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Capital Budgeting Decision Criteria

Capital Budgeting Decision Criteria. Should we build this plant?. What is an asset?. Which are monetarily significant items in a balance sheet?.

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Capital Budgeting Decision Criteria

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  1. Capital BudgetingDecision Criteria Should we build this plant?

  2. What is an asset?

  3. Which are monetarily significant items in a balance sheet?

  4. Incase you are required to purchase an asset for a value equivalent to your annual take home salary, how much time would you take to decide upon it?

  5. What could your objectives be for such an acquisition?

  6. I offer you INR 1 million today ………..or the same amount after 5 years, which one would you prefer?

  7. Are profit and cash different?

  8. Importance of capital budgeting • Investing in fixed assets is a strategic decision and determines company's destiny • Effect is long time and affects future cost structure • Not easily reversible • Involve huge costs and resources are always scarce with firms.

  9. Rationale of capital budgeting • Expanding revenues • expanding into new markets, product differentiation • Reducing costs • replacing equipment for better efficiency, safety/environmental projects

  10. Stages of capital budgeting • Identification stage • why a change? • Search stage • what needs a change? • Information acquisition stage • what are the expected costs and benefits? • Selection stage • which one should be selected? • Financing stage • where would the money come from? • Implementation and control stage • how is it performing?

  11. Decision-making Criteria in Capital Budgeting How do we decide if a capital investment project should be accepted or rejected?

  12. Capital budgeting decisions • Independent projects : Acceptance or rejection of project depends upon merits of project compared to decision criteria. • Mutually exclusive projects: The acceptance of one project excludes the possibility of accepting the other(s).

  13. Methods of capital budgeting • Traditional Techniques • Payback Period (PBP) • Accounting Rate of Return (ARR) • Discounted cash flow methods (Time Adjusted Techniques) • Net Present Value (NPV) • Internal Rate of Return (IRR) • Profitability index (PI)

  14. Evaluation of projects a) include 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.

  15. Payback Period • The number of years needed to recover the initial cash outlay. • How long will it take for the project to generate enough cash to pay for itself?

  16. Payback Period 8 7 0 1 2 3 4 5 6 • How long will it take for the project to generate enough cash to pay for itself? (500) 150 150 150 150 150 150 150 150

  17. Formula • PBP = Investment/Constant Annual cash flow • Ex. PBP=500/150=3.33 years

  18. Is a 3.33 year payback period good? • Is it acceptable? • Depends on whether the project is - Independent projects or a mutually exclusive projects.

  19. 8 7 0 1 2 3 4 5 6 Unequal cash flows • How long will it take for the project to generate enough cash to pay for itself? (680) 115 145 150 180 250 150 150 150

  20. 8 7 0 1 2 3 4 5 6 Unequal cash flows • How long will it take for the project to generate enough cash to pay for itself? (680) 115 145 150 180 250 150 150 150 PBP=4 years and 4 months

  21. Strengths and weaknesses of payback • Strengths • Provides an indication of a project’s risk and liquidity. • Easy to calculate and understand. • Weaknesses • Ignores the time value of money. • Ignores CFs occurring after the payback period.

  22. 8 7 0 1 2 3 4 5 6 • Does not consider all of the project’s cash flows. (500) 150 150 150 150 150 (300) 0 0 Consider this cash flow stream!

  23. ARR • ARR=Average annual PAT/Average investment % • Higher the better

  24. Example

  25. ARR=34.28%

  26. Merits and de-merits of ARR • Easy to calculate and understand • Based on accounting profits and not cash flows • Ignores time value of money

  27. Fundamental concepts • Calculating depreciation • Difference between profits and cash flows • Treatment of working capital • Present Value vs future value • Computing the discounting factor • Conventional cash flows and non-conventional cash flows

  28. Net Present Value n t=1 S CFt (1 + k) NPV = - CO t • NPV = the total PV of the annual net cash flows - the initial outlay.

  29. NPV Example • Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%.

  30. NPV Example 83,000 83,000 83,000 83,000 116,000 (276,400) 0 1 2 3 4 5 • Suppose we are considering a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for four years and $116,000 at the end of the fifth year. The firm’s required rate of return is 15%.

  31. Net Present Value • Decision Rule: • USD 18,236 • Accept or Reject?

  32. Thank You CA Kirti Sharma

  33. PI Formula • PI = PV of Future CFs/Initial Investment

  34. Profitability Index • Decision Rule: • If PI is greater than or equal to 1, ACCEPT. • If PI is less than 1, REJECT.

  35. Internal Rate of Return (IRR) • IRR: Solve for the discount rate which gives a zero NPV.

  36. Internal Rate of Return (IRR) n t=1 S ACFt (1 + k) NPV = - IO t ACFt (1 + IRR) IRR: = IO t n t=1 S

  37. Internal Rate of Return (IRR) n t=1 ACFt (1 + IRR) S IRR: = IO t • IRR is the rate of return that makes the PV of the cash flows equal to the initial outlay. • This looks very similar to our Yield to Maturity formula for bonds. In fact, YTM is the IRR of a bond.

  38. Calculating IRR 83,000 83,000 83,000 83,000 116,000 (276,400) 0 1 2 3 4 5 • Looking again at our problem: • The IRR is the discount rate that makes the PV of the projected cash flows equal to the initial outlay.

  39. 83,000 83,000 83,000 83,000 116,000 (276,400) 0 1 2 3 4 5 • This is what we are actually doing: 83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400

  40. 83,000 83,000 83,000 83,000 116,000 (276,400) 0 1 2 3 4 5 • This is what we are actually doing: 83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400 • This way, we have to solve for IRR by trial and error.

  41. IRR with your Calculator • IRR is easy to find with your financial calculator. • Just enter the cash flows as you did with the NPV problem and solve for IRR. • You should get IRR = 17.63%!

  42. IRR • Decision Rule: • 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.

  43. IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +)

  44. 0 1 2 3 4 5 • IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) (500) 200 100 (200) 400 300

  45. 0 1 2 3 4 5 • IRR is a good decision-making tool as long as cash flows are conventional. (- + + + + +) • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) (500) 200 100 (200) 400 300

  46. 1 2 3 0 1 2 3 4 5 • Problem: If there are multiple sign changes in the cash flow stream, we could get multiple IRRs. (- + + - + +) • We could find 3 different IRRs! (500) 200 100 (200) 400 300

  47. Summary Problem: (900) 300 400 400 500 600 0 1 2 3 4 5 • Enter the cash flows only once. • Find the IRR. • Using a discount rate of 15%, find NPV. • Add back IO and divide by IO to get PI.

  48. Summary Problem: (900) 300 400 400 500 600 0 1 2 3 4 5 • IRR = 34.37%. • Using a discount rate of 15%, NPV = $510.52. • PI = 1.57.

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