Strategic Corporate Finance. IIPM-PGP.

Investment- Concepts & Practice. Faculty-Malay K Ray.

The Basics of Capital Budgeting

Should we build this plant?

Investments - Approach
A function which has to reckon both internal firm specific issues as well as
external aspects.

The internal aspects could be the companys business strategy, nature of

products and services and their market impact, internal managerial views regarding specific fixed assets to be acquired or acquisitions to be carried out. economy, interest rates and inflation, the size and direction of capital flows in the country and industry, nature of competition, possible regulatory policy changes. for the requisite type of assets. This combined decision is called Capital budgeting. investment option.

The important external aspects are current and anticipated state of the

The next step is firming up the business decision and allocation of resources
There are various decision rules and techniques to identify the right

Accounting Income Based methods.

ROI- Post Tax operating Income/ Net Book value:
A plant generates earning of $130,000 on investment of $1 million. ROI= 130/1000=13%. If the cost of capital is 10%, the company is adding value of 3%. Return on Capital ( Post Tax) : EBIT(1-Tax Rate)/ Average book value of capital invested in a project: An one year project requires an initial investment of $ 1 million. The EBIT is $300,000. The project has a salvage Value of$800,000. The tax rate is 40% -------------------------------------------------Bv-$1,000,000. SV- $800,000. Av Bv of Capital=(1,000,000+800,000)/2= $900,000. ROC,Post Tax= $300,000(1-0.40)/$900,000=20%. This post tax Roc has to be compared to a hurdle rate which could be the cost of capital. The decision rule is :

ROC Contd.
If the post tax Roc > cost of capital, accept the project.
If post tax Roc is <cost of capital, Reject the project. If 10% were the cost of capital for the above example, the company should find the project as good for investment. Another measure is ROE. ROE=Net Income/ Average Book value of Equity investment in a project. The benchmark or hurdle rate would be the cost of equity. The decision rule is: If the ROE is > cost of equity , Accept the project. If the ROE is < cost of equity, reject the project.

Average Accounting Return (AAR).

Average Net Income/ Average Book Value. A project will be acceptable if its average

accounting return exceeds a target average accounting return. Average net income to be worked out by summing each periods income and dividing the sum by the sum of periods. Average book value will be sum of opening and closing book values/2.

Comments on the Accounting Return based methods.

These are based on earnings rather than cash

flows, thereby ignoring the time value of money. The returns are derived from the book value of investments rather than the cash invested in the relative assets. The target rate in case of AAR is rather an arbitrary benchmark cut off rate. Nonetheless, these techniques being simple and with intuitive appeal, are used by the investors and equity research analysts for assessing the overall performance of the companies.

Economic Value Added (EVA).

This measure introduced by the consulting firm Stern
Stewart, arrives at Net Income after deducting the cost of capital. This adjusted net income is called Residual income.

The formula for EVA = Income earned Cost of

Capital*(Investment).

Example: For an investment of $1million,if the income

earned is $130,000, and cost of capital is 10%,EVA= 130-(.10*1,000,000)=$30,000.

Economic Value Added (EVA)contd.

A positive EVA indicates adding value to the
shareholders. A negative EVA signifies non creation of additional wealth for shareholders.

This measure is akin to Mckinsey& cos Economic Profit

Measure or EP. EP=(ROI-r)*capital invested.

EVA tells the Managers that investment should be done

only if increase in earnings is enough to cover the cost of capital.

Cash flow based techniques and decision rules

Net Present value (NPV) is a measure of value created today
by undertaking an investment, which would generate cash flow over a period of time.

It reckons the time value of money. The capital budgeting process is a search for investments with
positive net present values.

Present value (PV)= c1/1+r^1, where c1 is cash flow for one

year and r^1 is the opportunity cost of investing money for one year. ct/(1+r^t)^t.

If there is more than one years cash flow, PV=sum

Cash flow based techniques and decision rules-contd.

NPV= CO+PV, meaning addition of the usually negative initial
cash flow.

NPV is thus the sum of the present values of the expected

cash flows on a project, net of the initial investment.

The NPV decision rule is: Accept an investment when its net

present value is positive and Reject it when NPV is negative.

It is most crucial that the estimates of the cash revenues and

costs are correctly prepared and an appropriate discounting rate is chosen.

Net Present Value (NPV)

Sum of the PVs of all cash inflows and outflows
of a project:

CFt NPV t ( 1 k ) t 0
n

PAY BACK.
It is a measure followed by some companies to find out if the
initial outlay on a project is getting recovered within a prespecified time period.

The payback period is found by counting the number of years

it takes before the forecasted cash flow equals the initial investment.
$100,200,500, over three years.

Illustration: A project costing $500, has cash flows of This project would pay back somewhere between end of yr 2
and end of yr3- 2.4 yrs precisely: 200(500-300)/500.

PAY BACK-contd.
If the desired payback period is 3 yrs, this project would be
accepted.

There being no discounting of cash flows, payback ignores time

value of money. safe projects.

Payback is calculated the same way for both very risky and very The cut off period is chosen arbitrarily. The cash flows beyond the cut off period are ignored leading many
a time to rejection of profitable long term investments.

Discounted Pay Back

It is an improvement over simple payback, as it involves discounting
the cash flows at a required rate to arrive at the length of time until the sum of the discounted cash flows is equal to the initial investment.

The decision rule is that an investment is acceptable if its

discounted payback time is less than some prespecified number of years.

after cut off date and also involves fixing of an arbitrary cut off point.

However, although it considers time value, it ignores cash flows On the whole, the payback and discounted payback is used by the

managers for relatively minor investment decisions, and as a kind of break even measure in an accounting sense.

Internal Rate of Return(IRR)

IRR is the rate of discount which makes NPV=0.
Illustration: There is a project where initial investment is $100, and
two annual cash flows of $60 each. To find out the return on the project we have to set NPV equal to zero and solve for the discount rate: NPV=0=-$100+(60/1+IRR)+(60/1+IRR^2) say a 0% rate, which would give a NPV of $20. A 10% discount rate would yield NPV=-$100+(60/1. 1)+(60/1. 1^2)=$4.13. ZERO somewhere between 10& 15%. When plotted on a graph, the point where the curve cuts through x axis ,NPV is =0. For the above example it is 13.1%.

We have to use trial & error to find the unknown rate starting with

Trying with 15%, the NPV becomes -$2.46. So the NPV would be

Internal Rate of Return(IRR)contd.

The decision rule is : if the required return is less than
13.1%, the project would be acceptable.

IRR is closely related to NPV, often leading to identical

decisions. The problems with IRR arise when there are projects with nonconventional cash flows or there are mutually exclusive investments.

Difference between independent and mutually exclusive projects.

Independent projects if the cash flows of
one are unaffected by the acceptance of the other. Mutually exclusive projects if the cash flows of one can be adversely impacted by the acceptance of the other.

Normal and nonnormal cash flow streams defined.

Normal cash flow stream Cost (negative CF)
followed by a series of positive cash inflows. One change of signs. Nonnormal cash flow stream Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine, etc.

More on the NPV method

= PV of inflows Cost = Net gain in wealth If projects are independent, accept if the project NPV > 0. If projects are mutually exclusive, accept projects with the highest positive NPV, those that add the most value. Between two projects-S&L, would accept S if mutually exclusive (NPVs > NPVL), and would accept both if independent. NPV

NPV Profiles
A graphical representation of project NPVs at
various different costs of capital. k 0 5 10 15 20 NPVL $50 33 19 7 (4) NPVS $40 29 20 12 5

Drawing NPV profiles

NPV 60 ($)
50

. 40 .
30 20

. .

Crossover Point = 8.7%

.
L
10

IRRL = 18.1%

10
0 5 -10

. .
15

20

. .

.
23.6

IRRS = 23.6% Discount Rate (%)

Comparing the NPV and IRR methods

If projects are independent, the two
methods always lead to the same accept/reject decisions. If projects are mutually exclusive

If k > crossover point, the two methods lead to the same decision and there is no conflict. If k < crossover point, the two methods lead to different accept/reject decisions.

Reinvestment rate assumptions

NPV method assumes CFs are reinvested at

k, the opportunity cost of capital. IRR method assumes CFs are reinvested at IRR. Assuming CFs are reinvested at the opportunity cost of capital is more realistic, so NPV method is the best. NPV method should be used to choose between mutually exclusive projects. Perhaps a hybrid of the IRR that assumes cost of capital reinvestment is needed.