Project Report on Evaluation of Capital Budgeting

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Submitted By:Itulung Kauring (13218)Junu Dhanawat (13217)Rajeev Taparia (13229)Rahul Abujam (13222)Raghav Bansal (13221)Sanjog Choudhary (13263)Project Report OnEvaluation of Capital Budgeting[Corporate Finance]Submitted for the partial completion of Bachelor in Management StudiesShaheed Sukhdev College of Business StudiesUniversity of Delhi

Submitted By:Itulung Kauring (13218)Junu Dhanawat (13217)Rajeev Taparia (13229)Rahul Abujam (13222)Raghav Bansal (13221)Sanjog Choudhary (13263)

Certificate

This is to certify that the project entitled Evaluation of Capital Budgeting, is submitted by Itulung Kauring(13218), Rahul Abujam(13222), Rajeev Taparia(13229), Junu Dhanawat(13217), Raghav Bansal(13221), Sanjog Choudhary(13263) of Third Semester during the Three Years Undergraduate Programme in Bachelor in Management Studies at Shaheed Sukhdev College of Business Studies, University of Delhi, under the supervision of Mr. Amit Kumar during the period of July 2014 to December 2014.They have successfully completed the project within the stipulated period of time.

Amit Kumar(Project Guide)

Declaration

We hereby declare that the work presented in the project report entitled Evaluation of Capital Budgeting, submitted for the partial fulfilment of Bachelor in Management Studies, is an authentic record of our own, carried out under the guidance of Mr. Amit Kumar, SSCBS, DU.

Itulung Kauring (13218)Date: 25/10/2014

Junu Dhanawat (13217)

Rajeev Taparia (13229)

Rahul Abujam (13222)

Raghav Bansal (13221)

Sanjog Choudhary (13263)

AcknowledgementFirst of all, we are very thankful to Shaheed Sukhdev College of Business Studies, University of Delhi for giving us an opportunity to work on this project.Through this project we have acquired invaluable knowledge about Evaluation of Capital Budgeting through online research study and various books.We express our sincere thanks to our project guide Mr. Amit Kumar, who had given us a thorough knowledge of Corporate Finance and guided us throughout the project.Any flaws found in this project is deeply regretted

Table of ContentsAbstract1Objective2Research methodology3Introduction4Capital budgeting principle5Important Concepts in Capital Budgeting6Capital Budgeting Process8Complexity of Capital Budgeting Process9Capital Budgeting Evaluation Methods10Understanding the Project Types10Net Present Value (NPV)11Internal Rate of Return11Payback Period11Profitability Index12Selection of method12Capital Budgeting Classification14Case Study: Evaluating the desirability of an investment16Conclusion18Bibliography19

Abstract

The term Capital Budgeting refers to long term planning for proposed capital outlay and their finance. It includes raising long-term funds and their utilization. It may be defined as a firm's formal process of acquisition and investment of capital. Capital budgeting may also be defined as "The decision making process by which a firm evaluates the purchase of major fixed assets". It involves firm's decision to invest its current funds for addition, disposition, modification and replacement of fixed assets. It deals exclusively with investment proposals, which is essentially long-term projects and is concerned with the allocation of firm's scarce financial resources among the available market opportunities.Some of the examples of Capital Expenditure areCost of acquisition of permanent assets as land and buildings.Cost of addition, expansion, improvement or alteration in the fixed assets.R&D project cost, etc.Capital budgeting is concerned with allocation of the firm's scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with immediate and subsequent streams of expenditure for it. In any growing concern, capital budgeting is more or less a continuous process and it is carried out by different functional areas of management such as production, marketing, engineering, financial management etc. all the relevant functional departments play a crucial role in the capital budgeting decision are considered.The role of a finance manager in the capital budgeting basically lies in the process of critical and in-depth analysis and evaluation of various alternative proposals, and then to select one out of them. As already stated, the basic objectives of financial management is to maximize the wealth of the shareholders, therefore the objectives of capital budgeting is to select those long term investment projects that are expected to make maximum contribution to the wealth of the shareholders in the long run.

