MANAGERIAL FINANCE

Submitted To: Topic: Submitted By: Roll No: Discipline: Professor Muhammad Akhtar Capital Budgeting Techniques Zahid Noor Mazari 3 MS Islamic Business & Finance

RIPHAHAH INTERNATIONAL UNIVERSITY ISLAMABAD

Investment Appraisal

Payback Period: Length of period required to recover the cost of an investment.

Example:

XYZ Corporation is considering the following project. It is the policy of XYZ for projects to have a payback period of 4 years or less. Evaluate the project based on the payback method. Should XYZ accept the project?

Year Cash Flow

0 -10000

1 5000

2 2000

3 4000

4 1000

5 1000

The cost of the project is $10,000. The payback period is the number of years it takes for the project's cash flows (positive) to payback the cost of the project. After year one, the project has paid back $5000 of the $10000 cost. After year two, the project has paid back $7000 of the $10000 cost. After year three, the project has paid a total of $11000. The project's payback period lies between 2 to 3 years. To payback the $10000 we only need $3000 of the $4000 that the project is expected to generate in year three. If we assume that the cash flows are paid evenly over the period, the payback period is 2.75 years (payback = year before full recovery + unrecovered cost at start of year/cash flow for year = 2 + 3000/4000). The project should be accepted since its payback period is less than the maximum acceptable payback period.

Calculating the payback period is easy if the positive cash flows are annuities. The payback period in this case is simply the cost divided by the annual cash flow. For example (11-1 on page 529), if the cost of a project is $52,125 and the project is expected to generate annual cash flows of $12,000 per year for eight years, the payback period is 4.34 years (Payback period = 52125/12000).

Advantages:

Easy to calculate and understand Provides and indication of a project's risk and liquidity

4 Disadvantages:

Ignores time value of money - to correct for this disadvantage the discounted payback period can be used. The discounted payback period is an improvement over the regular payback method because the present value (discounted) of the project's cash flows is used to calculate the payback period. The discounted payback method considers the time value of money. Does not consider cash flows occurring after the payback period No Concrete decision criteria to indicate whether an investment increase the firms value. Ignore the risk of future cash flow

B. Net Present Value

The net present value (NPV) is the difference between an investments market value and its cost OR NPV is method discounts all cash flows at the project's cost of capital (required rate of return) and then sums those cash flows. NPV gives a direct measure of the benefit in dollars of undertaking the project. NPV can be considered a measure of the project's profitability in dollars. NPV is also the amount of value ("value added") the project will add to the firm. The project is accepted if the NPV is positive. Positive NPV projects add value to the firm and increases shareholder's wealth. Decision Rule:

Accept project if NPV > 0. Reject project if NPV < 0.

Example: Assume that you convince XYZ Corporation that they should judge the project on a decision rule that considers time value of money, all the project's cash flows, and the project's required rate of return. XYZ tells you that the project has equivalent risk to the company and the company's WACC is 10%. Calculate the project's NPV and then make a recommendation concerning the acceptance or rejection of the project.

Year Cash Flow

0 -10000

1 5000

2 2000

3 4000

4 1000

5 1000

Project should be accepted because it will add value ($507.54) to the company.

Advantages:

Considers time value of money Considers all cash flows NPV is the value the project will add to the firm Considered to be the best decision criteria

Disadvantages:

NPV will be erroneous if cash flow estimates are incorrect (requires accurate cash flow estimations) NPV is a dollar return but percent returns are easier to communicate and understand

C. Internal Rate of Return:

The internal rate of return (IRR) is defined as the discount rate which forces a project's NPV to equal zero. The IRR is the project's expected rate of return (same as a bond's yield to maturity). The project is accepted if the IRR (expected return) is greater than the cost of capital (required return).

Decision Rule:

Accept project if IRR > k. OR If the IRR is greater than the cost of capital, accept the project. Reject project if IRR < k. If the IRR is less than the cost of capital, reject the project.

