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# Capital Budgeting

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### Transcript

• 1. Capital Budgeting
• 2. Contents
• Comparison.
10
• Standard deviation.
5
• Coefficient of Variation.
9
• Sensitivity analysis.
4
• Certainty Equivalent.
8
• Rate of discount.
3
• Inflation.
7
• IRR.
2
• Probability.
6
• NPV.
1 Sheet No. Sheet No Particulars Particulars
• 3. NPV
• NPV equals present value of cash inflows less present value of cash outflows.
• Probable / Expected NPV equals to the Σ(NPV n *probability n ) where n denotes the transaction in an year.
• EANPV equals present value of cash inflows divided by sum of PV factor for n number of years (life of the project).
• Base NPV = Simple NPV.
• Adjusted NPV = Base NPV + Present value of tax saving on
• interest(using interest rate as discount rate)
• – Floatation Cost.
• Overall NPV in case of joint probability = Σ Joint Probability*
• Inflow
• 4. IRR
• Simple formula = Lower rate + NPV at lower rate
• NPV at _ NPV at
• lower rate higher rate
• Conditional formula = Lower rate + Σ PV factor _ Σ PV factor
• at lower rate at IRR
• Σ PV factor _ Σ PV factor
• at lower rate at higher rate
• The condition lying above is that the annual cash flows are equal. This is so because the calculation of Σ PV factor at IRR above have a special formula i.e. = Outflows
• Annual Inflows
• When life is infinite the IRR = (Annual inflow / PV of outflows)
• 5. IRR
• IRR = 0, when life of project = Σ PV factor at IRR.
• Project IRR is the IRR calculated taking the cash flows as for the project as a whole.
• Equity IRR is the IRR calculated taking the cash flows as for the equity only (Equity cash flows = Project cash flows - Principal & Interest payment on other finances).
• IRR for long term funds is the IRR calculated as for the long term funds (Long term fund cash flows = Project cash flows - Principal & Interest payment on short term finances).
• Modified IRR is the IRR based on the assumption that the internal cash flows are re-invested at cost of capital whereas the simple IRR has an assumption that the internal cash flows are re-invested at IRR.
• 6. Rates of Discount
• These are decided as per the cash flows:
• 1. If the cash flows are risky then use riskier rate.
• 2. If the cash flows are risk adjusted / certain then use risk adjusted / free rate.
• 3. If the cash flows are in real terms then use real rate.
• 4. If the cash flows are inflation adjusted then use money / nominal rate.
• (Money rate+1) = (1+Real Rate)(1+Inflation Rate)
• 7. Sensitivity analysis
• The basic principle of sensitivity analysis is that we, hereby with this
• principle, have to think negative about the project’s NPV. For this we may
• be having two conditions. These are:
• 1. Given conditions – The question may provide the elements governing
• NPV, to make it (NPV) zero.
• 2. No specific condition – In this particular case we have o make NPV at
• zero by sensitivising Cash Inflows, Cash Outflows, Life & Discount Rate.
• Cash Inflows – Make it equal to Cash Outflows.
• Cash Outflows – Make it equal to Cash Inflows.
• Life – Use the formula of discounted payback period by taking inflows
• as equal to outflows.
• Discount Rate – Use IRRs conditional formula to arrive at NPV at zero.
• Finally we have to see what is the proportion in which the element is
• influencing the NPV to make it at zero.
• 8. Standard deviation S 1 denotes standard deviation of year 1 Overall  = √ ( S 1 ) 2 + ( S 2 ) 2 (1+K e ) 2 [(1+K e ) 2 ] 2 Independent cash flows Overall  = ( S 1 ) + ( S 2 ) (1+K e ) (1+K e ) 2 Perfectly correlated cash flows Normal conditions  = √ ( S 1 W 1 ) 2 + ( S 2 W 2 ) 2 + 2 ( S 1 W 1 S 2 W 2 R 12 ) S 1 denotes standard deviation of one asset. W 1 denotes weight of that asset. R 12 denotes correlation between those two assets S = √ Σ (Expected NPV- Actual NPV) 2 *probability More than one Asset Single Asset
• 9. Probability
• In capital budgeting the probability is found out by using normal distribution curve.
• Z = Required NPV – Expected NPV
• Prepare normal curve diagram & allocate the required NPV & expected NPV.
• Find probability using the normal distribution table.
• Joint probability is calculated in the condition where the first probability decides the happening of the second conditional event.
• Joint probability = Initial probability*Conditional probability.
• 10. Inflation
• If the cash flows are inflation adjusted, we use money rate for discounting the flows.
• Inflation adjusted cash flows = (Normal cash flows)(1+Inflation rate) for next year. The normal cash flows denotes the cash flows in real term i.e. at period zero.
• Depreciation do not attract inflation.
• 11. Certainty Equivalent
• Certain cash flows are found out by multiplying certainty equivalent by the given cash flows.
• Then it will be discounted using risk adjusted / free rate to arrive at present value of cash inflows.
• Finally the NPV can be found by deducting present value of cash outflows by above present value.
• 12. Coefficient of Variation
• Coefficient of Variation = Standard deviation *100
• NPV
• When the standard deviation & the NPV are not sufficient to make a perfect decision about the project the decision is taken up using C. V.
• 13. Profitability Index
• PI = PV of inflows
• PV of outflows
• When the organisation, don't have sufficient funds to select different projects, it use the process of PI i.e. project having high PI is selected.
• When there are outflows in multiple period of time the outflows except for the initial outflows are excluded.
• PI = PV of inflows
• Initial outflows
• Firstly find NPV of all the projects leaded by the step to find minimum number of projects with maximum amount arrange projects in the deceasing order of NPV & draw a table to finally conclude the result.
• Mutually exclusive projects, complimentary projects.
• 14. Replacement Decision
• Whether to replace the asset or not?
• When to replace the asset?
• When to replace the same kind of machine again?
• 15. Comparison
• N.P.V – Choose project having higher NPV.
• I.R.R. – Choose project having higher IRR.
• C. V. – Choose project having lower C. V.
•  – Choose project having lower standard deviation.
• If IRR & NPV are giving decision in opposite direction then select the project as per C. V.
• 16. General
• Depreciation have no relevance when no tax is provided as it provides only the tax saving.
• Allocable costs are excluded from the statement.
• Sunk costs are excluded from the statement.
• When we have more than one project to choose from having unequal life then the decision is taken-up by calculating EANPV.
• When there is a missing figure question, the NPV is taken as zero.
• In case of block of assets concept, the only change is that it affects the salvages value & the depreciation.
• Remember TAX & TIME effects.
• 17. Notes
• 18. Thank You