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Discounted & Non discounted Cash Flow Techniques

2

Capital Budgeting Why?

Allocating scarce resources among competing uses requires a mechanism or decision rule that separates those investments that are worth making from those that are not. The different proposals should be evaluated in terms of their economic worth to the firm. The economic worth can be measured in terms of cost and benefits of the proposals to the firm. These costs and benefits are measured in terms of cash flows generated by it.

3

Evaluation

**Features which a capital budgeting evaluation technique should possess:
**

1.The criterion must be able to incorporate all the cash flows associated with the proposal. 2.It should also incorporate the time value of money. 3.It should be capable of ranking different proposals in order of their worth to the firm. 4.It should be objective and unambiguous in its approach 5.It must be in line with the objective of maximization of shareholders wealth.

4

Techniques

Capital Budgeting Techniques

Traditional or Non - discounting

Time adjusted, Or Discounting

Pay back period

Accounting Rate of return

Net Present Value

Profitability Index

Internal Rate of Return

5

6

**Pay Back Period
**

Payback Period is defined as the number of years required for the proposal¶s cumulative cash inflows to be equal to its cash outflows Length of time required for a proposal to µbreak even¶ on its net investment. Computation: a) When annual inflows are equal: When the cash inflows being generated by a proposal are equal per time period, the payback period can be computed by dividing the cash outflow by the number of annuity. b) When annual cash inflows are unequal: In this case the cumulative cash inflows are used to compute the payback period

7

Example 1

A proposal requires a cash outflow of Rs. 1,00,000 and is expected to generate cash inflows of Rs. 20,000 p.a. for 6 years. What is its Pay Back period?

Solution: Pay Back Period

=

= =

Cash Outflow Annuity 1,00,000 20,000 5 years

The initial cash outflow of Rs. 1,00,000 will be fully recovered within a period of 5 years and the cash inflows occurring thereafter are ignored

8

Example 2

A proposal requires a cash outflow of Rs. 20,000 and is expected to generate cash inflows of Rs. 8,000, Rs. 6,000, Rs. 4,000, Rs. 2,000 and Rs. 2,000 over next 5 years respectively. Compute its Payback Period. Solution: Year 1 2 3 4 Annual Cash Flow Rs. 8,000 Rs. 6,000 Rs. 4,000 Rs. 2,000 Cumulative Cash Flow Rs. 8,000 Rs. 14,000 Rs. 18,000 Rs. 20,000

The pay back period is 4 years

9

The Decision Rule

The Payback Period calculated for a proposal is to be compared with some predetermined target period (set by management). If the payback period is more than the target period, then the proposal should be rejected otherwise it may be accepted. Further if different proposals are to be ranked in order of priority, then the proposal with the shortest payback period will be first in the priority list. Alternatively, Payback Period reciprocal = (1 / Payback Period) x 100. The higher the payback reciprocal (and hence, lower the payback period), the more worthwhile the proposal is.

10

Advantages

1. This method is simple and easy. In particular, it can be adopted by a small firm having limited man-power which does not have any special skill to apply other sophisticated techniques. 2. It gives an indication of liquidity as it emphasizes earlier cash inflows. 3. It deals with the risk also. The project with a shorter payback period will be less risky as compared to project with a longer payback period. As the cash inflows which arise further in the future will be less certain and hence more risky.

11

Disadvantages

1. The payback period entirely ignores many of the cash inflows which occur after the payback period. This could be misleading and could lead to discrimination against the proposal which generates substantial cash inflows in later years. 2. It ignores the timing of the occurrence of the cash flows. It considers the cash flows occurring at different points of time as equal in money worth and ignores the time value of money. 3. The payback period also ignores the salvage value of the total economic life of the project. 4. The payback period is more a method of capital recovery rather than a measure of profitability of project. 5. The payback period is designed to cover the conventional projects that involve large upfront investment followed by positive operating cash inflows. It breaks down however when the investment is spread over time or where there is no initial investment.

