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Session -2 & 3
Capital Budgeting & Project Valuation
Project Classifications
Independent Projects
If the cash flows of one are unaffected by the acceptance of
the other.
Contingent Projects
Complementary Projects
BRIDGEvs.BOATtoget
productsacrossariver.
Sunk Costs
Sunk cost is a cost that has already been incurred and as
such, exists irrespective of whether the project is
undertaken or not. This cost should not to be considered as
part of project cash flows
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Project A
(1000)
100
200
400
500
600
Project B
(1000)
500
400
300
200
100
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Payback PeriodContd
Project A
Initial cost = 1000
Recovery over the first 3 years = 100 + 200
+ 400 = 700
Balance amount to be recovered
= 1000 700 = 300
Cash flow during the 4th year = 500
So, payback period = 3+300/500 = 3.6 years
Similarly for Project B 2.3 years
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Payback PeriodContd
Advantages
Provides an indication of a projects risk and liquidity.
Because projects with lower payback period get selected.
These projects would free up cash for other uses more
quickly than projects with longer payback period.
Disadvantages
Does not consider the time value of money.
Ignores cash flows beyond the payback period.
Negatively biased towards projects like R&D which have
longer payback period.
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ARRExample
Suppose a project needs investment of Rs.1000, has a life of 5
years and PAT in each of the 5 years are as follows.
Year
Net Accounting Income (PAT)
1
112
2
167
3
233
4
150
5
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Then, the average net accounting income = Rs.144
The book values of investment at the start of the project and at
the end are Rs.1000 and zero respectively.
So, average book value of investment = Rs.500
So, accounting rate of return (ARR) = 144/500 = 28.8 %
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Disadvantages:
Does not consider time value of money,
Uses book value of investment and accounting income
instead of market value of investment and cash flows.
An arbitrary cut-off rate of return is used to approve a
project.
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NPV Profile
The Net present value profile is a graphical
representation of the relationship between an
investments NPVs and various discount rates.
Discount Rate
NPV Project A NPV Project B
NPVProfile
0%
6%
10%
14%
16%
17.73%
20.27%
NPVA
800.00
452.59
270.78
119.26
52.92
(0.08)
(71.26)
NPVB
500.00
312.73
209.21
119.23
78.57
45.46
0.03
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NPV ProfileContd
NPVProfile
900.00
800.00
700.00
Crossoverrate
CrossOverRate
600.00
500.00
400.00
300.00
200.00
100.00
0.00
0%
6%
10%
14%
16%
17.73%
20.27%
(100.00)
(200.00)
NPVA
NPVB
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NPV ProfileContd
NPVs of the projects A and B are same at the
discount rate of 14 %. This rate is called the crossover
rate.
The NPV of project A is higher than the NPV of
project B at discount rates lower than the crossover
rate but
the NPV of project B is higher than the NPV of project A at
discount rates higher than the crossover rate.
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NPV Vs IRR
NPV is calculated using a discount rate (k) and
assumes reinvest at k (opportunity cost of capital).
IRR is the discount rate at which NPV is equal to zero
and IRR assumes reinvest at IRR.
Reinvest at opportunity cost, k, is more realistic, so
NPV method is better. NPV should be used to choose
between mutually exclusive projects.
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NPV Vs IRRContd
For any independent project, if the project has a
positive NPV at a discount rate equal to the cost of
capital,
Then its IRR will automatically be higher than the cost of
capital.
This implies that both the NPV and the IRR decision
rules will lead to the same conclusion for independent
projects.
So, the IRR and the NPV rules have no conflict for
such projects.
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NPV Vs IRRContd
NPV and IRR always lead to the same accept/reject
decision for independent projects
N
P
V
IRR > k
and NPV > 0
Accept.
k > IRR
and NPV < 0.
Reject.
k (%)
IRR
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NPV Vs IRRContd
However, for mutually exclusive projects the
situation is different.
Suppose, the projects A and B are mutually exclusive
meaning that if the project A is taken up then the project B
need not be taken up.
NPV Vs IRRContd
If we apply the NPV rule and the cost of capital is
more than the crossover rate of 14 % then the NPV of
project B is higher than the NPV of project A. So, the
project B should be accepted.
If the cost of capital is less than the crossover rate of
14 % then the NPV of project A is higher than the
NPV of project B and the project A should be
accepted.
The conflict arises because of differences in scale and
timings of the cash flows.
