AG215 Business Finance
Week 1 – Capital budgeting introduction
Issues for this week
• Capital budgeting
•
is a financial process used by companies to evaluate long-term investments or projects. It involves determining which projects are worth
pursuing by comparing the expected cash inflows and outflows associated with the investment.
• Recognising relevant cash flows
•
When evaluating an investment, it's important to consider the cash flows that are directly related to the project. This may involve
recognising the initial investment, operating cash flows, and terminal cash flows, while excluding irrelevant cash flows.
• Long-lived projects
•
Some projects have a long lifespan, and their financial evaluation needs to consider the cash flows over an extended period, often
many years. The time value of money is an essential concept in these evaluations.
• Equivalent annual cost (EAC)
•
•
The EAC is a way to express the cost of a project on an annual basis. It helps in comparing the costs of different projects with
varying lifespans or cash flow patterns.
Better explanation of this point in the next slide ->
• Recognising real options in investment projects
•
•
Real options refer to the flexibility a company has in making decisions during the life of a project. Just like financial options (e.g.,
stock options), real options allow a company to adapt to changing circumstances or make strategic decisions as the project
unfolds.
Better explanation of this point in the next slide ->
A simple NPV appraisal
(A simple example of a Net Present Value appraisal for two projects.)
• A Net Present Value (NPV) appraisal is a financial tool used to evaluate the profitability of an investment or project. In simple terms, it helps
you answer the question: "Is this investment or project worth it financially?"
•
Assume the following cash flow forecasts for projects A and B. The opportunity
cost of capital / discount rate is 10%.
Project
A
B
•
CF(yr0)
-2000
-1000
CF (yr.1)
400
900
CF (yr.2)
1000
400
CF (yr.3)
1600
200
Assumptions:
• Accounting profits equal cash flows
– This means that the cash flows mentioned are equivalent to the
accounting profits generated by these projects.
• Asset is depreciated straight line over project’s life — This suggests that the asset's
depreciation expense is evenly spread over the project's life. Go to next slide for a better explanation ->
• All cash flows occur at end of year — This implies that all cash inflows and outflows happen at the end
of each year.
Formula for calculating the Net Present Value (NPV)
NPV and opportunity cost of capital
NPV
N
Cn
NPV = - C0 + 
n
n=1 (1 + r )
NPV – Net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.
It's used to determine whether an investment is profitable or not. If NPV is positive, the investment is typically considered worthwhile; if it's negative, the
investment may not be a good choice. Go to next slide for better explanation and understanding ->
C0 – initial investment outlay – This is the initial cash outflow or investment required to start the project or investment. It's typically incurred at
time zero (year 0).
Cn – cash flow in year n – This is the cash flow generated or incurred at the end of year 'n' as a result of the project or investment. It can be either
positive (cash inflow) or negative (cash outflow) and typically represents the profit or cost associated with the project for that year. Go to next slide for better
explanation ->
r – opportunity cost of capital –
This is the discount rate or the rate of return required for an investor, to consider investing their capital in
this project or investment. It reflects the risk and time value of money.
Extra note on the formula - The formula is used to assess the profitability of projects or investments by determining whether the present value of
expected cash inflows is greater than the present value of the initial outlay.
What is NPV of project A?
1)
Change the opportunity
cost of capital from a
percentage to a decimal
to get the r value
2)
Find the denominator of
the fraction -> (1+r)
3)
Add everything into the
formula and solve.
Remember to add the
correct powers. Eg. Power
of 2 for year 2
What is NPV of project B?
Interpreting our results
•
Accept both projects
o
Both projects have positive NPVs, this indicates that they are expected to generate more value than their
initial investments. In this scenario, the recommendation is to accept both projects. This is often the ideal
situation because it maximises the use of available capital.
•
If choosing between projects, A is better
o
If you have to choose between two projects, the recommendation is to choose the project with the higher NPV
because it is expected to generate more value for the company.
The reason for this recommendation is that the project with the higher NPV is expected to result in higher profits
and a better return on investment.
o
•
If projects are mutually exclusive
o
In some cases, you may have to select between projects that are mutually exclusive, meaning you can only
undertake one of them due to limited resources or other limitations.
•
If capital is rationed
•
Capital rationing occurs when there are limitations on the total amount of capital available for investment.
Cash flows vs accounting income
- Accounting income is the profit a company retains after paying off all relevant expenses from sales revenue earned.
•
Differentiation of accounting profit from cash flows (Difference between accounting
profit and cash flows)
o
o
Accounting profit, as reported in financial statements, is different from actual cash flows.
