module 11 budgeting and long term planning
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Acknowledgement These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian Development Bank’s Pacific Private Sector Development Initiative (PSDI). PSDI is a regional technical assistance facility co-financed by the Asian Development Bank, Australian Aid and the New Zealand Aid Programme.TRANSCRIPT
Module 11 Budgeting and long term planning
ADB Private Sector Development Initiative Corporate and Financial
Governance Training Solomon Islands Originally by Dr Judy Taylor
Acknowledgement These materials were produced by Dr Judy Taylor
from La Trobe University, through the Asian Development Banks
Pacific Private Sector Development Initiative (PSDI).PSDI is a
regional technical assistance facility co-financed by the Asian
Development Bank, Australian Aid and the New Zealand Aid Programme.
Module 11 Outline What is Capital budgeting Steps in capital
budgeting
Capital budgeting techniques explained Payback Net present value
Internal rate of return Accounting return How do I choose which
project to implement Capital Budgeting Capital budgeting is the
formal term for planninglong-term investment decisions. These
projects aredifferent from normal budgeting decisions due totheir
size and the time taken to implement them. The problem for the
business is threefold, how to evaluate a project, when they have a
number of such projects they canundertake how do they evaluate them
and then how to compare them. Investment in your business is
crucial to the ongoing growth and health of cash flows. Investment
decisions take time to plan, evaluate and implement. They take
careful and considered long term planning. Then, once implemented
investment decisions usually take time to mature as businesses and
become profitable. Capital Budgeting Techniques can be used to help
a company to assess if thecapital budgeting proposals will yield a
return and deliveran economic value to the company. usually focus
on the cash flows of the investment choices rather thanaccounting
profit. Module 8, we constructed a budget for our business.
Capitalbudgeting decisions require the company to complete
similarforecasts of costs as well as cash flows in and out
whenevaluating a business proposal. These projects should be found
in the long term businessplan, but they will be planned for and
evaluatedseparately. Capital Budgeting If there is more than one
project that the company isconsidering the company should evaluate
all theprojects in the same manner. Firstly estimating thecosts
then the cash flow. Taking care to allocateeach of these to the
correct period. . Capital Budgeting Once the capital budgeting is
undertaken for all theproposed projects the company must make a
decision ofwhich project they will undertake. companies usually
have access to limited resources and areunable to take up every
opportunity that presents itself. companies that grow too quickly
often fail or suffer loss for a period of time because they stretch
their management resources too thinly and it takes resources to
integrate new business into the old businessstructure. So even if
it is possible to undertake a number of projects it isoften not
wise to do so. Capital Budgeting Steps involved in capital
budgeting.
Identify long-term goals of the individual or business. Identify
potential investment proposals Estimate and analyse the relevant
cash ows of theinvestment Determine nancial feasibility of each of
theinvestment proposals using the capital budgetingmethods. Choose
the projects to implement Implement the projects chosen Monitor the
projects implemented. Capital Budgeting Different projects have
different timings of cash outflowsand inflows. There are a number
of techniques that a company canuse to evaluate the projects. Each
potential projectneeds to be evaluated. This can be done either
calculating the amount of time it takes to have your investment
fundsreturned, or converting the cash inflows and outflows into
currentdollars. Assume the following 4 projects are available for
yourcompany to undertake. In addition to the techniques we will
discuss below some businesses do not opt for the project that
yields the greatest return if there are other overriding
considerations that dictate a lesser profitable one be accepted. 4
different projects Project 1 Project 2 4 different projects Project
3 Project 4 4 different projects Which project is better?
Why?
How do you evaluate the different timing of thecash inflows and
outflows? Capital budgeting decisions
Understanding how the different methods forassessing capital
investments are calculated, iscritical to making a sound
responsible choice (eventhough staff will usually do it for the
board). Understanding discount rates and the time value ofmoney is
central to this solid understanding A dollar received in a year
from today is not asvaluable as a dollar received today, its value
isdiscounted by time - I year Capital budgeting decisions
If the dollar received today could be invested and earn 10%,then in
a year it will be worth $1.10, But, the dollar we receive is a year
will just that $1. To find the value of a dollar that will be
received in the futurewe discount it by the rate it could have
earned, 10%. So 1/1.10 =$.909. And $ .909 invested at 10% for I
year will grow to $1. That shows us that in todays terms a dollar
received today isworth $1 but a dollar received in inyear is worth
only $.909cents today This is why we prefer a dollar today and why
discountingfuture cash flows to todays value helps us make
soundresponsible financial investment decisions. Capital budgeting
decisions
If we discount by a set amount say 10% to find thevalue of a dollar
received in the future to a presentvalue $, the dollar value of the
discounted sums iscalled the net present value, NPV If we discount
so that the NPV = 0 this is called theinternal rate of return.
Capital Budgeting These techniques include:
Payback Period Discounted Payback Net Present value Internal rate
of return Modified internal rate of return Accounting rate of
Return How do I do this, Which one should I use, and Why? Payback
Period The payback period calculates how long it takes to have
yourinvestment returned to you in years, or months. This is the
simplest method for assessing a projects return. Using Project 1
above Year Cash Flow Cumulative cash flows0 -$40,000 -$40,0001
-$40,000-$80,000 2 $110,000 $30,0003 $130,000 $160,0000 It took
years to receive cash flows sufficient to return the
capitalinvested. Decision Rule The project that pays back in
shortest time is most desirable. Discounted Payback Period
The payback does not distinguish the future dollars from todays
dollars. A dollarreceived in 4 years hence is worth less than a
dollar received today. We can discountthe future values by a
discount rate, say 10% and recalculate the payback based on themore
realistic values. YearCash Flow Discount rateDiscounted
valueCumulative Cash Flows 0 -$40,000
$40,0001-$40,0001.1-36,366-$76,366 2 $110,000(1.1)2 +$ 3
$130,000(1.1)3 This gives a payback in 2.84 years as opposed to
Usually the discountedpayback takes longer. Decision Rule The
project that pays back in shortest time is most desirable. Net
Present Value (NPV)
This technique estimates the present value of a stream ofcash
inflows and outflows over different time periods. If the NPV is
greater than zero then the project is viable.It discounts cash
inflows and outflowsusing a discountrate, to find itsNPV. This
technique was first usedin 1951. Today it is the most common method
used in financialtextbooks and by companies. To undertake a NPV
calculation an estimate of the sizeand timing of all the cash flows
as well as an estimateof a discount rate is required. Net Present
Value (NPV)
Value of NPV Interpretation Action NPV > 0the project would add
the project value to the firmmay be accepted NPV < 0the project
would not the project add value to the firmshould be rejected NPV =
0the project would neitheras the project neither add nor lose value
adds nor subtracts from for the firmthe value we are indifferent to
the project The decision to proceed or reject the project will be
based onavailability of other projects or other criteria. Net
Present Value (NPV)
Selecting the proper discount rate is critical to thecorrect
calculation. The NPV is determined by thediscount rate, alsocalled
thehurdle rateis crucial to making the rightdecision. The hurdle
rate is the minimum acceptablerate of returnon an investment.
Choosing a discount Rate The discount rate is effectively a desired
return, or the return that an investor would expect to receive on
some other typical proposal of equal risk. The discount rate
typically includes: The rate of time preference. Most people prefer
consumption undertaken now rather than later. Thus, a dollar
available now is more highly valued than one received later.
