Capital budgeting advanced, Lecture notes of Financial Management

Download Capital budgeting advanced and more Lecture notes Financial Management in PDF only on Docsity!

© Correia, Flynn, Uliana & Wormald

Further Further

Issues in Issues in

Capital Capital

Budgeting Budgeting

CHAPTER 9 CHAPTER 9

© Correia Flynn, Uliana, 2

Objectives

 At the end of the chapter, you should be able to:At the end of the chapter, you should be able to:

 Evaluate projects with unequal economic livesEvaluate projects with unequal economic lives

 Adjust for the effects of inflation in the capital budgetingAdjust for the effects of inflation in the capital budgeting

analysisanalysis

 Rank and select projects under conditions of capitalRank and select projects under conditions of capital

rationingrationing

 Include the effects of tax losses on the capital budgetingInclude the effects of tax losses on the capital budgeting

decisiondecision

© Correia Flynn, Uliana, 4

Projects with Unequal Lives

How do we choose between alternativesHow do we choose between alternatives with unequal economic lives?with unequal economic lives?

It may not be possible to compare NetIt may not be possible to compare Net Present Values.Present Values.

Need a universal measure to ensureNeed a universal measure to ensure comparability.comparability.

© Correia Flynn, Uliana, 5  (^) Projects with unequal livesProjects with unequal lives  (^) Should we select Project Y with the higher NPV?Should we select Project Y with the higher NPV?  (^) If there is an opportunity to reinvest in a similarIf there is an opportunity to reinvest in a similar project X in 3 years, then the NPV for Project Xproject X in 3 years, then the NPV for Project X will be:will be:

Example

Project cash fows (Rm) 0 1 2 3 4 5 6 X -52 28 28 28 Y -80 25 25 25 25 25 25 NPV (X) 13. NPV (Y) 17. Project cash fows (Rm) 0 1 2 3 4 5 6 X (1) -52 28 28 28 X (2) -52 28 28 28 -52 28 28 -24 28 28 28 NPV (X) 21.

© Correia Flynn, Uliana, 7

Equivalent Annual Costs

 We can convert capital costs into EquivalentWe can convert capital costs into Equivalent Annual costs.Annual costs.  (^) Project X - 52m/2.3216 = 22.4mProject X - 52m/2.3216 = 22.4m  (^) Project Y - 80m/3.8887 = 20.57mProject Y - 80m/3.8887 = 20.57m  (^) If the annual cash flows were the same, Project YIf the annual cash flows were the same, Project Y would be selected as it minimises the annual costwould be selected as it minimises the annual cost of the investment.of the investment.  (^) Further adjustments required for capital taxFurther adjustments required for capital tax allowances, which will reduce the real cost ofallowances, which will reduce the real cost of investments in fixed assets.investments in fixed assets.

© Correia Flynn, Uliana, 8

Capital Budgeting and Inflation

No adjustment for inflation may result inNo adjustment for inflation may result in material errors in capital budgeting decisions.material errors in capital budgeting decisions.

Why? Inflation is included implicitly in theWhy? Inflation is included implicitly in the discount ratediscount rate

Nominal rateNominal rate (1+ Real rate)(1+Inflation rate) – 1 (1+ Real rate)(1+Inflation rate) – 1

If the expected inflation rate is 7% and theIf the expected inflation rate is 7% and the real rate is 4%, then the nominal (quoted) ratereal rate is 4%, then the nominal (quoted) rate is 11.3%.is 11.3%.

© Correia Flynn, Uliana,

Capital Budgeting and Inflation

 Adjust future cash flows by inflation of 4.72% per year andAdjust future cash flows by inflation of 4.72% per year and

NPV becomes positive.NPV becomes positive.

 Tax excluded in above example. Depreciation deductions doTax excluded in above example. Depreciation deductions do

not increase with inflation as tax allowances are based onnot increase with inflation as tax allowances are based on

historical cost.historical cost.

 Refer to example in textbook to see what happens.Refer to example in textbook to see what happens.

10

© Correia Flynn, Uliana,

Capital Rationing

Used when a lack of capital prevents aUsed when a lack of capital prevents a company from selecting all positive NPVcompany from selecting all positive NPV projects.projects. 11

Projects 1 – 4:

IRR > WACC

Should be accepted.

Project 5:

IRR < WACC

Should be rejected.

Capital constraint of

R70m means only

Project 1 and 2 can be

accepted.

© Correia Flynn, Uliana, 13 Capital Rationing

RulesRules

Maximise the total NPV subject to theMaximise the total NPV subject to the capital constraint.capital constraint.

Use the Profitability Index toUse the Profitability Index to rankrank projects if projects are divisible projects if projects are divisible

Why? The PI measures the returnWhy? The PI measures the return relative to cost.relative to cost.

© Correia Flynn, Uliana, 14 Capital Rationing & PI

Example:

Assume capital constraint = ZAR 15. 00 m Project 0 1 2 NPV PI A -1 5 30 15 23.7 2. B -8 4 25 15.5 2. C -7 6 22 15.9 3.

Note. PI =(NPV+Cost)/Cost

Cost of Capital = 12% Combined NPV = 31. As compared to A alone 23.

© Correia Flynn, Uliana,

Capital rationing: use of a hurdle

rate

In order to manage capital rationing, firmsIn order to manage capital rationing, firms may set a hurdle rate that is higher than themay set a hurdle rate that is higher than the cost of capitalcost of capital

In figure 9.3, if we use a hurdle rate ofIn figure 9.3, if we use a hurdle rate of 20%, then only projects 1 and 2 would be20%, then only projects 1 and 2 would be acceptedaccepted

What the disadvantages with using a hurdleWhat the disadvantages with using a hurdle rate?rate? 16

© Correia Flynn, Uliana, 17 Assessed Tax Losses

Assume:

New project results in a cash inflow of R5m per year.

That existing product lines are currently also producing

income of R5m per year. Assume tax rate = 30%.

Rm Rm

AssumeAssessed Loss = 3.5 or 10.

Other Product Lines 5.

If the Assessed Loss = 3.

The tax loss should be set off against income from existing products. The effect on the new project is zero.

If Assessed Loss = 10.

Year 1 2 Cash Flows 5.0 5. Tax - -1. 5 Tax -1. 5 5.0 2.

ASSESSED LOSSES

© Correia Flynn, Uliana, 19 Capital Budgeting Theory vs Practice

Which methods are used in practice?Which methods are used in practice?

TrendsTrends

Risk AppraisalRisk Appraisal

Firm SizeFirm Size

• (^) Inflation, Tax & Post-completion auditsInflation, Tax & Post-completion audits

© Correia Flynn, Uliana,

Methods used in practice

20