CAPITAL BUDGETING DECISION(INVEST-3.pptx

Notes on investment appraisal

1. CAPITAL BUDGETING DECISION BA, Msc AF, PMP AIDAN LUVANDA 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 1

2. CAPITAL BUDGETING DECISION Capital budgeting refers to the decision to invest in long term assets or projects. These assets or projects are expected to be used or benefit the company over a long period of time. PROCEDURE OR STEPS OF CAPITAL BUDGETING Identify the possible opportunities available. Screen them to reduce the number of alternatives to the most feasible alternatives. Estimate cash flows (inflows and outflows) for the feasible alternatives. Inflows are benefits while outflows are expenditure on the project. Evaluate and appraise to determine the feasibility of the project. Select and implement the most feasible alternative. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 2

3. DETERMINATION OF CASH FLOWS Determination of cash flows of a business is very important in making successful finance decisions. It involves the estimations of costs and benefits anticipated to be accrued in the investment and requires the help of different departments e.g. accounting, marketing, production etc. Which come together to forecast potential sales and costs of the investment. Cash flows can either be inflows or outflows. They can also be categorized basing on when they were realized i.e. initial cash outlays, intermediate cash flows and terminal cash flows (salvage value). 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 3

4. CONSIDERATION IN CASH FLOWS DETERMINATION Benefits from the investment should be on cash flows basis and not accounting profit basis. Benefits should be incremental and after tax. Consider changes in working capital 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 4

5. Depreciation: refers to gradual loss in value of an asset due to wear and tear. Whereas depreciation is deducted from net revenues in order to determine net earnings, it does not involve an actual movement of cash like other expenses. Depreciation also acts as a shield against taxes. The bigger the depreciation figure, the lower the level of earnings available for taxation. Hence, depreciation is regarded as a boost to inflow, which should be added back to the cash inflow after tax. Depreciation expense is added back because it does not involve actual cash flow much as is a tax deductible expenses 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 5

6. Salvage value which is the value at which an asset can be sold when the firm ceases to use it. It must be adjusted for tax to get net salvage value. NSV =SV (1 - t) Where SV=salvage value t=tax rate Sunk costs (cost of past investments that cannot be recovered) have no relevance to the new investment and they should be ignored. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 6

7. Opportunity cost i.e. the expected benefits which the company would have derived from those resources if they were not committed to the proposed project e.g. if a building was to be rented out at a certain amount but a company decides to use the building for a project, the money that would otherwise been received as rental income is an opportunity cost and should be incorporate in the initial cost of the project. The opportunity cost of other resources can also be computed in the same manner e.g. if the resource can be sold its opportunity cost is equal to the amount of price of that resource which the company misses by putting it in the alternative use. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 7

8. INITIAL CASH FLOWS (YEAR 0) These comprised of expenditures that are made before assets become operational. Initial cash flows include I. Cost of assets (invoice value of assets) II. Capitalized expenditure: this is the expenditure required to make the assets operational e.g. freight charges, insurance, installation cost. III. Opportunity cost. Investment allowances or tax holidays changes in working capital 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 8

9. FORMAT OF COMPUTING INITIAL CASH FLOWS Invoice value………………………………………………………….…..XX Add: Capital expenditure Transportation………………..……………XX Insurance…………………………………..XX Installation…………………………….…… XX XX Add: Increase in Working capital……………….XX Opportunity cost………………………….… XX XX Less : Decrease in working capital…………………………….…….…(XX) Investment allowances.…………………………………..…..…..(XX) Tax Holidays…………………………………………..……..……. (XX) NET INITIAL CASH FLOW/OUTLAY……..……………..……….……. XX 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 9

10. INTERMEDIATE CASH FLOW These are cash flows that the investor expects to generate after the initial out lay has been made. These cash inflows are expected from period 1 up to period n - 1 of the useful life of the assets. For example an asset with about 5 years lifespan will have intermediate cash flows accruing from year 1 to 4. Intermediate cash flows are realized from operating an asset inform of adjusted net revenues earned and any cost savings made by investing in the assets. Intermediate cash flows include: .increase in sale revenue offsets by increased expenses .cost savings 3. Adjustments of depreciation and other tax shield 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 10

11. THE FORMAT Revenue……………………………………………………….……….………....…………..XX Less: Costs (without depreciation, interest & tax)………………………….………….… XX Earnings before tax, depreciation & interest…………………………………..….XX Less : Interest………………………………………………………………………..…….… XX Earnings before tax and depreciation……………………….………………….....XX Less: Depreciation……………………………………………………………………....…. XX Earnings before tax……………………………………………………………….…XX Less: Tax…………………………….……………………………………………….…...… XX Earnings after tax……………………………………………………….……..….….XX Add back: Depreciation……………………………………………………….…………... XX NET INTERMEDIATE CASH FLOWS………………………………………….…..….… XX 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 11

12. TERMINAL CASH FLOWS These occur at the end of the investment life and they include Scrap value\salvage value (net salvage value) Tax saving or tax expenses Terminal cash flows =net cash flow in final year of project +net salvage value 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 12

13. PROJECT/INVESTMENT APPRAISAL TECHNIQUES Investment appraisal is the evaluation of the collected data about the cash flows so as to determine its viability. Once the cash flow rate has been determined and information has been derived, that information should be subjected to farther analysis using relevant techniques of investment appraisal. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 13

14. The techniques fall under three broad categories Where there is no formal analysis, rely on experience, rule of thumb and peer advice. These techniques are advantageous in that, they are quick and cheap, but they can be sometimes unreliable. Non-discount cash flows methods: the techniques ignore the time value of money. They do not discount future cash-flow when comparing inflows and outflows. They include payback period method, accounting rate of return method or average rates of return method. Discount cash flow methods: these take into account time value of money. Here future cash flows are discounted to their present worth. These methods include net present value (NPV), internal rate of return (IRR) and profitability index (benefit ratio). 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 14

15. NON DISCOUNTED CASH-FLOWS METHODS 1. Payback period This determines the period it takes for an investment to generate sufficient incremental cash to realize its capital outlay. Determination of payback period depends on the nature of cash flows which may either be: a. uniform or even b. varying or uneven over the useful life of the investment. For a uniform cash-flow pattern the payback period is calculated as follows Initial outlay PBP= Annual cash flow 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 15

16. Acceptance criteria Under this technique the PBP determined for the investment should be shorter than the useful life of the investment or at least equal to the PBP desired by the firm for that category of investment. When evaluating different projects, the most viable is the one with the shortest PBP. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 16

17. EXAMPLE 2 Constant cash flow An investment of initially out lay of Tshs400m/= generates uniform cash inflows of Tshs100m/= per year and the useful life of this investment is 6years. Evaluate the project using PBP. SOLUTION PBP= 400,000,000 = 4 years 100,000,000 The project is viable because the PBP is shorter than the useful life of the project. Unequal cash flows In case of unequal cash inflows, the payback period can be found out by accumulating the cash inflows until the total is equal to the initial cash outlay. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 17

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19. ADVANTAGES OF PBP It uses cash-flows information which is relevant information for the objective of the firm It is a simple technique to understand. It costs less than other methods in terms of time and cost. DISADVANTAGES OF PBP It ignores inflation i.e. time value of money. It does not consider all cash flows. The technique ignores cash-flows after the PBP. 3. Uniformity of conditions is unrealistic 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 19

20. ACCOUNTING RATE OF RETURN [ARR] The ARR, also known as the return on investment (ROI), uses accounting information, as revealed by financial statements, to measure the viability of an investment. The ARR is the ratio of the average after tax profit divided by the average investment. The average investment would be equal to half of the original investment if it were depreciated constantly. Alternatively, it can be found by dividing the total investment’s book values after depreciation by the life of the project. The ARR thus, is an average rate and can be determined by the following equation: 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 20

