CAPITAL BUDGETING

CAPITAL EXPENDITURES AND THEIR IMPORTANCE The basic characteristics of a capital expenditure (also referred to as a capital investment or just project) is that it involves a current outlay (or current and future outlays) of funds in the expectation of receiving a stream of benefits in future Importance stems from Long-term consequences Substantial outlays Difficulty in reversing

CAPITAL BUDGETING PROCESS Identification of Potential Investment Opportunities Assembling of Investment Proposals Decision Making Preparation of Capital Budget and Appropriations Implementation Performance Review

PROJECT CLASSIFICATION Mandatory Investments Replacement Projects Expansion Projects Diversification Projects Research and Development Projects Miscellaneous Projects

Techniques of Capital Budgeting Traditional Payback Period Accounting or Average Rate of Return Modern Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR)

The Payback Period Method How long does it take the project to “pay back” its initial investment? Payback Period = number of years to recover initial costs Minimum Acceptance Criteria: – Set by management Ranking Criteria: – Set by management

The Payback Period Method Advantages: – Easy to understand and calculate – Emphasizes earlier cash inflows Disadvantages: – Ignores the time value of money – Ignores cash flows after the payback period

PAYBACK PERIOD Saurabh Inc’s Capital Project YearCash flowCumulative cash flow

Accounting or Average Rate of Return Ranking Criteria and Minimum Acceptance Criteria set by management

Average Accounting Return Advantages: – The accounting information is usually available – Easy to calculate Disadvantages: – Ignores the time value of money – Uses an arbitrary benchmark cutoff rate – Based on book values, not cash flows and market values

AVERAGE RATE OF RETURN Average PAT Average Book Value of Investment (Beginning) Saurabh Inc’s Capital Project YearBook Value of PAT Investment(Beg) /5 ( ) 1/5( ) ARR = = 28.31%

NET PRESENT VALUE NPV = PRESENT VALUE OF CASH INFLOWS (-) PRESENT VALUE OF CASH OUTFLOWS

DECISION REGARDING PROJECT FOR NET PRESENT VALUE NPV Decision Positive Accept Negative Reject Zero May or may not

NET PRESENT VALUE The net present value of a project is the sum of the present value of all the cash flows associated with it. The cash flows are discounted at an appropriate discount rate (cost of capital) Saurabh Inc’s Capital Project( Cost of Capital=15%) YearCash flow Discount factor Present value Sum = 31.96

ProsCons Reflects the time value of money Is an absolute measure and not a relative measure Considers the cash flow in its entirety

BENEFIT COST RATIO OR PROFITABILITY INDEX Benefit-cost Ratio : BCR = PVB I PVB = present value of benefits I = initial investment

let us consider a project which is being evaluated by a firm that has a cost of capital of 12 percent. Initial investment :Rs 100,000 Benefits:Year 1 25,000 Year 2 40,000 Year 3 40,000 Year 4 50,000 The benefit cost ratio measures for this project are: 25, , , ,000 (1.12) (1.12) 2 (1.12) 3 (1.12) 4 BCR = = ,000 NBCR = BCR – 1= 0.145

DECISION REGARDING PROJECT FOR BENEFIT COST RATIO Benefit cost ratioDecision >1 Accept <1 Reject =1 May or may not

Discount rate Net Present Value INTERNAL RATE OF RETURN The internal rate of return (IRR) of a project is the discount rate that makes its NPV equal to zero. It is represented by the point of intersection in the above diagram Net Present Value Internal Rate of Return Assumes that the Assumes that the net discount rate (cost present value is zero of capital) is known. Calculates the net Figures out the discount rate present value, given that makes net present value zero the discount rate.

CALCULATION OF IRR You have to try a few discount rates till you find the one that makes the NPV zero YearCash Discounting Discounting Discounting flow rate : 20% rate : 24% rate : 28% Discount Present Discount Present Discount Present factor Value factorValue factor Value NPV = 15.88NPV = 5.13NPV =

CALCULATION OF IRR NPV at the smaller rate Sum of the absolute values of the NPV at the smaller and the bigger discount rates % + 28% - 24% = 26.24% Bigger Smaller X discount – discount rate rate Smaller discount + rate

DECISION REGARDING PROJECT FOR INTERNAL RATE OF RETURN IRR Decision >Cost of Capital Accept <Cost of Capital Reject = Cost of Capital May or may not

23 IRR Vs. NPV Vs. PI 1. IRR > COST OF CAPITAL NPV + ve PI > 1 Decision- ACCEPT the Project 2. IRR < COST OF CAPITAL NPV - ve PI < 1 Decision- REJECT the Project

24 IRR Vs. NPV Vs. PI(Contd.) 3. IRR = COST OF CAPITAL NPV = 0 PI = 1 Decision- Project may or may not be accepted