CAPITAL BUDGETING METHODS

INTRODUCTION

Capital budgeting is one of most important issues confronting a corporate finance

manager. Other important aspects like financing, liquidity management, and dividend

decisions are also of much significance, but how the allocation of capital is done

assumes significance. Capital budgeting reflects the long-term vision, direction and

business of the firm. The firms spend considerable time in making such decisions and

involve top hierarchy from every functional area. Capital budgeting assumes so much

significance due to its following features:

They involve relatively long time period between initial cash out flow and

expected future cash inflows resulting into long-term consequences;

Substantial amount of funds are normally involved in such decisions;

Involve a relatively high degree of risk;

Are nearly irreversible in nature and can be reversed only after incurring much

financial losses.

Thus, it can be deduced that capital budgeting decisions are of paramount importance to

the firm as its success and growth heavily depends on them. The rationale behind these

decisions is to bring in the efficiency in the firm’s operations. A firm must continuously

keep on replacing its worn out and obsolete plants and machinery and acquire new assts

for current and future operations. These help a firm in any of two ways, i.e., either by

expanding revenues or by reducing costs. But such decisions also come with some

inbuilt problems. To name a few, they are:

Benefits from investment are received in future period and therefore, involves

an element of risk due to uncertainties;

Costs incurred and benefits received occur in different time periods, therefore,

rendering comparison a difficult and complex job;

More often than not, it is very difficult to calculate in quantitative terms all the

costs and benefits associated to a specific investment decision.

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“Capital budgeting is process of selecting best long-term investment projects by

evaluating the present alternatives in the light of the share holder’s wealth

maximization objective”

CAPITAL BUDGETING PROCESS

Capital budgeting is a complex process comprising five distinct phases

a. Identification of potential investment opportunities or proposal generation;

b. Evaluation of available alternative proposals in the light of the objective of

shareholders’ wealth maximization;

c. Selection of best project proposal from amongst the available alternatives or

decision making;

d. Implementation of the selected project proposal; and

e. Performance Review or follow-up.

Firms are basically confronted with three types of capital budgeting decisions:

(i) Accept-reject decisions: In any capital budgeting project this is the most

fundamental decision to make. As a normally accepted principle, all those

projects which yield a rate of return greater than required rate of return are

accepted and rest stand rejected. This principle allows selection of all

independent projects.

(ii) Mutually Exclusive Project Decisions: Such projects are those which compete

with other projects in such a way that selection of one of them renders

selection of other projects impossible. Hence, amongst from all projects one

giving highest return is selected.

(iii) Capital Rationing Decisions: If the firm were having unlimited funds, all the

independent projects yielding a rate of return higher than required rate of

return would have been selected, but in reality such situation seldom prevails.

The firm’s have a fixed capital budget creating a competition among number

of alternative proposals. The firm allocates funds to these proposals in such a

way as to maximize long-term return. This process is known as capital

rationing.

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PROJECT CLASSIFICATION

Capital budgeting projects are classified in various categories depending on their

complexity and magnitude. While there is no fixed or hard bound system of

classification but normally following categories are found present in classification used

by various firms:

(a) Mandatory Investments: Such projects are required to be implemented to meet

statutory requirements. The focus of management in such projects is finding

out the most cost-effective way to meet statutory requirement. These projects

may range from buying a fire-fighting kit to opening a primary health centre

and so on.

(b) Replacement Projects: The firms’ continuously keep on replacing its worm

out or obsolete plants and machineries to increase efficiency. Such projects

either help by the way expanding revenues or by reducing costs. The focus of

firm while evaluating such proposals is quite straight forwards but at times

analysis may be a detailed one.

(c) Expansion Projects: The name itself suggests that such projects are either for

increasing the production capacity or widening the reach in the market place.

Since such projects involve substantial amount of risk, and cash outlay they

require meticulous analysis involving top management in the process.

(d) Diversification Projects: The proposals may be about producing a product or

service new to the firm or at times new to the world. These may also be about

entering into a totally new and unknown market. Such projects besides

substantial risk and cash out lay, require great managerial efforts also. They

also represent the future strategy and business of the firm. All these

circumstances force a thread-bare analysis of the proposal with significant

involvement of top management and Board of Directors.

(e) Research and Development Projects: The firms need to invest in research and

development (R&D) projects if they want to keep ahead of competitions and

survive in long-term. The focus of the firm while evaluating such projects is

based much on gut feeling or managerial judgment than on quantitative data.

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Evaluation Techniques

Traditional Techniques or Non-Discounted Cash Flow

Techniques

Time-Adjusted Techniques or Discounted Cash Flow

Techniques

Payback Period

Accounting Rate of Return

Net Present Value

Benefit Cost Ratio

Internal Rate of Return

(f) Miscellaneous Projects: All other projects except those described above find

their place in this category. Examples may include buying car to carry CEO or

a bungalow for COO or furnishing and decoration of visitors’ room. These

proposals are selected based on preferences as usual; of top management more

than on anything else.

EVALUATION TECHNIQUES

Numerous techniques for judging the worth whileness of a project have been

developed. These can be broadly grouped in two categories namely (i) Traditional or

Non-Discounted Cash Flow Techniques and (ii) Time-Adjusted or Discounted Cash

Flow techniques. These have been shown below:

Evaluation Techniques

Non Discounted cash Flow Techniques

These techniques of project evaluation do not take into account the time of money. In

these one rupee today is treated equivalent to one rupee even after ‘x’ time period. Two

prominent techniques are being discussed below:

(a) Payback Period (PB) Method: Payback period is the length of time required to

recover the initial cash outlay on a project or to say in other words, how much time will

be required by the cash benefits to recover the original investment. It is simplest

quantitative method of evaluating a capital budgeting project and, therefore, widely

accepted one.

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Computation: There are two methods for calculating payback period depending upon

the nature of future stream of cash inflows first, when future cash inflow is in the nature

of annuity through out the life of the project, then following formula may be applied:

Initial cost of Investment

PB =

Constant Annual Cash Inflow

Illustration: Suppose an investment of Rs 45,000.00 in a project is expected to

produce a cash inflow of Rs. 9,000.00 for next 8 years, then

Rs. 45,000.00

PB = = 5 years

Rs 9,000.00

Second, when future cash inflows from the project are not uniform i.e., they

result in a mixed stream of cash inflows then payback period is calculated by

cumulating the cash inflows till the time they become equal to original investment.

Illustration: Suppose initial cash outlay on purchase of machine A or B is Rs.

50,000.00. The future cash inflows given for a period of 5 years from Machine A are

Rs 15,000.00, Rs 15,000.00, Rs. 20,000.00, Rs. 10,000.00 and Rs. 25,000.00 whereas

from Machine B are Rs. 25,000.00, Rs. 25000.00, Rs. 10,000.00, Rs. 10,000.00 and Rs.

Rs. 10,000.00. The payback period will be calculated as below:

Years Machine A Machine A

Cumulative

Machine B Machine B

Cumulative

1. 15,000.00 15,000.00 25,000.00 25,000.00

2. 15,000.00 30,000.00 25,000.00 50,000.00

3. 20,000.00 50,000.00 10,000.00 60,000.00

4. 15,000.00 65,000.00 10,000.00 70,000.00

5. 20,000.00 85,000.00 10,000.00 80,000.00

Here, payback period for Machine A is 3 years whereas for Machine B is 2 years.

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Accept – Reject Criterion: The selection of projects based on payback period method

can be done in two ways:

(i) Management of the firm may have set a guideline for maximum period in which

initial investment may be recovered. The projects may be selected by making a

comparison between projects’ payback period and maximum duration set by

management for recovery of initial investment.

(ii) Payback period can also be utilized to rank the mutually exclusive projects

according to length of period and one with shortest payback period may be

selected.

Merits:

(i) It is easy to calculate and simple to understand as it does not involve

abstract concepts and tedious calculations.

(ii) It is a smooth and readymade method for dealing with risk as it favours

projects with shorter payback periods.

(iii) It assumes much significance when firm is hard pressed regarding liquidity

issues.

Demerits:

(i) It does not take into consideration time-value of money.

(ii) It completely ignores all cash inflows after the pay-back period.

(iii) It can be turned as a measure of capital recovery and not profitability.

(b) Accounting Rate of Return (ARR) method: This method is also known as

average rate of return method. The method is based on accounting information rather

than cash flows.

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Computation: ARR may be calculated by using following formula:

Profit after Tax

ARR =

Book value of the Investment

OR

Average Annual Profits after Taxes

ARR = × 100

Average investment over the life of the project

The numerator in this ratio may determined by adding up the after tax profits

over the life of the investment and denominator as average book value of fixed assets

committed to the project.

Illustration: Consider the given data on a project

Year Book value of investment Profit after tax

1. 1,00,000 22,000

2. 80,000 26,000

3. 80,000, 20,000

4. 70,000 28,000

5. 60,000 24,000

The (22000 + 26000 + 20000 + 28000 + 24000) /5

ARR = × 100

(100000 + 90000 + 80000 + 70000 + 60000) /15

Accept-reject criterion: The selection of projects based on ARR method can be done

in two ways:

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(i) Management of the firm may have set a guideline for minimum required

rate of return for any project to be accepted. Thus, by comparing actual

ARR with this standard a project may be accepted or rejected.

(ii) ARR can also be utilized as ranking tool for mutually exclusive projects.

Obviously, one having highest ARR will be ranked and others succeeding it

in same order.

Merit:

(i) It considers benefits flowing in through out the life of the project.

(ii) Information required for computation of ARR is readily available in the

books of accounts.

(iii) It is easy to calculate and understand.

Demerits:

(i) The computation is based on book profits and not on actual cash flows.

(ii) It does not make any adjustment for time value of money and treats two

projects with equal ARRs and varying cash inflows as similar.

(iii) It does not differentiate between the size of investment required for each

projects.

Discounted Cash Flow Techniques

These techniques are also known as time-adjusted techniques of project

evaluation, as they take into account time value of money. These methods apply a

certain discount rate to the future cash inflows. This discount rate is applied to take care

of the effect of cost of capital. These techniques also take into consideration all the

costs and benefits accruing throughout the life of the project. The discussion on these

techniques is followed below:

(a) Net Present Value (NPV): This technique recognizes the value of one rupee today

is not equal to the value of one rupee tomorrow. This means that the value of

streams of cash flows at different periods of time differs and can be compared only

when their present value is calculated.

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Computation: The total present value is summation of present value of all the future

cash inflows resulting throughout the life of the project. Where as net present value is

summation of all cash inflows which are treated as positive cash flows and cash out

flows which are treated as negative cash flows. Thus, the formula for NPV can be put

as

NPV= ∑t=1

n C t(1+r )t

− Co

Notations used are

NPV = Net Present Value

Σ = Summation symbol

Ct = Cash flow at the end of year t

n = life of project

r = discount rate

Co = Initial Investment

t = time

Illustration:

Consider a project having following cash flow streams:

Year Cash Flow

0 -1,00,000

1 20,000

2 30,000

3 40,000

4 50,000

5 30,000

The cost of capital, r, for the firm is per cent. The net present value of the proposal is:

1,00,000 (20,000) (30,000) (40,000) (50,000)

NPV = - + + + +

(1.12)0 (1.12)1 (1.12)2 (1.12)3 (1.12)4

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(30,000)

+

(1.12)5

= - 1,00,000 + 17,860 + 23,910 + 28,480 + 31,800 + 17,010

= 19,060

The NPV represents the net benefit over and above the compensation for time and risk.

Decision Rule:

(i) Accept the project proposal if NPV is positive.

(ii) Reject the project proposal it NPV is negative.

(iii) If NPV is equal to zero, an indifferent approach may be adopted.

Important Note: NPV can also be calculated by applying varying discount rates in

context of time. The risk increases/ decreases with respect to time, differential discount

rates can be applied.

Merits:

(i) It has additive property, i.e., NPV of a number/bundle of projects is sum of

NPV of individual projects.

(ii) It explicitly recognizes the time value of money.

(iii) It takes into account total benefits and costs arising throughout the life of the

project.

(iv) It considers differential discount rates also, if so required by the nature of

the project.

Demerits:

(i) As compared to payback period method and ARR, it is bit complex and

difficult to understand.

(ii) It is an absolute measure and therefore does not factor in the scale of

investment.

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(iii) It also does not consider the life of project and has a bias towards projects

having longer life.

(b) Benefit Cost (B/C) Ratio: This technique is also known as Profitability Index (PI)

method. It is much similar to NPV approach. The basic difference lies in the fact

that while NPV measures the difference between the present values of cash

outflows and inflows, the Benefit cost ratio measures the present values of returns

per rupee invested.

Computation: Two methods can be adopted to define the relationship between benefits

and costs:

Present value of Benefits (PVB)

Benefit-cost Ratio (BCR) =

Initial Investment (I)

OR

Present value of Benefits (PV) – Initial Investment (I)

Net Benefit – Cost Ratio (NBCR) =

Initial Investment (I)

PVB – I PVB I

= = -

I I I

NBCR = BCR – 1

Illustration:

Assume evaluating a project, for which the cost of capital for the firm is 12 percent.

Initial Investment 1,00,000

Benefits

Year 1 20,000

Year 2 30,000

Year 3 40,000

Year 4 50,000

Year 5 30,000

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(20,000) (30,000) (40,000) (50,000) (30,000)

+ + + +

(1.12) (1.12)2 (1.12)3 (1.12)4 (1.12)5

BCR =

1,00,000

17,860 + 23,910 + 28,480 + 31,800 + 17,010

=

1,00,000

1,19,060

= = 1.19

1,00,000

NBCR = BCR – 1 = 1.19 – 1 = 0.19

Decision Rule:

BCR NBCR Decision

> 1 > 0 Accept

= 1 + 0 Indifferent

< 1 < 0 Reject

Merits:

(i) It makes adjustment for all elements of capital budgeting like time value of

money and totality of benefits etc.

(ii) It measures the net present value per rupee of outlay, it can be used in

disseminating large and small investments.

Demerits:

(i) It does not have any additive effect like NPV.

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(ii) It more complicated and involves mole calculations a compared to other

methods discussed above.

(c) Internal Rate Return (IRR) method: It is yet another time adjusted technique

applied for evaluation of capital investment proposals. Like the net present value

method, it also takes into account the time-value of money by applying a proper

discount rate to cash flows. Put differently IRR of a project is the discount rate

which makes NPV equal to zero.

Important Note: In case of NPV, the discount rate is predetermined required rate of

return, usually cost of capital. The determinates of this rate or external to the proposal

under consideration. Whereas in IRR the rate depends entirely on the initial cash outlay

and stream of future cash inflows of the project under consideration.

Thus, IRR can be defined as the discount rate (r), which equates the present value of

stream of future cash inflows with that of initial cash outflow or initial investment.

Computation: In calculating NPV it is assumed that the discount rate, usually cost of

capital, is given, while calculating IRR, we put NPV equal to zero and determine the

discount rate that meets this condition, thus

NPV= ∑t=1

n C t(1+r )t

− Co = 0

Therefore,

Co=∑t=1

n C t(1+r )t

Or Initial Investment =∑

t=1

n C t(1+r )t

Notations:

Co = Initial Investment / Investment

Σ = Summation

Ct = Cash flow at the end of year t

r = Internal Rate of Return (IRR)

n = life of the project

t = time

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Illustration: Let us take an example

Year Cash flow

0 (1,00,000)

1 30,000

2 30,000

3 40,000

4 45,000

Note: Figures in brackets represent negative cash flows:

Now, the value of IRR is that meets flowing equation

30,000 30,000 40,000 45,000

1,00,000 = + + +

(1 + r)1 (1 + r)2 (1 + r)3 (1 + r)4

The computation of ‘r’ involves a process of trial and error. We will have to try

different values of ‘r’ till we arrive at a value that equates right hand side to 1,00,000.

