Function 1 Capital Budgeting decision

Capital Budgeting decision

Firms decision to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefits over a series of years. Examples

Expansion/acquisition/replacement of long-term assets Sale of a division/spin-off Change in methods of sales distribution/advertisement campaign

Features

Exchange of current funds for future benefits Funds are invested in long-term funds Future benefits will occur to a firm over a series of years

Importance

Growth Risk Funding Irreversible or reversible at a substantial loss Complex decision

Capital Budgeting Process

Identification
Development

Evaluation of Net benefits Authorization

Control

Types of Investment Decision

From the existence of the FIRM perspective

New Firm decisions Existing Firm decision

From the point of view of decision situation

Independent decisions Contingent decisions or dependent decisions Mutually exclusive investments

Type 1

Types of Investment Decision

Expansion and Diversification

Related Unrelated

Type 1

Types of Investment Decision

Replacement and Modernisation

Help introduce more efficient and economical assets Cost-reduction investments Change of technology

Type 2

Types of Investment Decision

Independent Investments Contingent Investments

Mutually Exclusive Investments

Either be Labour-intensive Semi-automatic machine More capital-intensive

Nature of Capital Budgeting

Large commitment of funds Long term effects on risk return trade-off Irreversible Strategic impact affect ability to compete Complex in nature

Estimating Project Characteristics

Technical Feasibility Economic Feasibility Financial Feasibility Managerial Competence Market Feasibility

Technical Feasibility

Location of the project Technology Used Plant and equipment Construction and installation

Economic Feasibility

A.k.a. social cost benefit analysis The project is viewed from social cost and benefits and not in monetary terms

More employment Expected to contribute to natural government department Development in the area

Financial Feasibility

Financial appraisal viability Cost of the project Sources of Finance

Investment or cost of project Means of financing Cost of capital Projected profitability Break even point Cash flows Risk

Market Feasibility

Aggregate demand Market share

Consumption trends of the past Supply trends of past and expected future Production possibilities and constraints Imports and Exports Structure of competition Cost structure Elasticity of demand Consumer behavior, intention Distribution channels

Evaluation of net benefits

Net Present Value Internal Rate of Return Payback period Accounting rate of return

Cut-off rate minimum required rate of return. Recognition of risk

Time Value of Money

Compounding Discounting

Time Value of Money

Discounting

Discounting

The process of determining the present value of a payment or a stream of payments that is to be received in the future. Given the time value of money, a dollar is worth more today than it would be worth tomorrow given its capacity to earn interest. Discounting is the method used to figure out how much these future payments are worth today.

Discounting

Discounting is one of the core principals of finance and is the primary factor used in pricing a stream of cash flows, such as those found in a traditional bond or annuity. For example, the succession of coupon payments found in a regular bond is discounted by a certain interest rate and summed together with the discounted par value to determine the bond's current value.

Concept

P = F / (1+i) .for single year n P = F / (1+i) .for multiple years n PVIF .1/(1+i)

Present Value Interest Factors for One Dollar Discounted at k Percent for n Periods

Present Value of Annuity

Suppose Mr X pays Rs 10000 at the end of each year for 7 years in PPF fund at 11% pa. What is the present value of this series. If this paid as a quarterly installment of Rs 2500. Other information being the same. What is the present value of this series?

Present Value Interest Factors for a One-Dollar Annuity Discounted at k Percent for n Periods

Investment Evaluation Criteria

Estimation of cashflows Estimation of required rate of return (opportunity cost of capital) Decision Rule

Should consider all cash flows Should help ranking the projects Should provide an objective and unambiguous way of separating good projects from bad ones. Bigger cashflows are better than smaller cashflows Early ones are better than later ones

Decision Rule or Evaluation Criteria

Discounted Cash Flow Criteria

Net Present Value Internal Rate of Return Profitability Index Payback period Discounted payback period Accounting Rate of Return

Non-discounted Cash Flow Criteria

Net Present Value (NPV)

Situation If a retail clothing business wants to purchase an existing store, it would first estimate the future cash flows that store would generate, and then discount those cash flows into one lump-sum present value amount, say $565,000. If the owner of the store was willing to sell his business for less than $565,000, the purchasing company would likely accept the offer as it presents a positive NPV investment. Conversely, if the owner would not sell for less than $565,000, the purchaser would not buy the store, as the investment would present a negative NPV at that time and would, therefore, reduce the overall value of the clothing company.