Uncertainty/risk. There is necessarily some degree of uncertainty
as to whether a future dollar will actually be received. Its value
is lessened in proportion to the expected size of this
uncertainty/risk factor. Well talk more on this shortly. Net
Present Value (NPV)
The formula to discount one future cash flow to itspresent value
is: PV = FV/(1+r)n PV= Present value FV = Future value r= discount
rate n = number of years Net Present Value (NPV)
However where there is more than one future cash flow you usethe
following formula Or -C0 = Initial Investment C = CashFlow r=
discount rate 1,2,3, n= time Net Present Value (NPV)
Looking at project 1. The project incurs cost of $40000 in each of
the 4 years, but In year 2 the project earns a net cash inflows for
the first time of $ In year 3 the project earns a net cash inflow
of $ Year Cash Flow Discount rate Present Value 0 -$40, $40, $40,
$36, $110,000 (1.1)2 $90, $130,000 (1.1)3 $97, Total costs$160,000
+$112,216.37 Net Present Value (NPV)
Net Present Value = $112,216.37 Net Present Value (NPV) The net
present value of this example can be shown in the formula Overall
the project revenue is $320,000 and the costs are$160,000 with net
cash profit of $160,000. Net Present Value (NPV)
Decision Rule. If at the end the NPV is greater than zero then
theproject is viable. Discount Rate The discount rate is the rate
used to convert the cashflows into todays value, the present value.
The rate used should reflect the riskiness of theinvestment, as
well as thevolatilityof the cash flows. It must also take into
account the financing mix,internal, raising capital from owners
plus outsidefinancing from banks or bond issuing. Net Present Value
(NPV)
Different discount rates If the company produces across a number
ofindustry types and the cost of capital is different ineach, a
different hurdle rate should be used for each projectthat reflects
the risk of each project. A higher discount rate would beused if a
project's risk is higher than the risk of the firm as awhole. Net
Present Value (NPV)
How do you estimate the discount rate? To estimate the cost of the
financing mix Managers often usemodels such as theCapital Asset
Pricing Model, (CAPM)toestimate the appropriate discount rate for
each particularproject. CAPM uses the cost of the financing mix -
debt plus equity, weighted by their respective share of the total.
This is called theweighted average cost of capital(WACC),when it is
used as the discount rate to calculate the NPV it isreferred to as
the hurdle rate. This is because each projectmust earn a return
greater than the cost of capital. If notthere is no
financial/economic reason to proceed with theproject. Net Present
Value (NPV)
Problems with the NPV Calculations Choosing the discount rate
Choosing the correct premium to add as a risk factor to thediscount
rate. If this is simply based on a bank premium itmay be incorrect
and result in a misleading indicator ofeconomic value. Depending
upon the industry, cash flows at the end of thelife of the project
may become negative (e.g. if largeremediation of the site is
required), in areas such as mining.This can be catered for by
explicitly allowing for financingthe losses- negative cash
outflows. The NPV shows you whether your return is above
yourrequired return but it does not give you an actual return.
Inorder to calculate this you need to do an IRR calculation.
Internal Rate of return
The IRR is the rate of return such that the presentvalueequals
zero. Internal rate of return and net present value IRR uses a
similar technique to the one used in NPV(to convert the future cash
flows into present daydollars) except a different discount rate is
used. TheIRR is thediscount rate that gives aNPV of zero. IRR is
used as a measure of investment efficiency. Internal Rate f return
= $40,000+$ $ $ Internal Rate of return
The IRR method will result in the same decision as theNPV method,
(see table below). In the usual cases where a negative cash flow
occurs atthe start of the project, followed by all positive
cashflows projects that have a higher IRR higher than thehurdle
rate should be accepted. Nevertheless, for mutually exclusive
projects, it ispossible that if a companys decision rule requires
themto choose the project with the highest IRR - which isoften used
they may be selecting a project with alower NPV. Internal Rate of
return
Value of NPVValue of IRRInterpretation/Action NPV > 0IRR>
NPVthe project would add value to the firm the project may be
accepted NPV < 0IRR 0 IRR> NPV the project would add value to
the firm the project may be accepted NPV < 0 IRR NPV Discounted
payback Net Present value NPV>0 NPV0 and IRR>NPV IRR0 and
MRR>NPV MRR required rate of return ARR< required rate of
return ARR=required rate of return NPV > 0IRR> NPVthe project
would add value to the firm the project may be accepted NPV <
0IRR