Capital budgeting


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Capital budgeting

  1. 1. WHAT IS CORPORATE FINANCEThe division of a company that is concerned with the financial operation of the company. In most businesses, corporate finance focuses on raising money for various projects or ventures.For investment banks and similar corporations, corporate finance focuses on the analysis of corporate acquisitions and other decisionsThis is basically about money OBJECTIVES SAN LIO 1
  2. 2. The primary goal of corporate finance is to Maximize corporate value while managing the firm’s financial risks SAN LIO 2
  3. 3. ANALYSIS OF FINANCIAL STATEMENTSPrimary goal of financial management is to maximize the stock price, not accounting measures such as the bottom line or EPS.Evaluation of accounting statements helps management appreciate the company’s performance trends, as well as to forecast where the company is goingThe primary financial statements include: The statement of financial position The income statement SAN LIO 3
  4. 4.  The statement of retained earnings or called statement of changes in equity The cash flow statementOTHERS ARE Notes to the financial statements Accounting policies Statement of financial position-retrospective restatementRatios analysis-important SAN LIO 4
  5. 5. RATIOSSolvency and financial strengthProfitability ratiosEarning value ratios (share value)Efficiency ratiosGearing/leverage ratios SAN LIO 5
  6. 6. CONSIDER THESE OBJECTIVES OF FMProvide support for decision makingEnsure the availability of timely, relevant and reliable financial and non-financial informationManage risksUse resources efficiently, effectively and economicallyStrengthen accountabilityProvide a supportive control environmentComply with authorities and safeguard assets SAN LIO 6
  7. 7. FINANCIAL PLANNING AND FORECASTINGWhat is a plan?-explain this to the studentsWhat is a forecast- explain this to the studentsThe optimal forecast becomes the budget SAN LIO 7
  8. 8. CAPITAL BUDGETING TECHNIQUES Defined- This is the process of evaluating specific investment decisions. Capital investment decisions are important because: They involve huge sums of money Hard to discover alternative economic use Difficult to get out of the project once funds are committed Aim is to increase owners wealth and thus Control Capital used to mean operating assets used in production SAN LIO 8
  9. 9. Budget is a plan (activities) that details projected cash flows during some future period.Thus capital budget is an outline of planned investments in operating assets while capital budgeting is the whole process of analysing projects and identifying the ones to include in the budget accordingly and these the ones that add to firm’s value SAN LIO 9
  10. 10. PROJECT CLASSIFICATION KEY Categories which firms analyse include: Replacement: MAINTENANCE OF BUSINESS-worn-out or damaged equipments –depends on whether to continue the business or go into new ventures- no need of elaborate decision process Replacement: COST REDUCTION- detailed analysis Expansion of existing products or markets- higher level decisions within the firm Expansion into new products or markets- boards decision as a part of firm’s strategic plan SAN LIO 10
  11. 11. Safety and/or environment projects- mandatory investments to comply with specific industry requirementsResearch and development- may use decision tree analysis rather than DCF techniquesLong-term contracts- to provide products or services to specific customers- DCF analysis necessary SAN LIO 11
  12. 12. CAPITAL BUDGETING DECISION RULESThere are seven key methods namelyPaybackDiscounted paybackAccounting rate of returnNet present value (NVP)Internal rate of return ( IRR)Modified internal rate of return (MIRR)Profitability index SAN LIO 12
  13. 13. PAYBACK PERIODExpected number of years required to cover the original investmentPayback = year before full recovery +unrecovered cost at start of yearCash flow during the yearEXAMPLETake two projects X and YX= -1000 Y1 500 Y2 400, Y3 300 Y4 100Y=-1000 Y1 100 Y2 300 Y3 400 Y4 600 SAN LIO 13
  14. 14. EXAMPLE CONTRequired: find payback period and advise which project should be undertaken if both projects are mutually exclusiveSOLUTIONX= 2 + 100/300 = 2.33Y= 3+ 200/600= 3.33CONCLUSION X has the shortest pay back period thus accepted accordingly. SAN LIO 14
  15. 15. DISCOUNTED PAYBACKHere the expected cash flows are discounted by the project’s cost of capitalDiscounted payback period defined as the number of years required to recover the investment from discounted net cash flowsEXAMPLE OF OUR PROJECTS X AND YDiscounting the cash inflows for both projects assuming a cost of capital of 10%Use tables accordingly SAN LIO 15
  16. 16. EXAMPLE CONTProject X = 2 + 214/225= 2.95 yearsProject Y = 3 + 360/410= 3.88 yearsProject X is preferred accordinglyPeriod discounting factor at 10%1 .90912 .82643 .75134 .68305 .6209 SAN LIO 16
  17. 17. PROJECT X YEAR CASH FLOW DIS FAC PV BAL 0 -1000 1 -1000 -1000 1 500 .9091 455 -545 2 4OO .8264 331 -214 3 300 .7513 225 11 4 100 .6830 68 79THUS: 2 + 214/225 = 2.95 SAN LIO 17
  18. 18. PROJECT Y Pay back 3 + 360/410 = 3.88ADVANTAGES OF PAYBACK METHODEasy to understand and calculateProvides some assessment of risk in a business environment of rapid technological changes, new plant and machinery may need to be replaced sooner than in the past, so a quick payback on investment is essential SAN LIO 18
  19. 19. The investment climate today in particular, demands that investors are rewarded with fast returns. Many profitable opportunities for long-term investment are overlooked because they involve a longer wait for revenues to flow SAN LIO 19
  20. 20. DISADVANTAGESIgnores cash flows after the payback period. Cash flows are regarded as either pre-payback or post- payback, but the latter tend to be ignored.Does not measure profitability. Payback takes no account of the effect on business profitability. Its sole concern is cash flowIgnores time value of moneyIt lacks objectivity. Who decides the length of optimal payback time? No one does - it is decided by pitting one investment opportunity against another. SAN LIO 20
  21. 21. NB/It is probably best to regard payback as one of the first methods you use to assess competing projects. It could be used as an initial screening tool, but it is inappropriate as a basis for sophisticated investment decisions SAN LIO 21
  22. 22. ACCOUNTING RATE OF RETURN (ARR)Focuses on a project’s net income and not its cash flowIs the ratio of the project’s average annual expected net income to its average investmentFormulaARR = Average annual income * 100 Average investmentEXAMPLELets Assume the case of our TWO projects X and Y SAN LIO 22
  23. 23. PROJECT XLets further assume that both projects will be depreciated using the straight line method- in their useful economic life of FOUR years and have a scrap value of zeroThe depreciation expense = 1000/4= 250 per yearAVERAGE ANNUAL INCOME= Average cash flow- Average annual depreciationThus: (500+400+300+100)/4=325-250=75 SAN LIO 23
  24. 24. AVERAGE INVESTMENT =Cost + Scrap Value 2THUS: 1000 + 0/2 = 500THUSARR = 75/500*100= 15%Lets determine ARR for Project Y- EVERY BODY SAN LIO 24
  25. 25. PROJECT Y1,400/4= 350-250= 1001000+0/2= 500THUSARR = 100/500*100= 20%CONCLUSIONThe ARR method ranks project Y over project X.If the firm accepts projects with say 18%, Then accordingly, project Y will be accepted and project X rejected. SAN LIO 25
  26. 26. ADVANTAGES OF ARREasy to understand and calculateManagers familiar with the key conceptsBrings into consideration the income earned over the whole life of projectThe idea of return on capital employed is generally understood and this aids the comprehension of the accounting rate of returnThe minimum required rate of return can be set with reference to the cost of the finance used by the company plus the additional return it requires for its own profit. SAN LIO 26
  27. 27. DISADVANTAGES OF ARRIgnores the time value of moneyThe timing of income arising from alternative projects is ignored SAN LIO 27
  28. 28. WHATS MORE ?We note that the rankings under the ARR method are exactly the opposite of the ones based on the Payback methodWhats the problem here?This is an argument we can have right here!Is it worth?Probably NO- Because these two method ignore a very fundamental issue- THE TIME VALUE of money. SAN LIO 28
  29. 29. CONCLUSION ON THE TWO METHODSThey both do not give us complete information on the projects contribution to the firm’s intrinsic value.DCF-Discounted Cash Flow techniques are therefore reliable because they address this problem SAN LIO 29
  30. 30. NET PRESENT VALUE (NPV)Present value (PV) is an accounting term that measures how money needs to be invested today in order to finance business initiatives, projects, and obligations tomorrowIn order to determine the present value of future costs, accountants use formulas based on the time value of money. These formulas feature variables such as the length of time involved and the prevailing interest rate and/or inflationary rates SAN LIO 30
  31. 31. In other words, the present value of an amount to be received in the future is the discounted face value considering the length of time the receipt is deferred and the required rate of return (or appropriate discount rate under the circumstances)Present value is the result of the time value of money concept, which works in recognition that todays Shilling is worth more than the same Shilling received at a future point in time. SAN LIO 31
  32. 32. NPV PROCEDUREFind the present value of each cash flow, including all inflows and outflows, discounted at the project’s cost of capitalSum these discounted cash flows; this particular sum is called the project’s NVPIf the NPV is positive, the project is accepted but rejected if the NPV is negativeIf two projects with positive NPV are mutually exclusive, the one with the higher NPV is selected SAN LIO 32
