CAPITAL BUDGETING
This unit introduces you to the concept of Capital Budgeting. A capital expenditure is an expenditure on fixed assets and other long-term infrastructure necessary for the implementation of projects. The assets bought for the project are expected to generate cash flows. The appraisal of capital projects is done in two steps. Firstly, we must determine the cash flows that are expected to be generated by the project. Secondly, we must estimate the cost of the funds (cost ofcapital ) that have been used in the project. Finally, we subject the expected cash flows to certain appraisal techniques.
Capital budgeting involves long-term decision making on the use of funds. This implies the evaluation of investment opportunities, the essence of which is the detailed consideration of expected future cash flows. A cash flow may be defined as the receipt or expenditure of cash during an interval of time. For the sake of simplicity, it is generally assumed that cash flows occur at the end of each interval of time (usually at the end of each year).
It is a budget that deals with Capital Expenditure, for example the purchase of plant and equipment, construction of a building .It is expenditure that is not easily reversible due to the values committed. There are different types of capital budgeting expenditures,e.g. Replacement projects and Expansion projects.
So a detailed risk analysis needs to be done before the investment introduction of new projects and regulatory projects. The investment in the project is prescribed by the regulatory board on the safety issues.
Importance of capital budgeting.
You recall that the goal of financial management is to maximize the wealth of shareholders by acquiring funds at the least possible cost and utilizing them to obtain the highest possible return for the shareholders.
Capital budgeting techniques are used to make an appraisal of the company’s investment projects, whereby assets are acquired in order to carry out approved investment projects. It is expected that a project will generate cash flows . In project appraisal, it is the project’s cash flows that are subjected to a series of tests in order to find out whether the wealth of the shareholders is being maximized by embarking on a particular project. In making this appraisal, we utilize the discounted cash flow [DCF] techniques, which are based on thetime value of money concept, as well as other methods which are not based on the time value of money concept.
Incremental cash flows
In capital budgeting we should be careful not to include cash flows that are not relevant to the decision under consideration. The relevant cash flows for capital budgeting purposes are incremental cash flows. Cash flows for a project are defined as the difference between the cash flows of the firm without the project and the cash flows with the project :
Project CFt = CFt for the firm - CFt for the firm
with project without project
Cash flow versus Accounting income.
Accounting income may differ from the cash flows that we consider under financial management. Income statements mix apples and oranges. For example, accountants deduct costs, which are cash outflows, from revenues, which may or may not be entirely cash inflows (some sales may be on credit). At the same time, they do not deduct capital outlays, which are cash outflows, but they also deduct depreciation, which is not a cash outflow. In capital budgeting, it is critical that we base our decisions strictly on cash flows, the actual dollars that flow into and out of the company during each time period.
Study the following example.
Example
A company is considering investing in a project for which the following information has been generated:
$
Initial capital outlay (600 000 )
Profit/loss for the year: Year 1 100 000
Year 2 150 000
Year 3 250 000
Year 4 300 000
The capital outlay was on plant and machinery which is expected to have an economic life of four years with no scarp value.
In capital budgeting, we are concerned with "cash flows", not "profits or losses". To turn these into cash flows, we add back the depreciation, which is not a cash outlay. The profits are therefore adjusted as follows :
Annual depreciation = 600 000 / 4 = 150 000
Annual cash flows = profit + depreciation
Year 1 100 000 + 150 000 =250 000
Year 2 150 000 + 150 000 =300 000
Year 3 250 000 + 150 000 =350 000
Year 4 300 000 + 150 000 =450 000
Sunk Costs
Sunk costs are not incremental costs, so they should not be included in capital budgeting. A sunk cost is an outlay that has already occurred (or been committed). Since the outlay has already occurred, it is not affected by the decision to accept or reject a project.
Opportunity Costs
An opportunity cost is the benefit lost or alternative foregone in making a decision. For example, the use of a factory building to implement a project may require that the other alternative uses to which the building could be put have to be foregone, for example rentals to other users of the building. Opportunity costs should be charged to the project as an additional cost.
Externalities
The effects of the project on other projects are called externalities. Externalities may be positive or negative. For example, a project may result in the production of a new product for the firm. If this results in the reduction of the demand for the firm’s other products as some of the existing customers shift to the new product ( this is known as “cannibalization”) , these reduced sales should be deducted from the new product sales [a negative externality]. On the other hand, the new product may create sales for other related existing products, and these should be attributed to the new product [ a positive externality].
Types of Project Cashflows
Project cash flows are dividedinto three categories : the initial investment; the annual cash flows; and the terminal cashflow.
