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Budgeting

Should we

build this

plant?

‹#›

What is capital budgeting?

• Horngreen, “Capital budgeting is long term planning for

making and financing proposed capital outlays”.

• G.C.Philippatos, “ Capital budgeting is concerned with

the allocation of the firm’s scarce financial resources

among the available market opportunities. The

consideration of investment opportunities involves the

comparison of the expected future streams of earnings

from a project with the immediate and subsequent

streams of earning from a project, with the immediate

and subsequent streams of expenditures for it.”

• Analysis of potential additions to fixed assets.

• Long-term decisions; involve large expenditures.

• Very important to firm’s future.

‹#›

Need and Importance of Capital

Budgeting

• Large investments

• Long-term commitment of funds

• Irreversible nature

• Long term effect on profitability

• Difficulties of investment decisions

• National importance

‹#›

Steps to capital budgeting

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine the appropriate cost of

capital.

4. Find NPV and/or IRR.

5. Accept if NPV > 0 and/or IRR >

WACC.

‹#›

The investment decision-

making process

Stage 1

Stage 2

Stage 3

Stage 4

Stage 5

Determine investment funds available

Identify profitable project opportunities

Evaluate the proposed project(s)

Stage 6

Monitor and control the project(s)

Approve and implement the

project(s)

Appraise and classify proposed projects

‹#›

Methods of investment appraisal

Payback period (PP)

Net present value (NPV)

Accounting rate of return (ARR)

Internal rate of return (IRR)

‹#›

Methods of Capital Budgeting

Methods of capital

Budgeting

Traditional Methods Discounted Methods

Pay back period

method

Accounting rate of

return

Net Present Value

Method

Internal Rate of

Return

Profitability Index

‹#›

Payback period

• The number of years required to recover a

project’s cost, or “How long does it take to

get our money back?”

• Calculated by adding project’s cash inflows

to its cost until the cumulative cash flow

for the project turns positive.

• Annual cash inflows (Net profit before

depreciation and after tax) are taken.

‹#›

Calculating payback

Payback

L

= 2 + / = 2.375 years

CF

t

-100 10 60 100

Cumulative -100 -90 0 50

0 1 2

3

=

2.4

30 80

80

-30

Project L

Payback

S

= 1 + / = 1.6 years

CF

t

-100 70 100 20

Cumulative -100 0 20 40

0 1 2

3

=

1.6

30 50

50

-30

Project S

‹#›

Strengths and weaknesses of

payback

• Strengths

– Provides an indication of a project’s risk

and liquidity.

– Easy to calculate and understand.

• Weaknesses

– Ignores the time value of money.

– Ignores CFs occurring after the

payback period.

‹#›

Accounting rate of return

Average annual profit after tax x 100

Average investment in the project

ARR

=

Also known as return on investment or

return on capital employed.

The ARR method distorts all cash flows by

averaging them over time.

It ignores the time value of money.

‹#›

Net Present Value (NPV)

• Considers the time value of money .

• NPV discounts all cash inflows and outflows

attributable to a capital investment project by a

chosen percentage eg. Weighted average cost of

capiatl.

• It takes sum of the PVs of all cash inflows and

deducts it from outflows of a project. If the

yield is positive the project is acceptable.

¿

=

+

=

n

0 t

t

t

) k 1 (

CF

NPV

‹#›

Present value of Re1 receivable at various times in the

future, assuming an annual financing cost of 20%

(1 + 0.2)

0

(1 + 0.2)

5

(1 + 0.2)

4

(1 + 0.2)

1

(1 + 0.2)

2

(1 + 0.2)

3

1.000

0.833

0.694

0.579

0.482

0.402

Year

1 2 3 4 5

Present value

of Re.1

‹#›

Rationale for the NPV

method

NPV = PV of inflows – Cost

= Net gain in wealth

• If projects are independent, accept if

the project NPV > 0.

• If projects are mutually exclusive,

accept projects with the highest

positive NPV, those that add the most

value.

‹#›

Why NPV is superior to ARR

The whole of the relevant cash flows

The objectives of the business

The timing of the cash flows

NPV is a better method of appraising

investment opportunities than ARR because it

fully addresses each of the following:

‹#›

Internal Rate of Return (IRR)

• IRR is the discount rate that forces PV of

inflows equal to cost, and the NPV = 0:

• It is the percentage rate of return, based

upon incremental time-weighted cash flows.

