COFIA3-33 - 2023 - Week 5 Capital Budgeting.pptx

Capital Budgeting

1. CHAPTER 8 CAPITAL BUDGETING

2. 2 Objectives At the end of the chapter, you should be able to: Set out the reasons that the capital budgeting decision is critical for the firm Understand why only cash flows matter Define the types of investment projects Apply NPV, IRR and other methods to evaluate capital projects Set out the advantages and disadvantages of each method Determine the relevant cash flows to be included in the analysis Include taxation and tax allowances and in the project cash flows Understand the role of post-audits in capital budgeting

3. 3 Outline Types of Projects Capital Budgeting Methods Net Present Value Internal Rate of Return Payback and Discounted Payback Accounting Rate of Return Profitability Index (PV Index or Benefit-Cost Ratio) Project Cash Flows Estimating future cash flows Taxation Some rules Post-Audits

4. 4 Outline Capital Budgeting Capital budgeting is the analysis and evaluation of investment projects that normally produce benefits over a number of years. The capital budgeting decision is important, because a firm’s future success will often depend on current investment decisions. Typical projects include the acquisition of plant and equipment, a marketing campaign, or the opening of a new retailing outlet. These projects are expected to produce future benefits.

5. 5 TYPES OF INVESTMENT PROJECTS Replacement Decisions Expansion : existing product lines Expansion : new product lines Other (IT, Pollution control, Corporate social investment) Mutually Exclusive vs. Independent Projects Divisible and non-divisible projects

6. 6 TYPES OF INVESTMENT PROJECTS Replacement Decisions Replacement refers to the acquisition of an asset to maintain existing production. The new machine may result in cost savings due to increased efficiencies. The firm is producing an established product line and the cost savings are usually relatively certain Expansion : existing product lines Expansion refers either to expansion of existing product lines to new markets, or to the introduction of new product lines. If the investment project refers to the introduction of a new product line, estimated demand may be highly uncertain. It will therefore be difficult to estimate future cash flows, and the investment project becomes more difficult to evaluate Expansion : new product lines Other (IT, Pollution control, Corporate social investment) Mutually Exclusive vs. Independent Projects Divisible and non-divisible projects

7. 7 TYPES OF INVESTMENT PROJECTS Mutually Exclusive vs. Independent Projects Mutually exclusive projects are alternatives. Either one or the other can be accepted, but not both. For example, if a firm has decided that it needs to invest in delivery vehicles, it may have the option to invest in either one large delivery truck or two smaller trucks. These are alternatives. If the company decides on the larger truck it will probably not need the two smaller trucks Independent projects are such that the acceptance of one does not affect the acceptance of another. Projects A and B are independent if Project B may be accepted or rejected irrespective of whether Project A was accepted or not. For example, a company may analyse two projects: a material cutting machine and a new delivery truck. The firm may decide to accept both projects if certain economic criteria are met

8. 8 TYPES OF INVESTMENT PROJECTS Divisible and non-divisible projects A divisible project may be split into a number of separate parts, each capable of being undertaken on its own. If the project is indivisible, then the entire project must be undertaken. In capital budgeting, financial managers will often face problems with project divisibility. For example, the decision to build a toll bridge may represent an investment in an indivisible project although, even in this case, the capacity provided in terms of the number of lanes will mean that the project is divisible to some degree.

9. 9 Why use Cash Flows ? Future benefits of the project Only use Cash flows, not earnings Accounting Earnings vs. Cash Flows Accounting is based on the Matching Concept Cost and Depreciation Taxation - GAAP & Inventory Valuation Tax is a cash flow and taxable income is based on the Accrual Accounting Model Accounting does not record opportunity costs; in Capital Budgeting we include cash flows foregone. Performance Appraisal Yet if Accounting results are used to measure management performance, then Accounting may be relevant

10. 10 Capital Budgeting Techniques Net Present Value (NPV) Internal Rate of Return (IRR) Payback Period and Discounted Payback Accounting Rate of Return Profitability Index (Benefit-cost ratio)

11. 11 Net Present Value (NPV) NPV = Future Cash flows discounted at the cost of capital less the Cost of the Project If NPV > 0, accept the project If NPV < 0, reject the project

