1. Techniques of Capital Budgeting

2. 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.

3. 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.

4. 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.

5. 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.

6. 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

7. 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

8. 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

9. 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.

10. 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

11. 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.

12. 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.

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

14. Investment Criteria

15. 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

16. 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?

17. 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

18. 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

19. 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

20. 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.

21. 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.

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

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

30. 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.

31. 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.

32. 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

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

34. 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

35. 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%

36. IRR Decision Rule

37. 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?)

38. 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: