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Chapter-4: Capital Budgeting: Required Readings
Chapter-4: Capital Budgeting: Required Readings
o Required Readings:
o Brigham E.F. & Ehrhardt M.C. (2011). Financial
Management: Theory and Practice. 13 th Edition. South-
Western, a part of Cengage Learning (Chapter 10)
Ø Introduction
Ø Types of Projects
Ø Capital Rationing
Financial Management, AU
Recall the Flows of funds and decisions
important to the financial manager
Investment Financing
Decision Decision
Reinvestment Refinancing
Real Assets Financial Financial
Manager Markets
16
con't...
ü Discounted cash flow methods:
• Discounted Cash flow techniques: are investment
evaluation criteria that consider the time value of
money or the concept of present value when evaluating
alternative investment projects.
v Discounted cash flow methods includes:
• The Discounted Payback (DPB)
• The Net Present Value (NPV)
• Internal Rate of Return (IRR)
• Modified Internal Rate of Return (MIRR)
• Profitability Index (PI)
What is the Simple payback period?
Initial Investment C0
Payback =
Annual Cash Inflow C
Example
Rs 50,000
PB 4 years
Rs 12,000
Con’t….
ü Case B: When the annual cash inflows are unequal/uneven:
o Unequal cash flows In case of unequal cash inflows, the payback
period can be found out by adding up the cash inflows until the
total is equal to the initial cash outlay.
Payback period = number of years prior to full recovery+
(unrecovered cost at start of year ÷ cash flow during recovery
year)
Financial Management, AU
Example ………..
o Chapter Four Capital Budgeting.doc page-11
Discounted Cash Flow (DCF) Techniques
o The main DCF techniques for capital budgeting include: Net
Present Value (NPV), Internal Rate of Return (IRR),
discounted payback period and Profitability Index (PI).
n Each requires estimates of expected cash flows (and
their timing) for the project.
o Including cash outflows (costs) and inflows (revenues or savings)
– normally tax effects are also considered.
n Each requires an estimate of the project’s risk so that an
appropriate discount rate (opportunity cost of capital)
can be determined.
o The discussion of risk will be deferred until later. For now, we
will assume we know the relevant opportunity cost of capital or
discount rate.
o Sometimes the above data is difficult to obtain – this is the
main weakness of all DCF techniques.
4. Discounted Payback Period
• Uses the same procedures as payback period and have all the
merits and demerits of payback period except the use of
discounted cash flows or time value of money.
Financial Management, AU
1. the discounted PAyBAck Period,
WAcc of 10% Assumed
Project A
Years 0 1 2 3 4
Cash flow (10,000) 5,000 4,000 3,000 1,000
D. Cash flows -10,000 4,545.45 3305.79 2253.9 683.01
4
C.D. Cash flows -10,000 -5454.55 -2148.76 105.18 788.20
Project B
Years 0 1 2 3 4
Cash flows -10,000 1,000 3,000 4,000 6,750
D. Cash flows -10,000 909.09 2,479.34 3,005.26 4,610.34
C.D. Cash flows -10,000 -9,090.91 -6,611.57 -3’606.31 1,004.03
37
Payback
• Project A
• 2+ (Birr 2,148.76/2,253.94)=2.95
years
• Project B
• 3+(Birr 3,606.31/Birr 4,610.34)=
3.78 years
• The DPB still shows A is preferred
• However the cumulative discounted
cash flow of A is 788.20 while that of
B is 1,004.03 in present value
38
WeAkness
39
2. Net Present Value (NPV)
o This method takes into consideration the time value
of money and attempts to calculate the return on
investments by introducing the factor of time
element.
o Net present value (NPV) method, relies
on discounted cash flow (DCF)
techniques.
Steps in Computing the Net Present Value:
PV of Inflows
PI = Initial Outlay
Con’t
<< OR >>
Method #2:
Con’t…
Con’t….
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Example (All $ numbers are in thousands)
2 $0 $0 $37.862 $0 $0
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Capital Rationing Example: Comparison of Rankings
• NPV rankings (best to worst)
• A, D, C, B, E
• A uses up the available capital
• Overall NPV = $4,545.45
• IRR rankings (best to worst)
• E, D, B, A, C
• E, D, B use up the available capital
• Overall NPV = NPVE+D+B=$6,181.82
• PI rankings (best to worst)
• E, D, C, B, A
• E, D, C use up the available capital
• Overall NPV = NPVE+D+C=$6,381.82
• The PI rankings produce the best set of investments to accept
given the capital rationing constraint.
Financial Management, AU
• ABC Company is a factory that is currently contemplating on investing
two projects: Project A and Project B. The relevant operating cash flows
for the two projects are presented below.
• Required: If the WACC = 10%, Evaluate the projects in terms of PBP,
DPBP, NPV, PI & IRR
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Solution: