Capital Budgeting

CAPITAL BUDGETING Capital budgeting is a decision situation where large funds are committed (invested) in the initial stages of the project and the returns are expected over a long period of time. These decisions are related to allocation of investible funds to different long-term assets.

Capital budgeting is a continuous process and it is carried out by different functional areas of management such as production, marketing, engineering, financial management etc. 1

BASIC FEATURES OF CAPITAL BUDGETING  Capital budgeting implications.

decisions

have

long-term

 These decisions involve substantial commitment of funds.  These decisions are irreversible and require analysis of minute details.  These decisions determine and affect the future growth of the firm. 2

CAPITAL BUDGETING DECISION INVOLVES THREE STEPS: o Estimation of costs and benefits of a proposal or of each alternative. o Estimation of the required rate of return, i.e., the cost of capital o Selection and applying the decision criterion.

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Capital-Budgeting Process • The process is designed to help policy makers: – In the selection of a few capital projects from many alternatives • From an inventory of capital projects to a capital budget

– In the timing of the expenditure to be incurred by the projects selected – In fitting the selected capital projects into the overall financial program of the government unit

• (1) Capital asset inventory  (2) capital improvement plan  (3) long-term financial analysis  (4) capital budget 4

(1) Capital Asset Inventory • An inventory and assessment of the existing capital facilities includes its: – – – – –

Age Condition Degree of use Capacity / LOS Replacement cost

• The inventory of capital facilities helps to determine whether the existing facilities are to be: – Renewed, replaced, expanded, or retired

• It also helps to determine repair and maintenance needs and estimated costs 5

1. ESTIMATION OF CASH FLOWS The costs and benefits for a capital budgeting decision situation are measured in terms of cash flows. An important point is that all cash flows are considered on after tax basis. The rule is that all financial decisions are subservient to tax laws. The cash flow from the project are compared with the cost of acquiring the project. 6

The cash flows may be grouped into relevant and irrelevant cash flows as follows: Relevant cash flows • Cost of new project • Scrap value of old / new plant • Trade-in-value of old plant • Cost reduction / savings • Effect on tax liability • Incremental repairs • Working capital flows • Revenue from new proposal • Tax benefit of incremental depreciation

Irrelevant cash flows Sunk cost Allocated overheads Financial cash flows

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Calculation of different cash flows may be summarized as follows: INITIAL CASH OUTFLOW: Cost of new plant + Installation expenses + Other Capital expenditure + Additional working capital – Tax benefit on account of capital loss on sale of old plant (if any) – Salvage value of old plant + Tax liability on account of capital gain on sale of old plant (if any).

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SUBSEQUENT ANNUAL INFLOWS: Profit after tax + Depreciation + Financial charge ( 1-t) – Repairs (if any) – Capital Expenditure (if any).

TERMINAL CASH FLOW: Annual cash inflow + Working capital released + Scrap value of the plant (if any).

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2. DECISION CRITERIA TECHNIQUES OF EVALUATION

Traditional or

Time-adjusted or

Non-discounting

Discounted cash flows

1. Payback period

1. Net Present Value

2. Accounting Rate of

2. Profitability Index

Return

3. Internal Rate of Return 10

TRADITIONAL OR NON-DISCOUNTING TECHNIQUES I . PAYBACK PERIOD: # The payback period is defined as “the number of years required for the proposal’s cumulative cash inflows to be equal to its cash outflows.” # The payback period is the length of time required to recover the initial cost of the project. # The payback period may be suitable if the firm has limited funds available and has no ability or willingness to raise additional funds. 11

II . ACCOUNTING RATE OF RETURN (OR) AVERAGE RATE OF RETURN (ARR) # The ARR may be defined as “the annualized net

income earned on the average funds invested in a project.” # The annual returns of a project are expressed as a percentage of the net investment in the project. COMPUTATION OF ARR: Average Annual profit (after tax) ARR =

x 100

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DISCOUNTED CASH FLOWS OR TIME ADJUSTED TECHNIQUES These are based upon the fact that the cash flows occurring at different point of time are not having same economic worth. I. NET PRESENT VALUE (NPV) METHOD: The NPV of an investment proposal may be defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with the proposal. The decision rule is “ Accept the proposal if its NPV is positive and reject the proposal if the NPV is negative”. 13

II. PROFITABILITY INDEX METHOD: This technique is a variant of the NPV technique and is also known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.

Total present value of cash inflows PI = Total present value of cash outflows.

Accept the project if its PI is more than 1 and reject the proposal if the PI is less than 1. 14

III. INTERNAL RATE OF RETURN (IRR) METHOD:  The IRR of a proposal is defined as the discount rate which produces a zero NPV, i.e., the IRR is the discount rate which will equate the present value of cash inflows with the present value of cash outflows.  The IRR is also known as Marginal Rate of Return or Time Adjusted Rate of Return.  The time-schedule of occurrence of future cash flows is known but the rate of discount is not.

 The discount rate calculated will equate the present value of cash inflows with the present value of cash outflows. ---------------------

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CAPITAL BUDGETING PRACTICES IN INDIA €

Capital budgeting decisions are undertaken at the top management level and are planned in advance. The Corporates follow mostly top-down approach in this regard. €

Discounted cash flow techniques are more popular now.

€ High growth firms use IRR more frequently whereas Payback period is more widely used by small firms. € PI technique is used more by public sector units than by private sector units.

Capital budgeting decisions are of paramount importance as they affect the profitability of a firm, and are the major determinants of its efficiency and competing power. 16