Summary of Last Lecture

1. Summary of Last Lecture • Discounted Cash Flows (DCF Analysis) • Annuities • Perpetuity

2. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES

3. Learning Objective • After going through this lecture, you would be able to have an understanding of the following concepts. • Capital Budgeting • Techniques of Capital Budgeting

4. Capital Budgeting • Today, we will discuss Capital Budgeting—one of the most important topics in financial management. • Capital budgeting is about investment in fixed assets. In addition, another type of investment could be in working capital, which we would study later. Fixed assets are the part of long-term assets in the balance sheet and working capital is net position of current assets and current liabilities on the balance sheet.

5. Capital Budgeting • We need to understand why capital budgeting is so important and why do we have to invest in fixed assets? The answer is simple; the equipment or machinery and other fixed assets depreciate over a period, they lose their productivity and get obsolete after sometime. These assets need to be replaced with new assets. This replacement involves investment in fixed assets.

6. Capital Budgeting • Moreover, if a company intends to start a new project, Capital Budgeting techniques are employed to assess the financial viability of the project. Suppose, for instance, a company wants to introduce a new soap and launching of the new product demands changes in the manufacturing process, the company will have to purchase new equipment in the form of fixed assets.

7. Capital Budgeting • Capital budgeting is a technique used to evaluate the value of investment and projects in fixed assets. It is also used to assess the working capital requirements. Combined together it helps the company management to decide whether the new venture should be taken up or not.

8. Capital Budgeting • Capital budgeting is a decentralized function. In big corporations, this function is not an individual’s job, rather, different departments and teams are assigned to work on different aspects of capital budgeting. Department managers prepare the budget for fixed assets in coming years, which is quite helpful in capital budgeting.

9. Capital Budgeting • Besides, there are project managers who make the budget for a new project; the cost accountants ‘count the cost’ and assess the expenses to be incurred; the market researches provide their input about the consumer psychology and sales potential. There may be as many departments involved in capital budgeting, as there are present in an organization.

10. Capital Budgeting • The biggest challenge in capital budgeting is to keep finding the valuable projects, i.e., projects that may add to the value of the firm. You must be familiar with the basic objective of financial management by now, which is to maximize shareholders’ wealth. This is possible only by investing in the projects, which have positive net present value, which in effect will increase the shareholders’ wealth.

11. Capital Budgeting • Most of the developed companies operate in an efficient market environment. We will discuss efficient markets at length after studying the concept of risk akin to financial decisions. However, to give you an idea, efficient markets can be described as highly competitive markets where good business ideas are taken up immediately.

12. Capital Budgeting • For instance, in Pakistan, about ten to fifteen years ago there was a video game craze. It was initially a good business idea, as it required a very low-level investment, good profit margins, and short payback periods.

13. Capital Budgeting • However, since the markets in Pakistan are quite efficient, the information about the business spread quickly. More and more people started entering into the business and as a result, the profit margins started shrinking and the lucrative business opportunity faded out in three or four years.

14. Capital Budgeting • The same situation comes across the departmental heads of different companies. They may start a new lucrative project, which may sound more than feasible at a given time. However, the competitors get to know the new business opportunity, and because of market efficiency, those lucrative profits do not remain lucrative anymore.

15. Techniques of capital budgeting: • Capital budgeting is a mathematical concept in the sense that we have to use different quantitative investments criteria to evaluate whether an opportunity is worth investing in or not. • Some of these techniques of capital budgeting are as under • 1. Pay back period • 2. Return on investment (ROI) • 3. Net Present Value (NPV) • 4. Profitability Index (PI) • 5. Internal Rate of Return (IRR)

16. Techniques of capital budgeting: • We will assume that the interest rate, or the discount rate, or the required of return, which we use in calculating the net present value is given, later on, when we will discuss the concept of risk, we would see how the discount rate is calculated . • For now, let us talk about the pay back period.

17. Pay back period: • In this technique, we try to figure out how long it would take to recover the invested capital through positive cash flows of the business. • Reverting back to the cafe example, an initial investment of Rs. 200,000 is required to start the business; Rs 10,000 per month are expected to be earned for the first year, and Rs 20,000 would be earned every month in the second year.

18. Pay back period: • Now according to the aforementioned assumptions, in the first year, you earn Rs.10, 000 per month, which make Rs. 120,000 for the year (twelve months). Since you had invested Rs. 200,000 initially of which Rs. 120,000 have been recovered in the first year, you are still Rs.80, 000 short of recovering your initial investment.

19. Pay back period: • In the second year, you would be earning Rs. 20,000 per month, so the remaining Rs. 80,000 can be recovered in the next four months. We can say that the initial invested capital can be recovered in 16 months, or the payback period for this investment is 16 months. The shorter the payback period of a project, the more an investor would be willing to invest his money in the project.

20. Pay back period: • While the payback period is a simple and straightforward method for analyzing a capital budgeting proposal, it has certain limitations. First and the foremost problem is that it does not take into account the concept of time value of money. The cash flows are considered regardless of the time in which they are occurring. You must have noticed that we have not used any interest rate while making calculation. • Now, let us talk about the next budgeting criteria called return on investment.

21. Return on Investments: • The concept of return on investment loosely defined, as there are a number of ratios that can be used to analyze return on investment. However, in capital budgeting it implies the annual average cash flow a business is making as a percentage of investment. In other words, it is an average percentage of investment recovered in cash every year.

