Capital budgeting - meaning

‘‘Capital budgeting is long term planning for making and financing proposed capital outlays’’– Charles T Horngreen

-          Capital budgeting decisions are strategic investment decisions that have an impact on future profitability and survival of business.
-          Capital budgeting involves planning and control of capital expenditure
-          Capital budgeting involves choice among several alternatives of capital expenditure
-          Capital budgeting involves exchange of current funds for future benefits

Relevance of CB decisions
1.       Capital budgeting involves investment of substantial amount of funds. Where the decision goes wrong, it would affect future profitability of the firm.
2.        C.B decisions have its effect over a long time span. Every firm would try to achieve maximum growth through incurring high capital cost. Capital budgeting decisions has an impact on future growth and survival of business. No one can accurately predict future. Longer the time period, greater the risk & uncertainty. The factor of risk cannot be eliminated fully. Wrong decisions would affect long term survival.
3.       Capital budgeting decisions once taken are irreversible in nature. After purchasing a capital asset the firm may not be in a capacity to reverse the decision. It would be difficult to reverse the decisions as the same would be expensive.
4.       Capital budgeting decisions are complex, as it involves estimation of costs and benefits that would arise in future. The factors which compel capital investment include rising demand for products, obsolescence of technology/equipment, need for improvement in product, wear and tear of equipments, diversification needs etc. These factors are directly related to profitability and survival of the firm.
5.       Capital budgeting or planning of capital expenditure is not a single transaction of acquisition/improvement of assets, but a process performed over a period of time (say each year) to ensure alteration/improvement/acquisition of assets in time.

Capital expenditure & Time value of money

As mentioned earlier, capital budgeting refers to process of making investment decisions in capital expenditure. Capital expenditure is the expenditure incurred for acquiring or improving the fixed assets, the benefits of which are expected be received over a number of years in future. E.g. for capital expenditure- expenditure incurred on acquisition of land and building, R & D project cost, expansion in fixed assets etc. A fixed asset here means an asset the benefits of which are expected to be received over period of time exceeding one year.

Capital budgeting decisions involving heavy investments considers time value of money. Why? The value of money is not stable every time. The firm pays money today the benefits of which arise in future. A rupee received today is better than a rupee received tomorrow. You can buy an item for Rs.5 today but the same quantity of same article may not available for Rs.5/- after 5 or 6 yrs. The value of Re.1 may be near 0.91 paisa next year. Capital budgeting involves exchange of current funds for future benefits. Hence, the firms resort to the discounting cash inflows while deciding upon investing in assets.

Types of decisions
1.       Mutually exclusive decisions:  There would be competing proposals and acceptance of one proposal automatically excludes acceptance of the other. For e.g. ABC ltd has two options- either it can purchase the machine using bank loan or it can take it on lease. ABC ltd (after evaluation) selects to lease the machine which automatically results in rejection of proposal for purchase.
2.       Accept reject decisions: Decisions on independent proposals on the basis of minimum rate of return. For e.g.: ABC ltd fixes a minimum rate of return on return @ 22%. It rejects proposal X on the reason that the return is only 19.5 %.
3.       Capital rationing decisions: When a firm fixes a limit on the maximum amount that can be invested during a given period of time, then it could be said that the firm is resorting to ‘capital rationing’. Where the firm decides to invest in a project, it has to select the most profitable proposal from the available ones. The firm should accept proposals with positive NPV. But there may arise situations where the firm will not be able to invest in all the profitable proposals due to constraints in the availability of funds. The constraints on procurement of necessary funds may be internal (self imposed) or external (external factors). Sometimes the top management may have fixed capital budget. E.g. there are profitable projects worth Rs. 1oo lac, but the management has limited the maximum amount of investment to Rs. 95 lacs. In such a case the firm has to compare between projects and select profitable projects of aggregate investment not exceeding Rs. 95 lacs. In simple words, capital rationing is the process whereby projects are ranked on the basis of rate of return and a combination of profitable projects are selected in order to utilize the available funds in an efficient manner.
The standard NPV decision rule – ‘’accept all positive NPV projects” will not apply here because of shortage of capital. The firm allocates limited funds to the projects in a manner so as to maximize the long run returns. Capital rationing also means that the firm forgoes the next most profitable investment falling after the budget ceiling even though it is estimated to yield a rate of return much higher than the required rate of return, thus, capital rationing does not lead to optimum results.
Capital budgeting process
Identification  à economic & non-economic criteria  à Screening à Evaluation à Capital expenditure budget à implementation and Control  à Performance review report
The first step in the process is identification of investment proposals. The firm should have a planning body and it should invite proposals from departments/ lower levels/top management. The management shall issue well defined guidelines for searching investment proposals to ensure that useful ideas reach the planning body. The depts shall submit the proposals to the planning body. The firm should have an economic (e.g. ROI) and non-economic (e.g. legal requirements, risk etc) criteria for selection for proposals which should be reviewed from time-to-time. Proposals which fail to comply with criteria should be rejected. It’s better to communicate the criteria to all depts in the beginning itself. In third step i.e. screening, conflicting/ duplicate proposals are to be eliminated/rejected and useful proposals are considered.  In the fourth step the profitability of the proposal is evaluated in detail (see ‘types of decisions’ above). The firm may use NPV method, ARR, payback period method, IRR etc for evaluation of proposals. In the fifth step, a capital budget which contains the amount of estimated expenditure (large outlay) to be incurred in the project during the budget period is prepared. However, projects involving small outlays may be decided at lower levels for expeditious action.  The sixth step is implementation of proposal within allowed time frame and costs. The management should have formulated a procedure to exercise control over projects while in process. PERT and CPM are effective techniques to control and monitor implementation of projects. The last step is review of performance of the project through post completion audit. Here, actual expenditure is compared with budgeted expenditure; actual return is compared with expected returns in order to find out variances and to take corrective action for the same.

Capital Budgeting Techniques (Evaluation methods)

A). Traditional methods
1.                                     Payback/ pay off/ payout period method

It’s the simplest method of evaluating investment proposals. Payback period means the number of years required to recover the original investment. Shortest the payback period, then more preferable and less risky.

Rule: Accept the proposal with low payback period.

Post payback profitability index = [cash inflows after recovery of original invt / original investment] * 100.

Some firms may select projects with highest post-payback period/ profitability index.
Payback period= Original cost / annual cash inflow.

[Author’s notes:
1. Where the cash flows are not uniform, then payback period = normal payback period + (Remaining cash to be recovered / next year cash inflow) * (12)}.
2. Cash inflow means profit after tax but before depreciation.
3. Salvage value to be treated as inflow and be discounted at that year’s rate]
2.                                     Average Rate of Return method

Rule:  Accept if ARR > cut off rate (min rate)
i. ARR on original invt = [Profits after dep & tax / net investment*no of years of profit]   * 100.

ii. ARR on avg invt = [Avg annual profits / avg invt] * 100
[Author’s note:
1.  Cash inflow  = PATD
2. Net invt = total invt less scrap
3.Avg invt = net invt/ 2
B) Discounted cash flow methods

1.                         Net present value method (NPV)

Rule: accept, if NPV > zero or greater than other projects (positive value)

An improvement over NPV method called Terminal value method or modified IRR method, assumes that the future cash inflows are immediately reinvested in another project at an interest rate or rate of return. The project to be accepted if total value of compounded reinvested CF is more( than PV of outlays/ pv of other project)
1.                        Calculate sum of Cash inflow * discount rate of corresponding year to obtain PV of cash inflows
2.                        NPV = Initial investment less total PV of inflows.
2. Internal Rate of Return method (IRR)

Here the rate of discount is to be determined by trial and error. IRR is the rate which equates pv of cash inflow and pv of cash outflows. It’s the rate at which NPV is zero. This method is also called time adjusted rate of return or discounted rate of return or yield method or trial & error yield method.

See the example given below this table.#

3.                        Profitability index method

Rule: Accept if PI  > or  = 1
P.I = PV of Cash inflows/ PV of cash outflows

IRR determination #

E.g.  Original investment of a project = Rs. 30,000.

Cash inflows
Discount factor = 12 %

IRR =?

First, multiply cash flows by different discount factor values till you receive a cash flow marginally greater than outflows and cash flow just below the outflow. Note both discount factors in mind.
DF@ 12 %
PV of CF
DF@14 %
PV of CF
DF@16 %
PV of CF

Rs. 32771

Rs. 31217

Rs. 29769

Now use following technique to find IRR i.e. true rate of return which equates PV of inflows with PV of outflows

[NB: Equation given below is a personally modified version (using interpolation concept) for convenience and not a standard equation. Refer study material for original equation].

IRR (true rate of return)   = R +  { (CIFR -  COF) / ( CIFR – CIF L ) } * (L - R)

R = D.F rate which gives cash inflows marginally greater than outflow (sometimes R will be given in the question. If not given, you have try DF rates on cash flows to get R), 
L = D.F rate which gives cash inflows just below the outflow.
CIFR = Cash inflows at R
COF = cash outflow
CIF L = cash inflow just below the COF
Thus, here

IRR = 12 % + {(32771 – 30000)/ (32771 -29769)} * (16-12) = 15.69 %.    
IRR= 12% + { (32771 – 30000)/ (32771-31217)} * (14-12) = 15.6%

Risk measurement and Sensitivity analysis

Risk and uncertainity are quite inherent in capital budgeting decisions. Future is uncertain and involves risk. Seasonal fluctuations, political environment, tax rates, market acceptability of the product, business cycles etc may influence implementation of the investment decision.  So, chance for variation of future returns from that of estimated ones cannot be eliminated. Greater the variability, greater would be the risk. Risk refers to probability that some unfavourable event is likely to happen. Hence risk could be measured by following methods -

1.       Risk adjusted NPV method: greater the uncertainty, greater the risk is said to be and larger would be the premium required from such projects. Risky project can be accepted if they can generate additional returns over and above what risk-less project could earn. The cash flows are discounted using discount factor calculated by adding risk premium rate to risk free rate.

NPV = Cash flows (discounted at free rate +premium rate) - original investment

2.       Certainty equivalent method: here, the expected cash inflows are reduced by multiplying them by certainity coefficients. The resulting cash flows are then discounted using risk free rate (DF)

3.       Standard Deviation: Standard deviation is a measure of average variance or deviation of possible cash flows from the expected cash flows. Lower SD indicates lower risk and vice versa.

SD =   /n  

Where, d= CF – mean, f= frequency or probability, n= total frequency & mean = total cash flows/ no. of CF

Wherever returns are expressed in revenue terms the coefficient of variation gives better measurement for risk evaluation. SD can also be used when two projects have same cost and same NPV to find which project is better.

Coefficient of variation = [SD / Mean] *100 

Both SD and CV require to be adjusted with the discount rate with which the project investments are evaluated. It is used when the projects under consideration have same cost but different NPV.

4.       Decision tree: Decision tree is a tree-form pictorial representation that takes into account, results of all expected outcomes. It is used when the decisions are sequential. It represents the relationship between a present decision and future events, future decisions and consequences.

5.       Sensitivity technique: under this approach, the cash flows are divided into three sections ‘optimistic’, ‘most likely’, and ‘pessimistic’. The NPV under these three situations are to be found out and where the NPVs differ widely, it means ‘great risk’. The company may reject or accept the project based on risk bearing ability.

6.       Simulation: Simulation is representation of reality in some physical form or in some form of mathematical equations. Simulation does not produce optimum results and it is used to obtain expected return for a risky investment involving heavy expenditure. It has been described as ‘what to do when all else fails’. This method involves use of computers to determine the distribution of rate of return and is expensive. The steps are given below –

i. Define the problem to determine the objectives and constraints.
ii. Randomly select a value of each variable from its distribution.
iii. take these values and other given information and calculate the projects IRR or NPV
iv. Repeat steps i and ii many times and
v. prepare IRR or NPV distribution which is the result of the above.

7.       Linear programming model: Linear programming is the most widely used Operation research technique which is concerned with developing optimal solutions to problems of business world. Oil refineries, steel industry, airlines, railways, textiles, defence establishments etc are users of LP.  LP problems are concerned with either minimizing the cost or maximizing the profit. They are used in planning of product mix, blending, diet, transportation, routing and assignment problems. It helps in optimum utilization of resources and be applied in investment decisions also.

Cost of capital

The cost of capital of company is the minimum required rate of earning or the cut-off rate for capital expenditure. Usually in discounted cash flow techniques cost of capital is used to discount the future cash flows. Companies use the concept of cost of capital for comparing proposals. The project which has a rate of earnings below cost of capital would be rejected. Generally, the sources of capital include –

i.         Equity Capital
ii.       Preference share capital
iii.      Debt
iv.     Retained earnings
v.       Depreciation  (But, not a source for assessment of cost of capital)
Cost of equity capital i.e.   Ke  = [D1/Po] + g
Where D1 = Dividend on equity paid in period 1, Po = market value and g = growth rate of dividend.
Cost of Preference capital i.e. Kp = D/R where D = fixed dividend on pref share capital and R= Net proceeds on sale of pref shares.
Cost of debt i.e. Kd= (1-T) R, where T = marginal tax rate, R= contracted rate of interest
Cost of retained earnings i.e.  KR =  D(1-T) , where D= dividend rate & T = tax rate.
If tax liability is presupposed / & capital gains tax is to be paid, then KR = D(1-T) / P(1-Tc) where  D= Dividend rate, T= Tax rate & Tc = Capital gains tax.

If no tax liability of the equity holder then KR = [Dividend /market price] * 100.

E.g. 1.  Suppose, XYZ & co has paid a dividend of Rs. 5 last year. The market price of share is Rs. 50 and dividend is expected to grow next year by  4%. . Cost of retained earnings = ?
Here D, Po and G are given. So, cost of retained earnings = [D (1+G) / Po] + G = [5 (1+.04) / 50] + .04 = 14.4 %

Eg.2. Where dividend= Rs. 1.50,  stock exchange price of shares = Rs. 14 and tax rate = 50% and capital gains tax @ 20 %,  then cost of retained earnings (KR) = 1.50 (1-0.50) / 14 (1-0.2)  = 6.7 %

[Authors note: where rate of return on security, rate of return on mkt portfolio and Beta coefficient is given then cost of retained earnings can also be calculated using CAPM method]

Composite cost of capital is calculated as combined weighted average of the cost of all different sources of capital (i.e. sum of weight * K….).

Source: ICSI study material, UNOM
Dedicated to CS professional programme students

Prepared by Victor J. Uruvath , CS Professional Programme,
Thrissur- Kerala
Published by: Santhosh Thomas Thaikkadan, CS Professional Student, Thrissur-Kerala
Disclaimer: The article may contain additional information/equations different from those available in the study material. The students are recommended to read the study material for more clarifications on the subject.  The author &/publisher could not be held liable for any loss/damage on account of any omissions/errors in the article.