flow of future benefit over a series of years.” The long-term activities are those activities which affect firms operation beyond the one year period. Capital budgeting is a many sided activity. It contains searching for new and more profitable investment proposals, investigating, engineering and marketing considerations to predict the consequences of accepting the investment and making economic analysis to determine the profit potential of investment proposal. The capital budgeting question is probably the most important issue in corporate finance. How a firm chooses to finance its operations (the capital structure question) and how a firm manages its short-term operating activities (the working capital question) are certainly issues of concern, but it is the fixed assets that define the business of the firm. Any firm possesses a huge number of possible investments. Each possible investment is an option available to the firm. Some options are valuable and some are not. The essence of successful financial management, of course, is learning to identify which are which. Popular methods of capital budgeting include net present value (NPV), internal rate of return (IRR), discounted cash flow (DCF) and payback period. Two approaches to making capital budgeting decisions use Discounted Cash Flow (DCF). One is the net present value method (NPV), and other is the internal rate of return method(also called the time adjusted rate of return method).

4.1 Cash Flows In capital budgeting decisions, the focus is on cash flows and not on accounting net income. The reason is that accounting net income is based on accruals that ignore the timing of cash flows into and out of an organization. From a capital budgeting standpoint, the timing of cash flows is important, since a dollar received today is more valuable than a dollar received in the future. Therefore, even though accounting net income is useful for many things, it is not ordinarily used in discounted cash flow analysis. Instead of determining accounting net income, the manager concentrates on identifying the specific cash flows of the investment project.

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What kind of cash flows should the manager look for? Although the specific cash flows will vary from project to project, certain type of cash flows tend to recur as explained in the following paragraphs.

4.1.1 Typical Cash Out Flows. Most projects will have an immediate cash outflows in the form of an initial investment or other assets. Any salvage value realized from the sale of the old equipment can be recognized as a cash inflow or as a reduction in the required investment. In addition, some projects require that a company expand its working capital. When a company takes on a new project, the balances in the current assets will often increase. For example, opening a new Nordstrom's department store would require additional cash in sales registers, increased accounts receivable for new customers, and more inventory to stock the shelves. These additional working capital needs should be treated as part of the initial investment in a project. Also, many projects require periodic outlays for repairs and maintenance and for additional operating costs. These should all be treated as cash outflows for capital budgeting purposes.

4.1.2 Typical Cash Inflows. On the cash inflow side, a project will normally either increase revenues or reduce costs. Either way, the amount involved should be treated as a cash inflow for capital capital budgeting purposes. Notice that so for as cash flows are concerned, a reduction in costs is equivalent to an increase in revenues. Cash inflows are also frequently realized from salvage of equipment when a project ends, although the company may actually have to pay to dispose of some low - value or hazardous items. In addition, any working capital that was tied up in the project can be released for use elsewhere at the end of the project and should be treated as a cash inflow at that time. Working capital is released, for example, when a company sells off its inventory or collects its receivables.

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4.2 Net Present Value (NPV) An investment is worth undertaking if it creates value for its owners. In the most general sense, we create value by identifying an investment worth more in the marketplace than it costs us to acquire It’s a case of the whole being worth more than the cost of the parts. The real challenge is to somehow identify ahead of time whether or not investing was a good idea in the first place. This is what capital budgeting is all about, namely, trying to determine whether a proposed investment or project will be worth more, once it is in place, than it costs. The difference between an investment’s market value and its cost is called the net present value of the investment, abbreviated NPV. In other words, net present value is a measure of how much value is created or added today by undertaking an investment. Given our goal of creating value for the stockholders, the capital budgeting process can be viewed as a search for investments with positive net present values. You can probably imagine how company would go about making the capital budgeting decision. It would first look at what comparable, fixed-up properties were selling for in the market. We would then get estimates of the cost of buying a particular property and bringing it to market. At this point, we would have an estimated total cost and an estimated market value. If the difference was positive, then this investment would be worth undertaking because it would have a positive estimated net present value. There is risk, of course, because there is no guarantee that our estimates will turn out to be correct. Investment decisions are greatly simplified when there is a market for assets similar to the investment we are considering. Capital budgeting becomes much more difficult when we cannot observe the market price for at least roughly comparable investments. The reason is that we are then faced with the problem of estimating the value of an investment using only indirect market information.

4.2.1 Estimating Net Present Value Imagine company is thinking of starting a business to produce and sell a new product. It can estimate the start-up costs with reasonable accuracy because we know what it will need to - 24 -

buy to begin production. It will first try to estimate the future cash flows we expect the new business to produce. It will then apply our basic discounted cash flow procedure to estimate the present value of those cash flows. Once it have this estimate, it will then estimate NPV as the difference between the present value of the future cash flows and the cost of the investment. This procedure is often called discounted cash flow (DCF) valuation. To see how we might go about estimating NPV, suppose we believe the cash revenues from our business will be $30 per year, assuming everything goes as expected. Cash costs will be $10 per year. We will wind down the business in 6 years. The plant, property, and equipment will be worth $50 as salvage at that time. The project costs $100 to launch. We use a 10 percent discount rate on new projects such as this one.

Table 1 Discount rate=

10%

Year Initial cost

0

1

2

3

4

5

6

-100

Salvage value

50

Cash infow

30

30

30

30

30

30

30

Cash outflow

-10

-10

-10

-10

-10

-10

-10

Net cash flow

20

20

20

20

20

20

20

Present value factor

1,00000

0,90909

0,82645

0,75131

0,68301

0,62092

0,56447

Present value cash flow

20,00

18,18

16,53

15,03

13,66

12,42

11,29

Total PV ofcash flow

107,11

+PV of savage value

28,22

28,2237

135,33 -Initial cost Net present value

- 100,00 35,33

From a purely mechanical perspective, we need to calculate the present value of the future cash flows at 10 percent. The net cash inflow will be $30 cash income less $10 in costs per year for eight years. These cash flows are illustrated in Table 1. As Table 1 suggests, we effectively have an six-year annuity of

$30 - 10 = $20

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per year, along with a single lump-sum inflow of $50 in six years. The total present value is:

6 30 50 100 Present value = ∑ + − = 135,33 6 0 i i = 0 (1 + 0,1) (1 + 0,1) (1 + 0,1)

When we compare this to the $100 estimated cost, we see that the NPV is:

NPV = 135,33 – 100 = 35,33

Therefore, this is a good investment. Based on our estimates, taking it would increase the total value of the stock by $35,33. Our example illustrates how NPV estimates can be used to determine whether or not an investment is desirable. From our example, notice that if the NPV is negative, the effect on share value will be unfavorable. If the NPV were positive, the effect would be favorable. As a consequence, all we need to know about a particular proposal for the purpose of making an accept-reject decision is whether the NPV is positive or negative.

4.2.2 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 such payback period and accounting rate of return. Also it is fairly easy to calculate. Disadvantage: It is based on estimated future cash flows of the project and estimates may be far from actual results.

4.3 Internal Rate Of Return (IRR) This approach seeks to identify the rate of return that an investment project yields on the basis of the amount of the original investment remaining outstanding during any period, compounding interest annually.

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4.3.1 Estimating Internal Rate Of Return A moment’s reflection should lead us to conclude that the IRR is closely related to the NPV discount rate. In fact the IRR of a project is the discount rate which if applied to the project yields a zero NPV. For example it is the solution, for i to the following expression − 120 69 69 + + =0 0 1 (1 + i ) (1 + i ) (1 + i ) 2

which could be solved using the standard solution to a quadratic equation, not a difficult matter, (The answer incidentally is i = 0,099, or 9.9 per cent.) When we look at a little bit complicated example the equation from which we must solve for i is: − 1000 300 300 300 300 300 + + + + + =0 0 1 2 3 4 (1 + i ) (1 + i ) (1 + i ) (1 + i) (1 + i ) (1 + i ) 5

Solving for i here is not so easy and in fact some iterative (trial and error) approach becomes the only practical one. One such method (involving differential calculus), Newton’s approximation, could he used. In practice however, we usually solve for i by trying various values of i until we find one which satisfies or almost satisfies the equation. We can calculate that the NPV of $137 when discounted at 10 per cent.

i= 0 1 2 3 4 5

CF - 1 000,00 300,00 300,00 300,00 300,00 300,00 NPV=

10,00% PV - 1 000 273 248 225 205 186 137 - 27 -

This tells us that it must have an IRR of above 10 per cent, because the higher the discount rate, the lower the present value of each cash flow. How much, above 10 per cent lies the IRR we do not know, so some higher discount rate needs to be tried, say 15 and 16 per cent. Referring to the 15 and 16 per cent we can calculate the following:

i= CF

15,00%

i=

PV

0 - 1 000,00

16,00%

CF

- 1 000

PV

0 - 1 000,00

- 1 000

1

300,00

261

1

300,00

259

2

300,00

227

2

300,00

223

3

300,00

197

3

300,00

192

4

300,00

172

4

300,00

166

5

300,00

149

5

300,00

143

NPV=

6

NPV= -

18

As the NPV when the cash flows are discounted at 16 per cent is negative and at 15 per cent is positive, we know that the discount rate which gives this project a zero NPV lies below 16 per cent and apparently close to the midpoint between 15 and 16 per cent. We can prove this by discounting at 15,5 per cent.

i= CF 0 - 1 000,00

15,50%

i=

PV - 1 000

15,25%

CF 0 - 1 000,00

PV -

1 000

1

300,00

260

1

300,00

260

2

300,00

225

2

300,00

226

3

300,00

195

3

300,00

196

4

300,00

169

4

300,00

170

5

300,00

146

5

300,00

148

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NPV= -

6

NPV=

0

As the NPV when the cash flows are discounted at 15,5 per cent is negative and at 15 per cent is positive, we know that the discount rate which gives this project a zero NPV lies between 15,0 per cent and 15,5 per cent. We can try discounting at 15, 25 per cent. An NPV is now close zero, so we can conclude that for practical purposes the IRR is 15,25 per cent. Where IRR is used to assess projects, the decision rule is that only those with an IRR above a predetermined hurdle rate would he accepted; where projects are competing, the project with the higher IRR is selected.

