Professional Documents
Culture Documents
Week 2 Lecture
(2010)
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CAPITAL EXPENDITURE
BUDGETING
- Concerned with decision-making in the following areas:
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BUDGET PROCEDURE
• Proposals usually analysed under the following headings:
• PROBLEMS?
• - Many new business proposals will be in outline form only
• - Some projects may be “emergency” replacements at last moment
• - There may be a shortage of available funds
• SOLUTION?
• Allocate a maximum amount to each “type” of expenditure known
as Capital Rationing
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COST v BENEFIT ANALYSIS
SUMMARY OF RELEVANT COSTS/INCOME BY
TYPE OF PROJECT
Type of project Costs Benefits
Expansion Plant & machinery Additional net cash inflow from
Additional working capital additional sales
Replacement Plant & machinery Opportunity income from
avoiding “lost” sales and/or
add’l prodn costs
Admin systems Computers, software etc Additional net cash inflow from
cost savings
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METHODS OF APPRAISING
CAPITAL EXPENDITURE
PROJECTS
ACCOUNTING PAY-BACK DISCOUNTED
RATE OF RETURN METHOD CASH FLOW
(DCF)
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ACCOUNTING RATE OF
RETURN
(ARR)
Accounting Rate of Return
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Seminar Question
Super Co. is considering a new product. The initial
expenditure on machinery is expected to be £200,000 for
machinery which is estimated to have a life of five years at
the end of which it will be expected to realize £20,000 in
disposal proceeds. Additional investment in working capital
(stocks plus debtors, less creditors) is expected to be in
the region of £10,000. Annual profits after depreciation are
expected to be £18,000 per annum. The company's cost of
capital is 10%.
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Seminar Question
1) What is the Annual Depreciation charge?
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ACCOUNTING RATE OF RETURN
(ARR)
Advantages:
- Easy to understand (similar to return on capital employed)
- Allows comparison of projects with differing initial investment
- Considers profit over entire life of project
Disadvantage:
- Ignores time value of money
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PAY-BACK
STEP 1 Calculate total cost of project
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Seminar Question
Super Co. is considering a new product. The initial
expenditure on machinery is expected to be £200,000 for
machinery which is estimated to have a life of five years at
the end of which it will be expected to realize £20,000 in
disposal proceeds. Additional investment in working capital
(stocks plus debtors, less creditors) is expected to be in
the region of £10,000. Annual profits after depreciation are
expected to be £18,000 per annum. The company's cost of
capital is 10%.
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Seminar Question
3) If profits are £18,000 per annum, what is the annual cash flow
resulting from trading?
5) How long does it take before the project will Pay-back the initial
investment?
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PAY-BACK
• Advantages
• - Easy to understand
• - Low risk as projects chosen are those
• with quickest “pay-back”
• Disadvantages
• - Ignores timing of receipts
• - Ignores receipts after pay-back period
• - Ignores profitability
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DISCOUNTED CASH FLOW
(DCF)
Based on principle that £1 received “today” is worth
more than £1 received “tomorrow” – time value of money
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Interest and the Time Value of
Money
• The present value of any sum to be received in the
future can be computed by solving for P:
1
P Fn n
(1 r )
P = present value
Fn= future cash flow at the end of n period
r = required rate of return or discount rate
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Interest and the Time Value of
Money
• A bond will pay $100 in two years. What is the
present value of the $100 if an investor can earn a
return of 12% on investments?
1
P $100
2
1 0.12
P = $100 (0.7972)
P = $79.72
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Interest and the Time Value of
Money
• A bond will pay $100 in two years. What is the present
value of the $100 if an investor can earn a return of 12% on
investments?
• Present Value = $79.72
•
What
What does
does this
this mean?
mean?
IfIf $79.72
$79.72 is
is invested
invested byby the
the investor
investor today,
today, itit will
will
be
be worth
worth $100
$100 in in two
two years.
years. In
In that
that sense,
sense, $79.72
$79.72
today
today is
is equivalent
equivalent to
to $100
$100 in in two
two years.
years.
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Interest and the Time Value of
Money
• Let’s verify that if we invest the $79.70 today at 12% interest that it
would grow to $100 at the end of two years.
Bank Balance
Bank Balance Year1 1
Year Year 22
Year
Beginning balance
Beginning balance $ 79.70
$79.72 $ 89.26
$89.29
Interest earned@
Interest earned @12%
12% 9.56
$9.57 10.71
$10.71
Ending balance
Ending balance $89.29
$ 89.26 $100.00
$ 99.97
We
We can
can also
also determine
determine the
the present
present value
value
using
using present
present value
value tables.
tables.
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Interest and the Time Value of
Money
• Excerpt from Discount cash flow Table
Rate
Rate
Periods
Periods 10%
10% 12%
12% 14%
14%
11 0.909
0.909 0.893
0.893 0.877
0.877
22 0.826
0.826 0.797
0.797 0.769
0.769
33 0.751
0.751 0.712
0.712 0.675
0.675
44 0.683
0.683 0.636
0.636 0.592
0.592
55 0.621
0.621 0.567
0.567 0.519
0.519
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Net Present Value Method
• To determine net present value we . . .
Calculate the present value of cash inflows,
Calculate the present value of cash outflows,
Subtract the present value of the outflows from the
present value of the inflows.
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Net Present Value Method
• General decision rule . . .
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Net Present Value Method
• Carver Hospital is considering the purchase of an attachment for its X-
ray machine.
Cost $3,169
Life 4 years
Salvage value zero
Increase in annual cash inflows 1,000
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Net Present Value Method
Present
Value of
Amount of Cash
Item Year(s) Cash Flow Flows
Initial investment(outflow) Now (3,169) (3,169)
Annual cash inflows 1-4 $ 1,000 $ 3,169
Net present value $ -0-
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Net Present Value Method
Present
Value of
Amount of Cash
Item Year(s) Cash Flow Flows
Initial investment(outflow) Now (3,169) (3,169)
Annual cash inflows 1-4 $ 1,000 $ 3,169
Net present value $ -0-
•• Suppose
Suppose that
that the
the investment
investment in in the
the attachment
attachment forfor
the
the X-ray
X-ray machine
machine hadhad cost
cost $4,000
$4,000 and
and generated
generated an an
increase
increase inin annual
annual cash
cash inflows
inflows of
of $1,200.
$1,200. What
What is
is the
the
net
net present
present value
value of
of the
the investment?
investment?
a.
a. $$ 800
800
b.
b. $$ 197
197
c.
c. $(197)
$(197)
d.
d. $(800)
$(800)
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Seminar Question
Annual cash flows
£
Year 0 £200,000 + £10,000 (210,000)
Year 1 54,000
Year 2 54,000
Year 3 54,000
Year 4 54,000
Year 5 £54,000+10,000+20,000= 84,000
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Net Present Value Method
OTHER THINGS TO CONSIDER
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Net Present Value Method
What factors could the company have taken
into consideration when deciding on the cost
of capital (the discount rate)?
Present Present
value of = value of
cash inflows cash outflows
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Internal Rate of Return (IRR)
• Projects with even annual cash flows
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Internal Rate of Return (IRR)
• Projects with even annual cash flows
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Using Internal Rate of Return
- It can be used either to screen or to
rank projects
- Any project whose IRR is less than
the required return is rejected.
- The higher the IRR of a project, the
more desirable it is considered to be.
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Internal Rate of Return (IRR)
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Net Present Value Method
vs
Internal Rate of Return (IRR)
While the IRR method may have intuitive appeal to
managers (accepting project if the IRR is higher than the
required return). It has the following main
disadvantages.
• Disadvantages of IRR:
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CAPITAL APPRAISAL IN
PRACTICE
More than one method is used when appraising projects
Managers are re-assured by QUICK PAY BACK!
Divisional performance often measured by ROCE (Return on capital
employed) which requires that rate of return is maintained and
short-life projects continually replaced
There are Potential conflict between DCF methods (NPV & IRR) in
the case of mutually exclusive projects – When two or more
projects are considered, a firm can select only one. (NPV of project
A is higher than NPV of project B, while IRR of project A is lower
than IRR of project B).
In this case, the NPV methods should be chosen. The amount of
positive NPV represents value added to a business.
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CAPITAL APPRAISAL IN
PRACTICE
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Tutorial Exercise
Seminar 3: Questions 1 – 4
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End of
Week 2
Lecture
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