Powered by Prime Academy

In pursuit of excellence
Compiled by: M. Sathya Kumar

Concepts of Capital Budgeting
Time Value of Money

The idea that money available at the present time is worth more than
the same amount in the future, due to its potential earning capacity.
This core principle of finance holds that, provided money can earn
interest, any amount of money is worth more the sooner it is received.
Also referred to as "present discounted value".

Everyone knows that money deposited in a savings account will earn
interest. Because of this universal fact, we would prefer to receive
money today rather than the same amount in the future.
For example, assuming a 5% interest rate, $100 invested today will be
worth $105 in one year ($100 multiplied by 1.05). Conversely, $100
received one year from now is only worth $95.24 today ($100 divided
by 1.05), assuming a 5% interest rate.
Payback Period
The length of time required to recover the cost of an investment.
Calculated as:


All other things being equal, the better investment is the one with the
shorter payback period.

For example, if a project cost $100,000 and was expected to return
$20,000 annually, the payback period would be $100,000 / $20,000, or
five years.

All other things being equal, the better investment is the one with the
shorter payback period.
For example, if a project cost $100,000 and was expected to return
$20,000 annually, the payback period would be $100,000 / $20,000, or
five years.

There are two main problems with the payback period method:

1) It ignores any benefits that occur after the payback period and,
therefore, does not measure profitability.
2) It ignores the time value of money.
Because of these reasons, other methods of capital budgeting like net
present value, internal rate of return or discounted cash flow are
generally preferred.

Net Present Value (NPV)

The difference between the present value of cash inflows and the
present value of cash outflows. NPV is used in capital budgeting to
analyze the profitability of an investment or project.

NPV analysis is sensitive to the reliability of future cash inflows that an
investment or project will yield.

Formula:

NPV compares the value of a dollar today to the value of that same
dollar in the future, taking inflation and returns into account. If the NPV
of a prospective project is positive, it should be accepted. However, if
NPV is negative, the project should probably be rejected because cash
flows will also be negative.

For example, if a retail clothing business wants to purchase an existing
store, it would first estimate the future cash flows that store would
generate, and then discount those cash flows into one lump-sum
present value amount, say $565,000. If the owner of the store was
willing to sell his business for less than $565,000, the purchasing
company would likely accept the offer as it presents a positive NPV
investment. Conversely, if the owner would not sell for less than
$565,000, the purchaser would not buy the store, as the investment
would present a negative NPV at that time and would, therefore, reduce
the overall value of the clothing company


The discount rate often used in capital budgeting that makes the net
present value of all cash flows from a particular project equal to zero.
Generally speaking, the higher a project's internal rate of return, the
more desirable it is to undertake the project. As such, IRR can be used
to rank several prospective projects a firm is considering. Assuming all
other factors are equal among the various projects, the project with the
highest IRR would probably be considered the best and undertaken
first.

Internal Rate Of Return (IRR)

IRR is sometimes referred to as "economic rate of return (ERR)".

You can think of IRR as the rate of growth a project is expected to
generate. While the actual rate of return that a given project ends up
generating will often differ from its estimated IRR rate, a project with a
substantially higher IRR value than other available options would still
provide a much better chance of strong growth.

IRRs can also be compared against prevailing rates of return in the
securities market. If a firm can't find any projects with IRRs greater
than the returns that can be generated in the financial markets, it may
simply choose to invest its retained earnings into the market.

Discounted Cash Flow (DCF)

A valuation method used to estimate the attractiveness of an
investment opportunity. Discounted cash flow (DCF) analysis uses
future free cash flow projections and discounts them (most often using
the weighted average cost of capital) to arrive at a present value, which
is used to evaluate the potential for investment. If the value arrived at
through DCF analysis is higher than the current cost of the investment,
the opportunity may be a good one.

Calculated as:


There are many variations when it comes to what you can use for your
cash flows and discount rate in a DCF analysis. Despite the complexity
of the calculations involved, the purpose of DCF analysis is just to
estimate the money you'd receive from an investment and to adjust for
the time value of money.
DCF models are powerful, but they do have shortcomings. DCF is
merely a mechanical valuation tool, which makes it subject to the
axiom "garbage in, garbage out". Small changes in inputs can result in
large changes in the value of a company. Instead of trying to project
the cash flows to infinity, a terminal value approach is often used. A
simple annuity is used to estimate the terminal value past 10 years, for
example. This is done because it is harder to come to a realistic
estimate of the cash flows as time goes on.

Profitability Index

An index that attempts to identify the relationship between the costs
and benefits of a proposed project through the use of a ratio calculated
as:



A ratio of 1.0 is logically the lowest acceptable measure on the index.
Any value lower than 1.0 would indicate that the project's PV is less
than the initial investment. As values on the profitability index increase,
so does the financial attractiveness of the proposed project.

NPV and IRR Methods: Possible Decision Conflicts
An accept/reject "conflict" occurs when NPV says "accept" and IRR says
"reject" or NPV says "reject" and IRR says "accept"
Note:
When projects are independent, no accept/reject conflict will arise
A ranking conflict occurs when one project has a higher NPV than
another while the lower NPV project has a higher IRR.
Note: Ranking conflicts are unusual but can occur. These conflicts are
relevant only when there are multiple acceptable mutually exclusive
projects
Ranking conflicts arise because of:
1) Timing differences in incremental cash flows
2) Magnitude differences in incremental cash flows
When a conflict arises among mutually exclusive projects, pick the one
with the highest NPV



M. Sathya Kumar E-mail : [email protected]. Contact No.:
+919884492226


Disclaimer: We believe that the information contained in this e-zine is true. If you do not wish
to receive Smart Trainee please click here.
Prime Academy - In Pursuit of excellence


Click here to contact us, if you are unable to view the content properly