Capital Budgeting Strategy: Learning objectives Define capital budgeting strategy and explain its importance. Explain and describe the characteristics and assumptions ofa capital budgeting strategy Classify capital projects Describe the capital budgeting process Analyse project cash flows Describe the features ofthe CB techniques Apply the CB techniques Evaluate the decision rules forthe CB techniques Appreciate the practical problems in CB Explain the CB problems > Classify gue CB techniques ‘Attempt to solve these problemsBasic Framework Capital budgeting strategy relates to investment in assets that are relatively large. Itis capital expenditure which is the commitment of resources in order to secure a stream of benefits in future years. Examples include investment equipment, buildings, land, introduction of a new product, a new distribution system or a new program for research and development. A conporate’s future success is dependent on long term decisions currently made. In general itis the initial outlay. ‘Two factors need to be considered: > Timing of benefits > Size and type of expenditure Dr. Makan GBS CUTCapital budgeting process * Itinvolves: > Generating investment project proposals consistent with the firm’s strategic objectives > Estimating after tax incremental operating cash flows for investment projects > Evaluating project incremental cash flows ® Select projects based on a value -maximising acceptance criteria » Re-evaluating implemented investment projects continually and performing post-audits for completed projectsCharacteristics of a capital budgeting strategy * Capital expenditure differs from revenue expenditure: > the size of the fund is huge > Long term benefits therefore subject to risk, judgemental risk, estimation errors, data errors and the unpredictability of the events > High visibility-great concern for all parties inside and outside > Expensive mistakes i.e. wrong project decisionsBasic assumptions of a capital budgeting strategy The primary function of management is to increase the firm’s value reflected by the price of common stock Owners have a preference for current as opposed to future cash flows ie. the time value of money Shareholders are risk averters i.e. they would want equate their return to the risk they are making In the evaluation of capital projects, the analysis is based upon the incremental cash flows directl attributed to the project. The cash inflows and outflows would not exist if the project were rejected. Drs, Malu GBS CUTcont- Cash flow analysis may differ from accounting income reporting (cash vs profit) Capital investment decisions rest upon multiple periods The trend in asset acquisition indicates management risk exposure Every capital project has tobe financed and there are no free sources of capital Capital budgeting always involves allocating scarce resources among competing needs (capital rationing) CB considers tax when considering‘cash flows SIA, Wear and Tear, corporate scrapping allowanceClassification of capital projects Independent projects — Accept and reject decision does not affect decision on another project (independence in decision making) Mutually exclusive- if acceptance of one project precludes the acceptance of another project, the two are mutually exclusive and are regarded as alternatives New projects-a project which does not affect existing project cash flows. It will have its own outlay, generate its cash flows independent to existing projects e.g. new product proposalsCont- * Replacement projects- proposals justified primarily to replace assets nearly exhausted * Cost reduction projects * Expansion or improvement projects * Complimentary projects- acceptance of one project enhances cash flows of another project * Prerequisite or contingent projects * Statutory or welfare proposals- these do not offer obvious financial returns.Nature of project cash flows Incremental After tax cash flows Include opportunity cost Exclude sunk costs Exclude interest paymentsCategories of cash flows » Initial investment or beginning of project cashflows » Annual operating cashflows » End of project cash flow or terminal cash flow = Tax allowances such as W &T, SIA influence project cash flows and the two could result in either recouping or scrapping allowance.Characteristics of the techniques > The method must be based on CEs and not Accounting profits. > It must consider all the cashflows generated by the project > Must take into account the time value of money > Must take into account the cost capital > It must adjust for any risk inherent in a project > One which can adjust in required rate of returns especially changes in market interest rates > One that can be used in an inflationary environment > One that can be used in situations of capital rationing (PI)Cont- > Must be consistent across time, space given the same data. Analysts must come up with the same decision » Must be an indicator of liquidity > Method can be used to measure project with different lives > Must be easy to use and apply Des, Mabe GBSCUTClassification of CB techniques > Non-discounting methods (do not adjust for the time value of money) » Discounting methods (Adjust for the time value of money) = Other textbooks, classify them into traditional methods and modern methods. eS. Maarumidee GS CUTThe techniques » Net terminal value > Net present value (NPV) > Profitability Index (GPI and NPI) > Internal Rate of Return (IRR) » Modified Internal Rate of Return (MIRR) > Payback (Pb) » Discounted Payback » Accounting / Average Rate of ReturnNet Terminal Value Te measures the future value of the project cash flows. ‘The NTV is determined by compounding all cashflows in the future. FV =CFo(1 +r)" NTV = YfoCF,(1 +r)" equation 1 ‘Separating cash inflows and out flows NTV = [Ef CF(1 +1)" ffo(1 + 7)"] equation 2 ‘Where CF,-cash inflow at time t = WACC. n= term of the project To-Initial investmentCont- Equation 1 & 2 can be combined as follows. NTV = CFo(1 + r)"+CF,(1 +r)" 14CF)(1 + 1)? 