BEA2010 Managerial Accounting

1. BEA2010 Managerial Accounting Lecture 3: Capital Budgeting

2. Learning outcomes • Apply the major techniques for capital budgeting • Understand the advantages and disadvantages of each • Understand the necessity of using cash flow in DCF calculations, adjust income statement figures to cash flows • Advise on project choice in situations of capital rationing • Calculate working capital requirements and feed them into DCF calculations • Take account of the impact of taxation on NPV calculations

3. Definition of Capital Budgeting The process of identifying, analysing and selecting projects whose cash flows are expected to extend beyond one year

4. Capital budgeting decisions Examples of decisions include: • Acquire new plant and machinery • Replace plant or machinery • Expand current facilities • R&D expenditure • Close a facility • Relocation

5. Three stages in capital budgeting • Selecting projects ii) Implementation iii) Post-implementation evaluation

6. Net present value Opportunity Cost of Capital using risk-adjusted discount rates to discount the cash flows from a project. T NPV = Σ CFt t=0 (1 + r)t

7. Cash Flows: - main adjustments to income statements • Depreciation • Working capital

8. Relevant cash flows Future and incremental • sunk costs • non-cash flows – depreciation and other provisions • book values • unavoidable costs • finance costs

9. Discounted Cash Flow (DCF) NPV IRR Discounted payback

10. WACC WACC % = (Proportion of debt capital x after tax cost of debt capital as a percentage) + (Proportion of equity capital x cost of equity capital as a percentage) Thus, if a company is 70% equity capital which costs 10% and 30% debt capital which costs 5%, The weighted average cost of capital is (0.7 x 0.1) + (0.3 x 0.05) = 0.085 = 8.5%.

11. NPV and wealth increase Suppose £1,000 invested now will yield three annual inflows of £500 with the first received in one year from now. The cost of capital (required rate of return) is 5%. NPV = -1,000 + [500 x 2.723] = £361.50 The £361.50 represents the money that could be borrowed now and paid to shareholders today with the borrowing repaid from the cash flows. To prove this borrow £1,361.50 @ 5%, and after one year you owe £1,429.575 that reduces to £929.575 with the first cash inflow. In year 2, the debt grows to £976.05 that reduces to £476.054 with the second installment and in the final year the debt grows to £500 and is exactly met by the last installment. 2.723 = 0.9524 + 0.9070 + 0.8638 because 0.9524X + 0.9070X + 0.8638X = X (0.9524 + 0.9070 + 0.8638)

12. Consider two projects in a firm whose cost of capital is 10%

13. Advantages of NPV The NPV approach takes into account the time value of money, and also takes into account the risk of the project. When several projects are bundled together, the NPV of the package is equal to the sum of the individual NPVs: NPVs can simply be added together. The NPV tells us the expected impact of the project on the firm’s market value. It is thus a ‘goal congruent’ measure, in that it is consistent with the shareholder value maximisation principle.

14. Disadvantages of NPV The correct discount rate is often difficult to estimate Cash flows have to be estimated for the whole life of the project Difficult for managers to understand

15. IRR –Interpolation example

16. IRR - Interpolation IRR = Lower discount rate + [A/(A + B)] x (higher discount rate – Lower discount rate) Where: A is the positive NPV to zero; and B is the negative NPV to zero So for above, we have 20 + [551/(551 + 856)] x (25 – 20) = 22%

17. PV £s £551 20% 25% Discount rate % -£856 IRR – Interpolation graphical representation

18. Reconciling NPV and IRR

19. PV £s 11% £1326 B A £1230 24%% DR % 10% 19% NPV v. IRR graphical representation

20. IRR - Advantages Takes account of the time value of money Considers all relevant cash flows Decision rule is easier for management to understand as it is expressed as a %

21. IRR - Disadvantages Relative not an absolute measure and therefore does not take account of the scale of investment Not suitable for multiple cash outflows and other situations so there may be multiple IRRs or no IRR

22. Payback/Discounted payback Payback period = Initial investment / annual net cash flow Discounted payback = Initial investment/ annual discounted net cash flows

23. Payback – Advantages and disadvantages Advantages • Simple • Caters for riskiness • Good if capital rationed Disadvantages • No account of the time value of money (not DPB) • No account of post cut-off cash flows • Required cut-off is arbitrary

24. ARR ARR = Average income / Average investment Where: Average income = (Net income year 1 + net income year 2 + ...)/ total number of years Average investment = (Initial investment + Final scrap value)/2

25. ARR – Advantages and disadvantages For Readily understood by managers Links to profit which may impact on bonuses Against Link between ARR and NPV may be weak Ignores cash flows No account of time value of money

26. Capital rationing • Hard rationing: where the external capital market limits the supply of funds. • Soft rationing:where internally the firm imposes its own constraints on the amount of funds raised.

27. Sensitivity analysis - Example

28. Sensitivity Table

29. Single period rationing

30. Projects infinitely divisible and only £65,000 to invest Choose highest NPV per £ invested: Investment NPV C 35,000 13,000 D 25,000 8,000 B (50%) 5,000 1,400 Total £65,000 £22,400

31. Projects discrete Need to look at all feasible combinations of investment to give as close to £65,000 as possible: Investment NPV A + B + C 65,000 20,800 A + B + D 55,000 15,800 C + D 60,000 21,000 Therefore C + D

32. Project synergy Suppose a firm has £100,000 available for investment at t0. Three divisible projects are available: Project £s NPV Funds PI required at t0 (£s) X 25,000 100,000 0.25 Y 11,000 50,000 0.22 Z 8,000 40,000 0.20 If Y and Z were undertaken together an extra £5,000 of NPV is generated

33. Project synergy Therefore before the synergy invest in X as 25p NPV per £ invested is the highest but the synergy allows consideration of a new project Y + Z with an investment of £90,000 and a NPV of £24,000 = 26.7p of NPV per £ invested so will invest in: Project £s NPV Funds required at t0 (£s) Y+Z 24,000 90,000 1/10 of X 2,500 10,000 26,500 100,000

34. Mutually exclusive projects Two projects

35. Working capital Suppose Gorgon plc expects the following sales from a new project over its three year life: t1 150,000 t2 175,000 t3 200,000 Working capital equal to 10% of annual sales is required and it needs to be in place at the start of each year. Calculate the working capital flows.

36. Gorgon solution First, calculate the absolute amounts of working capital needed at the start of each year: t0 t1 t2 t3 £ £ £ £ 15,000 17,500 20,000 Nil Cash flow (15,000) (2,500) (2,500) 20,000 Only the incremental flow is relevant, so at t1 an additional £2,500 is required over and above the £15,000 already in place. At the end of the project all working capital is assumed to be recovered through an inflow of £20,000 at t3.

37. Summary • discount the cash flows, not accounting earnings: • include working capital requirements for the project: you must also consider the increases and decreases in working capital over the period of the project. • include opportunity costs: • do not include fixed or sunk costs: • do not include financing costs: