What is Capital Budgeting? | Financial Management

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  • Last Updated on 20 June, 2022

Table of Contents

  1. Terminology and Concept Summary
  2. Frequently Asked Questions
  3. Illustrations

financial management; Investment Decision under Capital Budgeting; Capital Budgeting; DCF Method; ARR; IRR; Cash Flow; NPV

1. Terminology and Concept Summary

1. Capital Budgeting Decisions: Capital budgeting decision refers to the decision in respect of purchase or sale of fixed assets and long term investment.

Capital Budgeting Decisions

2. Capital Budgeting: Capital budgeting refers to application of appropriate capital budgeting technique (one or more) to evaluate any capital budgeting proposal and take capital budgeting decision.

3. Importance of Capital Budgeting Decisions:

    • Involvement of Substantial Expenditure
    • Long Term Effect/Growth
    • Involvement of High Risk
    • Irreversibility
    • Complex Decisions

4. Capital Budgeting Techniques:

Capital Budgeting Techniques

5. Book Profit VS Cash Flow:

Book Profit: It is also known as accounting profit.

Cash Flow: It is focused on cash inflow and outflow and ignore all non-cash activities

Proforma Book Profit and Cash Flow After Tax

Particulars INR
Sales XXX
Less: Variable Cost (Always Cash) (XXX)
Contribution XXX
Less: Cash Fixed Cost (XXX)
Less: Depreciation (Non-Cash Item) (XXX)
Profit Before Tax (Accounting or Book Profit) XXX
Less: Tax @ 50% (XXX)
Profit After Tax (Accounting or Book Profit) XXX
Add: Depreciation (Non-Cash Item) (XXX)
Cash Flow After Tax (CFAT)/Cash Receipts After Tax XXX

Cash Flow After Tax (CFAT):

CFAT = PAT + Depreciation
CFAT = Cash Receipt Before Tax (1 – t) + Depreciation × t
CFAT = Cash Receipt Before Tax (1 – t) + Tax Shield on Dep.
CFAT = Cash Receipt Before Tax – Tax on PBT

 6. Cash Flow & Discounted Cash Flow (DCF):

Cash Flow: Cash flow without considering time value of money.

Discounted Cash Flow: Cash flow after considering time value of money.

Discounted Cash Flow (Formulae):

Discounted Cash Flow

Sum of Discounted Cash Flow (In Case of Equal Inflow Formula):

Σ Discounted Cash Flow = Uniform Cash Flow × PVIFA or Sum of DF

Note:

    • ARR Technique is based on Accounting/Book Profit
    • Payback Period is based on Cash Flow (Non-Discounted)
    • Discounted Payback, NPV, PI and IRR Techniques are based on Discounted Cash Flow
    • MIRR technique if based on Future/Compounded Cash Flow
    • Discounted Cash Flow is also known as Present Value of Cash Flow

7. Accounting/Average Rate of Return (ARR): ARR is the rate of return in terms of average book profit on investment. It can be calculated by using one of the following three methods:

Formula 1: ARR (Total Investment Basis) = Average Rate of Return  × 100

Formula 2: ARR (Average Investment Basis) =Average Rate of Return  × 100

Formula 3: ARR (Annual Basis): Average Rate of Return

Step 1: Calculate Annual Rate of Return =

Step 2: Calculate Average Rate of Return of Annual ARR in Step 1

Note:

Average Investment = ½ × (Initial Investment + Salvage) + Additional Working Capital (If Any)

Or

Average Investment = (½ × Depreciable Investment) + Salvage + Additional Working Capital

8. Payback Period (Traditional) It is refers to the period within which entire amount of investment is expected to be recovered in form of Cash.

Situation 1:   Uniform Cash Receipts:

Payback Period

Situation 2:   Unequal Cash Receipts:

Step 1: Calculate Cumulative Cash Inflow

Step 2: Calculate Payback Period

9. Discounted Payback Period: It is refers to the period within which entire amount of investment is expected to be recovered in form of Discounted Cash.

Step 1: Calculate Cumulative Discounted Cash Inflow

Step 2: Calculate Discounted Payback Period

10. Net Present Value (NPV): The net present value of a project is the amount, in current value of amount, the investment earns after paying cost of capital in each period.

NPV = PV of Inflow – PV of Outflow/Initial Investment     Or

NPV = (PI – 1) × PV of Outflow/Initial Investment

11. Profitability Index (PI)/Desirability Factor (DF)/Present Value Index Method:

PI = PV of Inflow ÷ PV of Outflow/Initial investment Or

Profitability Index

Note: PI technique is useful:

    • In case of Capital Rationing with indivisible projects
    • In case of equal NPV under mutually exclusive projects

12. Internal Rate of Return (IRR): Internal rate of return refers to the actual rate of return generated by the project. Internal rate of return for an investment proposal is the discount rate that equates the present value of the expected cash inflows with the initial cash outflow.

Internal Rate of Return

Situation 1:   One Point Inflow & Outflow:

Internal Rate of Return

Situation 2:   Multiple Point Inflow (Unequal Cash) & Outflow:

Step 1:         Calculate one positive and one negative NPV by using random discount rate

Internal Rate of return

Where,

L          =  Lower Discount Rate

H         =  Higher Discount Rate

NPVL    =  NPV at Lower Discount Rate

NPVH   =  NPV at Higher Discount Rate

Situation 3: `Multiple Point Inflow (Equal Cash) & Outflow:

Step 1: `Calculate PVIFA at IRR:           PVIFAIRR = PVIF

Step 2: `Calculate IRR on the basis of PVIFA table:

(a)  If matched in table :   Matched PVIFA rate is IRR

(b)  If not matched then have to use interpolation: IRR

PVIF
13. Modified Internal Rate of Return (MIRR) The MIRR is obtained by assuming a single outflow in the zero year and the terminal cash inflow.

Step 1: Calculate cumulative compounded value of intermediate cash inflow by using cost of capital as rate of compounding.

Modified Internal rate of Return

14. Replacement Decision: Decision in respect of replacement of an existing working machine with new one having higher production capacity or lower operating cost or both.

Step 1: Calculate Initial Outflow:

Particulars INR
Purchase Cost of New Machine XXX
Less: Sale Value of Old Machine (XXX)
Less: Tax Saving on Loss on Sale of Old Machine (XXX)
Add: Tax Payment on Profit on Sale of Old Machine XXX
Add: Increase In Working Capital XXX
Less: Decrease in Working Capital (XXX)
Initial Outflow XXX

Step 2: Calculate Incremental CFAT.

Step 3: Calculate Incremental Terminal Value (net of tax).

Step 4: Calculate Incremental NPV and Take Replacement Decision.

15. Capital Rationing: Capital rationing refers to the process of selection of optimal combination of projects out of many subject to availability of funds.

Situation 1 : Projects are Divisible:

Step 1: Calculate PI of all the available projects

Step 2: Give Rank to all projects on the basis of PI

Step 3: Select Projects on the basis of Rank

Situation 2: Projects are Indivisible:

Step 1: Calculate all possible combinations

Step 2: Select combination of projects having higher combined NPV

16. Unequal Life of Projects: In case of comparison between two projects having different life we can solve the problem by using Equivalent Annualized Criterion:

Step 1: Calculate NPV of the projects or PV of outflow of the projects.

Step 2: Calculate Equivalent Annualized NPV or Outflow:

Equivalent Annualised NPV or Outflow = Unequal life of projects

Step 3: Select the proposal having higher annualised NPV or Lower annualised outflow.

Note: Such problems can also be solved by using Common Life/Replacement Chain Method

17. Decision Under Various Techniques

Techniques Yes No
ARR ARR ≥ Desired Return ARR < Desired Return
Traditional Payback Payback ≤ Desired Payback Payback > Desired Payback
Discounted Payback Payback ≤ Desired Payback Payback > Desired Payback
NPV NPV ≥ 0 NPV < 0
PI PI ≥ 1 PI < 1
IRR IRR ≥ Cost of Capital IRR < Cost of Capital
MIRR MIRR ≥ Cost of Capital MIRR < Cost of Capital

 18. Special Points:

    • Sunk Cost and Allocated Overheads are irrelevant in Capital Budgeting.
    • Opportunity Cost is considered in Capital Budgeting.
    • Working Capital introduced at the beginning of project (cash outflow) and recover (cash inflow) at the end of the project life.
    • Running Cost : Always Cash Cost.
    • Operating Cost : Variable Cost plus Fixed Cost (Including Depreciation) subject to operating cost must be > Depreciation.
    • Depreciation : Only as per Tax is relevant.
    • If nothing is specified: Depreciation as per books is assumed to be depreciation as per tax and Losses can be carry forwarded for tax benefit.

2. Frequently Asked Questions

FAQ 1. What is the difference between the Net Present Value (NPV) method and the Internal Rate of Return (IRR) method?

NPV: NPV or net present value refers to the net balance after subtracting present value of outflows from the present value of inflows. Present value is calculated by using cost of capital as discount rate. As per NPV technique internal cash inflows are re-invested at cost of capital rate. NPV higher than zero indicates that project will provide return higher than cost of capital, zero NPV indicates that expected cash inflow will provide return equal to cost of capital and negative NPV indicates that project will fail to recover even cost of funds to be invested in proposal. Negative NPV leads to rejection of proposal. NPV is expressed in financial values and fails to provide actual rate of return associated with proposal.

IRR: IRR technique refers to actual rate of return associated with proposal. IRR refers to rate of discount at which present value of inflows and outflows are same or NPV is zero. IRR is expressed in percentage terms. As per IRR technique internal cash inflows are re-invested at IRR rate. IRR rate is compared with desired rate of return. Proposal is accepted when IRR is higher than desired rate of return and rejected when it is lower than desired rate of return.

There may be contradictory results under NPV and IRR techniques in some situations due to size disparity problem, time disparity problem and unequal expected lives.

FAQ 2. What is ‘Internal Rate of Return’?

IRR technique refers to actual rate of return associated with proposal. IRR refers to rate of discount at which present value of inflows and outflows are same or NPV is zero. IRR is expressed in percentage terms. As per IRR technique internal cash inflows are re-invested at IRR rate. IRR rate is compared with desired rate of return. Proposal is accepted when IRR is higher than desired rate of return and rejected when it is lower than desired rate of return.

FAQ 3. Which method of comparing a number of investment proposals is most suited if each proposal involves different amount of cash inflows?

The best technique to compare number of investment proposals involves different amount of cash inflows is Profitability Index or Desirability Factor. In this technique present value of cash inflows is compared with present value of outflow and project is accepted if PI is 1 or above. It is calculated as :

Profitability Index

Limitations of Profitability Index :

(1)  This technique cannot be used in case of capital rationing with indivisible projects.

(2)  Many times single large project with high NPV is selected and ignored various small projects with higher cumulative NPV than selected single one.

(3)  There is a situation where a project with a lower profitability index may generate cash flows in such a way that another project can be also taken after one or two years later, the total NPV in such case will be higher than NPV of another project with highest Profitability Index today.

FAQ 4. What are the steps while using the equivalent annualized criterion?

Following are the steps involved in Equivalent Annualised Criterion :

Step 1: Calculate NPV of the projects or PV of outflow of the projects.

Step 2: Calculate Equivalent Annualized NPV or Outflow :

Equivalent annualized criterion

Step 3: Select the proposal having higher annualised NPV or Lower annualised outflow.

3. Illustrations

3.1 Net Present Value

1. Domestic services (P) Ltd. is in the business of providing cleaning sewerage line services at homes. There is a proposal before the company to purchase a mechanised sewerage cleaning system for a sum of ` 20 lakhs. The present system of the company is to use manual labour for the job.

You are provided with the following information :

Proposed Machanised System :

Cost of machine ` 20 lakhs
Life of machine 10 years
Depreciation (on straight line basis) 10%
Cash Operating cost of machanised system ` 5 lakhs per annum

Present System (manual) :

Manual labour 200 persons
Cost of manual labour ` 10,000 per person per annum

The company has after tax cost of fund at 10% per annum. The applicable tax rate is 30%.

PV factor for 10 years at 10% are as given below :

Years 1 2 3 4 5 6 7 8 9 10
PV factor 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

Whether it is advisable to purchase the machine?

Ans. Net Present Value

Year Particulars ` DF @ 10% PV
0 Cost of Machine (20,00,000) 1.000 (20,00,000)
1 – 10 Incremental CFAT 11,10,000 6.144 68,19,840
NPV 48,19,840

 Recommendation : Company should purchase the machine having positive NPV.

Working Notes :

Calculation of Incremental CFAT :

Particulars `
Saving in labour cost (200 persons @ `10,000 p.a.) 20,00,000
Less : Cash Operating cost of mechanized system p.a. (5,00,000)
Less : Depreciation (2,00,000)
PBT 13,00000
Less : Tax @ 30% (3,90,000)
PAT 9,10,000
Add : Depreciation (20,00,000 ÷ 10 years) 2,00,000
CFAT 11,10,000

2. PD Ltd. an existing company is planning to introduce a new product with projected life of 8 years. Project cost will be ` 2,40,00,000. At the end of 8 years no residual value will be realized. Working capital of ` 30,00,000 will be needed. The 100% capacity of the project is 2,00,000 units p.a. but the production and sales volume are expected as under :

