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10/2/2009

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Dr Gagan Pareek alias Dr Harish Pareek M.Com, A.I.C.W.A, PhD Area of Expertise : Accounting & Finance, Credit Risk Management Strategic Management Corporate Trainer & Key Resource Person : In the area of Finance and Strategy, Leadership, Team Building and Motivation ; Mobile: Research: Awarded PhD degree on “Operation of NBFCs in India- a changing profile “ in the Dept of Commerce, Calcutta University. Industry Exp: Having 12 years of experience in the area of accounting and finance, credit and risk analysis. Worked for companies like Kesoram Industries Ltd (B.K. Birla Group of Companies), UTI-ISL, Magma Fincorp Ltd. He has also been associated with academic research for the last 9 years. 10/2/2009www.gaganpareek.com

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Corporate Goal, Financial Management & Capital Budgeting Financing Decisions Dividend Decisions Investment Decisions Long-term Investments Short-term Investments Goal of the Firm Maximize the value of the Firm Capital Budgeting 10/2/2009

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Capital Budgeting – An Overview Capital budgeting is the making of long-run planning decisions for investments in projects and programs. It is concerned with sizeable investment in long term assets. These assets may be tangible such as plant and machinery, land and building, etc or intangible ones like new technology,patents, or trademarks etc. It is a decision-making and control tool that focuses primarily on projects or programs that span multiple years. 10/2/2009

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Importance of Capital Budgeting Capital budgeting decisions commit companies to courses of action Involve greater amount of risk on account of unforeseen situation. Investment decisions are not easily reversible within a short period. Capital is not cost free, etc….. 10/2/2009

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Types of Capital Investments Replacement of assets or group of assets already in use Purchase of completely new assets for expansion Other types of investments like welfare projects, projects to comply with statutory requirements, research and development cost, education and training cost, prestige value projects. etc… 10/2/2009

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Capital Budgeting Process 10/2/2009

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Corporate Goal Strategic Planning Investment Opportunities Preliminary Screening Financial Appraisal, Quantitative Analysis, Project Evaluation or Project Analysis Qualitative factors, judgements and gut feelings Accept /reject decisions on the projects Accept Reject Implementation Facilitation, monitoring, control and review Continue, expand or abandon project Post Implementation Audit 10/2/2009www.gaganpareek.com

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Techniques of Capital Budgeting Traditional Methods Pay Back Period, Accounting Rate of Return Modern Techniques Discounted Pay Back Period, Net Present Value, Internal Rate of Return, Profitability Index 10/2/2009

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Pay Back Period The payback period is defined as the number of years required for the proposal's cumulative cash inflows to be equal to it cash outflows. The payback period is the length of time required to recover the initial cost of the project. The payback period is length of time required for a proposal to 'break even' on its net investment 10/2/2009

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Capital Budgeting - Illustration Expected Net Cash Flow YearProject LProject S 0(Rs100)(Rs 100) Evaluate both the projects using payback period 10/2/2009

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Project L Expected Net Cash Flow YearAnnualCumulative 0(Rs100)(Rs100) 1 10 (90) 2 60 (30) Payback for project L= 2 + Rs30 / Rs80 years = 2.4 years Payback for project S= 1.6 years. Project S should be preferred because of low payback period. Weaknesses of Payback: Ignores the time value of money. This weakness is eliminated with the discounted payback period. Ignores cash flows occurring after the payback period. 10/2/2009

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Accounting Rate of Return (ROI) This method is also known as Return on Investment method. ARR is found out by dividing the average tax after profits by the average investment. ARR = Average Income Average Investment Example: A project will cost Rs 50,000.Its stream of income after depreciation, interest and taxes is expected to be Rs 20,000, Rs 12,000, Rs 14,000, Rs 16,000 and Rs,20,000. Assume tax rate of 50% and depreciation on straight line method. Calculate ARR. 10/2/2009

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Calculation of ARR Period12345Average EBDIT20,00012,00014,00016,00020,00016,400 Depreciation10,000 EBIT10,0002,0004,0006,00010,0006,400 Tax 50%5,0001,0002,0003,0005,0003,200 EAT5,0001,0002,0003,0005,0003,200 Investment Beginning 50,00040,00030,00020,00010,000 Investment Ending 40,00030,00020,00010,000- Average Investment 45,00035,00025,00015,0005,00025,000 Accounting Rate of Return = 3,200 x 100 = 12.8% 25,000 10/2/2009

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Modern Techniques Cutoff Rate Minimum acceptable rate of return required for decision making for capital expenditure is called a cutoff rate, hurdle rate, or target rate. 10/2/2009

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Discounted Payback Period This method is designed to overcome the drawback of ordinary payback period The payback period is determined on the basis of present value of cash flows. Weakness It still fails to take cash flows after recovery of initial investment into consideration. 10/2/2009

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Capital Budgeting – Illustration for Discounted Payback Period Expected Net Cash Flow YearProject LProject S DF 0(Rs100)(Rs 100) 10% Evaluate both the projects using discounted payback period? 10/2/2009

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Project L Expected Net Cash Flow YearAnnual DF Present Value Cumulative PV 0(Rs100) 10% Rs Rs Payback for project L= 2 + Rs / Rs years = 2.69 years Payback for project S= ?????????. Which project should be preferred???????? 10/2/2009

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Net Present Value (NPV) The net cash flows are discounted to present values using a stipulated compound rate of interest. From the sum of present values of various cash inflows present value of the cost of project is subtracted. The resulting surplus is the net present value of investment. 10/2/2009

