Topic6 ch11

Topic 6
Capital budgeting: concepts and methods
Petty, Keown, Scott Jr., Martin, Burrow, Martin & Nguyen: Financial Management 4e 2006 Pearson Education Australia
Objectives
Know the principles used to decide the most suitable capital-budgeting criteria Understand the main discounted cash flow criteria for project evaluation Appreciate when taxation affects capitalbudgeting decisions Understand the fundamentals of how to measure a projects benefits and costs Appreciate the nature of the keys to finding profitable projects Be able to apply the main non-discountedcash-flow criteria for evaluating projects
Capital budgeting
The decision-making process with respect to investment in fixed assets
Example Suppose our firm must decide whether to purchase a new plastic moulding machine for $125,000 How do we decide? Will the machine be profitable? Will our firm earn a sufficiently high rate of return on the investment?
Decision-making criteria in capital budgeting
How do we decide if a capital investment project should be accepted or rejected?
Principles for choosing capital budgeting criteria
The ideal evaluation method should: Include all cash flows that occur during the life of the project Ensure criteria are consistent with the goal of maximising shareholder wealth Consider the time value of money Incorporate the required rate of return on the project
Discounted cash flow criteria

1. Net present value 2. Profitability index 3. Internal rate of return NPV PI IRR
Each of these criteria: Examine all net cash flows Consider the time value of money Use the required rate of return
Net present value

NPV is the total present value of the annual net cash flows less the initial outlay
NPV =
n t =1
ACFt ( 1 + k )t If NPV 0 If NPV < 0
IO
Accept-reject criterion
Accept Reject
7
NPV Example
Should we proceed with a capital investment that costs $276,400 and provides annual net cash flows of $83,000 for 4 years and $116,000 at the end of the fifth year? The firms required rate of return is 15%.
-276,400 0
83,000 1
83,000 2
83,000 3
83,000 4
116,000 5
8
Example solution using NPV

Using a calculator 1. Clear the calculator
RCL CFi 2ndF C.CE =
3. Enter the discount rate 15

i
2. Enter the cash flows -276400 CFi 83000 CFi 116000 CFi
CFi CFi CFi
4. Calculate NPV
NPV
NPV = $18,235.71
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Profitability index
Alias: Benefit-cost ratio
PI =
n t =1
ACFt (1+k )t
IO
If PI 1 If PI < 1
Accept Reject
Compare with NPV
NPV =
n t =1
ACFt ( 1 + k )t
IO
If NPV 0 If NPV < 0
Accept Reject
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Example solution using PI

Using a calculator 1. Clear the calculator
RCL CFi 2ndF C.CE =
3. Enter the discount rate 15

i
2. Enter the cash flows 0 CFi 83000 CFi 116000 CFi

CFi CFi CFi
4. Calculate Sum
NPV
Sum = $294,635.71 PI = Sum / IO = 294635.71 / 276400 = 1.066

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Internal rate of return IRR

Simple concept: The rate of return that the firm earns on the capital budgeting project Technical definition: The discount rate that equates the present value of the projects expected future net cash flows with the projects initial cash outlay
12
IRR versus NPV

IRR
n t =1
ACFt ( 1 + IRR )t
= IO
If IRR R If IRR < R
Accept Reject
NPV
NPV =
n t =1
ACFt ( 1 + k )t
IO
If NPV 0 If NPV < 0
Accept Reject
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Calculating IRR
-276,400 0 83,000 1 83,000 2 83,000 3 83,000 4 116,000 5
1. Clear the calculator

RCL CFi 2ndF C.CE =
3. Calculate IRR
IRR
2. Enter the cash flows -276400 CFi 83000 CFi 116000 CFi
CFi CFi CFi
IRR = 17.63% Should we proceed with this project?

