CAPITAL BUDGETING | CAP CLASSES

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Hi Friends !!!

Good Evening. Today we are going to discuss the most important topic “Capital Budgeting”. If you are a student of accountancy and finance, it is impossible to you to complete your course without swimming through capital budgeting. Whatever course you are in, whatever curriculum you study, if you assign ranking to topics in financial management, Capital Budgeting will occupy place 1, without any doubt.

As all of you are aware of, the financial management is the process of three decisions.

1. Financing Decisions (Capital structure  decisions)
2. Investment Decisions (Capital budgeting decisions)
3. Dividend Decisions (Dividend policies)

Capital Budgeting decisions are also known as long term investment decisions. Capital Budgeting involves the Process of:

1. Decision making with regard to investment in Fixed Assets (Capital Projects) & Long-Term Projects; or
2. Evaluation of Expenditures Decisions, which involve current outlays/outflows but are likely to produce benefits over a longer period of time; or
3. Forecast of likely or Expected Returns from a new investment project and to determine whether returns are adequate.
4. However, Capital Budgeting excludes certain investment decisions, wherein, the benefits of investment proposals cannot be directly quantified.

TECHNIQUES OF CAPITAL BUDGETING

• Techniques of Capital Budgeting refer to the criteria used to evaluate the project.
• Some of the techniques of Capital Budgeting assuming that the proposed investment project does not involve any risk are:

 

ACCOUNTING  RATE OF RETURN

1)    Accounting Rate of Return is also known as average rate of return, annual rate of return.

2)    Accounting or Average Rate of Return (ARR) means the average annual yield on the project. It is found out by dividing the annual average profits after taxes by the average investments.

3)    ARR can be calculated in three ways as given below.

a)    Based on Initial Investment

b)    Based on Net Investment

c)    Based on Average Investment

Merits and Demerits of ARR Techniques:

The Merits and Demerits of ARR technique are as follows:

Merits	Demerits
It is easy to understand and calculate	It ignores the time value of money
It considers the entire profits over the entire life of the projects	It does not use the cash flows
It uses the accounting data with which managers are familiar	There is no objective way to determine the Minimum Acceptable Rate of Return

PAY BACK PERIOD

Meaning:

1. Payback period refers to the period within which the entire cost of the project is expected to be completely recovered by way of cash inflows.
2. It is the period within which the total cash inflows from the project equals the cost of investment in the project
3. The lower the payback period, the better it is, since initial investment is recouped faster.
4. Cash Inflow means Earnings after Tax but before Depreciation.

 Computation:

a)    In case of Equal Annual Cash Inflows        

PBP	=	Initial Investment
		Annual CFAT

b)   In case of Unequal Annual Cash Inflows

Payback period is calculated by computing cumulative cash inflows till the Cumulative Cash Inflows become equal to Initial Cash Outflow.

Pay Back Period =

PBP	=	LP	+	Investment - CCFATLP		X (HP - LP)
				CFATHP

Merits and Demerits

The merit and demerits of Payback Period are as follows:

Merits	Demerits
It is easy to understand and calculate	It ignores the time value of money
It emphasizes liquidity by stressing earlier cash inflows	It ignores the cash flows occurring after the payback period
It uses the cash flows rather than accounting data	There is no objective way to determine the maximum acceptable payback period
It enables the management to cope with the risk associated with the project by having a shorter payback period	It is not a measure of profitability since the cash flows occurring after the payback period are ignored
The reciprocal of the payback is a close approximation of the internal rate of return if the life of the project is atleast twice the payback period and the project generates equal annual cash inflows	It does not necessarily maximize the wealth of the shareholders

DISCOUNTED PAYBACK PERIOD

Meaning:

Discounted Payback Period refers to the period within which the entire cost of the project is expected to be completely recovered by way of discounted cash inflows. Cash inflow means earnings after tax but before depreciation. Discounted Cash inflow means present value of cash inflows using cost of capital as discount rate.

Computation:

Discounted payback period is calculated by computing cumulative discounted cash inflows till the cumulative discounted cash inflows become equal to the present value of Cash Outflows.

