1. 1 Capital Budgeting - Methods 1.Average Return on Investment 2.Payback 3.Net Present Value 4.Internal Rate of Return 5.Modified IRR

2. 2 Average Return on Investment AROI = Avg. Net Income Per Year Avg. Investment

3. 3 Average Return on Investment Example: YearNet Income Cost 1 6,000100,000 Initial 2 8,0000 Salvage Value 311,000 413,000 516,000 618,000

4. 4 Avg. Net Income72,000 6 Avg. Investment100,000 2 AROI12,000 50,000 Average Return on Investment = 12,000 = 24% = 50,000

5. 5 Advantages Disadvantages Average Return on Investment

6. 6 Payback Method # Years required to recover the original investment Example: YearNet IncomeCash FlowCumulative CF 16,00026,00026,000 28,00028,00054,000 311,00031,00085,000 413,00033,000118,000 516,00036,000154,000 618,00018,000172,000 Payback = 3 + 100,000 - 85,000 118,000 - 85,000 = 3.45 Years

7. 7 Payback Method Advantages Disadvantages

8. 8 Time Value of Money FV = PV (1 + r) n Compounding:Finding FV Discounting:Finding PV:PV = FV/(1 + r) n Internal Rate of Return:Finding r

9. 9 Net Present Value NPV =Present Value of All Future Cash Flows less Inital Cost =CF 1 + CF 2 + CF 3 +.......CF n - I o 1+r(1+r) 2 (1+r) 3 (1+r) n

10. 10 Net Present Value - Example YearCFDisc. Factor PV 0 -1000001-100000 1260001/1.1 =.9091 23637 2280001/(1.1) 2 =.8264 23139 3310001/(1.1) 3 =.7573 23290 4330001/(1.1) 4 =.6830 22539 5360001/(1.1) 5 =.6209 22352 6180001/(1.1) 6 =.5645 10161 NPV = 25121

11. 11 Net Present Value Advantages Disadvantages

12. 12 Internal Rate of Return Discount rate that makes NPV Zero (i.e., that equates PV of benefits with the cost). IRR: I o = CF 1 + CF 2 +..... + CF n 1+r (1+r) 2 (1+r) n Solve for r. Example: 100,000 = 26000 + 28000 + 31000 +.......... + 18000 1+r (1+r) 2 (1+r) 3 (1+r) 6 r = 18.2%

13. 13 Internal Rate of Return Advantages Disadvantages

14. 14 Profitability Index PI =PV of all Benefits PV of all Cost Example: PV (Benefits) = 26000 + 28000 +.......... + 18000 1.1 (1.1) 2 (1.1) 6 = 125121 PV (Cost)= 100000 PI = 125121 = 1.25 100000

15. 15 Profitability Index Advantages: Disadvantages:

16. 16 NPV Profile Year CFDisc. Factor PV 0-100,0001-100,000 1 26,0000.91 23,636 2 28,0000.83 23,140 3 31,0001/(1.1) 3 =.7573 23,291 4 33,0001/(1.1)4 =.6830 22,539 5 36,0001/(1.1)5 =.6209 22,352 6 18,0001/(1.1)6 =.5645 10,161 NPV = 25,121

17. 17 NPV Profile Dis. Rate NPV 0% 7200 5%45725.7 10%25120.76 15%8711.838 20% -4538.97 25% -15376.1

18. 18 NPV Profile 80000 60000 40000 20000 0 -20000 00.050.10.150.20.25 Disc. Rate NPV

19. 19 Choosing Between Projects YearCF(A)CF(B) 0-25000-25000 1 2000 21000 2 2000 10000 3 35000 2000 NPV 6351 4606 IRR 17% 22%

21. 21 Modified IRR Reinvestment Rate Assumption (Project A) Project Outlay 25,000 Cash Flows: YR1 2,000 YR2 2,000 YR3 35,000 NPV @ 8%: 6,351 IRR: 17%

