capital budgeting techniques

CAPITAL BUDGETING

Financial Management

Capital Budgeting Techniques

Introduction

The value of an entity today is the present value of all its future cash flows. The cash flows here includes the assets currently held by the company as well as any better investment opportunities that might be available in future .The value is calculated by discounting these future cash flows with investors required rate of return or what we can say is the degree of uncertainty attached to those future cash flows and expected time when these will occur. The managers of the business have a goal to maximize the entity’s value which in turn would help shareholders to maximize their wealth. In order to evaluate any long-term project that whether it is feasible for investment purpose or not there are different ways in which a project can be evaluated and these are as follows.

· Payback Period

· Discounted Payback Period

· Net Present Value

· Internal rate of return, and

Payback Period

The payback period for any project will be the time until when the investment can be recovered from a certain project for example if a project required initial investment of 20,000 dollars and the project will provide cash outflows of 10,000 in year 1 and then the same amount will be out flowed in year 2 then the payback period for the project will be 2 years.

Discounted Payback Period

The discounted payback period is basically the extension of payback period where the payback period is calculated that is the time in which the investment would be recovered through future cash outflows but the difference here is that it also requires the future cash flows to be discounted with the investors required rate of return that can be explained as the uncertainty of those future cash flows along with time value of money which in total becomes the required rate of return for the investor (owners of the capital invested) ,this is also known as the cost of capital.

Net Present Value

Net present value is nothing but the difference between present value of future expected cash inflows and initial investment. The present value of future cash inflows is being determined by using a discount rate which is normally the cost of capital. If the present value of inflow is greater than initial investment, it is called positive net present value; otherwise it is called negative net present value. The project is accepted if the net present value is positive and if one of the two projects is to be selected, the positive net present value with higher amount is selected.

The most widely used technique is net present value as it considers cash flows for the whole life of the project and time value of money. Only drawback for net present value method is that it can be used where the projects are mutually exclusive, it means that where company can opt for only one option for any reason. However, the drawback can be removed by finding the Profitability index or NPV index. The index can be used where the company can opt for various options. The company ranks each project according to its index in descending order and then select from the top till the investment is exhausted.

Internal Rate of Return

The Internal Rate of Return is the discount rate at which the net present value is zero. If the rate is more than the cost of capital, the project should be accepted, otherwise not. It is simple to express, but it is difficult to calculate manually. Like accounting rate of return method, it is also shown in percentage terms therefore it also ignores size of investment. It has another drawback that it is based on the assumption that future cash flow is reinvested at internal rate of return.

Weighted Average cost of Capital

Capital is the source of fiancé through which resources are provided. It may be debt financing or equity financing. The cost of debt financing is interest which is the before tax cost of capital, while after tax cost of capital is r (1-t). If suppose the interest rate is 10% and the rate of tax is 20%, it means that before tax cost of capital is 10% and after tax cost of capital is 8%.

In equity finance the cost of capital is dividend, if the rate of dividend is 10%. Then after tax cost of capital and before tax cost of capital are same, which is 10% as there is no tax shield available, as the dividend is not the expense, rather it is distribution of profit.

If a project is financed only from debt financing the cost of capital will be 8% and if it is only financed from equity the cost will be 10%. But if financing is done 50% from each, then the cost of capital will be 9%.

The increase in debt financing will reduce the overall cost of capital. For example if we raise the portion of debt financing to 60%, now the cost of capital will be 8.8%.

You can see that the percentage of financing provided from a source determines the weight age of financings. Another example can help, suppose a project requires $200 million and $120 from debt and $80 million from equity financing is provided therefore the weight age of debt is 60% and of equity it is 40%. Now to calculate WACC we will take 60% of the cost of debt and the after tax cost of debt is 8%, while the 60% of 8% is 4.8% and we will take 40% of cost of equity and the after tax cost of equity is 10%, we will take 40% of 10% which is 4%. Now add 4.4% and 4%, the WACC is 8.8% of the project financing.

Wheel Industries Investment Appraisal

Equity Financing

The wheel industries has used equity financing the cost of which to company is 11.90 % this has been calculated by using the dividend growth model by using the following formula.

{(Dividend x 1+ growth rate/Selling price-floatation cost) +Growth rate}.

The advantage of equity financing to company is the saving in interest expenses which in turn would reduces the profit before taxes and ultimately the total profits. However it can be argued that the cost of equity financing is higher than cost of debt financing but debt financing requires a constant interest expense regardless of the fact that whether company is making profits or not but on the other hand the equity financing thought more expensive but will only requires dividends to be paid if company is making enough profits else in losses company is not bound to pay unlike the debt financing.

Debt Financing

The after tax cost of debt financing can be calculated by deducting the tax shield from the 5% tax rate which is (0.05*0.65) =3.3%.

The debt financing is far cheaper than equity financing and one of the important factors making debt financing cheaper is the tax shield as interest expense is a tax allowable expense it means that though total cost of debt also has an advantage of reducing the tax expense. One of the disadvantages of debt financing is that it increases the gearing ratio and in times of losses it becomes a burden for the company in the form of compulsory interest payments to the lenders.

Weighted Average cost of Capital

Debt	30%	3.3%	0.98%
Equity	70%	11.9%	8.32%
WACC	9.30%

The weighted average cost of capital is being calculated by taking 30% of after tax cost of debt and 70% of cost of equity. The weighted average cost of capital is used in capital budgeting techniques as the discount rate or we can say the investors required rate of return.

After Tax Cash Flows

After tax cash flow
Revenues	1200000
less expenses	600000
Less Depreciation	500000
Earnings before taxes	100000
less taxes	35000
Earnings after taxes	65000
add depreciation	500000
Cash flow after taxes	$ 565,000	million

The after tax cash flows have been calculated using the income statement approach (indirect method).The depreciation has been added to net income to arrive at cash flows after tax.

Net Present Value and IRR

Year	Cash flow	PVIF at 6%
0	-1500000	1	-1500000
1	$ 565,000	0.943396226	533018.9
2	$ 565,000	0.88999644	502848
3	$ 565,000	0.839619283	474384.9
		NPV	10251.75
		IRR	6.37%

The project as per net present value technique can be accepted as it has a positive NPV of 10251 dollars .However the IRR is 6.37 percent which is below the WACC and a conflict between these two techniques is being raised and the project should be declined. The conflict has risen because the NPV has been calculated at 6% if it would be calculated at 9.32 percent the WACC it would be a negative NPV and hence the decision as per NPV would also be the one to decline the project. It is concluded that project should not be accepted.

Expected after tax cash flow

	Investment B	Investment C
	5000	6600
	16000	20000
	10000	10000
Expected after tax cash flow	31000	36600

The expected cash flows have been calculated by taking into account the probability and cash flow for each investment project.

Net Present Value and Internal Rate of Return

Year	B	C	PVIF at 8%
0	-120000	-120000	1	-120000	-120000
1	31000	36600	0.925926	28703.7037	33888.889
2	31000	36600	0.857339	26577.50343	31378.601
3	31000	36600	0.793832	24608.79947	29054.26
4	31000	36600	0.73503	22785.92544	26902.093
5	31000	36600	0.680583	21098.07911	24909.345
6	31000	36600	0.63017	19535.25843	23064.208
			NPV	143309	169197
			IRR	14%	21%

As the NPV and IRR of investment project C is higher than Investment Project B so project C should be accepted as it appears to be a feasible one. but when the projects are mutually exclusive the decision needs to be based on net present value .the project with higher NPV should be selected, because the IRR can be different for two projects due to difference in amount of investments, as the IRR is mentioned in percentage ,therefore it ignores the size of investment.