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Capital Budgeting – with real world examples

Capital budgeting is the planning process used to determine whether an organizations long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects can be done using the firms capitalization structures (debt, equity or retained earnings) to bring profit as well as to increase the value of the firm to the shareholders.

WHO DO THE CAPITAL BUDGETING IN A FIRM?

Finance Manager is the main decision making authority in capital budgeting of the firm.

Capital budgeting is a planning process used by companies to evaluate which large projects to invest in, and how to finance them. It is sometimes called “investment appraisal.”

CAPITAL BUDGETING TECHNIQUES:

Cash Inflow: Any source of income coming inside a company. Eg: receipt of loan from bank, interest from savings, investment made by shareholders

Cash outflow: Any source of income going out of a company. Eg: Dividend paid to shareholders, income tax, rent, buying of raw materials.

These two terms are important to understand about capital budgeting.

1.Payback period method

The payback period is the length of the time required to recover the initial cost of the project.

Example:

Certain projects require and initial cash outflow of Rs.23,000. The cash inflows for 6 years are Rs. 5000, Rs.8000, Rs.10000, Rs.12000, Rs.7000 and Rs.3000.

The above calculation shows Rs.23000 has been recovered in 3 years. Thus the payback period is 3 years for the invested amount.

2.Accounting rate of return

Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project.

Example:

An initial investment of Rs. 130,000 is expected to generate annual cash inflow of Rs.32,000 for 6 years. Depreciation is allowed on the straight line basis. It is estimated that the project will generate scrap value of Rs. 10,500 at end of the 6th year. Calculate its accounting rate of return assuming that there are no other expenses on the project.

Annual Depreciation = (Initial investment – Scrap value) / useful life in years

Annual Depreciation = (Rs.1,30,000-Rs. 10,500)/6 = Rs. 19,917 (approx)

Average accounting income = Rs. 32,000-Rs. 19,917 = Rs. 12,083. (approx)

Accounting rate of return = Rs. 12,083/Rs.1,30,000=9.3%(approx)

Accept the project only if its ARR is equal to or greater than the required accounting rate of return.

3. Net present Value

Net present Value is obtained by subtracting the present value of cash outflow (initial capital) from the present value of cash inflow for a particular period of time.

The following is the formula for calculating NPV:

Example:

Project X requires an initial investment of Rs. 35,000 but is expected to generate revenues of Rs. 10,000, Rs. 27,000 and Rs.19,000 for the first, second and third years, respectively. The target rate of return is 12%.

NPV = {Rs.10,000 / (1 + 0.12)1} + {Rs.27,000 / (1 + 0.12)2} + {Rs.19,000 / (1 + 0.12)3} – Rs.35,000

NPV = Rs.8,929 + Rs.21,524 + Rs13,524 – Rs.35,000 = Rs.8,977

If NPV is positive, cash inflow is good and the project is going in desired direction.

4. Profitability Index

The profitability index is an index that attempts to identify the relationship between the costs (negative cash flow or expenses) and benefits (positive cash flow or income) of a proposed project through the use of a ratio calculated as:

The present value of future cash inflow is calculated from the net present value.

If the profitability index is greater than or equal to 1.0 then the project is financially attractive else the investment in the project is rejected.

5. Internal rate of return

Internal rate of return is to make NPV value as zero.

If we borrow at 8% interest the IRR should be greater than 8% if the project is desired to go in right direction. This 8% is called hurdle value and the IRR should be greater than hurdle value to give profit. Internal rate of returns used to evaluate the attractiveness of a project or investment If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.

Example:

Find the IRR of an investment having initial cash outflow of Rs. 213,000. The cash inflows during the first, second, third and fourth years are expected to be Rs. 65,200, Rs.96,000, Rs.73,100 and Rs.55,400 respectively.

Assume that r is 10%.

NPV is calculated from the above formula.

NPV at 10% discount rate = +Rs.18,372

Since NPV is greater than zero we have to increase discount rate, thus

NPV at 13% discount rate = +Rs.4,521

But it is still greater than zero we have to further increase the discount rate, thus

NPV at 14% discount rate = +Rs.204

NPV at 15% discount rate = (-Rs.3,975)

Since NPV is fairly close to zero at 14% value of r, therefore

IRR ≈ 14%

MERITS OF CAPITAL BUDGETING

Merger and acquisition is one of the most important decisions in capital budgeting. This merger is evaluated with two perspectives separately:

  • Exchange rate determination
  • Impact on income per share

Out of these two factors income per share is given more importance.

How will you evaluate a target company?

Only after evaluating the target company’s profitability, the acquiring company finalizes the merger. In Evaluation of a Merger as a Capital Budgeting Decision, the acquiring company requires the following statements.

Financial statement:

This is considered to be the first step after deciding a merger. Both company’s financials are shared with each other.

  • Major customers
  • Interviews
  • Competitive companies

Income statement:

Before a merger, both companies can measure their revenue lines and compile their income statements to calculate their combined profitability. The acquiring company may check the expenses of the merger company in order to see whether they have used the resources in right way.

Balance sheet:

Balance sheet will provide information on lands, equipment, commonly known as assets and financial leverage, known as debts.

Cash flow statement:

After combining statements, necessary adjustments in tax rates, interest rates and expenses are calculated to finally measure the cash flow of this merger.

After go through all these statements and capital budgeting techniques the acquiring firm will decide whether to acquire the target firm or not.

Post Author: Anjana Vaithi

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