4-1 Business Finance (MGT 232) Lecture 18. 4-2 Capital Budgeting

4-14-1

Business Finance(MGT 232)

Lecture 18

4-24-2

Capital BudgetingCapital BudgetingCapital BudgetingCapital Budgeting

4-3

– The Capital Budgeting Process– Classification of Investment Project Proposals– Capital Budgeting Techniques

• Payback Period• Discounted Payback Period• Net Present Value

Overview of the Last Lecture

4-4

Proposed Project DataProposed Project Data

Mariam is evaluating a new project for her firm, Basket Wonders (BW). She has

determined that the after-tax cash flows for the project will be Rs.10,000;

Rs.12,000; Rs.15,000; Rs.10,000; and Rs.7,000, respectively, for each of the

Years 1 through 5. The initial cash outlay will be Rs.40,000.

Mariam is evaluating a new project for her firm, Basket Wonders (BW). She has

determined that the after-tax cash flows for the project will be Rs.10,000;

Rs.12,000; Rs.15,000; Rs.10,000; and Rs.7,000, respectively, for each of the

Years 1 through 5. The initial cash outlay will be Rs.40,000.

4-5

Independent Project

• IndependentIndependent -- A project whose acceptance (or rejection) does not prevent the acceptance of other projects under consideration.

For this project, assume that it is independent of any other potential projects that Basket Wonders may undertake.

4-6

Other Project Relationships

• Mutually ExclusiveMutually Exclusive -- A project whose acceptance precludes the acceptance of one or more alternative projects.

DependentDependent -- A project whose acceptance depends on the acceptance of one or more other projects.

4-7

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRR is the discount rate that equates the present value of the future net cash flows from an

investment project with the project’s initial cash outflow.

4-8

IRR Solution IRR Solution

Find the interest rate (IRR) that causes the discounted cash flows to equal Rs. 40,000.

4-9

IRR Solution (Try 15%)IRR Solution (Try 15%)

4-10

IRR Solution (Try 10%)IRR Solution (Try 10%)

4-11

.10 Rs. 41,444.05 IRR Rs. 40,000 Rs.

4,603.15 Rs. 36,841

X Rs. 1,444.05 Rs. 4,603

IRR Solution (Interpolate)IRR Solution (Interpolate)

Rs. 1,444X

=

4-12

.10 Rs. 41,444.05 IRR Rs. 40,000 Rs.

4,603.15 Rs. 36,841

(Rs. 1,444)(0.05) Rs. 4,603

IRR Solution (Interpolate)IRR Solution (Interpolate)

Rs. 1,444X

X = X = .0157

IRR = .10 + .0157 = .1157 or 11.57%

4-13

IRR Acceptance CriterionIRR Acceptance Criterion

No! The firm will receive 11.57% for each dollar invested in this project at a cost of

15%. [ IRR < Hurdle Rate ]

No! The firm will receive 11.57% for each dollar invested in this project at a cost of

15%. [ IRR < Hurdle Rate ]

The management of Basket Wonders has determined that the discount rate is 15%

for projects of this type. Should this project be accepted?

4-14

IRR Strengths and Weaknesses

IRR Strengths and Weaknesses

StrengthsStrengths: : – Accounts for

TVM– Considers all

cash flows– Less

subjectivity

StrengthsStrengths: : – Accounts for

TVM– Considers all

cash flows– Less

subjectivity

WeaknessesWeaknesses: : – Assumes all cash

flows reinvested at the IRR

– Difficulties with project rankings and Multiple IRRs

4-15

Multiple IRR Problem*Multiple IRR Problem*

Two!! Two!! There are as many potential IRRs as there are sign changes.

Two!! Two!! There are as many potential IRRs as there are sign changes.

Let us assume the following cash flow pattern for a project for Years 0 to 4:

-$100 +$100 +$900 -$1,000How many How many potentialpotential IRRs could this project IRRs could this project

have?have?

4-16

Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Return (MIRR)

When IRR fails and there are non-normal cash flows then we use a modified

technique Called as MIRR

4-17

Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Return (MIRR)

• Plot timeline separately for Cash inflows and outflows

• Discount all cash outflows to present value at r• Compound all cash inflows to Future value at r• Use the formula to get the answer

4-18

Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Return (MIRR)

4-19

Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Return (MIRR)

4-20

MIRR Acceptance CriterionMIRR Acceptance Criterion

No! The MIRRMIRR is less than discount rate. This means that the project is not profitable.

[Reject Reject as MIRR < rMIRR < r]

No! The MIRRMIRR is less than discount rate. This means that the project is not profitable.

[Reject Reject as MIRR < rMIRR < r]

Should this project be accepted?

4-21

Profitability Index (PI)Profitability Index (PI)

PI is the ratio of the present value of a project’s future net cash flows to the

project’s initial cash outflow.

4-22

Profitability Index (PI)Profitability Index (PI)

4-23

PI Acceptance Criterion PI Acceptance Criterion

No! The PIPI is less than 1.00. This means that the project is not profitable.

[Reject Reject as PIPI < 1.001.00 ]

No! The PIPI is less than 1.00. This means that the project is not profitable.

[Reject Reject as PIPI < 1.001.00 ]

Should this project be accepted?

4-24

PI Strengths and WeaknessesPI Strengths and Weaknesses

StrengthsStrengths::– Same as NPV– Allows comparison of different scale projects

StrengthsStrengths::– Same as NPV– Allows comparison of different scale projects

WeaknessesWeaknesses::– Same as NPV– Provides only relative profitability

4-25

Evaluation Summary

Method Project Comparison Decision

PBP 3.3 3.5 Accept

IRR 11.47% 15% Reject

NPV -$1,424 $0 Reject

MIRR 13.11% 15% Reject

PI .96 1.00 Reject

Basket Wonders Independent Project

4-26

Potential Problems Under Mutual Exclusivity

Potential Problems Under Mutual Exclusivity

A. Scale of InvestmentA. Scale of InvestmentB. Cash-flow PatternB. Cash-flow PatternC. Project LifeC. Project Life

A. Scale of InvestmentA. Scale of InvestmentB. Cash-flow PatternB. Cash-flow PatternC. Project LifeC. Project Life

Ranking of project proposals may create contradictory results.

4-27

A. Scale DifferencesA. Scale Differences

Compare a small (S) and a large (L) project.

NET CASH FLOWSProject S Project LEND OF YEAR

0 -Rs. 100 -Rs. 100,000

1 0 0

2 Rs. 400 Rs. 156,250

4-28

Scale DifferencesScale Differences

Calculate the PBP, IRR, NPV@10%, and PI@10%.

Which project is preferred? Why?

Project IRR NPV PI

S 100% Rs.231 3.31 L 25% Rs. 29,132 1.29

S 100% Rs.231 3.31 L 25% Rs. 29,132 1.29

4-29

B. Cash Flow PatternB. Cash Flow Pattern

Let us compare a decreasing cash-flow (D) project and an increasing cash-flow (I) project.

NET CASH FLOWSProject D Project IEND OF YEAR

0 -Rs. 1,200 -Rs. 1,200 1 1,000 100

2 500 600

3 100 1,080

4-30

D 23% Rs. 198 1.17Rs. 198 1.17 I 17% Rs. 198 1.17Rs. 198 1.17 D 23% Rs. 198 1.17Rs. 198 1.17 I 17% Rs. 198 1.17Rs. 198 1.17

Cash Flow PatternCash Flow Pattern

Calculate the IRR, NPV@10%, and PI@10%.

Which project is preferred?

Project IRR NPV PI

4-31

Examine NPV ProfilesExamine NPV Profiles

Discount Rate (%)0 5 10 15 20 25

-20

0

0

20

0

4

00

60

0

IRR

NPV@10%

Plot NPV for eachproject at various

discount rates.

Net

Pre

sen

t V

alu

e (

Rs.

)

4-32

C. Project Life DifferencesC. Project Life Differences

Let us compare a long life (X) project and a short life (Y) project.

NET CASH FLOWSProject X Project YEND OF YEAR

0 -Rs. 1,000 -Rs. 1,000 1 0 2,000

2 0 0

3 3,375 0

4-33

X 50% Rs. 1,536 2.54 Y 100% Rs. 818 1.82 X 50% Rs. 1,536 2.54 Y 100% Rs. 818 1.82

Project Life DifferencesProject Life Differences

Calculate the PBP, IRR, NPV@10%, and PI@10%.

Which project is preferred? Why?

Project IRR NPV PI

4-34

Summary

– The Capital Budgeting Process– Classification of Investment Project Proposals– Capital Budgeting Techniques

• Payback Period• Discounted Payback Period• Net Present Value• Internal Rate of Return• Modified Internal rate of return• Profitability index