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NPV Vs IRRContd
The critical issue is the reinvestment rate at which the
intermediate cash inflows can be reinvested.
The implicit assumption in the IRR method is that the
intermediate cash inflows are reinvested at the IRR
rate.
However, in case of NPV method, it is assumed
implicitly that the intermediate cash inflows are
reinvested at the cost of capital that is generally used
as the discount rate for estimating NPV.
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NPV Vs IRRContd
So, we need to decide which is the better reinvestment
rate
IRR or cost of capital.
Disadvantages of IRR
Lending/Investing or Borrowing/Financing
Multiple IRRs
The equation used to calculate IRR, is a polynomial equation of
degree n. So, there will be n solutions of IRR.
This is usually not a problem when initial negative cash flow is
followed by a series of positive cash flows. In this case, all
except one solution will be imaginary.
However, when project cash flows are such that initial negative
cash flows are followed by positive cash flows and again
followed by negative cash flows in some of the future periods,
then mathematically multiple real solutions of IRR are available.
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Disadvantages of IRRContd
Multiple IRRsExample
Suppose a company takes a machine on rent from a
supplier for a period of 2 years with the understanding that
the company will pay the rent of the machine of Rs.20
million at the end of 2 years when the machine will be
returned.
The company spends Rs.2 million to install the machine
and earns Rs.10.5 million and Rs.10 million in the 1st and
2nd year respectively before returning the machine. What is
the IRR of this investment?
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Disadvantages of IRRContd
Multiple IRRs..Example
The cash flows are as follows:
Time (Yrs)
Amount
0
- Rs.2 million
1
+ Rs.10.5 million
2
Rs.10 million [ -20+10 ]
So, the IRR of the investment can be calculated by solving
the equation,
- 2 + 10.5/(1+k) -10/(1+k)^2 = 0
Solving we get,
K = 25% and also 300%
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NP V (Rs. th o u san d )
Disadvantages of IRRContd
1000
0
0
25
90.5
300
-1000
-2000
Discount rate (%)
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Disadvantages of IRRContd
Multiple IRRsExample
Now, we are in a dilemma - which IRR is correct?
In some cases there may be more than two solutions
In all such cases, the NPV rule should be applied.
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Year
0
1
2
3
4
5
Project A
(400)
100
200
400
Project B
(1000)
500
400
300
200
100
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Similiarly
209.21 = B/1.1+B/1.1^2+B/1.1^3+B/1.1^4+B/1.1^5
B = 55.19
Therefore, Project A is better
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A 156
B 209
156
156
7 8
1
0
156
2
0
9
1 12
1
1
3
1 15
4
156
2
0
9
NPV(A) = 477.13
NPV(B) = 419.35
Therefore project A is better
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Capital Rationing
Capital rationing is undertaken when a company has
many positive NPV projects but not enough funds to
take up all of them.
This can be solved by linear programming but if the
number of projects is small, then all possible sets of
projects can be checked and the set which provides
the highest NPV can be selected.
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Capital RationingContd
Suppose, a company has five projects with investment,
NPV and PI as follows: Project
Investment
NPV
PI
1
Rs.100, 000
Rs.10, 000
1.1
2
Rs.100, 000
Rs.25, 000
1.25
3
Rs.200, 000
Rs.30, 000
1.15
4
Rs.200, 000
Rs.10, 000
0.95
5
Rs.300, 000
Rs.15, 000
1.05
Suppose, the company has Rs.400, 000 for investment.
Then, which projects are to be selected?
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Capital RationingContd
The project 4 need not be considered because PI < 1.0
and has negative NPV. In terms of ranking, the
project 2 is most profitable (highest PI) and the
projects 3, 1 and 5 are attractive in that order.
Now, since investible fund is Rs.400, 000, the
possible selection could be (2 and 5), (1 and 5) and
(1, 2 and 3). All these would require Rs.400, 000 of
investment.
The net NPVs of these sets are Rs.40,000, Rs.35,000
and Rs.65,000 respectively.
The final selection is the projects 1, 2 and 3 since this
set of projects would maximize the NPV.
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Exercise: 1
Identify which of the following items would be part
of net cash flow of an investment proposal.
1. Savings due to reduction of wastage of raw materials because
of the implementation of the project.
2. Depreciation of new machinery purchased for the project.
3. Fees of a consultant engaged for evaluating the investment
proposal.
4. Loss of sale of some existing products resulting from sale of
some products, available from the new investment project.
Options
a) 1, 2 and 3
b) 1 and 4
c) 1 and 2
d) all of them
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Exercise: 2
The implicit assumption in the IRR rule is that the
reinvestment of the intermediate cash flows takes
place at the rate equivalent to :
a) cost of capital
b) appropriate market rates prevailing when the cash
inflows are received
c) internal rate of return
d) none of the above rules
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Exercise: 3
A company is planning an overseas expansion
project. The estimated cash flows are as follows:Year
Cash flow
0
-Rs.2,000,000
1
Rs.200,000
2
Rs.300,000
3-10
Rs.500,000
The payback period for the project is
a) 10 years
b) 8 years
c) 5 years
d) None of the above
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Exercise: 4
A company is planning an overseas expansion
project. The estimated cash flows are as follows:Year
Cash flow
0
-Rs.2,000,000
1
Rs.200,000
2
Rs.300,000
3-10
Rs.500,000
The cost of capital is 10 %. The NPV of the project is:
a) Rs.634,268
b) Rs.441,496
c) Rs.2,634,268
d) None of the above
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Exercise: 5
A machine has an NPV of Rs.15 million for one 4year replacement cycle. The cost of capital for this
machine is 10 percent. The equivalent annuity for the
NPV of this machine is
a) Rs.3.75 million
b) Rs.1.50 million
c) Rs.4.73 million
d) None of the above
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Exercise: 6
A company is considering a capital investment project
that has the following expected cash flows.
abandonment values that the company expects to
receive if the project is Abandoned at the end of the
particular years are also given.
Year
0 1 2 3 4 5 6
Cash flow
- 80 30 30 40 30 20 10
Abandonment value
60 50 35 25 10
Exercise: 6Contd
Solution:
NPV of the project if not abandoned
= - 80 + 30/1.12 + 30/1.12^2 + 40/1.12^3 +
30/1.12^4 + 20/1.12^5 + 10/1.12^6 = 32.88
NPV if abandoned after one year
= - 80 + 90/1.12 = -5
NPV if abandoned after two years
= - 80 + 30/1.12 + 80/1.12^2 = 8.78
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Exercise: 6Contd
NPV if abandoned after three years
= - 80 + 30/1.12 + 30/1.12^2 + 40/1.12^3 = 22.30
NPV if abandoned after four years
= - 80 + 30/1.12 + 30/1.12^2 + 40/1.12^3 +
30/1.12^4 = 32.34
NPV if abandoned after five years
= - 80 + 30/1.12 + 30/1.12^2 + 40/1.12^3 +
30/1.12^4 + 20/1.12^5 = 33.48
So, NPV is maximized if the project is abandoned
after 5 years.
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Exercise: 7
For a project the projected initial investment is Rs.1m
The net cash flow after tax is expected to be Rs.0.5m
per year for each of five years of plant life. The
market- based marginal cost of capital is 15 %. The
new project will reduce the after-tax cash flow from
the existing lines by Rs.0.1m per year. Should the
project be taken?
a) Yes
b) No
c) Yes, if the cost of capital could be reduced to 12
percent
d) Do not know
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Exercise: 7Contd
The cash flows are as follows considering the reduced
cash flows from the existing lines.
Year
0
1
2
3
4
5
PV of cash flow
-1, 000, 000
347, 826
302, 457
263, 006
228, 701
198, 871
__________
340, 861
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Exercise: 8
A company takes a machine on rent from a supplier
for a period of 2 years with rent of Rs.2 million
payable at the time of return of the machine after 2
years. The company spends Rs.100, 000 for
installation of the machine and earns net cash revenue
(after deducting all cash expenses) of Rs.700,000 and
Rs.1,000,000 respectively in the first and second
years. What is the IRR of the investment? What is
your recommendation regarding the method to be
used for the appraisal of the project?
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Exercise: 8
Solution:
The project cash flows are: Year
Cash flow
0
- 100,000
1
+ 700,000
2
1,000,000 (- 2,000,000 + 1,000,000)
If the IRR is K, then,
-100,000+700,000/(1+k)-1,000,000/(1+K)^2 = 0
Solving, we get,
K = 4 or 1
or, IRR = 400% or 100%
This is a case of multiple IRR.
It is better to use NPV method.
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Thank You!
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