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- Chapter 09
- ezproxy for several universal library
- Chapter 13 - HW With Solutions
- Cost Benefit Analysis Toolkit
- VP Software Development in Atlanta GA Resume Mourad Bouhafs
- budgeting techniques
- Construction Materials, Prakash
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- FM10e_ch09
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- 14760 Capital Budgeting
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- Capital Budgeting
- Capital Budgeting or Investment Appraisal
- 0273685988_ch13.ppt
- Capital Budgeting
- HYPOTHESI
- SAMPLE SUMMARY
- Chapter 9
- Chap009.pptx

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Decisions

2

Capital Budgeting Techniques

1. Non-discounted Cash Flow Criteria

Payback Period (PB)

Discounted Payback Period (DPB)

Accounting Rate of Return (ARR)

2. Discounted Cash Flow (DCF) Criteria

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

3

Payback

Payback is the number of years required to recover the

original cash outlay invested in a project.

If the project generates constant annual cash inflows, the

payback period can be computed by dividing cash outlay

by the annual cash inflow. That is:

Assume that a project requires an outlay of Rs 50,000 and

yields annual cash inflow of Rs 12,500 for 7 years. The

payback period for the project is:

0

Initial Investment

Payback = =

Annual Cash Inflow

C

C

Rs 50,000

PB = = 4 years

Rs 12,000

4

Payback

Unequal cash flows In case of unequal cash

inflows, the payback period can be found out by

adding up the cash inflows until the total is equal

to the initial cash outlay.

Suppose that a project requires a cash outlay of

Rs 20,000, and generates cash inflows of

Rs 8,000; Rs 7,000; Rs 4,000; and Rs 3,000

during the next 4 years. What is the projects

payback?

3 years + 12 (1,000/3,000) months

3 years + 4 months

5

Acceptance Rule

The project would be accepted if its payback

period is less than the maximum or standard

payback period set by management.

As a ranking method, it gives highest ranking to

the project, which has the shortest payback

period and lowest ranking to the project with

highest payback period.

6

Evaluation of Payback

Serious limitations:

Cash flows after payback

Cash flow patterns

Time value ignored

7

Payback Reciprocal and the Rate of Return

The reciprocal of payback will be a close

approximation of the internal rate of return if

the following two conditions are satisfied:

The life of the project is large or at least twice the

payback period.

The project generates equal annual cash inflows.

8

Discounted Payback Period

The discounted payback period is the number of periods

taken in recovering the investment outlay on the present

value basis.

The discounted payback period still fails to consider the

cash flows occurring after the payback period.

3 DI SCOUNTED PAYBACK I LLUSTRATED

Cash Flows

(Rs)

C0 C1 C2 C3 C4

Simple

PB

Discounted

PB

NPV at

10%

P -4,000 3,000 1,000 1,000 1,000 2 yrs

PV of cash flows -4,000 2,727 826 751 683 2.6 yrs 987

Q -4,000 0 4,000 1,000 2,000 2 yrs

PV of cash flows -4,000 0 3,304 751 1,366 2.9 yrs 1,421

9

Accounting Rate of Return Method

The accounting rate of return is the ratio of the

average after-tax profit divided by the average

investment. The average investment would be equal

to half of the original investment if it were

depreciated constantly.

A variation of the ARR method is to divide average

earnings after taxes by the original cost of the

project instead of the average cost.

Average income

ARR =

Average investment

10

Acceptance Rule

This method will accept all those projects whose

ARR is higher than the minimum rate

established by the management and reject those

projects which have ARR less than the minimum

rate.

This method would rank a project as number

one if it has highest ARR and lowest rank would

be assigned to the project with lowest ARR.

11

Evaluation of ARR Method

Serious shortcoming

Cash flow patterns

Time value ignored

The following two projects A and B require an

investment of Rs. 2, 00,000 each. The income after taxes

for these projects is as follows:

Year Project A (in Rs.) Project B (in Rs.)

1 80,000 20,000

2 80,000 40,000

3 40,000 40,000

4 20,000 40,000

5 ------- 60,000

6 ----- 60,000

12

Using the following criteria, determine which of the

project is preferable:

(i)6 years pay back; (ii) Average Rate of Return

(iii) Present value approach if the companys cost

of capital is 10 per cent

Note 1: Depreciation = Initial cost Salvage value Life period

Project A: (Rs.2,00,000 0) 4 = Rs.50,000;

Project B: (Rs.2,00,000 0) 6 = Rs.33,333

13

Year Project A Project B

EAT Cash inflow

(Rs.)

