capital budgeting decision- sbs
TRANSCRIPT
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Financial Managment
Shanti business School
Capital Budgeting decision
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Capital budgeting
Capital budgeting is the process of making decision
regarding capital expenditure in projects or assets
Capital Expenditure
For acquiring capital assets which are usedin the business
and not for resale and such assets would give benefits for
long period
Example: Land, Plant & Equipments
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Importance of capital Budgeting
Heavy Investment
Permanent commitment of funds
Long term Impact on profitability
Irreversible in nature
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Capital Budgeting process
Find Projects
Determine cash flows
Determine risk of those cash flows
Choose budget
Post audit
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Session plan First Half : Estimation
of cash flows
What is Cash flow ?
How to calculateproject cash flow ?
Issues to look for whilecalculating Cash flows.
Second Half:Techniques to evaluateprojects cash flows
Traditional methods forevaluating a project
Discounted Methods ofevaluating a project
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Sound Investment Decision Sound investment decisions should be based on
the net present value (NPV) of Cash flows .
What should be discounted?
In theory, the answer is obvious: We shouldalways discount the cash flows.
What rate should be used to discount cash flows?
In principle, the opportunity cost of capital shouldbe used as the discount rate
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Cash flow Vs Profit The words profit and cash flows are often used
interchangeably. Cash flow is different from profitbecause of mainly two reasons.
Profit is calculated using accrual concept ofaccounting
( Which says record the revenue/expense even if cash isnot Received/paid)
While calculating profit depreciation is deducted asexpense.
As deprecation does not result into any cash outflow it isadded back as source of cash in cash flow statement.
In other worlds, Cash flow = Profit + Depreciation
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Cash Flows The cash flow approach for measuring benefits is
theoretically superior to the accounting profitapproach as it
Avoids the ambiguities of the accounting profitsconcept,
Measures the total benefits and
Takes into account the time value of money.
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How to Calculate Cash flow ? Cash flow is equal to,
Revenues
Less: Expenses
Less: Depreciation Profit
Add back : Depreciation ( As it is Non-Cash Expense)
Less : Capital expenditure
Less : Working capital requirement (+/-)
Free Cash flow or Cashflow
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Project Cash flows
When deciding whether or not to make an investment, we
must first estimate the cash flows that the investment will
provide
Generally, these cash flows can be categorized as follows:
The initial outlay (IO)
The annual after-tax cash flows (ATCF)
The terminal cash flow (TCF)
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Relevant cash flows Determining the relevant cash flows can sometimes
be difficult, here are some guidelines
Cash flows must be:
Incremental (i.e., in addition to what you alreadyhave)
After-tax
Ignore those cash flows that are:
Sunk costs (money already spent, and notrecoverable)
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The Initial outlay The initial outlay is the total up-front cost of the
investment
The initial outlay can consist of many components, amongthese are:
The cost of the investment
Shipping and setup costs
Training costs
Any increase in net working capital
When we are making a replacement decision, we alsoneed to subtract the after-tax salvage value of the oldmachine (or land, building, etc.)
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The Annual After tax cash flows The annual after-tax cash flows (ATCF) are the
incremental after-tax cash flows that the investment willprovide
Generally, these cash flows fall into four categories:
Incremental savings (positive cash flow) or expenses(negative cash flow)
Incremental income (positive cash flow)
The tax savings due to depreciation
Lost cash flows (negative cash flow) from the existingproject. This is an opportunity cost.
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Terminal Cash flows
The terminal cash flow consists of those cash flows that
are unique to the last year of the life of the project
There may be a number of components of the TCF, but
three common categories are:
Estimated salvage value
Shut-down costs
Recovery of the increase in net working capital
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Types of Projects
Single proposal or new project
Replacement project
Mutually Exclusive projects
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In case of single project cash flows would be.
Cash outflow Year 0 Cash inflows (total life)
Cost of new project
+ Installation cost of
plant and equipment
Revenues
Less: Expenses
Less: depreciation
Profit
Add Depreciation
Less: Working capitalrequirements
Less : capital Expenditure
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Incremental Cash flow Incremental cash flow is the additional cash flow (
Cash inflow and outflow) that firm will incur if it takesa project.
It is the difference between firm and projects cash
flow
Firms
Cash flow(Withoutproject)
Firms cash
flow+
ProjectCash flow
IncrementalCash Flow
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Example Following is Firm ABC Data
Rs.1,00,000, revenue, Rs,70,000 cost and Rs, 10,000deprecation.
There is a proposal of project Y. by taking project yfirms new revenue would be Rs.1,30,000. costRs.90,000 and 15,000 depreciation.
What would be the incremental cash flow. (Assume
working capital and capital expenditure requirementis Zero)
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Firm ABC Incremental CashFlow
Particulars Firm + Project Y Firm withoutproject Y
Incremental CashFlow
Revenue 1,30,000 1,00,000 30,000
Less: Expenses 90.000 70,000 20,000
Less :Depreciation
15.000 10,000 5,000
Profit 25.000 20,000 5,000
Add: Depreciation 15.000 10,000 5,000
Cash flows 40.000 30,000 10,000
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Replacement Proposal In the case of replacement situation, the sale
proceeds from the existing asset reduce the cashoutflows required to purchase the new Asset. Therelevant Cash flows are incremental after-tax cash
inflows.
Cost of the new machine
+ Installation Cost
Working Capital
Sale proceeds of existing machine
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Replacement proposal cashflows
Cash outflow (incremental) Cash Inflow (incremental )
Cost of the new machine
+ Installation Cost
Working Capital
Sale proceeds ofexisting machine
Revenues
Less: Expenses
Less: depreciation(Incremental
Profit
Add Depreciation
Less: Working capital
requirementsLess : capital Expenditure
Cash flow
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Mutually exclusive projects Projects are mutually exclusive if accepting one
implies that the other projects will be foregone.
When projects are mutually exclusive and have equallives, you have to rank the projects based on their Net
present value of cash flows.
Choose the best project, provided the projects NPV ispositive
With mutually exclusive projects, choosing theproject with the highest NPV is always correct.
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Example Company X is considering a proposal of purchasing either
machine A or B. following are the cash flow associate withboth machines.
Guide which machine should company choose if discountrate is 10%
Particulars Machine A Machine B
Cost of machine 1,50,000 2,50,000
Incremental Cash flow for5 years
18,000 25,000
Salvage value 25,000 30,000
Discount rate 10% 10%
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Solution
Step 1: Present Value Of Cash Inflow Discounted at10%
Machine A : $83,757
Machine B : $ 1,13,397
Step 2 : Deduct total PV of Cash outflow fromCash Inflow
Machine A : $83,757 75,000 = $8,757 Machine B : $ 1,13,397-1,00,00=$13,397
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Methods of Capital Budgeting
Traditional methods
Pay back period method or pay out or pay off method
Discounted pay back period method
Rate of return method or accounting method
Time adjusted method or discounting method
Net present value method
Internal rate of return method
Profitability index method
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Payback Method
Payback period is the length of time required torecover initial cash outlay.
For Example
Here the payback period is 4 years because sumof cash flows during first four years equals toinitial investment
Cash flows
Initial outlay Year 1 Year 2 Year 3 Year 4 Year 5
-6,00,000 2,00,000 1,50,000 1,50,000 1,00,000 1,50,000
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Payback method
Decision criteria under payback method isAccept the projects with shorter payback period.
