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The capital budgeting process


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The capital budgeting process

  1. 1. Present value and Opportunity cost of capital The Capital Budgeting Decision Risk and Capital Budgeting
  2. 2.  Introduction  Foundations of the Net PresentValue Rule  Calculating Present value
  3. 3.  The process of identifying, evaluating, planning, and financing capital investment projects of an organization.  Capital budgeting is defined “as the firm’s formal process for the acquisition and investment of capital. It involves firm’s decisions to invest its current funds for addition, disposition, modification and replacement of fixed assets”.  “Capital budgeting is long term planning for making and financing proposed capital outlays”- CharlesT. Horngreen.
  4. 4.  Capital budgeting involves capital investment projects which require large sum of outlay and involve a long period of time – longer than the usual cut-off of one year or normal operating cycle.  “Capital budgeting consists in planning development of available capital for the purpose of maximizing the long term profitability of the concern” – Lynch  The main features of capital budgeting are  Potentially large anticipated benefits  A relatively high degree of risk  Relatively long time period between the initial outlay and the anticipated return. - OsterYoung
  5. 5.  The success and failure of business mainly depends on how the available resources are being utilized.  Main tool of financial management  All types of capital budgeting decisions are exposed to risk and uncertainty.  They are irreversible in nature.  Capital rationing gives sufficient scope for the financial manager to evaluate different proposals and only viable project must be taken up for investments.  Capital budgeting offers effective control on cost of capital expenditure projects.  It helps the management to avoid over investment and under investments.
  6. 6.  Capital investment decisions usually require relatively large commitments of resources.  Most capital investment decisions involve long-term commitments.  Capital investment decisions are more difficult to reverse than short-term decisions.
  7. 7.  Identification of potential projects  Process of preparing the master budget plan for a certain period.  Generating the proposals for investment.  Proposals serve as the potential projects that will be evaluated by top management for inclusion in the over-all plan for the coming period.
  8. 8.  Estimation of costs and benefits  Project proposal must meet some minimum criteria set by the firm.  Estimates of expected costs that the firm would incur for the project as well as the revenues or cost savings that may be derived from the project.
  9. 9.  Evaluation  Proposals are evaluated in the light of the organizational goals and policies.  Various evaluation methods or analytical techniques are used to ensure that only the most desirable projects are accepted.
  10. 10.  Development of the capital expenditure budget  Consist all capital investment project proposals that have been approved for the budget period.  The budget may be a simple listing of the capital expenditure projects and the amounts of required investment for each, or it may provide additional descriptive data about the projects.
  11. 11.  Re-evaluation  Must be reviewed periodically to determine if the project meets the original expectations.
  12. 12.  Replacement  When an existing capital investment wears out, becomes obsolete, or suffers an irreparable damage, such item should be quickly replaced in kind so as not to unduly interrupt operations.
  13. 13.  Improvement  May consider improvement of a certain product or process, which may necessitate the acquisition of capital investment projects.
  14. 14.  Expansion  Involves enlargement of facilities, setting up an additional business segment and invasion of new markets.
  15. 15.  ProjectTypes and Risk  Capital projects have increasing risk according to whether they are replacements, expansion or new ventures.
  16. 16.  Stand-Alone and Mutually Exclusive Projects  Stand-alone project has no competing alternatives  Mutually exclusive projects involve selecting one project from among two or more alternatives
  17. 17.  The Cost of Capital  The average rate a firm pays investors for use of its long term money
  18. 18.  Net Investment  Net Returns  Cost of Capital
  19. 19.  Availability of funds  Structure of capital  Taxation policy  Government policy  Lending policies of financial institutions  Immediate need of the project  Earnings  Capital return  Economic value of the project  Working capital  Accounting practice  Trend of earning
  20. 20.  Payback  Net PresentValue  Internal Rate of Return
  21. 21. NET PRESENTVALUE RULE  NPV = PV-C0  The difference between the PresentValue of the investment (future net cash flows, i.e., benefits and its initial cost).  Ideas:  An investment is worth undertaking if it creates value for its owners  An investment creates value if it worth more than the costs within the time value of many framework.
