Session 4

Capital Budgeting

1
 Capital Budgeting - Methods

1. Average Return on Investment

2. Payback

3. Net Present Value

4. Internal Rate of Return

5. Modified IRR

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 Average Return on Investment

AROI = Avg. Net Income Per Year

Avg. Investment

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 Average Return on Investment

Example:
Year Net Income Cost
1 6,000 100,000 Initial
2 8,000 0 Salvage Value
3 11,000
4 13,000
5 16,000
6 18,000

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 Average Return on Investment

Avg. Net Income 72,000 = 12,000

6

Avg. Investment 100,000

= 50,000
2

AROI 12,000 = 24%

50,000

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 Average Return on Investment

Advantages

Disadvantages

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 Payback Method

# Years required to recover the original investment

Example:
Year Net Income Cash Flow Cumulative CF
1 6,000 26,000 26,000
2 8,000 28,000 54,000
3 11,000 31,000 85,000
4 13,000 33,000 118,000
5 16,000 36,000 154,000
6 18,000 18,000 172,000
Payback = 3 + 100,000 - 85,000
118,000 - 85,000 = 3.45 Years

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 Payback Method

Advantages

Disadvantages

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 Time Value of Money

FV = PV (1 + r)n

Compounding: Finding FV

Discounting: Finding PV: PV = FV/(1 + r) n

Internal Rate
of Return: Finding r

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 Net Present Value

NPV = Present Value of All Future Cash Flows less Inital Cost

= CF1 + CF2 + CF3 +.......CFn - Io

1+r (1+r)2 (1+r)3 (1+r)n

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 Net Present Value - Example

Year CF Disc. Factor PV

0 -100000 1 -100000
1 26000 1/1.1 = .9091 23637
2 28000 1/(1.1)2 = .8264 23139
3 31000 1/(1.1)3 = .7573 23290
4 33000 1/(1.1)4 = .6830 22539
5 36000 1/(1.1)5 = .6209 22352
6 18000 1/(1.1)6 = .5645 10161

NPV = 25121
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 Net Present Value

Advantages

Disadvantages

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 Internal Rate of Return

Discount rate that makes NPV Zero

(i.e., that equates PV of benefits with the cost).

IRR: Io = CF1 + CF2 + ..... + CFn

1+r (1+r)2 (1+r)n
Solve for r.

Example:
100,000 = 26000 + 28000 + 31000 + .......... + 18000
1+r (1+r)2 (1+r)3 (1+r)6

r = 18.2%

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 Internal Rate of Return

Advantages

Disadvantages

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 Profitability Index

PI = PV of all Benefits
PV of all Cost

Example:
PV (Benefits) = 26000 + 28000 +.......... + 18000
1.1 (1.1)2 (1.1)6
= 125121
PV (Cost) = 100000
PI = 125121 = 1.25
100000
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 Profitability Index

Advantages:

Disadvantages:

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 NPV Profile

Year CF Disc. Factor PV

0 -100,000 1 -100,000
1 26,000 0.91 23,636
2 28,000 0.83 23,140
3 31,000 1/(1.1)3 = .7573 23,291
4 33,000 1/(1.1)4 = .6830 22,539
5 36,000 1/(1.1)5 = .6209 22,352
6 18,000 1/(1.1)6 = .5645 10,161
NPV = 25,121

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 NPV Profile

Dis. Rate NPV

0% 7200

5% 45725.7

10% 25120.76

15% 8711.838

20% -4538.97

25% -15376.1

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 NPV Profile

80000
60000
40000
NPV

20000
0
-20000
0 0.05 0.1 0.15 0.2 0.25
Disc. Rate

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 Choosing Between Projects

Year CF(A) CF(B)

0 -25000 -25000
1 2000 21000
2 2000 10000
3 35000 2000

NPV 6351 4606

IRR 17% 22%

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 NPV Profile

20,000
15,000
10,000
NPV

5,000
0
-5,000 0% 5% 10% 15% 20% 25% 30%
-10,000
Discount rate
 Modified IRR

Reinvestment Rate Assumption (Project A)

   
Project  Outlay  25,000
Cash Flows: YR1  2,000
                    YR2  2,000
                    YR3  35,000
 
