Capital Budgeting Final (1)

7/31/2019 Capital Budgeting Final (1)

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Should webuild this

plant?

Capital Budgeting

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Presented by:

Krishna Jalan

Snehal Khannukar Sowmya C G

Chandasish Baissya

Shrey R Dhanawadkar2

Financial

Manage

ment

The Team


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Intro: Factors

Decision Making Criteria

Types of Projects:Process

Evaluation Criteria

Discounting Criteria:

NPVIRR

PI

Non-Discounting Criteria:PBP

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Capital budgeting is defined as The firms formal

process for the acquisition and investmentof capital.

Planning for purchasing long-term assets.

Consists of planning of the available capital to

maximize profits.

Definition


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Availability of funds.

Structure of capital.

Taxation policy.

Government policy.

Lending policies of financial institutions.

Immediate need of the project.


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Decision-Making Criteria in Capital Budgeting

How do we decide if

a capital

investment project

should be

accepted or

rejected?


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The Ideal Evaluation Method should:

a) Includes All cash flows that occur during the life

of the project.

b) Consider the Time value of money.

c) Incorporate the Required rate of return on the

project.

Contd


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Firms invest in Three types of projects:

Independent projects.

Mutually exclusive projects.

Contingent Investments.


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SELECTION PHASE

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PLANNING PHASE

PROPOSALS

ONLINE PROJECTS

PROJECTS

ACCEPTED PROJECTS

PROJECT TERMINATION

PROPOSALS

IMROVEMENTIN

PLANNINGANDEVALUATION

PROCEEDURE

NEWI

NVESTMENTOPPORTUNITIES

EVALUATION PHASE

IMPLEMENTATION PHASE

CONTROL PHASE

AUDITING PHASE

The Process


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EVALUATION CRITERIA

DISCOUNTING

CRITERIA

NON DISCOUNTING

CRITERIA

NET

PRESENT

VALUE

INTERNAL

RATE OF

RETURN

ACC. RATE

OF

RETURN

PAYBACK

PERIOD

PROBLTY

INDEX

(PI)

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MODIFIED

IRR

DISCD

PBP


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Discounting Criteria

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Decision Rule:

If NPV is positive, Accept.

If NPV is negative, Reject.

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Net Present Value Method

The total PV of the

annual net cash flowsThe initial outlay.


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Year Cash Flows NPV @ 14% PV @ 14%

0 -1100 1.000 -1100

1 358 0.877 313.966

2 246 0.769 189.174

3 325 0.675 219.375

4 385 0.592 227.92

5 467 0.519 242.373

6 349 0.456 159.144

TOTAL NPV 251.952


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Considers Time value of

money.

Relies on discount rate

and estimated cash

flows.

Consistent in maximizing

the owners wealth.

Merits

Demerits

Merits & Demerits of NPV

Difficult to ascertain

future cash flows.

Biased towards long

term projects.

May not give reliableresults while dealing

with projects under

unequal project life.

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Also known as the Marginal Rate of Return or

Time Adjusted Rate of Return.

It is the discount rate at which the present value of

cash inflows equals the present value of cash

outflows. i.e. NPV = 0

The rate of discount is determined by the Trial and

Error method.

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Internal Rate Of Return Method


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Year Cash Flows IRR @ 22.21% PV @ 22.21%

0 -1100 1.000 -1100

1 358 0.818 292.844

2 246 0.709 174.414

3 325 0.565 183.625

4 385 0.448 172.48

5 467 0.366 170.922

6 349 0.300 104.7

TOTAL NPV (1.015)


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If IRR is greater than or equal to the required rate of

return, ACCEPT.

If IRR is less than the required rate of return, REJECT.

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Considers Working

Capital and Scrap

value

Considers cash flows

during the whole

project life.

Maximizes the wealth

of the equity share

holders.

Merits

Demerits

Lengthy, Based on

trial & error

Assumes that future

cash flows are

reinvested at the rate

equal to IRR

NPV is more reliable.

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Merits & Demerits of IRR


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The calculation of the IRR implicitly assumes

that the cash flows are reinvested at the IRR.This may not always be realistic.

Percentages can be misleading (would you rather

earn 10% on a Rs.100 investment, or 10% on a

Rs.10,000 investment?)


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NPV and IRR do not always select the same project

in mutually exclusive decisions.

In the event of a conflict the selection of the NPV

method is preferred.

