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314 visualizzazioni13 pagineAuthor: Chayan K Sarker, Dhaka, Bangladesh

Jun 30, 2010

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Author: Chayan K Sarker, Dhaka, Bangladesh

Attribution Non-Commercial (BY-NC)

314 visualizzazioni

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Author: Chayan K Sarker, Dhaka, Bangladesh

Attribution Non-Commercial (BY-NC)

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CAPITAL BUDGETING

University, Bangladesh.

Presented By:

Chayan K Sarker

M.Sc (First Class), MBA (Human Resources)

Mobile : +880-1722350003

Email : chayan.sarker@yahoo.com

Email : sarker.ck@yahoo.com

Web : www.chayanlife.webs.com

Page 2 of 13

1. Introduction

commit a firm to some course of action. Consequently, the firm

needs procedures to analyze and properly select its long-term

investments. It must be able to measure cash flows and apply

appropriate decision techniques. As time passes, fixed assets may

become obsolete or may require an overhaul; at these points, too,

financial decisions may be required.

investments that are consistent with the firm’s goal of maximizing

owner wealth. Firms typically make a variety of long-term investments,

but the most common for the manufacturing firm is in fixed assets,

which include property (land), plant, and equipment. These assets,

often referred to as earning assets, generally provide the basis for the

firm’s earning power and value.

2. Definition

Finance), “Capital budgeting is the process of evaluating and

selecting long-term investments that are consistent with the

firm’s goal of maximizing owner wealth.”

decides whether to invest in specific capital projects or assets. In some

situations, the process may entail in acquiring assets that are

completely new to the firm. In other situations, it may mean replacing

an existing obsolete asset to maintain efficiency. The investment

decisions of a firm are generally known as the capital budgeting, or

capital expenditure decisions.

invest its current funds most efficiently in the long-term assets ill

anticipation of an expected flow of benefits over a series of years.

It includes the cash required to acquire the new equipment or build the

new plant less any net cash proceeds from the disposal of the replaced

equipment. The initial outlay also includes any additional working

capital related to the new equipment. Only changes that occur at the

beginning of the project are included as part of the initial investment

outlay. Any additional working capital needed or no longer needed in a

future period is accounted for as a cash outflow or cash inflow during

that period.

Page 3 of 13

The incremental change in operating revenues-The incremental change

in the operating cost = Incremental net revenue-Taxes ± Changes in

the working capital and other adjustments

3.3. Terminal Cash flow

It includes the net cash generated from the sale of the assets, tax

effects from the termination of the asset and the release of net working

capital.

Although there are several methods used in Capital Budgeting, the Net

Present Value technique is more commonly used. Under this method a

project with a positive NPV implies that it is worth investing in.

machine. This machine will cost $350,000 and have a useful life of

three years after which it will have no salvage value. It is estimated

that the machine will generate operating revenues of $300,000 and

incur $75,000 in annual operating expenses over the useful life of three

years. The project requires an initial investment of $15,000 in working

capital which will be recovered at the end of the three years. The firm’s

cost of capital is 16%. The firm’s tax rate is 25%.

expenditure is in a company's best interest. Here are the basics of

capital budgeting and how it works.

decisions about utilizing its limited capital. For example, if we are

considering opening a distribution center or investing in the

development of a new product, capital budgeting will be essential. It

will help we decide if the proposed project or investment is actually

worth it in the long run.

opportunities that we have. Many times, there is more than one

available path that a company could take. We have to identify which

projects we want to investigate further and which ones do not make

any sense for company. If we overlook a viable option, it could end up

costing us quite a bit of money in the long term.

Page 4 of 13

a given project. We also need to estimate how much cash would be

brought in by such a project. This process is truly one of estimating--it

takes a bit of guesswork. We need to try to be as realistic as we can in

this process. Do not use the best-case scenario for numbers. Most of

the time, we need to use a fraction of that number to be realistic. If the

project takes off and the best-case scenario is reached, that is great.

However, the odds of that happening are not the best on new projects.

determine which ones are the best. Look at them in relation to overall

business strategy and mission. See which opportunities are actually

realistic at the present time and which ones should be put off for later.

right project mix for company. Evaluate all of the different projects

separately on their own merits. We need to come up with the right

combination of projects that will work for company immediately.

Choose only the projects that mesh with company goals.

projects. Implementation is not really a budgeting issue, but we will

have to oversee everything to be sure it is done correctly. After the

project gets started, we will need to review everything to make sure

the finances still make sense.

project. He has to check the any one error and calculate the profit as

per cash flow.

decision for future financial investment for big amount.

Page 5 of 13

to purchases land, equipment, building for any company.

