Presented by: Erika Rossouw
erika.rossouw@wits.ac.za
FNB140
1
Agenda
1. Capital budgeting in context
2. Capital budgeting: Basic tools
3. Relevant cash flows and tax implications
4. Inflation, economic lives and capital rationing
5. Optimal economic lives and replacement decisions
6. Real options
7. Other practical issues
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Resources
• Capital budgeting week 1 lecture slides
• Textbook – Financial Management, Ninth edition, Carlos
Correia: Chapters 8 and 9
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Part 1: Capital budgeting in context
4
Objectives
At the end of this section, you should be able to:
Understand why the capital budgeting decision is critical for
the firm
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Objective of financial management
Maximise the value of the firm
Investment
decision
The return should
reflect the size and
the timing of the cash
flows (and consider
side effects/qualitative
considerations)
Discount rate should
reflect the risk of the
investment and the
mix of debt and equity
used to fund it
Financing
decision
Optimal mix of debt
and equity maximises
firm value
Right use of debt
means maturity
matches the lifetime
of your assets
Dividend
decision
Cash returned is
dependant on current
and potential
investment
opportunities
Method of returning
cash depends on
owners preferences
(dividends or share
buy-backs)
Source: Aswath Damodaran
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Some extra
context:
KIO
What is Capital Budgeting?
• Analysis and evaluation of investment projects that normally produce benefits over a number
of years
• Future success can depend on current investment decision. (Tie in to strategy)
• Evaluated over a number of years, therefore TVM skills are required.
• Evaluation is critically important because:
• Scale (KIO with R6.2bn)
• Over investment = higher costs, drain on cash flow
• Under investment = loss of market share, declining capacity
• Impact on flexibility (once a decision has been made you may be committed for a number of years)
• Timing (anticipate increases in demand and when to expand, anticipate competitors reactions)
• It impacts on the future performance of the business
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Reflection
Refer to the details of Kumba Iron Ore’s capital investments:
What do you think the mix of the investment to expand vs investment
to maintain indicates? Is this company specific/Industry driven/both?
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Reflection answers
• Kumba is spending approx. R1 bn more on maintenance.
• This indicates a focus on optimising current assets rather than expanding
• In Kumba’s case they are most likely maintaining existing mines and heavy equipment as
a priority and then expanding mines and opening new mines when it makes sense.
• Part of the Capital investments made by businesses would be industry specific, if an
industry is booming you would expect expansionary capex to increase. Also depends on
how capital intensive an industry is. Businesses would have slightly different approaches
within the industry but you would expect to notice a trend.
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Recap
• Important analysis as it impacts future performance of the
business
• Making the correct decision is important as there is a lot
at stake (under vs over investment)
• Control the controllables
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Part 2: Basic tools
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Objectives
At the end of this section, you should be able to:
Apply and explain the techniques used to evaluate capital
projects.
Understand the relative advantages and disadvantages of
each technique.
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Tools
• Methods that we use to analyse or evaluate an investment
opportunity
• Be aware of the underlying assumptions implied by each method
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What’s in the toolbox?
• Net Present Value (NPV)
• Internal Rate of Return (IRR) & Modified Internal Rate of Return
(MIRR)
• Payback period & Discounted Payback period
• Accounting rate of return
• Profitability Index
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NPV & IRR
• TVM techniques
• Understand the relationship
• IRR = WACC when NPV = 0
• IRR>WACC when NPV>0, IRR<WACC when NPV<0
• NPV: Accept project when NPV>0
• IRR: Accept project when IRR>WACC
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Do you see that both of
these are different ways
of saying the same thing?
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NPV & IRR
• What if the NPV and IRR contradict one another?
