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Capital Budget FINAL Slide

Capital Budget FINAL Slide

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  • Capital Budgeting Capital Budgeting
  • Capital Budgeting: Scholars· Points Capital Budgeting: Scholars· Points
  • of View of View
  • Scope of Capital Budgeting Scope of Capital Budgeting
  • Types of Investment Decisions Types of Investment Decisions
  • Good Investment Decision Good Investment Decision
  • Capital Budgeting Considerations Capital Budgeting Considerations
  • Phases of Capital Budgeting Phases of Capital Budgeting
  • Phases of Capital Budgeting Phases of Capital Budgeting contd
  • Project Appraisal Criteria Project Appraisal Criteria
  • Discounted Cash Flow Criteria Discounted Cash Flow Criteria
  • (DCF) (DCF)
  • Net Present Value (NPV) Net Present Value (NPV)
  • Formulation of NPV Formulation of NPV
  • Acceptance Rules of NPV Acceptance Rules of NPV
  • Calculation of NPV: An Example Calculation of NPV: An Example
  • Calculation of NPV Calculation of NPV
  • Decision Criteria Test: NPV Decision Criteria Test: NPV
  • NPV: Benefits & Drawbacks NPV: Benefits & Drawbacks
  • Internal Rate of Return (IRR) Internal Rate of Return (IRR)
  • Formulation of IRR Formulation of IRR
  • Acceptance Rules of IRR Acceptance Rules of IRR
  • Calculation of IRR Calculation of IRR
  • Calculation of IRR Calculation of IRRcontd
  • NPV Profile for the Project NPV Profile for the Project
  • Decision Criteria Test: IRR Decision Criteria Test: IRR
  • IRR: Benefits and Drawbacks IRR: Benefits and Drawbacks
  • NPV vs. IRR NPV vs. IRR
  • NPV vs. IRR NPV vs. IRR contd
  • IRR and Nonconventional IRR and Nonconventional
  • Cash Flows Cash Flows
  • Example : Nonconventional Cash Example : Nonconventional Cash
  • Flows Flows
  • NPV Profile NPV Profile
  • IRR and Mutually Exclusive IRR and Mutually Exclusive
  • Projects Projects
  • Example With Mutually Example With Mutually
  • Exclusive Projects Exclusive Projects
  • NPV Profiles NPV Profiles
  • Modified Internal Rate of Return Modified Internal Rate of Return
  • (MIRR) (MIRR)
  • MIRR: Benefits and Drawbacks MIRR: Benefits and Drawbacks
  • Profitability Index (PI) Profitability Index (PI)
  • Formulation of PI Formulation of PI
  • Acceptance Rules of PI Acceptance Rules of PI
  • Calculation of PI Calculation of PI
  • PI: Benefits and Drawbacks PI: Benefits and Drawbacks
  • NPV vs. PI NPV vs. PI
  • Payback period Payback period
  • Formulation of Payback Period Formulation of Payback Period
  • Acceptance Rules of Payback Acceptance Rules of Payback
  • period period
  • Calculation of Payback Period: Calculation of Payback Period:
  • Nonuniform NonuniformCash Flows Cash Flows
  • Goal Congruence Issues in Goal Congruence Issues in
  • Assessment of Basic Evaluation Assessment of Basic Evaluation
  • Methods Methods
  • Post Investment Audit Post Investment Audit
  • Qualitative Techniques of Project Qualitative Techniques of Project
  • Appraisal Appraisal
  • Role of Role of Judgement Judgement
  • Strategic Considerations in Capital Strategic Considerations in Capital
  • Budgeting Budgeting
  • Risks in Capital Budgeting Risks in Capital Budgeting
  • Stand Stand--Alone Risk Alone Risk
  • Corporate Risk Corporate Risk
  • Market Risk Market Risk
  • Techniques of Risk Analysis Techniques of Risk Analysis
  • Capital Rationing Capital Rationing
  • Sensitivity Analysis Sensitivity Analysis
  • Illustration: Sensitivity Analysis Illustration: Sensitivity Analysis
  • Results of Sensitivity Analysis Results of Sensitivity Analysis
  • Sensitivity Analysis: Benefits & Sensitivity Analysis: Benefits &
  • Scenario Analysis Scenario Analysis
  • Illustration: Scenario Analysis Illustration: Scenario Analysis
  • Simulation Analysis Simulation Analysis
  • Monte Carlo Simulation Monte Carlo Simulation
  • Computation Steps: Monte Computation Steps: Monte
  • Carlo Simulation Carlo Simulation
  • A Popular Survey A Popular Survey
  • Findings of the Research by Findings of the Research by
  • Graham & Campbell Graham & Campbell
  • Summary Summary
  • Summary Summary contd

Capital Budgeting For Project Appraisal


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.  