Step 1:	Calculate Cash Inflows after Tax (CFAT)
Step 2:	Calculate Cash Outflows
Step 3:	Calculate Present Value of all Cash Inflows (CFAT)
Step 4:	Calculate Present Value of all Cash Outflows
Step 5:	Calculate Cumulative CFAT
Step 6:	Calculate discounted Payback Period as follows:

Discounted Pay Back Period =

PBP	=	LP	+	Investment - CDCFATLP		X (HP - LP)
				DCFATHP

Merits and Demerits

Merits	Demerits
It is easy to understand and calculate	It ignores the cash flows occurring after the payback period
It emphasizes liquidity by stressing earlier cash inflows	There is no objective way to determine the maximum acceptable payback period
It uses the cash flows rather than accounting data	It is not a measure of profitability since the cash flows occurring after the payback period are ignored
It enables the management to cope with the risk associated with the project by having a shorter payback period	It does not necessarily maximize the wealth of the shareholders
The reciprocal of the payback is a close approximation of the internal rate of return if the life of the project is at least twice the payback period and the project generates equal annual cash inflows

PROFITABLE INDEX / DESIRABILITY FACTOR / PRESENT VALUE INDEX METHOD

Ø  Profitability Index/Desirability Factor technique is one of the discounted cash flow techniques, which takes into account the Time Value of Money.

Ø  Profitability index/Desirability Factor refers to the Ratio of the Present Value of all Cash Inflows to the Present Value of all Cash Outflows associated with the project.

Ø  The present value is ascertained using the firm’s Cost of Capital as the Discount Rate.

Computation

Step 1:	Calculate all the Cash Outflows associated with the Project
Step 2:	Calculate all the Cash Inflows associated with the Project
Step 3:	Calculate the Present Value of all cash Outflows associated with the project.
Step 4:	Calculate the present value of all cash inflows associated with the project.
Step 5:	Calculate Profitability Index/Desirability Factor as follows

Merits and Demerits

Merits	Demerits
It considers the time value of money	It requires the estimation of cash inflows and cash outflows, which is a difficult task.
It considers entire cash flows over entire life of the project	It requires the computation of the cost of capital to be used as discount rate
It is a relative measure of profitability since the ratio of cash inflows to cash outflows is considered	It may not provide satisfactory results in case of – a.    Projects involving different amounts of cash outflows b.    Projects having different lives c.    Projects involving different amounts of cash outflows and having different lives
It guides in resolving capital rationing where projects are divisible	The ranking of projects depends upon the discount rate
It guides the selection of Mutually Exclusive Projects having same Net Present Value	It ignores the difference in initial cash outflows, size of different projects, etc., while evaluating mutually exclusive projects
	it fails to guide in resolving capital rationing where projects are indivisible
	It ignores the absolute amount of NPV while taking decision. A project having lower PI but higher absolute NPV may be rejected although it increases the shareholder’s wealth
	It is not consistent with the objective of maximizing the wealth of owners since PI may not be interpreted as immediate increase in firm’s wealth if the project is accepted

NET PRESENT VALUE

Net Present Value technique is one of the discounted cash flow techniques which takes into account the time value of money.

·      It refers to difference between the present value of cash inflows and the present value of the cash outflows.

·       PV is ascertained using the Firm’s overall Cost of Capital as the Discount Rate.

Computation

Step 1:	Calculate all the cash outflows associated with the project.
Step 2:	Calculate all the cash Inflows associated with the project
Step 3:	Calculate the Present Value of all cash Outflows associated with the project
Step 4:	Calculate the Present Value of all cash Inflows associated with the project
Step 5:	Calculate Net Present Value as follows: Net Present Value = Present Value of all Cash Inflows – Present Value of all cash Outflows

Acceptance Rule:

If	Decision
NPV > 0	Accept the Project.  Surplus over and above the cut-off rate is obtained
NPV = 0	Project generates cash flows at a rate just equal to the Cost of Capital.  Hence, it may be accepted or rejected.  This constitutes an Indifference point.
NPV < 0	Reject the Project. The Project does not provide returns even equivalent to the cut–off rate.

Merits and Demerits

Merits	Demerits
It considers the time value of money.	It requires the estimation of cash Inflows and cash outflows, which is a difficult task.
It considers entire cash flows over entire life of the project.	It requires the computation of the cost of capital to be used as discount rate.
It is consistent with the objective of maximizing the wealth of owners since NPV may be interpreted as an immediate increase in firm’s wealth if the project is accepted.	It may not provide satisfactory results in case of – a.     Projects involving different amounts of cash outflows. b.     Projects having different lives. c.     Both (a) & (b)
It is measure of profitability since entire cash flows over entire life of the project are considered.	The ranking of projects depends upon the discount rate.
	It is an absolute measure. It ignores the difference in initial cash outflows, size of different projects, etc. while evaluating mutually exclusive projects

INTERNAL RATE OF RETURN

Meaning:  

·       Internal rate of return (IRR) is the rate at which the sum total of discounted cash inflows  equals the discounted cash outflows.

