Upload
naitik-modi
View
236
Download
0
Embed Size (px)
Citation preview
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 1/29
Techniques of Capital Budgeting
Investment Evaluation Criteria
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 2/29
Investment Evaluation CriteriaThree steps are involved in the evaluation of an
investment:
Estimation of Cash flows
Estimation of required RoR (i.e., the OCC)
Application of a decision rule for making the
choiceThe first two steps are assumed as given. The third
step is where we focus on its merits and demerits.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 3/29
Investment Decision Rule The rule may be referred to as capital
budgeting techniques, or investment criteria.
The essential property of a sound techniqueis that it should maximize the shareholders¶wealth.
A sound appraisal technique should be usedto measure the economic worth of aninvestment project.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 4/29
Evaluation CriteriaDiscounted Cash Flow (DCF) Criteria:
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Non-discounted Cash Flow Criteria: Payback Period (PB)
Accounting Rate of Return ( ARR)
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 5/29
Net Present Value It is a DCF technique that explicitly
recognizes the time value of money.
It correctly postulates that CFs arising atdifferent times differ in value;
And are comparable only when their
equivalents ± PVs ± are found out. Following steps are involved in calculating
the NPV:
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 6/29
CFs of the project should be forecastedbased on realistic assumptions.
Appropriate discount rate should beidentified to discount the forecasted CFs.This rate is the project¶s OCC, which is
equal to the required RoR expected byinvestors on investments of equivalent risk.
PV of CFs should be calculated using theOCC as the discount rate.
NPV should be found out by subtracting PVof cash outflows from PV of cash inflows.
The project should be accepted if NPV is
positive. That is,N
PV > 0.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 7/29
Example Assuming that project X costs Rs.2500 now
and is expected to generate year-end cash
inflows of Rs.900, 800, 700, 600, and 500
in years 1 thru 5. The OCC may be assumed
to be 10%. The NPV for the project can be
calculated by referring to the PV table. The calculations are as follows:
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 8/29
NPV = [(900 x 0.909) + (800 x 0.826) + (700 x 0.751) +
(600 x 0.683) + (500 x 0.620)] ± 2500
NPV = 2725 ± 2500 = Rs.225
Project X¶s PV of Cash inflows (Rs.2725) is greater than that of theCash outflow (Rs.2500).
Thus, it generates a positive NPV (Rs.225). This project adds to the
Wealth of owners, therefore, it should be accepted.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 9/29
Evaluation of the NPV Method
It recognizes the time value of money.
It uses all CFs occurring over the entire life of the project in calculating its worth. Hence, it is ameasure of project¶s true profitability.
If we know the NPVs of individual projects, thevalues of the firm will increase by the sum of their NPVs. This refers to the Value-additive principle. Inother words, if we know values of individual assets,the firm¶s value can be found simply by adding their values. That is, NPV(A + B) = NPV(A) + NPV(B).
This method is always consistent with the objectiveof the shareholder value maximization. This is thegreatest virtue of the method.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 10/29
Internal Rate of Return
It is the rate that equates the investmentoutlay with the PV of cash inflow receivedafter one period.
This also implies that the RoR is thediscount rate which makes NPV = 0. That is,
when there is no difference between the PV of cashoutflow and cash inflows.
There is no satisfactory way of defining thetrue RoR of a long-term asset.
IRR is the best available concept.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 11/29
The IRR equation is the same as the one
used for the NPV method.
In the NPV method, the required RoR is
known and the NPV is found;
While in the IRR method the value of µr¶
has to be determined at which the NPV
becomes zero.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 12/29
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 13/29
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:
6,
6,
6,
NPV Rs 20,000 + Rs 5,430(PVAF ) = 0
Rs 20,000 Rs 5,430(PVAF )
Rs 20,000
PVAF 3.683Rs 5,430
r
r
r
!
!
! !
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 14/29
The rate, which gives a PVIFA of 3.683 for 6 years, is the project¶s IRR. Looking at the
table across the 6-year row, we find it
approximately under the 16% column.
Thus, 16% is the project¶s IRR that equates
the present value of the initial cash outlay
(Rs.20,000) with the constant annual cash
flows (Rs.5,430 per year) for 6 years.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 15/29
NPV Profile and IRR NPV of a project declines as the discount
rate increases;
And for discount rates higher than the project¶s IRR, NPV will be negative.
At 16%, the NPV is zero; therefore, it is the
IRR of the project. NPV profile of the project at various
discount rates is shown in the next slide:
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 16/29
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 17/29
Evaluation of IRR Method
Merits of this method are as under:
Recognizes the time value of money.
Considers all CFs occurring over the entire life
of the project to calculate its of return. Gives the same acceptance rule as the NPV
method.
Consistent with the objective of maximizingshareholders¶ wealth. Whenever a project¶s IRR is greater than the OCC, the wealth will beenhanced.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 18/29
Like the NPV method, the IRR method is
also theoretically a sound investmentevaluation criterion.
However, IRR rule can give misleading andinconsistent results under certaincircumstances.
Also, properly stated, the two criteria areformally equivalent, the IRR rule contains
several pitfalls. The problems that IRR rule may suffer from
is mentioned in the subsequent slides.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 19/29
Profitability Index
Profitability index is the ratio of the presentvalue of cash inflows, at the required rate of return, to the initial cash outflow of the
investment. The initial cash outlay of a project is Rs
100,000 and it can generate cash inflow of Rs40,000, Rs 30,000, Rs 50,000 and Rs 20,000in year 1 through 4. Assume a 10 per cent rateof discount. The PV of cash inflows at 10 per cent discount rate is:
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 20/29
.1235.11,00,000s
1,12,350sI
12,350s100,000s112,350s
0.6820,000s0.75150,000s0.82630,000s0.90940,000s
)20,000(s)50,000(s)30,000(s)40,000(s 0.104,0.103,0.102,0.101,
!!
!
vvvv
!
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 project¶s NPV is negative.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 21/29
Evaluation of PI Method
It recognises the time value of money.
It is consistent with the shareholder valuemaximisation principle. A project with PI greater than one will have positive NPV and if accepted, itwill increase shareholders¶ wealth.
In the PI method, since the present value of cashinflows is divided by the initial cash outflow, it is arelative measure of a project¶s profitability.
Like NPV method, PI criterion also requirescalculation of cash flows and estimate of thediscount rate. In practice, estimation of cash flowsand discount rate pose problems.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 22/29
Payback Method
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:
0Initial InvestmentPayback
nnual ash Inflow
C
C
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 23/29
Assume that a project requires an outlay of Rs
50,000 and yields annual cash inflow of Rs12,500 for 7 years. The payback period for the
project is:
Rs 50,000PB = = 4 yearsRs 12,000
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.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 24/29
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 duringthe next 4 years. What is the project¶s payback?
3 years + 12 × (1,000/3,000) months
3 years + 4 months
The project would be accepted if its payback period is less than the maximum or standardpayback period set by management.
As a ranking method, it gives highest ranking tothe project, which has the shortest payback period and lowest ranking to the project withhighest payback period.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 25/29
Evaluation of Payback
Certain virtues
± Simpl icity. Simple to understand and easy to
calculate.
± o st effective. That is, not a sophisticated technique. ± Short-term effects. Favourable for short term effects
on EPS.
± Ri sk shield . By having a shorter payback period as a
Standard reduces risk.
± Liquid ity. Such situation is created when there is
early recovery of the investment.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 26/29
Serious limitations
± Ca sh f l ow s a fter pa yback . Does not take account of cash flows after payback period.
± Ca sh f l ow s ignored . That is, does not consider allcash flows.
± Ca
sh f l ow pa
ttern s. That is, it gives equal weightsto returns of equal amounts even though they occur in different times periods.
± Admini str ative d ifficul tie s. Difficulties indetermining maximum acceptable payback period.
± Incon si stent wit h sharehold er value. Share valuesdo not depend on payback periods of investment projects.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 27/29
Book Rate of Return Method Also known as 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 depreciatedconstantly.
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.
Average incomeARR
Average investmentor Book Income / Book Assets
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 28/29
Acceptance Rule
This method will accept all those projectswhose ARR is higher than the minimum
rate established by the management and
reject those projects which have ARR lessthan 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.
8/8/2019 DCF Modified
http://slidepdf.com/reader/full/dcf-modified 29/29
Evaluation of ARR Method
The ARR method may claim some merits
± Simpl icity
± Accounting d at a. Easy availability of information.
± Accounting profit abil ity. Incorporates entire stream of income.
Serious shortcoming
± Ca sh f l ow s ignored
± T ime value ignored
± Arbitr ary cut-off. Generally, this yardstick is the firm¶s currentreturn on its assets (book value). Because of this, the growth
companies earning very high rates on their existing assets may
reject profitable projects (positive NPVs).