• Solving for IRR :

– Trial and Error approach

¿

=

+

=

n

0 t

t

t

) IRR 1 (

CF

0

‹#›

Profitability Index

PI

PV of Future Cash Inflows

Initial Investment

NPV

Initial Investment

=

=

+

1

Decision Rule:

Undertake the project if PI > 1.0

‹#›

Profitability Index

• PI measures the NPV per rupee invested.

• For independent projects, the PI method

yields conclusions identical to the NPV

method.

• For mutually exclusive projects,

differences in project size can lead to

conflicting conclusions.

– Use the NPV method.

• PI is useful when there is capital rationing.

‹#›

Interest

forgone

Inflation

Discount

rate

Risk premium

The factors influencing the

discount rate to be applied

to a project

‹#›

Inflation

• Inflation effects can be complex

because asset value is a function of

both the required return and the

expected future cash flows.

• The changes can cancel each other

out, leaving the project’s NPV

unchanged.

‹#›

Inflation

• Inflation affects the cash flows

from a project.

– Effect on revenues

– Effect on expenses

• Inflation also affects the cost of

capital.

– The higher the expected inflation, the higher

the return required by investors.

• Thus, the effects of inflation must

be properly incorporated in the NPV

analysis.

‹#›

Effect of Inflation on the

Cost of Capital

• Notation:

r

r

= cost of capital in real terms

r

n

= cost of capital in nominal terms

i = expected annual inflation rate

• (1 + r

n

) = (1 + r

r

) (1 + i)

• r

n

= r

r

+ i + i r

r

‹#›

Inflation and NPV Analysis

• The NPV of the project is unchanged

as long as the cash flows and the

cost of capital are expressed in

consistent terms.

– Both in real terms

– Both in nominal terms

• If inflation is expected to affect

revenues and expenses differently,

these differences must be

incorporated in the analysis.

‹#›

Risk Analysis in Capital Budgeting

• Risk relates to uncertainty about a project’s

future profitability.

• Techniques:

– Certainity equivalent method

– Risk Adjusted discount rate

– Sensitivity analysis

– Scenario analysis

– Decision tree analysis

– Standard deviation method

– Co-efficient of Variation

‹#›

The Certainty Equivalent

Approach

• The project is adjusted for risk by

converting the expected cash flows

to certain amounts then discounting

at the risk-free rate.

• The NPV is computed as:

( ) ( )

¿ ¿

= = +

×

=

+

=

n

t

t

RF

t t

n

t

t

RF

t

k

CFAT

k

CECF

NPV

0 0 1 1

o

‹#›

The Risk-Adjusted Discount

Rate Approach

• Use CAPM to get relevant rate:

• Establish risk classes and assign

RADR

( )

b k k k k

project RF m RF project

× ÷ + =

‹#›

What is 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.

• Answers “what if” questions, e.g.

“What if sales decline by 30%?”

‹#›

Factors affecting the

sensitivity of NPV calculations

for a new machine

Operating

costs

Project

NPV

Financing

cost

Initial

outlay

Sales

price

Annual sales

volume

Project

life

‹#›

Sensitivity Analysis

• Change the value of an independent

variable by X%

• Calculate the resulting value of the

dependent variable

• Calculate the % A in the dependent

variable; compare!

• If % A > X%, then dependent variable

is sensitive to changes in the

independent variable

‹#›

What are the weaknesses of

sensitivity analysis?

• Does not reflect diversification.

• Says nothing about the likelihood

of change in a variable, i.e., a

steep sales line is not a problem if

sales won’t fall.

• Ignores relationships among

variables.

‹#›

Why is sensitivity analysis

useful?

• Gives some idea of stand-alone

risk.

• Identifies potentially

dangerous variables.

• Gives some breakeven

information.

‹#›

What is scenario analysis?

• Examines several possible

situations, usually worst case,

most likely case, and best case.

• Provides a range of possible

outcomes.

‹#›

Decision Tree

• A decision tree is diagramatic representation of

the relationships among decision states of nature

and outcomes (pay-offs).

• Decision trees are constructed left to right.

• The branches represents the possible alternative

decisions which could b made and the various

possible outcomes which may arise.

‹#›

Decision tree diagram showing

different possible project outcomes

Outcome 1

Outcome 2

Outcome 3

Outcome 4

Year 1 (0.6)

Year 2 (0.6)

Year 1 (0.4)

Year 2 (0.4)

Year 1 (0.4)

Year 2 (0.6)

Year 1 (0.6)

Year 2 (0.4)

0.6 x 0.6 = 0.36

0.4 x 0.4 = 0.16

0.4 x 0.6 = 0.24

0.6 x 0.4 = 0.24

8,000

8,000

8,000

12,000

12,000

12,000

8,000

12,000

Cash

flow

Rs.

