Chapter - 3 CAPITAL BUDGETING Decis.pptx

Capital budgeting

1. capital budgeting PROCESS: AN OVERVIEW CAPITAL BUDGETING DECISIONS CHAPTER 3

2. Learning Objectives By the end of this lecture, you should be able to: Understand the nature of capital budgeting/long-term Investment decisions Understand the types of capital budgeting decisions Understand the components of investment cash flows Understand the common techniques of project evaluation

3. What is capital budgeting? Capital Budgeting is the process of allocating current resources in a long-term asset by anticipating profit over a period of time Capital budgeting decision may be defined as the firm’s decision to invest its current funds most efficiently in the long term assets in anticipation of benefits over a series of years. Therefore a firm: Exchanges current funds for future benefits Invest the funds in long term assets Expect future benefits over a series of years.

4. Types of Long-term/Capital Budgeting decisions There are two types of Capital projects based on the benefits: Cost Reduction Projects : Are intended to reduce the operating costs such as cost of materials, cost of labor, and the like, whose benefit is measured in terms of cost saving Revenue Expansion Projects : Are intended to increase revenue whose benefit is measured in terms of cash flows

5. CAPITAL BUDGETING Investment decisions can also be classified into three categories as follows: Mutually Exclusive Investments. If one investment is taken, others will have to be excluded e.g. use of a labor intensive equipment or a capital intensive equipment. Mutually Exclusive: are those in which acceptance of one project will automatically preclude the possibility of accepting another project If you choose one, you can’t choose the other Example: You can choose to attend graduate school at either Harvard or Stanford, but not both The outcome from Tossing a coin

6. CAPITAL BUDGETING Independent Investments The investments that do not compete with each other. Depending on the availability of funding and their profitability, the company can undertake both investments. Independent projects: are those projects which do not compete with one another

7. CAPITAL BUDGETING Contingent Investments These are dependent projects and the choice of one investment necessitates undertaking one or more investment. E.g. if a company builds a factory in a remote area, they have to also build houses, roads and schools for the employees. These are Non-Revenue generating projects: Are intended to comply with government orders, labor agreements, or insurance policy terms

8. Cash flows involved in capital budgeting decisions Basically, there are three types of cash flows involved in Long-term investment/Capital budgeting decisions: Initial investment Operating cash flows Terminal cash flows

9. Components of Investment cash flows……. Initial investment: the initial outlay of cash invested on the project Components of initial investment: Gross investment (a) Increase in Net working capital (b) Salvage proceed from sale of old assets (c) Tax increase or tax shield (decrease) (d) Investment tax credit (e) Initial investment= a + b – c +/- d - e

10. Components of Investment cash flows……. Operating cash flow after tax (CFAT) The cash flow expected to be generated from the project during the life of the project NCFAT = Net Income + Non-cash Expenses or NCFAT = Net Income + Depreciation

11. Components of Investment cash flows……. Terminal cash flow: Terminal cash flows are those cash flows which are expected to occur at the end of the life of the project Salvage value of new investment (net of income tax) Recovery in net working capital Terminal Cash Flow =Salvage Value+Net Working Capital Recovery−Shutdown Costs±Tax Effects

12. Investment (Projects) Evaluation Techniques Project evaluation techniques are classified into two categories: Traditional (non-discounted Cash flow) techniques Average rate of return/Accounting Rate of Return Payback period Discounted Cash Flows (DCF) Techniques Net Present Value (NPV) Profitability Index Internal Rate of Return (IRR) The Ideal (perfect) Evaluation Method should: include all net cash flows that occur during the life of the project, consider the time value of money , incorporate the required rate of return on the project.

13. Traditional/Non-discounted Cash flow techniques  

14. ARR continued…………….. Example: Suppose that the project has original cost of Br. 80,000, life of five years, and salvage value of Br. 5,000. Annual net income is expected to be Birr 10,000 for each year for five years. What is accounting rate of return? Solution ARR= Average Net income/Average investment Average Investment = (80,000+5000)/2=42,500 Average Net income = (5x10,000)/5=10,000 ARR= 10,000/42,500 = 23.5%

15. ARR continued……………. Decision Rule: Accept the project if Accounting Rate of Return is equal to or greater than the standard set by the management. Reject the project if Accounting Rate of Return is less than the standard set by the management. Limitations (drawbacks) of Accounting Rate of Return  It neglects the timing of cash flows (it does not consider the time value of money concept) It is based on accounting income rather than cash flows

16. Traditional/Non-discounted Cash flow techniques Payback period (PBP) technique It is the most popular and widely recognized traditional method of evaluating investments. It is defined as the number of years required to recover the original cash outlay invested in the project If the project generates constant annual cash inflows the PB will be PBP=I/CFAT=Investment/Cash flow after tax Example Mr. H spent Birr 10,000,000 to build a house and expected to receive Birr1, 000,000 annually as rent income. The payback period is Birr 10m ÷ Birr 1m = 10 years.

17. Example: If the initial investment and annual net cash flows of the project are expected to be Br. 80,000 and Br. 20,000 respectively, the Payback period is equal to: 80,000/20,000 = 4 years If the net cash flows are not all the same, you simply sum the cash flows until the total equals or exceeds the cost of the project. You can use interpolation to narrow the result down to the desired level of accuracy. Example: Assume Two projects costing Br 100 each is expected to have the following cash inflows: Project A Project B Y1 Br 10 Br 70 Y2 Br 60 Br 50 Y3 Br 80 Br 20

18. Computation of Payback period in years for each project 10 80 60 1 2 3 -100 = CF t Cumulative -100 -90 -30 50 Payback A 2 + 30/80 = 2.375 years 100 2.4

19. Computation of Payback period in years for each project…….. 70 20 50 1 2 3 -100 CF t Cumulative -100 -30 20 40 Payback B 1 + 30/50 = 1.6 years 100 1.6 =

20. Payback Period Example : Bole Plc. is considering the following three projects for which associated cash flows are given thus: Required: Calculate the payback periods for each of the projects and advise Bole Plc. accordingly. Year projectA project B project C   birr'000 birr'000 birr'000 (500,000.00) (500,000.00) (500,000.00) 1 100,000.00 150,000.00 200,000.00 2 150,000.00 250,000.00 250,000.00 3 250,000.00 300,000.00 300,000.00 4 500,000.00 300,000.00 450,000.00

21. Payback Period Since project C has the least payback period of (2 1/6 years) compared with period B (2 1/3 years), or project A (3 years), the management of Bole Plc. is advised to embark on project C.

22. Payback period tech………….. Decision Rule: To be accepted, the project's payback period should be less than or equal to the standard (cut off) set by the management. For mutually exclusive projects, the project with a smaller payback period is accepted provided that its payback period is less than the firm’s cut-off. Mutually exclusive (dependent) projects are projects in which the acceptance one rejects the other .

23. Advantages and Disadvantages of Payback Advantages Easy to understand Based on cash flows rather than accounting income Disadvantages Ignores the time value of money Requires an arbitrary cutoff point Ignores cash flows beyond the cutoff date, i.e., Does not consider all of the project’s cash flows

24. Discounted Cash flow (DCF) Techniques All DCF techniques have the following characteristics: Examine all net cash flows Consider the time value of money Consider the required rate of return The major DCF techniques are: Net Present Value method Profitability Index Internal Rate of Return

25. Net Present Value It is the difference between the summation of the present values of cash inflows of a project and its cash outflow (cost) ; Steps: The first step is to estimate the expected future cash flows. The second step is to estimate the required return for projects of this risk level. The third step is to find the present value of the cash flows and subtract the initial investment.

26. NPV: Sum of the PVs of inflows and outflows. Cost often is CF and is negative.

27. Using Project A’s cash flow given in PBP secttion, what is NPV? 10 80 60 1 2 3 10% Project A: -100.00 9.09 49.59 60.11 Br 18.79 = NPV A NPV B = Br 19.98.

28. Rationale for the NPV Method NPV = PV inflows - Cost = Net gain in wealth. Decision Rule: Accept project if NPV > 0. Choose between mutually exclusive projects on basis of higher NPV. Adds most value.

29. NPV – Decision Rule A positive NPV means that the project is expected to add value to the firm and will therefore increase the wealth of the owners . Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will meet our goal.

