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Financial Management Session 11

The document discusses various capital budgeting techniques: 1. It provides an example of calculating the profitability index (PI) of two projects, with Project B having a higher PI of 1.97 compared to Project A's PI of 1.71, and thus being the better investment. 2. It shows calculations of PI at different discount rates of 10%, 15%, and 22% and discusses selecting the discount rate at which a project's PI is equal to or greater than 1. 3. It defines payback period analysis as the time required to recover the initial investment and discusses its pros and cons as a quick but less accurate method compared to more sophisticated techniques.

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60 views

Financial Management Session 11

The document discusses various capital budgeting techniques: 1. It provides an example of calculating the profitability index (PI) of two projects, with Project B having a higher PI of 1.97 compared to Project A's PI of 1.71, and thus being the better investment. 2. It shows calculations of PI at different discount rates of 10%, 15%, and 22% and discusses selecting the discount rate at which a project's PI is equal to or greater than 1. 3. It defines payback period analysis as the time required to recover the initial investment and discusses its pros and cons as a quick but less accurate method compared to more sophisticated techniques.

Uploaded by

vaidehirajput03
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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Capital Budgeting

Session 11
Question 2

• From the following data, compute the number of dollars returned for
every dollar invested. Recommend which is the best investment
proposal.
Solution
Question 3

• Using the following information compute the PI of each project, identify


the best project to pursue and give reasons for your answer
Solution

Year Project A Project B


0 -10000 -7000
1 5000 9000
2 7000 5000
3 9000 2000
NPV @ 10% $ 7,092.41 $ 6,816.68

• PI(A) = (NPV + Cost)/Cost = $ 17,092.41/ 10,000 = 1.71

• PI(B) = (NPV + Cost)/Cost = $ 13,816.68/ 7,000 = 1.97

• Project B may be chosen since it has a higher PI compared to Project A.


Question 4

• What is the profitability index for the following set of cashflows at a discount
rate of 10%. What would the PI be at 15% and 22% discount rate? At which
discount rate would the company be advised to proceed with the proposal?

Year Cash flow (in $)

0 -27,500
1 15,800
2 13,600
3 8,300
Solution
• Calculating PI at 10%

Year Cash inflow PVF at 10% Discounted CF


1 15800 0.909 14362
2 13600 0.826 11233
3 8300 0.751 6233
Total 31,829

PI = PV of discounted cash flow/ PV of cash inflow


Profitability index = 31829/27500 = 1.16
Solution contd..
• Calculating PI at 15% • Calculating PI at 22%
Question 5
• Geremy Company invests in a new project. Their initial investment is US
$10000. Calculate their PI at 10% discount rate. Given below is the cash inflow
for the next 5 years –
Solution

Year Cash flow PV of cash inflow ($)


1 4000 3636
2 4000 3304
3 4000 3004
4 2000 1366
5 2000 1242
Total 12552

PI Formula = PV of Future Cash Flows / Initial Investment Required

PV of cash inflow 12,552


Initial Investment 10000
PI 1.26
Question 6

• Paint & Co. wishes to Invest in a new painting technology. Using the PI
method advice them about the decision to accept/reject the proposals. The
company provides the following cash flows, to be estimated at a 10%
discount rate for project A and at 12% discount rate for project B.
Year Cash flows (Project A) Cashflows (Project B)
0 (20,00,000) (30,00,000)
1 3,00,000 6,00,000
2 6,00,000 8,00,000
3 9,00,000 9,00,000
4 7,00,000 10,00,000
5 6,00,000 12,00,000
Solution

Year Cash flows (A) PV of Cashflows Cash flows (B) PV of Cashflows


at 10% (A) at 12% (B)
1 3,00,000 2,72,700 6,00,000 5,35,800
2 6,00,000 4,95,600 8,00,000 6,37,600
3 9,00,000 6,75,900 9,00,000 6,40,800
4 7,00,000 4,78,100 10,00,000 6,36,000
5 6,00,000 3,72,600 12,00,000 680,400
Total 22,94,900 3,130,600

Profitability Index of Project A = 22,94,900 / 20,00,000 = 1.15


Profitability Index of Project B = 31,30,600 / 30,00,000 = 1.04

Using the formula of profitability index, it can be seen that Project A will create an additional value of
Re. 0.15 for every Re.1 invested in the project compared to Project B, which will create an additional
value of Re. 0.04 for every Re. 1 invested in the project. Therefore, Paint & Co. should select Project
A over Project B.
Method #3

Pay Back Period Analysis


Payback Period Analysis

• Payback analysis is the simplest form of capital budgeting


analysis, but it's also the least accurate.

• It's still widely used because it can give managers a quick


understanding of the real value of a proposed project.

• Usually used when companies have only a limited amount of


funds (or liquidity) to invest in a project.

• Payback analysis calculates how long it will take to recoup the


costs of an investment.
Interpreting PBP

• Payback period is a quick and easy way to assess


investment opportunities and risk, but instead of a
break-even analysis’s units, payback period is
expressed in years.

• The shorter the payback period, the more attractive the


investment would be, because this means it would take
less time to break even.
Computation of PBP

• The payback period is identified by dividing the initial investment in


the project by the average yearly cash inflow that the project will
generate.

Example:

• If it costs $400,000 for the initial cash outlay, and the project
generates $100,000 per year in revenue, how many years would it
take to recoup the investment?

• PBP = Initial Cash outlay/Revenue per year

• PBP = 4,00,000/1,00,000 = 4 years


The Pros and Cons of PBP Analysis

The payback period formula is easy


Though it shows the length of
to understand.
time it takes for a return on
Helps to know how quickly companies
investment, it doesn’t show the
can get back their investment.
specific profitability.
It facilitates side-by-side analysis of
It doesn’t take the time value of
two or more competing projects
money.

Payback analysis is thus, not considered a true measure of how profitable a project
is but instead, provides a rough estimate of how quickly an initial investment can be
recouped.

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