MODULE 4 LONG-TERM INVESTMENT DECISIONS CAPITAL BUDGETING Capital budgeting is the process of making investment decisions in long term assets. It ts the process of eciding whether or not to invest in a particular Project as all the investment possibilities may not be rewarding Thus, the manager has to choose a project that gives a rate of return more than the cost financing such a project. That is why he has to value a project in terms of cost and benefit Follovang are the categones of projects. that can be examined using capital budgeting process > The decision to buy new machinery > Expansion of business in other geographical areas > Repl ement of an obsolete equipment > New product or market development etc ‘Thus, capital budgeting is the most important Fesponsibility undertaken by a financial manager. This is because 1. involves the purchase of tong term assets and such decisions may determ the future su 88 of the firm 2. These decisions help in Maximizing shareholde 8 valueapplicable to capital budgeting also Apply to other corporate slike working capital management Procoss of Capital Budgoting Following aro tha stops of capital budgoting procoss: > Idea Genoration:The most important step of the capital budgeting process is generating good investment ideas, These investment ideas can come from a number of sources like the senior management, any department or functional area, employees, or sources outside the company, > Analyzing Individual Proposals:A manager must gather information to forecast cash flows for each project in order to determine its expected profitability. This is because the decision to accept or reject a capital investment is based on such an investment's future expected cash flows. > Planning Capital Budgot:An entity must give priority to profitable projects as per the timing of the project's cash flows, available company resources, and a company's overall strategies. The projects that look promising individually may be undesirable strategically. Thus, prioritizing and scheduling projects is important because of the financial and other resource issues, > Monitoring and Conducting a Post Audit:it is important for a manager to follow up or track all the capital budgeting decisions. He should compare actual with projected results and give reasons as to why projections did not match with actual performance, Therefore, a systematic post-audit is essential in order to find out systematic errors in the forecasting process and hence enhance company operations, Techniques of Capital BudgetingCapital budgeting techniques are the methods to evaluate an investment proposal in order to help the company decide upon the desirability of such a proposal. These techniques are categorized into two heads : traditional methods and discounted cash flow methods. Traditional Methods Traditional methods determine the desirability of an investment project based on its useful life and expected returns. Furthermore, these methods do not take into account the concept of time value of money. ov Payback Period Method Payback period refers to the number of years it takes to recover the cost of an investment. Therefore, it is a measure of liquidity for a firm. Thus, if an entity has liquidity issues, in such a case, the shorter a project's payback period, better it is for the firm. 7 = Initial Investment OR Payback Period _ Original Cost of the Asset Formula ~ Cash Inflows Therefore, Payback poriod = Full years until recovery + (unrecovorod cost at the beginning of tho last yoar)iCash flow during tho last yoarHere, full years until recovery is nothing but the Payback that occurs when cumulative net cash flow equals to zero. Cumulative net cash flow is the running total of cash flows at the end of each-time period. Average Rate of Return Method (ARR). Under the ARR method, the Profitability of an investment proposal can b& determined by dividing average income after taxes by average investment, which is average book value after depreciation. Thus, ARR = Average Net Income After Taxes/Average Investment x 100 Where, Average Income After Taxes = Total Income After Taxes/Total Number of Years Average Investment = Total Investment/2 Based on this method, a company can select those projects that have ARR higher than the minimum rate established by the company. And, it can reject the projects having ARR less than the expected rate of return. Discounted Cash Flow Methods As mentioned above, traditional methods do not take into the account time value of money, Rather, these methods take into consideration present and future flow of incomes, However, the DCF method accounts for the concept that a rupee earned today is worth more than a rupee earned tomorrow. This means that DCF methods take into account both profitability and time value of money.Net Present Value Method (NPV) NPV is the sum of the present values of all the expected incremental cash flows of a project discounted at a required rate of return less than the present value of the cost of the investment. — In other words, NPV is the difference between the present value of cash inflows of a project and the initial cost of the project. As per this technique, the projects whose NPV is positive or above zero shall be selected. If a project's NPV is less than zero or negative, the same must be rejected. Further, if there is more than one project with positive NPV, then the project with the highest NPV shall be selected. if NPV = CF4/(1 + k)1 +... » CFn/ (1 + k)n + CFO where CFO = Initial Investment Outlay (Negative Cash flow) CFt = after tax cash flow at time t k= required rate of return Internal Rate of Return (IRR) Internal Rate of Return refers to the discount rate that makes the present value of expected after-tax cash inflows equal to the initial cost of the project. In other words, IRR is the discount rate that makes present values of a project's estimated cash inflows equal to the present value of the project's estimated cash outflows.IF IRR is greater than the required rate of return for the project. then accept the project. And if IRR is less than the required rate of return, then reject the project. PV (inflows) = PV (outflows) NPV = 0 = CFO + CF1((1 +IRR)1 + ........... Fal (1 + IRR)n + CFO Profitability Index Profitability Index is the present value of a project's future cash flows divided by initial cash outlay. Thus, it is closely related to NPV. NPV is the difference between the present value of future cash flows and the initial cash outlay. Whereas, PI is the ratio of the present value of future cash flows and initial cash outlay. PI = PV of future cash flows/CFO = 1 + NPV/CFO Thus, if the NPV of a project is positive, Pl will be greater than 1. If NPV is negative, PI will be less than 1. Therefore, based on this, if Pl is greater than 1, accept the project otherwise reject. Reference Material Thus, the manager has to evaluate the project in terms of costs and benefits as all the investment possibilities may not be rewarding. This evaluation is done based on the incremental cash flows from a project, opportunity costs of “undertaking the project, timing of cash flows and financing costs.Therefore, it is the planning of expenditure and benefit that spreads over a number of years. Capital budgeting process used by managers depends upon the size and complexity of the project to be evaluated, size of the organization and the Position of the manager in the organization. Establish norms for a company on the basis of which it either accepts or fejects an investment project. The most widely used techniques in estimating cost-benefit of investment Projects. These methods are used to evaluate the worth of an investment project depending upon the accounting information available from a company’s books of accounts. Objectives of Capital Budgeting The following are the objectives of capital budgeting. 1. To find out the profitable capital expenditure. 2. To know whether the replacement of any existing fixed assets gives more return than earlier. 3. To decide whether a specified project is to be selected or not. 4. To find out the quantum of finance fequired for the capital expenditure. 5. To assess the various sources of finance for capital expenditure. 6. To evaluate the merits of each Proposal to decide which project is best. Features of Capital Budgeting The features of capital budgeting are briefly explained below:1, Capital budgeting involves the investment of funds currently for getting benefits in the future. 2. Generally, the future benefits are spread over several years. 3. The long term investment is fixed. The investments made in the project is determining the financial condition of business organization in future.” 5. Each project involves a huge amount of funds. . Capital expenditure decisions are irreversible. - The profitability of the business concer is based on the quantum of investments made in the project. Principles of Capital Budgeting Decisions should be based on incremental cash flows (not on accounting income based on accrual basis): « Exclude sunk costs For example, already incurred costs like Preliminary consulting fées should not be included in the: analysis. * Include externalities - Both Positive/negative externalities should be considered in the analysis. For example, the negative impact of a new diet sod la product launch on the sales of existing soda products, (Note: In a conventional cash flow, the sign of cash flows changes only once during the life of the project: while an unconventional cash flow has more than one sign change.)1. Timing of cash flows Is vital: Due to time value of money, cash flows received earlier are more valuable than cash flows received later. 2. Cash flows are based on opportunity cost For example, if you plan to use an existing office space rather than renting it out then rental income from the office space is an opportunity cost. 3. Cash flows are analyzed on an after-tax basis: Shareholder value increases only on the cash that they have earned. Hence, any tax expenses must be deducted from the cash flows.. 