significance of Capital Budgeting Analysis

Traditional Capital Budgeting TechniquesPayback Period Approach

Discounted Payback Period Approach

Discounted Cash Flow Techniques Net Present Value

Internal Rate of Return

Profitability Index

Net Present Value versus Internal Rate of Return


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Meaning of Capital Budgeting

Capital budgeting addresses the issue ofstrategic long-term investment decisions.

Capital budgeting can be defined as theprocess of analyzing, evaluating, and decidingwhether resources should be allocated to aproject or not.

Process of capital budgeting ensure optimalallocation of resources and helpsmanagement work towards the goal ofshareholder wealth maximization.


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Significance of Capital Budgeting:

Considered to be the most important

decision that a corporate treasurer hasto make.

So much is the significance of capitalbudgeting that many business schoolsoffer a separate course on capitalbudgeting


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Why Capital Budgeting is soImportant?Involve massive investment of

resourcesAre not easily reversible

Have long-term implications for the

firmInvolve uncertainty and risk for thefirm


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Due to the above factors, capital budgeting decisionsbecome critical and must be evaluated very carefully.Any firm that does not follow the capital budgetingprocess will not be maximizing shareholder wealthandmanagement will not be acting in the best interestsof shareholders.RJR Nabiscos smokeless cigarette project exampleSimilarly, Euro-Disney, Concorde Plane, Saturn of GMall faced problems due to bad capital budgeting,while Intel became global leader due to sound capital

budgeting decisions in 1990s.


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Classification Of Projects

The Capital budgeting process may be less or more ,it depends onthe type of the projects :

NEW PROJECTS -- Ex: establishment of a paper manufacturing company

requires machinery to produce paper ,which mayrequire investment of some crores of rupees.

EXPANSION PROJECTS-- Ex: same company which is currently producing

20,000 tones of paper may increase its plant capacityby 10,000 tonnes per year.

DIVERSIFICATION PROJECTS-- Ex: Reliance ,marketer of textiles, entering into

petroleum business.


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REPLACEMENT & MODERNISATION PROJECTS - - Ex: A cement manufacturing concern is planning to go for

modernization where it is changing its drying process fromsemi-automatic to fully automatic drying equipment orreplacement of manually operated machinery by the fully

automatic machinery.

R & D PROJECTS -- Majority of the large firms are setting up their own R & D

departments.

MISCELLANEOUS PROJECTS Ex: Reliance ,marketer of textiles, entering into petroleum

business.


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Kinds Of Capital BudgetingACCEPT-REJECT DECISIONS --

Basic decision in making capital expenditure decisions.

Used for all independent projects.

MUTUALLY EXCLUSIVE INVESTMENTSProjects do not depend upon each other ,one can be acceptedand the other can be rejected.

Ex: a company has an option of buying a component from anoutside or manufacturing within the firm.(In this situation , thecompany may accept the most profitable decision, based on thepurchase price or manufacturing cost whichever is less)


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CAPITAL RATIONING DECISIONS--

Arises when a firm has unlimited funds & several profitableinvestment projects.

CONTINGENT INVESTMENTS--

Contingent projects are dependent investment, acceptance ofone option needs to understand one or more other projects

Ex: location of a factory in a backwards area, instead ofindustrial area or urban ,may need to construct roads, quartersfor employees ,hospitals, schools, without which it is verydifficult to attract employees.


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Process Of Capital Budgeting

IDEA GENERATION

EVALUATION or ANALYSISSELECTION

FINANCING THE SELECTED PROJECT

EXECUTION or IMPLEMENTATIONREVIEW OF THE PROJECT


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Techniques of Capital

Budgeting Analysis

Payback Period Approach

Discounted Payback Period ApproachNet Present Value Approach


Profitability Index


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WhichTechnique should we

follow?

A technique that helps us in selecting projectsthat are consistent with the principle ofshareholder wealth maximization.

A technique is considered consistent withwealth maximization if

It is based on cash flowsConsiders all the cash flows

Considers time value of money

Is unbiased in selecting projects


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Pay Back Period

Pay Back Period may be defined as that period required to

recover the original cash outflow invested in the project.

Pay Back Period can be calculated in two ways :

i. Using formula

Pay Back Period = Original Investment / Constant Cash Flow

After Taxes

ii. Using Cumulative cash flow method

PBP = Year before full recovery + (Unrecovered Amount of

Investment, Cash flows during the year)


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Decision Rule

Accept: Cal PBP < Standard PBP

Reject: Cal PBP > Standard PBP

Advantages of PBP

Very simple and easy to understand

Cost involvement in calculating PBP is much less when

compared to modern methods.


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Limitations of PBP

It ignores cash flows after pay back period.

It is not an appropriate method of measuring the profitability of a

project, as it does not consider all cash inflows yielded by the

investment. It does not take into consideration time value of money.

There is no rationale basis for setting a minimum pay back

period.

It is not consistent with the objective of maximisingshareholders wealth since share value does not depend on pay

back periods of investments projects.


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Accounting Rate of Return (ARR)

Accounting rate of return method uses accounting

information as revealed by financial statements, to measure the

profitability of the investment proposals. It is also known as the

Return on Investment (ROI).

