BAC 815 TOPIC THREE Capiatl Budgeting.ppt

capital budgeting notes

1. TOPIC THREE: CAPITAL BUDGETING
Capital budgeting decision is the firm’s decision to invest its
current funds most efficiently in long term assets in
anticipation of an expected flow of benefits over a series of
years
Capital budgeting decisions are of great importance for a
business enterprise due to the following reasons:
The results of the decision continue for many years hence
such decisions affect the profitability of a firm
Large amounts of money are invested in capital projects
The resources that are invested in a project are often
committed for a long period of time
They are irreversible or if reversible, then at a substantial
loss
They are among the most difficult decision to make since
they involve assessment of future events which are difficult
to predict
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2. Types of investment decisions
Expansion and diversification: expansion involves a
company undertaking projects to increase
production, where diversification is investment in
plant and machinery to produce items which it has
not manufactured before.
Replacement and modernization: the main objective
of these is to improve operating efficiency and
reduce costs. This is reflected in increased profits.
The firm replaces obsolete assets with those that
operate more economically
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3. Cont’d
The success or failure of the company may
depend upon a single or relatively few investment
decisions. These decisions are made for an
uncertain future. Erroneous forecast of asset
requirements can have serious consequences. If it
invests too much-may incur unnecessarily high
depreciation and other expenses and if not
enough-may not produce
competitively(inadequate capacity) or may lose
market
Firms have scarce capital resources and therefore
timing is of essence. Capital assets must be
available when they are needed
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4. Investment evaluation criteria
•Steps involved in the evaluation of investment
include:
i. estimation of cash flows
ii. Estimation of the required rate of
return
iii. Application of a decision rule for
making the choice.
The various investment decision rules may be
regarded as capital budgeting techniques or
investment criteria
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5. Cont’d…..
Any investment to be undertaken will need to be assessed as
regards its viability using an acceptable approach. Any
appraisal method to be used to assess the viability of a
venture must fulfill the following requirements:
It should appreciate that bigger returns are preferable to
small ones and early returns are preferable to later benefits.
This is necessary because money loses value with time and
the method must accommodate this phenomenon
The method should be able to rank various ventures available
in the investment market in order of their profitability
The method should distinguish which investment ventures are
acceptable and which ones should be rejected and why.
The method should be able to be used for gauging the
viability of any investment ventures as and when they arise
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6. Cont’d…
There are two categories of assessing the viability of an
investment. These are:
1.Non-Discounted cash flow criteria/traditional methods
 Payback period
 accounting rate of return-ARR
2. Discounted cash flow criteria/modern methods/time
adjusted criteria
Net present value-NPV
Internal rate of return-IRR
Profitability Index-PI
Discounted payback period
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7. Payback period
•The payback period is the number of years in
which the capital expenditure incurred is
expected to be recovered. It means that the
PBP is the time required to pay back the
investment from the earnings. A project with
lowest PBP is selected on the basis of this
method
•Annual cash inflows represent the amount of
profit after tax but before depreciation
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8. Revision Question
You are a financial analyst of H ltd company. The
director of capital budgeting has asked you to
analyze two proposed capital investments,
project X and Y. Each project has a cost of
sh.100,000 and the cost of capital for each
project is 12%. The projects’ expected net
cash flows are as follows:
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9. Cont’d
EXPECTED NET CASH FLOWS
YEAR Project X Project Y
1 65,000 35,000
2 30,000 35,000
3 30,000 35,000
4 10,000 35,000
Required:
i.Calculate each project’s PBP,NPV and IRR
ii.Which project or projects should be acceptable if they
are independent
iii.Which project should be accepted if they are mutually
exclusive
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10. Cont’d…
Merits of PBP
a.It recognizes the timing of cash flow
b.It is reliable for investment decisions for
companies in high risk market
Demerits of PBP
a.It fails to take account of cash inflows earned
after the PBP
b.it ignores the profitability of the project
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11. Accounting rate of return(ARR)(average rate of
return)
•It is based on accounting information rather than
cash flows
•The rate of return is expressed as a percentage of
earnings to investment in a particular project. A
project with highest rate of return is selected on
the basis of this method
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12. Example
An embroidery machine is expected to cost sh.400,000.
Its stream of earnings before depreciation, interest
and taxes during first year through year five is
expected to be sh.100,000, sh.120,000, sh.140,000
sh.160,000 and sh.200,000.
The net book value at the end of year 5 is expected to
be sh. 80,000. The expected market value of the
machine is sh90,000.
Assume a 30% tax rate and depreciation on straight line
basis. The cost of capital is 12%
Required: the project’s:
i.payback period
ii.ARR
iii.NPV
iv.IRR
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13. Cont’d…
Advantages of ARR
1.ARR can be readily calculated from the accounting data
2.Unlike in the NPV and IRR methods, no adjustments are required to
arrive at cash flows of the project.
3.The ARR rule incorporates the entire stream of income in calculating the
project’s profitability
Disadvantages
1.ARR ignores the timing of cash flows
2.It uses the accounting profits rather than cash flows in appraising
projects –accounting profits are based on arbitrary assumptions and
choices and also include non cash items. Egdepreciation
3.A firm employing ARR method uses an arbitrary yardstick. Generally the
yardstick is the firm’s current return on its asset. As a result, companies
earning very high rates on their existing assets may reject profitable
projects with positive NPV and less profitable companies may accept bad
projects with negative NPV
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14. Discounted cash flow methods
a.Net Present Value(NPV) Method
This method discounts inflows and outflows and
ascertains the NPV by deducting discounted
outflows from discounted inflows to obtain
NPV of the cash flows.
A = cash flows for the respective years
Io = initial outlay
K = cost of capital
t = no. of periods (years) 14

15. Cont’d…
JT ltd wishes to expand its output by purchasing a new machine
worth sh.170,000 and installation cost estimated at sh.40,000.
In the fourth year, this machine will call for an overhaul at a
cost of sh.80,000.
Its expected inflows are as follows
Year cash flows (sh)
1 60,000
2 72,650
3 35,720
4 48,510
5 91,630
6 83,715
The firm can raise finance to purchase machine at 12% interest rate.
Required: Compute the NPV and advice the management
15

16. Cont’d…
Exercise
R ltd intends to purchase a machine worth sh.1,500,000 which will have a
residual value of sh.200,000 after 5 years useful life. The after tax savings
in costs resulting from the use of this machine are:
year sh.
1 800,000
2 350,000
3 ---
4 680,000
5 775,000
Required:
Using NPV method, advice the company whether this machine should be
purchased if the cut off rate is 14% and acceptable savings in cost is 12%
of the cost of investment.
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17. Cont’d…
Exercise
A section of a roadway pavement costs $400 p.a
to maintain. What new expenditure of new
pavement is justified if no maintenance will be
required for the first 5 years, then $100 for the
next 10 years and $400 per year there after.
Assume cost of finance to be 5% p.a
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18. Cont’d…
Exercise
A section of a roadway pavement costs $400 p.a
to maintain. What new expenditure of new
pavement is justified if no maintenance will be
required for the first 5 years, then $100 for the
next 10 years and $400 a year there after.
Assume cost of finance to be 5% p.a
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19. Cont’d….
Advantages of NPV method
1.It recognizes time value of money and appreciates that a shilling receivable now
is more valuable than a shilling tomorrow and the two can only be compared if
they are at their present value
2.It takes into account the entire inflows or returns and as such it is a realistic
gauge of a profitability of a venture
3.It is consistent with the value of a share in so far as a positive NPV will have the
implication of increasing the value of a share.
4.It is consistent with the objective of maximizing the wealth of owners because a
positive NPV will increase the net worth of owners
Disadvantages
1.Its calculation uses cost of finance which is a difficult concept because it
considers both implicit and explicit costs
2.It is not ideal for assessing the viability of an investment under certainty.
3.It ignores the PBP
4.It may not give good assessment of alternative projects if the projects have or
have unequal lives, returns or costs.
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20. Cont’d…
b. Internal Rate of Return(IRR)
It is that rate of return which equates the PV of
inflows to PV of outflows.
IRR
20

21. Cont’d…
Acceptance rule of IRR
A firm will accept a venture if its IRR is higher than or equal to
the minimum rate of return which is usually the cost of finance
also known as the cut off rate, discount rate, hurdle rate.
In this case, IRR will be the highest rate of interest a firm could
be ready to pay to finance a project using borrowed funds and
without being financially worse by paying back the loan out of
the cash flows generated by that project
Thus IRR is the breakeven rate of borrowing from commercial
banks
In the context of savings and loans the IRR is also called the
effective interest rate. The term internalrefers to the fact that
its calculation does not incorporate environmental factors
(e.g., the interest rateor inflation).
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22. GRAPHICALLY
Showing the position of the IRR on
the graph of NPV(r) (ris labelled 'i' in
the graph) 22

23. Cont’d…
Example
A project costs sh. 16,200 and is expected to
generate the following cash flows.
year sh.
1 8,000
2 7,000
3 3,000
Required: Compute the IRR of this venture
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24. Cont’d…
Advantages:
1.It is consistent with time value of money
2.It considers the cash flows over the entire life of the project
3.It is compatible with maximization of shareholders because
it is higher than the costs of finance, hence owners wealth
will be maximized.
