MAC2602 - Principles of strategy, risk and financial

management techniques
CAPITAL BUDGETING

MAC2602-22-S1@unisa.ac.za
Overview of this module
Topic 1 – Development of the organisation’s strategy
Topic 2 – Introduction to financial management
Topic 3 – Time value of money
Topic 4 – Sources and forms of finance
Topic 5 – Capital structure and the cost of capital
Topic 6 – Analysis of financial information
Topic 7 – Analysing and managing working capital
Topic 8 – Capital investments and capital budgeting techniques
Topic 9 – Risk theory and approaches to risk management
Topic 10 – Risk identification and documentation
Topic 11– Risk assessment, the management of risk and risk
reporting
Syllabus overview
FINANCIAL MANAGEMENT
Financial management,
financing and the cost of Managing and investing funds
capital

Introduction to financial
management
_______________________ Analysis of financial information
_______________________
Time value of money
_______________________ Analysing and managing working
capital
Sources and forms of finance _______________________
_______________________
Capital investment and capital
budgeting techniques
Capital structure and the cost of
capital
 TOPIC COVERED
• Topic 8 – Capital investments and capital budgeting
techniques
• Questions
Topic 8 – Capital Investments
This topic needs to be read in conjunction with Topic 3 - Time value of
money and Topic 4 – Sources and forms of finance

Definition of an investment project: Process of determining whether to

invest in a long-term project (> 1 year).

Examples of projects:
• Open a new branch
• Replace a machine
• Buy additional machine
• Bid for public sector contracts
• Invest in a start up project
• Expand existing facilities
Topic 8 – Capital Budgeting

Key terms:
• Objective of capital investments is to increase the long term
sustainable value of the organisation (capital investments
need to increase profits)
• Capital budgeting is the formal process for the acquisition and
investment of capital
• Types of capital expenditure are: Upgrades, replacements
and expansion
Topic 8 – Capital budgeting

Key terms:
• Factors affecting the capital budgeting decision include:
– Availability of funds
– Current and target capital structure
– Legal factors
– Lending policies of financial institutions
– Immediate need for the project
– Future earnings
Topic 8 – Capital budgeting

Key terms:
• Risks and uncertainties in budgeting decisions (include) p94:
– Expected economic life of the asset or project
– Reaction from competitors
– Selling price of the product
– Production cost
– Future demand of the product
– Tax rate
Topic 8 – Capital budgeting

Methods to evaluate capital budgeting techniques

• CONVENTIONAL methods:
– Payback period
– Accounting rate of return
• PROFITABILITY methods
– Net present value (NPV)
– Internal rate of return (IRR)
– Profitability index (PI)
Topic 8 – Capital investments

Traditional evaluation methods:

1) Payback period
• The period of time taken to recoup the capital amount
invested through the cash generated from the project
• A long pay back period means capital is tied up for a
long time which increases business risk
• Organisations set a maximum payback time to select
acceptable projects
Topic 8 – Capital investments – Payback
period
Traditional evaluation methods:
1) Payback period – Example
Company A incurs a cost of R10 million to expand its current
business with the development of a new product range.
The company estimates that the return on the investment will be
as follows:
Year 1: R2 million
Year 2: R3 million
Year 3: R6 million
Year 4: R2 million
What is the payback period?
Topic 8 – Capital investments – Payback
period
Traditional evaluation methods:
1) Payback period – Solution to the example
Year 0: Cost incurred = (R10 million)
Year 1: R2 million (8 million)
Year 2: R3 million (5 million)
Year 3: R6 million (break-even occurred somewhere in year 3)

Remaining cost to recover

Payback period= Years before cost recovery +
Cash flow during the year

= 2 + (5 / 6) = 2.8333
Topic 8 – Capital investments – Payback
period
Payback method:
- It is the time required to recoup the total capital amount invested
through the cash generation of the project.
- It calculates the time it takes the cash inflows from a capital project to
equal the cash outflows – that is “to break even”.

Disadvantages of payback method:

- Does not recognise the time value of money

- Does not recognise patterns of cash flow
- Does not take risk implicitly into account
- Ignores cash flows after the payback period (break-even point), therefore
ignoring the need for a project to make a profit.
- It is subjectively set by management.
 Topic 8 – Capital investments - ARR
Traditional evaluation methods:
1) The accounting rate of return (ARR method)
Also called Average rate of Return on Investment (ROI)

ARR = Average net profit after taxation X 100

Average investment 1
 Topic 8 – Capital investments - ARR
Traditional evaluation methods:
1) The accounting rate of return (ARR method) – continued – example:

Year 0: Cost incurred = (R10 million) – depreciated over 4 years

Year 1: R2 million
Year 2: R3 million
Year 3: R6 million
Year 4: R2 million
ARR = Average net profit after taxation X 100
Average investment 1
ARR = (13million / 4) X 100
10 / 2 1
 Topic 8 – Capital investments - PI
Traditional evaluation methods:
1) Profitability index method (PI method)
PI ratio is the ratio of the PRESENT VALUE OF CASH
FLOWS (PVCF) to the Initial Investment of the project.

