We've updated our privacy policy. Click here to review the details. Tap here to review the details.

Successfully reported this slideshow.

Your SlideShare is downloading.
×

Activate your 30 day free trial to unlock unlimited reading.

Activate your 30 day free trial to continue reading.

Top clipped slide

1 of 49
Ad

captital budegting of time value of money.

captital budegting of time value of money.

- 1. Capital Budgeting By- Ayisha Shaikh
- 2. Meaning Capital budgeting is a process of evaluating investments and huge expenses in order to obtain the best returns on investment. An organization is often faced with the challenges of selecting between two projects/investments or the buy vs replace decision. An organization would like to invest in all profitable projects but due to the limitation on the availability of capital an organization has to choose between different projects/investments. Capital budgeting is the budgeting of capital expense
- 3. Objectives To find out the profitable capital expenditure. 2. To know whether the replacement of any existing fixed assets gives more return than earlier. 3. To decide whether a specified project is to be selected or not. To find out the quantum of finance required for the capital expenditure To assess the various sources of finance for capital expenditure. 6. To evaluate the merits of each proposal to decide which project is best.
- 4. Features Capital budgeting involves the investment of funds currently for getting benefits in the future. 2. Generally, the future benefits are spread over several years. 3. The long term investment is fixed. 4. The investments made in the project is determining the financial condition of business organization in future. 5. Each project involves huge amount of funds. 6. Capital expenditure decisions are irreversible. 7. The profitability of the business concern is based on the quantum of investments made in the project.
- 5. Limitations The economic life of the project and annual cash inflows are only an estimation. The actual economic life of the project is either increased or decreased. Likewise, the actual annual cash inflows may be either more or less than the estimation. Hence, control over capital expenditure can not be exercised. 2. The application of capital budgeting technique is based on the presumed cash inflows and cash outflows. Since the future is uncertain, the presumed cash inflows and cash outflows may not be true. Therefore, the selection of profitable project may be wrong. 3. Capital budgeting process does not take into consideration of various non- financial aspects of the projects while they play an important role in successful and profitable implementation of them. Hence, true profitability of the project cannot be highlighted.
- 6. It is also not correct to assume that mathematically exact techniques always produce highly accurate results. 5. All the techniques of capital budgeting presume that various investment proposals under consideration are mutually exclusive which may not be practically true in some particular circumstances. 6. The morale of the employee, goodwill of the company etc. cannot be quantified accurately. Hence, these can substantially influence capital budgeting decision. 7. Risk of any project cannot be presumed accurately. The project risk is varying according to the changes made in the business world. 8. In case of urgency, the capital budgeting technique cannot be applied. 9. Only known factors are considered while applying capital budgeting decisions. There are so many unknown factors which are also affecting capital budgeting decisions. The unknown factors cannot be avoided or controlled.
- 7. Capital Budgeting Process
- 8. Techniques of Capital Budgeting
- 9. Modern Methods Modern Methods are also known as discounted cash flow techniques It takes into consideration time value of money There are broadly three methods NPV, PI, IRR and Cost Benefit Analysis
- 10. NET PRESENT VALUE The net present value of a project is equal to the sum of discounted cash flows associated with the project. Symbolically represented as NPV = CF0 / (1+r)0 +CF1 / (1+r)1 +CF2 / (1+r)2 +………… CFn / (1+r)n -I NPV = 𝒏=𝟏 ∞ CFn / (1+r)n - Initial Investment NPV= Net Present Value (summation of PV of all Cash flows) CF= Cash flow at the end of the year n r= Rate of Discount n= Life of the Project When NPV Rule > 1 Accept < 1 Reject
