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# Capital budgeting –

**In simple terms capital budgeting means evaluation of capital expenditure.
**

So now we need to understand two things – 1. What do we mean by evaluation – Evaluation means assessment , comparison of the available options to choose the best one. 2. What do we mean by capital expenditure - Capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life that extends beyond one year.

Some features of capital expenditures – - long term consequences -difficult to reverse - substantial outlays - affects the risk of the firm - effect on growth -complex decisions

Process of Capital Budgeting

Identify the investment opportunity Assemble the proposed investment

•Market Environment •SWOT

•Replacement and Modernization •Expansion and Diversification •New product decision

Make the decision

•By using different methods

Implementation

Performance review

Methods for capital budgeting decision making

Non discounted

Discounted

1. Payback Period 2. Average Accounting rate of return (ARR)

1. Net Present Value 2.IRR

3.PI

4.Discounted payback period

Components for an investment plan – 1. Initial outflows – cash outflow purchase of the plant , machinery and fixed assets (remember to consider the disposal proceeds of the old asset , if any) 2. Operational flows – cash inflows during the operational phase of the project (consider tax shields , ignore depreciation) 3. Terminal flows – Post tax salvage value of the asset

Types of Investment decisions1. Mutually exclusive - A or B – USE CAPITAL RATIONING 2. Independent – A and B depending on funds 3. Contingent – If A , B is mandatory

To understand the above points better lets analyze some investment decisions

Payback Period In simple terms it represents the time frame for the stream of cash proceeds generated by the investment to be equal to the original investment Example 1

Should I accept this investment ? – Answers depends upon the threshold the org has set up

Accounting rate of return (ARR) •Also known as return on investment • ARR = Average income / Average investment

We would like to buy a machine for a hospital Investment in the required machine – 500,000 $ Life of the machine – 5 years By SLM of depreciation the machine will get depreciated over 5 years by 500,000 / 5 = 100,000 $ p.a. Revenue generation and related calculation follows -

Years

1

2

3

4

5

Revenue

Expenses Earnings before dep Depreciatio n

433,333

200,000 233,333 100,000

450,000

150,000 300,000 100,000 200,000 50,000 150,000

266,667

100,000 166,667 100,000 66,667 16,667 50,000

200,000

100,000 100,000 100,000 0 0 0

133,333

100,000 33,333 100,000 - 16,667 -16,667 -50,000

Earnings 133,333 before taxes Taxes @ 25 % Net Income 33,333 100,000

Average net income = 100,000 + 150,000 + 50,000 +0 + (50,000) / 5 = 50,000 Average book value = 500,000 + 0 / 2 = 250,000 AAR = 50,000 / 250,000 = 20%

Net Present value Sum of present values of all cashflows All cashflows means PV (cash outflows ) + PV (cash inflows) Example – Consider the following cash flow stream for a project and calculate its NPV with a discount rate of 10 %

If... It means... the investment would add value to the firm the investment would subtract value from the firm Then... the project may be accepted NPV >0 NPV <0

Year 0 1 2 3

Cash Flow (100,000) 200,000 200,000 300,000

the project should be rejected We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation.

4

5

300,000

350,000

NPV =0

the investment would neither gain nor lose value for the firm

Year

0

1

2

3

4

5

Cash flow Discount factor @ 10 % p.a. PV (cash flow * discount factor)

(1,000,000) 200,000

200,000

300,000

300,000

350,000

NA

0.9091

0.8264

0.7513

0.6830

0.6209

(1,000,000) 181,820

165,280

225,390

204,900

217,315

Summation of the PV = NPV = 1000000+181820+165280+225390+204900+217315 = -5295 As NPV is –ve reject the project (NPV and discount rate are inversely proportional)

Internal rate of Return IRR is the discount rate at which NPV = 0 Year 0 1 2 Cash Flow (100,000) 30,000 30,000 Consider two discount rates IRR involves a trial and error basis calculation

3

4

40,000

45,000 15 % p.a PV of inflows =100,802 PV of inflows > 100,000 so I would have to increase my discount factor

16% p.a PV of inflows = 98,641

So now we have the equation as follows – Required PV of inflows = PV of outflows = (100,000)

**PV of inflows at 15 % = 100,802 PV of inflows at 16 % = 98,641
**

100,000 lies between 100,802 and 98,641 Hence the discount rate or the IRR is as follows L = Lower discount rate PVB(L) , PVB (U) – present value benefits at lower and upper discount rates I = Initial investment U = upper discount rate Hence the value of r is R=L+ PVB(L) – I PVB(L)-PVB(U) * (U-L) = 15 % + (100,802 – 100,000) 100,802-98,641 * (16% - 15%)

=15 % + 802/2161 * 1 % = 15.37 %

PI = Profitability Index The ratio of present value of cash flows to the initial outlays

**PI = PV of annual cash flows / Initial Investment
**

Acceptance rules - Accept if PI > 1 - Accept if PI < 1 - May be accepted if PI =1

Some different concepts Conventional Investment – Cash flows - -,+,+,+

Non-Conventional Investment – Cash flows - -,+,+,-,-,++-,+ - Problem of multiple IRR occurs due to algebraic equation we use for solving – we would solve a problem in class to understand it (textbook page 173)

a2

NPV a1 IRR r1 a3 r2 r3

At r2 NPV =0 So r2=IRR At r3 NPV will be –ve At r1 NPV will be +ve

Acceptance / Rejection of independent conventional investments – NPV And IRR yield the same result

