Capital Budgeting Decisions Tools

[Pages:26]Management Accounting | 217

Capital Budgeting Decisions Tools

In many businesses, growth is a major factor to business success. Substantial growth in sales may eventually means a need to expand plant capacity. In order to expand plant capacity, the company will have to invest considerably in more capital on a long term basis. A new assembly line or a chemical processing plant can cost millions or even hundreds of millions of dollars. An investment of large amounts of money on a long term basis should be founded on a thorough analysis of economic and financial conditions to determine that the prospects for success are favorable. The analysis should include computations that indicate the kind of return to expect. The project should return the invested capital in a reasonable length of time and also provide at a minimum the desired rate of return. The process of analyzing the future prospect of a project and using the appropriate tools to determine the rate of return is commonly called capital budgeting. Nature of Capital Budgeting

Capital budgeting is a system of long term financial planning involving: 1. Identifying investment opportunities (long term projects) 2. Determining profitability of investment projects 3. Ranking projects in terms of profitability 4. Selecting projects

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Step 1

Identifying projects

The object of capital budgeting is typically called a project. An investment project may be a:

a. New plant or equipment b. Expansion of existing plant and equipment c. Investment in information technology equipment d. Purchase of an existing business e. Opening a new territory f. Development of a new product

A potential project has the following characteristics that must be recognized:

1. An initial outlay of cash which is simply called the cost of the project. This cost is incurred in the time period that is commonly called period zero.

2. The project has a useful life which can be typically from five years or more to fifty years.

3. The project will generate in each period of its life starting with period 1 a net cash flow.

4. A desired rate of return for the project is set by management. 5. At the end of the life of the project, some residual value may exist.

This residual value or salvage value must be estimated because it is equivalent to a net cash flow amount in the year in which the project ends.

Step 2

Determining or measuring profitability

The most critical step is to measure the potential profitability of the project. In general, two measures of future profitability are available: (1) accounting net income and (2) net cash flow.

The process of determining profitability at a minimum involves the following steps:

1. Determine the cost of the project. 2. Determine the revenue expected in each period of the life of the

project. 3. Determine the cash expenses for each year of the life of the

project. 4. Determine the net cash flow for each period of the projects useful

life (cash revenue less cash expenses).

Step 3

Rank the projects in order of profitability. The term "profitability" is an ambiguous term and, consequently, has different meanings. For this reason different techniques of measuring profitability have been developed. The more important of these techniques include the following:

a. Average rate or return method (accounting method)

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b. Payback method c. Time adjusted rate of return method (Internal rate of return) d. Net present value method

The selection of a project should be taken very carefully. The project should fall within the experience and capabilities of management. New products are consequently being developed everyday. If a company is in the restaurant business, then it is highly unlikely management would want to expand into the electronics business. However, having a diversified business with different products or divisions can under the right circumstances be a good strategy. All projects involve risk and the risk potential in a given project should be evaluated. An important question is: if the project is undertaken, will failure of the project risk putting the company into bankruptcy?

Evaluating the profitability of a project perhaps is the most important and difficult task. First of all, it is important to have an accurate estimate of the cost of the project. Under estimating the cost can cause the eventual actual rate of return to be far less than the desired rate of return. Secondly, the expected net cash flow for each period of the life of the project must be measured. It is normal to expect that the farther the estimates are made into the future, the less reliable the will be estimates.

After the cost and future net cash flows have been determined, the next step is to actually compute the resulting rate of return. If the methods used are present value methods, then a discount rate must be determined. Theory holds that the discount rate should not be less than the company's cost of capital. Because companies use a combination of different sources of capital such as both debt and equity and use both internal financing and eternal financing, the company's cost of capital is usually an average. Computing cost of capital is a fairly complex subject and the techniques for doing so are beyond the scope of this book.

When several investment opportunities are being evaluated and the source of funds to invest is limited, then a decision has to be made concerning which of the available projects are the most profitable and most affordable. Modern capital budgeting theory maintains that the tools used to evaluate projects should be present value based. The two tools have received the most attention in the capital budgeting literature are the following:

1. Net present value method 2. Time adjusted rate of return method.

The Basic Present Value Equation

The basic fundamentals of present value are explained in Appendix B. If you have forgotten the basic fundamentals of computing present value, it is recommended that you first read and study this appendix before proceeding further. In order to understand the basic principles of capital budgeting, a sound understanding of present value is required.

