i y 14 Financial Management : Principles and Prague, | : | | There is no scarcity of capital and capital rationing is not required by the firm in Tunning thi, project. f3-Process of Capital Budgeting i i i ding of conventional and non-conventi The process of capital budgeting requires (i) understan d non-c 7 cash ow (i) the correct estimation ofthe cost of benefits of future years, (iti the increment, cash flows have to be measured, (iv) there should be a required rate of return, (v) an appropriays technique should be selected and (vi) ranking of the proposal. | 7.1.3.1 Cash Flows Capital budgeting is based on cash flows that may be conventional or non conventional, y conventional cash flows the initial outflow of funds or investment amount is followed by even cash inflows throughout the life of the asset. Example A firm purchases an asset for Rs.80,00,000 now followed by inflows of revenue of Rs. 10,00,000 every year for 8 years after which the life of the asset is finished. Fig, 7, depicts conventional cash flows. Cash Outflow (Rs. 80 lakhs) OL 1 2 3 4 5 6 7 8 > Yoyo yyy 10 10 10 10 10 10 10 10 (Cash Inflows) (Rs in Lakhs) Fig. 7.1 : Conventional Cash Flows In non-conventional cash flow pattern a firm makes an outflow of funds at the beginning as well as in later years of the life of the asset if the need arises. Due to repairs and technology upgrading of machines outflows may be more than once in the lifetime of an asset. Example Fig 7.2 depicts non-conventional cash flows. A firm, makes an investment of Rs. 80, 00,000. receives a return of Rs. 8, 00,000 till the 3° year. In the 4 year it has cash out flow of Rs. 90,000 for modernizing the machine. This enhances the life of the asset from 8 years to 10 Years. It also increases inflows to Rs. 9, 00,000 every year. This uneven cash inflows and outflows is called non-conventional cash flow analysis,ital Budgeting cap 7s Cash outflow Cash outflow (g0 lakhs) (3 lakhs) ! i 5 a 3 7 8 9 WW 4 ‘ y rye? 8 lakhs. 8 lakhs 8 lakhs lakhs lakhs Sakhs Oakhs lakhs 9 lakhs (Cash inflows) Fig.7.2 : Non Conventional Cash Flows 7.1.3.2 Estimating Costs and Benefits The cost of the proposals should be estimated as it will be required for purchasing an asset and installing it for implementing the decision. ‘The benefits have to be estimated in terms of an increase in production and sales as well as a decrease in costs of labour and overheads, Two are (i) Accounting alternative criteria are available to quantify the benefits and costs. Thes profits and (ii) cash flow analysis. The Accounting Profits method is a quantitative approach but it considers non cash items like depreciation so it has to be adjusted to arrive at the cash flow position of the company. Cash flow analysis is considered to be superior to the accounting profit method because it measures the economic value of the project through cash inflows and Gutflows. Cash flows are cash transactions and they measure the future net benefits in cash terms through the time value of money which is ignored by the accounting profit method. In decision criteria relating to estimation of future cost and benefits the cash flow approa considered to be most appropriate in calculation. Example of costs and benefits is explained is and Bene! Table 7.1.1: Cash Flow Ai Initial Cash Outflow Subsequen/Operational Terminal Cash Flows Cash Inflows Cost of new plant Annual cash inflows: Annual cash inflov: Installation cost Profit afler tax Add working capital released Additional working capital Add depreciation ‘Add scrap value Less tax benefits on capital loss Deduct repairs (Sale of old asset) Scrap/salvage value of old asset Deduct capital expenditure Add tax liability, capital gain (sale of old asset)the best suitable — — _ZaTMPORTANCE OF CAPITAL BUDGETING Capital budgeting is of great significance to a corporate organization. It controls a large volume of funds and it is for long term purposes. The profitability of the company depends on capitalCapital Budgeting an budgeting. The relevance of capital budgeting is as follows: 1. Volume of Funds Capital pace involves a heavy commitment of funds since the volume of funds is hi affects the profitability of the company, If decisions are not taken carefully it will result into heavy losses and the return on funds may not match the expectation of the shareholders. 2, Long Term Effect Capital budgeting decisions are taken for terms which are more than five years. It continues to affect the firm with long term risk and return considerations, Ifthe financial manager commits the funds and the decisions do not bring about the desired results the firm will be afflicted with Jong term losses and may ultimately not be able to function. 3, Irreversible Decisions The decisions taken in capital budgeting cannot be reversed because the assets cannot be used for any other purpose. They cannot be discarded because the value of the assets will be reduced to a small amount resulting into heavy losses. Therefore the decisions of capital budgeting should be taken with utmost consideration. 4. Cash Flow Analysis Capital budgeting decisions are made through cash flow analysis which is superior to accounting profit method. It measures the time value of money, actual cash flows, and incremental cash flows and considers only cash items. Unlike accounting profit that is based on accrual method. ‘Accounting profit method is a good measured for providing the accounting profit but it does not give a true picture of non cash items like depreciation and it does not estimate costs and benefits through incremental analysis. The distinctions between cash flow analysis and accounting profit is given in Table 7.2.1. Therefore decisions taken through capital budgeting techniques are superior and important for taking correct decisions. Table 7.2.1: Distinctions Between the Cash Flow Analysis and Accounting Profit Cash flow analysis Accounting profit (i) Itignores time value of money as it does not have any common required rate of return or cost of