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Capital Budgeting Techniques

Capital Budgeting Techniques. What is Capital Budgeting ?. The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year. Project Classifications.

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Capital Budgeting Techniques

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  1. Capital BudgetingTechniques

  2. What is Capital Budgeting? The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

  3. Project Classifications • Independent Projects: Projects whose cash flows are not affected by decisions made about other projects. • Mutually Exclusive Projects: A set of projects where the acceptance of one project means the others cannot be accepted. e.g. buying computers of different brands. • Dependent( contingent)projects: e.g. buying a new machine may force to extend the construction

  4. Project Evaluation: Alternative Methods • Payback Period (PBP) • Net Present Value (NPV) • Internal Rate of Return (IRR) • Profitability Index (PI)

  5. Ex p e ct e d A fte r -T ax ^ N et C as h F lo w s , C F t Y ea r ( T ) P r o jec t S P r o jec t L 0 $ ( 3,00 0 ) $ ( 3,00 0 ) a 1 1, 5 00 40 0 2 1, 2 00 90 0 3 80 0 1, 3 00 4 30 0 1, 5 00 Net Cash Flows for Project S and Project L

  6. What is the Payback Period? The length of time before the original cost of an investment is recovered from the expected cash flows or . . . How long it takes to get our money back.

  7. 0 1 2 3 4 PBS Net Cash Flow -3,000 -3,000 1,200 -300 800 500 300 800 1,500 -1,500 Cumulative Net CF PaybackS 2 + 300/800 = 2.375 years = Payback Period for Project S

  8. 0 1 2 3 4 PBL Net Cash Flow - 3,000 - 3,000 900 - 1,700 1,300 - 400 1,500 1,100 400 - 2,600 Cumulative Net CF PaybackL 3 + 400/1,500 = 3.3 years = Payback Period for Project L

  9. Net Present Value (NPV) NPV is the present value of an investment project’s net cash flows minus the project’s initial cash outflow. CF1CF2CFn -ICO NPV = + + . . . + • (1+k)1 (1+k)2 (1+k)n

  10. Proposed Project Data Julie Miller is evaluating a new project for her firm, Basket Wonders (BW). She has determined that the after-tax cash flows for the project will be $10,000; $12,000; $15,000; $10,000; and $7,000, respectively, for each of the Years 1 through 5. The initial cash outlay will be $40,000.

  11. NPV Solution Basket Wonders has determined that the appropriate discount rate (k) for this project is 13%. $10,000$12,000$15,000 NPV= + + + (1.13)1(1.13)2(1.13)3 $10,000$7,000 + - $40,000 (1.13)4(1.13)5

  12. NPV Solution NPV = $10,000(PVIF13%,1) + $12,000(PVIF13%,2) + $15,000(PVIF13%,3) + $10,000(PVIF13%,4) + $ 7,000(PVIF13%,5) - $40,000 NPV = $10,000(.885) + $12,000(.783) + $15,000(.693) + $10,000(.613) + $ 7,000(.543) - $40,000 NPV = $8,850 + $9,396 + $10,395 + $6,130 + $3,801 - $40,000 = - $1,428

  13. NPV Acceptance Criterion No! The NPV is negative. This means that the project is reducing shareholder wealth. [Reject as NPV< 0 ] The management of Basket Wonders has determined that the required rate is 13% for projects of this type. Should this project be accepted?

  14. IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. Internal Rate of Return (IRR) CF1 CF2 CFn ICO = + + . . . + • (1+IRR)1 (1+IRR)2 (1+IRR)n

  15. Find the interest rate (IRR) that causes the discounted cash flows to equal $40,000. IRR Solution $10,000 $12,000 $40,000 = + + (1+IRR)1(1+IRR)2 $15,000 $10,000 $7,000 + + (1+IRR)3(1+IRR)4(1+IRR)5

  16. $40,000= $10,000(PVIF10%,1) + $12,000(PVIF10%,2) + $15,000(PVIF10%,3) + $10,000(PVIF10%,4) + $ 7,000(PVIF10%,5) $40,000 = $10,000(.909) + $12,000(.826) + $15,000(.751) + $10,000(.683) + $ 7,000(.621) $40,000 = $9,090 + $9,912 + $11,265 + $6,830 + $4,347 = $41,444 [Rate is too low!!] IRR Solution (Try 10%)

  17. $40,000 = $10,000(PVIF15%,1) + $12,000(PVIF15%,2) + $15,000(PVIF15%,3) + $10,000(PVIF15%,4) + $ 7,000(PVIF15%,5) $40,000 = $10,000(.870) + $12,000(.756) + $15,000(.658) + $10,000(.572) + $ 7,000(.497) $40,000 = $8,700 + $9,072 + $9,870 + $5,720 + $3,479 = $36,841 [Rate is too high!!] IRR Solution (Try 15%)

  18. NPV at Lower Rate (10%) NPV = PV - ICO NPV = $ 41,444 - $ 40,000 = $ 1,444 NPV at Higher Rate (15%) NPV = PV - ICO NPV = $ 36,881 - $ 40,000 = $ - 3159 IRR Solution (Try 15%)

  19. IRR Solution IRR= LR + NPvL X (HR – LR) NPVL – NPvH

  20. IRR Solution IRR= 10 + 1444 x (15 – 10) 1444 – (-3159) IRR= 10 + 1444 x 5 4603 IRR= 10 + 0.3137 x 5 IRR= 10+ 1.57 = 11.57%

  21. Profitability Index (PI) PI is the ratio of the present value of a project’s future net cash flows to the project’s initial cash outflow. PI = PV / ICO

  22. PI Acceptance Criterion No! The PI is less than 1.00. This means that the project is not profitable. [Reject as PI< 1.00 ] PI = $38,572 / $40,000 = .9643 Should this project be accepted?

  23. Assignment Calculate NPV,PBP,IRR and PI for the following projects. Which project should be selected.(discount rate =13%)

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