Now guess estimation can tell you that value should fall some where between 15 and

16 percent.

Step 1

So let us do the computation initially for 15 percent:

30,000 30,000 40,000 45,000

+ + + = 1,00,802

(1.15) (1.15)2 (1.15)3 (1.15)4

Step 2

Now for 16 per cent

30,000 30,000 40,000 45,000

+ + + = 98,641

(1.16) (1.16)2 (1.16)3 (1.16)4

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Step 3

Take the total of absolute values obtained in step 1 and Step 2:

802 + 1,359 = 2,161

Step 4

Compute the ratio of net present value of smaller discount rate, found in step 1

to sum obtained in step 3:

802

= 0.37

2,161

Step 5

Add the number obtained in step 4 to the smaller discount rate:

15 + 0.37 = 15.37%

This method of calculation leads to very close approximation to real internal

rate of return.

Decision Rule:

If IRR > Cost of Capital Accept

If IRR < Cost of Capital Reject

If IRR = Cost of Capital Indifferent

Merits:

(i) It takes into consideration timer value of money and cash flows through out

the life of project.

(ii) It does not use the concept of required rate of return of the cost of capital,

but itself provides a rate of return indicative of profitability of project

proposal.

Demerits:

(i) It involves tedious calculations and is a bit complicated method for common

people.

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(ii) It assumes that intermediate cash inflows are being reinvested at the internal

rate of return.

We plan on purchasing a new assembly machine for $ 25,000.. It will cost $ 2,000 to have the new machine installed and we expect a $ 1,000 net increase in working capital. By making the investment, we will reduce our annual operating costs by $ 7,000 and we expect to save $ 500 a year in maintenance. The new machine will require $ 750 each year for technical support. We will depreciate the machine over 5 years under the straight-line method of depreciation with an expected salvage value of $ 5,000. The effective tax rate is 35%.

Annual Savings in Operating Costs $ 7,000

Annual Savings in Maintenance 500

Annual Costs for Technical Support ( 750)

Annual Depreciation ( 4,000) *

Revenues $ 2,750

Taxes @ 35% ( 962)

Net Project Income 1,788

Add Back Depreciation (non cash item) 4,000

Relevant Project Cash Flow $ 5,788

 * $ 25,000 - $ 5,000 / 5 years = $ 4,000

 

We will receive $ 5,788 of cash flow each year by investing in this new assembly machine. Since we have a salvage value, we have a terminal cash flow associated with this project.

Soln:

Year Cash Flow x P.V. Factor = P.V. Cash Flow Total to Date

1 $ 5,788 .893 $ 5,169 $ 5,169

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2 5,788 .797 4,613 9,782

3 5,788 .712 4,121 13,903

4 5,788 .636 3,681 17,584

5 5,788 .567 3,282 20,866

5 3,250 .567 1,843 22,709

 

Under the Discounted Payback Period, we would never receive a payback on our project; i.e. the total to date present cash flows never reached $ 24,100 (net investment). If we had relied on the regular payback calculation, we would falsely assume that this project does payback in the fourth year.

SUMMURY

* Capital budgeting decisions relate to long-term commitment of funds into assets

which provide future streams of benefits over a period of time.

* Capital budgeting process may be divided in following phases: (i) identification of

potential investment proposals, (ii) Evaluation of available alternative proposals; (iii)

selection of best project proposal, (iv) Implementation, and (v) Performance Review.

* Capital budgeting projects can be grouped in following categories: (i) Mandatory

investments, (ii) Replacement projects; (iii) Expansion projects; (iv)Diversification

projects; (v) R & D projects; and (vi) Miscellaneous projects.

* A wide range of techniques are applied to judge the worth whileness of a project.

These techniques may be grouped in two categories; (i) Non-Discounted Cash Flow

Techniques and (ii) Discounted Cash flow Techniques.

* In non-discounted cash flow techniques, two most often applied methods are payback

period method and accounting rate of return.

* Discounted cash flow techniques applied for evaluation are Net present value method,

Benefit-cost Ratio or Profitability Index method, Internal rate of Return Method.

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