4905761 3rd Session Capital Budgeting

8/7/2019 4905761 3rd Session Capital Budgeting

1/34

The Basics of Capital Budgeting:

Evaluating Cash Flows

Should we

build this

plant?


2/34

Capital BudgetingCapital Budgeting:: the process ofthe process of

planning for purchases of longplanning for purchases of long--

term assets.term assets.

exampleexample::

Suppose our firm must decide whether toSuppose our firm must decide whether topurchase a new plastic molding machinepurchase a new plastic molding machine

for Rs125,000. How do we decide?for Rs125,000. How do we decide?

Will the machine be profitable?Will the machine be profitable?

Will our firm earn a high rate of returnWill our firm earn a high rate of return

on the investment?on the investment?


3/34

DecisionDecision--making Criteria inmaking Criteria in

Capital BudgetingCapital Budgeting

How do we decideHow do we decide

if a capitalif a capital

investmentinvestment

project shouldproject should

be accepted orbe accepted or

rejected?rejected?


4/34

The Ideal Evaluation Method should:The Ideal Evaluation Method should:

a) includea) include all cash flowsall cash flows that occurthat occur

during the life of the project,during the life of the project,

b) consider theb) consider the time value of moneytime value of money,,c) incorporate thec) incorporate the required rate ofrequired rate of

returnreturn on the project.on the project.

DecisionDecision--making Criteria inmaking Criteria in

Capital BudgetingCapital Budgeting


5/34

Future valueFuture value

FV PV i! 1 .

Whats the FV of an initial Rs 100Whats the FV of an initial Rs 100

after 3 years if i = 10%?after 3 years if i = 10%?


6/34

After 3 years:

FV3 = PV(1 + i)3

= Rs 100(1.10)3

= Rs 133.10.


7/34

Present valuePresent value

Whats the PV of Rs 100 due in 3 years if i =Whats the PV of Rs 100 due in 3 years if i =

10%?10%?

PV =

FV

1 i= FV

1

1 i

PV = 100 1.10

1

3

Rs 75.13.=


8/34

PaybackPeriodPaybackPeriod

The number of years needed toThe number of years needed to

recover the initial cash outlay.recover the initial cash outlay.

How long will it take for the projectHow long will it take for the project

to generate enough cash to pay forto generate enough cash to pay for

itself?itself?


9/34




itself?itself?

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150


10/34




itself?itself?

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150

Payback period = 3.33 years.Payback period = 3.33 years.


11/34

Is a 3.33 year payback period good?Is a 3.33 year payback period good?

Is it acceptable?Is it acceptable?Firms that use this method willFirms that use this method will

compare the payback calculation tocompare the payback calculation to

some standard set by the firm.some standard set by the firm.

If our senior management had set aIf our senior management had set a

cutcut--off of 5 years for projects likeoff of 5 years for projects like

ours, what would be our decision?ours, what would be our decision?

Accept the projectAccept the project..


12/34

Drawbacks ofPaybackPeriod:Drawbacks ofPaybackPeriod:

Firm cutoffs areFirm cutoffs are subjectivesubjective..

Does not considerDoes not consider time value of moneytime value of money..

Does not consider anyDoes not consider any required rate ofrequired rate of

returnreturn..

Does not consider all of the projectsDoes not consider all of the projects

cash flowscash flows..


13/34



cash flows.cash flows.

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0

Consider this cash flow stream!


14/34



cash flows.cash flows.

00 11 22 33 44 55 8866 77

(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0

This project is clearly unprofitable, but we

would accept it based on a 4-year payback

criterion!


15/34

Discounted PaybackDiscounted Payback

Discounts the cash flows at the firmsDiscounts the cash flows at the firms

required rate of return.required rate of return.

Payback period is calculated usingPayback period is calculated usingthese discounted net cash flows.these discounted net cash flows.

ProblemsProblems::

Cutoffs are still subjective.Cutoffs are still subjective.

Still does not examine all cash flows.Still does not examine all cash flows.