capital. (ii) Accounting profit considers book entries (i) Itconsiders time value of money through a required discounting rate of return. (ii) Cash flow measures economic value through actual cash inflows and outflows. _value of an asset. (ii) Accounting profit considers non-cash items like depreciation for evaluating the worth of an asset. (iii) Cash flows consider only cash items. It does not consider items like depreciation thus creating economic value of the assets. (Wv) Cash flows have a uniform method of (iv) Accounting profit uses different techniq-a *VrTectly ~ RAISAL METHODS are different techniques of capital budgeting. This section will evaluate Cach of, 2 7 niques. ‘As-discussed above the traditional techniques consist of the non discounteg ey lows evaluation methods. The traditional techniques are: ca 1. Accounting Rate of Return (ARR) method 2. Pay Back Method of Evaluation. ¢ modern techniques that are also called the DCF techniques are the following: 1. Net Present Value (NPV) 2. Profitability Index (PI) 3. Internal Rate of Return (IRR) An appraisal of projects evaluates the advantages and disadvantages of the investment proposa, Appraisal techniques should have the following qualities: © Itshould be able to give an assessment of the profitability of the independent projec, © Itshould provide a ranking of the projects to identify the most suitable project, © Inmutually exclusive projects an appraisal techniques should be able to select the project that is preferred for the firm. The techniques should be able to recognize cash flows in different years. Early cash flows in financial management have a higher value. Therefore, cash flows should be identified to find out when the inflows and outflows occurred. The techniques used for appraisal should incorporate the time value of money to getat accurate estimation of the project. The techniques should be able to identify the right project as heavy losses acerue throu the choice of an incorrect project as capital budgeting affects a company over a long. term period of time.TRADITIONAL/NON DCF TECHNIQUES The techniques of evaluation are a measure provided for selection of a project. The simplest techniques that are still being used be accounting rate of return (ARR) and pay back method (PB). These measures are useful as they give an approximate idea of the return on investment.= ata Financial Management: Principles ang Pra ice 7.4.1 Accounting Rate of Return The accounting rate of return is also called the average rate of return. It is calculated the accounting information available from financial statements ofa firm for Measuring prog rough ofa project. It has the following formula: Nabil Average Profits (After Tax) Average Investment @ ARR = 100 Note: The decision rule to be applied while accepting or rejecting a proposal is: © Accept project when ARR > minimum rate © Reject project when ARR < minimum rate Average Investment Calculation (a) Average Investment = + (Initial cost of Machine — Salvage Value) + Additional Working Capital + Salvage Value. ARR can be calculated by different methods. It can be calculated by original cost instead of average investment. Then the calculation will be different. The second formula for ARR is Average Profits(Afier Tax) ARR = «100 1) Original Cost (b) Original Cost = Cost of the Asset + Installation Cost — Salvage Value/No. of years (c) Additional Working Capital: Sometimes additional working capital is required by a project. If it is not required itcan be omitted in the formula.Bratuation of ARR Method ARR method is simple and easy to comprehend. It requires no additional training for any staff member and it can be applied frequently to find out the rate of return on a project. The accepUreject technique is simple if ARR is higher than the minimum cut-off rate that is acceptable to a company preset by the company’s own requirements it will accept the proposal, The ARR method considers the average of the cash flows during the economic life of the project. It does not work under the principles of financial management. Although early cash flows have a higher value it does not consider it. This means that it has no consideration for time value of money. It is based on the accounting rate of retum and financial statements are used to project it The following are the merits and limitations of ARR techniques: The Merits of ARR Method 1. ARR is useful for small organization as the proprietor can have an approximate idea of his rate of return. It is simple for a person to understand and use without any mathematical formulae. 2. Itis based on accounting information and financial statements provide the profit and loss ofa concern, The information is known publicly and profitability of a company can be found out. 3. It provides information on average income and average investment throughout the economic life of an asset. The Limitations of ARR Method 1. ARR method does not work under the principles of financial management because it does not consider the time value of money of the proposals. It only gives averages in results. 2. Mis calculated through different methods which is very confusing. The results are veryFinancial Management: Principteg an, r n different Through average investment and original investment methods, The cu oy di nt through He, anges with the application of cin formulae. ges with the ap ion of change in fe smn punting principle ot cash flow analysis which pro, Rn od 4 d f realistic reeult and a o which capital budgeting principles are worpas’ 4 Mon, nd according to which capit 2 : Irdoes not consider differences in cash flows between the ances es AP tery, 1f two companies are compared in which the averse ies tae the same g _ company has higher cash flows ARR does not fin ia i ' i Perior, Hence ARR cannot be used in specialized cases to give accurate results while n aking compan ‘ for selecting mutually exclusive proj The ARK method has some merits but it cannot be called the best evaluation technique becany it does not satisfy the principles of financial management 7.4.2 PAYBACK METHOD The payback method is another simple method for calculation of the length of time Tequireds, a project for recovering the initial costs of investment ina project. Itis the recovery Period fy its cash inflows to be equal to its cash outflows. The payback method may be used : * When cash inflows are equal for a number of years. * When cash inflows over the years is unequal. When the cash inflows are equal, they are in the form ofan annuity The formula to find out iy pay back period when cash flows are equal is: , nitial Investmei Payback Petiod — _lnitial Investment Annual Cash Inflow When the annual cash inflows are a mixed stream or unequal or differe! nt, The formuta willbe payback Payback Period tC mulative After Ta «Cash Flows for N"Y ear CFAT(N +1) Note: The decision to accept or resect a project through the payback method is: Accept/ Reject Decision 1. Accept the project 2. Reject the proj Ff PB < predetery ect if PB > predeten mined Payback Period mined Payback Period ‘cision technique in case (i) 1 20.000 and itis key to genet Will be the payback period? What well 's What7.20 INE BE Mey | Cost has been recovered betwee! Payback period = 3 4 (35,00,000 yy 381 and 4 year 2 8,00,000 = 340.375 = 32,00,000)/8, 3.375 Year, No 0% ") snveon 3% year and 4" year The difference 4 The pay back period is benween 3 cee bey Ea Pe se Re 4.00,000.The investment is RS. 35,00,000.The cash inflow i - var iv Rs. 32,00,000, Therefore the initial investment minus the 3m Jey eet eat ard year provides the period po Ween " year minus » divided by cash inflows of #* year mi ear provides 1 ‘lak and 3” year The amount is recovered afier the 3rd year but before ayy ‘ih ey " the year. Evaluation of Payback Method The payback method is simple to apply to practical situations. It is based on cash flow analy which makes it superior to the ARR method of appraisal of a Project. Since it is as), calculate this method is useful but it is not the best method of evaluation. If a project has tobe selected out of many projects the project which has the quickest recovery period and conseaueng, the shortest payback period will be selected. If ranking is desired the project with the shone, payback period will be given the highest rank. This means that when two mutually exclu, projects are appraised the project with the shorter payback would be selected. The paybay period technique however does not consider the cash flows after the recovery period, The cash flows after the recovery of the investment are completely ignored however valuable in terms of volume of funds. Example 7.7 depicts this situation. Example 7.7 There are two mutually exclusive machines of Rs 20,00,000 each will be generating the following cash flows in the 6-year life of the machine. Machine A will give cash infloys (afier tax) in 1* year Rs. 8,00,000, 2” year Rs. 10,00,000, 3" year Rs. 3,00,000 then in 4%,5* and 6" year cash inflows are nil. Machine B generates 1* year Rs. 5,00,000 2™ year Rs 5,00,000 3" year Rs. 4,00,000 4" year also Rs. 4,00,000 5" and 6" year Rs. 3,00,000 each. Solution: Particulars (Year) Machine A Machine B (Rs) (Rs) Costs of the machine (0 period) 20,00,000 20,00,000 1 (inflows) 8,00,000 10,00,000 2 12,00,000 10,00,000 3 3,00,000 4,000 4 Nil 400,000 5 Nil 3,000 6 Nil 3,0 2 yes Payback period 2 yearsital Budgeting Wt This example shows that two proposals machine A and machine B have of Rs. 20.00,000 The payback period for both the irdlentiar recover their investment the same investment k machines is similar. After two years they Their payback period is of two years Therefore both the proposals would be given equal ranking. However this does not consider the acemue from the projects because it does not consider the recovering the investment. It complete benefits that cash flows of the proposal after : also does not consider projects in terms of timing, or magnitude of -tash flows. It ignores time value of money, It also does not indicate the cash in ty machine B in 4, 5° and 6" year, Machine n ‘Aand B are taken in the same bracket. ash inflows generated had a nil return after the third year but both The merits and demerits of the payback period technique follows: Merits of Payback Period 1. Itisa simple technique and does not require any special training. Anyone can calculate the period of recovery of investment, 2. Ituses Cash flow information, and works within the principles of financial management. 3. The payback technique indicates the period of liquidity. The choice of the project can be made according to the shortest period of recovery. 4, Payback method evaluates the project according to recovery of investment. Thus long time risk is not taken by an organization on a project. Shorter recove would mean that the project is less risky and has a good return: y of the investment 5. The payback method is useful for a small firm, with limited resources. It is an approximate method and will not help a large firm to plan its capital budgeting projects jitations of the Payback Method 1. It ignores time value cf money, as it does not consider the inflows and outflow afier the recovery of the investment. This does not work according to the principles of financial management. 2. Itignores cash flow after payback period and so it gives misleading results, The project that does not have any cash flows after the period of recovery is at par with another project which has cash flows after the pay back period 3. It ignores the magnitude and timing of cash flows. 4, The payback period is only useful as a measure of capital recovery and not as a measure of profitability. It does not cover projects, that have long term implications as investment is spread out without any high initial investment. 5. The payback period does not give any importance to salvage value. It does not consider the full economic life of a proposal. A solution to improve the payback method is by determining the payback period of discounted cash flows.