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100%(1)100% found this document useful (1 vote)

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Attribution Non-Commercial (BY-NC)

100%(1)100% found this document useful (1 vote)

16K views31 pagesAttribution Non-Commercial (BY-NC)

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• Capital budgeting is the process of evaluating &

selecting long-term investments that are consistent

with the goal of shareholders’ wealth maximization.

• Types of investment decisions:

1. Expansion & Diversification

2. Replacement & Modernization

• Investment Evaluation Criteria:

1. Estimation of cash flows,

2. Estimation of required rate of return (the opportunity

cost of capital),

3. Application of a Decision Rule (Capital budgeting

techniques) for making the choice.

Evaluation Criteria

• Discounted Cash • Non-Discounted

flow Techniques: Cash flow

1. Net Present Value Techniques:

(NPV) 1. Payback Period (PB)

2. Internal Rate of 2. Discounted Payback

Return (IRR) Period (DPB)

3. Profitability Index 3. Accounting Rate of

(PI) Return (ARR)

NDCF Techniques

1. Pay Back period

• Payback(PB): Refers to the number of years

required to recover the initial outlay of the

investment.

• If the project generate constant annual cash

flows, then PB = (Initial investment ÷ Annual

cash inflow) = [Co ÷ C]

• In case of unequal cash inflows, the PB period

can be found out by adding up the cash inflows

until the total is equal to the initial cash outlay.

Pay Back period………..

• Acceptance Rule : Accept if PB< Standard payback &

vice versa.

• An alternative way of expressing the payback period=

[(1 ÷ Payback Period) X 100]; if a project has a

payback of 2 ½ years, payback period reciprocal is

40%.

the lower payback period) the more worthwhile the

project becomes.

Pay Back period………..

• Merits:

1. Easy to compute and inexpensive to use;

2. Emphasizes liquidity;

3. Recognizes cash flows & a crude way to cope with risk.

• Demerits:

1. Ignores the time value of money (magnitude & timing of

cash inflows);

2. Ignores cash flows occurring after the PB period;

3. No objective way to determine the standard pay back.

NDCF Techniques

2. Discounted Pay Back period

• The number of years required in

recovering the cash outlay on the present

value basis.

• Cash inflows are discounted with the

opportunity cost of capital of the said

project.

• Still fails to consider the cash flows

occurring (magnitude & timing) after the

payback period.

NDCF Techniques

3. Accounting Rate of Return(ARR)

• ARR [ also known as ROI] method employs the

normal accounting technique to measure the

increase in profit expected to result from an

investment.

average net operating profit [EBIT(1 – T)] by the

average investment.

& vice versa.

Accounting Rate of Return…..

• Merits:

1. Uses accounting data with which executives are

familiar;

2. Easy to understand & compute;

3. Gives more weightage to future receipts.

• Demerits:

1. Ignores time value of money;

2. Does not use cash flows

3. No objective way to determine the minimum

acceptable rate of return.

DCF Techniques

1. Net Present value (NPV)

• The difference between PV of cash inflows and

PV of cash outflows is equal to NPV; the firm’s

opportunity cost of capital being the discount rate.

n

Ct

• NPV = t 1 (1 k ) t

Co

• Acceptance Rule:

• Accept if NPV > 0 (NPV is positive) & vice versa.

• Project may be accepted if NPV = 0.

Net Present value (NPV)

• Merits: • Demerits:

1. Considers all cash 1. Requires estimates of

flows; cash flows which is a

2. Based on the concept of tedious task;

time value of money; 2. Requires computation of

3. Satisfies the value the opportunity cost of

additivity principle capital which poses

(i.e.NPVs of two or more practical difficulty;

projects can be added); 3. Sensitive to discount

4. Consistent with rates.

shareholders wealth

maximization principle.

NPV sensitive to discount rates

• Example:

• Two projects A & B – both costing Rs.50

each. Project A returns Rs.100 after 1 year

& Rs. 25 after 2 years. Project B returns

Rs.30 after 1 year and Rs.100 after 2

years. At discount rates of 5% & 10%,

what will be the NPV of the projects & their

ranking ?

Solution

• Particulars NPV Rank NPV Rank

5% 10%

Project A 67.92 II 61.57 I

Project B 69.27 I 59.91 II

• Ranking reversed when discount rate changed from 5%

to 10%.

discounting becomes more severe for cash flows

occurring later in the life of the project.

discounting impact.

DCF Techniques

2. Internal Rate of Return (IRR)

• The discount rate which equates the present value of an

investment’s cash inflows and outflows is its internal rate

of return; or

• The discount rate at which the NPV = 0.

n

Ct

• NPV = (1 r ) t C0 0

t 1

method.

• For Even Cash flows= NPV= (-) Initial Investment + Cash

flows (PVFAn opportunity cost)

IRR for Uneven Cash flows

(Trail & Error Method)

• Steps:

1. Select any discount rate to compute the PV of cash

flows;

2. If the NPV is (+), try with a higher rate or vice versa;

3. Process repeated till NPV is zero (in reality, if we can

identify two NPVs at lower as well as higher rate, we

can use the method of interpolation to get the IRR).

Difference between two Discount rates (NPV at Lower

discount rate ÷ Absolute difference between two

NPVs)

IRR for Even Cash flows

NPV= (-) Co + CI (PVFAn opportunity cost)

of Rs.5430 p.a. for 6 years. If the opportunity cost of capital is 10%,

identify project’s NPV & IRR.