21. ARR = Average income Average Investment Average income should be defined in terms of earnings after taxes without an adjustment for the interest EBIT (1 - T) or net operating profit after tax. Thus 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 21

22. Where: EBIT = earnings before interest and taxes T= Tax rate 𝐈𝐨= book value of the investment at the beginning 𝐈𝐧=book value of the investment at the end of n number of years 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 22

23. EXAMPLE A project will cost Tshs40m/=. Its streams of earnings before depreciation, interest and taxes (EBDIT)during first year through five years is expected to be Tshs10m/=, Tshs12m/=, Tshs14m/=, Tshs16m/= and Tshs20m/=. Assume a 30% tax rate and depreciation on straight line basis. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 23

24. ACCEPTANCE RULE As an accept or reject criterion, this method will accept all those projects whose ARR is higher than the minimum rate established by the management and rejects those projects which have ARR less than the minimum rate. This method would rank projects as number one if it has highest ARR and lowest rank would be assigned to the project with the lowest ARR. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 24

25. DISCOUNTED CASH FLOW METHOD 1. Net present value method (NPV) The NPV of an investment is the difference between the present value of the initial outlay and the present value of the streams of the expected cash-inflows. It is the sum of the present value of the cash inflows minus the initial investment. It involves the process of calculating the present value of cash flows of an investment using the cost of capital as the discount rate. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 25

26. Whereas 𝐴 𝑖 =net cash flow in period r=the discount rate 𝐼 𝑜 =the initial investment 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 26

27. ACCEPTANCE CRITERIA I. All projects with positive NPV should be accepted because they add value to the firm [NPV > 0, accept] II. Projects with negative NPV should be rejected because they reduce the value of the firm [NPV < 0, reject] III. Projects with zero NPV can be accepted depending on the objectives of the investor. A zero NPV implies that, a project generates cash flows at a rate just equal to the opportunity cost of capital. [NPV=0, accept] IV. When considering several projects, the higher the NPV the better the project. The NPV method can be used to select between mutually exclusive projects; the one with the highest NPV should be selected. Using the NPV method, projects would be ranked in order of present value; that is, first priority will be given to the project with the highest positive NPV and so on. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 27

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30. Note: 0 year is the 1st year of investment and 1st year of the project is the 2nd year of the investment ADVANTAGES OF NPV METHODS I. It takes into account time value of money by discounting cash-flow to their present worth. II. It uses actual cash-flow and not book profit which is relevant to the objective of wealth maximization. III. It considers all the cash-flows over the entire life of the project. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 30

31. DISADVANTAGES There are difficulties in estimating cash-flows especially when long period of time are involved The method is tedious to use when the project cash flows are forecasted over a very long period of time. It involves complex calculation which may not be easy to understand by managers who have no formal background of quantitative technique. I V. It is difficult to determine the discount rate. N.B: However, NPV is considered to be superior over other techniques because of its advantages. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 31

32. 2. INTERNAL RATE OF RETURN METHOD (IRR) IRR is defined as the discount rate that equates the present value of the expected future net cash flow to the initial capital outlay. It is the discount rate that equates the present value of the expected cash outflow to the present value of the expected cash inflow. In other words, the IRR is the discount rate at which NPV=0. It is the discount rate at which the project breaks-even. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 32

33. Since we cannot reasonably and quickly determine the discount rate at which the NPV =0 we use trial and error together with either. Formula method. II. Graphical method. ACCEPTANCE CRITERIA Accept investment whose IRR>RRR and reject those investment, whose IRR<RRR The higher the IRR the better the project in case all projects have IRR>RRR. III. When IRR=RRR the project may be accepted depending on the objectives of the investor 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 33

