CAPITAL BUDGETING

S.CLEMENT
9869657034
cpmclement@reidffmail.com.
 Suggested reading
 Financial Management by
 1. Prasanna Chandra
 2. IM Pandey
 3. Khan & Jain.
 Principles of corporate finance by
 Brerly, Meyers & Mohanty
 Financial engineering – LJ Gitman
 Capital Budgeting
 Capital budgeting is not the budgeting for raising capital
from different source of finance but it is the planning and
control process of capital expenditure for the purpose of
maximizing the long profitability of the firm
 Capital budgeting consists in planning the employment of
available capital for the purpose of maximizing long term
return on investment.
 Proposed capital expenditures and their financing are
considered .Projects assuring highest returns are selected.
 L J Gitman – “ capital budgeting refers to the total
process of generating , evaluating , selecting and follow
up of capital expenditure alternatives”
 Balance sheet
 Liabilities  Assets
 Capital  Fixed assets
 Reserves  Investments
 Secured loans  Inventory
 Unsecured  Receivables
 Current liabilities  Others
 Provisions
 Capital structure
 Equity or debt options and leverage
 Which market to access
 Cost of financing – interest/ dividend
 Minimum cost
 Maximization of profit
 WC management
 Operating cycle
 Level of CA/CL
 Source of financing
 Parking of temporary surplus
 CAPITAL STRUCTURE
DEBBT
CAPITAL

DOMESTIC EXTERNAL

INEREST CURRENCY
MATURITY

MEDIUM FIXED
LONG TERM SHORT TERM FLOATING MARKET
 Capital Budgeting- implications
 Capital expenditure involves Long term implications
 Substantial out lay
 Difficult to reverse the decision. E.g. Infrastructure
projects in India.
 High risk. Difficult to predict future.
 Impact on firms’ competitive strength
 Impact on cost structure
 Difficult decision to make
 Maximization of share holders wealth vis-à-vis share
holders activism.
 Capital budgeting process
 Project generation – proposal to expand revenue or
control/reduce cost.
 Project evaluation – estimating the cost and beenfit
in terms of cash flows. Decide the selection
criteria. E.g. Huddle rate.
 Project selection
 Project execution – funds spent in accordance with
allocation made in the budget. Control over such
expenditure to regulate the cost.
 Monitoring .
 Capital Budgeting- Indian context
 LPG
 WTO
 TRADE BLOCKS –Comprehensive Economic
Cooperation Agreement. E.g. Agreement with
Thailand/SAFTA (South Asia Free Trade
Agreement)
 Government policies
 Economic cycle.
 Capital budgeting decisions
 Choose the business, the company wants to do
 Integrated view of the balance sheet –
investment & financing decisions
 Identify ,evaluate & implement
 Magnitude, timing & risks of cash flows
 Options in investment project
 Capital budgeting process
 Mandatory investment- E.g. pollution control.
 Replacement investment – for replacing old/obsolete
machinery – straight
 Expansion projects – complex & risky
 Diversification – new products or new geographical
ares. Complex and risky. Careful evaluation
 New – green field projects. E.g.RPL
 R & D – WTO impact (TRIPS)/tax rebate &
competition
 Capital budgeting-Decisions
 Accept or reject decision –independent
projects based minimum return
 Mutually exclusive decision – accepting one
automatically rejects the other one. E.g.
buying of new or secondhand mahinery or on
lease.
 Capital rationing – based on the order of
priority .
 Capital budgeting decision
 Capital budgeting depends more on cash flows rather accounting
profit. Even banks look at cash flows first.
 Net Cash out flows –
 Cost of new project+ Increased wrking capital
less sale proceeds of old assets + working capital freed.
 Net annual cash in flows – PAT+ Depreciation Terminal cash
Inflows i.e. salvage value of the asset.
 Required rate of return – to determine present value and
profitability of Capital budgeting process of the project
 Availability of funds and its cost
 Economic life of the project
 Tax implications – regular income tax + capital gain or loss.
 Capital budgeting decision
Determining the cash flow
 X ltd wants to purchase Savings 5600
a machine costing Re Depreciation 2400
12,000. Annual cash
savings Re 3200
5,600.Dereciation Re Tax@50% 1600
2400. Tax rate @ 50%. PAT 1600
Add 2400
Depreciation
Cash inflow 4000
 Techniques of capital budgeting
TRADITIONAL MEHTOD DISCOUNTED CASH FLOW

