INVESTMENT ANALYSISOR

CAPITAL BUDGETING

What is Capital Budgeting? THE PROCESS OF PLANNING

EXPENDITURES ON ASSETS WHOSE RETURN WILL EXTEND BEYOND ONE YEAR.

INVESTMENT THE ADDITION OF DURABLE ASSETS

TO A BUSINESS

INVESTMENT OPPORTUNITIES MAINTENANCE AND REPLACEMENT

OF DEPRECIABLE CAPITAL ITEMS ADOPTION OF COST-REDUCING

INVESTMENTS ADOPTION OF INCOME-INCREASING

INVESTMENTS A COMBINATION OF THE PRECEDING

STEPS IN INVESTMENT ANALYSIS:

1. IDENTIFY POTENTIALLY PROFITABLE INVESTMENT ALTERNATIVES

2. COLLECT RELEVANT DATA ON: CAPITAL OUTLAYS COSTS RETURNS

3. USE AN APPROPRIATE METHOD TO ANALYZE THE DATA.

4. DECIDE WHETHER TO ACCEPT OR REJECT THE INVESTMENT OR SELECT THE TOP RANKING AMONG MUTUALLY EXCLUSIVE PROJECTS.

CAPITAL BUDGETING METHODS OF CAPITAL BUDGETING

PAYBACK METHOD SIMPLE RATE OF RETURN NET PRESENT VALUE INTERNAL RATE OF RETURN

PAYBACK METHOD

THE PAYBACK METHOD GIVES THE NUMBER OF YEARS NECESSARY TO RECOVER THE INITIAL INVESTMENT.

DOES NOT ACCOUNT FOR THE TIMING OF CASH FLOWS.

P = I / E

WHERE:P = PAYBACK PERIOD IN YEARSI= INITIAL INVESTMENT OUTLAYE = ANNUAL NET CASH FLOWS

(CASH RECEIPTS LESS CASH EXPENSES)

SIMPLE RATE OF RETURN

EXPRESSES THE AVERAGE ANNUAL NET INCOME AS A PERCENTAGE OF THE AMOUNT INVESTED.

THIS MAY BE IN TERMS OF THE INITIAL CAPITAL OUTLAY OR THE AVERAGE AMOUNT INVESTED OVER THE USEFUL LIFE OF THE INVESTMENT.

RETURN AS A PERCENT OF INITIAL CAPITAL OUTLAY

SRR = Y/IWHERE:SRR = SIMPLE RATE OF RETURNY = AVERAGE ANNUAL NET

INCOME (DEPRECIATION TAKEN INTO ACCOUNT)

I = INITIAL INVESTMENT OUTLAY

CALCULATION OF ANNUAL NET INCOME

Y =(E – D)WHERE:Y = AVERAGE ANNUAL NET INCOMEE = TOTAL EXPECTED ANNUAL NET

CASH RECEIPTSD= TOTAL ANNUAL DEPRECIATION

STRAIGHT LINE DEPRECIATION

D =(INITIAL COST – SALVAGE VALUE) / DEPRECIABLE LIFE

RETURN AS A PERCENT OF AVERAGE AMOUNT INVESTED

SRR/ = Y/ (I + S)/2

WHERE: I = INITIAL INVESTMENTS = SALVAGE VALUE

NET PRESENT VALUE (NPV)

WITH THE NPV, THE CASH FLOWS OF THE INVESTMENT ARE DISCOUNTED BY A MINIMUM ACCEPTABLE COMPOUND ANNUAL RATE OF RETURN.

THE INVESTMENT IS JUDGED TO BE ACCEPTABLE IF THE PRESENT VALUE OF THE NET CASH FLOWS EXCEEDS THE INITIAL INVESTMENT OUTLAY.

NPV = - INV + P1/(1+i) + P2/(1+i)2 + …. + PN/(1+i)N + VN/(1+i)N

WHERE: INV = INITIAL INVESTMENTPN = ANNUAL NET CASH FLOWS

ATTRIBUTED TO THE INVESTMENT

VN = SALVAGE VALUE OR TERMINAL INVESTMENT VALUE

N = LENGTH OF PLANNING HORIZON

I = THE INTEREST RATE OR REQUIRED RATE-OF-RETURN OR DISCOUNT RATE

INTERNAL RATE OF RETURN (IRR) THE IRR IS THE COMPOUND

INTEREST RATE THAT EQUATES THE PRESENT VALUE OF THE FUTURE NET CASH FLOWS WITH THE INITIAL OUTLAY.

OR IN OTHER WORDS THE DISCOUNT RATE THAT GIVES A NPV = ZERO

BOTH THE NPV AND IRR TAKE INTO ACCOUNT THE TIME VALUE OF MONEY.

THE PURPOSE OF THESE INVESTMENT ANALYSIS TECHNIQUES IS TO EVALUATE THE ACCEPTABILITY OF INVESTMENTS RELATIVE TO AN ACCEPTABLE RATE OF RETURN.

