Capiatl Budgeting PPT

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CAPITAL BUDGETING:

EXTENSIONS

PRESENTED BY : GUNNIDHEE PATE;

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Choice between projects of

unequal life Let us assume that a firm has to choose between two

machine X & Y, which are designed differently, but

perform essentially the same function. X would involve

initial cash outlay of Rs 1,20,000 & operating cash

expenses of Rs 30,000 per year for 4 yrs on the other

hand Y would involve initial cash outlay of Rs 60,000 and

operating cash expenses of Rs 40,000 per year for 2 years

. Discount Rate is 10%.

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For machine X NPV after 4 years = 1,2o,000 x 1 +30,000x 0.909 + 30,000 x .826 + 30,000 x .751 + 30,000 x .683

= 2,15,070

For machine Y NPV after 2 years = 60,000 x 1 + 40,000 x

0.909 + 40,000 x 0.826 = 1,29,400


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Let us assume Y undertakes Y1, and Y replaced after 2 yrs. So Cash

flows after 2 years-

0 1 2 3 4 NPV at 10 %

Y1 60 40 40 0 0 129.42

Y2 00 00 60 40 40 106.96

Y (Y1+Y2) 60 40 100 40 40 236.38

X 120 30 30 30 30 215.10


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Investment Timing &

Duration A firm evaluate a number of investment

projects every year. In the absence of capitalconstraint, it will undertake all the all thoseprojects which have +ve NPVS & reject thosewhich have ve NPVS .

Some of profitable projects may be more

valuable if undertaken in future .Some of the unprofitable projects may yield

+ve NPV if they are accepted latter on.

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EXAMPLE- Suppose that the Alpha company is

considering an investment opportunity ,which can be

undertaken now, or after 1 year ,or after 2. The cash flows

of these mutually exclusive alternatives in terms oftiming : opportunity cost is assumed 10%.

Projectsundertakenat period

C0 C1 C2 C3

-100 150

1 -120 180

2 140 205

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investment and financing

aspectsFinancing & Investment decisions are likely to be

interrelated. When this is so, we must take into accountthe financing impact of an investment decisions. This maybe done either by calculating the adjusted NPV or by using

the adjusted discount rate.

Adjusted NPV- The adjusted NPV of a project is its NPVcalculated after making adjustment for financing impact ofthe project. The calculation of adjusted NPV begins with

the base case NPV is obtained, adjustment are made toit to reflect the impact of the project on financing.

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Hence, Adjusted NPV = Base case of NPV + NPV offinancing descions associated with the project.


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EXAMPLE- Parimala Company is considering a project requiring Rs.5 million of investment. It is expected to generate a net cash flow ofRs 1 million per years for 8 years. The opportunity cost of the capitalis 15% this reflect the return required by equity investors from theproject. The cost of issuing equity is 5 %. The project enables thefirm to raise Rs 2.4 million of debt finance. The debt finance willcarry 14% interest and will be repaid in equal annual installmentsover eight year period the first installment will be paid at the end ofthe first year . The tax rate applicable to the firm is 60%.

-

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Calculation of the presentvalue of the tax shield

Year Debt outstandingat the beginning

Interest Tax shield Present value of Tax Shield

1 2,400 336 202 177

2 2,100 294 176 135

3 1,800 252 151 102

4 1,500 210 126 75

5 1,200 168 101 52

6 900 126 76 34

7 600 84 50 20

8 300 42 25 9

Total 60412


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Capital Budgeting UnderConstraints

The objective of investment decision makingunder conditions of capital rationing should

be to maximize the NPV of the set selected.

Due to size disparity of projects, this objective

cannot be realized by merely choosing projectson the basis of individual NPV ranking till thebudget is exhausted.

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FEASIBLE COMBINATION APPROACH

Example- Consider the following projects that are beingevaluated by a Firm which has a Capital constraint of Rs

3,000,000.Project Outlay NPV

A Rs 1,800,000 Rs 750,000

B 1,500,000 600,000

C 1,200,000 500,000

D 750,000 360,000

E 600,000 300,000

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Projects B & C are mutually exclusive. Otherprojects are interdependent.

The feasible combinations and their NPV areshown -

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Feasiblecombination

Outlay NPV

A Rs 1,800,000 Rs 750,000

B 1,500,000 600,000

C 1,200,000 500,000

D 750,000 360,000

E 600,000 300,000

A & C 3,000,000 1,250,000

A & D 2,550,000 1,110,000A & E 2,400,000 1,050,000

B & D 2,250,000 960,000

B & E 2,100,000 900,000

C & D 1,950,000 860,000

C & E 1,800,000 800,000

B,D, & E 2,850,000 1,260,000

C, D, &E 2,550,000 1,160,000

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orporate trategyCapital Budgeting

Capital budgeting is the principal instrument for implementingcorporate strategy. Yet the tie-in between corporate strategy &capital budgeting is often loose & tenuous. With the following

Investment proposal are often considered as self- containedprojects and viewed more or less in isolation.

The sponsors of the proposals, particularly operating personnel ,tend to, quite understandably, view the proposals from theirlimited perspective.

Many investment proposals, suggested by people down the lineand apparently fulfilling certain standards of profitability, maybe rejected by the capital budgeting committee because they

conflict with the rationale of corporate strategy.

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QualitativeInfluencesA mosaic of influences that can be best be describedqualitatively have an important bearing on capitalexpenditure decisions. These are discussed below:

Intuition

Vision

Superstition

Politics

Sponsorship

Intangible Benefits

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THANK YOU

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Capiatl Budgeting PPT

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