NET PRESENT VALUE

URGENCY METHOD
PROFITABILTY INDEX
PAY BACK METHOD
INTERNAL RATE OF RETURN
AVERAGE RATE OF RETURN
 Urgency method
 Urgency is the criterion used to justify the
acceptance of capital to justify the acceptance
capital projects on the basis of emergency
requirements or under crisis conditions.
 E.g. sudden break down of machinery.
Necessity to replace immediately to avoid
production loss and keep delivery schedules.
 Unscientific method. Fails to capture capital
productivity.
 Pay back period
 Payback period is the length of time required
to recover the initial cost of project.
 How long it will to recover the initial outlay
on an investment from its cash flow returns.
 Net Investment /annual cash inflow
 E.g. initial cash out flow Re 15000.Annual net
cash inflow of Re 6000 for 4 years.
 Pay back period = 15000/6000 = 2 1/2 years
( cash flows are even)
 Pay back period
 Where cash flows are uneven.
 Pay back period – E + B/C
 ( E-No. of years immediately preceding the year
of recovery. B – balance amount of investment
to be recovered. C –cash inflow during the year.)
 E.g. investment Re 10,000. cash inflow Re
2000,4000 & 12000
 Cumulative cash flows are RE 18000.
 Payback period = 4000/12000*12=4 months in
the third year.
 Payback period 2yrs & 4 months.
 Pay back period
 Decision criteria.
 Shorter the period , the best for investment
 Project will be accepted if the pay back period
is less than the economic life or maximum pay
pack period fixed by the management
 Projects are ranked according to pay back
period.
 Pay back period - benefits
 Simple to calculate and understand. Useful for
small firms. Risk of obsolescence
 Liquidity oriented
 Risk curtailment. Shorter the periodlower the
risk.
 Uncertainty of returns after certain period.
 Pay back period – draw backs
 Ignores the profitability of the project. Capital
oriented and ignores profit.
 Ignores payback cash flows after the pay back period.
 Ignores magnitude and timing of cash flows
 Ignores time value of money.iscounted pay abck
period can be employed.
 Cost of capital is ignored ( dividend / Interest). One
of the important factors deciding the project.
 Pay back period – suitability
 Cost of the project is small and so also
completion period
 Limited availability of funds
 Cash generation capacity is low and loan is
available for shorter period
 Risk of obsolescence. E.g. – IT/ Telecom.
Industry with high obsolescence rate.
 Payback period- case study
 Machine A B
 Estimated life 5yrs 6 yrs
 Cost of machine Re 1,50,000 2,50,000
 Cost of indirect materials 6,000 8000
 Estimated savings –scrap 10,000 15,000 ( savings)
 Adl.cost of maintance 19,000 27,000
 Estimated savings in wages
 Employees not required 150 200
 Wages per employee Re 600 600
 Taxation -30%
 Decide which machinery to selected ?
 Statement of profitability
 A B
 Estimated savings in scrap 10,000 15,000
 ‘ wages 90,000 1,20,000
 Total savings 100 000 135 000
 Cost of indir.amaterials 6,000 8000
 Maintenance 19000 27000
 Total cost 25000 35000
 Net savings 75000 100000
 Less tax@ 30% 22500 30000
 Net savings p.a. 525000 70000

 Pay back period
 INVESTMENTS/SAVINS P.A.
 Machine A 150000/52500 =2.85 yrs
 Machine B 250000/70000 = 3.57 yrs
 Machine A is accepted since pay back period
is lesser.
 Average of rate of return
 It measures the rate of return on the investment. Average investment is
taken in to account for the purpose of calculation .
 Under this method annual average profit (PAT) is expressed as percentage
of investment
 Average return = total PAT/No. of years
 Average investment =
1/2 (initial investment+ salvage value)
 ARR = PAT/Average investment *100
 Average of rate of return
 Initial investment Re 30000. Salvage value Re
3000. Expected life 4 years. Average annual
income Re 5000.
 ½(Re30000+3000) = 16500
 Average Investment= 16500
5000/16500*100 =30.30 %
.
 Decision criteria
 Ranking of projects as per ARR criteria
 ARR above management huddle rate will be
accepted
 Among the projects , project with highest ARR
will be accepted.
 ARR-Advantages
 Simple to calculate and easy to under stand.
No need for any adjustment.
 It covers entire economic life.
 Profitability of investment is considered unlike
pay back period. It takes in to account cost of
capital.
 Proper criteria since it is based on profitability
which will lead to maximization share holders
wealth.
 ARR - Limitations
 Time value of money is not taken in to account
 Based on accounting income rather than cash
flows.
 Difficult to decide minimum acceptance rate.
 ARR – Case study
 A machinery purchased six year ago for Re 1.50
laces. Present book value (after depreciation) Re
90,000.it had originally and projected life of 15 years
and 0 salvage value. A new machine will cost Re2.50
laces and it will reduce operating cost of Re 30,000
p.a..for next 9 years. Older machine could be sold for
Re 50,000. new machine will be depreciated on SLM
for 9 year life with salvage value of Re 25,000. Tax
rate @ 30%. Required rate of return is 10 %.
 Decide whether the old machine can be replaced.