Date post: | 03-Apr-2018 |
Category: |
Documents |
Upload: | subhadeep-basu |
View: | 226 times |
Download: | 0 times |
of 103
7/28/2019 Capital Budgeting 1_1
1/103
1
7/28/2019 Capital Budgeting 1_1
2/103
CAPITAL BUDGETING
Capital budgeting refers to the process where we makedecisions concerning investments in the long-termassets of the firm.
Capital budgeting is a decision situation where largefunds are committed (invested) in the initial stages of
the project and the returns are expected over a longerperiod of time usually more than one year and in casethis decision goes wrong, it can not be changed whichwill affect the future growth of the firm.
2
7/28/2019 Capital Budgeting 1_1
3/103
3
FEATURES OF CAPITAL BUDGETING
1. Capital budgeting decisions have long-
term implications.
2. These decisions involve substantial
commitment of funds.
3. These decisions are irreversible and
require analysis of minute details.
4. These decisions determine and affect thefuture growth of the firm.
7/28/2019 Capital Budgeting 1_1
4/103
Decision-making Criteria in Capital
Budgeting
How do we decide if acapital investment
project should beaccepted or rejected?
4
7/28/2019 Capital Budgeting 1_1
5/103
To make decisions, we need:
Initial cash investment/outflows
Future cash benefits/inflows
Rate of return (why)
5
7/28/2019 Capital Budgeting 1_1
6/103
A case study
Suppose ABC firm must decidewhether to purchase a new machine
for Rs. 1,00,000. This machine isexpected to generate annual cashinflows of Rs. 20,000, Rs. 50,000 and
Rs. 60,000 during next 3 years at 10%capitalisation rate. How do wedecide?
6
7/28/2019 Capital Budgeting 1_1
7/103
Problems and constraints in cabital
budgeting
Time factor
Calculation of required rate ofreturn
Calculation of future benefits
7
7/28/2019 Capital Budgeting 1_1
8/103
Capital budgeting process
8
7/28/2019 Capital Budgeting 1_1
9/103
Evaluation consists of: Estimating relevant cash outflows and cash
inflows Estimating Appropriate rate of return
Comparing relevant cash outflows and cashinflows by any suitable technique to take thedecision:
1. Payback period2. Average rate of return3. Net present value4. Profitability index5. Internal rate of return
9
7/28/2019 Capital Budgeting 1_1
10/103
Estimating relevant cash outflows and cash
inflows Estimating relevant cash outflows and cash inflows
depend upon the nature of investment decisions:
1. Single/Independent decisions2. Replacement decisions
3. Mutually Exclusive decisions
10
7/28/2019 Capital Budgeting 1_1
11/103
Single/Independent decisionsCalculation of CO Cost of new plant
+ Installation expenses+ Other Capital expenditure
+ Additional working capital
11
7/28/2019 Capital Budgeting 1_1
12/103
Single/Independent decisions Calculation of CI for subsequent years
Cash sales revenue
- Cash operating cost
= Cash inflows before tax (CFBT)
- Depreciation= Profits before tax/Taxable income
- Tax
= Profit after tax+ Depreciation
= Cash inf lows after tax (CFAT)
12
7/28/2019 Capital Budgeting 1_1
13/103
Single/Independent decisionsCalculation of CI for TERMINAL CASH
FLOW:
Cash inflows after tax (CFAT) for last year+ Working capital released
+ Scrap value of the plant (if any).
13
7/28/2019 Capital Budgeting 1_1
14/103
Case A cosmetic company is considering introducing a new
lotion. The manufacturing equipment will cost Rs.5,60,000. Working capital requirement is expected toincrease by Rs. 40,000. The expected life of the equipmentis 8 years. The company is thinking of selling the lotion atRs. 12 each pack. It is estimated that variable cost per pack
would be Rs. 6 and annual fixed cost Rs. 3,50,000. Thecompany expects to sell 1,00,000 packs of the lotion eachyear. Tax rate is 45% and straight-line depreciation isallowed for tax purpose. Calculate the cash flowsassumimg:
1. Working capital requirement remains same eachyear.
2. Working capital requirement increases by Rs. 5,000each year
14
7/28/2019 Capital Budgeting 1_1
15/103
ANOTHER CASE
A manufacturing department of a firm estimates that 3,000units of a product can be sold annually at a unit cash saleprice of Rs. 14. The cash variable expenses will be Rs.9 perunit. It will also involve cash fixed cost of Rs. 5,000 yearly.The machine to manufacture the product is available at Rs.50,000. It expected useful life is 10 years. The installationcost would amount to Rs. 10,000. As a result of the
acquisition of the machine, the working capitalrequirement will increase by Rs. 40,000. The firm uses thestraight line method (SLM) of depreciation and is in the50% tax bracket. Your are required to compute the relevantcash flows associated with the acquisition of the machine,
assuming There is no salvage value The salvage value is Rs. 2,000 but for depreciation purpose:
a) It is ignoredb) it is considered
15
7/28/2019 Capital Budgeting 1_1
16/103
Lets try..
A firm plans to buy an asset costing Rs.1,00,000 and expects CFBT to be Rs.30,000 p.a. Depreciation will be
charged @20% WDV. Tax rate is 30%.Estimated life is 4 years after which it
will be disposed off for Rs. 45,000. Your
are required to compute the relevantcash flows
16
7/28/2019 Capital Budgeting 1_1
17/103
REPLACEMENT PROJECTS
Calculation of COCost of new plant
+ Installation expenses
+ Other Capital expenditure
+ Additional working capital Salvage value of old plant
+ Tax liability on account of
capital gain on sale of old plant /
Taxbenefit on account of capital loss onsale of old plant
17
7/28/2019 Capital Budgeting 1_1
18/103
REPLACEMENT PROJECTS
Calculation of CI for subsequent years
(incremental basis i.e., new
old)Cash sales revenue (N-O)
- Cash operating cost (N-O)= Cash inflows before tax (CFBT)
- Depreciation (N-O)= Profits before tax/Taxable income- Tax= Profit after tax+ Depreciation (N-O)= Cash inflows after tax (CFAT) (N-O)
18
7/28/2019 Capital Budgeting 1_1
19/103
7/28/2019 Capital Budgeting 1_1
20/103
Case A firm is currently using a machine which was purchased 2 years ago
for Rs. 70,000 and has a remaining useful life of 5 years. It isconsidering to replace the machine with a new one which will cost Rs.1,40,000. The cost of installation will amount to Rs. 10,000. Theincrease in working capital will be Rs. 20,000. The expected cashinflows before depreciation and taxes are as follows
Year Existing Machine New Machine
1 30,000 50,000 2 30,000 60,000 3 30,000 70,000 4 30,000 90,000 5 30,000 1,00,000
The firm uses SLM and is in 40% tax bracket. Calculate cash flowsassuming sale value of old machine is 1) 80,000
2) 60,0003) 50,0004) 30,000
20
7/28/2019 Capital Budgeting 1_1
21/103
Lets try.. ABC Ltd. in considering an investment proposal for which the relevant
information is as follows Purchase price of the new asset Rs.I0,00,000 Installation costs 2,00,000 increase in working capital in year zero 2,50,000 Scrap value of the new asset after 4 years 3,50,000 Revenues from new asset (Annual) 21,50,000
Cash expenses on new asset (Annual) 9,50,000 Current Book value (old asset) 4,00,000 Present scrap value (old asset) 5,00,000 Revenue from old asset (Annual) 19,25,000 Cash expenses on old asset (Annual) 11,25,000
Planning period is 4 years. Depreciation on new asset: 92% the cost is to be depreciated in the
ratio of5:8:6:4 over 4 years. Existing asset is depreciated at a rate of Rs.1,00,000 p.a. Tax rate is 40%. Your are required to compute the relevantcash flows
21
7/28/2019 Capital Budgeting 1_1
22/103
Mutually Exclusive
22
7/28/2019 Capital Budgeting 1_1
23/103
23
2. DECISION CRITERIA
TECHNIQUES OF EVALUATION
Traditional or Time-adjusted orNon-discounting Discounted cash flows
1. Payback period 1. Net Present Value
2. Accounting Rate of 2. Profitability Index
Return 3. Internal Rate of Return
7/28/2019 Capital Budgeting 1_1
24/103
Case A company is considering an investment proposal to instal new
milling controls. It will cost Rs. 50,000. The facility has a lifeexpectancy of 5 years and no salvage value. Company tax rate is
35%. The firm uses straight line depreciation. The estimated cashflows before depreciation and tax from the proposed investmentproposal are as follows:
Year Cashflows1 Rs. 10,0002 Rs. 10,692
3 Rs. 12,7694 Rs. 13,4625 Rs. 20,385
Compute the following: (a) Payback period.
