CAPITAL BUDGETING

Meaning - Capital budgeting is the process of making investment decision regarding capital expenditures. A capital expenditure is an expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected to be received over a number of years in future. Capital expenditure involves non - flexible long term - commitment of funds. Capital budgeting is also known as long - term planning for investment decisions.

Charles T. Horn green has defined capital budgeting as, “a long term planning for making and financing proposed capital outlays”.

It involves the entire process of decision making relating to long-term assets whose revenue / return are expected to arise over a period beyond one year.  Such return may be in the firm of increase in revenue (expansion program) and reduction in loss (replacement program).

Significance of Capital Budgeting
1.        It reflects the Profitability of the firm. It determines the future estimates of the firm. The proper investment decision can yield spectacles whereas an incurrent decision is danger of the firms.
2.        It has an effect over a long time span invariably expects the firms future cost structure.
For example: if a plant is purchased, to reduce a new product. The firm commits itself to a sizeable amount of fixed cost (labor, insurance etc.). Even if the investment in terms of unsuccessful in future, the firms will have to burden the fixed cost.
3.        It is an irreversible decision. There is no second hand market for fixed assets and their conversion to uses may not be financially viable. Hence, the loss suffered will be submitted.
4.        It involves huge cash outlay. The amount of cash to be invested in new projects, setting up of new plant, and for expansion program etc., is of very big budget.  
5.        It is very risky decision. Since it is based on the future benefits likely to arise from the current expense. Since the future is uncertain, the risk is very high. Future estimates relating to demand, Price, cost, shift into consumer preferences, competition action, technological development, political environmental are all difficult to make with certainty.
6.        Budgeting decision occur at different time periods. These are not logically comparable because of the time value of money and discounting techniques have to be used to make them comparable.

 Types of Capital Budgeting decision
        I.            For new Firms
a.        Setting up a plant
b.       Installing a new project
       II.            For existing firms (to meet competition and choosing environment)
a.        Replacement and modernization decision
b.        Expansion decision
c.        Diversification decision.

   III.            From the point of view of decision situations
a.         Mutually exclusive projects - The acceptance of the proposal automatically leads to the rejection of other.
b.       Independent Projects - All are projects which do not compete with one and other. All the projects may be accepted, provided they are financing viable.
c.        Contingent projects - The acceptance of one project is contingent on the acceptance of some other project. For ex., the project is located in remote area, it may be necessary to invest in a township.

Capital Budgeting Process
1)       Identification of potential investment opportunities - Searching from external environment for investment opportunities; identifying the company’s Strength, Weakness, Opportunity and Threat (SWOT) and motive employees to make suggestions.
2)       Assembling the investment proposals - Before submitting the proposals to capital budgeting committee it should be noted to different period. So that it is viewed from different angles and finally the decision will be taken regarding the proposals should be accepted.
3)       Preparation of the capital budgeting and the appropriations - Various expenses involved in the project are listed and the sources of funds must have expenses are identified.
4)       Implementation - It is a complex time consuming and risk. Delay in implementation can lead to substantial cost overrun. To ensure speedy implementation and a reasonable cost it is necessary into - (a)  make a details study of the project so that surprises do not arise during implementation; (b) deeide specific responsibility to project management to complete the project within the time frame and  cost limit and (c) use net worth techniques like PERT, CPM, etc.

