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6-1

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

How will one know whether we are


creating value or not?
Context:

Start with a idea / project (small or big??)


A collection of ideas / projects is a firm / company
Value creation only through good ideas/projects
How do you determine what is good idea or project
- history of classical finance
- how the world adopted them

6-3

Capital budgeting
Difference between revenue expenditure and capital

expenditure
Capital
Efficient allocation
Capital Budgeting

Introduction

The important points are:

Capital budgeting is the most significant financial activity


of the firm.
Capital budgeting determines the core activities of the firm
over a long term future.
Capital budgeting decisions must be made carefully and
rationally.

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

Capital Budgeting Within The Firm


T h e P o s it io n o f C a p it a l B u d g e t in g
F in a n c ia l G o a l o f t h e F ir m :
W e a lt h M a x im is a t io n
I n v e s t m e n t D e c is o n
L o n g T e rm A s s e ts

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

Examples of Long Term Assets

6-9

Project Types and Risk


Replacement projects
Expansion projects
New venture

Projects can be evaluated in another context also


Prerequisites
Stand alone or independent projects
Mutually exclusive

Two ways of doing (or) Monetary constraint

6-10

EVALUATION CRITERIA

6-11

Properties of a good evaluation criteria


Should make sense ( benefit should exceed costs)
Unit of measurement a criteria uses is extremely important.
What is the benchmark?( is it obvious??)
Easy to communicate, why? (research vs applied field)
Easy to compare different ideas
Easy to calculate

6-12

Net Present Value


Simple example:
Year
Year 0 :

CF

Years to discount

-1000

Year 1 :

1320
Similar investments earn 10%?
Difference between PV and NPV

PV

The Big Picture:


The Net Present Value of a
Project
Projects Cash Flows
(CFt)

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

r = opportunity cost of capital Rate of return required on


investments in the financial market with similar risk
A project creates value (NPV > 0) only if it has a higher
return than other investments with the same risk

6-15

NPV
Where do the cash flows come from?
Where does r come from? (opportunity cost of capital?)
What does the final number mean?

6-16

It tells us what is the value that is added because of the

project in rupee units.

What will happen if you dont have money to implement

your great project? What comes to our help?

6-17

NPV - what is it actually?


Value is incremental. To what?
Existing vs your idea

Investment decision
Cash

Investment
Opportunity
(real asset)

Firm
invest

shareholder

Alternative:
Pay dividend
To shareholders

Investment
Opportunities
(financial assets)

Shareholders
Invest for themselves

6-19

Why Use Net Present Value?


Accepting positive NPV projects benefits shareholders.
NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly

6-20

The Net Present Value (NPV) Rule


Net Present Value (NPV) =

Total PV of future CFs + Initial Investment


Estimating NPV:
1. Estimate future cash flows: how much? and when?
2. Estimate discount rate
3. Estimate initial costs

6-21

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

6-22

Good Attributes of the NPV Rule


1. Uses cash flows
2. Uses ALL cash flows of the project
3. Discounts ALL cash flows properly
Reinvestment assumption: the NPV rule assumes that all

cash flows can be reinvested at the discount rate.

Disadvantage: static

6-23

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

The Payback Period Rule


How long does it take the project to pay back its initial

investment?
Payback Period = number of years to recover initial costs
Minimum Acceptance Criteria:
set by management

Ranking Criteria:
set by management

6-25

The Payback Period Rule (continued)


Disadvantages:
Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria may not have a
positive NPV
Advantages:
Easy to understand
Biased toward liquidity
Deals with risk

6-26

The Discounted Payback Period


Rule

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.

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A
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N
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6-27

The Average Accounting Return Rule

Another attractive but fatally flawed approach.


Ranking Criteria and Minimum Acceptance Criteria

set by management
Disadvantages:

Ignores the time value of money


Uses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values

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?

What is the only thing that is needed to calculate IRR?


Is the idea good idea? very important

6-29

The Internal Rate of Return (IRR) Rule


IRR: the discount rate that sets NPV to zero
Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return.
Ranking Criteria:
Select alternative with the highest IRR
Reinvestment assumption:
All future cash flows assumed reinvested at the IRR.

6-30

The Internal Rate of Return (IRR) Rule


Disadvantages:
Does not distinguish between investing and borrowing.
IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investments
Advantages:
Easy to understand and communicate

5
0
1
0
1
5
0
N
PV02(1IR)(IR)2(IR)
6-31

The Internal Rate of Return: Example


Consider the following project:

0
-$200

$50

$100

$150

The internal rate of return for this project is ???

19.4

6-32

The NPV Payoff Profile for This Example


If we graph NPV versus discount rate, we can see the
IRR as the x-axis intercept.
Discount Rate
0%
4%
8%
12%
16%
20%
24%
28%
32%
36%
40%

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%

6-33

Problems with the IRR Approach


Multiple IRRs.
Are We Borrowing or Lending?
The Scale Problem
The Timing Problem

6-34

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

The Scale Problem


Would you rather make 100% or 50% on your

investments?
What if the 100% return is on a $1 investment while the
50% return is on a $1,000 investment?

6-36

The Timing Problem


$10,000
$1,000
$1,000

Project A
0

$10,000
Project B

$1,000
$12,000
0
1
$10,000

$1,000
2

6-37

What is the bias? What will you


choose?
IRR of A is 16.04 %
IRR of B is 12.94%

Now which will you choose?

What is the problem here?

6-38

The preferred project in this case depends on the discount rate,

not the IRR.

What is the NPV at 10%

NPV of A is rs 10668
NPV of B is rs 10751

6-39

The Timing Problem


$5,000.00
$4,000.00

Project A

$3,000.00

Project B

NPV

$2,000.00

10.55% = crossover rate

$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

Calculating the Crossover Rate


Compute the IRR for either project A-B or
B-A
Year Project A Project B Project A-B Project B-A
0 ($10,000) ($10,000)
$0
$0
1 $10,000
$1,000
$9,000
($9,000)
2 $1,000
$1,000
$0
$0
3 $1,000 $12,000
($11,000)
$11,000

$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

The Profitability Index (PI) Rule


Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:
Select alternative with highest PI

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

6-43

Why now amount of rupees instead of


rate of return?
Because now we are dealing with the

corporation not an individual investor


What is the difference??

investment of a

6-44

Mutually Exclusive vs.


Independent Project
Mutually Exclusive Projects: only ONE of several

potential projects can be chosen, e.g. acquiring an


accounting system.
RANK all alternatives and select the best one.

Independent Projects: accepting or rejecting one

project does not affect the decision of the other


projects.
Must exceed a MINIMUM acceptance criteria.

6-45

6.8 The Practice of Capital Budgeting


Varies by industry:
Earlier many firms used payback, others used accounting rate of
return.
Now many firms use IRR or NPV as the primary or secondary tool and
Payback continues to be a important tool albeit secondary .
The most frequently used technique for large corporations is

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

The cost of capital is 12%. Calculate


a) payback period b)discounted payback period
c) NPV d) IRR e) PI

6-47

Example of Investment Rules


Compute the IRR, NPV, PI, and payback period for
the following two projects. Assume the required
return is 10%.
Year
0
1
2
3

Project A
-$200
$200
$800
-$800

Project B
-$150
$50
$100
$150

6-48

Example of Investment Rules


CF0
PV0 of CF1-3
NPV =
IRR =
PI =

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

Example of Investment Rules


Payback Period:
Project A
Project B
Time
CF
Cum. CF CF Cum. CF
0
-200
-200
-150
-150
1
200
0
50
-100
2
800
800
100
0
3
-800
0
150
150
Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?

6-50

Relationship Between NPV and IRR


Discount rate
-10%
0%
20%
40%
60%
80%
100%
120%

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% 130% 160% 190%

($100)
($200)

Cross-over Rate

Discount rates

Project A
Project B

6-52

Summary and Conclusions


This chapter evaluates the most popular alternatives to

NPV:

Payback period
Internal rate of return
Profitability index

When it is all said and done, they are not the NPV rule; for

those of us in finance, it makes them decidedly secondrate.