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. 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. 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
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. Avg. Net Income 72,000
6
Avg. Investment 100,000
2
AROI 12,000
50,000
= 12,000
= 24%
= 50,000
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. 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. 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. 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. FV = PV (1 + r)n
Compounding:Finding FV
Discounting: Finding PV: PV = FV/(1 + r) n
Internal Rate of Return: Finding r
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. 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
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. 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. 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%
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. 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. 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. 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. 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. 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. 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. 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. 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. 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. 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.
