CAPITAL BUDGETING: It
is a decision tool with the help of which organization’s or company’s determine
that the decision related to long term investment like purchasing new machinery
, new company or new asset and taking new projects etc are worth for company’s
investment value or not.
There are 5 technique used in Capital budgeting these are as
follow:
v Discounted Cash Flow (NPV)
v Internal Rate of Return (IRR)
v Payback period
v Accounting Rate of Return
v
Profitability Index
Net Present Value
(NPV) or Discounted Cash Flow:
It helps to the companies or investors to take decision to
accept or reject the investment proposal. With the help of NPV companies or
investors will correctly determine the best investment proposal among many
alternatives.
If,
NPV > 0 investment proposal accepted,
NPV < 0 Investment proposal rejected and
NPV = 0 Investment proposal accepted
Formula for Net
Present Value (NPV):
Formula
|
Fixed cash flows
|
Uneven Cash Flows
|
NPV
|
-C0+ C*1-(1+r) –n/(1+r) n
|
-C0+C1/ (1+r) n+C2/
(1+r) n+…….C n/ (1+r) n
|
Where,
C0= Initial investment
C1, C2….C n = Future cash flows
R = rate of interest
Example: Find out
the NPV for a project that cost Rs. 2, 00,000 and it is expected cash flows are
as follows: Rs. 20,000, Rs. 27,000,Rs.39,000, Rs.53,000, Rs.64,000 and Rs.76,000
and cost of capital is 9%.
NPV = -C0+C1/ (1+r) n+C2/
(1+r) n+…….C n/ (1+r) n
=-2, 00,000+20,000/ (1+0.09) 1+27,000/ (1+0.09)
2+39,000/ (1+0.09) 3+53,000/ (1+0.09) 4+64,000/ (1+0.09)
5+76,000/ (1+0.09) 6
= -2, 00,000+18,348.62+22,725.35+30,115.15+37,548.70+41,596.25+45,316.31
=-2, 00,000+1, 95,650.38
=-4,349.62
NPV < 0 =-4,349.62 < 0
Therefore, Investment proposal is rejected.
To determine the true value of an investment project you
must consider two economic factors inflation and deflation.
NPV adjusting inflation:
There are two methods to calculate NPV in inflation-
·
Nominal Method: Estimating nominal cash flows
(it does not include effects of inflation) and then discounting them. In other
words this method discount inflated cash flow at inflated rate.
·
Real Method: Estimating real cash flows (it
includes effects of inflation) and then discounting them with the real discount
rate. In other words this method discount deflated cash flow at deflated discount
rate.
Nominal Method:
Nominal Cash Flows=Real cash flow *(1+inflation rate) n
Nominal Discount rate=Real discount rate + Inflation rate
Example: Company A has a proposal to invest in some project
whose initial investment is Rs.5, 00,000 and expected cash flow is Rs.200000
per year for 4 years. The inflation rate is 4% and nominal discount rate is
7.5%.Find out the NPV of a project.
Calculation of
Nominal Cash Flows:
Years
|
Calculation
|
Nominal
Cash Flow (Rs.)
|
1
|
200000*(1+0.04)
1
|
2,08,000
|
2
|
200000*(1+0.04) 2
|
2,16,320
|
3
|
200000*(1+0.04)
3
|
2,24,972.8
|
4
|
200000*(1+0.04) 4
|
2,33,971.7
|
Calculation of Net
Present Value:
Years
|
Nominal
Rate
7.5%
|
Nominal
cash flow
Rs.
|
Present
Value
Rs.
|
0
|
(7,00,000)
|
||
1
|
(1+0.075) 1=1.075
|
2,08,000
|
1,93,488.37
|
2
|
(1+0.075)
2=1.156
|
2,16,320
|
1,87,128.02
|
3
|
(1+0.075) 3=1.242
|
2,24,972.8
|
1,81,137.52
|
4
|
(1+0.075)
4=1.335
|
2,33,971.7
|
1,75,259.70
|
Total
|
7,37,013.61
|
||
NPV
|
37,013.61
|
Real Method:
Real cash flow = Nominal cash flow/ (1+inflation rate) n
Real Discount Rate = (1+Nominal Discount Rate)/ (1+Inflation
Rate)-1
OR
Nominal Discount
Rate-Inflation Rate
Let’s take above example to find NPV according to Real
Method
Calculation of Net
Present Value:
Years
|
*Real
Discount Rate
3.3%
|
Real
Cash Flow
|
Present
Value
|
0
|
(7,00,000)
|
||
1
|
(1+0.033) 1=1.033
|
2,00,000
|
1,93,610.84
|
2
|
(1+0.033)
2=1.067
|
2,00,000
|
1,87,441.42
|
3
|
(1+0.033) 3=1.102
|
2,00,000
|
1,81,488.20
|
4
|
(1+0.033)
4=1.138
|
2,00,000
|
1,75,746.92
|
Total
|
7,38,287.38
|
||
NPV
|
38,287.38
|
* Real Discount Rate = (1+Nominal Discount Rate)/ (1+Inflation
Rate)-1
= (1+0.075)/ (1+0.04)-1
=3.3%
In these two methods it is not necessary that the result
must be same .In above example NPV results are different so the management uses
lower NPV as a more reliable result that is Rs. 37013.61
NPV will provide more accurate results in comparison to
internal rate of return, payback period and accounting rate of return.
Calculations of NPV
in excel:
A
|
B
|
|
1
|
Cash
Flow
|
|
2
|
12000
|
|
3
|
18000
|
|
4
|
26000
|
|
5
|
32000
|
|
6
|
Rate
|
8%
|
7
|
NPV
|
INR 1,596.10
|
B7: “=NPV (8,A2:A5)”
In my next post we will discuss about Internal Rate of
Return technique of capital budgeting.
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