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    Chapter 11 Techniques of Capital Budgeting

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    lovejkbs
    The document discusses various capital budgeting techniques used to evaluate investment projects. It begins with an outline of topics to be covered, including the importance of capital budgeting, the capital budgeting process, ways to classify projects, and different investment criteria such as net present value, internal rate of return, payback period, etc. It then proceeds to define key capital budgeting concepts and provide examples to illustrate how techniques like net present value, internal rate of return, and benefit-cost ratio are calculated. The document also discusses some limitations and problems associated with techniques like internal rate of return.

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    Chapter 11 Techniques of Capital Budgeting

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    lovejkbs
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    The document discusses various capital budgeting techniques used to evaluate investment projects. It begins with an outline of topics to be covered, including the importance of capital budgeting, the capital budgeting process, ways to classify projects, and different investment criteria such as net present value, internal rate of return, payback period, etc. It then proceeds to define key capital budgeting concepts and provide examples to illustrate how techniques like net present value, internal rate of return, and benefit-cost ratio are calculated. The document also discusses some limitations and problems associated with techniques like internal rate of return.

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    The document discusses various capital budgeting techniques used to evaluate investment projects. It begins with an outline of topics to be covered, including the importance of capital budgeting, the capital budgeting process, ways to classify projects, and different investment criteria such as net present value, internal rate of return, payback period, etc. It then proceeds to define key capital budgeting concepts and provide examples to illustrate how techniques like net present value, internal rate of return, and benefit-cost ratio are calculated. The document also discusses some limitations and problems associated with techniques like internal rate of return.

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    5K views22 pages

    Chapter 11 Techniques of Capital Budgeting

    Uploaded by

    lovejkbs
    The document discusses various capital budgeting techniques used to evaluate investment projects. It begins with an outline of topics to be covered, including the importance of capital budgeting, the capital budgeting process, ways to classify projects, and different investment criteria such as net present value, internal rate of return, payback period, etc. It then proceeds to define key capital budgeting concepts and provide examples to illustrate how techniques like net present value, internal rate of return, and benefit-cost ratio are calculated. The document also discusses some limitations and problems associated with techniques like internal rate of return.

    Copyright:

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    Download as ppt, pdf, or txt
    of 22

    Chapter 11

    TECHNIQUES OF CAPITAL
    BUDGETING

     Centre for Financial Management , Bangalore


    OUTLINE
    • Importance
    • Capital Budgeting Process
    • Project Classification
    • Investment Criteria
    • Net Present Value
    • Benefit Cost Ratio
    • Internal Rate of Return
    • Modified Internal Rate of Return
    • Payback Period
    • Accounting Rate of Return
     Centre for Financial Management , Bangalore
    CAPITAL EXPENDITURES AND THEIR
    IMPORTANCE
    • The basic characteristics of a capital expenditure (also
    referred to as a capital investment or just project) is that
    it involves a current outlay (or current and future
    outlays) of funds in the expectation of receiving a stream
    of benefits in future

    • Importance stems from


    • Long-term consequences
    • Substantial outlays
    • Difficulty in reversing
     Centre for Financial Management , Bangalore
    CAPITAL BUDGETING PROCESS

    • Identification of Potential Investment Opportunities

    • Assembling of Investment Proposals

    • Decision Making

    • Preparation of Capital Budget and Appropriations

    • Implementation

    • Performance Review

     Centre for Financial Management , Bangalore


    PROJECT CLASSIFICATION

    • Mandatory Investments

    • Replacement Projects

    • Expansion Projects

    • Diversification Projects

    • Research and Development Projects

    • Miscellaneous Projects
     Centre for Financial Management , Bangalore
    INVESTMENT CRITERIA

    INVESTMENT
    CRITERIA

    DISCOUNTING NON-DISCOUNTING
    CRITERIA CRITERIA

    NET BENEFIT INTERNAL ACCOUNTING


    PAYBACK
    PRESENT COST RATE OF RATE OF
    PERIOD
    VALUE RATIO RETURN RETURN

     Centre for Financial Management , Bangalore


    NET PRESENT VALUE

    n Ct
    NPV = ∑ – Initial investment
    t=1 (1 + rt )t

     Centre for Financial Management , Bangalore


    NET PRESENT VALUE
    The net present value of a project is the sum of the present value of all the cash
    flows associated with it. The cash flows are discounted at an appropriate discount
    rate (cost of capital)
    Naveen Enterprise’s Capital Project ( Cost of Capital=15%)
    Year Cash flow Discount factor Present
    value
    0 -100.00 1.000 -100.00
    1 34.00 0.870 29.58
    2 32.50 0.756 24.57
    3 31.37 0.658 20.64
    4 30.53 0.572 17.46
    5 79.90 0.497 39.71
    Sum = 31.96

    Pros Cons
    • Reflects the time value of money • Is an absolute measure and not a relative
    • Considers the cash flow in its entirety measure
    • Squares with the objective of wealth maximisation
     Centre for Financial Management , Bangalore
    PROPERTIES OF THE NPV RULE

    • NPVs ARE ADDITIVE

    • INTERMEDIATE CASH FLOWS ARE INVESTED AT

    COST OF CAPITAL

    • NPV CALCULATION PERMITS TIME-VARYING


    DISCOUNT RATES

    • NPV OF A SIMPLE PROJECT AS THE DISCOUNT


    RATE  Centre for Financial Management , Bangalore
    BENEFIT COST RATIO
    PVB
    Benefit-cost Ratio : BCR =
    I
    PVB = present value of benefits
    I = initial investment
    To illustrate the calculation of these measures, let us consider a project which is being evaluated
    by a firm that has a cost of capital of 12 percent.
    Initial investment : Rs 100,000
    Benefits: Year 1 25,000
    Year 2 40,000
    Year 3 40,000
    Year 4 50,000
    The benefit cost ratio measures for this project are:
    25,000 40,000 40,000 50,000
    (1.12)
    + (1.12)2
    + (1.12)3
    + (1.12)4
    BCR = = 1.145 NBCR = BCR – 1= 0.145
    100,000
    Pros Cons
    Measures bang per buck Provides no means for aggregation
     Centre for Financial Management , Bangalore
    INTERNAL RATE OF RETURN
    Net Present Value

    Discount rate

    The internal rate of return (IRR) of a project is the discount rate that
    makes its NPV equal to zero. It is represented by the point of intersection
    in the above diagram
    Net Present Value Internal Rate of Return
    • Assumes that the • Assumes that the net
    discount rate (cost present value is zero
    of capital) is known.
    • Calculates the net • Figures out the discount rate
    present value, given that makes net present value zero
    the discount rate.
     Centre for Financial Management , Bangalore
    CALCULATION OF IRR
    You have to try a few discount rates till you find the one that makes the
    NPV zero
    Year Cash Discounting Discounting Discounting
    flow rate : 20% rate : 24% rate : 28%
    Discount Present Discount Present Discount Present
    factor Value factor Value factor Value

    0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00


    1 34.00 0.833 28.32 0.806 27.40 0.781 26.55
    2 32.50 0.694 22.56 0.650 21.13 0.610 19.83
    3 31.37 0.579 18.16 0.524 16.44 0.477 14.96
    4 30.53 0.482 14.72 0.423 12.91 0.373 11.39
    5 79.90 0.402 32.12 0.341 27.25 0.291 23.25

    NPV = 15.88 NPV = 5.13 NPV = - 4.02

     Centre for Financial Management , Bangalore


    CALCULATION OF IRR

    Smaller NPV at the smaller rate Bigger Smaller


    discount + X discount – discount
    rate Sum of the absolute values of the rate rate
    NPV at the smaller and the bigger
    discount rates

    5.13
    24% + 28% - 24% = 26.24%
    5.13 + 4.02

     Centre for Financial Management , Bangalore


    PROBLEMS WITH IRR

    • NON-CONVENTIONAL CASH FLOWS

    • MUTUALLY EXCLUSIVE PROJECTS

    • LENDING VS. BORROWING

    • DIFFERENCES BETWEEN SHORT-TERM AND

    LONG-TERM INTEREST RATES

     Centre for Financial Management , Bangalore


    NON-CONVENTIONAL CASH FLOWS

    C0 C1 C2
    -160 +1000 -1000

    TWO IRRs : 25% & 400%


    NPV

    25% 400%
    Discount rate( %)

    NO IRR : C0 C1 C2
    MUTUALLY EXCLUSIVE PROJECTS

    C0 C1 IRR NPV
    (12%)

    P -10,000 20,000 100% 7,857

    Q -50,000 75,000 50% 16,964

     Centre for Financial Management , Bangalore


    LENDING VS BORROWING

    C0 C1 IRR NPV
    (10%)
    A -4000 6000 50% 145

    B 4000 -7000 75% -236

     Centre for Financial Management , Bangalore


    MODIFIED IRR

    0 1 2 3 4 5 6

    -120 -80 20 60 80 100 120

    r=15% 115
    -69.6 r =15% r =15% 105.76
    PVC = 189.6 r =15% 91.26
    r =15% 34.98
    Terminal value (TV) = 467
    PV = 189.6 MIRR = 16.2%
    of TV

    NPV 0

     Centre for Financial Management , Bangalore


    PAYBACK PERIOD
    Payback period is the length of time required to recover the initial
    outlay on the project
    Naveen Enterprise’s Capital Project
    Year Cash flow Cumulative cash flow
    0 -100 -100
    1 34 - 66
    2 32.5 -33.5
    3 31.37 - 2.13
    4 30.53 28.40
    Pros Cons
    • Simple • Fails to consider the time value
    of money
    • Rough and ready method • Ignores cash flows beyond the
    for dealing with risk payback period
    • Emphasises earlier cash inflows
    Centre for Financial Management , Bangalore
    AVERAGE RATE OF RETURN
    Average PAT

    Average Book Value of Investment (Beginning)

    Naveen Enterprise’s Capital Project


    Year Book Value of PAT
    Investment(Beg)

    1 100 14
    2 80 17.5
    3 65 20.12
    4 53.75 22.09
    5 45.31 23.57

    1/5 (14+17.5 +20.12+22.09+23.57)


    ARR = 1/5(100+80+65+53.75+45.31) = 28.31%

    Pros Cons
    • Simple • Based on accounting profit,
    • Based on accounting information not cash flow
    businessmen are familiar with • Does not take into account the
    • Considers benefits over the entire project life time value of money
     Centre for Financial Management , Bangalore
    INVESTMENT APPRAISAL
    IN PRACTICE

    • Over time, discounted cash flow methods have gained in


    importance and internal rate of return is the most
    popular evaluation method.

    • Firms typically use multiple evaluation methods.

    • Accounting rate of return and payback period are


    widely employed as supplementary evaluation methods.

     Centre for Financial Management , Bangalore


    SUMMING UP
    n Ct
    • NPV = ∑ –I
    t=1 (1 + r)t
    PVB
    • BCR =
    I
    • IRR is the value of r in the following equation
    n Ct
    I= ∑
    t = 1 (1 + r)t
    • MIRR is calculated as follows:
    TV
    PVC =
    (1 + MIRR)n
    • The payback period is the length of time required to recover the initial cash outlay on the
    project
    • The accounting rate is defined as:
    Average profit after tax
    Average book value of investment
     Centre for Financial Management , Bangalore

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