Financial Management

Unit 3 Capital Budgeting:

Meaning, Definition and types of evaluating the project on the
basis of payback period, NPV, IRR, PI, ARR (8+2)


Introduction
Capital expenditures involve investments of significant financial resources in
projects to develop or introduce new products or services.
A basic requirement for a systematic approach to capital budgeting is a well-
defined set of long-range goals
An organization should have a well-defined business strategy.
Procedures should be developed for the review, evaluation, approval, and post-
audit of capital expenditure proposals.
Characteristics of capital purchases:
Large capital outlays are required
Long-term impact on earnings
Lack of liquidity (they cannot be readily disposed of)
WHAT IS CAPITAL BUDGETING?

Capital budgeting is a required managerial tool. One duty
of a financial manager is to choose investments with
satisfactory cash flows and rates of return. Therefore, a
financial manager must be able to decide whether an
investment is worth undertaking and be able to choose
intelligently between two or more alternatives. To do this, a
sound procedure to evaluate, compare, and select projects is
needed. This procedure is called capital budgeting.
Capital budgeting is investment decision-making as to
whether a project is worth undertaking. Capital budgeting
is basically concerned with the justification of capital
expenditures.


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Time value of Money
Money has time value if it can be invested at some
positive return






Today
$1.0000
Year 5
$1.6105
Value of $1.00 today
Value 5 years from today
$1.1000 $1.2100 $1.3310 $1.4641
Year 1 Year 2 Year 3 Year 4
Assume a 10% interest rate
Amounts of money received at different periods of time must be
converted to their value on a common date to be compared,
added or subtracted
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Time value of Money
Future value
It is the amount a current sum of money earning a stated rate of
interest will accumulate to at the end of the future period
FV = PV (1 + r)
n
where

r: compound rate
Present value
It is the current worth of a specified amount of money to be
received at some future date at some interest rate.
PV = FV / (1 + r)
n
where r: discount rate
It is very useful to draw a time line in calculations that
involve the time value of money
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Time value of Money

Annuities
An annuity is a stream of equal cash flows that occur at equal
intervals over a given period of time
2 types of annuity
Ordinary annuity: Cash flows occur at the end of each year
Formula: PVOA = (a / r) x [1 1/(1 + r)
n
]
Refer to annuity table
PVOA = Ordinary Annuity Factor (n, r) x Annuity
Annuity due: Cash flows occur at the beginning of each period
Formula: PVOAD = (a / r) x [1 1/(1 + r)
n-1
] + a
Refer to annuity table.
PVOAD = Ordinary Annuity Factor (n -1, r) x Annuity + Annuity
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Time value of Money
Practice questions on time value of money
Determine the answers to each of the following situations:

a. The future value in 2 years of $1,000 deposited today in a savings
account with interest compounded annually at 8%.
b. The present value of $9,000 to be received in five years, discounted
at 12%.
c. The present value of an annuity of $2,000 per year for five years
discounted at 16%.
d. A proposed investment of $32,010 is to be retuned in eight equal
annual payments. Determine the amount of each payment if the
interest rate is 10%.
e. A proposed investment will provide cash flows of $20,000; $8,000;
and $6,000 at the end of Years 1, 2 and 3 respectively. Using a
discount rate of 20%, determine the present value of these cash
flows.

What is capital budgeting?

Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to an organizations future.
Capital budgeting is a process that involves the
identification of potentially desirable projects for
capital expenditures, the subsequent evaluation of
capital expenditure proposals, and the selection of
proposals that meet certain criteria.

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Steps to capital budgeting
1. Estimate Cash Flows (inflows & outflows).
2. Assess riskiness of Cash Flows .
3. Determine the appropriate cost of capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR > WACC.
9
Relevancy in Capital Budgeting
Relevance analysis is very important in
capital budgeting because only relevant
information should be included.
To make a choice between 2 alternatives,
incremental relevance analysis often
simplifies the capital budgeting.

