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The Basics of Capital Budgeting

Should we Make this investment?

What is capital budgeting?


Analysis

of potential additions to fixed

assets. Long-term decisions; involving large expenditures. Replacement of fixed assets and modernization of plants.

Steps to capital budgeting


Estimate CFs (inflows & outflows).
Assess riskiness of CFs. Determine the appropriate cost of capital. Decision Making Time

What is the difference between independent and mutually exclusive projects?


Independent projects if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.

What is the difference between normal and nonnormal cash flow streams?
Normal cash flow stream Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Non-normal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

Calculations of Cash Flow


Revenue

Variable Costs Fixed Costs Depreciation Interest Tax = Profit After Tax flows = Profit After Tax + Depreciation

Cash

EVALUATION CRITERIA
NON-DISCOUNTED CASH FLOW CRITERIA DISCOUNTED CASH FLOW CRITERIA

Accounting Rate of Return (ARR) Payback Period (PB) Discounted Payback Period

Net Present Value (NPV) Profitability Index (PI) Internal Rate of Return (IRR)

What is the Accounting Rate of Return ?


Accounting

rate of return or simple rate of return is the ratio of the estimated accounting profit of a project to its average investment. It is an investment appraisal technique.
ARR =

Average Accounting Profit Average Investment

Calculation of ARR
Initial Investment Year Profit After Tax 1 0 2 450 3 1800 4 2250 5 6750 50000

ARR = 2250 (11250/5) * 100 = 9% 25000 (50000/2)

Strengths and weaknesses of accounting rate of return


Strengths

Provides an indication of a projects profitability Easy to calculate and understand.

Weaknesses

Ignores the time value of money. Profit values can be misleading.

What is the payback period?


The

number of years required to recover a projects cost, or How long does it take to get our money back? Calculated by adding projects cash inflows to its cost until the cumulative cash flow for the project turns positive.

Calculation of Payback Period


Year 0 1 2 3 4 5 In Rs Thousand Cumualtive Cash Flows Cash Flow -50000 20000 20000 10450 30450 11800 42250 12250 54500 16750 71250

Payback Period is 3 years and part of 4th year. The fraction of fourth year is calculated as 7750/12250 = 0.63. The Payback period in this case is 3.63 years

Strengths and weaknesses of payback


Strengths

Provides an indication of a projects risk and liquidity. Easy to calculate and understand.

Weaknesses

Ignores the time value of money. Ignores CFs occurring after the payback period.

What is the discounted payback period?


The

number of years required to recover a projects discounted cash flows. Calculated by adding projects discounted cash inflows to its cost until the cumulative cash flow for the project turns positive.

Calculation of Discounted Payback Period


Year 0 1 2 3 4 5 Cash Flows -50000 20000 10450 11800 12250 16750 PV @ 10% PV Cumualtive Cash Flow 18180 26811.7 35673.5 44040.25 54442

0.909 18180 0.826 8631.7 0.751 8861.8 0.683 8366.75 0.621 10401.75

Payback Period is 4 years and part of 5th year. The fraction of fifth year is calculated as 5959.75/10401.75 = 0.57. The Payback period in this case is 4.57 years

Strengths and weaknesses of discounted payback


Strengths

Provides an indication of a projects risk and liquidity. Easy to calculate and understand. Takes into account time value of money.

Weaknesses

Does not have much meaning. Ignores CFs occurring after the payback period.

Net Present Value (NPV)

Sum of the PVs of all cash inflows and outflows of a project:

CFt NPV t t 0 ( 1 k )

Rationale for the NPV method


If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value.

Calculating NPV
Year 0
1 2 3 4 5

Cash Flows -50000


20000 10450 11800 12250 16750

PV @ 10%
0.909

PV -50000
18180

0.826
0.751 0.683 0.621

8631.7
8861.8 8366.75 10401.75 4442

NPV

Strengths and weaknesses of net present value

Strengths:

It will give the correct decision advice assuming a perfect capital market. It will also give correct ranking for mutually exclusive projects. NPV gives an absolute value. NPV allows for the time value for the cash flows.

Weaknesses:

It is very difficult to identify the correct discount rate. NPV as method of investment appraisal requires the decision criteria to be specified before the appraisal can be undertaken.

Profitability Index (PI)

Ratio of the PVs of all cash inflows and outflows of a project:

Cash Inflows PI t 0 Cash Outflows

Rationale for the PI method


If projects are independent, accept if the project PI > 1. If projects are mutually exclusive, accept projects with the highest positive PI, those that add the most value.

Calculating PI
Year 0 1 2 3 4 5 PI Cash Flows PV @ 10% PV -50000 -50000 0.909 18180 20000 0.826 8631.7 10450 0.751 8861.8 11800 0.683 8366.75 12250 0.621 10401.75 16750 1.08884

Strengths and weaknesses of profitability index

Strengths:
It will give the correct decision advice assuming a perfect capital market. It will also give correct ranking for mutually exclusive projects. PI allows for the time value for the cash flows.

Weaknesses:
It is very difficult to identify the correct discount rate. It gives same information as NPV and does not add anything extra.

Internal Rate of Return (IRR)

IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

CFt 0 t ( 1 IRR ) t 0
n

Rationale for the IRR method


If

IRR > WACC, the projects rate of return is greater than its costs. There is some return left over to boost stockholders returns.

IRR Acceptance Criteria


If

IRR > k, accept project. If IRR < k, reject project.


If

projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept 2, because IRR2 > IRR1.

Calculating IRR
Year 0 1 2 3 4 5 IRR Cash Flows -50000 20000 10450 11800 12250 16750 13.57%

Strengths and weaknesses of internal rate of return


Strengths:

It shows returns on original money invested IRR allows for the time value for the cash flows.

Weaknesses:

It does not give correct answer in case of alternating negative and positive cash flows.

Comparing the NPV and IRR methods


If

projects are independent, the two methods always lead to the same accept/reject decisions. If projects are mutually exclusive
IRR and NPV may give conflicting results In case of any conflict, go with NPV method.

MIRR Modified Internal Rate of Return

While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that positive cash flows are reinvested at the firm's cost of capital, and the initial outlays are financed at the firm's financing cost. Therefore, MIRR more accurately reflects the cost and profitability of a project. MIRR = n FV (Future Cash Flows. Reinvestment Rate) n PV (Negative Cash Flows. Finance Rate) -1

Why use MIRR versus IRR?


MIRR

correctly assumes reinvestment at opportunity cost = WACC. MIRR also avoids the problem of multiple IRRs. Managers like rate of return comparisons, and MIRR is better for this than IRR.

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