Capital Budgeting

What is common in these statements ?

TATA motors plans to set up car plants at Bangalore, Nashik TATA steel acquired Corus King Fisher Airlines planning to buy 26 aircrafts Bank planning to computerize all its Branches Emcure planning to set up a R& D centre for treatment of HIV/ Aids

GMR Infra structure plan to raise Rs 3000 Crs through leasing

Capital Expenditure

It involves a current outlays (and future too) of funds in the expectation of a stream of benefits extending far into future

Capital Expenditure- features

Long term consequences

Benefits/risk
spending

Involve substantial outlays

Difficult or expensive to reverse

Typical Capital Expenditure Decisions

Production

Plant expansion

Marketing

Equipment selection Lease or buy

Equipment replacement

Cost reduction

Human Resource

Finance

Capital Budgeting

Strategic Investments Financing Investments Allocating Capital

Capital Budgeting

Capital Budgeting Process Project Classification Investment Criteria

Capital Budgeting Process

Identification of potential investment opportunities Assembling of proposed investments Decision Making Preparation and appropriation of Capital Budgets Implementation Performance Review

Projects Classification

Mandatory Investments Replacement Projects Expansion Projects Diversification Projects Research & Development Projects Miscellaneous Projects

Investment Criteria

Discounting Criteria

Non-Discounting Criteria

PBP

DPB

ARR

NPV

BCR

IRR

Non Discounting Methods

1 The Payback Period Method. 2 Discounted Payback period. 3 Accounting Rate of Return

The Payback Method

The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.

The Payback Method

When the net annual cash inflow is the same each year, this formula can be used to compute the payback period:

Payback period =

Investment required Net annual cash inflow

The Payback Method

Management at The Holiday Inn wants to install an espresso bar in its restaurant.

The espresso bar:

1. Costs Rs140,000 and has a 10-year life. 2. Will generate net annual cash inflows of Rs35,000.

Management requires a payback period of 5 years or less on all investments.

What is the payback period for the espresso bar?

The Payback Period Method

Investment required Payback period = Net annual cash inflow Payback period = Rs140,000 Rs35,000

Payback period =

4.0 years

According to the companys criterion, management would invest in the espresso bar because its payback period is less than 5 years.

Evaluation of the Payback Method

Ignores the time value of money.
Short Comings

Ignores cash flows after the payback period.

Discounted Payback Period Method

Cash flow are first converted into their PV and than added to recover the initial outlay on the Project

Discounted Payback Period Method

Year Cash flow discounted factor 10% 1.000 0.909 0.826 0.751 0.683 0.621 0.565 0.513 PV

0 1 2 3 4 5 6 7

-10000 3000 3000 4000 4000 5000 2000 3000

-10000 2727 2478 3004 2732 3105 1130 1539

Accounting Rate of Return

(average rate of return)
Average Profit after Tax ARR= Average Book Value of the Investment

Numerator may be measured as Average Annual Return over the life of the investment

Denominator may be measured is the average book value of fixed assets committed to the Project

Accounting Rate of Return

(average rate of return)
ARR= Average Profit after Tax Average Book Value of the Investment
Book value of FA Rs 90000 80000 70000 60000 50000 PAT RS20000 22000 24000 26000 28000

Year 1 2 3 4 5

1/5 (20000+22000+24000+26000+28000) =34% 1/5 (90000+80000+70000+60000+50000)

ARR=34%

Discounting Cash flows techniques

Cash flows occurring at different point of time are not having same economic worth Due to time value of Money To make equal it must be discounted wrt to time gap

present value

npv
of a project is the sum of the present value of all the cash flows- positive or negativethat are expected to occur over the life of the project

techniques
Present Value or discounting

PV Tables Tables are available for various ranges of i and n P= c (PVIF) Where
P is present value C is future Cash flow PVIF is present value interest factor

PV of Mixed Stream of Cash flows

Year End 1 Cash flows 2 PV IF 10% 3 Present Value 4

Rs

500

0.909

Rs

454.50

2
3

Rs 1,000
Rs 1,500

0.826
0.751

Rs 826.00
Rs 1,126.00

4
5

Rs 2,000
Rs 2,500

0.683
0.621

Rs 1,366.00
Rs 1,552.50

Rs 7,500

Rs 5,325.50

net present value

NPV of Project =

t=1

Ct
(1+r)t

- Initial investment

Ct=cash flow at the end of year t n= life of the project r= discount rate

net present value

Year cash flow

Cost of Capital is Rs 10,00,000,r for the firm is 10% 0 1 2 Rs (10,00,000) 2,00,000 2,00,000 3,00,000 3,00,000 3,50,000

NPV= = 5273

2,00,000+2,00,000+3,00,000 +3,00,000+3,50,000 (1.10)1 (1.10)2 ( 1.10)3 (1.104 (1.10)5

- 1000000

net present value- decision rule

Year cash flow

NPV IS POSITIVE NPV IS NEGATIVE NPV IS ZERO

ACCEPT REJECT INDIFFERENCE

Mutually Exclusive Proposals Highest positive NPV TOP PRIORITY Lowest NPV Low Priority Negative NPV Rejected
-

Benefit Cost Ratio- profitability index

PVB BCR= I NBCR=BCR-1 PVB= Present Value of Benefits I = Initial Investments

Initial investment Rs 100000 Cost of Capital 12% Benefits Year 1 25000 year 2 40000 Year 3 40000 Year 4 50000

BCR= 25000(if1)+40000(if2)+40000(if3)+50000(if4)=1.145 100000 When BCR NBCR= BCR-1= 0.145 >1 =1 <1 or NBCR >0 =0 <1 Rule is Accept indifferent Reject

Internal Rate of Return

Internal Rate of Return Method

The IRR is the rate of return expected from an investment project over its useful life.

Internal Rate of Return Method

The internal rate of return of a Project is the discount rate that makes its net present value to be zero.

IRR

Ct Investment = (1+r)t
t=1

Ct =cash flow at the end of year t r = internal rate of Return n = life of the Project

Example
Consider the cash flow of a company as follows Year Cash Flow For IRR 0 (1,00,000) 1 30,000 2 30,000 3 40,000 4 45,000

100,000 = 30000 + (1+r)1

30,000 (1+r)2

40000 + (1+r)3

45,000 (1+r)4

Let us take discount rate as 15% 100,802 = Take R=16% 98,641= 30000 + (1+16) 30,000 + (1+16)2 40000 + (1+16)3 45,000 (1+16)4 30000 + (1+15) 30,000 + (1+15)2 40000 + (1+15)3 45,000 (1+15)4

Example Continued..

Value lies between 15% and 16%

1 at 15% it is more by 802 2 at 16% it is less by1359

Find sum of NPV value in absolute terms 802+1359 =2161 Ratio of smaller discount rate 802 =0.37 2161

IRR= 15% + npv at 15%/Total difference x difference in rate

add the number to smaller discount rate = 15.37%

The expected cash flows of a Project are as follows

Year 0 1 2 3 4 5 Cash flows -Rs 100000 20000 30000 40000 50000 30000

The Cost of capital is 12%. Calculate

a) b) c) d) e) NPV BCR IRR PBP DPBP

NPV=20000/(1.12)+30000/(1.12)2 +40000/(1.12)3 +50000/(1.12)4+30000/(1.12)

= 20000(.893)+30000(.797)+40000(.712) +50000(.636) + 30000(.567)

=17860+23910+28480+31800+17010 = 119060 = 100000-119060

=19060
BCR= PVB I =119060/100000 =1.19

IRR

Average Inflow 170000/5=34000 PB =100000/34000 =2.9 It lies between 18 &19% rate

At 18% of discount Rate the NPV IS

Rs1750

At 19% of discount rate the NPV is Rs 780

IRR IS =18+1750/2530 =18.69%

Payback period
is slightly more than 3 years

Discounted Payback period

is slightly less than 4 years

thanks