Capital Budgeting-

Further Issues and Example

Dr. Md. Saiful Alam FCMA
Important Points– Inflation
• You must be aware of the two different methods of dealing with inflation
and when they should be used.
• The money method is where inflation is included in both the cash flow
forecast and the discount rate used while the real method is where
inflation is ignored in both the cash flow forecast and the discount rate.
• The money method should be used as soon as a question has cash flows
inflating at different rates or where a question involves both tax and
inflation.
• You must also be able to distinguish between a general inflation rate
which will impact on the money cost of capital and potentially some cash
flows and a specific inflation rate which only applies to particular cash
flows.

12/13/2022 DMSA, Special Class, SMA 2

Important Points– Working capital
• The key issue that must be remembered here is that an increase in
working capital is a cash outflow. If a company needs to buy more
inventories, for example, there will be a cash cost.
• Equally a decrease in working capital is a cash inflow. Hence at the
end of a project when the working capital invested in that project is
no longer required a cash inflow will arise.
• You must recognize that it is the change in working capital that is
the cash flow. There is often concern amongst students that the
inventories purchased last year will have been sold and hence
must be replaced. However, to the extent the items have been sold
their cost will be reflected elsewhere in the cash flow table.

12/13/2022 DMSA, Special Class, SMA 3

Important Points– Relevant/Irrelevant CFs
• This problem is rarely a big issue in Capital Investment.
• However you should remember the ‘Golden Rule’ which states
that
• to be included in a cash flow table an item must be a future,
incremental cash flow.
• Irrelevant items to look out for are sunk costs such as
amounts already spent on research and apportioned or
allocated fixed costs.
• Equally all financing costs should be ignored as the cost of
financing is accounted for in the discount rate used.

12/13/2022 DMSA, Special Class, SMA 4

Shadow Pricing
• Shadow pricing refers to the practice of assigning a monetary
value to something whose value can only be estimated
because it is not something regularly bought and sold in a
marketplace.
• Shadow pricing is often required when a financial analyst is
doing a cost-benefit analysis to decide regarding a proposed
investment.
• Shadow prices are commonly assigned to designate the value
of an intangible asset, such as the benefit to society of
creating a public asset (e.g., public transportation, a park, or
bike pathways).

12/13/2022 DMSA, Special Class, SMA 5

Shadow Pricing- Practical Example
• Company XYZ is a retailer that sells most of its merchandise online. Its current shipping
practice is to deliver items sold using UPS Ground Shipping, which ordinarily takes four to five
days. The company believes that it can substantially increase sales by offering a two-day
delivery service on all orders.
• It is impossible for the company to assign a definitive value to the increased sales revenues it
can gain by changing its shipping policy. Therefore, it assigns a shadow price of $50,000 that
represents its best estimate of the monetary benefit that can be obtained from the altered
shipping policy.
• The company then conducts a cost-benefit analysis, comparing the shadow price of the benefit
to be gained from added revenue to the extra shipping cost required for a two-day delivery
service.
• If the extra shipping costs total significantly less than $50,000, the company would determine
that changing its shipping policy would be beneficial to its bottom line.
• The above is an example of how companies use shadow pricing and cost-benefit analysis in
decision making. Of course, it’s important to note that the company’s cost-benefit analysis may
not be correct if it errs in estimating a shadow price to the additional business it can generate
from using a two-day delivery service.

12/13/2022 DMSA, Special Class, SMA 6

International Capital Budgeting
• There are two approaches to evaluate a foreign project: home currency approach and
foreign currency approach. The first involves converting the foreign project cash flows to
local currency based on expected forward exchange rates and discounting them based on
home country cost of capital. The second requires calculating NPV based on foreign
country cost of capital and then converting the foreign-currency NPV to local currency at
the spot exchange rate.
• Evaluating a foreign project is more complex than evaluating a local project due to multiple
factors. First, foreign projects are subject to foreign exchange risk. It is because foreign
project cash flows are in foreign currencies which must be converted to local currency.
Even though there are different approaches such as relative purchasing power parity and
relative interest rate parity, it is hard to accurately forecast exchange rates. Second,
multiple tax jurisdictions are involved potentially subjecting the cash flows to double-
taxation. Further, foreign governments may place restrictions on repatriation of earnings
back to the home country.

