BBA III Semester
Financial Management
Capital Budgeting
INTRODUCTION:
Capital Budgeting is the art of finding assets that are worth more than they cost to achieve a
predetermined goal i.e., ‘optimizing the wealth of a business enterprise’. Capital investment
involves a cash outflow in the immediate future in anticipation of returns at a future date. A
capital investment decision involves a largely irreversible commitment of resources that is
generally subject to significant degree of risk. Such decisions have for reading efforts on an
enterprise’s profitability and flexibility over the long-term. Acceptance of non-viable proposals
acts as a drag on the resources of an enterprise and may eventually lead to bankruptcy. For
making a rational decision regarding the capital investment proposals, the decision maker needs
some techniques to convert the cash outflows and cash inflows of a project into meaningful
yardsticks which can measure the economic worthiness of projects.
CAPITAL BUDGETING = Investing in Long-term Assets
Definition:
a. Capital: Fixed assets used in production
b. Budget: Plan of inflow and outflows during some period
c. Capital Budget: A list of planned investment (i.e., expenditures on fixed assets)
outlays for different projects.
d. Capital Budgeting: Process of selecting viable investment projects In this course,
investments (long term) are needed in order to:
o Expand in existing markets.
o Enter new markets.
o Replace existing capital assets
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Capital Budgeting Process: A Capital budgeting decision involves the following process:
(1) Investment screening and selection
(2) The Capital Budget proposal
(3) Budgeting Approval and Authorization
(4) Project Tracking
(5) Post-completion Auditor
Time Value of Money:
Concept We know that Rs. 100 in hand today is more valuable than Rs. 100 receivable after a
year. We will not part with Rs. 100 now if the same sum is repaid after a year. But we might part
with Rs. 100 now if we are assured that Rs. 110 will be paid at the end of the first year. This
“Additional Compensation” required for parting Rs. 100 today, is called “interest” or “the time
value of money”. It is expressed in terms of percentage per annum.
Why should money have time value?
Money should have time value for the following reasons:
(a) Money can be employed productively to generate real returns;
(b) In an inflationary period, a rupee today has higher purchasing power than a rupee in
the future;
(c) Due to uncertainties in the future, current consumption is preferred to future consumption.
The three determinants combined together can be expressed to determine the rate of interest as
follows:
Nominal or MV rate = Real rate of interest or return
(+) Expected rate of inflation
(+) Risk premiums to compensate for uncertainty.
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Methods of Time Value of Money
(i) Compounding: We find the Future Values (FV) of all the cash flows at the end of the
time period at a given rate of interest.
(ii) Discounting: We determine the Time Value of Money at Time “0” by comparing the
initial outflow with the sum of the Present Values (PV) of the future inflows at a
given rate of interest.
IMPORTANCE OF CAPITAL BUDGETING
Capital budgeting is important because of the following reasons:
1) Capital budgeting decisions involve long-term implication for the firm, and influence its
risk complexion.
2) Capital budgeting involves commitment of large amount of funds.
3) Capital decisions are required to assessment of future events which are uncertain.
4) Wrong sale forecast; may lead to over or under investment of resources.
5) In most cases, capital budgeting decisions are irreversible. This is because it is very
difficult to find a market for the capital goods. The only alternative available is to scrap
the asset, and incur heavy loss.
6) Capital budgeting ensures the selection of right source of finance at the right time
7) Many firms fail, because they have too much or too little capital equipment.
8) Investment decision taken by individual concern is of national importance because it
determines employment, economic activities and economic growth.
OBJECTIVES OF CAPITAL BUDGETING
The following are the important objectives of capital budgeting:
1. To ensure the selection of the possible profitable capital projects.
2. To ensure the effective control of capital expenditure in order to achieve by forecasting
the long-term financial requirements.
3. To make estimation of capital expenditure during the budget period and to see that the
benefits and costs may be measured in terms of cash flow.
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4. Determining the required quantum takes place as per authorization and sanctions.
5. To facilitate co-ordination of inter-departmental project funds among the competing
capital projects.
6. To ensure maximization of profit by allocating the available investible.
CAPITAL BUDGETING TECHNIQUES.
