Recall The Flows of Funds and Decisions Important To The Financial Manager

Recall the Flows of funds and decisions important to the financial manager
Investment Decision Project
Financing Decision Financial Markets
Financial Manager
Returns from Investment
Returns to Security Holders
Capital Budgeting is used to make the Investment Decision
Capital Bugeting
Capital budgeting Also known as INVESTMENT APPRAISAL, is the planning process used to determine whether an organization's long term investments, major capital, or expenditures are worth pursuing For example : Purchase of new equipment Rebuilding Existing equipment Expansion in products Launching new Franchises/Outlets Constructing additions to buildings etc.
The large amounts spent for these types of projects are known as Capital expenditures.
Capital Budgeting decision

A Capital Budgeting decision rule should satisfy the following criteria:
Must
consider all of the project's cash flows. Must consider the Time Value of Money Must always lead to the correct decision when choosing among Mutually Exclusive Projects
TIME VALUE MONEY

Time value of money says that a dollar today is worth more than a dollar tomorrow. Because of this we need a way to Convert future dollars into their equivalent present value. P Where: P = the present value F = the future value i = the rate of return = F (1 + i)n
Project Classification
Capital Budgeting projects are classified:
Independent Projects Mutually Exclusive Projects.

An Independent Project is a project whose cash flows are not affected by the accept/reject decision for other projects. Thus, all Independent Projects which meet the Capital Budgeting criterion should be accepted. Mutually Exclusive Projects are a set of projects from which at most one will be accepted. In Mutually Exclusive Projects more than one project may satisfy the Capital Budgeting criterion. However, only one the best project can be accepted.
Techniques of Capital Budgeting

Net Present Value Internal Rate of Return Payback period Profitability Index
NET PRESENT VALUE
Using a minimum rate of return known as the hurdle rate, the net present value of an investment is the present value of the cash inflows minus the present value of the cash outflows. A more common way of expressing this is to say that the net present value (NPV) is the present value of the benefits (PVB) minus the present value of the costs (PVC)
NPV = (Cash inflows from Investment) (cash outflows or costs of investment)
So $1,000 now is the same as $1,100 next year (at 10% interest).
Bigger Example
The example below illustrates the calculation of Net Present Value
Consider Capital Budgeting projects A and B which yield the following

cash flows over their five year lives. The cost of capital for the project is 10%. YEAR CASH FLOW Project (A) $ 0 1 2 3 4 -1000 500 400 200 200 CASH FLOW Project (B) $ -1000 100 200 200 400
100
700
NPV= Project (A)

500/(1+.10)1 + 400/(1+.10)2 + 200/(1+.10)3 + 200/(1+.10)4 + 100/(1+.10)5 - 1000
NPV= 134.08 $ NPV = Project (B)

100/(1+.10)1 + 200/(1+.10)2 + 200/(1+.10)3 + 400/(1+.10)4 + 700/(1+.10)5 - 1000
NPV= 114.31 $ Which Project Should be Accepted ?
Decision Rule

Accept the project only if its NPV is positive or zero & Reject the project having negative NPV. If the projects are mutually exclusive having positive NPVs, accept the one with highest NPV.
In our Scenario
Project (A) NVP = 134.08 $ Project (B) NVP = 114.31 $
There Projects have Mutually exclusive so we accept Project (A) Because it has highest NVP
Advantage and Disadvantage of NPV

Advantage:
Net present value accounts for time value of money. Thus it is more reliable than other investment appraisal techniques which do not discount future cash flows such payback period and accounting rate of return.
Disadvantage:
It is based on estimated future cash flows of the project and estimates may be far from actual results.
Internal Rate of Return

The Internal Rate of Return (IRR) is the rate of return that an investor can expect to earn on the investment. Internal rate of return (IRR) is the discount rate at which the net present value of an investment becomes zero. Technically, it is the discount rate that causes the present value of the benefits to equal the present value of the costs.
According to surveys of businesses, the IRR method is actually the most commonly used method for evaluating capital budgeting proposals. This is probably because the IRR is a very easy number to understand because it can be compared easily to the expected return on other types of investments (savings accounts, bonds, etc.). If the internal rate of return is greater than the Interpretation project's minimum rate of Project return, we Test Result would > PVC theThe project is expected to earn Accepted tendPVB to accept project.
more than the percentage rate used for the test PVB < PVC The project is expected to earn less than the percentage rate used for the test Rejected
Lets Take an Example :
Assume A Company Madina sugar mill must decide whether to purchase a piece of factory equipment or not :
Equipment Price > Rs.300,000 Life Span > 3 Expected Annual Profit > Rs.150,000 Sell the equipment for scrap afterward > Rs.10,000. Using IRR, Rate of return about 10%.
How to Know about the IRR rate :

