Capital Budgeting

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Session 4

• Capital Budgeting

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Capital Budgeting - Methods

• 1. Average Return on Investment
• 2. Payback
• 3. Net Present Value
• 4. Internal Rate of Return
• 5. Modified IRR

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Average Return on Investment

• AROI Avg. Net Income Per Year
• Avg. Investment

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Average Return on Investment

• Example
• Year Net Income Cost
• 1 6,000 100,000 Initial
• 2 8,000 0 Salvage Value
• 3 11,000
• 4 13,000
• 5 16,000
• 6 18,000

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Average Return on Investment

• Avg. Net Income 72,000
• 6
• Avg. Investment 100,000
• 2
• AROI 12,000
• 50,000

12,000
50,000
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Average Return on Investment

• Advantages
• Disadvantages

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Payback Method

• Years required to recover the original
  investment
• Example
• 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 18,000 172,000
• Payback 3 100,000 - 85,000
• 118,000 - 85,000

3.45 Years
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Payback Method

• Advantages
• Disadvantages

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Time Value of Money

• FV PV (1 r)n
• Compounding Finding FV
• Discounting Finding PV PV FV/(1 r) n
• Internal Rate of Return Finding r

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Net Present Value

• NPV Present Value of All Future Cash Flows less
  Inital Cost
• CF1 CF2 CF3 .......CFn -
  Io
• 1r (1r)2 (1r)3 (1r)n

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Net Present Value - Example

• Year CF Disc. Factor PV
• 0 -100000 1 -100000
• 1 26000 1/1.1 .9091 23637
• 2 28000 1/(1.1)2 .8264 23139
• 3 31000 1/(1.1)3 .7573 23290
• 4 33000 1/(1.1)4 .6830 22539
• 5 36000 1/(1.1)5 .6209 22352
• 6 18000 1/(1.1)6 .5645 10161
• NPV 25121

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Net Present Value

• Advantages
• Disadvantages

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Internal Rate of Return

• Discount rate that makes NPV Zero (i.e., that
  equates PV of benefits with the cost).
• IRR Io CF1 CF2 ..... CFn
• 1r (1r)2 (1r)n
• Solve for r.
• Example
• 100,000 26000 28000 31000 ..........
  18000
• 1r (1r)2 (1r)3
  (1r)6
• r 18.2

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Internal Rate of Return

• Advantages
• Disadvantages

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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 CF Disc. Factor PV
• 0 -100,000 1 -100,000
• 1 26,000 0.91 23,636
• 2 28,000 0.83 23,140
• 3 31,000 1/(1.1)3 .7573 23,291
• 4 33,000 1/(1.1)4 .6830 22,539
• 5 36,000 1/(1.1)5 .6209 22,352
• 6 18,000 1/(1.1)6 .5645 10,161
• NPV 25,121

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NPV Profile

• Dis. Rate NPV
• 0 7200
• 5 45725.7
• 10 25120.76
• 15 8711.838
• 20 -4538.97
• 25 -15376.1

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NPV Profile

• 80000
• 60000
• 40000
• 20000
• 0
• -20000
• 0 0.05 0.1 0.15 0.2 0.25
• Disc. Rate

NPV
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Choosing Between Projects

• Year CF(A) CF(B)
• 0 -25000 -25000
• 1 2000 21000
• 2 2000 10000
• 3 35000 2000
• NPV 6351 4606
• IRR 17 22

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Modified IRR
Reinvestment Rate Assumption (Project
A)     Project  Outlay  25,000 Cash Flows YR1 
2,000                     YR2  2,000
                    YR3  35,000       NPV _at_
8 6,351  IRR 17
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Modified IRR
NPV Project A     YR1   2,000     YR2  
2,000 2,000 160 4,160    YR3   35,000
4,160 333 39,493 Note PV of 39,493, three
years from now _at_ 8   31,351                    
                                      Less
outlay  25,000                                   
                                NPV 
6,351
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Modified IRR
IRR _at_ 17     YR1   2,000   2,000     YR2  
2,000 2,000 340 4,340     YR3   35,000
4,340 738 40,078 25,000 invested for three
years _at_ 17 25,000(1.17)3 40,040
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Modified IRR
Modified Internal Rate of Return     Find k
such that   (1k)nI0  Final value    
i.e.     (1k)3 25000  39,439
                                 k  16.5
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Modified IRR
Reinvestment Rate Assumption (Project
B)    Project  Outlay  25,000 Cash Flows YR1 
21,000                     YR2  10,000
                    YR3  2,000       NPV _at_ 8
4,606  IRR 22.12
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Modified IRR
NPV Project B         YR1 21,000
21,000        YR2 10,000 21,000 1,680
32,680         YR3  2,000 32,680 2,614  
37,294 Note PV of 37,294, three years from
now _at_ 8   29,606                               
                         Less outlay  25,000
                                                 
      NPV  4,606
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Modified IRR
   IRR of 22.12          YR1  
21,000    21,000         YR2   10,000
21,000 4,645 35,645         YR3   2,000
35,645 7,885 45,530 25,000 invested for
three years _at_ 22.12 25,000(1.2212)3 45,530
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Modified IRR
Modified Internal Rate of Return Find k such
that   (1k)nI0  Final value            
i.e.     (1k)3 25000  37,294
                                          k 
14.26
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Estimating Cash Flows

• NPV CF1 CF2 .............. CFn - Io
• lr (lr)2
  (lr)n
• Cash Flows Incremental
• After Tax
• Net Working Capital
• Sunk Costs

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Procedure

• 1. Initial Costs New CAPEX
• Additional W. Cap
• Sale of Old Assets
• 2. Annual Costs Revenue Less Costs
• After Tax
• 3. Terminal Cash Flows Salvage Value
• Recoupment of NWC

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Cash Flow Estimates

• Sale of Existing Plant
• CF Selling Price T (B.V. - S.P.)
• Annual Cash Flows
• OCF (Sales-Cost)(1-T) T, DEPREC
• or
• OCF Net Inc Depreciation

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New Product Proposal

• Annual Sales 20m
• Annual Costs 16m
• Net Working Capital 2m
• Plant Site 0.5m
• Plant and Equipment 10m
• Depreciation Straight Line over 20 years
• Salvage Value nil
• Tax Rate 40
• Required Return 8

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New Product Proposal

• INITIAL CASH FLOWS
• ANNUAL CASH FLOWS

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New Product Proposal

• TERMINAL CASH FLOWS
• CALCULATION

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Evaluating Capital Projects

• 1) Focus on Cash Flow, Not Profits.
• Cash Flow Economic Reality.
• Profits Can Be Managed.
• 2) Carefully Estimate Expected Future Cash Flows.
• 3) Select a Discount Rate Consistent with the
  Risk of Those Future Cash Flows.
• 4) Account for the Time Value of Money.
• 5) Compute a Base-Case NPV.

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Evaluating Capital Projects

• 6) Net Present Value Value Created or Destroyed
  by the Project.
• NPV is the Amount by which the Value of the Firm
  Will Change if you Undertake the Project.
• 7)Identify Risks and Uncertainties. Run a
  Sensitivity Analysis.
• Identify Key Value Drivers.
• Identify Breakeven Assumptions.
• Estimate Scenario Values.
• Bound the Range of Value

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Evaluating Capital Projects

• 8) Identify Qualitative Issues.
• Flexibility
• Quality
• Know-How
• Learning
• 9) Decide