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UNIVERSITY OF PRETORIA

FINANCIAL MANAGEMENT 200

CAPITAL BUDGETING

STUDY OUTCOME

• You should be able to prepare and

evaluate a capital budget.

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OBJECTIVES

In order to achieve the specific outcome you should be able

to:

• apply the concept of time value of money with regards to

relevant cash flows;

• describe the components of cost of capital;

• evaluate and apply the different capital budgeting

techniques for long term decision-making purposes;

• identify the relevant cash flows of different projects;

• account for the effects of taxation in capital budgets; and

• identify and evaluate the qualitative factors of different

projects.

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INTRODUCTION

• Knowledge of basic taxation principles is a prerequisite for

the successful studying of this learning area. It is therefore

critical that you review the taxation module of Financial

Accounting before attempting to study this learning area.

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INTRODUCTION

• Capital budgeting is the analysis and evaluation of

investment projects that normally produce benefits over a

number of years (long term investment decision)

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WHY IS CAPITAL BUDGETING

IMPORTANT?

• Firm’s future success may depend on current investment decisions

• Remain competitive / Develop new products / Research & development

• Significant amount of resources are tied up in such decisions and difficult to reverse

• Tied up for a considerable number of years

• More difficult to adjust to changing conditions due to term

• Over-investment: costs too high. Invest too little: lose market share (inferior products or insufficient capacity to meet demand)

• Timing of expansion or contraction critical.

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STEPS TO CAPITAL BUDGETING

1. Define objectives

2. Search for investment opportunities

3. Measure payoffs of opportunities

4. Select projects with payoffs > cost of capital

5. Obtain authorisation

6. Obtain financing

7. Implement

8. Post-implementation audit

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CAPITAL BUDGETING TECHNIQUES

ACCOUNT FOR TVM

• Net Present Value (NPV)

• Internal Rate of Return

(IRR)

– Modified Internal Rate of

Return (MIRR)

IGNORE TVM

• Payback

– Discounted payback

• Accounting Rate of

Return (ARR)

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NET PRESENT VALUE

• NPV = Discounted future cash flows less initial investment

• Net present value is found by subtracting the present

value of the after-tax outflows from the present value of

the after-tax inflows.

• By using DCF techniques and calculating PVs we can

compare the return on capital projects with an alternative

equal risk investment in securities traded in the financial

market.

Discount rate

• Cost of capital or Minimum required rate of return

• Acknowledges the time value of money & represents the opportunity cost of an investment elsewhere.

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NPV (Cont.)

Example

Year 0 1 2 3

Cash flow (10) 4 4 5

10% discount rate

What is the NPV?

Should we accept the project?

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NPV (Cont.)

• A positive NPV represents the amount with which

shareholders’ wealth will be increased

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Decision criteria

If NPV > R0, accept the project

If NPV < R0, reject the project

If NPV = R0, technically indifferent

NPV (Cont.)

ADVANTAGES

• Uses cash flows (not profit)

• Rand amount indicates the actual value added to shareholders’ wealth

• Takes time value of money into account

• Makes the right re-investment assumption (only one answer is possible)

DISADVANTAGES

• Absolute Rand amount (not comparable between projects)

• Have to know the cost of capital figure in advance

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CLASS EXAMPLE

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Internal Rate of Return (IRR)

• IRR = The actual or true interest rate earned on an

investment over the course of its economic life, or the rate

that causes the present value of net future cash flows to

equal the cost of the initial investment (NPV = 0).

• The IRR is the project’s intrinsic rate of return.

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Decision criteria

If IRR > cost of capital, accept the project

If IRR < cost of capital, reject the project

If IRR = cost of capital, technically indifferent

CLASS EXAMPLE

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IRR (Cont.)

ADVANTAGES

• Uses cash flows

• Takes the time value of

money into account

• Don’t need to know WACC

in advance (yet essential for

independent projects)

• % is comparable between

projects

• Easy to understand

(commonly used)

DISADVANTAGES

• Inappropriate with unconventional cash flows (2 IRRs result)

• Inappropriate for mutually exclusive projects of different sizes (answer conflicts with NPV results) – does not take the size of the initial investment into account (compare R1 investment with R1.75 return against R1m investment with a R300 000 return)

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CASH FLOWS

• Only relevant cash flows (excluding sunk cost, including opportunity cost)

• Commencement: – Purchase price of new machine

– Sales price of existing (old) machine

– Tax effects of sale (Year 1)

– Working capital investment (JIT )

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CASH FLOWS (Cont.)

• Operating cash flows: – After tax Not allocated costs (e.g. head office and

depreciation)

– Changes in working capital levels (PROVIDED not already cash based)

– Ignore all financing costs (already included in WACC)

– Tax allowances, e.g. S12C: 40% (in full), 20%, 20% & 20%

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CASH FLOWS (Cont.)

• End-of project cash flows: – Proceeds on the sale of the asset

– Taxable recoupment or scrapping allowance

– Capital gains tax

– Return of working capital

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CASH FLOWS (Cont.)

• Depreciation is NOT a cash flow.

• The wear-and-tear allowance granted by SARS should,

however, be taken into account when performing the TAX

calculation.

