Documente Academic
Documente Profesional
Documente Cultură
Introduction
Capital Budgeting is the process of determining which real investment
C0
C1
C2
C
........
(1 r ) 0 (1 r )1 (1 r ) 2
(1 r )
Cash Flow
Cumulative Cash
Flow
(50)
(50)
10
(40)
13
(27)
16
(11)
19
22
30
Payback Period,
= 3+ (-11)/ 19
= 3+ 0.58
= 3.58 years
Value (NPV), Internal Rate of Return (IRR), and Profitability Index (PI)
.
Each requires estimates of expected cash flows (and their timing) f
or the project.
Including cash outflows (costs) and inflows (revenues or saving
s) normally tax effects are also considered.
Each requires an estimate of the projects risk so that an appropriat
e discount rate (opportunity cost of capital) can be determined.
Sometimes the above data is difficult to obtain this is the main weak
NPV C0
C1
C2
C
......
(1 r ) (1 r ) 2
(1 r )
NPV: Example
Examples: Details of two projects investments and returns are given
below:
Particulars
Project A
Project B
C0
tk. 40,000
tk. 40,000
C1
14,000
22,000
C2
16,000
20,000
C3
18,000
18,000
C4
20,000
16,000
C5
25,000
17,000
If discount rate is 10%, the PV factors for (1-5) years are .909,.826,.75
1,.683 and .621 respectively.
The Bad:
Rejecting an investment when it should be accepted
The Ugly:
Accepting an investment when it should be rejected
C1
C2
C
0 C0
........
1
2
(1 irr ) (1 irr )
(1 irr )
IRR: Example
Example: A project costs tk. 36,000 and is expected to generate cash i
nflows of tk. 11,200 annually for 5 years. Calculate the IRR of the proje
ct.
The payback period is (tk. 36,000/tk. 11,200) 3.214.
According to factor tables, the factors closest to 3.214 for 5 years are 3
.274 (16% ) and 3.199 (17%).
So, PV (16%) tk. 11,200*3.274 = tk. 36,668.8
PV (17%). Tk.11,200 *3.199= tk. 35,828.8
So, IRR = 16 36668.8 36000 *1
36668.8 35828.8
= 16.8%
IRR: Weakness
Multiple rates of return: Helmsley Iron is proposing to develop a new
strip mine in Western Australia. The project has the following payoffs.
Cash Flows ( Billions of Australian Dollars)
C0
C1
C9
C10
-3
-6.5
NPV at 10%
$ A 253 Million
IRR :Weakness
Mutually Exclusive Projects: Helmsley Iron is proposing to develop a
new strip mine in Western Australia. The project has the following payoff
s.
Cash Flows ($)
Project
C0
C1
IRR (%)
NPV at 10%
-10000
+20000
100
+ 8182
-20000
+35000
75
+ 11,818
PVFCIFs
PI
CF0
Decision Criterion Using PI
For independent projects: Accept all projects with PI greater than one (this is i
dentical to the NPV rule).
For mutually exclusive projects: Among the projects with PI greater than one,
accept the one with the highest PI.
Weaknesses
Requires knowledge of finance to use.
It is possible that PI cannot be used if the initial cash flow is an inflo
w.
Method needs to be adjusted when there are mutually exclusive pr
ojects.
Project
Investment
($ Million)
NPV
($ Million)
Profitability
Index
10
21
2.1
16
3.2
12
2.4