18 Capital budgeting

P.G. Padma Gowri

Introduction:

Capital budgeting is a long term planning for proposed capital outlays and their financing. Thus, it includes both rising of long –term funds as well as their utilisation. It is defined as “The firm’s regular process for the acquisition and investment capital”. Capital budgeting is a many sided activity.

It includes searching for new and more profitable investment proposals, investigating engineering and marketing considerations to predict the consequences of accepting the investment and making economic analysis to determine the profit potential of each investment proposal.

Its basic features are:

It has the potentiality of making large anticipated profits.
It involves a high degree of risk.
It involves a relatively long time period between the initial outlay and anticipated return.

Objectives:

To understand various principle of Capital budgeting.
To know Capital investment procedure
To know various method to calculate Capital budgeting appraisal methods

Capital budgeting:

Capital budgeting defines decision making on investment. It is based on the returns which proposed investment will give. Project implementation process, capital financing, allocation functions and well –managed company are the part of capital budgeting process.

Capital budgeting is the allocation of available funds for capital projects. A capital project is a long-term investment on the tangible assets. The tools and principles capital budgeting is applied in different aspects of a business entity’s decision making and in security valuation

A company’s capital budgeting process is important in valuing a company.Capital Budgeting is a project selection exercise done by the business enterprise. Capital budgeting uses the concept of present value to select and implement the projects.

Capital budgeting uses tools such as payback period, net present value, internal rate of return and profitability index to select projects. To evaluate capital budgeting processes, their consistency with the goal of shareholder wealth maximization is of utmost importance.

Basic principles of Capital Budgeting

Principles

Capital Budgeting decisions are taken based on cash flow not by accounting income.
In capital budgeting, the timing of cash flows is crucial. The time value of money is important.
In capital Budgeting, Cash flows are incremental. Cash flows are based on opportunity costs.
In capital Budgeting cash flows are after-tax basis, because cash flow related to taxes is a part of the cash flow that must be analyzed.
In capital budgeting financing costs are ignored in the cash flow analysis. Financing costs enter the decision making through the proper rate of return.

Nature of Capital Budgeting

Nature of capital budgeting is Capital expenditure plans involving a huge investment in fixed assets. Capital expenditure once approved represents long-term investment that cannot be reserved or withdrawn without sustaining a loss.

Preparation of capital budget plans involves forecasting of several years profits in advance and judge the profitability of projects. It may be asserted here that decision regarding capital investment should be taken carefully so that the future plans of the company will not affected.

Capital financing and allocation functions:

The amounts of new funds are needed from investors and lenders. The funds are available from internal sources to support new capital projects. These two will determine the capital financing functions.

Sources of Capital funds:

Companies also use outside capital in addition to inside capital. The company in cease capital increases the company shares and issues large amount of common stock from outside. The outside sources of capital include equity partners, stockholders, bond holder’s banks and venture capitalists and all who expect return on investments.

Debt capital:

Any borrowed money act as source of capital. It’s called as Debt capital .The money may be obtained from the sale of bonds or debentures or may be loaned by banks as a line of credit

Equity capital:

Equity sources of funding include not only stockholders capital but also the earnings retained by the company for investment in the business and the cash flow resulting from depreciation charges against income.

Procedure for Capital investment:

Capital investment decision in the view of any firm is influence on the entire spectrum of entrepreneurial activities. So the careful consideration should be regarded to all aspects of financial management

In capital budgeting process, main points to be kept in mind are how much money will be needed for implementing immediate plans, how much money is available for its completion and how are the available funds going to be assigned to the various capital projects under consideration

The financial policy and risk policy of the management should be clear in mind before proceeding to the capital budgeting process.

The following procedure may be adopted in preparing capital budget:-

1) Investment Proposal for Organisation:

The first step in capital budgeting process is the conception of a profit making idea. The department head collects all the investment proposals and reviews them in the light of financial and risk policies of the organisation and send them to the capital expenditure planning committee for consideration.

2) Screening the Proposals.

The capital expenditure planning committee screens the various proposals within the long-range policy-frame work of the organisation

3)Evaluation of Projects:

The third step in capital budgeting process is to evaluate the different proposals in terms of the cost of capital, the expected returns from alternative investment opportunities and the life of the assets with evaluation techniques.

4) Establishing Priorities:

The profitable projects or the accepted projects are then put in priority.

5) Final Approval:

Proposals which are finally recommended by the committee are sent to the top management along with the detailed report, both of the capital expenditure and of sources of funds to meet them. The management affirms its final seal to proposals taking in view the urgency, profitability of the projects and the available financial resources. Projects are then sent to the budget committee for incorporating them in the capital budget.

6) Evaluation:

The important step in the capital budgeting process is an evaluation of the programme after it has been fully implemented. Budget proposals and the net investment in the projects are compared periodically. Then the budget figures are presented in a more realistic way.

Capital Budgeting appraisal methods:

There are several methods for evaluating and ranking the capital investment proposal. In case of all the methods the mail emphasis is on the return, which will be derived on the capital invested in the project. In other words, the basic approach is to compare the investment in the project with the benefits derived there from.

Payback Period method.
Accounting Rate of Return
Net Present Value
Internal Rate of Return
Profitability Index

Payback Period:

Payback period is the time duration required to expense the investment committed to a project. In Business enterprises payback period is used as “stipulated payback period”, which is a standard for screening the project.

Payback Period calculation

When the cash inflows are constant, the formula for payback period is cash outflow divided by annual cash inflow.

Computation of Payback Period

Payback Period=Initial Investment Annual Cash Inflow

Example :

If a project requires Rs.20, 000/- as initial investment and in will generate annual cash inflow of Rsa5,000/- for 10 years, the payback period will be 4 years, as calculated follows.

Payback Period =

Initial InvestmentAnnual Cash Inflow

= Rs.20,000 =4 5000

The annual cash inflow is calculated by taking into amount of net income on account of asset before depreciation but after taxation.

Advantages of Payback Period:

Payback period is easy to understand and apply. Payback period concept is familiar to every decision-maker.
All the Business enterprises facing uncertainty in terms of both product and technology. So the Business enterprises will benefit by the use of payback period method since the stress in this technique is on early recovery of investment.
Enterprises facing technological obsolescence and product obsolescence must prefer payback period method.
Enterprises having high liquidity requirement usually prefer this tool since it involves minimal waiting time for recovery of cash outflows as the emphasis is on early recoupment of investment.

Disadvantage of Payback Period

• The value of money in the particular period was ignored.

For example:

A project X of Rs.500 received at the end of 2nd and 3rd years are given same weight age. A rupee received in the first year and during any other year within the payback period is given same weight. But in practice and common knowledge that a rupee received today has higher value than a rupee to be received in future.

This drawback can be set right by using another type of the payback period method called discounted payback period method. The discounted payback period method looks at recovery of initial investment after considering the time value of inflows.

Investment decision is essentially concerned with a comparison of rate of return promised by a project with the cost of acquiring funds required by that project.

Payback period is essentially a time concept. it does not usually consider the rate of return.

Accounting Rate of Return

Accounting rate of return or Average rate of return (ARR) is a financial ratio used in capital budgeting. ARR calculates the return generated from net income of the proposed capital investment. ARR is called as percentage of return.

Example:

If ARR = 7%, then it means that the project is expected to earn yearly seven rupees out of 100 rupees invested .

Accounting rate of return is the rate arrived at by expressing the average annual net profit (after tax) as given in the income statement as a percentage of the total investment or average investment. The accounting rate of return is based on accounting profits.

Accounting profits are different from the cash flows from a project and hence, in many instances, accounting rate of return might not be used as a project evaluation decision.

Computation of Accounting Rate of Return ARR =

Average investment = the sum of the beginning and ending book value of the project / 2.

Advantage of Accounting Rate of Return:

• The calculation of Accounting Rate of Return is quite simple.

Disadvantages of Accounting Rate of Return:

The definition of cash inflows is inaccurate. It takes into account profit after tax only. It fails to present the true return.
The time value for money is not considered here

Net Present Value (NPV) method:

This is generally considered to be best method for evaluating the capital investment proposals.

The NPV is a difference between total present values of future has inflows and the total present value outflows.

Net present value of an investment/project is the difference between present value of cash inflows and cash outflows. The present values of cash flows are obtained at a discount rate equivalent to the cost of capital.

Computation of Net Present Value (NPV)

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.

The following is the formula for calculating NPV:

where

Ct = Total cash inflow during the period t

Co = net initial investment costs

r = discount rate

t = number of time periods in years

If net present value is positive it indicates that the projected earnings generated by a project or investment (in present rupees) exceeds the anticipated costs (also in present rupees).

1	NPV>ZERO	Accept the proposal

2	NPV< ZERO	Reject the proposal

3	PV>C	Accept the proposal

4	PV< C	Reject the proposal

PV = present value of cash inflows

C= present value of cash outflows

Example:

Calculate the net present value for small sized project requiring an initial investment Rs.20,000/- and which provides a net cash inflow of Rs.6,000/- each year for 6 years. Assume the cost of funds to be 8% per annual. No scrape value. The PV of an annuity of Rs.1 for 6 years at 18% p.a. interest is Rs.4.623. Hence the PV of Rs.6, 000 comes to:

6,000 x4.623	= 27,738Rs.
Less: Initial investment	= 20,000
	________
Net present value	= 7,738
	________

An investment with a positive NPV will be a profitable one and if with a negative NPV will result in loss in capital.

Capital asset pricing model:

In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.

Internal Rate of Return (IRR)

IRR is that rate at which the sum of discounted cash inflows equals the sum of discounted cash outflows. It can be stated in the form of a ratio as follows:

Example:

If a sum of Rs.800/- invested in a project becomes Rs.1,000/- at the end of the year, the rate of return comes to 25%, calculated as follows:

I = ( ℎ )1+

I = Cash outflow (that is initial investment)

R =- rate of return yielded by the investmen

Thus 800 = 1000/1+r

800r + 800 = 1000

800r =200

r = 200/800 =- .25 or 25%

IRR is the rate of return of the companies project generates. Mathematically IRR can be determined by setting up an NPV equation and solving for a discount rate that makes the NPV = 0. IRR is solved by determining the rate that equates the PV of cash inflows to the PV of cash outflows.

Advantages Internal Rate of Return:

IRR number is easy to interpret.
Acceptance criteria of IRR are generally consistent with shareholder wealth maximization.

Disadvantages Internal Rate of Return:

IRR requires knowledge of finance to use.
Difficult to calculate – need financial calculator.

Capital allocation:

Capital allocation for independent projects use the net present worth (PW) and payback period. If the projects risks are equal , the procedure is to compute the PW for each investment opportunity and then to enumerate all feasible combinations of the projects.

Profitability index: It is also known as profit investment ratio (PIR) and value investment ratio (VIR)

Profitability index (PI) is the ratio of payoff to investment of a proposed project.

It is a used for ranking the projects because it allows you to quantify the amount of value created per unit of investment.

Conclusion

Capital budgeting is the important process in which an organization decides whether certain large projects, such as building an addition or purchasing large equipment, are worth the investment for the organisation. Usually the limited amount of capital amount will be available in any organization at any given time, so it is critical that company leaders utilize capital budgeting methods to make the determination which ventures or projects will bring the company the biggest return on their investment.

In the above various capital budget methods like Payback Period, Net Present Value (NPV), and Internal Rate of Return (IRR) are explained. The payback period is the cash flow analysis metric that calculates the length of time for capital acquisitions or investments to pay for themselves.

It also provides the length of time it takes to cover costs, or what is the investment breakeven point.

Thus capital budgeting is very much needed for any industry or organisation.

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