Capital Budgeting Technique (1)

8/9/2019 Capital Budgeting Technique (1)

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Capital Budgeting Decisionsor

Investment Decisions


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• The investment decisions of a rm are generallyknown as capital budgeting.

• A capital budgeting decisions may be denedas the rms decisions to invest its currentfunds most e!ciently in the long term assets in

anticipation of an e"pected #ow of benets overa series of years.

• The rms investment decisions would generally

include expansion$ acquisition$modernisation and replacement of the long%term assets. &ale of a division or business'divestment( is also as an investment

decision.


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&teps in Capital Budgeting)rocess

• &tep I* )roposal +eneration

• &tep II* ,eview - Analysis

•

&tep III* Decision aking• &tep I/* Implementation

• &tep /* 0ollow%up


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Investment Decision or )ro1ect 2valuation

• A pro1ect is characteri3ed by a set of

periodic benets and costs involved.• )ro1ect evaluation is estimating the

worth of the pro1ect when compared

with alternate investment opportunity.• In order to take informed decisions$ the

benets and costs should be measured

in the same denomination.• 4orth of a pro1ect is simply the net

benet through the pro1ect.


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• The rms value will increase ifinvestments are protable and add to

the shareholders wealth.

• Thus$ investment should be evaluated

on the basis of a criteria$ which iscompatible with the ob1ective ofshareholders wealth ma"imi3ation.

• An investment will add to theshareholders wealth if its yields

benets in e"cess of cost of capital.


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&teps to evaluate of an investment

5. 2stimation of cash #ows.

6. 2stimation of the re7uired rate of return'the opportunity cost of capital(.

8. Application of a decision rule for

making the choice.


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Investment decisions rule

• It should provide for an ob1ective and

unambiguous way of separating goodpro1ects from bad pro1ects.

• It should help ranking of pro1ectsaccording to their true protability.

• It should help to choose amongmutually e"clusive pro1ects that pro1ectwhich ma"imises the shareholders

wealth.


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Evaluation Criteria

–

)ayback )eriod ')B( – Discounted payback period 'D)B(

– :et )resent /alue ':)/(

– Internal ,ate of ,eturn 'I,,(

– )rotability Inde" ')I(

– Accounting ,ate of ,eturn 'A,,(


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PAYBACK Period• Payback period is the number of

years re7uired to recover the originalcash outlay invested in a pro1ect.

• 2"ample* Assume that a pro1ectre7uires an outlay of ,s ;


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• Unequal cash o!s" In case of une7ual cashin#ows$ the payback period can be found out by

adding up the cash in#ows until the total is e7ualto the initial cash outlay.

• &uppose that a pro1ect re7uires a cash outlay of

,s.6


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• Certain virtues* – &implicity

– Cost eEective

• &erious vices*Cash #ows after payback

Time value of money

Discounted )ayback )eriod*


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:et )resent /alue

• It is the diEerence between the sum ofthe present value of future net cashin#ows - the initial investment.

• Decision rule*

• :)/ F < * Accepted

• :)/ G < * ,e1ected

• :)/ H < * IndiEerent


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:et )resent /alue

• The formula for the net present valuecan be written as follows*

∑=

−

+

=

−

+

+++

++

++

=

n

t

t

t

n

n

I

k

C

I k

C

k

C

k

C

k

C

1

0

0"

"

2

21

#1$

%P&

#1$#1$#1$#1$ %P&


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2"ample• Assume there are two mutually e"clusive pro1ects

with similar initial investment of ,s.;$56; and

e"pected life of ;years but diEerent e"pected cash#ows. The cost of capital is 5


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achine A

'ear Cash (low Present &alue ) 10* P& of C(

0 +5,125 1-000

1 14,000 0-.0. 12,/2

2 1,000 0-2 1",21

" 1,000 0-/51 1",51

4 20,000 0-" 14,0

5 25,000 0-21 15,525

otal .,45


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achine B

'ear Cash (low Present &alue ) 10* P& of C(

0 +5,125 1-000

1 22,000 0-.0. 1.,..

2 20,000 0-2 1,520

" 1,000 0-/51 1",51

4 1,000 0-" 10,.2

5 1/,000 0-21 10-55/

otal /1,521


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• :)/ of achine A H ,s.58$;6< i.e. ,s.'K$@; L;$56;(

• :)/ of achine B H ,s.5;$8K i.e. ,s.'=5$;65L

;$56;(

• $imitations" –

,anking of pro1ects* as per the :)/ rule is notindependent of discount rates.

Two pro1ects A - B both costing ,s.;


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:)/ Mimitations ContN

• The :)/ is e"pressed in absoluteterms - hence does not factor thescale of investment.

• :)/ rule is biased in favor of the longterm pro1ect.


