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CAPITAL BUDGETING

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:

It is relatively simple to calculate.

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.

Calculation of net cash flows is more objective than calculation of profitability.

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:

Time value of money may be ignored.

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 and Present value:


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:

PV = $10,000/ (1 + .05)10 = $6,139.13


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.

DCF can be applied to the 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

System cost at start

$320000

$375000

Estimated useful life

4 years

4 years

Scrap value at end of year 4

$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

Costs (excluding depreciation)

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)

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).

(c) Evaluate the financial implications of each system.


(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.

Paxton Ltd Estimated cost of take-over bid: $3.5 million


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).

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


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:

Initial cost at commencement of project


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)

Pay back period;


Accounting rate of return (ARR);
Discounted pay back period;
Net present value using the cost of capital and;
Internal rate of return (IRR).

(c) Evaluate the financial implications of each project.


(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:

Discounting rates Year 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)

Pay back period;


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.