• Save
Capital budgeting
Upcoming SlideShare
Loading in...5
×
 

Like this? Share it with your network

Share

Capital budgeting

on

  • 2,813 views

 

Statistics

Views

Total Views
2,813
Views on SlideShare
2,813
Embed Views
0

Actions

Likes
11
Downloads
0
Comments
0

0 Embeds 0

No embeds

Accessibility

Upload Details

Uploaded via as Microsoft PowerPoint

Usage Rights

© All Rights Reserved

Report content

Flagged as inappropriate Flag as inappropriate
Flag as inappropriate

Select your reason for flagging this presentation as inappropriate.

Cancel
  • Full Name Full Name Comment goes here.
    Are you sure you want to
    Your message goes here
    Processing…
Post Comment
Edit your comment

Capital budgeting Presentation Transcript

  • 1. Capital Budgeting Estimating Cash Flows & Techniques
  • 2. Meaning
    • Capital Budgeting is the process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.
  • 3.
    • Specifically, CB involves:
    • Generating investment project proposals consistent with the firm’s strategic objectives;
    • Estimating after-tax incremental operating cash flows for the investment projects;
    • Evaluating project incremental cash flows;
    • Selecting projects based on a value-maximizing acceptance criterion; and
    • Continually reevaluating implemented investment projects.
  • 4.
    • Since CASH is central to all decisions of the firm, the expected benefits to be received from the project is expressed in terms of Cash Flows and not income flows.
    • Cash flows should be measured on an incremental, after-tax basis. In addition, the stress is on operating , not financing flows.
    • It is helpful to place project CFs into 3 categories based on timing: (1) the initial CF , (2) interim incremental net CFs , and (3) the terminal-year incremental net CF.
  • 5. Capital Budgeting: The process of planning for purchases of long-term assets.
    • Example:
    • Suppose our firm must decide whether to purchase a new plastic molding machine for $125,000. How do we decide?
    • Will the machine be profitable ?
    • Will our firm earn a high rate of return on the investment?
  • 6. Decision-making Criteria in Capital Budgeting
    • How do we decide if a capital investment project should be accepted or rejected?
  • 7.
    • 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.
    Decision-making Criteria in Capital Budgeting
  • 8. Payback Period
    • How long will it take for the project to generate enough cash to pay for itself?
  • 9. Payback Period
    • How long will it take for the project to generate enough cash to pay for itself?
    0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
  • 10. Payback Period
    • How long will it take for the project to generate enough cash to pay for itself?
    Payback period = 3.33 years . 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
  • 11.
    • Is a 3.33 year payback period good?
    • Is it acceptable?
    • Firms that use this method will compare the payback calculation to some standard (maximum acceptable PB period) set by the firm.
    • If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision?
    • Accept the project .
    Payback Period (Acceptance Criterion)
  • 12. Drawbacks of Payback Period
    • Firm cutoffs are subjective .
    • Does not consider time value of money .
    • Does not consider any required rate of return .
    • Does not consider all of the project’s cash flows .
  • 13. Drawbacks of Payback Period
    • Does not consider all of the project’s cash flows.
    • Consider this cash flow stream!
    0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 (300) 0 0
  • 14. Drawbacks of Payback Period
    • Does not consider all of the project’s cash flows.
    • This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
    0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 (300) 0 0
  • 15. Other Methods
    • 1) Net Present Value (NPV)
    • 2) Profitability Index (PI)
    • 3) Internal Rate of Return (IRR)
    • Each of these decision-making criteria:
    • Examines all net cash flows,
    • Considers the time value of money, and
    • Considers the required rate of return.
  • 16. Net Present Value
    • NPV = the total PV of the annual net cash flows - the initial outlay (or cash outflows).
    NPV = - ICO CF t (1 + k) t n t=1 
  • 17. Net Present Value
    • Decision Rule:
    • If NPV is positive, accept .
    • If NPV is negative, reject .
  • 18.
    • Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15% .
    NPV Example
  • 19.
    • Suppose we are considering a capital investment that costs $250,000 and provides annual net cash flows of $100,000 for five years. The firm’s required rate of return is 15% .
    NPV Example 0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
  • 20. Net Present Value (NPV)
    • NPV is just the PV of the annual cash flows minus the initial outflow.
    • PV of cash flows = $335,216
    • - Initial outflow: ($250,000)
    • = Net PV $85,216
  • 21. Profitability Index
  • 22. Profitability Index NPV = - ICO CF t (1 + k) t n t=1 
  • 23. Profitability Index PI = ICO CF t (1 + k) n t=1  t NPV = - ICO CF t (1 + k) t n t=1 
  • 24.
    • Decision Rule :
    • If PI is greater than or equal to 1, accept .
    • If PI is less than 1, reject .
    Profitability Index
  • 25. PI Example
    • We know that from the previous example PV of cash flows is $335,216 and the Initial cash outflow is $250,000.
    • Therefore, PI = 335,216 / 250,000 = 1.34
    • You should accept as PI = 1.34 , which is more than 1.
  • 26. Internal Rate of Return (IRR)
    • IRR: The return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.
  • 27. Internal Rate of Return (IRR)
  • 28. Internal Rate of Return (IRR) NPV = - ICO CF t (1 + k) t n t=1 
  • 29. Internal Rate of Return (IRR) NPV = - ICO CF t (1 + k) t n t=1  n t=1  IRR: = ICO CF t (1 + IRR) t
  • 30. Internal Rate of Return (IRR)
    • IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay .
    • This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.
    n t=1  IRR: = ICO CF t (1 + IRR) t
  • 31. Calculating IRR
    • Looking again at our problem:
    • The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.
    0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
  • 32. IRR Decision Rule
    • If IRR is greater than or equal to the required rate of return, accept .
    • The acceptance criterion related to the IRR method is to compare it to the required r.o.r., known as the cutoff or hurdle rate . Hurdle rate is the rate at which a project is acceptable.
    • If IRR is less than the required rate of return, reject .
  • 33.
    • IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
  • 34.
    • IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
    0 1 2 3 4 5 (500) 200 100 (200) 400 300
  • 35.
    • IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
    1 0 1 2 3 4 5 (500) 200 100 (200) 400 300
  • 36.
    • IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
    0 1 2 3 4 5 (500) 200 100 (200) 400 300 1 2
  • 37.
    • IRR is a good decision-making tool as long as cash flows are conventional . (- + + + + +)
    • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)
    0 1 2 3 4 5 (500) 200 100 (200) 400 300 1 2 3
  • 38. Summary Problem
    • Enter the cash flows only once.
    • Find the IRR .
    • Using a discount rate of 15%, find NPV .
    • Add back IO and divide by IO to get PI .
    0 1 2 3 4 5 (900) 300 400 400 500 600
  • 39. Summary Problem
    • IRR = 34.37%.
    • Using a discount rate of 15%,
    • NPV = $510.52.
    • PI = 1.57 .
    0 1 2 3 4 5 (900) 300 400 400 500 600
  • 40. Capital Rationing
    • A final potential difficulty related to implementing the alternative methods of project evaluation and selection.
    • Refers to a situation where a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.
    • Constraints come when there is a policy of financing all capital expenditures.
  • 41.
    • CR also occurs when a division of a large company is allowed to make capital expenditure only upto a specified budget ceiling, over which the division usually has no control.
    • With such a constraint, the firm attempts to select the combination of investment proposals that will provide the greatest increase in the value of the firm subject to not exceeding the budget ceiling constraint.