Attribution Non-Commercial (BY-NC)

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Attribution Non-Commercial (BY-NC)

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TECHNIQUES

Presented to : Dr. Paresh Shah

Presented by:

Sonal Nagpal (23)

Nikita Porwal (27)

Bhawana Pokharna (36)

Priyanka Chaturvedi (38)

CAPITAL BUDGETING DECISIONS

Should we

build this

plant?

CAPITAL BUDGETING DECISIONS

The investment decisions of a firm are generally

known as the capital budgeting, or capital

expenditure decisions.

The firms investment decisions would generally

include expansion, acquisition, modernisation and

replacement of the long-term assets. Sale of a

division or business (divestment) is also an

investment decision.

Decisions like the change in the methods of sales

distribution, or an advertisement campaign or a

research and development programme have long-

term implications for the firms expenditures and

benefits, and therefore, they should also be evaluated

as investment decisions.

TYPES OF INVESTMENT DECISIONS

One classification is as follows:

Expansion of existing business

Expansion of new business

Replacement and modernisation

Yet another useful way to classify investments is as

follows:

Mutually exclusive investments

Independent investments

AN EXAMPLE OF MUTUALLY EXCLUSIVE

PROJECTS

BRIDGE vs. BOAT to get

products across a river.

CAPITAL BUDGETING DECISIONS

These are generally:

Long-term decisions; involving large

expenditures.

Have long term consequences.

Difficult or expensive to reverse.

Capital Budgeting

Methods

Discounting Criteria

NPV IRR PBP ARR

Non Discounting Criteria

NET PRESENT VALUE

NPV of a project is the sum of the present values of

all the cash flows positive as well as negative that

are expected to occur over the life of the project.

The formula for NPV is:

3 1 2

0

2 3

0

1

NPV

(1 ) (1 ) (1 ) (1 )

NPV

(1 )

n

n

n

t

t

t

C C C C

C

k k k k

C

C

k

=

(

= + + + +

(

+ + + +

=

+

Where,

C

t

= cash flow at the end of year t

n = Life of the project

k = discount rate (given by the projects opportunity

cost of capital which is equal to the required rate of

return expected by investors on investments of

equivalent risk).

C

0

= Initial investment

1 / (1 + k )

t

= known as discounting factor or PVIF

i.e present value interest factor.

CALCULATING NET PRESENT

VALUE

Assume that Project X costs Rs 2,500 now and is

expected to generate year-end cash inflows of Rs

900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1

through 5. The opportunity cost of the capital may be

assumed to be 10 per cent.

2 3 4 5

1, 0.10 2, 0.10 3, 0.10

4, 0.10 5, 0.

Rs 900 Rs 800 Rs 700 Rs 600 Rs 500

NPV Rs 2,500

(1+0.10) (1+0.10) (1+0.10) (1+0.10) (1+0.10)

NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )

+ Rs 600(PVF ) + Rs 500(PVF

(

= + + + +

(

=

10

)] Rs 2,500

NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683

+ Rs 500 0.620] Rs 2,500

NPV Rs 2,725 Rs 2,500 = + Rs 225

=

=

ACCEPTANCE RULE OF NPV

Accept the project when NPV is positive

NPV > 0

Reject the project when NPV is negative

NPV < 0

May accept or reject the project when NPV is zero

NPV = 0

( A project will have NPV = 0, only when the project generates

cash inflows at a rate just equal to the opportunity cost of

capital)

The NPV method can be used to select between

mutually exclusive projects; the one with the higher

NPV should be selected.

ADVANTAGES OF NPV METHOD

It considers time value of money.

It is a true measure of profitability as it uses the present

values of all cash flows (both outflows & inflows) &

opportunity cost as discount rate rather than any other

arbitrary assumption or subjective consideration.

The NPVs of individual projects can be simply added to

calculate the value of the firm . This is known as

Principle of value additivity.

