Capital budgeting

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Capital budgeting

  1. 1. Capital BudgetingDecision Criteria
  2. 2. What is Capital Expenditure? Capital expenditure involves a current outlay of funds in the expectation of a stream of benefits extending far into future. Long-term decisions Involve large expenditures
  3. 3. Mutually exclusive vs.Independent projects• Mutually exclusive projects are those projects for which the selection of one requires the rejection of the others.• Independent projects are those for which the acceptance of one does not preclude the acceptance of the other projects.
  4. 4. Project Classifications Replacement  Maintenance of Business  Cost Reduction Expansion  Existing Products/Markets  New Products/Markets Research and Development Other  Safety/Environmental Projects
  5. 5. Capital budgeting: stages Identification of Potential Investment Opportunities  Capital budget proposal  Selection, Budget approval and Authorization  Project tracking  Post-completion audit
  6. 6. Capital budgeting: the basics • Estimate incremental cash flows associated with a project. • Evaluate the risk of the project. • Evaluate the cash flows by applying one or more of the capital budgeting techniques.
  7. 7. Example Year Project S Project L Assumptions 0 -1000 -1000 1 600 400  Equally Risky 2 300 400  They have same cost 3 300 500  They have same life 4 200 400
  8. 8. Capital Budgeting Techniques Payback Period Discounted payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Benefit Cost Ratio Accounting Rate of Return
  9. 9. Payback Period Expected number of years required to recover the original investment Decision Rules:  PP = payback period  MDPP = maximum desired payback period Independent Projects:  PP MDPP - Accept  PP > MDPP - Reject Mutually Exclusive Projects:  Select the project with the fastest payback, assuming PP MDPP.
  10. 10. Payback Period How long will it take for the project to generate enough cash to pay for itself?(500) 150 150 150 150 150 150 150 150 0 1 2 3 4 5 6 7 8
  11. 11. Payback Period How long will it take for the project to generate enough cash to pay for itself?(500) 150 150 150 150 150 150 150 150 0 1 2 3 4 5 6 7 8 Payback period = 3.33 years.
  12. 12. Payback Period 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.
  13. 13. Payback Period (Continued) Advantages:  Easy to calculate and understand  Provides an indication of a project’s liquidity Drawbacks:  Ignores time value of money  Ignores all cash flows received after the payback period
  14. 14. Consider this cash flow stream(500) 150 150 150 150 150 (400) 100 0 0 1 2 3 4 5 6 7 8
  15. 15. Drawbacks of Payback Period:Does not consider all of the project’s cash flows.(500) 150 150 150 150 150 (400) 100 0 0 1 2 3 4 5 6 7 8This project is clearly unprofitable, but we wouldaccept it based on a 4-year payback criterion!
  16. 16. Discounted Payback Period Expected Cash Flows are discounted Advantages:  Improves over regular payback period method by taking into account the time value of money. Drawbacks  Still ignores all cash flows received after the payback period
  17. 17. Discounted Payback Period: (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%)0 -500 -500.001 250 219.30
  18. 18. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%)0 -500 -500.001 250 219.30 1 year 280.70
  19. 19. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38
  20. 20. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32
  21. 21. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32 3 250 168.75
  22. 22. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%) 0 -500 -500.00 1 250 219.30 1 year 280.70 2 250 192.38 2 years 88.32 3 250 168.75 .52 years
  23. 23. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%) The Discounted0 -500 -500.00 Payback1 250 219.30 1 year is 2.52 years 280.702 250 192.38 2 years 88.323 250 168.75 .52 years
  24. 24. Problem Expected Net Cash Flow Year Project L Project S 0 (100) (100) 1 10 70 2 60 50 3 80 20 Discount rate : 10%
  25. 25. Payback Project L 0 1 2 2.4 3CFt -100 10 60 100 80Cumulative -100 -90 -30 0 50PaybackL = 2 + 30/80 = 2.375 years
  26. 26. Payback Project S 0 1 1.6 2 3CFt -100 70 100 50 20Cumulative -100 -30 0 20 40PaybackS = 1 + 30/50 = 1.6 years
  27. 27. Discounted Payback Project L 0 1 2 3 10% CFt -100 10 60 80 PVCFt -100 9.09 49.59 60.11 Cumulative -100 -90.91 -41.32 18.79 Discounted payback = 2 + 41.32/60.11 = 2.7 yrs
  28. 28. Discounted Payback Project S 0 1 2 3 10% CFt -100 70 50 20 PVCFt -100 63.64 41.32 15.02 Cumulative -100 -36.36 4.96 19.98 Discounted payback = 1 + 36.36/41.32 = 1.9 yrs
  29. 29. Net Present Value Find the present values of Cash Outflows and Cash Inflows and sum them up. If NPV is positive the project is worth taking on. N CF1 CFN CFtNPV CF0 1 ...... (1 k ) (1 k ) 2 t 0 (1 k ) t Theoretically the best method n CFt NPV t CF0 . t 1 1 k
  30. 30. Notice that NPV of the project depends on the project’scost of capitalThere is a cost of capital for which the NPV is zero (andnegative if cost is higher)
  31. 31. Net Present Value Rationale for NPV  NPV= PV inflows – Cost = Net gain in wealth.  For independent projects, accept project if NPV > 0.  For mutually exclusive projects, choose the one with the highest NPV are selected. This adds the most value to the firm.
  32. 32. Problem Expected Net Cash Flow Year Project L Project S 0 (100) (100) 1 10 70 2 60 50 3 80 20 Discount rate : 10%
  33. 33. Net Present Value Project L 0 1 2 3 10% -100.00 10 60 80 9.09 49.59 60.11 18.79 = NPVL
  34. 34. Net Present Value Project S 0 1 2 3 10% -100.00 70 50 20 63.64 41.32 15.03 19.99 = NPVS
  35. 35. Net Present Value  If Projects S and L are mutually exclusive, accept S because NPVS > NPVL .  If S & L are independent, accept both since both NPVs > 0.
  36. 36. Advantages & Disadvantages Takes time value of money. Consider all the cash flows occurring over the life time. Consistent with the objective of maximizing the shareholder’s wealth Difficult to calculate and understand. Dependent on discount rates.
  37. 37. Problem Suppose we are considering a capital investment that costs Rs. 276,400 and provides annual net cash flows of Rs. 83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%. 83,000 83,000 83,000 83,000 116,000(276,400) 0 1 2 3 4 5 NPV = 18,235.71
  38. 38. Internal Rate of Return (IRR) IRR is simply the rate of return that the firm earns on its capital budgeting projects. IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay.
  39. 39. Internal Rate of Return (IRR) n CFtNPV = - IO (1 + k) t t=1 n CFtIRR: t = IO (1 + IRR) t=1
  40. 40. IRR (Continued) 1. Guess a rate. n CFt 2. Calculate: t 1 (1 IRR ) t 3. If the calculation = CF0 you guessed right If the calculation > CF0 try a higher rate If the calculation < CF0 try a lower rate L+ PVBL - I * (U – L)Accurate IRR = PVBL - PVBU
  41. 41. Calculate the IRR in the following project-(10000) 2,000 3,000 4,000 5,000 0 1 2 3 4At i= 10%PV = 1818.2+2479.3+3005.2+3415.1 = 10717.8At i= 15%PV= 1739.1+2268.4+2630.1+2858.8 = 9496.4Using interpolation-IRR = 10 + 10717.8- 10000 x (15-10) = 12.94% 10717.8 – 9496.4
  42. 42. Calculating IRR 83,000 83,000 83,000 83,000 116,000(276,400) 0 1 2 3 4 5 IRR = 17.63%
  43. 43. Decision Rule: If IRR is greater than the cost of capital (also called the hurdle rate) accept the project. IRR is independent of cost of capital(k) Mutually Exclusive Projects  Accept the project with the highest IRR, assuming IRR > k.
