Analysis on capital budgeting techniques

Manu        

 Hi Vinu! How are you?

Vinu

I am fine Manu! I need your Guidance.

Manu 

With pleasure! But, for what?

Vinu

Our company has plans to take up an investment project. I have to advice my management, whether they should take up a new project now? For that I have to brush up my basics in Evaluating Investment Proposals. Can you help me out?

Manu

Fine! It’s not an issue. So, you want to revise your knowledge in Capital Budgeting Process. I’ll teach you.

Vinu

Thanks Manu! Assume, I know nothing about Financial Management and guide me.

Manu 

That’s the fact right?

Vinu

:(

Manu

Ok! Ok! Jokes apart!

Before going technical, let us make ourselves comfortable in Fundamentals.

Vinu

Ok!

Manu

Why would you invest huge money in a Project?

Vinu  

Obviously for getting returns! For making money out of it!

Manu

Fine! How much returns?

Vinu 

Returns generally available for any business!

Manu

Please modify that Statement. Returns which you should get from Investment should not only be equal to returns available for any business, but it should also be greater than or equal to the cost of capital of business.

Vinu

Correct! When we invest in a project, it may be funded with debt & equity. Both the Funds have cost and returns should cover at least the cost!

Manu

Well said!

Returns > cost of capital.

That should be the objective of any investment.

Manu

Now tell me, how do you measure returns?

Vinu  

I am sorry Manu, I didn’t get you!

Manu

I asked ‘What is return for investing in project or what is the return for making any investment’?

Vinu

Profits!

Manu

Which profit? There are so many profits in Business. You have

a) Gross profit.

b) Operating Profit

c) Profit before Tax

d) Profit after Tax

e) Retained profit

Which profit is return for investment?

Vinu

Now, this buzzes me!  Please help me out!

Manu

Ok! Let us assume you are taking up a project at a cost of Rs.100 Crs and it will be funded by debt and equity.

Vinu

Ok.

Manu 

Let’s assume, Debt Equity combination as 50:50

Vinu

So funding composition should be like this?

 Is it right?

Manu

Yes! Now tell me, what is the profits / return available for owners (shareholders)?

Vinu

It is Dividend.

Manu

No! It is not mere dividend. It is entire Profit after Tax.

Vine

But only Dividend is paid to shareholders. Not the entire profits.

Manu

Yes! Only Dividend are paid or say distributed to the owners and balance is just unpaid. But still, it is payable to them. So it is also part of returns earned by the shareholders right?

Vinu

Yes! Yes!

 I got it!

 So Profit after Tax matters!

Manu 

Yes! But that is only for the shareholders. What is the returns for Bankers (Lenders)? They have also invested equally in your project (50%).

Vinu   

It is Interest!

Manu

That’s good. So return for Bankers are Interest and Return for Shareholders are Profit after Tax. So, if you sum up both the numbers, you would get the return expected out of the project. Is that right?

Vinu  

Yes! It makes sense. Can we understand this with some numbers?

Manu 

Ok! Take it now!

Your 100 Crs project is funded with Debt    – 50 Cr and Equity – 50 Cr.

Vinu

That’s already available. What is the cost of these funds?

Manu       

Say, Debt would cost 15% and Equity?

Can you assume a rate for Cost of Equity?

Vinu 

Equity, Shall we assume it as 10%?

Manu 

Then in that case, you should have invested your money in simple deposit with Banks / FIs which has less risk. Why anyone will invest huge money in business just to get 10% Return?

Cost of equity would always be higher than cost of risk free investment and debt.

Vinu

But why’s that?

Manu

Equity investors assume bigger risk!

They are responsible for running the business.

They take the risk of

-facing losses,

-fluctuating returns,

-business failure,

-insolvency

and so many.

So obviously they would expect high returns.

Whereas lenders (Bankers) will get back their return whether the business makers profit or suffers loss. Since they takes less risk, their return would also be less.

Vinu

Ok! Got that! Then shall we assume cost of Equity as 25%

Manu 

Fine! That’s reasonable for the effect and risk to be taken! Can you calculate and tabulate the cost of funds.

Vinu

Yes!

                                                          (Rs. In Cr.)

Manu

Good!

The table says, You are raising Rs.100 Crs and cost of the funds  is Rs.20 Crs.

Vinu   

Yes!

Rs.20 Crs is the cost for raising Rs.100 Crs.

So, the cost of capital is 20%

Manu 

That’s right!

Your cost of capital is 20%. It is also called as Weighted Average Cost of Capital (WACC). It means, if you earn 20% from this project, you will meet the expectation of Banker and Shareholders.

Both the group will be happy. What will happen if you earn 30%?

Vinu

Cost of capital is only 20%. So if I earn 30%, I will have additional earnings of 10%. It’s a bonus for me!

Manu   

Yes! It’s for you! Meaning, it’s for shareholders.

This additional Earnings is reward for the additional risk taken.

What will happen if you earn only 13%

Vinu

In that case, earnings from the project will be 100 x 13% = 13 Crs.

I should pay to two groups now.

One to lenders: They will rank first In view of agreement.

As per agreement, I have to pay Rs.7.50 Cr [50 x 15%] to them.

Manu  

So after paying 7.50 Cr to the Bankers you will be left with only 6.50 Cr

Vinu 

Yes!

Manu     

What was the expected return of Shareholders?

Vinu  

It is 25% in 50 Crs. , 12.50 Cr

Manu   

So expected return was 12.50 Cr whereas actual is going to be only 6.50 Cr.

Vinu 

Ya! 6.50 Cr on 50 Cr works out to 13% return against expected 25% return

Manu

So, this is the risk which shareholders are exposed to whereas lenders would pocket their return whether your business makes profit or suffers loss!

If your business doesn’t have cash generation to pay return to the lenders, they will not mind in forcing you to close the business, sell the assets and take back their money invested along with returns.

Vinu     

Very True!

Manu 

So the message is, before investing in any project, you have to work out the returns that can be generated which will match the expectations of both the investor groups. i.e. Both the  lenders and shareholders.

Vinu

Correct! The profit that will be generated should be sufficient enough to meet the expectation of both the groups. So if we take up any Project with returns lower than Cost of capital then in those projects the losers will be shareholders.

Manu  

Absolutely in those cases it would be ideal to abandon those Projects which will help to avoid opportunity losses.

Vinu   

That’s clear now! So we should look for appropriate profit for evaluating the investment proposals. Is that right?

Manu

A slight modification. Have your focus on cash flows than the profits.                    

Vinu

What that mean?

Manu

Always remember profit can be influenced by accounting policies. What is real is cash flow.

So you should evaluate investment proposals by analysing cash flows.

Vinu

Ya! I could recollect Profit is different from Cash. So please tell me how to find out Cash generated from Operations?

Manu

It is very simple. You have to make some minor adjustments to the Profits.

Vinu

Like?

Manu

The Profit you derive would be after providing for expenses like Interest, Depreciation, Taxes and some non-cash items, right?

Vinu          

Correct!

Manu

What you should do is, remove non-cash items from Profit to find out the cash profit.

Vinu

How would I do that?

Manu   

Let’s take extension of our example.

Vinu

Ok!

Manu     

Let’s say, if you take up this Rs.100 Cr Project, you will have Annual sales of around Rs.150 Crs.

Vinu

Ok!

Manu   

You will also have expenses for Production and other operations to the tune of Rs.100 Crs.

Vinu 

Fine!

Manu    

You should also be paying interest on your Bank loan of Rs.50 Cr

@ 15% right?

Vinu

Yes! It would work out to Rs.7.50 Cr.

Manu  

You will also depreciate your asset right?

Vinu

Yes!

Manu

Assume 8 years life for the asset and depreciate it equally using Straight Line Method.

Vinu

So my depreciation should be

Manu

Correct!

Can you tabulate all these and derive your profit?

Vinu

Yes!

Manu

Good!

You have sales of Rs.150 Crs; Expenses of Rs.120 Crs and Profit of Rs.30 Crs

Vinu

Oh! No!

I have not considered the effect of Tax pay-out. Should I?

Manu

Yes! You should!

Assume you have to pay Tax @ 30% on your profit and work out your profit after Tax.

Vinu

Ok!                                      

                                                                           Rs. In Crs

Manu

Now your Income Statement is complete. Let us try to understand the return earned for the project.

Vinu

Ok!

Manu

Which profit reflect returns now?

Is it PAT/PBT/EBIT/EBDIT?

Vinu

PAT?

Manu

Ok! Let’s analyse that!

Returns for this Project means, the profit that is available to meet the cost of both the investors (Lender & Equity) group, right?

Vinu

Yes!

Manu

From your Profit after Tax you will be able to able to pay shareholders right?

Vinu

Yes! Very much! It is from PAT, we pay dividend to the shareholders!

Manu

Ok! But, will you be able to pay your lender??

