CAPITAL BUDGETING (INVESTMENT DECISIONS) NOTES

Capital budgeting deals with the allocation of funds to competing
projects they involve commitment of funds to
receive future benefits.

2.1 Characteristics of Capital Budgeting Decisions

They involve investment in fixed assets whose useful life is more
than the effect of the investment decision and therefore felt longer
They affect the firm’s cash flows and therefore may change the risk
complexion of the firm.
They affect the company’s profitability and therefore will affect
the valve of the firm.
Most are irreversible because it is difficult to get a second hand
market for fixed assets

Steps in Investment Decisions

Generating investment proposals
Estimating future cash flows
Evaluating the cash flows
Making the selection decision & implementation
Re – evaluation (for replacement decision)

2.2.1 Generating Investment Proposals
Usually, investment proposals are generated by other departments, not
the finance department. E.g. the marketing department will generate
proposal on new product development; production department would
generate replacement proposals; Research and development would come up
with new technology, exploration etc. Other external sources include the
government through law legislation, competitors etc.

2.2.2 Estimating Cash Flows
In capital budgeting we are interested in after tax incremental cash
flows. We are interested in operating as opposed to financing cash
flows. In calculating the incremental cash flow, it is helpful to place
the project cash flows in to three categories based on
timing:

Initial cash out flow :The initial net cash investment
Interim incremental net cash flows: Those net cash flows occurring
after the initial cash investment but not including the final
period’s cash flow.
Terminal year incremental net cash flow: The final period net cash
flow (it is singled out for attention because a particular set of cash
often occur at project termination)

Basic Format for Determining Initial Cash Flows

Cost of new assets
+ Capitalized expenditures (e.g. installation costs, shipping costs)
+ (-) Increased (decreased) level of “net” working capital
– Net proceeds from sale of old assets(s) if the investment is a
replacement decision.
+ (-) Taxes (tax savings) due to the sale of “old” assets if the
investment is a replacement decision
= Initial cash out flow

Basic Format for Determining Interim and Terminal Year Incremental Net Cash Flow

Net increase (decrease) in operating revenue less (plus) any net
increases (decrease) in operating expenses excluding depreciation
– (+) Net increase (decrease) in depreciation charges
= Net change in income before taxes
– (+) Net increase (decrease) in taxes
= Net change in come after taxes
+ (-) Net increase (decrease) in tax depreciation charges
= Incremental cash flow for the terminal year before project wind up
+ (-) Final salvage valve (disposal/ reclamation) of ‘new’ assets
– (+) Taxes (tax saving) due to sale or disposal of “new” assets
+ (-) Decrease (increase) level of net working capital
- = Terminal year incremental net cash flow

Note: Items (a) to (g) constitute interim cash flows while (h) to (k)
constitute terminal year net cash flows

2.2.3 Evaluating the Cash Flows
Features of a sound investment evaluation method

It should be consistent with the overall objective of the firm-
shareholders wealth maximization; maximize the net present value.
It should be a measure of the projects over all profitability and
hence should consider all cash flows.
It provide a means of distinguishing between acceptable and
non-acceptable projects
It should provide a ranking of projects in order of economic importance
Should be rational and consistent
Should be applicable to any conceivable investment project

There are two methods of evaluating cash flows:

Discounted cash flow methods
Non-discounted cash flow methods

Advantages of ARR

Easy to compute and use
Computed from readily available accounting information

Disadvantages of ARR

Ignores time value of money
Ignores uncertainty of cash flows and there is no consideration of
risk in calculation
Uses accounting profits rather than cash flows
Doesn’t give a decision criteria
Not consistent with share holder wealth maximization

2.2.3.2 Non-discounted pay back period
This is the number of year taken to recover the original (initial)
investment from annual cash flows. The lower the pay back period the
better the project is

Advantages of Non-discounted pay back period

Easy to calculate
Uses project cash flows
Can be used as an indicator of projects risk. The longer the pay
back period the higher the risk of project

Disadvantages of Non-discounted pay back period

Ignores time value of money
Ignores cash flows beyond bay back period
doesn’t show/give a decision criteria
Not consistent with share holder wealth maximization

Advantages of NPV

Considers time value of money
Consistent with shareholder wealth maximization
Gives a decision
Recognizes uncertainty of cash flow by discounting

Disadvantages of NPV
Gives absolute values which cannot be used to compare project of
different sizes

Advantages of IRR

Can be used to compare projects of different sizes
Considers time value of money
Uses project cash flows

Disadvantages of IRR

Some project have multiple IRRs if their NPV profile crosses the
x-axis more than once (project cash flow signs change several time)
Some project may theoretically have no IRR if their NPV profile
doesn’t cross the x-axis ( no negative cash flow)
Assumes re-investment of cash flows occurs of project’s IRR which
could be exorbitantly high
Doesn’t provide a decision criteria

Advantages of PI

Recognized time value of money
Consistent with shareholders wealth maximization objects
Compares projects of different sizes
Gives a decision criteria disadvantages
Inapplicable for projects with no negative cash flows

2.3 Comparing Projects with Unequal Life

If we are choosing between two mutually exclusion alternatives with
significantly different lives, an adjustment would be necessary in order
to come up with a logical comparison. Two procedures may be used in
order to compare projects with unequal lives.

