Chapter
8
Overview of Capital Budgeting
Chapter Objectives:
Introduce students to the Civil Aviation Industry in India
The nature of capital investment appraisal
The techniques available for evaluating capital investments
The limitations of these techniques
The capital budgeting practices in select countries
Chapter
8
Overview of Capital Budgeting
In 1997 Federal Bank Ltd., a leading private sector bank in Kerala, was evaluating a loan proposal from Cochin International Airport promoted by Cochin International Airport Authority. Feaderal Bank was incorporated in 1931 as Travancore Federal Bank Ltd to cater to the banking needs of Travancore province by a small group of local citizens. In 1949 the board of directors of the bank reconstituted and the bank was renamed as The Federal Bank Ltd. The operations of the bank were confined to Kerala till 1972. After 1972, the bank expanded its operations to all the metros. The bank became an authorized dealer in foreign exchange in 1972. Since 1989, the bank has been active in Merchant Banking.
The bank's credit portfolio is well distributed over several sectors and sub sectors within prudential limits. Through careful monitoring of clients and timely initiatives in dealing with delinquency, the bank is able to contain its NPA (non performing assets) to low levels.
Cochin International Airport Limited
The project is a brainchild of the district collector of Ernakulam, Mr V J Kurian. He undertook a program to uplift the infrastructure facilities in Cochin. The increase in number of non-resident Indians traveling from Gulf countries to Kerala necessitated an airport in Cochin. Although there are two international airports in Kerala to cater to a growing traffic (8 %) the need for another airport was felt. In particular, a large number of passengers travel to Kottayam and Pattanamthitta districts close to Cochin. The chief promoter of CIAL is Cochin International Airport Society registered under the Travancore Cochin literary, scientific and charitable society registration act of 1955. Other promoters of the venture are Cochin Chamber of Commerce and Industry, Indian Chamber of Commerce and Industry, (late) Sri Madhavan Nair, Sri C V Jacob and Sri B Govinda Rao.
The Civil Aviation Industry in India
The Indian aviation industry can be broadly classified into two main segments - civil and cargo. Indeed mail and air cargo played a more important role in air carrier services than passengers. The Indian aviation sector till recently was highly regulated by the government. The government introduced new initiatives like Air taxi in the 80s to boost tourism. Domestic and international traffic is expected to grow at 12.5 % and 7 % respectively over the next decade. By 2005, Indian airports are likely to handle 60 million international passengers and 300,000 tons of domestic and 1.2 m tons of international cargo.
The civil aviation activities can be classified into three areas: operational, infrastructural and regulatory. On the operational front Indian Airlines and Air India provide domestic and international air services. Airports Authority of India formed in April 1995 by the merger of separate airport authorities that existed till then provides the infrastructure facility. In 1999 the aviation industry's turnover was Rs 90 billion. The demand for aviation is seasonal in nature with the demand being high during April-May and again in November-December.
Airport Infrastructure
There are a total of 449 airports / airstrips in the country. Airports are classified as domestic and international .The domestic airports (71) like those in Bangalore, Hyderabad and Ahmedabad have custom and immigration facilities for limited international operations by national carriers and for foreign tourist and cargo charter flights. The international airports in Mumbai, Delhi, Chennai, Calcutta and Tiruvanathapuram are available for acheduled international operations by Indian and foreign carriers. The Airports Authority of India was formed after the merger of International Airport Authorities of India and the National Airports Authority in 1994-1995. AAI manages 5 international airports, 87 domestic airports and 28 civil enclaves.
The current aviation policy allows private sector to build airports. Some airports to be developed by the private sector are in Hassan (Karnataka), Mumbai, Goa and Bangalore.
Public - Private Sector Partnerships
Till recently, much of the financing of infrastructure development in many countries came from government sources, multilateral institutions and export financing agencies. Quite often, governments in emerging markets lack the financial capacity or credit worthiness to support the volume of infrastructure projects required to develop their economies.
In case of large infrastructure projects it is becoming inevitable for public and private sector to come together and jointly apply their skills and strengths to develop the project more quickly and efficiently. The joint venture between Railtrack and British Rail in U.K to set up a high-speed rail project is an example of such a partnership. Such partnerships try to involve the private sector in the process of designing, building, financing and operating public utilities. The government defines the services required, makes arrangements which enables the private sector to be the service provider and ensures that public services will be delivered at a specified quality at competitive prices. A number of public – private financing structures exist. Some of the schemes which can achieve the objectives are:
Build – Operate - Transfer Model
Build- Transfer- Operate Model
Buy – Build – Operate Model
In a BOT model, a private entity gets the mandate to finance, build and operate the project (which is otherwise a public sector project) for a specified period of time (say 25 years) at the end of which ownership reverts to the local government. Typically, the sponsoring organization makes an equity investment of 20 to 30% of the project cost and the rest is raised from International Banks, Multilateral agencies and domestic Financial Institutions .The host government generally gives a concession to carry out the construction and operation of the project and credit support for project borrowings. The licence agreement clearly spells out the commercial and financial terms. The BOT concept has been used in transportation (Ex: roads), Energy (Power projects), Sewage & water treatment plants and hospitals.
In a BTO model, the private entity transfers the facility to the government soon after the project clears the completion test and leases it back for a specified period of time. The project company runs the facility and collects revenues during the lease term. At the end of the lease term the title passes on to the government (or the public sector entity).
In a BBO Model, a private entity buys an existing facility, modernizes it, and operates it as for– profit, public use facility. In many developing countries where existing facilities require modernization / expansion, BBO model is ideal. Roads and bridges are candidates for this model.
Since the Cochin airport project involves a huge outlay, the Government of Kerala was not keen to set up another airport. Consequently, the airport is being set up on a Build-Own-Operate basis with equity being contributed by people who benefit from the project. As a first step a society was formed. Mr Kurian and his team convinced the NRIs in Gulf that an airport in Cochin is desirable and raised (interest free) deposits from them. The government supported the effort by offering Indira Vikas Patra for 50 % of the amount deposited. A company was formed there after in 1994 with an authorized capital of Rs 90 cr to construct, own and operate an international airport with public participation and the support of Government of Kerala.
The airport is Cochin is expected to boost trade and tourism. The interest free deposits provided by people were later converted into shares. Initially Federal bank had provided a loan that was later replaced by a loan from HUDCO. The state government contributed Rs 1 cr and Federal Bank contributed Rs 2 cr in equity. Bharat petroleum, the airport service provider, contributed Rs 25 L in equity.
The project is being set up at a cost of Rs 204.48 cr in two phases, the first phase being pre-operative. Further expansion at Rs 89.83 cr has been planned after 5 years. Exhibit 8-1 provides the break up of the project cost.
Exhibit 8-1: Project Cost ( Rs L)
Phase 1 Phase 2 Total
Land 5500
Civil Works 5965 1980
Buildings 4270 6576
Contingency 511.75 427.8
Preliminary
Expenses 1256
Pre-operative
Expenses 2780
Margin money for
Working capital 165.36
20448.11 8983.80 29431.91
Contingency has been provided at 10 % of project cost to provide for escalation of prices, change in duty structure, devaluation of currency and so on. CIAL's cost is lower when compared to other airports at Bangalore and Hyderabad because:
Traffic control and navigational aid systems are being provided by AAI without any cost to CIAL
The state government is providing roads and other utilities.
The aviation fuel hydrant station is being set up by BPCL without any cost to CIAL
The project is being financed by a mix of debt and equity. Equity is from NRIs and service providers at the airport apart from a few banks and financial institutions. Term loan to the extent of 75.5 % of fixed assets has been provided by HUDCO and Federal Bank. The debt-equity ratio for the project is fixed at 1.5. The Rs 89.83 cr required for Phase 2 is being entirely from internal accruals.
Will the Project Pay?
Some of the major responsibilities of top management are in the area of long range planning. Allocating resources to competing uses is one of the most important decisions a manager has to make. Executives are constantly faced with such questions as:
Which projects should a firm accept?
How should the productivity of capital be measured?
Should the company take care of investments that reduce costs or that maintain profits or that add to profits?
What happens to the risk complexion and competitive position of the firm if the investment under consideration is accepted as opposed to not choosing it?
After reading this chapter you will know:
The nature of capital investment appraisal
The techniques available for evaluating capital investments
The limitations of these techniques
The capital budgeting practices in select countries
A typical capital budgeting decision involves commitment of large, initial cash outlay with the benefits spread out in time. The time to recoup initial investment could be long. This makes it imperative for the firm to carefully plan its investments to attain the corporate objectives. Capital Investments are typically irreversible in nature or costly to get out. Unwarranted investments can jeopardize the financial well being of the firm. Capital Budgeting deals with investment in real assets. A project requires a large, up front capital investment; generates cash flows for a specified period of time at the end of which the project can be liquidated. The liquidation value of assets at the end of the project life is called Salvage value. It should be noted that the term initial investment is a misnomer. The term is used even when the investment is spread over a number of years. It is indeed the case in many real life situations. A project is shown as a time line diagram below.
Time 0 1 2 N
___________________________________________________
Cash flow I CF1 CF2 …………………….. CFn
+ Salvage value.
Classification of Investments
Investments can be classified on several bases like importance, size, functional activity, cost reducing Vs revenue increasing, profit maintaining vs profit adding etc. The most appropriate way of classification is on the basis of relationship between investments. The possible relationship between investments can be plotted on a continuum as shown below
Prerequisite Independent Mutually
Exclusive
Complement Substitute
At one end of the spectrum, one investment might be a prerequisite for the other. At the other end we have investments that are complete substitutes. Accepting one will result in automatic rejection of the other. Two investments are said to be independent if the cash flows from one investment would be the same regardless of whether the second investment is undertaken or not. Thus, buying a Lathe for the machine shop and computerizing administration are independent investments. If the cash flows from one investment are affected by the decision to undertake another investment, they are said to be dependent. Dependence can be of four types. If the decision to undertake the second investment increases the benefit expected from the first (or decrease cost), then the second investment is said to be a complement of the first. Ex: Providing entertainment to visitors in a large clothing shop or manufacturing a primary input if it leads to cost advantage. If the decision to undertake the second investment decreases the benefit from the first investment (or increase costs), the second investment is said to be a substitute of the first. For example, making aircoolers and fans for the same market may lead to product cannibalization and erode profitability. In the extreme case, the benefits from the first may totally disappear if the second investment is accepted or it may be technically impossible to undertake both. Such investments are called mutually exclusive investments. For example, it is not possible to build one plant in two locations. Accepting one will result in automatic rejection of the other.
Techniques for Evaluating Capital Investments
Companies spend a great deal of time and money on new investments. Executives need measures of productivity of capital, which can be applied to distinguish good ones from bad ones. There are broadly two types of measures – some based on accounting income and some based on cash flows. The cash flow based measures can be further categorized as those that consider time value of money and those that don’t. Cash flow based measures that consider time value of money are called Discounted Cash Flow (DCF) techniques.
Return on Investment ROI is essentially a single period measure. Income is computed for a specified period and then divided by the average book value of assets of the same year
ROI= [EBIT (1- T) / Av. B.V of investment]
Where
EBIT= Earnings Before Interest And Tax
T= Marginal Tax Rate
Av. B V= {Beginning Book value + Ending Book Value} / 2
A variant of the above formula is:
ROI = {Net Income / Average BV}
ROI computed by the second method will be higher if equity financing is substituted for debt financing. This is because less interest expense increases net income ( PAT ).To separate investment and financing decisions it is better to use the first method. Consider a one-year project with an investment of Rs 1 million. The project is expected to generate Rs 400, 000 in pre tax earnings. The applicable tax rate is 36 % and the salvage value of the project is Rs 600,000.
ROI = [400000 ( 1- 0.36 ) / 800000 ]
= 32 %
Note that ROI is a percent return measure. Now consider a multi period project which has a life of 5 years.
Initial investment = Rs 1 m
Salvage value = Nil
Life = 5 years
Depreciation is provided on Straight-line basis
The project is expected to generate earnings of Rs 40000 (loss), Rs 60000, Rs 100000, Rs 150000 and Rs 200 000. How should the ROI be computed in this case? Should the ROI be measured for each of the years and averaged out or the average earnings and average book value of assets be used? ROI computed under the 2 methods is shown below:
Method 1
1. After tax operating (40000) 60000 100000 150000 200000 earnings
2. Beginning B. V 1 m 800000 600000 400000 200000
3. Depreciation 200000 200000 200000 200000 200000
4. Ending B.V 800000 600000 400000 200000 0
5. Avg. B.V 900000 700000 500000 300000 100000
6. ROI = (1) / (5) - 4.5 % 8.5% 20% 50% 100%
The return on Investment increases from – 4.5 % in the first year to 100 % in the fifth year. The average ROI is 35%.
Average ROI = [- 4.5 + 8.5 + 20 + 50 + 100 ] / 5 = 35 %
Method 2
Average earnings = [-40000 + 60000 + 100000 + 150000 +200000] / 5
= Rs 94000
Average Book Value of investment = [900000+700000+500000+300000+100000] / 5
= Rs 500000
ROI = (94000 / 500000) = 18.8 %
It can be seen that ROI computed under first method is almost twice that computed under second method. The rule is to accept the project if ROI > Cost of capital and reject if
ROI is < cost of capital
Limitations of ROI As is evident, ROI is a function of earnings and book value of investment. Both the numerator and the denominator are affected by accounting practices. Changing the method of depreciation or inventory costing will affect earnings and ROI. ROI typically understates return in early years and overstates return in later years. This is because the asset base is getting depreciated. In fact, ROI can increase for the same or lower earnings simply because the asset is being depreciated and becomes infinite when the denominator is zero! ROI does not consider time value of money in case of multi year projects. No distinction is made between earnings in first year and earnings in the last year. Further, ROI is an accrual accounting return whereas cost of capital is an economic return based on cash flows demanded by investors. The two cannot be compared.
Cash flow Based Measures
As the name itself suggests, these are based on cash flow rather than accounting income. Accounting earnings suffer from credibility problem. In the absence of real performance improvement, accountants may accelerate revenues and defer costs, leading to overstatement of true profits. Earnings and cash flows, though related, measure different things. Cash flow is the net of cash inflows and outflows within a time period. Earnings, on the other hand, are the net of inflows and outflows from completed operating cycles. Cash flow measures inflows and outflows within a period regardless of the state of operating cycle. Earnings measure inflows and outflows from operating cycles that the business has completed regardless of when the cash flow occurs. Put another way, there may be no cash flow even when there is a profit because profit is recorded on accrual basis.
It is inappropriate to value earnings per se. You must also take into account the investment in fixed assets and working capital required to generate a given level of earnings. It is for this reason cash flows are used to value projects.
