complete details of capital budgeting

1. Assignment:
Corporate Finance
Submitted to:
Dr Bilal Aziz
Submitted by:
Ateeq ur rehman
Roll No:
026
Date: 18-12-2015

2. Capital Budgeting
Introduction:
The term Capital Budgeting refers to long term planning for proposed capital
outlay and their financing. It includes raising long-term funds and their utilization.
It may be defined as a firm's formal process of acquisition and investment of
capital.
It deals exclusively with investment proposals, which an essentially long term
projects and is concerned with the allocation of firm's scarce financial resources
among the available market opportunities.
Capital budgeting:
The process through which different projects are evaluated is known as capital
budgeting.
Capital budgeting is defined “as the firm’s formal process for the acquisition and
investment of capital. It involves firm’s decisions to invest its current funds for
addition, disposition, modification and replacement of fixed assets”.
“Capital budgeting is long term planning for making and financing proposed
capital outlays”- Charles T Horngreen
“Capital budgeting consists in planning development of available capital for the
purpose of maximizing the long term profitability of the concern” – Lynch

3. The main features of capital budgeting are
a. potentially large anticipated benefits
b. a relatively high degree of risk
c. relatively long time period between the initial outlay and the anticipated return.
- Oster Young
Nature of capital budgeting:
Capital expenditure plans involve a huge investment in fixed assets.
Capital expenditure once approved represents long-term investment that cannot be
reserved or withdrawn without sustaining a loss.
Preparation of capital budget plans involve forecasting of several years profits in
advance in order to judge the profitability of projects.
It may be asserted that, decision regarding capital investment should be taken very
carefully so that the future plans of the company are not affected adversely.
Significance of capital budgeting:
The success and failure of business mainly depends on how the available resources
are being utilized. Main tool of financial management
All types of capital budgeting decisions are exposed to risk and uncertainty.
They are irreversible in nature. Capital rationing gives sufficient scope for the
financial manager to evaluate different proposals and only viable project must be
taken up for investments.
Capital budgeting offers effective control on cost of capital expenditure projects.
It helps the management to avoid over investment and under investment

4. Capital budgeting process
Capital budgeting process involves the following
1. Project generation:
Generating the proposals for investment is the first step.
The investment proposal may fall into one of the following categories:
Proposals to add new product to the product line,
Proposals to expand production capacity in existing lines
Proposals to reduce the cost of the output of the existing products without altering
the scale of operation.
Sales campaigning, trade fairs people in the industry, R and D institutes,
conferences and seminars will offer wide variety of innovations on capital assets
for investment.
2. Project Evaluation:
It involves two steps
Estimation of benefits and costs:
The benefits and costs are measured in terms of cash flows. The estimation of the
cash inflows and cash outflows mainly depends on future uncertainties. The risk
associated with each project must be carefully analyzed and sufficient provision
must be made for covering the different types of risks.

5. Selection of appropriate criteria to judge the desirability of the project:
It must be consistent with the firm’s objective of maximizing its market value.
The technique of time value of money may come as a handy tool in evaluation
such proposals.
3. Project Selection:
No standard administrative procedure can be laid down for approving the
investment proposal. The screening and selection procedures are different from
firm to firm.
4. Project Evaluation:
Once the proposal for capital expenditure is finalized, it is the duty of the finance
manager to explore the different alternatives available for acquiring the funds. He
has to prepare capital budget. Sufficient care must be taken to reduce the average
cost of funds. He has to prepare periodical reports and must seek prior permission
from the top management. Systematic procedure should be developed to review
the performance of projects during their lifetime and after completion.
5. The follow up:
Comparison of actual performance with original estimates not only ensures better
forecasting but also helps in sharpening the techniques for improving future
forecasts.

6. Factors influencing capital budgeting
The primary factors that influence a company's capital-structure decision are:
1. Business Risk
Excluding debt, business risk is the basic risk of the company's operations. The
greater the business risk, the lower the optimal debt ratio.
As an example, let's compare a utility company with a retail apparel company. A
utility company generally has more stability in earnings. The company has les risk
in its business given its stable revenue stream. However, a retail apparel company
has the potential for a bit more variability in its earnings. Since the sales of a retail
apparel company are driven primarily by trends in the fashion industry, the
business risk of a retail apparel company is much higher. Thus, a retail apparel
company would have a lower optimal debt ratio so that investors feel comfortable
with the company's ability to meet its responsibilities with the capital structure in
both good times and bad.
2. Company's Tax Exposure
Debt payments are tax deductible. As such, if a company's tax rate is high, using
debt as a means of financing a project is attractive becausethe tax deductibility of
the debt payments protects someincome from taxes.
3. Financial Flexibility
This is essentially the firm's ability to raise capital in bad times. It should come as
no surprise that companies typically have no problem raising capital when sales are
growing and earnings are strong. However, given a company's strong cash flow in
the good times, raising capital is not as hard. Companies should make an effort to
be prudent when raising capital in the good times, not stretching its capabilities too
far. The lower a company's debtlevel, the more financial flexibility a company
has.

7. The airline industry is a good example. In good times, the industry generates
significant amounts of sales and thus cash flow. However, in bad times, that
situation is reversed and the industry is in a position where it needs to borrow
funds. If an airline becomes too debt ridden, it may have a decreased ability to
raise debt capital during these bad times because investors may doubtthe airline's
ability to service its existing debt when it has new debtloaded on top.
4. Management Style
Management styles range from aggressive to conservative. The more conservative
a management's approachis, the less inclined it is to use debtto increase profits.
An aggressive management may try to grow the firm quickly, using significant
amounts of debt to ramp up the growth of the company's earnings per share (EPS).
5. Growth Rate
Firms that are in the growth stage of their cycle typically finance that growth
through debt, borrowing money to grow faster. The conflict that arises with this
method is that the revenues of growth firms are typically unstable and unproven.
As such, a high debt load is usually not appropriate.
More stable and mature firms typically need less debt to finance growth as its
revenues are stable and proven. These firms also generate cashflow, which can be
used to finance projects when they arise.
6. Market Conditions
Market conditions can have a significant impact on a company's capital-structure
condition. Supposea firm needs to borrow funds for a new plant. If the market is
struggling, meaning investors are limiting companies' access to capital because of
market concerns, the interest rate to borrow may be higher than a company would
want to pay. In that situation, it may be prudent for a company to wait until market
conditions return to a more normal state before the company tries to access funds
for the plant.

8. Methods of capital budgeting
Traditional methods
Payback period
Accounting rate of return method
Discounted cash flow methods
Net present value method
Profitability index method
Internal rate of return
Payback period method:
Payback period is the time in which the initial cash outflow of an investment
is expected to be recovered from the cash inflows generated by the investment. It is
one of the simplest investment appraisal techniques.
Formula
The formula to calculate payback period of a project depends on whether the cash
flow per period from the project is even or uneven. In case they are even, the
formula to calculate payback period is:
Payback Period =
Initial Investment
Cash Inflow per Period

9. When cash inflows are uneven, we need to calculate the cumulative net cash flow
for each period and then use the following formula for payback period:
In the above formula:
A is the last period with a negative cumulative cash flow;
B is the absolute value of cumulative cash flow at the end of the period A;
C is the total cash flow during the period after A
Both of the above situations are applied in the following examples.
Decision Rule
Accept the project only if it’s payback period is LESS than the target payback
period.
Example 1: Even Cash Flows
Company C is planning to undertake a project requiring initial investment of $105
million. The project is expected to generate $25 million per year for 7 years.
Calculate the payback period of the project.
Solution
Payback Period = Initial Investment ÷ Annual Cash Flow = $105M ÷ $25M = 4.2
years
Payback Period = A +
B
C

10. Example 2: Uneven Cash Flows
Company C is planning to undertake another project requiring initial investment of
$50 million and is expected to generate $10 million in Year 1, $13 million in Year
2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate
the payback value of the project.
Solution
(Cash flows in millions)
Cumulative
Year Cash Flow cash flow
0 (50) (50)
1 10 (40)
2 13 (27)
3 16 (11)
4 19 8
5 22 30
Payback Period
= 3 + (|-$11M| ÷ $19M)
= 3 + ($11M ÷ $19M)
≈ 3 + 0.58
≈ 3.58 years

