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Lecture 8 CAPITAL BUDGETING TECHNIQUES

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Basic Definitions & Concepts Capital Budgeting: The process of evaluating and selecting long-term investments consistent with the firm’s goal of owners wealth maximization. Or, The process of planning and evaluating expenditures on assets whose cash flows are expected to extend beyond one year.

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Basic Definitions & Concepts Capital Expenditures: An outlay of funds by the firm that is expected to produce benefits over a period of time greater than 1 year. Operating Expenditure: An outlay of funds by the firm resulting in benefits received within a year.

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Basic Definitions & Concepts Independent Projects: Projects whose cash flows are unrelated or independent of one another; the acceptance of one does not eliminate the others from further consideration. Mutually Exclusive Projects: Projects that compete with one another, so that the acceptance of one eliminates the others from further consideration.

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Basic Definitions & Concepts Unlimited Fund Capital Rationing Conventional Cash Flow Pattern Non-conventional Cash Flow Pattern Annuity Cash Flows Mixed Stream Cash Flows

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Key Motives for Capital Expenditure Expansion Replacement Renewal Other Purposes

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Steps in the Capital Budgeting Process Proposal Generation Review and Analysis Decision Making Implementation Follow-up

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Capital Budgeting Techniques Non-discounted Cash Flow Techniques: Payback Period (PP) Accounting Rate of Return (ARR) Discounted Cash Flow Techniques: Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Discounted Payback Period

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Payback Period (PP) The length of time required for the net revenues of an investment to recover the cost of the investment. If the project generates constant annual cash inflows, the pay back period can be computed as under: PP = Initial Investment Annual Cash Inflow

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Payback Period (PP) If the project generates mixed stream cash flows, Unrecovered Cost of start of the year PP= Year before full + Cash Inflow during recovery this Year If the PP is less than the maximum acceptable PP-accept the project. If the PP is greater than the maximum acceptable PP- reject the project.

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Payback Period (PP) The pay back period approach has a number of problems: First, There is no consideration of returns after the required payback period. Also ignored the savage value of projects. Secondly, Ignored the pattern of returns within the PP, i.e., the time value of money is not taken into account.

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Net Present Value (NPV) Present value of future net cash flows discounted at a rate equal to the firm’s cost of capital, found by subtracting a project’s initial investment from the present value of its cash inflows. NPV = PV of future cash flows - II

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Net Present Value (NPV) Decision Criteria If the NPV is greater than Tk.0, accept the project. If the NPV is less than Tk.0, reject the project. Greater than zero NPV means that firm will earn a return greater than its cost of capital which will enhance the market value of the firm. If a firm takes on a project with a positive NPV, the wealth of the current stockholders is increased.

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Internal Rate of Return (IRR) IRR- the discount rate which forces the present value of a projects cash inflows to equal the present value of its costs. If the rate of return exceeds the cost of capital ‘K’, its a profitable project since the cost of capital is the minimum required rate of return. If the IRR is less than the cost of capital, reject the project.

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Internal Rate of Return (IRR) Calculation Process (for an Annuity): Step1: Calculate the payback period for the project. Step2: Find, for the life of the project, the PVIFA closest to the payback value. The discount rate associated with that factor is the internal rate of return (IRR) to the nearest 1%. Step3: For finding actual value use the interpolation method.

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Internal Rate of Return (IRR) Calculation Process (for a Mixed Stream): St 1: Find the average cash inflow. St 2: Divide it to the initial investment to get an “average payback period”. St 3: Find the discount rate associated with the present value interest factor with the help of table for the life of the project that is closest to the average pay back period. St 4: Calculate the NPV for each rate and then use interpolation technique.

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NPV Vs IRR Among all techniques, NPV considered the best one for evaluating any long term investment project, because NPV shows the net benefit in an absolute amount. Another reason here is that in case of NPV, it is assumed that reinvestment should be made at the cost of capital rate. This evaluation makes the decision more effective in real World.

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