CAPITAL BUDGETING AND ITS TECHNIQUES IN THE BANK

BANGLADESH RESEARCH PUBLICATIONS JOURNAL ISSN: 1998-2003, Volume: 9, Issue: 4, Page: 249-259, March - April, 2014 Review Paper CAPITAL BUDGETING AND...
Author: Dorthy Hudson
0 downloads 1 Views 161KB Size
BANGLADESH RESEARCH PUBLICATIONS JOURNAL ISSN: 1998-2003, Volume: 9, Issue: 4, Page: 249-259, March - April, 2014

Review Paper

CAPITAL BUDGETING AND ITS TECHNIQUES IN THE BANK Sourav Paul Chowdhury1, Rony Kumar Datta3, *Md. Shamim Hossain2, Mahbuba Aktar3 and Jesmin Ara3

Sourav Paul Chowdhury, Rony Kumar Datta, Md. Shamim Hossain, Mahbuba Aktar and Jesmin Ara (2014) Capital Budgeting and its Techniques in the Bank. Bangladesh Res. Pub. J. 9(4): 249-259. Retrieve from http://www.bdresearchpublications.com/admin/journal/upload/1309134/1309134.pdf

Abstract This study attempts to highlight the capital budgeting phenomena and capital budgeting techniques on the cash flows of bank. Capital budgeting is the process that requires planning for setting up budgets on projects expected to have longterm implications, which is used as a standard for decision making for any organization. The study exposes as well that if a market based cost of capital is used to discount cash flows, the cash flows should be adjusted upwards to reflect the effects of inflation in forthcoming periods. The researchers find that bank lends its fund to the client at zero NPV that produces PI exactly 1. This study states that inflation adjusted to the risk factor result in less NPV than not adjusting inflation to the risk factor. The study finds the equality between the rate of cost of capital and IRR. In addition to it, the researchers find the MIRR greater than the IRR.

Keywords: Capital budgeting, Bank, Cash flow, Cost of Capital, Investment, Inflation and Discount Rate. Introduction Capital budgeting is an important aspect of decision-making in governments. Recent years have witnessed significant developments in the use of capital budgeting techniques which range from simple cost-benefit analysis to more complex decision-making models (Aman Khan, 1987). Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures (Sullivan, et al. 2003). Optimization can, at least intuitively, be seen as the method in assessing capital allocation problems (Luenberger, 1998). The study of Abuzar Eljelly & Abubakr; Abuidris (2001) surveys the capital budgeting practice in private and commercially-oriented public sector enterprises in the Sudan, an African Less Developed Country (LDC). Their study attempts to fill a gap in the existing literature by documenting the capital budgeting practice in an LDC where the economic environment is different than the developed and developing counterparts and where public sector still plays a major role in the economy. Edward et al. (2001) focus that the early 1950s, the academic community has tried lo convince corporate managers that there are sophisticated techniques that can improve the capital budgeting decision-making process. Over the years, many studies have documented a trend toward increasing business use of such sophisticated capital budgeting techniques. The capital budgeting techniques are focused in this study. The simple rate of return method is another capital budgeting technique that does not involve discounted cash flows. The method is also known as the accounting rate of return, the unadjusted rate of return, and the financial statement method. Unlike the other capital budgeting methods that have been discussed in this paper, the simple rate of return method does not focus on cash flows. Rather, it focuses on accounting net operating income/income. The approach is to estimate the revenue that will be generated by a *Corresponding Author: E-mail: [email protected] 1Dept. of Management, Hajee Mohammad Danesh Science and Technology University (HSTU), Dinajpur, Bangladesh. 2 Dept. of Marketing, HSTU, Dinajpur, Bangladesh. 3 Dept. of Finance and Banking, HSTU, Dinajpur, Bangladesh.

Chowdhury et al.

