cid introppt
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Course F-611:CAPITAL INVESTMENT
DECISION OR CAPITAL BUDGETING
Prof. Shabbir Ahmad
Course ContentsIntroduction
Cash Flow Estimation ± Determination of cash out flow and cashinflows
Techniques of Capital Budgeting ± Discounted (NPV, IRR, MIRR, PI,and DPB) and non-discounted (PB & AAR) cash flow techniques,decision criteria, advantages and disadvantages of each technique.
Special Issues in Capital Budgeting ±Projection evaluation, cost-cutting projects, bid price setting, projects with different lives.
Project Analysis and Evaluation ± Forecasting risk, sensitivity and
scenario analysis, break-even analysis, operating leverage and capital bud etin .
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Course F-611:CAPITAL INVESTMENTDECISION
Inflation and Capital Budgeting
Options in Capital Budgeting
Capital Budgeting for Levered Firm
Risk, Cost of Capital and Capital Budgeting
Risk and Capital Budgeting ± Absolute measure and relativemeasure of risk, certainty equivalent method and risk adjusteddiscount rate method.
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Course F-611:CAPITAL INVESTMENTDECISION
Text Books
Fundamentals of Corporate Finance ± Ross, Westerfield,Jordan
Corporate Finance ± Ross, Westerfield, JaffeCapital Budgeting and Long-term Financing ± Neil Seitz
Intermediate Financial Management ± Brigham
Managerial Finance ± Lawrence Gitman
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Course F-611:CAPITAL INVESTMENTDECISION
Course Evaluation
Class Attendance ----- 10Mid-term ± I -----------15
Mid-term ± II ----------15
Class Test/Quiz --------10Term Paper/Pres.------10
Final Exam -------------40
Total --------------------100
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CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION CAPITAL INVESTMENT DECISIONS (or Capital
Budgeting) involves company¶s long term investmentdecision. It includes evaluation of the firm¶s expenditure
decisions that involve current outlays but are likely to produce benefits or returns over a long period of time.
Capital Budgeting is the process of evaluating and selectinglong-term investments in fixed or capital assets that are
consistent with the firm¶s goal of maximizing owner wealth.
Capital Budgeting is the entire process of analyzing projectsand deciding whether they should be included in the
capital budget.
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CAPITAL INVESTMENT DECISION
Why a firm makes capital investment?
In order to secure a stream of benefit in future years that
add value to the firm through inflow over future times.
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FEATURES/CHARACTERISTICS
OF CID (IMPORTANCE) Long term investment decision (future profitability of
firm).
Returns or benefits are expected over number of years
Investment involves huge amount of cash outflow(determines the destiny of the firm)
Investment decision is generally irreversible (oncemade can not be changed)
Relatively high degree of risk
Relatively long time period between the initial outlayand the anticipated return
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CLASSIFICATION OF PROJECTS
By Degree of Dependence:
Mutually Exclusive Projects.
Independent Projects.
By Cash Flow pattern:
Conventional Project.( - + + + + + i.e. outflow
followed by a series of inflow). Non Conventional Projects ( - + + - + - + i.e. if the
project inflows & outflows are mixed & zigzag
pattern).
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CAPITAL INVESTMENT
DECISION Determination of Cash Outflow or
Investment
Projection or Forecast of Future Cash
Inflows
Determination of Appropriate Discount Rate(i.e. Cost of Capital)
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CASH FLOW DETERMINATION
A project should be evaluated on the basis of
Incremental After Tax Cash Flows.
Incremental After Tax Cash Flows consist of
any or all changes in the firm¶s future cash
flows that are direct consequence of taking the
project.
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CASH FLOW
DETERMINATIONOnly the relevant cash flows should be taken under
consideration in determination of cash flows (i.e.
inflows or outflows) for making capital investmentdecision.
Relevant cash flows should be included in a capital
budgeting analysis. These cash flows will only occur if
the project is accepted
Relevant cash flows are those which influence the
firm¶s decision regarding accepting or rejecting a
project.
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CASH FLOW
DETERMINATIONIrrelevant cash flows are those which do not
affect the firm¶s decision regarding accepting or
rejecting a project i.e. they exist if the firms
accepts a project or it rejects a project
Irrelevant cash flows should NOT be included
in capital budgeting analysis.
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CASH FLOW
DETERMINATION Asking the Right Question
Will this cash flow occur ONLY if we accept the project?´
If the answer is ³yes´, it should be included in the
analysis because it is incremental
If the answer is ³no´, it should not be included inthe analysis because it will occur anyway
If the answer is ³part of it´, then we should include
the part that occurs because of the project
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CASH OUTFLOW OR
INVESTMENT DETERMINATION Cost of new asset or project
Add installation cost (if any)
Add transportation cost (if any)
Add removal cost of old asset (only if borne by the company)
Less selling price of old asset (if new asset replaces
old asset)
+ / - Tax on sale of old assetLess Amount of investment tax credit (AITC)
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CASH OUTFLOW OR INVESTMENT
DETERMINATIONExample
The Sprint Inc. is trying to estimate the net cash outflow required toreplace an old machine with a new one. The new machine¶s purchase
price is $270,000. An additional $7,000 will be required for transportationand $5,000 will be required to install the machine. As the new machine
has greater capacity to produce, there will be an additional investment of $20,000 in raw material inventory in the initial year. The new machinewill be depreciated on straight-line basis over five years of useful life.The old machine was purchased two years ago at a cost of $70,000 has aremaining useful life of five years. It is also subject to straight-linedepreciation. The company is entitled to investment tax allowance of 25%. The corporate tax rate is 55% and the capital gain tax rate is 30%.Find the net cash outflow considering separately each of the followingscenarios:
i) If the old machine is sold for $40,000
ii) If the old machine is sold for $50,00. ..\NCO.xls
iii) If the old machine is sold for $60,000.
iv) If the old machine is sold for $90,000.
