3rd session capital budgeting

8/14/2019 3rd Session Capital Budgeting

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Indian School of Petroleum

The Basics of Capital Budgeting:

Evaluating Cash Flows

Should we

build thisplant?

By: Dr Pawan

Gupta


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Capital BudgetingC

apital Budgeting:: the process ofthe process of

planning for purchases of long-planning for purchases of long-

term assets.term assets.

s exampleexam

ple::

Suppose our firm must decide whether toSuppose our firm must decide whether topurchase a new plastic molding machinepurchase a new plastic molding machine

for Rs125,000. How do we decide?for Rs125,000. How do we decide?

s Will the machine be profitable?Will the machine be profitable?s Will our firm earn a high rate of returnWill our firm earn a high rate of return

on the investment?on the investment?


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Decision-making Criteria inDecision-making Criteria in

Capital BudgetingCapital Budgeting

How do we decideHow do we decide

if a capitalif a capital

investmentinvestment

project shouldproject should

be accepted orbe accepted or

rejected?rejected?


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s The Ideal Evaluation Method should:The Ideal Evaluation Method should:

a) includea) include all cash flowsall cash flows that occurthat occur

during the life of the project,during the life of the project,

b) consider theb) consider the time value of moneytime value of m

oney,,c) incorporate thec) incorporate the required rate ofr

equired rate of

returnreturn on the project.on the project.

Decision-making Criteria inDecision-making Criteria in

Capital BudgetingCapital Budgeting


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Future valueFuture value

( )FV PV in n= +1 .Whats the FV of an initial Rs 100

after 3 years if i = 10%?


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After 3 years:

FV3 = PV(1 + i)3

= Rs 100(1.10)3

= Rs 133.10.


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Present valuePresent value

s Whats the PV of Rs 100 due in 3 years if i =Whats the PV of Rs 100 due in 3 years if i =

10%?10%?

( )PV = FV1+ i = FV 11+ in n nn

PV = 100 1.1013

Rs 75.13.=


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Payback PeriodPayback Period

s The number of years needed toThe number of years needed torecover the initial cash outlay.recover the initial cash outlay.

s How long will it take for the projectHow long will it take for the project

to generate enough cash to pay forto generate enough cash to pay for

itself?itself?


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s How long will it take for the projectHow long will it take for the projectto generate enough cash to pay forto generate enough cash to pay for

itself?itself?

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150


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s How long will it take for the projectHow long will it take for the projectto generate enough cash to pay forto generate enough cash to pay for

itself?itself?

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150

Payback period = 3.33 years.Payback period = 3.33 years.


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s Is a 3.33 year payback period good?Is a 3.33 year payback period good?

s

Is it acceptable?Is it acceptable?s Firms that use this method willFirms that use this method will

compare the payback calculation tocompare the payback calculation to

some standard set by the firm.some standard set by the firm.s If our senior management had set aIf our senior management had set a

cut-off of 5 years for projects likecut-off of 5 years for projects like

ours, what would be our decision?ours, what would be our decision?

s Accept the projectAccept the project..


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Drawbacks of Payback Period:Drawbacks of Payback Period:

s Firm cutoffs areFirm cutoffs are subjectivesubjective..

s Does not considerDoes not consider time value of moneytime value of money..

s Does not consider anyDoes not consider any required rate ofrequired rate ofreturnreturn..

s Does not consider all of the projectsDoes not consider all of the projects

cash flowscash flows..


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Drawbacks of Payback Period:Drawbacks of Payback Period:

s Does not consider all of the projectsDoes not consider all of the projects

cash flows.cash flows.

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0

Consider this cash flow stream!


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Discounted PaybackDiscounted Payback

s Discounts the cash flows at the firmsDiscounts the cash flows at the firms

required rate of return.required rate of return.

s Payback period is calculated usingPayback period is calculated usingthese discounted net cash flows.these discounted net cash flows.

s ProblemsProblems::

s Cutoffs are still subjective.Cutoffs are still subjective.

s Still does not examine all cash flows.Still does not examine all cash flows.


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250

DiscountedDiscounted

YearYear Cash FlowCash Flow CF (14%)CF (14%) 00 -500-500 -500.00-500.00

11 250250 219.30219.30 1 year1 year

280.70280.70


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38 2 years2 years

88.3288.32


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38 2 years2 years

88.3288.32

33 250250 168.75168.75


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38 2 years2 years

88.3288.32

33 250250 168.75168.75 .52 years.52 years


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00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38 2 years2 years

88.3288.32

33 250250 168.75168.75 .52 years.52 years

The DiscountedThe Discounted

PaybackPayback

isis 2.522.52 yearsyears


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Other MethodsOther Methods

1)1) Net Present ValueNet Present Value (NPV)(NPV)

2)2) Profitability IndexProfitability Index (PI)(PI)

3)3) Internal Rate of ReturnInternal Rate of Return (IRR)(IRR)

Each of these decision-making criteria:Each of these decision-making criteria:

s Examines all net cash flows,Examines all net cash flows,

s Considers the time value of money, andConsiders the time value of money, and

s

Considers the required rate of return.Considers the required rate of return.


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Net Present ValueNet Present Value

NPV = the total PV of the annual netNPV = the total PV of the annual netcash flows - the initial outlay.cash flows - the initial outlay.

Decision RuleDecision Rule::

If NPV is positive,If NPV is positive, ACCEPTACCEPT..

If NPV is negative,If NPV is negative, REJECTREJECT..


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NPV ExampleNPV Example

0 1 2 3 4 5

(276,400)83,000 83,000 83,000 83,000 116,000

s Suppose we are considering a capitalSuppose we are considering a capital

investment that costs Rs276,400 and providesinvestment that costs Rs276,400 and providesannual net cash flows of Rs 83,000 for fourannual net cash flows of Rs 83,000 for four

years and Rs116,000 at the end of the fifth year.years and Rs116,000 at the end of the fifth year.

The firms required rate of return is 15%.The firms required rate of return is 15%.


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Profitability IndexProfitability Index

NPVNPV = - IO= - IOACFACFtt

(1 + k)(1 + k) tt

nn

t=1t=1


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t


(1 + k)(1 + k) tt

nn

t=1t=1

PI = IOACF

t

(1 + k)

n

t=1


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If PI is greater than or equalIf PI is greater than or equal

to 1,to 1, ACCEPTACCEPT..

If PI is less than 1,If PI is less than 1, REJECTREJECT..


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Internal Rate of Return (IRR)Internal Rate of Return (IRR)

s IRRIRR:: the return on the firmsthe return on the firms

invested capital.invested capital. IRR is simply theIRR is simply the

rate of return that the firm earnsrate of return that the firm earns

on its capital budgeting projects.on its capital budgeting projects.


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(1 + k)(1 + k) tt

nn

t=1t=1


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n

t=1IRR: = IOACFt(1 + IRR) t


(1 + k)(1 + k) tt

nn

t=1t=1


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s IRR is the rate of return that makes theIRR is the rate of return that makes the

PV of the cash flowsPV of the cash flows equalequal to the initialto the initial

outlay.outlay.

n

t=1

IRR: = IOACFt(1 + IRR) t


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Calculating IRRCalculating IRR

s

Looking again at our problem:Looking again at our problem:s The IRR is the discount rate thatThe IRR is the discount rate that

makes the PV of the projected cashmakes the PV of the projected cash

flowsflows equalequal to the initial outlay.to the initial outlay.

0 1 2 3 4 5

(276,400)

83,000 83,000 83,000 83,000 116,000


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s This is what we are actually doing:This is what we are actually doing:

83,000 (PVIFA83,000 (PVIFA 4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))

= 276,400= 276,400

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000

83 000 83 000 83 000 83 000 116 00083 000 83 000 83 000 83 000 116 000


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s This is what we are actually doing:This is what we are actually doing:

83,000 (PVIFA83,000 (PVIFA 4,4, IRRIRR) + 116,000 (PVIF) + 116,000 (PVIF 5,5, IRRIRR))

= 276,400= 276,400

You should getYou should get IRR = 17.63%!IRR = 17.63%!

s This way, we have to solve for IRR by trialThis way, we have to solve for IRR by trial

and error.and error.

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000


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IRRIRR


If IRR is greater than or equalIf IRR is greater than or equalto the required rate of return,to the required rate of return,

ACCEPTACCEPT..

If IRR is less than the requiredIf IRR is less than the required

rate of return,rate of return, REJECTREJECT..


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Capital RationingCapital Rationing

s Capital rationing occurs when a companyCapital rationing occurs when a company

chooses not to fund all positive NPV projects.chooses not to fund all positive NPV projects.

s The company typically sets an upper limit onThe company typically sets an upper limit onthe total amount of capital expenditures that itthe total amount of capital expenditures that it

will make in the upcoming year.will make in the upcoming year.


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Reason: Companies want to avoid the direct

costs (i.e., flotation costs) and the indirect costs

of issuing new capital.

Solution: Increase the cost of capital by enough

to reflect all of these costs, and then accept all

projects that still have a positive NPV with thehigher cost of capital.


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Reason: Companies dont have enough

managerial, marketing, or engineering staff to

implement all positive NPV projects.

Solution: Use linear programming to maximize

NPV subject to not exceeding the constraints on

staffing.


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Reason: Companies believe that the projects

managers forecast unreasonably high cash flow

estimates, so companies filter out the worst

projects by limiting the total amount of projects

that can be accepted.

Solution: Implement a post-audit process and tie

the managers compensation to the subsequent

performance of the project.


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I di S h l f P l

ThanksThanks

3rd session capital budgeting

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