4. Financial costs are ignored: Financial costs are already included in the cost of capital (discount rates) used to discount cash flows to arrive at the present value. Hence, to avoid double-counting, they must not be deducted from the project's cash flows. Principles of Capital Budgeting Capital Budgeting Proposal There are two broad evaluation methods for a capital budgeting proposal:1. Non-Discounted Cash Flow Methods: These are the traditional methods and include payback period and the accounting rate of return (ARR). Their biggest disadvantage is that they ignore the time value of money. The payback method is skewed towards selection of projects with the shortest payback period; it ignores the timing of profits as well as expected profits after the payback petiod.The ARR is the average annual expected profits from the project divided by the project cost. It is superior to the payback method because it considers all future’ profits but its value is affected by computation—average pre-tax profits and average. project cost will generate a higher ARR than post-tax profits and total project cost. 2. Discounted Cash Flow (DCF Methods):They take into account the time value of money. The methods include net present value, internal rate of return, and profitability index. All three methods consider the time value of money, use post-tax cash flows, and consider all cash flows over the project's life. They are therefore superior to traditional evaluation methods. Computation of Cash Flows A capital budgeting proposal requires an outflow of cash, either. at the beginning of the project, itself (initial outlay) or over the first few years. Depreciation (D) is a non-cash expense. The amount of depreciation per annum is known at the outset, based upon the depreciation method the company follows (such as the straight line method, or the written down value.method). Earnings before Depreciation and Taxes (EBDT) are revenues minus costs before deducting depreciation and corporate income tax payable. Earnings Before Tax (EBT) is the EBDT minus depreciation. Earnings after Tax (EAT) is EBT .minus the tax payable. Cash Flows After Tax (CFAT) is earnings after tax (EAT) plus depreciation.EAT = (EBDT — D) (1 — J) where 'T’is the tax rate CFAT = EAT +D or CFAT = (EBDT-D) (1-7) +D Cost of Capital: It is the weighted average cost of capital (WACC). Given cost of equity (ke), the after-tax cost of debt (kd), and weights of equity and debt (we and wd respectively), the WACC is: WACC = (k.) (We) + (Ke) (Wa) Under the NPV method, the cost of capital is the discount rate used to compute the present value of after-tax cash flows. Under IRR, the cost of capital is the hurdle rate against which the project's IRR is compared. Capital budgeting decisions Generally the business firms are confronted with three types of capital budgeting decisions. 1. Accept-reject decisions: Business firm is confronted with alternative investment proposals. If the proposal is accepted, the firm incur the investment and not otherwise. Broadly, all those investment proposals _Which yield a rate of return greater than cost of capital are accepted and the others are rejected. Under this criterion, all the independent proposals are accepted.2, Mutually exclusive decisions: It includes all those projects which compete with each other in a way that acceptance of one precludes the acceptance of other or others. Thus, some technique has to be used for selecting the best among all and eliminates other alternatives. Capital rationing decisions:, Capital budgeting decisions are a simple Process in those firms where funds are not the constraint, but in the majority of the cases, firms have fixed capital budgets. So a large amount of projects compete for these limited budgets. So the firm rations them in a manner so as to maximize the long run returns. Thus, capital rationing refers to the situations where the firm has more acceptable investment requiring a greater amount of finance than is available with the firm. It is coneemed with the selection of a group of. investment out of many investment proposals ranked in the descending order of the rate or return. | Kinds of Capital Budgeting Capital budgeting is basically a long term decision. Capital budgeting involves the planning and development of available financial resources with the object of maximising the long term profit eamin The different kinds of capital’ a) By project size:Small 9 Capacity of the company. budgeting proposals are as follows: Projects may be approved by departmental managers, More careful analysis and Board of Directors’ approval Is needed for large projects of, say, half a million dollars or more: b) By type of benefit to the firm: }) anincrease tn Cash flow. li) adecrease in risk, fii) an Indirect benefit (showers for workers, etc), ©) By degree of dependence:i) mutually exclusive projects (can execute project A or B, but not both). ii) complementary projects:t taking project A Increases the cash flow of project B. iii) substitute projects: taking project A decreases the cash flow of project B. d) By degree of statistical dependence: i). Positive dependence ji) Negative dependence iii) __ Statistical Independence. .