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Capital Budgeting Decision

&
Cash flow Analysis

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Meaning
Capital budgeting
making investment
expenditure. It is
benefits of which
received over period
year.

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is the process of
decisions in capital
an expenditure the
are expected to be
of time exceeding one

Example:
Cost of acquisition of permanent assets as land

and building, plant and machinery, etc.


Cost of addition, expansion, improvement or

alteration in the fixed assets.


Cost of replacement of permanent asset
Research and development project cost, etc.

Capital expenditure involves non-flexible longterm commitment of funds.

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Types of Investment decisions

Expansion of existing business


Expansion of new business
Replacement and modernisation

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Investment evaluation criteria


There are 3 steps are involved in the evaluation of an
investment;
1. Estimation of cash flow
2. Estimation of the required rate of return
3. Application of a decision rule for making the
choice.

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Components of Cash flows:


A typical investment will have three components
of cash flows:
a)

Initial Investment

b)

Annual net cash flows

c)

Terminal cash flows

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a) Computation of Initial Investment:


Purchase price of the asset (incl. duties and taxes)
Add : Insurance, freight, loading, installation
cost
Add : Net increase in working capital
requirement
Less ; Cash inflows in the form of sale
proceeds

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b) Annual Cash Flow:


Cash flow ignores depreciation since it is non-cash item
and includes cash paid for capital expenditures. Depreciation
is an accounting entry and does not involve any cash flow.

Cash flow can be calculated as;


CF = (REV EXP-DEP) (1-T)+ DEP
OR
CF = PROFIT + DEP
OR
CF = (REV-EXP) (1-T) + T(DEP)
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(c) Terminal cash flows:

At the end of the


economic life of a capital asset i.e. the last year
when the asset is terminated there is usually,
some value in the asset left. This inflow of the
last year is called Terminal Cash Flow.

Salvage Value : Is the market price of an


investment at the time of its sale. The cash
proceeds from the sale of the assets will be
treated as cash inflow in the terminal year.
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Techniques of capital
budgeting
(A) Discounted Cash Flow criteria

1.
2.
3.
4.

Net Present Value (NPV)


Internal Rate of Return (IRR)
Profitability Index (PI)
Discounted Pay Back Period (PBP)

(B) Non-discounted Cash Flow criteria

1. Pay Back Period (PBP)


2. Accounting Rate of Return (ARR)

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1. Net
Present
Value
(NPV):
It is one of the discounted cash flow
techniques explicitly recognising the time
value of money.
Acceptable Criteria:
If NPV > 0

- Accept

If NPV = 0 - May accept, May


not accept
If NPV < 0

Not accept )

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n
NPV =

C1
--------- - C0

t =1 (1+k)t
Where,
C1,C2 represent net cash inflows in
year 1, 2
K is the opportunity cost of capital.
C0
is the initial cost of the
investment and n is the expected
life of the investment.
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Example: Assume that project X costs Rs.2,500


now and is expected to generate year end
cash inflows of Rs.900, Rs.800, Rs.700, Rs.600
and Rs.500 in year 1 through 5. The
opportunity cost of capital may be assumed to
be 10 percent.
900
800
700
600
500
NPV = ----- + ------ + ------ + ------ + ------ - 2,500
(1+.1)1 (1+.1)2 (1+.1)3 (1+.1)4 (1+.1)5
= 900/1.1 +800/1.21+700/1.331+600/1/464 +
500/1.61 - 2,500
= 2,725 - 2,500 =
= +225 ( NPV is +ve ) accepted
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Other method by referring table values;


years Cash flow x PVF (10%) = PVof FCF
1
900
x 0.909
= 818
2
800
x 0.826
= 660
3
700
x 0.751
= 526
4
600
x 0.683
= 410
5
500
x 0.621
= 311
-----PV of future cash flow
2,725
Cash Outflow (Initial Invt.)
- 2,500
====
Project is accepted NPV + 225
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(2) Internal Rate of Return (IRR)


It is the rate which equates the present value of
cash inflows with the present value of cash outflows
of an investment. It is the rate at which NPV of the
investment is Zero.
n

Ct
INVT. = ------- - C0 = 0
t=1 (1+r)t
Ct = Cash flow at the end of the
r = Internal Rate of Return
n = life of the project