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. & Mudambi R.) .. A capital investment appraisal is not meant to provide an indication of profit or loss for the institution as a whole. (Sugden & Williams) A capital investment appraisal is a means of ensuring value for money in relation to developing an estate strategy and capital project. but rather a comparison of costs in relation to those areas of the estate where there is an opportunity or an inclination for change. (Baum T.

 Estimation of after-tax incremental operating cash flows for investment projects.  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.  Estimation and evaluation of how much cash flows incurred for each of the investment proposals. .Scope of Capital Budgeting Capital Budgeting involves: Evaluation of investment project proposals that are strategic to business¶s overall objectives.

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

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. 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? .

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.Capital Budgeting Considerations The capital budgeting decision.

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

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

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.

They are among the most difficult decisions to make. 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 affect the risk of the firm. Inadequate post-audits. . They involve commitment of large amount of funds. Reverse financial engineering. or reversible at substantial loss. Limitations Poor alignment between strategy and capital budgeting.Capital Budgeting: Importance & Limitations Importance Capital budgeting decisions influence the firm¶s growth in the long run. They are irreversible. Weak integration between capital budgeting and expense  budgeting.

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. .

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

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

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. .

000 ‡Year 1: CF = 63. a new project A of which the following cash flows have been estimated: Tk. ‡Year 0: CF = -1.800 ‡Year 3: CF = 91.65.Calculation of NPV: An Example Assuming.120 ‡Year 2: CF = 70.080 Required rate of return for assets=12% Whether the investment should be accepted or not? .

12)2 + 91.829 = Tk. -1.627 So.12) + 70.000 + 63.12)3 = Tk.120/(1.Calculation of NPV The calculation of the NPV of Project A will be: NPV = Tk. -165.65.000 + 56.080/(1.800/(1. 12. the investment¶s NPV is positive and therefore should be accepted according to the acceptance rule of NPV. .441 + 64.357 + 56.

 Here. the risk of the cash flows is accounted for through the choice of the discount rate.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. .

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

which includes:  Computation of NPV at the cost of capital (r1).  If NPV is positive. Using PV tables it is computed by trial.error interpolation.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 is higher than r1. If NPV is negative. then smaller rate r2 is selected rather than r 1. then r2 is selected.  Interpolation is used for the exact rate.and.  The true IRR at which NPV= 0 must be somewhere in between these two rates.  Again NPV is calculated using r2 .

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

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

080/(1. -2463 The true rate of return should lie between 16% and 17%. .16) + 70.17)2 + 91. a rate higher than 16% should be tried. -165. we will now find out the IRR (NPV=0) of that project by following the trial.error method: First.080/(1. let us try 16% as the discount rate. when we try 17% then the project¶s NPV will be: NPV= Tk.800/(1.000 + 63. -165. At 16%. So.000 + 63. 381 Since the project¶s NPV is still positive at 16%.and.16)2 + 91.17) + 70.Calculation of IRR Assuming the previously discussed example for NPV. the project¶s NPV will be: NPV= Tk. where NPV>0 at 12% discount rate.16)3 = Tk.800/(1.17)3 = Tk.120/(1.120/(1.

13= 16.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.13% Since the investment¶s IRR is greater than the cost of capital (12%).65.62.537 381 2.65. 1. 17% Tk.844) = 16%+ 0.381 1.000 1. the investment should be accepted.844 IRR= 16%+ (17%. 16% PV at higher rate. .16%) (381/2.

22 IRR = 16.000 20.000 0 -10.18 0.14 0.2 0.02 0.000 NPV 30.13% .04 0.000 0 -20.000 Discount Rate 0.000 60.NPV Profile for the Project 70.000 40.06 0.000 10.12 0.1 0.16 0.08 0.000 50.

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. . but not always as it has some problems that the NPV does not have.  We can consider IRR as our primary decision criteria . although it is not always as obvious.

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

. 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. IRR  NPV and IRR will generally give us the same decision.NPV vs.

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

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

000 Year 2: 100. 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? .

00 $0.00) ($8. .25 0.5 0.11% and 42.000.00) ($6.35 0.000.00) Discount Rate 0 0. simply we will follow NPV.00 NPV ($2.66% because none of the two rates of IRR will work satisfactorily.2 0.15 0.000.1 0. which is positive at a required return of 15%.000.000.66% We should accept the project if the required return is between 10.11% and 42. and should Accept.00 $2.55 IRR = 10.4 0.00) ($10.05 0. So.3 0.000.NPV Profile $4.00) ($4.000.45 0.

