Managing Financial Management

and Techniques

Topic 5
Using Financial Appraisal Techniques
to Make Strategic Investment
Decisions for an Organisation

Fathimath Rasheed
MBA batch 11
Introduction to Capital Budgeting
A capital expenditure is an outlay of funds by the firm that is expected
to produce benefits over a period of time greater than 1 year.
An operating expenditure is an outlay resulting in benefits received
within 1 year.
The goal with capital budgeting is to select the projects that bring the
most value to the firm.
Ideally, we’d like to select all of the projects that add value, and avoid
those that lose value.
In an ideal situation, we can raise sufficient financing to undertake all of
these value adding projects.
Some firms, however, have the additional limitation of using capital
rationing, in that they have a determined amount of funds available to
allocate to capital projects, and the projects will compete for these
funds.
Steps in the Process
1. Proposal generation. Proposals are made at all levels within a business
organization and are reviewed by finance personnel. Proposals that require
large outlays are more carefully scrutinized than less costly ones.
2. Review and analysis. Formal review and analysis is performed to assess
the appropriateness of proposals and evaluate their economic viability.
Once the analysis is complete, a summary report is submitted to decision
makers.
3. Decision making. Firms typically delegate capital expenditure decision
making on the basis of dollar limits. Generally, the board of directors must
authorize expenditures beyond a certain amount.
4. Implementation. Following approval, expenditures are made and projects
implemented. Expenditures for a large project often occur in phases.
5. Follow-up. Results are monitored, and actual costs and benefits are
compared with those that were expected
Key Motives for Making Capital
Expenditures
Independent vs. Mutually
Exclusive Projects
The two most common types of projects are (1) independent projects and
(2) mutually exclusive projects.
Independent projects are those whose cash flows are unrelated or
independent of one another; the acceptance of one does not eliminate the
others from further consideration.
Mutually exclusive projects are those that have the same function and
therefore compete with one another.
The acceptance of one eliminates from further consideration all other
projects that serve a similar function.
For example, a firm in need of increased production capacity could obtain it
by (1) expanding its plant, (2) acquiring another company, or (3) contracting
with another company for production. Clearly, accepting any one option
eliminates the need for either of the others.
Unlimited Funds versus Capital
Rationing
The availability of funds for capital expenditures affects the firm’s
decisions.
If a firm has unlimited funds for investment, making capital budgeting
decisions is quite simple:
All independent projects that will provide an acceptable return can be
accepted.
Typically, though, firms operate under capital rationing instead.
This means that they have only a fixed number of dollars available for
capital expenditures and that numerous projects will compete for these
dollars.
Accept–Reject versus Ranking
Approaches
Two basic approaches to capital budgeting decisions are available.
The accept– reject approach involves evaluating capital expenditure
proposals to determine whether they meet the firm’s minimum acceptance
criterion.
This approach can be used when the firm has unlimited funds, as a
preliminary step when evaluating mutually exclusive projects, or in a
situation in which capital must be rationed.
In these cases, only acceptable projects should be considered.
The second method, the ranking approach, involves ranking projects on the
basis of some predetermined measure, such as the rate of return.
The project with the highest return is ranked first, and the project with the
lowest return is ranked last.
Conventional versus Non
conventional Cash Flow Patterns
Cash flow patterns associated with capital investment projects can be
classified as
conventional or nonconventional.
A conventional cash flow pattern consists of an initial outflow followed
only by a series of inflows.
For example, a firm may spend $10,000 today and as a result expect to
receive equal annual cash inflows (an annuity) of $2,000 each year for
the next 8 years.
A nonconventional cash flow pattern is one in which an initial outflow
is followed by a series of inflows and outflows.
The Relevant Cash Flows
To evaluate capital expenditure alternatives, the firm must determine
the relevant cash flows.
These are the incremental cash outflow (investment) and resulting
subsequent inflows.
The incremental cash flows represent the additional cash flows—
outflows or inflows—expected to result from a proposed capital
expenditure.
