CHAPTER 14 CAPITAL BUDGETING

Question 1

what is capital investment

Answer 1

When a business spends money on new non-current assets it is known as capital investment or capital expenditure. Spending is normally irregular and for large amounts. It is expected to generate long-term benefits.

Capital investment decisions normally represent the most important decisions that an organisation makes, since they commit a substantial proportion of a firm’s resources to actions that are likely to be irreversible.

Question 2

what are examples of different capital investment projects

Answer 2

Many different investment projects exist including:
replacement of assets
cost-reduction schemes
new product/service developments
product/service expansions
statutory, environmental and welfare proposals.

Question 3

what are asset items

Answer 3

Asset items is expenditure incurred in:
(a) the acquisition of non-current assets required for use in the business and not for resale
(b) the alteration or significant improvement of non-current assets for the purpose of increasing their revenue-earning capacity.
Asset items are initially shown in the statement of financial position as non-current assets. It is then charged to the statement of profit or loss over a number of periods, via the depreciation charge.

Question 4

what are expense items

Answer 4

Expense items are expenditure incurred in:
(a) the purchase of assets acquired for conversion into cash (e.g. goods for resale)
(b) the manufacturing, selling and distribution of goods and the day-to-day administration of the business
(c) the maintenance of the revenue-earning capacity of the non-current assets (i.e. repairs, etc).
Expense items are generally charged to the statement of profit or loss for the period in which the expenditure was incurred.
In practice, there can be some difficulty in clearly distinguishing between alteration/improvement of non-current assets (asset) and their maintenance (expense). For example, is the installation of a modern heating system to replace an old inefficient system an improvement or maintenance? However, you should not need to make such decisions in your exam.

Question 5

what is a capital budget

Answer 5

A capital budget:
is a programme of capital expenditure covering several years
includes authorised future projects and projects currently under consideration.

Question 6

what is an investment appraisal

Answer 6

One stage in the capital budgeting process is investment appraisal. This appraisal has the following features:
estimates of future costs and benefits over the project’s life
assessment of the level of expected returns earned.
The capital budgeting process consists of a number of stages:

1 forecast capital requirements
2 identify suitable projects
3 appraise potential projects
4 select and approve the best alternative
5 make capital expenditure
6 compare actual and planned spending, investigate deviations and monitor benefits from project over time

Question 7

why is it important in capital investment appraisal to evaluate future cash flows rather than accounting profits

Answer 7

Cash and profit are very different. Profit is calculated on the statement of profit or loss and cash is a current asset on the statement of financial position. The differences arise because:

Revenue is recognised in the statement of profit or loss when it is earned but this is not necessarily when the cash is received.
Costs are recognised in the statement of profit or loss when they are incurred but this is not necessarily when the cash is paid.
Non-cash expenses – the statement of profit or loss of a business is charged with a number of non-cash expenses such as depreciation and provisions for doubtful debts. Although these are correctly charged as expenses in the statement of profit or loss, they are not cash flows and will not reduce the cash balance of the business.
Purchase of non-current assets – these are often large cash outflows of a business but the only amount that is charged to the statement of profit or loss is the annual depreciation charge not the entire cost of the non-current asset.
Sale of non-current assets – when a non-current asset is sold this will result in an inflow of cash to the business but the figure to appear in the statement of profit or loss is not the cash proceeds but any profit or loss on the sale.
Financing transactions – some transactions, such as issuing additional share capital and taking out or repaying a loan, will result in large cash flows in or out of the business with no effect on the profit figure at all.

Question 8

what relevant cash flows should be appraised

Answer 8

Cash flows that are appraised should be relevant to or change as a direct result of making a decision to invest. Relevant cash flows are:
future costs and revenues – it is not possible to change what has happened so any relevant costs or revenues are future ones
cash flows – actual cash coming in or leaving the business not including any non-cash items such as depreciation and notional costs
incremental costs and revenues – the change in costs or revenues that occurs as a direct result of a decision to invest.

Question 9

what are differential/opportunity/avoidable costs (relevant cost terminology)

Answer 9

Differential costs are the differences in total costs or revenues between two alternatives.
Opportunity cost is an important concept in decision making. It represents the best alternative that is foregone in taking the decision. The opportunity cost emphasises that decision making is concerned with alternatives and that the cost of taking one decision is the profit or contribution foregone by not taking the next best alternative.
Avoidable costs are the specific costs associated with an activity that would be avoided if that activity did not exist.

Question 10

what are sunk/committed/non cash-flow costs (non relevant cost terminology)

Answer 10

Sunk costs are past or historical costs which are not directly relevant in decision making, for example, development costs or market research costs.
Committed costs are future costs that cannot be avoided, whatever decision is taken.
Non-cash flow costs are costs which do not involve the flow of cash, for example, depreciation and notional costs. A notional cost is a cost that will not result in an outflow of cash either now or in the future, for example, sometimes the head office of an organisation may charge a ‘notional’ rent to its branches. This cost will appear in the accounts of the organ

Question 11

what is the time value of money

Answer 11

Money received today is worth more than the same sum received in the future, i.e. it has a time value.

Question 12

what is the time value effect of money due to

Answer 12

For an investor, the effective time value of money is due to:
1Cost of finance – if the funds were available now the cash could be used to repay or reduce a loan, in turn reducing interest charges on the loan
2Investment opportunities – the funds could be invested to earn a return, often expressed as a percentage return
3Inflation – erodes the purchasing power of the funds as prices of commodities increase
4Risk – funds received sooner are more certain.

Cost of finance and investment opportunities are often discussed in terms of “interest rates” – the interest being saved by reducing the loan amount outstanding and the interest received from an investment.
All four of the factors above combine to express the time value of money as an interest rate.

Question 13

what are the 4 types of interest

Answer 13

There are different forms of interest which are discussed in the next section:
Simple
Compound
Nominal
Effective.

Question 14

what is simple interest

Answer 14

Simple interest is calculated based on the original sum invested. Any interest earned in earlier periods is not included. Simple interest is often used for a single investment period that is less than a year.
To calculate the future value of an amount invested under these terms you could use the following formula:

V = X + (X x r x n)

V = future value
X = initial investment (present value)
r = interest rate (expressed as a decimal)
n = number of time periods

Question 15

what is compound interest

Answer 15

Compounding calculates the future (or terminal) value of a given sum invested today for a number of years.
To compound a sum, the figure is increased by the amount of interest it would earn over the period. Interest is earned on interest gained in earlier periods.

V = X(1 + r)^n

V = future value
X = initial investment (present value)
r = interest rate (expressed as a decimal)
n = number of time periods

Question 16

what is a nominal interest rate

Answer 16

The nominal interest rate is the stated interest rate for a time period – for example a month or a year.

Question 17

what is an effective interest rate

Answer 17

The effective interest rate is the interest rate that includes the effects of compounding a nominal interest rate.

r = (1 + I/n)^n - 1

r = effective interest rate
i = nominal interest rate
n = number of time periods

Question 18

what is discounting and present value PV

Answer 18

Discounting performs the opposite function to compounding. Compounding finds the future value of a sum invested now, whereas discounting considers a sum receivable in the future and establishes its equivalent value today. This value in today’s terms is known as the Present Value (PV).

Question 19

what assumptions are used in discounting

Answer 19

Unless told otherwise you should assume:
All cash flows occur at the start or end of a year.
Although in practice many cash flows accrue throughout the year, for discounting purposes they are all treated as occurring at the start or end of a year. Note that if today (T0) is 01/01/20X1, the dates 31/12/20X1 and 01/01/20X2, although technically separate days, can be treated for discounting as occurring at the same point in time, i.e. at T1.
Initial investments occur at once (T0), other cash flows start in one year’s time (T1).
In project appraisal, the investment needs to be made before the cash flows can accrue. Therefore, unless the examiner specifies otherwise, it is assumed that investments occur in advance. The first cash flows associated with running the project are therefore assumed to occur one year after the project begins, i.e. at T1.

Question 20

what is the formulae for discounting

Answer 20

learn:
present value = future value x discount factor

given:

discount factor = 1/(1+r)^n or (1+r)^-n

where r = the interest rate as a decimal
n = the number of time periods

Question 21

what are alternative terms used to account for the time value of money

Answer 21

In the above discussions we referred to the rate of interest. There are a number of alternative terms used to refer to the rate a firm should use to take account of the time value of money:
cost of capital
discount rate
required return.

Question 22

what are 3 appraisal methods

Answer 22

There are three widely used appraisal methods:
1The payback period (using both discounted and non-discounted cash flows).
2Net present value (NPV).
3Internal rate of return (IRR).
All three methods consider the time value of money, assuming the discounted payback method is used. They are known as discounted cash flow (DCF) techniques.

Question 23

what is the payback period

Answer 23

The payback period is the time a project will take to pay back the money spent on it. It is based on expected cash flows and provides a measure of liquidity.
It is the time which elapses until the invested capital is recovered. It considers cash flows only. It can be assumed that, with this technique, the cash flows can occur evenly during the year.

Question 24

how is the payback period identified and how do management use it to make decisions

Answer 24

Compare the payback period to the company’s maximum return time allowed and if the payback is quicker the project should be accepted.
Faced with mutually-exclusive projects choose the project with the shortest payback.

payback period = initial investment/annual cash inflow

A payback period may not be for an exact number of years. To calculate the payback in years and months you should multiply the decimal fraction of a year by 12 to get the number of months.

If cash flows are uneven (a more likely state of affairs), the payback has to be calculated by working out the cumulative cash flow over the life of a project.

Question 25

what is a disadvantage of payback period and what technique can overcome this

Answer 25

One of the major criticisms of using the payback period is that it does not take into account the time value of money. The discounted payback technique attempts to overcome this criticism. The technique is identical – but the present value of the cash flow is calculated before calculating the cumulative cash flow.

Question 26

what are the advantages of payback

Answer 26

Payback has a number of advantages
As a concept payback is easily understood and is easily calculated.
Rapidly changing technology. If new plant is likely to be scrapped in a short period because of obsolescence, a quick payback is essential.
Improving investment conditions. When investment conditions are expected to improve in the near future, attention is directed to those projects that will release funds soonest, to take advantage of the improving climate.
Payback favours projects with a quick return. It is often argued that these are to be preferred for three reasons.
Rapid project payback leads to rapid company growth – but in fact such a policy will lead to many profitable investment opportunities being overlooked because their payback period does not happen to be particularly swift.
Rapid payback minimises risk – the logic being that the shorter the payback period, the less there is that can go wrong. Not all risks are related to time, but payback is able to provide a useful means of assessing time risk. It is likely that earlier cash flows can be estimated with greater certainty.
Rapid payback maximises liquidity – but liquidity problems are best dealt with separately, through cash forecasting.
Payback uses cash flows, rather than profits, and so is less likely to produce an unduly optimistic figure distorted by assorted accounting conventions which might permit certain costs to be carried forward and not affect profit initially.

Question 27

what are the disadvantages of payback

Answer 27

The disadvantages of payback are:
Project returns may be ignored. In particular, cash flows arising after the payback period are totally ignored.
Timing of cash flows are ignored. Cash flows are effectively categorised as pre-payback or post-payback, but no more accurate measure is made.
The time value of money is ignored (unless discounted payback is used).
There is no objective measure as to what length of time should be set as the minimum or maximum payback period. Investment decisions are therefore subjective.
Payback takes no account of the effects on business profits and periodic performance of the project, as evidenced in the financial statements. This is critical if the business is to be reasonably viewed by users of the accounts.

Question 28

what is the net present value NPV and how is it used to make decisions

Answer 28

The NPV of an investment represents the net benefit or loss of benefit in present value terms for an investment opportunity.
A positive NPV represents the surplus funds earned on a project. This means that it tells us the impact on shareholder wealth.

Decision criteria
Any project with a positive NPV is viable.
Projects with a negative NPV are not viable.
Faced with mutually-exclusive projects, choose the project with the highest NPV.

Question 29

what are the advantages of NPV

Answer 29

When appraising projects or investments, NPV is considered to be superior to other methods. This is because it:
considers the time value of money – discounting cash flows to their present value takes account of the impact of interest, inflation and risk over time.
is an absolute measure of return – the NPV of an investment represents the potential surplus raised by the project. This allows a business to plan more effectively.
is based on cash flows not profits – the subjectivity of profits makes them less reliable than cash flows and therefore less appropriate for decision making.
considers the whole life of the project – NPV takes account of all relevant flows associated with the project. Discounting the flows takes account of the fact that later flows are less reliable.
should lead to maximisation of shareholder wealth. If the cost of capital reflects the investors’ (i.e. shareholders’) required return, then the NPV reflects the theoretical increase in their wealth. For a company, this is considered to be the primary objective of the business.

