CAPITAL BUDGETING DECISIONS.ppt

The investment decisions of a firm are generally known as the capital budgeting, or capital expenditure decisions.

The firm’s investment decisions would generally include expansion, acquisition, modernisation and replacement of the long-term assets. Sale of a division or business (divestment) is also as an investment decision.

Decisions like the change in the methods of sales distribution, or an advertisement campaign or a research and development programme have long-term implications for the firm’s expenditures and benefits, and therefore, they should also be evaluated as investment decisions.

1. Dr.K.Sivaperumal, M.Com.,M.Phil.,
Ph.D,
Assistant Professor
Department of Commerce,
College of Science and Humanities
SRM Institute of Science and Technology
SRM Nagar, Kattankulathur, Chennai
[email protected]

2. CAPITAL BUDGETING DECISIONS
Should we
build this
plant?

3. CAPITAL BUDGETING DECISIONS
The investment decisionsof a firm are generally known as
the capital budgeting, or capital expenditure decisions.
The firm’s investment decisions would generally include
expansion, acquisition, modernisation and replacementof
the long-term assets. Sale of a division or business
(divestment) is also as an investment decision.
Decisions like the change in the methods of sales
distribution,or an advertisement campaignor a research and
development programmehave long-term implications for the
firm’s expenditures and benefits, and therefore, they should
also be evaluated as investment decisions.

4. TYPES OF INVESTMENT DECISIONS
One classification is as follows:
Expansion of existing business
Expansion of new business
Replacement and modernisation
Yet another useful way to classify investments is as
follows:
Mutually exclusive investments
Independent investments
Contingent investments

5. AN EXAMPLE OF MUTUALLY EXCLUSIVE
PROJECTS
BRIDGEvs. BOATto get
products across a river.

6. TYPES OF CASH FLOWS
Normal or Conventional Cash Flow :
Onechangeofsigns.
Cost(negativeCF)followedbyaseriesofpositive
cashinflows.
•Non-normal or unconventional Cash Flow:
Two or more changes of signs.
Most common: Cost (negative CF), then string of
positive CFs,then cost to close project.
Example: Nuclear power plant, strip mine.

7. CAPITAL BUDGETING DECISIONS
These are generally:
Long-term decisions; involving large
expenditures.
Have long term consequences.
Difficult or expensive to reverse.

8. Capital Budgeting
Methods
Discounting Criteria
NPV BCR IRR
MIRR
PBP ARR
DPBP
Non Discounting Criteria

9. NET PRESENT VALUE
NPV of a project is the sum of the present values of
all the cash flows positive as well as negativethat
are expected to occur over the life of the project.
The formula for NPV is:312
023
0
1
NPV
(1 ) (1 ) (1 ) (1 )
NPV
(1 )
n
n
n
t
t
t
CCCC
C
k k k k
C
C
k


     

   




10. NET PRESENT VALUE
Where,
C
t = cash flow at the end of year t
n = Life of the project
k = discount rate (given by the projects opportunity
cost of capital which is equal to the required rate of
return expected by investors on investments of
equivalent risk).
C
0= Initial investment
1 / (1 + k )
t
= known as discounting factor or PVIF
i.e present value interest factor.

11. CALCULATING NET PRESENT VALUE
Assume that Project Xcosts Rs 2,500 now and is
expected to generate year-end cash inflows of Rs
900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1
through 5. The opportunity cost of the capital may be
assumed to be 10 per cent.2345
1, 0.10 2, 0.10 3, 0.10
4, 0.10 5, 0.
Rs 900 Rs 800 Rs 700 Rs 600 Rs 500
NPV Rs 2,500
(1+0.10)(1+0.10) (1+0.10) (1+0.10) (1+0.10)
NPV [Rs 900(PVF ) + Rs 800(PVF ) + Rs 700(PVF )
+ Rs 600(PVF ) + Rs 500(PVF

     



10)] Rs 2,500
NPV [Rs 900 0.909 + Rs 800 0.826 + Rs 700 0.751 + Rs 600 0.683
+ Rs 500 0.620] Rs 2,500
NPV Rs 2,725 Rs 2,500 = + Rs 225

    



12. ACCEPTANCE RULE OF NPV
Accept the project when NPV is positive
NPV > 0
Reject the project when NPV is negative
NPV< 0
May accept or reject the project when NPV is zero
NPV = 0
( A project will have NPV = 0, only when the project generates
cash inflows at a rate just equal to the opportunity cost of capital)
The NPV method can be used to select between
mutually exclusive projects; the one with the higher
NPV should be selected.

13. ADVANTAGES OF NPV METHOD
It considers time value of money.
It is a true measure of profitability as it uses the present
values of all cash flows (both outflows & inflows) &
opportunity cost as discount rate rather than any other
arbitrary assumption or subjective consideration.
The NPVs of individual projects can be simply added to
calculate the value of the firm . This is known as
“Principle of value additivity”.
It is consistent with the shareholders wealth
maximization principle as whenever a project with
positive NPV is undertaken, it results in positive cash
flows and hence the increase in the value of the firm.

14. DISADVANTAGES OF NPV METHOD
It is difficult to estimate the expected cash flows
from a project.
Discount rate to be used is very difficult to
determine.
Since this method does not consider the life of the
projects, in case of mutually exclusive projects with
different life, the NPV rule, tends to be biased in
favour of the longer term project.
Since NPV is expressed in absolute terms rather
than relative terms it does not consider the scale of
investment.

15. BENEFIT COST RATIO
It is calculated as:
Benefit-cost ratio = PVB / I
Where,
PVB = present value of benefits
I = Initial investments

16. ACCEPTANCE RULE FOR BCR
BCR > 1 = Accept
BCR = 1 = Indifferent
BCR < 1 = Reject

17. EVALUATION OF BCR METHOD
Advantages of BCR method:
Since it considers the investment in the project, it is
considered to be preferable to NPV method.
Disadvantages of BCR method:
It does not provide for a means through which a
number of smaller projects can be combined to be
compared to a bigger project.

18. Internal Rate of Return: IRR
0 1 2 3
CF
0
Cost
CF
1
CF
2 CF
3
Cash Inflow
IRR is the rate of return that equates PV of cash
inflows with investment outlay of a project
. This is the same as forcing NPV = 0.

19. INTERNAL RATE OF RETURN
METHOD
The internal rate of return (IRR) is the rate that
equates the investment outlay with the present value
of cash inflow received after one period. This also
implies that the rate of return is the discount rate
which makes NPV = 0.
The formula for calculating IRR is:312
0 23
0
1
0
1
(1 ) (1 ) (1 ) (1 )
(1 )
0
(1 )
n
n
n
t
t
t
n
t
t
t
CCCC
C
r r r r
C
C
r
C
C
r


    
   







20. INTERNAL RATE OF RETURN
METHOD
Where,
C
t = cash flow at the end of year t
n = Life of the project
r = discount rate
C
0= Initial investment
1 / (1 + r )
t
= known as discounting factor or PVIF
i.e present value interest factor.

21. CALCULATION OF IRR
Level or Even Cash Flows:
Let us assume that an investment would cost Rs
20,000 and provide annual cash inflow of Rs 5,430 for
6 years.
The IRR of the investment can be found out as follows:
IRR = 16% approx.( Refer to PVAF table @ 3.685 for 6 yrs 6,
6,
6,
NPV Rs 20,000 + Rs 5,430(PVAF ) = 0
Rs 20,000 Rs 5,430(PVAF )
Rs 20,000
PVAF 3.683
Rs 5,430
r
r
r




22. NPV Profile and IRR A B C D E F G H
1 N P V P r o f i l e



2 C a s h F l o w
D i s c o u n t
r a t e N P V
3 -2 0 0 0 0 0% 1 2 , 5 8 0
4 5430 5% 7 , 5 6 1
5 5430 10% 3 , 6 4 9
6 5430 15% 5 5 0
7 5430 16% 0
8 5430 20% ( 1 , 9 4 2 )
9 5430 25% ( 3 , 9 7 4 )
F i g u r e 8 . 1 N P V P r o f i l e

IR
R

23. CALCULATION OF IRR
Uneven or non–normal Cash Flows:Calculating
IRR by Trial and Error
The approach is to select any discount rate to
compute the present value of cash inflows. If the
calculated present value of the expected cash
inflow is lower than the present value of cash
outflows, a lower rate should be tried. On the other
hand, a higher value should be tried if the present
value of inflows is higher than the present value of
outflows. This process will be repeated unless the
net present value becomes zero.

24. CALCULATION OF IRR
A project costs Rs.16000 and is expected to generate
cash inflows of Rs. 8000, Rs.7000 & Rs.6000 at the
end of each year for next 3 years.

25. ACCEPTANCE RULE FOR IRR
Accept the project when r(IRR) > k (WACC).
Reject the project when r(IRR) < k (WACC).
May accept the project when r = k.
In case of independent projects, IRR and NPV rules
will give the same results if the firm has no shortage
of funds.
In case of projects with equal IRR & different NPV,
select project with higher NPV as it is consistent with
firm’s wealth maximisation objective.

26. ADVANTAGES OF IRR METHOD
It considers time value of money.
It is a true measure of profitability as it uses the
present values of all cash flows(both outflows &
inflows) rather than any other arbitrary assumption
or subjective consideration.
In case of conventional independent projects NPV &
IRR methods gives the same decision.
Whenever a project with higher IRR than WACC is
undertaken, it results in the increase in the
shareholder’s return. Hence, the value of the firm
also increases.

27. PROBLEMS WITH IRR
Lending & Borrowing projects:Project with initial
outflow followed by inflows is a lending type project
whereas a project with initial inflow followed by
outflows is a borrowing project. Since IRR does not
differentiate between lending and borrowing projects,
a higher IRR may not always be a desirable thing.
Multiple IRR:In case of projects with non-normal or
unconventional cash flows more than one IRR are
generated which are misleading.
Mutually Exclusive projects:In case of mutually
exclusive projects the results of NPV & IRR methods
may conflict each other. This is because the IRR
method does consider the scale of investment.

28. PROBLEMS WITH IRR
Different short term & Long term interest rates:Since
the cash flows are discounted at the opportunity cost
of capital, there arises a confusion regarding what
rate is to be used for discounting, if the short term and
long term lending rates are different.

29. LENDING & BROWING PROJECTS
Lending projects: Project with initial outflow followed
by inflows is a lending type project.
Borrowing projects: Project with initial inflow
followed by outflows is a borrowing project.
Cash Flows (Rs.)
Project C
o C
1 IRR NPV at 10%
X -100 110 10% 0
Y 100 -110 10% 0

30. LENDING &BORROWING PROJECTS
Cash Flows (Rs.)
ProjectC
o C
1 IRR NPV at
15%
X -100 110 10% -4.3
Y 100 -110 10% 4.3
Cash Flows (Rs.)
ProjectC
o C
1 IRR NPV at 5%
X -100 110 10% 4.72
Y 100 -110 10% -4.72

31. PROBLEM OF MULTIPLE IRRS
A project may have both lending and borrowing
features together. IRR method, when used to
evaluate such non-conventional investment can
yield multiple internal rates of return because of
more than one change of signs in cash flows.