  33. 33. THE FORMULA SAN LIO 33
  34. 34. The formula (We know it!)WHERE CFt= the expected net cash flow at period t r= the projects cost of capital n= the projects life CF0= a negative number being the cash outflowsNOTEWe can also use the tables of discounted factors accordingly SAN LIO 34
  35. 35. EXAMPLESLets compute NPV Of both our projects X and Y SAN LIO 35
  36. 36. NPV RATIONALEA NPV of zero signifies that the project’s cash flows are exactly sufficient to repay the invested capital and provide the required rate of return on that capital.A positive NPV means the project is generating more cash than needed to service the debt and to provide the required return to shareholders; and that this excess cash accrues solely to the entities stockholdersPositive NPV means the wealth of the stockholders increases SAN LIO 36
  37. 37. We may at this stage compare our two projects, X and Y, and see by how much each of them increases the shareholders wealth.NOTE: there is a direct relationship between NPV and EVA (Economic Value Added- which is the estimate of a business’s true economic profit for the year- and represents the residual income that remains after the cost of all capital, including equity capital. Quite different from accounting profit which does not include a charge for equity capital) SAN LIO 37
  38. 38. NPV is equal to the present value of the project’s future EVAs.Thus accepting a project with positive NPV results in a positive EVA and a positive MVA (Market Value Added- being the excess of a firm’s market value over its book value).Since entities should in fact reward managers for producing positive EVA-MVA; then NPV becomes a better method for making capital budgeting decisions accordingly. SAN LIO 38
  39. 39. ACCOUNTING OR ECONOMIC PROFITEconomic profit = (explicit and implicit revenue) Minus (explicit and implicit cost)Accounting Profit = TR (Total Revenue= Price * Quantity) - (Cost of land) - (cost of labor) – (cost of capital)Economic profit = accounting profit – cost of equity capital SAN LIO 39
  40. 40. ADVANTAGES OF NPVLinks capital budgeting decisions to EVA-MVARecognizes the time value of moneyCorrect ranking of mutually exclusive projectsDependent on forecast cash flows and opportunity cost of capital, instead of arbitrary guess work by managementNo arbitrary guess work SAN LIO 40
  41. 41. DISADVANTAGESPossible errors in forecastingHard to determine the minimum rate of return of a projectOther factors which may affect a project’s structure of cash flows e.g. government grants, taxation etc SAN LIO 41
  42. 42. THE INTERNAL RATE OF RETURNDefined as the discount rate that equates the present value of a project’s expected cash inflows to the present value of the project’s costs.This means:PV (Inflows) = PV (Investment costs)Further, this means IRR is simply the rate of return that forces the NPV to equal to ZeroFormula : CF0 + CFI + CF2 + CFn =0 (1+irr)0 (1+irr)1 (1+irr)2 (1+irr)nCan use the calculator to solve the equation SAN LIO 42
  43. 43. ALTERNATIVE FORMULAR TO IRRIRR = X + x * (Y-X) x+yWhere X = Discount rate for positive NPV Y= Discount rate for negative NPV x= positive NPV found using X y= negative NPV found using Y Ignore negative signs SAN LIO 43
  44. 44. EXAMPLE-OUR PROJECT X AND YNOTE- this is a trial and error process- whereby a higher rate of return (than the provided cost of capital) is used- until the result is a negative NPVLets use 18% as cost of capitalDiscount factors are: YEAR1 .8475, Y2.7182, Y3.6086,Y4.5158,Y5.4371Then solve IRR for both projects.Lets all do it SAN LIO 44
  45. 45. SOLVED-X 10 + 78.82 (18-10) 78.82+54= 14.75SOLVED Y10+ 49.18 (18-10) 49.18+ 148=11.99 SAN LIO 45
  46. 46. DECISION MAKINGBoth projects have a cost of capital ( hurdle rate) of 10%IRR rule indicates that if the projects are independent of each other, then the both are accepted since they earn more than the cost of capital needed to finance themIf the two projects are mutually exclusive, the project X ranks higher and should be selected and Y rejectedIf the cost of capital is above 14.75, both projects will be rejected SAN LIO 46
  47. 47. NOTEBoth NPV and IRR will always lead to the same decision (accept or reject) for INDEPENDENT projects (mathematical reasons)This so because if NPV is positive, IRR must exceed r (the cost of capital in NPV)This scenario is however not true for projects that are mutually exclusive SAN LIO 47
  48. 48. IRR RATIONALE This particular rate is critical because:The IRR on a project is the expected rate of return If the IRR exceeds the cost of capital (funds used to finance the project), then a surplus will remain after paying for the capital. This surplus will accrue to the entity’s stockholders This means a project whose IRR exceeds its cost of capital increases shareholders wealth. If the IRR is less than the cost of capital, then that particular project will impose a cost on stockholders SAN LIO 48
