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Capital budgeting is the decision making process for investment decisions, i.e., deciding how

much and what to invest in. It describes how a private sector firm might objectively evaluate an

investment project, to determine whether or not it is likely to be profitable.

Payback period:

It is the length of time until the accumulated cash flows from the investment are equal to or

exceed the original cost. Payback period is measured in years. Only cash paid or received

enters into the calculation; non- cash items such as Depreciation, accruals and prepayments

are ignored.

Payback rule If the calculated payback period is less than or equal to some pre-specified

payback period, then accept the project. Otherwise reject it.

Discounted Payback Period The length of time, until the accumulated discounted cash

flows from the investment equal or exceed the original cost.

The Discounted Payback Rule An investment is accepted if its calculated discounted

payback period is less than or equal to some pre-specified number of years.

Advantages:

Where competing projects are being considered, the risk factors may be compared. This

method identifies the project with the quickest payback- the project with the shortest risk

period.

Short payback periods benefit a firm liquidity and facilitate faster growth.

Cash flows can be objective measure of performance, whereas profits are dependent on the

accounting policies pursued by the managers of the business).

This method is useful when technology changes rapidly such as in the agriculture industry.

New farm machinery is designed and introduced into the market regularly. It is important to

recover the cost of investment before a new machine is designed.

Disadvantages:

This method ignores the profitability of the project, since the criterion used is the speed of

repayment.

Cash earned after the payback is not taken into account in the decision to invest.

Two projects may have the same payback period although they have different patterns of

cash inflows; one may make a more immediate improvement in the firms liquidity position

than the other.

Future value (FV) refers to a method of calculating how much the present value (PV) of

an asset or cash will be worth at a specific time in the future. It can be calculated using the

formula

There are two ways of calculating future value: simple annual interest and

annual compound interest. Future value with simple interest is calculated in the following

manner:

Future Value = Present Value x [1 + (Interest Rate x Number of Years)]

For example, Bob invests $1,000 for five years with an interest rate of 10%. The future value

would be $1,500.

FV = $1,000 x [1 + (0.1 x 5)]

FV = $1,000 x 1.5

FV = $1,500

Future value with compounded interest is calculated in the following manner:

Future Value = Present Value x [(1 + Interest Rate) Number of Years]

For example, John invests $1,000 for five years with an interest rate of 10%, compounded

annually. The future value of John's investment would be $1,610.51.

FV= $1,000 x [(1 + 0.1)5]

FV= $1,000 x 1.61051

FV= $1,610.51

It is important to remember that simple interest is always based on the present value, whereas

compounded interest means that the present value grows exponentially each year.

Present value describes how much a future sum of money is worth today. The formula for

present value is:

PV = CF /(1+r)n

Assume that you would like to put money in an account today to make sure u have enough

money in 10 years to buy a car. If you would like to get $10,000 in 10 years, and you know you

can get 5% interest per year from a savings account during that time, how much should you put

in the account now? The present value formula tells us:

Thus, $6,139.13 will be worth $10,000 in 10 years if you can earn 5% each year. In other words,

the present value of $10,000 in this scenario is $6,139.13.

It is important to note that the three most influential components of present value are time,

expected rate of return, and the size of the future cash flow.

Net Present Value (NPV) or Discounted Cash Flow (DCF):

Net present value method (also known as discounted cash flow method) is a popular capital

budgeting technique that takes into account the time value of money. It uses net present value

of the investment project as the base to accept or reject a proposed investment in projects like

purchase of new equipment, purchase of inventory, expansion or addition of existing plant

assets and the installation of new plants etc. The following is the formula for calculating NPV:

Where,

Ct = net cash inflow during the period t

Co = total initial investment costs

r = discount rate, and

t = number of time periods

A positive NPV suggests that the project concerned is worthy of further consideration; the larger

the amount of the NPV the better. A negative NPV indicates that the project should not be

considered.

Advantages:

This method takes the time value of money into consideration by discounting the cash flows

and produces more meaningful results than the simple payback method.

Disadvantages:

It is more complicated than ARR and payback and in practice can require a large volume of

complicated calculations to be made.

The cash flows are discounted by using the businesses cost of capital and this gives rise to

the problem that the rate may change in the future.

Projections into the future are of a speculative nature. Future cash flows are difficult to

predict, the life of the project is sometimes uncertain etc.

1.

Layla Ltd. is a major employer in a rural area. The directors are replacing the main production

line. The directors can choose between System A and System B. Details of the two systems are

as follows:

System A

System B

$320000

$375000

4 years

4 years

$16000

$32000

Company depreciates its non current assets using the reducing balance method at a rate of

30% per annum. System A produces slightly toxic waste which would be taken by lorry through

the local town for disposal elsewhere. System B would require fewer production staff. Estimated

receipts and costs (excluding depreciation) are as follows:

Receipts:

System A

System B

$000

$000

Year 1

224

280

Year 2

300

360

Year 3

400

400

Year 4

280

240

System A

System B

$000

$000

Year 1

124

167

Year 2

188

196

Year 3

273

268

Year 4

152

116

All receipts and payments take place at the end of the year. Company cost of capital is 9% per

annum.