Need to compare administrative disbursement, life time of

projects, salvage value, market price etc by financial

investment method and determine which is best one and which

method need to continuation of old method or set new

production method?

decision for such reason. Such needs to set a machine for

production. In this case, company production manager need to

calculate the total net cash outlet for machine setup and the

total profit from this machine for selected year.

market. The firm needs to know the public demand, production

cost, administrative cost, profit etc. By calculating all things,

firm will decide, they will enter market or not?

decision. So it needs special care on account of the following reasons:

A capital budgeting decision has its effect over a long time span and

inevitably affects the company’s future cost structure and growth. A

wrong decision can prove disastrous for the long-term survival of firm.

On the other hand, lack of investment in asset would influence the

competitive position of the firm. So the capital budgeting decisions

determine the future destiny of the company.

This underlines the need for thoughtful, wise and correct decisions as

an incorrect decision would not only result in losses but also prevent

Page 6 of 13

the firm from earning profit from other investments which could not be

undertaken.

because it is difficult to find a market for such assets. The only way out

will be scrap the capital assets so acquired and incur heavy losses.

uncertainties. Investment is present and investment is future. The

future is uncertain and full of risks. Longer the period of project,

greater may be the risk and uncertainty. The estimates about cost,

revenues and profits may not come true.

exercise for the management. These decisions require an over all

assessment of future events which are uncertain. It is really a

marathon job to estimate the future benefits and cost correctly in

quantitative terms subject to the uncertainties caused by economic-

political social and technological factors.

Generally the business firms are confronted with three types of capital

budgeting decisions.

the proposal is accepted, the firm incur the investment and not

otherwise. Broadly, all those investment proposals which yield a rate of

return greater than cost of capital are accepted and the others are

rejected. Under this criterion, all the independent proposals are

accepted.

It includes all those projects which compete with each other in a way

that acceptance of one precludes the acceptance of other or others.

Thus, some technique has to be used for selecting the best among all

and eliminates other alternatives.

Page 7 of 13

fund is not the constraint, but in majority of the cases, firms have fixed

capital budget. So large amount of projects compete for these limited

budgets. So the firm rations them in a manner so as to maximize the

long run returns. Thus, capital rationing refers to the situations where

the firm has more acceptable investment requiring greater amount of

finance than is available with the firm. It is concerned with the

selection of a group of investment out of many investment proposals

ranked in the descending order of the rate or return.

Because future profit and loss depends of capital budgeting. But capital

budgeting has some limitations. Such:

of Measuring Future, Timing of the Projects, Problems of

Quantification, Personal Judgment of the Decision.

few techniques of capital budgeting. These are given below with some

short discussion.

budgeting:

Problem:

Cost price of Assets: 540000 TK

Installation Charge: 50000

Salvage Value: 10000

Working Capital: 20000

Useful Life: 5years

Tax Rate: 40%

Depreciation: Straight Line

Cost of Capital: 10%

End of Year-2: 250000

End of Year-3: 200000

Page 8 of 13

End of Year-5: 150000

Now, Required:

(A) Pay back period (PBP)

(B) Average rate of return (ARR)

(C) Net present Value(NPV)

(D) Internal rate of return (IRR)

(E) Profitability index (PI)

(F) Discounted Pay back Period (DPBP)

(G) Comment on the acceptability of the project (based on DCF model)

Solution :

Working -1

C + I − SV

We know, Depreciation = L

(540000 + 50000 ) − 10000

=

5

590000 −10000

= 5

= 116000 TK

Working Table -1

(40%) NCB

(10%)

1 15000 1160 34000 13600 20400 13640 13640 1239 12398

0 00 0 0 88 8

2 25000 1160 13400 53600 80400 19640 33280 1622 28621

0 00 0 0 0 26 4

3 20000 1160 84000 33600 50400 16640 49920 1249 41118

0 00 0 0 66 0

4 13000 1160 14000 5600 8400 12440 62360 8496 49614

0 00 0 0 5 5

5 15000 1160 34000 13600 20400 13640 76000 8470 58084

0 00 0 0 4 9

Tota 18000

l 0

Working –2

Cost: 540000

Installation: 50000

Working capital: 20000

610000 TK

Mainly the techniques of project evaluations are tow types and they

have such branch also. These are..

Page 9 of 13

budgeting. How many years will be needed to pay back of

investment from income. But here, salvage value is not

counted.

investments. The payback period is the amount of time required for

the firm to recover its initial investment in a project, as calculated from

cash inflows. In the case of an annuity, the payback period can be

found by dividing the initial investment by the annual cash inflow. For a

mixed stream of cash inflows, the yearly cash inflows must be

accumulated until the initial investment is recovered. Although popular,

the payback period is generally viewed as an unsophisticated capital

budgeting technique, because it does not explicitly consider the time

value of money.

