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CAPITAL BUDGETING. What it is Large investment in plant or equipment with returns over a period of time. Investment may take place over a period of time A Strategic Investment Decision. CAPITAL BUDGETING. Purpose Expansion Improvement Replacement R & D. CAPITAL BUDGETING.

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Capital budgeting

CAPITAL BUDGETING

What it is

Large investment in plant or equipment

with returns over a period of time.

Investment may take place over a period of time

A Strategic Investment Decision


Capital budgeting1
CAPITAL BUDGETING

Purpose

  • Expansion

  • Improvement

  • Replacement

  • R & D


Capital budgeting2
CAPITAL BUDGETING

What do we need to think about?

  • Location

  • Infrastructure

  • Labour

  • Cash Flows

    What is the most important?


Overall aim
OVERALL AIM

To maximise shareholders wealth..

Projects should give a return over and above the marginal weighted average cost of capital.

Projects can be;

  • Mutually exclusive

  • Independent

  • Contingent

    Process of Choice


Ideal selection method
IDEAL SELECTION METHOD

Will

  • Select the project that maximises shareholders wealth

  • Consider all cash flows

  • Discount the cash flows at the appropriate market determined opportunity cost of capital

  • Will allow managers to consider each project independently from all others


Selection methods
SELECTION METHODS

  • Payback

  • ARR

  • Net Present Value (NPV)

  • Internal Rate of Return (IRR)


Choice
CHOICE

PAYBACK

Project AProject B

Yr 0 - 1,000,000 - 1,000,000

Yr 1 + 1,100,000 + 500,000

Yr 2 + 200,000 + 500,000

Yr 3 - 100,000 + 500,000

Project A = Year .909

Project B = ?


Payback
PAYBACK

Problems:-

  • Ignores overall return

  • Ignores impact of large flows

  • Ignores timing of flows


ARR

Project AProject B

Yr 0 - 1,000,000 - 1,000,000

Yr 1 + 1,100,000 + 500,000

Yr 2 + 200,000 + 500,000

Yr 3 - 100,000 + 500,000

n

RoA Project A = Σ ( cashflows) ÷ Io

t=o n

  • (200,000) = 66,666.66 ÷ 1,000,000 = .0666 or 6.67%

    3

    Project B?

    Problems?


Net present value
NET PRESENT VALUE

PROJECT A

Yr CF PV Factor @ 14% Present Value

0 - 1,000,000 1.000 - 1,000,000

1 500,000 .8772 438,600

2 500,000 .7695 384,750

3 500,000 .6750 337,500

4 500,000 .5921 296,050

5 - 500,000 .5194 - 259,700

NPV 197,200


Net present value1
NET PRESENT VALUE

PROJECT B

- 1,000,000

900,000

200,000

200,000

100,000

100,000


Net present value2
NET PRESENT VALUE

PROJECT B

- 1,000,000 - 1,000,000

900,000 789,480

200,000 153,900

200,000 135,000

100,000 59,210

100,000 51,940

NPV 189,530

Which project should we undertake?

Why?


Internal Rate of Return

Project A

Yr CF PVF@ 26% PV PVF@ 27%

0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000

1 500,000 .793651 = 396,825 .787401 393,701

2 500,000 .629881 = 314,941 .620001 310,000

3 500,000 .499906 = 249,953 .488190 244,095

4 500,000 .396751 = 198,376 .384401 192,200

5 - 500,000 .314881 = - 157,441 .302678 -151,339

2,654 -11,343

Interpolation

IRR = 26.19%

Project B

0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000

1 900,000 = 714,286 708,661

2 200,000 = 125,976 124,002

3 200,000 = 99,981 97,638

4 100,000 = 39,675 38,440

5 100,000 = 31,48830,268

IRR = 27%11,406 - 991


Interpolation
Interpolation

26% 27%

+2,654 -11,343

Q. Where on the line does 0 fall?

From + 2654 0 = 2654 = .1896 or 18.96% of distance

13997

Since distance = 27-26 = 1% = .1896 of 1%

 Answer = 26 + .1896 = 26.19%

13,997


Test @ 26 19
Test @ 26.19%

Yr CF PVIF PV

0 - 1,000,000 1.0000 -1,000,000

1 500,000 .7924558 396,228

2 500,000 .6279862 313,993

3 500,000 .4976513 248,826

4 500,000 .3943667 197,183

5 - 500,000 .3125182 - 156,259

- 29


Comparison of npv vs irr
Comparison of NPV vs. IRR

  • NPV accepts all projects with NPV > 0.

    Ranking of projects is by value of NPV.

  • IRR finds the value of the discount rate that

    makes NPV = 0. Project will be accepted if

    IRR > k (cost of capital)

    The big Q?

