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**Techniques of Capital Budgeting**

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Introduction A truck manufacturer is considering investment in a new plant. An airliner is planning to buy a fleet of jet aircrafts A commercial bank is thinking of an ambitious computerization programme A pharmaceutical firm is evaluating a major R&D programme. All these are the examples of situations involving capital expenditure decision. Essentially each of them represents a scheme for investing resources which can be analyzed and appraised reasonably independently.

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**Understanding Capital Expenditure**

Also referred to as Capital Investment or Capital Project or just Project. The basic characteristic of Capital Expenditure is : Typically involves a current outlay (or current and future outlays) of funds In the expectation of a stream of benefits extending far into the future. However, from accounting point of view, Capital Expenditure is the one shown as asset on the Balance Sheet. This assets, except in the case of non-depreciable asset like land, is depreciated over its life.

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**Understanding Capital Expenditure**

In accounting, the classification of an expenditure as capital expenditure or revenue expenditure is governed by: Certain conventions Provisions of law Management’s desire to enhance or depress reported profits. Outlays on R&D, major advertising campaign, reconditioning of P&M may be treated as revenue expenditure for accounting purposes, even though they are expected to generate a stream of benefits in future. Therefore, such expenditures qualify for being capital expenditures as per our definition.

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**Understanding Capital Expenditure**

Capital expenditures have three distinctive features: They have long-term consequences They often involve substantial outlays. They may be difficult or expensive to reverse. How a firm allocates its capital (the capital budgeting decision) reflects its strategy and business. That’s why the process of capital budgeting is also referred to as strategic asset allocation. Techniques of Capital Budgeting are helpful in identifying valuable investment opportunities.

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**What is Capital Budgeting?**

Capital budgeting refers to the process of deciding how to allocate the firm’s scarce capital resources (land, labor, and capital) to its various investment alternatives The process of planning for purchases of long-term assets. Nature of capital budgeting: Evaluating and selecting long-term investments in: tangible assets intangible assets Designed to carry out an organization’s strategy

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**Managing the Firm’s Resources**

The Manager Competition, Life cycle effects, International events, etc. Resource Decisions Cash Management Inventory Management Working Capital Management Investment in Human Capital Long-term Assets Accounts Receivable Investment Decisions Operating Decisions Recruitment, Selection Training, Productivity Performance Appraisal Compensation Unions & Labor Relations Cash Inflows & Earnings Human Resources Decisions Share- holder Value Economics of Information Database Management Data Modeling IS Planning & Development Information Decisions Risk-adjusted Discount Rate Debt vs. Equity Financing Financial Leverage Dividend Pay-out Cost of Capital Financial Markets Financing Decisions

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**General Steps in Capital Budgeting**

Translate strategy to capital needs Generate alternatives Project financial results Perform financial analysis Assess risks Consider non-financial factors Select projects Post-approval review

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**Capital Budgeting Process**

Identification of potential investment opportunities. (Planning Body) Estimate the criteria of target. Monitor external environment regularly to scout investment opportunities. Formulate a well defined corporate strategy based on thorough SWOT analysis Share corporate strategy and perspectives with persons who are involved in the process of capital budgeting. Motivate employees to make suggestions.

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**Capital Budgeting Process (contd..)**

Assembling of proposed investments. Investment proposal identified by the production department and other departments are submitted in a standardized capital investment proposal form. Routed through several persons before it arrives to Capital Budgeting Committee. Investment proposals are usually classified into various categories for facilitating decision making: Replacement investment Expansion investments New product investments Obligatory and welfare investments

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**Capital Budgeting Process (contd..)**

Decision making. A system of rupee gateways usually characterizes capital investment decision making. Executives at various levels are vested with the power to okay investment proposals up-to certain limits. Investment requiring higher outlays need the approval of the BoD. Preparation of Capital Budget and appropriations The purpose is to check in order to ensure that the fund position of the firm is satisfactory at the time of implementation. Provides an opportunity to review the project at the time of implementation.

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**Capital Budgeting Process (contd..)**

Implementation Translating an investment proposal into a concrete proposal is complex, time-consuming, and risk-fraught task. For expeditious implementation at a reasonable cost, the following are helpful: Adequate formulation of projects – necessary homework and preliminary studies. Use of the Principle of Responsibility Accounting Use of Network Techniques – CPM and PERT Performance review. Post-Completion Audit- provides feedback. Comparing actual performance with budgeted ones.

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**Project Classification**

Mandatory Investments Replacement Projects Expansion Projects Diversification Projects R&D Projects Miscellaneous: Recreational Facilities, Executive Aircrafts, Landscaping etc.

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Investment Criteria

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Overview All of these techniques attempt to compare the costs and benefits of a project The over-riding rule of capital budgeting is to accept all projects for which the cost is less than, or equal to, the benefit: Accept if: Cost £ Benefit Reject if: Cost > Benefit

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The Example We will use the following example to demonstrate the techniques of capital budgeting Assume that your company is investigating a new labor-saving machine that will cost $10,000. The machine is expected to provide cost savings each year as shown in the following timeline: 1 2 3 4 5 2000 2500 3000 3500 4000 -10,000 If your required return is 12%, should this machine be purchased?

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**1. The Payback Period Method**

The payback period measures the time that it takes to recoup the cost of the investment. If the cash flows are an annuity, then we can simply divide the cost by the annual cash flow to determine the payback period Otherwise, as in the example, we subtract the cash flows from the cost until the remainder is zero The shorter the payback period, the better Generally, firms will have some maximum allowable payback period against which all investments are compared

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**The Payback Period: An Example**

For our example project, we will subtract the cash flows from the initial outlay until the entire cost is recovered: Since it will take years (= 2500/3500) to recover the last 2,500, the payback period must be years

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**Cumulative Net Cash Flow**

Computation Year Cash Flow Cumulative Net Cash Flow -10,000 1 2,000 -8,000 2 2,500 -5,500 3 3,000 -2,500 4 3,500 1,000 Hence, Payback Period lies between year 3 and 4

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**Evaluation of Payback Period Method**

Simple; both in concept and application. Has only few hidden assumptions. Rough and Ready method for dealing with risk. Favors projects which generate substantial cash inflows in earlier years and discriminates against project which bring substantial cash inflows in later years but not in earlier years. If risk tends to increase with futurity – the payback criterion may be helpful in weeding out the risky projects. Since it emphasizes earlier cash inflows, it may be a sensible criterion when the firm is pressed with the problems of liquidity.

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**Problems with the Payback Period**

It ignores the time value of money It ignores all cash flows beyond the payback period It is a measure of project’s capital recovery, not profitability Though it measures a project’s liquidity, it doesn’t indicate the liquidity position of the firm as a whole, which is more important. The cutoff payback period is subjective.

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Example Year Cash flow of A Cash flow of B (100,000) 1 50,000 20,000 2 30,000 3 4 10,000 40,000 5 6 - 60,000 Payback Criterion prefers A with payback period of 3 years over B with payback period of 4 years. But B has very substantial cash inflows in the years 5 and 6

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**2. The Discounted Payback Period**

The discounted payback period is exactly the same as the regular payback period, except that we use the present values of the cash flows in the calculation Since our required return (WACC) is 12%, the timeline with the PVs looks like this: 1 2 3 4 5 -10,000 The discounted payback period is 4.82 years Note that the discounted payback period is always longer than the regular payback period

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**Cumulative net cash flow**

Computations Year Cash Flow Discounting 12 % Present Value Cumulative net cash flow -10,000 1.000 1 2,000 0.893 1,786 -8214 2 2,500 0.797 1992.5 3 3,000 0.712 2136 4 3,500 0.636 2226 5 4,000 0.567 2268 408.5 Payback Period = 4.1 years

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**Problems with Discounted Payback**

The discounted payback period solves the time value problem, but it still ignores the cash flows beyond the payback period Therefore, you may reject projects that have large cash flows in the outlying years that make it very profitable In other words, any measure of payback can lead to a focus on short-run profits at the expense of larger long-term profits

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**3. Accounting Rate of Return (ARR)**

Also called Average Rate of Return Also called Average Accounting Return (AAR) There are many different definitions of the ARR. However, in one form or other, ARR is always defined as Measure of accounting profit can be PAT or N Measure of accounting value is Book Value

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Example Suppose we are deciding whether or not to open a store in a new shopping mall. The required investment in improvements is $ 500,000. The store would have a five-year life because everything reverts to the mall owners after that time. The required investment would be 100 % depreciated over five years. So the depreciation would be $ 500,000 / 5 = $ 100,000 per year. The tax rate is 25 %. Table ahead shows the projected revenues and expenses

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**Computation Year 1 Year 2 Year 3 Year 4 Year 5 Revenue 433,333 450,000**

266,667 200,000 133,000 Expenses 150,000 100,000 EBDT 233,333 Depreciation EBT 133,333 25 % 33,333 NI 50,000

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Solution The project is acceptable if the ARR exceeds the target ARR

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**Evaluation of ARR method**

It is simple to calculate It is based on accounting information, which is readily available and familiar to businessmen. While it considers benefits over the entire life of the project, it can be used even with the limited data.

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**Problems with ARR method**

ARR is not the rate of return in any meaningful economic sense. It is just the ratio of two accounting numbers, and is not comparable to the returns actually offered. It is based upon accounting profit, not cash flow. It does not take into account the time value of money. The ARR measure is internally inconsistent. While the numerator represents profit belonging to equity and preference stockholders, its denominator represents fixed investments, which is rarely, if ever, equal to the contributions of equity and preference stockholders.

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The Net Present Value The net present value (NPV) is the difference between the present value of the cash flows (the benefit) and the cost of the investment (IO): In other words, this is the increase in wealth that the shareholders will receive if the project is accepted All projects with NPV greater than or equal to zero should be accepted

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**Present value of future cash flows**

NPV Decision Rule Present value of future cash flows = Profitability Index Investment Cost

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The NPV: An Example NPV is calculated by subtracting the initial outlay (cost) from the present value of the cash flows Note that the discount rate is the WACC (12% in this example) Since the NPV is positive, the project is acceptable Note that a positive NPV also means that the IRR is greater than the WACC

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**The Internal Rate of Return**

The internal rate of return (IRR) is the discount rate that equates the present value of the cash flows and the cost of the investment Usually, we cannot calculate the IRR directly, instead we must use a trial and error process For our example, the IRR is found by solving the following: In this case, the solution is 13.45%

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IRR Decision Rule

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Problems with the IRR The IRR is a popular technique primarily because it is a percentage which is easily compared to the WACC However, it suffers from a couple of flaws: The calculation of the IRR implicitly assumes that the cash flows are reinvested at the IRR. This may not always be realistic. Percentages can be misleading (would you rather earn 100% on a $100 investment, or 10% on a $10,000 investment?)

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**The Profitability Index**

The profitability index is the same as the NPV, except that we divide the PVCF by the initial outlay: Accept all projects with PI greater than or equal to 1.00 For the example, the PI is:

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© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter Nine.

© 2003 The McGraw-Hill Companies, Inc. All rights reserved. Net Present Value and Other Investment Criteria Chapter Nine.

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