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7/30/2019 14120 Capital Budgeting
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CAPITAL BUDGETING-INVESTMENT DECISION
Prepared by Sumit Goyal - LPU
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CONTENTS
Introduction
Techniques of capital budgeting Accounting Rate of Return Method
Payback Period Method Net Present Value (NPV) Method Internal Rate Return (IRR) Method
Issues with IRR Multiple IRRs
Mutually Exclusive Projects Advantages of NPV Method Advantages of IRR Method
Modified IRR Method
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LEARNING OBJECTIVES
Understand the nature and importance of investment
decisions
Explain the methods of calculating net present value (NPV)
and internal rate of return (IRR)
Show the implications of net present value (NPV) and
internal rate of return (IRR)
Describe the non-DCF evaluation criteria: payback and
accounting rate of return
Illustrate the computation of the discounted payback
Compare and contrast NPV and IRR and emphasize the
superiority of NPV rule
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Nature of Investment Decisions
The investment decisions of a firm aregenerally known as the capital budgeting, orcapital expenditure decisions.
The firms investment decisions wouldgenerally include expansion, acquisition,
modernisation and replacement of the long-term assets. Sale of a division or business(divestment) is also as an investment decision.
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Nature of Investment Decision
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 firms expenditures and benefits, and
therefore, they should also be evaluated as
investment decisions.
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Capital Budgeting
Capital budgeting decisions relate to acquisition of
assets that generally have long-term strategic
implications for the firm. Capital budgeting decisions become fairly intricate
as it impacts other areas of corporate finance like
capital structure, dividends and cost of capital.
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Features Of Capital Budgeting Decision
Capital budgeting decisions are characterized by:
Non-reversible,
Large initial outflow followed by small periodic inflows,
Information gap and inexperience,
Strategic and risky in nature,
No scope of learning and correcting from pastexperience,
Little flexibility.
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CAPITAL BUDGETING PROCESS
Identification of investment proposals - where
Screening and evaluation of the proposals
Fixing priorities Final approval and preparation of capital
expenditure budget
Implementing proposals
Performance review
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Investment Evaluation Criteria
Three steps are involved in the evaluation of
an investment:
1. Estimation of cash flows2. Estimation of the required rate of return (the
opportunity cost of capital)
3. Application of a decision rule for making the
choice
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Types Of Projects
Small vs Large Projects
New vs Expansion Projects
Independent and Mutually Exclusive projects Mutually exclusive projects are those where acceptance of
one implies automatic rejection of the other.
Research & Development and Mandatory Projects
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Techniques Of Evaluation
The methods of financial evaluation of the projects are
categorized into two:
Discounted Cash Flow (DCF) techniques and
Non DCF techniques.
DCF techniques value the projects with time value of money
and include a) NPV Method and b) IRR Method
Non-DCF based techniques of a) Accounting Rate of Return
and b) Pay Back Period.
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Evaluation Criteria
1. Non-discounted Cash Flow Criteria
Payback Period (PB)
Accounting Rate of Return (ARR)
2. Discounted Cash Flow (DCF) Criteria
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Discounted payback period (DPB)
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PAYBACK
Payback is the number of years required to recover theoriginal cash outlay invested in a project.
If the project generates constant annual cash inflows, the
payback period can be computed by dividing cash outlay by
the annual cash inflow. That is:
C
C
InflowCashAnnual
InvestmentInitial=Payback 0
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Example
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:
years412,000Rs
50,000RsPB
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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.
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 projects
payback?
3 years + 12 (1,000/3,000) months
3 years + 4 months
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Acceptance Rule
The project would be accepted if its paybackperiod is less than the maximum or standardpaybackperiod set by management.
As a ranking method, it gives highest rankingto the project, which has the shortest paybackperiod and lowest ranking to the project withhighest payback period.
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Payback Period Method
Payback period of the project is the amount of timerequired to recover the original investment.
Payback period for the project is 2 years.
Prepared by Sumit Goyal - LPU
Initial cash outflow 10,00,000
Cash inflows 1st Year 3,00,000
2nd Year 5,00,000
3rd Year 4,00,000
4th Year 5,00,000
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Payback period
A company is planning a major investment to expand its
current manufacturing of digital clocks with initial outlay of Rs
350 Lakh. The finance department has projected a following
cash flows over the next 7 years are, 100, 150, 400, 450, 300,
250, 50.
What is the payback period of the project?
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Evaluation of Payback
Certain virtues: Simplicity
Cost effective
Short-term effects
Risk shield Liquidity
Serious limitations:Cash flows after payback
Cash flows ignoredCash flow patterns
Administrative difficulties
Inconsistent with shareholder value
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Accounting Rate Of Return
Accounting Rate of Return is defined as average profit as% of average investment over the life of the project
It is merely a number, which reflects the worthiness of theproject in absolute terms.
To enable the firm make a conscious decision whether to
accept or reject a proposal, it needs to be compared withsome acceptance/ rejection criteria.
Prepared by Sumit Goyal - LPU
InvestmentAverage
ProfitAverage
=ReturnofRateAccounting
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ACCOUNTING RATE OF RETURN
METHOD
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.
A variation of the ARR method is to divide average earnings
after taxes by the original cost of the project instead of the
average cost.
or
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Example
A project will cost Rs 40,000. Its stream of
earnings before depreciation, interest and
taxes (EBDIT) during first year through five
years is expected to be Rs 10,000, Rs 12,000,Rs 14,000, Rs 16,000 and Rs 20,000. Assume a
50 per cent tax rate and depreciation on
straight-line basis.
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Calculation of Accounting Rate of
Return
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Practical Problem
A company is considering a proposal to purchase a new
machine. The equipment would involve a cash outlay of Rs.
5,00,000 and working capital of Rs. 60,000. the expected life
of the project is 5 years. Depreciation method is straight line
method.
The estimated before tax cash inflow (earnings before
depreciation and tax) are as 180000, 220000, 190000,
170000, 140000.
The applicable tax rate is 35%.
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Acceptance Rule
This method will accept all those projectswhose ARR is higher than the minimum rateestablished by the management and reject
those projects which have ARR less than theminimum rate.
This method would rank a project as numberone if it has highest ARR and lowest rankwould be assigned to the project with lowestARR.
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Accounting Rate Of Return
The advantage of the method is its simplicity of calculation
Limitations
Subjective Approach
Ignore Time Value of Money
Not Based on Cash Flow
Inconsistent definition
Pre tax or post tax
Accounting basis
Total investment or equity
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Discounted Cash Flow Methods
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DISCOUNTED PAYBACK
PERIOD The discounted payback period is the number of periods
taken in recovering the investment outlay on the present
value basis.
The discounted payback period still fails to consider thecash flows occurring after the payback period.
Discounted Payback Illustrated
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Net Present Value Method
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.
Present value of cash flows should be calculated using the
opportunity cost of capital as the discount rate.
Net present value should be found out by subtracting present
value of cash outflows from present value of cash inflows. The
project should be accepted if NPV is positive (i.e., NPV > 0).
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Steps And Meaning Of NPV
1. Estimate the initial cost to implement the project, CF0,
2. Estimate the cash flows of the project for each period over itslife, CFt,
3. Sum the discount the cash flows at an appropriate rate toarrive at present value of the cash flows,
4. Subtract the initial investment from the present value to getthe Net Present Value of the project.
NPV is value created by the acceptance of the project. It
reflects the increase in the market value of the firm.
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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; the one with the higher NPV should be
selected.
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Calculating Net Present Value
Assume that ProjectXcosts Rs 2,500 now and is expected togenerate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs
600 and Rs 500 in years 1 through 5. The opportunity cost of
the capital may be assumed to be 10 per cent.
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Practical Problem
A company is considering investment in a project that costs Rs. 200000.
the project has an expected life of 5 years and zero salvage value. The
company uses SLM of depreciation. The companys tax rate is 40%. .
Prepared by Sumit Goyal - LPU
Year EBDT1 70000
2 80000
3 120000
4 90000
5 60000
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Practical Problem
A company is considering a proposal to purchase a new
machine. The equipment would involve a cash outlay of Rs.
5,00,000 and working capital of Rs. 60,000. the expected life
of the project is 5 years. Depreciation method is straight line
method. The estimated before tax cash inflow (earnings before
depreciation and tax) are as 180000, 220000, 190000,
170000, 140000.
The applicable tax rate is 35%.
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Computing NPV
Project A
Year Cash flow Present Value at 10%
Year 0 -10,00,000 -10,00,000
Year 1 5,00,000 5,00,000/1.1 = 4,54,545
Year 2 5,00,000 5,00,000/1.12 = 4,13,223
Year 3 5,00,000 5,00,000/1.13 = 3,75,657
NET PRESENT VALUE 12,43,425 10,00,000
= 2,43,425
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Computing NPV
Project B
Year Cash flow Present Value at 10%
Year 0 -10,00,000 -10,00,000
Year 1 8,00,000 8,00,000/1.1 = 7,27,273
Year 2 2,00,000 2,00,000/1.12 = 1,65,289
Year 3 8,00,000 8,00,000/1.13 = 6,01,052
NET PRESENT VALUE 14,93,614 10,00,000
= 4,93,614
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Computing NPV
Projects A & B Combined
Year Cash flow Present Value at 10%
Year 0 -20,00,000 -20,00,000
Year 1 13,00,000 13,00,000/1.1 =11,81,818
Year 2 7,00,000 7,00,000/1.12 = 5,78,512
Year 3 13,00,000 13,00,000/1.13 = 9,76,709
NET PRESENT VALUE 27,37,039 20,00,000
= 7,37,039
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Additive Property Of NPV
NPVs of different projects can be added to arrive attotal NPV.
NPV (A+B) = NPV (A) + NPV (B) Additive property of NPVs helps in isolating the
impact that each project makes on the value of thefirm.
NPV of Project A 2,43,425NPV of Project B 4,93,614
NPV of A & B Combined 7,37,039
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Profitability index
Profitability index= present value of inflows/
present value of outflows
Net profitability index = P.I -1
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Advantages
In which different costs are there we can not
rank as NPV method so profitability index can
be used for the same.
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Internal Rate Of Return (IRR) Method
Internal Rate of Return (IRR) of the project is that rate of
return at which the net present value is zero.
For a project outlay of Rs. 200 and cash inflows for next 2 years
at Rs 110 and Rs 121, the IRR may be found as follows:
Prepared by Sumit Goyal - LPU
0
n
1t
t
CFr)+(1
CF
200rr1
110
2)1(
121
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IRR Decision Rule And NPV
Decision Rule:
The IRR of the project is 10%. It is compared with the
cost of capital to make judgment about its desirability.
ACCEPT IF IRR > COST OF CAPITAL
REJECT IF < COST OF CAPITAL
It is the maximum discount rate that the cash flows of
the project can support.
= 101.85 +103.74 200 = Rs 5.59
Prepared by Sumit Goyal - LPU
200-1.08
110=NPVValue,PresentNet
208.1
121
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Practical Problem
Suggest the company whether they should invest in the
project or not as per
1. Pay back period method2. Discounted pay back period method
3. Net present value
4. Internal rate of return5. Accounting rate of return.
6. Net Profitability index
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Practical Problem
A company is considering a proposal to purchase a new
machine. The equipment would involve a cash outlay of Rs.
5,00,000 and working capital of Rs. 60,000. the expected life
of the project is 5 years. Depreciation method is straight line
method. The estimated before tax cash inflow (earnings before
depreciation and tax) are as 180000, 220000, 190000,
170000, 140000.
The applicable tax rate is 35%.
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NPV And Discount Rate
As discount rate increases NPV falls.
The discount rate at which NPV is zero is called IRR.
Prepared by Sumit Goyal - LPU
Net PresentValues & Discount Rate
(20.00)
-
20.00
40.00
60.00
80.00
0 10 20 28.23 35
Discount Rate (%)
NPV
d l
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NPV And IRR Decision Rules
A Comparison
As per NPV rule:
The project is accepted as long as the discount rate is below28.23% because the net present value remains positive tillthen.
It is rejected for discount rate beyond 28.23%.As per IRR rule:
The project is accepted as long as cost of capital remainsbelow 28.23%, the IRR of the project.
It is rejected if cost of capital exceeds 28.23%.
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Advantages Of NPV Method
Simplicity of NPV
Re-investment rate
The implied assumption of IRR method is thatinterim cash flows are reinvested at IRR itself.
NPV method assumes reinvestment at discountrate. This assumption of IRR is challenged as itdefies conservatism
Flexibility in choosing discount rate
Measuring wealth creation Ranking of the project in capital rationing situation
Unambiguous acceptance and rejection criterion makes NPV rulesuperior to IRR rule.
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Advantages Of IRR Method
Despite its conflicts and drawbacks, IRR remains a popular
method of evaluation of projects because of Its ability to compare projects without the consideration of
discount rate, Easier comprehension.
Cost of capital not required to find IRR. It is required to makeselection or rejection decision. For comparative purposes noneed to know the cost of capital.
Priority for early cash flows.
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Inflation And Capital Budgeting
The principle of consistency in capital budgeting
demands that
nominal cash flows are discounted at nominaldiscount rate
real cash flows are discounted at real discount
rate.