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The Basics of Capital Budgeting

Should we build this

plant?

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What is capital budgeting?Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the goal pf shareholders wealth maximization.

It involves the following actions, Analysis of potential additions to fixed assets.Long-term decisions; involve large expenditures.

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Importance of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial decision making,First of all, such decision affects the profitability of a firm because of the fact that they relate to fixed assets. The fixed assets are the true earning assets of the firm. They enable the firm to generate finished goods that can ultimately be sold for profit. Thus capital budgeting decisions determine the future destiny of a firm.

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Importance of Capital Budgeting

Secondly, capital expenditure decisions has its effect over long time span and inevitably affect the company's future cost structure. For example, if a particular plant has been purchased by a company to start a new product, the company commits itself to a sizable amount of fixed cost, in terms of labor, insurance, rent, salaries and so on. If the investment turn-out to be unsuccessful in future, the firm will have to bear the burden of fixed costs. In short, future costs, break-even point, sales and profits will all be determined by the selection assets.

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Importance of Capital Budgeting

Thirdly, Capital investment decisions, once made are not easily reversible without much financial loss to the firm because there may be no market for second hand plant and equipment and their conversion to other users may not be financially viable.

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Capital Budgeting Process & Its Types

Capital Budgeting process refers to the total process of generating, evaluating, selecting and following up on capital expenditure alternatives. There are 3 types of capital budgeting decisions,

Accept/Reject decisions The mutually exclusive choice decisions The capital rationing decisions

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Accept/Reject decisionsThis is the fundamental decision in capital budgeting. If the project is accepted, the firm would invest in it; if the proposal is rejected, the firm does not invest in it. In general, all those proposals which yield a rate of return greater than a certain required rate of return or cost of capital are accepted and the rest are the rejected. By applying this criterion, all independent projects are accepted.

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The Mutually Exclusive choice decisions

The Mutually Exclusive projects are those which competes with other project in such a way that the acceptance of one will exclude the acceptance of other projects. The alternatives are mutually exclusive and only one may be chosen. For example, a company is intending to buy a folding machine. There are 3 competing brands each with a different initial investment and operating costs. The 3 machines represent mutually exclusive alternatives and only one of these can be selected.

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The capital rationing decisionsIt is the financial situation in which a firm has only fixed amount to allocate among competing capital expenditure. The firm allocates funds to projects in a manner that it maximizes long term return. Thus capital rationing refers to a situation in which a firm has more acceptable investments than it can finance. It is concerned with selection of group of investment proposals out of many acceptable under the accept/reject decision. Capital rationing employs ranking of the acceptable investments projects.

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Steps to capital budgeting process1. Identification of potential investment

opportunities2. Assembling of investment proposals3. Decision Making4. Preparation of capital budget and

appropriations5. Implementation6. Performance Review

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Investment Criteria

Investment Criteria

Discounting Criteria Non-discounting Criteria

NPV Benefit Cost Ratio IRR Payback

Period ARR

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Net Present ValueThe NPV (Net Present value) of a project is the sum of the present values of all the cash flows-positive as well as negative- that are expected to occur over the life of the project. The general formula of NPV is:

Ct

NPV of Project = initial

investment (1+r)t

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Net Present Valuewhere, Ct = Cash flow at the end of the year tn= life of the projectr = Discount rate

Decision Rule:NPV > Zero = AcceptedNPV < Zero = Rejected

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Net Present Value

Year Cash Flow0 Taka(10,00,000)1 200,0002 200,0003 300,0004 3,00,0005 350,000If the cost of capital (r) = 10%. Calculate the NPV.

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Net Present Value 200,000 200000

NPV = 1000,000 - + + (1.10)1 (1.10)2

300,000 300,000 350000 + + (1.10)3 (1.10)4 (1.10)5

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Net Present Value: Different discount rate

Year Cash Flow0 Taka(12000)1 40002 50003 70004 60005 5000If the cost of capital (r) = 14%,15%,16%,18%, & 20% respectively. Calculate the NPV.

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Net Present Value: Different discount rate

PV of C1= 4000 / 1.14 = 3,509 PV of C2= 5000 / 1.14 x 1.15 = 3,814 PV of C3= 7000 / 1.14 x 1.15 x 1.16 = 4,603 PV of C4= 6000 / 1.14 x 1.15 x 1.16 x 1.18

=3,344 PV of C5= 5000 / 1.14 x 1.15 x 1.16 x 1.18 x

1.20 = 2,322NPV =3509+3814+4603+3344+2322 –

12,000= 5,592

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Benefit Cost RatioBenefit cost ratio = PVB / I

Where, PVB = Present value of BenefitsI = Initial Investment

Net Benefit Cost ration = BCR – 1Where,

BCR = Benefit cost ration

Decision Rule:When BCR or NBCR Rule

>1 >0 = Accepted< 1 < 0 = Rejected

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Benefit Cost RatioProblem: Let us consider a project which is being evaluated by a firm that has a cost of capital of 12%Initial Investment = Tk. 100,000Benefits Year 1 25,000Year 2 40,000Year 3 40,000Year 4 50,000

