51 tayangan

Diunggah oleh mmuneebsda

Attribution Non-Commercial (BY-NC)

- Guide - BDM
- Financial Management
- Capital Budgeting
- Types of Project Selection Models
- Adv Issues in Cap Budgeting
- Capital-Budgeting in Finance
- MBALN-622 - Midterm Examination Brief (1)
- ch11_tb
- T1-FIN-MA2-Capital-Budgeting-Decisions.pptx
- Hanson 2009
- Capital Structure MBA
- Capital Budgeting 1
- Financial Management Set 2
- Capital Budgeting
- Assignment Solution Finance 29-9-16 (1)
- Chapter 9
- ACCT 2200 - Chapter 11 P2
- Corporate Finance Chapter2
- chapter 05 Net Present Value and Other Investment Rules.pdf
- 10 Capital Budgeting

Anda di halaman 1dari 51

CHAPTE

R 8

LEARNING OBJECTIVES

Understand the nature and importance of investment decisions

Explain the methods of calculating net present value (NPV)

and internal rate of return (IRR)

Show the implications of net present value (NPV) and

internal rate of return (IRR)

Describe the non-DCF evaluation criteria: payback and

accounting rate of return

Illustrate the computation of the discounted payback

Compare and contrast NPV and IRR and emphasize the

superiority of NPV rule

Nature of Investment

Decisions

The investment decisions of a firm are generally known as the

capital budgeting, or capital expenditure decisions.

The firms investment decisions would generally include

expansion, acquisition, modernisation and replacement of the

long-term assets. Sale of a division or business (divestment) is also

as an investment decision.

Decisions like the change in the methods of sales distribution, or

an advertisement campaign or a research and development

programme have long-term implications for the firms

expenditures and benefits, and therefore, they should also be

evaluated as investment decisions.

Features of Investment

Decisions

The exchange of current funds for future benefits.

The funds are invested in long-term assets.

The future benefits will occur to the firm over a

series of years.

Importance of Investment

Decisions

Growth

Risk

Funding

Irreversibility

Complexity

Types of Investment

Decisions

One classification is as follows:

Expansion of existing business

Expansion of new business

Replacement and modernisation

Yet another useful way to classify investments is as

follows:

Mutually exclusive investments

Independent investments

Contingent investments

Investment Evaluation

Criteria

Three steps are involved in the evaluation of an

investment:

1. Estimation of cash flows

2. Estimation of the required rate of return (the

opportunity cost of capital)

3. Application of a decision rule for making the choice

Investment Decision Rule

It should maximise the shareholders wealth.

It should consider all cash flows to determine the true profitability of

the project.

It should provide for an objective and unambiguous way of separating

good projects from bad projects.

It should help ranking of projects according to their true profitability.

It should recognise the fact that bigger cash flows are preferable to

smaller ones and early cash flows are preferable to later ones.

It should help to choose among mutually exclusive projects that project

which maximises the shareholders wealth.

It should be a criterion which is applicable to any conceivable

investment project independent of others.

Evaluation Criteria

1. Discounted Cash Flow (DCF) Criteria

Net Present Value (NPV)

Internal Rate of Return (IRR)

Profitability Index (PI)

2. Non-discounted Cash Flow Criteria

Payback Period (PB)

Discounted payback period (DPB)

Accounting Rate of Return (ARR)

Net Present Value Method

Cash flows of the investment project should be forecasted

based on realistic assumptions.

Appropriate discount rate should be identified to discount the

forecasted cash flows.

Present value of cash flows should be calculated using the

opportunity cost of capital as the discount rate.

Net present value should be found out by subtracting present

value of cash outflows from present value of cash inflows. The

project should be accepted if NPV is positive (i.e., NPV > 0).

Net Present Value Method

The formula for the net present value can be written

as follows:

=

+

=

(

(

+

+ +

+

+

+

+

+

=

n

1 t

0

t

t

0

n

n

3

3

2

2 1

C

) k 1 (

C

NPV

C

) k 1 (

C

) k 1 (

C

) k 1 (

C

) k 1 (

C

NPV

Calculating Net Present Value

Assume that Project X costs Rs 2,500 now and is expected to

generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs

600 and Rs 500 in years 1 through 5. The opportunity cost of

the capital may be assumed to be 10 per cent.

Why is NPV Important?

Positive net present value of an investment represents the maximum

amount a firm would be ready to pay for purchasing the opportunity

of making investment, or the amount at which the firm would be

willing to sell the right to invest without being financially worse-

off.

The net present value can also be interpreted to represent the

amount the firm could raise at the required rate of return, in addition

to the initial cash outlay, to distribute immediately to its

shareholders and by the end of the projects life, to have paid off all

the capital raised and return on it.

Acceptance Rule

Accept the project when NPV is positive

NPV > 0

Reject the project when NPV is negative

NPV < 0

May accept the project when NPV is zero

NPV = 0

The NPV method can be used to select between mutually

exclusive projects; the one with the higher NPV should be

selected.

Evaluation of the NPV Method

NPV is most acceptable investment rule for the

following reasons:

Time value

Measure of true profitability

Value-additivity

Shareholder value

Limitations:

Involved cash flow estimation

Discount rate difficult to determine

Mutually exclusive projects

Ranking of projects

INTERNAL RATE OF RETURN METHOD

The internal rate of return (IRR) is the rate that

equates the investment outlay with the present

value of cash inflow received after one period. This

also implies that the rate of return is the discount

rate which makes NPV = 0.

CALCULATION OF IRR

Uneven Cash Flows: Calculating IRR by Trial and

Error

The approach is to select any discount rate to compute

the present value of cash inflows. If the calculated

present value of the expected cash inflow is lower than

the present value of cash outflows, a lower rate should

be tried. On the other hand, a higher value should be

tried if the present value of inflows is higher than the

present value of outflows. This process will be repeated

unless the net present value becomes zero.

CALCULATION OF IRR

Level Cash Flows

Let us assume that an investment would cost Rs 20,000

and provide annual cash inflow of Rs 5,430 for 6 years

The IRR of the investment can be found out as follows

NPV Rs 20,000 + Rs 5,430(PVAF ) = 0

Rs 20,000 Rs 5,430(PVAF )

PVAF

Rs 20,000

Rs 5,430

6,

6,

6,

=

=

= =

r

r

r

3683 .

NPV Profile and IRR

NPV Profile

Acceptance Rule

Accept the project when r > k

Reject the project when r < k

May accept the project when r = k

In case of independent projects, IRR and NPV rules

will give the same results if the firm has no shortage

of funds.

Evaluation of IRR Method

IRR method has following merits:

Time value

Profitability measure

Acceptance rule

Shareholder value

IRR method may suffer from

Multiple rates

Mutually exclusive projects

Value additivity

PROFITABILITY INDEX

Profitability index is the ratio of the present value of

cash inflows, at the required rate of return, to the

initial cash outflow of the investment.

The formula for calculating benefit-cost ratio or

profitability index is as follows:

PROFITABILITY INDEX

The initial cash outlay of a project is Rs 100,000 and it can

generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000

and Rs 20,000 in year 1 through 4. Assume a 10 percent

rate of discount. The PV of cash inflows at 10 percent

discount rate is:

Acceptance Rule

The following are the PI acceptance rules:

Accept the project when PI is greater than one. PI > 1

Reject the project when PI is less than one. PI < 1

May accept the project when PI is equal to one. PI = 1

The project with positive NPV will have PI greater

than one. PI less than means that the projects NPV

is negative.

Evaluation of PI Method

Time value:It recognises the time value of money.

Value maximization: It is consistent with the shareholder

value maximisation principle. A project with PI greater than

one will have positive NPV and if accepted, it will increase

shareholders wealth.

Relative profitability:In the PI method, since the present value

of cash inflows is divided by the initial cash outflow, it is a

relative measure of a projects profitability.

Like NPV method, PI criterion also requires calculation of

cash flows and estimate of the discount rate. In practice,

estimation of cash flows and discount rate pose problems.

