Financial Management
Capital Budgeting – NPV Method
Part A:
Two Illustrations with solutions.
Part A
Definition of capital budgeting
Capital budgeting is a process of identifying,
evaluating and selecting the project/s to be taken up for execution, out of
many such projects to choose from, in such a way that the selection of the
project/s satisfies the following requirements:
1. The selected project/s give/s the best possible
returns. In other words, total return from the selected project/s is more than
total return from the projects not selected;
2. Net present value of cash flows from the project/s
selected is greater than that from the projects not selected;
3. The selected project/s return/s back the initial
investments faster than the projects not selected;
4. The rate of return on investment (ROI) is higher in
case of the selected project/s than the projects not selected;
5. The total capital requirement for investing in the
selected project/s is within the available resources (funds) earmarked for
investment in new projects;
6. The project/s so selected for future investment is/are
in line with the overall objectives and goal of the firm in terms of
maximisation of shareholders’ wealth.
Definition of project appraisal
Project appraisal is evaluating a proposed project
by undertaking a cost and benefits analysis of different aspects of the project
with an objective of determining its viability. A project involves employment
of scarce resources. An entrepreneur needs to appraise various alternative
projects before allocating the scarce resources for the best project. For
appraising a project, its economic, financial, technical market, managerial and
social aspects are analyzed. The effects of a project appraisal are long
reaching and have very definite long term effects because of the capital
investment that is always required in any project. Financial institutions carry
out project appraisal to assess its creditworthiness before extending finance
to a project.
Methods of project appraisal
Different techniques are used for appraisal of the
projects / capital investment proposals. They are classified into
Non-Discounted Cash Flow (or Traditional) and Discounted Cash Flow techniques.
A. Non-Discounted Cash Flow (or Traditional) Techniques
1.
Average/Accounting Rate of Return (ARR) method, and
2.
Pay Back (PB) period method.
3.
Pay Back Reciprocal method, and
4.
Pay Back Profitability method.
B. Discounted Cash Flow Techniques
1.
Net present value (NPV) method,
2.
Internal rate of return (IRR) method,
3.
Modified net present value (MNPV) method,
4.
Modified internal rate of return (MIRR) method,
5.
Profitability index (PI) method,
6.
Discounted pay back (DPB) period method, and
7.
Adjusted net present value method.
NPV (Net Present Value) Method
|
NPV = |
∑ PV of all CIATs − ∑ PV of all COs |
|
Where, |
|
|
CIAT = |
Cash inflow after tax |
|
CO = |
Cash outflow |
Decision criteria:
For a single project under consideration, the project
will be accepted if the NPV of the project is positive, i.e. if NPV > 0.
In case of two or more competing projects, the project
having highest positive NPV would be selected.
Types of cash flows
Cash flows associated with an investment proposal may
be classified into three components:
(i)
Initial cash outflow (i.e. initial investment)
(ii)
Annual operating cash inflow (i.e. cash inflow after tax, in short CIAT)
(iii) Terminal cash inflow
Initial investment
Initial investment comprises:
(a) Initial cost of the new project / asset,
(b) Installation charges, and
(c) Working capital introduced.
Cash inflow after tax (CIAT)
CIAT is calculated using either of the following two
formulas:
|
1. |
CIAT = |
PAT + Depreciation + Interest (1 – t) [Note: Here PAT is after charging interest] |
|
2. |
CIAT = |
EBIT (1 – t) + Depreciation |
If CIBT (Cash inflow before tax) is given in the
problem along with depreciation, etc., CIAT will be calculated as follows:
STEP 1:
|
PBT = |
CIBT – Depreciation |
STEP 2:
|
PAT = |
PBT – Tax |
STEP 3:
|
CIAT = |
PAT + Depreciation + Interest (1 – t) |
Therefore, if CIBT is given and there is no interest
cost,
|
CIAT = |
[(CIBT – D) – T] + D; where, D = Depreciation and, T = Tax |
Terminal cash inflow
Terminal cash inflow consists of
(i)
Working capital recovered, and
(ii)
Net cash inflow from the sale of scrap.
