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Lecture 6,7 & 8

Capital Budgeting Techniques

Presented by
Muhammad Khalid Sohail

Lecture 5
Review:

Present Value

Present Value is the current value of a future amount of


money, or a series of payments (single, un-even, same,
infinite), evaluated at a given interest rate.

1. General Present Value Formula


(single):
PV0 = C/Fn / (1+i)n
or

PV0 = C/Fn (PVIFi,n) -- See Table

2. Present Value (un-even C/F):


6-2

DF = PVIFi,n = 1 / (1+i)n

3. a. Present Value (Annuity):


PVAn
Or PVAn

= C/F (PVIFAi%,n)
= C/F * [(1-1/(1+i)^n) / i ]

b. PVADn = C/F (PVIFAi%,n)(1+i)


4. Present Value (infinite series):
PVp = CF / i = (1 / i) * CF = DFp * CF
5. Present Value (Mixed series):
solve according to above four
formulas.
6-3

1. PV of Single Value.
What will be the PV of $10,000 in 5 years
at a discount rate of 10%.

10%

PV0
6-4

5
$10,000

Calculation based on general formula:


PV0 = C/Fn / (1+i)n
PV0 = $10,000 / (1+ 0.10)5
= $6,209.21
Calculation based on Table:
PV0 = $10,000 (PVIF10%, 5)
= $10,000 (.621) = $6,210.00

Year CF-AT

6-5

DF@10%

[Rounding]

PV

0.9091

0.8264

0.7513

0.683

10000

0.6209

6209
6209

2. a. PV of Un-even C/F

What will be the


PV of $100, 200,

300 occurring in 3
years at a discount
rate of 10%.
0

6-6

100

200

300

Year C/F

DF@10 PV

100

0.9091

91

200

0.8264

165

300

0.7513

225
481

2. b. Un-even C/F when interest


rate is in fraction

What will be the


PV of $100, 200,

Year CF

300 occurring in 3
years at a discount
rate of 10.5%.

6-7

100

200

300

DF@10.5% PV

100

0.905

91

200

0.819

164

300

0.7412

222
477

3. a. What is PV of this
annuity at interest rate 10%
(Ordinary Annuity)
End of
Period 1

1
$1000

Today
6-8

End of
Period 2

End of
Period 3

2
1000

3
1000

Equal Cash Flows


Each 1 Period Apart

PVAn

= C/F (PVIFAi%,n)

PVA3 = $1,000 (PVIFA10%,3)


= $1,000 (2.4869)
= $2,487
i

n
0.10

DFA
3

2.624316
Year CF-AT DF@10% PV
0
1-3

6-9

1000 2.486852

2487
2487

3. b. What is PV of this annuity at


interest rate 10.5%
PVAn
PVA3

= C/F (PVIFAi%,n)
= $1,000 (PVIFA10.5%,3)
= $1,000 (2.2465)
= $2,465

Year

CF-AT
0

1-3
6-10

DF@10.5% PV
0

1000

2.465123

2465
2465

4.Present Value of Infinite


series
What will be the PV
of $70 occurring in
infinite years at a
discount rate of
10%.

PV = CF * DFp
PV = 70 * (1/.10)
= 70 * (10)
= 700
6-11

70

70

70

Find PV of this C/F

6-12

100

200

300

1000

1000

1000

70

70

..
.

481
6-13

100

200

300

1000

1000

1000

70

70

100

200

300

1000

1000

1000

70

70

2487

700

..
.

481

2487

Year

CF-AT

700
4

DF@10%

PV

481

481

2487

0.7513

1868

700

0.5645

395
2744

6-14

100

200

300

1000

1000

1000

70

70

Year CF-AT

DF@10% PV

100

0.9091

91

200

0.8264

165

300

0.7513

225

1000

1.8684

1868

70

5.6447

395

4-6
7-inf

2744
Annuity

Ann-diff

6-15

DFA

0.1

4.3553

0.1

2.4869

1.8684

Annuity

0.1
Perp

6
n

0.1 inf
Ann-prep-diff

DFA

4.3553
DFp
10
5.6447

Capital Budgeting
Techniques

6-16

Project Evaluation and Selection

Potential Difficulties

Capital Rationing

Project Monitoring

Post-Completion Audit

Project Evaluation:
Alternative Methods
Average Rate of Return
Payback Period (PBP)
Internal Rate of Return (IRR)
Net Present Value (NPV)
Profitability Index (PI)
Advanced Techniques
Discounted PBP, NTV, MIRR, APV

6-17

Project Types

Independent

A project whose
acceptance (or rejection) does not
prevent the acceptance of other
projects under consideration. project
do not compete with each other

Dependent

The acceptance of one


project also depends on the
acceptance of other project (s).

Mutually

exclusive Compete against


each other. Best project is selected.

6-18

Proposed Project Data


JM is evaluating a new project for her
firm, BW. She has determined that
the after-tax cash flows for the
project will be $10,000; $12,000;
$15,000; $10,000; and $7,000,
respectively, for each of the Years 1
through 5. The initial cash outlay
will be $40,000.
6-19

Payback Period (PBP)


0

-40

10

2
12

15

10

5
7

No. of year required to recover initial


C/F from future C/F
PBP is the period of time required for the
cumulative expected cash flows from an
investment project to equal the initial cash
outflow.
6-20

a: year at which cumulative total does not exceed its ICO


b: ICO
c: Cumulative total discussed in step-1
d: C/F of following years of commutative total in single C/F column

-40

(-b) 10
10

12
22

Cumulative
Inflows

6-21

PBP

3 (a)
15
37

(c)

4
10 (d)
47

=a+(b-c)/d
= 3 + (40 - 37) / 10
= 3 + (3) / 10
= 3.3 Years

5
7
54

PBP Acceptance Criterion


Based upon the management. e.g. The
management of BW has set a maximum
PBP of 3.5 years for projects of this type.

Should this project be accepted?


Yes! The firm will receive back the
initial cash outlay in less than 3.5
years. [3.3 Years < 3.5 Year Max.]
6-22

In case of annuity
PBP = ICO / [CFi (single)] (years)
PBP = 600 / 200 = 3 years

6-23

-600

200

200

200

200

PBP Strengths
and Weaknesses
Strengths:

Weaknesses:

Easy to use and


understand

Does not account


for TVM

Can be used as a
measure of
liquidity

Does not consider


cash flows beyond
the PBP

Easier to forecast
ST than LT flows

Cutoff period is
subjective

6-24

Lecture 6:
Net Present Value: NPV is the

present value of an investment


projects net cash flows minus the
projects initial cash outflow.

CF1
NPV =
(1+k)1
6-25

CF2
(1+k)2

CFn
- ICO
+...+
n
(1+k)

NPV = PV of CFi PV of CFo

More consistent with the goal i.e. Maximization of


wealth of owners.

NPV is $ amount of change in the value of firm as


a result of undertaking the project.

NPV positive means, the project will add value to


the firm, as a result MPS will also increase.

NPV0,

Firm value will not change, remain


same expected rate of return.

NPV+,

Firm value will , return exceeds the


firm RRR.

NPV-,

Firm value will , return will be less than


the firm RRR.

6-26

NPV Solution
BW has determined that the appropriate
discount rate (k) for this project is 13%.
-40000

40000

10000

12000

15000

10000

7000

PV of C/Fo ?

PV of C/Fi ?

Year

6-27

CF-AT

38577

DF@13%

PV

-40000

-40000

10000

0.885

8850

12000

0.7831

9397

15000

0.6931

10397

10000

0.6133

6133

7000

0.5428

3800

NPV

-1423

NPV Acceptance Criterion


The management of BW has
determined that the required rate is
13% for projects of this type.
Should this project be accepted?
No! The NPV is negative. This means
that the project is reducing shareholder
wealth. [Reject as NPV < 0 ]
* For Ind. Project: accept NPV>=0.
6-28
* For

M.E projects: rank according to higher NPV

NPV Strengths
and Weaknesses
Weaknesses:

Strengths:

Cash flows
assumed to be
reinvested at the
hurdle rate.

Accounts for TVM.

Considers all
cash flows.

6-29

May not include


managerial
options embedded
in the project.

Net Present Value Profile


Net Present Value

$000s
15

Plot NPV for each


discount rate.

