Capital Budgeting

Techniques (cntd.)
Lecture 13
EFM
MS REE
18 Aug 2014

Capitalized Equivalent
Method
lim N ( P / A, i, N ) lim N [((1 i ) N 1) / i (1 i ) N ] 1 / i
PV (i ) A( P / A, i, N ) A / i

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Capitalized Equivalent
Method
Another method of PV criterion is useful when
the life of project is perpetual or planning
horizon is very long.
Perpetual Service life
PV = A/i

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Capitalized Equivalent
Method
The process of calculating PV cost for infinite

period is called capitalization of project cost.

The cost is known as the Capitalized cost i.e.
the amount of money to be invested now to
get a certain return 'A' at the end of each and
every year forever.

A
PV
i
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Capitalized Equivalent
Method
A hydropower project is of 50 years life.

An entrepreneur spent $800,000 (not

considering time value of money) during
the last 10 years. We have to compute the
project value (worth) using different
interest rates.
(a) If the entrepreneurs MARR is 8%
compute NPV with 50 year service life and
infinity.
(b) Repeat the same at 12% MARR and see
the difference.
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Types of Projects
Mutually exclusive projects are those projects,

if you accept one project, you have to exclude

other project.
For service projects, we use the NPV of costs
and choose the project which has the least
negative NPV.
For revenue projects, we use NPV of revenues
and choose the project which ahs the highest
NPV.

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Annual Equivalent Value Analysis

The annual equivalent value (AE) criterion is a
basis for measuring investment value by
determining equal payments on an annual
basis.

First, we have to find the NPV of the project and

then convert it to equal annual payments.

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Annual Equivalent Value

(AEV)
AE(i) =PV(i)(A/P,i,n)
If AE>0, accept the project
If AE =0, remain indifferent
If AE <0, reject the project

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Benefits of AE analysis
1.Consistency of report format.

Financial and engineering managers may

prefer to work on yearly costs rather
than overall costs.
2.Need for unit costs. In many
situations, project must be broken down
into unit costs for comparison and ease.
3.Unequal project lives. Comparing
projects with unequal service lives is
complicated in calculations, but using AE
analysis, this problem can be easily
solved.
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Operating Costs and Capital Costs

Operating costs are incurred by the

operations of the plant or factory.

Capital costs are incurred only one time in
the project life, where operating costs incur
annually. The annual equivalent of the capital
cost is capital recovery cost 'CR'.
CR = P(A/P,i,n) - S(A/F,i,n)

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Operating Costs and Capital Costs

(A/F, i, n)=(A/P, i, N) I
CR(i) =(i-S)(A/P,i, N) +iS

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Life Cycle Cost (LCC)

If a project investment cost is P with the

service life of n period.

The annual operating cost is Ai.
The life cycle cost (LCC) is

LCC = Capital cost + operating cost

n

LCC P Ai ( P / A, i, n)
n 1

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Annualized Life Cycle Cost (ALCC)

Sometime in the big investment project, we

have to spread the capital cost for the entire

service period, in order to minimize the the
lumpy financial burden, then we have to
calculate ALCC.
ALCC = annual capital cost + annual
operating cost

ALCC = annual capital cost + annual operating cost

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Annualized Life Cycle Cost (ALCC)

ALCC =LCC (A/P, I,n)

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Selection of technology

(class

exercise)
For an average urban household in Nepal, the

monthly requirements of fuels are 17 liters of

kerosene, 10 Kg of LPG and 100 kWh of
electricity for cooking purposes. The cost of
cooking stoves and their service lives are as
follows:
Kerosene stove

LPG stove

Electric
hotplates

Costs for 2: NR 500 3,000 (with 2

burners)

4,000 (with 2
plates)

Life: 5 years

Life: 10 years

Life: 10 years

Selection of technology

(fuel

prices)
Year

Kerosene
Price

LPG Price

Electricity
tarif

2000

NR 17/lit

NR 550/cyl

NR 6.30/unit

2003

28

700

7.30

2006

48

900

7.30

2011

73.50

1,325

7.30

2012
93.00
1,415
8.75*
* If the current electricity tarif is raised by 20% from July 2012
Based on the monthly annualized life cycle costs, find out
the costs of monthly cooking at diferent years and select
the technology which has the lowest cost of cooking at present.

