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Management Accounting Financial Management a

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Management Accounting Financial Management a

Subject: Financial Management

    Chapter no. 11: Capital Budgeting

    Chapter No. 11 Capital Budgeting

    Choosing capital projects Conventional and Discounted Cash Flow techniques Basis for project cash flows and capital expenditure on projects

    A project owner wants return from the project higher than the cost of debt (borrowing) and the cost of equity (his

    own contribution). Please refer to the chapters on “time value of money” as well as “cost of capital”. He also wants

    the recovery of capital (total of equity and debt) within a period that he is comfortable with. This period is known as

    “pay back period”. Thus from the project owner’s point of view he has definite ideas on: ? The period for capital recovery and

    ? The rate of return from the project

    The finance manager or the consultant as the case may be proceeds to prepare the project cash flows based on certain

    assumptions that are central to the working of the project. Some of the assumptions are:

    ? The cost of the project and means of financing them

    ? The cost of all inputs like materials, power etc. and the selling prices of outputs

    ? The weighted average cost of capital

    ? The rates of depreciation on the fixed assets

    ? The requirement of working capital for the project

    ? The installed capacity (in terms of 100% production) of the plant

    ? The capacity utilisation in terms of % of the installed capacity

    ? The rate of corporate taxes that the business will be paying

    ? The repayment or redemption period for various loans, debentures or bonds

    ? The number of days working for the project

    ? The number of shifts on which the production will be done

    ? The cost of imported materials, components if any and the foreign exchange fluctuation if any etc.

    Note: As usual, this list is not exhaustive. These are some of the better-known assumptions for the project

    working. The success of the project lies in the assumptions being as close to reality as possible.

Methods of financial evaluation of the project:

    The methods take into account the following considerations from the project owners’ and project lenders’ points of

    view:

    1. Whether the project is earning a return that is higher then its cost of capital?

    2. Whether the project’s earnings recover the capital investment in the desired period called “pay back period”?

    3. Whether the objective of the project in creating assets is achieved through “wealth maximisation” – by adding

    further wealth?

    Broad classification of the methods of financial evaluation of projects Conventional methods these methods do not consider the timing of the future cash flows. Let us see the following

    example to understand this.

    Punjab Technical University, Online Virtual Campus 1

Subject: Financial Management

    Chapter no. 11: Capital Budgeting

    Example no. 1 We invest in a project Rs. 300 lacs. The projected cash flows at the end of three years is as under:

    Year 1 = Rs. 150 lacs

    Year 2 = Rs. 100 lacs

    Year 3 = Rs. 75 lacs

    Total = Rs. 325 lacs. In the conventional method the fact that cash flows occur at different periods is ignored. This is perhaps due to the fact that the importance of time value of money was not appreciated in the past.

    Conventional methods are:

    1Payback period This is defined as the period in which the original capital investment is recovered. In case there is more than one

    project with the same amount of investment to choose from, based on payback period method, the project having less

    payback period will be chosen.

    Example no. 2 Let us repeat the figures as per Example no. 1.

    2Cash flow at T= (Rs. 300 lacs) 0 Cash flow at T = Rs. 150 lacs 1Cash flow at T = Rs. 100 lacs 2Cash flow at T = Rs. 75 lacs 3At the end of two years, the capital recovery is Rs. 250 lacs. Remaining amount to the recovered = Rs. 50 lacs. We will have to find out in how many months, this stands recovered in the third year. This is based on the assumption that 3the cash flows occur uniformly in the project.

    (50/75) x 12 months = 8 months

    Thus payback period for this project is = 2 years + 8 months = 2.67 years

    Without this calculation, on the first reading of the figures of cash flows it can be seen that the pay back period lies between the second and the third year of the project.

    Merits:

    ? Easy to calculate

    ? Gives an idea of capital recovery

    Demerits:

    1. Does not consider the time value of money or timing of the cash flows. For example if Rs. 100 lacs were to be the

    cash flows at year 1 and year 3, both are considered to be equal. We know after going through the chapter on

    “Time value of money” that due to inflation these two are not equal to each other.

