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    Capital Budgeting: Financial Management

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    KaRin MerRo
    This document discusses capital budgeting and various techniques used to evaluate long-term investment projects. It defines capital expenditures and the capital budgeting process. It then explains several evaluation techniques including payback period, net present value (NPV), internal rate of return (IRR), profitability index, and accounting rate of return. It provides examples of how to calculate NPV, IRR, and the profitability index. The key techniques discussed are NPV, IRR, and profitability index, as NPV is considered the best technique but IRR and profitability index are also commonly used in capital budgeting decisions.

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    Capital Budgeting: Financial Management

    Uploaded by

    KaRin MerRo
    82 views22 pages
    This document discusses capital budgeting and various techniques used to evaluate long-term investment projects. It defines capital expenditures and the capital budgeting process. It then explains several evaluation techniques including payback period, net present value (NPV), internal rate of return (IRR), profitability index, and accounting rate of return. It provides examples of how to calculate NPV, IRR, and the profitability index. The key techniques discussed are NPV, IRR, and profitability index, as NPV is considered the best technique but IRR and profitability index are also commonly used in capital budgeting decisions.

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    Corporate Finance

    Original Title

    Capital Budgeting

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    This document discusses capital budgeting and various techniques used to evaluate long-term investment projects. It defines capital expenditures and the capital budgeting process. It then explains several evaluation techniques including payback period, net present value (NPV), internal rate of return (IRR), profitability index, and accounting rate of return. It provides examples of how to calculate NPV, IRR, and the profitability index. The key techniques discussed are NPV, IRR, and profitability index, as NPV is considered the best technique but IRR and profitability index are also commonly used in capital budgeting decisions.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    82 views22 pages

    Capital Budgeting: Financial Management

    Uploaded by

    KaRin MerRo
    This document discusses capital budgeting and various techniques used to evaluate long-term investment projects. It defines capital expenditures and the capital budgeting process. It then explains several evaluation techniques including payback period, net present value (NPV), internal rate of return (IRR), profitability index, and accounting rate of return. It provides examples of how to calculate NPV, IRR, and the profitability index. The key techniques discussed are NPV, IRR, and profitability index, as NPV is considered the best technique but IRR and profitability index are also commonly used in capital budgeting decisions.

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 22

    CAPITAL BUDGETING

    Financial Management

    LEARNING OBJECTIVES
    Define capital expenditure decisions and capital budgets.
    Evaluate investment opportunities using the following:
    Payback Period
    Discounted Payback Period
    Net Present Value (NPV)
    Average Rate of Return
    Profitability Index
    Internal Rate of Return (IRR)

    Calculate the depreciation tax shield, and explain why


    depreciation is important in investment analysis.

    CAPITAL BUDGETING WHAT


    IS IT?

    Long-term investments represent sizable outlays of funds that


    commit a firm to some course of action. Consequently, the
    firm needs procedures to analyze and select its long-term
    investments.
    Capital budgeting is the process of evaluating and selecting
    long-term investments that are consistent with the firms goal
    of maximizing owners wealth. Firms typically make a variety
    of long-term investments, but the most common is in fixed
    assets, which include property (land), plant, and equipment.
    These assets, often referred to as earning assets, generally
    provide the basis for the firms earning power and value

    CAPITAL EXPENDITURE
    A capital expenditure is an outlay of funds by the firm that is
    expected to produce benefits over a period of time greater
    than 1 year.
    Companies make capital expenditures for many reasons. Some
    reasons for capital expenditures are to:

    New products or expansion of existing products

    Replacement of existing equipment or buildings

    Research and development

    Exploration

    CAPITAL BUDGETING
    PROCESS
    The capital budgeting process consists of five distinct but
    interrelated steps:
    a.
    Proposal generation. Proposals for new investment projects are
    made at all levels within a business organization and are
    reviewed by finance personnel.
    b.
    Review and analysis. Financial Managers perform formal
    review and analysis to assess the merits of investment
    proposals.
    c.
    Decision making. Firms typically delegate capital expenditure
    decision making on the basis of dollar limits.
    d.
    Implementation. Following approval, expenditures are made
    and projects implemented.
    e.
    Follow-up. Results are monitored, and actual costs and benefits
    are compared with those that were expected.

    BASIC TERMINOLOGY
    IN CAPITAL BUDGETING
    Independent projects

    Projects whose cash flows are unrelated to


    (or independent of) one another; the
    acceptance of one does not eliminate the
    others from further consideration

    Mutually exclusive projects

    Projects that compete with one


    another, so that the acceptance of
    one eliminates from further
    consideration all other projects
    that serve a similar function.

