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massive investment of resources Are not easily reversible Have long-term implications for the firm Involve uncertainty and risk for the firm
Investment Decision
Financing Decision
Lease or buy
Cost reduction
CAPITAL BUDGETING
Why? Business Application
Valuing projects that affect firms strategic direction Methods of valuation used in business Parallels to valuing financial assets (securities)
Capital Budgeting
Describes how managers plan significant outlays on projects that have long-term implications such as the purchase of new equipment and introduction of new products.
Working capital
Initial investment
Reduction of costs
Incremental revenues
Projects are:
independent, if the cash flows of one are unaffected by the acceptance of the other. mutually exclusive, if the cash flows of one can be adversely impacted by the acceptance of the other.
Non-DCF TECHNIQUES:
Accounting rate of return Payback Period Approach
DCF TECHNIQUES:
Discounted Payback Period Approach Net Present Value Approach Internal Rate of Return Profitability Index
It is based on cash flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects
Strengths:
Easy to calculate and understand. Accounting information is easily available and easy to interpret.
Weaknesses:
Ignores the TVM. Ignores CFs occurring after payback period.
Strengths:
Provides an indication of a projects risk and liquidity. Easy to calculate and understand.
Weaknesses:
Ignores the TVM. Ignores CFs occurring after payback period. No specification of acceptable payback.
Similar to payback period approach with one difference that it considers time value of money The amount of time needed to recover initial investment given the present value of cash inflows Keep adding the discounted cash flows till the sum equals initial investment All other drawbacks of the payback period remains in this approach Not consistent with wealth maximization
The main DCF techniques for capital budgeting include: Net Present Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI) Each requires estimates of expected cash flows (and their timing) for the project.
Including cash outflows (costs) and inflows (revenues or savings) normally tax effects are also considered.
Each requires an estimate of the projects risk so that an appropriate discount rate (opportunity cost of capital) can be determined.
The discussion of risk will be deferred until later. For now, we will assume we know the relevant opportunity cost of capital or discount rate.
Sometimes the above data is difficult to obtain this is the main weakness of all DCF techniques.
Then the Project is . . . Acceptable, since it promises a return greater than the required rate of return. Acceptable, since it promises a return equal to the required rate of return. Not acceptable, since it promises a return less than the required rate of return.
Zero . . .
Negative . . .
The internal rate of return is the interest yield promised by an investment project over its useful life. The internal rate of return is computed by finding the discount rate that will cause the net present value of a project to be zero. Accept a project if IRR Cost of Capital
Strengths
IRR number is easy to interpret: shows the return the project generates. Acceptance criteria is generally consistent with shareholder wealth maximization.
Weaknesses
Requires knowledge of finance to use. Difficult to calculate need financial calculator.
A part of discounted cash flow family PI = PV of Cash Inflows/initial investment Accept a project if PI 1.0, which means positive NPV Usually, PI consistent with NPV PI may be in conflict with NPV if
Projects are mutually exclusive
Scale of projects differ Pattern of cash flows of projects is different
Strengths
PI number is easy to interpret: shows how many rupees (in PV terms) you get back per rupee invested. Acceptance criteria is generally consistent with shareholder wealth maximization. Relatively straightforward to calculate. Useful when there is capital rationing.
Weaknesses
Requires knowledge of finance to use. Method needs to be adjusted when there are mutually exclusive projects.
Although our decision should be based on NPV, but each technique contributes in its own way. Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the projects estimated cash flows PI is a measure of cost-benefit analysis. How much NPV for every rupee of initial investment