(b) Average Rate of Return. (c) Net Present Value at 10% discount rate. (d) Profitability Index at 10% discount rate. (e) Internal Rate of Return
24
7/28/2019 Capital Budgeting 1_1
25/103
25
TRADITIONAL OR NON-DISCOUNTING
TECHNIQUES
I . PAYBACK PERIOD:
The number of years required to recover
a projects cost,
or how long does it take to get thebusinesss money back?
7/28/2019 Capital Budgeting 1_1
26/103
7/28/2019 Capital Budgeting 1_1
27/103
27
Is a 3.33 year payback period good? Is it acceptable?
Firms that use this method will
compare the payback calculation tosome standard set by the firm.
If our senior management had set a
cut-off of 5 years for projects likeours, what would be our decision?
Accept
7/28/2019 Capital Budgeting 1_1
28/103
Unequal Cash inflowsPB ?
28
0 1 2 3 4 5 86 7
(500) 100 150 200 100 150 100 50 150
Payback period = 3.5 years.
7/28/2019 Capital Budgeting 1_1
29/103
TRY.. Delhi Machinery Manufacturing Company wants to replace
the manual oprations by new machine. There are twoalternative models X and Y of the new machine. UsingPayback period, suggest the most profitable investment.
Ignore taxation.X Y
Initial Investment (Rs.) 9,000 18,000Estimated life of the machine (Years) 4 5
Estimated savings in cost (Rs.) 500 800Estimated savings in Wages (Rs.) 6000 8000Additional cost of maintenance (Rs.) 800 1000Additional cost of supervision (Rs.) 1200 1800
29
7/28/2019 Capital Budgeting 1_1
30/103
Critical evaluationStrengths of Payback:
1. Easy to calculate and understand.
2. It serves the purpose of FM as it is based oncash flow analysis.
3. Provides an indication of a projects risk.Project with shorter PB will be less risky
30
7/28/2019 Capital Budgeting 1_1
31/103
Critical evaluationDrawbacks of Payback Period:
1.The payback period does not indicate whether the
project should be accepted or rejected. Forexample, we dont know whether 4.56 years is agood payback period, or not.
2. Cash flows that occur after the end of the payback
time are ignored in the calculation of paybackperiod. Yet, these latter cash flows may besignificant in making the decision.
31
7/28/2019 Capital Budgeting 1_1
32/103
Example(500) 150 150 150 150 150 (300) 0 0
32
0 1 2 3 4 5 86 7
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
7/28/2019 Capital Budgeting 1_1
33/103
7/28/2019 Capital Budgeting 1_1
34/103
Discounted Payback
Discounts the cash flows at thefirms required rate of return.
Payback period is calculated usingthese discounted net cashflows.Problems:
Di d P b k
7/28/2019 Capital Budgeting 1_1
35/103
Discounted Payback
0 1 2 3 4 5
(500) 250 250 250 250 250
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30
Di t d P b k
7/28/2019 Capital Budgeting 1_1
36/103
Discounted Payback
0 1 2 3 4 5
(500) 250 250 250 250 250
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
Di t d P b k
7/28/2019 Capital Budgeting 1_1
37/103
Discounted Payback
0 1 2 3 4 5
(500) 250 250 250 250 250
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38
Di t d P b k
7/28/2019 Capital Budgeting 1_1
38/103
Discounted Payback
0 1 2 3 4 5
(500) 250 250 250 250 250
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
Di t d P b k
7/28/2019 Capital Budgeting 1_1
39/103
Discounted Payback
0 1 2 3 4 5
(500) 250 250 250 250 250
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75
7/28/2019 Capital Budgeting 1_1
40/103
Di t d P b k
7/28/2019 Capital Budgeting 1_1
41/103
Discounted Payback
0 1 2 3 4 5
(500) 250 250 250 250 250
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years
The Discounted
Payback
is 2.52 years
7/28/2019 Capital Budgeting 1_1
42/103
42
II . ACCOUNTING RATE OF RETURN (OR) AVERAGERATE OF RETURN (ARR)
# ARR is a measure based on accounting profits ratherthan the cash flows. The ARR may be defined as the annualized
net income earned on the average funds invested in a project.
COMPUTATION OF ARR:
Average Annual profit (after tax)
ARR = x 100
Average Investment in the Project
7/28/2019 Capital Budgeting 1_1
43/103
Critical evaluation Merits
1). Easy to understand. Necessary information tocalculate average rate of return are available easy.
2). This method takes into account all the profitsduring the life time of the project, whereas pay backperiod ignores the profits accruing after the pay backperiod
43
7/28/2019 Capital Budgeting 1_1
44/103
Critical evaluation Demerits
1). Ignores the time value of money.2). Does not use cash flow so it does not serve the
purpose of FM.3) ARR method does not consider the sizeof investment for each project. It may be time that thecompeting ARR of two projects may be the same but
they may require different average investments.
44
7/28/2019 Capital Budgeting 1_1
45/103
45
DISCOUNTED CASH FLOWS OR TIME
ADJUSTED TECHNIQUES
These are based upon the fact that the cash flows occurring at
different point of time are not having same economic worth i.e.,TVM
7/28/2019 Capital Budgeting 1_1
46/103
Time Value of MoneyWhich would you prefer -- $10,000 todayor $10,000 in5 years?
Obviously, $10,000 today.
A dollar received today is worth more than a dollarreceived tomorrow This is because a dollar received today can be invested to
earn interest
Uncertainty Preference for present consumption
46
7/28/2019 Capital Budgeting 1_1
47/103
How can one compare amounts in
different time periods? One can adjust values from different time periods
using an interest rate.
Two techniques:
1. Compounding Technique
2. Discounting Technique
47
7/28/2019 Capital Budgeting 1_1
48/103
. NET PRESENT VALUE (NPV) METHOD The NPV of an investment proposal may be defined as
the sum of the present values of all the cash inflowsless the sum of present values of all the cash outflows
associated with the proposal. The decision rule is Accept the proposal if its NPV is
positive and reject the proposal if the NPV is negative.
48
7/28/2019 Capital Budgeting 1_1
49/103
Case XYZ Company is considering replacement of its existing
machine by a new machine, which is expected to cost Rs.1,60,000. The new machine will have a life of 5 years and willyield annual cash revenue of Rs. 2,50,000 and incur annualcash expenses of Rs. 1,30,000. The estimated salvage valueof the new machine is nil. The existing machine has a book
value of Rs. 40,000 and can be sold for Rs. 20,000 today. Itis good for next 5 years and is estimated to generate annualcash revenue Rs. 2,00,000 and to involve annual cashexpenses of Rs. 1,40,000. Its salvage value after 5 years iszero. Corporate tax rate is 40%. Depreciation rate is 25% on
WDV method. The companys opportunity cost of capital
is 20%. Ignore taxes on profit or loss on sale of machine.Advice whether the company should replace the machineor not.
49
7/28/2019 Capital Budgeting 1_1
50/103
7/28/2019 Capital Budgeting 1_1
51/103
Non conventional caseMachine A costs Rs. 1,00,000 payable immediately. Machine Bcosts Rs. 1,20,000 half payable immediately and half payable inone years time. The cash inflows expected are as follows:
Year (at end) Machine A Machine B
1 Rs. 20,000 2 60,000 Rs. 60,000 3 40,000 60,000; 4 30,000 80,000; 5 20,000
At 7% opportunity cost, which machine should be selected on the
basis of NPV?
51
7/28/2019 Capital Budgeting 1_1
52/103
Try this.
ABC Ltd. is in the business of manufacturing X product. It has aplant on a piece of landwhich was purchased 10 years ago for 10lakhs. The firm now plans to set up another plant on the sameland(50% of the existing plant). Capital Expenditure for settingup new plant (incurred in the beginning of the year):
Year 1 Cost of land Rs. 5,00,000Land Development 17,00,000
Payment for purchase of Machine 20,00,000Year 2 Final payment for Land Development 15,00,000Final payment to Machine supplier 70,00,000
The machine has an estimated useful life of5years and thecompany follows SL method of depreciation. The informationregarding sales and operational expenses is as follows
Year 1 2 3 4 5Sales (Rs. lacs) 25 30 35 40 45Expenses (Rs. lacs) 5 7 10 12 15
If the companys rate of discount is15% and the tax rate is 50%,should the above proposal be accepted assuming no depreciationon land.
