2. The Position of Capital Budgeting
Capital Budgeting
LongTerm Assets ShortTermAssets
Investment Decison
Debt/EquityMix
Financing Decision
Dividend Payout Ratio
Dividend Decision
Financial Goal oftheFirm:
WealthMaximisation
3. 1. Average Rate of Return
2. Payback Period
3. Discounted Payback Period
4. Net Present Value
5. Internal Rate of Return
6. Modified IRR
7. Profitability index
4. Estimating cash flow is more qualitative procedure than
quantitative. The reliable projection of the cash flow
depends upon the project specific knowledge and on the
capability of the management
The procedure of estimation of the cash flow may be different
as per the nature of the project
The basic procedure and the determinants in each steps are
discuss as below.
Step 1: Determination of Net Cash Outflow (NCO)
Step 2: Determination of Annual Cash Flow or CFAT
Step 3: Determination of Net Cash Flow for the Final
Year
5. For the mutually exclusive project : cannot accept both projects
Cost of the project (FA) - XXX
Transportation & Installation cost - XXX
Duty and clearance charges - XXX
Working capital requirements - XXX
Investment tax credit/allowance + XXX
NCO - XXX
6. For replacement projects: old equipments
Cost of new machine - XXX
Transportation & Installation cost - XXX
Duty and clearance charges - XXX
Working capital requirements - XXX
Working capital decrease + XXX
Proceed from sale of old machine + XXX
Tax payable (gain on sale of old machine) - XXX
Tax save (loss on sale of old machine) + XXX
Investment tax credit/Allowance - XXX
NCO - XXX
7. For the mutually exclusive project
Cash sales revenue + XXX
Cash operating cost - XXX
Cash before Dep. & Tax (EBDT) XXX
Depreciation - XXX
Taxable income XXX
Tax @ - XXX
Earning after tax (EAT) XXX
Depreciation + XXX
Cash flow after tax (CFAT) XXX
8. For replacement project
Increase in cash sales revenue + XXX
Decrease in cash operation cost + XXX
Increase in cash operation cost - XXX
Cash inflow before Dep. & Tax (EBDT) XXX
Decrease in depreciation + XXX
Increase in depreciation - XXX
Taxable income XXX
Tax @ - XXX
Earning after tax (EAT) XXX
Decrease in depreciation - XXX
Increase in depreciation + XXX
Cash flow after tax (CFAT) XXX
9. For the mutually exclusive project
Cash salvage value + XXX
Tax payable (gain on sale) - XXX
Tax save (loss on sale) + XXX
Working capital release (increase in year 0) + XXX
Working capital tied up (decrease in year 0) - XXX
Final year CFAT XXX
10. For replacement project
New Old Diff
BSV xxx Xxx
CSV xxx Xxx
Gain/loss on sale xxx Xxx
Tax payable or tax saving xxx Xxx
CSV xxx Xxx
Less/Add: Tax payable/tax saving xxx Xxx
Net cash salvage value xxx xxx Xxx
Less/add: Working capital Xxx
Final year cash inflow after tax (CFAT) XXX
11. Sale of Existing Plant
CF= Selling Price + T (B.V. - S.P.)
Annual Cash Flows
OCF= (Sales-Cost)(1-T) + T, DEPREC
or
OCF= Net Inc + Depreciation
12. 1. Initial Costs: New cost of assets
Additional WC requirement
Sale of Old Assets
2. Annual Costs: Revenue Less Costs
After Tax
3. Terminal Cash Flows: Salvage Value
Recovery of NWC
13. ARR = Avg. Net Income Per Year
Avg. Investment
14. Example:
Year Net Income Cost
1 6,000 100,000 Initial
2 8,000 0 Salvage Value
3 11,000
4 13,000
5 16,000
6 18,000
15. Avg. Net Income 72,000
6
Avg. Investment 100,000
2
AROI 12,000
50,000
= 12,000
= 24%
= 50,000
16. Advantages
◦ Simplicity
◦ Use the readily available accounting information
Disadvantages
◦ It is based on accounting information rather than
cash flows
◦ Fails to take account of the timing of the cash
inflows and outflows
◦ Time value of money is ignored
17. Years required to recover the original investment
Example:
Year Net Income Cash Flow Cumulative CF
1 6,000 26,000 26,000
2 8,000 28,000 54,000
3 11,000 31,000 85,000
4 13,000 33,000 118,000
5 16,000 36,000 154,000
6 18,000 18,000 172,000
Payback = 3 + 100,000 - 85,000
118,000 - 85,000
= 3.45 Years
18. The amount of time needed to recover the initial
investment
The number of years it takes including a fraction of the
year to recover initial investment is called payback period
To compute payback period, keep adding the cash flows
till the sum equals initial investment
Simplicity is the main benefit, but suffers from drawbacks
Technique is not consistent with wealth maximization—
Why? (lack of reinvestment)
19. Advantages
◦ Simplicity in use and a popular method
Disadvantages
◦ Fails to consider cash flows after the payback period
◦ It provides limited insight into risk and liquidity
◦ Ignore time value of money and cost of capital
(curved by DPBP)
◦ Ignore the risk of the project while evaluation
20. FV = PV (1 + r)n
Compounding: Finding FV
Discounting: Finding PV: PV = FV/(1 + r) n
Internal Rate of Return: Finding r
21. Similar to payback period approach with one difference
that it considers time value of money
The amount of time needed to recover initial investment
given the present value of cash inflows
Keep adding the discounted cash flows till the sum equals
initial investment
All other drawbacks of the payback period remains in this
approach
Not consistent with wealth maximization
22. NPV = Present Value of All Future Cash Flows less
Initial Cost
= CF1 + CF2 + CF3 +.......CFn - Io
1+r (1+r)2 (1+r)3 (1+r)n
24. Based on the amount of cash flows
NPV equals the present value of cash inflows
minus initial investment
Technique is consistent with the principle of
wealth maximization—Why?
