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CHAPTER- 2

Capital Budgeting
Discounted payback period
Time value of money principle allows for the valuation of a likely stream of income in the future, in
such a way that annual incomes are discounted and then added together, thus providing a lump-sum
"present value" of the entire income stream; all of the standard calculations for time value of money
derive from the most basic algebraic expression for the present value of a future sum, "discounted" to
the present by an amount equal to the time value of money.
For example, the future value sum FV to be received in one year is discounted at the rate of interest to
give the present value sum PV: = (1+)

Let's look at an example. Assume that you would like to put money in an account today to make sure your child
has enough money in 10 years to buy a car. If you would like to give your child $10,000 in 10 years, and you
know you can get 5% interest per year from a savings account during that time, how much should you put in the
account now? The present value formula tells us:
PV = $10,000/ (1 + .05)10 = $6,139.13

Thus, $6,139.13 will be worth $10,000 in 10 years if you can earn 5% each year. In other words, the present
value of $10,000 in this scenario is $6,139.13.
Discounted payback period
Discounted payback period
Discounted payback period is based on payback period and we also consider time value of money.
Discounted payback period
Accounting Rate of Return (ARR)
ARR means we invested money into the project and how much profit we can get as a percentage of
investment. If this is greater than the target accounting rate of return then we should accept this
project.
Average Investment = initial investment +residual value
2
Annual Avg Profit
ARR = X 100
Average Investment
Total cash profit (Sales-Expenses) X
-
Total depreciation(Cost-RV) (X)

Total profit X

No of years X

AAP X
Accounting Rate of Return (ARR)
Do it yourself
Net profit vs. cash flows
If income statement information is provided, there are two adjustments which should be made to convert
to cash flows:
Depreciation depreciation is not a cash flow and should be added back where it has been deducted
in arriving at profits. The initial outflow and scrap inflow will deal with depreciation at the appropriate
time
Working capital a project may involve not only investment in land, buildings etc. but also investment
in working capital (inventory + receivables payables). Increases in net working capital represent an
outflow, decreases an inflow.
Cost of Capital
What is that ?
Net Present Value (NPV)
The net present value (NPV), defined as the present value of a projects cash inflows minus the present
value of its costs, tells us how much the project contributes to shareholder wealththe larger the NPV, the
more value the project adds and thus the higher the projects value.

NPV compares PV of Cash flow with Investment.

If NPV is Positive
If NPV is negative
If NPV is NIL

Example:
A machine will cost $45,000 and is expected to generate $8,000 for each of the following 8 years.
The cost of capital is 15% p.a.
NPV for multiple years
Do this
Internal Rate of Return (IRR)
Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a
particular project equal to zero. IRR calculations rely on the same formula as NPV does.
IRR
Exercise
IRR
Profitability Index (PI)
Another tool used to evaluate projects is called the profitability index (PI), or benefit-
cost ratio. This index is defined as the present value of the future cash flows divided by
the initial investment.

PI = PV of future cash flows /Initial cost


Example
Profitability Index (PI)
Capital Rationing
Capital rationing is the term used to cover the situation when the company has limited funds available for
investment. This can either be because there is only a limited amount available to be borrowed (hard capital
rationing) or alternatively the company decides to itself place a limit on the amount that it is prepared to borrow
(soft capital rationing). The object of the exercise is to decide how best to invest a limited amount of capital
available when there are several investments available.
Types of investment in Capital Rationing
Infinitely divisible projects:
If projects are said to be infinitely divisible, it means that it is possible to invest in any fraction of a project (up to a
maximum of 100% of the project). We also assume that if we invest in (say) 10% of a project then all the flows will be
10% of the full project flows and that therefore the resulting NPV will be 10% of the full project NPV.

The approach is as follows:


calculate the NPV per $ of initial investment (the profitability index)
rank the projects in terms of their profitability indexes.
invest as much as possible in the project with the highest profitability index, then go to the
project with the next highest, and so on until the capital available is exhausted.

Non-infinitely divisible projects


If projects are not infinitely divisible it is only possible to invest in whole projects. In this situation there is no quick
method the only approach is to look at all possible combinations of projects that are possible using the limited
amount of capital available, and choose the combination that gives the highest total NPV.
Example:
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Nominal vs Real Interest
Nominal Interest : A nominal interest rate is the interest rate that does not take inflation into account. It is the
interest rate that is quoted on bonds and loans. The nominal interest rate is a simple concept to understand; for
example, if you borrow $100 at a 6% interest rate, you can expect to pay $6 in interest without taking inflation into
account.

Real Interest: A real interest rate is the interest rate that does take inflation into account. As opposed to the
nominal interest rate, the real interest rate adjusts for the inflation and gives the real rate of a bond or a loan.

For example, suppose a bank loans a person $200,000 to purchase a house at a 3% rate. The 3% rate is the
nominal interest rate, not taking factoring for inflation. Assume the inflation rate is 2%. The real interest rate the
borrower is paying is 1%; the real interest rate the bank is receiving is 1%. The purchasing power of the bank only
increases by 1%.
Sensitivity Analysis
A sensitivity analysis is a technique used to determine how different values of an independent variable impact a
particular dependent variable under a given set of assumptions.
Example
Daina has just set up a new company and estimates that the cost of capital is 15%. Her first project involves
investing in $150,000 of equipment with a life of 15 years and a final scrap value of $15,000. The equipment will
produce 15,000 units p.a. generating a contribution of $2.75 each. She estimates that additional fixed costs will
be $15,000 p.a..

Calculate the sensitivity to change of:


i. the initial investment
ii. the sales volume p.a.
iii. the contribution p.u.
iv. the fixed costs p.a.
v. the scrap value