1. DMH1

2. 2 The most widely accepted objective of the firm is to maximize the value of the firm. The financial management is largely concerned with investment, financing and dividend decision of the firm. The relationship between firm’s overall goal, financial management and capital budgeting is depicted in figure- Introduction….

3. DMH3 Investment Decision Financing Decision Dividend Decision Financial goal of the firm: Wealth maximization Long term asset Short term asset Debt equity mixDividend pay out ratio Capital Budgeting

4. DMH4 Funds are invested in both short-term and Long-term asset. Capital budgeting is primarily concerned with investment in long-term assets. Capital budgeting decision thus have a long range impact on the firm’s performance and they are critical to the firm’s success or failure.

5. DMH5 Capital Budgeting:  Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.  Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.

6. DMH6 Capital Budgeting Techniques A technique that helps us in selecting projects that are consistent with the principle of shareholder wealth maximization. A technique is considered consistent with wealth maximization if It is based on cash flows Considers all the cash flows Considers time value of money Is unbiased in selecting projects The over-riding rule of capital budgeting is to accept all projects for which the cost is less than, or equal to, the benefit: Accept if:Cost  Benefit Reject if:Cost > Benefit

7. DMH7 What is the difference between independent and mutually exclusive projects? Independent projects – if the cash flows of one are unaffected by the acceptance of the other. Mutually exclusive projects – if the cash flows of one can be adversely impacted by the acceptance of the other.

8. DMH8 Capital Budgeting techniques Discounted Cash Flow Criteria Net Present Value Internal Rate of Return Profitability Index Discounted Payback Period Non discounted Cash Flow Criteria Payback period Accounting Rate of Return

9. DMH9 What is the payback period? The number of years required to recover a project’s cost, or “How long does it take to get our money back?” Calculated by adding project’s cash inflows to its cost until the cumulative cash flow for the project turns positive.

10. DMH10 Calculating payback Payback L = 2 + / = 2.375 years CF t -100 10 60 100 Cumulative -100 -90 0 50 012 3 = 2.4 3080 -30 Project L Payback S = 1 + / = 1.6 years CF t -100 70 100 20 Cumulative -100 0 20 40 012 3 = 1.6 3050 -30 Project S

11. DMH11 Strengths and weaknesses of payback Strengths Provides an indication of a project’s risk and liquidity. Easy to calculate and understand. Weaknesses Ignores the time value of money. Ignores CFs occurring after the payback period.

12. DMH12 Discounted payback period  The discounted payback period is exactly the same as the regular payback period, except that we use the present values of the cash flows in the calculation  Discounted payback period is always longer than the regular payback period  Decision Rule - Accept the project if it pays back on a discounted basis within the specified time

13. DMH13 Discounted payback period Uses discounted cash flows rather than raw CFs. Disc Payback L = 2 + / = 2.7 years CF t -100 10 60 80 Cumulative -100 -90.91 18.79 012 3 = 2.7 60.11 -41.32 PV of CF t -100 9.09 49.59 41.3260.11 10%

14. DMH14 Net Present Value (NPV) Sum of the PVs of all cash inflows and outflows of a project:

15. DMH15 What is Project L’s NPV? Year CF t PV of CF t 0-100 -$100 1 10 9.09 2 60 49.59 3 80 60.11 NPV L = $18.79 NPV S = $19.98

16. DMH16 Rationale for the NPV method NPV= PV of inflows – Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value.

17. DMH17 Merits and demerits of NPV Merits: 1. Considers all cash flows 2. True measure of profitability 3. Based on the concept of the time value of money. 4. Consistent with wealth maximization principle. Demerits: 1. Requires estimates of cash flows which is a tedious task. 2. Requires computation of opportunity cost of capital which poses practical difficulties.

18. DMH18 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. CF 1 CF 2 CF n (1+k) 1 (1+k) 2 (1+k) n +... ++ ICOPI = NPVICO PI = 1 + [ NPV / ICO ] >

19. DMH19 Benefit Cost Ratio (BCR) Define the relationship between benefits & costs Benefit Cost Ratio: BCR = Net Benefit Cost Ratio: NBCR = = BCR-1 Where, PVB= present value of benefits I= initial investment (cost) Let consider a project of X company which has a cost of capital of 12 percent. Initial investment: Rs1,00,000 Benefits: Year 1 25,000 Year 2 40,000 Year 3 40,000 Year 4 50,000

20. DMH20 The benefit cost ratio measures for this project are: BCR= NBCR= BCR -1= 0.14 Decision rules When BCR or NBCR Rule is > 1 > 0 Accept = 1 = 0 Indifferent < 1 < 0 Reject BCR=1.145 >1 ACCEPT NBCR=0.145 >0 ACCEPT

21. DMH21 Ev aluation  When capital budget is limited in the current period, the benefit cost ratio criterion may rank projects correctly in the order of decreasingly efficient use of capital  When cash outflows occurred beyond the current period the benefit cost ratio criterion is unsuitable as a selection criterion.

