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Capital Budgeting Decisions

**Nature of Investment Decisions
**

• The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions. • The firm’s investment decisions would generally include expansion, acquisition, modernisation and replacement of the longterm assets. • Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions.

AKR IILM GSM 2

**Features of Investment Decisions
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• The exchange of current funds for future benefits. • The funds are invested in longterm assets. • The future benefits will occur to the firm over a series of years.

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**Importance of Investment Decisions
**

• • • • • Growth Risk Funding Irreversibility Complexity

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Types of Investment Decisions • One classification is as follows: – Expansion of existing business – Expansion of new business – Replacement and modernisation • Yet another useful way to classify investments is as follows: – Mutually exclusive investments – Independent investments – Contingent investments AKR IILM GSM 5 .

Investment Evaluation Criteria • 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 AKR IILM GSM 6 .

• It should recognise the fact that bigger cash flows are preferable to smaller ones and early cash flows are preferable to later ones. • It should help to choose among mutually exclusive projects that project which maximises the shareholders’ wealth. AKR IILM GSM 7 . • It should help ranking of projects according to their true profitability.Investment Decision Rule • It should maximise the shareholders’ wealth. • It should consider all cash flows to determine the true profitability of the project. • It should be a criterion which is applicable to any conceivable investment project independent of others. • It should provide for an objective and unambiguous way of separating good projects from bad projects.

Evaluation Criteria • 1. Discounted Cash Flow (DCF) Criteria – Net Present Value (NPV) – Internal Rate of Return (IRR) – Profitability Index (PI) • 2. Non-discounted Cash Flow Criteria – Payback Period (PB) – Discounted Payback Period (DPB) – Accounting Rate of Return (ARR) AKR IILM GSM 8 .

• Present value of cash flows should be calculated using the opportunity cost of capital as the discount rate. The appropriate discount rate is the project’s opportunity cost of capital. • Appropriate discount rate should be identified to discount the forecasted cash flows. AKR IILM GSM 9 .Net Present Value Method • Cash flows of the investment project should be forecasted based on realistic assumptions.

The formula for the net present C valueC can be C written as C NPV = follows: k ) + (3 k ) + (3 k ) + L + (3 k ) − C + + + + (3 3 3 3 n 3 3 n 3 Ct NPV = ∑ − C3 t + t =3 (3 k ) n AKR IILM GSM 10 .Net Present Value Method • Net present value should be found out by subtracting present value of cash outflows from present value of cash inflows.

be(3333 (3333to3333 (3333 cent. ) 3 3 3 3 NPV = [Rs 333 333 ) + Rs 333 333 ) + Rs 333 333 ) (PVF . .) − Rs 3333 assumed) ( + .333 Rs 333 =+ AKR IILM GSM 11 .333 NPV = [Rs 3333 33 3333 33 3333 7 Rs 77 7 7 × . 3 (PVF . . ) + .3 ] − Rs .3 + Rs × . .333 . Rs 600 and Rs 500 in years 1 through 5. 3 (PVF . The opportunity cost 333 Rs 333 Rs 333 Rs 333 Rs 333 Rs of the capital may NPV = + + + + . 3 + Rs 333 333 ) + Rs 333 333 )] − Rs 3 (PVF .500 now and is expected to generate year-end cash inflows of Rs 900. . 3 (PVF .77 + Rs 3333 33 3 × . )10 +per (3333 be + . . + .Calculating Net Present Value • Assume that Project X costs Rs 2.333 NPV = Rs 3 − Rs 3 .3 + Rs × . Rs 800. 3 .7 + 7 7 × . Rs 700. .

Acceptance Rule • 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. AKR IILM GSM 12 . the one with the higher NPV should be selected.

Evaluation of the NPV Method • NPV is most acceptable investment rule for the following reasons: – – – – – – – – Time value Measure of true profitability Value-additivity Shareholder value Involved cash flow estimation Discount rate difficult to determine Mutually exclusive projects Ranking of projects AKR IILM GSM 13 • Limitations: .

• 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 C C C C C = + + +L + the rate+ of return3 r ) the discount is (3 r ) (3 r ) + ( + (3 r ) + C rate which makes NPV = 0. C =∑ 3 3 3 3 n 3 3 n n 3 t t =3 n Internal Rate of Return Method (3 r )t + Ct ∑ (3 r )t − C3= 3 + t =3 AKR IILM GSM 14 .

If the calculated present value of the expected cash inflow is lower than the present value of cash outflows. AKR IILM GSM 15 .Calculation of IRR • Uneven Cash Flows: Calculating IRR by Trial and Error – The approach is to select any discount rate to compute the present value of cash inflows. On the other hand. a lower rate should be tried. This process will be repeated unless the net present value becomes zero. a higher value should be tried if the present value of inflows is higher than the present value of outflows.

