Lesson : 5 CAPITAL BUDGETING (DeNS. Malik) Introduction ‘The management of any business organisation has to make two types of decision i.e. short-term as well as long-term. Income determination and the planning and controlling of operations primarily have a current time-period orientation, ie. short-term decisions. On the other hand, a long range planning has a long-term perspective. These long-range decisions relate to capital budgeting which implies the budgeting of expenditure on capital assets. There is a great deal of controversy among the financial analysts as to the exact meaning of capital expenditure. To some people, if the returns from expenditures extend beyond a year, it should be treated as capital expenditure. According to an other point of view, any expenditure which yields returns beyond 5 years is a capital expenditure. Whatever may be the time dimension of capital expenditure, the decision on capital expenditure has importance because it affects the profitability of the organisation for a fairly long period. Prudence exercise in capital expenditure decisions not only fulfills the short- term objective of better profitability but also caters to the long-term objective of stabilised growth. Decisions in this area are among the most difficult because (10)the future is hard to predict. Because the unknowable factors are many, it becomes imperative that they be collected, properly analysed and measured before a decision is made. Capital budgeting helps a lot in the budgeting of expenditure on capital assets or fixed assets in order to maximise the worth of the firm. Capital budgeting is applicable to decide whether : 1 Anew project should be undertaken. | Existing projects should be abandoned. 1 Certain research and development costs should be undertaken, 1 Certain existing assets should be replaced with new ones. An efficient allocation of capital is the most important function in the modern times. It involves decisions to commit the firm’s funds to the long term assets. The capital budgeting decision has a direct impact on determining how many new proposals or projects the firm should undertake. Since these projects need to be financed, the capital budgeting process also leads to the identification of the firm’s need for capital resources. It also assists in allocating capital among various proposals and projects under consideration by management. Such decisions are of considerable importance to the firm since they tend to determine its value size by influecing its growth, profitability and risk. Meaning of Capital Budgeting Capital budgeting is concerned with designing and carrying through a systematic investment programme. According to Charles I. Horngren, "capital budgeting isa long-term planning for making and financing proposed capital anyoutlays.” According to G.C. Philippatos, "capital budgeting is concerned with the allocation of the firm's scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent stream of expenditure for it.” ‘Thus, the capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in long-term activities in anticipation of an expects flow of future benefits over a series of years. Such decisions may consist addition, disposition, modification, mechanisation or replacement of any fixed asset. ‘Type of Capital Budgeting Decisions Broadly speaking, capital budgeting decisions are long-term investment decisions. They include the following : Mechanisation of a Process - A firm may intend to mechanise its existing production process by installing machine. The machine is estimated to cost Rs. 1,50,000 and expected to save operating expenses of Rs. 25,000 perannum fora period of ten years. Thus, it is an investment decision involving cost outlay for Rs. 1,50,000 and an annual saving of Rs. 25,000 for 10 years ‘The firm would be interested in analysing whether it is worth to install the machine. Expansion Decisions - Every company wants to expand its existing business. In order to increase the scale of production and sale, the company may think of acquiring new machinery, addition of building, merger or takeover of another business etc. This all would require additional investment which be evaluated in terms of future expected earnings. 2)Replacement Decisions - A company may contemplate to replace an existing machine with a latest model. The use of new and latest model of machinery may possibly bring down operating costs and increase the production. Such replacement decision will be evaluated in terms of savings in operating costs and increase in annual profits. Buy or Lease Decisions - Capital budgeting is also helpful in making buying or lease decisions. The fixed assets can be purchased or arranged on lease arrangements. Such decisions create a great different in the demand of capital, Henee, a comparative study can be made with reference to future benefits from these two mutually exclusive alternatives Choice of Equipment - A company needs an equipment (plant or machinery) to perform certain process. Now a choice can be made between semi-automatic machine and fully automatic machine. Capital budgeting process helps a lot in such selections. Product and Process Innovation - The research and development department of a company may suggest that a new product should be manufactured and/or a new process should be introduced. The intrduction of new product and/ora new process will involve heavy capital expenditure and will eara profits also in the future. So, inflows (i.e. future operating income) will be very useful and the ultimate decision will depend upon the profitability of the product and/or process. House-Keeping Projects - House-keeping projects are such projects which exert indirect