  22. 22.  If NPV >= 0, accept the project  If NPV <= 0, reject the project
  23. 23. PRESENTVALUE - Amount of money today
  24. 24. PV = FV (1+i)-n or PV= FV x [1/(1+i)n] or PV= FV / (1+i)n
  25. 25. Let's assume we are to receive $100 at the end of two years. How do we calculate the present value of the amount, assuming the interest rate is 8% per year compounded annually? PV= FV / (1+i)n
  26. 26. Where; FV= $100 i=8% N=2 PV= FV / (1+i)n PV= 100/ (1.08)2 PV= 100/ 1.1664 PV= $ 85.73
  27. 27. Suppose you are depositing an amount today in an account that earns 5% interest, compounded annually. If your goal is to have Php. 5,000 in the account at the end of six years, how much must you deposit in the account today? PV= FV / (1+i)n
  28. 28. Where; FV= Php. 5,000 i= 5% N=6 PV= 5,000/(1.05)6 PV=5,000/(1.3401) PV=Php. 3,731.08
  29. 29.  Payback Method  Net PresentValue Method  Internal Rate of Return
  30. 30. “Payout method”  Involves computation of the payback period.  PAYBACK PERIOD ▪ Length of time required by the project to return the initial cost of time.
  31. 31. According to this method, the project that promises a quick recovery of initial investment is considered desirable. Example: If a company wants to recoup the cost of a machine within 5 years of purchase, the maximum desired payback period of the company would be 5 years.
  32. 32. ADVANTAGES 1. Payback is simple to compute and easy to understand. 2. Payback gives information about liquidity of the project. 3. Payback period reduces risk of loss.
  33. 33. DISADVANTAGES 1. Payback does not consider the time value of money. 2. It gives more emphasis on liquidity rather than profitability of the project. 3. It does not consider salvage value of the project. 4. It ignores the cash flows that may occur after the payback period.
  34. 34. Due to increased demand, the management of Rani Beverage Company is considering to purchase a new equipment to increase the production and revenues. The useful life of the equipment is 10 years and the company’s maximum desired payback period is 4 years. The inflow and outflow of cash associated with the new equipment is given below:
  35. 35. The initial cost of equipment $37,500 Annual cash inflow: Sales $75,000 Annual cash outflow: Cost of ingredients $45,000 Salaries expenses $13,500 Maintenance expenses $1,500 Non cash expenses: Depreciation $5,000  Required: Should Rani BeverageCompany purchase the new equipment? Use payback method for your answer.
  36. 36. Computation of net annual cash inflow: $75,000 – ($45,000 + $13,500 + $1,500) = $15,000 = $37,500/$15,000 =2.5 years
  37. 37. The management of Health Supplement Inc. wants to reduce its labor cost by installing a new machine.Two types of machines are available in the market – machine X and machineY. Machine X would cost $18,000 where as machineY would cost $15,000. Both the machines can reduce annual labor cost by $3,000. Required: Which is the best machine to purchase according to payback method?
  38. 38. Machine X MachineY Cost of machine (a) $18,000 $15,000 Annual cost saving (b) $3,000 $3,000 Payback period (a)/(b) 6 years 5 years
  39. 39. An investment of $200,000 is expected to generate the following cash flows in six years: Year Net cash flow 1 $30,000 2 $40,000 3 $60,000 4 $70,000 5 $55,000 6 $45,000 Required: Compute payback period of the investment. Should the investment be made if management wants to recover the initial investment in 3 years or less?
  40. 40. (1). Because the cash inflow is uneven, the payback period formula cannot be used to compute the payback period.We can compute the payback period by computing the cumulative net cash flow as follows: Year Net cash flow Cumulative net cash inflow 1 $30,000 $30,000 2 $40,000 $70,000 3 $60,000 $130,000 4 $70,000 $200,000 5 $55,000 $255,000 6 $45,000 $300,000
  41. 41. (2). As the payback period is longer than the maximum desired payback period of the management (3 years), the investment should not be made.
  42. 42.  - is the excess of the present value s of the projects cash inflow over the amount of the initial investment.  It provides an absolute measure of a projects worth because it measure the total present value of peso return. It also works equally well for independent projects as it does for choosing among mutually exclusive projects.  Estimate CFs (inflows & outflows).  Assess riskiness of CF’s.  Determine the appropriate cost of capital.
  43. 43.  Accept the project if it’s NPV is equal or greater than zero; otherwise, the project is rejected.This means that the firm will earn a return equal to or greater than its cost of capital. If the NPV is negative, it means the project does not meet the hurdle rate and it should be rejected as the funds that would be invested in it could earn a higher rate in some other investments.
  44. 44. Project A has a net investment of P 120,000 and annual net cash inflows of P 50,000 for five years. Management wants to calculate Project A’s net present value using a 16% discount.
  45. 45. Present value of cash inflows (P 50,000 x 3.274) P 163,700 Less: Net Investment 120,000 Net Present value P 43,700 Therefore, Project A should be accepted because it could earn more than the desired minimum rate of return as indicated by the positive net present value.
  46. 46. Agila Corp. plans to invest in a four-year project that will cost P 750,000. Agila’s cost of capital is 8%. Additional information on the project is as follows: Cash flow from Present value Year operations, net of taxes of P1 at 8% 1 P 200,000 0.926 2 220,000 0.857 3 240,000 0.794 4 260,000 0.735 Required: Using the net present value method, determine whether the project is accepted or not.
  47. 47. Present value of cash inflows at 8%: Cash Inflows Year Amount PV factor PV 1 P 200,000 0.926 P 185,200 2 220,000 0.857 188,540 3 240,000 0.794 190,560 4 260,000 0.735 191,100 Total P 755,400 Less: Present value of net investment 750,000 Excess or net present value P 5,400
  48. 48.  Rate of return – it measure the speed that money comes back to you after you invest. It is written in % per year/per annum.
  49. 49.  Also known as discounted rate of return and time-adjusted rate of return. It is the rate which equates the present value of the future cash inflows with the cost of the investment which produces them. It is also the equivalent maximum rate of interest that could be paid each year for the capital employed over the life of an investment without loss on the project.
  50. 50. Accept Project if IRR > Cost of Capital Reject Project if IRR < Cost of Capital
  51. 51. An investment of P 50,000 will yield an average annual cash return of P 7,500 a year for a period of 10 years.What is the discounted rate of return?
  52. 52. 1. PV Factor= Net Investment/AnnualCash Returns = 50,000/7,500 = 6.6667 2. Referring to the table for Present value of P1 received annually for 10 years, the column that gives the nearest value to 6.6667 is the column for 8 %.
  53. 53. 3.To get the exact rate of return, interpolate between 8% and 10%. 8% - 6.710 =0.043 ? - 6.667 =0.565 =0.522 10% - 6.145 Exact discounted rate of return = 8% + (0.043/0.565 x 2%) = 8% + 0.15% = 8.15%
  54. 54. An investment amounting to P 100,000 is expected to yield cash returns as follows: Year Amount 1 P 40,000 2 50,000 3 60,000 Required: Compute the discounted rate of return.
  55. 55. 1. Average cash return = P 150,000/3 = P 50,000 2. PV Factor = P 100,000/ 50,000 = 2 3. Referring to the table for PresentValue of P1 received annually period 3, the column that will give the nearest value of 2 is the column for 22%.