11. Why Use the Payback Method?
It’s quick and easy to apply
Serves as a rough screening device
Disadvantages of payback method:
It is based on principle of rule of thumb,
Does not recognize importance of time value of money,
Does not consider profitability of economic life of project,
Does not recognize pattern of cash flows,
Does not reflect all the relevant dimensions of profitability.
Example:
Assume that two gas stations are for sale with the following cash flows:
According to the payback period, when given the choice between two mutually
exclusive projects, Gas Station B should be selected. Although bothgas stations
costthe same, Gas Station B has a payback period of one year, whereas Gas
Station A will payback in roughly one and half years.

12. Accounting Rate of Return method:
It considers the earnings of the project of the economic life. This method is based
on conventional accounting concepts. The rate of return is expressed as percentage
of the earnings of the investment in a particular project. This method has been
introduced to overcome the disadvantage of payback period. The profits under this
method are calculated as profit after depreciation and tax of the entire life of the
project.
This method of ARR is not commonly accepted in assessing the profitability of
capital expenditure. Because the method does to consider the heavy cash inflow
during the project period as the earnings with be averaged. The cash flow
advantage derived by adopting different kinds of depreciation is also not
considered in this method.
Formula
Accounting Rate of Return is calculated using the following formula:
ARR = Average Accounting Profit
Average Investment
Average accounting profit is the arithmetic mean of accounting income expected to
be earned during each year of the project's life time. Average investment may be
calculated as the sum of the beginning and ending book value of the project
divided by 2. Another variation of ARR formula uses initial investment instead of
average investment.

13. Decision Rule
Accept the project only if its ARR is equal to or greater than the required
accounting rate of return. In case of mutually exclusive projects, accept the one
with highest ARR.
Example 1:
An initial investment of $130,000 is expected to generate annual cash inflow of
$32,000 for 6 years. Depreciation is allowed on the straight line basis. It is
estimated that the project will generate scrap value of $10,500 at end of the 6th
year. Calculate its accounting rate of return assuming that there are no other
expenses on the project.
Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷ Useful Life in Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6= $19,917
Average Accounting Income = $32,000 − $19,917 = $12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%
Accept or Reject Criterion:
Under the method, all project, having Accounting Rate of return higher than the
minimum rate establishment by management will be considered and those having
ARR less than the pre-determined rate. This method ranks a Project as number one,
if it has highest ARR, and lowest rank is assigned to the project with the lowest
ARR.

14. Merits
1. It is very simple to understand and use.
2. This method takes into account saving over the entire economic life of the
project. Therefore, it provides a better means of comparison of project than
the payback period.
3. This method through the concept of "net earnings" ensures a compensation
of expected profitability of the projects and
4. It can readily be calculated by using the accounting data.
Demerits
1. It ignores time value of money.
2. It does not consider the length of life of the projects.
3. It is not consistent with the firm's objective of maximizing the market value of
shares.
4. It ignores the fact that the profits earned can be reinvested.
Discounted cash flow method:
Time adjusted technique is an improvement over pay back method and ARR. An
investment is essentially out flow of funds aiming at fair percentage of return in
future. The presence of time as a factor in investment is fundamental for the
purpose of evaluating investment. Time is a crucial factor, because, the real value
of money fluctuates over a period of time.
A rupee received today has more value than a rupee received tomorrow. In
evaluating investment projects it is important to consider the timing of returns on
investment. Discounted cash flow technique takes into account both the interest
factor and the return after the payback 'period

