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DR ANJANA RAJU

CAPITAL
INVESTMENTS
DR ANJANA RAJU
DR ANJANA RAJU
CAPITAL INVESTMENT
ANALYSIS PROCESS OF
CAPITAL BUDGETING
TECHNIQUES OF EVALUATION
PROJECT OF CASH FLOWS
ASSESSMENT OF RISK
ANALYSIS APPRAISAL

DR ANJANA RAJU
CAPITAL INVESTMENT
ANALYSIS PROCESS OF CAPITAL
BUDGETING
DR ANJANA RAJU
ANALYSIS PROCESS OF CAPITAL BUDGETING

INVESTMENT DECISIONS


OF FIRM KNOWN AS

CAPITAL BUDGETING
DR ANJANA RAJU
ANALYSIS PROCESS OF CAPITAL
BUDGETING
INVEST CURRENT FUNDS


MOST EFFICIENTLY IN


LONG-TERM ASSETS
DR ANJANA RAJU
ANALYSIS PROCESS OF CAPITAL BUDGETING
IMPORTANCE OF INVESTMENT DECISIONS
REQUIRE SPECIAL ATTENTION BECAUSE

GROWTH (ENDURE FOR LONGER PERIOD)

RISK ( LONG-TERM COMMITMENT OF FUNDS)

FUNDING (MAKE ARRANGEMENTS FOR PROCURING
FINANCES)

IRREVERSIBILITY






DR ANJANA RAJU
ANALYSIS PROCESS OF CAPITAL BUDGETING
IMPORTANT FEATURES OF INVESTMENT DECISIONS

EXCHANGE OF CURRENT FUNDS

..FOR FUTURE BENEFITS.

FUNDS INVESTED IN
LONG-TERM ASSETS

BENEFITS OCCUR TO FIRM
. OVER SERIES OF YEARS






DR ANJANA RAJU
CAPITAL INVESTMENT
TECHNIQUES OF EVALUATION
DR ANJANA RAJU
TECHNIQUES OF EVALUATION OF INVESTMENT
THREE STEPS ARE INVOLVED

1. ESTIMATION OF CASH FLOWS

2. ESTIMATION OF REQUIRED RATE OF RETURN

3. APPLICATION OF A DECISION RULE FOR MAKING
THE CHOICE (CAPITAL BUDGETING
TECHNIQUES)

DR ANJANA RAJU
CAPITAL BUDGETING TECHNIQUES
INVESTMENT CRITERIA


DISCOUNTING NON-DISCOUNTING
CRITERIA CRITERIA


NET PRESENT IRR PROFITABILITY DISCOUNTED
VALUE INDEX PAYBACK PERIOD


PAYBACK PERIOD ACCOUNTING
RATE OF RETURN






DR ANJANA RAJU
STEPS TO CAPITAL BUDGETING
1. ESTIMATE CFS (INFLOWS &
OUTFLOWS).
2. ASSESS RISKINESS OF CFS.
3. DETERMINE THE APPROPRIATE COST OF
CAPITAL.
4. FIND NPV AND/OR IRR.
5. ACCEPT IF NPV > 0 AND/OR IRR >
WACC.
DR ANJANA RAJU
WHAT IS THE DIFFERENCE BETWEEN
INDEPENDENT AND MUTUALLY EXCLUSIVE
PROJECTS?
PROJECTS ARE:
INDEPENDENT, IF THE CASH FLOWS OF
ONE ARE UNAFFECTED BY THE ACCEPTANCE
OF THE OTHER.
MUTUALLY EXCLUSIVE, IF THE CASH
FLOWS OF ONE CAN BE ADVERSELY
IMPACTED BY THE ACCEPTANCE OF THE
OTHER.
DR ANJANA RAJU
NON-DISCOUNTING
CRITERIA

DR ANJANA RAJU
PAYBACK METHOD
DR ANJANA RAJU
WHAT IS THE PAYBACK PERIOD?


THE NUMBER OF YEARS REQUIRED TO
RECOVER A PROJECTS COST,


OR HOW LONG DOES IT TAKE TO GET THE
BUSINESSS MONEY BACK?