impact on the production. They are finanaced either on account of legal necessity or to boost up the morale and motivation level of the employees, say : (i) Health and Safety Projects. (113)Gi) Service Department Projects Gi) Welfare Projects (iv) Education, Training and Development Projects (¥) Status Projects (vi) Research and Development Projects. The decisions relating to financing of above-mentioned long-term projects are not made on the basis of profitability. They are approved orrejected in terms of their urgency, need, compulsion and desirability. Hence, no profitability analysis is made for them. The capital budgeting decisions exclude decisions regarding current assets. The management and investment problems of current assets are discussed under the head working capital management ‘The capital budgeting decisions are concerned with only those type of decision areas which have long-term implications for the firm in terms of current expenditure and future benefits. Current expenditure constitutes the outflow of cash and is represented by cost. The future benefits are measured in terms of annual cash inflows, Hence, in capital budgeting, it is the flow of cash- outflow and inflow which is important, not the earnings determined in accordance with the accrual concept of accounting. Importance of Capital Budgeting Capital budgeting decisions are among the most crucial and critical ‘business decisions, The selection of the most profitable assortment of capital investment can be considered a key function of management, On the other hand, it is the most important single area of decision-making for the financial executives. Actions taken by management in this area affect the operations of the firm for many years to come. The need and importance of capital budgeting «taycan be numerated as follows :~ Heavy Investment - Almost all the capital expenditure projects involved heavy investment of funds. These funds are accumulated by the firm from various external and internal sources at substantial cost of capital. So their proper planning becomes invitable. Permanent Commitment of Funds - The funds involved in capital expenditures are not only large but more or less permanently blocked also ‘Therefore, these are long-term investment decisions. The longer the time, the greater the risk is involved. Hence, a careful planning is essential Long-term impact on profitability - The capital expenditure decisions may have a great impact on the profitability of the firm for avery long time. If properly planned, they can increase not only the size, scale and volume of seales but firm growth potentiality also. Complicacies of Investment Decisions - The long-term investment decisions aremore complicated in nature. They entail more risk and uncertainly. Further, the acquistions of capital assets is a continuous process. So the management must be gitted ample prophetic skill to peep into future. Worth Maximisation of Shareholders - Capital budgeting decisions are very important as their impact on the well-being and economic health of the enterprise is far reaching. The main aim of this process is to avoid over~ investment and under-investment in fixed assets. By selecting the most profitable capital project, the management can maximize the worth of equity shareholder's investment. ‘Thus, the significance of capital budgeting decisions becomes quite obvious. The other facts for its significance can be summarised as follows :~ (iis)(2) Management loses its flexibility and liquidity of funds in making investment decisions, so it must consider each proposal very throughly. (b) Asset expansion is fundamentally related to future sales and assets aquistion decisions are based on capital budgeting. (c) The funds available for a firm are always in scarcity so they must be properly planned. Modern industrial organisations are characterised by large scale production and intensive mechanisation. This all requires balanced and properly planned allocation of scarce captial resources to the most profitable investment proposals. Hence, the procss of capital budgeting has become very significant now a days. Therefore, the financial executives plan capital budgets often years in advance Process of Capital Budgeting Capital budgeting decisions of a finn have a pervasive influence on the entire spectrum of entrepreneurial activities. Hence, they require a complex combination and knowledge of various disciplines for their effective administration, such as, Economics, Finance, Mathematics, Economic Forecasting, projection Techniques and Techniques of Finacial Engineering and Control. In order to combine all these elements, a finance manager must keep in mind the three dimensions of a capital budgeting programme : Policy, Plan and Programme. These three P’s constitute a sound capital budgeting programme. However, the important steps involved in the capital budgeting process are : (i) project generation; (ii) project evaluation, (iii) project selection; and (iv) project execution. These steps are necessary, but more may be added to make the process more effective. Joel Dean a famous economist has described the specific elements in an orderly investment programme which are as follows : (16)Creative Search for Profitable Opportunities - The first stage in the capital expenditure programme should be the conception of a profit making idea. It may be rightly called the origination of investment proposals. ‘The proposals may come from a rank and file worker of any department or from any line executive. To facilitate the origination of such ideas a periodic review and comparision of earnings, costs, procedures and product line should be made by the management on