about financial system

1. Capital Budgeting
Decision Criteria

2. What is Capital Expenditure?
Capital expenditure involves a current
outlay of funds in the expectation of a
stream of benefits extending far into
future.
Long-term decisions
Involve large expenditures

3. Mutually exclusive vs.
Independent projects
• Mutually exclusive projects are those
projects for which the selection of one
requires the rejection of the others.
• Independent projects are those for
which the acceptance of one does not
preclude the acceptance of the other
projects.

4. Project Classifications
Replacement
 Maintenance of Business
 Cost Reduction
Expansion
 Existing Products/Markets
 New Products/Markets
Research and Development
Other
 Safety/Environmental Projects

5. Capital budgeting: stages
Identification of Potential Investment
Opportunities

Capital budget proposal

Selection, Budget approval and Authorization

Project tracking

Post-completion audit

6. Capital budgeting: the basics
• Estimate incremental cash flows
associated with a project.
• Evaluate the risk of the project.
• Evaluate the cash flows by applying
one or more of the capital budgeting
techniques.

7. Example
Year Project S Project L
Assumptions
0 -1000 -1000
1 600 400  Equally Risky
2 300 400  They have same cost
3 300 500  They have same life
4 200 400

8. Capital Budgeting Techniques
Payback Period
Discounted payback Period
Net Present Value (NPV)
Internal Rate of Return (IRR)
Benefit Cost Ratio
Accounting Rate of Return

9. Payback Period
Expected number of years required to
recover the original investment
Decision Rules:
 PP = payback period
 MDPP = maximum desired payback period
Independent Projects:
 PP MDPP - Accept
 PP > MDPP - Reject
Mutually Exclusive Projects:
 Select the project with the fastest payback,
assuming PP MDPP.

10. Payback Period
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

11. Payback Period
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.

12. Payback Period
Is a 3.33 year payback period good?
Is it acceptable?
Firms that use this method will
compare the payback calculation to
some standard set by the firm.
If our senior management had set a
cut-off of 5 years for projects like
ours, what would be our decision?
Accept the project.

13. Payback Period (Continued)
Advantages:
 Easy to calculate and understand
 Provides an indication of a project’s liquidity
Drawbacks:
 Ignores time value of money
 Ignores all cash flows received after the payback
period

14. Consider this cash flow stream
(500) 150 150 150 150 150 (400) 100 0
0 1 2 3 4 5 6 7 8

15. Drawbacks of Payback Period:
Does not consider all of the project’s cash flows.
(500) 150 150 150 150 150 (400) 100 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!

16. Discounted Payback Period
Expected Cash Flows are discounted
Advantages:
 Improves over regular payback period method by
taking into account the time value of money.
Drawbacks
 Still ignores all cash flows received after the
payback period

17. Discounted Payback Period:
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30

18. Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70

19. Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38

20. Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32

21. Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75

22. Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
0 -500 -500.00
1 250 219.30 1 year
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years

23. Discounted Payback
(500) 250 250 250 250 250
0 1 2 3 4 5
Discounted
Year Cash Flow CF (14%)
The Discounted
0 -500 -500.00
Payback
1 250 219.30 1 year
is 2.52 years
280.70
2 250 192.38 2 years
88.32
3 250 168.75 .52 years

24. Problem
Expected Net Cash Flow
Year Project L Project S
0 (100) (100)
1 10 70
2 60 50
3 80 20
Discount rate : 10%

25. Payback
Project L
0 1 2 2.4 3
CFt -100 10 60 100 80
Cumulative -100 -90 -30 0 50
PaybackL = 2 + 30/80 = 2.375 years

26. Payback
Project S
0 1 1.6 2 3
CFt -100 70 100 50 20
Cumulative -100 -30 0 20 40
PaybackS = 1 + 30/50 = 1.6 years

27. Discounted Payback
Project L
0 1 2 3
10%
CFt -100 10 60 80
PVCFt -100 9.09 49.59 60.11
Cumulative -100 -90.91 -41.32 18.79
Discounted
payback = 2 + 41.32/60.11 = 2.7 yrs

28. Discounted Payback
Project S
0 1 2 3
10%
CFt -100 70 50 20
PVCFt -100 63.64 41.32 15.02
Cumulative -100 -36.36 4.96 19.98
Discounted
payback = 1 + 36.36/41.32 = 1.9 yrs

29. Net Present Value
Find the present values of Cash Outflows and
Cash Inflows and sum them up. If NPV is
positive the project is worth taking on.
N
CF1 CFN CFt
NPV CF0 1
......
(1 k ) (1 k ) 2 t 0 (1 k ) t
Theoretically the best method
n
CFt
NPV t
CF0 .
t 1 1 k

30. Notice that NPV of the project depends on the project’s
cost of capital
There is a cost of capital for which the NPV is zero (and
negative if cost is higher)

31. Net Present Value
Rationale for NPV
 NPV= PV inflows – Cost = Net gain in
wealth.
 For independent projects, accept project if
NPV > 0.
 For mutually exclusive projects, choose the
one with the highest NPV are selected.
This adds the most value to the firm.

32. Problem
Expected Net Cash Flow
Year Project L Project S
0 (100) (100)
1 10 70
2 60 50
3 80 20
Discount rate : 10%

33. Net Present Value
Project L
0 1 2 3
10%
-100.00 10 60 80
9.09
49.59
60.11
18.79 = NPVL

34. Net Present Value
Project S
0 1 2 3
10%
-100.00 70 50 20
63.64
41.32
15.03
19.99 = NPVS

35. Net Present Value
 If Projects S and L are mutually exclusive,
accept S because NPVS > NPVL .
 If S & L are independent, accept both since
both NPVs > 0.

36. Advantages & Disadvantages
Takes time value of money.
Consider all the cash flows occurring
over the life time.
Consistent with the objective of
maximizing the shareholder’s wealth
Difficult to calculate and understand.
Dependent on discount rates.

37. Problem
Suppose we are considering a capital investment
that costs Rs. 276,400 and provides annual net
cash flows of Rs. 83,000 for four years and
$116,000 at the end of the fifth year. The firm’s
required rate of return is 15%.
83,000 83,000 83,000 83,000 116,000
(276,400)
0 1 2 3 4 5
NPV = 18,235.71

38. Internal Rate of Return (IRR)
IRR is simply the rate of return that
the firm earns on its capital budgeting
projects.
IRR is the rate of return that makes
the PV of the cash flows equal to the
initial outlay.

39. Internal Rate of Return (IRR)
n
CFt
NPV = - IO
(1 + k) t
t=1
n
CFt
IRR: t = IO
(1 + IRR)
t=1

40. IRR (Continued)
1. Guess a rate.
n CFt
2. Calculate:
t 1 (1 IRR ) t
3. If the calculation = CF0 you guessed right
If the calculation > CF0 try a higher rate
If the calculation < CF0 try a lower rate
L+ PVBL - I * (U – L)
Accurate IRR =
PVBL - PVBU

41. Calculate the IRR in the following project-
(10000) 2,000 3,000 4,000 5,000
0 1 2 3 4
At i= 10%
PV = 1818.2+2479.3+3005.2+3415.1
= 10717.8
At i= 15%
PV= 1739.1+2268.4+2630.1+2858.8
= 9496.4
Using interpolation-
IRR = 10 + 10717.8- 10000 x (15-10) = 12.94%
10717.8 – 9496.4

42. Calculating IRR
83,000 83,000 83,000 83,000 116,000
(276,400)
0 1 2 3 4 5
IRR = 17.63%

43. Decision Rule:
If IRR is greater than the cost of capital (also
called the hurdle rate) accept the project.
IRR is independent of cost of capital(k)
Mutually Exclusive Projects
 Accept the project with the highest IRR,
assuming IRR > k.

44. Advantages & Disadvantages
Takes time value of money.
Consider all the cash flows occurring
over the life time.
Easier to understand.
Consistent with the objective of
maximizing the shareholder’s wealth
Difficult to calculate

45. Problem
Expected Net Cash Flow
Year Project L Project S
0 (100) (100)
1 10 70
2 60 50
3 80 20
Discount rate : 10%. Find IRR

46. Project L
0 1 2 3
IRR = ?
-100.00 10 60 80
PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 18.13%
IRRL = 18.13%.

47. Project S
0 1 2 3
IRR = ?
-100.00 70 50 20
PV1
PV2
PV3
0 = NPV
Enter CFs in CFLO, then press IRR:
IRRL = 23.56%
IRRS = 23.56%.

48. Problem
Expected Net Cash Flow
Year Project L Project S
0 (100) (100)
1 10 70
2 60 50
3 80 20
Discount rate : 10%. Draw NPV Profiles

49. NPV versus IRR
NPV k NPV L NPV S
60
0 50 40
50 5 33 29
40
L Crossover 10 19 20
Point = 8.7% 15 7 12
30 (4) 5
20
S
20
S
10
IRR S = 23.6%
L
0 Discount Rate (%)
0 5 10 15 20 23.6
-10
IRR L = 18.1%

50. NPV versus IRR
Independent Projects
 NPV and IRR will always result in the same
accept/reject decision

51. NPV versus IRR
Mutually Exclusive Projects having
substantially different outlays
Cash Flows IRR% NPV
0 1 k= 12%
P Rs(10000) 20000
Q Rs(50000) 75000

52. NPV versus IRR
1. Mutually Exclusive Projects having
substantially different outlays
Cash Flows IRR% NPV
0 1 k= 12%
P Rs(10000) 20000 100 7857
Q Rs(50000) 75000 50 16964
•Both are acceptable, but Q contributes more to the
wealth
•IRR unsuitable for ranking projects of different
scales

53. Drawbacks of IRR
+ +)
2. If there are multiple sign changes in the
cash flow stream, we could get multiple
IRRs.
+ + - + +)
1 2 3
(500) 200 100 (200) 400 300
0 1 2 3 4 5
We could find 3 different IRRs

54. Multiple IRRs
0 1 2
k = 10%
-800 5,000 -5,000
 NPV = -386.78
 IRR = ERROR. Why?

55. Multiple IRRs
NPV NPV Profile
IRR2 = 400%
450
0 k
100 400
IRR1 = 25%
-800

56. Multiple IRRs
0 1 2
k = 10%
-800 5,000 -5,000
Logic of Multiple IRRs
 At very low discount rates, the PV of CF2 is large &
negative, so NPV < 0.
 At very high discount rates, the PV of both CF1
and CF2 are low, so CF0 dominates and again NPV
< 0.
 In between, the discount rate hits CF2 harder than
CF1, so NPV > 0.
 Result: 2 IRRs.

57. NPV versus IRR
3. IRR cannot distinguish between lending
and borrowing.
Cash Flows
0 1
A Rs.(400) 600
B Rs. 400 (700)
IRR : A = 50%
B = 75%
NPV: A = +VE
B = -VE

58. A company is considering the purchase of a delivery
van and is evaluating the following two choices:
(a) The company can buy a used van for Rs 20,000,
after 4 years sell the same for Rs 2,500 and replace it
with another used van which is expected to cost Rs
30,000 and last 6 years with no terminating value.
(b) The company can buy a new van for Rs 40,000.
the projected life of the van is 10 years and has an
expected salvage value of Rs 5,000 at the end of ten
years.
The services provided by the vans under both choices
are the same. Assuming the cost of capital 10 percent,
which choice is preferable?