DR ANJANA RAJU
HOW IS PAYBACK PERIOD CALCULATED?
PAYBACK PERIOD

= CALULATION OF INVESTMENT RECOVERY
TIME BY ACCUMULATION OF THE CASH
INFLOWS (INCLUSIVE OF DEPRECIATION) YEAR BY
YEAR UNTIL CASH INFLOW EQUAL THE AMOUNT
OF ORIGINAL INVESTMENT







DR ANJANA RAJU
HOW IS PAYBACK PERIOD CALCULATED?
PAYBACK PERIOD



INITIAL INVESTMENT AVERAGE
= _______________________________
ANNUAL CASH INFLOWS




DR ANJANA RAJU
ACCEPTANCE RULE FOR PAY BACK PERIOD

RANKING METHOD ADOPTED

HIGHEST RANKING
TO SHORTEST PAYBACK PERIOD


LOWEST RANKING
TO HIGHEST PAYBACK PERIOD
DR ANJANA RAJU
PAYBACK FOR FRANCHISE L
(LONG: MOST CFS IN OUT YEARS)
10 80 60
0 1 2 3
-100
=
CF
t
Cumulative -100 -90 -30 50
Payback
L
2 + 30/80 = 2.375 years
0
100
2.4
DR ANJANA RAJU
FRANCHISE S (SHORT: CFS COME
QUICKLY)
70 20 50
0 1 2 3
-100 CF
t
Cumulative -100 -30 20 40
Payback
S
1 + 30/50 = 1.6 years
100
0
1.6
=
DR ANJANA RAJU
10 80 60
0 1 2 3
CF
t
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback
2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discounted
rather than raw CFs.
PVCF
t
-100
-100
10%
9.09 49.59 60.11
=
Recover invest. + cap. costs in 2.7 yrs.
DR ANJANA RAJU
Strengths of Payback:
1. Provides an indication of a
projects risk and liquidity.
2. Easy to calculate and understand.
Weaknesses of Payback:
1. Ignores the TVM.
2. Ignores CFs occurring after the
payback period.
DR ANJANA RAJU
ACCOUNTING RATE OF RETURN
METHOD (ARR)
DR ANJANA RAJU
ACCOUNTING RATE OF RETURN(ARR)

ARR.

ALSO KNOWN AS

RETURN ON INVESTMENT(ROI)

DR ANJANA RAJU
ACCOUNTING RATE OF RETURN METHOD(ARR)


ACCOUNTING RATE OF RETURN

AVERAGE ANNUAL PROFIT AFTER TAX
= ___________________________________________
AVERAGE OR INITIAL INVESTMENT

INITIAL INVESTMENT + SALVAGE VALUE
AVERAGE INVESTMENT = ____________________________________
2
DR ANJANA RAJU
ARR ACCEPTANCE RULE

ACCEPTA-OR REJECT CRITERION

ACCEPT ARR..
HIGHER THAN THE MINIMUM RATE


REJECT ARR .
LOWER THAN THE MINIMUM RATE
ESTABLISHED BY MGT

DR ANJANA RAJU
ARR
ADVANTAGES

SIMPLE TO UNDERSTAND AND USE

ARR READILY CALCULATED FROM
ACCOUNTING DATA

INCORPORATES THE ENTIRE STREAM OF
INCOME
DR ANJANA RAJU
ARR
DISADVANTAGES

USES ACCOUNTING PROFIT, NOT
CASH FLOWS

AVERAGING OF INCOME IGNORES
THE TIME VALUE OF MONEY
DR ANJANA RAJU
DISCOUNTED
CRITERIA
TECHNIQUE
DR ANJANA RAJU
NET PRESENT VALUE
DR ANJANA RAJU
NET PRESENT VALUE (NPV)


RECOGNISES THE

. TIME VALUE OF MONEY.





DR ANJANA RAJU
NET PRESENT VALUE (NPV)
STEPS INVOLVED IN CALCULATION OF NPV

STEP 1 CASH FLOWS OF INVESTED PROJECT
FORECASTED
(BASED ON REALISTIC ASSUMPTIONS)

STEP 2 APPROPRIATE DISCOUNT RATE
IDENTIFIED
( RATE OF OPPORTUNITY COST OF CAPITAL =REQUIRED
RATE OF RETURN)
DR ANJANA RAJU
NET PRESENT VALUE (NPV)
STEP 3 PRESENT VALUE OF CASH FLOW
SHOULD BE CALCULATED
(USING OPPORTUNITY COST OF CAPITAL AS DISCOUNT
RATE)

STEP 4 NPV SHOULD BE FOUND OUT BY
SUBSTRACTING PRESENT VALUE OF
CASH OUTFLOWS
( ACCEPTED IF NPV IS POSITIVE( NPV>0)
DR ANJANA RAJU
ACCEPTANCE RULES FOR (NPV)
NPV ACCEPTANCE RULES ARE

ACCEPT IF NPV > 0

REJECT IF NPV < 0

MAY ACCEPT IF NPV =0
DR ANJANA RAJU
NET PRESENT VALUE

NPV= TOTAL PRESENT VALUE OF
CASH INFLOWS

MINUS

TOTAL PRESENT VALUE OF
CASH OUTFLOWS
DR ANJANA RAJU

.
1
0
t
t
n
t
r
CF
NPV

NPV: Sum of the PVs of inflows and


outflows.
Cost often is CF
0
and is negative.

