capital budgeting final (1)
TRANSCRIPT
-
7/31/2019 Capital Budgeting Final (1)
1/40
Should webuild this
plant?
Capital Budgeting
1/5/12 1
-
7/31/2019 Capital Budgeting Final (1)
2/40
Presented by:
Krishna Jalan
Snehal Khannukar Sowmya C G
Chandasish Baissya
Shrey R Dhanawadkar2
Financial
Manage
ment
The Team
-
7/31/2019 Capital Budgeting Final (1)
3/40
Intro: Factors
Decision Making Criteria
Types of Projects:Process
Evaluation Criteria
Discounting Criteria:
NPVIRR
PI
Non-Discounting Criteria:PBP
ARR5/16/2012 3
-
7/31/2019 Capital Budgeting Final (1)
4/40
5/16/2012 4
Capital budgeting is defined as The firms formal
process for the acquisition and investmentof capital.
Planning for purchasing long-term assets.
Consists of planning of the available capital to
maximize profits.
Definition
-
7/31/2019 Capital Budgeting Final (1)
5/40
Availability of funds.
Structure of capital.
Taxation policy.
Government policy.
Lending policies of financial institutions.
Immediate need of the project.
-
7/31/2019 Capital Budgeting Final (1)
6/40
Decision-Making Criteria in Capital Budgeting
How do we decide if
a capital
investment project
should be
accepted or
rejected?
-
7/31/2019 Capital Budgeting Final (1)
7/40
The Ideal Evaluation Method should:
a) Includes All cash flows that occur during the life
of the project.
b) Consider the Time value of money.
c) Incorporate the Required rate of return on the
project.
Contd
-
7/31/2019 Capital Budgeting Final (1)
8/40
Firms invest in Three types of projects:
Independent projects.
Mutually exclusive projects.
Contingent Investments.
-
7/31/2019 Capital Budgeting Final (1)
9/40
SELECTION PHASE
5/16/2012 9
PLANNING PHASE
PROPOSALS
ONLINE PROJECTS
PROJECTS
ACCEPTED PROJECTS
PROJECT TERMINATION
PROPOSALS
IMROVEMENTIN
PLANNINGANDEVALUATION
PROCEEDURE
NEWI
NVESTMENTOPPORTUNITIES
EVALUATION PHASE
IMPLEMENTATION PHASE
CONTROL PHASE
AUDITING PHASE
The Process
-
7/31/2019 Capital Budgeting Final (1)
10/40
EVALUATION CRITERIA
DISCOUNTING
CRITERIA
NON DISCOUNTING
CRITERIA
NET
PRESENT
VALUE
INTERNAL
RATE OF
RETURN
ACC. RATE
OF
RETURN
PAYBACK
PERIOD
PROBLTY
INDEX
(PI)
5/16/2012 10
MODIFIED
IRR
DISCD
PBP
-
7/31/2019 Capital Budgeting Final (1)
11/40
Discounting Criteria
5/16/2012 11
-
7/31/2019 Capital Budgeting Final (1)
12/40
Decision Rule:
If NPV is positive, Accept.
If NPV is negative, Reject.
5/16/2012 12
Net Present Value Method
The total PV of the
annual net cash flowsThe initial outlay.
-
7/31/2019 Capital Budgeting Final (1)
13/40
Year Cash Flows NPV @ 14% PV @ 14%
0 -1100 1.000 -1100
1 358 0.877 313.966
2 246 0.769 189.174
3 325 0.675 219.375
4 385 0.592 227.92
5 467 0.519 242.373
6 349 0.456 159.144
TOTAL NPV 251.952
-
7/31/2019 Capital Budgeting Final (1)
14/40
Considers Time value of
money.
Relies on discount rate
and estimated cash
flows.
Consistent in maximizing
the owners wealth.
Merits
Demerits
Merits & Demerits of NPV
Difficult to ascertain
future cash flows.
Biased towards long
term projects.
May not give reliableresults while dealing
with projects under
unequal project life.