When using present value methods, the net cash flows of the project is regarded as a series of future amounts. Because they are future amounts, the process of discounting these amounts is logical. The cost of the project is an outlay in period zero and, therefore, does not require any discounting, After the individual future net

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cash flows have been discounted and the sum of these amounts found, the comparison of the sum of the discounted amounts to the cost of the project is appropriate.

The basic present value equation is as follows:

PV = ??F?V?1 ? + ??F?V?2? ? +... ??F??V?N?? (1 + i)1 (1 + i)2 (1 + i)N

Where:

PV -

FVi N -

i -

present value future value at time period i. life of project interest rate (discount rate)

Because we are now using present value fundamentals in the framework of capital budgeting, the equation will be revised as follows:

PV

= ?(?1N?+C?F?R?1) 1? + ?(?1N?+C?F?R?2) 2? + ... ?(?1N?+?C?FR?N)?N?

In principle, this equation is exactly the same. The net cash flows values of the project have been substituted for FV. Also, the desired rate of return for the project, R, is used as the discount rate. This equation can be used to compute the present value of net cash flows that are equal, unequal, or zero in some years.

There are two methods of computing net cash flows. The first method which is the more logical method simply involves subtracting from cash revenues the cash expenses.

NCF = CR - CE

Where

NCF CR CE -

net cash flow cash revenue cash expenses

The second method involves starting with net income and adding back depreciation.

NCF = NI + D

Where

NI

- net income

D

- depreciation

Illustration of Computing Present Value

From an accounting viewpoint, depreciation is a necessary expense in determining net income. In most business, it is the primary non cash expense. In the period in which depreciation is recorded, no cash outlay is involved. The cash outlay related to depreciation was incurred at the time the asset was purchased or at the time the debt incurred was paid. As used in capital budgeting the term net cash flow simply means cash revenue less cash expenses and starting with net income and adding back depreciation is simply a short cut method. Examples of computing present value using this basic equation will now be presented:

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Example 1

Equal periodic net cash flows where the desired rate of return is 10% and the life of the project is 4 years:

PV = ?1?0?0?? + ??1?0?0?? + ??1?0?0?? + ???1?0?0?? = $316.98 (1 +.1)1 (1 + .1)2 (1 +.1)3 (1 +.1)4

Example 2

One net cash flow amount at the end of 4 years where the desired rate of return is 10%:

PV = ???0? ?? + ???0??? + ???0?? ?? + ??1?0?0?? = $68.30 (1 +.1)1 (1 + .1)2 (1 +.1)3 1+.1)4

In this example, it is easy to recognize that the present value of a zero amount is zero.

Example 3

Unequal net cash flows where the desired rate of return is 10% and the life of the project is 4 years:

PV = ??1?0?0?? + ???2?0?0?? + ??3?0?0? ? + ??4?0?0?? = $754.80 (1 +.1)1 (1 + .1)2 (1 +.1)3 (1 +.1)4

If net cash flows are equal, then the net cash flows may be treated as though they are an annuity and the use of present values of an annuity of $1 tables may be used to compute the answer. An annuity may be defined as a series of equal payments at equal intervals of time.

As explained in chapter 8, Comprehensive Business Budgeting, the capital expenditures budget was one of the four elements of the final product of the total budget. The capital expenditures budget affects the following:

Cash balance Amount of stock issued or debt incurred Interest expense, if debt financing is used The size of the plant and equipment accounts Future depreciation Net income

In Figure 12.1 a diagram of capital budgeting as discussed above is illustrated.

Net Present Value Method

The net present value method is commonly used to evaluate capital budgeting projects. The steps involved in this method are the following:

Step 1

Determine the net cash flows for each period (normally each year) of the life of the project. This step involves estimating both cash inflows and cash outflows. Net cash flow is simply Cash inflows less cash outflows.

Step 2 Determine the cost of the project. The cost of the project might be a single contracted amount or the sum of many individual expenditures.

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A clear distinction should be made between cost expenditures made in period zero and expenditures that represent operating expenses during the life of the project.

Step 3

Compute the present value of the project using the net cash flows as the future amounts. The discount rate is the desired minimum rate of return as determined by management.

Step 4

Determine whether the project is acceptable. In the net present value method, the present value computed is compared to the cost of the project. If the present value exceeds the cost, then the project is acceptable. If the net present value is positive, then this means the rate of return of the project is greater than the discount rate. If the net present value in negative, then the rate of return of the project is less than the discount rate.