Question 30

what are the disadvantages of NPV

Answer 30

However, there are some potential drawbacks:
It is difficult to explain to managers. To understand the meaning of the NPV calculated requires an understanding of discounting. The method is not as intuitive as techniques such as payback.
It requires knowledge of the cost of capital. The calculation of the cost of capital is, in practice, more complex than identifying interest rates. It involves gathering data and making a number of calculations based on that data and some estimates. The process may be deemed too protracted for the appraisal to be carried out.
It is relatively complex. For the reasons explained above, NPV may be rejected in favour of simpler techniques.

Question 31

what is the internal rate of return IRR and how is it used to make decisions

Answer 31

This is the rate of return, or discount rate, at which a project has a NPV of zero.

Decision criteria
If the IRR is greater than the company’s cost of capital the project should be accepted.
Faced with mutually-exclusive projects choose the project with the higher IRR.

Question 32

what is the formula for IRR that needs to be learnt

Answer 32

IRR = L + (NL/(NL - NH)) x (H - L)

L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
N = NPV at higher rate of interest.

For examination purposes, the choice of rates to estimate the IRR is less important than your ability to perform the calculation to estimate it.

Question 33

what are the advantages of IRR

Answer 33

Using IRR as an appraisal technique has many advantages:
IRR considers the time value of money. The current value earned from an investment project is therefore more accurately measured.
IRR is a percentage and therefore easily understood. Although managers may not completely understand the detail of the IRR, the concept of a return earned is familiar and the IRR can be simply compared with the required return of the organisation.
IRR uses cash flows not profits. These are less subjective as discussed previously.
IRR considers the whole life of the project rather than ignoring later flows.
A firm selecting projects where the IRR exceeds the cost of capital should increase shareholders’ wealth. This holds true provided the project cash flows follow the standard pattern of an outflow followed by a series of inflows.

Question 34

what are the disadvantages of IRR

Answer 34

However there are a number of difficulties with the IRR approach:
It is not a measure of absolute profitability. A project of $1,000 invested now and paying back $1,100 in a year’s time has an IRR of 10%. If a company’s required return is 6%, then the project is viable according to the IRR rule but most businesses would consider the absolute return too small to be worth the investment.
Interpolation only provides an estimate (and an accurate estimate requires the use of a spreadsheet programme).
The cost of capital calculation itself is also only an estimate and if the margin between required return and the IRR is small, this lack of accuracy could actually mean the wrong decision is taken.
Non-conventional cash flows may give rise to no IRR or multiple IRRs. For example, a project with an outflow at T0 and T2 but income at T1 could, depending on the size of the cash flows, have a number of different profiles.

Question 35

what are annuities

Answer 35

An annuity is a constant annual cash flow for a number of years.

Question 36

calculating the NPV of a project with even cash flows (annuities)

Answer 36

When a project has equal annual cash flows the annuity factor may be used to calculate the NPV.
The annuity factor (AF) is the name given to the sum of the individual discount factors (also referred to as the cumulative discount factor).
The present value of an annuity can therefore be quickly found using the formula:
PV = Annual cash flow × AF
Like with calculating a discount factor, the AF can be found using an annuity formula or annuity tables.
The formula is:

AF = (1 - (1 + r)^-n)/r

Question 37

what are perpetuities

Answer 37

A perpetuity is an annual cash flow that occurs forever.
It is often described by examiners as a cash flow continuing ‘for the foreseeable future’.

Question 38

calculating the NPV of a project with a perpetuity

Answer 38

Calculating the NPV of a project with a perpetuity
The PV of a perpetuity is found using the formula:

PV = cashflow/r
or
PV = cashflow x 1/r

1/r is known as the perpetuity factor

IRR of a perpetuity = annual inflow/initial investment x 100

Question 39

how are advanced/delayed annuities and perpetuities dealt with

Answer 39

Advanced annuities and perpetuities
Some regular cash flows may start now (at T0) rather than in one years’ time (T1).
Calculate the PV by ignoring the payment at T0 when considering the number of cash flows and then adding one to the annuity or perpetuity factor.

Delayed annuities and perpetuities
Some regular cash flows may start later than T1.
These are dealt with by:
(a)applying the appropriate factor to the cash flow as normal
(b)discounting your answer back to T0.