COMPARING NPV AND IRR

AS THE DISCOUNT RATE USED TO CALCULATE NET PRESENT VALUE IS INCREASED THE NPV WILL DECREASE

THE IRR IS THE DISCOUNT RATE THAT GIVES A NPV OF ZERO

REINVESTMENT ASSUMPTION THE IRR METHOD IMPLICITLY ASSUMES

THAT NET CASH INFLOWS FROM AN INVESTMENT ARE REINVESTED TO EARN THE SAME RATE AS THE INTERNAL RATE OF RETURN.

THE NPV METHOD ASSUMES THAT NET CASH INFLOWS CAN BE REINVESTED AT THE DISCOUNT RATE USED.

WHICH REINVESTMENT RATE IS MORE REALISTIC?

THE DISCOUNT RATE USED TO CALCULATE THE NPV HAS THE ADVANTAGE OF BEING CONSISTENTLY APPLIED TO ALL INVESTMENTS BEING EVALUATED.

CASH FLOWS FOR THREE INVESTMENTS

YEAR INV A INV B INV C

0 -20,000 - 20,000 - 20,000

1 2,000 5,800 10,000

2 4,000 5,800 8,000

3 6,000 5,800 6,000

4 8,000 5,800 3,000

5 10,000 5,800 1,000

AVG 6,000 5,800 5,600

PAYBACK PERIOD

A 20000/6000 = 3.33 YEARS

B 20000/5800 = 3.45 YEARS

C 20000/5600 = 3.57 YEARS

SIMPLE RATE OF RETURN

A (30000-20000)/5 = 2000• 2000/20000 = 0.10 10%

B (29000-20000)/5 = 1800• 1800/20000 = 0.09 9%

C (28000-20000)/5 = 1600• 1600/20000 = 0.08 8%

* Assume that the investment is fully depreciated in 5 years

NET PRESENT VALUE

A NPV = -20000 + 2000/(1.08)+ 4000/(1.08)2 + 6000/(1.08)3 + 8000/(1.08)4 + 10000/(1.08)5 + 0/(1.08)5

NPV = -20000 + 1852 + 3429+ 4763 + 5880 + 6806 + 0

NPV = 2730

NET PRESENT VALUE AND INTERNAL RATE OF RETURN A NPV = 2730 IRR = 12.01

B NPV = 3158 IRR = 13.82

C NPV = 3766 IRR = 17.57

WHAT GOES INTO THE DISCOUNT RATE?

THE DISCOUNT RATE SHOULD REFLECT THE COST OF CAPITAL OR THE COST OF FUNDS USED TO FINANCE THE BUSINESS.

AN INVESTMENT IS NOT ACCEPTABLE UNLESS IT GENERATES A RETURN SUFFICIENT TO COVER THE COST OF FUNDS.

THE DISCOUNT RATE CONTAINS THREE COMPONENTS:

REAL RISK-FREE RATE RISK PREMIUM INFLATION EXPECTATIONS

WEIGHTED AVERAGE COST OF CAPITAL

THERE ARE TWO TYPES OF CAPITAL INVESTED IN A BUSINESS:

DEBT CAPITAL EQUITY CAPITAL

COST OF DEBT COST OF EQUITY

WEIGHTED AVERAGE COST OF CAPITAL Kc = wd Kd + we Ke Where:

Kc is the weighted average cost of capital wd is the proportion of assets financed with

debt Kd is the cost of debt capital

we is the proportion of assets financed with equity

Ke is the cost of equity capital

PROFITABILITY INDEX

USED TO ALLOCATE LIMITED CAPITAL AMONG SEVERAL INDEPENDENT PROJECTS

PRESENT VALUE OF THE CASH INFLOWS DIVIDED BY THE INITIAL CASH OUTLAY

ANNUITY EQUIVALENT

USED TO COMPARE NPVs WITH UNEQUAL LIVES.

DETERMINES THE SIZE OF ANNUAL ANNUITY FOR THE ECONOMIC LIFE OF THE INVESTMENT THAT COULD BE PROVIDED BY A SUM EQUAL TO THE PRESENT VALUE OF ITS PROJECTED CASH FLOW STREAM, GIVEN THE COST OF CAPITAL.

ANNUITY EQUIVALENT IS CALCULATED BY SETTING THE NPV OF THE INVESTMENT AS THE PV AND THEN SOLVING FOR THE PMT USING THE SAME PLANNING HORIZON AND DISCOUNT RATE TO DETERMINE NPV.

FINANCIAL FEASIBILITY

ONCE YOU HAVE EVALUATED AN INVESTMENT, THE FINANCING OF THE PROJECT SHOULD BE DETERMINED.

AFTER-TAX CASH FLOWS MAY NOT BE SUFFICIENT TO MEET DEBT REPAYMENT REQUIREMENTS.