27 views

Uploaded by mohitkripalani

capital investment decisions

- 130326936183795766
- 4.1TechniquesofCapitalBudgeting.ppt
- 10 Risk Refinements in Capital Budgeting
- 11W-Ch 10&11 Capital Budget Basics & CF estimation-2011-12-skraćeno
- Facilitation Session 3 Investment Appraisal 1
- Capital Budgeting ppt.pptx
- Cpital Budgeting
- PC Ch. 11 Techniques of Capital Budgeting
- Chapters 8-9-10 Questions
- Chp 8 Summary Investment Edit Bulan 28 May 2017
- Capital Budgeting Sums
- 1 Lecture FIN599
- QUESTION ONE investment appriasal.pdf
- Capital Budgeting
- payyyyyy
- CMA Part 2 Video Topics
- FM UNIT III_2_new
- NPV,IRR,payback peiod(imp).ppt
- Project Appraisal
- Practice Problem on Capital Budgeting

You are on page 1of 28

Learning Outcomes

By the end of the lecture you should be able to : Explain the concept on net present value (NPV) and internal rate of return (IRR); Calculate NPV, IRR, payback period and accounting rate of return; Justify the superiority of NPV over IRR; Explain the limitations of payback and accounting rate of return methods; Evaluate mutually exclusive projects with unequal lives; Explain capital rationing and the optimum combination of investments when capital is rationed for a period.

The only difference really is probably that we look at decisions that affect now in decision making and we look at decision that will affect the next few years in investment appraisal. Investment appraisal is about looking at decisions that are going to give money back over time. if relating to cost choose proposal

We can use investment appraisal techniques to judge between choices and whether to do something or do nothing. Remember, doing nothing can be a valid choice

Often very large amount of resources involved. 500k+ large buildings bridges etc. Often difficult or very expensive to get out once the decision has been made.

Payback Period

Main methods of investment appraisal Illustration data: Cost now of asset Cash inflow 1 years time Cash inflow 2 years time Cash inflow 3 years time Cash inflow 4 years time Cash inflow 5 years time Disposal proceeds of asset sale

Payback period the length of time it takes to repay the initial investment out of the cash inflows.

How long does it take to payback the investment?

Payback Period

Year Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 5 Payback lies between years 2 and 3 Yr 2 = (40,000) ; Yr 3 = 20,000; Movement = +60,000 in 12 months Inflow Cumulative cash flow (100,000) (80,000) (40,000) 20,000 80,000 100,000 120,000

Therefore payback = 2 years + 8 months = 2 years 8 months.

Payback Period

Advantages: Disadvantages:

ARR = Average annual profit x 100 Average investment to earn that profit

Total Profits / Years (Initial Investment + Disposal Proceeds) / 2

ARR =

= (Inflows (200,000) + Proceeds (20,000) Investment (100,000)) / 5 ( 100,000 + 20,000) / 2 = (120,000) / 5 60,000 = 24,000 = 40% 60,000 initial investment + disposal value 2

Average investment =

This gives us a percentage return that can be compared between projects or to a minimum required.

Important: You need to calculate the annual average profit and the average investment for ARR. Note it is profit not cashflow, so you may need to make an adjustment for depreciation in a question

Advantages:

Disadvantages:

A method that takes into account the time value of money. NPV reflects the value in todays terms of future cash flows. Cost of Capital of 20%.

Year Cost now of asset Cash inflow 1 years time Cash inflow 2 years time Cash inflow 3 years time Cash inflow 4 years time Cash inflow 5 years time Disposal proceeds of asset sale 0 1 2 3 4 5 5 Cashflow -100,000 20,000 40,000 60,000 60,000 20,000 20,000 20% 1.000 0.833 0.694 0.579 0.482 0.402 0.402 NPV (100,000) 16,660 27,760 34,740 28,920 8,040 8,040 24,160

Positive NPVs enhance shareholders wealth so accept. Negative NPVs reduce shareholders wealth so reject. The one with the biggest NPV is the best one to adopt.

Advantages The big advantage of NPV over ARR or Payback period is that it does take into account the time value of money. It also takes into account all of the cash flows over the whole project.

