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Capital Budgeting

By

Prof. Anirban

CCIM, B’lore

Prof. Anirban, CCIM, B’lore, Capital Budgeting

t The investment decisions of a firm is

generally known as the capital budgeting

decisions and it consists of the Long Term

planning for the proposed capital outlays

and their financing.

t C/B may be defined as the firm’s decision

to invest its current funds most effective

and efficient way in the long term assets

in anticipation of an expected flow of

benefits over a series of years.

Capital Budgeting…. What's that????

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Capital Budgeting Within The Firm

The Position of Capital Budgeting

Capital Budgeting

Long Term Assets Short Term Assets

Investment Decison

Debt/Equity Mix

Financing Decision

Dividend Payout Ratio

Dividend Decision

Financial Goal of the Firm:

Wealth Maximisation

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Examples of ‘Long Term Assets’

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Capital Budgeting…. Features

t It has potentiality to anticipate a huge profit.

t It involves high degree of risk.

t Involves relatively a long period of time

between the initial outlay and the anticipated

returns.

t Involves the exchange of current funds (which

are invested in long term assets) for the future

benefits.

t Future benefits will occur to the firm over a

series of time.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Importance of C/B Decisions

t Growth

t Risk

t Funding

t Irreversibility

t Complexity

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Capital Budgeting…. Process..

t Identification of the potential investment opportunities.

t Assembling of the proposed investments.

t Decision making.

t Preparation of the capital Budget and appropriation.

t Implementation

– Adequate formulation of the project.

– Use of the principle of responsibility

– Use of network techniques

t Performance Review

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Investment Evaluation Criteria

t Three steps are involved in the

evaluation of an investment:

– Estimation of cash flows

– Estimation of the required rate of return

(the opportunity cost of capital)

– Application of a decision rule for making

the choice

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Modern or

Discounted Cash flow

method

C/B

Techniques

Traditional or

Non Discounted Cash

flow method

ARR

PB

PI

IRR

NPV

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Net Present Value

t NPV is the classic economic and generally

considered to be the best method for

evaluating capital investment proposals.

t This is one of the discounted cash flow (DCF)

techniques which explicitly recognize Time

value of Money.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Steps in NPV calculation

t Cash flows of the investment project should be

forecasted based on realistic assumptions.

t Appropriate discount rate should be identified to

discount the forecasted cash flows. The appropriate

discount rate is the project’s opportunity cost of

capital.

t Present value of cash flows should be calculated using

the opportunity cost of capital as the discount rate.

t The NPV is the difference between the Total present

value of the Future Cash in Flows and Future cash

outflows.

t The project should be accepted if NPV is positive

(i.e., NPV > 0).

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Equation of NPV

3 1 2

0

2 3

0

1

NPV

(1 ) (1 ) (1 ) (1 )

NPV

(1 )

n

n

n

t

t

t

C C C C

C

k k k k

C

C

k

=

(

= + + + + ÷

(

+ + + +

¸ ¸

= ÷

+

¿

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Acceptance Rule

t Accept the project when NPV is positive NPV > 0

t Reject the project when NPV is negative NPV < 0

t May accept the project when NPV is zero NPV = 0

t The NPV method can be used to select between

mutually exclusive projects; the one with the higher

NPV should be selected.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Profitability Index

t Profitability index is the ratio of the

present value of cash inflows, at the

required rate of return, to the initial cash

outflow of the investment.

t Criterion :

– PI > 0 Implies Accept the project

– PI < 0 Implies Reject the project

– PI = 0 Implies the decision is indifferent

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Internal Rate of Return Method

t The internal rate of return (IRR) is the rate that equates the

investment outlay with the present value of cash inflow received

after one period. This also implies that the rate of return is the

discount rate which makes NPV = 0.

t i.e. PVCI – PVCO = 0, i.e. PVCI = PVCO

t So IRR will be rate of return where NPV =0

t This rate is also called as the rate at which the expected inflows

break even with the cash outflows of the project.

t Some time IRR lies between two trial rates called Higher or

Upper trial rate and Lower Trial rate. To calculate exact IRR we

can use the following interpolation formula.

t NPV at LTR

t Exact IRR = LTR + x Diff. of trial

NPV at LTR – NPV at HTR rates

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Acceptance Rule

t Accept the project when r > k.

t Reject the project when r < k.

t May accept the project when r = k.

t In case of independent projects, IRR and

NPV rules will give the same results if the

firm has no shortage of funds.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Average Rate of Return/ROI

t The accounting ratio and return also known as

the ROI uses accounting information as revealed

by financial statements to measure the

profitability of the investment.

t The accounting rate of return is the ratio of the

average after-tax profit divided by the average

investment. The average investment would be

equal to half of the original investment if it were

depreciated constantly.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Contd…

t ARR = [Average Return (PAT) / Average Invt]

t Where, AR = [Total Return / Time]

t AI = [{Cost - Scrap} / 2] or

[{Cost - Scrap } / 2} + Net W/C + Scrap Value

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Payback Period

t Payback is the number of years required to

recover the original cash outlay invested in a

project.

