LONG TERM DECISION MAKING

 Use capital investment appraisal technique:

o Accounting rate of return (ARR)
o Payback period
o Discounted Payback Period
o Net Present Value (NPV)
o Internal Rate of Return (IRR )
o Profitability index

 Effect on inflation and tax in capital budgeting

 Equivalent annual value(EAV)
 Capital rationing
 Behavioral and ethical issues in capital budgeting
ACCOUNTING RATE OF RETURN (ARR)

The ratio does not take into account the concept of time value of money. ARR calculates
the return, generated from net income of the proposed capital investment. The ARR is a
percentage return. Say, if ARR = 7%, then it means that the project is expected to earn
seven cents out each dollar invested. If the ARR is equal to or greater than the required
rate of return, the project is acceptable. If it is less than the desired rate, it should be
rejected. When comparing investments, the higher the ARR, the more attractive the
investment.

Formula of ARR

ARR = Average net income

Average investment

Steps to calculate ARR

1-caculate all cash in flow

2-subtract initial investment
3-divide the figure by life span of the investment
4-calculate what percentage is this of the initial investment by using average annual
profit/initial investment x100
Decision criteria
Based on this method, we will accept a project if its accounting rate of return (AROR) is
the higher or equal to the form’s minimum acceptable AROR

Advantages of AROR
1. AROR uses accounting profits ad therefore uses a familiar
2. Accounting profits is easily accessible and understood by most of us today

Disadvantages of AROR
1. It does not cash flows and therefore it does not reflect the exact timing of the
benefits and costs involved in the proposed projects
2. It also ignores the time value of money concept. Hence, it gives an equal weight
to all the return that occur within the projects life
PAYBACK PERIOD

Payback period in capital budgeting refers to the period of time required for the return
on an investment to "repay" the sum of the original investment. For example, a RM1000
investment which returned RM500 per year would have a two year payback period. The
time value of money is not taken into account. Payback period intuitively measures how
long something takes to "pay for itself." All else being equal, shorter payback periods are
preferable to longer payback periods. Payback period is widely used due to its ease of use
despite recognized limitations,

FORMULA OF PAYBACK PERIOD

All other things being equal, the better investment is the one with the shorter payback
period.

For example, if a project costs RM100,000 and is expected to return RM20,000

annually, the payback period will be RM100,000 / RM20,000, or five years.

There are two main problems with the payback period method:

1. It ignores any benefits that occur after the payback period and, therefore, does not
measure profitability.
2. It ignores the time value of money.

Because of these reasons, other methods of capital budgeting like net present value,
internal rate of return or discounted cash flow are generally preferred.
DISCOUNTED PAYBACK PERIOD

Payback Period does not consider time value of money when providing an answer
whereas with Discounted Payback Period we get to see the real value of cash inflows
when they are measured in today's amount of money as these are discounted at an interest
rate called the Discount Rate. We get to see the number of years required to recoup the
initial cash outlay or our investment

Discounted Payback Period Example

Let us illustrate finding Discounted Payback Period with an example investment

proposal. Let us say you were offered a series of cash inflows at the end of each of the
next four years as RM50,000, RM40,000, RM30,000, and RM10,000. Say the Initial Cost
Outlay for this proposal is RM100,000.

Discounted Payback Period Calculation

 
Year Cash Flows DCF Cumulative DCF
0 -RM100,000    
1 RM50,000 RM47,169 RM47,169
2 RM40,000 RM35,599 RM82,769
3 RM30,000 RM25,188 RM107,958
4 RM10,000 RM7,920 RM115,879
 

Discounted Payback Period Step by Step

  We add up the discounted cash inflows beginning after the initial cash outlay in
the cumulative cash inflows column
 We keep an eye on this last column and track the last year for which the
cumulative total does not exceed the initial cash outlay
 We compute the part or fraction of the next year's cash inflow need to payback the
initial cash outlay by taking the initial cash outlay less the cumulative total in the
last step then divide this amount by the next years cash inflow.
E.g., ( RM100,000 - RM82,769 ) / RM25,188 = 0.684
 To now obtain the Discounted Payback Period in years , we take the figure from
the last step and add it to the year from the step 2. Thus our Discounted Payback
Period is 2 + .684 = 2.684 years
 Instead of represent the years as decimal value we could represent the Discounted
Payback Period in years and months this way We take the fraction 0.684 and
multiply it by 12 to get the months which is 8.20 months. Thus our Discounted
Payback Period is 2 years and 8 months

NET PRESENT VALUE (NPV)

The difference between the present value of cash inflows and the present value of cash
outflows. NPV is used in capital budgeting to analyze the profitability of an investment
or project. 

NPV analysis is sensitive to the reliability of future cash inflows that an investment or

project will yield.  

Formula:
What is NPV?

Before I show you how to calculate the net present value or NPV, let me briefly explain
what it is. Simply put, it's a way to decide whether or not to invest in a project by looking
at the projected cash inflows and outflows.

How NPV helps you decide

Now that you understand what NPV is, let me tell you how you use it to decide if a
project is a go or not. Simple:

a) If the value of NPV is greater than 0, then the project is a go! In other words, it's
profitable and worth the risk.

b) If the value of NPV is less than 0, then the project isn't worth the risk and is a no-go. In
other words, you'll pass on it.

Example

In order for us to calculate NPV, let's use the following example.

Suppose we'd like to make 10% profit on a 3 year project that will initially cost us
RM10,000.

a) In the first year, we expect to make RM3000

b) In the second year, we expect to make RM4300
c) In the third year, we expect to make RM5800
STEP 1

Right now, the project is going to cost us RM10,000. So we won't be making any money
until at least a year from now. What we need to do is calculate how much each of those
future profit amounts will be worth right here, today.

This means we need to calculate the present value of each of those 3 cash flows we'll be
getting over the next three years. In other words, ask yourself:

a) How much is that RM3000 one year from now worth today?
b) How much is that RM4300 two years from now worth today?
c) How much is that RM5800 worth three years from now worth today?

The answers to each of these three questions is the present value for that particular cash
inflow.

STEP 2

In our example, I said I'd like to make a 10% profit. This is important because it's the
bare minimum we'll need to make in order to say yes to this project. In corporate finance,
we call this rate our required rate of return (ROR).

To get our present values, we use this ROR!

In other words, we ask ourselves:

a) Earning 10%, RM3000 one year from today would be worth how much right now?
b) Earning 10%, RM4300 two years from today would be worth how much right now?
c) Earning 10%, RM5800 three years from today would be worth how much right now?
STEP 3

Let's assume you're using present value tables to get your answers.

a) You'll go over to 10% and down to 1 in the time period column to get your interest
factor. It'll be something like 0.9091. Multiply this factor by the RM3000 we'll be getting
in the first year, and it gives us a present value of RM2727.27.

b) Do the same thing for the RM4300 we'll be getting in the second year. This time, you'll
go over to 10% and down to 2 in the time period column to get your interest factor.
That'll be 0.8264. Multiply this by the $4300 to get a present value of RM3,553.72

c) Do the same thing for the RM5800 we'll be getting in the third year. This time, you'll
go over to 10% and down to 3 in the time period column to get your interest factor.
That'll be 0.7513. Multiply this by the RM5800 to get a present value of RM4,357.63

STEP 4

Our next step is to add up all those present values we just calculated in step 6.

Adding RM2,727.27 + RM3,553.72 + RM4,357.63 gives us RM10,638.62.

FINAL STEP

The last thing we need to do is subtract our original investment in the project from the
result in step 7.

Doing this gives us RM10,638.62 - RM10,000 or RM638.62. This is our NPV!

So is this project a go? Well remember what I said at the very beginning. If NPV is
bigger than 0, then it's a go. Well RM638.62 is clearly larger than 0 which means the
project is worth it and is a go
INTERNAL RATE OF RETURN (IRR)

The internal rate of return (IRR) is a rate of return used in capital budgeting to measure
and compare the profitability of investments. It is also called the discounted cash flow
rate of return (DCFROR) or simply the rate of return (ROR). In the context of savings
and loans the IRR is also called the effective interest rate

Example

A company is considering a project requiring an initial outlay of RM 17,292 which will

generate the following uneven cash flow

Year 1 : RM 5,000
Year 2 : RM 8,000
Year 3 : RM 10,000
For the internal rate of return of this project

