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Techniques of capital budgeting

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- 1. Capital Budgeting • What is Capital Budgeting – Three Major Decision – Investing – Financing – Dividend • In capital Budgeting we will focus on the Investing Decision
- 2. Capital Budgeting • So investment decisions are also called Capital Budgeting Decision • Why organization face this kind of decisions – New Investment( Expansion) – Replacement
- 3. Capital Budgeting • Why Capital Budgeting Decision are Important • Large amount of money • Irreversible • Long term • Affects the firms long term profitability and standing in the industry • We can say these decisions are – Strategic Decisions
- 4. Capital Budgeting • Why Capital Budgeting Decision are Important • Large amount of money • Irreversible • Invest now but returns will come in later years • Long term • Affects the firms long term profitability and standing in the industry • We can say these decisions are – Strategic Decisions
- 5. Capital Budgeting • Types of Investment Proposals • Independent Proposals – Expansion in two separate geogrophies • Mutually Exclusive – Boat or Bridge • Dependent – New machine for new plant
- 6. Capital Budgeting • Capital Budgeting Decision Techniques • Pay back period method • NPV ( Net Present Value) • PI ( Profitability Index) • NTV ( Net Terminal Value) • ARR ( Accounting Rate of Return)
- 7. Capital Budgeting • Pay back period method – Even Cash Flows – Un Even Cash Flows • Refers to the “Time period” in which the money invested will come back • Example – Initial Investment = Rs 20,000.Annual Cash inflow from the project is 5000.What is the Payback Period. – 4 years
- 8. Capital Budgeting • Pay back period method ( Un Even Cash Flows) • What is the payback period • 3 full year + .25 year = 3.25 years Year Cash Flow Cumulative Cash Inflow 0 -20000 1 6000 6000 2 8000 14000 3 5000 19000 4 4000 23000 5 4000 27000
- 9. Capital Budgeting • Accept/Reject Criterion ? • On what basis should one accept or reject the project – All depends on the management in case of single project – In case of choice, the one having shorter duration is accepted
- 10. Capital Budgeting • Pay back period method ( Un Even Cash Flows) • Which Machine will be selected based on PB method Machine A Machine B Initial Investment 9000 18000 Estimated Life 4 years 5 years Estimated saving in scrap 500 800 Estimated saving in wages 6000 8000 Additional Cost of maintenance 800 1000 Additional Cost of Supervision 1200 1800
- 11. Capital Budgeting • Pay back period method ( Un Even Cash Flows) • Which Machine will be selected based on PB method Machine A Machine B Estimated saving in scrap 500 800 Estimated saving in wages 6000 8000 Total Savings 6500 8800 Additional Cost of Supervision 1200 1800 Additional Cost of maintenance 800 1000 Total Cost 2000 2800 Net Cash Inflow 4500 6000 PB 9000/4500 = 2 18000/6000 = 3
- 12. Capital Budgeting • Merits of Payback Period – Easy to calculate – This method is useful where the uncertainty is high – This method makes it clear that no profit arises till the payback period is over
- 13. Capital Budgeting • Demerits of Payback Period – Ignores the returns generated after the payback period Project A ( -10,000) Project B( -10,000) 4000 3000 4000 3000 2000 3000 3000 3000 PB = 3 years PB = 3.33 years
- 14. Capital Budgeting • Demerits of Payback Period – Ignores the Time Value of Money – Which one is better? – A is better as the money is recovered faster in A Project A ( -30,000) Project B( -30,000) 10000 2000 10000 4000 10000 24000 PB = 3 years PB = 3 years