To arrive at cash flow from earnings:
Add non cash charges like depreciation and amortization that reduce net income but not affect cash flow
B. Deduct investment in working capital and capital equipment in that year.
These cash outflows are not reflected in the net income as they are taken to the balance sheet. For instance, investment in inventory is not charged off to arrive at net income. But there is a cash outflow to bring the inventory to its present position. Monies would have been spent on raw materials, wages etc. Since the inventory has not been sold, no revenue or profit is recorded.
Cash flow = EBIT (1-T) + Depreciation – Capital Expenditure – (+) increase (decrease) in working capital.
Note that we have used Net operating profit after taxes in the above expression rather than Profit after tax in order to separate investment and financing decisions. That is interest is not deducted. The discount rate WACC incorporates after-tax cost of debt. Assume that a project has the following characteristics:
Year 1 2 3 4 5
NOPAT (40000) 60000 100000 150000 200000
Depreciation 200000 200000 200000 200000 200000
As there is no capital investment in any year, cash flow = NOPAT + Depreciation
The cash flow in last year should include salvage value of Plant and equipment, working capital etc. In the above example salvage value is zero and hence not considered.
Payback Period This is one of the simplest ways of measuring an investment’s worth. It is the length of time required to recoup initial investment. Payback period is expressed in years. Thus, the payback period for an investment of Rs. 1000 that generates cash flows of Rs 250 for 5 years is 4 years. The payback period is determined by adding up the expected cash flows in successive years until the total equals investment.
Assume that you are investing in a project with an initial investment of Rs 1 m. The cash flows from the project are given below:
Year Cash flow Cumulative cash flow
1 160000 160000
2 260000 420000
3 300000 720000
4 350000 1070000
5 400000 1470000
The payback period in this case lies in between 3rd and 4th years. If we assume that cash flows occur uniformly over the year,
Payback = 3 + [(1000000- 720000) / (1070000 – 720000)]
=3.8 years or 4 years.
The rule is to accept those projects that have a payback period less than the limit set by the management. Although all textbooks on Corporate Finance have declared that using payback period criterion is neanderthal, some managers still use it. Some use it as a secondary criterion.
Limitations of the Payback rule Although it is based on cash flows, time value of money is ignored. Cash flow in year 1 is considered on par with cash flow in any other year. It considers cash flows up till the investment is recouped. But it ignores cash flows that occur after that. So a project that generates substantial cash flows in the later years may be discarded in favor of another project that generates higher cash flows in the initial years even if the former makes more economic sense. Often projects with shorter payback are considered less risky. There is usually not much correlation between riskiness and payback. A project that has a shorter payback may be riskier than a project with longer payback.
Discounted Cash flow Measures (DCF)
The rules considered so far do not consider time value of money. Discounted cash flow measures are based on cash flows and explicitly consider time value of money. There are 3 DCF measures
Net Present Value (NPV)
Internal Rate of Return (IRR)
Discounted Pay Back
Net Present Value (NPV) The net present value of a project is the sum of the present values of expected project cash flows and the initial investment.
n
NPV = å [CFt / (1+K ) t ] - Initial investment
t=1
Where CFt = cash flow in any year t
K = Appropriate discount rate, usually the weighted average cost of
Capital
t = year 1, 2,……..,n
Thus, NPV is the excess of present value of cash inflows over the initial investment. It is an absolute number expressed in rupees. The rule is to accept the project if NPV is > 0 and reject if NPV is < 0. A firm accepting a negative NPV project will be financially worse off. If the NPV is zero, the firm is neither better off nor worse off .To calculate NPV:
Estimate project cash flows
Choose an appropriate discount rate.
Calculate PV of project cash flows and deduct initial investment.
The calculation of NPV is based on certain assumptions.
Cash flows occur at the beginning or end of the period rather than continuously throughout the period
Cash flows are certain
Consider a project that requires an initial investment of Rs 1 m. The expected cash flows are shown below.
Year Cash flow (Rs )
1 250,000
2 300,000
3 400,000
4 500,000
Assume that the appropriate discount rate is 15 %
NPV = [250000 / (1.15) + 300000 / (1.15) 2 + 400000 / (1.15) 3 + 500000 / (1.15) 4 ] –
10,00,000
NPV = Rs – 6500.
As the NPV is negative, the project should not be accepted.
NPV has certain properties:
It is in line with shareholder wealth maximization rule
It considers all cash flows unlike payback period
It is additive i.e., NPV (A+B) = NPV (A) + NPV (B). The NPV of two or more projects can be added.
It considers time value of money.
It assumes that all intermediate cash flows are reinvested at the discount rate (hurdle rate)
Limitations of NPV Although the NPV rule is conceptually sound, it has some limitations
Since it considers all cash flows, it is biased towards longer term projects
NPV is an absolute number. One can make the mistake of rejecting a project that has a slightly lower NPV by not asking what the initial investment is. A project that has an NPV of 150 might be better when compared to another with an NPV of 200 if the latter requires much higher investment.
Internal Rate of Return (IRR) The Internal rate of return is the discount rate at which present value of cash flows equals present value of cash outflows or NPV = 0 . The discount rate is calculated by trial and error. Note the similarity between IRR and Yield To Maturity (YTM) of a bond. The YTM of a bond is the discount rate that makes the present value of coupon and principal repayments equal to the market price of the bond.
IRR is the discount rate at which NPV = 0.
n
NPV = å [ CFt / ( 1+K ) t ] - Initial investment
t=1
The value of K in the above expression is the IRR.
The IRR for the previous example is shown below
Investment = Rs 10,00,000
NPV = [250000 * PVIF (r, 1)] + [300000* PVIF (r, 2)] + [400000* PVIF (r, 3)]+ [500000 * PVIF (r, 4)] - Rs10,00,000 = 0
At r = 14 %, NPV = Rs 15950
At r = 15 %, NPV= - Rs 6500
IRR lies in the range 14 – 15 %
Discount rate 14 % NPV = 15950
IRR NPV = 0
15% NPV = - 6500
By trial and error, IRR =14 + [15950 / (15950 +6500)] %
= 14.71 %
NPV Profile The relation ship between NPV and discount rate can be shown in a graph. The graph, called NPV profile, has NPV on the Y- axis and discount rate on the X – axis. The NPV profile for the previous example is shown in Exhibit 8-2. The point at which the profile cuts the X-axis is the IRR (NPV =0). Note the similarity between the bond price sensitivity to changes in YTM and the sensitivity of NPV to changes in discount rate. As can be expected, the NPV profile has a negative slope. The NPV decreases as the discount rate increases. There is an exception to this. All the examples considered so far were of the conventional kind – an initial outflow followed by inflows. When the sign of cash flows alternate or change during the life of the project, NPV can increase when discount rate increases.
Exhibit 8-2: NPV Profile
MORAL: NPV is dependent on timing, magnitude, sign of cash flows, discount rate and investment. NPV can be increased by simply understating investment / discount rate and overstating cash flows.
The rule is to accept the project if IRR is > Cost of capital and reject if IRR < cost of capital. IRR, unlike NPV, is a scaled measure. It is expressed in percentage terms.
Limitations of IRR Since IRR is a scaled measure, it is biased towards smaller projects. IRR assumes that intermediate cash flows are reinvested at IRR (> COC) during the life of the project. Competition may drive down earnings in the long run to normal levels. At times more than one IRR is obtained making decision difficult.
