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# Capital budgeting

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Detail View of Capital budgeting, with realistic clear point of view in present Era.

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### Capital budgeting

1. 1. The Basics of Capital Budgeting: Evaluating Cash Flows Should we build this plant? By: Dr Pawan Gupta Indian School of Petroleum
2. 2. Capital Budgeting: the process of planning for purchases of long- term assets.s example:Suppose our firm must decide whether to purchase a new plastic molding machine for Rs125,000. How do we decide?s Will the machine be profitable?s Will our firm earn a high rate of return on the investment? Indian School of Petroleum
3. 3. Decision-making Criteria in Capital Budgeting How do we decide if a capital investment project should be accepted or rejected? Indian School of Petroleum
4. 4. Decision-making Criteria in Capital Budgetings The Ideal Evaluation Method should:a) include all cash flows that occur during the life of the project,b) consider the time value of money,c) incorporate the required rate of return on the project. Indian School of Petroleum
5. 5. Future valueFVn = PV(1 + i) . nWhat’s the FV of an initial Rs 100 after 3 years if i = 10%? Indian School of Petroleum
6. 6. After 3 years: FV3 = PV(1 + i)3 = Rs 100(1.10)3 = Rs 133.10. Indian School of Petroleum
7. 7. Present values What’s the PV of Rs 100 due in 3 years if i = 10%? n FVn  1 PV = = FVn   ( i) 1+ n 1+ i 3  1  PV = 100    1.10  = Rs 75.13. Indian School of Petroleum
8. 8. Payback Periods The number of years needed to recover the initial cash outlay.s How long will it take for the project to generate enough cash to pay for itself? Indian School of Petroleum
9. 9. Payback Period s How long will it take for the project to generate enough cash to pay for itself?(500) 150 150 150 150 150 150 150 150 0 1 2 3 4 5 6 7 8 Indian School of Petroleum
10. 10. Payback Period s How long will it take for the project to generate enough cash to pay for itself?(500) 150 150 150 150 150 150 150 150 0 1 2 3 4 5 6 7 8 Payback period = 3.33 years. Indian School of Petroleum
11. 11. s Is a 3.33 year payback period good?s Is it acceptable?s Firms that use this method will compare the payback calculation to some standard set by the firm.s If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision?s Accept the project. Indian School of Petroleum
12. 12. Drawbacks of Payback Period:s Firm cutoffs are subjective.s Does not consider time value of money.s Does not consider any required rate of return.s Does not consider all of the project’s cash flows. Indian School of Petroleum
13. 13. Drawbacks of Payback Period: s Does not consider all of the project’s cash flows.(500) 150 150 150 150 150 (300) 0 0 0 1 2 3 4 5 6 7 8 Consider this cash flow stream! Indian School of Petroleum
14. 14. Drawbacks of Payback Period: s Does not consider all of the project’s cash flows.(500) 150 150 150 150 150 (300) 0 0 0 1 2 3 4 5 6 7 8 This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion! Indian School of Petroleum
15. 15. Discounted Paybacks Discounts the cash flows at the firm’s required rate of return.s Payback period is calculated using these discounted net cash flows.s Problems:s Cutoffs are still subjective.s Still does not examine all cash flows. Indian School of Petroleum
16. 16. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%)0 -500 -500.001 250 219.30 Indian School of Petroleum
17. 17. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%)0 -500 -500.001 250 219.30 1 year 280.70 Indian School of Petroleum
18. 18. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%)0 -500 -500.001 250 219.30 1 year 280.702 250 192.38 Indian School of Petroleum
19. 19. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%)0 -500 -500.001 250 219.30 1 year 280.702 250 192.38 2 years 88.32 Indian School of Petroleum
20. 20. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%)0 -500 -500.001 250 219.30 1 year 280.702 250 192.38 2 years 88.323 250 School of Petroleum Indian 168.75
21. 21. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%)0 -500 -500.001 250 219.30 1 year 280.702 250 192.38 2 years 88.323 250 School of Petroleum Indian 168.75 .52 years
22. 22. Discounted Payback (500) 250 250 250 250 250 0 1 2 3 4 5 DiscountedYear Cash Flow CF (14%) The Discounted0 -500 -500.00 Payback1 250 219.30 1 year is 2.52 years 280.70 280.702 250 192.38 2 years 88.323 250 School of Petroleum Indian 168.75 .52 years
23. 23. Other Methods1) Net Present Value (NPV)2) Profitability Index (PI)3) Internal Rate of Return (IRR)Each of these decision-making criteria:s Examines all net cash flows,s Considers the time value of money, ands Considers the required rate of return. Indian School of Petroleum
24. 24. Net Present Value• NPV = the total PV of the annual net cash flows - the initial outlay. • Decision Rule: • If NPV is positive, ACCEPT. • If NPV is negative, REJECT. Indian School of Petroleum
25. 25. NPV Examples Suppose we are considering a capital investment that costs Rs276,400 and provides annual net cash flows of Rs 83,000 for four years and Rs116,000 at the end of the fifth year. The firm’s required rate of return is 15%. 83,000 83,000 83,000 83,000 116,000(276,400) 0 1 2 3 4 5 Indian School of Petroleum
26. 26. Profitability Index n Σ ACFtNPV = t - IO (1 + k) t=1 Indian School of Petroleum
27. 27. Profitability Index n Σ ACFtNPV = t - IO (1 + k) t=1 n Σ ACFtPI = IO (1 + k) t t=1 Indian School of Petroleum
28. 28. Profitability Index• Decision Rule:• If PI is greater than or equal to 1, ACCEPT.• If PI is less than 1, REJECT. Indian School of Petroleum
29. 29. Internal Rate of Return (IRR)s IRR: the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects. Indian School of Petroleum
30. 30. Internal Rate of Return (IRR) n Σ ACFtNPV = - IO (1 + k) t t=1 Indian School of Petroleum
31. 31. Internal Rate of Return (IRR) n Σ ACFtNPV = - IO (1 + k) t t=1 n ACFtIRR: Σ t=1 (1 + IRR) t = IO Indian School of Petroleum
32. 32. Internal Rate of Return (IRR) n ACFt IRR: Σt=1 (1 + IRR) t = IOs IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. Indian School of Petroleum
33. 33. Calculating IRR s Looking again at our problem: s The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay. 83,000 83,000 83,000 83,000 116,000(276,400) 0 1 2 3 4 5 Indian School of Petroleum
34. 34. 83,000 83,000 83,000 83,000 116,000(276,400) 0 1 2 3 4 5s This is what we are actually doing:83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400 Indian School of Petroleum
35. 35. 83,000 83,000 83,000 83,000 116,000(276,400) 0 1 2 3 4 5s This is what we are actually doing:83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400You should get IRR = 17.63%!s This way, we have to solve for IRR by trial and error. Indian School of Petroleum
36. 36. IRR• Decision Rule:• If IRR is greater than or equal to the required rate of return, ACCEPT.• If IRR is less than the required rate of return, REJECT. Indian School of Petroleum
37. 37. Capital Rationings Capital rationing occurs when a company chooses not to fund all positive NPV projects.s The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year. Indian School of Petroleum
38. 38. Reason: Companies want to avoid the directcosts (i.e., flotation costs) and the indirect costsof issuing new capital.Solution: Increase the cost of capital by enoughto reflect all of these costs, and then accept allprojects that still have a positive NPV with thehigher cost of capital. Indian School of Petroleum
39. 39. Reason: Companies don’t have enoughmanagerial, marketing, or engineering staff toimplement all positive NPV projects.Solution: Use linear programming to maximizeNPV subject to not exceeding the constraints onstaffing. Indian School of Petroleum
40. 40. Reason: Companies believe that the project’smanagers forecast unreasonably high cash flowestimates, so companies “filter” out the worstprojects by limiting the total amount of projectsthat can be accepted.Solution: Implement a post-audit process and tiethe managers’ compensation to the subsequentperformance of the project. Indian School of Petroleum
41. 41. ThanksIndian School of Petroleum