    NPV @ 8%: 6,351  IRR: 17%

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 Modified IRR

NPV: Project A
    YR1:   2,000
    YR2:   2,000 + 2,000 + 160 = 4,160
   YR3:   35,000 + 4,160 + 333 = 39,493
[Note: PV of 39,493, three years from now @ 8% =  31,351
                                                         Less: outlay  25,000
                                                                  NPV  6,351]

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 Modified IRR

IRR @ 17%
    YR1:   2,000   = 2,000
    YR2:   2,000 + 2,000 + 340 = 4,340
    YR3:   35,000 + 4,340 + 738 = 40,078
[25,000 invested for three years @ 17% = 25,000(1.17)3 = 40,040]

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 Modified IRR

Modified Internal Rate of Return

   
Find k such that   (1+k)nI0  = Final value

    i.e.     (1+k)3 25000  = 39,439

                                 k  = 16.5%

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 Modified IRR

Reinvestment Rate Assumption (Project B)

  
Project  Outlay  25,000
Cash Flows: YR1  21,000
                    YR2  10,000
                    YR3  2,000
 
    NPV @ 8%: 4,606  IRR: 22.12%

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 Modified IRR

NPV: Project B
       
YR1: 21,000 = 21,000
        YR2: 10,000 + 21,000 + 1,680 = 32,680
        YR3:  2,000 + 32,680 + 2,614   = 37,294
[Note: PV of 37,294, three years from now @ 8% =  29,606
                                                       Less: outlay  25,000
                                                       NPV  4,606 ]

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 Modified IRR

   IRR of 22.12%
      
  YR1:   21,000    = 21,000
        YR2:   10,000 + 21,000 + 4,645 = 35,645
        YR3:   2,000 + 35,645 + 7,885 = 45,530
[25,000 invested for three years @ 22.12% = 25,000(1.2212)3 = 45,530]

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 Modified IRR

Modified Internal Rate of Return

Find k such that   (1+k)nI0  = Final value

            i.e.     (1+k)3 25000  = 37,294

                                          k  = 14.26%

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 Estimating Cash Flows

NPV = CF1 + CF2 +.............. + CFn - Io

l+r (l+r)2 (l+r)n

Cash Flows Incremental

After Tax
Net Working Capital
Sunk Costs

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 Procedure

1. Initial Costs: New CAPEX

Additional W. Cap
Sale of Old Assets

2. Annual Costs: Revenue Less Costs

After Tax

3. Terminal Cash Flows: Salvage Value

Recoupment of NWC

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 Cash Flow Estimates

Sale of Existing Plant

CF= Selling Price + T (B.V. - S.P.)

Annual Cash Flows

OCF= (Sales-Cost)(1-T) + T, DEPREC
or
OCF= Net Inc + Depreciation

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 New Product Proposal

Annual Sales $20m

Annual Costs $16m
Net Working Capital $2m
Plant Site $0.5m
Plant and Equipment $10m
Depreciation Straight Line over 20 years
Salvage Value nil
Tax Rate 40%
Required Return 8%

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 New Product Proposal

INITIAL CASH FLOWS

ANNUAL CASH FLOWS

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 New Product Proposal

TERMINAL CASH FLOWS

CALCULATION

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 Evaluating Capital Projects

1) Focus on Cash Flow, Not Profits.

– Cash Flow = Economic Reality.
– Profits Can Be Managed.
2) Carefully Estimate Expected Future Cash Flows.
3) Select a Discount Rate Consistent with the Risk of
Those Future Cash Flows.
4) Account for the Time Value of Money.
5) Compute a “Base-Case” NPV.

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 Evaluating Capital Projects

6) Net Present Value = Value Created or Destroyed by the

Project.
– NPV is the Amount by which the Value of the Firm
Will Change if you Undertake the Project.
7)Identify Risks and Uncertainties. Run a Sensitivity
Analysis.
– Identify “Key Value Drivers.”
– Identify Breakeven Assumptions.
– Estimate Scenario Values.
– Bound the Range of Value
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 Evaluating Capital Projects

8) Identify Qualitative Issues.

– Flexibility
– Quality
– Know-How
– Learning
9) Decide

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