The net present value does not tell us what the true rate of return is unless the net present value is zero. In other words, if the present value is exactly equal to the cost of the project, then we know that the true rate of return is equal to the discount rate.

Illustration - In order to illustrate the net present value method, let's assume we have been provided the following information.

Cost of project Life of project (years) Estimated net cash flow:

Year 1 Year 2 Year 3 Year 4 Year 5 Desired rate of return

$250,000 5

$ 50,000 $100,000 $150,000 $ 75,000 $ 25,000

10%

Periods (Years)

1

2

Net Cash Flow

$ 50,000 $ 100,000

Present Values

PV Factor

Net Cash Flow

.909090

$ 45,454.54

.826446

$ 82,644.62

3

$ 150,000

.751314

$ 112,697.72

4

$ 75,000

.683013

$ 51,225.99

5

$ 25,000

.620921

$ 15,523.27

Total present value

$ 307,546.14

The present value of each net cash flow is computed by multiplying the present value factor times each net cash flow amount. The present value of the project is, therefore, the sum of the individual present values. The present values could have been easily computed without the use of tables. For example, the present value of

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the net cash flow in year 2 ($100,000) could have been calculated as follows: $100,000 $100,000

PV = ??( ??1?.1?)?2 ? = ???1?.2?1??? = $82,644.62

A simple four function calculator makes the computation of present value fairly

easy. Is the project in the illustration above acceptable? The answer is yes as the

following comparison shows.

Present value of project

$ 307,546.14

Cost of project 250,000.00 ???????????

Net present value ?$??5?7?,?5?4?6?.1?4?

The true rate of return of this project is greater than the discount rate because the net present value is positive.

The main disadvantage of this method is that the true rate of return is not computed. This method only determines the present value of the project and indicates whether or not the project is acceptable. For this reason, many analysts prefer the time adjusted rate of return method.

Time Adjusted Rate of Return Method

The time adjusted rate of return method is a present value method that determines the true rate of return of a project. If the true rate of return is equal to or greater than the desired rate of return, then the project is acceptable. This method works

Figure 12.1 ? Outline of Capital Budgeting

CAPITAL BUDGETING

EVALUATION TECHNIQUES

Accounting rate of return

Payback period Timed adjusted rate

of return Net present value

TYPES OF PROJECTS

New products Replacement of assets New plants and

equipment Opening a new territory Purchase of an existing

business

CONCEPTS

Cost of capital Depreciation Desire rate of return Net cash flows Present value Future value Discount rate

EVALUATION

Quantity factors Cash inflows

OF INDIVIDUAL Cash outflows

PROJECTS Useful life

Present value

Recoverable value

Qualitative factors

Management ability

Management experience

Economic enviroment

Risk

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because the objective is to find the present value of the project that is exactly equal to the cost of the project. The cost of the project is considered to be the present value of the project. The problem is that this method has to be used on an iterative basis, that is a trial and error basis.

In using this method, it makes no difference whether the net cash flows are equal or unequal in amounts. If they are equal, the process is a bit easier because a present value of $1 annuity table may be used.

This method is also based on the same equation that was used in the net present value method, with the exception that cost now represents the present value of the project. In this method, we know at the start what the present value is. The problem is to find the rate that will generate this present value. Therefore, the goal is to solve for R.

Cost = ?N?C?F??)1+ ?N?C?F??2+... ?N?C?F?N? (1+R)1 (1+R)2 (1+R)N

Net Cash Flows Unequal - The procedure for finding R or the true rate of return is as follows:

Step 1 Select any interest rate to begin the process. The only guideline is to select a rate you intuitively think might be close to the answer.

Step 2 Using the selected rate in step 1, compute the present value of the project in the same manner used in the net present value method.

Step 3

Compare the computed present value to the cost of the project. If the present value if greater than the cost, then the true rate is greater than the discount rate used. If the present value is less than cost, then the true rate is less than the rate used.

Step 4

If the present value did not equal cost, then select a second rate. This rate should be greater or less than the rate first used according to the rules specified in step 3. A smaller rate will increase the present value while a greater rate will make the present value smaller.

Step 5

Again, compare the resulting present value computed to cost. If the two amounts are not substantially close, then a third attempt should be made.

The trial and error process should be repeated until there is no significant different between cost and the last present value amount computed. When the present value is equal or very close to cost, then the true rate of return has been found.

Illustration-This method will now be illustrated using the same problem used for the net present value method.

Cost of project Life of project (years) Estimated net cash flow:

Year 1 Year 2

$250,000 5

$ 50,000 $100,000

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