Abstract In today's fast growing world, companies are faced with tough competitive and its survival depends on its long term planning, A firm is successful only if it invests wisely by taking informed decisions and earn profits. Capital budgeting decision are usually long term decisions, so a firm needs to be much more cautious while taking the final decision whether to go for a project or not. Here, we are going to discuss a case of hypothetical company in which we get to learn different aspects of Capital Budgeting Decisions. Introduction Nowadays, everyone is looking for a quick bite. At present there are many companies offering a variety of ready to eat snacks. But there have been many reports cautioning us about the unhygienic and unhealthy constituents in these snacks. The growing demand of snacks among youth and children and the absence of a healthier alternative, caught Baba Ramdev’s attention. With the vision of providing better and healthier snacks he launched his own company “Ramdev Khanpan Pvt. Ltd”, After three years of extensive research, his team came up with a great product and is looking to start manufacturing it, After month of research his team came up with two business proposals. ‘The first proposal, hereafter referred as ‘Project A’ proposes in-house production by setting up own manufacturing plant which will involve huge capital investments. The other proposal, hereafter referred as ‘Project B’ proposes outsourcing of production to a. reputed manufacturing firm, thus saving capital investments but affecting profit margins. Baba Ramdev faced with these choices asked his CFO Kamlesh to evaluate these proposals and find the better proposal. The CFO analyses the two proposals using capital budgeting decisions by applying the concepts learned in MSLo2 course taught by Prof Shveta.Relevant Data 1. Project A: A) The proposal of setting up company’s own manufacturing plant involves initial investments as: 2) Buying a newly built factory building: Rs, 17.5 Cr: 2) Purchase of Machinery: Rs125 Cr. ‘Total Starting Investment: Rs 142.5 Cr. B) The newly set up factory will take some time in reaching its fill produetion capacity. The Market analyst forecasted the production volume as follows: Year 7 2 3 4 3 Expected Production 5 10 25 30 35 (units) Expected Sales Revenue ; F 3 Wace) 50 100 250 300 350 ©) Cash Flows: The company is likely to bear fixed operation and maintenance expenses of Rs. § Cr, Per annum. The production cost for company és Rs 3 per unit while the price of each unit is Rs 10. The Company is subjected to 95% tax on earnings and a straight line method of depreciation, Particulars Yeart | Year2 [ Year3 | Yeara | Years Sales Revenue 50 100 250 300 350 Less Fixed Cost 5 5 Ey 5 5 Less Variable cost 15 30 5 75 87.5 ‘Less depreciation(0.20) 25 25 25 25, 25 EBIT 5 ao 145 195 232.5, Less Taxes(35%) 175 4 50.75 | 68.25 | 81.975 EAT 335, 26 9425 | 12675 | a51a25 Add depreciation 25, 235 25 25 25 CEAT 5 5 | 176.195 *Allvalues in Rs Crore D) Total Investment = Initial Investment + Operating Expenses = 142.5 + 25 +28: Rs 450 Cr Total Earnings after taxes EAI ‘Total Cash Flows after Taxe Rsqoid Cr. Read Cr2. Project B: A) The proposal of outsourcing the production to another firm involved an initial investment for tenders, legal expenses and advance payments of Rs 6 Crores. B) The firm charged the following rates for production of snacks depending on the volumes: Production (Cr. 0-20 20-50 50-100 units) Gharges per unit Reg R35 Reg ©) The Market analyst forecasted the demand volume for snacks as follows: ‘Year 1 2 3 4 5 [Expected Demand (units)| 10 ry 20 30 ao Reposted Bakes Neves | o5 | ag | ann | aoa | aoa |} D) Cash Flows: The company is likely to bear distribution and processing charges of Rs 0.2 per unit other than contract charges. The price per unit is Rs 10 and the Company is subjected to 35% tax on earnings, Particulars Years | Year2 Sales Revenue 100 40 ‘Contract cost 4o 56 Distribution and processing, . | i cost (2%) : EBIT me ‘Less Taxes (35%) | 28.42 52.78 CFAT. 52.78 E) Total Investment = Initial Investment + Charges = Rs (6+ 421+23) Cr. = Rs 450 Cr ‘Total Earnings after taxes EAT = Rs 452.5 Cr. ‘Total Cash Flows after Taxes = Rs 452.5 Cr.Financial Analysis (Capital Budgeting Decisions) Forassessing the two proposals, company's CFO Kanilesh looked at some popular methods and compared the two projects. 