Capital Budgeting: Tools and Techniques On Corporate Finance and Corporate Government Sector Maria Ella T. Betos MAE 630: Managerial Economics

Capital Budgeting: Capital Budgeting: Tools and TechniquesTools and Techniques

Capital Budgeting: Capital Budgeting: Tools and TechniquesTools and Techniques

On Corporate Finance and Corporate Government

Sector

Maria Ella T. BetosMAE 630: Managerial

Economics

Discussion Proper:Discussion Proper:Overview and Process of Capital Budgeting

DecisionsProjected Cashflows – Cost of Investment

ComputationPayback Period and Discounted Payback

PeriodAccounting Rate of ReturnProfitability Index – Benefit-Cost AnalysisNet Present ValueInternal Rate of ReturnSample Problems and Cases

Overview of Capital Budgeting, its Decisions and Process

Overview of Capital Budgeting, its Decisions and Process Capital Budgeting – process of identifying, evaluating,

and implementing a firm’s investment opportunities The process of making long-term planning decisions

for investments (Investment Decisions – Selection decisions concerning projects and Replacement Decision)

The profitability of a firm is affected to the greatest extent by the success of its management in making capital budget investment decisions

A fixed-asset decision will be sound only if it produces a stream of future cash inflows that earns the firm an acceptable rate of return on its invested capital.


Overview of Capital Budgeting, its Decisions and ProcessCapital budgeting decisions involve mutually

exclusive or independent projects. Mutually exclusive projects

- two or more machines that perform the same function may be available from competing suppliers, possibly at different costs and with different expected cash benefits

Independent projects- Project not in direct competition with one

another- They are to be evaluated based on their

expected effect on shareholder wealth


Overview of Capital Budgeting, its Decisions and ProcessCapital Budgeting Processes: Identification stage – involves finding potential capital

investment opportunities and identifying whether a project involves a replacement decision and/or revenue expansion

Development stage – requires estimating relevant cash inflows and outflows

Selection stage – involves applying the appropriate capital budgeting techniques to help make a final accept or reject decision

Implementation stage – projects that are accepted must be executed in a timely fashion

Follow-up – a stage in the capital budgeting process during which managers track, review, or audit a project’s results.

Major Categories of Cash Flows Initial cash outflow -- the initial net

cash investment. Operating cash flows -- those net

cash flows occurring after the initial cash investment but not including the final period’s cash flow.

Projected Cash Flows ComputationProjected Cash Flows Computation

Initial Cash Outflowa) Cost of “new” assetsb) + Capitalized expendituresc) + (-) Increased (decreased)

NWCd) - Net proceeds from sale of

“old” asset(s) if replacemente) + (-) Taxes (savings) due to the

sale of “old” asset(s) if replacement

f) = Initial cash outflow

Operating Cash Flowsa) Operating Revenueb) (- )Operating Expensec) (-) Increase in net working capitald) (-) Depreciatione) = Taxable Incomef) (-) Income Taxesg) (=) Net Incomeh) (+) Depreciationi) (=) Operating Cash Flow

Example for Initial Cash Outflow Computation

Basket Wonders (BW) is considering the purchase of a new basket weaving machine. The machine will cost $50,000 plus $20,000 for shipping and installation and has 3-year useful life. NWC will rise by $5,000. Management forecasts indicates that revenues will increase by $110,000 for each of the next 4 years and will then be sold (scrapped) for $10,000 at the end of the fourth year, when the project ends. Operating costs will rise by $70,000 for each of the next four years. BW is in the 40% tax bracket.

Initial Cash Outflowa) $50,000b) + 20,000c) + 5,000d) - 0 (not a

replacement)e) + (-) 0 (not a

replacement)f) = $75,000*

* Note that we have calculated this value as a “positive” because it is a cash OUTFLOW (negative).

We plan on purchasing a new assembly machine for $25,000.. It will cost $2,000 to have the new machine installed and we expect a $ 1,000 net increase in working capital. By making the investment, we will reduce our annual operating costs by $ 7,000 and we expect to save $ 500 a year in maintenance. The new machine will require $ 750 each year for technical support. We will depreciate the machine over 5 years under the straight-line method of depreciation with an expected salvage value of $ 5,000. The effective tax rate is 35%.

Example for Operating Cash flowExample for Operating Cash flow

Operating Cash Flowsa) Annual Savings in Operating Costs $ 7,000b) Annual Savings in Maintenance 500c) Annual Costs for Technical Support (750)d) Annual Depreciation (4,000) *e) Revenues $ 2,750f) Taxes @ 35% (962)g) Net Project Income 1,788h) Add Back Depreciation 4,000i) Operating Cash Flow $ 5,788* $ 25,000 - $ 5,000 / 5 years = $ 4,000

It refers to the length of time the firm can recover its initial investment in a project.