Rs 33 .333 AKR IILM GSM 16 .777 Rs 3 . – The IRR of the investment can be found out as follows: NPV = −Rs 33 + Rs 3 (PVAF3r ) = 3 .000 and provide annual cash inflow of Rs 5. PVAF3r = .333 =7 .333 .333 . Rs 33 = Rs 3 (PVAF3r ) .333 .333 .Calculation of IRR • Level Cash Flows – Let us assume that an investment would cost Rs 20.430 for 6 years.

3 3333 33 % 333 3 3333 33 % 3 3 3333 33 % 3 (3 3 3 .NPV Profile and IRR A 3 N P V B P r o file C D E F G H D is c o u n t N P V 3 C a s h F l o rw a t e 3 -7 7 7 7 7 3% 7 7 7.7 7 3 3333 3% 3 333 . V r N P ro file AKR IILM GSM 17 . 3 3333 33 % 7 777 . IR R ) ) F i g u 3 e 3 P. 3 3333 33 % 3 (3 3 3 .

Acceptance Rule • • • • Accept the project when r > k. May accept the project when r = k. Reject the project when r < k. AKR IILM GSM 18 . In case of independent projects. IRR and NPV rules will give the same results if the firm has no shortage of funds.

Evaluation of IRR Method • IRR method has following merits: – – – – Time value Profitability measure Acceptance rule Shareholder value • IRR method may suffer from: – Multiple rates – Mutually exclusive projects – Value additivity AKR IILM GSM 19 .

at the required rate of return. to the initial cash outflow of the investment. AKR IILM GSM 20 .Profitability Index • Profitability index is the ratio of the present value of cash inflows.

Profitability Index • The initial cash outlay of a project is Rs 100.3 33 3 .33 7 7 3.3 33 3 .3(PVF ) + Rs 3. .3 33 3 .77 3 3 .000 and Rs 20.3 NPV = Rs 33 3 − Rs 33 3 = Rs 3.33 3.77 Rs 3 is: .33 3 discount.3 per Rs 3.33 3 3× 7+ 33× 33 3 .3. . Rs 50. Rs 7 7 7 .7 3 3 × . .33 33 Rs 3 3 3 .77 AKR IILM GSM 21 .33.33 3. .000. Assume a 10 per cent rate PV = Rsof 3(PVF 3.33 PI = = 3 33 .33 3 3(PVF ) = Rs10 3 7 7 + cent× 3 3 + Rs 3. Rs 30.33 discount.33 3 The PV 3.000.33 7 rate .000 in year 1 through 4.33 ) + Rs of (PVF 3 3 cash +inflows at ) Rs 3.7.000 and it can generate cash inflow of Rs 40.

PI > 1 – Reject the project when PI is less than one.Acceptance Rule • The following are the PI acceptance rules: – Accept the project when PI is greater than one. PI = 1 • The project with positive NPV will have PI greater than one. AKR IILM GSM 22 . PI less than means that the project’s NPV is negative. PI < 1 – May accept the project when PI is equal to one.

PI criterion also requires calculation of cash flows and estimate of the discount rate. • Like NPV method. AKR IILM GSM 23 . • It is consistent with the shareholder value maximisation principle. • In the PI method. it will increase shareholders’ wealth. it is a relative measure of a project’s profitability. In practice. estimation of cash flows and discount rate pose problems. A project with PI greater than one will have positive NPV and if accepted. since the present value of cash inflows is divided by the initial cash outflow.Evaluation of PI Method • It recognises the time value of money.

the payback period can be computed by dividing cash outlay by the annual 3 C cash inflow.500 for 7 years.000 and yields 33 Rs annual cash inflow of Rs . Initial Investment That is:Payback = Annual Cash Inflow = C • Assume that a project requires an outlay of Rs 50. The payback period for the Rs 33 .Payback • Payback is the number of years required to recover the original cash outlay invested in a project. • If the project generates constant annual cash inflows.333 PB = =3 years 12.333 AKR IILM GSM project is: 24 .

Payback • 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.000 during the next 4 years. What AKR IILM GSM 25 . and generates cash inflows of Rs 8.000. Rs 4.000. Rs 7.000.000. • Suppose that a project requires a cash outlay of Rs 20. and Rs 3.

Acceptance Rule • The project would be accepted if its payback period is less than the maximum or standard payback period set by management. • As a ranking method. which has the shortest payback period and lowest ranking to the project with highest payback period. it gives highest ranking to the project. AKR IILM GSM 26 .

Evaluation of Payback • Certain virtues: – – – – – – – – – – Simplicity Cost effective Short-term effects Risk shield Liquidity Cash flows after payback Cash flows ignored Cash flow patterns Administrative difficulties Inconsistent with shareholder value AKR IILM GSM 27 • Serious limitations: .

Payback Reciprocal and the Rate of Return AKR IILM GSM 28 . – The project generates equal annual cash inflows.• 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.

