Ujala Saleem Syed

50819327
0

Topic:

Capital Budgeting & Financing

Decisions
Financing Decisions
 
“A decision made for the investment of funds that will be used to
increase the firm’s value”

OR

“Deciding, between two or more projects the which will restore more
for the firm”
 Selecting investments that will improve the financial
performance of the business involves two fundamental
tasks:

 Economic profitability analysis and

Economic profitability will show if an alternative is

economically profitable. The purpose of an economic
profitability analysis is to determine whether the
investment will contribute to the long run profits of the
business.
 Financial feasibility analysis

Financial feasibility analysis determines whether or not the

investment will generate sufficient cash income.
Capital Budgeting
• “The budgeting process in which a company plans its
capital expenditure”
A financial manager must be able to decide between
two or more alternatives by comparing the amount of
cash spent on an investment today with the cash
inflows expected from it in the future
To do this, a sound procedure to evaluate, compare,
and select projects is needed. This procedure is
called capital budgeting. In this process a business
determines whether projects such as building a new
plant or investing in a long-term venture are worth
pursuing. 
 Kinds Of Capital Budgeting
Decisions

Generally the business firms are confronted with three types of

capital budgeting decisions.

• The Accept-reject Decisions

• Mutually Exclusive Decisions And

• Capital Rationing Decisions
Capital Budgeting Analysis is a process of evaluating how we invest in capital
assets the assets that provide cash flow benefits for more than one year. Capital
budgeting process basically has five main stages or steps these are:

Evaluation
Evaluation Or
Or Analysis
Analysis

Identification
Identification Or
Or
Conception
Conception
Monitoring
 STAGE 1

Identification Or Conception
The main point here is that successful, dynamic and growing companies are constantly on
the lookout for new projects to consider. In the largest organizations there are entire
departments looking for alternatives and opportunities. Also a need can derive the idea for
capital investment. The capital investment projects are of different types these are as under
Investment proposals are also often classified according to the firm’s need

•Required investments
•Replacement investments
•Expansion investments
•Research and Development Projects
•Miscellaneous Projects
 STAGE 2

Evaluation Or Analysis

Once someone has had the idea to invest, the next step is to look at suitable
projects: projects that complement current business, and so on. Initially, all
possibilities will be considered along the lines of a suggest exercise.
As time goes by, and as corporate objectives allow, the initial list of potential
projects will be whittled down to a more manageable number.
 Identify and consider alternatives
Capital Budgeting Techniques

Because the amount of capital available at any given time for new projects is limited,
management needs to use capital budgeting techniques to determine which projects will
yield the most return over an applicable period of time. These capital budgeting techniques
are as follow:

Capital Budgeting
Techniques

Net Present Internal Rate Profitability Index Pay Back

Value Of Return Period
 Net Present Value

NPV is a standard method for using the time value of money to appraise long-term projects. It
compares the value of money today to the value of that same money in the future, taking inflation
and returns into account. If the NPV of a prospective project is positive, it should be accepted.
However, if NPV is negative, the project should probably be rejected because cash flows will
also be negative.
NPV Analysis

There are six steps to complete this net present value analysis procedure and to decide whether to
accept or reject the project.
•Choosing an appropriate discount rate to reflect the time value of money.
•Calculating the present value of the cash payout
•Calculating the annual net cash flow for each year from the investment over its maturity.
•Calculate the present value of the annual net cash flows.
•Compute the net present value.
•Accept or reject the investment project.
 NPV = - Co + C1 + C2 + C3…………. Cn

(1+r)1 (1+r)2 (1+r)3 (1+r)n

On 10% for 6 years period at 100 million initial investment.

(In millions)
Year Project Y Project Z
1 50 10
2 40 20
3 30 30
4 10 40
5 1 50
6 1 60

If the present value is positive, the project will be accepted, if negative, it should be rejected. If the
projects under consideration are mutually exclusive the one with the highest net present value should be
chosen. So NPV of two projects
NPV Project Y = 9.01 million
NPV Project Z = 40.4 million
Investing in project Z will increase the value of the organization.
Making accurate forecasts of future costs and benefits can be the most difficult step in
net present value analysis. Analysts should follow five general rules when forecasting
costs and benefits.
 Forecast benefits and costs in today’s money

 Do not include sunk costs

 Include opportunity costs

 Use expected value to estimate uncertain benefits and costs

Internal Rate Of Return

A project's internal rate of return (IRR) is the discount rate that makes the
net present value (NPV) of the project equal to zero An investment’s IRR
summarizes its expected cash flow stream with a single rate of return that is
called internal because it only considers the expected cash flows related to the
investment it does not depend on rates that can be earned on alternative
investments.
I = PV OR NPV = 0

The IRR Rule

A project should be accepted if its IRR is higher than its cost of capital and
rejected if it is lower. If a project’s IRR is lower than its cost of capital, the project
does not earn its cost of capital and should be rejected. The rule takes risk into
consideration.
 Profitability Index

PI is the ratio of the present value of a project’s future net cash flows to the project’s initial
cash outflow.
Or
Benefit-to-cost ratio equal to the ratio of the present value of a project’s expected cash- flows to
its initial cash outlay

The PI Rule
According to the PI rule a project should be accepted if its profitability index is greater than one
and rejected if it is less than one.

PI > 1 accept the project

PI < 1 reject the project

Formula
Where ICO = initial cash outflow

PVof cashflows
PI = 1 + [ NPV / ICO ] PI 
initialcoast
Pay Back Period

•Payback period is the length of time required to recover the initial outlay on the
project

Payback period = Expected number of years required to recover a

project’s cost.