Major Cash Flow Components
The cash flows of any project having the conventional pattern can
include three basic components: (1) an initial investment, (2) operating
cash inflows, and (3) terminal cash flow.
Expansion versus Replacement
Cash Flows
Developing relevant cash flow estimates is most straightforward in the case
of expansion decisions.
In this case, the initial investment, operating cash inflows, and terminal cash
flow are merely the after-tax cash outflow and inflows associated with the
proposed capital expenditure.
Identifying relevant cash flows for replacement decisions is more
complicated, because the firm must identify the incremental cash outflow
and inflows that would result from the proposed replacement.
The initial investment in the case of replacement is the difference between
the initial investment needed to acquire the new asset and any after-tax
cash inflows expected from liquidation of the old asset.
The operating cash inflows are the difference between the operating cash
inflows from the new asset and those from the old asset. The terminal cash
flow is the difference between the after-tax cash flows expected upon
termination of the new and the old assets
Sunk Costs and Opportunity
Costs
When estimating the relevant cash flows associated with a proposed capital
expenditure, the firm must recognize any sunk costs and opportunity costs.
These costs are easy to mishandle or ignore, particularly when determining
a project’s incremental cash flows.
Sunk costs are cash outlays that have already been made (past outlays) and
therefore have no effect on the cash flows relevant to the current decision.
As a result, sunk costs should not be included in a project’s incremental cash
flows.
Opportunity costs are cash flows that could be realized from the best
alternative use of an owned asset.
They therefore represent cash flows that will not be realized as a result of
employing that asset in the proposed project.
Because of this, any opportunity costs should be included as cash outflows
when one is determining a project’s incremental cash flows.
Finding the Initial Investment
The term initial investment as used here refers to the relevant cash
outflows to be considered when evaluating a prospective capital
expenditure.
Because our discussion of capital budgeting is concerned only with
investments that exhibit conventional cash flows, the initial investment
occurs at time zero—the time at which the expenditure is made.
The initial investment is calculated by subtracting all cash inflows
occurring at time zero from all cash outflows occurring at time zero.
The cash flows that must be considered when determining the initial
investment associated with a capital expenditure are the installed cost
of the new asset, the after-tax proceeds (if any) from the sale of an old
asset, and the change (if any) in net working capital.
Installed Cost of New Asset
The cost of new asset is the net outflow that its acquisition requires.
Usually, we are concerned with the acquisition of a fixed asset for which
a definite purchase price is paid.
Installation costs are any added costs that are necessary to place an
asset into operation.
The Internal Revenue Service (IRS) requires the firm to add installation
costs to the purchase price of an asset to determine its depreciable
value, which is expensed over a period of years.
The installed cost of new asset, calculated by adding the cost of the
asset to its installation costs, equals its depreciable value.
After-Tax Proceeds from Sale of
Old Asset
after-tax proceeds from sale of old asset decrease the firm’s initial
investment in the new asset.
These proceeds are the difference between the old asset’s sale proceeds
and any applicable taxes or tax refunds related to its sale.
The proceeds from sale of old asset are the net cash inflows it provides.
This amount is net of any costs incurred in the process of removing the
asset.
Included in these removal costs are cleanup costs, such as those related to
removal and disposal of chemical and nuclear wastes.
These costs may not be trivial. The proceeds from the sale of an old asset
are normally subject to some type of tax.
This tax on sale of old asset depends on the relationship among its sale
price, initial purchase price, and book value, and on existing government tax
rules.
Change in Net Working Capital
Net working capital is the amount by which a firm’s current assets
exceed its current liabilities.
it is important to note that changes in net working capital often
accompany capital expenditure decisions.
If a firm acquires new machinery to expand its level of operations, it will
experience an increase in levels of cash, accounts receivable,
inventories, accounts payable, and accruals.
These increases result from the need for more cash to support
expanded operations, more accounts receivable and inventories to
support increased sales, and more accounts payable and accruals to
support increased outlays made to meet expanded product demand.
The difference between the change in current assets and the change in
current liabilities is the change in net working capital.
Generally, current assets increase by more than current liabilities,
resulting in an increased investment in net working capital.
This increased investment is treated as an initial outflow.
If the change in net working capital were negative, it would be shown as
an initial inflow.
The change in net working capital—regardless of whether it is an
increase or a decrease—is not taxable because it merely involves a net
buildup or net reduction of current accounts.
Finding the Terminal Cash Flow
Terminal cash flow is the cash flow resulting from termination and liquidation of a project
at the end of its economic life.
It represents the after-tax cash flow, exclusive of operating cash inflows, that occurs in the
final year of the project.
When it applies, this flow can significantly affect the capital expenditure decision.
Proceeds from Sale of Assets
The proceeds from sale of the new and the old asset, often called “salvage value,”
represent the amount net of any removal or cleanup costs expected upon termination of
the project.
For replacement projects, proceeds from both the new asset and the old asset must be
considered.
For expansion and renewal types of capital expenditures, the proceeds from the old asset
are zero.
Of course, it is not unusual for the value of an asset to be zero at the termination of a
project.
Payback Period
Payback periods are commonly used to evaluate proposed investments.
The payback period is the amount of time required for the firm to
recover its initial investment in a project, as calculated from cash
inflows.
In the case of an annuity, the payback period can be found by dividing
the initial investment by the annual cash inflow.
For a mixed stream of cash inflows, the yearly cash inflows must be
accumulated until the initial investment is recovered.
Although popular, the payback period is generally viewed as an
unsophisticated capital budgeting technique, because it does not
explicitly consider the time value of money.
The Decision Criteria
When the payback period is used to make accept–reject decisions, the decision
criteria are as follows:
• If the payback period is less than the maximum acceptable payback period, accept
the project.
• If the payback period is greater than the maximum acceptable payback period,
reject the project.
The length of the maximum acceptable payback period is determined by
management.
This value is set subjectively on the basis of a number of factors, including the type of
project (expansion, replacement, renewal), the perceived risk of the project, and the
perceived relationship between the payback period and the share value.
It is simply a value that management feels, on average, will result in value creating
investment decisions.
Pros and Cons of Payback
Periods
The payback period is widely used by large firms to evaluate small projects
and by small firms to evaluate most projects.
Its popularity results from its computational simplicity and intuitive appeal.
It is also appealing in that it considers cash flows rather than accounting
profits.
By measuring how quickly the firm recovers its initial investment, the
payback period also gives implicit consideration to the timing of cash flows
and therefore to the time value of money.
Because it can be viewed as a measure of risk exposure, many firms use the
payback period as a decision criterion or as a supplement to other decision
techniques.
The longer the firm must wait to recover its invested funds, the greater the
possibility of a calamity.
Therefore, the shorter the payback period, the lower the firm’s exposure to
such risk.
The major weakness of the payback period is that the appropriate
payback period is merely a subjectively determined number. It cannot
be specified in light of the wealth maximization goal because it is not
based on discounting cash flows to determine whether they add to the
firm’s value.
A second weakness is that this approach fails to take fully into account
the time factor in the value of money.
A third weakness of payback is its failure to recognize cash flows that
occur after the payback period.
Net Present Value (NPV)
Because net present value (NPV) gives explicit consideration to the time
value of money, it is considered a sophisticated capital budgeting
technique.
All such techniques in one way or another discount the firm’s cash flows
at a specified rate.
This rate—often called the discount rate, required return, cost of capital,
or opportunity cost—is the minimum return that must be earned on a
project to leave the firm’s market value unchanged. In this chapter, we
take this rate as a “given.”
The net present value (NPV) is found by subtracting a project’s initial
investment (CF0) from the present value of its cash inflows (CFt)
discounted at a rate equal to the firm’s cost of capital (k).
When NPV is used, both inflows and outflows are measured in terms of
present dollars.
Because we are dealing only with investments that have conventional
cash flow patterns, the initial investment is automatically stated in
terms of today’s dollars.
If it were not, the present value of a project would be found by
subtracting the present value of outflows from the present value of
inflows.