250

proposed investment and then to deduct from these revenues all of the projected expenses associated with the project. The net operating incomes then related to the initial investment in the project. Accounting rate of return (ARR) measures profitability from the conventional accounting standpoint by comparing the required investment (sometimes average investment) to future annual earnings. Brijlal, Pradeep‘s (2008) paper revealed that most businesses used the cost of bank loan as a basis in capital budgeting and more than two thirds of respondents used non-quantitative techniques to consider risk when making a decision on investing in fixed assets. Prather, et al. (2009) determine how small rural firms apply capital budgeting techniques; they surveyed 281 members of the Durant, Oklahoma Chamber of Commerce. Their goal is to determine whether these small rural firms practice what academics teach. Their survey covered a variety of discounted cash flow (DCF) and other traditional techniques and also examined the incidence and treatment of capital rationing. The survey design permits us to partition results to examine differences due to firm size, industry, form of business organization, firm age, age and education level of the primary decision-maker, and whether operations are international or domestic. They also examine the incidence and treatment of capital rationing. Finally, they examine the methods used to determine the required return and the use of sensitivity analysis, scenario analysis, and simulation. They also found that our sample firms operate in a far less structured manner than optimal. More than 71% of the sample firms did not have a written business plan. In addition, nearly 66% of the sample firms make capital budgeting decisions based on managerial judgment or "gut instinct." Moreover, when questioned about why sophisticated techniques are not used, more than 19% of respondents were not familiar with the techniques; another 19% did not believe using the techniques would affect profits, and 28% did not have the staff, time, or experience. Thus, improving the process might require that additional training be available to these decision makers. Rappaport and Taggart (1982) examined various methods for incorporating the effect of inflation into capital budgeting. They provided an analysis which showed the differential impact of using a gross profit per unit approach, a nominal cash flow approach (where individual forecasts are incorporated into each component of cash flow) and a real cash flow approach in which a general price deflator is used to deflate nominal cash flows. They attempt to combine the simplicity of a gross profit per unit methodology of adjusting for inflation with the more realistic nominal case flow and real cash flow approaches. Fama (1975) demonstrates that short term rates accurately reflect the expectations of future rates of inflation but his methodology and conclusions have been disputed by several rebuttals. Cagan and Goldolfi (1969) have achieved similar results for long term rates although they argue the results might not be applicable to short term rates. It is reasonable to expect that the rate of interest will increase when there are expectations of higher inflation, but there appears to be little evidence on the measurement of the cost of capital under inflationary expectations. This is understandable, given the difficulty in just measuring the cost of capital in a static sense. Van Horne (1971) showed that to be consistent, inflation in forecasting cash flows must also be reflected in a discount rate containing inflation; that is, a bias was introduced if nominal cash flows were discounted at the real and not nominal cost of capital. Geoffrey Mills (1996) has explored the question of the impact of inflation on the capital budgeting process. It has shown that it is reasonable to expect that the cost of capital will increase at the same rate as the rate of inflation on an ex ante basis, and that this increase will be a multiplicative relationship. The IRR method gives the rate of return result. This is especially important in our current economic climate, where businesses are trying to cut costs and only invest in those projects which will yield a higher rate of return (Gitman, 2009). The internal rate is the discount rate that equates the present value of cash inflows with initial investment associated with a project their by causing NPV= 0 (Khan & Jain 2007-08). The internal rate of return (IRR) is the rate of return promised by an investment project over its useful life. It is some time referred to simply as yield on project. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. Recent studies (Pradeep Brijlal, 2008)) highlight that financial managers worldwide favor methods such as the internal rate of return (IRR) over the net present value (NPV), which is the model academics consider superior. Despite the emergence of new methods, the traditional ones, NPV and IRR are still the most popular (Remer and Nieto, 1995). However, it can be argued that a shift from IRR methods towards the NPV methods has occurred http://www.bdresearchpublications.com/journal/

Capital Budgeting and its Techniques

251

from the 1970s to 1990s. They suggest the process of implementing NPV in capital budgeting problem being the following: determine the interest rate for the future cash flows, estimate the economic useful life of the project, estimate the cash flows of the project, calculate the net cash flows and calculate the present value (PV) of these net cash flows. As many scholars agree, NPV is simple to calculate (Dixit and Pindyck, 1995). Additionally, it holds no risk of ambiguous roots, as is in the case of IRR. On the other hand, IRR depends only on the properties of the cash flow stream, having nothing to do with the prevailing discount rate, which is sometimes troublesome to calculate. Considering these factors, it seems that both methods have their place in investment appraisal, but in different situations. Pandy (2005) states that the profitability index is the ratio of net present value of cash inflows at required rate of return to the initial cash out flows of investment. The profitability index, or PI, method compares the present value of future cash inflows with the initial investment on a relative basis and payback period is defined as the number of the years required to recover the original cash outlay invested in the project. He states that the number of period taken in recovering the investment outlay on presented value basis is the discounted payback period. Even though the payback method has some cons associated with it, the simplicity of the method can allow it to be used as a filter for those projects which should go on to a more in-depth method, if a project is not recommended based on the payback method, then chances are pretty high the project should not even be considered for the other method Gitman, (2009).The real options approach embraces the concept of uncertainty. There must be uncertainty in terms of future cash flows deriving from the investment, and management must have flexibility to assess this uncertainty as it evolves (Gilbert, 2004). As uncertainty is in the core of this approach, investments that can be described as 'cash cow' –investments are well analyzed with existing (DCF-based) techniques. Objectives This study covers the following objectives in respect to capital budgeting and its techniques in the bank. (i)

