C A P ITA L BU D GET ING

OR
IN VESTME NT
A NA LYS IS
WHAT AN INVESTMENT DECISION
COULD BE?
Y E S / N O T Y P E D E CI S I O N S
• There may be STAND
ALONE/INDEPENDENT DECISIONS like
new venture investment, expansion decisions
due to new markets or existing market, due to
change in policy of Govt., safety measures,
labour contracts, environment requirement, or
facilities creation like parking, pathway, parks
• While measuring cash flow, we will only
consider its own cash flows
E IT H E R / O R D E C IS I O N S
• These could be MUTUALLY EXCLUSIVE
DECISIONS like make or buy
• REPLACEMENT DECISION due to
technology, cost reduction
• There is comparison of investments
• Here we will consider INCREMENTAL
CASH FLOWS, that is, there will be
comparison of cash flows
RECIPE FOR INVESTMENT ANALYSIS
This is mainly part of
• Demand
Gathering • Cost of capital
forecasting. In this
inputs • Cost of course, we will
production
consider this as given.
More of this will be
taken in Elective
Forecasting • Preparing
various
course on Valuation
Cash flows schedules and in Management
accounting

Applying • Applying
Appraisal criteria based
on suitability
Criteria

Making
Final
Decision
GATHERING INPUTS
Sunk Cost: has
already gone

After spending $3 million on research, Better Mousetrap has developed a new trap. The project
requires an initial investment in plant and equipment of $6 million. Production costs are
estimated at $1.50 per trap and the traps will be sold for $4 each. Sales forecasts are given as
follows:

Per unit revenue:

Operational
Start-up cost: Initial Policy of Demand for product: cost: Data
cost to start project or company Sale forecast (techniques from Cost
business of demand forecasting sheets
and marketing research)
MEASUREMENT OF CASH FLOW
Project Valuation: OPERATING CASH FLOWS (OCF)
• OCF = Earnings before interest after tax (EBIAT) + depreciation
• OCF= (Revenue – operating expenses-Depreciation)*(1-tax rate)+ depreciation
• OCF= EBDIT (1-tax rate) + Depreciation*tax rate

Business Valuation: FREE CASH

FLOW to FIRM (FCFF)
FCFF = EBIT (1-tax rate) +
Chg(depreciation) - Chg(Net
working capital) – Chg(Capital
expenditure)
Equity Valuation: FREE CASH FLOW to EQUITY
(FCFE):
Free Cash flow to Equity = FCFF + chg (Debt) –
Interest *(1-tax)
MEASURING CASH FLOWS: THREE
THUMB RULES
Relevant and Incidental Cash
Flows

Incremental Cash flows

Consistent in treatment of
Inflation
STEPS FOR MEASUREMENT: PROJECT
APPROACH

Initial phase: Operating cash flows: Terminal Phase:

(i) initial investment, (i) revenue, (i) salvage value,
(ii) working capital, (ii) expenses, (ii) release of working
(iii) depreciation (iii) tax capital
CASE: INDEPENDENT INVESTMENT
Berley and Myers Q 11. (chapter 6) Page 148:
CSC is evaluating new project to produce encapsulators. The initial investment in
plant and equipment is $500,000. Sales of encapsulators in year 1 are forecasted
at $200,000 and costs at $100,000. Both are expected to increase by 10% a year.
Profits are taxed at 30%. Working capital in each year consists of inventories of
raw materials and is forecasted at 20% of sales in the following year. The project
will last five years and the equipment at the end of this period will have scrap
value of $50,000 but could be sold for $30,000. For tax purposes the equipment
can be depreciated straight line over these years.
Forecast cash flows from the project.
capital budgeting.xlsx
CASE: CONSIDERING OPPORTUNITY
COST
Berley and Myers Q 21. (chapter 6) Page 150:
United Pigpen is considering a proposal to manufacture high-protein hog feed. The project would
make use of an existing warehouse, which is currently rented out to a neighboring firm. The next
year’s rental charge on the warehouse is $100,000, and thereafter the rent is expected to grow in
line with inflation at 4% a year. In addition to using the warehouse, the proposal envisages an
investment in plant and equipment of $1.2 million. This could be depreciated for tax purposes
straight-line over 10 years. However, Pigpen expects to terminate the project at the end of eight
years and to resell the plant and equipment in year 8 for $400,000. Finally, the project requires an
initial investment in working capital of $350,000. Thereafter, working capital is forecasted to be
10% of sales in each of years 1 through 7. Year 1 sales of hog feed are expected to be $4.2 million,
and thereafter sales are forecasted to grow by 5% a year, slightly faster than the inflation rate.
Manufacturing costs are expected to be 90% of sales, and profits are subject to tax at 35%.
CASE: MUTUALLY EXCLUSIVE
A widget manufacturer currently produces 200,000 units a year. It buys widget lids from
an outside supplier at a price of $2 a lid. The plant manager believes that it would be
cheaper to make these lids rather than buy them. Direct production costs are estimated to
be only $1.50 a lid. The necessary machinery would cost $150,000 and would last 10
years. This investment could be written off for tax purposes using the seven-year tax
depreciation schedule. The plant manager estimates that the operation would require
additional working capital of $30,000 but argues that this sum can be ignored since it is
recoverable at the end of the 10 years. If the company pays tax at a rate of 35% and the
opportunity cost of capital is 15%, would you support the plant manager’s proposal?
State clearly any additional assumptions that you need to make.
EVALUATING PROJECT: APPRAISAL
METHODS
C O N S ID E R T IM E VA L U E O F
MONEY
• Sophisticated methods
• Net present Value (NPV)
• Internal Rate of Return (IRR)
• Profitability Index (PI)
• Modified Internal Rate of Return (MIRR)
• Discounted payback
D O N ’ T CO N S ID E R T IM E VA L U E
O F MO N E Y
• Compute dirty value
• Generally used as guesstimate
• Pay Back Period Method
• Accounting Rate of Return
PAY BACK PERIOD Lowe Payback period is preferred

0 1 2 3 4 5

OCF -5,30,000.00 93000 99600 106860 114846 120811

cumulative ocf 93,000.00 1,92,600.00 2,99,460.00 4,14,306.00 5,35,117.00

full
recovery
is
between
4th and
recovery -4,37,000.00 -3,37,400.00 -2,30,540.00 -1,15,694.00 5,117.00 5th year
Payback period 4.95years

 
Interpolation formula
*(final year-initial year)
 ACCOUNTING RATE OF RETURN
Higher ARR is preferred

0 1 2 3 4 5
Revenue 200000 220000 242000 266200 292820
Cost 100000 110000 121000 133100 146410
Depreciation 90000 90000 90000 90000 90000
Return=Revenue-operating
cost incl depreciation 10000 20000 31000 43100 56410
Average return 32102

Investment (total book value)

Initial
Investment 500000
salvage value 50000
depreciation 90000 90000 90000 90000 90000
net book
value 500000 410000 320000 230000 140000 50000
W.C. 40000 44000 48400 53240 58564
total book
value 540000 454000 368400 283240 58564 50000
average investment 98000

ARR= 32.76%
NET PRESENT VALUE

0 1 2 3 4 5

OCF -540000 93000 99600 106860 114846 120811

PV@10 84545.45 82314.05 80285.50 78441.36 75014.13

%
PV of cash inflow 400600.49

PV of cash outflow -540000

NPV -139399.51

Select the project when NPV>=0

INTERNAL RATE OF RETURN Rate at which NPV=0

0 1 2 3 4 5
OCF -450000 93000 99600 106860 114846 120811
NPV@8 -450000.00 86111.11 85390.95 84828.91 84415.24 82221.94 -27031.9
%
NPV@5 -450000.00 88571.43 90340.14 92309.69 94484.09 94658.5810363.92
%
IRR 5.83
(apply interpolation formula)

 
Interpolation formula
IRR*(higher rate-lower rate)

Select project with IRR>Cost of Capital

 PROFITABILITY INDEX

We mainly use this to compare projects with different initial

investment and life span
0 1 2 3 4 5
Project 1 450000 93000 99600 106860 114846 120811
PV@5% 450000.00 88571.43 90340.14 92309.69 94484.09 94658.58
PI 1.02

0 1 2 3
project 2 350000 93000 99600 106860
PV@5% 350000.00 88571.43 90340.14 92309.69
PI 0.774917858

  𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠h 𝑖𝑛𝑓𝑙𝑜𝑤
𝑃𝐼 = Select project with higher PI
𝑃𝑉 𝑜𝑓 𝑐𝑎𝑠h 𝑜𝑢𝑡𝑓𝑙𝑜𝑤
LET’S EVALUATE
METHODS
IRR OR NPV

P R O S O F IR R C O N S O F IR R

• IRR is preferred over NPV as it is • Difficult to compare projects with IRR

independent of financing decision at the when initial investment is different
first instance particularly in case of mutually exclusive
• IRR is ratio so easy to interpret projects
• No difference between borrowing Vs
Lending
• Multiple IRR/No IRR
MULTIPLE IRR/NO IRR
0 1 2 3 4 5 6 7 8 9 10
-3 1 1 1 1 1 1 1 1 1 -6.5
3.50%
19.54%

Value of IRR depends upon initial Guess.

This happens due to Change in Sign
There may be as many IRR as many sign changes
Mathematically, IRR is solving roots of higher order equation
When discriminant is less than zero, even no IRR will exist
 MUTUALLY EXCLUSIVE PROJECTS
• When base investment or time span is different then IRR are not comparable
• There may difference in decision based on NPV and IRR in such cases
• In such cases, either use NPV for decision making or consider IRR based on incremental cash
flows

NPV@10 IRR
0 1 2 3%
0 1IRR NPV@10% Project 1 -9000 6000 5000 4000 ₹ 3,265.49 33%
project 2 -90001800 for perpetuity
PV of
project 1 -10000 20000 100% ₹ 7,438.02 Cash
outflow -9000 9000 20%
PV of
project 2 -20000 35000 75% ₹ 10,743.80
cash
inflow
@10% 18000
INCREMENTAL CASH FLOW
0 1
project 2-project 1 -10000 15000 50%

• Compare project with higher investment – lower

investment
• Compute incremental cash flows
• Compute IRR
• If IRR>Cost of capital, select project 2 else project 1
MODIFIED INTERNAL RATE OF RETURN
Year Cash flow FV
0 -60
1 20 18.18182
2 40 33.05785
3 50 37.56574
4 30 20.4904
5 -15 -9.31382
FV at 5th year 99.98199
discounting factor 0.600108
mirr 0.107526  Discounting factor =

 Discounting factor =
RISK ANALYSIS
IN CAPITAL
BUDGETING
INCORPORATING RISK IN COST OF
CAPITAL
• For NPV and IRR, we need cost of capital either for discounting cash flows or comparison
• We can include risk of project in cost of capital with CAPM or market model
• In this way, we incorporate risk of project in financing

The project’s expected returns has standard deviation of

20%. The market during same period will have risk of 15%.
The correlation between market returns and project return is
0.5. If market return during this period is expected to be
20% then what should be the expected return from project.
Projects return entirely depend upon market and it has zero
alpha
SENSITIVITY ANALYSIS

• In this, we vary one aspect of project at a time

• We compute cash flows and NPV/IRR of project with revised estimates
• This provides sensitivity of project to different economic conditions
SCENARIO ANALYSIS

• In this we change all variables of project at one time and build scenario
of NPV/IRR of project under different economic conditions
SIMULATION

• We project demand/cost/cash flows based on probability

• We generate simulations of demand/cost/cash flows and estimate NPV
• This considers probability distribution of demand/cash flows/cost