capital budgeting decisions1
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Capital Budgeting Decisions
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The investment decisions of a firm are generally
known as capital budgeting.
A capital budgeting decisions may be defined as the
firms decisions to invest its current funds most
efficiently in the long term assets in anticipation ofan expected flow of benefits over a series of years.
The firms investment decisions would generally
include expansion,acquisition,modernisation and
replacement of the long-term assets. Sale of a
division or business (divestment) is also as an
investment decision.
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The firms value will increase if investments are
profitable and add to the shareholders wealth.
Thus, investment should be evaluated on the
basis of a criteria, which is compatible with the
objective of shareholders wealth maximization.
An investment will add to the shareholders
wealth if its yields benefits in excess of cost ofcapital.
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Steps to evaluate of an investment
1. Estimation of cash
flows.2. Estimation of the required rate of return (the
opportunity cost of capital).
3. Application of a decision rule for making the
choice.
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Investment decisions rule
It should maximise the shareholders wealth.
It should consider all cash flows to determine thetrue profitability of the project.
It should provide for an objective and unambiguousway of separating good projects from bad projects.
It should help ranking of projects according to theirtrue profitability.
It should help to choose among mutually exclusiveprojects that project which maximises theshareholders wealth.
It should be a criterion which is applicable to anyconceivable investment project independent of
oth
ers.
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Evaluation Criteria
Payback Period (PB) Discounted payback period (DPB)
Net Present Value (NPV)
Internal Rate of Return (IRR) Profitability Index (PI)
Accounting Rate of Return (ARR)
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PAYBACK Period
Payback period is the number of years required
to recover the original cash outlay invested in aproject.
Example: Assume that a project requires an
outlay of Rs 50,000 and yields annual cash inflow
of Rs 12,500 for 7 years. The payback period forthe project is
C
C
InflowCashAnnual
InvestmentInitial=Payback 0!
years412,500Rs
50,000RsPB !!
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Unequal cash flows In case of unequal cash inflows, the
payback period can be found out by adding up the cashinflows until the total is equal to the initial cash outlay.
Suppose that a project requires a cash outlay of Rs 20,000,
and generates cash
inflows of Rs 8,000; Rs 7,000; Rs 4,000;and Rs 3,000 during the next 4 years. What is the projects
payback?
3 years + 12 (1,000/3,000) months
3 years + 4 months
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Certain virtues: Simplicity
Cost effective
Serious vices:4Cash flows after payback
4Time value of money
Discounted Payback Period:
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Net Present Value
It is t
he difference between t
he sum of t
he present
value of future cash inflows & the initial investment.
Decision rule:
NPV > 0 : Accepted NPV < 0 : Rejected
NPV = 0 : Indifferent
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Net Present Value
The formula for the net present value can be
written as follows:
!
!
!
n
t
t
t
n
n
I
k
C
Ik
C
k
C
k
C
k
C
1
0
03
3
2
21
)1(
NPV
)1()1()1()1(NPV .
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Example
Assume there are two mutually exclusive projects with similar
initial investment of Rs.56,125 and expected life of 5years butdifferent expected cash flows. The cost of capital is 10%.
Year Project A Project B
0 56,125 56,125
1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000
Total 93,000 93,000
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Machine A
Year ash Flo resent alue @ 10% o F
0 56,125 1.000
1 14,000 0.909 12,726
2 16,000 0.826 13,2163 18,000 0.751 13,518
4 20,000 0.683 14,660
5 25,000 0.621 15,525Total 69,645
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Machine B
Year ash Flo resent alue @ 10% o F
0 56,125 1.000
1 22,000 0.909 19,998
2 20,000 0.826 16,520
3 18,000 0.751 13,518
4 16,000 0.683 10,928
5 17,000 0.621 10.557
Total 71,521
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NPV ofMachine A = Rs.13,520 i.e. Rs.(69,645 56,125)
NPV ofMachine B = Rs.15,396 i.e. Rs.(71,52156,125)
Limitations: Mutually exclusive projects
Alternative projects with unequal lives or limited fund constraintsthe NPV rule may give ambiguous results
Ranking of projects: as per the NPV rule is not independent ofdiscount rates.
Two projects A & B both costing Rs.50. Calculate NPV at 5% and 10%and rank the project.
Year Project A Project B
1 100 30
2 25 100
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Internal Rate of Return
The internal rate of return (IRR) is the rate that
equates the investment outlay with the present
value of cash inflow received after one period.
This also implies that the rate of return is the
discount rate which makes NPV = 0.
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Accept Reject decision:
The higher is better.
Should more than cut-off rate / required rateof return.
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Calculation ofIRR
When Cash Flows structure is annuity
Step 1: Determine the payback period
Step 2: Check PVIFA table
Step 3: Find the two Pay back value, one is higher & one is lower
Step 4: Determine IRR by interpolation
Example: Let us assume that an investment would cost Rs 20,000
and provide annual cash inflow of Rs 5,430 for 6 years.
NPV Rs 20,000 + Rs 5,430(PVAF ) 0
Rs 20,000 Rs 5,430(PVAF )
PVAFRs 20,000
Rs 5,430
6,
6,
6,
!
!
! !
r
r
r3683.
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Y
ear MachineA
Machine B0 56,125 56,125
1 14,000 22,000
2 16,000 20,000
3 18,000 18,000
4 20,000 16,000
5 25,000 17,000
Total 93,000 93,000
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Machine A @18%
Year ash Flo PV@18% PV o F
0 56,125 1.000 - (56,125)
1 14,000 0.847 11,856
2 16,000 0.718 11,488
3 18,000 0.609 10,962
4 20,000 0.516 10,3205 25,000 0.437 10,925
Net - (572)
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Machine A @17%
Year ash Flo PV@17% PV o F
0 56,125 1.000 - (56,125)
1 14,000 0.855 11,970
2 16,000 0.731 11,696
3 18,000 0.624 10,232
4 20,000 0.534 10,680
5 25,000 0.456 11,400
Net 853