Part-2 section-E
Ø
Capital investment analysis method:
Capital budgeting methods include,
1. Payback period
2.
Discount payback period
3.
NPV [ net present value]
4.
Internal rate of return [ IRR]
Ø 1. Payback period: [ undiscounted, traditional payback ]
It is several periods that the company takes to recover the
investment.
Case1: if the cashflows are constant:
Payback period = initial net investment ÷
constant cashflow
Ø Decision rule:
If the target payback period is greater than the payback period =
accept
Payback period greater than target payback period = reject
Case-2: if the accepted cash flows are nonconstant over the
life of the project.
Ø Benefits of payback period: [ essay imp]
It is as simple and easy to understand.
It can be useful for preliminary screening
It helps evaluate and invest when the company
desire to recoup [ recover] its initial investment quickly.
It used cashflows rather than net profit.
It can be used to concentrate on more liquid projects.
Ø Limitations:
1.
Time value of money is not considered.
2.
It encourages us to accept short time projects than long-term projects.
3.
It does not consider the whole life of the project.
4.
It does not consider a projected return on
investment.
5.
It does not consider risk and uncertainty in the project.
6.
It ignores the cost of capital.
Ø Time value of money:
Sum of money received today has more worth than the sum of money
received in the future.
Reasons:
1.
Inflation
2.
Risk and uncertainly
3.
Opportunity to invest.
Present value:
Present value = future value [ 1 ÷ 1+r ]n
N= number of counts or period
R= discount rate or interest rate
Ø Present value annuity:
It is used when consistent cash flows contain a period.
Present value annuity= FV[ 1÷ 1+r ] n GT
Ø 2. Discount payback period:
It is also called break-even time.
The payback period does not consider the time value of money.
But the discount payback period considered the time value of money.
Here expected cash flows are discounted to their present value
using an appropriate interest rate, usually companies' cost of capital.
Example: dividend and interest.
Ø Decision rule:
If target discount payback> discount payback period =
accepted.
If target discount payback period < discount payback =
reject.
Ø Advantages of discount payback period:
It is considered the time value of money.
It is used as a basic screening method.
It considers cash flow rather than accounting for profit.
It considers risk and uncertainty
Ø Limitations:
It may lead to accessive investment in short-term projects.
It does not consider the whole life of the project.
It does not consider the return on investment.
Note: discount payback is always greater than payback.
Ø 3. Net present value:
It is the best method.
NPV = present value of all cash inflow – the present value of
all outflow.
Ø
Decision rule:
If NPV positive = accept
If NPV negative = reject
Note: when the discount rate increases NPV will decrease
When the discount rate decreases NPVA will increases.
Example: NPV profit :
Ø
series of equal cash flows:
A series of equal cash flow with 1 unequal at the end :
[example in our youtube channel]
A series of unequal cash flows:
[ example in our youtube channel]
Ø Irrelevant cashflows:
Sunk cost:
Allocated common cost:
Common cost is not relevant unless the total common cost for the
company as a whole will change as a result of the project.
Ø
Financial cashflows:
Financial cash flow associated with the project tolerant payment
on new debt or dividend on new stock issues is not relevant and is not part of any capital budgeting analysis.
The cost of financing is captured in the discount rate,
Used to discount the future cashflows for discounted cashflows
method.
To include the cashflows for financing in the analysis would
be the double-count them.
Ø Perpetual annuity with NPV:
Perpetuity can be used when all annual cash flows are the same
for an indefinite period.
Under perpetuity,
Present value = cash flow ÷ discount rate
Ø A perpetual growing annuity and NPV:
Perpetuity present value = cashflow ÷ discount rate – growth rate.
Note: the discount rate is also called the interest rate, cost of
capital, required rate of return, hurdle rate, and opportunity cost.
Ø Benefits of NPV:
a.
It is considered the time value of money
b.
It considered cashflow rather than net income [
net profit]
c.
It is an absolute measure, not a relative measure
[%].
d.
It gives an indication of an increase or decrease
in the wealth of shareholders.
e.
NPV incorporators the impact of all cash flow associated with the project.
f.
It can be projected with non-conventional
cash flow.
Nonconventional cashflow:
A non-conventional cash flow project has a negative cash flow after a year 0 [ year zero].
Conventional cashflow:
Conventional cash flow projects begin with a cash outflow followed
by several cashflows.
g.
NPV helps to rank the potential project. according to their expected return, which
is useful when a firm has limited funds for capital projects.[investment]
h.
It gives a better ranking of mutually executive
projects.
Mutually executive project:
A company can choose only one project to the exclusion of
all others.
Ø Limitations of NPV:
It expresses as a monetary amount it does not provide an expected rate of return.
The NPV is very
sensitive to the discount rate used.
NPV incorporation is an assumption that all cash inflow from
the project will be re-invested at the required rate of return.
NPV is not useful for comparing projects of different sizes.
Changes in technology and other environmental factors may
affect the project.
Ø Internal rate of return [ IRR] :
It is a discount rate at which NPV is equal to zero.
Ø Decision rule:
If IRR is greater than the discount rate = accept
If discount rate greater than IRR = reject
Case 1: if the annual cash flow is the same for every year of a
project's life.
Ø Decision rule:
Here IRR greater than the discount rate= accept
Case2: when annual cashflows are not the same:
Finding the range where the NPV is zero.
The IRR can be calculated by calculating using different
discount rates and inter-policing.
[Discount rate increases NPV decreases]
Ø Benefits of IRR :
It considers the time value of money
It considers risk and uncertainty
It is easier for managers to understand and interpret NPV.
