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describes capital budgeting and its methods
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Capital
Budgeting
TATA motors plans to set up car plants at Bangalore, Nashik
TATA steel acquired Corus
King Fisher Airlines planning to buy 26 aircrafts
Bank planning to computerize all its Branches
Emcure planning to set up a R& D centre for treatment of HIV/ Aids
GMR Infra structure plan to raise Rs 3000 Crs through leasing
What is common in these statements ?
Capital Expenditure
It involves a current outlays (and future too) of funds in the expectation of a streamof benefits extending far into future
Capital Expenditure- features
Long term consequences
Involve substantial outlays
Difficult or expensive to reverse
Benefits/risk
spending
Typical Capital ExpenditureDecisions
Plant expansionPlant expansion
Equipment selectionEquipment selection Equipment replacement
Lease or buyLease or buy Cost reductionCost reduction
Production Marketing
FinanceHuman
Resource
Capital Budgeting
Strategic InvestmentsFinancing InvestmentsAllocating Capital
Capital Budgeting
Capital Budgeting Process
Project Classification
Investment Criteria
Capital Budgeting Process
Identification of potential investment opportunitiesAssembling of proposed investments Decision Making Preparation and appropriation of Capital Budgets Implementation Performance Review
Projects Classification
• Mandatory Investments• Replacement Projects• Expansion Projects• Diversification Projects• Research & Development Projects• Miscellaneous Projects
InvestmentCriteria
Non-DiscountingCriteria
DiscountingCriteria
NPV BCR IRR
DPB ARRPBP
Non Discounting Methods
1 1 The Payback Period Method. The Payback Period Method.
22 Discounted Payback period. Discounted Payback period.
3 3 Accounting Rate of Return Accounting Rate of Return
1 1 The Payback Period Method. The Payback Period Method.
22 Discounted Payback period. Discounted Payback period.
3 3 Accounting Rate of Return Accounting Rate of Return
The Payback Method
TheThe payback periodpayback period is the length of time is the length of time that it takes for a project to recover its that it takes for a project to recover its initial cost out of the cash receipts that initial cost out of the cash receipts that it generates.it generates.
TheThe payback periodpayback period is the length of time is the length of time that it takes for a project to recover its that it takes for a project to recover its initial cost out of the cash receipts that initial cost out of the cash receipts that it generates.it generates.
The Payback Method
When the net annual cash inflow is the same When the net annual cash inflow is the same each year, this formula can be used to each year, this formula can be used to compute the payback period:compute the payback period:
When the net annual cash inflow is the same When the net annual cash inflow is the same each year, this formula can be used to each year, this formula can be used to compute the payback period:compute the payback period:
Payback period = Investment required Net annual cash inflow
The Payback Method
Management at The Holiday Inn wants to Management at The Holiday Inn wants to install an espresso bar in its restaurantinstall an espresso bar in its restaurant..
The espresso bar:The espresso bar:1.1. Costs Rs140,000 and has a 10-year life.Costs Rs140,000 and has a 10-year life.2.2. Will generate net annual cash inflows of Will generate net annual cash inflows of
Rs35,000.Rs35,000.
Management requires a payback period Management requires a payback period of 5 years or less on all investments.of 5 years or less on all investments.
What is the payback period for the What is the payback period for the espresso bar?espresso bar?
Management at The Holiday Inn wants to Management at The Holiday Inn wants to install an espresso bar in its restaurantinstall an espresso bar in its restaurant..
The espresso bar:The espresso bar:1.1. Costs Rs140,000 and has a 10-year life.Costs Rs140,000 and has a 10-year life.2.2. Will generate net annual cash inflows of Will generate net annual cash inflows of
Rs35,000.Rs35,000.
Management requires a payback period Management requires a payback period of 5 years or less on all investments.of 5 years or less on all investments.
What is the payback period for the What is the payback period for the espresso bar?espresso bar?
The Payback Period Method
Payback period = Payback period = Investment required Investment required Net annual cash inflowNet annual cash inflow
Payback period = Payback period = Rs140,000 Rs140,000 Rs35,000Rs35,000
Payback period = Payback period = 4.0 years4.0 years
According to the company’s criterion, According to the company’s criterion, management would invest in the management would invest in the
espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.
According to the company’s criterion, According to the company’s criterion, management would invest in the management would invest in the
espresso bar because its payback espresso bar because its payback period is less than 5 years.period is less than 5 years.
Evaluation of the Payback Method
Ignores the Ignores the time valuetime valueof money.of money.
Ignores cashIgnores cashflows after flows after the paybackthe payback
period.period.
ShortComings
Discounted Payback Period Method
Cash flow are first converted intotheir PV and than added to recoverthe initial outlay on the Project
Discounted Payback Period Method
Year Cash flow discounted factor PV 10%
0 -10000 1.000 -10000
1 3000 0.909 2727
2 3000 0.826 2478
3 4000 0.751 3004
4 4000 0.683 2732
5 5000 0.621 3105
6 2000 0.565 1130
7 3000 0.513 1539
Accounting Rate of Return (average rate of return)
Average Profit after Tax Average Book Value of the InvestmentARR=
Numerator may be measured as Average Annual Return over the life of the investment
Denominator may be measured is the average book value of fixed assets committed to the Project
Accounting Rate of Return (average rate of return) Average Profit after Tax Average Book Value of the InvestmentARR=
Year Book value of FA PAT
1 Rs 90000 RS200002 80000 220003 70000 240004 60000 260005 50000 28000
1/5 (20000+22000+24000+26000+28000)1/5 (90000+80000+70000+60000+50000)
=34%
ARR=34%
Discounting Cash flows techniques
Cash flows occurring at different point of time are not having same economic worth
Due to time value of Money
To make equal it must be discounted wrt to time gap
present value
npvof a project is the sum of thepresent value of all the cashflows- positive or negative-that are expected to occurover the life of the project
techniquesPresent Value or discounting
PV Tables Tables are available for various ranges of i and n
P= c (PVIF)WhereP is present valueC is future Cash flowPVIF is present value interest factor
PV of Mixed Stream of Cash flows
Year End Cash flows PV IF Present Value 10%
1 2 3 4
1 Rs 500 0.909 Rs 454.50
2 Rs 1,000 0.826 Rs 826.00
3 Rs 1,500 0.751 Rs 1,126.00
4 Rs 2,000 0.683 Rs 1,366.00
5 Rs 2,500 0.621 Rs 1,552.50
Rs 7,500 Rs 5,325.50
net present value
NPV of Project =
Ct=cash flow at the end of year t n= life of the project r= discount rate
n
∑ Ct
(1+r)tt=1
- Initial investment
net present value
Year cash flow
0 Rs (10,00,000)1 2,00,0002 2,00,000• 3,00,000• 3,00,000• 3,50,000
Cost of Capital is Rs 10,00,000,r for the firm is 10%
2,00,000+2,00,000+3,00,000 +3,00,000+3,50,000 (1.10)1 (1.10)2 ( 1.10)3 (1.104 (1.10)5NPV=
= 5273
- 1000000
net present value- decision rule
Year cash flow
-
NPV IS POSITIVE ACCEPT
NPV IS NEGATIVE REJECT
NPV IS ZERO INDIFFERENCE
Mutually Exclusive Proposals
Highest positive NPV TOP PRIORITYLowest NPV Low PriorityNegative NPV Rejected
Benefit Cost Ratio- profitability index
BCR= PVB I
NBCR=BCR-1
PVB= Present Value of Benefits I = Initial Investments
Initial investment Rs 100000Cost of Capital 12%Benefits Year 1 25000 year 2 40000 Year 3 40000 Year 4 50000
25000(if1)+40000(if2)+40000(if3)+50000(if4)=1.145 100000
BCR=
NBCR= BCR-1= 0.145When BCR or NBCR Rule is
>1 >0 Accept=1 =0 indifferent<1 <1 Reject
Internal Rate of Return
Internal Rate of Return Method
• The The IRRIRR is the rate of return is the rate of return expected expected from from an investment project over its an investment project over its useful life.useful life.
Internal Rate of Return Method
• The internal rate of return of a Project The internal rate of return of a Project is the discount rate that makes its is the discount rate that makes its net present value to be to be zero.
IRR
Investment = Ct(1+r)t
Ct =cash flow at the end of year t r = internal rate of Return n = life of the Project
∑nn
t=1
Example
Consider the cash flow of a company as follows
Year 0 1 2 3 4
Cash Flow (1,00,000) 30,000 30,000 40,000 45,000
For IRR
100,000 = 30000 + 30,000 + 40000 + 45,000 (1+r)1 (1+r)2 (1+r)3 (1+r)4
Let us take discount rate as 15%
100,802 = 30000 + 30,000 + 40000 + 45,000 (1+15) (1+15)2 (1+15)3 (1+15)4
Take R=16%
98,641= 30000 + 30,000 + 40000 + 45,000 (1+16) (1+16)2 (1+16)3 (1+16)4
Example Continued…..
Value lies between 15% and 16%
1 at 15% it is more by 8022 at 16% it is less by1359
Find sum of NPV value in absolute terms 802+1359 =2161
Ratio of smaller discount rate 802 2161
IRR= 15% + npv at 15%/Total difference x difference in rate
add the number to smaller discount rate
= 15.37%
=0.37
Q
The expected cash flows of a Project are as follows
Year Cash flows
0 -Rs 1000001 200002 300003 400004 500005 30000
The Cost of capital is 12%.Calculatea) NPVb) BCRc) IRRd) PBPe) DPBP
NPV=20000/(1.12)+30000/(1.12)2
+40000/(1.12)3 +50000/(1.12)4+30000/(1.12)
= 20000(.893)+30000(.797)+40000(.712)
+50000(.636) + 30000(.567)
=17860+23910+28480+31800+17010
= 119060
= 100000-119060
=19060
BCR= PVB I
=119060/100000 =1.19
IRR
At 18% of discount Rate the NPV IS Rs1750
At 19% of discount rate the NPV is –Rs 780
IRR IS
=18+1750/2530 =18.69%
Average Inflow 170000/5=34000PB =100000/34000 =2.9It lies between 18 &19% rate
Payback period
is slightly more than 3 years
Discounted Payback period
is slightly less than 4 years
thanks