CAPITAL BUDGETING

DECISIONS
What is capital budgeting?

 Capital Budgeting is the process of determining which

real investment projects should be accepted.

 Capital budgeting is investing in long-lived assets

 Shareholder wealth maximization should be kept in

mind.

 Also called Investment Appraisal

Importance of Investment
Decisions
 Involve commitment of large amount of funds

 For a long time period

 Usually not reversible  

CAPITAL BUDGETING DECISIONS

 Accept / Reject decision–  If a proposal is accepted, the

firm invests in it and if rejected the firm does not invest.
 Mutually exclusive project decision–  Mutually exclusive
projects compete with other projects in such a way that
the acceptance of one will exclude the acceptance of
the other projects.
 Capital rationing decision–  Capital rationing refers to
the situation where the firm has more acceptable
investments requiring a greater amount of finance than
that is available with the firm.
Types of Investment Decisions

Expansion of
existing
business

Investing in
new business

Replacement
of assets
Investment Evaluation Criteria

Estimation of cash flows

Estimation of the required rate of

return (the opportunity cost of
capital)

Application of a decision rule for

making the choice
Evaluation Criteria

Discounted Cash Flow (DCF) Non-discounted Cash Flow

Criteria Criteria

Net Present Value

Payback Period (PB)
(NPV)

Internal Rate of Accounting Rate of

Return (IRR) Return (ARR)

Modified IRR

Discounted
Payback Period

Profitability Index
(PI)
Net Present Value Method

 NPV = PVinflows – PVoutflows

 Or NPV = PVinflows – Initial Investment

 If NPV > 0, then accept the project; otherwise

reject the project.
 If NPV=0, we may accept, or reject.
Net Present Value Method

 C1 C2 C3 Cn 
N PV    2
 3
  n 
 C0
 (1  k ) (1  k ) (1  k ) (1  k ) 
n
Ct
N PV   (1  k )
t
 C0
t 1

C0 is the initial investment.

Calculating Net Present Value

 Assume that a new plant costs Rs 2,500 crores now

 It is expected to generate year-end cash inflows as

follows:
Years 1 2 3 4 5
CFs 900 800 700 600 500
(Rs Crore)

 The opportunity cost of the capital may be assumed

to be 10 per cent.
Solution
Evaluation of the NPV Method

 NPV is most acceptable investment rule for the

following reasons:
Considers time value
Cash flows used
Maximises Shareholder value

 Limitations:
Difficult to estimate cash flows
Discount rate difficult to determine
Internal Rate of Return Method

 IRR is the rate of return that a project generates.

 Algebraically, IRR can be determined by setting up an

NPV equation and solving for a discount rate that
makes the NPV = 0.
 Equivalently, IRR is solved by determining the rate that
equates the PV of cash inflows to the PV of cash
outflows.

 Decision Rule:
 If IRR > opportunity cost of capital (or hurdle rate),
accept the project;
 If IRR < opportunity cost of capital reject it.
Calculation of IRR

• By Trial and Error

▫ The approach is to select any discount rate to compute the net
present value (NPV). If the calculated NPV is negative, a lower
rate should be tried.
▫ On the other hand, a higher value should be tried if the NPV is
positive. This process will be repeated till the net present value
becomes zero.
▫ For interpolation:
Example
 A project costs Rs 16000 crores and is expected to generate Rs
8000 cr, Rs 7000 cr and Rs 6000 cr at the end of each year for the
next 3 years. Evaluate the project using IRR. Cost of capital is 11%.
 Using trial and error, method:
 Select arbitrarily say 20%
 PV is 15000, NPV at this rate = (-)1000
 Select a lower rate, say 16%
 PV at 16% = 15942.64
 NPV at 16% = (-)57.36
 Select a lower rate, say 15%
 PV at 15% = 16194.63
 NPV at 15% = 194.63
 The IRR must lie between 15 and 16%
 Now use interpolation formula

Evaluation of IRR Method

 IRR method has following merits:

Time value
Shareholder value

 IRR method may suffer from:

Multiple rates
Reinvestment assumption
Profitability Index
 Profitability index is the ratio of the present value of
cash inflows, at the required rate of return, to the
initial cash outflow of the investment .
 Also called BENEFIT COST RATIO

 If PI > 1, then accept the project; otherwise reject the

project
Profitability Index
 The initial cash outlay of a project is Rs 100,000 and it
can generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,
000 and Rs 20,000 in year 1 through 4.

 Assume a 10 per cent rate of discount. Find the

Profitability index or Benefit Cost Ratio.
Solution
Evaluation of PI Method

 It recognises the time value of money.

 It is consistent with the shareholder value

maximisation principle.

 It is a relative measure of a project’s profitability.

 Like NPV method, PI criterion also requires

calculation of cash flows and estimate of the
discount rate. In practice, estimation of cash flows
and discount rate pose problems.
Payback


Example
 Assume that a project requires an outlay of Rs 50,000
and yields annual cash inflow of Rs 12,500 for 7 years.
The payback period for the project is:

Rs 50,000
PB   4 years
Rs 12,500

Evaluation of Payback

 Certain virtues:
Simple and easy to implement

 Serious limitations:
Cash flows after payback ignored
Timing of Cash flow ignored
Standard payback period is subjective in nature
Inconsistent with shareholder value

Can be used with NPV rule as a first step in roughly

screening the projects
ESTIMATING CASH FLOWS
ELEMENTS OF THE CASH FLOW STREAM

 Initial Investment
 Operating Cash Inflows
 Terminal Cash Inflow
Basic principles of Capital
Budgeting

Decisions are The timing of

based on cash cash flows is
flows. crucial.

Cash flows are Cash flows are on

incremental. an after-tax basis.

Financing costs
are ignored.
Some guidelines for Cash Flows

 Non cash charges or income not to be considered.

As PAT is calculated after reducing depreciation (non cash
charge) amount, add it back to get cash flows
 Financing costs should not be considered because they
will be reflected in the cost of capital figure. If we
subtract them from cash flows, we would be double
counting capital costs.

 To ascertain a project’s incremental cash flows you have

to look at what happens to the cash flows of the firm
with the project and without the project
 Ignore sunk costs like R&D expenses

 Opportunity costs are included

A plant space could be leased out for Rs 5,00,000 a
year. Accepting the project means we will not receive
the rentals. This is an opportunity cost and it should
be charged to the project.

 Cash flows should be measured on a post-tax basis

 Investment will be required for Working Capital and will
be returned by the end of the project’s life
Illustration

 Following information is available for a project:

 Initial investment outlay is 100m i.e. 80m on Plant and
Machinery and 20m on working capital
 Project will be financed with 45m of equity capital, 5m of
preference capital, 50m of debt capital.
 Preference capital has a cost of 15%, debt has after-tax
cost of 8.4%
 For Equity Capital we have the following information:
Beta of the company and the project is 1.2; the market
risk premium is 12% and the risk free rate of return is 8%.
 Expected life of the project is 5 years
 At the end of 5 years, fixed assets will fetch a value of
30m and Working Capital will be liquidated at book value
 Project is expected to increase the revenues by 120m
per year and increase the costs by 80m per year. The
costs do not include depreciation, interest and tax
 Effective tax rate will be 30%
 Plant and Machinery will be depreciated by 25% per year
on WDV method
 Estimate the project cash flows and find out its NPV and
IRR. Should the project be accepted?
 (` IN MILLION)
0 1 2 3 4 5
A. FIXED ASSETS -80
B. NET WORKING CAPITAL -20
C. REVENUES 120.00 120.00 120.00 120.00 120.00
D. COST (OTHER THAN DEPR’N AND
INT) 80.00 80.00 80.00 80.00 80.00
E. DEPRECIATION 20.00 15.00 11.25 8.44 6.33
F. PROFIT BEFORE TAX 20.00 25.00 28.75 31.56 33.67
G. TAX 6.00 7.50 8.63 9.47 10.10
H. PROFIT AFTER TAX 14.00 17.50 20.13 22.09 23.57
I. NET SALVAGE VALUE OF FIXED
ASSETS 26.69
J. RECOVERY OF NET WORKING
CAPITAL 20.00
K. INITIAL OUTLAY -100
L. OPERATING CASH FLOW (H+E) 34.00 32.50 31.38 30.53 29.90
M. TERMINAL CASH FLOW (I+J) 46.69
N. NET CASH FLOW (K+L+M) -100 34.00 32.50 31.37 30.53 76.59
Working notes for Depreciation and Net Salvage Value in the next slide
Depreciation
Schedule  
Beginning Balance 80.00 Sale price asset 30
Depreciation 20.00 BV of asset 18.98
Ending Balance 60.00 Profit on sale 11.02
Depreciation 15.00
Tax on profit 3.31
Ending Balance 45.00
Depreciation 11.25
SP 30
Ending Balance 33.75
Depreciation 8.44 Less tax 3.31
Ending Balance 25.31 Net 26.69
Depreciation 6.33
Ending Balance 18.98
 NPV `30.20 million Accept

IRR 25.72% Accept

Cost of Equity capital .08+(1.2*0.12) =0.224 = 22.4%

Cost of capital 0.224*0.45 + 0.084*0.5 + 0.15*0.05 = 15.03%
 Sampa Video Case Calculations

  0 1 2 3 4 5
EBITD   180 360 585 840 1125
Dep   -200 -225 -250 -275 -300
EBIT   -20 135 335 565 825
tax   8 -54 -134 -226 -330
EBIAT   -12 81 201 339 495
Add back Dep   200 225 250 275 300
Capexpenditure   -300 -300 -300 -300 -300
Free Cash Flows -1500 -112 6 151 314 495

Terminal
            5135.87 value
Total CFs -1500 -112 6 151 314 5630.87
NPV at 15.12% $1,469.97
Sampa Video Calculations

  Cost Weight  

Equity 18.80% 0.75 0.141

Debt 4.08% 0.25 0.0102

    WACC 0.1512