Capital Budgeting

Mubeen Rafat

Investment Decision
Capital Budgeting Decision
Current Liabilities
Long-Term Debt

Current Assets

Fixed Assets Tangible Intangible

Long-term Investment Decisions

Shareholders Equity

Learning Objectives
Capital Expenditure Decisions

Identify, measure and analyse relevant cash flows Evaluate the cash flows using the decision criteria

Capital Allocation Decisions

Ranking of Projects

Sensitivity Analysis

Capital Budgeting
The process of identifying, analyzing, and selecting investment projects whose returns (cash flows) are expected to extend beyond one year.

Capital Budgeting Process

Step 1: Generate proposals
Step 2: Estimate the cash flows Step 3: Evaluate alternatives and select projects Step 4: Review prior decisions

Project Classifications
Replacement Decisions
Maintain Existing Operations

Expansion Decisions
Increasing Existing Operations

Diversification Projects

Operations in a different industry

1) 2) 3) 4)

5) 6) 7)

Basic information Cost of investment project. Estimated life of project. Estimated net cash inflows from project. Estimated residual value of project at the end of its life Cost of capital. Taxation implications of project. Inflation rates and effect on project.

CHARACTERISTICS OF CAPITAL EXPENDITURES

SUBSTANTIAL CASH OUTLAYS TO-DAY BENEFITS EXTEND INTO THE FUTURE IRREVERSIBLE DECISIONS

DECISION MAKING
CASH FLOWS YEAR 0 1 2 3 A -1000 100 900 100 B -1000 0 0 300 C -1000 100 200 300 D -1000 200 300 500 4 -100 700 400 500 5 -400 1300 1250 600

Payback Period
Number of years required to recover back the investment Year before full recovery of investment + (Unrecovered cost Total Cash Flow during the year)

DECISION MAKING -ARR

CASH FLOWS YEAR 0 1 2 3 A -1000 100 900 100 B -1000 0 0 300 C -1000 100 200 300 D -1000 200 300 500 4 5 -100 -400 700 1300 400 1250 500 600

-8 26 25 22

Accounting Rate of Return

Average Cash Flows =Sum(Cash Flows)/N N= Number of Years Depreciation = Investment /Life of asset PAT= Cash Inflow-Depreciation ARR=Avg PAT/Avg Investment

TIME VALUE OF MONEY

0
5% * 1.05 -100

1
* 1.05

2
* 1.05

3
* 1.05

4
* 1.05

105

110.25

115.76

121.55

127.63

FVn = PV(1+i)n

TIME VALUE OF MONEY

0
5% / 1.05 -100

1
/ 1.05

2
/1.05

3
/ 1.05

4
/1.05

105

110.25

115.76

121.55

127.63

PV = FVn/(1+i)n PV= 127.63/(1.05)5 =127.63/1.27635 =100

TIME VALUE OF MONEY

0
5% / 1.05 -100

1
/ 1.05

2
/1.05

3
/ 1.05

4
/1.05

100
95.238

100
90.7

100
86.38

100
82.27

100
78.34

PV = FVn/(1+i)n PV= 100/(1.05)5 =100/1.27635 =78.3484

DECISION MAKING
YEAR A B C D
PV @ 10%

0 1 2 3 -1000 100 900 100 -1000 0 0 300 -1000 100 200 300 -1000 200 300 500 -1000 90.9 744 75.1 -1000 0 0 225 -1000 90.9 165 225 -1000 182 248 376

4 -100 700 400 500 -68 478 273 342

5 -400 1300 1250 600 NPV -248.4 -407 807.2 511 776.2 531 372.6 519
0.621

1.000 0.909 0.826 0.751 0.683

A B C D

DECISION MAKING

YEAR A B C D

0 1 2 3 -1000 100 900 100 -1000 0 0 300 -1000 100 200 300 -1000 200 300 500

4 5 IRR -100 -400 -200% 700 1300 21% 400 1250 23% 500 600 25%

Internal Rate of Return

The rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows. The interest yield of the potential investment.

