Capital budgeting

‡ It is the process of evaluating and selecting long-term investments that are consistent with the goal of shareholders wealth maximisation. ‡ Capital expenditure is an outlay of funds that is expected to produce benefits over a period of time exceeding one year.

Why capital budgeting is very important ?
‡ Huge funds involved ‡ Irreversible ‡ Lengthy time period

Techniques
‡ Traditional techniques ‡ Discounted cash flow techniques

Traditional techniques
‡ Accounting rate of return [ ARR ] ‡ Payback period [ PBP ]

DCF techniques ‡ Net present value [ NPV ] ‡ Internal rate of return [ IRR ] ‡ Profitability index [ PI ] .

.Two points to remember: ‡ Traditional techniques ignore time value of money whereas DCF techniques consider time value of money. ‡ ARR uses accounting profits whereas all other techniques use cash flow after tax.

Depreciation PBT .Tax PAT + Depreciation CFAT .Accounting profits vs Cash flows after tax CFBT .

‡ ARR = Average annual profit after tax / AI Where AI = Average investment .Accounting rate of return ‡ Accounting rate of return is the rate of return on an investment defined as accounting profit divided by book value of investment. It is also referred as average rate of return.

Average investment can be ‡ Investment / 2 ‡ ½ ( cost of machine ± salvage value) + salvage value ‡ ½ ( cost of machine ± salvage value) + salvage value + Net working capital .

. ‡ In case of multiple projects ± Choose that project that has maximum ARR.Decisions ‡ In case of single project ± Invest if ARR is greater than benchmark. subject to condition that it is greater than benchmark.

PBP is calculated as follows: ‡ PBP = Investment / annual cash flow ‡ In case of mixed stream of cash flows. cumulative cash flows are calculated to know the period between which entire investment outlay are collected. ‡ In case of annuity cash inflows.Pay back period ‡ It is the exact amount of time required for a firm to recover its initial investment in a project as calculated from cash inflows. .

‡ In case of multiple projects ± Choose that project that has minimum PBP. .Decisions ‡ In case of single project ± Invest if PBP is less than benchmark. subject to condition that it is less than benchmark.

Net present value ‡ Net present value is the difference between the present value of cash inflows and present value of cash outflows ‡ NPV = PVCIF .PVCOF .

( i. subject to condition that it is +ve. NPV is +ve) ‡ In case of multiple projects ± Choose that project that has maximum NPV.Decisions ‡ In case of single project ± Invest if NPV is greater than zero. .e.

Profitability index ‡ Profitability index is the ratio of present value of cash inflows to present values of cash outflows. ‡ PI = PVCIF / PVCOF .

Decisions ‡ In case of single project ± Invest. subject to condition that it is greater than one. . if PI is greater than one. ‡ In case of multiple projects ± Choose that project that has maximum PI.

‡ In other words. . the discount rate at which NPV = 0.Internal rate of return ‡ Internal rate of return is the discount rate that equates the present values of cash inflows with the initial investment associated with the project.

Internal rate of return ‡ Step 1: Calculate fake annuity ‡ Step 2: Calculate fake pay back period ‡ Step 3: Refer PVIFA table to identify any rate having a factor very close to fake payback period ‡ Step 4: Try with that rate to know whether NPV is zero. try with another rate. If not. . ‡ Step 5: Use IRR formula to know the answer.

IRR = LR +{(PVLR.PVCO) / (PVLR ± PVHR)} x (HR ± LR) .

. subject to condition that it is greater than cost of capital. if IRR is greater than cost of capital. IRR > (COST OF CAPITAL) ‡ In case of multiple projects. ‡ i. choose that project which gives maximum IRR.e.Decisions ‡ In case of single project ± Invest.

692 12.769 13.50.000 10.000 10.462 20.385 .Calculate (i) ARR (ii) PBP (iii) NPV (10%) (iv) IRR and (v) PI (10%)from the following data. Tax rate = 35% Year 0 1 2 3 4 5 CFBT (Rs ) .

year 1 2 3 4 5 CFBT DEP PBT 0 692 2.769 10.250 16.385 10.000 10.212 PAT 0 450 1.000 TAX (0.000 13.000 10.462 10.769 3.450 11.35) 0 242 969 1.000 12.800 2.250 6.750 10.385 3.635 .750 CFAT 10.000 20.462 10.000 10.692 10.800 12.

Accounting rate of return ‡ ARR = Average annual profit after tax / AI Where AI = Average Investment AI = Investment / 2 ARR = [ 11.250 / 5 ] / [ 50.000 / 2 ] x 100 = 9% .

.500 / 16.500 61.750 ] = 4.000 10.250 44.750 Cum CFAT 10.000 20.800 12.450 11.PAY BACK PERIOD Year 1 2 3 4 5 CFAT 10.450 32.250 16.328 x 12 ] = 4 yrs and 4 months.328 years 4 yrs + [ 0.250 PBP = 4 years + [ 5.

4.621 PV (Rs) 9.826 0.090 8.750 Total PV .450 11.000 .50.250 16.751 0.862 8.Net present value year 1 2 3 4 5 CFAT 10.909 0.800 12.683 0.352 .367 10.000 10.632 8.401 45.648 .Inv NPV PV@10% 0.