Performance review i.e., post completion audit to identify
1.        Cash flow concern - Cost and benefits must be measured in terms of cash flows. Costs are cash outflows which are cost of the projects plans, working capital requirement. Benefits are cash inflows which is trade up of operational cash inflow plus terminal cash inflows.
→Terminal cash inflows = Scrap value of the machine at the end of project life (+) working capital 
→Operational cash inflow   = PAT + Depreciation
2.        Incremental Principles - Only the change cash flow of the firm which can be attributed to the proposed project are relevant. In determining this the following should be note : -
a.        Consider all incidental effects - Apart from the direct cash flows of the project incidental effects on the rest of the firm should be considered. Eg. Loss of contribution from other products.
b.        Ignore sunk cost [eg. preliminary expenses] - Cost expenses which cannot be recovered e.g. market research expenses before designing to manufacture or not to manufacture a product. This sunk cost are not to be considered and the cost to be recovered in the project. Since the costs are already incurred and it is immaterial whether it is manufacture or do not manufacture of the product.
c.        Include opportunity cost - If a project requires the use of same resources already available to the firm. The opportunity cost of these resources should be charged to the product. For example, if the firm is going to make use of room property rented out at the rent of Rs. 2,000 p.m. for manufacturing new product, the opportunity cost would be the rental income (12 x 2,000 = Rs. 24,000 p.a.) lost. So this should be incurred as a cost of the new project.
d.        Include only relevant cost - The cost which are directly related to the acceptance of the project loan should be included. Allocated overhead costs are not relevant and should be ignored.
3.        Long – term fund principle - The project should evaluated from the point of view of long-term funds i.e., return of the project is sufficient to be the cost of capital.
4.        Interest exclusion principle - Calculating cash flows interest on long-term funds should not be treated. This is because the cost of capital it is used as discount rate and include the cost of long-term debt.
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Capital Budgeting Techniques -There are a number of methods use for evaluating capital investment proposals. Different firms may use different methods for evaluating the project proposals. While evaluating, two basic principles are kept in view namely, the bigger benefits are always preferable to small ones and that early benefits are always better than the deferred ones. The following methods are usually followed for evaluation.
        I.            Non-Discount Cash Flow Method
a)       Payback Period method (PBP) - It refers to the period in which initial investment excluding salvage value on the project is recovered.
PBP = Initial Investment / Annual cash inflow
                  (Cash inflow   = PAT + Depreciation) 
Decision - When there are more than one project, we have to select one project which has a shortest PBP. However, sometimes management fixes the cut off PBP beyond which projects will not be accepted. In such cases, only those projects whose PBP is less than the cut – off PBP will be accepted.
Merits
·         It is simple to understand and easy to calculate;
·          It is a useful method when period of project whose risk takes to increase the future since, the emphasis of earlier recovery of investment;
·         The use of method for firms liquidity problems since the emphasis of earlier recovery of investments.
Demerits
·         It fails to consider the time value of money;
·         It does not differentiate between the projects of magnitude and training of cash inflows;
·         It ignores all the cash flows after the PBP;
·         PBP is more a method of capital recovery rather than the measure of profitability of the project;
·         PBP cannot be used when investments are spread over the period of time.
Applicability - In spite of weakness of PBP, it gainfully employed in the following cases -
o    When the long-term output (above 3 years) of the project is lazy;
o    The firms suffering from liquidity process would prefer pay back criterion since it emphasis on quick cash recovery of investment;
o    Payback period method is useful to a firms which emphasis short-term money performance rather them long-term growth.

b)       Accounting Rate of Return (ARR) or Average Rate of Return - It is defined as the average annual profits earned and expressed as a percentage of the average funds invested in the project.
ARR = Average Annual Profit after Tax/Average Investment of the project x 100
 Average Investment = Initial Investment - Scrap value / 2 +     Working capital + Scrap value                        
                     
Decision
·         If the ARR is more than COC → Accept
·         If the ARR is less than COC → Reject
·         If the ARR is equal COC  → Ignore or indifferent
Merits
§  It is simple to understand and easy to calculate.
§  This method gives due Weightage to the profitability of the project.
§  It takes into consideration the total earnings from the project during its life time.
§  Rate of return may be readily calculated with the help of accounting data.
Demerits
§  It uses accounting profits and not the cash inflows in appraising the project.
§  It ignores the time value of money. Profits earned in different periods are valued equally.
§  It considers only the rate of return and not the life of theproject.
§  It ignores the fact that profits can be reinvested.
§  This method does not determine the fair rate of return oninvestment.

      II.             Discounted Cash Flow Techniques - The discounted cash flow method is an improvement on the pay back method. It takes into account both the profitability and the time value of money. This method is based on the fact that future value of money will not be equal to the present value of money. For example, a sum of Rs.100 received today is more valuable than a sum of Rs.100 received after one year because by receiving the amount now and investing it somewhere a firm can get Rs.110 (say including 10%interest) after one year. Discounted cash flow methods for evaluating capital investment proposals are of three types – (i) Net Present Value Method, (ii) Excess Present Value Index and (iii) Internal Rate of Return.

