CAPITAL BUDGETING DMH 1 Introduction The most widely
CAPITAL BUDGETING DMH 1
Introduction…. The most widely accepted objective of the firm is to maximize the value of the firm. The financial management is largely concerned with investment, financing and dividend decision of the firm. The relationship between firm’s overall goal, financial management and capital budgeting is depicted in figure- DMH 2
Position of capital budgeting Financial goal of the firm: Wealth maximization Investment Decision Long term asset Short term asset Financing Decision Dividend Decision Debt equity mix Dividend pay out ratio Capital Budgeting DMH 3
Funds are invested in both short-term and Long-term asset. Capital budgeting is primarily concerned with investment in long-term assets. Capital budgeting decision thus have a long range impact on the firm’s performance and they are critical to the firm’s success or failure. DMH 4
Capital Budgeting: q Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. q. Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization. DMH 5
Capital Budgeting Techniques A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization. A technique is considered consistent with wealth maximization if It is based on cash flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects The over-riding rule of capital budgeting is to accept all projects for which the cost is less than, or equal to, the benefit: Accept if: Cost £ Benefit Reject if: Cost > Benefit DMH 6
What is the difference between independent and mutually exclusive projects? Independent projects – if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other. DMH 7
Capital Budgeting techniques Discounted Cash Flow Criteria Net Present Value Internal Rate of Return Profitability Index Discounted Payback Period Non discounted Cash Flow Criteria Payback period Accounting Rate of Return DMH 8
What is the payback period? The number of years required to recover a project’s cost, or “How long does it take to get our money back? ” Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive. DMH 9
Calculating payback 0 Project L CFt Cumulative Payback. L -100 ==2 Payback. S 30 / 1 -100 DMH 60 + ==1 2 10 -90 0 Project S CFt Cumulative 1 70 + 100 -30 0 30 / 3 80 50 80= 2. 375 years 1. 6 100 -30 0 2. 4 3 2 50 20 20 40 50= 1. 6 years 10
Strengths and weaknesses of payback Strengths Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses Ignores the time value of money. Ignores CFs occurring after the payback period. DMH 11
Discounted payback period ØThe discounted payback period is exactly the same as the regular payback period, except that we use the present values of the cash flows in the calculation ØDiscounted payback period is always longer than the regular payback period ØDecision Rule - Accept the project if it pays back on a discounted basis within the specified time DMH 12
Discounted payback period Uses discounted cash flows rather than raw CFs. 0 10% 1 CFt -100 10 PV of CFt Cumulative -100 9. 09 -90. 91 Disc Payback. L == 2 DMH + 41. 32/ 2 60 49. 59 -41. 32 2. 7 3 80 60. 11 18. 79 60. 11= 2. 7 years 13
Net Present Value (NPV) Sum of the PVs of all cash inflows and outflows of a project: DMH 14
What is Project L’s NPV? Year 0 1 2 3 CFt -100 10 60 80 NPVL = PV of CFt -$100 9. 09 49. 59 60. 11 $18. 79 NPVS = $19. 98 DMH 15
Rationale for the NPV method NPV = PV of inflows – Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. DMH 16
Merits and demerits of NPV Merits: 1. Considers all cash flows 2. True measure of profitability 3. Based on the concept of the time value of money. 4. Consistent with wealth maximization principle. Demerits: 1. Requires estimates of cash flows which is a tedious task. 2. Requires computation of opportunity cost of capital which poses practical difficulties. DMH 17
Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. CF 1 PI = (1+k)1 CF 2 + (1+k)2 CFn +. . . + (1+k)n ICO << OR >> PI = 1 + [ NPV / ICO ] DMH 18
Benefit Cost Ratio (BCR) Define the relationship between benefits & costs Benefit Cost Ratio: BCR = Net Benefit Cost Ratio: NBCR = = BCR-1 Where, PVB= present value of benefits I= initial investment (cost) Let consider a project of X company which has a cost of capital of 12 percent. Initial investment: Benefits: DMH Year 1 Year 2 Year 3 Year 4 Rs 1, 000 25, 000 40, 000 50, 000 19
