Capital Budgeting Techniques (cntd.)

Project Evaluation Techniques (cntd.)Lecture 09MSREE07 Aug 2011

Capitalized Equivalent Method

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Capitalized Equivalent Method Another method of PV criterion is useful when the life of project is perpetual or planning horizon is very long.Perpetual Service lifePV = A/i

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Capitalized Equivalent MethodThe process of calculating PV cost for infinite period is called capitalization of project cost. The cost is known as the Capitalized cost i.e. the amount of money to be invested now to get a certain return 'A' at the end of each and every year forever.

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Capitalized Equivalent MethodA hydropower project is of 50 years life. An entrepreneur spent $800,000 (not considering time value of money) during the last 10 years. We have to compute the project value (worth) using different interest rates.(a) If the entrepreneurs MARR is 8% compute NPV with 50 year service life and infinity.(b) Repeat the same at 12% MARR and see the difference.8/4/20115

Types of ProjectsFor service projects, we use the NPV of costs and choose the project which has the least negative NPV.For revenue projects, we use NPV of revenues and choose the project which ahs the highest NPV.

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Annual Equivalent Value Analysis The annual equivalent value (AE) criterion is a basis for measuring investment value by determining equal payments on an annual basis.First, we have to find the NPV of the project and then convert it to equal annual payments.

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Annual Equivalent Value (AEV)AE(i) =PV(i)(A/P,i,n)

If AE>0, accept the projectIf AE =0, remain indifferentIf AE MARR, accept the projectIf IRR = MARR, remain indifferentIf IRR < MARR, reject the project 8/4/201120

Internal Rate of Return (IRR)Multiple IRRWhen there are multiple values of IRR, we can predict unique value of IRR by examining its cash flows.1. Net cash flow rule of sign2. Accumulated net cash flow rule of sign

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Cash Flow Rule of SignsNet Cash flow rule of signThe number of real i* that are greater than -100% for a project with 'n' periods is never greater than the number of sign changes in the sequence of the An values.Accumulated Cash flow rule of signIf the net cash flow sign test shows multiple values of i*, then we should proceed to this sign test.If the series of cumulative cash flows start negatively and changes the sign only once, then there exists a unique positive i*. 8/4/201122

Methods for determining IRR

1. The direct-solution method2. The trial-and-error method, and3. The graphic method

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Direct Solution MethodnProject 1Project 21-$1,000_$2,000201,300301,5004051,500

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Direct Solution Method8/4/201125

Project 1

25

Direct Solution Method8/4/201126Project 2

Incremental investment AnalysisUnder NPV and AEV analysis, the mutually exclusive project with the highest value is selected and this method is known as Total Investment Approach. NPV, NFV, and AEV methods of project evaluation are absolute measures, whereas the IRR method is a relative (percentage) measure, and it ignores the scale of investment. But for comparison of mutually exclusive projects by IRR method, we have to do Incremental Investment Analysis.8/4/201127

Incremental investment Analysis8/4/201128

If

DepreciationAsset DepreciationDepreciation is the gradual decrease in utility of fixed assets with use and time.Physical DepreciationIt is the reduction in an asset's capacity to perform its service due to physical impairment.8/4/201129

DepreciationFunctional DepreciationIt occurs as a result of changes in the organization or in technology that decrease or eliminate the need for an asset.Economic DepreciationEconomic Depreciation = purchase price - market value8/4/201130

DepreciationBoth physical and functional depreciation are categories of economic depreciation.Accounting DepreciationIt is the systematic allocation of the initial cost of an asset (machine or equipment) in parts over a time known as its depreciable life.8/4/201131

Depreciation8/4/201132DepreciationEconomic Depreciation

A gradual decrease in utility of assetPhysical DepreciationFunctional DepreciationBook DepreciationTax DepreciationAccounting Depreciation

The systematic allocation of an asset's value in parts over its depreciable life

Depreciation ImplicationNet IncomeWhen a project's revenue exceeds its expenses, we say that the project generated a profit or income. It the project's revenue is less than its expenses, then we say that the project resulted in a loss.8/4/201133

Depreciation ImplicationRevenue-Expenses (cost of goods sold)Gross Profit-Operating expenses-DepreciationTaxable Income (Income before tax)-Income TaxNet Income8/4/201134

Depreciation ImplicationCash flow = net income + depreciation8/4/201135

Depreciation MethodsThe most widely used methods are:Straight-line MethodDeclining Balance Method, andSum-of-years'- digit method8/4/201136

Depreciation MethodsStraight-Line MethodIn this method, it is assumed that the fixed asset is depreciated in a uniform way.

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Straight-Line Method

WhereDn = the depreciation charge during n yearP = the cost of the asset, including installation expensesS = salvage value at the end of the useful life of assetN = the useful life8/4/201138

Depreciation MethodsThe book value = cost base - total depreciation charges Bn = P - (D1 + D2 +.+ Dn)8/4/201139

Declining Balance Method

In this method, a fixed fraction of the initial book balance is deducted each year. The fraction or declining balance rate is obtained by d = 1/NThe most common multiplier is '1'. If this is '2', then it is called double-declining balance method.8/4/201140

Declining Balance MethodD1 =dPD2 =d(P - D1)= dP(1-d)D3 =d(P - D1- D2)=dP(1-d)2For 'n' year, Dn = dP(1-d)n-18/4/201141

Declining Balance MethodWe can also compute the total DB depreciation at the end of 'n' yearsTDB = D1 + D2 + D3 + D4 + .. + Dn = dP +dP(1 -d) +dP(1-d)2+ . +(1-d)n-1TDB = P[1-(1-d)n]8/4/201142

Sum-of-years'-Digit Method (SOYD)

In this method, SOYD = 1 +2 +. +N =N(N +1)/2Where, N = the useful lifeDn =(N -n +1)(P -S)/SOYD8/4/201143

Tax Depreciation RatesHouses & Building5 %Transportation equipmentCar, Jeep, Van & Motorcycle15 %Cycle20 %FurnitureMetal10 %Wooden15 %Equipment & MachineryMachinery15 %Computers20 %Laboratory equipment15 %X-Ray machine20 %Typewriter, photocopy machine15 %8/4/201144

Income Tax RatesCorporate Income Tax(Public Co.)20 %Private Co. 25 %(manufacturing)Other Industries25 %Value Added Tax13 %8/4/201145

DCF ModelInput factorMost likely valueMarket size250,000 tonsSelling price per ton$450Market growth rate3%Market share10%Total investment required$10 millionUseful life10 yearsResidual value of facility$ 4 millionOperating costs per ton$ 375 (mean)Fixed costs$325,000 (mean)

A factory is considering a $ 10 million expansion. The estimated life of the new facility will be 10 years. Estimating of key input factors are given in the table below. Develop the DCF model in EXCEL. Find the mean NPV, and explain whether the expansion plan is feasible. Tax rate is 20% and MARR is 12%. Interest and depreciation rates are 10%.

Assignment10/04/0747Please read and study carefully the design economics8.4 sub-chapterPage 3838.1, 8.2, 8.4, 8.6, 8.8, 8.9, 8.10, 8.13, 8.14, 8.15, 8.19, 8.208.22, 8.24, 8.30, 8.34, 8.36, 8.38, and 8.41Page 4369.4, 9.5,9.7,9.10,9.13,9.16,9.18,9.21,9.22,9.25,9.30,9.33 and 9.34Page 848A.1 to A.5, A.8, A.10