34. ADVANTAGES I. It recognizes the concepts of time value of money. II. It uses cash flows which is consistent with the objectives of wealth maximization. III. It considers the cash flow over the entire life of the project. IV . It has psychological appeal to the users because of the percentage figure. V. It helps one to look for the particular rate of return that will make the investment break-even.   DISADVANTAGES I. One may fail to get the exact rate that equates the PV of benefits (cash inflow) to the PV of cost (cash outflows). II. There are situation when one obtains multiple internal rates of returns. III. It is the most difficult one to compute. IV. Where projects differ (all have different cash outlay), it yields conflicting results with the NPV methods. N.B: where one has to choose between NPV and IRR, NPV should be considered because it is superior. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 34

35. PROFITABILITY INDEX METHOD OR BENEFIT COST RATIO This is the ratio of the present value of cash inflows to present value of cash outflow. It is given by PI=   11/23/2022 BA, Msc AF, PMP Aidan Luvanda 35

36. ACCEPTANCE CRITERIA If the P>1 it implies that the ∑PV of cash inflow is greater than ∑PV of cash outflow therefore, the project should be accepted. If PI=1 it implies that the project pays back what was invested. Depending on the aim of the project and the objectives of the investor it may be accepted.  If PI<1 it implies that ∑PV of cash inflows is less than ∑PV of cash out-flow and the NPV is negative. Therefore the project should be rejected. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 36

37. SPECIAL CONSIDERATION IN CAPITAL BUDGETING Generally, all investments which have NPV>0, IRR>RRR PI>1 are acceptable. Special considerations come to action when the general acceptance criteria need adjustments ASSUMPTION MADE WHEN USING ABOVE ACCEPTANCE CRITERIA I. Investment projects are independent of one another and therefore acceptance of one doesn’t affect acceptability of another. That is the investments are considered for different purposes and therefore, acceptance of one investment has no implication for the others. II . The firm has no restriction on the funds available for capital expenditure III . There is no risk associated with cash flows which have been injected into or are expected from the investment. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 37

38. IN THE REAL WORLD THESE ASSUMPTION MAY NOT HOLD BECAUSE: I. investment proposal can be dependent on one another such that acceptance of one would affect the acceptability of another. When this is the case then such investment are said to be mutually exclusive. II. In real world, funds are limited hence capital rationing has to be made. When you ration funds viable investments such that those with NPV>0, IRR>RRR and PI>1 may be left out. III. Investment decisions are normally undertaken under the conditions of risk. Assumptions such as increasing in economic growth are made before you invest. But these may change during implementation which will bring about variability in return (risk). Therefore one has to incorporate risk in capital budgeting decision. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 38

39. HOW TO DEAL WITH MUTUALITY EXCLUSIVE INVESTMENTS Two investments are said to be mutually exclusive if selecting one investment means that, the other must be excluded even if both of them are viable. Mutually exclusive investment cannot be accepted together. The issue is then, how to select the best investment. It is imperative that a system of ranking investments is designed so that only the best alternative is selected. Ranking will only be possible, if the following conditions hold : If the NPV, IRR and PI rank a particular investment to be superior to others such that if they consistently rank the certain investment as the best, then you take it up. However situation occurs when you get mixed signals. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 39

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41. CAPITAL BUDGETING UNDER THE CONDITION OF CAPITAL RATIONING Capital rationing is the process of allocating the limited amount of funds to investments. In practice managers are faced with a problem of allocating capital to various opportunities due to constraints of limited sources of funds. Capital rationing occurs when a firm can’t undertake all viable investments due to insufficient funds for capital expenditure. The insufficiency of funds could be due to internal or external factors. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 41

42. INTERNAL FACTORS 1. A risk profile of the manager. Risk averse managers will not go to raise funds from the markets (money or capital markets) even when they are available. 2. Internal borrowing restrictions These could be imposed by financial managers or could be in the memorandum of association, article of association or board restriction 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 42