a continuous basis. Long-range Capital Plans- When a specific proposal is made to management, its consistency with the long-range plans of the company must be verified. It requires the determination of over-all capital budgeting policies before hand based upon the projections of short and long-rum developments. Short-range Capital Budget- Once the timelines and priority of a proposal have been established, it should be listed on the one-year capital budget as an indication of its approval. Measurement of Project Worth- This stage involves the tentative acceptance of the proposal with other competitive projects, within the selection criteria of the company. Small projects under a certain rupee amount could be approved by the departmental head. Larger projects should be ranked according to their profitability, Any one or more tests of profitability may be used for it. For project evaluation, different techniques may be used, such as, payback period, accounting rate of return and discounted cashflow techniques. Screening and Selection - This stage involves the comparision of the proposal with other projects according to criteria of the firm. This is done either by financial manager or by a capital expenditure planning committee. Such criteria should encompass the supply and cost of capital and theexpected returns from alternative investment opportunities. Once the proposal passes this stage, it is authorised for outlays Establishing Priorities - Then comes the stage of establishing the priorities. When the accepted projects are put in priority, it facilities their «yyacquisition or construction, avoids costly delays and serious cost overruns. This stage is also called the ranking of projects. It helps in capital rationing and better utilisation of capital. Final Approval - Once the financial manager has reviewed the projects, he will recommended a detailed programme, both of capital expenditures and of sources of capital to meet them, to the top management. Possibly, the financial manager will present several alternative capital-expenditure budgets to the top management, it will finally approve the capital budget for the firm. Forms and Procedures - This isa continuous phase that involve the preparation of report for every other phase of the capital expenditure programme of the company. Retirement and Disposal - This phase marks the end of the cycle in the life of a project. It involves more than the recovery of the original cost plus and adjustment for replacement programmes. The old assets should be sold and realised sale price should be used for replacement financing. Evaluation - An important step in the process of capital budgeting is an evaluation of the programme after its implementation, The evaluation process answers such questions, say, was the investment greater than anticipated? Were the expected net cash inflows actually realised? Was the proper test of evaluating the profitability of project applied? Management can improve its capital budgeting programme for the future from past experience, Such evaluation has also the advantage of forcing departmental heads to be more realistic in their approach and careful in actual execution of the projects. Investment Evaluation Criteria Because of the utmost importance of the capital budgeting decisions, a cig)sound appraisal method should be adopted to measure the economic worth of each investment project. In most business firms, there are more than one investment proposals for a capital project than the firm is capable and willing to finance. Here the problem of ranking them in order of preference arises. Hence, the management has to select the most profitable project or to take up the most profitable project first. As we know that the ultimate goal of financial management is the worth maximisation of the firm, hence, in order to achieve this objective, the management must select those projects which deserve first priority in terms of their profitability. For evaulating the comparative profitability of capital projects many methods have been evolved. Bach method has its own merits and demertis. However, the method going to be used should, at least, possess the following characteristics : (a) Itshould provide a means of distinguishing between acceptable and unacceptable projects. (b) Itshould provide clear cut ranking of the projects in order of the profitability or desirability. (©) Itshould also solve the problem of choosing among alternative projects. (@) It should be a criterion which is applicable to any conceivable investment projects. (e) It should emphasize upon early and bigger cash benefits in comparision to distant and smaller benefits (£) In the last but not the least, the method should be suitable according to the nature and size of capital project to be evaluated. (is)Method of Evaluating Investment Proposals The various methods which are commonly used for evaluating the relative worth of investment proposals are as follwos : I. Non-discounted cashflow Techniques (NDCF) (A) Payback Period Method (PB) (B) Accounting Rate of Return Method (ARR) I. Discounted Cashflow ‘Techniques (DCF) (A) Net Present Value Method (NPV) (B) Present Value Index Method or Benefit-Cost Ratio Method (BCR) or Profitability Index Method (PI) (C) Internal Rate of Return Method (IRR) It is important fo note here that different methods may give different conclusions and different firms may use different methods. Which method is appropriate for a particular purpose of the firm will depend upon the circumstances. A large sized firm may use more than one method to evaluate each of its investment projects, while a small firm may apply only one technique which involves minimum funds and time. Moreover, these techniques assist the management only in taking objectively sound decisions. They do not provide the answer. The management has still to exercise its common sense, intuition and judgement in making final decisions. 