Cumulative EAT Cash

inflow

Cumulative

(Rs.) CFAT (Rs.) (Rs.) (Rs.) CFAT (Rs.)

1 80,000 1,30,000 1,30,000 20,000 53,333 53,333

2 80,000 1,30,000 2,60,000 40,000 73,333 1,26,666

3 40,000 90,000 3,50,000 40,000 73,333 1,99,999

4 20,000 70,000 4,20,000 40,000 73,333 2,73,332

5 ------- -------- -------- 60,000 93,333 3,66,665

6 ------- -------- -------- 60,000 93,333 4,59,998

PBP: Project A: 1+ (70,0001,30,000) = 1.583 Years;

Project B = 3 years

Decision: Based on 6 years pay back both the projects should be selected Project A should be

selected since their PBP is less than the 8 years pay back period which is to considered as standard

pay back period. But Project A should be selected because its pay back period is less than the

Project B.

14

ii) Computation of Average Rate of Return

= (Annual Avg. IAT Average investment) 100

Annual Average Income (AAI)= Total EAT No. of years

Project A: 2,20,000 4 = Rs.55,000;

Average Investment = 2,00,000 2 = Rs.1,00,000

Average rate of return = (55,000 / 1,00,000)100 = 55 per cent

Project B: AAI = 2,60,000 6 = Rs. 36,667

Average investment = 2,00,000 2 = Rs. 1,00,000

Average rate of return = (36,667 / 1,00,000)100 = 36.67 per cent

Decision: Project A should be selected since its ARR is greater than

the Project B.

15

c) Computation of Net Present Value (NPV)

Year CFAT (in Rs.) DF PVs (in Rs.)

Project A Project B 10 % Project A Project B

1 1,30,000 53,333 0.909 1,18,170 48,480

2 1,30,000 73,333 0.826 1,07,380 60,573

3 90,000 73,333 0.751 67,590 55,073

4 70,000 73,333 0.683 48,181 50,086

5 -------- 93,333 0.621 -------- 57,960

6 -------- 93,333 0.564 ------ 52,640

Present Value of cash inflows 3,41,321 3,24,812

Less: Cash outflows 2,00,000 2,00,000

Net Present Values (NPV) 1,41,321 1,24,812

Decision: Based on the NPV both the Projects A and B eligible to accept.

However, Project A is preferable since its NPV is more than that of Project B.

A project will cost Rs.40000. its stream of earnings

before depreciation, interest and taxes (EBDIT)

during first year through five years is expected to be

Rs.10000, Rs.12000, Rs.14000, Rs.16000 and

Rs.20000. Assume a 50 per cent tax and depreciation

on straight line basis. Calculate ARR of the project.

ARR = 3200/ 20000*100 = 16 %

16

17

Net Present Value Method

Cash flows of the investment project should be

forecasted based on realistic assumptions.

Appropriate discount rate should be identified to

discount the forecasted cash flows. The appropriate

discount rate is the projects opportunity cost of

capital.

Present value of cash flows should be calculated

using the opportunity cost of capital as the discount

rate.

The project should be accepted if NPV is positive

(i.e., NPV > 0).

18

Net Present Value Method

Net present value should be found out by

subtracting present value of cash outflows from

present value of cash inflows. The formula for the

net present value can be written as follows:

3 1 2

0

2 3

0

1

NPV

(1 ) (1 ) (1 ) (1 )

NPV

(1 )

n

n

n

t

t

t

C C C C

C

k k k k

C

C

k

=

(

= + + + +

(

+ + + +

=

+

19

Assume that Project X costs Rs 2,500 now and is

expected to generate year-end cash inflows of Rs

900, Rs 800, Rs 700, Rs 600 and Rs 500 in years

1 through 5. The opportunity cost of the capital

may be assumed to be 10 per cent.

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500

NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs 500(PVF

(

= + + + +

(

=

10

)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

=

=

20

Acceptance Rule

Accept the project when NPV is positive

NPV > 0

Reject the project when NPV is negative

NPV < 0

May accept the project when NPV is zero

NPV = 0

The NPV method can be used to select between

mutually exclusive projects; the one with the

higher NPV should be selected.

21

Evaluation of the NPV Method

NPV is most acceptable investment rule for the

following reasons:

Time value

Measure of true profitability

Value-additivity

Shareholder value

Limitations:

Involved cash flow estimation

Discount rate difficult to determine

Mutually exclusive projects

Ranking of projects

Suppose we are considering a capital investment

that costs Rs. 276,400 and provides annual net

cash flows of Rs. 83,000 for four years and

$116,000 at the end of the fifth year. The firms

required rate of return is 15%. Calculate (i)

Payback Period (ii) ARR (iii) NPV and (iv) IRR

22

PBP 3.33 Years

ARR 64.83%

NPV 18235.71

IRR 17.63%

23

Internal Rate of Return Method

The internal rate of return (IRR) is the rate that

equates the investment outlay with the present

value of cash inflow received after one period.

This also implies that the rate of return is the

discount rate which makes NPV = 0.

3 1 2

0

2 3

0

1

0

1

(1 ) (1 ) (1 ) (1 )

(1 )

0

(1 )

n

n

n

t

t

t

n

t

t

t

C C C C

C

r r r r

C

C

r

C

C

r

=

=

= + + + +

+ + + +

=

+

=

+

24

Calculation of IRR

Uneven Cash Flows:

Calculating IRR by Trial and Error

The approach is to select any discount rate to

compute the present value of cash inflows. If the

calculated present value of the expected cash

inflow is lower than the present value of cash

outflows, a lower rate should be tried. On the

other hand, a higher value should be tried if the

present value of inflows is higher than the present

value of outflows. This process will be repeated

unless the net present value becomes zero.

25

Calculation of IRR

Level Cash Flows

Let us assume that an investment would cost Rs

20,000 and provide annual cash inflow of Rs 5,430 for

6 years.

The IRR of the investment can be found out as

follows:

6,

6,

6,

NPV Rs 20,000 + Rs 5,430(PVAF ) = 0

Rs 20,000 Rs 5,430(PVAF )

Rs 20,000

PVAF 3.683

Rs 5,430

r

r

r

=

=

= =

26

NPV Profile and IRR

A B C D E F G H

1 N P V P r o f i l e

2 C a s h F l o w

D i s c o u n t

r a t e N P V

3 - 2 0 0 0 0 0 % 1 2 , 5 8 0

4 5 4 3 0 5 % 7 , 5 6 1

5 5 4 3 0 1 0 % 3 , 6 4 9

6 5 4 3 0 1 5 % 5 5 0

7 5 4 3 0 1 6 % 0

8 5 4 3 0 2 0 % ( 1 , 9 4 2 )

9 5 4 3 0 2 5 % ( 3 , 9 7 4 )

F i g u r e 8 . 1 N P V P r o f i l e

I R

R

27

Acceptance Rule

Accept the project when r > k.

Reject the project when r < k.

May accept the project when r = k.

In case of independent projects, IRR and NPV

rules will give the same results if the firm has no

shortage of funds.

28

Evaluation of IRR Method

IRR method has following merits:

Time value

Profitability measure

Acceptance rule

Shareholder value

IRR method may suffer from:

Multiple rates

Mutually exclusive projects

Value additivity

29

Profitability Index

Profitability index is the ratio of the present

value of cash inflows, at the required rate of

return, to the initial cash outflow of the

investment.

Profitability index (PI):

PV of Annual Cash Flows

PI =

Initial investment

30

Profitability Index

The initial cash outlay of a project is Rs 100,000

and it can generate cash inflow of Rs 40,000,

Rs 30,000, Rs 50,000 and Rs 20,000 in year 1

through 4. Assume a 10 per cent rate of

discount. The PV of cash inflows at 10 per cent

discount rate is:

. 1235 . 1

1,00,000 Rs

1,12,350 Rs

PI

12,350 Rs = 100,000 Rs 112,350 Rs NPV

Rs.112,350

0.68 20,000 Rs + 0.751 50,000 Rs + 0.826 30,000 Rs + 0.909 40,000 Rs =

) 20,000(PVF Rs + ) 50,000(PVF Rs + ) 30,000(PVF Rs + ) 40,000(PVF Rs PV

0.10 4, 0.10 3, 0.10 2, 0.10 1,

= =

=

=

=

31

Acceptance Rule

The following are the PI acceptance rules:

Accept the project when PI is greater than one.