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CASH IN FLOW DETERMINATION
Operating Cash Flow (OCF)
Opportunity Cost
Sunk CostErosion or Side Effects
Financing Cost
Change in Net Working Capital
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PROJECTCASH FLOW
DETERMINATION
Year
0 1 2 3
OCFChange in NWC
Opportunity Cost
Capital Spending/CO
PCF
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DecisionDecision--making Criteria inmaking Criteria in
Capital BudgetingCapital Budgeting
How do we
decide if acapital
investment
projectshould be
accepted or
rejected?
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TECHNIQUES OF CAPITAL
BUDGETING
The techniques of capital budgeting are dividedinto two broad groups
A) Non discounted cash flow techniques i.e.
techniques that do not consider time value of money as such do not discount the future cashflows
B) Discount cash flow (DCF) techniques i.e.
techniques that do not consider time value of money as such do not discount the future cashflows
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TECHNIQUES OF CAPITAL BUDGETING
A) Non-DCF techniques include the following:i) Payback Period Method
ii) Average Accounting Return or Accounting Rateof Return
B) DCF techniques include the following:
i) Net Present Value (NPV)
ii) Internal Rate of Return (IRR)
iii) Profitability Index (PI) or Benefit-CostRatio (BCR)
iv) Discounted Payback Period Method
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The Payback Period Rule
How long does it take the project to ³pay back´
its initial investment?
Payback Period = number of years to recover initial costs
Minimum Acceptance Criteria:
set by management
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The Payback Period Rule (continued)
Disadvantages:Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projectsRequires an arbitrary acceptance criteria
A project accepted based on the payback criteria maynot have a positive NPV
Advantages:Easy to understand
Biased toward liquidity
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The Discounted Payback
Period Rule How long does it take the project to ³pay back´
its initial investment taking the time value of
money into account?
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The Average Accounting Return Rule
Another attractive but fatally flawed approach.
Disadvantages:
Ignores the time value of money
Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Advantages:
The accounting information is usually available
Easy to calculate
Investentof ValueBook AverageIncome NetAverageAAR !
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The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CI¶s - Initial Investment
PV of Cash Inflows ± PV of Cash Outflows
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
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Good Attributes of the NPV Rule
1. Uses cash flows
2. Uses ALL cash flows of the project
Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the
discount rate or cost of capital.
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The Internal Rate of Return (IRR) Rule
IRR: the discount rate that sets NPV to zero or the rateof return available from investing in a project.Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return.Ranking Criteria:
Select alternative with the highest IRR Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.Disadvantages:
IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investmentsAdvantages:
Easy to understand and communicate
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The Internal Rate of Return: Example
Consider the following project:
0 1 2 3
$50 $100 $150
-$200
The internal rate of return for this project is 19.44%
32 )1(
150$
)1(
100$
)1(
50$0
IRR IRR IRR NPV
!!
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Problems with the IRR Approach
Multiple IRRs.
The Scale Problem
The Timing Problem
Investing or Financing
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Multiple IRRs
There are two IRRs for this project:
0 1 2 3
$200 $800
-$200 - $800
($150.00)
($100.00)
($50.00)
$0.00
$50.00
$100.00
-50% 0% 50% 100% 150% 200%
Discount rate
N P V
100% = IRR 2
0% = IRR 1
Which one
should we use?
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The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investmentwhile the 50% return is on a $1,000 investment?
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The Timing Problem
0 1 2 3
$10,000 $1,000 $1,000
-$10,000
Project A
0 1 2 3
$1,000 $1,000 $12,000
-$10,000
Project B
The preferred project in this case depends on the discount rate, not
the IRR.
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The Timing Problem..\TimingProb.xls
($4,000.00)
($3,000.00)($2,000.00)
($1,000.00)
$0.00
$1,000.00
$2,000.00
$3,000.00
$4,000.00
$5,000.00
0% 10% 20% 30% 40%
Discount rate
N P V
Project A
Project B10.55% = crossover rate
16.04% = IRR A
12.94% = IRR B
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Mutually Exclusive vs.
Independent Project Mutually Exclusive Projects: only ONE of several
potential projects can be chosen, e.g. acquiring anaccounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one projectdoes not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.
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The Profitability Index (PI) Rule
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
InvestentInitialFlowsCashFutureof PVTotalPI !
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The Practice of Capital Budgeting
Varies by industry:
Some firms use payback, others use accounting rate of
return.
The most frequently used technique for large
corporations is IRR or NPV.
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Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
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Example of Investment Rules
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
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Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
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Relationship Between NPV and IRR
Discount rate NPV for A NPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.9240% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64100% 0.00 -81.25
120% -18.93 -92.52