Professional Documents
Culture Documents
•
DECISIONS
Introduction
• Profitability Index
• Payback Method
• NPV Vs IRR
• Capital Rationing
• Excel Application
CAPITAL BUDGETING
DECISIONS
The investment decisions of a firm are generally known
as the Capital Budgeting or Capital Expenditure
decisions. A Capital Budgeting decision may be defined
as the firm’s decision to invest its current funds more
efficiently in the long term assets in anticipation of an
expected flow of benefits over a series of years to come.
The long term assets are those that affect the firm’s
operation beyond the one year period. The firm’s
investment decision would generally include expansion,
acquisition, modernization and replacement of long term
assets.
Examples :
Investment in Property, Plant and Equipment
Research and Development Projects
Large Advertising Campaigns
CAPITAL BUDGETING
DECISIONS
Investment Decisions require special
attention because of the following reason:
• Growth
• Risk
• Funding
• Irreversibility
• Complexity
CAPITAL BUDGETING
DECISIONS
The steps that are involved in the Capital Budgeting
decisions are as follows:
1. Cash Flow Estimation for different periods.
C1 C2 C3 C
NPV = + + 2 + + 3 −
L
n
C0
(1 + k) (1+ k) + + (1 n
(1 k) k)
n
Ct
NPV = ∑ − t C0
t =1 (1 + k)
n
Ct
∑
t=1 (1 +
)r t
−=
C0 0
NPV PROFILE AND IRR
A B C
1 N P V P r o file
D is c o u n t
2 C a s h F lo w r a te N P V
3 -2 0 0 0 0 0 % 1 2 ,5 8 0
4 5 4 3 0 5 % 7 ,5 6 1
5 5 4 3 0 1 0 % 3 ,6 4 9
6 5 4 3 0 1 5 % 5 5 0
7 5 4 3 0 1 6 % 0
8 5 4 3 0 2 0 % ( 1 ,9 4 2 )
INTERNAL RATE OF
RETURN (IRR)
Acceptance Rule:
Accept the project when r>k
Reject the Project when r<k
May accept the project when r=k
PI = PV of Cash inflows
Initial Cash Outlay
Acceptance Rule
Accept the Project when PI > 1
Reject the Project when PI < 1
May accept the project when PI = 1
PROFITABILITY INDEX
The initial cash outlay of a project is Rs 100,000
and it can generate cash inflow of Rs 40,000, Rs
30,000, Rs 50,000 and Rs 20,000 in year 1 through
4. Assume a 10 per cent rate of discount. The PV
of cash inflows at 10 per cent discount rate is:
PV = Rs 40,000(PVF1, 0.10 ) + Rs 30,000(PVF 2, 0.10 ) + Rs 50,000(PVF 3, 0.10 ) + Rs 20,000(PVF 4, 0.10 )
= Rs 40,000 × 0.909 + Rs 30,000 × 0.826 + Rs 50,000 × 0.751 + Rs 20,000 × 0.68
NPV = Rs 112,350 − Rs 100,000 = Rs 12,350
Rs 1,12,350
PI = = 1.1235 .
Rs 1,00,000
PROFITABILITY INDEX
MERITS DEMERITS
• Considers all cash • Estimating cash
flows flows a tedious
• Recognizes the Time task.
Value of Money • At times fails to
• Relative measure of indicate choice
profitability. between mutually
• Consistent with SWM exclusive projects.
PAYBACK METHOD
Payback is the number of years required to recover
the original cash outlay invested in a project.
If the project generates constant annual cash inflows,
the payback period can be computed by dividing cash
outlay by the annual cash inflow. That is:
Initial Investment C
Payback = = 0
Annual Cash Inflow C
Assume that a project requires an outlay of Rs 50,000
and yields annual cash inflow of Rs 12,500 for 7 years.
The payback period for the project is:
PB = 50000/12500 = 4 Years
PAYBACK METHOD
Suppose that a project requires a cash outlay of Rs 20,000, and
generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and Rs
3,000 during the next 4 years. What is the project’s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
C0 C
ACCOUNTING RATE OF
RETURN
• The accounting rate of return is the ratio of the average after-tax profit divided
by the average investment. The average investment would be equal to half of
the original investment if it were depreciated constantly.
• 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.
• 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.
• 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.
CONVENTIONAL AND NON
CONVENTIONAL CASH
•
FLOWS
A conventional investment has cash flows the
pattern of an initial cash outlay followed by cash
inflows. Conventional projects have only one
change in the sign of cash flows; for example, the
initial outflow followed by inflows, i.e., – + + +.
Scale of Investment
Cash Flow (Rs) NPV
Project C0 C1 at 10% IRR
A -1,000 1,500 364 50%
B -100,000 120,000 9,080 20%
RANKINGS
Project Life Span
C a sh F lo w(R
s s)
P ro ject C0 C1 C2 C3 C4 C5 NP V a t 1 0 % IR R
X – 10 ,0 0 0 12 ,0 0 0 – – – – 908 20%
Y – 10 ,0 0 0 0 0 0 0 20 ,1 2 0 2, 49 5 15%
CAPITAL BUDGETING
Reinvestment Assumption
The IRR method is assumed to imply that the cash flows generated by the project can be
reinvested at its internal rate of return, whereas the NPV method is thought to assume that the
cash flows are reinvested at the opportunity cost of capital.
MIRR
The modified internal rate of return (MIRR) is the compound average annual rate
that is calculated with a reinvestment rate different than the project’s IRR. The
modified internal rate of return (MIRR) is the compound average annual rate that
is calculated with a reinvestment rate different than the project’s IRR.
• There is no problem in using NPV method when the opportunity cost of capital varies
over time.
• If the opportunity cost of capital varies over time, the use of the IRR rule creates
problems, as there is not a unique benchmark opportunity cost of capital to compare
with IRR.
CAPITAL RATIONING
The Capital Rationing situation refers to the choice of
investment proposals under financial constraints in
terms of a given size of capital expenditure budget. The
objective is to select the combination of projects would
be the maximization of the total NPV. The project
selection under capital rationing involves two stages.
1. Identification of the acceptable projects.
2. Selection of the combination of projects.
Capital Rationing……….
• Leads to the acceptance of several small investment projects ( promising higher return per rupee
investment) rather than a few large investment projects. It does have a bearing on the risk
complexion of the firm.
•Management should consider more than one period in the allocation of limited capital for investment
projects .