chapter 8 capital budgeting correia, mayall, o’grady & pang copyright skystone ©2005 2...

CHAPTER 8

CAPITAL BUDGETING

2

Correia, Mayall, O’Grady & PangCopyright Skystone ©2005

Objectives At the end of the chapter, you should be able to;At the end of the chapter, you should be able to;

Understand the importance of the capital budgeting decisionUnderstand the importance of the capital budgeting decision Understand why only cash flows matterUnderstand why only cash flows matter Define the types of investment projectsDefine the types of investment projects Apply the methods used to evaluate capital projectsApply the methods used to evaluate capital projects Set out the advantages and disadvantages of each methodSet out the advantages and disadvantages of each method Understand why the Internal rate of return may result in a firm choosing Understand why the Internal rate of return may result in a firm choosing

the wrong projectthe wrong project Calculate a project’s modified internal rate of returnCalculate a project’s modified internal rate of return Understand the relationship of Economic Value Added (EVA) and net Understand the relationship of Economic Value Added (EVA) and net

present valuepresent value Determine the relevant cash flows to be included in the analysisDetermine the relevant cash flows to be included in the analysis Include taxation and tax allowances and in the project cash flowsInclude taxation and tax allowances and in the project cash flows Understand the role of Post-audits in capital budgetingUnderstand the role of Post-audits in capital budgeting Use Excel spreadsheets to solve applied Capital Budgeting problemsUse Excel spreadsheets to solve applied Capital Budgeting problems

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Outline Types of ProjectsTypes of Projects Capital Budgeting MethodsCapital Budgeting Methods

Net Present ValueNet Present Value Internal Rate of ReturnInternal Rate of Return Payback and Discounted PaybackPayback and Discounted Payback Accounting Rate of ReturnAccounting Rate of Return Profitability Index (PV Index or Benefit-Cost Ratio)Profitability Index (PV Index or Benefit-Cost Ratio)

Project Cash FlowsProject Cash Flows Estimating future cash flowsEstimating future cash flows TaxationTaxation Some rulesSome rules

Post-AuditsPost-Audits

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The Balance Sheet (Statement of Financial Position)

Capital Budgeting

Why did Wesfarmers invest in these assets?

5


Why is the Capital Budgeting decision so important for the firm?

The Balance SheetThe Balance Sheet The Balance Sheet includes past capital budgeting decisions. The Balance Sheet includes past capital budgeting decisions.

Tactical and Strategic InvestmentsTactical and Strategic Investments Consequences of Investment and non-investmentConsequences of Investment and non-investment

Over capacity resulting in high overheadsOver capacity resulting in high overheads Under-capacity resulting in loss of market shareUnder-capacity resulting in loss of market share High operating costsHigh operating costs Loss of Flexibility - a large investment results in a Loss of Flexibility - a large investment results in a

company losing the option to invest. company losing the option to invest. Microsoft & Netscape - Microsoft had to change Microsoft & Netscape - Microsoft had to change

from stand alone systems due to impact of the from stand alone systems due to impact of the Internet Internet

TimingTiming Columbus steel plantColumbus steel plant

The focus should also be on Project CreationThe focus should also be on Project Creation

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TYPES OF INVESTMENT PROJECTS Replacement decisionsReplacement decisions Expansion : existing product linesExpansion : existing product lines Expansion : new product linesExpansion : new product lines Other (IT, Pollution control, Corporate social Other (IT, Pollution control, Corporate social

investment)investment) Mutually Exclusive vs. Independent Mutually Exclusive vs. Independent

ProjectsProjects Divisible and non-divisible projectsDivisible and non-divisible projects

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Why use Cash Flows ? Future benefits of the projectFuture benefits of the project

Only use Cash flows, not earningsOnly use Cash flows, not earnings

Accounting Earnings vs. Cash FlowsAccounting Earnings vs. Cash Flows Accounting is based on the Matching ConceptAccounting is based on the Matching Concept Cost and DepreciationCost and Depreciation Taxation - GAAP & Inventory ValuationTaxation - GAAP & Inventory Valuation

Tax is a cash flow and taxable income is based on the Accrual Tax is a cash flow and taxable income is based on the Accrual Accounting ModelAccounting Model

Accounting does not record opportunity costs; in Capital Accounting does not record opportunity costs; in Capital Budgeting we include cash flows foregone.Budgeting we include cash flows foregone.

Performance AppraisalPerformance Appraisal Yet if Accounting results are used to measure management Yet if Accounting results are used to measure management

performance, then Accounting may be relevantperformance, then Accounting may be relevant

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Corporate Social & Infrastructural Investments Types of “non-economic” projectsTypes of “non-economic” projects

EnvironmentEnvironment Human ResourcesHuman Resources Small BusinessSmall Business Community InvestmentsCommunity Investments Information TechnologyInformation Technology

The relevance of DCF techniquesThe relevance of DCF techniques Materiality of InvestmentsMateriality of Investments References to Annual Financial StatementsReferences to Annual Financial Statements

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Capital Budgeting Techniques

Net Present Value (NPV)Net Present Value (NPV) Internal Rate of Return (IRR)Internal Rate of Return (IRR) Payback Period and Payback Period and

Discounted PaybackDiscounted Payback Accounting Rate of Return Accounting Rate of Return Profitability Index (Benefit-Profitability Index (Benefit-

cost ratio)cost ratio)

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Net Present Value (NPV) NPV = Future Cash flows discounted at the NPV = Future Cash flows discounted at the

cost of capital less the Cost of the Projectcost of capital less the Cost of the Project If NPV > 0, accept the projectIf NPV > 0, accept the project If NPV < 0, reject the projectIf NPV < 0, reject the project

NPV Analysis - 2 year project Cost of Capital 20%

Year 0 1 2

Cash Flows (10,000) 8,000 6,000

PV Factor 1/(1+r)t 1.0000 0.8333 0.6944 Present Values (10,000) 6,667 4,167

NPV 833

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Internal Rate of Return (IRR)

Year 0 1 2

Cash Flows (10,000) 8,000 6,000

PV Factor 1/(1+r)t 1.0000 0.7863 0.6183 Present Values (10,000) 6,290 3,710

IRR 27.2% 10,000 NPV 0

IRR = Discount rate which makes the IRR = Discount rate which makes the Present value of the Project’s Future Cash Present value of the Project’s Future Cash flows equal to the cost of the Project. flows equal to the cost of the Project.

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NPV ProfileHow will NPV change with a change in the discount rate?

NPV Profile

-2,000

-1,000

0

1,000

2,000

3,000

4,000

5,000

0% 3% 6% 9% 12%

15%

18%

21%

24%

27%

30%

33%

36%

39%

Discount rate

NP

V

NPV

IRR

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NPV or IRR? If we analyse the NPV Profile, a project with a If we analyse the NPV Profile, a project with a

positive NPV will also have an IRR to the right of positive NPV will also have an IRR to the right of the cost of capital. So the IRR and the NPV the cost of capital. So the IRR and the NPV methods will give the same answer. Is this methods will give the same answer. Is this always so?always so?

Assume Project A and B are alternative Assume Project A and B are alternative one yearone year investments. A firm can only select either A or B. investments. A firm can only select either A or B.

Year 0 1

Project A (10,000) 11,800 Project B (1,000) 1,400

NPV IRRCost of Capital 10%

Project A 727 18%Project B 273 40%

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NPV or IRR? Project A results in a higher NPV and Project A results in a higher NPV and

Project B results in a higher IRR. Which Project B results in a higher IRR. Which project should be accepted? project should be accepted?

Always select the project with the higher Always select the project with the higher NPV. Why?NPV. Why?

The difference in costs should not affect the The difference in costs should not affect the decision unless the company is subject to decision unless the company is subject to capital rationing. If markets are efficient, capital rationing. If markets are efficient, the company should be able to always raise the company should be able to always raise finance at its cost of capital.finance at its cost of capital.

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What is wrong with IRR?There could be more than one IRR for non-conventional projects.

Year 0 1 2

Project I (200) 1,000 (1,000) Cost of Capital 14%

NPV (92) IRR 38%IRR 262%

NPV Profile of Non-conventional Project

(250.00)

(200.00)

(150.00)

(100.00)

(50.00)

-

50.00

0%

22%

44%

66%

88%

110%

132%

154%

176%

198%

220%

242%

264%

286%

308%

330%

352%

374%

396%

418%

440%

NPV

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Payback Method Projects are evaluated according to the number of years Projects are evaluated according to the number of years

that it takes to recover the cost of the investment from the that it takes to recover the cost of the investment from the cash flows generated by the project.cash flows generated by the project.

The firm sets a required payback period, say 3 years. The firm sets a required payback period, say 3 years. Only projects with payback periods of less than 3 years Only projects with payback periods of less than 3 years are accepted.are accepted.

Year 0 1 2 3 4

Project I (12,000) 4,000 6,000 6,000 1,000 Project J (12,000) 2,000 4,000 4,000 8,000

Payback I 2.33Payback J 3.25

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What are the advantages and disadvantages of Payback? AdvantagesAdvantages

Simple to calculate and understandSimple to calculate and understand Widely used in practiceWidely used in practice Risk indicatorRisk indicator

DisadvantagesDisadvantages Ignores cash flows after the paybackIgnores cash flows after the payback Ignores time value of moneyIgnores time value of money Bias against long term projectsBias against long term projects

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Discounted Payback Discounted Payback = time it takes so that the PV Discounted Payback = time it takes so that the PV

of the project’s cash flows equals the cost of the of the project’s cash flows equals the cost of the project.project.

Year 0 1 2 3 4

Project I (12,000) 4,000 6,000 6,000 1,000 Project J (12,000) 2,000 4,000 4,000 8,000

Cost of Capital r = 15%

Project I (12,000) 3,478 4,537 3,945 572 Cumulative 11,960 Project J (12,000) 1,739 3,025 2,630 4,574

Cumulative 11,968 The discounted payback of I is very close to 3 years and the discountedpayback of J is very close to 4 years

If we discount each year by multiplying the cash flow by 1/1+r)t , then thepresent values of each year's cash flows are as follows;

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Accounting Rate of Return = Net Accounting Rate of Return = Net Income/Average book value. Income/Average book value.

The average book value if the residual The average book value if the residual value is zero, will be Cost/2value is zero, will be Cost/2

Net income is after depreciation.Net income is after depreciation. Advantages and disadvantages of ARRAdvantages and disadvantages of ARR

Accounting Rate of Return

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Profitability Index (Benefit-Cost Ratio) A project’s PI measures the return of a A project’s PI measures the return of a

project relative to costproject relative to cost PI = Present Value/CostPI = Present Value/Cost

If PI > 1 = Accept the projectIf PI > 1 = Accept the project If PI < 1 = Reject the projectIf PI < 1 = Reject the project

As NPV = PV - Cost, a PI greater than 1 As NPV = PV - Cost, a PI greater than 1 means a positive NPV.means a positive NPV.

When should we use the PI? When should we use the PI? If there is capital rationing and we wish to If there is capital rationing and we wish to

maximise returns relative to the costs of a maximise returns relative to the costs of a projects.projects.

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Economic Value Added (EVA) How do we use EVA to evaluate projects?How do we use EVA to evaluate projects? EVA = Net operating profit after tax - EVA = Net operating profit after tax -

(Invested Capital x Cost of Capital)(Invested Capital x Cost of Capital) Value of Project = Investment + PV of Value of Project = Investment + PV of

future EVAsfuture EVAs PV of future EVAs = project’s NPVPV of future EVAs = project’s NPV

EVA 0 1 2 3 4 5

Net Book Value 1,100,000 880,000 660,000 440,000 220,000 -

EBIT (1-t) 56,000 161,000 161,000 161,000 161,000Capital charge (Opening Book value x WACC) -165,000 -132,000 -99,000 -66,000 -33,000EVA -109,000 29,000 62,000 95,000 128,000

PV of EVAs = NPV 85,867

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Cash flows

Estimation of future cash flowsEstimation of future cash flows After tax cash flows, therefore need to After tax cash flows, therefore need to

consider the tax issuesconsider the tax issues Beginning-of-project cash flowsBeginning-of-project cash flows

Cost of project = cash outflowCost of project = cash outflow What about depreciation?What about depreciation? Sale of existing equipment?Sale of existing equipment? Working capital requirements?Working capital requirements?