In order to get the answer, the following steps should be followed

1. Pick a discount rate at random. Use this discount rate to calculate the present
value of the future cash flows.
2. Compare your answer with the initial outlay of the project. If they are equal, or
the NPV is zero, then the discount rate is the IRR of the project
3. However, if the present value is higher than the initial outlay, you have to increase
the discount rate and vice-versa
4. Calculate the present value of the cash inflows and compare again with the initial
outlay as in step 2
Solution

Try in 12%
Year Net cash flow(RM) PV @12% Present Value
1 5,000 0.8929 4,4464.50
2 8,000 0.7972 6,377.60
3 10.000 0.7118 7,118.00
Total present value of cash inflows 17,960.10
Less: Initial outlay (17,292.00)
Net present value 668.10

Since the NPV is positive, then the return of the project is higher than 12%. Therefore,
we have the choose a higher discount rate.

Try at 16%
Year Net cash flow(RM PV @16% Present Value
1 5,000 0.8621 4,310.50
2 8,000 0.7432 5,945.60
3 10.000 0.6407 6,407.00
Total present value of cash inflows 16,663.10
Less: Initial outlay (17,292.00)
Net present value (628.90)

With I = 16%,the NPV of the project is negative. Now, we know that the IRR of the
project will be between 12% and 16%

How to calculate IRR

IRR = 12% +(668.10/1297) X 4%

= 12% + 2.06%
= 14.06%
PROFITABILITY INDEX (PI)
  A profitability index (PI), alternatively referred to as a profit investment ratio or a
value investment ratio, is a method for discerning the relationship between the
costs and benefits of investing in a possible project.
 It calculates the cost/benefit ratio of the present value (PV) of a project’s future
cash flow over the price of the project’s initial investment

 Formula:

PI = PV of future cash flows

Initial investment
Alternatively, PI is also equal to:
PI = 1 + NPV
Initial Investment

 The figure this formula yields helps investors decide on whether or not a project is
financially attractive enough to pursue.
 Example of calculations:

Question : A project costs RM1,000 and the present value of the future
cash flows equals RM1,250. In this case, the PI of the project is :
Solution :
PI = RM1,250 = 1.25
RM1,000
Alternatively, PI = 1 + 250 = 1.25
1,000

Therefore, we can accept the project.

Interpretation of PI
  In this example, the PI of the project is 1.25. It means that for every one Ringgit
of our investment, we obtain a 25% return. Of course, the higher the PI, the higher
is the return of our investment.
 This method is suitable for companies with scare resources, government agencies
or non-profit making organizations. It allows us to measure the performance of
these organizations and hence, priority should normally be given to projects with
the highest PIs.
 However, just like IRR, there is a problem of using PI if the projects are mutually
exclusive. A project costing RM1,000 may have RM2,000 present value, and
therefore having PI of 2. Another project may cost RM10,000 with present value
of RM16,000 and therefore having PI of only 1.6. Since these are mutually
exclusive projects, we should select the project with the second highest NPV even
though the PI is lower. Hence, PI may not be suitable for mutually exclusive
projects. Therefore, managers usually rely on NPV rather than PI in capital
budgeting decisions

Advantages of PI
1. Easy to understand and communicate
2. Uses cash flows
3. Applies time value of money concept and is closely related to NPV method
4. Suitable for companies with limited investment resources of funds

Disadvantage of PI
May be misleading for mutually exclusive projects

EFFECT OF INFLATION AND TAX IN CAPITAL BUDGETING

INFLATION AND CAPITAL BUDGETING

Doesn't inflation have an impact in a capital budgeting analysis? The answer is

qualified yes in that inflation does have an impact on the numbers that are used in capital
budgeting analysis. But it does not have impact on the results of the analysis if certain
conditions are satisfied. To show what we mean by this statement, we will use the
following data.

