Capital Budgeting Er. S Sood

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Capital Budgeting Er. S Sood

  1. 1. Capital Budgeting Er. SS POWER GP.
  2. 2. Capital Budgeting : # The process of making investment decision in capital expenditures. # The planning for purchases of long- term assets. <ul><ul><li>Capital Expenditure: </li></ul></ul><ul><ul><li>An expenditure the benefits of which are received over a period of time exceeding one year. </li></ul></ul>
  3. 3. Examples of Capital Expenditure: <ul><li>Acquisition of permanent assets such as plant & mach. </li></ul><ul><li>Cost of addition, expansion, improvement or alteration of FA </li></ul><ul><li>Cost of replacement of FA </li></ul><ul><li>R&D project cost etc. </li></ul>
  4. 4. Need and Importance CB <ul><li>Exchange of current funds for future benefits </li></ul><ul><li>Large investment </li></ul><ul><li>Long term commitment of funds </li></ul><ul><li>Irreversible nature </li></ul><ul><li>Long term effect on profitability </li></ul><ul><li>Difficulties of investment decisions </li></ul><ul><li>Strategic investment decisions </li></ul><ul><li>National Importance </li></ul>
  5. 5. CB Process <ul><li>Identification of potential investment opportunities </li></ul><ul><li>Screening the opportunities </li></ul><ul><li>Evaluation of Various opportunities </li></ul><ul><li>Ranking the opportunities </li></ul><ul><li>Final approval & preparation of capital expenditure budget </li></ul><ul><li>Implementation </li></ul><ul><li>Review & follow up </li></ul>
  6. 6. CB Decisions <ul><li>Accept reject decisions </li></ul><ul><li>Mutually exclusive decisions </li></ul><ul><li>Capital Rationing decisions </li></ul>
  7. 7. Project Classification <ul><li>Mandatory investments </li></ul><ul><li>Replacement projects </li></ul><ul><li>Expansion Projects </li></ul><ul><li>Diversification projects </li></ul><ul><li>R &c D projects </li></ul><ul><li>Misc. projects: e.g. recreational facilities, landscaped gardens etc. </li></ul>
  8. 8. <ul><li>Example : </li></ul><ul><li>Suppose our firm wants to decide whether to purchase a new machine for Rs.15,00,000. How do we decide? </li></ul><ul><li>Will the machine be profitable? </li></ul><ul><li>Will our firm earn a high rate of return on the investment? </li></ul>
  9. 9. Decision-making Criteria in Capital Budgeting <ul><li>How do we decide if a capital investment project should be accepted or rejected? </li></ul>
  10. 10. <ul><li>The Ideal Evaluation Method should: </li></ul><ul><li>a) include all cash flows that occur during the life of the project, </li></ul><ul><li>b) consider the time value of money , </li></ul><ul><li>c) incorporate the required rate of return on the project. </li></ul>Decision-making Criteria in Capital Budgeting
  11. 11. Methods / Techniques of CB Traditional Methods Time adjusted or discounted Methods <ul><li>Net present value method - NPV </li></ul><ul><li>Internal rate of return method - IRR </li></ul><ul><li>Profitability Index – Benefit cost ratio </li></ul><ul><li>Pay Back period Method </li></ul><ul><li>Improvement over pay back period </li></ul><ul><li>Post pay back period </li></ul><ul><li>Post pay back profitability index </li></ul><ul><li>Reciprocal Pay back period </li></ul><ul><li>Discounted Pay back period </li></ul><ul><li>Accounting rate of return </li></ul>
  12. 12. A. Traditional Methods
  13. 13. 1. Payback Period <ul><li>How long will it take for the project to generate enough cash to pay for itself? </li></ul><ul><li>It is the length of the time required to recover initial cash outlay on the project </li></ul>
  14. 14. Payback Period Payback period = 3.33 years. Pay Back period = Original cost of the project Annual Cash Inflows CI = PAT + Dep 0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 150 150 150
  15. 15. <ul><li>Is a 3.33 year payback period good? </li></ul><ul><li>Is it acceptable? </li></ul><ul><li>Firms that use this method will compare the payback calculation to some standard set by the firm. </li></ul><ul><li>If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? </li></ul><ul><li>Accept the project . </li></ul>Payback Period
  16. 16. Drawbacks of Payback Period <ul><li>Firm cutoffs are subjective. </li></ul><ul><li>Does not consider time value of money. </li></ul><ul><li>Does not consider any required rate of return. </li></ul><ul><li>Does not consider all of the project’s cash flows. </li></ul>
  17. 17. Drawbacks of Payback Period <ul><li>Does not consider all of the project’s cash flows . </li></ul><ul><li>Consider this cash flow stream! </li></ul>0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 (300) 0 0
  18. 18. Drawbacks of Payback Period <ul><li>Does not consider all of the project’s cash flows . </li></ul><ul><li>This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! </li></ul>0 1 2 3 4 5 8 6 7 (500) 150 150 150 150 150 (300) 0 0
  19. 19. 2. Improvement over the Pay back period method <ul><li>Post pay back period method </li></ul><ul><li>= Life of the project – pay back period </li></ul>ii) Post pay back profitability index = Post pay back profits *100 Investments iii) Pay back reciprocal method = Annual cash inflows Total investment
  20. 20. iv) Discounted payback method <ul><li>Discounts the cash flows at the firm’s required rate of return. </li></ul><ul><li>Payback period is calculated using these discounted net cash flows. </li></ul><ul><li>Problems : </li></ul><ul><li>Cutoffs are still subjective. </li></ul><ul><li>Still does not examine all cash flows. </li></ul>
  21. 21. Discounted payback method <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul>0 1 2 3 4 5 ( 500) 250 250 250 250 250
  22. 22. Discounted payback method <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul><ul><li>2 250 192.37 2 year 88.33 </li></ul><ul><li>3 250 168.74 .52 years </li></ul>0 1 2 3 4 5 ( 500) 250 250 250 250 250
  23. 23. Discounted payback method <ul><li> Discounted </li></ul><ul><li>Year Cash Flow CF (14%) </li></ul><ul><li>0 -500 -500.00 </li></ul><ul><li>1 250 219.30 1 year </li></ul><ul><li> 280.70 </li></ul><ul><li>2 250 192.37 2 years </li></ul><ul><li> 88.33 </li></ul><ul><li>3 250 168.74 .52 years </li></ul>0 1 2 3 4 5 (500) 250 250 250 250 250 The Discounted Payback is 2.52 years
  24. 24. 3 . Accounting rate of return method -ARR <ul><li>Average rate of return: </li></ul><ul><li>= Average annual profits * 100 </li></ul><ul><li>Net Investment </li></ul><ul><li>Return per unit of investment: </li></ul><ul><li>= Total profits * 100 </li></ul><ul><li>Net Investment </li></ul><ul><li>Return on average investment: </li></ul><ul><li>= Total profits * 100 </li></ul><ul><li>Average Investment </li></ul><ul><li>Average return on average investment: </li></ul><ul><li>= Average annual profits * 100 </li></ul><ul><li>Average Investment </li></ul>
  25. 25. B. Time adjusted / discounted methods <ul><li>1) Net Present Value (NPV) </li></ul><ul><li>2) Profitability Index (PI) </li></ul><ul><li>3) Internal Rate of Return (IRR) </li></ul><ul><li>Each of these decision-making criteria: </li></ul><ul><li>Examines all net cash flows, </li></ul><ul><li>Considers the time value of money, and </li></ul><ul><li>Considers the required rate of return. </li></ul>
