capital budgeting_lesson 1

8/3/2019 Capital Budgeting_lesson 1

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Introduction



1. New Projects/Business

2. Replacement Decisions

Curr ent Outlays in long ter m assets

Benef its over a consider able period of

time

Decisions typically irr eversible



1. Identify Relevant Outflows and

Inflows.

2. Estimation of the cost of capital(WACC/Opportunity Cost)

3. Make an investment decision

using decision rules



` Non Discounting Techniques Accounting Rate of Return/ Aver age Rate of Return

Pay Back Period

` Discounting Technique Net Pr esent Value

Benef it Cost Ratio/Prof itability Index

Internal Rate of Return Discounted Pay back period



A company is considering an investment proposal costing Rs

100,000. The facility has a life expectancy of 5 years and no

salvage value. The tax r ate is 35%. Str aight Line Depr eciation is

used. Prof its Bef or e Depr eciation and Tax ar e as f ollows:

Use 10 % Cost of Capital f or NPV and Prof itability Index

Year Profits before tax

and depreciation

1 200002 24200

3 26500

4 27500

5 40700

Microsoft OfficeExcel Worksheet



[ Aver age Income(PAT)]

[ Aver age Investment]

Aver age Investment = Salvage Value + ½(Cost of Project-Salvage Value)

AverageInvestment



` Acceptance/Re jection Criteria If Project ARR > target ARR, then the project is accepted

If Project ARR < target ARR, then the project is r e jected.

If Project ARR = target ARR, acceptance or r e jection will

not make a differ ence to the value of the f ir m` Advantages ± Easy to calculate, data easily

available

` Disadvantages ± Use accounting r eturns, inferior

to cash flows, ignor e time value



` Time taken to r ecover the initial cost of investment

` Computation If cash flows in the f or m of annuity

Investment .Constant Annual Cash Flow (annuity)

Uneven flows ± compute cumulative cash flows and use

this to calculate the payback period



` Acceptance/Re jection Criteria If payback period > target payback period, then r e ject the

project

If the payback period < target payback period, then

accept the project

If the payback period = target payback period,

acceptance or r e jection will not make a differ ence to the

value of the f ir m

` Advantages ± Helps to ascertain how quicklyinvestment is r ecover ed, easy to calculate

` Disadvantages ± Ignor es time value, fails to see

complete pictur e,



` Pr esent Value of projects cash inflows minus the

pr esent value of projects cash outflow

NPV

={CI1/(1+k)1+CI2/(1+k)2+...+CIn/(1+k)n)} ± Co

CIi ± Cash Inflow at time n

CO ± Initial Investment

k- cost of capital



` Acceptance/Re jection All independent projects with positive NPV accepted

Mutually Exclusive Projects ± project with largest NPV

accepted



` Advantages

Considers all cash flows

Considers Time Value

Complies with ob jective of wealth maximization

Riskiness of project incor por ated

` Disadvantages

Discount r ate to be decided in advance

Expr essed in rupees not percentage

Cost of capital may not be constant

Cash flow estimation errors



PI= PV/I

PV = Pr esent value of cash Inflows

I = Initial Investment



` Accept/Re ject IF PI>1, then accept

IF PI<1 Re ject

IF PI= 1 Indiffer ent to the project

` Advantages Time Value, All cash flows consider ed

Reveals r elative prof it potential

Helps in capital r ationing decisions (next class)

` Disadvantages If initial investment amounts differ r esults contr adict with

NPV

Others same as NPV limitations



Discount RateDiscount Rate

NPV =

0

N

P V



` The r ate of r eturn that an investment gener ates

over its life.

` Cost of Capital f or which the NPV=0

{CI1/(1+k)1+CI2/(1+k)2+..+CIn/(1+k)n)} = Co

CIi ± Cash Inflow at time n

CO ± Initial InvestmentK ± irr



` Find the aver age cash flows f or the project E.g 3 lakh per year f or 5 years = 3

`

Divide initial outlay by aver age cash flow E.g assume initial outlay = 10 lakh

We get 10/3 =3.33

` Find f rom the PVIFA, f ind the inter est r ate which

has a PVIFA value of 3.33 f or 5 years Approximately 15% (PVIFA ± 3.3522)

` Checking by using this value. PV of Cash Inflows = 3*3.3522 = 10.0566

capital budgeting_lesson 1

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