.
1
0
1
CF
r
CF
NPV
t
t
n
t

DR ANJANA RAJU
WHATS FRANCHISE LS NPV?
10 80 60
0 1 2 3
10%
Project L:
-100.00
9.09
49.59
60.11
18.79 = NPV
L
NPV
S
= $19.98.
DR ANJANA RAJU
CALCULATOR SOLUTION
Enter in CFLO for L:
-100
10
60
80
10
CF
0
CF
1
NPV
CF
2
CF
3
I
= 18.78 = NPV
L
DR ANJANA RAJU
RATIONALE FOR THE NPV
METHOD
NPV = PV inflows - Cost
= Net gain in wealth.

Accept project if NPV > 0.

Choose between mutually
exclusive projects on basis of
higher NPV. Adds most value.
DR ANJANA RAJU
USING NPV METHOD, WHICH
FRANCHISE(S) SHOULD BE ACCEPTED?
IF FRANCHISE S AND L ARE MUTUALLY
EXCLUSIVE, ACCEPT S BECAUSE NPV
S
>
NPV
L
.

IF S & L ARE INDEPENDENT, ACCEPT
BOTH; NPV > 0.
DR ANJANA RAJU
INTERNAL RATE OF RETURN
DR ANJANA RAJU
INTERNAL RATE OF RETURN

IRR WHICH TAKES ACCOUNT OF


MAGNITUDE AND

TIMING

OF CASH FLOWS

DR ANJANA RAJU
INTERNAL RATE OF RETURN

FACTOR = ORIGINAL INVESTMENT
___________________________
AVERAGE CASH INFLOW PER YEAR

F= I/C

IRR= THE DISCOUNTING RATE THAT EQUATES
THE PV OF CASH INFLOWS AND PV OF CASH
OUTFLOWS LEADING NPV TO BE ZERO
DR ANJANA RAJU

.
1
0
NPV
r
CF
t
t
n
t

t
n
t
t
CF
IRR


0 1
0.
NPV: Enter r, solve for NPV.
IRR: Enter NPV = 0, solve for IRR.
DR ANJANA RAJU
INTERNAL RATE OF RETURN: IRR
0 1 2 3
CF
0
CF
1
CF
2
CF
3
Cost Inflows
IRR IS THE DISCOUNT RATE THAT FORCES PV
INFLOWS = COST.
THIS IS THE SAME AS FORCING NPV = 0.
DR ANJANA RAJU
WHATS FRANCHISE LS IRR?
10 80 60
0 1 2 3
IRR = ?
-100.00
PV
3
PV
2
PV
1
0 = NPV
Enter CFs in CFLO, then press IRR:
IRR
L
= 18.13%. IRR
S
= 23.56%.
DR ANJANA RAJU
40 40 40
0 1 2 3
IRR = ?
Find IRR if CFs are constant:
-100
OR, WITH CFLO, ENTER CFS AND
PRESS IRR = 9.70%.
3 -100 40 0

9.70%
N I/YR PV PMT FV
INPUTS
OUTPUT
DR ANJANA RAJU
RATIONALE FOR THE IRR METHOD
If IRR > WACC, then the projects
rate of return is greater than its
cost-- some return is left over to
boost stockholders returns.

Example: WACC = 10%, IRR = 15%.
Profitable.
DR ANJANA RAJU
DECISIONS ON PROJECTS S AND
L PER IRR
If S and L are independent, accept
both. IRRs > r = 10%.
If S and L are mutually exclusive,
accept S because IRR
S
> IRR
L
.
DR ANJANA RAJU
ACCEPTANCE RULES FOR (IRR)
IRR ACCEPTANCE RULES ARE

IRR IS HIGHER THAN OPPORTUNITY
COST OF CAPITAL
ACCEPT IF r > k

REJECT IF r <k

MAY ACCEPT IF r =k
DR ANJANA RAJU
PROFITABILITY INDEX
DR ANJANA RAJU
PROFITABILITY INDEX
RATIO OF


PRESENT VALUE OF CASH INFLOWS, AT
THE REQUIRED RATE OF RETURN,

TO THE INITIAL CASHOUTFLOW OF
THE INVESTMENT
DR ANJANA RAJU
PROFITABILITY INDEX
PI =

PRESENT VALUE OF CASHFLOWS
_________________________________
PRESENT VALUE OF CASH OUTLAY
DR ANJANA RAJU
ACCEPTANCE RULE OF PROFITABILITY INDEX (PI)

ACCEPT IF PI > 1

REJECT IF PI <1

MAY ACCEPT IF PI =1