MAF NOTES
CAPITAL BUDGETING
Consequences of Investment and non-Investment
• Over-capacity: resulting in high overheads
o Can be a positive as changes in future demand could be met quickly to
satisfy customer needs
• Under-capacity: resulting in loss of market share
• High operating costs
• Loss of flexibility: Cannot invest elsewhere easily
• Timing: needs to be correct as market conditions have a large impact on outcome
Types of investment projects:
• Replacement decisions
• Expansion: Existing product line or New product lines
• Mutually Exclusive (alternative projects)
• Independent (acceptance of one does not affect the other)
• Divisible (may be split into several different parts, each capable of being undertaken
on their own)
• Indivisible
Budgeting methods:
• NPV vs. IRR
o NPV:
▪ Estimates future cash flows
▪ Usually gives us a more correct answer than IRR
o IRR:
▪ Is the discount rate that causes the PV of net CF to equal the cost of
investment
▪ If IRR is > cost of capital = accept project
▪ Thus it is only useful to compare to COC
▪ If evaluating mutually exclusive projects: chose project with highest
IRR
▪ Problems:
• If projects have different cost outlays
• If timing of projects’ cash flows differ
• Payback method:
o Advantages:
▪ Simple to calculate and understand
▪ Widely used in practise
▪ Risk indicator
o Disadvantages:
▪ Ignores CF after payback
▪ Ignores TVM
▪ Bias against long term projects
• Profitability Index (Cost-Benefit ratio)
o Measure of a projects return to cost
𝑃𝑉
o PI = 𝐶𝑜𝑠𝑡
▪ If PI > 1 Accept (Means positive NPV)
▪ If PI < 1 Reject
SM 1
,Use of Cash Flows:
• Future benefits of the project (are CF not earnings)
• Accounting earnings vs. Cash flows
o Tax being a cash flow vs. Taxable Income
o Accounting does not report opportunity costs
o Cash flows avoid subjective accounting decisions
• Performance appraisal:
o If accounting results are used to measure performance then it may be
relevant to use accounting figures
Tax
• Sale of equipment
o SP > Tax Value= Recoupment
o SP < Tax Value = Scrapping Allowance
o Remember to include CGT at 80%
▪ If SP > Cost
• Depreciation
o S12C
o S13
o S11 (e)
o Plant purchase from connected persons, then cost may be limited to the
original cost to CP
Relevant Amounts:
• Incremental CF
• After-tax CF
• Ignore sunk costs
o Irrelevant to the decision
• Include opportunity costs
o Consequences of the investment
• Include effects of existing product lines
o I.e. Reduction in demand, etc.
o May not be very clear
• Evaluate all alternatives
• Ignore allocated costs
o Overheads should just be included to the extent that projects will result in
an increase in these costs
• Ignore financing charges
o Discount rate takes into account the cost of finance
▪ Thus would be double counting
• Include net incremental investment in working capital
o Changes and not levels of inventory
o WC is always redeemed at the end of the projects life
SM 2
,Post Audits:
• Formal assessment and comparison of actual returns achieved for specific projects
as compared to projected returns
• Objective is to improve capital budgeting process
• Advantages:
o Identify critical factors and ensures focus on achieving projected cash flows
o Improve future forecast
• Disadvantages:
o Sponsors may reduce investments due to personal risks
o Managers may become overly cautious (to beat forecast)
Projects with Unequal Lives:
• May not be possible to compare NPVs
• Qualitative factors:
o Inflation, foreign currency risk, firm flexibility, changes in tech
o Risk minimised by investing in shorter project
• Could use Replacement chains:
o Assumes projects are continuously replaced
o Can become impractical
• Equivalent Annual Annuities (EAA)
𝑁𝑃𝑉
o 𝑃𝑉 𝑓𝑎𝑐𝑡𝑜𝑟 𝑎𝑛𝑛𝑢𝑖𝑡𝑦
o Not applicable for independent projects and if projects cannot be repeated
Inflation:
• Nominal rate = (1+Real rate)(1+Inflation rate) – 1
• Can discount real CF at real rate of return
o Assumes inflation affect all components of CF equally
o Depreciation is on historical cost and not affected by inflation
Capital Rationing:
• Hard CR:
o Capital markets cannot fund project
• Soft CR:
o Firm may have capital constraints
• Profitability index is used to make decisions if projects are divisible