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PAYBACK

• The payback method simply measures how long (in

years and/or months) it takes to recover the initial

investment.

• The maximum acceptable payback period is determined

by management.

• If the payback period is less than the maximum

acceptable payback period, accept the project.

• If the payback period is greater than the maximum

acceptable payback period, reject the project.

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PAYBACK (Cont.)

• The payback method is widely used by large firms to

evaluate small projects and by small firms to evaluate

most projects.

• It is simple, intuitive and considers cash flows rather than

accounting profits.

• It also gives implicit consideration to the timing of cash

flows and is widely used as a supplement to other

methods such as net present value and internal rate of

return.

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CLASS EXAMPLE

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PAYBACK

ADVANTAGES

• Easy to use and understand

• Useful for initial sifting process

• Appropriate with liquidity constraints

• Appropriate when future or cash flows are particularly uncertain

DISADVANTAGES

• Ignores the time value of money

• Ignores cash flows after the payback period (bias against LT projects)

• Fails to take into account differences in the timing of proceeds which are earned during the payback period, when comparing projects.

• Leads to a short term focus

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DISCOUNTED PAYBACK

• Time required for discounted cash flows to recover initial

cash outlay.

Most NB shortcomings

• Ignores cash flows after the payback period

• High initial cash flows preferred

Advantages

• Easy to use

• Appropriate for initial sifting (rough risk indicator)

• Takes time value of money into account.

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ACCOUNTING RATE OF RETURN (ARR)

ARR (also return on investment or return on capital employed)

= Average annual net income

Average investment

= R142 000 / [(R1 100 000 + 0) / 2]

= 26%

Measures the effectiveness with which management uses the assets of the co

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ARR (Cont.)

ADVANTAGES

• Well-known ratio

• Easy to interpret

DISADVANTAGES

• Uses profit instead of cash flows

• Ignores the time value of money

• Result will be the same for projects with high income initially and low income in later years as for projects with low income initially and high income in later years

• May lead to sub-optimal decision-making by management (performance measurement)

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CHOICE OF TECHNIQUE

• On a purely theoretical basis, NPV is the better

approach because:

– NPV assumes that intermediate cash flows are

reinvested at the cost of capital whereas IRR assumes

they are reinvested at the IRR,

– Certain mathematical properties may cause a project

with non-conventional cash flows to have zero or more

than one real IRR.

• Despite its theoretical superiority, however,

financial managers prefer to use the IRR

because of the preference for rates of return.

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PART 2

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CAPITAL RATIONING

• ‘Soft’ cap rationing – not willing to issue capital or provide financing (internal);

• ‘Hard’ cap rationing – external constraints

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CAPITAL RATIONING (Cont.)

If the project is divisible, use the profitability index (Current value of cash inflow / Investment)

Project Cost NPV PI

A R4,0m R0,60m 1,15

B R3,0m R0,54m 1,18

C R5,0m R0,45m 1,09

D R2,5m R0,426m 1,17

E R1,0m R0,20m 1,20

Capital limited to R6m: Choose E, B & 80% of D

If projects are not divisible, test all combinations to find combo that will maximise NPV (e.g. A + E [which has an opportunity cost attached due to R1m capital not utilised], C + E, B + D, B + E, D + E).

Max = B + D

Multi-period cap. rationing – use LP.

May also apply a higher discount rate.

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UNEQUAL LIVES

Three methods: • Replacement chain – A 5yrs; B 7yrs. – lowest

common multiple 35 yrs – impractical • Equivalent annual annuities • Terminal value (shorter life span)

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UNEQUAL LIVES (Cont.)

Example WACC: 14% Proj. A: Cost R5,2m; inflow R2,8m 3yrs Proj. B: Cost R8,0m; inflow R2,5m 6yrs Replacement chain: A: 0 1 2 3 4 5 6 (5,2) 2,8 2,8 2,8 (5,2) 2,8 2,8 2,8 (5,2) 2,8 2,8 (2,4) 2,8 2,8 2,8 NPV of A = 2,178 (for 3 yrs = R1,301) NPV of B = 1,722 Choose A

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UNEQUAL LIVES (Cont.)

Equivalent annual annuities

A: R1,301 / 2,322 = R0,560

B: R1,722 / 3,889 = R0,443

Choose A

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UNEQUAL LIVES (Cont.)

Choose a terminal value

Assume a company has to decide which machine to pick. The project’s economic life is 10 years. Machine 1 will last for 8 years and machine 2 for 6 years.

The machines are not going to be replaced over and over for a period of 24 years.

Therefore accept that each machine will be replaced ONLY once, and include a terminal value (sales value) in the NPV calculation at the end of year ten. Discount cash flows for both machines for 10 year period.

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INFLATION

2 options:

• Include inflation in cash flows and discount rate or

• Use the real rate and real cash flows

Preferred: Nominal!

• Real rates may ONLY be used if there is either NO inflation, or ALL cash flows increase with exactly the same inflation rate.

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INFLATION (Cont.)

Formula

• (1 + n) = (1 + r) x (1 + i)

• Example

12% nominal rate, 4% inflation. What is die real growth rate?

(1.12) = (1 + r) x (1.04)

(1 + r) = 1.12 / 1.04 = 1.077

r = 0.077 = 7.7%

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