To know the meaning of capital budgeting and its techniques.

(ii) To find out the value of these techniques applied on bank cash flows. (iii) To find out the comparisons from these results achieved. Methodology This research was the descriptive in nature and the primary information was used in it. The researchers used the cash flows, here it was considered that monthly installments paid by the client were cash inflows and the amount lent to the client was the cash outflow made by the Prime Bank Ltd, Dinajpur Branch, Dinajpur. And the other cases the data had been made on the assumed basis. The methods of capital budgeting had been applied on the stated cash flows. The following equations of capital budgeting techniques had been set to the cash flows and the numerical data. The economic variable inflation that has the impact on the value of Net Present Value (NPV) was considered in the study. ARR=

N e t A n n u a l P ro fit ..............................................1 .1 In v e stm e n t O u tla y

Or ARR=

In c re m e n ta l n e t o p e ra tin g in c o m e .....................1 .2 In itia l In v e stm e n t

Or ARR=

A v e ra g e In c o m e ..........................................1 .3 A v e ra g e I n v e stm e n t

Or ARR=

In c re m e n ta l N e t O p e ra tin g In c o m e ....................1 .4 In itia l In v e stm e n t

http://www.bdresearchpublications.com/journal/

Chowdhury et al.

252  1NPV =CI    

r   1+ m    r m

-n m

-nm   r   1-  1+  m PI=CI   r   m 

IR R :

I

0

.. ..... ..... ..... ...... ..... ..... ..... ...... ..2

   .....................................................3  /I 0  

C Ft n  tk 0  N P V ......................4  t  0 1  I R R  t

TV

P V costs=

PBP= Y+

1 +M IR R 

n

....................................................5

U ......................................................................6 C U .. .. .. .. .. .. .. .. .. .. .. .. .. ... .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ... 7 C

D PBP= Y+

D C F=

      

C F1 1

1+r 

+

C F2

1+r 

2

+

C F3

1+r 

3

+..............+

C Fn

1+r 

n

...........8

ARR denotes accounting rate of return, CI denotes cash inflows, r is the discount rate, m is the frequency, n is the number of year, I 0 indicates initial investment, PI is the profitability index, IRR states internal rate of return, CFt represents cash flows at time period t, PV is the present value, TV is the terminal value, MIRR is the modified internal rate of return, PBP is the payback period, Y denotes year before full recovery, U is the unrecovered cost and C is the cash flow during recovery period, DPBP states discounted payback period and DCF is the discounted cash flow. Result and Discussion Terminologies to Capital Budgeting Time Value of Money: Investments commonly involve returns that extend over fairly long period of time. Therefore, in approaching capital budgeting decisions, it is necessary to employ techniques that recognize the time value of money. “A dollar today is worth more than a dollar a year from now” Cash out flows and Cash inflow: Cash outflow is the initial investment (including installation costs). It entails increased working capital needs for project and repairs and maintenance as well As incremental operating cost. Cash inflows include Incremental revenues reduction in costs, salvage value, release of working capital. Cost of capital: it is the required rate of return of different types of financings. Weighted average cost of capital is the composite cost of capital of financing or it is the total cost of capital. Present value and future value: Present value is the discounted value of the future receipt and future value is the compound interest rate of present receipt. F1 = P ( 1 + r ) and P = Fn / (1 + r )n where: F1 = the balance at the end of one period, P = the amount invested now, and r = the rate of interest per period. n = number of year. Terminal Cash flow: It includes the net cash generated from the sale of the assets, tax effects from the termination of the asset and the release of net working capital. Free Cash Flow: A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Techniques used in Capital Budgeting The accounting rate of return that does not involve discounted cash flows. The method is also the unadjusted rate of return, and the financial statement method. Accounting rate of return (ARR) measures profitability from the conventional accounting standpoint by comparing the required investment (sometimes average investment) to future annual http://www.bdresearchpublications.com/journal/