• For indivisible projects simply rank them in order to maximise sum of NPV
Assessed Tax Losses:
• Determine if tax loss:
o Is dependent on project acceptance
o Can be used in same period if project is accepted
o Can be utilised faster due to project
• Ring fencing:
o Tax losses from project may only be utilised against income of project
SM 3
, 5 Tax loss situations:
• Company is able to utilise tax loss from income of existing projects in the same time
o Ignore assessed loss
• New project enables a faster utilisation of a tax loss:
o Include:
▪ Benefit of faster utilisation &
▪ Opportunity cost of not being able to use loss in later years
• Tax loss & no other income:
o Include benefit as there is no opportunity cost
• Project creates a tax loss in early years but has profitable product lines
o Include tax savings and higher taxes in future
• Project creates a tax loss but cannot offset loss against other product lines or ring-
fenced
o Carry forward the tax loss until project creates taxable income
o (Start-ups are usually ring-fenced)
Optimal Economic Lives:
• Continuing evaluation
o If current abandonment value exceeds the present value of the projects
future CF the project should be abandoned
o Abandonment value analysis is particularly useful when there is an active
second-hand market
• Replacement timing
o Use EAC to determine to optimal time to replace assets
o Trade-off between rising maintenance costs and falling residual values and
the replacement cost of asset
Real Strategic Options:
• Real business decisions are more complex
o May included embedded options
o Projects may lead to future investment options
• Real NPV = NPV + NPV of strategic options
SM 4
CAPITAL BUDGETING
Consequences of Investment and non-Investment
• Over-capacity: resulting in high overheads
o Can be a positive as changes in future demand could be met quickly to
satisfy customer needs
• Under-capacity: resulting in loss of market share
• High operating costs
• Loss of flexibility: Cannot invest elsewhere easily
• Timing: needs to be correct as market conditions have a large impact on outcome
Types of investment projects:
• Replacement decisions
• Expansion: Existing product line or New product lines
• Mutually Exclusive (alternative projects)
• Independent (acceptance of one does not affect the other)
• Divisible (may be split into several different parts, each capable of being undertaken
on their own)
• Indivisible
Budgeting methods:
• NPV vs. IRR
o NPV:
▪ Estimates future cash flows
▪ Usually gives us a more correct answer than IRR
o IRR:
▪ Is the discount rate that causes the PV of net CF to equal the cost of
investment
▪ If IRR is > cost of capital = accept project
▪ Thus it is only useful to compare to COC
▪ If evaluating mutually exclusive projects: chose project with highest
IRR
▪ Problems:
• If projects have different cost outlays
• If timing of projects’ cash flows differ
• Payback method:
o Advantages:
▪ Simple to calculate and understand
▪ Widely used in practise
▪ Risk indicator
o Disadvantages:
▪ Ignores CF after payback
▪ Ignores TVM
▪ Bias against long term projects
• Profitability Index (Cost-Benefit ratio)
o Measure of a projects return to cost
𝑃𝑉
o PI = 𝐶𝑜𝑠𝑡
▪ If PI > 1 Accept (Means positive NPV)
▪ If PI < 1 Reject
SM 1
,Use of Cash Flows:
• Future benefits of the project (are CF not earnings)
• Accounting earnings vs. Cash flows
o Tax being a cash flow vs. Taxable Income
o Accounting does not report opportunity costs
o Cash flows avoid subjective accounting decisions
• Performance appraisal:
o If accounting results are used to measure performance then it may be
relevant to use accounting figures
Tax
• Sale of equipment
o SP > Tax Value= Recoupment
o SP < Tax Value = Scrapping Allowance
o Remember to include CGT at 80%
▪ If SP > Cost
• Depreciation
o S12C
o S13
o S11 (e)
o Plant purchase from connected persons, then cost may be limited to the
original cost to CP
Relevant Amounts:
• Incremental CF
• After-tax CF
• Ignore sunk costs
o Irrelevant to the decision
• Include opportunity costs
o Consequences of the investment
• Include effects of existing product lines
o I.e. Reduction in demand, etc.
o May not be very clear
• Evaluate all alternatives
• Ignore allocated costs
o Overheads should just be included to the extent that projects will result in
an increase in these costs
• Ignore financing charges
o Discount rate takes into account the cost of finance
▪ Thus would be double counting
• Include net incremental investment in working capital
o Changes and not levels of inventory
o WC is always redeemed at the end of the projects life
SM 2
,Post Audits:
• Formal assessment and comparison of actual returns achieved for specific projects
as compared to projected returns
• Objective is to improve capital budgeting process
• Advantages:
o Identify critical factors and ensures focus on achieving projected cash flows
o Improve future forecast
• Disadvantages:
o Sponsors may reduce investments due to personal risks
o Managers may become overly cautious (to beat forecast)
Projects with Unequal Lives:
• May not be possible to compare NPVs
• Qualitative factors:
o Inflation, foreign currency risk, firm flexibility, changes in tech
o Risk minimised by investing in shorter project
• Could use Replacement chains:
o Assumes projects are continuously replaced
o Can become impractical
• Equivalent Annual Annuities (EAA)
𝑁𝑃𝑉
o 𝑃𝑉 𝑓𝑎𝑐𝑡𝑜𝑟 𝑎𝑛𝑛𝑢𝑖𝑡𝑦
o Not applicable for independent projects and if projects cannot be repeated
Inflation:
• Nominal rate = (1+Real rate)(1+Inflation rate) – 1
• Can discount real CF at real rate of return
o Assumes inflation affect all components of CF equally
o Depreciation is on historical cost and not affected by inflation
Capital Rationing:
• Hard CR:
o Capital markets cannot fund project
• Soft CR:
o Firm may have capital constraints
• Profitability index is used to make decisions if projects are divisible
• For indivisible projects simply rank them in order to maximise sum of NPV
Assessed Tax Losses:
• Determine if tax loss:
o Is dependent on project acceptance
o Can be used in same period if project is accepted
o Can be utilised faster due to project
• Ring fencing:
o Tax losses from project may only be utilised against income of project
SM 3
, 5 Tax loss situations:
• Company is able to utilise tax loss from income of existing projects in the same time
o Ignore assessed loss
• New project enables a faster utilisation of a tax loss:
o Include:
▪ Benefit of faster utilisation &
▪ Opportunity cost of not being able to use loss in later years
• Tax loss & no other income:
o Include benefit as there is no opportunity cost
• Project creates a tax loss in early years but has profitable product lines
o Include tax savings and higher taxes in future
• Project creates a tax loss but cannot offset loss against other product lines or ring-
fenced
o Carry forward the tax loss until project creates taxable income
o (Start-ups are usually ring-fenced)
Optimal Economic Lives:
• Continuing evaluation
o If current abandonment value exceeds the present value of the projects
future CF the project should be abandoned
o Abandonment value analysis is particularly useful when there is an active
second-hand market
• Replacement timing
o Use EAC to determine to optimal time to replace assets
o Trade-off between rising maintenance costs and falling residual values and
the replacement cost of asset
Real Strategic Options:
• Real business decisions are more complex
o May included embedded options
o Projects may lead to future investment options
• Real NPV = NPV + NPV of strategic options
SM 4
