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Course F-303:CAPITAL BUDGETING &
Project Mgmnt.Prof. Shabbir Ahmad
Introduction Definition, types of projects, techniques of CID etc.
Cash Flow EstimationDetermination of cash out flow and cashinflows
Techniques of Capital BudgetingDiscounted (NPV, IRR, MIRR, PI,and DPB) and non-discounted (PB & AAR) cash flow techniques,
decision criteria, advantages and disadvantages of each technique.Special Issues in Capital BudgetingProjection evaluation, cost-cutting projects, bid price setting, projects with different lives.
Project Analysis and EvaluationForecasting risk, sensitivity andscenario analysis, break-even analysis, operating leverage and capitalbudgeting.
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Course F-303:CAPITAL BUDGETING &
Project Mgmnt.
Inflation and Capital Budgeting
Options in Capital Budgeting
Strategy and Analysis in Using Net Present Value
Cost of Capital and Capital BudgetingCapital Budgeting for Levered Firm
Risk and Capital BudgetingAbsolute measure and relative measureof risk, certainty equivalent method and risk adjusted discount ratemethod.
Text BooksFundamentals of Corporate Finance by Ross, Westerfield, JORDAN
Corporate Finance by Ross, Westerfield, JAFFE
Capital Budgeting & Long-term Finance by Neil Seitz
Managerial Finance by Lawrence J GITMAN
Essentials of Managerial Finance by Eugene F. Brigham
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CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION
Capital Investment Decisions or CapitalBudgeting involves companys long terminvestment decision. It includes evaluation of thefirms expenditure decisions that involve currentoutlays but are likely to produce benefits or returnsover a long period of time.
Capital Budgeting is the process of evaluating andselecting long-term investments in fixed or capitalassets that are consistent with the firms goal of
maximizing owners wealth.
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CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION
Why a firm makes capital investment?
In order to secure a stream of benefits in future years
that add value to the firm through cash inflows over
future times.
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CAPITAL BUDGETING OR
CAPITAL INVESTMENT DECISION
Applications
Purchase of fixed assets
Mechanization of production method
Selection from alternative equipments
Introduction of new products
Expansion of business
Modernization and replacement
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FEATURES/CHARACTERISTICS
OF CID (IMPORTANCE)
Long term investment decision (future profitability offirm).
Returns or benefits are expected over number of years
Investment involves huge amount of cash outflow(determines the destiny of the firm)
Investment decision is generally irreversible (oncemade can not be changed)
Relatively high degree of risk
Relatively long time period between the initial outlayand the anticipated return
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CLASSIFICATION OF PROJECTS
By Size:
Major Project.
Minor Project.
By Benefit:
Cost Reduction Project.
Market Expansion Project.Project for new products.
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CLASSIFICATION OF PROJECTS
By Degree of Dependence:
Mutually Exclusive Projects.
Independent Projects.
By Cash Flow pattern:
Conventional Project.( - + + + + + i.e. outflow
followed by a series of inflow).Non Conventional Projects ( - + + - + - + i.e. if the
project inflows & outflows are mixed & zigzag
pattern).
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CAPITAL INVESTMENT
DECISION
Determination of Cash Outflow or
Investment
Projection or Forecast or Estimation ofFuture Cash Inflows
Determination of Appropriate Discount Rate
(i.e. Cost of Capital)
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CASH FLOW DETERMINATION
A project should be evaluated on the basis of
Incremental After Tax Cash Flows.
Incremental After Tax Cash Flows for project
evaluation consist of any and all changes in the
firms future cash flows that are a direct
consequence of taking the project or thedifference between a firms future cash flows
with a project and those without the project.
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CASH FLOW
DETERMINATIONOnly the relevant cash flows should be taken under
consideration in determining the cash flows (i.e.
inflows or outflows) for making capital investmentdecision.
Relevant cash flows should be included in a capital
budgeting analysis. These cash flows will only occur if
the project is accepted
Relevant cash flows are those which influence the
firms decision regarding accepting or rejecting a
project.
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CASH FLOW
DETERMINATIONIrrelevant cash flows are those which do not
affect the firms decision regarding accepting or
rejecting a project i.e. they exist if the firmsaccepts a project or if rejects a project.
Irrelevant cash flowsshould NOT be included
in capital budgeting analysis.
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CASH FLOW
DETERMINATIONAsking the Right Question
Will this cash flow occur ONLY if we accept the
project?