- ) By type of cash flow: z i). Conventional cash flow: only.one ii) - Non-conventional cash flows; mo sign Methods for evaluating investment At each point of time a business firm has a number of proposals regarding various projects in which it can Invest funds. But the funds available are limited and it is not possible to invest funds in all proposals at one time. Hence there Is a need for evaluation of profitability of the different proposals. The commonly used “ methods for this purpose are: (A) Traditional Methods * (i) Payback Period method: The ‘Payback’ period method represents the period in which the total investment In permanent asset pays back itself. Thismethod is based on the principle that every capital expenditure pays itself back within a certain period out of the additional earnings generated from the capital assets. The investment with a shorter payback period is preferred to the one which has a longer payback period. act : Payback period = Lash outlay or Original Cost of Asset lyback period ‘Annual Cash inflows The main advantage of this method is that it is simple to understand and easy to calculate. It saves in cost, requires lesser time and labour as compared to other methods. However it does not take into account the c: e payback period and hence the true profitability of th It also ignores the time value of money and does inflows earned after the ‘oject cannot be assessed. t consider the magnitude and. timing of cash inflows. (ii) Average Rate of Return (ARR): This method takés into account the earnings expected from the investment over its whole life. Under this method, the accounting concept of profit is used rather than cash inflows. The project with the higher rate of return is selected as compared to the one with lower rate of return. ARR = Aetase t x 100 » This method is simple to understand and easy to operate. It uses the entire Warnings of a project in calculating rate of return. As this method is based upon the accounting concept of profits, it can be readily calculated from financial data. However this method ignores the time value of money as the profits earned at different points of time are given equal weight by averaging the profits. It ignores the cash flows which are more important than accounting profits. It cannot be applied to a situation where investment in a project is to be made in parts.(B) Time Adjusted Methods The time adjusted or discounted cash flow methods take into account tht profitability and also the time value of money. (i) Net Present Value Method (NPV): This method takes into consideration the time value of money and attempts to calculate the return on investment by introducing the factor of time element. It tecognises the fact that a Tupee earned today Is Worth more than the same rupee earned tomorrow. The net present values of all inflows and outflows of cash occupied-during the entire life of the project is determined separately for each year by discounting these flows by the firm's cost of.capital on a predetermined rate. The present value of Re. 1 due in ‘any number of years can be found by the following formula: PV= —1—where wo at" PV = Present Value r= Rate of Interest/discount rate n= number of years. ‘The present value for all the cash inflows for a number of years in thus found as follows: as A, A . 7 ead 7 a4n) asry amywhere, Ay, Aa, Ag,..-An= future net cash flows 2,3, r=rate of interest ed ,n= number of years i ‘ discount rate. (ii) Internal te of Return Method (IRR): Under this method the cash flows of a Project are discounted at a suitable-rate by hit and trial method, which equates the net ‘present value: so calculated to the amount of the investment. The discount rate’ is determined internally. The IRR can be defined as that rate of discount at which the present value of cash inflows is equal to the present value of cash outflows. A z— 2 aay "try * aan? Where, C= Initial outlay at Time ZeroAy, Aa, Ag,...An= Future net cash flows at different periods 2,3, ... n= number of years r= rate of discount of internal rate of return, This method takes into account ‘the time value of money. and can be usefully applied in situations with even as well as uneven cash flow at different Periods of time. It considers the ‘profitability of the project for its entire economic life. The determination of cost of capital is not a prerequisite for the use of this method. However, this method method of ‘evaluation of difficult to understand and is the most difficult of proposals. Also this method is based upon the assumption that the earnings are reinvested at the intemal rate of return for the remaining life of the proj f Pre “Index ‘or Benéfit Cost Ratio Method: It is. the relationship between sent value of cash inflows and the present value of cash outflows and is given by: Profitability Index (Pl) = Present value of cash nftows © Present value of cash outflows: a pj = Pep Cash ingtows é ‘Initial cash outlay “a ney Pi Nef= Initial Cash outlay or PA, (Net) = PL (Gross) -1 The proposal is accepted if P.l, is more than one and vice versa. ‘Under this method it is easy to rank projects particularly when the costs of the Projects differ significantly,(iv) Terminal Value Method: This method is an improvement. oyer the NPV method. Under this method it is assumed that each of the future cash flows is immediately reinvested in another project at a certain rate of return until the termination of the project. In other words, net cash flows and outlay are compounded forward rather than discounting them backward as followed in NPV method. In case of a single project, the project ls accepted if the present value of the total of the compounded reinvested cash inflows is greater than the present value of the outlays, otherwise it is rejected. In case of mutually exclusive projects, the project with higher present value of the total of the compounded cash flows is accepted. Compounded value of Cash Inflows. er: Hence, Present Value = Where, K = Cost of capital, n = life of project (years) Payback period (PBP) Payback period is the time required to recover the initial cost of an investment. It is the number of years it would take to get back the initial investment made for a project. Therefore, as a technique of capital budgeting, the payback period will be used to compare projects and derive the number of years it takes to get back the initial investment. The project with the least number of years usually is selected. > Payback period is a simple calculation of time for the initial investment to return. > It ignores the time value of money. All other techniques of capital budgeting consider the concept of time value of money. Time value of money means that a rupee today is more valuable than a rupee tomorrow.So other techniques discount the future inflows and arrive at discounted flows. > It is used in combination with other techniques of capital budgeting. Owing to its simplicity the payback period cannot be the only technique used. for deciding the project to be selected. e Advantages and Disadvantages The most important advantage of this method is that it is very simple to calculate and understand. If the manager requires a-fough idea about the time frame for which the money would be blocked, he need not sit with a pen, paper or a computer. It can be calculated on our fingertips. It can at least tell the manager-whether the project is worth spending further analysis time or not. There are two disadvantages to this method. One, it does not consider the cash flows’ after the payback period. Because of this, we cannot-consider two projects with the same payback period as equally good. This method will give the same rating to two projects with the same initial cash flow of 100 million where cash inflow of ofe is 50 million in first two years and the other is 50 million for three years. is Second, it does not consider the time value of money. So, it is avoiding the basic rule of finance i.e. ‘a dollar today is worth more than a dollar a year later.’ In PBP, we calculate the years where the total investment is recovered. In true ‘ sense, it is only the principle which is covered; the portion of interest is still to be covered, Other drawbacks include its inability to deal with uneven cash flows with negative cash flows in between. It may resull in dual results.Discounted Payback Period It's a solution to one of the disadvantages mentioned above which says it does not take into account the time value of money. The discounted payback period is just a little. differerit from the normal payback period calculations. We just need to replace the normal cash flows with discounted cash flows and the rest of the calculation will remain the same. It is also referred to as net present value (NPV) payback period. Accounting Rate of Return’ Accounting Rate of Return (ARR) is the percentage rate of return that is expected from an investment or asset compared to the initial cost of investment. Typically, ARR is used to make capital budgeting decisions. For example, if your business needs to decide whether to continue with a particular investment, whether it's a project or an acquisition, an ARR calculation can help to determine whether going ahead is the right move. The Accounting Rate of Return formula is as follows: ¢ ARR = average annual profit / average investment ARR= — AverageAccounting Profit = Average Investment Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the Project's lifetime, Average ‘investment may i Y be calculated as the sum of the beginning and ending book ae of the project divided by 2. Another variation of the ARR formula uses initial investment instead of average investment.Advantages and Disadvantages Advantages 1. Like payback period, ‘this method of investment appraisal. is easy to calculate. 