Capital Investment

Lecture Outline

Define Capital Budgeting. Explain the importance of Capital

Budgeting. Examine the method of implementing

and managing long term projects. Discuss the advantages/disadvantages

of the various analysis techniques.

Time Value of Money

Would you rather have $1,000 today or $1,000 in five years time?

Answer: $1,000 Today $1,000 can be invested today and if it earns

10% interest each year for the next 5 years it will accumulate to $1,610.

$1,000 today will also buy more than $1,000 in five years time.

Time Value of Money

$1 today is worth more than $1 in the future because of two factors:1. Interest rates

2. Inflation

Time Value of Money

(45,000) 20,000 20,000 20,000

0 1 2 3

(years)

Would you invest $45,000 now if you were to receive a return of $20,000 every year for the next three years

Time Value of Money

We cannot simply say:Cash Inflow 60,000

Less Cost 45,000

Gain 15,000

Money has a time value. $20,000 in one years time is worth more than $20,000 in three years time.

Time Value of Money

As cash flows for each year have a different inherent value, they cannot be simply added together.

Therefore we need to convert the annual cash flows into a common scale so that they can be added together. The common scale we use is called Present Value.

Time Value of Money

(45,000) 20,000 20,000 20,000

0 1 2 3

In calculating present value we convert (discount) all the annual cash flows into today’s dollars (ie what is $20,000 in two years time worth in today’s dollars).

Time Value of Money

It’s the same basic principle you follow when you have different currencies.

$A 100 = $A 100

$US100 = $A142

$HK100 = $A 26

$A268

Time Value of MoneyLump Sum

A lumps sum refers to a one off amount (ie what is the present value of $100 received in five years time).

Present Value = Future Value (1 + i)n

Where;

i: The interest rate

n: Number of years

Present ValueLump Sum

If the interest rate is 10%, what is the PV of $161 received in five years time?

? $161

0 1 2 3 4 5

Solution

Present Value = Future Value

(1 + i)n

Present Value = 161

(1.10)5

Present Value = $100

Practice Question

Using an interest rate of 12%, what is the PV of $15,000 received in seven years time?

?$15,000

0 1 2 3 4 5 6 7

Solution

Present Value = Future Value

(1 + i)n

Present Value = 15,000

(1.12)7

Present Value = $6,785.24

Present ValueAnnuity

Annuity Constant stream of cash flows (ie cash

flow received each year of a projects life).

PV = FV1 + FV2 + FV3

(1 + i) (1 +i)2 (1 + i)3

Present ValueAnnuity

Would you invest $45,000 now if you were to receive a return of $20,000 every year for the next three years. Use an interest rate of 8%.

Present ValueAnnuity

PV = 20,000 + 20,000 + 20,000 (1.08) (1.08)2 (1.08)3

PV = 18,518 + 17,146 + 15,877

PV = $51,541

Gain = 51,541 – 45,000Gain = 6,541

Practice Question

If the interest rate is 10%, how much would the government need to invest today to fund a road safety program costing $5m every year for the next three years?

PV = FV1 + FV2 + FV3

(1 + i) (1 +i)2 (1 + i)3

Solution

PV = 5,000,000 + 5,000,000 + 5,000,000

(1.10) (1.10)2 (1.10)3

PV = 4,545,454 + 4,132,231 + 3,756,574

PV = $12,434,259

Present Value of an AnnuityEqual Annual Cash Flows

If the net cash flows are the same each year:

PV = NCFi]n

Where:NCF: Net Annual Cash Flowi: Interest calculated each compounding

period.n: Number of repayments throughout life of

loan/investment.

Solution

PV = NCFi]n

PV = 5,000,00010%]3

PV = 5,000,000 x 2.4869

PV = $12,434,500

Capital Budgeting

The planning and financing of capital investments such as:

1. Replacement of Equipment

2. Enhancement of Production Facilities

3. Establishing a New Retail/Production Site.

Importance of Capital Budgeting

Capital investments usually have the

following characteristics.

• High Cost (relative to the size of the entity)

• Decision will extend well into the future.

• Difficult to reverse decision.

Capital Budgeting Process

Step One Calculate the net annual cash flows.

Step Two Apply one of the four evaluation techniques

• The Payback Method

• Net Present Value

• Internal Rate of Return

• Accounting Rate of Return

Step OneCalculating Net Annual Cash Flows

1. Estimate life of the project/asset.

2. Estimate cash inflows for each year• Additional sales

• Residual value

• Cost savings

3. Estimate cash outflows for each year• Cost of the project/asset

• Higher wages, training costs, higher electricity cost

4. Net Cash Flow = Inflow - Outflow

Analysis TechniquesPayback Method

The Payback Method Measures the time it will take the net annual

cash flows generated by the investment to recover the cost of the original investment.

To Calculate (assuming net cash flows are the same each year):

Initial Cost of Investment = ? Years Net Annual Cash flows

Analysis TechniquesPayback Method

The project is acceptable if the payback period is less than a pre-determined period of time.

The shorter the payback period the lower the risk of the investment.

Analysis TechniquesPayback Method

Benefits• Simple to use and understand.

• Provides a rough estimate of risk (ie earlier cash flows are less risky than later ones).

• Firms experiencing cash shortages may need to recover investments quickly.

Analysis TechniquesPayback Method

Limitations Ignores the time value of money.

Payback method ignores cash flows after the point at which the initial cash outlay has been received.

• Discriminates against projects with long gestation periods:

• Environmental Technology

• Robotic Equipment

Analysis TechniquesNet Present Value (NPV)

Step 1• Calculate the present value of the net annual

cash flows.

Step 2• Calculate the present value of the cost of the

project/asset.

Step 3• NPV = Answer to Step 1 – Answer to Step 2

Analysis TechniquesNet Present Value

If NPV ≧ 0 : Project is acceptable

The amount of any positive NPV represents the immediate increase in the entity’s wealth that will result from accepting the project.

Analysis TechniquesNet Present Value

Benefits• The time-value of money is considered.

• The entire life of the project is included in the analysis.

Qualitative Factors

Qualitative factors must also be taken into consideration before a capital investment is made. Examples of qualitative factors include:• Increase in the quality of the product.

• Introduction of labour saving machinery may be deferred due to union opposition.

• Higher ranked projects may require greater resources ie more labour or management supervision.