If the answer is yes, it should be included in the
analysis because it is incremental
If the answer is no, it should not be included inthe analysis because it will occur anyway
If the answer is part of it, then we should include
the part that occurs because of the project
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CASH OUTFLOWOR
INVESTMENT DETERMINATION
Cost of new asset or project
Add installation cost (if any)
Add transportation cost (if any)
Add removal cost of old asset (only if borneby the company)
Less selling price of old asset (if new asset replaces
old asset)
+ / - Tax on sale of old assetLess Amount of investment tax credit (AITC)
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Depreciation
Depreciation is a non-cash expense,consequently, it is only relevant because itaffects taxes
Depreciation tax shield = DTD = depreciation expense
T = tax rate
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Computing Depreciation
Straight-line depreciationAnnual Dep. = Installed cost / number of useful years
MACRSNeed to know which asset class is appropriate for tax
purposes
Multiply percentage given in table by the installedcost
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Example: Depreciation
You purchase equipment for $100,000 and it
costs $10,000 to have it installed. The companys
tax rate is 40%. What is the depreciation expenseeach year?
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Example: Three-year MACRS
Year MACRS
percent
D
1 .3333 .3333(110,000) =
36,663
2 .4444 .4444(110,000) =
48,884
3 .1482 .1482(110,000) =16,302
4 .0741 .0741(110,000) = 8,151
BV in year 6 =
110,00036,663
48,88416,302
8,151 = 0
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CASH OUTFLOW OR INVESTMENT
DETERMINATION
ExampleThe Sprint Inc. is trying to estimate the net cash outflow required toreplace an old machine with a new one. The new machines purchaseprice is $270,000. An additional $7,000 will be required for transportationand $5,000 will be required to install the machine. As the new machinehas greater capacity to produce, there will be an additional investment of
$20,000 in raw material inventory in the initial year. The new machinewill be depreciated on straight-line basis over five years of useful life.The old machine was purchased two years ago at a cost of $70,000 has aremaining useful life of five years. It is also subject to straight-linedepreciation. The company is entitled to investment tax allowance of25%. The corporate tax rate is 55% and the capital gain tax rate is 30%.
Find the net cash outflow considering separately each of the followingscenarios:
i) If the old machine is sold for $40,000
ii) If the old machine is sold for $50,00. NCO.xls
iii) If the old machine is sold for $60,000.
iv) If the old machine is sold for $90,000.
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CASHINFLOWDETERMINATION
Operating Cash Flow (OCF)Operating Cash Flow (OCF) = EBIT + depreciationtaxes
OCF = Net income + depreciation when there is no interestexpense
OCF = SalesCostsTaxes (Dont subtract non-cashdeductions)
OCF = (SalesCosts)(1T) + Depreciation*T
Opportunity Cost
Sunk Cost
Erosion or Side Effects
Financing Cost
Change in Net Working Capital
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Common Types of Cash Flows
Sunk costscosts that have accrued in the past and shouldnot be included capital budgeting analysis
Opportunity costscosts of lost options and should beincluded in capital budgeting analysis
Side effectsPositive side effectsbenefits to other projectsNegative side effectscosts to other projects
and should be included in capital budgeting analysis
Changes in net working capital (should be included incapital budgeting analysis)
Financing costs (should not be included in capital budgetinganalysis)
Taxes should be considered
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PROJECTCASH FLOW
DETERMINATION
Year
0 1 2 3
OCFChange in NWC
Opportunity Cost
Capital Spending/CO ATSV
PCF
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After-tax Salvage
If the salvage value is different from the book
value of the asset, then there is a tax effect
Book value = installed costaccumulated (i.e.
total ) depreciation
After-tax salvage value (ATSV) = salvage
Tc(salvagebook value)
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TECHNIQUES OF CAPITAL BUDGETING
The techniques of capital budgeting are dividedinto two broad groups
A) Non discounted cash flow techniques i.e.techniques that do not consider time value ofmoney as such do not discount the future cashflows
B) Discount cash flow (DCF) techniques i.e.
techniques that do not consider time value ofmoney as such do not discount the future cashflows
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TECHNIQUES OF CAPITAL BUDGETING
A) Non-DCF techniques include the following:i) Payback Period Method
ii) Average Accounting Return or Accounting Rateof Return
B) DCF techniques include the following:i) Net Present Value (NPV)
ii) Internal Rate of Return (IRR)
iii) Profitability Index (PI) or Benefit-CostRatio (BCR)
iv) Discounted Payback Period Method
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The Payback Period Rule
How long does it take the project to pay back
its initial investment?
Payback Period = number of years to recoverinitial costs
Minimum Acceptance Criteria:
set by management
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The Payback Period Rule (continued)
Disadvantages:Ignores the time value of money
Ignores cash flows after the payback period
Biased against long-term projects
Requires an arbitrary acceptance criteria
A project accepted based on the payback criteria maynot have a positive NPV
Advantages:Easy to understand
Biased toward liquidity
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The Discounted Payback
Period Rule
How long does it take the project to pay back
its initial investment taking the time value of
money into account?
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The Average Accounting Return Rule
Another attractive but fatally flawed approach.
