6.6 Capital Budgeting Techniques
Capital Budgeting is the process of identifying, evaluating and implementing a firm’s investment opportunities and the 4 approaches to capital budgeting are:
Capital Budgeting Techniques
There are several capital budgeting analysis methods that can be used to determine the economic feasibility of a capital investment.
- The Net Present Value (NPV) is found by subtracting the present value of the after-tax outflows from present value of the after-tax inflows
- The NPV represents the surplus funds (after funding the investment) earned on the project
- If the NPV is positive – the project is financially viable
- If the NPV is zero – the project breaks even
- If the NPV is negative – the project is not financially viable
- If the company has two or more mutually exclusive projects under consideration it should choose the one with the highest NPV
- The NPV gives the impact of the project on shareholder wealth
- NPV = t=1nCt(1+k)t – I
Ct = net cash flow at time t
I = cost of investment
k = cost of capital
You can assume that the target WACC is calculated at 12%. Required: Determine in which projects the management of Mabato should invest the R1 000 000.
The PV / Discount Factor is found by using table C at the back of the prescribed textbook. A calculator can be used by making use of the following formula:
PV Factor = 1(1+i)n i = interest and n = number of years
The project has a positive NPV and should be accepted as the shareholder’s wealth will be increased by the NPV amount.
Net Present Value
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
Assume Project T has a cost of R40m and results in equal cash flows of R20m for 3 years. The firms cost of capital is 18%.
The project NPV is:
NPV = (20m x PV Factor (annuity) – 40m)
= (20m x 2.1743) – 40m
= 43.49m – 40m
= 3.49m
Advantages
- This method recognises the time value of money
- It considers the cash inflow of the entire project
- The discount rate can be adjusted to take account of the riskiness of the investment or project
- It assumes that surplus cash inflows can be reinvested at the WACC
- The concept of WACC is difficult to understand
- The calculation of the WACC is complex and subject to interpretation
- The risk premium or discount that is added to the WACC can be manipulated by management
- The result of the discounted cash flows is a rand amount, rather than a rate (%) which makes it more difficult to interpret
- The IRR is the discount rate that will equate the present value of the outflows with the present value of the inflows
- The IRR is the discount rate at which the value of an investment becomes zero
- The IRR is the project’s intrinsic rate of return and is used for the appraisal of the project
- Decision criteria:
- If IRR > Cost of capital, accept the project
- If IRR < Cost of capital, reject the project
- If IRR = Cost of capital, technically indifferent
- The formula is t=1nCt(1+r)t – I = 0
r = Internal Rate of Return
- The IRR has to be higher than the cost of capital if we are to accept the project
- For projects with equal cash flows we use the formula
PV Factor (annuity) = costcash flow
- E.g. Assume that a project has a cost of R100 000 and results in equal cash inflows of R30 000 for the next 5 years, the IRR is = 100 00030 000 = 3.333 and from Table D in line with period 5 we find 15% being 3.3522 and 16% being 3.2743 thus to equates to 15.3%
- (3.3522 – 3.2743 =0.0799) and (3.3522 – 3.3333 = 0.0189) and 0.0189 / 0.0799 = 0.25)
Internal Rate of Return
The internal rate of return (IRR) is a metric used in financial analysis to estimate the profitability of potential investments. IRR is a discount rate that makes the net present value (NPV) of all cash flows equal to zero in a discounted cash flow analysis.
- The IRR is the discount rate at which the NPV will be equal to zero
- Let’s assume that our discount rate is 10%
- Since the NPV is greater than zero we have to increase the discount rate, assuming our discount rate is 13%
- Since the NPV is negative we should reduce the discount rate, let’s assume 15%
- Since the NPV is negative at 15% but still positive at 13% let’s assume a rate of 14%
- At 14% the NPV is closest to 0, thus we can safely assume that the IRR is 14%
- There are no rules guiding this process, it is based on assumption, the best procedure to follow is to use the rate you assume is closest to getting the NPV to 0, if the result is positive then increase it until the rate is negative and then reduce the rate until you get the NPV closest to 0
- This method recognises the time value of money
- It considers the cash inflow of the entire project
- The IRR attempts to find the maximum rate of interest at which funds invested in the project could be repaid out of the cash inflows arising from the project
- The result of the discounted cash flows is a rate which makes it easier to interpret (%)
- It is very popular in the business world
- It assumes that surplus cash inflows can be reinvested at the IRR, which is an unrealistic rate of future reinvestments
- It may give results that are inconsistent with the NPV method, especially in the case of mutually exclusive projects
- It can generate more than one IRR for the same project when there are inconsistent cash flows, that is net inflows followed by net losses again
- It measures how long (in years and or months) it takes to recover the initial investment
- The longer it takes for a project to pay back the money invested, the riskier the project is
Payback Period
The payback period is the length of time it takes to recover the cost of an investment or the length of time an investor needs to reach a breakeven point. Shorter paybacks mean more attractive investments, while longer payback periods are less desirable
- The payback method is widely used by large firms to evaluate small projects and by small firms to evaluate most projects
- It is simple, intuitive and considers cash flows rather than accounting profits
- It also gives implicit consideration to the timing of cash flows and is widely used as a supplement to other methods such as Net Present Value and Internal Rate of Return
- One major weakness of the payback method is that the appropriate payback period is a subjectively determined number
- It also fails to consider the principle of wealth maximisation because it is not based on discounted cash flows and thus provides no indication as to whether a project adds value to the firm
- Payback fails to fully consider the time value of money
- The return on assets or investment ratio is used to measure the effectiveness at which the assets are being utilised
- The Accounting Rate of Return can be explained by the following formula ARR = Average incremental net incomeAverage investment
- If the investment has a negligible residual value (i.e. the market value at the end of the project), the average investment will equal the average book value of the investment i.e. it is equal to the cost of the investment divided by 2
The following facts relate to Project R. The cost of the project is R1.1m and it is expected to have a residual value of zero in 5 years’ time. The cash flows for each year are depicted in the table below. The project is depreciated at a rate of 20% straight-line per year for accounting purposes, but this also reflects the depreciation deduction used for tax purposes.
A straight-line depreciation charge means that we deduct an equal depreciation amount per year over the life of the project. Depreciation is R220 000 per year (1 100 000 x 20%)
ARR = Average incremental net incomeAverage investment
= 57 600+165 600+165 600+165 600+165 600÷51 100 000 -0÷2
= 144 000550 000
= 26.2%
- It is very simple to understand and use
- It provides a better means of comparison of projects than the payback period method because it takes into account the savings over the entire economic life of the project
- It can be readily calculated by using the accounting data
- A rate is always easy to interpret
- It ignores cash flows
- It ignores time value of money
- It ignores risk
- It ignores the fact that the profits earned can be reinvested
- It does not consider the length of life of the projects
- The target rate of return is set subjectively by management
Tasks
Watch this video for more insight into Capital Budgeting Techniques: