5.
Capital Budgeting
5.1
Process
Capital Budgeting is a process
whereby it is identified if a project is profitable and then if found
profitable, how to go about investing in the project. This involves projects
where the earnings receive d will be longer than one period. Any decision which
will impact future earnings of the company will fall under capital budgeting
process and must be evaluated.
Capital budgeting is the process of planning
expenditures on fixed assets and projects that extend beyond one year.
Categories of Capital Budgeting Process:
·
Replacement projects to maintain
the business
·
Replacement project for cost
reduction
·
Expansion projects to expand the
business
·
New product or market development
·
Mandatory projects required by law
or government agencies
5.2
Basic Principals governing Capital
Budgeting Process
There are certain standard
principals according to which the Capital Budgeting technique is applied and
projects are evaluated. These are outlined below:
·
Cash
flows vs. accounting profits- while evaluating projects
the cash flows are considered, the cash flows which the project will generate
in future. The accounting profits are not taken into consideration because it
takes into account many items which are mere book entries and does not result
in any actual cash inflow or outflow. Example: Depreciation expense. Similarly
sunk costs are excluded while evaluating the project because these costs are
already incurred and it won’t have any bearing on the project.
·
Treatment
of Opportunity Costs- while calculating the cash flows
the opportunity costs must be taken into consideration. Opportunity costs are
costs that the company forgoes by undertaking the project. For example if the
firm has invested certain amount in a project, had the firm invested the same
amount in a bank then it would have earned certain rate of interest. This
interest amount is called as opportunity cost and must be deducted to calculate
the earnings from the project.
·
Cash flows are calculated on an after tax basis, thus the impact
of taxes are considered and cash flows are reduced accordingly.
·
Discounting-
As the cash flows are generated in the coming years, so the timing is
considered into consideration and the discounting of cash flows is done to get
a more clearer picture as to how much will generate today if a specific amount
is invested.
5.3
Techniques of Evaluating a Project
5.3.1 Payback
Period
This is the
expected number of years needed to recover the cost of investment in a project
based on net after-tax cash flows from the project.
The main
drawback of payback period is that it does not take into account any cash flows
after the payback period and thus also ignores the salvage value of any asset
purchased as a part of the project. Thus payback as a measure is profitability
is not very much popular. Payback period also does not consider the time value
of money, that it gives equal weight to all cash flows before the payback
period and does not discount them.
Payback as
a technique of evaluation is good if we want to gauge the liquidity of the
project. This technique gives us a better idea as to when the project is going
to generate the amount initially invested in it. Thus it is more useful to
firms who are faced with liquidity problems and face shortage of capital.
In order to
use the payback rule effectively, a firm has to decide on an appropriate cut
off date. If it uses the same cut off regardless of project life, it will tend
to accept many poor short-lived projects and reject many good long-lived ones.
Example:
The cost of a project is $ 2000000
and the following cash flows are anticipated:
Year Net Cash Flow
1
300000
2
700000
3
800000
4
800000
5
350000
Solution: Here, the cumulative net
Cash Flow till 3rd year is $ 1800000. Now remaining 200000 will be
realised in 4th year of operation.
It will take 200000 to be
realised/800000 which will be realised in 4th year = .25 year or 3
months in the 4th year.
So the projects payback period will
be 3 years and 3 months.
5.3.2 Discounted
payback period
This is a similar concept to the
payback period but it is based on the time taken to recover the investment
based on discounted cash flows, so the cash flows need to be
discounted to their present value. The discount rate used is the project’s cost
of capital.
Example:
The cost of
a project is $ 150 crores and the following cash flows are anticipated. The
cost of capital is 10%.
Year Net
Cash Flow Discounted
Cash Flow
1 25 22.7
2 50 41.3
3 55 41.3
4 40 27.3
5 60 37.3
Now the cumulative discounted cash
flow till 4th year is 132.6 crores. The remaining 17.6 crores will
be realised in 5th year. So the discounted payback will be
4 year + 17.6/37.3 years = 4 years
+ .5 years = 4 years and 6 months.
5.3.3 Average
Accounting rate of return
The average accounting rate of
return is defined as the ratio of project’s average net income to its average
book value.
Average Accounting rate of
return = Average Net Income
Average Book Value
The main advantage of AAR is that it is very easy to
calculate and understand. However it also suffers from some disadvantages like-
it does not discount the cash flows so it’s not a good measure of profitability
and further it takes in to account book profits or accounting profits not the
after tax cash flows thereby breaking one of the very basic principles of
capital budgeting evaluation techniques.
Because of the above mentioned limitations AAR is not
very much popular among companies as a measure of evaluating Capital Budgeting
decisions.
5.3.4 Net
Present Value
Net present
is one of the techniques whereby the discounting of cash flows is done which
serves as a good measure of profitability. NPV is the sum of all incremental
cash flows if a project is undertaken. The discount rate used is the firms cost
of capital adjusted for risk of the project.
For a normal project where there is initial cash outflow and then it’s
followed by a series of after tax cash inflows. The NPV in such case will be
present value of the expected cash inflows minus the initial cost of the
project. This can be represented in formula as:
-CFO+CF1/
(1+k) + CF2/ (1+k)2 + CF3/ (1+k)3+............CFn/(1+k)n
Here, CF0
is the initial cash outflow or the cost of the project.
CFt
is the after cash inflow in time interval t,
K is the
required rate of return or the cost of capital adjusted for the risk of the
project that the firm has undertaken.
A project
having Positive NPV will increase shareholders value and will be profitable,
while projects with negative NPV won’t be profitable and will decrease
shareholders value. So these projects should be rejected.
Example:
Calculate the NPV of each of the following project and
comment which one should be accepted, given that cost of capital is 10%:
Year Project A Project B Project C
0 -3000 -3000 -3000
1 1500
300 1000
2 1200
900 1000
3
900 1200 1000
4
300 1800 1000
Solution:
NPVProject A = -3000 + 1500/ (1.1)1+
1200/ (1.1)2+ 900/ (1.1)3+ 300/ (1.1)4 = 236.45
NPVProject B = -3000 + 300/ (1.1)1+
900/ (1.1)2+ 1200/ (1.1)3+ 1800/ (1.1)4 = 147.53
NPVProject C = -3000 + 1000/ (1.1)1+
1000/ (1.1)2+ 1000/ (1.1)3+ 1000/ (1.1)4=
169.86
The NPV of all the projects are positive, so we can accept
any of these projects, but had the projects been mutually exclusive then we
should have chosen Project A because of highest NPV.
Also, if we look carefully the cash flows from the project
are almost the same just that in Project A large inflows occur at the beginning
of the project while in Project B it occurs at the end. Therefore project A has
highest NPV, since more weight is given to cash flows which occur at the start
of the project. The more lately a cash flow occurs; accordingly a less weight
is assigned to it. As we can clearly see that Project B has the lowest NPV
because of low cash flows in the beginning of the project and Project C has NPV
in between of Project A and Project B.
5.3.5 Internal Rate of
Return
Internal rate of return is the rate
of return at which the NPV of the project is equal to zero. In other words IRR
is that discount rate that makes the present value of all cash outflows equal
to the present value of all after tax cash inflows.
Decision rule in case of IRR is
that, the IRR must be greater than the cost of capital or the hurdle rate.
Therefore if IRR is greater than the cost of capital then accept the project
else reject the project.
The calculation of IRR is a very
cumbersome process as it can only be done by hit and trial method. Only once we
have a fair idea about where the IRR will be we can use the unitary method to
calculate a more good approximate value of the IRR. It is always advisable to
calculate IRR using Microsoft Excel or using a financial calculator as it saves
a lot of time.
Example:
Calculate the IRR of each of the
following project and comment which one should be accepted:
Year Project A Project B Project C
0 -3000 -3000 -3000
1 1500
300 1000
2 1200
900 1000
3
900 1200 1000
4
300 1800 1000
Solution:
IRR Project A = 14.48%
IRR Project B = 11.79%
IRR Project C = 12.58%
According to IRR criteria Project A
must be chosen as it has got the highest IRR.
5.3.6 Profitability Index
The profitability index is the
present value of the projects future cash flows divided by the projects initial
cash outflow.
The formula for PI is given by-
PV of cash inflows
Initial cash outlay
The decision rule for profitability index is that it
should be greater than one. If the index is greater than one then the project
should be accepted else it should be rejected.
Profitability index is more or less the same as NPV.
It’s just a different way of presentation. While calculation NPV we subtract
the initial cash outlay, while in this case we divide the initial cash outlay
by the PV of all cash inflows. If the NPV is positive then the PI will be
greater than 1 and if the NPV is negative then the PI will be less than 1.
There can never be contradicting results between NPV and PI.
Example:
Calculate the PI for each of the
following project and comment which one should be accepted, the discount rate
to be used is 10%.
Year Project A Project B Project C
0 -3000 -3000 -3000
1 1500
300 1000
2 1200
900 1000
3
900 1200 1000
4
300 1800 1000
Solution:
PI Project A =
3236.45/3000 = 1.078
PI Project B =
3147.53/3000 = 1.049
PI Project C =
3169.86/3000 = 1.056
According to Profitability Index
criteria Project A must be chosen because it has got the highest PI.
5.3.7 Advantages
and Disadvantages of IRR and NPV
As a
measure of profitability and expected increase in shareholders wealth, NPV
method stands out and outshines all other measure. However it still has got
some drawbacks which are stated below:
NPV measure
just gives us the absolute increase in wealth or the expected increase in
wealth by undertaking the project. But it does not tell us on what how much we
are earning, that it it does not give us any percentage figure or any
comparative figure.
This
limitation is covered up in the case of IRR, because it gives us a rate of
return ain a percentage terms. IRR provides information on the margin of safety
which NPV does not provide. However IRR method is not preferred because as a
whole NPV method gives us a better idea about the project as in by how much the
wealth will increase and secondly there can be multiple IRR while calculating
IRR. When the cash flows are unconventional, that is it changes sign more than
once then there will be multiple IRR.
If there is
a conflicting project where both IRR and NPV give different results then the
project should be chosen according to the NPV measure, because it’s a better
criterion for decision making.