Capital Budgeting and its Techniques

253

earnings. Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). This valuation requires estimating the size and timing of all of the incremental cash flows from the project. The profitability index, by definition, is the ratio of the present value of the benefits (PVB) to the present value of the cost (PVC). This simple benefits-to-costs ratio will remove the scale effect's bias. We obviously prefer to invest in the asset that has the higher value for the profitability index. The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency. The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. The IRR equation generally cannot be solved analytically but only via iterations. One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. The cost of capital is a screening tool, in case of the Net Present Value Method and the cost of capital is used as the discount rate when computing the net present value of a project. Any project with a negative net present value is rejected unless other factors dictate its acceptance and in case of the Internal Rate of Return Method, the cost of capital is compared to the internal rate of return promised by a project. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR and therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used. The payback is another method to evaluate an investment project. The payback method focuses on the payback period. Payback is often used as a "first screening method". By this, it is meant that when a capital investment project is being considered, the first question to ask is: 'How long will it take to pay back its cost?' The bank / company might have a target payback, and so it would reject a capital project unless its payback period was less than a certain number of years. The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is sometimes referred to as" the time that it takes for an investment to pay for itself." The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one. Certainty Equivalent Technique is the common procedure for dealing with in capital budgeting is to reduce the forecast of cash flows to some conservative level. Risk adjusted discount rate states that if the time preference of money is to be recognized by discounting estimated future cash flows at some risk free rate to their present value, then to allow for the riskiness of those future cash flows at risk premium rate may be added to risk free discount rate such composite discount rate. The study reveals that that the bank use capital budgeting techniques in their capital investment decisions as well as the majority of private sector companies that these methods. Capital Budgeting Decisions and its Importance Business decisions that require capital budgeting analysis are decisions that involve in outlay now in order to obtain some return in the future. This return may be in the form of increased revenue or reduced costs. Capital budgeting decisions include: cost reduction decisions, expansion decisions, equipment selection decision, lease or buy decisions and equipment replacement decisions. Besides capital budgeting as a least cost decisions reveals that revenues are not directly involved in some decisions. The success of a business depends on the capital budgeting decisions taken by the management. The management of a company should analyze various factors before taking on a large project. Firstly, management should always keep in mind that capital expenditures require large outlays of funds. Secondly, firms should find modes to ascertain the best way to raise and repay the funds. The management should also keep in mind that capital budgeting requires a long-term commitment. The requirement for relevant information and analysis of capital budgeting has paved the way for a series of models to assist firms in amassing http://www.bdresearchpublications.com/journal/

Chowdhury et al.

254

the best of the allocated resources. One of the oldest methods used is the payback model; the process determines the length of time required for a business to recover its cash outlay. Another model, known as return on investment, evaluates the project based on standard historical cost accounting estimates. Popular methods of capital budgeting include net present value (NPV), discounted cash flow (DCF), internal rate of return (IRR), and payback period. While working with capital budgeting, a firm is involved in valuation of its business. By valuation, cash flow is identified and discounted at the present market value. In capital budgeting, valuation techniques are undertaken to analyze the impact of assets instead of financial assets. The importance of capital budgeting is not the mechanics used, such as NPV and IRR, but is the varying key involved in forecasting cash flow. William et al. (2001) state that capital budgeting decisions are crucial to a firm's success for several reasons first, capital expenditures typically require large outlays of funds. Second, firms must ascertain the best way to raise and repay these funds. Third, most capital budgeting decisions require a long-term commitment. Finally, the timing of capital budgeting decisions is important. When large amounts of funds are raised, firms must pay close attention to the financial markets because the cost of capital is directly related to the current interest rate. Inflation Involvement in cash flow term of Bank The effect of inflation is considered on the appraisal of capital investment proposals. Discounted cash flow techniques, such as the net present value method, consider the timing and amount of cash flows. To use the net present value method, you will need to know the cash inflows, the cash outflows, and the company's required rate of return on its investments. The required rate of return becomes the discount rate used in the net present value calculation. NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account Inflation is particularly important in developing countries like Bangladesh, as the rate of inflation tends to be rather high. As inflation rate increases, so will the minimum return required by an investor. For example, one might be happy with a return of 10% with zero inflation, but if inflation was 20%, one would expect a much greater return. A hypothetical example is provided below- Suppose X bank is considering in investing by giving loan to the account holder return backed within three year having the following uneven installments basis of Tk 1,00,000 investments. Table 1 Cash outflow and inflows Investment consideration of Bank Time period (year) at 0 ,, 1 ,, 2 ,, 3