10
5

IRR

NPV@13%

0
-4

6-30

Sum of CFs

6
9
12
Discount Rate (%)

15

Profitability Index (PI)


PI is the ratio of the present value of a
projects future net cash flows to the
projects initial cash outflow. OR BCR :
Benefit Cost Ratio.
PI = Benefits / Cost = PV of CFi / PV of CFo
Method #1:

CF1
PI =
(1+k)1

CF2
CFn
+...+
2
(1+k)
(1+k)n
<< OR >>

Method #2:
6-31

PI = 1 + [ NPV / ICO ]

ICO

PI Acceptance Criterion
PI = $38,577 / $40,000 = .9644 (Method #1)
PI = 1 + (-1423)/ 40,000 = .9644 (Method #2)
Should this project be accepted?
No! The PI is less than 1.00. This
means that the project is not profitable.
[Reject as PI < 1.00 ]
6-32

PI Strengths
and Weaknesses
Strengths:

Weaknesses:

Same as NPV

Same as NPV

Allows
comparison of
different scale
projects

Provides only
relative profitability

Potential Ranking
Problems

6-33

Internal Rate of Return (IRR):

IRR is the discount rate that equates


the present value of the future net cash
flows from an investment project with
the projects initial cash outflow. OR
The rate at which NPV becomes zero
CF1
CF2
+
ICO =
(1+IRR)1 (1+IRR)2
6-34

+...+

CFn
(1+IRR)n

IRR Solution
$10,000
$12,000
$40,000 =
+
+
(1+IRR)1 (1+IRR)2
$15,000
$10,000
$7,000
+
+
(1+IRR)3
(1+IRR)4 (1+IRR)5
Find the interest rate (IRR) that causes the
discounted cash flows to equal $40,000.
6-35

IRR : Single Value

For single value in CFi.

IRR = (CFi / CFo)^(1/n) - 1


-10000
0

6-36

30000
1

P:6.4
n=
CFi
CFo
IRR

4
30000
10000
0.316074

For Annuity
Calculate DF = CFo / Annuity
ii.
Locate two DFs close to DF in
PVIFA table under year n
iii. Interpolate IRR as:
LDR + (DRs) (LDF DF) / (LDF HDF)
or
HDR - (DRs) (DF HDF) / (LDF HDF)
i.

6-37

IRR: Annuity Case: Problem 6.4


-10000

5000

5000

5000

5000

PVIFA
LDF
(i) DF

Or

0.3 LDR

2.000
HDF

6-38

2.166

Rate
IRR

1.849

0.4 HDR

IRR

= 0.30 + (0.10) (0.5237) = 0.3524 = 35.24%

IRR

= 0.40 (0.10) (0.4763) = 0.3524 = 35.24%

Now

we Check,
whether NPV
becomes 0, at
35.24%.

Now, with the


help of computer
program, IRR is
34.90%, again we
check, whether
NPV becomes 0,
at this rate.

Yes

0.

6-39

it is near to

Annuity
Year

0.3524
CF-AT

DFA
4

DF@35.24%

1.9894
PV

-10000

-10000

5000

1.9894

9947

1-4
NPV

-53

i
Annuity
Year

0.349
CF-AT

0
1-4

DFA
4

2.0001

DF@35.24% PV

-10000

-10000

5000

2.0001

10001

NPV

Lecture 7

IRR : Mixed Stream of C/F, with the help of


NPV

Calculate Two NPVs, one + & other -

Interpolate IRR as:

LDR + (DRs) (|NPVLDR|) / (|NPVLDR|+ |NPVHDR|)


Or
HDR - (DRs) (|NPVHDR|) /(|NPVLDR|+ |NPVHDR|)
6-40

Annuity
Year

DFA

0.3
CF-AT

0
1-4

4
DF@30%

2.1662
PV

-10000

-10000

5000

2.1662

10831

NPV
i
Annuity

831

n
4

Diff
0.3

Fraction

0.05

IRR

0.98227 0.3491

OR

DFA

0.35

LDR

HDR

1.9969

Diff

0.35

Fraction

0.05

IRR

0.01773 0.3491

Check

Year

CF-AT
0

1-4

DF@35%

-10000

-10000

5000

1.9969

9985

NPV
6-41

PV

-15

Annuity
Year

0.3491
CF-AT

0
1-4

-10000
5000
NPV

DFA
4 1.9998

DF@35.91% PV
1 -10000
1.9998

9999
-1

IRR : Mixed Stream of C/F

i.
ii.
iii.
iv.

v.
vi.

vii.