TAXES AND CAPITAL BUDGETING

 In discussion of capital budgeting decisions in this chapter, we ignored income

taxes for two reasons.
o First, many organizations do not pay income taxes. Not-for-profit
organizations, such as hospitals and charitable foundations, and
government agencies are exempt from income taxes.
o Second, capital budgeting is complex and is best absorbed in small doses
 The US income tax code is enormously complex. We only scratch the surface on
this page. To keep the subject within reasonable bounds, we have made many
simplifying assumptions about the tax code throughout this section. Among the
most important of these assumptions are :
o Taxable income equals net income as computed for financial reports.
o The tax rate is flat percentage of taxable income. The actual tax code is for
more complex than this; indeed, experts acknowledge that no one person
knows or can know it all. However, the simplifications that we make
throughout this section allow us to cover the most important implications
of income taxes for capital budgeting without getting bogged down in
details
The Concept of After-Tax Cost

 Business, like individuals, must pay income taxes. In the case of business, the
amount of income tax that must be paid is determined by the company's net
taxable income.
 Tax deductible expenses (tax deductions) decrease the company's net taxable
income and hence reduce the taxes the company must pay. For this reason,
expenses are often stated on an after-tax basis.
 For example, if a company pays rent of $10 million a year but this expense
results in a reduction in income taxes of $3 million, the after-tax cost of the rent is
$7 million. An expenditure net of its tax effect is known as after-tax cost.

Depreciation Tax Shield

 Depreciation is not a cash flow

 For this reason, depreciation was ignored (in capital budgeting decisions chapter)
in all discounted cash flow computations. However depreciation does affect the
taxes that must be paid and therefore has an indirect effect on the company's cash
flows.
 To illustrate the effect of depreciation deductions on tax payments, consider a
company with annual cash sales of $500,000 and cash operating expenses of
$310,000. In addition, the company has a depreciable asset on which the
depreciation deduction is $90,000 per year. The tax rate is 30%. As shown below
the depreciation deduction reduces the company's taxes by $27,000.

 In effect, the depreciation deduction of $90,000 shields $90,000 in revenues from

taxation and thereby reduces the amount of taxes that the company must pay.
 Because depreciation deductions shield revenues from taxation, they generally
referred to as a depreciation tax shield. The reduction in the tax payments made
 possible by depreciation tax shield is equal to the amount of the depreciation
deduction, multiplied by the tax rate as follows:

(3): Tax savings from the depreciation tax shield = Tax rate × Depreciation
deduction

 We can verify this formula by applying it to the $90,000 depreciation deduction in

our example:

0.30 × $90,000 = $27,000 reduction in tax payments

 when we estimate after-tax cash flows for capital budgeting decisions, we will
include the tax savings provided by the depreciation tax shield.
 To keep matters simple, we will assume that depreciation reported for tax
purposes is straight line depreciation, with no deduction for zero salvage.
 In other words, we will assume that the entire original cost of the asset is written
evenly over its useful life. Since the net book value of the asset at the end of its
useful life will be zero under this depreciation method, we will assume that any
proceeds received on disposal of the asset at the end of its useful life will be taxed
as ordinary income.
 In actuality the rules are more complex than this and most companies take
advantage of accelerated depreciation methods allowed by the tax code. These
accelerated methods usually result in reduction in current taxes and an offsetting
increase in future taxes. This shifting of the part of the tax burden from the current
year to future years is advantageous from a present value point of view, since a
dollar today is worth more than a dollar in future.

 A summary of the concepts we have introduced so far is given below:

 Item Treatment
Tax-deductible cash expense Multiply by (1 - tax rate) to get after tax cost
Multiply by (1 - tax rate) to get after tax cash
Tax cash receipt
inflow.
Multiply by the tax rate to get the tax salvage
Depreciation deduction
from the depreciation tax shield.
 
Cash expenses can be deducted from the cash receipts and the difference multiplied by (1
- tax rate). See the example at the end of this page.

Cost of new equipment:

The initial investment of $300,000 in the new equipment is included in full with no
reduction for taxes. This represents an investment, not an expense, so no tax adjustment
is made. (Only revenue and expenses are adjusted for the effects of taxes.) However, this
investment does affect taxes through the depreciation deduction that are considered
below.

Working Capital:

Observe that the working capital needed for the project is included in full with no
reduction for taxes. Like the cost of new equipment, working capital is an investment and
no expense so no tax adjustment is made. Also observe that no tax adjustment is made
when the working capital is released at the end of the project's life. The release of
working capital is not a taxable cash flow, since it merely represents a return of
investment funds back to the company.

