4905761 3rd session capital budgeting
TRANSCRIPT
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The Basics of Capital Budgeting:
Evaluating Cash Flows
Should we
build this
plant?
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Capital BudgetingCapital Budgeting:: the process ofthe process of
planning for purchases of longplanning for purchases of long--
term assets.term assets.
exampleexample::
Suppose our firm must decide whether toSuppose our firm must decide whether topurchase a new plastic molding machinepurchase a new plastic molding machine
for Rs125,000. How do we decide?for Rs125,000. How do we decide?
Will the machine be profitable?Will the machine be profitable?
Will our firm earn a high rate of returnWill our firm earn a high rate of return
on the investment?on the investment?
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DecisionDecision--making Criteria inmaking Criteria in
Capital BudgetingCapital Budgeting
How do we decideHow do we decide
if a capitalif a capital
investmentinvestment
project shouldproject should
be accepted orbe accepted or
rejected?rejected?
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The Ideal Evaluation Method should:The Ideal Evaluation Method should:
a) includea) include all cash flowsall cash flows that occurthat occur
during the life of the project,during the life of the project,
b) consider theb) consider the time value of moneytime value of money,,c) incorporate thec) incorporate the required rate ofrequired rate of
returnreturn on the project.on the project.
DecisionDecision--making Criteria inmaking Criteria in
Capital BudgetingCapital Budgeting
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Future valueFuture value
FV PV i! 1 .
Whats the FV of an initial Rs 100Whats the FV of an initial Rs 100
after 3 years if i = 10%?after 3 years if i = 10%?
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After 3 years:
FV3 = PV(1 + i)3
= Rs 100(1.10)3
= Rs 133.10.
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Present valuePresent value
Whats the PV of Rs 100 due in 3 years if i =Whats the PV of Rs 100 due in 3 years if i =
10%?10%?
PV =
FV
1 i= FV
1
1 i
PV = 100 1.10
1
3
Rs 75.13.=
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PaybackPeriodPaybackPeriod
The number of years needed toThe number of years needed to
recover the initial cash outlay.recover the initial cash outlay.
How long will it take for the projectHow long will it take for the project
to generate enough cash to pay forto generate enough cash to pay for
itself?itself?
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PaybackPeriodPaybackPeriod
How long will it take for the projectHow long will it take for the project
to generate enough cash to pay forto generate enough cash to pay for
itself?itself?
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150
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PaybackPeriodPaybackPeriod
How long will it take for the projectHow long will it take for the project
to generate enough cash to pay forto generate enough cash to pay for
itself?itself?
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 150 150 150(500) 150 150 150 150 150 150 150 150
Payback period = 3.33 years.Payback period = 3.33 years.
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Is a 3.33 year payback period good?Is a 3.33 year payback period good?
Is it acceptable?Is it acceptable?Firms that use this method willFirms that use this method will
compare the payback calculation tocompare the payback calculation to
some standard set by the firm.some standard set by the firm.
If our senior management had set aIf our senior management had set a
cutcut--off of 5 years for projects likeoff of 5 years for projects like
ours, what would be our decision?ours, what would be our decision?
Accept the projectAccept the project..
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Drawbacks ofPaybackPeriod:Drawbacks ofPaybackPeriod:
Firm cutoffs areFirm cutoffs are subjectivesubjective..
Does not considerDoes not consider time value of moneytime value of money..
Does not consider anyDoes not consider any required rate ofrequired rate of
returnreturn..
Does not consider all of the projectsDoes not consider all of the projects
cash flowscash flows..
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Drawbacks ofPaybackPeriod:Drawbacks ofPaybackPeriod:
Does not consider all of the projectsDoes not consider all of the projects
cash flows.cash flows.
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0
Consider this cash flow stream!
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Drawbacks ofPaybackPeriod:Drawbacks ofPaybackPeriod:
Does not consider all of the projectsDoes not consider all of the projects
cash flows.cash flows.
00 11 22 33 44 55 8866 77
(500) 150 150 150 150 150 (300) 0 0(500) 150 150 150 150 150 (300) 0 0
This project is clearly unprofitable, but we
would accept it based on a 4-year payback
criterion!
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Discounted PaybackDiscounted Payback
Discounts the cash flows at the firmsDiscounts the cash flows at the firms
required rate of return.required rate of return.
Payback period is calculated usingPayback period is calculated usingthese discounted net cash flows.these discounted net cash flows.
ProblemsProblems::
Cutoffs are still subjective.Cutoffs are still subjective.
