capital budgeting
TRANSCRIPT
CAPITAL BUDGETING
Capital Budgeting Decisions
• Capital Budgeting is the process of evaluating and selecting long term investments that are consistent with the goal of shareholders (owners) wealth maximization.
• Capital budgeting decisions pertain to fixed/long term assets which, by definition, refers to assets which are in operation, and yield a return, over a period of time, usually, exceeding one year.
•
Type of decisions
• Investment decisions affecting revenues
• Investment decisions reducing costs
Capital Budgeting process
• Independent projects (whose cash flows are independent of one another and the acceptance of one does not eliminate the other from further consideration).
• Mutually exclusive projects (those compete with each other and the acceptance of one eliminates the other from further consideration)
• Capital rationing (the firm has fixed amount to allocate among competing capital expenditures)
B. An Example of Mutually Exclusive Projects
BRIDGE vs. BOAT to get products across a river.
Projects are:
mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.
Projects are: independent, if the cash flows of one are unaffected by the acceptance of the other.
Cash Flows v/s Accounting profit
Causes of differences:
• Ambiguity in the estimation of stock , depreciation
• Effect of taxes
• Time value of money
• X enterprise is determining the cash flow for a project involving replacement of an old machine by a new machine. The old machine, bought a few years ago, has a book value of Rs. 4 lac and it can be sold to realize a salvage value of Rs. 3 lac. It has a remaining life of 5 years after which its net salvage value is expected to be Rs. 160000. it is being depreciated annually at a rate of 25 percent under the written value method. The working Capital required for the old machine is 4 lac.
The new machine costs Rs. 16 lac. It is expected to fetch a net salvage of Rs. 8 lac after 5 years when it will no longer be required. The depreciation rate applicable to it is 25 percent under the written value method. The new working capital required for the new machine is Rs. 5 lac. The new machine is expected to bring a saving of Rs. 3 lac annually in manufacturing costs (other than depreciation). The tax rate applicable to the firm is 40 percent. The machine belongs to same asset class.
Calculate the incremental after tax cash flow associated with the project.
Evaluation Techniques
• Pay Back Method
• Net Present value Method
• Internal Rate of return Method
What is the payback period?
• The number of years required to recover a project’s cost,
or how long does it take to get the business’s money back?
PB= Investment
Constant Annual Cash Flow
Payback for Project L
10 8060
0 1 2 3
-100
=
CFt
Cumulative -100 -90 -30 50
Payback 2 + 30/80 = 2.375 years
0100
2.4
Project S
70 2050
0 1 2 3
-100CFt
Cumulative -100 -30 20 40
PaybackS 1 + 30/50 = 1.6 years
100
0
1.6
=
C.2. Strengths of Payback:
1. Provides an indication of a
project’s risk and liquidity.
2. Easy to calculate and
understand.
C.2. Weaknesses of Payback:
1. Ignores the TVM (time value of money).
2. Ignores CFs occurring
after the payback period.
Where is it useful?
• In a political unstable country.
• A firm with limited liquid assets and no ability to raise additional funds
• The firms which lay more emphasis on short run earning performance rather than its long term growth
• The pay back method is a good approximation of the internal rate of return.
10 8060
0 1 2 3
CFt
Cumulative -100 -90.91 -41.32 18.79
Discountedpayback 2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discountedrather than raw CFs.
PVCFt -100
-100
10%
9.09 49.59 60.11
=
Recover invest. + cap. costs in 2.7 yrs.
NPV
CF
kt
nt
t 0 1
.
NPV: Sum of the PVs of inflows and outflows.
Cost often is CF0 and is negative.
.CF
k1
CFNPV 0t
tn
1t
What’s Project L’s NPV?
10 8060
0 1 2 310%
Project L:
-100.00
9.09
49.59
60.1118.79 = NPVL
Rationale for the NPV Method
NPV = PV inflows - Cost= Net gain in wealth.
Accept project if NPV > 0.
Choose between mutually exclusive projects on basis ofhigher NPV. Adds most value.
NPV : An Evaluation
Advantages:• It recognizes the time value of money.• It considers the total benefits arising out of the
proposal.• A changing discount rate can be used
accordingly.• Particularly useful in mutually exclusive projectsLimitations:• Somewhat difficult to calculate as well as to
understand• Calculation of discount rate in the real world is
somewhat difficult.
Internal Rate of Return: IRR
0 1 2 3
CF0 CF1 CF2 CF3
outflow Inflows
IRR is the discount rate that equates the present value of cash inflows and present value of cash outflow. This is the same as forcing NPV = 0.
NPV
k
CF
k
CFt
itn
tt
otn
t
11 00
NPV: Enter k, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
NPV
k
CF
k
CFt
itn
tt
otn
t
11 00
Rationale for the IRR Method
If IRR > WACC, then the project’s rate of return is greater than its cost-some return is left over to boost stockholders’ returns.
Example: WACC = 10%, IRR = 15%. Profitable.
IRR Acceptance Criteria
• If IRR > k, accept project.
• If IRR < k, reject project.
If CFs are constant
A project costs Rs. 36000 and is expected to generate cash inflows of Rs. 11200 annually for 5 years. Calculate the IRR of the project.
For a mixed stream of cash flows
• If the cash flows are not constant, in that case , the trial-and-error method is used to calculate the IRR.
For example,Year Machine A Machine B0 56125 561251 14000 220002 16000 180003 18000 180004 20000 160005 25000 17000
Profitability Index• The ratio of the present value of a projects future
net cash inflows to the present value of project's cash outflow.
PV of cash inflowsPI=
PV of cash outflows
.
k1
COFk1
CIF
PIn
0tt
t
n
0tt
t
A company is contemplating the introduction of a new machine. From the following information given to you, determine the profitability of the project, assuming 10 percent as cost of capital.
Year Cash outflow Cash inflow
0 40000 -
1 - 20000
2 - 20000
3 30000 -
4 40000 80000