mba ii fm capital+budgeting

8/8/2019 MBA II FM Capital+Budgeting

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The Basics of CapitalThe Basics of CapitalBudgetingBudgetingThe Basics of CapitalThe Basics of CapitalBudgetingBudgeting

Should webuild this

plant?


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What is capital budgeting?What is capital budgeting?

Horngreen, Capital budgeting is long term planning for makingand financing proposed capital outlays.

G.C.Philippatos, Capital budgeting is concerned with theallocation of the firms scarce financial resources among the

available market opportunities. The consideration of investmentopportunities involves the comparison of the expected futurestreams of earnings from a project with the immediate andsubsequent streams of earning from a project, with theimmediate and subsequent streams of expenditures for it.

Analysis of potential additions to fixed assets.

Long-term decisions; involve large expenditures. Very important to firms future.


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Need and Importance of CapitalNeed and Importance of CapitalBudgetingBudgeting

Large investments

Long-term commitment of funds

Irreversible nature

Long term effect on profitability

Difficulties of investment decisions National importance


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Steps to capital budgetingSteps to capital budgeting

1. Estimate CFs (inflows & outflows).

2. Assess riskiness of CFs.

3. Determine the appropriate cost ofcapital.

4. Find NPV and/or IRR.

5. Accept if NPV > 0 and/or IRR >WACC.


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The investment decision-The investment decision-making processmaking process

Stage 1

Stage 2

Stage 3

Stage 4

Stage 5

Determine investment funds available

Identify profitable project opportunities

Evaluate the proposed project(s)

Stage 6 Monitor and control the project(s)

Approve and implement theproject(s)

Appraise and classify proposed projects


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Methods of investment appraisalMethods of investment appraisal

Payback period (PP)

Net present value (NPV)

Accounting rate of return (ARR)

Internal rate of return (IRR)


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Methods of Capital BudgetingMethods of Capital Budgeting

Methods of capitalBudgeting

Traditional Methods Discounted Methods

Pay back periodmethod

Accounting rate ofreturn

Net Present ValueMethod

Internal Rate ofReturn

Profitability Index


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Payback periodPayback period

The number of years required to recover aprojects cost, or How long does it take to

get our money back? Calculated by adding projects cash inflowsto its cost until the cumulative cash flow forthe project turns positive.

Annual cash inflows (Net profit beforedepreciation and after tax) are taken.


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Calculating paybackCalculating payback

PaybackL = 2 + / = 2.375 years

CFt -100 10 60 100

Cumulative -100 -90 0 50

0 1 2 3

=

2.4

30 80

80

-30

Project L

PaybackS = 1 + / = 1.6 years

CFt-100 70 100 20

Cumulative -100 0 20 40

0 1 2 3

=

1.6

30 50

50

-30

Project S


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Strengths and weaknesses ofStrengths and weaknesses ofpaybackpayback

Strengths

Provides an indication of a projects risk andliquidity.

Easy to calculate and understand.

Weaknesses

Ignores the time value of money.

Ignores CFs occurring after the payback period.


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Accounting rate of returnAccounting rate of return

Average annual profit after tax x 100Average investment in the project

ARR =

Also known as return on investment orreturn on capital employed.

The ARR method distorts all cash flows byaveraging them over time. It ignores the time value of money.


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Net Present Value (NPV)Net Present Value (NPV)

Considers the time value of money . NPV discounts all cash inflows and outflows

attributable to a capital investment project by a

chosen percentage eg. Weighted average cost ofcapiatl. It takes sum of the PVs of all cash inflows and

deducts it from outflows of a project. If theyield is positive the project is acceptable.

= +

=n

0tt

t

)k1(

CFNPV


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Present value of Re1 receivable at various times in thefuture, assuming an annual financing cost of 20%

(1 + 0.2)0

(1 + 0.2)5

(1 + 0.2)4

(1 + 0.2)1

(1 + 0.2)2

(1 + 0.2)

3

1.000

0.833

0.694

0.579

0.482

0.402

Year

1 2 3 4 5

Present value

of Re.1


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Rationale for the NPVRationale for the NPVmethodmethod

NPV = PV of inflows Cost= Net gain in wealth

If projects are independent, accept ifthe project NPV > 0.

If projects are mutually exclusive,

accept projects with the highestpositive NPV, those that add the mostvalue.


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Why NPV is superior to ARRWhy NPV is superior to ARR

The whole of the relevant cash flows

The objectives of the business

The timing of the cash flows

NPV is a better method of appraising

investment opportunities than ARR because it

fully addresses each of the following:


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Internal Rate of Return (IRR)Internal Rate of Return (IRR)

IRR is the discount rate that forces PV ofinflows equal to cost, and the NPV = 0:

It is the percentage rate of return, based

upon incremental time-weighted cash flows. Solving for IRR :

Trial and Error approach

= +

=

n

0tt

t

)IRR1(CF0


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Profitability IndexProfitability Index

PIPV of Future Cash Inflows

Initial Investment

NPVInitial Investment

=

= +1

Decision Rule:

Undertake the project if PI > 1.0


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Profitability IndexProfitability Index

PI measures the NPV per rupee invested.

For independent projects, the PI method yieldsconclusions identical to the NPV method.

For mutually exclusive projects, differences inproject size can lead to conflicting conclusions.

Use the NPV method.

PI is useful when there is capital rationing.


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Interestforgone

InflationDiscountrate

Risk premium

The factors influencing the

discount rate to be appliedto a project


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InflationInflation

Inflation effects can be complex becauseasset value is a function of both therequired return and the expected futurecash flows.

The changes can cancel each other out,leaving the projects NPV unchanged.


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InflationInflation

Inflation affects the cash flows from a project. Effect on revenues

Effect on expenses

Inflation also affects the cost of capital.

The higher the expected inflation, the higher the returnrequired by investors.

Thus, the effects of inflation must be properlyincorporated in the NPV analysis.

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Effect of Inflation on theEffect of Inflation on the

Cost of CapitalCost of Capital Notation:

rr= cost of capital in real terms

rn

= cost of capital in nominal terms

i = expected annual inflation rate

(1 +r

n) = (1 +r

r) (1 +i)

rn = rr + i+ i rr

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Inflation and NPV AnalysisInflation and NPV Analysis

The NPV of the project is unchanged as longas the cash flows and the cost of capital areexpressed in consistent terms. Both in real terms

Both in nominal terms

If inflation is expected to affect revenuesand expenses differently, these differences

must be incorporated in the analysis.

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Risk Analysis in Capital BudgetingRisk Analysis in Capital Budgeting

Risk relates to uncertainty about a projectsfuture profitability.

Techniques:

Certainity equivalent method Risk Adjusted discount rate

Sensitivity analysis

Scenario analysis

Decision tree analysis Standard deviation method

Co-efficient of Variation

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The Certainty EquivalentThe Certainty EquivalentApproachApproach

The project is adjusted for risk byconverting the expected cash flows

to certain amounts then discountingat the risk-free rate.

The NPV is computed as:

( ) ( )== +

=

+=

n

tt

RF

ttn

tt

RF

t

k

CFAT

k

CECFNPV

00 11

26


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The Risk-Adjusted DiscountThe Risk-Adjusted Discount

Rate ApproachRate Approach

Use CAPM to get relevant rate:

Establish risk classesand assignRADR

( ) bkkkk projectRFmRFproject +=

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Graphical Representation ofGraphical Representation of

the SMLthe SML

M

1.0

rf

Mr

)( fMifi rRrr +=

Riskless

return

Market

Risk

Premium

Risk

Premiumfor a stock

twice as

risky as

the market

2.0

)(2 fMfi rRrr +=

Risk Premium for a

stock half as risky

as the market

0.5

)(2

1fMfi rRrr +=

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What is sensitivity analysis?What is sensitivity analysis?

Shows how changes in a variable suchas unit sales affect NPV or IRR.

Each variable is fixed except one.Change this one variable to see theeffect on NPV or IRR.

Answers what if questions, e.g.What if sales decline by 30%?

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Factors affecting theFactors affecting thesensitivity of NPV calculationssensitivity of NPV calculations

for a new machinefor a new machine

Operatingcosts

ProjectNPV

Financingcost

Initialoutlay

Salesprice

Annual salesvolume

Project

life

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Sensitivity AnalysisSensitivity Analysis

Change the value of an independentvariable by X%

Calculate the resulting value of the

dependent variable Calculate the % in the dependent

variable; compare!

If % > X%, then dependent variableis sensitive to changes in theindependent variable

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What are the weaknesses ofWhat are the weaknesses of

sensitivity analysis?sensitivity analysis?

Does not reflect diversification.

Says nothing about the likelihoodof change in a variable, i.e., asteep sales line is not a problem if

sales wont fall. Ignores relationships among

variables.

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Why is sensitivity analysisWhy is sensitivity analysis

useful?useful? Gives some idea of stand-alone

risk. Identifies potentiallydangerous variables.

Gives some breakeveninformation.

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What is scenario analysis?What is scenario analysis?

Examines several possiblesituations, usually worst case,most likely case, and best case.

Provides a range of possibleoutcomes.

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Decision TreeDecision Tree

A decision tree is diagramatic representation ofthe relationships among decision states of natureand outcomes (pay-offs).

Decision trees are constructed left to right. The branches represents the possible alternative

decisions which could b made and the variouspossible outcomes which may arise.

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Decision tree diagram showingDecision tree diagram showingdifferent possible project outcomesdifferent possible project outcomes

Outcome 1

Outcome 2

Outcome 3

Outcome 4

Year 1 (0.6)

Year 2 (0.6)

Year 1 (0.4)

Year 2 (0.4)

Year 1 (0.4)

Year 2 (0.6)

Year 1 (0.6)

Year 2 (0.4)

0.6 x 0.6 = 0.36

0.4 x 0.4 = 0.16

0.4 x 0.6 = 0.24

0.6 x 0.4 = 0.24

8,000

8,000

8,000

12,000

12,000

12,000

8,000

12,000

Cash

flowRs.

Probability

Total 1.00

O

utlay

(R

s.6,000)

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Standard DeviationStandard Deviation

NPV = fd2n

Coefficient of VariationCoefficient of Variation

CVNPV = = = 2.0.

$30.3

$15

NPV

Mean

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What is a simulation analysis?What is a simulation analysis?

A computerized version of scenarioanalysis which uses continuous probability

distributions of input variables. Computer selects values for each variable

based on given probability distributions.

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NPV and IRR are calculated.

Process is repeated many times

(1,000 or more). End result: Probability

distribution of NPV and IRR based

on sample of simulated values. Generally shown graphically.

What is a simulation analysis?What is a simulation analysis?

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The main steps in simulationThe main steps in simulation

Identify the key variables and theirinterrelations

Specify the possible values for eachvariable

Carry out repeated trials using a selectedvalue for each key variable and obtain a

probability distribution of the cash flows ofthe project

Step 1

Step 2

Step 3

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Independent Variable A

-1 +1

40%

Value 1 Value 2

Independent

Variable B

60%

Independent

Variable C

Value = $Z, fixed

Dependent Variable--100 iterations

-1 +1

Independent

Variable D

Value = Y%, fixed

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Wh t th d t fWh t th d t f


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What are the advantages ofWhat are the advantages ofsimulation analysis?simulation analysis?

Reflects the probability distributions of each input.

Shows range of NPVs, the expected NPV, NPV , andCVNPV .

The model building process can provide valuableinsights about the interdependencies of the inputparameters.

The model can describe a complex situation thatcannot be described in simple terms.

Gives an intuitive graph of the risk situation.

42

h h


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What are the disadvantagesWhat are the disadvantagesof simulation?of simulation?

Difficult to specify theinterrelationships,probability

distributions, and correlations. If inputs are bad, output will be bad:

Garbage in, garbage out.

The model may be too complex. May look more accurate than it really

is. (Just a scientific guess!)

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Sensitivity, scenario, and simulationanalyses do not provide a decisionrule. They do not indicate whether a

projects expected return issufficient to compensate for its risk.

Sensitivity, scenario, and simulation

analyses all ignore diversification.Thus they measure only stand-alonerisk, which may not be the most

relevant risk in capital budgeting.

SummarySummary

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Risk preference of investorsRisk preference of investors

Risk-neutral investors

Risk-averse investors

Risk-seeking investors

Investors may display three possible attitudes

towards risk. They may be:

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