Capital budgeting
Introduction;
The efficient
allocation of capital is the most important finance function in the modern
times. it involves the decision to convert the small current funds into
long term benefits. Such decisions are of considerable importance to the firm.
since they tend to determine its value and size by influencing its growth,
profitability and risk.
NATURE:
Investment decisions of a
firm is generally known as the “capital budgeting” or “capital
expenditure decisions”. Capital budgeting is also known as investment
appraisal. A capital budgeting decisions may be defined as the firms decision
to invest its current funds most effectively in long term assets in
anticipation of an expected flow of benefits over a series of years. Long term
assets are those which effects the firms operations beyond one year
periods.
The firm’s investment decisions generally include the
following.
Expansion: a firm
may have to expand its production capacity on account of high demand for its
products and inadequate production capacity. this will need an additional
capital investment.
Diversification:
a firm may be interested in diversifying existing line of activity to reduce
risk by operating in several markets rather than in a single market. In such an
event, long term investment may become necessary for purchase of new machinery
and facilities.
Replacement and
modernization: replacement of fixed assets may become necessary on account
of there being worn-out or becoming outdated on account of new technology.
Research and
development: A huge amount may have to be expended for research and
development in case of those industries where technology is rapidly changing.
Miscellaneous: A
firm may have to invest money in projects which do not directly help in
achieving profit oriented goals. For ex:
installation of pollution control equipment may be necessary on account of
legal requirements.
Features of investment decisions:
1)
The
exchange of current funds for future benefits.
2)
The
funds are invested in long term assets.
3)
The
future benefits will occur to the firm over a series of years.
It is significant
to emphasize that expenditures and benefits of an investments should be
measured In cash. In the investment analysis, it is cash flow which is important
not the accounting profit. it may also be pointed out that investment decisions
affect the firms value. The firms value will increase if investments are
profitable and to the shareholders wealth. Thus investments should be evaluated
on the basis of criterion which is compatable with the objective of
shareholders wealth maximisation. An investment will add to the shareholders
wealth if it yields benefits in excess of the minimum benefits as per the
oppurtunity cost of capital.
Importance of investment decisions
Investment
decisions require special attention
because of the following reasons:
Growth: Firms decision to invest in long term assets has a decisive influence on
the rate and direction of its growth. Awrong decision can prove disasters for
the continue survival of the firm and unwanted expansion of assets will result
in heavy operationg costs.
Risk: Long term commitments of funds may also change the risk complexion of the
firm. In adoption of an investment increases average gain, but causes frequent
fluctuations in earnings, the firm will become more risky.
Funding: Investment decisions generally involve larger amount of funds which make
it imperative for the firm to plan its investment programs very carefully and
make advance arrangement for preparing finance internally and externally.
Irreversibility: Most of the investment decisions are irreversible.
It is difficult to find a market of such capital items once there has been
acquired. The firm will incur heavy losses if such assets are scraped.
Complexity: Investment decisions are among the firms most
difficult decisions. They are an assessment of future events which are
difficult to predict. It is really a complex problem to correctly estimate
future cash flows due to economic, social, political and technological factors.
Types of Capital
Budgeting:
Independent Projects;
These are the projects which do not
compete with one another depending upon the profitability of the project and
availability of funds. The company can undertake any number of projects
Mutually Exclusive
project : In case of this project acceptance of one project automatically
rejects the other project. Example If there are two alternative projects A and
B either A or B should be accepted
Contingent Projects
: These are dependent projects acceptance of one project depends upon
acceptance of one or more other projects For example Investment in machinery is
dependent upon expansion of plant or replacement of old machinery.
Capital Budgeting
Decision making Process:
Project Generation
;A project is an investment proposal. The first step in capital Budgeting
making process is idea generation. Idea generation means identifying the
potential areas where investments can be made
Developing the alternatives;
Next step is developing the alternative investment proposal for example if an
organization wants to replace the existing machineries it has two alternatives
either it can purchase ordinary machinery or automatic machinery.
Evolution of alternatives:
Next crucial stage it to estimate the cash outflows required for proposed
investment and expected benefits over a period of time for each alternative.
The problem with estimation of cash outflows is about certainty and
uncertainty. The outflows required for an investment proposal can be estimated
more or less accurately. After estimating cash flows evaluation techniques are
applied to study the relative profitability of the alternatives.
Selection of the projects; the next step it to select the
alternatives by comparing the costs and benefits involved in each alternative.
Implementation:
The next and crucial stage is immediate implementation of the selected
proposal. Undue delays result in cost escalation. So that profitability project
may turn out to be less profitable or unprofitable.
Performance review:
a continous monitoring of performance after the implementation of the project
is imperative. So that expected and actual operating results are compared.
These helps in taking corrective action against responsible persons.
Methods of capital
budgeting;
There are two
methods by which an investment opportunity or project can be evaluated. They
are
1. Traditional method:
a. Pay-back period
b. Average rate of return
2. Discounted cash flow techniques:
a. Net present value
b. Profitability index
c. Internal rate of return
Payback period:
”It
indicates the period within which the cost of the project will be completely
recovered. In the other words, it indicates the period within which the total
cash inflows equal to the total cash outflows.”
“The length of time
required to recover the cost of an investment.”
It is defined
as no. of years required to recover the initial investment.
It is perhaps the simplest method of looking at one or more
investment projects or ideas. It focuses on receiving the cost of investments.
It represents the amount of time that it takes for a capital budgeting project
to recover its initial cost.
For example, if a project cost $100,000 and
was expected to return $20,000 annually, the payback period would be
$100,000 / $20,000, or five years.
Formula :
The
cost of project or investment
Payback period
=
--------------------------------------
Annual cash inflows
Decision criteria:
in case of
independent projects the calculated pay back period should be compared with
standard set by company. If the calculated payback period is less than the
standard pay back period the project will be accepted otherwise rejected.
In case of mutually exclusive projects calculated payback
period of alternatives are compared and the project which has lowest pay back
period is accepted.
Merits :
Easy to compute ,
Easy to understand.
Simple to understand
It makes quite clear that there is no profit unless pay back
period is over.
It costs less.
It helps to evaluate the projects which is uncertain
Demerits :
It ignores any benefits that occur after the payback period,
and so does not measure total incomes.
It ignores time value of money.
It ignores inflation.
Shorter payback
periods are obviously preferable to longer payback periods.
Conclusion: Because of these
reasons, other methods of capital budgeting like net present value, internal
rate of return or discounted cash flow are generally preferred
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Average
rate of return (ARR)
.
The
ratio of the average cash inflow to the amount invested.
This method is also known as accounting rate of return. As
average of the net profit after taxes over the whole of the economic life of
the projects are taken. Under this method returns is expressed as percentage of
capital. It is
based on the concept of rate of return
Formula:
Average profit after depreciation and taxes / average
investments in the project.
Procedure for
calculating ARR;
Step 1: average
investment or average outflow
Initial asset cost+installation exp-salvage value/2+salvage
value+ additional working capital.
Step 2; average profit=opening PADT+closing PADT/2
Step 3: ARR=
step1/step2*100
Decision criteria:
In case of independent projects, calculated ARR should be
compared with standard ARR. If it is more calculated accept otherwise reject.
In case of mutually exclusive project, both projects should
be compared and highest ARR should be accepted.
In case of capital rationing, project with highest ARR
should be ranked first.
Merits:
It is simple to calculate and easy to understand
It uses entire earnings of the project in calculating ARR
It can be calculated from the accounting data
Demerits:
It ignores time value of money
It ignores the timing of returns
It does not take into consideration cash inflows
It is not suitable for investments in parts
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Discounted cash
flow techniques or modern techniques
Net present value
{NPV}
This method is generally considered to be modern and the
latest method for calculating capital budgeting proposals.
It can be defined as excess of present value of cash inflows
over the present value of cash outflows. It takes into consideration time value
of money and attempts to calculate the return on investments by introducing the
factors of time element.
Procedure for
calculating NPV
Step 1:
calculating present value of cash outflows
Year outflow pvf@10%etc pv of
outflow
Total
pv of outflows=
Step 2: calculating
present value of cash inflows
Year inflows pvf@-%
pv of inflows
Total pv of inflows=
Step 3: calculating
NPV
NPV=step 2
– step 1
Decision criteria:
For individual projects Accept positive NPV and reject
negative NPV
In mutually exclusive projects, two projects are compared
and highest NPV is selected
In capital rationing the project having maximum positive NPV
will be ranked first.
Merits:
It considers time value of money
It considers cash inflows from the project throughout its
life
It takes into consideration the objective of wealth
maximization to the shareholders
Demerits:
It is difficult to use, calculate and understand
It presupposes that the discounting ratio that is cost of
capital is known. But cost of capital is difficult to measure in practice.
It may give dissatisfactory results with unequal investments
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Profitability index:
It is a ratio between total discounted cash inflows and
total discounted cash outflows. It is also known as benefit cost ratio method. It measures the relationship between
present value of cash inflows and present value of cash outflows
Formula: Present
value of cash inflows/present value of cash outflows
Decision criteria:
The proposal is accepted if PI is more than 1 and rejected
in case of it is less than 1. In case of mutual exclusive projects and capital
rationing situation projects are ranked in order of their PI and accepted.
MERITS
This method is slightly modification of NPV. NPV is an
absolute measure where as PI is an relative method used to judge profitability
of project
The other advantages and disadvantages are same as NPV. The
only difference is PI can be used to rank the projects even in case of projects
with different size which is not possible in case of NPV method.
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Internal rate of
return {IRR}
IRR is the rate at which the discounted cash inflows match
with discounted cash outflows the indication given by IRR is that this is the
maximum rate at which the company will be able to pay towards the interest on
the amounts borrowed for investing in the projects with out losing any thing.
Thus, IRR may also be called as break
even rate of borrowing for the company. In simple words IRR indicates that
discounting rate at which NPV is 0.
Procedure for
calculating IRR
Step 1: calculate present value of outflow
Step 2; calculate
present value of inflows
Step 3; calculate
NPV
Note: if calculated NPV is positive, select higher rate of
return
if
calculated NPV is negative, select lower rate of return
Step 4: calculate
present value of outflow at selected rate
Step 5; calculate
present value of inflows at selected rate
Step 6; calculate
NPV
Step 7; calculate
IRR
Lower rate of return + pv value of inflows at l.r.- pv of
outflows/pv of inflows at l.r-pv of inflows at h.r*{HR-LR}
Decision criteria:
If calculated IRR is greater than cost of capital, accept
the project
If calculated IRR is less than cost of capital, reject the
project.
In mutually exclusive compare and take highest IRR
Merits;
It takes into account time value of money
It considers profitability of projects for entire economic
life
It provides uniform ranking
It is more reliable in case of wealth maximization
Demerits;
It is difficult to use, calculate and understand
The results may differ when projects differ in size, life
and timing of cash flows
It pre assumes that the cash inflows can be reinvested
immediately to yield the return equivalent to the cost of capital. Same with
NPV also.
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