MODULE 3
CAPITAL BUDGETING
A form of decision making where the investment occurs predominantly today, and the benefits of
the investment occur in future. Investment appraisal is of importance because of the following:




Long-term
Size (in relation to the business)
Outflow today (relatively certain)
Inflow in future (uncertain)
Methods of Capital Budgeting:
1.
2.
3.
4.
Payback
Return on capital employed (ROCE)
Net present value (NPV)
Internal Rate of return (IRR)
1. PAYBACK:
The length of time it takes for cash inflows from trading to pay back the initial investment.
Decision Criteria: Accept the project in the event that the time period is within the
acceptable time period.
Advantages:
i.
It is simple to use and easy to understand
ii.
It is a particularly useful approach for ranking projects where a company faces
liquidity constraints and requires a fast repayment of investment.
iii. It is appropriate in situations where risky investments are made in uncertain market
that are subject to fast design and product changes or where future cash flows are
particularly difficult to predict
iv.
The method is often used in conjunction with the NPV or IRR method and act as
the first screening device to identify projects which are worthy of further
investigation.
v.
Unlike the other traditional methods payback uses cash flows rather than
accounting profits, and so is less likely to produce an unduly optimistic figure
distorted by assorted accounting conventions.
Disadvantages:
i.
ii.
It does not give a measure of return, as such it can only be used in addition to other
investment appraisal methods.
It does not normally consider the impact of discounted cash flow although a
discounted payback may be calculated
iii.
iv.
It only considers cash flow up to the payback, any cash flows beyond that point are
ignored.
There is no objective measure of what an acceptable payback period is, any target
payback is necessarily subjective.
Sum 1: Rex Ltd has the opportunity to invest in an investment with the following initial costs and
returns:
Initial investment
Cash Flows
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Residual value
Yr 5
The cost of capital is 10%. Should the project be accepted?
Sum 2: Net cash inflow per annum $25,000
Investment $60,000
Calculate payback period.
Sum 3:
2. ACCOUNTING RATE OF RETURN (ARR)
$000s
(100)
50
40
30
25
20
5
Average Profits = Total cash flow less depreciation
Number of years
Average investment = Initial investment plus residual value
2
Decision Criteria:
A profit measure that must be compared to a target profit. The profit is likely to be related to the
target performance measure.
Advantages:
i. It is easy to understand and easy to calculate
ii. The impact of the project on a company’s financial statement can also be specified.
iii. ROCE is still the commonest way in which business unit performance is measured and
evaluated, and is certainly the most visible to shareholders
iv.
Managers may be happy in expressing project attractiveness in the same terms in which
their performance will be reported to shareholders and according to which they will be
evaluated and rewarded
v. The continuing use of the ARR method can be explained largely by its utilization of
statement of financial position and P&L account magnitudes familiar to managers, namely
profit and capital employed.
Disadvantages:
i. It fails to take account of the project life or the timing of cash flows and time value of
money within that life.
ii. It uses accounting profit, hence subject to various accounting conventions
iii. There is no definite investment signal. The decision to invest or not remains subjective in
view of the lack of objectivity set target ARR
iv.
Like all rate of return measures, it is not a measurement of absolute gain in wealth for the
business owners
v. The ARR can be expressed in a variety of ways and is therefore susceptible to manipulation
Sum 4:
3.
NET PRESENT VALUE (NPV)
The key investment appraisal method, it incorporates the time value of money in calculating an
absolute value of the project. It is called the Net present value because there will be a range of
outflows and inflows in the typical investment.
Decision criteria:
If the investment has a positive NPV, then the project will increase the wealth of the company by
the amount of the NPV at the current cost of capital.
Advantages:
i. A project with a positive NPV increase the wealth of the company’s, thus maximise the
shareholders wealth
ii. Takes into account the time value of money and therefore the opportunity cost of capital
iii. Discount rate can be adjusted to take account of different levels of inherent in different
projects
iv.
Unlike the payback period, the NPV takes into account events throughout the life of the
project.
v. Superior to the internals rate of return because it does not suffer the problem of multiple
rates of return
vi.
Better than accounting rate of return because it focuses on cash flows rather than profit
vii.
NPV technique can be combined with sensitivity analysis to quantify the risk of the
project’s result
viii. It can be used to determine the optimum policy for asset replacement
Disadvantages:
i. NPV assumes that firms pursue an objective of maximizing the wealth of their shareholders
ii. Determination of the correct discount rate can be difficult
iii. Non-financial managers may have difficulty understanding the concept
iv.
The speed of the repayment of the original investment is not highlighted
v. The cash flow figures are estimates and may turn out to be incorrect
vi.
NPV assumes cash flows occur at the beginning or end of the year and is not a technique
that s easily used when complicated, mid-period cash flows are present
Format (assuming 3-year project)
0
Revenue
Costs: VC/FC
Operating profit
Tax:
Same year
Arrears
Tax saved on depreciation
Investment
Scrap value
Working capital
Free
cash
flow(ready
discounting)
DF @ rate
PV
Sum 6:
2
X
(X)
X
3
X
(X)
X
X
X
X
(X)
X
X
(X)
(X)
(X)
for
(X)
(X)
(X)
X
(X)
X
X
X
X
(X)
X
X
X
Σ𝑃𝑉𝑠 = 𝑁𝑃𝑉
Sum 5:
1
X
(X)
X
4
X
4. INTERNAL RATE OF RETURN (IRR)
The rate of return at which NPV is zero.
Decision Criteria:
If the IRR is greater than the cost of capital, accept the project.
IRR=
L+
NL
NL-NH
x
(H-L)
Sum8: A project costing $1,000 will return $1,160 in the following year. Calculate IRR at 10%
and 20% discount rates.
Advantages:
i.
Recognises time value of money
ii. Based on cash flows, not accounting profits
iii. More easily understood than NPV by non-accountant being a percentage return on
investment
iv.
For accept/reject decisions on individual projects, the IRR method will reach the same
decision as the NPV method
Disadvantages:
i.
Does not indicate the size of the investment, thus the risk involved in the investment
ii.
Assumes that earnings throughout the period of the investment are re-invested at the
same rate of return
iii. It can give conflicting signals with mutually exclusive projects
iv.
If a project has irregular cash flows, there is more than one IRR for that project
v.
Is confused with accounting rate of return