Description
Capital Budgeting and its components
Assignment On Capital Budgeting
Submitted by: Muniram Prasad Sharma Roll no: 14/09 MBA 4th Semester NEHU Subject: International Financial Management
0
Introduction
The term Capital refers to operating assets used in production, while a Budget is a plan that details projected cash flows during some future period. Thus, the capital budget is an outline of planned investments in operating assets, and Capital Budgeting is the whole process of analyzing projects and deciding which ones to include in the capital budget. The decision to invest abroad takes a concrete shape when a future project is evaluated in order to ascertain whether the implementation of the project is going to add to the value of the investing company. The evaluation of long-term investment project is known as Capital Budgeting. Capital budgeting is the decision process that managers use to identify those projects that add to the firm¶s value, and as such it is perhaps the most important task faced by financial managers and their staffs. First, a firm¶s capital budgeting decisions define its strategic direction, because moves into new products, services, or markets must be preceded by capital expenditures. Second, the results of capital budgeting decisions continue for many years, reducing flexibility. Third, poor capital budgeting can have serious financial consequences. If the firm invests too much, it will incur unnecessarily high depreciation and other expenses. On the other hand, if it does not invest enough, its equipment and computer software may not be sufficiently modern to enable it to produce competitively. Also, if it has inadequate capacity, it may lose market share to rival firms, and regaining lost customers requires heavy selling expenses, price reductions, or product improvements, all of which are costly.
1
Project Evaluation Criteria
The methods for evaluating investments proposal are the Discounting and NonDiscounting methods. (A) Non-Discounting Methods: There exists two forms of this method; they are the Payback Period (PP) and the Accounting Rate of Return (AROR). 1. Payback Period Method: It is the number of years required to recover the initial investment. If the investment is not recovered within the pay-back period, the project should not be accepted. In other words, it is a measure of the rapidity with which the project will return the original capital outlay. The payback period is the number of years it takes the firm to recover the original outlay from the cash inflows of the project. When within the determined number of years, the projects offers the payback, then the projects are to be accepted or otherwise if it exceeds the number of years, then the projects are to be rejected. If, PP?N PP?N Accept Reject
This method is very popular and is easy to use and understand, compute and communicate to others. It is only used as a quick method of approximation for screening proposals and it is an adequate measure for firms with very profitable
2
internal investment opportunities, whose sources of funds are limited by internal low availability and external high costs. It is very useful for approximating the value of risky investments where the income from the investment is highly uncertain and its life expectancy more. It has an advantage because when the payback period is set at a large number of years and income streams are uniform for each year, the payback criterion is a good approximation to the reciprocal of the internal rate of return.
2. Accounting Rate of Return Method: It represents the mean profit on account of investment prior to interest and tax payment. The project is accepted if the mean profit is higher than the hurdle rate. It takes average income, as measured by a series of proforma income statements, as a percentage of average investments, i.e., average book value after deducting depreciation. The main limitation of this method is that it does not take into allow for the time element in the return of funds. In other words, it ignores the time value of money by giving the same weight to future money as it gives to the present ones. (B) Discounted Methods: This usually consists of three forms, namely, Net Present Value Method (NPV) Method Profitability Index (PI) Method Internal Rate of Return (IRR) Method
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1. Net Present Value (NPV) Method: The net present value of a project is defined as the difference between the present value of all cash outflows and the present values of the expected cash inflows when discounted at a rate of return, which may be firm¶s cost of capital or another rate developed using capital asset pricing model. NPV=
where, At k capital IO n = the initial cash outlay = the project¶s expected life. = the cash inflows for period = the appropriate discount rate, that is required rate of return or the cost of
If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen. 2. Profitability Index (PI) Method: It shows the relationship between the cash inflows and initial investment. It is the ratio of the present value of the future net cash flows to the initial outlay.
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It is expressed as: PI=
The Accepted criterion is given below: PI>1.0 PI?1.0 3. Internal Rate of Return (IRR) Method: The IRR is defined as the discount rate that equates the present value of a project¶s expected cash inflows to the present value of the project¶s costs: PV (Inflows) = PV (Investment costs) It is that rate of discount which equates the present value of the expected after tax cash inflows with the present value of the after-tax outflows. In other words, the internal rate of return is the rate of discount that sets the net present value equal to zero. Internal Rate of Return = =0 Accept Reject
The projects are accepted or rejected by comparing the internal rate of return (r) to the required rate of return (k) under the following decision rule.
