FINANCIAL TECHNIQUES

BY LUKAS NAKWEENDA
 CHAPTER 5

LONG-TERM INVETSMENT DECISIONS

CAPITAL BUDGETING

(For more detailed content, please refer to the text book and other sources)!

Source: Correia
 After engaging this chapter, you should be able to:

 Explain why capital budgeting decisions are critical for the firm;

 Discuss why cash flows are important than accounting earnings in the
evaluation of investment projects;

 Apply and explain the techniques used to evaluate capital projects – PBP, NPV,
IRR, and set out the pros and cons of each technique.

3
 5.1. Discussion outline
4
 Types of Projects

 Capital Budgeting Methods

 Net Present Value

 Internal Rate of Return

 Payback Period

 Accounting Rate of Return

 Profitability Index (PV Index or Benefit-Cost Ratio)

 5.2. Why is the CB decision so important for the firm?
5
 The Statement of Financial Position

 SoFP includes past capital budgeting decisions.

 Tactical and Strategic Investments

 Consequences of Investment and Non-investment

 Over capacity resulting in high overheads

 Under-capacity resulting in loss of market share

 Loss of Flexibility

 A large investment results in a company losing the option to invest.

 Timing

For acquisition for example, do it prior to the economic boom.

 5.3. TYPES OF INVESTMENT PROJECTS
6
 Replacement Decisions
 Expansion : existing product lines
 Expansion : new product lines
 Other (IT, Pollution control, Corporate social investment)
Different risk
 Mutually Exclusive vs. Independent Projects profile, hence
each project is
to be
accepted
Same risk profile, independently.
hence only one Where a project can
project should be be undertaken in
accepted at a time. part – Prof. Index
Where a project
cannot be
 Divisible and non-divisible projects undertaken in
parts – Max NPV
 5.4. Why use Cash Flows ?
7  Future benefits of the project
 Only use Cash flows, not earnings – timing, difference?
 Accounting Earnings vs. Cash Flows
 Accounting is based on the Matching Concept – meaning?
 Cost and Depreciation – meaning?
 Taxation - GAAP & Inventory Valuation
Tax is a cash flow and taxable income is based on the Accrual
Accounting Model (i.e. Accrual Basis of Accounting)
 Accounting does not record opportunity costs; in Capital Budgeting
we include cash flows foregone – e.g. Rental occupancy.
 Performance Appraisal
 Yet, if Accounting results are used to measure management
performance, then Accounting may be relevant.
8
5.5. What are some of the Capital Budgeting Techniques?

 Net Present Value (NPV)

 Internal Rate of Return (IRR)

 Payback Period and Discounted Payback

 Accounting Rate of Return

 Profitability Index (Benefit-cost ratio)

 5.6. Net Present Value (NPV)
9

 NPV = Future Cash flows discounted at the cost

of capital less the Cost of the Project
If NPV > 0, accept the project – meaning?
If NPV < 0, reject the project – meaning?
 5.7. Internal Rate of Return (IRR)
10
IRR = Discount rate which makes the Present value of the
Project’s Future Cash flows equal to the cost of the Project,
hence NPV = 0.

Calculated by iteration or by financial calculator or Excel.

 5.8. NPV Profile - How will NPV change with a change in the discount rate?
11

NPV Profile

5,000

4,000

3,000
What do you
think, why an
2,000
IRR inverse
NPV

relationship
1,000
between NPV
and Discount
0
rate?
0%

3%

6%

9%

%
12

15

18

21

24

27

30

33

36

39
-1,000

Discount rate
-2,000

NPV
 5.9. NPV or IRR?

 If we analyse the NPV Profile, a project with a positive NPV will also
12

have an IRR to the right of the cost of capital (i.e. IRR > Cost of Capital).
So the IRR and the NPV methods will give the same answer. Is this
always so?
 Assume Project A and B are alternative one year investments. A firm
can only select either A or B.

Year 0 1 NPV IRR

Cost of Capital 10%
Project A (10,000) 11,800
Project A 727 18%
Project B (1,000) 1,400
Project B 273 40%
 5.10. Question is: NPV or IRR?
13
 Using our example on the previous slide, Project A results in a
higher NPV and Project B results in a higher IRR. Which project
should be accepted?

 The difference in costs should not affect the decision unless the
company is subject to capital rationing. If markets are efficient,
the company should be able to always raise finance at its cost of
capital.

 Though Project B has a higher IRR, Project A; which has a higher

NPV would have been preferred based on the reliability of NPV.
 5.11. What is Wrong with IRR?
There could be more than one IRR for non-conventional projects.
14
Year 0 1 2

Project I (200) 1,000 (1,000)

Cost of Capital 14%
NPV (92)
IRR 38%
IRR 262%

NPV Profile of Non-conventional Project

50.00

-
22%
44%

66%
88%

110%
132%

154%
176%
198%

220%

242%
264%

286%

308%
330%
352%

374%

396%
418%

440%
0%

(50.00)

(100.00) NPV

(150.00)

(200.00)

(250.00)
 5.12. Payback Period Method
15
 Projects are evaluated according to the number of years that it
takes to recover the cost of the investment from the cash flows
generated by the project.
 Suppose the firm sets a required payback period of 3 years.
 Meaning, only projects with payback periods of less than 3
years are accepted. That would mean only Project I should be
accepted.

Year Rm 0 1 2 3 4
Project I -12 4 6 6 1
Project J -12 2 4 4 8
Payback I 2.33 years
Payback J 3.25 years
 5.13. What are the Advantages and Disadvantages of Payback?
16
 Advantages:

 Simple to calculate and understand.

 Widely used in practice.

 Risk indicator.

 Disadvantages:

 Ignores cash flows after the payback.

 Ignores time value of money.

 Bias against long term projects – e.g. Okahandja-Whk., expansion project

 5.14. Accounting Rate of Return
17

ARR = Average Incremental Net Income

Average book value

 The average book value if the residual value is zero, will be Cost÷2.
 Net income is after depreciation.
 See example below, assuming that all cash flows have been adjusted
for depreciation. Determine the ARR for each Project.

Year Rm 0 1 2 3 4
Project I -12 4 6 6 1
Project J -12 2 4 4 8
Payback I 2.33 years Project I: ((17/4)÷(12/2)) = 70.83%
Payback J 3.25 years Project J: (18/4) ÷(12/2)) = 75.00%
 5.15. Profitability Index (Benefit-Cost Ratio)
18

 A project’s PI measures the return of a project relative to cost.

 PI = Present Value ÷ Cost

 If PI > 1 = Accept the project

 If PI < 1 = Reject the project

 As NPV = PV - Cost, a PI greater than 1 means a positive NPV.

 When should we use the PI? If there is capital rationing and we

wish to maximise returns relative to the costs of a projects.

 Please refer to Slide 8.

THANK YOU!