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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


  1. APT TECHNICAL CPD - MAF (Capital Budgeting) 1

  2. Capital Budgets Nicholas Riemer Nicholas.Riemer@firstrand.co.za

  3. 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

  4. Generic problem. • “Capital budgeting is the analysis and evaluation of 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

  5. Philosophy behind capital budgeting • Value? How do businesses create value? Growth • Link to valuations

  6. 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)

  7. 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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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”)

  13. 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.

  14. 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

  15. 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?

  16. 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

  17. 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 17

  18. 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 18

  19. 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

  20. 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 20

  21. 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. 21

  22. 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?

  23. 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 outlook, 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.

  24. 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.

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