43. EXTERNAL FACTORS 1. Capital market imperfections e.g. lack of adequate information, high cost of capital etc. 2. Absence or lack of capital markets in some situations.   ACTIONS TO TAKE DURING CAPITAL RATIONING Capital rationing implies that you adjust your acceptance criteria and you must accept investment as a bundle which mixes the following: 1. A bundle that gives a highest NPV contribution. 2. A bundle which exhaust the available fund as much as possible. The above two conditions now become the criteria of acceptance.   11/23/2022 BA, Msc AF, PMP Aidan Luvanda 43

44. CAPITAL RATIONING COULD BE IN A SINGLE PERIOD OR IN SEVERAL PERIODS . Single period capital rationing is when you have limited funds in first year, whereas multiple periods capital rationing occurs even in subsequent years. Single period capital rationing: Investment funds are limited in the current period and the financial manager’s concern is to maximize return by choosing a mix of investment opportunities. Single period capital rationing may occur in: 1. Divisible projects and 2. Indivisible projects.   Single period divisible projects: Example; XYZ has 120m/= available for investment in the following projects at a cost of capital of 20%. Thereafter capital will be freely available. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 44

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46. Single period indivisible projects In this case there is no systematic way of allocating capital. We have to use trial and error method to select a combination which gives the highest NPV subject to the capital constraint even if it means rejecting investments which appear higher in ranks. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 46

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48. IMPLICATIONS OF CAPITAL RATIONING 1. The best investment can be left out. For example investment A has the highest NPV but is left out because of insufficient fund. 2. You may lose competitive advantage in the market because of leaving out viable investments. INCORPORATING RISK IN CAPITAL BUDGETING In capital budgeting risk refers to possible variability between the estimated cash flows and the realized cash flows in implementing projects. The variability may be due to economic changes, changes in government policy, changes in social cultural value etc. when these variations occur then there is risk. Risk is associated especially with cash inflows because they go further into the future. Risk can be incorporated in capital budgeting by; 1 . Measuring the extent of risk associated with the investment. 2. Adjust the expected cash inflows for risk.   11/23/2022 BA, Msc AF, PMP Aidan Luvanda 48

49. MEASUREMENT OF RISK Risk is generally an estimate and therefore involves subjectivity. Risk is determined by measures of Dispersion from the average cash flow of the investment. The investor has to establish the probability distribution of the cash flows so as to determine whether the cash flows are estimated by a normal distribution. To determine the extent of dispersion of the cash flow from the average we use the measure of dispersion i.e S. D and coefficient of variation. These measure the risk that the cash flow may or may not be realized. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 49

50. EXAMPLE Suppose there are 3 states, very optimistic, optimistic and pessimistic and they have cash flows of 500,300, and 200 respectively. Very optimistic has a probability of occurrence 0.10, optimistic 0.25 and pessimistic 0.65. Required; Find the mean Standard deviation Coefficient of variation 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 50

51. COMMON PROCEDURES FOR ADJUSTING FOR RISKS IN CAPITAL BUDGETING: 1. Certainty equivalent factors This technique incorporates risks in cash flows by adjusting them to a minimum level which is regarded as risk free. These factors are determined for each cash flow and range from zero to one certainty equivalent factors reflects the perception of the managers towards risk. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 51

52. 𝛼𝑖 = Certainty equivalent factor associated with cash flows in period i 𝐴𝑖 = Risk cash flow for period i K = Risk free rate of return determined from government securities like treasury bills n = Useful life of a project Io = Initial investment 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 52

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54. A certainty equivalent factors associates with this cash flows are 1.00, 0.95, 0.80, 0.72 and 0.60 respectively. The risk free rate of return as determined by the government treasury bills is 8% while the required rate of return of the firm is 12%. Determine the NPV using; i . Risky cash flows ii. Risk adjusted cash flows. 11/23/2022 BA, Msc AF, PMP Aidan Luvanda 54

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