IRR can be compared with any required rate of return [
discount rate]
For similar investments.
It is a percentage rather than an amount.
Ø Limitations:
a.
It is a complicated calculation
b.
It is a project that is non-conventional.
c.
It has a negative cash flow or flows after a year 0 more than 1 IRR.
Or the IRR is not able to be calculated when
investments are mutually exclusive and are of different sizes or have different
cashflow patterns the information provided by the IRR may not be useful for
decision making.
d.
The IRR incorporates an assumption that the cash
inflow from the project will be invested at the internal rate of return.
If that is not a valid assumption the calculated IRR will not represent the
project's true rate of return.
Ø Cross over rate : [ no qn]
It is a discount rate at which the NPV of 2 projects will be the same.
Example:
#####
Here cross over rate is 10%
When the discount rate is greater than the cross-over rate.
Project J IRR is greater than project K IRR.
Here both IRR and NPV give the same result.
Therefore project J is a better project.
Case2: when discount rate less than cross-over rate:
Project J NPV less than project K
Project J IRR is greater than project K IRR.
Here NPV and IRR give a different results.
Based on NPV, we will select project K.
Based on IRR, we will select project J.
Ø Assumption in capital budgeting:
: We need to assume that all of the cash flows are received or paid at the end of the year even though received or paid throughout the period.
Ø Capital rationing in capital budgeting:
It is a limitation of a fund that presents acceptance of all of the new projects with a positive NPV.
Two reasons for capital rationing:
1. Hard capital rationing
2. Soft capital rationing
Ø Hard capital rationing:
External factors:
It includes,
Banks are not given further loan
Poor track records
Restrictions on the banks due to government control.
Ø Soft capital rationing : [ internal factors]
]It includes,
Management may not wants to add debt because to commitment large interest payment.
Management may be unwilling to issue shares which leads to diluted earnings per share.
Ø Profitability index:
Under the profitability index company rank the project by calculating each project's profitability index and giving priority to those with the highest profitability index.
Profitability index = PV inflow ÷ PV outflow
Or
NPV ÷ initial investment
Ø Capital budgeting and inflation:
Inflation is an important consideration when evaluating a project, that will extend many years
Into the future,, because inflation causes a decline in general purchasing power over time.
For example, if inflation is 10% annually, then what $100 can buy on January 1st will cost $110 by Dec 31st.
Ø Real cashflows :
Real cash flows are those cash flows that have not been adjusted for inflation.[ without inflation]
Ø Nominal cash flows:
Nominal cash flows are considered inflation.
Normally nominal cashflows are used In a capital budgeting analysis.
Ø Nominal rate of return:
Nominal rate of return = 1+ real rate of return × [1+ inflation rate ] -1
Ø Real rate of return:
RRR= 1+ nominal rate ÷ 1+ inflation rate -1
Ø Calculation of nominal expected cashflows:
= real expected cashflows [ 1+ inflation rate]n
N= number of years
Ø Calculation of real expected cashflows:
Real expected cashflows= nominal expected CF ÷ [1+ inflation rate ]n
Ø Calculation of NPV:
Dean tax shield is not adjusted for inflation, because US IRS allows assets to be depreciated only on the original cost of the asset.
Future expected cashflows and required rate of return, both need to be adjusted for inflation.
In another word, if one is adjusted other must be also adjusted.
Ø Capital budgeting appraisal method :
1. Undiscounted cashflow model:
a. Payback
2. Discounted cashflow model:
a. Discounted payback
b. NPV
c. IRR
Note: for long-term decision making discounted cashflow models are best.
In the replacement decision, the disposed of the price of old equipment is more relevant.
The primary goal of a financial manager is to maximize shareholders' wealth.
Note: if the cost of capital decreases NPV increases but IRR does not change.
In an inflation environment, both the discount rate used and future expected cash flow should be increased.
Ø Capital budgeting method- another topic:
Ø Incremental analysis:
A new asset replaces an old asset.
An incremental capital budgeting analysis can help a company decide whether to continue fusing an old asset or replace with it a new asset.
The company needs to calculate the difference in cashflows between keeping or replacing the older asset.
Note: IRR may produce a different ranking from NPV on mutual exclusive.
Forecasting cash flow is the riskiest stage in the capital budgeting process.
Ø Risk in capital budgeting:
Capital budgeting always involves risk and risk must be considered in the capital budgeting process.
Ø Expected value:
[Example on youtube]
The expected value of project Bs cashflows is higher than the expected value of cash flow.
Ø Dispersion : [ no qn ]
The large potential cash flow is dispersion.
Project Bs lowest possible cash flow is 100k and the highest cash flow is 500k.
The range of project Bs cash flow is 400k.
Project As lowest cash flow possible is 400k, whereas the range of project As cash flow is only 200k.
Ø Analysis of risk:
Risk is a constant concern for decision-makers, and therefore it's essential to have the proper skill to analyze and calculate risk.
Managers can use several techniques to help them manage risk and reduce risk.
Ø Scenario analysis:
In scenario analysis, the NPV or IRR of a project is analyzed under a series of specific scenarios.
Revenue, expenses, and another ratio under each of the scenarios are estimated and the NPV or IRR of the project under each scenario is estimated.
The decision to accept or reject the project is based on the NPV and IRR under all the scenarios, not just one.
Ø Sensitivity analysis:
It tells about the sensitivity of the project to change in different functions.
It can be used to determine cash flow flows are expected to vary with changes in underline assumptions.
Example: sensitivity of sales revenue is 10% which means an advice change of 10% in sales revenue.
This will result in NPV becoming zero.