    2. Reliability as an evaluation method is very limited as the cash flows after the pay back period are ignored.

1The second method Accounting Rate of Return is omitted here as it is practically not used even by those who are not initiated into “finance”

    2 Figures within brackets indicate that there is cash out flow rather than inflow. This is because of the investment into fixed assets at the beginning of the project.

    3 In fact this assumption goes for all the methods of evaluation, both conventional and discounting cash flow methods.

    Punjab Technical University, Online Virtual Campus 2

Chapter no. 11: Capital Budgeting

    Note: The shortcoming in this method can be overcome by discounting the future cash flows at a

    suitable rate of discount and then determine the payback period. This is called “adjusted” or

    “discounted” payback method. As we apply the concept of “time value of money” the adjusted or

    discounted payback method more belongs the DCF techniques as discussed below. Subject: Financial Management

Modern methods or “Discounted Cash flow Techniques” are:

    1. Net Present Value

    2. Internal Rate of Return

    3. Profitability Index

    Net Present value method

    Example no. 3

    Consider the following 3 alternative projects. Assumptions are also given below:

    ? The initial investment for all the projects is Rs.500 lacs;

    ? The period of working is 5 years from the year Zero, i.e., the time of investment;

    ? Although the scale of operations for all the projects is the same, the projects have different future earnings or

    returns; and

    ? The rate of discount is 15% p.a., which is the rate of return expected from the project by the promoters. The st23future earning (at the end of the1 year) is discounted by (1.15), (1.15) for the second year, (1.15) for the third

    year and so on. The present value equivalent of the future earning or return is also known as the discounted

    value.

    (Rupees in Lacs)

     Project 1 Project 2 Project 3

Year Future Disc. Future Future Disc. Value Disc. Value No. Earnings Value Earnings Earnings

     1 100 150 130.44 175 86.96 152.18 2 120 150 113.42 150 90.73 113.42 3 200 150 180 98.63 131.5 118.35 4 250 200 114.36 225 142.95 128.66 5 250 200 250 99.44 124.3 124.3 Total 556.29 576.44 636.91

    Punjab Technical University, Online Virtual Campus 3

Subject: Financial Management

    Chapter no. 11: Capital Budgeting

Note: As Project 3 has the highest present value it would be selected. Net present value is equal to present value (-)

    original investment value, i.e., Rs.500 lacs. Accordingly, the net present values for the three projects would be:

    Project 1 76.44 lacs

    Project 2 56.29 lacs

    Project 3 136.91 lacs

    On the basis of net present value, project 3 would get selected.

Merits:

    1. Takes into consideration the project cash flows for the entire economic life of the project.

    2. Applies time value of money timing of the cash flows is the basis of evaluation. 3. Net present value truly represents the addition to the wealth of the shareholders.

    4. Reliable as a method of evaluation of alternative projects.

Demerits:

    41. It is not an easy exercise to estimate the discounting rate that is linked to “hurdle rate”

    2. In real life situations, alternative investment projects with the same amount of capital investment are non-

    existent practically

Internal Rate of Return method (IRR)

    Internal Rate of Return for an investment proposal is the discount rate that equates the present value of the expected

    net cash flows (CFs) with the initial cash outflow. If the initial cash outflow or cost occurs at time “zero”, it is

    represented by that rate, IRR such that

    Initial cash outflow (ICO) = CF1 CF2 CF3 CF4 CFn

     ------------- + -------------- + --------------- + -------------- + ………. + ---------------

    1234n (1+IRR) (1+ IRR) (1+IRR) (1+IRR) (1+IRR)

4 Hurdle rate = the minimum rate of return that should be had from any investment, especially in a project

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Chapter no. 11: Capital Budgeting

    This means that the Net present value in the case of IRR = “zero” or Present value of project cash flows = original

    investment at the beginning of the project.

    Subject: Financial Management

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