Finance Workshop 2

Capital Budgeting
Payback
Resolve the question
Drawbacks

 Ignores time value money

 Ignores cash flows beyond the year
Discounted Payback Period
We discount the Cash flows to zero, resolve the issue time value money
For this, we calculate the present value of X and present value of Y

 Calculate present value of X

 Cumulative present value of X
 Present value of Y
 Cumulative present value of y
Net present value

 Reflects d actual change in cashflows

 Is a function of discount rate
 10% or 20 % is better depends upon the situation to situation
 assumption : reinvest in the case of present value
 value at addivity:
 NPV = ZERO = depends on discount rate
IRR

 Rate that makes NPV equals to zero

 If we have multiple rates then what to choose ? – It can be upto n
 Lowest rate – select – k
 IRR could be confusing because of the multiple rates
 IRR can’t be equal with the individual rates
 IRR is in percentage which is misleading
 Govt n financial institutes use IRR bcoz with a single rate
 Projects are mutually exclusive ? which methods we chose NPV or IRR ?
 Y WE HAVE CONFLICT BETWEEN NPV and IRR ?
o The size of initial outflow
o Order and timing of cashflow
 o Reinvestment rate in NPV And IRR are not same
 In case of conflict which one is better?
o NPV is better
o IRR have multiple rates which is confusing
o Value addivity
o NPV reflects actual change in wealth while IRR is a rate with no economic
meaning
o Reinvest rate in NPV is more realistic than the reinvestment in IRR

Adjusted IRR
 Present value of cash outflows
 Future value of cash inflows
 Rate of Return
 It still has no economic meaning
 Reinvest rate is
Profitability Index

 Finance = Cashflows = Measure

 Economics = Benefits = Not measure

Problem of unequal lives

 Depends on criteria & growth

 EAA – Equivalent annual annuity
Rationing

 Optimize budget to get highest returns

How to handle uncertainty

 Sensitivity Analysis
 Scenario analysis
 Simulation analysis
 Break even analysis
WACC – Weighted average cost of capital
RISK AND RETURN

 Risk Taker
 Risk Averse -