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Lecture 6,7 & 8

Capital Budgeting Techniques

Presented by
Muhammad Khalid Sohail

Lecture 5
Review:

Present Value

Present Value is the current value of a future amount of
money, or a series of payments (single, un-even, same,
infinite), evaluated at a given interest rate.

1. General Present Value Formula
(single):
PV0 = C/Fn / (1+i)n
or

PV0 = C/Fn (PVIFi,n) -- See Table

2. Present Value (un-even C/F):
6-2

DF = PVIFi,n = 1 / (1+i)n

3. a. Present Value (Annuity):
PVAn
Or PVAn

= C/F (PVIFAi%,n)
= C/F * [(1-1/(1+i)^n) / i ]

b. PVADn = C/F (PVIFAi%,n)(1+i)
4. Present Value (infinite series):
PVp = CF / i = (1 / i) * CF = DFp * CF
5. Present Value (Mixed series):
solve according to above four
formulas.
6-3

0 10% PV0 6-4 1 2 3 4 5 $10.000 in 5 years at a discount rate of 10%. What will be the PV of $10.000 .1. PV of Single Value.

000 (.210. 5) = $10.6209 6209 6209 .683 0 5 10000 0.9091 0 2 0 0.10)5 = $6.21 Calculation based on Table: PV0 = $10.00 Year CF-AT 6-5 DF@10% [Rounding] PV 0 0 1 0 1 0 0.000 / (1+ 0.209.000 (PVIF10%.8264 0 3 0 0.  Calculation based on general formula: PV0 = C/Fn / (1+i)n PV0 = $10.7513 0 4 0 0.621) = $6.

8264 165 3 300 0.2. PV of Un-even C/F  What will be the PV of $100.7513 225 481 . 200. 0 6-6 100 200 300 1 2 3 Year C/F DF@10 PV 0 0 1 0 1 100 0.9091 91 2 200 0. 300 occurring in 3 years at a discount rate of 10%. a.

819 164 3 300 0.2. 200. 0 6-7 100 200 300 1 2 3 DF@10.7412 222 477 . Year CF 300 occurring in 3 years at a discount rate of 10.5% PV 0 0 1 0 1 100 0.5%. Un-even C/F when interest rate is in fraction  What will be the PV of $100. b.905 91 2 200 0.

3. What is PV of this annuity at interest rate 10% (Ordinary Annuity) End of Period 1 0 1 $1000 Today 6-8 End of Period 2 End of Period 3 2 1000 3 1000 Equal Cash Flows Each 1 Period Apart . a.

n) PVA3 = $1.487 i n 0.PVAn = C/F (PVIFAi%.10 DFA 3 2.624316 Year CF-AT DF@10% PV 0 1-3 6-9 0 1 0 1000 2.3) = $1.000 (2.4869) = $2.486852 2487 2487 .000 (PVIFA10%.

465 Year CF-AT 0 1-3 6-10 DF@10.5% PV 0 1 0 1000 2.n) = $1.3) = $1.000 (PVIFA10.5% PVAn PVA3 = C/F (PVIFAi%.000 (2. b.5%. What is PV of this annuity at interest rate 10.3.2465) = $2.465123 2465 2465 .

Present Value of Infinite series What will be the PV of $70 occurring in infinite years at a discount rate of 10%. PV = CF * DFp PV = 70 * (1/.10) = 70 * (10) = 700 6-11 0 70 70 70 ….4. 1 2 3 …. .

..Find PV of this C/F 0 6-12 100 200 300 1000 1000 1000 70 70 1 2 3 4 5 6 7 8 …. ……….

0 0 481 6-13 100 200 300 1000 1000 1000 70 70 1 2 3 4 5 6 7 8 100 200 300 1000 1000 1000 70 70 1 2 3 4 5 6 7 8 2487 700 ….. . ………. ……….

481 2487 0 1 Year 3 2 CF-AT 700 4 6 5 DF@10% PV 0 481 1 481 3 2487 0.7513 1868 6 700 0.5645 395 2744 6-14 7 .

8684 1868 70 5.6447 395 4-6 7-inf ……….7513 225 1000 1.3553 DFp 10 5.1 6 4.8684 Annuity i n 0.9091 91 2 200 0.8264 165 3 300 0.1 Perp i 6 n 0.1 inf Ann-prep-diff DFA 4.3553 0.0 100 200 300 1000 1000 1000 70 70 1 2 3 4 5 6 7 8 Year CF-AT DF@10% PV 0 0 1 0 1 100 0.6447 .4869 1. 2744 Annuity Ann-diff 6-15 i n DFA 0.1 3 2.

Capital Budgeting Techniques 6-16  Project Evaluation and Selection  Potential Difficulties  Capital Rationing  Project Monitoring  Post-Completion Audit .

APV  6-17 . NTV.Project Evaluation: Alternative Methods Average Rate of Return Payback Period (PBP)  Internal Rate of Return (IRR)  Net Present Value (NPV)  Profitability Index (PI)  Advanced Techniques Discounted PBP. MIRR.

Project Types  Independent A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration. 6-18 . Best project is selected. “project do not compete with each other”  Dependent The acceptance of one project also depends on the acceptance of other project ’(s).  Mutually exclusive Compete against each other.

000. 6-19 .000. The initial cash outlay will be $40. BW.000. She has determined that the after-tax cash flows for the project will be $10.000.Proposed Project Data JM is evaluating a new project for her firm. respectively.000. $12. for each of the Years 1 through 5. $15. and $7.000. $10.

of year required to recover initial C/F from future C/F” PBP is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow.Payback Period (PBP) 0 1 -40 10 2 12 3 4 15 10 5 7 “No. 6-20 .

a: year at which cumulative total does not exceed its ICO b: ICO c: Cumulative total discussed in step-1 d: C/F of following years of commutative total in single C/F column 0 1 2 -40 (-b) 10 10 12 22 Cumulative Inflows 6-21 PBP 3 (a) 15 37 (c) 4 10 (d) 47 =a+(b-c)/d = 3 + (40 .37) / 10 = 3 + (3) / 10 = 3.3 Years 5 7 54 .

[3.5 years. Should this project be accepted? Yes! The firm will receive back the initial cash outlay in less than 3. e.3 Years < 3.5 years for projects of this type.] 6-22 .5 Year Max.g. The management of BW has set a maximum PBP of 3.PBP Acceptance Criterion “Based upon the management”.

In case of annuity PBP = ICO / [CFi (single)] (years) PBP = 600 / 200 = 3 years 6-23 -600 200 200 200 200 0 1 2 3 4 .

PBP Strengths and Weaknesses Strengths: Weaknesses:  Easy to use and understand  Does not account for TVM  Can be used as a measure of liquidity  Does not consider cash flows beyond the PBP  Easier to forecast ST than LT flows  Cutoff period is subjective 6-24 .

Lecture 6: Net Present Value: NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow.ICO +.+ n (1+k) NPV = PV of CFi – PV of CFo ... CF1 NPV = (1+k)1 6-25 + CF2 (1+k)2 CFn .

remain same expected rate of return. return will be less than the firm RRR.  NPV→’0’. Firm value will .  NPV is $ amount of change in the value of firm as a result of undertaking the project. return exceeds the firm RRR. as a result MPS will also increase. Firm value will not change. 6-26 .e.  NPV→’-’. the project will add value to the firm. Firm value will ↓. Maximization of wealth of owners.  NPV→’+’. More consistent with the goal i.  NPV positive means.

885 8850 2 12000 0.5428 3800 NPV -1423 .7831 9397 3 15000 0. -40000 40000 0 10000 12000 15000 10000 7000 1 2 3 4 5 PV of C/Fo ? PV of C/Fi ? Year 6-27 CF-AT 38577 DF@13% PV 0 -40000 1 -40000 1 10000 0.6133 6133 5 7000 0.6931 10397 4 10000 0.NPV Solution BW has determined that the appropriate discount rate (k) for this project is 13%.

6-28 * For M.E projects: rank according to higher NPV .NPV Acceptance Criterion The management of BW has determined that the required rate is 13% for projects of this type. Project: accept NPV>=0. [Reject as NPV < 0 ] * For Ind. This means that the project is reducing shareholder wealth. Should this project be accepted? No! The NPV is negative.

.  Accounts for TVM.  Considers all cash flows. 6-29  May not include managerial options embedded in the project.NPV Strengths and Weaknesses Weaknesses: Strengths:  Cash flows assumed to be reinvested at the hurdle rate.

10 5 IRR NPV@13% 0 -4 6-30 Sum of CF’s 0 3 6 9 12 Discount Rate (%) 15 .Net Present Value Profile Net Present Value $000s 15 Plot NPV for each discount rate.

PI = Benefits / Cost = PV of CFi / PV of CFo Method #1: CF1 PI = (1+k)1 + CF2 CFn +.+ 2 (1+k) (1+k)n << OR >> Method #2: 6-31 PI = 1 + [ NPV / ICO ] ICO . OR BCR : Benefit Cost Ratio.Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow...

[Reject as PI < 1.9644 (Method #2) Should this project be accepted? No! The PI is less than 1.000 = .00. This means that the project is not profitable.9644 (Method #1) PI = 1 + (-1423)/ 40.000 = .00 ] 6-32 .PI Acceptance Criterion PI = $38.577 / $40.

PI Strengths and Weaknesses Strengths: Weaknesses:  Same as NPV  Same as NPV  Allows comparison of different scale projects  Provides only relative profitability  Potential Ranking Problems 6-33 .

OR “The rate at which NPV becomes zero” CF1 CF2 + ICO = (1+IRR)1 (1+IRR)2 6-34 +.+ CFn (1+IRR)n .Internal Rate of Return (IRR): IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow...

000 + + (1+IRR)3 (1+IRR)4 (1+IRR)5 Find the interest rate (IRR) that causes the discounted cash flows to equal $40.000.000 $40.000 $10. 6-35 .IRR Solution $10.000 = + + (1+IRR)1 (1+IRR)2 $15.000 $12.000 $7.

4 n= CFi CFo IRR 2 3 4 30000 10000 0.1 -10000 0 6-36 30000 1 P:6.  IRR = (CFi / CFo)^(1/n) .316074 4 .IRR : Single Value  For single value in CFi.

Locate two DFs close to DF in PVIFA table under year n iii. 6-37 .For Annuity Calculate DF = CFo / Annuity ii. Interpolate IRR as: LDR + (∆DRs) (LDF – DF) / (LDF – HDF) or HDR .(∆DRs) (DF – HDF) / (LDF – HDF) i.

4 HDR IRR = 0.3 LDR 2.3524 = 35.5237) = 0.30 + (0.24% .000 HDF 6-38 2.4763) = 0.166 Rate IRR 1.849 0.IRR: Annuity Case: Problem 6.4 -10000 5000 5000 5000 5000 0 1 2 3 4 PVIFA LDF (i) DF Or 0.10) (0.3524 = 35.24% IRR = 0.10) (0.40 – (0.

6-39 it is near to i n Annuity Year 0. Now we Check.  Yes 0.349 CF-AT 0 1-4 n DFA 4 2.90%.24% 1. at this rate. at 35.  Now. with the help of computer program.9894 PV -10000 1 -10000 5000 1. whether NPV becomes 0.9894 9947 1-4 NPV -53 i Annuity Year 0.24%.24% PV -10000 1 -10000 5000 2.0001 DF@35. whether NPV becomes 0.0001 10001 NPV 1 . IRR is 34.3524 CF-AT 0 DFA 4 DF@35. again we check.

Lecture 7 • IRR : Mixed Stream of C/F. one ‘+’ & other ‘-’ • Interpolate IRR as: LDR + (∆DRs) (|NPVLDR|) / (|NPVLDR|+ |NPVHDR|) Or HDR . with the help of NPV • Calculate Two NPVs.(∆DRs) (|NPVHDR|) /(|NPVLDR|+ |NPVHDR|) 6-40 .

9998 9999 -1 .1662 10831 NPV i Annuity 831 n 4 Diff 0.35 LDR HDR 1.i n Annuity Year DFA 0.91% PV 1 -10000 1.05 IRR 0.9969 9985 NPV 6-41 i PV -15 Annuity Year 0.3491 Check Year CF-AT 0 1-4 DF@35% -10000 1 -10000 5000 1.35 Fraction 0.1662 PV -10000 1 -10000 5000 2.01773 0.9969 Diff 0.05 IRR 0.3 Fraction 0.3491 CF-AT 0 1-4 n -10000 5000 NPV DFA 4 1.3 CF-AT 0 1-4 4 DF@30% 2.3491 OR DFA 0.9998 DF@35.98227 0.

Adjustment in k=Rough IRR [if required] If CFi >FA in earlier years: k=Rough IRR+1… If CFi <FA in earlier years: k=Rough IRR-1… Calculate NPV at k rate (step-iv). v. iv. 6-42 Get Fake Annuity : FA = ΣCFi / n Calculate DF = CFo / FA Find DF in PVIFA table under year n. then IRR = k.IRR : Mixed Stream of C/F i. iii. Then calculate another NPV at (k-5) rate: If NPV>0. Then calculate another NPV at (k+5) rate: [Make sure you have two NPVs. ii. If NPV=0. this will give rough IRR = k. [you are lucky]. . otherwise: If NPV<0 (step-v). vii. one +ve and other-ve]: Interpolate IRR. vi.

11 0.11 .696 Rate=k= 0.7037 step 3 in PVIFA step 4 Adjustment in k= 0 step 5 Find NPV at k= 3.IRR: solution with the help of 7-steps 6-43 -40000 10000 12000 15000 10000 7000 0 1 2 3 4 5 step 1 FA 10800 step 2 DF 3.

+ Find NPV at k= 0.6407 9611 0.8116 9739 0.7212 10818 4 10000 0.6468 6468 5 7000 0.11 NPV 458 HDR 0.8042 9650 3 15000 0.16 NPV -3994 LDR 6-44 Diff 0.8621 8621 0.11 PV Check 0.11 Fraction 0.5935 4155 0.8968 8968 2 12000 0.4761 3333 0.58 4060 NPV 458 NPV -3994 NPV -36 step 6 Now NPV.1151 PV 0 -40000 1 -40000 1 -40000 1 -40000 1 10000 0.9009 9009 0.102875 IRR 0.7312 10968 0.7432 8918 0.16 step 7 LDR 0.step 5 Year step 6 CF-AT 0.5523 5523 0.05 0.1151 .6587 6587 0.16 PV 0.

51% for each dollar invested in this project at a cost of 13%. [ IRR < Hurdle Rate ] 6-45 .IRR Acceptance Criterion The management of BW has determined that the hurdle rate is 13% for projects of this type. Should this project be accepted? No! The firm will receive 11.

3 Year 6-46 Net C/F .2169 step 3 in PVIFA step 4 Adjustment in k 0 step 5 Find NPV at k= 0.14 4.14 . C/F 1 8000 5600 2400 816 7184 2 8000 8960 -960 -326 8326 3 8000 5376 2624 892 7108 4 8000 3226 4774 1623 6377 5 8000 3226 4774 1623 6377 6 8000 1612 6388 2172 5828 7 8000 0 8000 2720 5280 step 1 FA 6640 step 2 DF 4.P:6.Tax Inc.288 rate = k = 0.Depr. = CF_BT .

14 Fraction 0.361798 IRR 0.5921 3776 0.7456 6208 3 7108 0. + Find NPV at k= 0.19 PV 0.419 2672 0.1581 PV 0 -28000 1 -28000 1 -28000 1 -28000 1 7184 0.14 PV 0.3579 1890 NPV 1360 NPV -2399 NPV -101 step 6 Now NPV.19 NPV -2399 LDR 6-47 Check Diff 0.4556 2655 0.7062 5880 0.3521 2052 0.2959 1562 0.5559 3545 5 6377 0.4987 3180 0.1581 .48 3061 6 5828 0.8772 6302 0.3996 2110 0.8403 6037 0.5194 3312 0.6438 4576 4 6377 0.8635 6203 2 8326 0.5934 4218 0.14 NPV 1360 HDR 0.7695 6407 0.step 5 step 6 Year CF-AT .05 0.19 step 7 LDR 0.4145 2416 7 5280 0.675 4798 0.

but overall do not change firm value.  Difficulties with project rankings and Multiple IRRs  .IRR Strengths and Weaknesses Strengths:    6-48 Accounts for TVM Considers all cash flows Less subjectivity Weaknesses: Assumes all cash flows reinvested at the IRR  smaller project may have higher IRR.

