Capital budgeting

436 views
350 views

Published on

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
436
On SlideShare
0
From Embeds
0
Number of Embeds
1
Actions
Shares
0
Downloads
36
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Capital budgeting

  1. 1. Session 4 <ul><li>Capital Budgeting </li></ul>
  2. 2. Capital Budgeting - Methods <ul><li>1. Average Return on Investment </li></ul><ul><li>2. Payback </li></ul><ul><li>3. Net Present Value </li></ul><ul><li>4. Internal Rate of Return </li></ul><ul><li>5. Modified IRR </li></ul>
  3. 3. Average Return on Investment <ul><li>AROI = Avg. Net Income Per Year </li></ul><ul><li>Avg. Investment </li></ul>
  4. 4. Average Return on Investment <ul><li>Example : </li></ul><ul><li>Year Net Income Cost </li></ul><ul><li>1 6,000 100,000 Initial </li></ul><ul><li>2 8,000 0 Salvage Value </li></ul><ul><li>3 11,000 </li></ul><ul><li>4 13,000 </li></ul><ul><li>5 16,000 </li></ul><ul><li>6 18,000 </li></ul>
  5. 5. <ul><li>Avg. Net Income 72,000 </li></ul><ul><li> 6 </li></ul><ul><li>Avg. Investment 100,000 </li></ul><ul><li> 2 </li></ul><ul><li>AROI 12,000 </li></ul><ul><li>50,000 </li></ul>Average Return on Investment = 12,000 = 24% = 50,000
  6. 6. <ul><li>Advantages </li></ul><ul><li>Disadvantages </li></ul>Average Return on Investment
  7. 7. Payback Method <ul><li># Years required to recover the original investment </li></ul><ul><li>Example : </li></ul><ul><li>Year Net Income Cash Flow Cumulative CF </li></ul><ul><li>1 6,000 26,000 26,000 </li></ul><ul><li>2 8,000 28,000 54,000 </li></ul><ul><li>3 11,000 31,000 85,000 </li></ul><ul><li>4 13,000 33,000 118,000 </li></ul><ul><li>5 16,000 36,000 154,000 </li></ul><ul><li>6 18,000 18,000 172,000 </li></ul><ul><li>Payback = 3 + 100,000 - 85,000 </li></ul><ul><li> 118,000 - 85,000 </li></ul>= 3.45 Years
  8. 8. Payback Method <ul><li>Advantages </li></ul><ul><li>Disadvantages </li></ul>
  9. 9. Time Value of Money <ul><li>FV = PV (1 + r) n </li></ul><ul><li>Compounding: Finding FV </li></ul><ul><li>Discounting: Finding PV: PV = FV/(1 + r) n </li></ul><ul><li>Internal Rate of Return: Finding r </li></ul>
  10. 10. Net Present Value <ul><li>NPV = Present Value of All Future Cash Flows less Inital Cost </li></ul><ul><li>= CF 1 + CF 2 + CF 3 +....... CF n - I o </li></ul><ul><li>1+r (1+r) 2 (1+r) 3 (1+r) n </li></ul>
  11. 11. Net Present Value - Example <ul><li>Year CF Disc. Factor PV </li></ul><ul><li>0 -100000 1 -100000 </li></ul><ul><li>1 26000 1/1.1 = .9091 23637 </li></ul><ul><li>2 28000 1/(1.1) 2 = .8264 23139 </li></ul><ul><li>3 31000 1/(1.1) 3 = .7573 23290 </li></ul><ul><li>4 33000 1/(1.1) 4 = .6830 22539 </li></ul><ul><li>5 36000 1/(1.1) 5 = .6209 22352 </li></ul><ul><li>6 18000 1/(1.1) 6 = .5645 10161 </li></ul><ul><li>NPV = 25121 </li></ul>
  12. 12. Net Present Value <ul><li>Advantages </li></ul><ul><li>Disadvantages </li></ul>
  13. 13. Internal Rate of Return <ul><li>Discount rate that makes NPV Zero (i.e., that equates PV of benefits with the cost). </li></ul><ul><li>IRR: I o = CF 1 + CF 2 + ..... + CF n </li></ul><ul><li> 1+r (1+r) 2 (1+r) n </li></ul><ul><li>Solve for r. </li></ul><ul><li>Example: </li></ul><ul><li>100,000 = 26000 + 28000 + 31000 + .......... + 18000 </li></ul><ul><li> 1+r (1+r) 2 (1+r) 3 (1+r) 6 </li></ul><ul><li>r = 18.2% </li></ul>
