Ch_08 Cap Budgeting

8/22/2019 Ch_08 Cap Budgeting

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Capital Budgeting

L. T. Investment decision


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2Financial Management, Ninth Edition I M Pandey

Vikas Publishing House Pvt. Ltd.

Chapter Objectives

Understand the nature and importance of investment decisions.

Capital Budgeting Process

Distinguish between discounted cash flow (DCF) and non-discounted cash flow (non-DCF) techniques of investment

Explain the methods of calculating net present value (NPV) and

internal rate of return (IRR). Show the implications of net present value (NPV) and internal rate

of return (IRR).

Describe the non-DCF evaluation criteria: payback and accountingrate of return and discuss the reasons for their popularity inpractice and their pitfalls.

Illustrate the computation of the discounted payback. Describe the merits and demerits of the DCF and Non-DCF

investment criteria.


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Nature of Investment

The investment decisions of a firm are generallyknown as the capital budgeting, or capitalexpenditure decisions.

The firms investment decisions would generally

include expansion, acquisition, modernisation andreplacement of the long-term assets. Sale of adivision or business (divestment) is also as aninvestment decision.

Decisions like the change in the methods of salesdistribution, or an advertisement campaign or aresearch and development programme have long-term implications for the firms expenditures andbenefits, and therefore, they should also beevaluated as investment decisions.


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Features of Investment in

Cap.Budgeting The exchange of current funds for futurebenefits on L. T. basis

Substantial funds are invested in long-term

assets. The future benefits will occur to the firm over

a series of years.

Difficult or expensive to reverse


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Importance of Capital Budgeting

Growth

Risk

Funding

Irreversibility

Complexity


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Steps involved in Capital Budging


Identification of Investment Projects

Investment Criteria (DCF & Non DCF)

DCF Deciding on the basis of

(a) NPV (b) Benefit Cost Ratio

(c)IRR & MIRR

Non-DCF on the basis of

(a) Pay back period & (b)Ac Rate of Ret

Investment Appraisal




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Identification of Potential Investment

Opportunities.

Assembling of Investment proposals.

Decision Making

Preparing of Capital Budget & appropriations

Implementation

Performance Review




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Mandatory Investments

New or Expansion Projects

Modernization Projects Project

Replacement Projects

Diversification Project

Research & Development projects

Contingent Investment Projects

Miscellaneous Project

Identification of Inv.Projects


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Rules for Investment Decision

It should maximise the shareholders wealth.

It should consider all cash flows to determine the true profitability of

the project.

It should provide for an objective and unambiguous way of

separating good projects from bad projects. It should help ranking of projects according to their true profitability.

It should recognise the fact that bigger cash flows are preferable to

smaller ones and early cash flows are preferable to later ones.

It should help to choose among mutually exclusive projects that

project which maximises the shareholders wealth.

It should be a criterion which is applicable to any conceivable

investment project independent of others.


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Investment Criteria

1. Discounted Cash Flow (DCF) Cri ter ia

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)/ Benefit Cost Ratio

2. Non-discounted Cash Flow Cri ter ia

Payback Period (PB)

Discounted Payback Period (DPB)

Accounting Rate of Return (ARR)


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Net Present Value Method: Steps

Cash flows of the investment project should beforecasted based on realistic assumptions.

Appropriate discount rate should be identified to

discount the forecasted cash flows. Theappropriate discount rate is the projectsopportunity cost of capital.

Present value of cash flows should be

calculated using the opportunity cost of capitalas the discount rate.

The project should be accepted if NPV ispositive (i.e., NPV > 0).


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Net Present Value Method

Net present value should be found out by

subtracting present value of cash outflows

from present value of cash inflows. The

formula for the net present value can bewritten as follows:

31 202 3

0

1

NPV(1 ) (1 ) (1 ) (1 )

NPV(1 )

n

n

n

t

t

t

C CC CC

k k k k

CC

k


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Calculating Net Present Value

Assume that ProjectXcosts Rs 2,500 nowand is expected to generate year-end cashinflows of Rs 900, Rs 800, Rs 700, Rs 600and Rs 500 in years 1 through 5. The

opportunity cost of the capital may beassumed to be 10 per cent.

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs 500(PVF

10)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225


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Acceptance Rule

Accept the project when NPV is positive

NPV > 0

Reject the project when NPV is negative

NPV< 0 May or may not accept the project when NPV

is zero NPV = 0 (indifferent attitude)

The NPV method can be used to selectbetween mutually exclusive projects; the one

with the higher NPV should be selected.


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Why NPV positive is a tool ?

Year Amt O/s

at the beg

of year

Ret on

O/s @

10%

Total O/s

flows

Cash

Repment

at yr end

Balance

O/s

1 2725 # 272.50 2997.50 900 2097.50

2 2097.50 209.75 2307.25 800 1507.25

3 1507.25 150.73 1657.98 700 957.98

4 957.98 95.80 1053.78 600 453.78

5 453.78 45.38 499.16 500 (0.84)*

# initial-. Outlay + NPV




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Considering initial outlay Rs2500/

Year Initial

amount

Ret on

O/s amt

@ 10%

Total O/s

flows

Repment Balance

1 2500 250 2750 900 18502 1850 185 2035 800 1235

3 1235 123.50 1358.50 700 658.50

4 658.50 65.85 724.35 600 124.35

5

* Amt Rs

124.35

363.20 is

12.45

Left after

136.80

Total repm

500

WhosePv= 225

(363.20)*




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Importance of NPV Method

NPV is most acceptable investment rule for thefollowing reasons: Time value

Measure of true profitability

Value-additivity

Shareholder value

Limitations:

Involved cash flow estimation Discount rate difficult to determine

Mutually exclusive projects

Ranking of projects


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Understanding Value Additivity

Value of a Firm = P.v. of all existing Proj +

NPV of all on going future projs;

When a firm undertakes a proj with +ve NPV

its value increases & visa a versa, When firm Terminates an existing proj which

has - ve NPV, the value of the firm increases

by that amount.

In Case ofDivestment:-

If D Value of the firm ( Existing + NPV) the

decision is favorable ,18Financial Management, Ninth Edition I M Pandey



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Contd

In case ofAcquisition, If the acquisition price

is > NPV the acquiring firm is paying more

money than worth,

In case ofNew projects with +ve NPV thevalue of the firm will increase so long actual

cash inflows are in line with expectations

otherwise it will decrease




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Time Varying Discount Rate

In certain cases, r may not be uniform.

--- __ Initial investment




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Internal Rate of Return Method

The internal rate of return (IRR) is the rate that

equates the investment outlay with the present

value of cash inflow received after one period.

This also implies that the rate of return is thediscount rate which makes NPV = 0.

31 20 2 3

0

1

0

1

(1 ) (1 ) (1 ) (1 )

(1 )

0(1 )

n

n

n

t

t

t

n

t

t

t

C CC CC

r r r r

CCr

CC

r


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Calculation of IRR

Uneven Cash Flows: Calculating IRR by Trialand Error The approach is to select any discount rate to

compute the present value of cash inflows. If thecalculated present value of the expected cash inflowis lower than the present value of cash outflows, alower rate should be tried. On the other hand, ahigher value should be tried if the present value of

inflows is higher than the present value of outflows.This process will be repeated unless the net presentvalue becomes zero.


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Calculation of IRR

Level Cash Flows Let us assume that an investment would cost

Rs 20,000 and provide annual cash inflow ofRs 5,430 for 6 years.

The IRR of the investment can be found outas follows:

6,

6,

6,

NPV Rs 20,000 + Rs 5,430(PVAF ) = 0

Rs 20,000 Rs 5,430(PVAF )

Rs 20,000PVAF 3.683

Rs 5,430

r

r

r


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NPV Profile and IRR

A B C D E F G H

1 N P V P r o f i l e

2 C a s h F l o w

D i s c o u n t

r a t e N P V

3 - 2 0 0 0 0 0 % 1 2 , 5 8 0

4 5 4 3 0 5 % 7 , 5 6 1

5 5 4 3 0 1 0 % 3 , 6 4 9

6 5 4 3 0 1 5 % 5 5 0

7 5 4 3 0 1 6 % 0

8 5 4 3 0 2 0 % ( 1 , 9 4 2 )

9 5 4 3 0 2 5 % ( 3 , 9 7 4 )

F i g u r e 8 . 1 N P V P r o f i l e

I R


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Acceptance Rule

Accept the project when r> k.

Reject the project when r< k.

May accept the project when r= k.

In case of independent projects, IRR and NPV

rules will give the same results if the firm has

no shortage of funds.


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Evaluation of IRR Method

IRR method has following merits: Time value

Profitability measure

Acceptance rule Shareholder value

IRR method may suffer from: Multiple rates

Misleading when Cash flows are NonConventional

Mutually exclusive projects Difficul to dicide

Value additivity

Fails to decide between Investing or Borrowing


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Modified Internal Rate Of Return (MIRR)




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Contd;

Advantage of MIRR :

Can take care of Non conventional Cash flows,

Problem of multiple rate is eliminated.

In MIRR Proj in flows are reinvested at the rate ofcost of capital which is a realistic rate where as in

case IRR the same is reinvested at projects IRR

which is estimated one of . Hence MIRR is superior.

In case of Projects of same size NPV & MIRR leadsto same decision.

In case




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Profitability Index

Profitability indexis the ratio of the present

value of cash inflows, at the required rate of

return, to the initial cash outflow of the

investment.


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Profitability Index

The initial cash outlay of a project is Rs 100,000and it can generate cash inflow of Rs 40,000,Rs 30,000, Rs 50,000 and Rs 20,000 in year 1through 4. Assume a 10 per cent rate of

discount. To Calculate PV of cash inflows at 10 per cent disct. rate then the ratio.

.1235.11,00,000Rs

1,12,350RsPI

12,350Rs=100,000Rs112,350RsNPV

0.6820,000Rs+0.75150,000Rs+0.82630,000Rs+0.90940,000Rs=

20,000(PVFRs+)50,000(PVFRs+)30,000(PVFRs+)40,000(PVFRsPV 0.14,0.103,0.102,0.101,


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Acceptance Rule

The following are the PI acceptance rules: Accept the project when PI is greater than one.

PI > 1

Reject the project when PI is less than one.PI < 1

May accept the project when PI is equal to one.PI = 1

The project with positive NPV will have PI

greater than one. PI less than means that theprojects NPV is negative.


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Evaluation of PI Method

It recognises the time value of money.

It is consistent with the shareholder valuemaximisation principle. A project with PI greater thanone will have positive NPV and if accepted, it willincrease shareholders wealth.

In the PI method, since the present value of cashinflows is divided by the initial cash outflow, it is arelative measure of a projects profitability.

Like NPV method, PI criterion also requires

calculation of cash flows and estimate of the discountrate. In practice, estimation of cash flows anddiscount rate pose problems.


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Problem:

If the expected cash flows of a Proj are :

Yr 0 1 2 3 4 5

-100000 20000 30000 40000 50000 30000

Considering Cost of Capital as 12% calculate

(i) NPV, (ii) IRR (iii) MIRR & ( iv) BCR

Ans: (i) 19060 (ii) 18.69 % (iii) 15.97 % (iv) 1.19




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Payback

Payback is the number of years required to recover the

original cash outlay invested in a project.

If the project generates constant annual cash inflows,

the payback period can be computed by dividing cash

outlay by the annual cash inflow.

Assume that a project requires an outlay of Rs 50,000

and yields annual cash inflow of Rs 12,500 for 7 years.

To find The payback period for the project

0Initial InvestmentPayback = =Annual Cash Inflow

C

C

Rs 50,000PB = = 4 years

Rs 12,000


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Payback

Unequal cash flows In case of unequal cash

inflows, the payback period can be found out by

adding up the cash inflows until the total is

equal to the initial cash outlay. Suppose that a project requires a cash outlay of

Rs 20,000, and generates cash inflows of

Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000

during the next 4 years. What is the projectspayback?

3 years + 12 (1,000/3,000) months

3 years + 4 months


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Acceptance Rule

The project would be accepted if its paybackperiod is less than the maximum orstandardpaybackperiod set by management.

As a ranking method, it gives highest rankingto the project, which has the shortest paybackperiod and lowest ranking to the project withhighest payback period.


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Evaluation of Payback

Certain virtues: Simplicity

Cost effective

Short-term effects

Risk shield Liquidity

Serious limitations: Cash flows after payback

Time effects on Cash flows ignored Cash flow patterns (Magnitude & Timing)

Administrative difficult in finding Maxm.P.B Period

Inconsistent with shareholder value


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Payback Reciprocal and the Rate of

Return The reciprocal of payback will be a closeapproximation of the internal rate of return if

the following two conditions are satisfied:

The life of the project is large or at least twice thepayback period.

The project generates equal annual cash inflows.


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Discounted Payback Period

The discounted payback period is the number of

periods taken in recovering the investment outlay on the

present value basis.

The discounted payback period still fails to consider the

cash flows occurring after the payback period.

3 DISCOUNTED PAYBACK ILLUSTRATED

Cash F lows

(Rs)

C0 C1 C2 C3 C4

Simple

PB

Discounted

PB

NPV at

10%

P -4,000 3,000 1,000 1,000 1,000 2 yrs

PV of cas h flows -4,000 2,727 826 751 683 2.6 yrs 987

Q -4,000 0 4,000 1,000 2,000 2 yrs

PV of cas h flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421


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Accounting Rate of Return Method

The accounting rate of return is the ratio of the

average after-tax profit divided by the average

investment. The average investment would be

equal to half of the original investment if it weredepreciated constantly.

A variation of the ARR method is to divide

average earnings after taxes by the original cost

of the project instead of the average cost.

Average incomeARR =

Average investment


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Acceptance Rule

This method will accept all those projectswhose ARR is higher than the minimum rateestablished by the management and rejectthose projects which have ARR less than theminimum rate.

This method would rank a project as numberone if it has highest ARR and lowest rankwould be assigned to the project with lowest

ARR.


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Evaluation of ARR Method

The ARR method may claim some merits

Simplicity

Accounting data

Accounting profitability Serious shortcoming

Cash flows ignored

Time value ignored

Arbitrary cut-off


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Conventional and Non-conventional

Cash FlowsA conventional investment has cash flows thepattern of an initial cash outlay followed by cashinflows. Conventional projects have only onechange in the sign of cash flows; for example,the initial outflow followed by inflows,i.e., + + +.

Anon-conventional investment, on the otherhand, has cash outflows mingled with cashinflows throughout the life of the project. Non-conventional investments have more than onechange in the signs of cash flows; for example,

+ + + ++ +.


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NPV Versus IRR

Conventional Independent Projects:

In case of conventional investments, which are

economically independentof each other, NPV

and IRR methods result in same accept-or-rejectdecision ifthe firm is not constrained for funds in

accepting allprofitable projects.


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NPV Versus IRR

Cash Flows (Rs)

Project C0 C1 IRR NPV at 10%

X -100 120 20% 9

Y 100 -120 20% -9

Lending and borrowing-type projects:

Project with initial outflow followed by inflows is

a lending type project, and project with initial

inflow followed by outflows is a lending typeproject, Both are conventional projects.


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Problem of Multiple IRRs

A project may have

both lending and

borrowing features

together. IRR method,when used to evaluate

such non-conventional

investment can yield

multiple internal ratesof return because of

more than one change

of signs in cash flows.

NPV Rs 63

-750

-500

-250

0

250

0 50 100 150 200 250

Discount Rate (%)

NPV (Rs)


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Case of Ranking Mutually Exclusive

Projects Investment projects are said to be mutually exclusivewhen only one investment could be accepted andothers would have to be excluded.

Two independent projects may also be mutually

exclusive if a financial constraint is imposed. The NPV and IRR rules give conflicting ranking to the

projects under the following conditions: The cash flow pattern of the projects may differ. That is, the

cash flows of one project may increase over time, while those

of others may decrease orvice-versa. The cash outlays of the projects may differ.

The projects may have different expected lives.


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Timing of Cash Flows

Cash F lows (Rs) NPV

Project C0 C1 C2 C3 at 9% IRR

M

1,680 1,400 700 140 301 23%

N 1,680 140 840 1,510 321 17%


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Scale of Investment

Cash F low (Rs) NPV

Project C0 C1 at 10% IRR

A -1,000 1,500 364 50%

B-100,000 120,000 9,080 20%


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Project Life SpanCash Flows(Rs)

Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR

X

10,000 12,000

908 20%Y 10,000 0 0 0 0 20,120 2,495 15%


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Reinvestment Assumption

The IRR method is assumed to imply that the

cash flows generated by the project can be

reinvested at its internal rate of return, whereas

the NPV method is thought to assume that thecash flows are reinvested at the opportunity

cost of capital.


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Modified Internal Rate of Return

(MIRR) The modified internal rate of return (MIRR)is the compound average annual rate that is

calculated with a reinvestment rate different

than the projects IRR. The modified internalrate of return (MIRR) is the compound

average annual rate that is calculated with a

reinvestment rate different than the projects

IRR.


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Varying Opportunity Cost of Capital

There is no problem in using NPV method

when the opportunity cost of capital varies

over time.

If the opportunity cost of capital varies overtime, the use of the IRR rule creates

problems, as there is not a unique benchmark

opportunity cost of capital to compare with

IRR.


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NPV Versus PI

A conflict may arise between the two methods

if a choice between mutually exclusive projects

has to be made. Follow NPV method:

Project C Project D

PV of cash inflows 100,000 50,000

Initial cash outflow 50,000 20,000

NPV 50,000 30,000

PI 2.00 2.50

Ch_08 Cap Budgeting

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