CAPITAL BUDGETING

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Types of Expenditures
- Revenue Expenditure

Regular spending on the day to day running of the business

- Working Capital Expenditure

Investment in short term net assets

- Capital Expenditure

Spend money on new non-current assets. Spending may be for: 1) Maintenance 2) Profitability 3) Expansion 4) Indirect purpose
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Capital budgeting
The process of identifying, analyzing and selecting investment projects whose return are expected to extend beyond one year. Classification of investment projects - New product/ Expansion of existing product - Replacement of equipment and building - Research and development - Exploration - Other (E.g. safety related or pollution controlling device)
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Return on Capital Employed (ROCE)

ROCE = Average annual profit before interest and tax X 100

Initial Capital Cost Or

ROCE = Average annual profit before interest and tax X 100 Average Capital investment Where Average Capital investment = Initial Investment + Scrape Value 2
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Practice Question 1
A Project involves the immediate purchase of an item of plant costing USD 110,000. It would generate annual cash flow of USD 24,400 for five year. Scrape value of the project is USD 10,000. Depreciation is straight line.
Determine ROCE using; a) Initial capital cost b) Average Capital investment

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Practice Question 2
(Amount in thousand) Yeas 1 2 Cash inflow 100 200 3 400

A Project requires an initial investment of Rs 800,000 and then earns net cash flows as follows

4 400

5 300

6 200

7 150

After 7 years scrape value will be Rs 100,000. assume current Interest rate is 15%

Determine ROCE using; a) Initial capital cost b) Average Capital investment

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Important concepts for cash flow based capital budgeting

1) A comparison of Cash flow and Accounting Profit Accounting Cash flow Sales 1,000 1,000 Less: Expenses Cash Expenses (500) (500) Depreciation (300) Earning before tax 200 500 Tax (35%) (70) (70) Net Profit 130 430 Which one approach is better for capital budgeting/ investment appraisal 1) Cash is what ultimately counts 2) Profit is Subjective due to assumptions and professional judgment
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2) Relevant and Irrelevant Cash flow

Relevant Cash Flow

1) Variable material cost 2) Variable labor cost 3) Additional Fixed cost 4) Cost of investment 5) Marginal Tax

Irrelevant Cash Flow

1) Fixed cost (Existing) 2) Dunk Cost (Past)

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PAY BACK METHOD

Decision Rule - Only select projects which pay back with in specific time period - Choose between options on basis of the fastest payback

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Constant annual cash flow

Payback period = Initial Investment Annual Cash flow Question: An expenditure of USD 1.8 million is expected to generate net cash inflow of USD 350.000 each year for the next 7 years. What is the payback period for the project?
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In consistent annual cash flow

YEAR 0 1 2 3 4 CASHFLOW (3,100) 1,000 900 800 500 5 500 What is the payback period for the project?

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Discounting 0 PV Discounting of Single Sum 1 2 3 4 5 6 7 8 FV

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Practice Question 1
A payment of USD 1,000 is to be made every year for 3 years, the first payment occurring in one years time. The interest rate is 10%. What is the PV of such payment?

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Practice Question 2
A payment of USD 3,000 is to be made every year for 5 years, the first payment occurring in one years time. The interest rate is 12%. What is the present value

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Practice Question 3
Investment required for a project is Rs 10,000. A payment of USD 3,000 is to be made every year for 5 years, the first payment occurring today. The interest rate is 12%. Should we make an investment?

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Present value of a perpetuities

PV = Cash flow r

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Practice Question 4
What is the present value of Rs 5,000 to be made annually. If the interest rate is 12%.

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Practice Question 5
A perpetuity of USD 2,000 is due to commence immediately. The interest rate is 9. What is the present value of it

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Practice Question 6
What is the present value of USD 200 incurred each year for 4 years, starting from third year. Interest rate is 5 %.

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Practice Question 7
Investment required for a project is Rs 10,000. A payment of USD 3,000 is to be made every year for 5 years, the first payment occurring in one years time. The interest rate is 12%. Should we make an investment?

