Program Semester Subject Code Subject Name Unit number

: MBA :I : MBF201 : Financial Management :8

Unit Title

: Capital Budgeting

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Introduction
All such businesses involve investment decisions. These investment decisions that corporates take are known as capital budgeting decisions. Capital budgeting decisions involve evaluation of specific investment proposals. Capital budgeting is a blue-print of planned investments in operating assets. It is the process of evaluating the profitability of the projects under consideration and deciding on the proposal to be included in the capital budget for implementation. Capital budgeting decisions involve investment of current funds in anticipation of cash flows occurring over a series of years in future. Investment of current funds in long-term assets for generation of cash flows in future over a series of years characterises the nature of capital budgeting decisions.
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Session Objectives:
To understand, The concept of capital budgeting The importance of capital budgeting The complexity of capital budgeting procedures Various techniques of appraisal methods Evaluation of capital budgeting decision

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Importance of Capital Budgeting

Grouping of Decisions Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant

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The reasons that make the capital budgeting decisions most crucial for finance managers are:

These decisions involve large outlay of funds in anticipation of cash flows in future.
Long time investments of the funds sometimes may change the risk profile of the firm. Capital budgeting decisions involve assessment of market for companys product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment.

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The growth and survival of any firm in todays business environment demands a firm to be pro-active. Capital budgeting decisions help in this process. The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex. Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project.

Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today.

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Complexities involved
Capital expenditure decision involves forecasting of future operating cash flows. Forecasting the future cash flows demands certain assumptions about the behaviour of costs and revenues in future. The following are complexities involved in capital budgeting decisions: Estimation of future cash flows Commitment of funds on long-term basis Problem of irreversibility of decisions

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Phases of Capital Expenditure decisions

Identification of investment opportunities. Evaluation of each investment proposal Examination of the investments required for each investment proposal Preparation of the statements of costs and benefits of investment proposals Estimation and comparison of the net present values of the investment proposals that have been cleared by the management on the basis of screening criteria Examination of the government policies and regulatory guidelines, for execution of each investment proposal screened and cleared based on the criteria stipulated by the management Budgeting for capital expenditure for approval by the management Implementation Post-completion audit

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Identification of investment opportunities

A firm is in a position to identify investment proposal only when it is responsive to the ideas of capital projects emerging from various levels of the organisation.

The proposal may be to: Add new products to the companys product line, Expand capacity to meet the emerging market at demand for companys products Add new technology based process of manufacture that will reduce the cost of production.
Generation of ideas with the feasibility to convert the same into investment proposals occupies a crucial place in the capital budgeting decisions. Proactive organisations encourage a continuous flow of investment proposals from all levels in the organisation.

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Important Points for consideration Analysing the demand and supply conditions of the market for the companys product could be a fertile source of potential investment proposals. Market surveys on customers perception of companys product could be a potential investment proposal to redefine the companys products in terms of customers expectations. Reports emerging from R & D section could be a potential source of investment proposal. Economic growth of the country and the emerging middle class endowed with purchasing power could generate new business opportunities in existing firms. Public awareness of their rights compels many firms to initiate projects from environmental protection angle.
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Rationale of Capital Budgeting Proposals

The investors and the stake-holders expect a firm to function efficiently to satisfy their expectations.

The stake-holders expectation and the performance of the company may clash among themselves.
The one that touches all these stake-holders expectation could be visualised in terms of firms obligation to reduce the operating costs on a continuous basis and increasing its revenues. Therefore, capital budgeting decisions could be grouped into two categories: Decisions on cost reduction programmes Decisions on revenue generation through expansion of installed capacity

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Capital Budgeting Process

The technical aspects of the project are: Selection of process know-how Decision on determination of plant capacity Selection of plant, equipment and scale of operation Plant design and layout General layout and material flow Construction schedule

Economic Appraisal / social cost benefit analysis examines: The impact of the project on the environment The impact of the project on the income distribution in the society The impact of the project on fulfilment of certain social objective like generation of employment and attainment of self sufficiency Will the project materially alter the level of savings and investment in the society?

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Financial appraisal technique examines: Cost of the project Investment outlay Means of financing and the cost of capital Expected profitability Expected incremental cash flows from the project Break-even point Cash break-even point Risk dimensions of the project Will the project materially alter the risk profile of the company ? If the project is financed by debt, expected Debt Service Coverage Ratio Tax holiday benefits, if any.

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Investment Evaluation
Steps involved in the evaluation of any investment proposal are: Estimation of cash flows both inflows and outflows occurring at different stages of project life cycle Examination of the risk profile of the project to be taken up and arriving at the required rate of return Formulation of the decision criteria

Estimation of cash flows Capital outlays are estimated by engineering departments after examining all aspects of production process. Marketing department on the basis of market survey forecasts the expected sales revenue during the period of accrual of benefits from project executions. Operating costs are estimated by cost accountants and production engineers.
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Incremental cash flows and cash out flow statement is prepared by the cost accountant on the basis of the details generated in the above steps.

Estimation of incremental cash flows Incremental cash flows stream of a capital expenditure decision has three components. Initial cash outlay (Initial investment) Operating cash inflows

Terminal cash inflows

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Basic principles of Cash Flow Estimation*

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Separation principle : The essence of this principle is the necessity to treat investment element of the project separately (i.e. independently) from that of financing element. The rate of return expected on implementation if the project is arrived at by the investment profile of the projects. Interest on debt is ignored while arriving at operating cash inflows. The following formula is used to calculate profit after tax Incremental PAT = Incremental EBIT (1-t) (Incremental) (Incremental) Where, EBIT = earnings (profit) before interest and taxes, t = tax rate

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Incremental principle : This principle states that cash flows of a project are to be considered in incremental terms. Following aspects have to be taken into account: Ignore sunk costs Consider opportunity costs Need to take into account all incident effect Cannibalisation

Post tax principle : All cash flows should be computed on post tax basis Consistency principle : Cash flows and discount rates used in project evaluation need to be consistent with the investor group and inflation.

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Appraisal Criteria Discounted Cash Flow methods

Traditional Methods

Modern Techniques

Payback Method

Net Present Value

Accounting Rate of Return

Internal Rate of Return

Modified Internal Rate of Return

Profitability Index

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Payback period is defined as the length of time required to recover the initial cash out lay.

(Year Prior to full recovery + Balance of initial out lay to be recovered of initial out lay at the beginning of the year in which full) / Cash inflow of the year in which full recovery takes place
Accounting rate of return (ARR) measures the profitability of investment (project) using information taken from financial statements: ARR = Average income / Average investment

ARR = Average of post tax operating profit / Average investment

Average investment = (Book Value of the investment at the beginning + Book Value of investment at the end of the life of the project or investment) / 2
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Net present value (NPV) method recognises the time value of money. It correctly admits that cash flows occurring at different time periods differ in value. Accept or reject criterion can be summarised as given below: NPV > Zero = accept NPV < Zero = reject

Internal rate of return (IRR) is the rate (i.e. discount rate) which makes the NPV of any project equal to zero. IRR is the rate of interest which equates the PV of cash inflows with the PV of cash outflows. IRR can be determined by solving the following equation:

Ct CF0 (1 r ) t
where t = 1 to n
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Modified internal rate of return (MIRR) is a distinct improvement over the IRR. Managers find IRR intuitively more appealing than the rupees of NPV because IRR is expressed on a percentage rate of return. MIRR modifies IRR. MIRR is a better indicator of relative profitability of the projects. MIRR is defined as PV of Costs = PV of terminal value cash inflow (1+r)
n-t

cash outflow / (1+r) MIRR is obtained on solving the following equation. PV of costs = TV/ (1 + MIRR)n
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Profitability index is also known as benefit cost ratio. Profitability index is the ratio of the present value of cash inflows to initial cash outlay. The discount factor based on the required rate of return is used to discount the cash inflows.

PI = Present value of cash inflows / initial cash outlay

Accept or reject criteria Accept the project if PI is greater than 1 Reject the project if PI is less than 1 If PI = 1, then the management may accept the project because the sum of the present value of cash inflows is equal to the sum of present value of cash outflows. It neither adds nor reduces the existing wealth of the company.
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Summary

You have learnt:

What is Capital Budgeting Importance of Capital Budgeting Complexities involved Capital Budgeting process Investment Evaluation Appraisal techniques Traditional and modern methods

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