Financial Management-I: chapter 5 Capital budgeting.pptx

Financial Management-I: chapter 5 Capital budgeting.pptx

1. Chapter Five Capital Budgeting

2. Key Concepts and Skills Understand the importance of capital budgeting in decision making. Explain the different types of investment project . Use the capital budgeting criteria-the non discounted and discounted methods to evaluate the worth of the projects . Explain the mechanics, advantages and disadvantages of the different investment decision criteria.

3. Introduction Business firms regularly make decisions involving capital goods purchases such as equipment and structures. Capital goods are business assets with an expected use of more than only one year. An investment in capital goods requires an outlay of funds by the firm in exchange for expected future benefits over a period greater than one year. Managers attempt to maximize value by selecting capital investments in which the value created by the project’s future cash flows exceeds the recurred cash outlay . Thus we need to use Capital Budgeting.

4. Capital Budgeting Defined Capital budgeting refers to the process we use to make decisions concerning investments in the long-term assets of the firm. investment decisions can be: Selection decisions concerning proposed projects Replacement decisions The general idea is that the capital or long term funds raised by the firms are used to invest in assets that will enable the firm to generate revenues several years in to the future . Often the funds raised to invest in such assets are not unrestricted or infinitely available; thus the firm must budget how these funds are invested.

5. Importance of Capital Budgeting Capital budgeting decisions are important to a firm for three major reasons Size of outlay Effect on future direction Difficulty to reverse Components of Capital Budgeting- cash flow can be: The initial investment The incremental (relevant) cash inflows over the life of the project; and The terminal cash flow

6. Capital Budgeting Decision Practices Financial managers apply two decision practices when selecting capital budgeting projects: accept /reject and ranking . The accept / reject decision focuses on the question of whether the proposed project would add value to the firm or earn a rate of return that is acceptable to the company . The accept / reject decision determines whether the project is acceptable in light of the firms financial objectives. That is, if a project meets the firms' basic risk and return requirements (cost and benefit requirements), it will be accepted , If not it will be rejected . The ranking decision lists competing projects in order of desirability to choose the best one.

7. Classification of Investment Projects Investment projects can be classified in to three categories on the basis of how they influence the investment decision process ; I ndependent projects M utually exclusive projects C ontingent projects- complementary

8. Capital Budgeting Decision Methods Capital budgeting methods Discounting methods (Modern approach) Discounted Payback Period (DPBP) Net Present Value (NPV) Internal Rate of Return (IRR ) Modified Internal Rate of Return (MIRR ) Profitability Index (PI) Non discounting methods (traditional approach) Payback Period (PBP) Accounting Rate of Return- (ARR)

9. The Discounted Methods (Modern Approaches) 1. Net Present Value (NPV) The project selection method that is most consistent with the goal of owner wealth maximization is the net present value method. It is the sum of the present values of the net investments NPV= the sum of the present value (PV) of after tax cash flows – initial investment

10. Decision rule : For Independent Projects: Accept the project if the NPV > 0 Reject the project if the NPV < 0 For Mutually Exclusive Projects : choose projects with the highest NPV. Example A project has a net investment of Br 5, 000 and a cash flow of Br800, Br900, Br 500, Br1200 and Br 3, 200 for period 1,2,3,4, and 5 .Compute the NPV and comment on the decision rule.

11. Decision rule : - Accept the project since the NPV > 0 i.e. Br 77. 82>0 and the positive NPV of Br 77.82 indicates that the projects rate of return is greater than the required 12 %. Advantages and Disadvantages of NPV Advantages Time value of money is considered Direct measure of the benefit It is an objective method of selecting and evaluating of the project. Disadvantages The NPV is expressed in absolute terms rather than relative terms and hence does not factor is the scale of investment. The NPV does not consider the life of the project.

12. Internal Rate of Return (IRR) The internal rate of return (IRR) of an investment proposal is defined as the discount rate that produces a Zero NPV.

13. Decision rule If the IRR of a project is greater than the firms cost of capital (the Hurdle rule) accept the project, if IRR is less than the cost of capital, reject the project Example , A project required a net investment of Br 100,000 produced 16 annual cash flows of Br 14,000 each, required a 10 percent rate of return, and had a NPV of Br 9,536 . Compute the IRR . Follow the following Steps Identify the closest rates of return Compute the Net resent Value (NPV) for each of these two closest rates. Compute the sum of the absolute values of the NPV obtained in step 2 Dived the sum obtained in Step3 in to the NPV of the smaller discount rate . A dd the resulting quotient to the smaller discount rate.

14. Step 1 ; Br 100, 000 Br 14, 000 = 7.143 Steps 2 ; (NPV, 11%) = Br 14, 000 (7.379) – Br 100,000 = Br 3,306 ( NPV , 12%) = Br 14,000 (6,974) – Br 100,000 = Br 2. 364 Steps3. Compute the sum of the absolute values of the NPVs obtained in steps2. Br 3, 306 + Br 2, 364= Br 5, 670 Steps 4 ; Divide the sum obtained in steps 3 in to the NPV of the smaller discount rate identified in step1. Then add the resulting quotient to the smaller discount rate.

15. Advantages and Disadvantages of IRR Advantages: - A number of surveys have shown that in practice the IRR method is more popular than the NPV approach. The reason may be that the IRR is straightforward like the ARR but it Recognizes the time value of money Recognizes income over the whole life of the project The percentage return allows a sound basis for ranking projects Disadvantages It of ten gives unrealistic rates of return: Suppose the cut-off rate (cost of capital) is 11% and the IRR is calculated as 40%, does this mean that management should immediately accept the project because its IRR is 40%? The answer is no! An IRR 40% assumes rate a firm has the opportunity to reinvest future cash flows at 40% Give different rates of return.

16. Which Method is better: the NPV or the IRR? The NPV is superior to the IRR method for at least two reasons Reinvestment of Cash flows Multiple Solutions for the IRR The Modified Internal Rate of Return (MIRR ) Overcome the two deficiencies in the IRR method????????????????????????????????????????????????

17. Profitability Index (PI) Sometimes called benefit cost ratio method compares the present value of future cash inflows with the initial investment on a relative basis. The PI is the ratio of the present value of cash flows (PVCF) to the initial investment of the project Decision rule In this method, a project with PI greater than 1 is accepted but a project is rejected when its PI is less than 1 . Example: Zuma Co. is considering a project with annual predicted cash flows of $ 5, 000, $3,000 and $ 4,000 respectively for three years. The initial investment is $ 10,000 using the PI method and a discount rate of 12%, determine the PI if the project is acceptable.  

18. Initial investment (Io) = $ 10,000 PI = PVCF/Io =9,704/1,000 =0.0704 . Since the PI value is less than 1, the project is rejected

19. Discounted Payback Period (DPBP) Out of the serious shortcomings of the payback period method is that it does not consider time value of money. The discounted payback period is the length of time it takes for the discounted cash flows equal to the amount of initial investment  

20. Example : Satcon Construction Company is considering investing in a project that has the following cash flows . And the required rate to purchase the asset is 12% .Compute the discounted payback period. Year Cash flow PV of CF Cumulative PV Br (5, 000) (5,000) Br (5,000) 1 800 714. 29 (4285. 71) 2 900 717. 47 (3,568.24) 3 1500 1,067.67 (2,500.57) 4 1,200 762.62 (1,737.95) 5 3,200 1,815.77 77.82 Year (t) 1 2 3 4 5 Expected cash flow (in Birr) (5000) 800 900 1500 1200 3200

21. 4 + Br 1, 737.95 Br . 1, 815. 77 = 4. 96 years Decision rule: A project is acceptable if its payback less than its life. In this case, 4.96 Years are less than five years, so, the project is acceptable Problems with Discounted Payback Period: The discounted payback period solves the time value problem, but it still ignores the cash flows beyond the payback period. You may reject projects that have large cash flows in the outlying years that make it very profitable. Any measure of payback can lead to focus on short run profits at the expense of larger long-term profits

22. Non Discounting Methods 1. The Payback Period) (PBP) The payback period is the number of years needed to recover the initial investment of a project . Payback period can be looked up on as the length of time required for a project to break even on its net investment. To calculate the payback period, simply add up a projects projected positive cash flows, one period at a time, until the sum equals the amount of the project’s initial investment . The rationale behind the shorter the payback period , the less risky the project and the greater the liquidity

23. Methods of Calculation of Payback Period (PBP) On the basis of uniform cash in flow (annuity form ) PBP = Net initial investment Uniform in crease in annual cash flows On the basis of non uniform cash inflow (non annuity form)  

24. Example: An investment has a net investment of Br 12,000 and annual cash flows of Br. 4, 000 for five years. If the project has a maximum desired payback period of 4 years, compute the payback period and what would be the decision rule? Sine the investment has uniform cash inflows The PBP = Net initial investment Uniform increase in annual cash flows = Br 12, 000 = 3 years 4.0 Decision Rule : - Accept the project because the calculated payback period is less than the specified payback period . Example 2 : Compute the payback period for the following cash flows, assuming a net investment of Br 20, 000 & What would be the decision rule if the specified PBP be three years?

25. the investments cash flows are not uniform (in annuity form), the cumulative cash flows are used in computing the payback period in the following table . The payback period is 4 years because four years are required before the cumulative cash flows equal the project net investment. And the decision rule is to reject the project because the calculated payback period is greater than the pre specified payback period. Year(t) 1 2 3 4 5 Yearly cash flows(Br) 8,000 6,000 4,000 2,000 2,000 Year 1 2 3 4 5 Yearly cash flows 8,000 6,000 4,000 2,000 2,000 Cumulative cash flows 8000 14,000 18,000 20,000 22,000

26. The Accounting Rate of Return (ARR Finding the average rate of return involves a simple accounting technique that determines the profitability of a project. This method of capital budgeting is perhaps the oldest technique used in business . Decision Rule : - a project is acceptable if its average accounting return exceeds a target average accounting return other wise it will be rejected

27. Example : - suppose the net earnings for the next four years are estimated to be Br 10, 000, Br 15, 000, Br 20, 000 and Br 30, 000, respectively. If the initial investment is Br 100, 000, find the average rate of return. The accounting rate of return can be calculated as follows Average net earnings= Br 10, 000 + Br 15, 000 + Br 20,000 + Br 30,000 4 years = Br 18,750 Thus, AAR= ANI/II = 18,750/100,000 = 0.1875 = 18.75%