16/34


00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250

DiscountedDiscounted

YearYear Cash FlowCash Flow CF (14%)CF (14%)

00 --500500 --500.00500.00

11 250250 219.30219.30


17/34


00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.70


18/34


00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38


19/34


00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38 2 years2 years

88.3288.32


20/34


00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38 2 years2 years

88.3288.32

33 250250 168.75168.75


21/34


00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38 2 years2 years

88.3288.32

33 250250 168.75168.75 .52 years.52 years


22/34


00 11 22 33 44 55

(500) 250 250 250 250 250(500) 250 250 250 250 250



00 --500500 --500.00500.00

11 250250 219.30219.30 1 year1 year

280.70280.70

22 250250 192.38192.38 2 years2 years

88.3288.32

33 250250 168.75168.75 .52 years.52 years

The DiscountedThe Discounted

PaybackPayback

isis 2.522.52 yearsyears


23/34

Other MethodsOther Methods

1)1) Net Present ValueNet Present Value (NPV)(NPV)

2)2) Profitability IndexProfitability Index (PI)(PI)

3)3) Internal Rate of ReturnInternal Rate of Return (IRR)(IRR)

Each of these decisionEach of these decision--making criteria:making criteria:

Examines all net cash flows,Examines all net cash flows,

Considers the time value of money, andConsiders the time value of money, and

Considers the required rate of return.Considers the required rate of return.


24/34

Net Present ValueNet Present Value

yyNPV = the total PV of the annual netNPV = the total PV of the annual netcash flowscash flows -- the initial outlay.the initial outlay.

yy Decision RuleDecision Rule::

yy If NPV is positive,If NPV is positive,ACCEPTACCEPT..

yy If NPV is negative,If NPV is negative, REJECTREJECT..


25/34

NPV ExampleNPV Example

0 1 2 3 4 5

(276,400)83,000 83,000 83,000 83,000 116,000

Suppose we are considering a capital investmentSuppose we are considering a capital investment

that costs Rs276,400 and provides annual netthat costs Rs276,400 and provides annual net

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

Rs116,000 at the end of the fifth year. TheRs116,000 at the end of the fifth year. The

firms required rate of return is 15%.firms required rate of return is 15%.


26/34

Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRRIRR: the return on the firms: the return on the firms

invested capital. IRR is simply theinvested capital. IRR is simply the

rate of return that the firm earnsrate of return that the firm earns

on its capital budgeting projects.on its capital budgeting projects.


27/34


NPVNPV == -- IOIOACFACFtt

(1 + k)(1 + k) tt

nn

t=1t=177


28/34


n

t=177

IRR: = IOA

CFt(1 + IRR) t

NPVNPV == -- IOIOACFACFtt

(1 + k)(1 + k) tt

nn

t=1t=177


29/34


IRR is the rate of return that makes theIRR is the rate of return that makes the

PV of the cash flowsPV of the cash flows equalequal to the initialto the initial

outlay.outlay.

n

t=1

77IRR: = IO

ACFt

(1 + IRR) t


30/34

Calculating IRRCalculating IRR

Looking again at our problem:Looking again at our problem:

The IRR is the discount rate thatThe IRR is the discount rate that

makes the PV of the projected cashmakes the PV of the projected cash

flowsflows equalequal to the initial outlay.to the initial outlay.

0 1 2 3 4 5

(276,400)

83,000 83,000 83,000 83,000 116,000


31/34

This is what we are actually doing:This is what we are actually doing:

83,000 (PVIFA83,000 (PVIFA4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))

= 276,400= 276,400

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000


32/34

This is what we are actually doing:This is what we are actually doing:

83,000 (PVIFA83,000 (PVIFA4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))

= 276,400= 276,400

You should getYou should get IRR = 17.63%!IRR = 17.63%!

This way, we have to solve for IRR by trialThis way, we have to solve for IRR by trial

and error.and error.

00 11 22 33 44 55

(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000


33/34

IRRIRR

yy Decision RuleDecision Rule::

yy If IRR is greater than or equalIf IRR is greater than or equalto the required rate of return,to the required rate of return,ACCEPTACCEPT..

yy If IRR is less than the requiredIf IRR is less than the requiredrate of return,rate of return, REJECTREJECT..


34/34

ThanksThanks

4905761 3rd Session Capital Budgeting

Documents

Transcript of 4905761 3rd Session Capital Budgeting