our capitalbudgeting

7/30/2019 Our Capitalbudgeting

1/19

Capital Budgeting Analysis

Abhisekh

Nitesh

Pankaj

Indrajit

kundan


2/19

OutlineMeaning of Capital Budgeting

Significance of Capital Budgeting Analysis

Traditional Capital Budgeting TechniquesPayback Period Approach

Discounted Payback Period Approach

Discounted Cash Flow Techniques Net Present Value

Internal Rate of Return

Profitability Index

Net Present Value versus Internal Rate of Return


3/19

Meaning of Capital BudgetingCapital budgeting addresses the issue ofstrategic long-term investment decisions.

Capital budgeting can be defined as theprocess of analyzing, evaluating, and decidingwhether resources should be allocated to aproject or not.

Process of capital budgeting ensure optimalallocation of resources and helpsmanagement work towards the goal ofshareholder wealth maximization.


4/19

Significance of Capital

BudgetingConsidered to be the most importantdecision that a corporate treasurer hasto make.

So much is the significance of capitalbudgeting that many business schoolsoffer a separate course on capitalbudgeting


5/19

Estimate cash flows (inflows & outflows).

Assess risk of cash flows.

Determine appropriate discount rateEvaluate cash flows. (Find NPV or IRR etc.)

Make Accept/Reject Decision

Steps in Capital Budgeting


6/19

Normal vs. Nonnormal Cash Flows

Normal Cash Flow Project:

Cost (negative CF) followed by a series of positivecash inflows.

One change of signs.

Nonnormal Cash Flow Project:

Two or more changes of signs.

Most common: Cost (negative CF), then string ofpositive CFs, then cost to close project.

For example, nuclear power plant or strip mine.


7/19

0 1 2 3 4 5 N NN

- + + + + + N- + + + + - NN

- - - + + + N

+ + + - - - N

- + + - + - NN

Inflow (+) or Outflow (-) in Year


8/19

Techniques of Capital Budgeting

AnalysisPayback Period Approach

Discounted Payback Period ApproachNet Present Value Approach

Internal Rate of Return

Profitability Index


9/19

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50

-30

Project S

Calculating payback


10/19

Strengths and Weaknesses of

PaybackStrengths:

Provides an indication of a projects risk andliquidity.

Easy to calculate and understand.

Weaknesses:

Ignores the TVM.

Ignores CFs occurring after payback period.No specification of acceptable payback.

CFs uniform??


11/19

What is Project L & Ss NPV @ 10%?

YEAR CF (L) PV OF CF (L) CF(S) PV OF CF (S)

O -100 -100 -100 -100

1 10 9.09 70 63.63

2 60 49.59 50 41.32

3 80 60.11 20 15.02

NPVL 18.79 NPVS 19.98


12/19

CF1 CF2 CFn

(1+IRR)1 (1+IRR)2 (1+IRR)n+ . . . ++ICO =

I RR

The Internal Rate of Return is a measure of your

investment performance, and is expressed aspercent return per year. .


13/19

$15,000 $10,000 $7,000

I RR Solution

$10,000 $12,000

(1+IRR)1

(1+IRR)2

Find the interest rate (IRR) that causes thediscounted cash flows to equal $40,000.

+ +

++$40,000 =

(1+IRR)3 (1+IRR)4 (1+IRR)5


14/19

rs.40,000= rs.10,000(PVIF10%,1) + rs.12,000(PVIF10%,2)+ rs.15,000(PVIF10%,3) + rs.10,000(PVIF10%,4)

+ rs. 7,000(PVIF10%,5)rs.40,000= rs.10,000(.909) + rs.12,000(.826) +

rs.15,000(.751) + rs.10,000(.683) +rs. 7,000(.621)

rs.40,000= rs.9,090 + rs.9,912 + rs.11,265 +rs.6,830 + rs.4,347

= rs.41,444 [Rate is too low!!]

I RR Solution (Try 10%)


15/19

I RR Solution (Try 15%)

rs.40,000= rs.10,000(PVIF15%,1) + rs.12,000(PVIF15%,2)+ rs.15,000(PVIF15%,3) +rs.10,000(PVIF15%,4) +

rs. 7,000(PVIF15%,5)rs.40,000= rs.10,000(.870) + rs.12,000(.756) +

rs.15,000(.658) +rs.10,000(.572) +rs. 7,000(.497)

rs.40,000= rs.8,700 +rs.9,072 + rs.9,870 +rs.5,720 + rs.3,479

= rs.36,841 [Rate is too high!!]


16/19

.10 rs.41,444

.05 IRR rs.40,000 rs.4,603

.15 rs.36,841

X rs.1,444

.05 rs.4,603

I RR Solution (I nterpolate)

Rs.1,444X

=


17/19

.10 rs.41,444

.05 IRR rs.40,000 rs.4,603

.15 rs.36,841

(rs.1,444)(0.05)

rs.4,603

I RR Solution (I nterpolate)

rs.1,444X

X =X = .0157

IRR = .10 + .0157 = .1157 or 11.57%


18/19

InvestmentInitial

PVPI

investmentinitialafter theflowsCash

Method :

Acceptance Rule:

Accept If PI >1.0

Reject If PI


19/19

Which technique is superior?Although our decision should be based onNPV, but each technique contributes in itsown way.

Payback period is a rough measure ofriskiness. The longer the payback period,more risky a project is

IRR is a measure of safety margin in aproject. Higher IRR means more safetymargin in the projects estimated cash flows

PI is a measure of cost-benefit analysis. Howmuch NPV for every dollar of initialinvestment

our capitalbudgeting

Documents