Investment Appraisal
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CAPITAL BUDGETING
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Introduction One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds. The main stages in the capital budgeting cycle can be summarized as follows: 1. 2. 3. 4. 5. 6.
Forecasting investment needs. Identifying project(s) to meet needs. Appraising the alternatives. Selecting the best alternatives. Making the expenditure. Monitoring project(s).
Looking at investment appraisal involves us in stage 3 and 4 of this cycle. We can classify capital expenditure projects into four broad categories:
• • • •
Maintenance - replacing old or obsolete assets for example. Profitability - quality, productivity or location improvement for example. Expansion - new products, markets and so on. Indirect - social and welfare facilities.
Even the projects that are unlikely to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the project's aims. So investment appraisal may help to find the cheapest way to provide a new staff restaurant, even though such a project may be unlikely to earn profits for the company.
Capital expenditure is expenditure on fixed assets (including additions to fixed assets) which is extended to benefit future periods. It usually involves large sum of money. In the case of the construction of very large assets such as factories, ships, bridges etc the expenditures may be committed for a long time. Capital expenditure may well decide the “shape” (i.e. the location, size, pattern of operation, efficiency, ability to compete in the market etc) of a business for a very long time. Errors of judgement in the capital expenditure decisions cannot be easily reversed. It is therefore extremely important that as much information as possible should be available to the management to make it a prudent capital expenditure decision. Some pieces of information provided for management may contradict other information because of the different methods used to provide the information assess the proposed expenditure from different point of views. It is then the management’s decision how much weight should be given to each piece of information. Management often have to take non-financial decisions into account. The concept of corporate social responsibility might be a deciding factor.
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ACCORETURN
Capital expenditure appraisal techniques ACCOUNTING RATE OF RETURN The average rate of return expresses the profits arising from a project as a percentage of the initial capital cost. However the definition of profits and capital cost are different depending on which textbook you use. For instance, the profits may be taken to include depreciation, or they may not. One of the most common approaches is as follows: ARR = (Average annual revenue / Initial capital costs) * 100 Let's use this simple example to illustrate the ARR: A project to replace an item of machinery is being appraised. The machine will cost £240 000 and is expected to generate total revenues of £45 000 over the project's five year life. What is the ARR for this project? ARR = (£45 000 / 5) / 240 000 * 100 = (£9 000) / 240 000 * 100 = 3.75%
Accounting rate of return is calculated the average annual profit as a percentage of average capital employed. Average capital is calculated as ½ of the capital required for the project. It is assumed that fixed assets will be depreciated fully by the end of the project. It must be emphasised that the profit for this purpose will be the additional profit similarly the capital expenditure will be the additional expenditure made. The return on the capital from the proposed project will be compared with the existing return the business is earning. If the return is greater the business should be willing to go ahead with the project. Example: Huzaifa Ltd presently earns a return of 18%. It proposes to manufacture new brand of cigarette Aji Biti. The manufacture of Aji Biti will require a new machine which would cost £100000 and an additional working capital would be £40000. Sales are expected to be £66000 p.a. other costs would be £28000. The machine would be depreciated by 10% on cost each year. ANSWER IN THE NEXT PAGE....
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Calculation of profit for Huzaifa Ltd. Sales
66000
Less manufacturing and other costs
28000
Less, Depreciation
10000
Net profit
28000
Additional capital employed Machinery Additional working capital
£100000 £40000 £140000 Average capital employed: £ (1/2x 100000) + £40000= £90000 So, ARR= £28000 x 100 £ 90000 = 31% The company may proceed with the project as it is generating more return than its existing one. Note: if a resale value of the machine bought is mentioned the proceeds will be added with the capital employed.
! a) b) ! a) b) c) d) e) f) g) h)
There are a lot of advantages by using ARR some of them are: Management can compare the expected profitability of a project with the present one. ARR is easy to calculate. Some disadvantages are: ARR is based on average annual profit which may not be the same for every year. The timings of cash inflows and outflows are ignored. ARR ignores the timings of cash inflows and outflows. ARR does not show wether, or how soon the receipts will cover the initial expenditure. It completely ignores the risk factor. ARR ignores the time value of money. Profits cannot be defined objectively. There is no commonly accepted method of calculating capital employed. It may or may not include the additional working capital. ARR does not take the project duration of the project
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PAY BACK PERIOD Payback: This is literally the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. Payback is often used as an initial screening method. Payback period = Initial payment / Annual cash inflow So, if £4 million is invested with the aim of earning £500 000 per year (net cash earnings), the payback period is calculated thus: P = £4 000 000 / £500 000 = 8 years This all looks fairly easy! But what if the project has more uneven cash inflows? Then we need to work out the payback period on the cumulative cash flow over the duration of the project as a whole.
⇒ ⇒ ⇒ ⇒ ⇒ ⇒
Risk is an important factor to be considered in capital expenditure. The sooner the investment is recovered by cash the better. This recovery of investment by cash is called the pay back. A long payback period increases the risk that the investment might not be recovered at all. The payback period is measured in years. Only cash paid or cash received is entered
⇒
Non cash expenditures even prepayments and accruals are ignored.
ADVANTAGES OF PAY BACK PERIOD 1. Payback period is relatively easy to calculate. 2. Calculation of net cash flows is more objective than calculation of profitability. 3. Pay back indicates the project which is at risk for the least time before the initial investment is recouped. 4. A short payback period benefits a firm’s liquidity. DISADVANTAGES OF PAY BACK PERIOD 1. Payback ignores the expectancy of the project. 2. Two projects may have the same pay back periods although they might have different cash inflow patterns.
3.
Pay back takes no consideration of time value of money.
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NET PRESENT VALUE (NPV) & DISCOUNTED CASH FLOW Discounted Cash Flow Methods Net Present Value: The Net Present Value (NPV) is the first Discounted Cash Flow (DCF) technique covered here. It relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment. Remember that opportunity cost is the calculation of what is sacrificed or foregone as a result of a particular decision. It is also referred to as the 'real' cost of taking some action. We can look at the concept of present value as being the cash equivalent now of a sum receivable at a later date. So how does the opportunity cost affect revenues that we can expect to receive later? Well, imagine what a business could do now with the cash sums it must wait some time to receive. In fact, if you receive cash you are quite likely to save it and put it in the bank. So what a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved. Looked at another way, it is likely that the business will have borrowed the capital to invest in the project. So, what it foregoes by having to wait for the revenues arising from the investment is the interest paid on the borrowed capital. NPV is a technique where cash inflows expected in future years are discounted back to their present value. This is calculated by using a discount rate equivalent to the interest that would have been received on the sums, had the inflows been saved, or the interest that has to be paid by the firm on funds borrowed.
ARR and payback period are criticised for not taking the time value of money into consideration. The time value of money recognises that £1 invested now will amount to £1.10 if invested at a compound rate of 10%. If meaningful comparisons are to be made the future receipts should be discounted to present day values. A positive NPV means that the project is worthy of further consideration and the larger the NPV the better. A negative NPV project should be rejected. When the finance of a project comes from a single source the cost of capital is clearly the expected rate of return by that source. However companies rarely have one source of finance and different sources or classes expect different return as for example a company might need to raise £10million for a new project. It might issue £5 million worth of ordinary share capital, where the shareholders expecting a return of 12%, £2 million at £1 each 9% preference share and £3 million 10% debentures. The corporation tax is 20%. In this type of case weighted average cost of capital will have to be calculated to make the calculations more meaningful and accurate. Weighted average cost of capital for the above mentioned example would be:
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Weighti Cost X weight
Ordinary shares
Cost % 12
Amount £million 5
50
600
Preference shares
9
2
20
180
Debentures
8ii
3
30
240
10
100
1020
Therefore weighted average cost of capital= 1020 100
Advantages of NPV of discounted cash flow method: This method recognises the time value of money and produces more meaningful than the simple than the simple pay back method. This method can be used on pay back method as well. Some disadvantages: It is more complicated than ARR and payback. In practise require very complex calculations to make. However the complex calculations can be made with minimum errors through the use of computer. Now with the weighted average cost of capital determined we need to discount them with appropriate discount factors. Referring back to the previous example we will now take the discounting factors for the weighted average cost of capital which is 10.2%. These discount factors are available from the table or can be calculated as well. It will be provided with you question paper. The additional cash flows after deducting all the expenditures were Year 1 £2m Year 2 £5m Year 3 £6m Year 4 £7m Calculation of NPV would be Year Average weight of capital/discounting factor at 10% Cash inflow £ in Million 0 1 2 3 4
1 (10) 0.893 2 0.797 5 0.712 6 0.636 7 Net present value Note: the weighted average cost has been rounded off to 10%.
N.P.V. £ in Million (10) 1.786 3.985 4.272 4.452 4.495
The project should be accepted as the net present value is positive if the net present value is negative the firm should have rejected the proposal if there had been non financial factors involved.
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INTERNAL RATE OF RETURN The Internal Rate of Return (IRR): We know that when a positive NPV is produced by our DCF calculations, a project is worthwhile. We have also seen that when there are competing projects, we should select the one that produces the highest NPV. But sometimes a firm will want to know how well a project will perform under a range of interest rate scenarios. The aim with IRR is to answer the question: 'What level of interest will this project be able to withstand?' Once we know this, the risk of changing interest rate conditions can effectively be minimised. The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested. Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.
The NPV calculates the net receipts and compares it with the initial investment if it is greater than the initial investment the project might receive the go ahead signal. However it ignores the current return which the company is enjoying and what rate of return the company must generate to make ends meet. This rate is determined by the internal rate of return. IRR is the discounting rate which equals the discounted net receipts i.e. the rate which will result in nil NPV. The IRR can be calculated as follows: i. Discounting the cash flows using two different rates sufficiently far apart to give one positive and one negative NPV. ii. “Interpolating” the NPV’s to arrive at the IRR.
Demonstration of IRR Example: a project involves an investment of £100000. The annual net receipts for each of the first five years are estimated to be £28000. Hint: use to distant discount rates for this purpose we use 10% and 14%. Cash inflow £ NPV Year Average Year Average weight of weight of capital at capital at 10% 14% 0 1 (100000) (100000) 0 1 1 0.909 28000 25452 1 0.877 2 0.826 28000 23128 2 0.769 3 0.751 28000 21028 3 0.675 4 0.683 28000 19124 4 0.592 5 0.621 28000 17388 5 0.519 Net present values £6120
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Cash inflow £
NPV
(100000) 28000 28000 28000 28000 28000
(100000) 24556 21532 18900 16576 14532 £(3904)
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Now the values just determined need to be put into this formula
IRR= X+ pq x ac ad where, X= the rate which is giving the positive NPV { here it will be 10%} pq= the difference between the two rate used to generate NPV’s { here it will be 14-10= 4} ac= positive NPV. The figure and not the rate { here it will be £6120} ad= the positive + the negative NPV’s. The figure and not the rate { here it will be £6120+ £3904) therefore IRR for the project is: 10%+ (4%x6120 ) 6120+3904 = 12.44% Now the business can compare the IRR of 12.44% with the return the business is currently earning with its existing capital and then can decide whether to proceed with the investment or shelve the expansion plans.
i
Individual amounts expressed as a percentage of total amount £10 million.
ii
If the rate of tax is 20%, the cost of debentures would be (1-0.2)= 8
Advantages of NPV of discounted cash flow method: This method recognises the time value of money and produces more meaningful than the simple than the simple pay back method. This method can be used on pay back method as well. Some disadvantages: It is more complicated than ARR and payback. In practise require very complex calculations to make. However the complex calculations can be made with minimum errors through the use of computer. Now with the weighted average cost of capital determined we need to discount them with appropriate discount factors. Referring back to the previous example we will now take the discounting factors for the weighted average cost of capital which is 10.2%. These discount factors are available from the table or can be calculated as well. It will be provided with you question paper. The additional cash flows after deducting all the expenditures were Year 1 £2m Year 2 £5m Year 3 £6m Year 4 £7m
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Calculation of NPV would be Year Average weight of capital/discounting factor at 10% Cash inflow £ in Million 0 1 2 3 4
1 (10) 0.893 2 0.797 5 0.712 6 0.636 7 Net present value Note: the weighted average cost has been rounded off to 10%.
N.P.V. £ in Million (10) 1.786 3.985 4.272 4.452 4.495
The project should be accepted as the net present value is positive if the net present value is negative the firm should have rejected the proposal if there had been non financial factors involved.
INTERNAL RATE OF RETURN The Internal Rate of Return (IRR): We know that when a positive NPV is produced by our DCF calculations, a project is worthwhile. We have also seen that when there are competing projects, we should select the one that produces the highest NPV. But sometimes a firm will want to know how well a project will perform under a range of interest rate scenarios. The aim with IRR is to answer the question: 'What level of interest will this project be able to withstand?' Once we know this, the risk of changing interest rate conditions can effectively be minimised. The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested. Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.
The NPV calculates the net receipts and compares it with the initial investment if it is greater than the initial investment the project might receive the go ahead signal. However it ignores the current return which the company is enjoying and what rate of return the company must generate to make ends meet. This rate is determined by the internal rate of return. IRR is the discounting rate which equals the discounted net receipts i.e. the rate which will result in nil NPV. The IRR can be calculated as follows: i. Discounting the cash flows using two different rates sufficiently far apart to give one positive and one negative NPV. ii. “Interpolating” the NPV’s to arrive at the IRR.
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Demonstration of IRR Example: a project involves an investment of £100000. The annual net receipts for each of the first five years are estimated to be £28000. Hint: use to distant discount rates for this purpose we use 10% and 14%. Year Average Cash inflow £ NPV Year Average weight of weight of capital at capital at 10% 14% 0 1 (100000) (100000) 0 1 1 0.909 28000 25452 1 0.877 2 0.826 28000 23128 2 0.769 3 0.751 28000 21028 3 0.675 4 0.683 28000 19124 4 0.592 5 0.621 28000 17388 5 0.519 Net present values £6120
Cash inflow £
NPV
(100000) 28000 28000 28000 28000 28000
(100000) 24556 21532 18900 16576 14532 £(3904)
Now the values just determined need to be put into this formula
IRR= X+ pq x ac ad where, X= the rate which is giving the positive NPV { here it will be 10%} pq= the difference between the two rate used to generate NPV’s { here it will be 14-10= 4} ac= positive NPV. The figure and not the rate { here it will be £6120} ad= the positive + the negative NPV’s. The figure and not the rate { here it will be £6120+ £3904) therefore IRR for the project is: 10%+ (4%x6120 ) 6120+3904 = 12.44% Now the business can compare the IRR of 12.44% with the return the business is currently earning with its existing capital and then can decide whether to proceed with the investment or shelve the expansion plans.
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1. What is capital expenditure? (3) 2. What is meant by capital expenditure appraisal? Discuss some of its techniques (6) 3. Despite so many calculations and predictions why might some projects still become unprofitable and loss making concerns. (5) 4. Billal and Hibban Company presently earns a return of 18%. It is considering manufacture of a new product which will require £100000. They have asked their finance manager to prepare some data for them to consider the project. He has come up with the following information: £75000 p.a. Sales Cost of manufacture
£35000 p.a.
Other expenses
£10000 p.a.
It is the company’s policy to charge 10% depreciation on all fixed assets. The manager has also added that the production of the new product will require an increase in the working capital of £12000. Required: a. Calculate the Accounting rate of return b. Discuss the advantages and disadvantages of ARR. (6) 5. Hammab and Shoaid Ltd is considering buying a machine which requires an investment of £450000. It they are trying to find out whether it will be profitable or not. They were suggested by a friend to calculate the accounting rate of return. They have gathered the following information. Sales
£125000 p.a.
Manufacturing expenses
£50000 p.a.
