FINANCIAL MANAGEMENT I

Capital Budgeting

Introduction to Capital Budgeting

Capital Budgeting is the firms decision to invest its funds most efficiently in long-term assets in anticipation of expected benefits over a number of years Capital Budgeting decisions include.. Expansion Acquisition Modernisation Replacement Divestment (selling off) of long term assets
FM I, Session 3&4 2

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Features of Investment Decisions

Exchange of current funds for future benefits Funds are invested in long term assets Future benefits will occur over a series of years

Kindly note. Expenditure and benefits is to be measured in cash Cash flows are important and not accounting profits Investment decisions affect the firms value

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FM I, Session 3&4

Why Investment Decisions are Important

Investment Decisions require special attention because. They influence the firms growth in the long run They affect the risk profile of the firm They involve commitments of large amount of funds They are largely irreversibleeven if reversible its at a substantial cost Most complex / difficult decisions to make

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FM I, Session 3&4

Evaluation of an Investment Opportunity

Evaluation of an Investment involves 3 key steps. 1) Estimation of Cash Flows 2) Estimation of Required Rate of Return (i.e. the discount rate) 3) Application of a Decision Rule for making the choice In our current discussion, we will assume that the first 2 steps as given. We will focus on the merits & demerits of various decision rules

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FM I, Session 3&4

Capital Budgeting Techniques

Capital Budgeting techniques can be broadly grouped into 2 categories. Discounted Cash Flow (DCF) criteria Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index Non DCF Criteria Payback Period (PB)(Non discounted PB) Accounting Rate of Return (ARR)
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Capital Budgeting Techniquescontd

No matter which evaluation criteria is applied, a sound appraisal technique should. Consider all cash flows Recognise the fact that larger cash flows are preferable to smaller ones and early cash flows are preferable to later ones

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FM I, Session 3&4

Payback Period(Non Discounted)

Defined as the Number of years required to recover the original cash outflow / investment in a project Payback = (Initial Investment) / ( Annual Cash Inflows) (The above formula is applicable when the project generates constant annual cash inflows)

Calculation of payback period when there is uneven cash flowsas discussed in class
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Payback Period.contd
Acceptance Rule for Payback..

If the Payback Period calculated for a project is less than the Maximum / Standard payback period set by the management, then it would be acceptedelse not Projects with Least Payback Period gets the Highest Ranking

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FM I, Session 3&4

Payback Period.contd
Merits of Payback Period It is one of the most popular & widely recognised methods of evaluation of an investment proposal Can be used to as an acceptance / rejection criterion as well as to rank projects Very simple to understand Liquidity-emphasis is on the early recovery of the investment,hence the fund released can be used for other purpose.
Drawbacks. Time Value of Money NOT considered. All cash flows NOT considered (cash flows after payback not considered in evaluation) Hence evaluation through Payback MAY NOT result in Wealth Maximisation
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Discounted Payback
The Discounted payback period is the number of periods taken in recovering the investment outlay on the present value basis. The discounted payback period still fails to consider the cash flows that occur after the payback period. Sum (Problem/Example) on discounted payback period discussed in class
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Accounting Rate of Return (ARR)

ARR, also known as Return on Investment (ROI) uses accounting information to measure profitability ARR = (Avg Income) / (Avg Investment) Acceptance Rule Accept projects whose ARR is higher than the minimum rate established by the management; a project with the highest ARR gets the highest rank Drawbacks Use of accounting profits & NOT cash flows.profits subject to accounting treatments Averaging of income ignores time value of money
Hence evaluation through ARR MAY NOT result in Wealth Maximisation; ARR more suitable as performance evaluation / control measure but NOT for Capital Budgeting
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Net Present Value (NPV)

NPV of a project is the sum of the present values of each of the cash flows positive as well as negative that occur over the life of the project

NPV = CFt / (1+r)t Initial Investment

Where CFt = Cash Flow in period t r = Discount Rate Decision rule: if NPV > 0, accept the project (as it is value accretive) if NPV < 0, reject the project

If there are 2 projects, both of which have a +ve NPV, and if we have to choose onewe should go for the one which has the higher NPV.so as to maximise wealth
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Internal Rate of Return (IRR)

Mathematically IRR is that Discount Rate at which NPV of a project = 0 Calculation of IRR is an iterative method (unless using excel) IRR is expressed as a % (as for a discount rate), hence easier to understand Decision rule: if IRR > Opportunity Cost of Capital of the project accept the project if IRR < Opportunity Cost of Capital of the project, reject the project
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NPV vs IRR
Evaluation under NPV and IRR is SUPPOSED to result in choosing the same project. ..however there are situations where the outcome of the two MAY be CONFLICTING We look at some of these situations. 1: Size Disparity sum(problem/example) discussed in class 2: Difference in Timing of CFs.. sum discussed in class 3: Difference in Project Lifespan sum discussed in
class
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Profitability Index (PI)

PI = (PV of Future Cash Flows) / (Initial Cash Outlay)
Acceptance Rule: Accept if PI > 1; Reject if PI < 1; May accept if PI = 1
( if PI > 1 => NPV > 0)

PI is a conceptually sound method of investment appraisal; it is a Relative Measure of a projects profitability

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References
Financial Management by I M Pandey Financial Management - Theory & Practice by Prasanna Chandra Principles of Corporate Finance by Brealey Myers Corporate Finance Theory & Practice by Aswath Damodaran
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Thank You!!

P.S: sums (problems/examples) on all the above topics as discussed in class in not covered in this PPT, pls refer to your class notes for the same. Pls refer to the mentioned books in this ppt for detailed reference
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