4 CAPITAL BUDGETING (GENERAL PRINCIPLES) Capital budgeting is concerned with long-term capita: expenditure decision- making, It can rightly be termed as perspective or long-term planning of capital expen- diture on new or on-going projects; the benefit of which would accrue to the firm for a number of years in future, It is virtually a mutli-sided process for planning and appraising proposals for heavy expenditure before implementing them. “It includes searching for new and more profitable investment proposals, investigating, engineering and marketing considerations to predict the consequences of accepting the investment and making economic analysis to determine the profit potential of each investmen proposal.” Thus, the important point to note is that capital budgeting is an exercise for fut and can be called a cost benefit analysis for prospective capital expenditure pt Itis related to the process of analysing alternative proposals for deployment of availab capital funds for carrying out some long-term projects involving creation or acquisiti of long-term or fixed assets which will result in increased profitability of the organisatit in future. In this way capital budgeting refers to the overall process of gener: evaluating, selecting and following up of capital expenditure alternatives. In other wor “It is the firm's formal process for acquisition and investment of capital. ‘The two terms ‘capital’ and ‘budgeting’ indicate budgeting of capital expenditure Budgeting stands for careful and well-thought out planning which interpolates ret or benefits expected to accrue to the firm; and then comparing them with initial subsequent outlays of capital. The process enables the management to select the be alternative out of a number of available alternative proposals under consideration. best alternative so selected is one which maximises the net present value of the ‘The gross present value (discounted at an appropriate rate of return) of future cashflo estimated to accrue from a particular capital expenditure proposal, are compared the present value of initial and subsequent outlays of capital funds and as a result t net present value is found out which provides meaningful clues for capital i decision. ; Apart from discounted cashflow methods,° there are other methods which used for capital expenditure decision-making; such as the pay-back period method. the accounting rate of return method or the internal rate of return method ete. will be discussed and explained in the next chapter. The main purpose of this ch is to present an overview of the concept of capital budgeting, Before going into the techniques of capital budgeting it seems more appropria to understand the various facets of capital budgeting as a decision-making proc 1 Bierman, Capital Budgening Second Edition, p. 5. 2 Hampton John J., Financial Decision Making p. 245 3 Also called the Present Value Methods @ scanned with OKEN Scanner42 | FINANCIAL MANAGEMENT Apart from its meaning there are other aspects, such as the role of capital budgeting as a tool of investment-criteria, various types of capital expenditure projects and the Process of capital budgeting, Knowledge of all these aspects is essential before stepping ¥up to understand the application part of capital budgeting. Moreover difficulties in Proper appraisal types of cashflows and their precise and correct estimates are some er hurdles confronted while arriving at appropriate capital budgeting decisions. ROLE OF CAPITAL BUDGETING _ It should be remembered that capital-budgeting is different from current or periodical budgeting. Capital budgeting is concerned with heavy capital expenditure decisions which are expected to give returns or benefits for many years in future. On the contrary, current or operating budgets are prepared for the next one year and are more concerned with short-term allocations and accruals of funds committed to current assets management. Thus, long-term nature of commitment of funds in fixed assets makes capital budgeting decisions more complex, requiring proper planning, forecasting and appraisal-Long-term commitment of funds can not be made at will or according to one’s own whims. Looking to the crucial and criti thorough planning and utmost care is needed before sanction for making any cay expenditure is actually accorded. The crucial role of capital budgeting or lon investment decisions can be discussed on the basis of the following points : — 1. Large Size of Funds ‘ja The decisions are concerned with investment of huge creation of fixed assets or for implementing certain big projects. It a business concern capital funds arc not only scarce or limited, but a uses. It is, therefore, essential that heavy capital funds should be inve profitable alternative after a thorough appraisal. 2, Crucial Nature Capital investment decisions for long-term commitment of funds crucial in nature, because they arc likely to improve upon the past p of the company through higher rates of returns on ca of the company in the eyes of the existing and prospective shareh This creates a favourable change in the market evaluation of the firm hand, hurried capital budgeting decisions without proper planning invite disaster to the firms. 3. Irreversibility Capital investment once made cannot be reversed casily and firm in financial terms. Short-term investments in current assets sooner or later depending on the time span of the operating cycl fixed assets cannot be realised back, because old and used plants and equ very low resale value; nor can such assets be put to some other pr uses within the organisation. Irreversibility is important in case a decision already made and implemented, later on proves to be profitable. 