PAYBACK

Payback is the number of years required to recover the

original cash outlay invested in a project.

If the project generates constant annual cash inflows, the

payback period can be computed by dividing cash outlay by

the annual cash inflow. That is:

C

C

Inflow Cash Annual

Investment Initial

= Payback

0

=

Example

Assume that a project requires an outlay of Rs

50,000 and yields annual cash inflow of Rs

12,500 for 7 years. The payback period for the

project is:

years 4

12,000 Rs

50,000 Rs

PB = =

PAYBACK

Unequal cash flows In case of unequal cash inflows, the

payback period can be found out by adding up the cash inflows

until the total is equal to the initial cash outlay.

Suppose that a project requires a cash outlay of Rs 20,000, and

generates cash inflows of Rs 8,000; Rs 7,000; Rs 4,000; and

Rs 3,000 during the next 4 years. What is the projects

payback?

3 years + 12 (1,000/3,000) months

3 years + 4 months

Acceptance Rule

The project would be accepted if its payback period

is less than the maximum or standard payback

period set by management.

As a ranking method, it gives highest ranking to the

project, which has the shortest payback period and

lowest ranking to the project with highest payback

period.

Evaluation of Payback

Certain virtues:

Simplicity

Cost effective

Short-term effects

Risk shield

Liquidity

Serious limitations:

Cash flows after payback

Cash flows ignored

Cash flow patterns

Administrative difficulties

Inconsistent with shareholder value

Payback Reciprocal and the

Rate of Return

The reciprocal of payback will be a close

approximation of the internal rate of return if the

following two conditions are satisfied:

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

payback period.

2. The project generates equal annual cash inflows.

DISCOUNTED PAYBACK

PERIOD

The discounted payback period is the number of periods

taken in recovering the investment outlay on the present

value basis.

The discounted payback period still fails to consider the

cash flows occurring after the payback period.

Discounted Payback Illustrated

ACCOUNTING RATE OF

RETURN METHOD

The accounting rate of return is the ratio of the average after-

tax profit divided by the average investment. The average

investment would be equal to half of the original investment if

it were depreciated constantly.

A variation of the ARR method is to divide average earnings

after taxes by the original cost of the project instead of the

average cost.

or

Example

A project will cost Rs 40,000. Its stream of

earnings before depreciation, interest and taxes

(EBDIT) during first year through five years is

expected to be Rs 10,000, Rs 12,000, Rs 14,000, Rs

16,000 and Rs 20,000. Assume a 50 per cent tax

rate and depreciation on straight-line basis.

Calculation of Accounting

Rate of Return

Acceptance Rule

This method will accept all those projects whose

ARR is higher than the minimum rate established

by the management and reject those projects which

have ARR less than the minimum rate.

This method would rank a project as number one if

it has highest ARR and lowest rank would be

assigned to the project with lowest ARR.

Evaluation of ARR Method

The ARR method may claim some merits

Simplicity

Accounting data

Accounting profitability

Serious shortcomings

Cash flows ignored

Time value ignored

Arbitrary cut-off

Conventional & Non-

Conventional Cash Flows

A conventional investment has cash flows the pattern of an

initial cash outlay followed by cash inflows. Conventional

projects have only one change in the sign of cash flows; for

example, the initial outflow followed by inflows, i.e., + + +.

A non-conventional investment, on the other hand, has cash

outflows mingled with cash inflows throughout the life of the

project. Non-conventional investments have more than one

change in the signs of cash flows; for example, + + + ++

+.

NPV vs. IRR

Conventional Independent Projects:

In case of conventional investments, which are

economically independent of each other, NPV and IRR

methods result in same accept-or-reject decision if the

firm is not constrained for funds in accepting all

profitable projects.

NPV vs. IRR

Lending and borrowing-type projects:

Project with initial outflow followed by inflows is a

lending type project, and project with initial inflow

followed by outflows is a lending type project, Both are

conventional projects.

