Capital Budgeting

Question 1

Introduction

Answer 1

-When taking capital expenditure decisions, a long
term view of costs and benefits must be taken into
account.
-It is important to understand how major investment
projects are assessed.
-Organisations need to apply both non-discounted and discounted cash flow techniques to compare costs and benefits of long term investment projects.

Question 2

RELEVANT COSTS

Answer 2

A relevant cost is a future cash flow arising as a direct consequence of a decision.
Relevant costs are future incremental cash flows.
Examples include:
-Avoidable costs
-Differential costs
-Opportunity cost

Question 3

Avoidable costs

Answer 3

• which would not be incurred if the activity to which they relate did not exist.
• For example, if a specific product is not produced, material and labour costs may not be incurred.

Question 4

Differential costs

Answer 4

• Differential costs is the difference in relevant cost between alternatives.
• For example, if the cost of alternative A is $10,000 per year and the cost of alternative B is $8,000 per year. The difference of $2,000 would be differential cost.

Question 5

Opportunity cost

Answer 5

• Opportunity cost is the benefit which has been given up, by choosing one option instead of another.
• For example, the sales proceeds which the firm would have obtained on sale of an existing machinery which it instead decides to use for carrying out production.

Question 6

NON-RELEVANT

COSTS

Answer 6

Non-relevant costs are those costs which are irrelevant for decision-making.
Examples include:
-A committed cost
-A sunk cost
-A notional cost

Question 7

A committed cost

Answer 7

a future cash flow that will be incurred anyway, whatever decision is taken now.
For example, a company buys a machine for $40,000 and also issues a purchase order to pay for a maintenance contract for $2,000 in each of the next three years, all $46,000 is a committed cost, because the company has already bought the machine and has a legal obligation to pay for the maintenance

Question 8

sunk cost

Answer 8

A sunk cost: a cost which has already been incurred and therefore not taken into account.
For example, the cost of conducting market research and surveys on customers’ preferences before introducing a new product.

Question 9

notional cost

Answer 9

A notional cost: a hypothetical accounting cost to reflect the use of a benefit for which there is no actual cash outflow.
For example, if a parent company lets a subsidiary company use one of its building, there wont be an actual payment for rent as they belong to the same
group of companies so the rent is a notional cost for the subsidiary company.

Question 10

RELEVANT AND NON-RELEVANT

COSTS

Answer 10

-Usually, variable costs are relevant costs while fixed costs are non-relevant to a decision.
-However, fixed costs have to be identified as being
either ‘specific’ or ‘general’.
-Usually, specific or directly attributable fixed costs are relevant. For example the salary of Manager A if department A closes down.
-General fixed overheads are non-relevant.

Question 11

Example: Relevant and non-relevant
costs
Which of the following should be treated as relevant cash flows?

Answer 11

a. A reduction in the sales of a company’s other products caused by the investment RELEVANT
b. An expenditure on plant and equipment that has not yet been made and will be made only if the project is accepted RELEVANT
c. Costs of research and development undertaken in connection with the product during the past three years NON RELEVANT
d. Annual depreciation expense from the investment NON RELEVANT
e. Dividend payments by the firm arising as a result of profit from the new investment. RELEVANT
f. The resale value of plant and equipment at the end of the project’s life RELEVANT
g. Salary and medical costs for production personnel who will be employed only if the project is accepted RELEVANT

Question 12

Methods of project appraisal

Answer 12

• Accounting rate of return
• Payback period
• Discounted payback period
• Net present value
• Internal rate of return (IRR)

Question 13

Payback period

Answer 13

Time taken for the cash flows generated by a project to
pay back the initial cash flows
Calculation is based on cash flows and not profit
Decision rule:
-accept the project with the shortest payback
-if an organisation has a target payback, it will reject a
capital project unless the payback period is less than the target payback
TARGET 3 years, actual payback 2 yrs, accept
TARGET 3 years, actual payback 5 yrs, reject

Question 14

Payback-Constant Cash Flows

Answer 14

Example 1:
-A project requires an initial outlay of Rs5,000,000
and generates cash inflows of Rs1,250,000 for six
years. Calculate the payback period for the project.
Payback = 5000000/1250000
= 4 years

Question 15

Payback-unequal Cash Flows

Answer 15

Payback period found by adding up the cash
inflows until the total is equal to the initial cash
outlay
Example 2:
A project requires an initial cash outlay of Rs20,000,000. Forecast cash inflows for years 1-4
are as follows: Rs8,000,000, Rs7,000,000, Rs4,000,000 and Rs3,000,000. Calculate the payback period for the project.

Question 16

Solution Example 2

Answer 16

(slide)

Question 17

Advantages of Payback

Answer 17

Advantages

• It is simple to understand and easy to calculate.
• It considers cash flows and not profit (therefore more objective)
• Useful when businesses are facing liquidity problems and need cash
• Appropriate for risky projects

Question 18

Disadvantages of Payback

Answer 18

Disadvantages
- Unable to distinguish between projects having the
same payback.
-It ignores cash flows after the payback period
Project A year 1 Rs1000 inflow, Project B Rs10000
year 1
In year 5 Project A Rs200000, Project B Rs2000
-The choice of a target payback period is arbitrary
-It does not consider the time value of money.

Question 19

Discounted Payback

Answer 19

To take into account the time value of money, a
discounted payback can be calculated.
Example 3:
A company invests in a project costing $210,000. the project will yield annual profits of $80,000 for the next 3 years after providing annual depreciation of $10,000. What is the discounted payback using a cost of capital of 10%?
Annual CFs = Annual profits + Annual Depn
Annual CFs = 80000 + 10000 = 90000
(slide)

Question 20

Accounting Rate of Return (ARR)

Answer 20

-Measure of the profitability of an investment
-Expresses profit from investment as a percentage of
the total investment (or alternatively, average
investment)
-Profit is the accounting profit taken from the income statement
Decision rule:-
Projects are accepted or rejected depending on
whether they meet the minimum return set by the
company
formula:
ARR = (Average Accounting Profit/ Original Investment) x 100
or (slide)

Question 21

Advantages of ARR

Answer 21

-Easy to understand and can readily be ascertained
from information available from financial statements.
-Considers profits for the entire life of the project.
- Produces a percentage figure, which is readily
understood by managers

Question 22

Disadvantages of ARR

Answer 22

• It is based on accounting information and not cash
  flows.
• Does not take into account the time value of money.
• There are several formulae for calculating ARR which can lead to problems during comparison.

Question 23

Example ARR

Answer 23

XYZ Company is considering investing in a project that requires an initial investment of $100,000 for some machinery. There will be net inflows of $20,000 for the first two years, $10,000 in years three and four, and $30,000 in year five. Finally, the machine has a salvage value of $25,000. Find the ARR assuming straight line depreciation method is applied.

Solution Example ARR
(slide)