Description
This is a PPT explaining capital budget expliained.
Capital Budgeting
Or, Whither to Invest!!!
Non DCF techniques
?
RoI:
Average Income/ Avg. Investment in Project
?
Pay Back Period: The length of time when the (non discounted) cash flows are enough to recover the initial investment in the project
Example
?
You are looking at a new project and you have estimated the following cash flows:
? ? ? ? ?
Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000
?
Your required return for assets of this risk is 12%.
Computing Payback For The Project
?
Assume we will accept the project if it pays back within two years.
? ? ?
Year 1: 165,000 – 63,120 = 101,880 still to recover Year 2: 101,880 – 70,800 = 31,080 still to recover Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3
?
Do we accept or reject the project?
Decision Criteria Test - Payback
Does the payback rule account for the time value of money? ? Does the payback rule account for the risk of the cash flows? ? Does the payback rule provide an indication about the increase in value? ? Should we consider the payback rule for our primary decision rule?
?
Advantages and Disadvantages of Payback
?
Advantages
?
? ?
?
Disadvantages
?
? ? ?
Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity
Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against longterm projects, such as research and development, and new projects
DCF Techniques
?
Net Present Value:
?
? ? ?
The excess of present values of cash inflows over the pv of outflows Absolute number expressed in rupees Norm is to accept project if PV>0 Need to choose appropriate discount rate
DCF Techniques
?
Internal Rate of Return (IRR)
?
? ? ?
It is the discount rate at which the present value of inflows of cash equal pv of outflows Calculated using trial and error method/spreadsheets Norm is to accept project if opportunity cost or desired rate is less than IRR Assumes cash flows are reinvested at IRR.
?
Profitability Index (PI)
PV of cash inflows/PV of outflows (Investment)
Example With Mutually Exclusive Projects
Period 0 1 2 IRR NPV Project A -500 325 325 19.43% 64.05 Project B -400 325 200 22.17% 60.74
The required return for both projects is 10%. Which project should you accept and why?
Project A has a smaller IRR but it is a larger project, thus generating greater value to the firm IRR can’t measure that, but NPV can.
Conflicts Between NPV and IRR
NPV directly measures the increase in value to the firm ? Whenever there is a conflict between NPV and another decision rule, you should prefer NPV ? IRR is unreliable in the following situations
?
? ?
Non-conventional cash flows Mutually exclusive projects
Capital Budgeting In Practice
We should consider several investment criteria when making decisions ? NPV and IRR are the most commonly used primary investment criteria ? Payback is a commonly used secondary investment criteria
?
• The projected investment and returns pattern of a project are as under: (Rs. In lakhs) Year Investment Cash Inflows 0 75 -1 25 5 2 10 35 3 --60 4 10 55 5 --40
If the ideal discounting rate has been agreed upon as 14%, find out the NPV and IRR of the project.
Capital Structure
?
? ? ?
Taxes Bankruptcy costs Management control Theories in Capital Structure: M&M theory
? ? ? ?
Value of firm remains constant irrespective of change in structure Cost of debt is unchanged Equity providers will demand higher compensation if risk increases Future cash flows remain constant.
M&M theory
?
Assume 2 firms:
Net Operating Income
Market value of equity Market value of 6% debt Ke Kd Ko
Unlevered
10,000
1,00,000 ---10% -10%
Levered
10,000
60,000 50,000 11.67% 6% 9.1%
Suppose you have a 10% holding in firm L. You also view firm U as undervalued…… (the price of shares of l are higher than those of U)
M&M theory
You currently hold Rs. 6000 worth of equity in firm L. Your returns on the investment are 10% of (Rs. 10,000interest) ? =10% of Rs. 7000, ie. Rs 700. ? Now if you decide to sell of your holding in firm L and buy 10% in firm U ? But you also realize the value of leverage in firm L and observe the lack of leverage in firm U
?
M&M theory
?
? ?
?
You decide to create your own leverage in your portfolio by borrowing exactly that much so as to maintain the D/E ratio in firm L, ie, you borrow Rs. 5000 @ 6% Now you have Rs. 11,000 and you need Rs. 10,000 to buy the 10% stake in firm U. The returns from firm U are @ 10%, ie Rs. 1000, from which you would have to pay the interest on the Rs. 5000 borrowed You have a net earning of Rs. 700….
M&M theory
And you have Rs. 1000 balance to invest in firm U. ? Hence, you find this proposition attractive and sell your stake in L and buy in U ? Others may also spot this arbitrage opportunity and follow suit, thus reducing the price of L and increasing the price of U ? This continues till parity is reached and Ko is the same for both firms. (M&M)
?
Other Theories in Capital Structure
The Static Theory: The company borrows up to the point where the tax benefits from the extra rupee borrowed equals the probable bankruptcy cost ? The Pecking Order theory: Use internal financing as far as possible
?
doc_103844706.ppt
This is a PPT explaining capital budget expliained.
Capital Budgeting
Or, Whither to Invest!!!
Non DCF techniques
?
RoI:
Average Income/ Avg. Investment in Project
?
