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# 2. capital budgeting review

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### 2. capital budgeting review

1. 1. Capital Budgeting By Sudarshan Kadariya IBM
2. 2. The Position of Capital Budgeting Capital Budgeting LongTerm Assets ShortTermAssets Investment Decison Debt/EquityMix Financing Decision Dividend Payout Ratio Dividend Decision Financial Goal oftheFirm: WealthMaximisation
3. 3. 1. Average Rate of Return 2. Payback Period 3. Discounted Payback Period 4. Net Present Value 5. Internal Rate of Return 6. Modified IRR 7. Profitability index
4. 4. Non-discounted Cash Flow Methods Discounted Cash Flow Methods i) ARR: Calculate & compare with cutoff rate /required rate of return/hurdle rate (Decision rule: if ARR>Cutoff = Accept, otherwise reject ) i) DPBP: Same except cash flow are discounted by project’s COC ii) PBP: Years to recover initial investment. Shorter the PBP, the better. ii) NPV: Find the discounted net cash flow of the project at 0 year. Higher NPV, the better iii) IRR: The discount rate that yield zero NPV. If IRR>hurdle rate = accept the project iv) MIRR: When the case of non-normal cash flow. Discount rate that equates PV of costs and PV of terminal value v) PI: Also known as benefit-cost ratio, PV of benefits/PV of costs. Acceptable of PI>1
5. 5. ARR = Avg. Net Income Per Year Avg. Investment
6. 6. Example: Year Net Income Cost 1 6,000 100,000 Initial 2 8,000 0 Salvage Value 3 11,000 4 13,000 5 16,000 6 18,000
7. 7. Avg. Net Income 72,000 6 Avg. Investment 100,000 2 AROI 12,000 50,000 = 12,000 = 24% = 50,000
8. 8.  Advantages ◦ Simplicity ◦ Use the readily available accounting information  Disadvantages ◦ It is based on accounting information rather than cash flows ◦ Fails to take account of the timing of the cash inflows and outflows ◦ Time value of money is ignored
9. 9. Years required to recover the original investment Example: Year Net Income Cash Flow Cumulative CF 1 6,000 26,000 26,000 2 8,000 28,000 54,000 3 11,000 31,000 85,000 4 13,000 33,000 118,000 5 16,000 36,000 154,000 6 18,000 18,000 172,000 Payback = 3 + 100,000 - 85,000 118,000 - 85,000 = 3.45 Years
10. 10.  The amount of time needed to recover the initial investment  The number of years it takes including a fraction of the year to recover initial investment is called payback period  To compute payback period, keep adding the cash flows till the sum equals initial investment  Simplicity is the main benefit, but suffers from drawbacks  Technique is not consistent with wealth maximization—Why? (lack of reinvestment)
11. 11.  Advantages ◦ Simplicity in use and a popular method  Disadvantages ◦ Fails to consider cash flows after the payback period ◦ It provides limited insight into risk and liquidity ◦ Ignore time value of money and cost of capital (curved by DPBP) ◦ Ignore the risk of the project while evaluation
12. 12. FV = PV (1 + r)n Compounding:Finding FV Discounting: Finding PV: PV = FV/(1 + r) n Internal Rate of Return: Finding r
13. 13.  Similar to payback period approach with one difference that it considers time value of money  The amount of time needed to recover initial investment given the present value of cash inflows  Keep adding the discounted cash flows till the sum equals initial investment  All other drawbacks of the payback period remains in this approach  Not consistent with wealth maximization
14. 14. NPV = Present Value of All Future Cash Flows less Inital Cost = CF1 + CF2 + CF3 +.......CFn - Io 1+r (1+r)2 (1+r)3 (1+r)n
15. 15. Year CF Disc. Factor PV 0 -100000 1 -100000 1 26000 1/1.1 = .9091 23637 2 28000 1/(1.1)2 = .8264 23139 3 31000 1/(1.1)3 = .7573 23290 4 33000 1/(1.1)4 = .6830 22539 5 36000 1/(1.1)5 = .6209 22352 6 18000 1/(1.1)6 = .5645 10161 NPV = 25121
16. 16.  Based on the amount of cash flows  NPV equals the present value of cash inflows minus initial investment  Technique is consistent with the principle of wealth maximization—Why?  Accept a project if NPV ≥ 0
