Capital Budgeting

CAPITAL BUDGETING Plays important role in success & failure of any organization.It involves substantial investment as well as period for completion.



CAPITAL BUDGETING PROCESS


* Gathering ideas

* Collecting Proposals

* Plan Capital budget

* Monitoring& post audit


Capital Budgeting Projects Categories


* Replacement projects

* Expansion projects

* Increase in services & products

* Safety, Regulatory Projects

* Others


Capital Budgeting Evaluation Criteria


* Net present value

* IRR

* Accounting rate of return

* Pay back period

* Discounted Pay back period

* Profitability Index


Net present value


N.P.V (FOR A PROJECT WITH ONE INITIAL OUTLEY) IS EQUAL TO PRESENT VALUE OF FUTURE AFTER TAX CASH FLOWS MINUS INITIAL OUTLEY



NPV = PV OF FUTURE AFTER TAX CASH FLOW MINUS INITIAL OUTLEY



DECISION RULE



ACCEPT PROJECT IF NPV > 0

reject project if NPV is less than 0
EXAMPLE

A PROJECT WITH INITIAL OUTLEY OF RS. 25 MILLION PRODUCING 10 MILLION FOR THREE YEARS WITH REQUIRED RATE OF RETURN 10%. WHETHER IT IS ACCEPTABLE OR NOT


ANSWER

IT IS not acceptable as NPV is less than 0.

IRR

IRR is the rate of discount that equates PV of future after tax cash flows with initial outley.


i-e at IRR PV of of future after tax cash flows = initial outley



Decision Rule



Accept project if IRR> r


Reject project if IRR is less than Accounting rate of return


AAR= average net income/average book value



Example
investment Rs. 100,000
Income
year 1 Rs. 5,000
year 2 Rs. 10,000
year 3 Rs. 15,000
then AAR = ((5000+10000+15000)/3)/(100000+0)/2
AAR=20%



DRAWBACKS



It is based on accounting income not on cash flows.
It does not take into accounts time value of money.



Payback period & discounted pay back period


Payback period



It is the number of years the project takes to recover its initial investment. It is based on cash flows. It is measure of payback not profitability.


TABLE


YEAR 0 1 2 3


CASH FLOW (M) -10 2.5 7.5 2


Cum. CASH FLOW -10 -7.5 0 2


PAY BACK PERIOD IS 2 YEARS.



MAIN DRAWBACKS



It ignores time value of money & risk of project.
it ignores cash flow after payback period.



Decision rule



As it is the measure of liquidity, the shorter the payback period the better the project is.



Discounted pay back period



It is the number of years the project takes to recover its initial investment in present value terms. (Discounted cash flows).



If NPV = negative , it will usually not have a discounted payback period.



It accounts time value of money & risk within the discounted payback period.



Decision rule



As it is the measure of liquidity, the shorter the discounted payback period the better the project is.



Main drawback




It does not take into account cash flows beyond the payback period.


Profitability index

It is the P.V of future after tax cash outflow of project divided by initial cash outley.

P.I = P.V of future after tax cash outflow /initial investment

P.I =1+NPV/initial investment

It indicates the value we are receiving in exchange for one unit of currency invested.

Example

If NPV is 100
initial investment is Rs. 1000
Then P.I will be =1+100/1000=1.1

Decision Rule

If P.I > 1 accept the project.
If P.I is less than 1 reject the project.


Mutually exclusive & Independent projects


Independent projects


are projects that are unrelated to each other and are separately evaluated for investment decisions.
Example If A & B are independent projects
& NPV of A = 10,000 NPV of B = 15,000 So both projects can be accepted.(assuming no financial constraints are there)



Mutually Exclusively Projects


mean that only one of them can be accepted and they compete with each other. Example If A & B are Mutually Exclusively projects & NPV of A = 10,000 NPV of B = 15,000 So only one of them i-e B can be accepted but not both.



CAPITAL RATIONING



A firm maximizes its wealth by accepting every project that has a positive NPV but the point is that capital is limited. So capital rationing is the limit set on the amount of investments utilized/available for investments.


Soft Capital rationing


Capital rationing is imposed by top management and not by investors. The factors leading to soft rationing are as under:
􀂃 Management is reluctant to issue new share because of the fear of outsider taking control of company.
􀂃 Dilution of EPS
􀂃 Increased interest payments in case of debt financing.
􀂃 Company’s will to maintain limited investment level that can be financed through retained earnings.


Hard Capital Rationing

It means that the firm cant raise the funds it needs & imposed by investors.This will not occur under perfect market.

􀂃 If share prices are depressed , raising capital is very difficult.
􀂃 Restriction on lending by Banks.
􀂃 High interest rate.
􀂃 High cost associated with issuance of share / debt instrument.


DECISION

If there is shortage of capital, the firm needs to pick projects that give highest NPV per dollar of investments i-e profitability index.

P.I= NPV/Initial investment