'Capital Budgeting' refers to long-term planning for proposed capital outlays and their financing.
Capital Budgeting: It is the Process of selecting viable investment projects.
3.
5.1. Investment Outlay (The Net Initial Investment)
The term Investment Outlay (net initial investment), as used here, refers to the relevant cash outflows to be considered when evaluating a prospective capital expenditure.
The net initial investment occurs at time zero - the time at which the expenditure is made.
The net initial investment is calculated by subtracting all cash inflows occurring at time zero from all cash outflows occurring at time zero.
The following table provides a general format for computing net initial investment:
5.
Format for Determining Net Initial Investment Project cost or cost of new fixed assets XXX Add: Cost of installation, insurance, transport XX Add: Positive net working capital XX Deduct Cash inflows from the proceeds of old fixed asset disposal XX A(D) Taxes (tax savings) on old asset disposal XX Net Initial investment (or net initial cash outflows) XXX
Let us assume that the Lalibela Corporation wants to introduce new production machinery. The cost of the needed machinery is Br. 1,000,000. The machinery is expected to last for 4 years, after which time it will have a scrap value of Br. 8,000. The corporation spends Br. 19,000 in transporting the machinery from the manufacturer and in installing the machinery in its plant .
The corporation pays for the machinery by making a down payment of Br. 100,000 and finances the remainder with a bank loan. What will be the net initial investment for the new production machinery?
The net initial investment is Br. 1,019,000. This is the sum of the cost of the machinery and the transportation and installation expenses (Br. 1000,000 + Br. 19,000). Scrap value of the new machinery and financing arrangements are not included in the computation.
In the case of replacement decisions, the existing fixed assets may be sold if the new fixed assets are to be purchased. ( in such case use the previous format for calculation Net initial investment)
The rules that determine the tax impact of selling a depreciable asset are summarized below:
1. If an asset is sold for less than its book value, the company realizes a decrease in its tax liability equal to 40 percent (assume) of the difference between the selling price and the book value of the asset.
2.If the asset is sold for its book value, there is no impact on corporate taxes.
If the asset is sold for more than its BV but for an amount equal to or less than its original cost, the corporation incurs an increase in its tax liability equal to 40 % of the difference between the selling price and the BV of the asset.
4.If the asset is sold for more than its original cost, the corporation incurs an increase in its tax liability equal to the tax on the capital gain plus the tax on the recaptured depreciation.
The capital gains tax is 20 % of the difference between the selling price and the original cost. The tax on the recaptured depreciation is 40 % of the difference between the original cost &BV.
Assume a new line of machinery is purchased to replace existing machinery by XYZ Corporation. The new machinery costs including installation cost amounts Br.2,500,000 and an expected salvage value of Br.250, 000 after ten years. The existing machinery originally cost Br. 800,000 and has a current book value of Br. 100,000.Based on the following independent assumptions with regard to old machinery disposal value, compute NII of the project.
It is defined as the number of years required for an investment’s cumulative cash flows to equal net initial investment.
Thus, PB can be looked upon as the length of time required for a project to recover on its net initial investment from project’s expected cash inflows.
Computation of Payback period. When an investment’s cash flows are in annuity form , payback period can be computed by dividing the value of net annual cash inflow into the project’s net initial investment.
It avoids making projections into the more distant future. The more uncertain the future is, the stronger may be the case for the use of the payback period criterion.
An investment alternative has a net initial investment of Br. 100,000 and produces a cash inflow annuity of Br. 14,000 for 16 years. Compute the NPV of the investment if the required rate of return (cost of capital) for the investment is 10 percent. Would you recommend accept or reject this project?
The present value factor corresponding to a 16 years payment annuity discounted at 10 percent is 7.824 (see present value for annuity case table or your calculator). NPV is calculated as follows:
IRR is the discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash outflow. Or It is defined as the discount rate that produces a zero NPV.
In the discussion of the NPV criterion (example 1), a project that required a NII of Br. 100,000 produced 16 annual cash flows of Br. 14,000 each. It required a 10 % rate of return, and had an NPV of Br. 9,536.
Since the NPV is positive at a discount rate of 10 %, the project’s actual rate of return exceeds 10%. Dividing the NII by the value of one net cash inflow and, then, locating the resulting quotient in the present value annuity table, helps to obtain the IRR for this project.
3. Compute the sum of the absolute values of the NPVs obtained in step 2.
Br. 3,306 + Br. 2,364 = Br. 5,670
4. Divide the smaller discount rate identified in step 1 in to the sum obtained in step 3. Then add the resulting quotient to the smaller discount rate:
Br. 3,306/ Br. 5,670 = .58
IRR = 11% + .58 = 11.58%
44.
Computation of IRR When CFs are Not in Annuity Form
It is necessary to make a good first guess of the project’s IRR. This can be done in either of the following two ways:
If the cash flows, at least, approximate an annuity, dominance techniques can be applied.
If the cash flows display no general annuity pattern, a weighted average can be used.
Chances are that the IRR based on the Br. 20,000 annuity will provide a better first guess because it is based on the cash flows that occur in the earliest years of the original project. An alternative is to take the arithmetic average of the IRRs of the two annuities as follows:
A third guess of the IRR at 20 % is made, based on the preceding two guesses and their corresponding NPVs. The NPV for the project discounted at 20 percent is:
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