Captial Budgeting Advanced

8/6/2019 Captial Budgeting Advanced

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CAPITAL BUDGETINGCAPITAL BUDGETING


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Meaning of Capital BudgetingMeaning of Capital Budgeting

SignificanceSignificance

Capital Budgeting processCapital Budgeting process

Project classification and Investment CriteriaProject classification and Investment Criteria --

Payback methodPayback method

ARR MethodARR Method

Net Present ValueNet Present Value

IRR MethodIRR Method

Profitability Index.Profitability Index.


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Introduction:Introduction:OneOne ofof thethe aspectaspect ofof financialfinancial managementmanagement isis investmentinvestment..

InvestmentInvestment meansmeans expenditureexpenditure inin cashcash oror itsits equivalentequivalent duringduring oneone oror moremore timetime

periodsperiods inin anticipationanticipation ofof enjoyingenjoying aa netnet inflowinflow ofof cashcash oror itsits equivalentequivalent inin somesome futurefuture

timetime periodsperiods..

AppraisalAppraisal ofof InvestmentInvestment isis essentialessential toto knowknow thatthat thethe investmentsinvestments willwill bringbring benefitsbenefits orornotnot..

InvestmentInvestment DecisionDecision:: InvestmentInvestment ProposalProposal

thesethese areare thethe termsterms associatedassociated withwith longlong termterm resourcesresources oror assetsassets

ProposalsProposals involvinginvolving investmentinvestment ofof fundsfunds forfor aa periodperiod ofof tenten oror moremore willwill fallfall inin thethe

categorycategory ofof investmentinvestment.. (( nono hardhard andand fastfast rules)rules)..

LongLong termterm decisionsdecisions regardingregarding planningplanning andand developmentdevelopment ofof availableavailable financialfinancial

resourcesresources forfor wealthwealth maximizationmaximization


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Why Investments are necessary ?Why Investments are necessary ?

Expansion of the business.Expansion of the business.

Diversification of the businessDiversification of the business

Replacement of the Assets/ TechnologyReplacement of the Assets/ Technology Research and DevelopmentResearch and Development


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Capital ExpenditureCapital Expenditure: Expenditure for: Expenditure for

longer period of time involving high risk.longer period of time involving high risk.

the benefit of these expenditure is spreadthe benefit of these expenditure is spreadover number of years.over number of years.

Right of PreRight of Pre--emptive: The right of theemptive: The right of theequity share holders to receive the newequity share holders to receive the new

issue on proissue on pro--rata basisrata basis


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Capital BudgetingCapital Budgeting:: the process ofthe process of

planning for purchases of longplanning for purchases of long--

term assets.term assets.

exampleexample::

Suppose our firm must decide whether toSuppose our firm must decide whether topurchase a new plastic molding machinepurchase a new plastic molding machine

for Rs 2,500,000. How do we decide?for Rs 2,500,000. How do we decide?

Will the machine be profitable?Will the machine be profitable?

Will our firm earn a high rate of returnWill our firm earn a high rate of return

on the investment?on the investment?


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DecisionDecision--making Criteria inmaking Criteria in

Capital BudgetingCapital Budgeting

How do we decide if a capitalHow do we decide if a capital

investment project should beinvestment project should be

accepted or rejected?accepted or rejected?


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The Ideal Evaluation Method should:The Ideal Evaluation Method should:

a) includea) include all cash flowsall cash flows that occurthat occur

during the life of the project,during the life of the project,

b) consider theb) consider the time value of moneytime value of money,,c) incorporate thec) incorporate the required rate ofrequired rate of

returnreturn on the project.on the project.

DecisionDecision--making Criteria inmaking Criteria in



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Capital budgeting consists in planningCapital budgeting consists in planning

development of available capital for the purpose ofdevelopment of available capital for the purpose ofmaximizing the long term profitability of themaximizing the long term profitability of the

concernconcern LynchLynch

The main features of capital budgeting areThe main features of capital budgeting area. potentially large anticipated benefitsa. potentially large anticipated benefits

b. a relatively high degree of riskb. a relatively high degree of risk

c. relatively long time period between the initialc. relatively long time period between the initialoutlay and the anticipated return.outlay and the anticipated return.

-- OsterOster YoungYoung


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Meaning of Capital Budgeting:Meaning of Capital Budgeting: Planning for capital assetsPlanning for capital assets

Capital budgeting decisionCapital budgeting decision means deciding whether or not the investment ismeans deciding whether or not the investment isto be made.to be made.

Capital budgeting is the processCapital budgeting is the process of allocating funds for longof allocating funds for long--term investmentterm investmentprojects or proposals,projects or proposals,

Importance of Capital Budgeting:Importance of Capital Budgeting:

Includes huge amount therefore necessary to consider to generate profits.Includes huge amount therefore necessary to consider to generate profits.

