15.capital budgeting

7/31/2019 15.Capital Budgeting

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The Basics of CapitalBudgeting

Should webuild this

plant?


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What is capital budgeting?

Horngreen, Capital budgeting is long term planning formaking and financing proposed capital outlays.

G.C.Philippatos, Capital budgeting is concerned withthe allocation of the firms scarce financial resourcesamong the available market opportunities. Theconsideration of investment opportunities involves thecomparison of the expected future streams of earningsfrom a project with the immediate and subsequentstreams of earning from a project, with the immediate

and subsequent streams of expenditures for it. Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firms future.


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Need and Importance of CapitalBudgeting

Large investments

Long-term commitment of funds

Irreversible nature

Long term effect on profitability

Difficulties of investment decisions National importance


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Steps to capital budgeting

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine the appropriate cost ofcapital.

4. Find NPV and/or IRR.

5. Accept if NPV > 0 and/or IRR >WACC.


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The investment decision-making process

Stage 1

Stage 2

Stage 3

Stage 4

Stage 5

Determine investment funds available

Identify profitable project opportunities

Evaluate the proposed project(s)

Stage 6 Monitor and control the project(s)

Approve and implement theproject(s)

Appraise and classify proposed projects


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Methods of investment appraisal

Payback period (PP)

Net present value (NPV)

Accounting rate of return (ARR)

Internal rate of return (IRR)


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Methods of Capital Budgeting

Methods of capitalBudgeting

Traditional Methods Discounted Methods

Pay back periodmethod

Accounting rate ofreturn

Net Present ValueMethod

Internal Rate ofReturn

Profitability Index


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Payback period

The number of years required to recover aprojects 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 flowfor the project turns positive.

Annual cash inflows (Net profit beforedepreciation and after tax) are taken.


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Calculating payback

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt -100 70 100 20

Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50

-30

Project S


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Strengths and weaknesses ofpayback

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.


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Accounting rate of return

Average annual profit after tax x 100Average investment in the project

ARR =

Also known as return on investment orreturn on capital employed.

The ARR method distorts all cash flows byaveraging them over time. It ignores the time value of money.


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Net Present Value (NPV)

Considers the time value of money . NPV discounts all cash inflows and outflows

attributable to a capital investment project by a

chosen percentage eg. Weighted average cost ofcapiatl. It takes sum of the PVs of all cash inflows and

deducts it from outflows of a project. If theyield is positive the project is acceptable.

n

0tt

t

)k1(

CFNPV


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Present value of Re1 receivable at various times in thefuture, assuming an annual financing cost of 20%

(1 + 0.2)0

(1 + 0.2)5

(1 + 0.2)4

(1 + 0.2)1

(1 + 0.2)2

(1 + 0.2)

3

1.000

0.833

0.694

0.579

0.482

0.402

Year

1 2 3 4 5

Present value

of Re.1


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#Rationale for the NPVmethod

NPV = PV of inflows Cost= Net gain in wealth

If projects are independent, accept ifthe project NPV > 0.

If projects are mutually exclusive,

accept projects with the highestpositive NPV, those that add the mostvalue.


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Why NPV is superior to ARR

The whole of the relevant cash flows

The objectives of the business

The timing of the cash flows

NPV is a better method of appraisinginvestment opportunities than ARR because it

fully addresses each of the following:


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Internal Rate of Return (IRR)

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

It is the percentage rate of return, basedupon incremental time-weighted cash flows.

Solving for IRR : Trial and Error approach

n

0tt

t

)IRR1(CF0


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Profitability Index

PIPV of Future Cash Inflows

Initial Investment

NPVInitial Investment

=

= +1

Decision Rule:

Undertake the project if PI > 1.0


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Profitability Index

PI measures the NPV per rupee invested.

For independent projects, the PI method

yields conclusions identical to the NPVmethod.

For mutually exclusive projects,differences in project size can lead to

conflicting conclusions. Use the NPV method.

PI is useful when there is capital rationing.