- 15. Capital Budgeting • Discounted Cash Flow Techniques – Considered to be the best method to evaluate the investment proposals – The cash inflows and out flows are calculated – These cash inflows and outflows are then discounted at an appropriate discount rate – The difference between the discounted cash inflow and discounted cash outflow is calculated
- 16. Capital Budgeting • How to calculate NPV = ∑discounted Cash inflows - ∑ discounted Cash Outflows .CF k1 CF NPV 0t t n 1t
- 17. Capital Budgeting • Accept/Reject Criterion – Single Project • NPV> 0 – Multiple Project • Accept the one with the maximum NPV
- 18. Example: Projects L and S Both projects require a return of 10%. Expected net cash flow Year Project L Project S 0 (RS100) (RS 100) 1 10 70 2 60 50 3 80 20 CAPITAL BUDGETING DECISION CRITERIA 2
- 19. What’s Project L’s NPV? 10 8060 0 1 2 3 10% Project L: -100.00 9.09 49.59 60.11 18.79 = NPVL NPVS = Rs 19.98. CAPITAL BUDGETING DECISION CRITERIA 2
- 20. Capital Budgeting • Example There are 3 mutually exclusive projects. All the three are expected to cost RS 2,50,000and have an estimated life if 5,4 and 3 years respectively. The company's required rate of return is 10%.The anticipated cash inflow after tax for the three plants are as follows .Which Plant should be accepted Year Plant I Plant II Plant III 1 80,000 1,10,000 1,30,000 2 60,000 90,000 1,10,000 3 60,000 85,000 20,000 4 60,000 35,000 - 5 1,80,000 - -
- 21. Capital Budgeting • Find out the Total PV of cash flows for all the three plants Year Plant I Plant II Plant III 1 80,000X.909 1,10,000 x .909 1,30,000 x.909 2 60,000x .826 90,000x .826 1,10,000x.826 3 60,000 x .751 85,000 x.751 20,000x.751 4 60,000 x .683 35,000x .683 - 5 1,80,000 x .621 - - Total PV 3,20,100 2,62,070 2,24,050 NPV 70,100 12070 25950
- 22. Capital Budgeting • A company ltd is considering the purchase of a new machine. Two alternative machines have been suggested, each having an initial cost of Rs 4,00,000 and requiring an additional working capital at the end of 1 year. Earnings after tax are expected to be as follows. The company has a required rate of return of 10%.Whihc machine would be bought. Use NPV method Year A B 1 40,000 1,20,000 2 1,20,000 1,60,000 3 1,60,000 2,00,000 4 2,40,000 1,20,000 5 1,60,000 80,000
- 23. Capital Budgeting 1. Find the Total PV of all the cash inflows for both the machines 2. Find the Total PV of all the cash outflows for both the machines 3. Subtract the 1 from 2 to get the NPV 4. One with the Greater NPV is selected Year A( PV of the cash inflows) B( PV of the cash inflows) 1 40,000X.91 1,20,000X.91 2 1,20,000X.826 1,60,000X.826 3 1,60,000 X.751 2,00,000X.751 4 2,40,000X.683 1,20,000X.683 5 1,60,000X.621 80,000X.621 5,18,920 5,23,080
- 24. Capital Budgeting 1. Find the Total PV of all the cash outflows for both the machines 2. Total Present value of the cash out flow = PV of the outflow at the beginning + the PV of the cash outflow in the future 3. = 4,00,000 + PV of the working capital expenditure after 1 year 4. = 4,00,000+ 0.909X20,000 = 4,18,200 5. NPV A = 5,18,400-4,18,200 = 1,00,200 6. NPV B = 5,23,200- 4,18,200 = 1,05,000
- 25. Capital Budgeting 1. Home Work XYZ company is considering replacement of its existing machine by a new machine which is expected to cost RS 1,60,000.The new machine will have a 5 years and will yield a cash revenue of Rs 2,50,000 and incur an annual cash expense of Rs 1,30,000.The estimated salvage value of the new machine is nil. The existing machine has a book value of Rs 40,000 and can be sold for Rs 20,00 today. It is good for the next 5 years and is estimated to generate a cash revenue of RS 2,00,000 and will incur annual expense of Rs 1,40,000.Its salvage value after 5 year is Nil. Corporate tax rate is 40%.Depriciation is25% on WDV method. The company’s opportunity cost is 20%.Ignore the taxes in the profit or loss on the sale of machine. Advise whether the company should replace the machine or not.
