UNIT -5

FINANCE MANAGEMENT

By
V. Kamala
Asst Prof
DOIE, Anna University
Capital Budgeting

◼ Capital Budgeting involves a current

investment in which the benefits are
expected to be received beyond one year.
▪ Heavy investments
▪ Long Term commitment of funds
▪ Irreversible Decision
▪ Most difficult to make
Benefit Measurement Methods

◼ Time Value of Money (TVM) Method

◼ Net Present Value
◼ Benefit/Cost Ratio
◼ Internal Rate of Return
◼ Payback Period
◼ Average Rate of return
Future Value of a Single Sum of
Money
◼ Future value of a present single sum of
money is the amount that will be obtained in
future if the present single sum of money is
invested on a given date at the given rate of
interest. The future value is the sum of
present value and the compound interest.
Time Value of Money (TVM) Method

FV = PV(1 + i)n
where: FV = Future Value of an investment (project)
PV = Present Value of that same investment
i = Interest rate, discount rate or cost of capital
n = Number of years
Example:
Invest $1000 today (PV)
for 1 year(n)
at an interest rate of 10% (i).
As a result, the investment is worth
$1000(1+.1)1 = $1,100 at the end of project year # 1,
$1000(1+.1)2 = $1210 at the end of project year # 2, etc.
What happens when you have two different investments (2 different projects)
with varying rates of return?
We need to adequately compare those 2 projects on equal terms (or, the same
basis) !
Time Value of Money Method:
Discount Rates
You put both on equal terms by changing the
formula slightly to evaluate all future cash flows at
time zero or today
PV = FV / (1+i) n
Example:
◼ You have a project that promises you $1000 of
profit at the end of the first year.
◼ Discount rate is 10%. So, Present Value (today)
of project is
◼ PV = $1,000/ = $909
(1+0.1)1
◼ The project is worth only $909 today
Net present value (NPV)
Net present value is the difference between the present value of cash
inflows and the present value of cash outflows that occur as a result of
undertaking an investment project. It may be positive, zero or negative.
These three possibilities of net present value are briefly explained below:
Positive NPV:
◼ If present value of cash inflows is greater than the present value of the
cash outflows, the net present value is said to be positive and the
investment proposal is considered to be acceptable.
Zero NPV:
◼ If present value of cash inflow is equal to present value of cash outflow,
the net present value is said to be zero and the investment proposal is
considered to be acceptable.
Negative NPV:
◼ If present value of cash inflow is less than present value of cash outflow,
the net present value is said to be negative and the investment proposal
is rejected.
◼ Projects with a positive NPV should be
considered if financial value is a key criterion

◼ Generally, the higher the NPV, the better

Discounted Cash flow/NPV

n
Ft
Σt=
(1 + t
k)
1
Determines the NPV of all cash flows by discounting them by
required rate of return.

Ft=net cash flow in period t

k=required rate of return
I0=Initial cash investment
Benefit/Cost Ratio

Profitability Index = Present value of expected cash flows

Initial investment

Profitability index is the ratio of payoff to investment of a

proposed project.
Question

◼ Consider the following 2 projects-

Project A Project B
Initial value of investment Rs. 5,00,000 Rs.11,00,000
Present value of cash inflows Rs.6,00,000 Rs. 12,50,000
NPV Rs.1,00,000 Rs. 1, 50,000

Which model will you chose to evaluate the 2 projects. Why

Solution

◼ Comparing NPV, project B will score high.

◼ However, NPV is only an absolute figure.
◼ For an investment of 5Lakh, Project A offers NPV of Rs. 1 lakh,
whereas for investment of 11 lakh, B offers NPV of 1.5 lakh.
◼ In such a situation, PI is a better indicator.
◼ PI=PV of cash flow/Initial cash outflow.
◼ PI for A=1.200 and PI for B=1.136
◼ Since PI of A is more than that of B, A is a better project.
Payback period

Payback Period = Initial fixed investment

Estimated annual net cash inflow

◼ It is the no. of years required for the project to repay the

initial fixed investment.
◼ The faster the investment recovered, the less the risk.
Advantages and Disadvantages
Advantages of payback period are:
◼ Payback period is very simple to calculate.
◼ It can be a measure of risk inherent in a project. Since cash flows that
occur later in a project's life are considered more uncertain, payback
period provides an indication of how certain the project cash inflows are.
◼ For companies facing liquidity problems, it provides a good ranking of
projects that would return money early.
Disadvantages of payback period are:
◼ Payback period does not take into account the time value of
money which is a serious drawback since it can lead to wrong decisions.
A variation of payback method that attempts to remove this drawback is
called discounted payback period method.
◼ It does not take into account, the cash flows that occur after the payback
period.
Average Rate of Return or acounting rate of return