52
7/28/2019 Capital Budgeting 1_1
53/103
Critical evaluation - merits
1 It recognizes the time value of money.
2. The NPV technique considers the entirecash flow stream and all the cash inflows andoutflows.
3. It serves the purpose of FM as it is based
on cash flow analysis.4. This method is particularly useful for theselection of Mutually Exclusive projects(mostly the case with the companies) .5. It represents the net contribution of aproposal towards the wealth of the firm and istherefore, in full conformity with theobjective of maximization of the wealth ofthe shareholders.
53
7/28/2019 Capital Budgeting 1_1
54/103
Critical evaluation - demeritsi) It involves difficult calculations .ii) The NPV technique requires thepredetermination of the required rate of return, k,
which itself is a difficult job. If the value of the kis not correctly taken, then the whole exercise ofthe NPV may give wrong results.
iii) The decision under the NPV technique isbased on a value which is an absolute measure. Itignores the difference in initial outflows, size ofdifferent proposals etc. while evaluating mutuallyexclusive proposals.
54
I I PROFITABILITY INDEX METHOD
7/28/2019 Capital Budgeting 1_1
55/103
55
I I . PROFITABILITY INDEX METHOD:
This technique is a variant of the NPV technique and is also
known as BENEFIT - COST RATIO or PRESENT VALUE INDEX.
Total present value of cash inflows
PI =
Total present value of cash outflows.
Accept the project if its PI is more than 1 and reject
the proposal if the PI is less than 1.
7/28/2019 Capital Budgeting 1_1
56/103
7/28/2019 Capital Budgeting 1_1
57/103
7/28/2019 Capital Budgeting 1_1
58/103
Calculation of IRR1) When CI are equal
2) When CI are unequal
58
7/28/2019 Capital Budgeting 1_1
59/103
IRR- When CI are equal
A firm is evaluating a proposalcosting Rs. 1,00,000 and havingannual inflows of Rs. 25,000
occurring at the end of each of nextsix years. Calculate the IRR of theproposal
59
7/28/2019 Capital Budgeting 1_1
60/103
Step 1 Calculate PB period = CO / Equal CI
The payback period in the given case is 4 years.
60
7/28/2019 Capital Budgeting 1_1
61/103
7/28/2019 Capital Budgeting 1_1
62/103
Step 3 In order to make aprecise estimate ofthe IRR, find outthe NPV of the
project for boththese rates. OneNPV will bepositive and otherwill be negative.
At 12%, NPV=25,000X 4.111 1,00,000
= Rs. +2,775.
At 13%, NPV=
25,000X 3.998 1,00,000
= Rs. -50.
62
7/28/2019 Capital Budgeting 1_1
63/103
7/28/2019 Capital Budgeting 1_1
64/103
Try this.A project costs Rs. 36,000 and is
expected to generate cash
inflows of Rs. 11,200 annually for5 years. Calculate IRR
64
7/28/2019 Capital Budgeting 1_1
65/103
IRR- When CI are unequalA firm is evaluating a proposal
costing Rs. 50,000 and having
annual inflows of Rs. 10,000;10,450; 11,800; 12,250; 16,750
occurring at the end of each of next5 years. Calculate the IRR of theproposal
65
Self assessment
7/28/2019 Capital Budgeting 1_1
66/103
Self assessment A company is considering as to which of two mutually exclusive
projects it should undertake. The Finance Director thinks that
the project with the higher NPV should be chosen whereas theManaging Director thinks that the one with the higher IRRshould be~ undertaken especially as both projects have the sameinitial outlay and length of life. The company anticipates a cost ofcapital of 10% and the net after-tax cash flows of the projects areas follows:(Figures in Rs. 000)
Year 0 1 2 3 4 5 Project X (200) 35 80 90 75 20 Project Y (200) 218 10 10 4 3Required:a) Calculate the NPV and IRR of each project.
b) State, with reasons, which project you would recommended.