= - 20,000 + (5430 X 4.355) = Rs.3,648.

or, 20,000 = 5430 (PVAF6,r)

or, (PVAF6,r) = (20,000 ÷ 5430) = 3.683

Rate which provides PVAF of 3.683 for 6 years is project’s IRR =

(Approximately 16%).

Internal Rate of Return (IRR)……

NPV Profile & IRR

• NPV of a project declines as the discount rate

increases & for discount rates higher than the

project’s IRR, NPV will be negative.

• If all NPVs and discount rates are plotted in a

graph, we get NPV profile and the discount rate

at which the NPV is zero can be identified as

IRR, or

• The point where its NPV profile crosses the

horizontal axis indicates a project’s Internal Rate

of Return.

NPV Profile & IRR

(Example)

Cash flow Discount NPV

rate

-20000 0% 12,580

5430 5% 7,561

5430 16% 0

Internal Rate of Return (IRR)……

• Acceptance Rule: Accept the project when r > k, and

reject when r < k; may accept the project when r = k.

• Merits: Same as of NPV criterion.

• Demerits:

1. Requires estimates of cash flows which is a tedious

task;

2. Does not hold the value additivity principle (i.e. IRRs of

two or more projects do not add);

3. At times fails to indicate correct choice between

mutually exclusive projects;

4. At times yields multiple rates;

5. Difficult to compute.

DCF Techniques

3. Profitability Index (PI)

• The ratio of present value of cash flows to the initial outlay is

Profitability Index or Benefit Cost Ratio.

and it can generate cash inflow of Rs 40,000, Rs

30,000, Rs 50,000 and Rs 20,000 in year 1 through 4.

Assume a 10 per cent rate of discount. Calculate the PV

of cash inflows at 10 % discount rate & the PI.

• Rs.12,350; & the PI = (Rs.12,350 ÷ Rs.1,00,000) = 1.235

Profitability Index (PI)…….

• Merits: 1) Considers all cash flows & recognizes

the time value of money.

• 2) A relative measure of profitability used at the

time of capital rationing.

• Demerits: 1) At times fails to indicate correct

choice between mutually exclusive projects;

• 2) Like NPV method, PI criterion also requires

calculation of cash flows and estimate of the

discount rate. In practice, estimation of cash

flows and discount rate pose problems.

Conventional and Non-conventional

Cash Flows

• A conventional investment has cash flows the

pattern of an initial cash outlay followed by cash

inflows. Conventional projects have only one

change in the sign of cash flows i.e., – + + +.

hand, has cash outflows mingled with cash

inflows throughout the life of the project. Non-

conventional investments have more than one

change in the signs of cash flows; for example,

– + + + – ++ – +.

NPV Versus IRR

economically independent of each other, NPV

and IRR methods result in same accept-or-reject

decision if the firm is not constrained for funds in

accepting all profitable projects.

NPV Versus IRR

• Lending and borrowing-type projects:

• Project with initial outflow followed by inflows is a

lending type project, and project with initial inflow

followed by outflows is a borrowing type project.

Both are conventional projects.

Cash Flows (Rs)

Project C0 C1 IRR NPV at 10%

X -100 120 20% 9

Y 100 -120 20% -9

Problem of Multiple IRRs

• A project may have both NPV (Rs)

250

lending and borrowing NPV Rs 63

features together. IRR 0

method, when used to

evaluate such non- -250

conventional investment

can yield multiple internal -500

rates of return because of

more than one change of -750

signs in cash flows. 0 50 100 150 200 250

Discount Rate (%)

Case of Ranking Mutually

Exclusive Projects

• Investment projects are said to be mutually

exclusive when only one investment could be

accepted and others would have to be excluded.

• Two independent projects may also be mutually

exclusive if a financial constraint is imposed.

• The NPV and IRR rules give conflicting ranking

to the projects under the following conditions:

– The cash flow pattern of the projects may differ. That is,

the cash flows of one project may increase over time, while

those of others may decrease or vice-versa.

– The cash outlays of the projects may differ.

– The projects may have different expected lives.

Timing of Cash Flows

• Refers to a situation where cash flows of one

project increases overtime & those of another

decreases.

Project C0 C1 C2 C3 at 9% IRR

M – 1,680 1,400 700 140 301 23%

N – 1,680 140 840 1,510 321 17%

Scale of Investment

• When costs of projects differ:

Project C0 C1 at 10% IRR

A -1,000 1,500 364 50%

B -100,000 120,000 9,080 20%

Project Life Span

• Difference in the life span of two mutually

exclusive projects can give rise to the conflict

between NPV & IRR rules.

Project C0 C1 C2 C3 C4 C5 NPV at 10% IRR

Y – 10,000 0 0 0 0 20,120 2,495 15%

Reinvestment Assumption

(Reason - why NPV & IRR differs)

• The IRR method is assumed to imply that

the cash flows generated by the project

can be reinvested at its internal rate of

return, whereas the NPV method is

thought to assume that the cash flows are

reinvested at the opportunity cost of

capital.

Varying Opportunity Cost of Capital

• There is no problem in using NPV method

when the opportunity cost of capital varies

over time.

• If the opportunity cost of capital varies

over time, the use of the IRR rule creates

problems, as there is not a unique

benchmark opportunity cost of capital to

compare with IRR.

NPV Versus PI

• A conflict may arise between the two

methods if a choice between mutually

exclusive projects has to be made. Follow

NPV method:

Project C Project D

PV of cash inflows 100,000 50,000

Initial cash outflow 50,000 20,000

NPV 50,000 30,000

PI 2.00 2.50