It is consistent with the shareholders wealth

maximization principle as whenever a project with

positive NPV is undertaken, it results in positive cash

flows and hence the increase in the value of the firm.

DISADVANTAGES OF NPV METHOD

It is difficult to estimate the expected cash flows

from a project.

Discount rate to be used is very difficult to

determine.

Since this method does not consider the life of the

projects, in case of mutually exclusive projects with

different life, the NPV rule, tends to be biased in

favour of the longer term project.

Since NPV is expressed in absolute terms rather

than relative terms it does not consider the scale of

investment.

Profitability Index

An index that attempts to identify the

relationship between the costs and benefits of

a proposed project through the use of a ratio

calculated as:

PI = Net Present Value * 100

Cost of Asset

Asset with the highest PI is selected.

Acceptance rule

A ratio of 1.0 is logically the lowest acceptable

measure on the index.

Any value lower than 1.0 would indicate that

the project's PV is less than the initial

investment.

As values on the profitability index increase,

so does the financial attractiveness of the

proposed project

INTERNAL RATE OF RETURN

METHOD

The internal rate of return (IRR) is the rate at which the

discounted net returns equal to the original investment

on the project.

This also implies that the rate of return is the discount

rate which makes NPV = 0.

The formula for calculating IRR is:

3 1 2

0

2 3

0

1

0

1

(1 ) (1 ) (1 ) (1 )

(1 )

0

(1 )

n

n

n

t

t

t

n

t

t

t

C C C C

C

r r r r

C

C

r

C

C

r

=

=

= + + + +

+ + + +

=

+

=

+

METHOD

Where,

C

t

= cash flow at the end of year t

n = Life of the project

r = discount rate

C

0

= Initial investment

1 / (1 + r )

t

= known as discounting factor or PVIF

i.e present value interest factor.

CALCULATION OF IRR

Uneven or nonnormal Cash Flows:

Calculating IRR by Trial and Error

The approach is to select any discount rate to

compute the present value of cash inflows.

If the calculated present value of the expected cash

inflow is lower than the present value of cash

outflows, a lower rate should be tried.

On the other hand, a higher value should be tried if

the present value of inflows is higher than the present

value of outflows.

This process will be repeated unless the net present

value becomes zero.

ACCEPTANCE RULE FOR IRR

Accept the project when r (IRR) > k (WACC).

Reject the project when r (IRR) < k (WACC).

May accept the project when r = k.

In case of independent projects, IRR and NPV rules will

give the same results if the firm has no shortage of

funds.

In case of projects with equal IRR & different NPV,

select project with higher NPV as it is consistent with

firms wealth maximisation objective.

ADVANTAGES OF IRR METHOD

It considers time value of money.

It is a true measure of profitability as it uses the

present values of all cash flows rather than any

other arbitrary assumption or subjective

consideration.

Whenever a project with higher IRR than WACC

is undertaken, it results in the increase in the

shareholders return. Hence, the value of the firm

also increases.

The percentage figure generally allows a sound,

uniform ranking of project.

PROBLEMS WITH IRR

It is not easy to understand and calculate the IRR as it

involves complex and tedious computational problems.

There may be some investment projects on which no

real value of IRR can be computed, e.g. Social

projects.

The result shown by NPV and IRR may differ if

projects are different in terms of

Expected life of project

Cash outlays

The use of multiple rates might create confusion.

PAY BACK PERIOD

It is the number of years required to recover a projects

cost, or how long does it take to get the businesss

money back?

10 80 60

0 1 2 3

-100

=

CF

Cumulative -100 -90 50

Payback

2 + 30/80 = 2.375 years

0

100

2.4

-30

Strengths of Payback:

1. Provides an indication of a projects risk and

liquidity.

2. Easy to calculate and understand.

Weaknesses of Payback:

1. Ignores the time value of money.

2. Ignores CFs occurring after the payback period.

3. It is a measure of capital recovery & not

profitability.

