Capital Budgeting: Jaiib /DBF Paper 2 (Module A) Unit 3:
Dear bankers,
As we all know that is Capital Budgeting for JAIIB Exam. JAIIB exam conducted twice in a year. So, here we are providing the Capital Budgeting (Unit-3), Business Mathematics and Finance (Module A), Accounting Finance for Bankers-Paper 2.
♦Capital Budgeting
- Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment.
- An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. Ideally, an organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments.
Capital budgeting as a concept affects our daily lives. Let’s look at an example-
- Your mobile phone has stopped working! Now, you have two choices: Either buy a new one or get the same mobile repaired. Here, you may conclude that the costs of repairing the mobile increases the life of the phone. However, there could be a possibility that the cost to buy a new cell phone would be lesser than its repair costs. So, you decide to replace your cell phone and you proceed to look at different phones that fit your budget!
♦Future Value
- Money has a time value, i.e a given sum of money has greater value if it is received earlier as it can be profitability invested. To illustrate, consider an investor, who is evaluating an investment opportunity that requires an immediate outlay is Rs 100000 that will generate income in subsequent years. In deciding whether to go ahead with the investment, the investor will be concerned with how much income generation will be there in future. A rational investor will be unwilling to undertake the investment if he knows that he will receive less than what he can earn as interest.
- Thus, if the project has the life of one year, P is the immediate outlay and r is the rate of interest, his return should be more than the sum F, where
F= P(1+r)=(100000)(1+.10)=1,10000 (current rate of interest r=10%)
And if the project has the life of 2 yrs and the return is only at the end of 2 yrs his return should be more than the sum F, where
F= P(1+r)^2=100000(1+r)^2=100000(1+.10)^2=121000
Clearly, if the investor has choose the project, he has to compare the yield on the investment to the yield from project’s cash flow, i.e. if the project has the life of two years then his return should be more 1,21,000.
Future value of Rs 100000 in year 20= 1,00,000(1+0.10)^20=6,72,750
♦ Present Value and Discounting
The Present value of a sum of money to be received in the future is calculated by dividing the future sum by (1+r)^n as follows:
Present Value= P=M/(1-+r)^n
The use of present time as a common reference point rather than some future point of time is particularly useful when comparing projects of different lengths of life. For Example, if two projects are to be compared, one that has an expected life of five years and the other having an expected life of nine year, it is easier to convert the cash flows to their preset value than to a future value.
♦Discounted cash flow Techniques for Investment Appraisal
This chapter sets out two main discounting techniques of investment appraisal namely the net present value (NPV) method and the internal rate of return (IRR) methods. Two main assumptions that are made in discussing the two techniques, are as follows:
- That the sums of moneys, resulting from an investment, that accrue in future, are know with certainty.
- That there is no inflation.
♦Net present value
- NPV method involves comparing the present value of the future cash flows of an investment opportunity with the cash outlay that is required to finance the opportunity. In this ways, we determine whether the investment opportunity provides a surplus, when the cash flows are measured in present value terms.
The stages involved in using the NPV method are as follows:
- Estimate all future net cash flows (revenue minus cost) associated with an investment opportunity.
- Convert these net cash flow figures to their present value equivalents by discounting at the appropriate discount rate;
- Add all the present value figures of future cash flows;
- Subtract from this value, the initial cost of investment.
Net Present Value(NPV) is a formula used to determine the present value of an investment by the discounted sum of all cash flows received from the project. The formula for the discounted sum of all cash flows can be rewritten as
When a company or investor takes on a project or investment, it is important to calculate an estimate of how profitable the project or investment will be. In the formula, the -C0 is the initial investment, which is a negative cash flow showing that money is going out as opposed to coming in. Considering that the money going out is subtracted from the discounted sum of cash flows coming in, the net present value would need to be positive in order to be considered a valuable investment.
How is NPV calculated?
- NPV tells you whether a certain project will generate cash flows according to your expectations or not. Using an assumed rate of return and investment horizon, it brings to light any adjustments required in your current investment to achieve a positive return.
NPV can be calculated by using the following formula:
NPV = [Cn/(1+r)^n], where n={0-N}
Where
Cn = difference of cash flows
r = discount rate
n = time in years
You need to follow selection criteria with regards to the usage of NPV. Calculation of NPV will result in three possible outcomes:
- Positive NPV: In this situation, the present value of cash inflows is greater than the present value of cash outflows. This is an ideal situation for investment
- Negative NPV: In this situation, the present value of cash inflows is less than the present value of cash outflows. This is not an ideal situation and any project with this NPV should not be accepted.
- Zero NPV: In this situation, the present value of cash inflows equals the present value of cash outflows. You may or may not accept the project.
♦Internal Rate of Return (IRR)
- The internal rate of return (IRR) is a discounting cash flow technique which gives a rate of return earned by a project. The internal rate of return is the discounting rate where the total of initial cash outlay and discounted cash inflows are equal to zero. In other words, it is the discounting rate at which the net present value(NPV) is equal to zero.
How is the Internal Rate of Return computed?
