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Économie & finance

It is about long term investment decision making..

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- FINANCIAL MANAGEMENT Semester 3 Unit 2 Long-Term Investment Decisions (30%) Dr. Radha Vyas
- CHAPTER OUTLINE Nature & Meaning of Capital Budgeting Principles & Techniques Estimation of Relevant Cash Flows & Terminal Value Evaluation Techniques – 1. Accounting Rate of Return, 2. Net Present Value, 3. Internal Rate of Return, 4. Net Terminal Value, 5. Profitability Index Method 6. Pay Back Period 2
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- INTRODUCTION OF CAPITAL BUDGETING Capital budgeting is made up of two words ‘capital’ and ‘budgeting.’ In this context, capital expenditure is the spending of funds for large expenditures like purchasing fixed assets and equipment, repairs to fixed assets or equipment, research and development, expansion and the like. Budgeting is setting targets for projects to ensure maximum profitability. Capital budgeting is the process a business undertakes to evaluate potential major projects or investments. Construction of a new plant or a big investment in an outside venture are examples of projects that would require capital budgeting before they are approved or rejected. 4
- Meaning of Capital Budgeting: The process of taking decisions as to which assets should be purchased and how to spend the funds for this purpose is called Capital Budgeting. Definition of Capital Budgeting: According to I. M. Pandey, “Capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in long run activities in anticipation of an expected flow of future benefits over series of year.” According to Shall and Haley, “The process of determining both how much to spend on capital assets and which assets to acquire is called capital budgeting. The plan for such expenditure is called a capital budget.” 5
- NATURE OF CAPITAL BUDGETING It is a long-term investment decision. It is irreversible in nature. It requires a large amount of funds. It is most critical and complicated decision for a finance manager. It involves an element of risk as the investment is to be recovered in future. 6
- IMPORTANCE OF CAPITAL BUDGETING 1. Large Expenditure 2. Long Term Effects 3. Estimates and Uncertainty 4. Effect on Profitability 5. Irreversible Decisions 7
- PROCESS OF CAPITAL BUDGETING 1. Origin of Investment Proposal 2. Evaluation of the Projects 3. Selection of the Project 4. Implementation and Follow - up 8
- PRINCIPLES Incremental Cash flows Opportunity Cost Sunk Costs Financing Costs Tax Considerations Timing of Cash flows 9
- Relevant Cash Flow Relevant cash flow is the incremental after – tax cash outflow (investment) and resulting subsequent inflows associated with a proposed capital expenditure. Incremental Cash Flows Incremental cash flows are the additional cash flows (outflows as well as inflows) expected to result from a proposed capital expenditure. Sunk Costs Sunk costs are cash outflows that have already been made and therefore have no effect on the cash flows relevant to a current decision. 10
- ESTIMATION OF RELEVANT CASH FLOWS 1. Single Proposal Cash Outflows of New Project (1) Cost of new project (2) + Installation cost of plant and equipments (3) + Working capital requirements Determination of Cash Inflows Cash sales revenues Less: Cash operating cost Cash inflows before taxes (CFBT) Less: Depreciation Taxable income Less: Tax Earning after taxes Plus: Depreciation Cash inflows after tax (CFAT) Plus: Salvage value Plus: Recovery of working capital 11
- 2. Replacement Situation Cash Outflows in a Replacement Situation (1) Cost of the new machine (2) + Installation cost (3) + Working Capital (4) - Sale proceeds of existing machine Depreciation Base of New Machine in a Replacement Situation (1) WDV of the existing machine (2) + Cost of the acquisition of new machine (including installation costs) (3) - Sale proceeds of existing machine 12
- 3. Mutually Exclusive Situations In the case of mutually exclusive proposals, the selection of one proposal exclude the choice of other. The calculation of the cash outflows and inflows are same as the replacement situations. 13
- EVALUATION TECHNIQUES Non-Discounted Methods/Traditional Methods Accounting Rate of Return Payback Period Discounted Methods/Modern Methods Net Present Value Internal Rate of Return Net Terminal Value Profitability Index 14
