Capital investment decisions

Stages in the capital investment process

1. Search for investment opportunities 2.Initial Screening 3.Project Authorizations 4.Control during the installation stage 5.Post-completion audit
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Objective of capital investment decisions

Objective of capital investment decisions is to decide

which project to be accepted The total amount of capital expenditure How the capital expenditure is financed

The objective is to accept all those investments whose returns are in excess of the cost of capital A firm should invest in capital projects only if they yield a return in excess of the opportunity cost of an investment (also known as the minimum rate of return, cost of capital, discount/hurdle rate).

Objective of capital investment decisions (Cont.)

Example Project are accepted

Identify which projects to be invested in.

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Risk-return trade-off
Risk Free Rate of Return
Opportunity cost of investment = returns available to shareholders in financial markets from investments with the same risk as the project.
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Capital investment decision ranking techniques 1. NPV 2.IRR 3. Pay Back Period 4.MRR 5.Discounted Payback Period 6. ARR 7. Net Terminal Value 8. EIRR- Economic Internal Rate of Return
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Basis of Capital budgeting

Capital investment decision must be based on cash flows Only incremental cash flows are relevant Sunk Cost Should not be included Opportunity costs should be included Effects of their parts of the firm should be included Changes in net working capital to be included

Compounding and discounting

1. Compounding is to expresses today s cash flows in future values. FV n = V0 (1+K)

2. Discounting is to convert future cash flows into a value at the present time.
Present value (V0) =
FV
(1+K)

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Net Present Value (NPV)

Example
Answer 0 (1000) x 1 1 300 x 0.893 2 1000 x 797.0 3 400 x 0.712 NPV = (1000) = 267.9 = 797.0 = 284.8 349.7

Year 0 1 2 3

Cost 000s (1 000) 300 1 000 400

Calculate the NPV of the project

Annuities and perpetuities

If annual cash flows are constant, the cumulative discount tables can be used.

Example
An insurance scheme requires you to pay Rs. 120, 000 pa for next 25 years. It guarantees to repay you Rs. 2.5 mn pa for 20 years thereafter. If the discount rate is 10% what is the NPV of the investment.

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Internal rate of return (IRR)

The decision rule is to accept the project if IRR is greater than the cost of capital. Example NPV at 25% = Rs. 84.8 mn NPV at 35% = Rs. -66.53 mn

Calculate the IRR.

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Comparison of NPV and IRR

NPV is preferred to IRR because:

IRR can incorrectly rank mutually exclusive project IRR is expressed in percentage terms IRR assumes internal cash flows are reinvested at the IRR where as NPV Assumes they are invested at the cost of capital Unconventional cash flows can result in multiple rates of return
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Economic internal rate of return (EIRR)

The cash flows already developed to be revised by taking into consideration: Transfers (receipts and payment) Shadow Prices Externalities
Re-calculate the IRR which is now termed EIRR

Economic internal rate of return (EIRR) (Cont.)

Transfer payments/ receipts do not involve corresponding real resource usage. e.g. duties, taxes and grants; Shadow prices are market prices paid for resources and received for outputs to reflect their true opportunity costs; e.g. subsidies, price controlled items; Externalities constitute costs/ benefits attributable to the project borne or enjoyed by persons or institutions external to the project, but within the economy.

Payback method
Measures the length of time that is required for a stream of cash flows from an investment to Recover the original cash outlay required by the investment. Example
Year
Project A CF Project B CF

0
(400) (400)

1
400 200

2
100

3
200

4
1000

Calculate the payback period of the projects

Project A 1 year Project B 2 Years and 6 Month
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Evaluation of payback method

Limitations
Ignores time value of money.
Ignores cash flows after the payback period.

Why widely used?

