Capital budgeting (part 1)

Financial analysis is the means of appraising whether a proposed investment in a commercial activity is likely to be of value from the point of view of the stockholders. Investments in commercial activities are called capital projects. They usually involve the purchase of a physical asset, such as a machine or a new factory; a capital project may also involve investment in a less tangible asset, such as a new product or an advertising campaign. An essential characteristic of most capital projects is that cash is paid out now or in the near term in order to increase cash returns subsequently.  Using discounted cash flow methods, it is possible to determine whether a project is worth more to the company than it costs.

1 The capital budgeting process

Companies usually follow a capital budgeting procedure for allocating funds to capital projects. The company budgets such funds in advance for its individual divisions. Budgets are established on the basis of plans for growth in different markets and in response to emerging opportunities for exploiting new products and for reducing costs. Larger projects, such as chemical plants, for example, are often anticipated in budgets five or more years in advance of the actual expenditure; on the other hand, funds are also budgeted for smaller investments (machine tools, for example) about which little may be known until the time when the investment is proposed for formal approval.

In large companies, the capital budgets may be drawn up by a high-level capital appropriations committee and then ratified by the board of directors. Even if a project can be included in a budget, the money will not be spent until the capital project has been approved formally at the appropriate level of management. For example, a company may permit plant managers to approve projects costing up to $10,000, but more costly projects must go to the divisional manager for final approval and projects costing $50,000 or more must be ratified at board level after having first been approved at the lower levels. In addition to financial analysis, a formal project proposal report may have to include an analysis of how the project fits into the company’s overall commercial strategy.

2 Incremental cash flow

The object of financial analysis in a project appraisal is to compare the return on investment in the project with the return on investing the same amount of capital in the financial market. The major technique that is used in industry to make this comparison is discounted cash flow (DCF) analysis. DCF methods are used to put a value on the net incremental (after tax) cash flows that result from investment in a capital project.

A cash flow is a receipt or an expenditure of cash by the company at a particular point in time. An expected future cash flow is a probability-weighted average of all the different values that the cash flow might take at a future point in time. An expected net incremental cash flow is the net change in an expected future cash flow resulting from an investment decision. Net incremental cash flows are found by asking three separate questions:

  1. What items of company cash flow would be affected if the project goes ahead?
  2. What would be the expected levels of these cash flows after tax in each period if the project goes ahead?
  3. What would be the expected levels of these cash flows after tax in each period if the project does not go ahead?

The net incremental cash flow is the difference between the cash flows for the company with and without the project, and thus represents the net impact of the investment decision on the overall cash flows of the firm. DCF is used to make an estimate of how much the increase in cash flow would increase the value of the firm as reflected in the market prices of the company’s securities.

3. How much is a project worth?

The purpose of the discounted cash flow method is to determine the present value of each expected future cash flow from the project and the total of these present values. This total can then be compared with the capital cost of the project. By this means one can estimate whether the project is worth more to the company than it costs.

The present value (PV) of an expected future cash flow is found simply by multiplying the cash flow by its discount factor. The present value of a whole sequence of future cash flows is the sum of the present values of the individual cash flows. If the present value of the project’s net operating cash flows is worth more than the present value of its investment expenditures, the project is said to have a positive net present value (NPV).

The discount factor represents the financial market price today of a dollar to be received n periods later. This price depends upon just two things: the cost of capital for the cash flow and the length of time before the cash flow is to be received. The cost of capital depends in turn on the riskiness of the cash flow. For example, suppose that one dollar is to be received in two years’ time (n = 2) and the cost of capital considering the risk is equal to 10 per cent. The price today (its discount factor) in the financial market would be given by the following formula:

Discount factor = 1/(1 + cost of capital)n = 1/(1 + 0.10)2 = 0.82645

Discount factors can easily be determined in this way and incorporated for automatic calculation within financial spreadsheet software. Alternatively, tables of discount factors are readily available.As an hypothetical example of this process, a firm might consider a proposed investment in machinery and equipment and in working capital for a total of $1,200,000. The first step is to identify the cash flows of the firm that would be affected by the investment decision. The impact of the project on these cash flows is the project’s net incremental cash flow. In this case the net incremental cash flows can be divided into two parts, investment and operating cash flows, as shown in Table 1.

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The investment shown in line 1 of Table 1 – $1,100,000 in machinery and equipment – takes place at the beginning of the project at the end of year 0. At the end of five years, the equipment will have a second-hand market value of only $100,000. In line 2, an investment of $100,000 in working capital is also required at the time the machinery and equipment are put into use. The working capital includes cash investment in raw materials, semi-finished and finished goods inventories, and in debtors (less creditors). At the end of the project in year 5, $100,000 cash is realized from the working capital when inventories are finally depleted and the remaining debtors and creditors accounts are settled.

The operating cash flows in lines 3 and 4 of Table 1 represent the increase in cash receipts from sales less operating expenditures that result from the operation of the machinery and equipment. The operating expenditure includes both variable and fixed cash expenditure, including the incremental costs of marketing and administration. Line 5 shows the calculated net cash flows before tax; Line 6 subtracts the incremental tax cash flows, leaving the after-tax cash flow in line 7. It should be noted that the incremental tax impact can be positive in those periods in which the project actually saves taxes.

It is now possible to calculate the project’s net present value. Table 2 shows the project’s cash flows in the second column; in the third column, a discount factor has been assigned to each cash flow depending upon the timing of the cash flow. The discount factors are based on a discount rate of 10 per cent in this particular case. In principle, the choice of discount rate should reflect the rate of return that could be obtained in the financial market on securities of similar risk to the project, because management (and the shareholders) always have the alternative of investing the same funds in the market. In practice, the required rate of return can be obtained from the company’s risk-adjusted weighted average cost of capital for the project.

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The fourth column of Table 2 shows the discounted cash flows, which were obtained by multiplying the net cash flow in column 2 by the discount factor in column 3. The sum of the discounted present values of the incremental cash flow benefits of the project is $1,424.33. The fifth column compares the project’s present value of net cash inflows of $1,424.33 with its cost of $1,200.00. Therefore the project’s present value exceeds its cost by $224.33. This difference is called the project’s net present value.

The positive net present value indicates that the project is expected to earn a higher rate of return than the 10 per cent discount rate. The comparable investment in the financial market earning only 10 per cent would have an expected zero net present value when discounted at this rate. As a result, it is more profitable to capture the project’s positive NPV for the shareholders than to invest in the financial market at this level of risk.

Testing questions:

  1. What are capital projects?
  2. Why is it essential to work within a budget?
  3. What is the object of financial analysis in a project appraisal?
  4. What is meant by the net incremental cash flow?
  5. Briefly explain the net present value method.

Extension work:

A business is considering purchasing a machine costing €10 000. The business estimates that the future cash flows generated from the investment is:

YearRevenue €Operating costs €
14 0004 000
26 0005 000
39 0006 000
410 0007 000
512 008 000

The capital cost is 10% and all costs and revenues are received on the last day of each year. The discount factor is given in table 2 column 4. Complete the table below and advise the business.

Net present value table
YearCash flowDiscount factorNet present value
0(now)(10 000)1(10 000)
100.9090
21 0000.826826
3   
4 & 
5   

Information source:

This is an extract by Jack Broyles from Volume 1 of the IEBM. It is the first part of two that make up the full article.

 

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