Module 11 Budgeting and long term planning
ADB Private Sector Development Initiative Corporate and Financial Governance Training Solomon Islands Originally by Dr Judy Taylor Acknowledgement These materials were produced by Dr Judy Taylor from La Trobe University, through the Asian Development Banks Pacific Private Sector Development Initiative (PSDI).PSDI is a regional technical assistance facility co-financed by the Asian Development Bank, Australian Aid and the New Zealand Aid Programme. Module 11 Outline What is Capital budgeting Steps in capital budgeting
Capital budgeting techniques explained Payback Net present value Internal rate of return Accounting return How do I choose which project to implement Capital Budgeting Capital budgeting is the formal term for planninglong-term investment decisions. These projects aredifferent from normal budgeting decisions due totheir size and the time taken to implement them. The problem for the business is threefold, how to evaluate a project, when they have a number of such projects they canundertake how do they evaluate them and then how to compare them. Investment in your business is crucial to the ongoing growth and health of cash flows. Investment decisions take time to plan, evaluate and implement. They take careful and considered long term planning. Then, once implemented investment decisions usually take time to mature as businesses and become profitable. Capital Budgeting Techniques can be used to help a company to assess if thecapital budgeting proposals will yield a return and deliveran economic value to the company. usually focus on the cash flows of the investment choices rather thanaccounting profit. Module 8, we constructed a budget for our business. Capitalbudgeting decisions require the company to complete similarforecasts of costs as well as cash flows in and out whenevaluating a business proposal. These projects should be found in the long term businessplan, but they will be planned for and evaluatedseparately. Capital Budgeting If there is more than one project that the company isconsidering the company should evaluate all theprojects in the same manner. Firstly estimating thecosts then the cash flow. Taking care to allocateeach of these to the correct period. . Capital Budgeting Once the capital budgeting is undertaken for all theproposed projects the company must make a decision ofwhich project they will undertake. companies usually have access to limited resources and areunable to take up every opportunity that presents itself. companies that grow too quickly often fail or suffer loss for a period of time because they stretch their management resources too thinly and it takes resources to integrate new business into the old businessstructure. So even if it is possible to undertake a number of projects it isoften not wise to do so. Capital Budgeting Steps involved in capital budgeting.
Identify long-term goals of the individual or business. Identify potential investment proposals Estimate and analyse the relevant cash ows of theinvestment Determine nancial feasibility of each of theinvestment proposals using the capital budgetingmethods. Choose the projects to implement Implement the projects chosen Monitor the projects implemented. Capital Budgeting Different projects have different timings of cash outflowsand inflows. There are a number of techniques that a company canuse to evaluate the projects. Each potential projectneeds to be evaluated. This can be done either calculating the amount of time it takes to have your investment fundsreturned, or converting the cash inflows and outflows into currentdollars. Assume the following 4 projects are available for yourcompany to undertake. In addition to the techniques we will discuss below some businesses do not opt for the project that yields the greatest return if there are other overriding considerations that dictate a lesser profitable one be accepted. 4 different projects Project 1 Project 2 4 different projects Project 3 Project 4 4 different projects Which project is better? Why?
How do you evaluate the different timing of thecash inflows and outflows? Capital budgeting decisions
Understanding how the different methods forassessing capital investments are calculated, iscritical to making a sound responsible choice (eventhough staff will usually do it for the board). Understanding discount rates and the time value ofmoney is central to this solid understanding A dollar received in a year from today is not asvaluable as a dollar received today, its value isdiscounted by time - I year Capital budgeting decisions
If the dollar received today could be invested and earn 10%,then in a year it will be worth $1.10, But, the dollar we receive is a year will just that $1. To find the value of a dollar that will be received in the futurewe discount it by the rate it could have earned, 10%. So 1/1.10 =$.909. And $ .909 invested at 10% for I year will grow to $1. That shows us that in todays terms a dollar received today isworth $1 but a dollar received in inyear is worth only $.909cents today This is why we prefer a dollar today and why discountingfuture cash flows to todays value helps us make soundresponsible financial investment decisions. Capital budgeting decisions
If we discount by a set amount say 10% to find thevalue of a dollar received in the future to a presentvalue $, the dollar value of the discounted sums iscalled the net present value, NPV If we discount so that the NPV = 0 this is called theinternal rate of return. Capital Budgeting These techniques include:
Payback Period Discounted Payback Net Present value Internal rate of return Modified internal rate of return Accounting rate of Return How do I do this, Which one should I use, and Why? Payback Period The payback period calculates how long it takes to have yourinvestment returned to you in years, or months. This is the simplest method for assessing a projects return. Using Project 1 above Year Cash Flow Cumulative cash flows0 -$40,000 -$40,0001 -$40,000-$80,000 2 $110,000 $30,0003 $130,000 $160,0000 It took years to receive cash flows sufficient to return the capitalinvested. Decision Rule The project that pays back in shortest time is most desirable. Discounted Payback Period
The payback does not distinguish the future dollars from todays dollars. A dollarreceived in 4 years hence is worth less than a dollar received today. We can discountthe future values by a discount rate, say 10% and recalculate the payback based on themore realistic values. YearCash Flow Discount rateDiscounted valueCumulative Cash Flows 0 -$40,000 $40,0001-$40,0001.1-36,366-$76,366 2 $110,000(1.1)2 +$ 3 $130,000(1.1)3 This gives a payback in 2.84 years as opposed to Usually the discountedpayback takes longer. Decision Rule The project that pays back in shortest time is most desirable. Net Present Value (NPV)
