1 Capital Budgeting - Methods 1.Average Return on Investment 2.Payback 3.Net Present Value 4.Internal Rate of Return 5.Modified IRR

2 Average Return on Investment AROI = Avg. Net Income Per Year Avg. Investment

3 Average Return on Investment Example: YearNet Income Cost 1 6,000100,000 Initial 2 8,0000 Salvage Value 311, , , ,000

4 Avg. Net Income72,000 6 Avg. Investment100,000 2 AROI12,000 50,000 Average Return on Investment = 12,000 = 24% = 50,000

5 Advantages Disadvantages Average Return on Investment

6 Payback Method # Years required to recover the original investment Example: YearNet IncomeCash FlowCumulative CF 16,00026,00026,000 28,00028,00054, ,00031,00085, ,00033,000118, ,00036,000154, ,00018,000172,000 Payback = , , , ,000 = 3.45 Years

7 Payback Method Advantages Disadvantages

8 Time Value of Money FV = PV (1 + r) n Compounding:Finding FV Discounting:Finding PV:PV = FV/(1 + r) n Internal Rate of Return:Finding r

9 Net Present Value NPV =Present Value of All Future Cash Flows less Inital Cost =CF 1 + CF 2 + CF CF n - I o 1+r(1+r) 2 (1+r) 3 (1+r) n

10 Net Present Value - Example YearCFDisc. Factor PV /1.1 = /(1.1) 2 = /(1.1) 3 = /(1.1) 4 = /(1.1) 5 = /(1.1) 6 = NPV = 25121

11 Net Present Value Advantages Disadvantages

12 Internal Rate of Return Discount rate that makes NPV Zero (i.e., that equates PV of benefits with the cost). IRR: I o = CF 1 + CF CF n 1+r (1+r) 2 (1+r) n Solve for r. Example: 100,000 = r (1+r) 2 (1+r) 3 (1+r) 6 r = 18.2%

13 Internal Rate of Return Advantages Disadvantages

14 Profitability Index PI =PV of all Benefits PV of all Cost Example: PV (Benefits) = (1.1) 2 (1.1) 6 = PV (Cost)= PI = =

15 Profitability Index Advantages: Disadvantages:

16 NPV Profile Year CFDisc. Factor PV 0-100, , , , , , ,0001/(1.1) 3 = , ,0001/(1.1)4 = , ,0001/(1.1)5 = , ,0001/(1.1)6 = ,161 NPV = 25,121

17 NPV Profile Dis. Rate NPV 0% % % % % %

18 NPV Profile Disc. Rate NPV

19 Choosing Between Projects YearCF(A)CF(B) NPV IRR 17% 22%

21 Modified IRR Reinvestment Rate Assumption (Project A) Project Outlay 25,000 Cash Flows: YR1 2,000 YR2 2,000 YR3 35,000 8%: 6,351 IRR: 17%

22 NPV: Project A YR1: 2,000 YR2: 2, , = 4,160 YR3: 35, , = 39,493 [Note: PV of 39,493, three years from 8% = 31,351 Less: outlay 25,000 NPV 6,351] Modified IRR

23 17% YR1: 2,000 = 2,000 YR2: 2, , = 4,340 YR3: 35, , = 40,078 [25,000 invested for three 17% = 25,000(1.17) 3 = 40,040] Modified IRR

24 Modified Internal Rate of Return Find k such that (1+k) n I 0 = Final value i.e. (1+k) = 39,439 k = 16.5% Modified IRR

25 Reinvestment Rate Assumption (Project B) Project Outlay 25,000 Cash Flows: YR1 21,000 YR2 10,000 YR3 2,000 8%: 4,606 IRR: 22.12% Modified IRR

26 NPV: Project B YR1:21,000 = 21,000 YR2:10, , ,680 = 32,680 YR3: 2, , ,614 = 37,294 [Note: PV of 37,294, three years from 8% = 29,606 Less: outlay 25,000 NPV 4,606 ] Modified IRR

27 IRR of 22.12% YR1: 21,000 = 21,000 YR2: 10, , ,645 = 35,645 YR3: 2, , ,885 = 45,530 [25,000 invested for three 22.12% = 25,000(1.2212)3 = 45,530] Modified IRR

28 Modified Internal Rate of Return Find k such that (1+k) n I 0 = Final value i.e. (1+k) = 37,294 k = 14.26% Modified IRR

29 Estimating Cash Flows NPV = CF 1 + CF CF n - I o l+r (l+r) 2 (l+r) n Cash FlowsIncremental After Tax Net Working Capital Sunk Costs

30 Procedure 1.Initial Costs:New CAPEX Additional W. Cap Sale of Old Assets 2.Annual Costs:Revenue Less Costs After Tax 3.Terminal Cash Flows:Salvage Value Recoupment of NWC

31 Cash Flow Estimates Sale of Existing Plant CF= Selling Price + T (B.V. - S.P.) Annual Cash Flows OCF= (Sales-Cost)(1-T) + T, DEPREC or OCF= Net Inc + Depreciation

32 New Product Proposal Annual Sales$20m Annual Costs$16m Net Working Capital$2m Plant Site$0.5m Plant and Equipment$10m DepreciationStraight Line over 20 years Salvage Valuenil Tax Rate40% Required Return 8%

33 New Product Proposal INITIAL CASH FLOWS ANNUAL CASH FLOWS

34 New Product Proposal TERMINAL CASH FLOWS CALCULATION

35 Evaluating Capital Projects 1) Focus on Cash Flow, Not Profits. –Cash Flow = Economic Reality. –Profits Can Be Managed. 2) Carefully Estimate Expected Future Cash Flows. 3) Select a Discount Rate Consistent with the Risk of Those Future Cash Flows. 4) Account for the Time Value of Money. 5) Compute a “Base-Case” NPV.

36 6) Net Present Value = Value Created or Destroyed by the Project. –NPV is the Amount by which the Value of the Firm Will Change if you Undertake the Project. 7)Identify Risks and Uncertainties. Run a Sensitivity Analysis. –Identify “Key Value Drivers.” –Identify Breakeven Assumptions. –Estimate Scenario Values. –Bound the Range of Value Evaluating Capital Projects

37 8) Identify Qualitative Issues. –Flexibility –Quality –Know-How –Learning 9) Decide Evaluating Capital Projects