Capital Budgeting and Investment

Decision

Kings College

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Capital budgeting decision

Capital budgeting: describes
decisions where expenditures and
receipts for a particular undertaking will
continue over a period of time.
In other words, it is the process in
which a business determines whether
projects such as building a new plant or
investing in a long-term venture are
worth pursuing.
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Capital budgeting decision

Types of capital budgeting decisions
expansion of facilities because of
growing demand
new or improved products
Replacement - of plant or machines
lease or buy
make or buy
Other if mandated by law
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What is Time Value?

We say that money has a time value because
that money can be invested with the
expectation of earning a positive rate of return
In other words, a Rupee received today is
worth more than a Rupee to be received
tomorrow
That is because todays Rupee can be invested
so that we have more than one Rupee
tomorrow

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The Terminology of Time Value

Present Value - An amount of money today,
or the current value of a future cash flow
Future Value - An amount of money at some
future time period
Period - A length of time (often a year, but can
be a month, week, day, hour, etc.)
Interest Rate - The compensation paid to a
lender (or saver) for the use of funds
expressed as a percentage for a period
(normally expressed as an annual rate)
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Timelines
A timeline is a graphical device used to clarify
the timing of the cash flows for an investment
Each number represents one time period

PV
0

FV
1

Today
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Calculating the Future Value

Suppose that you have an extra Rs 100 today
that you wish to invest for one year. If you can
earn 10% per year on your investment, how
much will you have in one year?
100

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Calculating the Future Value (cont.)

Suppose that at the end of year 1 you decide to
extend the investment for a second year. How much
will you have accumulated at the end of year 2?

110

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Generalizing the Future Value

Recognizing the pattern that is developing, we can generalize the
future value calculations as follows:
FV = PV(1 + r)n
also

If you extended the investment for a

third year, you would have:

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Compound Interest
Note from the example that the future value
is increasing at an increasing rate
In other words, the amount of interest
earned each year is increasing
Year 1: Rs 10
Year 2: Rs 11
Year 3: Rs 12.10

The reason for the increase is that each year

you are earning interest on the interest that
was earned in previous years in addition to
the interest on the original principle amount
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Calculating the Present Value

So far, we have seen how to calculate
the future value of an investment
But we can turn this around to find the
amount that needs to be invested to
achieve some desired future value:

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Present Value: An Example

Suppose that your five-year old daughter has
just announced her desire to attend college.
After some research, you determine that you will
need about $100,000 on her 18th birthday to
pay for four years of college. If you can earn
8% per year on your investments, how much do
you need to invest today to achieve your goal?

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Non-annual Compounding
Suppose that you have Rs 1,000 available for
investment. You have compiled the following
table for comparison for the investment. In
which bank should you deposit your funds?

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Non-annual Compounding (cont.)

To solve this problem, you need to determine
which bank will pay you the most interest
In other words, at which bank will you have
the highest future value?
To find out, lets change our basic FV equation
slightly:

In this version of the equation m is the number of

compounding periods per year
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Non-annual Compounding (cont.)

We can find the FV for each bank as follows:

First National Bank:

Second National Bank:

Third National Bank:

Obviously, you should choose the Third National Bank
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The present value of a stream

of cash flows
Suppose that you won the lotto, paying you Rs 1,000,000
per year for 25 years. Now some dude offers to buy your
winning lotto ticket for Rs 15 million. Should you accept the
offer? (And lets ignore taxes here)
Well, we can use the present value formula 25 times, to
calculate the present value of each of the Rs 1,000,000
payments. Then we can add up the 25 results, to get the
present value of this stream of twenty-five Rs 1 million cash
flows. (We should accept the dudes Rs 15 million offer if it
is greater than the present value of the alternativethe 25
payments.)
A difficulty arises: what do we use for r the discount
rate? For now, lets just assume an 8% return.
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The present value contd..

For example:
PV of the first Rs1 million

Rs1 million

PV of the second Rs1 million

= Rs 925,926
In the handy table on the next page, the PVs of
all the 25 payments, at 8% discount rate are
presented.
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The present value contd..

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The result
The dudes offer of Rs15 million looks awfully
good, compared to the PV of the 25 payments
Rs 11.5 million!
In other words, if you take the dudes offer of
Rs 15 million and you earn an 8% return with it
then you will do much better than keeping the
lotto ticketaround Rs 3.5 million better in
todays dollars.

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Net Present Value Investment Decision

Now suppose that you are a firm thinking of making an
investment; it will cost money today, and will result in
higher revenue in the future. There will be a cash outflow
today, and cash inflows in the future.
You would like to evaluate the merits of this investment,
relative to alternate investments that you could make. The
net present value of the investment is the present
value of all of the cash outflows and inflows that
result from the investment.
If an investments net present value is positive, then it is a
superior investment relative to the average investment in
the economy. The higher an investments net present value,
the more superior it is relative to the average investment.
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NPV contd..
Example:
A machine costs Rs.1000 to buy. It will result in Rs.300 of
revenue at the end of each year, for 4 years. At the end
of the four years it can be sold for scrap for Rs.100. This
investment has five cash flows:

Let us use the present value formula to calculate the PV

of each of these cash flows. Then well add up the PVs to
get the Net Present Value (NPV).
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NPV contd..
One important question: what discount rate to
use? For now, lets just say that it is 11%.

The negative NPV tells us that we could do better

with an average investment elsewhere in the
economy, so this one doesnt look very good.

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Internal Rate of Return (IRR) Method

The internal rate of return of a project
is the discount rate that causes NPV to
equal zero. Formula:
n
n
Rt
Ot

t
t
(
1

r
)
(
1

r
)
t 1
t 0
Where, t = time period, n = last period of
project, Rt = cash inflow in the period of t,
Ot = cash outflow in the period of t, r = IRR
Rt
C0

t
t 1 (1 r )
n

Also

where, C0 = investment

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IRR contd..
The internal rate of return on an investment or
project is the "annualized effective
compounded return rate" or "rate of return"
that makes the net present value (NPV) of all
cash flows (both positive and negative) from a
particular investment equal to zero.
It can also be defined as the discount rate at
which the present value of all future cash flow
is equal to the initial investment
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IRR contd..
If the IRR is larger than the cost of
capital it signals acceptance. If the
IRR is less than the cost of capital the
proposed project should be rejected.
In other words,
If the IRR is greater than the cost of
capital, accept the project.
If the IRR is less than the cost of capital,
reject the project.
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Asymmetric information
Asymmetric information: market
situation in which one party in a
transaction has more information
than the other party. Leads to many
problems in markets:
too much or too little production
contracting can be difficult
Economic imbalances
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Asymmetric information
Adverse selection: it occurs before a
transaction takes place, one party
may know more about the value of a
good being offered than the others
Example: lemons (bad used
cars) seller knows the vehicle well,
but buyer does not, yet market does
not divide in two. It causes good car
to be sold at lower prices.
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Asymmetric information
Moral Hazard: this problem may
arise after the transaction has
occurred.
Example: it is common is
insurance because the firm can not
completely monitor the activities or
conditions of the insured.
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