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Capital budgeting Concept and PP Solution

Financial Management, Capital budgeting Concept and PP Solution

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Capital budgeting Concept and PP Solution

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  1. FUNDAMENTAL OFFINANCIALMANAGEMENT CHAPTER-8 Capital Budgeting

  2. Capital budgeting involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery involves choosing projects that add value to a company. The capital budgeting process can involve almost anything including acquiring land or purchasing fixed assets like a new truck or machinery. • Corporations are typically required, or at least recommended, to undertake those projects that will increase profitability and thus enhance shareholders' wealth. • However, the rate of return deemed acceptable or unacceptable is influenced by other factors specific to the company as well as the project Sources: invstopedia PRESENTED BY: SHIBA PRASAD DAHAL

  3. Capital budgeting is the process by which investors determine the value of a potential investment project. • The three most common approaches to project selection are payback period (PB), internal rate of return (IRR), and net present value (NPV). • The payback period determines how long it would take a company to see enough in cash flows to recover the original investment. • The internal rate of return is the expected return on a project—if the rate is higher than the cost of capital, it's a good project. • The net present value shows how profitable a project will be versus alternatives and is perhaps the most effective of the three methods. • Sources: invstopedia PRESENTED BY: SHIBA PRASAD DAHAL

  4. How Capital Budgeting Works? • When a firm is presented with a capital budgeting decision, one of its first tasks is to determine whether or not the project will prove to be profitable. The payback period (PBP), internal rate of return (IRR) and net present value (NPV) methods are the most common approaches to project selection. • Although an ideal capital budgeting solution is such that all three metrics will indicate the same decision, these approaches will often produce contradictory results. Depending on management's preferences and selection criteria, more emphasis will be put on one approach over another. Nonetheless, there are common advantages and disadvantages associated with these widely used valuation methods. • Sources: invstopedia PRESENTED BY: SHIBA PRASAD DAHAL

  5. CAPITAL BUDGETING TECHNIQUES / METHODS There are different methods adopted for capital budgeting. The traditional methods or non discount methods include: Payback period and Accounting rate of return method. The discounted cash flow method includes the NPV method, profitability index method and IRR. Payback period method: As the name suggests, this method refers to the period in which the proposal will generate cash to recover the initial investment made. It purely emphasizes on the cash inflows, economic life of the project and the investment made in the project, with no consideration to time value of money. Through this method selection of a proposal is based on the earning capacity of the project. With simple calculations, selection or rejection of the project can be done, with results that will help gauge the risks involved. However, as the method is based on thumb rule, it does not consider the importance of time value of money and so the relevant dimensions of profitability. Payback period = Cash outlay (investment) / Annual cash inflow PRESENTED BY: SHIBA PRASAD DAHAL

  6. Accounting rate of return method (ARR): This method helps to overcome the disadvantages of the payback period method. The rate of return is expressed as a percentage of the earnings of the investment in a particular project. It works on the criteria that any project having ARR higher than the minimum rate established by the management will be considered and those below the predetermined rate are rejected. This method takes into account the entire economic life of a project providing a better means of comparison. It also ensures compensation of expected profitability of projects through the concept of net earnings. However, this method also ignores time value of money and doesn’t consider the length of life of the projects. Also it is not consistent with the firm’s objective of maximizing the market value of shares. ARR= Average income/Average Investment PRESENTED BY: SHIBA PRASAD DAHAL

  7. Discounted cash flow method: The discounted cash flow technique calculates the cash inflow and outflow through the life of an asset. These are then discounted through a discounting factor. The discounted cash inflows and outflows are then compared. This technique takes into account the interest factor and the return after the payback period. Net present Value (NPV) Method: This is one of the widely used methods for evaluating capital investment proposals. In this technique the cash inflow that is expected at different periods of time is discounted at a particular rate. The present values of the cash inflow are compared to the original investment. If the difference between them is positive (+) then it is accepted or otherwise rejected. This method considers the time value of money and is consistent with the objective of maximizing profits for the owners. However, understanding the concept of cost of capital is not an easy task. PRESENTED BY: SHIBA PRASAD DAHAL

  8. The equation for the net present value, assuming that all cash outflows are made in the initial year (t), will be: Net Present Value Method for Capital Budgeting Where A1, A2, …. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known, otherwise the net present, value can not be known. NPV = PVB – PVC where, PVB = Present value of benefits PVC = Present value of Costs PRESENTED BY: SHIBA PRASAD DAHAL

  9. Internal Rate of Return (IRR): This is defined as the rate at which the net present value of the investment is zero. The discounted cash inflow is equal to the discounted cash outflow. This method also considers time value of money. It tries to arrive to a rate of interest at which funds invested in the project could be repaid out of the cash inflows. However, computation of IRR is a tedious task. It is called internal rate because it depends solely on the outlay and proceeds associated with the project and not any rate determined outside the investment. It can be determined by solving the following equation: Internal Rate of Return Method for Capital Budgeting If IRR > WACC then the project is profitable. If IRR > k = accept If IR < k = reject PRESENTED BY: SHIBA PRASAD DAHAL

