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LESSON
18
CAPITAL BUDGETING
CONTENTS
18.0 18.1 18.2 18.3 Aims and Objectives Introduction Aim of Capital Budgeting Methods of Capital Budgeting 18.3.1 Pay Back Period Method 18.3.2 Accounting or Average Rate of Return 18.3.3 Discounted Cash Flows Method 18.4 18.5 18.6 18.7 18.8 18.9 18.10 18.11 18.12 18.13 Present Value Method Capital Rationing Divisible Project Indivisible Project Risk Analysis in Capital Budgeting Let us Sum up Lesson-end Activity Keywords Questions for Discussion Suggested Readings
18.1 INTRODUCTION
The capital budgeting is one of the important decisions of the financial management of the enterprise. The decisions pertaining to the financial management of the firm are following:
Decisions of Financial Management
Financing
Investment
Dividend
Liquidity
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Capital Budgeting
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Why the capital budgeting is considered as most important decision over the others? The capital budgeting is the decision of long term investments, which mainly focuses the acquisition or improvement on fixed assets. The importance of the capital budgeting is only due to the benefits of the long term assets stretched to many number of years in the future. It is a tool of analysis which mainly focuses on the quality of earning pattern of the fixed assets. The capital budgeting decision is a decision of capital expenditure or long term investment or long term commitment of funds on the fixed assets. Charles T. Horngreen A long-term planning for making and financing proposed capital outlays.
Capital Budgeting
(1)
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(c) (d)
Budgeting of short-term assets Worthiness of long-term assets Yearly basis On the basis of return On the basis of present value of money (a), (b) & (c) Acceptance of the investment proposal Rejection of investment proposal Neither can be accepted nor rejected
(2)
(3)
(i) only (ii) only (iii) only (iv), (ii) & (iii)
The classification of methods are generally in two categories: Traditional methods v Pay Back Period method v Accounting Rate of Return Discounted cash flow methods v Net present value method v Internal Rate of Return method v Present value index method v Discounted pay back period method
Initial Investment Average Annual Earnings Rs. 1,00,000 = = 5 Years Rs. 20,000
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It is obviously understood that, Rs.20,000 of annual earnings (cash inflows) requires 5 years time period to get back the original volume of the investment. If the cash flows are not equivalent, How the pay back period is to be calculated ? The cost of the project is Rs.1,00,000. The annual earnings of the project are as follows
Year Net Income Amount Rs 1st 40,000 2nd 30,000 3rd 20,000 4th 20,000 5th 20,000
Capital Budgeting
The ultimate aim of determining the cumulative cash inflows to find out how many number of years taken by the firm to recover the initial investment. The next step under this method is to determine the cumulative cash flows
Year 1. 2. 3. 4. 5. Annual Net Incomes Rs 40,000 30,000 20,000 20,000 20,000 Cumulative cash flows Rs. 40,000 70,000 90,000 1,10,000 1,30,000
3 years full time required to recover the major portion of investment Rs.90,000
The uncollected portion of the investment is Rs,10,000. This Rs.10,000 is collected from the 4th year Net income / cash inflows of the enterprise. During the 4th year the total earnings amounted Rs.20,000 but the amount required to recover is only Rs.10,000. For earning Rs.20,000 one full year is required but the amount required to collect it back is amounted Rs.10,000. How many months the firm may require to collect Rs.10,000 out of the entire earnings Rs.20,000? Pay back period consists of two different components
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Pay back period for the major portion of the investment collection in full course E.g.: 3 years Pay back period for the left /uncollected portion of the investment
Rs.10,000 = 0.5 years Rs. 20,000
Total pay back period= 3 Years +.5 year = 3.5 years Criterion for selection: If two or more projects are given for appraisal, considered to be mutually exclusive to each other for selection, the pay back period of the projects should tabulated in accordance with the ascending order. The project which has lesser pay back period only to be selected over the other projects given for scrutiny. Why lesser pay back has to be chosen? The reason behind is that the project which has lesser pay back period got faster recovery of the initial investment through cash inflows/Net income. Selection criterion
Lesser the pay back period is better for acceptance of the project
Illustration 1: A project costs Rs.2,00,000 and yields and an annual cash inflow of Rs.40,000 for 7 years. Calculate pay back period First step is identify the nature of the annual cash inflows
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In this problem, the annual cash inflows are equivalent throughout life period of the project Pay Back Period =
Initial Investment Rs. 2,00,000 = = 5 years Annual Cash Inflows Rs. 40,000
Illustration 2: Calculate the pay back period for a project which requires a cash outlay of Rs.20,000 and generates cash inflows of Rs 4,000 Rs.8,000 Rs. 6,000 and Rs. 4,000 in the first, second, third, and fourth year respectively First step is to identify the nature of the cash inflows The cash inflows are not equivalent/constant Year Cash Inflows Rs 4,000 8,000 6,000 4,000 Cumulative Cash Inflows Rs 4,000 12,000 18,000 22,000
1. 2. 3. 4.
Cost of the project is to be recovered Rs.20,000. The project takes 3 full years time period to recover the major portion of the initial investment which amounted Rs.18,000 out of Rs.20,000 The remaining amount of the initial investment is recovered only during the fourth year. The left portion Rs.2,000 has to be recovered only from the fourth year cash inflows of Rs.4,000. Pay Back Period = Pay Back period of the major portion + Pay Back period of the remaining portion Pay Back period of the major portion = 3 years Pay Back period of the remaining portio: For the entire earnings of Rs.4,000, the firm consumed one full year/12 months time period. How many number of months required to recover Rs.2,000 ?
Rs. 2,000 = 0.5 12 months = 6 months Rs. 4,000
Total pay back period = 3 years + 6 months = 3 years 6 months Illustration 3: A project cost of Rs.10,00,000 and yields annually a profit of Rs.1,60,000 after depreciation and depreciation at 12% per annum but before tax 50% calculate pay back period. Pay Back Period =
In this problem, the initial investment is given which amounted Rs.5,00,000. The annual cash inflow is not given directly; to determine the cash inflow; what is meant by the cash inflow ? Cash inflow = Profit after tax + Depreciation
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= Rs.1,60,000
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(-)Taxation Profit after taxation (+)Depreciation 12% on Annual Cash Inflow Pay Back Period
= Rs. 80,000 = Rs. 80,000 = Rs. 10,00,000 = Rs. 1,20,000 = Rs. 2,00,000 = Rs.10,00,000 = 5 years = Rs.2,00,000
Capital Budgeting
Illustration 4: A company proposing to expand its production can go in either for an automatic machine costing Rs.2,24,000 with an estimated life of 5 years or an ordinary machine costing Rs.60,000 having an estimated life of 8 years. The annual sales and costs are estimated as follows: Particulars Sales Costs Material Labour Variable overheads Automatic Machine Rs 1,50,000 50,000 12,000 24,000 Ordinary Machine Rs 1,50,000 50,000 60,000 20,000
Compute the comparative profitability of the proposals under the pay back period method. Ignore Income Tax (I.C.W.A.Final) The first step is to find out the Annual profits of the two different machines The next step is to find out the pay back period of the two different machines respectively Profitability Statement Automatic Machine Rs Sales Less : Material Labour Variable overheads Annual profit 1,50,000 50,000 12,000 24,000 64,000 Pay Back Period Particulars Cost of the Machine Annual Profit Pay Back Period Initial Investment Annual profit Automatic Machine Rs 2,24,000 64,000 Rs.2,24,000 Rs.64,000 = 3 years Ordinary Machine Rs 60,000 20,000 Rs 60,000 Rs 20,000 = 3 years Ordinary Machine Rs 1,50,000 50,000 60,000 20,000 20,000
The pay back period method highlights that the ordinary machine is more ideal than the automatic machine due to lesser pay back period i.e., 3 years. It means that the ordinary machine is bearing the faster rate in getting back the investment invested than the automatic machine.
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The another method to discuss is post pay back impact of the two different machines Post pay back profit is the profit of the two different machines after the recovery of the initial investment. The machine which has greater post pay back profit construe. Post Pay Back Profit Particulars Annual Profit R.No.1 Estimated Life R.No.2 Pay Back Period R.No.3 Post Pay Back Period R.No. 4=R.No.2-R.No.3 Post Pay Back Profit R.No5=R.No.1R.No.4 2 years = Rs.64,0002 years = Rs.20,0005years 5 years = Rs.1,28,000 = Rs.1,00,000 Automatic Machine Rs 64,000 5 years 3 years Ordinary Machine Rs 20,000 8 years 3 years
Post pay back profit of the Automatic machine is higher than the Ordinary machine ; which amounted Rs.1,28,000.. It means that the profit of the automatic machine after the recovery of the initial investment is greater than that of the ordinary machine. Illustration 5: A company has to choose one of the following two mutually exclusive projects. Investment required for each project is Rs 30,000. Both the projects have to be depreciated on straight line basis The tax rate is 50%. Year Profit Before Depreciation Project A Rs 1. 2. 3. 4. 5. Calculate pay back period First step is to find out the depreciation under the straight line method The next step is to determine the pay back period of the both projects A and B respectively The next step is to compare both pay back periods of two different projects. The depreciation under the straight line method is as follows For Project A 8,400 9,600 14,000 14,000 4,000 Project B Rs 8,400 9,000 8,000 10,000 20,000
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Project A Add Depreciation Less Depreciation Cumulative Cash inflows Profit Before Depreciation
Capital Budgeting
1. 2. 3. 4. 5.
Cash in flows
Years
Profit
Pay back period = Pay back period of a major portion + Pay back period for remaining Pay back period of the major portion= the firm has recovered a major portion of the initial investment of Rs.25,000 within 3 full years out of Rs.30,000 The second half of the equation is that pay back period for the remaining i.e., Rs.5000 of initial investment which is to be recovered during the fourth year out of Rs.10,000 If Rs.10,000 earned throughout the year /12 months, how many months taken by the firm in recovering Rs.5,000 out of Rs10,000
= Rs. 5,000 = .5 12 months = 6 months Rs.10,000
Pay back period (Project A) = 3.6 years The next stage to find out the pay back period of the project B Project B Add Depreciation Less Depreciation Cumulative Cash inflows 7,200 14,700 21,700 29,700 42,700 Profit Before Depreciation Profit after tax Less Tax 50%
1. 2. 3. 4. 5.
= 4 years +.02 365 days = 4 years + 8 days = 4 years and 8 days Pay back period of the project B is greater than that of the earlier Project A. It means that the Project A is bearing the faster rate in getting back the investment invested.
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Cash in flows
Years
Profit
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Merits
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It is a simple method to calculate and understand It is a method in terms of years for easier appraisal
Demerits:
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It is a method rigid It has completely discarded the principle of time value of money It has not given any due weight age to cash inflows after the pay back period It has sidelined the profitability of the project.
18.3.2 Accounting or Average Rate of Return: Under this method, the profits are extracted from the book of accounts to denominate the rate of return. The profits which are extracted are nothing but after depreciation and taxation and not cash inflows. Selection criterion of the projects:
Highest rate of return of the project only is given appropriate weightage. The Accounting rate of return can be computed as follows
Annual Return 100 Original Investment Average Annual Return 100 Average Investment
Average annual return= Average profit after depreciation and taxation of the entire life of project i.e. for many number of years Average Investment =
= Illustration 6
Calculate the average rate of return for Projects X and Y from the following Project X Investments Expected Life Rs.40,000 4 years Project Y Rs.60,000 5 years
Projected net income ( after interest, depreciation and taxes) Year Project X Rs Project Y Rs 1. 2. 3. 4. 5.