1. Non-discounted cashflow Techniques (NDCF) (A) Payback Period Method (PB) This method is also known as pay-off, pay-out or recoupment period (120)method, It gives the number of years in which the total investment in a particular capital project pays back itself. This method is based on the principle that every capital expenditure pays itself back over a number of years. It means that it generates income regularly during its estimated economic life. When the total cash inflows from investment equals the total outlay, that period is the payback period of that project. While comparing between two or more projects, the project with lesser payback period will be acceptable. Calculation or Payback Period - The payback period can be calculated in the follwoing manner :~ (a) Inthe case of even cash inflows = Ifthe pattern of annual cash inflow is of conventional character or they are in the form of annuity, the computation of payback period is very simple, as follow : Payback Period= Initia Investment Annual Cash Inflow For example, if an investment of Rs. 10,000 in amachine is expected to produce annual cash inflow of Rs. 2,500 for 6 years, then Payback Period= B8-10.000_ _ 4 yr. Rs. 2,500 (b) Im the case of uneven cash inflows - When a project’s cash flows are not equal, but vary from year fo year, i.e., they are of non-conventional nature, the calculation of payback period takes @ cumulative form of annual cash inflows, In such a situation, payback period is calculated by the process of cumulating cash inflows till the time when cumulative cash inflows become equal to the original investment outlay: ‘The following example wil illustrate the point. Ilustration : A project requires an investment of Rs. 10,000. Its estimated a2annual cash inflows have been given below : Year Annual Cash Inflows Cumulative Cash inflows (ACF) (Rs) (CCF) (Rs.) 1 2,500 2,500 2 3,500 6,000 3 4,000 10,000 4 5,000 15,000 5 3,000 18,000 Thus, Rs. 10,000 is recovered fully in 3rd year, hence, payback period is 3 yrs. IMlustration : A project requires an ivestment of Rs. 10,000 and its estimated annual cash inflows areas follows : ‘Year (ACF) (Rs,) (CCF) (Rs.) 1 2,000 2,000 2 3,000 5,000 3 4,000 9,000 4 2,000 11,000 5 3,000 14,000 Here, payback period will be = 3 years + 10000-9000 — 3.5 yrs, 2000 Accept-Reject Criterion - The paback period can be used as a decision- criterion to accept or reject investment proposals. If only one independent project is to be evaluated its actual payable period should be compared with a (122)pre-determined (standard) payback, ic., the payback set up by the management in terms of maximum period during which the initial investment must be recovered, Ifthe actual payback period is less than the standard payback period, the project would be accepted, if not, it would be rejected, Alternatively, the payback can be used as a ranking method also. When mutually exclusive projects are under consideration they may be ranked according to the length of the payback period. ‘Thus, the project having the shortest payback may be assigned rank one, followed in that order so that project with the longest payback would beranked the lowest. Merits of Payback Method - The payback period method for choosing among alternative projects is very popular among corporate managers. The chief merits of this method are as follows : (i) Iris easy to understand and simple to compute and communicate to others. Its quick computation makes it favourite among executive who prefer snap answers. (ii) It gives importance to the speedy recovery of investinent in capital assets. So, it is @ useful technique in industries where technical developments are in full swing necessitating the replacements at an early date. Gi) Itisan adequate measure for firms with very profitable internal investment opportunities, whose sources of funds are limited by intemal low availability and external high costs (iv) Iti usefull for approximating the value of risky investments whose rate of capital wastage (economic depreciation and obsolescene rate) is hard to predict. Since the payback period method weights only ealry return heavily and ignores distant returns it contains a built-in hedge against the possibility of limited economic life. (2a)) When the payback period is set at large number of years and income streams are uniform each year, the payback criterion is a good approximation to the reciprocal of the internal rate of discount. Demerits of Payback Approach - The payback approach, however, suffers from serious limitations also. Its major shortcomings are as follows : @ (ii) Gi) (iv) w (wi) (wii) It treats each asset individually in isolation with the other assets. While assets in actual practice can not be treated in isolation. ‘The method is delicate and rigid. A slight change in the division of labour and cost of maintenance will affect the earning and as such it may also affect the payback period. It overplays the importance of liquidity as a goal of the capital expenditure decisions. While no firm can ignore its liquidity of safeguarding liquidity levels. The overlooking of profitability and overstressing the liquidity of funds can in no way be justified. It ignores capital wastage and economic life by restricting consideration to the projects” gross earnings. This approach fails to take fully into account the time factor in the value of money; by measuring how quickly the firm recovers its initial investment, it only implicity