1. The Basics of Capital Budgeting:Evaluating Cash FlowsShould webuild thisplant?By: Dr PawanGupta Indian School of Petroleum

2. Capital Budgeting: the process of planning for purchases of long-term assets.s example:Suppose our firm must decide whether topurchase a new plastic molding machinefor Rs125,000. How do we decide?s Will the machine be profitable?s Will our firm earn a high rate of returnon the investment? Indian School of Petroleum 3. Decision-making Criteria inCapital Budgeting How do we decide if a capitalinvestment project should be accepted orrejected?Indian School of Petroleum 4. Decision-making Criteria inCapital Budgetings The Ideal Evaluation Method should:a) include all cash flows that occurduring the life of the project,b) consider the time value of money,c) incorporate the required rate ofreturn on the project. Indian School of Petroleum 5. Future valueFVn = PV(1 + i) .nWhats the FV of an initial Rs 100after 3 years if i = 10%? Indian School of Petroleum 6. After 3 years:FV3 = PV(1 + i)3= Rs 100(1.10)3= Rs 133.10. Indian School of Petroleum 7. Present values Whats the PV of Rs 100 due in 3 years if i =10%?nFVn 1 PV == FVn ( i)1+ n1+ i3 1 PV = 100 1.10 = Rs 75.13. Indian School of Petroleum 8. Payback Periods The number of years needed torecover the initial cash outlay.s How long will it take for the projectto generate enough cash to pay foritself? Indian School of Petroleum 9. Payback Periods How long will it take for the project to generate enough cash to pay for itself?(500) 150 150 150 150 150 150 150150 0 123 456 78Indian School of Petroleum 10. Payback Periods How long will it take for the project to generate enough cash to pay for itself?(500) 150 150 150 150 150 150 150150 0 123 456 78 Payback period = 3.33 years.Indian School of Petroleum 11. s Is a 3.33 year payback period good?s Is it acceptable?s Firms that use this method willcompare the payback calculation tosome standard set by the firm.s If our senior management had set acut-off of 5 years for projects likeours, what would be our decision?s Accept the project. Indian School of Petroleum 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 ofreturn.s Does not consider all of the projectscash flows. Indian School of Petroleum 13. Drawbacks of Payback Period: s Does not consider all of the projects cash flows.(500) 150 150 150 150 150 (300) 0 0 0 123456 7 8Consider this cash flow stream! Indian School of Petroleum 14. Drawbacks of Payback Period: s Does not consider all of the projects cash flows.(500) 150 150 150 150 150 (300) 0 0 0 123456 7 8 This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!Indian School of Petroleum 15. Discounted Paybacks Discounts the cash flows at the firmsrequired rate of return.s Payback period is calculated usingthese discounted net cash flows.s Problems:s Cutoffs are still subjective.s Still does not examine all cash flows.Indian School of Petroleum 16. Discounted Payback (500)250250 250 250 25001 2 3 4 5DiscountedYear Cash Flow CF (14%)0-500-500.001 250 219.30Indian School of Petroleum 17. Discounted Payback (500)250250 250 250 25001 2 3 45DiscountedYear Cash Flow CF (14%)0-500-500.001 250 219.30 1 year280.70Indian School of Petroleum 18. Discounted Payback (500)250250 250 250 25001 2 3 45DiscountedYear Cash Flow CF (14%)0-500-500.001 250 219.30 1 year280.702 250 192.38Indian School of Petroleum 19. Discounted Payback (500)250250 250 250 25001 2 3 45DiscountedYear Cash Flow CF (14%)0-500-500.001 250 219.30 1 year280.702 250 192.38 2 years 88.32Indian School of Petroleum 20. Discounted Payback (500)250 250 250 250 25001 23 4 5 DiscountedYear Cash FlowCF (14%)0-500-500.001 250 219.30 1 year280.702 250 192.38 2 years 88.323 250 School of PetroleumIndian168.75 21. Discounted Payback (500)250 250 250 250 25001 23 4 5 DiscountedYear Cash FlowCF (14%)0-500-500.001 250 219.30 1 year280.702 250 192.38 2 years 88.323 250 School of PetroleumIndian168.75 .52 years 22. Discounted Payback (500)250250 250 250 2500 123 4 5 DiscountedYear Cash FlowCF (14%) The Discounted0-500 -500.00 Payback1 250219.301 year is 2.52 years 280.70280.702 250 192.38 2 years 88.323 250 School of PetroleumIndian168.75 .52 years 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. Net Present Value NPV = the total PV of the annual netcash flows - the initial outlay. Decision Rule: If NPV is positive, ACCEPT. If NPV is negative, REJECT. Indian School of Petroleum 25. NPV Examples Suppose we are considering a capitalinvestment that costs Rs276,400 and providesannual net cash flows of Rs 83,000 for fouryears and Rs116,000 at the end of the fifth year. The firms required rate of return is 15%.83,00083,000 83,000 83,000 116,000(276,400)0 1234 5 Indian School of Petroleum 26. Profitability Index n ACFtNPV = t - IO(1 + k)t=1 Indian School of Petroleum 27. Profitability Indexn ACFtNPV =t - IO (1 + k) t=1n ACFtPI = IO (1 + k) tt=1Indian School of Petroleum 28. Profitability Index Decision Rule: If PI is greater than or equalto 1, ACCEPT. If PI is less than 1, REJECT. Indian School of Petroleum 29. Internal Rate of Return (IRR)s IRR:the return on the firms invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.Indian School of Petroleum 30. Internal Rate of Return (IRR) n ACFtNPV = - IO(1 + k) tt=1 Indian School of Petroleum 31. Internal Rate of Return (IRR) n ACFtNPV = - IO(1 + k) t t=1n ACFtIRR: t=1 (1 + IRR) t= IO Indian School of Petroleum 32. Internal Rate of Return (IRR)n ACFtIRR:t=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. Calculating IRRs Looking again at our problem:s The IRR is the discount rate thatmakes the PV of the projected cashflows equal to the initial outlay.83,00083,00083,000 83,000 116,000(276,400)01234 5Indian School of Petroleum 34. 83,000 83,000 83,000 83,000 116,000(276,400) 0 123 4 5s This is what we are actually doing:83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR)= 276,400Indian School of Petroleum 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 trialand error. Indian School of Petroleum 36. IRR Decision Rule: If IRR is greater than or equalto the required rate of return,ACCEPT. If IRR is less than the requiredrate of return, REJECT.Indian School of Petroleum 37. Capital Rationings Capital rationing occurs when a companychooses not to fund all positive NPV projects.s The company typically sets an upper limit onthe total amount of capital expenditures that itwill make in the upcoming year. Indian School of Petroleum 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. Reason: Companies dont 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. Reason: Companies believe that the projectsmanagers 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. ThanksIndian School of Petroleum