CAPITAL BUDGETING

1. CAPITAL BUDGETING The term capital budgeting consists of two words, capital and budgeting. Capital means funds currently available with the company and budgeting means planning the investment of these funds in a project. It is a process of determining Thus, capital budgeting involves firm’s decision to invest its current funds in a project. Capital budgeting decisions require comparison of cost against benefits over a long period.

2. Charles T. Horngreen has defined capital planning as, “Capital Budgeting is long term planning for making and financing proposed capital outlays.” • In words of Lynch,” Capital Budgeting consists in planning development of available capital for the purpose of maximising the long term profitability of the concern.”

3. NEED/ SIGNICANCE OF CAPITAL BUDGETING • Maximization of shareholder’s wealth • Large investment of funds • Long time period • Irreversible Decisions • Selection of Best Investment Proposal

4. CAPITAL BUDGETING PROCESS

5. METHODS OF CAPITAL BUDGETING

6. 1. PAY BACK PERIOD METHOD Pay back period is the most popular traditional method of evaluating investment proposals. Under this method, investment proposals are ranked according to the length of their pay back period. Step 1: Calculate Pay Back Period of Each Project: Pay back period of a project refers to the number of years required to recover the initial investment in that project.

7. Case (a): If the project generates constant annual cash inflows: Pay Back Period= Initial Investment in the Project (i.e. Original Cost of the Asset) Annual Cash Inflows (i.e. Net Profits before depreciation and after tax Case (b): If the project generates unequal annual cash inflows: Calculate cumulative cash inflows of project during its life. Pay Back Period = No. of years in which the cumulative cash inflows becomes equal to the original cost of the project/ asset.

8. Step 2: Select the Project which have a Shorter Pay Back Period: After ascertaining the pay back periods of different projects, the next step is to select tha project which has the shortest pay back period.

10. 2. POST PAY- BACK PROFITABILITY METHOD Step 1: Calculate Post Pay-Back Profits of Each Project Post pay-back profits refers to the profits (cash inflows) earned by the project after its pay back periods. Post Pay- Back Profits = Total cash inflows of the project during its whole life – Investment in the Project Or Annual Cash Inflows (Estimated Life of the Project/ Asset – Pay back period)

11. Step 2: Ascertain Post Pay- back Profitability Index of Each Project Post pay-back profitability index = Post Pay- back Profits X 100 Investment in the Project Step 3: Select the Project which has Higher Post Pay- back Profitability Index After ascertaining the post pay- back profitability index of different projects, the last step is to select that project which gives the highest pay-back profitability index.

12. 3. POST PAY- BACK PERIOD METHOD Step 1: Calculate the Post Pay-back Period of Each Project Post pay back period refers to the surplus life of the project over its pay- back period. Post Pay-Back Period= Life of the Project- Pay-back Period. Step 2: Select the Project which has the Maximum Post Pay-back Period After ascertaining the post pay-back period of different projects, select that project which gives the greatest post pay-back period.

13. 4. DISCOUNTED PAY BACK PERIOD METHOD One of the serious limitations of the pay-back period method is that it does not consider the time value of money. This limitation is overcome by the ‘Discounted pay-back period method’. Under this method, first the present values of all future cash inflows are calculated by applying suitable discount rate and then the pay-back period is calculated on the basis of these present values. The pay-back period so calculated by taking into account the present values is known as discounted pay-back period. The project which gives a shorter discounted pay-back period should be selected.

14. 5. ACCOUNTING OR AVERAGE RATE OF RETURN (ARR) METHOD Accounting or Average Rate of Return (based on net investment): Step 1: Calculate average annual profits Average Annual Profits = Total profits after depreciation and tax No. of Years Step 2: Calculate net investment in project Net Investment in Project = Initial investment/Cost of Project – Scrap Value

15. Step 3: Calculate average rate of return (ARR) Average Rate of Return on Investment = Average Annual Profits X 100 Net Investment in Project Step 4: In case of independent projects, choose the project if ARR > Minimum required rate of return. In case of mutually exclusive projects, select the project with highest ARR.

16. Accounting or Average Rate of Return (based on average investment): Step 1: Calculate average annual profits Average Annual Profits = Total profits after depreciation and tax No. of Years Step 2: Calculate average investment Average Investment = Net Investment in Project 2

17. Step 3: Calculate average rate of return (ARR) Average Rate of Return = Average Annual Profits X 100 Average Investment Step 4: In case of independent projects, choose the project if it’s ARR is greater than cut-off. In case of mutually exclusive projects, select the project with highest ARR.

19. 6. NET PRESENT VALUE (NPV) METHOD Net present value method is considered to be the best method for evaluating the investment proposals, as it takes into consideration the time value of money. Under this method, the following steps are taken to analyze the profitability of an investment or project: Step 1: Select an appropriate discount rate First step under NPV method is to select an appropriate discounted rate. Discount rate also known as cut off rate or minimum required rate of return rate is determined by the company after taking into consideration various factors like interest rate prevailing in the market, opportunity cost of capital etc.

