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Capital Budgeting: Tools and Techniques

Capital Budgeting: Tools and Techniques. On Corporate Finance and Corporate Government Sector. Maria Ella T. Betos MAE 630: Managerial Economics. Discussion Proper:. Overview and Process of Capital Budgeting Decisions Projected Cashflows – Cost of Investment Computation

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Capital Budgeting: Tools and Techniques

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  1. Capital Budgeting: Tools and Techniques On Corporate Finance and Corporate Government Sector Maria Ella T. Betos MAE 630: Managerial Economics

  2. Discussion Proper: • Overview and Process of Capital Budgeting Decisions • Projected Cashflows – Cost of Investment Computation • Payback Period and Discounted Payback Period • Accounting Rate of Return • Profitability Index – Benefit-Cost Analysis • Net Present Value • Internal Rate of Return • Sample Problems and Cases

  3. Overview of Capital Budgeting, its Decisions and Process • Capital Budgeting – process of identifying, evaluating, and implementing a firm’s investment opportunities • The process of making long-term planning decisions for investments (Investment Decisions – Selection decisions concerning projects and Replacement Decision) • The profitability of a firm is affected to the greatest extent by the success of its management in making capital budget investment decisions • A fixed-asset decision will be sound only if it produces a stream of future cash inflows that earns the firm an acceptable rate of return on its invested capital.

  4. Overview of Capital Budgeting, its Decisions and Process • Capital budgeting decisions involve mutually exclusive or independent projects. • Mutually exclusive projects - two or more machines that perform the same function may be available from competing suppliers, possibly at different costs and with different expected cash benefits • Independent projects - Project not in direct competition with one another - They are to be evaluated based on their expected effect on shareholder wealth

  5. Overview of Capital Budgeting, its Decisions and Process Capital Budgeting Processes: • Identification stage – involves finding potential capital investment opportunities and identifying whether a project involves a replacement decision and/or revenue expansion • Development stage – requires estimating relevant cash inflows and outflows • Selection stage – involves applying the appropriate capital budgeting techniques to help make a final accept or reject decision • Implementation stage – projects that are accepted must be executed in a timely fashion • Follow-up – a stage in the capital budgeting process during which managers track, review, or audit a project’s results.

  6. Projected Cash Flows Computation Major Categories of Cash Flows • Initial cash outflow -- the initial net cash investment. • Operating cash flows -- those net cash flows occurring after the initial cash investment but not including the final period’s cash flow.

  7. Initial Cash Outflow a) Cost of “new” assets b) + Capitalized expenditures c) + (-) Increased (decreased) NWC d) - Net proceeds from sale of “old” asset(s) if replacement e) + (-) Taxes (savings) due to the sale of “old” asset(s) if replacement f) = Initial cash outflow

  8. Operating Cash Flows • Operating Revenue • (- )Operating Expense • (-) Increase in net working capital • (-) Depreciation • = Taxable Income • (-) Income Taxes • (=) Net Income • (+) Depreciation • (=) Operating Cash Flow

  9. Example for Initial Cash Outflow Computation Basket Wonders (BW) is considering the purchase of a new basket weaving machine. The machine will cost $50,000 plus $20,000 for shipping and installation and has 3-year useful life. NWC will rise by $5,000. Management forecasts indicates that revenues will increase by $110,000 for each of the next 4 years and will then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends. Operating costs will rise by $70,000 for each of the next four years. BW is in the 40% tax bracket.

  10. Initial Cash Outflow a) $50,000 b) + 20,000 c) + 5,000 d) - 0 (not a replacement) e) + (-) 0 (not a replacement) f) = $75,000* * Note that we have calculated this value as a “positive” because it is a cash OUTFLOW (negative).

  11. Example for Operating Cash flow We plan on purchasing a new assembly machine for $25,000.. It will cost $2,000 to have the new machine installed and we expect a $ 1,000 net increase in working capital. By making the investment, we will reduce our annual operating costs by $ 7,000 and we expect to save $ 500 a year in maintenance. The new machine will require $ 750 each year for technical support. We will depreciate the machine over 5 years under the straight-line method of depreciation with an expected salvage value of $ 5,000. The effective tax rate is 35%.

  12. Operating Cash Flows • Annual Savings in Operating Costs $ 7,000 • Annual Savings in Maintenance 500 • Annual Costs for Technical Support (750) • Annual Depreciation (4,000) * • Revenues $ 2,750 • Taxes @ 35% (962) • Net Project Income 1,788 • Add Back Depreciation 4,000 • Operating Cash Flow $ 5,788 * $ 25,000 - $ 5,000 / 5 years = $ 4,000

  13. Payback Period • It refers to the length of time the firm can recover its initial investment in a project. • The management will choose the projects whose paybacks are less than a management-specific period. • Payback period is computed by dividing the initial investment by the cash inflows in the case of annuity; for a mixed stream, the yearly cash inflows must be accumulated until the initial investment is covered.