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If the required rate of return is 10% which project should be undertaken? Average Rate of Return =
Capital Budgeting
The first step is to find out the average annual income of the two different projects X and Y Average Annual Income =
Total income throughout the Project Life of the Project Rs.12,000 = Rs. 3,000 4 years Rs. 20,000 = Rs. 4,000 5 years
The next step is to find out the Average rate of return : Average rate of return ( Project X) = Average rate of return ( Project Y) =
Rs. 3,000 100 = 7.5% Rs.40,000 Rs.5,000 100 = 8.33% Rs. 60,000
Both the projects are lesser than the given required rate of return. These two projects are not advisable to invest only due to lesser accounting rate of return. Illustration 7 The alpha limited is considering the purchase of a machine to replace a machine which has been in operation in the factory for the last 5 years. Ignoring interest pay but considering tax at 50% of net earnings suggest which on the two alternatives should be preferred. The following are the details Particulars Purchase price Economic life of the machine Machine running hours per annum Units per hour Wages running per hour Power per annum Consumable stores per annum Other charges per annum Material cost per unit Selling price per unit Old Machine Rs.80,000 10 years 2,000 24 3 2,000 6,000 8,000 .50 1.25 New Machine Rs,1,20,000 10 years 2,000 36 5.25 3,500 7,500 9,000 .50 125
First step is to consider that few assumptions to proceed the problem without any technical difficulties. First assumption is that there is no closing stock i.e. what ever goods produced are sold out in the market. Second assumption is that the volume of the sales is expected to be remain throughout the life of the period. Third assumption is that the depreciation charged by the firm is on the basis of straight line method.
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Steps involved in the computation of the accounting rate of return The first is to compute the total number of units expected to produce Total number of units of production = Total machine hours per annum Units per hour For old machine For new machine Total volume of sales For old machine For new machine = 2,000 Hrs 24= 48,000 units = 2,000 Hrs 36= 72,000 units = Total number of units Selling price per unit = 48,000 units Rs 1.25= Rs.60,000 = 72,000 units Rs.1.25= Rs.90,000
According to the second assumption, the volume of sales is known as unaffected throughout the life period of the projects. The next step is to find out the volume of the wages Total wages For old machine For new machine = wages per hour Machine running hours = Rs.3 2000 Hrs= Rs.6,000 = Rs5.25 2000 Hrs=Rs.10,500
The next step is to find out the total material cost Total material cost per unit = Total number of units Material cost per unit For old machine For new machine = 48,000 .5= Rs.24,000 = 72,000 .5=Rs.36,000
Initial investment Depreciation under straight line method = Economic life period of the asset
For old machine For new machine = Rs.8,000 = Rs.12,000
The next step is to draft the profitability statement of the enterprise under the head of two different machine viz old and new. To find out the annual income of the enterprise under two different machines
Profitability Statement
Particulars Sales Less Direct Material Wages Power Consumable stores Other charges Depreciation Profit before tax Tax at 50% Profit after tax Old Machine Rs Rs 60,000 24,000 6,000 2,000 6,000 8,000 8,000 54,000 6,000 3,000 3,000 New Machine Rs Rs 90,000 36,000 10,500 4,500 7,500 9,000 12,000 79,500 10,500 5,250 5,250
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Average Annual Return 100 Original Investment Average Annual Return = 100 Average Investment
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Capital Budgeting
Particulars Average Rate of Return On the basis of original investment Average Rate of Return On the basis of average investment
Old Machine Rs3,000 100 Rs.80,000 =3.75% Rs.3,000 100 Rs.40,000 =7.5%
Merits
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It is simple method to compute the rate of return Average return is calculated from the total earnings of the enterprise through out the life of the firm The entire rate of return is being computed on the basis of the available accounting data
Demerits
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Under this method, the rate of return is calculated on the basis of profits extracted from the books but not on the basis of cash inflows The time value of money is not considered It does not consider the life period of the project The accounting profits are different from one concept to another which leads to greater confusion in determining the accounting rate of return of the projects
Present value Index Method Net Present value method Internal Rate of Return method
The discounted cash flows method is the only method nullifies the drawbacks associated with the traditional methods viz Pay back period method and Accounting rate of return method. The underlying principle of the method is time value of money. The value of 1 Re which is going to be received on today bears greater value than that of 1 Re expected to receive on one month or one year later. The main reason is that "Earlier the benefits better the principle". It means that the benefits whatever are going to be accrued during the present will be immediately reinvested again to maximize the earnings, so that the earlier benefits are weighed greater than the later benefits. The later benefits are expected to receive only during the future which is connected with the future i.e., future is uncertain. It means that there is greater uncertainty involved in the receipt of the benefits connected with the future. Why the time value of money concept is inserted on the capital budgeting tools? The main reason is that the capital expenditure is expected to extend the benefits for many number of years. The 1 Re is expected to receive one year later cannot be treated at par with the 1 Re of 2 years later. This is the only method considers the profitability as well as the timing of benefits. This method gives an appropriate qualitative consideration to the benefits of various time periods.