1, Average Rate of Return (ARR) Method Accounting rate of return is also called the simple rate of return and isa metric useful in the quiek calculation of a company’s profitability, ARR is used mainly as.a general comparison between multiple projects as itis a very basic look al how a project is doing. Project A: Average EAT = (Total EAT / Time Period) = Rs go1g8/5C. = Rs 80.276 Ce. “Averge Investment = Total Investment / 2 = Rs.q50 /2Cr. = Rs, 225 Cr, ARR = (Average EAT + Average Investment) "100 % = 80.276 / 225° 100 = 35.67% Project B: Average EAT = (Total EAT / Time Period) = Rs. 45253 /5€r. = Rsgo.506 Cr. Average Investment » Total Investment / 2 = Rs ago /2 Cr. = Rs. 225 ARR = (Averuge EAT = Average Investment) *100.% = 90.506 / 225 * 100 = 40.22% He observed that both of the projects have very good rate of return and project B has slightly better ARR. But ARR does not consider the time value of money, which that returns taken in during later years may be worth less than those taken in now, and does not consider cash flows, which can be an integral part of maintaining a business. Thus, he must not solely depend on ARR as tie method for selecting the Project. ote secentig rate of return dows not conser the increased risk of ng-term and the increased variability associated with long periods of time.2. Pay Back Method This method indicates the time period required to recover the initial investment outlays of the ‘apital budgeting proposal. The earlicris the sum received, the better it is as per the payback period. ‘Year 7 2 3 4 3 ProjectA | 28. 925 Page al CEAT 5 5 19.25, ISL75, ProjectB | 37.7 | 5278 | 75a | 1285 ProjectA | 28.25 25 | BS | 3502) Cumulative CEAT is * ” a ProjectB | 37.7 | 0048 | 10588 | a8875 values in’ Rs Crores ‘We need to recover our total Investment of Rs, 450 Cr, thus payback period for each project is 1. Project A: CFAT at end of year 4 = 350.25, CFAT at end of year 5 = 526.375 ‘Therefore, by interpolation, PB = 4.566 years 2 Project Be CEAT at end of year 4 = 288.73, CFAT at end of year 5 = 452.53 ‘Therefore, by interpolition, PB = 4.98 years ‘On evaluating on the basis of Payback Method he found that Project A is better whereas project B has higher ARR. The payback period does not concern itself with the time value of money. In fact, the time value of money is completely disregarded in the payback method, which is calculated by counting the number of years it takes to recover the cash invested. So before taking the final decision he thought of doing more research and analysis as te had heard that ARR and Payback period methods are the cruce method of evaluating capital budgeting proposals. He remembered about the time value of money concept that he had studied in the course of MS1.902, Financial Management and Accounting. He realized that to get the true picture of the projects he needs to discount the cash inflows. He now thought of using the internal rate of return methad hich is quite popular in the corporate sector to identify the best proposal.3. Internal Rate of Return (IRR) Method “This method indicates the expected rate of return likely to be provided by the capital budgeting proposal. The project is accepted if the cost of capital is less than the IRR and rejected ifit is more than IRR. To calculate IRR, we use an approximate method where we first calculate fake payback period to estimate the likely rate of return and then use Annuity table to find the best match. a, Project Fake Annuity = (Total CFAT) + (Total Time) = 526.38 / 5 = Rs. 105.27 Cr. Fake Payback Period= (Total Investment) + (Fake Annuity) 440.5/105.27 =4.18 years Now he found the PVIF close to 4.18 years in the table giving present value of an annuity of One Rupee for § years (Table A-2 of the course pack of MSL-302) to be between 6 and 7% as shown below. Year Raed facaeetg) facamnton) saceaet 7%) < Evan ~ 1 28.25 095 0.94 004 26.89 26.64 26at 2 51.00, 0.91 0.89 0.87 46.26 45.39 44.52 3 one 103.03 | 100.47 97-38 7 0.76 124.89 | 12019 | 15.79 = ot 138.08 | isa? 441.00 | 423.95 | 409.61 values in Rs Crores He observed that the PVEF of 6% and 7% did not give the results, so he tried with 5%. Now he used interpolation to find the IRR, IRR = 5 + (441-440) / (441-424) = 5.06%= (Total CFAT)=(TotlTime) = 452.53 /5 Fake Payback Period= (Total Investment) + (Fake Annuity) Rs. 90.5 Cr, 443.5/90.5 = 4.8 years Similarly, he found the PVIF close to 4.8 years in the table giving present value of an annuity of One Rupee for 5 years to be between 1% and 2% as shown below: Year Peer fas as PV factor(2%) | PV at 2% PV at2% 1 37.70 099 008 3695 2 52.78 0.08 0.96 5O72 3 OOF 0.94 70.88 4 0.96 0.92 118.07 ngsl 3 oo 155.77 148.40 ‘Total Present Value aaean 420.46 “All values in Rs Cro Now he used interpolation to find the