Slide 1 : Copyright @ 2011 IILM Institute of Higher Learning. All rights Reserved. Corporate Finance Capital Budgeting
Slide 2 : Lecture Objectives Explain the meaning of capital budgeting and kinds of proposal.
Discuss various techniques of appraising projects.
Demonstrate how to compute payback period, ARR, Net present value, PI and internal rate of returns.
Slide 3 : Contents Lecture Objectives
Concept of Capital Budgeting
Importance of capital Budgeting decisions & their types.
Techniques of capital Budgeting
Payback Period, Accounting Rate of return
Net Present Value
Profitability Index
Internal Rate of Return 3 2 1 4 5 6 7 8 3
Concept of Capital Budgeting : Concept of Capital Budgeting Capital budgeting decision relates to acquisition of assets that have long term implications of the capacity of the enterprise for production, revenue and profits.
Capital budgeting decision is often referred to as investment decision of the firm where allocation of capital among the different projects is decided.
Slide 5 : Contents Lecture Objectives
Concept of Capital Budgeting
Importance of capital Budgeting decisions & their types.
Techniques of capital Budgeting
Payback Period, Accounting Rate of return
Net Present Value
Profitability Index
Internal Rate of Return 3 2 1 4 5 6 7 8 5
Importance of Capital Budgeting : Importance of Capital Budgeting Capital budgeting is considered strategic in nature affecting the competitive position of the firm. Lack of capital budgeting proposals in any enterprise signals a bleak future of the firm because the existing projects would have some limited life as new products and competitors emerge.
These are important because of their following features:
Huge Outlay is involved
Irreversible in nature
Experience of the firms is less.
Slide 7 : Contents Lecture Objectives
Concept of Capital Budgeting
Importance of capital Budgeting decisions & their types.
Techniques of capital Budgeting
Payback Period, Accounting Rate of return
Net Present Value
Profitability Index
Internal Rate of Return 3 2 1 4 5 6 7 8 7
Slide 8 : Techniques of Capital Budgeting
Slide 9 : Contents Lecture Objectives
Concept of Capital Budgeting
Importance of capital Budgeting decisions & their types.
Techniques of capital Budgeting
Payback Period, Accounting Rate of return
Net Present Value
Profitability Index
Internal Rate of Return 3 2 1 4 5 6 7 8 9
Slide 10 : Even Cash Flows Payback = Initial investment / annual cash inflow
PB = C0/C
Slide 11 : Uneven Cash Flows Payback period = E + B/C
Where
E = no. of years immediately preceding the year of final recovery
B = balance amount to be recovered
C = cash flow during the year of final recovery
Slide 12 : Capital Budgeting techniques—Payback (even cash flows) Consider the following cash flows (stand alone project) Payback = Initial investment / annual cash inflow = 2,00,000 / 60000
= 3.33 years
Slide 13 : Capital Budgeting Techniques—Payback—uneven cash flows B's Payback Period
= E + B / C
= 3 + 50 / 200
= 3 + .25
= 3.25 years
Slide 14 : Capital Budgeting Techniques—Payback Why Use the Payback Method?
It’s quick and easy to apply
Serves as a rough screening device
The Present Value Payback Method
Involves finding the present value of the project’s cash flows then calculating the project’s payback
Slide 15 : Contents Lecture Objectives
Concept of Capital Budgeting
Importance of capital Budgeting decisions & their types.
Techniques of capital Budgeting
Payback Period, Accounting Rate of return
Net Present Value
Profitability Index
Internal Rate of Return 3 2 1 4 5 6 7 8 15
Slide 16 : Capital Budgeting Techniques-ARR Accounting rate of return also known as ROI uses accounting profit and not CFAT
ARR = average income/ average investment
where
Average income = (PAT for each year/no. of years) (in case of annuity , any year’s profit can be considered)
Average investment =(initial investment + salvage value)/2
Slide 17 : Capital Budgeting Techniques—ARR Decision Rules
Stand-alone Projects
ARR > REQUIRED RATE OF RETURN accept
ARR < ROR reject
Mutually Exclusive Projects
ARRA >ARRB choose Project A over B
Question : Question A machine will cost Rs. 10,000. It is expected to provide profits before depreciation of Rs. 3,000 in year 1 & 2 and Rs. 4,000 each in years 3 & 4.
Assuming a SLM for depreciation & no taxes, Calculate ARR if tax rate is 35%.
Solution : Solution
Slide 20 : Contents Lecture Objectives
Concept of Capital Budgeting
Importance of capital Budgeting decisions & their types.
Techniques of capital Budgeting
Payback Period, Accounting Rate of return
Net Present Value
Profitability Index
Internal Rate of Return 3 2 1 4 5 6 7 8 20
Slide 21 : Discounted Cash flow (DCF) The process of valuing an investment by discounting its future cash flows, including NPV, PI, and IRR
Primary investment decision criteria as each of the three methods:
Considers the time value of money,
Examines all net CFs, and
Considers the required rate of return
Slide 22 : Capital Budgeting Techniques—NPV The NPV of an investment is the present value of proposal’s/project’s net cash flows less the proposal’s initial cash outflow / initial investment.
NPV = CF1 + CF2 + ………..+CFn – ICO
(1 + k)1 (1 +k)2 (1+k)n
NPV =Σ {CFt / (1+k)t } - ICO
t=1 n
Slide 23 : Capital Budgeting Techniques—Net Present Value (NPV) NPV and Shareholder Wealth
A project’s NPV is the net effect that undertaking a project is expected to have on the firm’s value
A project with an NPV > (<) 0 should increase (decrease) firm value
Since the firm desires to maximize shareholder wealth, it should select the capital spending program with the highest NPV
Slide 24 : Capital Budgeting Techniques—Net Present Value (NPV) Decision Rules
Stand-alone Projects
NPV > 0 accept
NPV < 0 reject
Mutually Exclusive Projects
NPVA > NPVB choose Project A over B
Slide 25 : Capital Budgeting Techniques—Net Present Value (NPV) Example
Slide 26 : Contents Lecture Objectives
Concept of Capital Budgeting
Importance of capital Budgeting decisions & their types.
Techniques of capital Budgeting
Payback Period, Accounting Rate of return
Net Present Value
Profitability Index
Internal Rate of Return 3 2 1 4 5 6 7 8 26
Slide 27 : Profitability Index (PI) The profitability index is a variation on the NPV method
It is a ratio of the present value of a project’s inflows to the present value of a project’s outflows
Projects are acceptable if PI>1
Larger PIs are preferred
Slide 28 : Profitability Index (PI) Also known as the benefit/cost ratio
Positive future cash flows are the benefit
Negative initial outlay is the cost
Slide 29 : Profitability Index (PI) Decision Rules
Stand-alone Projects
If PI > 1.0 accept
If PI < 1.0 reject
Mutually Exclusive Projects
PIA > PIB choose Project A over Project B
Comparison with NPV
With mutually exclusive projects the two methods may not lead to the same choices
Slide 30 : Contents Lecture Objectives
Concept of Capital Budgeting
Importance of capital Budgeting decisions & their types.
Techniques of capital Budgeting
Payback Period, Accounting Rate of return
Net Present Value
Profitability Index
Internal Rate of Return 3 2 1 4 5 6 7 8 30
Slide 31 : Techniques—Internal Rate of Return (IRR) It is the discount rate that equates the present value of net cash inflows during the life of the project with the initial cash outflow.
Equation: PV of future CFs – IC = 0
Solve the interest rate and the solved rate is IRR
Slide 32 : Techniques—Internal Rate of Return (IRR) IRR is the required return that makes NPV = 0 when it is used as the discount rate.
NPV = CF1 + CF2 + ……….. +CFn = 0
(1 + IRR)1 (1 +IRR)2 (1+IRR)n
Σ {CFt / (1+r)t } – ICO = 0 where, r = IRR
t=1 n
Slide 33 : Acknowledgments We wish to acknowledge the people who actively contributed to the writing and delivery of the learning material
Author
Prof. Rajiv Srivastava
Presenter
Dr. Anubha Gupta
A special thanks to the technical support team who were instrumental in the design and implementation of this presentation.
Slide 34 : Contact Details For further information, please contact:
IILM Institute for Higher Education
3, Lodhi Institutional Area,
Lodhi Road, New Delhi- 110003
Email: learning@iilm.edu
Web : www.iilm.edu