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Capital Budgeting Techniques
Capital Budgeting Techniques
Profitability Index Profitability index (PI) is the ratio of investment to payoff of a suggested project. It is a useful capital budgeting technique for grading projects because it measures the value created by per unit of investment made by the investor. This technique is also known as profit investment ratio (PIR), benefit-cost ratio and value investment ratio (VIR). The ratio is calculated as follows: Profitability Index = Present Value of Future Cash Flows / Initial Investment If project has positive NPV, then the PV of future cash flows must be higher than the initial investment. Thus the Profitability Index for a project with positive NPV is greater than 1 and less than 1 for a project with negative NPV. This technique may be useful when available capital is limited and we can allocate funds to projects with the highest PIs. Decision Rule: Rules for the selection or rejection of a proposed project: If Profit Index is greater than 1, then project should be accepted. If Profit Index is less than 1, then reject the project.
Suppose if we want $10,000 in one year and $15,000 more in two years. If we can earn 8% on this money, how much we need to invest today to exactly earn this much in the future? In other words, what is the present value of two cash flows at 8%. Present value of $15,000 in 2 years at 8 percent is: $15000/1.082 =$12860.082 Present value of $100 in 1 years at 8% is: $10,000/1.08 =$9259.259 The total present value is : $12860.082+$9259.259=$22119.341
Decision Rule of Discounted Payback: If discounted payback period is smaller than some pre-determined number of years then an investment is worth undertaking.
First, the cost of that particular project must be known. Second, estimates the expected cash out flows from the project, including residual value of the asset at the end of its useful life. Third, riskiness of the cash flows must be estimated. This requires information about the probability distribution of the cash outflows. Based on projects riskiness, Management find outs the cost of capital at which the cash out flows should be discounted. Next determine the present value of expected cash flows. Finally, compare the present value of expected cash flows with the required outlay. If the present value of the cash flows is greater than the cost, the project should be taken. Otherwise, it should be rejected.
OR
If the expected rate of return on the project exceeds its cost of capital, that project is worth taking.
Firms stock price directly depends how effective are the firms capital budgeting procedures. If the firm finds or creates an investment opportunity with a present value higher than its cost of capital, this would effect firms value positively.
The calculation of net present value is useful when a business has to identify a viable investment opportunity. There are many ways to calculate the NPV. The simplest way is: By Use of NPV function in Excel: The NPV function consists of the following arguments: =NPV (Rate, FCF 1, FCF 2 FCF n)
This function gives the NPV of an investment based on a discount rate and a series on cash outflows (future payments) and cash inflows (income). The calculation of NPV is based on expected future cash flows of a project. For example, if cash flows occur at the beginning of the period, the first value should be added to the NPV result, should not include in the values arguments. Example: Consider the following example to understand how NPV function works. Suppose a company AtlanticWorld Co. is considering an investment in a machine that costs $150,000 and the additional cash inflows from the machine will be $80,000, $ 50,500, and $76,600 over the next three years. The firms cost of capital is 12%. Consider the following example to understand how NPV function works. DATA (A) 1 2 3 4 5 12% (150,000) 80,000 50,500 76,600 DESCRIPTION (B) Annual Discount Rate (Cost of Capital) Initial Cost of Investment Return from First Year Return from second Year Return from Third Year
Net Present Value of the Investment is $14,472.53 As NPV of the purposed investment is positive so the company should invest in the machine.
NPV=Present Value of Future Cash Inflows Cash Outflows (Investment Cost) In addition to this formula, there are various tools available to calculate the net present value e.g. by using tables and spreadsheets such as Microsoft Excel. Decision Rule:
A prospective investment should be accepted if its Net Present Value is positive and rejected if it is negative.
Debt vs Equity Financing Equity equals Ownership (Share Profits and Control)
Most small or growth-stage businesses use limited equity financing. As with debt financing, additional equity often comes from non-professional investors such as friends, relatives, employees, customers, or industry colleagues. However, the most common source of professional equity funding comes from venture capitalists. Equity financing requires that you sell an ownership interest in the business in exchange for capital. The most basic hurdle to equity financing is finding investors who are willing to buy into your business; however, the amount of equity financing that you undertake may depend more upon your willingness to share management control than upon the investor appeal of the business. By selling equity interests in your business, you sacrifice some of your autonomy and management rights. The effect of selling a large percentage of the ownership interest in your business may mean that your own investment will be short-term, unless you retain a majority interest in the business and control over future sale of the business. Of course, many small business operators are not necessarily interested in maintaining their business indefinitely, and your personal motives for pursuing a small business will determine the value you place upon business ownership. Sometimes the bottom line is whether you would rather operate a successful business for several years and then sell your interests for a fair profit, or be repeatedly frustrated in attempts at financing a business that cannot achieve its potential because of insufficient capital.