Prep

Session 2
Capital
Budgeting
Time Value of
Money
▶ A dollar today is worth more than a dollar tomorrow

▶ The same amount of money becomes less valuable as time passes due to –

▪ Opportunity Cost (Potential of Earning Positive Returns)

▪ Inflation
 ▪ Uncertainty

▶ Factors affecting the erosion of value due to time –

▪ Interest Rate

▪ Time Period

Time Value of
Money FV = PV x [ 1 + (i / n) ] (n x t) Here,
▪ FV = Future Value

▪ PV = Present Value

▪ n = Number of compounding periods per year

▪ t = Number of years

▶ Compounding – Calculating FV from a given PV

▶ Discounting – Calculating PV from a given FV

▶ TVM is used extensively in Loan Amortization, Capital Budgeting,

 Valuation Methodologies, Trading, etc.
▶ Common Variations used – Annuity, Continuous Compounding

TVM Examples

▶ Assume a sum of $10,000 is invested for one year at 10% interest

compounded annually. The future value of that money is:
FV = 10,000* (1+10%) = $11,000
• Quarterly Compounding: FV = $10,000 x [1 + (10% / 4)] ^ (4 x 1) = $11,038 •
Monthly Compounding: FV = $10,000 x [1 + (10% / 12)] ^ (12 x 1) = $11,047 •
Daily Compounding: FV = $10,000 x [1 + (1g0% / 365)] ^ (365 x 1) = $11,052

▶ Present Value of sum compounded annually at 7% interest that would

be worth $5,000 one year from today is:
PV = $5,000 / (1 + 7%) = $4,673
Capital Budgeting
 ▶ Capital budgeting refers to the decision-making process that companies follow
with regard to which capital-intensive projects they should pursue.

▶ Such capital-intensive projects could be anything from opening a new factory to a

significant workforce expansion, entering a new market, or the research and
development of new products.

▶ Capital budgeting decisions are based on incremental after-tax cash flows

discounted at the opportunity cost of capital.

Some important concepts

▶ Incremental cash flow is the net cash flow attributable to an investment project. It represents
the change in the firm's total cash flow that occurs as a direct result of accepting the project

▶ A sunk cost is a cost that has already occurred and cannot be recovered by any means. Sunk costs
are independent of any event and should not be considered when
making investment or project decisions. Only relevant costs (costs that relate to a specific
decision and will change depending on that decision) should be considered when making such
decisions
 ▶ Independent versus mutually exclusive projects - Mutually exclusive are investments that
compete in some way for a company's resources - a firm can select one or another but not
both. Independent projects, on the other hand, do not compete with the firm's resources. A
company can select one or the other or both, so long as minimum profitability thresholds are
met.

Net Present
Value
▶ This method discounts all cash flows (including both inflows and outflows) at the
project's cost of capital and then sums those cash flows. The project is accepted if
the NPV is positive.

σ
▶ NPV = ������
(1+��)^��

Where CFt is the expected cash flow at period t, k is the project's cost of
capital

▶ Decision rules

1. The higher the NPV, the better.

2. Reject if NPV is less than or equal to 0
Illustration Cashflows (CFt)

Year (t) Project A Project B 0 -5,000 -5,000 1 750 500 2

2000 1500 3 2000 2000 4 2500 3000

▶ Assuming the cost of capital for the firm is 10%, calculate each cash flow by
dividing the cash flow by (1 + k)^t where k is the cost of capital and t is the year
number.
Calculate the NPV for Project A and B above.
▶ NPV = CF0 + CF1 + CF2 + CF3 + CF4

▶ Project A's NPV = −5,000 +750 +2000 +2000 +2500 = $549 1.1
1.121.131.14

▶ Project B's NPV = −5,000 +500 +1500 +2000 +3000 = $246 1.1
1.121.131.14

Internal Rate of
Return (IRR)
▶ It is the discount rate at which a project's NPV is equal to
zero.
 ������
σ =0
▶ NPV = (1+������)^��

▶ Note this formula is simply the NPV formula solved for the particular discount rate
that results in NPV to equal zero. The IRR on a project is its expected rate of
return.
▶ The NPV and IRR methods will usually lead to the same accept or reject
decisions.
▶ Decision rules

1. The higher the IRR, the better.

2. Define the hurdle rate, which typically is the cost of capital.

3. Reject if IRR is less than or equal to the hurdle rate.

Illustration Cashflows (CFt)

Year (t) Project A Project B 0 -5,000 -5,000 1 750 500 2

2000 1500 3 2000 2000 4 2500 3000▶ Project A’s IRR can be
calculated by solving the following equation -
750 2000 2000 2500
−5,000 + + + + =0
 (1+������) (1+������)2(1+������)3(1+������)4

▶ Since it is difficult to determine the IRR by hand, the use of a financial

calculator is needed to solve for IRR.
▶ The IRR for Project A is 14% and for Project B is 12%
Cashflows (CFt)
Conflict between NPV
and IRR
Case 1: Different cashflow pattern and
timing
Year (t) Project A Project B 0 (5,000) (5,000) 1 2,000 0 2
2,000 0 3 2,000 0 4 2,000 0 5 2,000 15,000 NPV 2,581.57 4,313.82 IRR 29%
25% ▶ Solution: Project B i.e. project with a higher NPV is chosen.
▶ Reason: In the NPV calculation, the implicit assumption for
reinvestment rate is 10% Is present
project
Conflict between NPV
and IRR
Case 2: Different size and investment of
Cashflows (CFt)
Year (t) Project A Project B 0 (5,000) (20,000) 1 2,000 7,000
2 2,000 7,000 3 2,000 7,000 4 2,000 7,000 5 2,000 7,000 NPV 2,581.57
6,535.51 IRR 29% 22% ▶ Solution: Project B i.e. project with a higher
NPV is chosen.
▶ Reason: In the NPV calculation, the implicit assumption for
reinvestment rate is 10% Is present

Payback
Period
▶ It is the expected number of years required to recover the original
investment. ▶ Payback occurs when the cumulative net cash flow equals 0 ▶
Decision rules
• The shorter the payback period, the better.
•A firm should establish a benchmark payback period. Reject if payback is
greater than benchmark.
▶ Drawbacks
• It ignores cash flows beyond the payback period. Payback period is a type of
 "break even" analysis: it cares about how quickly you can make your
money to recover the initial investment, not how much money you can
make during the life of the project.
• It does not consider the time value of money. Therefore, the cost of capital is
not reflected in the cash flows or calculations.