  56. 56. For trial at 22% Amount of Cash PV of Cash Year Returns PV Factor Returns 1 P 40,000 0.820 P 32,800 2 50,000 0.672 33,600 3 60,000 0.551 33,060 P 99,460
  57. 57. ForTrial at 20 % 1 P 40,000 0.833 P 33,320 2 50,000 0.694 34,700 3 60,000 0.579 34,740 P 102,760
  58. 58. Discounted rate of return is 22%. If the exact discount rate of return is required, interpolation may be necessary. Computation will be: 22% - 99,460 =540 ? - 100,000 =3,300 =2,760 20% - 102,760 Discounted rate of return = 22% - (540/3,300 x 2%) = 22% - 0.30 % = 21.70%
  59. 59.  Definition of Risk  The concept of Risk Averse  Measurement of Risk
  60. 60.  Risk exists because of the inability of the decision-maker to make perfect forecasts.  Risk is referred to a situation where the probability distribution of the cash flow of an investment proposal is known. 65 FORECASTING RISK OR ESTIMATION RISK Is the possibility that a bad decision will be made because errors in the projected cash flows.  There is a danger that will conclude a project has a positive NPV.  Risk should be considered in evaluating capital budgeting projects in both informal and formal ways.
  61. 61.  is a concept that addresses how people will react to a situation with uncertain outcomes.  It attempts to measure the tolerance for risk and uncertainty.  Risk aversion is the reluctance of a person to accept a bargain with an uncertain payoff rather than another bargain with a more certain, but possibly lower, expected payoff. 66
  62. 62.  Aversion is also a concept that addresses how people will react to a situation with uncertain outcomes. It attempts to measure the tolerance for risk and uncertainty.  In the realm of finance and economics, Risk Aversion is a concept that addresses how people will react to a situation with uncertain outcomes. 67
  64. 64.  The basic form of “what-if” analysis.  One way to examine the risk of investment is to analyse the impact of alternative combinations of variables, called scenarios, on the project’s NPV (or IRR).  The decision-maker can develop some plausible scenarios for this purpose. 69
  65. 65.  This is also known as a “what if analysis”.  This is calculated in terms of NPV, or net present value.  Sensitivity analysis allows to see the impact of the change in the behaviour of critical variables on the project profitability.  Conservative forecasts include using short payback or higher discount rate for discounting cash flows. 70
  66. 66.  Except a very few companies most companies do not use the statistical and other sophisticated techniques for analysing risk in investment decisions.  Identification of all those variables, which have an influence on the project’s NPV (or IRR).  Sensitivity analysis is a way of analysing change in the project’s NPV (or IRR) for a given change in one of the variables.  The decision maker, while performing sensitivity analysis, computes the project’s NPV (or IRR) 71
  67. 67.  It compels the decision-maker to identify the variables, which affect the cash flow forecasts. This helps him in understanding the investment project in totality.  It indicates the critical variables for which additional information may be obtained. The decision-maker can consider actions, which may help in strengthening the ‘weak spots’ in the project.  It helps to expose inappropriate forecasts, and thus guides the decision-maker to concentrate on relevant variables. 72
  68. 68. It does not provide clear-cut results. The terms ‘optimistic’ and ‘pessimistic’ could mean different things to different persons in an organisation. Thus, the range of values suggested may be inconsistent. It fails to focus on the interrelationship between variables. 73
  69. 69.  Considers the interactions among variables and probabilities of the change in variables. It computes the probability distribution of NPV.  The simulation analysis involves the following steps:  First, you should identify variables that influence cash inflows and outflows.  Second, specify the formula that relate variables.  Third, indicate the probability distribution for each variable.  Fourth, develop a computer programme that randomly selects one value from the probability distribution of each variable and uses these values to calculate the project’s NPV. 74
  70. 70.  Beta is a measure firms can use in order to determine an investment's return sensitivity in relation to overall market risk.  Beta describes the correlated volatility of an asset in relation to the volatility of the benchmark that said asset is being compared to. 75
  71. 71.  Beta is also referred to as financial elasticity or correlated relative volatility, and can be referred to as a measure of the sensitivity of the asset's returns to market returns, its non-diversifiable risk, its systematic risk, or market risk.  Higher-beta investments tend to be more volatile and therefore riskier, but provide the potential for higher returns. Lower-beta investments pose less risk, but generally offer lower returns. 76