Taka (1,00,000) 90,000 80,000 70,000

The Bank requires a minimum return of 40% under the present conditions. Inflation (assumed) is currently running at 30% a year and this is expected to continue indefinitely. Should The Bank go ahead with the investment? Let us take a look at the Bank’s required rate of return, if it invested Tk10,000 for one year on 1 January, then on 31 December it would require a minimum return of Tk 4,000. With the initial investment of Tk10,000, the total value of the investment by 31 December must increase to Tk 14,000. During the year, the purchasing value of the dollar would fall due to inflation. It can be restated the amount received on 31 December in terms of the purchasing power of the taka at 1 January as follows: Amount received on 31 December in terms of the value of the taka at 1 January: = Tk 14,000/ (1+ 30%) 1 = Tk 10,769 In terms of the value of the taka at 1 January, Bank would make a profit of Tk 769 which represents a rate of return of 7.69% in "today's money" terms. This is known as the real rate of return. The required rate of 40% is a money rate of return (sometimes known as a nominal rate of return). The money rate measures the return in terms of the dollar, which is http://www.bdresearchpublications.com/journal/

Capital Budgeting and its Techniques

255

falling in value. The real rate measures the return in constant price level terms. The two rates of return and the inflation rate are linked by the equation: (1 + MR) = (1 + real rate) x (1 +IR) and IR: Inflation rate (1 + 0.40) = (1 + 0.0769) x (1 + 0.3) = 1.40

Where, MR: Money Rate, RR: Real Rate

Which rate is used in discounting? As a rule of thumb: a) If the cash flows are expressed in terms of actual taka that will be received or paid in the future, the money rate for discounting should be used. b) If the cash flows are expressed in terms of the value of the taka at time 0 (i.e. in constant price level terms), the real rate of discounting should be used. In the Bank’s case, the cash flows are expressed in terms of the actual taka that will be received or paid at the relevant dates. Therefore, we should discount them using the money rate of return. Table 2. Present value from cash flows Time

Cash Flow Taka

1 0 1 2 3 NPV

2 ( 1,00,000) 90,000 80,000 70,000

PV at 40% rate Discount PV Factor (Taka) 3 4=2x3 1.000 (1,00,000) .714 64,260 .510 40,800 .364 25,480 30,540

PV at 30% inflation rate Discount PV Factor (Taka) 5 6=2x5 1.000 (1,00,000) .769 69210 .592 47360 .455 31850

PV at 7.69% real rate Discount PV Factor (Taka) 7 8=6x7 1.000 (1,00,000) 1.0769 -1 64268 1.0769 -2 40838 1.0769 -3 25502 30,608

The NPV is greater at 30% inflation rate plus 7.69% real rate that is 30,608>30,540. The investment has a positive net present value of Tk 30,540, so Bank should go ahead with the this investment of loan to client. Inflation and Tax Effect on Capital Budgeting in Bank Much research has been published examining the impact of inflation on the capital budgeting decision making process, and, although inflation is not currently the serious problem, rapid prices increases, coupled with the potential of future inflation, argue for continued research in this field. Inflation of the national economy is one of the important drives to influence the capital budgeting decision in the banking sectors in this country. The inflation rate is adjusted with interest rate having for the maintenance of real/ actual cash flows. Many organizations do not pay income taxes. Not-for-profit organizations, such as hospitals and charitable foundations, and government agencies are exempt from income taxes. The organizations that earn profit are not exempted from income tax the Bank as the profit organizations is responsible to pay tax to the state government at the given percent on income. Interest rate of the bank is the required rate of return/ hurdle rate. The empirical evidence with respect to whether or not interest rates would perfectly reflect expected inflation is strong but also controversial. Cooley, et al (1975) revealed the mechanics by which inflation adjustments can be incorporated into the capital budgeting process. At the same time, Nelson (1976) demonstrated the theoretical impact of inflation on capital budgeting and showed how inflation would shift the entire NPV schedule of a capital budget downward for a set or projects. Baily and Jensen (1977) have analyzed how price level adjustments affect the process in detail and specifically how various price level adjustments might change the ranking of projects. It is assumed that Prime Bank Limited wants to purchase generator to supply electricity that cost Tk 40,000. The generator would provide annual cost savings of Tk 30,000, and it would have a three-year life with no salvage value. The Real cost of capital is 12%. For each of the next three years, Prime Bank Limited expects a 10% inflation rate in the cash flows associated with the new generator. If Prime Bank Limited’s cost of capital is 23.2%, should the new generator be purchased? To answer this question, it is important to know how the cost of capital was derived. Ordinarily, it is based on the market rates of return on the Bank's various sources of financing - both debt and equity. This market rate of return includes expected inflation; the higher the expected rate of inflation, the higher the market rate of return on debt and equity. When the inflationary effect is removed from the market rate of return, the result is called a real rate of return. For example if the inflation rate of 10% is http://www.bdresearchpublications.com/journal/

Chowdhury et al.

256

removed from Prime Bank Limited’s cost of capital of 23.2% the real cost of capital is only 12% as shown below: Table 3. Inflation and Capital Budgeting Reconciliation of the Market-Based and Real Costs of Capital The real cost of capital The inflation factor The combined effect (12% x 10% = 1.2%) The market based cost of capital While Inflation is not Considered Particular Initial investment Annual cost savings

Year(s) Now 1-3

Amount of Cash Flows Tk (40000) 30,000

12% Factor 1.000 2.402

Net present value While Inflation is Considered Year(s) Particular Amount of Cash Flows Initial investment Now Tk (40,000) Annual cost 1 30,000 savings ,, 2 30,000 ,, 3 30,000 Net present value

Price Index Number** 1.000

Price Adjusted Cash Flows

23.2% Factor***

Tk (40,000)

1.000

1.100

33,000

0.812

1.210 1.331

36,300 39,390

0.659 0.535

12.0% 10.0 1.2 23.2% Present Value of Cash Flows Tk (40,000) 72,060 Tk 32060* ======== Present Value of Cash Flows Tk (40,000) 26,796 23,922 21,074 Tk 31,792* ========

*These amounts are different. **Computation of the price index numbers, assuming a 10% inflation rate each year: Year 1, (1.10) = 1.10; Year 2, (1.10)2 = 1.21; Year 3, (1.10)3 = 1.331 ***Discount formulas are computed using the formula 1/(1 + r)n, where r is the discount factor and n is the number of years. The computations are 1/1.232 = 0.812 for year 1; 1/ (1.232)2 = 0.659 for year 2; and 1/(1.232)3 = 0.535 for year 3.

When performing a net present value analysis, one must be consistent. The market based cost of capital reflects inflation. Therefore, if a market based cost of capital is used to discount cash flows, then the cash flows should be adjusted upwards to reflect the effects of inflation in forthcoming periods. Computations of Prime Bank Limited under this approach are given above. On the other hand, there is no need to adjust the cash flows upward if the "real cost of capital" is used in the analysis (Since the inflationary effects have been taken out of the discount rat). The cash flows associated with the project are affected in the same way by inflation. Several points should be noted where the effects of inflation are explicitly taken into account, first, not that the annual cost savings are adjusted for the effects of inflation by multiplying each year's cash savings by a price index number that reflects a 10% inflation rate. Second, note that the net present value obtained in where inflation is explicitly taken into account, is not the same that obtained in where the inflation effects are ignored. This result may seem surprising, but it is logical. The reason is that it has been adjusted both the cash flows and the discount rate so that they are consistent, and these adjustments cancel each other out across the two results. When there is inflation, the unadjusted cash flows can be used in the analysis if all of the cash flows are affected identically by inflation and the real cost of capital is used to discount the cash flows. Otherwise, the cash flows should be adjusted for inflation and the market-based cost of capital should be used in the analysis. Capital Budgeting Techniques to Bank’s cash flows The ARR method (also called the return on capital employed (ROCE) or the return on investment (ROI) method) of appraising a capital project is to estimate the accounting rate of return that the project should yield. If it exceeds a target rate of return, the project will be undertaken. It is a relative measure rather than an absolute measure and hence takes no account of the size of the investment. Despite of limitation the ARR method of capital budgeting is used due to simplicity in manner. To measure the as usual return this method is used to take decision. The bank, easily and quickly estimating the ARR in respect of investment, can reach in the quick decision. As it relative measure, the http://www.bdresearchpublications.com/journal/