Relating to future period therefore affects the growthRelating to future period therefore affects the growth

Once taken difficult to reverseOnce taken difficult to reverse

Complex decisionsComplex decisions Helps for long term financial planningHelps for long term financial planning

Helps of proper replacement and researchHelps of proper replacement and research

Helps to control capital expendituresHelps to control capital expenditures


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ON THE BASIS OFON THE BASIS OF

FIRMSS EXISTENCEFIRMSS EXISTENCE

Replacement andReplacement and

Modernization Decision.Modernization Decision.

(aim is to improve operating(aim is to improve operating

efficiency)efficiency)

Expansion DecisionExpansion Decision

( existing successful firms)( existing successful firms)

Diversification DecisionDiversification Decision

DECISION SITUATIONDECISION SITUATION

Mutually ExclusiveMutually Exclusive

Decision(one taken otherDecision(one taken other

will be excluded).will be excluded).

Accept or Reject Decision.(Accept or Reject Decision.(

when proposals arewhen proposals areindependent and do notindependent and do not

compete with each other).compete with each other).

Contingent DecisionContingent Decision

(depending upon other)(depending upon other)If want start a factory u have toIf want start a factory u have to

build infra ( in remote area)build infra ( in remote area)

TYPES OF CAPITAL INVESTMENT DECISIONSTYPES OF CAPITAL INVESTMENT DECISIONS


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Capital Budgeting ProcessCapital Budgeting Process Examine the various steeps involved inExamine the various steeps involved in


Project Generation ( investment generationProject Generation ( investment generation

for the project)for the project) Project Evaluation( evaluation ofProject Evaluation( evaluation of

alternatives).alternatives).

Project Selection (Best)Project Selection (Best) Project Execution ( implementation)Project Execution ( implementation)

FollowFollow--up of the Project( assessment ofup of the Project( assessment of

subsequent results)subsequent results)


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Capital budgeting process involves the followingCapital budgeting process involves the following

11.. ProjectProject generationgeneration:: GeneratingGenerating thethe proposalsproposals forfor investmentinvestment

isis thethe firstfirst stepstep..TheThe investmentinvestment proposalproposal maymay fallfall intointo oneone of of thethe followingfollowing

categoriescategories::

ProposalsProposals toto addadd newnew productproduct toto thethe productproduct line,line,

proposalsproposals toto expandexpand productionproduction capacitycapacity inin existingexisting lineslines

proposalsproposals toto reducereduce thethe costscosts ofof thethe outputoutput ofof thethe existingexisting

productsproducts withoutwithout alteringaltering thethe scalescale ofof operationoperation..

SalesSales campaining,campaining, tradetrade fairsfairs peoplepeople inin thethe industry,industry, RR andand DD

institutes,institutes, conferencesconferences andand seminarsseminars willwill offeroffer widewide varietyvariety ofof

innovationsinnovations onon capitalcapital assetsassets forfor investmentinvestment..


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2.2. Project EvaluationProject Evaluation: it involves two steps: it involves two steps

Estimation of benefits and costs: the benefits and costsEstimation of benefits and costs: the benefits and costs

are measured in terms of cash flows. The estimation ofare measured in terms of cash flows. The estimation ofthe cash inflows and cash outflows mainly depends onthe cash inflows and cash outflows mainly depends on

future uncertainities. The risk associated with eachfuture uncertainities. The risk associated with each

project must be carefully analysed and sufficeintproject must be carefully analysed and sufficeint

provision must be made for covering the differentprovision must be made for covering the differenttypes of risks.types of risks.

Selection of an appropriate criteria to judge theSelection of an appropriate criteria to judge the

desirability of the project: It must be consistent withdesirability of the project: It must be consistent with

the firms objective of maximising its market value.the firms objective of maximising its market value.

The technique of time value of money may come as aThe technique of time value of money may come as a

handy tool in evaluation such proposals.handy tool in evaluation such proposals.


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3.3. ProjectProject SelectionSelection:: NoNo standardstandard administrativeadministrativeprocedureprocedure cancan bebe laidlaid downdown for for approvingapproving thetheinvestmentinvestment proposalproposal.. TheThe screeningscreening andand selectionselectionproceduresprocedures areare differentdifferent fromfrom firmfirm toto firmfirm..

4.4. ProjectProject EvaluationEvaluation:: OnceOnce thethe proposalproposal forfor capitalcapitalexpenditureexpenditure isis finalised,finalised, itit isis thethe dutyduty ofof thethe financefinancemanagermanager toto exploreexplore thethe differentdifferent alternativesalternatives availableavailableforfor acquiringacquiring thethe fundsfunds.. HeHe hashas toto prepareprepare capitalcapitalbudgetbudget.. SufficientSufficient carecare mustmust bebe takentaken toto reducereduce thetheaverageaverage costcost ofof fundsfunds.. HeHe hashas toto prepareprepare periodicalperiodicalreportsreports andand mustmust seekseek priorprior permissionpermission fromfrom thethe toptop

managementmanagement.. SystematicSystematic procedureprocedure shouldshould bebedevelopeddeveloped toto reviewreview thethe performanceperformance ofof projectsprojects duringduringtheirtheir lifetimelifetime andand afterafter completioncompletion..


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TheThe followfollow up,up, comparisoncomparison ofof actualactual performanceperformance withwith

originaloriginal estimatesestimates notnot onlyonly ensuresensures betterbetter forecastingforecasting

butbut alsoalso helpshelps inin sharpeningsharpening thethe techniquestechniques forforimprovingimproving futurefuture forecastsforecasts..


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MMention the factors influencing theention the factors influencing the

capital budgetingcapital budgeting


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Availability of Funds:Availability of Funds:

Company has 3 projects which require 3Company has 3 projects which require 3

Rs 50,000, 1,00,000 and 25,000Rs 50,000, 1,00,000 and 25,000

The company has Rs 75,000 to invest.The company has Rs 75,000 to invest. Working Capital Requirements:Working Capital Requirements: Starting of new project may requireStarting of new project may require

modification in working capital requirements.modification in working capital requirements.

Immediate need of the projectImmediate need of the project : Even if the projects may not earn: Even if the projects may not earn

immediately some of them need to be implemented urgently.immediately some of them need to be implemented urgently.

CuttCutt-- Off Rate:Off Rate: if estimated Return is < Cutt off Rateif estimated Return is < Cutt off Rate-------- Reject theReject theprojectproject

Capital returnCapital return : How much time it takes to return the investments: How much time it takes to return the investments

Taxation policyTaxation policy : Liberal: Liberal helps for easy recovery of investmenthelps for easy recovery of investment Structure of capitalStructure of capital : Leveraged helps to earn more however risk is more: Leveraged helps to earn more however risk is more

Lending policies of financial institutions:Lending policies of financial institutions: Lending rate, surety etc playLending rate, surety etc playrolerole

Government policyGovernment policy: Economic policy: Economic policy------ Direct impact on investmentDirect impact on investmentdecisions.decisions.


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Capital Investment ProposalsCapital Investment Proposals

Independent Proposals: do not compete withIndependent Proposals: do not compete with

another in a way of acceptance . Straightanother in a way of acceptance . Straight

way accepted or rejected directly by theway accepted or rejected directly by the

firm.firm.

Dependent or Contingent: acceptanceDependent or Contingent: acceptance

dependence on another proposal.dependence on another proposal.

Mutually Exclusive Proposals.Mutually Exclusive Proposals.


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Techniques of Evaluating Investment ProposalsTechniques of Evaluating Investment Proposals

Capital Budgeting Appraisal TechniquesCapital Budgeting Appraisal Techniques

What are the techniques of evaluation ofWhat are the techniques of evaluation ofinvestment? Discussinvestment? Discuss

Number of ProposalsNumber of Proposals

Which is to be selectedWhich is to be selected

Number of factorsNumber of factors------ returnsreturns timetime----

benefitsbenefits------ safetysafety------ riskrisk

Finance Manger is responsible to take theFinance Manger is responsible to take the

decision of selectiondecision of selection


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Methods of AppraisalMethods of Appraisal

Traditional Methods:Traditional Methods:

Pay Back PeriodPay Back Period

Accounting Rate of Return ( Return onAccounting Rate of Return ( Return on

Investment)Investment)

Discounted Cash Flow MethodsDiscounted Cash Flow Methods

Net Present Value MethodNet Present Value Method

Internal Rate of Return MethodInternal Rate of Return Method

Profitability Index Method.Profitability Index Method.


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Pay back period methodPay back period method

It refers to the period in which the project will generate theIt refers to the period in which the project will generate the

necessary cash to recover the initial investment.necessary cash to recover the initial investment.It does not take the effect of time value of money.It does not take the effect of time value of money.

It emphasizes more on annual cash inflows, economic lifeIt emphasizes more on annual cash inflows, economic life

of the project and original investment.of the project and original investment.

The selection of the project is based on the earning capacityThe selection of the project is based on the earning capacity

of a project.of a project.

It involves simple calculation, selection or rejection of theIt involves simple calculation, selection or rejection of the

project can be made easily, results obtained is moreproject can be made easily, results obtained is morereliable, best method for evaluating high risk projects.reliable, best method for evaluating high risk projects.


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Cons/ DemeritsCons/ Demerits

It is based on principle of rule of thumb,It is based on principle of rule of thumb,

Does not recognize importance of time value ofDoes not recognize importance of time value of

money,money,

Does not consider profitability of the project,Does not consider profitability of the project,

Does not recognize income beyond pay backDoes not recognize income beyond pay back

period.period.

