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Capital Budgeting For Project Appraisal

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Capital Budgeting 

Capital budgeting (or project/ investment appraisal) is the process of planning, evaluating and selecting long-term investment decisions that are in line with the goal of investors¶ wealth maximization. Firm¶s long-term investment decisions generally include expansion, acquisition, modernization and replacement of long-term assets and research and development projects. It is used to compare and evaluate alternative projects‡ financial and nonfinancial criteria ‡ short and long-term benefits ‡ fit with existing technology ‡ effect on marketing and cost management.  

but rather a comparison of costs in relation to those areas of the estate where there is an opportunity or an inclination for change. (Sugden & Williams) A capital investment appraisal is a means of ensuring value for money in relation to developing an estate strategy and capital project.. & Mudambi R.) . (Baum T. A capital investment appraisal is not meant to provide an indication of profit or loss for the institution as a whole.Capital Budgeting: Scholars· Points of View Project appraisal is a process of investigation and reasoning designed to assist a decision maker to reach an informed and rational choice.

 Estimation and evaluation of how much cash flows incurred for each of the investment proposals.  Reevaluation of implemented investment projects continually and performing post audits for completed projects. .  Selection of an investment proposal that maximizes the return to the investors.Scope of Capital Budgeting Capital Budgeting involves: Evaluation of investment project proposals that are strategic to business¶s overall objectives.  Estimation of after-tax incremental operating cash flows for investment projects.

Examples include: 1. market research.Types of Investment Decisions There are typically two types of investment decisions: Selection decisions in terms of obtaining new facilities or expanding existing facilities. Examples include: 1. 2. etc. . Replacing a manual bookkeeping system with a computerized system. Resource commitments in the form of new product development. 2. Investment in long term assets such as property. plant and equipment. Replacement decisions in terms of replacing existing facilities with new facilities. refunding of long term debt. introduction of a computer. Replacing an inefficient lathe with one that is numerically controlled.

Criteria: We need to ask ourselves the following questions when evaluating capital budgeting decision rules:  Does the decision rule adjust for the time value of money?  Does the decision rule adjust for risk?  Does the decision rule provide information on whether we are creating value for the firm? .Good Investment Decision Nature:  The exchange of current funds for future benefits  The funds are invested in long-term assets  The future benefits will occur to the firm over a series of years.

Capital Budgeting Considerations The capital budgeting decision. depends in part on a variety of considerations:  The availability of funds  The relationships among proposed projects  The company¶s basic decision-making approach  The risk associated with a particular project . under any technique.

Phases of Capital Budgeting Capital budgeting is a multi-faceted activity. Planning Analysis Selection Financing Implementation Review . There are several sequential stages in the process.

Phases of Capital Budgeting contd« contd« Planning: A firm¶s mission and vision is encapsulated in its strategic planning framework. and guides the planning process in the pursuit of solid objectives. specifies the structural. and summarizing relevant information about various project proposals which are being considered for inclusion in the capital budget. preparing. strategic and tactical areas of business development. Strategic planning translates the firm¶s corporate goal into specific policies and directions. A strategic plan is the grand design of the firm and clearly identifies the business the firm is in and where it intends to position itself in the future. Analysis: The focus of this phase of capital budgeting is on gathering. sets priorities. .

Phases of Capital Budgeting contd« contd«
Selection: In the selection phases project worthwhileness is being judged by applying various appraisal criteria. The selection rules associated with these criteria are as follows:
Criterion Payback period (PBP) Accounting rate of return (ARR) Net present value (NPV) Internal rate of return (IRR) Benefit cost ratio (BCR) Accept PBP< target period ARR>target rate NPV>0 IRR>cost of capital BCR>1 Reject PBP> target period ARR<target rate NPV<0 IRR<cost of capital BCR<1

Phases of Capital Budgeting contd« contd«
Financing: Once a project is selected, suitable financing arrangements have to be made. The two broad sources of finance for a project are equity and debt. Implementation: The implementation phase for an industrial project, consists of several stages: i. ii. iii. iv. v. Project and engineering designs, Negotiations and contracting, Construction, Training and Plant commissioning.

Phases of Capital Budgeting contd« contd«
Review: Performance review should be done periodically to compare actual performance with projected performance. It is useful in the following ways: i. ii. iii. iv. v. It throws light on how realistic were the assumptions underlying the project; It provides a documented log of experience that is highly valuable in future decision making; It suggests corrective action to be taken in the light of actual performance; It helps in uncovering judgmental biases; It induces a desired caution among project sponsors.

