UNIVERSITY OF PRETORIA FINANCIAL MANAGEMENT 200 CAPITAL BUDGETING
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1 UNIVERSITY OF PRETORIA FINANCIAL MANAGEMENT 200 CAPITAL BUDGETING 1
2 STUDY OUTCOME You should be able to prepare and evaluate a capital budget. 2
3 OBJECTIVES In order to achieve the specific outcome you should be able to: apply the concept of time value of money with regards to relevant cash flows; describe the components of cost of capital; evaluate and apply the different capital budgeting techniques for long term decision-making purposes; identify the relevant cash flows of different projects; account for the effects of taxation in capital budgets; and identify and evaluate the qualitative factors of different projects. 3
4 INTRODUCTION Knowledge of basic taxation principles is a prerequisite for the successful studying of this learning area. It is therefore critical that you review the taxation module of Financial Accounting before attempting to study this learning area. 4
5 INTRODUCTION Capital budgeting is the analysis and evaluation of investment projects that normally produce benefits over a number of years (long term investment decision) 5
6 WHY IS CAPITAL BUDGETING IMPORTANT? Firm s future success may depend on current investment decisions Remain competitive / Develop new products / Research & development Significant amount of resources are tied up in such decisions and difficult to reverse Tied up for a considerable number of years More difficult to adjust to changing conditions due to term Over-investment: costs too high. Invest too little: lose market share (inferior products or insufficient capacity to meet demand) Timing of expansion or contraction critical. 6
7 STEPS TO CAPITAL BUDGETING 1. Define objectives 2. Search for investment opportunities 3. Measure payoffs of opportunities 4. Select projects with payoffs > cost of capital 5. Obtain authorisation 6. Obtain financing 7. Implement 8. Post-implementation audit 7
8 CAPITAL BUDGETING TECHNIQUES ACCOUNT FOR TVM Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) IGNORE TVM Payback Discounted payback Accounting Rate of Return (ARR) 8
9 NET PRESENT VALUE NPV = Discounted future cash flows less initial investment Net present value is found by subtracting the present value of the after-tax outflows from the present value of the after-tax inflows. By using DCF techniques and calculating PVs we can compare the return on capital projects with an alternative equal risk investment in securities traded in the financial market. Discount rate Cost of capital or Minimum required rate of return Acknowledges the time value of money & represents the opportunity cost of an investment elsewhere. 9
10 NPV (Cont.) Example Year Cash flow (10) % discount rate What is the NPV? Should we accept the project? 10
11 NPV (Cont.) A positive NPV represents the amount with which shareholders wealth will be increased Decision criteria If NPV > R0, accept the project If NPV < R0, reject the project If NPV = R0, technically indifferent 11
12 NPV (Cont.) ADVANTAGES Uses cash flows (not profit) Rand amount indicates the actual value added to shareholders wealth Takes time value of money into account Makes the right reinvestment assumption (only one answer is possible) DISADVANTAGES Absolute Rand amount (not comparable between projects) Have to know the cost of capital figure in advance 12
13 CLASS EXAMPLE 13
14 Internal Rate of Return (IRR) IRR = The actual or true interest rate earned on an investment over the course of its economic life, or the rate that causes the present value of net future cash flows to equal the cost of the initial investment (NPV = 0). The IRR is the project s intrinsic rate of return. Decision criteria If IRR > cost of capital, accept the project If IRR < cost of capital, reject the project If IRR = cost of capital, technically indifferent 14
15 CLASS EXAMPLE 15
16 IRR (Cont.) ADVANTAGES Uses cash flows Takes the time value of money into account Don t need to know WACC in advance (yet essential for independent projects) % is comparable between projects Easy to understand (commonly used) DISADVANTAGES Inappropriate with unconventional cash flows (2 IRRs result) Inappropriate for mutually exclusive projects of different sizes (answer conflicts with NPV results) does not take the size of the initial investment into account (compare R1 investment with R1.75 return against R1m investment with a R return) 16
17 CASH FLOWS Only relevant cash flows (excluding sunk cost, including opportunity cost) Commencement: Purchase price of new machine Sales price of existing (old) machine Tax effects of sale (Year 1) Working capital investment (JIT ) 17
18 CASH FLOWS (Cont.) Operating cash flows: After tax Not allocated costs (e.g. head office and depreciation) Changes in working capital levels (PROVIDED not already cash based) Ignore all financing costs (already included in WACC) Tax allowances, e.g. S12C: 40% (in full), 20%, 20% & 20% 18
19 CASH FLOWS (Cont.) End-of project cash flows: Proceeds on the sale of the asset Taxable recoupment or scrapping allowance Capital gains tax Return of working capital 19
20 CASH FLOWS (Cont.) Depreciation is NOT a cash flow. The wear-and-tear allowance granted by SARS should, however, be taken into account when performing the TAX calculation. 20
21 PAYBACK The payback method simply measures how long (in years and/or months) it takes to recover the initial investment. The maximum acceptable payback period is determined by management. If the payback period is less than the maximum acceptable payback period, accept the project. If the payback period is greater than the maximum acceptable payback period, reject the project. 21
22 PAYBACK (Cont.) The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects. It is simple, intuitive and considers cash flows rather than accounting profits. It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as net present value and internal rate of return. 22
23 CLASS EXAMPLE 23
24 PAYBACK ADVANTAGES Easy to use and understand Useful for initial sifting process Appropriate with liquidity constraints Appropriate when future or cash flows are particularly uncertain DISADVANTAGES Ignores the time value of money Ignores cash flows after the payback period (bias against LT projects) Fails to take into account differences in the timing of proceeds which are earned during the payback period, when comparing projects. Leads to a short term focus 24
25 DISCOUNTED PAYBACK Time required for discounted cash flows to recover initial cash outlay. Most NB shortcomings Ignores cash flows after the payback period High initial cash flows preferred Advantages Easy to use Appropriate for initial sifting (rough risk indicator) Takes time value of money into account. 25
26 ACCOUNTING RATE OF RETURN (ARR) ARR (also return on investment or return on capital employed) = Average annual net income Average investment = R / [(R ) / 2] = 26% Measures the effectiveness with which management uses the assets of the co 26
27 ARR (Cont.) ADVANTAGES Well-known ratio Easy to interpret DISADVANTAGES Uses profit instead of cash flows Ignores the time value of money Result will be the same for projects with high income initially and low income in later years as for projects with low income initially and high income in later years May lead to sub-optimal decision-making by management (performance measurement) 27
28 CHOICE OF TECHNIQUE On a purely theoretical basis, NPV is the better approach because: NPV assumes that intermediate cash flows are reinvested at the cost of capital whereas IRR assumes they are reinvested at the IRR, Certain mathematical properties may cause a project with non-conventional cash flows to have zero or more than one real IRR. Despite its theoretical superiority, however, financial managers prefer to use the IRR because of the preference for rates of return. 28
29 PART 2 29
30 CAPITAL RATIONING Soft cap rationing not willing to issue capital or provide financing (internal); Hard cap rationing external constraints 30
31 CAPITAL RATIONING (Cont.) If the project is divisible, use the profitability index (Current value of cash inflow / Investment) Project Cost NPV PI A R4,0m R0,60m 1,15 B R3,0m R0,54m 1,18 C R5,0m R0,45m 1,09 D R2,5m R0,426m 1,17 E R1,0m R0,20m 1,20 Capital limited to R6m: Choose E, B & 80% of D If projects are not divisible, test all combinations to find combo that will maximise NPV (e.g. A + E [which has an opportunity cost attached due to R1m capital not utilised], C + E, B + D, B + E, D + E). Max = B + D Multi-period cap. rationing use LP. May also apply a higher discount rate. 31
32 UNEQUAL LIVES Three methods: Replacement chain A 5yrs; B 7yrs. lowest common multiple 35 yrs impractical Equivalent annual annuities Terminal value (shorter life span) 32
33 UNEQUAL LIVES (Cont.) Example WACC: 14% Proj. A: Cost R5,2m; inflow R2,8m 3yrs Proj. B: Cost R8,0m; inflow R2,5m 6yrs Replacement chain: A: (5,2) 2,8 2,8 2,8 (5,2) 2,8 2,8 2,8 (5,2) 2,8 2,8 (2,4) 2,8 2,8 2,8 NPV of A = 2,178 (for 3 yrs = R1,301) NPV of B = 1,722 Choose A 33
34 UNEQUAL LIVES (Cont.) Equivalent annual annuities A: R1,301 / 2,322 = R0,560 B: R1,722 / 3,889 = R0,443 Choose A 34
35 UNEQUAL LIVES (Cont.) Choose a terminal value Assume a company has to decide which machine to pick. The project s economic life is 10 years. Machine 1 will last for 8 years and machine 2 for 6 years. The machines are not going to be replaced over and over for a period of 24 years. Therefore accept that each machine will be replaced ONLY once, and include a terminal value (sales value) in the NPV calculation at the end of year ten. Discount cash flows for both machines for 10 year period. 35
36 INFLATION 2 options: Include inflation in cash flows and discount rate or Use the real rate and real cash flows Preferred: Nominal! Real rates may ONLY be used if there is either NO inflation, or ALL cash flows increase with exactly the same inflation rate. 36
37 INFLATION (Cont.) Formula (1 + n) = (1 + r) x (1 + i) Example 12% nominal rate, 4% inflation. What is die real growth rate? (1.12) = (1 + r) x (1.04) (1 + r) = 1.12 / 1.04 = r = = 7.7% 37
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