© All Rights Reserved

8 views

© All Rights Reserved

- Capital Budgeting Capital Budgeting Techniques Techniques
- ACCA F9 - Financia Management - Lsbf Class Notes 2011 (Free)
- Capital Budgeting
- Capital Expenditure
- LSBF F9 2011
- 2011 Finance Lecture 3
- Capital Budgeting
- Capital Budgeting Notes
- Introduction of cp
- MANAGING FINANCE
- Port Capital Investment Decision
- FNC535 Midterms Draft
- Modes of Project Financing
- UT Dallas Syllabus for ba3341.004 05f taught by Larry Merville (merville)
- Capital Budgeting Decisions
- CAPITAL_BUDGETING_HDFC[1]-1.doc
- Mcb Bank Managerial Finance Project 5th
- Risk Free Rate
- Capital Budgeting
- Investment A

You are on page 1of 46

Meaning, Definition and types of evaluating the project on the

basis of payback period, NPV, IRR, PI, ARR (8+2)

Introduction

Capital expenditures involve investments of significant financial resources in

projects to develop or introduce new products or services.

A basic requirement for a systematic approach to capital budgeting is a well-

defined set of long-range goals

An organization should have a well-defined business strategy.

Procedures should be developed for the review, evaluation, approval, and post-

audit of capital expenditure proposals.

Characteristics of capital purchases:

Large capital outlays are required

Long-term impact on earnings

Lack of liquidity (they cannot be readily disposed of)

WHAT IS CAPITAL BUDGETING?

Capital budgeting is a required managerial tool. One duty

of a financial manager is to choose investments with

satisfactory cash flows and rates of return. Therefore, a

financial manager must be able to decide whether an

investment is worth undertaking and be able to choose

intelligently between two or more alternatives. To do this, a

sound procedure to evaluate, compare, and select projects is

needed. This procedure is called capital budgeting.

Capital budgeting is investment decision-making as to

whether a project is worth undertaking. Capital budgeting

is basically concerned with the justification of capital

expenditures.

4

Time value of Money

Money has time value if it can be invested at some

positive return

Today

$1.0000

Year 5

$1.6105

Value of $1.00 today

Value 5 years from today

$1.1000 $1.2100 $1.3310 $1.4641

Year 1 Year 2 Year 3 Year 4

Assume a 10% interest rate

Amounts of money received at different periods of time must be

converted to their value on a common date to be compared,

added or subtracted

5

Time value of Money

Future value

It is the amount a current sum of money earning a stated rate of

interest will accumulate to at the end of the future period

FV = PV (1 + r)

n

where

r: compound rate

Present value

It is the current worth of a specified amount of money to be

received at some future date at some interest rate.

PV = FV / (1 + r)

n

where r: discount rate

It is very useful to draw a time line in calculations that

involve the time value of money

6

Time value of Money

Annuities

An annuity is a stream of equal cash flows that occur at equal

intervals over a given period of time

2 types of annuity

Ordinary annuity: Cash flows occur at the end of each year

Formula: PVOA = (a / r) x [1 1/(1 + r)

n

]

Refer to annuity table

PVOA = Ordinary Annuity Factor (n, r) x Annuity

Annuity due: Cash flows occur at the beginning of each period

Formula: PVOAD = (a / r) x [1 1/(1 + r)

n-1

] + a

Refer to annuity table.

PVOAD = Ordinary Annuity Factor (n -1, r) x Annuity + Annuity

7

Time value of Money

Practice questions on time value of money

Determine the answers to each of the following situations:

a. The future value in 2 years of $1,000 deposited today in a savings

account with interest compounded annually at 8%.

b. The present value of $9,000 to be received in five years, discounted

at 12%.

c. The present value of an annuity of $2,000 per year for five years

discounted at 16%.

d. A proposed investment of $32,010 is to be retuned in eight equal

annual payments. Determine the amount of each payment if the

interest rate is 10%.

e. A proposed investment will provide cash flows of $20,000; $8,000;

and $6,000 at the end of Years 1, 2 and 3 respectively. Using a

discount rate of 20%, determine the present value of these cash

flows.

What is capital budgeting?

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures.

Very important to an organizations future.

Capital budgeting is a process that involves the

identification of potentially desirable projects for

capital expenditures, the subsequent evaluation of

capital expenditure proposals, and the selection of

proposals that meet certain criteria.