15. Discounted cash flow technique involves the following steps:
Calculation of cash inflow and out flows over the entire life of the asset.
Discounting the cash flows by a discount factor
Aggregating the discounted cash inflows and comparing the total so obtained with
the discounted out flows.
Net present value method
It recognizes the impact of time value of money. It is considered as the best
method of evaluating the capital investment proposal.
It is widely used in practice. The cash inflow to be received at different period of
time will be discounted at a particular discount rate. The present values of the cash
inflow are compared with the original investment. The difference between the two
will be used for accept or reject criteria. If the different yields (+) positive value,
the proposal is selected for investment. If the difference shows (-) negative values,
it will be rejected.
Formula:
NPV = ∑ {Net Period Cash Flow/(1+R)^T} - Initial Investment
Where R is the rate of return and T is the number of time periods.
Advantages:
1. It recognizes the time value of money.
2. It considers the cash inflow of the entire project.
3. It estimates the present value of their cash inflows by using a discount rate
equal to the cost of capital.
4. It is consistent with the objective of maximizing the welfare of owners.

16. Disadvantages:
1. It is very difficult to find and understand the concept of cost of capital
2. It may not give reliable answers when dealing with alternative projects under
the conditions of unequal lives of project
Example of Net present Value:
As was mentioned earlier, the payback period is a very basic capital budgeting
decision tool that ignores the timing of cash flows. Since most capital investment
projects have a life span of many years, a shorter payback period may not
necessarily be the best project.
Consider the gas station example above under the NPV method, and a discount
rate of 10%:
NPVgas station A = $100,000/(1+.10)2 - $50,000 = $32,644
NPVgas station B = $50,000/(1+.10) + $25,000/(1+.10)2 - $50,000 = $16,115
In our gas station example, the net present value tool illustrates the limitations of
the payback period. Under the payback period, the decision would have been to
pick gas station B because it had the shorter payback period. Under the NPV
criteria, however, the decision favors gas station A, as it has the higher net present
value. In this particular case, the NPV of gas station A is more than twice that of
gas station B, which implies that gas station A is a vastly better investment project
to undertake.

17. Profitability Index (PI):
Method:
Note: PI should always be expressed as a positive number.
If PI ≥ 1, then accept the real investment project; otherwise, reject it.
Example of profitability index:
Initial investment required: $100,000
Opportunity cost of capital: 15%
The PI is …
Year Cash Revenues less Expenses after tax
1 $20,000
2-9 $40,000
10 $10,000
InvestmentInitial
PV
PI investmentinitialafter theflowsCash


18. PI: Strengths and Weaknesses:
Strengths
1. PI number is easy to interpret: shows how many $ (in PV terms) you get
back per $ invested.
2. Acceptance criteria are generally consistent with shareholder wealth
maximization.
3. Relatively straightforward to calculate.
4. Useful when there is capital rationing.
Weaknesses
1. Requires knowledge of finance to use.
2. It is possible that PI cannot be used if the initial cash flow is an inflow.
3. Method needs to be adjusted when there are mutually exclusive projects.
Internal Rate of Return
It is that rate at which the sum of discounted cash inflows equals the sum of
Discounted cash outflows. It is the rate at which the net present value of the
investment is zero.
It is the rate of discount which reduces the NPV of an investment to zero. It is
called internal rate because it depends mainly on the outlay and proceeds
associated with the project and not on any rate determined outside the investment.

19. Merits of IRR method:
It consider the time value of money
Calculation of cost of capital is not a prerequisite for adopting IRR
IRR attempts to find the maximum rate of interest at which funds invested in the
project could be repaid out of the cash inflows arising from the project.
It is not in conflict with the concept of maximizing the welfare of the equity
shareholders.
It considers cash inflows throughout the life of the project.
Demerits of IRR method:
Computation of IRR is tedious and difficult to understand
Both NPV and IRR assume that the cash inflows can be reinvested at the
discounting rate in the new projects. However, reinvestment of funds at the cut off
rate is more appropriate than at the IRR.
IT may give results inconsistent with NPV method. This is especially true in case
of mutually exclusive project.
Internal Rate of Return:
The internal rate of return (IRR) method can perhaps be the more complicated and
subjective of the three capital budgeting decision tools. Similar to the NPV, the
IRR accounts for the time value of money. It is useful here to repeat the definition
of the IRR:

20. The IRR of any project is the rate of return that sets the NPV of a project zero.
Since the general NPV rule is to only pick projects with an NPV greater than zero
with the highest net present value, the internal rate of return, by definition, is the
breakeven interest rate. In other words, the IRR decision criteria conceptually
obvious:
Choose projects with an IRR that is greater than the cost of financing
This rule is easy to understand: if your cost of capital is 10%, projects with an
internal rate of return of 8% would destroy value, while projects with an internal
rate of return of 15% with increase value.
While it's conceptually simple to understand the internal rate of return process,
calculating IRR can be a bit tricky. The calculation of a project's IRR is essentially
a trial and error one. Consider the following example of a project with the
following cash flows:
There is no simple formula to calculate the IRR. It's either done by trial and error
or a financial calculator. Remember, however, that the IRR is that rate where NPV
is equal to zero; the equation would be set up like this:
CF0 + CF1/(1+IRR) + CF2/(1+IRR)2 + CF3/(1+IRR)3 = 0, or
-$1,000+ $100/(1+IRR) + $600/(1+IRR)2 + $800/(1+IRR)3 = 0
Believe or not, from here the next step is to guess a number for IRR, plug in and
see if it equals zero.
When IRR = 20%, or .20, the result is a number greater than zero (you can try it
yourself, just enter "0.20" in place of "IRR." Performing a trial and error
calculation here would be too cumbersome but it's very simple and good practice,
to try it yourself).

21. Thus 20% is too big a number. The next step would be to try a lower number.
When IRR = 17%, the NPV is less than zero, so that IRR is too low.
The IRR of this particular project is 18.1%. That is the interest where the NPV of
the above project is zero. Plug it in and you should get zero or an insignificantly
lower number that equates to zero.
Thus, if the cost of financing the above the project is below 18.1%, the project
creates value under the IRR calculation; if the cost of financing is greater than
18.1%, the project will destroy value.
Just as is the case with the payback method and NPV, the IRR decision will not
always agree with the NPV decision in mutually-exclusive projects. Again, this has
to do with initial cash flow outlay and timing of future cash flows. However, in the
end, despite the its flaws, percentages are more intuitive and useful in business,
thus rendering value to the IRR method.
Capital Budgeting conclusion:
All for-profit business seemingly exist on the mandate of maximizing shareholder,
or owner, value. A business is essentially a series of transactions that aim at
generating greater revenue and profits. The capital budgeting process, or the
methods employed by a company to invest in activities to generate additional
value, is a dynamic process, to say the least.
In a way, a business is nothing more than a series of many capital budgeting
decisions. Decisions to hire a new CEO, negotiate contracts, maintain efficient
operations, compete in the mergers and acquisitions arena, among others, are all
capital budgeting decisions, in one way or another.

22. Even decisions to reduce employees, shut down a division or the sale of part or all
the company are capital budgeting decisions. Businesses are often observed being
sold under the mandate of maximizing shareholder value.
Whether minor or major, all business decisions involve an accounting of costs
versus benefits. In a way, that's the essence of the capital budgeting process.
Shareholders put their trust in management to constantly assess the costs versus
benefits – the risk versus the reward – of their corporate actions. When a CEO is
fired, it's often because a company has failed to create shareholder value. Put
another way, which CEO or executive has failed to successfully engage in value-
creating projects; the capital budgeting process under that CEO was ineffective.
Understanding the capital budgeting process is not only important from an
intellectual standpoint, but vital to understanding how a business can and will
create future value. The world's greatest executives – Sam Walton of Wal-Mart,
Roberto Goizueta of Coca Cola, Warren Buffett at Berkshire Hathaway, Jack
Welch at General Electric – have a long history of making value creating
decisions. These executives got capital budgeting process right.
Individual investors also benefit from the capital budgeting process. Investing in a
company's stock is much like investing in a project. At a given share price,
investors ought to be able to figure out if that share price is below the intrinsic
value of those shares. One determines the intrinsic value by conducting a
discounted cash flow analysis, essentially finding the net present value of that
company. Being able to seek out undervalued investments is clearly the ultimate
objective for investors and corporate executives. In one form or another, the capital
budgeting process is the set of tools that facilitates that value seeking process.