Merits  
§  This method considers the economic life of the project.
§  It gives due Weight age to time factor. That is, time value of money is considered.
§  It facilitates comparison between projects.
§  This approach by recognizing time factor, makes sufficient provision for uncertainty and risk.
§  It is the best method where cash inflows are uneven.
Demerits
§  It involves a great deal of calculations. Hence it is difficult and complicated.
§  It is very difficult to forecast the economic life of any investment exactly.
§  The selection of an appropriate rate of interest is also difficult.
§  It does not correspond to accounting concepts for recording costs and revenues.

a)       Net Present Value (NPV) - This method emphasizes that the cash inflows at the different points of time different values and it can be computed only when they are expressed in terms of the value only.   Under this method, we first calculate the cash inflow and the cash outflow associated in the projects. These cash inflows and outflows can be converted in to present value. Using the discount rate which is the COC or such higher rate may be acceptable to management.
          NPV   = PV of cash inflow – PV of cash outflows
Decision
  1. If the NPV is Positive         accept the project.
  2. If the NPV is Negative         reject the project.
  3. If the NPV is zero          indifferent i.e., may or may not accept.
Treatment of scrap value of the project - Treated as cash inflow in the last year i. e.  at the end of the year it will be treated as cash inflow.
Treatment of Working Capital - It includes as an inflow and outflows and it is an inflow in the last year when it is recovered.
 
b)       Present Value Index (PI) or Benefit cost = Index or NPV Index / Profitability Index
 Profitability Index = PV of cash inflows / PV of cash outflows
Decision
·           If the PI is more than 1 →     Accept the project
·           If the PI is less than 1   →     Reject the project
·           If the PI is equal to 1   →      May or may not accept the project.

c)        Internal Rate of Return (IRR) - This method is defined as that discount rates which equates the aggregate present value of net cash inflows with the aggregate present value of the cash outflows of the project. In other words, it is that rate, assume it makes NPV of the project is zero.
Decision
·         If the IRR is more than the COC    →   Accept the project
·         If the IRR is less than the COC       →   Reject the project
·         If the IRR is equal to COC   → It is indifferent i.e. may or may not accept the project.
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Risk Analysis in Capital Budgeting - Risk in reference to Capital Budgeting may be defined as the variability which is likely to occur in future between estimated on the actual returns. The greater the variability is more risky in the project.
A decision situation as to risk may be classified into – (i) Certainty (no risk), (ii) Uncertainty and (iii) Risk.
The risk situation is on in which the probability of particular event occuring are known while in uncertain situation is one where these probability are unknown.

Types of risks in Capital Budgeting
1)       Project Specific Risk - It affects only that project on consideration.
2)       Competitive Risk - Risk arising for competition of that project.
3)       Industry Specific Risk - The risk in primarily affects all earnings in cash flow of firms in specific industry. This arises due to technological changes. Changes are loss affecting in the industry etc.
4)       International Risk - In the case of projects executed outside India – loss due to exchange rate changes, political changes etc.
5)       Market Risk - Changes are affecting in all companies and projects in varying degree etc. Ex. Interest rate changes etc.

Techniques of Risk analysis – (a) Risk adjusted discount rate, (b) Certainty equivalent co-efficient and (c) Probability Assignment.

(a) Risk adjusted discount rate - This method is based on the assumption that investor expects the higher rate of return on risky projects as compared to a less risky project. The rate will comprise of - (i) a risk free rate and (ii) risk premium rate which is the extra return required to hope within the risk associated with the  project.
They are higher discount rate is used for more risky projects and lower rate is used for less risky projects.

(b) Certainty equivalent co-efficient - Under this method the cash inflows are adjusted to reflect the risk. This method requires the calculation of certainty equivalent factors, which is the future cash inflow.

 (c) Probability Assignment - Probability means the likely hood of a given happening. Initial step requires evaluating risky project is to find out the expected value of probability distribution for each share. For this each cash flow is multiplied by corresponding probability sum of the resulting of cash inflow for that year.  =====================================================================
Capital Rationing and Capital Budgeting - Capital Rationing refers to situation where a company, cannot undertake all projects with a positive NPV because of shortage of funds / capital. Such shortage of capital may arise due to -
1)       Firms’ inability to raise fresh funds, due to an already debt equity ratio or covenants / clauses in existing loan agreements which restrict future borrowings.
2)       Self imposed restrictions – Management reluctant to borrow to additional risks reluctant to issue fresh equity for fear of losing control.
  
