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Capital Budgeting Learning objectives
Geoff Frost
1. Explain the concepts and techniques of
capital budgeting decisions
ACCT2012
Topic9 Lecture
2. Demonstrate ability to use discounted cash
flow methods and payback
methods and payback method to
method to
evaluate an investment proposal
BUSINESS SCHOOL
3. Discuss advantages and disadvantages of
capital budgeting methods
Agenda
1. Introduction 1. Introduction
– Capital budgeting decisions Capital budgeting decisions
– Capital budgeting methods
2.
2 Net present value (NPV) method
N t t l (NPV) th d
3. Internal rate of return (IRR) method
4. Comparison of NPV and IRR
5. Payback method
In the news Types of capital budgeting decisions
Fighter Plane Market Plant expansion
Plant expansion –– new products, new markets
Source: FT
http://video.ft.com/3356691819001/Saab‐upturns‐fighter‐jet‐market/companies
Customer analysis and retention
Newcrest’s Woes
Source: AFR 24 April 2012 E i
Equipment replacement
t l t
http://afr.com/p/home/video_chanticleer_newcrest_woes_JgBUZBLJdxwudWDiFeHP8M
Equipment selection
Major IT/IS implementation
Cost reduction Lease or buy
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Capital budgeting decisions Two types of capital budgeting decisions
• Are major decisions about planning, investment and 1. Acceptance or rejection decision
financing and involve cash flows over several years e.g. Should the City of Sydney purchase a new street cleaner?
• Involve analysis of cash inflows and outflows over several Should NAB upgrade its IT systems?
years • Funds readily available/obtainable?
– Cash inflows include cost savings + additional revenues + any • Will cost savings justify the expenditure?
proceeds of the sale of assets that result from the project
proceeds of the sale of assets that result from the project • Poor performance of current machinery?
– Cash outflows include the initial cost of the project + any
increases in costs incurred as a result of the project over its life • Non financial factors?
• Have implications for firm’s competitiveness and long‐ 2. Capital rationing decisions
term viability and strategic planning e.g. In a constrained economy which project should BHP
Billiton pursue?
• Limited investment funds?
• Which projects to pursue?
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Other considerations An organisation as a collection of projects
• Opportunity costs
– What are the alternate uses of the resources?
– What are the forgone opportunities of using cash?
– Important: ability to compare cash flows over different
time periods in evaluating investment decisions
time periods in evaluating investment decisions
• Focus on projects
– Organisational performance is a combined result of all
the projects underway during that year
– Capital expenditure decisions focus on specific
projects or programs
Source: Langfield‐Smith 2009, p 1079.
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Steps for capital budgeting decision making Capital budgeting methods
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Net Present Value (NPV) method
• NPV computed by discounting the investment’s
2. Net present value method future cash flows to their equivalent present
value.
• Requires that a discount rate/hurdle rate be
selected for the computation
selected for the computation.
• Selection of a project based on a comparison of
the computed PV and the initial cost of
investment.
• When selecting between projects, the project
with the highest positive present value, less cost
of investment is the most preferred.
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4 steps for an NPV analysis Present Value of $1.00
• 4 steps constituting an NPV analysis of an investment
proposal:
1. Prepare a table showing cash flows for each year
2. Calculate present value of each cash flow using a discount rate
(discount rate also called hurdle rate or minimum desired rate
of return or opportunity cost of capital or cost of capital)
3. Compute net present value, which is the sum of the present
values of the cash flows.
4. If the NPV is positive (equal or greater than zero), accept the
proposal. Otherwise, reject.
Source: Table 2, Horngren et al 2014, p 796.
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An NPV example An NPV example (2)
Intent Corporation has been offered a five year contract to • At the end of five years the working capital will
provide component parts for a large manufacturer. be released and may be used elsewhere by
Cost and revenue information Intent.
Cost of special equipment $160,000 • Intent uses a discount rate of 10%.
W orking capital required 100,000
Relining equipment in 3 years 30,000
Salvage value of equipment in 5 years 5,000 Should the contract be accepted?
Annual cash revenue and costs:
Sales revenue from parts 750,000
Cost of parts sold 400,000
Salaries, shipping, etc. 270,000
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An NPV example (3) An NPV example (4)
Cash 10% Present
Annual net cash inflows from operations Years Flows Factor Value
Investment in equipment Now $(160,000) 1.000 $ (160,000)
W orking capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Sales revenue $ 750,000 Relining of equipment 3 (30,000) 0.751 (22,530)
Cost of parts sold 400,000 Salvage value of equip. 5 5,000 0.621 3,105
W orking capital released 5 100,000 0.621 62,100
Gross margin 350,000 Net present value $ 85,955
Less out-of-pocket costs 270,000
Annual net cash inflows $ 80,000 Intel should accept the contract because the present value
of the cash inflows exceeds the present value of the cash
outflows by $85,955. The project has a positive net
present value.
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0.909 + 0.826
+ 0.751 +
Present Value of $1.00 0.683 + 0.621 Advantages and disadvantages of NPV method
= 3.79
• Advantages:
– Recognises time value of money
– Dollars can be added because they are in present values (for
multiple projects)
– Gives correct ranking (re. rate of return) of mutually exclusive
projects
– Dependent on forecasted cash flows and the opportunity cost of
capital rather than on some arbitrary guess
• Disadvantages :
– How do you determine the minimum desired rate of return or
hurdle rate?