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The time value of money principle is used for an analysis to study about the quality of the investments in receiving the future benefits. There are general classifications which are as follows
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Net present value method Present value index method Internal rate of return method
What is present value index? The major lacuna of the Net present value method is unable to rank the projects one after the another, only due to the volume of the investment involved. To rank the projects meaningfully, the present value index method is adopted. The present value index of the investment can be calculated with the help of following formula: Present value index method Selection criterion If the present value index is greater than one, accept the proposal; otherwise vice versa
Present value index>1:- Accept the investment proposal Present value index<1:-Reject the investment proposal
Pr esent value of the cash inflows Pr esent value of the cash outflows
What is internal rate of return method? IRR is the rate at which initial investment is equal to the Present Value of future case in -flows. Under this method, while matching, these two are known but the rate which is taken for equation not given or known. The rate of discounting for matching should be determined through trial and error method.
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Once the Internal rate of return is found out, the found IRR should be compared with the required rate of return. Decision criterion If the IRR is more than the Required rate of return, the project has to be accepted If the IRR is less than the Required rate of return, the project has to be rejected
Check Your Progress
Capital Budgeting
(1)
(2)
Why Discounted cash flows method is considered to be a superior than the Traditional method ?
(a) (b) (c) (d) Simple to understand Accuracy Time value of money Easy to calculate
Illustration 8 Project ABC Ltd. costs Rs 1,00,000. It produces the following cash flows
Year Cash Inflows Rs Present value of Re1 at 10% 1 40,000 .909 2 30,000 .826 3 10,000 .751 4 20,000 .683 5 30,000 .621
The investment proposal has to be accepted only due to positive Net present value. It means that the present value of the cash inflows are greater than the present value of the outlay. It means the discounted future earnings are greater than the present initial investment outlay. Illustration 9 The Alpha Co Ltd., is considering the purchase of a new machine. Two alternative machines (A and B) have been suggested, each having an initial coast of Rs.4,00,000 and requiring of Rs.20,000 an additional working capital at the end of 1st year. Earnings after taxation are expected to be follows
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Year 1. 2. 3. 4. 5.
