Sei sulla pagina 1di 13

Page 1 of 13

CAPITAL BUDGETING

Actually it is an assignment for MBA in Daffodil International


University, Bangladesh.

Presented By:

Thanks & Best Regards


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

L ong-term investments represent sizable outlays of funds that


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.

Capital budgeting is the process of evaluating and selecting long-term


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

According to Larence J Gitman (Principles of Managerial


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.”

Capital budgeting is the process by which the financial manager


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.

A capital budgeting decision may be defined as the firm’s decision to


invest its current funds most efficiently in the long-term assets ill
anticipation of an expected flow of benefits over a series of years.

3. Component of Capital Budget

3.1. Initial Investment Outlay

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

3.2. Net Cash benefits or savings from the operations:

This component is calculated as follow:


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.

3.4 The Net Present Value technique

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.

Example: A company is studying the feasibility of acquiring a new


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%.

4.1. Steps in Capital Budgeting

Capital budgeting is the process of determining whether a big


expenditure is in a company's best interest. Here are the basics of
capital budgeting and how it works.

Company undertakes capital budgeting in order to make the best


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.

4.1. Identification or Innovation of Investment Projects

The first step in the capital budgeting process is to identify the


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

4.2. Estimating Cash Flow

We need to determine how much cash flow it would take to implement


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.

4.3. Evaluate The Investment Projects

Once have identified the reasonable opportunities, we need to


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.

4.4. Selection the Best Investment Project

After we look at all of the possible projects, it is time to choose the


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.

4.5. Implementation of The Project

Once the decisions have been made, it is time to implement the


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.

4.6. Continious Evaluation of The Selected Project

Here, project manager has to see the performance of the selected


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

5. Application/Grounds of Capital Budgeting

Have already discussed capital budgeting is used to talk


decision for future financial investment for big amount.

5.1. Purchases of Fixed Assets


Page 5 of 13

Capital budgeting is used to take decision for new investment


to purchases land, equipment, building for any company.

5.2. Replacement of fixed assets

5.3. Modernization of Production Process

Here need to distinguish a new production method and old.


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?

5.4. Expansion of business

When a company wants to expanse business, he needs to take


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.

5.5. Introduction of new product

When a firm invent a new product and going to enter the


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?

6. Importance of Capital Budgeting

Capital budgeting decisions are of paramount importance in financial


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

6.1. Long-term Implications

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.

6.2. Involvement of large amount of funds

Capital budgeting decisions need substantial amount of capital outlay.


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.

6.3. Irreversible decisions

Capital budgeting decisions in most of the cases are irreversible


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.

6.4. Risk and uncertainty

Capital budgeting decision is surrounded by great number of


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.

6.5. Difficult to make

Capital budgeting decision making is a difficult and complicated


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.

7. Kinds of capital budgeting decisions

Generally the business firms are confronted with three types of capital
budgeting decisions.

7.1. Accept-reject decisions

Business firm is confronted with alternative investment proposals. If


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.

7.2. Mutually exclusive decisions

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.

7.3. Capital rationing decisions


Page 7 of 13

Capital budgeting decision is a simple process in those firms where


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.

8. Limitation of Capital Budget

Capital budgeting is very important to take future financial decision.


Because future profit and loss depends of capital budgeting. But capital
budgeting has some limitations. Such:

Lack of Adequate Data, Lack of Reliability of the Data, Problem


of Measuring Future, Timing of the Projects, Problems of
Quantification, Personal Judgment of the Decision.

9. Technique of projects evaluation

To take right decision capital budgeting is very important. There are


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

We use here a problem solution to discuss the techniques of capital


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%

Cash Flow Before Tax (CFBT):

End of Year-1: 150000 TK


End of Year-2: 250000
End of Year-3: 200000
Page 8 of 13

End of Year-4: 130000


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

Year CFBT Dep NPBT Tax NPAT NCB CNCB PV of CNCB


(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

Net cash outlay(NCO)


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

9.1. Traditional Method

A. Pay Back Period Method (PBP)

Pay back period is very easy and popular techniques of capital


budgeting. How many years will be needed to pay back of
investment from income. But here, salvage value is not
counted.

Payback periods are commonly used to evaluate proposed


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

NCO= Net Cash Outlay


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

C=Cumulative Net Cash Flow of Year A


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

Example: From Above Problem Solution

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

B. Pay Back Reciprocal (PBR)


1
Pay Back Reciprocal (PBR)= ×100
PBP
1
= x 100
3.89
= 25.70%

C. Average Rate of Return/Accounting Rate of Return (ARR)

Example: From Above Problem Solution

AverageofN PAT AverageofN PAT


AAR= ×100 or AAR= AverageInv estmetnt ×100
Initial .Investmetn t

Based on Average Investment

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%

9.2. Discounted Cash Flow Method

D. Net Present Value Method (NPV)

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

required return, cost of capital, or opportunity cost is the minimum


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

NPV=Present Value of Cash Inflows - Initial Investment (NCO)

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

NPV =Net Present Value


A=Net Cash Flow (Net Cash Benefit)
R = Discount Rate
NCO= Net Cash Outlay
N= Number of year
S= Salvage Value

E. Internal Rate of Return Method (IRR)

IRR is the amount of profit we get by investing in a certain project. It is


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)

The profitability index, or PI, method compares the present value of


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

In this method, a project with a PI greater than 1 is accepted, but a


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.

Profitability Index (at 10%)

599621
PI = =.98
610000

Under the PI method, the project shouldn’t be accepted because the


value of PI is less than 1.

(G) Discount Pay back period


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:

Here we have found that


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.