Selling and distribution expenses
£12000 p.a.
The company charges 12% depreciation on all its fixed assets. It is currently earning a return of 15% on its existing capital. The accountant predicts the machine can be sold for £3000 after the end of five year period. The company will also require increasing their working capital by £5000 to manage the production and sale of their new product. Required: a. Calculate the Accounting rate of return b. Evaluate the feasibility of the investment by your calculations. (4) c. Assume you are Hammab a director in the company. Would you approve the project based on the above calculations? Give explanation of your opinion. (6)
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6. Jabbar and Akkas Company presently earns a return of 25%. The firm has £1000000. They have asked their finance manager to come up some projects where they can invest the money. He has come up with the following information: Year
1 2 3 4 5
Cash inflow £ 50000 25000 90000 150000 100000
Project A Net profit before & interest £ 6900 14000 9700 12000 9800
Cash inflow £ 25000 35000 15000 35000 75000
Project A Net profit before & interest £ 12000 14000 6000 16000 5000
Additional information: The finance manager adds that the machine used in project B can be sold for £40000 after the end of year 5. Required: a. b. c. d.
Calculate the Accounting rate of return, payback period for both the projects. Outline the advantage and disadvantages of payback period. (4) Recommend an investment. (4) Would you give your go ahead to the investment just with the calculations done above? Explain your opinion. (6)
7. Billal and Hibban Company presently earns a return of 27%. The firm has £900000. They have asked their finance manager to come up some projects where they can invest the money. He has come up with the following information: Year
1 2 3 4 5
Cash inflow £ 150000 350000 500000 100000 90000
Project A Net profit before & interest £ 79000 150000 95000 200000 78000
Cash inflow £ 150000 350000 150000 200000 200000
Project A Net profit before & interest £ 120000 140000 120000 56000 50000
Additional information: The finance manager adds that working capital would have to be increased by £50000. Required: a. b. c. d.
Calculate the Accounting rate of return, payback period for both the projects. Outline the advantage and disadvantages of payback period. (4) Recommend an investment. (4) What other information or calculations do you think is required to make the investment decision more meaningful and accurate? (6)
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8. Following are the sources of finance of three different companies. Company A Company B £ £
• •
Company C £
Ordinary share
1800000
300000
5000000
(9%, 8%, 9.5%)Preference share
900000
100000
2500000
(10%, 7.5%, 9%) Debentures
300000
400000
1500000
Additional information Ordinary share holders expect 6%, 7% and 8% From Company A, Company B, Company C respectively. The rate of corporation tax is 30% applicable to all firms. Required: a. Calculate the weighted average cost of capital for the three firms. b. Assume that all of the above firms have equal access to funds. Which firm has the cheapest source of finance?
9. Following are the sources of finance of three different companies. Company X Company Y Company Z £ £ £ Ordinary share 1700000 300000 4500000 (9%, 8.5%, 10%)Preference share 800000 100000 100000 (10%, 11%, 9%) Debentures 200000 400000 2000000 Additional information • Ordinary share holders expect 8%, 7% and 9% From Company A, Company B, Company C respectively. • The rate of corporation tax is 20% applicable to all firms. Required: a. Calculate the weighted average cost of capital for the three firms. b. Assume that all of the above firms have equal access to funds. Which firm has the cheapest source of finance? 10. Following are the sources of finance of three different companies. Company X Company Y Company Z £ £ £ Ordinary share 1500000 300000 4000000 (6%, 8.5%, 10%)Preference share 600000 100000 100000 (10%, 11%, 9%) Debentures 200000 400000 2000000 Additional information • Ordinary share holders expect 12%, 9% and 10% From Company A, Company B, Company C respectively. • The rate of corporation tax is 40% applicable to all firms. Required: a. Calculate the weighted average cost of capital for the three firms. b. Assume that all of the above firms have equal access to funds. Which firm has the cheapest source of finance?
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11. a. What factors influence a company’s cost of capital? (5) b. Hammad Plc’s financial Director made a serious mistake in calculating average cost of capital he had calculated 14% but later a more experienced accountant commented that the average cost of capital should be 18%. Following are the cash flows. Year Cash flow £ 0 (100000) 1 17540 2 23070 3 33750 4 35520 Copy and complete the following table. Year 0 1 2 3 4
14% 0.877 0.675
Cash inflow £ (100000) 17540 23070 33750 35520
N.P.V. £
18%
0.718 0.516
Cash inflow £ (100000) 17540 23070 33750 35520
N.P.V. £
Net present value c. Discuss the attractiveness of the project after the given revised cost of capital. (5) 12. a. Two firms Jabbar ltd and Akkas Ltd have following the cash flows. The cost of capital for Jabbar ltd is 12% while Akkas ltd has 15%. Year Cash flow £ 0 (200000) 1 17000 2 25000 3 300000 4 50000 Copy and complete the following table. Year 0 1 2 3 4
12% 0.893
Cash inflow £ (200000) 17000 25000 300000 50000
N.P.V. £
15%
0.756 0.572
0.636 Net present value b. Which company should be investing in the project? (4) Period 10% 11% 12% 13% 14% 15% 1 0.909 0.901 0.893 0.885 0.877 0.870 2 0.826 0.826 0.797 0.783 0.769 0.756 3 0.751 0.751 0.712 0.693 0.675 0.658 4 0.683 0.683 0.636 0.613 0.592 0.572 5 0.621 0.621 0.567 0.543 0.519 0.497
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Cash inflow £ (200000) 17000 25000 300000 50000
16% 0.862 0.743 0.641 0.552 0.476
N.P.V. £
18% 0.847 0.718 0.609 0.516
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13. a. Two firms Huzaifa ltd and Khubaib Ltd have following the cash flows. The cost of capital for both Huzaifa ltd & Khubaib Ltd is 15%. Huzaifa ltd Khubaib Ltd Year Cash flow £ Cash flow £ 0 (200000) (200000) 1 17000 15000 2 25000 26000 3 300000 32000 4 50000 55000 Copy and complete the following table. Huzaifa ltd
Year 0 1 2 3 4
Khubaib Ltd
15%
Cash inflow £ (200000) 17000 25000 300000 50000
N.P.V. £
15%
Cash inflow £ (200000) 15000 26000 32000 55000
N.P.V. £
Net present value Period 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
b. Which company should be investing in the project? (4) c. Assume that the NPV calculations reveal a positive result what factors might be considered to reject the investment even then. (5) d. The cost of capital will be different for each organisation. Explain, using a suitable example, how the cost of capital will change in an organisation when the capital gearing of that organisation rises. (6)
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14. Akij Limited had the following capital structure. £(000) Ordinary share 1000 11%Preference share 400 10% Debentures 600 The holders of ordinary shares expect a dividend of 14% p.a. the corporation tax rate stands at 30% which is an allowable tax expense. Akij limited also have a capital project under consideration; it would cost £50000 and the estimated net cash flows are as follows: Year Net cash flow £ Net profit £ 0 (50000) 1 12000 15000 2 16000 15000 3 18000 15000 4 26000 15000 Akij Limited currently earn 25% rate of return on its existing capital. An inexperienced clerk has calculated the company’s average cost of capital as 16%. a. Explain why the clerk’s calculation is incorrect. b. Calculate the weighted average cost of capital correctly. c. Calculate the payback period, NPV and accounting rate of return. d. Explain the suitability of the project with respect to all your calculations.
Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
18% 0.847 0.718 0.609 0.516
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15. TOTO Company had the following capital structure. £(000) Ordinary share 900 11%Preference share 400 10% Debentures 700 The holders of ordinary shares expect a dividend of 13% p.a. the corporation tax rate stands at 30% which is an allowable tax expense. TOTO Company also has a capital project under consideration; it would cost £150000 and the estimated net cash flows are as follows: Year Net cash receipts £ Net profit £ 0 (150000) 1 52000 15000 2 16000 15000 3 48000 15000 4 26000 15000 Akij Limited currently earn 25% rate of return on its existing capital. i. Calculate the weighted average cost of capital ii. Calculate the payback period, NPV and accounting rate of return. iii. Calculate the Internal rate of return. iv. Explain the suitability of the project with respect to all your calculations.
Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
18% 0.847 0.718 0.609 0.516 -
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Page 18
16. Hagi Company is the manufacturer of the popular soap brand Pocha. They are planning to introduce a new soap. Due to their capital structure, managerial abilities and lack of funds they cannot proceed with more than one new product. the details of which appear below; Pocha Plus £ Pocha Premium £ Pocha Classic £ Initial investment 20000 45000 55000 Selling price 9 12 15 Material costs/unit 3 6 5 Labour costs/unit 2 2 3 2001 2002 2003 2004 2005 Sales in units Pocha Plus 6000 7000 8000 9000 12000 Pocha Premium 5000 7000 5000 4500 5000 Pocha Classic 3000 6000 4000 2000 6000 Operating expenses Pocha Plus £20000 £25000 £25000 £25000 £25000 Pocha Premium £20000 £20000 £20000 £15000 £15000 Pocha Classic £15000 £15000 £25000 £24000 £12000 Resale value of machinery Pocha Plus 1000 Pocha Premium 15000 Pocha Classic 20000 Hagi Company had the following capital structure. £(000) Ordinary share 900 11%Preference share 400 10% Debentures 700 The holders of ordinary shares expect a dividend of 13% p.a. the corporation tax rate stands at 30% which is an allowable tax expense. Calculate the following for all the three projects: a. The weighted average cost of capital. b. The accounting rate of return. c. The payback period d. The Net Present Value. e. Calculate the Internal rate of return. f. Based on all your calculations done from (a-e) suggest which product Hagi Company should produce. (5) Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
18% 0.847 0.718 0.609 0.516 -
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Page 19
17. Dhaka tobacco industries Ltd have developed a new type of cigarette which is less harmful for liver and is free of nearly all the harmful effects of cigarettes. The company is now considering manufacturing and marketing the product. The project will require £200000 investment. The following estimates of costs and revenues for the products have been made: a. Year Quantities sold Selling price/unit £ 1 9000 2.5 2 8600 2.5 3 10000 2.75 4 9000 3 5 15000 5 b. The new plant and machinery which will be bought for £200000 will have a resale value of £20000 at the end of five years. c. Labour costs will be £0.5/unit in year 1 and rising by 25% in every proceeding year. d. Material costs will be £0.25/unit for the first two years of production rising by 10% in year 3 and a further 10% in both the years 5and 6. e. Other costs will be £5000 for year and will remain the same for first three years of production. It will fall by 10% in every year for production after the third year. f. The cost of the capital for the company is 12%. g. The company is earning 15% in its existing capital. Calculate the following for all the three projects: a. The weighted average cost of capital. b. The accounting rate of return. c. The payback period d. The Net Present Value. e. Calculate the Internal rate of return. f. The funds for the project will be raised either by a rights issue or issuing 10% debentures: Explain the effect of two alternatives for funding the project upon the company’s: i. Profitability ii. Gearing
Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
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18% 0.847 0.718 0.609 0.516 -
Page 20
18. Huzaifa Ltd produces components for electronics industry. The company has up to £100000 available for capital investment and considers that this sum could be invested in one of the following two projects. Both the projects involve the purchase of manufacturing machinery. Additional profits: Year Project A £ Project B £ 0 (100000) (100000) 1 50000 20000 2 40000 25000 3 25000 40000 4 20000 50000 5 10000 30000 Resale value at the end of year 5 5000 20000 Additional information: The company requires a minimum return on capital of 14%. Additional profit generated by each product has been calculated before deducting straight line depreciation. Project A involves the purchases of machinery to manufacture a product for which there is rapid technological change. Required: a. Payback period b. Average annual rate of return on average capital invested. c. Net present vale d. Internal rate of return e. Advise the management of Huzaifa Ltd: I. The nonfinancial factors that it should consider in deciding between projects A and B. II. That the project which should be selected, stating your reasons for that recommendations. Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
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18% 0.847 0.718 0.609 0.516 -
Page 21
19. A new company Hammad Motel co. Is to be formed with an initial capital of £1 million to operate a motel in coxsbazar. Two proposals are being considered for the funding of the company. Proposal A Proposal B £000 £000 Ordinary shares 750 250 6%preferance shares 250 250 _____ 500 4% debentures 900 1000 You are informed that ordinary shareholders would expect a return of 10% for proposal A and 20% for proposal B. The rate of corporation tax is 25%. This is an allowable tax expense. Required: a. Calculate the weighted average cost of capital for the two proposals. b. Explain why the ordinary shareholders require higher return in Proposal B than in Proposal A. (3) c. When the capital has been raised it is proposed to construct and operate the motel. The following details relate to the construction and operation. Construction and fitting out cost would be £800000. The motel will contain 40 letting bedrooms and be open for 350 days per year. The company will require an internal rate of return of 10%. The motel will have a useful life of five years, at the end of which it will require redevelopment and will only be sold at the sale value of land, estimated to be £200000. Hammad Motel co. Is considering two pricing strategies, option 1, to charge £50/night and option 2, charge £35/night. The following information is also available for the two options: option 1 option 2 Room charge (tariff/night) £50 £35 Average occupancy 60% 75% Running costs per annum £200000 £250000
It is forecasted that for both the options running costs will increase by £10000 for each year of operation commencing in year 2. The room charge will be increased by £2/night for both options commencing in year 3. The occupancy rate will remain the same throughout the five year period. Required: I. Evaluate the motel project for the two pricing options using the discounted cash flow technique. II. Advise the directors of Hammad Motel Co. Of the pricing option they should use. (4).
Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
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18% 0.847 0.718 0.609 0.516 -
Page 22
20. G- Series operates in the media and the music industry, owning a record label and a radio station. It is now considering starting a music television channel called Music Series TV. This project will cost £20,000,000. Finance has been raised with the following capital structure: £(000) Ordinary share 10000 10%Preference share 5000 12% Bank loan 5000 The ordinary shareholders expect a return of 9% per annum. The following information is forecast for Music Series TV. Income will be received from advertisers. Advertisements will be broadcast for 8 minutes in every hour. The Music Series TV will be broad cast 24 hours a day, 365 days a year. The fees charged to the advertisers consists of four levels: Level A Midnight to 06:00 hours £150/ minute Level B 06:00 to 12:00 hours £100/minute Level C 12:00 to 18:00 hours £200/minute Level D 18:00 to Midnight £250/minute Running expenses for the TV, mainly royalties on video broadcast are expected to be £120000/week. Depreciation is expected to be 20% of the running expenses and is included in the running expenses. In years 3, 4 and 5 it is expected that the channel will be able to raise the fees charged to advertisers. A 10% increase in the fees is planned at the beginning of year 3 as the channel becomes popular. Fees will be held at this level for the following years. At the beginning that all the running expenses will rise by 5%. Expenses will be held at this level for years 4 and 5. Depreciation is expected to stay at 20% of all running expenses. Required: a. Calculate the weighted average cost of capital for the two proposals. b. Calculate the net present value of the new project c. Advise G- Series, giving two reasons, wether to invest in the new project. (2) d. Evaluate the capital structure proposed for the new project. (6). Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
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18% 0.847 0.718 0.609 0.516 -
Page 23
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Introduction One of the key areas of long-term decision-making that firms must tackle is that of investment - the need to commit funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached and the cost of obtaining funds. The main stages in the capital budgeting cycle can be summarized as follows: 1. 2. 3. 4. 5. 6.
Forecasting investment needs. Identifying project(s) to meet needs. Appraising the alternatives. Selecting the best alternatives. Making the expenditure. Monitoring project(s).
Looking at investment appraisal involves us in stage 3 and 4 of this cycle. We can classify capital expenditure projects into four broad categories:
• • • •
Maintenance - replacing old or obsolete assets for example. Profitability - quality, productivity or location improvement for example. Expansion - new products, markets and so on. Indirect - social and welfare facilities.
Even the projects that are unlikely to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the project's aims. So investment appraisal may help to find the cheapest way to provide a new staff restaurant, even though such a project may be unlikely to earn profits for the company.
Capital expenditure is expenditure on fixed assets (including additions to fixed assets) which is extended to benefit future periods. It usually involves large sum of money. In the case of the construction of very large assets such as factories, ships, bridges etc the expenditures may be committed for a long time. Capital expenditure may well decide the “shape” (i.e. the location, size, pattern of operation, efficiency, ability to compete in the market etc) of a business for a very long time. Errors of judgement in the capital expenditure decisions cannot be easily reversed. It is therefore extremely important that as much information as possible should be available to the management to make it a prudent capital expenditure decision. Some pieces of information provided for management may contradict other information because of the different methods used to provide the information assess the proposed expenditure from different point of views. It is then the management’s decision how much weight should be given to each piece of information. Management often have to take non-financial decisions into account. The concept of corporate social responsibility might be a deciding factor.
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ACCORETURN
Capital expenditure appraisal techniques ACCOUNTING RATE OF RETURN The average rate of return expresses the profits arising from a project as a percentage of the initial capital cost. However the definition of profits and capital cost are different depending on which textbook you use. For instance, the profits may be taken to include depreciation, or they may not. One of the most common approaches is as follows: ARR = (Average annual revenue / Initial capital costs) * 100 Let's use this simple example to illustrate the ARR: A project to replace an item of machinery is being appraised. The machine will cost £240 000 and is expected to generate total revenues of £45 000 over the project's five year life. What is the ARR for this project? ARR = (£45 000 / 5) / 240 000 * 100 = (£9 000) / 240 000 * 100 = 3.75%
Accounting rate of return is calculated the average annual profit as a percentage of average capital employed. Average capital is calculated as ½ of the capital required for the project. It is assumed that fixed assets will be depreciated fully by the end of the project. It must be emphasised that the profit for this purpose will be the additional profit similarly the capital expenditure will be the additional expenditure made. The return on the capital from the proposed project will be compared with the existing return the business is earning. If the return is greater the business should be willing to go ahead with the project. Example: Huzaifa Ltd presently earns a return of 18%. It proposes to manufacture new brand of cigarette Aji Biti. The manufacture of Aji Biti will require a new machine which would cost £100000 and an additional working capital would be £40000. Sales are expected to be £66000 p.a. other costs would be £28000. The machine would be depreciated by 10% on cost each year. ANSWER IN THE NEXT PAGE....
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Calculation of profit for Huzaifa Ltd. Sales
66000
Less manufacturing and other costs
28000
Less, Depreciation
10000
Net profit
28000
Additional capital employed Machinery Additional working capital
£100000 £40000 £140000 Average capital employed: £ (1/2x 100000) + £40000= £90000 So, ARR= £28000 x 100 £ 90000 = 31% The company may proceed with the project as it is generating more return than its existing one. Note: if a resale value of the machine bought is mentioned the proceeds will be added with the capital employed.
! a) b) ! a) b) c) d) e) f) g) h)
There are a lot of advantages by using ARR some of them are: Management can compare the expected profitability of a project with the present one. ARR is easy to calculate. Some disadvantages are: ARR is based on average annual profit which may not be the same for every year. The timings of cash inflows and outflows are ignored. ARR ignores the timings of cash inflows and outflows. ARR does not show wether, or how soon the receipts will cover the initial expenditure. It completely ignores the risk factor. ARR ignores the time value of money. Profits cannot be defined objectively. There is no commonly accepted method of calculating capital employed. It may or may not include the additional working capital. ARR does not take the project duration of the project
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PAY BACK PERIOD Payback: This is literally the amount of time required for the cash inflows from a capital investment project to equal the cash outflows. The usual way that firms deal with deciding between two or more competing projects is to accept the project that has the shortest payback period. Payback is often used as an initial screening method. Payback period = Initial payment / Annual cash inflow So, if £4 million is invested with the aim of earning £500 000 per year (net cash earnings), the payback period is calculated thus: P = £4 000 000 / £500 000 = 8 years This all looks fairly easy! But what if the project has more uneven cash inflows? Then we need to work out the payback period on the cumulative cash flow over the duration of the project as a whole.
⇒ ⇒ ⇒ ⇒ ⇒ ⇒
Risk is an important factor to be considered in capital expenditure. The sooner the investment is recovered by cash the better. This recovery of investment by cash is called the pay back. A long payback period increases the risk that the investment might not be recovered at all. The payback period is measured in years. Only cash paid or cash received is entered
⇒
Non cash expenditures even prepayments and accruals are ignored.
ADVANTAGES OF PAY BACK PERIOD 1. Payback period is relatively easy to calculate. 2. Calculation of net cash flows is more objective than calculation of profitability. 3. Pay back indicates the project which is at risk for the least time before the initial investment is recouped. 4. A short payback period benefits a firm’s liquidity. DISADVANTAGES OF PAY BACK PERIOD 1. Payback ignores the expectancy of the project. 2. Two projects may have the same pay back periods although they might have different cash inflow patterns.
3.
Pay back takes no consideration of time value of money.
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NET PRESENT VALUE (NPV) & DISCOUNTED CASH FLOW Discounted Cash Flow Methods Net Present Value: The Net Present Value (NPV) is the first Discounted Cash Flow (DCF) technique covered here. It relies on the concept of opportunity cost to place a value on cash inflows arising from capital investment. Remember that opportunity cost is the calculation of what is sacrificed or foregone as a result of a particular decision. It is also referred to as the 'real' cost of taking some action. We can look at the concept of present value as being the cash equivalent now of a sum receivable at a later date. So how does the opportunity cost affect revenues that we can expect to receive later? Well, imagine what a business could do now with the cash sums it must wait some time to receive. In fact, if you receive cash you are quite likely to save it and put it in the bank. So what a business sacrifices by having to wait for the cash inflows is the interest lost on the sum that would have been saved. Looked at another way, it is likely that the business will have borrowed the capital to invest in the project. So, what it foregoes by having to wait for the revenues arising from the investment is the interest paid on the borrowed capital. NPV is a technique where cash inflows expected in future years are discounted back to their present value. This is calculated by using a discount rate equivalent to the interest that would have been received on the sums, had the inflows been saved, or the interest that has to be paid by the firm on funds borrowed.
ARR and payback period are criticised for not taking the time value of money into consideration. The time value of money recognises that £1 invested now will amount to £1.10 if invested at a compound rate of 10%. If meaningful comparisons are to be made the future receipts should be discounted to present day values. A positive NPV means that the project is worthy of further consideration and the larger the NPV the better. A negative NPV project should be rejected. When the finance of a project comes from a single source the cost of capital is clearly the expected rate of return by that source. However companies rarely have one source of finance and different sources or classes expect different return as for example a company might need to raise £10million for a new project. It might issue £5 million worth of ordinary share capital, where the shareholders expecting a return of 12%, £2 million at £1 each 9% preference share and £3 million 10% debentures. The corporation tax is 20%. In this type of case weighted average cost of capital will have to be calculated to make the calculations more meaningful and accurate. Weighted average cost of capital for the above mentioned example would be:
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Weighti Cost X weight
Ordinary shares
Cost % 12
Amount £million 5
50
600
Preference shares
9
2
20
180
Debentures
8ii
3
30
240
10
100
1020
Therefore weighted average cost of capital= 1020 100
Advantages of NPV of discounted cash flow method: This method recognises the time value of money and produces more meaningful than the simple than the simple pay back method. This method can be used on pay back method as well. Some disadvantages: It is more complicated than ARR and payback. In practise require very complex calculations to make. However the complex calculations can be made with minimum errors through the use of computer. Now with the weighted average cost of capital determined we need to discount them with appropriate discount factors. Referring back to the previous example we will now take the discounting factors for the weighted average cost of capital which is 10.2%. These discount factors are available from the table or can be calculated as well. It will be provided with you question paper. The additional cash flows after deducting all the expenditures were Year 1 £2m Year 2 £5m Year 3 £6m Year 4 £7m Calculation of NPV would be Year Average weight of capital/discounting factor at 10% Cash inflow £ in Million 0 1 2 3 4
1 (10) 0.893 2 0.797 5 0.712 6 0.636 7 Net present value Note: the weighted average cost has been rounded off to 10%.
