Download - Capital Exp Decisions1
-
7/30/2019 Capital Exp Decisions1
1/24
Click to edit Master subtitle style
1/10/13
Capital Expenditure Decisions
-
7/30/2019 Capital Exp Decisions1
2/24
Capital Expenditure Decisions
DiscountingNon Discounting
Evaluation Criteria
Payback
period
Accounting
Rate of Return(ARR)
Net Present
Value(NPV)
Internal
Rate ofReturn(IRR)
Profitability
Ratio/BenefitCost Ratio( PI/BCR)
-
7/30/2019 Capital Exp Decisions1
3/24
Net Present Value
( )=
+=
n
t
t
tc
k
cNPV
1
0
1
( ) ( ) ( ) ( )03
3
2
21
1
........
111c
k
c
k
c
k
c
k
cNPV
n
n
++
++
++
+=
Where,C1, C2 represent the net cash inflow in year 1,2K is the opportunity cost of CapitalC0 is the initial cost of investmentn is the expected life of investment
-
7/30/2019 Capital Exp Decisions1
4/24
Net Present Value
o Acceptance Rule NPVn Accept NPV > 0n Reject NPV < 0n May accept NPV = 0
o Evaluation of NPV methodn It recognizes the time value of moneyn It uses all cash flows occurring over the entire life of
the projectn
NPVs of the projects can be addedNPV(A+B)=NPV(A)+NPV(B)-Value Additively Principle
n NPV method is consistent with the objective ofmaximizing the shareholders wealth
-
7/30/2019 Capital Exp Decisions1
5/24
Net Present Value
Y e a r A m o u n t o u t s t
b e g i n n i n g
R e t u r n o n o u
a m o u n t a t
T o t a l a m
o u t s t a n d i
R e p a y m e
c a s h a t t
B a l a n
o u t s t a
R s R s R s R s R s1 2 5 0 0 2 5 0 2 7 5 0 9 0 0 1 8 5 0
2 1 8 5 0 1 8 5 2 0 3 5 8 0 0 1 2 3 5
3 1 2 3 5 1 2 3 . 5 1 3 5 8 . 5 7 0 0 6 5 8 . 5
4 6 5 8 . 5 6 5 . 8 5 7 2 4 . 3 5 6 0 0 1 2 4 . 3
5 1 2 4 . 3 5 1 2 . 4 3 5 1 3 6 . 7 8 5 5 0 0 - 3 6 3 . 2
-
7/30/2019 Capital Exp Decisions1
6/24
Internal Rate of Return
o Acceptance Rule IRRn Accept r > kn Reject r < kn May accept r = k
o
Evaluation of IRR methodn It recognizes the time value of moneyn It uses all cash flows occurring over the entire life of
the projectn IRR method is consistent with the objective of
maximizing the shareholders wealth
( )=
+=
n
t
t
tc
r
c
1
0
10
-
7/30/2019 Capital Exp Decisions1
7/24
Internal Rate of Return
o Unlike in the case of NPV method, the value additivityprinciple does not hold.
o IRR method can yield multiple internal rates of return
P r o j e c t C0 C1 N P V @ 1 0 % IR R %
A - 1 0 0 1 2 0 9 . 0 8 2 0 %
B - 1 5 0 1 6 8 2 . 7 1 2 1 2 %A + B - 2 5 0 2 8 8 1 1 . 7 9 2 1 5 . 2 0 %
Initial cost 0 -20,000
Net cash flow 1 90,000
Net cash flow 2 -80,000
IRR 21.9%, 228%
-
7/30/2019 Capital Exp Decisions1
8/24
Conflict in ranking
Different rankings given by the NPV and IRRmethods can be illustrated under the followingheads:
n Size-disparity problemn Time-disparity problemn Unequal expected lives
-
7/30/2019 Capital Exp Decisions1
9/24
Size Disparity Problem
P a r t i c u l a r s P r o j e c t A P r o j e c t B P r o j e c t
C a s h o u t l a y s - 5 0 0 0 - 7 5 0 0 - 2 5 0 0
C a s h i n f l o we n d o f t h e 6 2 5 0 9 1 5 0 2 9 0 0
I R R ( % ) 2 5 2 2 1 6
k
N P V 6 8 1 . 2 5 8 1 7 . 3 5
1 0
-
7/30/2019 Capital Exp Decisions1
10/24
Time Disparity Problem
C0 C1 C2 C3 N P V @ 9 % IR R
M - 1 6 8 0 1 4 0 0 7 0 0 4 0 0 3 0 1 2 3
N - 1 6 8 0 1 4 0 8 4 0 1 5 1 0 3 2 1 1 7
C a s h F l o w s ( R s .)