Disadvantages The only real problem is choosing the right rate to discount at. It may vary from project to project or a company may apply the same rate to all projects.

A development of the NPV method. Essentially, it is only another way of looking at the problem. With NPV you choose the discount rate and then see if it makes a positive cash flow at that rate. With IRR you find out the discount rate at which the cash inflows equal the investment. The IRR is the discount rate which, when applied to the future cash flows, will make them equal the initial outlay (cost). Choose a discount rate (that you think will be higher) and one that you think will be lower. Calculate the NPV using both. One will be positive, one will be negative. Calculate the rate at which the NPV will be zero from these. Could use trial and error (iteration). Could put it on a graph. Could work it out mathematically.

We already have the data with a cost of capital of 20%; we have just calculated it. Lets use a Cost of Capital of 30% as our other calculation

Year Cost now of asset Cash inflow 1 years time Cash inflow 2 years time Cash inflow 3 years time Cash inflow 4 years time Cash inflow 5 years time Disposal proceeds of asset sale 0 1 2 3 4 5 5 Cashflow -100,000 20,000 40,000 60,000 60,000 20,000 20,000 30% 1.000 0.769 0.592 0.455 0.350 0.269 0.269 NPV (100,000) 15,380 23,680 27,300 21,000 5,380 5,380 (1,880)

Change from previous NPV = + 24,160 to (-1,880) = 26,040 for change of 10% increase of discount rate Therefore change for 1% = 26,040 / 10 = 2,604 So to get to zero from 24,160 need 24,160 / 2,604 = 9.28% increase in rate Therefore new rate = IRR = 20% + 9.28% = 29.28% Alternatively Reduction of rate by 1,880 / 2,604 = 0.72% will again give IRR = 30% - 0.72%

= 29.28%

Where projects are independent then you will get the same answer using NPV or IRR to distinguish between them. If the projects are mutually exclusive, then sometimes you can get a different answer. This is because NPV assumes that the project cash flows are invested at the cost of capital, while the IRR method assumes that the cash flows are invested at the IRR.

The hardest part of any business plan or investment decision is always predicting the future. Interest rates Inflation Availability of raw materials, energy and other resources Will the business be viable, changes in law, demand, competition, alternative products etc

What will any scrap, facilities etc. be worth at the end

The main factors that influence the selection of a discount rate are:

If we wanted to put our money somewhere without any risk we would invest it with the Government, for example Treasury Bonds with a rate of return of, for example, 4%. If we assumed inflation of 1% then this would give us a real risk free return of 3%. Anything we do then which has a risk attached to it will mean we will want to get more than 4%. For example the average rate of return on equities recently (in more normal times) has been 8%. If you deduct the risk free rate represented by Treasury Bonds you get 4%.

Clearly, the additional 4% is the level of additional rate of return that is required to compensate for the level of risk inherent in investing in the stock market. Not every investment carries the same level of risk as investing in equities. For example, Property is considered to be half as risky as the stock market. You would only then need half the risk premium over the Treasury Bond rate, here that would be an additional 2%. So you would use a discount rate of 4+2 = 6%. Allowing for inflation at 1% this would give you a real rate of return of 5%. (Obviously these figures change with varying economic circumstances).

Problems can arise in a number of situations where you are calculating the NPV.

If a project has a positive NPV at the companys cost of capital then it can be done. If you can do every project with a positive NPV, which one will you do? Usually though, the company doesnt have money to follow up every good idea that managers have, it can only do a few. This is a situation usually described as being where there is . In this case it will usually choose the ones with the highest NPV

What if the projects are of a different size? Clearly, a project with an NPV of 80,000 looks much better than one with an NPV of 50,000 and it would be the right choice if the two projects required the same capital investments. But what if they required different investments. Example in Drury p 508 (5th edition p 470).

Initial investment Project C Project D 50,000 100,000 Present Net Present value of Value inflows 100,000 180,000 50,000 80,000

We compare the Present Value (that is the value in todays terms of the cash inflows) to the Investment made to earn those monies. Note it is the Present Value, not the Net Present Value.

