9a7b4MODULE 3- Capital Budgeting STUDENT

8/8/2019 9a7b4MODULE 3- Capital Budgeting STUDENT

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Module 3:The Basics of Capital Budgeting

Should we

build this

plant?


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The Basics of Capital Budgeting

AN INVESTMENT WILL ADD TO

SHAREHOLDERS WEALTH IF IT YIELDS

BENEFITS AS PER THEHURDLERATE/DISCOUNT RATE

(PRINCIPLE RELATED TO INVESTMENT

DECISION)


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Capital Budgeting The process of identifying, analyzing, and selecting

investment projects whose returns (cash flows) are expectedto extend beyond one year

Importance:

Influence the firms growth Affect the risk of the firm

Involve commitment of large funds

Irreversibility

Complexity of decision making

Investment decisions influence firms value

Firms value will increase if investment is profitable & addsto shareholders wealth


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Capital budgeting process Generating investment project proposals

consistent with the firms strategic objectives

Estimating after-tax incremental operating cashflows for investment projects

Evaluating project incremental cash flows

Selecting projects based on value maximizingacceptance criterion

Re-evaluating implemented investment projectscontinually & performing post audits forcompleted projects


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Steps in Project Appraisal

Forecast Cost & Benefits

Assess Risk

Estimate Cost of Capital

Value the Options

Consider the overall

corporate perspective

Select Appraisal Criteria


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Types of Investment Decisions

May be classified as: New Products or expansion of existing products

Replacement of equipment or buildings

Research & Development

Exploration

Other (for e.g. safety related or pollution control

devices)


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Types of Investment Decisions

Mutually Exclusive investments

A project whose acceptance exclude theacceptance of one or more alternative projects

Independent investments A project whose acceptance or rejection does

not prevent the acceptance of other projectsunder consideration

Contingent investments A project whose acceptance depends on the

acceptance of one or more other projects


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Basic Principles

Focus on Cash Flows Measure Cash flows on Incremental Basis

Exclude Financing Costs

Treat inflation Consistently

Types of Cash Flows

Initial flows

Operational Cash Flows

Terminal Flows


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Evaluation Criteria

Discounted Cash Flow Criteria

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

Terminal Value Method (TV)

Discounted Payback period

Non-Discounted Cash Flow Criteria Payback Period (PB)

Accounting rate of return (ARR)


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Discounted Cash Flow CriteriaDiscounted Cash Flow Criteria

Considering thatrupee has timevalue, How dowe decide if a

capitalinvestment

project shouldbe accepted or

rejected?


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Net Present Value Method

The PV of an investment projects net cash

flows minus the projects initial cash outflow

Following steps are involved: Cash flows to be forecasted

Appropriate discount rate to be identified

PV of cash flows to be calculated NPV should be found out; Project should be

accepted if NPV>0


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Net Present Value Method

Net Present Value can be calculated by using

the following formula:

01 1C

k

CNPV

n

t

nt

!

!

Where C1

, C2

..represent net cash inflows in the

year 1,2,n;

k is the cost of capital,

C0 is the initial cost of investment


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Example : NPV

Assume that for an initial cash outflow of Rs.

1,00,000. It is expected to generate net cash

flows of Rs 34,432, Rs. 39,530 Rs 39,359

and Rs 32,219 over the next 4 years. Whatwould be the NPV


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Merits of NPV method

Time Value

Measure of true profitability

Value Additive

ShareholderWealth Maximization

Demerits of NPV method Cash Flow estimation

Discount rate

Mutually exclusive projects ( details to be studied later )

Ranking of Projects


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Profitability Index (PI) Also called as Benefit cost ratio PI is the ratio of the PV of cash inflows, at the required rate of

return, to the initial cash outflow of the investment

Evaluates the projects in terms of relative rather than

absolute

Can be calculated as:

o

n

t

t

t

o

tC

k

C

C

CPVPI z

!! !1 )1(

)(

Accept the project when PI > 1; Reject the project if PI < 1


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Profitability Index (PI) Example:

A company is considering an investment proposal to installnew milling controls at a cost of Rs. 50,000. The facility hasexpected life of 5 years. Following are the expected aftertax cash flows:

Year Ct1 10000

2 10450

3 11800

4 122505 16750

Calculate the PI for the project. Should the company acceptthe project? Will NPV give similar results?


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Merits of PI method Like the NPV, PI is a conceptually sound method; it

requires same computations as NPV. Following are theMerits: Time Value

Relative Profitability

Value Maximization

Demerits of PI method

PI criterion also involves calculation of Cash Flows &Discount rates that pose problems


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Payback Period (PB) The payback period tells us the number of years required to recover

our initial cash investment based on the projects expected cashflows

Payback period can be calculated as per the two situations:

1. When the project generates constant annual cash flow(annuity):

InflowCashAnnual

InvestmentInitial!Payback

2. When the projects cash flows are not uniform

Acceptance criterion: If the payback calculated is less than some

maximum acceptable payback period, the project will be accepted,

if not, its rejected


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Payback Period (PB)

Example 1: When the project generates constant annual cash

flow (annuity)

An investment in a machine of Rs. 40,000is expected

to produce cash flow of Rs. 10,000 for 10 years. What

is the Payback Period?

Example 2: When the projects cash flows are not uniform

Assume that for an initial cash outflow of Rs. 1,00,000.

It is expected to generate net cash flows of Rs 34,432,

Rs. 39,530 Rs 39,359 and Rs 32,219 over the next 4

years. Calculate the PB


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Merits of PB method Simplicity

Cost Effective

Short term effects

Risk Shield

Liquidity

Demerits of PB method Cash Flows after payback

Does not consider cash received after the payback period

Cash Flows Patterns

Does not consider the magnitude & timing of cash flows

Administrative Difficulties

Difficult to set up a standard/maximum payback

Inconsistent with shareholder value

Does not consider time value of money


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Discounted Payback Period

Number of periods taken in recovering the investmentoutlay on thepresent value basis

Except using discounted cash flows in calculating payback,

this method has all the demerits of payback method.

Using the previous sum calculate the discounted paybackperiod

9a7b4MODULE 3- Capital Budgeting STUDENT

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