INVESTMENT ANALYSIS OR CAPITAL BUDGETING

What is Capital Budgeting? THE PROCESS OF PLANNING EXPENDITURES ON ASSETS WHOSE RETURN WILL EXTEND BEYOND ONE YEAR.

INVESTMENT THE ADDITION OF DURABLE ASSETS TO A BUSINESS

INVESTMENT OPPORTUNITIES MAINTENANCE AND REPLACEMENT OF DEPRECIABLE CAPITAL ITEMS ADOPTION OF COST-REDUCING INVESTMENTS ADOPTION OF INCOME-INCREASING INVESTMENTS A COMBINATION OF THE PRECEDING

STEPS IN INVESTMENT ANALYSIS: 1. IDENTIFY POTENTIALLY PROFITABLE INVESTMENT ALTERNATIVES 2. COLLECT RELEVANT DATA ON: CAPITAL OUTLAYS COSTS RETURNS

3. USE AN APPROPRIATE METHOD TO ANALYZE THE DATA. 4. DECIDE WHETHER TO ACCEPT OR REJECT THE INVESTMENT OR SELECT THE TOP RANKING AMONG MUTUALLY EXCLUSIVE PROJECTS.

CAPITAL BUDGETING METHODS OF CAPITAL BUDGETING PAYBACK METHOD SIMPLE RATE OF RETURN NET PRESENT VALUE INTERNAL RATE OF RETURN

PAYBACK METHOD THE PAYBACK METHOD GIVES THE NUMBER OF YEARS NECESSARY TO RECOVER THE INITIAL INVESTMENT. DOES NOT ACCOUNT FOR THE TIMING OF CASH FLOWS.

P = I / E WHERE: P = PAYBACK PERIOD IN YEARS I= INITIAL INVESTMENT OUTLAY E = ANNUAL NET CASH FLOWS (CASH RECEIPTS LESS CASH EXPENSES)

SIMPLE RATE OF RETURN EXPRESSES THE AVERAGE ANNUAL NET INCOME AS A PERCENTAGE OF THE AMOUNT INVESTED. THIS MAY BE IN TERMS OF THE INITIAL CAPITAL OUTLAY OR THE AVERAGE AMOUNT INVESTED OVER THE USEFUL LIFE OF THE INVESTMENT.

RETURN AS A PERCENT OF INITIAL CAPITAL OUTLAY SRR = Y/I WHERE: SRR = SIMPLE RATE OF RETURN Y = AVERAGE ANNUAL NET INCOME (DEPRECIATION TAKEN INTO ACCOUNT) I = INITIAL INVESTMENT OUTLAY

CALCULATION OF ANNUAL NET INCOME Y =(E – D) WHERE: Y = AVERAGE ANNUAL NET INCOME E = TOTAL EXPECTED ANNUAL NET CASH RECEIPTS D= TOTAL ANNUAL DEPRECIATION

STRAIGHT LINE DEPRECIATION D =(INITIAL COST – SALVAGE VALUE) / DEPRECIABLE LIFE

RETURN AS A PERCENT OF AVERAGE AMOUNT INVESTED SRR/ = Y/ (I + S)/2 WHERE: I = INITIAL INVESTMENT S = SALVAGE VALUE

NET PRESENT VALUE (NPV) WITH THE NPV, THE CASH FLOWS OF THE INVESTMENT ARE DISCOUNTED BY A MINIMUM ACCEPTABLE COMPOUND ANNUAL RATE OF RETURN.

THE INVESTMENT IS JUDGED TO BE ACCEPTABLE IF THE PRESENT VALUE OF THE NET CASH FLOWS EXCEEDS THE INITIAL INVESTMENT OUTLAY.

NPV = - INV + P1/(1+i) + P2/(1+i)2 + …. + PN/(1+i)N + VN/(1+i)N WHERE: INV = INITIAL INVESTMENT PN = ANNUAL NET CASH FLOWS ATTRIBUTED TO THE INVESTMENT VN = SALVAGE VALUE OR TERMINAL INVESTMENT VALUE

N = LENGTH OF PLANNING HORIZON I = THE INTEREST RATE OR REQUIRED RATE-OF-RETURN OR DISCOUNT RATE

INTERNAL RATE OF RETURN (IRR) THE IRR IS THE COMPOUND INTEREST RATE THAT EQUATES THE PRESENT VALUE OF THE FUTURE NET CASH FLOWS WITH THE INITIAL OUTLAY. OR IN OTHER WORDS THE DISCOUNT RATE THAT GIVES A NPV = ZERO

BOTH THE NPV AND IRR TAKE INTO ACCOUNT THE TIME VALUE OF MONEY. THE PURPOSE OF THESE INVESTMENT ANALYSIS TECHNIQUES IS TO EVALUATE THE ACCEPTABILITY OF INVESTMENTS RELATIVE TO AN ACCEPTABLE RATE OF RETURN.

