ESOFT METRO CAMPUS

BUSINESS IN PRACTICE
Module Code – CI7600

By
Pradeep Alexander
MBA (Finance), MA in Financial Economics, MSc in Proj.Mgt.

Bcom.Sp.Acc.Hons, ICMA, CILT, CA-Inter, ACCA-Skill .

 Chapter - 09

Capital Budgeting.
Time Value of Money
Time Value Topics

ØFuture value
ØPresent value
ØRates of return
ØAmortization
Time Value Basic Concepts
ØTimelines
ØFuture value / Present value of lump sum
ØFV / PV of annuity
ØPerpetuities
ØUneven CF stream
ØCompounding periods
ØNominal / Effective / Periodic rates
ØAmortization
 Determinants of Intrinsic Value:
The Present Value Equation

Net operating Required investments

profit after taxes Free cash flow in operating capital
(FCF)

FCF1 FCF2 ... FCF∞

Value = + + +
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Market interest rates Cost of debt Firm’s debt/equity mix

Market risk aversion Cost of equity Firm’s business risk

Compounding $$

Ø Growing Money to accumulate value in

future
Ø Solve for Future Value (FV)
Ø Mathematical process (multiply)
 FV of an initial $100 after
3 years (I = 10%)

0 1 2 3
10%

100 FV = ?
Finding FVs (moving to the right
on a time line) is called compounding.
After 1 year

FV1 = PV + INT1 = PV + PV (I)

= PV(1 + I)
= $100(1.10)
= $110.00
After 2 years

FV2 = FV1(1+I) = PV(1 + I)(1+I)

= PV(1+I)2
= $100(1.10)2
= $121.00
After 3 years
FV3 = FV2(1+I)=PV(1 + I)2(1+I)
= PV(1+I)3
= $100(1.10)3
= $133.10
In general,
FVN = PV(1 + I)N
 After 4 years

PV = $100
N=4
i = 10%
FV = ? = $146.41
After 4 years, but different compounding per year

Semi-annual Quarterly
PV = $100 PV = $100
N = 4 yrs x 2 = 8 periods N = 4 yrs x 4 = 16
i = 10% / 2 = 5% per periods
period i = 10% / 4 = 2.5% per
FV = ? = period
FV = ? =
 Discounting $$

Ø Money needed today to accumulate x$ value in

future
Ø Solve for Present Value (PV)
Ø Mathematical process (divide)
 What’s the PV of $110 due in 1
year if I/YR = 10%?

Finding PVs is discounting, it’s reverse of

compounding.

0 1 2 3
10%

PV = ? 110
Solve FVN = PV(1 + I )N for PV

FVN N
1
PV = = FVN
(1+I)N 1+I

1
110
PV =
1.10
PV= $110
What’s the PV of $110 due in 1 year if I/YR =
10%?
Annual Semi-annually
Compounding

FV = $110 FV = $110
N = 1 yr N = 1 yr x 2 = 2 periods
i = 10% i = 10% / 2 = 5.0% per
PV = ? = period
FV = ? =

17
 What’s the PV of $100 due in 3
years if I/YR = 10%?

Finding PVs is discounting, and it’s the

reverse of compounding.

0 1 2 3
10%

PV = ? 100
Solve FVN = PV(1 + I )N for PV

FVN N
1
PV = = FVN
(1+I)N 1+I

3
1
PV = $100
1.10
= $100(0.7513) = $75.13
Cash Flow signs

Investing $ today Borrowing $ today

Outlay (invest) $ today in Take in (borrow) $ today in

present to earn greater present to use now, then
return in the future. repay with interest in the
Earn interest (revenue), plus future.
principal Pay interest (expense), plus
PV = <-> principal
FV = + PV = +
FV = <->
Periods or Interest Rate unknown

Solve for N Solve for i

Invest $100 today Deposit $100 today. You
earning 10% & need need $148.45 in 4 years.
$146.41. How long will it What’s the annual
take interest rate if the money
is compounded
quarterly?
 Ordinary Annuity vs. Annuity Due

Series of equal payments made at fixed

intervals or specified number of periods.
Ordinary Annuity @ end
Annuity Due @ beg
Ordinary Annuity vs. Annuity
Due
Ordinary Annuity
0 1 2 3
I%

$100=PMT $100 $100

Annuity Due
0 1 2 3
I%

$100=PMT $100 $100

What’s the FV of a 3-year
ordinary annuity of $100 at 10%?

