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Capital budgeting

Advanced financial management

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Investment decisions
 Capital budgeting decisions
 Evaluation criteria DCF –NPV-IRR
 Reinvestment assumption
 Modified IRR
 Investment decision under inflation
 Complex investment decisions
 Investment decisions under capital rationing
 Is the process of making investment
decisions in capital expenditures
 A capital expenditure may be defined as an
expenditure the benefits of which are
expected to be received over a period of time
exceeding one year.
 The main characteristic of capital
expenditure is that expenditure is incurred at
one point of time where as benefits of
expenditure are realized at different points
of time in future.
 Cost of acquisition of permanent assets
land & buildings, Plant & machinery,
goodwill etc
 Cost of addition, expansion, improvement
or alteration in the fixed assets
 Cost of replacement of permanent assets
 Research and development project cost
 According to CharlesT.Horngreen “ capital
budgeting is long term planning for making
finance proposed capital outlays”.
 Large investments
 Long – term commitment of funds
 Irreversible in nature
 Long – term effect on profitability
 Difficulties of investment decisions
 National importance

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Capital budgeting

  • 2.  Capital budgeting decisions  Evaluation criteria DCF –NPV-IRR  Reinvestment assumption  Modified IRR  Investment decision under inflation  Complex investment decisions  Investment decisions under capital rationing
  • 3.  Is the process of making investment decisions in capital expenditures  A capital expenditure may be defined as an expenditure the benefits of which are expected to be received over a period of time exceeding one year.  The main characteristic of capital expenditure is that expenditure is incurred at one point of time where as benefits of expenditure are realized at different points of time in future.
  • 4.  Cost of acquisition of permanent assets land & buildings, Plant & machinery, goodwill etc  Cost of addition, expansion, improvement or alteration in the fixed assets  Cost of replacement of permanent assets  Research and development project cost
  • 5.  According to CharlesT.Horngreen “ capital budgeting is long term planning for making finance proposed capital outlays”.
  • 6.  Large investments  Long – term commitment of funds  Irreversible in nature  Long – term effect on profitability  Difficulties of investment decisions  National importance
  • 7.  Identification of investment proposals  Screening the proposals  Evaluation of various proposals  Fixing priorities  Final approval and preparation of capital expenditure budget  Implementing proposal  Performance review
  • 8.  Accept or reject decisions  Mutually Exclusive project decisions  Capital rationing decisions
  • 9.  Traditional or Non-discounted methods  (i) Pay back period  (ii) Accounting rate of return  Modern or Discounted Cash flow  (i) Net present value  (ii) Internal rate of return  (iii) Profitability index
  • 10.  A project costs Rs.1,00,000 and yields an annual cash inflow of Rs.20,000 for 8 years. Calculate its payback.  Pay back period = Initial investment / Annual cash flows  1,00,000/20,000 = 5 years
  • 11.  Accept less than cut off point or standard point  Reject if the pay back period is greater than cut off point or standard point
  • 12.  XYZ ltd is considering two projects. Each projects requires an investment of Rs.10,000. The firm’s cost of capital is 10%. The net cash inflows from investments in two projects X and Y are as follows:  The company has fixed 3 years PBP as cut off point. State which project should be accepted?
  • 13. Years Cash flows Cumulative cash flows 1 5,000 5,000 2 4,000 9,000 3 3,000 12,000 4 1,000 5 - Years 1 2 3 4 5 X 5,000 4,000 3,000 1,000 - Y 1,000 2,000 3,000 4,000 5,000
  • 14.  2+ 10,000 – 9,000 / 3,000 = 2+ 0.33  2.33 years
  • 15.  This method takes into consideration the time value of money and attempts to calculate the return on investments by introducing the factor of time element.  The net present values of all inflows and outflows of cash occurring during the during the entire life of the project is determined separately for each year by discounting these flows cost of capital or pre-determined rate.
  • 16.  Accept when it is positive  Reject when it is negative
  • 17.  NPV = Present value of cash inflows – Present value of cash outflows  No project is acceptable unless the yield is 10%. Cash inflows of a certain project along with cash outflows are given below:  The salvage value at the end of 5th year is 40,000. Calculate NPV Years 0 1 2 3 4 5 Cash flow 1,50,000 30,000 - - - - Cash flow - 20,000 30,000 60,000 80,000 30,000
  • 18.  Calculation of present value of cash outflows Years Cash flow PV factor @ 10% Pv of cash flow 0 1,50,000 1 1,50,000 1 30,000 0.909 27,270 Total 1,77,270
  • 19. Years Cash flow PV factor @ 10% Pv of cash inflows 1 20,000 0.909 18,180 2 30,000 0.826 24,780 3 60,000 0.751 45,060 4 80,000 0.683 54,640 5 30,000 0.621 18,630 5 40,000(scrap value) 0.621 24,840 Total 1,86,130
  • 20. NPV = 1,86,130 – 1,77,270 = 8,860 2. From the following information calculate the net present value of the two projects and suggest which of the two projects should be accepted assuming a discount rate of 10%.
  • 21.  The profits before depreciation and after taxes (cash flows) are as follows: Particulars year1 year2 year3 year4 year5 Project X 5,000 10,000 10,000 3,000 2,000 ProjectY 20,000 10,000 5,000 3,000 2,000
  • 22. Particulars Project X ProjectY Initial investment 20,000 30,000 Estimated life 5 years 5 years Scrap value 1,000 2,000
