CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES FOR ENTERPRISE

Chapter 5

objective

• Capital Budgeting

• Techniques of Capital Budgeting

• Pay back period

• Return on investment (ROI)

• Net Present Value (NPV)

• Profitability Index (PI)

• Internal Rate of Return (IRR)

Capital budgeting

• Capital budgeting is the process of evaluating long-range investment proposals for the purpose of allocating limited resources effectively and efficiently.

• Capital Budgeting techniques are employed to assess the financial viability of the project.

• Suppose, for instance, a company wants to introduce a new soap and launching of the new product demands changes in the manufacturing process, the company will have to purchase new equipment in the form of fixed assets.

• Capital budgeting is a technique used to evaluate the value of investment and projects in fixed assets. It is also used to assess the working capital requirements.

CAPITAL BUDGETING• Is the activity worth the investment?

• Which assets can be used for the activity?

• Of the suitable assets, which are the best investments?

– Screening decision

– Preference decision

• Which of the best investments should the company choose?

– Mutually exclusive projects

– Independent projects

– Mutually inclusive projects

Pay back period:

• In this technique, we try to figure out how long it would take to recover the invested capital through positive cash flows of the business.

• Decision Criteria:

• In two projects, the project with less payback period should be acceptable.

Limitations

1. It stresses capital recovery rather than profitability. It does not takes into account the returns from the project after its payback period. Thus project A may have a payback period of 5 years whereas project B may have payback period of 3 years. According to this method, project B will be selected

2. First and the foremost problem is that it does not

take into account the concept of time value of

money.

• There is a project of initial investment of $16000. its cash flow for eight years is 3000, 4000, 4000, 4000, 5000,3000, 2000, 2000 respectively. Find out its payback period?

Venture Capitalism!

The cafe example • Q1. An initial investment of $ 200,000 is

required to start the business; $ 10,000 per month are expected to be earned for the first year, and $ 20,000 would be earned every month in the second year. Acceptance policy for payback period is 16 months.

• Q2. Consider Capital Budgeting project A which yields the following cash flows over its five year life with initial investment of $1000.

• Year Cash Flows, -1000, 500, 400, 200, 200, 100. find out its payback period? If your company policy for acceptable payback period is 3, will you reject or select this project?

Return on Investments

• A performance measure used to evaluate the efficiency of an investment or to compare the efficiency of a number of different investments.

• It implies the annual average cash flow a business is making as a percentage of investment. In other words, it is an average percentage of investment recovered in cash every year.

• The concept of return on investment loosely defined, as there are a number of ratios that can be used to analyze return on investment.

• The formula for return on investment is as follows:

ROI= (ΣCF/n)/IO

• Dividing the average annual cash flow by the initial investment, we can calculate the return on investment.

Limitations of ROI

1. it does not take into account the time value of money concept.

2. Ignores the risk associated with a project or investment.

Example of ROI

• Taking the same example of a café, the initial investment of $ 200,000, $ 10,000 per month profit in the 1st year in $ 20,000 per month profit for the second year, we can easily calculate the ROI.

ROI= ((120,000+240,000)/2)/200,000= 0.90 = 90%

• Where, $ 120,000=cash flow for 1st year at $ 10,000 per month

• $ 240,000=cash flow for the 2nd year at $ 20,000 per month.

• n=2 years

Decision criteria• A high ROI ratio is considered better and

90% is a very good rate of return but before deciding whether or not this project should be taken up, we should compare this project with the alternative opportunities on hand.

Net Present Value (NPV)• NPV is a mathematical tool which uses the discounting

process, something that we have found missing in the aforementioned capital budgeting techniques. Net Present Value is defined as the value today of the Future Incremental After-tax Net Cash Flows less the initial investment.

• Determines whether the rate of return (ROR) on a project is equal to, higher than, or lower than the desired ROR

• Accept if:

– If NPV = 0, actual ROR = desired ROR

– If NPV > 0, actual ROR > desired ROR

• Reject if:

– If NPV < 0, actual ROR < desired ROR

• Does not determine expected ROR

NPV

The formula for calculating NPV is as follows:

NPV=-IO+ΣCFt/ (1+i) t

• Where, CFt=cash flows occurring in different time periods

• -IO= Initial cash outflow

• i=discount /interest rate

• t=year in which the cash flow takes place

• Initial cash outflow, being an outflow, is always expressed as a negative figure.

Limitation

• The disadvantage with the NPV is that it is difficult to calculate since these calculations are based on too many estimates.

• Decision criteria:

• If the NPV of a project is more than zero, it should be accepted.

• If two or more projects under contemplation, then the one with the higher NPV, should be accepted.

ExampleTaking the same example of a café, an initial investment of $ 200, 000, $10,000 per month profit in the 1st year in $ 20,000 per month profit for the second year. Assume the discount rate is 10 percent.

