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
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