·      The internal rate of return of a project is the discount rate, which makes net presen       t value of the project equal to zero.

·      The Discounted Rate i.e. Cost of Capital is assumed to be known in the determination of net present value.

·       While in the Internal Rate of Return calculation, the Net Present Value is set equal to zero and the discount rate, which satisfies this condition, is determined.

     Interpretation:

     Internal rate of retune can be interpreted in two ways:

·       IRR represents the Rate to return on the unrecovered investment balance in the project.

·       IRR is the Rate of Return earned on the initial investments made in the project.

     Of these, the first view seems to be more realistic, since it may not always be possible for an enterprise to reinvest intermediate cash flows at a rate equal to the IRR.

Acceptance Rule:

If	Decision
IRR > Ko	Accept the Project.  Surplus over and above the cut-off rate is obtained
IRR = Ko	Project generates cash flows at a rate just equal to the Cost of Capital.  Hence, it may be accepted or rejected.  This constitutes an Indifference Point.
IRR < Ko	Reject the Project. The Project does not provide returns even equivalent to the cut-off rate

Procedure for computation of IRR:

Step 1	Calculate NPV at a given rate say 10%
Step 2	Calculate NPV at  an alternate  rate. Ensure that if one NPV is positive, the other one must be negative. This is because “0” NPV lies between a positive and a negative NPV.
Step 3	Apply the formula given below. (interpolation)

IRR	=	LR	+	NPVLR		X (HR - LR)
				NPVLR - NPVHR

Merits and Demerits

Merits	Demerits
Ø  Time value of money is taken into account	It is tedious to compute in case of multiple cash outflows. Multiple IRR’s may result, leading to difficulty in interpretation.
Ø  All cash inflows of the project arising at different points of time are considered.	It may conflict with NPV in case inflow/ outflow patterns are different in alternative proposals.
Ø  Decisions are immediately taken by comparing IRR with the Cost of Capital.	The presumption that all the future cash flows of a proposal are reinvested at a rate equal to the IRR may not be practically valid.
Ø  It helps in achieving the basic objective of maximizations of shareholders Wealth

CONFLICTS BETWEEN NPV, PI & IRR

All the three techniques viz. NPV, PI and IRR use the time value of money, But there are some conflicts among them.

NPV versus PI:

·         The Discount Rates used in NPV and PI methods are the same. Hence for a given project NPV and PI method give the same result, i.e. accept or Reject.

·         However if we have to select one project out of two mutually excusive projects, the NPV method should be preferred.

·         This is because the NPV indicates the economic contribution or surplus of the project in absolute terms. The higher the NPV, the better it is. 

NPV versus IRR:

Ø  Higher the NPV, higher will be the IRR However, NPV and IRR may give conflicting results in certain cases particularly when:

ü  Cash Outflows arise at different points of time, rather than as Initial Investment only.

ü  There is a huge difference between initial CFAT and later years CFAT.

Ø  A project with heavy initial CFAT than compared to later years will have higher IRR and vice-versa.

Ø  The NPV method considers the timing differences at the appropriate discount rate.

Ø  The presumption in IRR is that intermediate cash inflows will be reinvested at that rate (IRR);

Ø  Where as in the case of NPV method; intermediate cash inflows are presumed to be reinvested at the cut-off rate.

Ø  The latter presumption viz. Reinvestment at the Cut-off Rate is more realistic than reinvestment at IRR.

Ø  Hence in case of conflicting decisions based on NPV and IRR, the NPV method must prevail.

LIFE DISPARITY

It means projects having unequal lives.

Conflict Resolution:

Equated Annual Benefit Method (EAB)

EAB represents the annuity which is desired in order to get the original NPV.

EAB = NPV / PVAF(n,r)

CAPITAL RATIONING

Ø  When the most important resource in investment decisions i.e funds, are not fully available, it is said to be a Resource Constraint situation.

Ø  Generally, firms fix up maximum amount that can be invested in capital project, during a given period of time, say a year.

Return Maximisation:

Ø  In case of restricted availability of funds, the objective of the firm is to maximise the wealth of shareholders with the available funds.

Ø  Such investment planning is called Capital Rationing.

Classification of Investment Proposals: 

For Capital Rationing purposes, the investment proposals are classified as under.

DECISION MAKING BASED ON VARIOUS TECHNIQUES