17. 17.  Advantages ◦ Consider time value of money ◦ Maximize shareholders wealth (reinvestment) ◦ Use all cash flow during the project life ◦ Based on estimated cash flow rather than accounting information of the project  Disadvantages ◦ The estimation of cash flows is difficult due to uncertainty ◦ Difficult to determine the appropriate discount rate ◦ In case of projects with unequal life, proper consideration has to be given while applying NPV rules
18. 18. Discount rate that makes NPV Zero (i.e., that equates PV of benefits with the cost). IRR: Io = CF1 + CF2 + ..... + CFn 1+r (1+r)2 (1+r)n Solve for r. Example: 100,000 = 26000 + 28000 + 31000 + ... +18000 1+r (1+r)2 (1+r)3 (1+r)6 r = 18.2%
19. 19. )(0 LH HL L L RRx PVPV CFPV RIRR    
20. 20.  Advantages ◦ Consider time value of money ◦ Maximize shareholders wealth (reinvestment) ◦ Use all cash flow during the project life ◦ Based on estimated cash flow rather than accounting information of the project ◦ Easy to understand  Disadvantages ◦ IRR has problem when non-normal cash flow, multiple IRR arise ◦ The estimation of cash flows is difficult due to uncertainty ◦ In case of mutually exclusive projects (that does not occur at the same time) IRR may give the conflicting results because of its assumption.
21. 21.  The rate at which the net present value of cash flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment  Project’s promised rate of return given initial investment and cash flows  Consistent with wealth maximization  Accept a project if IRR ≥ Cost of Capital
22. 22. n CIF O MIRR TV PV )1(    MIRR is the discount rate at which present value of project’s cost is equal to the present value of its terminal value  Cross over rate is that discount rate where NPVs of two projects are equal  NPV profile is a graph that plots a project’s NPV against the COC rates
23. 23.  Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project  IRR can be in conflict with NPV if ◦ Investing or Financing Decisions ◦ Projects are mutually exclusive  Projects differ in scale of investment  Cash flow patterns of projects is different ◦ If cash flows alternate in sign—problem of multiple IRR  If IRR and NPV conflict, use NPV approach
24. 24. PI = PV of all Benefits PV of all Cost Example: PV (Benefits) = 26000 + 28000 +..+18000 1.1 (1.1)2 (1.1)6 = 125121 PV (Cost) = 100000 PI = 125121 = 1.25 100000
25. 25. NPV = CF1 + CF2 +.............. + CFn - Io l+r (l+r)2 (l+r)n Cash Flows Incremental After Tax Net Working Capital Estimating cash flow is more qualitative approach and base on the knowledge of the projects and the capability of the management
26. 26. 1. Initial Costs: New cost of assets Additional WC requirement Sale of Old Assets 2. Annual Costs: Revenue Less Costs After Tax 3. Terminal Cash Flows: Salvage Value Recovery of NWC
27. 27. Sale of Existing Plant CF= Selling Price + T (B.V. - S.P.) Annual Cash Flows OCF= (Sales-Cost)(1-T) + T, DEPREC or OCF= Net Inc + Depreciation
28. 28. Evaluating Capital Projects 1) Focus on Cash Flow, Not Profits. – Cash Flow = Economic Reality. – Profits can be managed/manipulated. 2) Carefully Estimate Expected Future Cash Flows. 3) Select a Discount Rate Consistent with the Risk of Those Future Cash Flows. 4) Account for the Time Value of Money. 5) Compute NPV
29. 29. 6) Net Present Value = Value Created or Destroyed by the Project. NPV is the amount by which the value of the firm will change if you undertake the project. 7)Identify Risks and Uncertainties. Run a Sensitivity Analysis. 8) Identify Qualitative Issues. – Flexibility, Quality, Know-How, Learning, etc 9) Decide
30. 30. Which technique is superior?  Although our decision should be based on NPV, but each technique contributes in its own way.  Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is.  IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the project’s estimated cash flows.  PI is a measure of cost-benefit analysis. How much NPV for every rupee of initial investment.
31. 31. Thank you.