- 11. MINI CASESTUDY-2 2. ABC Ltd has been pondering of the different investment opportunities it has. Help it to invest in the most profitable one if the rate of interest is 8% p.a. The cash flow from both the projects are as listed below and the investment required for each project is Rs. 1,20,000 PV of cash flow of Project-A= Rs. 1,93,336 PV of cash flow of Project-B = Rs. 2,24,989 Year Project-A Project-B 1 40,000 50000 2 60,000 30,000 3 75,000 90,000 4 20,000 60,000 5 45,000 55,000
- 12. Merits of NPV It takes into consideration tive value of money It considers cash flow stream of the project in its entirety. Ie till the life of the project It perfectly aligns with the financial objective of maximization of wealth of the shareholders The additive property of NPV makes it unique and distinct from all the other techniques Its easy to understand and calculate, whichever project has a higher NPV that project is considered Future investment in the project is also taken into consideration
- 13. Project A 1,00,000 45,000 PROJECT B 1,00,000 40,000 PROJECT C 50,000 25,000 PROJECT D 50,000 23,000
- 14. Demerits of NPV Though one of the most popular method of capital budgeting it suffers from the following demerits It is expressed in absolute term and not relative term
- 15. Profitability Index Profitability index is also known as benefit cost ratio The formula to calculate it is as follows PI or BCR = PVB/ I Where PVB = present value of benefits I = initial Investment When PI/BCR Rule is > 1 Accept = 1 Indifferent < 1 Reject
- 16. Example-1 Year Cashflow 1 25,000 2 40,000 3 40,000 4 50,000 XYZ Ltd. Is expecting the following cashflow from a project which requires an Investment of Rs.1,00,000, if the rate of interest applicable is 12% p.a
- 17. Solution BCR = PVB/I BCR = 25,000 + 40,000 + 40000 + 50,000 (1.12)1 (1.12)2 (1.12)3 (1.12)4 1,00,000 BCR = 1.145 Accept the project
- 18. Merits & Demerits of BCR Merits Considers time value of Money It is expressed in relative term and hence comparison of projects with different outlay can be done Demerits When the cash outlay occurs in other than the initial year it does not take it into consideration Aggregating several smaller projects is not possible because it does not have addition property
- 19. Internal Rate of Return Internal rate of return calculate the rate of return from the project The formula to calculate IRR is I = CF0 / (1+r)0 +CF1 / (1+r)1 +CF2 / (1+r)2 +………… CFn / (1+r)n I= 𝒏=𝟏 ∞ CFn / (1+r)n where I = Initial Investment CF= Cash flow from the project n= life of the project r= ? ( Internal Rate of Return)
- 20. Internal Rate of Return This is a trial and error method When IRR Rule > Rate of interest Accept = Rate of interest Indifferent < Rate of interest Reject
- 21. Example-2 PQR Ltd. Is expecting the following cashflow from a project which requires an Investment of Rs.1,00,000, if the rate of interest applicable is 12% p.a Year Cashflow 1 30,000 2 30,000 3 40,000 4 45,000
- 22. Solution I= 𝒏=𝟏 ∞ CFn / (1+r)n 1,00,000 = 30,000 + 30,000 + 40000 + 45,000 (1+r)1 (1+r )2 (1+r)3 (1+r)4 With r= 15%, Rs.100802 With r= 16%, Rs 98641 Hence IRR is between 15% and 16% With Linear Interpolation 15% + 100802-100000 = 15.37% 100802-98641
- 23. Merits & Demerits of IRR Merits It takes into consideration time value of money It take the cash flow of the project for its entire life Its highly relative since its in form of percentage so the changing rate of interest can be easily compared Demerits Its quite difficult to calculate It cannot distinguish between cash outflow and inflow ( table1) Smaller projects cannot be compared to larger projects It sometimes gives out more than 1 IRR which can be misleading (table-2)
- 24. Table 1 Year 0 Year1 IRR NPV (@10%) Project A (4000) 6000 50% 145 Project B 4000 (7000) 75% -236
- 25. Table 2 Year 0 Year 1 Year 2 (1,60,000) 10,00,000 (10,00,000) According to IRR Formula 1,60,000 = 10,00,000/(1+r)1 - 10,00,000/(1+r)2 Solving the equation we get 1,60,000r2 -6,80,000r + 1,60,000 = 0 Dividing the whole equation with 40,000 we get 4r2 – 17r + 4 = 0 Solving the equation we get r=0.25 and r=4 Hence the rate of both 25% and 400% stands correct for this equation When there is cash outflow in more than the initial year you will be getting more than 1 IRR which is misleading