Where, CFt=cash flows occurring in different time periods, i.e., $ 120,000 in the first year and $ 240,000 in the second year

-IO= Initial cash outflow = -200,000i=discount /interest rate = 10 percent

t = 2 yearsPutting in the values in the formula

NPV=-IO+ΣCF/i =-200,000+120,000/(1+0.10)+240,000(1+0.10)2 = - 200,000 + 109,091 + 198,347 =+$107438

At the end of 2nd year, the NPV is +ve, you can also solve this example by monthly compounding if you want to have a more precise answer.

Example• Let us suppose that you invest Afs 100,000 in a Savings

Certificate. After 1 Year you will receive a coupon payment (or profit) of Afs 12,000 and you also reclaim your initial investment (principal). Now a day applied interest rate offered by the banks is 10%.

• Sol:

NPV = -Io + CF1 / (1+ i) + CF 2 / (1+ i)

• = -100,000 + 12,000/ (1+0.10) + 100,000/ (1+0.10)

• = -100,000 + 10,909 + 90,909

• = + Afs 1,818 NPV positive so investment acceptable

• NOTE: PV = NPV + Io = 1,818 + 100,000 = Afs 101,818

Profitability Index• It is quite similar to the NPV in terms of concept and

calculation. Profitability index may be defined as the ratio of the present value of future cash flows to the initial investment.

• The profitability index can be calculated using the following formula.

PI = [Σ CFt / (1+ i) t ]/ IO

• Decision criteria: Those projects with a profitability index ratio of more than one (PI >= 1.0) are considered acceptable.

• Here it is important to mention that those projects, which are ranked as acceptable using the NPV method, would also be acceptable on the profitability index criteria.

Example• Example of a café, an initial investment of $

200, 000, $10,000 per month profit in the 1st year in $ 20,000 per month profit for the second year. Assume the discount rate is 10 percent.

• The profitability index for the café example can be calculated as under.

• PI = [120,000]/ (1+ 0.1) + [240,000 / (1+ 0.1)2]/200,000

• = (109,091 + 198,347) / 200,000 = 1. 54

• PI = 1.54 > 1.0

• If there were two or more projects that need ranking, the one with the highest profitability index would be acceptable.

Internal Rate of Return (IRR)• IRR is a widely used and an important measure,

which is more common in practice than the NPV.

• IRR, unlike NPV that is expressed in dollar amounts, is always quoted in terms of percentage, which makes it comparable to the other market interest rates or the inflation rate.

• IRR calculation involves the same equation that we have earlier used for the calculation of NPV. The only difference is that while calculating IRR we would set the value of NPV equal to zero and then solve the equation for the value if ‘i’. In other words, the value of ‘i’, at which the net present value of the project equals zero would be considered as the internal rate of return of the project.

• IRR is calculated by a trial and error method or iteration.

• In a trial-and-error method, we tryout a value of ‘i’, and see if the equation comes to the value of zero; if it does not, try another value, even if the second value does not bring the equation down to zero and so on.

NPV= -IO +CF1/ (1+IRR) + CF2/ (1+IRR) 2

• Solving the equation assuming IRR to be 10 percent, we have obtained a figure of 107,438, which was calculated as our NPV for the café project. However, in order to bring the NPV down to zero, we need to apply a higher rate as an assumed IRR. If we assume IRR to be 50 percent the equation can be solved as follows.

NPV= -IO +CF1/ (1+IRR) + CF2/ (1+IRR) 2

• = 0= -200,000 + 120,000/(1+0.5) + 240,000/(1+0.5)2

• The calculation gives us a figure of -13,333, which is lesser than zero. In order to bring the value equal to zero we would use a rate lesser than 50 percent.

• Trying out various IRR rates, we can finally reach a rate of 43.6 percent at which the value of NPV would come down to -48 which is close to zero. If we try out IRR with more decimal places, we can bring the value of NPV equal to zero. However, with approximation, 43.6 percent is the actual IRR of the project.

Example• Consider the Same Savings Certificate example for

IRR calculation. The only difference is that this time, we will not assume any value for “i” as we had done in the NPV calculation. We set the NPV = 0 and solve the equation for “i” (or IRR).

• NPV = 0 = -Io + [CF1 / (1+IRR)] + [CFI1 / (1+IRR)]

• We add Rs 12,000 & Rs 10,000 as both appearing at the same time.

• 0 = -100,000 + [(CF1 + CFI1) / (1+IRR)]

• 0 = -100,000 + [(12,000+100,000) / (1+IRR)]

• IRR= (112,000 / 100,000) - 1

• (No need for trial & error because you have one variable & one unknown)

• = 1.12 - 1.00 = 0.12 = 12 % per annum

THE END