The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR, Net Present Value (NPV) is zero, thus: NPV = 0 OR NPV Formula = 0 OR PV of future cash flows Initial Investment = 0
Lets suppose Initial cash outflow of $213,000. The cash inflows during the first, second, third and fourth years are expected to be $65,200, $96,000, $73,100 and $55,400 respectively. Solution Assume that r is 10%. NPV at 10% discount rate = $18,372 Since NPV is greater than zero we have to increase discount rate, thus NPV at 13% discount rate = $4,521 But it is still greater than zero we have to further increase the discount rate, thus NPV at 14% discount rate = $204 NPV at 15% discount rate = ($3,975) Since NPV is fairly close to zero at 14% value of r, therefore IRR 14%
In Our Case (Madina Sugar Mill)
IRR rate at which Net present value become 0 is 24.13 % IRR equation looks in this scenario:
0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431)2 + ($150,000)/(1+.2431)3 + $10,000/(1+.2431)4
24.13% > 10 %
Sugar Mill must purchase that equipment because its IRR is greater than the rate of investment return which is 10 percent
Advantage :
If there is only project which we have to select, if we check its IRR and it is higher than its cut off rate, then it will give maximum profitability to shareholder
Dis-advantage :

To understand IRR is difficult Unrealistic assumption
Which Method Is Better: the NPV or the IRR?

The NPV is better than the IRR. It is superior to the IRR method for at least two reasons: Reinvestment of Cash Flows:
The NPV method assumes that the project's cash inflows are reinvested to earn the hurdle rate; the IRR assumes that the cash inflows are reinvested to earn the IRR. Of the two, the NPV's assumption is more realistic in most situations since the IRR can be very high on some projects.
Multiple
Solutions for the IRR:
It is possible for the IRR to have more than one solution. If the cash flows experience a sign change (e.g., positive cash flow in one year, negative in the next), the IRR method will have more than one solution. In other words, there will be more than one percentage number that will cause the PVB to equal the PVC.
Pay-Back Period
Payback period is the time in which the initial cash outflow of an investment is expected to be recovered from the cash inflows generated by the investment.
The Simplest Technique of Investment Appraisal
Consider Capital Budgeting project A which yields the following cash flows over its five year life
YEAR 0 1 2
CASHFLOW -1000 500 400
NET CASH FLOW -1000 -500 -100
3
4
200
200
100
300
100
400
Notice that after two years the Net Cash Flow is negative (-1000 + 500 + 400 = -100) while after three years the Net Cash Flow is positive (-1000 + 500 + 400 + 200 = 100). Thus the Payback Period, or breakeven point, occurs sometime during the third year.
Apply Formula :
Payback Period = 2 + (100)/(200) = 2.5 years Thus, the project will recoup its initial investment in 2.5 years. Decision Criteria : Independent Projects : Accept Lowest PBP Mutually exclusive : Accept the project who has Less PBP
Drawbacks of PBP
Does
not account for TVM Does not consider all cash flows It does not take into account, the cash flows that
occur after the payback period.
Profitability Index
The profitability index of an investment by a company is an indication of the costs and benefits of investing in a particular capital project by a business firm. 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.
PI = 1 The projects benefits are expected to equal its costs. PI < 1 The projects costs are expected to exceed its benefits; reject the project. PI > 1 The projects benefits are expected to exceed its costs; accept the project.
EXAMPLE :
The Company manager is deciding whether the company should open a new Profit Center or not? They expect income from the project to total $5,000,000. The profit center will also cost a total of $10,000,000 to build. What should he choose? If: Present value of cash inflows for the project = $5,000,000 Present value of cash outflows for the project = $10,000,000
Profitability Index = PV of Cash Inflows / PV of Cash Outflows Profitability Index = $5,000,000 / $10,000,000 = .5
The profitability index of the project is studying is .5. This is less than 1 so He rejects to build a profit center

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Recall the Flows of funds and decisions important to the financial manager

Investment Decision Project

Financing Decision Financial Markets

Returns from Investment

Returns to Security Holders

Capital Budgeting is used to make the Investment Decision

Capital Budgeting decision

TIME VALUE MONEY

Independent Projects Mutually Exclusive Projects.

Techniques of Capital Budgeting

NET PRESENT VALUE

NPV = (Cash inflows from Investment) (cash outflows or costs of investment)

Consider Capital Budgeting projects A and B which yield the following

NPV= Project (A)

NPV= 134.08 $ NPV = Project (B)

NPV= 114.31 $ Which Project Should be Accepted ?

Advantage and Disadvantage of NPV

Internal Rate of Return

Lets Take an Example :

How to Know about the IRR rate :

In Our Case (Madina Sugar Mill)

0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431)2 + ($150,000)/(1+.2431)3 + $10,000/(1+.2431)4

To understand IRR is difficult Unrealistic assumption

Which Method Is Better: the NPV or the IRR?

Solutions for the IRR:

The Simplest Technique of Investment Appraisal

CASHFLOW -1000 500 400

NET CASH FLOW -1000 -500 -100

occur after the payback period.

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