  44. 44. Advantages & Disadvantages Takes time value of money. Consider all the cash flows occurring over the life time. Easier to understand. Consistent with the objective of maximizing the shareholder’s wealth Difficult to calculate
  45. 45. Problem Expected Net Cash Flow Year Project L Project S 0 (100) (100) 1 10 70 2 60 50 3 80 20 Discount rate : 10%. Find IRR
  46. 46. Project L 0 1 2 3 IRR = ?-100.00 10 60 80 PV1 PV2 PV3 0 = NPVEnter CFs in CFLO, then press IRR: IRRL = 18.13% IRRL = 18.13%.
  47. 47. Project S 0 1 2 3 IRR = ? -100.00 70 50 20 PV1 PV2 PV3 0 = NPV Enter CFs in CFLO, then press IRR: IRRL = 23.56% IRRS = 23.56%.
  48. 48. Problem Expected Net Cash Flow Year Project L Project S 0 (100) (100) 1 10 70 2 60 50 3 80 20 Discount rate : 10%. Draw NPV Profiles
  49. 49. NPV versus IRR NPV k NPV L NPV S 60 0 50 40 50 5 33 29 40 L Crossover 10 19 20 Point = 8.7% 15 7 12 30 (4) 5 20 S 20 S 10 IRR S = 23.6% L 0 Discount Rate (%) 0 5 10 15 20 23.6 -10 IRR L = 18.1%
  50. 50. NPV versus IRR Independent Projects  NPV and IRR will always result in the same accept/reject decision
  51. 51. NPV versus IRR Mutually Exclusive Projects having substantially different outlays Cash Flows IRR% NPV 0 1 k= 12% P Rs(10000) 20000 Q Rs(50000) 75000
  52. 52. NPV versus IRR 1. Mutually Exclusive Projects having substantially different outlays Cash Flows IRR% NPV 0 1 k= 12% P Rs(10000) 20000 100 7857 Q Rs(50000) 75000 50 16964•Both are acceptable, but Q contributes more to thewealth•IRR unsuitable for ranking projects of differentscales
  53. 53. Drawbacks of IRR+ +)2. If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. + + - + +) 1 2 3(500) 200 100 (200) 400 300 0 1 2 3 4 5 We could find 3 different IRRs
  54. 54. Multiple IRRs 0 1 2 k = 10% -800 5,000 -5,000  NPV = -386.78  IRR = ERROR. Why?
  55. 55. Multiple IRRs NPV NPV Profile IRR2 = 400% 450 0 k 100 400 IRR1 = 25% -800
  56. 56. Multiple IRRs 0 1 2 k = 10% -800 5,000 -5,000 Logic of Multiple IRRs  At very low discount rates, the PV of CF2 is large & negative, so NPV < 0.  At very high discount rates, the PV of both CF1 and CF2 are low, so CF0 dominates and again NPV < 0.  In between, the discount rate hits CF2 harder than CF1, so NPV > 0.  Result: 2 IRRs.
  57. 57. NPV versus IRR3. IRR cannot distinguish between lending and borrowing. Cash Flows 0 1 A Rs.(400) 600 B Rs. 400 (700) IRR : A = 50% B = 75% NPV: A = +VE B = -VE
  58. 58. A company is considering the purchase of a deliveryvan and is evaluating the following two choices:(a) The company can buy a used van for Rs 20,000,after 4 years sell the same for Rs 2,500 and replace itwith another used van which is expected to cost Rs30,000 and last 6 years with no terminating value.(b) The company can buy a new van for Rs 40,000.the projected life of the van is 10 years and has anexpected salvage value of Rs 5,000 at the end of tenyears.The services provided by the vans under both choicesare the same. Assuming the cost of capital 10 percent,which choice is preferable?

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