12

Suitability

1. In a politically unstable country, a firm may have a primary consideration of recovering the initial cost at the earliest opportunity and thus the payback period may be a suitable technique. 2. It may be suitable if the firm has limited funds available and has no ability or willingness to raise additional funds. In such a case the firm may wish to undertake those projects which ensure early liquidity / recovery.

13

14

ARR

ARR may be defined as the annualized net income earned on the average funds invested in a project. Computation: a) Equal profits: ARR = Annual Profit (after tax) Average investment in the project x 100

b) Unequal profits: ARR = Average Annual Profit (after tax) Average investment in the project x 100

15

Average Investment

Average Investment is affected by the method of depreciation, salvage value and the additional working capital required by the proposal. Computation: a) Initial Cash Outlay as average investment: The original cost of investment and the installation expenses if any, is taken as the amount invested in the project.. b) Average annual book value after depreciation as average investment: In case the firm has adopted a method of depreciation other than straight line method: In this case, the opening and closing book values of the project for all the years of its economic life are found out. Then, the average book values for all the years are found out by taking simple arithmetic mean of the opening and closing book values. And then, the average of all the yearly averages is calculated. This average will be the average investment of the proposal. In case, firm adopts straight line method of depreciation: Avg. Investment = ½ (Initial Cost + Installation Exp. ± Salvage Value) + Salvage Value

16

Example 3

ABC Ltd. Takes a project costing Rs. 1,20,000 with expected life of 5-years and salvage value of Rs. 20,000. Calculate its average investment. Solution: Average Investment = ½ (1,20,000 ± 20,000) + 20,000 = Rs. 70,000

The average investment can also be calculated as follows: Year 1 2 3 4 5 Opening BV Rs. 1,20,000 1,00,000 80,000 60,000 40,000 Closing BV Rs. 1,00,000 80,000 60,000 40,000 20,000 Total Average Investment = Rs. 3,50,000 / 5 = Rs. 70,000

17

Average BV Rs. 1,10,000 90,000 70,000 50,000 30,000 3,50,000

Average Investment

Additional Working Capital: Sometimes the project requires additional working capital. Though this additional working capital will be released back, when the proposal will be scrapped and terminated, yet this amount of additional working capital is blocked throughout the life of the project. So this should also be added to the average investment. Therefore, Average Investment = ½ (Initial Cost + Installation Expenses ± Salvage Value) + Salvage Value + Additional Working Capital

18

Example 4

ABC Ltd. Takes a project costing Rs. 1,20,000 with expected life of 5-years and salvage value of Rs. 20,000. Further it requires an additional working capital of Rs. 20,000 and is expected to generate annual average profit (after tax) of Rs. 18,000. Calculate its average investment. Solution: Average Investment = ½ (1,20,000 ± 20,000) + 20,000 + 20,000 = Rs. 90,000 ARR = Annual Profit (after tax) x 100 Average Investment in the project

= 18,000 x 100 90,000 = 20%

19

The Decision Rule

The actual ARR is to be compared with a predetermined or a minimum required rate of return or cut off rate (set by management). If the actual ARR is higher than the minimum desired ARR, then the proposal would be accepted otherwise it may be rejected. Further if different proposals are to be ranked in order of priority, then the proposal with the highest ARR will be first in the priority list. Obviously projects having higher ARR would be preferred to projects with lower ARR.

20

Advantages

1. This method is easy to understand and use. What is required is only the figure of accounting profits after taxes which should be easily obtainable. 2. Total benefits associated with the project are taken into account while calculating ARR unlike some methods like payback which do not use the entire stream of incomes.

21

Disadvantages

This method uses accounting income instead of cash flows. Cash flow approach is superior to accounting earnings for project evaluation as it takes into account the reinvestment potential of a project¶s benefits

22

23

NPV

The NPV may be defined as the sum of the present values of all the cash inflows less the sum of present values of all the cash outflows associated with a proposal. A rate of discount must be specified and applied to both inflows and outflows in order to find out their present values. When the present values of all inflows and outflows are added, the resultant figure is denoted as net present value. The figure can be positive or negative depending on whether there is a net inflow or outflow from the project. Computation: NPV - C0

where, NPV = Net Present Value CFi = Cash flows occurring at time 0,1,2««.,n k = The discount rate, and n = Life of the project in years C0 = Initial Cost of the proposal at time T0

24

Example 5

Calculation of the Net Present Value: Time T0 T1 T2 T3 T4 T5 Cash Flows (Rs.) - 1,70,000 20,000 50,000 60,000 40,000 75,000 PVF (10%,T) 1.000 0.909 0.826 0.751 0.683 0.621 Total or NPV Present Values (Rs.) - 1,70,000 18,180 41,300 45,060 27,320 46,575 8,435

**NPV = -1,70,000 + 20,000 + 50,000 + 60,000 + 40,000 + 75,000 (1 + 0.10)0 (1 + 0.10)1 (1 + 0.10)2 (1 + 0.10)3 (1 + 0.10)4 (1 + 0.10)5 = Rs. 8,435
**

25

**The Decision Rule
**

Accept the proposal if its NPV is positive and reject the proposal if the NPV is negative. NPV is the change expected in the wealth of the shareholder as a result of the acceptance of a particular proposal. Further if different proposals are to be ranked in order of priority, then the proposal with the highest positive NPV will be first in the priority list. Obviously projects having higher positive NPV would be preferred to projects with lower positive NPV. However, the proposals with negative NPV should be rejected as these entail decrease in the wealth of the shareholders

26

Advantages

1. This technique recognizes the Time Value of money 2. This technique considers the entire cash flow stream, all the cash inflows and outflows, irrespective of the timing of their occurrence 3. It is based on cash flows rather than the accounting profit. 4. The discount rate applied for discounting the future cash flows is in fact, the minimum required rate of return which incorporates both the pure return as well as the premium required to set off the risk. 5. NPV concept has a built-in earnings requirements in addition to the recovery of the investment. Thus this cushion implicit is truly an economic gain that goes beyond satisfying the required rate of return.

27

Disadvantages

1. It involves difficult calculations. It may not be able to overcome the uncertainty involved with cash flows occurring after a sizeable time gap. 2. It requires the predetermination of the required rate of return, k, which is a difficult job. If the value of µk¶ is not correct, then the whole exercise of the NPV may give wrong results. 3. This technique does not provide a measure of project¶s own rate of return, rather it evaluates a proposal against an external variable i.e., the minimum required rate of return. 4. The decision under this technique is based on a value which is an absolute measure. It ignores the difference in initial outflows, size of different proposals etc. while evaluating mutually exclusive proposals.

28

29

PI

This technique is a variant of the NPV Technique. It is also known as Benefit ± cost ratio, or Present value Index. It is also based upon the basic concept of discounting the future cash flows and is ascertained by comparing the present value of the future cash inflows with the present value of the future cash outflows. Computation: PI = Total Present Value of cash inflows Total Present Value of cash outflows or ÷C0

where, CFi k n C0

= Cash flows occurring at time 0,1,2««.,n = The discount rate, and = Life of the project in years = Initial Cost of the proposal at time T0

30

Example 6

A firm is evaluating a proposal which requires a cash outlay of Rs. 40,000 at present and of Rs. 20,000 at the end of third from now. It is expected to generate cash inflows of Rs. 20,000, Rs. 40,000 and Rs. 20,000 at the end of 1st, 2nd and 4th year respectively. Given the rate of discount of 10%, calculate PI. Calculation of the Profitability Index Year 0 1 2 3 4 Cash flows (Rs.) - 40,000 20,000 40,000 - 20,000 20,000 PVF (10%,n) 1.000 0.909 0.826 0.751 0.683 = Rs. 40,000 + 15,020 = 55,020 = Rs. 18,180 + 33,040 + 13,660 = 64,880 = Rs. 64,880 = 1.18 Rs. 55,020 Present Values (Rs.) - 40,000 18,180 33,040 - 15,020 13,660

