cid intropptbba

7/31/2019 Cid Intropptbba

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Course F-303:CAPITAL BUDGETING &

Project Mgmnt.Prof. Shabbir Ahmad

Introduction Definition, types of projects, techniques of CID etc.

Cash Flow EstimationDetermination of cash out flow and cashinflows

Techniques of Capital BudgetingDiscounted (NPV, IRR, MIRR, PI,and DPB) and non-discounted (PB & AAR) cash flow techniques,

decision criteria, advantages and disadvantages of each technique.Special Issues in Capital BudgetingProjection evaluation, cost-cutting projects, bid price setting, projects with different lives.

Project Analysis and EvaluationForecasting risk, sensitivity andscenario analysis, break-even analysis, operating leverage and capitalbudgeting.


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Course F-303:CAPITAL BUDGETING &

Project Mgmnt.

Inflation and Capital Budgeting

Options in Capital Budgeting

Strategy and Analysis in Using Net Present Value

Cost of Capital and Capital BudgetingCapital Budgeting for Levered Firm

Risk and Capital BudgetingAbsolute measure and relative measureof risk, certainty equivalent method and risk adjusted discount ratemethod.

Text BooksFundamentals of Corporate Finance by Ross, Westerfield, JORDAN

Corporate Finance by Ross, Westerfield, JAFFE

Capital Budgeting & Long-term Finance by Neil Seitz

Managerial Finance by Lawrence J GITMAN

Essentials of Managerial Finance by Eugene F. Brigham


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CAPITAL BUDGETING OR

CAPITAL INVESTMENT DECISION

Capital Investment Decisions or CapitalBudgeting involves companys long terminvestment decision. It includes evaluation of thefirms expenditure decisions that involve currentoutlays but are likely to produce benefits or returnsover a long period of time.

Capital Budgeting is the process of evaluating andselecting long-term investments in fixed or capitalassets that are consistent with the firms goal of

maximizing owners wealth.


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Why a firm makes capital investment?

In order to secure a stream of benefits in future years

that add value to the firm through cash inflows over

future times.


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Applications

Purchase of fixed assets

Mechanization of production method

Selection from alternative equipments

Introduction of new products

Expansion of business

Modernization and replacement


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FEATURES/CHARACTERISTICS

OF CID (IMPORTANCE)

Long term investment decision (future profitability offirm).

Returns or benefits are expected over number of years

Investment involves huge amount of cash outflow(determines the destiny of the firm)

Investment decision is generally irreversible (oncemade can not be changed)

Relatively high degree of risk

Relatively long time period between the initial outlayand the anticipated return


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CLASSIFICATION OF PROJECTS

By Size:

Major Project.

Minor Project.

By Benefit:

Cost Reduction Project.

Market Expansion Project.Project for new products.


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CLASSIFICATION OF PROJECTS

By Degree of Dependence:

Mutually Exclusive Projects.

Independent Projects.

By Cash Flow pattern:

Conventional Project.( - + + + + + i.e. outflow

followed by a series of inflow).Non Conventional Projects ( - + + - + - + i.e. if the

project inflows & outflows are mixed & zigzag

pattern).


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CAPITAL INVESTMENT

DECISION

Determination of Cash Outflow or

Investment

Projection or Forecast or Estimation ofFuture Cash Inflows

Determination of Appropriate Discount Rate

(i.e. Cost of Capital)


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CASH FLOW DETERMINATION

A project should be evaluated on the basis of

Incremental After Tax Cash Flows.

Incremental After Tax Cash Flows for project

evaluation consist of any and all changes in the

firms future cash flows that are a direct

consequence of taking the project or thedifference between a firms future cash flows

with a project and those without the project.


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CASH FLOW

DETERMINATIONOnly the relevant cash flows should be taken under

consideration in determining the cash flows (i.e.

inflows or outflows) for making capital investmentdecision.

Relevant cash flows should be included in a capital

budgeting analysis. These cash flows will only occur if

the project is accepted

Relevant cash flows are those which influence the

firms decision regarding accepting or rejecting a

project.


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CASH FLOW

DETERMINATIONIrrelevant cash flows are those which do not

affect the firms decision regarding accepting or

rejecting a project i.e. they exist if the firmsaccepts a project or if rejects a project.

Irrelevant cash flowsshould NOT be included

in capital budgeting analysis.


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CASH FLOW

DETERMINATIONAsking the Right Question

Will this cash flow occur ONLY if we accept the

project?

If the answer is yes, it should be included in the

analysis because it is incremental

If the answer is no, it should not be included inthe analysis because it will occur anyway

If the answer is part of it, then we should include

the part that occurs because of the project


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CASH OUTFLOWOR

INVESTMENT DETERMINATION

Cost of new asset or project

Add installation cost (if any)

Add transportation cost (if any)

Add removal cost of old asset (only if borneby the company)

Less selling price of old asset (if new asset replaces

old asset)

+ / - Tax on sale of old assetLess Amount of investment tax credit (AITC)


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Depreciation

Depreciation is a non-cash expense,consequently, it is only relevant because itaffects taxes

Depreciation tax shield = DTD = depreciation expense

T = tax rate


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Computing Depreciation

Straight-line depreciationAnnual Dep. = Installed cost / number of useful years

MACRSNeed to know which asset class is appropriate for tax

purposes

Multiply percentage given in table by the installedcost


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Example: Depreciation

You purchase equipment for $100,000 and it

costs $10,000 to have it installed. The companys

tax rate is 40%. What is the depreciation expenseeach year?


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Example: Three-year MACRS

Year MACRS

percent

D

1 .3333 .3333(110,000) =

36,663

2 .4444 .4444(110,000) =

48,884

3 .1482 .1482(110,000) =16,302

4 .0741 .0741(110,000) = 8,151

BV in year 6 =

110,00036,663

48,88416,302

8,151 = 0


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CASH OUTFLOW OR INVESTMENT

DETERMINATION

ExampleThe Sprint Inc. is trying to estimate the net cash outflow required toreplace an old machine with a new one. The new machines purchaseprice is $270,000. An additional $7,000 will be required for transportationand $5,000 will be required to install the machine. As the new machinehas greater capacity to produce, there will be an additional investment of

$20,000 in raw material inventory in the initial year. The new machinewill be depreciated on straight-line basis over five years of useful life.The old machine was purchased two years ago at a cost of $70,000 has aremaining useful life of five years. It is also subject to straight-linedepreciation. The company is entitled to investment tax allowance of25%. The corporate tax rate is 55% and the capital gain tax rate is 30%.

Find the net cash outflow considering separately each of the followingscenarios:

i) If the old machine is sold for $40,000

ii) If the old machine is sold for $50,00. NCO.xls

iii) If the old machine is sold for $60,000.

iv) If the old machine is sold for $90,000.
http://ppt/NCO.xlshttp://ppt/NCO.xlshttp://ppt/NCO.xlshttp://ppt/NCO.xls


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CASHINFLOWDETERMINATION

Operating Cash Flow (OCF)Operating Cash Flow (OCF) = EBIT + depreciationtaxes

OCF = Net income + depreciation when there is no interestexpense

OCF = SalesCostsTaxes (Dont subtract non-cashdeductions)

OCF = (SalesCosts)(1T) + Depreciation*T

Opportunity Cost

Sunk Cost

Erosion or Side Effects

Financing Cost

Change in Net Working Capital


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Common Types of Cash Flows

Sunk costscosts that have accrued in the past and shouldnot be included capital budgeting analysis

Opportunity costscosts of lost options and should beincluded in capital budgeting analysis

Side effectsPositive side effectsbenefits to other projectsNegative side effectscosts to other projects

and should be included in capital budgeting analysis

Changes in net working capital (should be included incapital budgeting analysis)

Financing costs (should not be included in capital budgetinganalysis)

Taxes should be considered


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PROJECTCASH FLOW

DETERMINATION

Year

0 1 2 3

OCFChange in NWC

Opportunity Cost

Capital Spending/CO ATSV

PCF


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After-tax Salvage

If the salvage value is different from the book

value of the asset, then there is a tax effect

Book value = installed costaccumulated (i.e.

total ) depreciation

After-tax salvage value (ATSV) = salvage

Tc(salvagebook value)


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TECHNIQUES OF CAPITAL BUDGETING

The techniques of capital budgeting are dividedinto two broad groups

A) Non discounted cash flow techniques i.e.techniques that do not consider time value ofmoney as such do not discount the future cashflows

B) Discount cash flow (DCF) techniques i.e.

techniques that do not consider time value ofmoney as such do not discount the future cashflows


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TECHNIQUES OF CAPITAL BUDGETING

A) Non-DCF techniques include the following:i) Payback Period Method

ii) Average Accounting Return or Accounting Rateof Return

B) DCF techniques include the following:i) Net Present Value (NPV)

ii) Internal Rate of Return (IRR)

iii) Profitability Index (PI) or Benefit-CostRatio (BCR)

iv) Discounted Payback Period Method


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The Payback Period Rule

How long does it take the project to pay back

its initial investment?

Payback Period = number of years to recoverinitial costs

Minimum Acceptance Criteria:

set by management


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The Payback Period Rule (continued)

Disadvantages:Ignores the time value of money

Ignores cash flows after the payback period

Biased against long-term projects

Requires an arbitrary acceptance criteria

A project accepted based on the payback criteria maynot have a positive NPV

Advantages:Easy to understand

Biased toward liquidity


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The Discounted Payback

Period Rule

How long does it take the project to pay back

its initial investment taking the time value of

money into account?


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The Average Accounting Return Rule

Another attractive but fatally flawed approach.

Disadvantages:

Ignores the time value of moneyUses an arbitrary benchmark cutoff rate

Based on book values, not cash flows and market values

Advantages:

The accounting information is usually availableEasy to calculate

InvestentofValueBookAverage

IncomeNetAverage

AAR


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The Net Present Value (NPV) Rule

Net Present Value (NPV) =

Total PV of future CIs - Initial Investment

PV of Cash Inflows PV of Cash Outflows

Minimum Acceptance Criteria: Accept if NPV > 0

Ranking Criteria: Choose the highest NPV


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Why Use Net Present Value?

Accepting positive NPV projects benefits

shareholders.

NPV uses cash flows

NPV uses all the cash flows of the project

NPV discounts the cash flows properly


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Good Attributes of the NPV Rule

1. Uses cash flows

2. Uses ALL cash flows of the project

Reinvestment assumption: the NPV rule assumes

that all cash flows can be reinvested at the

discount rate or cost of capital.


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The Internal Rate of Return (IRR) Rule

IRR: the discount rate that sets NPV to zero or the rateof return available from investing in a project.Minimum Acceptance Criteria:

Accept if the IRR exceeds the required return.Ranking Criteria:

Select alternative with the highest IRRReinvestment assumption:All future cash flows assumed reinvested at the IRR.

Disadvantages:IRR may not exist or there may be multiple IRR

Problems with mutually exclusive investmentsAdvantages:

Easy to understand and communicate


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The Internal Rate of Return: Example

Consider the following project:

0 1 2 3

$50 $100 $150

-$200

The internal rate of return for this project is 19.44%

32 )1(

150$

)1(

100$

)1(

50$0

IRRIRRIRRNPV


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The NPV Payoff Profile for This Example

Discount Rate NPV

0% $100.00

4% $71.04

8% $47.3212% $27.79

16% $11.65

20% ($1.74)

24% ($12.88)

28% ($22.17)

32% ($29.93)36% ($36.43)

40% ($41.86)

If we graph NPV versus discount rate, we can see the

IRR as the x-axis intercept.

IRR = 19.44%

($60.00)

($40.00)($20.00)

$0.00

$20.00

$40.00

$60.00$80.00

$100.00

$120.00

-1% 9% 19% 29% 39%

Discount rate

NPV


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Problems with the IRR Approach

Multiple IRRs.

The Scale Problem

The Timing ProblemInvesting or Financing


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Multiple IRRs

There are two IRRs for this project:

0 1 2 3

$200 $800

-$200 - $800

($150.00)

($100.00)

($50.00)

$0.00

$50.00

$100.00

-50% 0% 50% 100% 150% 200%

Discount rate

NPV

100% = IRR2

0% = IRR1

Which one

should we use?


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The Scale Problem

Would you rather make 100% or 50% on your

investments?

What if the 100% return is on a $1 investmentwhile the 50% return is on a $1,000 investment?


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The Timing Problem

0 1 2 3

$10,000 $1,000 $1,000

-$10,000

Project A

0 1 2 3

$1,000 $1,000 $12,000

-$10,000

Project B

The preferred project in this case depends on the discount rate, not

the IRR.


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The Timing Problem..\TimingProb.xls

($4,000.00)

($3,000.00)

($2,000.00)

($1,000.00)

$0.00

$1,000.00$2,000.00

$3,000.00

$4,000.00

$5,000.00

0% 10% 20% 30% 40%

Discount rate

NPV

Project A

Project B

10.55% = crossover rate

16.04% = IRRA12.94% = IRRB
http://timingprob.xls/http://timingprob.xls/http://timingprob.xls/http://timingprob.xls/


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Mutually Exclusive vs.

Independent Project

Mutually Exclusive Projects: only ONE of severalpotential projects can be chosen, e.g. acquiring anaccounting system.

RANK all alternatives and select the best one.

Independent Projects: accepting or rejecting one projectdoes not affect the decision of the other projects.

Must exceed a MINIMUM acceptance criteria.


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The Profitability Index (PI) Rule

Minimum Acceptance Criteria:

Accept if PI > 1

Ranking Criteria:Select alternative with highest PI

Disadvantages:

Problems with mutually exclusive investments

Advantages:May be useful when available investment funds are limited

Easy to understand and communicate

Correct decision when evaluating independent projects

InvestentInitial

FlowsCashFutureofPVTotal

PI


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The Practice of Capital Budgeting

Varies by industry:

Some firms use payback, others use accounting rate of

return.

The most frequently used technique for largecorporations is IRR or NPV.


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Example of Investment Rules

Compute the IRR, NPV, PI, and payback period for the

following two projects. Assume the required return is

10%.

Year Project A Project B

0 -$200 -$150

1 $200 $502 $800 $100

3 -$800 $150


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Project A Project B

CF0 -$200.00 -$150.00

PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%

PI = 1.2096 1.6053


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Payback Period:

Project A Project B

Time CF Cum. CF CF Cum. CF

0 -200 -200 -150 -1501 200 0 50 -100

2 800 800 100 0

3 -800 0 150 150Payback period for project B = 2 years.

Payback period for project A = 1 or 3 years?


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Relationship Between NPV and IRR

Discount rate NPV for A NPV for B-10% -87.52 234.77

0% 0.00 150.00

20% 59.26 47.9240% 59.48 -8.60

60% 42.19 -43.07

80% 20.85 -65.64100% 0.00 -81.25

120% -18.93 -92.52

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