Capital Budgeting

Should we build this plant?

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The Team

Financial Management

Presented by: Krishna Jalan Snehal Khannukar Sowmya C G Chandasish Baissya Shrey R Dhanawadkar
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Intro:
Factors
Decision Making Criteria

Types of Projects:
Process Evaluation Criteria

Discounting Criteria:
NPV IRR PI

Non-Discounting Criteria:
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PBP ARR

Definition

Capital budgeting is defined as The firms formal

process for the acquisition and investment of capital.

Planning for purchasing long-term assets.

Consists of planning of the available capital to

maximize profits.

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Availability of funds.
Structure of capital. Taxation policy. Government policy. Lending policies of financial institutions. Immediate need of the project.

Decision-Making Criteria in Capital Budgeting

How do we decide if a capital investment project should be accepted or rejected?

Contd
The Ideal Evaluation Method should:

a) Includes All cash flows that occur during the life

of the project.

b) Consider the Time value of money. c) Incorporate the Required rate of return on the project.

Firms invest in Three types of projects:

Independent projects.
Mutually exclusive projects. Contingent Investments.

The Process
PROPOSALS

IMROVEMENT IN PLANNING AND EVALUATION PROCEEDURE

PLANNING PHASE
PROPOSALS

NEW INVESTMENT OPPORTUNITIES

EVALUATION PHASE
PROJECTS

SELECTION PHASE
ACCEPTED PROJECTS

IMPLEMENTATION PHASE
ONLINE PROJECTS

CONTROL PHASE
PROJECT TERMINATION

AUDITING PHASE
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EVALUATION CRITERIA

DISCOUNTING CRITERIA

NON DISCOUNTING CRITERIA

NET PRESENT VALUE

INTERNAL RATE OF RETURN

PROBLTY INDEX (PI)

DISCD PBP

MODIFIED IRR
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ACC. RATE OF RETURN

PAYBACK PERIOD
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Discounting Criteria

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Net Present Value Method

The total PV of the annual net cash flows

The initial outlay.

Decision Rule:
If NPV is positive, Accept.

If NPV is negative, Reject.

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Year 0 1 2 3 4 5

Cash Flows -1100 358 246 325 385 467

NPV @ 14% 1.000 0.877 0.769 0.675 0.592 0.519

PV @ 14% -1100 313.966 189.174 219.375 227.92 242.373

6 TOTAL NPV

349

0.456

159.144 251.952

Merits & Demerits of NPV

Difficult to ascertain future cash flows.
Demerits

Considers Time value of money.

Relies on discount rate and estimated cash flows.
Merits

Biased towards long term projects.

May not give reliable results while dealing with projects under unequal project life.
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Consistent in maximizing the owners wealth.

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Internal Rate Of Return Method

Also known as the Marginal Rate of Return or

Time Adjusted Rate of Return.

It is the discount rate at which the present value of cash inflows equals the present value of cash outflows. i.e. NPV = 0

The rate of discount is determined by the Trial and Error method.

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Year 0 1

Cash Flows -1100 358

IRR @ 22.21% 1.000 0.818

PV @ 22.21% -1100 292.844

2
3 4 5 6

246
325 385 467 349

0.709
0.565 0.448 0.366 0.300

174.414
183.625 172.48 170.922 104.7

TOTAL NPV

(1.015)

If IRR is greater than or equal to the required rate of return, ACCEPT.

If IRR is less than the required rate of return, REJECT.

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Merits & Demerits of IRR

Considers Working

Demerits

Merits

Capital and Scrap value Considers cash flows during the whole project life.

Lengthy, Based on trial & error Assumes that future cash flows are reinvested at the rate equal to IRR NPV is more reliable.
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Maximizes the wealth of the equity share 5/16/2012 holders.

The calculation of the IRR implicitly assumes that the cash flows are reinvested at the IRR. This may not always be realistic.
Percentages can be misleading (would you rather

earn 10% on a Rs.100 investment, or 10% on a Rs.10,000 investment?)

NPV and IRR do not always select the same project in mutually exclusive decisions.