Still does not examine all cash flows.Still does not examine all cash flows.
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.38192.38
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.38192.38 2 years2 years
88.3288.32
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.38192.38 2 years2 years
88.3288.32
33 250250 168.75168.75
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.38192.38 2 years2 years
88.3288.32
33 250250 168.75168.75 .52 years.52 years
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Discounted PaybackDiscounted Payback
00 11 22 33 44 55
(500) 250 250 250 250 250(500) 250 250 250 250 250
DiscountedDiscounted
YearYear Cash FlowCash Flow CF (14%)CF (14%)
00 --500500 --500.00500.00
11 250250 219.30219.30 1 year1 year
280.70280.70
22 250250 192.38192.38 2 years2 years
88.3288.32
33 250250 168.75168.75 .52 years.52 years
The DiscountedThe Discounted
PaybackPayback
isis 2.522.52 yearsyears
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Other MethodsOther Methods
1)1) Net Present ValueNet Present Value (NPV)(NPV)
2)2) Profitability IndexProfitability Index (PI)(PI)
3)3) Internal Rate of ReturnInternal Rate of Return (IRR)(IRR)
Each of these decisionEach of these decision--making criteria:making criteria:
Examines all net cash flows,Examines all net cash flows,
Considers the time value of money, andConsiders the time value of money, and
Considers the required rate of return.Considers the required rate of return.
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Net Present ValueNet Present Value
yyNPV = the total PV of the annual netNPV = the total PV of the annual netcash flowscash flows -- the initial outlay.the initial outlay.
yy Decision RuleDecision Rule::
yy If NPV is positive,If NPV is positive,ACCEPTACCEPT..
yy If NPV is negative,If NPV is negative, REJECTREJECT..
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NPV ExampleNPV Example
0 1 2 3 4 5
(276,400)83,000 83,000 83,000 83,000 116,000
Suppose we are considering a capital investmentSuppose we are considering a capital investment
that costs Rs276,400 and provides annual netthat costs Rs276,400 and provides annual net
cash flows of Rs 83,000 for four years andcash flows of Rs 83,000 for four years and
Rs116,000 at the end of the fifth year. TheRs116,000 at the end of the fifth year. The
firms required rate of return is 15%.firms required rate of return is 15%.
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRRIRR: the return on the firms: the return on the firms
invested capital. IRR is simply theinvested capital. IRR is simply the
rate of return that the firm earnsrate of return that the firm earns
on its capital budgeting projects.on its capital budgeting projects.
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
NPVNPV == -- IOIOACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=177
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
n
t=177
IRR: = IOA
CFt(1 + IRR) t
NPVNPV == -- IOIOACFACFtt
(1 + k)(1 + k) tt
nn
t=1t=177
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Internal Rate of Return (IRR)Internal Rate of Return (IRR)
IRR is the rate of return that makes theIRR is the rate of return that makes the
PV of the cash flowsPV of the cash flows equalequal to the initialto the initial
outlay.outlay.
n
t=1
77IRR: = IO
ACFt
(1 + IRR) t
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Calculating IRRCalculating IRR
Looking again at our problem:Looking again at our problem:
The IRR is the discount rate thatThe IRR is the discount rate that
makes the PV of the projected cashmakes the PV of the projected cash
flowsflows equalequal to the initial outlay.to the initial outlay.
0 1 2 3 4 5
(276,400)
83,000 83,000 83,000 83,000 116,000
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This is what we are actually doing:This is what we are actually doing:
83,000 (PVIFA83,000 (PVIFA4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))
= 276,400= 276,400
00 11 22 33 44 55
(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000
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This is what we are actually doing:This is what we are actually doing:
83,000 (PVIFA83,000 (PVIFA4, IRR4, IRR) + 116,000 (PVIF) + 116,000 (PVIF 5, IRR5, IRR))
= 276,400= 276,400
You should getYou should get IRR = 17.63%!IRR = 17.63%!
This way, we have to solve for IRR by trialThis way, we have to solve for IRR by trial
and error.and error.
00 11 22 33 44 55
(276,400)(276,400)83,000 83,000 83,000 83,000 116,00083,000 83,000 83,000 83,000 116,000
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IRRIRR
yy Decision RuleDecision Rule::
yy If IRR is greater than or equalIf IRR is greater than or equalto the required rate of return,to the required rate of return,ACCEPTACCEPT..
yy If IRR is less than the requiredIf IRR is less than the requiredrate of return,rate of return, REJECTREJECT..
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ThanksThanks