Cash inflows Machine A Rs Machine B Rs 40,000 1,20,000 1,20,000 1,60,000 1,60,000 2,00,000 2,40,000 1.,20,000 1,60,000 80,000
(CA Final Nov, 1972) The profitability statement of Two machines -Alpha company
Year Present value factor@ 10% Machine A Cash Inflow Rs 1. .91 40,000 2. .83 1,20,000 3. .75 1,60,000 4. .68 2,40,000 5. .62 1,60,000 Present value cash inflows Present value cash outflows= Rs.4,00,000+ 20,000 X.91 Net present value Present Value Rs 36,400 99,600 1,20,000 1,63,200 99,200 5,18,400 4,18,200 1,00,200 Machine B Cash Inflow Rs 1,20,000 1,60,000 2,00,000 1.,20,000 80,000 Present Value Rs 1,09,200 1,32,000 1,50,000 81,600 49,600 5,23,200 4,18,200 1,05,000
In the above problem, among the given machines, the firm is required to chose only one machinery. To chose the ideal machinery among the given two, the net present value should be ranked. The Machine B has been considered as preferable over the machine A due to higher net present value. The ranking of the machines do not indulge any difficulties. Why it so ? The main reason is that both machines are having equivalent volume of investment outlay. Out of the same initial outlays, we can rank that both machines one after the another based upon the net present value. Illustration 10 The initial cost of an equipment is Rs. 50,000. Cash inflows for 5 years are estimated to be Rs.20,000 per year. The management's desired minimum rate of return is 15%. Calculate Net present value and Excess present value index. At the end of every year, the firm expects to earn Rs.20,000. The amount expects to earn Rs.20,000 on every year is nothing but future value of money. The future value of money should be converted into the present value for having comparison with the initial investment. On every Rs.20,000 expected to receive forms a series of future cash inflows which should be converted into present value. This conversion process i.e the process of converting the future value into present value is known as discounting process. For discounting, the rate which is used for the process pronounced as discount rate or minimum rate of return. The conversion process can be done in two different ways. Discounting process :- PV= FV/ (1+r)n For first year cash inflow Rs.20,000:PV=20,000/(1.15)=20,000.870 For second year cash inflow Rs.20,000;PV=20,000/(1.15)2 =20,000.756
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=Rs.17,400
=Rs.15,120
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For third year cash inflow Rs.20,000:PV=20,000/(1.15)3=20,000.658 For fourth year cash inflow Rs.20,000:PV=20,000/(1.15)4=20,000.572 For fifth year cash inflow Rs.20,000:PV=20,000/(1.15)5=20,000.497 =Rs.9,940 Rs.67,060 OR Alternately, the discounting can be done as follows Being Rs.20,000 is nothing but as common cash inflow throughout 5 years of the project, considered to be a series of cash inflows Rs.20,000(.870+.756+.658+.572+.497) =Rs.67,060 =Rs.11,440 =Rs.13,160
Capital Budgeting
Net present value = Present value of cash inflows - Present value of cash outlay =Rs.67,060- Rs.50,000= Rs.17,060 The net present value of the project is +ve. Hence, the project can be accepted. Illustration 11 A project costs Rs.36,000 and is expected to generate cash inflows of Rs.11,200 annually for 5 years. Calculate the IRR of the project. First step is to find out the fake pay back quotient Pay back =
Initial Investment Rs. 36,000 = = 3.214 Annual average return Rs. 11,200
The next step is to locate the pay back quotient in the table M-4. The present value of 1 Re should be computed for 5 number of years. The location of the pay back quotient is in between the values of table M-4 The value 3.214 which lies in between 3.274 of 16% and 3.199 of 17% The next step in the IRR calculation is that locating the maximum rate of return which equates the initial outlay with the cash inflows of various time periods. While equating the initial outlay with discounted cash inflows at certain percentage will derive the original rate of return. The process may be started from two different angles viz
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The computation of IRR can be had through either low discount rate or high discount rate. This is further extended to different methods of calculation., which are as follows
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On the basis of values extracted from the table On the basis of volume
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On the basis of Lower % of discount rate =Lower discount rate + Discount rate difference
(Pay Back quotient - Higher discount rate) (Lower discount - Higher discount rate) 3.214 3.199 = 17% 1% = 17% .2% = 16.8% 3.274 3.199
Alternately, on the basis of volume, the methodology to be adopted for the determination of IRR The cash inflows of Rs.11,200 for 5 years are discounted @ 16% which amounted Rs.36,668.8. Like wise the cash inflows of the same should be discounted at the rate of 17% which amounted Rs.35,828.8 The next step is to find out the IRR. The IRR can be found out either on the basis of lower discounted cash inflows or higher discounted cash inflows.
