The Basics of Capital Budgeting
What is capital budgeting? <ul><li>Analysis of potential additions to fixed assets. </li></ul><ul><li>Long-term decisions;...
Examples: <ul><li>Expansion </li></ul><ul><li>Replacement </li></ul><ul><li>Buy or lease </li></ul><ul><li>Choice of equip...
Problems: <ul><li>Demand for capital-how much money needed for expenditure </li></ul><ul><li>Supply of capital – internal ...
Types of capital <ul><li>Debt </li></ul><ul><li>Preference share </li></ul><ul><li>Equity capital </li></ul><ul><li>Retain...
methods <ul><li>Pay back method </li></ul><ul><li>Accounting rate of return </li></ul><ul><li>Internal rate of return </li...
Steps to capital budgeting <ul><li>Estimate CFs (inflows & outflows). </li></ul><ul><li>Assess riskiness of CFs. </li></ul...
What is the difference between independent and mutually exclusive projects? <ul><li>Independent projects – if the cash flo...
What is the difference between normal and nonnormal cash flow streams? <ul><li>Normal cash flow stream – Cost (negative CF...
What is the payback period? <ul><li>The number of years required to recover a project’s cost, or “How long does it take to...
Calculating payback Payback L   =  2  +  /  =  2.375 years CF t   -100  10  60  100 Cumulative  -100  -90  0  50 0 1 2 3 =...
Strengths and weaknesses of payback <ul><li>Strengths </li></ul><ul><ul><li>Provides an indication of a project’s risk and...
Discounted payback period <ul><li>Uses discounted cash flows rather than raw CFs. </li></ul>Disc Payback L  =  2  +  /  = ...
Accounting rate of return <ul><li>= estimated net profits/ capital employed . 100 </li></ul><ul><li>Average investment =( ...
Net Present Value (NPV) <ul><li>Sum of the PVs of all cash inflows and outflows of a project: </li></ul>
What is Project L’s NPV? <ul><li>Year   CF t PV of CF t </li></ul><ul><li>  0 -100  -$100 </li></ul><ul><li>  1   10   9.0...
Rationale for the NPV method <ul><li>NPV = PV of inflows – Cost </li></ul><ul><li>= Net gain in wealth </li></ul><ul><li>I...
Internal Rate of Return (IRR) <ul><li>IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0: <...
How is a project’s IRR similar to a bond’s YTM? <ul><li>They are the same thing. </li></ul><ul><li>Think of a bond as a pr...
Rationale for the IRR method <ul><li>If IRR > WACC, the project’s rate of return is greater than its costs.  There is some...
IRR Acceptance Criteria <ul><li>If IRR > k, accept project. </li></ul><ul><li>If IRR < k, reject project. </li></ul><ul><l...
NPV Profiles <ul><li>A graphical representation of project NPVs at various different costs of capital. </li></ul><ul><li> ...
Comparing the NPV and IRR methods <ul><li>If projects are independent, the two methods always lead to the same accept/reje...
Comparisons : proposals Initial  inv Annual cash flow Life in years 1 60,000 12000 15 2 88,000 22,500 22 3 2150 1,500 3 4 ...
Pay back method Pay back period  = Initial investment/annual cash flow 1 60,000/12,000 5 2 88,00/22500 3.9 3 21,50/1500 1....
Accounting rate  proposal Initial investment Annual cash flow Life in years Annual depreciation Net profits Rate of return...
NPV proposal Initial inv Annual cash low life Pv(10%) Pv npvi 1 60,000 12,000 15 7.7688 93225.6 1.55 2 88,000 22,500 22 8....
DCF <ul><li>Discounted cash flows or internal rate of return may sometimes give different results </li></ul>
<ul><li>All methods do not give the same interpretation </li></ul>methods payback accounting DCF NPV Proposal rank ranks r...