Objective

To study the relevance of capital budgeting in an organization and its evaluation To study the technique of capital budgeting for decision making To understand an item wise study of the organization financial performance To know about an organizations operation of using various capital budgeting techniques To know how the organization gets funds from various resources

Research methodology

The research design of this study is descriptive in nature. This study is based on secondary data which was obtained from various sources online as mentioned in the bibliography of this project report. With the help of the secondary data we have studied about the detailed evaluation of capital budgeting, capital budgeting principle, capital budgeting process and capital budgeting classifications. We have also done cases study of capital budgeting, evaluating the desirability of an investment and discussed about the factors involved in decision making.

Introduction

In todays ever changing world, the only thing that does not change is change itself. Successful companies are always looking at ways in which they can change and develop. Change can trigger corporate growth and Growth is essential for sustaining the viability, dynamism and value enhancing capability of a company, which lead to a higher profit and better the shareholders value. To achieve the desired growth, the firm has to be competitive in all functional areas especially in financial management which is the back bone of any business. Primarily growth can be measured in terms of change in investments or sales. A progressive business firm continually needs to expand its fixed assets and other resources to be competitive in the race. Investment in fixed assets is an important indicator of corporate growth. The success of the corporate in the long run depends upon the effectiveness with which management makes capital expenditure decisions. The finance manager should ensure that he has explored and identified potentially lucrative investment opportunities and proposals and select the best one based on the opportunities identified.In dynamic business environment, making capital budgeting decisions are among the most important and multifaceted of all management decisions as it represents major commitments of companys resources and have serious consequences on the profitability and financial stability. Evaluation need to be done for the extent of financial stability achieved by the firms capital budgeting decisions over a period of time. In view of this, this study has made an attempt to know the efficiency of the corporate sectors capital budgeting decisions.

Capital budgeting principle

Capital budgeting is a complex process that involves careful analysis and calculation especially for large projects. There are some basic principles to take into consideration when performing capital budgeting.There are several key principles we need to follow: Decisions are based on cash flows. The decisions are not based on accounting concepts, such as net income. Furthermore, intangible costs and benefits are often ignored because, if they are real, they should result in cash flows at some other time. Timing of cash flows is crucial. Analysts make an extraordinary effort to detail precisely when cash flows occur. Cash flows are based on opportunity costs. What are the incremental cash flows that occur with an investment compared to what they would have been without the investment? Cash flows are analyzed on an after-tax basis. Taxes must be fully reflected in all capital budgeting decisions. Financing costs are ignored. This may be unrealistic. But it is not. Most of the time, analysts want to know the after-tax operating cash flows that result from a capital investment. Then, these after-tax cash flows and the investment outlays are discounted at the "required rate of return" to find the net present value (NPV). Financing costs are reflected in the required rate of return. If we included financing costs in the cash flows and in the discount rate, we would be double-counting the financing costs. So even though a project may be financed with some combination of debt and equity, we ignore these costs, focusing on the operating cash flows and capturing the costs of debt (and other capital) in the discount rate. The required rate of return is the discount rate that investors should require given the riskiness of the project. This discount rate is frequently called the "opportunity cost of funds" or the "cost of capital." If the company can invest elsewhere and earn a return of r, or if the company can repay its sources of capital and save a cost of r then it is the company's opportunity cost of funds. If the company cannot earn more than its opportunity cost of funds on an investment, it should not undertake that investment. Unless an investment earns more than the cost of funds from its suppliers of capital, the investment should not be undertaken. Capital budgeting cash flows are not accounting net income. Accounting net income is reduced by non-cash charges such as accounting depreciation. Furthermore, to reflect the cost of debt financing, interest expenses are also subtracted from accounting net income. Accounting net income also differs from economic income, which is the cash inflow plus the change in the market value of the company. Economic income does not subtract the cost of debt financing, and it is based on the changes in the market value of the company, not changes in its book value (accounting depreciation).

Important Concepts in Capital Budgeting

When performing capital budgeting, you need to know the following concepts: A sunk cost is one that has already been incurred. You cannot change a sunk cost. Today's decisions, on the other hand, should be based on current and future cash flows and should not be affected by prior, or sunk, costs. An opportunity cost is what a resource is worth in its next-best use. For example, if a company uses some idle property, what should it record as the investment outlay: the purchase price several years ago, the current market value, or nothing? If you replace an old machine with a new one, what is the opportunity cost? If you invest $10 million, what is the opportunity cost? The answers to these three questions are, respectively: the current market value, the cash' flows the old machine would generate, and $10 million (which you could invest elsewhere). An incremental cash flow is the cash flow that is realized because of a decision: the cash flow with a decision minus the cash flow without tb.at decision. If opportunity costs are correctly assessed, the incremental cash flows provide a sound basis for capital budgeting. An externality is the effect on other things besides the investment itself. Frequently, an investment affects the cash flows of other parts of the company, and these externalities can be positive or negative. If possible, these should be part of the investment decision. Sometimes externalities occur outside of the company. An investment might benefit (or harm) other companies or society at large, and yet the company is not compensated for these benefits (or charged for the costs). Cannibalization is one externality. Cannibalization occurs when an investment takes customers and sales away from another part of the company.