  10. Profitability Index (PI): It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate profitability index (PI) or benefit cost (BC) ratio is as follows. PI = PV cash inflows/Initial cash outlay Profitability Index Method for Capital Budgeting PI = NPV (benefits) / NPV (Costs) All projects with PI > 1.0 is accepted. PRESENTED BY: SHIBA PRASAD DAHAL

  11. IMPORTANCE OF CAPITAL BUDGETING 1) Long term investments involve risks: Capital expenditures are long term investments which involve more financial risks. That is why proper planning through capital budgeting is needed. 2) Huge investments and irreversible ones: As the investments are huge but the funds are limited, proper planning through capital expenditure is a pre-requisite. Also, the capital investment decisions are irreversible in nature, i.e. once a permanent asset is purchased its disposal shall incur losses. 3) Long run in the business: Capital budgeting reduces the costs as well as brings changes in the profitability of the company. It helps avoid over or under investments. Proper planning and analysis of the projects helps in the long run. PRESENTED BY: SHIBA PRASAD DAHAL

  12. SIGNIFICANCE OF CAPITAL BUDGETING Capital budgeting is an essential tool in financial management. Capital budgeting provides a wide scope for financial managers to evaluate different projects in terms of their viability to be taken up for investments. It helps in exposing the risk and uncertainty of different projects. It helps in keeping a check on over or under investments. The management is provided with an effective control on cost of capital expenditure projects. Ultimately the fate of a business is decided on how optimally the available resources are used. PRESENTED BY: SHIBA PRASAD DAHAL

  13. Chapter 8: Concept Check PP solution Manual 12:Given Initial Cost Rs. 250000 Annual Cash flow Rs. 40,000 Payback Period=? Soln: Payback Period= ==6.25 Yrs If project is shorter than 6.25 yrs we could not invest. 13: Given, Initial investment= 5 million, Annual net income = 1.5 million, AARR=? We have AARR= ==0.6or 60% 14: Given: Initial Investment=Rs.52000 Annual average Net income=(15000+20000)/2 = Rs. 17500, We have AARR= ==0.6731or 67.31% PRESENTED BY: SHIBA PRASAD DAHAL

  14. Chapter 8: Concept Check PP solution Manual 15:Given, Initial Cost Rs.122000 Total Present Value Rs. 150000 Profitability index (PI)=? Soln: Profitability index (PI)= ==1.23 Project is accepted because its PI is greater than 1. 16: Given, Initial investment= 24 million, NPV=6 million, PI=? We haveProfitability index (PI)= ==1.25 Project is accepted because its PI is greater than 1. 17: Solution: If Project A & B are Mutually Exclusive the NPV approach suggest that Project B is Preferable because of higher NPV, However NPV method only is insufficient to make decision because this two projects have different investment amount. PI method also used to get final decision, PI of Bis higher so, Project B is more Profitable. PRESENTED BY: SHIBA PRASAD DAHAL

  15. Chapter 8: Concept Check PP solution Manual 18:Given, Initial Cost Rs.500000 Annual Cash inflow Rs. 150000, Life of project (n)=4 yrs Required return (K)=9%, NPV=? Soln: We have, NPV= Annual CF(PVIFAk%,n)-Initial Cost = 150000(PVIFA 9%,4Yrs)-500000 = 150000*3.2397-500000 = 485955-500000 = -14045 The project have negative NPV so it is rejected. 19:Given, Initial Cost Rs.100000 Cash inflow in year 10, Rs. 200000, Life of project(n)=10 yrs. Required return (K)=6%, NPV=? Soln: NPV=-100000= 11681.93 NPV is Positive Project accepted 20. PRESENTED BY: SHIBA PRASAD DAHAL

  16. Chapter 8: Concept Check PP solution Manual 18:Given, Initial Cost Rs.500000 Annual Cash inflow Rs. 150000, Life of project (n)=4 yrs Required return (K)=9%, NPV=? Soln: We have, NPV= Annual CF(PVIFAk%,n)-Initial Cost = 150000(PVIFA 9%,4Yrs)-500000 = 150000*3.2397-500000 = 485955-500000 = -14045 The project have negative NPV so it is rejected. 19:Given, Initial Cost Rs.100000 Cash inflow in year 10, Rs. 200000, Life of project(n)=10 yrs. Required return (K)=6%, NPV=? Soln: NPV=-100000= 11681.93 NPV is Positive Project accepted 20. PRESENTED BY: SHIBA PRASAD DAHAL

  17. The cost of preferred stock capital is the preferred dividend divided by the net issue price. Preference dividend is not deductible expenses. It is paid from the profit after tax. Therefore tax adjustment is not required, but adjustment is required in the net value of the preferred stock. Dividend rate of preferred stock is predetermined. • Cost of Perpetual preferred stock. • When Preferred stocks are selling at par. • Kps= Dividend rate OR Dps/P0 • When Preferred stocks are selling at not par Kps=Dps/NP • Cost of redeemable preferred stock • (Maturity Period is given) • Kps= PRESENTED BY: SHIBA PRASAD DAHAL