4. Long Time-span Capital budgeting is an exercise in distant future which is u be predicted precisely. Expectations and estimates made may no implementation of a project. Uncertainty increases the element minimised only when long-term investment proposals are thoroug and techniques of capital budgeting. Unwise the wrong capital b put to peril the very servival of the firm and spoil its image in JC series of such wroug decisions may ultimately bring even verge of liquidation @ scanned with OKEN ScannerCAPITAL BUDGETING | 43 ¢, Impact on Cost-structure Acquisition and installation of costly plants and equipment involves certain opera tional costs (apart from the initial capital cost) which are of a fixed nature; such as interest charges, supervision costs, property insurance costs, rent of premises and other fixed overhead costs. In case of unplanned and wrong capital budgeting decision, the burden of these fixed costs may be too heavy and may not be covered partly or even fully by the meagre income generated by such additional investment. Difficulties Capital budgeting decisions are very complicated and difficult in nature, which require broad vision, foresight and correct forecast of uncertain future course of events and changes. An accurate estimate of future cashflows related to a particular project may not always be possible. To ascertain the number of years during which a machine or any other fixed asset will prove economically useful or to make a correct estimate ofits salvage (scrap) value after its economic life is over may simply be mere guestimates. Expenditure on fixed assets creates problem of proper maintenance, depreciation and replacement, Major maintenance and repair expenditure from time to time results in substantial cash outflows. An appropriate amount is also charged to the annual profits, by way of depreciation in a manner so as to write-off the cost of an asset during its life span — leaving only its salvage valuc. All these considerations have to be foreseen while making capital budgeting decision. This makes the entire exercise still more complex. Thus it is now clear that capital budgeting decisions occupy a crucial place in corporate planning; because the very growth of the firm rests on the accuracy and quality of such decisions. These decisions enable the company to match productive facilities with budgeted sales targets and are helpful in long-term planning, forecasting and price policy formulation. They are also essential for cash-forecasting and cash- budgeting and helpful in adopting a suitable and stable depreciation and replacement policy. ‘Types of Capital Investment Projects ital investment projects are of varying type and nature. There is a varicty of capital investment proposals which necessitates their proper classification. They differ widely in size of investment, time-span of commitment ‘of funds and the extent and pattern of their cashflows. Based according to their purpose, the various types of capital expenditure projects can be classified as follows : “ = 1. Expansion Projects b 2 f Firms usually are faced with increasing demand for their output which cannot be met by their existing installed capacity. Thus they have to take a decision for their installed capacity. Expansion involves huge capital expenditure, Need of addi capital for expansion has to be quantified. The sources for mobilising funds have to be identified. TI sources may be partly! Gite apie isi depends on a satisfactory comparative analysis of the total present value of cash-outflaws and the total present vaiue of cash-inflows from the project . This has been further elaborated in the next chapters fare tos 2, Replacement Projects i The economic life of every mad becomes wornout, or obsolete (witht the wear and tear of the asset is ch only the written down value of the depreciation reserv least partly) to finance the p the absence of such an arrange 3. Modernisation Projects Alongwith the consi technology every now: @ scanned with OKEN Scanner44 | FINANCIAL MANAGEMENT for the very existence of the firm; otherwise it may become outdated and may not be im a Position to face competing forces in the industry. Modernisation programmes Fequire heavy capital expenditure for which proper capital budgeting decisions have to be taken. 4. Diversification Projects ___ In these days of dynamic business world, firms or corporations ¢ single line production activity. They have to diversify by taking up mani Products which may involve installation of new plant or plants. The process may . involve introduction of suitable changes in the production and sales organisation. All this needs capital funds and thus project planning and capital budgeting automatically come in the way of decision-making, 5. Market Surveys and Sales Campaigns Manufacturing firms are always on the look out for new markets. They try to find new areas where they can sell their products. With this end in view, market surveys have to be conducted followed by advertisement and sales campaigns requiring heavy capital expenditure. 6. Production Research and Development F This requires setting up of research labs and availing of the services of scientists and technologists which may result in substantial capital outflows. The resultant cash- inflows (benefits) from R & D projects cannot be estimated precisely or directly; partly because such benefits may be abstract in nature and partly because they may accrue in distant future, 7. Miscellaneous Projects In this category may be included many other projects which have not been covered by the above classification. Construction of captive power plants (to meet with frequent power-cuts or breakdowns), anti-pollution treatment plants (under Water and Air Pollution Control Acts) arc a few examples under this category. These projects, although not directly concerned with the basic objectives of the firm, may be implemented cither under compulsion or as a statutory obligation to be fulfilled by large manufacturing units. -annot bank on a ufacture of new INDEPENDENT VS. MUTUALLY EXCLUSIVE PROJECTS Out of a number of capital investment proposals or projects the firm has to select those projects which may seem to be profitable, that is to say that those projects which satisfy the firm's select-reject criteria are selected for being implemented. At this stage, itis important to distinguish between projects which are ‘independent’ and those which are ‘mutually exclusive Independent projects are those projects which do not compete with one another in such a way that the selection of one project does not come in the way of selection of other projects. For example, ifa firm has under consideration the following projects. installing an additional plant in the existing unit, setting up of a new unit in nearby town, construction of a commercial complex and starting production of a new product so 20 to meet its growing demand in the market. All the above-mentioned projects satisly the selection-rejection criteria ofthe firm and these projects do not clash with one another, Lethe acceptance of one of them does not exclude the acceptance of other projects ‘These projects, therefore, arc independent projects. As all of them satisty the Pens ‘accept-rsject criteria’ the firm can select all such projects, provided the haarend resources at the disposal ofthe firm so allow. Matually exclusive capital investment projects compete with one another in such a way that the acceptance of one excludes the acceptance of ather projects: even i a the projects under consideration satisfy the firm's ‘accept-reject criteria: Inwike viene it can be said that out of a sumber of viable or profitable mutually exclusive projects only one project can be accepted. Naturally, the choice wil fll on the most prohable projec from amongst the available projects: Suppose the existing plam inte be solaned @ scanned with OKEN ScannerCAPTTAL BUDGET by amore expensive modern plant, In the market four different are available at different costs and with varying production eapacit only one plant which may prove most profitable (| value of the res akes of such a plant Tn such a situation seal on its initial cost and the present ultant expected future cash-intlows) will be accepted and this will exclude the acceptance of other three plants (even if they satisfy the firm's accept- criteria), In such a situation although Net Present Values of all the projects may be positive. Yet the project with the highest Net-V'resent Value will have to be accepted Capital Rationing and Investment Decisions In case a business firm had the advantage of haying uni capital investment decisions would have been an easy process, Such a firm could accept all independent capital investment projects which satisfied its ct criteria, In other words, it can be said that all independent projects which © net present value (discounted at a pre-determined rate of return) would have been accepted by such a firm. In fact, such a situation can be called an ideal one, beeause it would certainly maximise the wealth of the owners. However, in actual practice, business firms are not so lucky. Most of them are constrained by a limited size of investible funds, either duc to external factors or on account of internal management policies. Thus, the firm has to select the more profitable projects out of a number of acceptable projects and leave other projects even though they may be profitable (with positive net present value or with an internal rate of return higher than the cost of capital of the firm). =}, Capital rationing thus indicates a situation in which the firm has under its con- sideration more acceptable investment proposals which require greater amount of funds than are available with the firm.,In such a situation the available investment proposals have to be ranked accordin firm's accept-reject criteria, First, those projects which show the highest profitability are selected, The ranking of proposals is in a descending order and thus the process of selection of proposals according to their degree of profitability goes on till the allocated capital expenditure budget allows it. © Suppose a firm has at its disposal a sum of Rs. 30,00,000 for capital expenditure. Out of many available capital expenditure proposals the management has ranked the following six projects (A, B, C, D, E, F) in order of their profitability. The outlays and Profitability Index (P.1.) ' of each project are given below. All the six projects are independent, that is, they are not mutually exclusive, Ranking of the Six Acceptable Projects Capital Outlay Profital Ranking Ind 10,00,000 1.20 Vv 20,00,000 1.20 Ml 15,00,000 1.30 u 5,00,000 115 4,00,000 1.25 um 1,00,000 1.40 i ity, the management will have to select project F, C, E and outlay of Rs. 30,00,000. This will exhaust the total allocated. “ith the result that the firm will have to forego profitable by projects D and B simply because tis facing 2 ital rationing, The above example shows ranking of acceptable projects fo A italy index. Such ranking may also be based on a comparison Internal Rate of Return (IRR) with the average cost of capital of the firm. The oncept of IRR has been explained in detail in the next chapter ex (P.L) ts computed by divwding the gross present value of future cashflows frm next chapter. ihflows, from @ scanned with OKEN ScannerOrn A Ae | FINANCIAL MANAGEMENT / p Irivetple? Haltattal, REE “In this way it can be concluded that capital a rationing are ee optimal because they ie in the way of maximisation of one wealth, In case the firm (as referred to above) can arrange additional finance amc ing to Rs. 25,00,000, it can select projects D and B also, As these two projects also sYow 4 profitability index of more than one they can indicate a positive Net Present Value (NPV) which can certainly result in further maximising the owners’ wealth. h ba fp veo AA) OOP OU oie ae are bi ‘ Sone ee of Ea, expenditure decisions under capital DS Heavy capital investment projects involve immediate substantial cash-cualhe (costs) with the expectation that regular cash-inflows (benefits) will occur for aoumber of years in future. The decision is based on comparison of initial c future ate, i 'As the investments involve outlays of cash, the benefits (00, have to be measured Uhrough cashflows and not the accounting profits, Thus, ats ine eter al expenditure project in contrast to The pattern of cashflows may be conventional or non-conventional, In the case of conventional cashflows, ‘or example, an investment project invol 1 capital outlay of Rs. 2,50,000 at zero time period. The useful economic life of the project is 10 years with zero salvage value at the end of the period. The investment is expected to result in an annual cash-inflow of Rs. 60,000 at the end of each year for the next 10 years. The pattern can be shown diagrammatically as follows : CONVENTIONAL CASHFLOW PATTERN CASH-INFLOWS (Rupees) CASH-OUTFLOWS (Rupees) O__.2,50,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 60,000 i Non-conventional Cashflows In the conventional pattern, @ scanned with OKEN Scannerpronttnrg ¢-> Tromlehaiing ( v CAPITAL BUDGETING | 47 sject).alongwith the he a project)! heavy initial cas fof course, Tallowed by a series of even considering purchai h outlay at zero time period. The investment is, we or uneven cash-inflows, The example, a firm is rei nie Hie span at ieee machine costing Rs. 10,0000. The machine bas a total ceo L000 at the ead eet Tbe investment will result in an annual cash-inflow of Re ool Sth year the cegeatch Year tll the economic life of the machine. However, a aoe of Sh seal emachine vil need thorough overhauling which is expected to cos 3,000, ‘in example of a non-conventional cashflow pate be depicted well with the help of the folowing ition: ance ae NON-CONVENTIONAL CASI OW PATTE! SS er eee r ERN SH-INFLOWS (Rupees) CASH-OUTFLOWS (Rupees) —- 10,00,000 2,50,000 2,50,000 50,000 50,000 2,50,000 5 2,50,000 6 2,50,000 7 2,50,000 8 9 0 —- 2,00,000 2,50,000 2,50,000 The investment decision will depend on a comparison of preset discount rate) of cash-outflows and cash-inflows occurring at d explained in detail in the next chapter under techniques of cay Initial Outlays or Cash-outflows: Cash-outflow refers to initial investments on a capital ey project, It includes the cost of the new project plus installa machine. As the outlays relate to zero time period (in most case: involved can be assessed easily. In some cases expenses (relatin plant or substantial replacements of the plant) have to be inci future outflows pertaining to the project are treated project have to be discounted back (at the required rate of return) so as tof values (at zero time period) for being added to the initial out ‘© Incase a proposal implies replacement of an existing mach then the sale proceeds of the old plant (net after tax low at zero time period and are deducted fror ‘ain the net initial outflow of cash, » 7 increase in working capital (current assets mint riod (if any) is also, added, to the initial outlay. 