COMPARING NPV AND IRR AS THE DISCOUNT RATE USED TO CALCULATE NET PRESENT VALUE IS INCREASED THE NPV WILL DECREASE THE IRR IS THE DISCOUNT RATE THAT GIVES A NPV OF ZERO

REINVESTMENT ASSUMPTION THE IRR METHOD IMPLICITLY ASSUMES THAT NET CASH INFLOWS FROM AN INVESTMENT ARE REINVESTED TO EARN THE SAME RATE AS THE INTERNAL RATE OF RETURN. THE NPV METHOD ASSUMES THAT NET CASH INFLOWS CAN BE REINVESTED AT THE DISCOUNT RATE USED.

WHICH REINVESTMENT RATE IS MORE REALISTIC? THE DISCOUNT RATE USED TO CALCULATE THE NPV HAS THE ADVANTAGE OF BEING CONSISTENTLY APPLIED TO ALL INVESTMENTS BEING EVALUATED.

CASH FLOWS FOR THREE INVESTMENTS YEAR INV A INV B INV C -20,000 - 20,000 1 2,000 5,800 10,000 2 4,000 8,000 3 6,000 4 3,000 5 1,000 AVG 5,600

PAYBACK PERIOD A 20000/6000 = 3.33 YEARS B 20000/5800 = 3.45 YEARS C 20000/5600 = 3.57 YEARS

SIMPLE RATE OF RETURN A (30000-20000)/5 = 2000 2000/20000 = 0.10 10% B (29000-20000)/5 = 1800 1800/20000 = 0.09 9% C (28000-20000)/5 = 1600 1600/20000 = 0.08 8% * Assume that the investment is fully depreciated in 5 years

NET PRESENT VALUE A NPV = -20000 + 2000/(1.08) + 4000/(1.08)2 + 6000/(1.08)3 + 8000/(1.08)4 + 10000/(1.08)5 + 0/(1.08)5 NPV = -20000 + 1852 + 3429 + 4763 + 5880 + 6806 + 0 NPV = 2730

NET PRESENT VALUE AND INTERNAL RATE OF RETURN A NPV = 2730 IRR = 12.01 B NPV = 3158 IRR = 13.82 C NPV = 3766 IRR = 17.57

WHAT GOES INTO THE DISCOUNT RATE? THE DISCOUNT RATE SHOULD REFLECT THE COST OF CAPITAL OR THE COST OF FUNDS USED TO FINANCE THE BUSINESS. AN INVESTMENT IS NOT ACCEPTABLE UNLESS IT GENERATES A RETURN SUFFICIENT TO COVER THE COST OF FUNDS.

THE DISCOUNT RATE CONTAINS THREE COMPONENTS: REAL RISK-FREE RATE RISK PREMIUM INFLATION EXPECTATIONS

WEIGHTED AVERAGE COST OF CAPITAL THERE ARE TWO TYPES OF CAPITAL INVESTED IN A BUSINESS: DEBT CAPITAL EQUITY CAPITAL COST OF DEBT COST OF EQUITY

WEIGHTED AVERAGE COST OF CAPITAL Kc = wd Kd + we Ke Where: Kc is the weighted average cost of capital wd is the proportion of assets financed with debt Kd is the cost of debt capital we is the proportion of assets financed with equity Ke is the cost of equity capital

PROFITABILITY INDEX USED TO ALLOCATE LIMITED CAPITAL AMONG SEVERAL INDEPENDENT PROJECTS PRESENT VALUE OF THE CASH INFLOWS DIVIDED BY THE INITIAL CASH OUTLAY

ANNUITY EQUIVALENT USED TO COMPARE NPVs WITH UNEQUAL LIVES. DETERMINES THE SIZE OF ANNUAL ANNUITY FOR THE ECONOMIC LIFE OF THE INVESTMENT THAT COULD BE PROVIDED BY A SUM EQUAL TO THE PRESENT VALUE OF ITS PROJECTED CASH FLOW STREAM, GIVEN THE COST OF CAPITAL.

ANNUITY EQUIVALENT IS CALCULATED BY SETTING THE NPV OF THE INVESTMENT AS THE PV AND THEN SOLVING FOR THE PMT USING THE SAME PLANNING HORIZON AND DISCOUNT RATE TO DETERMINE NPV.

FINANCIAL FEASIBILITY ONCE YOU HAVE EVALUATED AN INVESTMENT, THE FINANCING OF THE PROJECT SHOULD BE DETERMINED. AFTER-TAX CASH FLOWS MAY NOT BE SUFFICIENT TO MEET DEBT REPAYMENT REQUIREMENTS.