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Compiled by: M. Sathya Kumar

Concepts of Capital Budgeting

Time Value of Money The idea that money available at the present time is worth more thanthe same amount in the future, due to its potential earning capacity.This core principle of finance holds that, provided money can earninterest, any amount of money is worth more the sooner it is received.Also referred to as "present discounted value". Everyone knows that money deposited in a savings account will earninterest. Because of this universal fact, we would prefer to receivemoney today rather than the same amount in the future.

For example, assuming a 5% interest rate, $100 invested today will beworth $105 in one year ($100 multiplied by 1.05). Conversely, $100received one year from now is only worth $95.24 today ($100 dividedby 1.05), assuming a 5% interest rate.

Payback Period

The length of time required to recover the cost of an investment.

Calculated as:

All other things being equal, the better investment is the one with theshorter payback period. For example, if a project cost $100,000 and was expected to return$20,000 annually, the payback period would be $100,000 / $20,000, orfive years. All other things being equal, the better investment is the one with theshorter payback period.

For example, if a project cost $100,000 and was expected to return$20,000 annually, the payback period would be $100,000 / $20,000, orfive years. There are two main problems with the payback period method:

1) It ignores any benefits that occur after the payback period and,therefore, does not measure profitability. 2) It ignores the time value of money.

Because of these reasons, other methods of capital budgeting like netpresent value, internal rate of return or discounted cash flow aregenerally preferred. Net Present Value (NPV) The difference between the present value of cash inflows and thepresent value of cash outflows. NPV is used in capital budgeting toanalyze the profitability of an investment or project. NPV analysis is sensitive to the reliability of future cash inflows that aninvestment or project will yield. Formula:

NPV compares the value of a dollar today to the value of that samedollar in the future, taking inflation and returns into account. If the NPVof a prospective project is positive, it should be accepted. However, ifNPV is negative, the project should probably be rejected because cashflows will also be negative. For example, if a retail clothing business wants to purchase an existingstore, it would first estimate the future cash flows that store wouldgenerate, and then discount those cash flows into one lump-sumpresent value amount, say $565,000. If the owner of the store waswilling to sell his business for less than $565,000, the purchasingcompany would likely accept the offer as it presents a positive NPVinvestment. Conversely, if the owner would not sell for less than$565,000, the purchaser would not buy the store, as the investmentwould present a negative NPV at that time and would, therefore, reducethe overall value of the clothing company The discount rate often used in capital budgeting that makes the netpresent value of all cash flows from a particular project equal to zero.Generally speaking, the higher a project's internal rate of return, themore desirable it is to undertake the project. As such, IRR can be usedto rank several prospective projects a firm is considering. Assuming allother factors are equal among the various projects, the project with thehighest IRR would probably be considered the best and undertakenfirst. Internal Rate Of Return (IRR) IRR is sometimes referred to as "economic rate of return (ERR)". You can think of IRR as the rate of growth a project is expected togenerate. While the actual rate of return that a given project ends upgenerating will often differ from its estimated IRR rate, a project with asubstantially higher IRR value than other available options would stillprovide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in thesecurities market. If a firm can't find any projects with IRRs greaterthan the returns that can be generated in the financial markets, it maysimply choose to invest its retained earnings into the market.

Discounted Cash Flow (DCF) A valuation method used to estimate the attractiveness of aninvestment opportunity. Discounted cash flow (DCF) analysis usesfuture free cash flow projections and discounts them (most often usingthe weighted average cost of capital) to arrive at a present value, whichis used to evaluate the potential for investment. If the value arrived atthrough DCF analysis is higher than the current cost of the investment,the opportunity may be a good one. Calculated as:

There are many variations when it comes to what you can use for yourcash flows and discount rate in a DCF analysis. Despite the complexityof the calculations involved, the purpose of DCF analysis is just toestimate the money you'd receive from an investment and to adjust forthe time value of money.

DCF models are powerful, but they do have shortcomings. DCF ismerely a mechanical valuation tool, which makes it subject to theaxiom "garbage in, garbage out". Small changes in inputs can result inlarge changes in the value of a company. Instead of trying to projectthe cash flows to infinity, a terminal value approach is often used. Asimple annuity is used to estimate the terminal value past 10 years, forexample. This is done because it is harder to come to a realisticestimate of the cash flows as time goes on.

Profitability Index An index that attempts to identify the relationship between the costs and benefits of a proposed project through the use of a ratio calculated as:

A ratio of 1.0 is logically the lowest acceptable measure on the index.Any value lower than 1.0 would indicate that the project's PV is lessthan the initial investment. As values on the profitability index increase,so does the financial attractiveness of the proposed project.

NPV and IRR Methods: Possible Decision Conflicts

An accept/reject "conflict" occurs when NPV says "accept" and IRR says"reject" or NPV says "reject" and IRR says "accept"

Note:

When projects are independent, no accept/reject conflict will arise A ranking conflict occurs when one project has a higher NPV thananother while the lower NPV project has a higher IRR.

Note: Ranking conflicts are unusual but can occur. These conflicts arerelevant only when there are multiple acceptable mutually exclusiveprojects

Ranking conflicts arise because of:

1) Timing differences in incremental cash flows

2) Magnitude differences in incremental cash flows When a conflict arises among mutually exclusive projects, pick the one with the highest NPV

M. Sathya Kumar E-mail : sathyaakumar@gmail.com. Contact No.:

+919884492226

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