CAPITAL BUDGETING
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Transcript of CAPITAL BUDGETING
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CAPITAL BUDGETING
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Group Members
Adeel AkbarTaimoor ShahzadaMoqeet Ahmad Muhammad Shoaib
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What is Capital Budgeting?
“Capital Budgeting is the process of identifying, Analyzing and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.”
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What is Capital Budgeting?
“Capital Budgeting is the process of planning expenditures on assets with cash flows that are expected to extend beyond one year”
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Functions of Capital Budgeting
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FunctionsGenerating Investment projects
proposals consistent with firm’s strategy.
Estimating after tax operating cash flows for investment projects.
Evaluating project cash flows.Selecting a project based on
Value-Maximizing criteria.
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Our Focused Area
Selecting a project based on Value-Maximizing criteria.
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Techniques
PBP NPV
IRR PI
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Pay Back Period (PBP)
“The Length of time required for an investment’s net Revenues to cover its cost.”
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Can be Calculated as:
PBP= a + (b-c) d
Project with Minimum PBP will be Accepted.
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Net Present Value (NPV)
“The Present value of an investment project’s is net cash flows minus the Project’s initial cash outflow.”
NPV=Present value of cash flows – Initial Investment
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NPV= cf1+ cf2 + …….. + cfn -
ICO
(1+r)1 (1+r)2 (1+r)n
Where: cf = Cash flow r = Interest rate ICO= Initial Cash out flow
Project with +ve NPV will be selected
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Internal Rate of Return (IRR)“The discount Rate that equates the
present value of the future net cash flows from an investment project’s initial cash out flow.”
If IRR > Given Rate, project will b accepted.
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Formula
IRR = LDR + diff b/w NPV of LDR
two rates sum of both NPVs
where:
LDR = Lower Discount Rate
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Profitability Index (PI)
“The Ratio of the present value of a project’s future net cash flow to the project’s initial cash out flow”
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Example
ABC company has two projects Project A and Project B, the maximum pay back period and interest rate for both projects is 4years and 12% respectively, cash flows of different years for both projects is given. Evaluate both projects on the basis of four capital budgeting techniques and decide which project is beneficial for the company.
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Cash Flows:Project A Project B
Years Cash Flow
1 15,000
2 20,000
3 30,000
4 35,000
5 40,000
Years Cash Flow
1 12,000
2 14,000
3 30,000
4 25,000
5 20,000
Initial Investment 70,000
Initial Investment 90,000
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Calculation of PBP
Initial Investment = 70,000Years Cash Inflow Cumulative Cash Inflow
1 15,000 15000
2 20,000 (15000+20000) 35,000
3 30,000 (35000+30000) 65,000
4 35,000 (65000+35000) 1,00,000
5 40,000 (100000+40000) 1,40,000
a = 3 , b = 70,000 , c = 65,000 , d = 35,000
Project A
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Calculation of PBP
Initial Investment 90,000Years Cash Inflow Cumulative Cash Inflow
1 12,000 12,000
2 14,000 (12,000+14,000) 26,000
3 30,000 (26,000+30,000) 56,000
4 25,000 (56,000+25,000) 81,000
5 20,000 (81,000+20,000) 1,01,000
Project B
a = 4 , b = 90,000 , c = 81,000 , d = 20,000
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Pay Back Period (PBP)
Project APBP =3 + 70,000 – 65,000
30,000
= 3+ 5,000
30,000
= 3+ 0.14
= 3.14
3 Year,1 Month & 20 days
Project BPBP = 4 + 90,000 – 81,000
20,000
= 4 + 9,000
20,000
= 4 + 0.45
= 4.45 Years
4 Years, 5 Months & 12 days
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Calculation Of Net Present Value
Initial Investment = 70,000Year
sCash
InflowPVIF PVCI
1 15,000 0.893 (0.893 ˣ 15,000) 13,395
2 20,000 0.791 (0.791 ˣ 20,000) 15,940
3 30,000 0.712 (0.712 ˣ 30,000) 21,360
4 35,000 0.636 (0.636 ˣ 35,000) 22,260
5 40,000 0.567 (0.567 ˣ 40,000) 22,680
Total Present Value 95,635
Project A
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Calculation Of Net Present Value
Initial Investment = 90,000Year
sCash
InflowPVIF PVCI
1 12,000 0.893 (0.893 ˣ 12,000) 10,716
2 14,000 0.791 (0.791 ˣ 14,000) 11,158
3 30,000 0.712 (0.712 ˣ 30,000) 21,360
4 25,000 0.636 (0.636 ˣ 25,000) 15,900
5 20,000 0.567 (0.567 ˣ 20,000) 11,340
Total Present Value 70,474
Project B
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Net Present Value (NPV)
NPV = Total Present Value – Initial Investment
= 95,635 – 70,000
= 25,635
NPV = Total Present Value – Initial Investment
= 70,474 –
90,000 = -19,526
Project A Project B
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Steps for Calculation of IRR