Accept a project if NPV ≥ 0
25. Advantages
◦ Consider time value of money
◦ Maximize shareholders wealth (reinvestment)
◦ Use all cash flow during the project life
◦ Based on estimated cash flow rather than accounting
information of the project
Disadvantages
◦ The estimation of cash flows is difficult due to uncertainty
◦ Difficult to determine the appropriate discount rate
◦ In case of projects with unequal life, proper consideration
has to be given while applying NPV rules
26. Discount rate that makes NPV Zero
(i.e., that equates PV of benefits with the cost).
IRR: Io = CF1 + CF2 + ..... + CFn
1+r (1+r)2 (1+r)n
Solve for r.
Example:
100,000 = 26000 + 28000 + 31000 + ... +18000
1+r (1+r)2 (1+r)3 (1+r)6
r = 18.2%
28. Advantages
◦ Consider time value of money
◦ Maximize shareholders wealth (reinvestment)
◦ Use all cash flow during the project life
◦ Based on estimated cash flow rather than accounting
information of the project
◦ Easy to understand
Disadvantages
◦ IRR has problem when non-normal cash flow, multiple IRR
arise
◦ The estimation of cash flows is difficult due to uncertainty
◦ In case of mutually exclusive projects (that does not occur at
the same time) IRR may give the conflicting results because
of its assumption.
29. The rate at which the net present value of cash flows
of a project is zero, I.e., the rate at which the present
value of cash inflows equals initial investment
Project’s promised rate of return given initial
investment and cash flows
Consistent with wealth maximization
Accept a project if IRR ≥ Cost of Capital
30. n
CIF
O
MIRR
TV
PV
)1(
MIRR is the discount rate at which present value of
project’s cost is equal to the present value of its
terminal value
Cross over rate is that discount rate where NPVs of
two projects are equal
NPV profile is a graph that plots a project’s NPV
against the COC rates
31. Usually, NPV and IRR are consistent with each
other. If IRR says accept the project, NPV will
also say accept the project
IRR can be in conflict with NPV if
◦ Investing or Financing Decisions
◦ Projects are mutually exclusive
Projects differ in scale of investment
Cash flow patterns of projects is different
◦ If cash flows alternate in sign—problem of multiple IRR
If IRR and NPV conflict, use NPV approach
32. 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
33. Non-discounted Cash Flow Methods Discounted Cash Flow Methods
i) ARR: Calculate & compare with cutoff rate
/required rate of return/hurdle rate (Decision
rule: if ARR>Cutoff = Accept, otherwise reject
)
i) DPBP: Same except cash flow are discounted
by project’s COC
ii) PBP: Years to recover initial investment.
Shorter the PBP, the better.
ii) NPV: Find the discounted net cash flow of
the project at 0 year. Higher NPV, the better
iii) IRR: The discount rate that yield zero NPV.
If IRR>hurdle rate = accept the project
iv) MIRR: When the case of non-normal cash
flow. Discount rate that equates PV of costs and
PV of terminal value
v) PI: Also known as benefit-cost ratio, PV of
benefits/PV of costs. Acceptable of PI>1
34. Evaluating Capital Projects
1) Focus on Cash Flow, Not Profits.
– Cash Flow = Economic Reality.
– Profits can be managed/manipulated.
2) Carefully Estimate Expected Future Cash Flows.
3) Select a Discount Rate Consistent with the Risk of Those
Future Cash Flows.
4) Account for the Time Value of Money.
5) Compute NPV
35. 6) Net Present Value = Value Created or Destroyed by the
Project.
NPV is the amount by which the value of the firm will
change if you undertake the project.
7)Identify Risks and Uncertainties. Run a Sensitivity
Analysis.
8) Identify Qualitative Issues.
– Flexibility, Quality, Know-How, Learning, etc
9) Decide
36. Which technique is superior?
Although our decision should be based on NPV, but each
technique contributes in its own way.
Payback period is a rough measure of riskiness. The
longer the payback period, more risky a project is.
IRR is a measure of safety margin in a project. Higher
IRR means more safety margin in the project’s estimated
cash flows.
PI is a measure of cost-benefit analysis. How much NPV
for every rupee of initial investment.
