ACC209 Lecture 3

Financial Management Capital Budgeting

 At the end of the lecture, students are expected
to:
1. Understand the different investment
appraisal techniques
2. Evaluate asset replacement projects
Objectives 3. Distinguish between soft capital rationing
and hard capital rationing
4. Carry out NPV calculations based on both
nominal and real cash flows
5. Understand the impact of tax on the
discount rate

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 • Investment appraisal techniques
• Asset replacement decisions
Contents • Capital rationing decisions
• Impact of inflation on projects
• Impact of taxation

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 Capital Budgeting
• Capital budgeting is the process of identifying, • To evaluate investment opportunities, financial
analyzing and selecting investment projects managers must determine the relevant costs
whose returns are expected to extend beyond associated with the project. And also, non-
one year. relevant cost.
• A typical model for investment decision • Relevant benefits from investments include
making has a number of distinct stages. not only increased cash flows, but also savings
– Origination of proposals and better relationships with customers and
employees.
– Project screening
– Analysis and acceptance
– Monitoring and review
Capital Budgeting
• Every firm is faced with investment projects which has to be done as part of
their investment decisions to primarily create shareholder wealth.
• For e.g. setting up factories, buying other companies, launching new products
etc. This involves committing sums of money today(generally) to experience
cash flows in the future which are often subject to risk and uncertainty.
• Investment appraisal techniques are part of the financial managers tool kit to
assess if these investments are worthwhile.
• In reality, a combination of techniques are used to give a 360-degree view of
the investment from many angles.
 Payback method

Return on Capital Employed (ROCE)

Investment Net Present Value (NPV) method

Appraisal
Techniques Internal Rate of Return (IRR)method

The discounted payback method

Profitability Index
 Payback period: is the number of years it takes to recover
the original investment in nominal cash flows
• It takes into account the risk factor

Payback – Distant cash flows are given less importance

• It is a simple method to understand

method
• However, it ignores:
– the time value of money
– the timing of cash flows within the payback
period
– Any cash flows after the payback period.

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Payback method - Example
Year: 0 1 2 3 4
5
Cash flow ($’000): (450) 100 200 100 100
80

Calculate the payback period

• Payback period falls between 3rd and 4th year

• Payback period = 3.5 years
Payback decision rule

If the payback period is less than the maximum acceptable

Accept payback period, accept the project.

If the payback period is greater than the maximum acceptable

Reject payback period, reject the project.

When comparing two projects, select the one with the shorter
Select payback period
Advantages and disadvantages of Payback

Advantages Disadvantages
• Easy to compute • Does not consider time value of
• Very useful in situation of money
uncertainty where ‘quick wins’ • Does not consider cash flows
are considered beyond the payback
• A very arbitrary measure
• Does not show wealth
created….more a break even

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 • Return on capital employed is the ratio of
average annual profit to capital invested
The return on • Other names used
– ROI (Return on Investment)
capital – ARR (Accounting Rate of Return)
employed • The most widely used formulae is:

method
ROCE - Example

• Carbon plc is considering the purchase of a new machine and has found two which
meet its specification. Each machine has an expected life of five years.
• Machine 1 would generate annual cash flows (receipts less payments) of £210,000
and would cost £570,000. Its scrap value at the end of five years would be £70,000.
• Machine 2 would generate annual cash flows of £510,000 and would cost
£1,616,000. The scrap value of this machine at the end of five years would be
£301,000. Carbon plc uses the straight-line method of depreciation and has a target
return on capital employed of 20 per cent.
• Calculate the return on capital employed for both Machine 1 and Machine 2 on an
average investment basis and state which machine you would recommend, giving
reasons.
ROCE -
Solution

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 Advantages
• It is a quick and simple calculation
• Does not require a discount rate to be
established
• Considers profit over the life of the
investment
ROCE
Disadvantages
• Based on profits and NOT cash flows
• Length of the project is not considered
• Ignores the time value of money
• Does not show wealth created

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 • Net present value is the difference
between the present value of future
benefits and the present value of
capital invested, discounted at a
company’s cost of capital
Net Present
Value • The NPV decision rule:

POSITIVE NEGATIVE

ACCEPT REJECT

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Advantages and disadvantages of NPV

Advantages Disadvantages
• Considers time value of money • Complicated
• Considers all cash flows during the • Not preferred by non-financial
life of the projects managers
• Absolute measure of shareholder • Difficulty of estimating a suitable
wealth created cost of capital in practice
• Has an additive property useful
• Assumes borrowing and lending
when faced with capital rationing
or deposit rates are the same
• Can cope with choosing mutually
exclusive investments

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 • The internal rate of return (IRR) of an
investment project is the cost of capital
or required rate of return which, when
used to discount the cash flows of a
project, produces a net present value of
zero.
Internal Rate
of Return (IRR) • IRR Decision rule for projects:
IRR > target rate of return, accept
IRR < target rate of return, reject

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 • The IRR method of investment appraisal
is to accept projects whose IRR (the rate
at which the NPV is zero) exceeds a
target rate of return.
• The IRR is calculated using interpolation.

Internal Rate
of return (IRR)
Where,
• a is lower of two rates of return used
• b is higher of two rates of return used
• NPVa is NPV obtained using rate a
• NPVb is NPV obtained using rate b
Advantages and disadvantages of IRR

Advantages Disadvantages
• Considers time value of money • Does not show the absolute wealth
created as a result of the decision
• Easy to understand
• Assumes re-investment at the IRR rate
• Considers all cash flows of the (which is unreasonable in practice)
project • Cannot cope with mutually exclusive
• Show how much the opportunity projects
cost of capital can increase by • The problem of multiple IRR (each time
(useful for sensitivity analysis) there is a change of sign there is
potential for another IRR)

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Profitability Index
• The ratio of the present value of the project's future cash flows (not
including the capital investment) divided by the present value of the total
capital investment.
• E.g., Project A requiring an investment of $10,000 gives an PV of $12,400
and Project B requiring an investment of $20,000 gives an PV of $22,800
– Profitability Index: Project A 1.24, B 1.14

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Problems with Profitability Index Method

• Only applicable if projects are divisible

• Selection criteria is too simple
– Strategic importance is not
considered
• Limited use when there is differing cash
flow patterns
• Ignores the absolute size of the projects

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Specific • Assets replacement decision
investment
decisions • Capital rationing

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 • DCF techniques can be used in asset
Asset replacement decisions to assess when and
how frequently an asset should be replaced.
replacement • 2 methods:
decisions Equivalent annual cost method
Equivalent annual benefit method
 • When an asset is being replaced with an
Equivalent identical asset
annual cost • This method can be used to calculate an
optimum replacement cycle
method • Most convenient to use in a period of no
inflation.

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 • Step 1: Calculate the present value of costs
for each replacement cycle over one cycle
only.
Equivalent – These costs are not comparable because
they refer to different time periods,
annual cost whereas replacement is continuous.
method • Step 2: Turn the present value of costs for
each replacement cycle into an equivalent
annual cost (an annuity).

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 A company operates a machine which has the
following costs and resale values over its four-
year life.
Equivalent Cash flows Year 1 Year 2 Year 3 Year 4
$ $ $ $

Annual Cost - Running Costs 7,500 11,00

0
12,50
0
15,000

Example Resale Value (end of

year)
15,000 10,00
0
7,500 2,500

• Purchase cost: $25,000

• The organization's cost of capital is 10%.
• You are required to assess how frequently
the asset should be replaced.
 Year 1 Year 2 Year 3
Step – 1:
Cash flows Year 4
$ $ $ $

Calculate PVs Running Costs 7,500 11,00

0
12,50
0
15,000

Resale Value (end of 15,000 10,00 7,500 2,500

year) 0

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Step – 2:
Calculate EAC

The optimum replacement policy is the one with the lowest equivalent annual cost, every three years.

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 • The equivalent annual benefit is the annual
annuity with the same value as the net present
value of an investment project.