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project

Example:

Year
0
1
2
3
4
Steps:

NCF
-1,00,000 (Investment)
30,000
30,000
40,000
45,000

1. Determine the NPV of the two closest rate


of return (Trial & Error)
NPV @ 15%
Rs.802
(-1,00,000 + 1,00,802)
NPV @ 16%
Rs.(1,359)
(-1,00,000 +98,641)
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2. Find the sum of the absolute value of the NPV


obtained in step 1
802 + 1,359 = 2,161
3. Calculate the ratio of NPV of the smaller
discount rate:
PV required
Rs.1,00,000
802
PV @ Lower Rate Rs.1,00,802
2,161
PV @ Higher Rate Rs.98,641
PV @LR
r = LR + (HR LR) ---------------Cumulative PV
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802

r = 15 + (16-15) -------2,161
= 15 + (1) 0.37
r = 15.37%
Acceptance Rule:
If
r>k
Accept
r<k
Reject
r = k May accept
or reject
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(3) Profitability Index (PI) or


Cost-Benefit Analysis
It is the ratio of the present value of cash
inflows, at the required rate of return, to the
initial cash outflow of the investment.
PV of cash inflows
PI = -----------------------Initial cash outflows

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Example :

The initial cash outlay of a project is Rs.100000 and


it can generate cash inflow of Rs.40000, Rs.30000,
Rs.50000 and Rs.20000 in year 1 through 4.
Assume a 10% rate of discount.
PI =

Rs.1,12,350
--------------- = 1.1235
Rs.1,00,000
Project is Accepted

Acceptance
If PI > 1
If PI < 1
If PI = 1

Rule ;
Accept
Reject
May accept or reject
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(4) Pay Back Period (PBP):

(Non-

discounted cash flow)

It is defined as the number of years


required to recover the original cash outlay
invested in a project.
If the project generates constant cash
inflows, the PBP can be computed by;
Initial Investment
PBP = ----------------------Annual cash inflows

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Example:
Assume that a project requires an outlay of
Rs.50000 and yields an annual cash inflow of
Rs.12,500 for 7 years. The PBP for the project is;
Rs.50,000
PBP = ------------- = 4 years
Rs. 12,500

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Ex : (when cash inflows unequal)


Year
1
2
3
cash inflows
8000 7000
4000

4
3000

Solution :
Year
CF
Cumulative CF
1
8000
8000
2
7000
15000
3
4000
19000
4
3000
22000
When we add up the cash flows, we find that in the
first three years Rs.19,000 of the original outlays is
recovered. In the fourth year cash inflow generated
is Rs.3000 and only Rs.1000 (20,000 19000) of the
original outlay remains to be recovered.
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The time required to recover Rs.1000 will be;


= (1000 / 3000 ) x 12
= 4 months
PBP = 3 yrs. + 4 months
= 3 yrs. 4 months.
Acceptance rule:
If the PBP calculated for a project is less than
the maximum or standard payback period
set by the management, it would be
accepted.
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(5) Average Rate of Return (ARR)


(Non-discount cash flow technique)

It measures the profitability of an


investment.
Average Income
ARR = ------------------------Average Investment

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Example:
Year
1
2
3
4
5
Cash inflow 8000 10000 11000 10000 12000
Initial Investment ; Rs.40000
Solution:

8000+10000+11000+10000+12000
Avg. Income = -----------------------------------------5 years
= Rs. 10,200

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Rs. 40000
Avg. Investment = ----------- = Rs.20,000
2
10,200
ARR = ----------- x 100
20,000
ARR = 51%
Acceptance rule: If ARR is higher the the
minimum
rate
established
by
the
management and reject those projects
which has ARR less than the minimum rate.
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Reinvestment Assumption
The IRR method is assumed to imply that

the cash flows generated by the project can


be reinvested at its internal rate of return,
whereas the NPV method is thought to
assume that the cash flows are reinvested
at the opportunity cost of capital.

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Modified Internal Rate of Return


(MIRR)
The modified internal rate of return (MIRR)

is the compound average annual rate that is


calculated with a reinvestment rate different
than the projects IRR. The modified internal
rate of return (MIRR) is the compound
average annual rate that is calculated with a
reinvestment rate different than the projects
IRR.

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MIRR: Procedure
MIRR involves finding the Terminal Value (TV) of

the cash inflows, compounded at the firms cost


of capital, and then determining the discount
rate that forces the present value of the TV to
equal the present value of the outflows.
Step 1: Calculate present value of the costs
associate with the project, using the cost of
capital (r) as the discount rate:

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Cash Outflowt
PVC = n ------------------t=0
(1+r)t
TV =
Cash Inflowt (1+r)n-t
Step 2: Calculate the terminal value (TV) of
the inflows expected from the project:
Step3: Obtain MIRR BY
PVC = TV / (1+MIRR)n
MIRR = (TV/PVC)1/n 1
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Example:
Pentagon ltd. is evaluating a project that has the
following cash flows:
Year
0
CF -120

1
-80

2
20

3
60

4
80

5
100

6
120

(Rs. in million)

The cost of capital for Pentagon is 15 percent.


1. The Present value of costs is:
80
PVC = 120 + ------------ = 189.6
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(1 + 0.15)

2. The Terminal Value of CIF is


TV = CIFt(1 + r)n-t
20(1.15)4+60(1.15)3+80(1.15)2+100(1.15)1+120
= 34.98+91.26+105.76+115+120
= 467
3. MIRR:

189.6=467/(1+MIRR)6
(1+MIRR)6 = 2.463
1 + MIRR = (2.463)1/6 = 1.162
MIRR = .162 OR 16.2
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Conventional and Non-conventional


Cash Flows
A conventional investment has cash flows the

pattern of an initial cash outlay followed by cash


inflows. Conventional projects have only one
change in the sign of cash flows; for example, the
initial outflow followed by inflows,
i.e.,
+ + +.
A non-conventional investment, on the other
hand, has cash outflows mingled with cash inflows
throughout the life of the project. Nonconventional investments have more than one
change in the signs of cash flows; for example,
+ + + ++ +.
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NPV Versus IRR


Conventional Independent Projects:

In case of conventional investments,


which are economically independent
of each other, NPV and IRR methods
result in same accept-or-reject
decision if the firm is not constrained
for funds in accepting all profitable
projects.
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NPV Versus IRR


Lending and borrowing-type projects:
Project with initial outflow followed by inflows is
a lending type project, and project with initial
inflow followed by outflows is a borrowing type
project, Both are conventional projects.
Cash Flows (Rs)
Project
X
Y

C0
-100
100

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C1
120
-120

IRR
20%
20%

NPV at 10%
9
-9

Case of Ranking Mutually Exclusive


Projects
Investment projects are said to be mutually

exclusive when only one investment could be


accepted and others would have to be
excluded.
Two independent projects may also be
mutually exclusive if a financial constraint is
imposed.

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Case of Ranking Mutually Exclusive


Projects
The NPV and IRR rules give conflicting

ranking to the projects under the following


conditions:
The cash flow pattern of the projects may
differ. That is, the cash flows of one project
may increase over time, while those of
others may decrease or vice-versa.
The cash outlays of the projects may differ.
The projects may have different expected
lives.
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Timing of Cash Flows

Which project should we choose between Project M and


N? Both projects generate positive NPV at 9%
opportunity cost of capital. Both are profitable. But
Project N is better since NPV is higher.
C0

C1

C2

C3

NPV

IRR

at 9%
(N-M)

-1260

140

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1370

20

10%

Scale of Investment
Cash Flow (Rs)
Project
A
B

C0
-1,000
-100,000

C1
1,500
120,000

NPV
at 10%
364
9,080

IRR
50%
20%

When the cash outlays are different sizes, the NPV methods
gives unambiguous results.
Project
(A-B)

C0
-99000

C1
118,500

NPV at 10%

IRR

8,727

19.7%

The return on the incremental investment is 19.7 percent,


which is in excess of the 10 percent required rate of return.
Therefore, Project B to Project A.
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Project Life Span


Cash Flows (Rs)
Project
X
Y

C0
10,000
10,000

Both the
Rs.10,000
to choose
consistent

C1

C2

C3

C4

C5

NPV at 10%

IRR

12,000
0

20,120

908
2,495

20%
15%

project require initial cash outlays of


each. In this case NPV rule can be used
between the projects since it is always
with the wealth maximization principle.

Project Y is accepted.
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