The Initial investment [I0]
The initial investment is the net cash outlay on buying the capital, that is the plant andequipment, buildings, and other infrastructure for the project. The amount of the initialpayment and the way it is calculated is determined by whether the project is a newinvestment project or a replacement project.
A new investment is when a totally new project is being analysed , or the implementation ofthe project does not have any effect on the present cash flows of the firm. If a newinvestment is being considered the initial investment can be made up of the following:
1. Thecost of the assets and installation, and
2. Change in net working capital.
The cost of the assetsincluding installation costs is an outflow (-) including any other opportunity costs.
Change in net working capital caused by the implementation of the project. Normallyadditional inventories are required to support a new project, and the new sales will alsogenerate additional accounts receivable. At the same time, accounts payable and accrualsmay also spontaneously increase. If there is a net increase, this is anoutflow (-). At the end of the project’s life, the firm’s total working capital may revert toprior levels, the net increase in net working capital is therefore recovered and becomes aninflow (+).
In a replacement project, some assets are replaced, and this may result in the firm nolonger deriving any cash flows from the replaced assets but from the new assets. Thefollowing factors make up the initial investment in a replacement project:
- The cost of the new project + installation costs + changes in net working capital. This isa cash outflow (-).
- The disposal value of the old assets. The implementation of the new project results inthe old assets being disposed of. The funds that are received at the disposal of the oldassets are an inflow (+).
Tax effects. Selling a fixed asset can result in tax effects. The tax savings or taxpayable as a result of the disposal of the old assets must be incorporated in the initialinvestment calculation.
Annual Cash Flows.
The annual cash flows are the result of revenues less expenses. Remember we always use net incremental, relevant, after-tax cash flows. We therefore need to incorporate tax effects in these cash flows. Let us do this now.
To convert before-tax cash flows into after-tax cash flows we use the following procedure:
1. After-tax cash flow = Before-tax CF - Tax payable.
2. Tax payable = Taxable × tax rate.
3. Taxable CFs = Before-tax CF - Tax allowance.
In Zimbabwe, tax allowances e.g W&T and SIA are claimed in place of depreciation charges, which are notrecognized for tax purposes.
The terminal cash flow
The terminal cash flow is the net after tax amount received by the firm when a project is terminated. For anew investment the estimated terminal cash flow might include the following : the estimated salvage value of the new assets, the tax effects due to the disposal of the assets and the recovery of the net working capital.
- The estimated salvage value of the new assets is the amount that is expected to be received when the assets are sold at the termination of the project. This is a cash inflow (+).
- The tax effects due to the disposal of the assets. This depends on whether there is a net taxable recoupment (-) or scraping allowance (+)
- Recovery of the net working capital. If there is a change in net working capital when the project is implemented, we expect an opposite change to occur at termination of the project. The change is usually an inflow (+).
Thus, the terminal cash flow will be equal to:
Proceeds from sale of assets XXXX
Tax on recoupment (XXXX)
Recovery of working capital(XXXX)
Total (XXXX)
Practice Question
Thodes Bus Company is considering the replacement of one of its buses with a new one.
It is estimated that the new bus will bring in extra revenues amounting to $12 000 000 per year as well as savings in maintenance costs amounting to $1 300 000 per year. The new bus is expected to cost $19 000 000 plus shipping costs of $1 200 000. The bus is expected to operate for five years and to have a salvage value of $5 000 000. There will be an increase of $100 000 per year in working capital resulting from the use of the new bus.
The old bus was bought four years ago and now has a market value of $300 000 and a zero book value.
The company elects to claim SIA on the bus using the current rates and has a tax rate of 30% per year.
Calculate:
1. The initial investment.
2. The annual cash flows.
3. The terminal cash flow of the project.
Classification of Capital Projects
The effects of a capital budgeting decision continue over many years and therefore, such a decision may not be easy to reverse. Capital budgeting decisions also define the strategic direction of the firm because a decision to move into new products, services or markets, for example, must be preceded by a capital budgeting expenditure.
A company usually considers more than one project at a time. Based on this notion, there
are basically two types of the projects: mutually exclusive or independent.
Mutually exclusive projects cannot be carried out at the same time. If project A and project B are mutually exclusive, for example, accepting one of them means the rejection of the other. On the other hand,
Independent projects, the acceptance of one may not necessarily mean the rejection of other projects that may be under consideration.
Another issue related to the classification of projects is the types of decisions. In investment appraisal there are two types of decision that we face.
1. We either have to accept or reject decisions, for mutually exclusive projects.
2. We have to rank independent projects. Projects which are more attractive according to the appraisal, are ranked higher than those which are less attractive.
Steps in Investment Appraisal
We have seen that the first step in the appraisal of a capital expenditure project is the determination of the project's net, after-tax cash flows. The next step after this, is to determine the cost of the funds used in the project. This is especially important if we are to use discounted cash flow techniques in our appraisal.
In estimating the cost of funds, we need to consider the sources of those funds, since the cost of funds is the return that is required by the suppliers of both debt and equity capital that has been used to finance the project, taking into account the risk of the project. In other words, it is the weighted average cost of debt and equity.
The following example clarifies this.
Example
A firm requires $400m to finance its capital project. $300 of this will come from the issue of new shares on which the investors require a return of 20%. The balance will be borrowed at an interest rate of 18%.
Ignoring taxation, the weighted average cost of capital for this project would be:
[(300 / 400) x 0.20] + [(100 /400) x 0.18] = 0.195 = 19.5%.
Project appraisal techniques
After we have got our cash flows as well as the cost of the funds used in the project, we are now in a position to make an appraisal of the project. There are various elements of the accounting system that are used including;
- Payback period.
- Discounted payback period.
- Net Present Value [NPV] method
- Internal Rate of Return [IRR] method.
- Modified Internal Rate of Return [MIRR] method.
- Profitability Index [PI].
We discuss each of these, including the problems associated with them, and their merits and demerits in the following subsections.
The Payback method
The payback period tells us the number of years required to recover the initial cash outlay from the project’s expected net cash flows (The payback period, defined as the expected number of years required to recover the original investment). It is the ratio of the initial cash outlay to the annual net cash flows.
Example: payback period with equal annual cash flows .
A firm is considering a project whose expected net, after-tax cash flows are as follows:
Initial Investment = $ 18 000.00
Annual cash flows = $ 5 600.00 per year for the next 5 years. What is the payback period?
Solution
The payback period = 18 000 / 5 600 = 3.2 years.
Example: payback period with unequal annual cash flows .
A project has the following expected annual net, after-tax cash flows :
Year Expected Net Cash flow Cumulative Cash Flow
0 ($ 18 000) ($ 18 000)
1 $ 4 000 ($ 14 000)
2 $ 6 000 ($ 8 000)
3 $ 6 000 ($ 2 000)
4$ 4 000 $ 2 000
5 $ 4 000 $ 600
In this example, you can see that the payback period falls between 3 years and 4 years. Toget the actual payback period, we use the following formula:
Payback = Year before full recovery + [unrecovered cost at start of year / cash flowduring year]
Therefore the payback period = 3 + [ 2 000 / 4 000 ] = 3.5 years.
Decision criteria of Payback period
A company might have a standing policy that all projects must recover their full cost within a certain period of time. If the payback for a particular project falls within this stipulated period, then the project is acceptable.
If, for example, the company policy payback was 3 years, then the project would be accepted. In this sense therefore, the payback period may be said to be a rough measure of the risk associated with the project. The longer the payback, the greater the risk, therefore the less acceptable a project is.
In the case of mutually exclusive projects, those with longer paybacks are eliminated in favour of those with shorter paybacks. As for independent projects, those with shorter paybacks would be ranked higher than those with longer paybacks.
Criticism of payback period
- The regular payback does not take into account the time value of money, assuming that cash flows received in the future are just as good as cash flows received today. In this sense it does not take into account the cost of capital. A project may be financed by both debt and equity and we need to factor in the cost of obtaining these funds, using an appropriate discount rate.
- It suffers from “Fish-bait criteria” i.e. (the size of the fish matters, not just catching something). It focuses only on the covering the initial investment than profitability.
- it ignores cash flows beyond the payback period, as is evident from the above examples.
Discounted Payback Method
It is a refinement of the payback method and seeks to overcome the problems of the time value of money before calculated.
To overcome the problems of the regular payback, the expected cash flows are discounted at the project’s cost of capital. The discounted payback period is therefore the number of years required to recover the investment from discounted cash flows .
Example
A project has the following net after tax cash flows;
Year / 0 / 1 / 2 / 3 / 4Cash flows / -1000 / 500 / 400 / 300 / 100
Calculate the discounted payback period if the cost of capital is 10%.
Solution
Year / 0 / 1 / 2 / 3 / 4Cash flows / -1000 / 500 / 400 / 300 / 100
Discounted Cash flows / -1000 / =454.55 / =330.5 / =225.39 / =68.30
Cumulative cash flow / -1000 / -545.45 / -214.89 / 10.5 / 78.8
Discounted Payback Period=2 years + 214.89/225.39
= 2.95 years