Problem of Multiple IRRs

A project may have both

lending and borrowing

features together. IRR

method, when used to

evaluate such non-

conventional investment can

yield multiple internal rates

of return because of more

than one change of signs in

cash flows.

Case of Ranking Mutually

Exclusive Projects

Investment projects are said to be mutually exclusive when

only one investment could be accepted and others would

have to be excluded.

Two independent projects may also be mutually exclusive if

a financial constraint is imposed.

The NPV and IRR rules give conflicting ranking to the

projects under the following conditions:

The cash flow pattern of the projects may differ. That is, the cash

flows of one project may increase over time, while those of others

may decrease or vice-versa.

The cash outlays of the projects may differ.

The projects may have different expected lives.

Timing of cash flows

The most commonly found condition for the conflict between the

NPV and IRR methods is the difference in the timing of cash

flows. Let us consider the following two Projects, M and N.

Cont

NPV Profiles of Projects M and N NPV versus IRR

The NPV profiles of two projects intersect at 10 per cent discount

rate. This is called Fishers intersection.

Incremental approach

It is argued that the IRR method can still be used to choose

between mutually exclusive projects if we adapt it to calculate

rate of return on the incremental cash flows.

The incremental approach is a satisfactory way of salvaging

the IRR rule. But the series of incremental cash flows may

result in negative and positive cash flows. This would result in

multiple rates of return and ultimately the NPV method will

have to be used.

Scale of investment

Project life span

REINVESTMENT ASSUMPTION

The IRR method is assumed to imply that the cash

flows generated by the project can be reinvested at

its internal rate of return, whereas the NPV method

is thought to assume that the cash flows are

reinvested at the opportunity cost of capital.

MODIFIED INTERNAL RATE OF

RETURN (MIRR)

The modified internal rate of return (MIRR) is

the compound average annual rate that is calculated

with a reinvestment rate different than the projects

IRR.

VARYING OPPORTUNITY

COST OF CAPITAL

There is no problem in using NPV method when

the opportunity cost of capital varies over time.

If the opportunity cost of capital varies over time,

the use of the IRR rule creates problems, as there is

not a unique benchmark opportunity cost of capital

to compare with IRR.

NPV VERSUS PI

A conflict may arise between the two methods if a

choice between mutually exclusive projects has to

be made. NPV method should be followed.

- Guide - BDMDiunggah olehDao Hoang Ngan
- Financial ManagementDiunggah olehShofiq
- Capital BudgetingDiunggah olehMuhammad Arslan
- Types of Project Selection ModelsDiunggah olehMaria Javed
- Adv Issues in Cap BudgetingDiunggah olehIshu Garg
- Capital-Budgeting in FinanceDiunggah olehswati_rathour
- MBALN-622 - Midterm Examination Brief (1)Diunggah olehwebsternhidza
- ch11_tbDiunggah olehsofikhdy
- T1-FIN-MA2-Capital-Budgeting-Decisions.pptxDiunggah olehMangoStarr Aibelle Vegas
- Hanson 2009Diunggah olehmarcleo1974
- Capital Structure MBADiunggah olehShahbaz Ahmed Afsar
- Capital Budgeting 1Diunggah olehSagar Paul'g
- Financial Management Set 2Diunggah olehSampath Raj
- Capital BudgetingDiunggah olehRahul Dewakar
- Assignment Solution Finance 29-9-16 (1)Diunggah olehMudassir Ali
- Chapter 9Diunggah olehNicole Liew
- ACCT 2200 - Chapter 11 P2Diunggah olehBrenda Wijaya
- Corporate Finance Chapter2Diunggah olehMohsin Shaikh
- chapter 05 Net Present Value and Other Investment Rules.pdfDiunggah olehWan Maulana Akbar
- 10 Capital BudgetingDiunggah olehRakshit Bapna
- AValiaçao de ProjetosDiunggah olehDani Gil
- 2011-04-10_152123_mutuallyexclusiveDiunggah olehErwin Wijaya
- Finc5880 Lo Wk1Diunggah olehjamn1979
- Capital BudgetingDiunggah olehhkmaplevtest
- 01_Adv Issues in Cap BudgetingDiunggah olehMudit Kumar
- assignment_AFM.docDiunggah olehKenneth Mo
- FIN303_chapter11Diunggah olehgeorge
- Capital BudgetingDiunggah olehaayush
- Bmanac2 Management Accounting 2 June 2018Diunggah olehMichele
- Div F_Group3_FM.docxDiunggah olehShreya Srivastava