6-42

Get Fake Annuity : FA = CFi / n


Calculate DF = CFo / FA
Find DF in PVIFA table under year n, this will
give rough IRR = k.
Adjustment in k=Rough IRR [if required]
If CFi >FA in earlier years: k=Rough IRR+1
If CFi <FA in earlier years: k=Rough IRR-1
Calculate NPV at k rate (step-iv). If NPV=0,
then IRR = k. [you are lucky], otherwise:
If NPV<0 (step-v), Then calculate another NPV
at (k-5) rate: If NPV>0, Then calculate another
NPV at (k+5) rate: [Make sure you have two
NPVs, one +ve and other-ve]:
Interpolate IRR.

IRR: solution with the help of 7-steps

6-43

-40000

10000

12000

15000

10000

7000

step 1

FA

10800

step 2

DF

3.7037

step 3

in PVIFA

step 4

Adjustment in k= 0

step 5

Find NPV at k=

3.696 Rate=k=
0.11

0.11

step 5
Year

step 6
CF-AT

0.11 PV

Check

0.16 PV

0.1151 PV

-40000

-40000

-40000

-40000

10000

0.9009

9009

0.8621

8621

0.8968

8968

12000

0.8116

9739

0.7432

8918

0.8042

9650

15000

0.7312

10968

0.6407

9611

0.7212

10818

10000

0.6587

6587

0.5523

5523

0.6468

6468

7000

0.5935

4155

0.4761

3333

0.58

4060

NPV

458 NPV

-3994 NPV

-36

step 6

Now NPV, + Find NPV at k= 0.16

step 7

LDR

0.11 NPV

458

HDR

0.16 NPV

-3994

LDR
6-44

Diff
0.11

Fraction
0.05

0.102875

IRR
0.1151

IRR Acceptance Criterion


The management of BW has
determined that the hurdle rate is
13% for projects of this type.
Should this project be accepted?
No! The firm will receive 11.51% for
each dollar invested in this project at
a cost of 13%. [ IRR < Hurdle Rate ]
6-45

P:6.3
Year

6-46

Net C/F

- Depr.

= CF_BT

- Tax

Inc. C/F

8000

5600

2400

816

7184

8000

8960

-960

-326

8326

8000

5376

2624

892

7108

8000

3226

4774

1623

6377

8000

3226

4774

1623

6377

8000

1612

6388

2172

5828

8000

8000

2720

5280

step 1

FA

6640

step 2

DF

4.2169

step 3

in PVIFA

step 4

Adjustment in k

step 5

Find NPV at k=

0.14

4.288 rate = k =

0.14

step 5

step 6

Year

CF-AT

.14 PV

0.19 PV

0.1581 PV

-28000

-28000

-28000

-28000

7184

0.8772

6302

0.8403

6037

0.8635

6203

8326

0.7695

6407

0.7062

5880

0.7456

6208

7108

0.675

4798

0.5934

4218

0.6438

4576

6377

0.5921

3776

0.4987

3180

0.5559

3545

6377

0.5194

3312

0.419

2672

0.48

3061

5828

0.4556

2655

0.3521

2052

0.4145

2416

5280

0.3996

2110

0.2959

1562

0.3579

1890

NPV

1360 NPV

-2399 NPV

-101

step 6

Now NPV, + Find NPV at k=

0.19

step 7

LDR

0.14 NPV

1360

HDR

0.19 NPV

-2399

LDR
6-47

Check

Diff
0.14

Fraction
0.05

0.361798

IRR
0.1581

IRR Strengths
and Weaknesses
Strengths:

6-48

Accounts for
TVM
Considers all
cash flows
Less
subjectivity

Weaknesses:
Assumes all cash
flows reinvested at
the IRR
smaller project may
have higher IRR, but
overall do not change
firm value.
Difficulties with
project rankings and
Multiple IRRs

Evaluation Summary
BW Independent Project

Method Project Comparison Decision

6-49

PBP

3.3

3.5

Accept

IRR

11.51%

13%

Reject

NPV

-$1,423

$0

Reject

PI

.96

1.00

Reject

Potential Problems
Under Mutual Exclusivity
Ranking of project proposals may
create contradictory results.
A. Scale of Investment
B. Cash-flow Pattern
C. Project Life
6-50

A. Scale Differences
Compare a small (S) and a
large (L) project.
END OF YEAR

6-51

NET CASH FLOWS


Project S
Project L

-$100

-$100,000

$400

$156,250

Scale Differences
Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?