If the cash flow is uniform, in this case the pay back period will:

NCO

PBP = (When Cash Flow will uniform)

NCB

NCB= Net Cash Benefit

And if the cash flow is not uniform, this case the pay back period will:

NCO − C

PBP = A+ (When Cash Flow will not uniform)

D

D=Net Cash Flow of the Year Following the Year A

A= The year in which the cumulative net cash flow is nearer to NCO

We know, Here,

NCO − C NCO = Tk.610000

PBP = A+

D A = The year at which CNCB is Nearer to

NCO=3

610000 - 499200

∴PBP =3+

124400 C = CNCB of year A=499200

110800 D = NCB of the year following the year

=3+

124400

= 3+0.89

= 3.89 Years

Page 10 of 13

1

Pay Back Reciprocal (PBR)= ×100

PBP

1

= x 100

3.89

= 25.70%

AAR= ×100 or AAR= AverageInv estmetnt ×100

Initial .Investmetn t

AverageofN PAT

ARR = AverageInv estmetnt ×100

180000 ÷ 5

=

( 610000 + 10000 ) ÷ 2 ×100

36000

= ×100

310000

= 11.61

∴ARR = 11.61%

ARR including working capital

AverageofN PAT

ARR = AverageInv estmetnt ×100

180000 ÷ 5

=

( 590000 +10000 ) ÷ 2 + 20000 ×100

36000

= ×100

320000

= 11.25%

Net present value (NPV) gives explicit consideration to the time value

of money; it is considered a sophisticated capital budgeting technique.

All such techniques in one way or another discount the firm’s cash

flows at a specified rate. This rate—often called the discount rate,

Page 11 of 13

return that must be earned on a project to leave the firm’s market

value unchanged.

A1 A2 A3 A4 A5 + S

NPV = [ + + + +

(1 + R ) 1

(1 + R ) 2

(1 + R ) 3

(1 + R ) 4

(1 + R ) 5 ] - NCO

136400 196400 166400 124400 136400 + 10000 + 20000

[ + + + + ]

=

(1 + 0.1)1 (1 + 0.1) 2 (1 + 0.1) 3 (1 + 0.1) 4 (1 + 0.1) 5

- NCO

= [124000+162314+125019+84967+103321]-610000

= 599621 – 610000 = -10379

A=Net Cash Flow (Net Cash Benefit)

R = Discount Rate

NCO= Net Cash Outlay

N= Number of year

S= Salvage Value

a percentage. An IRR of 10% means we make 10% profit per year on

the money invested in the project.

C

IRR = [A+ × (B-A)] ×100

C −D

IRR= Internal Rate of Return

A = Lower Discount Rate

B = Higher Discount Rate

C= Net Present Value (NPV) at lower discounting rate

D = Difference between the NPV at higher discounting rate and the

lower discounting rate.

Here,

NCO =610000 TK

A = Lower Discount Rate = 6% = 0.06

B = Higher Discount Rate = 10% = 0.10

C = NPV of HDR

= -10379

D = NPV of LDR

136400 196400 166400 124400 136400 + 10000 + 20000

NPV (6%)=[ ]

(1 + .06 )1 (1 + .06 ) 2 (1 + .06 ) 3 (1 + .06 ) 4 (1 + .06 ) 5

+ + + +

– NCO

Page 12 of 13

=[128679+174795+139713+98537+124346] -610000

=666070 - 610000 =56070

56070

∴IRR = [0.06 + 56070 − (−10379 )

× (0.10-0.06)] ×100

56070

= [0.06 + × 0.04] ×100 =(0.06 + 0.0338) ×100

66446

=0.0938×100 =9.38

∴IRR =9.38%

F. Profitability Index Method (PI)

future cash inflows with the initial investment on a relative basis.

Therefore, the PI is the ratio of the present value of cash flows (PVCF)

to the initial investment of the project.

PVCF

PI =

Initial Investment

project is rejected when its PI is less than 1. Note that the PI method is

closely related to the NPV approach. In fact, if the net present value of

a project is positive, the PI will be greater than 1. On the other hand, if

the net present value is negative, the project will have a PI of less than

1. The same conclusion is reached, therefore, whether the net present

value or the PI is used. In other words, if the present value of cash

flows exceeds the initial investment, there is a positive net present

value and a PI greater than 1, indicating that the project is acceptable.

599621

PI = =.98

610000

value of PI is less than 1.

We know,

NCO − C Here,

PBP = A+ NCO = Tk. 610000

D

A = The year at which CNCB is nearer to

∴PBP = 5+ 610000 −? 580849NCO= 5

29151 C = CNCB of year A= 580849

= 5+ D = NCB of the year following the year A=?

?

= 5 +?

= More than 5years

Page 13 of 13

Under the DPBP method, the project should not be accepted due to its

required more than 5 years to pay back the net cash outlay.

(H)Comments:

NPV is negative

IRR is below cost of capital

PI is below (+1)

So under the DCF model the project should not be acceptable.

10. Conclusion

The capital investment decision rules may be referred to as capital

budgeting techniques, or investment criteria. A sound appraisal

technique should be used to measure the economic worth of an

investment project The essential property of a sound technique is that

it should maximize the shareholders wealth.

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