This technique estimates the present value of a stream ofcash inflows and outflows over different time periods. If the NPV is greater than zero then the project is viable.It discounts cash inflows and outflowsusing a discountrate, to find itsNPV. This technique was first usedin 1951. Today it is the most common method used in financialtextbooks and by companies. To undertake a NPV calculation an estimate of the sizeand timing of all the cash flows as well as an estimateof a discount rate is required. Net Present Value (NPV)
Value of NPV Interpretation Action NPV > 0the project would add the project value to the firmmay be accepted NPV < 0the project would not the project add value to the firmshould be rejected NPV = 0the project would neitheras the project neither add nor lose value adds nor subtracts from for the firmthe value we are indifferent to the project The decision to proceed or reject the project will be based onavailability of other projects or other criteria. Net Present Value (NPV)
Selecting the proper discount rate is critical to thecorrect calculation. The NPV is determined by thediscount rate, alsocalled thehurdle rateis crucial to making the rightdecision. The hurdle rate is the minimum acceptablerate of returnon an investment. Choosing a discount Rate The discount rate is effectively a desired return, or the return that an investor would expect to receive on some other typical proposal of equal risk. The discount rate typically includes: The rate of time preference. Most people prefer consumption undertaken now rather than later. Thus, a dollar available now is more highly valued than one received later. Uncertainty/risk. There is necessarily some degree of uncertainty as to whether a future dollar will actually be received. Its value is lessened in proportion to the expected size of this uncertainty/risk factor. Well talk more on this shortly. Net Present Value (NPV)
The formula to discount one future cash flow to itspresent value is: PV = FV/(1+r)n PV= Present value FV = Future value r= discount rate n = number of years Net Present Value (NPV)
However where there is more than one future cash flow you usethe following formula Or -C0 = Initial Investment C = CashFlow r= discount rate 1,2,3, n= time Net Present Value (NPV)
Looking at project 1. The project incurs cost of $40000 in each of the 4 years, but In year 2 the project earns a net cash inflows for the first time of $ In year 3 the project earns a net cash inflow of $ Year Cash Flow Discount rate Present Value 0 -$40, $40, $40, $36, $110,000 (1.1)2 $90, $130,000 (1.1)3 $97, Total costs$160,000 +$112,216.37 Net Present Value (NPV)
Net Present Value = $112,216.37 Net Present Value (NPV) The net present value of this example can be shown in the formula Overall the project revenue is $320,000 and the costs are$160,000 with net cash profit of $160,000. Net Present Value (NPV)
Decision Rule. If at the end the NPV is greater than zero then theproject is viable. Discount Rate The discount rate is the rate used to convert the cashflows into todays value, the present value. The rate used should reflect the riskiness of theinvestment, as well as thevolatilityof the cash flows. It must also take into account the financing mix,internal, raising capital from owners plus outsidefinancing from banks or bond issuing. Net Present Value (NPV)
Different discount rates If the company produces across a number ofindustry types and the cost of capital is different ineach, a different hurdle rate should be used for each projectthat reflects the risk of each project. A higher discount rate would beused if a project's risk is higher than the risk of the firm as awhole. Net Present Value (NPV)
How do you estimate the discount rate? To estimate the cost of the financing mix Managers often usemodels such as theCapital Asset Pricing Model, (CAPM)toestimate the appropriate discount rate for each particularproject. CAPM uses the cost of the financing mix - debt plus equity, weighted by their respective share of the total. This is called theweighted average cost of capital(WACC),when it is used as the discount rate to calculate the NPV it isreferred to as the hurdle rate. This is because each projectmust earn a return greater than the cost of capital. If notthere is no financial/economic reason to proceed with theproject. Net Present Value (NPV)
Problems with the NPV Calculations Choosing the discount rate Choosing the correct premium to add as a risk factor to thediscount rate. If this is simply based on a bank premium itmay be incorrect and result in a misleading indicator ofeconomic value. Depending upon the industry, cash flows at the end of thelife of the project may become negative (e.g. if largeremediation of the site is required), in areas such as mining.This can be catered for by explicitly allowing for financingthe losses- negative cash outflows. The NPV shows you whether your return is above yourrequired return but it does not give you an actual return. Inorder to calculate this you need to do an IRR calculation. Internal Rate of return
The IRR is the rate of return such that the presentvalueequals zero. Internal rate of return and net present value IRR uses a similar technique to the one used in NPV(to convert the future cash flows into present daydollars) except a different discount rate is used. TheIRR is thediscount rate that gives aNPV of zero. IRR is used as a measure of investment efficiency. Internal Rate f return = $40,000+$ $ $ Internal Rate of return
The IRR method will result in the same decision as theNPV method, (see table below). In the usual cases where a negative cash flow occurs atthe start of the project, followed by all positive cashflows projects that have a higher IRR higher than thehurdle rate should be accepted. Nevertheless, for mutually exclusive projects, it ispossible that if a companys decision rule requires themto choose the project with the highest IRR - which isoften used they may be selecting a project with alower NPV. Internal Rate of return
Value of NPVValue of IRRInterpretation/Action NPV > 0IRR> NPVthe project would add value to the firm the project may be accepted NPV < 0IRR 0 IRR> NPV the project would add value to the firm the project may be accepted NPV < 0 IRR NPV Discounted payback Net Present value NPV>0 NPV0 and IRR>NPV IRR0 and MRR>NPV MRR required rate of return ARR< required rate of return ARR=required rate of return NPV > 0IRR> NPVthe project would add value to the firm the project may be accepted NPV < 0IRR