14120 Capital Budgeting

7/30/2019 14120 Capital Budgeting

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CAPITAL BUDGETING-INVESTMENT DECISION

Prepared by Sumit Goyal - LPU


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CONTENTS

Introduction

Techniques of capital budgeting Accounting Rate of Return Method

Payback Period Method Net Present Value (NPV) Method Internal Rate Return (IRR) Method

Issues with IRR Multiple IRRs

Mutually Exclusive Projects Advantages of NPV Method Advantages of IRR Method

Modified IRR Method



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LEARNING OBJECTIVES

Understand the nature and importance of investment

decisions

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

accounting rate of return

Illustrate the computation of the discounted payback

Compare and contrast NPV and IRR and emphasize the

superiority of NPV rule



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Nature of Investment Decisions

The investment decisions of a firm aregenerally known as the capital budgeting, orcapital expenditure decisions.

The firms investment decisions wouldgenerally include expansion, acquisition,

modernisation and replacement of the long-term assets. Sale of a division or business(divestment) is also as an investment decision.



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Nature of Investment Decision

Decisions like the change in the methods of

sales distribution, or an advertisement

campaign or a research and development

programme have long-term implications for

the firms expenditures and benefits, and

therefore, they should also be evaluated as

investment decisions.



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Capital Budgeting

Capital budgeting decisions relate to acquisition of

assets that generally have long-term strategic

implications for the firm. Capital budgeting decisions become fairly intricate

as it impacts other areas of corporate finance like

capital structure, dividends and cost of capital.



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Features Of Capital Budgeting Decision

Capital budgeting decisions are characterized by:

Non-reversible,

Large initial outflow followed by small periodic inflows,

Information gap and inexperience,

Strategic and risky in nature,

No scope of learning and correcting from pastexperience,

Little flexibility.



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CAPITAL BUDGETING PROCESS

Identification of investment proposals - where

Screening and evaluation of the proposals

Fixing priorities Final approval and preparation of capital

expenditure budget

Implementing proposals

Performance review



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Investment Evaluation Criteria

Three steps are involved in the evaluation of

an investment:

1. Estimation of cash flows2. Estimation of the required rate of return (the

opportunity cost of capital)

3. Application of a decision rule for making the

choice



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Types Of Projects

Small vs Large Projects

New vs Expansion Projects

Independent and Mutually Exclusive projects Mutually exclusive projects are those where acceptance of

one implies automatic rejection of the other.

Research & Development and Mandatory Projects



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Techniques Of Evaluation

The methods of financial evaluation of the projects are

categorized into two:

Discounted Cash Flow (DCF) techniques and

Non DCF techniques.

DCF techniques value the projects with time value of money

and include a) NPV Method and b) IRR Method

Non-DCF based techniques of a) Accounting Rate of Return

and b) Pay Back Period.



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Evaluation Criteria

1. Non-discounted Cash Flow Criteria

Payback Period (PB)

Accounting Rate of Return (ARR)

2. Discounted Cash Flow (DCF) Criteria

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

Discounted payback period (DPB)


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PAYBACK

Payback is the number of years required to recover theoriginal 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. That is:

C

C

InflowCashAnnual

InvestmentInitial=Payback 0


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Example

Assume that a project requires an outlay of Rs

50,000 and yields annual cash inflow of Rs

12,500 for 7 years. The payback period for the

project is:

years412,000Rs

50,000RsPB


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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 projects

payback?

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 or standardpaybackperiod 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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Payback Period Method

Payback period of the project is the amount of timerequired to recover the original investment.

Payback period for the project is 2 years.


Initial cash outflow 10,00,000

Cash inflows 1st Year 3,00,000

2nd Year 5,00,000

3rd Year 4,00,000

4th Year 5,00,000


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Payback period

A company is planning a major investment to expand its

current manufacturing of digital clocks with initial outlay of Rs

350 Lakh. The finance department has projected a following

cash flows over the next 7 years are, 100, 150, 400, 450, 300,

250, 50.

What is the payback period of the project?



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Evaluation of Payback

Certain virtues: Simplicity

Cost effective

Short-term effects

Risk shield Liquidity

Serious limitations:Cash flows after payback

Cash flows ignoredCash flow patterns

Administrative difficulties

Inconsistent with shareholder value


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Accounting Rate Of Return

Accounting Rate of Return is defined as average profit as% of average investment over the life of the project

It is merely a number, which reflects the worthiness of theproject in absolute terms.

To enable the firm make a conscious decision whether to

accept or reject a proposal, it needs to be compared withsome acceptance/ rejection criteria.


InvestmentAverage

ProfitAverage

=ReturnofRateAccounting


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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 were depreciated 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.

or


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Example

A project will cost Rs 40,000. Its stream of

earnings before depreciation, interest and

taxes (EBDIT) during first year through five

years is expected to be Rs 10,000, Rs 12,000,Rs 14,000, Rs 16,000 and Rs 20,000. Assume a

50 per cent tax rate and depreciation on

straight-line basis.


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Calculation of Accounting Rate of

Return


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Practical Problem

A company is considering a proposal to purchase a new

machine. The equipment would involve a cash outlay of Rs.

5,00,000 and working capital of Rs. 60,000. the expected life

of the project is 5 years. Depreciation method is straight line

method.

The estimated before tax cash inflow (earnings before

depreciation and tax) are as 180000, 220000, 190000,

170000, 140000.

The applicable tax rate is 35%.



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Acceptance Rule

This method will accept all those projectswhose ARR is higher than the minimum rateestablished by the management and reject

those 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 lowestARR.


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Accounting Rate Of Return

The advantage of the method is its simplicity of calculation

Limitations

Subjective Approach

Ignore Time Value of Money

Not Based on Cash Flow

Inconsistent definition

Pre tax or post tax

Accounting basis

Total investment or equity



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Discounted Cash Flow Methods



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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 thecash flows occurring after the payback period.

Discounted Payback Illustrated


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Net Present Value Method

Cash flows of the investment project should be forecasted

based on realistic assumptions.

Appropriate discount rate should be identified to discount the

forecasted cash flows.

Present value of cash flows should be calculated using the

opportunity cost of capital as the discount rate.

Net present value should be found out by subtracting present

value of cash outflows from present value of cash inflows. The

project should be accepted if NPV is positive (i.e., NPV > 0).


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Steps And Meaning Of NPV

1. Estimate the initial cost to implement the project, CF0,

2. Estimate the cash flows of the project for each period over itslife, CFt,

3. Sum the discount the cash flows at an appropriate rate toarrive at present value of the cash flows,

4. Subtract the initial investment from the present value to getthe Net Present Value of the project.

NPV is value created by the acceptance of the project. It

reflects the increase in the market value of the firm.



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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 accept the project when NPV is zero

NPV = 0

The NPV method can be used to select between mutually

exclusive projects; the one with the higher NPV should be

selected.


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Calculating Net Present Value

Assume that ProjectXcosts Rs 2,500 now and is expected togenerate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs

600 and Rs 500 in years 1 through 5. The opportunity cost of

the capital may be assumed to be 10 per cent.


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Practical Problem

A company is considering investment in a project that costs Rs. 200000.

the project has an expected life of 5 years and zero salvage value. The

company uses SLM of depreciation. The companys tax rate is 40%. .


Year EBDT1 70000

2 80000

3 120000

4 90000

5 60000


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Practical Problem





method. The estimated before tax cash inflow (earnings before


170000, 140000.




