The Basics of Capital Budgeting

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The Basics of Capital Budgeting
Should we build this plant?
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What is capital budgeting?

• Capital Budgeting is the process of evaluating
• and selecting long term investments that are
  consistent with the goal pf shareholders wealth
  maximization.
• It involves the following actions,
• Analysis of potential additions to fixed assets.
• Long-term decisions involve large expenditures.

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Importance of Capital Budgeting

• Capital budgeting decisions are of paramount
  importance in financial decision making,
• First of all, such decision affects the
  profitability of a firm because of the fact that
  they relate to fixed assets. The fixed assets are
  the true earning assets of the firm. They enable
  the firm to generate finished goods that can
  ultimately be sold for profit. Thus capital
  budgeting decisions determine the future destiny
  of a firm.

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Importance of Capital Budgeting

• Secondly, capital expenditure decisions has its
  effect over long time span and inevitably affect
  the company's future cost structure. For example,
  if a particular plant has been purchased by a
  company to start a new product, the company
  commits itself to a sizable amount of fixed cost,
  in terms of labor, insurance, rent, salaries and
  so on. If the investment turn-out to be
  unsuccessful in future, the firm will have to
  bear the burden of fixed costs.
• In short, future costs, break-even point, sales
  and profits will all be determined by the
  selection assets.

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Importance of Capital Budgeting

• Thirdly, Capital investment decisions, once made
  are not easily reversible without much financial
  loss to the firm because there may be no market
  for second hand plant and equipment and their
  conversion to other users may not be financially
  viable.

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Capital Budgeting Process Its Types

• Capital Budgeting process refers to the total
  process of generating, evaluating, selecting and
  following up on capital expenditure alternatives.
  
• There are 3 types of capital budgeting
  decisions,
• Accept/Reject decisions
• The mutually exclusive choice decisions
• The capital rationing decisions

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Accept/Reject decisions

• This is the fundamental decision in capital
  budgeting. If the project is accepted, the firm
  would invest in it if the proposal is rejected,
  the firm does not invest in it.
• In general, all those proposals which yield a
  rate of return greater than a certain required
  rate of return or cost of capital are accepted
  and the rest are the rejected.
• By applying this criterion, all independent
  projects are accepted.

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The Mutually Exclusive choice decisions

• The Mutually Exclusive projects are those which
  competes with other project in such a way that
  the acceptance of one will exclude the acceptance
  of other projects. The alternatives are mutually
  exclusive and only one may be chosen. For
  example, a company is intending to buy a folding
  machine. There are 3 competing brands each with a
  different initial investment and operating costs.
  The 3 machines represent mutually exclusive
  alternatives and only one of these can be
  selected.

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The capital rationing decisions

• It is the financial situation in which a firm
  has only fixed amount to allocate among competing
  capital expenditure. The firm allocates funds to
  projects in a manner that it maximizes long term
  return.
• Thus capital rationing refers to a situation in
  which a firm has more acceptable investments than
  it can finance. It is concerned with selection of
  group of investment proposals out of many
  acceptable under the accept/reject decision.
  Capital rationing employs ranking of the
  acceptable investments projects.

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Steps to capital budgeting process

1. Identification of potential investment
   opportunities
2. Assembling of investment proposals
3. Decision Making
4. Preparation of capital budget and appropriations
5. Implementation
6. Performance Review

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Investment Criteria
Investment Criteria
Discounting Criteria
Non-discounting Criteria
NPV
Benefit Cost Ratio
IRR
Payback Period
ARR
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Net Present Value

• The NPV (Net Present value) of a project is the
  sum of the present values of all the cash
  flows-positive as well as negative- that are
  expected to occur over the life of the project.
  The general formula of NPV is
• Ct
• NPV of Project ? initial
  investment (1r)t

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Net Present Value

• where,
• Ct Cash flow at the end of the year t
• n life of the project
• r Discount rate
• Decision Rule
• NPV gt Zero Accepted
• NPV lt Zero Rejected

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Net Present Value

Year Cash Flow
0 Taka(10,00,000)
1 200,000
2 200,000
3 300,000
4 3,00,000
5 350,000
If the cost of capital (r) 10. Calculate the NPV. If the cost of capital (r) 10. Calculate the NPV.
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Net Present Value

• 200,000 200000
• NPV 1000,000 -
• (1.10)1 (1.10)2
• 300,000 300,000 350000
• (1.10)3 (1.10)4 (1.10)5

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Net Present Value Different discount rate

Year Cash Flow
0 Taka(12000)
1 4000
2 5000
3 7000
4 6000
5 5000
If the cost of capital (r) 14,15,16,18, 20 respectively. Calculate the NPV. If the cost of capital (r) 14,15,16,18, 20 respectively. Calculate the NPV.
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Net Present Value Different discount rate

• PV of C1 4000 / 1.14 3,509
• PV of C2 5000 / 1.14 x 1.15 3,814
• PV of C3 7000 / 1.14 x 1.15 x 1.16 4,603
• PV of C4 6000 / 1.14 x 1.15 x 1.16 x 1.18
• 3,344
• PV of C5 5000 / 1.14 x 1.15 x 1.16 x 1.18 x
  1.20 2,322
• NPV 35093814460333442322 12,000
• 5,592

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Benefit Cost Ratio

• Benefit cost ratio PVB / I
• Where,
• PVB Present value of Benefits
• I Initial Investment
• Net Benefit Cost ration BCR 1
• Where,
• BCR Benefit cost ration
• Decision Rule
• When BCR or NBCR Rule
• gt1 gt0 Accepted
• lt 1 lt 0 Rejected

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Benefit Cost Ratio

• Problem Let us consider a project which is
  being evaluated by a firm that has a cost of
  capital of 12
• Initial Investment Tk. 100,000
• Benefits Year 1 25,000
• Year 2 40,000
• Year 3 40,000
• Year 4 50,000
• 1 Calculate the Benefit cost ratio
• 2 Calculate Net Benefit cost ratio

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Benefit Cost Ratio

• BCR 25000/1.12 40000/(1.12)2 40000/(1.12)3
  50000/(1.12)4 / 100000
• 1.145
• NBCR BCR 1
• 1.145 1
• 0.145

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Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV 0 Put
differently, it is the discount rate which
equates the present value of future cash flows
with the initial investment.
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Internal Rate of Return (IRR)

• In the NPV calculation we assume that the
  discount rate (cost of capital) is known and
  determine the NPV. In the IRR calculation, we set
  the NPV equal to Zero and determine the discount
  rate that satisfy this condition.
• Decision rule
• If the IRR is gt Cost of Capital Accept
• If the IRR is lt Cost of Capital Rejected

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Internal Rate of Return (IRR)

• Problem
• year 0 1 2 3 4 Cash flow
  (100000) 30000 30000 40000 45000
• The IRR is the value of r which satisfies the
  following equations
• 100,000 30000/(1r)1 30000/(1r)2
  40000/(1r)3 45000/(1r)4
• The calculation of r involves a process of Trial
  Error method. We will try different values of r
  till we find the right hand side of the above
  equation is equal to left hand side.

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Internal Rate of Return (IRR)

• Let us, to begin with, Try r 15
• 30000/(1.15)1 30000/(1.15)2 40000/(1.15)3
  45000/(1.15)4
• 100,802
• This value is slightly higher than our initial
  investmentleft hand side. So we will increase
  the value of r from 15 to 16.
• (a higher r lowers and smaller r increases the
  right hand side value)

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Internal Rate of Return (IRR)

• Try r 16
• 30000/(1.16)1 30000/(1.16)2 40000/(1.16)3
  45000/(1.16)4
• 98,641
• As the value is now less than 100,000, we may
  conclude that the value of r lies between 15
  16.
• If we need more refined estimate of r, then
  use the following procedure

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Internal Rate of Return (IRR)

• 1 determine the Net present value of the two
  closest rate of return
• (100802 100000) 802
• (100000 98,641) 1,359
• 2 Find the sum of the absolute values of the
  NPV obtained in step 1.
• (8021359) 2,161.
• 3 Calculate the ratio of the net present value
  of the smaller discount rate,

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Internal Rate of Return (IRR)

• 802/2161 0.37
• 4 Add the number obtained in step 3 to the
  smaller discount rate
• 150.3715.37.

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Pay Back Period

• Pay back period is the length of time required
  to recover the initial cash outlay on the
  project.
• The number of years required to recover a
  projects cost, or How long does it take to get
  our money back?
• For Example, if a project involves in cash
  outlay of Tk. 60000 and generate cash inflow of
  Tk. 100000,Tk. 150,000 Tk. 150,000 and Tk. 200000
  in the 1st,2nd,3rd 4th year respectively. Its
  pay back period will be 4 years.

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Pay Back Period

• Because the sum of the cash inflows during 4
  years is equal to the initial outlay.
• When the annual cash inflow is a constant sum
  the pay back period is simply the initial outlay
  divided by the annual cash inflow.
• For example, A project involves in a initial
  cash outlay of Tk. 1000,000 and a constant annual
  cash inflow of Tk. 300,000. Calculate the payback
  period.
• 1000,000/300,000 3 1/3 years.

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Pay Back Period

• Strengths
• Provides an indication of a projects risk and
  liquidity.
• Easy to calculate and understand.
• Weaknesses
• Ignores the time value of money.
• Ignores CFs occurring after the payback period.
• It is a measure of Projects capital recovery,
  not profitability.

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Accounting Rate of Return

• It is also know as average rate of return.
• Can be defined as
• Profit after Tax
• Book value of the investment
• The numerator of this ratio may be measured as
  the average annual post tax profit over the life
  of the investment.
• The Denominator is the average book value of
  fixed assets committed to the project.

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Accounting Rate of Return

• Acceptance/Rejection Criteria
• The higher the accounting rate of return, the
  better the project.
• In general, projects which have an accounting
  rate of return equal to or greater than a pre
  specified cut-off rate of return which is
  usually between 10 to 30 are acceptedothers
  are rejected.

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Accounting Rate of Return

• Year Book Value Profit
• of fixed Asset after Tax
• 1 90,000 20,000
• 2 80,000 22,000
• 3 70,000 24,000
• 4 60,000 26,000
• 5 50,000 28,000

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Accounting Rate of Return

• The Accounting rate of Return is
• (20,00022,00024,00026,00028,000)
• 5
• (90,00080,00070,00060,00050,000)
• 5
• 34

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Problem The expected cash flow of a project are
as follows
Year Cash Flow
0 Taka(100,000)
1 20,000
2 30,000
3 40,000
4 50,000
5 30,000
If the cost of capital (r) 12. If the cost of capital (r) 12.
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• Calculate the NPV.
• Benefit Cost ratio
• Net Benefit cost ratio
• Internal rate of Return
• Payback Period