– How accurate are forecast cash flows?
Source: Table 2, Horngren et al 2014, p 796.
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Internal Rate of Return (IRR) method
• Another widely used approach of discounting cash flows
3. Internal rate of return method • Considered the true economic return earned by an asset
over the asset’s life
• Using IRR as the method of assessing projects, the most
acceptable project is the one with the highest IRR
acceptable project is the one with the highest IRR
• Accept the proposal if its IRR is equal to or greater than
the organization’s hurdle rate; otherwise reject it
• IRR is the maximum interest rate that could be paid to a
financial institution for borrowing the money invested
over the life of the project to breakeven
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Internal Rate of Return (IRR) method (2) Present Value of Series of $1.00 cash flows
• When the cash inflows are identical each year, the IRR is
calculated by performing the following steps:
1. Divide the initial cash outflow on the acquisition date by the
amount of the annual cash inflow to derive the annuity discount
factor.
2. Locate the factor in the annuity table by using the appropriate
number of years, and note the rate for that factor.
b f d t th t f th t f t
3. Compare the internal rate of return to the hurdle rate. If the IRR
is greater, accept the project.
• If the cash inflows change from year to year, the internal rate
of return is more difficult to calculate manually, and the
analyst typically turns to calculators and/or software for
assistance.
Source: Table 4, Horngren et al 2014, p 798.
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Advantages and disadvantages of IRR method
• Advantages:
– It measures a rate of return which is familiar to
4. Comparing NPV and IRR
management
– It incorporates the time value of money
• Disadvantages:
– With certain cash flows there can be multiple IRRs
or no IRR
– For mutually exclusive projects, IRR can provide an
incorrect ranking of projects
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Comparison of NPV and IRR Discounted cash flow analysis
• Assumptions:
• In many situations NPV and IRR yield similar results – All cash flows are treated as though they occur at year end
• NPV is preferred as it gives the end result in dollar terms – Assumes perfect capital market
rather than percentage – Each cash inflow is immediately reinvested
• NPV is easier to compute than IRR – Cash flows treated as if they are known with certainty
p j
• Individual project’s NPV can be added to obtain a valid
estimate of the effect of accepting a combination of
projects • Determining the Hurdle Rate
• In contrast IRRs for individual projects cannot be added – The discount rate generally is associated with the
company’s cost of capital
to derive a combined internal rate of return
– The cost of capital involves a blending of the costs of all
• In NPV method analyst can adjust for risk factors by using sources of investment funds, both debt and equity.
higher discount rate for later cash flows than earlier cash – When cash flow projections are uncertain, increase the
flows hurdle rate and/or use sensitivity analysis
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Payback method
5. Payback method • Payback period is the amount of time it will take for an
organization to recoup its investment:
Payback = Initial investment/annual after tax cash inflow
• Calculated by using cash flows
• Decision based on the payback time required by
management, provides a simple measure
• In ranking investment choices, the project with the
shortest payback time is the most desirable
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Payback simple example A Payback example B
• Purchasing a computer for $5,400 is expected to generate cash savings of
$15,000 over the next five years (due to reduction in admin time etc)
Payback Initial investment • Note cash savings occur in a non uniform rate in this example
=
period Annual after‐tax cash inflow
Year Cash Accumulated Cash invested, yet to be
savings cash savings recovered at end of year
A company can purchase a machine for $20,000 that 0 -- -- $5400
will provide annual cash inflows of $4,000 for 7 years. 1 $1500 (A) $1500 5400-1500 (A) = $3900
2 $2300 (B) $3800 3900-2300 (B) = $1600 (C)
3 $3000 (D) $6800 ---
Payback $20,000 4 $3700 $10500 ---
= = 5 years
period $4,000 5 $4500 $15000 ---
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Payback example B (2) Payback method
• After two years $3800 from the initial $5400 investment has been
recovered. • Advantages:
• Thus, at the start of the third year, only $1600 (C) needs to be recovered. – Ease of understanding and operation; useful for initial rough
• Yet the cash savings for the third year amount to $3,000 (D). screening of proposals
• Therefore the final $1,600 needed to recover will be saved just after half – Clearly shows the period of time needed to recover the
way through year three. investment
– It selects projects with rapid payback, thereby comforting and
$1 600 (C)
$1,600 (C) protecting management from future uncertainty
protecting management from future uncertainty.
Payback period = 2 years + $3,000 (D) = 2.53 years • Disadvantages:
– Ignores time value of money
– Neglects the concept of profit, thereby under certain
circumstances selecting projects that are unprofitable
– No allowance for the timing of receipts of cash
– Ignores cash flows that occur after the payback period has been
reached
– Lacks acceptable benchmark
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Conclusions
• Capital expenditure decisions involve cash
flows over several periods of time
• Time value of money = key feature in
discounted cash flow methods (NPV and IRR)
discounted cash flow methods (NPV and IRR)
• Accuracy of cash flow estimates = a key factor
determining validity of analysis
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