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

43% 64.74 Which project should we accept and why? The required return for both projects is 10%.17% 60.Example With Mutually Exclusive Projects Period 0 1 2 IRR NPV Project A -500 325 325 19.05 Project B -400 325 200 22. .

NPV Profiles $160.25 0. Here. A fulfills the condition and also has higher NPV.00 $40.00 $0.00 $100.8% A B If the required return is less than the crossover point of 11.15 0.00 ($20.17% Crossover Point = 11. and B will be chosen in the opposite case. to maximize wealth and to avoid unreliability of IRR we¶ll go for the project with larger NPV. which is project A.00 $140.00 $120.2 0.00 $20. then we should choose A.00 NPV $80.00 $60.43% IRR for B = 22. So.00) 0 ($40.1 0.05 0.00) Discount Rate 0.8%.3 IRR for A = 19. .

Modified Internal Rate of Return (MIRR) To overcome the limitations of IRR.  Finds the rate of return that equates these values. 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.  Calculates the net future value of all cash inflows using the investing rate.  .

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. Hence it alternative in measuring the reflects better the profitability contribution of each project to of a project. the value of the firm.  The problem of multiple rates does not exist. NPV is a better cost of capital. .

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

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

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

the project should be rejected.077 / Since this project generates Tk. 1.Calculation of PI The Profitability Index of project A will be: PI= Tk.65.077 for each Taka invested and its PI< 1.000 = Tk. 0. . 0.77.627/ Tk. 1.

 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. Drawbacks  It provides no means for aggregating several smaller projects into a package that can be compared with a large project.PI: Benefits and Drawbacks Benefits  It can discriminate better between large and small investments and hence is preferable to the NPV criterion. .  When the capital budget is limited in the current period. the PI criterion is unsuitable as a selection criterion.

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

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

50.000. 12.500 .500 for 7 years. 12.Formulation of Payback Period In case of Uniform Cash Flows. 50. then: Tk. annual cash inflow= Tk.000 PB= ------------------= 4 years Tk. 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.

. two mutually exclusive projects. Shortest Between Generally According to some advisors. a payback period of 3 years or less is preferred. where lowest ranking is given to a project with highest payback period.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. the project with shorter payback period will be selected. project with payback period of less than a year should be considered essential. payback period gives highest ranking to a project.

080) X 12 months= 4 months. 31.080 and only Tk. Third year¶s cash inflow is Tk. the project should be rejected. So. if the cash inflows occur at the end of the year. the time required to recover Tk. 70. payback period is more than the standard period of 2 years.800. Thus. the payback period will be 3 years.080 will be: (Tk. project A will be accepted if it pays back within 2 years (standard payback period).080).080 of the original outlay remains to be recovered. As in both the cases. and Tk.120.920 of the original outlay of Tk.Calculation of Payback Period: Nonuniform Cash Flows Assuming that.080/Tk. Now. -1. if the cash inflows occur evenly during the year. 31.65. 31. 1.000 is recovered. . we find that in the first 2 years Tk. Tk. whether we will accept or reject the project? Adding up the cash inflows (Tk.33. the payback period is 2 years and 4 months. 91. 91. 63. 91. Again.

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. .

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

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.  Compares  Acceptance Rule ± The project should be accepted if it pays back on a discounted basis within the specified time. .

121 = 108.202 ± 91.627 So.202 Year 3: 52.643 Year 2: 108. 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: 165.122 = 52.800/1.Calculation of Discounted Payback Period: An Example Assuming that.120/1. . we should reject the project. the project pays back in year 3 Since. we will accept project A if it pays back on a discounted basis in 2 years.643 ± 70. it doesn¶t pay back on a discounted basis within the required 2-year period.123 = -12.080/1.000 ± 63.

.  Since the rule does not indicate whether or not we are creating value for the firm.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. answer to the third question is No because of the arbitrary cut-off date. it should not be the primary decision rule.

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

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

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 .

We also assume that. an average return of 15% from project A is required.800 7.000 27.000 15.500 82. a straight.000 1.080 55. 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 1.000 36.000 82.060 Year 2 70.) Average 75.10.000 1.65.120 4.040 18.060 4.800 55.000 20.500 1.500 63.10.120 55.900 Year 3 91.37.040 (Tk.000 8.000 10.000 55.line depreciation method is also assumed to be used here.000 10.500 55.000 55.900 7.Calculation of ARR Assuming a 50% tax rate for project A and.080 18.000 .

the ARR of the project is lower than the preset rate. ARR of project A= -----------. the project should be rejected. .000 So.Calculation of ARR contd« contd« 10.500 = 12.12% Since.X 100 82.

