Capital Budgeting

Techniques (cntd.)
Lecture 12
EFM
MS ESPM
5 Feb 2019
Capitalized Equivalent Method
lim N   ( P / A, i, N )  lim N   [((1  i ) N  1) / i (1  i ) N ]  1 / i
PV (i )  A( P / A, i, N  )  A / i

06/13/2020 2
Capitalized Equivalent Method
Another method of PV criterion is useful when the life of
project is perpetual or planning horizon is very long.
Perpetual Service life 
PV = A/i

06/13/2020 3
Capitalized Equivalent Method
The process of calculating PV cost for infinite period is
called capitalization of project cost. The cost is known
as the Capitalized cost i.e. the amount of money to be
invested now to get a certain return 'A' at the end of
each and every year forever.

A
PV 
i
06/13/2020 4
Capitalized Equivalent Method
A hydropower project is of 50 years’ life. An
entrepreneur spent $800,000 (not considering
time value of money) during the last 10 years. We
have to compute the project value (worth) using
different interest rates.
(a) If the entrepreneur’s MARR is 8% compute
NPV with 50 year service life and infinity.
(b) Repeat the same at 12% MARR and see the
difference.

06/13/2020 5
Types of Projects
Mutually exclusive projects are those projects, if you
accept one project, you have to exclude other project.
For service projects, we use the NPV of costs and
choose the project which has the least negative NPV.
For revenue projects, we use NPV of revenues and
choose the project which ahs the highest NPV.

06/13/2020 6
Annual Equivalent Value Analysis
The annual equivalent value (AE) criterion is a basis for
measuring investment value by determining equal
payments on an annual basis.
 
First, we have to find the NPV of the project and then
convert it to equal annual payments.

06/13/2020 7
Annual Equivalent Value (AEV)
AE(i) =PV(i)(A/P,i,n)

If AE>0, accept the project

 If AE =0, remain indifferent
 If AE <0, reject the project

06/13/2020 8
Benefits of AE analysis
1.   Consistency of report format. Financial and
engineering managers may prefer to work on
yearly costs rather than overall costs.
2.   Need for unit costs. In many situations,
project must be broken down into unit costs for
comparison and ease.
3.   Unequal project lives. Comparing projects
with unequal service lives is complicated in
calculations, but using AE analysis, this problem
can be easily solved.

06/13/2020 9
Operating Costs and Capital Costs
Operating costs are incurred by the operations of the
plant or factory.
 Capital costs are incurred only one time in the project
life, where operating costs incur annually. The annual
equivalent of the capital cost is capital recovery cost
'CR'.
CR = P(A/P,i,n) - S(A/F,i,n)

06/13/2020 10
Operating Costs and Capital Costs
(A/F, i, n)=(A/P, i, N) –I
CR(i) =(i-S)(A/P,i, N) +iS

06/13/2020 11
Life Cycle Cost (LCC)
If a project investment cost is ‘P’ with the service life of
‘n’ period.
The annual operating cost is ‘Ai’.
The life cycle cost (LCC) is

LCC = Capital cost + operating cost

n
LCC  P   Ai ( P / A, i , n)
n 1

06/13/2020 12
Annualized Life Cycle Cost (ALCC)
Sometime in the big investment project, we have to
spread the capital cost for the entire service period, in
order to minimize the the lumpy financial burden,
then we have to calculate ALCC.
ALCC = annual capital cost + annual
operating cost

ALCC = annual capital cost + annual operating cost

06/13/2020 13
Annualized Life Cycle Cost (ALCC)

ALCC =LCC (A/P, I,n)

06/13/2020 14
Selection of technology (class exercise)
For an average urban household in Nepal, the monthly
requirements of fuels are 17 liters of kerosene, 10 Kg of
LPG and 100 kWh of electricity for cooking purposes.
The cost of cooking stoves and their service lives are as
follows:

Kerosene stove LPG stove Electric hotplates

Costs for 2: NR 500 3,000 (with 2 burners) 4,000 (with 2 plates)
Life: 5 years Life: 10 years Life: 10 years
 Selection of technology (fuel prices)
Year Kerosene Price LPG Price Electricity tariff
2000 NR 17/lit NR 550/cyl NR 6.30/unit
2003 28 700 7.30
2006 48 900 7.30
2011 73.50 1,325 7.30
2012 93.00 1,415 8.75*
2018 83.00 1,375 10.50**

• *If the current electricity tariff is raised by 20% from July 2012
• ** effective tariff between 250 kWh/month
• There is subsidy of NR 200/cyl in LPG currrently
Based on the monthly annualized life cycle costs, find out
the costs of monthly cooking at different years and select
the technology which has the lowest cost of cooking at present.
Levelized cost of electricity (LCOE)

Where
Lcoe levelized cost of electricity in NR/kWh
Capex Capital cost (expenditure) in NR
Opex Annual Operating and maintenance cost (expenditure) in
NR
R Discount rate
Ei Electricity generated in year ‘ i’ (kWh)
N Service life of the plant in years
ACCOUNTING RATE OF RETURN METHOD
The accounting rate of return is the ratio of the average
after-tax profit divided by the average investment. The
average investment would be equal to half of the original
investment if it were depreciated constantly.
or

A variation of the ARR method is to divide average earnings

after taxes by the original cost of the project instead of the
average cost.
Example
A project will cost Rs 40,000. Its stream of earnings
before depreciation, interest and taxes (EBDIT)
during first year through five years is expected to be Rs
10,000, Rs 12,000, Rs 14,000, Rs 16,000 and Rs 20,000.
Assume a 50 per cent tax rate and depreciation on
straight-line basis.
Calculation of Accounting Rate of Return
Acceptance Rule
This method will accept all those projects whose ARR
is higher than the minimum rate established by the
management and reject those projects which have
ARR less than the minimum rate.

 This method would rank a project as number one if it

has highest ARR and lowest rank would be assigned to
the project with lowest ARR.
Evaluation of ARR Method
The ARR method may claim some merits
Simplicity
Accounting data
Accounting profitability
Serious shortcomings
Cash flows ignored
Time value ignored
Arbitrary cut-off
Internal Rate of Return (IRR)
IRR is the interest rate earned on the unrecovered
project balance of investment such that, when the
project terminates, the unrecovered project balance
will be zero.
 
NPV = A0/(1+i*)0 + A1/(1+i*)1 + A2/(1+i*)2 …….+ An/(1+i*)n =0

06/13/2020 23
Internal Rate of Return (IRR)
Simple Investments
A simple investment is defined as that investment, when
the sign change in the project cash flow occurs only
once.
A non-simple investment is that investment where the
sign change occurs more than once.

06/13/2020 24
Investment Classification
Investm 0 period 1 2 3 4 5
ent type

Simple - + + + + +

Simple - - + + 0 +

Non- _ + _ + + _
simple

Non- _ + + - 0 +
simple

06/13/2020 25
Internal Rate of Return (IRR)
Methods of project Evaluation by IRR
If IRR>MARR, accept the project
If IRR = MARR, remain indifferent 
If IRR < MARR, reject the project

06/13/2020 26
Internal Rate of Return (IRR)
Multiple IRR
When there are multiple values of IRR, we can predict
unique value of IRR by examining its cash flows.
1.   Net cash flow rule of sign
2.   Accumulated net cash flow rule of sign

06/13/2020 27
Cash Flow Rule of Signs
Net Cash flow rule of sign
The number of real i* that are greater than -100% for a
project with 'n' periods is never greater than the number
of sign changes in the sequence of the An values.
Accumulated Cash flow rule of sign
If the net cash flow sign test shows multiple values of i*,
then we should proceed to this sign test.
If the series of cumulative cash flows start negatively
and changes the sign only once, then there exists a
unique positive i*.