Discount Rate

Fischer’s intersection – Discount rate at which NPVs of two projects are equal Project Cash flow (0) Cash flow (1) Cash flow (2) Cash flow (3) NPV at 9% IRR

M

N

-1680

-1680

1400

140

700

840

140

1510

301

321

23%

17%

The NPV and IRR of these projects is conflicting …..the question is WHY ? – TIMING OF CASH FLOWS – NPV would be a better choice Project M – Largest cash flows early when compounding effect is not so severe Project N – Largest cash flows late when compounding effect is severe

**NPV Profiles of Projects
**

Discount rate Project M Project N 0 5 560 409 810 520

NPV

**Fischer's intersection - NPV versus IRR
**

1000 800 600 400 200 0 -200 -400 -600 Project M Project N

10

15 20 25 30

276

159 54 -40 -125

276

70 -106 -257 -388

0 560 810

5 409 520

10 276 276

15 159 70

20 54 -106

25 -40 -257

30 -125 -388

Under what conditions can NPV or IRR give conflicting results – 1. Timing of cash flow

2. Cash outflows

3. Project life span

Modified internal rate of return - As the name implies, MIRR is a modification of (IRR) and as such aims to resolve some problems with the IRR. Problems with the IRR MIRR resolves two problems arising with IRR First, IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the project that generated them. This is usually an unrealistic scenario and a more likely situation is that the funds will be reinvested at a rate closer to the firm's cost of capital. The IRR therefore often gives an unduly optimistic picture of the projects under study. Generally for comparing projects more fairly, the WACC should be used for reinvesting the interim cash flows. Second, more than one IRR can be found for projects with alternating positive and negative cash flows, which leads to confusion and ambiguity. (Remember the problem we solved in the classroom) MIRR finds only one value. Calculation MIRR is calculated as follows: where n is the number of equal periods at the end of which the cash flows occur (not the number of cash flows), PV is present value (at the beginning of the first period), FV is future value (at the end of the last period). The formula adds up the negative cash flows after discounting them to time zero, adds up the positive cash flows after factoring in the proceeds of reinvestment at the final period, then works out what rate of return would equate the discounted negative cash flows at time zero to the future value of the positive cash flows at the final time period.

For example, say a two-year project with an initial outlay of $195 and a cost of capital of 12%, will return $121 in the first year and $131 in the second year. To find the IRR of the project so that the net present value (NPV) = 0:

NPV = 0 = -195 + 121/(1+ IRR) + 131/(1 + IRR)2

NPV = 0 when IRR = 18.66%

To calculate the MIRR of the project, we have to assume that the positive cash flows will be reinvested at the 12% cost of capital. So the future value of the positive cash flows is computed as:

**$121(1.12) + $131 = $266.52 = Future Value of positive cash flows at t = 2
**

Now you divide the future value of the cash flows by the present value of the initial outlay, which was $195, and find the geometric return for 2 periods. =sqrt($266.52/195) -1 = 16.91% MIRR You can see here that the 16.91% MIRR is materially lower than the IRR of 18.66%. In this case, the IRR gives a too optimistic picture of the potential of the project, while the MIRR gives a more realistic evaluation of the project.

Advantages Payback Period 1. 2. 3. Accounting rate of return 1. 2. Simple Weeds out risky projects (initial cash flows imp) Good for Co. having a liquidity crunch Easy to calculate Needed information easily available as it is accounting data Considers all cash flows Considers time value of money Value –additivity principle is satisfied (NPV’s can be added for one or more projects) Consistent with the wealth maximization project Considers all cash flows Considers time value of money Consistent with wealth maximization principle Considers all cash flows Considers time value of money Consistent with wealth

Disadvantages 1. 2. Ignores time value of money Ignores cash flows after the payback period Ignores time value of money Arbitrary cut off rate Cash flow estimation is tedious Opportunity cost of capital computation is difficult Sensitive to discount rate used

1. 2. 1. 2. 3.

Net Present Value

1. 2. 3.

4. IRR (Internal rate of return) 1. 2. 3. Profitability Index (PI) 1. 2. 3.

1. 2. 3. 1.

Cash flow estimation is tedious No value additivity Relatively difficult to compute Cash flows estimation is tedious

Risk analysis in capital budgeting Risk - inability of perfect forecasts Categories influencing forecasts • General economic conditions •Industry factors •Company factors Techniques for analysis risk – Probability Defined Standard deviation / Co-efficient of variation - riskier Payback Risk adjusted Discount rate Certainty equivalent – lower alpha when greater risk Sensitivity analysis – impact due to change in variables Scenario analysis – Pessimistic/ Optimistic/Expected Simulation – probability distribution of NPV Decision tree

Required formulae – •Expected value of cash flow = Summation (Probability * Cash flow) •Standard deviation = Summation ((Cash flow –Expected cash flow)2 * probability)) •Coefficient of variation = Standard deviation / Expected value •Alpha = Certain cash flow / Risky cash flow and then while calculating the NPV multiply the net cash flow with alpha to arrive at the cash flows that then would be discounted

Utility theory An investor prefers a higher return to a lower return and each successive identical increment of money is worthless to him than the preceding one