P r o j e c t
M N
Rs. Rs.
0 560 810
5 409 520
10 276 276
15 159 70
20 53 -106
25 -40 -25730 -125 -388
Discount rate %
NPV
-
7/30/2019 Capital Exp Decisions1
11/24
Unequal expected lives (Common TimeHorizon Approach)
Particular Project A Project B
Initial outlay(Rs.) 10000 20000
Year
1 8000 8000
2 7000 9000
3 Nil 7000
4 Nil 6000
Servicelife(years) 2 4
Requiredrateof return
CashInflowsafter taxes
10%
Year Cashflow(Rs.) PVfactor Total PV(Rs.)
0 -10000 1.000 -10000
1 8000 0.909 72722 7000 0.826 5782
3 -10000 0.826 -8260
3 8000 0.751 60084 7000 0.683 4781
NPV 5583
Year Cashflow(Rs.) PVfactor Total PV(Rs.)
0 -20000 1.000 -20000
1 8000 0.909 7272
2 9000 0.826 74343 7000 0.751 5257
4 6000 0.683 4098
NPV 4061
Project A
Project B
-
7/30/2019 Capital Exp Decisions1
12/24
Unequal expected lives (EquivalentAnnual Value/Cost Approach)
P r o j e c t Y e a r s C F A T ( R s )P V f a c t o r T o t a l P V ( R s )N P V ( R s )A 1 - 5 3 0 , 0 0 0 3 . 7 9 1 1 , 1 3 , 7 3 0 1 3 , 7 3 0
B 1 - 8 2 7 , 0 0 0 5 . 3 3 5 1 , 4 4 , 0 4 5 1 9 , 0 4 5
P r o j e c t N P V ( R s ) P V f a c t o r ( E A N P V ( R s )
A 1 3 , 7 3 0 3 . 7 9 1 3 6 2 1 . 7 4
B 1 9 , 0 4 5 5 . 3 3 5 3 5 6 9 . 8 2
D e t e r m in a t io n o f N P V o f P r o j e c t s A a n d B
D e t e r m in a t i o n o f E A N P V
E A N P V= N etpresent value of the project
PV of ann uity correspond ing to l ife of the project at g iven cost ocap ital
-
7/30/2019 Capital Exp Decisions1
13/24
Unequal expected lives (EquivalentAnnual Value/Cost Approach)
P V f a c t o r
M a c h i n e AM a c h i n e B M a c h i n e AM a c h i n e
0 ( I n i t i a l C o s t ) 5 0 , 0 0 0 6 5 , 0 0 0 1 5 0 , 0 0 0 6 5 , 0
( O p e r a t in g c o s t ) :1 - 6 y e a r s ( A ) 6 9 5 0 4 . 3 5 5 3 0 2 6 7 . 2 5
1 - 1 0 y e a r s ( B ) 5 7 0 0 6 . 1 4 5 3 5 0 2
8 0 2 6 7 . 2 5 1 0 0 0 2
L e s s : S a l v a g e v a l u e
6 t h y e a r ( A ) 2 0 0 0 0 . 5 6 4 1 1 2 81 0 t h y e a r ( B ) 5 0 0 0 0 . 3 8 6 1 9 3
P V o f t o t a l c o s t s 7 9 1 3 9 . 2 5 9 8 0 9
E A C 1 8 1 7 2 . 0 4 1 5 9 6 3
C o s t s ( R s ) A d j u s t e d P V ( R
E q u i v a l e n t A n n u a l C o s t s o f M a c h i n e s A a n d
P a r t i c u l a r s
-
7/30/2019 Capital Exp Decisions1
14/24
Profitability Index
o
PI = PV of cash inflowsInitial cash outlay
o Acceptance Rule PIn Accept PI > 1n Reject PI < 1n May accept PI = 1
o Evaluation of PI method
n
It recognizes the time value of moneyn It uses all cash flows occurring over the entire life of
the projectn It is a relative measure of a projects profitability
-
7/30/2019 Capital Exp Decisions1
15/24
Conflict in ranking
Y e a r P ro je c t A (R s )P ro jec t B (R
0 -5 0 ,0 0 0 -3 5 ,0 0 0
1 4 0 ,0 0 0 3 0 ,0 0 0
2 4 0 ,0 0 0 3 0 ,0 0 0
P V o f cash in f lo w ( 0 .10 ) 6 9 ,4 4 0 5 2 ,0 8 0
N P V 1 9 ,4 4 0 1 7 ,0 8 0
P I 1 .3 8 8 8 1 .4 8 8
-
7/30/2019 Capital Exp Decisions1
16/24
Capital Rationing
Project
Initial
Investment (Rs
crore) NPV ( Rs crore) PI
X 3 0.6 1.2
Y 2 0.5 1.25
Z 2.5 1.5 1.6
W 6 1.8 1.3
Project
n a
Investment (Rs
crore) NPV ( Rs crore) PIZ 2.5 1.5 1.6
W 6 1.8 1.3
Y 2 0.5 1.25X 3 0.6 1.2
-
7/30/2019 Capital Exp Decisions1
17/24
Payback Period
o
Payback Period (Constant annual cash inflows)Payback = Initial Investment
Annual Cash Inflow
o Acceptance Rule Payback Period
Accept Payback Period < Max. payback period set
Reject Payback Period > Max. payback period set
o Evaluation of Payback Period methodn Simple to understand, easy to calculate and focus on
riskn Fails to take account of the cash inflows earned after
payback periodP r o j e c t C0 C1 C2 C3 P a y b a c kN P V @
X - 4 0 0 0 0 4 0 0 0 2 0 0 0 2 y r s 8 0 6
Y - 4 0 0 0 2 0 0 0 2 0 0 0 0 2 y r s - 5 3 0
C a s h F l o w s ( R s )
-
7/30/2019 Capital Exp Decisions1
18/24
Payback Period
n
Fails to consider the pattern of cash flows i.e. magnitudeand timing of cash flows
n Administrative difficulties may be faced in determining
the maximum acceptable payback periodn Not consistent with the objective of maximizing the
market value of the firms share.
P r o j e c t C0 C1 C2 C3 P a y b a c kN P V @
X - 5 0 0 0 3 0 0 0 2 0 0 0 2 0 0 0 2 y r s 8 8 1Y - 5 0 0 0 2 0 0 0 3 0 0 0 2 0 0 0 2 y r s 7 9 8
C a s h F l o w s ( R s )
-
7/30/2019 Capital Exp Decisions1
19/24
Accounting Rate of Return
ARR = Average income
Average investment
P e r i o d 1 2 3 4 5 A v e r a g e (
E B D I T 1 0 0 0 0 1 2 0 0 0 1 4 0 0 0 1 6 0 0 0 2 0 0 0 0 1 4 4
L e s s : D e p r e c i a t io n 8 0 0 0 8 0 0 0 8 0 0 0 8 0 0 0 8 0 0 0 8 0 0
E B I T 2 0 0 0 4 0 0 0 6 0 0 0 8 0 0 0 1 2 0 0 0 6 4 0
T a x e s @ 5 0 % 1 0 0 0 2 0 0 0 3 0 0 0 4 0 0 0 6 0 0 0 3 2 0
E B IT ( 1 - T ) 1 0 0 0 2 0 0 0 3 0 0 0 4 0 0 0 6 0 0 0 3 2 0
B o o k v a l u e o f In v e s t m e n t
B e g i n n i n g 4 0 0 0 0 3 2 0 0 0 2 4 0 0 0 1 6 0 0 0 8 0 0 0
E n d i n g 3 2 0 0 0 2 4 0 0 0 1 6 0 0 0 8 0 0 0 0
A v e r a g e 3 6 0 0 0 2 8 0 0 0 2 0 0 0 0 1 2 0 0 0 4 0 0 0 2 0 0
A R R 0 .1 6
C a l c u l a t i o n o f A c c o u n t in g R a t e o f R e t u r n
-
7/30/2019 Capital Exp Decisions1
20/24
Accounting Rate of Return
o Acceptance Rule ARRAccept ARR >Min. rate set
Reject ARR< Min. rate set
o Evaluation of ARR methodn It is simple to understand and usen ARR can be readily calculated from the accounting
datan
It incorporates the entire stream of income in calculatingthe projects profitabilityn It uses accounting profits and not cash flowsn The averaging of income ignores the time value of
moneyn It uses an arbitrary cut-off yardstick
-
7/30/2019 Capital Exp Decisions1
21/24
Investment decisions under inflation
Discount nominal cash flows at nominal discount rate ordiscount real cash flows at real discount rate.
