cap budget discounted

8/12/2019 Cap Budget Discounted

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Methods

Non-Discounted

PB ARR

Discounted

DiscountedPayback

NPV PI IRR

Methods of Capital Budgeting


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Discounted Payback

It is very similar to payback period

In this method the cash inflows are

adjusted with time value of money and

then the payback period is calculated.


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Discounted Payback

A project requires investment of Rs.5,00,000 and will generate cash flow

after taxes of Rs. 2,00,000 for first

three year and Rs. 3,00,000 for 4thand 5thyear. The life of the project is 5

years. The cost of capital is assumed

to be 10%. Calculate the discountedpay back period.


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Discounted Payback Period

Year Annual

Cash

Flows

PV factor

@ 10%

PV of cash flow Cumulative PV

1 2,00,000 0.909 1,81,800 1,81,800

2 2,00,000 0.826 1,65,200 3,47,000

3 2,00,000 0.751 1,50,200 4,97,200

4 3,00,000 0.683 2,04,900 7,02,100

5 3,00,000 0.621 1,86,300 8,88,400

Pay back period = 3 years + 2,800/2,04,900

= 3.013 years


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Discounted Payback Period

A company is contemplating to purchase amachine. Two machines, A and B areavailable, each costing Rs. 7,50,000.Calculate the discounted payback period forboth the machines. The cost of capital is12%. Which machine will be selected, if thecut-off payback period is 3 years and 3months? Cash flows (in Rs.) are expected asfollows:

Machine/Year 1 2 3 4 5

A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000

B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000


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Accept/Reject Criteria:

Discounted Payback Period The firm sets a standard or a target

discounted payback period. Thediscounted payback period of the project

is compared with the target paybackperiod. If the projects discounted PB > target PB,

then the project is rejected.

If the projects discounted PB < target PB,then the project is accepted.

If the project's discounted PB = target PBthen one is indifferent to the project.


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Net Present Value (NPV)

The method recognizes the time valueof money

It considers all the cash flow occuring

over the life of the projectA positive NPV results in creation of

wealth for the shareholders

The discount rate used for thecomputing NPV is the companyscost

of capital


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It helps in determining as to the

project generate positive value or not.

If the NPV is positive it adds value tothe firm and is desirable


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n

1tt

t

)k1(

CFNPV - Co

Sn+Wn

(1+k)n

n

1tt

t

)k1(

CFNPV - Co

NPV= PV of CF-C0


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Net Present Value

Year Annual Cash Flows PV factor @ 10% Present Value

1 2,00,000 0.909 1,81,800

2 2,00,000 0.826 1,65,200

3 2,00,000 0.751 1,50,200

4 3,00,000 0.683 2,04,900

5 3,00,000 0.621 1,86,300

8,88,400

NPV = 8,88,400 - 5,00,000

= 3,88,400


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Practice Question : NPV

QYear 1 2 3 4 5

Estimated CF before depreciation & Tax (Rs. in

Lakh)4 6 8 8 10


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Accept/Reject Criteria: Net

Present Value If the projectsNPV < 0, then the project is

rejected.

If the projectsNPV > 0, then the project

is accepted. If the project's NPV = 0 then one is

indifferent to the project.


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Evaluation: Net Present Value

Advantages:-Considers time value of money thus more

rational method

Considers all the cash flows occuring over the

life of the projectConsistent with shareholders wealth

maximization principle


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Evaluation : NPV

Disadvantages:-

It relies on the expected cash flow which

are quite difficult to estimate

The discount rate used to discount thecash flow is difficult to estimate and

moreover the discount rate may change

with time

Ranking of the project is given according

to the discount rate, if the discount rate

changes, then the ranking may change


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Profitability Index (B/C Ratio)

It measures the present value ofreturns per rupee invested

It is a ratio of present value of cash

inflows at the required rate of return,to the initial cash outflow of the

investment.


