cap budget discounted
TRANSCRIPT
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Methods
Non-Discounted
PB ARR
Discounted
DiscountedPayback
NPV PI IRR
Methods of Capital Budgeting
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Discounted Payback
It is very similar to payback period
In this method the cash inflows are
adjusted with time value of money and
then the payback period is calculated.
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Discounted Payback
A project requires investment of Rs.5,00,000 and will generate cash flow
after taxes of Rs. 2,00,000 for first
three year and Rs. 3,00,000 for 4thand 5thyear. The life of the project is 5
years. The cost of capital is assumed
to be 10%. Calculate the discountedpay back period.
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Discounted Payback Period
Year Annual
Cash
Flows
PV factor
@ 10%
PV of cash flow Cumulative PV
1 2,00,000 0.909 1,81,800 1,81,800
2 2,00,000 0.826 1,65,200 3,47,000
3 2,00,000 0.751 1,50,200 4,97,200
4 3,00,000 0.683 2,04,900 7,02,100
5 3,00,000 0.621 1,86,300 8,88,400
Pay back period = 3 years + 2,800/2,04,900
= 3.013 years
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Discounted Payback Period
A company is contemplating to purchase amachine. Two machines, A and B areavailable, each costing Rs. 7,50,000.Calculate the discounted payback period forboth the machines. The cost of capital is12%. Which machine will be selected, if thecut-off payback period is 3 years and 3months? Cash flows (in Rs.) are expected asfollows:
Machine/Year 1 2 3 4 5
A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000
B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000
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Accept/Reject Criteria:
Discounted Payback Period The firm sets a standard or a target
discounted payback period. Thediscounted payback period of the project
is compared with the target paybackperiod. If the projects discounted PB > target PB,
then the project is rejected.
If the projects discounted PB < target PB,then the project is accepted.
If the project's discounted PB = target PBthen one is indifferent to the project.
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Net Present Value (NPV)
The method recognizes the time valueof money
It considers all the cash flow occuring
over the life of the projectA positive NPV results in creation of
wealth for the shareholders
The discount rate used for thecomputing NPV is the companyscost
of capital
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Net Present Value (NPV)
It helps in determining as to the
project generate positive value or not.
If the NPV is positive it adds value tothe firm and is desirable
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Net Present Value (NPV)
n
1tt
t
)k1(
CFNPV - Co
Sn+Wn
(1+k)n
n
1tt
t
)k1(
CFNPV - Co
NPV= PV of CF-C0
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Net Present Value
Year Annual Cash Flows PV factor @ 10% Present Value
1 2,00,000 0.909 1,81,800
2 2,00,000 0.826 1,65,200
3 2,00,000 0.751 1,50,200
4 3,00,000 0.683 2,04,900
5 3,00,000 0.621 1,86,300
8,88,400
NPV = 8,88,400 - 5,00,000
= 3,88,400
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Practice Question : NPV
QYear 1 2 3 4 5
Estimated CF before depreciation & Tax (Rs. in
Lakh)4 6 8 8 10
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Accept/Reject Criteria: Net
Present Value If the projectsNPV < 0, then the project is
rejected.
If the projectsNPV > 0, then the project
is accepted. If the project's NPV = 0 then one is
indifferent to the project.
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Evaluation: Net Present Value
Advantages:-Considers time value of money thus more
rational method
Considers all the cash flows occuring over the
life of the projectConsistent with shareholders wealth
maximization principle
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Evaluation : NPV
Disadvantages:-
It relies on the expected cash flow which
are quite difficult to estimate
The discount rate used to discount thecash flow is difficult to estimate and
moreover the discount rate may change
with time
Ranking of the project is given according
to the discount rate, if the discount rate
changes, then the ranking may change
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Profitability Index (B/C Ratio)
It measures the present value ofreturns per rupee invested
It is a ratio of present value of cash
inflows at the required rate of return,to the initial cash outflow of the
investment.
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Profitability Index (B/C Ratio)
PI = PV of cash inflows
Initial cash outflow
= PV(Ct
)
C0
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Profitability Index (B/C Ratio)
A company is contemplating to purchase amachine. Two machines, A and B areavailable, each costing Rs. 7,50,000.Calculate the Profitability index. The cost of
capital is 12%. Which machine will beselected? Cash flows (in Rs.) are expected asfollows:
Machine/Year 1 2 3 4 5
A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000
B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000
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Accept/Reject Criteria: PI (B/C
ratio) If the projectsPI < 1, then the project is
rejected.
If the projectsPI > 1, then the project is
accepted. If the project's PI = 1 then one is
indifferent to the project.
For any given project NPV and PI should
give the same accept-reject decision.
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Evaluation: PI (B/C Ratio)
Advantages:-Considers time value of money thus more
rational method
Considers all the cash flows occuring over the
life of the projectConsistent with shareholders wealth
maximization principle
Measure of relative profitability
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Evaluation : PI (B/C ratio)
Disadvantages:-
It relies on the expected cash flow which
are quite difficult to estimate
The discount rate used to discount thecash flow is difficult to estimate and
moreover the discount rate may change
with time
Ranking of the project is given according
to the discount rate, if the discount rate
changes, then the ranking may change
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IRR(Internal
Rate ofReturn)
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Internal Rate of Return (IRR)
It is the internal rate of return that a given
investment generates over its useful life.
When evaluating an investment, it takes into
account both the magnitude and timings ofthe expected cash flows in every time period
of the projectslife.
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IRR
It shows the discount rate below whichan investment results in a positive NPVand should be selected and vice-versa
IRR computes the break even rate ofreturn.
IRR is not the return on the fundsinitially invested in the project , unlessthe cash inflow are reinvestedelsewhere to earn the same rate ofreturn as in the project.
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Internal Rate of Return (IRR)
Internal rate of return is the discount
rate at which the Present value of
cash inflow is equal to the cost of the
project
It is the rate at which NPV is 0
n
1tt
t
0 )IRR1(
CF
C
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Internal Rate of Return
Year Annual Cash Flows
1 2,00,000
2 2,00,000
3 2,00,000
4 3,00,000
5 3,00,000
Calculate IRR of the project which requiresinvestment of Rs. 5,00,000, if the cash flow are as
follows:-
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Practice Question: IRR
A company is contemplating to purchase amachine. Two machines, A and B areavailable, each costing Rs. 7,50,000.Calculate IRR Which machine will be
selected? The cost of capital for the firm is15%. Cash flows (in Rs.) are expected asfollows:Machine
/Year
1 2 3 4 5
A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000
B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000
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Accept/Reject Criteria: IRR
If the projectsIRR < k, then the project isrejected.
If the projectsIRR > k, then the project is
accepted. If the project's IRR = k, then one is
indifferent to the project.
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Evaluation of IRR
Advantages:- Considers all the cash flows occuring over
the life of the project
Considers time value of money
It reveals the true profit potential of any
investment
It complies with the firms objective of
shareholders wealth maximization
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Evaluation of IRR
Disadvantages:- The IRR of two projects can not be added
to get the cumulative value of two projects
At times, IRR gives multiple results, hencefails to act as selection criteria
Many a time, it gives contradictory resultswith NPV method
Computation of IRR is also difficultA project may have multiple IRR:- If there are more than one change in sigh,
there are more than one IRR
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Investment Decision Rule
Sound investment evaluation criterionshould have the followingcharacteristics:-
1. Consider all the cash flow2. An objective and unambiguous way of
selection3. Ranking of projects according to
profitability4. Bigger cash flows are better than
smaller and earlier cash flows are betterthan later
5. Should maximize the wealth ofshareholders
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Conclusion
Pay back period, Net Present Valueand Internal Rate of Return arepopularly used method of capitalbudgeting
Among all, NPV is preferred as itconsiders the time value of moneyand gives a single NPV as a result
Pay back period is simple and gives arough idea about the recovery of thecost of the project