Contents

• Capital Budgeting• Methods of Capital Budgeting– Payback– Discounted payback– Net Present Value– Profitability Index– Internal Rate Return

• Mutually Exclusive & Independent Projects• Methods of Financing• Capital Structure & Cost of Capital

1. Capital Budgeting

• Capital budgeting (or investment appraisal) is the planning process used to determine whether a business organization’s long term investments such as new machinery, replacement machinery, new plants, new products, and research & development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

• Methods: Payback, Discounted Payback, Net Present value, Profitability Index, Internal Rate of Return

2. Independent vs Mutually Exclusive Projects

3.Payback Period (Conventional)

Illustration Question: 1

Year (n) Cash Inflows (SR) Cash Outflows (SR)

1 0 650,000

2 215,500 53,000

2 215,500 53,000

--- ---- ----

8 215,500 53,000

The Cash flows of a computer-process control system project is given below. Determine the payback period for this project

Answer

Initial Cost = SR 650,000Annual Cash receipt = SR 162,500

Payback Period = Initial Cost Annual Cash receipt= 650,000 = 4 Years

162,500

Illustration Question: 2

Period Cash inflow (SR)

1 15,000

2 25,000

3 35,000

4 45,000

5 45,000

6 35,000

Auto numeric's Company has just bought a new spindle machine at a cost of SR 105,000 to replace one that had a salvage value of SR 20,000. The projected annual returns via improved efficiency are as follows. Calculate the payback period.

AnswerInitial Cost = SR 105,000Scrap Value (Salvage) = SR 20,000Calculate the cumulative values (From the initial cost the salvage value to be

subtracted to get the real cost)Period Cash inflow (SR) Cumulative

Cash Flow0 -105,000 + 20,000 -85,000

1 15,000 -70,000

2 25,000 -45,000

3 35,000 -10,000

4 45,000 35,000

5 45,000 80,000

6 35,000 115,000

Answer Continues (Graph)

0 1 2 3 4 5 6

1 00,000

1 50,000

50,000

-50,000

-100,000

Cumulative Cash Flow

Year

Payback period = 3.7 Years

4. Discounted Payback

Illustration Question: 3

Auto numeric's Company has just bought a new spindle machine at a cost of SR 105,000 to replace one that had a salvage value of SR 20,000. The projected annual savings via improved efficiency are as follows. Calculate the discounted payback period, if the rate of return is 15%.

Period Cash inflow (SR)

1 15,000

2 25,000

3 35,000

4 45,000

5 45,000

6 35,000

Answer

Period Cash inflow (SR) Time Value @15%

Discounted Cumulative Cash Flow

Remarks

0 -105,000 + 20,000 = -85,000

- -85,000

1 15,000 -12,750.0 -82,750.0 -85000+ -12750+ 15000

2 25,000 -12,412.5 -70,162.5 -82750.5+-12412.5+25000

3 35,000 -10,524.38 -45,686.88 -70,162.5+-10,524.38+35000

4 45,000 -6,853.03 -7,539.91 -45,686.88+-6853.03+45000

5 45,000 -1130.99 36,329.1 -7539.91+-1130.99+45000

6 35,000 5,449.37 76,778.47 36329.1+5449.37+35000

Answer (Graph)

0 1 2 3 4 5 6

100,000

75,000

50,000

25,000

25,000

50,000

75,000

100,000

Payback period = 4.4 Years

YearDiscounted Cumulative Cash Flow

5. Net Present Value (Net Present Worth)

• The net present value (NPV) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows.

• In the case when all future cash flows are incoming and the only outflow of cash is the initial cost, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV).

• Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed.

Net Present Value

ojecttheofLifeN

turnofRateAttractiveMinimumMARR

ORrateInterestcapitalofCosti

nperiodofendatFlowCashNetA

Where

i

A

i

A

i

A

i

ANPV

n

N

n

nn

NN

Pr

))Re

(

;

)1(

)1()1()1(

0

11

00

Business Decision based on NPV

Value of NPV Meaning Business Decisions

NPV > 0The investment would add value to the firm

The project may be accepted

NPV < 0The investment would subtract value from the firm

The project should be rejected

NPV = 0The investment would neither gain nor lose value for the firm

We should be indifferent in the decision whether to accept or reject the project.

Illustration Question: 1

A corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over six years. This project will have an immediate (n=0) cash outflow of SR 100,000 (which might include machinery, and employee training costs). Other cash outflows for years 1–6 are expected to be SR 5,000 per year. Cash inflows are expected to be SR 30,000 each for years 1–6. There are no cash flows expected after year 6. The required rate of return is 10%. Calculate the NPV.

Answer Year Cash flow Present value (SR)

n = 0 -100,000/(1+0.10)0 -100,000

n= 1 30,000-5000/(1+0.10)1 22,727

n= 2 30,000-5000/(1+0.10)2 20,661

n= 3 30,000-5000/(1+0.10)3 18,783

n= 4 30,000-5000/(1+0.10)4 17,075

n= 5 30,000-5000/(1+0.10)5 15,523

n= 6 30,000-5000/(1+0.10)6 14,112

NPV 8,881.52

nn

i

ANPV

)1(

Conclusion for the Problem

• Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no mutually exclusive alternative with a higher NPV.

Illustration Question: 2

Tiger Machine Tool Company is considering acquiring a new metal-cutting machine. The required initial investment of SR 76,000 and the projected cash benefits over the project’s 4 year life are as follows. You have been asked by the CEO of the company to evaluate the economic merit of acquisition. The interest rate is 12% .

Year Net Cash Flows (An)

n = 0 76,000

n= 1 35,560

n= 2 37,360

n= 3 31,850

n= 4 34,400

AnswerYear Cash flow Present value (SR)

n = 0 -76,000/(1+0.12)0 -76,000

n= 1 35,560/(1+0.12)1 31,750

n= 2 37,360/(1+0.12)2 29,783

n= 3 31,850/(1+0.12)3 22,670

n= 4 34,400/(1+0.12)4 21,862

NPV SR 30,065

n

n

i

ANPV

)1(

Since the NPV is greater than zero, it would be better to invest in the Machine

6. Profitability Index

• Profitability index (PI) is the ratio of payoff to investment of a proposed project.

• It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

Calculation of Profitability Index

InvestmentInitial

FlowsCashFutureofPVIndextyproftabili

The Cash Flow calculated does not include the investment made in the project

A profitability index of 1 indicates breakeven

Rules for selection or rejection of a project:•If PI > 1 then accept the project •If PI < 1 then reject the project

Illustration Question-1

Year Cash Flow

1 18000

2 12000

3 10000

4 9000

5 6000

Question: One business man wanted to invest SR 40,000 and the life of the machines is 5 years. Based on the following information calculate the NPV at 10% and PI of the project.

Solution

Year Cash flow Present value (SR)

1 18000/(1+0.10)1 16363

2 12000/(1+0.10)2 9917

3 10000/(1+0.10)3 7519

4 9000/(1+0.10)4 6147

5 6000/(1+0.10)5 3727

Total Present Value 43673

Solution (Continues)

Total present value = 43673Investment = 40000 NPV = Total present value – Investment

= 43673 – 40000 = 3673 PI = Total Present Value/ Initial Investment

= 43673 / 40000 = 1.091

Since the value of PI is >1, accept the project

7. Internal Rate of Return

• The internal rate of return (IRR) is a rate of return used in capital budgeting to measure and compare the profitability of investments.

• The term internal refers to the fact that its calculation does not incorporate environmental factors (e.g., the interest rate or inflation).

• The internal rate of return on an investment or project is the "annualized effective compounded return of rate" or discount rate that makes the Net Present Value (NPV) of all cash flows (both positive and negative) from a particular investment equal to zero.

Internal Rate of Return (Continues)

• The IRR of an investment is the Discount Rate at which the Net Present Value of costs (negative cash flows) of the investment equals the Net Present value of the benefits (positive cash flows) of the investment.

• It is a commonly used as a measure of investment efficiency.

• The higher a project's internal rate of return, the more desirable it is to undertake the project.

Calculation of IRR

Given the period (n), cash flow (Cn) total number of periods (N) and the net present value (NPV), the internal rate of return (r) is given by in:

0)1(0

N

nn

n

i

ANPV

Any fixed time can be used in place of the present (e.g., the end of one interval of an annuity); the value obtained is zero if and only if the NPV is zero.

Illustration Question: 1

Question: Calculate the IRR of an investment project based on the cash flows as indicated below.

Year (n) Cash Flow (An)

0 −4000

1 1200

2 1410

3 1875

4 1050

Answer

Year (n) Cash Flow (Cn) Present Values

i= 5% i = 10% i= 15% i = 20%

0 −4000 = -4000

= -4000

= -4000

= -4000

1 1200 =1143

=1091

=1043

=1000

2 1410 =1279

=1165

=1068

=979

3 1875 =1620

=1409

=1234

=1085

4 1050 =864

=717

=600

=506

Net Present Value (NPV) 906 382 -65-430

0)05.01(

4000

0)10.01(

4000

0)15.01(

4000

0)20.01(

4000

1)05.01(

1200

1)10.01(

1200

1)15.01(

1200

1)20.01(

1200

2)05.01(

1410

2)10.01(

1410

2)15.01(

1410

2)20.01(

1410

3)05.01(

1875

3)10.01(

1875

3)15.01(

1875

3)20.01(

1875

4)05.01(

1050

4)10.01(

1050

4)15.01(

1050

4)20.01(

1050

Solution (Continues)

Then the IRR is given by

NPV = -4000 + 1200/(1+i)1 + 1410/(1+i)2 + 1875/(1+i)3 + 1050/(1+i)4 = 0

Graphical Derivation of IRR

R20%15%10% 5%

0

1000

800

600

400

200

-200

-400

-600

14.3%

In this case, the answer is 14.3%.

8. Methods of Financing

Equity Financing

Debt Financing

9. Capital Structure

Major Factor affecting Capital Structure Policy of a Company

1. Capital Structure policy involves the trade-off between risk and return (The optimal capital structure make a balance between business risks and expected future earnings).

2. Major reason for using debt is that, interest is a deductible expense for business operations.

3. Financial flexibility – The ability to raise capital on reasonable terms from the financial market.

10. Cost of Capital