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Capital budgeting Learning objectives. Understand the concept of capital budgeting i.e. long term investments The nature and scope of investment decisions The methods of appraising the investment decisions. Define

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## Capital budgeting Learning objectives

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**Capital budgetingLearning objectives**• Understand the concept of capital budgeting i.e. long term investments • The nature and scope of investment decisions • The methods of appraising the investment decisions**Define**The decision as to which projects should be undertaken by a corporation is known as the ‘investment decision’, and the process is known as ‘capital budgeting’ Capital budgeting is essentially the process used to decide on the optimum use of scarce resources**Steps in CBP**• Identify the Invst. Opportunities • Select the feasible ones • Evaluate the project as to whether or not the proposal provides an adequate return to investors • Accept & implement the project • Online monitoring**Investment evaluation techniques**Categorized into two groups • Non-discounting techniques: • Payback • (Average) accounting rate of return (ARR) • Discounting techniques • Net present value • Internal rate of return (IRR) • PI (profitability method) • TV (terminal value method)**The payback technique**• This method involves determining the time taken for the initial outlay to be repaid by the project’s expected cash flows • PB = Initial Investment (Co) • Annual Cash Inflow (CI) • Unequal cash flows • Cumulative cash inflow**Selecting project according PB**• When selecting among a number of projects, the one with the shortest payback period should be chosen • However, there is little guidance on what an appropriate payback period should be, making it difficult to decide whether a project should be accepted or not.**Limitations of PB**• Calculation of payback period ignores the time value of money • Cash flows that occur after the end of the payback time are ignored in the calculation of payback period. Yet, these latter cash flows may be significant in making the decision. • Cutoff period is subjective • Cannot rank projects that have the same PB • Does not indicate the project wealth creation**DPB**• Where cash flows are discounted • PB is calculated**Average /Accounting rate of return (ARR)**• The ARR is given by:**Acceptance rule**• Acceptance rule: • The ARR is compared with a predetermined ARR target, or ‘cut-off’ rate, to determine whether to proceed with a project • When n projects then select the one with greatest ARR**Limitations of ARR**Is based on accounting figures which are not necessarily related to cash flows and are based on accounting techniques that may vary from company to company Ignores the time value of money Requires an arbitrary target or “cut-off” rate, but there is little theoretical or other guidance in setting an appropriate target ARR**Net present value (NPV)**• Calculate the PV of all future cash inflows and cash outflows that will result from undertaking a project • These positive and negative present values are then netted off against one another to determine the net present value of the project**Acceptance rule**• The firm should accept all positive-NPV projects and reject negative-NPV projects, because NPV is a measure of the increase in firm value (and therefore the wealth of the firm’s owners) from undertaking the project • If the NPV of a project is zero, it is a matter of indifference as to whether the firm should undertake the project or pay the available cash back to shareholders • This is because zero NPV indicates that the project yields the same future cash that the investors could obtain by investing themselves**The net present value is calculated as follows:**where: CIFt =cash flow generated by the project in year t k = the opportunity cost of capital C0 = the cost of the project (initial cash flow, if any) n = the life of the project in years**NPV is the sum of the present values of a project’s cash**flows at the cost of capital • If PVinflows > PVoutflows, NPV > 0**Decision Rules**• Stand-alone Projects • NPV > 0 accept • NPV < 0 reject • Mutually Exclusive Projects • NPVA > NPVB choose Project A over B**The advantages of NPV technique are:**• It always ensures the selection of projects that maximise the wealth of shareholders • It takes into account the time value of money • It considers all cash flows expected to be generated by a project • Value additivity : NPV (A+B) = NPV(A)+NPV(B)**Limitations are:**• It requires extensive forecasts of the costs and benefits of a project, which can be problematic • Ranking of projects changes with change in CFs / K**Internal rate of return (IRR)**• The IRR technique is also based on a DCF model, but focuses on the rate of return in the DCF equation rather than the NPV • The IRR is defined as the discount rate that equates the present value of a project’s cash inflows with the present value of the its cash outflows • This is the equivalent of saying that the IRR is the discount rate at which the NPV of the project is equal to 0**A project’s IRR is the return it generates on the**investment of its cash outflows • For example, if a project has the following cash flows The “price” of receiving the inflows • The IRR is the interest rate at which the present value of the three inflows just equals the NR 10,000 outflow**Defining IRR Through the NPV Equation**• The IRR is the interest rate that makes a project’s NPV zero**Stated formally:**where: CIFt =the cash flow generated by the project in year t C0 = the initial cost of the project (initial cash flow, if any) n = the life of the project in years irr = the internal rate of return of the project**The unknown variable can be solved by trial-and-error**• NPV and IRR use the same framework and inputs, so they should result in the same accept/reject decision**Acceptance of project**• The decision rule is to accept a project if its IRR is greater than the cost of capital and reject it if its IRR is less than the cost of capital • When IRR > k : accept • When IRR < k : reject**To solve this problem using trial-and-error, you select a**discount rate and substitute it into the equation. If the NPV is negative (positive) the discount rate is too high (low). By narrowing down the difference between the two rates, we can approach the IRR. In this case the IRR is approximately 31%.**Short cut method for IRR**• Calculate the PB • Look in PV annuity table for the PB in the year row • Find two rates close to the PB • Actual IRR by INTERPOLATION**The project cost is Rs 36000 and is expected to generate CF**of Rs 11200 p.a. for 5 years. Calculate the IRR • Solution • PB = 36000/11200= 3.214 (PVAF) • Table PVAF look for PB in 5th row • 16% & 17%**Limitations**• It is difficult to calculate – in most circumstances it can only be found by trial-and-error • For projects involving both positive and negative future cash flows, multiple internal rates of return can exist • It can give an incorrect ranking when evaluating projects of different size**PI- Profitability Method**• PI = PV of cash inflows PV of cash outflows Acceptance rule When PV > 1**Example**Initial investment of a project is 100000 and it generates CF of Rs 40,000, Rs30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. calculate the NPV & PI of the project at 10%.**Terminal value method**• Here the assumption is that each cash flow is reinvested at a certain rate of return from the moment it is received until the termination of the project. • Example • Original outlay is 10,000, years 5, CF 4000 p.a. for 5yrs, k 10%. • In year 1&2 the CF reinvested at 6% • In year 3 to 5 the CFs reinvested at 8%**NPV Vs IRR**• SIZE DISPARITY PROBLEM**Unequal lives project**• Two projects A with service life of 1 yr, B with 5 yrs. Initial investment in both projects 20,000 each. • Project A CF 24000, B 5th yr 40200. at 10%

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