Average rate of return = Average accounting profit

avg. investment

Average accounting profit is the arithmetic mean of accounting

income expected to be earned during each year of the project's life
time. Average investment may be calculated as the sum of the
beginning and ending book value of the project divided by 2. Another
variation of ARR formula uses initial investment instead of average
investment.
◼ Accept the project only if its ARR is equal to or greater than the
required accounting rate of return. In case of mutually exclusive
projects, accept the one with highest ARR.
Problem 1
◼ An initial investment of $130,000 is expected to generate
annual cash inflow of $32,000 for 6 years. Depreciation is
allowed on the straight line basis. It is estimated that the
project will generate scrap value of $10,500 at end of the 6th
year. Calculate its accounting rate of return assuming that
there are no other expenses on the project.
◼ Solution
Annual Depreciation = (Initial Investment − Scrap Value) ÷
Useful Life in Years
Annual Depreciation = ($130,000 − $10,500) ÷ 6 ≈ $19,917
Average Accounting Income = $32,000 − $19,917 = $12,083
Accounting Rate of Return = $12,083 ÷ $130,000 ≈ 9.3%
Problem 2

◼ Compare the following two mutually exclusive projects on

the basis of ARR. Cash flows and salvage values are in
thousands of dollars. Use the straight line
depreciation method.
Solution
Internal Rate of Return (IRR)

IRR=discount rate that equates the present values of the cash

inflows and outflows.
IRR is simply the rate of return that the firm earns on its capital
budgeting projects.

n
CFt
IRR:
IO
(1 +
t= IRR)
Σ t =

1
◼ Step 1: Select 2 discount rates for the calculation of NPVs
You can start by selecting any 2 discount rates on a random
basis that will be used to calculate the net present values in
Step 2.
◼ Step 2: Calculate NPVs of the investment using the 2
discount rates
◼ Step 3: Calculate the IRR
Using the 2 discount rates from Step 1 and the 2 net
present values derived in Step 2, you shall calculate the IRR by
applying the IRR Formula stated below.
 Internal Rate of Return

Internal Rate of NPV1 x (R2 - R1)

Return = R1 + (NPV1 - NPV2)

Where:
R1 = Lower discount rate
R2 = Higher discount rate
NPV1 = Higher Net Present Value (derived from R1)
NPV2 = Lower Net Present Value (derived from R2)
IRR

◼ The decision rule for IRR is that an

investment should only be selected where
the cost of capital (WACC) is lower than the
IRR
 Example
Mr. A is considering investing $250,000 in a business.
The cost of capital for the investment is 13%.
Following cash flows are expected from the investment:
Calculate the IRR for the proposed investment and interpret your
answer.
R1 = 10% R2 =20 %
NPV 1= (50000/(1+0.10))+ (100000/1.10^2)+(200000/1.10^3). - 250000
=28,250
NPV 2 = (50000/(1+0.20))+ (100000/1.20^2)+(200000/1.20^3). – 250000=-23,150
Year $
0 (250,000)
1 50,000
2 100,000
3 200,000
We can take 10% (R1) and 20% (R2) as our discount rates.
Step 2: Calculate NPVs of the investment using the 2 discount rates
Net Present Value @ 10% Net Present Value @ 20%

Cash Discoun Present Cash Discoun Present

Flow t Factor Value Flow t Factor Value
A B AxB A B AxB
(250,000 (250,000 (250,000 (250,000
1.000 1.000
) ) ) )
50,000 0.909 45,450 50,000 0.833 41,650
100,000 0.826 82,600 100,000 0.694 69,400
200,000 0.751 150,200 200,000 0.579 115,800
NPV1 28,250 NPV2 -23,150
Step 3: Calculate the IRR
Internal Rate of Return = R1% + NPV1 x (R2 - R1)% /
(NPV1 - NPV2)
= 10% + 28,250 x (20 - 10)% / (28,250 - (- 23,150))
= 10% + 28,250 x 10%/ (28,250 + 23,150)
= 10% + 5.5%
= 15.5%