In the event of a conflict the selection of the NPV method is preferred.

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9-22

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.

Therefore, MIRR more accurately reflects the profitability of a project.

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MIRR correctly assumes reinvestment at opportunity cost.

MIRR also avoids the problem of multiple IRRs. Managers prefer MIRR method better for this than IRR.

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Profitability Index

The Ratio of payoff to investment. Also known as The Benefit cost ratio is the present value of forecasted future cash flows divided by the initial investment:

PROFITABILITY INDEX
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P/V OF CASH INFLOW INITIAL CASH OUTFLOW

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Year

Cash Flows

NPV @ 14%

PV @ 14%

0
1

-1100
358

1.000
0.877

-1100
313.966

2
3

246
325

0.769
0.675

189.174
219.375

PI: 1351.93 1100 = 1.22:1

4
5 6

385
467 349

0.592
0.519 0.456

227.92
242.373 159.144

TOTAL CASH INFLOW

1351.93

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

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Merits & Demerits of PI

Allows comparison of

Provides only relative

different scale projects

Undertakes Time value

profitability
Demerits
Potential Ranking

Merits

of money

Problems

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The discounted payback period is the number of

periods taken in recovering the investment outlay on

the present value basis.

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Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5 Discounted CF

Year Cash Flow

0 1 -500 250

@ (14%)

-500.00 219.30 1 year The Discounted280.70 Payback is 2.52 years 2 250 192.38 2 years 88.32 3 250 168.75 .52 years

Merits & Demerits of DPBP

Demerits

Discounts the cash flows at the firms required rate of return.

Still does not examine all cash flows.

Merits

Payback period is calculated using these discounted net cash flows.

Difficult to ascertain future cash flows.

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Non Discounting Criteria

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Payback Period

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Defined as the numbers of years required to cover the

original cost outlay.

INITIAL INVESTMENT

ANNUAL CASH FLOW

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Cash out flow = 1100 crores Cash IN Flow Year 1st Year 2nd Year 3rd Year 4th Year 5th Year 6th year Amt in crore 358 246 325 385 929 + 171/385 =0.44 3 years

0.44

467 349 3.44 years

Merits & Demerits of PBP

Simple.
DISADVANTAGES ADVANTAGES

Ignores cash after the payback period.

Emphasizes on earlier cash flows. Selection or rejection of any project is easier.

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Fails to consider time value of the money Based on the principle of rule of thumb.
No recognition for the pattern of cash flows & its timing.

Best suited for evaluating high-risks projects.

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Average Rate Of Return

Project Investment is judged by looking at its rate of return on book value. Evaluates return on accounting profits. i.e. on accrual basis. Annual returns are expressed in percentage of net investment.

AVERAGE RATE OF RETURN

AVERAGE PROFIT AFTER TAX

AVERAGE INVESTMENT

100

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Project A: Step 1: Annual Depreciation = Step 2: Year Cash Inflow (+) Salvage Value (+) Depreciation* Accounting Income Step 3: Average Accounting Income

( 220 10 ) / 3 = 70 1 2 3 91 130 105 10 -70 -70 -70 16 60 45

( 16 + 60 + 45 ) 3 40.333 220 = 40.333 = 8.3%

Step 4: Accounting Rate of Return

Average Rate Of Return

Project B: Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60 Step 2: Year 1 2 3 Cash Inflow 87 110 84 Salvage Value 18 Deprecation* -60 -60 -60 Accounting Income 27 50 42 Step 3: Average Accounting Income = ( 27 + 50 + 42 ) = 39.666 3 Step 4: Accounting Rate of Return = 39.666 =20.0% 198

Merits & Demerits of ARR

It can be affected by noncash items such as depreciation & bad debts

Simple.

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Demerits

Merits

Considers value of project to its economic life.

Easy to calculate using the accounting data. Ensured earnings of profitability of the project using net earnings concept.
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Fails to consider time value of money.

Ignores the fact that profits earned can be reinvested. Can be calculated in a wide variety.
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Thank You Open for Queries

ips

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