Capital Budgeting: Importance & Limitations Importance Capital budgeting decisions influence the firm¶s growth in the long run. Deficiencies in analytical techniques Poorly identified base case  Inadequately treated risk  Improperly evaluated options  Lack of uniformity in assumptions  Side effects are ignored No linkage between compensation and financial measures. They involve commitment of large amount of funds. Limitations Poor alignment between strategy and capital budgeting. Reverse financial engineering. They are irreversible. or reversible at substantial loss. Weak integration between capital budgeting and expense  budgeting. They are among the most difficult decisions to make. . They affect the risk of the firm. Inadequate post-audits.

discounted Cash Flow Criteria Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Payback Period (PB) Discounted Payback Period Accounting Rate of Return (ARR) .Project Appraisal Criteria Project Appraisal Criteria Discounted Cash Flow Criteria (DCF) Non.

 Discounting ± reduce value of future earnings to reflect opportunity cost of an investment.Discounted Cash Flow Criteria (DCF)  It considers what money will be worth in the future. .

Net Present Value (NPV)  Evaluates if project rate of return is greater than. equal to.  It  The . or less than the desired rate of return. PV of future cash flows is computed using the cost of capital or minimum required rate of return as the discount rate. is the excess of the present value (PV) of cash inflows generated by the project over the amount of initial investment (I).

Formulation of NPV General formula for NPV is as follows: CFt NPV ! § ( 1  k )t t !0 n Where. CFt = Expected net cash flow at Period t k = Cost of capital or Discount rate n = Life of the project .

.Acceptance Rules of NPV NPV > 0 NPV < 0 NPV = 0 Accept Reject Indifferent (+) (-) () A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners.

‡Year 0: CF = -1.Calculation of NPV: An Example Assuming.120 ‡Year 2: CF = 70.800 ‡Year 3: CF = 91.080 Required rate of return for assets=12% Whether the investment should be accepted or not? . a new project A of which the following cash flows have been estimated: Tk.000 ‡Year 1: CF = 63.65.

-165.829 = Tk.12) + 70.080/(1.000 + 56. 12.65.800/(1.000 + 63.441 + 64.120/(1.12)2 + 91. the investment¶s NPV is positive and therefore should be accepted according to the acceptance rule of NPV.357 + 56.Calculation of NPV The calculation of the NPV of Project A will be: NPV = Tk. .627 So.12)3 = Tk. -1.

.Decision Criteria Test: NPV Does the NPV rule account for the time value of money? Does the NPV rule account for the risk of the cash flows? Does the NPV rule provide an indication about the increase in value? Should we consider the NPV rule for our primary decision rule?  The answer to all of these questions is Yes.  Here. the risk of the cash flows is accounted for through the choice of the discount rate.

 Enables comparisons at different interest rates to be considered. .  Sensitive to discount rates value of money. Drawbacks  Requires detailed long.NPV: Benefits & Drawbacks Benefits  Gives the correct financial decision in all cases.  Useful for comparing similar projects with same cost.  Is relatively simple to calculate.  Recognizes time value of money.term forecasts of incremental cash flow data.

 If NPV is positive.error interpolation.  Interpolation is used for the exact rate.Internal Rate of Return (IRR)  The discount rate which equates the PV of future cash inflows with the initial investment of a project and thus makes its NPV equal to zero. which includes:  Computation of NPV at the cost of capital (r1).and. then smaller rate r2 is selected rather than r 1. which is higher than r1. then r2 is selected. If NPV is negative. Using PV tables it is computed by trial.  Again NPV is calculated using r2 .  .  The true IRR at which NPV= 0 must be somewhere in between these two rates.

CFt = Expected net cash flow at Period t r = Internal Rate of Return (IRR) n = Life of the project n .Formulation of IRR IRR is the value of r in the following equation: CFt Investment ! § t t !0 ( 1  r ) Where.

Acceptance Rules of IRR All projects should be accepted whose IRR exceeds the company¶s cost of capital. IRR> Cost of Capital IRR< Cost of Capital Accept Reject (+) (-) For mutually exclusive projects. the projects with the highest IRR should be chosen. .

So. a rate higher than 16% should be tried. let us try 16% as the discount rate. the project¶s NPV will be: NPV= Tk. -165.17) + 70.120/(1. -165.17)2 + 91. where NPV>0 at 12% discount rate.error method: First.800/(1.Calculation of IRR Assuming the previously discussed example for NPV.16) + 70.000 + 63. when we try 17% then the project¶s NPV will be: NPV= Tk. we will now find out the IRR (NPV=0) of that project by following the trial.080/(1.17)3 = Tk.120/(1. 381 Since the project¶s NPV is still positive at 16%.and.16)2 + 91. -2463 The true rate of return should lie between 16% and 17%.000 + 63.080/(1.800/(1. .16)3 = Tk. At 16%.

1.844) = 16%+ 0.Calculation of IRR contd« contd« We can find out a close approximation of the rate of return by the method of linear interpolation as follows: Difference PV required PV at lower rate.844 IRR= 16%+ (17%.381 1.65.13= 16.13% Since the investment¶s IRR is greater than the cost of capital (12%).537 381 2.000 1.65. the investment should be accepted. 17% Tk.62. . 16% PV at higher rate.16%) (381/2.

000 20.02 0.22 IRR = 16.14 0.000 60.000 0 -20.2 0.12 0.13% .000 50.NPV Profile for the Project 70.000 Discount Rate 0.1 0.000 40.08 0.06 0.000 0 -10.000 NPV 30.18 0.16 0.04 0.000 10.

although it is not always as obvious. but not always as it has some problems that the NPV does not have.  We can consider IRR as our primary decision criteria . .Decision Criteria Test: IRR Does the IRR rule account for the time value of money? Does the IRR rule account for the risk of the cash flows? Does the IRR rule provide an indication about the increase in value? Should we consider the IRR rule for our primary decision criteria?  The answer to all of these questions is yes.

 Helps measure the worth of an investment.  Allows the risk associated with an investment project to be assessed. Drawbacks  Difficult to compute.  It may also fail to indicate a correct choice between mutually exclusive projects under certain situations. as a project may have multiple rates rather than a unique rate of return. etc. . would yield a better return based on internal standards of return.  Allows comparison of projects with different initial outlays.IRR: Benefits and Drawbacks Benefits  Recognizes time value of money.  Fails to recognize the varying size of investment in competing projects and their respective profitabilities.  Allows the firm to assess whether an investment in the machine.

. IRR  NPV and IRR will generally give us the same decision. Exceptions:  Nonconventional cash flows ± cash flow signs change more than once  Mutually exclusive projects ‡ Initial investments are substantially different (issue of scale) ‡ Timing of cash flows is substantially different  The NPV method has the advantage that the end result of the computations is expressed in amount and not in a percentage.NPV vs.

IRR contd« contd«  Whenever there is a conflict between NPV and another decision rule. Because:  Individual projects can be added.  It can be used in situations where the required rate of return varies over the life of the project. NPV should always be chosen.  The IRR of individual projects cannot be added or averaged to derive the IRR of a combination of projects.NPV vs. .

where there is a positive cash flow followed by a series of negative cash flows. our decision rule reverses. which one should we use to make our decision? When we solve for IRR we are solving for the root of an equation. and we accept a project if the IRR is less than the cost of capital.   . there is more than one IRR. Then problem occurs like. there will be more than one return that solves the equation.IRR and Nonconventional Cash Flows  When the cash flows change sign more than once. since we are borrowing at a lower rate. and when we cross the x-axis more than once. In this case. Another type of nonconventional cash flow involves a ³financing´ project.

90.000 y The required return is 15%.000 initially and will generate the following cash flows: Year 1: 132.Example : Nonconventional Cash Flows Assuming an investment will cost Tk.000 Year 3: -150. y Should we accept or reject the project? .000 Year 2: 100.

000.2 0. which is positive at a required return of 15%.00 NPV ($2. So.66% because none of the two rates of IRR will work satisfactorily.00) Discount Rate 0 0.00 $0.05 0.00) ($4. simply we will follow NPV.45 0.000. .55 IRR = 10.00 $2. and should Accept.11% and 42.00) ($6.25 0.000.000.4 0.000.35 0.000.66% We should accept the project if the required return is between 10.00) ($10.NPV Profile $4.00) ($8.3 0.11% and 42.15 0.000.1 0.5 0.

we would use the following decision rules:  NPV ± project with the higher NPV should be chosen. ‡ Example: We can choose to get admitted in either A&IS or Finance Department. but not both.IRR and Mutually Exclusive Projects  Mutually exclusive projects ‡ If we choose one.  Intuitively. . we cannot choose the other.  IRR ± project with the higher IRR should be chosen.

05 Project B -400 325 200 22. .17% 60.74 Which project should we accept and why? The required return for both projects is 10%.Example With Mutually Exclusive Projects Period 0 1 2 IRR NPV Project A -500 325 325 19.43% 64.

to maximize wealth and to avoid unreliability of IRR we¶ll go for the project with larger NPV.00 $100.00 NPV $80. and B will be chosen in the opposite case. A fulfills the condition and also has higher NPV.00 $120.1 0.17% Crossover Point = 11.00 $140.00 ($20.8%.2 0.8% A B If the required return is less than the crossover point of 11.00 $40.25 0. . Here.05 0.43% IRR for B = 22. So.00 $20.00) 0 ($40.00) Discount Rate 0.00 $60. which is project A.00 $0.15 0. then we should choose A.3 IRR for A = 19.NPV Profiles $160.

Modified Internal Rate of Return method (MIRR) can be adopted: Terminal value of cash inflow PV of cash outflow = --------------------------------------(1 + MIRR) Calculates the net present value of all cash outflows using the borrowing rate.  .  Finds the rate of return that equates these values.  Calculates the net future value of all cash inflows using the investing rate.Modified Internal Rate of Return (MIRR) To overcome the limitations of IRR.