12/13/2022 DMSA, Special Class, SMA 7

Foreign Project Cash Flows
• Foreign projects must be evaluated from the perspective of the parent company. A project
might make sense in the foreign country when executed by a company based in that
country but might not be feasible after considering the foreign exchange risk, taxation and
restriction of repatriation of income back to the home country.
• Foreign currency cash flows should be projected based on the foreign currency inflation
rate.
• Foreign tax laws are relevant in determining the depreciation that can be charged and the
ultimate tax outflows. Both the corporate tax outflows and the tax outflows if any
associated with repatriation of income back to the home country must be considered.
• Following is a general equation that can be used to work out the after-tax repatriable cash
flows of a project: CFi = [(CI − VC − FC − D) × (1 - tc) + D] × (1 - tr)
Where CI is the project cash inflows, VC is the variable cost outflows, FC is the fixed cost outflows, D
is depreciation expense determined based on foreign country tax laws, tc is the foreign corporate tax rate
and td is the tax rate applicable to repatriation such as dividends.

12/13/2022 DMSA, Special Class, SMA 8

Example
• Let us imagine you work for a US company that wants to set up a telecommunication
company in Bangladesh. The project costs BDT6 billion to set up. A local business
conglomerate has agreed to buy the business for BDT10 billion in 5 years. In the
meanwhile, the project will generate cash inflows of BDT2 billion in first year, thereby
growing at 10% per annum. Variable cash outflows are 30% of the cash inflows and fixed
costs are BDT200 million per annum. Initial investment of BDT6 billion is required,
including BDT1 billion working capital. The difference is depreciable based on 5-year
straight-line method. Corporate tax rate is 33% and a 10% tax rate applies to any
dividends paid.

12/13/2022 DMSA, Special Class, SMA 9

Example
The following schedule shows cash flows of the project for five years:
Now, that we have determined the project cash flows in foreign-currency, we need to work out the relevant net present value. There are two
approaches: (a) home currency approach and (b) foreign currency approach.
Year 1 2 3 4 5
Cash inflows CI 2,000 2,200 2,420 2,662 2,928

Less: variable cash outflows VC 600 660 726 799 878

Less:: fixed cash outflows FC 200 200 200 200 200

Less: depreciation D 1000 1000 1000 1000 1000

Cash flows before corporate

200 340 494 663 850
tax

Less: corporate tax Tc 66 112 163 219 280

Add: depreciation D 1,000 1,000 1,000 1,000 1,000

After-tax corporate tax flows 1,134 1,228 1,331 1,444 1,569

Less: dividend tax Td 113 123 133 144 157

Net repatriable cash flows 1,021 1,105 1,198 1,300 1,412

12/13/2022 DMSA, Special Class, SMA 10

Home Currency Approach
• In the home currency approach, the net present value of a foreign project is determined by
(a) converting the foreign-currency cash flows of the project to the domestic currency
based on the expected forward exchange rates, and (b) discounting the cash flows based
on the domestic currency cost of capital.
• In the above example, the BDT cash flows will be converted to USD based on the forward
exchange rate forecasted based on either relative purchasing power parity or relative
interest rate parity. USD equivalent cash flows can be discounted using USD cost of
capital. Forward exchange rates can be determined based on the difference in interest
1+𝑟𝑑 𝑡
rates between the domestic currency: 𝐹𝑡 = 𝑆0 × Where Fi and 𝑆0 are the forward
1+𝑟𝑓
exchange rate t years in future and spot exchange rate time 0 respectively expressed as
domestic currency per unit of foreign currency (i.e. USD per BDT in this case), 𝑟𝑑 is the
nominal interest rate in domestic currency i.e. USD and 𝑟𝑓 is the nominal interest rate in
foreign currency i.e. BDT
• If the current USD/BDT exchange rate is 0.0086 and the expected interest rate for BDT
and USD are 6% and 4% respectively, we can work out the following forward rates and
convert the cash flows to USD:
12/13/2022 DMSA, Special Class, SMA 11
Home Currency Approach