- 26. Modified Internal Rate of Return (MIRR) The two major shortcomings of IRR namely difficulty to calculate and two IRR has lead to the formulation of MIRR which nullifies its shortcoming MIRR takes into consideration the rate of interest and calculate the return from a project MIRR is simple to calculate MIRR gives out single rate of return PVC = FV / (1+MIRR)n The formula to calculate MIRR is same as the formula to calculate present value
- 27. MIRR Formula Step 1: Calculate PV of all the cash outflow pertaining to the project Step 2: Calculate the FV of all the cash inflow pertaining to the project Step 3: Use the formula to find MIRR, PVC = FV / (1+MIRR)n When MIRR Rule > Rate of interest Accept = Rate of interest Indifferent < Rate of interest Reject
- 28. Example 3 Year 0 1 2 3 4 5 6 Cashflow (120) (80) 20 60 80 100 120 Pentagon Ltd is expecting the following cashflow from a project it is planning to undertake. You are required to calculate MIRR for the project if the rate of interest is 15% p.a. Suggest whether the company should go for the project or not
- 29. Solution Step 1: Calculate PV of all the cash outflow pertaining to the project PV = 120 + {80 /(1.15)} = 189.56 Step 2: Calculate the FV of all the cash inflow pertaining to the project FV= 20(1.15)4+ 60(1.15)3+80(1.15)2+100(1.15)1+120 = 467 Step 3: PVC = FV / (1+MIRR)n 189.56 = 467 / (1+MIRR)6 (1+MIRR)6 = 2.463 1+ MIRR = 1.1615 Hence MIRR= 16.2% Approx Since MIRR is greater than the prevailing interest rate of 15% in the market we will accept the project
- 30. Pay back Period The pay back period is the length of time required to recover the initial outlay on the project This method does not take into consideration time value of money This is simple to calculate According to this method, the shorter the pay back period the more desirable the project will be.
- 31. Example 4 Year Project A Project B 0 (1,00,000) (1,00,000) 1 50,000 20,000 2 30,000 20,000 3 20,000 20,000 4 10,000 40,000 5 10,000 50,000 6 10,000 60,000 Here the Project A has a pay back period of 3 yrs While Project B has a pay back period of 4 yrs, Hence according to pay back period method we will go for project A
- 32. Merits & Demerits of Pay Back Period Method Merits Easy to calculate It is a rough and ready method to deal with risk It is good method if the firm is looking for liquidity Demerits It does not take into consideration time value of money It does not take into consideration cash flow after the pay back period It’s a method of capital recovery and not profitability
- 33. Discounted Payback Method Example-5 To address the major flaw of payback period method that it does not consider time value of money , discounted pay back period method was introduced. Lets assume that the rate of interest is 10%
- 34. Solution Year Project A pvif Discounted value Cumulative 0 (1,00,000) (1,00,000) (1,00,000) 1 50,000 0.9091 45,455 (54,545) 2 30,000 0.8264 24,792 (29,753) 3 20,000 0.7513 15,026 (14,727) 4 10,000 0.6830 6830 (7897) 5 10,000 0.6209 6209 (1690) 6 10,000 0.5645 5645 3955 So here the discounted PBP is 5yrs + (1690/5645) months Hence the Discounted Pay back Period is 5.3 yrs approx.
- 35. Post Pay back Period Method Its very simple method where all the cashflow of the project is taken into consideration The formula to Calculate Post Payback period PPBP = Total Cash Flows – Initial Investment Project A PPBP = 1,30,000 – 1,00,000 = Rs 30,000 Project B PPBP = 2,10,000-1,00,000 = Rs. 1,10,000
- 36. Accounting Rate of Return The accounting rate of return also known as the average rate of return is calculated as = Av. Profit after tax Av. Book value of Investment Here the numerator is the average annual post tax profit over the life of investment The denominator is the average of book value of the investment in the project When ARR Rule > Rate of interest Accept = Rate of interest Indifferent < Rate of interest Reject
- 37. Example-6 Year Book Value of Invstment Profit After Tax 1 90,000 20,000 2 80,000 22,000 3 70,000 24,000 4 60,000 26,000 5 50,000 28,000
- 38. Solution ARR= Av. Profit after tax Av. Book value of Investment Step 1: Calculate Average PAT = 20,000+22,000+24,000+26,000+28000 = 24000 5 Step 2: Calculate Average BV of Investment = 90,000+80,000+70,000+60,000+50,000 =70,000 5 ARR= 24,000/70,000 = 0.3428 ARR= 34.28% Accept The Project