  49. 49. NOTE: This break-even quality of IRR makes it fairly useful in evaluating capital projects SAN LIO 49
  50. 50. NPV VERSUS IRRNPV is better than IRR in many aspects.IRR however can not be ignored- popular with many managers and seriously entrenched into the business industryImportant to understand why a project with a lower IRR may be more attractive to a mutually exclusive one with a higher IRRLook at the NVP Profile curve SLIDE 56- simply plots a projects NPV and cost of capital- And if a project has its cash flows coming in the early year; SAN LIO 50
  51. 51. Then its NPV will not decline very much if the cost of capital increases but a project with cash flows which come later will be severely penalized by high capital costs. –Y in our case and it has a steeper slopeNOTE NPV profiles decline as the cost of capital increases SAN LIO 51
  52. 52. EVALUATING INDEPENDENT PROJECTSBoth the NPV and IRR criteria always lead to the same accept/reject decisionEVALUATING MUTUALLY EXCLUSIVE PROJECTSIf we assume that our projects X and Y are mutually exclusiveThis means we can either choose X or Y or reject both BUT cannot accept both SAN LIO 52
  53. 53.  A conflict exists where the cost of capital is less than the crossover rate- NPV will choose X whereas IRR will choose Y If r is greater than cross point-both NPV and RRR take X This conflict is resolved by asking the question- how useful is it to generate cash flows sooner rather than later This really depends on how on the return we can earn from those cash flows ie the rate at which we can reinvest them. The NPV assumes that the rate at which cash flows can be reinvested is the cost of capital SAN LIO 53
  54. 54. IRR assumes that the firm can reinvest at the IRR rateIn this particular case, NPV prevails as a better method since it is better to reinvest at the cost of capital rather than at IRR rateThus where the conflict exist, NPV is used accordingly SAN LIO 54
  55. 55. • NPV• 400• 300 Ys NPV profile• Xs NPV profile• IRR SAN LIO 55
  56. 56. MULTIPLE IRRs This exists if a project is regarded as having nonnormal cash flows. Nonnormal cash flows occur when there is more than one change in the sign e.g. a project starts with negative cash flows and switch to positive cash flows and switch again to negative cash flows These kinds of projects can have two or more IRRsILLUSTRATIONImagine a firm is considering the expenditure of Ksh 1.6 million to develop an equipment to manufacture balls. The balls will produce a cash flow of Ksh 10 million at the end of year 1. SAN LIO 56
  57. 57. At the end of year 2, additional Ksh 10 million must be utilised to expand this project due to increasing demand due to the upcoming world cup championshipREQUIREDIRR of the projectSOLUTIONNPV=Ksh 1.6 + Ksh 10 + -Ksh10 = 0 (1+IRR)0 (1+IRR)1 (1+IRR)2=Ksh 1.6 +Ksh 10 + -Ksh10 = 0 (1+IRR)1 (1+IRR)2 SAN LIO 57
  58. 58. 1.6 (1+IRR)2 = 10(1+IRR) -101.6(1+IRR)2= 10 + 10IRR -101.6IRR2 + 3.2IRR + 1.6= 10IRR1.6IRR2 -6.8IRR +1.6 = 04IRR2 -17IRR +4 =0 SOLVING EQUATIONIRR = 25% OR 400%MULTIPLE IRRsMEANING SAN LIO 58
  59. 59. 1. If NPV were used, then there would be no dilema in making the decision2. if the r were between 25% and 400%, the NPV would be positive SAN LIO 59
  60. 60. MODOFIED IRRNPV prevails over IRR in times of conflict but IRR continues to be popular and many executives prefer IRR to NPV because it is apparently easy to work with a percentageThe idea here is to device a percentage evaluator that is better than IRRThis is basically done by modifying the IRR rate and make it a better indicator of relative profitability and therefore better for use in capital budgetingThis is called MIRR SAN LIO 60
  61. 61.  Formula : PV OF COSTS= TERMINAL VALUE (1+MIRR)n- COF= Cash outflows (negative numbers)- CIF = cash inflows (positive numbers)- r= the cost of capital- The compounded future value of the cash inflows is called the TERMINAL VALUE (TV)- The discount rate that makes PV of TV equal to the PV of the costs is the MIRRASSIGNMENTLets attempt the MIRR for projects X and Y SAN LIO 61
  62. 62. PROJECT X1000= 1579.50 (1 +irr)4Irr= 12.1% SAN LIO 62
  63. 63. IRR ADVANTAGESThe rate of return measured is familiar with managers incorporates the time value of moneyDISADVANTAGESNonnormal cash flows produces multiple IRRsFor mutually exclusive projects, there is conflict with NPV- although this problem is solved by MIRR SAN LIO 63
  64. 64. PROFITABILITY INDEXComputed asPI = PV of future cash flows Initial costEXAMPLE PROJECT XPIX = 1,078.82/1000= 1.079A project is accepted if its PI is greater than 1The higher the PI the higher the project’s rankingSSIGNMENTWhich project would be selected between X and Y SAN LIO 64