While accounting profit represents revenue and expenses over a specific period, cash flows represent the actual cash coming into and
going out of a business. Go to next slide for better explanation and understanding ->
•
Accounting focus on periodic performance versus finance focus on cash coming in and cash going
out
o
Accounting focuses on measuring and reporting periodic performance, which includes recognising revenue and expenses when
transactions occur, even if cash hasn't exchanged hands. In contrast, finance places a stronger emphasis on the timing and
magnitude of cash flows, as it's concerned with the liquidity and solvency of a business. Go to slide after the next slide for better
explanation ->
•
Key issues for concern
•
Accounting depreciation of capital investment VS Initial cost of purchasing the asset
o
Accounting typically depreciates capital investments (e.g., machinery, buildings) over time, which affects
reported profit but doesn't reflect the actual cash outflow that occurred when the asset was purchased.
Finance considerations often focus on the initial cost of purchasing the asset, which is the actual cash flow. 3rd
slide after this one for better explanation ->
o
•
Accounting treatment of working capital
o
Accounting may not account for changes in working capital (current assets and liabilities) when recognising
profits, but these changes can significantly impact cash flows. Cash flow analysis considers the changes in
working capital as they represent cash movements. 4th slide after this one for better explanation ->
•
Calculating operating cash flows for project
•
Operating cash flows are crucial in financial analysis. These are the cash flows generated or used by the core operations
of a project or business and exclude financing activities.
This slide hints at the importance of accurately calculating these operating cash flows for project evaluation. 5th slide after
this one to understand this issue better ->
-
•
•
Calculating total cash flows
— This slide introduces the concept of calculating total cash flows for a project or investment. It
breaks down the calculation into three main components:
• Total cash flow =
o
The total cash flow is the net amount of cash that a project or investment generates or consumes over its lifespan. It represents the sum
of all cash movements associated with the project.
• Cash flows from capital investments +
o
o
This component represents the cash flows associated with the initial capital investment, including the purchase of assets,
equipment, or any other capital costs required to start the project. These cash flows are typically negative (outflows) in the early
years of the project due to the initial costs associated with acquiring assets.
This component includes the cash flows related to the initial capital investment outlay and any additional capital investments or
expenditures made during the life of the project. Capital investments typically involve the purchase of assets, such as machinery,
equipment, or real estate, and the associated cash outflows. (The same point in different words for better understanding)
• Cash flows from working capital +
o
Working capital refers to the capital used in a business’s day-to-day operations and includes current assets (e.g., accounts
receivable and inventory) and current liabilities (e.g., accounts payable). The cash flows from working capital account for the
changes in these current assets and liabilities as they relate to the project. For example, an increase in accounts receivable
represents cash invested in unpaid payments, while an increase in accounts payable means a reduction in cash outflow.
The net effect on working capital should be considered when calculating total cash flows.
Go to next slide for better
explanation
of this point.
• After-tax operating cash flow
o
This is a critical component of total cash flows and represents the cash generated by the core operations of the project after
accounting for operating expenses, taxes, and depreciation. After-tax operating cash flow is an indicator of the project's ability to
generate positive cash flow from its ongoing operations. It's important to consider the tax impact (taxes paid or saved) when
calculating this component.
Go to next slide for better understanding ->
Calculating after-tax operating CFs
– This slide discusses the process of calculating after-tax operating cash flows and highlights the challenges and
considerations involved in this calculation.
• Information used is typically provided by accountants
o
The information required to calculate after-tax operating cash flows is often derived from financial statements prepared by accountants. These financial statements, such
as income statements and balance sheets, provide data on revenues, expenses, and other financial activities.
•
Accountants focus on money earned rather than cash
o
Accountants primarily focus on recording revenue and expenses when they are earned or incurred, following accrual accounting principles, rather than focusing
on actual transactions/exchanges. This approach can lead to differences between accounting profits and actual cash flows because it may not account for the
timing of cash transactions/exchanges.
•
Need to adjust accounting profits to calculate actual operating cash flows
o
To calculate after-tax operating cash flows, adjustments are needed to convert accounting profits to actual cash flows. This involves accounting
for the timing of cash inflows and outflows, as well as the tax implications of different items.
Next slide for better understanding ->
• Non-cash expenses complicate the issue
•
Primarily depreciation of assets for accounting and tax purposes
o
o
o
Non-cash expenses are expenses that affect accounting profits but don't involve actual cash outflows.
The slide mentions depreciation as one of the primary non-cash expenses. Depreciation is a systematic allocation of the cost of an asset over its
useful life, but it doesn't involve the expenditure of cash.
To calculate actual cash flows, depreciation needs to be added back because it doesn't represent a cash cost.
o
Go to next slide for more/extra notes on this slide ->
Tax depreciation and Timing of tax
•
Tax depreciation ≠ accounting depreciation
• Rules of allowable tax depreciation specified by inland revenue or
equivalent
Tax Depreciation vs Accounting Depreciation
o
Tax Depreciation: Tax depreciation refers to the depreciation of assets for tax purposes. Tax
authorities, such as the Inland Revenue, provide specific rules and guidelines regarding allowable
tax depreciation. These rules dictate how a business can calculate depreciation expenses for tax
reporting. These rules may differ from accounting standards.
o
Accounting Depreciation: Accounting depreciation, on the other hand, is based on generally
accepted accounting principles (GAAP) and is used for financial reporting. It often follows different
methods, such as straight-line depreciation, to allocate the cost of assets over their useful lives.
Accounting depreciation is used to calculate expenses for profit and loss reporting.
Tax depreciation and Timing of tax
• Timing of tax payments relative to profits
• Tax paid 9 months after year-end for ‘small’ companies
o For "small" companies, taxes are often paid 9 months after the year-end.
 This means that the tax is paid relatively late compared to when the profits are recognised in the financial
statements.
 This provides these companies with more time to settle their tax liabilities.
• Paid on quarterly basis at ‘large’ companies
o “large" companies often make tax payments on a quarterly basis.
 This means they are making tax payments throughout the year as profits are earned.
 This means that they are required to make more frequent payments throughout the year.
• Common assumption in capital budgeting that tax is paid in year
during which it arises or one year later
o
In capital budgeting and financial analysis, it's common to make an assumption that taxes are paid
in the year during which they arise or one year later. This assumption simplifies the process of
aligning cash flows with associated profits when evaluating the financial viability of projects or
investments.
A simple example
• Mogga’s toy manufacturing is considering the purchase of a
new machine facility for £120,000. The facility is to be fully
depreciated on a straight-line basis for tax and accounting
purposes over its expected 6 year useful life and will have no
resale value in year 6. Assume tax is paid during the year in
which it arises and the corporate tax rate is 30%.
• Operating revenues from the project are expected to be
£50,000 in each year and production costs are expected to be
£20,000 in each year. Should the company undertake the
project if the opportunity cost of capital is 20%?
•
o
o
o
o
o
o
o
•
o
Given Information:
Mogga’s toy manufacturing is considering
the purchase of a new machine facility for
£120,000.
The facility is to be fully depreciated on a
straight-line basis for tax and accounting
purposes over its expected 6-year useful
life.
The facility will have no resale value in year
6.
The corporate tax rate is 30%, and tax is
paid during the year in which it arises.
Operating revenues from the project are
expected to be £50,000 in each year.
Production costs are expected to be
£20,000 in each year.
The opportunity cost of capital is 20%.
• Analysis:
o Depreciation: Since the facility is to be depreciated on
a straight-line basis over 6 years for both tax and
accounting purposes, you'll need to calculate the
annual depreciation expense. This will help determine
the taxable income, as tax depreciation affects the tax
liability.
o Operating Cash Flows: Calculate the operating cash
flows for each year by subtracting production costs and
depreciation expenses from operating revenues. These
represent the cash flows generated by the project's
core operations.
o Taxable Income: Calculate the taxable income for
each year. This involves taking the difference between
operating revenues and production costs and adjusting
for depreciation.
o Tax Payments: Calculate the tax payments for each
year based on the taxable income and the 30%
corporate tax rate.
o Net Cash Flows: Determine the net cash flows for
Should the Company Undertake the Project?
each year by subtracting tax payments from the
To make a decision, compare the NPV of the project to zero. If the
operating cash flows.
NPV is positive, it indicates that the project is expected to generate o NPV Calculation: Calculate the Net Present Value
a return greater than the opportunity cost of capital (20%).
(NPV) of the project by discounting the net cash flows
Therefore, it is financially viable and should be undertaken. If the
to their present value using the opportunity cost of
NPV is negative, it suggests that the project is not expected to
capital, which is 20% in this case.
generate a return higher than the opportunity cost of capital and,
therefore, should not be pursued.
Calculating net cash flows for this
project
Year
0
1
2
3
4
5
6
Revenues
50,000
50,000
50,000
50,000
50,000
50,000
Costs
-20,000
-20,000
-20,000
-20,000
-20,000
-20,000
Depreciation
-20,000
-20,000
-20,000
-20,000
-20,000
-20,000
Taxable Profit
10,000
10,000
10,000
10,000
10,000
10,000
Taxes
-3,000
-3,000
-3,000
-3,000
-3,000
-3,000
Add back
depreciation
20,000
20,000
20,000
20,000
20,000
20,000
After-tax operating
cash flow
27,000
27,000
27,000
27,000
27,000
27,000
27,000
27,000
27,000
27,000
27,000
27,000
Capital cost
-120,000
Free / Net cash flow
-120,000
Discount cash flows at cost of capital
Year
0
1
2
3
-120,000
27,000
27,000
27,000
27,000
27,000
27,000
Discount factor
1.0000
0.8333
0.6944
0.5787
0.4823
0.4019
0.3349
Present value
-120000
22500
18750
15625
Free / Net cash
flow
-30,211
Net cash flow
4
5
13020.83 10850.69
6
9042.25
• Project has a negative net present value
• Do not proceed with this project
• Solution presented uses net operating cash flow approach
Introduction to capital budgeting
• Identifying relevant / incremental cash flows
• Forecasting uncertain future cash flows
• General guidance
• Focus on incremental cash flows
• “With or without” analysis
• Focus on after-tax cash flows
• Be consistent in treatment for inflation
• How to deal with long-lived projects
Incremental cash flows
•
•
•
•
•
•
•
•
Investment
Sunk costs
Opportunity costs
Incidental cash flows
Corporate overhead allocations
Working capital
Abandonment costs
Taxes
Capital budget step 1 – tax
depreciation
Time
Machinery value
Tax depreciation
Resale value
0
1
2
3
4
5
£1,500,000 £1,200,000 £900,000 £600,000 £300,000
£300,000 £300,000 £300,000 £300,000 -£200,000
£500,000
• Annual charge is initial purchase price divided by five year
expected life of asset (not project lifetime, which is the same in
this case)
• Final year charge is difference between written down value and
resale value
• Can be negative (a tax gain) if asset is expected to be sold for more
Capital budget step 2 – income
statement
Time
0
Revenue
1
2
3
4
5
£1,250,000 £1,250,000 £1,250,000 £1,250,000 £1,250,000
Materials and labour
-£375,000
-£375,000
-£375,000
-£375,000
-£375,000
Other direct costs
-£150,000
-£150,000
-£150,000
-£150,000
-£150,000
Fixed costs
-£100,000
-£100,000
-£100,000
-£100,000
-£100,000
£0
£0
£0
£0
£0
-£75,000
-£75,000
-£75,000
-£75,000
-£75,000
-£300,000
-£300,000
-£300,000
-£300,000
+£200,000
Allocated overheads
Variable overheads
Tax depreciation
Tax gain - old machine
-£200,000
Taxable profit
-£200,000
£250,000
£250,000
£250,000
£250,000
£750,000
Taxes payable
£50,000
-£62,500
-£62,500
-£62,500
-£62,500
-£187,500
Capital budget step 3 – cash flow
schedule
Time
Revenue
Materials and labour
Other direct costs
Fixed costs
Allocated overheads
Variiable overheads
Taxes
Machinery - new
Machinery - old
Working capital
Net cash flows
Discount factors
Present value
NPV
0
1
2
3
4
5
£1,250,000 £1,250,000 £1,250,000 £1,250,000 £1,250,000
-£375,000 -£375,000 -£375,000 -£375,000 -£375,000
-£150,000 -£150,000 -£150,000 -£150,000 -£150,000
-£100,000 -£100,000 -£100,000 -£100,000 -£100,000
£0
£0
£0
£0
£0
-£75,000
-£75,000
-£75,000
-£75,000
-£75,000
£50,000
-£62,500
-£62,500
-£62,500
-£62,500 -£187,500
-£1,500,000
£500,000
-£200,000
-£50,000
£50,000
-£1,700,000
£487,500
£487,500
£487,500
£487,500
£912,500
1
0.9091
0.8264
0.7513
0.683
0.6209
-£1,700,000
£443,186
£402,870
£366,259
£332,963
£566,571
£411,849
Assumptions of analysis
• Tax and discount rates are constant across time
• The taxable loss at time zero can be written off against
other projects within the company
• No incidental effects on sales, costs, etc. for existing
projects
Week 1 – what you need to know
• Complete capital budgeting exercise
• Tax depreciation / capital allowances
• Straight line or reducing balance basis
• Income statement
• Cash flow schedule and NPV calculation
• Where students struggle / make mistakes
• Complete all three workings
• Depreciation / capital allowances are NEVER cash flows
• Value and timing of working capital