Does not reflect all the relevant dimensions ofDoes not reflect all the relevant dimensions of

profitability.profitability.


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Payback PeriodPayback Period

The number of years needed to recoverThe number of years needed to recover

the initial cash outlay.the initial cash outlay.

How long will it take for the project toHow long will it take for the project to

generate enough cash to pay for itself?generate enough cash to pay for itself?

PB = InitialPB = Initial cashoutlaycashoutlay

Annual Cash InflowsAnnual Cash Inflows


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How long will it take for the project toHow long will it take for the project to

generate enough cash to pay for itself?generate enough cash to pay for itself?

( CASH INFLOW is UNIFORM)( CASH INFLOW is UNIFORM)

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150


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PBP =PBP = Initial cash outlayInitial cash outlay

Annual Cash InflowsAnnual Cash Inflows

= 500/150= 3.33years= 500/150= 3.33years


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How long will it take for the projectHow long will it take for the project

to generate enough cash to pay forto generate enough cash to pay for

itself?itself?

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150

Payback period = 3.33 years.Payback period = 3.33 years.


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Is a 3.33 year payback period good?Is a 3.33 year payback period good?

Is it acceptable?Is it acceptable?Firms that use this method willFirms that use this method will

compare the payback calculation tocompare the payback calculation to

some standard set by the firm.some standard set by the firm. If our senior management had set aIf our senior management had set a

cutcut--off of 5 years for projects likeoff of 5 years for projects like

ours, what would be our decision?ours, what would be our decision?

Accept the projectAccept the project..


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Drawbacks of Payback Period:Drawbacks of Payback Period:

Firm cutoffs areFirm cutoffs are subjectivesubjective..

Does not considerDoes not consider time value of moneytime value of money..

Does not consider anyDoes not consider any required rate ofrequired rate ofreturnreturn..

Does not consider all of the projectsDoes not consider all of the projects

cash flowscash flows..


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cash flows.cash flows.

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0

Consider this cash flow stream!


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cash flows.cash flows.

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0

This project is clearly unprofitable, but we

would accept it based on a 4-year payback

criterion!


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Discounted PaybackDiscounted Payback

Discounts the cash flows at the firmsDiscounts the cash flows at the firms

required rate of return.required rate of return.

Payback period is calculated usingPayback period is calculated usingthese discounted net cash flows.these discounted net cash flows.

ProblemsProblems::

Cutoffs are still subjective.Cutoffs are still subjective.

Still does not examine all cash flows.Still does not examine all cash flows.


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250

DiscountedDiscounted

YearYear Cash FlowCash Flow CF (14%)CF (14%)

00 --500500 --500.00500.00

11 250250 219.30219.30


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.70


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.7022 250250 192.38192.38


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.7022 250250 192.38192.38 2 years2 years

88.3288.32


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.7022 250250 192.38192.38 2 years2 years

88.3288.32

33250250 168.75168.75


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.7022 250250 192.38192.38 2 years2 years

88.3288.32

33250250 168.75168.75 .52 years.52 years


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.7022 250250 192.38192.38 2 years2 years

88.3288.32

33250250 168.75168.75 .52 years.52 years

The DiscountedThe Discounted

PaybackPayback

isis 2.522.52 yearsyears


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Discounted PBP=Discounted PBP=

year of Max recovery + Balance to be recoveredyear of Max recovery + Balance to be recovered

Discounted Cash inflow of the year of Last recoveryDiscounted Cash inflow of the year of Last recovery


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Accounting Rate of Return method/ AverageAccounting Rate of Return method/ Average

Rate of Return MethodRate of Return Method

What is accounting rate of return? Briefly explainWhat is accounting rate of return? Briefly explainits limitations :its limitations :

Accounting ROR means the average annual yieldAccounting ROR means the average annual yield

on the project. Profit after tax and depreciation ason the project. Profit after tax and depreciation asa percentage to the total investment is considered.a percentage to the total investment is considered.

.. ConsidersConsiders thethe earningsearnings ofof thethe projectproject ofof thethe economiceconomic lifelife..

BasedBased onon conventionalconventional accountingaccounting conceptsconcepts..

ThisThis methodmethod hashas beenbeen introducedintroduced toto overcomeovercome thethe disadvantagedisadvantage ofof

paypay backback periodperiod....


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This method of ARR is not commonlyThis method of ARR is not commonly

accepted in assessing the profitability ofaccepted in assessing the profitability ofcapital expenditure. Because the methodcapital expenditure. Because the method

does to consider the heavy cash inflowdoes to consider the heavy cash inflow

during the project period as the earningsduring the project period as the earnings

with be averaged.with be averaged.

The cash flow advantage derived byThe cash flow advantage derived by

adopting different kinds of depreciation isadopting different kinds of depreciation is

also not considered in this method.also not considered in this method.