22. DMH22 Profitability Index Merits: 1. Considers all cash flows 2. Recognizes the time value of money 3. Generally consistent with the wealth maximization principle. Demerits: 1. Requires estimates of the cash flows which is a tedious task 2. At times fails to correct choice between mutually exclusive projects.

23. DMH23 Accounting Rate of Return (ARR) The accounting rate of return uses accounting information as revealed by the financial statements, to measure the profitability of an investment. The accounting rate of return is found out by dividing the average after tax profit by the average investment. ARR= (Average income/ Average investment) Decision: Accept if ARR> minimum rate Reject if ARR< minimum rate

24. DMH24 Computing AAR for the Project Assume we require an average accounting return of 25% Average Net Income: (13,620 + 3,300 + 29,100) / 3 = 15,340 AAR = 15,340 / 72,000 =.213 = 21.3% Reject the project

25. DMH25 Merits and Demerits of ARR Merits: 1. Uses accounting data with which executives are familiar. 2. Easy to understand and calculate. Demerits: 1. Ignores the time value of money 2. Does not use cash flows 3. No objective way to determine the minimum acceptable rate of return.

26. DMH26 The rate at which the NPV of cash flows of a project is zero, i.e., the rate at which the present value of cash inflows equals initial investment Consistent with wealth maximizations. Accept a project if IRR > Cost of Capital Internal Rate of Return (IRR)

27. DMH27 Internal Rate of Return (IRR) IRR is the discount rate that forces PV of inflows equal to cost, and the NPV = 0:

28. DMH28 How is a project’s IRR similar to a bond’s YTM? They are the same thing. Think of a bond as a project. The YTM on the bond would be the IRR of the “bond” project. EXAMPLE: Suppose a 10-year bond with a 9% annual coupon sells for $1,134.20. Solve for IRR = YTM = 7.08%, the annual return for this project/bond.

29. DMH29 Rationale for the IRR method If IRR > WACC, the project’s rate of return is greater than its costs. There is some return left over to boost stockholders’ returns.

30. DMH30 IRR Acceptance Criteria If IRR > k, accept project. If IRR < k, reject project. If projects are independent, accept both projects, as both IRR > k = 10%. If projects are mutually exclusive, accept S, because IRR s > IRR L.

31. DMH31 Merits and Demerits Considers all cash flows True measure of profitability Based on the concept of time value of money. Generally consistent with wealth maximization principle. Demerits: Requires estimates of cash flows which is tedious task. At times fails to indicate correct choice between mutually exclusive projects. At times yields multiple rates. Relatively difficult to compute.

32. DMH32 NPV and IRR NPV and IRR will generally give us the same decision. Whenever there is a conflict between NPV and IRR, NPV should always be used. NPV directly measures the increase in value to the firm NPV deals with cost of capital where as IRR deals with rate of return. IRR method assumes the cash flows from the project are reinvested at a rate of return equal to IRR, which we generally view as unrealistic.

33. DMH33 MIRR (Modified Internal Rate of Return) MIRR is the discount rate that causes the PV of a project’s terminal value (TV) to equal the PV of costs. TV is found by compounding inflows at WACC. MIRR assumes cash flows are reinvested at the WACC.

34. DMH34 Calculating MIRR 66.0 12.1 10% -100.0 10.0 60.0 80.0 0 1 2 3 10% PV outflows -100.0 $100 MIRR = 16.5% 158.1 TV inflows MIRR L = 16.5% $158.1 (1 + MIRR L ) 3 =

35. DMH35 MIRR……. IRR method assumes the cash flows from the project are reinvested at a rate of return equal to IRR, which we generally view as unrealistic.  While the internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR, the modified IRR assumes that all cash flows are reinvested at the firm's cost of capital. Therefore, MIRR more accurately reflects the profitability of a project. Managers like rate of return comparisons, and MIRR is better for this than IRR.  This is preferable because:  Any series of cash flows has a single MIRR.  It takes account of the rate at which cash generated is re-invested.