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CAPITAL BUDGETING

CAPITAL BUDGETING. What it is Large investment in plant or equipment with returns over a period of time. Investment may take place over a period of time A Strategic Investment Decision. CAPITAL BUDGETING. Purpose Expansion Improvement Replacement R & D. CAPITAL BUDGETING.

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CAPITAL BUDGETING

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  1. CAPITAL BUDGETING What it is Large investment in plant or equipment with returns over a period of time. Investment may take place over a period of time A Strategic Investment Decision

  2. CAPITAL BUDGETING Purpose • Expansion • Improvement • Replacement • R & D

  3. CAPITAL BUDGETING What do we need to think about? • Location • Infrastructure • Labour • Cash Flows What is the most important?

  4. OVERALL AIM To maximise shareholders wealth.. Projects should give a return over and above the marginal weighted average cost of capital. Projects can be; • Mutually exclusive • Independent • Contingent Process of Choice

  5. IDEAL SELECTION METHOD Will • Select the project that maximises shareholders wealth • Consider all cash flows • Discount the cash flows at the appropriate market determined opportunity cost of capital • Will allow managers to consider each project independently from all others

  6. SELECTION METHODS • Payback • ARR • Net Present Value (NPV) • Internal Rate of Return (IRR)

  7. CHOICE PAYBACK Project AProject B Yr 0 - 1,000,000 - 1,000,000 Yr 1 + 1,100,000 + 500,000 Yr 2 + 200,000 + 500,000 Yr 3 - 100,000 + 500,000 Project A = Year .909 Project B = ?

  8. PAYBACK Problems:- • Ignores overall return • Ignores impact of large flows • Ignores timing of flows

  9. ARR Project AProject B Yr 0 - 1,000,000 - 1,000,000 Yr 1 + 1,100,000 + 500,000 Yr 2 + 200,000 + 500,000 Yr 3 - 100,000 + 500,000 n RoA Project A = Σ ( cashflows) ÷ Io t=o n • (200,000) = 66,666.66 ÷ 1,000,000 = .0666 or 6.67% 3 Project B? Problems?

  10. NET PRESENT VALUE PROJECT A Yr CF PV Factor @ 14% Present Value 0 - 1,000,000 1.000 - 1,000,000 1 500,000 .8772 438,600 2 500,000 .7695 384,750 3 500,000 .6750 337,500 4 500,000 .5921 296,050 5 - 500,000 .5194 - 259,700 NPV 197,200

  11. NET PRESENT VALUE PROJECT B - 1,000,000 900,000 200,000 200,000 100,000 100,000

  12. NET PRESENT VALUE PROJECT B - 1,000,000 - 1,000,000 900,000 789,480 200,000 153,900 200,000 135,000 100,000 59,210 100,000 51,940 NPV 189,530 Which project should we undertake? Why?

  13. Internal Rate of Return Project A Yr CF PVF@ 26% PV PVF@ 27% 0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000 1 500,000 .793651 = 396,825 .787401 393,701 2 500,000 .629881 = 314,941 .620001 310,000 3 500,000 .499906 = 249,953 .488190 244,095 4 500,000 .396751 = 198,376 .384401 192,200 5 - 500,000 .314881 = - 157,441 .302678 -151,339 2,654 -11,343 Interpolation IRR = 26.19% Project B 0 -1,000,000 1.0000 = - 1,000,000 1.0000 - 1,000,000 1 900,000 = 714,286 708,661 2 200,000 = 125,976 124,002 3 200,000 = 99,981 97,638 4 100,000 = 39,675 38,440 5 100,000 = 31,48830,268 IRR = 27%11,406 - 991

  14. Interpolation 26% 27% +2,654 -11,343 Q. Where on the line does 0 fall? From + 2654 0 = 2654 = .1896 or 18.96% of distance 13997 Since distance = 27-26 = 1% = .1896 of 1%  Answer = 26 + .1896 = 26.19% 13,997

  15. Test @ 26.19% Yr CF PVIF PV 0 - 1,000,000 1.0000 -1,000,000 1 500,000 .7924558 396,228 2 500,000 .6279862 313,993 3 500,000 .4976513 248,826 4 500,000 .3943667 197,183 5 - 500,000 .3125182 - 156,259 - 29

  16. Comparison of NPV vs. IRR • NPV accepts all projects with NPV > 0. Ranking of projects is by value of NPV. • IRR finds the value of the discount rate that makes NPV = 0. Project will be accepted if IRR > k (cost of capital) The big Q? Will the two methods always give the same answer? No, unfortunately not

