SESSION 02

Long-term Decision Analysis: Capital Budgeting (CB)

Decisions II
 COST OF CAPITAL
Cost of capital: The annual cost of using capital. This reflects the
return expected by the providers of capital.

Alternative terms

• Cost of capital

• Discount rate

• Required rate of return

PROJECT APPRAISAL
PROJECT APPRAISAL
 PROJECT APPRAISAL METHODS
There are four widely used appraisal methods

1) The payback period

2) Accounting rate of return (ARR)

3) Net Present Value (NPV)

4) Internal Rate of return (IRR)

The NPV and IRR both consider the time value of money. They are
discounted cash flow (DCF) techniques.
 SIMPLE PROJECT EVALUATION TECHNIQUES
Payback

The time required for the cash inflows from a capital investment
project to equal the cash outflows.(CIMA Official Terminology)

Payback period = Initial investment

Annual cash inflow

• Payback should be an initial screening process and the project

should be evaluated using a more sophisticated project appraisal
techniques.
• A project should not be evaluated on the basis of payback along.
• Payback is based n cashflows, non-cash flow items should be
ignored (eg: depreciation)
 PAYBACK
Decision rule

A project is rejected if its payback period is longer than the

company’s target payback.

Eg: An expenditure of Rs. 2 Mn is expected to generate net cash

inflows of Rs.500,000 each year for the next seven years. Calculate
the payback period.

= 2,000,000
500,000

= 4 years.
 PAYBACK
Eg 1: An asset costing Rs. 120,000 is to be deprecated over 10
years to a nil residual value. Forecast profits after depreciation for
the first 5 years are as follows.
Year Rs.
1 12,000
2 17,000
3 28,000
4 37,000
5 8,000

How long is the payback period to the nearest month?

A 3 years 7 months
B 3 years 6 months
C 3 years
D The project does not pay back in 5 years
GENERAL ADVANTAGES AND DISADVANTAGES OF
PAYBACK
Advantages
Simple to understand
Quick for initial screening of
projects
Considers uncertainty (later cash
flows are more uncertain)
Uses cash flows, not subjective
accounting profits
Disadvantages
Cash flows received/paid after
payback are ignored
Ignores the time value of
money(discounted payback period
may be calculated to overcome this
problem)
Is not a measure of absolute
profitability
Does not take into account cash
flows beyond the payback period
The choice of any cut off payback
period by an organizations arbitrary
 DISCOUNTED PAYBACK

Payback can be based on discounted cash flows (discussed

later), which is called discounted payback period.
 PAYBACK
Eg: 2
 PAYBACK
Eg: 3
 ACCOUNTING RATE OF RETURN (ARR)
The ARR method calculates a percentage return provided by the
accounting profits of the project

ARR= Average annual PBIT

Initial or average investment

Average annual profit= Net cash flows less depreciation

Average value of investment = initial investment+ residual value

2
 ACCOUNTING RATE OF RETURN (ARR)
Decision rule

• Accept all projects with an ARR above the company’s target ARR

• Faced with a choice of mutually-exclusive investments, the

project with highest ARR should be chosen. (provided it meets
the company’s target return)
 ACCOUNTING RATE OF RETURN (ARR)
Eg:4
Project A
Initial investment Rs.450,000
Scrap value Rs.20,000
Year 1 2 3 4 5
Annual CFs(Rs.’000) 200 150 100 100 100

Project B
Initial investment Rs.100,000
Scrap value Rs.10,000
Year 1 2 3 4 5
Annual CFs(Rs.’000) 50 40 30 20 20

Calculate the ARR for each project,and indicate which project should
be chosen.
GENERAL ADVANTAGES AND DISADVANTAGES OF
ACCOUNTING RATE OF RETURN (ARR)
Advantages Disadvantages
Simple to understand Ignores the time value of money
Widely used and accepted Profits can be manipulated
Looks at the whole project life Does not consider cash flows. Uses
subjective accounting profits, which
include depreciation
 TIME VALUE OF MONEY
There are three main reasons for the time value of money.

