Chapter 11

TECHNIQUES OF CAPITAL BUDGETING

CAPITAL EXPENDITURES AND THEIR

IMPORTANCE

• The basic characteristics of a capital expenditure (also referred to as a capital investment or just project) is that it involves a current outlay (or current and future outlays) of funds in receiving a stream of benefits in future

• Importance stems from

• Long-term consequences

• Substantial outlays

• Difficulty in reversing

ImportanceImportance

Issues of concern in Corporate Finance

Financing its Investments( cap. Structure)Managing short term operations (WCM)Allocation of capital( Cap. budgeting)

OUTLINE

• Importance

• Capital Budgeting Process

• Project Classification

• Investment Criteria

• Net Present Value

• Benefit Cost Ratio

• Internal Rate of Return

• Modified Internal Rate of Return

• Payback Period

• Accounting Rate of Return

CAPITAL BUDGETING PROCESS

1.Identification of Potential Investment Opportunities

•Develop estimates of future sales

•Monitor external environment

•Formulate well defined corporate strategy

•Thorough analysis of SWOT

2.Assembling of Investment Proposals

For facilitating decision making, budgeting &

control

Process3. Decision Making

4.Preparation of Capital Budget and AppropriationsFunds position to be analyzed

5.Implementation

Adequate implementation of projectsUse of Responsibility accountingUse of Network techniques

6. Performance Review

PROJECT CLASSIFICATION

• Mandatory Investments

• Replacement Projects

• Expansion Projects

• Diversification Projects

• Research and Development Projects

• Miscellaneous Projects

INVESTMENT CRITERIA

INVESTMENT CRITERIA

DISCOUNTING CRITERIA

NON-DISCOUNTING CRITERIA

NET PRESENT

VALUE

BENEFIT COST

RATIO

INTERNAL RATE OF RETURN

PAYBACK PERIOD

ACCOUNTING RATE OF RETURN

NET PRESENT VALUE

n Ct

NPV = – Initial investment t=1 (1 + rt )t

NET PRESENT VALUEThe net present value of a project is the sum of the present value of all the cash flows associated with it. The cash flows are discounted at an appropriate discount rate (cost of capital)

Naveen Enterprise’s Capital Project

Year Cash flow Discount factor Present value 

0 -100.00 1.000 -100.001 34.00 0.870 29.582 32.50 0.756 24.573 31.37 0.658 20.644 30.53 0.572 17.465 79.90 0.497 39.71

Sum = 31.96

  Pros Cons

• Reflects the time value of money • Is an absolute measure and not a relative

• Considers the cash flow in its entirely measure

• Squares with the objective of wealth maximisation

PROPERTIES OF THE NPV RULE

• NPVs ARE ADDITIVE

• INTERMEDIATE CASH FLOWS ARE INVESTED AT

COST OF CAPITAL

• NPV CALCULATION PERMITS TIME-VARYING

DISCOUNT RATES

• NPV OF A SIMPLE PROJECT AS THE DISCOUNT

RATE

BENEFIT COST RATIO PVB

Benefit-cost Ratio : BCR = I

PVB = present value of benefits I = initial investment

To illustrate the calculation of these measures, let us consider a project which is being evaluated by a firm that has a cost of capital of 12 percent.

Initial investment : Rs 100,000Benefits: Year 1 25,000

Year 2 40,000Year 3 40,000Year 4 50,000

The benefit cost ratio measures for this project are:

25,000 40,000 40,000 50,000(1.12) (1.12)2 (1.12)3 (1.12)4

BCR = = 1.145100,000

Pros ConsMeasures bang per buck Provides no means for aggregation

+ + +

Discount rate

Net Present Value

INTERNAL RATE OF RETURN

The internal rate of return (IRR) of a project is the discount rate that makes its NPV equal to zero. It is represented by the point of intersection in the above diagram

Net Present Value Internal Rate of Return

• Assumes that the • Assumes that the net

discount rate (cost present value is zero of capital) is known.

• Calculates the net • Figures out the discount rate

present value, given that makes net present value zero the discount rate.