1 capital expenditure projects involve some increase in for the additional requirements for day-to-day © work-in-progress, finished goods etc.) and of a new plant may minimise the need for elliciency and waste control), Such a dect time period is to be treated.as a ci I is to be remembered tl @ scanned with OKEN Scanner48 | FINANCIAL MANAGEMENT Annual Cash-inflows , These are also called ‘annual operating These represeat the cstamated future benefits from the project and are different from ‘net profit’ or ‘nct-sscome = already explained, Contrary to cash-outflows, accurate estimation of ature ansssal ost inflows from a project is a difficult exercise; because of the rick and uncertamnty im feture YeatsqThe assumptions made carlier for computing future cash-mflows sy D° belied ‘on account of certain changes or events that may take place in the economic and socal environment, It must, therefore, 8 pointed © c : consideration will depend to a lar; connected future cash-inflows from Annual cash-inflows are computed strictly oa cash Thus, in order to find out annual cash- inflows from a project, Rom as depreciation) are added back to after tax, As dep expenditure (allowed according to tax-laws) to be deducted from income before com puting the taxable income, the amount of such depreciation in a part is added back to the amount of net profit after tax and this gives the amount of cash-sflow for that particular year4In this way, estimates of cash-inflows of furure years cam be made by ascertaining accounting profit (excess of total income over total aes depreciation) deducting the tax payable on such accounting profit am the amount of depreciation pertaining to those years. One point deserves special mention at this stage. For various methods! of depreciation arc in vogus and this va tion provision does affect the size of tax lability and in its turn, The point has been claborated below in a separate paragrap The |two items|which need special treatment in the ter are ‘the salvage-value’ and ;the release or recovery of working the residual estimate of the scrap- ‘useful economic life, Hence, itis to be treated as a casb-inflo year of the project, It has already been explained that the recovered or released in the terminal year of the project ist the year of such recovery. Impact of Depreciation in Cashflows ‘The particular method of depreciation adopted by a fi impact on the size of tax liability of a firm. Depreciation is the period income of a firm which implies that the income b extent of the amount of depreciation provisions This in tur of the firm and at the same time increases the total cashl it can be said that lower depreciation charge will result consequently lower cash-inflow., ee Tt is a well-known fact that every asset has a limit after which the asset becomes either totally or substantially: of useful economic life differs from asset to asset, based 9 and economic obsolescence,.Depreciation accounting is a rite off the entire cost of the asset during its useful econ should be charged in each accounting period by reference’ amount (initial or historical cost minus the salvage or scrap tive of an increase in the market value of the asset. It is depreciation once adopted should be applied con TT ee eee 7 One of the 10 Accounting Standards laid down by Instirute relate to depreciation accounting. It stipulates that according depreciation should either be based on the reds ‘or on the corresponding straight tine criginal cost over the specified period. @ scanned with OKEN ScannerCAPITAL BUDGETING | 49 ability of the result of operations of the enterprise from period to period. ' aheady been made lear that according ae dep ther hel * = 5 I budgeting decisions, whal is more significant isto ascertain, the impact of a particular method of depreciation on the size of ‘cash-inflows ‘of a firm. “athe indian content wo methods which arin opt ar () the straight fine method,’ . and (ii) nethod. D = Amount of annual depreciation C = Historical or original cost of the asset Salvage or scrap value of the asset, in the terminal year n= Number of years of the useful economic life— span of the asset. In case the salvage value of the asset is zero, then the straight line depreciation can be ascertained by diving the orginal cost by the mumber of usefil if ofthe ase in years. Thus : 5 — Original Cost pasa ~ No. of years of Economic Life depreciation a Hence, according to this method depreciation cach yes Gi) Te Dectning Batonce Method This comes under accelerated method of depreciation’ tionately higher amounts of depreciation : youth tha adopted s a take into account this characteristic productivit Ee oul be cae way of According to declining balance method a vogue in India specify that a change in the method of depreciation should be considered as 4 change in accounting policy and the same should be disclosed accoruingly sn the financial statements. Along wth disclosure of other accounting policies the depreciation method used. the total amount of depreciation for each class of assets, the gross amount of each class of depreciable assets and the related accumulated depreciation should be disclosed in annual Gnancial statements d @ scanned with OKEN ScannerS| FINANCIAL MANAGEMENT According to the straight line met Example 4.1 f ’A firm purchases a plant costing, Rs. 1,00,000,, The plant has a useful economic life of 10 years with no salvage value at the end. Prepare a statement showing the annual accounts of depreci n according to (i) Straight Line Method, and (ii) The Declining Balance Method. Solution ‘The rate of depreciation according to Straight Line Method can