Vinu

Lender? Oops! This Profit after Tax is after paying interest!

Manu

Yes! So understand Profit after Tax would reflect return for shareholders only but not for lenders.

Since you are interested in finding return for both the group, what you should do is?

Vinu

Add back interest with Profit after Tax?

Manu

Absolutely!

By adding back, Interest, you will now have return for both the group.

Vinu

Yes!

Shall I work out for our example?

Manu

Please!

Vinu

Manu

Vinu! I want to take you through an important concept now.

What you have done now by adding back interest is right! But please visualise what would have been the Profit after Tax, if there is no Interest expenses.

Vinu

Let me try!

We know EBIT was Rs.37.50 Cr. If there is no Interest Expenses, then PBT and PAT would be,

 Like this?

Manu

Yes! Now please compare your old and new PBT, Tax & PAT.

Vinu

Manu

Now look at your Tax obligation.

In your old case, your tax was Rs.9.00 Cr where as in new case (without interest), your tax was Rs.11.25 Cr.

You will be forced to pay higher tax if you don’t have interest.

Is that right?

Vinu

Yes Manu!

When I have interest, my profit was less and I would be obliged to pay only Rs. 9 Cr. as Tax.

When I don’t have interest, my profit will go up and I have to pay more tax in view of higher profits.

My additional tax would be 11.25 - 9.00 Cr = 2.25 Cr.

Manu

You are right!

Presence of Interest has saved you tax of Rs.2.25 Cr

Vinu

Yes Manu!

Manu

Now, come back to our example.

Your interest obligation was 7.50 Cr [ 50 x 15%]

Your Tax rate is 30%

Presence of 7.50 Cr expense will directly give you 30% tax benefit.

Vinu

Yes!

By claiming Interest Expense of Rs.7.50 Cr, I will save 30% tax on 7.50 Cr which works out of Rs.2.25 Cr.

Hey it matches with our recent workings!

Manu

Yes! It would match.

Get back to track now.

You have added back interest to Profit after Tax to find out return out of the project.

Vinu

Yes!

Manu

Now my question is, what is exact cash outflow on account of interest?

Vinu

Hey!! It is 7.50 Cr less tax benefit. Because, I saved Rs.2.25 Cr tax on account of interest.

Manu

So, what amount you should add back now?

Vinu

It is Rs.5.25 Cr [7.50 x 70%]

But Manu! We have to add back only what is deducted

In our case, we have deducted Rs.7.50 Cr as expense.

Then how can I add back Rs.5.25 Cr?

Manu

Your question has logic Vinu!

You are now adding back Interest with Profit after Tax to know what is the return available for the project.

If that is the objective, you should add back or deduct all the items related to interest, right?

Vinu

Yes Manu!

Manu

You are going to pay tax of 9 Cr which would have been 11.25 Cr, it there is no interest, right?

Vinu

Yes Manu?

Manu

So, already your tax figure is adjusted to 9.00 Cr from 11.25 Cr due to presence of Interest, right?

Vinu

Yes!

Manu

So add back that also!

Vinu

Now it makes sense.

Manu

This tax benefit would be negative figure of – 2.25 and your interest expense will be Rs.7.50 Cr.

Vinu

Yes! so my effective Interest cost is

Manu

Good!

Only this cost should be added.

Please continue with your table!

Vinu

Is that correct?

Manu

Good!

Vinu ! I told you !

It is not profit but the cash generation is important!

Vinu

Yes!

Manu

The profit you have derived now is after providing for non-cash expenses like depreciation

Vinu

So, I should add back that also right?

Manu

Yes!

Go ahead and complete the cash generation.

Vinu

Manu

Good! This is the cash that is generated from the project for a year. We call it as flows from operations.

If you want to know, whether the project which you have taken up at Rs.100 Crs is a viable project, then you have to test, what will be the cash generation for the entire project life.

Only then you will have sufficient information on hand, to take a decision whether or not to go ahead with the project.

Vinu

Do you mean I have to work out projections?

Manu

Yes Vinu!

You know your project has life of 8 years.

You have to see, how much the project can earn over its useful life of 8 years and whether the returns it will generate will match your expectations.

Vinu

Ok! How do we go with the projections?

Manu

You need to visualise the Sales and expenses for 8 years

Vinu

Ok! Now I have the above information for one year. Should I extrapolate it for 8 year?

Manu

Yes!

But pay attention to growth factors, increase or decrease in expenses, etc.

Vinu

Yes! You are correct.