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Tax Effects - Introduction

Depreciation deductionDepreciation deduction Deduction from taxable incomeDeduction from taxable income

Adjustable Value [undeducted cost]Adjustable Value [undeducted cost] Cost less depreciation deductions to Cost less depreciation deductions to

datedate Effect on Cash FlowEffect on Cash Flow

Net operating income x (1-tax rate)Net operating income x (1-tax rate) Deduction x tax rateDeduction x tax rate

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Diminishing Value methodDiminishing Value method

=Opening value x 150%/Asset’s effective =Opening value x 150%/Asset’s effective lifelife

Prime Cost methodPrime Cost method

=Cost x 100%/Asset’s effective life=Cost x 100%/Asset’s effective life

Depreciation Methods

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Balancing Adjustments Balancing adjustmentBalancing adjustment

= selling price – adjustable value= selling price – adjustable value

If selling price > adjustable value, then this an If selling price > adjustable value, then this an assessable balancing adjustment. Add to income.assessable balancing adjustment. Add to income.

If selling price < adjustable value, then the If selling price < adjustable value, then the difference is a deductible balancing adjustment. difference is a deductible balancing adjustment. Deduct from taxable income.Deduct from taxable income.

Capital gains do not apply to depreciating assets – Capital gains do not apply to depreciating assets – the difference between selling price and the the difference between selling price and the undeducted cost ( adjustable value) is a balancing undeducted cost ( adjustable value) is a balancing adjustment.adjustment.

26


Depreciation rates for Tax purposes

The ATO has issued recommended effective The ATO has issued recommended effective economic lives for various categories of assetseconomic lives for various categories of assets

Effective life = number of years that company can use the Effective life = number of years that company can use the asset for a taxable purpose.asset for a taxable purpose. Examples: Computers – 4 yrs, forklifts – 11 yrs pumps Examples: Computers – 4 yrs, forklifts – 11 yrs pumps

– 20 yrs, trucks (heavy haulage) – 5 yrs, lathes – 10 yrs– 20 yrs, trucks (heavy haulage) – 5 yrs, lathes – 10 yrs Patent = 20 yearsPatent = 20 years

27


Capital Gains Tax Companies are subject to Capital Gains Tax on Companies are subject to Capital Gains Tax on

the the disposal of fixed assets.the the disposal of fixed assets. If the sales price > cost, the difference will be If the sales price > cost, the difference will be

subject to CGT if the asset is NOT a depreciating subject to CGT if the asset is NOT a depreciating asset.asset.

CGT = Selling price – base cost.CGT = Selling price – base cost. CGT may apply on the sale of land and other non-CGT may apply on the sale of land and other non-

depreciating assets.depreciating assets. No inflation indexation, so inflationary gains may No inflation indexation, so inflationary gains may

be subject to tax.be subject to tax.

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The effect of depreciation on cash flow Example: Cost = $800 000. Prime cost depreciation of Example: Cost = $800 000. Prime cost depreciation of

20% per year. What is the effect on cash flow?20% per year. What is the effect on cash flow?

TaxationNet operating income 300,000 Less: decline in value (depreciation) 160,000- [800000 x 0.20]Assessable income 140,000

Tax charge 42,000 [140000 x 0.30]

The net cash flows would be determined as follows:

Net operating cash flow 300,000 Less: taxation 42,000- Net Cash flow 258,000

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Relevant revenues & costs - some rules. Only include Incremental cash flowsOnly include Incremental cash flows Use future after-tax cash flowsUse future after-tax cash flows Ignore Sunk costsIgnore Sunk costs Opportunity costs - foregone cash flowsOpportunity costs - foregone cash flows Include the negative and positive effects of new product Include the negative and positive effects of new product

lines on existing lineslines on existing lines Evaluate all alternativesEvaluate all alternatives Ignore all Allocated costsIgnore all Allocated costs Ignore Financing charges, as this would amount to double Ignore Financing charges, as this would amount to double

counting.counting. Working capitalWorking capital

Net incrementalNet incremental Changes, not levelsChanges, not levels Separate accounting from cash flowsSeparate accounting from cash flows

Separation of the financing from the investment decisionSeparation of the financing from the investment decision

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Working Capital

SALES 10000000COST OF SALES 4500000OPENING STOCK 0PURCHASES 6000000CLOSING STOCK -1500000GROSS PROFIT 5500000

Expense

Cash out flow

Income Statement

31


Working Capital

Year 0 1 2

Sales 12,000.00 12,000.00

Cost of Sales -8,000.00 -8,000.00 Opening inventory - -1,600.00 Purchases -9,600.00 -8,000.00 Closing inventory 1,600.00 1,600.00

Gross profit 4,000.00 4,000.00

To Cash flows

Sales 12,000.00 12,000.00 Cost of sales -8,000.00 -8,000.00 Investment in inventory* -1,600.00 Investment in debtors# -2,000.00

-3,600.00 4,000.00 4,000.00

* The investment in inventory is assumed to take place at the beginning of the project.

# The investment in debtors will occur in the first 60 days but is assumed to take place atthe beginning of the project.

From Accounting

Investment in working capital changes accounting earnings to cash flows

32


Inventory

Inventory as a percentage of Sales

1 2 3

Sales R000s 15,000 18,000 9,000

Inventory 10% 1,500 1,800 900

Cash flow (1,500) (300) 900

Sometimes future inventory levels are stated as a percentage ofsales. The cash flows are represented as changes in the inventorylevels.

33


Post Audits What are post audits?What are post audits?

Formal assessment and comparison of actual returns Formal assessment and comparison of actual returns achieved for specific projects as compared to projected achieved for specific projects as compared to projected returns.returns.

AdvantagesAdvantages Lessons for management. Identify critical factors and Lessons for management. Identify critical factors and

ensures focus on achieving projected cash flowsensures focus on achieving projected cash flows

DisadvantagesDisadvantages Sponsors may reduce investments due to personal risksSponsors may reduce investments due to personal risks Difficulties in separation of project cash flows from Difficulties in separation of project cash flows from

other business investmentsother business investments

34


Modified Internal rate of Return (MIRR)

Year 0 1 2 3 Total

Project E -100.00 20.00 20.00 100.00 140.00Project F -100.00 80.00 50.00 10.00 140.00

E IRR 14.2%F IRR 26.0%Cost of Capital 10.0%

If we compare IRRs than the second project is muchmore attractive and would be selected. However,comparing IRRs may overstate the return as the IRRmethod assumes reinvestment at the IRR. This may bean unreasonable assumption.

35


MIRRWhat happens if we assume that cashflows are reinvested at the cost of capital?

Reinvestment at Cost of Capital 0 1 2 3

Project E -100.00 20.00 20.00 100.0024.2022.00

-100.00 146.20

Project F -100.00 80.00 50.00 10.0096.8055.00

-100.00 161.80

Project E -100.00 0 0 146.20Project F -100.00 0 0 161.80

E MIRR 13.5%F MIRR 17.4%

If we assume reinvestment at the cost of capital, thenthe relative return of the second project is reducedsignificantly. As this project has significant cash flowsearly on, changing the reinvestment assumption canmake a large difference to the expected return.

36


Modified Internal Rate of Return (MIRR) NPV - assumes reinvestment at the cost of capitalNPV - assumes reinvestment at the cost of capital IRR - assumes reinvestment at the IRRIRR - assumes reinvestment at the IRR MIRR - Assume a reinvestment rate until end of MIRR - Assume a reinvestment rate until end of

projectproject MIRR = Rate that causes PV of the terminal value MIRR = Rate that causes PV of the terminal value

to equal PV of cash outflowsto equal PV of cash outflows

chapter 8 capital budgeting correia, mayall, o’grady & pang copyright skystone ©2005 2...

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