CALCULATION OF IRR

You have to try a few discount rates till you find the one that makes the NPV zero

Year Cash Discounting Discounting Discounting

flow rate : 20% rate : 24% rate : 28%

Discount Present Discount Present Discount Present

factor Value factor Value factor Value

0 -100 1.000 -100.00 1.000 -100.00 1.000 -100.00

1 34.00 0.833 28.32 0.806 27.40 0.781 26.55

2 32.50 0.694 22.56 0.650 21.13 0.610 19.83

3 31.37 0.579 18.16 0.524 16.44 0.477 14.96

4 30.53 0.482 14.72 0.423 12.91 0.373 11.39

5 79.90 0.402 32.12 0.341 27.25 0.291 23.25

NPV = 15.88 NPV = 5.13 NPV = - 4.02

CALCULATION OF IRR

NPV at the smaller rate

Sum of the absolute values of the NPV at the smaller and the bigger discount rates

5.13 24% + 28% - 24% = 26.24%

5.13 + 4.02

Bigger SmallerX discount – discount rate rate

Smaller discount + rate

PROBLEMS WITH IRR

• NON-CONVENTIONAL CASH FLOWS

• MUTUALLY EXCLUSIVE PROJECTS

• LENDING VS. BORROWING

• DIFFERENCES BETWEEN SHORT-TERM AND

LONG-TERM INTEREST RATES

NON-CONVENTIONAL CASH FLOWS

C0 C1 C2

-160 +1000 -1000

TWO IRRs : 25% & 400%

NPV

25% 400%

NO IRR : C0 C1 C2

150 -450 375

MUTUALLY EXCLUSIVE PROJECTS

C0 C1 IRR NPV(12%)

P -10,000 20,000 100% 7,857

Q -50,000 75,000 50% 16,964

LENDING VS BORROWING

C0 C1 IRR NPV(10%)

A -4000 6000 50% 145

B 4000 -7000 75% -236

MIRRMIRR

The procedure for calculating MIRR is

Step.1. Calculate PVC associated with the project using cost of capital (r) as the discount rate.

Step.2. Calculate the terminal value (TV) of the cash flows expected from the project.

Step.3.Obtain MIRR using the equation.

MODIFIED IRR

0 1 2 3 4 5 6

-120 -80 20 60 80 100 120 r=15% 115 -69.6 r =15% r =15% 105.76 PVC = 189.6 r =15% 91.26 r =15% 34.98 Terminal value (TV) = 467 PV = 189.6 MIRR = 16.2% of TV NPV 0

PAYBACK PERIOD

Payback period is the length of time required to recover the initial

outlay on the project

Naveen Enterprise’s Capital Project

Year Cash flow Cumulative cash flow

0 -100 -1001 34 - 662 32.5 -33.53 31.37 - 2.134 30.53 28.40

Pros Cons• Simple • Fails to consider the time value

of money• Rough and ready method • Ignores cash flows beyond

the for dealing with risk payback period• Emphasises earlier cash inflows

AVERAGE RATE OF RETURN Average PAT

Average Book Value of Investment (Beginning)

Naveen Enterprise’s Capital ProjectYear Book Value of PAT

Investment(Beg)

1 100 142 80 17.53 65 20.124 53.75 22.095 45.31 23.57

1/5 (14+17.5 +20.12+22.09+23.57) 1/5(100+80+65+53.75+45.31)

Pros Cons

• Simple • Based on accounting profit,

• Based on accounting information not cash flow

businessmen are familiar with • Does not take into account the

• Considers benefits over the entire project life time value of money

ARR = = 28.31%

INVESTMENT APPRAISAL

IN PRACTICE

• Over time, discounted cash flow methods have gained in importance and internal rate of return is the most popular evaluation method.

• Firms typically use multiple evaluation methods.

• Accounting rate of return and payback period are widely employed as supplementary evaluation methods.

SUMMING UP

n Ct

• NPV = – I t = 1 (1 + r)t

PVB• BCR =

I

• IRR is the value of r in the following equation n Ct

I = t = 1 (1 + r)t

• MIRR is calculated as follows: TV

PVC = (1 + MIRR)n

• The payback period is the length of time required to recover the initial cash outlay on the project

• The accounting rate is defined as:

Average profit after tax

Average book value of investment