Capital Budgeting is Vital in Marketing Decisions

8/13/2019 Capital Budgeting is Vital in Marketing Decisions

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Capital budgeting is vital in marketing decisions. Decisions on investment, which take time to mature, haveto be based on the returns which that investment will make. Unless the project is for social reasons only, ifthe investment is unprofitable in the long run, it is unwise to invest in it now.

Often, it would be good to know what the present value of the future investment is, or how long it will taketo mature (give returns . !t could be much more profitable putting the planned investment money in thebank and earning interest, or investing in an alternative project.

"ypical investment decisions include the decision to build another grain silo, cotton gin or cold store orinvest in a new distribution depot. #t a lower level, marketers may wish to evaluate whether to spend moreon advertising or increase the sales force, although it is difficult to measure the sales to advertising ratio.

Chapter objectives"his chapter is intended to provide$

% #n understanding of the importance of capital budgeting in marketing decision making% #n e&planation of the different types of investment project

% #n introduction to the economic evaluation of investment proposals

% "he importance of the concept and calculation of net present value and internal rate of return in decision

making

% "he advantages and disadvantages of the payback method as a techni'ue for initial screening of two ormore competing projects.

tructure of the chapterCapital budgeting is very obviously a vital activity in business. )ast sums of money can be easily wasted ifthe investment turns out to be wrong or uneconomic. "he subject matter is difficult to grasp by nature ofthe topic covered and also because of the mathematical content involved. *owever, it seeks to build on theconcept of the future value of money which may be spent now. !t does this by e&amining the techni'ues ofnet present value, internal rate of return and annuities. "he timing of cash flows are important in newinvestment decisions and so the chapter looks at this +payback+ concept. One problem which plaguesdeveloping countries is +inflation rates+ which can, in some cases, e&ceed -- per annum. "he chapterends by showing how marketers can take this in to account.

Capital budgeting versus current e&penditures# capital investment project can be distinguished from current e&penditures by two features$

a such projects are relatively largeb a significant period of time (more than one year elapses between the investment outlay and the receiptof the benefits..#s a result, most medium/si0ed and large organisations have developed special procedures and methods fordealing with these decisions. # systematic approach to capital budgeting implies$

a the formulation of long/term goalsb the creative search for and identification of new investment opportunities

c classification of projects and recognition of economically and1or statistically dependent proposals

d the estimation and forecasting of current and future cash flows

e a suitable administrative framework capable of transferring the re'uired information to the decision level

f the controlling of e&penditures and careful monitoring of crucial aspects of project e&ecution

g a set of decision rules which can differentiate acceptable from unacceptable alternatives is re'uired.

"he last point (g is crucial and this is the subject of later sections of the chapter.


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"he classification of investment projectsa 2y project si0e

mall projects may be approved by departmental managers. 3ore careful analysis and 2oard of Directors4approval is needed for large projects of, say, half a million dollars or more.

b 2y type of benefit to the firm

% an increase in cash flow% a decrease in risk% an indirect benefit (showers for workers, etc .c 2y degree of dependence

% mutually e&clusive projects (can e&ecute project # or 2, but not both% complementary projects$ taking project # increases the cash flow of project 2.% substitute projects$ taking project # decreases the cash flow of project 2.d 2y degree of statistical dependence

% 5ositive dependence% 6egative dependence% tatistical independence.e 2y type of cash flow

% Conventional cash flow$ only one change in the cash flow signe.g. /17777 or 71////, etc

% 6on/conventional cash flows$ more than one change in the cash flow sign,

e.g. 71/1777 or /171/17777, etc.

"he economic evaluation of investment proposals"he analysis stipulates a decision rule for$

! accepting or!! rejectinginvestment projects

"he time value of money

8ecall that the interaction of lenders with borrowers sets an e'uilibrium rate of interest. 2orrowing is onlyworthwhile if the return on the loan e&ceeds the cost of the borrowed funds. 9ending is only worthwhile ifthe return is at least e'ual to that which can be obtained from alternative opportunities in the same riskclass.

"he interest rate received by the lender is made up of$

i "he time value of money$ the receipt of money is preferred sooner rather than later. 3oney can be usedto earn more money. "he earlier the money is received, the greater the potential for increasing wealth."hus, to forego the use of money, you must get some compensation.ii "he risk of the capital sum not being repaid. "his uncertainty re'uires a premium as a hedge against therisk, hence the return must be commensurate with the risk being undertaken.

iii !nflation$ money may lose its purchasing power over time. "he lender must be compensated for thedeclining spending1purchasing power of money. !f the lender receives no compensation, he1she will beworse off when the loan is repaid than at the time of lending the money.


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a :uture values1compound interest

:uture value (:) is the value in dollars at some point in the future of one or more investments.

:) consists of$

i the original sum of money invested, andii the return in the form of interest."he general formula for computing :uture )alue is as follows$

:)n ; )o (l 7 r nwhere

)o is the initial sum investedr is the interest raten is the number of periods for which the investment is to receive interest."hus we can compute the future value of what )o will accumulate to in n years when it is compoundedannually at the same rate of r by using the above formula.

6ow attempt e&ercise hat is the future value of ? - invested at - at the end of A years@>e can derive the 5resent )alue (5) by using the formula$

:)n ; )o (! 7 r n

2y denoting )o by 5) we obtain$

:)n ; 5) (! 7 r n

by dividing both sides of the formula by (! 7 r n we derive$

8ationale for the formula$

#s you will see from the following e&ercise, given the alternative of earning - on his money, an individual(or firm should never offer (invest more than ? -.-- to obtain ? .-- with certainty at the end of theyear.

6ow attempt e&ercise hat is the 5) of ?


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where$

Ct ; the net cash receipt at the end of year t!o ; the initial investment outlayr ; the discount rate1the re'uired minimum rate of return on investment

n ; the project1investment4s duration in years."he discount factor r can be calculated using$

=&amples$

6.2. #t this point the tutor should introduce the net present value tables from any recognised publishedsource. Do that now.

Decision rule$

!f 65) is positive (7 $ accept the project!f 65) is negative(/ $ reject the project6ow attempt e&ercise


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5) ; ?G--(-.E-E 7 ?G--(-. B


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; ?H, A-

e "he internal rate of return (!88

8efer students to the tables in any recognised published source.

% "he !88 is the discount rate at which the 65) for a project e'uals 0ero. "his rate means that the presentvalue of the cash inflows for the project would e'ual the present value of its outflows.% "he !88 is the break/even discount rate.

% "he !88 is found by trial and error.

where r ; !88

!88 of an annuity$

where$

J (n,r is the discount factor!o is the initial outlayC is the uniform annual receipt (C ; CB ;....; Cn .=&ample$

>hat is the !88 of an e'ual annual income of ?B- per annum which accrues for H years and costs ? B-@

; hen deciding between two or more competing projects, the

usual decision is to accept the one with the shortest payback.

5ayback is often used as a +first screening method+. 2y this, we mean that when a capital investmentproject is being considered, the first 'uestion to ask is$ 4*ow long will it take to pay back its cost@4 "hecompany might have a target payback, and so it would reject a capital project unless its payback periodwere less than a certain number of years.

=&ample $

Fears-

B

G

A

5roject #,---,---

BA-,---BA-,---BA-,---BA-,---BA-,---

:or a project with e'ual annual receipts$

; G years

=&ample B$

Fears-

B

G

5roject 2/ -,---A,---B,A--G,---

,---

5ayback period lies between year B and year . um of money recovered by the end of the second year


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; ?H,A--, i.e. (?A,--- 7 ?B,A--um of money to be recovered by end of rd year

; ? -,--- / ?H,A--; ?B,A--

; B.


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% !t implicitly assumes stable cash receipts over time.

% !t is based on accounting profits and not cash flows. #ccounting profits are subject to a number of differentaccounting treatments.

% !t is a relative measure rather than an absolute measure and hence takes no account of the si0e of theinvestment.

% !t takes no account of the length of the project.

% it ignores the time value of money.

"he payback and #88 methods in practice

Despite the limitations of the payback method, it is the method most widely used in practice. "here are anumber of reasons for this$

% !t is a particularly useful approach for ranking projects where a firm faces li'uidity constraints and re'uiresfast repayment of investments.% !t is appropriate in situations where risky investments are made in uncertain markets that are subject tofast design and product changes or where future cash flows are particularly difficult to predict.

% "he method is often used in conjunction with 65) or !88 method and acts as a first screening device toidentify projects which are worthy of further investigation.

% it is easily understood by all levels of management .

% !t provides an important summary method$ how 'uickly will the initial investment be recouped@

6ow attempt e&ercise


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G,A--

Fear G9oss ,A--5rofit G,A--

=stimated scrap value at the end of Fear G

G,---G,---

Depreciation is charged on the straight line basis. 5roblem$

a Calculate the following for both proposals$

i the payback period to one decimal placeii the average rate of return on initial investment, to one decimal place.#llowing for inflation

o far, the effect of inflation has not been considered on the appraisal of capital investment proposals.!nflation is particularly important in developing countries as the rate of inflation tends to be rather high. #s

inflation rate increases, so will the minimum return re'uired by an investor. :or e&ample, one might behappy with a return of - with 0ero inflation, but if inflation was B- , one would e&pect a much greaterreturn.

=&ample$

eymer :arm is considering investing in a project with the following cash flows$

"!3=#C"U#9 C# * :9O>

P?

-( --,---

E-,---

B-,---

H-,---

eymer :arm re'uires a minimum return of G- under the present conditions. !nflation is currently runningat - a year, and this is e&pected to continue indefinitely. hould eymer :arm go ahead with the project@

9et us take a look at eymer :arm4s re'uired rate of return. !f it invested ? -,--- for one year on Qanuary, then on December it would re'uire a minimum return of ?G,---. >ith the initial investment of? -,---, the total value of the investment by December must increase to ? G,---. During the year, thepurchasing value of the dollar would fall due to inflation. >e can restate the amount received on December in terms of the purchasing power of the dollar at Qanuary as follows$


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#mount received on December in terms of the value of the dollar at Qanuary$

; ? -,HD! COU6" :#C"O85)

?G-?

-( A-,---

.---( --,---

E-,----.H G


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BA,G -

-,AG-

"he project has a positive net present value of ? -,AG-, so eymer :arm should go ahead with the project.

"he future cash flows can be re/e&pressed in terms of the value of the dollar at time - as follows, giveninflation at - a year$

"!3=#C"U#9 C# * :9O>C# * :9O> #" "!3= - 58!C= 9=)=9

?

?

-( --,---( --,---

E-,---

D! COU6" :#C"O85)

?H.


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( --,---


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groups of assets , but not of general price inflation. !t involves adjusting accounts to reflect the currentvalues of assets owned and used.

#t present, there is very little measure of agreement as to the best approach to the problem of 4accountingfor inflation4. 2oth these approaches are still being debated by the accountancy bodies.

6ow attempt e&ercise

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Capital Budgeting is Vital in Marketing Decisions