- 39. Merits & Demerits of ARR Merits It is simple to calculate It is based on accounting information which is readily available It takes into consideration benefits over the entire life of the project Demerits It is based on accounting profit and cash flow It does not take into consideration time value of money
- 40. Capital Budgeting techniques in Practice Over the time NPV and IRR are the most widely used techniques Firms typically use multiple evaluation methods ARR and PBP are widely used as a supplementary methods Weighted Average Cost of Capital (WACC) is widely used as the discount rate by the firms The most widely used discount rate is 15% Risk assessment and adjustment techniques have gained popularity and are adjusted by increasing the discount rate
- 41. Techniques in Practice Method % of Companies considering it Internal Rate of Return 85% Payback Period 67.5% Net Present Value 66.3% Breakeven Analysis 58.2% Profitability Index 35.1% According to a research conducted by researchers about the different techniques and importance given to those techniques by companies, the following was revealed
- 42. Question 1 Year Cashflow 0 (1,00,000) 1 20,000 2 30,000 3 40,000 4 50,000 5 30,000 The expected cash flow from a project is as follows. The cost of capital is 12% per annum. Calculate the following a) NPV b) BCR c) IRR d) MIRR e) Payback Period f)Discounted Payback period
- 43. Solution NPV- Rs. 19060 BCR= 1.19 IRR=18.69% MIRR=15.97% PBP= 3.2 YEARS DPBP- 3.9 YEARS
- 44. Question 2 What is the Internal rate of return for a project that involves an outlay of Rs.30,00,000 now which will result in an annual cashflow of Rs 6,00,000 for a period of 7 yrs?
- 45. Solution 2 IRR= 9% TO 10%
- 46. Question 3 Calculate the Internal rate of return of the project which has the following cash flow Year Cash flow 0 (3000) 1 9000 2 (3000)
- 47. Case Study -1 Alpha Ltd has been using a machine that needs an urgent overhauling, the company is also considering the option of outsourcing the production or purchasing a new smaller machine. Help the company take the most profitable decision. Calculate MIRR, PI and NPV if the rate of interest is 12%pa. Year Outsource the production Purchase a smaller machine Overhaul the current machine 0 (15000) (15000) (15000) 1 11000 3500 42000 2 7000 8000 (4000) 3 4800 13000 -
- 48. Case Study 2 ABC Ltd is considering two mutually exclusive projects with the following cash flow if the cost of capital is 12% Year Project P Project Q 0 (1000) (1600) 1 (1200) 200 2 (600) 400 3 (250) 600 4 2000 800 5 4000 100 Which Project should the company choose. Which technique will you use to find out the profitable project and why ?
- 49. Case Study- 3 Year Project A Project B Project C 0 (6000) (6000) (6000) 1 3000 1000 2000 2 2000 2000 2000 3 1000 3000 2000 4 4000 6000 5000 a)Which project will you choose according to payback period technique. b) Will you go for post payback period method or discounted payback period method if the rate of interest applicable is 12% and why ?

No public clipboards found for this slide

You just clipped your first slide!

Clipping is a handy way to collect important slides you want to go back to later. Now customize the name of a clipboard to store your clips.Hate ads?

Enjoy access to millions of presentations, documents, ebooks, audiobooks, magazines, and more **ad-free.**

The SlideShare family just got bigger. Enjoy access to millions of ebooks, audiobooks, magazines, and more from Scribd.

Cancel anytime.
Be the first to like this

Total views

3

On SlideShare

0

From Embeds

0

Number of Embeds

1

Unlimited Reading

Learn faster and smarter from top experts

Unlimited Downloading

Download to take your learnings offline and on the go

You also get free access to Scribd!

Instant access to millions of ebooks, audiobooks, magazines, podcasts and more.

Read and listen offline with any device.

Free access to premium services like Tuneln, Mubi and more.

We’ve updated our privacy policy so that we are compliant with changing global privacy regulations and to provide you with insight into the limited ways in which we use your data.

You can read the details below. By accepting, you agree to the updated privacy policy.

Thank you!

We've encountered a problem, please try again.