    Will the two methods always give the same

    answer?

    No, unfortunately not


Npv vs irr
NPV Vs IRR

Relationship between NPV,IRR and Discount Rates

  • 0 10 20 30 40 50 Disc rate

  • NPV



Reinvestment rate assumption
Reinvestment Rate Assumption

Project Yr0 Yr1 Yr2 Yr3 C of K NPV IRR

X -10,000 5,000 5,000 5,000 10% 2,430 23.4%

Y -10,000 0 0 17,280 10% 2,977 20.0%

Illustration

Reinvestment

@23.4% End Yr 1 End Yr 2 End Yr 3

5,000 6,170 7,613

5,000 6,170

5,000

18,783

@ 10% 5,000 5,500 6,050

5,000 5,500

5,000

16,550


Value additivity
Value Additivity

Project NPV @10% IRR%

1 354 134.5

2 104 125.0

3 309 350.0

1 + 3 663 212.8

2 + 3 413 237.5


Multiple rates of return
Multiple Rates of Return

  • Multiple Rates of Return

    NPV

    400

    200 IRR 15%

    Discount Rate

    0

    IRR – 12%

  • 200

  • 400


Npv vs irr1
NPV Vs IRR

Conclusion

NPV is the correct method to use

But - there are some additional issues


Other issues
Other Issues

  • Scale

    How do we evaluate between projects of different scale?

    Project Outlay PV @ 10 % NPV

    A - 400 572 172

    B - 500 683 183

    How do we compare?

    If we have plenty of capital then it is not a problem.

    Both have a positive NPV so do both.


Other issues scale
Other IssuesScale

  • Suppose we only have 600 worth of capital. Which project should we take?

  • Work out the Profitability Index

    Present Value = PI

    Cost

  • Project A = 572 = 1.43

    400

    Project B = 683 = 1.37

    500


Other issues scale1
Other IssuesScale

  • Now work out the weighted PI

  • For A (1.43 x 400) + (1 x 200) = 1.2866

    600 600

    .9533 .3333

    For B (1.37 x 500) + (1 x 100) = 1.3084

    600 600

    Therefore take Project B


Other issues project lives
Other IssuesProject Lives

  • What if projects take place over different time scales?

    Yr Project A Project B

    0 - 17,500 -17,500

    1 10,500 7,000

    2 10,500 7,000

    3 8,313

    NPV @ 10% 723 894


Other issues project lives1
Other IssuesProject Lives

  • How to choose

  • Assume you are able to repeat the projects until they have the same end date

    0 2 4 6 A

    3 B

    723

  • 723 (discount at 10%)

  • 723 (discount at 10%)

    1813


Project lives
Project Lives

0 2 4 6

3

894

672 894 (discount at 10%)

1566

  • Project B


Project lives1
Project Lives

  • This approach is fine for simple project lives but what if they are complex?

  • E.g.lives of 7 years, 9 years and 13 years

  • Answer make them all last for ever!

  • NPV(n, to inf) = NPVn (1+ k)n

    (1+ k)n – 1


Project lives2
Project Lives

  • E.g. NPV2 to inf = 723 (1.1)2= 723 x 1.21

    (1.1)2 - 1.21

    723 x 5.76 = 4,165

    NPV3 to inf = 894 (1.1)3= 894 x 1.331

  • (1.1)3 – 1 .331

    894 x 4.02 = 3,596


Cash flows
Cash Flows

Example –

Consider the following new project:-

Initial capital investment of £15m.

It will generate sales for 5 years.

Variable Costs equal 70% of sales.

Fixed cost of project =£200,000 P.A.

A feasibility study, cost £5000, has already been carried out.

Discount rate = 12%.

Should we take the project?



Cash flows2
Cash Flows

Treatment of depreciation in NPV analysis.

-We only use cashflows in investment appraisal.

-Depreciation is not a cashflow.

-However, depreciation (capital allowances) is allowable against tax (see income statement), which affects cashflow.

For cashflow, add depreciation back:-



Issues to consider cash flows
Issues to ConsiderCash Flows

  • But not in detail!

  • Cash flows should be incremental

    - include all incidental effects (redundancy)

    - Do not forget working capital

    - Do forget sunk costs!

    - Be careful with allocated overheads


Issues to consider cash flows1
Issues to ConsiderCash Flows

  • ‘Uncertainty means more things can happen than will happen’ Brealy and Myers.

  • How do we obtain a feel for what the cash flows are most likely to be?

  • - Sensitivity Analysis

  • - Scenario Analysis

  • - Break Even Analysis

  • - Simulation

  • - Decision Trees


Issues to consider discount rate
Issues to ConsiderDiscount Rate

  • We also need to consider what discount rate to use as this will also effect the outcome.

  • This is the next subject


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