For the computation of the internal rate of return, we use the same formula as NPV. To derive the IRR, an analyst has to rely on trial and error method and cannot use analytical methods. With automation, various software (like Microsoft Excel) is also available to calculate IRR. In Excel, there is a financial function that uses cash flows at regular intervals for calculation.
The rate at which the cost of investment and the present value of future cash flows match will be considered as the ideal rate of return. A project that can achieve this is a profitable project. In other words, at this rate the cash outflows and the present value of inflows are equal, making the project attractive.
How is IRR used for capital budgeting?
- If the same costs apply for different projects, then the project with the highest IRR will be selected. If an organization needs to choose between multiple investment options wherein the cost of investment remains constant, then IRR will be used to rank the projects and select the most profitable one. Ideally, the IRR higher than the cost of capital is selected.
- In real life scenarios, since the investment in any project will be huge and will have a long-term effect, an organization uses a combination of various techniques of capital budgeting like NPV, IRR and payback period to select the best project.
Illustration
Let us say a company has an option to replace its machinery. The cost and return are as follows:
Initial investment = Rs.5,00,000
Incremental increase per year = Rs.2,00,000
Replacement value = Rs.45,270
Life of asset = 3 years
If we assume IRR to be 13%, the computation will be as follows.
Year | Cash flows | Discounted cash flows |
0 | -500000 | (500000)(5,00,000 * 1) |
1 | 200000 | 176991 |
(2,00,000 * [1/1.13]) | ||
2 | 200000 | 156229 (2,00,000 * [1/1.13]2 |
3 | 200000 | 138610 |
(2,00,000 * [1/1.13]3 | ||
4 | 45270 | 27765(45,270 * [1/1.13]4 |
The total of the column Discounted Cash Flows approximately sums up to zero making the NPV equal to Zero. Hence, this discounted rate is the best rate.
As can be seen from the above, using the rate of 13%, the cash flows, both positive and negative become minimum. Hence, it is the best rate of return on investment.
The cost of capital of the company is 10%. Since the IRR is higher than the cost of capital, the project can be selected.
If the company has another opportunity to invest the money in a project that gives a 12% return, the company will still go in for the machinery replacement since it gives the highest IRR.
♦NPV and IRR Compared
- NPV and IRR methods have the advantage that they take into account the time value of money and thus, they are viewed as being superior to the non-discounting technique.
- In addition, these two techniques have the advantage that they focus on cash flows rather than on accounting profits.
- Given that both the NPV and IRR are characterised by these advantages, it may be thought that either is equally acceptable, in terms of proving decision advice, which will help to meet the goals of the organization. However, while the two techniques are clearly, similar they do not always guarantee to provide the same investment decision advice. We therefore, need to make a comparison of the two techniques to understand which one is superior. This is particularly important because, as we will see, is more reliable. The preference of decision makers for the IRR results from the fact that the business people are more used to thinking in terms of rates of return. However, in some situations, the use of the IRR approach may lead to inappropriate investment decision guidance.
♦Investment Opportunities with capital Rationing
- In situations, Where the funds for investment are rationed, it will not be possible to undertake all investment opportunities that have a positive NPV or for which the IRR is greater than the cost of capital. Even where the projects are not mutually exclusive, capital rationing raise problems for both the NPV method and the IRR method.
♦Risk Adjusted Discount Rate Approach for NPV Determination
This approach to investment decision making process is an attempt to deal with the problem caused by an absence of certainty in relation to the cash flows in a manner that takes account of the risk attitudes of those people on whose behalf the decision is being made. When faced with a situation of risk, investors who are averse risk will require a higher rate of return to compensate them for taking on that risk. The higher the level of risk, the grater must be the rate of return. The risk –adjusted rate of return approach puts this simple concept into practice. This method involves the following steps:
- The decision makers should determine the rate of return that would be required for taking on investment with zero risk.
- Then add on to this rate of return, a risk premium, to take account of the risk factor of the investment under consideration.
- Rate of return, when calculated this way, is used as the discount rate in the NPV calculation.
♦Non- Discounted Cash Flow Techniques
Payback period method:
- As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability.
Payback period = Cash outlay (investment) / Annual cash inflow
Accounting rate of return method (ARR):
- This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected.
- This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method also ignores time value of money and doesn’t consider the length of life of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of shares.
ARR= Average profit after tax/Average Investment
♦IMPORTANCE OF CAPITAL BUDGETING
- Long term investments involve risks: Capital expenditures are long term investments which involve more financial risks. That is why proper planning through capital budgeting is needed.
- Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses.
- Long run in the business: Capital budgeting reduces the costs as well as brings changes in the profitability of the company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long run.
SIGNIFICANCE OF CAPITAL BUDGETING
- Capital budgeting is an essential tool in financial management
- Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken up for investments
- It helps in exposing the risk and uncertainty of different projects
- It helps in keeping a check on over or under investments
- The management is provided with an effective control on cost of capital expenditure projects
- Ultimately the fate of a business is decided on how optimally the available resources are used
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