RELEVANT CASHFLOWS IN CAPITAL BUDGETING
Initial Investment cost
Annual operating cash flows.
Terminal cash flow
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What is the difference between independent and
mutually exclusive projects?
Independent projects if the cash flows of one
are unaffected by the acceptance of the other.
Mutually exclusive projects if the cash flows
of one can be adversely impacted by the
acceptance of the other.
12
What is the difference between normal and
non-normal cash flow streams?
Normal cash flow stream Cost (negative CF)
followed by a series of positive cash inflows.
One change of signs.
Non-normal cash flow stream Two or more
changes of signs. Most common: Cost
(negative CF), then string of positive CFs, then
cost to close project. Nuclear power plant, strip
mine, etc.
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14
Capital Budgeting Models
There are two main types of Capital Budgeting
Models:
Capital budgeting models that consider the time value
of money
Net Present Value (NPV)
Internal Rate of Return (IRR)
Discounted Payback Period

Capital budgeting models that do not consider the
time value of money
Payback Period
Accounting Rate of Return (ARR)
What is the Payback period?
The number of years required to recover a
projects cost, or How long does it take to
get our money back?
Calculated by adding projects cash inflows
to its cost until the cumulative cash flow for
the project turns positive.

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PAYBACK PERIOD
SITUATION 1: EVEN (SAME) CASHLOWS

PAY BACKPERIOD= CAPITAL OUTLAY
CASHFLOWS PER PERIOD

SITUATION 2: UNEVEN CASHFLOWS

PAY BACK PERIOD= A + B/C

Where: A is the number of full years immediately before covering the
capital outlay
B is the balance remaining to cover the capital outlay
C is the total amount that is received in the year when the capital
outlay is fully covered
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Calculating Payback
Payback
L
= 2 + / = 2.375 years

CF
t
-100 10 60 100

Cumulative -100 -90 0 50
0 1 2
3
=
2.4
30 80
80
-30
Project L
Payback
S
= 1 + / = 1.6 years

CF
t
-100 70 100 20

Cumulative -100 0 20 40
0 1 2
3
=
1.6
30 50
50
-30
Project S
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Strengths &weaknesses of
Payback
Strengths
Provides an indication of a projects risk and
liquidity.
Easy to calculate and understand.
Weaknesses
Ignores the time value of money.
Ignores Cash Flows occurring after the payback
period.
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Discounted payback period
Uses discounted cash flows rather than raw
CFs.
Disc Payback
L
= 2 + / = 2.7 years

CF
t
-100 10 60 80

Cumulative -100 -90.91 18.79
0 1 2
3
=
2.7
60.11
-41.32
PV of CF
t
-100 9.09 49.59
41.32 60.11
10%
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Net Present Value
Net present value is the present value of the
projects net cash inflows from operations...
and disinvestment less the amount of the
initial investment.

Net Present Value (NPV)
Sum of the PVs of all cash inflows and outflows
of a project:

n
0 t
t
t
) k 1 (
CF
NPV
PRESENT VALUE INTEREST FACTOR AT r%=1/(1+r)^n
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What is Project Ls NPV?
Year CF
t
PVIF@10% PV of CF
t

0 -100 1 -$100
1 10 0.909 9.09
2 60 0.8264 49.59
3 80 0.7513 60.11
NPV
L
=
Rs.18.79

NPV
S
= Rs.19.98
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Rationale for the NPV method
NPV = PV of inflows Cost
= Net gain in wealth
If projects are independent, accept if the
project NPV > 0.
If projects are mutually exclusive, accept
projects with the highest positive NPV, those
that add the most value.
In this example, would accept S if mutually
exclusive (NPV
s
> NPV
L
), and would accept
both if independent.
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Internal Rate of Return (IRR)
1. Also called the time-adjusted rate of return.
2. It is the minimum rate that could be paid for the
money invested in a project without losing
money.
3. It is also described as the discount rate that
results in a projects net present value equaling
zero.
Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of inflows
to be equal to cost, and the NPV = 0:




25

n
0 t
t
t
) IRR 1 (
CF
0
Rationale for the IRR method
If IRR > WACC, the projects rate of
return is greater than its costs. There is
some return left over to boost
stockholders returns.
26
Calculate IRR using the
previous example
Calculate IRR using the previous example
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IRR Acceptance Criteria
If IRR > k, accept project.
If IRR < k, reject project.

If projects are independent, accept both
projects, as both IRR > k = 10%.
If projects are mutually exclusive, accept
S, because IRR
s
> IRR
L
.
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The higher the internal rate
of return, the more desirable
the project.
When using the internal rate of return method to
rank competing investment projects, the
preference rule is:
Internal Rate of Return Method
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Internal Rate of Return (IRR)
Spreadsheet Approach
1. Input
A B
1 Year of cash flow Cash flow
2 0 Rs.-94,554
3 1 30,000
4 2 30,000
5 3 30,000
6 4 30,000
7 5 42,000
8 IRR =IRR(B2:B7,0.08)
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2. Output
A B
1 Year of cash flow Cash flow
2 0 Rs.-94,554
3 1 30,000
4 2 30,000
5 3 30,000
6 4 30,000
7 5 42,000
8 IRR 0.20
Internal Rate of Return (IRR)
Spreadsheet Approach

Differences Between Net Present Value and
the Internal Rate of Return Models

The net present value model gives explicit
consideration to investment size. The internal
rate of return does not.
The net present value model assumes all net
cash inflows are reinvested at the discount rate.
The internal rate of return model assumes all
net cash inflows are reinvested at the projects
internal rate of return.


Other Capital budgeting Techniques:

Profitability Index:
The profitability index, or PI, method compares the present
value of future cash inflows with the initial investment on a
relative basis.
Therefore, the PI is the ratio of the present value of cash
flows (PVCF) to the initial investment of the project.
= PV
Initial Investment
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Capital budgeting Techniques:

Profitability Index cont:
Decision Criterion
In this method, a project with a PI
greater than 1 is accepted, but a
project is rejected when its PI is less
than 1.
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Capital budgeting Techniques:

Average Rate of Return
- Non discounting method:
- ARR = Average annual profits
- Average Investment
- Where average investment =
- (Initial outlay+scrap value)/2
- & Average annual profits =
- sum of annual profits/ no. of years.

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NPV Profiles
A graphical representation of project NPVs at
various different costs of capital.

k NPV
L
NPV
S

0 $50 $40
5 33 29
10 19 20
15 7 12
20 (4) 5
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Drawing NPV profiles
-10
0
10
20
30
40
50
60
5 10 15 20 23.6
NPV
($)
Discount Rate (%)
IRR
L
= 18.1%
IRR
S
= 23.6%
Crossover Point = 8.7%
S
L
.
.
.
.
.
.
.
.
.
.
.
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Comparing the NPV and IRR
methods
If projects are independent, the two methods
always lead to the same accept/reject decisions.
If projects are mutually exclusive
If k > crossover point, the two methods lead to the
same decision and there is no conflict.
If k < crossover point, the two methods lead to
different accept/reject decisions.
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Reasons Why NPV profiles cross
Size (scale) differences the smaller project
frees up funds at t = 0 for investment. The higher
the opportunity cost, the more valuable these
funds, so high k favors small projects.
Timing differences the project with faster
payback provides more CF in early years for
reinvestment. If k is high, early CF especially
good, NPV
S
> NPV
L
.
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Capital Budgeting Techniques:

A good method of investment appraisal must:
Take time value of money into account.
Use cash flows instead of profits
Use all cash flows.
Take into account cost of capital of the firm.
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Accounting Rate of Return
The accounting rate of return is the average
annual increase in net income that results
from acceptance of a capital expenditure
proposal divided by the initial investment or
the average investment in the project.

Accounting Rate of Return
Cake Shoppe purchased a vehicle and equipment
costing Rs.90,554. It has a disposal value of Rs.8,000
at the end of 5 years.
Annual net cash inflow from operations Rs.30,000
Less average annual depreciation:
[Rs.90,554 Rs.8,000]/5) 16,511
Average annual increase in net income Rs.13,489


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Accounting rate of
return on initial
investment
Average annual increase
in net income
Initial investment
=
Accounting rate of
return on initial
investment
=
Rs.13,489
Rs.94,554
= 0.1427
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Accounting rate of
return on average
investment
Average annual increase
in net income
Average investment
=
Accounting rate of
return on average
investment
=
13,489
53,277
= 0.2532
([94,554 + 12,000])/2
Rs.94,544 = initial investment, Rs.12,000 =
disinvestment
Present value index

A frequent criticism of NPV, when it is used to
rank proposals, is that it fails to adjust for the
size of the proposed investment
To overcome this difficulty, managers may
rank projects on the basis of each projects
present value index, which is computed as the
present value of the projects subsequent cash
flows divided by the initial investment.


Present value index

Present value index =

Present value of subsequent cash flows
Initial investment