  • 23.  It is e net present valuknown as time adjusted rate of return, discounted cash flow, yield method. The cash flows of a project are discounted at a suitable rate by trial and error method.  It equates the net present value so calculated to the amount of the investment.  Since the discount rate is determined internally, this method is called as internal rate of return
  • 24.  Initial outlay / Annual cash flow  Problem:  Initial outlay : 50,000  Life of the asset : 5 years  Estimated annual cash flow: 12,500  Calculate the internal rate of return.  50,000/12,500 = 4  Decision rule :  Accept if the IRR is greater than cost of capital  Reject if the IRR is lesser than cost of capital
  • 25.  Initial investment : 60,000  Life of the asset : 4 years  Estimated net annual cash flows:  1 year : 15,000  2 year : 20,000  3 year : 30,000  4 year : 20,000  Calculate internal rate of return
  • 26. Years Cash flows Discount rate @ 14% PV cashflows 1 15,000 0.877 13,155 2 20,000 0.769 15,380 3 30,000 0.674 20,220 4 20,000 0.592 11,840 Total 60,595
  • 27. Years Cash flows Discount rate @ 15% PV cashflows 1 15,000 0.869 13,035 2 20,000 0.756 15,120 3 30,000 0.657 19,710 4 20,000 0.571 11,420 TOTAL 59,285
  • 28.  IRR = LDR + (Initial investment – cash flows of lower discount rate /( Initial investment – cash flows of lower discount rate +Initial investment -cash flows of higher discount rate ) * (HDR –LDR)  14%+ 595/595+715 * (15%-14%) = 14.45%
  • 29.  It is also called as Benefit cost ratio, it is the relationship between present value of cash inflows and the present value of cash outflows.  PI = PV of cash inflows/ PV of Outflows  Decision rule:  Accept when it is greater than 1  Reject if it is lesser than 1
  • 30.  Differences between the NPV and IRR  The net present value method and the Internal rate of return method are similar in the sense that both are modern techniques of capital budgeting and both take into account the time value of money.  There are certain basic differences between these two methods of capital budgeting.
  • 31.  Conflicting ranking: is conflict in ranking of a given project by NPV or IRR resulting from differences in magnitude or timing of cash flows.  Differences in ranking by the these two methods will arise in case of mutually exclusive projects.  The differences can be illustrated under the following heads:
  • 32.  Size disparity problem  Time disparity problem  Unequal expected lives  Size disparity problem:This arises when the initial investment in projects under consideration that is mutually exclusive projects is different.The cash outlay of some projects is larger than that of others. In such a situation the NPV and IRR will give a different ranking.
  • 33.  A and B are mutually exclusive investments involving different outlays:  Particulars Project A Project B Project B-A Cash outtlays (5,000) (7,500) (2,500) Cash inflows at the end of year 1 6,250 9,150 2,900 IRR% 25 22 16 Cost of capital 10 NPV 681.25 817.35
  • 34.  The mutually exclusive proposals may differ on the basis of the pattern of cash flows generated, although their initial investment may be the same.This may be called the time disparity problem.  It may be the conflict arising because of conflict in ranking of proposals by NPV and IRR which have different cash flow patterns. In such cases NPV method would give superior results than IRR.
  • 35.  Another situation in which the IRR and the NPV methods would give conflicting ranking to mutually exclusive projects is when the projects have different expected lives.  The conflict in the ranking by the two methods in such cases may be resolved by adopting a modified procedure.  There are two approaches to do this(i) Common time horizon (ii) equivalent annual value or cost
  • 36.  Common time horizon:This approach makes a comparison between projects that extends over multiples of the each.  Equivalent annual value: Evaluates unequal lived projects that converts the net present value of unequal lived mutually exclusive projects into an equivalent (in NPV terms) annual amount.
  • 37.  The conflict between these two methods is mainly due to different assumptions with regard to reinvestment rate on funds released from the proposal.  The assumption underlying the IRR method seems to be incorrect and deficient.  The IRR method implicitly assumes that the cash flows generated by the projects will be reinvested at the internal rate of return I,e the same rate as the proposal itself offers.
  • 38.  With the NPV method the assumption is that funds released can be reinvested at the rate equal to the cost of capital I,e required rate of return.  The assumption of the NPV method is considered to be theoretically superior because it has the virtue of having a rate which is consistently be applied to all investment proposals.
  • 39.  In contrast to NPV method,The IRR method assumes a high reinvestment rate of investment proposals having a high IRR and a low investment proposals having a low IRR.  The implicit reinvestment rate will differ depending upon the cash flow stream for each investment proposal.  It is the rate at which interim cash flows can be invested.
  • 40.  Both NPV and IRR will show similar results in the following cases:  (i) Independent investment proposals which do not compete with one another and which may be either accepted or rejected on the basis of a minimum required rate of return.  (ii) Conventional investment proposals which involve cash outflows or outlays in the initial period followed by a series of cash inflows.
  • 41.  The reason why they provide similar results is on the basis of decision making.  Under NPV method proposal is accepted with NPV positive, where as under IRR method it is accepted if the internal rate of return is higher than the cut off rate.  The projects which have positive NPV will have internal rate of return higher than the required rate of return.