capital budgeting
TRANSCRIPT
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Session 4
Capital Budgeting
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Capital Budgeting - Methods
1. Average Return on Investment
2. Payback
3. Net Present Value
4. Internal Rate of Return
5. Modified IRR
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Average Return on Investment
AROI = Avg. Net Income Per Year
Avg. Investment
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Average Return on Investment
Example:
Year Net Income Cost
1 6,000 100,000 Initial
2 8,000 0 Salvage Value
3 11,000
4 13,000
5 16,000
6 18,000
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Avg. Net Income 72,000
6
Avg. Investment 100,000
2
AROI 12,000
50,000
Average Return on Investment
= 12,000
= 24%
= 50,000
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Advantages
Disadvantages
Average Return on Investment
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Payback Method
# Years required to recover the original investment
Example:
Year Net Income Cash Flow Cumulative CF
1 6,000 26,000 26,000
2 8,000 28,000 54,000
3 11,000 31,000 85,000
4 13,000 33,000 118,000
5 16,000 36,000 154,000
6 18,000 18,000 172,000
Payback = 3 + 100,000 - 85,000
118,000 - 85,000 = 3.45 Years
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Payback Method
Advantages
Disadvantages
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Time Value of Money
FV = PV (1 + r)n
Compounding: Finding FV
Discounting: Finding PV: PV = FV/(1 + r) n
Internal Rate of Return: Finding r
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Net Present Value
NPV = Present Value of All Future Cash Flows less Inital Cost
= CF1 + CF2 + CF3 +.......CFn - Io
1+r (1+r)2 (1+r)3 (1+r)n
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Net Present Value - Example
Year CF Disc. Factor PV
0 -100000 1 -100000
1 26000 1/1.1 = .9091 23637
2 28000 1/(1.1)2 = .8264 23139
3 31000 1/(1.1)3 = .7573 23290
4 33000 1/(1.1)4 = .6830 22539
5 36000 1/(1.1)5 = .6209 22352
6 18000 1/(1.1)6 = .5645 10161
NPV = 25121
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Net Present Value
Advantages
Disadvantages
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Internal Rate of Return
Discount rate that makes NPV Zero (i.e., that equates PV of benefits with the cost).
IRR: Io = CF1 + CF2 + ..... + CFn
1+r (1+r)2 (1+r)n
Solve for r.
Example:
100,000 = 26000 + 28000 + 31000 + .......... + 18000
1+r (1+r)2 (1+r)3 (1+r)6
r = 18.2%
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Internal Rate of Return
Advantages
Disadvantages
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Profitability Index
PI = PV of all Benefits
PV of all Cost
Example:
PV (Benefits) = 26000 + 28000 +.......... + 18000
1.1 (1.1)2 (1.1)6
= 125121
PV (Cost) = 100000
PI = 125121 = 1.25
100000
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Profitability Index
Advantages:
Disadvantages:
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NPV Profile
Year CF Disc. Factor PV
0 -100,000 1 -100,000
1 26,000 0.91 23,636
2 28,000 0.83 23,140
3 31,000 1/(1.1)3 = .7573 23,291
4 33,000 1/(1.1)4 = .6830 22,539
5 36,000 1/(1.1)5 = .6209 22,352
6 18,000 1/(1.1)6 = .5645 10,161
NPV = 25,121
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NPV Profile
Dis. Rate NPV
0% 7200
5% 45725.7
10% 25120.76
15% 8711.838
20% -4538.97
25% -15376.1
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NPV Profile
80000
60000
40000
20000
0
-20000
0 0.05 0.1 0.15 0.2 0.25
Disc. Rate
NP
V
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Choosing Between Projects
Year CF(A) CF(B)
0 -25000 -25000
1 2000 21000
2 2000 10000
3 35000 2000
NPV 6351 4606
IRR 17% 22%
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NPV Profile
-10,000
-5,000
0
5,000
10,000
15,000
20,000
0% 5% 10% 15% 20% 25% 30%