• Net repatriable cash flows C 1,021 1,105 1,198 1,300 1,412

• Forward exchange rate f 0.0084 0.0083 0.0081 0.0080
0.0078
• Net repatriable CFs in USD C×f $8.61 $9.15 $9.73 $10.36 $11.04
• The initial investment of BDT 6 billion equals USD 51.60 million. The terminal value of the
project is BDT 9 billion (=BDT 10 billion multiplied by (1 – dividend tax rate of 10%)). It
equals USD 70.37 million (=BDT 9 billion multiplied by 5-year forward rate of 0.0078).
• Under the home currency approach, you will discount the cash flows based on the USD
cost of capital which is 10%. You can adjust the discount rate up by 5% reflecting the
additional risk.

12/13/2022 DMSA, Special Class, SMA 12

 Home Currency Approach
Discounting the cash flows at 15%, the project NPV works out to $15.60 million:
Year 0 1 2 3 4 5

Net reptriable cash flows in

$8.61 $9.15 $9.73 $10.36 $11.04
USD

Add: terminal cash flows $70.37

Initial investment (51.60)

Total cash flows (51.60) 8.61 9.15 9.73 10.36 81.41

Discount factor at 15% 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972

Present value of cash flows (51.60) 7.49 6.92 6.40 5.92 40.48

Net present value (USD) 15.60

12/13/2022 DMSA, Special Class, SMA 13

Foreign Currency Approach
• In the foreign-currency approach, the foreign-currency cash flows are discounted based
on implied cost of capital that would apply to the foreign currency to arrive at the foreign-
currency NPV. The NPV denominated in foreign currency (BDT) is then converted to
domestic currency (USD) using the spot exchange rate.

• Net present value under this second approach should be equal the NPV under the first
approach i.e. domestic currency approach.

• The implied cost of capital roughly equals the domestic currency cost of capital adjusted
for the differences in inflation rates, i.e. 15% plus the nominal interest rate difference of
2%, i.e. 17%.

12/13/2022 DMSA, Special Class, SMA 14

Foreign Currency Approach
Please note that the net present value under both the approaches is (almost) the same. The difference is attributable to rounding error.

Year 0 1 2 3 4 5
Net reptriable cash flows in
1,021 1,105 1,198 1,300 1,412
BDT
Add: terminal cash flows 9,000
Initial investment (6,000)
Total cash flows (6,000) 1,021 1,105 1,198 1,300 10,412
Discount factor at 17% 1.0000 0.8525 0.7268 0.6196 0.5282 0.4503
Present value of cash flows (6,000) 870 803 742 687 4,689
Net present value (BDT) 1,790.86
Spot exchange rate 0.0086
Net present value (USD) 15.40

12/13/2022 DMSA, Special Class, SMA 15

Investment Cycle Phases
The four phases of the investment cycle are:
1. Plan Strategically
Assess, set and communicate sector priorities, and identify projects for implementation.
2. Design Investment
Analyze context and alternatives and carry out detailed project design.
3. Implement and Monitor
Get the job done, monitor and communicate progress towards objectives, make necessary
adjustments.
4. Evaluate and Capitalize
Review and evaluate implementation experience to inform scaling up and future plans and
projects.

12/13/2022 DMSA, Special Class, SMA 16

Post Audit of an Investment Project

• Post audit refers to an analysis of the outcome of a capital budgeting investment. This

analysis is conducted to see if the assumptions incorporated into the original capital

proposal turned out to be accurate, and whether the project outcome was as expected. The

results of this audit are then incorporated into future capital budgeting decisions, thereby

improving the decision-making process. A post audit may also be used to see if any

managers who submitted budget proposals might have deliberately inflated the benefits to

be derived from their proposals.

