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Capital budgeting
How do we know whether your idea create value or not.
We understood how market works?
How is pricing done?
How to make risk adjustments?
Now the perspective changes to that of the corporation.
How to take projects?
6-2
6-3
Capital budgeting
Difference between revenue expenditure and capital
expenditure
Capital
Efficient allocation
Capital Budgeting
Introduction
6-5
Capital budgeting
Long term Investment decision of a firm is known as
capital budgeting.
Capital budgeting decision is the decision to invest current
funds efficiently in the long term assets in anticipation of
future cash flow/benefits over a series of years
Capital budgeting involves planning and justifying how
capital rupees are spent on long term projects
S h o r t T e r m A s s e ts
F in a n c in g D e c is io n
D iv id e n d D e c is io n
D e b t / E q u it y M ix
D iv id e n d P a y o u t R a t io
C a p ita l B u d g e tin g
6
Capital budgeting
What projects should the firm take?
Marketing and advertising
R&D
Choices among different production processes
Expanding into new products, industries, or markets
Investments in new technology
Acquisitions
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6-10
EVALUATION CRITERIA
6-11
6-12
CF
Years to discount
-1000
Year 1 :
1320
Similar investments earn 10%?
Difference between PV and NPV
PV
CF
NPV =
1
(1 +
1 r )
Market
interest rates
Market
risk aversion
CF
CFN
+
+
+
2
N
2
(1 +
r)
Initial
cost (1 + r)
Projects risk-adjusted
cost of capital
(r)
Projects
debt/equity capacity
Projects
business risk
Review
Valuation
The value of any asset or project equals the net present
value of its expected cashflows
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NPV
Where do the cash flows come from?
Where does r come from? (opportunity cost of capital?)
What does the final number mean?
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Investment decision
Cash
Investment
Opportunity
(real asset)
Firm
invest
shareholder
Alternative:
Pay dividend
To shareholders
Investment
Opportunities
(financial assets)
Shareholders
Invest for themselves
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NPV
Minimum Acceptance Criteria: Accept if NPV > 0
For a single project, take if it and only if its NPV is positive
For many independent projects, take all those with
positive NPV
For mutually exclusive projects, take the one with positive
and highest NPV
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Disadvantage: static
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CHECK!!
Should make sense ( benefit should exceed costs)
Unit of measurement a criteria uses is extremely
important.
What is the benchmark?
Easy to communicate, why? (research vs applied field)
Easy to compare different ideas
Easy to calculate
6-24
investment?
Payback Period = number of years to recover initial costs
Minimum Acceptance Criteria:
set by management
Ranking Criteria:
set by management
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How long does it take the project to pay back its initial
investment taking the time value of money into account?
By the time you have discounted the cash flows, you
might as well calculate the NPV.
rA
A
v
e
a
g
N
t
I
n
c
o
m
e
RB
okV
lufvstn
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set by management
Disadvantages:
Advantages:
The accounting information is usually available
Easy to calculate
6-28
IRR
Year
0
1
Cashflow (Rs)
- 100
110
IRR intuition
What is the NPV if I use the IRR to calculate it?
IF one uses IRR to calculate NPV , it should be always be zero. What is it saying?
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6-30
5
0
1
0
1
5
0
N
PV02(1IR)(IR)2(IR)
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0
-$200
$50
$100
$150
19.4
6-32
NPV
$100.00
$71.04
$47.32
$27.79
$11.65
($1.74)
($12.88)
($22.17)
($29.93)
($36.43)
($41.86)
IRR = 19.44%
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Multiple IRRs
There are two IRRs for this project:
$200
$800
1
Which one
should
3 we use?
$100.00
$200
NPV
$8
00 100% = IRR2
$50.00
$0.00
-50%
0%
($50.00)
($100.00)
($150.00)
50%
100%
0% = IRR1
150%
200%
Discount rate
6-35
investments?
What if the 100% return is on a $1 investment while the
50% return is on a $1,000 investment?
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Project A
0
$10,000
Project B
$1,000
$12,000
0
1
$10,000
$1,000
2
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6-38
NPV of A is rs 10668
NPV of B is rs 10751
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Project A
$3,000.00
Project B
NPV
$2,000.00
$1,000.00
$0.00
($1,000.00) 0%
10%
20%
30%
40%
($2,000.00)
($3,000.00)
($4,000.00)
12.94% = IRRB
16.04% = IRRA
Discount rate
6-40
$3,000.00
NPV
$2,000.00
10.55% = IRR
$1,000.00
$0.00
($1,000.00) 0%
5%
10%
($2,000.00)
($3,000.00)
Discount rate
15%
20%
A-B
B-A
6-41
CHECK!!
Should make sense ( benefit should exceed costs)
Unit of measurement a criteria uses is extremely
important.
What is the benchmark?
Easy to communicate, why? (research vs applied field)
Easy to compare different ideas
Easy to calculate
oPItalPV
T
fIniFutvreCnashFlow
6-42
Disadvantages:
Problems of scale and hence
Problems with mutually exclusive investments
Advantages:
May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
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investment of a
6-44
6-45
IRR or NPV.
6-46
Problems
The expected cash flow of a project are as follows
Year
Cash flow
-100000
20,000
30,000
40,000
50,000
30,000
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Project A
-$200
$200
$800
-$800
Project B
-$150
$50
$100
$150
6-48
Project A
-$200.00
Project B
-$150.00
$241.92
$240.80
$41.92
0%, 100%
1.2096
$90.80
36.19%
1.6053
6-49
6-50
NPV for A
-87.52
0.00
59.26
59.48
42.19
20.85
0.00
-18.93
NPV for B
234.77
150.00
47.92
-8.60
-43.07
-65.64
-81.25
-92.52
6-51
NPV
NPV Profiles
$400
$300
IRR 1(A)
IRR (B)
IRR 2(A)
$200
$100
$0
-15%
0%
15%
30%
45%
70%
($100)
($200)
Cross-over Rate
Discount rates
Project A
Project B
6-52
NPV:
Payback period
Internal rate of return
Profitability index
When it is all said and done, they are not the NPV rule; for