Expected Net Cash Flow

Year Project L Project S
0 ($100) ($100)
1 10 (90)
2 60 (30)
3 80 50

Pay Back L = 2.4 years.

Pay Back S = 1.6 years.
 STAGE 3

Selection Or Decision

Once managers have determined the feasible/acceptable projects, then have to

make a decision of which to accept. If they have capital rationing problems, they
might be restricted to one project only. If they have no cash problems, they
might choose two or more. Whatever the cash position is they would like to
invest in project that has a positive NPV, whose IRR is greater than cut off rate
and so on.
STAGE 4

Implementation Stage
The fourth stage in capital budgeting process is the implementation stage in this stage the
management or authorized persons has the answer of these questions like
•What projects are good investment opportunities to the firm
•From this group which assets are the most desirable to acquire
•How much should the firm invest in each of these assets
Because they now know the possible profitability of the evaluated project and at this
evaluation basis they can now implement the project or other capital investment .
 STAGE 5

Monitoring
The project must be monitored as it progresses. If the project can be kept as a separate part
of the business, it might be set as its own department or division and it might have its own
performance reports prepared for it.

Post completion audit

Once the project has been up and running for six months or a year or so, there must be a
post completion audit or a post audit. A post audit looks at the project from start to finish:
stages 1 - 5 and looks at how it was thought of, chosen, analyzed, decided, implemented,
monitored and so on. The purpose of the post audit is to test whether capital budgeting
procedures have been fully and fairly applied to the project under review. At these basis
they can decide
•To continue the project
•Modify the project or
•Terminate the project
 Introduction
Packages Limited was established in 1957, to convert paper and paperboard into packaging
for consumer industry. Over the years, Packages has continued to enhance its facilities to
meet the growing demand of packaging products.

Different business divisions/units are

Paper and Board Mill

Packaging Division
Flexible Packaging Lin Carton
Consumer product division
 Consumer Products Division
In 1981 Packages modified a paper machine to produce tissue paper in response to
growing awareness and demand for hygienic and disposable issues. The “Rose Petal”
Brand name was launched with facial tissues and was later expanded to include toilet
paper, kitchen roll, and table napkins. In 2007, the company also invested in a new
35,000 tons tissue paper machine which started commercial production in 2008.

Decision To Expand the Capacity

The decision analyzed in this section was taken by the consumer product
Division. Capital expenditure proposals are motivated at the divisional level but
permission has to be obtained at the group level if the amount to be spent is above R1
million. This is formally done through a presentation to Board of Directors. An overview
of the capital investment decision-making process followed by theBoa
Division.
Recogniti
on of the
Identify
List of
Pre- rd
need for
additional
options:
Option B
engineer
ing Pres
Study
capacity selected
enta
tion
 Step 1: Recognition of the need for additional capacity

Two reasons were given by the division’s management for the need to
consider additional production capacity.
Firstly, the rate of growth of market demand was expected to increase;
and
Secondly, they believed it to be a strategic necessity to continue to
maintain sufficient excess capacity to protect the firm’s dominant market
position.
In July 2008 management indicated to the Division that they should base
their capital expenditure planning on three scenarios: five, ten and fifteen
percent annual growth in levels of market demand. The division thus proceeded
to look for alternative ways to supply the perceived need for an increase in
productive capacity.
 Step 2: Identify list of options

The Two options which were initially presented to the Division capital
expenditure committee for consideration in August 2008 was at number one to rebuilt
the PM 4 to fulfill the market demand and second option was to built a new paper
machine for higher demand .
Options Description Additional capacity
(000tons )

A To Up grading the PM4 9000

B TO Built PM9( A new paper machine) 27000

As shown in Table 2nd, each option was presented with its expected benefit
& its relative (estimated) capital costs, and finally its NPV

Option Description Estimated cost NPV Payback

period

A To Up grading the PM4 10 million 21.55 4 years 10

months
B TO Built PM9( A new paper 45 million 23.45 4 years 6
machine) months
Step 4: Pre-engineering study

The process of elimination of option A outlined in this step clearly

highlights the continued importance of qualitative variables in the decision-
making process. Each alternative was carefully evaluated judged in terms
of its alignment with the strategic goals and finally option B to purchase a
new paper machine is accepted on October 2008.
Step 5: Board presentation

The final stage of the decision-making process was to present the results to
the Capital Expenditure Committee of the Firm’s Board of Directors in
October 2008. The proposal to built PM9 The division’s management
clearly communicated this choice as an opportunity to improve the
production of its capital stock .This alternative allowed it revitalized the
capacity to produce more. The board approved the application and the
purchase of PM9 took place.
 Financial figures
This decision resulted in net increase of capital expenditure of Packages limited in
2008 (000)
Total Funds Invested 33,865
Long-Term Liabilities 7,971
Long Term Debt : Equity Ratio 25:75

Consumer Products Division has achieved sales growth of 37% during the
2009 over the corresponding period with export values three times more than
the 2008. This growth is mainly attributable to enhanced production capacity
available to the company through installation of new tissue paper
manufacturing machine with production capacity of 33,000 tons in September
2008 (total production capacity 41,000 tons per annum) that has enabled the
company to exploit opportunities available in international market particularly
Middle East. During the year, the company has also registered 22% sales
growth in the local market. Moving forward, the management is working hard
to further capitalize on the opportunities of business expansion.
 Conclusion
In brief, this assignment has demonstrated that capital budgeting
involves a lot more than just carrying out a few calculations for payback,
ARR and so on.
The capital budgeting process involves expenditures and
investments that are relatively large and that must then be undertaken and
controlled in a serious, professional way. Capital budgeting is the
process by which the financial manager decides whether to invest in
specific capital projects or assets.