MIRR: Benefits and Drawbacks Benefits  MIRR Drawbacks  For choosing among mutually assumes that project cash flows are reinvested at the exclusive projects of different size. the value of the firm. . Hence it alternative in measuring the reflects better the profitability contribution of each project to of a project.  The problem of multiple rates does not exist. NPV is a better cost of capital.

known as benefit. at the required rate of return. to the initial cash outflow of the investment.Profitability Index (PI)  PI is the ratio of the discounted cash inflows.cost ratio. especially when resources are limited.   Also . It is used as a mean of ranking projects in descending order of attractiveness.

/ CFo t=1 (1 + k)t n .Formulation of PI The formula for calculating PI is as follows: PV of cash inflows PV(CFt) PI= ------------------------.= ------------Initial cash outlay Co CFt = ------------.

0 PI= 1.0 PI< 1.Acceptance Rules of PI PI> 1.0 Accept Reject Indifferent (+) (-) () .

1.65.000 = Tk.77. .627/ Tk. 0. 1.077 / Since this project generates Tk. the project should be rejected. 0.Calculation of PI The Profitability Index of project A will be: PI= Tk.077 for each Taka invested and its PI< 1.

PI: Benefits and Drawbacks Benefits  It can discriminate better between large and small investments and hence is preferable to the NPV criterion. Drawbacks  It provides no means for aggregating several smaller projects into a package that can be compared with a large project.  When cash outflows occur beyond the current period. . PI may rank projects correctly in the order of decreasingly efficient use of capital.  Recognizes time value of money and easy to compute as well.  When the capital budget is limited in the current period. the PI criterion is unsuitable as a selection criterion.

PI The NPV and PI yield same accept or reject rules.NPV vs.  . because the NPV reflects the net increase in the firm¶s wealth.  In case of marginal projects. In this case between projects with same NPV.  The NPV method should be preferred. the one with lower initial cost or higher PI will be selected.  But a conflict may arise between the methods if a choice between mutually exclusive projects has to be made. NPV will be zero and PI will be equal to one. because PI can be grater than one only when the project¶s NPV is positive. except under capital rationing.

and  Subtracting the future cash flows from the initial cost until the initial investment has been recovered.Payback period  The payback period is the length of time required for a firm to recover its original investment .   .it tells how long it will take a project to break even. Calculated by: Estimating the cash flows.

000.500 .Formulation of Payback Period In case of Uniform Cash Flows. annual cash inflow= Tk. 50. 50. the formula of Payback period is: Net initial investment Payback period= -----------------------------------------Uniform increase in annual future cash flows Example: If a project¶s initial outlay= Tk. 12. 12.000 PB= ------------------= 4 years Tk.500 for 7 years. then: Tk.

Acceptance Rules of Payback period A project would be accepted if its payback period is less than the maximum or standard payback period set by management. . project with payback period of less than a year should be considered essential. Shortest Between Generally According to some advisors. where lowest ranking is given to a project with highest payback period. a payback period of 3 years or less is preferred. the project with shorter payback period will be selected. payback period gives highest ranking to a project. two mutually exclusive projects.

and Tk. 31.000 is recovered.65. -1. if the cash inflows occur evenly during the year. Third year¶s cash inflow is Tk. whether we will accept or reject the project? Adding up the cash inflows (Tk. Tk. the payback period will be 3 years.Calculation of Payback Period: Nonuniform Cash Flows Assuming that. the time required to recover Tk. As in both the cases.080 will be: (Tk.800. 91. we find that in the first 2 years Tk.080) X 12 months= 4 months. project A will be accepted if it pays back within 2 years (standard payback period). 31.120. 31.080/Tk.920 of the original outlay of Tk. payback period is more than the standard period of 2 years.080 and only Tk. 70. . the payback period is 2 years and 4 months. Now. 1.33. if the cash inflows occur at the end of the year. Thus. So. the project should be rejected. 63. 91.080 of the original outlay remains to be recovered.080). Again. 91.

Decision Criteria Test: Payback Period Does the payback rule account for the time value of money? Does the payback rule account for the risk of the cash flows? Does the payback rule provide an indication about the increase in value? Should we consider the payback rule for our primary decision rule?  The answer to all of these questions is No. .

Payback Period: Benefits and Drawbacks Benefits  Easy Drawbacks  Ignores the time to understand.  Ignores cash  Biased flows beyond the cutoff date. and new projects. value of money. towards liquidity. .  Biased against long-term projects. such as research and development. point.  Adjusts for uncertainty of later  Requires an arbitrary cutoff cash flows.

 Compares  Acceptance Rule ± The project should be accepted if it pays back on a discounted basis within the specified time.Discounted Payback Period  Computes the present value of each cash flow and then determine how long it takes to pay back on a discounted basis. to a specified required period. .

