Capital Budgeting

 

Capital Budgeting

Meaning: Capital Budgeting is a process of long range planning involving investments of funds in long term activities whose benefits are expected over series of years. Capital budgeting is mainly used in decision making involving purchase of Assets or projects.

Classification of Capital Budgeting decisions

Capital Budgeting decisions may be classified as follows:

1.     Replacement Decisions

2.     Modernization Decisions

3.     Expansion Decisions

4.     Diversification Decisions

5.     Mutually Exclusive Decisions

6.     Accept /Reject Decisions

7.     Contingent Decisions/ Complimentary Decisions

Calculation of CFAT

Earnings before Depreciation & Tax

Less: Depreciation

Earnings before Tax

Less: Tax @ ____ %

Earnings after Tax

Add: Deprecation

Cash Flows after Taxes (CFAT)

Note: In last year if there is any receipt in form of Release of Working Capital or Sale of Scrap should be added to the CFAT of last year. In case of any Profit on Sale of Scrap the Tax on such profit should be deducted.

Traditional Methods

Pay Back Period

Pay Back Period refers to the period within which the entire cost of the project is expected to be completely recovered by way of cash inflows, cash inflow means earnings after tax but before depreciation.

Calculation of Pay Back Period

a)      Equal Annual Cash Inflows

Pay Back Period = Initial Cash Outflow
                  Annual Cash Inflows       

b)      Unequal Annual Cash Inflows

Payback period is calculated by computing cumulative cash inflows till the cumulative cash inflows become equal to initial cash outflow.

Pay Back Period = (Year upto which Cumulative CFAT is less then Cash Outflow) X                          Balance Cash flow to be recovered 

                      CFAT of Next Year

        Average Rate of Return (ARR)

This technique is also called as Accounting Rate of Return.

ARR means the Average annual yield on the project. It is found out by dividing the annual average profits after taxes by the average investments.

Average Rate of Return = Annual Average Earnings after Taxes   X 100

                           Average Investments

Annual Average Earnings After Taxes = Total Earnings after Tax + Interest
                                          Total period of project

Average Investments = (Opening Investments + Closing Investments) / 2

OR Average Investment = 1/2 (Original Cost - Salvage Value) + Salvage Value + WC

Discounting Methods

Net Present Value (NPV)

Accept/ Reject Rule

Accept if NPV > 0, Reject if NPV < 0

If NPV = 0, then the management would be indifferent as to whether to accept or reject.

NPV = PV of Cash Inflows - PV of Cash Outflows

Profitability Index (PI)

Accept/ Reject Rule

Accept if PI > 1, Reject if PI < 1

If PI = 1, then the management would be indifferent as to whether to accept or reject.

PI = PV of Cash Inflows

    PV of Cash Outflows

Internal Rate of Return (IRR)

Accept/ Reject Rule

Accept the proposal if IRR > k, Reject the proposal if IRR < k (k = Cost of Capital)

Calculation of IRR

Step 1. Calculate Fake Payback period

            Fake Payback Period =         Cash Outflows           

                                Average Annual Cash Inflows

Step 2. Find out 2 discount factors within which the above Fake Payback period lies from the Present Value of Annuity (PVAF) Table 

Step 3. Find out 2 discount rates corresponding to these above discount factors from the top row of the PVAF Table.

Step 4. Calculate NPV at both the discount rates so as to have one negative NPV and one positive NPV

Notes:

1. If both NPV's are positive, calculate again NPV at some higher discount rate so as to have negative NPV.

2. If both NPV's are negative, calculate again NPV at some lower discount rate so as to have positive NPV.

3. Repeat this process unless you get one lower rate at which NPV is positive and one higher rate at which NPV is negative.

Step 5. Calculate IRR by interpolation as follows:

IRR = Lower Discount Rate + 

                       NPV at lower rate              X (Higher Rate - Lower Rate)

              NPV at lower rate - NPV at higher rate