Capital Budgeting

& Analysis - Demo

Presentation by Amlan Biswas

Details to be studied from book (Chap-11)

Agenda

• Concept & Overview

• Evaluation Principles & Methods

Details to be studied from book (Chap-11)

 Capital Budgeting
• Capital budgeting (or investment appraisal) is the process of determining the viability to long-term
investments on purchase or replacement of property; plant & equipment; introducing new product line;
or other projects.

• Capital budgets are a way to assess the plan for fixed asset sales and purchases.

• Essentially it’s a tool for the management team to identify what capital projects will create the biggest
return compared with the funds invested in the project.

• Capital budgeting process helps the management arrive at difficult decisions like investing in fixed assets
which are capital intensive. The eternal question is : will they give the proper Return-on-Investment ?

• Each project is ranked by its potential future return, so the company management can choose which one
to invest in first.

• Usually these budgets help management analyze different long-term strategies that the company can
take to achieve its expansion goals.
Details to be studied from book (Chap-11)
Evaluation: Principles and Methods
• Capital budgeting consists of various techniques used by managers
• Different methods of evaluation and decision rules are used such as:
• Normal Methods of Evaluation
• Accounting Rate of Return
• Payback Period
• Time-Value Methods of Evaluation
• Discounted Payback Period
• Net Present Value
• Internal Rate of Return
• Profitability Index
• The above discounting techniques are based on the comparison of cash inflows and
outflow of a project; however they are substantially different in their approach.
Details to be studied from book (Chap-11)
 Brief Introduction to the Evaluation Methods
• Accounting Rate of Return (ARR) is the profitability of the project calculated as
projected total net income divided by initial or average investment. Net income is not discounted.

• Payback Period measures the time in which the initial cash flow is returned by the project.
Cash flows are not discounted. Lower payback period is preferred.

• Net Present Value (NPV) is equal to initial cash outflow less sum of discounted cash
inflows. Higher NPV is preferred and an investment is only viable if its NPV is positive.

• Internal Rate of Return (IRR) is the discount rate at which net present value of the
project becomes zero. Higher IRR should be preferred.

• Profitability Index (PI) is the ratio of present value of future cash flows of a project to
initial investment required for the project.
Details to be studied from book (Chap-11)
Accounting Rate of Return
• Earnings (after depreciation and tax) (PAT) from a project expressed as a percentage of the
investment outlay.

• The calculation involves:

– Estimating the average annual earnings to be generated by the project.
– Investment outlay (initial or average).

• Fundamental problems of ARR in project evaluation:

> Arbitrary measure — based on accounting profit as opposed to cash flows;

dependency on some accounting decisions such as treatment of inventory & depreciation.
> Ignores timing of the earnings stream — no time value of money concepts are
applied, as equal weight is given to accounting profits in each year of the project’s life.
Details to be studied from book (Chap-11)
Payback Period
• This concept highlights the Time required to recover the Investment of the Capital
• The time it takes for the initial cash outlay on a project to be recovered from the project’s
after-tax net cash flows.

Illustrative Example –
Assuming cash flow occurring throughout year; the payback period of the project:
Project cost: (–) 9000
Net Cash Flow Year 1: +5090
Balance Cost 3910
Net Cash Flow Year 2: +4500
Recovery of Capital Cost 3910/4500 = 0.87,

So it takes 1.87 years for the project to recover its initial cost.
Details to be studied from book (Chap-11)
Payback Period (cont.)

• Strengths:
– It is a simple method to apply.
– It identifies how long funds are committed to a project.

• Weaknesses:
– Inferior to discounted cash flow techniques because it fails to account for the
magnitude and timing of all the project’s cash flows.
– Does not consider how profitable a project will be, just highlights how quickly outlay
will be recovered

Details to be studied from book (Chap-11)

Discounted Pay-Back Period
• The major disadvantages of simple payback period is that it ignores the time value of money.
• To counter this limitation, an alternative procedure called discounted payback period may
be followed,
• It accounts for time-value-of- money by discounting the cash inflows of the project.

Formulas and Calculation Procedure

• In discounted payback period we have to calculate the present value of each cash inflow
• The rest of the procedure is similar to the calculation of simple payback period
• The cumulative cash flows are replaced by cumulative discounted cash flow.

Details to be studied from book (Chap-11)

DPB - Illustrative Example
An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years.
Calculate the discounted payback period of the investment if the discount rate is 11%.

Solution
Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash
flows by present value factor. Create a cumulative discounted cash flow column.

