CAPITAL BUDGETING DAVID ABBAM ADJEI

David Adjei

INTRODUCTION
WHAT IS CAPITAL BUDGETING? This is the process of identifying which long-lived investment projects a firm should undertake. Selecting which investment opportunities to pursue and which ones to avoid is important because: 1. Individual projects frequently involve relatively substantial capital outlay
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INTRODUCTION
2. 3.

These capital decisions and outlays are very difficult and expensive to reverse They have long term consequences on the success or otherwise of the business.

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TYPES OF CAPITAL BUDGETING DECISIONS 1. Expansion projects 2. Diversification projects 3. Replacement and modernisation projects 4. Research and development projects 5. Mandatory capital projects
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CLASSIFICATION OF INVESTMENT PROJECTS

Investments projects can be classified as follows: independent projects mutually exclusive projects contingent project

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CAPITAL BUDGETING PROCESS

1. 2.

3.
4. 5. 6. 7.

The following are the comprehensive steps to be undertaken in capital budgeting: Identification of investment needs Initial screening of the proposals Evaluation/appraisal of various projects Selection of the best alternatives Final approval and making expenditure Implementation of proposals Performance monitoring and review

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1. 2. 3.

The number of steps to follow in capital budgeting process will depend on the following: The size of the firm undertaking the capital expenditure The nature of the projects The number of projects to be undertaken at a point in time

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4. 5.

Complexities and diversities of the projects to be undertaken The time frame for the initiation up to the completion of the project

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FACTORS CRITICAL TO CAPITAL BUDGETING

Security of the investment 2. Liquidity of the capital investment 3. The returns generated by the investment 4. Spreading of risk 5. Growth prospects
1.

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KEY REASONS FOR CAPITAL BUDGETING

Renewal Over time, equipment must be repaired, overhauled, rebuilt, or retrofitted with new technology to keep the firm's manufacturing or service operations going.
1.

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Replacement At some point, an asset will have to be replaced rather than repaired or overhauled. This typically happens when the asset is worn out or damaged.
2.

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Expansion Strategically, the most important motive for capital expenditures is to expand the level of operating output. One type of expansion decision involves increasing the output of existing products.
3.

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Regulatory Some capital expenditures are required by state regulations. These mandatory expenditures usually involve meeting workplace safety standards and environmental standards.
4.

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BASIC INFORMATION FOR CAPITAL BUDGETING

1. 2. 3. 4. 5.

6.

The initial capital outlay (the cost of the project) The estimated life of the project The estimated net cash inflows and outflows The estimated residual value of the project The cost of capital of the project/company Taxation implications of the project

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7.

Inflation and its effect on the project

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METHODS FOR INVESTMENT APPRAISAL

The following methods or techniques are used to evaluate or appraise capital investment: 1. Accounting Rate of Return 2. Payback Period 3. Discounted Payback Period 4. Net Present Value 5. Internal Rate of Return
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ACCOUNTING RATE OF RETURN

The ARR employ the normal accounting technique to measure the increase in profit expected to result from an investment. ARR = Average annual profit Gross investment ARR = Average annual profit Average net investment

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ACCOUNTING RATE OF RETURN

This method is also called: 1. Return on capital employed (ROCE) 2. Return on Investment (ROI) DECISION RULE UNDER ARR 1. One project accept if above managements acceptable return cut-off point.

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ACCOUNTING RATE OF RETURN

Mutually exclusive projects whichever offers the highest return. ADVANTAGES OF A.R.R 1. It uses readily available accounting information 2. It is more readily understood by managers 3. It is also a reasonably simple method to apply and can be used to compare mutually Exclusive projects
2.
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ACCOUNTING RATE OF RETURN

DISADVANTAGES OF A.R.R 1. It deals with accounting profit, rather than cash flows 2. It fails to take account of time value of money 3. There are different methods for calculating depreciation and stock

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PAYBACK PERIOD

The payback method is used to determine how long it will take for future cash inflows from the project to equal the initial cost of the project. Payback period with equal annual cash flows is calculated as PB = Initial capital outlay Annual cash inflow

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PAYBACK PERIOD

If cash inflows are uneven the PB has to be calculated by working out the cumulative cash flow over the life of the project until the initial outlay is covered DECISION RULE 1. One project accept as long as within managements acceptable payback period;
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PAYBACK PERIOD
Mutually exclusive projects Accept whichever pays back first. ADVANTAGES OF PAYBACK 1. It is simple to use and understand 2. It is very useful when liquidity is important and early recovery of funds is required 3. The method promotes a policy of caution
2.

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PAYBACK PERIOD
DISADVANTAGES OF PAYBACK 1. The cash flows after the payback are ignored 2. It fails to take account of the time value of money 3. It also fails to the account of the magnitude of cash flows during the payback period. 4. It also ignores the timing of the cash flows within the period

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DISCOUNTED PAYBACK

This is essentially the same as PB except that in calculating the PB period, managers discount the cash flows first. The added advantage is that it considers the time value of money

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NET PRESENT VALUE

Of all the investment appraisal methods, NPV is often argued to be the most superior. This is because it takes into account the time value of money. It uses a target rate of return or cost of capital to discount all cash inflows and outflows to their present values

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NET PRESENT VALUE

DECISION RULE 1. One project accept if NPV is positive 2. Mutual exclusive projects whichever offers the highest NPV

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NET PRESENT VALUE

ADVANTAGES OF NPV METHOD 1. I t uses cash flow information. 2. It takes account of both the magnitude and timing of cash flows 3. It maximizes shareholders wealth 4. It takes account of time value of money

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NET PRESENT VALUE

DISADVANTAGES OF NPV METHOD 1. The cost and time involved in gathering information and making calculations may not be merited. 2. The method is conceptually difficult to understand. 3. The selection of an appropriate discount rate is far from straight forward

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INTERNAL RATE OF RETURN

By IRR we mean a rate that will be used to discount future cash inflows to make the total of the present values equal the cost of the project The attempt being made under IRR is to find a rate that will equate the NPV of a project to be zero

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INTERNAL RATE OF RETURN

The IRR therefore is the maximum rate of discount that will be used to finance a project without making a loss from it. DECISION RULE 1. one project - accept if IRR is above managements return cut-off point; 2. mutually exclusive projects - whichever offers the highest IRR.
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INTERNAL RATE OF RETURN

NOTE: THE ADVANTAGES AND DISADVANTAGES OF IRR ARE THE SAME AS THAT OF NPV PITFALL OF THE IRR 1. Lending and borrowing 2. Multiple rate of return 3. Mutually exclusive projects
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NPV VRS IRR

There is no conflict between NPV and IRR when a single investment project with conventional cash flows is being evaluated. In the ff situations, NPV is preferred: 1. Where mutually exclusive projects are being compared 2. Where the cash flows of a project are not conventional
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NPV VRS IRR

3. Where the discount rate changes during the life of the project

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SUPERIORITY OF THE NPV METHOD

The NPV method gives the correct decision as regards mutually exclusive projects without doubt, where as the IRR method requires the consideration of incremental yields. The NPV can accommodate nonconventional cash flows, a situation where the IRR may offer multiple solutions.
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SUPERIORITY OF THE NPV METHOD

The reinvestment assumption underlying the NPV method is reasonable, but that underlying the IRR method is not. The NPV can easily incorporate changes in the discount rate, where as the IRR method ignores them.

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CAPITAL RATIONING
If a company does not have sufficient funds with which to undertake all projects that have a positive NPV, it is in a capital rationing situation CAUSES OF CAPITAL RATIONING There are two causes of capital rationing as follows:

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HARD CAPITAL RATIONING When there is a limitation on investment funds which is externally imposed, then the capital rationing is described as hard. The reasons for this are: 1. A company may be unable to raise capital for investment because the capital markets are depressed.
a.
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2. Investors may consider the company too risky with poor business prospects and operating cash flows. 3. If only a small amount of finance is required, issue costs might make raising it unacceptably expensive.

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SOFT CAPITAL RATIONING The term soft capital rationing is often used to refer to situations where, for various reasons the firm internally imposes a budget ceiling on the amount of capital expenditure Investment funds may be restricted internally by company management for a number of reasons:
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Managers may prefer slower organic growth to a sudden increase in size arising from accepting several large investment projects 2. Managers may wish to avoid raising further equity finance if this will dilute the control of the existing shareholders and dilution of earnings per share.
1.

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Managers may wish to avoid new debt if their expectations of future economic conditions are such to suggest that an increased commitment to fixed interest payments would be unwise. There are two types of capital rationing: 1. Single period capital rationing, and 2. Multiple period capital rationing
3.

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1.

2.

CAPITAL RATIONING AND PROJECT SELECTION Where the projects are divisible then we use the profitability index to rank the projects Where the projects are not divisible, we combine the projects that will make use of the funds and also produce the highest NPV
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INFLATION AND CAPITAL BUDGETING

Inflation may be defined as a general increase in prices, leading to a general decline in the real value of money There are two impacts of inflation on project appraisal as follows: The discount rate given may include an allowance for a general rate of inflation The cash flows may be subject to inflation, possibly at different rates for different flows.
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1. 2.

The discount rate used in investment appraisal reflects the finance providers required rate of return In times of inflation this required rate of return is affected Therefore, the fund providers will require a return made up of two elements:

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A return to compensate for inflation (to maintain purchasing power) A real return on top of this for the use of their funds. The required return that incorporates both of these elements is known as money return

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It is essential, when evaluating projects under inflation, to ensure that like is compared with like (i.e. cash flows and cost of capital must both be measured either in money terms or in real terms). Money terms involves the estimation of what the cash flows will actually be when they occur at some future time, which are then discounted by a cost of capital based on rates of return including inflation.
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Real terms involve the estimation of future cash flows expressed in terms of prices prevailing at the time the investment is being appraised Cash flows in real terms are then discounted at a cost of capital which is net of inflation.

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In order to reduce the cost of capital in money terms to the cost of capital in real terms the following relationships apply: (1+m) = (1 + r) x (1+ i) Where: m is the money cost of capital rate i is the inflation rate r is the real cost of capital rate.

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The golden rule is to discount real cash flows with real costs of capital, and to discount nominal cash flows with nominal costs of capital

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TAXATION AND CAPITAL BUDGETING

Taxation has two major effects on discounted cash flow project appraisal. Project cash flow will give rise to taxation which itself has an impact on project appraisal. Tax relief on interest payment will reduce the effective rate of interest which a firm pays on its borrowing, and hence the opportunity cost of capital.
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1.

2.

RISK AND INVESTMENT APPRAISAL

In the appraisal methods used, we have made decisions based upon future cash flows, discount rates, etc All these figures were estimated. This means they may change and when they do they will affect the viability of the project To incorporate these issues we need to deal with risk and uncertainties
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Risk refers to a set of circumstances regarding a given decision which can be assigned probabilities. Probabilities are attached to possible outcomes, giving an expected outcome that can be calculated mathematically.

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Uncertainty implies that it is not possible to assign probabilities to different set of circumstances. The probabilities of future events are either not meaningful or unknown. Thus the future outcome cannot be predicted mathematically from available data.

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Steps may be taken by management to reduce the risk and uncertainty affecting the project appraisal: 1. Selection of projects with low payback periods to reflect the fact that uncertainty increases, the longer the time horizon under consideration.

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2. 3.

4. 5.

Use of a high discounting rate to reflect risk. The use of sensitivity analysis to determine the critical factors within the decision-making process. Assessing both best and worst possible situations to obtain a range of NPVs. The use of probabilities to calculate expect values before discounting the flows
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The use of decision trees 7. The use of Simulation

6.

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ASSET REPLACEMENT DECISIONS

Once the decision has been made to acquire an asset for a long term project, it is quite likely that the asset will need to be replaced periodically throughout the life of the project The decision we are concerned here with is: how often should the asset be replaced?

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The factors to be considered when making replacement decisions are as follows: 1. Capital cost of new equipment 2. Operating costs 3. Residual values 4. Taxation and investment incentives 5. Inflation
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