  17. NPV Vs IRR Relationship between NPV,IRR and Discount Rates • 0 10 20 30 40 50 Disc rate • NPV

  18. Yr CF PV@10% PV@20% 1 400 363.6 333.3 2 400 330.4 277.763 - 1,000 - 751.0- 578.70 - 57 32.4IRR = 15.8%

  19. Reinvestment Rate Assumption Project Yr0 Yr1 Yr2 Yr3 C of K NPV IRR X -10,000 5,000 5,000 5,000 10% 2,430 23.4% Y -10,000 0 0 17,280 10% 2,977 20.0% Illustration Reinvestment @23.4% End Yr 1 End Yr 2 End Yr 3 5,000 6,170 7,613 5,000 6,170 5,000 18,783 @ 10% 5,000 5,500 6,050 5,000 5,500 5,000 16,550

  20. Value Additivity Project NPV @10% IRR% 1 354 134.5 2 104 125.0 3 309 350.0 1 + 3 663 212.8 2 + 3 413 237.5

  21. Multiple Rates of Return • Multiple Rates of Return NPV 400 200 IRR 15% Discount Rate 0 IRR – 12% • 200 • 400

  22. NPV Vs IRR Conclusion NPV is the correct method to use But - there are some additional issues

  23. Other Issues • Scale How do we evaluate between projects of different scale? Project Outlay PV @ 10 % NPV A - 400 572 172 B - 500 683 183 How do we compare? If we have plenty of capital then it is not a problem. Both have a positive NPV so do both.

  24. Other IssuesScale • Suppose we only have 600 worth of capital. Which project should we take? • Work out the Profitability Index Present Value = PI Cost • Project A = 572 = 1.43 400 Project B = 683 = 1.37 500

  25. Other IssuesScale • Now work out the weighted PI • For A (1.43 x 400) + (1 x 200) = 1.2866 600 600 .9533 .3333 For B (1.37 x 500) + (1 x 100) = 1.3084 600 600 Therefore take Project B

  26. Other IssuesProject Lives • What if projects take place over different time scales? Yr Project A Project B 0 - 17,500 -17,500 1 10,500 7,000 2 10,500 7,000 3 8,313 NPV @ 10% 723 894

  27. Other IssuesProject Lives • How to choose • Assume you are able to repeat the projects until they have the same end date 0 2 4 6 A 3 B 723 • 723 (discount at 10%) • 723 (discount at 10%) 1813

  28. Project Lives 0 2 4 6 3 894 672 894 (discount at 10%) 1566 • Project B

  29. Project Lives • This approach is fine for simple project lives but what if they are complex? • E.g.lives of 7 years, 9 years and 13 years • Answer make them all last for ever! • NPV(n, to inf) = NPVn (1+ k)n (1+ k)n – 1

  30. Project Lives • E.g. NPV2 to inf = 723 (1.1)2= 723 x 1.21 (1.1)2 - 1.21 723 x 5.76 = 4,165 NPV3 to inf = 894 (1.1)3= 894 x 1.331 • (1.1)3 – 1 .331 894 x 4.02 = 3,596

  31. Cash Flows Example – Consider the following new project:- Initial capital investment of £15m. It will generate sales for 5 years. Variable Costs equal 70% of sales. Fixed cost of project =£200,000 P.A. A feasibility study, cost £5000, has already been carried out. Discount rate = 12%. Should we take the project?

  32. Cash Flows

  33. Cash Flows Treatment of depreciation in NPV analysis. -We only use cashflows in investment appraisal. -Depreciation is not a cashflow. -However, depreciation (capital allowances) is allowable against tax (see income statement), which affects cashflow. For cashflow, add depreciation back:-

  34. Treatment of Depreciation

  35. Issues to ConsiderCash Flows • But not in detail! • Cash flows should be incremental - include all incidental effects (redundancy) - Do not forget working capital - Do forget sunk costs! - Be careful with allocated overheads

  36. Issues to ConsiderCash Flows • ‘Uncertainty means more things can happen than will happen’ Brealy and Myers. • How do we obtain a feel for what the cash flows are most likely to be? • - Sensitivity Analysis • - Scenario Analysis • - Break Even Analysis • - Simulation • - Decision Trees

  37. Issues to ConsiderDiscount Rate • We also need to consider what discount rate to use as this will also effect the outcome. • This is the next subject

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