Ch2.1 Capital Budgeting Techniques

7/29/2019 Ch2.1 Capital Budgeting Techniques

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Capital Budgeting Decisions


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NATURE OF INVEST DECISIONS

Invest decisions also known as Capital

Budgeting decisions

It may be defined as firms decision to invest

its current funds most efficiently in the long-

term assets in anticipation of an expected flow

of benefits over a series of years.


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FEATURES

Exchange of current funds for future benefits

Funds are invested in long-term assets

The future benefits will occur to the firm over a series

of years

In invest analysis it is CF which is imp not the

accounting profit.

IMPORTANCE OF INVEST DECISIONS

They influence the firms growth in long term

They affect the risk of the firm

They involve commitment of large amt of funds

They are irreversible

They are among the most difficult decisions to make


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TYPES OF INVEST DECISIONS

One way of classifying

Expansion & diversification

Replacement & modernisation

Another way of classifying

Mutually exclusive investments

Independent investments

Contingent investments


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INVEST EVALUATION CRITERIA

Steps

Estimation of CFs

Estimation of required rate of return

Application of decision rule for making the choice


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CAPITAL BUDGETING METHODS IN

PRACTICE

In a survey of 14 cos it found out that all

except one use payback method. With

payback 2/3rd use IRR and 2/5th NPV. IRR was

second most popular method.

DCF methods were secondary because of

difficulty in understanding and using the

techniques, lack of qualified professionals andunwillingness of top mgmt to use DCF


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NET PRESENT VALUE METHOD

It is a DCF technique

Accept-Reject Rule Accept the project if NPV > 0

Reject the project if NPV < 0

May accept the project if NPV = 0

If projects are mutually exclusive then one with

higher NPV shd be selected.


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Advantages

Time value

Measure of true profitability ( considers all CFs)

Valueadditivity [ NPV(A+B) = NPV (A) = NPV (B) ]

Shholder value (consistent with SWM)

Limitations

CF estimation (uncertainty)

Discount rate Mutually exclusive projects with unequal lives or

under funds constraint

Ranking of projects not independent of dis rate


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INTERNAL RATE OF RETURN METHOD

IRR is the rate that equates invest outlay withthe present value of cash inflow received after

one period.

IRR is the discount rate which makes the NPV

zero.

Accept-Reject Rule

(IRR=r & Opportunity cost of capital = k) Accept the project when r > k

Reject the project when r < k

May accept the project when r = k


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Advantages

Time value

Profitability measure (all CFs considered)

Acceptance rule (same as NPV)

Shholders value (consistent with SWM Obj)

Demerits

Multiple rates

Mutually exclusive projects

Value additivity (IRR cannot be added)


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PROFITABILITY INDEX METHOD

PI also known as BCR, is the ratio of the

present value of cash inflows to the initial cash

outflow.

Accept-Reject Rule

Accept project when PI > 1

Reject project when PI < 1

May accept the project when PI = 1


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Advantages

Time value

Value maximisation (consistent with SWM obj)

Relative profitability (ratio i.e. relative measure)

Demerits

Cash flow estimation

Discount rate


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PAYBACK METHOD

It is the no of years req to recover the original

cash outlay invested in a project.

Accept-Reject Rule

Project would be accepted if the projects payback

is less than the standard payback decided by the

mgmt.

It gives highest ranking to the project which has

the shortest payback.


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Merits

Simplicity

Cost effective

Risk shield (risk can be tackled by having a shorter

std payback period)

Liquidity (emphasis is on recovery)

Limitations

Cash flow after payback ignored

Cash flow patterns (magnitude & timings of CFs

ignored) Administrative difficulty (deciding std payback)

Inconsistent with shholders value maximisation


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Payback reciprocal and the rate of return

Payback reciprocal is a good approximation of the

rate of return when

The life of the project is large or at least twice the

payback period

The project generates equal annual cash inflows


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DISCOUNTED PAYBACK PERIOD

METHOD

It is the no of periods taken in recovering the

invest outlay on the present value basis.

But it still fails to consider the cash flows

occurring after the payback period.


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ACCOUNTING RATE OF RETURN

METHOD

It is also known as return on Investment.

It is the ratio of the average after tax profit

divided by the average investment.

Accept-Reject Rule

Accept those projects whose ARR is greater than

min rate decided by the mgmt and vice versa.

Highest ARR project would be ranked no1.


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Merits

Simplicity Accounting data

Entire stream of profits

Demerits

CFs ignored

Time value ignored Arbitrary cut-off


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NPV V/S IRR EQUIVALENCE OF NPV & IRR

In case of Conventional Independent Projects,

NPV and IRR will result in same accept or reject

decision if the firm is not constrained for funds.

NON CONVENTIONAL INVEST: PROBLEM OFMULTIPLE IRRs

The no of rates of return depends on the no of

times the sign of the CF stream changes.

No of adaptations of the IRR criterion are there to

take care of multiple IRR problem but not very

satisfactory. Hence best alternative is NPV

method.


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MUTUALLY EXCLUSIVE PROJECTS: NPV AND

IRR WILL GIVE CONFLICTING RANKINGS

BECAUSE

CF pattern of project may differ

Initial invest of projects may differ

Projects may have diff expected lives


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CF pattern of projects may differ:

Fishers intersection rate

Compare NPV of mutually exclusive projects andchoose one with larger NPV

Incremental Approach

Series of incremental CFs may result inve and +ve CFsand it would result in problem multiple rate of return

and we would revert back to NPV method

Initial Investment of Projects NPV method shd be used


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Projects life span

NPV rule can be used to choose since it is always

consistent with SWM.


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REINVEST ASSUMPTION AND

MODIFIED IRR

NPV & IRR are assumed to rest on an

underlying implicit assumption about reinvest

of the CFs generated during the lifetime of the

project.

The source of conflict lies in their diff implicit

reinvest rates.

The MIRR is the compound average annual

rate that is calculated with a reinvest rate diff

than the projects IRR.


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All do not accept the implicit reinvest

assumption vis--vis the IRR. They do not

consider it valid. The IRR is a time-adjusted percentage of the

principal amt outst and it is independent of how

CFs are received and utilised. The reason for the ranking conflict bet the IRR

and NPV rules lies in the diff timing of the

projects CFs rather than in the wrongly

conceived reinvestment assumption.

VARYING OPPORTUNITY COST OF


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VARYING OPPORTUNITY COST OF

CAPITAL

If the opportunity cost of capital varies overtime, the use of the IRR rule creates problems,

as there is not a unique benchmark

opportunity cost of capital to compare with

IRR.

To get a comparable opportunity cost one will

have to compute weighted average of these

opportunity costs. This is tedious

There is no problem in using NPV method

each CF can be discounted by the relevant

opportunity cost of capital.


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NPV V/s PI

NPV method shd be preferred except under

capital rationing because the net present

value represents the net increase in the firmswealth.

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Ch2.1 Capital Budgeting Techniques