Illustration

When a firm is embarking upon a project, it needs tools to assist in making the decision of whether to
invest in the project or not. In order to demonstrate the use of these four methods, the cash flows
presented below will be used

Cashflows (CFt)
Year (t) Project A Project B 0 (1,000) (1,000) 1 750 100
2 350 250
3 150 450
4 50 750
Illustration Year (t)
 CF Cumulative CF CF Cumulative CF
Project A Project B
0 (1,000) (1,000) (1,000) (1,000) 1 750 (250) 100 (900) 2 350 100 250 (650) 3
150 250 450 (200) 4 50 300 750 550

We see that in case of project A, the cumulative cashflows reach 0 between

time 1 and 2. Thus, by simple interpolation,

���� − 1 0 − −250
=
2 − 1 100 − −250
Solving the eqn, PP = 1.71 years
Similarly, payback period for project B is 3.27 years

Discounted Payback
Period
▶ Itis similar to the regular payback method except that it discounts
cash flows at the project's cost of capital. It considers the time value
of money, but it ignores cash flows beyond the payback period.
Illustration
Cum. CF
Project B
CF Discounted CF Discounted Cum. CF
Year Project A
(t) CF

0 (1,000)

Discounted CF Discounted
(1,000) (1,000) (1,000) (1,000) (1,000)
1 750 750/1.1 = 681 (319) 100 100/1.1 = 91 (909) 2 350 350/1.12 = 289 (30) 250 250/1.12 = 207 (702) 3 150
150/1.13 = 113 83 450 450/1.13 = 338 (364) 4 50 50/1.14 = 34 117 750 750/1.14 = 512 148

We see that in case of project A, the discounted cumulative cashflows reach 0 between time 2 and 3.
Thus, by simple interpolation,

������ − 2 0 − −30
=
3 − 2 83 − −30
Solving the eqn, PP = 2.26 years

Similarly, discounted payback period for project B is 3.71 years

Profitability Index
▶ This is an index used to evaluate proposals for which net present values have been
determined. The profitability index is determined by dividing the present value of each
proposal by its initial investment.
▶ PI = PV of future cash flows / Initial investment = 1 + (NPV / Initial investment) ▶ The PI

indicates the value you are receiving in exchange for one unit of currency invested.

▶ An index value greater than 1.0 is acceptable and the higher the number, the more financially
attractive the proposal.
▶ A ratio of 1.0 is logically the lowest acceptable measure on the index. Any value lower than 1.0
would indicate that the project's PV is less than the initial investment.

Common Questions/ Topics

Understanding the 3
Financial Statements
▶ Impacton the three financial statements if
depreciation increases by $10
 ▶ Impact on three financial statements if a
machine of $100
Qis sold for uestion 1 $80 Amount ($)
Question 2 Amount ($) Decrease in Other Income

Decrease in Operating Income -10 (Loss) -20

Decrease in Net Income (Tax – 30%*) -7 Decrease in N.I -7 Decrease in Net Income (Tax – 20%)
-16

Increase in Dep (Non Cash) +10 Increase in +20 Increase in Operating CF +4 Increase in Investing
Operating CF +3 Balance Sheet (Liabilities) -7 CF +80 Balance Sheet (Liabilities) -16 Balance Sheet
Balance Sheet (PPE, Cash) -10+3 = -7 (PPE, Cash) -100+84 = -16
Decrease in N.I -16 Increase in Loss (Non Operating)

Operating & Financial Leverage

▶ What is operating and financial

leverage? ▶ Impact of Fixed Assets on
Profits

▶ Operating Leverage – Impact on Operating Income due to Change in

Sales (Lever: Fixed Cost)
▶ DOL = Contribution/(Contribution – Fixed Cost)
= %Δ in EBIT/%Δ in Sales

▶ onNet Income due to change in Capital Structure (Lever:

Debt component in capital)
▶ DFL = EBIT/(EBIT – Finance Cost)
=%Δ in EPS/%Δ in EBIT
▶ Extra: DuPont Analysis

Minority Interest

▶ What is minority interest and how does it reflect in

the financial statements?
▶ Definition – Ownership of less than 50% of an enterprise.
▶ FinancialStatements – Equity and Income
attributable to the minority shareholders of a
company shows up separately in the Equity (IFRS,
GAAP) or NCL (GAAP) of the consolidated statement
of the parent company.
Financial Ratios

▶ Which financial ratio will you look at if you want

to know about the health of a company
▶ Name 5 financial ratios you would look at to
judge a manufacturing company
More Questions
(Corporate Finance/Accounting)
✔ Explain IFRS-16/INDAS-116, how it has
changed accounting?
• Lease accounting
✔ What is the effect of taking more debt on Cost
of capital (WACC)? Does WACC change
proportionally? • Modigliani & Miller theory
✔ Can Beta be negative? If yes, then in what
scenarios? • Gold