- ACCOUNTING RATE OF RETURN The accounting rate of return (ARR) method of evaluating proposed capital expenditure is also known as the average rate of return method. It is based on accounting information rather than cash flows. ARR = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑜𝑣𝑒𝑟 𝑡ℎ𝑒 𝑙𝑖𝑓𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 X 100 Average investment = Net working capital + Salvage value + ½ (Initial cost of machine – Salvage value) 15
- Advantages: 1) It is easy to understand and convenient to use. 2) The figures of incomes are to be obtained from profit and loss account; no other calculations are required. 3) The entire income of the project is taken into account. 4) It points to different alternative avenues of investment. 5) It takes into consideration the savings over the whole working life of the project. 6) With the help of this method, the most profitable investment project can be selected from among the various proposals. 16
- Limitations: 1) It does not consider cash flow. 2) Project yields different amounts of income at different points of time is ignored in this method. In short, the time element is not given importance. Only total income of the project is taken into account. 3) The difference in investment outlays is not taken into account under this method. 4) It ignores the fact that useful life of different projects may be different. 5) It does not take note of all factors affecting rate of profit. 6) It does not suggest whether a project should be accepted or not, unless it is compared with a cut off rate decided by management. 17
- EXAMPLE Determine the average rate of return from the following for Machine A; Cost Rs. 56,125 Annual estimated income after depreciation and income tax: Year Amount 1 3375 2 5375 3 7375 4 9375 5 11,375 36,875 Estimated life 5 years Estimated salvage value Rs. 3000 Depreciation has been charged on straight line basis. 18
- ARR = Average Annual PAT/ Average Investment X 100 Average Annual PAT = Total PAT/No. of Years = 36,875/5 = Rs. 7375 Average Investment = Net working capital + Salvage value + ½(Cost of machine – Salvage value) = 0 + 3000 + ½ (56,125 – 3000) = 3000 + 26, 562.5 = Rs. 29, 562.5 ARR = 7375/29,562.5 X 100 = 24.95% 19
- PAYBACK PERIOD Payback period is the exact amount of time required for a firm to recover its initial investment in a project as calculated from cash inflows. Payback period is calculated as; (1) In the case of annuity CFAT: PB = 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤 (2) In the case of mixed CFAT: It is obtained by cumulating CFAT till the cumulative CFAT equal the initial investment. 20
- Advantages: 1) It is simple to understand and easy to calculate. 2) It is highly useful for a firm facing liquidity problem. 3) It gives protection against risk of obsolescence in the modern age where technology is changing very fast. 4) The profitability of a project does not depend on total return only, but on when it is available and how speedily it is available. 5) The cost and sales price can be easily estimated if the pay – back period is short. 6) It is an useful guide to investment policy. 7) It is most suitable when the future is very uncertain. 21
- Limitations: 1) It fails to take into account time factor. It gives equal weight to cash flows received at different points of time. For example; Project Investment CFAT CFAT Total (Year 1) (Year 2) X Rs. 11,000 Rs. 4,000 Rs. 7,000 = Rs. 11,000 Y Rs. 11,000 Rs. 6,000 Rs. 5,000 = Rs. 11,000 2) This method does not give a correct idea of the profitability of a project as it does not take into account cash proceeds received after the pay-back period. 22
- 3) This method prefers only those projects which have short pay-back period, hence, it rejects modern machines and equipments which may be highly profitable but may give profits in the long run. 4) It ignores the time value of money. It gives equal weight to cash flow at different points of time. It does not discount the cash inflows. 5) It does not take note of the cost of capital which is the basis of investment decisions. 23
- EXAMPLE Determine the pay-back period from the following for Machine A; Cost Rs. 56,125 Annual estimated income after depreciation and income tax: Year Amount 1 3375 2 5375 3 7375 4 9375 5 11,375 36,875 Estimated life 5 years Estimated salvage value Rs. 3000 Depreciation has been charged on straight line basis. 24
- D = C –S N = 56,125 – 3000 5 = RS. 10,625 YEAR PAT DEPRECIATI ON CFAT CUMULATIVE CFAT 1 3375 10,625 14,000 14,000 2 5375 10,625 16,000 30,000 3 7375 10,625 18,000 48,000 4 9375 10,625 20,000 68,000 5 11375 10,625 22,000+3000 =25,000 93,000 25 Initial Investment = Rs. 56,125 PB = 3 years + 8125/20,000 PB = 3 + 0.41 = 3.41 Years