be computed as follows [ sv 10 = 1/10th or 10% of the origi 7 bs ‘The rate of depreciation under the can be ascertain fained the rates of depreciation it is now easy to prepare the & ;nnual amount of depreciation under the two me Having ascert parative statement (0 show th Comparative Statement Showing Depreciation Charge (Rup ‘Straight Line Method ‘Declining Balance Method Book Value ‘Annual Book Value Annual Year Depreciation @ Depreciation 10% of original 20%, on writ _cost down value 0 1,00,000 - 1,00,000 1 90,000 10,000 80,000 2 80,000, 10,000 64,000 3 70,000 10,000 51,200 4 60,000 10,000 40,960 5 50,000 10,000 32,768 6 40,000 10,000 26,214 U 30,000 | 10,000 20971 c 7 20,00 10,000 16,777 9 10,000 13,422 Ww 10,000___|___10,738 fe 1,00,000 =o @ scanned with OKEN ScannerCAPITAL BUDGETING | st Sit is to be noted that at the end of 10th year the (otal accumulated depreciati equals the orginal cost under the straight fine method, However, under the Declining Balance Method, the total accumulated depreciation amounts to only Rs. 89,262 and thus the asset has a written down value (or book value) or Rs. 10,738 at the end of 10th year. The usual practice is either to continue the asset al this value tll tis disposed of, ~or to continue to provide depreciation (@ 20% in the above example on W.D.V.) even after the expiry of the terminal period till the entire cost of the asset is written off. Towards the close of the useful economic life period, it has been observed that some companies opt to switch over to Straight Line Method for depreciating the remaining coat of that asset. Nevertheless, such a change in the method of providing depreciation has to be disclosed inthe annual financial statements. , Tn the above discussion regarding the provision of depreciation only two methods, ie, the Straight Line Method and the Declining Balance Method, have been explained because these two methods are allowed in India under the existing laws, However, for jhe sake of conceptual knowledge, it will be appropriate to throw some light on another method of depreciation, usually known as ‘Sum of the Digits Method of Depreciation’. Sumi of the Digits Method of Depreciation Under this method the rate of depreciation is a fraction in which the numerator is the unexpired period in years of the useful life of the asset and the denominator is. ihe sum of the number of the various years of the useful life of the asset. ‘Taking data from example 4.1, the unexpired period (numerator) at the year-end is 10 at the end of year one, 9 (101) at the end of year two, 8 (10—2) at the end of year three and four and so on. The sum of the digits (denominator) is 55— (1 + 2 + P44 +5 +6 +7 +8 + 9-+ 10), The method can be illustrated as follows + Sum of the Digits Method of Depreciation Year Rate 7 Written Down Value | Amount of Depreciation Rs. Rs. 0 - 1,00,000 a 1 10/55 81,818 18,182 2 9/55 65,454 16,364 3 8/55 50,909 14,545 4 55 38,181 12,727 5 6/55 21,293 10,909 6 5/55 18,182 9,091 7 4/55 10,909 1288 8 3/55 5,454 5,455 9 2/55 1,818 3,636 10 4/55 Zero 1,818 Total Rs. 1,00,000 Sum of the Digits Method of Depreciation has ¢ so.far as Indian ta laws are concerned, However, itis allowed in some of the Western countries: This meth en ccimes under the category of accelerated methods of eiregations Te most important point to observe is that according to this metho third ofthe asset is written-off as depreciation during the firs in line with the contention that an asset @ scanned with OKEN ScannerSi | MINANCIAL MANAGEMENT As already explained, larger amounts by way of depreciation charge re redlucing Lay liability and) thus increasing the size of cash-fows after significant point so Lar as capital budgeting decisions are concer cash-llows in initial years have more present values rather tha cash-flows in subsequent years. This aspect has been dealt with i next chapter ’ is ver ned, because higher n that of equivalent in greater detail in the QUESTIONS AND PROBLEMS 1 What is capital budgeting and what 18 ats role in investment decision-making, ? Discuss the various types of capital investment projects. How will expansion project and a replacement project? you differentiate between an 3 How are decisions taken under capital-ravioning ? Should such decisions be based strictly on the ranking of profitable investment proposals.” 4. Chucally examine the difference between independent projects and. mutuall ly exclusive projects, Give a few examples of mutually exclusive projects. 5 What is the difference between conventional and non-conventional cash-flows and what is their relevance 1n capital budgeting decisions, 6 Discuss the process of estimatin Proposal under consideration, What is the impact of depreci help of an example. 1g the cash-outflows and cash-inflows connected with an investment on the cashflows from a project ? Musrate it with the 8. What's the ilference between straight line method and declining balance method of deprecation 7 Which method is more rational in your opinion and why ? The cvst of @ plant including installation charges is Rs. 20,00,000, ‘The plant is expected to hi useful economic life of six years; after which it will have a salvage value of Rs. 2,00,000. Compute the annual depreciation charge for the plant as based on the straight line methy 10 Explain by taking an example, the sum of the digits method of depreciation, What is its releva tm the Indian context ? Should it be allowed under our tax laws ? Critically examine. 11 The Sunrise Paterprises Ltd.,is intending (0 purchase a new machine which will cost Rs. 5,00,00 and will replace the existing” machine. ‘The old machine has a book value of Rs. 2,00,000 if sold in the market, 1 wall fetch an amount equal to its book value. Either of the two machit will provide uscful service for five years from now with zero written down value at the end five years penod. Deasion 10 instal the new machine will reduce the raw material wastage to the extent of 70,000. The company will be entitled to an investment allowance of RS. 30,000. Tax rate the company 1s 30 per cent. You are required to compute the annual after-tax cashflow fF the new plant 12. Why should cash-flows and not the accounting profits be taken into consideration while estimat the benefits {rom a capital expenditure project ? 13. How should changes in working capital consequent to the acceptance of a project be treat while analysing & capi 14. Discuss the tax imphicat I expenditure project ? Wn connected with the replacement proposals of fixed assets IS. A company 1s considering the following five projects for capital expenditure. The investible apailable with the company ts only Re 300000 on which a espets-a before tax return of per cent, sf snvested. The details of the projects are as under : Estimated Savings Percentage Renum on pe Tax Investment (Before Tax) ri 70.000 20 b 18.000 4 c 16,000 16 D 50,000 40 ! 