t If the project generates constant annual cash

inflows, the payback period can be computed by

dividing cash outlay by the annual cash inflow.

t PBP = [Initial Investment / Annual Cash Flows]

t Assume that a project requires an outlay of Rs

50,000 and yields annual cash inflow of Rs 12,500

for 7 years. The payback period for the project

is:

50000 / 12500 = 4 years

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Payback Period

t Unequal cash flows In case of unequal cash

inflows, the payback period can be found out

by adding up the cash inflows until the total is

equal to the initial cash outlay.

t Suppose that a project requires a cash outlay

of Rs 20,000, and generates cash inflows of

Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000

during the next 4 years. What is the project’s

payback?

3 years + 12 × (1,000/3,000) months

3 years + 4 months

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Acceptance Rule

t The project would be accepted if its payback

period is less than the maximum or standard

payback period set by management.

t As a ranking method, it gives highest

ranking to the project, which has the

shortest payback period and lowest ranking

to the project with highest payback period.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Payback Reciprocal and Rate of Return

t The reciprocal of payback will be a close

approximation of the internal rate of

return if the following two conditions are

satisfied:

– The life of the project is large or at least twice

the payback period.

– The project generates equal annual cash

inflows.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Capital Rationing

t Capital Rationing is the financial

situation in which a firm has only fixed

amount of allocate among competing

capital expenditure.

t It means a situation in which a firm has

more acceptable investments than it can

finance.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Risk & Sensitivity Analysis

t Sensitivity analysis is a behavioral

approach that uses a number of possible

values for a given variable to assess its

impact on a firm’s returns.

t It provides different cash flow estimates

under three assumptions:

• The worst i.e. most pessimistic

• The expected i.e. most likely

• The best i.e. the most optimistic

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Any

Questions

????

**Capital Budgeting…. What's that????
**

t

t

The investment decisions of a firm is generally known as the capital budgeting decisions and it consists of the Long Term planning for the proposed capital outlays and their financing. C/B may be defined as the firm’s decision to invest its current funds most effective and efficient way in the long term assets in anticipation of an expected flow of benefits over a series of years.

Prof. Anirban, CCIM, B’lore, Capital Budgeting

Capital Budgeting . CCIM. B’lore. Anirban.Capital Budgeting Within The Firm The Position of Capital Budgeting Financial Goal of the Firm: Wealth Maximisation Investment Decison Long Term Assets Short Term Assets Financing Decision Debt/Equity Mix Dividend Decision Dividend Payout Ratio Capital Budgeting Prof.

Examples of ‘Long Term Assets’ Prof. CCIM. Capital Budgeting . Anirban. B’lore.

CCIM. Anirban.Capital Budgeting…. Future benefits will occur to the firm over a series of time. It involves high degree of risk. Involves relatively a long period of time between the initial outlay and the anticipated returns. B’lore. Capital Budgeting . Features t t t t t It has potentiality to anticipate a huge profit. Involves the exchange of current funds (which are invested in long term assets) for the future benefits. Prof.

CCIM.Importance of C/B Decisions t t t t t Growth Risk Funding Irreversibility Complexity Prof. Capital Budgeting . B’lore. Anirban.

Anirban. Assembling of the proposed investments. – Use of the principle of responsibility – Use of network techniques t Performance Review Prof. Preparation of the capital Budget and appropriation. t t t t t Identification of the potential investment opportunities. Decision making. Process. Implementation – Adequate formulation of the project.. Capital Budgeting .Capital Budgeting…. CCIM. B’lore.

B’lore.Investment Evaluation Criteria t Three steps are involved in the evaluation of an investment: – Estimation of cash flows – Estimation of the required rate of return (the opportunity cost of capital) – Application of a decision rule for making the choice Prof. Capital Budgeting . CCIM. Anirban.

Capital Budgeting PI .Traditional or Non Discounted Cash flow method Modern or Discounted Cash flow method NPV ARR C/B Techniques IRR PB Prof. Anirban. CCIM. B’lore.

B’lore. Prof. Anirban.Net Present Value t t NPV is the classic economic and generally considered to be the best method for evaluating capital investment proposals. CCIM. Capital Budgeting . This is one of the discounted cash flow (DCF) techniques which explicitly recognize Time value of Money.

The project should be accepted if NPV is positive (i. The appropriate discount rate is the project’s opportunity cost of capital. Capital Budgeting .Steps in NPV calculation t t t t t Cash flows of the investment project should be forecasted based on realistic assumptions. Appropriate discount rate should be identified to discount the forecasted cash flows. CCIM. Anirban.. The NPV is the difference between the Total present value of the Future Cash in Flows and Future cash outflows.e. Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. NPV > 0). B’lore. Prof.

