Capital Budgeting Assignment 2c5f3b

Capital Budgeting Assignment

Submitted to: Mr. Muntazir Hussain By: Adnan Rashid M.Phil. II (Finance) University of Lahore

Capital Budgeting When one can look at the word capital budgeting, he can find a combination of two words “capital” and “budget”. Where capital refers to the long term investment in assets for production or shareholder maximization, and budgeting represents the planning for getting the maximum income from such investment over the extended life of the investment. So, normally we can say that Capital budgeting is a process or combination of steps that help the organization to evaluate the long term investments, and enable them to invest in a bets suitable / optimal investment. It is a process that contains several techniques through which organization as well as individual investor can easily find the best suitable project for investment and also find out its future performance. In capital budgeting, the decision of either acceptance of rejection is made on the basis of cash generation capacity of the project. The background of capital budgeting resembles with security valuation, but different from that valuation in sense of difference between organization and individual investor. The importance of capital budgeting process is not ignorable for an organization, because of its involvement in the achievement of organization primary goal. This is because organization manages finance to raise the wealth of the shareholders and in this regard, capital budgeting techniques or process enable managers to effectively manage investments by raising ability and measurability. The importance of capital budgeting can also be observed from the situation of the organization, who make investment in projects without consideration of risk and return find less return and cannot fulfill the main objective of the organization. As we discussed earlier that capital budgeting is a process, and this process contains several stages that starts from analyzing the projects, creation of their lists and comes through an end of investment in an project through evaluation stage, which shows the analysis of taxes, incremental costs etc. So, in nutshell capital budgeting process is also somewhat similar to decision making process. However there are certain factors that can affect the capital budgeting process of an organization. Like any other process there are certain factors that influence the capital budgeting process, and are as following: Availability of Funds Capital Structure of an organization Urgency of investment Exchange rate position and policy Taxation and other governmental policies Trends of risk and return adoption Capital Budgeting Process:

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First, the cost of that particular project must be known. Second, estimates the expected cash out flows from the project, including residual value of the asset at the end of its useful life. Third, riskiness of the cash flows must be estimated. This requires information about the probability distribution of the cash outflows. Based on project’s riskiness, Management find outs the cost of capital at which the cash out flows should be discounted. Next determine the present value of expected cash flows. Finally, compare the present value of expected cash flows with the required outlay. If the present value of the cash flows is greater than the cost, the project should be taken. Otherwise, it should be rejected.

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OR If the expected rate of return on the project exceeds its cost of capital, that project is worth taking.

Capital Budgeting Techniques: 1) Profitability Index Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor. This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR). The ratio is calculated as follows: Profitability Index = Present Value of Future Cash Flows / Initial Investment If project has positive NPV, then the PV of future cash flows must be higher than the initial investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV. This technique may be useful when available capital is limited and we can allocate funds to projects with the highest PIs. 2) Discounted Payback Period

One of the limitations in using payback period is that it does not take into the time value of money. Thus, future cash inflows are not discounted or adjusted for debt/equity used to undertake the project, inflation, etc. However, the discounted payback period solves this problem. It considers the time value of money, it shows the breakeven after covering such costs. This technique is somewhat similar to payback period except that the expected future cash flows are discounted for computing payback period. Discounted payback period is how long an investment’s cash flows, discounted at project’s cost of capital, will take to cover the initial cost of the project. In this approach, the PV of future cash inflows are cumulated up to time they cover the initial cost of the project. Discounted payback period is generally higher than payback period because it is money you will get in the future and will be less valuable than money today. For example, assume a company purchased a machine for $10000 which yields cash inflows of $8000, $2000, and $1000 in year 1, 2 and 3 respectively. The cost of capital is 15%. The regular payback period for this project is exactly 2 year. But the discounted payback period will be more than 2 years because the first 2 years cumulative discounted cash flow of $8695.66 is not sufficient to cover the initial investment of $10000. The discounted payback period is 3 years. Decision Rule of Discounted Payback: If discounted payback period is smaller than some pre-determined number of years then an investment is worth undertaking. 3) Internal Rate of Return Internal Rate of Return is another important technique used in Capital Budgeting Analysis to access the viability of an investment proposal. This is considered to be most important alternative to Net Present Value (NPV). IRR is “The Discount rate at which the costs of investment equal to the benefits of the investment. Or in other words IRR is the Required Rate that equates the NPV of an investment zero. NPV and IRR methods will always result identical accept/reject decisions for independent projects. The reason is that whenever NPV is positive , IRR must exceed Cost of Capital. However this is not true in case of mutually exclusive projects. The problem with IRR comes about when Cash Flows are non-conventional or when we are looking for two projects which are mutually exclusive. Under such circumstances IRR can be misleading. Suppose we have to evaluate two mutually exclusive projects. One of the project requires a higher initial investment than the second project; the first project may have a lower IRR value,

but a higher NPV and should thus be accepted over the second project (assuming no capital rationing constraint). Decision Rule of Internal Rate of Return: If Internal Rate of Return exceeds the required rate of Return, the investment should be accepted or should be rejected otherwise. 4) Payback Period Payback period is the first formal and basic capital budgeting technique used to assess the viability of the project. It is defined as the time period required for the investment’s returns to cover its cost. Payback period is easy to apply and easy to understand technique; therefore, widely used by investors. For example, an investment of $5000 which returns $1000 per year will have a five year payback period. Shorter payback periods are more desirable for the investors than longer payback periods. It is considered as a method of analysis with serious limitations and qualifications for its use. Because it does not properly for the time value of money, risk and other important considerations such as opportunity cost. 5) Net Present value: Net present value among other techniques of capital budgeting simply tell us about the contribution of a certain project to the shareholder’s wealth. The higher the addition of wealth by the project, higher will be the shareholders wealth, which means the higher will be the share price. A formal definition of this technique of capital budgeting defines it as a ranking methods of projects, which rank the projects on the basis of their difference between outflow and present value of inflows. Formula of this technique is as following: NPV= present value of Inflow + Outflow The higher the net present value of the project, higher will be the chances of profitability from that project. Here we talk about chance of profitability because on the basis of prediction of future. So, the decision criteria in this approach of capital budgeting is the selection of project with a higher net present value. For example, we find a project which requires an outflow of RS. 1000 and inflows of 500, 400, 300, 200 at the required rate of 10% for next 4 years. Is it project is feasible for investment. NPV= -1000 + 500/(1.10)^4 + 400/(1.10)^3 +300/(1.10)^2 + 200/(1.10)^1 NPV= -1000 + 1071.785 NPV= 71.785 As the Net present value of this project is positive, so we can conclude that the investment in this project is feasible and result in profitable investment.