Replacement chain method
Equivalent annual annuity method
Replacement Chain (Common Life) Approach
This is a method of comparing projects of unequal lives which assumes
that each project can be repeated as many times as necessary to reach a
common life span. The NPVs over the life span are then compared and the
project with the higher common life NPV is
chosen.
Equivalent Annual Annuity (EAA) Approach
This is a method which calculates the annual payments a project would
provide if it were an annuity. When comparing project of unequal lives,
the one with the higher EAA should be chosen.

2.4 Capital Rationing

This is a situation where a constraint (or budget ceiling) is placed on
the total size of capital expenditures during a particular period

2.4.1 Causes of Capital Rationing

Capital constraints a rising from the market (external capital
rationing) As the firm goes for more capital, the additional capital
comes at an increased cost to the form. The increase in price of
capital is so great that it renders low return projects undesirable.
Managerial imposed capital constraint (internal capital rationing)
Policy of reliance on internally generated funds
Dilution effect:- to prevent outsiders from gaining control of the form
Capital rationing for units of on organization:- fixed allocation
from the headquarters to departments
Higher cut off ratio:- setting the firms at off rte for investments
higher than the firms cost of money.
Organizational limits on the growth of the firm:- when the desirable
investment is larger than the size of the firm it is thought that
the firm will be unable to exploit the project due to short term
constraints on the availability of managerial talent.

Methods of Selecting Investment Proposal under a Capital Constraint

Profitability Index

Steps:

Compute the index for all proposals
For mutually exclusive proposals retain the one having the positive
index
Rank them in the order of their index values
Begin with the proposal having the highest index value until their
accumulated total costs exhaust the available capital.

2.5 Inflation and Capital Budgeting

Does inflation have an impact in capital budgeting analysis? The answer
is a qualified yes in that inflation does have an impact on the numbers
that are used in a capital budgeting analysis, but it does not have an
impact on the results of the analysis if certain conditions are
satisfied. To show what this statement means consider the following
illustration.

Illustration:
XYZ Company wants to purchase a new machine that costs $36,000. The
machine would provide annual cost savings of $ 20,000, and it would have
a three year life with no salvage value. For each of the nest three
years, the company expects a 10% inflation rate in the cash flow
associated with the new machine. If the company’s cost of capital is
23.2%, should the new machine be purchased?

To answer this question, it is important to know how the cost of capital
was derived. Ordinarily, it is based on the markets rates of return on
the company’s various sources of financing- both debt and equity. This
market rate of return includes expected inflation; the higher the
expected rate of inflation, the higher the market rate of return on debt
and equity. When the inflationary effect is removed from the market rate
of return, the results is called a real rate of return. For example, if
the inflation rate of 10% is removed from martin’s cost of capital of
23.2 %, the “Real cost of the capital” is only 12%, as shown in below
(You can simply subtract the inflation rate from the market cost of
capital to obtain the real cost of capital. The computations are a bit
more complex than that)

When performing a net present value analysis, one must be consistent.
The market based cost of capital reflects inflation. Therefore, if a
market based cost of capital is used to discount cash flows, then the
cash flows should be adjusted upwards to reflect the effects of
inflation in forthcoming periods. Computations for XYZ Company under
this approach are given in solution B above On the other hand, there is
no need to adjust the cash flows upwards if the “real cost of capital”
is used in the analysis (since the inflationary effects have been taken
out of the discount rate). Computations for XYZ Company under this
approach are given is solution A above. Note that under solutions A and
B that the answer will be the same (within rounding error) regardless of
which approach is used, so long as one is consistent and all of the cash
flows associated with the project are affected equally by inflation.

Several points should be noted about solution B, where the effects of
inflation are explicitly taken into account. First, note that the annual
cost savings are adjusted for the effects of inflation by multiplying
each year’s cash savings by price-index number that
reflects a 10% inflation rate. Second, note that the net present value
obtained in solution B, where inflation is explicitly taken into
account, is the same, within rounding error, to that obtained in
solution A, where the inflation effects are ignored. This result may
seem surprising, but it is logical. The reason is we have adjusted both
the cash flows and the discount rate so that they are consistent, and
these adjustments cancel each other across the two solutions.

Throughout the topic we assumed for simplicity that there is no
inflation. In that case, the market based and real costs of capital are
the same, and there is no reason to adjust the cash flow for inflation
since there is none. When there is inflation, the unadjusted cash flows
can be used in the analysis if all of the cash flows are affected
equally by inflation and the real cost of capital is used to discount
the cash flows. Otherwise, the cash flows should be adjusted for
inflation and the market based cost of capital should be used in the
analysis.

FUNDAMENTALS OF ACCOUNTING II

DIVIDEND THEORIES AND POLICY NOTES

CAPITAL BUDGETING AND RISK- Risk Analysis NOTES

CAPITAL BUDGETING (INVESTMENT DECISIONS) NOTES

AGENCY THEORY NOTES