120/1.121 = 108. we should reject the project.Calculation of Discounted Payback Period: An Example Assuming that. we will accept project A if it pays back on a discounted basis in 2 years. .643 ± 70.122 = 52. it doesn¶t pay back on a discounted basis within the required 2-year period.643 Year 2: 108.000 ± 63.202 Year 3: 52.080/1.627 So. the project pays back in year 3 Since.202 ± 91. Shall we accept or reject the project? First we will Compute the PV for each cash flow and determine the payback period using discounted cash flows: Year 1: 165.800/1.123 = -12.

.Decision Criteria Test: Discounted Payback Period Does the discounted payback rule account for the time value of money? Does the discounted payback rule account for the risk of the cash flows? Does the discounted payback rule provide an indication about the increase in value? Should we consider the discounted payback rule for our primary decision rule?  The  The answer to the first two questions is Yes. it should not be the primary decision rule.  Since the rule does not indicate whether or not we are creating value for the firm. answer to the third question is No because of the arbitrary cut-off date.

 This gives  Businesses can then compare this figure to how much they would get with alternative investments or the bank.Accounting Rate of Return (ARR)  Looks at the profit generated by the investment compared to the cost of the investment. and µReturn on Investment (ROI)¶.  Also . known as µAverage Rate of Return¶. the business a percentage figure showing the average rate of return.

EBIT(1-T). Io= BV of investment in the beginning. it can be defined in terms of earnings after taxes without an adjustment for interest i.Formulation of ARR ARR can be determined by the following equation: Average income ARR= ----------------------------------Average investment Or. T= tax rate. Thus: n ™ EBITt( 1-T) /n t=1 ARR= -----------------------------(Io+ In)/2 Where.e. EBIT= earnings before interest & taxes. In= BV of investment at the end of n number of years. .

Acceptance Rules of ARR  All those projects are to be accepted whose ARR is higher than the minimum rate established by the management and projects are to be rejected which have ARR less than that preset rate. with highest ARR will be ranked as number one and lower rank would be assigned to the project with lowest ARR.  Project .

040 (Tk.000 10.500 55.060 4.10.000 20.65.10.040 18.000 1.000 36.500 1. Shall we accept or reject the project? Calculation of ARR Year 1 EBDIT Depreciation EBIT Taxes at 50% [EBIT(1-T)] Book value of investment: Beginning Ending Average 1.120 55.000 27.800 55.000 1.800 7.500 82. a straight.37. We also assume that.900 7.080 18.Calculation of ARR Assuming a 50% tax rate for project A and.120 4.900 Year 3 91.060 Year 2 70.000 55.) Average 75. an average return of 15% from project A is required.000 10.000 15.080 55.line depreciation method is also assumed to be used here.500 63.000 .000 55.000 8.000 82.

.X 100 82. ARR of project A= -----------. the project should be rejected. the ARR of the project is lower than the preset rate.Calculation of ARR contd« contd« 10.000 So.500 = 12.12% Since.

 Only a few large firms employ the payback and/or ARR methods exclusively.Decision Criteria Test: ARR Does the AAR rule account for the time value of money? Does the AAR rule account for the risk of the cash flows? Does the AAR rule provide an indication about the increase in value? Should we consider the AAR rule for our primary decision rule?  The answer to all of these questions is No. .  In fact. this rule is even worse than the payback rule in that it doesn¶t even use cash flows for the analysis.

time value of money is ignored.  Based . an arbitrary benchmark cutoff rate.ARR: Benefits and Drawbacks Benefits  Easy Drawbacks  Not a to calculate. on accounting net income and book values. true rate of return.  Needed information will  Uses usually be available. not cash flows and market values.

 Inflation and creative accounting tend to create a discrepancy between the ARR and the IRR.  The ARR and the IRR can be the same only if the depreciation schedule is equal to the economic depreciation schedule.ARR and IRR  The ARR tends to understate the IRR for earlier years and overstate it for later years. .

Goal Congruence Issues in Capital Budgeting  Inconsistency between capital budgeting decision making and management performance evaluation persists when a company uses. .  NPV method for capital budgeting decisions and ARR method to evaluate performance or  ARR for both purposes  Inconsistency means managers are tempted to make capital budgeting decisions on the basis of the method by which they are being evaluated.  This conflict can be reduced by evaluating managers on a project-by-project basis and by the amount and timing of forecasted cash flows.

Assessment of Basic Evaluation Methods Considerations Theoretical Considers all cash flows Discounts CFs at the opportunity cost of fund Satisfies the principle of value additivity From a set of mutually exclusive projects chooses the projects which maximize shareholder wealth Practical Simple method Requires limited information Gives a relative measure NPV PI IRR Payback Period No No ? ARR Yes Yes Yes Yes Yes No Yes No No ? No ? Yes Yes No No No Yes No Yes No Yes No Yes ? Yes Perhaps No ? Yes Yes Yes .

