Capital Budgeting

o Estimation of cash flows

o Project evaluation techniques

The Position of Capital Budgeting

Capital Budgeting

Long Term Assets Short Term Assets

Investment Decison

Debt/Equity Mix

Financing Decision

Dividend Payout Ratio

Dividend Decision

Financial Goal of the Firm:

Wealth Maximisation

1. Average Rate of Return

2. Payback Period

3. Discounted Payback Period

4. Net Present Value

5. Internal Rate of Return

6. Modified IRR

7. Profitability index

Estimating cash flow is more qualitative procedure than quantitative. The reliable projection of the cash flow depends upon the project specific knowledge and on the capability of the management

The procedure of estimation of the cash flow may be different as per the nature of the project

The basic procedure and the determinants in each steps are discuss as below.

Step 1: Determination of Net Cash Outflow (NCO)Step 2: Determination of Annual Cash Flow or CFATStep 3: Determination of Net Cash Flow for the Final

Year

For the mutually exclusive project : cannot accept both projects

Cost of the project (FA) - XXX

Transportation & Installation cost - XXX

Duty and clearance charges - XXX

Working capital requirements - XXX

Investment tax credit/allowance + XXX

NCO - XXX

For replacement projects: old equipments

Cost of new machine - XXX

Transportation & Installation cost - XXX

Duty and clearance charges - XXX

Working capital requirements - XXX

Working capital decrease + XXX

Proceed from sale of old machine + XXX

Tax payable (gain on sale of old machine) - XXX

Tax save (loss on sale of old machine) + XXX

Investment tax credit/Allowance - XXX

NCO - XXX

For the mutually exclusive project

Cash sales revenue + XXX

Cash operating cost - XXX

Cash before Dep. & Tax (EBDT) XXX

Depreciation - XXX

Taxable income XXX

Tax @ - XXX

Earning after tax (EAT) XXX

Depreciation + XXX

Cash flow after tax (CFAT) XXX

For replacement project

Increase in cash sales revenue + XXX

Decrease in cash operation cost + XXX

Increase in cash operation cost - XXX

Cash inflow before Dep. & Tax (EBDT) XXX

Decrease in depreciation + XXX

Increase in depreciation - XXX

Taxable income XXX

Tax @ - XXX

Earning after tax (EAT) XXX

Decrease in depreciation - XXX

Increase in depreciation + XXX

Cash flow after tax (CFAT) XXX

For the mutually exclusive project

Cash salvage value + XXX

Tax payable (gain on sale) - XXX

Tax save (loss on sale) + XXX

Working capital release (increase in year 0) + XXX

Working capital tied up (decrease in year 0) - XXX

Final year CFAT XXX

For replacement project

New Old Diff

BSV xxx Xxx

CSV xxx Xxx

Gain/loss on sale xxx Xxx

Tax payable or tax saving xxx Xxx

CSV xxx Xxx

Less/Add: Tax payable/tax saving xxx Xxx

Net cash salvage value xxx xxx Xxx

Less/add: Working capital Xxx

Final year cash inflow after tax (CFAT) XXX

Sale of Existing Plant

CF= Selling Price + T (B.V. - S.P.)

Annual Cash Flows

OCF= (Sales-Cost)(1-T) + T, DEPREC

or

OCF= Net Inc + Depreciation

1. Initial Costs: New cost of assets

Additional WC requirement

Sale of Old Assets

2. Annual Costs: Revenue Less Costs

After Tax

3. Terminal Cash Flows: Salvage Value

Recovery of NWC

ARR = Avg. Net Income Per Year

Avg. Investment

Example:

Year Net Income Cost

1 6,000 100,000 Initial

2 8,000 0 Salvage Value

3 11,000

4 13,000

5 16,000

6 18,000

Avg. Net Income 72,000

6

Avg. Investment 100,000

2

AROI 12,000

50,000

= 12,000

= 24%

= 50,000

Advantages◦ Simplicity

◦ Use the readily available accounting information

Disadvantages◦ It is based on accounting information rather than

cash flows

◦ Fails to take account of the timing of the cash inflows and outflows

◦ Time value of money is ignored

Years required to recover the original investment

Example:

Year Net Income Cash Flow Cumulative CF

1 6,000 26,000 26,000

2 8,000 28,000 54,000

3 11,000 31,000 85,000

4 13,000 33,000 118,000

5 16,000 36,000 154,000

6 18,000 18,000 172,000

Payback = 3 + 100,000 - 85,000

118,000 - 85,000= 3.45 Years

The amount of time needed to recover the initial investment

The number of years it takes including a fraction of the year to recover initial investment is called payback period

To compute payback period, keep adding the cash flows till the sum equals initial investment

Simplicity is the main benefit, but suffers from drawbacks

Technique is not consistent with wealth maximization—Why? (lack of reinvestment)

Advantages

◦ Simplicity in use and a popular method

Disadvantages

◦ Fails to consider cash flows after the payback period

◦ It provides limited insight into risk and liquidity

◦ Ignore time value of money and cost of capital

(curved by DPBP)

◦ Ignore the risk of the project while evaluation

FV = PV (1 + r)n

Compounding: Finding FV

Discounting: Finding PV: PV = FV/(1 + r) n

Internal Rate of Return: Finding r

Similar to payback period approach with one difference that it considers time value of money

