Introduction:
Capital budgeting decision are considered to be extremely important of strategic impact, huge amounts involved and irreversibility
A project may be defined as a huge outflow of fund followed by a stream of future inflow.
Steps in capital budgeting
Generation of cash flow
Estimation of discount rate
Selection criteria
Cash flow or accounting profits
Demerits of accounting profit for capital budgeting problems
Affected by non cash items like depreciation
Ignores time value of money
Manipulative
Techniques of Evaluation
Accounting rate of return (ARR)
Accept/Reject: higher the better
A project involves a capital outlay of Rs 1,00,000. PBDIT for 5 years is expected to be Rs 25,000, Rs 30,000 Rs 40,000 Rs 45,000 & Rs 48,000. Corp[orate tax rate is 50% and depreciation on WDV basis is 40%. Find the AROR of the project. (Assume that the entire profit is withdrawn)
Earnings Per Share (EPS)
EPS is one of the major criterion for capital investment appraisal. The value of a firm is maximised if the market price of equity shares are maximised.
Net present value (NPV)
NPV= PV of inflows-PV of outflows
Important points to consider:
Cash outgo
Cash inflow
Discounting rate
Tax rate
Depreciation
Scrap
Carry forward & set off of losses
Subsidy
Use of probabilities
Overhead allocation
Release of working capital
Earnings
Accept/Reject:
NPV>0: Accept
NPV=0: Indifferent
NPV<0: Reject
The projects are mutually exclusive. Life for project A is 4 years & project B is 3 years. Salvage
value NIL for both the projects. Tax Rate 33.99%. Cost of Capital is 15%
Internal rate of return (IRR)
Allows the risk associated with an investment project to be assessed
The IRR is the rate of interest (or discount rate) that makes the net present value = to zero
Accept/Reject:
IRR>cost of capital: Accept
IRR=cost of capital : Indifferent
IRR<cost of capital : Reject
Conflict between NPV and IRR:
For a single project NPV and IRR will give the same accept or reject decision i.e. conflict does not exist.
For two mutually exclusive projects there may be conflict between NPV and IRR.
Cause of conflict- the conflict between NPV and IRR arises mainly on account of the difference in reinvestment assumption. NPV assume reinvestment rate of the intermediate cash flows to be Kc while IRR assume reinvestment to be IRR itself.
Situation in which conflict occurs
Size disparity
Cash flow timing disparity
Profitability index (PI)
Allows a comparison of the costs and benefits of different projects to be assessed and thus allow decision making to be carried out
Accept/Reject:
PI>1: Accept
PI=1: Indifferent
PI<1: Reject
Project
Amount (Rs.)
Profitability Index
1 3,00,000 1.22 2 1,50,000 0.95 3 3,50,000 1.20 4 4,50,000 1.18 5 2,00,000 1.20 6 4,00,000 1.05 Which of the above investments should be undertaken? Assume that projects are indivisible and there is no alternative use of the money allocated for capital budgeting. ) (November 1998)
Pay back period/pay off period/capital recovery period
The length of time taken to repay the initial capital cost
Accept/Reject:
Project with lower pay back period is preferred
One of the limitation of the PBP is that no rate of return can be disclosed. If ROR is required to be computed in the PB situations, compute PB reciprocal as below, which is submitted as ROR:
Discounted pay back period
In Traditional Payback period, the time value of money is not considered. Under discounted payback period, the expected future cash flows are discounted by applying the appropriate rate, i.e., the cost of capital.
Summary
| Particulars | NPV | IRR | BCR | Dis PB |
| Interpretation | It is net addition to the wealth of ESH | It is the rate of return on unrecovered Inv bal. | It is the profitability per unit of funds invested | It is the no. of yrs in which the project pay back the amt invested in it considering TV |
| Discount rate | Ke, Kc,K | NA | Ke, Kc,K | Ke, Kc,K |
| Hurdle/cut off | 0 | Discount rate | 1 | subjective |
| Absolute/relative | Absolute | Relative | Relative | NA |
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