Disadvantages.
1.It is tedious to use
2.Expensive to use because it calls for trained manpower and
may use computers especially where inflows are of large
magnitude and extending beyond the normal limits
3.It may give multiple results–some involving positive IRR in
which case, it may be difficult to use in choosing the venture
that is more viable
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25. Assessment of Replacement Decisions
A company may buy a new fixed asset either to:
i. Replace the existing ageing asset or
ii. To expand its business.
There are two types of replacement decisions
a.Replacement of an existing asset with anew but identical
asset. In this case the problem will simply be one of deciding
how frequently the asset should be replaced. iewhat is the
optimum replacement cycle?
b.The replacement of existing asset with a different asset. i.e
an asset which is technologically different. In this case there
is need to assess the incremental cash flows to make a
decision
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26. Cont’d…
Factors to be considered in making replacement decisions.
1.Operating and maintenance costs-
2.Technological changes
3.Future expansion programmes
4.Taxation and investment incentives-the company’s decision
will be influenced by taxation, capital allowance and
availability of government investment incentives
5.Opportunity cost-a new asset is probably capable of greater
productivity than an ageing asset. Therefore any delay in
replacement may involve loss of output which could have
been obtained from a new asset.
6.Inflation effects and import duties
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27. Cont’d…
7. Realizable value-the realizable value of an
asset will decline as the asset becomes older
and more worn out. Early replacement means
that higher resale value should be obtained
for the existing equipment
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28. Depreciation tax shield(DTS)
Depreciation as per income tax rules is a deductible
expense for computing taxes. It indirectly influences
cash flow since it reduces the firm’s tax liability.
Cash outflow for tax saved is in fact an inflow of cash.
The saving resulting from depreciation is called
depreciation tax shield.
NOTE
NCF = REV-EXP-TAX Tax= tax rate(REV-EXP-DEP)
Hence;
NCF = REV-EXP-T(REV-EXP-DEP)
= (REV-EXP)-T(REV-EXP)+T(DEP)
= (REV-EXP)(1-T) + T(DEP)
= EBDIT(1-T) + DTS
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29. Replacement procedure
A project creates value for the firm’s shareholders if
and only if the NPV of its incremental cash flow is
positive. Incremental cash flow can be classified
into:
Incremental initial investment outlay-is the up
front cost plus any increase in net working capital
Incremental operating cash flows over the
project’s life
Terminal year cash flows-this include salvage
value of fixed asset adjusted for taxes if asset is
not sold at its book value plus the return of the
net working capital
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30. Revision question
The PUC Ltd is using a machine whose original cost was sh.720,000. The
machine is two years old, and it has a current market value of
sh.160,000. The asset is fully being depreciated over a twelve year
period. At the end of the twelve years, the asset will have a zero salvage
value. Depreciation is on a straight line basis.
The management is contemplating the purchase of a new machine to
replace the old one. The new machine costs sh.600,000 and installation
estimated at sh.150,000. It has an estimated salvage value of sh.100,000.
The new machine will have a greater technological capacity and
therefore annual sales are expected to increase from sh. 10,000,000 to
sh.10,100,000. Operating efficiencies with the new machine will produce
an expected saving of sh.120,000 a year. Depreciation would be on a
straight line basis over a ten year life. The cost of capital is 12% and a
40% tax rate is applicable. In addition, if the new machine is purchased,
inventories will increase by sh.150,000 and payables by sh.50,000 during
the life of the project.
Required:
i.Should the new machine be purchased?
ii.What factors in addition to the quantitative ones above are likely to
require consideration in a practical situation?
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31. Revision question
A lathe for trimming molded plastics was purchased 10 years ago at a cost of sh.75,000. The
machine had an expected life of 15 years at the time it was purchased and management
originally estimated and still believes that the salvage value will be zero at the end of the 15
year life. The machine is being depreciated on a straight line basis. Its present book value is
sh.25,000.
The R & D manager reports that a special purpose machine can be purchased for sh.120,000
(including freight and installation) and over its five year life it will reduce labourand raw
material usage sufficiently to cut annual operating cost from sh.70,000 to sh.40,000. This
reduction in costs will cause PBT to rise by sh.30,000.
It is estimated that the new machine can be sold for sh.20,000 at the end of five years. The old
machine’s actual current value is sh.10,000 which is below its sh.25,000 book value. Net
working capital will increase by sh.10,000 at the time of replacement. The company is in 40%
tax bracket and the project cost of capital is 12% p.a
Required: compute
i.The incremental cash outlay
ii.Operating inflows over the project’s life
iii.Terminal year cash flow
iv.Net cash flow
Should the machine be replaced? (10 marks)
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32. Revision Qs
The management Mojo Ltd intends to replace its existing two year old milk
scheming machine whose original cost was sh. 500,000. The machine is two
years old, and it has a current market value of sh.350, 000. The capital
budgeting analysts believe that the machine has five more years of useful life.
