Capital Budgeting

Question 1

Cap budget

Types of investment projects

Answer 1

Replacement or expansion- may result in cost saving or new products and revenue. New product demand will be uncertain thus estimated cf will be hard to determine. Globalization reduces life of products

Independent or mutually exclusive projects
Independent… Accept of one not affect accept of other
Mutually exclusive… One or the other can be accepted

Divisible or indivisible
Can be split or not.

Question 2

Cap budgeting

Why use cf

Answer 2

Acc is based on matching principle
Acc include non cf amounts like depreciation
Tax is based on accrual and is a cf
Acc does not include opportunity cost

Question 3

Cap budgeting

Npv

Answer 3

Takes into acc tvm

Use estimated cf and discount at wacc. Accept if positive

Question 4

Cap budgeting

Irr

Answer 4

Rate where npv equals 0. Npv=cost of project
If irr>wacc accept project
If there is capital rationing the project with the highest irr may not be accepted.

Problems
If there are different levels of investment, the irr may give wrong decision between projects
If there are timing differences between cf of mutually exclusive projects, irr may give wrong conclusion due to reinvestment assumption at irr and not wacc.

Solve by using mirr.

Question 5

Cap budgeting

Mirr

Answer 5

Fv cf using wacc then get irr. Thus assuming reinvestment at wacc.

Question 6

Cap budgeting

Payback method and discounted payback method

Answer 6

Payback
Time it takes to recover cost of investment
Indicate how long funds are at risk, thus a risk indicator
Ignores cf after payback, thus not take into acc profitability. Ignores tvm. Bias against long term projects
Adv. it is simple to calculate and understand and widely used. Risk indicator

Discounted payback
Pv of cf using wacc. Thus take tvm into account.
Still not a profitability indicator

Question 7

Cap budgeting

Accounting rate of return

Answer 7

Mgmt are evaluated using roa or roi. Thus they might find it important to accept projects with positive effect on these ratios.
Arr… Avg incremental net income/ avg investment

Avg investment = cost/2
Avg incremental net income = net income after depreciation/life of project.

Mgmt might accept projects with higher initial cf rather than higher capital gain later but have a negative short term effect on roi.
Ignores tvm, thus short term projects may be accepted due to increased initial cf.
It’s based on acc figures thus not good.

Question 8

Cap budgeting

Pi

Answer 8

Measures return in relation to cost… Benefit cost ratio
Pv/cost
If more than 1 accept

Question 9

Cap budgeting

Eva

Answer 9

Economic profit= nopat - inv capital x wacc

Eva= (roc - wacc) x investment capital

Pv of Eva’s = npv

Mgmt might be reluctant to invest in project with short term negative Eva

Question 10

Cap budgeting

Cash flows to include

Answer 10

Beginning of project cf… Cost of acquisition, sale of existing, tax, change in wc. Wc changes are due to funds tied up in wc.

Annual operating cf… Increased revenue, decreased costs

Include opportunity cost. Ignore sunk cost. Use after tax cf.

Question 11

Cap budgeting

Working capital

Answer 11

Include net incremental investment in wc. May be recovered at end.
This is for tvm.
Jit systems reduce wc investments.

Include incremental changes in working capital.
Investment in debtors will be related to time given to pay… Investment deemed to take place at start of project.

Question 12

Cap budgeting

Post audits

Answer 12

Compare actual results with estimations.

Improve cap budgeting process. Lessons to mgmt. ensure focus on achieving projected cf.

Sponsors may reduce investment due to personal risk. Difficult to separate projected cf from other business investments.

Question 13

Cap budgeting

Compare projects with unequal lives

Answer 13

Mutually exclusive projects should be compared. If they have unequal lives npv will not be comparable.
Can reinvest until projects has comparable lives(replacement chains), but this assumes will and can reinvest in same project.

Equivalent annual annuities
Get npv of each project, this will be the pv, fv will be 0, i will be wacc. Compute payment. Accept higher eaa
Can compute eac.

Question 14

Cap budgeting

Inflation

Answer 14

Use nominal rate to discount nominal cf
Nom i = (1+R)(1+i)

Thus if cf is stated at current prices adjust by x (1+infl) to get to nominal cf or discount at real rate.
Depreciation allowance is not adjusted as it relates to historic amounts. Thus only adjust other cf.

Question 15

Capital budgeting

Capital rationing

Answer 15

Small firms may have trouble raising finance and long term debt at fixed rates. Can use rationing hurdle rate to accept projects.

Rank using pi if divisible. If not divisible get max sum of npv.

Question 16

Capital budgeting

Assessed tax losses

Answer 16

Co has an al and is able to utilize it from existing operations
Ignore al.

Co has al and new project allows faster utilization of it
Include benefit of faster utilization initially as well as opportunity cost of not being able to use it later. (Tvm)

Co has an al but no other income.
No opportunity cost

Project creates an al an co can set it off against other profits.
Saving initially included in calculation as well as normal tax charge later.

Project creates al and unable to set off against other inc.
Al carried forward.

If ring fenced, may only set off al against income of that project.

Question 17

Capital budgeting

Abandonment value and optimal useful life

Answer 17

If current abandonment value exceeds the npv, it should be sold.
By estimating the abandonment value throughout the life of the asset, the optimal economic life can be determined.

Replacement timing using eac. Determine lowest eac over life of asset.

Question 18

Capital budgeting

Risk and risk measures

Answer 18

Risk is taken into account by adjusting the rate of return or cf. adjust rate for risk by increasing the risk premium, thus the Rf wil be the same.

Probability distributions… Expected return vs deviation

Points to remember.
Possibility of negative npv, will the firm be able to survive it. Size of investment impacts on risk. Number of similar projects by that company offsetting some of the risk.

Question 19

Capital budgeting

Decision trees

Answer 19

Analyze project when sequential investment decisions are involved.
Probability of income for all decisions, and returns expected to get total return expected.

Question 20

Capital budgeting

Sensitivity analysis

Answer 20

Measure how npv or irr change if certain input variables change.
Risk may be reduced by qualitative factors for example, if there is high sensitivity of material prices and a contract was entered into with the supplier, risk will be lower as prices will not likely change.

Limitations
As only one variable is changed at a time, it assumes they are independent. Can be overcome through scenario analysis.
Does not indicate probability of occurrence.
Risk evaluation is subjective.

Question 21

Capital budgeting

Break even analysis

Answer 21

Number of units to be produced to get 0 npv.
Useful where there is uncertainty of demand.
Can be used to calculate selling price pu to break even.
Includes cost of debt and equity.

Get fc and eac of project.
Divide by contribution pu after tax.

Rather use…
Get pv of fc and capital costs net of tax and residual values.
Get annual contribution required pa equal to pv of these cost, which is the eac of this amount. Divide this by contribution pu to get the be unit pa.

If the be selling price is required and the nr of units sold each year varies, use pv of units method:
Pv all costs and revenues not linked to nr of units sold.
Divide this by the nr of pv of number of units sold.
Add this to the vc of each unit to get the selling price to be.

Question 22

Capital budgeting

Scenario analysis

Answer 22

Extension of sensitivity analysis where certain scenarios are examined.
Use base, worst and best case.

Question 23

Why is capital budgeting important

Answer 23

Funds are tied up for many years and thus should take place in context of strategic plan.
Under investment cause loss of market share and over results in higher costs.
Loss of flexibility if invest in a project for long period.
Timing. Anticipate demand
Think of capacity
Focus on wealth creation thus, wacc should be less than return.