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Long Term Investment Decisions -Capital Budgeting
By :
Anmol Saini
OutlineWhat is Capital Budgeting?
Classification of investment
Stages in Capital Budgeting Process
Decision-making Criteria in Capital Budgeting
Methods of Evaluating Investment Proposals
Payback PeriodNet Present Value (NPV)Profitability IndexInternal Rate of Return (IRR)
Summary and Conclusions
What is Capital Budgeting? Capital Budgeting is the process of evaluating and selecting long-term
investment projects that achieve the goal of owner wealth maximization.
Features of investment decision:
1. exchange of current funds for future benefits
2. funds are invested in long term assets
3. future benefits will occur to firm over a series of year
The purposes of Capital Budgeting Projects include: to expand, replace, or renew fixed assets over a long period.
requires intensive planning
As It involve commitment of financial resources to a project on a long-term basis, it is important that a firm makes the right decision.
A wrong decision can lead to huge financial distress and even bankruptcy for a firm.
The longer the time horizon associated with a capital expenditure, the greater the uncertainty ( outflow and inflow, product life, economic conditions, cost of capital, technological change)
Type I: a: expansion and diversification
- adding capacity to expand existing operations
- expand by adding a new business or new product
b: replacement and modernization
- to improve operational efficiency and reducing the cost
Type II: a: mutually exclusive( serve same purpose, compete with each other)
b: independent(different purposes, do not compete)
c: contingent (dependent projects)
Classification of Investment Decisions
Stages in Investment Process
1. Generating alternative investment proposals
2. Estimating the incremental cash flows associated with projects
3. Estimation of required rate of return (opportunity cost of capital)
4. Evaluating and selecting project
Decision-making Criteria in Capital Budgeting
The Ideal Evaluation Method: considers the time value of money, focuses on resultant cash flows, uses a firm’s cost of capital as the discount rate to evaluate a project. Consider all cash flows to determine profitability Should help ranking the projects according to their true profitability Should recognize the fact that bigger cash flows are preferable to smaller
ones and early cash flows are preferable to later ones Should help in choosing among mutually exclusive projects
Converting Accounting Flow to Cash Flow
Earnings before depreciation and taxes . . . . . . 20,000Depreciation . . . . . . . . . . . . . . -5,000Earnings before taxes . . . . . . . . . . . 15,000Taxes (50%) . . . . . . . . . . . . . . - 7,500Earnings after taxes . . . . . . . . . . . . 7,500Depreciation . . . . . . . . . . . . . . + 5,000Cash flow . . . . . . . . . . . . . . . 12,500
Methods of Evaluating Investment Proposals
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Accounting rate of return (ARR)
Payback Period (PP)
Net Present ValueNet Present Value (NPV):
the present value of the cash inflows minus the present value of the cash outflows
the future cash flows are discounted back over the life of the investment
the basic discount rate is usually the firm’s cost of capital Accept/Reject Decision:
if NPV > 0, accept the project
if NPV < 0, reject the project
Internal Rate of Return Is the Rate of Return that equates the initial cash outflow (cost) with
the future cash inflows (benefits)
is the discount rate where the cash outflows equal the cash inflows (or NPV = 0), that is, IRR is simply the discount rate at which the NPV of the project equals zero.
Accept/Reject Decision:
if IRR > cost of capital, accept the project
if IRR < cost of capital, reject the project
Profitability Index (PI)
Profitability Index (PI):
is computed by dividing the present value of inflows by the present value of outflows.
Accept/Reject Decision:
if PI > 1, accept the project
if PI < 1, reject the project
Payback Period
computes the amount of time required to recover the initial investment
Advantages:
Easy to understand and use
Emphasizes the shorter time-horizon
Disadvantages:
ignores inflows after the cutoff period
fails to consider the time value of money
fails to consider any required rate of return
Project Data
Net Cash Inflows (of a 10,000 investment)
Year Investment A Investment B
1 3000 1,500
2 5,000 2,000
3 2,000 2,500
4 2000 5,000
5 3000 5,000
cost of capital = 10%
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Capital budgeting results
Investment A Investment B SelectionPayback period . . . . 3 years 3.8 years Quickest payback:
Investment A
Net present value . . . 1588 1,413 Highest net present value:
Investment A
Internal rate of return 16.54% 14.33% Highest yield: Investment A
Profitability Index . . 1.16 1.141 Highest relativeprofitability:
Investment A
NPV – most reliable measure
Payback period is the least reliable measure of project acceptability. NPV, PI and IRR are more reliable measure.
In case of conflict among NPV, PI and IRR, NPV should prevail. NPV has proven to be the only reliable measure of a project’s acceptability.
Consider all cash flow
True measure of profigtability
Recognizes time values of money
Consistent with SWM principle
NPV is the only measure which always gives the correct decision when evaluating projects.
Only NPV measures the amount by which a project would increase the value of the firm.
Summary and Conclusions
A capital budgeting decision involves planning cash flows for a long-term investment
Several methods are used to analyse investment proposals: payback, net present value, internal rate of return, and profitability index
The net present value method, in particular, considers the amount and timing of cash flows
The analysis is based upon estimates of incremental cash flows after tax that will result from the investment