- NET PRESENT VALUE Net present value is found by subtracting a project’s initial investment from the present value of its cash inflows discounted at the firm’s cost of capital. NPV = PV of Cash Inflows – PV of Cash Outflow The accept – reject criteria: If NPV is positive or NPV > 0, accept project. If NPV is negative or NPV < 0, reject project. If NPV = 0, the firm is indifferent between accepting or rejecting the project. 26
- Advantages: 1) Since this method recognizes the time value of money, it is the best guide in long term decision – making. 2) The cash flow over the whole working life of the project is taken into consideration in this method. 3) This method is consistent with the shareholders’ objective of maximizing the wealth as if a project which gives maximum present value of cash flows is accepted, the market price of the shares will be favorably affected. 4) Under this method, a comparison is possible among different projects with different working lives as also yielding different incomes in different years. 5) It takes into account the risk and uncertainties of business. 6) It takes into account cash flows and not profit, which is more logical. 27
- Year CFAT PVIF@10% 1 120000 0.909 2 170000 0.826 3 150000 28
- Limitations: 1) It necessitates calculations which are complicated and difficult to understand. 2) It is difficult to determine the rate of discount to be used in this method. 3) Under this method the present value of cash flows of different projects are compared. Thus, no absolute criteria is provided to judge the desirability of investment projects. 4) The result may be misleading when the lengths of working life of two investment projects are unequal. 29
- EXAMPLE Determine the Net present value from the following for Machine A; Cost Rs. 56,125; Discount rate is 10% Annual estimated income after depreciation and income tax: Year Amount 1 3375 2 5375 3 7375 4 9375 5 11,375 36,875 Estimated life 5 years Estimated salvage value Rs. 3000 Depreciation has been charged on straight line basis. 30
- Year PAT Deprecia tion CFAT PVIF@ 10% PV of CFAT 1 3375 10625 14,000 0.909 12,726 2 5375 10625 16,000 0.826 13,216 3 7375 10625 18,000 0.751 13,518 4 9375 10625 20,000 0.683 13,660 5 11375 10625 22,000 + 3000 = 25,000 0.621 15,525 Total PV of CFAT 68,645 Less: PV of Cash Outflow 56,125 NPV 12,520 31
- INTERNAL RATE OF RETURN Internal rate of return (IRR) is the discount rate that equates the present values of cash inflows with the initial investment associated with a project, thereby causing NPV = 0. If the IRR ( r ) exceeds the cut-off rate (k), accept the project. Calculation of IRR: 1) Calculate the average annual cash inflow. 2) Determine pay back period dividing the initial outlay by the average annual CFAT determined in step 1. 3) Look for the factor in Table A-4, closest to the pay back value. 32
- 4) If the actual cash inflows are higher in the initial years of the project’s life than the average CFAT, adjust IRR a few percentage points upward. 5) If in the early years the actual cash inflows are below the average CFAT, adjust IRR a few percentage points downward. 6) If the average CFAT seems fairly close to the actual cash flows, no adjustment is to be made. 7) Find out the present value (using Table A-3), taking discount rates as estimated earlier. 8) If the PV of CFAT equals the initial outlay, NPV is zero, it is the IRR. Otherwise, repeat step 7 till two consecutive discount rates that cause the NPV to be positive and negative respectively. 33
- 9) The actual value can be calculated by the method of interpolation as; IRR = A + C C −D X (B – A) Where A = Lower Rate of Discount at first trial B = Higher Rate of Discount at second trial C = Excess of PV of trial at lower rate D = Shortfall in PV of trial at higher rate 34
- Advantages: 1) It considers time value of money. 2) The cash flow available for the whole life of the project is taken into account. 3) It is easier to understand by management and other non-technical personnel as here the rate of interest is computed which is better understood than present value. 4) There is no need to fix the rate of return in advance because the method itself is used to determine the rate. 5) The objective of any business is to maximise the owners’ wealth and this method satisfies it. 35