Capital Budgeting Process

Capital budgeting is the process that companies use for decision making on capital project. The capital project lasts for longer time, usually more than one year. As the project is usually large and has important impact on the long term success of the business, it is crucial for the business to make the right decision.The specific capital budgeting procedures that the manager uses depend on the manger's level in the organization and the complexities of the organization and the size of the projects. The typical steps in the capital budgeting process are as follows: Brainstorming: Investment ideas can come from anywhere, from the top or the bottom of the organization, from any department or functional area, or from outside the company. Generating good investment ideas to consider is the most important step in the process. Project analysis: This step involves gathering the information to forecast cash flows for each project and then evaluating the project's profitability. Capital budget planning: The Company must organize the profitable proposals into a coordinated whole that fits within the company's overall strategies, and it also must consider the projects' timing. Some projects that look good when considered in isolation may be undesirable strategically. Because of financial and real resource issues, the scheduling and prioritizing of projects is important. Performance monitoring: In a post-audit, actual results are compared to planned or predicted results, and any differences must be explained. For example, how do the revenues, expenses, and cash flows realized from an investment compare to the predictions? Post-auditing capital projects is important for several reasons. First, it helps monitor the forecasts and analysis that underlie the capital budgeting process. Systematic errors, such as overly optimistic forecasts, become apparent. Second, it helps improve business operations. If sales or costs are out of line, it will focus attention on bringing performance closer to expectations if at all possible. Finally, monitoring and post-auditing recent capital investments will produce concrete ideas for future investments. Managers can decide to invest more heavily in profitable areas and scale down or cancel investments in areas that are disappointing.Complexity of Capital Budgeting ProcessThe budgeting process needs the involvement of different departments in the business. Planning for capital investments can be very complex, often involving many persons inside and outside of the company. Information about marketing, science, engineering, regulation, taxation, finance, production, and behavioral issues must be systematically gathered and evaluated.The authority to make capital decisions depends on the size and complexity of the project. Lower-level managers may have discretion to make decisions that involve less than a given amount of money, or that do not exceed a given capital budget. Larger and more complex decisions are reserved for top management, and some are so significant that the company's board of directors ultimately has the decision-making authority. Like everything else, capital budgeting is a cost-benefit exercise. At the margin, the benefits from the improved decision making should exceed the costs of the capital budgeting efforts.

Capital Budgeting Evaluation Methods

When evaluating a project or long term investment of company, it is important to reach right decisions based on the capital budgeting methods. Analysts often use several important criteria to evaluate capital investments. The two most comprehensive measures of whether a project is profitable or unprofitable are the net present value (NPV) and internal rate of return (IRR). In addition to these, there are four other criteria that are frequently used: the payback period. The article gives instructions on each of the evaluation methods.Understanding the Project TypesOne of the key things in evaluating the project is to estimate the future cash flow of the projects, however, several types of project interactions make the future cash flow analysis challenging. The following are some of these interactions:

Independent versus mutually exclusive projects: Independent projects are projects whose cash flows are independent of each other. Mutually exclusive projects compete directly with each other. For example, if Projects A and B are mutually exclusive, you can choose A or B, but you cannot choose both. Sometimes there are several mutually exclusive projects, and you can choose only one from the group.Project sequencing. Many projects are sequenced through time, so that investing in a project creates the option to invest in future projects. For example, you might invest in a project today and then in one year invest in a second project if the financial results of the first project or new economic conditions are favorable. If the results of the first project or new economic conditions are not favorable, you do not invest in the second project.Unlimited funds versus capital rationing. -An unlimited funds environment assumes that the company can raise the funds it wants for all profitable projects simply by paying the required rate of return. Capital rationing exists when the company has a fixed amount of funds to invest If the company has more profitable projects than it has funds for, it must allocate the funds to achieve the maximum shareholder value subject to the funding constraints.Net Present Value (NPV)For a project with one investment outlay, made initially, the net present value (NPV) is the present value of the future after-tax cash flows minus the investment outlay.