0 1 2 3
10%

100 100 100

110
121
FV = 331
FV Annuity Formula

• The future value of an annuity with N periods

and an interest rate of I can be found with the
following formula:

(1+I)N-1
= PMT
I
(1+0.10)3-1
= $100 = $331
0.10
What’s the PV of this ordinary
annuity?
0 1 2 3
10%

100 100 100

90.91
82.64
75.13
248.69 = PV
PV Annuity Formula

• The present value of an annuity with N periods

and an interest rate of I can be found with the
following formula:

1 1
= PMT −
I I (1+I)N
1 1
= $100 − = $248.69
0.1 0.1(1+0.1)3
27
Find the FV and PV if the
annuity were an annuity due.

0 1 2 3
10%

100 100 100

PV and FV of Annuity Due
vs. Ordinary Annuity
• PV of annuity due:
• = (PV of ordinary annuity) (1+I)
• = ($248.69) (1+ 0.10) = $273.56

• FV of annuity due:
• = (FV of ordinary annuity) (1+I)
• = ($331.00) (1+ 0.10) = $364.10
Retirement problem for you

Scenario Solution

Want to retire in 35 years Pmt = $2500

Deposit (invest) $2500 year N= 35
into an S&P 500 Index fund i = 12.1%
(which returns 12.1% FV = ? = $1,104,853
annually)
How much will you have to $2500/yr x 35 yrs = $87,500
retire on in 35 years? total cash outlay
How much cash did you have
to outlay in total to
accumulate that much?
What is the PV of this
uneven cash flow stream?

0 1 2 3 4
10%

100 300 300 -50

90.91
247.93
225.39
-34.15
530.08 = PV
What’s PV of this 3-yr, $100 per yr CF
Stream, 10%=I, semi-annual compounding?

10%
0 1 2 3

100 100 100

= PV
Nominal rate (INOM)

• Stated in contracts, and quoted by banks and

brokers.
• Not used in calculations or shown on time lines
• Periods per year (M) must be given.
• Examples:
• 8%; Quarterly
• 8%, Daily interest (365 days)
Periodic rate (IPER )

• IPER = INOM/M, where M is number of compounding

periods per year. M = 4 for quarterly, 12 for monthly,
and 360 or 365 for daily compounding.

• Used in calculations, shown on time lines.

• Examples:
• 8% quarterly: IPER = 8%/4 = 2%.
• 8% daily (365): IPER = 8%/365 = 0.021918%.
The Impact of Compounding

• Will the FV of a lump sum be larger or smaller

if we compound more often, holding the stated
I% constant?
• Why?
The Impact of Compounding
(Answer)
• LARGER!

• If compounding is more frequent than once a

year--for example, semiannually, quarterly, or
daily--interest is earned on interest more often.
FV Formula with Different
Compounding Periods

MN
INOM
FVN = PV 1 +
M
$100 at a 12% nominal rate with
semiannual compounding for 5 years

MN
INOM
FVN = PV 1 +
M
2x5
0.12
FV5S = $100 1 +
2
= $100(1.06)10 = $179.08
 FV of $100 at a 12% nominal rate for
5 years with different compounding

FV(Ann.) = $100(1.12)5 = $176.23

FV(Semi.) = $100(1.06)10 = $179.08
FV(Quar.) = $100(1.03)20 = $180.61
FV(Mon.) = $100(1.01)60 = $181.67
FV(Daily) = $100(1+(0.12/365))(5x365) = $182.19
 Nominal vs. Effective Rates
(APR vs. EAR or Eff)

$100 today, 10% nominal rate compounded annually

vs. semi-annually.
Effective Annual Rate (EAR =
EFF%)
• The EAR is the annual rate that causes PV to
grow to the same FV as under multi-period
compounding.
Effective Annual Rate Example

• Example: Invest $1 for one year at 12%,

semiannual:
FV = PV(1 + INOM/M)M
FV = $1 (1.06)2 = $1.1236.
• EFF% = 12.36%, because $1 invested for one
year at 12% semiannual compounding would
grow to the same value as $1 invested for one
year at 12.36% annual compounding.
Comparing Rates

• An investment with monthly payments is

different from one with quarterly payments.
Must put on EFF% basis to compare rates of
return. Use EFF% only for comparisons.
• Banks say “interest paid daily.” Same as
compounded daily.
EFF% for a nominal rate of 12%,
compounded semiannually

M
INOM
EFF% = 1 + −1
M
2
0.12
= 1 + −1
2

= (1.06)2 - 1.0
= 0.1236 = 12.36%.
 EAR (or EFF%) for a Nominal
Rate of 12% (APR)

EARAnnual = 12%.

EARQ = 2 p/yr = 12.55%.

EARM = 12 p/yr = 12.68%.

EARD(365) = 365 p/yr = 12.75%.

Amortization

• Construct an amortization schedule for a

$1,000, 10% annual rate loan with 3 equal
payments.
 Step 1: Find the required
payments.

0 1 2 3
10%

-1,000 PMT PMT PMT

INPUTS 3 10 -1000 0
N I/Y PV PMT FV
OUTPUT R
402.11
47
Step 2: Find interest charge for
Year 1.

INTt = Beg balt (I)

INT1 = $1,000(0.10) = $100

Step 3: Find repayment of principal in
Year 1.

Repmt = PMT - INT

= $402.11 - $100
= $302.11
 Step 4: Find ending balance after Year 1.

End bal = Beg bal - Repmt

= $1,000 - $302.11 = $697.89

Repeat these steps for Years 2 and 3

to complete the amortization table.
 Amortization Table

PRIN
YEAR BEG BAL PMT INT PMT END BAL
1 $1,000 $402 $100 $302 $698

2 698 402 70 332 366

3 366 402 37 366 0

TOT 1,206.34 206.34 1,000

Interest declines because outstanding
balance declines.
$450
$400
$350
$300
$250 Interest
$200 Principal
$150
$100
$50
$0
PMT 1 PMT 2 PMT 3

52
• Amortization tables are widely used--for home mortgages, auto
loans, business loans, retirement plans, and more. They are
very important!
• Financial calculators (and spreadsheets) are great for setting up
amortization tables.
Capital Budgeting – Introduction & Non
Discounting Techniques
Investment Decisions in Corporates:

ØShort Term Investments – Working Capital

ØLong Term Investments – Non Current Assets
Capital budgeting is made up of two words ‘capital’ and
‘budgeting.’ In this context, capital expenditure is the spending of
funds for large expenditures like purchasing fixed assets and
equipment, repairs to fixed assets or equipment, research and
development, expansion and the like. Budgeting is setting targets
for projects to ensure maximum profitability.
What is Capital Budgeting?

Capital budgeting is a process of evaluating investments and huge

expenses in order to obtain the best return on investment.
An organization is often faced with the challenges of selecting between
two projects/investments or the buy vs replace decision. Ideally, an
organization would like to invest in all profitable projects but due to
the limitation on the availability of capital an organization has to
choose between different projects/investments.
What are the objectives of Capital budgeting?
Capital expenditures are huge and have a long-term effect. Therefore,
while performing a capital budgeting analysis an organization must keep
the following objectives in mind:

Selecting profitable projects

An organization comes across various profitable projects frequently. But
due to capital restrictions, an organization needs to select the right mix of
profitable projects that will increase its shareholders’ wealth.
.
 Capital expenditure control
Selecting the most profitable investment is the main objective of capital
budgeting. However, controlling capital costs is also an important
objective. Forecasting capital expenditure requirements and budgeting for
it, and ensuring no investment opportunities are lost is the crux of
budgeting.

Finding the right sources for funds

Determining the quantum of funds and the sources for procuring them is
another important objective of capital budgeting. Finding the balance
between the cost of borrowing and returns on investment is an important
goal of Capital Budgeting.
Capital Budgeting Process
Identifying investment opportunities

An organization needs to first identify an investment opportunity. An

investment opportunity can be anything from a new business line to
product expansion to purchasing a new asset. For example, a company
finds two new products that they can add to their product line.
Evaluating investment proposals

