The document discusses various capital budgeting techniques used to evaluate long-term investment projects, including payback period, net present value (NPV), internal rate of return (IRR), and profitability index (PI). It provides examples of how to calculate each metric and the decision rules for whether to accept or reject a project based on the results. Modified IRR is also introduced as an alternative to standard IRR. Finally, the importance of ethics in capital budgeting decisions is highlighted.
risk and return. Defining Return, Return Example, Defining Risk,Determining Expected Return , How to Determine the Expected Return and Standard Deviation, Determining Standard Deviation (Risk Measure), Portfolio Risk and Expected Return Example, Determining Portfolio Expected Return, Determining Portfolio Standard Deviation, Summary of the Portfolio Return and Risk Calculation, Total Risk = Systematic Risk + Unsystematic Risk,
risk and return. Defining Return, Return Example, Defining Risk,Determining Expected Return , How to Determine the Expected Return and Standard Deviation, Determining Standard Deviation (Risk Measure), Portfolio Risk and Expected Return Example, Determining Portfolio Expected Return, Determining Portfolio Standard Deviation, Summary of the Portfolio Return and Risk Calculation, Total Risk = Systematic Risk + Unsystematic Risk,
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
time value of money
,
concept of time value of money
,
significance of time value of money
,
present value vs future value
,
solve for the present value
,
simple vs compound interest rate
,
nominal vs effective annual interest rates
,
future value of a lump sum
,
solve for the future value
,
present value of a lump sum
,
types of annuity
,
future value of an annuity
| Capital Budgeting | CB | Payback Period | PBP | Accounting Rate of Return |...Ahmad Hassan
After studying this, you should be able to:
• Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability.
• Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and accounting rate of return (ARR).
• Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. l Define, construct, and interpret a graph called an “NPV profile.”
• Understand why ranking project proposals on the basis of the IRR, NPV, and ARR methods “may” lead to conflicts in rankings.
• Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or ARR rankings.
• Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis.
• Explain the role and process of project monitoring, including “progress reviews” and “postcompletion audits.”
The difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of an investment or project.
Capital Budgeting is about how one should evaluate the financing options based on the superior financial performance through mathematical techniques. These techniques have been discussed in the presentation in detail.
time value of money
,
concept of time value of money
,
significance of time value of money
,
present value vs future value
,
solve for the present value
,
simple vs compound interest rate
,
nominal vs effective annual interest rates
,
future value of a lump sum
,
solve for the future value
,
present value of a lump sum
,
types of annuity
,
future value of an annuity
| Capital Budgeting | CB | Payback Period | PBP | Accounting Rate of Return |...Ahmad Hassan
After studying this, you should be able to:
• Understand the payback period (PBP) method of project evaluation and selection, including its: (a) calculation; (b) acceptance criterion; (c) advantages and disadvantages; and (d) focus on liquidity rather than profitability.
• Understand the three major discounted cash flow (DCF) methods of project evaluation and selection – internal rate of return (IRR), net present value (NPV), and accounting rate of return (ARR).
• Explain the calculation, acceptance criterion, and advantages (over the PBP method) for each of the three major DCF methods. l Define, construct, and interpret a graph called an “NPV profile.”
• Understand why ranking project proposals on the basis of the IRR, NPV, and ARR methods “may” lead to conflicts in rankings.
• Describe the situations where ranking projects may be necessary and justify when to use either IRR, NPV, or ARR rankings.
• Understand how “sensitivity analysis” allows us to challenge the single-point input estimates used in traditional capital budgeting analysis.
• Explain the role and process of project monitoring, including “progress reviews” and “postcompletion audits.”
Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices.
The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.
The firm’s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.
Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions.
Investment Decision — Capital Budgeting Techniques — Pay Back Method — Accounting Rate Of Return — NPV — IRR — Discounted Pay Back Method — Capital Rationing — Risk Adjusted Techniques Of Capital Budgeting. — Capital Budgeting Practices
It is the process of considering alternative capital projects and selecting those alternatives that provide the most profitable return on available funds.
Examples of capital projects include land, buildings, equipment and other major fixed asset items.
Snam 2023-27 Industrial Plan - Financial Presentation
Chapter 9: CAPITAL BUDGETING
1.
2. Capital budgeting – is the process of planning
for purchases of long – term assets.
Capital Budgeting
Decision Criteria
The Payback Period
Net Present Value
Profitability Index
Internal Rate of Return
3.
4. The number of years needed to recover the
initial cash outlay.
How long will it take for the project to
generate enough cash to pay for itself?
RULE:
If payback is ≤ maximum acceptable payback period, ACCEPT
If payback is > maximum acceptable payback period, REJECT
= Initial InvestmentPayback Period
Average Annual Cash Inflow
It is calculated as:
5. Alaskan Lumber is considering the
purchase of a band saw that costs
$50,000 and which will generate
$10,000 per year of net cash flow.
Alaskan is also considering the
purchase of a conveyor system for
$36,000, which will reduce saw mill
transport costs by $12,000 per year. If
Alaskan only has sufficient funds to
invest in one of these projects, and if it
were only using the payback method as
the basis for its investment decision, it
would buy the conveyor system, since it
has a shorter payback period.
EXAMPLE 1:
= Initial InvestmentPayback Period
Average Annual Cash Inflow
(for band saw)
A
= $50,000/$10,000
= 5.0 years, payback
period for this
capital investment.
(for conveyor system)
B
= $36,000/$12,000
= 3.0 years, , payback
period for this capital
investment.
6. Year Cash Flow
0 -1000
1 500
2 400
3 200
4 200
5 100
The calculation of
the Payback Period
is best illustrated
with an example.
Consider Capital
Budgeting project
A which yields the
following cash
flows over its five
year life.
EXAMPLE 2:
7. Year Cash Flow Net Cash Flow
0 -1000 -1000
1 500 -500
2 400 -100
3 200 100
4 200 300
5 100 400
To begin the calculation of the Payback
Period for project A let's add an additional column
to the above table which represents the Net Cash
Flow (NCF) for the project in each year.
8. Notice that after two years the Net Cash
Flow is negative (-1000 + 500 + 400 = -100)
while after three years the Net Cash Flow is
positive (-1000 + 500 + 400 + 200 = 100). Thus
the Payback Period, or breakeven point,
occurs sometime during the third year. If we
assume that the cash flows occur regularly
over the course of the year, the Payback
Period can be computed using the following
equation:
Payback Period = 2 + (100)/(200) = 2.5 yearsrs
9. ADVANTAGES
Uses Free Cash Flows
Is Easy To Calculate And Understand
May Be Use As Rough Screening Device
DISADVANTAGES
Ignores The Time Value Of Money
Ignores Free Cash Flows Occurring After The
Payback Period
Selection Of The Maximum Acceptable Payback
Period Is Arbitrary
10.
11. It determines how long it takes an
investment to recover its costs.
It’s similar to a simple payback, but a
discounted payback period accounts for
money’s time value.
It’s more precise estimate of when
investors will recover their total
investment.
12.
13. Table 10-2 shows the difference
between traditional payback and
discounted payback methods.
With undiscounted free cash flows,
the payback period is only 2 years
while with discounted free cash flows
(at 17%), the discounted payback
period is 3.07 years.
Discounted Payback
Period Example
14. Uses Free Cash Flows
Is Easy To Calculate And Understand
Considers time value of money
DISADVANTAGES
Ignores free cash flows occurring after the
discounted payback period
Selection Of The Maximum Acceptable
Payback Period Is Arbitrary
ADVANTAGES
15.
16. DECISION RULE:
If NPV is positive, ACCEPT
If NPV is negative, REJECT
where
• CFt = the cash flow at time t
and
• r = the cost of capital.
17. The example below illustrates the
calculation of Net Present Value. Consider
Capital Budgeting projects A and B which
yield the following cash flows over their five
year lives. The cost of capital for the project is
10%.
Year Cash Flow Net Cash Flow
0 -1000 -1000
1 500 100
2 400 200
3 200 200
4 200 400
5 100 700
18.
19. Uses Free Cash Flows
Recognizes the time value of money
Is consistent with the firm’s goal of
shareholder wealth maximization
DISADVANTAGES
Requires detailed long-term forecasts of a
project’s free cash flows
Sensitivity to the choice of the discount rate
ADVANTAGES
20.
21. Profitability Index, divides the projected capital
inflow by the projected capital outflow to
determine the profitability of a project.
DECISION RULE:
If PI is greater or equal to 1, ACCEPT
If PI is less than 1, REJECT
PI = PV of FCF/Initial outlay
22. A firm with a 10% required rate of
return is considering investing in a
new machine with an expected life
of six years. The initial cash outlay
is $50,000.
EXAMPLE:
23. FCF PVF @ 10% PV
Initial Outlay –$50,000 1.000 –$50,000
Year 1 15,000 0.909 13,636
Year 2 8,000 0.826 6,612
Year 3 10,000 0.751 7,513
Year 4 12,000 0.683 8,196
Year 5 14,000 0.621 8,693
Year 6 16,000 0.564 9,032
24. PI = ($13,636 + $6,612+$7,513 + $8,196
+ $8,693+ $9,032) / $50,000
= $53,682/$50,000
= 1.0736
Project’s PI is greater than 1. Therefore,
accept.
25. Uses Free Cash Flows
Recognizes the time value of money
Is consistent with the firm’s goal of
shareholder wealth maximization
DISADVANTAGES
Requires detailed long-term forecasts of a
project’s free cash flows
ADVANTAGES
26.
27. The return on the firm’s
invested capital. IRR is simply the
rate of return that the firm earns
on its capital budgeting projects.
DECISION RULE:
If IRR is greater or equal to the
required rate of return, ACCEPT
If IRR is less than the required rate
of return, REJECT
IRR is the discount rate that equates the
present value of a project’s future net cash
flows with the project’s initial cash outlay.
28.
29. Uses Free Cash Flows
Recognizes the time value of money
Is in general consistent with the firm’s goal of
shareholder wealth maximization.
DISADVANTAGES
Requires detailed long-term forecasts of a
project’s free cash flows
Possibility of multiple IRRs
Assumes cash flows over the life of the project
are reinvested at the IRR
ADVANTAGES
30. Initial Outlay: $3,817
Cash flows: Yr.1=$1,000, Yr. 2=$2,000,
Yr. 3=$3,000
Discount rate NPV
15% $4,356
20% $3,958
22% $3,817
IRR is 22% because the NPV equals the
initial cash outlay at that rate.
EXAMPLE:
31. FCF PVF @ 15% PV
Initial Outlay –$3,817
Year 1 $1,000 .870 $ 870
Year 2 2,000 .756 1,512
Year 3 3,000 .658 1,974
Present value of
inflows
$4,356
Initial outlay -$3,817
32. FCF PVF @ 20% PV
Initial Outlay –$3,817
Year 1 $1,000 .833 $ 833
Year 2 2,000 .694 1,388
Year 3 3,000 .579 1,737
Present value of
inflows
$3,958
Initial outlay -$3,817
33. FCF PVF @ 22% PV
Initial Outlay –$3,817
Year 1 $1,000 .820 $ 820
Year 2 2,000 .672 1,344
Year 3 3,000 .551 1,653
Present value of
inflows
$3,817
Initial outlay -$3,817
34. The discount rate that equates the present value of the
project’s cash outflows with the present value of the
project’s terminal value.
ADVANTAGES
• Use free cash flows
• Recognizes the time value of money
• In general, is consistent with the goal of maximization of
shareholder wealth
DISADVANTAGES
• Requires detailed long- term forecasts of a project’s free cash
flows
35. Modified IRR allows the decision maker to
directly specify the appropriate reinvestment rate.
DECISION RULE:
If MIRR is ≥ to the required rate of return, ACCEPT
If MIRR is < to the required rate of return, REJECT
36. FCF
Initial Outlay –$6,000
Year 1 $2,000
Year 2 3,000
Year 3 4,000
Project having a 3 year life and a
required rate of return of 10% with the
following cash flows:
EXAMPLE:
37. Step 3: Determine the discount rate that
equates to the PV of the terminal value
and the PV of the project’s cash outflows.
MIRR = 17.446%. It is greater than required
rate of return so Accept.
Step 1: Determine the PV of the project’s
cash outflows. $6,000 is already at present.
Step 2: Determine the terminal value of the
project’s free cash flows. To do this use the
project’s required rate of return to calculate
the FV of the project’s three cash flows of the
project’s cash outflows. They turn out to be
$2,420 + $3,300 + $4,000 = $9,720 for the
terminal value.
41. Ethics play a role in capital budgeting
Any actions that violate ethical
standards can have a negative impact
on the image of the firm and
consequently, future cash flows.
Ethics in Capital Budgeting