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PI = PV of cash inflows

Initial cash outflow

= PV(Ct

)

C0


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A company is contemplating to purchase amachine. Two machines, A and B areavailable, each costing Rs. 7,50,000.Calculate the Profitability index. The cost of

capital is 12%. Which machine will beselected? Cash flows (in Rs.) are expected asfollows:

Machine/Year 1 2 3 4 5

A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000

B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000


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Accept/Reject Criteria: PI (B/C

ratio) If the projectsPI < 1, then the project is

rejected.

If the projectsPI > 1, then the project is

accepted. If the project's PI = 1 then one is


For any given project NPV and PI should

give the same accept-reject decision.


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Evaluation: PI (B/C Ratio)

Advantages:-Considers time value of money thus more

rational method

Considers all the cash flows occuring over the

life of the projectConsistent with shareholders wealth

maximization principle

Measure of relative profitability


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Evaluation : PI (B/C ratio)

Disadvantages:-

It relies on the expected cash flow which

are quite difficult to estimate

The discount rate used to discount thecash flow is difficult to estimate and

moreover the discount rate may change

with time

Ranking of the project is given according

to the discount rate, if the discount rate

changes, then the ranking may change


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IRR(Internal

Rate ofReturn)


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Internal Rate of Return (IRR)

It is the internal rate of return that a given

investment generates over its useful life.

When evaluating an investment, it takes into

account both the magnitude and timings ofthe expected cash flows in every time period

of the projectslife.


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IRR

It shows the discount rate below whichan investment results in a positive NPVand should be selected and vice-versa

IRR computes the break even rate ofreturn.

IRR is not the return on the fundsinitially invested in the project , unlessthe cash inflow are reinvestedelsewhere to earn the same rate ofreturn as in the project.


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Internal Rate of Return (IRR)

Internal rate of return is the discount

rate at which the Present value of

cash inflow is equal to the cost of the

project

It is the rate at which NPV is 0

n

1tt

t

0 )IRR1(

CF

C


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Internal Rate of Return

Year Annual Cash Flows

1 2,00,000

2 2,00,000

3 2,00,000

4 3,00,000

5 3,00,000

Calculate IRR of the project which requiresinvestment of Rs. 5,00,000, if the cash flow are as

follows:-


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Practice Question: IRR

A company is contemplating to purchase amachine. Two machines, A and B areavailable, each costing Rs. 7,50,000.Calculate IRR Which machine will be

selected? The cost of capital for the firm is15%. Cash flows (in Rs.) are expected asfollows:Machine

/Year

1 2 3 4 5

A 1,00,000 2,80,000 2,90,000 2,50,000 2,00,000

B 1,90,000 2,50,000 2,60,000 3,10,000 2,50,000


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Accept/Reject Criteria: IRR

If the projectsIRR < k, then the project isrejected.

If the projectsIRR > k, then the project is

accepted. If the project's IRR = k, then one is



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Evaluation of IRR

Advantages:- Considers all the cash flows occuring over

the life of the project

Considers time value of money

It reveals the true profit potential of any

investment

It complies with the firms objective of

shareholders wealth maximization


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Evaluation of IRR

Disadvantages:- The IRR of two projects can not be added

to get the cumulative value of two projects

At times, IRR gives multiple results, hencefails to act as selection criteria

Many a time, it gives contradictory resultswith NPV method

Computation of IRR is also difficultA project may have multiple IRR:- If there are more than one change in sigh,

there are more than one IRR


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Investment Decision Rule

Sound investment evaluation criterionshould have the followingcharacteristics:-

1. Consider all the cash flow2. An objective and unambiguous way of

selection3. Ranking of projects according to

profitability4. Bigger cash flows are better than

smaller and earlier cash flows are betterthan later

5. Should maximize the wealth ofshareholders


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Conclusion

Pay back period, Net Present Valueand Internal Rate of Return arepopularly used method of capitalbudgeting

Among all, NPV is preferred as itconsiders the time value of moneyand gives a single NPV as a result

Pay back period is simple and gives arough idea about the recovery of thecost of the project

cap budget discounted

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