N.P.V. £ in Million (10) 1.786 3.985 4.272 4.452 4.495
The project should be accepted as the net present value is positive if the net present value is negative the firm should have rejected the proposal if there had been non financial factors involved.
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INTERNAL RATE OF RETURN The Internal Rate of Return (IRR): We know that when a positive NPV is produced by our DCF calculations, a project is worthwhile. We have also seen that when there are competing projects, we should select the one that produces the highest NPV. But sometimes a firm will want to know how well a project will perform under a range of interest rate scenarios. The aim with IRR is to answer the question: 'What level of interest will this project be able to withstand?' Once we know this, the risk of changing interest rate conditions can effectively be minimised. The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested. Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.
The NPV calculates the net receipts and compares it with the initial investment if it is greater than the initial investment the project might receive the go ahead signal. However it ignores the current return which the company is enjoying and what rate of return the company must generate to make ends meet. This rate is determined by the internal rate of return. IRR is the discounting rate which equals the discounted net receipts i.e. the rate which will result in nil NPV. The IRR can be calculated as follows: i. Discounting the cash flows using two different rates sufficiently far apart to give one positive and one negative NPV. ii. “Interpolating” the NPV’s to arrive at the IRR.
Demonstration of IRR Example: a project involves an investment of £100000. The annual net receipts for each of the first five years are estimated to be £28000. Hint: use to distant discount rates for this purpose we use 10% and 14%. Cash inflow £ NPV Year Average Year Average weight of weight of capital at capital at 10% 14% 0 1 (100000) (100000) 0 1 1 0.909 28000 25452 1 0.877 2 0.826 28000 23128 2 0.769 3 0.751 28000 21028 3 0.675 4 0.683 28000 19124 4 0.592 5 0.621 28000 17388 5 0.519 Net present values £6120
CAPITAL BUDGETING
Cash inflow £
NPV
(100000) 28000 28000 28000 28000 28000
(100000) 24556 21532 18900 16576 14532 £(3904)
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Now the values just determined need to be put into this formula
IRR= X+ pq x ac ad where, X= the rate which is giving the positive NPV { here it will be 10%} pq= the difference between the two rate used to generate NPV’s { here it will be 14-10= 4} ac= positive NPV. The figure and not the rate { here it will be £6120} ad= the positive + the negative NPV’s. The figure and not the rate { here it will be £6120+ £3904) therefore IRR for the project is: 10%+ (4%x6120 ) 6120+3904 = 12.44% Now the business can compare the IRR of 12.44% with the return the business is currently earning with its existing capital and then can decide whether to proceed with the investment or shelve the expansion plans.
i
Individual amounts expressed as a percentage of total amount £10 million.
ii
If the rate of tax is 20%, the cost of debentures would be (1-0.2)= 8
Advantages of NPV of discounted cash flow method: This method recognises the time value of money and produces more meaningful than the simple than the simple pay back method. This method can be used on pay back method as well. Some disadvantages: It is more complicated than ARR and payback. In practise require very complex calculations to make. However the complex calculations can be made with minimum errors through the use of computer. Now with the weighted average cost of capital determined we need to discount them with appropriate discount factors. Referring back to the previous example we will now take the discounting factors for the weighted average cost of capital which is 10.2%. These discount factors are available from the table or can be calculated as well. It will be provided with you question paper. The additional cash flows after deducting all the expenditures were Year 1 £2m Year 2 £5m Year 3 £6m Year 4 £7m
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Calculation of NPV would be Year Average weight of capital/discounting factor at 10% Cash inflow £ in Million 0 1 2 3 4
1 (10) 0.893 2 0.797 5 0.712 6 0.636 7 Net present value Note: the weighted average cost has been rounded off to 10%.
N.P.V. £ in Million (10) 1.786 3.985 4.272 4.452 4.495
The project should be accepted as the net present value is positive if the net present value is negative the firm should have rejected the proposal if there had been non financial factors involved.
INTERNAL RATE OF RETURN The Internal Rate of Return (IRR): We know that when a positive NPV is produced by our DCF calculations, a project is worthwhile. We have also seen that when there are competing projects, we should select the one that produces the highest NPV. But sometimes a firm will want to know how well a project will perform under a range of interest rate scenarios. The aim with IRR is to answer the question: 'What level of interest will this project be able to withstand?' Once we know this, the risk of changing interest rate conditions can effectively be minimised. The IRR is the annual percentage return achieved by a project, at which the sum of the discounted cash inflows over the life of the project is equal to the sum of the capital invested. Another way of looking at this is that the IRR is the rate of interest that reduces the NPV to zero.
The NPV calculates the net receipts and compares it with the initial investment if it is greater than the initial investment the project might receive the go ahead signal. However it ignores the current return which the company is enjoying and what rate of return the company must generate to make ends meet. This rate is determined by the internal rate of return. IRR is the discounting rate which equals the discounted net receipts i.e. the rate which will result in nil NPV. The IRR can be calculated as follows: i. Discounting the cash flows using two different rates sufficiently far apart to give one positive and one negative NPV. ii. “Interpolating” the NPV’s to arrive at the IRR.
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Demonstration of IRR Example: a project involves an investment of £100000. The annual net receipts for each of the first five years are estimated to be £28000. Hint: use to distant discount rates for this purpose we use 10% and 14%. Year Average Cash inflow £ NPV Year Average weight of weight of capital at capital at 10% 14% 0 1 (100000) (100000) 0 1 1 0.909 28000 25452 1 0.877 2 0.826 28000 23128 2 0.769 3 0.751 28000 21028 3 0.675 4 0.683 28000 19124 4 0.592 5 0.621 28000 17388 5 0.519 Net present values £6120
Cash inflow £
NPV
(100000) 28000 28000 28000 28000 28000
(100000) 24556 21532 18900 16576 14532 £(3904)
Now the values just determined need to be put into this formula
IRR= X+ pq x ac ad where, X= the rate which is giving the positive NPV { here it will be 10%} pq= the difference between the two rate used to generate NPV’s { here it will be 14-10= 4} ac= positive NPV. The figure and not the rate { here it will be £6120} ad= the positive + the negative NPV’s. The figure and not the rate { here it will be £6120+ £3904) therefore IRR for the project is: 10%+ (4%x6120 ) 6120+3904 = 12.44% Now the business can compare the IRR of 12.44% with the return the business is currently earning with its existing capital and then can decide whether to proceed with the investment or shelve the expansion plans.
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1. What is capital expenditure? (3) 2. What is meant by capital expenditure appraisal? Discuss some of its techniques (6) 3. Despite so many calculations and predictions why might some projects still become unprofitable and loss making concerns. (5) 4. Billal and Hibban Company presently earns a return of 18%. It is considering manufacture of a new product which will require £100000. They have asked their finance manager to prepare some data for them to consider the project. He has come up with the following information: £75000 p.a. Sales Cost of manufacture
£35000 p.a.
Other expenses
£10000 p.a.
It is the company’s policy to charge 10% depreciation on all fixed assets. The manager has also added that the production of the new product will require an increase in the working capital of £12000. Required: a. Calculate the Accounting rate of return b. Discuss the advantages and disadvantages of ARR. (6) 5. Hammab and Shoaid Ltd is considering buying a machine which requires an investment of £450000. It they are trying to find out whether it will be profitable or not. They were suggested by a friend to calculate the accounting rate of return. They have gathered the following information. Sales
£125000 p.a.
Manufacturing expenses
£50000 p.a.
Selling and distribution expenses
£12000 p.a.