Net Annual Cash Receipts:

The net annual cash receipts from sales of ore are adjusted for the effects of income
taxes, as discounted earlier. Not from the above example that annual cash expenses are
deducted from the annual cash receipts to obtain the net cash receipts. This just simplifies
computations.

Road Repairs:

Since the road repairs occur once (in the sixth year), they are treated separately from
other expenses. Road repairs would be a tax deductible cash expense, and therefore they
are adjusted for the effects of income taxes, as discussed earlier.

Depreciation Deductions:

The equipment is the MACRS seven-year property class. The tax savings provided by
depreciation deductions is essentially an annuity that is included in the present value
computations in the same way as other cash flows.

Salvage Value of the Equipment:

Since the company does not consider salvage value when computing depreciation
deductions, book value will be zero at the end of the life of an asset. Thus, any salvage
value received is taxable as income to the company. The after-tax benefit is determined
by multiplying the salvage value by (1 - Tax rate).

Since the net present value of the proposed project is positive, the equipment should be
purchased and the mine opened.

EQUIVALENT ANNUAL VALUE (EAV)

 Equivalent annual value (EAV), enables the cost engineer to compare alternatives
of different
Lifetimes
 An appropriate formula allows variable period cash flows to be converted to a
single value or
annuity, which occurs each period throughout the lifetime of the investment
 One can repeat cash flows of alternatives until their study durations are equal
 For example, if the lifetime of one alternative is seven years, and that of the
possible investment to which it is compared is eight years, then the period of
study between the alternatives would need to be 7 x 8 = 56 years to make their
NPVs comparable. That approach would be burdensome
 The cost engineer would almost certainly find it more efficient to calculate the
EAV of both alternatives and recommend selection of that which has the greater
EAV.

CAPITAL RATIONONG

 Capital rationing refers to a situation where the firm is constrained for external, or
self imposed, reasons to obtain necessary funds to invest in all investment projects
with positive net present value.

 Under capital rationing, the management has not simply to determine the
profitable investment opportunities, but it has also to decide to obtain that
combination of the profitable projects which yields highest net present value
within the available funds.
Why capital rationing?

Capital rationing may rise due to external factors or internal constraints imposed by the
management. Thus there are two types.
• External rationing
• Internal rationing

External capital rationing

This mainly occurs on account of the imperfections in capital markets. Imperfections may
be caused by deficiencies in market information, or by rigidities of attitude that hamper
the free flow of capital. The net present value rule will not work if shareholders do not
have access to the capital markets. Imperfections in capital markets alone do not
invalidate use of the net present value rule. In reality, we will have very few situations
where capital markets do not exist for shareholders.

Internal capital rationing

This is caused by self imposed restrictions by the management. Various types of

constraints may be imposed. For example, it may be decide not to obtain additional funds
by incurring debt. This may be a part of the firms conservative financial policy.
Management may fix an arbitrary limit to the amount of funds to be invested by the
divisional managers. Sometimes management may resort to capital rationing by requiring
a minimum rate of return higher than the cost of capital. Whatever, may be the type of
restrictions, the implication is that some of the profitable projects will have to be forgone
because of the lack of funds. However, the net present value rule will work since
shareholders can borrow or lend in the capital markets.

It is quite difficult sometimes justify the internal rationing. But generally it is used as a
means of financial controls. In a divisional set up, the divisional managers may overstate
their investment requirements. One way of forcing them to carefully assess their
investment opportunities and set priorities is to put upper limits to their capital
expenditures. Similarly, a company may put investment limits if it finds itself incapable
of coping with the strains and organizational problems of a fast growth.

BEHAVIOURAL AND IN CAPITAL BUDGETING

Behavior Congruence in Capital Budgeting Judgments

 An experimental exercise was designed in order to provide insight into the

behavior congruence of managers in relation to capital budgeting judgments
 Behavior congruence was operationalised by adopting judgment consensus
measures used in the Human Information Processing literature
 A large firm processing natural resources provided the setting for the study.
Seventy-eight managers, with an average of twenty years of experience with this
one company, were the subjects
 Differences in the judgment behaviors were found to exist by organizational level
and educational background of the managers
 The results were counter-intuitive in that consensus among managers was found
to be higher at lower levels in the organization
 The relative importance of investment project attributes as well as judgment
consistency measures are also reported