Equivalent • This method is a useful way of comparing

annual benefit projects with unequal lives.
 • For example, a project A with an NPV of $3.75m
and a duration of 6 years, given a discount rate
of 12%, will have an equivalent annual annuity
of:
Equivalent Equivalent Annual Annuity =
Annual • An alternative project B with an NPV of $4.45m
Benefit- and a duration of 7 years will have an
equivalent annual annuity of
Example
Equivalent Annual Annuity =

Project B will therefore be ranked higher than

project A.
 • A situation in which a company has a limited
amount of capital to invest in potential projects,
Capital such that the different possible investments
need to be compared with one another in order
rationing to allocate the capital available most effectively.

decisions • Two types of capital rationing

– Soft capital rationing
– Hard capital rationing

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 • or "internal" rationing is caused due to internal
Soft capital policies of company.
rationing • The company may voluntarily have certain
decisions restrictions that limit the amount of funds
available for investments in projects.

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 1. Reluctant to issue additional capital
– Concerns about outsiders gaining control
of the business
Reasons for – Dilution of earnings per share

soft capital 2. Do NOT want to raise additional debt capital

– Do not wish to be committed to large fixed
rationing interest payments
3. Management may wish to limit investment to
a level that can be financed solely from
retained earnings

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 • or "external" rationing occurs when the
Hard capital company faces problems in raising funds in the
external equity markets.
rationing
decisions • This can lead to the shortage of capital to
finance the new projects in the company.

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 • Share prices are depressed
• Restrictions on bank lending due to government
Reasons for control

hard capital • Lending institutions perception about the

business
rationing – Consider some businesses to be too risky
• The costs associated with making small issues of
capital may be too great.

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 Seek joint venture partners

Licensing and franchising agreements

Outsourcing
Reducing the
strain on capital Alternative sources of capital

– Venture capital
– Debt finance secured on the assets of the
project
– Sale and leaseback
– Grant aid
– More effective capital management

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Capital Rationing -
Example

Assuming that projects are divisible and only $60,000 available, determine the projects,
or part thereof, will give rise to highest NPV in total.
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Capital Rationing - solution
• The assumption here is that the projects are divisible.

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Capital Rationing – Example contd..

• Profitability Index is a better indicator of which projects create the highest

increase in shareholder wealth.

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Allowing inflation and taxation in
investment appraisal
 • Real cash flows (ie adjusted for inflation) should
be discounted at a real discount rate.
• Nominal cash flows should be discounted at a
Incorporating nominal discount rate.
• Fisher Formula on real and nominal rates
inflation into (1 + i) = (1 + r)(1 + h)
NPV Where:
h = rate of inflation
r = real rate of interest
i = nominal (money) rate of interest

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 Nominal rate, if:
• cash flows are expressed in terms of the
actual number of dollars that will be
received or paid on the various future dates

Which rate to
Real rate, if:
use?
• If the cash flows are expressed in terms of
the value of the dollar at time 0 (that is, in
constant price level terms)

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 • Is a major practical consideration for businesses
• It is vital to take it into account in making
decisions
Taxation • Some accounting expenses have restrictions
when it comes to taxation
• In investment appraisal, tax is often assumed to
be payable one year in arrears.

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Taxation - Example
• A company is considering whether or not to purchase an item of machinery
costing $40,000 payable immediately. It would have a life of four years, after
which it would be sold for $5,000. The machinery would create annual cost
savings of $14,000.
• The company pays tax one year in arrears at an annual rate of 30% and can claim
tax-allowable depreciation on a 25% reducing balance basis. A balancing
allowance is claimed in the final year of operation. The company's cost of capital
is 8%.
• Should the machinery be purchased?
Solution

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Solution • The net present value is $5,187 and so the purchase
contd... appears to be worthwhile.

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References

• Gitman, L. J., & Zutter, C. J. (2014).

Principles of Managerial Finance,
14th Edition. Prentice Hall.
(Chapter 10)

• BPP Publishers (2016) ACCA - F9:

Financial Management: Study Text
(Chapter 7 & 9)
Questions?