In this eight years,

-certain expenses will increase with increase in sales;

-certain expenses like interest will come down with the repayment of loans;

-certain other expenses like salary & wages will go up since we have to provide increments. 

Manu

Correct!

-Variable expenses will move along with sales!

-Fixed Expense would remain fixed and

-Expenses like interest would eventually come down.

So go ahead with your projection for 8 years assuming sales to grow 5% every year.

Vinu

Ok! How about Manufacturing & Operating Expenses.

Manu

Assume

-60% of your expense are variable. So they will also have 5% increase every year.

-Keep 40% of your expenses as fixed.

Vinu

Ok! Let me try. I have to increase sales every year by 5%

Manu

You are going good Vinu! For simplicity, let us avoid decimals and round off to next highest number.

Vinu

Ok Manu!

I’ll rework:

Manu

You know your expenses are Rs.100 Crs.

As discussed split 60% as Variable and 40% as Fixed Expenses in year 1 and keep providing 5% increase for your variable expenses every year.

Vinu

Ok. I’ll do that!

Manu

Vinu! You have done very well so far.

The EBDIT which you have derived now will be the profits which can be earned without any influence of Debt & Equity structure.

Vinu

Means?

Manu

This is the level of profit which any similar business units can earn in the Industry. Because till this point, your profit is decided by operating income which is your sales and your operating expenses which are basically RM, Labour, Power, other production expenses. If you want you can also consider depreciation. In that case, it would be

Vinu

Yes! I understand.

Manu

After EBIT, the profit that is available to owners will be decided by capital structure of business.

If business has more loans, then chunk of EBIT will go for paying interest and you will have very little PBT & PAT.

Vinu

Yes! I can follow.

Manu

Since I have worked out EBIT, you continue the balance.

You have to account for Interest, and Tax.

Vinu

Correct.

In our case, whether this 50 Cr Debt will remain for entire 8 Years in the business?

Manu

No Vinu!

Debt funds like Term loans are repayable over 3-5-8 years

You please assume 8 years repayment.

Vinu

Whether repayment starts from day one?

Manu

That’s a good question.

You would need time for project completion & stabilisation in business. So consider one year repayment holiday for principal (which generally bankers would give) and 7 year principal repayment period.

Vinu

So, my interest on loan will coming down year-after-year right?

Manu

Yes! It would come down with repayment.

Work out repayment schedule and interest schedule for loan before proceeding further.

Vinu

Ok! I’ll assume like this:

(Rs. In Cr.)

Manu

Ok! Proceed. Assume you take loan in beginning of the year. Also compute average loan balance for all the years.

Vinu

Am I correct? And why do you wanted to calculate Average loan balance?

Manu

You are correct Vinu!

I wanted you to calculate Average loan balance to estimate Interest on loan.

You can apply Interest on the average balance for forecasting purposes.

Vinu

Ok! I’ll do that!

Manu

Good!

Already you have EBIT.

Now deduct this Interest to find profit before Tax & after Tax.

Vinu

Ok I’ll proceed.

Manu

Great! You have done wonderful job.

But it’s just a starting point for evaluating investment proposals.

Now, you have to find out what will be the cash flows from the project.

But before that, can you bring you entire projection in one place?

Vinu

Let me do that first!

Manu

It’s nice to see all in one place.

Now only the game starts.

You have the information about the earning capacity of your project.

Now you know, how much is your sales, expense, interest, tax, etc.

Now you have to analyse these number to take a decision.

Vinu

Ok!

Manu

First compute cash flows from this project for 8 years.

Hope you already done it for year 1.

Vinu

Ya! I can!

I’ll do it.

Cash flow from the project

Manu

You are going fantastic Vinu!

Now you got the critical details for evaluating the investment proposal.

That is ‘cash flows ‘.

Your decision depends on accuracy of these cash flows and now you have it right!

With this cash flow, we are going to use Capital Budgeting Techniques like

a) Payback period;

b) Discounted Payback Period;

c) Net Present Value Method;

d) Internal Rate of Return of Method;

e) Accounting / Average Rate of Return Method;

f) Profitability Index;

g) Modified Internal Rate of Return Method, etc.

to evaluate Investment Proposals.

We will also discuss how to select a project when there is a conflict between these methods and understand importance of Capital Budgeting Process.

Vinu

So, what we have discussed so far is only tip of an iceberg?

Manu

Yes Vinu! But they are not that difficult.

Every technique works on common sense. So, you would be able to understand them without any difficulty.

Vinu

I am eager! Shall we start?

Manu

Yes Vinu!