Capital Budgeting and Financial Management.pptx

Financial Management

1. Financial Management and Audit April 7 – April 11 , 2016 Day 4

2. Day 4, Session 1

3. Corporate Finance, Capital Budgeting and Cost of Capital Capital budgeting is the process of identifying which long lived investment projects a firm should undertake. The capital budgeting or capital expenditure involves huge amount of money. Such a decision is made for longer period of time. It involves a greater amount of risk on account of unforeseen situations. The risk increases because of large amount of investment for a long period of time.

4. Corporate Finance, Capital Budgeting and Cost of Capital Therefore , a right decision has to be taken to ensure a favorable impact on the sustainability and competitive position of the organization. These decisions are not easily reversible. If wrong decision is taken, it can lead to a heavy capital loss. It also influences the other two important financial decisions of the firm, like, financing decision.

5. Steps of Capital Budgeting Process >GESIM< Project Generation Project Evaluation Project Selection Project Implementation Monitoring and Reporting

6. Capital Budgeting Process 1 . Project generation : this is initial task be guided by the objectives that the organization wants to achieve from the proposed expenditure .

7. Capital Budgeting Process 2 . Project Evaluation : available alternatives are to be evaluated on the basis of the forecast made. Evaluation involves the application of a good investment criterion for accessing the desirability or otherwise the projects under consideration. A decision requires to be taken only in the context of the availability of a number of alternatives. For example, some of feasible alternatives that may be considered in a replacement proposal are: Remodeling the present equipment Leasing another one Buying a second hand equipment Buying a new equipment

8. Capital Budgeting Process 3 . Project selection : the alternative that mostly nearly promises attainment of the objectives of the organization should be selected .

9. Capital Budgeting Process 4 . Project implementation : it means to ensure that project is implemented or executed in time and within the estimated cost so that there is no time and cost overrun .

10. Capital Budgeting Process 5 . Monitoring and reporting : this is essential aspects of planning and control for taking corrective and preventive actions in the process.

11. Net Present Value Net present value (NPV) is an investment measure that tells an investor whether the investment is achieving a target yield at a given initial investment . Formally , the net present value is simply the summation of cash flows (C) for each period (n) in the holding period (N), discounted at the investor’s required rate of return (r):

12. Internal Rate of Return (IRR) Internal rate of return (IRR) for an investment is the percentage rate earned on each dollar invested for each period it is invested . IRR is also another term people use for interest. Ultimately , IRR gives an investor the means to compare alternative investments based on their yield.

13. Internal Rate of Return (IRR) Mathematically , the IRR can be found by setting the above NPV equation equal to zero (0) and solving for the rate of return (IRR).

14. Distinction Between NPV vs IRR So, what’s the difference between NPV and IRR? As shown in the formulas above, the NPV formula solves for the present value of a stream of cash flows, given a discount rate. The IRR on the other hand, solves for a rate of return when setting the NPV equal to zero ( ).

15. Distinction Between NPV vs IRR NPV answers the question “ what is the following stream of cash flows worth at a particular discount rate, in today’s dollars ? IRR answers the question “ what rate of return will I achieve, given the following stream of cash flows? ”, Note: NPV and IRR method leads to acceptance or rejection decision when a single project involved, for required rate of return greater than the IRR, the NPV of the project is negative and project would be rejected.

16. Activity 1 Q1: Consider a property with expected future net cash flows of $30,000 per year for the next five years (starting one year from now). If you expect to sell the property 5 years from now for a price 10 times the net cash flow at that time, what is the value of the property if the required return is 12%? Year Cash Flow $0 1 $30,000 2 $30,000 3 $30,000 4 $30,000 5 $330,000

17. Activity 2 Q2: Suppose the seller of the above building wants $300,000. Should you do the deal still assuming your required rate of return is 12 %? Year Cash Flow -$300,000 1 $30,000 2 $30,000 3 $30,000 4 $30,000 5 $330,000

18. Activity 3 Q3: What is the IRR if you pay $260,000 and how does this compare to the required return of 12 %? Year Cash Flow -$260,000 1 $30,000 2 $30,000 3 $30,000 4 $30,000 5 $330,000

19. Activity 4 1. Calculate the internal rate of return for the following set of cash flows by first using trial and error. The initial cash outflow is $8,145, followed by seven years of semiannual cash inflows of $890. The associated discount rate is 5.6 percent.

20. Activity 5 2. Your company will invest $5 million to receive payments of $2 million for the next 10 years. Calculate the NPV if the required rate of return is 14 percent per year.

21. Activity 6 3 . After graduation, you landed a job at a large, multinational media corporation. Your firm has been negotiating a license agreement to use a certain documentary film for a term of 2.5 years. You expect that the film will return cash flows of $12.5 million at the end of each six-month period. The company licensing the rights to use the film is asking $50 million. Your company's required rate of return is 17.5 percent. Should you purchase the license to show the film?

22. Activity 7 4. Consider the following information pertaining to a project that your company is currently evaluating. The project calls for your factory to add a second canning machine that will result in end-of-year cash flows of $3,200, $3,700, $4,100, $4,500, and $4,900 over the next five years. The canning machine will cost $15,000, and your company uses a 13 percent discount rate when evaluating projects. What is the net present value of these cash flows?

23. Payback Period Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment. It is one of the simplest investment appraisal techniques .

24. Payback Period The formula to calculate payback period of a project depends on whether the cash flow per period from the project is even or uneven. In case they are even, the formula to calculate payback period is : Payback Period = Initial Investment Cash Inflow per Period

25. Activity 8 Organization C is planning to undertake a project requiring initial investment of $105 million. The project is expected to generate $25 million per year for 7 years. Calculate the payback period of the project . Decision Rule: Accept the project only if its payback period is LESS than the target payback period .

26. Activity 9 Organization F is planning to undertake a project requiring initial investment of $ 125 million. The project is expected to generate $35 million per year for 7.5 years. Calculate the payback period of the project .

27. Activity 10 Organization D is planning to undertake a project requiring initial investment of $705 million. The project is expected to generate $55 million per year for 10 years. Calculate the payback period of the project .

28. Un Even Cash for Payback Period When cash inflows are uneven, we need to calculate the cumulative net cash flow for each period and then use the following formula for payback period : In the above formula, A  is the last period with a negative cumulative cash flow; B  is the absolute value of cumulative cash flow at the end of the period A; C  is the total cash flow during the period after A Payback Period = A + B C

29. Activity 11 Organization C is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2, $16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project . Decision Rule: Accept the project only if its payback period is LESS than the target payback period .

30. Activity 11 Solution (cash flows in millions) Cumulative Cash Flow Year Cash Flow (50) (50) 1 10 (40) 2 13 (27) 3 16 (11) 4 19 8 5 22 30 Payback Period = 3 + (|-$11M| ÷ $19M) = 3 + ($11M ÷ $19M) ≈ 3 + 0.58 ≈ 3.58 years

31. Activity 12 Organization AC is planning to undertake another project requiring initial investment of $160 million and is expected to generate $23 million in Year 1, $28 million in Year 2, $30 million in year 3, $34 million in Year 4 and $36 million in Year 5. Calculate the payback value of the project . Decision Rule: Accept the project only if its payback period is LESS than the target payback period.

32. Advantages of payback period Payback period is very simple to calculate. It can be a measure of risk inherent in a project. Since cash flows that occur later in a project's life are considered more uncertain, payback period provides an indication of how certain the project cash inflows are. For companies facing liquidity problems, it provides a good ranking of projects that would return money early.

33. Disadvantages of payback period Payback period does not take into account the time value of money which is a serious drawback since it can lead to wrong decisions. A variation of payback method that attempts to remove this drawback is called discounted payback period method. It does not take into account, the cash flows that occur after the payback period.

34. Discounted Payback Period One of the major disadvantages of simple payback period is that it ignores the time value of money. To counter this limitation, an alternative procedure called discounted payback period may be followed, which accounts for time value of money by discounting the cash inflows of the project.

35. Discounted Payback Period In discounted payback period we have to calculate the present value of each cash inflow taking the start of the first period as zero point. For this purpose the management has to set a suitable discount rate.

36. Discounted Payback Period The discounted cash inflow for each period is to be calculated using the formula : Where, i  is the discount rate; n is the period to which the cash inflow relates. Discounted Cash Inflow =  Actual Cash Inflow (1 + i )^n

37. Steps of Discounted Payback Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present value factor. Create a cumulative discounted cash flow column . Step 2: Discounted Payback Period

38. Activity 13 An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted payback period of the investment if the discount rate is 11%.

39. Activity 13 Solution Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present value factor. Create a cumulative discounted cash flow column . Year n Cash Flow CF Present Value Factor PV$1=1/(1+i )^n Discounted Cash Flow CF×PV$1 Cumulative Discounted Cash Flow $ −2,324,000 1.0000 $ −2,324,000 $ −2,324,000 1 600,000 0.9009 540,541 − 1,783,459 2 600,000 0.8116 486,973 − 1,296,486 3 600,000 0.7312 438,715 − 857,771 4 600,000 0.6587 395,239 − 462,533 5 600,000 0.5935 356,071 − 106,462 6 600,000 0.5346 320,785 214,323

40. Activity 13 Solution Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years

41. Activity 14 Mr. John is starting a business with a n initial investment of $1,500,000 is expected to generate $300,000 per year for 5 years. Calculate the discounted payback period of the investment if the discount rate is 10%.

42. Advantages and Disadvantages Advantage: Discounted payback period is more reliable than simple payback period since it accounts for time value of money. It is interesting to note that if a project has negative net present value it won't pay back the initial investment. Disadvantage : It ignores the cash inflows from project after the payback period.

43. Profitability Index Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project . Profitability Index =  Present Value of Future Cash Flows Initial Investment Required =  1 +  Net Present Value Initial Investment Required

44. Profitability Index Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profitability index is a relative measure (i.e. it gives as the figure as a ratio).

45. Profitability Index Decision Rule: Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is zero and don't accept a project if the profitability index is below 1. Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.

46. Activity 15 Organization C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a present value of $65 million. Calculate the profitability index.

47. Activity 15 Solution Profitability Index = PV of Future Net Cash Flows / Initial Investment Required Profitability Index = $65M / $50M = 1.3 Net Present Value = PV of Net Future Cash Flows − Initial Investment Required Net Present Value = $65M-$50M = $15M. The information about NPV and initial investment can be used to calculate profitability index as follows: Profitability Index = 1 + (Net Present Value / Initial Investment Required) Profitability Index = 1 + $15M/$50M = 1.3

48. Activity 16 Organization Euro is undertaking a project at a cost of $150 million which is expected to generate future net cash flows with a present value of $85 million. Calculate the profitability index.

49. Please refer to your Training Manual for the Assignment of Day 4, ‘Capital Budgeting’. You are required to complete that assignment before the start of the next day End of Day, Assignment