On the basis of discounted cash inflows Lower rate Rs.36.668.8 On the basis of discounted cash inflows Higher rate-Rs.35.828.8
(+)
(-)
(Rs. 36,000 - Rs. 35.828.8) (172) = 17% - 1% (Rs. 36.668.8 - 35,828.8) (840)
== 17% -.204=16.796% Merits of DCF methods
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It is only the best method incorporates the timing of benefits - time value of money It considers the economic life of the project It is a best method for both even and uneven cash inflows
It involves with tedious method of computation It is very difficult to locate or identify the exact discounting factor It never performs functions of discounting to the tune of accounting concepts.
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Illustration 12 XYZ company is considering an investment proposal to install new drilling controls at a cost of Rs.1,00,000. The facility has a life expectancy of 5 years and no salvage value. The tax rate is 35%. Assume the firm uses straight line depreciation and the same is allowed for tax purposes. The estimated cash flows before depreciation and tax form the investment proposal are as follows:
Year 1. 2. 3. 4. 5. Cash flows Before Tax Rs 20,000 21,384 25,538 26,924 40,770
Capital Budgeting
Calculate the following 1. 2. 3. 4. Pay back period Average rate of return Net present value at 10 percent discount rate Profitability index at 10 percent discount rate
The first and foremost step is to find out the Cash Flows After Taxation For finding out the Cash flows after taxation, the amount of depreciation i.e non recurring expenditure should be appropriately considered for calculation. The depreciation has to be computed in accordance with the stipulation given in the problem. The depreciation charged by the firm is nothing but straight line method. Straight line method of depreciation =
Initial Investment - Scrap value Economic life period of the machine Rs.1,00,000 = = Rs. 20,000 5 Years
The depreciation has to be deducted initially from the cash flows before taxation, after the deduction of taxation, the earnings after taxation should be added with the depreciation which was already deducted in order to find out the total cash flows after taxation. The purpose of deducting the depreciation is nothing but an amount to be charged under the Profit & Loss account against the total revenue. Being as a non-recurring expenditure not created any outflow cash resources. When there is no cash outflow, the amount of depreciation should be added finally to derive CFAT(Col 7)
Table
Year Col 1 CFBT Rs Col 2 Depreciation Rs Col 3 Profits Before Tax Rs Col 4=Col2Col3 Nil 1,384 5,538 6,924 20,770 Taxes (.35) Col 5 Earnings After tax Rs Col6=Col4 -Col5 Nil 900 3,600 4,500 13,500 22,500 Cash flows after tax Rs Col7= Col6+Col3
1. 2. 3. 4. 5.
1.
Pay back period method: Under this, method most important step is to identify the nature of the cash flows after taxation. Are they uniform ? No, they are not even cash flows. Hence, the cumulative cash flows after taxation has to be found in order to find out the pay back period of the investment.
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Year 1. 2. 3. 4. 5.
Pay back period= Pay back period for the major portion of the investment + Pay back period for the remaining portion unrecovered = 4 year +
Rs.11,000 = 4 year + .328 year Rs. 33,500
ARR =
Average Income is the average of earnings after taxation of the entire duration. Why earnings after taxation has to be taken into consideration ? Why not the cash flows after taxation to be taken for consideration ? The main purpose of considering the earnings after taxation is that the amount extracted from the book of accounts and taken for the computation of ARR, and immediately after the payment of taxation. Average investment is the average of opening and closing investment. If the depreciation charge given is nothing but straight line method, automatically final value of the asset will become equivalent to zero. The closing balance of the asset /investment is zero. How the closing balance of the investment could be adjudged as equivalent to zero?