  14. Payback Period PAYBACK PERIOD = INITIAL INVESTMENT ANNUAL CASH INFLOW

  15. Payback Period EXAMPLE : Calculate the firm’s payback period assuming their initial investments and operating cash inflows are as follows:

  16. Payback Period PAYBACK PERIOD FOR Project X PP = Initial Investment Cash Inflows = 150,000 40,000 = 3.75 years of 3 years and 270 days

  17. Payback Period EXAMPLE : Calculate the firm’s payback period assuming their initial investments and operating cash inflows are as follows:

  18. Payback Period PAYBACK PERIOD FOR Project Y

  19. Payback Period PAYBACK PERIOD FOR Project Y 190,000 (cash inflows for 4 years) + 10,000/60,000 X 360 = 60 days PBP = 4 years and 60 days

  20. Discounted Payback Period • Payback Period does not consider time value of money when providing an answer whereas with Discounted Payback Period we get to see the real value of cash inflows when they are measured in today's amount of money as these are discounted at an interest rate called the Discount Rate • Discounted Payback Period is computed as follows:

  21. Discounted Payback Period EXAMPLE : • For example, assume a machine purchased for $5000 yields cash inflows of $5000, $4000, and $4000. The cost of capital is 10%.

  22. Discounted Payback Period SOLUTION: • The payback period (without discounting the future cash flows) is exactly 1 year. However, the discounted payback period is a little over 1 year because the first year discounted cash flow of $4545 is not enough to cover the initial investment of $5000. • The discounted payback period is 1.14 years (1 year + ($5000 - $4545)/$3304 = 1 year + .14 year).

  23. Accounting Rate of Return • Accounting Rate of Return calculates the return, generated from net income of the proposed capital investment • This doesn’t take into account the time value of money • If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment.

  24. Accounting Rate of Return • The ARR is computed as follows: • DECISION CRITERIA: ARR > COI= ACCEPT THE PROJECT ARR < COI = REJECT THE PROJECT

  25. Accounting Rate of Return • EXAMPLE: Let's say you're looking at equipment costing $7,500 that is expected to return roughly Php2,000 per year for five years. After five years you'll sell the equipment for Php500. The depreciation would be (Php7,500 - $500) ÷ 5, or Php1,400.

  26. Profitability Index • Also known as benefit-cost ratio, desirability index • It expresses the present value of cash benefits as to an amount per peso of investment in a project • It is also used as a measure of ranking projects in descending order of desirability • The formula is as follows:

  27. Profitability Index • DECISION RULE: The higher the profitability index, the more desirable the project. Projects with index of less than 1 are rejected. Thus: If PI > 1; ACCEPT If PI < 1; REJECT

  28. Profitability Index • ILLUSTRATION Company XYZ has Php 200,000 funds available for investment. It is considering the following projects:

  29. Profitability Index • COMPUTATION Project A: Php 244,000 / 200,000 = 1.22 Project B: 130,000 / 100,000 = 1.30 • DECISION – The company should invest in Project B since it has higher profitability index than Project A

  30. Net Present Value • Net Present Value (NPV) is a sophisticated capital budgeting technique because it gives explicit consideration to the time value of money. • It is computed as: NPV = PV of Cash Inflows – Initial Investment

  31. Net Present Value • The Decision Criteria If the NPV is greater than 0, accept the project If the NPV is less than 0, reject the project • If the NPV is greater than 0, the firm will earn a return greater than its cost of capital. Such action should enhance the market value of the firm and therefore the wealth of its owners.

  32. Net Present Value • ILLUSTRATION: Marga Company, a medium sized metal fabricator is currently contemplating two projects. Project A requires an initial investment of 42,000 and Project B an initial investment of 45,000. The projected relevant operating cash inflows for the two projects are as follows:

  33. Net Present Value

  34. Net Present Value

  35. Net Present Value • The calculations results in net present value for projects A and B of 11,071 and 10,924, respectively. • Both projects are acceptable because the net present value of each is greater than 0. If the projects were being ranked, however, project A would be considered superior to B, because it has a higher net present value than that of B.

  36. Internal Rate of Return • The internal rate of return method differs from the Net Present Value method in that it finds the interest yield of the potential investment • Sometimes known as the Economic Rate of Return • The internal rate of return is the discount rate that makes the net present value of all cash flows from a particular project equal to zero

  37. Internal Rate of Return • FORMULA:

  38. Internal Rate of Return • EXAMPLE: A company is considering to purchase an equipment at a cost of Php244,371. Net annual cash flows for this equipment is estimated to be Php100, 000 for three years. To determine for the IRR, look for the PV factor first: *the factor of 2.4437 is the PV factor of annuity of 1 at 11%

  39. Internal Rate of Return • EXAMPLE: Ella Company, is currently contemplating on a project. Project A requires an initial investment of Php52,000. The projected relevant operating cash inflows for the term of five years is equal to Php14000. What is the internal rate of return?

  40. Internal Rate of Return • Using the rate of 10%, the PV factor of annuity of 1 is 3.7908; whereas using the rate of 11%, the PV factor of annuity of 1 is 3.6959 • The NPV at 10% is equal to Php1, 071.01 while the NPV at 11% is (Php257.44). To interpolate for the IRR:

  41. Internal Rate of Return • SOLUTION:

  42. Corporate Finance and Corporate Government Sector • Official Development Assistance - Assistance being provided or granted by a foreign government/multilateral agency, which is usually a developed country, to another nation, which is categorized as a developing country.

  43. Corporate Finance and Corporate Government Sector • KEY TERMS: Profitability – ability to gain Sustainability – ability to stand on the long term Serviceability – ability to “service” the benefits to the end-users

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