Professional Documents
Culture Documents
Capital Budgeting
Capital Budgeting
CAPITAL BUDGETING
Definition
Payback Period
Time value adjusted payback period
Internal Rate of Return
Modified Internal Rate of Return
Net Present Value
Profitability Index
Payback Period
After factoring in time value of money(@15%), how long does it take to recover initial investment.
Incremental Pv of Cash Flows Cumulative Pv of
Year Cash Flows Cash Flow (CPV) Project A Project A
Project A
0 (Taka 10,000) (Taka 10,000) (10,000)
1 1,000 869.57 ( 9,130.43)
2 2,000 1,512.29 ( 7,618.14)
3 3,000 1,972.55 ( 5,645.59)
4 5,000 2,858.77 ( 2,786.82)
5 Payback Year6,000 2,983.06 196.24
6 6,000 2,593.97
Adjusted Payback Period = (Adjusted payback year -1) + (Last negative CPV/PV in PBY)
= 4 + (2786.82/2983.06 = 4.93
Net Present Value
Keep in mind, flows are certain. You can mortgage the inflows for 27,859 at 15%.
Invest 25,000 leaving 2859 in the bag (yours NPV).
Your interest on the loan in first year: 4,179.
When your first inflow occurs, pay the interest and pay (12000-4179) in loan repayment.
Remaining Balance: 20,038
Your interest on loan in second year: 3006
When your second inflow occurs, pay the interest and pay (10000-3006) in loan
repayment. Remaining Balance: 13044
Your interest on loan in third year: 1957
When your third inflow occurs, pay the interest and pay (15000-1957) in loan repayment.
Last payment pays off the loan.
You increased your wealth by 2859 today.
NPV Profiles
NPV Profile.xlsx
Internal Rate of Return
(IRR)
It is that rate that makes present value of
inflows equal to the present value of outflows,
NPV = 0, it is the geometric rate of return.
Solve by interpolation.
Solve by using Financial Calculators.
You must have both inflows and outflows.
Some projects may not have IRR
Some projects may have multiple IRR
IRR- Financial Calculator Example
Be sure to clear your calculator first. [2nd CF, 2nd Clr work Clr work]
Incremental C fo = - 10,000
Year Cash Flows CO1 = 1,000 Project A
FO1 = 1
0 (Taka 10,000) CO2 = 2,000
1 1,000 FO2 = 1
2 2,000 -
3 3,000 -
4 5,000 CO6 = 6,000
5 6,000 FO6 = 1
6 6,000 IRR [CPT] 22.35%
IRR: Some problems
Chart Title
$8,000.00
$7,000.00
$6,000.00
$5,000.00
C
$4,000.00
D
NPV
$3,000.00
$2,000.00
$1,000.00
$0.00
7% 9% 11% 13% 15% 17% 19% 21% 23% 25% 27% 29% 31% 33%
($1,000.00)
($2,000.00)
Finding Crossover Rate
Replacement Chain
Keep renewing the projects until both Projects end in The
Same Year
Find the NPV on a common life basis. Project with Higher
NPV is The better Value Creator
Equivalent Annual Annuity (EAA)/Annual Net
Present Value (ANPV)
First find Regular one Cycle NPV
Second, Divide Above by Appropriate PVIFA. This is
Equivalent Annual Annuity or ANPV.
Assumption: Unlimited Renewal
Example:
Year CF(X) CF(Y)
0 (6,000) (8,500)
1 2,500 4,000
2 3,000 4,000
3 4,600 3,000
4 2,000
5 2,000
6 1,000
Project(X) Project(Y)
IRR 27,76% 28.34%
NPV Taka 1,331.69 Taka 2,310.15
PI 1.22 1.27
Common Life (Replacement Chain)
Return ** Risk-
*
* * *
* WACC
*
* *
Risk
Risk-Adjustment in Capital
Budgeting
Risk Adjusted Discount Rate
RADR
Risk
Use judgment to add 3 to 4 % to previous level of required
return
Risk Adjustment Using Certainty Equivalents
Use the following cash flows and certainty equivalent coefficients to evaluate the
worthiness of the project.
Year Cash Flow Certain Equivalent
Coefficients
0 (2,00,000) 1
1 60,000 .95
2 75,000 .85
3 80,000 .75
4 75,000 .70
5 78,000 .70
Use a risk-free rate of 11 percent and a risk-adjusted discount rate of 25 percent.
Compute the IRR and apply the RADR decision rule. Should the project be accepted?
Compute the certainty equivalent net present value. Should the project be selected on a certainty
equivalent basis?