considers the timing of cash flows It overlooks the cost of capital which is a main factor in sound capital budgeting decisions. Another major weakness of this approach is that it completely ignores all cash inflows arising after the payback preiod. This could be very misleading in capital budgeting decisions. It may be possible that two projects have similar payback period but their post-payback profitability differs significantly. The following (24)examples will illustrate the point. Project A Project B @s.) Rs.) Cost of Project 15,000 15,000 Year Annual Cash Inflows 1 5,000 4,000 2 6,000 5,000 3 4,000 6,000 4 0 6,000 5 0 4,000 6 0 3,000 Payback period B yrs. 3 yrs. ‘Thus, project B is certainly advantageous as its post-payback profitability is more in spite of similar payback period of 3 years. Look at this example also, Project x Project y (Rs.) (Rs.) ‘Total Investment 10,000 10,000 Year Annual Cash Inflows 1 5,000 3,000 2 5,000 4,000 3 2,000 3,000 4 1,000 4,000 5 500 2,000 Payback period 2 yrs, 3 yrs. (125)Thus, the payback period for project x is 2 years and for project y it is 3 years. Obviously, project x will be preferable on the basis of payback period. However, if we look beyond the payback period, we see that project x returns only Rs. 3,500 while project y returns Rs. 6,000. Thus, project y should be preferred. (viii) Another weakness of this method is that it does not measure correctly even the cash flows expected to be received within the paybak period as it does nof differentiate between projects in terms of the timing or magnitude of cashflows. It considers only payback period asa whole while the pattern of cashflows may affect the value of firm considerably. The following example will illustrate the point. Project O Project P (Rs.) (Rs) ‘Total Cost of the Project 10,000 10,000 Year Annual Cash Inflows 1 2,000 5,000 2 3,000 3,000 3 5,000 2,000 Payback period 3 yrs. 3 yrs. Above example shows that both the projects OandPhave the same cash outlays in the zero time period, the same total cash inflows of Rs. 10,000; the same payback period of 3 years. But intuitively the project P would be preferable as it returns cash earlier than first project. Hence, the internal composition of cash inflows is also very important which should not be ignored. But inspite of the above-mentioned weaknesses, the payback method can (126)‘Thus, this method considers whole earnings over the entire economic life of an asset. The project with highest return will be acceptable. (ii) Earnings Per Unit of Money Invested - As per this method, we find out the total net earings (after taxes) and then divide it by the total investment. ‘This gives us the average rate of return per unit of amount invested in the project, as follows : Earnings Per Unit of Investment = Total Earnings (after taxes) _ ‘Total Outlay of the Project Higher the earnings per rupee, the project deserves to be selected. ( percentage of average return on average amount of investment is calculated. Average Return on Average Investment - Under this method the To calculate the average investment, the outlay of the project is divided by two. ARR is calculated as follows : Averae Rate of Return = Avetage Profits (after taxes) _ x 199 Average Investment ‘The average profits after taxes - Average profits afer taxes are found by taking the sum of the expected after-tax profits of the project during its life and dividing the sum by the number of years of its life. In the case of an annuity, the average after-tax profits are equal to any year’s profits. ‘The average investments - Any of the following three formulae may be applied to calculate average investment : (a) Initial Investment 2 (b) Initial Investment + Scrap V_alue 2 (128)be gainfully employed under certain circumstances. In a politically unstable economy, a quick return of investment is a must. Shortest payback period is the only answer to such investments, In case of foreign investments, the firms experiencing sever shortage of liquidity, for assessing short-run and medium term capital projects, the payback period is the only good technique for assessing their profitability. In fact, the payback period is a measure of liquidity of investinent rather than their profitability. Thus, the payback period should more appropriately be treated as a constraint to be satisfied than as a profitability measure to be maximised, (B) Accounting Rate of Return Method (ARR) This method is also known as Financial Statement Method, Return on Investment Method or Unadjusted Rate of Return Method. It is based on operating eamings computed in the Profit & Loss Account, hence, no separate calculations are necessary to compute annual cash inflows, Finding the average rate of return is a quite popular approach for evaluating proposed capital expenditures. Its appeal stems from the fact that the average rate of return is, typically calculated from accounting data (i.e. profits after taxes). According to this method, capital projects are ranked in order of their rate of earnings. Projects which yield the highest earnings are selected and others are ruled out, This return on investment can be expressed in several ways as below : (i) Average Rate of Return on Total Investment - This method established the relationship between the average annual profits to total outlay of capital project, as follows : Average Rafe of Return = Avenige Profits (aftertaxes) _— 19 ‘Total Outlay of the Project (127)(c) Recovered Capital + scrap Value 2 ‘The averaging process outlined above assumes that the firm is using straight line method of depreciation. Merits of ARR Method ‘The approach has the following merits : (1) Like payback method it is also simple and