Discounted Payback It measures the time required for discounted cash flows to cover initial investment. Unlike the payback period, discounted payback period considers time value of money. The discount rate is the firm’s cost of capital.
Consider a project has an initial investment of Rs 700,000
Year Cash flow PV @ 15% Cumulative PV
1 160,000 139,200 139,200
260,000 196,560 335,760
300,000 197,400 533,160
350,000 200,200 733,360
400,000 198,800 932,160
Discounted Pay back = 4 Years (approximately)
Capital Budgeting Practices: Survey Results
The result of survey conducted in some countries is shown in Exhibit 8-3. The survey results are slightly old. Management practices might have changed in the meantime. Nevertheless, they do throw light on what firms do in real life. Payback and IRR seem to be the favorite methods in US, Australia, UK, Canada and Japan.
Exhibit 8-3: Capital Budgeting Practices in Select Countries
(in %)
U.S Australia Canada Ireland Japan UK Korea
Payback 59 61 50 84 52 76 75
IRR 52 37 62 84 4 39 75
NPV 28 45 41 84 6 38 60
ARR 13 24 17 24 36 28 68
Source: Charles T Horngren et al, Cost Accounting: A managerial Emphasis, PHI, 9th Ed, 1997
IRR and Average rate of return seems to be the favorite methods in USA. More recently Graham and Harvey (2001) conducted a survey of 329 CFOs in the U.S . The summary of their findings is presented in Exhibit 8-4. They find that NPV and IRR are more popular than other approaches in line with theory.
Exhibit 8-4: Survey responses to the question: How frequently does your firm use the following techniques when deciding which projects or acquisitions to pursue?
% always
or almost Company Size
always Mean Small Large
IRR 75.61 3.09 2.87 3.41
NPV 74.93 3.08 2.83 3.42
Payback 56.74 2.53 2.72 2.25
ROI 20.29 1.34 1.41 1.25
Discounted payback 29.45 1.56 1.58 1.55
Another survey of capital budgeting practices in Asia-Pacific suggests that DCF techniques are considered important in Australia, Malaysia, Philippines and Indonesia where as Payback and IRR are considered important in Singapore and Hong Kong .
Back to Cochin International Airport. Will the project pay? I intend to answer this question in the next chapter.
Concluding Comments
In this chapter we considered several capital budgeting techniques. Each has its limitation. Which is the right technique then? In other words, what are the characteristics of the ‘right’ technique?
It should distinguish between good and bad investments
It should summarize what the investment will do to the profitability of the organization
It should factor in time value of money
It should be unambiguous.
It should be in line with the corporate objective – maximization of shareholders wealth.
It should be applicable to a wide range of business situations
It should not be biased and permit realistic comparison of one investment proposal with another.
It should permit simple adjustments to allow for ranges of uncertainty.
It should take into account the life pattern of cash flows.
Clearly NPV is the only criterion that satisfies most of these. So NPV is recommended. NPV is not an abstract concept. A company accepting a negative NPV project will really be worse off. Many managers do not buy this argument either because they don’t know or don’t care. The second reason is more likely. Managers are appraised on the basis of current earnings and profits. Naturally, any manager would be biased towards those projects that generate revenues during his / her tenure even if the NPV is negative. Why should anyone care about investments that are likely to generate returns during another executive’s regime? Finally, note that the discount rate used in the NPV calculation is usually the weighted average cost of capital. We’ll get back to project discount rate at a later stage. Till such time keep using WACC.
Investment Appraisal using DCF methodology
Choice of method Estimation of
NPV Discount rate
IRR
Discounted payback
Determination of cash flows Cost of capital
Relevant cash flows for the project
Collect data on Sales,
Growth rate, capital expenditure
Working capital investment, tax rate
Depreciation schedule, Periodic
Expenses
Develop assumptions regarding
business drivers
SUMMARY MEASURE – NPV, IRR Questions
A Caselet: Nirmal Chemical Company
The Nirmal Chemical Company is planning to invest in a new plant. The team of analysts responsible for investment appraisal has arrived at the following information:
Estimated Investment -- 10 Lakhs
Estimated life of the plant -- 7 years
Annual Cash flows: Years 1 – 3 -- 1.5 lakhs
Years 4 – 7 -- 2 lakhs
Appropriate discount rate -- 15%
Find the present value of all cash flows
How would your answer change if cash flows were to grow at 40% per year after year 3 uptill the 7th year.
Now reduce the life of the plant to 6 years. Keeping the other data constant, find the present value.
Recalculate the present value using a discount rate of 14%.
Questions
1 .A fuel injection company has 4 investments. Classify them as Cost reducing, revenue expanding (related business) and revenue expanding (unrelated business)
a. A project to implement ERP software in the company
b. A proposal to start a software subsidiary
c. Repairing an old assembly line
d. A proposal to manufacture spark plugs
2. The initial investment and NOPAT for 3 projects is given below.
Years
Investment Outlay 1 2 3 4
A 10000 2000 3000 4000 4000
B 7500 1500 2000 2500 5000
C 5000 2000 1500 1000 500
Salvage value is zero for all the projects. Depreciation is provided on straight-line basis. Calculate average Return on investment for the projects. If the cost of capital is 20 % which of the projects (if any) would you choose? Is it meaningful to calculate ROI for the projects? Why or why not? Calculate ROI by the second method and compare it that obtained from first method.
3. Calculate the payback period for each of the investments. If the maximum acceptable payback period is 3 years, which of the investments would be accepted?
Years
Investment 0 1 2 3 4
A (1000) 500 300 300 900
B (1000) (100) 200 500 600
C (1000) 250 250 250 250
4. A project requires an initial investment of Rs 10,00,000. The first year cash flow is expected to be Rs 100,000. It is expected to grow at 20 % p.a. for 5 years and remain at year 6 level for 4 more years. Calculate the payback.
5. Calculate the discounted payback for question (1) if the discount rate is 13 %
6. The Primitive Car company is evaluating a project which requires an initial investment of Rs 2 million. The project cash flows are given below.
Year Cash flow
100000
2-5 200000
6-10 400000
Calculate the Net Present Value if the discount rate is 14.5 % . Draw the NPV profile for the above question
7. You are evaluating a project that has the following characteristics.
Initial investment = Rs 2 million. Cash flows are expected to remain constant for 5 years, double in the 6th year and remain at that level for 4 years, and then grow at 5 % p.a. forever after that. The discount rate is 11%. Calculate the cash flows that make NPV = 0.
For the two mutually exclusive projects given below calculate IRR.
Project A Project B
Year Cash flow Cash flow
0 500000 1500000
1-4 100000 200000
5-10 150000 250000
If the cost of capital is 18 % which of the projects (if any) would you choose.
Calculate NPV if cost of capital is 14 %.
Growth company has Rs 40 million to invest in any or all of the following projects:
(in Rs ‘000)
Years
Project Type of cash 0 1 2 3
Flow
1. Investment (10000)
Revenue 21000
Operating 11000
expenses
2. Investment (10000)
Revenue 15000 17000
Operating 5833 7833
Expenses
3. Investment (10000)
Revenue 10000 11000 30000
Operating 5555 4889 15555
Expenses
4. Investment (10000)
Revenue 30000 10000 5000
Operating 15555 5555 2222
Expenses
Assume that all expenses are on cash basis. Tax rate = 35 %. Depreciation will be on a straight-line basis. Ignore salvage value. Rank projects on the basis of Payback, NPV, IRR, ROI. The cost of capital for the company is 15 %.