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.
or

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.

Example
A project will cost Rs 40,000. Its stream of

earnings before depreciation, interest and

taxes (EBDIT) during first year through five
years is expected to be Rs 10,000, Rs 12,000,
Rs 14,000, Rs 16,000 and Rs 20,000. Assume
a 50 per cent tax rate and depreciation on
straight-line basis.

Calculation of Accounting Rate of

Return

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.

Evaluation of ARR
Method
The ARR method may claim some merits
Simplicity
Accounting data
Accounting profitability
Serious shortcomings
Cash flows ignored
Time value ignored
Arbitrary cut-off

Internal Rate of Return

(IRR)
IRR is the interest rate earned on the
unrecovered project balance of investment
such that, when the project terminates, the
unrecovered project balance will be zero.

NPV = A0/(1+i*)0 + A1/(1+i*)1 + A2/(1+i*)2 .+

An/(1+i*)n =0

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Internal Rate of Return

(IRR)
Simple Investments
A simple investment is defined as that
investment, when the sign change in the
project cash flow occurs only once.
A non-simple investment is that investment
where the sign change occurs more than once.

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Investment
Classification
Invest
ment
type

0
period

Simple

Simple

Nonsimple

Nonsimple

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Internal Rate of Return

(IRR)
Methods of project Evaluation by IRR
If IRR>MARR, accept the project
If IRR = MARR, remain indifferent
If IRR < MARR, reject the project

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Internal Rate of Return

(IRR)
Multiple IRR
When there are multiple values of IRR, we can
predict unique value of IRR by examining its
cash flows.
1.Net cash flow rule of sign
2.Accumulated net cash flow rule of sign

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Cash Flow Rule of Signs

Net Cash flow rule of sign
The number of real i* that are greater than

-100% for a project with 'n' periods is never

greater than the number of sign changes in the
sequence of the An values.
Accumulated Cash flow rule of sign
If the net cash flow sign test shows multiple
values of i*, then we should proceed to this sign
test.
If the series of cumulative cash flows start
negatively and changes the sign only once,
then there exists a unique positive i*.
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Methods for determining IRR

1.The direct-solution method

2.The trial-and-error method, and
3.The graphic method

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Direct Solution Method

n

Project 1

Project 2

-$1,000

_$2,000

1,300

1,500

1,500

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Direct Solution Method

Project 1

FV (i* ) $1, 000( F / P, i* , 4) $1,500 0

$1,500 $1, 000( F / P, i* , 4) $1, 000(1 i* ) 4
1.5 (1 i* ) 4
1
4

i* 1.5 1
i* 0.1067or10.67%
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Direct Solution Method

Project 2

NPV $2, 000

$1, 300 $1, 500

0
2
(1 i )
(1 i )

Let
x

1
(1 i )

NPV $2, 000 $1, 300 x $1, 500 x 2 0

1, 300

1, 300 2 4(1, 500)( 2, 000)

x
2(1, 500)
1, 300 3, 700
x
3, 000
x 0.8or 1.667
1
1 i
i 25%
0.8

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NPV
vs.
IRR
Conventional Independent Projects:
In case of conventional investments, which
are economically independent of each other,
NPV and IRR methods result in same acceptor-reject decision if the firm is not constrained
for funds in accepting all profitable projects.

NPV vs. IRR

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 borrowing type
project, Both are conventional projects.

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.

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.

Timing of cash flows

Themostcommonlyfoundconditionfortheconflictbetweenthe
NPV and IRR methods is the difference in the timing of cash
flows.LetusconsiderthefollowingtwoProjects,MandN.

Cont

NPV Profiles of Projects M and N

NPV versus IRR

The NPV profiles of two projects intersect at 10 per cent

discount rate. This is called Fishers intersection.

Scale of investment

Project life span

Incremental investment Analysis

Under NPV and AEV analysis, the mutually

exclusive project with the highest value is

selected and this method is known as
Total Investment Approach. NPV, NFV,
and AEV methods of project evaluation are
absolute measures, whereas the IRR
method is a relative (percentage) measure,
and it ignores the scale of investment. But
for comparison of mutually exclusive
projects by IRR method, we have to do
Incremental Investment Analysis.

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Incremental investment Analysis

If
IRRB A MARR, SelectB
IRRB A MARR, Beindifferent
IRRB A MARR, SelectA

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Depreciation
Asset Depreciation
Depreciation is the gradual decrease in
utility of fixed assets with use and time.
Physical Depreciation
It is the reduction in an asset's capacity to
perform its service due to physical
impairment.

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Depreciation
Functional Depreciation
It occurs as a result of changes in the
organization or in technology that decrease or
eliminate the need for an asset.
Economic Depreciation

Economic Depreciation = purchase price market value

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Depreciation
Both physical and functional depreciation are

categories of economic depreciation.

Accounting Depreciation
It is the systematic allocation of the initial cost

of an asset (machine or equipment) in parts

over a time known as its depreciable life.

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Depreciation
Economic
Depreciation
A gradual decrease
in utility of asset

Depreciation

Physical
Depreciation
Functional
Depreciation

Book
Depreciation
Accounting
Depreciation
The systematic
allocation of an
asset's value in
parts over its
depreciable life

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Tax
Depreciation

45

Depreciation Implication
Net Income
When a project's revenue exceeds its expenses,
we say that the project generated a profit or
income. It the project's revenue is less than its
expenses, then we say that the project resulted
in a loss.

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Depreciation Implication
Revenue
-Expenses (cost of goods sold)
Gross Profit
-Operating expenses
-Depreciation
Taxable Income (Income before tax)
-Income Tax
Net Income
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Depreciation Implication
Cash flow = net income +
depreciation

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Depreciation Methods
The most widely used methods are:
Straight-line Method
Declining Balance Method, and
Sum-of-years'- digit method

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Depreciation Methods
Straight-Line Method
In this method, it is assumed that the

fixed asset is depreciated in a uniform

way.

PS
Dn N

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Straight-Line Method
Where
Dn = the depreciation charge during n
year
P = the cost of the asset, including
installation expenses
S = salvage value at the end of the useful life
of asset
N = the useful life

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Depreciation Methods
The book value = cost base - total depreciation
charges
Bn = P - (D1 + D2 +.+ Dn)

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Declining Balance
Method
In this method, a fixed fraction of the initial
book balance is deducted each year. The
fraction or declining balance rate is
obtained by
d = 1/N
The most common multiplier is '1'. If this is
'2', then it is called double-declining
balance method.
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Declining Balance
Method
D1 =dP
D2 =d(P - D1)= dP(1-d)
D3 =d(P - D1- D2)=dP(1-d)2
For 'n' year, Dn = dP(1-d)n-1

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Declining Balance
Method
We can also compute the total DB

depreciation at the end of 'n' years

TDB = D1 + D2 + D3 + D4 + .. + Dn

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= dP +dP(1 -d) +dP(1-d)2+ . +(1-d)n-1

TDB = P[1-(1-d)n]

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Sum-of-years'-Digit Method (SOYD)

In this method, SOYD = 1 +2 +. +N =N(N
+1)/2
Where, N = the useful life
Dn =(N -n +1)(P -S)/SOYD

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Tax Depreciation Rates

Houses & Building
Transportation equipment

5%

Car, Jeep, Van & Motorcycle

Cycle
20 %

Furniture

Metal
Wooden

15 %

10 %
15 %

Equipment & Machinery

Machinery
15 %
Computers
20 %
Laboratory equipment
15 %
X-Ray machine
20 %
Typewriter, photocopy machine 15 %

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Income Tax Rates

Corporate Income Tax

(Public Co.)
Private Co.
(manufacturing)
Other Industries
Value Added Tax

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20 %
25 %
25 %
13 %

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DCF Model
A factory is considering a $ 10 million expansion. The estimated life of the
new facility will be 10 years. Estimating of key input factors are given in the
table below. Develop the DCF model in EXCEL. Find the mean NPV, and
explain whether the expansion plan is feasible. Tax rate is 20% and MARR
is 12%. Interest and depreciation rates are 10%.
Input factor

Most likely value

Market size

250,000 tons

Selling price per ton

$450

Market growth rate

3%

Market share

10%

Total investment required

$10 million

Useful life

10 years

Residual value of facility

$ 4 million

Operating costs per ton

$ 375 (mean)

Fixed costs

$325,000 (mean)