Finance Management Session 5- Capital Budgeting. SHL Specialist Diploma in Events, Sports & Leisure Management

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1 Finance Management Session 5- Capital Budgeting SHL Specialist Diploma in Events, Sports & Leisure Management

2 Content page Specific Learning objectives Capital Budgeting Investment Criteria Types of Project Capital budgeting methods Other factors to consider Dealing with risks & uncertainty Conclusion

3 Specific Learning Objectives Explain capital budgeting. Evaluate how an entity assesses an investment project. Explain the various criteria of an investment appraisal. Evaluate the use of the various appraisal methods, i.e. Payback period / NPV / IRR / Profitability index. Describe the practical problems faced in using the appraisal methods.

4 Content page Specific Learning objectives Capital Budgeting Investment Criteria Types of Project Capital budgeting methods Other factors to consider Dealing with risks & uncertainty Conclusion

5 What is Capital budgeting? How managers plan significant outlays on projects that have long term implications. Typical examples: Expansion decisions Equipment selection decisions Cost reduction decisions The decision to accept or reject a project depends on an analysis of the cash flows generated by the project and its cost

6 Capital budgeting programme 1. Search for & discovery of investment opportunities 2. Collection of data 3. Evaluation & decision-making 4. Reevaluation & adjustment

7 Content page Specific Learning objectives Capital Budgeting Investment Criteria Types of Project Capital budgeting methods Other factors to consider Dealing with risks & uncertainty Conclusion

8 Investment Criteria Is a particular project a good investment? If more than 1 good project but can only afford 1, which to choose? Evaluation Methods and Identify Relevant Cashflows Payback Period Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) Chosen Methods Must Satisfy 3 Capital Budgeting Decision Rules: 1.Must consider all of the project s cashflows 2.Must consider Time Value of Money 3.Must lead to correct decision when choosing mutually exclusive projects

9 Content page Specific Learning objectives Capital Budgeting Investment Criteria Types of Project Capital budgeting methods Other factors to consider Dealing with risks & uncertainty Conclusion

10 Types of projects Independent Projects A Project whose cash flows are not affected by accept/reject decision for other projects Projects which meet Capital Budgeting criterion should be accepted Mutually Exclusive Projects A set of projects from which at most one will be accepted Best project to be accepted and provided it meets the Capital Budgeting criterion as well

11 Determining cashflow Types of Cashflows Relevant Cashflows Irrelevant Cashflows Opportunity Costs Incremental Costs and Revenue Sunk Costs Non-Incremental Costs and Revenue

12 Content page Specific Learning objectives Capital Budgeting Investment Criteria Types of Project Capital budgeting methods Other factors to consider Dealing with risks & uncertainty Conclusion

13 Capital Budgeting Methods 1. Payback Period 2. Net Present Value 3. Internal Rate of Return 4. Profitability Index

14 Mtd 1: Payback Period The time required to recoup the initial investment Management will decide the maximum payback period allowable Acceptance Criteria Independent Projects Accept all projects with Payback Period < Predetermined period Mutually Exclusive Projects Accept projects with fastest payback and provided it is less than the predetermined period

15 Example 1: Payback Period Assume Project A and B has the following cash inflows for $10,000 invested. Year Project A Project B 1 $5,000 $1,500 2 $5,000 $2,000 3 $3,000 $2,500 4 $8,000 $5,000

16 Example 1: Payback Period Year Project A Cumulative Cash flow Project B Cumulative Cash flow 1 $5,000 $1,500 2 $5,000 $2,000 3 $3,000 $2,500 4 $8,000 $5,000 Payback Period Based on payback period, Project is better. Really?

17 Example 1: Payback Period Choice: Project payback period. If the company policy is to have projects that have payback period of not more than 1.5 years, is your choice still the same?

18 More about Payback Period Strengths 1.Simple to use 2.Bias towards liquidity as it is bias towards ST projects Weaknesses 1.Ignore Time Value of money 2.Ignore Cashflows after payback period 3.No Objective basis for right payback period 4.Bias against LT project

19 Activity 1: Payback Period Assume a $100,000 investment and the following cash flows for two alternatives. Which of the following alternatives would you select under the payback method? Year Investment A Investment B 1 $30,000 $40,000 2 $50,000 $30,000 3 $30,000 $20,000 4 $60,000 $20, $50,000

20 Activity 1: Payback Period (Soln) Year Investment A Cumulative Cash flow Investment B 1 $30,000 $40,000 2 $50,000 $30,000 3 $30,000 $20,000 4 $60,000 $20, $50,000 Cumulative Cash flow Payback period of A = Payback period of B = Based on payback period, investment should be chosen since it pays back earlier.