8
Overview of Capital Budgeting
Chapter Objectives:
Introduce students to the Civil Aviation Industry in India
The nature of capital investment appraisal
The techniques available for evaluating capital investments
The limitations of these techniques
The capital budgeting practices in select countries
Chapter
8
Overview of Capital Budgeting
In 1997 Federal Bank Ltd., a leading private sector bank in Kerala, was evaluating a loan proposal from Cochin International Airport promoted by Cochin International Airport Authority. Feaderal Bank was incorporated in 1931 as Travancore Federal Bank Ltd to cater to the banking needs of Travancore province by a small group of local citizens. In 1949 the board of directors of the bank reconstituted and the bank was renamed as The Federal Bank Ltd. The operations of the bank were confined to Kerala till 1972. After 1972, the bank expanded its operations to all the metros. The bank became an authorized dealer in foreign exchange in 1972. Since 1989, the bank has been active in Merchant Banking.
The bank's credit portfolio is well distributed over several sectors and sub sectors within prudential limits. Through careful monitoring of clients and timely initiatives in dealing with delinquency, the bank is able to contain its NPA (non performing assets) to low levels.
Cochin International Airport Limited
The project is a brainchild of the district collector of Ernakulam, Mr V J Kurian. He undertook a program to uplift the infrastructure facilities in Cochin. The increase in number of non-resident Indians traveling from Gulf countries to Kerala necessitated an airport in Cochin. Although there are two international airports in Kerala to cater to a growing traffic (8 %) the need for another airport was felt. In particular, a large number of passengers travel to Kottayam and Pattanamthitta districts close to Cochin. The chief promoter of CIAL is Cochin International Airport Society registered under the Travancore Cochin literary, scientific and charitable society registration act of 1955. Other promoters of the venture are Cochin Chamber of Commerce and Industry, Indian Chamber of Commerce and Industry, (late) Sri Madhavan Nair, Sri C V Jacob and Sri B Govinda Rao.
The Civil Aviation Industry in India
The Indian aviation industry can be broadly classified into two main segments - civil and cargo. Indeed mail and air cargo played a more important role in air carrier services than passengers. The Indian aviation sector till recently was highly regulated by the government. The government introduced new initiatives like Air taxi in the 80s to boost tourism. Domestic and international traffic is expected to grow at 12.5 % and 7 % respectively over the next decade. By 2005, Indian airports are likely to handle 60 million international passengers and 300,000 tons of domestic and 1.2 m tons of international cargo.
The civil aviation activities can be classified into three areas: operational, infrastructural and regulatory. On the operational front Indian Airlines and Air India provide domestic and international air services. Airports Authority of India formed in April 1995 by the merger of separate airport authorities that existed till then provides the infrastructure facility. In 1999 the aviation industry's turnover was Rs 90 billion. The demand for aviation is seasonal in nature with the demand being high during April-May and again in November-December.
Airport Infrastructure
There are a total of 449 airports / airstrips in the country. Airports are classified as domestic and international .The domestic airports (71) like those in Bangalore, Hyderabad and Ahmedabad have custom and immigration facilities for limited international operations by national carriers and for foreign tourist and cargo charter flights. The international airports in Mumbai, Delhi, Chennai, Calcutta and Tiruvanathapuram are available for acheduled international operations by Indian and foreign carriers. The Airports Authority of India was formed after the merger of International Airport Authorities of India and the National Airports Authority in 1994-1995. AAI manages 5 international airports, 87 domestic airports and 28 civil enclaves.
The current aviation policy allows private sector to build airports. Some airports to be developed by the private sector are in Hassan (Karnataka), Mumbai, Goa and Bangalore.
Public - Private Sector Partnerships
Till recently, much of the financing of infrastructure development in many countries came from government sources, multilateral institutions and export financing agencies. Quite often, governments in emerging markets lack the financial capacity or credit worthiness to support the volume of infrastructure projects required to develop their economies.
In case of large infrastructure projects it is becoming inevitable for public and private sector to come together and jointly apply their skills and strengths to develop the project more quickly and efficiently. The joint venture between Railtrack and British Rail in U.K to set up a high-speed rail project is an example of such a partnership. Such partnerships try to involve the private sector in the process of designing, building, financing and operating public utilities. The government defines the services required, makes arrangements which enables the private sector to be the service provider and ensures that public services will be delivered at a specified quality at competitive prices. A number of public – private financing structures exist. Some of the schemes which can achieve the objectives are:
Build – Operate - Transfer Model
Build- Transfer- Operate Model
Buy – Build – Operate Model
In a BOT model, a private entity gets the mandate to finance, build and operate the project (which is otherwise a public sector project) for a specified period of time (say 25 years) at the end of which ownership reverts to the local government. Typically, the sponsoring organization makes an equity investment of 20 to 30% of the project cost and the rest is raised from International Banks, Multilateral agencies and domestic Financial Institutions .The host government generally gives a concession to carry out the construction and operation of the project and credit support for project borrowings. The licence agreement clearly spells out the commercial and financial terms. The BOT concept has been used in transportation (Ex: roads), Energy (Power projects), Sewage & water treatment plants and hospitals.
In a BTO model, the private entity transfers the facility to the government soon after the project clears the completion test and leases it back for a specified period of time. The project company runs the facility and collects revenues during the lease term. At the end of the lease term the title passes on to the government (or the public sector entity).
In a BBO Model, a private entity buys an existing facility, modernizes it, and operates it as for– profit, public use facility. In many developing countries where existing facilities require modernization / expansion, BBO model is ideal. Roads and bridges are candidates for this model.
Since the Cochin airport project involves a huge outlay, the Government of Kerala was not keen to set up another airport. Consequently, the airport is being set up on a Build-Own-Operate basis with equity being contributed by people who benefit from the project. As a first step a society was formed. Mr Kurian and his team convinced the NRIs in Gulf that an airport in Cochin is desirable and raised (interest free) deposits from them. The government supported the effort by offering Indira Vikas Patra for 50 % of the amount deposited. A company was formed there after in 1994 with an authorized capital of Rs 90 cr to construct, own and operate an international airport with public participation and the support of Government of Kerala.
The airport is Cochin is expected to boost trade and tourism. The interest free deposits provided by people were later converted into shares. Initially Federal bank had provided a loan that was later replaced by a loan from HUDCO. The state government contributed Rs 1 cr and Federal Bank contributed Rs 2 cr in equity. Bharat petroleum, the airport service provider, contributed Rs 25 L in equity.
The project is being set up at a cost of Rs 204.48 cr in two phases, the first phase being pre-operative. Further expansion at Rs 89.83 cr has been planned after 5 years. Exhibit 8-1 provides the break up of the project cost.
Exhibit 8-1: Project Cost ( Rs L)
Phase 1 Phase 2 Total
Land 5500
Civil Works 5965 1980
Buildings 4270 6576
Contingency 511.75 427.8
Preliminary
Expenses 1256
Pre-operative
Expenses 2780
Margin money for
Working capital 165.36
20448.11 8983.80 29431.91
Contingency has been provided at 10 % of project cost to provide for escalation of prices, change in duty structure, devaluation of currency and so on. CIAL's cost is lower when compared to other airports at Bangalore and Hyderabad because:
Traffic control and navigational aid systems are being provided by AAI without any cost to CIAL
The state government is providing roads and other utilities.