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AcceptAccept oror RejectReject CriterionCriterion:: UnderUnder thethe method,method, allall project,project, havinghaving

AccountingAccounting RateRate of of returnreturn higherhigher thanthan thethe minimumminimum raterate

establishmentestablishment byby managementmanagement willwill bebe consideredconsidered andand thosethose havinghavingARRARR lessless thanthan thethe prepre--determineddetermined raterate.. ThisThis methodmethod ranksranks aa

ProjectProject asas numbernumber one,one, ifif itit hashas highesthighest ARR,ARR, andand lowestlowest rankrank isis

assignedassigned toto thethe projectproject withwith thethe lowestlowest ARRARR..

MeritsMerits

ItIt isis veryvery simplesimple toto understandunderstand andand useuse..

ThisThis methodmethod takestakes intointo accountaccount savingsaving overover thethe entireentire economiceconomic

lifelife of of thethe projectproject.. Therefore,Therefore, itit providesprovides aa better better meansmeans of of

comparisoncomparison ofof projectproject thanthan thethe paypay backback periodperiod..

ThisThis methodmethod throughthrough thethe conceptconcept ofof "net"net earnings"earnings" ensuresensures aacompensationcompensation ofof expectedexpected profitabilityprofitability ofof thethe projectsprojects andand

ItIt cancan readilyreadily bebe calculatedcalculated byby usingusing thethe accountingaccounting datadata..


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DemeritsDemerits

1. It ignores time value of money.1. It ignores time value of money.

2. It does not consider the length of life of the projects.2. It does not consider the length of life of the projects. 3. It is not consistent with the firm's objective of maximizing the3. It is not consistent with the firm's objective of maximizing the

market value of shares.market value of shares.

4. It ignores the fact that the profits earned can be reinvested.4. It ignores the fact that the profits earned can be reinvested. --


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Give the meaning of discounted cash flow method. WhatGive the meaning of discounted cash flow method. What

are its advantages?are its advantages?

Discounted cash flow methodDiscounted cash flow methodTimeTime adjustedadjusted techniquetechnique isis anan improvementimprovement overover paypay backback methodmethod

andand ARRARR..

AnAn investmentinvestment isis essentiallyessentially outout flowflow of of fundsfunds aimingaiming atat fair fair

percentagepercentage ofof returnreturn inin futurefuture.. TheThe presencepresence ofof timetime asas aa factorfactor inin

investmentinvestment isis fundamentalfundamental forfor thethe purposepurpose of of evaluatingevaluating

investmentinvestment.. TimeTime isis aa crucialcrucial factor,factor, because,because, thethe realreal valuevalue ofof

moneymoney fluctuatesfluctuates overover aa periodperiod ofof timetime.. AA rupeerupee receivedreceived todaytoday hashas

moremore valuevalue thanthan aa rupeerupee receivedreceived tomorrowtomorrow..

InIn evaluatingevaluating investmentinvestment projectsprojects itit isis importantimportant toto considerconsider thethetimingtiming ofof returnsreturns onon investmentinvestment.. DiscountedDiscounted cashcash flowflow techniquetechnique

takestakes intointo accountaccount bothboth thethe interestinterest factorfactor andand thethe returnreturn afterafter thethe

paybackpayback 'period'period..


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Discounted Cash Flow TechniqueDiscounted Cash Flow Technique

It is based on time value of money,It is based on time value of money,

income is spread over a few yearsincome is spread over a few years

Rupee today is more important.Rupee today is more important.

Therefore future income is to be discounted.Therefore future income is to be discounted.

1.1. NPVNPV

2.2. 2. IRR2. IRR

( mention the merits of NPV and IRR)( mention the merits of NPV and IRR)


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DiscountedDiscounted cashcash flowflow techniquetechnique involvesinvolves thethe followingfollowing

stepssteps::

CalculationCalculation ofof cashcash inflowinflow andand outout flowsflows overover thethe entireentirelifelife ofof thethe assetasset..

DiscountingDiscounting thethe cashcash flowsflows byby aa discountdiscount factorfactor

AggregatingAggregating thethe discounteddiscounted cashcash inflowsinflows andand comparingcomparing

thethe totaltotal soso obtainedobtained withwith thethe discounteddiscounted outout flowsflows..


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Net present value methodNet present value method ::

Sum of the present values of all the cash inflows less theSum of the present values of all the cash inflows less the

sum of the present values of all the cash outflowssum of the present values of all the cash outflowsassociated with the proposal.associated with the proposal.

It recognizes the impact of time value of money.It recognizes the impact of time value of money.

It is considered as the best methodIt is considered as the best method

It is widely used in practice.It is widely used in practice.