Present Value of cash outflows Present Value of cash inflows PI =

**Total Present Value of cash inflows Total Present Value of cash outflows
**

31

The Decision Rule

Accept the proposal if its PI is more than 1 and reject the proposal if the PI is less than 1. Further if different proposals are to be ranked in order of priority, then the proposal with the highest positive PI will be first in the priority list. Obviously projects having higher positive PI would be preferred to projects with lower positive PI. However, the proposals having PI of less than 1 should be rejected.

32

Advantages

1. This technique recognizes the Time Value of money 2. This technique considers the entire cash flow stream, all the cash inflows and outflows, irrespective of the timing of their occurrence 3. It is based on cash flows rather than the accounting profit. 4. The discount rate applied for discounting the future cash flows is in fact, the minimum required rate of return which incorporates both the pure return as well as the premium required to set off the risk. 5. PI concept has a built-in earnings requirements in addition to the recovery of the investment. Thus this cushion implicit is truly an economic gain that goes beyond satisfying the required rate of return.

33

Disadvantages

1. It involves difficult calculations. It may not be able to overcome the uncertainty involved with cash flows occurring after a sizeable time gap. 2. It requires the predetermination of the required rate of return, k, which is a difficult job. If the value of µk¶ is not correct, then the whole exercise of the PI may give wrong results. 3. This technique does not provide a measure of project¶s own rate of return, rather it evaluates a proposal against an external variable i.e., the minimum required rate of return. 4. The decision under this technique is based on a value which is an absolute measure. It ignores the difference in initial outflows, size of different proposals etc. while evaluating mutually exclusive proposals.

34

NPV vs PI

1. Due to the built ±in mechanism, the PI technique can discriminate between the projects having large outlays and projects having small outlays. Example 7: A firm is evaluating two proposals, A & B having costs of Rs. 1,00,000 and Rs. 80,000 respectively. The present value of the inflows of these projects are Rs. 1,20,000 and Rs. 1,00,000. Consequently both the proposals have NPV of Rs. 20,000 and therefore are alike but in terms of PI technique project B is better. [PI(A) = 1.20 and PI(B) = 1.25 2. Similarly NPV and PI may give contradictory decisions even if the net monetary benefits and the initial cost are different

35

36

IRR

The IRR of a proposal is defined as the discount rate which produces a zero NPV i.e., the IRR is the discount rate which will equate the present value of cash inflows with the present value of cash outflows This discount rate is ascertained by the trial and error method Computation: CO0 where, CFi k n C0 + SV +WC (1+r)n = Cash flows occurring at time 0,1,2««.,n = The discount rate, and = Life of the project in years = Initial Cost of the proposal at time T0

37

**Equal Cash flows
**

Steps in computation of IRR when future cash flows are in the form of annuities: 1. Determine the payback period of the proposed investment. 2. In Table of µPresent value of an annuity¶, look for the payback period that is equal to or closest to the life of the project. 3. In the year row, find two PV values or discount factor (DFr) closest to PB period but one bigger and other smaller than it. 4. From the top row of the table, note interest rate (r) corresponding to these PV values (DFr) 5. Determine the actual IRR by interpolation. IRR = r ± ( PB ± DFr) DFrL ± DFrH where, PB = Payback Period DFr = Discount factor for interest rate r, and DFrL= Discount factor for lower interest rate DFrH= Discount factor for higher interest rate

38

Example 8

A project costs Rs. 36,000 and is expected to generate cash inflows of Rs. 11,200 annually for 5 years. Calculate IRR. 1. The payback period is 3.214 (Rs. 36,000/ Rs. 11,200) 2. According to the table, discount factors closest to 3.214 for 5 years are 3.274 (rate of interest is 16%) and 3.199 (rate of interest is 17%) 3. Substituting the values in the equation, we get, IRR = 16 ± (3.274 ± 3.214) 3.274 ± 3.199 = 16.8%

39

**Unequal Cash flows
**

Steps in computation of IRR when future cash flows are not equal: Example 9: Suppose a firm is evaluating a proposal costing Rs. 1,60,000 and expected to generate cash inflows of Rs. 40,000, Rs. 60,000, Rs. 50,000, Rs. 50,000 and Rs. 40,000 at the end of each of next 5 years respectively. There is no salvage value. IRR will be approximated as follows: Step 1: Find out the weighted average of cash inflows Year Cash Inflow (Rs.) CF 1 40,000 2 60,000 3 50,000 4 50,000 5 40,000 Total Weight (W) 5 4 3 2 1 15

40

CF X W 2,00,000 2,40,000 1,50,000 1,00,000 40,000 7,30,000

Continued .

Weighted average = 7,30,000/ 15 = Rs. 48,667

**Unequal cash flows
**

Step 2: Consider the weighted average as the annuity of cash inflows and find out the payback period. For this case, the Payback period is Rs. 1,60,000/ 48,667 = 3.288 Step 3: The closest figures given in the PVAF Table for a value nearest to 3.288 in 5 years row are at 15% (3.352) and at 16% (3.274) Step 4: The NPV of the proposal for both of these approximate rates are: Year 1 2 3 4 5 Cash inflow 40,000 60,000 50,000 50,000 40,000 PVF (16%, 5 yrs.) 0.862 0.743 0.641 0.552 0.476 Total At 16%, NPV = Rs. 1,57,750 ± Rs. 1,60,000 = Rs. -2,250

41

PVF (15%, 5 yrs.) 0.870 0.756 0.658 0.572 0.497

PV (16%) 34,480 44,580 32,050 27,600 19,040 1,57,750

PV (15%) 34,800 45,360 32,900 28,600 19,880

1,61,540

At 15%, NPV = Rs. 1,61,540 ± Rs.1,60,000 = Rs. 1,540

**Unequal cash flows
**

Step 5: Find out the exact IRR by interpolating between 15% and 16%. IRR = 15% + 1,61,540 ± 1,60,000 1,61,540 ± 1,57,750 So, the IRR of the Project is 15.40% = 15.40%

42

The Decision Rule

The actual IRR, r, is to be compared with a predetermined or a minimum required rate of return or cut off rate, k, (set by management). If the actual IRR is higher than the minimum desired IRR, then the proposal would be accepted otherwise it may be rejected. Further if different proposals are to be ranked in order of priority, then the proposal with the highest IRR will be first in the priority list. Obviously projects having higher IRR would be preferred to projects with lower IRR.

43

Advantages

1. This technique recognizes the Time Value of money 2. It is a profit oriented concept and helps selecting those proposals which are expected to earn more than the minimum required rate of return. 3. The IRR has an appeal for those who want to analyze a proposal in terms of its percentage return. 4. This technique considers the entire cash flow stream, all the cash inflows and outflows, irrespective of the timing of their occurrence 5. It is based on cash flows rather than the accounting profit.

44

Disadvantages

1. It involves difficult calculations, a tedious and complicated trial and error procedure. 2. It requires the predetermination of the required rate of return, k, which is a difficult job. If the value of µk¶ is not correct, then the whole exercise may give wrong results. 3. It makes an implied assumption that the future cash inflows of a proposal are reinvested at a rate equal to the IRR 4. Since IRR is a scaled measure, it tends to be biased towards the smaller projects which are much more likely to yield high percentage returns over the larger projects. 5. This technique may give dubious results in some cases. For instance when there is more than one IRR for a project and it is not clear which one the decision maker should use or where IRR cannot be computed or if computed is likely to be meaningless.

45

QUESTIONS ?

46

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