Description
Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure
The Basics of Capital Budgeting: Evaluating Cash Flows
Should we build this plant?
By: Dr Pawan Gupta
Indian School of Petroleum
Capital Budgeting: the process of planning for purchases of longterm assets.
s example:
Suppose our firm must decide whether to purchase a new plastic molding machine for Rs125,000. How do we decide? s Will the machine be profitable? s Will our firm earn a high rate of return on the investment?
Indian School of Petroleum
Decision-making Criteria in Capital Budgeting
How do we decide if a capital investment project should be accepted or rejected?
Indian School of Petroleum
Decision-making Criteria in Capital Budgeting
s The Ideal Evaluation Method should:
a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project.
Indian School of Petroleum
Future value
FVn = PV(1 + i) .
n
What’s the FV of an initial Rs 100 after 3 years if i = 10%?
Indian School of Petroleum
After 3 years: FV3 = PV(1 + i)3 = Rs 100(1.10)3 = Rs 133.10.
Indian School of Petroleum
Present value
s
What’s the PV of Rs 100 due in 3 years if i = 10%?
FVn n 1+ i) ( 1 ? ? = FVn ? ? ?1+ i?
3
n
PV
=
1 ? ? ? PV = 100 ? ? 1.10 ?
= Rs 75.13.
Indian School of Petroleum
Payback Period
s The number of years needed to
recover the initial cash outlay. s How long will it take for the project to generate enough cash to pay for itself?
Indian School of Petroleum
Payback Period
s How long will it take for the project
to generate enough cash to pay for itself?
(500) 150 150 150 150 150 150 150 150
0
1
2
3
4
5
6
7
8
Indian School of Petroleum
Payback Period
s How long will it take for the project
to generate enough cash to pay for itself?
(500) 150 150 150 150 150 150 150 150
0
1
2
3
4
5
6
7
8
Payback period = 3.33 years.
Indian School of Petroleum
s Is a 3.33 year payback period good? s Is it acceptable? s Firms that use this method will
compare the payback calculation to some standard set by the firm. s If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? s Accept the project.
Indian School of Petroleum
Drawbacks of Payback Period:
s Firm cutoffs are subjective. s Does not consider time value of money. s Does not consider any required rate of
return. s Does not consider all of the project’s cash flows.
Indian School of Petroleum
Drawbacks of Payback Period:
s Does not consider all of the project’s
cash flows.
(500) 150 150 150 150 150 (300) 0 0
0
1
2
3
4
5
6
7
8
Consider this cash flow stream!
Indian School of Petroleum
Drawbacks of Payback Period:
s Does not consider all of the project’s
cash flows.
(500) 150 150 150 150 150 (300) 0 0
0
1
2
3
4
5
6
7
8
This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
Indian School of Petroleum
Discounted Payback
s Discounts the cash flows at the firm’s
required rate of return. s Payback period is calculated using these discounted net cash flows. s Problems: s Cutoffs are still subjective. s Still does not examine all cash flows.
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 -500 250
CF (14%)
-500.00 219.30
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 -500 250
CF (14%)
-500.00 219.30 280.70 1 year
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 -500 250 250
CF (14%)
-500.00 219.30 280.70 192.38 1 year
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 -500 250 250
CF (14%)
-500.00 219.30 280.70 192.38 88.32 1 year 2 years
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 3 -500 250
CF (14%)
1 year 2 years
-500.00 219.30 280.70 250 192.38 88.32 250 168.75 Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 3 -500 250
CF (14%)
1 year 2 years .52 years
-500.00 219.30 280.70 250 192.38 88.32 250 168.75 Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 3
The Discounted -500 -500.00 Payback 250 219.30 is 2.52 years 280.70
280.70 250 192.38 88.32 250 168.75 Indian School of Petroleum
CF (14%)
1 year 2 years .52 years
Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Each of these decision-making criteria: s Examines all net cash flows, s Considers the time value of money, and s Considers the required rate of return.
Indian School of Petroleum
Net Present Value
• NPV = the total PV of the annual net cash flows - the initial outlay.
•
Decision Rule:
If NPV is positive, ACCEPT. • If NPV is negative, REJECT.
•
Indian School of Petroleum
NPV Example
s
Suppose we are considering a capital investment that costs Rs276,400 and provides annual net cash flows of Rs 83,000 for four years and Rs116,000 at the end of the fifth year. The firm’s required rate of return is 15%. 83,000 83,000 83,000 116,000
83,000 (276,400)
0
1
2
3
4
5
Indian School of Petroleum
Profitability Index
NPV =
?
t=1
n
ACFt t (1 + k)
- IO
Indian School of Petroleum
Profitability Index
NPV =
?
t=1
n
ACFt t (1 + k)
- IO
PI
=
?
t=1
n
ACFt (1 + k) t
IO
Indian School of Petroleum
Profitability Index
•
Decision Rule:
If PI is greater than or equal to 1, ACCEPT. • If PI is less than 1, REJECT.
•
Indian School of Petroleum
Internal Rate of Return (IRR)
s IRR:
the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.
Indian School of Petroleum
Internal Rate of Return (IRR)
NPV =
?
t=1
n
ACFt (1 + k) t
- IO
Indian School of Petroleum
Internal Rate of Return (IRR)
NPV =
?
t=1 n
n
ACFt (1 + k) t
- IO
IRR:
?
t=1
ACFt t (1 + IRR)
Indian School of Petroleum
= IO
Internal Rate of Return (IRR)
IRR:
?
t=1
n
ACFt t (1 + IRR)
= IO
s IRR is the rate of return that makes the
PV of the cash flows equal to the initial outlay.
Indian School of Petroleum
Calculating IRR
s Looking again at our problem: s The IRR is the discount rate that
makes the PV of the projected cash flows equal to the initial outlay.
83,000 (276,400) 83,000 83,000 83,000 116,000
0
1
2
3
4
5
Indian School of Petroleum
83,000 83,000 83,000 83,000 116,000 (276,400)
0 1 2 3 4 s This is what we are actually doing:
5
83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400
Indian School of Petroleum
83,000 83,000 83,000 83,000 116,000 (276,400)
0
1
2
3
4
5
s This is what we are actually doing:
83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400 You should get IRR = 17.63%! s This way, we have to solve for IRR by trial and error.
Indian School of Petroleum
IRR
• •
Decision Rule: If IRR is greater than or equal to the required rate of return, ACCEPT. If IRR is less than the required rate of return, REJECT.
Indian School of Petroleum
•
Capital Rationing
Capital rationing occurs when a company chooses not to fund all positive NPV projects. s The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
s
Indian School of Petroleum
Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.
Indian School of Petroleum
Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
Indian School of Petroleum
Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted. Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.
Indian School of Petroleum
Thanks
Indian School of Petroleum
doc_951299961.pdf
Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure
The Basics of Capital Budgeting: Evaluating Cash Flows
Should we build this plant?
By: Dr Pawan Gupta
Indian School of Petroleum
Capital Budgeting: the process of planning for purchases of longterm assets.
s example:
Suppose our firm must decide whether to purchase a new plastic molding machine for Rs125,000. How do we decide? s Will the machine be profitable? s Will our firm earn a high rate of return on the investment?
Indian School of Petroleum
Decision-making Criteria in Capital Budgeting
How do we decide if a capital investment project should be accepted or rejected?
Indian School of Petroleum
Decision-making Criteria in Capital Budgeting
s The Ideal Evaluation Method should:
a) include all cash flows that occur during the life of the project, b) consider the time value of money, c) incorporate the required rate of return on the project.
Indian School of Petroleum
Future value
FVn = PV(1 + i) .
n
What’s the FV of an initial Rs 100 after 3 years if i = 10%?
Indian School of Petroleum
After 3 years: FV3 = PV(1 + i)3 = Rs 100(1.10)3 = Rs 133.10.
Indian School of Petroleum
Present value
s
What’s the PV of Rs 100 due in 3 years if i = 10%?
FVn n 1+ i) ( 1 ? ? = FVn ? ? ?1+ i?
3
n
PV
=
1 ? ? ? PV = 100 ? ? 1.10 ?
= Rs 75.13.
Indian School of Petroleum
Payback Period
s The number of years needed to
recover the initial cash outlay. s How long will it take for the project to generate enough cash to pay for itself?
Indian School of Petroleum
Payback Period
s How long will it take for the project
to generate enough cash to pay for itself?
(500) 150 150 150 150 150 150 150 150
0
1
2
3
4
5
6
7
8
Indian School of Petroleum
Payback Period
s How long will it take for the project
to generate enough cash to pay for itself?
(500) 150 150 150 150 150 150 150 150
0
1
2
3
4
5
6
7
8
Payback period = 3.33 years.
Indian School of Petroleum
s Is a 3.33 year payback period good? s Is it acceptable? s Firms that use this method will
compare the payback calculation to some standard set by the firm. s If our senior management had set a cut-off of 5 years for projects like ours, what would be our decision? s Accept the project.
Indian School of Petroleum
Drawbacks of Payback Period:
s Firm cutoffs are subjective. s Does not consider time value of money. s Does not consider any required rate of
return. s Does not consider all of the project’s cash flows.
Indian School of Petroleum
Drawbacks of Payback Period:
s Does not consider all of the project’s
cash flows.
(500) 150 150 150 150 150 (300) 0 0
0
1
2
3
4
5
6
7
8
Consider this cash flow stream!
Indian School of Petroleum
Drawbacks of Payback Period:
s Does not consider all of the project’s
cash flows.
(500) 150 150 150 150 150 (300) 0 0
0
1
2
3
4
5
6
7
8
This project is clearly unprofitable, but we would accept it based on a 4-year payback criterion!
Indian School of Petroleum
Discounted Payback
s Discounts the cash flows at the firm’s
required rate of return. s Payback period is calculated using these discounted net cash flows. s Problems: s Cutoffs are still subjective. s Still does not examine all cash flows.