    BASIC TERMINOLOGY
    IN CAPITAL BUDGETING
    Unlimited Funds

    The financial situation in which a firm is


    able to accept all independent projects that
    provide an acceptable return.

    Capital Rationing

    The financial situation in which a


    firm has only a fixed number of
    dollars available for capital
    expenditures, and numerous
    projects compete for these dollars.

    BASIC TERMINOLOGY
    IN CAPITAL BUDGETING
    Acceptreject approach

    The evaluation of capital expenditure


    proposals to determine whether they meet
    the firms minimum acceptance Criterion.

    Ranking approach

    The ranking of capital


    expenditure projects on the basis
    of some predetermined measure,
    such as the rate of return.

    PRINCIPLES OF CAPITAL BUDGETING


    Capital budgeting has five principles that play a crucial role in
    the allocation of money and the process of capital budgeting.
    The five principles are:
    (1) Decisions are based on cash flows, not accounting
    income,
    (2) Cash flows are based on opportunity cost,
    (3) The timing of cash flows are important,
    (4) Cash flows are analyzed on an after tax basis,
    (5) Financing costs are reflected on projects required rate of
    return.

    CAPITAL BUDGETING
    TECHNIQUES - PAYBACK
    The payback period is the amount
    of time required for the firm to
    recover its initial investment in a
    project, as calculated from cash
    inflows
    For example, if an investment
    costs $15,000 and generates
    returns of $5,000 per year, it has a
    payback period of 3 years.
    Question 1
    Investment Cost $120,000
    generates annual cash flows of
    $35,000. What is the payback
    period?

    There are 2 serious limitations with


    this method.
    It does not consider cash inflows in
    years beyond the payback year (e. g.
    years, 4, 5 and 6 in the example
    above.
    It does not consider the time value of
    money.

    Question 2
    Investment Cost $120,000 generates
    the following cash inflows Yr 1
    $35,000, Yr 2 $30,000, Yr 3 30,000
    and Yr 4 $45,000. What is the
    payback period?

    CAPITAL BUDGETING TECHNIQUES


    DISCOUNTED PAYBACK
    Discounted payback period is
    a variation of payback period
    which accounts for time value
    of money by discounting the
    cash inflows from a project.

    Question
    Using the information above
    calculate the payback period
    and discounted payback period
    for projects A and B . The initial
    investment is $50,000 and the
    discount rate is 5%

    Year

    Cash
    Flow
    A

    Cash
    Flow
    B

    10,000

    47,000

    10,000

    2,000

    30,000

    1,000

    5,000

    5,000

    5,000

    5,000

    TECHNIQUES - ACCOUNTING
    RATE OF RETURN
    Accounting rate of return (ARR, also known as average rate of return) is
    used to estimate the rate of return for an investment project. The higher
    the ARR, the more attractive the project is.
    ARR = Average Net Income
    Average Investment
    Example :
    An investment of $600,000 is expected to give returns as follows: Year 1 ($50,000), Year
    2 ($150,000), Year 3 ($80,000), Year 4 ($20,000).Calculate the average rate of return.
    Solution:
    Total returns over the four years
    = 50,000 + 150,000 + 80,000 + 20,000 = $300,000
    Average returns per annum = 300,000 / 4 = $75,000
    ARR = 75,000 / 600,000 = 12.5%

    CAPITAL BUDGETING TECHNIQUES NET


    PRESENT VALUE

    The method used by most large companies to evaluate


    investment projects is called net present value (NPV).
    When firms make investments, they are spending money that
    they obtained, in one form or another, from investors.
    Investors expect a return on the money that they give to
    firms, so a firm should undertake an investment only if the
    present value of the cash flows that the investment generates
    is greater than the cost of making the investment in the first
    place

    NPV is the present value of net cash inflows generated by a


    project including salvage value, if any, less the initial investment
    on the project. It is one of the most reliable measures used in
    capital budgeting because it accounts for time value of money.

    CAPITAL BUDGETING TECHNIQUES NET PRESENT


    VALUE
    Steps to calculate NPV
    1.
    Identify the amount and time period of each cash flow associated with a
    potential investment. Investment projects have both cash inflows and
    cash outflows.
    2.
    Equate or discount the cash flows to their present values using a
    required rate of return (cost of capital). This is the minimum return that
    management will accept.
    3.
    Evaluate the net present value. This is the sum of all of the cash inflows
    and cash outflows
    Decision Criteria
    . When NPV is used to make acceptreject decisions, the decision criteria
    are as follows:
    If the NPV is greater than $0, accept the project.
    If the NPV is less than $0, reject the project.
    . If the NPV is greater than $0, the firm will earn a return greater than its
    cost of capital. Such action should increase the market value of the firm,
    and therefore the wealth of its owners by an amount equal to the NPV.

    CAPITAL BUDGETING TECHNIQUES


    NET PRESENT VALUE
    Class example
    Using the information in the
    table calculate the NPV for
    projects A and B . The
    initial investment is $50,000
    and the discount rate is 5%
    What is the profitability
    index for each project?

    Year

    Cash
    Flow
    A

    Cash
    Flow
    B

    10,000

    40,000

    10,000

    2,000

    30,000

    1,000

    5,000

    8,000

    5,000

    9,000

    CAPITAL BUDGETING TECHNIQUES


    PROFITABILITY INDEX
    Profitability index is an investment appraisal technique calculated by
    dividing the present value of future cash flows of a project by the
    initial investment required for the project.
    Formula:
    Profitability Index = Present Value of Future Cash Flows
    Initial Investment Required
    =1+
    Net Present Value
    Initial Investment Required
    Explanation:
    Profitability index is actually a modification of the net present value
    method. While present value is an absolute measure (i.e. it gives as the
    total dollar figure for a project), the profitability index is a relative
    measure (i.e. it gives as the figure as a ratio).

    CAPITAL BUDGETING TECHNIQUES


    INTERNAL RATE OF RETURN
    Internal Rate of Return - the IRR of an investment is the
    discount rate at which the present value of costs (negative
    cash flows) of the investment is equal to the present value of
    the benefits (positive cash flows) of the investment. It is the
    rate of return at which the net present value of a project is
    zero.
    The IRR can be defined as the break-even interest rate that
    equates the present value of project inflows with project
    outflows.

    CAPITAL BUDGETING TECHNIQUES


    INTERNAL RATE OF RETURN
    Example
    Co. A wants to replace an old
    machine with a new one. The new
    machine will cost $8,475 and will
    reduce the annual labor cost by
    $1,500. The useful life of the
    machine will be 10 years with no
    salvage value. The minimum
    required rate of return is 15%.
    Required:
    Should Co. A purchase the machine?
    Use internal rate of return (IRR)
    method for your conclusion.
    .

    Solution
    To conclude whether the
    proposal should be accepted or
    not
    the internal rate of return
    promised by machine
    would be found out first
    and then compared to the
    companys minimum
    required rate of return

    CAPITAL BUDGETING TECHNIQUES


    INTERNAL RATE OF RETURN
    Solution
    The first step in finding out the internal rate
    of return is to compute a discount factor
    called internal rate of return factor. It is
    computed by dividing the investment
    required for the project by net annual cash
    inflow to be generated by the project. The
    formula is given below:
    Formula of internal rate of return factor
    =
    Investment required
    Net Annual cash Flow
    After computing the internal rate of return
    factor, the next step is to locate this
    discount factor in present value of an
    ordinary annuity table. This rate of return
    will be based on the number of periods that
    the investment generates cash flows.

    Internal rate of return factor


    = 8475 1500
    =5.650

    Nic\4ePresentValueOrdinaryAnnuityof1
    _table4.pdf
    Since the useful life of the machine is 10
    years, the factor would be found in 10period line or row.
    After finding this factor, see the rate of
    return written at the top of the column in
    which factor 5.650 is written. It is 12%. It
    means the internal rate of return promised
    by the project is 12%.
    According to IRR method, the proposal is
    not acceptable because the IRR promised by
    the proposal (12%) is less than the minimum
    required rate of return (15%).

    PROJECT/INVESTMENT
    CASH FLOWS
    Basic characteristics of relevant cash flows
    Cash (not accounting income) flows
    Operating (not financing) flows
    After-tax flows
    Incremental flows

    PROJECT/INVESTMENT
    CASH FLOWS
    Principles that must be adhered to in estimating the cash flows
    Ignore sunk costs
    Include opportunity costs
    Include project-driven changes in working capital net of
    spontaneous changes in current liabilities
    Include effects of inflation

    ESTIMATING CASH
    FLOWS TAX AND DEPN
    Cash Flow
    Revenue $1000
    Taxes @ 35% 350
    After-Tax Income $650
    Since there are no noncash expenditures included
    above, after-tax revenue is
    equal to cash flow.

    Cash Flow
    Revenue
    $1000
    Depreciation
    200
    Taxable Income $800
    Taxes @ 35% 280
    After-Tax Income $520
    Plus Depreciation
    200
    Cash Flow
    $720

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