The management will choose the projects whose paybacks are less than a management-specific period.

Payback period is computed by dividing the initial investment by the cash inflows in the case of annuity; for a mixed stream, the yearly cash inflows must be accumulated until the initial investment is covered.

Payback PeriodPayback Period

PAYBACK PERIOD = INITIAL INVESTMENT ANNUAL CASH INFLOW


EXAMPLE :Calculate the firm’s payback period

assuming their initial investments and operating cash inflows are as follows:


Initial Investment Year

Php150, 000 Project X

Cash Inflows

1 Php40,000

2 Php40,000

3 Php40,000

4 Php40,000

5 Php40,000

PAYBACK PERIOD FOR Project XPP = Initial Investment

Cash Inflows

= 150,000 40,000

= 3.75 years of 3 years and 270 days


EXAMPLE :Calculate the firm’s payback period

assuming their initial investments and operating cash inflows are as follows:


Initial Investment Year

Php200, 000 Project Y

Cash Inflows

1 Php40,000

2 Php45,000

3 Php50,000

4 Php55,000

5 Php60,000

PAYBACK PERIOD FOR Project Y


Initial Investment

Year

Cost of Investment

Net Annual Cash Flow

Cumulative Net Cash

Flow

0 Php200,000

1 Php40,000 Php40,000

2 Php45,000 Php85,000

3 Php50,000 Php135,000

4 Php55,000 Php190,000

5 Php60,000 Php250,000

PAYBACK PERIOD FOR Project Y

190,000 (cash inflows for 4 years)

+ 10,000/60,000 X 360 = 60 days

PBP = 4 years and 60 days


Payback Period does not consider time value of money when providing an answer whereas with Discounted Payback Period we get to see the real value of cash inflows when they are measured in today's amount of money as these are discounted at an interest rate called the Discount Rate

Discounted Payback Period is computed as follows:

Discounted Payback PeriodDiscounted Payback Period

Discounted PP = year before recovery +

Unrecovered cost at the start of the year

Initial cash flows during the year

EXAMPLE :For example, assume a machine

purchased for $5000 yields cash inflows of $5000, $4000, and $4000. The cost of capital is 10%.


Year Cash Inflows

PV Factor at

10%

PV of Cash

Inflow

1 Php5,000 0.909 Php4,545

2 Php4,000 0.826 Php3,304

3 Php4,000 0.751 Php3,004

SOLUTION:The payback period (without discounting

the future cash flows) is exactly 1 year. However, the discounted payback period is a little over 1 year because the first year discounted cash flow of $4545 is not enough to cover the initial investment of $5000.

The discounted payback period is 1.14 years (1 year + ($5000 - $4545)/$3304 = 1 year + .14 year).


Accounting Rate of Return calculates the return, generated from net income of the proposed capital investment

This doesn’t take into account the time value of money

If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment.

Accounting Rate of ReturnAccounting Rate of Return

The ARR is computed as follows:

DECISION CRITERIA:ARR > COI= ACCEPT THE PROJECTARR < COI = REJECT THE PROJECT


ARR =

Annual Cash Inflows - Depreciation

Average Investment

EXAMPLE: Let's say you're looking at equipment costing $7,500 that is expected to return roughly Php2,000 per year for five years. After five years you'll sell the equipment for Php500. The depreciation would be (Php7,500 - $500) ÷ 5, or Php1,400.


ARR =

Php2,000 – 1400= 8%

Php7,500

Also known as benefit-cost ratio, desirability index

It expresses the present value of cash benefits as to an amount per peso of investment in a project

It is also used as a measure of ranking projects in descending order of desirability

The formula is as follows:

Profitability IndexProfitability Index

Profitability Index =

Present Value of Net Cash Flows

Initial Investment

DECISION RULE: The higher the profitability index, the more desirable the project. Projects with index of less than 1 are rejected. Thus:

If PI > 1; ACCEPTIf PI < 1; REJECT


ILLUSTRATIONCompany XYZ has Php 200,000 funds available for investment. It is considering the following projects:


A B

PV of annual Cash inflows

Php244,000

Php130,000

Less Investment Required

Php200,000

Php100,000

Net PV Php44,000

Php30,000

COMPUTATIONProject A: Php 244,000 / 200,000 = 1.22Project B: 130,000 / 100,000 = 1.30

DECISION – The company should invest in Project B since it has higher profitability index than Project A


Net Present Value (NPV) is a sophisticated capital budgeting technique because it gives explicit consideration to the time value of money.

It is computed as:NPV = PV of Cash Inflows – Initial Investment

NPV=

∑CFt – CF0(1+r)t

Net Present ValueNet Present Value

The Decision CriteriaIf the NPV is greater than 0, accept the projectIf the NPV is less than 0, reject the project

If the NPV is greater than 0, the firm will earn a return greater than its cost of capital. Such action should enhance the market value of the firm and therefore the wealth of its owners.

Net Present Value Net Present Value

ILLUSTRATION:Marga Company, a medium sized metal

fabricator is currently contemplating two projects. Project A requires an initial investment of 42,000 and Project B an initial investment of 45,000. The projected relevant operating cash inflows for the two projects are as follows:


Project A Project B

Initial Investment

Php42,000 Php45,000

Year Operating Cash Inflows (PV Factor at 10%)

1 Php14,000 Php28,000

2 Php14,000 Php12,000

3 Php14,000 Php10,000

4 Php14,000 Php10,000

5 Php14,000 Php10,000


Project A Project B

Total Cash Inflows

Php70, 000 Php70,000

PV of Inflows at

10%

Php14,000 x 3.791 = Php53, 071

(Php28,000 x 0.909)+

(Php12,000 x 0.826)+ (Php10,000

x 0.751)+(Php10,000 x

0.683)+(Php10,000 x 0.621)

= Php55,924

Initial Investmen

t Php42,000 Php45,000

Net Present Value

Php11,071 Php10,924

Net Present ValueNet Present ValueNet Present ValueNet Present Value

The calculations results in net present value for projects A and B of 11,071 and 10,924, respectively.

Both projects are acceptable because the net present value of each is greater than 0. If the projects were being ranked, however, project A would be considered superior to B, because it has a higher net present value than that of B.


The internal rate of return method differs from the Net Present Value method in that it finds the interest yield of the potential investment

Sometimes known as the Economic Rate of Return

The internal rate of return is the discount rate that makes the net present value of all cash flows from a particular project equal to zero

Internal Rate of ReturnInternal Rate of Return

FORMULA:


IRR= Lower Rate +

NPV at lower rate x (Higher

rate – Lower rate)

NPV at lower rate – NPV at higher rate

Initial Cost of Investment =

CF1+

CF2+

CF3+

CFn

(1+irr)1

(1+irr)2

(1+irr)3

(1+irr)n

PV factor at the number of periods at

IRR=

Initial Cost of Investment

Equal Cash Inflows

EXAMPLE:A company is considering to purchase an

equipment at a cost of Php244,371. Net annual cash flows for this equipment is estimated to be Php100, 000 for three years. To determine for the IRR, look for the PV factor first:

*the factor of 2.4437 is the PV factor of annuity of 1 at 11%


PV factor at the number of periods at IRR

=Php244,371

=2.443

7Php100,000

EXAMPLE:Ella Company, is currently

contemplating on a project. Project A requires an initial investment of Php52,000. The projected relevant operating cash inflows for the term of five years is equal to Php14000. What is the internal rate of return?


Using the rate of 10%, the PV factor of annuity of 1 is 3.7908; whereas using the rate of 11%, the PV factor of annuity of 1 is 3.6959

The NPV at 10% is equal to Php1, 071.01 while the NPV at 11% is (Php257.44). To interpolate for the IRR:


Rate NPV

11% (Php257.44)

IRR 0

10% Php1,071

Internal Rate of ReturnInternal Rate of ReturnSOLUTION:

IRR= Lower Rate +

NPV at lower rate x (Higher

rate – Lower rate)

NPV at lower rate – NPV at higher rate

IRR= 10% +

1,071.01x (11% –

10%)(1,071.01 – (257.44))

IRR= 10% +

1,071.01x

1%=10% + 0.81% x 1 =

10.81%1328.46

Official Development Assistance - Assistance being provided or granted

by a foreign government/multilateral agency, which is usually a developed country, to another nation, which is categorized as a developing country.

Corporate Finance and Corporate Government Sector


KEY TERMS:Profitability – ability to gainSustainability – ability to stand on

the long termServiceability – ability to “service”

the benefits to the end-users



Documents

Capital Budgeting: Tools and Techniques On Corporate Finance and Corporate Government Sector Maria Ella T. Betos MAE 630: Managerial Economics