CHAPTER 8
CAPITAL
BUDGETING
Objectives

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At the end of the chapter, you should be able to;
 Understand the importance of the capital budgeting decision
 Understand why only cash flows matter
 Define the types of investment projects
 Apply the methods used to evaluate capital projects
 Set out the advantages and disadvantages of each method
 Understand why the Internal rate of return may result in a firm
choosing the wrong project
 Calculate a project’s modified internal rate of return
 Understand the relationship of Economic Value Added (EVA) and
net present value
 Determine the relevant cash flows to be included in the analysis
 Include taxation and tax allowances and in the project cash flows
 Understand the role of Post-audits in capital budgeting
 Use Excel spreadsheets to solve applied Capital Budgeting problems
2
Outline


Types of Projects
Capital Budgeting Methods
 Net
Present Value
 Internal Rate of Return
 Payback and Discounted Payback
 Accounting Rate of Return
 Profitability Index (PV Index or Benefit-Cost Ratio)

Project Cash Flows
 Estimating
future cash flows
 Taxation
 Some
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
rules
Post-Audits
3
The Balance Sheet (Statement of
Financial Position)
Why did
Wesfarmers
invest in these
assets?
Capital Budgeting
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Why is the Capital Budgeting decision so
important for the firm?

The Balance Sheet

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Tactical and Strategic Investments
Consequences of Investment and non-investment

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
The Balance Sheet includes past capital budgeting decisions.
Over capacity resulting in high overheads
Under-capacity resulting in loss of market share
High operating costs
Loss of Flexibility - a large investment results in a company losing the
option to invest.
 Microsoft & Netscape - Microsoft had to change from stand alone
systems due to impact of the Internet
Timing
 Columbus steel plant
The focus should also be on Project Creation
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TYPES OF INVESTMENT
PROJECTS

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Replacement decisions
Expansion : existing product lines
Expansion : new product lines
Other (IT, Pollution control, Corporate social
investment)
Mutually Exclusive vs. Independent
Projects
Divisible and non-divisible projects
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Why use Cash Flows ?

Future benefits of the project
 Only

use Cash flows, not earnings
Accounting Earnings vs. Cash Flows
 Accounting
is based on the Matching Concept
 Cost and Depreciation
 Taxation - GAAP & Inventory Valuation

Tax is a cash flow and taxable income is based on the Accrual
Accounting Model
 Accounting
does not record opportunity costs; in Capital
Budgeting we include cash flows foregone.

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Performance Appraisal
 Yet
if Accounting results are used to measure management
performance, then Accounting may be relevant
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Corporate Social &
Infrastructural Investments

Types of “non-economic” projects
Environment
Human
Resources
Small Business
Community Investments
Information Technology


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
The relevance of DCF techniques
Materiality of Investments
References to Annual Financial Statements
8
Capital Budgeting Techniques
Net Present Value (NPV)
 Internal Rate of Return (IRR)
 Payback Period and Discounted
Payback
 Accounting Rate of Return
 Profitability Index (Benefitcost ratio)

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Net Present Value (NPV)

NPV = Future Cash flows discounted at the
cost of capital less the Cost of the Project
If NPV > 0, accept the project
If NPV < 0, reject the project
NPV Analysis - 2 year project
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Cost of Capital
20%
Year
0
1
2
Cash Flows
PV Factor 1/(1+r)t
Present Values
(10,000)
1.0000
(10,000)
8,000
0.8333
6,667
6,000
0.6944
4,167
NPV
833
10
Internal Rate of Return (IRR)

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IRR = Discount rate which makes the
Present value of the Project’s Future Cash
flows equal to the cost of the Project.
Year
0
1
2
Cash Flows
t
PV Factor 1/(1+r)
Present Values
(10,000)
1.0000
(10,000)
8,000
0.7863
6,290
6,000
0.6183
3,710
IRR
NPV
27.2%
0
10,000
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NPV Profile
How will NPV change with a change in the
discount rate?
NPV Profile
5,000
4,000
NPV
3,000
IRR
2,000
1,000
0
0%
-1,000
-2,000
3%
6%
9%
12
%
15
%
18
%
21
%
24
%
27
%
30
%
33
%
36
%
39
%
Discount rate
NPV
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NPV or IRR?


If we analyse the NPV Profile, a project with a
positive NPV will also have an IRR to the right of
the cost of capital. So the IRR and the NPV
methods will give the same answer. Is this always
so?
Assume Project A and B are alternative one year
investments. A firm can only select either A or B.
Year
0
Project A
Project B
(10,000)
(1,000)
NPV
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Cost of Capital
Project A
Project B
1
11,800
1,400
IRR
10%
727
273
18%
40%
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NPV or IRR?
Project A results in a higher NPV and
Project B results in a higher IRR. Which
project should be accepted?
 Always select the project with the higher
NPV. Why?
 The difference in costs should not affect the
decision unless the company is subject to
capital rationing. If markets are efficient,
the company should be able to always raise
finance at its cost of capital.

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What is wrong with IRR?
There could be more than one IRR for non-conventional projects.
Year
0
Project I
1
(200)
Cost of Capital
2
1,000
(1,000)
14%
NPV
IRR
IRR
(92)
38%
262%
NPV Profile of Non-conventional Project
50.00
440%
418%
396%
374%
352%
330%
308%
286%
264%
242%
220%
198%
176%
154%
132%
110%
88%
66%
44%
22%
0%
-
(50.00)
(100.00)
NPV
(150.00)
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(200.00)
(250.00)
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Payback Method


Projects are evaluated according to the number of years
that it takes to recover the cost of the investment from the
cash flows generated by the project.
The firm sets a required payback period, say 3 years.
Only projects with payback periods of less than 3 years
are accepted.
Year
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Project I
Project J
(12,000)
(12,000)
Payback I
Payback J
2.33
3.25
1
4,000
2,000
2
6,000
4,000
3
6,000
4,000
4
1,000
8,000
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What are the advantages and
disadvantages of Payback?
Advantages
Simple to calculate and understand
Widely used in practice
Risk indicator
 Disadvantages
Ignores cash flows after the payback
Ignores time value of money
Bias against long term projects

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Discounted Payback

Discounted Payback = time it takes so that the PV
of the project’s cash flows equals the cost of the
project.
Year
Project I
Project J
Cost of Capital
0
(12,000)
(12,000)
1
4,000
2,000
2
6,000
4,000
3
6,000
4,000
4
1,000
8,000
r = 15%
t
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If we discount each year by multiplying the cash flow by 1/1+r) , then the
present values of each year's cash flows are as follows;
Project I
(12,000)
3,478
4,537
3,945
572
Cumulative
11,960
Project J
(12,000)
1,739
3,025
2,630
4,574
Cumulative
11,968
The discounted payback of I is very close to 3 years and the discounted
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payback of J is very close to 4 years
Accounting Rate of Return
Accounting Rate of Return = Net
Income/Average book value.
 The average book value if the residual
value is zero, will be Cost/2
 Net income is after depreciation.
 Advantages and disadvantages of ARR

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Profitability Index (Benefit-Cost Ratio)
A project’s PI measures the return of a
project relative to cost
 PI = Present Value/Cost

 If
PI > 1 = Accept the project
 If PI < 1 = Reject the project
As NPV = PV - Cost, a PI greater than 1
means a positive NPV.
 When should we use the PI?
 If there is capital rationing and we wish to
maximise returns relative to the costs of a
projects.

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Economic Value Added (EVA)
How do we use EVA to evaluate projects?
 EVA = Net operating profit after tax (Invested Capital x Cost of Capital)
 Value of Project = Investment + PV of
future EVAs
 PV of future EVAs = project’s NPV

EVA
Net Book Value
0
1,100,000
EBIT (1-t)
Capital charge (Opening Book value x WACC)
EVA
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PV of EVAs = NPV
1
2
880,000
660,000
56,000
-165,000
-109,000
161,000
-132,000
29,000
3
440,000
161,000
-99,000
62,000
4
220,000
161,000
-66,000
95,000
5
161,000
-33,000
128,000
85,867
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Cash flows
Estimation of future cash flows
 After tax cash flows, therefore need to
consider the tax issues
 Beginning-of-project cash flows
Cost of project = cash outflow
What about depreciation?
Sale of existing equipment?
Working capital requirements?

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Tax Effects - Introduction
Depreciation deduction
Deduction from taxable income
 Adjustable Value [undeducted cost]
Cost less depreciation deductions to
date
 Effect on Cash Flow
Net operating income x (1-tax rate)
Deduction x tax rate

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Depreciation Methods
Diminishing Value method
=Opening value x 150%/Asset’s effective
life
 Prime Cost method
=Cost x 100%/Asset’s effective life

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Balancing Adjustments
Balancing adjustment
= selling price – adjustable value
If selling price > adjustable value, then this an
assessable balancing adjustment. Add to income.
If selling price < adjustable value, then the
difference is a deductible balancing adjustment.
Deduct from taxable income.
Capital gains do not apply to depreciating assets –
the difference between selling price and the
undeducted cost ( adjustable value) is a balancing
adjustment.

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Depreciation rates for Tax
purposes
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
The ATO has issued recommended effective
economic lives for various categories of assets

Effective life = number of years that company can use the
asset for a taxable purpose.
 Examples: Computers – 4 yrs, forklifts – 11 yrs pumps –
20 yrs, trucks (heavy haulage) – 5 yrs, lathes – 10 yrs
 Patent = 20 years
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Capital Gains Tax

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


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Companies are subject to Capital Gains Tax on
the the disposal of fixed assets.
If the sales price > cost, the difference will be
subject to CGT if the asset is NOT a depreciating
asset.
CGT = Selling price – base cost.
CGT may apply on the sale of land and other nondepreciating assets.
No inflation indexation, so inflationary gains may
be subject to tax.
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The effect of depreciation on cash
flow

Example: Cost = $800 000. Prime cost depreciation of
20% per year. What is the effect on cash flow?
Taxation
Net operating income
Less: decline in value (depreciation)
Assessable income
Tax charge
-
300,000
160,000 [800000 x 0.20]
140,000
42,000 [140000 x 0.30]
The net cash flows would be determined as follows:
Net operating cash flow
Less: taxation
Net Cash flow
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-
300,000
42,000
258,000
28
Relevant revenues & costs - some rules.

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Only include Incremental cash flows
Use future after-tax cash flows
Ignore Sunk costs
Opportunity costs - foregone cash flows
Include the negative and positive effects of new product
lines on existing lines
Evaluate all alternatives
Ignore all Allocated costs
Ignore Financing charges, as this would amount to double
counting.
Working capital


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

Net incremental
Changes, not levels
Separate accounting from cash flows
Separation of the financing from the investment decision
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Working Capital
Income Statement
S A L ES
Expense
10000000
CO S T O F S A L E S
4500000
O P E N IN G S TO C K
0
P URCHA S E S
C L O S IN G S TO C K
G RO S S PRO F IT
6000000
-1 5 0 0 0 0 0
5500000
Cash out flow
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Working Capital
Investment in working capital changes accounting earnings to cash flows
From Accounting
Year
0
1
2
Sales
12,000.00
12,000.00
Cost of Sales
Opening inventory
Purchases
Closing inventory
-8,000.00
-9,600.00
1,600.00
-8,000.00
-1,600.00
-8,000.00
1,600.00
4,000.00
4,000.00
12,000.00
-8,000.00
12,000.00
-8,000.00
4,000.00
4,000.00
Gross profit
To Cash flows
Sales
Cost of sales
Investment in inventory*
Investment in debtors#
-1,600.00
-2,000.00
-3,600.00
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* The investment in inventory is assumed to take place at the beginning of the project.
# The investment in debtors will occur in the first 60 days but is assumed to take place at
the beginning of the project.
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Inventory
Sometimes future inventory levels are stated as a percentage of
sales. The cash flows are represented as changes in the inventory
levels.
Inventory as a percentage of Sales
1
Sales
Inventory
Cash flow
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R000s
10%
2
3
15,000
18,000
9,000
1,500
1,800
900
(1,500)
(300)
900
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Post Audits

What are post audits?
 Formal
assessment and comparison of actual returns
achieved for specific projects as compared to projected
returns.

Advantages
 Lessons
for management. Identify critical factors and
ensures focus on achieving projected cash flows

Disadvantages
 Sponsors
may reduce investments due to personal risks
 Difficulties in separation of project cash flows from
other business investments
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Modified Internal rate of Return
(MIRR)
Year
Project E
Project F
E
F
Cost of Capital
IRR
IRR
0
1
2
-100.00
-100.00
20.00
80.00
20.00
50.00
3 Total
100.00 140.00
10.00 140.00
14.2%
26.0%
10.0%
If we compare IRRs than the second project is much
more attractive and would be selected. However,
comparing IRRs may overstate the return as the IRR
method assumes reinvestment at the IRR. This may be
an unreasonable assumption.
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MIRR
What happens if we assume that cashflows are reinvested at the cost of capital?
Reinvestment at Cost of Capital
Project E
0
1
2
3
-100.00
20.00
20.00
100.00
24.20
22.00
146.20
80.00
50.00
10.00
96.80
55.00
161.80
0
0
0
0
146.20
161.80
-100.00
Project F
-100.00
-100.00
Project E
Project F
E
F
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-100.00
-100.00
MIRR
MIRR
13.5%
17.4%
If we assume reinvestment at the cost of capital, then
the relative return of the second project is reduced
significantly. As this project has significant cash flows
early on, changing the reinvestment assumption can
make a large difference to the expected return.
35
Modified Internal Rate of Return
(MIRR)
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

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NPV - assumes reinvestment at the cost of capital
IRR - assumes reinvestment at the IRR
MIRR - Assume a reinvestment rate until end of
project
MIRR = Rate that causes PV of the terminal value
to equal PV of cash outflows
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