Capital Budgeting under Certainty C Ghanendra Fago M

Capital Budgeting under Certainty (C) Ghanendra Fago ( M. Phil, MBA) 1

Capital Budgeting l ‘The Planning for the Promotion Campaign and Development of available capital for the purpose of maximizing the long term profitability of the firm. l The capital is relatively scarce and non-human resources of productive enterprise. l As the firm’s decision to invest its current funds most effectively in long term activities in anticipation of an expected flow of future benefits over a series of years. l Capital budgeting are (i) potentially large anticipated benefits (ii) a relatively high degree of risk and (iii) a relatively long time period between the initial outlay and the anticipated return. l Paramount importance in financial decision making. Such decisions affect profitability of the firm and also have a bearing on the competitive position of the enterprise. (C) Ghanendra Fago ( M. Phil, MBA) 2

Importance of Capital Budgeting Decision 1. It determines the future destiny of the company. 2. A capital expenditure decision has its effect over a long time span and inevitably affects the company’s future cost structure. 3. Capital investment decisions, once made, are not easily reversible without much financial loss to the firm. 4. Capital investment involves costs and the majority of the firms have scarce capital resources. (C) Ghanendra Fago ( M. Phil, MBA) 3

Steps of Capital Budgeting 1. Calculation of Net Cash Outlay (NCO) 2. Calculation of Annual Depreciation 3. Calculation of Annual Cash Flow After Tax (CFAT) 4. Calculation of Cash Flow in Final Year 5. Evaluation technique 6. Decision of projects using (C) Ghanendra Fago ( M. Phil, MBA) capital budgeting 4

Step 1: Calculation of Net Cash Outlay (NCO) - Purchase Price of New Assets –xxxx - Transportation and Installation Cost –xxxx ± Decrease or Increase in Working Capital – x x + Cash salvage value of Old Machine ±xxxx + Tax saving on loss on sale of old machine +xxxx – Tax paid on profit on sale - x x + Investment tax credit +xxxx Net cash outlay Investment cost (C) Ghanendra Fago ( M. Phil, MBA) (NCO) – x x 5

Step 2: Calculation of Annual Depreciation l Annual depreciation of new machine xxxx l Less: Annual depreciation of old machine –xxxx l Annual differential depreciation (New – old) x x (C) Ghanendra Fago ( M. Phil, MBA) 6

Step 3: Calculation of Annual Cash inflow after tax l Annual increase in sales (New – old) x x l Less: Annual increase in expenses (New – old) – x x l Add: Annual decrease in expenses (old – new) + x x l Cash flow before tax and depreciation (EBDT) x x l Less: Annual differential depreciation l Earning before tax (EBT) l Less: Tax @. . . . % – x x x l Earning after tax (EAT) l Add back Annual differential depreciation l Annual cash flow after tax (CFAT) – x x x + x x x x (C) Ghanendra Fago ( M. Phil, MBA) 7

Step 4: Calculation of Final Year CFAT l Differential Cash salvage value at end (New-Old) l Book salvage value at end (New-Old) x x xx l Gain / Loss x x l Tax paid on gai – x xx x l Tax saving on loss + x x x l Add: Differential cash salvage value + x x x l Add: Increase in working capital + x x x l Less: Decrease in working capital – x x x l Add: Annual differential CFAT + x x x l Final year’s CFAT x x x x (C) Ghanendra Fago ( M. Phil, MBA) 8

Note: Special assumptions for salvage value: 1. When only the book salvage value is given, BSV = CSV 2. When only the cash salvage value is give BSV = 0 3. When only the salvage value is given, salvage value = BSV = CSV Special Assumption for depreciation 1. When the income is given as earning, depreciation already deducted but not added. 2. When the inflow is given as earning, depreciation is already deducted and added. (C) Ghanendra Fago ( M. Phil, MBA) 9

Methods for Depreciation 1. Straight line method; Depreciation = (Cost –Salvage Value)/N 1. Diminishing balance method Depreciation = (Total cost or remaining value) . . . % p. a. 1. Diminishing balance when rate of depreciation is not given, Depreciation Rate = (2/n) 100% Depreciation = (Total cost or remaining value) . . . % p. a. 1. Sum of year's digit method Depreciation = (NCO x Remaining Life ) (n(n+1)/2 (C) Ghanendra Fago ( M. Phil, MBA) 10

Evaluation Methods Of Capital Budgeting 1. Traditional or Non-discounted Methods (a) Payback Period (PBP) (b) Accounting Rate of Return (ARR) 2. Discounted Cash flow/Time Adjusted Methods (a) Net Present Value (NPV) (b) Profitability Index (PI) (c) Internal Rate of Return (IRR) (C) Ghanendra Fago ( M. Phil, MBA) 11

Traditional Method or Non-discounted Cash Flow Method (a)Payback Period: Even Cash flow: PBP = NCO/CFAT Uneven cash flow: PBP = Min. Year + (NCO-Cum. CFAT)/Next year’s CFAT (b) Accounting Rate of Return: Even case: ARR =( EAT/Average Investment) 100% Uneven case: ARR = ( AEAT/Average Investment) 100% (C) Ghanendra Fago ( M. Phil, MBA) 12

Discounted Cash Flow Method NET PRESENT VALUE: Uneven case: NPV = Total Present Value – Net Cash Outlay = CFAT 1 x. PVIF 1 +CFAT 2 x. PVIF 2 + …… CFAT 3 x. PVIFN - NCO Even case: Net Present Value NPV = Total Present Value – Net Cash Outlay = CFAT x PVIFA - NCO (C) Ghanendra Fago ( M. Phil, MBA) 13

Profitability Index Profitability index measures present value of return per rupee invested while the NPV shows the present value of return in lump sum. PI = Total present value (TPV)/Net cash Outlay (NCO) The profitability index greater than one is accepted and less than one is rejected on the ranking of the projects, higher the profitability index is preferred. (C) Ghanendra Fago ( M. Phil, MBA) 14

Internal Rate of Return (IRR l It is the rate that discounts an investment’s future cash flows to the present so that the present value of those cash flow exactly equals the cost of the investment. This rate is also called as time adjusted rate of return, marginal rate of return, yield of investment and so on. The procedure of calculation of internal rate of return under even cash flow and uneven cash flow is different. EVEN CASH FLOW Step 1: To determine the factor by using the following formula Factor = NCO/CFAT l (C) Ghanendra Fago ( M. Phil, MBA) 15

Step 2: Locate the factor in the annuity table on the line representing the number of years corresponding to the estimated useful life of the project. Determine two rates, one more than and another less than factor. PVIFALr = …… PVIFAHr = …… Step 3: Interpolate the two factors from the following formula. IRR = Lower Rate + (PVIFALr-Pbf)/ (PVIFALr. PVIFAHR) (Higher Rate – Lower Rate) IRR must be greater than cost of capital. The higher rate of return is acceptable among the mutually exclusive proposals. (C) Ghanendra Fago ( M. Phil, MBA) 16

UNEVEN CASH FLOW -To determine the factor by using the following formula Factor = NCO/Average CFAT - Locate the factor in the annuity table on the line representing the number of years corresponding to the estimated useful life of the project. Determine one rate close to payback factor, and compute NPV. If NPV is positive, increase discount rate, If negative decrease discount rate and Find one positive and one negative NPV. - To prepare the trial and error table and interpolate the two factors from the following formula: IRR = Lower Rate + (TPV at LR –NCO)/ (TPV at LR- TPV at HR) (Higher Rate – Lower Rate) (C) Ghanendra Fago ( M. Phil, MBA) 17