The aviation fuel hydrant station is being set up by BPCL without any cost to CIAL
The project is being financed by a mix of debt and equity. Equity is from NRIs and service providers at the airport apart from a few banks and financial institutions. Term loan to the extent of 75.5 % of fixed assets has been provided by HUDCO and Federal Bank. The debt-equity ratio for the project is fixed at 1.5. The Rs 89.83 cr required for Phase 2 is being entirely from internal accruals.
Will the Project Pay?
Some of the major responsibilities of top management are in the area of long range planning. Allocating resources to competing uses is one of the most important decisions a manager has to make. Executives are constantly faced with such questions as:
Which projects should a firm accept?
How should the productivity of capital be measured?
Should the company take care of investments that reduce costs or that maintain profits or that add to profits?
What happens to the risk complexion and competitive position of the firm if the investment under consideration is accepted as opposed to not choosing it?
After reading this chapter you will know:
The nature of capital investment appraisal
The techniques available for evaluating capital investments
The limitations of these techniques
The capital budgeting practices in select countries
A typical capital budgeting decision involves commitment of large, initial cash outlay with the benefits spread out in time. The time to recoup initial investment could be long. This makes it imperative for the firm to carefully plan its investments to attain the corporate objectives. Capital Investments are typically irreversible in nature or costly to get out. Unwarranted investments can jeopardize the financial well being of the firm. Capital Budgeting deals with investment in real assets. A project requires a large, up front capital investment; generates cash flows for a specified period of time at the end of which the project can be liquidated. The liquidation value of assets at the end of the project life is called Salvage value. It should be noted that the term initial investment is a misnomer. The term is used even when the investment is spread over a number of years. It is indeed the case in many real life situations. A project is shown as a time line diagram below.
Time 0 1 2 N
___________________________________________________
Cash flow I CF1 CF2 …………………….. CFn
+ Salvage value.
Classification of Investments
Investments can be classified on several bases like importance, size, functional activity, cost reducing Vs revenue increasing, profit maintaining vs profit adding etc. The most appropriate way of classification is on the basis of relationship between investments. The possible relationship between investments can be plotted on a continuum as shown below
Prerequisite Independent Mutually
Exclusive
Complement Substitute
At one end of the spectrum, one investment might be a prerequisite for the other. At the other end we have investments that are complete substitutes. Accepting one will result in automatic rejection of the other. Two investments are said to be independent if the cash flows from one investment would be the same regardless of whether the second investment is undertaken or not. Thus, buying a Lathe for the machine shop and computerizing administration are independent investments. If the cash flows from one investment are affected by the decision to undertake another investment, they are said to be dependent. Dependence can be of four types. If the decision to undertake the second investment increases the benefit expected from the first (or decrease cost), then the second investment is said to be a complement of the first. Ex: Providing entertainment to visitors in a large clothing shop or manufacturing a primary input if it leads to cost advantage. If the decision to undertake the second investment decreases the benefit from the first investment (or increase costs), the second investment is said to be a substitute of the first. For example, making aircoolers and fans for the same market may lead to product cannibalization and erode profitability. In the extreme case, the benefits from the first may totally disappear if the second investment is accepted or it may be technically impossible to undertake both. Such investments are called mutually exclusive investments. For example, it is not possible to build one plant in two locations. Accepting one will result in automatic rejection of the other.
Techniques for Evaluating Capital Investments
Companies spend a great deal of time and money on new investments. Executives need measures of productivity of capital, which can be applied to distinguish good ones from bad ones. There are broadly two types of measures – some based on accounting income and some based on cash flows. The cash flow based measures can be further categorized as those that consider time value of money and those that don’t. Cash flow based measures that consider time value of money are called Discounted Cash Flow (DCF) techniques.
Return on Investment ROI is essentially a single period measure. Income is computed for a specified period and then divided by the average book value of assets of the same year
ROI= [EBIT (1- T) / Av. B.V of investment]
Where
EBIT= Earnings Before Interest And Tax
T= Marginal Tax Rate
Av. B V= {Beginning Book value + Ending Book Value} / 2
A variant of the above formula is:
ROI = {Net Income / Average BV}
ROI computed by the second method will be higher if equity financing is substituted for debt financing. This is because less interest expense increases net income ( PAT ).To separate investment and financing decisions it is better to use the first method. Consider a one-year project with an investment of Rs 1 million. The project is expected to generate Rs 400, 000 in pre tax earnings. The applicable tax rate is 36 % and the salvage value of the project is Rs 600,000.
ROI = [400000 ( 1- 0.36 ) / 800000 ]
= 32 %
Note that ROI is a percent return measure. Now consider a multi period project which has a life of 5 years.
Initial investment = Rs 1 m
Salvage value = Nil
Life = 5 years
Depreciation is provided on Straight-line basis
The project is expected to generate earnings of Rs 40000 (loss), Rs 60000, Rs 100000, Rs 150000 and Rs 200 000. How should the ROI be computed in this case? Should the ROI be measured for each of the years and averaged out or the average earnings and average book value of assets be used? ROI computed under the 2 methods is shown below:
Method 1
1. After tax operating (40000) 60000 100000 150000 200000 earnings
2. Beginning B. V 1 m 800000 600000 400000 200000
3. Depreciation 200000 200000 200000 200000 200000
4. Ending B.V 800000 600000 400000 200000 0
5. Avg. B.V 900000 700000 500000 300000 100000
6. ROI = (1) / (5) - 4.5 % 8.5% 20% 50% 100%
The return on Investment increases from – 4.5 % in the first year to 100 % in the fifth year. The average ROI is 35%.
Average ROI = [- 4.5 + 8.5 + 20 + 50 + 100 ] / 5 = 35 %
Method 2
Average earnings = [-40000 + 60000 + 100000 + 150000 +200000] / 5
= Rs 94000
Average Book Value of investment = [900000+700000+500000+300000+100000] / 5
= Rs 500000
ROI = (94000 / 500000) = 18.8 %
It can be seen that ROI computed under first method is almost twice that computed under second method. The rule is to accept the project if ROI > Cost of capital and reject if
ROI is < cost of capital
Limitations of ROI As is evident, ROI is a function of earnings and book value of investment. Both the numerator and the denominator are affected by accounting practices. Changing the method of depreciation or inventory costing will affect earnings and ROI. ROI typically understates return in early years and overstates return in later years. This is because the asset base is getting depreciated. In fact, ROI can increase for the same or lower earnings simply because the asset is being depreciated and becomes infinite when the denominator is zero! ROI does not consider time value of money in case of multi year projects. No distinction is made between earnings in first year and earnings in the last year. Further, ROI is an accrual accounting return whereas cost of capital is an economic return based on cash flows demanded by investors. The two cannot be compared.
Cash flow Based Measures
As the name itself suggests, these are based on cash flow rather than accounting income. Accounting earnings suffer from credibility problem. In the absence of real performance improvement, accountants may accelerate revenues and defer costs, leading to overstatement of true profits. Earnings and cash flows, though related, measure different things. Cash flow is the net of cash inflows and outflows within a time period. Earnings, on the other hand, are the net of inflows and outflows from completed operating cycles. Cash flow measures inflows and outflows within a period regardless of the state of operating cycle. Earnings measure inflows and outflows from operating cycles that the business has completed regardless of when the cash flow occurs. Put another way, there may be no cash flow even when there is a profit because profit is recorded on accrual basis.
It is inappropriate to value earnings per se. You must also take into account the investment in fixed assets and working capital required to generate a given level of earnings. It is for this reason cash flows are used to value projects.