Simple to understand Appropriate where liquidity constraints exist and a fast payback is required Appropriate for risky investments in uncertain markets Often wed as an initial screening device
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Accounting rate of return

Calculated by dividing the average annual profits from a project into the average investment cost. Example

Project X

Book value Cash flow

0 24

1 16 12 16 10

Years

2 8 11 8 11

3 0 10 0 12

Project Y

Book value Cash flow

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Calculate the ARR of the projects.

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Capital investments with unequal lives

When faced with a replacement chain problem and as long as the common denominator for the project lives is less than the task life, we can use either

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Example There are two machines that ABC Plc can buy, Machine x and machine Y. Machine X has two useful life years while machine Y has only one useful life. Identify the best machine to buy.

Machine X
Year Capital 0 1200 1 2

Operating cost

240

240

Machine Y
Year Capital Operating cost 0 600 360 1

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Equivalent annual cost method:

The costs are made comparable by converting the cash flows to an equivalent annual cost (EAC).

EAC =

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Assume the task life < lowest common denominator Task life = 10 years Machine X life = 6 years Machine Y life = 8 years

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Single period capital rationing

A situation where investment funds are restricted and it is not possible to accept all positive NPV projects. Where capital rationing exists, ranking in terms of NPVs will normally result in an incorrect allocation of scarce capital. The correct approach is to rank by profitability index (PI): PI =

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Example
Project I0 Rs. 25 000 100 000 50 000 100 000 125 000 25 000 50 000 PV Rs. 32 500 108 250 75 750 123 500 133 500 30 000 59 000

A B C D E F G

Funds available for investment are restricted to 200 000. Identify the projects to invest in based on NPV and PI.

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Taxation and investment decisions

Taxation legislation specifies that net cash inflows of companies are subject to taxes, and capital allowances (writing down allowances) are available on capital expenditure. Example I0 Cash inflows Estimated disposal vale Capital allowances Corporate tax rate = = = = = Rs. 100 000, Rs. 50 000 for four years Rs. 30 000 at end of year 4 25% on a straight line basis 30%

Identify the investment is worthwhile

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Inflation and investment decisions

Cash flows can be expressed in

Monetary units at the time they are received (i.e.

nominal cash flows )

Today s (time zero) purchasing power (i.e. real cash

flows)

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Impact of inflation on interest/discount rates

Real rate of interest = what the interest rate would be in a world of no inflation

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Investment appraisal and inflation

Two correct approaches: 1. 2.

Example

A company is appraising a project with an investment outlay of Rs. 200,000 with estimated annual cash inflows of Rs. 100,000 per annum for years 1, 2 and 3.The cost of capital is 9% and the expected rate of inflation is 10%.
Calculate the NPV of the project.

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Calculating risk adjusted discount rates

The returns which shareholders require from investing in risky securities = The market portfolio is used as a benchmark for determining risk/return relationships. The risk of an investment relative to the market portfolio is measured by beta: An investment with identical risk to the market portfolio will have a beta of 1.

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The return that shareholders require = Risk free rate + (Risk premium Beta) = CAPM formula Risk premium = Example The past average risk premium is 8%, the risk free rate is 4%. Calculate the expected return if beta values are 1, 0.5 and 2.

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Weighted average cost of capital (WACC)

The CAPM is used to calculate the cost of equity finance. Most firms use a combination of debt and equity finance. Where combinations of debt and equity are used, the WACC is used to discount project cash flows.

Example

Cost of equity capital = 18% Cost of debt capital = 10% Projects financed by 50% debt and 50% equity Calculate the WACC

The WACC represents the firm s overall cost of capital based on the average risk of all the firm s projects. If the risk of a project differs from average firm risk the WACC of the firm will not reflect the correct riskadjusted discount rate.
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Dealing with risk

The following methods can be used.

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Sensitivity analysis
Shows how sensitive NPV is to a change in the assumptions relating to the variables used to compute it. Can also be used to indicate the extent to which variables may change before NPV becomes negative.

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Sensitivity analysis (cont.)

Highlights those variables that are most sensitive so that their estimates can be thoroughly reviewed.
Limitations

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