Because the NPV is the amount by which the investor's wealth increases as a result of the investment, the decision rule for the NPV is as follows:

Invest if: NPV>0;Do not invest if NPV 1.0 should be accepted. Between two or more mutually exclusive projects having different costs, we must choose project with highest profitability index. Investment decisions based on profitability index will be same as decisions made using net present value. All projects having net present value have profitability index larger than 1.0 and therefore are acceptable.Selection of methodAll 3 methods (net present value, internal rate of return, profitability index) result in same accept-reject decision for given investment opportunity. There are three important circumstances under which methods may yield conflicting decisions:1. Choosing from among mutually exclusive investment projects with similar costs, but radically differing time patterns of cash inflows. Example: One project provides large cash flows in early years and small cash flows in later years compared with another project providing small cash flows in early years but large cash flows in later years. Project having highest net present value and profitability may have lowers internal rate of return. Choice of methods depends on which assumption is closest to reality. Choice should be based on which reinvestment rate is closest to rate that firm will be able to earn on cash flows generated by project. If cash flows can be reinvested at cost of capital, select project with higher net present value. If cash inflows can be reinvested at cost of capital, select project with higher net present value. If cash inflows can be reinvested at IRR of project, select project with higher IRR. General rule: NPV methods should be preferred if conflicts arises because projects with very high IRRs relative to firms cost of capital are rare. In most cases, reinvestment rate will be closer to cost of capital than to IRR and thus, NPV method is normally preferred to IRR method.2. Choosing from among mutually exclusive projects with widely differing costs. If project with highest NPV has lowest PI and IRR, in general, give preference to project with highest NPV since this will maximize value of firm. If project with highest PI and IRR is substantially less expensive than competing project, former is selected because low cost project may be perceived as less risky than higher cost project.3. Capital rationing where insufficient capital is available to accept all projects having positive NPVs. Rank order projects from highest IRR to lowest and select projects that firm has sufficient capital to accept. In general, NPV method preferred over IRR and PI methods.In practice uncertainty is often dealt with through simple mechanism of assigning higher discount rate to riskier projects. How much higher depends on managements perception of degree of risk and additional compensation required because of that risk.

Capital Budgeting Classification

Companies often put capital budgeting projects into some rough categories for analysis. One such classification would be: replacement projects, expansion projects, new product and service, Regulatory, safety, and environmental projects and others. The below is the details of each category: Replacement projects: These are among the easier capital budgeting decisions. If a piece of equipment breaks down or wears out, whether to replace it may not require careful analysis. If the expenditure is modest and if not investing has significant implications for production, operations, or sales, it would be a waste of resources to over-analyze the decision. Just make the replacement. Other replacement decisions involve replacing existing equipment with newer, more efficient equipment, or perhaps choosing one type of equipment over another. These replacement decisions are often amenable to very detailed analysis, and you might have a lot of confidence in the final decision. Expansion projects: Instead of merely maintaining a company's existing business activities, expansion projects increase the size of the business. These expansion decisions may involve more uncertainties than replacement decisions, and these decisions may be more carefully considered. New products and services: These investments expose the company to even more uncertainties than expansion projects. These decisions are more complex and will involve more people in the decision-making process. Regulatory, safety, and environmental projects: These projects are frequently required by a governmental agency, an insurance company, or some other external party. They may generate no revenue and might not be undertaken by a company maximizing its own private interests. Often, the company will accept the required investment and continue to operate. Occasionally, however, the cost of the project is sufficiently high that the company would do better to cease operating altogether or to shut down any part of the business that is related to the project. Other: The projects above are all susceptible to capital budgeting analysis, and tl1ey can be accepted or rejected using tl1e net present value (NPV) or some other criterion. Some projects escape such analysis. These are either pet projects of someone in the company (such as the CEO buying a new aircraft) or so risky that they are difficult to analyze by the usual methods (such as some research and development decisions).