At the end of the five years, the asset will have a zero salvage value. The net
book value of the machine is sh.400,000.
The management is contemplating the purchase of a new machine to replace
the old one. The new machine costs sh.800,000 and installation estimated at
sh.150,000. It has an estimated salvage value of sh.100,000 at the end of five
year useful life. The new machine will have a greater technological capacity
and therefore annual sales are expected to increase by sh.120, 000. Operating
efficiencies with the new machine will produce an expected saving of
sh.130,000 a year. The company uses modified accelerated capital recovery
depreciation method of 23%, 17% 20%, 21% and 19% from year one to year
five respectively.
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33. Cont’d…
The cost of capital is 12% and a 40% tax rate is applicable. In addition, if the
new machine is purchased, inventories will increase by sh.150,000 and
payables by sh.50,000 during the life of the project.
Required:
i.Compute the project’s:
Incremental initial outlay 6 marks
ii. Incremental operating cash inflow 6marks
iii.Theterminal cash flows 4 marks
iv.Advisethe management on whether to replace the machine 4 marks
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34. Capital Rationing
Capital rationing occurs when the company
has more profitable projects than it can
finance.
Because of the limited financial resources,
firms may have to make a choice from among
profitable investment opportunities.
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35. Types of capital rationing
i.Hard or externally imposed capital rationing
Hard capital rationing occurs when the company fails to raise investment
funds from the capital market despite having viable projects. This could
be attributed to the following factors:
depressed economy-national and international factors may make the
market highly volatile and unstable. E.g issue of capital funds via
additional shares or corporate bonds is not attainable
Inability of the firm to procure required funds from capital market
because the firm does not command the required investors’ confidence.
E.g poor rating of the company’s performance
Inability of the firm to satisfy the regularity norms for issue of
instruments for tapping the market for funds.
High cost of issue of securities i.e high flotation cost. Smaller firms may
have to incur high costs of issue of securities. This discourages small
firms from tapping the capital markets for funds.
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36. Cont’d
ii. Soft or internally imposed capital rationing.
This is a deliberate attempt by company’s top management to impose
restrictions on the funds allocated to fresh investment. This may be done
in order for the firm to concentrate on a few projects so as to identify the
company’s
Flag bearers-cash cows. Are products with high market share but low
growth potential. They generate a lot of profits and cash flows but their
investment requirements are moderate.
Stars-are products with high market share and high growth rate. They earn
high profits but they need high commitment of funds to increase growth in
sales and production.
Dogs. Are products with low market share and limited growth potential.
The firm should divest from them and hence release funds for production
of stars
Soft capital rationing can be imposed on a firm because of lack of qualified
staff to manage specific projects to the company’s required standards. (
this gives a negative image on the company’s planning process and should
be discouraged as much as possible)
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37. Ranking of different investment proposals
The various investment proposals should be
ranked on the basis of their profitability.
Ranking is done on the basis of NPV,
Profitability Index or IRR in the descending
order.
Divisible capital projects are those project that
can be done in parts.
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38. illustration
The following six projects have been submitted for inclusion in 2017 capital
expenditure budget for Limuru Ltd.
Year A B C D E F
sh. sh. Sh. sh. sh. Sh.
Investment O(2017) 250,000 250,000 500,000 500,000 500,000 125,000
1 0 50,000 175,000 0 12,500 57,500
2 25,000 50,000 175,000 0 12,500 57,500
3 50,000 50,000 175,000 0 37,500 50,000
4 50,000 50,000 175,000 0 125,000 25,000
5 50,000 50,000 175,000 0 125,000
PER YEAR 6-9 50,000 50,000 500,000 125,000
10 50,000 50,000 125,000
PER YEAR 11-15 50,000 50,000
IRR 14% ? ? ? 12.6% 12.0%
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39. CONT’D
Required:
a.Rates of returns for projects B,C and D and a ranking of all
projects in descending order.
b.Based on the answers in (a), which projects would you
select, assuming a 10% hurdle rate and the following
independent limits in expenditure
i. sh.1,250,000
ii. Sh.1,375,000
iii. Sh. 1,625,000
c.i. If 16% minimum is the desired rate of return, compute
the NPV and ranked all the projects.
ii. Which project is more desirable between C and D?
iii. If project C and D are mutually exclusive, which would
you choose? Why?
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