14
When NPV, PI and IRR are all needed

1. 2. 3. 4. 5. Enter the cash flows only once Find the IRR Enter the required rate of return Find the NPV Find the PI using the following formula: PI = ( NPV +IO ) / IO
15
Example
Using a required rate of rate of return of 15%, find the NPV, PI and IRR for the following cash flows:
-900 0 300 1 400 2 400 3 500 4 600 5
IRR = 34.37% Using a discount rate of 15%: NPV = $510.52 PI = ( NPV + IO ) / IO = ( 510.52 + 900 ) / 900 = 1.57
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The role of taxation in capital budgeting

Should pre-tax or after-tax cash flows be used?
It depends on the nature of the organisation making the capital budgeting decision
Does this affect the discount rate (cost of capital) being used?
Yes! The discount rate must be consistent with the type of cash flows used
Since Investments typically are made using after-tax cash, we generally use after-tax WACC as the discount rate for project evaluation.
17
Tax issues
Tax savings due to the project reducing cash flows Tax payments due to the project increasing cash flows Tax deductions including depreciation Tax timing
18
Measuring a projects benefits and costs

Capital budgeting decisions must always be based on incremental (or differential) cash flows A good test If a cash flow exists with the project and does not exist without the project, it is incremental also exists without the project, it is not incremental
19
Time pattern of a projects cash flows

The initial outlay The differential cash flows over the projects life The terminal cash flow
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Initial outlay
Typical items: Installed cost of asset Additional non-expense outlays incurred
e.g. Working-capital investments
Additional expenses
e.g. Training expenses
Cash flows associated with the sale of a replaced asset Tax effects
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Differential cash flows over the projects life

Typical items: Added revenue from incremental sales Extra expenses Labour and material savings Increases in overheads incurred Increased taxes on incremental profits
22
Terminal cash flows

Salvage or disposal value of the project Tax payable or deductible from gains or losses on disposal Cash outlays to wind up the project Recovery of non-expense outlays incurred at the projects start
e.g. Investment in working-capital
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Non-discounted cash flow criteria
Payback period Accounting rate of return
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Payback period
The number of years needed to recover the initial cash outlay
Alternatively: How long will it take for the project to generate enough cash to pay for itself?
25
Payback period example

Suppose our firm is considering a project which will generate cash flows of $150,000 per year for the next 8 years and have an initial cash outlay of $500,000. What is the projects payback period?
-500 150 150 150 150 150 150 150 150 0 1 2 3 4 5 6 7 8
Payback period = 3.33 years

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Example decision
Is a 3.33 year payback period acceptable? We should compare this value with some standard set by the firm If senior management have set a cut-off period of 5 years for project like ours, what would be our decision? Accept the project
27
Limitations of payback period

Firm cut-off standards are subjective Does not consider the time value of money Does not consider any required rate of return Does not consider all of the projects cash flows
28
Discounted payback period

Discounts the cash flows at the firms required rate of return Payback period is calculated using these discounted net cash flows Problems Cut-offs are still subjective Still does not examine all cash flows
29
Accounting rate of return
Relates the average accounting profits generated by the project to the average dollar size of the investment required
AROR =
( Accounting profit in year t ) /

t=1
( Initial outlay + Expected salvage value ) / 2

30
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Limitations of the AROR

Time value of money is ignored Concerned with accounting profits rather than cash flows
Cash is interesting Cash has value Cash is King!
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Topic 6

Capital budgeting: concepts and methods

Decision-making criteria in capital budgeting

How do we decide if a capital investment project should be accepted or rejected?

Principles for choosing capital budgeting criteria

Discounted cash flow criteria

Net present value

ACFt ( 1 + k )t If NPV 0 If NPV < 0

Example solution using NPV

3. Enter the discount rate 15

Compare with NPV

If NPV 0 If NPV < 0

Example solution using PI

3. Enter the discount rate 15

2. Enter the cash flows 0 CFi 83000 CFi 116000 CFi

Sum = $294,635.71 PI = Sum / IO = 294635.71 / 276400 = 1.066

Internal rate of return IRR

IRR versus NPV

If IRR R If IRR < R

If NPV 0 If NPV < 0

1. Clear the calculator

IRR = 17.63% Should we proceed with this project?

When NPV, PI and IRR are all needed

The role of taxation in capital budgeting

Measuring a projects benefits and costs

Time pattern of a projects cash flows

Differential cash flows over the projects life

Terminal cash flows

Non-discounted cash flow criteria

Payback period Accounting rate of return

The number of years needed to recover the initial cash outlay

Payback period example

Payback period = 3.33 years

Limitations of payback period

Discounted payback period

Accounting rate of return

( Accounting profit in year t ) /

( Initial outlay + Expected salvage value ) / 2

Limitations of the AROR

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