Capital budgeting –

In simple terms capital budgeting means evaluation of capital expenditure.

So now we need to understand two things –

1. What do we mean by evaluation – Evaluation means assessment , comparison of

the available options to choose the best one.

2. What do we mean by capital expenditure - Capital expenditure is incurred

when a business spends money either to buy fixed assets or to add to the value
of an existing fixed asset with a useful life that extends beyond one year.

Some features of capital

expenditures –
- long term consequences
-difficult to reverse
- substantial outlays
- affects the risk of the firm
- effect on growth
-complex decisions
Process of Capital Budgeting

Identify the
•Market Environment
investment •SWOT
opportunity

•Replacement and Modernization

Assemble the
•Expansion and Diversification
proposed investment •New product decision

Make the decision •By using different methods

Implementation

Performance review
 Methods for capital budgeting
decision making

Non discounted
Discounted

1. Payback
Period 1. Net Present
2. Average Value
Accounting 2.IRR
rate of return
3.PI
(ARR)
4.Discounted
payback period
Components for an investment plan –

1. Initial outflows – cash outflow purchase of the plant , machinery and fixed
assets (remember to consider the disposal proceeds of the old asset , if any)

2. Operational flows – cash inflows during the operational phase of the project
(consider tax shields , ignore depreciation)

3. Terminal flows – Post tax salvage value of the asset

Types of Investment decisions-

1. Mutually exclusive - A or B – USE CAPITAL RATIONING
2. Independent – A and B depending on funds
3. Contingent – If A , B is mandatory

To understand the above points better

lets analyze some investment decisions
Payback Period

In simple terms it represents the time frame for the stream of cash proceeds
generated by the investment to be equal to the original investment

Example 1

Should I accept
this investment ?
– Answers
depends upon
the threshold the
org has set up
Accounting rate of return (ARR)
•Also known as return on investment
• ARR = Average income / Average investment

We would like to buy a machine for a hospital

Investment in the required machine – 500,000 $
Life of the machine – 5 years
By SLM of depreciation the machine will get depreciated over 5 years
by 500,000 / 5 = 100,000 $ p.a.
Revenue generation and related calculation follows -
Years 1 2 3 4 5
Revenue 433,333 450,000 266,667 200,000 133,333
Expenses 200,000 150,000 100,000 100,000 100,000
Earnings 233,333 300,000 166,667 100,000 33,333
before dep
Depreciatio 100,000 100,000 100,000 100,000 100,000
n
Earnings 133,333 200,000 66,667 0 - 16,667
before taxes
Taxes @ 25 33,333 50,000 16,667 0 -16,667
%
Net Income 100,000 150,000 50,000 0 -50,000

Average net income = 100,000 + 150,000 + 50,000 +0 + (50,000) / 5 =

50,000

Average book value = 500,000 + 0 / 2 = 250,000

AAR = 50,000 / 250,000 = 20%

Net Present value

Sum of present values of all cashflows

All cashflows means PV (cash outflows ) + PV (cash inflows)

Example –

Consider the following cash flow stream for a project and calculate its
NPV with a discount rate of 10 %
If... It means... Then...

NPV the investment would

the project may be accepted
Year Cash >0 add value to the firm
Flow the investment would
NPV
0 (100,000) <0
subtract value from the the project should be rejected
firm
1 200,000
We should be indifferent in the
2 200,000 decision whether to accept or reject
the project. This project adds no
3 300,000 NPV
the investment would
monetary value. Decision should be
neither gain nor lose
4 300,000 =0 based on other criteria, e.g. strategic
value for the firm
positioning or other factors not
5 350,000 explicitly included in the
calculation.
Year 0 1 2 3 4 5

Cash (1,000,000) 200,000 200,000 300,000 300,000 350,000

flow

Discount NA 0.9091 0.8264 0.7513 0.6830 0.6209

factor @
10 % p.a.
PV (cash (1,000,000) 181,820 165,280 225,390 204,900 217,315
flow *
discount
factor)

Summation of the PV = NPV = -

1000000+181820+165280+225390+204900+217315 = -5295

As NPV is –ve reject the project

(NPV and discount rate are inversely proportional)

Internal rate of Return

IRR is the discount rate at which NPV = 0

IRR involves a
Year Cash trial and error
Flow basis calculation
0 (100,000)
1 30,000
Consider two
2 30,000
discount rates
3 40,000
4 45,000

15 % p.a 16% p.a

PV of inflows PV of inflows =
=100,802 98,641

PV of inflows > 100,000 so I

would have to increase my
discount factor
So now we have the equation as follows –

Required PV of inflows = PV of outflows = (100,000)

PV of inflows at 15 % = 100,802
PV of inflows at 16 % = 98,641

100,000 lies between 100,802 and 98,641

Hence the discount rate or the IRR is as follows

L = Lower discount rate
PVB(L) , PVB (U) – present value benefits at lower and upper discount rates
I = Initial investment
U = upper discount rate

Hence the value of r is

R=L+ PVB(L) – I * (U-L) = 15 % + (100,802 – 100,000) * (16% - 15%)

PVB(L)-PVB(U) 100,802-98,641

=15 % + 802/2161 * 1 % = 15.37 %

PI = Profitability Index

The ratio of present value of cash flows to the initial outlays

PI = PV of annual cash flows / Initial Investment

Acceptance rules
- Accept if PI > 1
- Accept if PI < 1
- May be accepted if PI =1
Some different concepts

Conventional Investment – Cash flows - -,+,+,+

Non-Conventional Investment – Cash flows - -,+,+,-,-,++-,+ - Problem of multiple

IRR occurs due to algebraic equation we use for solving – we would solve a
problem in class to understand it (textbook page 173)

a2
At r2 NPV =0 So r2=IRR
At r3 NPV will be –ve
At r1 NPV will be +ve
NPV

Acceptance / Rejection
a1 of independent
conventional
IRR investments – NPV And
IRR yield the same
result
r1 r2 r3
a3 Discount Rate
Fischer’s intersection – Discount rate at which NPVs of two projects are equal

Project Cash Cash Cash Cash NPV at IRR

flow (0) flow (1) flow (2) flow (3) 9%
M -1680 1400 700 140 301 23%
N -1680 140 840 1510 321 17%

The NPV and IRR of these projects is conflicting …..the question is WHY ? –
TIMING OF CASH FLOWS – NPV would be a better choice
Project M – Largest cash flows early when compounding effect is not so severe
Project N – Largest cash flows late when compounding effect is severe

NPV Profiles of Projects Fischer's intersection - NPV versus

IRR
1000
Discount rate Project M Project N 800
600
0 560 810 400
NPV

5 409 520 200

0
10 276 276 -200
-400
15 159 70
-600
0 5 10 15 20 25 30
20 54 -106 Project M 560 409 276 159 54 -40 -125
25 -40 -257 Project N 810 520 276 70 -106 -257 -388

30 -125 -388
Under what conditions can NPV or IRR give conflicting results –

1. Timing of cash flow

2. Cash outflows

3. Project life span

Modified internal rate of return - As the name implies, MIRR is a modification of
(IRR) and as such aims to resolve some problems with the IRR.

Problems with the IRR

MIRR resolves two problems arising with IRR
First, IRR assumes that interim positive cash flows are reinvested at the same rate
of return as that of the project that generated them. This is usually an unrealistic
scenario and a more likely situation is that the funds will be reinvested at a rate
closer to the firm's cost of capital. The IRR therefore often gives an unduly
optimistic picture of the projects under study. Generally for comparing projects
more fairly, the WACC should be used for reinvesting the interim cash flows.
Second, more than one IRR can be found for projects with alternating positive and
negative cash flows, which leads to confusion and ambiguity. (Remember the
problem we solved in the classroom) MIRR finds only one value.

Calculation
MIRR is calculated as follows:
where n is the number of equal periods at the end of which the cash flows occur
(not the number of cash flows), PV is present value (at the beginning of the first
period), FV is future value (at the end of the last period). The formula adds up the
negative cash flows after discounting them to time zero, adds up the positive cash
flows after factoring in the proceeds of reinvestment at the final period, then
works out what rate of return would equate the discounted negative cash flows at
time zero to the future value of the positive cash flows at the final time period.
For example, say a two-year project with an initial outlay of $195 and a cost of capital
of 12%, will return $121 in the first year and $131 in the second year. To find the IRR
of the project so that the net present value (NPV) = 0:

NPV = 0 = -195 + 121/(1+ IRR) + 131/(1 + IRR)2 NPV = 0 when IRR = 18.66%

To calculate the MIRR of the project, we have to assume that the positive cash flows
will be reinvested at the 12% cost of capital. So the future value of the positive cash
flows is computed as:

$121(1.12) + $131 = $266.52 = Future Value of positive cash flows at t = 2

Now you divide the future value of the cash flows by the present value of the initial
outlay, which was $195, and find the geometric return for 2 periods.

=sqrt($266.52/195) -1 = 16.91% MIRR

You can see here that the 16.91% MIRR is materially lower than the IRR of 18.66%. In
this case, the IRR gives a too optimistic picture of the potential of the project, while
the MIRR gives a more realistic evaluation of the project.
 Advantages Disadvantages
Payback Period 1. Simple 1. Ignores time value of
2. Weeds out risky projects money
(initial cash flows imp) 2. Ignores cash flows after the
3. Good for Co. having a payback period
liquidity crunch
Accounting rate of return 1. Easy to calculate 1. Ignores time value of
2. Needed information easily money
available as it is accounting 2. Arbitrary cut off rate
data
Net Present Value 1. Considers all cash flows 1. Cash flow estimation is
2. Considers time value of tedious
money 2. Opportunity cost of capital
3. Value –additivity principle computation is difficult
is satisfied (NPV’s can be 3. Sensitive to discount rate
added for one or more used
projects)
4. Consistent with the wealth
maximization project
IRR (Internal rate of return) 1. Considers all cash flows 1. Cash flow estimation is
2. Considers time value of tedious
money 2. No value additivity
3. Consistent with wealth 3. Relatively difficult to
maximization principle compute
Profitability Index (PI) 1. Considers all cash flows 1. Cash flows estimation is
2. Considers time value of tedious
money
3. Consistent with wealth
Risk analysis in capital budgeting Required formulae –
•Expected value of cash
Risk - inability of perfect forecasts flow = Summation
(Probability * Cash flow)
Categories influencing forecasts
•Standard deviation =
• General economic conditions Summation ((Cash flow
•Industry factors –Expected cash flow)2 *
•Company factors probability))
Techniques for analysis risk – •Coefficient of variation =
Probability Defined Standard deviation /
Standard deviation / Co-efficient of variation - riskier Expected value
Payback
Risk adjusted Discount rate •Alpha = Certain cash
Certainty equivalent – lower alpha when greater risk flow / Risky cash flow and
Sensitivity analysis – impact due to change in variables then while calculating the
Scenario analysis – Pessimistic/ Optimistic/Expected NPV multiply the net cash
Simulation – probability distribution of NPV flow with alpha to arrive
Decision tree at the cash flows that then
would be discounted
Utility theory
An investor prefers a higher return to a lower return and each successive identical
increment of money is worthless to him than the preceding one