Advantage:1.Easy to calculate
Disadvantage:
1.Ignores the time value of money
2. Ignores the cash flows beyond payback period
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Discounted Payback
All cash flows are calculated taking into consideration
appropriate discount rate
Advantages:
It takes into consideration time value of money
Cash flows
Initial outlay Year 1 Year 2 Year 3 Year 4 Year 5
-4,00,000 2,00,000 1,50,000 1,50,000 1,00,000 1,50,000
Discounted2,00,000/
1.101,50,000/(1.10)^2
1,50,000/(1.10)^3
1,00,000/(1.10)^4
1,50,000/(1.10)^5
D. payback 1,81,818 123967 112697 68301 93138
A i A R f R
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Accounting or Average Rate of ReturnMethod
ARR = Average annual profit / original investment * 100
For example
Average annual profit = (1,50,000 / 6,00,000) * 100
Here the ARR is 25%
Decision criteria: Accept the projects which gives you the
ARR higherthen the return required by company
Cash flows
Initial outlay Year 1 Year 2 Year 3 Year 4 Year 5
-6,00,000 2,00,000 1,50,000 1,50,000 1,00,000 1,50,000
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Accounting or Average Rate ofReturn Method
Advantages:
Simple to calculate
No estimation Required
Disadvantages:
It is based on accounting profit not cash flow
It does not take into account time value of money
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Net present value [NPV] method
Decide appropriate discounting rate
Present value of estimated cash inflows and outflows
should also be computed
Equation for calculating NPV is as follows
NPV = P.V cash inflows P.V cash out flows
Criteria for Selection
Accept when NPV > zero
Reject when NPV < zero
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Net present value [NPV] method
For example
Find the NPV if Required rate of return is 10%
NPV is Rs. 10124.74
Cash flows
Initial outlay Year 1 Year 2 Year 3 Year 4 Year 5
-1,00,000 20,000 25,000 30,000 35,000 40,000
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Net present value [NPV] method
Advantage:
Takes into account time value of money
Additive property: NPV (A+B) = NPV of project A +
NPV of project B
Limitations:
Its in Absolute terms not relative terms
Biased to long term projects in case projects are
mutually exclusive.
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P.I = Present value future cash inflow / Present value of futurecash outflow
For Example:
At 10% discount rate,
Profitability index for the project is 1,10,000 / 1,00,000 = 1.1Criteria for decision
Accept the project in P.I >1
Reject the project if P.I
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Profitability index [PI] or excesspresent value index method
Advantages:
Takes in to account Time value of money
Takes into account Scale on investment
Used when capital is scare
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Internal Rate of Return
Rate which makes present value of all future cash flows equals to
values of initial outlay or which makes NPV=0 (PV of Inflows = PV of
outflow)
IRR=Cash Inflows/ Cash outflows=1
Methods of finding IRR
Trial and Error
Excel
Example
IRR = 12%
Cash flowsInitial outlay Year 1 Year 2 Year 3 Year 4
-1,00,000 25,000 30,000 40,000 40,000
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Internal Rate of Return
Decision criteria
Accept the project If IRR is greaterthan required
rate of return by the investor.
Advantages
It takes into consideration Time value of money
It gives the same result as given by NPV
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Internal Rate of Return
Disadvantages: Projects with negative cash flows
For example
Cash flows Year 0 Year 1 Year 2-16,000 10,000 -10,000
Mutually exclusive projects
Project Initial investment Cash flow IRR NPV
A -10,000 20,000 100% 7,857.14
B -50,000 75,000 50% 16,964.29
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Which one to choose?
Survey evidence on percentage of CFOs using particular techniquefor evaluating investment projects
Source:J. R. Graham and C. R. Harvey, The Theory and Practice of Finance: Evidence from the Field, Journal ofFinancial Economics 61 (2001)
12%
20%
57%
76%
75%
0% 20% 40% 60% 80%
Profitability Index
ARR
Payback
IRR
NPV
Methods
Capital Budgeting Techniques
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In class exercise
Suppose you buy a land at Rs 10 lac and you
construct a building which costs Rs 5. you can
rent it to a hotel with annual rent of Rs 4 lac per
year for 5 years. If the Rate of interest is 10%
Will you invest in the project ?
In case the rate of interest increases to 12%
would it impact your decision?
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In class Exercise
Project InitialInvestment
Cash Flows1st Year 2nd Year 3rd Year 4th year 5th year
A -100,000 20000 30000 40000 40000 50000
B -75000 15000 15000 15000 15000 15000
C -150,000 50000 60000 40000 40000 50000
D -200,000 80000 70000 40000 40000 30000
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Decision
Based on each criteria which project would you
select
Payback
ARR
NPV
IRR
P.I.