Pay Back Period: The length of time when the (non discounted) cash flows are enough to recover the initial investment in the project
Example
?
You are looking at a new project and you have estimated the following cash flows:
? ? ? ? ?
Year 0: CF = -165,000 Year 1: CF = 63,120; NI = 13,620 Year 2: CF = 70,800; NI = 3,300 Year 3: CF = 91,080; NI = 29,100 Average Book Value = 72,000
?
Your required return for assets of this risk is 12%.
Computing Payback For The Project
?
Assume we will accept the project if it pays back within two years.
? ? ?
Year 1: 165,000 – 63,120 = 101,880 still to recover Year 2: 101,880 – 70,800 = 31,080 still to recover Year 3: 31,080 – 91,080 = -60,000 project pays back in year 3
?
Do we accept or reject the project?
Decision Criteria Test - Payback
Does the payback rule account for the time value of money? ? Does the payback rule account for the risk of the cash flows? ? Does the payback rule provide an indication about the increase in value? ? Should we consider the payback rule for our primary decision rule?
?
Advantages and Disadvantages of Payback
?
Advantages
?
? ?
?
Disadvantages
?
? ? ?
Easy to understand Adjusts for uncertainty of later cash flows Biased towards liquidity
Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date Biased against longterm projects, such as research and development, and new projects
DCF Techniques
?
Net Present Value:
?
? ? ?
The excess of present values of cash inflows over the pv of outflows Absolute number expressed in rupees Norm is to accept project if PV>0 Need to choose appropriate discount rate
DCF Techniques
?
Internal Rate of Return (IRR)
?
? ? ?
It is the discount rate at which the present value of inflows of cash equal pv of outflows Calculated using trial and error method/spreadsheets Norm is to accept project if opportunity cost or desired rate is less than IRR Assumes cash flows are reinvested at IRR.
?
Profitability Index (PI)
PV of cash inflows/PV of outflows (Investment)
Example With Mutually Exclusive Projects
Period 0 1 2 IRR NPV Project A -500 325 325 19.43% 64.05 Project B -400 325 200 22.17% 60.74
The required return for both projects is 10%. Which project should you accept and why?
Project A has a smaller IRR but it is a larger project, thus generating greater value to the firm IRR can’t measure that, but NPV can.
Conflicts Between NPV and IRR
NPV directly measures the increase in value to the firm ? Whenever there is a conflict between NPV and another decision rule, you should prefer NPV ? IRR is unreliable in the following situations
?
? ?
Non-conventional cash flows Mutually exclusive projects
Capital Budgeting In Practice
We should consider several investment criteria when making decisions ? NPV and IRR are the most commonly used primary investment criteria ? Payback is a commonly used secondary investment criteria
?
• The projected investment and returns pattern of a project are as under: (Rs. In lakhs) Year Investment Cash Inflows 0 75 -1 25 5 2 10 35 3 --60 4 10 55 5 --40
If the ideal discounting rate has been agreed upon as 14%, find out the NPV and IRR of the project.
Capital Structure
?
? ? ?
Taxes Bankruptcy costs Management control Theories in Capital Structure: M&M theory
? ? ? ?
Value of firm remains constant irrespective of change in structure Cost of debt is unchanged Equity providers will demand higher compensation if risk increases Future cash flows remain constant.
M&M theory
?
Assume 2 firms:
Net Operating Income
Market value of equity Market value of 6% debt Ke Kd Ko
Unlevered
10,000
1,00,000 ---10% -10%
Levered
10,000
60,000 50,000 11.67% 6% 9.1%
Suppose you have a 10% holding in firm L. You also view firm U as undervalued…… (the price of shares of l are higher than those of U)
M&M theory
You currently hold Rs. 6000 worth of equity in firm L. Your returns on the investment are 10% of (Rs. 10,000interest) ? =10% of Rs. 7000, ie. Rs 700. ? Now if you decide to sell of your holding in firm L and buy 10% in firm U ? But you also realize the value of leverage in firm L and observe the lack of leverage in firm U
?
M&M theory
?
? ?
?
You decide to create your own leverage in your portfolio by borrowing exactly that much so as to maintain the D/E ratio in firm L, ie, you borrow Rs. 5000 @ 6% Now you have Rs. 11,000 and you need Rs. 10,000 to buy the 10% stake in firm U. The returns from firm U are @ 10%, ie Rs. 1000, from which you would have to pay the interest on the Rs. 5000 borrowed You have a net earning of Rs. 700….
M&M theory
And you have Rs. 1000 balance to invest in firm U. ? Hence, you find this proposition attractive and sell your stake in L and buy in U ? Others may also spot this arbitrage opportunity and follow suit, thus reducing the price of L and increasing the price of U ? This continues till parity is reached and Ko is the same for both firms. (M&M)
?
Other Theories in Capital Structure
The Static Theory: The company borrows up to the point where the tax benefits from the extra rupee borrowed equals the probable bankruptcy cost ? The Pecking Order theory: Use internal financing as far as possible
?
doc_103844706.ppt