PI > 1

Reject the project when PI is less than one.

PI < 1

May accept the project when PI is equal to one.

PI = 1

The project with positive NPV will have PI greater than one.

PI less than means that the projects NPV is negative.

32

Evaluation of PI Method

It recognises the time value of money.

It is consistent with the shareholder value maximisation

principle. A project with PI greater than one will have

positive NPV and if accepted, it will increase

shareholders wealth.

In the PI method, since the present value of cash

inflows is divided by the initial cash outflow, it is a

relative measure of a projects profitability.

Like NPV method, PI criterion also requires calculation

of cash flows and estimate of the discount rate. In

practice, estimation of cash flows and discount rate

pose problems.

33

Conventional and Non-conventional Cash Flows

A conventional investment has cash flows the

pattern of an initial cash outlay followed by cash

inflows. Conventional projects have only one

change in the sign of cash flows; for example,

the initial outflow followed by inflows,

i.e., + + +.

A non-conventional investment, on the other

hand, has cash outflows mingled with cash

inflows throughout the life of the project. Non-

conventional investments have more than one

change in the signs of cash flows; for example,

+ + + ++ +.

34

NPV Versus IRR

Conventional Independent Projects:

In case of conventional investments, which are

economically independent of each other, NPV

and IRR methods result in same accept-or-reject

decision if the firm is not constrained for funds in

accepting all profitable projects.

35

NPV Versus IRR

Cash Flows (Rs)

Project C0 C1 IRR NPV at 10%

X -100 120 20% 9

Y 100 -120 20% -9

Lending and borrowing-type projects:

Project with initial outflow followed by inflows is

a lending type project, and project with initial

inflow followed by outflows is a lending type

project, Both are conventional projects.

36

Problem of Multiple IRRs

A project may have

both lending and

borrowing features

together. IRR method,

when used to evaluate

such non-conventional

investment can yield

multiple internal rates

of return because of

more than one change

of signs in cash flows.

NPV Rs 63

-750

-500

-250

0

250

0 50 100 150 200 250

Discount Rate (%)

NPV (Rs)

37

Case of Ranking Mutually Exclusive Projects

Investment projects are said to be mutually exclusive when

only one investment could be accepted and others would

have to be excluded.

Two independent projects may also be mutually exclusive if

a financial constraint is imposed.

The NPV and IRR rules give conflicting ranking to the

projects under the following conditions:

The cash flow pattern of the projects may differ. That is, the cash

flows of one project may increase over time, while those of others

may decrease or vice-versa.

The cash outlays of the projects may differ.

The projects may have different expected lives.

38

Timing of Cash Flows

Cash Flows (Rs) NPV

Project C0 C1 C2 C3 at 9% IRR

M 1,680 1,400 700 140 301 23%

N 1,680 140 840 1,510 321 17%

39

Scale of Investment

Cash Flow (Rs) NPV

Project C0 C1 at 10% IRR

A -1,000 1,500 364 50%

B -100,000 120,000 9,080 20%

40

Project Life Span

Cash Flows (Rs)

Project C

0

C

1

C

2

C

3

C

4

C

5

NPV at 10% IRR

X 10,000 12,000 908 20%

Y 10,000 0 0 0 0 20,120 2,495 15%

41

Reinvestment Assumption

The IRR method is assumed to imply that the

cash flows generated by the project can be

reinvested at its internal rate of return, whereas

the NPV method is thought to assume that the

cash flows are reinvested at the opportunity

cost of capital.

42

Modified Internal Rate of Return (MIRR)

The modified internal rate of return (MIRR) is

the compound average annual rate that is

calculated with a reinvestment rate different than

the projects IRR.

43

Varying Opportunity Cost of Capital

There is no problem in using NPV method when

the opportunity cost of capital varies over time.

If the opportunity cost of capital varies over time,

the use of the IRR rule creates problems, as

there is not a unique benchmark opportunity cost

of capital to compare with IRR.

44

NPV Versus PI

A conflict may arise between the two methods if a

choice between mutually exclusive projects has to

be made. Follow NPV method:

Project C Project D

PV of cash inflows 100,000 50,000

Initial cash outflow 50,000 20,000

NPV

50,000 30,000

PI 2.00 2.50

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