8

Steps to capital budgeting

1. Estimate Cash Flows (inflows & outflows).

2. Assess riskiness of Cash Flows .

3. Determine the appropriate cost of capital.

4. Find NPV and/or IRR.

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

9

Relevancy in Capital Budgeting

Relevance analysis is very important in

capital budgeting because only relevant

information should be included.

To make a choice between 2 alternatives,

incremental relevance analysis often

simplifies the capital budgeting.

RELEVANT CASHFLOWS IN CAPITAL BUDGETING

Initial Investment cost

Annual operating cash flows.

Terminal cash flow

11

What is the difference between independent and

mutually exclusive projects?

Independent projects if the cash flows of one

are unaffected by the acceptance of the other.

Mutually exclusive projects if the cash flows

of one can be adversely impacted by the

acceptance of the other.

12

What is the difference between normal and

non-normal cash flow streams?

Normal cash flow stream Cost (negative CF)

followed by a series of positive cash inflows.

One change of signs.

Non-normal cash flow stream Two or more

changes of signs. Most common: Cost

(negative CF), then string of positive CFs, then

cost to close project. Nuclear power plant, strip

mine, etc.

13

14

Capital Budgeting Models

There are two main types of Capital Budgeting

Models:

Capital budgeting models that consider the time value

of money

Net Present Value (NPV)

Internal Rate of Return (IRR)

Discounted Payback Period

Capital budgeting models that do not consider the

time value of money

Payback Period

Accounting Rate of Return (ARR)

What is the Payback period?

The number of years required to recover a

projects cost, or How long does it take to

get our money back?

Calculated by adding projects cash inflows

to its cost until the cumulative cash flow for

the project turns positive.

15

PAYBACK PERIOD

SITUATION 1: EVEN (SAME) CASHLOWS

PAY BACKPERIOD= CAPITAL OUTLAY

CASHFLOWS PER PERIOD

SITUATION 2: UNEVEN CASHFLOWS

PAY BACK PERIOD= A + B/C

Where: A is the number of full years immediately before covering the

capital outlay

B is the balance remaining to cover the capital outlay

C is the total amount that is received in the year when the capital

outlay is fully covered

16

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

17

Strengths &weaknesses of

Payback

Strengths

Provides an indication of a projects risk and

liquidity.

Easy to calculate and understand.

Weaknesses

Ignores the time value of money.

Ignores Cash Flows occurring after the payback

period.

18

Discounted payback period

Uses discounted cash flows rather than raw

CFs.

Disc Payback

L

= 2 + / = 2.7 years

CF

t

-100 10 60 80

Cumulative -100 -90.91 18.79

0 1 2

3

=

2.7

60.11

-41.32

PV of CF

t

-100 9.09 49.59

41.32 60.11

10%

19

Net Present Value

Net present value is the present value of the

projects net cash inflows from operations...

and disinvestment less the amount of the

initial investment.

Net Present Value (NPV)

Sum of the PVs of all cash inflows and outflows

of a project:

n

0 t

t

t

) k 1 (

CF

NPV

PRESENT VALUE INTEREST FACTOR AT r%=1/(1+r)^n

21

What is Project Ls NPV?

Year CF

t

PVIF@10% PV of CF

t

0 -100 1 -$100

1 10 0.909 9.09

2 60 0.8264 49.59

3 80 0.7513 60.11

NPV

L

=

Rs.18.79

NPV

S

= Rs.19.98

22

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.

In this example, would accept S if mutually

exclusive (NPV

s

> NPV

L

), and would accept

both if independent.

23

24

Internal Rate of Return (IRR)

1. Also called the time-adjusted rate of return.

2. It is the minimum rate that could be paid for the

money invested in a project without losing

money.

3. It is also described as the discount rate that

results in a projects net present value equaling

zero.

Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows

to be equal to cost, and the NPV = 0:

25

n

0 t

t

t

) IRR 1 (

CF

0

Rationale for the IRR method

If IRR > WACC, the projects rate of

return is greater than its costs. There is

some return left over to boost

stockholders returns.

26

Calculate IRR using the

previous example

Calculate IRR using the previous example

27

IRR Acceptance Criteria

If IRR > k, accept project.

If IRR < k, reject project.

If projects are independent, accept both

projects, as both IRR > k = 10%.

If projects are mutually exclusive, accept

S, because IRR

s

> IRR

L

.

28

The higher the internal rate

of return, the more desirable

the project.

When using the internal rate of return method to

rank competing investment projects, the

preference rule is:

Internal Rate of Return Method

30

Internal Rate of Return (IRR)

Spreadsheet Approach

1. Input

A B

1 Year of cash flow Cash flow

2 0 Rs.-94,554

3 1 30,000

4 2 30,000

5 3 30,000

6 4 30,000

7 5 42,000

8 IRR =IRR(B2:B7,0.08)

31

2. Output

A B

1 Year of cash flow Cash flow

2 0 Rs.-94,554

3 1 30,000

4 2 30,000

5 3 30,000

6 4 30,000

7 5 42,000

8 IRR 0.20

Internal Rate of Return (IRR)

Spreadsheet Approach

Differences Between Net Present Value and

the Internal Rate of Return Models

The net present value model gives explicit

consideration to investment size. The internal

rate of return does not.

The net present value model assumes all net

cash inflows are reinvested at the discount rate.

The internal rate of return model assumes all

net cash inflows are reinvested at the projects

internal rate of return.

Other Capital budgeting Techniques:

Profitability Index:

The profitability index, or PI, method compares the present

value of future cash inflows with the initial investment on a

relative basis.

Therefore, the PI is the ratio of the present value of cash

flows (PVCF) to the initial investment of the project.

= PV

Initial Investment

33

Capital budgeting Techniques:

Profitability Index cont:

Decision Criterion

In this method, a project with a PI

greater than 1 is accepted, but a

project is rejected when its PI is less

than 1.

34

Capital budgeting Techniques:

Average Rate of Return

- Non discounting method:

- ARR = Average annual profits

- Average Investment

- Where average investment =

- (Initial outlay+scrap value)/2

- & Average annual profits =

- sum of annual profits/ no. of years.

35

NPV Profiles

A graphical representation of project NPVs at

various different costs of capital.

k NPV

L

NPV

S

0 $50 $40

5 33 29

10 19 20

15 7 12

20 (4) 5

36

Drawing NPV profiles

-10

0

10

20

30

40

50

60

5 10 15 20 23.6

NPV

($)

Discount Rate (%)

IRR

L

= 18.1%

IRR

S

= 23.6%

Crossover Point = 8.7%

S

L

.

.

.

.

.

.

.

.

.

.

.

37

Comparing the NPV and IRR

methods

If projects are independent, the two methods

always lead to the same accept/reject decisions.

If projects are mutually exclusive

If k > crossover point, the two methods lead to the

same decision and there is no conflict.

If k < crossover point, the two methods lead to

different accept/reject decisions.

38

Reasons Why NPV profiles cross

Size (scale) differences the smaller project

frees up funds at t = 0 for investment. The higher

the opportunity cost, the more valuable these

funds, so high k favors small projects.

Timing differences the project with faster

payback provides more CF in early years for

reinvestment. If k is high, early CF especially

good, NPV

S

> NPV

L

.

39

Capital Budgeting Techniques:

A good method of investment appraisal must:

Take time value of money into account.

Use cash flows instead of profits

Use all cash flows.

Take into account cost of capital of the firm.

40

Accounting Rate of Return

The accounting rate of return is the average

annual increase in net income that results

from acceptance of a capital expenditure

proposal divided by the initial investment or

the average investment in the project.

Accounting Rate of Return

Cake Shoppe purchased a vehicle and equipment

costing Rs.90,554. It has a disposal value of Rs.8,000

at the end of 5 years.

Annual net cash inflow from operations Rs.30,000

Less average annual depreciation:

[Rs.90,554 Rs.8,000]/5) 16,511

Average annual increase in net income Rs.13,489

43

Accounting rate of

return on initial

investment

Average annual increase

in net income

Initial investment

=

Accounting rate of

return on initial

investment

=

Rs.13,489

Rs.94,554

= 0.1427

44

Accounting rate of

return on average

investment

Average annual increase

in net income

Average investment

=

Accounting rate of

return on average

investment

=

13,489

53,277

= 0.2532

([94,554 + 12,000])/2

Rs.94,544 = initial investment, Rs.12,000 =

disinvestment

Present value index

A frequent criticism of NPV, when it is used to

rank proposals, is that it fails to adjust for the

size of the proposed investment

To overcome this difficulty, managers may

rank projects on the basis of each projects

present value index, which is computed as the

present value of the projects subsequent cash

flows divided by the initial investment.

Present value index

Present value index =

Present value of subsequent cash flows

Initial investment

- Capital Budgeting Capital Budgeting Techniques TechniquesUploaded byzahid833
- ACCA F9 - Financia Management - Lsbf Class Notes 2011 (Free)Uploaded byRahib Jaskani
- Capital BudgetingUploaded bySatish Singh ॐ
- Capital ExpenditureUploaded byRoshan Poudel
- LSBF F9 2011Uploaded byegemencoskun
- Capital BudgetingUploaded byPrabath Suranaga Morawakage
- Capital Budgeting NotesUploaded byNeelabh Kumar
- Port Capital Investment DecisionUploaded byaccount_me
- 2011 Finance Lecture 3Uploaded byeholmes80
- Introduction of cpUploaded byvenkat
- FNC535 Midterms DraftUploaded byRufino Gerard Moreno
- MANAGING FINANCEUploaded byShaji Viswanathan. Mcom, MBA (U.K)
- Modes of Project FinancingUploaded byShah Faizi
- UT Dallas Syllabus for ba3341.004 05f taught by Larry Merville (merville)Uploaded byUT Dallas Provost's Technology Group
- Capital Budgeting DecisionsUploaded byMourya Rajnikant
- CAPITAL_BUDGETING_HDFC[1]-1.docUploaded byprem kumar
- Mcb Bank Managerial Finance Project 5thUploaded bychoudarynazakat
- Risk Free RateUploaded bybikash25
- Capital BudgetingUploaded byAmith Kumar Chegomma
- Investment AUploaded byJayna Crichlow
- Upload - Capital Budgeting TechniqueUploaded byDeri Muhamad Hardiana
- Fina Capital BudgetingUploaded bykwaileunglo
- 0324180187_11Uploaded byVivek Thakur
- Investment Decison Rules and ApplicationsUploaded byFrancis Abdiel Grajales Jaen
- Course 3Uploaded byEdy Sutiarso
- Capital Budgetting New IndroductionUploaded byvishanth
- ross chapter 9Uploaded byYuk Sim
- 917720_634368916573663512Uploaded bynidhinambu
- Ch.6.1Uploaded byshakeel_dayo3402
- Chapter 14Uploaded byWeaFernandez

- JAN 2011 EC1Uploaded byprofoundlife
- LP 2nd Set.pdfUploaded byKaran Kakkar
- Slavic Elements in Greek Idioms of AlbaniaUploaded byAna B. Adams
- Edited.pdfUploaded byCarlo Edolmo
- Chapter_ch 1616 Auditing Cash InvestmentsUploaded bySalman Ahmad Kahloon
- Problem IdentificationUploaded byDaniele DeBattista
- Venture Capital Investment in PakistanUploaded byShaheen Books
- final assignment part bUploaded byapi-292268385
- Assignment 14 Ok tUploaded byJu Raizah
- Security Analysis Fortfolio at india in foline ltdUploaded byNagireddy Kalluri
- Feb_16_Lease accounting will never be the same again.pdfUploaded bykae
- Chapter 05 Net Present Value and Other Investment RulesUploaded bydewimachfud
- York Daily Record/Sunday News - 3AUploaded byAbby
- Restructuring of FCCBs - Global Absolute - Raj Rajinder Singh NegiUploaded byAnkit Jain
- IRCTC Ltd,Booked Ticket PrintingUploaded bykishore2285
- S1474-787120140000024006.pdfUploaded byFuad Al-Fadhil
- Trade Policy Review 2017 - Brazil - Government ReportUploaded byFernanda Torres
- Cffinals SolutionUploaded byDavid Lim
- Project Feasibility Study of Project.docxUploaded byMobasshera Jahan
- CT1-PU-15Uploaded bylloydhuni
- Final Project_mgt 368( Mini Golf)Uploaded bymail4abid
- Mission Driven Government sosUploaded byZiyaadul Murtado
- Limited Liability Partnership-LABUploaded byakarawal
- Risk & Historical)Uploaded byyu_zhen_3
- Ms Conservatives Loan Promissory Note FEC FilingUploaded bySam Hall
- Prospectus of ACMEUploaded bymeftahul arnob
- Staff Accountant or Accounting Manager or Office Manager or AccoUploaded byapi-79074279
- Omaxe eternity,vrindavan, ,09958959555, Sarthak Estates , Real Estate Delhi NCRUploaded byRealEstate-Property-Delhi-NCR
- Dlf New Town Heights Sector 90Uploaded byInvest Gurgaon Properties
- Demolition Procurement Process ReportUploaded byClickon Detroit