Internal Rate of Return

TECHNIQUE FOR CAPITAL BUDGETING ESSENTIAL CHARACTERISTICS

1. ALL CASH FLOWS SHOULD BE CONSIDERED

2. ALL CASH FLOWS SHOULD DISCOUNTED AT OPPORTUNITY COST OF FUNDS 3. ENSURE SELECTION OF THAT PROJECT WHICH MAXIMISES PROFITS 4. ENABLE ONE PROJECT TO BE CONSIDERED INDEPENDENTLY FROM ALL OTHERS

Project Cash Flow Estimation

Significance of Cash Flows and Cash Flow Estimation Relevant cash flows Estimating project operating cash flows and project total cash flows

Categorisation of Cash Flows

Operating Cash Flows

Terminal Cash Flows Recovery of Salvage Value Working Capital

Initial Cash Flows Cost of Asset + Revenue Expenses Less: Disposal of old asset Increase in working Capital

Cash Flows
Wealth maximization principle - evaluation of a project must be based on cash flows and not on accounting profits

an unbiased estimate of the expected future cash flows of the project including time to completion and estimate initial investment/cost extremely important and most difficult task

Estimating After-Tax Incremental Cash Flows

Cash (not accounting income) flows Operating (not financing) flows After-tax flows Incremental flows

Something to remember
Projects have failed or succeeded due to incorrect or correct estimates of the cash flows of the project. If cash flow estimates are incorrect, it doesnt matter which technique we use, the project is doomed to fail

Relevant versus Irrelevant Cash Flows

The results of an acceptance of a project is to change the cash flows. Cash flows of a firm that change because of the project are called relevant cash flows; Any cash flows that do not change irrespective of the acceptance/rejection of the project is irrelevant to decision making and should not be considered.

Cash Flow Estimation

Sunk Costs Opportunity Costs Project Externalities Change in Net Working Capital

Measuring Cash Flow to the Firm

EBIT ( 1 - tax rate) - (Capital Expenditures - Depreciation) - Change in Working Capital = Cash flow to the firm Where are the tax savings from interest payments in this cash flow?

Sunk Costs
Sunk Costs cost that has already been incurred and cannot be recovered irrespective of the decision to accept or reject the project. R&D, Market Research, General & Admin Expenses, Consultants Fees

Opportunity Costs
Opportunity Costs--The cash flow foregone by using the resources in this way. Resources have multiple uses You can use them in one way to the exclusion of other uses and this gives rise to opportunity costs By using own building for business, the rent that could have been earned by renting it out is an opportunity cost Is this relevant or irrelevant to decision making?

Project Externalities
Project Externalities--the effect of a new project (positive or negative) on an existing project or division of a firm. Sales erosion (cannibalization)when firm sells a product that competes with other products within the same firm (Diet Coke vs. Coke Classic) or introduction of a new model of a car on other existing models Margin lost in other linenegative cash flow for project Is it relevant or irrelevant to decision making?

Net Working Capital

Change in Net Working Capital--Net working capital is defined as current assets minus current liabilities. Investment in working capital is a cash outflow during the year in which investment takes place Any investment in working capital is a cash inflow during the last year of the project and must be treated accordingly

Principles in estimating the cash flows

Ignore sunk costs Exclude interest costs Include opportunity costs Include project-driven changes in working capital net of changes in current liabilities

COMPARISON OF NPV & IRR METHODS

REINVESTMENT RATE ASSUMPTION
VALUE ADDITIVITY PRINCIPLE MULTIPLE RATES

RANKING OF PROJECTS
THE FOLLOWING PROJECTS ARE AVAILABLE FOR INVESTMENT Rs. 000s

PROJECT A PROJECT B PROJECT C PROJECT D PROJECT E PROJECT F

OUTLAY 300 250 250 150 100 50

NPV 40 30 35 22 15 10

IRR 18% 16% 17% 19% 18% 16%

RANKING OF PROJECTS
THE FOLLOWING PROJECTS ARE AVAILABLE FOR INVESTMENT Rs. 000s

PROJECT A PROJECT B PROJECT C PROJECT D PROJECT E PROJECT F

OUTLAY NPV 300 40 250 30 250 35 150 22 100 15 50 10

IRR 18% 16% 17% 19% 18% 16%

PI 1.13 1.12 1.14 1.15 1.15 1.20

PROFITABILITY INDEX=PRESENT VALUE OF INFLOWS PRESENT VALUE OF OUTFLOWS

The Optimal Capital Budget

Rate

Return exceeds cost

WACC
Fund these projects Cost exceeds return Funding available

What can go wrong?

Technology failures
Force majeure or necessary variations Time overrun leading to cost overrun Permission not forthcoming or subject to costly conditions The project may take longer to break even Initial teething problems may continue long after commercial production has commenced decline in capacity utilisation

What can go wrong?

Projected sales volume not achieved Actual sales realisation per unit < projected sales price/unit Input costs may go up sharply