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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.