NAME : Indranil Paul

ENROLLMENT

NO :A91801919092

DEPARTMENT : MBA

SEM : 4th

SUBJECT : STRATEGIC FINANCIAL

MANAGEMENT

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Capital Budgeting:

Capital budgeting is the process of making investment decisions in long term assets.
It is the process of deciding whether or not to invest in a particular project as all the
investment possibilities may not be rewarding.
Thus, the manager has to choose a project that gives a rate of return more than the
cost financing such a project. That is why he has to value a project in terms of cost
and benefit.
Following are the categories of projects that can be examined using capital budgeting
process:
• The decision to buy new machinery
• Expansion of business in other geographical areas
• Replacement of an obsolete equipment
• New product or market development etc
Thus, capital budgeting is the most important responsibility undertaken by a financial
manager. This is because:
1. It involves the purchase of long term assets and such decisions may determine
the future success of the firm.
2. These decisions help in maximizing shareholder’s value.
3. Principles applicable to capital budgeting process also apply to other corporate
decisions like working capital management.
Process of Capital Budgeting
Following are the steps of capital budgeting process:
• Idea Generation
The most important step of the capital budgeting process is generating good
investment ideas. These investment ideas can come from a number of sources like the
senior management, any department or functional area, employees, or sources outside
the company.
• Analyzing Individual Proposals
A manager must gather information to forecast cash flows for each project in order to
determine its expected profitability. This is because the decision to accept or reject a
capital investment is based on such an investment’s future expected cash flows.
• Planning Capital Budget
An entity must give priority to profitable projects as per the timing of the project’s
cash flows, available company resources, and a company’s overall strategies. The
projects that look promising individually may be undesirable strategically. Thus,
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prioritising and scheduling projects is important because of the financial and other
resource issues.
• Monitoring and Conducting a Post Audit
It is important for a manager to follow up or track all the capital budgeting decisions.
He should compare actual with projected results and give reasons as to why
projections did not match with actual performance. Therefore, a systematic post-audit
is essential in order to find out systematic errors in the forecasting process and hence
enhance company operations.

Techniques of Capital Budgeting:

Capital budgeting techniques are the methods to evaluate an investment proposal in
order to help the company decide upon the desirability of such a proposal. These
techniques are categorized into two heads : traditional methods and discounted cash
flow methods.

Traditional Methods
Traditional methods determine the desirability of an investment project based on its
useful life and expected returns. Furthermore, these methods do not take into account
the concept of time value of money.

Pay Back Period Method

Payback period refers to the number of years it takes to recover the initial cost of an
investment. Therefore, it is a measure of liquidity for a firm. Thus, if an entity has
liquidity issues, in such a case, shorter a project’s payback period, better it is for the
firm.
Therefore,
Payback period = Full years until recovery + (unrecovered cost at the beginning of
the last year)/
Cash flow during the last year
Here, full years until recovery is nothing but the payback that occurs when
cumulative net cash flow equals to zero. Cumulative net cash flow is the running total
of cash flows at the end of each time period.

Average Rate of Return Method (ARR)

Under ARR method, the profitability of an investment proposal can be determined by
dividing average income after taxes by average investment, which is average book
value after depreciation.
Thus, ARR = Average Net Income After Taxes/Average Investment x 100
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Where, Average Income After Taxes = Total Income After Taxes/Total Number of
Years
Average Investment = Total Investment/2
Based on this method, a company can select those projects that have ARR higher
than the minimum rate established by the company. And, it can reject the projects
having ARR less than the expected rate of return.

Discounted Cash Flow Methods

As mentioned above, traditional methods do not take into the account time value of
money. Rather, these methods take into consideration present and future flow of
incomes. However, the DCF method accounts for the concept that a rupee earned
today is worth more than a rupee earned tomorrow. This means that DCF methods
take into account both profitability and time value of money.

Net Present Value Method (NPV)

NPV is the sum of the present values of all the expected incremental cash flows of a
project discounted at a required rate of return less than the present value of the cost of
the investment.
In other words, NPV is the difference between the present value of cash inflows of a
project and the initial cost of the project. As per this technique, the projects whose
NPV is positive or above zero shall be selected.
If a project’s NPV is less than zero or negative, the same must be rejected. Further, if
there is more than one project with positive NPV, then the project with the highest
NPV shall be selected.
NPV = CF1/(1 + k)1 + ……….. CFn/ (1 + k)n + CF0
where CF0 = Initial Investment Outlay (Negative Cash flow)
CFt = after tax cash flow at time t
k = required rate of return

Internal Rate of Return (IRR)

Internal Rate of Return refers to the discount rate that makes the present value of
expected after-tax cash inflows equal to the initial cost of the project.
In other words, IRR is the discount rate that makes present values of a project’s
estimated cash inflows equal to the present value of the project’s estimated cash
outflows.
If IRR is greater than the required rate of return for the project, then accept the
project. And if IRR is less than the required rate of return, then reject the project.
PV (inflows) = PV (outflows)
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NPV = 0 = CF0 + CF1/(1 + IRR)1 + ……….. CFn/ (1 + IRR)n + CF0
Profitability Index
Profitability Index is the present value of a project’s future cash flows divided by
initial cash outlay. Thus, it si closely related to NPV. NPV is the difference between
the present value of future cash flows and the initial cash outlay.
Whereas, PI is the ratio of the present value of future cash flows and initial cash
outlay.
PI = PV of future cash flows/CF0 = 1 + NPV/CF0
Thus, if the NPV of a project is positive, PI will be greater than 1. If NPV is negative,
PI will be less than 1. Therefore, based on this, if PI is greater than 1, accept the
project otherwise reject.

1.Certainty Equivalent Factor (CEF):

Certainty Equivalent Factor (CEF) is the ratio of assured cash flows to uncertain cash
flows. under this approach, the cash flows expected in a project are converted into
risk-less equivalent amount. The adjustment factor used is called CEF. This varies
between 0 and 1. A co-efficient of 1 indicates that cash flows are certain. The greater
the risk in cash flow, the smaller will be CEF ‘for receipts’, and larger will be the
CEF ‘for payments’. While employing this method, the decision maker estimates the
sum he must be assured of receiving, in order that he is indifferent between an
assured sum and expected value of a risky sum.
Method of Computation under CE approach:
Step 1: Convert uncertain cash flows to certain cash flows by multiplying it with the
CEF.
Step 2: Discount the certain cash flows at the risk free rate to arrive at NPV.
Decision Rule: If the resultant NPV is positive project can be accepted.
Illustration: NZ ltd. is considering to take a new project. The management of the
company use Certainty Equivalent (CE) approach to evaluate such type of projects.
Following information is available for the project:
Year CFAT CE
1 1,15,000 0.90
2 1,15,000 0.85
3 1,15,000 0.75
4 1,15,000 0.70
5 1,15,000 0.65
Projects requires initial investment of ` 3,00,000. The Company’s cost of capital is
12% and risk free borrowing rate is 7%.
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Advise the company whether it should take project or not?
Solution:
Year CFAT CE Adjusted Pv PV Factor PV

1 1,15,000 0.90 103500 0.935 96722

2 1,15,000 0.85 97750 0.873 85366

3 1,15,000 0.75 86250 0.816 70380

4 1,15,000 0.70 80500 0.763 61422

5 1,15,000 0.65 74750 0.713 53297

Total Present Valve 367207

(-)
Initial Investment (300000)

67207
Net Present Value
Since NPV is positive, project can be accepted.

2.Estimated cash flows in capital budgeting:

The concept of probability is fundamental to the use of the risk analysis techniques. it
may be defined as the likelihood of occurrence of an event. if an event is certain to
occur, the probability of its occurrence is one but if an event is certain not to occur,
the probability of its occurrence is zero. thus, probability of all events to occur lies
between zero and one.
probability distribution can be used to compute expected values. For this purpose
following procedure is adopted:
step 1: establish probability distribution
step 2: Multiply values with probability of each outcome
step 3: aggregate the result of step 2
Illustration: X ltd. is considering to start a new project for which it has gathered
following data:
Cash flow Probability
30,000 0.1
60,000 0.4
1,20,000 0.4
1,50,000 0.1
Calculate the expected cash flow.

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Cash Flow Probability Expected Cash Flow

3000 0.1 300

6000 0.4 2400

12000 0.4 4800

15000 0.1 1500

CF= 9000

3.Standard deviation (i.e. risk)

Standard deviation is a statistical measure of dispersion. it measures the deviation
from a central number i.e. mean. By calculating standard deviation in capital
budgeting, we can measure in each case the extent of variation. Higher the standard
deviation, higher is the risk associated with the project.
However, wherever returns are expressed in revenue terms the co-efficient of
variation gives better measurement for risk evaluation.
Coefficient of variation is calculated as follows:
Coefficient of variation = σ /npV

Illustration 1: X ltd. is considering to start a new project for which it has gathered
following data:
NPV Probability
80,000 0.3
1,10,000 0.3
1,42,500 0.2
Compute the risk associated with the project i.e. standard deviation.

Solution:
NPV Probability Expected NPV
80,000 0.3 24000
1,10,000. 0.3 33000
1,42,500 0.2 28500
NPV= 85500

NPV D D^2 P PD^2

80000 -5500 30250000 0.3 9075000

110000 24500 600250000 0.3 180075000

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 142500 57000 3249000000 0.2 649800000

σ2= 838950000
σ = 28965
Coefficient of variation = σ/ NPV = 28965/85,500 = 0.34

4.Coefficient of variation
Coefficient of Variation = σ/ npv

Project Expected NPV (` ) Standard deviation

X 18,000 6,500
Y 22,000 7,200

Which project willyou recommend?