51% 13% Reject NPV -$1.3 3.96 1.423 $0 Reject PI .00 Reject .5 Accept IRR 11.Evaluation Summary BW Independent Project Method Project Comparison Decision 6-49 PBP 3.

Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
6-50

A. Scale Differences
Compare a small (S) and a
large (L) project.
END OF YEAR

6-51

NET CASH FLOWS
Project S
Project L

0

-$100

-$100,000

1

0

0

2

$400

$156,250

Scale Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?

6-52

Project

IRR

S

100%

L

25%

NPV

$

PI

231

3.31

$29,132

1.29

END OF YEAR 6-53 NET CASH FLOWS Project D Project I 0 1 -$1.000 -$1.B. Cash Flow Pattern Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.200 1.200 100 2 500 600 3 100 1.080 .

17 I 17% $198 1. NPV@10%.Cash Flow Pattern Calculate the IRR.17 . and PI@10%. Which project is preferred? Project 6-54 IRR NPV PI D 23% $198 1.

375 0 .C.000 2.000 2 0 0 3 3.000 0 -$1. END OF YEAR 6-55 NET CASH FLOWS Project X Project Y 0 1 -$1. Project Life Differences Let us compare a long life (X) project and a short life (Y) project.

Project Life Differences Calculate the PBP.82 . and PI@10%.536 2. Which project is preferred? Why? 6-56 Project IRR NPV PI X 50% $1. NPV@10%.54 Y 100% $ 818 1. IRR.

Capital Rationing Capital Rationing occurs when a constraint (or budget ceiling) is placed on the total size of capital expenditures during a particular period.. 6-57 Example: JM must determine what investment opportunities to undertake for BW Co. She is limited to a maximum expenditure of $32.500 only for this capital budgeting period. .

000 7.000 2.500 25.10 6.500 1.000 1.24 .000 1.04 21.10 5.500 15.67 500 1.500 2.000 IRR 18% 25 37 20 26 28 19 15 NPV $ PI 50 1.40 7.Available Projects for BW Project A B C D E F G H 6-58 ICO $ 500 5.500 2.000 17.000 5.500 12.43 6.30 5.

000 37% 28 26 25 $ 5.500 outlay.000 12.500 21. 6-59 .000 500 6.04 2. F. The resulting increase in shareholder wealth is $27. and E have the three largest IRRs.10 2.000 with a $32.500 5.Choosing by IRRs for BW Project C F E B ICO IRR NPV PI $ 5.40 1.000 15.500 2.30 Projects C.

The resulting increase in shareholder wealth is $28.000 IRR NPV PI 28% 19 25 $21.500 outlay.Choosing by NPVs for BW Project F G B ICO $15.000 7. 6-60 .40 1.000 17.500 2.30 Projects F and G have the two largest NPVs.500 with a $32.500 5.43 2.500 6.

500 28% 25 37 20 19 $21.10 1. and D have the four largest PIs.000 7.000 with a $32.500 outlay.500 5.43 Projects F.Choosing by PIs for BW Project F B C D G ICO IRR NPV PI $15. 6-61 .000 7. The resulting increase in shareholder wealth is $38.500 2.500 5.40 2.000 6. C.30 2. B.67 1.000 5.500 17.000 5.

and D $38.000 NPV F and G $28. and E $27. B.000 PI generates the greatest increase in shareholder wealth when a limited capital budget exists for a single period. 6-62 . C. F.Summary of Comparison Method Projects Accepted Value Added PI F.500 IRR C.

  Identify any project weaknesses Develop a possible set of corrective actions  Provide appropriate feedback Result: Making better future decisions! 6-63 .Post-Completion Audit Post-completion Audit A formal comparison of the actual costs and benefits of a project with original estimates.

Multiple IRR Problem* Let us assume the following cash flow pattern for a project for Years 0 to 4: -$100 +$100 +$900 -$1. 6-64 .000 How many potential IRRs could this project have? Two!! There are as many potential IRRs as there are sign changes.

8 4000 2 -5000 0.04 -200 NPV 6-65 0 0 .64 -3200 NPV Year CF-AT DF@400% PV 0 -800 1 -800 1 5000 0.2 1000 2 -5000 0.Multiple IRR example P:6-10 Year CF-AT DF@25% PV 0 -800 1 -800 1 5000 0.