Steps in selection of Project under Capital Rationing
1)       Identifying the projects which are acceptance is having positive NPV.
2)       Selecting combination of project which would maximize NPV with the limited funds available.
The method of selection will depend upon -
·         Whether the projects are divisible [ can be accepted or rejected in part].
·         Whether projects are indivisible [ should be accepted / rejected in entirely].
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CAPITAL BUDGETING - PROBLEMS AND SOLUTIONS

Capital Budgeting Techniques
        I.             Non-Discount Cash Flow Method – (a) Payback Period method (PBP); (b) Accounting Rate of Return (ARR) or Average Rate of Return
      II.             Discounted Cash Flow Techniques – (a) Net Present Value (NPV); (b) Present Value Index (PI) or Benefit cost ; (c) Internal Rate of Return (IRR)

I.                     Payback Period method (PBP)
When cash inflow is uniform
1)       A project costs Rs. 15,60,000 and yields annually a profit of Rs.2,70,400 after depreciation of 12% p.a. but before tax at 25%. Calculate Pay-back Period.
Solution
Pay-back period = Initial Investment / Annual cash inflow
Initial investment (given) = Rs.15,60,000
Annual cash inflow = Rs.3,90,000*
 So, Pay-back period = 15,60,000/3,90,000 = 4 years
Working Note=
Annual profit after depreciation, before tax
2,70,400
(- )  Tax at 25%
67,400
Annual profit, after depreciation and tax
2,02,800
(+) Depreciation (15,60,000 x 12%)
1,87,200
Annual cash inflow
3,90,000*

Discounted pay-back method
2)       Calculate discounted pay-back period from the details given below –
Cost of project Rs. 6,00,000; Life of the project 5 years; Annual cash inflow (CIF) Rs. 2,00,00; Cut-off rate 10%.
Year
1
2
3
4
5
Discounting Factor (10%)
0.909
0.827
0.751
0.683
0.621
Solution
Statement showing present values of cash inflows
Year (1)
CIF (2)
Discounting
Factor @ 10%  (3)
PV of CIF (4)
(2) x (3)
Cumulative CIF
1
2,00,000
0.909
1,81,800
1,81,800
2
2,00,000
0.827
1,65,200
3,47,000
3
2,00,000
0.751
1,50,200
4,97,200
4
2,00,000
0.683
1,36,600
6,33,800
5
2,00,000
0.621
1,24,200
7,58,000
Total of CIF
7,58,000
Initial cost of project
6,00,000
Discounted pay-back period = 3 years + 1,02,800/1,36,600  = 3.75 years
When cash inflow is not uniform
3)       J Products Ltd. has two projects under consideration which are mutually exclusive. The cost of each of them is Rs. 1,00,000. Both projects have to be depreciated on straight line basis and the tax rate may be taken as 50%. Determine which project is better on the ‘pay-back period’ criterion:
Year
1
2
3
4
5
Cash inflow of Project A (Rs.)
80,000
60,000
40,000
20,000
10,000
Cash inflow of Project B (Rs.)
20,000
40,000
60,000
80,000
1,00,000
Solution
WN-1 Statement showing  annual cash inflows (CIF)  of Project A
Particulars
Year 1
 Year 2
Year 3
Year 4
Year 5
Cash inflow before depreciation and tax
80,000
60,000
 40,000
 20,000
 10,000
(-)  Depreciation  (1,00,000/5)
20,000
20,000
 20,000
20,000
20,000

60,000
40,000
20,000
---
(-) 10,000
(-) Tax at 50%
30,000
20,000
10,000
---
---

30,000
20,000
10,000
---
(-) 10,000
 (+) Depreciation
20,000
20,000
20,000
20,000
20,000
Net cash inflows
50,000
40,000
30, 000
20,000
10,000

WN-2 Statement showing  annual cash inflows (CIF) of Project B
Particulars
Year 1
 Year 2
Year 3
Year 4
Year 5
Cash inflow before depreciation and tax
20,000
40,000
60,000
80,000
1,00,000
(-)  Depreciation  (1,00,000/5)
20,000
20,000
20,000
20,000
20,000

