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Session 4

Session 4. Capital Budgeting. Capital Budgeting - Methods. 1. Average Return on Investment 2. Payback 3. Net Present Value 4. Internal Rate of Return 5. Modified IRR. Average Return on Investment. AROI = Avg. Net Income Per Year Avg. Investment.

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Session 4

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  1. Session 4 • Capital Budgeting

  2. Capital Budgeting - Methods • 1. Average Return on Investment • 2. Payback • 3. Net Present Value • 4. Internal Rate of Return • 5. Modified IRR

  3. Average Return on Investment • AROI = Avg. Net Income Per Year • Avg. Investment

  4. Average Return on Investment • Example: • YearNet IncomeCost • 1 6,000 100,000 Initial • 2 8,000 0 Salvage Value • 3 11,000 • 4 13,000 • 5 16,000 • 6 18,000

  5. Average Return on Investment • Avg. Net Income 72,000 • 6 • Avg. Investment 100,000 • 2 • AROI 12,000 • 50,000 = 12,000 = 50,000 = 24%

  6. Average Return on Investment • Advantages • Disadvantages

  7. Payback Method • # Years required to recover the original investment • Example: • YearNet IncomeCash FlowCumulative 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

  8. Advantages Disadvantages Payback Method

  9. Time Value of Money • FV = PV (1 + r)n • Compounding: Finding FV • Discounting: Finding PV: PV = FV/(1 + r) n • Internal Rate of Return: Finding r

  10. Net Present Value • NPV = Present Value of All Future Cash Flows less Inital Cost • = CF1 + CF2 + CF3 +.......CFn - Io • 1+r (1+r)2 (1+r)3 (1+r)n

  11. Net Present Value - Example • YearCFDisc. FactorPV • 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

  12. Advantages Disadvantages Net Present Value

  13. Internal Rate of Return • 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%

  14. Advantages Disadvantages Internal Rate of Return

  15. Profitability Index 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

  16. Profitability Index • Advantages: • Disadvantages:

  17. NPV Profile • YearCFDisc. FactorPV • 0 -100,000 1 -100,000 • 1 26,000 0.91 23,636 • 2 28,000 0.83 23,140 • 3 31,000 1/(1.1)3 = .7573 23,291 • 4 33,000 1/(1.1)4 = .6830 22,539 • 5 36,000 1/(1.1)5 = .6209 22,352 • 6 18,000 1/(1.1)6 = .5645 10,161 • NPV = 25,121

  18. NPV Profile • Dis. RateNPV • 0% 7200 • 5% 45725.7 • 10% 25120.76 • 15% 8711.838 • 20% -4538.97 • 25% -15376.1

  19. NPV Profile • 80000 • 60000 • 40000 • 20000 • 0 • -20000 • 0 0.05 0.1 0.15 0.2 0.25 • Disc. Rate NPV

  20. Choosing Between Projects • YearCF(A)CF(B) • 0 -25000 -25000 • 1 2000 21000 • 2 2000 10000 • 3 35000 2000 • NPV 6351 4606 • IRR 17% 22%

  21. Modified IRR • Reinvestment Rate Assumption (Project A) • Project  Outlay  25,000 • Cash Flows: YR1  2,000                     YR2  2,000                     YR3  35,000 •     NPV @ 8%: 6,351  IRR: 17%

  22. Modified IRR • NPV: Project A •     YR1:   2,000     YR2:   2,000 + 2,000 + 160 = 4,160    YR3:   35,000 + 4,160 + 333 = 39,493 • [Note: PV of 39,493, three years from now @ 8% =  31,351                                                          Less: outlay  25,000 • NPV  6,351]

  23. Modified IRR • IRR @ 17%    YR1:   2,000   = 2,000     YR2:   2,000 + 2,000 + 340 = 4,340     YR3:   35,000 + 4,340 + 738 = 40,078 • [25,000 invested for three years @ 17% = 25,000(1.17)3 = 40,040]

  24. Modified IRR • Modified Internal Rate of Return • Find k such that   (1+k)nI0  = Final value •     i.e.     (1+k)3 25000  = 39,439                                  k  = 16.5%

  25. Modified IRR • Reinvestment Rate Assumption (Project B) • Project  Outlay  25,000 • Cash Flows: YR1  21,000                     YR2  10,000                     YR3  2,000 •     NPV @ 8%: 4,606  IRR: 22.12%

  26. Modified IRR • NPV: Project B • YR1: 21,000 = 21,000        YR2: 10,000 + 21,000 + 1,680 = 32,680         YR3:  2,000 + 32,680 + 2,614   = 37,294 • [Note: PV of 37,294, three years from now @ 8% =  29,606                                                        Less: outlay  25,000 NPV  4,606 ]

  27. Modified IRR • IRR of 22.12% •   YR1:   21,000    = 21,000         YR2:   10,000 + 21,000 + 4,645 = 35,645         YR3:   2,000 + 35,645 + 7,885 = 45,530 • [25,000 invested for three years @ 22.12% = 25,000(1.2212)3 = 45,530]

  28. Modified IRR • Modified Internal Rate of Return • Find k such that   (1+k)nI0  = Final value •             i.e.     (1+k)3 25000  = 37,294                                           k  = 14.26%

  29. Estimating Cash Flows • NPV = CF1+ CF2 +.............. + CFn - Io • l+r (l+r)2 (l+r)n • Cash Flows Incremental • After Tax • Net Working Capital • Sunk Costs

  30. Procedure • 1. Initial Costs: New CAPEX • Additional W. Cap • Sale of Old Assets • 2. Annual Costs: Revenue Less Costs • After Tax • 3. Terminal Cash Flows: Salvage Value • Recoupment of NWC

  31. Cash Flow Estimates • 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

  32. New Product Proposal • Annual Sales $20m • Annual Costs $16m • Net Working Capital $2m • Plant Site $0.5m • Plant and Equipment $10m • Depreciation Straight Line over 20 years • Salvage Value nil • Tax Rate 40% • Required Return 8%

  33. New Product Proposal • INITIAL CASH FLOWS • ANNUAL CASH FLOWS

  34. New Product Proposal • TERMINAL CASH FLOWS • CALCULATION

  35. Evaluating Capital Projects • 1) Focus on Cash Flow, Not Profits. • Cash Flow = Economic Reality. • Profits Can Be Managed. • 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 a “Base-Case” NPV.

  36. Evaluating Capital Projects • 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. • Identify “Key Value Drivers.” • Identify Breakeven Assumptions. • Estimate Scenario Values. • Bound the Range of Value

  37. Evaluating Capital Projects • 8) Identify Qualitative Issues. • Flexibility • Quality • Know-How • Learning • 9) Decide

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