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The cash inflow to be received at differentThe cash inflow to be received at different

period of time will be discounted at aperiod of time will be discounted at a

particular discount rate. The present valuesparticular discount rate. The present values

of the cash inflow are compared with theof the cash inflow are compared with the

original investment. The differenceoriginal investment. The difference

between the two will be used for accept orbetween the two will be used for accept orreject criteria. If the different yields (+)reject criteria. If the different yields (+)

positive value , the proposal is selected forpositive value , the proposal is selected for

investment. If the difference shows (investment. If the difference shows (--))negative values, it will be rejected.negative values, it will be rejected.


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ProsPros::

ItIt recognizesrecognizes thethe timetime valuevalue ofof moneymoney..

ItIt considersconsiders thethe cashcash inflowinflow ofof thethe entireentire projectproject..ItIt estimatesestimates thethe presentpresent valuevalue ofof theirtheir cashcash inflowsinflows byby usingusing

aa discountdiscount raterate equalequal toto thethe costcost ofof capitalcapital..

ItIt isis consistentconsistent withwith thethe objectiveobjective ofof maximizingmaximizing thethe

welfarewelfare ofof ownersowners..ConsCons::

ItIt isis veryvery difficultdifficult toto findfind andand understandunderstand thethe conceptconcept ofofcostcost ofof capitalcapital

ItIt maymay notnot givegive reliablereliable answersanswers whenwhen dealingdealing withwithalternativealternative projectsprojects underunder thethe conditionsconditions ofof unequalunequal liveslivesofof projectproject..


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yyNPV = the total PV of the annual netNPV = the total PV of the annual netcash flowscash flows -- the initial outlay.the initial outlay.

NPVNPV == -- IOIOCFCFtt

(1 + k)(1 + k) tt

nn

t=1t=177


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yy Decision RuleDecision Rule::

yy If NPV is positive,If NPV is positive, ACCEPTACCEPT..

yy If NPV is negative,If NPV is negative, REJECTREJECT..


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NPV ExampleNPV Example

Suppose we are considering a capitalSuppose we are considering a capitalinvestment that costs Rs 56,000 and providesinvestment that costs Rs 56,000 and provides

annual net cash flows of Rs.4,000, Rs 16,000 ,annual net cash flows of Rs.4,000, Rs 16,000 ,

Rs 18,000, Rs 20,000 and Rs 25,000 in 1Rs 18,000, Rs 20,000 and Rs 25,000 in 1stst , 2, 2ndnd,,

33rdrd, 4, 4thth and 5and 5thth year. The firms cost of capitalyear. The firms cost of capital

is 10%.Determine whether firm should acceptis 10%.Determine whether firm should accept

the proposal or not?the proposal or not?


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NPV CalculationNPV Calculation

YearYear AnnualAnnual

Cash FlowCash Flow

PV FactorPV Factor PV of CashPV of Cash

FlowsFlows

11 4,0004,000 0.9090.909 3,6363,636

22 16,00016,000 0.8260.826 1321613216

33 18,00018,000 0.7510.751 1351813518

44 20,00020,000 0.6830.683 1366013660

55 25,00025,000 0.6210.621 1552515525

TotalTotal 83,00083,000 68,64568,645

LessLess Initial InvestmentInitial Investment 56,00056,000


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NPV CALCULATION:NPV CALCULATION:

yyNPV = the total PV of the annual netNPV = the total PV of the annual netcash flowscash flows -- the initial outlay.the initial outlay.


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Internal Rate of ReturnInternal Rate of Return

It is that rate at which the sum of discounted cashIt is that rate at which the sum of discounted cash

inflows equals the sum of discounted cashinflows equals the sum of discounted cash

outflows for the proposal. It is the rate at whichoutflows for the proposal. It is the rate at which

the net present value of the investment is zero.the net present value of the investment is zero.

It is the rate of discount which reduces the NPV ofIt is the rate of discount which reduces the NPV ofan investment to zero. It is called internal ratean investment to zero. It is called internal rate

because it depends mainly on the outlay andbecause it depends mainly on the outlay and

proceeds associated with the project and not onproceeds associated with the project and not onany rate determined outside the investment.any rate determined outside the investment.


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MeritsMerits ofof IRRIRR methodmethod

ItIt considerconsider thethe timetime valuevalue ofof moneymoney

CalculationCalculation ofof casotcasot of of capitalcapital isis notnot aaprerequisiteprerequisite forfor adoptingadopting IRRIRR

IRRIRR attemptsattempts toto findfind thethe maximummaximum raterate ofof interestinterestatat whichwhich fundsfunds investedinvested inin thethe projectproject couldcould beberepaidrepaid outout of of thethe cashcash inflowsinflows arisingarising fromfrom thetheprojectproject..

ItIt isis notnot inin conflictconflict withwith thethe conceptconcept of of

maximisingmaximising thethe welfarewelfare of of thethe equityequityshareholdersshareholders..