1. Calculate average cash flow
2. Divide Initial Investment by answer of above step
3. Find the Answer of above step in table and see % of rate
4. Calculate total present value with the help of above found rate
5. Get another total present value with another supposed rate.
6. Apply the formula
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Calculation of Avg. Cash Flow
Years Cash Inflow
1 15,000
2 20,000
3 30,000
4 35,000
5 40,000
Total 1,40,000
Project A Project B
Years Cash Inflow
1 12,000
2 14,000
3 30,000
4 25,000
5 20,000
Total 1,01,000
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Step 1 : Average Cash Inflow
Average = Total Cash Inflow
No. of Years
= 1,40,000
5
= 28,000
Average = Total Cash Inflow
No. of Years
= 1,01,000
5
= 20,200
Project A Project B
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Step 2: Division
Divide Initial Investment by answer of previous step.
= 70,000
28,000
= 2.5
Divide Initial Investment by answer of previous step.
= 90,000
20,200
= 4.45
Project A Project B
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Step 3 : See The Table
Periods 27% 28% 29%
3 1.896 1.868 1.842
4 2.280 2.241 2.203
5 2.583 2.532 2.483
Periods 3% 4% 5%
3 2.829 2.775 2.723
4 3.717 3.630 3.546
5 4.580 4.452 4.329
Project A Project B
28% 4%Periods 28%
1 0.781
2 0.610
3 0.477
4 0.373
5 0.291
Periods 4%
1 0.962
2 0.925
3 0.889
4 0.855
5 0.822
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With 28% With 23%
PVIF TPV PVIF TPV0.781 11,715 0.813 12,195
0.620 12,200 0.661 13,220
0.477 14,310 0.537 16,110
0.373 13,055 0.437 15,295
0.291 11,640 0.355 14,200
62,920 71,020
With 4% With 2 %
PVIF PV PVIF PV0.962 11,544 0.980 11,760
0.925 12,950 0.961 13,454
0.889 26,670 0.942 28,260
0.855 21,375 0.924 23,100
0.822 16,440 0.906 18,120
88,979 94,694
Project A Project B
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Step 4 & 5: Calculate NPV
Present value with 28%
= 62,920 – 70,000
= -7080
Present value with 23%
= 71020 – 70000
= 1020
Present value with 4%
= 88,979 – 90,000
= -1021
Present value with 2%
=94,694 – 90,000
= 4694
Project A Project B
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Step 6: Apply The Formula
IRR = 23%+5% 1020
1020 + 7080
=23%+5% 1020
8100
= 23%+5% (0.125925)
= 23% + 0.63%
= 23.62%
IRR= 2%+2% 4694
4694 + 1021
=2%+2% 4694
5715
= 2% + 2% ( 0.8213)
= 2% + 1.64%
= 3.64%
Project A Project B
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Profitability Index
PI = Net Present Value
Initial Investment
= 95,635
70,000
= 1.36
PI = Net Present Value
Initial Investment
= 70,474
90,000
= 0.78
Project A Project B
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Conclusion
Project A Project B
PBP 2 Y ,1M, 20 D 4Y ,5M, 12 D
NPV 25,635 (19,526)
IRR 23.62% 3.64%
PI 1.36 0.78
On the basis of above Techniques The Project B is Not Beneficial for Company ABC.
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Thank you!!!
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