66
T i l
7/28/2019 Capital Budgeting 1_1
67/103
Typical caseA share of the face value of Rs. 100 has current
market price of Rs. 480. Annual expected dividendis 30%. During the fifth year, the shareholder isexpecting a bonus in the ratio of 1:5. Dividend rateis expected to be maintained on the expandedcapital base. The shareholder intends to retain theshare till the end of the eighth year. At that timethe value of share is expected to be Rs. 1,000.
Additional expenses at the time of purchase andsale are estimated at5% on the market price. There
is no tax on dividend income and capital gain. Theshareholder expects a minimum return of15% perannum. Should he buy the share
67
7/28/2019 Capital Budgeting 1_1
68/103
7/28/2019 Capital Budgeting 1_1
69/103
7/28/2019 Capital Budgeting 1_1
70/103
2. Reinvestment rate assumption The IRR criterion implicitly assumes that the cash flow
generated by the projects will be reinvested at theinternal rate of return, that is, the same rate as the
proposal itself offers. With the NPV method, theassumption is that the funds released can bereinvested at a rate equal to the cost of capital, that is,the required rate of return.
70
The crucial factor is which assumption is
7/28/2019 Capital Budgeting 1_1
71/103
correct?
The assumption of the NPV method is consideredto be superior theoretically because it has the
virtue of having a rate which can consistently be
applied to all investment proposals.
In contrast to the NPV method, the IRR methodassumes a high reinvestment rate for investment
proposals having a high IRR and a low investmentrate for investment proposals having a low IRR
71
7/28/2019 Capital Budgeting 1_1
72/103
Therefore it becomes importantto incorporate consistent
reinvestment rate in IRR. ButHOW ?????
72
Th M difi d I t l R t f R t
7/28/2019 Capital Budgeting 1_1
73/103
The Modified Internal Rate of Return
Modified Internal Rate of Return or MIRR is the
investor's required rate of return which equates theInitial Cost Outlay with the present value of futurevalue of cash inflows
73
7/28/2019 Capital Budgeting 1_1
74/103
Conti The modified IRR
(MIRR) is the averageannual rate of returnthat will be earned on aninvestment if the cash
flows are reinvested atthe specified rate ofreturn (usually, theWACC)
To calculate the MIRR,
first find the total futurevalue of the cash flows atthe reinvestment rate,and then apply theformula:
MIRRFVCF
IO
N 1
74
7/28/2019 Capital Budgeting 1_1
75/103
The MIRR: An ExampleAssume that your company is investigating a newlabor-saving machine that will cost $10,000. Themachine is expected to provide cost savings each
year as shown in the following timeline:
75
0 1 2 3 4 5
2000 2500 3000 3500 4000-10,000
7/28/2019 Capital Budgeting 1_1
76/103
7/28/2019 Capital Budgeting 1_1
77/103
Conclusion This is the amount that
you will have accumulatedby the end of the life of theinvestment
Now, find the averageannual rate of return
Since the MIRR is greaterthan the WACC, this
project is acceptable
MIRR 1834256
10000
1 12899%5.
.
77
7/28/2019 Capital Budgeting 1_1
78/103
3. Multiple Rates of Return If a project has more than one rate of return, howwould you make an accept/reject decision?
78
Investment Classification
7/28/2019 Capital Budgeting 1_1
79/103
Simple Investment
Def: Initial cash flowsare negative, and onlyone sign change occursin the net cash flows
series. Example: -$100, $250,
$300 (-, +, +)
ROR: A unique ROR
Non simple Investment
Def: Initial cash flowsare negative, but morethan one sign changesin the remaining cashflow series.
Example: -$100, $300, -$120 (-, +, -)
ROR: A possibility ofmultiple RORs
79
7/28/2019 Capital Budgeting 1_1
80/103
Multiple Rates of Return Problem
80
Find the rate(s) of return:
2$2,300 $1,320( ) $1, 000
1 (1 )
0
PW ii i
CO $1,000
CI $2,300
CO $1,320
7/28/2019 Capital Budgeting 1_1
81/103
81
Let Then,
Solving for yields,
or
Solving for yields
or 20%
xi
PW ii i
x x
x
x x
i
i
1
1
000300
1
320
1
000 300 320
0
10 11 10 12
10%
2
2
.
