Capital Budgeting Decisions1

8/7/2019 Capital Budgeting Decisions1

1/21

Capital Budgeting Decisions


2/21

The investment decisions of a firm are generally

known as capital budgeting.

A capital budgeting decisions may be defined as the

firms decisions to invest its current funds most

efficiently in the long term assets in anticipation ofan expected flow of benefits over a series of years.

The firms investment decisions would generally

include expansion,acquisition,modernisation and

replacement of the long-term assets. Sale of a

division or business (divestment) is also as an

investment decision.


3/21

The firms value will increase if investments are

profitable and add to the shareholders wealth.

Thus, investment should be evaluated on the

basis of a criteria, which is compatible with the

objective of shareholders wealth maximization.

An investment will add to the shareholders

wealth if its yields benefits in excess of cost ofcapital.


4/21

Steps to evaluate of an investment

1. Estimation of cash

flows.2. Estimation of the required rate of return (the

opportunity cost of capital).

3. Application of a decision rule for making the

choice.


5/21

Investment decisions rule

It should maximise the shareholders wealth.

It should consider all cash flows to determine thetrue profitability of the project.

It should provide for an objective and unambiguousway of separating good projects from bad projects.

It should help ranking of projects according to theirtrue profitability.

It should help to choose among mutually exclusiveprojects that project which maximises theshareholders wealth.

It should be a criterion which is applicable to anyconceivable investment project independent of

oth

ers.


6/21

Evaluation Criteria

Payback Period (PB) Discounted payback period (DPB)

Net Present Value (NPV)

Internal Rate of Return (IRR) Profitability Index (PI)

Accounting Rate of Return (ARR)


7/21

PAYBACK Period

Payback period is the number of years required

to recover the original cash outlay invested in aproject.

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 forthe project is

C

C

InflowCashAnnual

InvestmentInitial=Payback 0!

years412,500Rs

50,000RsPB !!


8/21

Unequal cash flows In case of unequal cash inflows, the

payback period can be found out by adding up the cashinflows 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


9/21

Certain virtues: Simplicity

Cost effective

Serious vices:4Cash flows after payback

4Time value of money

Discounted Payback Period:


10/21

Net Present Value

It is t

he difference between t

he sum of t

he present

value of future cash inflows & the initial investment.

Decision rule:

NPV > 0 : Accepted NPV < 0 : Rejected

NPV = 0 : Indifferent


11/21

Net Present Value

The formula for the net present value can be

written as follows:

!

!

!

n

t

t

t

n

n

I

k

C

Ik

C

k

C

k

C

k

C

1

0

03

3

2

21

)1(

NPV

)1()1()1()1(NPV .


12/21

Example

Assume there are two mutually exclusive projects with similar

initial investment of Rs.56,125 and expected life of 5years butdifferent expected cash flows. The cost of capital is 10%.

Year Project A Project B

0 56,125 56,125

1 14,000 22,000

2 16,000 20,000

3 18,000 18,000

4 20,000 16,000

5 25,000 17,000

Total 93,000 93,000


13/21

Machine A

Year ash Flo resent alue @ 10% o F

0 56,125 1.000

1 14,000 0.909 12,726

2 16,000 0.826 13,2163 18,000 0.751 13,518

4 20,000 0.683 14,660

5 25,000 0.621 15,525Total 69,645


14/21

Machine B

Year ash Flo resent alue @ 10% o F

0 56,125 1.000

1 22,000 0.909 19,998

2 20,000 0.826 16,520

3 18,000 0.751 13,518

4 16,000 0.683 10,928

5 17,000 0.621 10.557

Total 71,521


15/21

NPV ofMachine A = Rs.13,520 i.e. Rs.(69,645 56,125)

NPV ofMachine B = Rs.15,396 i.e. Rs.(71,52156,125)

Limitations: Mutually exclusive projects

Alternative projects with unequal lives or limited fund constraintsthe NPV rule may give ambiguous results

Ranking of projects: as per the NPV rule is not independent ofdiscount rates.

Two projects A & B both costing Rs.50. Calculate NPV at 5% and 10%and rank the project.

Year Project A Project B

1 100 30

2 25 100


16/21

Internal Rate of Return

The internal rate of return (IRR) is the rate that

equates the investment outlay with the present

value of cash inflow received after one period.

This also implies that the rate of return is the

discount rate which makes NPV = 0.


17/21

Accept Reject decision:

The higher is better.

Should more than cut-off rate / required rateof return.


18/21

Calculation ofIRR

When Cash Flows structure is annuity

Step 1: Determine the payback period

Step 2: Check PVIFA table

Step 3: Find the two Pay back value, one is higher & one is lower

Step 4: Determine IRR by interpolation

Example: Let us assume that an investment would cost Rs 20,000

and provide annual cash inflow of Rs 5,430 for 6 years.

NPV Rs 20,000 + Rs 5,430(PVAF ) 0

Rs 20,000 Rs 5,430(PVAF )

PVAFRs 20,000

Rs 5,430

6,

6,

6,

!

!

! !

r

r

r3683.


19/21

Y

ear MachineA

Machine B0 56,125 56,125

1 14,000 22,000

2 16,000 20,000

3 18,000 18,000

4 20,000 16,000

5 25,000 17,000

Total 93,000 93,000


20/21

Machine A @18%

Year ash Flo PV@18% PV o F

0 56,125 1.000 - (56,125)

1 14,000 0.847 11,856

2 16,000 0.718 11,488

3 18,000 0.609 10,962

4 20,000 0.516 10,3205 25,000 0.437 10,925

Net - (572)


21/21

Machine A @17%

Year ash Flo PV@17% PV o F

0 56,125 1.000 - (56,125)

1 14,000 0.855 11,970

2 16,000 0.731 11,696

3 18,000 0.624 10,232

4 20,000 0.534 10,680

5 25,000 0.456 11,400

Net 853

Capital Budgeting Decisions1

Documents

Transcript of Capital Budgeting Decisions1