[1] Calculate the Benefit cost ratio[2] Calculate Net Benefit cost ratio

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Benefit Cost Ratio BCR = [25000/1.12 + 40000/(1.12)2+

40000/(1.12)3+ 50000/(1.12)4] / 100000= 1.145

NBCR = BCR – 1= 1.145 – 1= 0.145

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Internal Rate of Return (IRR)IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0Put differently, it is the discount rate which equates the present value of future cash flows with the initial investment.

n

0tt

t) IRR 1 (

CF 0

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Internal Rate of Return (IRR)In the NPV calculation we assume that the discount rate (cost of capital) is known and determine the NPV. In the IRR calculation, we set the NPV equal to Zero and determine the discount rate that satisfy this condition.

Decision ruleIf the IRR is > Cost of Capital = AcceptIf the IRR is < Cost of Capital = Rejected

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Internal Rate of Return (IRR)Problem:

year 0 1 23 4 Cash flow (100000) 30000 30000 40000 45000The IRR is the value of r which satisfies the following equations100,000 = 30000/(1+r)1 + 30000/(1+r)2 + 40000/(1+r)3 + 45000/(1+r)4 The calculation of r involves a process of Trial & Error method. We will try different values of r till we find the right hand side of the above equation is equal to left hand side.

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Internal Rate of Return (IRR)Let us, to begin with, Try “r” = 15% 30000/(1.15)1 + 30000/(1.15)2 +

40000/(1.15)3 + 45000/(1.15)4 =100,802This value is slightly higher than our initial investment[left hand side]. So we will increase the value of r from 15% to 16%. (a higher r lowers and smaller r increases the right hand side value)

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Internal Rate of Return (IRR)Try “r” = 16%

30000/(1.16)1 + 30000/(1.16)2 + 40000/(1.16)3 + 45000/(1.16)4 =98,641As the value is now less than 100,000, we may conclude that the value of “r” lies between 15% & 16%.If we need more refined estimate of “r”, then use the following procedure

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Internal Rate of Return (IRR)[1] determine the Net present value of the two closest rate of return(100802 – 100000) = 802(100000 – 98,641) = 1,359[2] Find the sum of the absolute values of the NPV obtained in step 1.(802+1359) = 2,161.[3] Calculate the ratio of the net present value of the smaller discount rate,

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Internal Rate of Return (IRR)

802/2161 = 0.37[4] Add the number obtained in step 3 to

the smaller discount rate15+0.37=15.37%.

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Pay Back PeriodPay back period is the length of time required to recover the initial cash outlay on the project.The number of years required to recover a project’s cost, or “How long does it take to get our money back?”For Example, if a project involves in cash outlay of Tk. 60000 and generate cash inflow of Tk. 100000,Tk. 150,000 Tk. 150,000 and Tk. 200000 in the 1st,2nd,3rd & 4th year respectively. Its pay back period will be 4 years.

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Pay Back PeriodBecause the sum of the cash inflows during 4 years is equal to the initial outlay. When the annual cash inflow is a constant sum the pay back period is simply the initial outlay divided by the annual cash inflow. For example, A project involves in a initial cash outlay of Tk. 1000,000 and a constant annual cash inflow of Tk. 300,000. Calculate the payback period.1000,000/300,000 = 3 1/3 years.

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Pay Back Period Strengths

Provides an indication of a project’s risk and liquidity.

Easy to calculate and understand. Weaknesses

Ignores the time value of money. Ignores CFs occurring after the payback

period. It is a measure of Project’s capital

recovery, not profitability.

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Accounting Rate of ReturnIt is also know as average rate of return.Can be defined as

Profit after Tax

Book value of the investment The numerator of this ratio may be

measured as the average annual post tax profit over the life of the investment.

The Denominator is the average book value of fixed assets committed to the project.

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Accounting Rate of ReturnAcceptance/Rejection CriteriaThe higher the accounting rate of return, the better the project.In general, project’s which have an accounting rate of return equal to or greater than a pre specified cut-off rate of return – which is usually between 10% to 30% are accepted;others are rejected.

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Accounting Rate of ReturnYear Book Value Profit

of fixed Asset after Tax

1 90,000 20,0002 80,000 22,0003 70,000 24,0004 60,000 26,0005 50,000 28,000

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Accounting Rate of Return

The Accounting rate of Return is(20,000+22,000+24,000+26,000+28,000)

5(90,000+80,000+70,000+60,000+50,000)

5

= 34%

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Problem: The expected cash flow of a project are as follows

Year Cash Flow0 Taka(100,000)1 20,0002 30,0003 40,0004 50,0005 30,000If the cost of capital (r) = 12%.

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Calculate the NPV. Benefit Cost ratio Net Benefit cost ratio Internal rate of Return Payback Period