Once an investment opportunity has been recognized an organization

needs to evaluate its options for investment. That is to say, once it is
decided that new product/products should be added to the product line,
the next step would be deciding on how to acquire these products.
There might be multiple ways of acquiring them. Some of these
products could be:
•Manufactured In-house
•Manufactured by Outsourcing manufacturing the process, or
•Purchased from the market
Choosing a profitable investment

Once the investment opportunities are identified and all proposals are
evaluated an organization needs to decide the most profitable investment
and select it. While selecting a particular project an organization may have
to use the technique of capital rationing to rank the projects as per returns
and select the best option available. In our example, the company here has
to decide what is more profitable for them. Manufacturing or purchasing
one or both of the products or scrapping the idea of acquiring both.
Capital Budgeting and Apportionment

After the project is selected an organization needs to fund this project.

To fund the project it needs to identify the sources of funds and allocate
it accordingly. The sources of these funds could be reserves,
investments, loans or any other available channel.
Performance Review

The last step in the process of capital budgeting is reviewing the

investment. Initially, the organization had selected a particular
investment for a predicted return. So now, they will
compare the investments expected performance to the actual
performance.
Capital Budgeting Techniques

ØNon Discounting Techniques – Average Rate od Return (ARR), Pay

Back Period-PBP
ØDiscounting Techniques – Discounted Payback Period, Net Present
Value (NPV), Internal Rate of Return (IRR), Profitability Index (PI)
What is the Difference Between Discounted and Undiscounted
Cash Flows?

key difference between discounted and undiscounted cash flows:

discounted cash flows have been adjusted to incorporate the time value
of money, unlike undiscounted cash flows which aren’t adjusted to
include the time value of money.
Undiscounted Cash Flows
Undiscounted cash flows don’t incorporate the time value of money,
and is the opposite of discounted cash flows — they solely consider the
normal value of cash flows when it comes to making investment
decisions.
Because undiscounted cash flows don’t consider the reduction in the
value of money over time, it isn’t used to assist accurate investment
decisions.
Discounted Cash Flow

In finance, DCF stands for discounted cash flow, which is an

analysis method of valuing a project, asset, company, or
security using the concepts of the time value of money.
Non Discounting Techniques

Payback Period

One of the simplest investment appraisal techniques is the

payback period. The payback technique states how long it
takes for the project to generate sufficient cash flow to cover
the project’s initial cost.
Constant annual cash flows:
Uneven annual cash flows:

Where cash flows are uneven, payback is calculated by working out the
cumulative cash flow over the life of the project.

Decision rule:
When using Payback, the company must first set a target payback period.
• Select projects which pay back within the specified time period
• Choose between options on the basis of the fastest payback
For Example,

XYZ Inc. is considering buying a machine costing $100,000. There are

two options Machine A and Machine B. Machine A will generate
revenue of $ 50,000, $ 50,000 & $ 20,000 in year 1, year 2 & year 3
respectively. Machine B will generate revenue of $ 30,000, $ 40,000 & $
60,000 in year 1, year 2 & year 3 respectively.
Machne – A
YEAR CFL CCFL
0 (100000) (100000)
1 50000 (50000)
2 50000 (0)
3 20000 20000

PBP = 1+(50000/50000) = 2 Years

Machne – B
YEAR CFL CCFL
0 (100000) (100000)
1 30000 (70000)
2 40000 (30000)
3 60000 30000

PBP = 2+(30000/60000) = 2.5 Years

Average Rate of Return

Average Rate of Return (ARR) refers to the percentage rate of return

expected on investment or asset is the initial investment cost or average
investment over the life of the project. The formula for an average rate of
return is derived by dividing the average annual net earnings after taxes or
return on the investment by the original investment or the average
investment during the life of the project and then expressed in terms of
percentage.
Average Rate of Return formula = Average Annual
Net Earnings After Taxes / Initial investment *
100%
Example
Let us take the example of real estate investment that is likely to
generate returns of $25,000 in Year 1, $30,000 in Year 2, and $35,000 in
Year 3. The initial investment is $350,000, with a salvage of $50,000
and estimated life of 3 years. Do the Calculation the average rate of
return of the investment based on the given information.
Average annual return = Sum of earnings in Year 1, Year 2 and Year 3 /
Estimated life
= ($25,000 + $30,000 + $35,000) / 3
= $30,000

Average return = $30,000 / ($350,000 – $50,000) * 100%

Average return= 10.00%

Accounting Rate of Return -ARR
Accounting Rate of Return (ARR) is the average net income an asset is
expected to generate divided by its average capital cost, expressed as an
annual percentage. The ARR is a formula used to make capital budgeting
decisions. It is used in situations where companies are deciding on whether
or not to invest in an asset (a project, an acquisition, etc.) based on the
future net earnings expected compared to the capital cost.
ARR Formula

The formula for ARR is:

ARR = Average Annual Profit / Average Investment
Where:
•Average Annual Profit = Total profit over Investment Period / Number
of Years
•Average Investment = (Book Value at Year 1 + Book Value at End of
Useful Life) / 2
Components of ARR

If the ARR is equal to 5%, this means that the project is expected to earn five
cents for every dollar invested per year.
In terms of decision making, if the ARR is equal to or greater than a
company’s required rate of return, the project is acceptable because the
company will earn at least the required rate of return.
If the ARR is less than the required rate of return, the project should be
rejected. Therefore, the higher the ARR, the more profitable the company will
become.
ARR – Example 1

XYZ Company is looking to invest in some new machinery to replace

its current malfunctioning one. The new machine, which costs
$420,000, would increase annual revenue by $200,000 and annual
expenses by $50,000. The machine is estimated to have a useful life of
12 years and zero salvage value.
Average Annual Cashflows = 200000*12 = 2400000
Less : Annual Expenditure = 50000*12 = 600000
Depreciation = 420000
Total Profit = 1380000
Average Annual profit = 1380000/12 = 115000
Average Investment = (420000+0)/2 = 210000

Accounting Rate of Return = 115000/210000 = 54.76%

Example

A Project will cost Rs. 40,000. Its stream of earnings before depreciations,
interest and taxes (EBDIT) during the first year through five years is
expected to be Rs.10,000, Rs.12,000, Rs.14,000, Rs.16,000 and Rs.20,000.
Assume a 50% tax rate and depreciation on straight line basis.
Calculate the project Accounting Rate of Return (ARR)
Capital Budgeting – Discounting Techniques
Discounted Payback Period
The discounted payback period is a modified version of the payback
period that accounts for the time value of money. Both metrics are
used to calculate the amount of time that it will take for a project to
“break even,” or to get the point where the net cash flows generated
cover the initial cost of the project. Both the payback period and the
discounted payback period can be used to evaluate the profitability and
feasibility of a specific project.
Example :

An organisation is considering a project which has an initial investment

of $40,000 and is expected to generate profit after depreciation but
before tax of $12,500 each year for eight years. Depreciation will be on
a straight line basis over the life of the project.
Net Present Value
Net Present Value (NPV) is the value of all future cashflow (positive and
negative) over the entire life of an investment discounted to the present.
NPV analysis is a form of intrinsic valuation and is used extensively
across finance and accounting for determining the value of a business,
investment security, capital project, new venture, cost reduction program,
and anything that involves cash flow.
NPV Formula
The formula for Net Present Value is:

Where:
•Z1 = Cash flow in time 1
•Z2 = Cash flow in time 2
•r = Discount rate
•X0 = Cash outflow in time 0 (i.e. the purchase price / initial investment)
The Cost of Capital

In discounted cash flow techniques, the rate of interest is required.

There are a number of alternative terms used to refer to the rate of
interest:
• cost of capital
• discount rate
• Required return.
Decision rule:
The NPV represents the surplus funds (after funding the investment)
earned on the project, therefore:
• if the NPV is positive - the project is financially viable
• if the NPV is zero - the project breaks even
• if the NPV is negative - the project is not financially viable
• if the company has two or more mutually exclusive projects under
consideration it should choose the one with the highest NPV
Why is Net Present Value (NPV) Analysis Used?

NPV analysis is used to help determine how much an investment, project,

or any series of cash flows is worth. It is an all-encompassing metric, as it
takes into account all revenue , expenses, and capital costs associated with
an investment in its free cashflow (FCF).
In addition to factoring all revenues and costs, it also takes into account
the timing of each cash flow that can result in a large impact on the
present value of an investment.
Why Are Cash Flows Discounted?