Solution:
On the basis of information about standard deviation of Project X & Y, the Project X is

Project X = 6500/18000 = 0.36

Project Y = 7200/22000 = 0.327

Project Y is better as its CV is lesser than Project X.

5. Decision tree technique:

Decision tree technique is a method to evaluate risky proposals. a decision tree shows
the sequential outcome of a risky decision. the decision tree approach gets its name
because of resemblance with a having number of branches. A capital budgeting
decision tree shows the cash flows and net present
value of the project under differing possible circumstances.
Illustration: A company has made following estimates if the CFAT of the proposed
project. The company use decision tree analysis to get clear picture of project’s cash
inflow. The project cost ` 80,000 and the expected life of the project is 2 years. The
net cash inflows are:
In year 1, there is 0.4 probability that CFAT will be ` 50,000 and 0.6

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 probability that CFAT will be ` 60,000. The probabilities assigned to CFAT for the
year 2 are as follows:
If CFAT = Rs 60,000
Rs Probability
40,000 0.4
50,000 0.5
60,000 0.1 `

If CFAT = Rs 5000
Rs. Probability
24,000 0.3
32,000. 0.2
44,000 0.5
The firm uses 10% discount rate for this type of investments.
Solution: Decision Tree:

Combination CFAT1 PV Factor PV 1 CFAT2 PV Factor PV 2

A 50,000 0.909 45,450 24,000 0.826 19,824
B 50,000 0.909 45,450 32,000 0.826 26,432
C 50,000 0.909 45,450 44,000 0.826 36,344
D 60,000 0.909 54,540 40,000 0.826 33,040
E 60,000 0.909 54,540 50,000 0.826 41,300
F 60,000 0.909 54,540 60,000 0.826 49,560

Combination Total PV Initial NPV Joint Expected NPV

(PV 1 + investment Probabilities
PV2)
A 65,274 80,000 - 14,276 0.08 - 1,178
B C 71,882 80,000 - 8,118 0.12 - 974
D
81,794 80,000 1,794 0.20 358
E F
87,850 80,000 7,580 0.24 1,819
95,840 80,000 15,840 0.30 4,752
1,04,100 80,000 24,100 0.06 1,446
6,223

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 ` 24,000 0.2

` 32,000 0.3
0.4

Cash ` 44,000 0.5

Outflow

` 40,000 0.4

` 50,000 0.5
0.6
` 60,000 0.1

5. Discounted Cash Flow Models:

Assume that your company, Rudolph Incorporated, is determining the NPV for a new
X-ray machine. The X-ray machine has an initial investment of ?200,000 and an
expected cash flow of ?40,000 each period for the next 10 years. The expected ?
40,000 cash flows from the new X-ray machine can be attributed to either additional
revenue generated or cost savings realized by more efficient operations of the new
machine. Since these annual cash flows of ?40,000 are the same amount in each
period over the ten-years this will be a stream of annuity amounts received. The
required rate of return on such an investment is 8%. The present value factor (i = 8, n
= 10) is 6.710 using the Present Value of an Ordinary Annuity table. Multiplying the
present value factor (6.710) by the equal cash flow (?40,000) gives a present value
of ?268,400. NPV is found by taking the present value of ?268,400 and subtracting
the initial investment of ?200,000 to arrive at ?68,400. This is a positive NPV, so the
company would consider investment.

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 6.Sensitivity Analysis

• For evaluation of projects cash flows are estimated

• The forecasted cash flow depends upon several factors, like volume of sales,
selling price, variable costs, fixed costs etc., which are subject to change
• Thus, NPV and IRR calculated on the basis of estimates depends upon several
factors and it is very difficult to estimate or arrive at an accurate and unbiased
forecast of these variables
• Accuracy and reliability of NPV and IRR is questioned and depends upon
correct estimate of these variables and reliability
• To ensure reliability and accuracy, impact of these variables are
ascertained –This method consider

Steps involved in Sensitivity Analysis:

1. Identify the variables which influence NPV/IRR

2. Define the underlying relationship with the help of mathematical
equations
3. Analyze the impact of changes in each of these variables
In sensitivity analyze, the decision maker makes three assumptions – pessimistic,
expected and optimistic
On the basis of these assumptions, he can conduct “what …. if” analysis. WHAT will

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Then values of these variables are changed (at least three times, considering
pessimistic, expected and optimistic) and NPV / IRR are recalculated under
these assumptions.

This method of recalculating NPV / IRR by changing each of the

forecast variable is called SENSITIVITY ANALYSIS

It is a behavioral approach that uses a number of possible values for a given

variable to assess the impact on a firms return

It is a way of analyzing change in the project’s NPV /IRR for a given change in
one of the variables

It indicates how sensitive a project’s NPV/IRR is to changes in particular

variables

The more sensitive the NPV/IRR, the more critical is the variable

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