NPV

The difference between the present inflows and the present value of cash is used in capital budgeting to profitability of an investment

value of cash outflows. NPV analyze the or project.

NPV analysis is sensitive to the reliability of future cash inflows that an investment or project will yield.

Acceptance Rule

NPV > 0Accept NPV < 0...Reject NPV = 0May accept/reject.

Evaluation of NPV

Time Value Measure of true profitability Principle of Value-additivity

NPV(A) + NPV(B) = NPV(A+B) Benefits are measured in cash flows. Maximization of market price of the shares.

Evaluation of NPV

Cash flow estimation Discount Rate Ranking of projects (as discount rates are changed, the ranking also changes.) Mutually exclusive projects with unequal lives.

Internal Rate of Return

Magnitude and timing of cashflows is taken into account. Yield on investment or marginal efficiency of capital or rate of return over cost, time-adjusted rate of internal return

IRR

Rate at which NPV is zero

Calculating IRR

Assume an initial mortgage amount of Rs. 200,000 and monthly payments of Rs. 1,050 for 30 years. Find IRR. 200000 = 1050 x 12 x PVAF 30,r PVAF 30,r = 15.873 Check the tables and find the answer.

Trial and Error method

Assume an initial mortgage amount of Rs. 200,000 and yearly payments as 40K, 40K, 80K, 100K for next 4 years. Find IRR? Assume a rate and move forward.

Trial and Error method

Assume an initial mortgage amount of Rs. 200,000 and yearly payments as 40K, 40K, 80K, 100K for next 4 years. Find IRR? Assume a rate and move forward. Check at 0%, 10% and at IRR%

NPV and IRR profileat different %ages

Acceptance Rule

Merits of IRR

Time Value Profitability measureall cash flows Acceptance Rulesame as NPV Shareholder Value

Demerits

Multiple Rates Ideal k? Mutually exclusive projects with unequal lives?

Profitability Index

A.k.a. Benefit-Cost Ratio. Ratio of PV of cash inflows, at K, to initial cash outflow.

Example

Questions..

Assume an initial mortgage amount of Rs. 200,000 and yearly payments as 40K, 40K, 80K, 100K for next 4 years. Find PI? Assume an initial mortgage amount of Rs. 200,000 and monthly payments of Rs. 1,050 for 30 years. Find PI?

Acceptance Rule

Non-Discounted Methods

Payback period

The length of time required to recover the cost of an investment.

Question

Uneven Cashflows

Assume an initial mortgage amount of Rs. 200,000 and yearly payments as 40K, 40K, 80K, 100K for next 4 years. Find payback period. In case yearly payments are 50K each yearfind payback period.

Even Cashflows

Positives

Simplicity Cost Effective Short-term effects Risk Shield Liquidity

Negatives

Cash flows after payback period Cash flow patterns Ideal payback period? Inconsistent with shareholder value.

Discounted Payback period

Number of periods taken in recovering the investment outlay on the present value basis.

Demerits Cash flows after payback period Cash flow patterns Ideal payback period? Inconsistent with shareholder value

Accounting Rate of Return (ARR)

ARR provides a quick estimate of a project's worth over its useful life. ARR is derived by finding profits before taxes and interest.

Question

A project will cost Rs 40000. Its stream of EBDIT during first year through five years is expected to be Rs 10k, Rs 12k, Rs 14k, Rs 16k, Rs 20k. Assume 50% taxes and depreciation on straight line method basis. Find the projects ARR.

Solution
Period 1 2 3 4 5 Average Earnings before dep, interest and taxes (EBDIT) 10000 Depreciation EBIT Taxes @ 50% PAT (EBIT(1-T)) 8000 2000 1000 1000

12000 14000 8000 4000 2000 2000 8000 6000 3000 3000

16000 8000 8000 4000 4000

20000 8000 12000 6000 6000

14400 8000 6400 3200 3200

Book Value of investment Beginning Ending 40000 32000 32000 24000 24000 16000 16000 8000 8000 0

Average

36000

28000 20000

12000

4000

20000

Positives

Simplicity Accounting data Accounting profitability

Negatives

Cash flows ignored Time Value ignored Arbitrary cut-off rate

Lending and Borrowing-type

Project X Y C0 -100 100 C1 120 -120 IRR 20% 20% NPV at 10% 9 -9