PAY BACK PERIOD

DISCOUNTED PAYBACK PERIOD

(DPBP)

10 80 60

0 1 2 3

CF

t

Cumulative

-100

-90.91 -41.32 18.79

Discounted

payback

2 + 41.32/60.11 = 2.7 yrs

Discounted Payback: Uses discounted

rather than raw CFs.

PVCF

t

-100

-100

9.09 49.59 60.11

=

ACCOUNTING RATE OF RETURN ACCOUNTING RATE OF RETURN

The accounting rate of return is the ratio of the average

profit after-tax divided by the average investment.

ARR = Average Profit After Tax *100

Average Investment

Where;

Average Investment = Initial Investment + Scrap Value

2

A variation of the ARR method is to divide average

earnings after taxes by the original cost of the project

instead of the average cost.

ACCEPTANCE RULE OF ARR

This method will accept all those projects whose ARR is

higher than the minimum rate established by the

management and reject those projects which have ARR

less than the minimum rate.

Accept if ARR > minimum rate.

Reject if ARR < minimum rate

This method would rank a project as number one if it

has highest ARR and lowest rank would be assigned to

the project with lowest ARR.

ACCOUNTING RATE OF RETURN

The ARR method has certain advantages as:

It is very simple to understand.

This method takes into account all the profits

during the life time of the project, whereas pay

back period ignores the profits accruing after

the pay back period .

Dependency on accounting data which is

readily available.

Shows the profitability of the project.

ACCOUNTING RATE OF RETURN

The disadvantages of ARR include:

It is based on accounting profit rather than cash flows.

Time value of money is ignored.

This method does not account for the profits arising on

sale of profit on old machinery on replacement.

ARR method does not consider the size

of investment for each project.

It may be time that the competing ARR of two projects

may be the same but they may require different

average investments. It becomes difficult for the

management to decide which project should be

implemented.

CASE STUDY OF TREE HOUSE

EDUCATION IPO 2011

ASSUMPTIONS:

Cost of capital i.e. discount rate is 15%

Inflation rate for calculating future cash flows is

taken as 55%

Initial investment is assumed to be Rs 50

million

The cash flow of year 2007 is taken as cash

flow of 2012 and cash flow of year 2008 as

2013 and so on....

CALCULATION OF NET

PRESENT VALUE

YEAR NET CASH FLOW INFLATED CASH

FLOWS

DIS

FACTOR@15%

P.V OF C.F

2012 2.8 4.34 0.87

3.7758

2013 -1 -1.55 0.756

-1.1718

2014 19.66 30.47 0.657

20.01879

2015 81.98 127.06 0.571

72.55126

2016 175.27 271.67 0.497

135.01999

(Rs. In millions)

NPV OF CASH FLOW=230.19404(Rs

million)

Therefore NPV of the project

= NPV Of Cashflow - Initial Investment

= 230.19404 50

=180.19404(Rs million)

CALCULATING THE

PROFITABILITY INDEX

Profitability index= NPV/cost of assets * 100

=180.19/50 * 100

=360.38(%)

The NPV is positive and the profitability index

is more than unity. Hence the project may be

accepted.

CALCULATION OF THE

PAYBACK PERIOD

YEAR INFLATED CASH

FLOWS

2012 4.34

2013 -1.55

2014 30.47

2015 127.06

2016 271.67

Payback period

= 4.34 + (-1.55) + 30.47 + 16.47

= 50million.

That is 3 years + (16.47*12)/127.06

= 3years + 48 days

=36 months and 48 days.

CONCLUSION

From the above study, we can conclude that

DCF is a better technique than NON DCF.

As DCF technique considers the time value of

money which is a very important factor.

On the basis of time value you can consider

the future value and discount them and judge

whether to invest or not on the basis of NPV of

a project.

While in NON-DCF, time value factor is not

taken which is a disadvantage.

It does not take into account any discount

factor. On the basis of payback period also you

cannot judge the value of firm.

Cashflows after the payback period are not

taken into consideration which does not let you

know the over all return on investment and the

profitability.

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