Capital Budgeting Decisions By Heena Malhotra
Payback Period Traditional or Non Discounting ccounting Rat of Return (ARR) Capital Budgeting Techniques Net Present Value (NPV) Profitability Index (PI) Time adjusted or Discounted Cash Flows Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Discounted Payback By Heena Malhotra
Net present value Present value of net cash inflow - Total net initial investment Since it might be possible that some additional investment may also be required during the life time of the project then appropriate formula shall be: Net present value = Present value of cash inflow-Present value of cash outflow It can be expressed as below: Cn a+k a+k" (kp t-I C Cash flow of various years K discount rate N Life of the project I Investment By Heena Malhotra
NPV PVC1 - PVCo By Heena Malhotra
Compute the net present value for a project with a net investment o 1, 00,000 and net cash flows year one is 55,000; for year two is 80,000 and for year three is 15,000 Further, the company's cost of capital is 10%? [PVIF @ 10% for three years are 0.909, 0.826 and 0.751] SOLUTION Year Net Cash PVIF @ 10% 0 (1,00,000) 1.000 0.909 0.826 0.751 Discounted Cash Flows (1,00,000) 49,995 66,080 11,265 27,340 Flows 55,000 80,000 15,000 2 3 Net Present Value Recommendation: Since the net present value of the project is positive, the company should accept the project. By Heena Malhotra
NPV PVCI - PVCo 127340-100000-27340 By Heena Malhotra
Decision Rule: If NPV 20LAccept the Proposal If NPV s0 Reject the Proposal The NPV method can be used to select between mutually exclusive projects, the one with the higher NPV should be selected By Heena Malhotra
ABC Ltd is a small company that is currently analyzing capital expenditure proposals for the purchase of equipment; the company uses the net present value technique to evaluate projects. The capital budget is limited to 500,000 which ABC Ltd believes is the maximum capital it can raise. The initial investment and projected net cash flows for each project are shown below. The cost of capital of ABC Ltd is 12%. You are required to compute the NPV of the different projects. Project A Project B Project C Project D 200,000 190,000 250,000 210,000 Initial Investment Project Cash Inflows Year 1 50,000 40,000 75,00075,000 75,000 60,000 40,000 20,000 50,00050,000 50,000 50,000 50,000 75,000 60,000 80,000 75,000 100,000 2 70,000 75,000 4 5 By Heena Malhotra
SOLUTION Calculation of net present value: Period PV factor Project A Project B Project C Project D 0.893 0.797 0.712 0.636 0.567 1.000 (2,00,000) (1,90,000) (2,50,000) (2,10,000) 35,720 39,850 49,840 47,700 42,525 25,635 44,650 39,850 35,600 31,800 28,350 (19,750) 66,975 59,775 42,720 42,720 50,880 56,700 27,050 3.750 66,975 59,775 25,440 11,340 4 Net Present Value By Heena Malhotra
Present value interest factor of 1 per period at i% for n periods, PVIF(i,n). 0.980 0.97 0.962 0.952 0.943 0.935 0.926 0.917 0.909 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 0.942 0.915 0.889 0.924 0.888 0.855 0.9060.8630.822 0.784 07470.7130.681 0.650 0.621 0.888 0.837 0.790 0.7 0.990 2 0.980 3 0.971 4 0.961 5 0.951 6 0.942 7 0.933 0.871 0.813 0.760 0.711 0.665 .623 0.583 0.547 0.513 8 0.923 9 0.864 0.823 0.840 0.816 0.794 0.772 0.751 0.792 0.763 0.735 0.708 0.683 46 0.705 0.666 0.630 0.596 0.564 0.853 0.789 0.731770.627 0.582 0540 0.502 0.467 0.837 0.766 0.703 0.914 0.592 0.5440.500 0.460 0.424 0.558 0.508 0.463 0422 820 0.744 0.676 0.614 0.804 0.722 0.650 0.5 0.788 0.701 0.625 0.5570.497 0.4440.397 0.356 0.319 0.773 0.681 0.601 0.758 0.661 0.577 0.50 0.743 0642 0.555 0481 0417 0.362 0.315 0.275 0.239 0.728 0.623 0.534 0.714 0.605 0.513 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 0.180 0.896 120.887 13 0.879 14 0.870 85 0.527 0.475 0.429 0.388 0.350 0.530 0.469 0.415 0.368 0.326 0.290 0.442 0.388 0.340 0.299 0.263 16 0.853 17 0.844 18 0.836 0.458 0.436 0.394 0.339 0.292 0.252 0.218 0.371 0.317 0.270 0.231 0.198