The Basics of Capital

Budgeting
Should we
build this
plant?
#
What is capital budgeting?
Horngreen, Capital budgeting is long term planning for
making and financing proposed capital outlays.
G.C.Philippatos, Capital budgeting is concerned with
the allocation of the firms scarce financial resources
among the available market opportunities. The
consideration of investment opportunities involves the
comparison of the expected future streams of earnings
from a project with the immediate and subsequent
streams of earning from a project, with the immediate
and subsequent streams of expenditures for it.
Analysis of potential additions to fixed assets.
Long-term decisions; involve large expenditures.
Very important to firms future.
#
Need and Importance of Capital
Budgeting
Large investments
Long-term commitment of funds
Irreversible nature
Long term effect on profitability
Difficulties of investment decisions
National importance
#
Steps to capital budgeting
1. Estimate CFs (inflows & outflows).
2. Assess riskiness of CFs.
3. Determine the appropriate cost of
capital.
4. Find NPV and/or IRR.
5. Accept if NPV > 0 and/or IRR >
WACC.
#
The investment decision-
making process
Stage 1
Stage 2
Stage 3
Stage 4
Stage 5
Determine investment funds available
Identify profitable project opportunities
Evaluate the proposed project(s)
Stage 6
Monitor and control the project(s)
Approve and implement the
project(s)
Appraise and classify proposed projects
#
Methods of investment appraisal
Payback period (PP)
Net present value (NPV)
Accounting rate of return (ARR)
Internal rate of return (IRR)
#
Methods of Capital Budgeting
Methods of capital
Budgeting
Traditional Methods Discounted Methods
Pay back period
method
Accounting rate of
return
Net Present Value
Method
Internal Rate of
Return
Profitability Index
#
Payback period
The number of years required to recover a
projects cost, or How long does it take to
get our money back?
Calculated by adding projects cash inflows
to its cost until the cumulative cash flow
for the project turns positive.
Annual cash inflows (Net profit before
depreciation and after tax) are taken.
#
Calculating payback
Payback
L
= 2 + / = 2.375 years

CF
t
-100 10 60 100

Cumulative -100 -90 0 50
0 1 2
3
=
2.4
30 80
80
-30
Project L
Payback
S
= 1 + / = 1.6 years

CF
t
-100 70 100 20

Cumulative -100 0 20 40
0 1 2
3
=
1.6
30 50
50
-30
Project S
#
Strengths and weaknesses of
payback
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.
#
Accounting rate of return
Average annual profit after tax x 100
Average investment in the project
ARR

=
Also known as return on investment or
return on capital employed.
The ARR method distorts all cash flows by
averaging them over time.
It ignores the time value of money.
#
Net Present Value (NPV)
Considers the time value of money .
NPV discounts all cash inflows and outflows
attributable to a capital investment project by a
chosen percentage eg. Weighted average cost of
capiatl.
It takes sum of the PVs of all cash inflows and
deducts it from outflows of a project. If the
yield is positive the project is acceptable.

=
+
=
n
0 t
t
t
) k 1 (
CF
NPV
#
Present value of Re1 receivable at various times in the
future, assuming an annual financing cost of 20%
(1 + 0.2)
0
(1 + 0.2)
5
(1 + 0.2)
4
(1 + 0.2)
1
(1 + 0.2)
2
(1 + 0.2)
3
1.000

0.833

0.694

0.579

0.482

0.402

Year
1 2 3 4 5
Present value
of Re.1
#
Rationale for the NPV
method
NPV = PV of inflows Cost
= Net gain in wealth
If projects are independent, accept if
the project NPV > 0.
If projects are mutually exclusive,
accept projects with the highest
positive NPV, those that add the most
value.
#
Why NPV is superior to ARR
The whole of the relevant cash flows
The objectives of the business
The timing of the cash flows
NPV is a better method of appraising
investment opportunities than ARR because it
fully addresses each of the following:
#
Internal Rate of Return (IRR)
IRR is the discount rate that forces PV of
inflows equal to cost, and the NPV = 0:



It is the percentage rate of return, based
upon incremental time-weighted cash flows.
Solving for IRR :
Trial and Error approach

=
+
=
n
0 t
t
t
) IRR 1 (
CF
0
#
Profitability Index
PI
PV of Future Cash Inflows
Initial Investment
NPV
Initial Investment
=
=
+
1
Decision Rule:
Undertake the project if PI > 1.0
#
Profitability Index
PI measures the NPV per rupee invested.
For independent projects, the PI method
yields conclusions identical to the NPV
method.
For mutually exclusive projects,
differences in project size can lead to
conflicting conclusions.
Use the NPV method.
PI is useful when there is capital rationing.
#
Interest
forgone
Inflation
Discount
rate
Risk premium
The factors influencing the
discount rate to be applied
to a project
#
Inflation
Inflation effects can be complex
because asset value is a function of
both the required return and the
expected future cash flows.
The changes can cancel each other
out, leaving the projects NPV
unchanged.
#
Inflation
Inflation affects the cash flows
from a project.
Effect on revenues
Effect on expenses
Inflation also affects the cost of
capital.
The higher the expected inflation, the higher
the return required by investors.
Thus, the effects of inflation must
be properly incorporated in the NPV
analysis.
#
Effect of Inflation on the
Cost of Capital
Notation:
r
r
= cost of capital in real terms
r
n
= cost of capital in nominal terms
i = expected annual inflation rate
(1 + r
n
) = (1 + r
r
) (1 + i)
r
n
= r
r
+ i + i r
r
#
Inflation and NPV Analysis
The NPV of the project is unchanged
as long as the cash flows and the
cost of capital are expressed in
consistent terms.
Both in real terms
Both in nominal terms
If inflation is expected to affect
revenues and expenses differently,
these differences must be
incorporated in the analysis.
#
Risk Analysis in Capital Budgeting
Risk relates to uncertainty about a projects
future profitability.
Techniques:
Certainity equivalent method
Risk Adjusted discount rate
Sensitivity analysis
Scenario analysis
Decision tree analysis
Standard deviation method
Co-efficient of Variation
#
The Certainty Equivalent
Approach
The project is adjusted for risk by
converting the expected cash flows
to certain amounts then discounting
at the risk-free rate.
The NPV is computed as:
( ) ( )

= = +

=
+
=
n
t
t
RF
t t
n
t
t
RF
t
k
CFAT
k
CECF
NPV
0 0 1 1
o
#
The Risk-Adjusted Discount
Rate Approach
Use CAPM to get relevant rate:


Establish risk classes and assign
RADR
( )
b k k k k
project RF m RF project
+ =
#
What is sensitivity analysis?
Shows how changes in a variable
such as unit sales affect NPV or
IRR.
Each variable is fixed except one.
Change this one variable to see the
effect on NPV or IRR.
Answers what if questions, e.g.
What if sales decline by 30%?
#
Factors affecting the
sensitivity of NPV calculations
for a new machine
Operating
costs
Project
NPV
Financing
cost
Initial
outlay
Sales
price
Annual sales
volume
Project
life
#
Sensitivity Analysis
Change the value of an independent
variable by X%
Calculate the resulting value of the
dependent variable
Calculate the % A in the dependent
variable; compare!
If % A > X%, then dependent variable
is sensitive to changes in the
independent variable

#
What are the weaknesses of
sensitivity analysis?
Does not reflect diversification.
Says nothing about the likelihood
of change in a variable, i.e., a
steep sales line is not a problem if
sales wont fall.
Ignores relationships among
variables.
#
Why is sensitivity analysis
useful?
Gives some idea of stand-alone
risk.
Identifies potentially
dangerous variables.
Gives some breakeven
information.
#
What is scenario analysis?
Examines several possible
situations, usually worst case,
most likely case, and best case.
Provides a range of possible
outcomes.
#
Decision Tree
A decision tree is diagramatic representation of
the relationships among decision states of nature
and outcomes (pay-offs).
Decision trees are constructed left to right.
The branches represents the possible alternative
decisions which could b made and the various
possible outcomes which may arise.
#
Decision tree diagram showing
different possible project outcomes
Outcome 1
Outcome 2
Outcome 3
Outcome 4
Year 1 (0.6)
Year 2 (0.6)
Year 1 (0.4)
Year 2 (0.4)
Year 1 (0.4)
Year 2 (0.6)
Year 1 (0.6)
Year 2 (0.4)
0.6 x 0.6 = 0.36
0.4 x 0.4 = 0.16
0.4 x 0.6 = 0.24
0.6 x 0.4 = 0.24
8,000
8,000
8,000
12,000
12,000
12,000
8,000
12,000
Cash
flow
Rs.
Probability
Total 1.00
O
u
t
l
a
y

(
R
s
.
6
,
0
0
0
)

#
Standard Deviation
o
NPV
= E fd
2
n
Coefficient of Variation
CV
NPV
= = = 2.0.
$30.3
$15
Eo
NPV

Mean
Thank You