Probability

Total 1.00

O

u

t

l

a

y

(

R

s

.

6

,

0

0

0

)

‹#›

Standard Deviation

o

NPV

= E fd

2

n

Coefficient of Variation

CV

NPV

= = = 2.0.

$30.3

$15

Eo

NPV

Mean

Thank You

‹#›

**What is capital budgeting?
**

• Horngreen, “Capital budgeting is long term planning for making and financing proposed capital outlays”. • G.C.Philippatos, “ Capital budgeting is concerned with the allocation of the firm’s scarce financial resources among the available market opportunities. The consideration of investment opportunities involves the comparison of the expected future streams of earnings from a project with the immediate and subsequent streams of earning from a project, with the immediate and subsequent streams of expenditures for it.” • Analysis of potential additions to fixed assets. • Long-term decisions; involve large expenditures. • Very important to firm’s future.

**Need and Importance of Capital Budgeting
**

• • • • • • Large investments Long-term commitment of funds Irreversible nature Long term effect on profitability Difficulties of investment decisions National importance

‹#›

. 2. Estimate CFs (inflows & outflows). Determine the appropriate cost of capital. 5. 3. 4. Accept if NPV > 0 and/or IRR > WACC. Assess riskiness of CFs. Find NPV and/or IRR.‹#› Steps to capital budgeting 1.

The investment decisionmaking process Stage 1 Determine investment funds available ‹#› Stage 2 Identify profitable project opportunities Stage 3 Appraise and classify proposed projects Stage 4 Evaluate the proposed project(s) Stage 5 Approve and implement the project(s) Monitor and control the project(s) Stage 6 .

‹#› Methods of investment appraisal Accounting rate of return (ARR) Payback period (PP) Net present value (NPV) Internal rate of return (IRR) .

‹#› Methods of Capital Budgeting Methods of capital Budgeting Traditional Methods Discounted Methods Pay back period method Accounting rate of return Net Present Value Method Internal Rate of Return Profitability Index .

. or “How long does it take to get our money back?” • Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.‹#› Payback period • The number of years required to recover a project’s cost. • Annual cash inflows (Net profit before depreciation and after tax) are taken.

6 2 = 2.375 years 3 20 40 CFt Cumulative PaybackS 70 -30 100 50 0 20 = 1 = + 30 / 50 = 1.6 years .Calculating payback Project L 0 1 2 ‹#› 2.4 100 0 3 80 50 CFt Cumulative PaybackL Project S -100 -100 10 -90 60 -30 = 2 = 0 -100 -100 + 1 30 / 80 1.

– Ignores CFs occurring after the payback period. ‹#› • Weaknesses – Ignores the time value of money.Strengths and weaknesses of payback • Strengths – Provides an indication of a project’s risk and liquidity. – Easy to calculate and understand. .

The ARR method distorts all cash flows by averaging them over time. .‹#› Accounting rate of return ARR = Average annual profit after tax x 100 Average investment in the project Also known as return on investment or return on capital employed. It ignores the time value of money.

‹#› Net Present Value (NPV) • Considers the time value of money . • NPV discounts all cash inflows and outflows attributable to a capital investment project by a chosen percentage eg. CFt NPV t t 0 ( 1 k ) n . Weighted average cost of capiatl. If the yield is positive the project is acceptable. • It takes sum of the PVs of all cash inflows and deducts it from outflows of a project.

833 0.2)4 (1 + 0.000 0.Present value of Re1 receivable at various times in the future.2)1 1.2)2 (1 + 0.1 1 2 Year 3 4 5 ‹#› (1 + 0.694 (1 + 0.2)5 0. assuming an annual financing cost of 20% Present value of Re.579 0.2)3 (1 + 0.402 .2)0 (1 + 0.482 0.

Rationale for the NPV method NPV = PV of inflows – Cost = Net gain in wealth ‹#› • If projects are independent. accept projects with the highest positive NPV. . accept if the project NPV > 0. • If projects are mutually exclusive. those that add the most value.

‹#› Why NPV is superior to ARR NPV is a better method of appraising investment opportunities than ARR because it fully addresses each of the following: The timing of the cash flows The whole of the relevant cash flows The objectives of the business .

• Solving for IRR : – Trial and Error approach . based upon incremental time-weighted cash flows.‹#› Internal Rate of Return (IRR) • IRR is the discount rate that forces PV of inflows equal to cost. and the NPV = 0: CFt 0 ( 1 IRR ) t t 0 n • It is the percentage rate of return.

‹#› Profitability Index PV of Future Cash Inflows PI = Initial Investment NPV =1 + Initial Investment Decision Rule: Undertake the project if PI > 1.0 .

the PI method yields conclusions identical to the NPV method. • For mutually exclusive projects. – Use the NPV method. • For independent projects. .‹#› Profitability Index • PI measures the NPV per rupee invested. differences in project size can lead to conflicting conclusions. • PI is useful when there is capital rationing.

‹#› The factors influencing the discount rate to be applied to a project Interest forgone Discount rate Inflation Risk premium .

leaving the project’s NPV unchanged. .‹#› Inflation • Inflation effects can be complex because asset value is a function of both the required return and the expected future cash flows. • The changes can cancel each other out.

the higher the return required by investors.‹#› Inflation • Inflation affects the cash flows from a project. the effects of inflation must be properly incorporated in the NPV analysis. – Effect on revenues – Effect on expenses • Inflation also affects the cost of capital. . – The higher the expected inflation. • Thus.

‹#› Effect of Inflation on the Cost of Capital • Notation: rr = cost of capital in real terms rn = cost of capital in nominal terms i = expected annual inflation rate • (1 + rn) = (1 + rr) (1 + i) • rn = rr + i + i rr .

‹#› Inflation and NPV Analysis • The NPV of the project is unchanged as long as the cash flows and the cost of capital are expressed in consistent terms. . – Both in real terms – Both in nominal terms • If inflation is expected to affect revenues and expenses differently. these differences must be incorporated in the analysis.

• Techniques: – Certainity equivalent method – Risk Adjusted discount rate – Sensitivity analysis – Scenario analysis – Decision tree analysis – Standard deviation method – Co-efficient of Variation .‹#› Risk Analysis in Capital Budgeting • Risk relates to uncertainty about a project’s future profitability.

• The NPV is computed as: ‹#› CECF t t CFAT t NPV t t t 0 1 k RF t 0 1 k RF n n .The Certainty Equivalent Approach • The project is adjusted for risk by converting the expected cash flows to certain amounts then discounting at the risk-free rate.

‹#› The Risk-Adjusted Discount Rate Approach • Use CAPM to get relevant rate: k project k RF k m k RF b project • Establish risk classes and assign RADR .

g. • Each variable is fixed except one. Change this one variable to see the effect on NPV or IRR. e. • Answers “what if” questions.‹#› What is sensitivity analysis? • Shows how changes in a variable such as unit sales affect NPV or IRR. “What if sales decline by 30%?” .

Factors affecting the sensitivity of NPV calculations for a new machine Sales price Annual sales volume Project life ‹#› Project NPV Financing cost Operating costs Initial outlay .

‹#› Sensitivity Analysis • Change the value of an independent variable by X% • Calculate the resulting value of the dependent variable • Calculate the % in the dependent variable. compare! • If % > X%. then dependent variable is sensitive to changes in the independent variable .

‹#› What are the weaknesses of sensitivity analysis? • Does not reflect diversification. a steep sales line is not a problem if sales won’t fall.. • Ignores relationships among variables. i. • Says nothing about the likelihood of change in a variable. .e.

. • Gives some breakeven information.‹#› Why is sensitivity analysis useful? • Gives some idea of stand-alone risk. • Identifies potentially dangerous variables.

‹#› What is scenario analysis? • Examines several possible situations. • Provides a range of possible outcomes. . and best case. most likely case. usually worst case.

• The branches represents the possible alternative decisions which could b made and the various possible outcomes which may arise. • Decision trees are constructed left to right.‹#› Decision Tree • A decision tree is diagramatic representation of the relationships among decision states of nature and outcomes (pay-offs). .

00 .000 Outcome 3 Year 2 (0.6) Year 1 (0.6) Year 1 (0.4 = 0.6 = 0.6.24 Outcome 4 Year 2 (0.6 x 0.4 x 0.4) 8.6) 8.4) 12.6 x 0.000 12.Decision tree diagram showing different possible project outcomes Cash flow Rs.4) 12.000 0.36 12.000 8.6 = 0.4 = 0.4 x 0.6) 8.16 Outcome 2 Outlay (Rs. Year 1 (0.000 0.000 Probability ‹#› Outcome 1 Year 2 (0.000 0.4) Year 1 (0.000 0.000) Year 2 (0.24 Total 1.

Mean $15 SNPV .‹#› Standard Deviation NPV = S fd2 n Coefficient of Variation $30.3 CVNPV = = = 2.0.

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