21 Mtd 2: Net Present Value (NPV) Sum of Present Value of Inflows and Outflows ie discounting back the inflows over the life of the investment to determine whether they equal or exceed the required investment. Acceptance criteria Independent Projects accept any project whose NPV > 0 Mutually Exclusive projects choose projects with highest NPV and it must be >0

22 Mtd 2: Net Present Value (NPV) Net Present Value = Present Value of future cashflows Initial investment

23 Recap from session 4: Present & Future Value Total value at the end of the n period (Future Value) = Principal (1+i) n Can be rewritten: Where FV = PV (1+i) n FV = Future Value PV = Present Value for Sum of Money i = Interest Rate (per period) n = No. of periods = No. of Years x No. of compounding per year)

24 Example 2: NPV Assume Project A and B has the following cash inflows for $10,000 invested. Assuming the cost of capital is 10% pa. Year Project A Project B 1 $5,000 $1,500 2 $5,000 $2,000 3 $3,000 $2,500 4 $8,000 $5,000

25 Example 2: NPV Year Project A Present Value 1 $5,000 2 $5,000 3 $3,000 4 $8,000 Net Present value Year Project B Present Value 1 $1,500 2 $2,000 3 $2,500 4 $5,000 Net Present Value

26 More about NPV Strengths 1.Take into account all cashflows 2.Take into account time value of money (hence more superior than payback period) Weaknesses 1.Estimates for cashflows and discount rate difficult to apply 3.Calculation quite straightforward

27 Activity 2: NPV Skyline Corp will invest $60,000 in a temporary project that will generate the following cash inflows for the next 3 years. Calculate the net present value assuming interest rate of 5% pa and decide if this project should be undertaken. Year Cash flow 1 $15,000 2 $25,000 3 $40,000

28 Activity 2: NPV (Solution) Year Cash flow PV of cash flow 1 $15,000 2 $25,000 3 $40,000 Net present value As the NPV is this project should be.

29 Mtd 3: Internal Rate of return(irr) It is the discount rate that equates cash outflows (cost) of an investment with the subsequent cash inflows. The discount rate that gives the project NPV = 0 (zero) Aka the discounted cash flow (DCF) rate of return. 0 IRR=? Cashflows -100k 10k 60k 80k PV 1 PV 2 PV 3 Time

30 Mtd 3: Internal Rate of return(irr) Acceptance Criteria Independent Projects Accept projects where IRR > Cost of capital Mutually exclusive projects Accept projects with highest IRR and whose IRR > cost of capital.

31 Example 3: IRR Moon Pte Ltd is evaluating the Project Evergreen. Calculate the rate of return of Project Evergreen that will make the present value of all cash flows equal to the initial outlay? (Hint: You can use one of the functions in Excel) Project Evergreen Initial Outlay (10,000) Year 1 5,000 Year 2 4,000 Year 3 6,000

32 Example 3: IRR Internal rate of return =

33 More on IRR Strengths 1.State in relative percentages not absolute value 2.This can be compared with cost of capital easily to determine if the project is viable. Weaknesses 1.More complicated calculations 2.When there are multiple changes in the sign of the cash flows, the IRR rule does not work.

34 Activity 3: IRR Moon Pte Ltd is evaluating Project Everbloom. Calculate the rate of return that will make the present value of all cash flows equal to the initial outlay? (Hint: You can use one of the functions in Excel) Project Everbloom Initial Outlay (15,000) Year 1 8,000 Year 2 5,000 Year 3 9,000

35 Activity 3: IRR (Solution) Using Excel (instead of trial & error method): Internal rate of return =

36 Mtd 4: Profitability Index (PI) It is the highest net present value per dollar of investment. Acceptance criteria: Independent Projects accept projects whose PI >0 Mutually exclusive projects accept projects with highest PI and whose PI > 0. Profitabil ity Index (PI) PV of PV of FutureCashflows Initial Investment

37 Example 4: PI There are three projects to be evaluated. Based on the profitability index, which project should be selected? Project PV of future cashflows Investment NPV X $4,000 $3,000 $1,000 Y $6,000 $5,000 $1,000 Z $10,000 $7,000 $3,000

38 Example 4: PI Project PV Investment NPV PI X $4,000 $3,000 Y $6,000 $5,000 Z $10,000 $7,000 Based on the PI, the project with the highest PI should be selected first. For every $1 invested, project provides the highest return ($ ). Profitabil ity Index (PI) PV of PV of FutureCashflows Initial Investment

39 More on PI Strengths 1.Take into account all cash flows. Weaknesses 1.Size problems since it is not in absolute figures. 2.Takes into account time value of money 2.Estimates for cash flows and discount rate is difficult to apply

40 Activity 4: PI Evaluate two projects for Adventurer Club Pte Ltd using the profitability index method. Project A and B requires investment of $10,000 and $22,000 respectively. Assuming the current interest rate is 3% pa. Year Cash flow for Project A Cash flow for Project B 1 $4,000 $10,800 2 $5,000 $9,600 3 $4,200 $6,000 4 $3,600 $7,000

41 Activity 4: PI (Solution) Year Cash flow for Project A Cash flow for Project B 1 $4,000 $10,800 2 $5,000 $9,600 3 $4,200 $6,000 4 $3,600 $7,000 Total PV Outlay PI The PI of Project is higher, so should choose this.

42 Comparison of methods Payback or Discounted Payback Period NPV IRR Criteria for Independent Projects Accept if Payback is less than a specified no. of years Accept any projects whose NPV > 0 Accept any projects that IRR > Costs of Capital (k) Criteria for Mutually Exclusive Projects Choose projects that offers Quickest Payback Period and if the payback is less than specified number of years Choose the Highest NPV Project and with NPV > 0 Choose the highest IRR projects and with IRR>k Weaknesses 1. Ignore Time Value* 2. Ignore risk differences 3. Ignore Cashflows after payback period 4. No Objective basis for right payback period 5. Bias against LT project 1. Estimates for cashflows and discount rate difficult to apply 1. More complicated calculations 2. Unconventional Cashflows may have more than 1 IRR 3. Assumes reinvestment at IRR which is less realistic than NPV 4. Size problem since it is not absolute figures Strengths 1. Simple to use 2. Bias towards liquidity as it bias towards ST projects 3. Cashflow towards end is uncertain so ignoring it seems to adjust for risk 1. Take into account all cashflows 2. Take into account time value of money 3. Calculation quite straightforward 1. State in relative % not absolute value 2. Can estimate IRR without discount rate

43 Comparison of methods Criteria for Independent Projects Accept if PI > 1 Profitability Index (PI) Criteria for Mutually Exclusive Projects Weaknesses Choose projects PI > 1 and highest PI 1. Size problems since it is not in absolute figures 2. Estimates for cashflows and discount rate difficult to apply Strengths 1. Take into account all cashflows 2. Take into account time value of money

44 So which method? Different capital budgeting methods may yield different results. So which is the preferred method? Rule of the thumb is to follow the recommendation by NPV method.

45 Other factors to consider Certainty of cashflows Availability of capital Availability of financing Whether cost of capital will remain the same

46 Content page Specific Learning objectives Capital Budgeting Investment Criteria Types of Project Capital budgeting methods Other factors to consider Dealing with risks & uncertainty Conclusion

47 Dealing with risks & uncertainty Sensitivity Analysis a technique that indicates how much NPV will change in response to a given change in an input variable, other things held constant. Scenario Analysis - a risk analysis technique in which bad and good sets of financial circumstances are compared with a most likely, or base case situation.

48 Dealing with risks & uncertainty Monte Carlo Simulation - a risk analysis technique in which probable future events are simulated on a computer, generating estimated rates of return and risk indexes. Decision Tree - a diagram that shows all possible outcomes that result from a decision. Each possible outcome is shown as a branch on the tree. Decision trees are especially useful to analyse the effects of real options in investment decisions. Decision trees take into consideration the probability of each outcome

49 Content page Specific Learning objectives Capital Budgeting Investment Criteria Types of Project Capital budgeting methods Other factors to consider Dealing with risks & uncertainty Conclusion

50 Conclusion Evaluating Projects Independent Projects Mutually Exclusive Projects Types of Cash Flows Time Value of Cash Flows Capital Budgeting Methods Resources Constraints and Benchmarks Sunk Costs Interest rate NPV Opportunity Costs Timing of cash flows IRR Standard Payback Incremental Costs Profitability Index Cash Inflows and Outflows

51 RESOURCES Textbooks: Block, Hirt, Danielsen; Foundations of Financial Management; 13 th edition; McGraw Hill; Chapter 12 Graham Peirson, Rob Brown, Steve Easton and Peter Howard; Business Finance (8th Edition); Irwin/McGraw-Hill; 2003; Chapter 5 and 6. Eugene F. Brigham and Joel F. Houston; Fundamentals of Financial Management (Concise Fourth Edition); Thomson South-Western; 2004; Chapter 10 and 11. Lawrence J. Gitman; Principles of Managerial Finance (8th Edition); Addison Wesley Longman, Inc; 1997; Chapter 8 and 9. Jae K. Shim and Joel G. Siegel; Schaum s Outline of Theory and Problems of Financial Management (2nd Edition); Irwin/McGraw-Hill; 1998; Chapter 8 and 9. William L. Megginson and Scott B. Smart; Introduction to Financial Management (International Student Edition); Thomson South-Western; 2006; Chapter 8 and 9.