Business Funding & Financial Awareness CAPITAL BUDETING J R Davies May 2011

Capital Budgeting Capital budgeting is concerned with the evaluation of capital expenditure proposals It requires the identification of the various costs and benefits anticipated as a result of implementing a proposal It is necessary to forecast the future values of these costs and benefits The predicted future net cash flows are discounted to obtain the net present value of the investment proposal

Investment Appraisal (1) To determine an investment’s NPV it is necessary to identify the change in the company’s expected net cash flows as a result of accepting the investment proposal Cash flows to be considered include any tax payments or savings To calculate the expected change in tax payments it is necessary to evaluate the investment’s impact on the company’s profit and loss account (P&L AC) It is advisable to take a systematic approach and develop both a profit and loss account (to determine tax) and a net cash flow statement (recognising that many of the entries will be common to both ).

Format of Statements Normally Required PROFIT AND LOSS ACCOUNT

Investment Appraisal (2) It is often useful to take a simple overall view before starting the more detailed and systematic analysis - specifying the nature and timing of the costs and benefits relevant for the particular decision Outlay- machines etc Recovery Value StartFinish Working capital required Working capital recovered Revenues-direct costs-fixed costs-appropriate overheads-taxes etc.

Investment Appraisal and Incremental NCFs Costs and benefits are measured in terms of cash flows rather than in terms of profits – though there is a tendency to refer to the anticipated “profitability” of a project (IRR?) The definition of net cash flow needs to be extended to include net cash flow equivalents – for example, the opportunity cost of employing an asset previously acquired The impact of inflation should be allowed for in a consistent way

Change in Annual Profit and Tax (1) Items to be Included Expected change in net revenues (Price times quantity) Expected change in operating costs Expected change in fixed costs and overheads Expected change in capital allowances (depreciation for tax purposes, based on the purchase price of the asset, and ignoring the expected recovery value) Expected capital gains and losses Expected change in tax payments stemming from change in profit

Change in Annual Profit and Tax (2) Cash outlays on machines, buildings, land etc. are not included in the P&L A/C These expenditures are recorded in the NCF statement Capital items are recognised in the profit and loss account in the form of capital allowances (the depreciation charge for tax purposes) – an accounting entry that does not correspond to a cash outflow The tax authorities specify the way in which capital allowances have to be calculated

Annual Net Cash Flows Change in net revenues (not necessarily equal the cash inflow as a result of credit sales) Changes in operating costs, e.g.. wages, materials, etc. Treatment of overheads - only include the change in overheads resulting from the project and it is necessary to be very careful of accounting allocations (discuss your assumption to show awareness of the problem) Exclude depreciation charges (capital allowances) and interest charges (covered by discounting) Change in net working capital – corrects for the difference between revenues and cash inflows and differences between expenses and cash outflows Change in tax cash flows - calculated on the basis of the change in profits expected by the acceptance of the project

Investment in Net Working Capital Investment in working capital –stocks (inventory) –debtors (credit extended) less creditors (credit received) Recovery of investment in net working capital –in principle a non-depreciating asset, therefore it is assumed that a full recovery is possible –tax implications no impact on profits or tax as a result of the non-depreciating nature of the asset only enter working capital investment in the net cash flow statement Investment in net working capital is given by the change in the level of working capital, measured at cost, and stocks are required at the start of the period rather than at the end

CALADONIA plc Illustration of the Structure of Capital Budgeting Calculations

CALADONIA plc: A simple illustration Investment outlay £8000 Life 4 years Price £100 Average variable (direct) cost £70 Sales (units) 200 Fixed cost per annum £1000 Depreciation charge £2000 Discount rate10 per cent Tax rate40 per cent

(1) CALADONIA plc: basic version

(1a) CALADONIA plc: basic version

(2)Caladonia plc: with resale value Investment outlay £8000 Resale value £1000 Working capital Life 4 years Price £100 Average variable cost £70 Fixed cost £1000 Depreciation charge £2000 Discount rate10 per cent

(2b)Caladonia plc: with resale value

(2c)Caladonia plc: with resale value

(3)Caladonia plc: With working capital Investment outlay £8000 Resale value (Zero) Working capital £3500 Life 4 years Price £100 Average variable cost £70 Fixed cost £1000 Depreciation charge £2000 Discount rate10 per cent

(3b)Caladonia plc: With working capital

(3c)Caladonia plc: With working capital

Sunk Costs Are Irrelevant Costs should be recognised on an opportunity cost basis Costs already incurred, historic costs, are not relevant for decision taking Focus on the change in costs - how will the decision affect the level of benefits and costs?

Replacement Investment Book or accounting value of the asset to be replaced is only relevant for tax implications The resale proceeds that can be expected from the sale of the asset should be considered to be a benefit and entered in the NCF statement Capital gain or loss on sale and its tax implications must be taken into account –if the resale value exceeds the book value (the purchase price less the sum of capital allowances already claimed) tax must be paid on the excess –if the resale value falls short of the book value the loss should be recognised as a cost and this will result in less tax being paid The annual capital allowance to be entered into the P&L A/C is the difference between the charge for the old and new assets i.e. the incremental capital allowance

Overhead Allocations and Real Costs Overheads include costs of providing various services that are not directly attributable to the production of a particular product or service Eg head office costs Overheads are often allocated to products or services through a company’s accounting system on the basis of some rule of thumb Such overhead allocations should not be recognised in the cash flow statement – only recognise the incremental cash (out) flows resulting from the adoption of the investment

Inflation and Financial Decision Taking-Prices Inflation affects both the expected net cash flows and the market rate of interest. If the price of an asset today is P 0 and the rate of inflation is f, the price in one year from now will be P 1 = P 0 + fP 0 = P 0 (1+f) and with a constant rate of inflation the price after n periods is given by P n = P 0 (1+f)(1+f) … (1+f) P n = P 0 (1+f) n

Inflation and Financial Decision Taking Assume the expected cash flow in year n in the absence of inflation is C n. When inflation is anticipated at a constant rate for n years at f per annum the expected net cash flow becomes

Inflation and Interest Rates If prices are expected to increase savers will only be prepared to deposit money in the bank, and banks to lend this money out, if they are compensated for the loss of purchasing power due to inflation in the form of a higher interest rate Borrowers on the other hand will be prepared to pay a higher interest rate as they recognise they will be repay the loan in form of money that will have lower purchasing power.

Inflation and the Interest Rates (2) To fully compensate for inflation the interest rate has to increase from r 0 to r m r m = r 0 + f + r 0 f Where r m = market rate of interest (quoted by banks etc.) r 0 = real rate of interest (rate in a non-inflation world) f = expected rate of inflation

Inflation and the Interest Rates (3) f compensates for the loss of purchasing power of capital (loss) r 0 f compensates for the loss of purchasing power of interest receipts Note: (1+r m )= (1+r 0 )(1+f) = (1+ r 0 + f + r 0 m)

Inflation and Capital Budgeting: Illustration An investment of £1000 is expected to produce two annual net cash flows of £700 for each of the next two years. In the absence of inflation the required rate of return is 5per cent. This will be evaluated first and then the consequences of an expected rate of inflation of 10 per cent will be investigated.

NPV without inflation

NPV with inflation

Inflation and Capital Budgeting: A Summary

Allowing for Inflation Utilise net cash flows specified in real terms (today’s prices) and the real rate of interest Utilise net cash flows specified in future expected prices and the monetary rate of interest that incorporates an allowance for the expected inflation rate In principle both should provide the same answer

Capital Budgeting –Sensitivity Analysis MBA Finance and Financial Management

Sensitivity Analysis in Capital Budgeting When an investment is implemented the outcomes will almost invariably differ from the forecasted values Sensitivity analysis evaluates the consequences of a given proportionate change in the value of each input into the analysis (standard approach is to consider a 10 per cent adverse change for each input) Sensitivity analysis does not introduce any assessment of the probability of changes in the values of inputs into the analysis It simply identifies the inputs that are the most influential in determining the value of the NPV.

Some Limitations of Sensitivity Analysis Provides no information on the likelihood of deviations from the assumed values occurring It does not take into account the possibility of the simultaneous occurrence of adverse changes in more than one input ( eg price and level of sales falling )

Sensitivity Analysis