---
20,000
40,000
60,000
80,000
(-) Tax at 50%
---
10,000
20,000
30,000
40,000

---
10,000
20,000
30,000
40,000
 (+) Depreciation
20,000
20,000
20,000
20,000
20,000
Net cash inflows
20,000
30,000
40,000
50,000
60,000
Note – When income is ‘nil’ or it is negative figure after charging depreciation, tax is ‘nil’ in such years.
Statement showing cumulative cash inflows and pay-back period of projects A and B
Year
Project A
Project B
CIF
Cumulative CIF
CIF
Cumulative CIF
1
50,000
50,000
20,000
20,000
2
40,000
90,000
30,000
50,000
3
30,000
1,20,000
40,000
90,000
4
20,000
1,40,000
50,000
1,40,000
5
10,000
1,50,000
60,000
2,00,000
Initial Investment

1,00,000

1,00,000
 Pay-back period
2 years + 10,000/30,000
= 2.33 years
3 years + 10,000/50,000
 = 3.2 years

a.        Accounting Rate of Return (ARR) or Average Rate of Return
4)       A company is considering investment of Rs. 10,00,000 in a project. The following are the income forecasts, after depreciation and tax:
1st year loss
(Rs. 1,00.000)
2nd year profit
Rs. 3,00,000
3rd year profit
Rs. 4,00,000
4th year profit
Rs. 2,00,000
5th year profit
Rs. 2,00,000
Net profit (Total)
Rs.10,00,000
Calculate the Accounting Rate of Return –
(a)      on original Investment Method and
(b)     on Average Investment Method.
Solution
(a)     Calculation of Accounting Rate of return (ARR) on Original Investment Method
-          ARR = Annual Average net earnings /original investment x 100
-          Annual average net earnings = Earnings of five years /5 = 10,00,000/5 = 2,00,000
-          Original investment (given) = Rs. 10,00,000
-          So, ARR = 2,00,000/10,00,000  x 100 =  20%

(b)     Calculation of Accounting Rate of return (ARR) on Average Investment Method
-          ARR = Annual Average net earnings /Average investment x 100
-          Annual average net earnings = Earnings of five years /5 = 10,00,000/5 = 2,00,000
-          Average Investment =
Original investment – scrap value / 2 + Additional net WC + scrap value
= 10,00,000 – 0 / 2  + 0 + 0 = Rs. 5,00,000
-          So, ARR = 2,00,000/5,00,000  x 100 =  40%.

a)       Net Present Value (NPV)
b)        Present Value Index (PI) or Benefit cost
5)       Two projects M and N which are mutually exclusive are being under consideration. Both of them require an investment of Rs. 1,00,000 each. The net cash inflows are estimated as under –
Year
1
2
3
4
5
Project M (Rs.)
10,000
40,000
30,000
60,000
90,000
Project N (Rs.)
30,000
50,000
80,000
40,000
60,000
The company’s targeted rate of return on investments is 12%. You are required to assess the projects on the basis of their present values, using (i) NPV Method and (ii) Profitability Index Method –
-          Present value of Re.1 at 12% interest for five years are given below –
-          1st year: 0.893; 2nd year:0.797; 3rd year: 0.712; 4th year: 0.636; 5th year: 0.567.


Solution
 Statement showing present values of projects

Year
(1)
PV of Re. at 12% p.a
(2)
Project M
Project N
Cash inflows (3)
PV (4)
(2) x (3)
Cash inflows (5)
PV (6)
(2) x (5)
1
0.893
10,000
8,930
30,000
26,790
2
0.797
40,000
31,880
50,000
39,850
3
0.712
30,000
21,360
80,000
56,960
4
0.636
60,000
38,160
40,000
25,440
5
0.567
90,000
51,030
60,000
34,020



1,51,360

1,83,060
(a) Net Present Value Method


PV of Cash inflows
1,51,360
1,83,060
(-) Initial Investment
(1,00,000)
(1,00,000)
Net Present Value
51,360
83,060
Conclusion
Both the projects have positive NPV and are desirable and acceptable. Among them, Project N is preferred for a better NPV
(b) Profitability Index (PI)
= PV of cash inflows/PV of cash outflow (initial investment)
1,51,360 / 1,00,000
=  1.5136
1,83,060 / 1,00,000
=  1.8306
Conclusion
Both projects are acceptable since the PI is more than 1. However, Project N with higher PI of 1.8306 should be taken up and Project M may be rejected.