Step 2: Discounted Payback Period = 5 + |-106,462| / 320,785 ≈ 5.32 years

Year Cash Flow Present Value Factor Discounted Cash Flow Cumulative Discounted
n
n CF PV$1=1/(1+i) CF×PV$1 Cash Flow
0 $ −2,324,000 1 $ −2,324,000 $ −2,324,000
1 6,00,000 0.9009 5,40,541 − 1,783,459
2 6,00,000 0.8116 4,86,973 − 1,296,486
3 6,00,000 0.7312 4,38,715 − 857,771
4 6,00,000 0.6587 3,95,239 − 462,533
5 6,00,000 0.5935 3,56,071 − 106,462
6 studied from
Details to be 6,00,000
book (Chap-11) 0.5346 3,20,785 2,14,323
Net Present Value (NPV)
• NPV is the difference between the PV of the net cash flows (NCF) from a Capital investment
and the initial investment outlay, discounted at the required rate of return.

• Measuring a project’s net cash flows:

– Forecast expected net profit from project.
– Estimate net cash flows directly.

• The standard NPV formula is given by:

where:
C0= initial cash outlay on project
Ct = net cash flow generated by project at time t
n= life of the project
k= required rate of return
Details to be studied from book (Chap-11)
NPV Example
• Investment of $9000.
– Net cash flows of $5090, $4500 and $4000 at the end of years 1, 2 and 3 respectively.
– Assume required rate of return is 10% p.a.
– What is the NPV of the project?

Solution:
• Apply the NPV formula

• Thus, using a discount rate of 10%, the project’s NPV = +$2351 > 0, and is therefore acceptable.
Details to be studied from book (Chap-11)
Evaluation of NPV
• NPV method is consistent with the company’s objective of maximising
shareholders’ wealth.
– A project with a positive NPV will leave the company better off than before-the-project and,
other things being equal,
- the market value of the company’s shares should increase.

• Decision rule for NPV method:

– Accept a project if its NPV is positive when the project’s NCFs are discounted at the required
rate of return.

Details to be studied from book (Chap-11)

Internal Rate of Return (IRR)
• The internal rate of return (IRR) is the discount rate that equates the PV of a project’s net cash flows
with its initial cash outlay.
– IRR is the discount rate (or rate of return) at which the net present value is zero.
• The IRR is compared to the required rate of return (k).
• If IRR > k, the project should be accepted.

• Computation :- By setting the NPV formula to zero and treating the rate of return as the unknown, the
IRR is given by:

where:
C0= initial cash outlay on project
Ct = net cash flow generated by project at time t
n= life of the project
k= required rate of return
Details to be studied from book (Chap-11)
EXCEL WORKSHOP

YEAR
Project 0 1 2 3 4 5 6 IRR (%) NPV
A -250 100 100 75 75 50 25 ?? ??
B -250 50 50 75 100 100 125 ?? ??

* Discounting Rate for NPV 9.25%

Details to be studied from book (Chap-11)

IRR – Manual Calculation
Formula
Internal Rate of Return = R1 + [(NPV1 x (R2 - R1)) / (NPV1 - NPV2)]
Where:
R1 = Lower discount rate
R2 = Higher discount rate
NPV1 = Higher Net Present Value (derived from R1)
NPV2 = Lower Net Present Value (derived from R2)

Example
Mr. A is considering investing $250,000 in a business. The cost of capital for the investment is 13%.

Following cash flows are expected from the investment:

Year $
0 (250,000)
1 50,000
2 100,000
3 200,000
Calculate
Details thefrom
to be studied IRRbook
for(Chap-11)
the proposed investment and interpret your answer.
Details to be studied from book (Chap-11)
 IRR – Advantages & Limitations
Advantages
•IRR is expressed in percentage terms which is often easier to understand for people from non-
financial background;
•Helps in the assessment of sensitivity of an investment towards changes in cost of capital.

Limitations
•May not lead to the optimum decision where multiple investment options are being considered (e.g.
investment with the highest IRR is selected instead of investment that will generate the highest net
present value). NPV analysis remains the most effective investment appraisal tool in this regard.
•Multiple IRRs can exist for the same investment where the timing of cash outflows is unusual.
Interpreting IRR can be tricky in such scenarios.
•The calculation of IRR assumes that the cash inflows earned during the project life are 're-invested'
at the rate of the IRR. As the rate of IRR is usually higher than the cost of capital, some financial
experts argue that a more prudent assumption would be to re-invest the cash inflows at the rate of the
cost of capital. This forms the basis for the development of Modified Internal Rate of Return (MIRR).
Details to be studied from book (Chap-11)
Benefit-Cost Ratio (Profitability Index)
• The profitability index is calculated by dividing the present value of the future net

cash flows by the initial cash outlay:

Benefit Cost Ratio =

• Decision rule:

– Accept if benefit–cost ratio > 1

– Reject if benefit–cost ratio < 1

Details to be studied from book (Chap-11)

 Thank You

Details to be studied from book (Chap-11)