- 26. Capital Budgeting 1. Excess Present Value Index 2. A refinement over NPV method = PV of the future cash inflows X 100 PV of the future cash outflows • A good indicator in case when the investments of the projects are different • Example: Project A : PV of cash out flow= 1,00,000 PV of cash inflow = 1,20,000 NPV = 20,000 • Project B : PV of cash out flow= 15,000 PV of cash inflow = 20,000 NPV = 5000 Excess PV index A =1,20,000/1,00,000 = 120% Excess PV index B =20,000/15,000 = 150%
- 27. Capital Budgeting 1. Internal Rate of Return 2. It is that “ discount rate “ at which the net cash flows becomes zero 3. In other words the ∑discounted Cash inflows - ∑ discounted Cash Outflows =0 Which also means that discount rate at which NPV =0 • Interpretation – Why I am interested in finding IRR – For example for project A IRR = 10% and from another project B the IRR is 12% – This means that from project A I will get a return of 10% on my investment and from project B I will get a return of 12%. So which project should I invest in? – Accept Reject Criterion – A project with higher IRR is always accepted. But the decision will also depend upon your Cost of capital. – Some times a project with higher IRR may also get rejected if the cost of capital is Higher.
- 28. Capital Budgeting 1. How to calculate IRR ? IRR is the rate at which NPV is 0.
- 29. Capital Budgeting 1. How to calculate IRR ? 2. Two Methods 1. When cash inflows are equal 1. Approximation Method 2. When the cash flows are unequal 1. Hit and trial method 1. When cash inflows are equal Example: An equipment requires an initial investment of Rs 6,000.The annual cash inflow is estimated to be Rs 2000 for 5 years. Find the IRR?
- 30. 30 Single Sum - Future & Present Value 1 2 30 PV1 = 2000/(1+k/100) 2000 PV2 = 2000/(1+k/100)2 2000 PV3 = 2000/(1+k/100)3 200 • The inflows are equal each year for the next 5 years • Need to find K at which the diff, between PV of cash flows and PV of cash inflows is zero -6000
- 31. Capital Budgeting • Steps – Find factor F = I/C I = initial Investment C = cash inflows per year F = 6000/2000 = 3 • Go to PVIF Annuity table and locate the value 3( or near 3 in the 5th year row) • The nearest value is 2.99 at 20% • So IRR is 20%
- 32. Capital Budgeting • Case II when the Cash inflows are not equal Example : A company has an investment opportunity costing Rs 40,000 with the following expected net cash inflows. Year Cash inflow 1 7000 2 7000 3 7000 4 7000 5 7000 6 8000 7 10000 8 15000 9 10000 10 4000
- 33. Capital Budgeting • Steps – Find factor F = I/C I = initial Investment C = Average cash inflows per year F = 40,000/8200 F = 4.87 The possible IRR lies between 15% and 16% Find out the NPV at both the discount rates.
- 34. Capital Budgeting Ye ar Cash inflow DF(15%) DF(16%) DF(14%) 1 7000 .870 .862 .877 2 7000 .756 .743 .769 3 7000 .658 .641 .675 4 7000 .572 .552 .592 5 7000 .497 .476 .519 6 8000 .432 .410 .456 7 10000 .376 .354 .400 8 15000 .327 .305 .351 9 10000 .284 .263 .308 10 4000 .247 .227 .270
- 35. Capital Budgeting • NPV (at 15%) = 39420-40,000= -580 • NPV(at 16%) = 37851-40000 = -2149 • Since it is negative at both the rates I need to calculate at 14% • NPV at 14 % = 41097-40,000= 1097 • Thus IRR lies between 14% and 15% So we need the extrapolation formula IRR = 14% + 1097 X 1 = 14+0.65 = 14.65% 1097+ (580) Ignore the Sign
- 36. Capital Budgeting • Example: A company has to select one project out of the following 2.Which one of them will be selected. Year A B 0 -11000 -10000 1 6000 1000 2 2000 1000 3 1000 2000 4 5000 10000
- 37. Capital Budgeting • Steps – Find factor F = I/C I = initial Investment C = Average cash inflows per year F = 10,000/3500 F(A) = 3.14 ( IRR is around 10%) F(B) = 2.86 ( IRR around 15%) Find out the IRR of both the projects One with the higher IRR is selected.
- 38. Capital Budgeting • NTV( Net Terminal Value) • An improvement over NPV method • It is based on the assumption that the future cash inflows can be reinvested again at an appropriate interest rate. • Steps in Calculating NTV • Compound all the future cash inflows at appropriate compounding rate • Discount the compounded value calculate at an appropriate discount rate. • Subtract the discounted value from the cash outflow • Projects with positive NTV are accepted .