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Interestforgone

InflationDiscountrate

Risk premium

The factors influencing the

discount rate to be appliedto a project


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Inflation

Inflation effects can be complexbecause asset value is a function of

both the required return and theexpected future cash flows.

The changes can cancel each other

out, leaving the projects NPVunchanged.


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Inflation

Inflation affects the cash flowsfrom a project. Effect on revenues

Effect on expenses

Inflation also affects the cost ofcapital. The higher the expected inflation, the higher

the return required by investors.

Thus, the effects of inflation mustbe properly incorporated in the NPV

analysis.

#


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Effect of Inflation on the

Cost of Capital Notation:

rr= cost of capital in real termsrn= cost of capital in nominal terms

i= expected annual inflation rate

(1 + rn) = (1 + rr) (1 + i) rn= rr+ i+ irr

#


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Inflation and NPV Analysis

The NPV of the project is unchangedas long as the cash flows and thecost of capital are expressed in

consistent terms. Both in real terms

Both in nominal terms

If inflation is expected to affectrevenues and expenses differently,these differences must be

incorporated in the analysis.

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Risk Analysis in Capital Budgeting

Risk relates to uncertainty about a projectsfuture profitability.

Techniques:

Certainity equivalent method Risk Adjusted discount rate

Sensitivity analysis

Scenario analysis

Decision tree analysis Standard deviation method

Co-efficient of Variation

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The Certainty EquivalentApproach

The project is adjusted for risk byconverting the expected cash flows

to certain amounts then discountingat the risk-free rate.

The NPV is computed as:

n

tt

RF

ttn

tt

RF

t

k

CFAT

k

CECFNPV

00 11

#


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The Risk-Adjusted Discount

Rate Approach

Use CAPM to get relevant rate:

Establish risk classesand assignRADR

bkkkk projectRFmRFproject

#


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What is sensitivity analysis?

Shows how changes in a variablesuch as unit sales affect NPV or

IRR. Each variable is fixed except one.

Change this one variable to see the

effect on NPV or IRR. Answers what if questions, e.g.

What if sales decline by 30%?

#


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Factors affecting thesensitivity of NPV calculations

for a new machine

Operatingcosts

ProjectNPV

Financingcost

Initialoutlay

Salesprice

Annual salesvolume

Project

life

#


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Sensitivity Analysis

Change the value of an independentvariable by X%

Calculate the resulting value of the

dependent variable Calculate the % in the dependent

variable; compare!

If %

> X%, then dependent variableis sensitive to changes in theindependent variable

#


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What are the weaknesses of

sensitivity analysis? Does not reflect diversification.

Says nothing about the likelihoodof change in a variable, i.e., asteep sales line is not a problem if

sales wont fall. Ignores relationships among

variables.

#


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Why is sensitivity analysis

useful? Gives some idea of stand-alone

risk. Identifies potentiallydangerous variables.

Gives some breakeveninformation.

#


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What is scenario analysis?

Examines several possiblesituations, usually worst case,most likely case, and best case.

Provides a range of possibleoutcomes.

#


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Decision Tree

A decision tree is diagramatic representation ofthe relationships among decision states of natureand outcomes (pay-offs).

Decision trees are constructed left to right. The branches represents the possible alternative

decisions which could b made and the variouspossible outcomes which may arise.

#


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Decision tree diagram showingdifferent possible project outcomes

Outcome 1

Outcome 2

Outcome 3

Outcome 4

Year 1 (0.6)

Year 2 (0.6)

Year 1 (0.4)

Year 2 (0.4)

Year 1 (0.4)

Year 2 (0.6)

Year 1 (0.6)

Year 2 (0.4)

0.6 x 0.6 = 0.36

0.4 x 0.4 = 0.16

0.4 x 0.6 = 0.24

0.6 x 0.4 = 0.24

8,000

8,000

8,000

12,000

12,000

12,000

8,000

12,000

Cash

flowRs.

Probability

Total 1.00

O

utlay

(R

s.6,0

00)

#


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Standard Deviation

NPV = fd2

n

Coefficient of Variation

CVNPV = = = 2.0.

$30.3

$15

NPV

Mean


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Thank You

15.capital budgeting

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