FINANCIAL MANAGEMENT(UNIT -ll)

               Unit-ll  Capital Budgeting  Decisions 

                      Capital budgeting is a company’s formal process used for evaluating potential expenditures or investments that are significant in amount. It involves the decision to invest the current funds for addition, disposition, modification or replacement of fixed assets. The large expenditures include the purchase of fixed assets like land and building, newequipments, rebuilding or replacing existing equipments, research and development, etc. The large amounts spent for these types of projects are known as capital expenditures. Capital Budgeting is a tool for maximizing a company’s future profits since most companies are able to manage only a limited number of large projects at any one time.

                Capital budgeting usually involves calculation of each project’s future accounting profit by period, the cash flow by period, the present value of cash flows after considering time value of money, the number of years it takes for a project’s cash flow to pay back the initial cash investment, an assessment of risk, and various other factors.

FEATURES OF CAPITAL BUDGETING

1) It involves high risk
2) Large profits are estimated
3) Long time period between the initial investments       and estimated returns

CAPITAL BUDGETING PROCESS:

A) Project identification and generation:

The first step towards capital budgeting is to generate a proposal for investments. There could be various reasons for taking up investments in a business. It could be addition of a new product line or expanding the existing one. It could be a proposal to either increase the production or reduce the costs of outputs.

B) Project Screening and Evaluation:

This step mainly involves selecting all correct criteria’s to judge the desirability of a proposal. This has to match the objective of the firm to maximize its market value. The tool of time value of money comes handy in this step.

Also the estimation of the benefits and the costs needs to be done. The total cash inflow and outflow along with the uncertainties and risks associated with the proposal has to be analyzed thoroughly and appropriate provisioning has to be done for the same.

 C) Project Selection:   There is no such defined method for the selection of a proposal for investments as different businesses have different requirements. That is why, the approval of an investment proposal is done based on the selection criteria and screening process which is defined for every firm keeping in mind the objectives of the investment being undertaken.

Once the proposal has been finalized, the different alternatives for raising or acquiring funds have to be explored by the finance team. This is called preparing the capital budget. The average cost of funds has to be reduced. A detailed procedure for periodical reports and tracking the project for the lifetime needs to be streamlined in the initial phase itself. The final approvals are based on profitability, Economic constituents, viability and market conditions.

D) Implementation:

Money is spent and thus proposal is implemented. The different responsibilities like implementing the proposals, completion of the project within the requisite time period and reduction of cost are allotted. The management then takes up the task of monitoring and containing the implementation of the proposals.

E) Performance review:

The final stage of capital budgeting involves comparison of actual results with the standard ones. The unfavorable results are identified and removing the various difficulties of the projects helps for future selection and execution of the proposals.

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             Capital  Budgeting  Techniques/ Methods

Accounting method (Traditional) : 

1. Average(or accounting) rate of return :    It is also known as the return on investment , uses the accounting information as revealed by financial statements, to measure the profitability of an investment.

ARR =Average profit after tax ÷Average investment ×100

Merits :
1.  Simple to understand
2. Easy to operate & compute.
3. Income throughout the project life is considered.
Demerits : 
1. Doesnot consider cash inflows which is more important than profit after tax (PAT) , in project evaluation.
2. Takes a rough average of profits of future years.
3. Ignores time value of money which is important in capital budgeting decision.
2. Pay back period :   It is the period / no.of years in which the project pays back the cost of investment & it is the period taken by the project to return the investment. Pay back period is divided in 2 methods.
1. Even  2. Uneven
Even:  If there are even cash flows the pay back period may be calculated as follows.
     PBP =Cost of the project÷ Annual profit after tax
Uneven :
Step 1 :find cumulative
Step 2 : Identify the no.of full years& the fraction of the year.
Step 3 : Fraction of the year can be calculated by dividing the balance of cost to be recovered by profits after tax of the year multiplied by 12months.

Modern / discounted cash flow techniques :

1. Net present value (NPV) :    The difference between present value of cash in flows & present value of cash outflows / cost of the project is known as net present value. If the net result is either 'zero'/ positive the project will be accepted. If it is negative the project will be rejected. 
Decision criteria :
1. If sum of present value of cash flows after tax is greater than cost of the project then NPV >0 / will be positive( Accept the project)
2. If sum of PVCFAT is equal to cost of the project , then NPV =0 (indifference)
3. If sum of PVCFAT is less than to cost of the project, then NPV<0 (Reject the project)
Internal rate of return (IRR) :  The IRR can be defined as that rate which equates the present value of cash in flows with the present value of cash outflows of an investment. In other words, it is the rate at which the net presnt value of the investment is zero.
Procedure: When there are even cash flows.
Step 1:  Divide the cost of the project by annual cash flows after tax.
Step 2 : Find the value in present value table
Step 3 : The rate corresponds to the value is IRR
IRR is compared with required rate of return(RRR)
      RRR=r     ;  IRR=r*
Decision criteria : 
1. If IRR is greater than RRR (Accept the project)
2. If IRR is less than RRR(Reject the project)
3. If IRR is equal to RRR( indifference)
When there are uneven cashflows :
1. Find fake pay back period .
2. Locate approximate rate in the present value of annuity table.
3. Use trial & error method to calculate IRR.
NOTE :
1. If the project has low cash flows in the initial years & high cash flows in the later years IRR< approximate rate.
2. If the project has high cash flows in the initial years & low cash flows in the later years IRR > approximate rate.
Profitability index :  It is the ratio of present value of cash flows after tax & cost of the project.
             PI = Sum of PVCFAT÷ cost of the project
Decision criteria : 
1. If PI > 1 (project accepted)
2. If PI < 1 ( Reject the project ) 
3. If PI =0 (indifference)
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              Risk analysis in capital budgeting
               Investment decisions are made on the basis of forecasts which depend on future events whose occurance cannot be anticipated with absolute certainity. So ,risk also varies from one investment proposal to another investment proposal. Some investment proposals may not involve any risk, example : Investment in government securities which assures a fixed return. Some may be less risky, example : Expansion of the existing business whereas some may be more risky, example : Starting a new business venture etc.
           Various techniques are used  to measure risks and uncertainity to assist the management to assess the expected impact of an investment decision on the firms profitability . Riskiness of an investment proposal can be judged from the variability of its returns.Example : Investment in government securities is risk free as compared to investment in shares of company's. Hence, the term 'risk' with reference to capital budgeting decisions may be defined as the variability i.e., likely to occur in future between estimated & actual returns. The greater is the variability between the two , the more risky is the project & vice- versa.
  
Techniques / methods of measuring risk :
Non statistical  method :
1.  Risk - adjusted discount rate
2. Certainty equivalent method
Statistical  Method :
1.Range
2. Standard deviation
3. Co-efficient of variation
4. Probability

Non statistical method : 
1. Risk adjusted discount rate :  RADR assumes that investors expect a higher rate of return on risky projects as compared to less risky projects. It is the discount rate which is used to convert future cash inflows into present value.
RADR =Risk-free interest rate + Risk premium
(a) Risk - free rate is the rate at which future cashflows should be discounted if there is no risk.
(b) Risk premium is the extra return expected over the free rate on a/c of project being risky. This method is used in discounted cash flow techniques.
Merits :
1.  It is easy to understand & very simple to calculated.
2. It gives some premium for the risk.
Demerits :
1. It is difficult to calculate the RADR as there is no proper method.
2. It doesnot may use of information from probability distribution.
3. Risk premium is assigned on the basis of subjective judgement.

2. Certainty equivalent co- efficient method :  It is a risk incorporation technique which adjust the expected cashflows instead of adjusting the discount rate. The estimated cashflows are reduced to certain amount by applying a correction factor known as 'certainty eqivalent co- efficient. This correction factor is the ratio of riskless cashflows & risky cash flows.
(a) Riskless cashflows are the cashflows , which the management is prepared to accept in case there is no risk involved.
(b) The co- efficient assumes that the value between 'zero' & '1'.
(c) The cashflows are adjusted by multiplying estimated cash flows with certainty equivalent co- efficient.
(c) A discount rate is equal to the riskless rate is used to calculate present value of adjusted cashflows.
Merits :
1. It is simple to understand & easy to calculate .
2. It is superior to risk adjusted discount rate because it doesnot consider that the risk increases with increase in time.
Demerits :
1. It is difficult to consider increasing risk capacity.
2. It is difficult to allocate certainty equivalent co-efficient.

Statistical method : 

1. Range :   It means difference between maximum value of net present value & minimum value of net present value. If range is high risk also increases.

2. Standard deviation :   It may be defined as sum of square deviation of mean value multiplied by the respective probabilities. In case of capital budgeting , it is measured & is used to compare its variability of possible cashflows of different projects from their respective mean / expected value. Project having a large standard will be more when compared to a project having a smaller deviation.

3. Co- efficient of variation :  Standard deviation method is helpful & measuring risk when cashflows of evaluating projects are equal..When there are 4 projects A,B,C & D whose investment is rs.1 lakh for each project SD is suitable. If projects A,B,C,& D requiring 50,000 ; 75,000 ; 1,00,000 ; 125000 investment . SD is not  suitable ,as cash flows are not equal. When projects cashflows differ from each other co-efficient of variation is a suitable technique to measure risk & to take right decision.
Co-efficient of variation = Standard deviatiin÷Mean

4. Probability :     Probability is the likelyhood of happening of an event . It is the percentage chance of occurance of each possible events or cashflows. The chance of occurance if any event lies between '0 &1 ' .