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TATA motors plans to set up car plants at Bangalore, Nashik TATA steel acquired Corus King Fisher Airlines planning to buy 26 aircrafts Bank planning to computerize all its Branches Emcure planning to set up a R& D centre for treatment of HIV/ Aids
Capital Expenditure
It involves a current outlays (and future too) of funds in the expectation of a stream of benefits extending far into future
Benefits/risk
spending
Plant expansion
Marketing
Equipment replacement
Cost reduction
Human Resource
Finance
Capital Budgeting
Capital Budgeting
Identification of potential investment opportunities Assembling of proposed investments Decision Making Preparation and appropriation of Capital Budgets Implementation Performance Review
Projects Classification
Mandatory Investments Replacement Projects Expansion Projects Diversification Projects Research & Development Projects Miscellaneous Projects
Investment Criteria
Discounting Criteria
Non-Discounting Criteria
PBP
DPB
ARR
NPV
BCR
IRR
1 The Payback Period Method. 2 Discounted Payback period. 3 Accounting Rate of Return
The payback period is the length of time that it takes for a project to recover its initial cost out of the cash receipts that it generates.
Payback period =
Payback period =
4.0 years
According to the companys criterion, management would invest in the espresso bar because its payback period is less than 5 years.
Cash flow are first converted into their PV and than added to recover the initial outlay on the Project
0 1 2 3 4 5 6 7
Numerator may be measured as Average Annual Return over the life of the investment
Denominator may be measured is the average book value of fixed assets committed to the Project
Year 1 2 3 4 5
ARR=34%
Cash flows occurring at different point of time are not having same economic worth Due to time value of Money To make equal it must be discounted wrt to time gap
present value
npv
of a project is the sum of the present value of all the cash flows- positive or negativethat are expected to occur over the life of the project
techniques
Present Value or discounting
PV Tables Tables are available for various ranges of i and n P= c (PVIF) Where
P is present value C is future Cash flow PVIF is present value interest factor
Rs
500
0.909
Rs
454.50
2
3
Rs 1,000
Rs 1,500
0.826
0.751
Rs 826.00
Rs 1,126.00
4
5
Rs 2,000
Rs 2,500
0.683
0.621
Rs 1,366.00
Rs 1,552.50
Rs 7,500
Rs 5,325.50
NPV of Project =
t=1
Ct
(1+r)t
- Initial investment
Ct=cash flow at the end of year t n= life of the project r= discount rate
Cost of Capital is Rs 10,00,000,r for the firm is 10% 0 1 2 Rs (10,00,000) 2,00,000 2,00,000 3,00,000 3,00,000 3,50,000
NPV= = 5273
- 1000000
Mutually Exclusive Proposals Highest positive NPV TOP PRIORITY Lowest NPV Low Priority Negative NPV Rejected
-
Initial investment Rs 100000 Cost of Capital 12% Benefits Year 1 25000 year 2 40000 Year 3 40000 Year 4 50000
BCR= 25000(if1)+40000(if2)+40000(if3)+50000(if4)=1.145 100000 When BCR NBCR= BCR-1= 0.145 >1 =1 <1 or NBCR >0 =0 <1 Rule is Accept indifferent Reject
The IRR is the rate of return expected from an investment project over its useful life.
The internal rate of return of a Project is the discount rate that makes its net present value to be zero.
IRR
Ct Investment = (1+r)t
t=1
Ct =cash flow at the end of year t r = internal rate of Return n = life of the Project
Example
Consider the cash flow of a company as follows Year Cash Flow For IRR 0 (1,00,000) 1 30,000 2 30,000 3 40,000 4 45,000
30,000 (1+r)2
40000 + (1+r)3
45,000 (1+r)4
Let us take discount rate as 15% 100,802 = Take R=16% 98,641= 30000 + (1+16) 30,000 + (1+16)2 40000 + (1+16)3 45,000 (1+16)4 30000 + (1+15) 30,000 + (1+15)2 40000 + (1+15)3 45,000 (1+15)4
Example Continued..
Find sum of NPV value in absolute terms 802+1359 =2161 Ratio of smaller discount rate 802 =0.37 2161
=19060
BCR= PVB I =119060/100000 =1.19
IRR
Rs1750
Payback period
is slightly more than 3 years
thanks