 .  Same analysis techniques are used.  Identifies areas where results differ from expectation.  Evaluates capital budgeting process. problems with implementation.  It provides management with feedback about performance.Post Investment Audit A post investment audit compares the actual results for a project to the costs and benefits expected at the time the project was selected. and sponsors credibility. particularly original projections.  It is performed after project has stabilized.

security and social considerations as important qualitative factors.  . ‡ Corporate objectives ± also have to judge if the investment is aligned to our corporate objectives ‡ Environmental and ethical reasons ± is the investment environmentally and ethically sound ‡ Industrial relations ± what is the impact on the work force ± does it decrease jobs?  Some companies also consider intuition.Qualitative Techniques of Project Appraisal As well as financial methods firms need to consider: ‡ Corporate image ± we may reject an investment opportunity as it will reflect badly on our business.

etc.  Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate. cost-benefit analysis. its evaluation of qualitative and quantitative factors.  .Role of Judgement The opportunities and constraints of selecting a project.  Judgement and intuition should definitely be used when a decision of choice has to be made between two or more. are essential elements of judgement. or when it involves changing the long-term strategy of the company. and the weightage on every bit of pros and cons. closely beneficial projects.. liquidity and profits should be preferred over judgement. For routine matters.  It plays a very important role in determining the reliability of figures with the help of qualitative methods as well as other known financial matters affecting the projects.

 The higher the profitability of ³customer churn´. the lower the NPV of the customer. .  Investment in Research and Development  ³Real options´ of R&D investments increases the NPV of investment projects.Strategic Considerations in Capital Budgeting Capital investment decisions that are strategic in nature require managers to consider a broad range of factors that may be difficult to estimate.  Customer Value and Capital Budgeting  NPV can also be used to evaluate the value of customers.

Project Cash Flow and Risk Analysis .

Risks in Capital Budgeting Three types of risk are relevant in capital budgeting:    Stand-alone risk Corporate risk Market (or beta) risk .

. IRR. or MIRR. Ignores both firm and shareholder diversification. Measured by the W or CV of NPV.StandStand.Alone Risk The project¶s risk if it were the firm¶s only asset and there were no shareholders.

Measured by the project¶s corporate beta. Depends on:  project¶s W. and  its correlation with returns on firm¶s other assets. Considers firm¶s other assets (diversification within firm). .Corporate Risk Reflects the project¶s effect on corporate earnings stability.

Depends on project¶s s and correlation with the stock market. .Market Risk Reflects the project¶s effect on a well-diversified stock portfolio. Takes account of stockholders¶ other assets. Measured by the project¶s market beta.

Such as: they may use a shorter payback period. or discount net cash flows at the risk. Conventional Techniques: Decision.makers in practice may handle risk in conventional ways. or conservative forecasts of cash flows. which are: expected monetary value.Techniques of Risk Analysis Statistical Techniques: To measure and incorporate risk in capital budgeting two important statistical methods are used.adjusted discount rates. . and standard deviation.

Capital Rationing 

It occurs any time there is a budget ceiling, or constraints, on the amount of funds that can be invested during a specific period, such as a year. capital is rationed over multiple periods; several alternative methods can be applied to the capital rationing problem. 

When 

If capital is to be rationed for only the current period, selecting projects by descending order of profitability index generally leads to a selection of a project mix that adds most of firm value.

Sensitivity Analysis 

Shows how changes in a variable such as unit sales affect NPV or IRR. Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. ³what if´ questions, e.g. ³What if sales decline by 30%?´  

Answers

Illustration: Sensitivity Analysis
Change from Base Level __ Resulting NPV (000s)_____ Unit Sales Salvage k_

30% -20 -10 0 +10 +20 +30

$ 10 35 58 82 105 129 153

$78 80 81 82 83 84 85

$105 97 89 82 74 67 61

NPV (000s) Unit Sales 82 k Salvage -30 -20 -10 10 20 Base Value 30 .

Results of Sensitivity Analysis  Steeper sensitivity lines show greater risk. should worry most about accuracy of sales forecast. Unit sales line is steeper than salvage value or k. so for this project. Small changes result in large declines in NPV.  .

nothing about the likelihood of change in a variable.  Ignores relationships among . i. variables. a steep sales line is not a problem if sales won¶t fall. variables.Sensitivity Analysis: Benefits & Drawbacks Benefits  Gives some Drawbacks  Does  Says idea of stand- alone risk.e.  Gives some breakeven information.  Identifies dangerous not reflect diversification.

and best case. Provides . most likely case. usually worst case.Scenario Analysis Examines several possible situations. a range of possible outcomes.

25 148 E(NPV) = $ 82 W(NPV) = 47 CV(NPV) = s(NPV)/E(NPV) = 0. we know with certainty all variables except unit sales. which could range from 900 to 1.Illustration: Scenario Analysis Assuming that.600.57 .50 82 Best 0. Scenario Probability NPV(000) NPV(000) Worst 0.25 $ 15 Base 0.

