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Capital Budgeting PPT 1
Capital Budgeting PPT 1
Narain
Time value of money
Narain
Constructing the Timeline
Suppose you must pay tuition fee of Rs.
50,000 per year for the next two years.
Your tuition payments must be made in
equal instalments at the start of each
semester.
1. What is the timeline of your tuition
payments?
2. What is the cost of the program?
Narain
Three rules of time travel
1. It is only possible to compare or
combine values at the same point
in time.
2. To move a cash flow forward in
time, you must compound it.
3. To move a cash flow backward in
time, you must discount it.
Narain
The 1st Rule of Time Travel
❑ A rupee today and a rupee after one year
are
not equivalent.
❑ It is only possible to compare or combine
values at the same point in time.
– Which would you prefer: A gift of Rs. 1,000
today or Rs. 1,210 at a later date?
– To answer this, you will have to compare the
alternatives to decide which is worth more.
One factor to consider: How long is “later?”
Narain
The 2nd Rule of Time Travel
❑ To move a cash flow forward in time, you
must compound it.
– Suppose you have a choice between
receiving Rs. 1,000 today or Rs. 1,250
after two years. You believe you can
earn 10% on the Rs. 1,000 today, but
want to know what Rs. 1,000 will be
worth after two years.
Narain
Compounding Example
Narain
rd
The 3 Rule of Time Travel
❑ To move a cash flow backward in time, you
must discount it.
– Suppose you have a choice between
receiving Rs. 1,000 today or Rs. 1,250
in two years. You believe you can earn
10% on the Rs. 1,000 today, but want
to know what the Rs. 1,250 will be
worth now.
Narain
Exercise
Narain
Cash flow computation
With the help of following projected Income Statement,
calculate the cash inflow:
Net Sales Revenue 475000
Cost of goods sold 200000
General expenses 100000
Depreciation 50000 350000
Profit before interest and taxes 125000
Interest 25000
Profit before tax 100000
Tax @30% 30000
Profit after tax 70000
Narain
Cash flow computations
The cost of a new plant is Rs. 5,00,000. It
has an estimated life of 5 years after
which it would be disposed off (scrap
value is nil). Profit before depreciation,
interest and taxes (EBITDA) is estimated
to be Rs. 1,75,000 p.a.
Find out the yearly cash flow from the plant,
if tax rate is assumed to be 30% and
depreciation is 20% provided on wdv
basis. It is the only asset in the block
Narain
Cash flow computations
ABC Ltd. is evaluating a capital budgeting
proposal for which relevant figures are as
follows:
Cost of Plant Rs. 10,00,000
Installation cost Rs. 5,000
Economic life 5 years
Scrap value Rs. 80,000
Profit before depreciation and tax Rs. 5,00,000 p.a.
Tax rate 30%
1. Simplicity
2. Sufficiency
3. Objectivity
4. Consistency
5. Reasonable
Narain
Desirable features of evaluation
techniques in Capital Budgeting
2. Payback Period
3. Profitability Index
4. Project Duration
2. Integer Programming
or Zero-one Programming
3. Goal Programming
Narain
Accounting Rate of Return
It compares the average annual profits to average
investment
❑ The steps to determine the ARR is:
1. Determine after tax expected Profits for the
life of the project
2. Take the average of these profits for the life
of the project
3. Determine average investment over the life of
the project like: Average investment = Net
working capital + (Initial outlay + Salvage
value)/2
4. Divide the two average figures to get the ARR
❑ It ignore the time value of money Narain
Illustration
A company takes a project costing Rs.
1,20,000 with expected life of 5-years
and the salvage value of Rs. 20,000.
The project requires an additional
working capital of Rs. 20,000 and is
expected to generate annual average
profit after tax of Rs. 18,000.
What is the Accounting Rate of Return of
this project?
Narain
Exercise 1
Narain
Exercise 3
Determine the payback period of the following
projects: Annual CFAT Cumulative CFAT
Narain
Illustration 1.8
Project A Project B
Cash 50,000 35,000
outflow
Cash inflows
1 40,000 30,000
2 40,000 30,000
Narain
Exercise
Narain
Illustration 1.9
Narain
Illustration
Narain
Exercise
You are required to analyse following two projects, each
with a cost of Rs. 10,000 and cost of capital is 5%. The
projects’ expected net cash flows are as follows:
Year 1 2 3 4
Project X 6,500 3,000 3,000 1,000
Project Y 3,500 3,500 3,500 3,500
What is their Internal rate of return?
Which project should be accepted if they are
independent?
Which project should be accepted if they are mutually
exclusive?
Evaluating IRR method
Period 0 1 2
Cash flows 1,000 -3,000 2,500
❑ Try this:
Machin CF0 CF1 CF2 CF3 CF4 IRR NPV
e @
10%
A -10,500 6,000 5,000 4,000 1,500 26% 3,117
B -10,500 3,000 4,000 5,000 6,000 22% 3,388
C -6,000 2,700 2,700 2,700 17% 715
❑ Which of the projects will you prefer?
❑ Project A has lower payback period, which can be
preferred in the case of capital rationing
❑ Use incremental project analysis if IRR has to be
computed
Narain
Life Disparity Problem
❑ Try this:
Machine Outlay CF1 CF2 IRR NPV @ 10%
P 2,000 2,400 - 20% 182
Q 2,000 - 2,650 15% 190
❑ The key question here is:
What happens at the end of the shorter-lived
project?
– If we replace the project with identical project
– may use Equivalent Annual NPV
– If we reinvest in some other project – use NPV
❑ Use incremental project analysis if IRR has to be
computed
Narain
Pitfall 4: Term structure of required return
Narain
INDIAN PRACTICES
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CAPITAL BUDGETING TECHNIQUES…
International usage
RESPONSE TO THE QUESTION: HOW FREQUENTLY YOU USE THE FOLLOWING TECHNIQUES?
% ALWAYS OR ALMOST ALWAYS
US UK
INTERNAL RATE OF RETURN 75.61 53.13
NET PRESENT VALUE 74.93 46.97
PAYBACK PERIOD 56.74 69.23
HURDLE RATE 56.94 26.98
SENSITIVITY ANALYSIS 51.54 42.86
EARNINGS MULTIPLE APPROACH 38.92 39.06
DISCOUNTED PAYBACK PERIOD 29.45 25.40
WE INCORPORATE THE REAL OPTIONS OF A PROJECT
26.56 29.03
WHEN EVALUATING IT
ACCOUNTING RATE OF RETURN 20.29 38.10
VALUE AT RISK 13.66 14.52
ADJUSTED PRESENT VALUE 10.78 14.06
Narain
PROFITABILITY INDEX 11.87 15.87
THANKS FOR YOUR TIME!