The benefit cost ratio measures for this project are: BCR= NBCR= BCR -1= 0. 14 Decision rules When BCR or NBCR >1 >0 =1 =0 <1 <0 BCR=1. 145 >1 NBCR=0. 145 >0 DMH Rule is Accept Indifferent Reject ACCEPT 20
Evaluation q. When capital budget is limited in the current period, the benefit cost ratio criterion may rank projects correctly in the order of decreasingly efficient use of capital q. When cash outflows occurred beyond the current period the benefit cost ratio criterion is unsuitable as a selection criterion. DMH 21
Profitability Index Merits: 1. Considers all cash flows 2. Recognizes the time value of money 3. Generally consistent with the wealth maximization principle. Demerits: 1. Requires estimates of the cash flows which is a tedious task 2. At times fails to correct choice between mutually exclusive projects. DMH 22
Accounting Rate of Return (ARR) The accounting rate of return uses accounting information as revealed by the financial statements, to measure the profitability of an investment. The accounting rate of return is found out by dividing the average after tax profit by the average investment. ARR= (Average income/ Average investment) Decision: Accept if ARR> minimum rate Reject if ARR< minimum rate DMH 23
Computing AAR for the Project Assume we require an average accounting return of 25% Average Net Income: (13, 620 + 3, 300 + 29, 100) / 3 = 15, 340 AAR = 15, 340 / 72, 000 =. 213 = 21. 3% Reject the project DMH 24
Merits and Demerits of ARR Merits: 1. Uses accounting data with which executives are familiar. 2. Easy to understand calculate. Demerits: 1. Ignores the time value of money 2. Does not use cash flows 3. No objective way to determine the minimum acceptable rate of return. DMH 25
Internal Rate of Return (IRR) The rate at which the NPV of cash flows of a project is zero, i. e. , the rate at which the present value of cash inflows equals initial investment Consistent with wealth maximizations. Accept a project if IRR > Cost of Capital DMH 26
Internal Rate of Return (IRR) IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0: DMH 27
How is a project’s IRR similar to a bond’s YTM? They are the same thing. Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project. EXAMPLE: Suppose a 10 -year bond with a 9% annual coupon sells for $1, 134. 20. Solve for IRR = YTM = 7. 08%, the annual return for this project/bond. DMH 28
Rationale for the IRR method If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns. DMH 29
IRR Acceptance Criteria If IRR > k, accept project. If IRR < k, reject project. If projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept S, because IRRs > IRRL. DMH 30
Merits and Demerits Considers all cash flows True measure of profitability Based on the concept of time value of money. Generally consistent with wealth maximization principle. Demerits: Requires estimates of cash flows which is tedious task. At times fails to indicate correct choice between mutually exclusive projects. At times yields multiple rates. Relatively difficult to compute. DMH 31
NPV and IRR will generally give us the same decision. Whenever there is a conflict between NPV and IRR, NPV should always be used. NPV directly measures the increase in value to the firm NPV deals with cost of capital where as IRR deals with rate of return. IRR method assumes the cash flows from the project are reinvested at a rate of return equal to IRR, which we generally view as unrealistic. DMH 32
MIRR (Modified Internal Rate of Return) MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. MIRR assumes cash flows are reinvested at the WACC. DMH 33
Calculating MIRR 0 1 10% -100. 0 2 10. 0 60. 0 3 10% MIRR = 16. 5% -100. 0 $100 PV outflows = $158. 1 (1 + MIRRL)3 80. 0 66. 0 12. 1 158. 1 TV inflows MIRRL = 16. 5% DMH 34
MIRR……. IRR method assumes the cash flows from the project are reinvested at a rate of return equal to IRR, which we generally view as unrealistic. Ø While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that all cash flows are reinvested at the firm's cost of capital. Therefore, MIRR more accurately reflects the profitability of a project. Managers like rate of return comparisons, and MIRR is better for this than IRR. Ø This is preferable because: Ø Any series of cash flows has a single MIRR. Ø It takes account of the rate at which cash generated is re. DMH 35
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