Hotel Aston, Jakarta 15 April 2016
Facilitator : Ahmad Subagyo
Valuation
Investment Workshop
Capital-Budgeting
• The process of decision making with respect to investments in fixed assets – that is, should a proposed project be accepted or rejected.
• It is easier to “evaluate” profitable projects than to “find them.”
Source of Ideas for projects
• Within the Firm: Typically, a firm has a research &
development (R&D) department that searches for ways of improving existing products or finding new projects.
• Other sources: Competition, Suppliers, Customers
3. CAPITAL-BUDGETING DECISION
CRITERIA
Decision Criteria
1. Payback Period
2. Net Present Value
3. Profitability Index
4. Internal Rate of Return
5. Capital Rationing
Payback Period
•
Number of years needed to recover the initial cash outlay of a capital-budgeting project
•
Decision Rule: Project feasible or desirable if
the payback period is less than or equal to the
firm’s maximum desired payback period.
Payback Period Example
Example: Project with an initial cash outlay of $20,000 with following free cash flows for 5 years.
YEAR CASH FLOW BALANCE
1 $ 8,000 ($ 12,000) 2 4,000 ( 8,000) 3 3,000 ( 5,000) 4 5,000 0
5 10,000 12,000
Payback is 4 years
Trade-offs
•
Benefits:
• Uses cash flows rather than accounting profits
• Easy to compute and understand
• Useful for firms that have capital constraints
•
Drawbacks:
• Ignores the time value of money and
• Does not consider cash flows beyond the payback period.
Net Present Value or NPV
•
NPV is equal to the present value of all future free cash flows less the investment’s initial
outlay. It measures the net value of a project in today’s dollars.
NPV = FCF - Initial outlay (1+k)n
•
Decision Rule:
If NPV > 0, accept If NPV < 0, reject
NPV Example
Example: Project with an initial cash outlay of $60,000 with following free cash flows for 5 years.
Yr FCF Yr FCF Initial outlay -60,000 3 13,000
1 25,000 4 12,000 2 24,000 5 11,000
The firm has a 15% required rate of return.
• NPV = FCF - Initial outlay
(1+k)
n• PV of FCF = $60,764
• Subtracting the initial cash outlay of $60,000 leaves an NPV of $764.
• Since NPV>0, project is feasible.
NPV Trade-offs
• Benefits
• Considers cash flows, not profits
• Considers all cash flows
• Recognizes time value of money
• By accepting only positive NPV projects, increases value of the firm
• Drawbacks
• Requires detailed long-term forecast of cash flows
• NPV is considered to be the most theoretically correct criterion for evaluating capital-budgeting projects.
Profitability Index (PI)
•
PI is the ratio of the present value of the future free cash flows to the initial outlay. It yields the same accept/reject decision as NPV.
• PI = PV FCF/ Initial outlay
•
Decision Rule:
PI > 1 = accept
PI < 1 = reject
PI Example
A firm with a 10% required rate of return is
considering investing in a new machine with an expected life of six years. The initial cash outlay is
$50,000.
PI Example
FCF PVF @ 10% PV
Initial
Outlay -$50,000 1.000 -$50,000
Year 1 15,000 0.909 13,636
Year 2 8,000 0.826 6,612
Year 3 10,000 0.751 7,513
Year 4 12,000 0.683 8,196
Year 5 14,000 0.621 8,693
Year 6 16,000 0.564 9,032
PI Example
• PI =
($13,636 + $6,612+$7,513 + $8,196 +
$8,693+ $9,032) / $50,000
=$53,682/$50,000
= 1.0736
• Project PI > 1, accept.
NPV and PI
• When the present value of a project’s free cash inflows are greater than the initial cash outlay, the project NPV will be positive. PI will also be greater than 1.
• NPV and PI will always yield the same decision.
Internal Rate of Return or IRR
• IRR is the discount rate that equates the present value of a project’s future net cash flows with the project’s initial cash outlay
• Decision Rule:
• If IRR > Required rate of return, accept
• IF IRR < Required rate of return, reject
IRR and NPV
• If NPV is positive, IRR will be greater than the required rate of return
• If NPV is negative, IRR will be less than required rate of return
• If NPV = 0, IRR is the required rate of return.
IRR Example
Initial Outlay: $3,817 Cash flows:
Yr.1=$1,000, Yr. 2=$2,000, Yr. 3=$3,000
Discount rate NPV
15% $4,356
20% $3,958
22% $3,817
IRR is 22% because the NPV equals the initial
cash outlay
4. CAPITAL RATIONING
Capital Rationing
•
Capital rationing occurs when a limit is placed on the dollar size of the capital budget.
•
How to select: Select a set of projects with the highest NPVs – subject to the capital
constraint. Using NPV may preclude accepting the highest ranked project in terms of PI or
IRR.
5. RANKING
PROBLEMS
6. ETHICS IN CAPITAL-
BUDGETING
Ethics in Capital-Budgeting
• Ethics do play a role in capital-budgeting.
• Any actions that violate ethical standards can have a negative impact on the image of the firm and
consequently, future cash flows.
Popularity of Capital-Budgeting Techniques
Percent of Firms Using Each
Method used Primary Secondary Total Method Method
IRR 88% 11% 99%
NPV 63% 22% 85%
Payback 24% 59% 83%
PI 15% 18% 33%
Source: Harold Bierman, Jr.,”Capital-Budgeting in 1992: A Survey,”
Financial Management (Autumn 1993):24.
Capital-Budgeting
• The key to success in capital-budgeting is finding good projects. Finding new projects and correctly evaluating them are key to the continued success of firms.
• For many companies, finding new projects involves going overseas through joint ventures or strategic alliances or establishing subsidiaries abroad.
• Some companies generate > 50% of their revenues from sales abroad.
End of Part Three
The Way Ahead..
• The world needs a new system…rights??
• What we got….
• Still Confused ..yes I mean the world !!
• Third way Economics .
• Islamic Finance Vs. Traditional Finance