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The modified internal rate of return (MIRR) is the

compound average annual rate that is calculated

with a reinvestment rate different than the projects

IRR.

Therefore, MIRR more accurately reflects the

profitability of a project.

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MIRR correctly assumes reinvestment at opportunitycost.

MIRR also avoids the problem of multiple IRRs.

Managers prefer MIRR method better for this thanIRR.

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The Ratio of payoff to investment.

Also known as The Benefit cost ratio is the present

value of forecasted future cash flows divided by the

initial investment:

PROFITABILITY

INDEX

P/V OF CASH INFLOW

INITIAL CASH OUTFLOW

Profitability Index


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Year Cash Flows NPV @ 14% PV @ 14%

0 -1100 1.000 -1100

1 358 0.877 313.966

2 246 0.769 189.174

3 325 0.675 219.375

4 385 0.592 227.92

5 467 0.519 242.373

6 349 0.456 159.144

TOTAL CASH INFLOW 1351.93

PI:

1351.93

1100= 1.22:1


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Accept the project when PI is greater than one.

PI > 1

Reject the project when PI is less than one.

PI < 1 May accept the project when PI is equal to one.

PI = 1

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Allows comparison of

different scale projects

Undertakes Time value

of money

Provides only relative

profitability

Potential Ranking

Problems

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Merits & Demerits of PI

Merits

Demerits


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The discounted payback period is the number of

periods taken in recovering the investment outlay on

the present value basis.

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Discounted Payback

0 1 2 3 4 5

(500) 250 250 250 250 250

Discounted CF

Year Cash Flow @ (14%)

0 -500 -500.00

1 250 219.30 1 year280.70

2 250 192.38 2 years

88.32

3 250 168.75 .52 years

The Discounted Payback

is 2.52 years


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Discounts the cash flows

at the firms required rate

of return.

Payback period is

calculated using these

discounted net cash

flows.

Still does not

examine all cash

flows.

Difficult to ascertain

future cash flows.

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Merits & Demerits of DPBP

Merits

Demerit

s


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Non Discounting Criteria

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Defined as the numbers of years required to cover theoriginal cost outlay.

INITIAL INVESTMENT

ANNUAL CASH FLOW

Payback Period


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Cash out flow = 1100

crores

Cash IN Flow Year Amt in crore

1st Year 3582nd

Year 246 929 3 years

3rd

Year 325 +

4thYear 385

171/385=0.44 0.44

5th

Year 467

6th

year 349 3.44 years


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Simple.

Emphasizes on earlier

cash flows.

Selection or rejection

of any project is easier.

Best suited for

evaluating high-risks

projects.

ADVANTAG

ES

DISADVANTA

GES

Ignores cash after thepayback period.

Fails to consider time

value of the money

Based on the principle

of rule of thumb.

No recognition for the

pattern of cash flows &

its timing.

Merits & Demerits of PBP


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Project Investment is judged by looking at its rate of

return on book value.

Evaluates return on accounting profits. i.e. on accrual

basis. Annual returns are expressed in percentage of net

investment.

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AVERAGE PROFIT AFTER TAX

AVERAGE INVESTMENT

AVERAGE RATE OF

RETURN 100

Average Rate Of Return


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Project A: Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70

Step 2: Year 1 2 3

Cash Inflow (+) 91 130 105

Salvage Value (+) 10Depreciation* -70 -70 -70

Accounting Income 16 60 45

Step 3:

Average Accounting Income ( 16 + 60 + 45 )

3

Step 4:

Accounting Rate of Return 40.333

220

= 40.333

= 8.3%


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Project B:

Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60

Step 2: Year 1 2 3

Cash Inflow 87 110 84

Salvage Value 18Deprecation* -60 -60 -60

Accounting Income 27 50 42

Step 3:

Average Accounting Income = ( 27 + 50 + 42 )3

Step 4:

Accounting Rate of Return = 39.666

198

Average Rate Of Return

= 39.666

=20.0%


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Simple. Considers value of project to

its economic life.

Easy to calculate using the

accounting data.

Ensured earnings of

profitability of the project

using net earnings concept.

Merits

Demerit

s

It can be affected by non-cash items such as

depreciation & bad debts

Fails to consider timevalue of money.

Ignores the fact that

profits earned can be

reinvested.

Can be calculated in awide variety.

Merits & Demerits of ARR


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ips

Thank YouOpen for Queries

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Capital Budgeting Final (1)