Year Units
1 60,000
2 80,000
3-5 1,40,000
6-8 1,20,000

Other information :

     1.  Selling price per unit ` 200.

     2.  Variable cost is 40% of sales.

     3.  Fixed cost p.a. ` 30,00,000.

     4.  In addition to these advertisement expenditure will have to be incurred as under :

Year (` in lacs)
1 50
2 25
3-5 10
6-8 5

     5.  Income tax is 25%.

     6.  Straight line method of depreciation is permissible for tax purpose.

     7.  Cost of capital is 10%.

     8.  Assume that loss cannot be carried forward.

Present value table

Year 1 2 3 4 5 6 7 8
PVF@10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467

Advise about the project acceptability.

 Ans. Net Present Value

Year Particulars ` DF @ 10% PV
0 Initial outflows (2,40,00,000 + 30,00,000) (2,70,00,000) 1.000 (2,70,00,000)
1 CFAT (8,00,000) 0.909 (7,27,200)
2 CFAT 38,25,000 0.826 31,59,450
3 – 5 CFAT 1,03,50,000 2.055 2,12,69,250
6 – 8 CFAT 89,25,000 1.544 1,37,80,200
8 Working Capital 30,00,000 0.467 14,01,000
NPV 1,18,82,700

 Company should accept the proposal having positive NPV of the project.

Working Notes :

    1. Statement showing CFAT :
Particulars 1 2 3 – 5 6 – 8
Units sold 60,000 80,000 1,40,000 1,20,000
Sales @ ` 200 p.u. 1,20,00,000 1,60,00,000 2,80,00,000 2,40,00,000
Less : VC @ 40% 48,00,000 64,00,000 1,12,00,000 96,00,000
Contribution 72,00,000 96,00,000 1,68,00,000 1,44,00,000
Less : Advertisement expenses (50,00,000) (25,00,000) (10,00,000) (5,00,000)
Less : Cash fixed cost (30,00,000) (30,00,000) (30,00,000) (30,00,000)
Less : Depreciation (30,00,000) (30,00,000) (30,00,000) (30,00,000)
PBT (38,00,000) 11,00,000 98,00,000 79,00,000
Less : Tax @ 25% (2,75,000) (24,50,000) (19,75,000)
PAT (38,00,000) 8,25,000 73,50,000 59,25,000
Add : Depreciation 30,00,000 30,00,000 30,00,000 30,00,000
CFAT (8,00,000) 38,25,000 1,03,50,000 89,25,000

3. CK Ltd. is planning to buy a new machine. Details of which are as follows :

Cost of the machine at the commencement ` 2,50,000
Economic life of the machine 8 years
Residual value Nil
Annual production capacity of the machine 1,00,000 units
Estimated selling price per unit ` 6
Estimated variable cost per unit ` 3
Estimated annual fixed cost

(Excluding depreciation)

` 1,00,000
Advertisement expenses in 1st year in addition of fixed cost ` 20,000
Maintenance expenses in 5th year in addition of fixed cost ` 30,000
Cost of capital 12%

Ignore tax.

Analyse the abovementioned proposal using the Net Present Value method and advice.

Note : The PV factors at 12% are

Year 1 2 3 4 5 6 7 8
PV Factor .893 .797 .712 .636 .567 .507 .452 .404

Ans. Statement of NPV

Year Particulars ` DF @ 12% PV
0 Initial outflows (2,50,000) 1.000 (2,50,000)
1 Cash inflow 1,80,000 0.893 1,60,740
2 – 4 Cash inflow 2,00,000 2.145 4,29,000
5 Cash inflow 1,70,000 0.567 96,390
6 – 8 Cash inflow 2,00,000 1.363 2,72,600
NPV 7,08,730

Working Note :

Calculation of Annual Cash Inflow

Particulars 1 2 – 4 5 6 – 8
Sales value @ ` 6 per unit of 1,00,000 units 6,00,000 6,00,000 6,00,000 6,00,000
Less : Variable costs @ ` 3 per unit 3,00,000 3,00,000 3,00,000 3,00,000
Less : Annual cash fixed cost 1,00,000 1,00,000 1,00,000 1,00,000
Less : Advertisement expenses 20,000
Less : Maintenance expenses 30,000
Cash Inflow 1,80,000 2,00,000 1,70,000 2,00,000

Advise: CK limited should buy machine having positive NPV.


 

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  1. Way cool! Some extremely valid points! I appreciate you writing this post and also the rest of the website is really good.

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