Discount rate
NP
V
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Modified IRR
Reinvestment Rate Assumption (Project A)
Project Outlay 25,000
Cash Flows: YR1 2,000 YR2 2,000 YR3 35,000
NPV @ 8%: 6,351 IRR: 17%
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NPV: Project A
YR1: 2,000 YR2: 2,000 + 2,000 + 160 = 4,160 YR3: 35,000 + 4,160 + 333 = 39,493
[Note: PV of 39,493, three years from now @ 8% = 31,351 Less: outlay 25,000
NPV 6,351]
Modified IRR
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IRR @ 17% YR1: 2,000 = 2,000 YR2: 2,000 + 2,000 + 340 = 4,340 YR3: 35,000 + 4,340 + 738 = 40,078
[25,000 invested for three years @ 17% = 25,000(1.17)3 = 40,040]
Modified IRR
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Modified Internal Rate of Return
Find k such that (1+k)nI0 = Final value
i.e. (1+k)3 25000 = 39,439 k = 16.5%
Modified IRR
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Reinvestment Rate Assumption (Project B)
Project Outlay 25,000
Cash Flows: YR1 21,000 YR2 10,000 YR3 2,000
NPV @ 8%: 4,606 IRR: 22.12%
Modified IRR
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NPV: Project B
YR1: 21,000 = 21,000 YR2: 10,000 + 21,000 + 1,680 = 32,680 YR3: 2,000 + 32,680 + 2,614 = 37,294
[Note: PV of 37,294, three years from now @ 8% = 29,606 Less: outlay 25,000 NPV 4,606 ]
Modified IRR
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IRR of 22.12%
YR1: 21,000 = 21,000 YR2: 10,000 + 21,000 + 4,645 = 35,645 YR3: 2,000 + 35,645 + 7,885 = 45,530
[25,000 invested for three years @ 22.12% = 25,000(1.2212)3 = 45,530]
Modified IRR
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Modified Internal Rate of Return
Find k such that (1+k)nI0 = Final value
i.e. (1+k)3 25000 = 37,294 k = 14.26%
Modified IRR
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Estimating Cash Flows
NPV = CF1 + CF2 +.............. + CFn - Io
l+r (l+r)2 (l+r)n
Cash Flows Incremental
After Tax
Net Working Capital
Sunk Costs
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Procedure
1. Initial Costs: New CAPEX
Additional W. Cap
Sale of Old Assets
2. Annual Costs: Revenue Less Costs
After Tax
3. Terminal Cash Flows: Salvage Value
Recoupment of NWC
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Cash Flow Estimates
Sale of Existing Plant
CF= Selling Price + T (B.V. - S.P.)
Annual Cash Flows
OCF= (Sales-Cost)(1-T) + T, DEPREC
or
OCF= Net Inc + Depreciation
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New Product Proposal
Annual Sales $20m
Annual Costs $16m
Net Working Capital $2m
Plant Site $0.5m
Plant and Equipment $10m
Depreciation Straight Line over 20 years
Salvage Value nil
Tax Rate 40%
Required Return 8%
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New Product Proposal
INITIAL CASH FLOWS
ANNUAL CASH FLOWS
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New Product Proposal
TERMINAL CASH FLOWS
CALCULATION
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Evaluating Capital Projects
1) Focus on Cash Flow, Not Profits.
– Cash Flow = Economic Reality.
– Profits Can Be Managed.
2) Carefully Estimate Expected Future Cash Flows.
3) Select a Discount Rate Consistent with the Risk of Those Future Cash Flows.
4) Account for the Time Value of Money.
5) Compute a “Base-Case” NPV.
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6) Net Present Value = Value Created or Destroyed by the Project.– NPV is the Amount by which the Value of the Firm Will
Change if you Undertake the Project.
7)Identify Risks and Uncertainties. Run a Sensitivity Analysis.– Identify “Key Value Drivers.”– Identify Breakeven Assumptions.– Estimate Scenario Values.– Bound the Range of Value
Evaluating Capital Projects
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8) Identify Qualitative Issues.
– Flexibility
– Quality
– Know-How
– Learning
9) Decide
Evaluating Capital Projects