Advantages:

Considers time value of money Considers all cash flows IRR is the expected rate of return for the project

IRR is a percent return that is considered easier to communicate and understand

Disadvantages:

IRR will be erroneous if cash flow estimates are incorrect (requires accurate cash flow estimations) May not give value maximizing decision when used to compare mutually exclusive projects. Can not be used in situation in which the sign of cash flows of project change more than once during the projects life. May not give value maximizing decision when used to choose project when there is capital rationing Multiple IRRs are possible for non normal cash flow streams. A normal cash flow stream is one where there the project's cost (negative cash flow) is followed by positive cash flows. In other words, there is only one sign change (negative cash flows followed by positive cash flows). A non normal cash flow stream is one in which there are multiple sign changes (negative cash flows followed by positive and negative cash flows). A non normal cash flow stream will result in multiple IRRs but DOES NOT affect the NPV calculation. Reinvestment rate assumption - Both NPV and IRR have an implied reinvestment rate assumption. For the NPV calculation, it is assumed that all of the project's cash flows are reinvested at the project's required rate of return (k). For the IRR calculation, it is assumed that all of the project's cash flows are reinvested at the project's expected rate of return (IRR). For a project that has the same level of risk as the firm, the NPV method assumes that cash flows will be reinvested at the firm's cost of capital, while the IRR method assumes reinvestment at the project's IRR. Reinvestment at the cost of capital is generally a better assumption in that it is closer to reality.

For a given project, the NPV and IRR will give the same accept/reject decision. In other words, if the NPV > 0, then IRR > k; or if the NPV = 0, then IRR = k; or if NPV<0, then IRR<k.

D. Profitability Index
Allows a comparison of the costs and benefits of different projects to be assessed and thus allow decision making to be carried out
Net Present Value Profitability Index = --------------------Initial Capital Cost

Advantages:

Tells whether an investment increase the firms value Consider all cash flow of the firm Consider the time value of money

Consider the risk of future cash flows (through the cost of capital).

Disadvantages:

Requires an estimate of cost of the capital in order to calculate the profitability index. May not give correct decision when used to compare mutually exclusive projects.

E. Accounting Rate of Return

A Comparison of profit generated by the investment with the cost of the investment
Average annual return or annual profit ARR = -------------------------------------------Initial cost of investment

Average Accounting Return Rule

Table 1 Revenue Expense Before tax Cash flow
Depreciati on

Year 1 433,333 200,000 233,333 100,000 133,333 33,333 100,000

Year 2 450,000 150,000 300,000 100,000 200,000 50,000 150,000

Year 3 266,667 100,000 166,667 100,000 66,667 16,667 50,000

Year 4 200,000 100,000 100,000 100,000 0 0 0

Year 5 133,333 100,000 33,333 100,000 -66,667 -16,667 -50,000

Earning before tax tax Net Income

Then, the average net income is given by Average Net Income =(100,000+150,000+50,000+050,000)/5=50,000 Average Accounting Return Rule

Table 2 Value of the Investment

Year 0

Year 1

Year2

Year3

Year4

Year5

500,000

400,000

300,000

200,000

100,000

Average Investment =(500,000+400,000+300,000+200,000+100,000+0)/6=250, 000

We simply take the average of the investment. Notice that investment occurs at date 0. Therefore, there are 6 periods in this table. The average investment is then determined by

AAR =

$50 ,000 = 20 % $250 ,000

Average Investment =(500,000+400,000+300,000+200,000+100,000+0)/6=250,000

Thus, the average accounting return of this example is given by

AAR = $50 ,000 = 20 % $250 ,000

If the company has a target average accounting return smaller than 20% (say 15%), the project will be accepted. If the company had a target AAR greater than 20%, the project will be rejected.

Disadvantages: AAR uses accounting number. Since the decision to depreciate or expense a certain item depends on accountant judgment, the computed AAR is influenced by accountant judgment. A minimum acceptance criterion is set arbitrarily by management. AAR does not take into account the time value of money.