12. Advantages and disadvantages of NPV Advantages Ability to determine whether the project will increase the firm’s value Takes in to account the time value of money Looks at all the cash flows involved through the life of the project Has a decision making mechanism – reject projects with negative NPV Disadvantages More complicated method – users may find it difficult to understand Difficult to select the most appropriate discount rate - may lead to good projects being rejected

13. 13 Internal Rate of Return (IRR) IRR = Discount rate which makes the Present value of the Project ’ s Future Cash flows equal to the cost of the Project. (where NPV = 0)

14. Example Project X has the following cash flow stream (R000): Year 0 1 2 Cash flow –10 000 8 000 6 000 Calculate the IRR of Project X, the firm’s cost of capital is 14%. At a discount rate of 14%, the NPV is R1.634m. To find the IRR we have to reduce the NPV to zero. It is therefore necessary to increase the discount rate further to reduce the NPV. Let us try 25%.

15. Advantages and disadvantages of IRR Advantages It shows the return on the original money invested It include the effect of time value of money IRR provides a quick snapshot of what capital projects would provide the greatest potential cash flow Disadvantages It can give conflicting answers when compared to NPV for mutually exclusive projects Ignores future cash flows

16. 16 Payback Method Projects are evaluated according to the number of years that it takes to recover the cost of the investment from the cash flows generated by the project. The firm sets a required payback period, say 3 years. Only projects with payback periods of less than 3 years are accepted.

17. 17 What are the Advantages and Disadvantages of Payback? Advantages Simple to calculate and understand Widely used in practice Risk indicator Disadvantages Ignores cash flows after the payback Ignores time value of money Bias against long term projects

18. 18 Discounted Payback Discounted Payback = time it takes so that the PV of the project ’ s cash flows equals the cost of the project. The payback period is just over 3 years in this case.

19. 19 Accounting Rate of Return: ARR = Average Incremental Net Income Average book value The average book value if the residual value is zero, will be Cost/2 Net income is after depreciation . Advantages and disadvantages of ARR Accepts the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR. Accounting Rate of Return

20. 20 Profitability Index (Benefit-Cost Ratio) A project ’ s PI measures the return of a project relative to cost PI = Present Value/Cost If PI > 1 = Accept the project If PI < 1 = Reject the project As NPV = PV - Cost, a PI greater than 1 means a positive NPV. When should we use the PI? If there is capital rationing and we wish to maximise returns relative to the costs of a projects.

21. 21 Cash Flows In capital budgeting, cash flows are crucial Estimation of future cash flows After tax cash flows, therefore need to consider the tax issues Beginning-of-project cash flows Cost of project = cash outflow What about depreciation? Sale of existing equipment? Working capital requirements?

22. Cash flow determination-Rules The initial investment may result in the following cash flows: cost of acquisition, proceeds from the sale of existing assets, tax effects, and change in working capital requirements. The cost of the acquisition of equipment or property is recorded as a cash outflow in our analysis.

23. Cont … Use only incremental cash flows In most cases, firms are operating as going concerns and the evaluation of any project should include only incremental cash flows and not existing cash flows. The focus is on how cash flows change and on how the firm is affected by the decision to invest in a particular project. Use after-tax cash flows The evaluation of projects refers to after-tax returns and the required return includes an adjustment for taxation. The principle of consistency requires that the firm discount after tax cash flows at the after-tax required return. Ignore sunk costs A firm should ignore sunk costs when evaluating a project. Sunk costs are those already incurred or contracted.(costs that has been incurred and can not be recovered

24. Cont … Include all opportunity costs The evaluation of a capital project should include all opportunity costs. For example, if new machinery is to be placed in empty factory space, that could otherwise have been let, such lost rental should be included as a cost of investing in the new machinery. Include the effects of new product lines on existing product lines The introduction of a new product line may result in a reduction in the demand for existing product lines. This is particularly relevant when new products are competitive in nature or are substitute products. The reduction in the net cash flows from existing products should be taken into account as a cost in evaluating the new project. However, if the new product line is complementary in nature, then there may be positive effects on the cash flows generated by existing products, and the increase in net cash flows from existing product lines should be included in the evaluation of the new project

25. Cont … Include the net incremental investment in working capital A new project often requires an incremental investment in working capital, and this should be included as an outlay at the beginning of the project. If the net investment in working capital is to be recovered at the end of the project, then this amount is included as an inflow. Taxation(Tax table calculation) Taxation is a major expense for most companies. It is therefore necessary to determine the effect that a project will have on the firm’s tax charge. Depreciation allowances The SA Revenue Service (SARS) allows a company to write off the cost of an asset for tax purposes, usually over a number of years. The recorded depreciation expense in a company’s financial statements does not necessarily reflect an allowable expense for tax purposes.

26. Cont … Recoupments and scrapping allowances If the project represents a replacement decision, the sale of existing equipment may result in certain tax effects. A long-term asset that qualifies for tax allowances will have a tax value that will differ from the asset’s accounting book value if the accounting and tax depreciation rates differ. The tax value of an asset is determined as follows: R Cost xxx Less: tax allowances to date( depn to date) xxx Tax value xxx A tax recoupment represents a cash outflow; a scrapping allowance represents a cash inflow. In terms of section 8(4)(a) of the Income Tax Act, if the selling price of an asset, up to cost, is greater than the asset’s tax value, the difference represents a recoupment which must be added to taxable income in the year the asset is sold.

27. Cont … If the selling price is below the asset’s tax value, and the disposal is in the ordinary course of trading, then the difference between the selling price and the tax value is deducted from a company’s taxable income. Cash outflow (recoupment) = (selling price (up to cost) – tax value) × tax rate Cash inflow (scrapping allowance) = (tax value – selling price) × tax rate End-of-project cash flows The end of a project may involve cash flows arising from: proceeds on the sale of the asset; recoupments or scrapping allowances; and return of working capital.

28. 28 Tax Effects - Introduction Depreciation deduction A deduction from taxable income. This causes a reduction in the tax expense. Tax Value Cost less tax deductions to date Effect on Cash Flow Net operating income x (1-tax rate) Deduction x tax rate

29. 29 Sale of Equipment: Tax effects There may be tax cash flows on the sale of assets Sales Price > Tax value = Recoupment Cash flow: (SP (up to cost)-TV) x tax rate Tax value > Sales Price = Scrapping allowance Cash flow: (TV-SP) x tax rate Capital Gains Tax SP = Selling Price TV = Tax Value

30. 30 Capital Gains Tax SA companies are subject to Capital Gains Tax on the the disposal of fixed assets. If the sales price > cost, the difference will be subject to CGT

31. Example : Net present value calculation Capex Ltd is considering a new investment, Project J at a cost of R4.3m. The economic life of the asset is 5 years. The residual value (market value) of the project in 5 years time is expected to be R700 000. Operating sales revenue per year is expected to be R4.6m and operating costs are expected to be R2.8m per year. The cost of capital is 14%. What is the project’s net present value if there is no taxation?

32. NPV of project, including taxation Assume now that the project will require Capex Ltd to invest R400 000 in working capital at the beginning of the project, which will be recovered at the end of 5 years What happens to the project’s NPV if we include the effects of taxation? The corporate tax rate is 28%. Assume that the project qualifies for a depreciation deduction of 40% of cost in the first year and 20% of cost per year for each of the three subsequent years. For comparative purposes, we will assume that the cost of capital will remain at 14% even though the pre-tax cost of capital will differ from the after-tax cost of capital. The investment in working capital results in a cash outlay at the beginning of the project but this investment is recovered at the end of 5 years. The effect is to reduce the NPV, due to the time value of money, as we are investing R400 000 today and the present value of R400 000 to be recovered in 5 years’ time is only R207 760 (R400 000 × 0.5194).

33. Solution

34. Tax Calculation The depreciation deduction in Year 1 is R1.72m (R4.3m × 40%) and the depreciation deduction in Years 2–4 is R860 000 per year. There is a recoupment of R700 000 at the end of Year 5 as the tax value will be zero at the end of Year 5 [R4.3m – (40% × R4.3m + 20% ×R4.3m × 3)]. This means that R700 000 represents a tax recoupment of prior depreciation deductions. The tax calculation is set out as follows: Selling price @ R700 000 compare with tax value is 0 (4.3 -1 720-860-860-860)