capital budgeting (1)- management accounting

Investment Decision Rules and Capital Budgeting

Presented ByGopi Kumar VJMC Thrissur

Investment Decision Rules

• When faced with new investments, firms have to decide whether or not to invest in them. Investment decision rules allow us to formalize the process and specify what conditions need to be met for a project to be acceptable.

• The characteristics of a good investment decision rule:– An investment decision rule that is too mechanical or too malleable is not a good rule. It

should maintain a fair balance between allowing a manager to analyze a proposal bringing in his subjective assessments in the decision making process

– A good rule will allow the firm to maximize the value of the firm.– A good rule should work across a variety of investments. Investments can be revenue

generating or they can be cost saving. Some projects have large upfront costs while some others have costs spread out across time. A good rule will provide answers on all of these different kinds of investments.


• Categorizing Investment Decision Rules: the rules can be broadly classified into accounting earnings based rules, cash flow based rules and time weighted cash flow based rules.

• Accounting Income based rules: these rules are drawn from the accounting measures of income or the accounting statements. Some of these are based on income to equity investors and others are based on operating income. In each case the return is compared to the appropriate hurdle rate to decide whether the investment is worthwhile.

• The accounting income based rules falls short of consistency between analysis of various projects because they are affected by accounting choices. For instance changing from straight line to accelerated depreciation affects both the earnings and the book value of assets.

• Similarly as the BV of assets decreases over a period of time, the operating income increases and the ROCE increases.

• Accounting methods are relatively simple.


• Mutually exclusive investments: they serve the same purpose and compete with each other. If one investment is undertaken, others will have to be excluded. A company may for example use a labor intensive semi automatic investment or employ a more capital intensive automatic machine for production. Choosing the semi automatic machine precludes the acceptance of the highly automatic machine.

• Independent investments: they serve different purposes and do not compete with each other. A heavy engineering company may be considering expansion of plant capacity to manufacture excavators and addition of production facilities to manufacture light commercial vehicles. Depending on their profitability & availability of funds, they can undertake both projects.

• Contingent investments: they are dependent projects. The choice of one investment necessitates undertaking one or more other investments. For example, if a company decides to build a factory in a remote area, it may have to invest in houses, roads, hospitals etc to attract quality workforce.


Year 1 2 3 4

EBIT(1-T) 180 240 300 360

Average BV of assets

1400 1200 1000 800

ROCE ( after tax)

12.86% 20% 30% 45%%

0 2 3 41

1500 1300 1100 900 700


• The accounting returns used are:

• Decision Rule• If ROCE > Cost of capital accept the project• If ROCE < Cost of capital reject the project• If ROE is > Cost of equity accept the project• If ROE is < Cost of Equity reject the project

Projectsin sinvestmentequity of BV AverageIncomeNet

Projectsin Investment of BV Averagerate) tax -(1 Taxes &Interest Before Earnings Tax)After (

ROE

ROCE


• Cash Flow based decision rules:

Equity of BV AverageIncomeEquity Cash ROECash

chargescash non other &on Depreciati IncomeNet IncomeEquity

capital of BV AverageIncome OperatingCash ROCECash

chargescash non other &on Depreciati T)-EBIT(1 income operating

Cash

Cash


• Decision Rule

• If Cash ROC > Cost of capital accept the project• If Cash ROC < Cost of capital reject the project• If Cash ROE is > Cost of equity accept the project• If Cash ROE is < Cost of Equity reject the project

• Although cash returns take a partial step from accounting earnings, the non cash expenses are added back and hence they are less influenced by accounting decisions on depreciation.


• Payback Period: the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow. It tells us the number of years required to recover our initial cash investment based on the project’s expected cash flows.

Year Cash Flows Cumulative Inflows

0 (100000)(b)

1 34432 34432

2(a) 39530 73962(c)

3 39359(d) 113321

4 32219 145540

Payback period a+(b-c)/d = 2.66 yrs


• If the payback period calculated is less than some maximum acceptable period, the proposal is accepted, if not rejected.

• A major shortcoming of payback period is that it fails to consider cash flows occurring after the expiration of payback period., consequently it cannot be regarded as a measure of profitability. Two proposals costing Rs 10,000 each would have the same payback period if both had annual cash flows of Rs 5000 each in the first two years. But one project might be expected to provide no cash flows after two years, whereas the other might be expected to provide cash flows of Rs 5000 in each of the next three years. Thus the payback method might be deceptive as a yardstick of profitability.


• Discounted cash flow measures: Investment decision rules based on discounted cash flows not only replace accounting income with cash flows but explicitly consider the time value of money. The two most widely used discounted cash flow rules are net present value and the internal rate of return.

• Because of the various shortcomings of payback method it is felt that DCF methods provide a more objective basis for evaluating and selecting investments.

• DCF methods enable us to capture differences in the timing of cash flows for various projects through the discounting process. In addition, through our choice of hurdle rate, we can also account for project risk.


• Net Present Value:• The NPV of a project is the sum of the present values of each of the cash

flows – positive as well as negative that occur over the life of the project.

• It can be calculated from the perspective of all investors in the project, by discounting cash flows to the firm at the cost of capital and netting out the total initial investment in the project.

• It can also be calculated from the perspective of the equity investors in the project by discounting cash flows to equity at the cost of equity and netting out the initial investment in the project. The cost of equity should reflect the riskiness of the project.

Investment Initial -

1 r1tCF

Project a of

Nt

t tNPV


• Decision Rule• If NPV > 0 accept the project.• If NPV < 0 reject the project.• The NPV has several important properties that make it an attractive

decision rule.• Net present values are additive: the NPV of individual projects can be

added to arrive at a total NPV for a business or division.

• When a firm terminates a negative NPV project the value of the firm will increase by the amount of the negative NPV. Similarly, when a firm accepts a project with negative NPV, the value of the firm will decrease by the same amount.

projects future expected of NPV placein projects of PV firm a of Value


• When a firm divests itself of an existing asset and if the price received exceeds the PV of the anticipated cash flows, then value of the firm will increase with the divestiture.

• When a firm makes an acquisition at a price that exceeds the PV of the expected cash flows of the firm being acquired, the value of the firm will drop. This is one of the reasons why the stock price of the acquiring firms sometimes drop after an acquisition, as the market believes that the firm has paid more for the acquisition.

• NPV calculations allow for interest rate shifts: NPV can be computed using time varying discount rates. The discount rates may vary for three reasons: the level of interest rates may vary over time, the risk characteristics of the project may be expected to change in a predictable way across time resulting in changes in the discount rate, financing mix may change over time resulting in changes in both the cost of equity and the cost of capital.


• Points to remember about NPV: – NPV rule recognizes that a dollar today is worth more than a dollar tomorrow, because

the dollar today can be invested to start earning interest immediately.– NPV depends solely on the forecasted cash flows from the project and the opportunity

cost of capital ( discount rate)– Since present values are all measured in today’s dollars, they can be added.

• Comparison of NPV and Payback methods:

Project c0 c1 c2 c3 PB period

NPV@10%

A (2000) 500 500 5000 3 2624

B (2000) 500 1800 0 2 -58

C (2000) 1800 500 0 2 50


• In the example given, if the company were to follow the payback rule, they would have accepted projects B&C as they take only 2 yrs for the initial investment to be recovered.

• The payback rule ignores all the cash flows after the cut off date. • The payback rule gives equal weight to all cash flows before the cut off

date. Payback rule says that both projects B&C are equally attractive. • In order to use the payback rule the firm has to use an appropriate cut off

date. If it uses same cut off date regardless of the project life, it will tend to accept many poor short lived projects and reject many good long lived ones.

• The discounted payback rule surmounts the objection that equal weight is given to all flows before the cut off date. However it takes no account of the cash flows after the cut off date.


• Internal Rate of Return: The discount rate that equates the present value of the future net cash flows from an investment project with the project’s initial cash flow. IRR is that discount rate that makes the NPV zero.

• A graphical plot of the NPV and the discount rate (NPV Profile) will reveal that as the discount rate increases, the NPV decreases. The IRR is the point at which the profile crosses the x- axis. The slope of the profile also provides a measure of the sensitivity of NPV to discount rates.

• If IRR > Cost of capital accept the project• If IRR < Cost of capital reject the project• If IRR > Cost of equity accept the project• If IRR < Cost of Equity reject the project


Year Net Cash Flows PVIF(15%) PVIF(20%)

1 34432 29955.84 28681.86

2 39530 29884.68 27433.82

3 39359 25898.22 22788.86

4 32219 18429.27 15529.56

104168 94434.1

Initial Investment is Rs 100,000.