3DISCOUNTEDPAYBACK ILLUSTRATED P PV of cash flows Q PV of cash flows C3 -3 3 .33 -3 3 .33 77 .33 333 3 3 .33 3 33 .33 33 .33 777 33 3 33 .33 -3 3 .33 33 .33 -3 3 .33 Cash Flows (Rs) C3 C3 33 .77 33 3 3 33 .Discounted Payback Period • The discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis.3 – 3 yrs .33 33 . • The discounted payback period still fails to consider the cash flows occurring after the payback period.33 AKR IILM GSM 29 .3 NPV at 3% 3 – 33 3 – 33 .33 Simple PB 3 yrs 3 yrs Discounted PB – 3 yrs .33 C3 C3 33 .

The average investment would be equal to half of theincome original Average ARR investment =ifAverage investment it were depreciated constantly. Accounting Rate of Return Method • A variation of the ARR method is to AKR IILM GSM 30 .• The accounting rate of return is the ratio of the average after-tax profit divided by the average investment.

• This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.Acceptance Rule • This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate. AKR IILM GSM 31 .

Evaluation of ARR Method • The ARR method may claim some merits – Simplicity – Accounting data – Accounting profitability • Serious shortcoming – Cash flows ignored – Time value ignored – Arbitrary cut-off AKR IILM GSM 32 .

NonAKR IILM GSM 33 Conventional and Nonconventional Cash Flows . Conventional projects have only one change in the sign of cash flows. has cash outflows mingled with cash inflows throughout the life of the project. – + + +.• A conventional investment has cash flows the pattern of an initial cash outlay followed by cash inflows. the initial outflow followed by inflows. on the other hand. • A non-conventional investment. i. for example..e.

NPV and IRR methods result in same accept-or-reject decision if the firm is not constrained for funds in accepting all profitable projects.NPV Versus IRR • Conventional Independent Projects: In case of conventional investments. AKR IILM GSM 34 . which are economically independent of each other.

and project with initial inflow followed by outflows is a lending type project.NPV Versus IRR •Lending and borrowing-type projects: Project with initial outflow followed by inflows is a lending type project. Both are conventional projects. Project X Y Cash Flows (Rs) C3 C3 -33 3 77 7 33 3 -33 3 IRR 3% 3 3% 3 NPV at 33 % 3 -3 AKR IILM GSM 35 .

Problem of Multiple IRRs • A project may have both lending and borrowing features together. when used to evaluate such nonconventional NPV (Rs) 33 3 NPV Rs 33 3 -333 -333 -333 3 3 3 33 3 33 3 33 3 33 3 Discount Rate (%) AKR IILM GSM 36 . IRR method.

– The projects may have different expected lives. • Two independent projects may also be mutually exclusive if a financial constraint is imposed. • The NPV and IRR rules give conflicting ranking to the projects under the following conditions: – The cash flow pattern of the projects may differ. – The cash outlays of the projects may differ. while those of others may decrease or viceversa. the cash flows of one project may increase over time.• Investment projects are said to be mutually exclusive when only one investment could be accepted and others would have to be excluded. AKR IILM GSM 37 Case of Ranking Mutually Exclusive Projects . That is.

77 NPV at 3 % 33 3 33 3 IRR 3% 3 3% 3 AKR IILM GSM 38 .77 33 3 C3 33 3 33 3 C3 33 3 77 .Timing of Cash Flows Cash Flows (Rs) Project M N C3 –3 .333 –3 .333 C3 77 .

Scale of Investment Cash Flow (Rs) Project A B C3 -3 3 .77 33 3 77 7 7.33 -33 3 3.77 3 3 .33 AKR IILM GSM 39 .33 NPV IRR 3% 3 3% 3 C3 at 33 % 77 .

77 IRR 3% 3 3% 3 AKR IILM GSM 40 .333 – 33 .333 C3 7.3 3 33 NPV at 33 % 333 77 .7 7 77 3 C3 – 3 C3 – 3 C3 – 3 C3 – 3.Project Life Span Cash Flows (Rs) Project X Y C3 – 33 .

AKR IILM GSM 41 .Reinvestment Assumption • The IRR method is assumed to imply that the cash flows generated by the project can be reinvested at its internal rate of return. whereas the NPV method is thought to assume that the cash flows are reinvested at the opportunity cost of capital.

The modified internal rate of return (MIRR) is the compound average annual rate that is calculated with a reinvestment rate different than the project’s AKR IILM GSM Modified Internal Rate of Return (MIRR) 42 .• The modified internal rate of return (MIRR) is the compound average annual rate that is calculated with a reinvestment rate different than the project’s IRR.

AKR IILM GSM Varying Opportunity Cost of Capital 43 . as there is not a unique benchmark opportunity cost of capital to compare with IRR. the use of the IRR rule creates problems. • If the opportunity cost of capital varies over time.• There is no problem in using NPV method when the opportunity cost of capital varies over time.

33 33 33 .33 33 33 .3 AKR IILM GSM 44 .33 33 3.NPV Versus PI • A conflict may arise between the two methods if a choice between mutually exclusive projects has to be made. Follow NPV method: Project C PV of cash inflows Initial cash outflow NPV PI 33 3 3.33 33 3.33 3.33 33 3.3 Project D 3.

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