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Capital Budgeting and Cash Flows
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Transcript of Capital Budgeting and Cash Flows
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PROJECT APPRAISAL CRITERIA
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CAPITAL EXPENDITURES AND THEIR
IMPORTANCE
The basic characteristics of a capital expenditure (also
referred to as a capital investment or just project) is that
it involves a current outlay (or current and futureoutlays) of funds in the receiving a stream of benefits infuture
Importance stems from
Long-term consequences
Substantial outlays
Difficulty in reversing
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PROCESS
Identification of Potential Investment Opportunities
Assembling of Investment Proposals
Decision Making
Preparation of Capital Budget and Appropriations
Implementation
Performance Review
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PROJECT CLASSIFICATION
Mandatory Investments
Replacement Projects
Expansion Projects
Diversification Projects
Research and Development Projects
Miscellaneous Projects
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INVESTMENT CRITERIA
INVESTMENT
CRITERIA
DISCOUNTING
CRITERIA
NON-DISCOUNTING
CRITERIA
NET
PRESENTVALUE
BENEFIT
COSTRATIO
INTERNAL
RATE OFRETURN
PAYBACK
PERIODACCOUNTING
RATE OFRETURN
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PAYBACK PERIOD
Payback period is the length of time required to recover the initial
outlay on the projectCapital Project
Year Cash flow Cumulative cash flow
0 -100 -100
1 34 - 66
2 32.5 -33.53 31.37 - 2.13
4 30.53 28.40
Pros Cons
Simple Fails to consider the time valueof money
Rough and ready method Ignores cash flows beyond thefor dealing with risk payback period
Emphasises earlier cash inflows
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Payback The payback period of a project is the number of
years it takes before the cumulative forecastedcash flow equals the initial outlay.
The payback rule says only accept projects thatpayback in the desired time frame.
This method is flawed, primarily because itignores later year cash flows and the the present
value of future cash flows.
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PaybackExample
Examine the three projects and note the mistakewe would make if we insisted on only takingprojects with a payback period of 2 years or less.
502050018002000-C
58-2018005002000-B
2,624350005005002000-A
10%@NPVPeriod
PaybackCCCCProject 3210
+
+
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NET PRESENT VALUE
n CtNPV = Initial investment
t=1 (1 +rt )t
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NET PRESENT VALUE
The net present value of a project is the sum of the present value of all the cash
flows associated with it. The cash flows are discounted at an appropriate discount
rate (cost of capital)
Capital Project
Year Cash flow Discount factor (15%) Presentvalue
0 -100.00 1.000 -100.00
1 34.00 0.870 29.58
2 32.50 0.756 24.57
3 31.37 0.658 20.64
4 30.53 0.572 17.46
5 79.90 0.497 39.71
Sum = 31.96
Pros Cons
Reflects the time value of money Is an absolute measure and not a relative
Considers the cash flow in its entirely measure
Squares with the objective of wealth maximisation
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NPV
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PROPERTIES OF THE NPV RULE
NPVs ARE ADDITIVE
INTERMEDIATE CASH FLOWS ARE INVESTED AT
COST OF CAPITAL
NPV CALCULATION PERMITS TIME-VARYINGDISCOUNT RATES
NPV OF A SIMPLE PROJECT AS THE DISCOUNT
RATE
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BENEFIT COST RATIO
PVB
Benefit-cost Ratio :BCR =
I
PVB = present value of benefits
I = initial investment
To illustrate the calculation of these measures, let us consider a project which is being evaluatedby a firm that has a cost of capital of 12 percent.
Initial investment : Rs 100,000
Benefits: Year 1 25,000
Year 2 40,000Year 3 40,000
Year 4 50,000
The benefit cost ratio measures for this project are:
25,000 40,000 40,000 50,000
(1.12) (1.12)2 (1.12)3 (1.12)4
BCR = = 1.145
100,000
Pros Cons
Measures benefit per buck Provides no means for aggregation
+ + +
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Discount rate
Net Present Value
INTERNAL RATE OF RETURN
The internal rate of return (IRR) of a project is the discount rate that
makes its NPV equal to zero. It is represented by the point of intersectionin the above diagram
Net Present Value Internal Rate of Return
Assumes that the Assumes that the netdiscount rate (cost present value is zero
of capital) is known.
Calculates the net Figures out the discount rate
present value, given that makes net present value zero
the discount rate.
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IRR
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NPV & IRR
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PROBLEMS WITH IRR
NON-CONVENTIONAL CASH FLOWS
MUTUALLY EXCLUSIVE PROJECTS
LENDING VS. BORROWING
DIFFERENCES BETWEEN SHORT-TERM AND
LONG-TERM INTEREST RATES
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Internal Rate of ReturnPitfall 1 - Lending or Borrowing? With some cash flows the NPV of the project increases
s the discount rate increases. This is contrary to the normal relationship between NPV
and discount rates.
364%50500,1000,1364%50500,1000,1
%10@Project 10
++
+++
B
A
NPVIRRCC
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Internal Rate of ReturnPitfall 2 - Multiple Rates of Return Certain cash flows can generate NPV=0 at two different discount rates.
The following cash flow generates NPV= 0 at both IRR% of (-44%)and +11.6%.
600
NPV
300
0
-30
-600
Discount
Rate
IRR=11.6%
IRR=-44%
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IRR
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Internal Rate of Return
Pitfall 2 - Multiple Rates of Return
It is possible to have a zero IRR and a positive NPV
339500,2000,3000,1
%10@Project 210
++++ NoneC
NPVIRRCCC
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Internal Rate of ReturnPitfall 3 - Mutually Exclusive Projects
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Profitability Index When resources are limited, the profitability
index (PI) provides a tool for selecting amongvarious project combinations and alternatives
A set of limited resources and projects can yieldvarious combinations.
The highest weighted average PI can indicatewhich projects to select.
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Profitability Index
Investment
NPVIndexityProfitabil =
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Profitability Index
121555
1620552153010
%10@Project 210
++
++
++
C
BA
NPVCCC
121555
1620552153010
%10@Project 210
++
++
++
C
BA
NPVCCC
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Profitability Index
2.4125C
3.2165B2.12110A
IndexityProfitabil($)NPV($)InvestmentProject
2.4125C
3.2165B2.12110A
IndexityProfitabil($)NPV($)InvestmentProject
Cash Flows ($ millions)
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Profitability IndexProj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13C 177,600 160,000 1.11
D 162,000 150,000 1.08
Select projects with highest Weighted AvgPI
WAPI (BD) = 1.13(125) + 1.08(150) + 0.0 (25)(300) (300) (300)
= 1.01
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Profitability IndexProj NPV Investment PI
A 230,000 200,000 1.15
B 141,250 125,000 1.13C 177,600 160,000 1.11
D 162,000 150,000 1.08
Select projects with highest Weighted AvgPI
WAPI (BD) = 1.01WAPI (A) = 0.77
WAPI (BC) = 1.06
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Multi Period
121555
162055
2153010
%10@Project 210
++
++
++
C
B
A
NPVCCC
121555
162055
2153010
%10@Project 210
++
++
++
C
B
A
NPVCCC
4.0
136040%10@Project 210
PI
D
NPVCCC
+
4.0
136040%10@Project 210
PI
D
NPVCCC
+
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Linear Programming Maximize Cash flows or NPV
Minimize costs
Example
Max NPV = 21Xn + 16 Xb + 12 Xc + 13 Xdsubject to
10Xa + 5Xb + 5Xc + 0Xd
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INVESTMENT APPRAISAL
IN PRACTICE
Over time, discounted cash flow methods have gained in
importance and internal rate of return is the mostpopular evaluation method.
Firms typically use multiple evaluation methods.
Accounting rate of return and payback period are
widely employed as supplementary evaluation methods.
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CFO Decision Tools
Profitability
Index, 12%
Payback, 57%
IRR, 76%
NPV, 75%
Book rate of
return, 20%
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
Survey Data on CFO Use of Investment Evaluation Techniques
SOURCE: Graham and Harvey, The Theory and Practice of Finance: Evidence from the Field,
Journal of Financial Economics
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Be consistent in how you handle inflation!!Use nominal interest rates to discount
nominal cash flows.