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Internal ,ate of ,eturn• The internal rate of return 'I,,( is the

rate that e7uates the investmentoutlay with the present value of cashin#ow received after one period. This

also implies that the rate of return isthe discount rate which makes :)/ H


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• Accept L ,e1ect decision*

• The higher is better.

•

&hould more than cut%oE rate re7uired rate of return.

l l i f


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Calculation of I,,

• 4hen Cash 0lows structure is annuity

•

&tep 5* Determine the payback period• &tep 6* Check )/I0A table

• &tep 8* 0ind the two )ay back value$ one is higher -one is lower

•

&tep @* Determine I,, by interpolation2"ample* Met us assume that an investment would cost,s 6


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'ear 3achine A 3achine !

0 +5,125 +5,125

1 14,000 22,000

2 1,000 20,000" 1,000 1,000

4 20,000 1,000

5 25,000 1/,000

otal .",000 .",000


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&electing a +uidance ,ate

• Computation" 0or the mi"edstream of cash #ow structure*

• &tep 5* Calculate the average annualcash in#ows

• &tep 6* Determine the Ofake paybackperiod

• &tep 8* Mook at the )/I0A table

• &tep @* 0ind the guidance rate.


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achine A P5KJ

'ear Cash (low P& )1.* P& of C(

0 +5,125 1-000 + $5,125#

1 14,000 0-40 11,/0

2 1,000 0-/0 11,2.

" 1,000 0-5." 10,/4

4 20,000 0-4.. .,.05 25,000 0-41. 10,4/5

%et + $1.40#


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achine A P5=J

'ear Cash (low P& )1/* P& of C(

0 +5,125 1-000 + $5,125#

1 14,000 0-55 11,./0

2 1,000 0-/"1 11,.

" 1,000 0-24 10,2"2

4 20,000 0-5"4 10,0

5 25,000 0-45 11,400

%et 5"


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achine B P5KJ

'ear Cash (low P& )1.* P& of C(

0 +5,125 1-000 + $5,125#

1 22,000 0-4 1,40

2 20,000 0-/0 14,120

" 1,000 0-5." 10,/4

4 1,000 0-4.. /,.4

5 1/,000 0-41. /,12"

%et 225


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achine B P65J

'ear Cash (low P& )21* P& of C(

0 +5,125 1-000 + $5,125#

1 22,000 0-2 1,1/2

2 20,000 0-" 1",0

" 1,000 0-54 10,152

4 1,000 0-4 /,45

5 1/,000 0-"5 ,545

%et +140


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lti l I,, : ti l C h 0l


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ultiple I,,s L :on%conventional Cash 0lows

• Conventional pro1ects cash #owsinitially have single cash out#owsfollowed by several net cash in#owsover the life of the pro1ects.

• There are some pro1ects that may havemore than one net cash out#ow duringthe life of the pro1ect.

• 2"ample*

Year . ( - 0 1

%;6 %


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• odied I,, is the solution to thenon%conventional cash #ows.


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:)/ /s. I,,

C. C( C- C0 C1 %&& 2P34(.,

Q %5$5


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)rotability Inde"

• )rotability inde" is the ratio of the

present value of cash in#ows$ at there7uired rate of return$ to the initialcash out#ow of the investment.

•

)I H '&um of )/ of cash in#ows( InitialSut#ow

• Accept L re1ect decision*

•

BC, )I F 5 accepted• BC, )I G 5 re1ected

i f


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Accounting ,ate of ,eturn• The accounting rate of return is the ratio of

the average after%ta" prot divided by theaverage investment.

• igher is better.

2"ample*• A pro1ect will cost ,s.@


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Calculation o5 Accounting &ateo5 &eturn

Period ( - 0 1 6

Earnings be5ore %nterest7epn* And 8ax

(.9...

(-9...

(19...

(+9...

-.9...

7epreciation :9... :9... :9... :9... :9...

Earning be5ore %nterestand 8ax

-9... 19... +9... :9... (-9...

$ess" 8ax 4 6., (9... -9... 09... 19... +9...

Earning a5ter %nterest and8ax

(9... -9... 09... 19... +9...

Average After Ta" prot H 5$


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Comparing utually 2"clusive )ro1ectswith Une7ual lives

Year Pro#ectA

Pro#ectB

< =


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Annuali3ed :)/ or 27uivalentAnnuity Approach

• A:)/ H

• &elect the pro1ect with highest A:)/

• A:)/A H H H @$;68

• A:)/BH H H @$8;K

•

Th ) i f C i l B d i


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The )ractice of Capital Budgeting

, Al!ays orAlmostAl!ays

Internal ,ate of

,eturn

=;.J

:et )resent /alue [email protected]

)ay%back )eriod ;.=J

Discounted )ayback)eriod

6K.;J

Accounting ,ate of,eturn

8

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Capital Budgeting Technique (1)