Capital Budgeting. Gavin Crosthwaite. Mindarie Senior College

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1 Capital Budgeting Gavin Crosthwaite Mindarie Senior College

2 Capital Budgeting Capital budgeting is difficult because it involves estimates in cash flows over time and the time value of money should be incorporated into the decision. Sometimes, it is also difficult to know how long a particular asset will last.

3 Payback Period Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment.

4 Payback Period It is considered to be one of the weaker capital budgeting techniques due to its limitations. It is, however, still widely used in business today due to its ease of use.

5 Advantages of Payback It is easy to understand It provides some assessment of risk

6 Disadvantages of Payback It ignores cash flows after the payback period and does not measure profitability. It ignores the time value of money because cash flows are not discounted. (this is done in NPV)

7 Summary In summary, the payback period provides information to managers that can be used as follows: Help control the risks associated with the uncertainty of future cash flows Help minimise the impact of an investment on a firm s liquidity problems Help control the risk of obsolescence

8 Payback Equation Payback Period = Initial Investment Net Cash Inflow

9 Options There are 2 different examples we will look at using the payback period. One involves having the same cash inflows each period while the other one involves different cash inflows each period.

10 Example 1 Project X costs $ and will return a net cash inflow of $5 000 per period. What will the payback period be for this project?

11 Example 1 Solution Payback Period = Payback Period = Initial Investment Net Cash Inflow $ $5 000 Payback Period = 4.2 We keep the 4 years and now times the.2 by 12 for the number of months in a year. This will give us 2.4 months which we can then round up to 3 as that will be the minimum amount of time

12 Example 2 Project Y has an initial investment of $ and will offer the following net cash inflows over the next 5 years. YEAR NET CASH INFLOW CUMULATIVE TOTAL

13 Example 2 Solution Payback Period = Initial Investment Net Cash Inflow YEAR NET CASH INFLOW CUMULATIVE TOTAL $21 000

14 Example Solution 2 Therefore, we know that it will take at least 4 years to pay the project back as the cumulative net cash inflow up to year 4 is $ That leaves us to calculate how many months it will take to get the extra $2 000 from the $9 000 in Year 5. 9,000/12 = $750 per month. Thus it will take 3 months to reach $ ie: $750 x 3 = 2 250

15 Example 1 and 2 So we can see from these examples that both projects would take the same amount of time so how would we choose which one to invest in?

16 Payback Student Example Millipore Mechanics have decided that they need to replace some of the machinery in their workshop. The new assets will cost $80,000 and is depreciated at 20% pa on cost using the straight line method. The estimated cash inflows over the next few years is listed here: Year 1 15, , , , , , , ,000

17 Student Solution Payback Period = Initial Investment Net Cash Inflow Year 1 15, , , , , ,000 $68, , ,000

18 Student Solution Therefore, we know that it will take at least 5 years to pay the project back as the cumulative net cash inflow up to year 5 is $ That leaves us to calculate how many months it will take to get the extra $ from the $ in Year 6. 16,000/12 = $1,333 per month. Thus it will take 9 months to reach $ ie: $1,333 x 9 = $ Thus it will take 5 years and 9 months

19 Payback + Cost Savings There are times when a business will look at implementing some new machinery in order to save costs and they have to decide whether it s worthwhile investing in it. There normally is a time period associated with these types of investment.

20 Example 1 Spacely Sprockets is looking to get a new piece of machinery that will replace 5 workers who currently do the packing manually on the conveyer belt. The workers are each paid $40,000 a year and the new machinery costs $850,000. Spacely Sprockets has a rule that says the payback period must be 5 years of less.

21 Example 1 Solution Payback Period = Payback Period = Initial Investment Annual Net Cost Saving $850,000 $200,000 The payback period will be 4.25 years and thus would be accepted as it fits within the 5 year pattern.

22 Payback + Cost Savings + Different Inflows There are times when a business will look at implementing some new machinery in order to save costs but will also have an impact on their overall cashflows as well. There normally is a time period associated with these types of investment.

23 Example 1 Spacely Sprockets is looking to get a new piece of machinery that will replace 5 workers who currently do the packing manually on the conveyer belt. The workers are each paid $40,000 a year and the new machinery costs $850,000. The business will have to pay additional insurance costs of $20,000 per year and repair and maintenance costs of $30,000. Spacely Sprockets has a rule that says the payback period must be 5 years of less.

24 Example 1 Solution Payback Period = Payback Period = Initial Investment Annual Net Cost Saving $850,000 $150,000 Savings = 200,000-30,000-20,000 = $150,000 The payback period will be 5.66 years & thus would NOT be accepted as it fits within the 5 year criteria.

25 Payback Cost Saving Student Example Gledhow Industries are deciding whether to replace their manual packing system with a more automated approach. The cost of the automated system will set back the company $90,000. The business state the payback period must be less than 5 years to be accepted. The business will have the following additional costs and savings with the introduction of the new system. Savings Per Year Costs Per Year Wages 30,000 Electricity 4,000 Packing Materials 4,000 Repairs 2,000 Insurance 1,500 Parts 1,500

26 Student Solution Payback Period = Payback Period = Initial Investment Annual Net Cost Saving $90,000 $25,000 Savings = 30, ,000-4,000-2,000-1,500-1,500 = $25,000 The payback period will be 3.6 years & thus WOULD be accepted as it fits within the 5 year criteria.

27 Return on Average Investment This method is no longer popular for assessing capital budgeting decisions but is still important that you understand it.

28 Advantages It is easy to understand Most people including managers are familiar with the concepts of income, book value, profit, residual value and rate of return.

29 Disadvantages It ignores the time value of money It uses accounting measures of income rather than cash flows. Income can be easily manipulated by managers while cash flow can t.

30 Formula Return on Average Investment = Average Profit after Tax Average Investment Average Investment = Initial Investment + Residual Value 2

31 Example 1 Return on Average Investment = Average Profit after Tax Average Investment Average Investment = Initial Investment + Residual Value 2 An investment proposal is being looked at by Business P. It has an initial investment of $500,000 and residual value of $40,000 and should generate the following profits after tax: Year 1 Year 2 Year 3 Profit after Tax $ $ $80 000

32 Example 1 Solution Return on Average Investment = Average Profit after Tax Average Investment An investment proposal is being looked at by Business P. It has an initial investment of $500,000 and residual value of $40,000 and should generate the following profits after tax: Year 1 Year 2 Year 3 Profit after Tax $ $ $ Step 1: Average Profit 72, , ,000 /3 $72 000

33 Example 1 Solution Return on Average Investment = Average Profit after Tax Average Investment An investment proposal is being looked at by Business P. It has an initial investment of $500,000 and residual value of $40,000 and should generate the following profits after tax: Year 1 Year 2 Year 3 Profit after Tax $ $ $ Step 2: Average Investment 500, ,000 /2 $

34 Example 1 Solution Return on Average Investment = Average Profit after Tax Average Investment Step 1: Average Profit 72, , ,000 /3 $ Step 2: Average Investment 500, ,000 /2 $ Return on Average Investment = 72, ,000 Return on Average Investment = 26.67%

35 Things to be wary of When doing these questions, make sure that you look carefully at the question, particularly in terms of the following items: Depreciation on Asset Prepaid and Accrued Items

36 Return on Investment Student example Forest Hill Couriers are looking to buy a new vehicle to expand their business into the Albany area. The new vehicle will cost $35,000 and have a residual value of $9,000. They want a return of 15% to go ahead with it. By expanding the business into Albany they expect to have the following estimates for income and expenses per year: Income Expenses Courier Fees 60,000 Petrol 15,000 Wages 30,000 Advertising 5,000

37 Return on Investment Student Solution Income Courier Fees 60,000 Less Expenses Petrol 15,000 Wages 30,000 Advertising 5,000 Profit $10,000 10,000 Return on Average Investment = 22,000 Return on Average Investment = 45 % Therefore, we should progress with the investment.

38 Net Present Value This involves the discounting of the cash flows for a project to a present value using the minimum desired rate of return as the discount rate. The decision criteria is to accept all projects with a positive NPV except for mutually exclusive ones where we would choose the one with the highest NPV.

39 Advantages It recognises the time value of money Dollars can be added because they are in present values It gives correct ranking of mutually exclusive projects It is dependant on future cash flows and the opportunity cost of capital rather than some arbitrary guess by management.

40 Disadvantages How do we determine the minimum desired rate of return? How accurate are future cash forecasts

41 Formula Present Value = Future Value (1 + i) n where: i = Interest rate per period n = Number of periods

42 Example 1- Different inflows Dog Rock Industries have been handed a proposal where they would invest in a new piece of machinery. The piece of machinery is going to cost $ and have the following net cash inflows over the 5 years of the assets life and cost of capital is 10%: Net Cash Inflow Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 10,000 12,000 13,000 11,000 15,000

43 Example 1 Solution Present Value = Future Value (1 + i) n 10,000 12,000 13,000 11,000 15, (1.10) 1 (1.10) 2 (1.10) 3 (1.10) 4 (1.10)

44 Example 2 There are times when we are doing the Capital Budgeting NPV technique where the net cash inflow will be the same for each period. This allows us to do the calculation much easier. Let s look at an example of how this works.