The Decision Criteria
When NPV is used to make accept–reject decisions, the decision criteria are
as follows:
• If the NPV is greater than $0, accept the project.
• If 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.
Shortfalls of NPV
NPV is a little less intuitive than payback period, so it might be more difficult
to explain to others who aren’t as well versed in finance.
To use NPV requires a discount rate; if we don’t have an accurate guage of
the cost of capital, it can be difficult to calculate an NPV.
PVIF or Discount factor = 1/ (1+k)n
For example if the cost of capital is 10%, the discount value for the first
year would be 1/ (1+0.1)1
2nd year = 1/ (1+0.1)2

Find the PVIF (discount factor) for 5 years is the cost of capital is
15%.
Internal Rate of Return (IRR)
The internal rate of return (IRR) is probably the most widely used
sophisticated capital budgeting technique.
However, it is considerably more difficult than NPV to calculate by hand.
The internal rate of return (IRR) is the discount rate that equates the
NPV of an investment opportunity with $0 (because the present value
of cash inflows equals the initial investment).
It is the compound annual rate of return that the firm will earn if it
invests in the project and receives the given cash inflows.
IRR = a + A/ (A+B) * (b-a)
The Decision Criteria
When IRR is used to make accept–reject decisions, the decision criteria are
as follows:
• If the IRR is greater than the cost of capital, accept the project.
• If the IRR is less than the cost of capital, reject the project.
These criteria guarantee that the firm earns at least its required return.
Such an outcome should enhance the market value of the firm and
therefore the wealth of its owners.
Shortfalls of IRR
IRR is more difficult than NPV to calculate by hand because we are
calculating a rate of return.
Profitability index (PI)
Profitability index (PI) shows the relative profitability of any project: in
essence, a ‘bang for your buck’ calculation.
It is the present value per dollar of initial cost.
The higher the profitability index, the better, and any PI greater than 1.0
indicates that the project is acceptable because it adds to corporate
value.
Which Approach Is Better?
It is difficult to choose one approach over the other, because the theoretical and
practical strengths of the approaches differ.
Theoretical View
On a purely theoretical basis, NPV is the better approach to capital budgeting as a
result of several factors.
Most important is that the use of NPV implicitly assumes that any intermediate cash
inflows generated by an investment are reinvested at the firm’s cost of capital.
The use of IRR assumes reinvestment at the often high rate specified by the IRR.
Because the cost of capital tends to be a reasonable estimate of the rate at which
the firm could actually reinvest intermediate cash inflows, the use of NPV, with its
more conservative and realistic reinvestment rate, is in theory preferable.
In addition, certain mathematical properties may cause a project with a
nonconventional cash flow pattern to have zero or more than one real IRR; this
problem does not occur with the NPV approach.
Practical View
Evidence suggests that in spite of the theoretical superiority of NPV,
financial managers prefer to use IRR.
The preference for IRR is due to the general disposition of businesspeople
toward rates of return rather than actual dollar returns.
Because interest rates, profitability, and so on are most often expressed as
annual rates of return, the use of IRR makes sense to financial decision
makers.
They tend to find NPV less intuitive because it does not measure benefits
relative to the amount invested.
Because a variety of techniques are available for avoiding the pitfalls of the
IRR, its widespread use does not imply a lack of sophistication on the part of
financial decision makers.
The directors of ABC Ltd are considering whether to accept one of the two
mutually exclusive projects and, if so, which one to accept. Each project
involves and immediate outlay of $250,000 and estimates of subsequent
cash flows are as follows.
Net cash flow Project A Project B
1 100,000 30,000
2 70,000 50,000
3 70,000 70,000
4 70,000 100,000
5 30,000 150,000
ABC’s cost of capital is 10%
1. For each project calculate 1) the payback period, 2) The Net present
value discounted at 10% and 15% 3) The Internal Rate of Return
2. Evaluate the results you have obtained and recommend which project
should be undertaken. Discuss what other factors should be taken into
consideration.
Question and Answer Session

Q&A