Capital Budgeting

By

Sudarshan Kadariya

IBM

The Position of Capital Budgeting

Capital Budgeting

L o n g T e rm A sse ts S h o rt T e rm A sse ts

Investm ent D ecison

D e b t/E qu ity M ix

Financing D ecis ion

D iv id en d P a yo u t R a tio

D ividend D ecision

Financial Goa l of the F irm :W ealth Maxim isation

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

Capital Budgeting - Methods

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

ARR = Avg. Net Income Per Year Avg. Investment

Average Rate of Return

Example:Year Net Income Cost1 6,000 100,000

Initial2 8,000 0 Salvage

Value3 11,0004 13,0005 16,0006 18,000

ARR

Avg. Net Income 72,000 6

Avg. Investment 100,000 2

AROI 12,000 50,000

ARR

= 12,000

= 24%

= 50,000

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

ARR

Years required to recover the original investment

Example:Year Net Income Cash Flow Cumulative CF1 6,000 26,000 26,0002 8,000 28,000 54,0003 11,000 31,000 85,0004 13,000 33,000

118,0005 16,000 36,000

154,0006 18,000 18,000

172,000

Payback = 3 + 100,000 - 85,000 118,000 - 85,000

Payback Method

= 3.45 Years

PBP 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)

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

PBP

FV = PV (1 + r)n

Compounding: Finding FV

Discounting:Finding PV:PV = FV/(1 + r) n

Internal Rate of Return:Finding r

Time Value of Money

Discounted Payback Period

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

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

Net Present Value

Year CF Disc. Factor PV

0 -100000 1 -100000

1 26000 1/1.1 = .9091 23637

2 28000 1/(1.1)2 = .8264 23139

3 31000 1/(1.1)3 = .7573 23290

4 33000 1/(1.1)4 = .6830 22539

5 36000 1/(1.1)5 = .6209 22352

6 18000 1/(1.1)6 = .5645 10161

NPV = 25121

NPV - Example

NPV 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

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

NPV

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%

Internal Rate of Return

IRR

)(0LH

HL

LL RRx

PVPV

CFPVRIRR

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.

IRR

Internal Rate of Return

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

Modified IRR

nCIF

O MIRR

TVPV

)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

NPV versus IRR 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

Profitability IndexPI = 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

NPV = CF1 + CF2 +.............. + CFn - Io

l+r (l+r)2 (l+r)n

Cash Flows IncrementalAfter TaxNet Working Capital

Estimating cash flow is more qualitative approach and base on the knowledge of the projects and the capability of the management

Estimating Cash Flows

1. Initial Costs: New cost of assetsAdditional WC

requirementSale of Old Assets

2. Annual Costs: Revenue Less CostsAfter Tax

3. Terminal Cash Flows: Salvage ValueRecovery of NWC

Procedure

Sale of Existing PlantCF= Selling Price + T (B.V. - S.P.)

Annual Cash FlowsOCF= (Sales-Cost)(1-T) + T, DEPREC

orOCF= Net Inc + Depreciation

Cash Flow Estimates

Evaluating Capital Projects1) 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

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

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.

Thank you.