Capital budgeting refers to a firm's decision to invest funds in long-term assets that are expected to generate benefits over several years. It is important because such decisions influence long-term growth, profitability, and risk. Capital budgeting methods can be divided into non-discounted cash flow methods (such as payback period) and discounted cash flow methods (such as net present value and internal rate of return). The net present value and internal rate of return methods may provide conflicting rankings for mutually exclusive projects under certain conditions related to cash flows and project lives. The net present value method is generally preferred for decision making because it is consistent with maximizing shareholder wealth.
Strategic fit expresses the degree to which an organization is matching its resources and capabilities with the opportunities in the external environment.
In addition, strategic fit also examines the resource base of the organization and explores how they can be utilized to achieve maximum benefits.
Strategic fit expresses the degree to which an organization is matching its resources and capabilities with the opportunities in the external environment.
In addition, strategic fit also examines the resource base of the organization and explores how they can be utilized to achieve maximum benefits.
The presentation talks about why is it necessary to carry out Financial appraisal and the different methods to analyse it. It also discusses the steps involved in a financial appraisal of a project.
The presentation talks about why is it necessary to carry out Financial appraisal and the different methods to analyse it. It also discusses the steps involved in a financial appraisal of a 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.
Chapter- III Techniques of Capital Budgeting
Concept, Significance, Nature and classification of capital budgeting decisions, cash flow computation- Incremental approach; Evaluation criteria- Pay Back Period, ARR, NPV, IRR and PI methods; capital rationing, Capital budgeting under risk and uncertainty.
WORKING CAPITAL PRACTICESWORKING CAPITAL PRACTICES.docxericbrooks84875
WORKING CAPITAL PRACTICES
WORKING CAPITAL PRACTICES
Tanelle Peppers
Business 650
Ashford University
WORKING CAPITAL PRACTICESCapital budgeting are the planning methods used by organza tons to decide which of its long Term investments are worth pursuing. Since most organizations are at the moment restructuring Their working capital practices, in order to discover untapped cash sources .The main methods Used for capital budgeting are Internal rate of return, Net present value, Real options analysis, Payback period, Profitability index, and Equivalent annuity.
Net Present Value
It’s used in estimating each potential project's worth using a discounted cash flow valuation. The valuation requires estimating the size and timing of all the incremental cash flows from the project. The NPV is greatly affected by the discount rate, so selecting the proper rate–sometimes called the hurdle rate–is critical to making the right decision.
This should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models, such as the CAPM or the APT, to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.
Internal Rate of Return
The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.
The IRR method will result in the same decision as the NPV method for non-mutually exclusive projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR, which is often used, may select a project with a lower NPV.
One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. Accordingly, a measure called "Modified Internal Rate of Return (MIRR)" is often used.
Payback Period
Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. Payback period intuitively measures how long something takes to "pay for itself.” All else being equal, shorter payback periods are preferable to longer payback periods.
The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not account for the time value of money, risk, financing, or other important considerations, such as the opportunity cost.
Profitability Index
Prof.
Slide 1
8-1
Capital Budgeting
• Analysis of potential projects
• Long-term decisions
• Large expenditures
• Difficult/impossible to reverse
• Determines firm’s strategic direction
When a company is deciding whether to invest in a new project, large sums of money can be at stake. For
example, the Artic LNG project would build a pipeline from Alaska’s North Slope to allow natural gas to
be sent from the area. The cost of the pipeline and plant to clean the gas of impurities was expected to be
$45 to $65 billion. Decisions such as these long-term investments, with price tags in the billions, are
obviously major undertakings, and the risks and rewards must be carefully weighed. We called this the
capital budgeting decision. This module introduces you to the practice of capital budgeting. We will
consider a variety of techniques financial analysts and corporate executives routinely use for the capital
budgeting decisions.
1. Net Present Value (NPV)
2. Payback Period
3. Average Accounting Rate (AAR)
4. Internal Rate of Return (IRR) or Modified Internal Rate of Return (MIRR)
5. Profitability Index (PI)
Slide 2
8-2
• All cash flows considered?
• TVM considered?
• Risk-adjusted?
• Ability to rank projects?
• Indicates added value to the firm?
Good Decision Criteria
All things here are related to maximize the stock price. We need to ask ourselves the following
questions when evaluating capital budgeting decision rules:
Does the decision rule adjust for the time value of money?
Does the decision rule adjust for risk?
Does the decision rule provide information on whether we are creating value for the firm?
Slide 3
8-3
Net Present Value
• The difference between the market value of a
project and its cost
• How much value is created from undertaking
an investment?
Step 1: Estimate the expected future cash flows.
Step 2: Estimate the required return for projects of
this risk level.
Step 3: Find the present value of the cash flows and
subtract the initial investment to arrive at the Net
Present Value.
Net present value—the difference between the market value of an investment and its cost.
The NPV measures the increase in firm value, which is also the increase in the value of what the
shareholders own. Thus, making decisions with the NPV rule facilitates the achievement of our
goal – making decisions that will maximize shareholder wealth.
Slide 4
8-4
Net Present Value
Sum of the PVs of all cash flows
Initial cost often is CF0 and is an outflow.
NPV =∑
n
t = 0
CFt
(1 + R)t
NPV =∑
n
t = 1
CFt
(1 + R)t
- CF0
NOTE: t=0
Up to now, we’ve avoided cash flows at time t = 0, the summation begins with cash flow zero—
not one.
The PV of future cash flows is not NPV; rather, NPV is the amount remaining after offsetting the
PV of future cash flows with the initial cost. Thus, the NPV amount determines the incremental
value created by unde.
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1. CHAPTER 8
CAPITAL BUDGETING DECISIONS
Q.1. What is capital budgeting? Why is it significant for a firm?
A.1. A capital budgeting decision may be defined as the firm’s decision to invest its
current funds most efficiently in the long-term assets in anticipation of an
expected flow of benefits over a series of years.
Investment decisions require special attention because of the following reasons:
1. They influence the firm’s growth and profitability in the long run
2. They affect the risk of the firm
3. They involve commitment of large amount of funds
4. They are irreversible, or reversible at substantial loss
5. They are among the most difficult decisions to make.
Q.2. Despite its weaknesses, the payback period method is popular in practice? What
are the reasons for its popularity?
A.2. Payback is considered to have the following virtues, which makes it popular in
practice.
1. Simplicity Payback is simple to understand and easy to calculate. The business
executives consider the simplicity of method as a virtue. This is evident from
their heavy reliance on it for appraising investment proposals in practice.
2. Cost effective Payback method costs less than most of the sophisticated
techniques that require a lot of the analysts’ time and the use of computers.
3. Short-term effects A company can have more favourable short-run effects on
earnings per share by setting up a shorter standard payback period. It should,
however, be remembered that this may not be a wise long-term policy as the
company may have to sacrifice its future growth for current earnings.
4. Risk shield The risk of the project can be tackled by having a shorter standard
payback period as it may ensure guarantee against loss. A company has to
invest in many projects where the cash inflows and life expectancies are
highly uncertain. Under such circumstances, payback may become important,
not so much as a measure of profitability but as a means of establishing an
upper bound on the acceptable degree of risk.
5. Liquidity The emphasis in payback is on the early recovery of the investment.
Thus, it gives an insight into the liquidity of the project. The funds so released
can be put to other uses.
Q.3. How do you calculate the accounting rate of return? What are its limitations?
A.3. The accounting rate of return, ARR (or return on investment, ROI), is the ratio of
the average net operating after-tax profit (NOPAT) divided by the average
investment. The average investment would be equal to half of the original
investment if it were depreciated constantly. Alternatively, it can be found out by
dividing the total of the investment’s book values after depreciation by the life of
the project. Generally, a higher ROI is considered better. For making a decision, a
cut-off rate is needed.
2. As a decision criterion, however, it has serious shortcomings:
1. Cash flows ignored The ARR method uses accounting profits, not cash
flows, in appraising the projects. Accounting profits are based on arbitrary
assumptions and choices and also include non-cash items. It is, therefore,
inappropriate to rely on them for measuring the acceptability of the
investment projects.
2. Time value ignored The averaging of income ignores the time value of
money. In fact, this procedure gives more weightage to the distant
receipts.
3. Arbitrary cut-off The firm employing the ARR rule uses an arbitrary cut-
off yardstick. Generally, the yardstick is the firm’s current return on its
assets (book-value). Because of this, the growth companies earning very
high rates on their existing assets may reject profitable projects (i.e., with
positive NPVs) and the less profitable companies may accept bad projects
(i.e., with negative NPVs).
Q.4. Explain the merits and demerits of the time-adjusted methods of evaluating the
investment projects.
A.4. Merits:
Time value of money: Time-adjusted or discounted cash flow (DCF) techniques
recognise the time value of money—a rupee received today is worth more than a
rupee received tomorrow.
Risk: DCF techniques use the cost of capital as the discount rate, which includes a
premium for risk of the project under evaluation.
Measure of true profitability: They use all cash flows occurring over the entire
life of the project in calculating its worth. Hence, it is a measure of the project’s
true profitability.
Demerits:
In practice, it is quite difficult to obtain the estimates of cash flows due to
uncertainty. It is also difficult in practice to precisely measure the discount rate.
Q.5. What is meant by the term time value of money? Which capital budgeting
methods take into consideration this concept? How is it possible for the capital
budgeting methods, that do not consider the time value of money, to lead to
wrong capital budgeting decisions?
A.5. The time value of money is based on the premise that the value of money changes
because of investment opportunities available to investors. Hence, Rs 100 today is
not same as Rs 100 after one year. The capital budgeting methods that are based
on the time value of money are called discounted cash flow (DCF) Criteria. They
include two methods: (1) Net Present Value (NPV) and (2) Internal Rate of
Return (IRR). Profitability Index (PI), is a variant of the NPV method, also a DCF
technique.
Non-DCF techniques are not able to differentiate between cash flows
occurring in different time periods. They not focus on value, and hence, they
violate the principle of the shareholder wealth maximization.
3. Q.6. Under what circumstances do the net present value and internal rate of return
methods differ? Which method would you prefer and why?
A.6. The NPV and IRR methods can give conflicting ranking to mutually exclusive
projects. In the case of independent projects ranking is not important since all
profitable projects will be accepted. Ranking of projects, however, becomes
crucial in the case of mutually exclusive projects. Since the NPV and IRR rules
can give conflicting ranking to projects, one cannot remain indifferent as to the
choice of the rule. NPV method is consistent with the shareholder wealth
maximization; hence, it should be preferred over IRR method.
Q.7. What are the mutually exclusive projects? Explain the conditions when
conflicting ranking would be given by the internal rate of return and net present
value methods to such projects.
A7 Investment projects are said to be mutually exclusive when only one investment
could be accepted and others would have to be excluded. The NPV and IRR
methods can give conflicting ranking to mutually exclusive projects under the
following conditions:
1. The cash flow pattern of the projects may differ. That is, the cash flows of
one project may increase over time, while those of others may decrease or
vice-versa.
2. The cash outlays (initial investments) of the projects may differ.
3. The projects may have different expected lives.
Q.8. What is profitability index? Which is a superior ranking criterion, profitability
index or the net present value?
A.8. Profitability index is the ratio of the present value of cash inflows, at the required
rate of return, to the initial cash outflow of the investment. The formula for
calculating benefit-cost ratio or profitability index is as follows:
PV of cash inflows PV (C t ) n Ct
PI = = =∑ t
÷ C0
Initial cash outlay C0 t =1 (1 + k )
The NPV method and PI yield same accept-or-reject rules, because PI can
be greater than one only when the project’s net present value is positive. In case
of marginal projects, NPV will be zero and PI will be equal to one. But a conflict
may arise between the two methods if a choice between mutually exclusive
projects has to be made The NPV method should be preferred, except under
capital rationing. Between two mutually exclusive projects with same NPV, the
one with lower initial cost (or higher PI) will be selected.
Q.9. Under what conditions would the internal rate of return be a reciprocal of the
payback period?
A.9. The reciprocal of payback will be a close approximation of the internal rate of
return if the following two conditions are satisfied:
1. The life of the project is large or at least twice the payback period.
2. The project generates equal annual cash inflows.
4. Q.10. ‘The payback reciprocal has wide applicability as a meaningful approximation of
the time adjusted rate of return. But it suffers from certain major limitations.’
Explain.
A.10. The payback reciprocal is a useful technique to quickly estimate the true rate of
return. But its major limitation is that every investment project dose not satisfies
the conditions on which this method is based. When the useful life of the project
is not at least twice the payback period, the payback reciprocal will always exceed
the rate of return. Similarly, it cannot be used as an approximation of the rate of
return if the project yields uneven cash inflows
Q.11. Comment on the following statements:
(a) ‘We use payback primarily as a method of coping with risk.’
(b) ‘The virtue of the IRR rule is that it does not require the computation of the
required rate of return.’
(c) ‘The average accounting rate of return fails to give weight to the later cash
flows.’
A.11. (a) The risk of the project under payback is tackled by having a shorter standard
payback period. A company has to invest in many projects where the cash inflows
and life expectancies are highly uncertain. Under such circumstances, payback
may become important, not so much as a measure of profitability but as a means
of establishing an upper bound on the acceptable degree of risk It must be realised
that payback does not really consider risk of cash flows as it treats cash flows
occurring at different time periods as of equal importance and quality.
(b) The required rate of return does not enter in the computation of IRR. But this
information is needed in making the investment decision. The accept-or-reject
rule, using the IRR method, is to accept the project if its internal rate of return is
higher than the required rate of return or opportunity cost of capital (r > k). The
project shall be rejected if its internal rate of return is lower than the opportunity
cost of capital (r < k). The decision maker may remain indifferent if the internal
rate of return is equal to the opportunity cost of capital. So even in case of IRR
rule we require the computation of the required rate of return.”
(c) The ARR method uses accounting profits, not cash flows, in appraising the
projects. Accounting profits are based on arbitrary assumptions and choices and
also include non-cash items. It is, therefore, inappropriate to rely on them for
measuring the acceptability of the investment projects. The averaging of income
ignores the time value of money. In fact, this procedure gives more weightage to
the distant receipts.
Q.12. ‘Discounted payback ensures that you don’t accept an investment with negative
NPV, but it can’t stop you from rejecting projects with a positive NPV.’ Illustrate
why this can happen.
5. A.12. The discounted payback period is the number of periods taken in recovering the
investment outlay on the present value basis. The discounted payback period still
fails to consider the cash flows occurring after the payback period. Thus, it may
reject positive NPV projects.
Discounted payback period illustrated: Project A involves a cash outlay of
Rs 10,000 and its discounted cash flows over its life of five years are: Rs 5,000;
Rs 4,000; Rs 1,000; Rs 0 and Rs 0. The discounted payback period is 3 years.
Project B also involves a cash outlay of Rs 10,000 and its discounted cash flows
over its life of five years are: Rs 5,000; Rs 3,000; Rs 1,000; Rs 1,000 and Rs
5,000. The discounted payback period is 4 years. On the basis of the discounted
payback period, Project A will be preferred. However, Project B generates
positive NPV.