06/13/2020 28
Methods for determining IRR

1.   The direct-solution method

2.   The trial-and-error method, and
3.   The graphic method

06/13/2020 29
Direct Solution Method
n Project 1 Project 2
1 -$1,000 _$2,000
2 0 1,300
3 0 1,500
4 0
5 1,500

06/13/2020 30
Direct Solution Method
Project 1

FV (i* )  $1, 000( F / P, i* , 4)  $1,500  0

$1,500  $1, 000( F / P, i* , 4)  $1, 000(1  i* ) 4
1.5  (1  i* ) 4
1
i*  1.5  1 4

i*  0.1067or10.67%
06/13/2020 31
Direct Solution Method
Project 2 $1, 300 $1, 500
NPV  $2, 000   0
(1  i ) (1  i ) 2
Let
1
x
(1  i )
NPV  $2, 000  $1, 300 x  $1, 500 x 2  0
1, 300  1, 300 2  4(1, 500)( 2, 000)
x
2(1, 500)
1, 300  3, 700
x
3, 000
x  0.8or  1.667
1
0.8 
1 i
i  25%
06/13/2020 32
NPV vs. IRR
Conventional Independent Projects:
In case of conventional investments, which are
economically independent of each other, NPV and IRR
methods result in same accept-or-reject decision if the
firm is not constrained for funds in accepting all
profitable projects.
NPV vs. IRR
•Lending and borrowing-type projects:
Project with initial outflow followed by inflows is a
lending type project, and project with initial inflow
followed by outflows is a borrowing type project, Both are
conventional projects.
Problem of Multiple IRRs
A project may have both
lending and borrowing
features together. IRR
method, when used to
evaluate such non-
conventional investment
can yield multiple internal
rates of return because of
more than one change of
signs in cash flows.
Case of Ranking Mutually Exclusive Projects
Investment projects are said to be mutually exclusive
when only one investment could be accepted and others
would have to be excluded.
Two independent projects may also be mutually exclusive
if a financial constraint is imposed.
The NPV and IRR rules give conflicting ranking to the
projects under the following conditions:
 The cash flow pattern of the projects may differ. That is, the cash
flows of one project may increase over time, while those of others
may decrease or vice-versa.
 The cash outlays of the projects may differ.
 The projects may have different expected lives.
Timing of cash flows  
The most commonly found condition for the conflict between
the NPV and IRR methods is the difference in the timing of cash
flows. Let us consider the following two Projects, M and N.
Cont…

NPV Profiles of Projects M and N NPV versus IRR

The NPV profiles of two projects intersect at 10 per cent discount rate.
This is called Fisher’s intersection.
Scale of investment  
Project life span  
Incremental investment Analysis
Under NPV and AEV analysis, the mutually
exclusive project with the highest value is selected
and this method is known as “Total Investment
Approach”. NPV, NFV, and AEV methods of
project evaluation are absolute measures, whereas
the IRR method is a relative (percentage) measure,
and it ignores the scale of investment. But for
comparison of mutually exclusive projects by IRR
method, we have to do Incremental Investment
Analysis.

06/13/2020 41
Incremental investment Analysis
If
IRRB  A  MARR, SelectB
IRRB  A  MARR, Beindifferent
IRRB  A  MARR, SelectA

06/13/2020 42
Depreciation
Asset Depreciation
Depreciation is the gradual decrease in utility of
fixed assets with use and time.
Physical Depreciation
It is the reduction in an asset's capacity to perform
its service due to physical impairment.

06/13/2020 43
Depreciation
Functional Depreciation
It occurs as a result of changes in the organization or in
technology that decrease or eliminate the need for an
asset.
Economic Depreciation
Economic Depreciation = purchase price - market
value

06/13/2020 44
Depreciation
Both physical and functional depreciation are
categories of economic depreciation.
Accounting Depreciation
It is the systematic allocation of the initial cost of an
asset (machine or equipment) in parts over a time
known as its depreciable life.