  26. 26. 1. Net Present Value <ul><li>NPV = PV CI - PV CO </li></ul><ul><li>Total PV of annual net cash flows - Initial outlay. </li></ul>NPV = - IO FCF t (1 + k) t n t=1 
  27. 27. Net Present Value <ul><li>Decision Rule : </li></ul><ul><li>In case of independent projects </li></ul><ul><li>If NPV is positive, accept. </li></ul><ul><li>If NPV is negative, reject. </li></ul><ul><li>In case of mutually exclusive projects </li></ul><ul><li>Accept the project with highest positive NPV </li></ul>
  28. 28. <ul><li>Suppose we are considering a capital investment that costs Rs. 250,000 and provides annual net cash flows of Rs. 100,000 for five years. The firm’s required rate of return is 15%. </li></ul>NPV Example 0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
  29. 29. Net Present Value (NPV) <ul><li>NPV is just the PV of the annual cash flows minus the initial outflow. </li></ul><ul><li>Using PVM: </li></ul><ul><li>Present value of annuity of Rs. 1 in 5 years = 3.3522 </li></ul><ul><li>PV CI = 100,000 *3.3522 = 3,35,220 </li></ul><ul><li>PV CO = 250,000 </li></ul><ul><li>PV of cash flows = Rs.335,220 </li></ul><ul><li>- Initial outflow: (Rs. 250,000) </li></ul><ul><li>= Net PV Rs. 85,220 </li></ul>
  30. 30. 2. Internal Rate of Return (IRR) <ul><li>The return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects. </li></ul>The rate at which PV CI =PV CO n t=1  IRR: = IO FCF t (1 + IRR) t
  31. 31. Internal Rate of Return (IRR) <ul><li>IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. </li></ul><ul><li>This looks very similar to the Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond. </li></ul>n t=1  IRR: = IO FCF t (1 + IRR) t
  32. 32. Calculating IRR <ul><li>When cash inflows are equal </li></ul><ul><li>When cash inflows are not equal </li></ul><ul><li>When cash inflows are equal: </li></ul><ul><li>PVF = Initial outlay / Annual cash inflow </li></ul><ul><li>Then consult the PV table with the number </li></ul><ul><li>of years equal to the life of the assets & find </li></ul><ul><li>out the rate at which calculated PVF =PV </li></ul><ul><li>given in the table </li></ul>
  33. 33. b) When cash inflows are not equal over the life of the asset: <ul><li>Hit & trial method </li></ul><ul><li>Process </li></ul><ul><li>Calculate PV CI by using an arbitrary assumed arte of discount. </li></ul><ul><li>Find out NPV </li></ul><ul><li>If NPV is positive, apply higher rate of discount </li></ul><ul><li>If still NPV is positive, apply further higher rate of discount </li></ul><ul><li>If NPV is negative, the IRR must be between two rates </li></ul>
  34. 34. IRR = LR + PV LR - I PV LR - PV HR * Difference between two rates IRR
  35. 35. Calculating IRR <ul><li>Looking again at the problem: </li></ul><ul><li>The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay. </li></ul>IRR =28% appox. 0 1 2 3 4 5 (250,000) 100,000 100,000 100,000 100,000 100,000
  36. 36. IRR <ul><li>Decision Rule : </li></ul><ul><li>In case of independent projects: </li></ul><ul><li>If IRR > required rate of return(K o ), accept. </li></ul><ul><li>If IRR < the required rate of return ( K o ) , reject. </li></ul><ul><li>In case of mutually exclusive projects: </li></ul><ul><li>Accept the project with highest IRR, provided it is greater than required rate of return(K o ). </li></ul>
  37. 37. Modified Internal Rate of Return - MIRR <ul><li>IRR assumes that all cash flows are reinvested at the IRR. </li></ul><ul><li>MIRR provides a rate of return measure that assumes cash flows are reinvested at the required rate of return. </li></ul>
  38. 38. MIRR Steps: <ul><li>Calculate the PV of the cash outflows. </li></ul><ul><ul><li>Using the required rate of return. </li></ul></ul><ul><li>Calculate the FV of the cash inflows at the last year of the project’s time line. This is called the terminal value (TV). </li></ul><ul><ul><li>Using the required rate of return. </li></ul></ul><ul><li>MIRR: the discount rate that equates the PV of the cash outflows with the PV of the terminal value, ie, that makes : </li></ul><ul><li>PV outflows = PV inflows </li></ul>
  39. 39. MIRR <ul><li>Using our time line and a 15% rate: </li></ul><ul><li>PV outflows = (900) </li></ul><ul><li>FV inflows (at the end of year 5) = 2,837 . </li></ul><ul><li>MIRR: FV = 2837, PV = (900), N = 5 </li></ul><ul><li>solve: I = 25.81%. </li></ul>0 1 2 3 4 5 (900) 300 400 400 500 600
  40. 40. MIRR <ul><li>Using our time line and a 15% rate: </li></ul><ul><li>PV outflows = (900) </li></ul><ul><li>FV inflows (at the end of year 5) = 2,837. </li></ul><ul><li>MIRR: FV = 2837, PV = (900), N = 5 </li></ul><ul><li>solve: I = 25.81%. </li></ul><ul><li>Conclusion : The project’s IRR of 34.37%, assumes that cash flows are reinvested at 34.37%. </li></ul><ul><li>Assuming a reinvestment rate of 15%, the project’s MIRR is 25.81%. </li></ul>
  41. 41. 3. Profitability Index PI = PV CI PV CO PI = IO FCF t (1 + k) n t=1  t
  42. 42. <ul><ul><li>Decision Rule : </li></ul></ul><ul><li>If PI > 1, accept. </li></ul><ul><li>If PI < 1, reject. </li></ul>Profitability Index
  43. 43. Example of PI <ul><li>-250,000 PV of cash outflows </li></ul><ul><li>335,220 PV of cash inflows </li></ul><ul><li>PI = PV CI / PV CO </li></ul><ul><li> = 3,35,220/2,50,000 </li></ul><ul><li> = 1.34 </li></ul><ul><li>As PI > 1, Accept the project </li></ul>
  44. 44. Factors affecting CB decisions <ul><li>Urgency </li></ul><ul><li>Degree of certainty </li></ul><ul><li>Intangible factors </li></ul><ul><li>Legal factors </li></ul><ul><li>Availability of funds </li></ul><ul><li>Future earnings </li></ul><ul><li>Obsolescence </li></ul><ul><li>R&D projects </li></ul><ul><li>Cost considerations </li></ul>
  45. 45. Risk & uncertainty in CB <ul><li>Expected economic life of the asset </li></ul><ul><li>Salvage value </li></ul><ul><li>Capacity of the project </li></ul><ul><li>Selling price of the product </li></ul><ul><li>Depreciation rate </li></ul><ul><li>Production cost </li></ul><ul><li>Rate of taxation </li></ul><ul><li>Future demand of the product </li></ul>
  46. 46. Methods for ascertaining risk & uncertainty in CB <ul><li>Risk adjusted cut off or varying discount rate </li></ul><ul><li>Certainity equivalent method </li></ul><ul><li>Sensitivity technique </li></ul><ul><li>Probability technique </li></ul><ul><li>Standard deviation method </li></ul><ul><li>Coefficient variation method </li></ul><ul><li>Decision tree analysis </li></ul>
  47. 47. Method of appraisal & their rationale <ul><li>Wide variety of measures </li></ul><ul><li>Small size investment projects – pay back period method </li></ul><ul><li>Large size investment projects – ARR method </li></ul><ul><li>Large size investment projects – Discounted cash flows method </li></ul><ul><li>Several other criteria: profit per rupee invested, cost saving per unit etc. </li></ul><ul><li>By and large no fixed standard </li></ul><ul><li>Bottleneck due to limited funds </li></ul>

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