Simulation Analysis  A computerized version of scenario analysis which uses continuous probability distributions.  Generally shown graphically.  NPV and IRR are calculated.000 or more).  End result: Probability distribution of NPV and IRR based on sample of simulated values.  Computer selects values for each variable based on given probability distributions. .  Process is repeated many times (1.

so.Monte Carlo Simulation  Monte Carlo simulation of capital budgeting projects is often viewed as a step beyond either sensitivity analysis or scenario analysis. at least theoretically.   While . this methodology provides a more complete analysis. its use in other industries is far from widespread. the pharmaceutical industry has pioneered applications of this methodology. Interactions between the variables are explicitly specified in Monte Carlo simulation.

Computation Steps: Monte Carlo Simulation Step 1: Specify the Basic Model Step 2: Specify a Distribution for Each Variable in the Model Step 3: The Computer Draws One Outcome Step 4: Repeat the Procedure Step 5: Calculate NPV .

. It is the most critical step.so subtracting interest payment from the project cash flow would amount to double counting interest costs. Suitable example may be Padma bridge. Interest Payment: Common mistakes made by many students and financial analysts is that they subtracts interest payment in estimating project cash flows . Because the cost and revenue forecasting of a large complex project often shows a big forecasting error.Relevant Issues in Capital Budgeting When we talk about a project we have to keep full attention on the cash flows of that project . we should keep in mind some relevant Issues.the cost of the debt is already embedded in the WACC(weighted average cost of capital). Before making cash flow analysis.

which is suitable for a branch location. For this task they paid tk.000 and undoubtedly it is a sunk cost for that firm.Relevant Issues in Capital Budgeting Contd« Contd« Sunk Cost: Cost: We focus on the cash flow if and only if we accept the project this cash flows are called incremental cash flows. now in project cash flow analysis should the cost of the land be disregarded in cash flow estimation in the argue that no additional cash outlay be required? The answer is no because there is an opportunity cost.50.so Either the project accepted or rejected.00. Opportunity cost: cost: Agrani bank owns a piece of land in Konabari. If this land have a market value tk. .000. 2.1. should this cost be taken into consideration in project cash flow analysis ? The answer is no. For example assuming. Gazipur. standard chartered has considered whether to establish a branch in Sylhet and for site analysis they hired a consulting firm. Because we know a sunk cost is an outlay that has already occurred & it is not affected by the decision under condition. because sunk cost does not fall under incremental cash flow. then that value should be charged against the project.

Now many of its customers who previously purchased their daily necessities from mohammadpur branch. ‡ A suitable example would be Mina bazar. then it could potentially increase its profit margin by huge amount. Thus net income provided by this customers should not be treated as incremental cash flows in the capital budgeting decision.Relevant Issues in Capital Budgeting Contd« Contd« Externalities: Another potential problem involves the effects of a project on the other parts on the firm. When a new product takes away sales from existing product . Nautica sales its products to the traditional retailers. . which is called externalities. Cannibalization: Another problem in project cash flow estimation is cannibalization. ‡ Now if Nautica open a new own online store . then we call this situation as Cannibalization. suppose Mina bazar opened its new branch in dhanmondi-5. is a American company that sales sport wares. A suitable example may clear this concept‡ Nautica international inc. will come to this new branch. These retailers adds a mark up &they further sales this commodities to the consumers.

Even worse . Inflation Adjustment: inflation is a fact of life in Bangladesh. the real & nominal expected cash flow RCFt & NCFt would also be equal . result will be . in this case the nominal net cash flow NCFt will increase at the rate of i percent. that is the new project will decrease its existing sales stream.But when the expected rate of inflation is positive then all of the projects cash flow including depreciation related items also should be rise at the rate i.Relevant Issues in Capital Budgeting Contd« Contd« ‡ But internet sales would most probably cannibalize its existing sales. Moreover . NCFt =RCFt (1+i)^t Thus the cost of capital which is used as the discount rate calculation formula will be: (1+rn) = (1+rr) X (1+i) . Recently it has been touched two digit. dealers/ retailers might react adversely by moving their product line to another brands. In the absence of inflation the real rate (rr) would be equal to nominal rate.

In many cases tax effect will make or break a project. Depreciation must be added to NOPAT in following estimating a projects cash flow- FCF =EBIT(1-t)+ depreciation. Because accountants do not subtract the purchase price of fixed assets when calculating net income . therefore it is critical that taxes should be dealt with correctly. . depreciation shelters income from taxation.¨ in net operating working capital asset ‡ The main effect of depreciation is-higher depreciation expense results in lower taxes in the early years that shows a higher net present value in cash flow analysis.they do subtract a charge each year for depreciation.gross fixed expenditure. ‡ Depreciation on assets should be considered in cash flow estimation.Relevant Issues in Capital Budgeting Contd« Contd« Tax & Depreciation Effect: ‡ Tax have a major effect on cash flows.