20. Step 2: Compute the present value of future cash inflows from the project Cash inflows means earnings before depreciation and after tax excepted from the project. Present Value= Cash Inflows X Present Value of Re 1 at discount rate Step 3: Compute the present value of cash outflows Cash outflows means investments made by the company in the project. As the investments are usually made in the initial stage, so the present value of cash outflows will be the same as the cost of project.

21. Step 4: Compute the net present value (NPV) of the project NPV = Present value of cash inflows – Present value of cash outflows Mathematical formula for calculation of NPV is as follows: NPV = 1 (1 + r) n r = discount rate n = number of years

22. Step 5: Accept or reject the proposal In case the NPV is positive, the project should be accepted. However if the NPV is negative, the project should be rejected. If projects are mutually exclusive, accept the one with the highest NPV. Symbolically, Accept the Proposal = If, NPV > Zero Reject the Proposal = If, NPV < Zero

24. 7. PROFITABILITY INDEX METHOD Case (a) Gross Profitability Index Gross Profitability Index = Present value of Cash Inflows Present value of Cash Outflows Decision: If Gross Profitability Index > 1 Accept the Project If Gross Profitability Index < 1 Reject the Project

25. Case (b) Net Profitability Index Net Profitability Index = Net Present Value Initial Cash Outlay Or Gross Profitability Index – 1 Decision: If Net Profitability Index > 0 Accept the Project If Net Profitability Index < 0 Reject the Project

26. 8. INTERNAL RATE OF RETURN (IRR) METHOD Internal rate of return (IRR) can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows. In other words, it is the rate that gives a net present value (NPV) of zero. Step 1: Find out the initial investments in the project/ asset and estimate its future annual cash inflows (i.e. profits before depreciation but after tax)

27. Step 2: Determine IRR i.e. rate of discount at which the present value of cash outflows. This rate is calculated as follow: Case (a): When the annual cash inflows are uniform over the life of the asset: Step(a): Calculate present value factor PV Factor = Initial Investment Annual Cash Inflow Step (b): Find out IRR by locating the PV factor in present value annuity table.

28. Case (b); When the annual cash inflows are not uniform: Step (a); Take a trial rate (i.e. arbitrary assumed discounted rate). Step (b): Calculate NPV at above rate. If NPV is positive, apply higher rate. If NPV is negative, apply lower rate. Step (c): By repeated efforts, find two trial rates. For finding out the exact IRR, the following formula should be used: IRR =LR+ NPV at LR X (HR-LR ) PV at LR – PV at HR HR = Higher Rate LR = Lower Rate

29. Step 3: Take the final decision as follow: In case of independent Projects: Select the project if – IRR > Minimum required rate of return Reject the project if – IRR < Minimum required rate of return In case of mutually exclusive projects: Select the project with highest IRR

31. SIMILARITIES BETWEEN NPV or IRR • Modern methods: Both are modern methods of capital budgeting • Time value of money: Both methods take into consideration the time value of money. • Discounting of cash flows: Both methods involves the discounting of cash flows into present values. • Similar Results: Both methods will give same results in terms of acceptance or rejection of an investment proposal in the following cases: • When the investment proposals are independent (i.e. projects are not mutually exclusive). • When the investment proposals involve cash outflows in the initial period followed by a series of cash inflows.

32. COMPARISON BETWEEN NPP or IRR • Discount Rate: In the NPV method the present value is determined by discounting the future cash flows at a pre-determined rate. But in case of IRR method discount rate is not pre-determined but is found by repeated trials. • Assumptions: NPV method is based upon the assumptions that all the future cash inflows are reinvested at cut off rate. IRR method is based upon the assumption that the all future cash inflows are reinvested at IRR. • Contradictory Results: In case of Mutually exclusive investment proposals, the NPV method may favour one project while IRR method may favour another project. • When projects under consideration require different cash outlays. • When projects under consideration have different expected lives. • When projects under consideration have different patterns of cash flows.

33. FACTORS INFLUENCING CAPITAL BUDGETING

34. CAPITAL RATIONING Capital rationing refers to a situation where a firm is not in a position to invest in all profitable projects due to the constraints on availability of funds. The resources are always limited and the demand for them far exceeds their availability.

35. LIMITATIONS OF CAPITAL BUDGETING • All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not practically be true in some particular circumstances. • The techniques of capital budgeting require estimation of future cash inflows and outflows. • There are certain factors like morale of the employees, goodwill of the firm, etc, which cannot be correctly quantifies but which other wise substantially influence the capital decision.

36. 4) Urgency is another limitation in the evaluation of capital investment decisions. 5) Uncertainty and risk pose the biggest limitation to the techniques of capital budgeting.