easy to understand. (2) Itis based on the accounting concept of operating income and accounting profit figures are used in analysing the profitability of alternative capital projects, hence no separate calculations are required. (3) It takes into consideration the total earnings from the project during its entire economic life. (4) This approach gives due weight to the profitability of the project. (5) Ininvestments with extremely long lives, the simple rate of return will be fairly close to the true rate of returns. It is often used by financial analysts to measure current performance of a firm. Demerits of ARR Method a) @) This method has a following demerits : One apparent disadvantage of this approach is this that its results by different methods are inconsistent Itis simply an averaging technique which does not take into account the impact of various external factors on over all profits of the firm. (129)(3) The method ignores the time factor of future cash streams which is crucial in business decisions as the amount of interest and discount is substantially affected by it. (4) This method does not determine the fair rate of return on investments. It is left at the discreation of the management. Hence, the use of this arbitrary rate of return may cause serious distortions in the selection of profitable projects Discounted Cash Flow Techniques (DCE) Although, return on investment has been considered a satisfactory technique of capital budgeting in accounting circles for long. Next came the payback approach which is based on cash flow technique. But the lacuna of the above methods is that they do not take the time factor of the income into account. The earlier receipts are certainly more important than the income to be received in later years. A bird in hand is worth than the two in the bush. is, aptly applicable to the management of capital. Accordingly, a rupee in the hand has more worth than a rupee to be received five year later, because the use of money has a cost (interest) just as the use of building or an automobile may have a cost (rent), The DCF techniques take care of these both aspects, i.e, time value of money and cost of capital. As a capital project yields returns spread over a number of years, correct assessment of its profitability can be made only ifthe annual returas of the future years are brought to their present value after applying a discounting rate (i.e. cost of capital or interest rate). Similarly, if the investment is to be made over a number of years, the cash outflows have to be brought down to their present value. Thus these techniques recognise time-adjusted rate of return as well as the cost of capital. The aggregate of future cash flows discounted at a given rate of cost of capital is called the present value of those cash inflows. (130)The calculation of present value consists of the following steps : (a) Estimating future cash inflows from the project. (b) Selecting a discount rate which is commonly known as opportunity cost or cost of capital also. (©) Discounting those cash inflows with the discount factors or present value factors picked up from the present value fables according to the rate of cost of capital. There are three methods to judge the profitability of different proposals on the basis of discounted cashflow technique. These are as follows (A) Net Present Value Method (NPV) The calculation of net present value (NPV) of projectis one of the most commonly used capital budgeting techniques. This method is also known as Excess Present Value of Net Gain Method. The definition of net present value can be expressed as follows NPV = Total Present value of Future Cash inflows - Initial Investment, The total present value of future cash inflows is calculated with the help of the following formula: p- § 3 (+i) asi)” (iti) where, P= Present Value of future cash inflows S= Future Value of cash inflows for n years. i= Rate of interest n= number of years (1,2,3,...- 31)Based on the above equation, the present value factors tables have been prepared. In these tables, the present value of Re. | at different rates of interest have been given. The second type of present value tables provide us the cumulative amount of an annuity of Re. 1 for a given rate of interest. If the anmual cash inflows are of even nature, the compound present value factor should be used and ifit is of uneven nature, the simple present value factor should be applied. If the NPV is in positive the project should be accepted. If it is in negative, it should be rejected. In mutually exclusive projects, the project with higher NPY should be preferred. The following example will explain the procedure. Mlustration : Suppose a project costs Rs. 5,000. lis estimated economic life is 2 years. The firm’s cost of capital is estimated to be 10%. ‘The estimated cash inflows from the project are Rs. 2,800 p.a. Calculate its NPV. Solution : As the firm’s cash inflows are of conventional pattern (i.e. even amount), the compound value factor can be used for calculating thier NPV. Rs. Total Present Value = Rs. 2,800 x 1.813 5,272 Less Cost of the Project 5,000 ‘Net Present Value 272 Merits of NPV Method (1) The NPV method takes into consideration the time factor of earnings as well as cost of capital (2) Itis very easy to calculate, simple to understand and useful for simply “accept” or “reject” type of projects. (3) Itcan be applied to both types of cash inflows pattems -even and uneven cash inflows. (132)«@ 6) © ‘The NPV method is generally preferred by economists. If one wishes to maximise profits, the use of NPV always finds the correct decisions. It takes care of entire earnings. ‘The concept of the present value of series