Capital Budgeting

Most Important in Corporate Finance

 Meaning
A firm’s decision to
“invest its current funds
most efficiently in the long-term
assets in anticipation of an expected
flow of benefits over a series of
years”
 Meaning…
Capital budgeting refers to planning the
deployment of available capital for the purpose
of maximizing the long-term profitability of
the firm.
Involves
• Search for new and more profitable investment
proposals
•Economic analysis to determine the profit potential of
each investment proposal
 Features
• Involves commitment of large amount of
funds
• Commitments are irreversible or reversible
at a substantial loss
• Among the most difficult decisions to make
 The Process
Identification of
potential In line with
investment firm’s overall Decision
opportunities objectives criteria??
Proposal Review and Decision-
generation analysis making

Performance Implementation Capital Budget

review Preparation

Formulation
Responsibility accounting
Network techniques
 Identification of Investment
Opportunities
• Role of promoters:
– Scan the various sources
– Understand regulatory framework & policies
– Appraise the in relation to organisation’s
strengths and weaknesses
 Potential Sources
• Characteristics of different industries
• Product profile of various industries
• Imports & exports
• Emerging technologies
• Scio-economic trends
• Consumption pattern in foreign countries
• Revival of sick units
• Backward & forward integration
 Project Classification
• Mandatory investments
• Replacement projects
• Expansion projects
• Diversification projects
• R&D projects
• Miscellaneous projects
 Preliminary Screening
• Compatibility with promoters
• Compatibility with government priorities
• Availability of input resources
• Size & potential of the market
• Risk inherent in the project
 Feasibility Study
• Market & demand analysis
• Technical appraisal
• Financial appraisal
• Economic appraisal
 Detailed Project Report (DPR)
• Project cost
• Means of financing
• Schedule of implementation
• Estimates of profitability
• Cash inflow/ outflow estimations
• Debt servicing capability
 Implementation & Review
• Construction: Buildings; installation of
machinery, etc
• Sourcing of funds for the project
• Training of engineers, technicians &
workers
• Plant commissioning & trial runs
• Commercial production
• Review of actual performance vs planned
 Financial Appraisal
STEPS
• Define the stream of cash flows
• Appraise the cash flow stream to determine
whether the project is financially viable or
not
Estimation of Project Cash Flows
• Defining costs & benefits
– Measured in terms of cash flows
• Net cash flows relating to long-term funds
– Initial flow (net investments)
– Operating flow (adjusting PAT)
– Terminal flow (salvage value of assets at the
end of the project life)
 Illustration Terminal
Cash inflows

Operating Cash inflows 50 K

10 K 15 K 30 K 50 K 50 K 40 K 30 K 20 K
0
1 2 3 4 5 6 7 8

150 K
Initial
Investment
 Illustration: Cash Flow Estimation
• ABC Ltd. Is considering investments in a project with
following information:
– Investment outlay will be Rs. 100 mn (Rs. 80 mn in Plant &
machinery and Rs. 20 mn as working capital margin
– Project will be financed with Rs. 45 mn of equity capital, Rs. 5
mn preference capital (15%), and 50 mn of debt capital (15%)
– Project life is expected to be 5 years Salvage value of fixed
assets will be Rs. 30mn while working capital margin will be
liquidated at par
– Project is expected to generate revenues of Rs. 120 mn per
year. Costs (other than depreciation, interest & tax) will be Rs.
80 mn per year. Tax rate is 30%
– Depreciation will be 25% on a WDV method
 Rs. Million
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Fixed Assets -80.00
WC Margin -20.00
Revenues 120.00 120.00 120.00 120.00 120.00
Costs 80.00 80.00 80.00 80.00 80.00
Depreciation 20.00 15.00 11.25 8.44 6.33
PBT 20.00 25.00 28.75 31.56 33.67
Tax 6.00 7.50 8.63 9.47 10.10
PAT 14.00 17.50 20.13 22.09 23.57
Salvage Value of FA 30.00
Recovery of WC
margin 20.00
Initial Outlay -100.00
Operating Cash inflows 34.00 32.50 31.38 30.53 29.90
Terminal cash inflows 50.00
Net Cash Flow -100.00 34.00 32.50 31.38 30.53 79.90
 Investment Evaluation