30. Using NPV method, which project (s) should be accepted? NPV A = Br. 18.79, NPV B = Br. 19.98 If projects A & B are mutually exclusive, accept B because NPV B > NPV A If A & B are independent, accept both; NPV > 0.

31. Net Present Value Example

32. Example 2: NPV tech…….. Example 2: Assume that the project requires initial investment of Br. 400,000. Annual net cash flows are expected to be as follows:   Year 1 60,000 Year 4 80,000 Year 2 70,000 Year 5 100,000 Year 3 90,000 Year 6 120,000 If the required rate of return is 10%, what is NPV? Solution Net cash flows are not all the same. Thus, NPV is computed as follows:

33. Solution Example 2: NPV tech. Year NCF (2) Discount factor at 10% (3) Present Value (4) = (2) X (3) 1 60,000 0.909 54,540 2 70,000 0.826 57,820 3 90,000 0.751 67,590 4 80,000 0.683 54,640 5 100,000 0.621 62,100 6 120,000 0.564 67,680 Total Present Value of NCF 364,370 Deduct: Initial Investment 400,000 NPV (35,630)

34. Profitability Index (PI) Profitability index is the ratio of the total present value of net cash flows and the project’s initial investment. It simply converts the NPV criterion into a relative measure. PI = PV CFAT /Initial investment CFAT = Cash flow after tax If the project’s initial investment and annual net cash flows are Br. 50,000 and Br. 20,000 for five years respectively. The discount rate is 8%. What is its profitability index? Total present value of NCF = 20,000 (3.993) = 79,860 pI= Decision Rule: Accept the project if its profitability index is greater than 1 Reject the project if its profitability index is less than one   N.B. If the project’s profitability index is equal to 1, its NPV is equal to 0, and vice versa.

35. Internal Rate of Return (IRR) What is The Internal Rate of Return? Is the discount rate which equates the total present value of expected net cash flows with initial investment. IRR is the rate of return that makes the NPV result to be zero, i.e., @IRR, PV of CFAT = Initial investment, as a result NPV =0.

36. Internal Rate of Return: IRR 1 2 3 CF CF 1 CF 2 CF 3 Cost Inflows IRR is the discount rate that forces “ PV inflows = cost ” . This is the same as forcing NPV = 0.

37. Rationale for the IRR Method Decision rule : Accept the project if the IRR is greater than the required rate of return, a benchmark rate . “Required rate of return = cost of capital” If IRR > WACC(weighted average cost of Cost of Capital), then the project’s rate of return is greater than its cost-- some return is left over to boost stockholders’ returns.

38. A. Determining IRR when Net Cash flows are annuity Example 1 : Assume that the project requires initial investment of Br. 379,820. Annual net cash flows are expected to be Br. 70,000 for 10 years. If the required rate of return is 10%, what is IRR?   Solution   The following steps can be used to determine IRR:   Step 1 : Compute the leading discount factor or Payback period

39. Step 2 : Locate the IRR by looking along the appropriate period (n) in the present value of an annuity table until the column which includes the leading discount factor is reached. The discount rate of this column is the IRR for the project. In the example under consideration, the leading discount factor is found under i = 13%. Thus, the IRR of the project is 13%. Decision Rule: Accept the project if its IRR is greater than the required rate of return. Reject the project if its IRR is less than the required rate of return In the ongoing example, the project can be accepted because its IRR (13%) exceeds the required rate of return (10%).

40. What if the leading discount factor is not exactly found at the present value of an annuity table ? The following example illustrates this case? Example 2: Assume that the project requires initial investment of Br. 380,000. Annual net cash flows are expected to be Br. 70,000 for 10 years. If the required rate of return is 10%, what is IRR? Solution: The following steps can be used to determine IRR: Step 1: Compute the leading discount factor or Payback period

41. Step 2 : Locate the IRR by looking along the appropriate period (n) in the present value of an annuity table until the column which includes the leading discount factor is reached. The discount rate of this column is the IRR for the project. In this example, the leading discount factor is not found in the table. Step 3 : In the year row (n=10) of the present value of an annuity table, take two discount factors closest to the leading discount factor but one bigger and the other smaller than it.

42. Summary Mathematically, the NPV, IRR, and PI methods will always lead to the same accept/reject decisions for independent projects. However, these methods can give conflicting rankings for mutually exclusive projects.