Use real interest rates to discount real cash
flows.
You will get the same results, whether youuse nominal or real figures
InflationINFLATION RULE
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InflationExample
You own a lease that will cost you 8,000 nextyear, increasing at 3% a year (the forecastedinflation rate) for 3 additional years (4 years
total). If discount rates are 10% what is thepresent value cost of the lease?
1 + real interest rate = 1+nominal interest rate1+inflation rate
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InflationExample - nominal figures
Year Cash Flow PV @ 10%1 8000
2 8000x1.03 = 82408000x1.03 = 8240
8000x1.03 = 8487.20
80001.10
2
3
=
=
=
=
7272 73
6809 923 6376 56
4 5970 78429 99
8240
1 10
8487 20
1 10
8741 82
1 10
2
3
4
.
..
.$26, .
.
.
.
.
.
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InflationExample - real figures
Year Cash Flow [email protected]%1 = 7766.99
2 = 7766.99= 7766.99
= 7766.99
80001.03
7766.991.068
8240
1.03
8487.20
1.03
8741.82
1.03
2
3
4
=
=
=
=
7272 73
6809 923 637656
4 5970 7826 429 99
7766 99
1 068
7766 99
1 068
7766 99
1 068
2
3
4
.
.
.
.
.
.
.
.
.
.
= $ , .
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Equivalent Annual CostEquivalent Annual Cost - The cost per
period with the same present value as thecost of buying and operating a machine.
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Equivalent Annual CostEquivalent Annual Cost - The cost per
period with the same present value as thecost of buying and operating a machine.
Equivalent annual cost =present value of costs
annuity factor
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Example
Given the following costs of operating two
machines and a 6% cost of capital, select thelower cost machine using equivalent annual cost
method.
Year
Machine 1 2 3 4 PV@6% EAC
A 15 5 5 5 28.37 10.61
B 10 6 6 21.00 11.45
Equivalent Annual Cost
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Timing Even projects with positive NPV may be
more valuable if deferred. The actual NPV is then the current value
of some future value of the deferredproject.
tr
t
)1(
dateofasvaluefutureNet
NPVCurrent +=
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TimingExample
You may harvest a set of trees at anytime overthe next 5 years. Given the FV of delaying the
harvest, which harvest date maximizes current
NPV?
9.411.915.420.328.8in valuechange%109.410089.477.564.450(1000s)FVNet
543210
YearHarvest
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TimingExample - continued
You may harvest a set of trees at anytime over the next 5 years.Given the FV of delaying the harvest, which harvest date maximizescurrent NPV?
5.581.10
64.41yearinharvestedif ==NPV
67.968.367.264.058.550(1000s)NPV
543210
YearHarvest
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Fluctuating Load Factors
$30,00015,0002machinestwoofcostoperatingPV
$15,0001,500/.10pachinepercostoperatingPV$1,5007502machinepercostOperating
units750machineperoutputAnnual
MachinesOldTwo
=
=
=
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Fluctuating Load Factors
$27,000500,132machinestwoofcostoperatingPV
$13,500750/.106,000pachinepercostoperatingPV
$7507501machinepercostOperating
000,6$machinepercostCapital
units750machineperoutputAnnual
MachinesNewTwo
=
=+
=
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Fluctuating Load Factors
000,26..$..............................machinestwoofcostoperatingPV
$16,000.10/000,16,000$10,000,000/.101machinepercostoperatingPV
$1,000000,11$1,0005002machinepercostOperating
000,6$0machinepercostCapital
units1,000units500machineperoutputAnnual
MachineNewOneMachineOldOne
=+=
==
What To Discount
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What To Discount Cash Flows.not accounting
income/expenses
Estimate Cash Flows on an Incremental
BasisDo not confuse average with incremental
payoffs
Beware of allocated overhead costsInclude all incidental effects
Do not forget working capital requirements
Include opportunity costs
Forget sunk costs
Treat inflation consistently
Post Tax