  14. 14. Internal Rate of Return <ul><li>Advantages </li></ul><ul><li>Disadvantages </li></ul>
  15. 15. Profitability Index PI = PV of all Benefits PV of all Cost Example : PV (Benefits) = 26000 + 28000 +.......... + 18000 1.1 (1.1) 2 (1.1) 6 = 125121 PV (Cost) = 100000 PI = 125121 = 1.25 100000
  16. 16. Profitability Index <ul><li>Advantages: </li></ul><ul><li>Disadvantages: </li></ul>
  17. 17. NPV Profile <ul><li>Year CF Disc. Factor PV </li></ul><ul><li>0 -100,000 1 -100,000 </li></ul><ul><li>1 26,000 0.91 23,636 </li></ul><ul><li>2 28,000 0.83 23,140 </li></ul><ul><li>3 31,000 1/(1.1) 3 = .7573 23,291 </li></ul><ul><li>4 33,000 1/(1.1)4 = .6830 22,539 </li></ul><ul><li>5 36,000 1/(1.1)5 = .6209 22,352 </li></ul><ul><li>6 18,000 1/(1.1)6 = .5645 10,161 </li></ul><ul><li>NPV = 25,121 </li></ul>
  18. 18. NPV Profile <ul><li>Dis. Rate NPV </li></ul><ul><li> 0% 7200 </li></ul><ul><li> 5% 45725.7 </li></ul><ul><li>10% 25120.76 </li></ul><ul><li>15% 8711.838 </li></ul><ul><li>20% -4538.97 </li></ul><ul><li>25% -15376.1 </li></ul>
  19. 19. NPV Profile <ul><li>80000 </li></ul><ul><li>60000 </li></ul><ul><li>40000 </li></ul><ul><li>20000 </li></ul><ul><li>0 </li></ul><ul><li>-20000 </li></ul><ul><li>0 0.05 0.1 0.15 0.2 0.25 </li></ul><ul><li> Disc. Rate </li></ul>NPV
  20. 20. Choosing Between Projects <ul><li>Year CF(A) CF(B) </li></ul><ul><li>0 -25000 -25000 </li></ul><ul><li>1 2000 21000 </li></ul><ul><li>2 2000 10000 </li></ul><ul><li>3 35000 2000 </li></ul><ul><li>NPV 6351 4606 </li></ul><ul><li>IRR 17% 22% </li></ul>
  21. 22. Modified IRR Reinvestment Rate Assumption (Project A)     Project  Outlay  25,000 Cash Flows: YR1  2,000                     YR2  2,000                     YR3  35,000       NPV @ 8%: 6,351  IRR: 17%
  22. 23. NPV: Project A     YR1:   2,000     YR2:   2,000 + 2,000 + 160 = 4,160    YR3:   35,000 + 4,160 + 333 = 39,493 [Note: PV of 39,493, three years from now @ 8% =  31,351                                                          Less: outlay  25,000                                                                   NPV  6,351] Modified IRR
  23. 24. IRR @ 17%     YR1:   2,000   = 2,000     YR2:   2,000 + 2,000 + 340 = 4,340     YR3:   35,000 + 4,340 + 738 = 40,078 [25,000 invested for three years @ 17% = 25,000(1.17) 3 = 40,040] Modified IRR
  24. 25. Modified Internal Rate of Return     Find k such that   (1+k) n I 0   = Final value     i.e.     (1+k) 3 25000  = 39,439                                  k  = 16.5% Modified IRR
  25. 26. Reinvestment Rate Assumption (Project B)    Project  Outlay  25,000 Cash Flows: YR1  21,000                     YR2  10,000                     YR3  2,000       NPV @ 8%: 4,606  IRR: 22.12% Modified IRR
  26. 27. NPV: Project B         YR1: 21,000 = 21,000         YR2: 10,000 + 21,000 + 1,680 = 32,680         YR3:  2,000 + 32,680 + 2,614   = 37,294 [Note: PV of 37,294, three years from now @ 8% =  29,606                                                        Less: outlay  25,000                                                        NPV  4,606 ] Modified IRR
