Capital Budgeting Techniques Flashcards
What does capital budgeting involve?
Involve significant outlays in the current year in return for a stream of benefits in future years
What is there between teh time of the investment and teh returns of the investment?
Long time gap between outlay and its recoupment
Is capital easy to reverse?
Not easy to reverse a capital investment once it has been undertaken; aborting capital investment may involve additional cost
What are the two broad capital investment decisions? What are these?
- Screening decisions
-Does a proposed investment meet a pre-set criteria of acceptance? - Preference/choice decisions
-Which is the best project out of a number of competing alternatives?
What are some assumption we make to simplify the unit?
- All cash inflows and outflows occur at year end
- All cash inflows and cash outflows are known with certainty
- No taxes
- No inflation
How can we categorise investment appraisal techniques and what are in these categories?
Based on non-discounted cash flow:
* Accounting rate of return (ARR)
* Payback period
Based on discounted cash flow:
* Discounted payback period
* Net present value (NPV)
* Internal rate of return (IRR)
Define relevant cash flows.
Incremental future revenues and
cash-related costs
i.e., avoidable if project is not undertaken
What are the relevant cash flows in an investment appraisal? What does it not include?
Opportunity costs
Cost savings
Sunk costs
Depreciation (not cash)
In year 0, what tends to be the initial outlay cashflows?
- Initial asset investment (-)
- Initial working capital requirements (-)
What tends to be the cash flows during the lifespan of the project (Y1-Yn)?
- Cash inflows from sales (+)
- Cash outflows to pay for operating costs (-)
- Cash savings (+)
- Opportunity costs (-)
- Any other incremental cash inflows and/or outflows
What tends to be the cash flows at the end of the project, Yn?
- Estimated proceeds from disposal if asset is sold (+)
– usually the scrap value/residual value - Initial investment in working capital is usually fully
recovered when the project is terminated (+)
How do we calculate the accounting rate of return (ARR)?
ARR = Average annual profit / Average investment
How do we calculate average annual profit?
= (Sum of Expected net cash flows during the project* - Total Depreciation)/Life of the project in Years
*this excludes proceeds from disposal of non-current asset at the end of the project
How do we calculate average investment?
Average investment = (Initial investment cost + residual value)/2
When using ARR, what do we need to account for?
Depreciation
What is the screening decision for ARR?
Project should meet internally set minimum ARR %
What is the choice decision for ARR?
Choose project with the higher ARR %
What are the advantages of ARR?
Conceptually similar to return on capital employed which is commonly used by business analysts
Both ARR and ROCE relate operating profits to the investment
required to generate said profit
* ARR assesses the performance of a given investment before it has performed; ROCE assesses historical performance
* ARR can be thought of as a target ROCE %
Allows assets/projects with different useful lives to be compared
What are the limitations of ARR?
Doesn’t consider the timing of cash flows- the time value of money is not considered.
What is the payback period?
The time it takes for the initial outlay to be recouped from net cashflows during the project’s life
Does the payback period consider the timing of cash flows?
Yes
How do you calculate payback period?
Calculate cumulative cash flows at the end of each year
CCF Year 0 = Year 0 Cashflow
CCF Year 1 = Year 0 Cashflow + Year 1 Cashflow
And so on…when the CCF is > 0 the initial outlay has been recouped
What is the screening decision for payback period?
If the project’s payback period exceeds internally set maximum payback period, then reject
What is the choice decision for payback period ?
Choose project with the shorter payback period
What is the assumption of payback period that allows us to calculate the exact payback period?
Cash flows for a year are spread evenly over 12 months
What are the advantages of payback period?
Easy to calculate
Easy to understand
Focuses on liquidity, a constraint for many businesses.
Projects where initial outlays can be recouped quickly are more appealing than those with longer payback periods
Indirectly accounts for uncertainty of later cash flows by ignoring cash flows after payback is achieved
What are the limitations of payback period?
Does not fully consider the timing and amount of cash flows over the life of the project - ignores cash flows after the payback period
Not concerned with overall profitability of the investment
Deals with uncertainty of later cashflows in a relatively simplistic manner by favouring projects with shorter payback periods
Ignores the time value of money:
How can we improve on the payback period?
Calculate the discounted payback period- time value of money is included
What does the time value of money say?
A £1 today is worth more than a £1 tomorrow
What can we do with future cash flows?
Calculate the PV through discounting
What is the PV formula?
PV = FV/(1+r)^n
What do the PV tables show us?
Present value tables shows the present value of £1 received in n years from now at various interest rates
What is the interets rate of a company called?
Cost of capital
What is the discount factor?
PV of a £ for a certain number of years
What are the advantages of discounted payback period?
Relatively easy to calculate and understand
Takes into account time value of money
Why is the discounted payback period always longer than the payback period?
As later cash flows are discounted more compared to earlier cash flows
What are the limitations of the discounted payback period?
However, like the simple payback period, the
DPP method also ignores cash flows after the
(discounted) payback period
Accuracy of DPP depends largely on interest
rate chosen – what is the appropriate interest
rate to use?
Contradictory assumptions in DPP
* To discount future cash flows back to the
present, we assume all cash flows occur
at year end
* To work out a more exact (discounted)
payback period, we assume cash flows
are spread evenly throughout the year
How do we calculate net present value (NPV)?
NPV = PV of all future cash flows – initial outlay
What are the screening decisions for NPV?
- If the project’s NPV > 0, then it is
acceptable as it would increase
shareholder’s wealth - If NPV = 0, still acceptable as it would not
decrease shareholder’s wealth - If NPV < 0, reject the project as it would
decrease shareholder’s wealth
What is the choice decision for NPV?
Choose the project with the highest NPV
What are the advantages of NPV?
Considered the most theoretically superior and logical investment appraisal method
* Considers all cash flows over the project life – can deal with projects with unconventional cash flows
* Incorporates the time value of money
* Aligned with shareholder’s objectives: wealth
maximisation
* Relatively easy to compare NPV of different projects and to reject projects with negative NPV
What are the limitations of NPV?
Difficulties in estimating future cash flows –
common issue for all investment appraisal
methods
Not easy to select appropriate interest rate –
common issue for all investment appraisal
methods based on discounted cash flows
What is the cost of capital said to be?
The opportunity cost of the shareholders’ funds to be invested in the project
What is the opportunity cost interest rate said to be?
More than one possible answer:
* The interest rate that could be earned if the funds were invested in another company, or say government bonds – what are the opportunities available outside the company?
* The interest rate that could be earned if the funds were invested in existing projects in the company
Why can the cost of capital be difficult to determine?
Need to incorporate risk premium – the riskier the project, the higher the required return.
What is the internal rate of return (IRR)?
Similar to NPV
But instead of using a pre-determined interest
rate, IRR involves estimating, by trial and error,
the interest rate at which NPV equals zero
Look at slides to see diagrams for interpreting IRR
The lower the interest rate…
The higher the NPV
How can you approximate NPV?
Calculate two interest rates NPV on a diagram and draw a line connecting them. Where NPV =0 is IRR.
What is the formula for IRR?
Look at slides
What is the screening decision for IRR?
- Project must at least meet internally set IRR, if not reject
- What should this minimum IRR be? Varies across businesses and industries
What is the choice decision for IRR?
Choose project with the higher IRR
What are the advantages of IRR?
Similar to NPV, all cash flows of the project are taken into account
IRR can be compared directly to an internal “hurdle” rate, usually returns foregone from other available opportunities in the financial markets instead of the project, i.e., opportunity cost of capital
* If IRR of the project is higher than the opportunity
cost of capital, then the project can be accepted
What are the limitations of IRR?
Laborious to calculate
Cannot be determined directly, only an approximate IRR can be determined via interpolation
Unlike NPV, IRR does not directly address wealth maximisation. IRR is expressed in percentage form, thus obscuring the scale of each investment opportunity and how much would shareholder wealth increase/decrease in absolute terms.
Where unconventional cash flow occur (i.e.,
anything other than initial cash outflow followed by successive cash inflows), multiple IRRs (or even no IRR) may be possible
IRR implicitly assumes that cashflows generated from an investment project could be reinvested at the IRR
* Not very realistic compared to NPV which
assumes reinvestment at cost of capital
Can IRR and NPV give different answers?
IRR and NPV can produce conflicting
rankings