IRR, IRR = 1 + (436-432)/ (436-420) = 1.25% He observed that project.A conclusively autperforms project B in terms of Internal Rate of Return. On having a closer took he found out the reason for project A having higher IRR has to do with higher CEAT on account of full capacity production in the: So he was convinced that project A és better and going to convey this to Baba Ramdew next day, but in the meantime he wanted to consult his professor Mrs. Shveta Singh about the latest research in Financial Analysis of projects in capital budgeting. During the conversation, he also discussed about his on-going case and his findings. After listening to him, professor reminded him the importance of NPV in capital budgeting decisions and stated that although IRR is an appeating metric to many, it should aheays be used én conjunction with NPV for a clearer picture of the value represented by @ potential project a firm may undertake, ‘Thus before taking the final call he analyzed the projects using NPV method.4. Net Present Value (NPV) Method Determining the value of a project is challenging because there are different ways: to measure the value of future cash flows. Because of the time value of money (TVM), money in the present is worth: more than the same amount in the future. This is both because of earnings that could potentially be made using the money during the intervening time and because of inflation. In other words, a dollar earned in the future won't be worth as much as one earned in the present. ‘The discount rate element of the NPV formula is a way to account for this. Companies may often have different ways of identifying the discount rate. He used the discount rate of 10% which was close to the company’s expected rate of returns, Here, PV = Present Value Year | project | Projects | PY FOG | ta | ujeet a 28.25 37-70 0.91 25.68 = BL00 5278 ony a 3 119.35 75.40 O75 9.56 4 151.75, 122.85 0.68 103.65 Ss 176.13, 163.80 0.62 209.37, 7 Total PV of cash inflow so38 Total PV of cash outflow 143.00 Net PV of Cash Flow 23h Big.00 T All valties in Rs Crores: Analysis with NPV gave some surprising results, both projects have NPV Positive and so both are good projects to invest in. But Project B had Significantly higher NPV than Project A, implying that project B is more profitable. But this was completely opposite of what ke got from the IRR method where he got four times higher IRR from project A. Faced with completely opposite result from the two methods he was unsureaf whieh project to recommend. So he decided to study the implications of both the methods thet would result in greater fiture value of the company and came 10 the below conclusion. |Conclusion We have seen different methods ised for capital budgeting proposals but sometimes we are faced with situations where all methods give opposite results such as the situation of Kamlesh, He needs to select the better of the two proposals by either relying on the results of IRR or NPV method. To: solve this dilemma, we closely look at both these methods find the better method. The key differences between the two most popular methods NPV and ERR are 1. NPV is an absolute measure and is calculated in currency whereas IRR is relative method based on pettetitage return a firm expects the capital project to return. 2, NPVis suitable for projects with changing cash flows while IRR assumes consistent cash flows. 3. NPV method gives more importance to time value of money but its value is dependent on the chosen discount rate. 4. IRR method hasan advantage that Managers tend to better understand concepts in percentages but for it to bea valid way, it needs to be compared to a discount rate, 5. A project is a good project ifit has a positive NPV or if its IRR is higher than thediseount rate, Due to above reasons, academicians consider NPV to be a better option for evaluation than IRR. Majority of companies use IRR and NPV, but some also use simple methods like Pay Back and ARR. Based on the knowledge we have acquired after studying the MSLgo2 course, we will suggest Kamlesh to recommend the project with higher NPV i.e project B of outsaureing the manufacturing to company’s CEO Baba Ramdev: Acknowledgement We would like to acknowledge the support of Prof. Shveta Singh, Department of Management Studies, IIT Delhi and help of various online resources for helping us in understanding of the nuances of accounting and financial management and completion of this term paper: References © http://www.wallstreetmojo.com © https://index investopedia.com ‘= ttp://nmw.wikipedia.com © MSL302 Course Pack 10