The company charges 12% depreciation on all its fixed assets. It is currently earning a return of 15% on its existing capital. The accountant predicts the machine can be sold for £3000 after the end of five year period. The company will also require increasing their working capital by £5000 to manage the production and sale of their new product. Required: a. Calculate the Accounting rate of return b. Evaluate the feasibility of the investment by your calculations. (4) c. Assume you are Hammab a director in the company. Would you approve the project based on the above calculations? Give explanation of your opinion. (6)
CAPITAL BUDGETING
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Page 12
6. Jabbar and Akkas Company presently earns a return of 25%. The firm has £1000000. They have asked their finance manager to come up some projects where they can invest the money. He has come up with the following information: Year
1 2 3 4 5
Cash inflow £ 50000 25000 90000 150000 100000
Project A Net profit before & interest £ 6900 14000 9700 12000 9800
Cash inflow £ 25000 35000 15000 35000 75000
Project A Net profit before & interest £ 12000 14000 6000 16000 5000
Additional information: The finance manager adds that the machine used in project B can be sold for £40000 after the end of year 5. Required: a. b. c. d.
Calculate the Accounting rate of return, payback period for both the projects. Outline the advantage and disadvantages of payback period. (4) Recommend an investment. (4) Would you give your go ahead to the investment just with the calculations done above? Explain your opinion. (6)
7. Billal and Hibban Company presently earns a return of 27%. The firm has £900000. They have asked their finance manager to come up some projects where they can invest the money. He has come up with the following information: Year
1 2 3 4 5
Cash inflow £ 150000 350000 500000 100000 90000
Project A Net profit before & interest £ 79000 150000 95000 200000 78000
Cash inflow £ 150000 350000 150000 200000 200000
Project A Net profit before & interest £ 120000 140000 120000 56000 50000
Additional information: The finance manager adds that working capital would have to be increased by £50000. Required: a. b. c. d.
Calculate the Accounting rate of return, payback period for both the projects. Outline the advantage and disadvantages of payback period. (4) Recommend an investment. (4) What other information or calculations do you think is required to make the investment decision more meaningful and accurate? (6)
CAPITAL BUDGETING
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Page 13
8. Following are the sources of finance of three different companies. Company A Company B £ £
• •
Company C £
Ordinary share
1800000
300000
5000000
(9%, 8%, 9.5%)Preference share
900000
100000
2500000
(10%, 7.5%, 9%) Debentures
300000
400000
1500000
Additional information Ordinary share holders expect 6%, 7% and 8% From Company A, Company B, Company C respectively. The rate of corporation tax is 30% applicable to all firms. Required: a. Calculate the weighted average cost of capital for the three firms. b. Assume that all of the above firms have equal access to funds. Which firm has the cheapest source of finance?
9. Following are the sources of finance of three different companies. Company X Company Y Company Z £ £ £ Ordinary share 1700000 300000 4500000 (9%, 8.5%, 10%)Preference share 800000 100000 100000 (10%, 11%, 9%) Debentures 200000 400000 2000000 Additional information • Ordinary share holders expect 8%, 7% and 9% From Company A, Company B, Company C respectively. • The rate of corporation tax is 20% applicable to all firms. Required: a. Calculate the weighted average cost of capital for the three firms. b. Assume that all of the above firms have equal access to funds. Which firm has the cheapest source of finance? 10. Following are the sources of finance of three different companies. Company X Company Y Company Z £ £ £ Ordinary share 1500000 300000 4000000 (6%, 8.5%, 10%)Preference share 600000 100000 100000 (10%, 11%, 9%) Debentures 200000 400000 2000000 Additional information • Ordinary share holders expect 12%, 9% and 10% From Company A, Company B, Company C respectively. • The rate of corporation tax is 40% applicable to all firms. Required: a. Calculate the weighted average cost of capital for the three firms. b. Assume that all of the above firms have equal access to funds. Which firm has the cheapest source of finance?
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Page 14
11. a. What factors influence a company’s cost of capital? (5) b. Hammad Plc’s financial Director made a serious mistake in calculating average cost of capital he had calculated 14% but later a more experienced accountant commented that the average cost of capital should be 18%. Following are the cash flows. Year Cash flow £ 0 (100000) 1 17540 2 23070 3 33750 4 35520 Copy and complete the following table. Year 0 1 2 3 4
14% 0.877 0.675
Cash inflow £ (100000) 17540 23070 33750 35520
N.P.V. £
18%
0.718 0.516
Cash inflow £ (100000) 17540 23070 33750 35520
N.P.V. £
Net present value c. Discuss the attractiveness of the project after the given revised cost of capital. (5) 12. a. Two firms Jabbar ltd and Akkas Ltd have following the cash flows. The cost of capital for Jabbar ltd is 12% while Akkas ltd has 15%. Year Cash flow £ 0 (200000) 1 17000 2 25000 3 300000 4 50000 Copy and complete the following table. Year 0 1 2 3 4
12% 0.893
Cash inflow £ (200000) 17000 25000 300000 50000
N.P.V. £
15%
0.756 0.572
0.636 Net present value b. Which company should be investing in the project? (4) Period 10% 11% 12% 13% 14% 15% 1 0.909 0.901 0.893 0.885 0.877 0.870 2 0.826 0.826 0.797 0.783 0.769 0.756 3 0.751 0.751 0.712 0.693 0.675 0.658 4 0.683 0.683 0.636 0.613 0.592 0.572 5 0.621 0.621 0.567 0.543 0.519 0.497
CAPITAL BUDGETING
Cash inflow £ (200000) 17000 25000 300000 50000
16% 0.862 0.743 0.641 0.552 0.476
N.P.V. £
18% 0.847 0.718 0.609 0.516
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Page 15
13. a. Two firms Huzaifa ltd and Khubaib Ltd have following the cash flows. The cost of capital for both Huzaifa ltd & Khubaib Ltd is 15%. Huzaifa ltd Khubaib Ltd Year Cash flow £ Cash flow £ 0 (200000) (200000) 1 17000 15000 2 25000 26000 3 300000 32000 4 50000 55000 Copy and complete the following table. Huzaifa ltd
Year 0 1 2 3 4
Khubaib Ltd
15%
Cash inflow £ (200000) 17000 25000 300000 50000
N.P.V. £
15%
Cash inflow £ (200000) 15000 26000 32000 55000
N.P.V. £
Net present value Period 1 2 3 4 5
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
b. Which company should be investing in the project? (4) c. Assume that the NPV calculations reveal a positive result what factors might be considered to reject the investment even then. (5) d. The cost of capital will be different for each organisation. Explain, using a suitable example, how the cost of capital will change in an organisation when the capital gearing of that organisation rises. (6)
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Page 16
14. Akij Limited had the following capital structure. £(000) Ordinary share 1000 11%Preference share 400 10% Debentures 600 The holders of ordinary shares expect a dividend of 14% p.a. the corporation tax rate stands at 30% which is an allowable tax expense. Akij limited also have a capital project under consideration; it would cost £50000 and the estimated net cash flows are as follows: Year Net cash flow £ Net profit £ 0 (50000) 1 12000 15000 2 16000 15000 3 18000 15000 4 26000 15000 Akij Limited currently earn 25% rate of return on its existing capital. An inexperienced clerk has calculated the company’s average cost of capital as 16%. a. Explain why the clerk’s calculation is incorrect. b. Calculate the weighted average cost of capital correctly. c. Calculate the payback period, NPV and accounting rate of return. d. Explain the suitability of the project with respect to all your calculations.
Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
18% 0.847 0.718 0.609 0.516
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Page 17
15. TOTO Company had the following capital structure. £(000) Ordinary share 900 11%Preference share 400 10% Debentures 700 The holders of ordinary shares expect a dividend of 13% p.a. the corporation tax rate stands at 30% which is an allowable tax expense. TOTO Company also has a capital project under consideration; it would cost £150000 and the estimated net cash flows are as follows: Year Net cash receipts £ Net profit £ 0 (150000) 1 52000 15000 2 16000 15000 3 48000 15000 4 26000 15000 Akij Limited currently earn 25% rate of return on its existing capital. i. Calculate the weighted average cost of capital ii. Calculate the payback period, NPV and accounting rate of return. iii. Calculate the Internal rate of return. iv. Explain the suitability of the project with respect to all your calculations.
Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
18% 0.847 0.718 0.609 0.516 -
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Page 18
16. Hagi Company is the manufacturer of the popular soap brand Pocha. They are planning to introduce a new soap. Due to their capital structure, managerial abilities and lack of funds they cannot proceed with more than one new product. the details of which appear below; Pocha Plus £ Pocha Premium £ Pocha Classic £ Initial investment 20000 45000 55000 Selling price 9 12 15 Material costs/unit 3 6 5 Labour costs/unit 2 2 3 2001 2002 2003 2004 2005 Sales in units Pocha Plus 6000 7000 8000 9000 12000 Pocha Premium 5000 7000 5000 4500 5000 Pocha Classic 3000 6000 4000 2000 6000 Operating expenses Pocha Plus £20000 £25000 £25000 £25000 £25000 Pocha Premium £20000 £20000 £20000 £15000 £15000 Pocha Classic £15000 £15000 £25000 £24000 £12000 Resale value of machinery Pocha Plus 1000 Pocha Premium 15000 Pocha Classic 20000 Hagi Company had the following capital structure. £(000) Ordinary share 900 11%Preference share 400 10% Debentures 700 The holders of ordinary shares expect a dividend of 13% p.a. the corporation tax rate stands at 30% which is an allowable tax expense. Calculate the following for all the three projects: a. The weighted average cost of capital. b. The accounting rate of return. c. The payback period d. The Net Present Value. e. Calculate the Internal rate of return. f. Based on all your calculations done from (a-e) suggest which product Hagi Company should produce. (5) Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
18% 0.847 0.718 0.609 0.516 -
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Page 19
17. Dhaka tobacco industries Ltd have developed a new type of cigarette which is less harmful for liver and is free of nearly all the harmful effects of cigarettes. The company is now considering manufacturing and marketing the product. The project will require £200000 investment. The following estimates of costs and revenues for the products have been made: a. Year Quantities sold Selling price/unit £ 1 9000 2.5 2 8600 2.5 3 10000 2.75 4 9000 3 5 15000 5 b. The new plant and machinery which will be bought for £200000 will have a resale value of £20000 at the end of five years. c. Labour costs will be £0.5/unit in year 1 and rising by 25% in every proceeding year. d. Material costs will be £0.25/unit for the first two years of production rising by 10% in year 3 and a further 10% in both the years 5and 6. e. Other costs will be £5000 for year and will remain the same for first three years of production. It will fall by 10% in every year for production after the third year. f. The cost of the capital for the company is 12%. g. The company is earning 15% in its existing capital. Calculate the following for all the three projects: a. The weighted average cost of capital. b. The accounting rate of return. c. The payback period d. The Net Present Value. e. Calculate the Internal rate of return. f. The funds for the project will be raised either by a rights issue or issuing 10% debentures: Explain the effect of two alternatives for funding the project upon the company’s: i. Profitability ii. Gearing
Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
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18% 0.847 0.718 0.609 0.516 -
Page 20
18. Huzaifa Ltd produces components for electronics industry. The company has up to £100000 available for capital investment and considers that this sum could be invested in one of the following two projects. Both the projects involve the purchase of manufacturing machinery. Additional profits: Year Project A £ Project B £ 0 (100000) (100000) 1 50000 20000 2 40000 25000 3 25000 40000 4 20000 50000 5 10000 30000 Resale value at the end of year 5 5000 20000 Additional information: The company requires a minimum return on capital of 14%. Additional profit generated by each product has been calculated before deducting straight line depreciation. Project A involves the purchases of machinery to manufacture a product for which there is rapid technological change. Required: a. Payback period b. Average annual rate of return on average capital invested. c. Net present vale d. Internal rate of return e. Advise the management of Huzaifa Ltd: I. The nonfinancial factors that it should consider in deciding between projects A and B. II. That the project which should be selected, stating your reasons for that recommendations. Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
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18% 0.847 0.718 0.609 0.516 -
Page 21
19. A new company Hammad Motel co. Is to be formed with an initial capital of £1 million to operate a motel in coxsbazar. Two proposals are being considered for the funding of the company. Proposal A Proposal B £000 £000 Ordinary shares 750 250 6%preferance shares 250 250 _____ 500 4% debentures 900 1000 You are informed that ordinary shareholders would expect a return of 10% for proposal A and 20% for proposal B. The rate of corporation tax is 25%. This is an allowable tax expense. Required: a. Calculate the weighted average cost of capital for the two proposals. b. Explain why the ordinary shareholders require higher return in Proposal B than in Proposal A. (3) c. When the capital has been raised it is proposed to construct and operate the motel. The following details relate to the construction and operation. Construction and fitting out cost would be £800000. The motel will contain 40 letting bedrooms and be open for 350 days per year. The company will require an internal rate of return of 10%. The motel will have a useful life of five years, at the end of which it will require redevelopment and will only be sold at the sale value of land, estimated to be £200000. Hammad Motel co. Is considering two pricing strategies, option 1, to charge £50/night and option 2, charge £35/night. The following information is also available for the two options: option 1 option 2 Room charge (tariff/night) £50 £35 Average occupancy 60% 75% Running costs per annum £200000 £250000
It is forecasted that for both the options running costs will increase by £10000 for each year of operation commencing in year 2. The room charge will be increased by £2/night for both options commencing in year 3. The occupancy rate will remain the same throughout the five year period. Required: I. Evaluate the motel project for the two pricing options using the discounted cash flow technique. II. Advise the directors of Hammad Motel Co. Of the pricing option they should use. (4).
Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
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18% 0.847 0.718 0.609 0.516 -
Page 22
20. G- Series operates in the media and the music industry, owning a record label and a radio station. It is now considering starting a music television channel called Music Series TV. This project will cost £20,000,000. Finance has been raised with the following capital structure: £(000) Ordinary share 10000 10%Preference share 5000 12% Bank loan 5000 The ordinary shareholders expect a return of 9% per annum. The following information is forecast for Music Series TV. Income will be received from advertisers. Advertisements will be broadcast for 8 minutes in every hour. The Music Series TV will be broad cast 24 hours a day, 365 days a year. The fees charged to the advertisers consists of four levels: Level A Midnight to 06:00 hours £150/ minute Level B 06:00 to 12:00 hours £100/minute Level C 12:00 to 18:00 hours £200/minute Level D 18:00 to Midnight £250/minute Running expenses for the TV, mainly royalties on video broadcast are expected to be £120000/week. Depreciation is expected to be 20% of the running expenses and is included in the running expenses. In years 3, 4 and 5 it is expected that the channel will be able to raise the fees charged to advertisers. A 10% increase in the fees is planned at the beginning of year 3 as the channel becomes popular. Fees will be held at this level for the following years. At the beginning that all the running expenses will rise by 5%. Expenses will be held at this level for years 4 and 5. Depreciation is expected to stay at 20% of all running expenses. Required: a. Calculate the weighted average cost of capital for the two proposals. b. Calculate the net present value of the new project c. Advise G- Series, giving two reasons, wether to invest in the new project. (2) d. Evaluate the capital structure proposed for the new project. (6). Period 1 2 3 4 5
CAPITAL BUDGETING
10% 0.909 0.826 0.751 0.683 0.621
11% 0.901 0.826 0.751 0.683 0.621
12% 0.893 0.797 0.712 0.636 0.567
13% 0.885 0.783 0.693 0.613 0.543
14% 0.877 0.769 0.675 0.592 0.519
15% 0.870 0.756 0.658 0.572 0.497
16% 0.862 0.743 0.641 0.552 0.476
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18% 0.847 0.718 0.609 0.516 -
Page 23
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