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 -500 250
CF (14%)
-500.00 219.30
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 -500 250
CF (14%)
-500.00 219.30 280.70 1 year
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 -500 250 250
CF (14%)
-500.00 219.30 280.70 192.38 1 year
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 -500 250 250
CF (14%)
-500.00 219.30 280.70 192.38 88.32 1 year 2 years
Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 3 -500 250
CF (14%)
1 year 2 years
-500.00 219.30 280.70 250 192.38 88.32 250 168.75 Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 3 -500 250
CF (14%)
1 year 2 years .52 years
-500.00 219.30 280.70 250 192.38 88.32 250 168.75 Indian School of Petroleum
Discounted Payback
(500) 0 250 1 250 250 250 250 2 3 4 5
Discounted
Year Cash Flow
0 1 2 3
The Discounted -500 -500.00 Payback 250 219.30 is 2.52 years 280.70
280.70 250 192.38 88.32 250 168.75 Indian School of Petroleum
CF (14%)
1 year 2 years .52 years
Other Methods
1) Net Present Value (NPV) 2) Profitability Index (PI) 3) Internal Rate of Return (IRR) Each of these decision-making criteria: s Examines all net cash flows, s Considers the time value of money, and s Considers the required rate of return.
Indian School of Petroleum
Net Present Value
• NPV = the total PV of the annual net cash flows - the initial outlay.
•
Decision Rule:
If NPV is positive, ACCEPT. • If NPV is negative, REJECT.
•
Indian School of Petroleum
NPV Example
s
Suppose we are considering a capital investment that costs Rs276,400 and provides annual net cash flows of Rs 83,000 for four years and Rs116,000 at the end of the fifth year. The firm’s required rate of return is 15%. 83,000 83,000 83,000 116,000
83,000 (276,400)
0
1
2
3
4
5
Indian School of Petroleum
Profitability Index
NPV =
?
t=1
n
ACFt t (1 + k)
- IO
Indian School of Petroleum
Profitability Index
NPV =
?
t=1
n
ACFt t (1 + k)
- IO
PI
=
?
t=1
n
ACFt (1 + k) t
IO
Indian School of Petroleum
Profitability Index
•
Decision Rule:
If PI is greater than or equal to 1, ACCEPT. • If PI is less than 1, REJECT.
•
Indian School of Petroleum
Internal Rate of Return (IRR)
s IRR:
the return on the firm’s invested capital. IRR is simply the rate of return that the firm earns on its capital budgeting projects.
Indian School of Petroleum
Internal Rate of Return (IRR)
NPV =
?
t=1
n
ACFt (1 + k) t
- IO
Indian School of Petroleum
Internal Rate of Return (IRR)
NPV =
?
t=1 n
n
ACFt (1 + k) t
- IO
IRR:
?
t=1
ACFt t (1 + IRR)
Indian School of Petroleum
= IO
Internal Rate of Return (IRR)
IRR:
?
t=1
n
ACFt t (1 + IRR)
= IO
s IRR is the rate of return that makes the
PV of the cash flows equal to the initial outlay.
Indian School of Petroleum
Calculating IRR
s Looking again at our problem: s The IRR is the discount rate that
makes the PV of the projected cash flows equal to the initial outlay.
83,000 (276,400) 83,000 83,000 83,000 116,000
0
1
2
3
4
5
Indian School of Petroleum
83,000 83,000 83,000 83,000 116,000 (276,400)
0 1 2 3 4 s This is what we are actually doing:
5
83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400
Indian School of Petroleum
83,000 83,000 83,000 83,000 116,000 (276,400)
0
1
2
3
4
5
s This is what we are actually doing:
83,000 (PVIFA 4, IRR) + 116,000 (PVIF 5, IRR) = 276,400 You should get IRR = 17.63%! s This way, we have to solve for IRR by trial and error.
Indian School of Petroleum
IRR
• •
Decision Rule: If IRR is greater than or equal to the required rate of return, ACCEPT. If IRR is less than the required rate of return, REJECT.
Indian School of Petroleum
•
Capital Rationing
Capital rationing occurs when a company chooses not to fund all positive NPV projects. s The company typically sets an upper limit on the total amount of capital expenditures that it will make in the upcoming year.
s
Indian School of Petroleum
Reason: Companies want to avoid the direct costs (i.e., flotation costs) and the indirect costs of issuing new capital. Solution: Increase the cost of capital by enough to reflect all of these costs, and then accept all projects that still have a positive NPV with the higher cost of capital.
Indian School of Petroleum
Reason: Companies don’t have enough managerial, marketing, or engineering staff to implement all positive NPV projects. Solution: Use linear programming to maximize NPV subject to not exceeding the constraints on staffing.
Indian School of Petroleum
Reason: Companies believe that the project’s managers forecast unreasonably high cash flow estimates, so companies “filter” out the worst projects by limiting the total amount of projects that can be accepted. Solution: Implement a post-audit process and tie the managers’ compensation to the subsequent performance of the project.
Indian School of Petroleum
Thanks
Indian School of Petroleum
doc_951299961.pdf