The amount of time needed to recover initial investment given the present value of cash inflows

Keep adding the discounted cash flows till the sum equals initial investment

All other drawbacks of the payback period remains in this approach

Not consistent with wealth maximization

NPV = Present Value of All Future Cash Flows less

Initial Cost

= CF1 + CF2 + CF3 +.......CFn - Io

1+r (1+r)2 (1+r)3 (1+r)n

Year CF Disc. Factor PV

0 -100000 1 -100000

1 26000 1/1.1 = .9091 23637

2 28000 1/(1.1)2 = .8264 23139

3 31000 1/(1.1)3 = .7573 23290

4 33000 1/(1.1)4 = .6830 22539

5 36000 1/(1.1)5 = .6209 22352

6 18000 1/(1.1)6 = .5645 10161

NPV = 25121

Based on the amount of cash flows

NPV equals the present value of cash inflows

minus initial investment

Technique is consistent with the principle of

wealth maximization—Why?

Accept a project if NPV ≥ 0

Advantages

◦ Consider time value of money

◦ Maximize shareholders wealth (reinvestment)

◦ Use all cash flow during the project life

◦ Based on estimated cash flow rather than accounting

information of the project

Disadvantages

◦ The estimation of cash flows is difficult due to uncertainty

◦ Difficult to determine the appropriate discount rate

◦ In case of projects with unequal life, proper consideration

has to be given while applying NPV rules

Discount rate that makes NPV Zero (i.e., that equates PV of benefits with the cost).

IRR: Io = CF1 + CF2 + ..... + CFn

1+r (1+r)2 (1+r)n

Solve for r.

Example:

100,000 = 26000 + 28000 + 31000 + ... +18000

1+r (1+r)2 (1+r)3 (1+r)6

r = 18.2%

)(0LH

HL

LL RRx

PVPV

CFPVRIRR

Advantages◦ Consider time value of money

◦ Maximize shareholders wealth (reinvestment)

◦ Use all cash flow during the project life

◦ Based on estimated cash flow rather than accounting information of the project

◦ Easy to understand

Disadvantages◦ IRR has problem when non-normal cash flow, multiple IRR

arise

◦ The estimation of cash flows is difficult due to uncertainty

◦ In case of mutually exclusive projects (that does not occur at the same time) IRR may give the conflicting results because of its assumption.

The rate at which the net present value of cash flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment

Project’s promised rate of return given initial investment and cash flows

Consistent with wealth maximization

Accept a project if IRR ≥ Cost of Capital

n

CIFO

MIRR

TVPV

)1(

MIRR is the discount rate at which present value of project’s cost is equal to the present value of its terminal value

Cross over rate is that discount rate where NPVs of two projects are equal

NPV profile is a graph that plots a project’s NPV against the COC rates

Usually, NPV and IRR are consistent with each other. If IRR says accept the project, NPV will also say accept the project

IRR can be in conflict with NPV if ◦ Investing or Financing Decisions

◦ Projects are mutually exclusive Projects differ in scale of investment

Cash flow patterns of projects is different

◦ If cash flows alternate in sign—problem of multiple IRR

If IRR and NPV conflict, use NPV approach

PI = PV of all Benefits

PV of all Cost

Example:

PV (Benefits) = 26000 + 28000 +..+18000

1.1 (1.1)2 (1.1)6

= 125121

PV (Cost) = 100000

PI = 125121 = 1.25

100000

Non-discounted Cash Flow Methods Discounted Cash Flow Methods

i) ARR: Calculate & compare with cutoff rate

/required rate of return/hurdle rate (Decision

rule: if ARR>Cutoff = Accept, otherwise reject

)

i) DPBP: Same except cash flow are discounted

by project’s COC

ii) PBP: Years to recover initial investment.

Shorter the PBP, the better.

ii) NPV: Find the discounted net cash flow of

the project at 0 year. Higher NPV, the better

iii) IRR: The discount rate that yield zero NPV.

If IRR>hurdle rate = accept the project

iv) MIRR: When the case of non-normal cash

flow. Discount rate that equates PV of costs and

PV of terminal value

v) PI: Also known as benefit-cost ratio, PV of

benefits/PV of costs. Acceptable of PI>1

Evaluating Capital Projects1) Focus on Cash Flow, Not Profits.

– Cash Flow = Economic Reality.

– Profits can be managed/manipulated.

2) Carefully Estimate Expected Future Cash Flows.

3) Select a Discount Rate Consistent with the Risk of Those

Future Cash Flows.

4) Account for the Time Value of Money.

5) Compute NPV

6) Net Present Value = Value Created or Destroyed by the

Project.

NPV is the amount by which the value of the firm will

change if you undertake the project.

7)Identify Risks and Uncertainties. Run a Sensitivity

Analysis.

8) Identify Qualitative Issues.

– Flexibility, Quality, Know-How, Learning, etc

9) Decide

Which technique is superior?

Although our decision should be based on NPV, but each technique contributes in its own way.

Payback period is a rough measure of riskiness. The longer the payback period, more risky a project is.

IRR is a measure of safety margin in a project. Higher IRR means more safety margin in the project’s estimated cash flows.

PI is a measure of cost-benefit analysis. How much NPV for every rupee of initial investment.

Thank you.