Interpolate to find the discount rate for Rs 1,00,000.

Formula: 0 x- 1x0y - 1y

00

xxyy


• Accounting Rate of return: The ARR or the book rate of return is defined as:

• ARR of a project is compared with the ARR of the firm as a whole or against some external yard stick like the ARR for the industry.

• Merits & Demerits: – Like payback method the concept and application is simple.– It considers the returns over the entire life of the project and therefore serves as a

measure of profitability unlike payback method which is only a method of capital recovery.– This method ignores the time value of money.– This method depends on accounting income and not on cash flows and hence is not a

reliable method for investment appraisal as investment appraisal emphasizes on cash flows

– The firm using ARR has to fix a yard stick for judging a project either based on their current book return or external yard stick. This can cause good projects to be rejected and bad ones accepted.

Investment of BV AveragePAT Average Return of Rate Accounting


• Discounted Payback Period: the number of periods taken in recovering the investment outlay on the present value basis. This is similar to payback period method, however the payback period only measures how long it takes for initial cash outflow to be paid back, ignoring the time value of money.

• Projects that have a negative NPV, will not have a discounted payback as the initial outlay will never be fully repaid. This is in contrast to payback method, where the gross inflow of future cash flows could be greater than the initial outflow, but when the inflows are discounted, the NPV is negative.


• Evaluate the project under the discounted payback period method. Cost of project is 50,500. Annual cash flows are:

Initial investment = 50,500 (b)

Year Annual CF PV@10% PV of CF Cumulative

1 5000 0.909 4545 4545

2(a) 50000 0.826 41300 45845(c)

3 30000 0.751 22530(d) 68375

4 30000 0.683 20490 88865

5 10000 0.621 6210 95075

D-PB period = a+[ ( b-c)/d] = 2.20

Capital Budgeting - Overview

• Capital budgeting is the process of identifying, analyzing and selecting investment projects whose returns ( cash flows) are expected to extent beyond one year.

• When a business takes up a capital investment it incurs a current cash outlay in the expectation of future benefits. Examples include investment in assets such as equipments, buildings and land, introduction of new products, a new program for research and development etc.

• Investment proposals can be classified into one of the below mentioned categories:– New products or expansion of existing products– Replacement of equipment or buildings– Research and development– Exploration– others


• One of the most important tasks in capital budgeting is estimating future cash flows for a project.

• Cash flows is central to all investment decisions of a firm and not accounting income.• For each investment proposal we need to provide information on operating cash

flows as opposed to financing cash flows. Financing payments like interest payments, principal payments and dividend payments are excluded from the cash flow analysis. The use of a discount rate (hurdle rate) will capture the financing cost dimension.

• The cash flows need to be determined on an after tax basis. • The information must be presented on an incremental basis so that we analyze only

the difference between the cash flows of the firm with and without the project. For example, if a firm contemplates a new product that is likely to compete with existing products, it is not appropriate to express cash flows in terms of estimated total sales of the new product. We must take into account the probable cannibalization of existing products and make our cash flow estimates on the basis of incremental sales. The key is to analyze the situation with and without the investment.


• In this regard the sunk costs must be ignored. Sunk costs are unrecoverable past outlays. Sunk costs are irrelevant and should not enter into the decision process. Apart from this we also have to include the opportunity cost in the project’s evaluation. Ex: if a currently unused building needed for a project can be sold for Rs 30 lacs, then that amount should be treated as a cash outlay. Thus in deriving cash flows we need to consider any appropriate opportunity costs.

• In estimating cash flows, anticipated inflation must be taken into account. If required rate of return embodies a premium for inflation, cash flows like future prices of products, future wages, material costs etc must also factor in inflation.


Format of determining Initial Cash Outflow

Cost of new assets

+ Capitalized Expenditures ( Installation, shipping expense etc

+/(-) Increased(decreased) level of net working capital

- Net proceeds from sale of old assets if replacement decision

+(-) taxes (tax savings) due to sale of old assets

∑ above = Initial Cash outflow


Interim Incremental Net Cash Flow

Net Increase(decrease) in operating revenue less net increase (decrease) in operating expense excluding depreciation-/(+) net increase(decrease) in tax depreciation charges (a)

= net change in income before taxes

-/(+) net increase ( decrease) in taxes

= net change in income after taxes

+/(-) net increase( decrease) in tax depreciation charges (same as item (a) above)= incremental net cash flow for the period.