ItIt considersconsiders cashcash inflowsinflows throughoutthroughout thethe lifelife ofofthethe projectproject..


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ConsCons

Computation of IRR is tedious and difficult toComputation of IRR is tedious and difficult to

understandunderstand

Both NPV and IRR assume that the cash inflowsBoth NPV and IRR assume that the cash inflows

can be reinvested at the discounting rate in thecan be reinvested at the discounting rate in the

new projects. However, reinvestment of funds atnew projects. However, reinvestment of funds atthe cut off rate is more appropriate than at thethe cut off rate is more appropriate than at the

IRR.IRR.

IT may give results inconsistent with NPVIT may give results inconsistent with NPVmethod. This is especially true in case ofmethod. This is especially true in case of

mutually exclusive project.mutually exclusive project.


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Step 1:Calculation of cash outflowStep 1:Calculation of cash outflow

Cost of project/assetCost of project/asset xxxxxxxx

Transportation/installation chargesTransportation/installation charges xxxxxxxx

Working capitalWorking capital xxxxxxxxCash outflowCash outflow xxxxxxxx


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Step 2: Calculation of cash inflowStep 2: Calculation of cash inflow

SalesSales xxxxxxxx

Less: Cash expensesLess: Cash expenses xxxxxxxx

PBDTPBDT xxxxxxxx

Less: DepreciationLess: Depreciation xxxxxxxx

PBTPBT xxxxxxxx

less: Taxless: Tax xxxxxxxx

PATPAT xxxxxxxx

Add: DepreciationAdd: Depreciation xxxxxxxx

Cash inflow p.aCash inflow p.a xxxxxxxx


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Note:Note:

Depreciation = St.Line methodDepreciation = St.Line method

PBDTPBDT Tax is Cash inflow ( if the tax amount isTax is Cash inflow ( if the tax amount is

given)given)

PATBD = Cash inflowPATBD = Cash inflow

Cash inflowCash inflow-- Scrap and working capital must beScrap and working capital must be

added.added.


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Step 3: Apply the different techniquesStep 3: Apply the different techniques

Pay back period= No. of years + Amt to recover/ totalPay back period= No. of years + Amt to recover/ total

cash of next years.cash of next years. ARR = Average Profits after tax/ Net investment x 100ARR = Average Profits after tax/ Net investment x 100

NPV= PV of cash inflowsNPV= PV of cash inflows PV of cash outflowsPV of cash outflows

Profitability index = PV of cash inflows/ PV of cashProfitability index = PV of cash inflows/ PV of cash

outflowsoutflows IRR :IRR :

Pay back factor: Cash outflow/ Avg cash inflow p.a.Pay back factor: Cash outflow/ Avg cash inflow p.a.

Find IRR rangeFind IRR range

PV of Cash inflows for IRR range and then calculate IRRPV of Cash inflows for IRR range and then calculate IRR


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Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRRIRR: the return on the firms: the return on the firms

invested capital. IRR is simplyinvested capital. IRR is simply

the rate of return that the firmthe rate of return that the firm

earns on its capital budgetingearns on its capital budgeting

projects.projects.


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NPVNPV == -- IOIOACFACFtt

(1 + k)(1 + k) tt

nn

t=1t=1

77


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n

t=177

IRR: = IOACFt

(1 + IRR) t


(1 + k)(1 + k) tt

nn

t=1t=1

77


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IRR is the rate of return that makes theIRR is the rate of return that makes the

PV of the cash flowsPV of the cash flows equalequal to the initialto the initial

outlay.outlay.

This looks very similar to our Yield toThis looks very similar to our Yield to

Maturity formula for bonds. In fact, YTMMaturity formula for bonds. In fact, YTM

isis the IRR of a bond.the IRR of a bond.

n

t=1

77IRR: = IO

ACFt

(1 + IRR) t


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Calculating IRRCalculating IRR

Looking again at our problem:Looking again at our problem:The IRR is the discount rate thatThe IRR is the discount rate that

makes the PV of the projected cashmakes the PV of the projected cash

flowsflows equalequal to the initial outlay.to the initial outlay.

0 1 2 3 4 5

(276,400)

83,000 83,000 83,000 83,000 116,000


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This is what we are actually doing:This is what we are actually doing:

83,000 (PVIFA83,000 (PVIFA 4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))

= 276,400= 276,400

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000

83 000 83 000 83 000 83 000 116 00083 000 83 000 83 000 83 000 116 000


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This is what we are actually doing:This is what we are actually doing:

83,000 (PVIFA83,000 (PVIFA 4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))

= 276,400= 276,400

This way, we have to solve for IRR by trialThis way, we have to solve for IRR by trial

and error.and error.

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000


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IRR with your CalculatorIRR with your Calculator

IRR is easy to find with yourIRR is easy to find with your

financial calculator.financial calculator.

