APT TECHNICAL CPD - MAF (Capital Budgeting) 1 Capital Budgets - - PowerPoint PPT Presentation

APT TECHNICAL CPD - MAF

(Capital Budgeting)

1

Capital Budgets

Nicholas Riemer Nicholas.Riemer@firstrand.co.za

Agenda

• Workflow to understanding capital budgets
• What capital budgeting? Generic Problem
• How are capital budgets performed in the real

world, industries?

• What is the specific problem in the case study?
• How to incorporate into your file

Generic problem.

• “Capital budgeting is the analysis and evaluation
• f investment projects that normally produce

benefits over a number of years”

• “Tie in with strategy – plan of action – especially

because its over the long term”

• Strategy – timing – loose flexibility – Outsourcing

(“not merely only a decision on positive NPV and then no further management!”)

• The calc is not sufficient to make a call!

– Qualitative vs. Quantitative-APT/APC

• DECISION MAKING – RELEVANCY PRINCIPLES

Philosophy behind capital budgeting

• Value? How do businesses create value? Growth
• Link to valuations

Types of decisions

• Replacement decision (Less risky why? Cash flows?, cost savings)
• Expansion (Risky why? Over estimate future cash flows, Subjective)
• Abandonment decisions NPV vs Cash now?
• Optimal economic lives APT(something that will need to be

researched)

• REMEMBER

– Independent (eg both) vs. Mutually exclusive(One or the other) – Divisible and Indivisible projects (piece of the project, split up)

Cash flows

• Incremental vs Total approach

– Which one?

• Tax calculation

– Integrated or separate? Accrual

• Initial cash flows
• After tax operating cash flows
• End of project cash flows (terminal value)
• Financing costs?

– Separate investment and financing decisions – One exception –

• Special financing schemes – asset specific
• financing. Net advantage NB

Initial cash flows

• Occur at t0

– Does it need to be discounted?

• Initial investment – installed cash cost

– Cash cost – Therefore, ignore method of financing – What about VAT?

• Past research costs?

– Relevant or irrelevant?

• Proceeds on disposal

– Replacement decision

• Tax arising on the disposal

– Tax payable – Capital gains tax – 1 October 2001

• Investment in working capital

– No tax effect

Operating cash flows

• Cash vs profit

– Therefore, adjust for: – Non-cash items – depreciation NB why?? Key principle – We only apply the accrual principle for tax, why?

• Finance charges

– Include or exclude?

• Only include relevant cash flows
• Opportunity costs

– Tax effect thereon?

• Do payments have to occur annually or

can they occur monthly?

• Tax

– Time lag – Assumption

End of project cash flows

• Proceeds on disposal of asset
• Terminal value??
• Tax consequences on the disposal
• Assessed tax losses?
• Reversal of working capital requirements

Capital budgeting techniques

Payback period (How long funds are at risk) Discounted payback Net present value (NPV) Internal rate of return (IRR) Discount rate where NPV =0 Profitability index (Capital rationing, NPV/cost >1 Modified internal rate of return (MIRR)`Reinvestment at WACC and not IRR for duration of project

Payback period

• Example

– Initial investment = R 40 000 – Annual cash flows = R 10 000 – Payback period???

• Weaknesses:

– Ignores the time value of money – What is an acceptable payback period? – Ignores the cash flows after the payback period – Doesn’t take risk explicitly into account – TVM (“Crude indicator of risk”)

Discounted payback period

• To overcome the weakness regarding TVM of the payback period

– Initial investment = R 40 000 – Annual cash flows:

t0 t1 t2 t3 t4

Take each cash flow, discount each at the COC, and use the PV of each one to determine Payback Period.

Net present value

• Discount the cash flows at the cost of capital
• Why the cost of capital?
• Accept

– IF NPV > 0 – What does a negative NPV mean? – Replacement decision – when should you accept?

• Ranking

Internal rate of return

• Definition

– The rate that discounts the cash flows to an NPV of zero

• Can also be interpreted as the return on investment
• Accept decisions

– When the IRR > Cost of capital

• Ranking
• Conflicting rankings

– Example

Project A Project B NPV 100 80 IRR 18 30

Which project should you accept?

Conflicting rankings

• Why?
• IRR assumes that cash flows can be invested at

the IRR

• NPV assumes cash flows can be invested at the

COC

• Where there is unconventional cash flow, there is

more than 1 IRR

• So which do you use?
• Solution: Modified internal rate of return

The impact of inflation (1)

• Real discount rate vs Nominal discount rate
• By default: WACC = Nominal rate
• M = (1+R)(1+I) – 1

– M = Nominal rate of return – R = real discount rate – I = inflation rate

• Real cash flows vs Nominal cash flows
• Match

– Real cash flows with real discount rate – Nominal cash flows with nominal discount rate

• Single inflation rate or different inflation rates for different line items

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The impact of inflation (2)

• Adjust for:

– All cash flows – that have an inflation effect – Including working capital “stepped” increase and release – But - Don’t adjust:

• Tax allowances
• Proceeds on disposal

– “The machine can be sold for R 100 000 at the end of its useful life”

• So which should you use?
• Nominal superior

– Real assumes each cash flow is affected equally by inflation

• What if inflation rates are different for different years?
• What if inflation effects cash flows differently?