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Practice Question 8
Project A Investment required for a project is Rs 10,000. A payment of Rs 3,000 is to be made every year for 5 years, the first payment occurring in one years time.
Project B Investment required for a project is Rs 15,000. A payment of Rs 4,500 is to be made every year for 5 years, the first payment occurring in one years time. The interest rate is 12%. Which project is better??
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Practice Question 9
Project A Investment required for a project is Rs 150,000. A payment of Rs 25,000 is to be made every year. Project B Investment required for a project is Rs 170,000. A payment of Rs 27,000 is to be made for 10 years. Scrape value of Project B is Rs 10,000.
The interest rate is 12%. Which project is better??
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Present value Annuity

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Practice Question 10
Investment required for a project is Rs 70,000. A payment of Rs 8,000 is to be made every year for 20 years, the first payment occurring in one years time. The interest rate is 10%. Should we make an investment?

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Practice Question 11
Project A Investment required for a project is Rs 70,000. A payment of Rs 9,000 is to be made every year for 20 years, the first payment occurring in one years time.
Project B Investment required for a project is Rs 75,000. A payment of Rs 8,000 is to be made every year for 30 years, the first payment occurring in one years time. The interest rate is 12%. Should we make invest if yes then which project is better??
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Question 12
ABC ltd is considering an expansion of the installed capacity of one of its plant at a cost of Rs. 3,500,000. The firm has a minimum required rate of return of 12%. The following are the expected cash inflow over next 6 years after which plant will be scrapped away for nil value
YEAR 1 Cash Inflow Rs 1,000,000

2
3 4 5

Rs 1,000,000
Rs 1,000,000 Rs 1,000,000 Rs 500,000

Rs 500,000

Consider the proposal on the basis of the NPV

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Practice Question 13
Investment required for a project is Rs 100,000. A payment of Rs 40,000 is to be made every year for 5 years, the first payment occurring in one years time. Tax rate is 30% and scrape value is RS 10,000. The interest rate is 10%. Should we make an investment?

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Internal Rate of Return

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Formula for IRR

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Practice Question 1
Investment required for a project is Rs 10,000. A payment of Rs 3,000 is to be made every year for 5 years, the first payment occurring in one years time.
a) What is IRR b) Should we make an investment if Bank interest rate is 12%?

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Practice Question 2
Investment required for a project is Rs 100,000. A payment of Rs 40,000 is to be made every year for 5 years, the first payment occurring in one years time. Scrape value is Rs 20,000 and tax rate is 20%.
a) What is IRR

b) Should we make an investment if Bank interest rate is 15%?

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Sensitivity Analysis
Sensitivity analysis typically involves posing What if

Sensitivity Margin =

NPV
PV of flow under consideration

X 100

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Practice Question 1
An investment of USD 40,000 today is expected to give rise to annual contribution of USD 25,000 and annual fixed cost of USD 10,000 for the next four years; discount rate is 10%. Required: (a) Calculate NPV (b) Calculate and explain the sensitivity of your calculation to the following; - Initial Investment - Contribution - Fixed cost - Discount rate - Life of the project
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Practice Question 2
An investment of USD 50,000 today is expected to give rise to annual contribution of USD 20,000 and annual fixed cost of USD 7,500 for the next four years; discount rate is 12%. Required: (a) Calculate NPV (b) Calculate and explain the sensitivity of your calculation to the following; - Initial Investment - Contribution - Fixed cost - Discount rate - Life of the project
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Probability Analysis
Calculation of; - Expected value (EV) - Measure risk

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Practice Question 1
A newsagent sells a weekly magazine. Purchase price is Rs 15 and the selling price is Rs 25. Unsold magazines are obsolete and have no value. The owner estimates a probability distribution as follows Weekly demand in units Probability 10 20% 15 55% 20 25%
(a) What is the ES of demand? (b) If the owner is to order a fixed quantity of magazines how

many should that be?

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Practice Question 2
A newsagent sells a weekly magazine. Purchase price is Rs 10 and the selling price is Rs 30. Unsold magazines are obsolete and have no value. The owner estimates a probability distribution as follows Weekly demand in units Probability 10 40% 15 40% 20 20%
(a) What is the ES of demand? (b) If the owner is to order a fixed quantity of magazines how

many should that be?

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Real option
Types of Real option based on activities - Call option - Put option
Types of Real option based on maturity - American Call - European Call

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Methods of measuring Real option

BlackScholes Model For Call Options

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For put option

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Practice Question 1
Current Price = 100 Future Price = 105 Standard deviation = 50% Interest Rate = 10% Time = 1 Year
What is the cost of this call option and as well as put option

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