- 39. Capital Budgeting • NTV( Net Terminal Value) • Example: From the following data calculate the NTV of the project – Initial capital investment = Rs2,40,000 – Useful Economic Life of the project = 4years – Annual cash inflows ( at the end of the year) = Rs80,000 – Cost of capital( discount rate) = 10% – Reinvestment Rate = 8%
- 40. Capital Budgeting • Now discount the compounded value at discount rate of 10% • PVIF(10%, 4years) = 0.683 • Discounted Value = 0.683X 3,60,480 = 2,46,208 • NTV = 2,46,208-2,40,00 = Rs 6208 Year Cash Inflow Compounding Factor Compounded Value 1 80,000 1.260 100800 2 80,000 1.166 93280 3 80,000 1.080 86400 4 80,000 1 80000 Total 3,60,480
- 41. Capital Budgeting • Comparison between NPV and NTV • Both will give the same result if the Compounding rate and discounting rate are equal • But if they are different they give different results • For example: In the previous case NPV will come out to be = Rs 13,600 while NTV is 6208 • When Discount rate and Investment rate are equal at 10% • NTV will be 80,00X 4.641=3,71,280 X0.683 = 2,53,584-2,40,000= 13,584 • NPV will be 13,600 and thus both are almost equal
- 42. Capital Budgeting • ARR ( Accounting Rate of Return/Average Rate of Return) • According to this method the projects are judged in the basis of their relative profitabilty • The Profitability is calculated over the entire life of the project • The ARR is calculated by following methods – Annual Average Net Earnings X 100 Original Investments – Annual Average Net Earnings X 100 Average Investment – Increase in expected future annual net earnings Increase in the Investment X 100
- 43. Capital Budgeting • What is Annual Average Net Earnings ? – This is the average net earnings( after depreciation and tax) over the whole life of the project • Average Investment can be calculates by any of the following methods – Original Investment 2 – Original Investment – Scrap value of the asset 2 – Original Investment – Scrap value of the asset + Addl Working Capital + Scrap Value 2
- 44. Capital Budgeting • Example: The FM of company is considering the replacement of an old machine with a new machine .The old machine has been in operation for last 5 years.The tax rate is 50%.Which of the two alternatives will be considered based in ARR. Old Machine New Machine Purchase Price 40,000 60,000 LIfe 10 years 10 years M/C running Hours per annum 2000 2000 Units /Hour 24 35 Wages/Hr 3 5.25 Power /Year 2000 4500 Consumables/year 6000 7500 Other charges/annum 8000 9000 Material cost /unit 0.50 0.50 Selling Price/unit 1.25 1.25
- 45. Capital Budgeting Old Machine New Machine Sales 2000X24X1.25 =60,000 87500 Cost Material Cost 0.5X2000x 24= 24000 35000 Wages 6000 10,500 Power 2000 4500 Consumables 6000 7500 Other charges 8000 9000 Depreciation 40,000/10 = 4000 60,000/10 = 6000 PBT 10,000 15000 PAT 5000 7500
- 46. Capital Budgeting – Annual Average Net Earnings X 100 Original Investments = 5000/40,000 x 100 = 12.5 % New Mchine = 8250/60,000 X 100 = 13.75% – Annual Average Net Earnings X 100 Average Investment – OLD 5000/ 20,000 X 100 = 25% – New 8250/30,000 X 100 = 27.50% – Increase in expected future annual net earnings Increase in the Investment X 100 8250-5000 X 100 = 16.25% 20,000
- 47. Capital Budgeting • Home Work : Find ARR for the following two machines by all the three methods A B Purchase Price 56125 56125 Life 5 years 5 years Salvage Value 3000 3000 Tax rate 55% 55% Addition in Net Working Capital 5000 5000 Annual Income After Depr. And Tax 1 3375 11375 2 5375 9375 3 7375 7375 4 9375 5375 5 11375 3375
- 48. Capital Budgeting • Read Capital Rationing : Page C-56 to C-58 from Maheshwari.

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