The cash flows in net present value analysis are discounted

for two main reasons,
(1) to adjust for the risk of an investment opportunity,
(2) to account for the time value of money (TVM).
The first point (to adjust for risk) is necessary because not all businesses,
projects, or investment opportunities have the same level of risk. Put
another way, the probability of receiving cash flow from a US Treasury
bill is much higher than the probability of receiving cash flow from a
young technology start up.
The second point (to account for the time value of money) is required
because due to inflation, interest rates, and opportunity costs, money is
more valuable the sooner it’s received. For example, receiving $1
million today is much better than the $1 million received five years
from now. If the money is received today, it can be invested and earn
interest, so it will be worth more than $1 million in five years’ time.
Example of Net Present Value (NPV)

Let’s look at an example of how to calculate the net present value of a

series of cashflow. As you can see in the screenshot below, the
assumption is that an investment will return $10,000 per year over a
period of 10 years, and the discount rate required is 10%.
Drawbacks of Net Present Value

While net present value (NPV) is the most commonly used method for
evaluating investment opportunities, it does have some drawbacks that
should be carefully considered.
Key challenges to NPV analysis include:

•A long list of assumptions has to be made

•Sensitive to small changes in assumptions and drivers
•Easily manipulated to produce the desired output
•May not capture second- and third-order benefits/impacts (i.e., on
other parts of a business)
•Assumes a constant discount rate over time
•Accurate risk adjustment is challenging to perform (hard to get data
on correlations, probabilities)
Profitability Index
The Profitability Index (PI) measures the ratio between the present
value of future cash flows and the initial investment. The index is a
useful tool for ranking investment projects and showing the value
created per unit of investment.
The Profitability Index is also known as the Profit Investment Ratio
(PIR) or the Value Investment Ratio (VIR).
Profitability Index Formula
The formula for the PI is as follows:
Therefore:

•If the PI is greater than 1, the project generates value and the
company may want to proceed with the project.
•If the PI is less than 1, the project destroys value and the company
should not proceed with the project.
•If the PI is equal to 1, the project breaks even and the company is
indifferent between proceeding or not proceeding with the project.
• The higher the profitability index, the more attractive the
investment.
Advantages of the Profitability Index

•The profitability index indicates whether an investment should create or

destroy company value.

•It takes into consideration the time value of money and the risk of future
cashflows through the cost of capital.

•It is useful for ranking and choosing between projects when capital is
rationed.
Disadvantages of the Profitability Index

• The profitability index requires an estimate of the cost of

capital to calculate.

• In mutually exclusive projects where the initial investments are

different, it may not indicate the correct decision.
Example of Profitability Index

Company A is considering two projects:

Project A requires an initial investment of $1,500,000 to yield estimated
annual cashflow of:
•$150,000 in Year 1
•$300,000 in Year 2
•$500,000 in Year 3
•$200,000 in Year 4
•$600,000 in Year 5
•$500,000 in Year 6
•$100,000 in Year 7

The appropriate discount rate for this project is 10%.

Project B requires an initial investment of $3,000,000 to yield estimated
annual cash flows of:
$100,000 in Year 1
$500,000 in Year 2
$1,000,000 in Year 3
$1,500,000 in Year 4
$200,000 in Year 5
$500,000 in Year 6
$1,000,000 in Year 7

The appropriate discount rate for this project is 13%.

Company A is only able to undertake one project. Using the profitability
index method, which project should the company undertake?
Internal Rate of Return - IRR

The internal rate of return is the discount rate that sets the present
value of all cash inflows of a project equal to the present value of all
cash outflows of the same project. In other words, it is the effective
rate of return that makes a project have a net present value of zero.
Thus:
NPV = 0 if r = IRR, for any given project.
Or
PV outgo = PV income when r = IRR

The internal rate of return method of project appraisal assumes that all
proceeds from the project can be re-invested immediately, and in projects
offering returns equal to the IRR, until maturity. A higher IRR indicates a
more “profitable” project.
Calculating the IRR using linear interpolation
The steps in linear interpolation are:
(1)Calculate two NPVs for the project at two different costs of capital
(2)Use the following formula to find the IRR:

where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest.
Decision rule:

• projects should be accepted if their IRR is greater than the cost of

capital.
References
Ø Benedict, A and Elliott, B. (2008). Financial accounting: an introduction. Australia: Persons
Education.
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Thank you