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Capital budgeting (or investment appraisal) is the process of determining the viability to long-term investments on purchase or replacement of property plant and equipment, new product line or other projects.
NPV Example: Invest $2,000 now, receive 3 yearly payments of $100 each, plus $2,500 in the 3rd year. Use 10% Interest Rate.
Let us work year by year (remembering to subtract what you pay out): Now: PV = -$2,000 Year 1: PV = $100 / 1.10 = $90.91 Year 2: PV = $100 / 1.102 = $82.64 Year 3: PV = $100 / 1.103 = $75.13 Year 3 (final payment): PV = $2,500 / 1.103 = $1,878.29 Adding those up gets: NPV = -$2,000 + $90.91 + $82.64 + $75.13 + $1,878.29 = $126.97 Looks like a good investment.
Accounting Income 21
Step 3: Average Accounting Income = ( 21 + 60 + 45 ) / 3 = 42 Step 4: Accounting Rate of Return = 42 / 220 = 19.1%
An initial investment of $2,324,000 is expected to generate $600,000 per year for 6 years. Calculate the discounted payback period of the investment if the discount rate is 11%. Solution Step 1: Prepare a table to calculate discounted cash flow of each period by multiplying the actual cash flows by present value factor. Create a cumulative discounted cash flow
column. Year n 0 1 2 3 4 5 6 Cash Flow CF $ 2,324,000 600,000 600,000 600,000 600,000 600,000 600,000 Present Value Factor PV$1=1/(1+i) 1.0000 0.9009 0.8116 0.7312 0.6587 0.5935 0.5346
n
Discounted Cash Flow CFPV$1 $ 2,324,000 540,541 486,973 438,715 395,239 356,071 320,785
Cumulative Discounted Cash Flow $ 2,324,000 1,783,459 1,296,486 857,771 462,533 106,462 214,323
Company C is planning to undertake another project requiring initial investment of $50 million and is expected to generate $10 million in Year 1, $13 million in Year 2,
$16 million in year 3, $19 million in Year 4 and $22 million in Year 5. Calculate the payback value of the project.
Solution (cash flows in millions) Year 0 1 2 3 4 5 Payback Period = 3 + (|-$11M| $19M) = 3 + ($11M $19M) 3 + 0.58 3.58 years Cash Flow (50) 10 13 16 19 22 Cumulative Cash Flow (50) (40) (27) (11) 8 30
Profitability Index
Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project.
Formula:
Profitability Index Present Value of Future Cash Flows = Initial Investment Required
Explanation:
Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project), the profibality index is a relative measure (i.e. it gives as the figure as a ratio).
Decision Rule
Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is zero and don't accept a project if the profitability index is below 1. Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.
Example
Company C is undertaking a project at a cost of $50 million which is expected to generate future net cash flows with a present value of $65 million. Calculate the profitability index. Solution Profitability Index = PV of Future Net Cash Flows / Initial Investment Required Profitability Index = $65M / $50M = 1.3 Net Present Value = PV of Net Future Cash Flows Initial Investment Rquired Net Present Value = $65M-$50M = $15M.
The information about NPV and initial investment can be used to calculate profitability index as follows: Profitability Index = 1 + (Net Present Value / Initial Investment Required) Profitability Index = 1 + $15M/$50M = 1.3