6-52

Project

IRR

100%

25%

NPV

PI

231

3.31

$29,132

1.29

B. Cash Flow Pattern


Let us compare a decreasing cash-flow (D)
project and an increasing cash-flow (I) project.
END OF YEAR

6-53

NET CASH FLOWS


Project D
Project I

0
1

-$1,200
1,000

-$1,200
100

500

600

100

1,080

Cash Flow Pattern


Calculate the IRR, NPV@10%,
and PI@10%.
Which project is preferred?
Project

6-54

IRR

NPV

PI

23%

$198

1.17

17%

$198

1.17

C. Project Life Differences


Let us compare a long life (X) project
and a short life (Y) project.
END OF YEAR

6-55

NET CASH FLOWS


Project X
Project Y

0
1

-$1,000
0

-$1,000
2,000

3,375

Project Life Differences


Calculate the PBP, IRR, NPV@10%,
and PI@10%.
Which project is preferred? Why?

6-56

Project

IRR

NPV

PI

50%

$1,536

2.54

100%

$ 818

1.82

Capital Rationing
Capital Rationing occurs when a
constraint (or budget ceiling) is placed
on the total size of capital expenditures
during a particular period.

6-57

Example: JM must determine what


investment opportunities to undertake
for BW Co.. She is limited to a
maximum expenditure of $32,500 only
for this capital budgeting period.

Available Projects for BW


Project
A
B
C
D
E
F
G
H
6-58

ICO
$

500
5,000
5,000
7,500
12,500
15,000
17,500
25,000

IRR
18%
25
37
20
26
28
19
15

NPV
$

PI

50 1.10
6,500 2.30
5,500 2.10
5,000 1.67
500 1.04
21,000 2.40
7,500 1.43
6,000 1.24

Choosing by IRRs for BW


Project
C
F
E
B

ICO

IRR

NPV

PI

$ 5,000
15,000
12,500
5,000

37%
28
26
25

$ 5,500
21,000
500
6,500

2.10
2.40
1.04
2.30

Projects C, F, and E have the


three largest IRRs.
The resulting increase in shareholder wealth
is $27,000 with a $32,500 outlay.
6-59

Choosing by NPVs for BW


Project
F
G
B

ICO
$15,000
17,500
5,000

IRR

NPV

PI

28%
19
25

$21,000
7,500
6,500

2.40
1.43
2.30

Projects F and G have the


two largest NPVs.
The resulting increase in shareholder wealth
is $28,500 with a $32,500 outlay.
6-60

Choosing by PIs for BW


Project
F
B
C
D
G

ICO

IRR

NPV

PI

$15,000
5,000
5,000
7,500
17,500

28%
25
37
20
19

$21,000
6,500
5,500
5,000
7,500

2.40
2.30
2.10
1.67
1.43

Projects F, B, C, and D have the four largest PIs.


The resulting increase in shareholder wealth is
$38,000 with a $32,500 outlay.
6-61

Summary of Comparison
Method Projects Accepted

Value Added

PI

F, B, C, and D

$38,000

NPV

F and G

$28,500

IRR

C, F, and E

$27,000

PI generates the greatest increase in


shareholder wealth when a limited capital
budget exists for a single period.
6-62

Post-Completion Audit
Post-completion Audit
A formal comparison of the actual costs and
benefits of a project with original estimates.

Identify any project weaknesses

Develop a possible set of corrective actions

Provide appropriate feedback

Result: Making better future decisions!


6-63

Multiple IRR Problem*


Let us assume the following cash flow
pattern for a project for Years 0 to 4:
-$100 +$100 +$900 -$1,000
How many potential IRRs could this
project have?
Two!! There are as many potential
IRRs as there are sign changes.
6-64

Multiple IRR example


P:6-10
Year

CF-AT

DF@25%

PV

-800

-800

5000

0.8

4000

-5000

0.64

-3200

NPV
Year

CF-AT

DF@400%

PV

-800

-800

5000

0.2

1000

-5000

0.04

-200

NPV
6-65