To arrive at cash flow from earnings:
Add non cash charges like depreciation and amortization that reduce net income but not affect cash flow
B. Deduct investment in working capital and capital equipment in that year.
These cash outflows are not reflected in the net income as they are taken to the balance sheet. For instance, investment in inventory is not charged off to arrive at net income. But there is a cash outflow to bring the inventory to its present position. Monies would have been spent on raw materials, wages etc. Since the inventory has not been sold, no revenue or profit is recorded.
Cash flow = EBIT (1-T) + Depreciation – Capital Expenditure – (+) increase (decrease) in working capital.
Note that we have used Net operating profit after taxes in the above expression rather than Profit after tax in order to separate investment and financing decisions. That is interest is not deducted. The discount rate WACC incorporates after-tax cost of debt. Assume that a project has the following characteristics:
Year 1 2 3 4 5
NOPAT (40000) 60000 100000 150000 200000
Depreciation 200000 200000 200000 200000 200000
As there is no capital investment in any year, cash flow = NOPAT + Depreciation
The cash flow in last year should include salvage value of Plant and equipment, working capital etc. In the above example salvage value is zero and hence not considered.
Payback Period This is one of the simplest ways of measuring an investment’s worth. It is the length of time required to recoup initial investment. Payback period is expressed in years. Thus, the payback period for an investment of Rs. 1000 that generates cash flows of Rs 250 for 5 years is 4 years. The payback period is determined by adding up the expected cash flows in successive years until the total equals investment.
Assume that you are investing in a project with an initial investment of Rs 1 m. The cash flows from the project are given below:
Year Cash flow Cumulative cash flow
1 160000 160000
2 260000 420000
3 300000 720000
4 350000 1070000
5 400000 1470000
The payback period in this case lies in between 3rd and 4th years. If we assume that cash flows occur uniformly over the year,
Payback = 3 + [(1000000- 720000) / (1070000 – 720000)]
=3.8 years or 4 years.
The rule is to accept those projects that have a payback period less than the limit set by the management. Although all textbooks on Corporate Finance have declared that using payback period criterion is neanderthal, some managers still use it. Some use it as a secondary criterion.
Limitations of the Payback rule Although it is based on cash flows, time value of money is ignored. Cash flow in year 1 is considered on par with cash flow in any other year. It considers cash flows up till the investment is recouped. But it ignores cash flows that occur after that. So a project that generates substantial cash flows in the later years may be discarded in favor of another project that generates higher cash flows in the initial years even if the former makes more economic sense. Often projects with shorter payback are considered less risky. There is usually not much correlation between riskiness and payback. A project that has a shorter payback may be riskier than a project with longer payback.
Discounted Cash flow Measures (DCF)
The rules considered so far do not consider time value of money. Discounted cash flow measures are based on cash flows and explicitly consider time value of money. There are 3 DCF measures
Net Present Value (NPV)
Internal Rate of Return (IRR)
Discounted Pay Back
Net Present Value (NPV) The net present value of a project is the sum of the present values of expected project cash flows and the initial investment.
n
NPV = å [CFt / (1+K ) t ] - Initial investment
t=1
Where CFt = cash flow in any year t
K = Appropriate discount rate, usually the weighted average cost of
Capital
t = year 1, 2,……..,n
Thus, NPV is the excess of present value of cash inflows over the initial investment. It is an absolute number expressed in rupees. The rule is to accept the project if NPV is > 0 and reject if NPV is < 0. A firm accepting a negative NPV project will be financially worse off. If the NPV is zero, the firm is neither better off nor worse off .To calculate NPV:
Estimate project cash flows
Choose an appropriate discount rate.
Calculate PV of project cash flows and deduct initial investment.
The calculation of NPV is based on certain assumptions.
Cash flows occur at the beginning or end of the period rather than continuously throughout the period
Cash flows are certain
Consider a project that requires an initial investment of Rs 1 m. The expected cash flows are shown below.
Year Cash flow (Rs )
1 250,000
2 300,000
3 400,000
4 500,000
Assume that the appropriate discount rate is 15 %
NPV = [250000 / (1.15) + 300000 / (1.15) 2 + 400000 / (1.15) 3 + 500000 / (1.15) 4 ] –
10,00,000
NPV = Rs – 6500.
As the NPV is negative, the project should not be accepted.
NPV has certain properties:
It is in line with shareholder wealth maximization rule
It considers all cash flows unlike payback period
It is additive i.e., NPV (A+B) = NPV (A) + NPV (B). The NPV of two or more projects can be added.
It considers time value of money.
It assumes that all intermediate cash flows are reinvested at the discount rate (hurdle rate)
Limitations of NPV Although the NPV rule is conceptually sound, it has some limitations
Since it considers all cash flows, it is biased towards longer term projects
NPV is an absolute number. One can make the mistake of rejecting a project that has a slightly lower NPV by not asking what the initial investment is. A project that has an NPV of 150 might be better when compared to another with an NPV of 200 if the latter requires much higher investment.
Internal Rate of Return (IRR) The Internal rate of return is the discount rate at which present value of cash flows equals present value of cash outflows or NPV = 0 . The discount rate is calculated by trial and error. Note the similarity between IRR and Yield To Maturity (YTM) of a bond. The YTM of a bond is the discount rate that makes the present value of coupon and principal repayments equal to the market price of the bond.
IRR is the discount rate at which NPV = 0.
n
NPV = å [ CFt / ( 1+K ) t ] - Initial investment
t=1
The value of K in the above expression is the IRR.
The IRR for the previous example is shown below
Investment = Rs 10,00,000
NPV = [250000 * PVIF (r, 1)] + [300000* PVIF (r, 2)] + [400000* PVIF (r, 3)]+ [500000 * PVIF (r, 4)] - Rs10,00,000 = 0
At r = 14 %, NPV = Rs 15950
At r = 15 %, NPV= - Rs 6500
IRR lies in the range 14 – 15 %
Discount rate 14 % NPV = 15950
IRR NPV = 0
15% NPV = - 6500
By trial and error, IRR =14 + [15950 / (15950 +6500)] %
= 14.71 %
NPV Profile The relation ship between NPV and discount rate can be shown in a graph. The graph, called NPV profile, has NPV on the Y- axis and discount rate on the X – axis. The NPV profile for the previous example is shown in Exhibit 8-2. The point at which the profile cuts the X-axis is the IRR (NPV =0). Note the similarity between the bond price sensitivity to changes in YTM and the sensitivity of NPV to changes in discount rate. As can be expected, the NPV profile has a negative slope. The NPV decreases as the discount rate increases. There is an exception to this. All the examples considered so far were of the conventional kind – an initial outflow followed by inflows. When the sign of cash flows alternate or change during the life of the project, NPV can increase when discount rate increases.
Exhibit 8-2: NPV Profile
MORAL: NPV is dependent on timing, magnitude, sign of cash flows, discount rate and investment. NPV can be increased by simply understating investment / discount rate and overstating cash flows.
The rule is to accept the project if IRR is > Cost of capital and reject if IRR < cost of capital. IRR, unlike NPV, is a scaled measure. It is expressed in percentage terms.
Limitations of IRR Since IRR is a scaled measure, it is biased towards smaller projects. IRR assumes that intermediate cash flows are reinvested at IRR (> COC) during the life of the project. Competition may drive down earnings in the long run to normal levels. At times more than one IRR is obtained making decision difficult.
Discounted Payback It measures the time required for discounted cash flows to cover initial investment. Unlike the payback period, discounted payback period considers time value of money. The discount rate is the firm’s cost of capital.
Consider a project has an initial investment of Rs 700,000
Year Cash flow PV @ 15% Cumulative PV
1 160,000 139,200 139,200
260,000 196,560 335,760
300,000 197,400 533,160
350,000 200,200 733,360
400,000 198,800 932,160
Discounted Pay back = 4 Years (approximately)
Capital Budgeting Practices: Survey Results
The result of survey conducted in some countries is shown in Exhibit 8-3. The survey results are slightly old. Management practices might have changed in the meantime. Nevertheless, they do throw light on what firms do in real life. Payback and IRR seem to be the favorite methods in US, Australia, UK, Canada and Japan.
Exhibit 8-3: Capital Budgeting Practices in Select Countries
(in %)
U.S Australia Canada Ireland Japan UK Korea
Payback 59 61 50 84 52 76 75
IRR 52 37 62 84 4 39 75
NPV 28 45 41 84 6 38 60
ARR 13 24 17 24 36 28 68
Source: Charles T Horngren et al, Cost Accounting: A managerial Emphasis, PHI, 9th Ed, 1997
IRR and Average rate of return seems to be the favorite methods in USA. More recently Graham and Harvey (2001) conducted a survey of 329 CFOs in the U.S . The summary of their findings is presented in Exhibit 8-4. They find that NPV and IRR are more popular than other approaches in line with theory.
Exhibit 8-4: Survey responses to the question: How frequently does your firm use the following techniques when deciding which projects or acquisitions to pursue?
% always
or almost Company Size
always Mean Small Large
IRR 75.61 3.09 2.87 3.41
NPV 74.93 3.08 2.83 3.42
Payback 56.74 2.53 2.72 2.25
ROI 20.29 1.34 1.41 1.25
Discounted payback 29.45 1.56 1.58 1.55
Another survey of capital budgeting practices in Asia-Pacific suggests that DCF techniques are considered important in Australia, Malaysia, Philippines and Indonesia where as Payback and IRR are considered important in Singapore and Hong Kong .
Back to Cochin International Airport. Will the project pay? I intend to answer this question in the next chapter.
Concluding Comments
In this chapter we considered several capital budgeting techniques. Each has its limitation. Which is the right technique then? In other words, what are the characteristics of the ‘right’ technique?
It should distinguish between good and bad investments
It should summarize what the investment will do to the profitability of the organization
It should factor in time value of money
It should be unambiguous.
It should be in line with the corporate objective – maximization of shareholders wealth.
It should be applicable to a wide range of business situations
It should not be biased and permit realistic comparison of one investment proposal with another.
It should permit simple adjustments to allow for ranges of uncertainty.
It should take into account the life pattern of cash flows.
Clearly NPV is the only criterion that satisfies most of these. So NPV is recommended. NPV is not an abstract concept. A company accepting a negative NPV project will really be worse off. Many managers do not buy this argument either because they don’t know or don’t care. The second reason is more likely. Managers are appraised on the basis of current earnings and profits. Naturally, any manager would be biased towards those projects that generate revenues during his / her tenure even if the NPV is negative. Why should anyone care about investments that are likely to generate returns during another executive’s regime? Finally, note that the discount rate used in the NPV calculation is usually the weighted average cost of capital. We’ll get back to project discount rate at a later stage. Till such time keep using WACC.
Investment Appraisal using DCF methodology
Choice of method Estimation of
NPV Discount rate
IRR
Discounted payback
Determination of cash flows Cost of capital
Relevant cash flows for the project
Collect data on Sales,
Growth rate, capital expenditure
Working capital investment, tax rate
Depreciation schedule, Periodic
Expenses
Develop assumptions regarding
business drivers
SUMMARY MEASURE – NPV, IRR Questions
A Caselet: Nirmal Chemical Company
The Nirmal Chemical Company is planning to invest in a new plant. The team of analysts responsible for investment appraisal has arrived at the following information:
Estimated Investment -- 10 Lakhs
Estimated life of the plant -- 7 years
Annual Cash flows: Years 1 – 3 -- 1.5 lakhs
Years 4 – 7 -- 2 lakhs
Appropriate discount rate -- 15%
Find the present value of all cash flows
How would your answer change if cash flows were to grow at 40% per year after year 3 uptill the 7th year.
Now reduce the life of the plant to 6 years. Keeping the other data constant, find the present value.
Recalculate the present value using a discount rate of 14%.
Questions
1 .A fuel injection company has 4 investments. Classify them as Cost reducing, revenue expanding (related business) and revenue expanding (unrelated business)
a. A project to implement ERP software in the company
b. A proposal to start a software subsidiary
c. Repairing an old assembly line
d. A proposal to manufacture spark plugs
2. The initial investment and NOPAT for 3 projects is given below.
Years
Investment Outlay 1 2 3 4
A 10000 2000 3000 4000 4000
B 7500 1500 2000 2500 5000
C 5000 2000 1500 1000 500
Salvage value is zero for all the projects. Depreciation is provided on straight-line basis. Calculate average Return on investment for the projects. If the cost of capital is 20 % which of the projects (if any) would you choose? Is it meaningful to calculate ROI for the projects? Why or why not? Calculate ROI by the second method and compare it that obtained from first method.
3. Calculate the payback period for each of the investments. If the maximum acceptable payback period is 3 years, which of the investments would be accepted?
Years
Investment 0 1 2 3 4
A (1000) 500 300 300 900
B (1000) (100) 200 500 600
C (1000) 250 250 250 250
4. A project requires an initial investment of Rs 10,00,000. The first year cash flow is expected to be Rs 100,000. It is expected to grow at 20 % p.a. for 5 years and remain at year 6 level for 4 more years. Calculate the payback.
5. Calculate the discounted payback for question (1) if the discount rate is 13 %
6. The Primitive Car company is evaluating a project which requires an initial investment of Rs 2 million. The project cash flows are given below.
Year Cash flow
100000
2-5 200000
6-10 400000
Calculate the Net Present Value if the discount rate is 14.5 % . Draw the NPV profile for the above question
7. You are evaluating a project that has the following characteristics.
Initial investment = Rs 2 million. Cash flows are expected to remain constant for 5 years, double in the 6th year and remain at that level for 4 years, and then grow at 5 % p.a. forever after that. The discount rate is 11%. Calculate the cash flows that make NPV = 0.
For the two mutually exclusive projects given below calculate IRR.
Project A Project B
Year Cash flow Cash flow
0 500000 1500000
1-4 100000 200000
5-10 150000 250000
If the cost of capital is 18 % which of the projects (if any) would you choose.
Calculate NPV if cost of capital is 14 %.
Growth company has Rs 40 million to invest in any or all of the following projects:
(in Rs ‘000)
Years
Project Type of cash 0 1 2 3
Flow
1. Investment (10000)
Revenue 21000
Operating 11000
expenses
2. Investment (10000)
Revenue 15000 17000
Operating 5833 7833
Expenses
3. Investment (10000)
Revenue 10000 11000 30000
Operating 5555 4889 15555
Expenses
4. Investment (10000)
Revenue 30000 10000 5000
Operating 15555 5555 2222
Expenses
Assume that all expenses are on cash basis. Tax rate = 35 %. Depreciation will be on a straight-line basis. Ignore salvage value. Rank projects on the basis of Payback, NPV, IRR, ROI. The cost of capital for the company is 15 %.