1 - Cap Budgeting Upload

11/24/2020
“In a market-based economy that recognizes the rights of private

property, the only social responsibility of business is to create
shareholder value and to do so legally and with integrity.
Corporate Finance
“…It would be a profound error to view increases in a
L Ramprasath company's value as concern just for the shareholders. Enlightened
managers and public officials recognize that increases in stock
prices reflect improvement in competitiveness - an issue that
affects everyone with a stake in the company - or the economy.
1 2
It would not be wrong to say that the goal of Financial So how do you reconcile the above?
management is to Maximize shareholder wealth.
Only by focusing on creating value for its shareholders can a
Are we overlooking firm ensure that it has durable and mutually beneficial
Customers? relationships with their customers, employees and suppliers.
Employees?
Suppliers?
3 4
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With this understanding of the goal of FM, let’s look at the Why is the process of allocating or budgeting capital the most
first main concern of a firm. important issue in Corporate Finance?
How do you select projects? What investments should you
make? “Airlines, for example, are airlines because they operate
airplanes, regardless of how they finance them”
How do firms create value for its shareholders?
5 6
You are managing a firm in the agri sector. Suppose you get a
business proposal for producing and selling organic fertilizers.
What is the real challenge?
Is this a good investment?
Cash revenues: 20 lakhs p.a.
Net Present Value (NPV) of an investment is the difference
Cash costs: 14 lakhs p.a.
between the investment’s market value and its costs.
Life of the business: 8 yrs with salvage value of 2 lakhs
Set-up costs: 30 lakhs
How is it implemented in practice?
We will use a 15% discount rate on projects like this one.
Capital budgeting becomes more difficult when we cannot

observe the market price of comparable investments. If there are 1 lakh shares of stock outstanding, what will be
the effect on the price per share from taking the investment?
7 8
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Another popular method: How long does it take the project Despite its shortcomings, Payback period rule is often used
to “pay back” its initial investment? by large companies for making relatively minor decisions.
Year A B C D E Many decisions do not warrant detailed analysis

0 -100 -200 -200 -200 -50
Small investment decisions are made by the hundreds every day
1 30 40 40 100 100 in large organizations at all levels.
2 40 20 20 100 -50,000 Require a PB of 2 yr or less for all investments < 25,000.
3 50 10 10 -200 Investments higher than this will be subject to greater
4 60 130 200 scrutiny.
(figures in ₹ ‘000s)
9 10
Internal Rate of Return – IRR
With the IRR, we find a single rate of return that summarizes IRR: the discount rate that sets NPV to zero
the merits of a project.
And more importantly, this rate is internal ! IRR rule: Accept if the IRR exceeds the required return
Why is this important?

Many a times there are heated debates on what should be the
correct discount (risk-adjusted) rate?
11 12
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Suppose we have a mining project that requires a 60ℓ Two investments, X and Y, are said to be mutually exclusive if
investment. CFs in the first year will be 155ℓ and in the taking one of them means we cannot take the other.
second year, you incur a cost of 100ℓ in order to reclaim the What should be the acceptance rule?
land as part of environment regulations.
Is this a value creating project, worth taking up?
Independent Projects: accepting or rejecting one project does
not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria
13 14
Modified IRR
Consider this situation To address the multiple IRR problem, a modified version is
sometimes used.
Year A B Recall the mining e.g.
0 -100 -100
1 50 20
2 40 40
3 40 50
4 30 60
15 16
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Capital budgeting in reality
Cost benefit ratio (also known as Profitability Index) Which criterion do mangers use?
The most frequently used technique for large corporations is
An extension of mutually exclusive investments: Capital either IRR or NPV
rationing. Varies with industry
17 18
Try this
Problems 11, 12, 13 and 25
19

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11/24/2020

“In a market-based economy that recognizes the rights of private

How do firms create value for its shareholders?

Capital budgeting becomes more difficult when we cannot

Year A B C D E Many decisions do not warrant detailed analysis

Internal Rate of Return – IRR

Why is this important?

Capital budgeting in reality

Problems 11, 12, 13 and 25

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