Unit-2 Capital Budgeting: Value, Size by Influencing Its Growth, Profitability and Risk
Unit-2 Capital Budgeting: Value, Size by Influencing Its Growth, Profitability and Risk
CAPITAL BUDGETING
Capital Budgeting – An Overview
An efficient allocation of capital (investment) is
the most important finance function in the
modern times.
It involves decisions to commit the business firm’s
funds to the long-term assets.
Such decisions are of considerable importance to
the firm since they tend to determine its
value,
size by influencing its growth, profitability and risk.
The investment decision of a firm on fixed
assets/long-term assets are generally known as the
capital budgeting or capital expenditure decisions.
As capital budgeting decision may be defined as
the firm’s decision to invest its current funds most
efficiently in the long-term assets in anticipation of
an expected flow of benefits over a serious of
years.
The main characteristic of a capital expenditure is
that
the expenditure is incurred at one point of time
whereas benefits of the expenditure are realized at
different points of time in future.
Techniques/methods of Capital Budgeting
At each point of time a business firm has a
number of proposals regarding various projects in
which it can invest funds.
But the funds available with the firm are always
limited and it is not possible to invest funds in all
the proposals at a time.
Hence, it is very essential to select from amongst
the various competing proposals, those which
give the highest benefits.
There are several criteria that have been suggested
by economists, accountants, and others to judge the
worthwhileness of investment projects.
The important investment criteria, classified into two
broad categories:
Non-discounting criteria or traditional techniques:
Payback period
Accounting rate of return
Discounting criteria or time adjusted techniques:
Net present value
Benefit cost ratio or profitability index method
Internal rate of return
Non-discounting criteria or traditional techniques:
Payback period:
The payback period is the length of time required
to recover the initial investment/cash outlay on
the project.
Decision rule:
Accept the project if the actual or computed
payback period is less than the maximum PB
period set by the firm, otherwise the project is
rejected.
In ranking two investment projects, the project
with shorter payback period should be chosen
because it pays for itself more quickly.
A. Payback period with equal cash inflows:
Profit before depreciation and after taxes are known as cash
inflows.
When the project generates constant annual cash inflows, the
following one is the formula to calculate payback period.
PBP = Net investment/Annual cash inflows
For example, XYZ business firm is considering an investment
in project ‘A’. The maximum payback period set by the firm’s
management is 4 years.
Net investment = $12,000
Annual cash inflows = $4000
Estimated life = 5years
Required:- Compute the payback period and give your
decision.
The PBP = $12,000/$4,000 = 3 years
Decision: XYZ business firm should accept the investment in
project ‘A’ because the computed PBP (3 years) is less than
the maximum allowable PBP (4 years).
B:Payback period with unequal cash inflows:
If the expected cash inflows are unequal, the PBP
is calculated by determining the length of requires
for cumulative cash inflows to equal the net
investment.
PBP = Year before recovery + Unrecovered cost at
start of year/Cash flow during the next year.
Case-1: There are two projects ‘x’ and ‘y’. Each
project requires an investment of $56,000. You
are required to rank these projects according to
the pay-back period method form the following
information.
Cash inflows
Year Project ‘X’ Project ‘Y’
1 $14,000 $22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Limitations of payback period method:
Though payback period method is the simplest,
oldest and most frequently used method, it
suffers from the following limitations.
It does not take into account the cash inflows
earned after the payback period and hence the
true profitability of the projects cannot be
correctly assessed.
For example, there are two projects ‘x’ and ‘y’. Each
project requires an investment of $25,000. The cash
inflows from the two projects are as follows:
Year Project ‘X’ Project ‘Y’
1 $5,000 $4,000
2 8,000 6,000
3 12,000 8,000
4 3,000 7,000
5 - 6,000
6 - 4,000
According to the payback method, project ‘x’ is better
because of earlier payback period of 3 years as compared
to 4 years payback period in case of project ‘y’.
But it ignores the earnings after the payback
period.
Project ‘x’ gives only $3,000 of earnings after the
payback period while project ‘y’ gives more
earnings i.e. $10,000 after the payback period.
It may not be appropriate to ignore earnings after
the payback period especially when these are
substantial.
It is a measure of the project’s capital recovery,
not profitability.
Another limitation of this method is that it ignores
the time value of money and does not consider
the magnitude and timing of cash inflows.
It treats all cash flows as equal though they occur
in different periods.
It ignores the fact that cash received today is
more important than the same amount of cash
received after some years.
For example:
Year Annual cash inflows
Project-1 Project-2
1 $10,000 $4,000
2 8,000 6,000
3 7,000 7,000
4 6,000 8,000
5 4,000 10,000
Total $35,000 $35,000
According to the payback method both the projects may be treated
equal as both have the same cash inflows in 5 years.
But in reality project no.1 gives more rapid returns in the initial
years and is better than project no.2.
C. Discounted payback period:
As we discussed above the serious limitation of the
payback period method is that it ignores the time value
of money.
Hence, an improvement over this method can be made
by employing the discounted payback period method.
Under this method, the present values of all cash
outflows and inflows are computed at an appropriate
discount rate,
The present values of all inflows are cumulated in order
of time.
The time period at which the cumulated present values
of cash inflows equals the present value of cash outflows
is known as discounted payback period.
The project which gives a shorter discounted payback
period is accepted.
Case-2: The following information regarding to project ‘A’ and ‘B’ of
XYZ corporation.
Cost of the projects = $56,000
Life of the projects = 5 years
Cost of capital (cut off rate) = 10%
Annual cash inflows of projects are as follows:
Cash inflows
Year Project ‘A’ Project ‘B’
1 $14,000 $22,000
2 16,000 20,000
3 18,000 20,000
4 20,000 14,000
5 25,000 17,000
Total $93,000 $93,000
(or)