Capital Budgeting and its Techniques

257

performance can be measured by ARR method for different period of same bank, for different periods of different bank / companies or for same period of the different banks. So, this technique of capital budgeting is useful and bears importance. Table 4. ARR Calculation Year 2007 2008

Investment 7550606492 9031698884

Operating Profit 2572192720 3510266937

ARR 34.07% 38.87%

Calculated values of Different Capital Budgeting Techniques An NPV calculated using variable discount rates (if they are known for the duration of the investment) better reflects the real situation than one calculated from a constant discount rate for the entire investment duration. To find the NPV, the researchers used the equation 2. To find out PI, IRR, MIRR, PBP and DPBP, the equations stated in the researcher methodology were used. Here, the researchers had used the transacted cash flows of Prim Bank Limited, Dinajpur Branch, Dinajpur in where M/S New Sobhania Library, Proprietor Mr. Sobhania who had the account in the Prime Bank Limited, Dinajpur Branch. Mr Sobhania had taken loan from Prime Bank Limited Tk 80, 00,000 at 16% interest for two year schedule payment. The Prime Bank imposed schedule number of payment 24 monthly basis in equal amount presented in the following table 5. Table 5 Cash inflows and their calculation

Date / period

Monthly installment paid by customer / Monthly Cash Inflows

Discou nt Factor

12/27/08

Tk 391,704.88

0.987

386678.07 12/27/09

1/27/09

391,704.88

0.974

381715.76

1/27/09

2/27/09

391,704.88

0.962

376817.14

3/27/09

391,704.88

0.95

371981.38

4/27/09

391,704.88

0.937

5/27/09

391,704.88

6/27/09

Monthly installment paid by customer / Monthly Cash Inflows 391,704.88

Discoun t Factor

DCF

0.845

331158.72

391,704.88

0.835

326908.9

2/27/09

391,704.88

0.824

322713.63

3/27/09

391,704.88

0.813

318572.19

367207.68

4/27/09

391,704.88

0.803

314483.9

0.925

362495.24

5/27/09

391,704.88

0.793

310448.07

391,704.88

0.914

357843.28

6/27/09

391,704.88

0.782

306464.04

7/27/09

391,704.88

0.902

353251.02

7/27/09

391,704.88

0.772

302531.13

8/27/09

391,704.88

0.89

348717.69

8/27/09

391,704.88

0.762

298648.7

9/27/09

391,704.88

0.879

344242.53

9/27/09

391,704.88

0.753

294816.09

10/27/09

391,704.88

0.868

339824.81 10/27/09

391,704.88

0.743

291032.67

11/27/09

391,704.88

0.856

335463.78 11/27/09

391,704.88

0.733

287297.8

1st Year CI

4,700,458.56

DCF

4326238

Date/ period

2nd Year CI

4,700,458.56

-2 4   .1 6   1-  1 +  12  N P V = tk 3 917 04.88   .16   12 

    tk 8 000 000   

=Tk 0 -24   .1 6  1 1 +    12  P I= tk 3 9 1 7 0 4 .8 8   .1 6   12 

=1 http://www.bdresearchpublications.com/journal/

   / tk 8 0 0 0 0 0 0   

3705076

Chowdhury et al.

258

P V c o sts=

T k 8000000=

M IR R =

TV

1 + M IR R 

n

T k10949979 1+M IR R  2

T k 1 0 9 4 9 9 7 9 / 8 0 0 0 0 0 0   1

=16.993%

P BP= 1 Y ear +

Tk 8000000-Tk 4700458.56 Tk 4700458.56

= 1 Year +.70 Year =1.70 Year

D PBP= 1 Y ear +

Tk 8000000-T k 4326238 Tk 3705076

= 1 Year +.99 Year =1.99 Year The results of this study were found that bank invested its fund at 0 NPV that is sum of the present value of cash inflows equals to its initial cash outlay, PI is exactly 1, IRR equals to the rate of cost of capital or required rate of return. MIRR > IRR, PBP< DPBP, when inflation was considered, NPV was lower than that of when inflation was not considered. DCFs are different in different periods. Conclusion The banks are the money sensitive organizations that deal their investment projects verifying the positive value from them, so as the capital budgeting decision is strongly supported by the researcher for decision making. Capital budgeting decision requires planning for setting up budgets on projects expected to have long-term implication having entailed its approaches/ techniques significantly is applied in banking sector. Now a day, the techniques of capital budgeting are systematic. The banks or any organization cannot control over the operation of them as per plan beyond the meaning full capital budgeting decision and application of capital budgeting techniques. So, capital budgeting decision and practice of capital budgeting techniques bear the significance and importance for successful operation of banking business along with any other business. References Abuzar M. A. Eljelly & Abubakr M. Abuidris (2001). A Survey of Capital Budgeting Techniques in the Public and Private Sectors of a Less Developed Country (LDC) , Journal of African Business, Volume 2, Issue 1 , pp 75 – 93. Aman Khan (1987). Florida International University. Capital Budgeting Practices in Large U.S. Cities. Published in: The Engineering Economist, Volume 33, Issue 1 , pp.1 -12. Andres D. Baily, Jr. and Daniel L. Jensen (1977). General Price Level Adjustments in the Capital Budgeting Decision, Financial Management, pp. 26-32. Cagan P. and Gandolfi, A. (1969). The Lag in Monetary Policy as Implied by the Time Pattern of Monetary Effects on Interest Rates, American Economic Review. Charles R. Nelson (1976). Inflation and Capital Budgeting, Journal of Finance, pp. 923-931. Dixit A. and R. Pindyck (1995). The options approach to capital investment, Harvard Business Review. Edward J. Farragher Robert T. Kleiman Anandi P. Sahu (2001). A Oakland University, Michigan York University, The Association between the Use of Sophisticated Capital Budgeting Practices and Corporate Performance, Published in: The Engineering Economist, Volume 46, Issue 4, pp 300 – 311. http://www.bdresearchpublications.com/journal/

Capital Budgeting and its Techniques

259

Eugene F. Fama (1975). Short Term Interest Rates as Predictors of Inflation, American Economic Review, pp. 269-282. Geoffrey T. Mills (1996). The impact of inflation on the capital budgeting process, Journal of Financial and Strategic Decisions Vol. 9 No.1, pp.8. Gilbert E. (2004). Investment Basics, An introduction to real options, Investment Analysis Journal, 60: pp. 49-52. Gitman, L. (2009). Principles of Managerial Finance (12th Ed.). Pearson Prentice Hall: Boston, MA. pp. 425- 439. James C. Van Horne (1971). A Note on Biases in Capital Budgeting Introduced by Inflation, Journal of Financial and Quantitative Analysis, pp. 653-658. Khan M Y and Jain P. K. (2007-08). Financial Management 4th edition, Mc Graw Hill Publishing Company Limited, pp. 10.26. Luenberger D. (1998), Investment Science. Oxford University Press, New York. Pandy I. M. (2005). Financial Management eight edition, Vikas publishing house Pvt. Limited, pp. 411- 579. Phillip L. Cooley, Rodney L. Roenfeldt, and It-Keong Chew (1975).Capital Budgeting Procedures under Inflation, Financial Management, pp. 12-17. Pradeep Brijlal (2008). University of the Western Cape, Australasian Finance and Banking Conference Paper. Prather, Larry J, Topuz, John C, Benco, Daniel C, Romer, David A. (2009). How Small Rural Firms Apply Capital Budgeting Techniques, Journal of Business and Entrepreneurship, pp 1-2. Rappaport A. and Taggart RA. (1982). Evaluation of Capital Expenditure Proposals under Inflation,” Financial Management, pp. 5-14. Remer D. and A. Nieto (1995). A compendium and comparison of 25 project evaluation techniques. Part 1: Net present value and rate of return methods, International Journal of Production Economics, 42: pp. 79-96. Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey Pearson Prentice Hall. pp.375. William D. Cooper & Robert G. Morgan & Alonzo Redman & Margart Smith (2001) Business Forum Winter-Spring, pp. 1-3.

http://www.bdresearchpublications.com/journal/