  18. Cost of Equity • Cost of equity (common stock) is broadly known as the dividend payment rate to equity capital. Cost of external equity (When there is no retained earning & new share are issued) Ke=D1/p0(1-f)+g • Cost of internal Equity (Cost of retained earning) • (When there is sufficient retained earning New share are not issued) • Ks=D1/P0+g Discount cash flow approach Ks=D1/p0+g Capital Asset Pricing Model(CAPM) Ks=Rf+(E.Rm-Rf)βs Bond Yield Plus Risk Premium Ks= Bond Yield +Risk Premium PRESENTED BY: SHIBA PRASAD DAHAL

  19. WACC is the composite cost of capital which is computed by taking the cost of each component of capital used in the capital structure mix along with the effect of their respective weight. • It is calculated by using following Formula. • WACC= We*Ke+Wp*Kps +Wd*Kdt PRESENTED BY: SHIBA PRASAD DAHAL

  20. 7-1 a. Given, • Par Value (m)=Rs.1000 • Coupon interest(I)=15% of Rs.1000= Rs. 150 • Floatation Cost=Rs.50 • Net Proceed=Par Value-Floatation cost=1000-50 • Cost of debt(Kd)=Coupon interest/(M-FC) • =Rs.150/(1000-50) • =15.79% • b. Given, Par Value(M)=Rs.1000, I=13%of 1000 • Time to maturity(n)=15yrs. • Net Proceed (NP)=Rs. 1060, Tax rate (T)=30% • We Have, KdT= • KdT= KdT= • KdT=0.1212*0.7 =8.48% PRESENTED BY: SHIBA PRASAD DAHAL

  21. 7-2Given, • DPS=Rs.12, Price of Preferred stock(Rs.)=Rs.84 • Net Proceed(NP)=Rs. 80, Taxt rate (T)=40 • a. If the stock is perpetual • Cost of Preferred stock(Kps)= DPS/NP*100 • =12/80*100= 15% • b. Given, Call Price(CP)=Rs.100, NP=RS.80 • DPS=Rs. 12, Callable Period(nc)=5yrs. • We Have, Kps= • = = 0.1846=18.46% PRESENTED BY: SHIBA PRASAD DAHAL

  22. 7-3Given, • Dividend at the end of year (D1)=RS.8, • Growth Rate(g=4%) • Current Price(p0)=Rs. 80, • Floatation Cost(F)=10% of 80=Rs.8 • Net Proceeds(NP)= (P0-F) =80-8= RS. 72 • Cost of internal equity(Ks)= ?, Cost of external equity(Ke)=? • We have, (Ks)=(D1/P0)+g =8/80+0.04 =0.14=14% • Ke=(D1/NP)+g = 8/72+0.04=0.1511=15.11% • 7.4, a. Given, • Face Value (M)=Rs. 1000, Coupon Interest(I)=8.5% =Rs.85 • Underwriting Fee(F)=2% of Rs. 1000= Rs. 20 • Maturity Period(n)=10 Yrs. Corporate Tax Rate(T)=30% • Selling Price=Rs.950, Net Proceeds(NP)= 950-20= Rs.930 • We Have • KdT= • KdT= • KdT=0.965*0.7 =6.76% PRESENTED BY: SHIBA PRASAD DAHAL

  23. 7-4 b.Given, • Price of Preferred stock(P0)=RS.47.50 • Dividend on Preferred stock(Dps)=Rs.8 • Flotation Cost(F)=Rs.2.5 • Net Proceeds(NP)= (P0-F) =47.50-2.5= RS. 45 • Cost of Preferred Stock (Kps)= ?, • We have, Kps=(Dps/NP)=Rs.8/Rs.45= 0.1778=17.78% • 7.4, C. Given, • Dividend(D0) =Rs. 5, Growth Rate (g)= 8% • Selling Price (P0)=Rs. 40 • Cost of equity(Ks)=? • We Have, • Ks= D1/P0+g • =5*1.08/40+0.08 • =5.4/80+0.08 • =0.215 • =21.5% • 7.4, d. Given, • Next Expected dividend(D1)=Rs. 4.4 • Growth Rate(g)=10% Current Stock Price(P0)=Rs.90 • Net Proceeds(NP) =Rs. 88 • Cost of external equity(Ke)=? • We Have, (Ke)= D1/Np+g • =4.4/88+0.10 • =0.05+0.10 • =15% PRESENTED BY: SHIBA PRASAD DAHAL

  24. PP-7.6 • PP-7.7 PRESENTED BY: SHIBA PRASAD DAHAL

  25. PP-7.8 • PP-7.9 • After tax Weighted average cost of Capital(WACC) • Cost Of Equity(Ks)= D1/p0+g =20/200+0.05 =0.15=15% PRESENTED BY: SHIBA PRASAD DAHAL

  26. PP-7.10 • PP-7.11 PRESENTED BY: SHIBA PRASAD DAHAL

  27. PP-7.12 • b. Calculation of Weighted Average Cost Of Capital PRESENTED BY: SHIBA PRASAD DAHAL

  28. PRESENTED BY: SHIBA PRASAD DAHAL

  29. b. Weighted average cost of capital assuming internal equity financing

  30. PP-22, Given

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