907 .000 = 0.352 / 50.Profitability Index ‡ PI = PVCIF / PVCOF ‡ PI = 45.

try with another rate.Internal rate of return ‡ Step 1: Calculate fake annuity ‡ Step 2: Calculate fake pay back period ‡ Step 3: Refer Table 4 to identify any rate having a factor very close to fake payback period ‡ Step 4: Try with that rate to know whether NPV is zero. . ‡ Step 5: Use IRR formula to know the answer. If not.

PVCO) / (PVLR ± PVHR)} x (HR ± LR) .IRR = LR +{(PVLR.

Calculation of IRR Step 1: Fake annuity = 61. Now let us try with 6%. we can find the factor very close to 7% . Using IRR formula. Then NPV comes to ±609.4.6% . IRR = 6.100 Step 4: Let us try with 7%.250 / 5 = Rs 12.250 = 4.0816 Step 3: Referring Table 4.250 Step 2: Fake Pay back period = 50. wherein NPV comes to 856.000 / 12.

00.000.000 and year 2 is ±10.000. 25% and 400%. We have two IRRs for this case i.000.000 and year 2 is 37. IRR and NPV give opposite results. multiple IRRs are possible.e. ‡ In some cases.00. year 1 is ±45. year 1 is 10. .Problems of IRR ‡ For non conventional cash flows.500. Eg: cash flows at year 0 is ±1. ‡ No IRR exists for some cases. Cash flows at Eg: year 0 is 15.60.

000 IRR 50% 75% NPV@10 % 145 -236 . Proj.Problems in IRR ‡ IRR can be misleading when a choice has to be made between mutually exclusive projects which have different patterns of cash flow over time.000 4.000 CF 1 6.000 -7. A B CF 0 -4. ‡ IRR cannot differentiate lending and borrowing.

500 now. Rs 600 and Rs 500 in years 1 to 5. ‡ Rs 225 . Calculate NPV. is expected to generate year end cash inflows of Rs 900. The cost of capital is 10%. Rs 800.A project costing Rs 2. Rs 700.

000.(i) Calculate IRR.000 and is expected to generate cash inflows of Rs 8.A project costs Rs 16.000 for next 3 years. (ii) If cost of capital is 20%. Rs 7.000 and Rs 6. will you undertake the project? ‡ IRR = 15.8% ‡ No .

Its expected EBDIT during first five years are expected to be Rs 10.000.000 and Rs 20. Calculate ARR. Rs 12.A project will cost Rs 40.000.000.000. ‡ ARR = 16% .000. Rs 14. Rs 16. Assume 50% tax and depreciation is on straight line method.

Other techniques ‡ Modified NPV ‡ Modified IRR ‡ Discounted Pay back period .

‡ Step 2 :Calculate modified NPV using the formula NPV = [TV / ( 1 + r )n] .I * .Modified NPV ‡ Step 1 : calculate the terminal value of the project¶s cash inflows using the explicitly defined reinvestment rates.

‡ Step 2 : Calculate the terminal value of the cash inflows [ TV ].Modified IRR ‡ Step 1 : Calculate the present value of costs associated with the project [ PVC ]. PVC = [ TV / ( 1 + MIRR )n ] . ‡ Step 3 : Calculate MIRR by solving the following equation.

Discounted pay back period ‡ Step 1 : calculate the present value of cash inflows and outflows using the discount rate. ‡ Step 3 : Identify the payback period in the routine way. ‡ Step 2 : calculate the cumulative value of discounted cash flows. .

000 20.000 Project Y Rs 1.000 40.10.000 50.000 40.Calculate Modified NPV from the following data Project X Investments CF ± Year 1 CF ± Year 2 CF ± Year 3 CF ± Year 4 Rs 1.000 71.000 31.000 Assume reinvestment rate and cost of capital to be 14% and 10% respectively .000 70.000 40.10.

000 = Rs 2.14)3 + 40.000 (1.Solution ‡ Step 1 : calculate the terminal value of the project¶s cash inflows using the explicitly defined reinvestment rates.14)2 + 50.911 ‡ Step 2 :Calculate modified NPV using the formula NPV = [TV / ( 1 + r )n] .000(1.000 (1.24.I * . = 31.14)1 + 70.

I NPV = [2.10.Solution NPV = [TV / ( 1 + r )n] .1)4] ± 1.000 NPV = Rs 43.614. * * * .911 / (1.24.

.Calculate Modified IRR from the following data year 0 CF 1 2 20 3 60 4 80 5 100 6 120 -120 -80 The cost of capital is 15%.

15)2 + 100 (1.Step 1 : Calculate the present value of costs associated with the project [ PVC ].6 ‡ Step 2 : Calculate the terminal value of the cash inflows [ TV ] = 20 (1.15)4 + 60 (1.1) = 189.15)3 + 80 (1. = 120 + 80 x PVIF (15%.15) + 120 = 467 .

2% .6 = 2.162 or 16.Step 3 : Calculate MIRR by solving the following equation.162 ± 1 = MIRR = 0.463 = 1 + MIRR = 2.6 = [ 467 / ( 1 + MIRR )6 ] = ( 1 + MIRR )6 = 467 / 189. PVC = [ TV / ( 1 + MIRR )n ] 189.4631/6 = MIRR = 1.