Net cash inflow from the sale of scrap can be
calculated as follows:
A. If the Income-Tax Rules regarding depreciation on block of assets are not required to be
followed –
|
Particulars |
Rs |
|
Proceeds from the sale of scrap |
××× |
|
ADD: Tax on capital loss [(Cost of acquisition – Sale proceeds) x Rate of capital gains tax] |
××× |
|
LESS: Tax on capital gain [(Sale proceeds – Cost of acquisition) x Rate of capital gains tax] |
××× |
|
LESS: Tax on profit on sale of asset [(Cost of acquisition – Book value of the asset) × Normal
rate of tax |
××× |
|
NET CASH INFLOW FROM THE SALE OF SCRAP |
××× |
Important note:
Under straight line method of depreciation, book value
and sale proceeds in the terminal year of the project are same. Therefore,
there will be no tax benefit or tax loss on capital loss or capital gain
respectively under the straight line method of depreciation.
B. If the Income-Tax Rules regarding depreciation on block of assets are required to be
followed –
|
Particulars |
Rs |
|
Proceeds from the sale of scrap |
××× |
|
ADD: Tax on short term capital loss [STCL x Normal rate of tax] |
××× |
|
LESS: Tax on short term capital gain [STCG x Normal rate of tax] |
××× |
|
NET CASH INFLOW FROM THE SALE OF SCRAP |
××× |
Important notes:
1. Under section 50 of the Income Tax Act, there cannot
be any long term capital gain / loss on disposal of depreciable assets.
2. There will be short term capital gain / loss on
disposal of depreciable assets only in case of the following two situations –
Situation one:
Under section 50(1), there will be short term capital
gain, if on the last day of the previous year WDV of the block of assets is
zero. No depreciation will be allowed under this situation.
Situation two:
Under section 50(2), there will be short term capital
gain or loss, if the block of assets is empty on the last day of the previous
year. No depreciation will be allowed under this situation.
3. There will be no short term capital gain / loss if the
disposal of depreciable assets does not fall under any of the above two
situations. In this case depreciation will be allowed under section 32 of the
Income Tax Act.
Part B
Capital Budgeting – NPV Method
Selected Problems
Illustration: 1
Techtronics
Ltd., an existing company, is considering a new project for manufacture of
pocket video games involving a capital expenditure of Rs 600 lakhs and working
capital of Rs 150 lakhs. The capacity of the plant is for an annual production of 12 lakh units
and capacity utilisation during the 6-year working life of the project is
expected to be as indicated below.
|
Year |
Capacity Utilisation (%) |
|
1 |
33 1/3 % |
|
2 |
66 2/3 % |
|
3 |
90% |
|
4 - 6 |
100% |
The
average price per unit of the product is expected to be Rs 200 netting a
contribution of 40%. Annual fixed costs, excluding depreciation, are estimated
to be Rs 480 lakhs per annum from the third year onwards; for the first and
second year it would be Rs 240 lakhs and Rs 360 lakhs respectively. The average
rate of depreciation for tax purposes is 33 1/3 % on the
capital assets. No other tax reliefs are anticipated. The rate of income-tax
may be taken at 50%.
At
the end of the third year, an additional investment of Rs 100 lakhs would be
required for working capital.
The
company, without taking into account the effects of financial leverage, has
targeted for a rate of return of 15%.
You
are required to indicate whether the proposal is viable giving your working
notes and analysis.
Terminal
value for the fixed assets may be taken at 10% and for the current assets at
100%. Calculation may be rounded off to lakhs of rupees. For the purpose of
your calculations, the recent amendments to tax laws with regard to balancing
charge may be ignored.
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The Solution to Illustration: 1
Illustration: 2
Dey’s
Chemical, a chemical company, is considering replacing an existing machine with
one costing Rs 65,000. The existing machine was originally purchased two years ago for
Rs 28,000 and is being depreciated by the straight line method over its
seven-year life period. It can currently be sold for Rs 30,000 with no removal
costs. The new machine would cost Rs 10,000 to install and would be depreciate
over five years. The management believes that the new machine would have a
salvage value of Rs 5,000 at the end of year 5. The management also estimates
an increase in net working capital requirement of Rs 10,000 as a result of
expanded operations with the new machine. The firm is taxed at a rate of 55% on
normal income and 30% on capital gains. The company’s expected after-tax
profits for next 5 years with existing machine and with new machine are given
as follows:
|
|
Expected after-tax profit (Rs) |
|
|
Year |
With existing machine |
With new machine |
|
1 |
2,00,000 |
2,16,000 |
|
2 |
1,50,000 |
1,50,000 |
|
3 |
1,80,000 |
2,00,000 |
|
4 |
2,10,000 |
2,40,000 |
|
5 |
2,20,000 |
2,30,000 |
(a)
Calculate the
net investment required by the new machine.
(b) If the company’s cost of capital is 15%, determine whether the new machine should be purchased.
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The Solution to Illustration: 2
Good article and helpful for my CMA inter exam.
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