Unsophisticated capital budgeting techniques

Simple (unsophisticated) capital budgeting techniques include average rate of return (ARR) and the payback method (also called PB or payback period).

Average Rate of Return


Average Rate of Return (ARR) is an unsophisticated budgeting technique and generally considered to be ineffective. Average Rate of Return (ARR) evaluates relative profitability of the investment. In other words, it evaluates how project affects accounting profits. Average Rate of Return (ARR) is calculated as follows:

ARR = Average income / Average investment

Average income refers to annual average net profits after tax (refer to income statement to see how net profits after tax are determined). Annual average net profits after tax is found by taking total net profits after tax over the useful life of the project and dividing it by number of years over useful life of the project. Average investment refers to average investment over the economic life of the project. The ARR capital budgeting technique does not consider the time value of money. It also considers net profits rather than cash inflows. Consequently, the technique overlooks the possibility of reinvestment of returns.

The positive side of this technique, as compared to payback period discussed below, is that it considers returns on investment over entire useful life of the project. However, this technique is generally not recommended.

Payback method


Payback period (PB), also called a payback method, is another unsophisticated budgeting technique. It determines how long it takes to recover the initial investment by taking into account cash inflows from the investment. If we deal with an annuity (an equal periodic cash flow over a specific period) than all we need to do is to divide initial investment by an annuity.

However, if we deal with a mixed stream of cash inflows (unequal cash flows during specific period with no precise pattern) than we need to add up cash flows until the initial investment is recovered.

Management needs to subjectively determine the maximum payback period and then projects are evaluated according to this. If the project’s payback period is below maximum than the project is acceptable and vice versa.

The payback period budgeting technique measures business’s risk exposure because the project’s risk level depends on how long it takes to recover the initial investment. However, it does not explicitly consider the time value of money.

Moreover, this budgeting technique is weak because it is subjective in nature since the minimum payback period is subjectively determined. Furthermore, it does not take into account the cash flows that occur after the payback period.

A variation of payback period capital budgeting technique allows to account for time value of money and risk (due to usage of discount rate which incorporates risk). Such variation is called discounted payback period technique. This technique determines how long it takes for discounted cash flows to recover the investment. However, this variation still does not consider cash flows after the payback period.

Test Yourself


ABC Corp has a proposed project A, which has expected cash inflows of $4,000 over 10 years period. The initial investment is $30,000. Find the payback period.

SOLUTION:

Payback period = 30,000/4,000 = 7.5 years

This means that it will take 7.5 years for ABC to recover its investment in project A.

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Terminal Cash flow in capital budgeting decisions

Terminal cash flow refers to the cash flow, which takes place at the end of the project life. Terminal cash flow takes into account a net salvage value received at the end (liquidation) of the project (such as sale of the asset).

Terminal cash flow excludes operation cash inflow from the last year of the project but includes cash flow due to change in net working capital. Generally, change in net working capital results in the cash inflow which is the recovered amount of cash outflow (due to increase in net working capital) that were taken into account at the beginning of the project (when calculating the initial investment).

The calculation of the terminal cash flow is as follows:

After-tax proceeds from the new asset

LESS: After-tax proceeds from the old asset

LESS/ADD: Change in net working capital

= TERMINAL CASH FLOW

As stated above, when we calculate a terminal cash flow, we reverse the change in net working capital, which was taken into account during the calculation of the initial cash outflow (initial investment) .

If there was an increase in net working capital at the beginning of the project than we see it as inflow when calculating the terminal cash flow and vice versa. In other words, if there was an outflow due to change in net working capital at the beginning of the project than we reverse it by adding it back during calculation of the terminal cash flow.

Tax considerations in calculation of the terminal cash flow are the same as explained in initial cash outflow (initial investment) section earlier.

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Operating Cash Inflows

Operating cash inflows is a second variable that we must take into account when determining cash flows from the project. It refers to incremental (additional) cash inflows over the duration of the project. The cash inflows do not take into account interest payments and are calculated as follows:

Revenue

LESS: Expenses (excluding depreciation and interest

 

= EBDIT (Earnings before depreciation, interest and taxes)

LESS: Depreciation

 

= EBIT (Earnings before interest and tax)

LESS: Taxes

 

= NOPAT (Net operating profit after taxes)

ADD: Depreciation

 

= OPERATING CASH INFLOWS

 

Initial investment in capital budgeting decisions

Within context of capital budgeting decisions, initial investment refers to the cash outflow at the beginning of the project and is calculated by taking the total cost of the new asset (cost plus all expenses required to make asset operational), less after-tax proceeds from sale of the old assets and further adding or subtracting change in the net working capital, as shown below.

Initial investment (Initial cash outflow) determined as follows:

Total cost of the new asset (cost plus installation)

Less: After-tax proceeds from sale of the old asset (proceeds from sale of the old asset less cost of removing asset less tax on sale of the old assets.

Less or Add: Change in net working capital

Tax on the sale of the old asset is only paid if the asset sold for more than asset’s book value. Book value of an asset refers to the total cost of the asset (cost of the asset at the time it was purchased + installation cost) less accumulated depreciation.

Accumulated depreciation refers to the collective depreciation of an asset up to a point under consideration. For example, if asset were bought exactly 5 years ago, than accumulated depreciation will include sum of individual depreciation amounts for each of the five years.

If the asset sold for more than its book value than any value above original total cost of asset referred to as capital gain and any value above book value and up to original total cost of asset referred to as recaptured depreciation.

If asset is sold for less than book value than tax credit is generated, provided the country specific legal requirements for such tax credit to be effective are met.

As stated above, an initial investment is affected by the change in net working capital. This occurs because organization’s working capital requirements will change if project will be undertaken and it should be incorporated into calculations. A change in net working capital is calculated as change in current assets (e.g. accounts receivable and inventories) less change in current liabilities (e.g. accounts payable and accruals).

If net working capital increased (increase in current assets larger than increase in current liabilities) than we treat it as cash outflow and add it to the initial investment amount in calculation of the initial cash out flow. This is because the company’s investment in current assets increased due to the new project being undertaken. Therefore, it is an additional cash outflow.

If, however, an increase in current liabilities was higher than increase in current assets (if net working capital decreased) than we subtract this change in net working capital from the initial investment amount in calculating initial investment (outflow at time zero).

Commonly, there is an increase in net working capital (cash outflow) at the beginning of the project life. Such cash outflow is recovered at the end of the project when the terminal cash flow is calculated.

When determining cash flows we also need to consider opportunity and sunk costs.

Opportunity costs


Opportunity costs refer to the cash inflows that could have been earned in case of alternative employment of the asset. Therefore, it should be taken into consideration when determining cash flows.

For example, if success of the proposed project requires use of the equipment which organization already owns, the usage of equipment should be considered as a cost as if it would have to be bought or rented. Moreover, if such equipment could generate higher cash inflows in alternative use than this also should be incorporated.

Sunk costs


Sunk costs refer to the costs associated with the asset which is already was incurred in the past and cannot be recovered in spite of whether the particular project is undertaken or not.

An example of sunk costs is the feasibility study cost or marketing expenses which were already incurred for the project. In other words, any past costs that were incurred are not pertinent. Since sunk cost cannot be recovered – it should not affect decision regarding whether proposed project should be undertaken. In other words, sunk costs are not taken into account when cash flows for the potential project are calculated.

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An understanding of how the initial investment is calculated is an important first step in understanding how to properly make capital budgeting decisions. Make sure you gained a good understanding of concepts discussed above before moving on to further sub-sections on capital budgeting decisions.

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International Capital Budgeting Decisions

International capital budgeting decisions are similar to domestic capital decisions but are more demanding due to additional considerations that must be taken into account. Such additional considerations may include foreign currency considerations, transfer pricing and political (country) risk.

Exchange rate risk is one of the additional considerations that has to be taken into account. Exchange rate risk refers to the risk that arises due to fluctuations in the exchange rate between foreign and domestic currency. To counteract this risk, at least partly, organization may use various techniques. Particular cash flows can be hedged in the short-term. Further, an organization can borrow in the foreign market in the foreign currency to counteract long-term exchange rate risk.

Transfer Prices


Transfer prices is another consideration to be taken into account and refer to internal prices (which are different from market prices) on goods which are moving from one subsidiary to another within multinational corporation (MNE). It arises due to the tendency of multinational corporations (MNEs) to price products exchanged between subsidiaries at prices which are not aligned with the market prices to minimize the overall tax that the organization (MNE) has to pay.

Transfer prices have distorting and misleading effects on the capital budgeting decisions. In other words, due to transfer prices, the value of the cash flows and that of the project is likely to be distorted. This occurs because value of costs and incremental cash flows are distorted and therefore incorrect data is used in the capital budgeting analysis.

To counteract distorting and misleading effects of transfer prices on capital budgeting decisions, MNEs need to make few adjustments. Firstly, MNEs need to use market prices in capital budgeting decisions. Secondly, any fees and royalties paid from one subsidiary to another or to parent as well as appropriate fixed costs must be added back to the cash inflows.

Political (Country) Risk


Political (country) risk is another consideration that must be taken into account and refers to risks associated with doing business in particular country. Political risks may include difficulties with transferring returns on investment (repatriating profits) from the foreign country to domestic due to foreign government’s actions or even expropriation.

Political risk can be partly counteracted by sharing risks via partnerships with local businesses that will have a better understanding of how to most efficiently and safely conduct business in that specific country. Discount rates (cost of capital) should reflect the level of political risk.

Other country risks include domestics uprisings such as the May 2010 demonstrations in Bangkok, Thailand which effectively shutdown the commercial hub of the country. Such an upheaval would have impact the both domestic (delays in building hotels etc) and international decisions (changes in forex, country risk profiles, international insurance rates etc).

Overall, international capital budgeting decisions incorporate all the issues that must be considered when operating domestically. However, there are also few additional considerations that must be taken into account. The adjusted present value technique is often used to incorporate such additional risks into calculations.

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Capital Budgeting Techniques

The Capital budgeting techniques discussed here focus on financial considerations, although, there are financial and non-financial considerations that should be taken into account when selecting a project for capital expenditure.

There are unsophisticated (simple) and sophisticated (advanced) techniques.

1 – Unsophisticated techniques include payback period (PB, also called payback method) and average rate of return(ARR).

2 – Sophisticated techniques include net present value (NPV), internal rate of return (IRR), equivalent annual annuity (AEE) and profitability index (PI).

Out of this range of techniques, payback period is the most popular unsophisticated technique. From the sophisticated techniques, the most popular methods are net present value (NPV) and internal rate of return (IRR).

Capital budgeting techniques used to select most profitable projects for capital expenditure, which is aligned with enterprise’s objective of maximizing shareholder’s wealth. Sophisticated techniques are considered to be the most effective means of selecting the most appropriate projects for capital expenditures. Such techniques take into account risk, the time value of money and focus on cash flows rather than on accounting profits.

The result of educated usage of capital budgeting techniques knowledge generated on which projects and in which order should be accepted based on the available funds for investment.