Disadvantages:
Ignores the time value of moneyUses an arbitrary benchmark cutoff rate
Based on book values, not cash flows and market values
Advantages:
The accounting information is usually availableEasy to calculate
InvestentofValueBookAverage
IncomeNetAverage
AAR
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The Net Present Value (NPV) Rule
Net Present Value (NPV) =
Total PV of future CIs - Initial Investment
PV of Cash Inflows PV of Cash Outflows
Minimum Acceptance Criteria: Accept if NPV > 0
Ranking Criteria: Choose the highest NPV
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Why Use Net Present Value?
Accepting positive NPV projects benefits
shareholders.
NPV uses cash flows
NPV uses all the cash flows of the project
NPV discounts the cash flows properly
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Good Attributes of the NPV Rule
1. Uses cash flows
2. Uses ALL cash flows of the project
Reinvestment assumption: the NPV rule assumes
that all cash flows can be reinvested at the
discount rate or cost of capital.
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The Internal Rate of Return (IRR) Rule
IRR: the discount rate that sets NPV to zero or the rateof return available from investing in a project.Minimum Acceptance Criteria:
Accept if the IRR exceeds the required return.Ranking Criteria:
Select alternative with the highest IRRReinvestment assumption:All future cash flows assumed reinvested at the IRR.
Disadvantages:IRR may not exist or there may be multiple IRR
Problems with mutually exclusive investmentsAdvantages:
Easy to understand and communicate
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The Internal Rate of Return: Example
Consider the following project:
0 1 2 3
$50 $100 $150
-$200
The internal rate of return for this project is 19.44%
32 )1(
150$
)1(
100$
)1(
50$0
IRRIRRIRRNPV
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The NPV Payoff Profile for This Example
Discount Rate NPV
0% $100.00
4% $71.04
8% $47.3212% $27.79
16% $11.65
20% ($1.74)
24% ($12.88)
28% ($22.17)
32% ($29.93)36% ($36.43)
40% ($41.86)
If we graph NPV versus discount rate, we can see the
IRR as the x-axis intercept.
IRR = 19.44%
($60.00)
($40.00)($20.00)
$0.00
$20.00
$40.00
$60.00$80.00
$100.00
$120.00
-1% 9% 19% 29% 39%
Discount rate
NPV
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Problems with the IRR Approach
Multiple IRRs.
The Scale Problem
The Timing ProblemInvesting or Financing
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Multiple IRRs
There are two IRRs for this project:
0 1 2 3
$200 $800
-$200 - $800
($150.00)
($100.00)
($50.00)
$0.00
$50.00
$100.00
-50% 0% 50% 100% 150% 200%
Discount rate
NPV
100% = IRR2
0% = IRR1
Which one
should we use?
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The Scale Problem
Would you rather make 100% or 50% on your
investments?
What if the 100% return is on a $1 investmentwhile the 50% return is on a $1,000 investment?
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The Timing Problem
0 1 2 3
$10,000 $1,000 $1,000
-$10,000
Project A
0 1 2 3
$1,000 $1,000 $12,000
-$10,000
Project B
The preferred project in this case depends on the discount rate, not
the IRR.
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The Timing Problem..\TimingProb.xls
($4,000.00)
($3,000.00)
($2,000.00)
($1,000.00)
$0.00
$1,000.00$2,000.00
$3,000.00
$4,000.00
$5,000.00
0% 10% 20% 30% 40%
Discount rate
NPV
Project A
Project B
10.55% = crossover rate
16.04% = IRRA12.94% = IRRB
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Mutually Exclusive vs.
Independent Project
Mutually Exclusive Projects: only ONE of severalpotential projects can be chosen, e.g. acquiring anaccounting system.
RANK all alternatives and select the best one.
Independent Projects: accepting or rejecting one projectdoes not affect the decision of the other projects.
Must exceed a MINIMUM acceptance criteria.
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The Profitability Index (PI) Rule
Minimum Acceptance Criteria:
Accept if PI > 1
Ranking Criteria:Select alternative with highest PI
Disadvantages:
Problems with mutually exclusive investments
Advantages:May be useful when available investment funds are limited
Easy to understand and communicate
Correct decision when evaluating independent projects
InvestentInitial
FlowsCashFutureofPVTotal
PI
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The Practice of Capital Budgeting
Varies by industry:
Some firms use payback, others use accounting rate of
return.
The most frequently used technique for largecorporations is IRR or NPV.
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Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for the
following two projects. Assume the required return is
10%.
Year Project A Project B
0 -$200 -$150
1 $200 $502 $800 $100
3 -$800 $150
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Example of Investment Rules
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80
NPV = $41.92 $90.80
IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
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Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -1501 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150Payback period for project B = 2 years.
Payback period for project A = 1 or 3 years?
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Relationship Between NPV and IRR
Discount rate NPV for A NPV for B-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.9240% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64100% 0.00 -81.25
120% -18.93 -92.52