Profitability Index = Present Value of inflows / Initial Investment Project C 100,000 = 2 50,000 180,000 = 1.8 100,000

Project D

Usually a company would have far more than two projects to consider between. The process would be to rank them in order of NPV if there was no capital rationing. If there were a restriction on the availability of capital then the projects would be by index. The company would then start with the projects with the profitability index, doing as many as the available capital would allow. This may mean that we dont use all the capital available in the period.

When you are considering between projects that dont run for the same length of time you have to consider what would happen when the shorter project finishes. There is an example (14.1) in Drury on page 336 (7th edition.). Bothnia is choosing between two machines, X and Y. They are designed differently, but have the same capacity and do the same job. The significant difference is that X costs 1.2 million and lasts three years and Y costs 600,000 and lasts only two years. To make the comparison harder, X costs 240,000 p.a. to run and Y costs 360,000 p.a. to run.

With a cost of capital of 10%, which machine should Bothnia choose to buy?

We can initially look at the cash flows. In this case, they are all cash outflows. Machine Year 0 Year 1 Year 2 Year 3 PV at 10%

X Y

(1,200) (600)

(240) (360)

(240) (360)

(240) -

(1,796.832) (1,224.78)

On the face of it, the PV of costs is lower for Machine Y so it should be chosen. Unfortunately, it means we wont be doing any work in Year Three unless we buy another machine then.

How can we take this mismatch into account? There are three main methods: Evaluate the two over a period equal to the lives. Calculate an . Estimate a

of the two

You look for a number of years where both machines will need to be replaced at the end of the period.

When one lasts for two years and the other for three, then the lowest common multiple method would be to work out the costs over six years. At the end of the six years, two Machine Xs would have been bought and three Machine Ys would have been bought and we would be about to buy a new one of each.

Machine Year 0 Year 1 (240) Year 2 (240) Year 3 (240) (1200) (360) Year 4 (240) Year 5 (240) Year 6 (240) PV at 10% (3,146.76)

(360)

(360) (600)

(360) (600)

(360)

(360)

(3,073.44)

We can see that it is cheaper to buy Machine Y even though we will have to buy three of them If we are going to buy a new machine at Year 6 we could choose Machine Y, but whether we do or not will depend on how long we are going to need machines for in the future. Doing this method can be tedious, especially if the lowest common multiple is a lot of years (7 years and 3 years = 21 years). In that case we may prefer the next method.

We make the costs of the two machines comparable by converting them into an equivalent annuity.

Machine X present value is (1,796.832) for three years (from our earlier calculation) and for machine Y is (1224.74). X Factor PV Y Factor PV (1,200) 1.000 (1,200) (600) 1.000 (600.00) (240) 0.9080 (218.16) (360) 0.9080 (327.24) (240) 0.8264 (198.33) (360) 0.8264 (297.50) (240) 0.7513 (180.31) 2.4868 (1,796.8) 1.7354 (1,224.74)

The annuity factor is obtained from annuity tables (also called cumulative discount tables) for the number of years (3 in this case) and at the appropriate discount factor (10% in this case).

If there isnt an annuity table to hand, you can calculate it from an NPV table. 1 2 3 = = = = 0.9091 0.8264 0.7513 2.4868

Equivalent annual cost for Machine Y. (1,224.780) 1.7355 = (705.722) Cost at the end of year 1 year; 2; year 3 ; etc.

If we had a machine that lasted eight years and one that lasted six years we would have to do a lowest common multiple calculation over 24 years. This wouldnt be much good if we only wanted the machines for a job that lasted 10 years as it is shorter. This stops us using either of the previous two methods. Both machines will need to be replaced if we worked for 10 years. So we assume we are going to replace each and attempt to determine what their disposal values will be at Year 10 when one machine is two years old and the other is four years old and we take these estimates into account as cash inflows in Year 10

