Published On:Sunday 27 November 2011
Posted by Muhammad Atif Saeed
CAPITAL BUDGETING
CAPITAL BUDGETING
Capital budgeting is the process of evaluating long-range investment proposals for the purpose of allocating limited resources effectively and efficiently. The Ideal Evaluation Method should:
a) include all cash flows that occur during the life of the project,
b) consider the time value of money,
c) incorporate the required rate of return on the project.
SELECTION METHODS
1. Payback
2. Return on Assets/Return on Investment
3. Net Present Value (NPV)
4. Internal Rate of Return (IRR)
5. Accounting Rate of Return (ARR
RISK IN CAPITAL BUDGETING
The application of the net present value rule to the selection of capital investment projects having uncertain future cash flows requires an implicit adjustment for the associated risk.
This adjustment can be made using either of two alternative (but equivalent) methods.
Certainty equivalent approach, estimates of the expected of the future cash flows are reduced by a complicated risk adjustment factor to create a certainty equivalent future cash flow which is then discounted using a risk-free rate of interest. Alternatively,
Risk-adjusted discount rate approach, the present value of the expected future cash flows is computed using a discount rate that properly account for the risk associated with the cash flows in question. Before discussing the theory and empirical procedures used to estimate risk-adjusted discount rates, it is useful to consider the way in which the measurement of risk has evolved over the last century.
CAPITAL RATIONING
Capital Rationing is a financial condition occurring when there are more acceptable projects than funds available to finance them
The objective of capital rationing is to find the projects that provide the highest overall NPV without exceeding the amount of funds budgeted for capital projects
There are following popular approaches used in capital rationing
· Internal rate of return approach
· The net present value approach
· Profitability Index
COMPARING PROJECTS WITH UNEQUAL LIVES
· The impact of differing lives must be considered
· Annualized net present value (ANPV) approach
STEPS:
· Calculate the NPV of each project
· Divide the NPV of each project by the PVIFA at the given cost of capital and life of the project to determine the annualized NPV (ANPV) for each project
· The project with the highest ANPV would be the most preferred
Inflation
The cost of capital that a company uses is known as the monetary cost of capital and it includes an element that is due to inflation. That is, part of the rate includes a factor for the anticipated decline in the general purchasing power of the cash that the investment generates. If this element is stripped from the monetary rate the real rate of return is left. The real rate of return is the return required to cover the investment risk. There are two approaches of dealing with inflation in investment appraisal.
- The real approach :- This uses the real rate of return rather than the monetary cost of capital. If this is done all cash flows must be predicted in terms of today’s Rupees.
- The monetary approach:- This uses monetary cost of capital. As a consequence future cash flows must be predicted in term of their monetary value in year to come, which means adjusting the values by the predicted inflation rates. Formula is
RR= (1+MR) - 1
(1+IR)
If the monetary rate (MR) is 13.4% and Inflation Rate (IR) is 5% then
RR= (1+0.134) -1 = 8%
(1+0.05)
CAPM Investors’ expected rate of return:
E(r) = rrf + rrp
E(r) = expected rate of return
rrf = risk-free rate
rrp = risk premium
Modified Internal Rate of Return
Consider a project requiring an initial investment of Rs. 8,000 with cash inflows of Rs. 5,000 in year 1 and 2 and inflow of Rs. 900 in year 3 & 4. the cost of capital is 10%.
Year cash flow interest Amount when reinvested
1 5,000 1.331 6,655
2 5,000 1.21 6,050
3 900 1.1 990
4 900 1. 900 14,595
The total cash outflow Rs.8,000 is compared with the possible inflow at year 4 and the resulting figure of 8,000/14,595= 0.548 is the discount factor in year 4. By looking along the year 4 row in present value tables you will see that this gives a return of 16%. This means that the Rs. 14,595 received in year 4 is equivelent to Rs. 8,000 if the discount rate is 16%
Simple interest
A sum of money invested or borrowed is known as the Principal. With simple interest the interest is payable or recoverable each year but it is not added to the principal
Compound interest
With compound interest , the interest is added each year to the principal and for the following year the interest is calculated on their sum.
Future value and annuities
An annuity is a regular payment of the same amount each year. The future value of an annuity can be calculates
Future value at year n = P(1+r)n -1
r
Annual percentage return
a = p[1 + r/100]n
P= original sum r= interest rate, n time period and a= amount at year end
The value chain
Excellence in manufacturing is a necessary condition, it is not of itself sufficient to ensure success. It must be accompanied by a thorough appreciation of the relationship between all factors within value chain- the sequence of business factors by which value is added to the organization’s products and services. The value chain is
R & D> Design>Production>Marketing> Distribution>customer services> Customer
Process of value chain analysis
- Divide the firm into strategic business unit (SBU).
- Identify the value creating activities in each SBU.
- Assign costs, assets and value to each activity.
- Use cost drivers to investigate the cost behavior of each value activity and how it relates to other value activities in value chain.
- Repeat the process for competitots.
Activity Bases Costing
Cost Object is any item for which cost measurement is required, a product or customer.
Cost driver is any factor that causes a change in the cost of an activity. Following are two categories
A resource cost driver is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool.
An activity cost driver is a measure of the frequency and intensity of demand placed on activities by cost objects. It is used to assign activity costs to cost objects.
Cost Centre Vs Profit Centre Vs Investment Centre.
Pareto analysis
Pareto analysis is based on the 80:20 rule that was phenomenon first observed by Pareto. He noticed that 80% of the wealth of Milan was owned by 20% of its citizen. The management accountant can use it in a number of different circumstances to help direct management’s attention to the key control mechanism or planning aspect.
Throughput Accounting (TA)
TA is a method of performance measurement which seeks to identify rate at which the organisation generates profit from sale through analysis of constrains and bottlenecks.
Theory of constraints
There are five steps of focusing in the theory of constraints used to deal with a constraints or bottleneck.
- Identify the system constraint.
- Exploit what resource is available to reduce the effect of constraint.
- Subordinate everything else to the constraints.
- Elevate. In the event of steps 1 through 3 not breaking the constraints then it must be elevated i.e. broken by adding additional resource.
Go back to step 1 in order to reveal the next constraint to the organizational goal
What if analysis
What if analysis looks at the results of varying a model’s key variables, parameters or estimates. It examines how a result will change if the original predicted values are not achieved or if underlying assumptions changes.
Simulation
The term simulation model is often used more specifically to refer to modelleing which make use of random numbers. This is Mote Carlo method of simulation . In business environment if can be used to examine inventory, queuing scheduling and forecasting problem.
Value Analysis
Value analysis is a systematic inter disciplinary examination of factors affecting the cost of a product or service, in order to devise means of achieving the specified purpose most economically at the required standard of quality and reliability.
Steps in value analysis
1. Select a product or service for study
2. obtaining and recording information
3. Analyzing the information and evaluating the product
4. Consider alternatives
5. Select the least cost alternative
6. Recommendation
7. Implementation and follow up
Functional Analysis
An analysis of the relationship between product functions, their perceived value to the customer and their cost provision.
Basic steps in Functional Analysis
The technique involve nine steps some of which are similar to value analysis.
1. Choose the object of analysis. High volume product with a complex design and relatively large production costs is often an ideal candidate.
2. select members for the functional analysis team. ( six to eight members)
3. Gather information
4. Define the functions of the object.
5. Draw functional family tree
6. Evaluate the functions
7. Suggest alternative and compare these with the target cost
8. choose the alternatives for manufacturing
9. review the actual result.
Life Cycle Costing
1. Product Specification
2. Target Price
3. Target Profit
4. Target Cost
5. Major Product and Process Design Changes
6. Does the design meet target cost?
7. Estimate Life Cycle Cost
8. Is project life cycle cost acceptable?
9. Put product into production
10. Minor Product and Process Design Changes
11. Product Abandonment