36,000 at Assuming a tax rate of 50 per cent for the company suggest the best course of invest Uceision which the company should adopt under the capital rationing situation. 16 A company purchased a machine some time back for Rs. 30,000. Now a decision 10 re the oly machine by a new machine 1s under consideration. The cost of the new mi he Is 45.000 The written down value of the old muchine is Rs. 18,000, @ scanned with OKEN ScannerCAPITAL BUDGETING | 58 ‘Assuming an income-tax rate of $0% for the company, calewlate the net initial outflow of cash Pa decision to replace the old machine is taken and in each of the following, sale. proceeds from the old machine wil be (a) Rs. 18.000, (b) Rs. 24,000. (c) Rs. 36,000, and (d) Re 12,00 [Explain the importance of proper planning and control of capital expenditure and indicate the main factors 10 be considered in investment decisions Wate bref ential notes on the following : {a) Accelerated depreciation methods {(@) Independent and mutually exclusive investment projects {€) Conventional and Non-conventional cash-flows (@) Capital rationing ‘A plastic container manufacturing company is contemplating to purchase a new plant which wil cost Rs. $0,000. The useful economic life of the plant will be five years with zero salvage value at the end, The company hopes 10 sell 25,000 containers every year at a. price of Rs, 10 each. ‘An increase of RS. 10,000 by way of working capital would be required initially. Assuming income tax-rate of 50 per cent for the company, determine the cash-flows after tax under (a) Straight line depreciation, and (b) Double declining balance depreciation. What are the components of net cash outlay in the process of eapital budgeting, decision making? At what time such an outlay is incurred in case of conventional cashflows 7 @ scanned with OKEN Scanner5 TECHNIQUES OF CAPITAL BUDGETING Inthe preceding chapter, an effort was made to present an overview of the concept of capital budgeting. This chapter deals with the tools or techniques of capital budgeting. It discusses the various criteria which form the basis for capital budgeting, decisions. While investing capital funds, the management is faced with the difficult issue of selecting the best alternative out of so many alternatives which may be under consideration. Capital budgeting techniques provide meaningful guidelines to the management in search for the best (or at least the optimum) alternative, Normally, the following four techniques of capital budgeting are used for appraisal of long-term capital investment proposals. These techniques are : 1. Payback Period Method 2. Average Rate of Return Method 3. Present Value Method or Discounted Cash Flow Technique 4. Internal Rate of Return Methad . It would be appropriate to discuss in the following pages cach of the above methods or techniques in detail. 1. PAYBACK PERIOD METHOD This method measures the time-span during which the generated future cashflows from an investment proposal will be equal to the initial investment of capital funds How many years will be needed to recover the capital outlay made for a project ? Payback period method virtually provides an answer to this question. In other words, it can be said that the Payback Period Technique of capital budgeting ascertains the time duration required for the project o repay ar payback the initial investment, Payback _ Period is computed by dividing the initial capital invested in the project by the annual _ cashflows. It can be expressed as follows : } NI | Payback Perio (where: ‘NP represents initial investment, and ‘OS’ stands for operating saving or cashflows) Example 5. | Outlay on a project is Rs. 1,00,000, The annual cashflow is estimated to be Rs. 20,000. Find out the payback p Solution Payback Period = ~~ @ scanned with OKEN ScannerTECIINIQUES OF CAPITAL BUDGETING | 55 Gut of a number of proposals for capital investment the best prop determined on the basis of its payback period. The project or proposal with the shortest y-back is usually selected for investment, because it will bring back the committed funds for being recycled in other better viable investment opportunities. Example 5.2 given below will make it more clear. fesample 5.2 ‘A’, B’ and °C’ are three different projects. Initial outlay required for investment will be Rs. 1,25,000 in each case. Annual cashllow is estimated to be Rs. 25,000 from each project. The economic life span of project ‘A’ is 10 years, of project ‘B’ is 15 years, and of project °C’ is 25 yea ee You are required to find out the payback period of each project and rank them in order of preference. Solution Particulars al PROJECTS | &@ B c 1. Initial Investment (Rs.) | 1,25,000 ; —1,25,000 1,25,000 2. Annual Cashflow (Rs.) | 25,000 25,000 25,000 3. Payback Period (Years) 5 5 5 4. Economic Life Span (Years) 10 15 5 5, Post-Payback profits or cashflows | (Rs.) 1.25000 | 2,50,000 5,00,000, Third __|_Second First 6. Ranking Tn the above example net investment annual cashflows and payback periods are equal in case of all the three projects; yet their ranking is diferent. This is becatae of Giference in their economic life spans which generate higher post-payback cashflows or profits to some project. Post-payback profits ean be. found out_by deducting net investment from total cashflows. ‘Thus post-payback profits will be Project ‘A’ = Rs. (10 x 25,000) ~ 1,25,000 = 1,25,000 Project ‘B’ = Rs. 15 X 25,000 = (3,75,000 = 1,25,000) = 2,50,000 Project ‘C’ = Rs. 25 x 25,000 = (6,25,000 = 1,25,000) = $,00,000. ‘ence will hold good only when the time factor is not a constraint and no risk is forescen in investments for longer periodgln cases where tim: factor is a constraint and the funds arc needed for being recycl into other bett opportunities or where the distant future is uncertain and the risk unvolved cannot be predicted precisely, the above order of preference wall have Lo Be reversed. , Example 8.3 : ‘The management ofa firmis considering purchase ofa new machine. Two machines ‘A* and ‘B' are available in the market costing Rs. 1,00,000.in each case, Both the machines will have an economic life of 10 years, Salvage value at the end of economic life will be zero in each case. Estimated annual net profit (after tax) will be Rs. 15,000 for Machine °A’ and Rs. 10,000 for Machine ‘B". Provision for depreciation is to be made on straight line method for both the machines. Find out payback period for machine ‘A’ and machine ‘B" and suggest which machine will be more desirable, Solution The above order of prefer Payback Period -Net-investmentill Net Investment back Period = yal Cashflow Net Profit + Depreciation @ scanned with OKEN Scanner56 | FINANCIAL MANAGEMENT Machine A = ——1:00,000__ 1,00,000 — + 15,000 + 10,000 ~ 25,000 =4 Years 100,000 1,00,000 » p= ——1:00,000___ 1,00,000 Machine B= Ta + 10,000 ~ 20,000 = 5 Years Wis clear that out of the two machines, the better choice will be to purchase machine ‘A’ because its payback period is less as compared to machine ‘B’. Working Note: Depreciatior Net Investment __ 1,00,000 Feonomic Life in Years 10 = Rs, 10,000 for both the machines Example 5.4 A proposal to purchase a printing press is under consideration before the board of directors of a company. The cost of the press will be Rs. 1,00,000, The economic life of the Press will be,10 years after which its salvage value will be zero. For depreciation provision straight line method is used in the company. Tax rate for the company is 50 per cent. | follow? Amnval cashflows before tax from this investment are estimated to be as | follows : : Years Before Tax Cashflows : (in Rupees) i 1 20,000 7; 2 30,000 ; 3 30,000 4 40,000 5 30,000 6 20,000 7 20,000 8 15,000 9 15,000 10 10,000 You are required to calculate the payback period of the investment proposal alongwith the post-payback profits. 5 ; Solution , (Amount in Rupees) Annual ine CAT OT Cumulative Year | Cashflows Tax cashflows. Cashflows (Before Tax) | (After Tax) — | (After Tax) 1 20,000- 29-1 5,000 15,000 15,000 2 30,000 10,000 20,000 35,000 3 30,000 10,000 20,000 55,000 4 40,000 15,000 25,000 80,000 5 30,000 10,000 20,000 1,00,000 6 20,000 5,000 15,000 1,15,000 7 20,000 5,000 15,000 130,000 8 15,000 2,500 12,500 142,500 9 | 15,000 2,500 12,500 155,000 10 | 10,000 Nil 10,000 165,000 % (Annual cashflows before Tax-Depreciation) Cashflow after Tax = (Net Profit after Tax + Depreciation) @ scanned with OKEN ScannerTECHNIQUES OF CAPITAL BUDGETING | 57 Payback Period = 5 Years (The initial investment of Rs. 10,000 is recovered in the fifth year as shown in the last column of the Statement). ‘Total cashflow - Initial investment 4 = 1,65,000 - 1,00,000 = Rs. 65,600. Post-Payback Profit Example 5.5 / The following data are available for a machine : Net investment in the machine ~ PF Rs, 1,00,000 Annual Cashflows ~ a Rs, 20,000 Estimated life in years >9 Salvage value of the machine Rs. 10,000 From the ae information, calculate the pay-back period of the investment proposal by way of the purchase of the machine. = 4,00s90 -40,00b Solution dep = sion Payback Period = Netnvestment — Salvage Value = 46,000 | Annual Cashflow 1,00,000 — 10,000 “20,000 eee = cla 20,000 ( Dot = ab Years i Asample 5.6 > ‘Three alternative proposals for purchase of a machine are under In the market three machines ‘A’, ‘B’ and ‘C’ are available costing Rs. case, Estimated economic life span is 5 years for cach machine. Annual ¢ the machines are estimated as follows + ite Years Machine A Machine B 1 80,000 1,00,000 2 90,000 1,00,000 3 1,00,000 1,00,000 4 130,000 1,00,000 5 100,000 100,000 5,00,000 5,00,000 ‘Assuming salvage (scrap) value as zero in each case, rank inorder of preference. py Solution 1. The three investment alternatives are at par or equal in th (a) Payback period is 4 years in each case (on the b it is clear that the initial investment of Rs. 4,004 years). (b) Economic life span is 5 years in each case (as giv (©) Post-payback p.ofits are also equal in each 4,00,000) = Rs. 1,00,000. 2. But the variability consists in the pattern of annual im the case of Machine 'C 3.11 is a well-known fact that a rupee in hand is wor Feceived after ane or more years. (as already discussed ‘Value of money). Accordingly the total present value of cash @ scanned with OKEN Scanner$8 | FINANCIAL MANAGEMENT. 4 given rate will be more in the case of Machine C in comparison with the other two machines. 4. Hence, the first preference should be given to investment in Machine ‘C’. Next in order of preference are Machine ‘B’ and Machine ‘A’. Example 5.7 The estimated cost of ‘A’ and ‘B’ machines is Rs. 1,00,000 in each case. The economic lifespan of each of the two machinesis6 years, The estimated annual cashflows are given below : Cashflows (in Rupees) Years Machine A Machine B 1 17,500 20,000 2 20,000 30,000 3 25,000 30,000 4 30,000 25,000 5 22,500 20,000 6 20,000 20,000 _ Assuming salvage value or scrap value as nil in each case, compute the Payback Period for each machine and suggest which machine should be preferred. Solution ‘Machine A” Machine ‘B? Years Cashfiows | Cumulative | YS | Cashftows | Cumulative Cashfiows Cashflows Rs Rs. Rs | Rs. 1 17,500 17,500 1 20,000 20,000 2 20,000 37,500 2 30,000 50,000 3 25,000 62,500 3 30,000 80,000 | 4 30,000 92,500 4 25,000 1,05,000 5 22,500 | 1,15,000 5 20,000 125,000 6 20,000 | _1,35,000 6 20,000 1,45,000 (i) Payback Period (i) Pay back Period Machine ‘A’ Machine ‘B’ i 7,500 = 3 Yearg + 20.000 | = 4 Years + 35595 3 Years + E00 | 42 Years, or 4 years 4 months = 3£ Years, or 3 years 9 months | (ji) Post-Payback Profits |. and 18 days | = 1,35,000 ~ 1,00,000 (Gi) Post-Payback Profits Rs. 35,000 1,45,000 - 1,00,000 > Rs. 45,000 : 3 Machine ‘B" should be preferred as its payback period is less (by 6 months and 12 days) as well as its post-payback profits are also higher (by Rs, 10,000) as compared to Machine ‘A’. Hints for Calculation {The cumulative column (Machine A shows that the initia investment is paid back some time inthe sunyear In fouryears only Rs 92:00 are recovered and Rs, 7590 (10 000 ~ 92500) reman oe recovered In the fifth year the tutal cashflow is Rs 22,500, ‘Therefore Rs. 7500 will be recovered in V/3rd 7,500 ied for a he same method is to be applied for computing payback period of Machine year |35.s00)° 7 i pay f Machine "Br @ scanned with OKEN Scanner(oh, OF CAPITAL HUDGETING | 59 la wek Example 5.8 ‘The management of a firm is considering purchase of a new plant, Two plants ‘A’ lable costing Rs. 10,00,000 each, Estimated economic life is 10 years for oth the plants, The salvage value, at the end of the economic life is Rs. 1,00,000 for plant ‘A’ and Rs, 1,50,000 for plant ‘B’. ~ Estimated annual net profits after tax will be Rs. 1,50,000 for plant ‘A’ and Rs. 1,00,000 for plant ‘B'. Depre n is to be provided on straight line method for both jon criterion, suggest which plant should be purchased. Solution s a idl Method A ub & an (nvestment — Salvage Value) oy iu Payback Period = ammnane ‘Annual Cashilow* Plont A a Se spp. — (20,00,000 ~ 1,00,000) _ 9,00,000 PRP = 750,000 + 1,00,000 ~ 2,50,000 ™ = 3-6 Yeurs, Plant B pap = 100,000 1,00,000 + 1,00,000, © 2,00,000 425 Years ‘Therefore, The choice should be to purchase Plant ‘A" as its payback period is less ay compared to that of Plant “B'. open yah here ( Mee wate 24 5 Working Note (© Cashflow = Profit after Tax + Depreciation Sige tana = ne 2030 | ¢*-- Aladia we Pa ne ian oie zinae J AT CBee eeeeetemel Method B zen ® ‘According to another alternative method some authors yest that depreciation should be calculated after deducting salvage value from the initial investment and then dividing the same by the number of years of economic life of the plant. If it is so then the payback period will be calculated as follows Investment — Salvage Value ‘conomic Life in Y (i) Annual Depreciation = Plant ‘A’ Plant ‘ (ii), Annual Cashflow = Profits after Tax + Depreciation — Plant ‘A’ = 1,50,000 + 90,000 = Rs. 2,40,000 7 Plant ‘B’ = 1,00,000 + 85,000 = Rs. 1,85,000 (iii) Payback Period Plant ‘A’ = Plant ‘B The decision in either of the above two methods de this ease will be the same that: is to purchase Plant ‘A’. But the question arises as to which method ott cof the two, is: @ scanned with OKEN Scannerc habs) vb dan Sholted 60 | FINANCIAL MANAGEMENT : a ing to one cron oeetal OF seientie, Opinions may be divided on this pot. eer ceenaly view, “The net cost of the asset toa company is its original cost Said be chiargedey an recovered through sale or salvage, and it is this net-cost that shoul ¢ esti vag expense over the asset's life, [n a great many situations, however Reems sale value is so small and uncertain that it is slsregarded in the {investment} ‘um of salvage value cannot be said to be so small (looking to the sae of investmea) though it may be uncertain; because to foresee as to what would be the sal be bel of a plant after 10 years of its operation is not so casy. “ Business afar aket airvoyant (far-sighted) cannot know in advance how long the assct tio ar sts salvage value will be; and they usually have no scientific or strictly logical ri deciding the best depreciation method. The figure of depreciation expense thai results from all these judgements is therefore an estimate and often it is only a rough estimate.” Example 5.9 The ini follows : From the above find out Post Payback Profits. Solution (i) Payback Period = Syears + ( lee = 3 years + 8 months Economic Life ~ Payback Period 5 years ~ 3 years 8 months = 1 year and 4 months 2 (ii) Post-Payback Period (iii) Post-Payback Profit: Fourth Year 90,000 - 60,000 Rs. Fifth Year = 30,000 50,000 Rs, 80,000 Alternatively ~— Post-Payback Profits Total Cashflows ~ Payback Cashflows = 3,30,000 — 2,50,000 = Rs. $0,000 Example 5.10 Three mutually exclusive projects A, B and C are under conside: management. The initial capital cost is Rs. 1,50,000 for each project. cashflow generated by cach project will be Rs. 25,000 per year. The total Projects A, B and C will be 6 years, 10 years and 15 years respectively. Calculate the payback neriod for cach project and rank them in order of Assume salvage (scrap) value as zero for each project. 1 Anthony Robert N. Management Accounting. Text and Causes, 3rd edition, p @ scanned with OKEN ScannerFREHNIQUES OF CAPITAL MUDGETING | ot PROJECTS ] A B c L Initial Capital Cost (Rs.) 1,50,000 1,50,000 450,000 2 Annual Cash flows (Rs) | 25,000 25,000 25,000 pan (Y 6 10 15, 4. Payback Period in yours 6 6 6 apital costs, Annual Cashflows and Payback Periods projects. Hence their ranking will be based on the size of ted by each project as shown below. Itis to be noted that ini ¢ the same in all the thr back profits Life Span Total Cash flow Initial Cast Post Payback Profits x 6 = 1,350,000 = 1,50,000 Zero x 10 = 2,50,000 — - 1,50,000 = 1,00,000 tC 3 3,75,000 - 1,50,000 = — 2,25,000 In order of preference the ranking will be project C (first) project B (Second) and project A (third). Example 5.11 c is Rs. 2,50,000. The machine will generate The initial investment of a machi annual cashflows as follows : Years Cashflows (Rupees) 1 60,000 2 70,000 3 60,000 4 90,000 tnd 50,000 ‘Assuming, scrap value at the end of its life span (whieh is 5 years) Calculate (a) Payback Period (b) Post Payback Period and (c) Post Payback Profits. Solution “Annual Cashftows ‘Cumulative Cashflows Rs. 60,000 1,30,000 1,90,000 2,80,000 3,30,000, 1 2 3 4 5 000 (a) Payback Period = 3 years + (55 900 (b) Post Payback Period = Economic Life ~ Payback Period Years — 3 years 8 months = 1 year 4 months Years8 months x2 mont) (c) Post Payback Profits (Rupees) Fourth Year 90,000 ~ 60,000) = ai Fifth Year = 50, Total 780,000 @ scanned with OKEN Scanner62 | FINANCIAL MANAGE Example 5.12 ‘The management of the company is considering a propos machine. In the market two machines X and Y are available Annual Cashflows from the machines are estimated as follows : | for purchase of a new for Rs. 8,00,000 each. Cashflows Years Machine X (Rupees) ‘Machine Y (Rupees) 1 2,50,000 3,00,000 2 3,00,000 2,50,000 3 5,00,000 2,50,000 4 2,00,000 3,00,000 5 1,00,000 100 (sO (On the basis of the above informations calculate (i) Payback Period and (it) Post Payback Profits of machine X and ¥ and also advise which of the two machines should be purchased. The total life span of both the machines is 5 years with zero scrap or salvage value at the end. Solution PAYBACK PERIOD (Rupees) Machine %" ‘Machine Y Years Cashflows Cumulative Cashflows | Cumulative Cashflows Cashflows op Rs. Rs. Rs. Rs. 1 2,50,000 2,50,000 | 300,000 300,000 2 3,00,000 5550,000 | — 2,50,000 5,50,000 3 5,00,000 10,50,000 | 250,000 300,000 Payback 2,50,000 3 Years Period 2 Years + '5,00,000 x 12 months 2 Years 6 months (ii) POST PAYBACK PROFITS (Amount in Rs.) Years Machine X (Rupees) Machine Y (Rupees) 3 2,50,000 a 4 2,00,000 3,00,000 5 1,00,000 3,00,000 Total 5,50,000 00,000 ion in favour of machine X, because its Payback Period is only 2+ Years as compared with 3 years in case of machine Y, despite the fact that post payback profits in case of machine Y are marginally higher by Rs | @ al | 4 50,000. Refinements in Payback Period Method Looking to the drawbacks or shortcomings of payback period techni : budgeting, elfors have been made to improve this method, so as to make ana meaningful for effective investment decision-making. These are discussed below. hich is found out by dividing sisal ‘or example, an initial investment is Rs, 1,00,000 and the rt the initial annual cashflow @ scanned with OKEN Scanner