(1+Nominal rate) = (1+Real rate)(1+inflation rate)
C0 C1 C2 C3 C4
-100 00 300 0 300 0 3 00 0 30 00
N P V @ 1 4%
N P V @ 6 .5 4 %
C0 C1 C2 C3 C4
-100 00 321 0 3434 .7 36 75 .13 39 32 .39
N P V @ 1 4% 26 6
Rea l Cash F lows (Rs )
-1258
26 6
N om ina l Cas h F lows (Rs)
-
7/30/2019 Capital Exp Decisions1
22/24
Risk in Capital Budgeting
Initial Investment (Rs) 8,000 8,000 8,000 8,000 8,000
Life of the project (Years) 10 10 10 10 10
Discount Rate 15% 15% 15% 15% 15%
Operating Level (Nos) 3,000 3,000 3,000 3,000 3,000
Selling Price falls by 5% 10% 15% 20%
Selling Price (Rs) 3.2 3.04 2.88 2.72 2.56
Revenue 9,600 9,120 8,640 8,160 7,680Variable Cost 5,400 5,400 5,400 5,400 5,400
Contribution 4,200 3,720 3,240 2,760 2,280
Fixed Costs 1,200 1,200 1,200 1,200 1,200
Depreciation 1,200 1,200 1,200 1,200 1,200
PBIT 1,800 1,320 840 360 -120
Interest ---- ---- ---- ---- ----
PBT 1,800 1,320 840 360 -120
Tax @ 40% 720 528 336 144 -48PAT 1,080 792 504 216 -72
Cash flow from Operations 2,280 1,992 1,704 1,416 1,128
PV of Cash in flows 11,443 9,997 8,552 7,107 5,661
Net Present Value at 15% 3,443 1,997 552 -893 -2,339
% fall in NPV for 1% fall in selling price -8.40%
(Figure in Rs)
Sensitivity Analysis: Sensor Corporation
Sensitivity
all in NPV for 1% fall in selling price -289
-
7/30/2019 Capital Exp Decisions1
23/24
Risk in Capital Budgeting
Normal
Initial cost
increases
by 10%
Cost ofcapital
increases
by 10%
Variablecost
increases
by 10%
Fixed cost
increases
by 10%
Initial Investment (Rs) 8000 8800 8000 8000 8000
Life of the project (Years) 10 10 10 10 10
Discount Rate 15% 15% 16.50% 15% 15%
Operating Level (Nos) 3000 3000 3000 3000 3000
Selling Price (Rs) 3.2 3.2 3.2 3.2 3.2
Revenue 9600 9600 9600 9600 9600Variable Cost 5400 5400 5400 5940 5400
Contribution 4200 4200 4200 3660 4200
Fixed Costs 1200 1200 1200 1200 1320
Depreciation 1200 1320 1200 1200 1200
PBIT 1800 1680 1800 1260 1680
Interest
PBT 1800 1680 1800 1260 1680
Tax @40% 720 672 720 504 672
PAT 1080 1008 1080 756 1008Cash flow from Operations 2280 2328 2280 1956 2208
Net Present Value at 15% 3443 2884 2818 1817 3082
Change in NPV for 1%change
in variable -56 -63 -163 -36% fall in NPV for 1%fall in
selling price
-8.40% -1.62% -1.82% -4.78% -1.05%
Sensitivity
-
7/30/2019 Capital Exp Decisions1
24/24
Excellent Good Normal Bad Worst
Demand Level (no.s) 10% 5% 3000 -5% -10%
Selling Price (Rs./unit) 5% same 3.2 -5% -10%
Variable cost 10% same 5400 same 10%
Overheads 5% -5% 1200 10% 20%
Initial Investment (Rs) 8000 8000 8000 8000 8000
Life of the project (Years) 10 10 10 10 10
Discount Rate 15% 15% 15% 15% 15%
Scenario Excellent Good Normal Bad WorstOperating Level (Nos) 3300 3150 3000 2850 2700
Selling Price (Rs) 3.36 3.00 3.20 3.04 2.88
Revenue 11088 9450 9600 8664 7776
Variable Cost 5940 5400 5400 5400 5940
Contribution 5148 4050 4200 3264 1836
Fixed Costs 1260 1140 1200 1320 1440
Depreciation 1200 1200 1200 1200 1200
PBIT 2688 1710 1800 744 -804
Interest 0 0 0 0 0
PBT 2688 1710 1800 744 -804Tax @40% 1075.2 684 720 297.6 -321.6
PAT 1612.8 1026 1080 446.4 -482.4
Cash flowfromOperations 2812.8 2226 2280 1646.4 717.6
Present Value of Cash in flows 14117 11172 11443 8263 3601
Net Present Value 6117 3172 3443 263 -4399
Probability (%) 15% 20% 30% 20% 15%
Expected NPV
Standard Deviaion of NPV
Coefficient of Variation
1978
1607
0.81
Scenario Analysis: Sensonr Corporation
Risk in Capital Budgeting