of cash flows is an important feature in the analysis of different investment potentialities. The net present worth technique analyses the merit of relative capital investments in a nice and exact manner. Demerits of NPV Method a @) QB) @ It involves a good amount of calculations. Hence, it is a complicated method. ‘The use of this method requires the knowledge of cost of capital. Ifit is unknown, the method can not be used. Tt leads to confusing and contradictory answers for the ranking of complicated projects. Keeping in view the substantial difference in time-span and involved risk in various capital projects, the use of one common. rate of cost of capital for discounting cash inflows is not desirable. B. Profitability Index Method This method is also known as Benefit-Cost Ratio. One major demerit of NPV method is that it can not be applied to compare those mutually exclusive projects which differ in costs substantially. To compare and evaluate such projects, the profitability index should be calculated. The profitability index (133)is the relationship that exists between the present values of net cash inflows and cost ontlays of the projects. Itcan be calculated in two manners : (i) Gross BCR = Total Present Values of Cash Inflows intial Investment (ii) Net BCR = NetPresent Values of Cash Inflows Intial Investment (where NPV of cash inflows in Total Present value of cash inflows minus initial investment) ‘These both can be expressed in percentage also. Their expression in percentage helps in comparing the relative profitability of capital projects. ‘The higher the profitability index, the more desirable is the investment. (C) Internal Rate of Return (IRR) Method ‘The third DCF technique is the Internal Rate of Return Method which is commonly known as Time-adjusted Rate of Return method also. Like the present value method, the IRR method also considers the time value of money by discounting the annual cash inflows. But present vahte method can be applied only when the discount rate (i.e. cost of capital) is known to us, On the other hand, in IRR technique we find out that rate of return which will equate the present value of future cash streams to the present cash outlay of the project. Itis usually the rate of return that the project earns. "It may be defined as the discount rate (r) which equates the aggregate present value of the net cash inflows with the aggregate present value of cash outflows of a project”. In other words, "IRR is the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project”. Thus, it is that rate which gives the projects NPV of zero. (134)Assuming conventional cash inflows, mathematically, the IRR is represented by that rate, , such that, ACF +: dey? Here : C= Cost of the Project ACE = Annual Cash Inflows S = Sorap Value of the Project W = Working capital involved and recovered + = __ estimated rate of interest Fortunately tabular values of present values of future earnings are readily available. So, usually these tables are used for this purpose. Computation of IRR (a) Inthe case of even cash inflows - Ifthe cash inflows are uniform each year then the computation of IRR involves the following two steps : () Calculate Present Values Factor by applying the following formula : PV. Factor = Initial Investment Annual Cash Inflow Gi) Locate the factor calculated in (i) in the compount Present Value Table on the line corresponding the life span of investment in years, The interest rate of the line of that factor will be the required IRR. It is to be noted that the present value of cash inflows at this computed (135)rate must be equal to the present value of cash outflows. Illustration : A project costs Rs. 10,000 and is expected to generate cash- inflows of Rs. 1,750 annually for 10 years. Its salvage value is nil. Calculate its IRR Solution : PV. Factor= Investment + Annual Cash Inflow = 10,000 + 1,750= 5.714 Locating this factor in the compound present value table on the line corresponding to the 10th year. we find that this factor is most close to the factor in the table at 12%. Hence, the approximate rate of return is 12%. ‘As the factor given in the table is less than the factor computed above, actual rate will be a bit less than 12%. It can, however, be ascertained by applying the interpolation technique as follows : Where, 1 = lewermteofreum © = higher mate ofretun ¥__ = Present valte fatorat lowsrrite ofretam =10%+ (12% 10%) vi = Present veluefectorat higher ate of vena 46.145-5.652 Y= Present vl factor for which IRR is 1 be = 10+ LH = 11.04% interposied Aherative Formula: vev, x (12% 10%) 6145-5650 = 12%-0.26%4= 1.4% (b) In the case of uneven cash inflows - Here the computation of (136)IRR involves a trial and error procedure. To find the rate of interest that equates the cash inflows with the cash outflows, we start with an assumed rated and calculate the NPV. This NPV may be more than zero, less than zero or just equal to zero. If more than zero, a higher rate of interest should be tried to calculate NPV. Conversely, when the NPV is less than zero, a lower rate would be used. The procedure will go on till we find the rate which gives zero forthe NPV. Under IRR approach, the calculated IRR (i.e. actual rate) is compared with the required rate of return, also known as the cut-off rate or hurdle rate (.e. the cost of capital or interest rate on which the funds will be available). If the actual IRR is higher than the cut-off rate, the project is accepted, if lower itis rejected. Jf the [RR and cut-off are just equal, the firm will be indifferent as to whether to accept or reject the project. IMustration : A project requires an initial outlay of Rs. 32,400. Its estimated economic life is 3 years. The cash streams generated by it are expected to be as follows : Years Estimated ACF (Bs.) 1 16,000 2 14,000 3 12,000 Computed its IRR. If the cost of capital to the firm is 12% Advise the management whether the project should be accepted or rejected. Solution : To compute IRR, we have to follow the trial and error procedure with various rate of interest. The following table presents the calculations : (137)Table showing calculations of IRR for unequal cash inflows Total Present Values at different rate of interest Year ACF DF atl4% PV. DP atl6% PY — DFat 15% PV (Rs.) (Bs.) (Rs) Rs.) 1 16,000 0.877 14,032 0.862 13,795 0.870 13,920 2 14,000 0.769 10766 0.743 10,402 0.756 10,584 3 12,000 0.675 8100 0.641 1.692 0.658 1.896. 