( ) $1,$2,
( )
$1,
( )
$1, $2, $1,
/ /
7/28/2019 Capital Budgeting 1_1
82/103
Plot for Investment with Multiple Rates of Return
82
Why use MIRR versus IRR?
7/28/2019 Capital Budgeting 1_1
83/103
Why use MIRR versus IRR?
83
MIRR correctly assumes reinvestmentat opportunity cost = WACC and alsoavoids the problem of multiple IRRs.
Managers like rate of returncomparisons, so when there are nonnormal CFs and more than one IRR,MIRR is better than IRR
7/28/2019 Capital Budgeting 1_1
84/103
7/28/2019 Capital Budgeting 1_1
85/103
Net Present Value(NPV) A
Snapshot The Net Present Value (NPV) or Net Present
Worth (NPW) of a investment proposal, is definedas the sum of the present values (PVs) of the
individual cash Inflows less the sum of presentvalue of all the cash outflows associated with theproposal
The decision rule is
Accept the proposal if itsNPV is positive and reject the proposal if the NPVis negative.
Internal Rate of Return(IRR)
7/28/2019 Capital Budgeting 1_1
86/103
The IRR of a proposal is defined as the discountrate which produces a zero NPV, i.e., the IRR is thediscount rate which will equate the present value
of cash inflows with the present value of cashoutflows
It is also known as Marginal Rate of Return or
Time Adjusted Rate of Return If IRR > Cost of Capital, then the project is
accepted, If IRR < Cost of Capital, then project isRejected
Internal Rate of Return(IRR)A Snapshot
7/28/2019 Capital Budgeting 1_1
87/103
Similarities between NPV and IRR
Both NPV and IRR will gave the same result (i.e.t d j ti ) di i t t
7/28/2019 Capital Budgeting 1_1
88/103
acceptance and rejection) regarding an investmentproposal in the following cases:
When project involving conventional cash flows Independent Investment Proposals, i.e. , acceptance of
which does not preclude the acceptance of the others(Single Machine)
Reason for the same results is, NPV will be positiveonly when the actual return on investment is morethan the cut-off rate (required rate of return/ cost ofcapital), whereas IRR support projects in whose case
the IRR is more than the cut-off rate
Consider the following case
7/28/2019 Capital Budgeting 1_1
89/103
Consider the following case
(Already discussed) Following information regarding Machine A is availableand suggest that machine will be purchased or not on the
basis of NPV method and IRR method:Cash Outflow Rs. 50,000Cost of Capital 10%
Year CFAT PVF@10 %1 Rs. 10,000 .9092 Rs. 10,450 .8263 Rs. 11,800 .7514 Rs. 12,250 .683
5 Rs. 16,750 .621
NPV (-4648) Reject the proposalIRR (6.58%) Reject the proposal
7/28/2019 Capital Budgeting 1_1
90/103
The big Q?
Will the two methods always give the same
answer?
No, unfortunately not
7/28/2019 Capital Budgeting 1_1
91/103
Dissimilarities between NPV and
IRR
In certain situations NPV and IRR gives contradictoryl h h if NPV h d fi d l
7/28/2019 Capital Budgeting 1_1
92/103
results such that if NPV methods find one proposalacceptable, while IRR favors the other
This sort of problems will be faced in mutuallyexclusive projects
The problem of the conflicting results can be classifieddue to the following differences in the projects
Size Disparity problem Time Disparity problem
Unequal expected lives
7/28/2019 Capital Budgeting 1_1
93/103
Size Disparity Problem It arises when the initial investment in mutuallyexclusive projects are different
Particulars Project A Project BCash Outlays (Rs. 5000) (Rs 7500)
Cash Inflow at
the end of year
6250 9150
Cost of Capital 10%
NPV @10% 681.25 817.35
IRR 25% 22%
Time Disparity Problem
7/28/2019 Capital Budgeting 1_1
94/103
This problem arises when the cash
flow pattern of mutually exclusiveprojects is different. i.e., most ofthe cash flows from one projectcome in the early years, while mostof the cash flows from the other
project come in the later years
Example already discussed
7/28/2019 Capital Budgeting 1_1
95/103
Example already discussed A company is considering as to which of two mutually
exclusive projects it should undertake. The FinanceDirector thinks that the project with the higher NPVshould be chosen whereas the Managing Directorthinks that the one with the higher IRR should beundertaken especially as both projects have the sameinitial outlay and length of life. The companyanticipates a cost of capital of 10% and the net after-tax cash flows of the projects are as follows:(Figures in Rs. 000)
Year 0 1 2 3 4 5 Project X (200) 35 80 90 75 20 Project Y (200) 218 10 10 4 3
95
7/28/2019 Capital Budgeting 1_1
96/103
Proposals having unequal lives If a firm is evaluating two mutually exclusive proposals
having unequal lives, then the decision may be takenin normal course on the basis of NPV of the two
proposals. The proposal with the higher NPV will beselected. The difference in economic lives may not beof much importance, unless they can be repeatedindefinitely.
96
Example
7/28/2019 Capital Budgeting 1_1
97/103
A firm is evaluating the following two proposals @15% discountrate
Year X Y 0 24,000 44,000
1 14,000 16,000
2 14,000 16,000
3 14,000 16,000
4 16,000
5 16,000
Evaluate the proposal if:
1) They are one off investment2) They can be repeated indefinitely.
97
7/28/2019 Capital Budgeting 1_1
98/103
This is done by Equivalent Annuity Method (EAM).
The equivalent annuity is defined as the amount ofannuity for n years, which has a present valuesdiscounted at r percent per annum equivalent to thegiven amount.
98
7/28/2019 Capital Budgeting 1_1
99/103
In our case, The project X has the NPV of Rs. 7,962.
Considering this to be the present value of annuityof three years at discount rate of 15%, the annuity
amount can be calculated asX/1.15+ X/(1.15)(1.15)+ X/(1.15)(1.15)(1.15)=7962
Annuity Amount (X) = Rs.7,962/2.283
= Rs.3,488.
Similarly, for project Y,
Annuity Amount (Y) = Rs.9,632/3.352
= Rs.2,873.
99
Interpretation
7/28/2019 Capital Budgeting 1_1
100/103
ProjectXProject X is giving NPV of Rs. 7,962 after
a period of every three years. This can also beconsidered as an annuity of Rs. 3,488 for threeyears; and with replacement every three years, thiscan be considered as a perpetuity of Rs.3,488
forever. Project Y: Project Y is giving NPV of Rs. 9,632 after
a period of every five years. This can also beconsidered as an annuity of Rs. 2,873 for five years;and with replacement every five years, this can beconsidered as a perpetuity of Rs. 2,873 forever.
100
7/28/2019 Capital Budgeting 1_1
101/103
Question is To select between the NPV of Rs. 7,962 (Project X)
every three years or the NPV of Rs. 9,632 (Project Y)every five years. Now, in the light of the above, the
same can be expressed as a choice between aperpetuity of Rs. 3,488 (Project X) and Rs. 2,873(Project Y). The choice now, is obvious and the firmwill like to select project X only.
101
Conclusion
7/28/2019 Capital Budgeting 1_1
102/103
To conclude, the two methods would give similar accept-reject decisions in the case of independent conventional
investments. They would, however, rank mutually exclusiveprojects differently in the case of the (i) size-disparityproblem, (ii) time-disparity problem, and (iii) unequalservice life of projects.
The ranking by the NPV decision criterion would be
theoretically correct as it is consistent with the goal ofmaximization of shareholders wealth. Further, thereinvestment rate of funds released by the project is basedon assumptions which can be consistently applied. The IRRcan, of course, be modified by adopting the incrementalapproach to resolve the conflict in ranking. But it involves
additional computation. Another deficiency of the IRR isthat it may be indeterminate and give multiple rates in thecase of a non-conventional cash flow pattern. In sum,therefore, the NPV emerges as a superior evaluationtechnique.
102
CAPITAL BUDGETING PRACTICES IN INDIA
1 Capital budgeting decisions are undertaken at the
7/28/2019 Capital Budgeting 1_1
103/103
1. Capital budgeting decisions are undertaken at the
top management level and are planned in
advance. The Corporates follow mostly top-downapproach in this regard.
2. Discounted cash flow techniques are more
popular now.3. High growth firms use IRR more frequently
whereas Payback period is more widely used by
small firms.
4. PI technique is used more by public sector units
than by private sector units.