CAPITAL BUDGETING
A. Definition
Capital budgeting is a financial planning process that involves evaluating, selecting, and
managing long-term investments to maximize the value of the firm. It goes beyond routine
operational expenditures and focuses on substantial capital investments, such as acquiring new
assets, launching new products, or expanding existing facilities.
B. Importance
Crucial for strategic decision-making: Capital budgeting decisions have a long-lasting impact
on the organization's growth and profitability. Thus, careful consideration is essential for the
overall strategic direction of the company.
- Involves substantial financial commitments: These decisions often require a significant
financial investment, and making the wrong choices can lead to financial strain or missed
opportunities.
- Impacts the company's future cash flows and profitability: Successful capital budgeting can
enhance future cash inflows, improve profitability, and strengthen the financial position of the
organization.
II. Methods of Capital Budgeting
A. Payback Period Method
1. Definition
- The payback period is the time required for the initial investment to be recovered through
the project's net cash inflows. It is a simple measure that focuses on the breakeven point.
2. Formula
Payback Period = Initial Investment / Annual Cash Inflow
3. Advantages
Simple and easy to understand: The method provides a straightforward metric for assessing
how quickly an investment will generate returns. Emphasizes quick recovery of the investment:
Suitable for projects where a rapid return of capital is a critical consideration.
4 Limitations
- Ignores time value of money: The payback period method does not consider the fact that a
dollar received in the future is worth less than a dollar received today.
- Ignores cash flows beyond the payback period: It provides limited insight into the project's
long-term profitability.
B. Net Present Value (NPV) Method
1. Definition
- The Net Present Value (NPV) method evaluates the profitability of an investment by
calculating the present value of its expected cash flows minus the initial investment. It accounts
for the time value of money.
2. Formula
- NPV = Σ (Cash inflow / (1 + r) ^t) - Initial Investment
3. Advantages
- Considers the time value of money: NPV discounts future cash flows to their present value,
providing a more accurate representation of the investment's true worth.
- Indicates the actual value addition to shareholder wealth: Positive NPV indicates that the
investment is expected to increase shareholder wealth.
4. Limitations
- Requires discount rate estimation: The accuracy of NPV calculations depends on the
appropriate selection of the discount rate.
- Complex calculations may be challenging for some: NPV computations involve multiple steps
and may be difficult for individuals without a strong financial background.
C. Internal Rate of Return (IRR) Method
1. Definition
- The Internal Rate of Return (IRR) is the discount rate at which the NPV of a project is zero. It
represents the project's expected rate of return.
2. Formula
Solve for IRR: NPV = 0
3. Advantages
- Considers the time value of money: Similar to NPV, IRR accounts for the present value of
future cash flows.
- Provides a percentage return on investment: IRR expresses the project's return as a
percentage, making it easier to compare against the cost of capital or other investment
opportunities.
4. Limitations
- Multiple IRRs may exist: In some cases, a project may have multiple discount rates that yield
an NPV of zero, complicating interpretation.
- Can be challenging to interpret: IRR may not always provide clear guidance on whether an
investment should be accepted or rejected.
D. Accounting Rate of Return (ARR) Method
1. Definition
- The Accounting Rate of Return (ARR) is a method for evaluating the profitability of an
investment based on accounting measures such as net income and average accounting book
value.
2. Formula
- Average Accounting Profit = (Average Net Income + Depreciation) / 2
- Average Investment = (Initial Investment + Residual Value) / 2
3. Advantages
- Simple calculation: ARR is relatively easy to calculate and understand.
- Based on accounting measures: Utilizes accounting information readily available in financial
statements.
4. Limitations
- Ignores time value of money: Similar to the payback period, ARR does not consider the time
value of money.
- Dependent on accounting methods: Variations in accounting methods can impact the
calculated rate of return.
III. Decision Criteria and Considerations
A. Risk Analysis
- Evaluate the risk associated with each investment project: Assess the potential impact of
uncertainties on project outcomes. Consider external factors such as market conditions,
economic trends, and industry competition.
B. Sensitivity Analysis
- Assess how changes in key variables impact project viability: Conduct sensitivity analyses to
understand how variations in critical factors, such as sales volume, cost of capital, or operating
costs, affect project outcomes.
C. Capital Rationing
- Allocate capital to projects that maximize overall profitability: When faced with budget
constraints, prioritize projects that provide the highest returns relative to their capital
requirements. This ensures optimal resource allocation.
IV. Case Studies and Practical Applications
Some Practical Points
When undertaking capital budgeting /investment appraisal, there are several practical points to
bear in mind:
Past costs. As with all decisions, we should take account only of relevant costs in our
analysis. This means that only costs that vary with the decision should be considered.
Thus, all past costs should be ignored as they cannot vary with the decision. A business
may incur costs (such as development costs and market research costs) before the
evaluation of an opportunity to launch a new product. As those costs have already been
incurred, they should be disregarded, even though the amounts may be substantial and
relate directly to the project. Costs that have already been committed but not yet paid
should also be disregarded. Where a business has entered into a binding contract to
incur a particular cost, it becomes in effect a past cost even though payment may not be
due until some point in the future.
Common future costs. It is not only past costs that do not vary with the decision; some
future costs may be the same. For example, the cost of raw materials may not vary with
the decision whether to invest in a new piece of manufacturing plant or to continue to
use existing plant.
Opportunity costs. Opportunity costs arising from benefits forgone must be taken into
account. Thus, for example, when considering a decision concerning whether or not to
continue to use a machine already owned by the business, the realisable value of the
machine may be an important opportunity cost
Taxation. Owners will be interested in the after-tax returns generated from the business.
Profits from the project will be taxed, the capital investment may attract tax relief and so
on. As the rate of tax is often significant, taxation becomes an important consideration
when making an investment decision. Unless tax is formally taken into account, the
wrong decision could easily be made. This means that both the amount and the timing of
tax outflows should be reflected in the cash flows for the project.
Cash flows not profit flows. We have seen that for the NPV, IRR and PP methods, it is
cash flows rather than profit flows that are relevant for the assessment of investment
proposals. Nevertheless, some proposals may contain only data relating to profits over
the investment period. These will need to be adjusted in order to derive the cash flows.
As mentioned earlier, operating profit before non-cash items (such as depreciation)
provides an approximation to the cash flows for a particular period. We should,
therefore, work back to this figure.
Working capital adjustment. Where data relating to profit rather than cash flows has
been provided, some adjustment for changes in working capital may also be needed.
Launching a new product, for example, may give rise to an increase in the net
investment made in working capital (trade receivables and inventories less trade
payables). This would normally lead to an immediate outlay of cash, which should be
shown as a cash outflow in the NPV calculations. However, at the end of the life of the
project, the additional working capital will be released. This divestment results in an
effective inflow of cash at the end of the project. This should be shown in the NPV
calculations at the point at which it is received.
Year-end assumption. In the examples and activities considered so far, we have assumed
that cash flows arise at the end of the relevant year. This simplifying assumption is used
to make the calculations easier. As already mentioned, this assumption is unrealistic as
employees are paid on a weekly or monthly basis, credit customers pay within a month
or two of the sale and so on. Nevertheless, it is probably not a serious distortion. If
required, it is perfectly possible to deal more precisely with the timing of cash flows.
Interest payments. When using discounted cash flow techniques (NPV and IRR), interest
payments should not be taken into account in deriving cash flows for the period. The
discount factor already takes account of the costs of financing. To include interest
charges in deriving cash flows for the period would, therefore, be double counting.
Non-quantifiable factors. Investment decision making must not be viewed as simply a
mechanical exercise. The results derived from a particular investment appraisal method
will be only one input to the decision-making process. There may be broader issues
connected to the decision that have to be taken into account but may be difficult or
impossible to quantify. Nevertheless, they may be critical to the final decision. The
degree of confidence in the reliability of the forecasts and the validity of the assumptions
used in the evaluation will also have a bearing on the final decision
QUESTIONS
Exercise 1
XYZ Company has carried out research relating to a service that it has recently developed.
Provision of the service would require investment in a machine that would cost £100,000,
payable immediately. Sales of the service would take place throughout the next five years. At the
end of that time, it is estimated that the machine could be sold for £20,000. The cost of capital is
assumed at 20%.
You are required to calculate the net present value of XYZ company investment.
Exercise 2
John Plc is considering a project having the following cash flow profile.
Year Outlay Savings Running Cost
Fcfa Fcfa Fcfa
0 (100,000) - -
1 42,000 14,000
2 56,000 24,500
3 84,000 35,000
4 105,000 42,000
The company’s cost of capital is 10%.
a) You are required to calculate the project viability.
b) Calculate the followings:
i. The project’s sensitivity to the outlay.
ii. The project’s sensitivity to the savings.
iii. The project’s sensitivity to the running cost.
The discounting factor should be in 3 decimal places.
Exercise 3