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Conclusion If the projects are independent, accept both. If the projects are mutually exclusive, accept Project S since NPV S > NPV L Independent: A project that has nothing to do with other projects under investigation. E.g. : Replace xerox machine and build a new plant. Mutually Exclusive: You only need one of these alternative projects. E.g. : Buy Acer or Lenovo PC? 10/2/2009

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NPV concept for replacement of an asset XYZ Ltd is considering replacing an old machine with a new machine, each with a 5-year life and zero salvage. 10/2/2009

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Depreciation is a non cash expenditure. Tax savings from loss on disposal of old machine: Rs15,000 × 40% = Rs 6,000 10/2/2009

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XYZ’s machine Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV) 10/2/2009

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XYZ’s machine Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV) 10/2/2009

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XYZ’s machine Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV) 10/2/2009

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Since the NPV is negative, we know the rate of return is less than the 15 percent discount rate. XYZ’s machine Net Present Value Analysis, using a 15 percent discount rate. Net Present Value (NPV) 10/2/2009

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Net Present Value : Decision Criteria Net present value Equal to or greater than zero Less than zero Accept the investment Reject the investment 10/2/2009

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Profitability Index Profitability Index: Is the relation between present value of future net cash flow and the initial cash outlay PI = Present value of net cash flow Initial cash outlay So long as the PI is equal to greater than 1 an investment proposal is acceptable. 10/2/2009

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Internal Rate of Return The IRR is the discount rate that equates the present value of initial outlay with the present value of the expected net cash flows. The IRR should be compared with the required rate of return(cut off rate). If IRR is not less than the cut off rate then the project is profitable otherwise it is rejected. 10/2/2009

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IRR : Decision Criteria Net present value Equal to or greater than required rate of return Less than required rate of return Accept the investment Reject the investment 10/2/2009

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Calculation of IRR To calculate IRR there is no simple formula to use. We need to use either trial & error method or a calculator. 10/2/2009

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Computation of IRR: Example A project requires investment of Rs 16lakhs, it is being financed by debt fund of Rs lakhs carrying annual interest of 10% and the rest by equity funds. The loan is repayable in 5 equal year end installments. The project is expected to save pre tax expenses Rs 3 lakh in year 1,6lakh in year 2,7.5lakh in year 3, 6.5 lakh in year 4, and Rs 5 lakh in year 5.The residual value after 5 years of the assets deployed is Rs 40, %reducing balance depreciation is allowed for income tax purpose. Tax rate is 50%. Determine the IRR. 10/2/2009

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Projected Cash Flow Year 0 Rs’000 Year 1 Rs’000 Year 2 Rs’000 Year 3 Rs’000 Year 4 Rs’000 Year 5 Rs’000 Initial Investment(1600) Cost saved (post tax) Add: Depreciation tax shield Add: Terminal Cash Flow40 Cash Flow(1600) /2/2009

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Project IRR YearCash Flow Rs’000 9% 9% Rs’000 11% Rs’000 0(1600)1.000(1600)1.000(1600) NPV29.49(46.03) PV falls by when discounting rate is increased by 2% Project IRR = 9% + {(2/75.52) X 29.49} Project IRR = 9% % = 9.78% 10/2/2009

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NPV v/s IRR Between the two IRR is the most popular and sophisticated method since IRR obviates the subjective decision regarding discounting rate. Under NPV method the main basis of selection of a project is comparison of NPVs of different projects, while under IRR method, a number of bases is available for comparison such as…… contd….. 10/2/2009

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Contd.. IRR rate vs Rate of Return on normal operations IRR rate vs Cut-off Rate of the company IRR rate vs Cost of Capital (cost of borrowing) IRR rates of different projects IRR rates of similar projects undertaken in the past IRR rate is simpler for the management to understand and appreciate. 10/2/2009

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NPV v/s IRR We should be careful when NPV and IRR calculations show divergent rules. The rules are NPV should be the basis of decisions when The projects are mutually exclusive in character There is a capital rationing 10/2/2009

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Capital Rationing The situation that exists if the firm has positive NPV projects but cannot find necessary funds for financing the projects. It refers to the choice of investment projects under capital constraints. 10/2/2009

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Example on Capital Rationing Potential Investment Opportunities ProjectsCapital Required (in Rs) Internal Rate of Return A60,00030% B50,00028% C50,00024% D40,00010% Suppose that that the firm has only Rs 1,00,000 to spend on various projects. Which project should be selected for funding? 10/2/2009

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Suppose the firm selects Project A due to higher IRR than it is left with only Rs 40,000/=, so the firm cannot go for Project B & C due to capital constrain, it can only fund Project D. So the firm’s Average Rate of Return on its total investment will be = 0.6x x0.10 =22% 10/2/2009

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The firm could follow another strategy, it can go for Project B & C bypassing Project A and D. Its average rate of return on its total investment of Rs 1,00,000 will be = 0.50x x0.24 =26% The rate of return on second strategy is 4% higher so the firm should go for funding Project B&C instead of Project A&D. 10/2/2009

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References: Ross Westerfield Jordan, Fundamentals of Corporate Finance,, 8 th Edition, Tata McGraw Hill Berk Jonathan & DeMarzo Peter,Financial Management, Pearson Education, 2008 Khan & Jain, Financial Management, 5 th Edition, Tata McGraw Hill Publishing Co Ltd Chandra Prasanna,Financial Management, 7 th Edition, Tata McGraw Hill Publishing Co Ltd Banerjee. B, Financial Policy & Management Accounting, 7 th Edition, Prentice Hall India 10/2/2009

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