– Real assumes tax allowances is affected by inflation – adjusted real approach

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Capital Rationing

• No capital constraint – will accept all independent projects

with a positive NPV

• If there is a capital constraint – independent projects must be

ranked

• Rank – NPV – doesn’t take size of investment into account!
• Objective is to maximize sum of NPV’s in such a way that

capital limit is reached but not exceeded

• Two cases

– Projects divisible use PI = PV/I – Projects indivisible determine combinations that will maximize NPV

19

Abandonment decisions and optimal economic lives

• Should I abandon?
• Compare the abandonment value to the present

value of future cash flows

• Example:

– Company A invested in a machine 1 year ago. The cash flows were predicted last year as follows WACC 12%: t 0 = (100 000) t 1 = 50 000 t 2 = 75 000 t 3 = 80 000 t 4 = 100 000 – If Company A abandons today, it will receive R 175 000. NPV R111 000

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Strategic options (Real options)

• A project can have a negative NPV, but may

have certain qualitative aspects to consider Employees, Distribution, Vertical and horizontal integration.

• Specific asset financing may be available to

reduce the NPC and compare the added benefit.

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Specific Industry?

• What is the industry?
• How are capital budgets performed in this industry,

what types of decisions? Fast food, pharmaceutical, Fuel, banking?

• Research, but what kind of research? What type of

information are you looking for?

• Are you applying the technical detail of the topic to the

industry in your research time? Need to know different decisions, types of capital budgets NPV, IRR, Discounted pay back what is the valuation metric this industry uses? Cost of capital?

Capital budgets in practice?

• Investment decisions, are we taking this project on?

What types of projects are the industries taking on at the moment? Qualitative aspects might come from industry

• utlook, Banks Digital etc
• Growth rates in the industry, industry outlook, discount

rate(WACC) but? CAPM requires the Rf rate, Market risk premium and b. do you have those?

• Could you critically comment on growth rates used,

discounts rates used, over all decision in the context of the industry?

• Need this information as its not ITC now.

Industry Banking:

• In the pre release the Banking industry is triggered.
• How would I handle this industry?
• 1) Identify the technical concepts and basics of capital budgeting.
• 2) Start with general research, google. What are you seeing, what are

banks investing in right now….. Card tech, ATM’s, Digitalization?

• 3) From simple research you will identify the key issues at hand for capital

budgeting in the banking industry. Banks investing in Digital. Digital platforms, Instant card issuances (machines) (Capitec ,Tyme). Macro analysis? (FirstRand acquiring Aldermore, Discovery digital bank, Bank Zero (free banking no branches), Banks need to invest in Technology, else Kodak case study. These are the qualitative aspects you are picking up.

• This is what you are identifying with regards to the trigger industry
• research. Cannot just rely on overall industry research for Capital budgets.

Banking Industry

– Banks needing to invest in technology. Banks needing to make the user experience quick and simple. – Elimination of branches, link to Standard bank and ABSA. Closing of

• branches. Decision making around this? Capital budgeting, money saved

and invested in technology. – From a model point of view Client growth is real, yet pricing charged is inflationary, need to link this to your nominal calculations in the Capital budget if asked to perform. – WACC used. Some banks give you WACC used in the AFS. Get an idea of the WACC. – Instant card issuances like Capitec, Tyme bank. In flows….Clients transacting faster, on average 5-7 days to get a card, now instant. Can look at that income from a capital budget. Outflows, cost of machines, maintenance etc. – Specific asset financing, for these machines. Exists in the market. – IFRS 16, need to work back to cash from a DCF point of view.

Banks Instant card issue

• Need to look at why bank’s are going this way. Do we

understand the move to Instant cards?

• What are the incomes in a budget? Savings on Fancy cards,

Delivery costs, Branch staff, Faster time to transact so looking at Average fees charged per day times number of days saved to get card.

• What are the costs? Machine outlay need to look at number
• f machines needed, average cost of these machines, Printing

costs, cost of plastic, new cards needed more regularly, any

• pportunity costs?
• Understand the industry and what Banks are looking at in

these budgets and the strategy behind it.

Specific Case study

• What is the specific problem for the specific case
• Determine what information is available to prepare a capital
• budget. What is missing what methods are used?
• Now link Technical, Industry research the case study at hand.

What is the problem? Bank moving to digital, need to know to invest or not. Can we prepare a budget like constructco, prepare and then add of the day or use budget to write a report to CFO on the decision thus bringing in all qualitative aspects you have researched and from case study.

• Not predicting the question for the day. Arriving with a full

tool box, but might mean some prep in terms of a budget before hand to use for the day.

• Coverage Coverage Coverage NB

Specific case study

• Always answer all the questions related to the

Decision, the NPV is 50% of the work.

• Tone when assisting if asked not over critical.
• Preferred tasks with regards to budgets, comment
• n, assist, how would you approach in terms of just

talking a CFO through it. Need to know basics well.

Building a file for coverage

• My File.
• Everything summarized in sequence NB

1) Industry research for the trigger, 2) Technical principles summarized for each of the applicable methods and 3) all my key coverage points from the pre release for coverage 4) the capital budget if enough information is available. Below this in the file, the rest of your notes.

• You got this.