2. It recognizes the Profitability factor of investment. Disadvantages 1. It ignores the time value of money. Suj f two projects having equal initial investments. annual income in the latter years of its useft ay frank higher than the ig years, even if the consistency. g . It uses accounting income rather than cash flow information. Thus it is not Suitable -for projects which have high mai intenance costs because their Viability also depends upon timely cash inflows. Internal Rate of Return (IRR) - The internal rate of return (IRR) is.a discounting cash flow technique which @ rate of return eamed by a project. The internal rate of return is the discounting rate where the total of initial cash outl are equal to zero. In other words, it is the di present value(NPV) is equal to zero, If the cash flows of a ‘normal’ ( ‘gives lay and discounted Cash inflows iscounting rate at which the net ‘cash o} Project are taken and discounted at di Plot the following graph; ulflow followed by a series of cash inflows) ifferent discount rates, it will be possible toNPV The discount rates used are on the axis, and the NPV ($) is on the y-axis. As you can see, the graph is a smooth curve, which crosses:the x-axis. It is this point that we need to calculate the discount rate, which has produced a NPV of zero — this is the IRR. It would. be very time consuming to calculate the NPV of a project for many different discount factors and then plot the graph and estimate where the graph crosses the x-axis. Instead, there is a shortcut using the formula: NPV, IRR =1,+ —-—2-— (r= r,) b NPV, - NPV, * r, = lower discount rate chosen r, = higher discount rate chosen N, = NPVatr, N, = NPVatr,In order to use the formula then, we need to take the cash flows of the project and discount them twice — once using a discount rate a%, and once using a discount rate b%. If we plot these results on a graph it would be as follows: NPV Discount rate We know that the line joining these two points should be a curve, but the formula approximates the curve with a straight line and so calculates the point at which a straight line crosses the x-axis and is therefore the IRR: NPV $ IRR calculated using the formula f f NPV, _b Discount rate True IRRThe estimation is most accurate if one NPV used in the formula is positive and the other one is negative. So if a candidate chooses a discount factor and calculates the NPV of the project which turns out to be negative, a lower discount Tate should be chosen for the next discounting so that there is a possibility of obtaining a positive NPV. Net Present Value (NPV) The Formula for NPV NPV = Cash flow (1+i Where: i=Required return or discount rate t=Number of time periods If analyzing a longer-term project with multiple cash flows, the formula for the net present value of a project is: n R NPV = Sy _ > (1+ i) 'scount rate or return thal could be earned in altemative investments {number of time periodsPositive NPV: If the present value of cash inflows is greater than the present value of the cash outflows, the net present value is said to be positive and the investment proposal is considered to be acceptable. Zero NPV: If the present value of cash inflow is equal to the present value of cash outflow, the net present value is said to be zero and the investment Proposal is considered to be acceptable. Negative NPV: If the present value of cash inflow is less than the present value of cash outflow, the net present value is said to be negative and the investment proposal is rejected. 1, Present value of cash inflow > Present value of cash outflow NPV is positive and the project is acceptable 2. Present value of cash inflow = Present value of cash sutflow NPV is zero and the project is acceptable 3. Present Value of cash inflow < Present value of cash outflow NPV is negative and the project is not acceptable : Advantages ~ 4. Considers the time value of money 2. Considers cash inflow of the entire project. 3. Estimation of present value of their cash flows based on a discounting rate equal to cost of capital. 4. Consistent with the objective of maximising the shareholders’ wealth. 5. One of the most acceptable and adaptable methods of capital budgeting evaluation.Disadvantages 1. Based on discount rate: In practical life, it is very difficult to understand and calculate as compared to ARR method or payback method 2. It does not consider the magnitude of the initial outlay and cash. benefits together. : 3. Does not give reliable answers if alternative projects have unequal effective lives. 4. This method is an ‘absolute measure. When two projects are being considered, this method favours the project with higher NPV. Modified Internal Rate of Return (MIRR) Modified: internal rate of return (MIRR) is a similar technique to IRR. Technically, MIRR is the IRR for a project with an identical level of investment and NPV to that being considered but with a single terminal payment. In order to calculate MIRR, we first need to find future value of all cash inflows at the end of the project using an appropriate reinvestment rate, calculate the “present value of all cash outflows at the relevant discount rate and then use the following formula to work out MIRR: MIRR = (FVCIPVco)!" - 1 Profitability Index (PI) Profitability Index (Pl) Is a capital budgeting technique to evaluate the investment projects for their viability or profitability. Discounted cash flow technique is used in arriving at the profitability index. It is also known as a benefit-cost ratio, Calculation of profitability index is possible’ with a simpleformula with inputs as — discount rate, cash inflows, and outflows. PI greater than or equal to 1 is interpreted as a good