It is calculated in two ways:

i. Whenever it is clearly mentioned as Accounting Rate of Return

Accounting Rate of Return(ARR)= Average Annual EAT or PAT100

Original Investment (OI)

OI= Original investment + additional NWC + Installation Charges +

Transportation Charge


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ii. Whenever it is clearly mentioned as Average Rate of Return

Average Rate of Return = Average Annual EAT 100

Average Investment (AI)

AI = (Original investment Scrap value)1/2+Additional NWC

+ Scrap Value

Decision Rule

Accept: Cal ARR > Predetermined ARR or Cut-off rate

Reject: Cal ARR < Predetermined ARR or Cut-off rate


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Advantages of ARR method

Very simple to understand and easy to calculate.

Information can easily can be drawn from accounting records.

It takes into account all profits of the projects life period.

Cost involvement in calculating ARR is much less is comparisionwith the modern methods, since it saves analysts time


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Limitations of ARR method

Accounting profits are inappropriate for evaluating and accepting

projects, Since they are computed based on arbitrary assumptions

and choices and also include non-cash items.

It ignores the concept of time value of money.

It does not allow the fact that the profits can be reinvested. It does not differentiate between the size of the investment

required for each project.

It does not take into consideration any benefits, which can accrue

to the firm from the sale of abundance of equipment, which isreplaced by the new investment.

It feels that 10% rate of return for 10 years is more beneficial

than 8% rate of return for 25 years.


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Discounted Payback Period

Similar to payback period approach with onedifference that it considers time value ofmoney

The amount of time needed to recover initialinvestment given the present value of cashinflows

Keep adding the discounted cash flows till thesum equals initial investment

All other drawbacks of the payback periodremains in this approach

Not consistent with wealth maximization


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Net Present Value Approach

NPV defined as preset value of benefits minuspreset value of costs

It may be positive or negative

Accept a project if NPV 0


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Steps involved in computation of

Net Present Value

Forecasting of cash inflow of the

project based on realistic assumptionscomputation of cost of capital

calculation of PV cash flows using cost

of capital as discounting rateFinding out NPV


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Advantages

It takes in to account the time value of money

It is particularly useful for the selection of mutually exclusive project

it is consistent with the objective of maximization of shareholderswealth

It takes into consideration the changing discount rate

Disadvantages

It is difficult to understand when compared with PBR and ARR

It does not give satisfactory result s when comparing two projects

with different life periodIn cash of project involving different cash outlays NPV method maynot give dependable results


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Internal rate of return may be definedas that discounting factor at which thepresent value of cash inflow is equal topresent value of cash outflows

Projects promised rate of return given

initial investment and cash flowsConsistent with wealth maximization

Accept a project if IRR Cost of Capital


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Advantages

It takes in to account the time value if money

It considers cash flows throughout the project life

It gives more psychological satisfaction to the user

It is consistent with the objective of shareholders wealthmaximization

Disadvantages

It is difficult to understand and to calculate since it involvestedious calculation

It implies that profits can be reinvested at internal rate ofreturn which is not logical

It produce multiple rate of return which can be confusing


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NPV versus IRR

Usually, NPV and IRR are consistent witheach other. If IRR says accept the project,

NPV will also say accept the projectIRR can be in conflict with NPV if

Investing or Financing Decisions

Projects are mutually exclusive

Projects differ in scale of investment Cash flow patterns of projects is different

If cash flows alternate in signproblem ofmultiple IRR

If IRR and NPV conflict, use NPV approach


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Profitability Index (PI)

PI is also known as discounted benefit costratio

PI measures the present value of future cashper rupee of investment

PI is the ratio which derived by dividingpresent value of cash inflow by present value

of cash outflows.PI=present vale of cash inflow /present valueof cash out flows


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Advantages

It gives due consideration to time value of money.

It considers all cash flows to determine PI.It will help to rank projects according to their PI.

It can also be used to choose mutually exclusive projects bycalculating the incremental benefit cost ratio.


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Evaluating Projects with

Unequal Lives

Replacement Chain Analysis

Equivalent Annual Cost MethodIf two machines are unequal in life, weneed to make adjustment beforecomputing NPV.


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Which technique is superior?

Although our decision should be based onNPV, but each technique contributes in itsown way.

Payback period is a rough measure ofriskiness. The longer the payback period,more risky a project is

IRR is a measure of safety margin in a

project. Higher IRR means more safetymargin in the projects estimated cash flows

PI is a measure of cost-benefit analysis. Howmuch NPV for every dollar of initial

investment


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Q) A Project costs rs. 20 lakhs and yields annually profit of Rs. 3

lakhs after depreciation at 12.5% but before tax at 50%. Calc PayBack Period & suggest whether it should be accepted or rejectedbased on 6-year standard pay back period.

Q) A company is considering expanding its production. It can go

either for an automatic machine costing Rs 2,24,000 with anestimated life of 5 years or an ordinary machine costing Rs60,000 having an estimated life of 8 years. The annual sales andcosts are estimated as follows:

Sales Auto machine Ordinary mach

1,50,000 1,50,000Costs:

Materials: 50,000 50,000

Labour: 12,000 60,000

Variable overHs: 24,000 20,000


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Risk analysis in capital budgeting

Project specific riskCompetitive risk

Industry specific risk

Market riskInternational risk

Sources of risk


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Three different perspectives

Standalone risk - It refers to the risk of a

project when it is viewed in isolation.

Firm risk It is the projects risk to thecorporation , that affects firms earnings.

Market risk It refers to the risk of a projectfrom the viewpoint of a diversified investor.

Perspectives of risk


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Thank You!

Documents

Capital Bud ..Updated Final