Investment Appraisal
Criteria

Discounting Non-discounting

IRR NPV Benefit-cost Ratio Payback Period ARR

 NPV
STEPS
• Cash flows of the investment project should
be forecasted based on realistic assumptions
• Appropriate discount rate should be identified
Discount Rate = Opportunity cost of Capital =
RRR expected by investors at equivalent risk
Acceptance Rule
– Accept if NPV > 0
– Reject if NPV < 0
– May accept if NPV = 0
 …NPV
Ct
NPV = Σ
n
- C0
t=1
(1+ k)t
 Properties of NPV
• NPVs are additive
• Intermediate cash flows are invested at cost
of capital
• Permits time varying discount rates
– The risk characteristics of a project may change
over time
– The interest rates may change
– The financing mix may, also, change
 Limitations of NPV
• NPV is expressed in absolute terms rather than
relative terms
– Total outlay is not considered to distinguish between
two projects
• NPV concept does not consider life of the
projects, hence
– Comparison of two mutually exclusive projects with
different life period is biased
 IRR
• Yield on an investment
• It is the discount rate which makes NPV = 0
• It is the discount rate which equates the PV of
future cash flows with the initial investment
• Depends solely on outlay and proceeds
associated with the investment
 IRR: Formula
Determine k at which net present value is zero
Ct
Σ
n
- C0 = 0
t=1
(1+ k)t

Acceptance Rule
–Accept if IRR > required rate of return
–Reject if IRR < required rate of return
 Compute NPV: k = 12%
CFs
Year
Project A Project B
0 -350 -100
1 30 18
2 67 23
3 83 45
4 124 87
5 156
6 177
 Illustration
• The cash flows of a project being considered
by Trechon Limited is as follows:
Year Cash flow
0 (100,000)
1 30,000
2 30,000
3 40,000
4 45,000
 NPV & IRR
• If NPV and discount rates are plotted on y-axis
& x-axis respectively,
• IRR is the point at which the slope crosses
x-axis
• NPV and IRR leads to identical decisions,
provided
– There is conventional cash flows
– Project under consideration is independent
 Computation of NPV & IRR
Year CFs
Project A Project B
0 -350 -100
1 30 18
2 67 23
3 83 45
4 124 87
5 156
6 177
NPV 46.27 21.73
IRR 15.52% 19.58%
 Problems with IRR
• Non-conventional cash flows in a project
could result in multiple IRRs / no IRR
• Projects of different scale could have
inconsistent IRRs with NPV
• IRR does not distinguish between lending &
borrowing
• Comparing becomes difficult if there are
different opportunity costs (short-term &
long-term)
Compute IRR
Year Cash Flow
0 -145
1 100
2 100
3 100
4 100
5 -275
 BCR or Profitability Index
PV of cash inflows
PI =
Initial cash outlay
Accept if PI > 1
Reject if PI < 1
NBCR??
 Payback Period
Initial investment
Payback Period =
Annual cash inflow

- It does not measure profitability of a project

- Time value of money is ignored
 ARR
Average Income
ARR = x 100
Average Investment

- Ignores time value of money

- Ignores the fact that profits earned can be re-invested
 CFO Decision Tools
Survey Data on CFO Use of Investment Evaluation
Techniques
NPV, 75%

IRR, 76%

Payback, 57%

Book rate of
return, 20%

Profitability
Index, 12%

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
 CFO Decision Tools
Indian Survey Results

Net Present Value 65

Internal Rate of Return 85

Payback Period 67.5

Break-even Analysis 58.2

Profitability Index 35.1

Accounting Rate of Return 34.6

0 20 40 60 80 100
Percentage