- Creative Time - Manage the Mundane - Create The ExtraordinaryDiunggah olehSolomon
- Volume5No1Article7Diunggah olehmmuneebsda
- Article 10Diunggah olehPooja Grover Shandilya
- Working Capital Management in Cement IndustryDiunggah olehmmuneebsda
- capital budgeting with illustration and theoryDiunggah olehmmuneebsda
- 11.Piecemeal Distn. Solution Dt.27!8!2010Diunggah olehmmuneebsda
- 6_277-299Diunggah olehKARISHMAATA2
- The Role of Financial Statement in the Investment Decisions of a Micro Finance Institution (Mfi)Diunggah olehmmuneebsda
- jointventureDiunggah olehmmuneebsda
- Supplementary NotesDiunggah olehmmuneebsda
- Technical analysisDiunggah olehnimbarknimawat
- Financial Statements Content and Investment Decisions –a Study of Selected FirmsDiunggah olehmmuneebsda
- sukukDiunggah olehmmuneebsda
- Formation of a Public CompanyDiunggah olehmmuneebsda
- Legal Frame Work for Small BusinessDiunggah olehmmuneebsda
- Women Entrepreneur PptDiunggah olehmmuneebsda
- Role of Entrepreneur in Economic Development SlideDiunggah olehmmuneebsda
- Evolution of Ssi Units in IndiaDiunggah olehmmuneebsda
- Single Entry SystemDiunggah olehmmuneebsda

- WIPO_ISR AND IPRP.pdfDiunggah olehShailesh Kumar
- Asset Allocation (Sharpe)Diunggah olehmjvicuna
- B_F_RDiunggah olehAniruddh Kanade
- Chapter 3Diunggah olehDavidVizcaíno
- Factoring TrinomialsDiunggah olehEthel826Butkovich
- International Business by Saylor OrgDiunggah olehCJ Ibale
- Final Draft Cynthea's Marketing PlanDiunggah olehJordan Sedwin
- Sample ChapterDiunggah olehZaman Parvez
- Mock Unit04 OligopolyDiunggah olehpalashndc
- Procurement Oracle R12 Invoice AP AdjustmentDiunggah olehyasserlion
- Adidas present.pptxDiunggah olehDuc Nguyen Manh
- Accounting ChangesDiunggah olehShielle Azon
- Assignment FSADiunggah olehgeo023
- LNWDiunggah olehchristoofar2190
- 2006 Structures and Budgets of National Tourism OrganizationsDiunggah olehPantazis Pastras
- 4500722329-Lekhwair FlowlinesDiunggah olehMohsin Waseem
- Swot for HotelDiunggah olehRobin Bahuguna
- 2004 Trial General Mathematics Year 11 PaperDiunggah olehYon Seo Yoo
- tbch16Diunggah olehTornike Jashi
- Computation of Income TaxDiunggah olehCatherine Shaina O. Pasion
- 7. Ficha de Trabalho - Present Simple (1)Diunggah olehCarlaPadrãoAzevedo
- Cement MainDiunggah olehMallikarjun Chakinala
- LITERATURE REVIEWDiunggah olehsnravi
- Pwc Mongolia ServicesDiunggah olehAriunbayarByambajav
- Accidentes CaravanDiunggah olehDavid Fernando Espinel Preciado
- Chapter 28 Standard Costing and Variance AnalysisDiunggah olehBansal Rakesh
- Temperature Guide for Indian Cooking - CopyDiunggah olehrathodu
- MDRT10JanDiunggah olehNur Takaful
- Advertising AppealsDiunggah olehcat20091
- IT Tincodes RulesDiunggah olehtojo116732