5
IRR (r) > RRR (k) IRR (r) < RRR (k) IRR (r) = RRR (k) Adjusted Present Value Method:
Accept Reject Indifferent
Under this technique, the initial cash flow consists of the capital cost of the project minus the blocked funds, if any, in the host country activated by the project. This amount is converted into home-country currency at the spot exchange rate. The operating cash flow under the APV technique consists of the: Present value of after-tax cash flow from subsidiary to parent converted into the home-country currency at the expected spot rate minus the profits on the lost sales of the parent company. Present value of the tax-adjusted depreciation allowances in terms of the home-country currency. Present value of the contribution of the subject to borrowing capacity in terms of home-country currency subject to adjustment for taxes. Face value of loan in the host-country currency minus the present value of repayments converted into the home-country currency. Present value of the expected savings on account of tax deferrals and transfer pricing and, Present value of expected illegal repatriation of income. Terminal cash flow consists of the present value of the residual plant and equipment. This APV technique is useful because it takes into account the higher
6
of the home-country and host-country tax rates. This technique is unique in that it uses different discount rates for different types of cash flows.
Conclusion
In making the accept/reject decision, most large, sophisticated firms calculate and consider all of the measures, because each one provides decision makers with a somewhat different piece of relevant information. Payback and discounted payback provide an indication of both the risk and the liquidity of a project²a long payback means (1) that the investment dollars will be locked up for many years, hence the project is relatively illiquid, and (2) that the project¶s cash flows must be forecasted far out into the future, hence the project is probably quite risky.
NPV is important because it gives a direct measure of the dollar benefit of the project to shareholders. Therefore, it is regarded that NPV is the best single measure of profitability. IRR also measures profitability, but here it is expressed as a percentage rate of return, which many decision makers prefer. Further, IRR contains information concerning a project¶s ³safety margin.´ The NPV provides no information about either of these factors²the ³safety margin´ inherent in the cash flow forecasts or the amount of capital at risk. However, the IRR does provide ³safety margin´ information. The PI measures profitability relative to the cost of a project. Like the IRR, it gives an indication of the project¶s risk, because a high PI means that cash flows could fall quite a bit and the project would still be profitable.
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Thus, quantitative methods provide valuable information, but they should not be used as the sole criteria for accept/reject decisions in the capital budgeting process. In summary, quantitative methods such as NPV and IRR should be considered as an aid to informed decisions but not as a substitute for sound managerial judgment.
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doc_332143619.docx
Capital Budgeting and its components
Assignment On Capital Budgeting
Submitted by: Muniram Prasad Sharma Roll no: 14/09 MBA 4th Semester NEHU Subject: International Financial Management
0
Introduction
The term Capital refers to operating assets used in production, while a Budget is a plan that details projected cash flows during some future period. Thus, the capital budget is an outline of planned investments in operating assets, and Capital Budgeting is the whole process of analyzing projects and deciding which ones to include in the capital budget. The decision to invest abroad takes a concrete shape when a future project is evaluated in order to ascertain whether the implementation of the project is going to add to the value of the investing company. The evaluation of long-term investment project is known as Capital Budgeting. Capital budgeting is the decision process that managers use to identify those projects that add to the firm¶s value, and as such it is perhaps the most important task faced by financial managers and their staffs. First, a firm¶s capital budgeting decisions define its strategic direction, because moves into new products, services, or markets must be preceded by capital expenditures. Second, the results of capital budgeting decisions continue for many years, reducing flexibility. Third, poor capital budgeting can have serious financial consequences. If the firm invests too much, it will incur unnecessarily high depreciation and other expenses. On the other hand, if it does not invest enough, its equipment and computer software may not be sufficiently modern to enable it to produce competitively. Also, if it has inadequate capacity, it may lose market share to rival firms, and regaining lost customers requires heavy selling expenses, price reductions, or product improvements, all of which are costly.
1
Project Evaluation Criteria
The methods for evaluating investments proposal are the Discounting and NonDiscounting methods. (A) Non-Discounting Methods: There exists two forms of this method; they are the Payback Period (PP) and the Accounting Rate of Return (AROR). 1. Payback Period Method: It is the number of years required to recover the initial investment. If the investment is not recovered within the pay-back period, the project should not be accepted. In other words, it is a measure of the rapidity with which the project will return the original capital outlay. The payback period is the number of years it takes the firm to recover the original outlay from the cash inflows of the project. When within the determined number of years, the projects offers the payback, then the projects are to be accepted or otherwise if it exceeds the number of years, then the projects are to be rejected. If, PP?N PP?N Accept Reject
This method is very popular and is easy to use and understand, compute and communicate to others. It is only used as a quick method of approximation for screening proposals and it is an adequate measure for firms with very profitable
2
internal investment opportunities, whose sources of funds are limited by internal low availability and external high costs. It is very useful for approximating the value of risky investments where the income from the investment is highly uncertain and its life expectancy more. It has an advantage because when the payback period is set at a large number of years and income streams are uniform for each year, the payback criterion is a good approximation to the reciprocal of the internal rate of return.
