Capital Budgeting Final

8/22/2019 Capital Budgeting Final

1/46

Capital Budgeting

Session 4


2/46

Session 4Capital Budgeting

Should we

build this

plant?


3/46

Understand the payback period (PBP) method of project evaluation and selection,including its: (a) calculation; (b) acceptance criterion; (c) advantages anddisadvantages; and (d) focus on liquidity rather than profitability.

Understand the three major discounted cash flow (DCF) methods of projectevaluation and selection internal rate of return (IRR), net present value (NPV), andprofitability index (PI).

Explain the calculation, acceptance criterion, and advantages (over the PBP method)for each of the three major DCF methods.

Define, construct, and interpret a graph called an NPV profile.

Understand why ranking project proposals on the basis of the IRR, NPV, and PImethods may lead to conflicts in rankings.

Describe the situations where ranking projects may be necessary and justify when touse either IRR, NPV, or PI rankings.

Understand how sensitivity analysis allows us to challenge the single-point inputestimates used in traditional capital budgeting analysis.

Explain the role and process of project monitoring, including progress reviews and

post-completion audits.


4/46

What is Capital Budgeting???

Analysis of potential projects.

Deciding which one is more important

Adds to the firm value

Long-term decisions; involve large expenditures.

Very importantto firms future.

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures. Very important to firms future.


5/46

Capital budgeting is investment decision-making as to whether a project is worthundertaking. Capital budgeting is basically

concerned with the justification of capitalexpenditures.

Current expenditures are short-term and arecompletely written off in the same year that

expenses occur. Capital expenditures arelong-term and are amortized over a period ofyears are required by the IRS.


6/46

Importance of capital budgeting

Strategic direction

Long term decision and effects last long time

It might have serious financial consequences


7/46

Capital Budgeting Process

Identification of potential investmentopportunities

Assembling of proposed investments

Decision making

Preparation of capital budget andappropriations

Implementation

Performance review


8/46

Independent & mutually

exclusive projects?

Projects are: independent, if the cash flows ofone are unaffected by the acceptance of theother.

mutually exclusive, if the cash flows of onecan be adversely impact


9/46

Project Classification

Mandatory investment

Replacement projects

Expansion projects

Diversification project

Research and development projects

Miscellaneous project


10/46

Investment criteria

Investmentcriteria

Nondiscounting

criteria

Discountingcriteria

NPVBenefit

cost ratio

Internalrate of

return

Paybackperiod

Accountingrate of

return


11/46

Capital budgeting decision rules

Payback period

Discounted payback period

NPV

IRR

MIRR

Accounting Rate of Return


12/46

PAY BACK PERIOD


13/46

What is the payback period?

The number of years required to recover a

projects cost,

or how long does it take to get the

businesss money back?

The number of years required to recover aprojects cost, or How long does it take to get

our money back? Calculated by adding projects cash inflows to

its cost until the cumulative cash flow for the

project turns positive.


14/46

uncovered cost at start of year

PB =yr before +

full recovery cash flow during year


15/46

Year Project L Project S

0 ($ 100) ($100)

1 10 70

2 60 50

3 80 20


16/46

Calculating payback

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100

Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50

-30

Project S


17/46

Decision

The shorter the payback peroid the moreattractive is investment. Reason??

The erlier the investment is recovered, the

sooner the cash can be used for otherpurpose.

The risk of loss from obsolence and changed

economic conditions is less in a shorterpayback peroid


18/46

Strengths and weaknesses of payback

Strengths

Provides an indication of a projects risk and

liquidity.

Easy to calculate and understand.

Weaknesses

Ignores the time value of money.

Ignores CFs occurring after the payback period.


19/46


20/46

DISCOUNTED PAYBACKPERIOD


21/46

Length of time required to recover the initial cash outflowfrom the discounted future cash inflows. This is theapproach where the present values of cash inflows arecumulated until they equal the initial investment.

An investment decision rule in which cash flows arediscounted at an interest rate and then one determineshow long it takes for the sum of the discounted cashflows to equal the initial investment.

Discounted cash flow (DCF) Future cash flows multiplied by discount factors to obtain

present values.


22/46

Example

Assume a machine purchased for $5000yields cash inflows of $5000, $4000, and$4000. The cost of capital is 10%. Then we

have


23/46

The payback period (without discounting thefuture cash flows) is exactly 1 year. However,the discounted payback period is a little over

1 year because the first year discounted cashflow of $4545 is not enough to cover theinitial investment of $5000. The discountedpayback period is 1.14 years (1 year +($5000 - $4545)/$3304 = 1 year + .14 year).


24/46

Discounted payback period

Uses discounted cash flows rather thanraw CFs.

Disc PaybackL = 2 + / = 2.7 years

CFt -100 10 60 80

Cumulative -100 -90.91 18.79

0 1 2 3

=

2.7

60.11

-41.32

PV of CFt -100 9.09 49.59

41.32 60.11

10%


25/46

NET PRESENT VALUE


26/46

Cash flow

Conventional cash flow

Non- conventional cash flow


27/46

What is the difference between normal and non-

normal cash flow streams?

Normal cash flow stream Cost (negativeCF) followed by a series of positive cash

inflows. One change of signs. Nonnormal cash flow stream Two or

more changes of signs. Most common:Cost (negative CF), then string of positive

CFs, then cost to close project. Nuclearpower plant, strip mine, etc.


28/46

Net Present Value (NPV)

Sum of the PVs of all the cash inflows andoutflows of a project that are expected tooccur over the life of the project.

Formula :

n

0tt

t .)r1(

CFNPV investmentInitial

CFt = cash flow at the end of year t N = life of the project

R = discount rate (cost of capital)


29/46

NPV Method

Under the NPV net cash flows are discountedto their present value and then comparedwith the capital outlay required by the

investment. The differnce between these twoamounts is refered to as NPV.


30/46

Year Project L Project S

0 ($ 100) ($100)

1 10 (90)

2 60 (30)

3 80 50


31/46

What is Project Ls NPV?

Year CFt PV of CFt

0 -100 -$100

1 10 9.09

2 60 49.59

3 80 60.11

NPVL = $18.79

NPVS = $19.98


32/46

Decision : accept the project if the net presentvalue is positive and reject the project if the netpresent value is negative

If the NPV is positive, then approve the project.It shows that you are making more money on theinvestment than you are spending on your costof capital. If NPV is negative, then do not

approve the project because you are payingmore in interest on the borrowed money thanyou are making from the project.


33/46

Discount rate- cost of capital

The rate used to discount future cash flows to their present values is a key variable ofthis process. A firm's weighted average cost of capital (after tax) is often used, butmany people believe that it is appropriate to use higher discount rates to adjust forrisk for riskier projects or other factors. A variable discount rate with higher ratesapplied to cash flows occurring further along the time span might be used to reflectthe yield curve premium for long-term debt.

Another approach to choosing the discount rate factor is to decide the rate which thecapital needed for the project could return if invested in an alternative venture. If, forexample, the capital required for Project A can earn five percent elsewhere, use thisdiscount rate in the NPV calculation to allow a direct comparison to be made betweenProject A and the alternative. Related to this concept is to use the firm'sReinvestment Rate. Reinvestment rate can be defined as the rate of return for thefirm's investments on average. When analyzing projects in a capital constrainedenvironment, it may be appropriate to use the reinvestment rate rather than the firm'sweighted average cost of capital as the discount factor. It reflects opportunity cost ofinvestment, rather than the possibly lower cost of capital.
http://en.wikipedia.org/wiki/Weighted_average_cost_of_capitalhttp://en.wikipedia.org/wiki/Yield_curvehttp://en.wikipedia.org/wiki/Yield_curvehttp://en.wikipedia.org/wiki/Weighted_average_cost_of_capital


34/46

Example

A corporation must decide whether to introduce a newproduct line. The new product will have startup costs,operational costs, and incoming cash flows over sixyears. This project will have an immediate (t=0) cash

outflow of $100,000 (which might include machinery, andemployee training costs). Other cash outflows for years1-6 are expected to be $5,000 per year. Cash inflows areexpected to be $30,000 each for years 1-6. All cash

flows are after-tax, and there are no cash flows expectedafter year 6. The required rate of return is 10%. Thepresent value (PV) can be calculated for each year:
http://en.wikipedia.org/wiki/Required_rate_of_returnhttp://en.wikipedia.org/wiki/Required_rate_of_return


35/46

Solution

Year Cashflow Present Value T=0 -$100,000

T=1 $22,727 (30,000-5000 / (1+0.10)1)

T=2 $20,661

T=3 $18,783

T=4 $17,075 T=5 $15,523

T=6 $14,112

The sum of all these present values is the net present value,which equals $8,881.52. Since the NPV is greater than zero, itwould be better to invest in the project than to do nothing, andthe corporation should invest in this project if there is noalternative with a higher NPV.


36/46

Question 1


37/46

BENEFIT COST RATIO


38/46

A ratio attempting to identify the relationship between thecost and benefits of a proposed project.

This ratio is used to measure both quantitative andqualitative factors since sometimes benefits and costs

cannot be measured exclusively

A benefit-cost ratio (BCR) is an indicator, used in theformal discipline ofcost-benefit analysis, that attempts tosummarize the overall value for money of a project or

proposal. A BCR is the ratio of the benefits of a projector proposal, expressed in monetary terms, relative to itscosts, also expressed in monetary terms. All benefitsand costs should be expressed in discounted present

values
http://en.wikipedia.org/wiki/Cost-benefit_analysishttp://en.wikipedia.org/wiki/Value_for_moneyhttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Value_for_moneyhttp://en.wikipedia.org/wiki/Cost-benefit_analysishttp://en.wikipedia.org/wiki/Cost-benefit_analysishttp://en.wikipedia.org/wiki/Cost-benefit_analysis


39/46

Formula

BCR = PVB

I

NBCR = PVB I = BCR - 1

I


40/46

Example

A Project which is being evaluated by a firmthat has a cost of capital of 12%.

Initial investment Rs 1,00,000

Benefits Yr 1 25,000

Yr 2 40,000

Yr 3 40,000

Yr 4 50,000


41/46

Solution

BCR = 25000 /(1.12) + 40000/(1.12)2 +40000/(1.12)3 +50000/(1.12)4

1,00,000

=1.145

NCBR = 0.145


42/46

Decision rule

BCR NBCR Rule is

Greater than 1 Greater than 0 Accept

Equal to 1 Equal to 0 Indifferent

Less than 1 Less than 0 Reject


43/46

INTERNAL RATE OF RETURN


44/46

Internal rate of return

This technique is also known as yield oninvestment, marginal efficiency of capital,marginal productivity of capital, rate of return,time adjusted rate of return.

It is usually the rate of return that a projectearns. It is defined as the discount rate (r)which equates the aggregate present value of

the net cash inflows with the aggregate PV ofcash outflows of a project. It is that rate whichgives the project NPV of zero


45/46

Internal Rate of Return (IRR)

IRR is the discount rate that forces PV ofinflows equal to cost, and the NPV = 0:

Solving for IRR with a financial calculator: Enter CFs in CFLO register.

Press IRR; IRRL = 18.13% and IRRS = 23.56%.

n

0tt

t

)IRR1(CF0


46/46

Decision rule

Accept if the IRR exceeds the cost of capital

Capital Budgeting Final

Documents