1 / 38

Session 4

Session 4. Capital Budgeting. Capital Budgeting - Methods. 1. Average Return on Investment 2. Payback 3. Net Present Value 4. Internal Rate of Return 5. Modified IRR. Average Return on Investment. AROI = Avg. Net Income Per Year Avg. Investment.

kitra
Download Presentation

Session 4

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  1. Session 4 • Capital Budgeting

  2. Capital Budgeting - Methods • 1. Average Return on Investment • 2. Payback • 3. Net Present Value • 4. Internal Rate of Return • 5. Modified IRR

  3. Average Return on Investment • AROI = Avg. Net Income Per Year • Avg. Investment

  4. Average Return on Investment • Example: • YearNet IncomeCost • 1 6,000 100,000 Initial • 2 8,000 0 Salvage Value • 3 11,000 • 4 13,000 • 5 16,000 • 6 18,000

  5. Average Return on Investment • Avg. Net Income 72,000 • 6 • Avg. Investment 100,000 • 2 • AROI 12,000 • 50,000 = 12,000 = 50,000 = 24%

  6. Average Return on Investment • Advantages • Disadvantages

  7. Payback Method • # Years required to recover the original investment • Example: • YearNet IncomeCash FlowCumulative CF • 1 6,000 26,000 26,000 • 2 8,000 28,000 54,000 • 3 11,000 31,000 85,000 • 4 13,000 33,000 118,000 • 5 16,000 36,000 154,000 • 6 18,000 18,000 172,000 • Payback = 3 + 100,000 - 85,000 • 118,000 - 85,000 = 3.45 Years

  8. Advantages Disadvantages Payback Method

  9. Time Value of Money • FV = PV (1 + r)n • Compounding: Finding FV • Discounting: Finding PV: PV = FV/(1 + r) n • Internal Rate of Return: Finding r

  10. Net Present Value • NPV = Present Value of All Future Cash Flows less Inital Cost • = CF1 + CF2 + CF3 +.......CFn - Io • 1+r (1+r)2 (1+r)3 (1+r)n

  11. Net Present Value - Example • YearCFDisc. FactorPV • 0 -100000 1 -100000 • 1 26000 1/1.1 = .9091 23637 • 2 28000 1/(1.1)2 = .8264 23139 • 3 31000 1/(1.1)3 = .7573 23290 • 4 33000 1/(1.1)4 = .6830 22539 • 5 36000 1/(1.1)5 = .6209 22352 • 6 18000 1/(1.1)6 = .5645 10161 • NPV = 25121

  12. Advantages Disadvantages Net Present Value

  13. Internal Rate of Return • Discount rate that makes NPV Zero (i.e., that equates PV of benefits with the cost). • IRR: Io = CF1 + CF2 + ..... + CFn • 1+r (1+r)2 (1+r)n • Solve for r. • Example: • 100,000= 26000 + 28000 + 31000 + .......... + 18000 • 1+r (1+r)2 (1+r)3 (1+r)6 • r = 18.2%

  14. Advantages Disadvantages Internal Rate of Return

  15. Profitability Index PI = PV of all Benefits PV of all Cost Example: PV (Benefits) = 26000+28000 +.......... + 18000 1.1 (1.1)2 (1.1)6 = 125121 PV (Cost) = 100000 PI = 125121 = 1.25 100000

  16. Profitability Index • Advantages: • Disadvantages:

  17. NPV Profile • YearCFDisc. FactorPV • 0 -100,000 1 -100,000 • 1 26,000 0.91 23,636 • 2 28,000 0.83 23,140 • 3 31,000 1/(1.1)3 = .7573 23,291 • 4 33,000 1/(1.1)4 = .6830 22,539 • 5 36,000 1/(1.1)5 = .6209 22,352 • 6 18,000 1/(1.1)6 = .5645 10,161 • NPV = 25,121

  18. NPV Profile • Dis. RateNPV • 0% 7200 • 5% 45725.7 • 10% 25120.76 • 15% 8711.838 • 20% -4538.97 • 25% -15376.1

  19. NPV Profile • 80000 • 60000 • 40000 • 20000 • 0 • -20000 • 0 0.05 0.1 0.15 0.2 0.25 • Disc. Rate NPV

  20. Choosing Between Projects • YearCF(A)CF(B) • 0 -25000 -25000 • 1 2000 21000 • 2 2000 10000 • 3 35000 2000 • NPV 6351 4606 • IRR 17% 22%

  21. Modified IRR • Reinvestment Rate Assumption (Project A) • Project  Outlay  25,000 • Cash Flows: YR1  2,000                     YR2  2,000                     YR3  35,000 •     NPV @ 8%: 6,351  IRR: 17%

  22. Modified IRR • NPV: Project A •     YR1:   2,000     YR2:   2,000 + 2,000 + 160 = 4,160    YR3:   35,000 + 4,160 + 333 = 39,493 • [Note: PV of 39,493, three years from now @ 8% =  31,351                                                          Less: outlay  25,000 • NPV  6,351]

  23. Modified IRR • IRR @ 17%    YR1:   2,000   = 2,000     YR2:   2,000 + 2,000 + 340 = 4,340     YR3:   35,000 + 4,340 + 738 = 40,078 • [25,000 invested for three years @ 17% = 25,000(1.17)3 = 40,040]

  24. Modified IRR • Modified Internal Rate of Return • Find k such that   (1+k)nI0  = Final value •     i.e.     (1+k)3 25000  = 39,439                                  k  = 16.5%

  25. Modified IRR • Reinvestment Rate Assumption (Project B) • Project  Outlay  25,000 • Cash Flows: YR1  21,000                     YR2  10,000                     YR3  2,000 •     NPV @ 8%: 4,606  IRR: 22.12%

  26. Modified IRR • NPV: Project B • YR1: 21,000 = 21,000        YR2: 10,000 + 21,000 + 1,680 = 32,680         YR3:  2,000 + 32,680 + 2,614   = 37,294 • [Note: PV of 37,294, three years from now @ 8% =  29,606                                                        Less: outlay  25,000 NPV  4,606 ]

  27. Modified IRR • IRR of 22.12% •   YR1:   21,000    = 21,000         YR2:   10,000 + 21,000 + 4,645 = 35,645         YR3:   2,000 + 35,645 + 7,885 = 45,530 • [25,000 invested for three years @ 22.12% = 25,000(1.2212)3 = 45,530]

  28. Modified IRR • Modified Internal Rate of Return • Find k such that   (1+k)nI0  = Final value •             i.e.     (1+k)3 25000  = 37,294                                           k  = 14.26%

  29. Estimating Cash Flows • NPV = CF1+ CF2 +.............. + CFn - Io • l+r (l+r)2 (l+r)n • Cash Flows Incremental • After Tax • Net Working Capital • Sunk Costs

  30. Procedure • 1. Initial Costs: New CAPEX • Additional W. Cap • Sale of Old Assets • 2. Annual Costs: Revenue Less Costs • After Tax • 3. Terminal Cash Flows: Salvage Value • Recoupment of NWC

  31. Cash Flow Estimates • Sale of Existing Plant • CF= Selling Price + T (B.V. - S.P.) • Annual Cash Flows • OCF= (Sales-Cost)(1-T) + T, DEPREC • or • OCF= Net Inc + Depreciation

  32. New Product Proposal • Annual Sales $20m • Annual Costs $16m • Net Working Capital $2m • Plant Site $0.5m • Plant and Equipment $10m • Depreciation Straight Line over 20 years • Salvage Value nil • Tax Rate 40% • Required Return 8%

  33. New Product Proposal • INITIAL CASH FLOWS • ANNUAL CASH FLOWS

  34. New Product Proposal • TERMINAL CASH FLOWS • CALCULATION

  35. Evaluating Capital Projects • 1) Focus on Cash Flow, Not Profits. • Cash Flow = Economic Reality. • Profits Can Be Managed. • 2) Carefully Estimate Expected Future Cash Flows. • 3) Select a Discount Rate Consistent with the Risk of Those Future Cash Flows. • 4) Account for the Time Value of Money. • 5) Compute a “Base-Case” NPV.

  36. Evaluating Capital Projects • 6) Net Present Value = Value Created or Destroyed by the Project. • NPV is the Amount by which the Value of the Firm Will Change if you Undertake the Project. • 7)Identify Risks and Uncertainties. Run a Sensitivity Analysis. • Identify “Key Value Drivers.” • Identify Breakeven Assumptions. • Estimate Scenario Values. • Bound the Range of Value

  37. Evaluating Capital Projects • 8) Identify Qualitative Issues. • Flexibility • Quality • Know-How • Learning • 9) Decide

More Related