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Cap budget [autosaved]

  1. 1. The Basics of Capital Budgeting
  2. 2. What is capital budgeting? <ul><li>Analysis of potential additions to fixed assets. </li></ul><ul><li>Long-term decisions; involve large expenditures. </li></ul><ul><li>Very important to firm’s future. </li></ul>
  3. 3. Examples: <ul><li>Expansion </li></ul><ul><li>Replacement </li></ul><ul><li>Buy or lease </li></ul><ul><li>Choice of equipment </li></ul><ul><li>Capital expenditure </li></ul>
  4. 4. Problems: <ul><li>Demand for capital-how much money needed for expenditure </li></ul><ul><li>Supply of capital – internal and external </li></ul><ul><li>Capital rationing – selection of the projects </li></ul>
  5. 5. Types of capital <ul><li>Debt </li></ul><ul><li>Preference share </li></ul><ul><li>Equity capital </li></ul><ul><li>Retained earnings </li></ul><ul><li>WACC: weighted average cost of capital </li></ul>
  6. 6. methods <ul><li>Pay back method </li></ul><ul><li>Accounting rate of return </li></ul><ul><li>Internal rate of return </li></ul><ul><li>Net present value </li></ul>
  7. 7. Steps to capital budgeting <ul><li>Estimate CFs (inflows & outflows). </li></ul><ul><li>Assess riskiness of CFs. </li></ul><ul><li>Determine the appropriate cost of capital. </li></ul><ul><li>Find NPV and/or IRR. </li></ul><ul><li>Accept if NPV > 0 and/or IRR > WACC. </li></ul>
  8. 8. What is the difference between independent and mutually exclusive projects? <ul><li>Independent projects – if the cash flows of one are unaffected by the acceptance of the other. </li></ul><ul><li>Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other. </li></ul>
  9. 9. What is the difference between normal and nonnormal cash flow streams? <ul><li>Normal cash flow stream – Cost (negative CF) followed by a series of positive cash inflows. One change of signs. </li></ul><ul><li>Nonnormal cash flow stream – Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc. </li></ul>
  10. 10. What is the payback period? <ul><li>The number of years required to recover a project’s cost, or “How long does it take to get our money back?” </li></ul><ul><li>Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive. </li></ul>
  11. 11. Calculating payback Payback L = 2 + / = 2.375 years CF t -100 10 60 100 Cumulative -100 -90 0 50 0 1 2 3 = 2.4 30 80 80 -30 Project L Payback S = 1 + / = 1.6 years CF t -100 70 100 20 Cumulative -100 0 20 40 0 1 2 3 = 1.6 30 50 50 -30 Project S
  12. 12. Strengths and weaknesses of payback <ul><li>Strengths </li></ul><ul><ul><li>Provides an indication of a project’s risk and liquidity. </li></ul></ul><ul><ul><li>Easy to calculate and understand. </li></ul></ul><ul><li>Weaknesses </li></ul><ul><ul><li>Ignores the time value of money. </li></ul></ul><ul><ul><li>Ignores CFs occurring after the payback period. </li></ul></ul>
  13. 13. Discounted payback period <ul><li>Uses discounted cash flows rather than raw CFs. </li></ul>Disc Payback L = 2 + / = 2.7 years CF t -100 10 60 80 Cumulative -100 -90.91 18.79 0 1 2 3 = 2.7 60.11 -41.32 PV of CF t -100 9.09 49.59 41.32 60.11 10%
  14. 14. Accounting rate of return <ul><li>= estimated net profits/ capital employed . 100 </li></ul><ul><li>Average investment =( initial investment + scrap value) / 2 </li></ul><ul><li>Limitation : does not look at time value of money </li></ul>
  15. 15. Net Present Value (NPV) <ul><li>Sum of the PVs of all cash inflows and outflows of a project: </li></ul>
  16. 16. What is Project L’s NPV? <ul><li>Year CF t PV of CF t </li></ul><ul><li> 0 -100 -$100 </li></ul><ul><li> 1 10 9.09 </li></ul><ul><li> 2 60 49.59 </li></ul><ul><li> 3 80 60.11 </li></ul><ul><li> NPV L = $18.79 </li></ul><ul><li>NPV S = $19.98 </li></ul>
  17. 17. Rationale for the NPV method <ul><li>NPV = PV of inflows – Cost </li></ul><ul><li>= Net gain in wealth </li></ul><ul><li>If projects are independent, accept if the project NPV > 0. </li></ul><ul><li>If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. </li></ul><ul><li>In this example, would accept S if mutually exclusive (NPV s > NPV L ), and would accept both if independent. </li></ul>
  18. 18. Internal Rate of Return (IRR) <ul><li>IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0: </li></ul><ul><li>Normally NPV METHOD and IRR method gives the same result </li></ul>
  19. 19. How is a project’s IRR similar to a bond’s YTM? <ul><li>They are the same thing. </li></ul><ul><li>Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project. </li></ul><ul><li>EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20. </li></ul><ul><ul><li>Solve for IRR = YTM = 7.08%, the annual return for this project/bond. </li></ul></ul>
  20. 20. Rationale for the IRR method <ul><li>If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns. </li></ul>
  21. 21. IRR Acceptance Criteria <ul><li>If IRR > k, accept project. </li></ul><ul><li>If IRR < k, reject project. </li></ul><ul><li>If projects are independent, accept both projects, as both IRR > k = 10%. </li></ul><ul><li>If projects are mutually exclusive, accept S, because IRR s > IRR L . </li></ul>
  22. 22. NPV Profiles <ul><li>A graphical representation of project NPVs at various different costs of capital. </li></ul><ul><li> k NPV L NPV S </li></ul><ul><li> 0 $50 $40 </li></ul><ul><li> 5 33 29 </li></ul><ul><li>10 19 20 </li></ul><ul><li>15 7 12 </li></ul><ul><li>20 (4) 5 </li></ul>
  23. 23. Comparing the NPV and IRR methods <ul><li>If projects are independent, the two methods always lead to the same accept/reject decisions. </li></ul><ul><li>If projects are mutually exclusive … </li></ul><ul><ul><li>If k > crossover point, the two methods lead to the same decision and there is no conflict. </li></ul></ul><ul><ul><li>If k < crossover point, the two methods lead to different accept/reject decisions. </li></ul></ul>
  24. 24. Comparisons : proposals Initial inv Annual cash flow Life in years 1 60,000 12000 15 2 88,000 22,500 22 3 2150 1,500 3 4 20,500 4500 10 5 4,25,000 2,25000 20
  25. 25. Pay back method Pay back period = Initial investment/annual cash flow 1 60,000/12,000 5 2 88,00/22500 3.9 3 21,50/1500 1.4 4 2,5000/4500 4.6 5 4,25000/2,25000 1.9
  26. 26. Accounting rate proposal Initial investment Annual cash flow Life in years Annual depreciation Net profits Rate of return 1 60,000 12000 15 4000 8000 26.67 2 88,000 22,500 22 4000 18,500 42 3 2150 1500 3 717 783 72.84 4 20,500 4500 10 2050 2450 23.9 5 4,25000 2,25000 20 21,250 203750 95.88
  27. 27. NPV proposal Initial inv Annual cash low life Pv(10%) Pv npvi 1 60,000 12,000 15 7.7688 93225.6 1.55 2 88,000 22,500 22 8.8919 200,067.75 2.27 3 2150 1500 3 2.5918 3887.7 1.81 4 20,500 4500 10 6.3213 28445.8 1.39 5 425,000 2,25000 20 8.6466 1945485 4.56
  28. 28. DCF <ul><li>Discounted cash flows or internal rate of return may sometimes give different results </li></ul>
  29. 29. <ul><li>All methods do not give the same interpretation </li></ul>methods payback accounting DCF NPV Proposal rank ranks ranks ranks 1 5 4 4 4 2 3 3 3 2 3 1 2 2 3 4 4 5 5 5 5 2 1 1 1

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