32. Case of Ranking Mutually Exclusive Projects
Investment projects are said to be mutually exclusive
when only one investment could be accepted and
others would have to be excluded.
Two independent projects may also be mutually
exclusive if a financial constraint is imposed.
The NPV and IRR rules give conflicting ranking to the
projects under the following conditions:
The cash flow pattern of the projects may differ. That
is, the cash flows of one project may increase over
time, while those of others may decrease or vice-
versa.
The cash outlays of the projects may differ.
The projects may have different expected lives.

33. RANKING MUTUALLY EXCLUSIVE PROJECTS
(Timing of Cash Flows) Cash Flows (Rs) NPV
Project C0 C1 C2 C3 at 9% IRR
M – 1,680 1,400 700 140 301 23%
N – 1,680 140 840 1,510 321 17%

Discount Rate Project M Project N
0 560 810
5 409 520
10 276 276
15 159 70
20 54 -106
25 -40 -257
30 -125 -388

34. 1000
800
600
400
200
0
-200
-400
5% 10% 15% 20% 25% 30%
NPV
Discount Rate
NPV INR 276/-
___ Project M
----Project N
RANKING MUTUALLY EXCLUSIVE PROJECTS
(Timing of Cash Flows)
10% discount is k/as Fisher’s
intersection.

35. RANKING MUTUALLY EXCLUSIVE PROJECTS
(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%

36. RANKING MUTUALLY EXCLUSIVE PROJECTS
(Project Life Span) Cash Flows (Rs)
Project C
0
C
1
C
2
C
3
C
4
C
5
NPV at 10% IRR
X – 10,000 12,000 – – – – 908 20%
Y – 10,000 0 0 0 0 20,120 2,495 15%

37. Modified Internal Rate of Return (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.
Both NPV & IRR methods assume that the entire
cash flow generated during the life time of the project
is reinvested at project cost of capital (i.e k) & internal
rate of return (i.e r) respectively in each of the above
two methods.
But, in MIRR the cashflows are assumed to be
reinvested at cost of capital ( k) instead of internal
rate of return ( r )as in IRR method.

38. PAY BACK PERIOD
It is the number of years required to recover a
project’s cost, or how long does it take to get the
business’s money back?
Pay Back Period = Investment Cost / Net Cash Flows

39. sales
Less: All Costs( Including
non cash & financial
costs)
PBT
Deduct Tax (calculated on
PBT)
PAT
Add: Non Cash Costs
NetCash Flow Received

40. 10 8060
0 1 2 3
-100
=
CF
Cumulative-100 -90 50
Payback 2 + 30/80= 2.375 years
0
100
2.4
PAY BACK PERIOD
-30

41. Strengths of Payback:
1.Provides an indication of a project’s risk and
liquidity.
2.Easy to calculate and understand.
Weaknesses of Payback:
1.Ignores the time value of money.
2.Ignores CFs occurring after the payback period.
3.It is a measure of capital recovery & not
profitability.
PAY BACK PERIOD

42. DISCOUNTED PAYBACK PERIOD
(DPBP)
10 8060
0 1 2 3
CF
t
Cumulative-100 -90.91 -41.32 18.79
Discounted
payback
2 + 41.32/60.11 = 2.7 yrs
Discounted Payback: Uses discounted
rather than raw CFs.
PVCF
t -100
-100
9.09 49.59 60.11
=

43. ACCOUNTING RATE OF RETURN
The accounting rate of return is the ratio of the
average after-tax profit divided by the average
investment.
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.

44. ACCEPTANCE RULE OF ARR
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.

45. ACCOUNTING RATE OF RETURN
The ARR method has certain advantages as:
It is very simple to understand.
Dependency on accounting data which is readily
available.
Shows the profitability of the project.

46. ACCOUNTING RATE OF RETURN
The disadvantages of ARR include:
It is based on accounting profit rather than cash
flows.
Time value of money is ignored.
It is inconsistent in the sense that the numerator
represents the profit belonging to equity and
preference shareholders whereas the fixed assets
used in denominator rarely if ever represents
contribution equal to equity & preference
shareholders.