45 Different Inflows Student Example Walpole Investments have 3 projects presented to them and they are not sure which one to choose. Given the cost of capital is 10% which of the following 3 projects would you recommend and why? Project Cost Year 1 Year 2 Year 3 Year 4 A 10,000 1,000 1,300 1,500 2,000 B 25,000 2,500 4,000 6,000 8,000 C 50,000 12,000 15,000 18,000 32,000

46 Different Inflows Student Solution Project Cost Year Year Year Year Total A 10,000 1, , , , B 25,000 2, , , , C 50,000 12, , , , Total Project Future Value Initial Investment NPV A $ B $ C $ The business should accept proposal C as it its the only one which has a positive NPV.

47 Example 2 - Same inflows Walpole Manufacturers have been handed a proposal where they would invest in a new piece of machinery. The piece of machinery is going to cost $ and have the following net cash inflows over the 5 years of the assets life and cost of capital is 10%: Net Cash Inflow Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 8,000 8,000 8,000 8,000 8,000

48 Example 2 - Solution In this case the present value will be calculated as follows: PV = 8,000 x = $30, If we take this off the initial value of $50,000 it leaves us a negative value of $19, Therefore, we should reject this proposal.

49 Same Inflows Student Example Emu Point Sports Store is looking at 2 different sites in expand its business. Proposal A will cost $60,000 while Proposal B will cost $75,000. The business is expected to have the following net cash inflows over the next 5 years and the cost of capital will be 10%. Which one would you recommend? Year 1 Year 2 Year 3 Year 4 Year 5 Proposal A 18,000 18,000 18,000 18,000 18,000 Proposal B 21,000 21,000 21,000 21,000 21,000

50 Same Inflows Student Solution Year 1 Year 2 Year 3 Year 4 Year 5 Proposal A 18,000 18,000 18,000 18,000 18,000 Proposal B 21,000 21,000 21,000 21,000 21,000 Proposal A 18,000 * $ ,000 $8,232.6 Proposal B 21,000 * $ ,000 $

51 Example 3 - Same & Different inflows There are also scenarios that will show inflows the same for a number of periods and different for other periods. Depending on when the same period is will determine how we will approach the solution and which recommendation we would make to the business.

52 Example 3 - Same first Denmark Timbers have been given the opportunity to expand their business by investing in a new business opportunity. The cost to invest in the new business will be $35,000 and the business wants a minimum return of 8%. The business expects the following returns over the next 5 years. Net Cash Inflow Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 8,000 8,000 8,000 11,000 15,000

53 Example 3 Solution In this case the present value will be calculated as follows: PV = 8,000 x = $20, 616 This will cover the first 3 years. For the next 2 years, we need to use table to calculate each year individually. Year 4 PV = 11,000 x.7351 = $8, Year 4 PV = 15,000 x.6806 = $10,209 Total = 20, , ,209 = $38,911.10

54 Example 3 Solution cont. In this scenario, we can see that the business would have a positive net value by $38, $35,000 = $3, Therefore, we would recommend that Denmark Timbers invest in the new business.

55 Situation 4 - Different First Denmark Timbers have been given the opportunity to expand their business by investing in a new business opportunity. The cost to invest in the new business will be $35,000 and the business wants a minimum return of 8%. The business expects the following returns over the next 5 years. Net Cash Inflow Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 11,000 15,000 8,000 8,000 8,000

56 Different 4 Solution Present Value = Future Value (1 + i) n 11,000 15,000 8,000 8,000 8, (1.08) 1 (1.08) 2 (1.08) 3 (1.08) 4 (1.08) 5 10, , , , , Project Future Value Initial Investment NPV A ,000 $4,827.38

57 Same and Different Student Examples Little Grove Traders have the opportunity to invest in a new property development down at Goode Beach. The property development will cost $250,000 and is expected to have the following net cash inflows over the 10 years with a cost of capital of 8%. Year Return Year Return , , , , , , ,000

58 Same and Different Student Solution Year Return Year Return , , , , , , , ,000 30,000 + (1.08) 4 (1.08) 5 40,000 40,000 50,000 50,000 50, (1.08) 6 (1.08) 7 (1.08) 8 (1.08) 9 (1.08) , , , , , , Project Future Value Initial Investment NPV A 159, ,