Capital Budgeting
Capital Budgeting
Capital Budgeting
Capital Budget
Capital budget is the budget of capital expenditures. Capital Expenditures are those expenditures whose benefit spread in number of years e.g., purchase of Plant and Machinery , Land and building and starting a new factory plant etc.
CAPITAL BUDGETING
Capital budgeting: is the planning process for allocating all expenditures that will have an expected benefit to the firm for more than one year.
Investment Appraisal
Firms normally place projects in the following categories:
OVERALL AIM
To maximise shareholders wealth.. Projects should give a return over and above the marginal weighted average cost of capital.
Discount the cash flows at the appropriate market determined opportunity cost of capital
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Avg. Investment
AROI
= 24%
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Advantages
Disadvantages
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Payback Method
# Years required to recover the original investment Example: CFO: 100,000 Year Net Income Cash Flow Cumulative CF 1 6,000 26,000 26,000 2 8,000 28,000 54,000 3 11,000 31,000 85,000 4 13,000 33,000 118,000 5 16,000 36,000 154,000 6 18,000 18,000 = 3.45 Years 172,000 Payback = 3 + 100,000 - 85,000 118,000 - 85,000
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Payback Method
Advantages
Disadvantages
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Finding r
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Definitions
Present value:- the amount of money you must invest or lend at the present time so as to end up with a particular amount of money in the future.
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Where: CF0 = Cash flow at time zero (t0) CF1 = Cash flow at time one (t1), one year after time zero
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Example-1
A company can purchase a machine at the price of 2200. The machine has a productive life of three years and the net additions to cash inflows at the end of each of the three years are 770, 968 and 1331. The company can buy the machine without having to borrow and the best alternative is investment elsewhere at an interest rate of 10%. Evaluate the project using the a) Net present value method. b) Internal rate of return
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Example-1
NPV = 770 + 968 + 1331 -2,200 = 300 (1.1) (1.1)2 (1.1)3 OR Year Cash flow Discount Factor (10%) 0 (2200) 1.000 1 770 0.9091 2 968 0.8264 3 1331 0.7513 NPV
Comments: The project is worthwhile and the machine should be bought (can you suggest why?) 25
NPV-Example-2
A firm invest 180,000 in a project that will give a net cash inflow of 50,000 in real terms in each of the next six years. Its real pre-tax cost of capital is 13%. Required: Calculate NPV
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Example-2
Solution
Year Cash Flow PV factor 13% 0 (180,000) 1.00 1 50,000 0.885 2 50,000 0.783 3 50,000 0.693 4 50,000 0.613 5 50,000 0.543 6 50,000 0.480 NPV Positive NPV indicates viability of the project. Negative NPV indicates non-viability of the project. Present (180,000) 44,250 39,150 34,650 30,650 27,150 24,000 19,850
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Disc. Factor 1 1/1.1 = .9091 1/(1.1)2 = .8264 1/(1.1)3 = .7573 1/(1.1)4 = .6830 1/(1.1)5 = .6209 1/(1.1)6 = .5645 NPV =
Advantages
Disadvantages
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Where: L = Lower rate of interest H = Higher rate of interest NL = NPV at lower rate of interest NH = NPV at higher rate of interest
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r = 18.2%
Advantages
Disadvantages
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Example-IRR
Using Lecture example 1(above), calculate the internal rate of return for the project.
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Example-IRR
Solution IRR Try 15% Year Cash flow Discount Factor (15%) PV 0 (2200) 1.000 (2200) 1 770 0.8696 669.59 2 968 0.7561 731.90 3 1331 0.6575 875.13 NPV 76.62
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Profitability Index
What Does Profitability Index Mean? An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:
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Profitability Index
PI = PV of all Benefits PV of all Cost
Example: PV (Benefits) = 26000 + 28000 +.......... + 18000 1.1 (1.1)2 (1.1)6 = 125121 PV (Cost) = 100000 PI = 125121 = 1.25 100000
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Profitability Index
Advantages:
Disadvantages:
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NPV Profile
Year 0 1 2 3 4 5 6 CF -100,000 26,000 28,000 31,000 33,000 36,000 18,000 Disc. Factor 1 0.91 0.83 1/(1.1)3 = .7573 1/(1.1)4 = .6830 1/(1.1)5 = .6209 1/(1.1)6 = .5645 NPV =
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NPV Profile
Dis. Rate 0% 5% NPV 7200 45725.7
10%
15% 20% 25%
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25120.76
8711.838 -4538.97 -15376.1
NPV Profile
80000 60000
NPV
40000
20000
0 -20000 0 0.05 0.1 0.15 0.2 0.25
Disc. Rate
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NPV IRR
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6351 17%
4606 22%
NPV Profile
20,000 15,000 10,000
NPV
5,000 0 -5,000 0% -10,000 Discount rate 5% 10% 15% 20% 25% 30%
Modified IRR
The regular IRR may not always yield a value and in some cases a solution may not exist for IRR. To overcome this shortcomings of IRR we extend it to define a modified internal rate of return. MIRR value is always unique given that we have at least one negative and one positive net cash flow. The modified internal rate of return is a geometric average of the compounded future value of positive cash flows over the discounted present value of negative cash flows. Here we compound each positive cash flow at the reinvestment rate aka WACC or discount rate to find future value, and we discount each negative cash flow at the finance rate to find the present value. We then find the geometric average of this ratio of net future value over the net present value to come up with MIRR value
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MIRR Formula
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MIRR Example
Let us show you MIRR Calculation with an example investment proposal. Let us assume we set out on an investment that requires an initial outlay of $100,000 and we expect to receive benefits and incur costs as $40,000 35,000 -20,000 40,000 38,000 40,000. We further assume that our reinvestment rate (WACC or simply the discount rate) is 11% and finance rate is 13%.
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MIRR Calculation
I will now show you step by step MIRR calculation for the net cash flows from our example. As you can see we compound each of the positive net cash flows at the reinvestment rate and get a net future value. We also discount each of the negative net cash flows to get a net present value. Finally we find the geometric average of the these two values to get the required MIRR value
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Discounted Net Cash Flows at 13% DCF0 = -100000 / (1+13%)0 = -100000 x 1 = -100000 DCF3 = -20000 / (1+13%)3 = -20000 x 1.4429 = -13861 PV = -113861
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MIRR Calculation
MIRR Calculation MIRR = (-FV/PV)1/n-1-1 MIRR = (-251998.79/-113861)1/6-1 MIRR = 1.1415735830404 - 1 MIRR = 0.14157358304039 MIRR = 14.16%
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Cash Flows
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Procedure
1. Initial Costs: New CAPEX Additional W. Cap Sale of Old Assets
2. Annual Costs:
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$20m $16m $2m $0.5m $10m Straight Line over 20 years nil 40% 8%
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CALCULATION
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