Capital Budgeting . Anirban. B’lore.Equation of NPV C1 C3 Cn C2 NPV C0 2 3 n (1 k ) (1 k ) (1 k ) (1 k ) n Ct NPV C0 t t 1 (1 k ) Prof. CCIM.

Prof. Anirban.Acceptance Rule t t t t Accept the project when NPV is positive NPV > 0 Reject the project when NPV is negative NPV < 0 May accept the project when NPV is zero NPV = 0 The NPV method can be used to select between mutually exclusive projects. Capital Budgeting . CCIM. the one with the higher NPV should be selected. B’lore.

Profitability Index t t Profitability index is the ratio of the present value of cash inflows. Capital Budgeting . to the initial cash outflow of the investment. at the required rate of return. B’lore. CCIM. Criterion : – PI > 0 Implies Accept the project – PI < 0 Implies Reject the project – PI = 0 Implies the decision is indifferent Prof. Anirban.

e. To calculate exact IRR we can use the following interpolation formula. PVCI – PVCO = 0. i. NPV at LTR Exact IRR = LTR + x Diff. This also implies that the rate of return is the discount rate which makes NPV = 0. B’lore. Capital Budgeting . of trial NPV at LTR – NPV at HTR rates Prof. CCIM. i. PVCI = PVCO So IRR will be rate of return where NPV =0 This rate is also called as the rate at which the expected inflows break even with the cash outflows of the project.e. Anirban. Some time IRR lies between two trial rates called Higher or Upper trial rate and Lower Trial rate.Internal Rate of Return Method t t t t t t t The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period.

In case of independent projects. IRR and NPV rules will give the same results if the firm has no shortage of funds. May accept the project when r = k. CCIM. B’lore. Anirban. Reject the project when r < k. Capital Budgeting . Prof.Acceptance Rule t t t t Accept the project when r > k.

Average Rate of Return/ROI t t The accounting ratio and return also known as the ROI uses accounting information as revealed by financial statements to measure the profitability of the investment. Capital Budgeting . B’lore. CCIM. The accounting rate of return is the ratio of the average after-tax profit divided by the average investment. Anirban. Prof. The average investment would be equal to half of the original investment if it were depreciated constantly.

CCIM.Scrap} / 2] or [{Cost . Capital Budgeting .Contd… t t t ARR = [Average Return (PAT) / Average Invt] Where.Scrap } / 2} + Net W/C + Scrap Value Prof. AR = [Total Return / Time] AI = [{Cost . Anirban. B’lore.

B’lore.Payback Period t t t t Payback is the number of years required to recover the original cash outlay invested in a project. PBP = [Initial Investment / Annual Cash Flows] Assume that a project requires an outlay of Rs 50.000 and yields annual cash inflow of Rs 12. Capital Budgeting . Anirban. The payback period for the project is: 50000 / 12500 = 4 years Prof. CCIM. If the project generates constant annual cash inflows.500 for 7 years. the payback period can be computed by dividing cash outlay by the annual cash inflow.

000 during the next 4 years. and Rs 3.000) months 3 years + 4 months Prof. What is the project’s payback? 3 years + 12 × (1.Payback Period t t Unequal cash flows In case of unequal cash inflows.000/3. Anirban. Capital Budgeting . and generates cash inflows of Rs 8. Rs 4. the payback period can be found out by adding up the cash inflows until the total is equal to the initial cash outlay.000. B’lore. CCIM. Rs 7.000.000.000. Suppose that a project requires a cash outlay of Rs 20.

Capital Budgeting .Acceptance Rule t t The project would be accepted if its payback period is less than the maximum or standard payback period set by management. Prof. Anirban. which has the shortest payback period and lowest ranking to the project with highest payback period. As a ranking method. CCIM. it gives highest ranking to the project. B’lore.

– The project generates equal annual cash inflows. Capital Budgeting . B’lore. Anirban. Prof.Payback Reciprocal and Rate of Return t The reciprocal of payback will be a close approximation of the internal rate of return if the following two conditions are satisfied: – The life of the project is large or at least twice the payback period. CCIM.

CCIM. It means a situation in which a firm has more acceptable investments than it can finance. Anirban. B’lore.Capital Rationing t t Capital Rationing is the financial situation in which a firm has only fixed amount of allocate among competing capital expenditure. Prof. Capital Budgeting .

most pessimistic • The expected i.e.Risk & Sensitivity Analysis t t Sensitivity analysis is a behavioral approach that uses a number of possible values for a given variable to assess its impact on a firm’s returns.e.e. the most optimistic Prof. most likely • The best i. It provides different cash flow estimates under three assumptions: • The worst i. Anirban. B’lore. Capital Budgeting . CCIM.

Anirban. B’lore. CCIM. Capital Budgeting .Any Questions ???? Prof.

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