Scenario 1 Project A Project B
Year 0
Year 1
Year 2
Year 3
Year 4
NPV at
10%
IRR
-50 000
25 000
20 000
20 000
15 000
-50 000
0
8 000
25 000
65 000
14 527,7
19 790,3
24,0%
20,9%
Scenario 2
Project A
Project B
Year 0
-50 000
-10 000
Year 1
25 000
2 000
Year 2
20 000
8 000
Year 3
20 000
7 000
Year 4
15 000
5 000
NPV at 10%
14 527,7
7 104,0
IRR
24,0%
36,2%
• NPV/IRR assumptions, cash flow profile, divisibility/upscaling of projects
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MIRR
• IRR assumes that cash flows are reinvested at the IRR
• This assumption is often unrealistic
• MIRR allows us to circumvent this by setting a reinvestment rate.
• In Excel = MIRR(values, finance rate, reinvest rate)
• Manual calculation = done in 3rd year = revise.
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Payback Period
• Time to recover the cost of the investment from the cash flows generated by the project.
• Can give a basic indication of risk as it indicates how long the funds are at risk
• Downfalls: Ignores cash flows after payback and no TVM!
• Discounted payback: Same principle but discount cash flows at WACC (Only eliminates one downfall)
• Short payback does not mean that value is created
Annuity cash flows (Investment/cash flow)
Irregular cash flows
Project investment = 150 000
year 1
year 2
30 000
25 000
year 3
year 4
37 000
35 000
year 5
40 000
Payback period = 4.575 years
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Accounting rate of return
• 𝐴𝐴𝐴𝐴𝐴𝐴 =
• 𝐴𝐴𝐴𝐴𝐴𝐴 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖
• Management bias when performance is evaluated on basis of ROI
• Reluctant to replace assets when needed due to higher book values
• No TVM incorporated; not cash flows; use book values only; no risk measurement
• ARR < TARGET ROI might result in rejection despite positive NPV – ROI is arbitrary
benchmark. May also prefer short-term projects with higher initial returns
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Reflection
Based on the advantages and disadvantages that we have learnt about
each of these tools, identify scenarios when a specific tool would be most
helpful.
• Consider complexity of tool, shortcomings etc
• Most importantly a number of tools should be used, should not be overly
reliant on one tool
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Recap
• These are just tools, need to understand what they
represent
• Better to have required return taken into account
• Interpretation is vital
• Control the controllables
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Part 3: Relevant cash flows and tax
considerations
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Objectives
At the end of this section, you should be able to:
Understand importance of cash flows rather than
accounting earnings in the evaluation of investment
projects
Understand and calculate the impact of tax and tax
allowances on the investment decision (including the
impact of tax losses)
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Cash is king
• Relevant cash flows only (inflows and outflows)
• Incremental
• Including opportunity costs
• After-tax
• Ignore sunk costs
• Ignore allocated costs (not relevant)
• Ignore financing charges (do not double count)
• Working capital (incremental and then the changes over the project)
• Categories of cash flows (beginning of project, operating cash flows, end of project, tax)
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Working capital
• Important cash flow implications
• Incremental investment in working capital (beginning-of-project cash flow)
• Changes in working capital are relevant to annual operating cash flow
• End-of-project cash flows – is working capital recouped?
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Taxation
“Only two certainties in life: death and taxes” Benjamin Franklin
• Taxation implications are pervasive to all capital budgeting decisions and
influence all the other categories of cash flows
• Often has a lot of strategic importance
• Best practice to conduct a separate calculation:
• Enables the impact of capital allowances to be considered
• Can consider if project is in a tax paying position – Assessed losses
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Capital allowances
• Tax implications can be significant (why structuring is given so much attention)
• Consider 2 machines that both cost R1m and expect to generate incremental
cash flows before tax of R350k for 10 years. Assume a WACC of 14%
• After tax cash flow = R252k (assuming 28% tax rate)
• PV of cash flows = R1.314m*, therefore NPV R314k
• THIS ASSUMES NO CAPITAL ALLOWANCES
• * I = 14%, PMT = 252k, n=10
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Capital allowances (ctd.)
• If one of the machines qualifies for a 10% tax deduction of cost per year.
• Remember to think about other capital allowances (S12C etc..)
• Does the NPV change?
• Yes, the after-tax cash flows will be impacted.
• NPV increases to R460k
• Value of capital allowance = R0.46m – R0.314m = R0.146m
• Calculated differently = R0.1m x 28% = R0.028m x 5.22 (PVAF) = R0.146m
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Capital allowances (ctd.)
• Remember to think through all of the tax consequences…
• If asset that qualified for deductions/capital allowances is sold then it may be
subject to a recoupment upon sale.
• Be aware of interactions between current and future tax effects and the
opportunity costs associated (sale of assets).
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Capital allowances (ctd.)
• What are the cash flow and tax effects of the following:
• Planning to replace Equipment
• Current tax value = R8m
• Cost = R20m, purchased three years ago
• Qualifies for allowance of 20% per year
• Market value = R11m
• Remaining economic life = 5 years, residual value = R4.5m
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Capital allowances (ctd.)
All amounts are in R'000
Sale
Opportunity cost: Sale in year 5
Tax effect at 28% (W1)
Total net cash flows
W1: Taxation
Recoupment on sale (W2)
Opportunity cost: Loss of future
capital allowance (R20m x 20%)
Opportunity cost: Recoupment
avoided (W3)
Net effect on taxable income
Tax effect at 28%
W2: Tax impact: Sale in year 0
Sales proceeds
Tax value on date of sale
Recoupment
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Year 0 Year 1
11 000
Year 2
(1 960) (1 120 )
11 000 (1 960) (1 120 )
Year 3
Year 4
Year 5
-
(4 500)
- 1 260
- (3 240 )
-
-
Decision to sell
results in opportunity
costs that must be
factored in
3 000
4 000
11 000
(8 000)
3 000
7 000
(1 960)
4 000
4 000
(1 120)
-
-
(4 500)
- (4 500)
- 1 260
W3: Tax impact: Sale in year 5
Sales proceeds
4 500
Tax value on date of sale
Recoupment
4 500
Tax implications of
opportunity costs
must also be taken
into account (lost
capital allowances
and recoupment)
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Assessed losses
• Determine if the assessed loss is relevant to the project (will it be utilised
whether or not the project is accepted?)
• If it is not relevant ignore it!
• Utilisation of an assessed loss has value so this must be incorporated into the
analysis (think deferred tax assets)
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Assessed losses example
• Specific utilisation (will it be utilised faster/sooner?)
• X ltd has existing assessed loss of R9m, currently earning R3m before tax.
• New project will increase before tax-earnings by R1.5m. Tax rate = 28%
All amounts are in R’000
Utilisation of tax loss without the new project
Year 1
3 000
Year 2
3 000
Year 3
3 000
Utilisation of tax loss with the new project
4 500
4 500
0
Earlier usage of tax loss
1 500
1 500
- 3 000
Year 0
Year 1
420
Year 2
420
0
124,6
420
420
Year 3
0
-840
-840
All amounts are in R’000
Cash flows (benefit) from tax loss usage
Opportunity cost - assessed loss utilised earlier
Cash flows from tax loss
NPV of cash flows from tax loss at WACC 14%
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Year 0
New project
results in
FASTER
utilisation of tax
loss.
R1,5m x 28%
R3,0m x 28%
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Assessed losses
• No change in utilising the assessed loss – ignore as it’s irrelevant
• Faster utilisation – incorporate the benefits as well as the opportunity cost at a later stage
• Company has an assessed loss and no other income – no opportunity cost. No tax
implications until assessed loss is fully utilised.
• Project creates a tax loss with no ringfencing and entity has other profits – include the tax
savings owing to acceptance of project.
• Project creates a tax loss with ringfencing in place. Carry forward losses until project can fully
utilise them.
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Recap
• Relevant cash flows, including opportunity costs
• Tax is a significant component of the project’s return,
rather do a separate calculation
• Assessed losses have value!
• Control the controllables
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Part 4: Inflation, economic lives
and capital rationing
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Objectives
At the end of this section, you should be able to:
Evaluate projects with unequal economic lives
Understand the effects of inflation on the capital budgeting
decision
Rank and evaluate projects under conditions of capital
rationing
Understand the relationship between optimal economic
lives and abandonment values
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Comparing projects with unequal lives
• Only relevant if projects are mutually exclusive and repeatable
• Need to use replacement chains to build projects with comparable lengths
Project 1: 6 years
Project 2(1):
3 years
Project 2(2):
3 years
Replacement chain allows us to
assume we can repeat the
project with the same cash
flows to give us a comparison.
• Downfalls include – inflation (how does this impact the investment amount), technological advancement,
and doesn’t fully take flexibility benefits into account.
• Replacement chains assume a continuous replacement of projects until the entire length of the projects
is comparable (finding a common multiple)
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Comparing projects with unequal lives
• Alternative to replacement chains is Equivalent annual annuity (EAA) / Equivalent annual costs (EAC)
• Still assumes continuous replacement in future
• Principle is that this allows the NPV to be restated into an equivalent annuity, so the firm would be indifferent between
the NPV today or the annuity (annual cash flows over project’s life)
• Projects A and B are mutually exclusive. WACC = 12%
A
B
0
-100
-91.5
NPV A
NPV B
8.7
9.3
1
34
26
2
35
27
3
37
29
4
38
29
5
30
EAA (A) = 2.88
EAA (B) = 2.59
• NPV as PV, i = WACC, n = life of project and solve for PMT.
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Capital budgeting and inflation
• NPV is influenced by a company’s WACC
• WACC is a nominal discount rate as it is a required rate of return that includes expectations of inflation
• Nominal rate of return = M = (1+R)(1+i)-1
•
M = nominal rate of return
•
R = real rate of return
•
i = expected inflation rate
• Cash flows must be consistent with WACC – if cash flows are not adjusted for inflation a project’s NPV will be
understated.
• This creates an investment bias and companies will reject projects that should be accepted if they are assessed using
appropriate cash flows
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Capital rationing
• Generally a firm will accept all independent projects with NPV>0
• However if capital rationing is in place, the firm has a constraint and the returns must be maximised given this constraint
•
When capital rationing is in place even independent projects must be ranked
• First we must identify if the projects are divisible or indivisible
• Divisible projects may be split into a number of separate parts where each part is capable of being entered into
• Indivisible projects must be accepted entirely or not at all (purchasing a business)
• Divisible projects are ranked using the profitability index (PV of investment/cost) Note: PV not NPV (PV = NPV + Cost)
• Maximises NPV per R of investment
• Indivisible projects are ranked by finding the combination that maximises the sum of the NPV
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Capital rationing
• Capital limit of R50million
• Divisible projects:
Investment
Cost
NPV
Profitability index
A
20
7
1.35
B
30
8
1.27
C
25
9
1.36
D
27.5
8.5
1.31
• Should prioritise investment in C & A & 18% of D (to meet the limit of 50 million investment)
• Remember if no capital rationing and assuming they were all independent we would accept them all
• Indivisible projects (assume projects are indivisible)
Investment combo
A&B
A&C
A&D
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Cost
50
45
47.5
NPV
15
16
15.5
Cannot do B&C or B&D or C&D as all are
over the 50 million limit.
A&C maximise the NPV, would assume
that 5mil left over will earn return = WACC.
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Recap
• Make projects as comparable as possible
• Discount rate and cash flows must be consistent
• Capital rationing means we must maximise NPV per R of
investment
• Control the controllables
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Part 5: Optimal economic lives and
replacement decisions
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Abandonment value
• Decision to invest is only the first step
• Evaluation of the project needs to continue to decide if project should be abandoned or not
• Considering the abandonment value ensures that the project’s life can be optimised
• Abandonment value represents an opportunity cost of continuing with the project.
•
Assume a project with required rate of return of 12% with cash flows and abandonment values as follows:
R'millions
Cash flows
Abandonment value
year
0
-500
1
250
350
2
200
250
3
150
175
4
100
160
5
50
0
If project is abandoned at the end of the year –
i.e. only count the value for that particular year
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Abandonment value
Time period
NPV
5 years
NPV = 81.34
4 years
NPV = 154.65
3 years
NPV = 113.98
2 years
NPV = 81.95
1 year
NPV = 35.71
Refer to lecture
example excel
workbook for
more detail
• Therefore the optimal economic life of the project is 4 years.
• Essential to evaluate over the life of the project as the abandonment values
may change
• Particularly useful when there is an active market for used assets
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Replacement timing
• Abandonment values enable us to calculate optimal economic lives
• If projects are expected to continue indefinitely and the decision is rather
focused on when we replace capacity
• Transport industry: replacement of fleets of trucks
• As we own an asset maintenance costs increase each year and residual
values fall
• Therefore we can calculate an optimal replacement cycle by finding the point
with the lowest Equivalent annual cost (EAC)
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Replacement timing
• Assume an asset costs R20million. Residual value reduces by 10% p.a
• Maintenance costs are R2mil p.a and increase at 15% p.a.
• Required return of 14%
• What is the optimal replacement cycle? (I.e. find the point with the
lowest EAC)
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Replacement timing
EAC -replacement timing
R6 973
7000
6900
6800
R6 868
R6 800
R6 781
R6 716
6700
R6 713
R6 663
R6 638
R6 639
4
5
R6 665
6600
6500
6400
1
2
3
6
7
8
9
10
• Please refer to excel document for more details
• Optimal replacement when EAC is at its lowest
• Similar thought process as when comparing projects with different useful lives
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Recap
• Continuous evaluation of project to determine if it’s
worthwhile continuing
• Replacement is optimal when EAC is at it’s lowest
• Control the controllables
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Part 6: Real options
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Real options
• Real business decisions are complex
• Management must ensure that future options are considered when
making an investment decision
• This is typically evaluated through a qualitative assessment
• If possible it should be quantified
• Real NPV = NPV of original project + NPV of strategic options
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Real options
• Practically this can mean that option pricing is considered in order to
quantify the true NPV
• The most important implication is how this is treated in qualitative
assessment of investment opportunities
• Consider the effect of future decisions
• Consider the flexibility inherent in the project
• Many options relate to windfall gains which are difficult to anticipate
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Real options – examples
• Ability to abandon the project
• Flexible production processes – use of inputs and ability to produce different products
given the same inputs
• Ability to expand the project
• Demand higher than expected
• Ability to temporarily close down (when VC > Revenues)
• Ability to delay project
• Lease an asset with favourable cancellation clauses
• R&D costs often contain optionality
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Recap
• Real business decisions can be complex and include
hidden optionality
• Flexibility can create a real option
• Important to assess this qualitatively
• Control the controllables
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Part 7: Other practical issues
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Post audits
• Analysis of the outcome of a capital budgeting investment
• Evaluate if assumptions used were accurate and whether the outcome
was as expected
• These findings need to be incorporated into future capital budgeting
decisions to improve the decision making process
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Behavioural finance perspective
• We have just dealt with a number of ways to analyse how to make a
decision
• Be aware that as humans we are prone to cognitive biases which
impact our decision making ability
• By having awareness of some common biases you will hopefully be
able to avoid common errors and improve capital budgeting decisions
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Behavioural finance perspective
• Overconfidence and over-optimism
• Overconfidence leads to underestimating the range of possible outcomes
• Over-optimism leads to overstated cash flows (underestimated costs and
overestimated)
• Anchoring, availability and confirmation bias
• Anchoring means managers are unwilling to change estimates even as facts change
• Availability bias means an overreliance on only recent data (which may not give an
accurate indication of future conditions)
• Confirmation bias means managers will look for information that confirms their views
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Behavioural finance perspective
• Herding behaviour
• Follow the actions of other firms (South African offshore investments by listed companies)
• Loss aversion and sunk costs
• Sunk costs can influence decisions meaning that managers will continue to invest
• Loss aversion means that humans experience losses more severely than equivalent gains
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Recap
• Humans are involved and therefore the decision making
can still be faulty
• Refer to Correia 9-24 for a comprehensive list of how to
avoid some common cognitive biases.
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