32,898 31,886 32,400 Less Cost of Project 32.400 32.400, 32,400, +498 “S14 0 Since NPV is zero at 15% discount rate, it is its IRR. If the cost of capital is 12%, the project must be accepted as its internal retum is 15% while cost of funds is only 12%. The project will contribute 3% to the value of the firm. Merit of Discount Cashflow Techniques (1) This method takes into account the entire economic life ofan investment and income therefrom. It gives the true rate of return offered by anew project. (2) It gives due weight to time factor of financing. It is more suitable for long-term planning. In the words of Charles Horngren. "Because the discounted cashflow method explicity and routinely weights the time value of money, it is the best method to use for long-range decisions. (3) It permits direct comparison of the projected returns on investments with the cost of borrowing money which is not possible in othermethods. (138)@ (5) It makes allowance for difference in the time at which investments generate their income. This approach by recognising the time factor makes sufficient provision for handling uncertainly and risk. It offers a good measure of relative profitability of capital expenditures by reducing the earnings to their present value, The concept of "discounted cash flow" has evoked considerable interest in regular commercial enterprises as well as among financial institutions. The World Bank and other financial institutions use the DCF techniques extensively while measuring the success of new development ventures in order to arrive at sound capital expenditure decisions. Demerits and Criticism of Discounted Cashflow Techniques: a @) @) (4) (3) ‘This method is criticised on the following grounds : It involves a good amount of calculations. Hence, it is a difficult and complicated one. But this criticism has no force, particularly with the advent of very sophisticated and speedy calculating and other aiding machanisations. It is very difficult to forecast the economic life of any investment exactly. The selection of cash-inflow is based on sales forecasts which is in itself an interminable element. The selection of an appropriate rate of interest is also difficult. The DCF approaches do not consider the impact of an investment on accounting profits. The investment may generate a low, or even a negative (139)net cash inflow in early years, but produce high cash inflows in subsequent years. In such cases, the accounting profits of a firm are adversely affected. But despite these defects, this approach affords an opportunity for making valid comparisons between several long-term competing capital projects. J Batty has very rightly remarked - "Allowing for these apparent defects there is still a very sirong case for using the present value concept. Values and costs should be shown at their true worth, only then can the management accountant say that he is truely representing facts which represent economic realities and not simply a list of unrelated figures. The process of discounting brings them all into present day terms allowing valid comparisons to be made." Limitations of Capital Budgeting a (2) Q) ‘Various data such as investment, return, estimated economic life of the asset, to a great extent, are only estimates. Even with all the "knowledgeable factors" collected and duly analysed, there are many unknown factors which can not be foreseen and which can not be avoided or controlled. Financial planning for liquidity and profitability is fraught with many of the same risks that apply to other phases of business activity. The risks of faulty projections of financial requirements are particularly great in the planning of capital expenditures for long-term fixed-asset expansion. Capital Budgeting process does not take into consideration various non- figure aspects of the project while they play an important role in successful and profitable implementation of them. Hence, non- profitability considerations should also be considered by the management (140)while takinga final decision. (4) _ Itis also not correct to assume that mathematically exact techniques, always produce highly accurate results. Standard Questions : (1) Whats capital Budgeting? Explain the relevance of capital budgeting decisions from the point of view of an industrial concern, (2) Examine various methods of ranking investment proposals in respect to their relative merits & demerits. (3) "The investment alternative yielding the highest discounted rate of return is the most acceptable”. Will this always be true? (4) What do you understand by the term “return on investment"? Do you consider it a yard stick for measuring efficiency? Discuss the various purposes for which this yardstick could be used. Suggested Reading : (1) Khan Jain: Financial Management-Text and Problems (2) LM.Pandey Financial Management (3) PrasanaChandra : Financial Management-Theory & Practice (4) John J, Hempton ; Financial Decisions Making JJJ aay