4.3.2 NPV and IRR The net present value (NPV) method has several important advantages over the internal rate of return (IRR) method. First the net present value method is often simpler to use. The internal rate of return method may require hunting for the discount rate that results in a net present value of zero. This can be a very laborious trial-and-error process, although it can be automated to some degree using a computer spreadsheet. Second, a key assumption made by the internal rate of return (IRR) method is questionable. Both methods assume that cash flows generated by a project during its useful life are immediately reinvested elsewhere. However, the two methods make different assumptions concerning the rate of return that is earned on those cash flow. The net present value method assumes the rate of return is the discount rate, whereas the internal rate of return method assumes the rate of return is the internal rate of return on the project. Specifically, it the internal rate of return of the project is high, this assumption may not be realistic. It is generally more realistic to assume that cash inflows can be reinvested at a rate of return equal to the discount rate - particularly if the discount rate is the company's cost of capital or an opportunity rate of return. If the discount rate is the company's cost of capital, this rate of return can be actually realized by paying off the company's creditors and buying back the company's stock with cash flows from the project.

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In short, when the net present value method and the internal rate of return method do not agree concerning the attractiveness of a project, it is best to go with the net present value method. Of the two methods, it makes the more realistic assumption about the rate of return that can be earned on cash flows from the project.

4.4 Payback Period. The payback is another method to evaluate an investment project. The payback method focuses on the payback period. The payback period is the length of time that it takes for a project to recoup its initial cost out of the cash receipts that it generates. This period is sometimes referred to as "the time that it takes for an investment to pay for itself." The basic premise of the payback method is that the more quickly the cost of an investment can be recovered, the more desirable is the investment. The payback period is expressed in years. When the net annual cash inflow is the same every year, the following formula can be used to calculate the payback period.

4.4.1 Formula / Equation: The formula or equation for the calculation of payback period is as follows:

Payback period = Investment required / Net annual cash inflow

To illustrate the payback method, consider the following example: The company needs a new milling machine. The company is considering two machines. Machine A and machine B. Machine A costs $15,000 and will reduce operating cost by $5,000 per year. Machine B costs only $12,000 but will also reduce operating costs by $5,000 per year. Machine A payback period = $15,000 / $5,000 = 3.0 years Machine B payback period = $12,000 / $5,000 = 2.4 years

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According to payback calculations, The company should purchase machine B, since it has a shorter payback period than machine A.

4.4.2 Evaluation of the Payback Period Method: The payback method is not a true measure of the profitability of an investment. Rather, it simply tells the manager how many years will be required to recover the original investment. Unfortunately, a shorter payback period does not always mean that one investment is more desirable than another. To illustrate, consider again the two machines used in the example above. since machine B has a shorter payback period than machine A, it appears that machine B is more desirable than machine A. But if we add one more piece of information, this illusion quickly disappears. Machine A has a project 10-years life, and machine B has a projected 5 years life. It would take two purchases of machine B to provide the same length of service as would be provided by a single purchase of machine A. Under these circumstances, machine A would be a much better investment than machine B, even though machine B has a shorter payback period. Unfortunately, the payback method has no inherent mechanism for highlighting differences in useful life between investments. Such differences can be very important, and relying on payback alone may result in incorrect decisions.

4.4.3 Criticism of payback method Criticism of payback method is that it does not consider the time value of money. A cash inflow to be received several years in the future is weighed equally with a cash inflow to be received right now. On the other hand, under certain conditions the payback method can be very useful. For one thing, it can help identify which investment proposals are in the "ballpark." That is, it can be used as a screening tool to help answer the question, "Should I consider this proposal further?" If a proposal does not provide a payback within some specified period, then there may be no need to consider it further. In addition, the payback period is often of great importance to new firms that are "cash poor."

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When a firm is cash poor, a project with a short payback period but a low rate of return might be preferred over another project with a high rate of return but a long payback period. The reason is that the company may simply need a faster return of its cash investment. And finally, the payback method is sometimes used in industries where products become obsolete very rapidly - such as consumer electronics. Since products may last only a year or two, the payback period on investments must be very short.

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