Consumption preference

• There is a strong preference for the immediate rather than

delayed consumption. Investors prefer to receive returns sooner
rather than later.

• Given a choice of Rs.100 now or the same amount in one year, it

is always preferable to take Rs.100 now because it could be
invested over the next year at say 10% interest rate to produce
Rs.110 at the end of the year.
 TIME VALUE OF MONEY
Impact of inflation

In most countries, in most years prices rise as a result of inflation.

Therefore funds received today will buy more than the same amount
a year later, as prices will have risen in the meantime. The funds are
subject to a loss of purchasing power over time.

Risk

The earlier cash flows are due to be received, the more certain they
are-there is less chance that events will prevent payment. Earlier
cash flows are therefore considered to be less risky.
 DISCOUNTED CASH FLOW TECHNIQUES
Time value of money

Money received today is worth more than the same sum received in
the future. i.e it has a time value.

If a project involved the outlay of Rs. 20,000 and provided a definite

return of Rs.21,000 in one year’s time, would you accept it if you
could get a return of 6% on investments of similar risk?

If you had Rs.20,000 today and invested it for one year at 6% then
you would have Rs.20,000 x 1.06=Rs. 21,200. (this is called
compounding) This is more than is generated by the project so the
project is not acceptable.
 DISCOUNTED CASH FLOW TECHNIQUES
Alternatively
We can multiply Rs. 21,000 by
1
1.06

Which gives a value of Rs. 19,811

This shows the value today, or present value, of receiving

Rs.21,000 in one year’s time to reflect the return available to
investors. Again we can see that the project is unacceptable
because this present value is below the cost of the project of Rs.
20,000.
 DISCOUNTED CASH FLOW TECHNIQUES
We could express this as a net present value of Rs.19,811-Rs.
20,000= (Rs.189)

A negative net present value is not attractive so again we

reject the project
 COMPOUNDING
A sum invested today will earn interest. Compounding
calculates the future (or terminal value) of a given sum
invested today for a number of years.

Formula for compounding

V = X (1+r)n

Where V = Future value

X = Initial investment (present value)
r = Interest rate
n = Number of periods
 COMPOUNDING
Eg:

Rs.100 is invested in an account for five years. The interest rate

is 10% per annum. The value of the account after five years
can be calculated as follows.

V = 100 (1.10)5 = 161.05

Similarly, if your time value of money is 10% per annum, then

you would be indifferent between receiving Rs.100 now or
Rs.161.05 in five years’ time. They would have the same value
to you.
 COMPOUNDING
Eg: Solution - method 1
End of year Interest earned (Rs.) Total Investment (Rs.)

0 100.00
1 100 x 10% 10.00
110.00
2 110 x 10% 11.00
121.00
3 121 x 10% 12.10
133.10
4 133.10 x 10% 13.31
146.41
5 146.41 x 10% 14.641
161.05
 COMPOUNDING
Eg: solution method 2

Using a scientific calculator = xy

V = 100 (1.10)5 = 161.05

 DISCOUNTING
• Discounting performs the opposite function to compounding.
Compounding finds the future value of a sum invested now.

• Discounting considers a sum receivable in the future and

establishes its equivalent value today.

• This value in today’s terms is known as the Present Value

(PV)

• In investments projects, cash flows will arise at many

different points in time. Calculating the PV of future flows is
a key technique in investment appraisal decisions.
 DISCOUNTING
Formula for compounding

PV = FV
(1+r)n

Where PV = Present value

FV = Future value
r = Interest rate
n = Number of periods

1 or (1+r)-n
(1+r)n

Present values can be looked up in discounting tables.

 DISCOUNTING
Eg: Rs.5,000 is required in 10 years. Rs. X is invested in an account
earning 5% interest p.a.

The value of Rs. X may be established as follows.

X = 5,000 = 3,070
(1.05)10