Just enter the cash flows as you didJust enter the cash flows as you did

with the NPV problem and solve forwith the NPV problem and solve for

IRR.IRR.

You should getYou should get IRR = 17.63%!IRR = 17.63%!


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IRRIRR


yy If IRR is greater than or equalIf IRR is greater than or equalto the required rate of return,to the required rate of return,ACCEPTACCEPT..

yy If IRR is less than the requiredIf IRR is less than the requiredrate of return,rate of return, REJECTREJECT..

IRR is a good decisionIRR is a good decision makingmaking


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IRR is a good decisionIRR is a good decision--makingmaking

tool as long as cash flows aretool as long as cash flows are

conventionalconventional.. ((-- + + + + +)+ + + + +)

Problem: If there are multipleProblem: If there are multiple

sign changes in the cash flowsign changes in the cash flow

stream, we could get multiplestream, we could get multiple

IRRs.IRRs. ((-- + ++ + -- + +)+ +)



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IRRs.IRRs. ((-- + ++ + -- + +)+ +)

0 1 2 3 4 5

(500) 200 100 (200) 400 300



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IRRs.IRRs. ((-- + ++ + -- + +)+ +)

0 1 2 3 4 5

(500) 200 100 (200) 400 300


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IRRs.IRRs. ((-- + ++ + -- + +)+ +)

We could find 3 different IRRs!We could find 3 different IRRs!

0 1 2 3 4 5

(500) 200 100 (200) 400 300

1 2 31 2 3


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Summary Problem:Summary Problem:

Enter the cash flows only once.Enter the cash flows only once.

Find theFind the IRRIRR..

Using a discount rate of 15%, findUsing a discount rate of 15%, find NPVNPV..Add back IO and divide by IO to getAdd back IO and divide by IO to get PIPI..

0 1 2 3 4 5

(900) 300 400 400 500 600


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Summary Problem:Summary Problem:

IRR =IRR = 34.37%.34.37%.

Using a discount rate of 15%,Using a discount rate of 15%,

NPV =NPV = $510.52.$510.52.PI =PI = 1.57.1.57.

0 1 2 3 4 5

(900) 300 400 400 500 600

P fi bili I dP fi bili I d


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Profitability IndexProfitability Index


(1 + k)(1 + k) tt

nn

t=1t=1

77

P fit bilit I dP fit bilit I d


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t


(1 + k)(1 + k) tt

nn

t=1t=1

77

PI = IOACFt(1 + k)

n

t=177


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yy If PI is greater than or equalIf PI is greater than or equal

to 1,to 1, ACCEPTACCEPT..

yy If PI is less than 1,If PI is less than 1, REJECTREJECT..

P fit bilit I d M th d/ B fit C tP fit bilit I d M th d/ B fit C t


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Profitability Index Method/ Benefit CostProfitability Index Method/ Benefit Cost

Ratio Method/ Desirability FactorRatio Method/ Desirability Factor

Method for comparing the proposals eachMethod for comparing the proposals each

involving different amount of cash inflows.involving different amount of cash inflows.

PI is worked out , if index value = 1 projectPI is worked out , if index value = 1 project

is accepted otherwise rejected.is accepted otherwise rejected.


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Merits:Merits:

Uses the concept of time value.Uses the concept of time value.

Better than NPVBetter than NPV

Demerits:Demerits: Fails to as a guide in resolving capitalFails to as a guide in resolving capital

rationing.rationing.

Project with a lower profitability index mayProject with a lower profitability index maybe selected which may generate cash flowbe selected which may generate cash flow

which can be used for another project.which can be used for another project.

C i l R i i A i i h fiC i l R i i A i i h fi


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Capital Rationing: A situation where a firmCapital Rationing: A situation where a firm

has more investment proposals than it canhas more investment proposals than it can

finance. It may be defined as a situationfinance. It may be defined as a situationwhere a constraint is placed on the total sixewhere a constraint is placed on the total sixe

of capital investment during a particularof capital investment during a particular

period.period. firm to select combination of investmentsfirm to select combination of investments

proposals that provide the highest NPVproposals that provide the highest NPV

subject to the budget constraint for thesubject to the budget constraint for the

period.period.


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CutCut ofof Rate: Minimum rate which theRate: Minimum rate which the

management wishes to have from anymanagement wishes to have from any

project. It is usually based on cost ofproject. It is usually based on cost of

capital.capital.

Factoring:Factoring:

a factor is a financial institution whicha factor is a financial institution which

provides the management and financialprovides the management and financial

services like financing of debt arising out ofservices like financing of debt arising out of

credit sales.credit sales.They maintain required records and renderThey maintain required records and render

advisory service to the clients.advisory service to the clients.


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Thank YouThank You

Captial Budgeting Advanced

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