22. 22 NPV: Project A YR1: 2,000 YR2: 2,000 + 2,000 + 160 = 4,160 YR3: 35,000 + 4,160 + 333 = 39,493 [Note: PV of 39,493, three years from now @ 8% = 31,351 Less: outlay 25,000 NPV 6,351] Modified IRR

23. 23 IRR @ 17% YR1: 2,000 = 2,000 YR2: 2,000 + 2,000 + 340 = 4,340 YR3: 35,000 + 4,340 + 738 = 40,078 [25,000 invested for three years @ 17% = 25,000(1.17) 3 = 40,040] Modified IRR

24. 24 Modified Internal Rate of Return Find k such that (1+k) n I 0 = Final value i.e. (1+k) 3 25000 = 39,439 k = 16.5% Modified IRR

25. 25 Reinvestment Rate Assumption (Project B) Project Outlay 25,000 Cash Flows: YR1 21,000 YR2 10,000 YR3 2,000 NPV @ 8%: 4,606 IRR: 22.12% Modified IRR

26. 26 NPV: Project B YR1:21,000 = 21,000 YR2:10,000 + 21,000 + 1,680 = 32,680 YR3: 2,000 + 32,680 + 2,614 = 37,294 [Note: PV of 37,294, three years from now @ 8% = 29,606 Less: outlay 25,000 NPV 4,606 ] Modified IRR

27. 27 IRR of 22.12% YR1: 21,000 = 21,000 YR2: 10,000 + 21,000 + 4,645 = 35,645 YR3: 2,000 + 35,645 + 7,885 = 45,530 [25,000 invested for three years @ 22.12% = 25,000(1.2212)3 = 45,530] Modified IRR

28. 28 Modified Internal Rate of Return Find k such that (1+k) n I 0 = Final value i.e. (1+k) 3 25000 = 37,294 k = 14.26% Modified IRR

29. 29 Estimating Cash Flows NPV = CF 1 + CF 2 +.............. + CF n - I o l+r (l+r) 2 (l+r) n Cash FlowsIncremental After Tax Net Working Capital Sunk Costs

30. 30 Procedure 1.Initial Costs:New CAPEX Additional W. Cap Sale of Old Assets 2.Annual Costs:Revenue Less Costs After Tax 3.Terminal Cash Flows:Salvage Value Recoupment of NWC

31. 31 Cash Flow Estimates Sale of Existing Plant CF= Selling Price + T (B.V. - S.P.) Annual Cash Flows OCF= (Sales-Cost)(1-T) + T, DEPREC or OCF= Net Inc + Depreciation

32. 32 New Product Proposal Annual Sales$20m Annual Costs$16m Net Working Capital$2m Plant Site$0.5m Plant and Equipment$10m DepreciationStraight Line over 20 years Salvage Valuenil Tax Rate40% Required Return 8%

33. 33 New Product Proposal INITIAL CASH FLOWS ANNUAL CASH FLOWS

34. 34 New Product Proposal TERMINAL CASH FLOWS CALCULATION

35. 35 Evaluating Capital Projects 1) Focus on Cash Flow, Not Profits. –Cash Flow = Economic Reality. –Profits Can Be Managed. 2) Carefully Estimate Expected Future Cash Flows. 3) Select a Discount Rate Consistent with the Risk of Those Future Cash Flows. 4) Account for the Time Value of Money. 5) Compute a “Base-Case” NPV.

36. 36 6) Net Present Value = Value Created or Destroyed by the Project. –NPV is the Amount by which the Value of the Firm Will Change if you Undertake the Project. 7)Identify Risks and Uncertainties. Run a Sensitivity Analysis. –Identify “Key Value Drivers.” –Identify Breakeven Assumptions. –Estimate Scenario Values. –Bound the Range of Value Evaluating Capital Projects

37. 37 8) Identify Qualitative Issues. –Flexibility –Quality –Know-How –Learning 9) Decide Evaluating Capital Projects