There are different methods of analyzing the viability of an investment. The preferred technique
should consider time value procedures, risk and return considerations and valuation concepts to
select capital expenditures that are consistent with the firm’s goals of maximizing owner’s
wealth.
Capital budgeting techniques are grouped in two:
a) Non-discounted cash flow techniques (traditional methods)
Payback period method (PBP)
Accounting rate of return method (ARR)
b) Discounted cash flow techniques (DCF) (modern methods)
Net present value method (NPV)
Internal rate of return method (IRR)
Profitability index method (PI)
Discounted Payback Period
NON-DISCOUNTED CASH FLOW TECHNIQUES
1) PAY BACK PERIOD METHOD (PBP) Payback period refers to the number of periods/
years that a project will take to recoup its initial cash outlay. This technique applies cash
flows and not accounting profits.
If the project generates constant annual cash inflows, the Payback period will be given by,
PBP = Initial Investment (Io)
Annual cash flow (ACF)
When ACF is not equal:
PBP = n + Initial Investment- Pre CCF
Annual cash flow
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N = Previous year before the amount is recovered.
CCF = Cumulative Cash Flow
ACF = Annual Cash Flow
Decision Rules: In the case of two or more mutually exclusive projects, the one with a lower
payback period is accepted.
Advantages of PBP
It’s simple to understand and use.
It’s ideal under high risk investment as it identifies which project will payback as soon as
possible
PBP is cost effective as it does not require use of computers and a lot of analysis
PBP emphasizes on liquidity hence funds which are released as early as possible can be
reinvested elsewhere
Weaknesses of PBP
It does not consider all the cash flows in the entire life of the project.
It does not measure the profitability of a project but rather the time it will take to payback
the initial outlay
PBP does not take into account the time value of money
It does not have clear decision criteria as a firm may face difficulty in determining the
minimum acceptable payback period
It is inconsistent with the shareholders wealth maximization objective. Share values do
not depend on the payback period but on the total cash flows.
1) ACCOUNTING RATE OF RETURN METHOD (ARR) This is the only method that does not
use cash flows but instead uses accounting profits as shown in the financial statements of a
company. It is also known as Return on Investment (ROI). The ARR is given by:
ARR = Average annual profit after tax ×100
Average investment
Average Investment = Investment + Installation Charges
2
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If Scrap Value is given-
Average Investment = Investment – Scrap Value + Scrap Value
2
If Scrap Value and Working Capital is given-
Average Investment = Investment – Scrap Value + Scrap Value + Working Capital
2
Average Annual Profit after Tax = Total PAT/No. of Years
OR
(Average Inflow – Average Outflow)
Decision Rule: Select the one that offers highest rate of return or Select the projects whose
rates of return are higher than the cut-off rate.
Advantages of ARR:
Simple to understand and use.
The accounting information used is readily available from the financial statements.
All the returns in the entire life of the project are used in determining the project’s
profitability.
Weaknesses of ARR:
Ignores time value of money.
Uses accounting profits instead of cash flows which could have been arbitrarily
determined.
Growth companies earning very high rates of return on the existing assets may reject
profitable projects as they have set a higher minimum acceptable ARR, the less profitable
companies may set a very low acceptable ARR and may end up accepting bad projects.
Does not allow for the fact that profits can be reinvested.
DISCOUNTED CASHFLOW TECHNIQUES
1. NET PRESENT VALUE (NPV)
This is the difference between the present value of cash inflows and the present value of cash
outflows of a project. To get the present values a discount rate is used which is the rate of
return or the opportunity cost of capital. The opportunity cost of capital is the expected rate
of return that an investor could earn if the money would have been invested in financial
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assets of equivalent risk. Hence it’s the return that an investor would expect to earn. When
calculating the NPV the cash flows are used and this implies that any non-cash item such as
depreciation if included in the cash flows should be adjusted for. In computing NPV the
following steps should be followed:
a. Cash flows of the investment should be forecasted based on realistic assumptions. If
sufficient information is given one should make the appropriate adjustments for non-cash
items
b. Identify the appropriate discount rate. (It is usually provided)
c. Compute the present value of cash flows identified in step 1 using the discount rate in
Step-2
d. The NPV is found by subtracting the present value of cash out flows from present value
of cash inflows.
Year ACF PVF PV
NPV = ∑ Discounted ACF + Disc. WC + Disc. Salvage Value - I 0
OR
NPV= PV (inflows) – PV (outflows)
I0 = Initial investment
ACF = Annual Cash Flow
PV = Present Value
Decision Rule: Select every project whose NPV >= 0 or Select the one with a higher NPV (In
case of more than one proposals).
2. INTERNAL RATE OF RETURN (IRR)
The internal rate of return method is also known as the yield method. The IRR of a
project/investment is defined as the rate of discount at which the present value of cash
inflows and present value of cash outflows are equal.
This is the discounting rate that equates present value of expected future cash flows to the
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cost of the investment .It is therefore the discounting rate that equates NPV to zero.
IRR = LR + NPVLR X Difference in Rate
Diff. in NPV
LR = Lower Rate of Interest
Difference in Rate = Higher Rate – Lower Rate of Interest
Decision Rule: Accept every project whose IRR (r) = k, where k is the cost of capital or
Select the one with higher IRR (In case of more than one Proposals).
Merits:
It considers the time value of money and it also takes into account the total cash flows
generated by any project over the life of the project.
IRR is a very much acceptable capital budgeting method in real life as it measures
profitability of the projects in percentage and can be easily compared with the
opportunity cost of capital.
It is consistent with the overall objective of maximizing shareholders wealth.
Demerits:
It requires lengthy and complicated calculations.
When projects under consideration are mutually exclusive, IRR may give conflicting
results.
We may get multiple IRRs for the same project when there are non-conventional cash
flows especially.
It does not satisfy the value additivity principle which is the unique virtue of NPV.
3. PROFITABILITY INDEX (PI)
It is defined as the ratio of the present value of the cash flows at the required rate of return to
the initial cash out flow on the investment.
PI = Present value of cash inflow X100
Initial cash outflow
It is also called the benefit – cost ratio because it shows the present value of benefits per
shilling of the cost. It is therefore a relative means of measuring a project’s return. It thus can
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be used to compare projects of different sizes.
Decision Rule: Select all projects whose profitability index is greater than or equal to 1 or
Select the project with higher PI.
Advantages of PI:
It considers time value of money.
It considers all cash flows yielded by the project.
It ranks projects in order of the economic desirer ability.
It gives a unique decision criterion.
It is a relative measure of profitability and therefore can be used to compare projects of
different sizes.
Weaknesses of PI:
It is not consistent with maximizing shareholders wealth.
It assumes the discount rate is known and consistency which might not be the case.
3. DISCOUNTED PAY BACK PERIOD METHOD (PBP)
Payback period refers to the number of periods/ years that a project will take to recoup its
initial cash outlay. This technique applies cash flows and not accounting profits. The
Discounted Payback period will be given by,
PBP = n + Initial Investment - Pre CPV
PV
N = Previous year before the amount is recovered.
CPV = Cumulative Present Value
PV = Present Value
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Important Points:
1. If PBT or PAT is not given in the question, savings from investment and estimated
expenses are given then prepare Statement for Annual Cash Inflow.
Incomes/Savings Savings from… xxx
Less: Expenses Cost of maintenance xxx
Cost of indirect materials etc. xxx
Depreciation xxx
PBT xxx
Less: Tax xxx
PAT xxx
Add: Depreciation xxx
ACF XX
2. ACF = Profit After Tax (PAT) but before Depreciation
Or
= Cash Income – Cash Expenses – Tax
3. If PAT is given in the question then,
ACF = PAT + Depreciation
4. If PBT and after Depreciation is given then,
ACF = PBT & after Depreciation –Tax + Depreciation
5. If PBT and before Depreciation is given then,
ACF = PBT & Depreciation – Depreciation – Tax + Depreciation
6. Depreciation = Cost of asset – Estimated Scrap/Salvage
Value Estimated life in years
7. CFAT – Cash Flow After Tax is ACF
8. CFBT – Cash Flow Before Tax is PBDT (Profit Before Depreciation & Tax)
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