Capital Budgeting Techiques

8/7/2019 Capital Budgeting Techiques

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Capital BudgetingCapital BudgetingTechniquesTechniques

Prof. Nidhi Bandaru


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Commitment of resources made in the hopeof getting benefits that are expected to occurover a reasonably long period of time intothe future.

Bierman & Smith

Investment for a long-term purpose

Irreversibility of Decisions

IntroductionIntroduction


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Capital Budgeting ProcessCapital Budgeting Process


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Mandatory investmentsReplacement projects / Investment in new

technologyDiversification projects

R & D projectsMiscellaneous projectsMarketing and AdvertisingChoices among different production processes

Expanding into new products, industries, ormarketsAcquisitions

Project ClassificationProject Classification


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Investment CriteriaInvestment Criteria


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It is simple to understand and easy tocalculate.

It facilitates to determine the liquidity andsolvency of the firm.

It enables the firm to select an investmentthat yields a quick return on cash funds.

It is used as a measure of rankingcompetitive projects.

It ensures the reduction of cost of capitalexpenditure.

Pay back periodPay back period


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If pay back period is less than themaximum pay back period which is set up bythe management, the project would beaccepted, on the contrary, it would berejected. Project which has a shorter periodwill be selected between the two.

Acceptance Rule of PBPAcceptance Rule of PBP


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It does not measure the profitability of aproject.

It does not consider income beyond the payback period.

It does not give proper weightage to timingof cash flows.

It does not consider cost of capital andinterest factors, which are very importantfactors in taking sound investmentdecisions.

Disadvantages of PBPDisadvantages of PBP


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Average Rate of Return / Return onInvestment

According to this technique all thoseprojects whose ARR is higher than theminimum rate of return established by themanagement and reject those projectsexpected to give a return below theminimum rate.

Accounting Rate of ReturnAccounting Rate of Return


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It considers all years involved in the life of aproject rather than only the pay backyears.

It is simple to use and understand.It applies accounting profit as a criteria of

measurement and not cash flow.

Advantages of ARRAdvantages of ARR


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It applies profit as a measure of yardstickand not cash flows.

The time value of money is ignored.Determining yearly profit may be a difficult

task sometimes.It does not consider the length of lives of the

project.

Disadvantages of ARRDisadvantages of ARR


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Excess Present Value/ Net Gain MethodAll cash inflows and outflows are converted

into PV by discountingNPV = PV of cash inflows - PV of cash

outflowsAcceptance rule:

PV of cash inflows >= PV of cash out flows(accept)

NPV is positive (accept) PV of cash inflows < PV of cash out flows (reject) NPV is negative (reject)

Net Present Value (NPV)Net Present Value (NPV)


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Scientific approach as it recognizes TVMAll cash flows spread out through the life of

the project are usedFacilitates comparison between projects

This method can be applied where cashflows are uneven

Advantages of NPVAdvantages of NPV


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Not easy to determine the discounting rateComparatively difficult than non-discounted

techniquesDifficult to forecast economic life of any

investment exactlyWhen the projects in consideration involve

different amounts of investment, the NPVmethod may not give satisfactory results

Disadvantages of NPVDisadvantages of NPV


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Time adjusted Rate of Return MethodIt I defined as that rate which equates the PV of

each cash inflows with the PV of cash outflowsof an investment

IRR is that discount rate at which NPV of theinvestment is zeroThe trail and error method needs to be

used to calculate IRRInterpolation:

IRR = lower interest rate + (NPV of LowerRate /NPV of lower rate NPV of higher rate)* (lower rate higher rate)

Internal Rate of ReturnInternal Rate of Return(IRR)(IRR)


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Accept the project when IRR>kReject the project when IRR


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Benefit Cost RatioGives the PV of future benefits, computed at

the required rate of return The ratio of the present value of the cash

flows to the initial outlays in profitabilityindex or benefit cost ratio. The profitability index = PV of cash inflows /

Initial Cash Outlays

Profitability Index (PI)Profitability Index (PI)


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Profitability Index > 1 (accept)Profitability Index < 1 (reject)Profitability Index = 1 (may accept)

Rules of Acceptance of PIRules of Acceptance of PI


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It duly recognizes the TVMFor calculations, when compared with IRR

method it requires less timeIt helps in ranking the project for investment

decisionsIt considers all cash flowsIt is consistent with the shareholders wealth

maximization objective.

Advantages of PIAdvantages of PI


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It is similar to NPV approachIt measures the present value of return per

rupee investedIt measures the PV of return per rupee

invested. Whereas NPV depends on thedifference between PV of NCF and PV of cash outflow.

Disadvantages of PIDisadvantages of PI


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How much to invest (capital decision)What are the recurring expenses (revenue

decision)Cost for day to day activities (Working

Capital decision)

Estimation of Project CashEstimation of Project Cashflowsflows


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Conventional project stream

Initial Investment

Operating Cash Inflows

Terminal Cash Inflows

Elements of Cash FlowElements of Cash FlowStreamStream


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Physical Life of the Plant

Technological Life of the Plant

Product Market life of the Plant

Investment Planning Horizon of the Firm

Time Horizon for AnalysisTime Horizon for Analysis


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Separation Principle

Incremental Principle

Post-tax Principle

Consistency Principle

Basic Principles of CFBasic Principles of CFEstimationEstimation


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Cash flows associated with investment sideand financing side should always beseparated.

Separation PrincipleSeparation Principle


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Operationally it means that interest of debtis ignored while computing profits andtaxes thereon.

If, interest is deducted for arriving at profitafter tax, an amount equal to interest (1-tax) should be added to PAT.

PBIT = (PBT + I) (1-Tax) =(PBT)(1-Tax) + Interest (1-Tax) = PAT + Interest (1-Tax)


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Cash flows should always be measured inincremental terms (dynamic approach)

Consider position of cash flows with andwithout the project

Consider all Incidental EffectsIgnore Sunk CostsInclude Opportunity Costs

Estimate Working Capital properly

Incremental PrincipleIncremental Principle


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Post-Tax Principle Cash flows should be measured on post tax

basis

Consistency Principle The cash flow of a project may be estimated

from the point of view of all investors or fromthe point of view of equity shareholders.

The discount rate must be consistent. Cash flow to all investors WACC Cash flow to equity Cost of Equity

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Capital Budgeting Techiques