1 Capital budgeting Learning objectives Understand the concept of capital budgeting i.e. long term investments The nature and scope of investment decisions The methods of appraising the investment decisions

2 Define The decision as to which projects should be undertaken by a corporation is known as the ‘investment decision’, and the process is known as ‘capital budgeting’ Capital budgeting is essentially the process used to decide on the optimum use of scarce resources

3 Steps in CBP Identify the Invst. Opportunities Select the feasible ones Evaluate the project as to whether or not the proposal provides an adequate return to investors Accept & implement the project Online monitoring

4 Investment evaluation techniques Categorized into two groups 1.Non-discounting techniques: –Payback –(Average) accounting rate of return (ARR) 2.Discounting techniques –Net present value –Internal rate of return (IRR) –PI (profitability method) –TV (terminal value method)

5 The payback technique This method involves determining the time taken for the initial outlay to be repaid by the project’s expected cash flows PB = Initial Investment (Co) Annual Cash Inflow (CI) Unequal cash flows Cumulative cash inflow

66 Example: Year Payback Project B Cum NCF

7 Example: Year Project A Cum CF

8 ProjectCoC1C2C3PB X Y

9 ProjectCoC1C2C3 A B C D

10 Selecting project according PB When selecting among a number of projects, the one with the shortest payback period should be chosen However, there is little guidance on what an appropriate payback period should be, making it difficult to decide whether a project should be accepted or not.

11 Limitations of PB Calculation of payback period ignores the time value of money Cash flows that occur after the end of the payback time are ignored in the calculation of payback period. Yet, these latter cash flows may be significant in making the decision. Cutoff period is subjective Cannot rank projects that have the same PB Does not indicate the project wealth creation

12 DPB Where cash flows are discounted PB is calculated

13 CoC1C2C3C4 X Y CALCULATE THE PB &

14 The ARR is given by: Average /Accounting rate of return (ARR)

15 Example: Step 1 Calculate the ARR for a 2-year project that involves a machine costing Rs100 lacs and is expected to generate EBDIT of Rs 60 L & 70 L in years 1 & 2. The machine is to be depreciated on a straight-line basis, and the corporate tax rate is 30%. Calculate average net income Year12 EBDIT6070 Less depreciation50 Taxable income1020 Less tax (30%)36 Net income714 Average = (7 + 14) / 2 = 10.5

16 Example: Step 2.Calculate average investment Year012 Machine cost100 Less accum. depreciation Investment Average investment = ( ) / 3 = 50

17 Example: Step 3 Calculate the ARR Step 4 Compare the ARR to a target or “cut- off” rate to accept or reject

18 Acceptance rule Acceptance rule: The ARR is compared with a predetermined ARR target, or ‘cut-off’ rate, to determine whether to proceed with a project When n projects then select the one with greatest ARR

19 Limitations of ARR Is based on accounting figures which are not necessarily related to cash flows and are based on accounting techniques that may vary from company to company Ignores the time value of money Requires an arbitrary target or “cut-off” rate, but there is little theoretical or other guidance in setting an appropriate target ARR

20 Net present value (NPV) Calculate the PV of all future cash inflows and cash outflows that will result from undertaking a project These positive and negative present values are then netted off against one another to determine the net present value of the project

21 Acceptance rule The firm should accept all positive-NPV projects and reject negative-NPV projects, because NPV is a measure of the increase in firm value (and therefore the wealth of the firm’s owners) from undertaking the project If the NPV of a project is zero, it is a matter of indifference as to whether the firm should undertake the project or pay the available cash back to shareholders This is because zero NPV indicates that the project yields the same future cash that the investors could obtain by investing themselves

22 The net present value is calculated as follows: where: CIF t =cash flow generated by the project in year t k=the opportunity cost of capital C 0 =the cost of the project (initial cash flow, if any) n=the life of the project in years

23 NPV is the sum of the present values of a project’s cash flows at the cost of capital  If PV inflows > PV outflows, NPV > 0

24 Decision Rules –Stand-alone Projects NPV > 0  accept NPV < 0  reject –Mutually Exclusive Projects NPV A > NPV B  choose Project A over B

25 Example: Apply the NPV rule to a project that costs Rs 210 L and yields Rs 216 L in one year when the opportunity cost of capital is 7%. Since the NPV is negative, it should be rejected.

26 Example: A company is considering whether to purchase a machine worth Rs 500,000 that will generate Rs 150,000 p.a. over the next 5 years. What is the NPV of this project, given an opportunity cost of capital of 10%?

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28 The advantages of NPV technique are: It always ensures the selection of projects that maximise the wealth of shareholders It takes into account the time value of money It considers all cash flows expected to be generated by a project Value additivity : NPV (A+B) = NPV(A)+NPV(B)

29 Limitations are: It requires extensive forecasts of the costs and benefits of a project, which can be problematic Ranking of projects changes with change in CFs / K

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31 Internal rate of return (IRR) The IRR technique is also based on a DCF model, but focuses on the rate of return in the DCF equation rather than the NPV The IRR is defined as the discount rate that equates the present value of a project’s cash inflows with the present value of the its cash outflows This is the equivalent of saying that the IRR is the discount rate at which the NPV of the project is equal to 0

32 A project’s IRR is the return it generates on the investment of its cash outflows –For example, if a project has the following cash flows ,0002,0004,0006,000 The IRR is the interest rate at which the present value of the three inflows just equals the NR 10,000 outflow The “price” of receiving the inflows

33 Defining IRR Through the NPV Equation –The IRR is the interest rate that makes a project’s NPV zero

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35 Stated formally: where: CIF t =the cash flow generated by the project in year t C 0 =the initial cost of the project (initial cash flow, if any) n=the life of the project in years irr=the internal rate of return of the project

36 The unknown variable can be solved by trial- and-error NPV and IRR use the same framework and inputs, so they should result in the same accept/reject decision

37 Acceptance of project The decision rule is to accept a project if its IRR is greater than the cost of capital and reject it if its IRR is less than the cost of capital When IRR > k : accept When IRR < k : reject

38 Example: Apply the IRR rule to a project that costs Rs100 L and yields Rs106 L in one year when the opportunity cost of capital is 7%.

39 Example: The IRR solved by trial and error. YEAR Net cash flows To solve this problem using trial-and-error, you select a discount rate and substitute it into the equation. If the NPV is negative (positive) the discount rate is too high (low). By narrowing down the difference between the two rates, we can approach the IRR. In this case the IRR is approximately 31%.

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41 Short cut method for IRR Calculate the PB Look in PV annuity table for the PB in the year row Find two rates close to the PB Actual IRR by INTERPOLATION

42 The project cost is Rs and is expected to generate CF of Rs p.a. for 5 years. Calculate the IRR Solution PB = 36000/11200= (PVAF) Table PVAF look for PB in 5 th row 16% & 17%

43 Limitations It is difficult to calculate – in most circumstances it can only be found by trial-and-error For projects involving both positive and negative future cash flows, multiple internal rates of return can exist It can give an incorrect ranking when evaluating projects of different size

44 PI- Profitability Method PI = PV of cash inflows PV of cash outflows Acceptance rule When PV > 1

45 Example Initial investment of a project is and it generates CF of Rs 40,000, Rs30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. calculate the NPV & PI of the project at 10%.

46 Terminal value method Here the assumption is that each cash flow is reinvested at a certain rate of return from the moment it is received until the termination of the project. Example Original outlay is 10,000, years 5, CF 4000 p.a. for 5yrs, k 10%. In year 1&2 the CF reinvested at 6% In year 3 to 5 the CFs reinvested at 8%

47 YrintReinvst yrs FVFTFV Find the PV of at 10% X.621 = Rs

48 NPV Vs IRR SIZE DISPARITY PROBLEM AB Co C IRR2522 K 10% NPV

49 Time disparity problem YrAB IRR

50 Unequal lives project Two projects A with service life of 1 yr, B with 5 yrs. Initial investment in both projects 20,000 each. Project A CF 24000, B 5 th yr at 10% IRRNPV A B154900

51 Lending & Borrowing type X %9 Y %-9