  27. 28.    IRR of 22.12%          YR1:   21,000    = 21,000         YR2:   10,000 + 21,000 + 4,645 = 35,645         YR3:   2,000 + 35,645 + 7,885 = 45,530 [25,000 invested for three years @ 22.12% = 25,000(1.2212)3 = 45,530] Modified IRR
  28. 29. Modified Internal Rate of Return Find k such that   (1+k) n I 0   = Final value             i.e.     (1+k) 3 25000  = 37,294                                           k  = 14.26% Modified IRR
  29. 30. Estimating Cash Flows <ul><li>NPV = CF 1 + CF 2 +.............. + CF n - I o </li></ul><ul><li>l+r (l+r) 2 (l+r) n </li></ul><ul><li>Cash Flows Incremental </li></ul><ul><li>After Tax </li></ul><ul><li>Net Working Capital </li></ul><ul><li>Sunk Costs </li></ul>
  30. 31. Procedure <ul><li>1. Initial Costs: New CAPEX </li></ul><ul><li>Additional W. Cap </li></ul><ul><li>Sale of Old Assets </li></ul><ul><li>2. Annual Costs: Revenue Less Costs </li></ul><ul><li>After Tax </li></ul><ul><li>3. Terminal Cash Flows: Salvage Value </li></ul><ul><li>Recoupment of NWC </li></ul>
  31. 32. Cash Flow Estimates <ul><li>Sale of Existing Plant </li></ul><ul><li>CF= Selling Price + T (B.V. - S.P.) </li></ul><ul><li>Annual Cash Flows </li></ul><ul><li>OCF= (Sales-Cost)(1-T) + T, DEPREC </li></ul><ul><li> or </li></ul><ul><li>OCF= Net Inc + Depreciation </li></ul>
  32. 33. New Product Proposal <ul><li>Annual Sales $20m </li></ul><ul><li>Annual Costs $16m </li></ul><ul><li>Net Working Capital $2m </li></ul><ul><li>Plant Site $0.5m </li></ul><ul><li>Plant and Equipment $10m </li></ul><ul><li>Depreciation Straight Line over 20 years </li></ul><ul><li>Salvage Value nil </li></ul><ul><li>Tax Rate 40% </li></ul><ul><li>Required Return 8% </li></ul>
  33. 34. New Product Proposal <ul><li>INITIAL CASH FLOWS </li></ul><ul><li>ANNUAL CASH FLOWS </li></ul>
  34. 35. New Product Proposal <ul><li>TERMINAL CASH FLOWS </li></ul><ul><li>CALCULATION </li></ul>
  35. 36. Evaluating Capital Projects <ul><li>1) Focus on Cash Flow, Not Profits. </li></ul><ul><ul><li>Cash Flow = Economic Reality. </li></ul></ul><ul><ul><li>Profits Can Be Managed. </li></ul></ul><ul><li>2) Carefully Estimate Expected Future Cash Flows. </li></ul><ul><li>3) Select a Discount Rate Consistent with the Risk of Those Future Cash Flows. </li></ul><ul><li>4) Account for the Time Value of Money. </li></ul><ul><li>5) Compute a “Base-Case” NPV. </li></ul>
  36. 37. <ul><li>6) Net Present Value = Value Created or Destroyed by the Project. </li></ul><ul><ul><li>NPV is the Amount by which the Value of the Firm Will Change if you Undertake the Project. </li></ul></ul><ul><li>7)Identify Risks and Uncertainties. Run a Sensitivity Analysis. </li></ul><ul><ul><li>Identify “Key Value Drivers.” </li></ul></ul><ul><ul><li>Identify Breakeven Assumptions. </li></ul></ul><ul><ul><li>Estimate Scenario Values. </li></ul></ul><ul><ul><li>Bound the Range of Value </li></ul></ul>Evaluating Capital Projects
  37. 38. <ul><li>8) Identify Qualitative Issues. </li></ul><ul><ul><li>Flexibility </li></ul></ul><ul><ul><li>Quality </li></ul></ul><ul><ul><li>Know-How </li></ul></ul><ul><ul><li>Learning </li></ul></ul><ul><li>9) Decide </li></ul>Evaluating Capital Projects

×