4.... CF,(1 +r)" note CFy is negative. Alternatively it can be expressed as follows: NTV = CF\(1 + r)""+CF(1 + r)"*+.... CR +r)" "= [Ig(1 + r)"] Financial tables can also be used as follows: NTV = [CF,X FVIF,9n-1yr + CF2X FVIFya¢n-2years + CF3X FVIF 94,3 yearst.--CFy (1)] — lo X FVIF,%nyearsCont- Net terminal Value can be applied on equal and unequal cashflows. For equal cashflows: CF\=CF,=CF;_ CF, The cashflows are an annuity. NTV = CF X FVIFAynyears — Uo(1 +1)"] Thus: NIV = CF) [id +9")Decision rule * For independent projects > Accept projects with +ve NTV > Reject all projects with -ve NTV » If NTV=0 the firm is indifferent * For Mutually exclusive projects » Accept projects with the highest +ve NTV » Reject projects with -ve NTVExample * Given a4 year project with the following cash flow patterns. Year | foam) (100) 60 50 30 20 * Find the NTV of the project assuming WACC of 10%Net Present Value Itis the present value of project profitability With the NPV we discount the cashflows but with the NTV we compound the cash flows. With NPY the decision is made now whereas with NTV the decision is made at the end of the life of the project. In excel: =NPV(rate; CF ;CF,;...CF,) + CF, which is negative ED Sec ch Ch aa ery Gr) CF is always negative Which is CF +Cont- NPY = Si aah — Io Thats sear tae DF “This canbe rewrite CEX PV Fy + CBX PVF yrs + CF X PV Fars Foran annuity: GEXPVIFA rn yrs ~ lo = oF ($= sao) ~ lp Toe PVIPAcnte enpesed tol astoloys 020" CBX PVE pn yrsDecision rule ° Independent projects > Accept all projects with +ve NPV > Reject all projects with -ve NPV > When NPV =0 the corporate is indifferent * Mutually exclusive > Accept project with the highest positive NPV > Reject project with -ve NPVProfitability Index (PI) Temeasures the reuen for each dollar invested, PI can be computed based on Gross PI and net PI eee Ger Decision rule-Independent projects ‘Accept ll projects with GPI>1 Reectall projects with GPI<1 Indifferent to projects with GPI=1 Mutually Exclusive projects ‘Accept project with the highest GPI provided it>1Itis computed as follows Npy = Net Present values of cash flows initial investment np = Decision rule —Independent projects Accept all projects if NPI>O Reject all if NPI cost of capital » Reject all projects with IRR< cost of capital = Mutually exclusive projects > Accept project that has IRR > cost of capital = NB: for independent projects IRR, NPV and the PI will give the same decision. = Results are different for mutually exclusive projects. eS Maurie GBS CUTFurther notes on IRR The formula applies to conventional cashflows i.e. -++++++ project cash flows Reverse cash flows + -------- for a Loan Unconventional cashflows -+-++ a 2 stage project For reverse cash flows you reverse the decision that you make i.e. you make opposite decision. Unconventional cashflows become quadratic in the form: ax? + bx + c = 0 such that: ~bivb?=40e 1+IRR= s =0Modified IRR This is used to compare terminal and the value of cashflows and the PV of outflows. t_ _FV of all inflows (+ve) (1 + MIRR)'= PV of all out flows (—ve) RU -\| PV of all out flow: For longer projects [RR = ‘i Payback periodPayback Method * The average period taken to recover the initial outlay and is measured in years. * Payback is simple and a good method to measure the risk by measuring the liquidity of a project. * The method does not penalise the CFs for the time value of money explicitly. It cannot be used as a measure of profitability for the shareholder. * The method ignores the cashflows after the payback. DS, Mabunnee GBS CUTExample * You are given the following projectsCalculation of the Payback a) For annuity cash flows ___Initial outlay Payback = Annuity cashflow b) When dealing with unequal cash flow Ps initial investment, cCF-cumulative cash flow at the end of year t and CF;, is the cash flow at period citals » Where t-the last full year , [y-Decision rule * The argument is not accepting a period shorter but compare to tolerant payback and the actual payback. * For independent projects accept all projects with the actual P, being shorter than the tolerant payback. ° For mutually exclusive projects we accept projects that have the shortest payback as long as the payback is within the tolerant range.Reciprocal payback * Itis the inverse of the payback and can be used a proxy for the IRR. . i ee Reciprocal Pb = i * For instance if it 0.15 it means it will take 15% of the lifespan of the project to pay itself or to recover the initial outlay.Discounted Payback (Advanced Payback) * Average period the project takes to recover its initial investment but based on discounted cashflows. * Discounted cash flow is less that non-discounted cash flow. Therefore it takes longer to recover the Tes * A project accepted under conventional payback may be rejected under discounted payback.Accounting Rate of Return Average annual profit Average capital outlay * ARR= ‘ Ip+residual value * Average capital outlay = a ae * ARR is used for academic argument because it does not use cashflows and does not take into account the time value of money. * Averages can be affected by extremes