Terminal year incremental net cash flows

Net increase(decrease) in operating revenue less(plus) any net increase( decrease) in operating expenses excluding depreciation.-/(+) Net increase(decrease) in tax depreciation charges

= net change in income before taxes

-/(+) net increase(decrease) in taxes

= net change in income after taxes

+/(-) Net increase(decrease) in tax depreciation charges

= incremental cash flows in terminal year before project windup considerations=/(-) final salvage value

-/(+) taxes ( tax savings) due to sale of new assets

+/(-) decreased ( increased) level of net working capital ( generally initial WC investment is returned as cash inflow)∑ = terminal year incremental cash flow

Capital Rationing

• A situation where a constraint or budget ceiling is placed on the total size of the capital expenditures during a particular period.

• Capital rationing occurs anytime there is a budget ceiling on the amount of funds that can be invested during a specified period, such as a year. An example of capital rationing is when a division of a large company is allowed to make capital expenditures only up to a specified budget ceiling.

• With capital rationing, the firm selects the combination of budget proposals that will provide the greatest increase in the value of the firm.

• A budget ceiling carries a real cost when it bars us from taking advantage of any additional profitable opportunities.

• Capital rationing results in an investment policy that is less than optimal as a firm should accept all projects yielding more than the required rate of return. However the constraint here is that unlimited amount of capital is not available at any one cost.

Capital Rationing

Project C0 C1 C2 NPV@10% Profitability Index

A -10 30 5 21 2.1

B -5 5 20 16 3.2

C -5 5 15 12 2.4

Although, projects B & C have a lower NPV than A, the biggest bang for the buck is given by B&C as the profitability index is higher than A. Profitability Index is defined as ( NPV / Investment). When funds are limited, a firm needs to concentrate on getting the biggest bang for the buck. PI and NPV methods gives the same accept – reject signals. If PI is >1, then NPV will be > 0. But NPV is preferred over PI as it gives the absolute economic contribution whereas PI expresses only relative profitability.

Risk Analysis in Capital Budgeting

• Projects differ in risk and it should be reflected in capital budgeting decisions. However, it is difficult to measure risk, especially for new projects without history.

• Three separate and distinct types of risks involved are:

Stand alone risk – the risk an asset would have if it was a firm’s only asset and if investor’s owned only one stock. It is measured by the variability of the assets expected returns.

Corporate risk – risk considering the firm’s diversification but not stock holder diversification. It is measured by the project’s effect on uncertainty about the firm’s expected future returns.

Mark et risk – considers both firm and stock holder diversification. It is measured by the project’s beta coefficient.

Risk Analysis in Capital Budgeting• Decision maker’s do a quantitative analysis of the stand alone risk and make qualitative

analysis if the other two risks.• The three methods used for measuring the stand alone risks are:• Sensitivity analysis – Percentage change in NPV resulting from a given percentage change in

an input variable, other things held constant. The analysis begins with a base case situation where the project’s NPV is found using the base case value for each input variable. Further to this “What if” questions are asked and analyzed to fathom the sensitivity to different variables.

• Scenario analysis – a risk analysis technique in which bad and good sets of financial circumstances are compared with a most likely or base case situation. A worst case scenario is analyzed by setting all the input variables at their worst forecasted values. A best case scenario is analyzed by setting input variables at their best forecasted values. In sensitivity analysis, we change one variable at a time and in scenario analysis we change the whole set of data. Scenario analysis allows to assign probabilities for various scenarios and then find the expected values.

• Monte Carlo Simulation – a risk analysis technique in which probable future events are simulated on a computer generating estimated rates of return and risk indexes. The computer generates random numbers for input variable and NPVs and standard deviations of NPVs are calculated multiple times. This is a sophisticated version of scenario analysis.

• Risks exists because of the inability of the decision maker to make perfect forecasts. An investment is not risky, if we can specify a unique sequence of cash flows for it. But the trouble is that cash flows cannot be forecasted accurately.

• Three broad categories of events influencing the investment forecasts are:– General economic conditions– Industry factors– Company factors.

• Risk is associated with the variability of future returns of a project. The greater the variability, the riskier the projects.

• The most common measures of risk are standard deviation and coefficient of variation. Standard deviation is an absolute measure of risk and CoV is a relative measure.

NCF of Variance

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