Case Study: Evaluating the desirability of an investmentIn sum, the capital budgeting process is the tool by which a company administers its investment opportunities in additionalfixed assetsbyevaluating the cash inflows and outflowsof such opportunities. Once such opportunities have been identified or selected, management is then tasked with evaluating whether or not the project is desirable.Depending on the business, the competitive environment and industry forces, companies will certainly have some unique desirability criteria. As noted earlier, it's very crucial to remember that the capital budgeting process involves two sets of decisions, investment decisions and financial decisions; given the unique business and market environments that exist at the time, each decision may not initially be seen as worthwhile individually, but could be worthwhile if both were to be undertaken.Consider an example involving the coffee chain Starbucks. On Nov. 14, 2012, Starbucks announced its intent to acquire Teavana, a high-end specialty retailer of tea, for $620 million. The offer price for Teavana represented a 50% premium over the then market value of Teavana. Based on the acquisition price, Starbucks would paying over 36 times earnings for Teavana. Looking at this capital investment today, one can suggest that the financial decision paying $620 million for a company that generated $167 and $18 million in sales and profits in 2011 was not a desirable one for Starbucks. On the other hand, from an investment perspective, Starbucks is paying $620 million for ownership of a fast-growing, leading tea retailer. Teavana gives Starbucks direct access to the fast-growing underpenetrated tea market. In addition, Teavana instantly gives Starbucks approximately 200 high-traffic retail locations and, more importantly, a very visible, high-quality tea brand to complement its coffee offerings. Had Starbucks merely evaluated Teavana from a purely financial perspective, the decision would have ignored that highly-valuable benefit of combining the most well-known coffee brand with the highest-quality tea brand.Generally speaking however, businesses will consider the following questions when evaluating whether or not a project is desirable and should be pursued.

What Will the Project Cost?This is the first and most basic question a company must answer before pursuing a project. Identifying the cost, which includes the actual purchase price of the assets along with any future investment costs, determines whether or not the business can afford to take on such a project.How Long Will It Take to Re-coup the Investment?Once the costs have been identified, management must determine the cash return on that investment. An affordable project that has little chance of recouping the initial investment, in a reasonable period of time, would likely be rejected unless there were some unique strategic decisions involved. For Starbucks, it is counting on the fact that when Teavana's brand is matched with Starbucks vast distribution network, the rapid growth in sales of tea and tea related projects will deliver tremendous cash flows to Starbucks. Of course, there is no guarantee that management's forecast will prove accurate or correct; nevertheless, forecasting future cash inflows and outflows are a vital exercise in the capital budgeting process.Mutually Exclusive or Independent? All investment projects are considered to be mutually exclusive or independent. An independent project is one where the decision to accept or reject the project has no effect on any other projects being considered by the company. The cash flows of an independent project have no effect on the cash flows of other projects or divisions of the business. For example the decision to replace a company's computer system would be considered independent of a decision to build a new factory. A mutually-exclusive project is one where acceptance of such a project will have an effect on the acceptance of another project. In mutually exclusive projects, the cash flows of one project can have an impact on the cash flows of another. Most business investment decisions fall into this category. Starbucks decision to buy Teavana will most certainly have a profound effect on the future cash flows of the coffee business as well as influence the decision making process of other future projects undertaken by Starbucks.

Conclusion

Capital budgeting decision involves the exchange of current funds for the benefit to be achieved in future. The future benefits are expected and are to be realized over a series of years. The funds are invested in non-flexible long-term funds. They have a long term and significant effect on the profitability of the concern. They involve huge funds. They are irreversible decisions. They are strategic decision associated with high degree of risk.Through this project we can conclude the importance of capital budgeting as follows: Capital budgeting decision, generally involves large investment of funds. But the funds available with the firm are scarce and the demand for funds for exceeds resources. Hence, it is very important for a firm to plan and control its capital expenditure. Capital expenditure involves not only large amount of funds but also funds for long-term or a permanent basis. The long-term commitment of funds increases the financial risk involved in the investment decision. The capital expenditure decisions are of irreversible nature. Once, the decision for acquiring a permanent asset is taken, it becomes very difficult to impose of these assets without incurring heavy losses. Capital budgeting decision has a long term and significant effect on the profitability of a concern. Not only the present earnings of the firm are affected by the investment in capital assets but also the future growth and profitability of the firm depends up to the investment decision taken today. Capital budgeting decision has utmost has importance to avoid over or under investment in fixed assets. The long-term investment decision are difficult to be taken because uncertainties of future and higher degree of risk. Investment decision though taken by individual concern is of national importance because it determines employment, economic activities and economic growth.

Bibliography

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