2. Accounting Rate of Return Method: It represents the mean profit on account of investment prior to interest and tax payment. The project is accepted if the mean profit is higher than the hurdle rate. It takes average income, as measured by a series of proforma income statements, as a percentage of average investments, i.e., average book value after deducting depreciation. The main limitation of this method is that it does not take into allow for the time element in the return of funds. In other words, it ignores the time value of money by giving the same weight to future money as it gives to the present ones. (B) Discounted Methods: This usually consists of three forms, namely, Net Present Value Method (NPV) Method Profitability Index (PI) Method Internal Rate of Return (IRR) Method
3
1. Net Present Value (NPV) Method: The net present value of a project is defined as the difference between the present value of all cash outflows and the present values of the expected cash inflows when discounted at a rate of return, which may be firm¶s cost of capital or another rate developed using capital asset pricing model. NPV=
where, At k capital IO n = the initial cash outlay = the project¶s expected life. = the cash inflows for period = the appropriate discount rate, that is required rate of return or the cost of
If the NPV is positive, the project should be accepted, while if the NPV is negative, it should be rejected. If two projects with positive NPVs are mutually exclusive, the one with the higher NPV should be chosen. 2. Profitability Index (PI) Method: It shows the relationship between the cash inflows and initial investment. It is the ratio of the present value of the future net cash flows to the initial outlay.
4
It is expressed as: PI=
The Accepted criterion is given below: PI>1.0 PI?1.0 3. Internal Rate of Return (IRR) Method: The IRR is defined as the discount rate that equates the present value of a project¶s expected cash inflows to the present value of the project¶s costs: PV (Inflows) = PV (Investment costs) It is that rate of discount which equates the present value of the expected after tax cash inflows with the present value of the after-tax outflows. In other words, the internal rate of return is the rate of discount that sets the net present value equal to zero. Internal Rate of Return = =0 Accept Reject
The projects are accepted or rejected by comparing the internal rate of return (r) to the required rate of return (k) under the following decision rule.
5
IRR (r) > RRR (k) IRR (r) < RRR (k) IRR (r) = RRR (k) Adjusted Present Value Method:
Accept Reject Indifferent
Under this technique, the initial cash flow consists of the capital cost of the project minus the blocked funds, if any, in the host country activated by the project. This amount is converted into home-country currency at the spot exchange rate. The operating cash flow under the APV technique consists of the: Present value of after-tax cash flow from subsidiary to parent converted into the home-country currency at the expected spot rate minus the profits on the lost sales of the parent company. Present value of the tax-adjusted depreciation allowances in terms of the home-country currency. Present value of the contribution of the subject to borrowing capacity in terms of home-country currency subject to adjustment for taxes. Face value of loan in the host-country currency minus the present value of repayments converted into the home-country currency. Present value of the expected savings on account of tax deferrals and transfer pricing and, Present value of expected illegal repatriation of income. Terminal cash flow consists of the present value of the residual plant and equipment. This APV technique is useful because it takes into account the higher
6
of the home-country and host-country tax rates. This technique is unique in that it uses different discount rates for different types of cash flows.
Conclusion
In making the accept/reject decision, most large, sophisticated firms calculate and consider all of the measures, because each one provides decision makers with a somewhat different piece of relevant information. Payback and discounted payback provide an indication of both the risk and the liquidity of a project²a long payback means (1) that the investment dollars will be locked up for many years, hence the project is relatively illiquid, and (2) that the project¶s cash flows must be forecasted far out into the future, hence the project is probably quite risky.
NPV is important because it gives a direct measure of the dollar benefit of the project to shareholders. Therefore, it is regarded that NPV is the best single measure of profitability. IRR also measures profitability, but here it is expressed as a percentage rate of return, which many decision makers prefer. Further, IRR contains information concerning a project¶s ³safety margin.´ The NPV provides no information about either of these factors²the ³safety margin´ inherent in the cash flow forecasts or the amount of capital at risk. However, the IRR does provide ³safety margin´ information. The PI measures profitability relative to the cost of a project. Like the IRR, it gives an indication of the project¶s risk, because a high PI means that cash flows could fall quite a bit and the project would still be profitable.
7
Thus, quantitative methods provide valuable information, but they should not be used as the sole criteria for accept/reject decisions in the capital budgeting process. In summary, quantitative methods such as NPV and IRR should be considered as an aid to informed decisions but not as a substitute for sound managerial judgment.
.
8
9
doc_332143619.docx