06/13/2020 45
Depreciation
Physical
Economic Depreciation
Depreciation

A gradual decrease in Functional

utility of asset Depreciation

Depreciation
Book Depreciation

Accounting
Depreciation

The systematic Tax Depreciation

allocation of an asset's
value in parts over its
depreciable life

06/13/2020 46
Depreciation Implication
Net Income
When a project's revenue exceeds its expenses, we say
that the project generated a profit or income. It the
project's revenue is less than its expenses, then we say
that the project resulted in a loss.

06/13/2020 47
Depreciation Implication
Revenue
-Expenses (cost of goods sold)
Gross Profit
-Operating expenses
-Depreciation
Taxable Income (Income before tax)
-Income Tax
Net Income

06/13/2020 48
Depreciation Implication

Cash flow = net income + depreciation

Free Cash flow (FCF) = net income + depreciation

- ∆ capital exp.

06/13/2020 49
Depreciation Methods
The most widely used methods are:
Straight-line Method
Declining Balance Method, and
Sum-of-years'- digit method

06/13/2020 50
Depreciation Methods
Straight-Line Method
In this method, it is assumed that the fixed
asset is depreciated in a uniform way.

PS
Dn  N

06/13/2020 51
Straight-Line Method

Where
Dn = the depreciation charge during n year
P = the cost of the asset, including installation
expenses
S = salvage value at the end of the useful life of asset
N = the useful life

06/13/2020 52
Depreciation Methods
The book value = cost base - total depreciation charges
Bn = P - (D1 + D2 +……….+ Dn)

06/13/2020 53
Declining Balance Method
In this method, a fixed fraction of the initial book
balance is deducted each year. The fraction or
declining balance rate is obtained by
d = 1/N
The most common multiplier is '1'. If this is '2',
then it is called double-declining balance method.

06/13/2020 54
Declining Balance Method
D1 =dP
D2 =d(P - D1)= dP(1-d)
D3 =d(P - D1- D2)=dP(1-d)2
For 'n' year, Dn = dP(1-d)n-1

06/13/2020 55
Declining Balance Method
We can also compute the total DB depreciation at the
end of 'n' years
TDB = D1 + D2 + D3 + D4 + …….. + Dn
 = dP +dP(1 -d) +dP(1-d)2+ ……. +(1-d)n-1
 TDB = P[1-(1-d)n]

06/13/2020 56
Sum-of-years'-Digit Method (SOYD)

In this method, SOYD = 1 +2 +……. +N =N(N +1)/2

Where, N = the useful life
Dn =(N -n +1)(P -S)/SOYD

06/13/2020 57
Tax Depreciation Rates
 Houses & Building 5%
 Transportation equipment
 Car, Jeep, Van & Motorcycle 15 %
 Cycle 20 %
 Furniture
 Metal 10 %
 Wooden 15 %
 Equipment & Machinery
 Machinery 15 %
 Computers 20 %
 Laboratory equipment 15 %
 X-Ray machine 20 %
 Typewriter, photocopy machine 15 %

06/13/2020 58
Income Tax Rates
Corporate Income Tax
(Public Co.) 20 %
Private Co. 25 %
(manufacturing)
Other Industries 25 %
Value Added Tax 13 %

06/13/2020 59
DCF Model
A factory is considering a $ 10 million expansion. The estimated life of the
new facility will be 10 years. Estimating of key input factors are given in the
table below. Develop the DCF model in EXCEL. Find the mean NPV, and
explain whether the expansion plan is feasible. Tax rate is 20% and MARR
is 12%. Interest and depreciation rates are 10%.
Input factor Most likely value
Market size 250,000 tons
Selling price per ton $450
Market growth rate 3%
Market share 10%
Total investment required $10 million
Useful life 10 years
Residual value of facility $ 4 million
Operating costs per ton $ 375 (mean)
Fixed costs $325,000 (mean)