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Capital Budgeting Er. S Sood
 

Capital Budgeting Er. S Sood

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    Capital Budgeting Er. S Sood Capital Budgeting Er. S Sood Presentation Transcript

    • Capital Budgeting Er. SS POWER GP.
    • Capital Budgeting : # The process of making investment decision in capital expenditures. # The planning for purchases of long- term assets.
        • Capital Expenditure:
        • An expenditure the benefits of which are received over a period of time exceeding one year.
    • Examples of Capital Expenditure:
      • Acquisition of permanent assets such as plant & mach.
      • Cost of addition, expansion, improvement or alteration of FA
      • Cost of replacement of FA
      • R&D project cost etc.
    • Need and Importance CB
      • Exchange of current funds for future benefits
      • Large investment
      • Long term commitment of funds
      • Irreversible nature
      • Long term effect on profitability
      • Difficulties of investment decisions
      • Strategic investment decisions
      • National Importance
    • CB Process
      • Identification of potential investment opportunities
      • Screening the opportunities
      • Evaluation of Various opportunities
      • Ranking the opportunities
      • Final approval & preparation of capital expenditure budget
      • Implementation
      • Review & follow up
    • CB Decisions
      • Accept reject decisions
      • Mutually exclusive decisions
      • Capital Rationing decisions
    • Project Classification
      • Mandatory investments
      • Replacement projects
      • Expansion Projects
      • Diversification projects
      • R &c D projects
      • Misc. projects: e.g. recreational facilities, landscaped gardens etc.
      • Example :
      • Suppose our firm wants to decide whether to purchase a new machine for Rs.15,00,000. How do we decide?
      • Will the machine be profitable?
      • Will our firm earn a high rate of return on the investment?
    • Decision-making Criteria in Capital Budgeting
      • How do we decide if a capital investment project should be accepted or rejected?
      • 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
    • Methods / Techniques of CB Traditional Methods Time adjusted or discounted Methods
      • Net present value method - NPV
      • Internal rate of return method - IRR
      • Profitability Index – Benefit cost ratio
      • Pay Back period Method
      • Improvement over pay back period
      • Post pay back period
      • Post pay back profitability index
      • Reciprocal Pay back period
      • Discounted Pay back period
      • Accounting rate of return
    • A. Traditional Methods
    • 1. Payback Period
      • How long will it take for the project to generate enough cash to pay for itself?
      • It is the length of the time required to recover initial cash outlay on the project
    • Payback Period Payback period = 3.33 years. Pay Back period = Original cost of the project Annual Cash Inflows CI = PAT + Dep 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
      • Is a 3.33 year payback period good?
      • Is it acceptable?
      • Firms that use this method will compare the payback calculation to some standard 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
    • 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.
    • 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
    • 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
    • 2. Improvement over the Pay back period method
      • Post pay back period method
      • = Life of the project – pay back period
      ii) Post pay back profitability index = Post pay back profits *100 Investments iii) Pay back reciprocal method = Annual cash inflows Total investment
    • iv) Discounted payback method
      • Discounts the cash flows at the firm’s required rate of return.
      • Payback period is calculated using these discounted net cash flows.
      • Problems :
      • Cutoffs are still subjective.
      • Still does not examine all cash flows.
    • Discounted payback method
      • Discounted
      • Year Cash Flow CF (14%)
      • 0 -500 -500.00
      • 1 250 219.30 1 year
      • 280.70
      0 1 2 3 4 5 ( 500) 250 250 250 250 250
    • Discounted payback method
      • Discounted
      • Year Cash Flow CF (14%)
      • 0 -500 -500.00
      • 1 250 219.30 1 year
      • 280.70
      • 2 250 192.37 2 year 88.33
      • 3 250 168.74 .52 years
      0 1 2 3 4 5 ( 500) 250 250 250 250 250
    • Discounted payback method
      • Discounted
      • Year Cash Flow CF (14%)
      • 0 -500 -500.00
      • 1 250 219.30 1 year
      • 280.70
      • 2 250 192.37 2 years
      • 88.33
      • 3 250 168.74 .52 years
      0 1 2 3 4 5 (500) 250 250 250 250 250 The Discounted Payback is 2.52 years
    • 3 . Accounting rate of return method -ARR
      • Average rate of return:
      • = Average annual profits * 100
      • Net Investment
      • Return per unit of investment:
      • = Total profits * 100
      • Net Investment
      • Return on average investment:
      • = Total profits * 100
      • Average Investment
      • Average return on average investment:
      • = Average annual profits * 100
      • Average Investment
    • B. Time adjusted / discounted 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.
    • 1. Net Present Value
      • NPV = PV CI - PV CO
      • Total PV of annual net cash flows - Initial outlay.
      NPV = - IO FCF t (1 + k) t n t=1 
    • Net Present Value
      • Decision Rule :
      • In case of independent projects
      • If NPV is positive, accept.
      • If NPV is negative, reject.
      • In case of mutually exclusive projects
      • Accept the project with highest positive NPV
      • Suppose we are considering a capital investment that costs Rs. 250,000 and provides annual net cash flows of Rs. 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
    • Net Present Value (NPV)
      • NPV is just the PV of the annual cash flows minus the initial outflow.
      • Using PVM:
      • Present value of annuity of Rs. 1 in 5 years = 3.3522
      • PV CI = 100,000 *3.3522 = 3,35,220
      • PV CO = 250,000
      • PV of cash flows = Rs.335,220
      • - Initial outflow: (Rs. 250,000)
      • = Net PV Rs. 85,220
    • 2. Internal Rate of Return (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.
      The rate at which PV CI =PV CO n t=1  IRR: = IO FCF t (1 + IRR) t
    • 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 the Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.
      n t=1  IRR: = IO FCF t (1 + IRR) t
    • Calculating IRR
      • When cash inflows are equal
      • When cash inflows are not equal
      • When cash inflows are equal:
      • PVF = Initial outlay / Annual cash inflow
      • Then consult the PV table with the number
      • of years equal to the life of the assets & find
      • out the rate at which calculated PVF =PV
      • given in the table
    • b) When cash inflows are not equal over the life of the asset:
      • Hit & trial method
      • Process
      • Calculate PV CI by using an arbitrary assumed arte of discount.
      • Find out NPV
      • If NPV is positive, apply higher rate of discount
      • If still NPV is positive, apply further higher rate of discount
      • If NPV is negative, the IRR must be between two rates
    • IRR = LR + PV LR - I PV LR - PV HR * Difference between two rates IRR
    • Calculating IRR
      • Looking again at the problem:
      • The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.
      IRR =28% appox. 0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
    • IRR
      • Decision Rule :
      • In case of independent projects:
      • If IRR > required rate of return(K o ), accept.
      • If IRR < the required rate of return ( K o ) , reject.
      • In case of mutually exclusive projects:
      • Accept the project with highest IRR, provided it is greater than required rate of return(K o ).
    • Modified Internal Rate of Return - MIRR
      • IRR assumes that all cash flows are reinvested at the IRR.
      • MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return.
    • MIRR Steps:
      • Calculate the PV of the cash outflows.
        • Using the required rate of return.
      • Calculate the FV of the cash inflows at the last year of the project’s time line. This is called the terminal value (TV).
        • Using the required rate of return.
      • MIRR: the discount rate that equates the PV of the cash outflows with the PV of the terminal value, ie, that makes :
      • PV outflows = PV inflows
    • MIRR
      • Using our time line and a 15% rate:
      • PV outflows = (900)
      • FV inflows (at the end of year 5) = 2,837 .
      • MIRR: FV = 2837, PV = (900), N = 5
      • solve: I = 25.81%.
      0 1 2 3 4 5 (900) 300 400 400 500 600
    • MIRR
      • Using our time line and a 15% rate:
      • PV outflows = (900)
      • FV inflows (at the end of year 5) = 2,837.
      • MIRR: FV = 2837, PV = (900), N = 5
      • solve: I = 25.81%.
      • Conclusion : The project’s IRR of 34.37%, assumes that cash flows are reinvested at 34.37%.
      • Assuming a reinvestment rate of 15%, the project’s MIRR is 25.81%.
    • 3. Profitability Index PI = PV CI PV CO PI = IO FCF t (1 + k) n t=1  t
        • Decision Rule :
      • If PI > 1, accept.
      • If PI < 1, reject.
      Profitability Index
    • Example of PI
      • -250,000 PV of cash outflows
      • 335,220 PV of cash inflows
      • PI = PV CI / PV CO
      • = 3,35,220/2,50,000
      • = 1.34
      • As PI > 1, Accept the project
    • Factors affecting CB decisions
      • Urgency
      • Degree of certainty
      • Intangible factors
      • Legal factors
      • Availability of funds
      • Future earnings
      • Obsolescence
      • R&D projects
      • Cost considerations
    • Risk & uncertainty in CB
      • Expected economic life of the asset
      • Salvage value
      • Capacity of the project
      • Selling price of the product
      • Depreciation rate
      • Production cost
      • Rate of taxation
      • Future demand of the product
    • Methods for ascertaining risk & uncertainty in CB
      • Risk adjusted cut off or varying discount rate
      • Certainity equivalent method
      • Sensitivity technique
      • Probability technique
      • Standard deviation method
      • Coefficient variation method
      • Decision tree analysis
    • Method of appraisal & their rationale
      • Wide variety of measures
      • Small size investment projects – pay back period method
      • Large size investment projects – ARR method
      • Large size investment projects – Discounted cash flows method
      • Several other criteria: profit per rupee invested, cost saving per unit etc.
      • By and large no fixed standard
      • Bottleneck due to limited funds