.  Only a few large firms employ the payback and/or ARR methods exclusively.  In fact. this rule is even worse than the payback rule in that it doesn¶t even use cash flows for the analysis.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.

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

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

.  This conflict can be reduced by evaluating managers on a project-by-project basis and by the amount and timing of forecasted cash flows.  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.Goal Congruence Issues in Capital Budgeting  Inconsistency between capital budgeting decision making and management performance evaluation persists when a company uses.

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 .

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.  Identifies areas where results differ from expectation.  Evaluates capital budgeting process. and sponsors credibility.  It provides management with feedback about performance.  Same analysis techniques are used.  . particularly original projections.  It is performed after project has stabilized. problems with implementation.

‡ 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.  . security and social considerations as important qualitative factors.

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

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. . the lower the NPV of the customer.  The higher the profitability of ³customer churn´.  Investment in Research and Development  ³Real options´ of R&D investments increases the NPV of investment projects.  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 .

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

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

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.

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


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%?´  


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. Small changes result in large declines in NPV. Unit sales line is steeper than salvage value or k. so for this project.  . should worry most about accuracy of sales forecast.

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

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

25 $ 15 Base 0.50 82 Best 0.25 148 E(NPV) = $ 82 W(NPV) = 47 CV(NPV) = s(NPV)/E(NPV) = 0.57 .600. which could range from 900 to 1. we know with certainty all variables except unit sales.Illustration: Scenario Analysis Assuming that. Scenario Probability NPV(000) NPV(000) Worst 0.

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

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

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 .

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

1.00. then that value should be charged against the project.000. Because we know a sunk cost is an outlay that has already occurred & it is not affected by the decision under condition.000 and undoubtedly it is a sunk cost for that firm. which is suitable for a branch location. 2. Gazipur. standard chartered has considered whether to establish a branch in Sylhet and for site analysis they hired a consulting firm.50.so Either the project accepted or rejected.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. . For this task they paid tk. For example assuming. If this land have a market value tk. Opportunity cost: cost: Agrani bank owns a piece of land in Konabari. because sunk cost does not fall under incremental cash flow. should this cost be taken into consideration in project cash flow analysis ? The answer is no. 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.

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

dealers/ retailers might react adversely by moving their product line to another brands. that is the new project will decrease its existing sales stream. In the absence of inflation the real rate (rr) would be equal to nominal rate. Recently it has been touched two digit.Relevant Issues in Capital Budgeting Contd« Contd« ‡ But internet sales would most probably cannibalize its existing sales. Moreover . the real & nominal expected cash flow RCFt & NCFt would also be equal .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. Inflation Adjustment: inflation is a fact of life in Bangladesh. result will be . in this case the nominal net cash flow NCFt will increase at the rate of i percent. 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) . Even worse .

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

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

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

For example. The main problem with using the former is that. managers intent on maximizing IRR may actually reduce value by rejecting positive.Findings of the Research by Graham & Campbell NPV has been the dominant method taught in business schools.NPV projects. but past surveys have suggested that IRR was for long the primary corporate criterion for evaluating investment projects. in some cases. while over 50% said they relied mainly on IRR. 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. . Although the two measures are similar in several respects.

Findings of the Research by Graham & Campbell .

large companies were significantly more likely to use NPV than were small firms. regardless of firm size. However. companies that pay dividends .Findings of the Research by Graham & Campbell As shown in Figure 1. .were also significantly more likely to use NPV and IRR than firms that do not pay dividends.7% always or almost always used IRR.9% of CFOs always or almost always used NPV and 75. most respondents cited net present value and internal rate of return as their most frequently used capital budgeting techniques. 74. Highly leveraged firms were significantly more likely to use NPV and IRR than firms with low debt ratios. And as in the case of highly leveraged companies.

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

14% always or almost always used value at risk or some other form of simulation.Findings of the Research by Graham & Campbell Finally the other capital budgeting techniques were used less frequently. 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. 12% used a profitability index. . For example. 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. Somewhat surprisingly. and 11% used adjusted present value (APV).

Payback method looks at how long it will take to pay back the cost of the initial investment. NPV. Project appraisal techniques aim to assess the financial feasibility of investment options and based on a number of assumptions. Discounted PB and ARR are the non discounted criteria for appraising the worth of an investment project. .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. IRR and PI are the discounted cash flow criteria and PB.

Summary contd« contd« Average rate of return looks at the percentage rate of return on the investment. 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. . Capital rationing occurs when a company chooses not to fund all positive NPV projects. 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.

Group : Ever Shiners Name of Members Md Delowar Hossain Touhidul Islam Ashraful Islam Kazi Tasnim Afroz Fahmida Sharmin ID No. 13055 13062 13089 13132 13149 .


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