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Capital budgeting

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Capital budgeting

  1. 1. Capital Budgeting
  2. 2. JOIN KHALID AZIZ <ul><li>ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. </li></ul><ul><li>FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. </li></ul><ul><li>COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. </li></ul><ul><li>CONTACT: </li></ul><ul><li>0322-3385752 </li></ul><ul><li>0312-2302870 </li></ul><ul><li>0300-2540827 </li></ul><ul><li>R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. </li></ul>
  3. 3. <ul><li>The capital budgeting process involves three basic steps: </li></ul>The Capital Budgeting Decision Process <ul><ul><li>Generating long-term investment proposals; </li></ul></ul><ul><ul><li>Reviewing, analyzing, and selecting from the proposals that have been granted, and </li></ul></ul><ul><ul><li>Implementing and monitoring the proposals that have been selected. </li></ul></ul><ul><ul><li>Managers should separate investment and financing decisions. </li></ul></ul>
  4. 4. Capital Budgeting Decision Techniques <ul><ul><li>Payback period : most commonly used </li></ul></ul>Accounting rate of return (ARR): focuses on project’s impact on accounting profits Net present value (NPV): best technique theoretically; difficult to calculate realistically Internal rate of return (IRR): widely used with strong intuitive appeal Profitability index (PI): related to NPV
  5. 5. A Capital Budgeting Process Should: Account for the time value of money; Account for risk; Focus on cash flow; Rank competing projects appropriately, and Lead to investment decisions that maximize shareholders’ wealth.
  6. 6. Example: Global Wireless <ul><li>Global Wireless is a worldwide provider of wireless telephony devices. </li></ul><ul><li>Global Wireless is contemplating a major expansion of its wireless network in two different regions: </li></ul><ul><ul><li>Western Europe expansion </li></ul></ul><ul><ul><li>A smaller investment in Southeast U.S. to establish a toehold </li></ul></ul>
  7. 7. Global Wireless $175 Year 5 inflow $160 Year 4 inflow $130 Year 3 inflow $80 Year 2 inflow $35 Year 1 inflow -$250 Initial Outlay $32 Year 5 inflow $30 Year 4 inflow $25 Year 3 inflow $22 Year 2 inflow $18 Year 1 inflow -$50 Initial Outlay
  8. 8. Accounting Rate Of Return (ARR) Can be computed from available accounting data ARR uses accounting numbers, not cash flows; no time value of money. <ul><li>Need only profits after taxes and depreciation. </li></ul><ul><li>Average profits after taxes are estimated by subtracting average annual depreciation from the average annual operating cash inflows. </li></ul>Average profits after taxes Average annual operating cash inflows Average annual depreciation = –
  9. 9. <ul><li>The payback period is the amount of time required for the firm to recover its initial investment. </li></ul>Payback Period <ul><ul><li>If the project’s payback period is less than the maximum acceptable payback period, accept the project. </li></ul></ul><ul><ul><li>If the project’s payback period is greater than the maximum acceptable payback period, reject the project. </li></ul></ul>Management determines maximum acceptable payback period.
  10. 10. <ul><li>Management’s cutoff is 2.75 years. </li></ul><ul><li>Western Europe project: initial outflow of -$250M </li></ul><ul><ul><li>But cash inflows over first 3 years is only $245 million. </li></ul></ul><ul><ul><li>Global Wireless will reject the project (3>2.75). </li></ul></ul><ul><li>Southeast U.S. project: initial outflow of -$50M </li></ul><ul><ul><li>Cash inflows over first 2 years cumulate to $40 million. </li></ul></ul><ul><ul><li>Project recovers initial outflow after 2.40 years. </li></ul></ul><ul><ul><ul><li>Total inflow in year 3 is $25 million. So, the project generates $10 million in year 3 in 0.40 years ($10 million  $25 million). </li></ul></ul></ul><ul><ul><li>Global Wireless will accept the project (2.4<2.75). </li></ul></ul>Payback Analysis For Global Wireless
  11. 11. Pros and Cons of the Payback Method <ul><li>Advantages of payback method: </li></ul><ul><ul><li>Computational simplicity </li></ul></ul><ul><ul><li>Easy to understand </li></ul></ul><ul><ul><li>Focus on cash flow </li></ul></ul>Disadvantages of payback method: <ul><li>Does not account properly for time value of money </li></ul><ul><ul><li>Does not account properly for risk </li></ul></ul><ul><ul><li>Cutoff period is arbitrary </li></ul></ul><ul><ul><li>Does not lead to value-maximizing decisions </li></ul></ul>
  12. 12. <ul><li>Discounted payback accounts for time value. </li></ul><ul><ul><li>Apply discount rate to cash flows during payback period. </li></ul></ul><ul><ul><li>Still ignores cash flows after payback period. </li></ul></ul><ul><li>Global Wireless uses an 18% discount rate. </li></ul>Discounted Payback Reject (46.3<50) Reject (166.2 < 250)
  13. 13. Net Present Value (NPV) NPV: The sum of the present values of a project’s cash inflows and outflows. Discounting cash flows accounts for the time value of money. Choosing the appropriate discount rate accounts for risk. Accept projects if NPV > 0.
  14. 14. <ul><li>A key input in NPV analysis is the discount rate. </li></ul>Net Present Value (NPV) <ul><ul><li>r represents the minimum return that the project must earn to satisfy investors. </li></ul></ul><ul><ul><li>r varies with the risk of the firm and /or the risk of the project. </li></ul></ul>
  15. 15. <ul><li>Assuming Global Wireless uses 18% discount rate, NPVs are: </li></ul>NPV Analysis for Global Wireless Should Global Wireless invest in one project or both? Western Europe project: NPV = $75.3 million Southeast U.S. project: NPV = $25.7 million
  16. 16. The NPV Rule and Shareholder Wealth
  17. 17. Pros and Cons of NPV NPV is the “gold standard” of investment decision rules. <ul><li>Key benefits of using NPV as decision rule: </li></ul><ul><ul><li>Focuses on cash flows, not accounting earnings </li></ul></ul><ul><ul><li>Makes appropriate adjustment for time value of money </li></ul></ul><ul><ul><li>Can properly account for risk differences between projects </li></ul></ul>Though best measure, NPV has some drawbacks: <ul><ul><li>Lacks the intuitive appeal of payback, and </li></ul></ul><ul><ul><li>Doesn’t capture managerial flexibility (option value) well. </li></ul></ul>
  18. 18. Internal Rate of Return (IRR) IRR: the discount rate that results in a zero NPV for a project. The IRR decision rule for an investing project is : <ul><li>If IRR is greater than the cost of capital, accept the project . </li></ul><ul><li>If IRR is less than the cost of capital, reject the project . </li></ul>
  19. 19. NPV Profile and Shareholder Wealth
  20. 20. IRR Analysis for Global Wireless Global Wireless will accept all projects with at least 18% IRR. Western Europe project: IRR ( r WE ) = 27.8% Southeast U.S. project: IRR (r SE ) = 36.7%
  21. 21. JOIN KHALID AZIZ <ul><li>ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. </li></ul><ul><li>FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. </li></ul><ul><li>COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. </li></ul><ul><li>CONTACT: </li></ul><ul><li>0322-3385752 </li></ul><ul><li>0312-2302870 </li></ul><ul><li>0300-2540827 </li></ul><ul><li>R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. </li></ul>
  22. 22. Pros and Cons of IRR <ul><li>Advantages of IRR: </li></ul><ul><ul><li>Properly adjusts for time value of money </li></ul></ul><ul><ul><li>Uses cash flows rather than earnings </li></ul></ul><ul><ul><li>Accounts for all cash flows </li></ul></ul><ul><ul><li>Project IRR is a number with intuitive appeal </li></ul></ul>Disadvantages of IRR: <ul><ul><li>“ Mathematical problems”: multiple IRRs, no real solutions </li></ul></ul><ul><ul><li>Scale problem </li></ul></ul><ul><ul><li>Timing problem </li></ul></ul>
  23. 23. Multiple IRRs Which IRR do we use? When project cash flows have multiple sign changes, there can be multiple IRRs. IRR IRR
  24. 24. No Real Solution Sometimes projects do not have a real IRR solution . Modify Global Wireless’ s Western Europe project to include a large negative outflow ( -$ 355 million ) in year 6 . <ul><li>There is no real number that will make NPV=0, so no real IRR . </li></ul>Project is a bad idea based on NPV. At r =1 8 %, project has negative NPV, so reject!
  25. 25. Conflicts Between NPV and IRR: The Scale Problem NPV and IRR do not always agree when ranking competing projects. <ul><li>The Southeast U.S. project has a higher IRR, but doesn’t increase shareholders’ wealth as much as the Western Europe project. </li></ul>The scale problem: $25.7 mn 36.7% Southeast U.S. $75.3 mn 27.8% Western Europe NPV (18%) IRR Project
  26. 26. Conflicts Between NPV and IRR: The Scale Problem <ul><li>Why the conflict? </li></ul><ul><li>The scale of the Western Europe expansion is roughly five times that of the Southeast U.S. project. </li></ul><ul><li>Even though the Southeast U.S. investment provides a higher rate of return, the opportunity to make the much larger Western Europe investment is more attractive. </li></ul>
  27. 27. Conflicts Between NPV and IRR: The Timing Problem <ul><li>The product development proposal generates a higher NPV, whereas the marketing campaign proposal offers a higher IRR. </li></ul>
  28. 28. Conflicts Between NPV and IRR: The Timing Problem <ul><li>Because of the differences in the timing of the two projects’ cash flows, the NPV for the Product Development proposal at 10% exceeds the NPV for the Marketing Campaign. </li></ul>
  29. 29. Profitability Index Decision rule: Accept project with PI > 1.0, equal to NPV > 0 <ul><li>Both PI > 1.0, so both acceptable if independent. </li></ul>Calculated by dividing the PV of a project’s cash inflows by the PV of its initial cash outflows. Like IRR, PI suffers from the scale problem. 1.5 $50 million $75.7 million Southeast U.S. 1.3 $250 million $325.3 million Western Europe PI Initial Outlay PV of CF (yrs1-5) Project
  30. 30. <ul><li>Methods to generate, review, analyze, select, and implement long-term investment proposals: </li></ul><ul><li>Accounting rate of return </li></ul><ul><li>Payback Period </li></ul><ul><li>Discounted payback period </li></ul><ul><li>Net Present Value (NPV) </li></ul><ul><li>Internal rate of return (IRR) </li></ul><ul><li>Profitability index (PI) </li></ul>Capital Budgeting
  31. 31. JOIN KHALID AZIZ <ul><li>ECONOMICS OF ICMAP, ICAP, MA-ECONOMICS, B.COM. </li></ul><ul><li>FINANCIAL ACCOUNTING OF ICMAP STAGE 1,3,4 ICAP MODULE B, B.COM, BBA, MBA & PIPFA. </li></ul><ul><li>COST ACCOUNTING OF ICMAP STAGE 2,3 ICAP MODULE D, BBA, MBA & PIPFA. </li></ul><ul><li>CONTACT: </li></ul><ul><li>0322-3385752 </li></ul><ul><li>0312-2302870 </li></ul><ul><li>0300-2540827 </li></ul><ul><li>R-1173,ALNOOR SOCIETY, BLOCK 19,F.B.AREA, KARACHI, PAKISTAN. </li></ul>

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