5/16/2012 14
-
7/31/2019 Capital Budgeting Final (1)
15/40
Also known as the Marginal Rate of Return or
Time Adjusted Rate of Return.
It is the discount rate at which the present value of
cash inflows equals the present value of cash
outflows. i.e. NPV = 0
The rate of discount is determined by the Trial and
Error method.
5/16/2012 15
Internal Rate Of Return Method
-
7/31/2019 Capital Budgeting Final (1)
16/40
Year Cash Flows IRR @ 22.21% PV @ 22.21%
0 -1100 1.000 -1100
1 358 0.818 292.844
2 246 0.709 174.414
3 325 0.565 183.625
4 385 0.448 172.48
5 467 0.366 170.922
6 349 0.300 104.7
TOTAL NPV (1.015)
-
7/31/2019 Capital Budgeting Final (1)
17/40
-
7/31/2019 Capital Budgeting Final (1)
18/40
If IRR is greater than or equal to the required rate of
return, ACCEPT.
If IRR is less than the required rate of return, REJECT.
5/16/2012 18
-
7/31/2019 Capital Budgeting Final (1)
19/40
Considers Working
Capital and Scrap
value
Considers cash flows
during the whole
project life.
Maximizes the wealth
of the equity share
holders.
Merits
Demerits
Lengthy, Based on
trial & error
Assumes that future
cash flows are
reinvested at the rate
equal to IRR
NPV is more reliable.
5/16/2012 19
Merits & Demerits of IRR
-
7/31/2019 Capital Budgeting Final (1)
20/40
The calculation of the IRR implicitly assumes
that the cash flows are reinvested at the IRR.This may not always be realistic.
Percentages can be misleading (would you rather
earn 10% on a Rs.100 investment, or 10% on a
Rs.10,000 investment?)
-
7/31/2019 Capital Budgeting Final (1)
21/40
NPV and IRR do not always select the same project
in mutually exclusive decisions.
In the event of a conflict the selection of the NPV
method is preferred.
5/16/2012 21
-
7/31/2019 Capital Budgeting Final (1)
22/40
9-22
-
7/31/2019 Capital Budgeting Final (1)
23/40
The modified internal rate of return (MIRR) is the
compound average annual rate that is calculated
with a reinvestment rate different than the projects
IRR.
Therefore, MIRR more accurately reflects the
profitability of a project.
5/16/2012 23
-
7/31/2019 Capital Budgeting Final (1)
24/40
MIRR correctly assumes reinvestment at opportunitycost.
MIRR also avoids the problem of multiple IRRs.
Managers prefer MIRR method better for this thanIRR.
5/16/2012 24
-
7/31/2019 Capital Budgeting Final (1)
25/40
5/16/2012 25
The Ratio of payoff to investment.
Also known as The Benefit cost ratio is the present
value of forecasted future cash flows divided by the
initial investment:
PROFITABILITY
INDEX
P/V OF CASH INFLOW
INITIAL CASH OUTFLOW
Profitability Index
-
7/31/2019 Capital Budgeting Final (1)
26/40
Year Cash Flows NPV @ 14% PV @ 14%
0 -1100 1.000 -1100
1 358 0.877 313.966
2 246 0.769 189.174
3 325 0.675 219.375
4 385 0.592 227.92
5 467 0.519 242.373
6 349 0.456 159.144
TOTAL CASH INFLOW 1351.93
PI:
1351.93
1100= 1.22:1
-
7/31/2019 Capital Budgeting Final (1)
27/40
Accept the project when PI is greater than one.
PI > 1
Reject the project when PI is less than one.
PI < 1 May accept the project when PI is equal to one.
PI = 1
5/16/2012 27
-
7/31/2019 Capital Budgeting Final (1)
28/40
Allows comparison of
different scale projects
Undertakes Time value
of money
Provides only relative
profitability
Potential Ranking
Problems
5/16/2012 28
Merits & Demerits of PI
Merits
Demerits
-
7/31/2019 Capital Budgeting Final (1)
29/40
The discounted payback period is the number of
periods taken in recovering the investment outlay on
the present value basis.
5/16/2012 29
-
7/31/2019 Capital Budgeting Final (1)
30/40
Discounted Payback
0 1 2 3 4 5
(500) 250 250 250 250 250
Discounted CF
Year Cash Flow @ (14%)
0 -500 -500.00
1 250 219.30 1 year280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years
The Discounted Payback
is 2.52 years
-
7/31/2019 Capital Budgeting Final (1)
31/40
Discounts the cash flows
at the firms required rate
of return.
Payback period is
calculated using these
discounted net cash
flows.
Still does not
examine all cash
flows.
Difficult to ascertain
future cash flows.
5/16/2012 31
Merits & Demerits of DPBP
Merits
Demerit
s
-
7/31/2019 Capital Budgeting Final (1)
32/40
Non Discounting Criteria
5/16/2012 32
-
7/31/2019 Capital Budgeting Final (1)
33/40
5/16/2012 33
ips
Defined as the numbers of years required to cover theoriginal cost outlay.
INITIAL INVESTMENT
ANNUAL CASH FLOW
Payback Period
-
7/31/2019 Capital Budgeting Final (1)
34/40
Cash out flow = 1100
crores
Cash IN Flow Year Amt in crore
1st Year 3582nd
Year 246 929 3 years
3rd
Year 325 +
4thYear 385
171/385=0.44 0.44
5th
Year 467
6th
year 349 3.44 years
-
7/31/2019 Capital Budgeting Final (1)
35/40
5/16/2012 35
ips
Simple.
Emphasizes on earlier
cash flows.
Selection or rejection
of any project is easier.
Best suited for
evaluating high-risks
projects.
ADVANTAG
ES
DISADVANTA
GES
Ignores cash after thepayback period.
Fails to consider time
value of the money
Based on the principle
of rule of thumb.
No recognition for the
pattern of cash flows &
its timing.
Merits & Demerits of PBP
-
7/31/2019 Capital Budgeting Final (1)
36/40
Project Investment is judged by looking at its rate of
return on book value.
Evaluates return on accounting profits. i.e. on accrual
basis. Annual returns are expressed in percentage of net
investment.
5/16/2012 36
AVERAGE PROFIT AFTER TAX
AVERAGE INVESTMENT
AVERAGE RATE OF
RETURN 100
Average Rate Of Return
-
7/31/2019 Capital Budgeting Final (1)
37/40
Project A: Step 1: Annual Depreciation = ( 220 10 ) / 3 = 70
Step 2: Year 1 2 3
Cash Inflow (+) 91 130 105
Salvage Value (+) 10Depreciation* -70 -70 -70
Accounting Income 16 60 45
Step 3:
Average Accounting Income ( 16 + 60 + 45 )
3
Step 4:
Accounting Rate of Return 40.333
220
= 40.333
= 8.3%
-
7/31/2019 Capital Budgeting Final (1)
38/40
Project B:
Step 1: Annual Depreciation = ( 198 18 ) / 3 = 60
Step 2: Year 1 2 3
Cash Inflow 87 110 84
Salvage Value 18Deprecation* -60 -60 -60
Accounting Income 27 50 42
Step 3:
Average Accounting Income = ( 27 + 50 + 42 )3
Step 4:
Accounting Rate of Return = 39.666
198
Average Rate Of Return
= 39.666
=20.0%
-
7/31/2019 Capital Budgeting Final (1)
39/40
5/16/2012 39
ips
Simple. Considers value of project to
its economic life.
Easy to calculate using the
accounting data.
Ensured earnings of
profitability of the project
using net earnings concept.
Merits
Demerit
s
It can be affected by non-cash items such as
depreciation & bad debts
Fails to consider timevalue of money.
Ignores the fact that
profits earned can be
reinvested.
Can be calculated in awide variety.
Merits & Demerits of ARR
-
7/31/2019 Capital Budgeting Final (1)
40/40
ips
Thank YouOpen for Queries