22. Return on Investments: • The formula for return on investment is as follows: • ROI= (ΣCF/n)/I • Dividing the average annual cash flow by the initial investment, we can calculate the return on investment.

23. Return on Investments: • Taking the same example of a cafe, the initial investment of Rs.200,000, Rs 10,000 per month profit in the 1st year in Rs 20,000 per month profit for the second year, we can easily calculate the ROI. • ROI= ((120,000+240,000)/2)/200,000= 0.90 = 90% • Where, Rs 120,000=cash flow for 1st year at Rs 10,000 per month Rs 240,000=cash flow for the 2nd year at Rs 20,000 per month. n=2 years

24. Return on Investments: • Return on Investment is also very easy to calculate, but like payback period, it does not take into account the time value of money concept.

25. Net Present Value (NPV): • NPV is a mathematical tool which uses the discounting process, something that we have found missing in the aforementioned capital budgeting techniques. Net Present Value is defined as the value today of the Future Incremental After-tax Net Cash Flows less the initial investment. • The formula for calculating NPV is as follows:

26. Net Present Value (NPV): • NPV=-IO+ΣCFt/ (1+i) t • Where,CFt=cash flows occurring in different time periods • -IO= Initial cash outflow • i=discount /interest rate • t=year in which the cash flow takes place • Initial cash outflow, being an outflow, is always expressed as a negative figure.

27. Net Present Value (NPV): • NPV is considered one of the most popular capital budgeting criteria. The disadvantage with the NPV is that it is difficult to calculate since these calculations are based on too many estimates. • In order to calculate the NPV we need to forecast the future cash flows and sales; the discount factor is also an estimate. If the NPV of a project is more than zero, it should be accepted.

28. Net Present Value (NPV): • If two or more projects under contemplation, then the one with the higher NPV, should be accepted. When a company invests in projects with positive NPV, they raise the shareholders’ wealth or company’s value. This would also increase the market value added and the economic value added for the firm.

29. Net Present Value (NPV): • Example: • Taking the same example of a cafe, an initial investment of Rs.200, 000, Rs 10,000 per month profit in the 1st year in Rs 20,000 per month profit for the second year. However, for the calculation of the NPV we would be requiring another important input—the discount rate.

30. Net Present Value (NPV): • Assume the discount rate is 10 percent. Ten percent is what you at least expect to earn from the business. This is the rate of return, which you can get by simply putting your money with a bank. If the business cannot yield more than 10 percent, then it is pointless to take unnecessary headache of setting up a business and running it, since ten percent can be earned with a no-sweat-effort of placing the money with a bank.

31. Net Present Value (NPV): • Where,CFt=cash flows occurring in different time periods, i.e., Rs 120,000 in the first year and Rs • 240,000 in the second year • -IO= Initial cash outflow = -200,000 • i=discount /interest rate = 10 percent • t= 2 years

32. Net Present Value (NPV): • Putting in the values in the formula • NPV=-IO+ΣCF/i = -200,000+120,000/(1+0.10)+240,000(1+0.10)2 = - 200,000 + 109,091 + 198,347 =+Rs.107438

33. Net Present Value (NPV): • At the end of 2nd year, the NPV is +ve, you can also solve this example by monthly compounding if you want to have a more precise answer.

34. Net Present Value (NPV): • The cash flows at the end of the first year and second year will have to be brought back to the present. • The present value of the cash flows occurring at the end of the first year can be calculated by dividing the cash flows by 1 plus discount factor as under. • 120000/(1+0.10) = 109,091

35. Net Present Value (NPV): • The cash flow occurring at the end of the second year can be calculated by dividing the cash flow by one plus discount factor squared. • 240,000/1+(0.10)2 = 198,347 NPV=-2000000+120000/(1+0.10)+240000/(1+0.10) ^2 • =-200000+109091+198347 • =+Rs.107438 at the end of second year NPV is +ve

36. Net Present Value (NPV): • In other words, according to your cash flow forecast and required return, two years of running this business is worth Rs 107,438 in cash to you today. The following diagram can explain the point further.

37. Net Present Value (NPV):

38. Profitability Index: • It is quite similar to the NPV in terms of concept and calculation. Profitability index may be defined as the ratio of the present value of future cash flows to the initial investment. • The profitability index can be calculated using the following formula. • PI = [Σ CFt / (1+ i) t ]/ IO

39. Profitability Index: • Those projects with a profitability index ratio of more than one (PI >= 1.0) are considered • acceptable. Here it is important to mention that those projects, which are ranked as acceptable using the NPV method, would also be acceptable on the profitability index criteria.

40. Profitability Index: • Example: The profitability index for the cafe example can be calculated as under. • PI = [120,000]/ (1+ 0.1) + [240,000 / (1+ 0.1) ^ 2]/200,000 • = (109,091 + 198,347) / 200,000 = 1. 54 • PI = 1.54 > 1.0

41. Profitability Index: • Therefore, the project is acceptable. Notice that we have taken into consideration the annualized return. The same can be calculated using the monthly returns with a slight adjustment in the formula as we have studied in the previous lectures. If there were two or more projects that need ranking, the one with the highest profitability index would be acceptable.

42. Summary • Capital Budgeting • Techniques of Capital Budgeting

43. Next Lecture • NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR)