7/23/2019 Capital Budget & Cash Budget http://slidepdf.com/reader/full/capital-budget-cash-budget 1/33 Payback Period = Initial Investment Cash Inflow per Period Payback Period = A + B C In the above formula, Decision ule !"amples Example 1: Even Cash Flows #olution Example 2: Uneven Cash Flows #olution (cash flows in millions) $ear Cash %low & '(& ) )& * ) hen cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the followin- formula for payback period. A is the last period with a ne-ative cumulative cash flow/ cumulative cash flow at the end of the period A/ C is the total cash flow durin- the period after A Both of the above situations are applied in the followin- e"amples0 Accept the pro1ect only if its payback period is 2!## than the tar-et payback period0 Company C is plannin- to undertake a pro1ect re3uirin- initial investment of 4)&( million0 5he pro1ect is e"pected to -enerate 4*( million per year for 6 years0 Calculate the payback period of the pro1ect0 Payback Period = Initial Investment 7 Annual Cash %low = 4)&(8 7 4*(8 = 90* years Company C is plannin- to undertake another pro1ect re3uirin- initial investment of 4(& million and is e"pected to -enerate 4)& million in $ear ), 4) million in $ear *, 4): million in year , 4); million in $ear 9 and 4** million in $ear (0 Calculate the payback value of the pro1ect0
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hen cash inflows are uneven, weneed to calculate the cumulativenet cash flow for each period andthen use the followin- formula forpayback period.
A is the last period with ane-ative cumulative cash flow/
cumulative cash flow at theend of the period A/
C is the total cash flow durin-the period after A
Both of the above situations areapplied in the followin- e"amples0
Accept the pro1ect only if itspayback period is 2!## than thetar-et payback period0
Company C is plannin- toundertake a pro1ect re3uirin- initialinvestment of 4)&( million0 5hepro1ect is e"pected to -enerate4*( million per year for 6 years0
Calculate the payback period of thepro1ect0
Payback Period = InitialInvestment 7 Annual Cash %low =4)&(8 7 4*(8 = 90* years
Company C is plannin- toundertake another pro1ectre3uirin- initial investment of 4(&million and is e"pected to -enerate4)& million in $ear ), 4) million in$ear *, 4): million in year , 4);million in $ear 9 and 4** million in$ear (0 Calculate the paybackvalue of the pro1ect0
)0 Payback period is very simpleto calculate0inherent in a pro1ect0 #ince cashflows that occur later in apro1ects life are consideredmore uncertain, payback periodprovides an indication of howcertain the pro1ect cash inflows
are00 %or companies facin- li3uidity
problems, it provides a -oodrankin- of pro1ects that wouldreturn money early0Disadvantages of payback period
are.)0 Payback period does not takeinto account the time value ofmoney which is a seriousdrawback since it can lead to
wron- decisions0 A variation ofpayback method that attemptsto remove this drawback iscalleddiscounted paybackperiod method0
*0 It does not take into account,
the cash flows that occur afterthe payback period0
Example 2: Uneven Cash Inflows: An initial investment of 4@,*&thousand on plant and machinery is e"pected to -enerate cash inflows of4,9)) thousand, 49,&6& thousand, 4(,@*9 thousand and 4*,&:(
thousand at the end of first, second, third and fourth year respectively0 Atthe end of the fourth year, the machinery will be sold for 4;&& thousand0Calculate the net present value of the investment if the discount rate is)@0 ound your answer to nearest thousand dollars0
Fet present value accounts for time value of money which makes it asounder approach than other investment appraisal techni3ues which donot discount future cash flows such payback period and accountin- rate ofreturn0
Fet present value is even better than some other discounted cash flowstechni3ues such as I0 In situations where I and FP -ive conflictin-decisions, FP decision should be preferred0
FP is after all an estimation0 It is sensitive to chan-es in estimates for
future cash flows, salva-e value and the cost of capital0
#ince FP is -reater than Eero we have to increase discount rate, thus
FP at ) discount rate = 49,(*)
FP at )9 discount rate = 4*&9
FP at )( discount rate = <4,;6(>
Fet present value does not take into account the siEe of the pro1ect0 %ore"ample, say Pro1ect A re3uires initial investment of 49 million to -enerateFP of 4) million while a competin- Pro1ect B re3uires 4* millioninvestment to -enerate an FP of 4&0@ million0 If we base our decision onFP alone, we will prefer Pro1ect A because it has hi-her FP, but Pro1ectB has -enerated more shareholders wealth per dollar of initial investment
<4&0@ millionJ4* million vs 4) millionJ49 million>0
%ind the I of an investment havin- initial cash outflow of 4*),&&&0 5hecash inflows durin- the first, second, third and fourth years are e"pectedto be 4:(,*&&, 4;:,&&&, 46,)&& and 4((,9&& respectively0
But it is still -reater than Eero we have to further increase the discount
Profitability inde" is actually amodification of the net presentvalue method0 hile presentvalue is an absolute measure<i0e0 it -ives as the total dollarfi-ure for a pro1ect>, the