and acceptable criterion. The method used for arriving at profitability index of a proposed project is _ explained stepwise below: 4. Find the expected cash inflows of the project 2. Find the cash outflows of the project (Initial Investment + any other cash outflow) 3. Decide an appropriate discount rate 4. Discount the expected cash inflows using the discount rate 5, Discount the future cash outflows and add to initial investment dex (PI) is a capital budgeting technique to evaluate the investment projects for bitty. ity. ( STEPS TO CALCULATE PI ) C PROS AND CONS ADVANTAGES : It considers time value of meney concept Itako allows two investment comparison. Find the expected Cash Inflow > Find the cash outflow > Decide upon the Discount Rate > Discount the expected. cash inflows using the discount rate > Discount the fumre cash oudlows and add to initial investment > Divide step (d) by step (ce) DISADVANTAGES : Two projects having the vast difference in mvestment and dollar ame PI. In such ethod works. yetum can have situaton, the NPV Advantages of profitability Index 1., It recognizes the time value of money.2. It considers all cash flows over the entire life of the project In its calculation. 3. If one tries to maximize projects, the use of NPV always finds the correct costs and revenues. 4. Its easy to calculate compared to IRR. 5. Its consistent with the objective of maximizing the welfare of owners. .’ 6. It Is quite suitable for evaluating ee proposals when their costs differ significantly. Disadvantages of profitability method 1. It is a complicated method, In the sense that it Involves‘a good amount of calculations. 2. It is not suitable for ranking projects requiring different capital outlay. 3. There is a difficulty in determining the discount rate. Economic value added method (EVA) ° The -EVA (Economic Value Added) is an indicator of profitability and a measure of financial_performance, based on residual wealth. It is the excess profit above: the cost of capital, generated by the business, adjusted for taxes, and presented on-a cash basis. The consulting firm Stern Value Management developed the method. It represents the difference between the Rate of Return and Cost of Capital and measures the value generated by invested capital. 4 The Economic Value Added (EVA) attempts to capture the truest economic profitability of the company. Therefore, we also refer to it as Economic Profit. A negative EVA means that the business is generating no value. Whereas, a Poslilve, EVA implies the company is creating value for the shareholders.Capital Rationing Capital rationing is defined as the process of placing a limit on the extent of New projects or investments that a company decides to undertake. This is made passible by placing a much higher cost of capital for the consideration of the investments or by placing a ceiling on a particular proportion of a budget. A company might intend to implement capital rationing in scenarios where the past revenues generated through investments were not up to the mark. Capital rationing is necessarily an approach of management in allocating the funds available across various opportunities of investment, thereby enhancing the bottom line of the company. The company will go on to accept the blend of projects that have the net present value (NPV) on the higher side. The primary intention: of the capital rationing is to make sure that a company is not going to invest heavily in assets. With insufficient rationing, a company may go on to witness the returns provided by their investments going on the lower side and may even reach a scenario where the company enters the stage of financial insolvency. The first type of capital rationing is called hard capital rationing. This type of rationing happens if a company is having issues with raising excessive funds, either by means of debt or equity. The rationing happens from an external dependence in order to cut down on expenses and may result in the shortage of capital to raise enough money for projects in future. The second kind of capital, rationing, is referred to as the soft capital fationing, It is also called internal rationing. This happens because of the internal policies of an organisation. A company that is financially conservative will have ahigh required retum on the capital invested in taking up projects in the corning days, thereby imposing self capital rationing PRACTICAL PROBLEMS 4. A project requires an initial investment of & 1,20,000 and yields an annual cash inflow of % 40,000 for 7 years. What is the Payback period? Solution: fod = 2tizinal investment _ 120,000 Payback period = ~jrtualcaskinflow = “ano = 3Years 2. Compute NPV from the following information given below. A project which requires an initial investment of % 40,000 and which has a net cash inflow of 2 12,000 per annum for 6 years. The cost of funds is 8% . There is no scrap value (PV. of annuity of Re. 1 for 6 years @ 8% per annum is 4.623) Solution: Present value of cash inflow (12,000x4.623) 55,476 LESS: Initial cash outlay 40,000 Net Present value 15,4763. If the discount factor (cost of capital) is 12% and if tl is received after 2 years what is the present value? Solution: ‘The formula for computing the Pv is 4. Keerthi Co., Ltd is considering the purchase of machinery. Two machinery S and T each costing % 2,00,000 are available. Cash inflows are expected to be as under. Calculate a) Payback Period b) Post Pay back period Method. Year Machine S Machine T 1 60,000 20,000 2 80,000 60,000 s 1,00,000 80,000 4 60,000 1,20,000 5 40,000 80,000 Solution: PBP = 2tgtal invescnThe above formula cannot be applied as the cash inflow of the projects are not uniform, thereby the second method i.e, cumulative method has to be adopted. Machin Payback period method Year Cash Inflow Cumulative Cash Inflow i 60,000 60,000 2 80,000 1,40,000 .’. PBP is 2.6 years for Machine "S" Machine ” = 0000) = Favor = 9-6 Year Cash Inflow Cumulative Cash Inflow 1 _| 20,000 20,000 \ 2 60,000 80,000 3 80,000 1,60,000 — 40000) 120000 = 0.33 .”. PBP is 3.33 years for Machine "T" From the above, it is clear that Machine “S" is profitable according to pay back period method as it gives the Investment early. Post Payback profitability ’ Machine "S"Total Cash infiows of the project 3,40,000 (60,000+80,000+1,00,000+60,000+40,000) Less: Original Investment 2,00,000 Post Payback Profitability 4,40,000 Machine "T* 2 Total cash inflows of the project ~~ 3,60,000 (20,000+60,000+80,000+1 ;20,000+80,000) Less: Original Investment Ses From the above: it is clear that Machine | ai is profitable: ccording to the post payback profitability method as the profit is more: -— 5. Kiran Industries Limited is considering the purchase of a new machine which would carry out some operations; there are 2 alternative models under consideration for investment they are Polar & Sony. The following information is available in respect of both the machine: Polar Sony Estimated life in years 20 22 Cost of machines %42,00,000 ® 20,00,000Estimated savings in scrap p.a, ‘Additional cost of supervision p.a, Additional cost of maintenance p.a, Cost of indirect material p.a, Estimated savings in wages a) Wages per worker pa b) No, of workers not required © 0,000 = 06,000 ® 56,000 © 48,000 © 4,800 4,20,000 ® 1,28,000 % 88,000 % 64,000 2 4,800 200 Using the method of pay back period suggest which is profitable Solution: Comparative Analysis of Cash inflows of two machine Polar (2) Sony (2) Total savings a, Estimated savings in scrap. 80,000 1,20,000 b, Estimated savings in wages Polar 4,800 x.450 Sony 4,800 x 200 7,20,000 9,60,000 8,00,000 10,80,000 ‘Total additional cost 8. Cost of supervision 96,000 1,28,000 b. Cost of maintenance 56,000 88,00048,000 64,000 2,00,000 280,000 8,00,000 1-0,80,000 2,00,000 280,000 6,00,000 8,00,000 Machine Polar is profitable 6. Zenith Industries Itd., are thinking of investing in a project costing & 20 lakhs. The life. of the project is five years and the estimated salvage value of the project is zero. Straight line method of charging depreciation is followed. The tax rate is 50%. The expected cash flows before tax are as follows: Year 1 2 3 Estimated cash flow before depreciation and tax (t lakhs) 4 6 8You are required to determine the (i) Payback period for the investment (ii) Average rate of return (iii) Net present value (iv) Internal rate of return. Cost of capital is 10% Solution: a. Payback period Year 1 2 3 4 Cash Inflow before tax & depreciation 4,00,000 6,00,000 | 8,00,000 8,00,000 (2 Depreciation 4,00,000 4,00,000 | 4,00,000 4,00,000 Cash inflow before tax - 2,00,000 | 4,00,000 4,00,000 () Tax (50%) : 1,00,000 | 2,00,000 2,00,000 Net cash inflow - 1,00,000 | 2,00,000 2,00,000 Add: Depreciation 4,00,000 4,00,000 | 4,00,000 4,00,000 Cash inflow before 4,00 000 §,00,000 | 6,00,000 6,00,000 depreciation & after tax ist year cash inflow= 4,00,000 2 year cash inflow= 5,00,000 %d year cash inflow = 6,00,000 4th year cash inflow (required)= §,00,000 0.000 Payback period = 3 year & 2tiule = 3.63yearsb. Average Rate of Return . Annual average net earning = 2+ 100000 + 2.00000 + 2.00000 +3000 — 4, 60,000 = Armual Average Net earnings '__1,60,000 on ‘Average Investment 10, x 100 = 16% c. Net Present value Year Cashinflow | PVat 10% discount PV of cash inflow | 1 4,00,000. ‘ose 3,863,600 2 500,000 0.826 - _ [413,000 3% 6,00,000 781 4,50,600 4 i 6,00,000 0.683 é 4,09,800 6. 7,00,000 0.624 ss 4,34,700 20,71,700 Net Present value = PV of cash Inflow - original investment = 71,700 iv) Internal Rate of Return Original Investment = -Orighal Investment — Factor = “trerage cashin/low Factor, 3.57, will be between 11% and 13% _ PV of cash inflow @ 11% Year Cash inflow PV factor PV of cash inflow 1 4,00,000 0.901 3,60,4002 5,00,000 0.812 4,06,000 3 6,00,000 0.731 438,600 4 6,00,000 0.659 3.95.400 5 7,00,000 0.593 4,15.100 20,15,500 PV of cash inflow @ 13% Year Cash inflow PV factor PV of cash inflow ff 4,00,000 0.885 3,54,000 z= 5,00,000 - 0.783 3.91,500 3 6,09,000 0.693 4,15,800 4 6,00,000 ~ 0.613 3.67,800 5 7,00,000 0.543 3,80,100 19,09,200 IRR =A+-22 x (B - A) where A= 11, B= 13, C= 20,D =114- 20.15,500~20,00,000, 20.35,500—19,09,200 x2e1+ '9,09,200, O = 2,00,00,000 15,500 Theta X 2 = 11.29%