12/13/2022 DMSA, Special Class, SMA 17

Measuring Risk and Uncertainty of Different Projects

• The following points highlight the four popular techniques for measuring risk and

uncertainty in different projects. The techniques are:

1. Risk Adjusted Discount Rate Method

2. The Certainty Equivalent Method

3. Sensitivity Analysis

4. Probability Method.

12/13/2022 DMSA, Special Class, SMA 18

Risk Adjusted Discount Rate Method

• This method calls for adjusting the discount rate to reflect the degree of the risk
and uncertainty of the project. The risk adjusted discount rate is based on the
assumption that investors expect a higher rate of return on risky projects as
compared to less risky projects.
• The rate requires determination of:
• (i) Risk free rate, and

• (ii) Risk premium rate.

• Risk-free rate is the rate at which the future cash inflows should be discounted. It
is the borrowing rate of the investor. Risk premium rate is the extra return
expected by the investor over the normal rate. The adjusted discount rate is a
composite discount rate.

12/13/2022 DMSA, Special Class, SMA 19

The Certainty Equivalent Method

• According to this method, the estimated cash flows are reduced to a conservative
level by applying a correction factor termed as certainty equivalent coefficient. The
correction factor is the ratio of riskless cash flow to risky cash flow.
• The certainty equivalent coefficient which reflects the management’s attitude
towards risk is
• Certainty Equivalent Coefficient = Riskless Cash Flow/Risky Cash Flow.

If a project is expected to generate a cash of Rs. 40,000, the project is risky. But the management feels that
it will get at least a cash flow of Rs. 24,000. It means that the certainty equivalent coefficient is 0.6.
Under the certainty equivalent method, the net present value is calculated as:

Where αt = Certainty Equivalent Coefficient

At = Expected Cash Flow for year t
I = Initial outlay on the project
i = Discount rate
12/13/2022 DMSA, Special Class, SMA 20
Sensitivity Analysis
• The future is not certain and involves uncertainties and risks. The cost and benefits projected over the lifetime
of the project may turn out to be different. This deviation has an important bearing on the selection of a
project.
• If the project can stand the test of changes in the future, affecting costs and benefits, the project will be
selected. The technique to find out this strength of the project is covered under the sensitivity analysis of the
project. This analysis tries to avoid overestimation or underestimation of the costs and benefits of the project.
• In sensitive analysis, a range of possible values of uncertain costs and benefits are given to find out whether
the projects desirability is sensitive to these different values. In this analysis, we try to find out the critical
elements which have a vital bearing on the costs or benefits of the project.
(i) The most pessimistic where all the worst possible outcomes are estimated.
(ii) The most likely where all the middle of the range outcomes are estimated.
(iii) The most optimistic where all the best possible outcomes are estimated.
• It explains how sensitive the cash flows are under these three different situations. If the difference is larger
between the optimistic and pessimistic cash flows, the more risky is the project. The most likely outcome can
give a good guide to how ‘borderline’ is the project.

12/13/2022 DMSA, Special Class, SMA 21

Probability Analysis
• Another method for dealing with risks and uncertainties is to estimate the probable value for a result.
Here one has to see a range of possible cash flows from the most optimistic to the most pessimistic for
each pertinent year. Probability means the likelihood of happening of an event. It is the proportion of
times an event occurs i.e. its frequency. It is the ratio of favourable number of events to the total number
of events.
• In a particular situation, if all possible outcomes of an event are listed and the probability of occurrence
is assigned to each outcome, it is called a probability distribution. For any probability distribution there
is an expected value. The expected value is the weighted average of the values associated with the various
outcomes, using the probabilities of outcome as weights.
• If NPV1 NPV2 and NPV3 are three possible estimates of the net prevent value of a project under
uncertainty, and’ the probability of each outcome of NPV is P1 P2 and P3 then the expected net present
value is

Ev (NPV) = P1 (NPV1) + P2 (NPV2) + P3 (NPV3).

• This method is conceptually sound. But it lacks objectivity as it is not possible to find out the probabilities of different
outcomes.

12/13/2022 DMSA, Special Class, SMA 22

Thank you
[email protected]