The following is an extract from the present value table for $1.

Year

1

2

3

4

9%

0.917

0.842

0.772

0.708

16%

0.862

0.743

0.641

0.525

Required:

(a) Calculate the expected net cash flows for each system.

(b) For each system calculate the;

(i)

(ii)

(iii)

(iv)

(v)

(d) Discuss three non financial factors Layla Ltd needs to consider before buying either

system.

2.

Lakeside plc is considering purchasing one of two businesses in order to expand its

operations. The options are:

Turner Ltd

Estimated cost of the take-over bid: $2.15 million

Production: 100000 units per annum.

Sales: 80% of the output will be sold under an existing fixed price contract which has a

further four years to run at $15 per unit. The remainder of the production will be sold on

the open market at the following selling prices:

Year

Selling price per unit

1

$14

2

$14

3

$15

4

$15

Operating costs (including depreciation): $750000 over each of years 1 and 2; and

$800000 over each of years 3 and 4.

Depreciation: $60000 per year.

Increase in working capital is $0.5m.

Production: 200000 units per annum.

Sales: A contract already exists covering the next four years under which the entire

product will be taken at a price of $13 per unit for years 1 and 2, $14 per unit in year 3

and $15 per unit in year 4.

Operating costs (including depreciation): $1.2 million in the first year; $1.3 million in

the second year; $1.5 million in the third year and $1.7 million in the fourth year

Depreciation: $90000 per year.

Increase in working capital is $1m.

The cost of capital for Lakeside plc is 12%. All receipts and payments take place at the

end of each year. Extract from present value tables of $1:

Years

1

2

3

4

12%

0.893

0.797

0.712

0.636

20%

0.833

0.694

0.579

0.482

Required:

(a) Calculate the expected net cash flows for each business.

(b) For each business calculate the;

(i) Pay back period;

(ii) Accounting rate of return (ARR);

(iii) Discounted pay back period;

(iv) Net present value using the cost of capital and;

(v) Internal rate of return (IRR).

better investment.

(d) Give some advantages and disadvantages of each method of investment appraisal.

3.

Trifid Ltd. has $200000 available for investment. Two new projects are being considered. Both

projects are to be appraised over a four year life. Project X11 involves the production of a

disease resistant cereal crop. Project X12 involves the production of a powerful pesticide.

Details of each project are given below:

Sales Year 1

Year 2

Year 3

Year 4

Project X11

$

200000

240000

290000

120000

50000

700000

Project X12

$

180000

180000

210000

180000

150000

720000

Net profit before depreciation as a percentage of sales is forecast to be 15% of sales for each

project and the non current asset to be depreciated by using reducing balance method at a rate

of 10% per annum. The company cost of capital is 6% per annum. Extract from present value

tables of $1:

Years

1

2

3

4

6%

0.943

0.890

0.840

0.792

12%

0.893

0.797

0.712

0.636

Required:

(a) Calculate the expected net cash flows for each project.

(b) For each project calculate the;

(i)

(ii)

(iii)

(iv)

(v)

Accounting rate of return (ARR);

Discounted pay back period;

Net present value using the cost of capital and;

Internal rate of return (IRR).

(d) Discuss two non financial factors Trifid Ltd needs to consider before buying either project.

4.

During 2011 Song Ltd spent $30000 on market research into potential new products. As a

result two new products are under consideration, only one of which will be undertaken. These

have been coded as Product X and Product Y. The estimated profits arising from each product

are as follows:

Annual sales

Cost of sales

Other expenses

Net Profit

Product X

$

$

200000

84000

65000 (149000)

51000

Product Y

$

240000

108000

84000

(192000)

48000

$

No change is anticipated in the above costs and revenues during each products life. The cost of

new equipment involved in making each product is $90000 for Product X and $124000 for

Product Y. The estimated economic lives are 3 years for Product X and 4 years for Product Y.

Depreciation is included in the figure for other expenses and is calculated on a straight line

basis assuming a nil residual value for Product X and an estimated residual value of $12000 for

Product Y. The company cost of capital is 10%. Extract from present value tables of $1:

2

3

4

10%

0.909

0.826

0.751

0.683

20%

0.833

0.694

0.578

0.482

Required:

(a) Calculate the expected net cash flows for each product.

(b) For each product calculate the;

(i)

(ii)

(iii)

(iv)

(v)

Accounting rate of return (ARR);

Discounted pay back period;

Net present value using the cost of capital and;

Internal rate of return (IRR).

(c) Make a recommendation, with reasons, as to which Product appears to be the better

investment.

(d) Explain the reasons for the treatment you have adopted in relation to the cost of market

research carried out in 2011.

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