- 130326936183795766Uploaded byammar123
- 4.1TechniquesofCapitalBudgeting.pptUploaded byLefty Renewang
- 10 Risk Refinements in Capital BudgetingUploaded byMo Mindalano Mandangan
- 11W-Ch 10&11 Capital Budget Basics & CF estimation-2011-12-skraćenoUploaded byRachel Palos
- Facilitation Session 3 Investment Appraisal 1Uploaded byMGUNGWE P
- Capital Budgeting ppt.pptxUploaded bymoosanippp
- Cpital BudgetingUploaded byMuhammad Zubair
- PC Ch. 11 Techniques of Capital BudgetingUploaded byVinod Mathews
- Chapters 8-9-10 QuestionsUploaded byKaran Singh
- Chp 8 Summary Investment Edit Bulan 28 May 2017Uploaded bykhairul izzudin
- Capital Budgeting SumsUploaded byDeep Debnath
- 1 Lecture FIN599Uploaded bykalkar
- QUESTION ONE investment appriasal.pdfUploaded bypenyia
- Capital BudgetingUploaded byMZK videos
- payyyyyyUploaded byAhmad Rahhal
- CMA Part 2 Video TopicsUploaded byvmkakumanu
- FM UNIT III_2_newUploaded byvamsibrilliant
- NPV,IRR,payback peiod(imp).pptUploaded bynikowawa
- Project AppraisalUploaded byTauqir Ahmed
- Practice Problem on Capital BudgetingUploaded byPadyala Sriram
- 6891851 Capital BudgetingUploaded byprairna
- Corporate Ch08Uploaded byWallStreet Coley
- Chapter20 Solutions Hansen6eUploaded byLibyaFlower
- Introduction to Investment Decision in Financial Management( Open Compatibility)Uploaded bykarl markx
- Brealey6ce_Ch08_Final2Uploaded byDerron Whittle
- capital%20budgeting1.docxUploaded byOmkar Gaikwad
- Chapter 2 - Part 3Uploaded byChu Minh Lan
- Capital ManagementUploaded bySheshu Babu
- MGT201FinancialManagementFINALOBJECTIVEUploaded byPranav Kolagani
- MEFA Important Questions JWFILESUploaded byNaresh Guduru

- Summary Writing Spm 2016Uploaded byKomalata Manokaran
- IS 4000 for BOLT TIGHTENINGUploaded byinfinite
- Yarn FormationSpinningUploaded byMohammed Atiqul Hoque Chowdhury
- 3.1.FinancingSlidesUploaded byಲೋಕೇಶ್ ಎಂ ಗೌಡ
- Sheff Green Roof HAP Scoring System FINAL Feb 2010Uploaded byGarden Gorilla
- user-guide-zecircle.pdfUploaded byAyoub Boulhaz
- Slides+for+Posting+Lecture+25+Skin+Blood+Muscle+FungalUploaded byFFAULO
- D. Tong et al- Local Blockade of Rydberg Excitation in an Ultracold GasUploaded byItama23
- Nyeri ZaldiarUploaded byEuginia Edgar
- Oracle EAM R12 - OverviewUploaded byGuillermo Todd
- Arts Lesson 2nd GradingUploaded bySa Ku Ra
- Cardiology to Impress 6Uploaded byThirugnana Thiru
- A Level Physics WorksheetsUploaded bySalama Badawi
- Myths Folktales and LegendsUploaded byMarian Ilas Pizaña
- Empirical Formula of Magnesium OxideUploaded byIra Munirah
- AutoUploaded byKushal Mansukhani
- 2 George JergesUploaded byinitiative1972
- JSS 4210-20Uploaded byKaushik Sengupta
- Residents Handbook 2011Uploaded byAgnes Cheverloo Castillo
- ch28_sp17Uploaded byPrem
- Ta - Ingles III - Bustinza Luz - 2015127512Uploaded byLuz Allison Bustinza
- Reading the Ground (Hutchinson)Uploaded byNathan Vincent
- Hydraulic Whipstock CHUploaded byAnonymous kEC3kiy
- 1414Uploaded byrajpal146
- TATA NANO Section1 Group7Uploaded byVineet Khandelwal
- Umts 3g Questions & AnswersUploaded byArvind Solanki
- 7_kakolUploaded bySumanth Varma
- Design Modification and Analysis of Exhaust Valve in Single Cylinder SI Engine to Improve its TorqueUploaded byIJIRST
- Young Goodman BrownUploaded byCiamin Yeap
- Manual FX9500Uploaded byGerardo Leyes