- Limitations: 1) The calculations are complicated because they are based on trial and error method. 2) Uniform internal rate is not available under this method. It may give multiple rates which become confusing. 3) In certain situations, ranking of mutually exclusive projects may be different by IRR method and NPV methods. 36
- EXAMPLE By investing Rs. 60,000 in a project, the cash flow available for 5 years is as follows: 1st year Rs. 22,000 2nd year Rs. 18,000 3rd year Rs. 14,000 4th year Rs. 16,000 5th year Rs. 10,000 Calculate Internal Rate of Return (IRR). 37
- 1) Average CFAT = 22000+18000+14000+16000+10000 5 = Rs. 16000 2) PB = Investment/Average CFAT = 60000/16000 = 3.75 3) At 10% = Factor 3.79, We will try at 11% & 12% as initial years cash inflows are higher than average CFAT Rs. 16,000 38
- Year CFAT PVIF@11% PV of CFAT 1 22000 0.901 19,822 2 18000 0.812 14,616 3 14000 0.731 10,234 4 16000 0.659 10,544 5 10000 0.593 5930 Total PV of CFAT 61,146 Less: PV of Cash Outflow 60,000 NPV 1146 39
- Year CFAT PVIF@12% PV of CFAT 1 22000 0.893 19,646 2 18000 0.797 14,346 3 14000 0.712 9968 4 16000 0.636 10,176 5 10000 0.567 5670 Total PV of CFAT 59,806 Less: PV of Cash Outflow 60,000 NPV (194) 40
- By using interpolation IRR = A + C C −D X (B – A) = 11 + 1146 X (12-11) 1146 + 194 = 11 + 0.86 X 1 = 11.86% 41
- NET TERMINAL VALUE This method assumes that each cash inflow received is reinvested in another asset at a certain rate of interest. It is reinvested from the time it is received until the completion of the project. NTV = PVTS – PVO Where, PVTS = Present value of the sum total of the compounded reinvested cash inflows PVO = Present value of the outflows If the NTV is positive, accept the project If the NTV is negative, reject the project 42
- Advantages: 1) It has the advantage of cash inflow being reinvested, once they are received. 2) It is mathematically easier to compute than the IRR method. 3) The business executives who are not trained in Accountancy and Statistics can understand this compounding technique better than discounting technique. 4) It is more suitable for cash budgeting requirements as it also considers interest earnings. 43
- Limitation: The major practical problem of this method lies in determining the future rates of interest at which the intermediate cash inflows received will be reinvested. Example: Original outlay Rs. 10,000; Life of the project 5 years; Cash inflows Rs. 4000 each for 5 years and cost of capital (k) 10 per cent. Calculate NTV. Expected interest rates at which cash inflows will be reinvested; Year-end Per cent 1 6 2 6 3 8 4 8 5 8 44
- Year Cash Inflows Rate of Interest for Investmen t (%) Years for Investme nt Compou nding Factor (CVIF) Compound ing Value 1 4000 6 4 1.262 5048 2 4000 6 3 1.191 4764 3 4000 8 2 1.166 4664 4 4000 8 1 1.080 4320 5 4000 8 0 1.000 4000 20,000 Sum Total of Compounding Value 22,796 45 PV of Sum Total of Compound Value of Cash Inflow = (22,796 X PVIFi,n) = 22,796 X PVIF10%,5) = 22,796 X 0.621 = 14,156.32 NTV = 14,156.32 – 10,000 = Rs. 4156.32
- PROFITABILITY INDEX OR BENEFIT COST RATIO It gives a proportion of present value of cash inflow and present value of cash outflow or investment. It is also known as Benefit – Cost Ratio as it is the ratio of future cash benefit to initial cash outflow. PI = 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝐼𝑛𝑓𝑙𝑜𝑤 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝑎𝑠ℎ 𝑂𝑢𝑡𝑓𝑙𝑜𝑤 If the index is greater than 1, the project becomes acceptable as it indicates that the present value of cash inflow is more. If PI or BC > 1, accept project If PI or BC < 1, reject project 46
- Advantages: 1) It gives due importance to time factor. 2) It considers the cash inflow during the whole life of the project. 3) PI method gives a better indication of the project to be selected in case there is scarcity of funds available for investment. 47
- EXAMPLE Determine the Benefit – Cost Ratio from the following for Machine A; Cost Rs. 56,125; Discount rate is 10% Annual estimated income after depreciation and income tax: Year Amount 1 3375 2 5375 3 7375 4 9375 5 11,375 36,875 Estimated life 5 years Estimated salvage value Rs. 3000 Depreciation has been charged on straight line basis. 48
- Year PAT Depreciat ion CFAT PVIF @10% PV of CFAT 1 3375 10,625 14,000 0.909 12,726 2 5375 10,625 16,000 0.826 13,216 3 7375 10,625 18,000 0.751 13,518 4 9375 10,625 20,000 0.683 13,660 5 11,375 10,625 25,000 0.621 15,525 Total PV of CFAT 68,645 49 BC = PV of Cash Inflow PV of Cash Outflow = 68,645 56,125 = 1.22
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