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Computing NPV

Project A

Year Cash flow Present Value at 10%

Year 0 -10,00,000 -10,00,000

Year 1 5,00,000 5,00,000/1.1 = 4,54,545

Year 2 5,00,000 5,00,000/1.12 = 4,13,223

Year 3 5,00,000 5,00,000/1.13 = 3,75,657

NET PRESENT VALUE 12,43,425 10,00,000

= 2,43,425



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Computing NPV

Project B


Year 0 -10,00,000 -10,00,000

Year 1 8,00,000 8,00,000/1.1 = 7,27,273

Year 2 2,00,000 2,00,000/1.12 = 1,65,289

Year 3 8,00,000 8,00,000/1.13 = 6,01,052


= 4,93,614



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Computing NPV

Projects A & B Combined


Year 0 -20,00,000 -20,00,000

Year 1 13,00,000 13,00,000/1.1 =11,81,818

Year 2 7,00,000 7,00,000/1.12 = 5,78,512

Year 3 13,00,000 13,00,000/1.13 = 9,76,709


= 7,37,039



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Additive Property Of NPV

NPVs of different projects can be added to arrive attotal NPV.

NPV (A+B) = NPV (A) + NPV (B) Additive property of NPVs helps in isolating the

impact that each project makes on the value of thefirm.

NPV of Project A 2,43,425NPV of Project B 4,93,614

NPV of A & B Combined 7,37,039



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Profitability index

Profitability index= present value of inflows/

present value of outflows

Net profitability index = P.I -1



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Advantages

In which different costs are there we can not

rank as NPV method so profitability index can

be used for the same.



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Internal Rate Of Return (IRR) Method

Internal Rate of Return (IRR) of the project is that rate of

return at which the net present value is zero.

For a project outlay of Rs. 200 and cash inflows for next 2 years

at Rs 110 and Rs 121, the IRR may be found as follows:


0

n

1t

t

CFr)+(1

CF

200rr1

110

2)1(

121


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IRR Decision Rule And NPV

Decision Rule:

The IRR of the project is 10%. It is compared with the

cost of capital to make judgment about its desirability.

ACCEPT IF IRR > COST OF CAPITAL

REJECT IF < COST OF CAPITAL

It is the maximum discount rate that the cash flows of

the project can support.

= 101.85 +103.74 200 = Rs 5.59


200-1.08

110=NPVValue,PresentNet

208.1

121


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Practical Problem

Suggest the company whether they should invest in the

project or not as per

1. Pay back period method2. Discounted pay back period method

3. Net present value

4. Internal rate of return5. Accounting rate of return.

6. Net Profitability index



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Practical Problem





method. The estimated before tax cash inflow (earnings before


170000, 140000.




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NPV And Discount Rate

As discount rate increases NPV falls.

The discount rate at which NPV is zero is called IRR.


Net PresentValues & Discount Rate

(20.00)

-

20.00

40.00

60.00

80.00

0 10 20 28.23 35

Discount Rate (%)

NPV

d l


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NPV And IRR Decision Rules

A Comparison

As per NPV rule:

The project is accepted as long as the discount rate is below28.23% because the net present value remains positive tillthen.

It is rejected for discount rate beyond 28.23%.As per IRR rule:

The project is accepted as long as cost of capital remainsbelow 28.23%, the IRR of the project.

It is rejected if cost of capital exceeds 28.23%.



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Advantages Of NPV Method

Simplicity of NPV

Re-investment rate

The implied assumption of IRR method is thatinterim cash flows are reinvested at IRR itself.

NPV method assumes reinvestment at discountrate. This assumption of IRR is challenged as itdefies conservatism

Flexibility in choosing discount rate

Measuring wealth creation Ranking of the project in capital rationing situation

Unambiguous acceptance and rejection criterion makes NPV rulesuperior to IRR rule.



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Advantages Of IRR Method

Despite its conflicts and drawbacks, IRR remains a popular

method of evaluation of projects because of Its ability to compare projects without the consideration of

discount rate, Easier comprehension.

Cost of capital not required to find IRR. It is required to makeselection or rejection decision. For comparative purposes noneed to know the cost of capital.

Priority for early cash flows.



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Inflation And Capital Budgeting

The principle of consistency in capital budgeting

demands that

nominal cash flows are discounted at nominaldiscount rate

real cash flows are discounted at real discount

rate.

14120 Capital Budgeting

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