If the NPV is positive, the PI will be greater than 1 and the

project will be ACCEPTED!!!
PI = PVCF X 100
Initial investments 1
 Topic 8 – Capital Investments - NPV
• Discounted cash flow methods:
1. Net present value
2. Internal rate of return
3. Profitability index (PI)

• Net present value - Cash flow estimation – Important concepts

1. Relevant cash flows – cash flows that result from the investment decision. Non-cash
flow items are not included!
2. Working capital – relates to the change in working capital due to the project (page 96)
 Topic 8 – Capital Investments - NPV
• Net present value - Cash flow estimation - Continued

3. Sunk cost – Costs that have already been committed or already taken place
should be excluded as non-relevant cost. Examples?
4. Depreciation – not a cash flow item! Read the questions carefully and don’t
count is back if already done in the question.
5. Wear and tear allowances:
• Not into account for the cash flow, but taken into account when
determining the tax payable (tax is a cash flow item)
• Could be different to the depreciation allowed for accounting purposes
• No correlation to the life of the asset.
6. Normal income tax – Cash flow item
7. Opportunity cost – Cash flows that could have been generated from an
alternative investment
8. Financing cost – NEVER taken into account. It is already taken into account
when determining the discount rate (usually WACC).
Capital Budgeting – Basic example

EXAMPLE

A company that sells football merchandise decides to

manufacture and sell vuvuzelas to football fans over the
four years preceding the world cup.

Projections are as follows:

Cost of machine R50 000

Sales (Year 1) R10 000
Sales (Year 2) R15 000
Sales (Year 3) R25 000
Sales (Year 4) R50 000

Salaries (all years) R20 000

Material (all years) R15 000
Other expenses R10 000

Advise if the company should manufacture the

vuvuzelas.
Capital Budgeting

SOLUTION

Total sales (all years) R100 000

Cost of machine (R 50 000)
Salaries (all years) (R 20 000)
Material (all years) (R 15 000)

Other expenses (R 10 000)

PROFIT
R 5 000

Conclusion: Accept the project as it

yields a profit of R5 000.
Capital Budgeting

• Problem – Time Value of Money

• The R5 000 profit is only made over a period
of 4 years
• Better is the R5 000 made today than R5 000
received after 4 years:
o If R5 000 is received today, it can be invested in
money markets and will be worth more in 4 years
Capital Budgeting – Discount the cash
flows (NPV)

Using the same EXAMPLE given above, consider

the additional information below:

The company is required to pay an upfront deposit of

R2 000 for leasing the factory. SARS allows a wear and
tear on the vuvuzela machine over 4 years.

The company’s WACC is 8% and tax rate is 28%.

REQUIRED
Advise if the company should manufacture the
vuvuzelas.
Capital Budgeting

Sum of
these is
+R3 600
Capital Budgeting

Tax calculation
Capital Budgeting

Advice: Reject project as the NPV is negative (-R8 794)

Capital Budgeting
BASIC principles
• Discount all cash flows received after a year
• Use WACC rate to discount cash flows
• Treat the financing and investing decisions
separately
• If choosing between two options, treat each option
separately (avoid incremental approach)
• Exclude non cash, sunk and financing costs
Capital Budgeting
• Question 3 (page 135)
Capital Budgeting

Classification

Independent projects
Acceptance/rejection of one project has no bearing on accepting or rejecting another

Example: Deciding to introduce a new product range is not likely to have

impact on deciding whether the company must open a new store outside
the country.

Impact: Any project that yields a positive NPV is accepted.

Capital Budgeting

Classification

Mutually exclusive projects

These are projects that do compete with one another (competing alternatives). The
acceptance of one project prevents the acceptance of the other. The different
projects are alternatives for one another and ONE has to be selected at a time.

Example: Consider a company has to replace a machine. There are two

types of machines that can do the job. These two projects (machines)
compete with each other because they have the same function. Only one
project can be chosen. Choosing one project automatically eliminates the
other from further consideration.

Impact: A project with a higher NPV is chosen.

Capital Budgeting

Classification

Divisible projects
The project size can be increased or decreased

Example: A construction of a stadium can be viewed as a divisible

project – capacity can be increased from say, 10 000 seater to 100 000
seater.

Impact: Undertake to do more of the project that maximises NPV.

Capital Budgeting

Classification

Indivisible projects
A project that cannot be broken down in subparts is indivisible and can only be
undertaken in its entirety.

Example: Where an organisation wants to erect a new bottling facility in

a new area to service a different market. The whole project has to be
completed as no smaller part of the plant can operate on its own.

Impact: The entire project as one unit must be evaluated.

Capital Budgeting

Classification
Contingent projects
Acceptance of the project depends on acceptance of another project. If there are
different (sub) projects required to complete a larger project it is called a contingent
project. These different projects are treated as a single investment for the purpose of
evaluation.

Example: A mining company expected to start mining operations in a

specific town is required to build roads and clinic for the community.

Impact: An aggregated NPV for all the projects (including contingent

projects – roads & clinic) should be calculated.
Capital Budgeting
Net Present Value
Discount future cash flows using WACC rate
(NPV)

Payback Period =
(PB)

Accounting rate of return

(ARR) =

Internal rate of return IRR is the cost of capital where NPV = 0

(IRR)

Profitability index =
(PI)
Time value of money
• Present value – perpetuity (formula):
Annuity or guaranteed annual return received or paid (I)
Required rate of return

• Present value – periodic payment (formula):

I = PV annuity x i
 1 
1  n 
 (1 i) 

• Present value – single payment (factor table):

PV = FV x present value of R1 factor

• Interpolation (formula):
 (x  y) 
 x (b  a) Interpolation = a +
 ( x  z) 