Table of Depreciation
Year 1. 2. 3. 4. 5. Opening balance of the year Rs 1,00,000 80,000 60,000 40,000 20,000 Closing balance of the year Rs 80,000 60,000 40,000 20,000 0
At the end of the year, the closing balance amounted Rs.0 after charging the depreciation year after year constantly in volume
Opening balance + Closing balance 2 Rs. 1,00,000 + Rs. 0 = 2 = Rs. 50.000 Rs. 22,500 Average Income = = Rs.4,500 5 years Rs. 4,500 Average rate of return = 100 = 9% Rs.50,000 Average =
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3.
Net present value method: Under this method, the future cash flow after taxation should be discounted at the rate 10%
Capital Budgeting
Year Cash flows after tax 1. 20,000 2. 20,900 3. 23,600 4. 24,500 5. 33,500 Total Present value Less Initial outlay Net present value
Total Present Value Rs 18,180 17,263 17,724 16,734 20,803 90,704 1,00,000 ( 9,296)
The net present value is negative due to excessive investment more that of the present value of future earnings of the enterprise. Under this method, the investment is not advisable to procure for the firm's requirements. 4. Profitability Index The profitability index method is more useful in the case of more number of investments, having uneven investment outlays, but this problem comes with only one investment proposal It is much easier to assess even in the case of Net present value method. Profitability Index (PI) =
Pr esent value of cash inflows Rs.90,704 = Pr esent value of cash outflows Rs. 100,000 =.90704
The present value index quotient is less than that of the norms which should be greater than one but it secures only 90704. It means that the present value earnings are not sufficient to meet the initial cost of the machine.
Check Your Progress
(1)
Why the depreciation is added at the end of computation to derive the cash flow ?
(a) (b) (c) (d) Being as recurring charge Being considered as tax shield Being as non recurring charge None of the above
(2)
Why "0" value is taken as closing balance of the investment for the computation of Average investment ?
(a) (b) (c) (d) No value for the closing balance No value due to the application of straight line method of depreciation No scrap value at the end of the life of the asset None of the above
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(i) (ii)
The selection of the investment proposals are on the basis of Discounted cash flows method. The selection of the investment proposals are subject to two different categories viz indivisible and divisible. The investment which is wholly accepted or rejected due to decision criterion which is known as indivisible project but the divisible projects are able to either accept or reject in parts.
Out of the available Rs. 7 Cr, the first two projects selected on the basis of Profitability index viz Z and W. The total amount of investment required to invest in both the projects amounted Rs 8.50 Cr but the financial constraint is Rs.7 Cr. By considering the constraint, the first project fully accepted and the part of the next project W accepted for the remaining amount of corpus available by considering to maximize the NPV of the project as a whole.
The D, E and B are the project for making an investment which jointly amounted Rs 64 Cr and the remaining the Rs 6 cr to be invested into the project.
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be known and distinguished from the uncertainty. The risk situation is one in which the probabilities of one particular event are known but the uncertainty is the situation in which the probabilities are not known. In the case of risk situation, the future losses can be foreseen unlike the uncertainty situation. The incorporation of the risk factor in the discount rate in accordance with the variability of the returns. If the variability of the returns are more, the investor may prefer higher return in the form of risk premium for risky project unlike in the case of government securities. The government securities are not having any variability in the returns which require the risk free return to discount only in order to know the worth of the investment but the risky projects are to be discounted only with the help of higher discount rates. There quite number of techniques available for incorporating the risk component in the capital budgeting are follows: Sensitivity analysis Standard deviation Coefficient of variation and so on.
Capital Budgeting
18.11 KEYWORDS
Capital budgeting: A study on Long term investment decision in terms of quality of benefits Pay back period: It is a time period during which the initial investment is recovered ARR: Accounting rate of return - It is being calculated in accordance with the financial statements PV: Present value IO: Initial outlay which is nothing but initial investment NPV: Net present value which is the difference in between the Initial investment and Present value of future cash inflows IRR: Internal rate of return which is nothing but highest rate of return expected to earn
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PI: Profitability Index is the ratio in between the present value of future cash inflows and present value of initial
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