Tax Effect in Bangladesh In Bangladesh taxation system is not so critical as the MACRS of USA. Tourism Industry Eligible for Tax holiday. ‡ Accelerated depreciation: Accelerated depreciation on cost of machinery is admissible for new industrial undertaking in the first year of commercial production 50%. container freight station. ‡ Industry set up in EPZ is exempt from tax for a period of 10 years from the date of commencement of commercial production. LNG terminal and transmission line. diamond cutting. flyover. ship building. container terminals. There are a lot of exemption & incentives to encourage investment . CNG terminal and transmission line. in the second year 30% and in the third year 20%. ‡ Income derived from any Small and Medium Enterprise (SME) engaged in production of any goods and having an annual turnover of not more than taka twenty four lakh is exempt from tax. Physical Sea or river port. mono rail. large water. . ‡ Avoidance of Double Taxation Agreement : There are agreements on avoidance of double taxation between Bangladesh and 28 countries.Some of them are ‡ Industry engaged in agro-processing. underground rail.

ranging from small(26% has sales less then $100 million) to very large(42% had sales at least $1 billion. This survey conducted in 1998 published in 2001 in the µjournal of financial economics¶ & it won the best best JFE paper in 2001. J.) 40% of them was manufacturing firm. Paul Sticht Professor of Finance at Duke University¶s Fuqua School of Business. & CAMPBELL HARVEY .A Popular Survey Author ±JOHN GRAHAM. It represented a wide verity of companies . The 3.11% retailers & 9% high tech firms.page long survey was conducted on all of the Fortune-500 company CFOs .Associate Professor of Finance at Duke University¶s Fuqua School of Business.15% was financial . . they also asked a number of questions to the CEOs because they are the ultimate decision.

a 1977 survey of 103 large companies reported that fewer than 10% of the firms relied on NPV as their primary method. the critical difference is that IRR is a ratio while NPV is a dollar measure of value added. but past surveys have suggested that IRR was for long the primary corporate criterion for evaluating investment projects.NPV projects. managers intent on maximizing IRR may actually reduce value by rejecting positive. while over 50% said they relied mainly on IRR. .Findings of the Research by Graham & Campbell NPV has been the dominant method taught in business schools. The main problem with using the former is that. Although the two measures are similar in several respects. For example. in some cases.

Findings of the Research by Graham & Campbell .

most respondents cited net present value and internal rate of return as their most frequently used capital budgeting techniques. regardless of firm size. However. 74.were also significantly more likely to use NPV and IRR than firms that do not pay dividends.9% of CFOs always or almost always used NPV and 75. Highly leveraged firms were significantly more likely to use NPV and IRR than firms with low debt ratios. companies that pay dividends . large companies were significantly more likely to use NPV than were small firms.Findings of the Research by Graham & Campbell As shown in Figure 1.7% always or almost always used IRR. . And as in the case of highly leveraged companies.

Findings of the Research by Graham & Campbell Highly levered firms were also more likely to use sensitivity and simulation analysis.7% always or almost always used it). in part to assess (and limit to acceptable levels) the probability of financial distress. Public companies were significantly more likely to use NPV and IRR than were private corporations. The simplicity of the method. also found that. Other than NPV and IRR (and the hurdle rate). combined in some cases with top management¶s lack of familiarity with more sophisticated techniques. perhaps because of regulatory requirements. among small firms. It also found that companies whose CEOs had MBAs were more likely to use NPV than firms whose CEOs did not. Utilities. older CEOs with long tenures and without MBAs were more likely to use the payback criterion. were also more likely to use IRR and NPV and to perform sensitivity and simulation analyses. too. the payback period was the most frequently used capital budgeting technique (56. .

Findings of the Research by Graham & Campbell Finally the other capital budgeting techniques were used less frequently. 12% used a profitability index. 14% always or almost always used value at risk or some other form of simulation. Somewhat surprisingly. it is also surprising that only 11% of firms used APV since the method is fairly easy to use while at the same time flexible enough to handle a wide variety of project evaluation situations. . only about 20% of the companies said they used accounting rate of return. more than one-fourth of the companies claimed to be using real options (RO) evaluation techniques In comparison. and 11% used adjusted present value (APV). For example.

IRR and PI are the discounted cash flow criteria and PB.Summary In this chapter we have discussed about the following issues: Capital budgeting or project appraisal is the process of selecting investment projects whose returns or cash flows are expected to extend beyond one year. Discounted PB and ARR are the non discounted criteria for appraising the worth of an investment project. . Project appraisal techniques aim to assess the financial feasibility of investment options and based on a number of assumptions. Payback method looks at how long it will take to pay back the cost of the initial investment. NPV.

Capital rationing occurs when a company chooses not to fund all positive NPV projects. Discounted cash flow (NPV) looks at the present values of any future revenues from the investment. But for larger projects IRR appears to be the most commonly used method as the end result of the computations is expressed in percentage. For small sized projects payback method & ARR are preferred to be used. NPV method is the most superior investment criterion as it always consistent with the wealth maximization principle.Summary contd« contd« Average rate of return looks at the percentage rate of return on the investment. .

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